Why Investors are Under-Allocating to Trend Following? ft. Alan Dunne

[00:00:00] Intro

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

[00:00:23] Niels

Welcome and welcome back to this week’s edition of the Systematic Investor series with Alan Dunne and I, Niels Kaastrup-Larsen, where each week we take the pulse of the global market through the lens of a rules-based investor. Alan, great to be back with you this week. How are you doing? And more importantly, has Dublin recovered after St. Patrick’s Day?

[00:00:42] Alan

Yeah, it has. It was a pretty quiet weekend. We had success in the rugby. That was the main highlight, so we are the Six Nations champions. But we’re back to normal here by now.

[00:00:58] Niels

I know you and I spoke actually yesterday, and you said that you had snow early in March. That’s quite unusual.

[00:01:03] Alan

We did. We had no snow all winter and then on the 1st of March, at least a couple of inches fell that morning. But now today, lovely sunshine here so it definitely feels like spring is certainly in the air.

[00:01:16] Niels

I can tell you that. Switzerland today really feels almost like summer. It is very nice I have to say.

Anyways, we have a few topics that you kindly brought along so they’ll be interesting to dive into. We don’t have any questions, but as we always do, we start off with hearing a little bit of what’s been on your radar recently or since we last spoke. What’s catching your attention at the moment?

[00:01:43] Alan

Well, it’s been a very interesting week in the last week. We’ve had the monumental ending of ZERP in Japan which was obviously long heralded. But I suppose it is certainly a noteworthy historical event. But then just as interestingly, in the week where the Bank of Japan raises rates, the Swiss National Bank went and cut rates and the Fed was on hold. So we had the full spectrum of actions from central banks.

I think it really does highlight a couple of things. We’ve been long talking about the desynchronized cycles, and I think that’s pretty good evidence of one central bank easing, another one hiking in the same week.

I saw an interesting chart from Peter Berezin at BCA who we’ve had on global macro before. Actually, historically, when Japan has hiked rates, it’s tended to be just before the global economy has gone into recession, so it remains to be seen whether that’s a good indicator.

Speaking of indicators, I saw an article there, just before I came on, that 2s10s yield curve in the US is inverted for the longest it’s ever been inverted, at least relative to the data that they had. So certainly a lot of interesting stuff going on from a monetary policy perspective and a markets perspective.

One other interesting story I just picked up on this morning, and it was about in Japan. Obviously, we’ve had an end of zero interest rate policy, and also the reason we’ve had that is because inflation has started to pick up. But that’s also starting to motivate a change in investor behavior in Japan. This Bloomberg article was highlighting that there’s one quadrillion yen in bank deposits in Japan. I had to go and look up what a quadrillion is. There’s a lot of zeros there.

So basically, I think it’s 1000 billion. Yeah, that’s what it is. So that’s about a $7 trillion U.S. dollars equivalent in yen. And so the point is that, all joking aside, that’s a pretty big number and if we did start to see Japanese investors doing something different, the amount of cash they hold is about 62% of their total assets. That’s very high relative to international norms.

Potentially, that could start going into the stock market or else it could go overseas. A lot of people have been expecting a rebound in the yen on the back of normalization of interest rate policy in Japan. But there is also now a sense where maybe they’re not going to tighten that much and that might be it for now. And we’ve got this war
wall of money in Japan.

Okay, maybe it’s too aggressive to say that it’s going to start moving somewhere, but at the margin, it does sound like investors are now changing their mindset given that you’ve got higher inflation. So I think that’s a really interesting story, something to keep an eye on going forward, because as I said, the general sense had been when Japan raises rates, money is going to flow back. But maybe that won’t be the case. We’ll have to monitor that one.

[00:04:51] Niels

Yeah, absolutely. I think we’ll talk a little bit around this in some ways maybe when we get to your big macro picture in a couple of minutes. It is interesting. Of course you mentioned that Japan has been hiking and the Swiss National Bank surprised I think a lot of people yesterday when they cut.

What’s also interesting is that both the yen and the Swiss franc is down 1.5%, more or less exactly the same in the last week, against the dollar. So that’s an interesting outcome. But of course, as you say, other things have done well. European stocks, Japanese stocks, US stocks are all making new all-time highs this week. So yes, 2024 is turning into a very interesting year for investors that’s for sure.

Now, let’s just swiftly move on to something incredibly related to what we’ve started off talking about, and that’s as we normally do when you and I talk. Let’s just talk a little bit about your big-picture framework. Obviously, you have the luxury of talking to some global macro thinkers in between when you do your recordings and I’m sure maybe some of the conversations make you think about some of these topics in a bigger sense. So I’m curious as to where we going to go today.

[00:06:15] Alan

Well, I just wanted to focus in on one element of what I’m seeing and reading and hearing. I agree. Ever since we had that pivot from the Fed at the end of last year and equities started to move up and I suppose there’s more and more evidence so far, it’s a work in progress, of the soft landing. People have been saying, well, what’s the historical parallel?

People like Chen Zhao who’s been on with us, from Alpine Macro, have been making the case that actually maybe the parallel is not so much with the 1970s or post World War II but it might be the mid-1990s. That could be the historical parallel. The reason for that is that was the one tightening cycle where the Fed did engineer a soft landing. If you go back to 1994, rates were raised very aggressively in that year from I think it was 3% to about 6% or so, maybe 5.5%, 6%, and equities took a bit of a correction, I don’t think as much as 2022.

But it was a tough year for bonds. And then as soon as the soft landing was achieved and as soon as the Fed stopped tightening, the equity market took off and bonds recovered and we have started to see that to an extent. We’ve also had a few more parallels. I think productivity growth has been strong in the last few quarters, hasn’t been very weak.

People point to AI and say, oh, yeah, sure, AI, productivity of course is picking up, but I’m a bit skeptical as to whether AI has actually contributed to productivity growth yet. But you could make that case. So certainly, there is that parallel being drawn from some commentators like are we in a scenario similar to the 1990s or the late 1990s? I think you can draw that parallel in terms of the soft landing and possibly on the productivity side.

The question then is, is it more like 1995 or 1999? Because obviously other people are pointing to bubbles and that’s something I wanted to talk about as well. There is a lot more talk in markets about bubbles which kind of surprises me a little bit because yes, S&P 500 forward PE is high, but not as high as say 2021. We’ve had more elevated valuations in absolute terms. Maybe in relative terms it might be a different story, but in absolute terms, it’s not as high.

That whole question around are we in a bubble, are valuations high, got me thinking about the past and looking back to the period of the 1990s. And of course people who were in the markets back then will remember Greenspan’s famous speech around irrational exuberance which was in December 1996. At the time, the Fed was worried about was the equity market in a bubble.

If you read around what the Fed was debating at the time, there was this debate as to whether valuations were too high and what should they do about it. So they got people like Robert Shiller to come in. They had a meeting of all the good and great on Wall Street around what their views were around valuations, people like Abby Cohen who was a big cheerleader for the bull market back then.

There was no particular consensus reached and Greenspan wasn’t quite sure whether he should be talking down the market. And then famously, he made his speech in December ‘96 where he asked the question, was the market subject to irrational exuberance? The market sold off initially but then absolutely skyrocketed after the fact. So that was December ’96. In ’97, the market was up 31%, in ‘98 up 27%, in ‘99 up 20%, and after he spoke, the market doubled, more than doubled. So it’s interesting.

I don’t think you could say we’re in a bubble at the moment looking at the market as a whole. Certainly, valuations are expensive relative to history, but we’re not seeing the bubble-like behavior we saw back then. But certainly the conditions could possibly come into place to fuel that. I’m not predicting that, but I’m saying you could conceive of it.

Particularly back in that period, there was that debate about the central banks being just purely focused on inflation and if you’re going to cut rates because you say inflation allows it, by cutting rates, you could be adding fuel to an equity bubble. I think that’s the scenario that I think about. If we do actually see these rate cuts coming through even though growth is still fairly solid just because inflation has come back down, you could have all of this debate revisited again.

So what does that mean from a global macro perspective? Look, I think we’re in a holding pattern. The data is still pretty solid, lots of people are still looking for an eventual softening of the data in the labor market, but we’re not there yet. And obviously, if you look at the Fed’s projections this week, they’re actually getting more upbeat on economic growth and they’re nudging those growth forecasts higher and the rate forecasts higher.

So for the moment, Goldilocks is still in play. Unless we see either much stronger growth to take rate cuts totally off the table or much weaker growth, for the moment, it’s hard to stand in the way of the equity market rally. That’s what a trend following position is doing for you at the moment. It’s just keeping you with the trend for the moment and it’s hard to disagree with that.

[00:11:50] Niels

Yeah. Absolutely. I think the reason why part of the conversation we see nowadays is focused on this, are we in a bubble, I guess you could say that certain thing looks like they’re a little bit in a bubble when you look around the market. Clearly, this AI-driven thing is in a bubble. I’m going to get into massive amount of trouble when I say this because I really have no idea about individual stocks.

But I did pick up someone saying that if you look at Nvidia has been the poster child for this AI rally. I’m pretty sure he said that about 78% of their revenue comes from data centers that they have built out which has nothing to do with AI. So it’s kind of interesting that they are the poster child for AI. But in any event, as I said, I’m probably not the best person to talk about these things. There’s a couple of other things. We are talking about the global macro picture.

I was telling you before coming on or before we pressed record, a couple of interesting things just happening today, Friday. One is that Putin apparently has to come out saying that they’re no longer doing a special military operation in Ukraine. They are now at war with Ukraine. I think that is an interesting change of language. And I also think from memory, from the early days of the war, that it changes certain authorities that he gets in Russia in terms of getting people drafted for soldiers if it’s a war versus if it’s an operation. Something like that, maybe I’m completely wrong here.

And then the second thing that I thought was interesting is that there’s some news out just as we speak where according to this source which is a Danish newspaper, the US is asking Ukraine not to do these deep into Russia military operations where they target oil installations because they’re worried that Russia will then retaliate and hit Western oil installations and that’s going to drive up the price of energy considerably. So all to play for here I think in terms of what markets can do as we head into 2024.

But I want to take you back to something you kind of mentioned a little bit, but I actually think it’s quite interesting. Something that I’ve been hearing more and more about on a few podcasts that I’ve been listening to, and that’s the whole topic of liquidity. You know what? I think this is an episode that hasn’t come out yet that we actually have to rerecord because the quality wasn’t good enough.

But anyway, in that conversation, I mentioned something that I had just heard, not just I heard but came out about the change of the US balance sheet, the Federal Reserve’s balance sheet. The idea is here that they have been forced to fund themselves at much shorter duration because last year, essentially, bond markets collapsed when they tried to sell a lot of long-term debt.

I was listening to actually one of our former guests, Michael Howell, who’s an excellent person when it comes to topics of liquidity. His firm CrossBorder Capital specializes in this. He estimates that the world has to refinance something like $70 trillion every year for the next five years. But at the same time, Janet Yellen has decided to move most of their refinancing, which is not the way it’s normally done. She’s moving most of the refinancing into the shorter end of the curve, which by the way also means- you mentioned the yield curve has been inverted for the longest time. Well, I think his argument is that it’s being artificially inverted because they’re restricting the issuance of longer-term paper that drives prices up, yields down. So that helps with the inversion, right? But if you look at another yield curve, the question is, are you looking at the right yield curve when you say about the inversion?

So I think it’s very interesting and I think obviously closer to your home, what we saw in it must have been September 2022 when the gilt market collapsed due to the fact that Liz Truss was trying to introduce some unfinanced tax cuts or whatever it was. Essentially, the bond market reacted and basically threw that idea out and her at the same time. I’d love to hear your thoughts about if you have followed this a little bit in terms of what you think all of this may lead to.

Because one of the things that I seem to remember is that a lot of the crisis we end up getting and having, a lot of them is really refinance crisis. It’s to do with not being able to issue debt at levels you expect them to be accepted by the market. Is this something you’re keeping an eye on?

[00:17:06] Alan

Yeah. I think there’s a couple of different points here. I think the first one around Yellen and the US issuance, I have seen people looking at this and saying basically, it’s the treasury taking control of monetary policy a little bit as well from the perspective of you’re doing quantitative tightening which should be a force for nudging up long-term bond yields.

But then by tactically issuing at the short end instead of at the long end, you’re basically providing a bit of balance to that and taking some of the pressure off long-term bond yields where the whole point of doing that is to tighten financial conditions gradually. Obviously, you don’t want an exaggerated move at the long end and maybe that was the concern in August of last year when 10-year yields in the US hit 5% that it was going to become unruly, so I can see that. But yeah, it is this issue of fiscal dominance and who’s actually controlling monetary policy and economic policy. Is it more Janet Yellen or is it the Fed? I think that’s one point.

I think in terms of refinancing, I don’t have the stats to hand, but it’s certainly something we’ve talked about before. We talked about it with Christopher Zook at CAZ. It has come up a number of times. There’s a huge amount of refinancing in commercial real estate in the next number of years and that’s already leading to strains in that market. I think in certain segments of the corporate bond market, obviously a lot of this stuff was refinanced around 2019, 2020 in particular when rates and yields hit extremely low levels, and very often it’s over a five-year tenor, so this period of 2024, ’25, ’26. On that commercial real estate and corporate side, that’s certainly a theme.

Now, the question is, is that systemic? The issue was it was largely US regional banks that were going to be impacted by that. I did see actually a story in Bloomberg. I think it was actually Ontario Teachers’ were selling a building in the US for $1 because it was going to cost them more in terms of refinancing costs and all of that and a refurb was probably needed. So nobody was going to take it on without basically getting it for nothing. But that highlights the extent of the challenges in the commercial real estate market. I think that’s the second stress.

I think a third theme here that we might hear a little bit more of is if you’re doing your issuance at the short end and as interest rates are coming up at the short end, there’s a cost for the central bank now of paying these higher rates on an ongoing basis. So we’re seeing losses, basically, at central banks around the world.

Now, strictly speaking, it doesn’t matter, and that’s always been the theoretical argument. Central banks don’t even have to be solvent. They certainly don’t have to make money. But from an independent populist perspective when you hear that the central bank is losing money, and practically is no longer sending a check to the treasury every year to buffer the coffers, that becomes more of a political issue.

So I think certainly central bank mandates could come under stress in relation to that, and I think that’s another theme related to this whole interest rate readjustment that we’re seeing that we’re going to hear more about.

[00:20:44] Niels

All right. Let’s move on in our line of topics, talk a little bit about trend following for change. So far, in March, it’s been not as, should I say, buoyant as we saw in February. February was pretty extraordinary. But it’s still a pretty good solid performance so far, which I’ll come to in a second.

As far as I can tell, people are still enjoying the trend in cocoa. That’s still in force very much so. And of course, we have equities as a sector doing really well. And then a few other markets. Mexican peso has been pretty good. Maybe some of the trends that we saw earlier in the year like short grains and stuff like that has petered out a little bit. That’s probably being replaced, to some extent,by some long-term biases in the energy sector, and I mean the oils not the gases. So far, so good.

Looking at the numbers, and these are as of Wednesday because they are not out just yet for Thursday night. I think Thursday by the way was a good day for trend followers and CTAs. But as of Wednesday night, BTOP 50 was up 1.5%, up almost 7% for the year. SocGen CTA Index up 1.75% for the month, up 7.8% for the year. SocGen Trend Index up 1.75% as well, up 9.6% for the year. And the Short-Term Traders Index up about 0.5%, up 1.1% for the year.

My own trend barometer by the way finished yesterday at 43, but it has been up in the 50s during the last few days, but it has come off a little bit the last two days. Anyways, MSCI World also enjoying a good month so far. Up almost 3% for the month, up 8.38% for the year. World Government Bonds fairly quiet, up 22 basis points in March. And the S&P 500 Total Return index up almost 3% so far as of last night, up 10.25 so far this year. Anything that you are noticing about the CTAs, trend followers, Alan?

[00:23:02] Alan

It’s been a very good start obviously. I guess the noteworthy thing is the breadth of trending activity across markets. Obviously, cocoa has been the headline story in terms of a really exaggerated move. But equities as well, even metals, obviously gold has been trending very nicely and some of the other markets. Copper started to move up a little bit. It has paused. And as you say, energies as well, for some managers has been a more important driver.

As we’ve been talking about, it’s not the typical crisis alpha risk-off type of phase but it is a period where we’re seeing a lot more trending behavior, and an environment of positive equity returns. So I think that’s interesting. The magnitude of the returns we’re seeing across the industry, we’re seeing up 10% in the first two to three months of the year, and it doesn’t sound too unusual. If you went back a number of years, that would have been a headline that CTAs are making a comeback.

So I think it’s just all in the picture of the normalization of the trading environment that we’re seeing in recent years that we’re seeing this kind of, I wouldn’t say consistency but, obviously, the returns are still episodic, but the fact that we’re seeing another burst of positive performance is reflected in that environment.

[00:24:29] Niels

I don’t follow this, but I wonder what the chocolate factories or companies are doing in terms of share price at a time when the price of cocoa has gone up 300% or something like that by now. Anyways, I’m sure someone out there will know and share that with us.

You brought along a few topics that we’re going to be diving into. Some of them I managed to have a quick look at, but certainly, the first one was so long that I gave up. So I’m going to let you lead the way. We’re going to be talking about the outlook I think from the perspective of UBS.

[00:25:16] Alan

Well, it’s the outlook and it’s a history. This is now the UBS Investment Returns Yearbook. It was historically the Credit Suisse Investment Returns Yearbook. Obviously, now UBS and Credit Suisse are one. As you say, it’s a really long document. It’s published every year. The people behind this, Dimson and Marsh, there might have been a third person, they wrote a book in 2000 called “Triumph of The Optimists” which looked at long-term equity and asset market returns. And ever since then, they’ve been producing this annual reference book.

It really is a great reference book, so if you can get access to that, I’d certainly recommend it. But I just thought we’re picking out a few of the interesting insights that come from it because I’ve often on this podcast talked about what are the long-term return expectations for the different asset classes. Last time we were talking about two different research papers on that. So it’s definitely interesting to get their perspective on that and also if they have insights as to what the outlook is going forward.

So a few things that I picked out. When they look back, they look at the asset market returns back to 1900 and they are a pretty comprehensive dataset that not all markets were continuous through that whole period. But in the US, equities produced 9.6% annualized over that whole period, and that’s a 6.5% real return which is very consistent with Jeremy Siegel’s estimates. Very often that’s the number that people think about if you say what’s the long-term return on equities, 6.5% real or maybe 9%, 10% nominal.

But an important point that they make is that number is very US specific, that if you look at the equity returns around the world, it’s not as strong everywhere. So certainly the US is unusual in that respect. Actually, the rest of the world ex US annualize 4.3%. So that’s actually a pretty meaningful difference between the US and the rest. Now, what you do with that, that’s I guess an open question. Was it going to be a reversion to the mean or does that just reflect the fact that the US is the most progressive, most open, most capitalistic market that lends itself to generating better returns in equities?

So that’s a call you have to make. But certainly in terms of formulating a return expectation for the very long term like a pension fund might have to do, it probably would make more sense to be more cautious and tilt it towards that global return as opposed to taking the US return.

[00:27:45] Niels

Quick question for you here. Do you know, and I could be completely wrong, but is it true that the US equity total valuation is something like 60% of global markets?

[00:27:45] Alan

That was one of my other insights to share.

[00:27:59] Niels

Sorry. Okay.

[00:28:00] Alan

The US market is 60.5% of the total world value, which is extremely high. I think it’s the highest they have in the data. The next biggest is Japan, 6.2%, which for a single country- obviously, Eurozone was the Eurozone. But for a single country, it’s Japan. I think back in 1990 when Japan was at its peak, it accounted for 40% of the total world market. So this is highly unusual that the US is so dominant.

If you go back to 1900, the US was 14.5% of the global market and the UK was 24%. So the UK was the biggest trading nation and obviously the reserve currency back then. So highly unusual that the world is so dominated by the US equity market, and of course within the US equity market dominated by a small, few stocks.

[00:28:56] Niels

Do they break that down as well?

[00:29:00] Alan

I’m sure it’s there somewhere, but I didn’t get it in terms of what those individual stats are.

[00:29:04] Niels

Because a lot of people talk about this concentration risk. We’ve never seen so much concentration because if the US market is 60% of the world market, we know that the Magnificent 7, 6, 5, however many there are left, have a very large share of that, which means that you have a handful of companies making up a huge percentage of total global equity capitalization.

[00:29:34] Alan

That’s true for sure. There are different views on that. Obviously, some people say that’s just the nature of how the global economic system has evolved, that you have these big heavyweights that have built these businesses that are going to be around for a long time that are effectively more significant economically than many countries. Mean reversion is a theme that runs throughout their paper.

So I would have thought that if they were to make the call on that, it would be more likely that that won’t be sustained because they also talk about the sectoral composition and how that’s shifted over time. For example, if you go back to 1900, the market was dominated by the railroads, and in the US, about 80% of the market back then, it doesn’t even exist now, they were all these small industrial type markets.

[00:30:29] Niels

Energy a few decades ago, right?

[00:32:32] Alan

Exactly. Obviously, what we spend our money on now is totally different. Obviously, technology is a big component of the index, but that is something that shifts over time and it naturally evolves.

[00:30:45] Niels

Sorry to interrupt you again Alan, but it’s kind of interesting as you’re sharing this insight, I’m thinking of the headlines that I’m seeing at the moment in the papers about maybe there is an attempt to break up Apple with all these antitrust lawsuits now being filed in the last couple of days. So yeah, these leaderships change over time. Who knows? And it reminds me about what happened. I’m sure you remember everything that happened with Microsoft and Bill Gates back in whatever it was, the ’90s with all these antitrust cases.

[00:31:22] Alan

Yeah, that’s right. Some of the other points that they make, it was interesting, we talked about the difference between the US at 6.5% and the rest of the world at 4.3%. That doesn’t sound that dramatic. To highlight the power of compounding, a dollar invested in the US grew to $2,443 in real terms, whereas at the 4.3%, it only grows to $191, so less than 8% of the value. That just shows the power of compounding when applied to a very long time period.

You might think the difference between 9.6% which is the nominal return in the US, and 9.1% which is the nominal return in the UK over the period, so you say, that’s about the same, a little bit less, not much. But in terms of compounding over a period, the US dollar grew to $87,620 where the UK pound grew to £49,404 just driven by that 0.5% difference. So it does really highlight, for long-term investors, eking out those small incremental gains that are so massively important when they get compounded over time.

Of the other important interesting points from it, we talk about long-term, and they make the point that you really have to take a very long term if you’re thinking long-term. You might think 20 years is a long time or 40 years, but as we’ve said many times before, the last 40 years had been unusually favorable for financial assets because the starting point was 1982, 42 years since then, bond yields were at their peak, so it was a phenomenal time. And that’s borne out by the data.

So they point out that I think into 40 years to the end of 2021, world bonds generated 6.3% real versus 7.4% for equities. So granted the comments we made about compounding, but not far off for a lot less in terms of volatility. But that’s an unusual 40-year period. If you go back over the full 100 years, they significantly underperform. So that’s an important point to highlight again that within those 124 years, you have smaller periods, obviously the lost decades such as the early 2000s.

They do highlight the magnitudes of the drawdowns which are very eye-opening when you look at them. Again, in the US, largest drawdown in real terms of over 80%. In the UK, not so long ago, well, I say not so long ago, 50 years ago, 70% drawdown in 1973, 1974. And equally, investors in some countries have lost everything. Like Russia and China in 1917 and 1949, basically the market disappeared. So equities, yeah, the returns are there for the long-term, state buy and hold, but it’s not one at risk.

We talk about drawdowns in managed futures and trend following, nothing of that magnitude in terms of 80%. Interestingly, on the EM theme, actually, developed markets have outperformed emerging markets over that period as well. And they have a mechanism of categorizing emerging markets at that time. So it’s like obviously a market that now is developed was emerging at certain points back then. But it does highlight that risk in emerging markets. The fact that one or two might go completely bust is interesting.

They also talk about inflation and the inflation side is interesting as well. They look at the average inflation rates. In Argentina since 1960, inflation has averaged 71.6% on an annual basis. It’s not hard to understand why Argentina has economic challenges. But interestingly, if you look at the US on average between 1900 to 2023, inflation is 2.9%. So that’s interesting because if somebody was to say what do you think inflation will be for the next 10 years, I would say probably 3%.

Obviously, we’ve had periods of lower, and higher, and deflation as well in that decade. But actually, the US is one of the lower countries. If you look at places like France, Spain, Italy, I think French inflation has averaged 6.6% over that whole period as well. They also pointed out this idea of are equities an equity hedge, and they were negative on that from the perspective of equities do beat inflation over time, but in the years when you’re suffering that high inflation, equities tend to do poorly.

So not so much a hedge as more of an asset class so can over the long term withstand inflation and do better. But in those years when you tend to have higher inflation, they highlight the assets that tend to well, obviously commodities and gold as well. They also had an interesting section in it on looking at the returns in periods of rising rates and falling rates, which is obviously very topical at the moment.

I guess unsurprisingly, equity returns are a lot stronger when rates are rising, and that’s even taking the starting point once the rate hike or the rate cut has happened, so not taking into account of expectations around that.

[00:36:33] Niels

Alan, I just want to make sure you said it the right way. Can you just repeat what you said about when equity returns are strongest?

[00:36:39] Alan

Strongest when rates are being cut if I didn’t get that right. Strongest when rates have been cut, less when they are being raised. In the UK actually, almost all of the returns come when rates are being cut. I don’t know if that will be the same, if that changes now that everything is so analyzed and people anticipate the rate hike or rate cutting cycle, but certainly there is a huge bias in that way.

And then finally, just in terms of forward-looking expectations, they talk about what their estimates are for the equity risk premium. And they came down, considering a lot of different factors for the world equity risk premium of about 3.5% over builds which is less than what it has been historically. Historically, it was about 4.7%. So still good returns, but certainly consistent with the idea that valuations are certainly on the higher side, not saying they’re necessarily a bubble, but certainly on the higher side and return expectations should be accordingly lower looking forward.

[00:37:42] Niels

That’s a fascinating piece of information, I have to say. I really appreciate you sharing some of these highlights because it is actually quite a long piece of research and it’s interesting that they have all that historical data, I think.

Based on what we’ve just talked about, you would think that you should put all your money in equities to some extent, so I’m kind of thinking you may have something up your sleeve to that point.

[00:38:14] Alan

That’s right. That was the perfect segue into what I wanted to talk about next, which was the obvious implication is you just put all your money in equities, and you ride out the volatility, and that’s indeed what some researchers in the US were highlighting recently, which prompted Cliff Asness, at AQR, to write a blog piece. Basically, it was an academic piece done on looking at how a lot of money is managed according to target date type mandates where the asset allocation is set according to your age.

So if you’re far from retirement, your portfolio will have more equities, and if you’re getting closer to retirement, more bonds. This study questioned whether that was actually the right method. They were saying actually, an all-equity portfolio, if you diversify globally, did better obviously. Admittedly, it probably had higher drawdowns.

And then Cliff Asness, the question is, should investors be 100% equities? It is a valid question.

A lot of people would say, yes, just be 100% equities because equities have historically been the asset class with the highest returns. But I suppose the point is yes, they are the ones with the highest returns but they’re also maybe the highest risk. It depends how you measure risk. Is it volatility or not, or drawdown or what? I suppose the point he’s making is that it’s no surprise that the assets with the highest expected return has had the highest realized return.

I guess more generally, he makes the point that certainly if you’re an institutional investor, actually you can make a case very easily for not being 100% equities because as you know and as we know, if you combine equities with something that’s uncorrelated, you can generate a higher Sharpe ratio. So whether that’s a 60/40 portfolio or maybe equities plus trend following or something like that. And then what you can do is lever that portfolio to the same volatility as equities and you’d actually get a higher return.

So in that instance, what he points out is I suppose this is one of the basic tenets of the modern portfolio theory that what you should do is formulate the best Sharpe maximizing or the best, most robust portfolio that’s most diversified, etc. The second question is, how much of that portfolio do you want to hold in risk terms and leverage up or down according to your risk profile?

Whereas what you tend to find in the asset management industry, in the wealth management industry is if you want to take more risk, get more equities, if you want to take less risk, it’s less equities. In actual fact, it should be a diversified portfolio levered up or down. Now, you might say a lot of investors can’t get the leverage, and that’s a valid point.

If you want to lever up a portfolio, the obvious way to do it would be to rather than buying the S&P 500 ETF, you would buy the S&P 500 futures, and then you’d have some spare cash that you could go and invest elsewhere. So this is the whole idea of capital efficiency, what people are now calling return stacking, etc. That’s a valid way of doing it.

Now, a lot of people will say, I don’t know about trading futures, how do I do it? I think this is where it gets interesting and maybe links to some of the issues around trend following and manager selection.

Actually, one way you can get that leverage or build more leverage into your portfolio is when you’re selecting your alternative strategy or your diversifying strategies is to allocate to the more higher vol strategies and the higher vol managers within those categories because you’re basically getting the leverage from that manager. You don’t have to go lever up your portfolio.

You’re basically allocating to a manager who is doing that for you, and that creates the capital efficiency. that’s something that I looked at some stats around this. For example, if you just invested between equities and the SocGen Trend Index 80/20, yes, it improves your return, it improves your drawdown. But if you go and invest in equities plus a one-and-a-half times levered version of the SocGen Trend, you get a much higher return and you still get the benefits of the drawdown, etc.

So it’s one of these issues that I think it’s interesting. I talked to Peter Madsen one of the allocators recently. It’s like the disconnect between what makes sense from a pure portfolio perspective, selecting uncorrelated assets but trying to get as much volatility from them as possible. The reality is people don’t do that. Why is that? I think it’s things like career risk, it’s not wanting to fail. Unconventionally, it’s looking at the portfolio on a line-item basis rather than saying we’re getting this capital efficiency from the high vol strategy, instead to say we’ll getting this massive drawdown here at this point in time forgetting that they’re making money on the equity side at the same time. So he raises a good point. Just because equities have the highest historic return doesn’t mean it’s 100% equities. There are things you can do.

Obviously, leveraging a portfolio is the obvious way to balance that off. But there are other practical techniques that even an investor who is limited to investing in funds and can’t lever, they can actually achieve much the same of that leverage by actually finding high vol strategies that are uncorrelated with equities, and obviously trend following is one of those. It does highlight the benefit within the trend space of selecting managers who do run at a reasonable level of volatility.

[00:44:18] Niels

I completely agree with all of these points and also the reasoning why you mentioned that investors, and in this case institutional investors, are way under-corelated really to alternatives and certainly to trend following. We know that for sure. But when I hear the reasoning, and as much as I agree with him, you’d think, well, people who work as PMs or CIOs or sit on an investment committee at a big institution, they’re all very well educated. They know all this. They know not to look at line items. They know it’s about what the portfolio improvement is. They also know not to look at a Sharpe ratio on a single item because Sharpe was not invented for that, frankly. So why do you think they still don’t do what they should? That I don’t understand.

[00:45:11] Alan

I don’t agree that they all necessarily know. If you look at the multi asset space, very often people come from a fixed income background or an equity background and people are always comfortable what they know. So I think there is an element of lack of knowledge around maybe some trading strategies. I think the behavioral biases, or the career risk is certainly part of the story. But it is an interesting question. I do make that point when the simple math shows the benefit, but yet why are so many people under allocated to it? So I think it’s a combination of reasons.

[00:45:50] Niels

It reminds me of certainly one investor, a famous investor, who probably knew that the evidence was suggesting that diversification is a good thing but clearly he didn’t want to embrace diversification, and that’s Charlie Munger. I think he was out always saying that the trade-off between safety and return, etc., that he just didn’t believe in it, and you should just stay fully invested in equities, so yeah.

Now, we’ve talked a little bit about some of the challenges that some of these portfolios have and how they should embrace alternatives. So why don’t we dive into another paper you found which highlights the issue because if you have decided that you want to diversify, if you have decided that, yeah, probably in the world of hedge funds, somewhere, there should be something that would work well for you, you need to have a framework for picking which hedge funds and what’s their role in this portfolio, and so on and so forth, and you found a paper on that topic. So why don’t you share what you found?

[00:47:03] Alan

Yeah, I came across this paper from Wellington, obviously a big US asset manager. It’s not a very scientific or detailed paper, it’s more of an education, more of an educational piece. But I did think it had an important message in there but equally raised some other points as well. It’s about “Can Hedge Funds Play the Role?” is what it’s called.

I think that what it got is that very often you hear these very broad brush statements like oh, well, maybe we should allocate 5% to hedge funds or 10% to hedge funds, but that’s obviously literally a meaningless comment from the perspective of there are so many different strategies, and they point that out that.

They make the I suppose the point that when investors are constructing portfolios, they are typically looking for a return consistency or return enhancement or diversification or downside protection. So when you’re looking at the various building blocks, you’ve got to think about which strategies can help you achieve it.

They start off from the perspective of if you take an equity portfolio or a fixed income portfolio or a 60/40 portfolio, which of those is that good at and then where are the gaps? Obviously, I guess with a 60/40 portfolio, you’ve got your equities for growth, you’ve got your bonds for diversification and for downside protection and maybe for consistency.

Obviously, we know there are issues with that, that that’s not a given as well because that only works in a growth shock environment. In an inflation or supply shock environment, your fixed income is challenged as well. But then the question is well, okay, if you’re going to look at strategies like equity long-short, event-driven, macro, relative value, where do all of these fit in?

So, I thought it was good in the sense of highlighting that don’t put your equity long-short into your diversifiers. It sounds pretty straightforward, but I have seen it in multiple asset allocation plans, 5% to hedge funds and within that market neutral and long-short. Sometimes, that’s behavioral because it’s managed as an old portfolio and they want to have a reasonably consistent return, so that’s fair enough.

But I think in terms of managing, from the overall portfolio perspective, that doesn’t make sense that anything that’s equity biased should be in the equity bucket. And things like obviously macro, they don’t specifically talk about trend following or managed futures, but that is in their broad macro category.

Historically, that would be in the downside protection and the diversification but as we’re seeing in the current environment, and the conversation I was having with one allocator, and that’ll be coming out soon on the Allocator Series, they could equally be seen as return generators. Now, go back five years, it was harder to make convince people of that, but we always knew that an environment where you get strong trends in a pro risk environment, it can contribute strongly.

[00:50:19] Niels

I have one question for you actually as you go through these strategies. I think they raised the point, but I didn’t read the answer that they wrote. But it’s something that I come across a lot because they are so popular at the moment, and that’s these multi-strat funds. Where do they fit in all of this? Can you even categorize them except maybe for return consistency, I guess?

[00:50:44] Alan

I think it’s a good point, and it’s something that I think about too and I get asked by investors the same question. I suppose there is this general question that if something fulfills a couple of different mandates, then how does that play out or is that a good thing or a bad thing? I suppose you could ask the question, are they more growth or defensive or could you construct a portfolio of say a growth asset and have some diversifying strategies with that? Would that do as well as a multi-strat? Probably, I would guess.

So the question then is of having this multi-stat that has growth and some consistency. Well, that’s good. But are you going to have the downside protection from those multi-strat products? I think that’s somewhat questionable. My sense is a lot of those strategies did reasonably well in 2022. But actually if you go back to Q1 2020, a number of these strategies got stressed during the basis trades issue in March 2020. So are they really a strategy that are going to be bomb-proof in that type of scenario? I’m not sure.

So I certainly wouldn’t be holding a lot of that multi-strat type exposure in the downside protection bucket. That’s not to say there’s no role for it, but I think it’d be more tilted towards your return enhancement element. What they’ve done here well is highlight the general point. I suppose what they haven’t talked about at all is what we were talking a little bit earlier, things like sizing and how much.

What we tend to see is maybe the 5% allocation to trend following, why isn’t it much higher? So, they don’t bring into the discussion around what level of volatility, how much leverage? These are all the next level up in terms of constructing a good portfolio as well. I think arguably, you could probably be more dynamic in allocating across the strategies as well from the perspective of if volatility is unusually low, there might be a case for tail risk protection type strategies, whereas if it’s higher, the hurdle is going to be greater.

If interest rates are higher, you get a higher return in trend following or managed futures. That can be an additional reason for putting it into return generating. So I think there are tactical moves you can make depending on the macro environment. But I thought this was a good starting point, but it’s kind of like maybe building a liquid alts portfolio 101 or 201. It’s a bit better than you see in a lot of places, but there’s a lot more to think about than just the I suppose the role of each of the strategies.

[00:53:32] Niels

Unfortunately, I forget the name of this hedge fund manager based in Spain, I think well known, it just escapes my brain right now. But I remember that he’s written and talked a lot about this idea of different strategies from the perspective of if you’re constructing a soccer team or a football team, as we would say, I’m sure you know who I’m thinking about, and how the various strategies would fit a place on the pitch and so on and so forth. I think sometimes these analogies can be helpful for people to understand the benefits and the purpose and the role as they say.

[00:54:15] Alan

Is it Diego?

[00:54:16] Niels

It was Diego. Yeah, you’re absolutely right. So yeah, we should come up with more analogies. What would the rugby analogy be?

[00:54:27] Alan

It’s a really good question. Yeah.

[00:54:31] Niels

They’re all in somewhere.

[00:54:34] Alan

Good. I’ll have to think about that. You’ve put me on the spot. But it’s interesting. You’re talking about Diego. We’ve had this David Dredge as well, goalkeeper type analogy for the tail risk protection. Do you need the midfielders? I suppose the point is you have different strategies who can play multiple roles, but still you’ll have debates among asset allocators about how to use them and I think that depends on if you’re a long-term compounder or if you actually you want a bit more consistency in return generating.

A lot of people say consistency, it’s all about staying the course, managing the vol. But actually, we often forget that for a lot of investors, because of their makeup, they actually like consistency in performance, something wrong with that, it’s just constructing a portfolio that best suits the investor’s needs. So I think that’s an important takeaway as well.

[00:55:28] Niels

Yeah, but at least we have seen some developments in our space, I guess, from people who have, as you said, stacked returns together. It’s nothing new. It just came back a few years ago to the forefront and now there are products out there that do the work for investors where they can just choose one ticker and they get the benefits of putting at least a couple of non-correlated return streams together and it makes a lot of sense at the end of the day. If more investors would invest like that in the long run, that’s a good thing.

[00:56:05] Alan

Yeah, I think so. I think the challenge is that by doing that, you’re using futures, markets, you’re using leverage, derivatives, and these are all highly charged expressions. I think even Buffett has called derivatives weapons of mass destruction.

[00:56:22] Niels

Whilst he’s using them himself, to a high degree, which is kind of funny.

[00:56:29] Alan

Yeah. So it’s always a matter of how to use in mob context. But absolutely, I think this idea that the pie is already 100%, and it doesn’t make sense to lever beyond that is not correct. But you have to know what you’re doing. I think that’s the other point. The risk is you have a lot of the same exposures in your portfolio, and you lever that up, and that’s where you run into problems. Obviously, the benefit of combining trend following through with equities or bonds or whatever is they’re naturally uncorrelated.

[00:57:04] Niels

I can think of a few pension funds that have come up publicly and said we’re going to lever up our portfolio, one of them being the largest Danish pension fund a couple of years back. They managed to lose 50% of their reserves in one year, namely 2022, and then when the bounce back came last year, they only made 5% or 10%. Co clearly, they could have used a little bit of a few other types of players on their team. Anyways, Alan, as usual, fun, insightful, great stuff. Anything else you want to bring up as we wrap up? Anything that you’ve been inspired to share?

[00:57:49] Alan

Trying to think, was there anything that we didn’t get to speak about?

[00:57:54] Niels

I think we followed the outline pretty well but there could have been something else that came to mind as we were talking.

[00:58:01] Alan

No, I think that was it.

[00:58:03] Niels

Good stuff. Well, with that, Alan and I are going to wrap up. As usual, we would be so grateful if you would go to your favorite podcast platform and share a rating and review. It really does help us become more visible to more podcast listeners, so we would appreciate that. Also, as usual, you can send questions for us to info@toptradersunplugged.com.

The next guest or co-host will be Mark. As you know, Mark has decades of experience in this industry, so if you want to throw some challenging questions at him, then now’s the time, and the sooner I get them, the better. Then I can organize my lineout for next week. In any event, from Alan and me, thanks ever so much for listening. We certainly look forward to being back with you next week. In the meantime, as usual, take care of yourself and take care of each other.

[00:59:02] Ending

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

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

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

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

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