Episode #45: Gary Antonacci, Dual Momentum, “You Get A Synergy That Happens When You Use Dual Momentum
Guest: Gary Antonacci has over 40 years’ experience as an investment professional focusing on underexploited investment opportunities. Since receiving his MBA degree from the Harvard Business School, Gary has concentrated on researching, developing, and applying innovative investment strategies that have their basis in academic research. His research introduced the investment world to dual momentum, which combines relative strength price momentum with trend following absolute momentum.
Date Recorded: 3/23/17 | Run-Time: 54:38
Summary: After a few minutes on Gary’s background, the guys dive into Gary’s “Dual Momentum” research. To make sure everyone is on the same page, Meb asks for definitions before theory. “Relative momentum” compares one asset to another. “Absolute momentum” compares performance to its own track record over time, also called time-series momentum. Gary uses a 12-month lookback, and compares his results to the S&P and other global markets. In essence, you’re combining these two types of momentum for outperformance.
The guys talk a bit about using just one of the types of momentum versus combining them, but Gary tells us “You get a synergy that happens when you use (Dual Momentum).” The compound annual growth rate applied to the indices is 16.2% dating back to 1971, compared to the S&P’s 10.5%. And the reduction in volatility and drawdown is under 20% compared to 51% for the S&P.
With the basics of Gary’s Dual Momentum out of the way, Meb decides to go down some rabbit holes. He asks about the various extensions on Dual Momentum. It turns out, Gary says you can introduce some additional granularity, but not a lot. Almost nothing really improves the current version of Dual Momentum substantially. (And in case you’re wondering, you can go to Optimalmomentum.com to track Gary’s performance.)
Meb then brings up questions that came in via Twitter. The first: “What sort of evidence would be required to convince Gary that Dual Momentum won’t work in the future?”
Gary tells us that because the evidence for Dual Momentum is so strong, the evidence against it would have to be strong. We would need more than a few years of underperformance, and instead, a full market cycle of underperformance. But more importantly, he’d want to understand why it would underperform – for instance, perhaps everyone decided to become a trend follower, squeezing out the alpha? Gary quickly ads that such a scenario will likely never happen due to our behavioral tendencies as investors.
The next Twitter question: “What are your thoughts on doing something alpha oriented versus just dropping into cash and bonds when you’re in a downtrend?”
Gary says shorting doesn’t work because of an upward bias to stocks. Meb agrees, saying that shorting actually amps up risk and volatility, but doesn’t really add to risk-adjusted returns.
Next, Meb brings up a post Gary wrote about commodities – are they still a good diversifier? The idea is that markets and their participants change over time. Gary thinks passive commodities have changed over time. And while they were a good diversifier to a stock/bond portfolio before, everyone has started doing it, which changed the nature of the market, reducing the benefit.
Gary also mentions the risk of others front-running you. Meb chimes in, agreeing – you’re going to want to hear this back-and-forth.
There’s tons more in this episode: moving away from market cap weighting when using Dual Momentum… Dual Momentum applied to sector rotation… sports gambling… our tendencies to stray from our investment plans… and Gary’s most memorable trade – hint: it involves an options blow-up.
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Transcript of Episode 45:
- Welcome Message: Welcome, to “The Meb Faber Show” where the focus is on helping you grow and preserve your wealth. Join us as we discuss the craft of investing and uncover new and profitable ideas, all to help you grow wealthier and wiser. Better investing starts here.Disclaimer: Meb Faber is the co-founder and Chief Investment Officer at Cambria Investment Management. Due to industry regulations, he will not discuss any of Cambria’s funds on this podcast. All opinions expressed by podcast participants are solely their own opinions and do not reflect the opinion of Cambria Investment Management or its affiliates. For more information visit cambriainvestments.com.Sponsor: Today’s podcast is sponsored by Founders Card. I usually don’t spring for paid membership programs but this one is a little different. The offering has targeted entrepreneurs and business owners and the card enables premier benefits from leading airlines, hotels, lifestyle brands, and business services. A few of my favorite benefits include free access to MailChimp Pro, Dashlane Premium, and Tripit Pro. You can even get big discounts to services I love like SilverCar, 99designs, Apple and AT&T. My favorite though are the travel benefits where you get an automatic status such as Hilton Honors gold, American Airlines platinum, and Virgin America gold. And while I often use the great app HotelTonight for travel the Founders Card discounts can be massive too. If you go to founderscard.com/meb, podcast listeners can sign up for the discounted 395 bucks a year with no initiation fee, and that’s a saving from the normal cost of around 600 bucks per year. Again that’s founderscard.com/meb.Meb: Welcome to the podcast ladies and gentlemen, we have a very special guest today, Gary Antonacci, welcome to the show.Gary: Thanks, Meb, great to be here.
Meb: So, Gary has been a oft requested guest, a lot of people send in ideas and thoughts on who to have on the show and keep sending those email@example.com and Gary’s name has come up many, many times. And Gary and I got to hang out a couple months ago, in Vancouver where we were both giving a speech and had a great time. What a wonderful, beautiful city. And I got to watch Gary speak and he got to watch me speak and turned out Gary’s was during my fantasy football draft which I had forgotten about. So, I could have drafted in real time but Gary’s presentation was actually so interesting that I ended up with seven kickers on my team. Which, by the way, seems like a flaw on Yahoo’s algorithm to draft a bunch of kickers but whatever. So, Gary I kind of hold you responsible for losing my fantasy football league last year that’s kind of hard to recover from but it was worth it. Because I actually really enjoyed your speech. So, I figured we’d start by…I was reading your book again and it’s a great book called “Dual Momentum Investing” which came out in 2013, 2014?
Meb: Okay, great book, highly recommended we’ll add links in the show notes. But I was reading the intro from our prior podcast guest and common friend Professor Wes Gray, and in the intro, he had a great description where he said, where you guys were hanging out in Lake Tahoe. And he says Gary was talking about it, he says, “Yeah, I’ve done some cool things. I lived in India for a few years, went on tour as a comedy magician for a while, was an award-winning artist and I have an MBA from Harvard Business School.” So, that’s pretty eclectic Gary. Why don’t you just give us a super quick overview of kind of how you got to writing “Dual Momentum Investing” and what came before that?
Gary: Well sure, I started my investment career in 1974 with Merrill Lynch, I had always been interested in exploring underexploited-type investments. So, at that time, I specialized in gold stocks and stock options. I went on to get my MBA at Harvard and was managing money part time, but some option strategies I came up with I would sit in the back of class and import numbers into my TI calculator, and then run to the phone booth during classes and phone in my orders. And by the time I graduated I didn’t have to go look for a job I was managing money from fellow students, their families, even one of my professors.
So, I came back to California and set up a market maker organization on all the option exchange floors, and after a while, I realized I didn’t really have an edge over people on the floor or upstairs traders. So, I took a look at commodity futures trading. Which was a fragmented industry at that time, there were people doing great things but nobody had really put it together very well. So, I remembered Markowitz’ work which was sitting off in a corner somewhere people weren’t really using it, they were more focused on capital asset pricing models.
So, I dug out Markowitz and put together some programs to input different commodity trading approaches, because that had an advantage not only of trading different markets but of trading them with different kinds of ideas. So, I put together some partnerships and worked with people like Paul Tudor Jones, Richard Dennis, Louis Bacon, John Henry and did very well. Was able to semi-retire after about 10 years, and that’s when I did some of those other things that was mentioned in my book. Like being an artist, and a comedy magician and that kind of stuff. But I always kept an eye on what was going on in the markets because I had my own assets to manage. I didn’t know if I’d ever find anything as good as what I had been doing until about seven years ago when I came across momentum and read all the academic papers on it. Now, let me add, that you were one of the inspirations I had. I’ve been following you since you first came out with your blog and put together your first white paper.
So, back in 2006, I saw how you had applied trend following to different asset classes. And I thought that made sense to me even though I had been brought up in the academic side of things I was open to trend following because I had witnessed people like Paul Tudor Jones, looked at their trading every day. So, I didn’t need any convincing that there was something there that could be exploited. So, I dug in and I read all the academic papers on momentum there’s a lot of ’em. And when I finished I concluded that there’s some tremendous opportunity there, but that it wasn’t being exploited very well in the marketplace. So, I did my own research and wrote a couple of papers that won awards. 2012 I got 1st place Wagner Award from National Association [crosstalk]…
Meb: [inaudible 00:07:30] There’s a lot of vowels in that one. The National Association of Active Investment Managers.
Gary: Active Investment Managers, thank you. I also started working on some proprietary momentum models that I license now to investment advisors, and they use them to manage customer’s accounts. But I wanted to do something that the general public could use, so that’s when I wrote my book “Dual Momentum Investing” and it came out in 2014 and it’s been very popular. The book has won some awards and has about 300 reviews up on Amazon, most of them 5-star reviews.
Meb: Man, I should have thought about it, one of my favorite first episodes was Patrick O’Shaughnessy and I downloaded all of our negative reviews and kind of read them out, and there was some pretty funny ones like the book didn’t show up ever one star. If I’d known that I would have printed yours out and we could have had some laughs. So, one of the cool things about the book is that you know, we talk about momentum and the papers and a lot of the academics really only go back to kind of the Jegadeesh and Titman, which is a very seminal paper but in the early 90s. But in reality, momentum and trend following has been something that are close cousins and we’ll talk about definitions in a minute. But it’s really something that’s been around for a really long time not just Charles Dow in 1900, but you even take a quote in your book that says…I’m gonna read it here it says, “The first notable person to express momentum principles in investment terms is the great classical economist David Ricardo. He is widely considered downside as well as upside momentum when he said in 1838, ‘cut your losses let your profits run on.’ Followed his own advice, and retired at the age of 42 having amassed a fortune of 65 million in today’s dollars.” Gary, maybe touch on a few of the highlights sort of in your mind of kind of the momentum literature, or some of the names you’ve mentioned kind of over the years that kind of got you in the frame of thinking to where you are today. And then we’ll start to go down the theory behind the genesis of dual momentum and what that means.
Gary: Sure. Well, Jesse Livermore in his book How to Trade in Stocks said, “One should buy the strongest stocks” that’s obliviously momentum. Richard Wyckoff in 1924 said, “Buy the strongest stocks and the strongest industries when the trend is up.” That’s dual momentum and Wyckoff was able to retire to an estate in the Hamptons where he was a neighbor of Alfred P. Sloan. Jack Dreyfus would only buy stocks that were making new highs. And when he managed in his Dreyfus fund greatly outperformed the indices. Richard Driehaus is another person who used momentum. He retired as a philanthropist, was managing $10 billion using momentum. And I had read Nick Darvas back in the 1970s who wrote a book “How I Made $ 2,000,000 In Stocks” and it was basically a rotational momentum-type approach.
Meb: Wasn’t Darvas a dancer in [crosstalk]…
Gary: Yeah, he was a dancer, and he would travel around and send cables to his brokers telling them what to buy and sell based on stocks that were showing high momentum. And when the momentum started to wane, he would know when to get out. Now that’s great you know if you have a good sense of the markets like all these people did. But for most of us we don’t, so we needed something that’s rules-based and systematic.
And that’s where the research came in, and the actual first research on momentum was done in 1937 by Cowles and Jones. And they looked at every New York Stock Exchange stock from 1920 through 1935, and they had to tabulate that by hand. And when they had finished they concluded that stocks that have been strong over the preceding year continued to be strong going forward. That’s really the basis of modern day momentum as it’s practiced today.
Meb: And so, let’s start with some definitions maybe before we start to go into the theory behind the book. And so, much like other areas of finance very jargony and you know, people talk about momentum and trend following all that sort of stuff. And you simplify it into really two types of momentum it’s relative and absolute. So maybe, would that be a good starting point on kind of defining those, and then starting to talk about the steps in your theory, and kind of how to put it all together?
Gary: Sure. Well, relative momentum or relative strength is the one that has most commonly been written about and that most people are familiar with. And that’s where you’re comparing one asset to others. Relative strength is nothing new, it’s been used effectively for a long time, and the research on it goes back about 200 years. Grazerman [SP] and his partner…drawing a blank right now. But they…oh, Samonov. They did a paper called “215 Years of Global Multi-Asset Momentum” in which they looked at relative strength applied to geographically diversified stock indices, currencies, bonds, commodities, global industry sectors, and U.S. stocks. And then they looked across all of them and they looked at what they all did together. And they found that it held up consistently from the year 1800 all the way until now. So, momentum has shown robustness, consistency, persistence all the things you wanna see when you look at a factor.
Meb: So, 200 years is a pretty decent out of sample performance. And so, okay so, just definitional. So, relative momentum, also relative strength, cross-sectional, those all mean the same thing. And on the opposite side, just to collect the words before we get started, you also talk about absolute momentum. Maybe talk about what the definition of that is.
Gary: Absolute momentum, you’re comparing performance to yourself over time. So, sometimes it’s called time series momentum and the best way is to give an example. Let’s say the S&P 500 has been up over the past year, well then you say it has positive absolute momentum and it should continue to go up because momentum means persistence and performance. Whereas if the S&P 500 has been down over the preceding year you say the absolute momentum is negative and you’d wanna stand aside. Now what’s interesting about Geczy and Samonov and I actually showed this in my first paper written in 2011 as well, is that momentum, while it performs well universally, it actually does best historically when applied to geographically diversified stock indices. And so, that’s how I like to use it. For relative momentum, what I’ll do is I’ll compare the performance of the S&P 500 to the rest of the world. And I’ll say whichever’s been stronger over the preceding 12 months, that’s the one I wanna go with. And I’ll use 12 months as my look back because Cowles and Jones showed that that worked in 1937. And we don’t have to engage in any kind of data mining, we just use that and it’s held up well ever since then.
And it’s quite remarkable what happens when you do that, it’s a very simple approach. All you’re doing is saying whichever had been stronger over the past year that’s what you’ll invest in. And then you go through and you reevaluate month by month and you see if that continues to be the case. And the increase in return you get from that simple approach over the S&P 500 since 1971 is 270 basis points a year. Now I use 1971 as a starting point because that’s when stock indices were available that included the whole world. So, MSCI indices go back to 1970. You don’t have any problems that you might have associated with individual stocks in terms of scalability, you can invest as much as you want in these broad-based indices. And transaction costs are not a problem either because there’s fewer than one switch a year with that strategy. That earned 270 basis points a year from something that simple, is pretty remarkable I think. I don’t know any money managers since 1971 who’ve beat the S&P 500 by 270 basis points a year on average, except maybe Warren Buffett, and I don’t think he thinks he can do that anymore.
Meb: So, the basics all right, so we got the first step which is you look at the S&P versus foreign stocks whichever one has the best performance over the last year you invest in that one. And 100% of assets and that’s pretty simple. And that leads to like you mentioned a couple hundred basis point outperformance, and it’s actually even higher outperformance by the way, if you compare it to the foreign stocks. Because over that period they didn’t have as high returns as the S&P. And so, this sort of relative strength or relative momentum that people always talk about is you know, in many ways, a outperformance system, so you’re looking to outperform. But one of the challenges of that of course, is that equities being equities you know, they have a higher volatility and longer drawdown. So, you also talk a little bit about the concept of adding in absolute momentum. And so maybe kind of talk about the next extension there as part of the dual momentum approach.
Gary: Yeah, so that’s the other part of dual momentum and that’s where I think I have something interesting to offer. Is that when you use absolute momentum you don’t get as high a return as applying just relative momentum. So, if you’re doing a switching strategy where you’re in the S&P 500 if it’s been positive with respect to Treasury bills over the past 12 months. And when it’s not, you switch into something safe like aggregate bonds, then you make an extra 210 basis points a year on average over the S&P 500 still quite respectable. Not as high as 270 basis points, but 210 basis points is still pretty good. And what you do along the way is you mitigate much of the drawdown that happens during bear markets.
So, a lot of people would prefer to use something like trend following or absolute momentum. Now absolute momentum has been validated by Geczy and Samonov also back the 210 years. And it’s been validated even further by Greyserman and Kaminsky who did a study all the way back to the 1200s believe it or not. Using this absolute momentum approach with a 12-month look back. Now they weren’t able to invest in fixed income when they were out of the risky asset because there were no bonds available during much that time, so they just held it in cash. And what they found was that there was more than a doubling in the rate of return, a doubling in the Sharpe ratio, and a reduction in drawdowns of over 30% using this trend following approach compared to buy and hold. They applied it to stocks going back to the 1600s and to other assets going all the way back to the 1200s.
Meb: Wow, why was this such a short backtest? You should at least be able to take that to zero. Okay. So, the combination of the two you call, I believe, global equities momentum. Do you see GEM is that a reasonable acronym?
Gary: Yeah, I like that term GEM but it’s dual momentum. And you get a synergy that happens when you do that. The compound annual growth rate from dual momentum, the combination of these two approaches applied to the indices is 16.2% a year from 1971. So, that’s a considerable increase over the 10 and a half percent a year from S&P 500. What’s most impressive, though, is the reduction in volatility and drawdown. Your maximum month-end drawdown on the S&P has been 51% during that time from dual momentum it’s under 20%.
Meb: That’s awesome, and so you kind of combine the benefits of trend following or this absolute momentum which is kind of risk reduction or getting out when you’re having a long bear market, as well as the benefits of the relative momentum. Which is the outperformance and it’s kind of the best of both worlds and so the cool part about Gary’s approach… and you can by the way, go to his website and it has not only the historical performance by month all the way to the 70s but also out of sample performance since the book has been published, which he updates every month. And then also the allocation and the cool thing Gary…I mean and this seems obvious to me in retrospect. But I mean looking back to the financial crisis and I mean you’ve basically been in U.S. stocks almost since I guess 2009 with very, very few trades you know, a real quick in and out into bonds or into foreign. And it’s almost that whole period, right?
Gary: That’s correct.
Meb: And you know, one, that’s the best place to be. U.S. stocks has been the number one performing stock market in the world. So clearly it did a good job of that, and it’s interesting in it hasn’t pulled the trigger yet to my knowledge. But I imagine in the next few months it’s gonna be interesting to see if that finally starts to flip over to foreign. Because kind of since last summer, I believe, when interest rates bottom we’ve seen foreign really start to pick up the slack and start to outperform. So, it’ll be interesting to see when that flip happens, if it does, who knows U.S. stocks keep running.
Gary: Won’t happen again in the U.S., so.
Meb: And what’s the website where people can track the allocation and performance?
Gary: They can go to optimalmomentum.com.
Meb: Okay. Perfect, all right. So, you know, the cool part is everyone listening could just full stop, you’ve just been given a very simple implemental model that works with like one or two trades per year. It’s the old cement kind of what we call coffee can or lazy portfolio, but just for our own edification and to go down some more interesting rabbit holes we’re gonna get a little more deep and granular. Because Gary, on his blog and articles, loves to get deep on some topics. So, one is as an expansion of your simple idea and the beauty, one, is that it’s simple so you don’t need to mess with it. But I’m an engineer so I love to tinker. What have you thought about more granularity? So, you know, a lot of people out there would say, “Hey, you know, what about adding instead of just foreign markets why not emerging or why not adding you know, foreign bonds or real estate, or commodities have you thought about that at all? What’s kind of your thinking there?
Gary: Yes, I’ve done more than just think about it. Well, first of all, emerging markets are included in the foreign index that I use. I try to be all inclusive so there’s no selection biases. There’s the U.S. and there’s the whole rest of the world. So, they represent 10%-15% of the world and they get included. But yes, you can, and there’s a little more granularity, not a lot. I’ve tried adding all the MSCI-type indices that I can find data for you know, having to do with factors and everything else under the sun and almost nothing really improves upon it. I do have some proprietary models as I mentioned that I license, and they do expand the granularity a little bit but the biggest benefit comes from doing some work on the timing side of things. Just making the absolute momentum part of it a little more robust.
So I get emails all the time from people saying, “Well, have you looked at this that and the other thing?” And chances are I have, but I usually go back to ’em and I say, “Well if you like that idea fine, but you have to see if it passes certain tests. Are the results robust, are they consistent, are they persistent, do they make sense, do you have plenty of data to ascertain all of those things?” And usually, that’s the last I hear from them.
Meb: So, we’re gonna pepper the rest of the conversation. I’m gonna interject because I asked Twitter and I said, “Hey, Twitter do you have any good questions for Gary as we go along?” And some are a little bit relevant to what we’re talking about at the same time, and some we’ll just ask at the end. But there was a good question that Wes actually chimed in earlier and he said, you know, “What sort of evidence would be required to convince you that this dual momentum model which has worked historically and then after publication won’t work in the future?” This is something we struggle a lot with and there’s various answers. But what’s your perspective on what kind of evidence would you need to say okay maybe this time is different or maybe this model is kaput?
Gary: That’s a very good question. And because the evidence is so strong on both types of momentum I think the evidence against it would need to be strong too. With relative momentum, we have evidence across multiple kinds of markets going all the way back 200 plus years. On absolute momentum, we have evidence going back even further you know, as I mentioned. So, we would need more than just a little bit of underperformance and there’s always going to be underperformance. So, if we were to see a full market cycle of a severe bear market and a healthy bull market and dual momentum underperformed, then I think I might you know, take some notice. But what I’d really wanna see and try to understand would be is there some reason for it not to work going forward?
One possible reason might be that everybody becomes a trend follower. I very much doubt that’s going to happen. You know, actually, the biases are all going the other way. There’s plenty of behavioral biases that keep people away from momentum, particularly dual momentum. Some people think it’s too simple or the disposition effect makes people inclined to sell things when they start to go up instead of buy them which is what momentum tells you you should do. There’s familiarity bias anchoring, slow diffusion of this information a preference that people have for stocks over indices. There’s all these things working against it in terms of being overly popular. But those are the kinds of things I would look for.
Meb: There’s another question from EconomPic, which is Jake, and he says, “What are your thoughts on doing something alpha-oriented versus just dropping it into cash and bonds? So, when you’re having the downtrend in stocks have you ever played around with any ideas there? Is there any sort of thoughts or is there not much to go down that path?
Gary: Well, I’m not sure what he means by alpha-oriented there’s not a lot of alpha out there.
Meb: Yeah. I think he just means what like okay if you’re getting out of stocks is there any other sort of alternatives to just going in T-bills or bonds or this aggregate they use. So, whether it’s shorting, whether is it some other system I think people love to think about just…I wanna do something else other than just sit in bonds for the people that need a little more rocket fuel. Is, there any other ideas?
Gary: Yes, there are. Shorting doesn’t work, I looked at that. But the problem is you’ve got an upward bias to stocks and by the time you get out and then get back in you know, there’s no real advantage to going in on the short side. Because what happens is when the stock market starts to weaken and people see that there’s a flow of money away from stocks into bonds and the stock market is a lead indicator. So when the fed sees that they might think a recession is coming and they have an incentive to try to have interest rates low that’s another positive thing for bonds. So, I prefer to be in bonds. Now you don’t just have to be in AG bonds. I chose AG bonds because they’re very stable and you don’t have to worry much about duration risk. But I also have a dual momentum fixed income model that can go into different areas of the fixed income market. That’s something that I use in my proprietary modeling. Where I’ll combine for a more conservative type people I can combine a dual momentum fixed income along with the enhanced global equities momentum.
Meb: And that makes sense. I mean we’ve looked at it with a lot of trend following stuff in the past and sitting in T-bills of course, is the lowest vol sort of cash substitute in moving out to like a 10 year or an AG certainly will give you another hundred basis points issue or a higher yield. But also introduces a little more volatility. And the biggest point you touched on is the shorting and we talked about this, where we said look shorting really doesn’t increase returns or risk numbers it actually amps up the volatility largely because when markets are down trending their higher volatility than when they’re up trending. The only time that we usually recommended a traditional shorting is if someone’s using it as a hedge to a portfolio they have elsewhere. So, meaning they’re like, “Hey, I have my 401K I can’t move it it’s a long onlys.” In that case, shorting may make little sense because it may help to hedge that out. But in general, shorting, if you were to do it through your entire portfolio, it certainly doesn’t add to the risk-adjusted returns really.
One of the posts you have written recently in January which is also curious because you know, commodities for many people there’s lots of different types of commodities, you know, whether it’s just the broad base indices which are mostly energy or whether it’s gold or whether you know, other natural resource stocks, the commodities space is a bit different for most. And so, you wrote a post called “Are Commodities Still a Good Portfolio Diversifier?” I wonder if you’d walk us down the theory and thoughts in that article.
Gary: Well, the problem there and this problem applies in other areas too, is that people read some research and they think that that’s the state of the world forever, and that’s not necessarily the case. Markets and their participants change over time, and they can change in response to the research too. And I think that’s what’s happened in the area of passive commodities. There was a paper that came out saying that commodities are a good diversifier to a stock bond portfolio and they gave the suggestion that everybody put some money into passive commodity futures. Some of the brokers and the funds out there went out and started marketing it. So, that enormous number of pension funds started dumping money into commodities, now that created a problem in the marketplace because of the equilibrium that goes on here.
When I was involved with futures back in the 1980s the market was dominated by hedgers. People who needed to lay off the risk that they had and they were willing to give up a premium to do that so that they wouldn’t go out of business. But as more and more speculators entered the market and as more and more people enter on the other side of things, you know, the premium that they have to offer to people will decrease as you get more participants on the other side. And I think that’s what’s happened in the commodity futures area and if you go in and you look more deeply at what’s been going on in those markets you can see that there has been a shift over time. And I was calling people’s attention to that.
So, if you go on to my blog which is dualmomentum.com you can find the references that I give. And I even go into some of the papers that purport to still support allocations to commodities. And I even show how if you look more closely at some of the things that are in those papers you can see that you can make a case for the other side. You also have complications like front running that’s been going on, and that can happen in the equity side too. But there was a paper done that shows it’s very serious in terms of the Goldman Sachs commodity index, that there’s a considerable amount of return that gets taken away from speculators because there are parties out there who know what the rollover dates are and they just stepped in ahead of time and then take their profits afterwards.
Meb: You touched on a lot there and there’s a couple good points. And one, I think the hardest part for a lot of people is understanding or knowing what you own. And so, for commodities, most these ETFs people think, hey I’m buying you know, this commodity index and I’m getting exposure to commodity spot prices when in reality you’re not you’re getting exposure to futures. And I think particularly with the 1.0 version of futures products they were very suboptimal and a lot of them now are starting to incorporate say roll yield or other sort of factors like momentum or perhaps value, which is a little wonky in commodities but are getting better. But I think it’s a very great example of knowing what you own.
And then on top of that you know, I think the comment on what we call the dirty little secret of indexing which is front running. And it’s not a huge deal in say the S&P 500 but it is certainly a major, major problem in smaller equity markets like micro-caps as well as commodities. And I think in some markets I think you mentioned the Goldman Sachs index it’s a multiple 100 basis point drag on returns. And so, I always say my ideal approach is an active approach that’s just objective and rules based, but you don’t actually publish the index rules because there’s a lot of wolfs out there on Wall Street that’ll front run you to their heart’s content.
So, indices are a good first step but you just shouldn’t tell anybody what you’re doing. So, it’s interesting because there’s some models out there that whether they’ve been based on your work or other people’s. I know Ned Davis publishes one called “The Three-way Model” which instead of your foreign equity and bonds they introduced gold as a third asset class. And you know, it’s the same sort of thing and the rotation has pretty good returns. Have you ever thought about moving away from market cap waiting in these indices? So, a lot of people say well not just momentum on the macro top down level, but what about using say, value or momentum factors instead of the market cap indices what’s the thoughts there?
Gary: I’ve looked at those and they really don’t add anything. And value, in particular, is not very responsive to momentum. I think it’s because they have a different kind of thing they’re trying to accomplish. Momentum is based on autocorrelation and trend persistence and value is more mean-reverting. So, it’s kind of like mixing oil and water together. Value doesn’t respond so well to momentum. Equal weight is I mean, you can break that down into you know, what does it really mean and it’s really just going to a lower, smaller type capitalization. And it’s not bad, but I haven’t found any real advantage to incorporate in it.
Meb: Interesting, and one of the benefits of market cap investing will always be size, so for the people listening here that have multiple billions and want to implement this, it shouldn’t be a problem. And as you get away from market cap investing certainly the smaller and tinier granularity get, the little harder it is to move around big pieces of money. But you have talked about granularity within the U.S. as far as sector rotation, maybe give us some insight and talk about that a bit.
Gary: When I wrote my book, I had taken a look at sector rotation and I had data like everybody else going back to around 1990 on the sectors. And I applied a dual momentum approach to it and it looked okay. I mean it was comparable to my other models, so I put it in towards the back of my book as just an example of another way that you might wanna to use dual momentum. What happened then was I started getting tons of emails from people saying, “Tell me more I’m attracted to sectors.” Because I think people naturally prefer things that have more moving parts, they prefer the complicated over the simple which is… I don’t think the way [inaudible 00:38:45] should be. I think the other way makes more sense. But I kept telling people well you can if you want but I wouldn’t do it.
And then I was able to get data going back to the early 1970s after a while and I went and I reran the sector-type models and I found lo and behold that the volatility shot way up and the returns dropped way down. And so now if you compared it, it just didn’t make any sense. Although there were still people attracted to it so I said, “Okay well, from a diversification point of view maybe you could put 20% or so into sector rotation.” Because sometimes you can include things that are suboptimal by themselves just because in a portfolio context it can make some sense because of their diversification value. But I found as I did more work with momentum and I developed my proprietary models that sector rotation just fell out of the possible portfolio framework entirely.
Meb: Interesting, and by the way, I’ll give you some homework for the weekend the French/Fama database has sector and industry data for free going back to the 20s. Now I’m not sure how much you wanna go play around with it, or if you have, but if you really, really wanna go far back there’s is a lot in there. And by the way how many sectors were you looking at when you said the sector rotation? Were you just taking just 1 out of 10 or was it 3 or 5 out of 10?
Gary: I took the 10 sectors and then I worked with different algorithms to try to see what seemed to make sense. It generally ended up being three or four sectors but I also had a way of…and this is done in other areas too where you have different criteria for getting in than getting out so that there’s not so much turnover. You might go with something when it’s in the top one or two and then hold it till it drops below the four or five. So, I experimented with all of that and…still and I use straight numbers as well. But still, there’s nothing I could do that convinced me that it was worth continuing in sectors.
Meb: All right, well I know you tinker and read a lot of research and think about a lot of things, what’s on the plate for 2017? What unanswered questions, what areas of research are you thinking about these days? What on the horizon that’s on Gary’s mind?
Gary: Well, it’s funny you should ask because I was thinking about the other day. I really can’t think of anything more. I’ve exhausted pretty much everything that I could come up with. And what I try to do actually is follow along with what Voltaire said. He said, “First you start with a basic idea then you develop it, and expand on it and then if you’re really good you end up simplifying things and just coming back to basics, to where you capture the essence of something.” So, I think I’ve got the essence here of what I’m trying to do and I’m happy with the models that I have now.
Meb: That’s great that’s a wonderful answer. I wish I was in that situation right now I end up downloading a new paper etc. I just need to start reading Wes’s summaries at this point. I need to outsource all of my academic paper reading to what Wes is doing. Let’s take a hard-right turn and there’s something I didn’t know about you but. But, back in the day, I learned that you used to think about approach to sports and sports betting. Back in the day a couple decades ago. Tell us a little bit about that what was that like? What sort of ideas were you kicking around and working with then?
Gary: I had a family member who was into betting on football games and he knew I was into quantitative investing. So, he said, “Why don’t you take a look at the home underdogs in the NFL I think there’s something there.” And at first I just pooh poohed it, but then I thought well, okay I’ll take a look. So, I got a hold of some data and I went through and after looking at it I saw well, yeah, there was something there. And so, I got intrigued by it and I started looking at other ways of approaching it. And I hired some Cal Berkeley students to assist me because you had to do all this by hand then, there were no computer databases. So, we just started working away and looking at things and pretty soon we came up with a number of things like that. And so, I would send one of them on the bus each weekend up to Reno to place bets on the football games and we did pretty well. So, I figured well, let’s expand on that and we started looking at other sports like basketball, and baseball, and colleges as well, and even hockey. And we built up a Monte Carlo simulator for baseball games which did well early in the season because players had shifted around to different teams and nobody could quite figure out how they all fit together but we had it. And it was intriguing. You know, this was before behavioral economics, behavioral sciences back in the 1980s. And a lot of those same principles I could see applying. And I actually learned some valuable lessons from it which I have been able to apply to my investing now.
So, what happened was that I had to start dealing with bookmakers because we were doing things on a daily basis, and some of them after a while wouldn’t do business with me anymore. And others became real friendly with me they wanted me to bet early with them so they could use that information. But after awhile it just took over my life too much. I had a large satellite dish put on my house and I was ignoring my family and so forth, so I just walked away from it. But I did learn some valuable lessons from it. One was you have to have an edge, you have a positive expectation before doing anything. And I think the way this applies to investing is I see a lot of people who don’t have an edge, who think they might, who are doing active-type investing or even some factor-based investing. Which I go into in my last blog post. They’d be better off just going into Buy and Hold passive type index investing.
The other thing is you need to keep things simple. When I started doing this I thought well gee this is great maybe I can hit 70% winners or high 60s or whatever. And I could, by manipulating the data I could find models that fit the data and would give that to me, but they would never hold up real time. So, I realized after a while you know, hitting in the high 50s is about what should be expected, and keep things as simple as possible. Lem Banker made a tremendous living just hitting about 57% of his game.
So, you really need to keep things from being over fit and over optimized. And then I learned you have to have positive but realistic expectations. So, that…like I say I couldn’t expect to be hitting 70% winners and people out there in the markets they shouldn’t expect too much either. One of the biggest problems I’ve seen in investing is people have too high an expectation and they lose interest when you underperform for a little while. Now the only thing I guarantee people is that using my approach or any other approach there will be periods of underperformance, and a lot of people just move on to the next thing and that happens. So, you have to be even-minded and persistent and you know, keep the big picture in mind.
Some people are…I quote Warren Buffet who once said, “There are two rules to investing, one is to not lose money and the second is to remember rule number one.” Well, that’s bull hockey. I mean Warren Buffett hasn’t followed that himself. His Berkshire Hathaway has had 50% drawdowns twice in the past 20 years. He’s persisted because he knows he has an edge, a positive expectation. And he’s been able to have the confidence and the persistence to continue. So, I think that’s another lesson that I learned from sports. Because if you’re not 57% or 58% winners you’re gonna have a lot of losers along the way and you just have to learn to accept that.
Meb: Yeah, I think Buffett’s biggest piece of alpha I like you mentioned is simply sticking to his system, and his system’s not that complicated for the most part. Buying a high-quality value stocks, but it’s not deviating when he goes through a period of 1, 5, 10 years’ under-performance to the market. But also, too like you mentioned where you have these big drawdowns. So, we’re gonna do about one or two more questions and start to wind down, because we’ve had you for about an hour, and I don’t wanna take too long.
Gary, what sort of one piece of advice would you give? There’s a lot of people on this podcast that are probably saying, “Okay, I’m on board, I want a simple approach dual momentum makes sense to me.” What’s your one piece of advice for a kind of implementation so how they wanna to go about it actually putting this to work, whether it’s through how do you track it, or how do you stick to it? What’s your one kinda overarching theme or piece of advice?
Gary: Well, if they wanna do it themselves get my book there’s instructions in there. You don’t need to do any fancy calculations you can use a chart-based approach it takes about two minutes a month to check. And you’re only trading with the dual momentum approach I mentioned here. It’s an average of 1.3 trades per year. So most of the time you’re doing nothing.
Meb: And so, can they find the signals on your website or do you recommend a particular charting site like Stock Charts or YCharts is there any…where do you recommend that they go follow this?
Gary: Stock Charts is good because they include dividends, it’s total returns. A lot of charting packages don’t its only price information.
Meb: That’s a great piece of information, I think BigCharts was one that doesn’t include dividends and you’d see these huge moves down for investments at year end or when mutual funds would distribute cash. And there’s a lot of back testers out there, by the way, listeners that wouldn’t include stuff like delisted stocks or wouldn’t include distributions whether it’s through dividends and all this other stuff. So, buyer beware on that. All right last question, you may have to think about this one for a second. Over your career in history and involved the markets what is the most memorable trade? And this can be a winner, it can be a loser, it can be whatever it may be. Is there one that sticks out as the most memorable trade you’ve had?
Gary: Well, when I was managing money in options I thought I had something good going on. I was capturing premium and you know, I thought I had an edge because there were no data feeds out there I kind of built my own. I ordered a quote machine and I had an electrical engineer tear it apart and dump the data into a microprocessor and then into our minicomputer, and I’d have my own sophisticated pricing models, not the normal Black-Scholes stuff. So, I thought I have some, a little bit of an edge.
And you know, I’d been doing well I was able to not go out and find a job and managing money and attracting money, and I made the same mistake I guess Long Term Capital Management made. I didn’t consider omitted factors, such as the fact that some options could be overpriced for a reason, a very good reason, that wasn’t well known. So, one week we had short positions in two copper companies that were taken over at the same time. Which is you know, talk about tail events that’s about far out on the tail that you’re gonna get. And that effectively taught me that I should not be doing this anymore.
Meb: Yeah. So, by the way, mine was basically the same was involving options a strangle back in the day I’ve told that story before, so I’m not gonna repeat it here. Gary, it’s been awesome, it’s been a lot of fun, we’ve mentioned it a few times but where can people track you, follow your writing, tweeting, anything else if they want more information?
Gary: My website is optimalmomentum.com and my blog is dualmomentum.com.
Meb: And you’re on Twitter, what’s Twitter handle?
Gary: Twitter is my name.
Meb: Good, well there’s a few questions that we didn’t get to today so feel free to answer those, and people y’all can follow Gary on Twitter and see what he has to say about FX and all sorts of other questions we didn’t have time for today. Listeners, thanks for taking the time to listen today, we always welcome feedback and questions for the mailbag at firstname.lastname@example.org. As a reminder, you can always find the show notes Gary mentioned lots of papers and books and references here, we’ll try to link to as many of ’em as we can. For further research in the episodes at Mebfaber.com/podcast. Remember to subscribe to the show on iTunes if you’re enjoying the podcasts or hating them, please leave a review. Thanks for listening friends, and good investing.
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