Guest: Marty Bergin is the President and Owner of Dunn Capital Management. He oversees all mission-critical operations of the firm, including the firm’s research and development efforts as well as the construction and management of the firm’s managed futures portfolios.
Date Recorded: 2/22/19 | Run-Time: 56:30
Summary: Marty begins by going through his background, the history of Dunn Capital and the relationship he had with Bill Dunn, the founder of Dunn Capital. That relationship opened the door for Marty to ultimately work or Bill, and to later become the owner of the firm as part of a transition plan. Next, Meb asks Marty to describe trend following as it relates to Dunn. Marty describes that trend following is pretty basic, but there’s magic in how you develop a portfolio with the strategy. At Dunn, Marty and his team rely on an adaptive trend-following system. From a portfolio management perspective, they look for markets with enough volume to trade in 55 markets across commodities, currencies, interest rates, bonds, equities, and volatility with an equal allocation of risk buckets for each market they trade.
Meb follows that with a question about how it all fits together on a high level. Marty explains the program is not restricted in any way, and multiple methods are used for determining noise. He adds that when looking at possibilities, they are looking at a few days all the way out to a couple of years, and update weekly, yet he doesn’t believe there would be a major drift in performance if it were updated on a 12 or 18 month basis. The program gets into positions slowly, and is designed to get out quickly to protect downside.
The conversation then transitions into how the system has evolved over time. Marty walks through the core tweaks Dunn has undergone to adapt and improve the trading system, from looking at trading from a market-by-market basis, to applying the same techniques to every market, to taking a fresh approach to risk.
Meb then asks about what Dunn’s strategy looks like during various environments. Marty goes on to talk about how a trend follower is looking for directional volatility that is consistently applied, and the difficulty of environments like 2018 when trend followers can become overweight and get caught in corrections that can lead to aggressive reversals.
He follows that with some insight into thinking about the current environment through the lens of Dunn Capital, and talks about risk metrics setting up to look conducive for trend following. Meb and Marty wind down with a chat about how Dunn is very focused on education. They also touch on Dunn’s unique fee structure, and the place for a strategy like Dunn’s in investment portfolios.
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Links from the Episode:
- 0:50 – Welcome to Marty Bergin
- 1:20 – History of Dunn
- 3:57 – Marty’s career with Dunn
- 6:27 – What trend following means to Dunn
- 10:23 – Thinking about portfolios
- 12:48 – Trading time horizons
- 15:34 – Research and how Dunn’s strategy adapts
- 23:01 – Differentiation from other firms
- 24:31 – Concepts driving portfolios
- 26:05 – Most challenging environments for trend following
- 29:10 – Investment landscape 2019
- 30:50 – Common misconceptions about trend following
- 35:40 – Dunn’s fee structure
- 37:28 – How trend following fits into portfolios
- 41:28 – Reluctance to trend following
- 45:00 – Largest allocation an institution has been willing to make to trend following
- 48:11 – Why do most active managers fail? (Verdad)
- 49:18 – Restrictions with the 40 Act space and fees
- 52:07 – Resources for those interested in trend following
- 52:34 – Top Traders Unplugged
- 54:16 – Most memorable investment
- 55:55 – Best way to connect – DunnCapital.com
Transcript of Episode 144:
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.
Meb: Welcome podcast listeners. We’re winding down February. We have a very special show for you today. Our guest is the President and owner of one of the longest continually running trend following shops over 40 years old, Dunn Capital Management. He oversees mission-critical ops of the firm, including R&D efforts as well as ongoing construction and management of the firm’s managed futures portfolios. Welcome to the show, Marty Bergin.
Marty: Thank you very much. I’m gonna use that introduction on our website.
Meb: Yeah, well Marty, I’m super excited to have you. I mean, we talk obviously a lot about trend following and quant stuff on this podcast, but if you’re really gonna go back to the OG, the old school trend followers, Dunn is a name that’s been around if not the first, it’s one of the pioneers certainly. But a lot of our younger audience may not have heard of Dunn, one, being located in Florida and two, since you all been around so long, maybe give us a little history of the firm. I think it would be helpful for some context before we dive into all things trend following.
Marty: All right. Well, we were founded by William A. Dunn, who’s a PhD in physics. He was also in the military and he had gotten his degrees through the GI Bill. And he at the time was working in DC as a government contractor for the Defense Department. And that night he was looking at markets, kind of had the idea that there had to be a better way of making a living and working for the government as a contractor. And he first started applying trend concept to equities, but determined that the equity universe was so large that there was no way to crunch the data in a timely fashion to where he would be ready to trade the next day. So at the time, there was only, like, a dozen futures markets. They were all traded out of Chicago and he applied what he had developed to the futures markets and realized that it worked.
So the next issue was, “Where do I get capital?” And he ended up the better part of the year trying to raise money. He didn’t have any luck and his fellow employees, at the defense [inaudible 00:03:03] was working at, came to him and said, “Hey, if we all pool our money, do you have enough money to trade?” And that’s where Dunn got started. So he was originally working out of his basement in Northern Virginia, moved down to Florida because the weather, the East coast, and wanted to be close to the water. He knew that he could go anywhere he wanted to and he decided that Florida would be the best place. We’re on the east coast of Florida, right on the ocean in the inlet at the St. Lucie River.
Meb: I spent a lot of time in Land of lakes growing up as a child. I had some relatives there outside of Tampa learning how to water ski. They didn’t have wakeboarding back then really, knee boarding which is if you look back on it, like, the world’s worst sport, really painful. But now, I’m a wakesurfer, which is much more mellow and amazing. Listeners, if you haven’t tried it, it’s great. All right. Talk to me a little bit about where you come in. How did you get involved? How did you meet the firm?
Marty: So my background is I’m an accountant. And I was a CPA and I was working for an auditing firm in Northern Virginia. It just happened that the partner, the firm that I was with, was Bill’s next door neighbour when he developed algorithms that he used to trade. And so when he decided to set up Dunn Capital as an entity his next door neighbour, the accountant, helped him establish everything. From that time on, he was always the accountant for the company. When I got hired there, one of the first jobs that I went on as a junior auditor was to go down to Florida and audit the funds for Dunn Capital, and that’s where I met Bill and we hit it off.
I guess at some point Bill decided he wanted to add to his staff. His vice president of finance and I had a very good rapport. And they had talked to my firm about me coming to work for Dunn and they told him no. I guess they had their ideas for me. Once I became a partner in the firm, Bill approached me about coming to work down here and it didn’t take me long to make the decision to join Dunn and that was in 1997. So back then we only had 8, 10 employees, and everybody kind of had to roll up their sleeves and do everything. So I’ve worked the night shifts as a trader. I’ve worked day shifts as a trader. I was an accountant, fund accounting. I handled a lot of Bill’s personal things. Basically, had a hand in everything over the years.
And then nine years ago, Bill and I entered into an agreement where I bought the firm as he was phasing out as a part of our transition plan. At that time, we probably had 18 employees. We’re in the same number now. We fluctuate between 18 and 20. Five years into the plan… It was supposed to be a 10-year transition, which means we would have one more year left. Now, five years into it, he accelerated it. So I guess he was pretty happy with the trajection of everything. And I’ve been running the firm ever since. Bill is still around as a confidant, but he’s not active at all in the business.
Meb: Talk to me a little bit about trend following and what it means to Dunn, you know, so many different people. It’s like saying, value investing, and everybody’s got a different description of it. Talk to me a little bit about what trend following means to the culture and how Dunn thinks about it either philosophically, mathematically? Any way you wanna describe it.
Marty: Well, so trend following is pretty straightforward. It’s pretty big. The mathematical formulas that you do there in any textbook. Really, the magic around it is the way you develop a portfolio or you manage the risk and stuff. So in its simplest approach, trend following if the price is moving up you’re long and if the price is moving down you go short. The misnomer about it as the price continues to go long you continue to add to your positioning. So the more the price moves in your favour the more condensed you are that it’s gonna continue moving in your favour, which is also the downfall for trend following from time to time because you tend to really get loaded up in long trends and then when they reverse, if they reverse in a very aggressive manner, you take a lot of pain. So by definition, you have to be willing to accept those losses. So the idea behind it from a theory standpoint is you take a lot of small losses and you have fewer but much larger profits in trades.
I think what’s happened over the last year as you’ve seen some of these aggressive reversals that have really bitten the trend followers. So looking back at 2018, for example, we did a little study here in-house to figure out okay, trend following is nothing but time and noise, right? So you look back [inaudible 00:08:23] to see if the price is moving up or moving down. The noise is how much pain you’re willing to accept before you get out of your position. So a lot of times when you’re not doing well, it’s because you picked a bad time horizon or your noise component, you know, needed to be different. But we looked back over 2017 and ’18, and there are virtually very few, if any, time horizons or noise parameters that would have worked. So for a trend follower to make money in ’18 it would be virtually nil if they made any money. Most of them got hurt pretty badly.
And, you know, these are the type of market environments that happen from time to time. It’s nothing to be unexpected. We feel pretty good about our system because it’s adaptive. We move between time horizons that are working at the time. And it makes us feel pretty good. When you look back and you say, “Well, none of the time horizons would have worked.” So there’s nothing wrong with the system. You know, it’s just a matter of having markets coming around, which they always do. I can remember prior to 2008 financial crisis, everybody was talking about the death of trend following. And then, you know, during that financial crisis, the only investment strategy that basically did well at all was trend following strategies, managed futures. I’m not saying that we’re in that type of environment now, but I know when we talk to institutions, that is the biggest concern out there today is market corrections.
Meb: It’s funny. I love talking to the older school trend followers because they seem to despite how complicated is actual systems may be described, the actual big muscle movements of trend following in such a simplistic way, there may be a lot of dials to turn, but the simplicity of price moving up and down, it’s refreshing to hear. Talk to me a little bit more about how you guys put together the portfolio. As you mentioned a little bit about diversifying or selecting different time horizons. I’d love to hear some more about that. I’d love to hear a little bit about what sort of markets you guys trade around the world too.
Marty: Our approach may be a little different than what people think. And I think it’s a little different than the financial community views things because we’re very agnostic about what the market is. In other words, what’s it called and what sector it works in. We just look for any markets that have enough volume and volatility for us to trade. It has to be on a regulated market. It can be anywhere in the world. And we can’t be in a situation where there isn’t enough buy and being traded where we can’t get out of a position. We have to be able to trade at any given time.
So we’re not looking to develop the portfolio around a given sector. We don’t look at risk by sector. We look at risk as each individual contract has an equal amount of risk available for us to trade. And when we look at correlations we look at each market, in a correlation matrix against the whole portfolio. So we trade commodities, currencies, interest rates, bonds, equities, volatility. So we trade the VIX, the S&P, and the S&P options in the volatility portion.
Then the equities are all over the world from Asia, Hang Seng, all over Europe, the U.S., Australia. The same thing with the interest rates geographically worldwide. Currencies, we’re trading all the major currencies against the U.S. dollar. We do not trade the crosses because the funds denominated in U.S. dollar to it doesn’t make much sense to us that we trade the crosses. And then the commodities, we’re trading energies, metals, grains, meats, sugar, basically everything that’s available that’s commonly traded. And we trade 55 markets in total. As I said with the portfolio, it’s an equal allocation of risk buckets for each market we trade.
Meb: And you mentioned the time horizons. Is it something that you’d be comfortable saying, “Look, we’re a long-term trend follower,” or it’s something that you use multiple systems? Is it one single algorithm? How do you think about kind of putting it all together across those 50-plus markets?
Marty: Well, we do. We don’t restrict ourselves in any way. So when we’re looking at the possibilities, we look at everything from a few days to a number of years, and we run an update every week. Now, we’ve done studies on this and we could basically update it once a year, once every 18 months, and we still wouldn’t have any major drift in performance, but it’s just easy to do because in bottom we just do it every week. We update the parameter set, the parameter set being the time and the noise. We do use multiple methods for determining trends. So we might have a breakout methodology. We might have a momentum methodology. We have some methodologies where we smooth the data before we run the system. We have other ones where we run the system and then we smooth the parameters after we run the system.
And then the only other thing to do is we have developed an asset strategy, which unlike most people, it is not a stop loss strategy. So we may be getting out of a position before the position actually reverses price wise. And this is where I was talking about how you can get really loaded up in an extended trend, and that’s where you get a lot of pain. What we tend to do or what we’ve tried to do is we get into a position fairly slow, but we try to get out of that position quicker than what we would get into the position to protect us on the downside. And then the only other thing we do and we kind of look at some smaller components that are more geared to how we get in and get out of a position. So the system is absolutely trend following when you look at it from a holistic view. You would never look at it and say there’s anything else going on but trend following. But we do have these components that kind of tweak or entry points and our exit points sometimes. So that’s basically what I’m willing to divulge.
Meb: Good, good. Well, I wasn’t asking for the exact formula and as plenty of people have said in the past, you could probably print it in the newspaper and no one will follow it anyway.
Marty: That’s a quote from Bill Dunn.
Meb: Yeah, yeah.
Marty: Yeah. He said, “I’ll give you the code and you won’t have the guts to trade it.”
Meb: And it’s true. You know, so talk to me about look, you guys have been around for a while. And a lot of people I think have a couple different views around how quants adapt or build a system and how it changes over time. Can you talk a little bit about you’ve had a half dozen research people on staff, if not more, that are thinking about these markets over the years. Is the R&D impacting the portfolio? Are you making kind of consistent tweaks and changes? Is it something that you have structural changes where you’ve seen markets change in a way that you need to adapt? I’d love to hear how the kind of portfolio and thinking behind it has changed over the decades.
Marty: Well, you couldn’t say it better. I mean, it’s adapt or die. So if you look back at the people that were doing it in the ’70s, there’s a reason why there’s nobody else around because if you don’t adapt your systems and you don’t keep up with the technology that’s available to you, it’s not gonna continue to work. If we were trading what we initially had back in the 2000s or early 2000, we wouldn’t be here today. We would have lost enough money that our investors would have said, “Forget this. We’re moving on.”
So our first major tweak prior to 2006, we always looked at it as a market-by-market basis, and developed everything for each market and then kind of flood the portfolio together and then use lots of simulations to determine what the risk allocation would be to each market. 2006, we discovered or it was kind of I wouldn’t say discovered, it’s just common sense. People don’t care about what each individual market is doing. All that they care about is their portfolio.
So we started taking a more robust view of things and determining parameter sets and looking at every market as it fits into the portfolio as a whole. So now, when we’re doing our work, we look at the portfolio and we apply exactly the same technique to every single market. And the beauty of this is it makes the system much more robust. You’ve got more confidence that it’s gonna work in more market conditions, per se. So that was the big first change that came about in 2006. And then from there on we have continued… April of ’09, we added other algorithms to calculate trends so we became more diversified in that route. 2012, we developed the exit strategy I was telling you about and added that to the portfolio.
And the other thing to remember, these projects can take years to develop or sometimes it takes months. It just depends on the idea and how difficult it is to do it through the research process. And then while we do that we paper trade it to make sure all our operational facilities are set up to handle whatever it is we’re trying to do. And then we’ll open up a proprietary account and trade it with our own money because, you know, we don’t want our client’s money being used as a test vehicle. And once they’re comfortable with it and that trading in our proprietary accounts can go from several months to several years, depending on how the process goes. And then we implement it in our portfolio.
So when I talk about something that was [inaudible 00:19:12] in February 2012, I mean, that work may have started in 2010, 2011. This is an ongoing process. We’re always looking at things. And then the next major improvement was in January of 2013, where we took a different approach to risk. So most managers… Well, let’s take it a step back. Equity managers tend to target a performance or a return and they build their portfolio around what they think that performance will be. And they don’t really control the volatility of their portfolio. And it’s hard to control the volatility of a long-only equity portfolio because it’s driven really by a market environment whereas what we do is we look at our volatility on an ongoing basis and we actually look at the bar or the value at risk at any given point.
And historically, we had always traded with a very high bar in comparison to the industry, but it was what Bill was comfortable with, which was a 1% chance of losing 20% or more in a month, which, think about that for a minute. You open up your statement and the $100,000 that you invested is now only $80,000 and it’s the first month of your experience with us. Do you feel good about that? Probably not. So that’s always the way we’ve done it though historically. And we’ve lost more than 20%, 1.2% of the time, if you look at our track record from 1974 forward.
Well, in January 2013, we took a different approach. Instead of having a static target for risk we said, “Let’s adapt this for whatever the market environment is. If it’s 2017 or 2018, and the markets absolutely suck for trend following, then why do we wanna continually put on all these risk knowing or it looks like we’re not gonna make any money?” So we had a proprietary measure of the market conditions of how it matches up with our positioning. And in doing that we’ve come up with this thing that we call R for adaptive risk profile. And the way we size it now is 1 out of 20 days, we’re gonna be at a maximum risk level, which is this 1% chance of losing 20%. And the rest of the time we’re at some level less than that. And the key is it’s not risk on, risk off, where it’s a light switch and we’re switching, you know, oh, great. Today, it’s good environment. Switch the risk on and vice versa. It adjusts very gradually each day a few basis points.
But what it’s done our studies had showed it would reduce the downside volatility about 25%, reduce drawdowns which is a key from an investor perspective by 25%, and what we’ve seen in action because we’ve get plenty of data, is that it’s done exactly what we expected. And then the only other thing we introduced was we introduced the VIX trading index in February 2016. We did that because it’s completely uncorrelated to trend following, and it’s a huge market. And we thought it had to help the performance of the [inaudible 00:22:38] strategy. When we originally thought about bringing it on board we wanted to do it with trend following, but you cannot trend follow the VIX. The type of market and what it’s based off doesn’t really allow trend following, unless you wanted to do it over a very short term. And what we found is trading costs will just eat up short-term trend following type of programs.
Meb: Would you consider VIX to be one of the more, you know, because you look at a lot of trend followers and the broad brushstrokes often are fairly similar as far as markets traded. As you look at your portfolio, what are the more differentiated markets that most other trend followers don’t allocate that you guys possibly do? Is it VIX? I know some do single stock futures, some do carbon, some new crypto. Anything stick out?
Marty: We really only look at the large trend followers because we consider that’s our target audience is the, you know, the people that are investing with Winton, or CFM, or some of the other big houses that have accumulated lots of assets. And I think the biggest thing that differentiates us from them is the commodities because they just can’t trade the size and the commodities. They all talk about that they still include commodities, but they can’t trade them on the markets.
And if they’re trading them with any size, they have to be using over-the-counter swaps, which if you’re in a position that moves against you, it becomes very difficult to get out of that position if you’re in a swap with a bank. Trust me, the bank’s not gonna lose money on that swap. So I think that’s the biggest thing that differentiates us. The other thing is yeah, the VIX. I don’t think there’s very many trend followers that trade in VIX. And we can pull that out of a portfolio, if we have a client that wants a true trend following system without the exposure.
Meb: As you think about the portfolio, there are kind of two questions here and then I’m gonna kind of shift over to some more allocation type of topics. Would you say that most of your or all of your portfolio construction algos are price only? And I guess volatility would be a derivative of that, but have you guys ever considered adding any other concepts, whether it be fundamental or any other sort of indicators or inputs into the models or strategies?
Marty: So from the beginning it’s always been price data. I can say we’ve looked real hard at volatility and we do look at some other things. When I was talking about these methodologies we used to tweak entries and exit points, we have developed some things where we’re looking at open entrance, where we’re looking at term structure, where we’re looking at yields. There are other concepts that we have applied, but it’s all systematic.
So we’re pulling data from sources that all goes into the algorithm and makes the decision of what is the number of contracts that we wanna hold on at any given day per million dollars that we have to invest. And it’s not a black box. I mean, I always hear this, you know, idea that it’s a black box and everything we do can be calculated with a pen and paper. It’s just that it would take you several days to do all the calculations and the chances are you would also make a mistake somewhere along way, which is why the computers are so valuable to us.
Meb: As you talk a little bit about the historical context. I know you mentioned 2017, 2018, a lot of listeners should be familiar with trend following, but for those that aren’t, and this may be a little basic, but what environments are most challenging? I know every trend follower’s nightmare phrase of the whipsaw comes to mind. But talk a little bit about what environments does this sort of strategy work best? When is it really gonna struggle? And along those lines, are there any common misconceptions people have about the strategy in general?
Marty: Yeah, that’s an easy one. Let’s look back at last year as an example. So after 2008, everybody kind of considered trend following as this hedge against equity corrections, per se. And historically, when equities have gotten hammered, trend following has always done well. And then comes February 2018, and what happens? I don’t know the exact number, but let’s say the S&P is running a sharp ratio above 1.5 for, you know, the last 5 years prior to this.
It just keeps moving up and it’s in a straight line. It’s just constant and you constantly look at how much money people have made in equity over this period of time. Well, where do you think trend followers are gonna be positioned? In that environment, you’re long equities. You’re not only long equities, but you’re as long as you can be on equities. Your strengths are as high as they’ve ever been. And this is gonna be true for every trend follower out there. I mean, there’s no way around it.
And then in that environment, there’s also not many opportunities in any other market. So your exposure is very high to equities. February comes around. You have this huge correction. Every trend follower gets hammered. And that’s exactly the kind of environment that hurts. It’s not just a reversal, but an aggressive reversal that’s violent and painful and, you know, you pay the price for that. And not only do you get hurt from a performance point of view, but then your strengths and your positioning and also you end up selling into that, which makes it even more painful.
And then when the market bounces back like it did throughout ’18, you don’t get to partake in that because you’ve gotten out of your positions. So that’s the perfect storm and that describes exactly the worst case scenario from a trend follower’s standpoint. What a trend follower’s looking for is directional volatility that is consistently applied. So we had that event in February. We had another event similar to that in October. And it’s very unusual that you see multiple events of that type in the course of one year. So, you know, that’s really the answer to ’18.
Meb: And so as we roll into ’19, to the extent you’re comfortable talking about it, how does the world look today? Are there a lot of trends that are established or have you seen some that are just starting to take shape or is it a bit muddled?
Marty: Yeah, I’d say muddled because I’m not gonna try to predict the future, nor can anybody. And people that get on your show or any show and start talking about what’s gonna happen in the next 12 months, they’re basically lying because they have no idea. I can tell you that our risk, as calculated by the ARP, has been creeping up over the last month, which means the market environment is more conducive for trends. January wasn’t particularly good, but December was. So we may be in one of these transitional periods where you’re starting to see the trends come back into the marketplace. But I have no way of knowing that that’s true or not.
Meb: It sounds familiar to the response we usually give clients and friends when they ask me about a particular market. And I say, “You know, I’m gonna caveat this by saying that we’re systematic and rules-based. So nothing I’m about to say would actually have any influence or impact on our portfolios. And it’s really just gossip. Do you still wanna know what I have to hear?” And they, of course, 100% of time say “Yes, absolutely. What do you think gold is doing?” And so then I can just gossip and have a beer and talk about it, but it’s always funny. People want the crystal ball and want to forecast. That certainly never changes about human nature for sure.
Marty: Oh, absolutely.
Meb: As far as common misconceptions, you guys have had a lot of discussions with clients, individual, institutional, big and small over the past four decades despite having compounded one of the best, longest-term track records, not just in trend following, but also in the investment management industry. What’s something that you guys hear that you feel like either people don’t get or you wish they had a better understanding about kind of [inaudible 00:31:18] portfolios and trend following in general?
Marty: So we’re very predicated on education. So why am I doing this with you today? It’s to try to reach out to people to educate them about trend following in general, managed futures space, the idea to diversify in revenue streams. So I don’t run into problems with our investors. Our investors are great people. I love these guys because they understand what they’re getting involved in. And one of the things that we do here, which I doubt many firms do, but if you invest directly with us, they have to have a conversation with me before we will actually accept the investment at which time, you know, it’s just like this conversation here where I’m gonna tell them how they’re gonna lose their money, what environment you’re gonna lose in and what the size of the losses can be so there’s no unexpected behaviour that happens and people understand why they’re investing in it. If they understand why, then they can accept the down periods knowing that the opportunity is still there to make a lot of money.
And then historically, let’s say you put $1,000 with us in 1984, which was when the W-made strategy has been trading since. You would have made 58 almost 59 times your money today. If you did that in S&P, you’d make 36 times your money. If you did that with just another trend follower, you know, the Barclay CTA index, let’s say, you’d be up 10 times your money. So, I mean, you’re right. Our track record is very impressive. And we can live off of that, but it’s more than just that. You have to educate investors on what the expectation is. Why are they investing in this? Everybody who has an investment portfolio should have an allocation in managed futures. I mean, it just boggles my mind that people aren’t putting money in this space.
And we had a bad year last year and the one thing I’m really proud of is the fact that we haven’t lost a lot of money. I mean, people are continuing to add to their balances/ We’re getting new investors every day. And that’s pretty hard for somebody to pull the trigger when there is a manager that just lost 19% the prior year. But it is the right thing to do because our performance from a drawdown period are amazing. And that’s to be expected. We wouldn’t be here today if it wasn’t, right? At some point somebody gets a drawdown that they don’t recover from and then they go out of business. But we recovered from everything. So by definition our performance has to be pretty good after drawdowns.
Meb: Well, it’s funny that you mention that because, you know, reviewing long-term performance, you notice and it’s pretty amazing to note that the funds first year in operation was down, I think… The first full year in operation had a negative 20% year. In 2018, 99% of hedge funds have minus 20% first year. They closed up shop, go find another job, or just start a new fund and reset the high watermark because a lot of funds are just unwilling to sit through that that pain of being able to compound and make up that money plus people will just not allocate to them. But it’s an amazing testament to the strategy and fortitude of the PM to be able to sit through that first year. Not a lot of fund track records you see have that sort of beginnings.
Marty: Right, but that’s all driven by the man, right, by Bill Dunn. And, you know, that’s the character that the firm has adopted, and that’s something we continue to live by, what he showed us, the way he handled the process, the systematic nature of it always being scientific. Like, we never just assume that anything that people are telling us or what we read in the paper or what we read in a textbook, even software that you might buy off the shelf. And we do everything in-house because we don’t just assume that people are doing things right. And I think that’s the key to why we’ve been around forever.
Meb: And that’s a interesting segue too to also the…you guys have a fairly…at least the standard. I don’t know if it’s all of them, but it’s a fairly atypical fee structure. Could you talk a little bit about that?
Marty: Yeah. So Bill always believed that he wanted to be treated as he would wanna be treated. He wanted us to treat his investors the same way that he would expect to be treated as an investor. And we always wanted to be on the same side of the table. So we don’t charge a management fee. So there is no asset-based fee that people have to pay us. And our expenses in our funds are extremely low because the only thing that we went to there’s direct required expense, like the audit fee. There’s some registration fees, and that’s basically it.
There’s some legal costs in there, but it’s all small. So we’re talking about an expense ratio that are less than 10 basis points. I mean, it’s just small. The interest…even during the bad times when we were hardly earning any interest still outweighs the expense for the most part. Now, it absolutely does. We’re all incentive fee-based and it’s always to a new high. So the investor comes to us with $100,000 in our fund. If we make money the first month out, they pay us a fee. But if they lose money in the next month, we have to make back those losses before we get paid a fee again.
Meb: That’s a pretty rare business model, but one that is hard to argue against that it’s a nice alignment with interests with clients, for sure. You don’t see that too much.
Marty: Everybody loves paying a fee. There’s never an argument. So it makes all of us happy. We’re happy. They’re happy.
Meb: Yeah. You alluded to this a little bit about… And this is a topic that’s been pretty near and dear to my heart, but also a frustration. Talk to me a little bit about how managed futures or trend following fits into a traditional portfolio. And, you know, you mentioned that almost everyone should have some. How do you guys think about it? How do you talk to or educate institutions, individuals, about how they put it all together and how to incorporate it for those investors listening whether an individual or institutional? How should they think about folding it into a more traditional portfolio?
Marty: Well, so the biggest aspect of it is it’s completely uncorrelated to any other investment class. So if you take that to heart, what does that mean? That means that an allocation to manage futures can actually reduce your overall portfolio volatility at the same time as increasing the overall return. So but who wouldn’t like that? I mean, you decrease the risk, increase the return. And even if the return doesn’t increase because let’s say we’re in a bad period, your risk adjusted returns has still increased because the overall volatility of your portfolio has gone down.
But more importantly than that, go back and look at environments of stress. And I always go back to the 2008 credit crisis because that’s the most recent one. I can remember prior to that from 2002 through 2007, everybody was allocating the hedge funds because they wanted diversity in their portfolio. And you had people going to the equity long short technology, emerging markets, event driven, distressed securities, merger arbitrage. I mean, all these things became something that people wanted to allocate to diversify their portfolio and increase their risk adjusted returns and that was the talk.
And the financial crisis comes along and what happens? Every one of those supposed diversifiers all became correlated to long only equities. They all looked identical, they all lost a lot of money, and the only things that didn’t were CTAs and global macro. And if you go back and look today at those hedge funds and that type of environment, they’re even more correlated now than they were prior to the financial crisis, except for managed futures, which is still highly uncorrelated. So I think that’s the biggest thing.
The other thing is people always ask me, “Well, how much should I allocate to it?” And if you just run numbers, we always talk about allocating risk, not allocating AUM, because risk is really the key aspect. Historically, our risks tend to be a little higher than the S&P’s so you can get the same bang for your buck with an allocation to us. And say you allocate 10% of your AUM. It might be actually 13% to 15% of your risk, if that makes any sense.
Meb: It does. And so what do you think is the biggest, you know, because we’ve been saying for a long time, we go to a lot of conferences and a big buzzword this day and age is evidence-based investing. And I said this at a conference a few years ago. I said, “Everyone in the room,” I said, “If you close your eyes and you put a number of historical returns streams into an optimizer and included managed futures, and we’re honest about it, often the optimizer is going to spit out something, like, 50% of the portfolio should be in managed futures or trend following.”
Marty: I mean, you said that because I was just getting ready to say that if you ask me, I think the managed futures should be the basis of your portfolio and then everything else should be built around it.
Meb: What do you think is the biggest reluctance or reticence of why that realization or that understanding hasn’t caught on or percolated across asset management industry? Why do you think it’s been a not commonly-held belief?
Marty: Because I think futures in general has always had a bad connotation over the years. It’s a derivative product. It provides additional leverage so people get the idea that you’re actually borrowing to apply the leverage but you’re not. I mean, it’s a built-in leverage. So for instance, if we build out a portfolio, we’re only using about 20% of the cash to put the futures on positions. The rest of the money is sitting in cash. So 80% of the money in our funds, on average, is going to a cash manager to be managed. And it only requires the margin requirements to do the futures [inaudible 00:42:29]. So you’ve got that inherent idea that this is very risky, and people aren’t necessarily comfortable with it.
But the offset is this. If you look at a long only equity portfolio, and let’s say they divide it up between 100 different equities and people think, “Wow. I’m really diversified. I’m across all these equities,” not one of them has more than 8% of the portfolio. Well, they’re all long and they’re only gonna be long. They’re all equities and they’re only going to be equities. Period. Now, yeah, maybe those businesses are global, but trust me, it’s a small world out there. Our portfolio could be long, It could be short. We’re in grains. We’re in meat. We’re in energies. We’re in gold, silver. We’re in equities. We’re in bonds. We’re in interest rates. We’re in currencies on every geographical location in the world, long and short. You’re not gonna get more diversified than that I would state. The only thing that’s left out of there is probably real estate and I don’t know, maybe private equity investments.
Meb: There was briefly some real estate or housing futures, but that didn’t last very long. You know, it’s funny, you mentioned…there’s two comments I wanna make on some of the things you said that I think are very accurate because we hear a lot of the same objections. The leverage one is always humorous to me because I tell people I say, “You know that stocks, one, are inherently leveraged. They have debt on their books. Every company, the debt to equity ratio is not zero.” And so you have leveraged when you buy stocks, you certainly have leveraged when you buy [inaudible 00:44:11] or your house. Most people don’t have a fully paid off house so you essentially have leverage.
And the futures one is probably just if we could go back in time 30, 40 years, we should have hired a branding expert instead of calling this managed futures. We could have called it a trend following index or something like that because, you know, the guys that did market cap waiting on stocks and John Bogle is now RIP and I think he’s a national treasure. But the branding of passive indexing applied to stocks is literally a trend following methodology where you invest more as price goes up, less as price goes down. And that has been pervasive across the industry, but as applied to a global portfolio in long short, I think if we could go back and call it something like passive trend following indexing, we’d both be in a trillion-dollar industry.
And this is the question I love asking people because it just makes me shake my head. Probably excluding the individuals, because there’s more outliers there, of the institutions you guys have talked to over the years, what’s been the largest allocation that institutions that you’ve ever heard of willing to allocate to kind of the managed futures trend following allocation? I don’t know that I’ve ever heard of any that’s allocated more than, say, 15%. I’m talking pension funds, sovereign funds, endowments, anything in corporate funds. Have you ever heard of any that have a pretty outsized allocation?
Marty: You know, there are some sovereign wealth funds that have been very aggressive in the space especially early on because they were really the only people that did allocate to this space from an institutional point of view. But there is no way for me to know what percentage of their total investment allocation is because they’re not gonna disclose. The people I’m talking about, there’s estimates all over the world about what their investable assets are, but they’re not confirming any of them. I do know that they will allocate billions of dollars to individual managers.
Meb: Well, it’s funny because, you know, I think we’re probably the biggest outlier that I ever talked to that’s not a pure managed futures shop because we allocate roughly half to traditional trend following strategies. And I think the biggest reason why most don’t it’s not… You know, if you talk to people honestly, and you pull them aside and you’re having coffee, or a beer, or something, they may admit that they think that they should have more, but it’s a lot of career risk wrapped in that I think for people, particularly investment advisors, and brokers, and institutions. You know, if you have a 30% or 50% allocation to managed futures and you do very poorly, then you get shown the door, but if you have global 60/40, you basically cannot ever get fired, no matter what.
Marty: That’s exactly right. And so let’s take it a step farther. Those people who are willing to allocate the managed features because of the career risk, they’re only willing to invest with the big houses. And the thing that I find concerning is the bigger players in this industry are really collecting management fees. They’re not motivated by making money. So if you can get your institution not only to take 20% to managed futures, which would be huge. That would be amazing. The chances are, you’re allocating to a manager that’s never gonna make you a lot of money. So it doesn’t move the dial and in the end, the institution thinks it’s a waste. And it probably is a waste because unless you’re willing to get the risk of exposure that you need, it doesn’t make any sense.
Meb: Well, and on top of that, a big thing you mentioned earlier is that, particularly if you get to 10, 20, 50 billion, you can’t trade a lot of the markets that are arguably less efficient. And same thing with equities. A friend had a good post the other day about the capacity constraints of traditional value strategies. And they said, “If you look at a lot of historical studies with French [inaudible 00:48:19] stuff, with price to book, or whatever it may be, and you look at actually the portfolio size where all the alpha came from, and the bottom two deciles of the cheap stuff, you hit your head on the ceiling as being a manager at a very, very low amount of AUM.”
But you see these value funds that are 10, 20 billion and you say, “That’s, you know, if you’re being intellectually honest, that’s nothing more than a closet indexer and you have zero chance of ever generating alpha. The mathematics don’t work out.” You can invest in the companies that gives you the potential and same thing in I think in probably trend following where a lot of the markets that are probably less efficient you just can’t participate because you’re too big.
Marty: It’s too little capacity for the money that wants to find the space. It’s like the tech boom back in early 2000s, or in the 90s, or maybe the pot space today where there’s only so many companies that are doing these things, and there’s so much money chasing it.
Meb: Frustrating. Well, I’d love to keep you all day. As we start to wind down, anything that we didn’t chat about today, topics about trend, about allocation that you think is particularly important or the investors that may not be that familiar with this world think about or anything else that is on your mind?
Marty: I think the only other thing that I’m gonna gripe about the space in general maybe, or maybe the investment community in general, is the idea that the 40X space hasn’t become more populated with managed futures type products. And some of the restrictions that are incurred in the 40X space related to fees, so it used to be in a big negative where people would talk about, you know, trend followers and they tend to hide their fees. They’re charging these incentive fees but they’re not reporting them on their disclosure documents.
We weren’t allowed to because you can’t have an incentive fee in a 40X space. So you have to use it do it through a swap vehicle. But it just blows my mind that the regulator doesn’t think that it’s a good idea for an investor only to pay based on performance. I mean, if I wanted to launch of 40X fund, I could not do it with a zero management fee and incentive fee only. And that just seems crazy to me. And the other thing that bothers me about it is you aren’t allowing the small investor to have access to managed features, which is the best way in the world that they could diversify their portfolio. The regulators consider it too complicated or too risky to allow it to be available to that investor class.
Meb: We had considered doing an ETF for a long time. But the struggle was that as far as exposure and how you structure portfolio is challenging, because it ends up as a very low volatility watered down version of a traditional strategy, which if you’re allocating towards a traditional portfolio isn’t that helpful. And it’s funny you mentioned that about the performance fee because they actually allow a…I forget what it’s called.
Marty: Fulcrum fee?
Meb: A fulcrum fee, thank you, which makes absolutely no sense because if a fund outperforms in say 2018, then you can raise your management fee, which again makes no sense because now you’re raising the management fee for future shareholders not prior shareholders investors and vice versa. But they allow that, which is crazy.
Marty: Yeah, I mean, it makes no sense at all. And even in the fulcrum fee, you can’t lower the fee it has to be proportional, the increase to the decrease, but you can’t decrease it below zero. It’s just mind boggling.
Meb: Yeah, it’s unfortunate, but that’s the structure and you gotta work with it unfortunately. As you think about investors that are interested in this world, what would you say are some good resources for those that wanna get up to speed? It could be websites. It could be books. It could be conferences. It could be podcasts. Anything you can think of that you think is a good resource for both individuals or institutions that really wanna get first and in our world.
Marty: Well, we really like, like “Traders Unplugged.” We do a number of things that you can go to our website and we have a number of programs that are done. Neil Larson is affiliated with us in Europe and he’s doing all kinds of things similar to what you’re doing. The one that comes up the most from an investor standpoint from a books is Michael Covel’s “Trend Following” book. You would be surprised at the number of people that call us to invest with us, and when I ask them where they found out about us, they talk about this book they read three or four years ago. And that’s where they first got introduced to Dunn Capital and Bill Dunn.
Meb: Yeah, Michael’s got a great pod…I mean, I think he’s over something like 500 podcasts at this point. So he’s one of the old school as far as podcast hosts. It’s become very popular and recently, but man, he’s been around. He was somewhere floating around Asia I think last time.
Marty: You wanna hear what a small world it is?
Marty: So he came walking into our office at Dunn Capital one time to talk to Bill about something unannounced. It turns out I coached him when he was 13 years old in baseball.
Meb: No way. What are the chances?
Marty: It might have been 16. It’s either 13 or 16. But yeah.
Meb: How was he? Was he a decent player or was he at the end of the bench?
Marty: Are you kidding? He was a catcher. You know, he was a team leader for sure.
Meb: I would have pegged him for a third or first baseman. I wouldn’t have pick him a catcher. Wow.
Marty: He was a catcher.
Meb: That’s funny.
Marty: He was definitely a team leader.
Meb: That’s awesome. That’s a great way to start to end the podcast. We always ask people the following question. As you look back on your career, and this could be personal, this could be prior to Dunn, this could Dunn, this could be anything imaginable, but we always like to ask people what their most memorable investment or trade was? It could be a big winner, it could be a big loser, or it could be neither. It could just be something that sticks in your head. Anything come to mind?
Marty: Yeah, I’ll give you one. It’s not a trade particularly because, you know, it’s systematic. So I don’t take credit for any of the trades we make. But there’s an event in my life that sticks forward and has to do with me being at Dunn, a conversation between Bill and I. So when Bill approached me about joining Dunn, you have to remember I was a partner in a CPA firm. So I had just been a partner for a year. And he said, “Look, I’d like to hire one of your people.”
And I said, “Well, that would be great. You know, I’d love it if one of my guys is working for you.” He said, “Well, I really was thinking about hiring you.” My comment to him was, “Well, I got a pretty good thing going here. I’m a partner in Virginia. I’m close to home. My family’s here. I like it.” And his comment was, “Well, that’s okay. I’m not even sure you could really handle it.”
Meb: That’s a great psychological trick right there.
Marty: Yep. And then, you know, he told me he wanted me to come down and meet everybody. I said, “Bill, I’ve been down there two times a year for the last seven years. I think I know everybody.” “Well, just come down anyhow.” It took me about two seconds to say yes. So the rest is history.
Meb: Awesome. I love it, Marty. Where can people find more information if they wanna track what you guys are up to? Where’s the best place?
Marty: Just search us at dunncapital.com.
Meb: Easy enough. Marty, it’s been a blast. Thanks so much for joining us today.
Marty: All right. Thank you.
Meb: Listeners, we’ll add show notes, links, everything we talked about today, to mebfaber.com/podcast. You can shoot us any comments, questions, input, email@example.com. You can subscribe to the show on iTunes as well as any of the podcast apps, Overcast, Stitcher, Breaker, Radio Public, any of those are great. Thanks for listening, friends and good investing.