Episode #317: Chris Cole, Artemis Capital Management, “You Want To Diversify Based On How Assets Perform In Different Market Regimes”
Guest: Christopher R. Cole, CFA, is the Founder & CIO of Artemis Capital Management LP. Mr. Cole’s core focus is systematic, quantitative, and behavioral based trading of volatility and derivatives. His decision to form a fund came after achieving significant proprietary returns during the 2008 financial crash trading volatility futures and options (verified by independent auditor).
Date Recorded: 5/12/2021 | Run-Time: 52:05
Summary: In today’s episode, we cover the optimal portfolio to help you grow and protect your wealth for the next 100 years. Chris shares why recency bias has led investors to be poorly positioned for secular change. We cover the issues with the 60/40 portfolio and then walk through the five asset classes that he believes belong in your portfolio at all times. Then Chris explains how investors should think about diversification, and his new metric to help you do so. And of course, we talk some long volatility!
Click here to see some slides our guest put together for today’s episode.
Sponsor: AcreTrader– AcreTrader is an investment platform that makes it simple to own shares of farmland and earn passive income, and you can start investing in just minutes online. AcreTrader provides access, transparency, and liquidity to investors, while handling all aspects of administration and property management so that you can sit back and watch your investment grow. If you’re interested in a deeper understanding, and for more information on how to become a farmland investor through their platform, please visit acretrader.com/meb.
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Interested in sponsoring an episode? Email Justin at jb@cambriainvestments.com
Links from the Episode:
- 0:40 – Sponsor: AcreTrader
- 1:32 – Intro
- 2:34 – Welcome to our guest, Chris Cole
- 2:43 – The Meb Faber Show Episode #134: Chris Cole, Artemis Capital Management, “Volatility Is The Instrument That Makes Us Face Truth”
- 4:06 – Artemis’ expansion over the last year
- 5:30 – The Allegory of the Hawk and Serpent (Cole)
- 6:47– The foundation of the Dragon Portfolio
- 8:51 – How market cycles shape our view of the world
- 10:59 – Testing a buy the dip strategy
- 12:06 – Major systemic risk caused by recency bias
- 15:50 – Construction of the average 60/40 portfolio
- 16:59 – Constructing a portfolio to last 100 years
- 19:10 – Five core market regime diversifiers
- 20:36 – 2020 as a sample test of the market regime balanced portfolio
- 21:45 – Rise of the Dragon (Cole)
- 21:46 – Benefits of a market regime balanced portfolio versus a traditional portfolio
- 24:12 – The difficulty with constructing a 100-year portfolio
- 25:29 – Issues with relying on fixed income as a hedge
- 26:41 – Testing classic portfolio strategies
- 29:29 – How most active strategies are shorting volatility
- 31:23 – Separating true diversifiers from risk enhancers
- 33:29 – Modern asset management as an impending Greek tragedy
- 40:33 – Taking a long-term view on diversification
- 42:04 – The social aspect of asset management
- 44:10 – Major problems with using the Sharpe Ratio to choose investments
- 47:50 – Artemis’ new alternative to the Sharpe ratio
- 52:46 – Average hedge fund CWARP results
- 53:52 – Artemis’ findings on the biggest diversifiers to a traditional portfolio
- 54:37 – XIV as a case study on CWARP versus Sharpe ratio usefulness
- 59:20 – Factoring in opportunity cost and liquidity
- 1:02:06 – Chris’ approach to the 100 year-portfolio paper
- 1:04:59 – Criticisms to the Dragon Portfolio
- 1:11:06 – The right way to use these diversifiers
- 1:13:35 – Why a disciplined approach is vital
- 1:15:10 – Codifying your investment strategy
- 1:18:33 – Chris Cole’s research papers
- 1:20:45 – Artemis Capital Management; Chris Cole on Twitter
Transcript of Episode 317:
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 Message: Today’s episode is sponsored by AcreTrader. I personally invested on AcreTrader and I can say it is a very easy way to access one of my favorite investment asset classes, farmland. AcreTrader is investment platform that makes it simple to own shares of farmland and earn passive income. And you can start investing in just minutes online. AcreTrader provides access, transparency, and liquidity to investors, while handling all aspects of administration and property management so you can sit back and watch your investment grow. We recently had the founder of the company, Carter Malloy back on the podcast for a second time in Episode 312. Make sure you check out that great conversation. And if you’re interested in deeper understanding, for more information on how to become a farmland investor through their platform, please visit acretrader.com/meb. And now back to our great episode.
What’s up my friends? We have a killer show for you today. Our guest is the founder and chief investment officer of Artemis Capital Management, which aims to transform market volatility into opportunities for clients. In today’s episode, our guest shares why recency bias has led investors to be poorly positioned for secular change. We cover the issues with the traditional 60/40 portfolio, and then walk through the five asset classes and strategies our guest believes belong in your portfolio at all times. We cover one of my favorite research pieces of the past few years, a paper our guests authored prior to the pandemic. And we see how it did during the pandemic, as well as talk about the optimal portfolio to help you grow and protect your wealth for the next 100 years. Then, our guest shares how investors should think about diversification and talks about his new metric to help them do so. And of course, we talk about volatility. Be sure to check out the show notes to see some slides our guests specifically put together for today’s show. Please, enjoy this episode with Artemis Capital Management’s Chris Cole. Chris, welcome back to the show.
Chris: It’s great to be back. It’s been too long, so it’s really great to be back on your show.
Meb: It has been, man. Last time, listeners, we had you on, go take it for a spin, Episode 134 at the end of 2018. Where do we find you? You still in Austin?
Chris: Still in Austin, Texas right behind us. Every time I look out this window seems like another skyscraper comes on up.
Meb: I need to make it to Austin along with the rest of the Californians and I think you’re probably between you guys in Miami just getting the deluge of VCs and everyone else into town, but to come visit, what is the best two months to come to Austin?
Chris: I think in the spring or the fall. But please, you’re welcome to come anytime in the summer if you want, I would not recommend it given the heat.
Meb: So, like April, May, September, October?
Chris: Yeah, that’s right. Absolutely. Or even the wintertime is quite nice, actually.
Meb: All right. Listeners, I’ll book a trip. We’ll definitely do a meet up if that sort of thing is happening this day and age and Chris said before the show, he’ll pay for all the beers and snacks. So, you heard it here first. All right, man. Well, last two years, not much has gone on, right? It just been kind of smooth sailing and markets and everything else?
Last time, we were talking about volatility, which no one really seemed to care about and tail events and long vol and then, sure enough, my goodness, we turn the page on a decade and wham, what’s been going on? Walk us through kind of last couple years in Artemis and Cole’s world.
Chris: What’s been amazing is I like to say this, the last 12 months or 2020 was essentially an entire business cycle condensed into one year. I mean, boy, obviously we know about the March crisis, the COVID crisis, which really started before March because we had the big sell-off in markets, the reflation and equity markets, the Fiat devaluation and now we’re kind of in a stagflation. I mean, today with the inflation print that is at the highest level since 2007, fascinating. But Artemis has been doing great. We’ve been standing our firm out here in Austin, Texas. We’ve held true to our legacy long vol roots.
Meb: Good. Let’s dig into that. Last time we talked, you had so many great nuggets, quotable pieces, volatility, being the only asset class and then fast forward, you arguably wrote my favorite piece, that was 2019. I remember sitting down at my local coffee shop, Phil’s and printing out, I killed like six trees, your piece and Raoul Pal had a piece out, too, and had intended to be there for like 30 minutes, ended up being there for like two hours. But listeners, if we don’t get deep into dragon or parts of this, we can do that. Then you put out another one, which probably was, even more encompassing called the 100-year portfolio. Do you want to give us overview?
Chris: First of all, I really love Raoul’s piece as well. I sat down pre-COVID and devoured that one as well. The paper I wrote over a year ago, “The Allegory of the Hawk and the Serpent” that introduced the concept of this Dragon Portfolio, and that’s the nickname that we use for it. I really wanted to look at and say, okay, the last 40 years has been this highly unusual period of time, it’s actually been one of the most incredible periods of growth for bonds and stocks. In fact, this is amazing stat. Ninety-one percent of the performance of a stock-bond portfolio, over the last 100 years has come from just the period between 1982 and 2007. Everyone that we know, every financial advisor, every person who has experience in markets has existed in this highly unique cycle, that truly is unique. If you look at any range of history, of financial history, where stocks and bonds have been going up together at an incredible pace. I mean, that obviously has been spurred on by numerous factors, this kind of pro reflexive virtuous cycle between lower interest rates, which peaked 17% in the early ’80s, that have dropped all the way down to zero. Demographic boom, with baby boomers coming into the workforce, lower taxation, deregulation, globalization, all these things have been very helpful for asset prices, both stocks and bonds. But now we’ve reached the end of that. And it’s important to understand exactly how anomalous that is. And in this paper, we actually show some graphs that I think are just quite shocking to anyone who has an opportunity to look at them.
I posed this question to myself, if you had to have a portfolio, and you could rebalance it, but you had to have a portfolio for the next 100 years, and your children’s children depended on this portfolio, what portfolio, what collection of strategies and assets would you want to employ? I started quite honestly with this question. And to figure out an answer, what I did is I immediately said, okay, most of the backtested history, we have all these quants strategies, they really start, if you’re lucky, in the ’80s. Most of it starts in the ’90s or later. I said, okay, I’m going to go back, I’m going to backtest every conceivable financial engineering strategy, portfolio strategy, and even option strategies. I can get into that a little bit because the options market didn’t really exist prior to the 1980s. Using justifiable metrics and assumptions, backtest this using data from the global financial database, and look, how did risk parity perform in the ’30s and ’70s? How would a rolling call overwriting strategy perform? How would rolling put strategy perform? How does a 60/40 portfolio perform?
And I looked at this with the intention of actually finding the optimal mix of assets that can perform through every market cycle. And that’s how I came to this determination of this unique portfolio, which we call the Dragon Portfolio. And the reason why I love these allegories, the paper was called “The Allegory of the Hawk and Serpent” because a serpent represents this pro-cyclical growth phase. That’s kind of what we’ve been through the last 40 years for stocks and bonds do very well in accumulation of debt. A hawk represents a period of secular change. And that change is where debt is wiped out, either through stagflation or deflation. Well, a dragon is a combination between a hawk and a serpent. That’s a dragon. And what I mean by that is, it’s a strategy and a framework that performs every market cycle. Obviously, we can get into that a little bit more, but I wrote the paper prior to the COVID crisis. And the COVID crisis actually was this incredible testing ground for the theory.
Meb: It’s like the most immediate out of sample test ever. It’s like here you go, boom, 2020. I love your pieces, not just because of the graphics and drawings, you have some of the best subject line titles for the various paragraphs. I was smiling, I said, “To thrive we must embody the cosmic duality between the hawk and the serpent.” Every time I read this paper or think about it, the East Coast raw, I guess this is everywhere now Blues Traveler had a song called “100 Years.” And it reminds me of this, although, their main verse from that was it won’t mean a thing in 100 years, because we’ll all be dead but surviving for our kids and future children.
You know, it’s funny, you mentioned that part about the environment we grew up in because it’s such a massively imprinting factor on how we all view the world. And it’s only natural like you go, you talk to our parent’s generation about how to invest, my mom, you buy stocks, and you hold them forever. My grandparent’s generation talked about a totally different mindset, which was children of the depression, living through a totally different environment. And there’s a great book and I’m blanking on it. It’s something like the diary, the depression or something along those lines that is talking about it through the lens of a journal in real-time, and my God, what a different world and conclusions you would come to than someone who lived in this post-war period. Anyway, keep telling the story, walk us through the paper and the takeaways.
Chris: Well, I’m so glad you bring up that concept actually because it’s so powerful to actually go back and read these old I have a Barron’s subscription. One of the things I love about Barron’s.
Meb: They just hit 100-year anniversary this past week.
Chris: There we go. It’s incredibly informative, for example, to go read all of their headline articles from the 1990s. It’s incredible to put yourself in that mindset. If you go back to the mindset of somebody who… First of all, the average financial advisor is about 55 years old. They were a kindergartener last time we had debilitating stagflation. All we have known in our entire lives is a regime where stocks, you buy on dips on stocks, stocks go up. And anytime they don’t go up, the Fed intervenes, cuts rates, does QE, and that has resulted in this incredible kind of buy the dip regime. Well, one of things I tested is I actually looked at a buy the dip strategy, going back 100 years, we went bankrupt three times, employing that strategy in a kind of systematic way. It’s actually incredible to say, “Oh, my goodness, why is that?” Well, for the greater part of most of 70 years, stocks were autocorrelated. What that means is that if yesterday was up, today is likely to be up, and if yesterday was down, today is likely to be down again. That ended during the Nixon Shock, where they actually had devaluation against gold.
And then at that point, stocks went from being trend-based to kind of mean-reverting based until it mean reversion reached all-time highs last year. Truly incredible. So, you know, the question at the end of the day, I mean, if history repeats, okay, you know, the 60/40 portfolio, fine, but it’s very difficult to sit back and say with rates where they are, stocks where they are, and valuations where they are, could we get a repeat of that? And where corporate debt to GDP is at all-time highs, U.S. government deficits to GDP are at the highest level since World War II, can we expect the next 40 years to repeat?
So, based on this, I like to say that recency bias is a systemic risk. The expectation that the next 40 years will look like the last 40 years is actually a systemic risk to pension solvency and retirement solvency. And that, if people think that they can apply the formula that worked yesterday, over the next 20 years, or for their retirement, they’re going to be sorely mistaken. I think a deep study of 100 years of history shows us that. Right now, everyone’s racing to buy real estate. You talked about this dynamic, the Great Depression was stagflation. Everyone’s racing to buy real estate, everyone’s racing to buy stocks, everyone’s racing to buy crypto tokens. Well, think in the context of the GI coming back from World War II, in the mid-1940s. And the mid-1940s was one of the best times to possibly invest in blue-chip stocks and in-homes. So, you had all these GIs coming back huge baby boom, huge growth, U.S. is the manufacturing center of the world, it’s a great time.
Well, try convincing that to a GI who has a little bit of savings. And that GI is going to look at you and say, who’s probably about 25, 30 years old, he’s going to say, “My God, the last 20 years, I’ve seen my family lose their home, lose their stocks.” Stocks and real estate were down for close to two decades, so that GI knew nothing except that those were a casino. It would be highly difficult for that GI to put his money in anything than cash and most conservative investments. Well, the same thing with the early ’80s, bonds were considered certificates of confiscation. So, when inflation has exploded, and you’re looking at 14% to 16% Treasury yields, and mortgages are close to 25%, as they were back in the late ’70s, early ’80s. Try walking into a boardroom and saying, hey, not only should we buy fixed income, we should lever it.
It’s funny because we did this trading simulation years ago when I was a analyst, when I was coming into the analyst training program, they started out and gave us all… It was like this fast trading simulator, you’re supposed to trade it and pretend to be a trader, which is kind of an absurd exercise. And it would go through 20 years of market history, you could buy different things. I won and there was like a $500 cash prize. I won the cash prize because simply, I knew the simulation was starting in 1980. I sat there and put my portfolio in zero-coupon long-duration debt, literally walked away to go get coffee, I came back at the end of the simulation and I had won. It’s humorous, right? To this point, recency is a major systemic risk because we just can’t use what worked yesterday to inform what might occur tomorrow. And I think today’s a great example of that, where we actually simultaneously are seeing declines in stocks and bonds on the inflation part.
Meb: It’s always a surprise to people the correlation between stocks and bonds, one is not really stable. People assume it’s just like, hey, stocks go down and bonds are going to save you. But historically, it’s been a bit of a coin flip depending on the environment. The beauty of your paper, and everything you’re talking about, is that the appreciation for history of what has happened, even in this limited amount of time, you call it 200 years of history, 50 years of sort of floating rate currencies, actually not that long. But even within that amount of time, the tiny subset that people extrapolate from is so tiny, and even more so, so much of people we talked to, even just the last 10 years, post-financial crisis of things like the U.S. always outperforms the rest of the world, which is, not only not true in history but it’s not even close to being true and is the exception, not the rule. So, systemic risk, and you’re walking through looking back in history… Keep going.
Chris: So, let’s talk a little bit about what I learned and what came out of this process. The first concept at the end of the day is that the way most portfolios are constructed today, this includes the biggest pensions in the world and sovereign wealth funds in the world. And it also includes, you know, the average grandma down the street, they have a portfolio that is mostly 60/40 stocks and bonds. Now, some of the pension systems might get tricky diversifying their portfolio with a bunch of hedge funds, that actually, if you look at it, are mostly replicating that data component of the portfolio with some short tails. So, I always talk about this idea that most of these strategies are short volatility in disguise, right? They’re shorting correlations, they’re literally shorting vol, or they’re shorting trend in some mean reversionary state. So, the average portfolio, a 60/40 portfolio, for example, diversifies based on asset classes, well, that’s silly. Like, what is an asset class? You don’t really care about what something is determined an asset class, you care about what its performance is in different regimes. Other portfolios like risk parity vol target will diversify based on rolling correlations and rolling volatility. Once again, that reflects recency bias.
So, what we said is, when constructing a portfolio to last 100 years, what you want to do is you want to diversify based on how assets perform in different market regimes. And those market regimes are incredibly important. If we look at what that means, well, look at certain strategies that perform in secular growth cycles. That’s the experience we’ve had the last 40 years. Now, that’s things like stocks, private equity, all the typical asset classes, you know, value stocks, everything else. Then, you want to look at strategies that perform in periods of secular stagflation. So, what performs in a period of depression, like a deflationary crisis? Well, strategies like long volatility actually performed very well. If you look at something like the 1930s, volatility realized over 40 for a decade. That’s absolutely incredible. So, in that sense, some long vol strategies would have carried extremely well and saved your portfolio. Now, fixed income does very well in deflation, if you’re starting at an already high-interest rate point. We saw this in the 1930s, rates came very down close to zero and the efficacy of fixed income as a defensive product becomes problematic. You can go to negative rates, but the likelihood of going to negative 3%, in a deflationary crisis is very difficult.
I mean, you consider that convexity or that non-linearity you get, bond yields go down, bond prices go up and they go up in a nonlinear fashion. That’s been the basis. When your rates are already at zero, you can’t rely on bonds in that deflationary environment. What performs in a stagflationary bond like the 1970s. Well, that’s when you want to be in things like commodity or trend-following, momentum trend following strategies, particularly in raw commodities. Well, when you put all this together, we found that actually a portfolio of five core asset classes, what we call market regime diversifiers because they’re not assets, they’re regime diversifiers, is a portfolio that lasts for 100 years and performs consistently through every market cycle. And this portfolio, not only performed in every single market cycle but also was able to do so with about 1/5 to 1/6 the drawdown of a 60/40 portfolio and a risk parity. That’s comprised of really five core diversifiers. Assets like equity that performed during secular growth, equity-linked assets like that. And that could include real estate and private equity, anything that’s long GDP based.
The second asset class is, of course, fixed income. The third asset class is what we call fiat alternatives. And that’s mostly precious metals, and gold. You could actually, although, we can’t backtest this, you could actually maybe include a little bit of crypto in there. The fourth asset class is long volatility and conducts hedging. And the fifth asset class is trend following commodities and CTAs. When you put all of those asset classes together in one commingle portfolio, whether you’re dealing with secular growth, whether you’re dealing with stagflation, whether you’re dealing with deflation, your portfolio consistently performs. And the rebalancing of all these different asset classes, they diversify based on market regime. That’s the key. Diversification by market regime is what creates a steady growth cycle. This is, I think, incredibly important.
The challenge is, I think modern portfolio theory, in terms of the way… It’s a simple thing to understand, but it’s a very, very powerful idea. And the proof is in the pudding. Anyone can look at our paper, anyone can replicate the backtest we’ve done on the paper, we provide… It’s a very long paper with a very long appendix and quantitative notes. So, certainly anyone please feel free to replicate this. But I think it’s a very defensible and realistic framework.
And last year, when we saw all of these, all of these factors come into play. We had deflation in the first quarter, then the Fed came in and global central banks stepped in with $10 trillion, with the stimulus. We had a huge equity boom, which was really a fiat devaluation. And then we had this kind of rise in interest rates and commodity prices in the fourth quarter. That portfolio, those five core asset classes, what we call the Dragon Portfolio, performed incredibly throughout 2020. The long volatility cushioned your blow from equities, actually resulted in a 13% gain in the first quarter. The rising oil prices during the summer along with equities provided huge gains during that period. And then the latter part of the year, the continuation of the gains from equities, and the gains in trend following commodities actually produced gains in the portfolio.
So, unlike many portfolios, which really stumbled in the first quarter, and then struggled to regain this market regime balanced portfolio consistently made money every single quarter last year, through every regime, because it’s diversified for each of those regimes. So, this was not a surprise to us, but I think it was a wonderful out of sample test to look at the theory that was presented in the paper. And then we released a new paper this year, which actually kind of looked at that performance, and it’s a shorter paper. And it reviewed the performance of those core asset classes through the year using actual numbers.
Meb: Going back to what you mentioned earlier about investors and the 60/40. And even if you have 60/40, the risk because stock volatility is more than bonds, it ends up looking like essentially an all-stock portfolio. And if you look at even every country in the world, 60/40 loses like two thirds at some point. So, not at all what you would consider in your mind is a low loss balanced portfolio. And the challenge with that, too, on top of it is that everyone… That’s all U.S. The amount that people allocate to foreign markets is tiny on average in the U.S. The average allocation of the globe is 80% plus. So, in reality, you have this portfolio, this is essentially just stocks, stonks, as they would call them now. And the problem with that is you have such a massive multi levered approach with your portfolio and your human capital with what goes on in the real world. The stock market returns are so highly correlated to when shit hits the fan. It makes absolutely no sense.
I mean, last year is such a recent clear example when the world’s going to hell, when unemployment goes from 4% to 15%, when the economy is going down the tank, yadda, yadda, on and on and on, oh, by the way, your portfolio’s also getting smashed. I mean, that makes no sense. There’s no sense of balance. And financial advisors, it’s even worse because your business revenue is tied to the stock market, clients freak out, they pull their assets. And by the way, if you don’t own your own company, you’re also subject to getting fired because your company’s out, anyway, on and on and on. It’s such an unbalanced portfolio. The beauty of what you have, and it’s hard for, I think, a lot of people thinking about true diversification and what that actually means because you have three big muscle movements that are missing from other traditional portfolios, people may have 2%, 3%, I don’t hardly ever see more than 5%, any of these being the precious metals kind of gold sleeve, the long vol, and then the trend following sleeves ends up being actually over half the portfolio.
Chris: Yeah, 20% to each of those sleeves. So, that’s the thing. There are pension systems out there where, you know, they’ve tried to take 5% of their portfolio to gold, it’s very difficult for them to even do that. The concept of this 100-year portfolio is actually quite a radical concept, because we’re saying, look, put 20% to each of these sub-asset classes, or thematic diversification buckets. Now, what’s actually a little bit difficult about this is that to do it optimally, the best thing to do is actually to commingle this and it’s actually somewhat hard for people to get diversification and things like commodity trend, or long volatility. Artemis has been a long volatility manager, and that’s been our bread and butter for a long time. But a lot of times, people will take those products and oftentimes for a long vol fund, you might only need 2% to 10% of the capital. So, what a lot of smart investors do is they’ll commingle that with equities and share the capitals. But it’s difficult to do that for some retail investors.
But to go back to the 60/40 portfolio concept, which, you know, if you look at most pension systems now it’s about 70/20. You know, I always say this is that people think they’re diversified. You know, they might have all these sub baskets, that diversification actually is short volatility in some capacity and long GDP. If you’re investing in a private equity fund, along with your home, along with an average hedge fund, actually, you’re just correlated to equity baiting correlated to the market cycle, everything turns out at the same time.
Well, what’s the central problem with a 60/40 portfolio and also risk parity? Well, the first central problem is becomes neuter when rates are at the zero bound. And that’s what happened in the 1930s. We saw it happen last year. If you were relying on fixed income to help you in March, well, there was a period of time where fixed income was actually declining simultaneously with stocks at the same time, which is also what is happening now, or happened today, at least. That occurs sometimes or the efficacy of fixed income becomes neuter when rates are at the zero bound, because you just can’t lower rates much more. So, although fixed income helped you in the first quarter of 2020, not that much.
Meb: It also didn’t help. If I recall, in most foreign markets where interest rates were already at zero or negative, it actually didn’t hedge, I think most of the foreign bonds, right? So, if you’re living in Europe or other places, counting on fixed income to hedge the market puke, it didn’t.
Chris: You consider fixed income worked as a wonderful hedge in ’08, well, you were able to take rates from 5% down to zero. Well, today, we’d have to move deep into negative territory, in Europe even more so, to get that same convexity exposure on bonds. Big problem. So, the second big issue… So, bonds of the zero bound don’t really work as diversifiers in deflation, I mean, a 60/40 portfolio would have had drawdowns of close to 70% or 80% in the period of the Great Depression. If we go back to that same portfolio, and risk parity actually has the same problem. Risk parity that oftentimes leverages the bonds, has the exact same problem. If we go to something like the stagflation of the 1970s, which maybe we’ll enter into, something like that, the 60/40 portfolio had reasonable drawdowns of about 30%. The problem at the end of the day is if you look at that after inflation, it’s almost the same as the Great Depression, you had an over 60% drawdown in the classic portfolio after you take into account inflation.
So, you’re getting hit… In the ’70s, stocks did nothing and they declined and there was a big bear market, and when they weren’t declining, they were just kind of going sideways. And then you heard bonds are getting hit by the high inflation, they were getting hammered. And then on top of that, when you have 10% inflation a year, and your bonds are losing money, and your stocks aren’t doing anything, you’re losing money on a real basis. So, in those environments, these classic portfolios just don’t work. Now, some people might turn to some of these other strategies, like shorting volatility or risk premia strategies, we tested those two, they’re a disaster, truly a disaster.
Meb: Well, Chris, every five years, you’re telling me that I see this over and over and over again, you get some beautiful looking equity curve, and some managers raised $500 million, $1 billion, $2 billion and then they disappear, at some point.
Chris: Oftentimes, they’re shorting tails in some capacity or leveraging beta. If you look at something like a covered call overwriting strategy, for example, that strategy right after 2008 performed really admirably for a period of time, it looked fantastic. Some individuals actually were able to actually generate a lot of EEMO for that. Well, if you go back and you test that strategy, through the Great Depression, it was absolutely a disaster, because what ended up happening, and this is also true with the’ 70s, as well, it was a disaster in the ’70s as well, because what was happening is, in effect, you had these big declines in markets. So, you’re taking the brunt of your declines and your linear exposure in the S&P. And then what happened is that there were these periods, much like last year, where when they introduced the Banking Act of 1932, or when Roosevelt devalued versus gold, where the market will explode. Actually, there were two episodes in the 1930s, where there were over 60% gains in equity markets in a period of under six months. So, you can imagine that if you’re doing like a covered call overwriting strategy, you’re realizing all these losses on the way down, and then you’re selling offside. And then when there’s that 80% rebound, you’re selling that vol. So, you’re getting hammered on the rebound.
What most hedge funds have been doing, and what most active strategies have been doing is they’ve actually been shorting volatility, either implicitly or explicitly. And they’re either literally shorting volatility, like selling options for extra income, or they’re shorting correlation, which is what risk parity does. They’re shorting trend, which is what a lot of strategies do, we call it short gamma, or they’re shorting interest rates in some component, the expectation that rates drop. Well, in these other environments, where you have trending markets, explosive markets on both tails, huge tail exposure, you have breakdowns and correlation between asset classes. And then you have, in some cases very rapidly rising interest rates, or at least a scenario where rates can’t drop anymore because they’re already close to zero. All of a sudden, all of these different components that people have used, and all of these financial engineering strategies to augment and enhance portfolio returns actually fail.
That’s true for things like… I mean, if you look at it, even something like private equity, for example, where private equity, in essence, requires inexpensive debt in rising markets, that’s a secular growth strategy. In many ways, it’s actually short a straddle in some components, because you’re exposed on the left side in effect. Because if there’s big declines in growth, you have negative exposure to that left side of the return distribution. If there are huge gains, but rapidly rising inflation, it becomes really, really difficult to debt finance, all these acquisition targets, and you run into the same problems. There’s many strategies that actually have, they may not seem like they’re short vol, in many instances, they have aspects that replicate a short vol trade.
Meb: The private equity you touch on is near and dear to my heart, because, you know, you chat with a lot of institutions, and it’s universally seen. I feel like a lot of institutions understand the 60/40 problem. And their conclusion is simply to add more stocks through essentially private equity as their savior and they say, okay, I get U.S. 60/40 is going to have low returns, so my savior, my solution is to add more stocks through private equity. And you left out one piece, which is that private equity historically had a big valuation discount to the public markets. And that’s now gone. And in some cases, it’s more expensive than the public market, which is totally crazy. As more and more of the flows have been pushed into that, why do you think that these three strategy buckets, so gold, precious metals, potentially crypto, I’m saying the three diversifiers to traditional stocks and fixed income, the three that people are highly under-allocated to? Is it just career risk? Is it lack of understanding? Is it not wanting to look too different? Is it a combination? Is it something else I’m missing? Why do people never have, and we’ve talked, ad nauseam, on this podcast specifically about the trend component, which we never see an institution have more than 5%, is probably the most I’ve ever seen. Why do you think that’s the way that it is?
Chris: Why are these other three components of what we call the 100-year portfolios under-allocated, like the precious metals, the long volatility and also trend following? It might sound like I’m ripping on private equity. There’s nothing wrong with private equity. But I actually see it as something that should be an alternative to equity or the passive equity. It shouldn’t be a diversifier on top of the portfolio. That’s the problem. People are using it as a diversification tool, it’s not a diversification tool. Many of these things that people talk about as diversification tools are actually risk enhancers during periods of secular change, stagflation, deflation. Of course, those three assets class… the three thematic baskets, the long vol, precious metals or fiat alternatives, and commodity trend or trend.
These are true diversifiers. Why are people so under-allocated to these? I think there are actually two reasons for this. I like to talk about modern asset management as almost like a Greek tragedy. This is a Greek tragedy waiting to happen. When we enter into a period of secular change, the way that most people’s portfolios are constructed are set up for failure if we enter into either stagflation or deflation. Now, if you look at most Greek tragedies, like Oedipus Rex, or any classic Greek tragedy, the hero is blind to their fate, they’re warned of their fate, but they can’t prevent it. Either, they can’t prevent it because they are unwilling to or they’re unable to. The unwilling and the unable.
I think the unwilling are the big institutional pension systems, the big institutional investors. Now, they might be unwilling for a variety of reasons. One reason is simply that they’re so big, that it’s almost impossible. If you’re $100 billion, it’s very, very difficult to allocate $25 billion to long vol and CTAs. But even if they wanted to do something like that with gold or something, they oftentimes have to face this massive bureaucracy. There are some incredibly smart people in these institutions, incredibly smart people who have to answer to a whole range of boards and oversight boards and trustees, some of which aren’t financially educated. Even though they might see this problem and many of them are incredibly intelligent and understand this, they are unable to change in that bureaucracy, the bureaucracy makes it unwilling to do so.
But the true tragedy is the unable, and the unable is the average retail investor. And I should commend you because you’ve done a great job with your products here. I guess, you can’t talk about that. But even a great product, a job with your products that are actually broadening and making some of these strategies available to people to some degree. But the unable are really the average retail investor because it is absolutely crazy to me. Someone who has a long track record of running money responsibly in a, like, a long volatility fund, for example, can only accept accredited, sophisticated investors, yet regulators will allow an 18-year-old to get on their iPhone, buy a double levered VIX, CTP or buy a Dogecoin, obscure cryptocurrency. How does that make any sense?
Meb: Don’t forget micro caps, don’t forget lottery tickets, going to a casino. More importantly, currency, leveraged currency, you can get currency at like 20 to one, you can trade futures. This topic is one of the most preposterous things. I think the rules are going away. That’s my two cents. You’ve already had it go like halfway to where you can submit some sort of industry qualifications. I would love to see it be like a DMV test. You just take it online, it takes 10 minutes, right? Fine. You want to nuke your money, have at it, at least they could then wash their hands of any responsibility. But the fact that there’s an entire category of infinitely worse garbage to incinerate all your money already. And I actually think probably, a lot of government legislation, this had good intentions when it was drafted. But at this point, it’s totally… It applies to startup investing, too. It’s totally past its expiration date.
Chris: It’s going to be a Greek tragedy, the worst situation is retail because these are true diversifiers. I think our world would be a better place if the average pension system, the average retiree had a portfolio that more closely resembled the 100-year strategy, I really believe that. I think I’ve done a tremendous amount of research, and I’m happy for anyone to look through that research, look through the results of the paper, reread the results, and tell me if I’m not seeing something because I think it’s all there. They block it to save people, but they’re not saving people. That is a great tragedy.
Meb: You know, I love this very fine paper. Because once you get past page 20, there’s just reams and reams of tables and historical data, the 1920s, graphs. I mean, this is literally probably my favorite paper for the last three years. About the institutions, by the way, they’re often just as guilty or a mess. And it illustrates something you were talking about, which is the struggle of having multiple parties involved in the unwillingness of people to have a long enough time horizon. I mean, my God, look at CalPERS management and all the drama they’ve had over the last five years. Multiple CIOs humorously or not, I guess, getting rid of all their tail risk funds right before the pandemic started. And then places like Harvard, which has had one of the most successful endowments in history, that is essentially moving almost to, it seems like a much more watered down situation. And most recently, it’ll be interesting being the wrong word, but Swensen arguably, the greatest institutional allocator in history, he had a pass because of his amazing performance. But you see that the challenge of these structures with so many people involved it’s hard to look different, almost, which in many ways is a big shame. There’s a lot in there. That’s a little bit of a rant, sorry.
Chris: No, I think you’re right. I should say, I mean, I know people who are in these financial systems, many of them are brilliant people, very smart, incredible people. But you’re trying to turn Titanic in some of these things. And it’s like one person doesn’t have unilateral power. And it’s incredibly difficult to do something outside the norm. And it’s quite interesting most people would rather fail conventionally than succeed unconventionally. And that’s the problem.
Meb: The good news is, at least, maybe I have a small subset, I mean, from this audience. I feel like a lot of the investors we talk to on the individual and professional level want to “Do the right thing,” you know, they’re willing to look and act different and at least be open to some of these ideas. And I think the last year is such a beautiful example. Because it’s literally every asset in your entire mix had a moment in the sun and shade, right? So, like Q1 last year, you’re like, thank God I have the long volatility and the bonds and gold. Fast forward to Q2 or Q3 thank God I had equities to rebound and on and on and on and this year trend following is having a great year. As you see some of these commodities prices go bananas to the upside on and on, right? Like, it’s… But the challenge is not getting wedded to just one of those because you can get totally upside down. And the beauty, which you’ve also mentioned, is they have the ability to rebalance towards the stuff that’s gotten nuked because of the things that are appreciating.
Chris: Exactly. And that’s the whole point is that in that portfolio that is balanced by thematic diversification or rebalanced by market regime. So, what you’re doing is we’re looking at the way that the different asset classes performed in different regimes. It’s not about diversification over a day or a week, it’s about diversification over an entire decade. There’s a solution to all this, you don’t be afraid, you don’t predict, you don’t need to predict, everyone wants to predict. Don’t be afraid, don’t predict, prepare. And if you have this diversification by regime, in the first quarter, your long vol is doing well, and then you rebalance. And then in the second quarter gold, and equities are doing well, while your long vol is suffering. In the fourth quarter, equities and then CTAs they’re doing really well. So, at any point in time, two or three of these diversifiers are outperforming by a wide margin, paying for any of the losses in the other framework, creating a nice upward trajectory. And we saw that last year and you see it over 100 years and we actually give you some slides and it’s in our paper, you can absolutely see that. Really at the end of the day, it’s about rebalancing and it requires extreme discipline because it’s very, very hard. You talk about people firing their tail risk manager, right before the crisis. Well, right when you need a diversifier is probably where it looks the worst in the rearview mirror.
Long volatility looked terrible until March. Looked absolutely terrible until March. And then all of a sudden, everyone wants to get into it when they actually probably should be selling it and rebalancing into equities and other things. That is the lesson and I think it’s incredibly difficult. The problem of asset management, the problem of the 100-year portfolio, the portfolio is simple. The problem that we have is not a mathematics, or portfolio management, or economical problem. It is a social problem. We can’t stay with these things. In the same vein, if you were that GI coming back from World War II, you wanted to be in cash and long vol., that’s the thing that worked during the Great Depression. The last thing you’d want to be in, looking in the rearview mirror, is real estate and equity in 1945, emotionally, the last thing you want to be in, even though that was the very thing you needed to buy at that point in time. But most of asset management is looking in the rearview mirror, either emotionally, or literally in the case of some of these strategies. On a quantitative basis, many of these modern portfolio-engineering strategies are using some window. When you look at a risk parity portfolio, which actually performs all right over 100 years. It’s not damning. There are definitely problems. But it’s literally using some historical period of correlations and covariance.
Meb: I always wondered to me when I chat with my friends that do risk parity, or really almost any strategy, and they mentioned they do a shorter rolling. I always said, you know, “Why wouldn’t you just use the entire period, sort of statistics to encompass as many possible market outcomes?” And I remember back to talking about some of the options strategies from an option index company that excluded 1987 because he said that’s not part of it, or never happened again, or somebody excludes Japan as an outlier. And it’s always a head-scratcher because you come to a totally different conclusion.
Chris: And you know, part of this is part of the problem with the tools that we have. So, I’ll be coming out with a new paper, by the time this podcast hits this paper will probably be out there. It’ll be called “Moneyball For Modern Portfolio Theory.” And it’s more of a white paper. It’s more of a… It’s full of formulas and everything else and we actually will have Python code that will come with it, but we introduced some new ideas. So, the majority of the asset management industry is based around the Sharpe ratio. Someone’s looking at one of your funds or someone comes to evaluate a hedge fund manager, the first thing an allocator asks, what is your Sharpe ratio? The Sharpe ratio at the end of the day is the functional equivalent of a scoring average or batting average for a hedge fund manager or any asset manager. And what it is, is actually the return of the asset minus the risk-free rate divided by the volatility of the asset.
The Sharpe ratio has several major problems as a methodology for choosing investments. The first is that if you go back and read the original paper by William Sharpe, it was never ever intended to be used for sub-asset selection. It’s only used to compare aggregate portfolio against average portfolio. So, it’s actually useless to choose managers. It’s only useful once you have a collection of managers in a portfolio.
And a big problem is that it does not take into account correlations between asset classes. And it does not take into account skew, or how an asset performs on the right and left tail, or the return distribution, the extreme environments. Those are the environments you care about, where are you afraid of, you’re afraid of stagflation and you’re afraid of deflation. And so the Sharpe ratio doesn’t tell you how an asset performs in those environments. Well, let me explain this in just simple English, there’s the quote from Paul DePodesta, from “Moneyball,” and he’s in the movie. I guess, they had him under a pseudonym in the movie. He says, you know, “You’re not buying the players, you’re buying wins and to buy wins, you need to buy runs.”
Sports has long figured this out. And we all know this, whatever sport you follow, I’m a basketball guy. But you might be a baseball guy, or someone might be a soccer person. When you get a big free agent, you don’t really care about that free agent stats. It matters, but that’s not what you really care about their individual statistics. What you actually care about is if you add that player to your team, will that help your team win? Will the player enhance the number of wins of your ball club? And we all know, examples of players with very gaudy individual statistics. And then they put them on a team, your team actually gets worse because maybe that player is a ball hawk, or maybe that player doesn’t play defense or all these other things. And then there are players with less impressive statistics, where you add them to the team, and the team improves and wins. Because that player is doing things that are not necessarily recorded in statistics as well but greatly help team success.
I published a paper years ago, I talked about this, like, Dennis Rodman is an example of this in basketball. Rodman was six standard deviations better at rebounding than the average player. So, when you put Dennis Rodman on a team of mediocre scores, the team’s offensive efficiency went up and their wins went up, even though Rodman himself was not a great score. You add this guy to your team, and then all of a sudden your team’s offence gets better, even though he’s a terrible offensive player. How does that happen? Well, he’s so good at rebounding the basketball, he would rebound close to 20 rebounds a game when he played with Michael Jordan. You give Michael Jordan a second and third chance by rebounding the basketball, Michael Jordan is not going to miss that shot a second and the third time. So, you put Rodman on a team with average scores, the team became really good. You put Rodman on a team with great scores, like Scottie Pippen and Michael Jordan, and it becomes an all-time historically good team. Well, this is what Paul DePodesta meant by saying, you don’t buy players, you buy wins. And the sports industry is always been focused on these new metrics, like wins over replacement value, plus-minus that actually measure how does a player effect team winning?
The investment management industry is stuck measuring the player and not the wins. They’re so focused on individual asset or manager performance, that they’re not focused on how that manager or how that asset helps your total portfolio. And in many, many cases, actually, long volatility is a perfect example of this. A strategy that doesn’t have a great Sharpe ratio, if you combine it with other strategies, like equity and bonds, dramatically improves the risk-adjusted performance of the total portfolio. In fact, every asset in the dragon portfolio is like that. So, the Sharpe ratio is useless because it does nothing. It only measures the player, it doesn’t measure the player’s effect on a winning portfolio. That’s what you want. That’s what’s important. That’s what you care about.
So, we took inspiration from the world of sports, and we’ve invented a metric called CWARP. And what that stands for is Cole Wins Above Replacement Portfolio, CWARP is what we’re calling it. And we’ll release analytics on this, anyone will be able to calculate this, and it’s alternative to the Sharpe ratio. And what it does, is that you’re able to run a very quick calculation to determine whether or not an asset is improving the risk-adjusted performance of your already existing portfolio. And unlike Sharpe ratios, collections of high CWARP of assets will dramatically result in a better portfolio. If you took the highest Sharpe ratio assets and put them into one portfolio, you actually can get a worse portfolio. This, I think is shocking for most people to understand, and one of the biggest flaws in portfolio construction.
Meb: There’s a bunch in there. You know, we used to talk a lot about the Sharpe ratio. And we said it’s an okay rule of thumb when you’re looking at assets that are kind of similar being, like long-only equities. But there’s other problems such as it penalizes up volatility if a traditional asset is high volatile, but to the upside, that actually hurts the Sharpe ratio. But the main criticism I have of the Sharpe ratio is the way that our industry knowingly misuse it, which is, you try to find a fund that has a one or a two-year track record, or often backtests and say Sharpe ratio four, here we go, and don’t even get me started on the interval funds that price their portfolio, like once a quarter or once a year, and they’ll be like, hey, we have a volatility of four, and we’re investing in private equity or real estate or something. First of all, there’s zero chance.
We did a chart over a decade ago, and this was inspired by some trend-following friends, Eric Crittenden and crew. But basically, it’s like people get marketed these high Sharpe ratio strategies, which by the way, are usually if it is that on paper, it’s like the turnaround and run, as you mentioned, like the option selling but even if you think something as a 2, 3, 4 Sharpe, and you look at all the managers over history, there’s none that over time, they all kind of declined to below one. So, this dream of this magical land of alpha juice just flowing in rivers, I think is unrealistic, even looking at the top investors of all time. So, there’s multiple things wrapped up in the problems of Sharpe. But you make such a good point of all that matters is the sum total and people love to bucket the investments and they look at one thing, trend following, gold, whatever, hasn’t gone anywhere for a few years. I’m out. And in reality, nothing matters other than this, like, bowl of soup together. It’s like bay leaves, right? Bay leaves, I don’t think they do anything to a soup. Every chef on the planet, they’re like, you put it in the soup, it’s going to be better. You wouldn’t eat a bay leaf.
Chris: It’s a matter of what happens with the average, not the pieces. So, it’s absolutely fascinating. Like, what this CWARP metric does is it removes some of that, because the Sharpe ratio, you’re right, it does not look at the tails. It treats upside volatility, the same as downside volatility. It doesn’t look at correlations. And that’s so important. What our metric does is essentially incredibly simple. What you do is you assume, you take out a loan and finance an asset at 25% and add it to your existing portfolio, does that improve your risk-adjusted performance and your return to drawdown? And if that’s positive, then it’s improving your portfolio. If it’s negative, it’s hurting your portfolio. What we found is that if you run this metric on most hedge funds using a 60/40 portfolio, only 1/3 of hedge fund strategies actually generate a positive wins above replacement portfolio value.
Meb: I’m surprised it’s so high given that the vast majority of hedge funds as a category is simply long, short equity. Is that accurate? Which seems just like adding a little more equity.
Chris: Yeah, I mean, this is exactly right. Because what that’s telling you is that most of these strategies are simply layering on more equity-linked correlation risk, or they’re shorting tails or they’re shorting vol and some components to generate their alpha. Those strategies may not be bad, necessarily, but they shouldn’t be considered diversifiers for the portfolio, they should be considered like an equity or a bond replacement, not a diversifier. You can quantitatively prove they’re not diversifiers. And what we found, based on this metric, and we’re going to give people the tools to do this themselves in the new paper, there’ll be a website and some work to that effect. It’ll help people have fun with this, but like we found that long volatility obviously is a true diversifier, gold is a true diversifier, treasuries in an equity portfolio are diversifier. As far as the actively managed, obviously, commodity trend advisors are a true diversifier. Weirdly, and I never saw this one coming merger arbitrage.
Meb: I just assume it just kind of does its own thing.
Chris: You look at this framework, and these are the diversifiers that actually generate and those are for the metric, you could actually take out a loan at LIBOR plus something, layer any of those strategies on top of your pre-existing 60/40 portfolio and you end up having a better portfolio. Lower drawdowns and better risk returns. Those are really some of the only strategies or assets where you can do that. To explain this concept, LTCM had a Sharpe ratio of 4.35 before it blew up. Years ago, I warned about XIV. We first warned about that in 2015, then again in 2017, and then Mike Green, I don’t if you had him on the show, but Mike is an amazing, brilliant talent, smart guy, but him and I actually had an argument at a Derivatives Conference, we were doing the keynote together. And we actually argued with one of the creators of XIV that the product would eventually fail.
If you looked at XIV, it had a Sharpe ratio of 1.78. Someone naively looking at XIV would say, “Okay, well, maybe I can add that to my S&P and I’ll have a better portfolio.” And then if you did that, if you added XIV to the S&P, you’d be like, “Oh, wow. Okay, my Sharpe ratio goes up.” Then, we had February were XIV imploded. It was a short vol product that imploded and it lost 99% of its value immediately.
Well, what’s interesting about that, is that if you looked at XIV on a Sharpe ratio basis, it showed that this was an incredible investment. But if you looked at it on a wins above replacement portfolio, CWARP metric, it showed incredible negative value. And the reason being is that XIV was correlated, incredibly correlated to equities. And when equities lost money, XIV lost even more money. So, XIV was really just a form of a levered beta trade with short tails. It was a levered equity trade, with short tails. So, even though combining XIV with the S&P, prior to the day it blew up, look better on a Sharpe ratio basis. If you actually looked at it on a risk-adjusted basis, measuring drawdowns and the combined only left tail volatility, and you looked at that as a composite wins above replacement portfolio value, it actually resulted in a much more fragile portfolio.
Well, that’s an extreme example. But one of the things that you’ll find is if you go out there, and you find lots of high Sharpe ratio investments, and you just layer them on top of your 60/40 portfolio, you actually end up with bigger drawdowns and worse risk-adjusted performance. It’s the classic problem of teams going out there buying high priced free agents who have gaudy statistics but don’t actually contribute to team success. I think any Knicks fan until recently, probably has known that problem.
Meb: You like basketball, I almost always wear my Nuggets hat during the show, they at least have something to cheer for. I’m optimistic. The weird thing about your paper and I got a sneak peek. And it’s great. The biggest diversifiers to a traditional portfolio, and this is obvious to you and I. But it’s like a who’s who of categories that no one allocates to. Is that a fair assessment of like…? Or sorry, like, not at least, if they do, it’s tiny. But most… If I had to talk to the average advisor, and I’m going down this list, long vol, gold, CTA, systematic, merger, maybe no one has any of those that I ever talk to. The exact opposite conclusion is what you would expect.
Chris: I think everyone looks at this 100-year portfolio concept, and they’ll nod their heads, they’ll be like, “Yeah, that makes a lot of sense and make sense in the data.” But when it actually comes to putting 20% of your money in long volatility overlay and precious metal or rebalancing out of long volatility in March and into equities in April, and vice versa. When equities are killing it, rebalancing out of equities into something like long vol and CTAs that are losing money, most people can’t do it.
Meb: I’m surprised the short bias and market neutral ranked as poorly, do you think that’s partially just due to the subset of time and if we get a haymaker of U.S. bear market, they might bubble up into the better ranking or what’s your opinion?
Chris: Yeah, I think that’s right. I think in the paper that is yet to be released, we had a preview of it. I mean, that data is only from ’07 to…
Meb: So, it still includes financial crisis for the most part?
Chris: It does. Yeah, but short bias managers have had really a tough go of it, especially recently. Oh, my goodness.
Meb: I don’t think there’s any left, there’s a list of short hedge funds. And it’s like the worst equity curve, it just goes down and down and down. I think it’s like, there’s probably like five left.
Chris: Yeah. That’s really, really tough. I would think that if you had 100 years of records for short biased hedge funds, which don’t, but I would theorize that that would rank higher on that wins above replacement portfolio metrics. So, in that sense, you know, you are, like any metric, you know, you are limited to the history of data that you have. Yeah, it also gets into this concept too, which is really interesting. Most people don’t consider opportunity cost. And that’s another problem with the Sharpe ratio or just the way people think about portfolio construction, because… And what is the opportunity cost? Well, $1 at the bottom of a market after a crash is worth way more than $1 at the top. $1 in March of 2009 is worth far more than $1 presumably in 1999 or $1 presumably today. And likewise a $1 at the end of March 2020, is worth more than $1 of today.
Well, many investments give you liquidity based on, in those periods of crisis. So, investments like long vol and CTAs, and investments that actually profit from extreme right or left tails will give you money when capital is scarce. People are not selling out of some panic and out of control, emotional thing. They’re selling because they’re over-leveraged, and they have to sell. They’re selling because they need liquidity and capital is scarce in a crisis. That’s why assets go from being overvalued to undervalued so quickly. Well, in that sense, somebody who… an asset that is giving you liquidity in a crisis has tremendous value if you’re able to rebalance during that period of time. If we go back to the sports analogy, a rebound when your team is missing in the fourth quarter is worth a ton. Every rebound that Dennis Rodman can get in the fourth quarter and pass it back to Michael Jordan for another shot is worth a ton of points. So, not these true diversifying asset classes rebound your portfolio when there’s a crisis. And that more than pays for any negative lead during these other periods. This is true of any of these, this is true to some extent, any of these other diversifiers. A lot of asset classes, like, you look at something like private equity actually takes liquidity away, you don’t have the ability to rebalance. In fact, there might even be capital calls.
Meb: You think back to the financial crisis all the way down and it’s got upside down on that problem specifically, they went through 50% portfolio drawdown all of a sudden, private equity, they’re stuck.
Chris: When somebody looks at the performance metrics of those investment products, it does not take into account the opportunity cost of capital and the value of the capital during the cycle. So, something like a wins above replacement portfolio it does. It does, because it’s constantly looking at the rebalancing of that, and how that plays into something. So, it will take into account that framework or something like a Sharpe ratio if it’s not. It’s interesting because when I did the 100-year portfolio paper, I didn’t know what the answer would be. I didn’t do that paper with a product in mind, I didn’t do that paper… I had a sense that it would show that something like long vol would be helpful, but it was truly like an intellectual exercise. That’s like the brute force method. And from this brute force method, we came up with this conclusion as to what this collection of assets works great as a team. But then we worked out and developed a new mathematical formula from a more elegant mathematical formula that looks at portfolio construction. And we then apply that framework to a range of assets, and we get the same answer. And that’s not by design, that’s like purely the fact that we’re approaching this problem by two entirely separate analytical methods. And you get the same answer, plus merger arbitrage, which is something I never saw coming.
Meb: What’s been the main response to the paper? I mean, to me, it seems obvious, but you’re kind of speaking to your wheelhouse. When people have emailed you or talked with you about this paper and subsequent last year, this year, any consistent responses from the investor community, or what’s been the general feedback?
Chris: I think one of the first big considerations that people have is how do I get access to long vol and CTAs being a retail investor? And that is admittedly difficult. If you’re a big institution or a family office, it’s relatively easy to do that, and in an efficient way, it’s harder if you’re a retail investor, and I admit that. Hence, some of my frustration that we expressed at the beginning of the show, both of our frustration with some of the way that regulators look at the world. I think that’s particularly interesting. I get a lot of questions on how to construct this independently. And I think I addressed some of that in the other paper, it’s actually relatively hard. One of the biggest problems is the dead cash problem. If an institution gives me capital to run my vol strategies, or a CTA strategy, of all our CTA strategy, oftentimes only needs anywhere between 2% to 20% of the money that comes on in, in order to run its core strategy. So, what an institution will do is they’ll take that excess cash, and they’ll use it for equities or bonds.
But oftentimes, it just sits there. If you’re on allocating to an external fund, it just kind of sits there dead in basic cash reinvestment, but isn’t even matching the management fees. So, that is one of the huge advantages that institutions have. And it’s also one of the advantages of actually working with an advisor that can actually commingle all these things, do it the best possible way and to hit return targets over 10% a year and 15% vol, you have to commingle all of these assets and manage the cash efficiency problem. We call it the dead cash problem. One of the big criticisms that I’ve got on the paper, which I think is a little bit unfair, which is like, well, you’re still having correlation risk in that portfolio, in the Dragon Portfolio, I would agree, there’s still a correlation risk in the Dragon portfolio. It’s entirely possible, yes, in a world that stocks, volatility, CTAs, gold, and bonds all declined together. Is that possible? Absolutely. Is that more likely to happen than what most the average portfolio is? The average portfolio has far more correlation problems than that diversified portfolio. So, there is a correlation dynamic there as there is with any portfolio, but I think it’s a much better diversified portfolio.
Meb: I’m trying to even figuring out how that could possibly happen. And it’s like a brain pretzel not to try to figure out what environment that can possibly exist in because theoretically, the trend side will pick up whatever is happening eventually. So, it’d have to be a sharp move. And then the volatility, I don’t even know how that would possibly miss… I don’t know. I don’t know.
Chris: It’s a pretzel. There’s one environment, it’s never happened historically, there’s no proxy for this. I don’t see a world where this would happen. But I can think of one environment where all the asset classes would go down together. And that would be an environment like, let’s imagine, hypothetically, I’m trying to poke holes in my own theories here.
Meb: Q1, theoretically, could have been the runway because bonds terrible starting point, stocks terrible starting point, gold, like you could just… Gold, who knows with gold, and the commodity could just be off on the wrong foot at the beginning of it. But how could volatility not capture that part?
Chris: Let’s imagine that central banks have already reduced interest rates to zero. So, bonds can’t go any lower, so you’re not going to get any performance out of your bonds. So, then what happens is that interest rates are going up slightly, not massively, but a little bit, teeny bit at a time. So, bonds are taking small losses. Equities decline, three basis points a day consistently, they decline three basis points a day. So, every single day, the equity market is down two, three basis points without fail. So, it’s just this, drip, drip, drip, drip, teeny drip. This has never happened. We’re talking hypothetically. So, as a result of that, volatility is sub 10. In fact, it’s probably would be sub-five, even though the equity markets are declining bit by bit every day, you’re not getting a payout in your long vol. Because there’s no vol, vol’s actually low despite the fact that the equity market is dropping. By the same reason, there is no breakout performance in commodities, because there’s no rampant out of control inflation because rates are ticking up bit by bit by bit a day. So, you get trickling losses in fixed income, trickling losses in equities, trickling losses in commodities, gold does nothing, and vol just bleeds out because you’re… That scenario, there is no historical record of that in financial history.
Meb: But seems like the good news is at least that it’s not going to be hard left, like, you’re going to lose half. It’d be like a sunburn, it’s got to go away, eventually.
Chris: It’d be a slow sunburn. So, could that happen? Sure. Anything can happen. There’s a probability of anything, but I think the probability of that occurring, I mean, generally speaking, you have very hard right or left environments, I think the risk of that is far less than the risk of stocks and bonds declining together, destroying conventional portfolios.
Meb: If you had to shoot one of the five in your portfolio, it’s like the old game like marry, mate with or murder. Which of the five would you shoot in 2021? I think I’ll know the answer.
Chris: If I’d just shoot one in 2021, it’d be the bonds.
Meb: Bonds.
Chris: This is the problem. I wouldn’t want to shoot one of the five because, we get asked this question sometimes, well, why not just take the bonds down to zero? Well, you talked to Lacey Hunt, who’s here in Austin. Lacey is one of the smartest guys I know. He knows way more about inflation than I do. Well, at the end of the day, you know, he’s truly a proponent of deflation and continues to be a proponent of deflation. So, it may look like we’d want to shoot the bonds in this environment, but maybe when all of this, we get to kind of wear out of the stimulus and people… The full scope of the unemployment problems and the fact that people solvency problems comes to light, maybe we get a sharp left turn back to deflation and then, all of a sudden, you end up getting some solid performance out of the bond portfolio. This is why I say don’t fear, don’t predict because in me shooting one of those assets, there’s an implicit prediction about what I think will happen. The beauty is that, the beauty in this diversification by market regime, over 100 years is that you don’t predict. I might want to shoot bonds and I might regret it.
Meb: You’re a rare bird despite being someone who’s on the long vol camp. So, many people become wedded to their strategy, or style or asset class… So, many portfolios we see all the time are so lopsided. And even if people move off zero, it’s like a couple percent.
Chris: It’s sad because we want to play these games where we pigeonhole people into these personalities. “The New York Times” did an article about me several years ago, and I was a little sad about how it turned out. Because it just kind of painted me as this kind of end of the world guy. We’ve always believed that the right way to, we tell our clients, the right way to run long vol is to pair it with equity, and risk. We exist to help you take risk responsibly. Dennis Rodman with a bunch of scores is a great team, you’ve got balance. A team of Dennis Rodmans is a terrible team.
Meb: Who’s “the Worm” in this analogy, is it long vol?
Chris: Long vol is “the Worm” in this analogy, exactly. So, you got a guy that can rebound the shots, but no one can score. So, the whole point is that these things should be used together. I think the wrong impulse is to say, I’m going to invest in long vol, gold, cash, and build a bunker, use these as diversifiers, and rebalance them accordingly. And use them to help take risk responsibly. But that’s not what sells newspapers. That’s not what people want to hear on fin twit. People want to create characters and create heroes and villains. I don’t care, but when it comes down to the right way to use these products, I care. I think our clients are smart about that. I think the hardest part of that 100-year portfolio is the long vol, I truly believe it’s the hardest thing to do and do well. Being able to carry left tail exposure, and non-correlation and not bleed is one of the most difficult things and probably one of the only things worth paying for in the investment world, paying a premium for. There is value in having someone put the pieces together for you, though. I think there is a tremendous value there.
Meb: It’s a very non-trivial mental hack. And you’ve seen a lot of institutions go this way on their own, where they’ll like, it could be a managed futures manager, it could be a long vol manager, and I say, “Look, I know you’re not going to be able to stomach this on your own because we’re human. And this is the way it is. So, we’re going to wrap it where it’s half managed futures and half equity and call it something else.” And so this concept of whether an advisor does it, whether Artemis does it, whether it’s an actual fund that puts the two together, the hard part for an individual and many professionals too, is they still look at like the line item and they see one thing could be long vol, could be trend, who knows, that’s like consistently red, whatever the runway is, maybe it’s a year, maybe it’s two, but even large asset classes that were yesterday’s darling, emerging markets, my God, no one could get enough emerging markets in the 2000 to 2007 period. Every person on the planet commodities, real estate, and then flip, no one wanted stocks.
Chris: When was the most popular period for tail risk hedging? Was right after the ’08 financial crisis. So, I always say this, we’ll still have our bread and butter in long volatility. It’s always what we do, and always will be what we do. I will tell you after doing this for over a decade, our phone is ringing off the hook. For our long vol product, the VIX is at 70. It’s too late. That’s not when you want to be putting money in long vol. You need to be putting money in long vol when it’s a net loser, and in the rearview mirror and evolves slow, and equity market’s doing well, and vice versa. Everyone’s scared of equity, when in March of 2009. And that’s when you should be putting money.
A disciplined approach that has a discipline of rebalancing these is what’s so vital. You don’t need to time anything. You don’t need to time if you have all the components together. You don’t need to predict or time. If you have all the components together, you put them together, you trust in them, you know what they’re there for, we sit back. And I told those guys, I’m like, “I don’t care if you’re flat to down for decades, but what I care about is if we enter into stagflation, you do well.” That’s what I care about. Because I want my commodity trend guys to do really, really well during runaway momentum periods of stagflation, inflation, and commodity prices are exploding. If your rebounder or your defensive player or your goalie hasn’t been used for most of the game because your offence is doing so well, you don’t pull your defenders, investors do it all the time. They’re constantly pulling their goalie, and their defenders put on more offensive players on the table.
Meb: This is why we say it’s so essential that investors try to codify or write down their investment plan and rules on paper, even if it’s one page, could be half a page, here’s my Dragon Portfolio and I’m going to rebalance this once a year, wipe my hands, done, but then you have to stick to it. That could be tolerance based, you know, something declines 20%, whatever, doesn’t matter. The whole key is having that sort of methodology that allows you to take advantage of exactly what you’re talking about, which is last March, thank God, you had some long vol sort of investments and you could rebalance, or vice versa. Thank God, it’s lost money, while the stock market’s up 30%, rebalance.
If you took your paper, and maybe you can add this to your website at one point because it’s a great game. Again, referencing my buddy Eric Crittenden used to do with investors is he would make all the asset classes anonymous, and give it to an investor and say, “Okay, look at these stats, you pick, what do you want, and/or put them together and show the final portfolios.” And of course, he was looking at the trend following world, invariably, they would end up with a huge chunk and trend following of which they hadn’t done. But then when they actually had to go implement it, no chance. So, this concept of what you mentioned of mentally stepping away from these labels and your emotional attachment to them, I don’t want my identity to be attached to my ideas. Because if you’re an equities guy, and all of a sudden you have to sell some or to think back 2007, you didn’t want to sell your real estate, so bulls peak of their run. We’ve already identified of the dragon, the five pieces, who “the Worm” is, he’s long vol. Who are the other five players? Jordan’s got to be equity, right? The most popular.
Chris: Yeah, Jordan is equity, for sure. Absolutely. Jordan is definitely equity. Let’s look at this because you had Longley, you had Pippen, and you had Ron Harper. I’m going to call Ron Harper CTAs because Ron Harper was a great perimeter defender. So, that was the guy who was creating havoc on the perimeter. I’m going to call Scottie Pippen bonds. Jordan and Pippen, the meat and potatoes. And Pippen was also a great defender. Longley, I guess, is gold, because he’s Australian. And they make gold and they mine gold in Australia, so.
Meb: Who’s like the most inconsistent of the bulls? That’s who I would have said with gold. It’s like, you never know if they’re going to show up and play good or terrible.
Chris: Toni Kukoč, of course.
Meb: Yeah, he could be a good gold, too. I was going to say Steve Kerr could be bonds just because he’s so boring, but he didn’t have enough of a role. So, you couldn’t include him. I think Pippen is right on.
Chris: That’s your Dragon Portfolio, 98 Chicago Bulls. Hopefully, it lasts more than the last dance though. And hopefully, you can ride that team for 100 years rather than just three championships.
Meb: That’s like institutional portfolio manager messing up a good thing. You had a good portfolio and then they started mucking around with it. What are you going to do? Chris, I’ve been holding you for a long time. Anything else you’re thinking about? We’ve already talked about your new pieces. As you look out, it’s been a weird last two years, as you look out to the rest of 2021. Anything else on your brain, confused, excited about as you sip a beer or go to sleep, wake up in the middle of the night? What’s on the frontal lobe?
Chris: I think it’s been interesting just to sort of see some of these, you know, some of the stuff we’ve talked about for five years, the correlation breakdown between stocks and bonds, which you and I talked about, I think in our first podcast, first time I was on the show and was talked about in the 2015 paper. I think the reflexivity in the short VIX, excuse me, the reflexivity in the global short volatility trade, you know, that $3 trillion short vol trade that is on both implicitly and explicitly. You know, in the unwind of that, which I think was talked about in some of the papers in 2017. And now, I think, most recently, you know, it’s Mike Greene’s theory, but the dominance of passive and how that’s affecting different flows, as well… I think, you know, one of the things I’m proud of across my career is that a lot of these themes, and I know you and I have discussed many of these in the past, both in the podcast and offline as well. It is interesting to see some of these themes and theories really come to fruition.
And we are entering a period of secular decline in some capacity, the framework where, I don’t know if it’s going to be stagflation. I don’t know if it’s going to be deflation, but we have an unprecedented level of global debt, highest corporate debt to GDP in American history, some of the highest government deficits, and the spending isn’t stopping, whether that’s good or bad. I don’t know. But I do know that there’s two ways to deal with excess overhanging debt is deflation and stagflation. And the structure of markets, I think is particularly fragile. I think we’ve seen that the last two years. I think there are ways to improve portfolios, you don’t need to be afraid, not everything needs to be as Doomsday end of the world. These inefficiencies can be opportunities for people. The Dragon Portfolio, 100-year portfolio had an amazing year last year, that portfolio consistently made money throughout the year. So, you can transform this period of secular change to your benefit. But you can’t, if you’re just looking at the last 40 years as your baseline. I really appreciate having the opportunity to talk about some of these things with you and bring it to full circle.
Meb: Well, good. We can rope everyone in at your large happy hour gathering. We’ll post links to this, we’ll post links to this soon when we get a date on the books. I miss Austin, I need to get back down there. Chris, best place people to go if they want to find all these papers. I mean, we’ll post them to the show notes, listeners, mebfaber.com/podcast, but keep up with what y’all are doing, inquire into your funds, everything else? Where do they go?
Chris: Yeah, just go to www@artemiscm.com, www.artemiscm.com right on the website, all the research is up there, so you can download it. Unfortunately, I’m also on Twitter. But come to our website. The best framework is the deep dive on the research papers. I think that is some of the best stuff.
Meb: Awesome, my friend. Thanks so much for joining us and next time we won’t wait too long.
Chris: Thank you, Meb. I appreciate it.
Meb: Podcast listeners, we’ll post show notes to today’s conversation at mebfaber.com/podcast. If you love the show, if you hate it, shoot us feedback at feedback@themebfarbershow.com, we love to read the reviews, please review us on iTunes and subscribe to the show, anywhere good podcasts are found. Thanks for listening friends and good investing.
