Episode #389: Eric Crittenden, Standpoint Asset Management – The Market Owes You Nothing
Guest: Eric Crittenden is Chief Investment Officer of Standpoint Asset Management. He has over 20 years of experience designing and managing investment strategies, with an expertise in systematic trading in both mutual funds and hedge funds.
Date Recorded: 1/26/2022 | Run-Time: 1:15:09
Summary: In today’s episode, we’re talking with one of the true systematic investors out there. We start by discussing the potential impact of inflation on investors’ portfolios. Then Eric shares what led him to start a new firm focused on giving people what they need in a format they want – a mix of trend following and global equity beta. We touch on diversification and why Eric’s a true believer in trend following.
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Links from the Episode:
- 0:40 – Sponsor: The Idea Farm
- 1:09 – Intro
- 1:48 – Welcome back to our guest, Eric Crittenden; Episode #225 & Episode #14
- 2:46 – Episode #2 Tom McLellan, The McLellan Market Report
- 3:59 – The stealth bull market as told by copper
- 4:56 – Eric’s view on how inflation can impact portfolios
- 6:20 – What’s good to know about the 1970’s in regards to inflation
- 9:00 – The volatility of today’s markets given valuations at all time highs
- 11:48 – What Eric means by “the market owes you nothing”
- 21:29 – The false assumption that bonds are always a good diversifier for stocks
- 23:14 – The risk of stagflation
- 29:40 – Why Eric likes trend following
- 37:54 – Eric’s decision to pair equities with managed futures
- 45:02 – Eric’s view on commodities
- 57:21 – What percentage advisors allocate to these strategies?
- 59:00 – Episode 368 – Return Stacking
- 1:07:02 – What else has Eric curious as he looks out at 2022
- 1:10:29 – Spending time diving more into computer science
- 1:11:36 – Learn more about Eric; standpointfunds.com
Transcript of Episode 389:
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Meb: What’s up everybody? Today we’re bringing back a fan favorite for the third time. Our guest is the Chief Investment Officer at Standpoint Asset Management, an investment firm focused on bringing all-weather portfolio solutions to U.S. investors. In today’s show we’re talking with one of the true systematic investors out there. We start by discussing the potential impact of inflation on investors’ portfolios, then he shares what led him to start a new firm focused on giving people what they need in a format they want, which is a mix of trend following and global equity beta. We touch on diversification and why he’s a true believer in trend following. Please enjoy this episode with Standpoint Asset Management’s, Eric Crittenden.
Meb: Eric, welcome back to the show.
Eric: Thanks for having me back on, Meb.
Meb: It’s good to see you, my friend. Last time we had you on it was back in 2020, which seems so much more recent. Maybe you and I just caught up. Where do we find you today?
Eric: Safely at home in Scottsdale, Arizona. Sunny Scottsdale.
Meb: And as well as I know you, I know that you’ve just been prepping all week to watch and trade-off the Federal Reserve press conference. Right? Isn’t that your style?
Eric: Anything but I didn’t even know it was a fed day until a couple of hours ago.
Meb: It would have been a great bet. Does Eric know there’s a fed meeting today? I’m the same as you. It’s a little bit of theatre, but there’s good Alison Krauss song, one of my favorite singer/songwriter, is a bluegrass and she’s got a song, the name of it’s “You say best if you say nothing at all.” People love to try to divine every single word, and space, and sentence, and response to what people mean by some of these fed meetings. It’s funny because I posted a Tom McClellan, another old podcast guest, chart. And I said, “You know, wouldn’t it be funny if the fed just goes to these meetings, drink some beer, watch “Seinfeld” reruns, and just pegs the fed Funds rates to the two-year?” Because if you look at fed funds rate against a two-year, they’re not exact clones, but they’re pretty close. And all this time people spend prognosticating and pulling their hair out is really just an exercise and nothing. Hopefully, Jay Powell saw that. I don’t know.
Eric: I couldn’t agree more. I’ve looked at that lead-lag effect between fed funds rate and the two-year and it definitely seems like they just follow that thing around and gravitate towards it. If I had a nickel for every person I’ve known that blew themselves up trying to trade on fed days, I’d be richer.
Meb: Speaking of nickels, I wonder how Kyle Bass famously bought, was hoarding and storing a bunch of nickels back in the day, because the melt value is worth higher than the actual nickel. Do you remember this? And it’s a big problem with telling people this. Which is the same problem of telling…if you’re Jay Powell, telling people you would peg it to the two-year because then people would start to know that you’re pegging it to the two-year. But the nickel thing is illegal, the meltdown currency. So I think as soon as you tell people you have $20 million in nickels, what are you supposed to do with it anyway? What’s going on with copper right now? Been going sideways for a little bit, but it’s pretty darn near all-time highs, five bucks, I think. Isn’t that a copper resistance that’s never been breached, or am I way off base here?
Eric: I’m not sure. It’s not in our portfolio. It hasn’t done much, like you mentioned, over the recent history. And we’re trend following at heart, so it’s just not in the portfolio. But I’m going to take a look right now, see if there’s truth to what you’re saying.
Meb: It’s been kind of sideways for the past, I don’t know, six months, or a year even. But it had a huge run in 2020 and isn’t consolidating. But if you look back, all the way back to 2011 maybe, it hit this four and a half range.
Eric: You’re right. It’s not that far away from an all-time high, or at least going back to 2003, which would be an all-time high. So yeah, that’s kind of a stealth bull market that not a lot of people are paying attention to. Another piece of evidence for potential inflation.
Meb: You’re a systematic guy. So I’m drinking tea right now, but a happy hour sort of conversation. What’s your kind of general view on inflation and what’s going on in the world right now? Heading down to Miami in a couple of weeks, and I was trying to book a hotel and half the hotels were $1,300. And I was like, “Oh my God, what is even happening?” You got any off-the-record insight into how you think about inflation and how it impacts portfolios keep you up at night, or is it something you don’t think about at all?
Eric: Yeah, it’s a complex topic. I have a lot of opinions about inflation. But I think before you get into those, you have to ask the person you’re talking to what’s their definition of inflation. You ask 10 different people, you’ll get 6, 7 different answers. So some people will say it’s CPI and other people will say no, it’s the prices that I pay for the goods that I consume. It’s not owner equivalent rent and whatnot.
So the truth is right now we don’t know if the deflationary pressures are going to come back, the demographic deflationary pressures, and then this ends up being transitory. Or if it’s sticky and the debts getting monetized and you have negative real yields, and this turns into something meaningful like the 1970s, we don’t know, I don’t know. Which is why we invest the way we do, disciplined and tactical. And if it turns into something sticky, that sticks around, we’re comfortable with that, we’ll roll with those punches. If it turns out to be transitory and we go back to deflation, we’re comfortable with that reality, too, going forward. But I can’t tell you which one we’re going to get. I don’t think anyone can.
Meb: The beauty of having the trend-following approach and being systematic is those two outcomes are pretty different. You harken back to the days, the ’70s and inflation, and most traditional portfolios just really sucked when. If you look at our old asset allocation book, unless you had some real asset exposure or were actively trading, almost every buy-and-hold portfolio was challenged. And then flipside is you have a deflationary Japan scenario on the other side, that’s hard too. And no one seemingly wants any fixed income treasuries where they are here, but you have that sort of world that’s a pretty interesting asset to have as well.
Eric: Let’s talk a little bit more about the 1970s and inflation. As my co-workers like to point out to me, because I’m so buried in the empirical data, and have a scientific process to investing, they always remind me to be open-minded about getting an environment like nothing we’ve ever seen before. That guy, Mike Green, over at Simplify comes up with these elaborate, well-thought-out scenarios about how we might be going into an environment where there is no historical precedent. So like you said, it could be inflation, it could be deflation, it could be something in between, or both at the same time in competing sectors. We truly are in very different times. I’ve been doing this for 25 years, I’ve never seen anything like the current environment.
Meb: What does that mean?
Eric: If you look at valuations and stocks, they’re definitely not low. You look at the real yields and bonds, they’re deeply negative. You look at the fragility in the system and the sentiment, there are some parallels. The other day when Netflix blew up, that felt like a lucid moment to me. Do you remember when Lucent blew up in 2000?
Meb: Actually, that was a stock that I used to own. And I remember being an intern at Lockheed Martin. And the way you’d check quotes back then, you just read the newspaper. They were in fractions. Pulled the business section. “Oh my God, Lucent’s up another $2 LU.” So I have a very fond tax loss carried for a long time from Lucent.
Eric: I worked for a big family office in Kansas. And I was next to all the traders that work there. And then the patriarch of the family, when the earnings news came across and they saw Lucent was down 50% in the aftermarket, and they owned an enormous amount of that stock, it was gut-wrenching to look at the psychological reaction to losing 50% in half a second. That was a learning moment for me to see all these people and their reactions. And in hindsight, that was the peak in 2000. I call it the Lucent moment. Then there was the Bear Stearns moment, I think it was 2007. These moments, and maybe Netflix was another moment or maybe not, you never know. You know after the fact when the dust settles. But right now we don’t know.
Meb: You did a tweet, I think it was last year actually. Let’s pull it up. You said something along the lines of, “This feels like one of these environments where you blink, look around and wonder, ‘Man, when did all these high-flying expensive stocks go down 80%?'” Look at a lot of the tech stocks and there’s an absolute carnage over the past year, seemingly peaking around Feb, March of almost a year ago, with the broad cap-weighted markets being at all-time highs, which is an interesting differentiation. You see a lot of people tweeting or talking about how much they’re struggling, and their portfolios are down so much. But at the same time, you see the market-cap-weighted stuff shrugging it all off and still chugging along. And that’s a reminder that indices are not necessarily what people own. And the Lucent example, I think is a great one.
Eric: That’s another observation of things that have happened in the past that are not particularly bullish. Were you trading in ’98?
Meb: Yeah. So I would have been in university. And I tell a lot of stories about this because my engineering professors would straight up be trading stocks in class. This is more ’99, 2000, you would see them checking quotes. And E-Trade was the Robin Hood of the day back then. And so I remember getting some of these IPO allocations and a lot of very seared-in-my-memory experiences from that period, good and bad.
Eric: I had a finance professor, she’s probably the best finance professor at my university, constantly buying puts on Amazon in ’98, and just losing gobs of money and just couldn’t figure out why these valuations make no sense. But my point though is that the average U.S. stock peaked in ’98, didn’t peak in 2000, small-caps, mid-caps, the breath in the market. The market-cap-weighted index has carried the market to a new high, I think, in what was that? March of 2000. But the average stock peaked approximately a year and a half, two years before.
Same thing happened in 2008. I was running a long-short program and a futures program in 2008. And I remember looking at the breath in the spring of 2008, when the long-short program was really starting to deleverage and get out of the stock market. But the stock market was at a new all-time high, but the average stock had been deteriorating for three quarters. And then by the time Lehman blew up, most stocks were down meaningfully off their highs. It didn’t look anything like the market-cap-weighted indexes.
So here we are, again, today kind of the same phenomenon. You just brought it up that a lot of these high-flying tech stocks have been struggling for over a year now. Yet, the market-cap-weighted indexes really aren’t much off their all-time high. So these parallels are interesting to me. I don’t make investment decisions off of them. Like you said, we have a systematic rules-based process. But still, these things jump out at you infrequently, you know, once a decade, once every 15 years, it’s hard to ignore them.
Meb: You see these spreads in the performance, sometimes you’ll see the market cap, so S&P 500 versus, say, small-caps or micro-caps, or value versus growth, or U.S. versus foreign. People love to talk as if there’s just one market everywhere, TV and Twitter, that are seeing the market. And usually, that’s referring to S&P 500. That’s the default. But at the same time, it’s like talking about PE ratios. I got into getting ratio’d on Twitter the other day, because I did a tweet about PE ratios and I said the 10-year PE ratio. And all the responses were talking about some other PE ratio. There’s like 10 different PE ratios. You have to have the common language or else you may not be talking about the same thing. And it goes back to your original comments on inflation, too, you can have inflation and say higher education, but deflation and TVs or whatever. It’s not one uniform market as people talk about. Unless they’re just talking about the S&P.
Eric: Right, which they usually are. Okay, so I went off on a tangent there. But your question was about a statement that I evidently made that the market owes you nothing. So I don’t recall making that statement publicly. But I say it all the time, even when no one else is in the room. So I guess we should cover it.
Meb: Well, because people expect… I’m not sure, what do you mean they owe you nothing? People expect 10% returns on stocks, pension funds, expect 7%, 8% returns on their pensions, and that’s both public and private, corporate as well. The pensioners expect their pension to be there. What do you mean? What are you telling me that the market owes me nothing? It owes me 10%, 8% returns.
Eric: So this concept’s important to me because I think that it’s important to understand the ecosystem in which you’re participating, why it actually exists. There’s valuable knowledge and potentially wisdom in understanding what this whole thing is set up for, you know, why it exists in the first place. When I look at the stock market, what I see is a capital formation market. It’s a place where people can go and sell equity and raise capital in order to go out do a business with the kind of risk structure that they want, limited liability or they can do preferred, or convertibles, or whatever.
It’s nothing more than that. It’s not a utility that was designed to give you 8% a year. It doesn’t have to go up. It can go down 50%, as we’ve seen. It can go down 90%, as we saw in the Great Depression. It doesn’t need to be consistent and it hasn’t been. There’s been decades where it’s been 25% a year and there have been other decades where it’s zero. So all the empirical data comes back and says that if you want a consistent, smooth return, the stock market is not the place to get that. And there probably isn’t a place to get a smooth, high consistent return. I’ve not seen one.
Meb: What do you mean? It’s all these private real estate interval mutual funds that, you know, they check your balance once a year and they report 4% vol. And same with private equities. Private equity is the savior for everyone, Eric. The pension funds all have been taking their cash balance down and putting it in private equity because you only check once a year. There are no drawdowns there.
Eric: None that you can see until they happen and then there’s nothing you can do about it. But yeah, that’s just the Titanic iceberg risk. The risk is there, you’re just not seeing it. The fact that you’re not checking the temperature of the risk doesn’t mean it’s not there. And yeah, the industry is plagued with products and programs that are designed to obscure the risk you’re taking so that you are less afraid. And that actually works to some people’s benefit, because they won’t sell prematurely. But the risk is there. Risk cannot be created or destroyed, just transformed. So the fact that you’re not seeing it does not mean it’s not there.
So the markets owe you nothing. So there are two kinds of markets in the world that I concern myself with, capital formation markets, that’s stocks and bonds. That’s where you go to essentially sell a piece of your business to someone else or borrow money at some sort of a structured or at an interest rate with on covenants and whatnot. And they don’t owe you anything. And if you get 8% a year from that, that’s great but you’re not guaranteed that. And they’re not set up for you, they’re set up for the person that wants to sell equity, and someone else that wants to buy equity. And their job is to clear the market, to bring those buyers and sellers together at a price where they can both agree. And that might be 30% higher, it might be 50% lower, it might be yesterday’s close. It is what it is. It’s supply and demand. And that’s all these markets were designed to do.
We become accustomed to everyone just putting their money in there like it’s a bank and earning a return. And that’s okay. It’s okay to invest like that. But just realize that these markets weren’t designed for you. Therefore, there’s going to be times where they do stuff that doesn’t make you happy. And that’s not something to sue someone over or get angry or be confused about. They’re just not designed to be utilities for you. It’s not like your stove, when you turn it on the natural gas is supposed to flow.
Now, the other kind of market is what I call a risk transfer market. Those are the futures, forwards, swaps. They’re designed also to bring buyers and sellers together, but not for capital formation purposes, for risk transfer purposes. It’s a place where hedgers can go and eliminate or lay off certain risks that they don’t want to take that may be redundant with what’s on their balance sheet and their income statement and then their core business. So those are the two primary kind of markets that I concern myself with. And neither one is designed to conveniently and safely deliver you the return that you want over time. If you want that, you have to build a strategy and participate in these markets in a way that’s accretive to those markets. Especially in the risk transfer markets, if you want to earn a return, you need to participate in a way that’s beneficial to the marketplace as a whole.
And I bring this up because it may not be important to other people, but it’s very important to me to understand the ecosystem and what the rules are. And how you can create a situation where any returns that you get are actually justified.
Meb: A conversation I was having with an adviser yesterday. And by the time this drops, it will have been published on the podcast. Whitney Baker, she has a nice chart of household net worth and household income, both relative to GDP. And it’s at the highest level it’s ever been for both. But the second-highest was the ’20s. And the reason talking about it is that anytime you have money, it sort of resets your expectations. So as anyone knows, with this hedonic adaptation of a new salary, where if you get inheritance, whatever happens in your life where you come into some money, athletes are a great example, you have this honeymoon period, maybe it’s three months, maybe it’s six months, where you’re probably a lot happier. And then you kind of adjust and you start, most people, spending money on bigger houses, and nicer cars, and fancy vacations, and better dinners, on and on and then you kind of readjust back to normal happiness.
But he was talking, he says, “You know, I’ve been in this business a long time. And one of the problems of bull markets last a while is the expectations ratchet up.” And we see these with the surveys all the time where they expect stocks return more and more and more as the market goes up and up and up. So some of the crazy ones last year were north of 15% on stocks and portfolio. But they say it also creates some interesting behavioral challenges. So he says you see a wave of retirees, or people all of a sudden see their investment portfolios get to a certain point, because they’re always heavy in equities, particularly in the U.S.
And then the US has had this run and then they get to a point where they’re, “Oh, I can retire now, I’m fat and happy.” They retire and then they have one of the normal bear markets, which happens all the time, it goes down 20%, or 40%, or 50%. And it creates a huge behavioral problem because they get to the point of the whole, “I can’t take it anymore. I’ve retired. I can’t lose this all,” on and on and on. And so the sequence, which you and I used to talk about 10 years ago, I think, of returns comes a big behavioral challenge, particularly at turning points in the big bull markets.
Eric: Yeah. I mean, it’s the bane of every financial adviser’s existence, right? It’s the constantly repeating whipsaw of client emotions, and expectations being a function of the recent performance. A nonlinear function, too, meaning the longer it goes, the more entitled people… This applies to all of us. Our brains are all basically hardwired the same way. If something’s been working for seven years, you don’t want to bet against that. It’s irresponsible.
You and I have talked for over a decade about ways to deal with this. I think the big mistake that a lot of practitioners make… And this is just my opinion, I’m not an expert on the subject matter. But it does seem apparent to me that the big mistake is they try to change the investor’s behavior and the investor’s psychology. And that’s a one-to-many relationship.
Let’s say you have an adviser and she has 600 clients. So that’s 600 really tough conversations where you’re swimming upstream and going against the grain. And everyone talks about it, everyone’s bright-eyed and bushy-tailed when they get their CFP, or they get some other designation and they go out and they’re going to change the world. And then check back with them 10, 15 years later, and they’re just worn out and having the same conversations with clients over and over and over. Then they start using the word education a lot. “I need to educate my clients,” this type of thing. I’ve been hearing that from people for as long as I’ve been paying attention, and they take that phrase all the way to their grave, and pretty much don’t make a dent. It’s just, look, we’re hardwired that way. That’s our software. It’s entrenched. It is what it is.
I think that a better approach, though, is to actually build products that have the cyclicality diversified out. And then just trying to do business with people that are enthusiastic about having realistic expectations. Because they’re out there. That’s actually the majority of people. They get carried away at times, sure. But it’s not that hard to talk someone down off the ledge if you have a credible alternative to the roller coaster, something they can actually believe in. So if you can diversify away the cyclicality, in my experience, it’s not that hard to talk sense to most people.
Meb: It seems like the nightmare scenario that we talk a lot about as a potential that I think everyone assumes can’t happen. And we’ve been talking about this for over a decade. But the thing that would really, I think, inflict the most pain is a scenario where both U.S. stocks and U.S. bonds do poorly. And a lot of people just assume that U.S. stocks and bonds are always negatively correlated. And so in the bad times for stocks, bonds will do okay and vice versa. Is that a dangerous assumption? 60/40 has crushed just about everything, including a lot of the biggest, smartest institutions in the world the past decade. What sort of problems does that cause? And then let’s start to move toward what can we do about it?
Eric: I think the assumption that bonds will always bail you out when stocks go down is the most dangerous assumption in the asset management industry. And that’s why I think the 1970s are such an important decade to familiarize yourself with and wrap your head around. A lot of my peers say that was an aberration anomaly and not something to be taken seriously. I think they’re wrong. I think it’s a very valid data point. I think stagflation is a very real risk, and that it’s terribly irresponsible to not have a plan for dealing with it. Because I think it’s actually a very likely scenario. I’m not saying 90% or anything like that. I’m just saying that I look at the algebra of the central bank balance sheets, the demographics, the valuations, the bond yields, the real yields, I look at the algebra of all this and say, “Like water, it’s going to go to its lowest common denominator. It’s going to sink and it’s going to find balance somehow.” The path of least resistance is stagflation. It’s a decade of stagflation. Again, I can’t guarantee that’ll happen.
Meb: Explain to the listeners what stagflation is, if they don’t know.
Eric: Depending upon who you ask, you’ll get different answers. But to me, stagflation is something along the lines in the 1970s where the stock market does not generate a positive return and it has severe downside volatility, a couple of 40%, 50% drawdowns. And basically, you’re right where you started, say, 12, 14 years ago. So I think in ’82, you were right where you started in 1968. That’s a long time to make no money in stocks, and to have a couple of 40% and 50% drawdowns along the way. But at the same time, bonds don’t work for you either. And in fact, the bonds go down the same time the stocks go down. That’s what we saw in the 1970s.
And you can feel those same correlations creeping up in today’s environment. We see days, even today, I think stocks and bonds were down at the same time. Meb, sometimes bonds are the problem, not the solution. It’s infrequent. It’s kind of like that iceberg risk we talked about earlier where it is infrequent, but it is terrible when it happens. And I’m not predicting it will happen, but I’m not going to be the least bit surprised if we get a meaningful bout of stagflation. And it could drag on for a long time. And I just don’t see any reason to be proud of not having any preparation or any thought that goes into dealing with stagflation, considering that it’s such a horrible experience. And it would be the worst possible experience for baby boomers and people that are going into retirement right now. The last thing that they need is drawdowns and no diversification right now. And my fear is that not very many people are prepared for that, and it’s very possible.
Meb: I remember maybe a year ago when bonds were plumbing the lows on yield and you’re pulling your hair out and showing me some simulations. You’re like, “Meb, there’s just basically no way possible bonds can have a positive return over the next five years, even if they go hard into negative yields.” We kind of went through all these simulations and it was a fun chat. Similar analogue, I think, is during the pandemic, if I recall, a lot of the foreign sovereign yields in a lot of these countries were already zero and negative. And when the coronavirus panic happened and it hit the fan in a lot of these countries, their sovereigns didn’t really help. If I recall, they didn’t provide much cushion to the equity markets getting pummeled in those countries. They did in the U.S., but the U.S. was a relatively higher-yielding bond market at the time. So this assumption that treasuries will always hedge a market puke, I think, is problematic if you’re relying on it to outperform.
Eric: Yeah, and I would echo those thoughts. I remember looking at some of the German, UK debt markets and seeing that they didn’t bounce much at all, when the stock market was just ripping off huge losses. And in the U.S. they bounced a little bit, but not like what people were expecting. I know. I was long treasuries during COVID. And that’s not what saved us during COVID. Not at all. It was being short energy, and longs on flight to quality currencies. We made a little bit of money being long treasuries, but not the kind of money you expect to during a risk-off event like COVID.
So this has been happening for a while now. Here’s my point, if we get a really bad outcome going forward, let’s say we get five years of really bad results, no one’s going to be surprised. They’re going to look back, and it’ll be very easy to say, “Well, the correlations between stocks and bonds had been steadily rising. Bonds hadn’t been paying off on down days for years. What was everyone so confused about?” That’ll be with hindsight, but that’s the conversation people will be having if we do get serious risk-off market environment.
Meb: Before we start talking about solutions, I love being devil’s advocate. And people always ask me, they say, “Okay, Meb, how do stocks do 10% for the next 10 years, if you could wave a wand? How does this possibly happen?” What needs to happen for 60/40 to be okay, or this be a decade in the 2020s where things work out and it’s not meager returns, but we do hit 8% a year, or I’d say 5% real on stocks and bonds, 60/40 for the next decade? Can you envision a world where that happens?
Eric: Yeah, we’ve been in that world, actually, for quite a few years now. I don’t think it’s realistically possible to get a positive real return from government bonds going forward. I’ll extend that to corporate bonds as well, those are a little harder to model. That simulation that you referenced, I did that video I think it was in August of 2020, maybe September, where I just shared the results of a Monte Carlo simulation that took the mathematics of bonds and basically extrapolated the amount of 3,000 different future scenarios, and showed that I think out of 3,000 possible scenarios, only 1 had a positive real rate of return.
Meb: That’s the whole plot of “Avengers End Game” when Dr. Strange is like, “I did a million scenarios and there’s one that worked.” And look what happened with the Avengers, it worked out for them. One could be the possible path. Let’s hear what happens in that path.
Eric: Well, the weight of the evidence strongly suggests that a reasonable person who’s informed about bond math shouldn’t expect a positive real return. They could get it, but it’s pretty unreasonable to expect it going forward, at least over the short and intermediate-term. One way it could happen is if you get negative yields. You can make money from capital gains and bonds if yields go negative. And I’m not ruling that out, it is possible. You do have the demographic fuel for negative yields. But they literally have to go to negative six on the 10-year for you to get the normal, I think, 7% return a year from 10-year bonds that people have been accustomed to over the last 40 years.
So if the 10-year goes to negative six, people are going to be eating each other in the streets. Like, that’s going to be a real bad environment. So I don’t think it’s a good bet. I think it’s a bad business decision to expect that. But still bonds have been holding up. I mean, they haven’t been doing well for the last year and a half. But over the long-term, they have held up really well and no one does the analysis. And we don’t have a problem until we feel the pain. That’s kind of the mentality. But you ask the question, how does the 60/40 portfolio make 5% real over the next 10 years? Well, I think based on what I just said, most of that’s got to come from the stocks. I don’t think you’re going to get any real from bonds. Possible, just very, very unlikely. So if 60% of your money’s in stocks and you need 5%, you just do a little bit of algebra and you need a certain return from stocks over the next 10 years. And is that possible? Yeah, it’s a lot more possible than bonds getting out a real positive return. Is it likely? No, it’s not likely.
Meb: I had a tweet about this, but Oracle had put out an expectation for the disruption companies they invest in to go from a market cap currently, I think, of a 10 trillion to 200 trillion at the end of this decade. And I scratched my head and the current market cap of global equities is 100 trillion. So their expectations was that this group of innovation across the five or six sectors they look at would compound the market cap by 37% a year and the rest of the companies outside of that is minus 8% or something. And it’s one of these things you look at and you say, “Look, is it a possible scenario?” It is. Is that the probable outcome? It’s hard to see, at least in my mind, that sort of outcome happening. But you got to think about these things. Because as a student of history, we’ve certainly seen weird things happen plenty of times and trend following, from one trend follower to another, at least lets you ride along with these possible crazy outlier scenarios, both up and down, good and bad, right?
Eric: Yeah, totally. I was going to talk about that. I may sound like an overly pragmatic person that’s stuck in the textbooks and the fundamentals, I’m not. The disciplined trend-following approach just drags us along into whatever is working, no matter how crazy it seems. And you apply some risk management to it, and a guy like me can sleep at night. So I’ll give you an example. One of our biggest winning positions over the past of couple years have been carbon emission credits. Now, while everyone’s talking about Ethereum and Bitcoin, and all these other things, carbon emission credits are the best performing market in the world, from what I’ve seen, over the last two, three, and I think four years and no one’s even talking about them. It’s a huge market, deeply liquid, a lot of open interest in volume. It’s an interesting story. And it’s the best performing market that I’ve seen, and no one’s talking about it. And it’s correlated with nothing.
We were buying this thing a year ago, I think it was around five. Now it’s it at 88. I mean, that’s a big move for a deeply-liquid futures market. And we won’t go into the details about what it is, but briefly, the EU has capped the amount of carbon emissions that are allowed, and then they issue credits to people. And if you want to admit more, you got to buy credits from someone else. If you become efficient, and you can cut your emissions, then you sell your credits to someone else. It creates a supply and demand. It’s going to reward people that are cleaner and penalize people and they have to pay more if they just can’t get their stuff together and reduce their emissions. No politics involved, it’s just risk transfer market that I’m trading.
Meb: The philosophy of trend following that I’ve always been drawn to is so many investors are intentionally or not, leverage to certain market outcomes. So they’re either tied to inflation, or deflation, or U.S. assets performing well, or value stocks. The beauty of the trend is it will often lead you to places that you may not go otherwise and have exposures as these markets get out of whack. So if U.S. stocks keep going up market-cap-weighted, you’ll be invested despite our feelings of nervousness about that possibility. And ditto with all these other markets and what’s happening. Talk to us a little bit about okay, so you’re a trend follower, you do it a little different now, you got a couple of mutual funds, some of my favorite tickers, BLEND-X and RIMIX. Tell us a little bit about how you guys put together your strategies, because it’s not pure-managed futures in the traditional sense of what most people would think. How’s it all fit together and why?
Eric: We consider ourselves to be rules-based macro, and totally global in nature. So we track the 75 most liquid futures markets around the world. And then we use cash equities, particularly ETFs, for our equity exposure, both domestically and internationally. So we care about taxes. And we structure our products, we think, in an intelligent manner to minimize the tax bill and to minimize the fees and the acquired fund fees that you pay and whatnot.
So from a trend perspective, after I left my last firm, I had to take about a year and a half off. And that was great, because when you have a non-compete, you need to move away from the industry and just take time off. I don’t know that I ever would have had the ability to stop participating in the markets for a year and a half. And that’s valuable. In fact, I would recommend that people do this. It’s like fasting or something like that where you just have a different perspective on life when the pressures, and the stress, and the expectations, and the routine deadlines that you have when you’re actually running money. When you don’t have that your brain works differently. Creativity is different.
So I decided to go back to the drawing board and retest every assumption. Every nugget of wisdom that I thought I had, I wanted to retest it. And when you take a year and a half off, you have time to do that. I also went back to school and for the second time, studied some of these concepts like artificial intelligence, and machine learning, and all that other stuff. So I learned a couple of things that were inconsistent with some of the prior beliefs that I held. So it was actually quite a humbling experience.
The first one is that I was highly biased towards what I call the small-cap premium. And I still am, it’s just part of my software and hardwiring. I naturally assume that if it’s hard to do, there must be more risk premia there, more upside reward. If it’s small and limited, it must be valuable. If it’s scarce, it must be valuable. And I think that’s just human nature to feel that way. So I wanted to trade obscure markets like Malaysian palm oil and Japanese platinum in these tiny markets. And I wanted to trade synthetic markets and go where a seemingly wasn’t crowded. I thought that was a source of alpha and return. And there are many people out there that will argue forcefully that it is. It’s a prominent thing in their programs.
But when I objectively looked at this and said, “All right, I’ll play devil’s advocate and take the other side,” what I found is if you just concentrate in the most liquid markets, you still diversify, you’ve got energies, you’ve got grains, you’ve got livestock, you’ve got bonds, you’ve got currencies, you’re still diversified, but you’re just going to focus on the most liquid markets in each sector, there is literally no deterioration whatsoever. And I run my simulations back to 1970. So I want to cover most plausible market environments, I think it’s important to include the ’70s. And it’s because you have much lower slippage, market impact, transaction costs, and your scale is 10, 20 times greater. I just had to admit that I was wrong. There’s just not that much alpha associated with going into these obscure markets, even though they’re uncorrelated with the core markets.
So I thought about, well, why would that be true? And it got me back to my thesis about the risk transfer markets being a negative-sum game, and the source of the returns that trend followers collect it comes from the hedgers. It can’t come from anyone else. They’re the only ones that have the deep pockets that are both willing and able to lose money in the futures markets. It’s got to come from somewhere, and that’s it. And they’re not participating in a meaningful way in these tiny markets.
And the other thing I did is I looked at who the really big boys, the people that have been doing this for decades successfully, they’re all managing $10 billion to $40 billion. So they can’t be trading in these tiny markets, not in any kind of size that’s meaningful. So that was a liberating experience for me, because I thought, “Well, I’m an empirical guy. Yeah, I’ve got my biases, but I’m not a slave to them. So I’m going to build something that is durable, reliable, and scalable this time around.” And that’s what I did. So it’s pretty simple. Like I mentioned earlier, I studied AI, machine learning, neural networks, genetic algorithms, all that stuff. And I found that there’s just no need for them in this space for what I want to accomplish.
I am not crapping on what other people are doing. But at the end of the day, the risk premia I’m looking for, you can’t manufacture it. It’s not alchemy. If it doesn’t exist, you can’t collect it. You can’t go out and create it. And the risk premia that I’m looking for from the hedgers is thick, it’s available, and it’s not complicated to extract from the markets. I’m not saying it’s easy, but it is simple. Psychologically, it’s not easy at all. Nobody likes trend following in practice because you’re buying things that are up and you’re selling things that are down, and you’re laying out risk after a drawdown. Psychologically, it’s not fun. But boy, is it effective, especially when you pair it up with risk assets like global equities or corporate bonds.
Meb: The decision to pair traditional equities with managed futures, remind us…we talked about this last time, but give us a quick overview of what the decision was there, and then a quick review of how you do the manage future side, the trend-following side of the portfolio in general, long, short markets traded.
Eric: Why did we not just build a good global trend program, or managed futures, or global macro, whatever you want to call it? Part of that was just business where the managed futures industry shoots itself in the foot because it’s so uncorrelated to equities. People can see the math. When you bring in a good, even decent trend-following program into a portfolio, it adds a lot of value. The same way bonds add a lot of value. Because it tends to be uncorrelated, especially in hostile market conditions. And a lot of the time, historically, makes money when everything else in the portfolio is going down. So it adds a lot of value.
But that doesn’t translate into happiness because there are times when the stock market’s soaring and your alternative investments, whether they’re managed futures or global macro are going sideways, you’re losing money. And it just drives a wedge in between the adviser and the client. And it requires all these conversations. And it’s just crappy business to be in. And you end up not helping people because they buy you when they’re scared, and you’ve been going up, and then they sell you when you’ve gone sideways for a couple of quarters and the stock market’s going up. And they end up being worse off for the allocation. It’s the way it’s always been with human nature.
So my team and I, we sat down and said, all right, is there a responsible creative way that we can solve this problem? And think back to our conversation from 20 minutes ago where I said, you can just keep yelling at people, and having all this education, and keep going and going and going, but it just doesn’t really make a dent. Even if you can bully people into being educated in dollar-cost averaging and rewarding diversification, it’s not in their nature to be happy about that. It’s in their nature to be envious of relative performance. They just want all their money in the best-performing asset class.
So is there a better way? And what we found is that yeah, there’s a better way. You handle the diversification internally. Do it inside of your own fund so that they don’t have to deal with a line item risk and see these things moving in different directions. So in other words, you build the optimal portfolio and offer that as a fund. Make sure there’s enough managed futures or trend in there to make a big difference. But don’t force them to deal with what we call the statement risk or line item risk. And then everyone can be happy.
But what really sold me mad was one of my co-workers said to me one day, and he said, “Eric, what do you do with your own money?” He already knew but he was asking me. And I looked and said, “Well, I run a blend of our managed futures program and global equity beta.” And he said, “Why do you do that?” I said, “Well, because that’s the optimal portfolio.” And he said, “What’s your definition of optimal?” And I said, “I want to put myself in a position to compound at a reasonable rate with the least amount of iceberg risk through any kind of market environment that we get in the future, any plausible market environments.”
And he said, “And what about taxes?” And I said, “I like it because it’s reasonably tax-efficient.” “Fees?” And I said, “Yeah, it’s pretty fee-efficient, too.” And he said, “So why are you not building a business around that? Don’t you think that other people would appreciate something like that?” And then it hit me that I’m an idiot and I just need to stop, put my ego in a closet and say, “I don’t need to create the best-managed futures fund in the world, or macro, or whatever. I just need to offer something I believe in and find out if there’s a fit in the marketplace.” And so far, I think the marketplace has said, “Yeah, this makes sense to us.”
Meb: An interesting setup could potentially be, and you could walk us through how much this would happen, global equities going to a downtrend. Presumably, the trend side could short equities. Is that true? And then how much of the equity exposure would that take down? Would it take down half of it, all of it?
Eric: It’s a great question. And that is what keeps trend followers up at night when you convince them to put some dedicated long exposure in their portfolios. Because they all think the next Great Depression is right around the corner, or a crash of ’87, or a 35-year bear market like the Nikkei. So here’s how I sleep at night. I look at the dedicated equity exposure, which is generally about half our money. Half our money goes into low fee, low tax global equities. That’s allowed to oscillate. So it can go as high as two-thirds or can go as low as one-third. If it gets down to one-third, we don’t rebalance back to half. Because that’s kind of an extreme thing to do. Because you know how dangerous it is to rebalance on the wrong day.
In 2008, I know a lot of people that were rebalancing right before Lehman. They just bought a bunch of stocks because the market was down and then they just got buried. And then it happened to them again the next February where they bought a bunch of stocks and got buried. So there are responsible ways to rebalance. You can tranche it up and do one-twelfth every month, or one-fifty second every week, or whatever, there are responsible ways. But anytime that you’re rebalancing, you’re creating a counter-trend effect. And that’s okay, if that’s the risk you want to run. And there’s a reason that it’s worked historically.
Well, we found a way to essentially regulate the amount of long-only exposure in the portfolio without binomial, large transaction rebalancing. And that is just to enforce those guardrails. If it goes below a third, we will buy to keep it at a third and not let it go any lower than that. Likewise, if there’s a huge bull market and our equity exposure goes all the way up to two-thirds, we will sell, tiny sell transactions to keep it from going any higher. But if it’s going to go from one-third to two-thirds, or two-thirds to one-third, it’s got to do it on its own.
And the reason I like this approach…because I simulated every kind of rebalancing strategy I could come up, with calendar-based, standard deviation based, the whole bunch of different strategies. And you probably already know this, but they all basically get you to the same destination. The only difference is the path travelled and the turnover. The approach that we use in the fund right now is 90% less turnover than the median rebalancing approach, but basically gets you to the same destination. So not paying taxes, not churning the portfolio, transaction costs, those are all real costs.
So you asked the question, though, what would happen if we went into a vicious bear market and you are holding it steady at one-third of the portfolio? You’re right, on the trend side, the same indexes that underlie the ETFs that we’re holding are in the futures program. It’s the exact same indexes. And in a runaway bear market, you’re almost certainly going to have meaningful short positions on those same indexes. And that’s going to go a long way towards offsetting that dedicated long-equity exposure in a way that doesn’t require you to sell your equities and generate capital gains or losses.
So is it one-to-one? No, but it’s pretty close to that. It’s enough to offset it meaningfully. And same on upside, too. You could be doubling up on your equity exposure. That happened for us over the last couple of years. Doesn’t mean that you’re using leverage or going more than, say, 70% or 80% net long, but you can be stacking on top of the exposure that you already have. And that’s the beauty of a trend-following program is that it’s completely indifferent to fundamentals, sentiment, it’s just going to get in line with whatever the current trend is and calibrate your risk to the volatility of that market. Wash, rinse, repeat.
Meb: That’s a great way to think about it. I like to think about it’s like a tactical or dynamic neutralizer or market-neutral approach that you want the equities, but it can take it down to a near probably zero beta. But if you think about the ’70s, and you think about all these potential outcomes, one of the things that a lot of portfolios have zero allocated to, and I’m not going to say emerging markets, listeners, because I know you guys don’t have any of that anyway. But mainly, it’s a relative of the real asset trade, which a lot of asset classes can rhyme.
So whether it’s dollar down, or emerging markets up, commodities, REITs, tips, they may not correlate all the time, and they may correlate at different points. But we consistently do polls, and we ask people if they have anything allocated to real assets, and it’s almost always negligible. With the exception of my Canadian and Australian followers, probably, they got a chunk in gold or miners. But is that a potential savior? If we go through the ’70s as a commodities and things like that, which all seem to be, with the exception of metals, long currently and having some big moves over the past year or two? What are your general thoughts on if equities and bonds aren’t going to be the savior, what might be?
Eric: It’s hard to know in advance. We talked about this a little bit earlier, where we could get an environment that’s very different from anything we’ve seen before. So if the ’70s are the proxy for what we’re talking about, it was being long, anything tangible. If there were bond contracts back then, you could have been short bonds, you could have been short equities. But the bulk of the returns that trend followers enjoyed in the ’70s was basically being long, tangible things wheat, corn, canola, livestock, things like that. So will it repeat? I don’t know. But I like having the ability to cast my net that wide.
You’re familiar with principal component analysis. In the markets, you’ve got the main principal component, and that’s probably the stock market. And then you’ve got the second component, and that’s probably going to be the bond market. The third one is probably energy right now. And then you’ve got fourth, and fifth, and sixth. And like you just pointed out, most investment portfolios are betting it all on the first two components and relying on them to be negatively correlated. Because that’s what they’re accustomed to, and not aware and not paying attention that they’ve become positively correlated recently. And they’re moving off the same theme. And if that theme goes south, and there’s a very real risk that it will, they could both lose a lot of money at the same time. And you’re going to regret, I think, not having those other components in there that aren’t moving off that same theme.
It’s the diversification argument 101, just take into its natural conclusion. Bring in those risk transfer markets into the portfolio and actually implement modern portfolio theory. And do it when it’s most important, when the diversification you’re getting between stocks and bonds is low and potentially going lower, at the same time the stocks are not undervalued and then bonds have negative real yields.
Meb: And to be clear, when you look at all these categories, do you have the ability to go short on all of them? Or do you do long flat on some?
Eric: No, we keep it symmetrical. It’s long-short. It gets important, and case in point, during COVID, our biggest exposure was short energy. And I’ll tell you that shorting energy in January of 2020 when crude was $60 a barrel, I had a few people questioning my sanity. Even people in the industry saying, “How can you short crude all the way down at $60 a barrel? How much lower can it possibly go?” Well, the answer was it went to negative 30. And it’s because I think they just didn’t understand that this is a risk transfer market. And crude oil is a toxic substance that requires storage and insurance. And when the storage facilities are full, you have to pay someone to take that worthless crude oil off your hands.
And it’s also time-sensitive, too, meaning these things are, to some degree, perishable. And there are other considerations. So understanding the markets that you’re trading and being open-minded and trading long and short, being open-minded to the symmetry makes a lot of sense. I see a lot of people, and I think it’s a terrible mistake, flipping and becoming long-only on commodities. And the only reason they’re doing that is because long-only has worked better over the last 15, 20, 25 years.
Meb: Well, yes and no. You had the period 2000, 2007 commodities did amazing. And every institution, and endowment, and pension fund on the planet was now investing in the commodity indices. Then commodities got destroyed and every institution, I feel like, over the past five years has been puking up those allocations. You see them all the time where you’re like, “CalPERS is liquidating their commodity real asset exposure. They just can’t take it anymore.” And then they sell and rinse, repeat. But I agree with you, the interesting part on the trend-following side, when you talk about the potential outcomes in the future, and a good example will be let’s say something similar the ’70s where inflation is taking hold. But let’s say commodities don’t do a whole lot, the ability to short things like short bonds means you participate if, say, 10-year goes to 3%, 4%, or 5%. The short exposure is an interesting take that zero investors almost have exposure to. There’s very few that actually allocate to investing strategies that short as well.
Eric: Yeah, I sometimes play this game. When I’m dealing with really skeptical, more traditional financial advisers, the idea of shorting, that’s completely insane. The deviating from a 60/40 portfolio is a crazy idea. I will do this fun experiment with them where I’ll tell them, “I’m going to describe an investment to you and you tell me if you would like to learn more about this.” I describe the attributes of the 10-year treasury. So I talk about the yield, I talk about the duration, I talk about the interest rate sensitivity, and the upside potential, and the real return right now. I don’t tell them it’s the 10-year treasury, I just describe the attributes. They think I’m talking about some managed account, or LP, or whatever.
And when I’m done, they scratch their head and they’re saying, “So you’re telling me that this thing’s expected return, based upon what you’re telling me, is less than 2% a year, inflation’s eight, and it’s highly sensitive to interest rates?” And I say, “Yeah.” And they’re like, “Well, first of all, every one of my clients should sue me if I bought anything like that. And I would like to short that if I could.” And then I tell them it’s the 10-year treasury and they get real mad. So if you take away the label and you anonymize things, people oftentimes come to completely different conclusions, because now they’re forced to be objective. The reason I bring that up, as you said, a lot of people don’t like to short. Unless you strip away the label and you just show them the attributes, the investment, then I think most people would say, “I would short that,” without realizing it’s the 10-year treasury. Who wouldn’t want to be able to short that? The government must be really enjoying themselves being able to borrow money at 1.5 when inflation’s eight.
Meb: Advisers, phone Eric to walk you through that example. Email, call him, not me. He’s got all sorts of Excel simulations and various games he can play with your behavioral biases. On the broad portfolio diversification side, what is it, like 50, 70 markets you guys trade? How many is it?
Eric: It’s 75 most liquid futures markets that we trade. And that’s down from what we did at our previous firm, we tracked, I think, 120 markets. But like I said, I gave up on the small, obscure markets because they just don’t move the needle.
Meb: What are some of the trend-following discussions and myths? You guys have had a nice run since launching the fund. The best thing can happen when you launch a new fund is you have good performance. And you guys have shot out of the cannon out of the gate. But as you talk to people, I imagine the receptivity varies by what’s going on in the market. So you may have the crowd that, “Okay, I’m a little nervous, but the markets haven’t turned on me yet.” S&P printed a big up here last year, has been on a run. So a lot of people usually don’t invoke any action until things start to happen. But the last handful of months seem to be regime-changing, even the last two years. What are some of the conversations you’re having with people? What are their concerns? What are the myths that you displace? In general, what’s the tenor of what the advisers are talking about and you guys are getting into debates with currently?
Eric: It’s very different from previous experiences where I had to convince advisers to do something that they weren’t comfortable with. There’s something about blending it all together into one portfolio and delivering the net-result benefit of the diversifications. Very different than trying to get them to invest in the single ingredient that will improve their diversification. It’s kind of like giving people what they need in a format that they actually want, rather than a format that they don’t want. So the conversations have been a lot easier. And I feel like we do business with more pragmatic, more conservative advisers, and less risk junkies than we did in years prior. I don’t mean that word in a pejorative manner. I just mean highly-innovative people aren’t our focus. It’s more people that want to be practical. They care about the risk, they care about the downside, they want you to have enough long GDP assets to not get left behind, but just do something intelligent with the rest of the money that’s going to be beneficial from a diversification perspective.
And we’ve done well in the sense that it was a good time to launch a macro-oriented program. The end of 2019 definitely was not a bad time. And we were able to navigate the COVID situation, which wasn’t skill-based, that’s a rules-based process that I will follow for the next 20 years. We’re not sitting around making calls or guesses. It’s not a skill-based thing. It’s just a prescription for collecting those risk premiums in a risk-managed way. And so far, it has been a pleasant experience, at least for us so far, both from running the fund, but also from dealing with clients. Conversations haven’t been strained at all.
Meb: How do most advisers think about it? Regardless of the fact that you guys give them some equity exposure already in the fund, do they still treat it like an alternative or satellite bucket? How do most advisers think about and implement this? And is that different than individuals, institutions?
Eric: That I don’t have a great answer for yet, because what we’re attempting to do is create our own category. That wasn’t by design, it’s just effectively what we’re doing is this is an all-weather vehicle. That’s what it is. When you mix macro, multiple sectors, multiple time zones, multiple time frames with long GDP, global equities, you’ve essentially cobbled together an all-weather investment solution. And you can see this. If you pull down the data from the biggest multi-strike hedge funds in the world, and you just mix and match the different betas together, it’s not hard to replicate their track records. It’s experts global equity, it’s experts global bond beta, and experts trend. And then sometimes there are some carrier, maybe some corporate bonds in there, too. But for the most part, 80% of it is easy to explain with just three betas.
So we’ve created what we think is an all-weather global investment program, and just offering in a mutual fund, but it doesn’t fit nicely into any category yet. So they stuck us in macro trading, which I can understand why but it’s not really a pure macro fund in the sense that those guys are just making calls on directional bets.
Meb: Probably a good category to be in.
Eric: For now. Yeah, that’s where we’re at. But if there was an all-weather category, that’s where we would end up being.
Meb: Well, there’s a world allocation category, but the thing is, that’s going to end up being long-only. So you’ll look brilliant or distance yourself when things are jiggy or down. There’s a tactical category. There’s all sorts of categories and it’s a challenge, as always, to slot in funds like yours.
Eric: We started off in the world allocation category. But the problem with those is they’re all just basically equities. And that’s not what we are. Equities are a component, but we’ve got all this other stuff going on. So it’s really an all-weather, I call it an all-weather program. When my co-worker ask me, “Why don’t you just, you know, do what you do with your own money?” And I’m like, “Well, it’s an all-weather program.” “Well, obviously, you believe in it. So why not offer it to the public and see if the marketplace wants it?” I’m like, “Okay, let’s do that.” So I just hope Morningstar or somebody will create an all-weather category, and we can be a fund in there.
Meb: We’d asked a tweet, and you can answer this first, and then we’ll see where it slots in. The people that do allocate, what sort of chunk do they traditionally target? Is it, all right, we’ll start you all at 5%, 10%? Or are there people they’re like, “This is all-weather, I get it. This is going to be 50%, 75% of my allocation.”?
Eric: We have some individuals doing that. But when it comes to dealing with advisers, there are some rules of thumb. They’re not going to put more than 15% with any one adviser. It doesn’t matter how good your strategy is, anything can go wrong with an individual. You could die, whatever. So there are some practical limits for people. Definitely, I have felt what you talked about, though, where they look at it and say, “Well, this is not a convertible arbitrage strategy, or a peer-managed futures, or something like that. So I can go higher than what I was doing before.” And we try to be conscious of fees and taxes to make it easier for people to do meaningful allocations. So yeah, I think it’ll come in on the higher side relative to what I’ve used to in the past.
Meb: We’ve done a tweet or asked people last year, I said, “How much do you allocate the trend-following strategies?” Almost half was zero, which isn’t surprising. Another 25% was zero to 20. So you get about 70%, 75% that essentially have very little exposure to trend. And then the remainder, there are some that have 20 to 40. This is a very biased sample size. My audience that follows me, where I’ve been preaching trend following for 15 years, is probably higher than if someone else asked that question. So along with real asset exposure and foreign…it goes back to everything we always talk about is that everyone just says U.S. 60/40 or 80/20 probably would be the natural default, and nothing in trend, and nothing in foreign usually.
Talk to me a little bit about, you guys use futures, use ETFs. There’s a little bit of efficiency tied in. We did a podcast with Corey Hoffstein talking about return stacking. And others have talked about this concept where you get some efficiency of using futures. Talk to the audience about what that means. How should they think about this in terms of portfolio? Are you guys targeting a certain level of vol? How does it fit together?
Eric: And this is actually my favorite topic, and I think the most important one. This is a topic that people who are considering this space, this asset class, really should pay attention to this and ask themselves what is the source of the returns? If these guys do well, it will be because of what? What is that thing? Is it skill? Is it market calls? Is it market timing? So in our case, I’d say it’s none of those things. Our edge has to do with the fact that we’re leveraging the capital efficiency of being able to mix uncorrelated returns from these six different future sectors with global equities. And do it in a very efficient manner without having to borrow money, and without having to pay, and also not suffering opportunity costs.
So let me just tell you a brief story. Let’s say we got off this call and you sent me an email and said, “Hey, Eric, I’m going to send you 10 million bucks. I want you to run just your futures program for me.” And I would say, “Okay.” You’d wire the money in, so I got $10 million, I only need 1 million of that 10 million to put all the futures contracts on. That’s all because futures are inherently leveraged by design. They have to be because the hedgers don’t want to part with their money. So what do I do, Meb, with the other nine million bucks? Do I just leave it sitting in cash? Do I put it in T-bills?
Most macro managers will invest in some sort of a bond portfolio like three-month T-bills, one-year, or they’ll ladder it out for two or three years. We take a portion of that money and dedicate it to global equities. But the important part here, though, is that we’re not having to share the money. It’s not that the equities are coming at the expense of the futures program. You’re still getting the full futures program. The macro program is unchanged. What you’re giving up is the ability to invest in the T-bills. But remember what we talked about earlier, the real yields are negative. Who’s going to complain about missing the opportunity to invest in T-bills?
And you take that money, or a portion of it, and you go allocate global equities. And you should be asking yourself, “Well, is that the prudent thing to do?” Well, another question that one of my co-workers asked me back when we were in the design phase, he asked me, “What is the best diversifier in the world to our macro program? You have all the data, Eric, going back to 1970, and in some cases 1920. Just run the analysis and tell me what is the best diversifier in the world to what we’re doing? What should we be putting our idle capital into?” And I said, “You know, that’s a great question. I actually don’t know the answer. I’ve done it the other way around, but I’ve never done it this way.” So I did the analysis, and it came back and there was a tie for first place. It was global corporate bonds and global market-cap-weighted equities.
Meb: Global corporate bonds. That’s interesting.
Eric: Yeah. And global market-cap-weighted equity. So which one do you think I chose? I don’t want to trade global corporate bonds. It’s a tax nightmare. But global market-cap-weighted equities, you couldn’t come up with something easier to source right now in a fee and tax-efficient manner. So that’s the best diversifier. And it’s like, how consistent is it? Well, very consistent through time. I couldn’t find anything. T-bills aren’t a great diversifier. Bonds weren’t a great diversifier. The bonds and managed features are trend-oriented, actually kind of positively correlated, especially in the risk-off environments. It was the global equities. And I’m like, “Well, I think that’s why I do that with my own money. So I have to respect the breadth of the empirical data.” What I talked about earlier between risk transfer markets and capital formation markets, there’s a reason that those are uncorrelated with one another. So what’s not to love about that? So we pulled the trigger and said that’s what we’re going to do.
So we were talking about you give me 10 million bucks, I only need a million to run the full-futures program. I got nine million dollars left, I put about half of that in equities and then the balance goes into either T-bills or some sort of a fixed income proxy.
Meb: This concept is seeing some traction, I think you’re going to see a lot more development on some of these ideas. The history of being comfortable with things like futures and markets, it’s scary on the surface. But when you think about doing it at a totally thoughtful and non-leveraged way that people associate it with, which is the blow-up risk, there’s some pretty cool stuff that can happen. And it’s not just about leveraging, it’s just about getting exposures and reasonable cost efficiencies as well.
Eric: Well, using futures are as scary as you want them to be. It’s up to you, how much heat or risk do you want to take in the portfolio? You asked me a moment ago about our volatility. I think the annualized volatility for our fund’s been between 10% and 11% so far, and this has been a really volatile couple of year period with some extreme market conditions. So I’m not saying our volatility can’t go higher, but there’s your data point. That’s the kind of risk that we ran over that two-year window. And what we do is peg to a risk target. It’s not 10% vol, it’s actually a limit on the risk that we’re taking. Volatility is a proxy for risk. It’s the result. The risk is how much you’re going to lose if all of your positions go against you meaningfully and you have to close them all at a loss. We have a limit on that, but it generally leads to about 10% or 11% annualized vol.
Meb: Which is totally reasonable vol. Pretty mellow. Most people can handle that.
Eric: I think so, we’re going to find out. I’ll tell you another story that drives home the capital efficiency argument. When I was in college, I got a job as a security guard. I decided to go become a security guard. And it was a low-paying, 14 bucks an hour job and I had to wear a uniform. And my friends made fun of me because they were doing things like construction and roofing and they’re making 26 bucks an hour, and they get to take their shirts off in the sun and flirt with pretty girls. They thought they just had it made and that I was an idiot. And I remember explaining to them I said, “Look, this security guard job, first of all, I’m not going to die.” It was at an old folks’ home, working the front desk. And I worked from 4 to midnight. And the kitchen brought me a meal. A nice meal. This is an expensive retirement community. So they fed me, they brought me a meal, they brought me coffee, they brought me an apple every night. Also, there was nothing to do. And I was sitting there at a desk…
Meb: Only security risk is somebody making a run for it?
Eric: Yeah, exactly. So I have seven hours to burn. And I have all my homework, I’ve got calculus homework, I’ve got geography homework, and they’ve got a printer, they had a Word processor, this was back in the early ’90s, so before Windows 95, they’ve got pencils, they’ve got a copy machine, they got everything that I need. And seven hours, six of which are completely free time for me to do all my homework. They also had a gym on-site. And they said, “If you want to come an hour early, you can work out, use the showers, use the locker room, and then change into your outfit.” This was like living in a resort.
So I would show up at 3, workout, shower, and then go sit down, do a little bit of paperwork for 20 minutes. And then for the next four hours, do all my homework. And then they would feed me dinner, and then I’d go home and just go to sleep. My friends who were out in the sun swinging a hammer all day long, sweaty, they’re exhausted. They can’t go to the gym, they’re exhausted. And they get home and now they have to do three and a half, four hours of homework. And so they thought they were getting ahead, but I knew I was getting ahead because I was using my time and my resources more wisely. And I was able to get good grades, and I was refreshed every morning when I woke up, and I got plenty of sleep.
So something that looks like a loser on the surface, “Oh, you have to be a security guard and I’m a construction worker,” that’s an egotistical decision. And I felt like the synergies that I was getting from making that decision outweighed the embarrassment of being a security guard. So I bring that same mentality to the portfolio management world. I’m going to use the same pool of capital to run both of these uncorrelated strategies in a risk-managed way and force them to work together as a team to deliver a smoother ride. And that’s what we do.
Meb: You’re always a curious mind. I talk to you all the time about all sorts of oddball topics, and ideas, and thoughts. What else has got you curious, excited, depressed, angry, filling your mind with wonder, nervous as we look out toward 2022?
Eric: Well, we’re also running a business, not just a fund. So there’s that aspect. Think back to year 2 of Cambria. You had a lot of stuff on your mind about how to position the business, your marketing, your messaging, your philosophy, your behaviors. So that’s exciting to us, though. Standpoint’s our baby. I will work here for the rest of my life because it’s everything that we wanted in a firm. So that’s not exhausting. That’s fun coming into year 3. And we’re just thrilled with how things are going. I don’t talk too much about that. But things are going well. We’re really enjoying ourselves.
Meb: How many folks have you guys got now?
Eric: So we’ve got five employees. Everyone’s an owner in the business. And then we have a board of directors. You know Tom Basso, he’s the chairman of the board.
Meb: He’s the best.
Eric: So what’s on my mind, not a lot actually beyond the business. I’ve kind of shut down because it’s all junk food out there. It’s just all politics, and hate, and anger, and misery, and misunderstandings, and exaggerations every which way you look. So I don’t use Twitter, I’ve never used Facebook, I don’t even know what Instagram is. And then there’s like a clock tick or something out there, it’s not for me. So my gym’s across the street. I go swim laps once a day after the market closes typically, except for today, and just enjoying life and just stay disciplined, stick to the process, tell clients the truth, have realistic expectations and see where that takes you.
Meb: The beauty of the systematic approach, of course, is that you have an approach. When I ask most investors on across a lot of different ways of asking the question, do you have a plan? Do you have a written plan? Have you thought of your sell decision when you place the buy? That one was like 90 something percent have no criteria for sell when they make the buy decision. That’s a stressful way to go about life, man. Waking up every day thinking about the fed, thinking about interest rates, and inflation, and corona. My God, I like the idea of having a system that you can lean on. Because otherwise, it’s stressful enough already thinking about money and trying to figure it all out discretionary. Sounds like my idea of a total nightmare.
Eric: I’m old now. You see all the grey hair here. So I’m 50 now, and I’ve been doing this since I was in my 20s. I’ve known a lot of traders. And the overwhelming common denominator amongst the successful is they know two things. They know what price is going to force them to liquidate a position. So if you’re long, it’s the stop-loss below. If you’re short, it’s some sort of a stop-loss above. They know that on the day they put the trade on, it’s essential to know what it is the day you put the trade on. The other half is they know how much approximately they’re going to lose if they’re wrong on every single trade in the portfolio. They know what that number is, and they can live with that number. They can come back. That’s not enough to knock them out.
Without those two things, I wouldn’t have made it. Those are absolutely essential. It’s just part of the algebra of success, at least for a trend follower. I don’t know why anybody would choose not to lean on that. I use the word lean, that’s the word I use all the time. That takes so much of the bad behavior, and the cognitive biases, and all that other crap off the table completely. It is such a tremendous advantage to have and is valuable and works. So I strongly encourage people to think that through. Because otherwise, I mean, look, I’m a pretty emotionless guy. I’m tough. I wouldn’t want that lifestyle, so I don’t know why anyone else would.
Meb: You read anything good, anything come across your plate that’s been particularly interesting over the last few months? I guess I could say a year because we haven’t talked publicly in a while.
Eric: Been spending a lot of time on computer science stuff, which is not the least bit interesting to other people.
Meb: Depends on the audience. I listen to some of these podcasts and some… I had an entire bookshelf in my house that was just books people recommended on podcasts. It’s getting totally out of hand because it was just queuing up and stacking a bunch of sci-fi, a bunch of other stuff. But we’re moving. So a lot of those are getting recycled to the local library.
Eric: I moved recently back in November, and I took that opportunity to get rid of about two-thirds of my library. And that was enormous. I’ve probably spent 50 grand on books in my lifetime. So I just donated them to…I don’t know what it was, the local library or the Goodwill or something. But I got rid of all the books that I’ve been dragging around for the past 25 years and found some gems, too, that I haven’t seen. They’re just buried so deep. But you know what, I don’t read anymore. I’m too busy. Just too much stuff going on with actually running a business.
Meb: You just swim and listen to “The Meb Faber Show” podcast and otherwise pretty zen lifestyle. I like it. If people, they want to find out more to go into your matrix, Excel simulations, call you, send you guys some money, what’s the best places?
Eric: Go to standpointfunds.com And right there on the front page, go down to the bottom and sign up for our monthly updates. We did a really good job on those. I’m proud of those and I think you’ll enjoy those. And then our content library is a bunch of stuff, videos that I’ve made about the blind taste test where you anonymize asset classes, the bond simulator. There are some other cool stuff on there that I think will spark some thoughts, questions, maybe some existing beliefs and maybe put you in a position to make some different business decisions going forward.
Meb: It was too long having this gap in our conversation, but glad to have you back on, Eric. I really appreciate it. Thanks for joining us again today.
Eric: Thanks, man. Keep fighting the good fight. Thanks for having me on.
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 firstname.lastname@example.org. 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.