Animal Spirits Podcast - Talk Your Book: The Case for Tactical Equity

Episode Date: December 16, 2019

On today's show we talk with Corey Hoffstein of Newfound Research about all things tactical, including their new ETF, ROMO. Find complete shownotes on our blogs... Ben Carlson’s A Wealth of Common Sense Michael Batnick’s The Irrelevant Investor Like us on Facebook And feel free to shoot us an email at [e-mail] with any feedback, questions, recommendations, or ideas for future topics of conversation. Learn more about your ad choices. Visit megaphone.fm/adchoices

Welcome to Animal Spirits, a show about markets, life, and investing. Join Michael Batnik and Ben Carlson as they talk about what they're reading, writing, and watching. Michael Battenick and Ben Carlson work for Ritt Holt's Wealth Management. All opinions expressed by Michael and Ben or any podcast guests are solely their own opinions and do not reflect the opinion of Ritt Holt's wealth management. This podcast is for informational purposes only and should not be relied upon for investment decisions. Clients of Rithold's wealth management may maintain position, and the securities discussed in this podcast.

I'm sitting here with Corey Hofstein, chief investment officer of newfound research. Newfound research. Newfound research. So I have followed you on Twitter for a long time. I've learned a lot from your writing. It is impressive. It is robust to use a quantum.

It is prolific. You do this deep dive every single week. Try to do it every week. So I had a realization like a few months ago, and I think we might have spoken about this, but what do you do? What's your day job? So Newfound Research is a quantitative asset management firm. So we work with intermediaries, financial advisors, institutions. We're a traditional asset management firm. But what we really specialize in is high conviction, tactical asset management. So from a philosophical perspective, we believe that the greatest opportunity for differentiation comes from the asset class level decisions. And where we take a particular tilt is towards the risk management side of things. A lot of firms really,

focus on trying to outperform the market. Our view is that for most individuals and institutions to meet their financial objectives, it's really more about the risk management side of things. And we just let the returns take care of themselves. So let me ask a really simple question. Why be tactical? So when we look at the market, we see that the opportunity set is constantly changing. When we look at the opportunity of where we think bonds are going to return over the next decade versus what we think equities can do, it's not the same at the top of dot com bubble as it was at the bottom of the financial crisis. We think that opportunity set is constantly changing. And so for us, tactical is the opportunity to tilt your portfolio

towards those areas where there is the greatest opportunity, whether that is in the preservation of capital or the ability to participate with continued growth. So in bold markets like one way and now, risk management looks foolish with the benefit of hindsight. Anytime you de-risk in this bull run, you look like an idiot after the fact. So how do you keep an environment, investor on track and remind them that, listen, maybe view this as an insurance premium. Yes, we're buying back higher or whatever we're doing. But how do you like marry the common sense sort of evergreen like buying hold stuff with, listen, yes, this is not working now, but it's a very important piece of your mental wherewithal to stay invested. I think there's really two important

pieces of this. One is how you frame the conversation. And then the second is how you use these types of strategies in a portfolio. So if we take a step back, I think it's very common people evaluate these strategies in isolation. But when you look at them in the context of a portfolio, most investors carry around a very significant amount of risk mitigating assets. They carry around a large chunk of fixed income that serves as a ballast of their portfolio, but they never evaluate at what cost. What's the opportunity cost of being invested in 10-year U.S. Treasuries when they're yielding 1.75%. But the reality is if you're going to have that large chunk of your portfolio in fixed income, you really do need to evaluate it that way.

So the first thing we do is we take a step back and say, you really shouldn't compare this type of stuff to just equities. If you're going to focus on risk management, you need to think about other ways in which you're managing risk in your portfolio and evaluate it in the context of other ways of doing that. The second is, again, thinking about how you're funding an allocation to this type of tactical strategy. So I know you guys, for example, use some tactical strategies with your clients where you will maybe use some trend following techniques to try to participate on the upside and avoid hopefully some of those prolonged drawdowns. In a perfect world.

In a perfect world. And that's the objective. I think when you, let's take a very simple example, what we would call trend equity, which is using these trend following techniques on broad equity indices where you're trying to capture that upside and avoid that prolonged downside, a lot of people look at that and would say, well, let's replace some of our equity exposure. And I think a better use of that type of strategy is actually to replace a little bit of fixed income and a little bit of equity. Because what happens in that case is we know almost for certain

that that strategy is not going to keep up 100% with equities in a bull market. You're going to get whipsawed. You're only going to hopefully capture 70 to 80% of the upside. If you're replacing equities, there is some true costs there. But if you replace a little bit of fixed income and a little bit of equity, say 5% from fixed income and 5% from equity with this tactical equity strategy. Even if you don't keep up 100% with equity in a bull market, if you've used it to tilt your entire portfolio a little bit more towards equities, the entire portfolio can do a little bit better. And similarly, in a bear market, if that pivot piece then is able to de-risk, it can take the entire portfolio and reduce the allocation to equities.

And in that context, your benchmark becomes something more like a 50-50, and you have the opportunity to add value in all market environments. So what you're saying makes a ton of sense to me, but we know that at the end of the day, clients look at performance. And it doesn't matter whether you're talking to a retail or a giant endowment. People are people and we all look at performance. So you do as good a job as anybody at educating and framing the conversation. But how should people?

So you're saying, I mean, the 50-50 makes sense. You have to be benchmarked to something. So how do you, before you sign on a client, how do they judge your success or fail? I think the question is how do you judge it prior to allocating something like this? And then in reality, just having an honest conversation, how do clients end up judging it afterwards? Two different things. Right. Two totally different things. I think judging it afterwards is a game of continuing them what the benchmark is, reminding them the conversations we have around how do you fund this position? Why they said yes in the first place? Why they said yes in the first place. And that is a continuous game. It's not something you can ever stop. It is an education game. It's a reminder. game. I do think going into it, we do use something like a 50-50 or a 60-40 as the core benchmark because we think it both informs the right expectations for performance. We think it informs the right expectations of how you should fund the position. And I think that's really what a benchmark should do. It should not just tell you, hey, this is what we're trying

to beat over the long run, but it should tell you, hey, this is how you should actually allocate to this. This is what you should sell from your portfolio to buy this position. let's get into the nitty gritty. The newfound resolve robust equity momentum index attempts to provide dynamic exposure to broad U.S. international and market equities while simultaneously seek it to avoid significant and prolonged drawdowns by tactically allocated to short or intermediate term U.S. Treasuries. It's a mouthful. It is. But I think it makes sense. It's intuitive. You're trying to capture the upside to the extent that you can and also to the extent that you can mitigate the catastrophic drawdown. I'm putting words into

your mouth. I can't imagine that you're trying to avoid every 10% correction. I know I think that's spot on. I think when you have the objective of meaningfully participating in equity market growth, you have to also participate in some of those drawdowns. You have to be willing to bear a little bit of risk. Our view is that it's ultimately those really significant prolonged drawdowns that can be really damaging. A 5, 10% drawdown is just something you have to live through. But when you start to get to 20. Where do you think that level is where People are like, psychologically, I think it's any drawdown, honestly. I mean, you get a 5% dip, 10% dip like we did this last August. And if clients haven't experienced that in a while, it's very uncomfortable. The reality for me, at least, though, is when you look at the math and you start to look at the asymmetry of the sorts of gains you need to get back to break even, you lose 50%. You need 100% to get back to break even. That math really starts to matter sort of after a 20% drawdown. So the way we've looked at all of our research. evidence suggests if you want to capture 70 to 80% of the upside, you probably need to stomach

10, 15% drawdowns in inequities at least. Don't you think everybody in theory would make that trade? You would think objectively, but the reality is that comes with a lot of tracking error. So these types of strategies, what's really interesting about them is I can say over a full market cycle with a good deal of confidence, I think that these types of strategies can capture 70 to 80% of the upside. But what happens in practice is that 70 to 80% is not. continuous. The market's up 10. You're not necessarily up 7 or 8%. The math doesn't work that way. What you find with this type of strategy is there's some years where you capture 100%. So trend following strategies when they're really easy trends, 2013, 2017. 16 to 18. Well, 16 was actually pretty

tough coming into 16. February. But 2017, I mean, you can sit on your hands and you're great all year. You capture 100%. 2015, though. 15 was rough. A very rough period for trend following. How many whips as can a client date before they're like, this is dumb. Why am I doing this? I think it honestly has a lot to to do with when the experience comes for them. Meaning in terms of their life cycle of investing? Not only just life cycle of investing, but when they allocate to you. Oh, you had a great presentation. Where were we? Was that inside ETFs? You said a client could start with you in January and have the greatest experience and another client could start with you in July and you're fired in September. Yeah. And that can absolutely happen. That if someone allocates right into a whipsaw,

they sort of lose faith immediately. So December 2018 or November 2018 or I had a client who allocated, this was an institution that allocated end of January 2018, literally three or four days before the massive February sell off. And fortunately, we weren't whipsaw too badly. But like most tactical strategies, we took a little risk off the table and ended up having some whipsaw. And that was their experience within one week of allocating to us.

And you would hope that an institution would say we get it. This is the risk. It was poor timing. Unlucky, but this is just sort of how this strategy works. But the reality was after nine months, they said, you want it. This strategy isn't for us. They sort of experienced what we tried to explain to them and they realized it just didn't work. When did you have that moment of nothing will shock me anymore? Because to me, that's shocking. I think you have enough conversations with clients about what's actually important to them. I've come to, at least for me, the realization that it's not about objectively what the best investment strategy is. Because what I've found is if a client can't stick with the strategy, they're never going to realize all of its benefits or its perceived

benefits. So to me, I stopped being shocked once I had enough conversations where I saw what the real incentive was, either of the intermediary I was working with or what the real risk appetite was of the client that I was with. They might think, for example, that they want this type of strategy and then realize that their capacity for tracking error to just the benchmark or whatever market they track on a daily basis was a lot lower than they objectively thought it was. And so for me, it probably took a couple of years of really talking to people and saying there's all these competing objectives, all these competing wants and needs, all these competing incentives that make this a lot harder than just sitting down and engineering a portfolio in a vacuum.

So let me ask you a sort of personal philosophic question. Where this strategy really shines and where clients are hugging you and kissing you and saying, thank you so much, Corey, is in a bare market. Now, I know you. I can't imagine that you root for bare market. But how do you sort of square that circle every day? I think we were laughing before we started recording. I mean, I would hope to never live through another 2008 again. If we could never have another recession again, I think we'd all be pretty happy. But you can't count on that. And so again, for me, when I live, look at someone's financial plan, when I look at someone who's about to retire what the biggest impact is on their ability to meet their financial goals and objectives, it is the ability

to continue participating without realizing big drawdowns. And so for us, we certainly would never root for a bare market, but I want to be prepared for it. The same way that you might have someone de-risk from all equities to hold some fixed income as they go towards retirement, to me, this strategy meets a similar need. And you're not rooting for a bare market by allocating to fixed income. You're just making a prudent risk management decision. And all we're trying to do is provide a way for people to diversify the way they diversify, a different way of managing risk. Another potential benefit to a strategy like this is you might not feel it in a bull market, but in a bear market, let's say, heaven forbid, you're drawing down your portfolio. If you're

doing that in a portfolio, that's 30% off its highs, you're pouring fuel onto a fire in a negative way. Absolutely. I use this idea of there's really this idea of failing slow and failing fast. When you're young, by the way, I love that analogy. Thank you. When you're young, you have this risk of not saving enough, of not investing aggressively enough. And this idea of failing slow is you don't grow your money to a point where you can eventually forego taking a salary or income and just live off your investments makes it very difficult to retire. As you get towards retirement age and start withdrawing to your point, all of a sudden you have this risk of failing fast. If you have a million dollars in 2007 and decide to take a 4% withdrawal rate and then your portfolio gets cut in half, well, that 4% withdrawal rate is now an 8% withdrawal rate. And if 4% was prudent, 8% might not be. And so it becomes very difficult to live off that and it has compounding impact on the type of lifestyle you can lead. And so again, this is why glide paths exist.

But our view, especially where rates are today, is that it can be very costly to have a huge portion of fixed income. And so we would never say replace all your fixed income. I think every investor should start with a well-balanced strategic portfolio. But what we're effectively trying to do is say, look, there's certain types of risky environments that that does really well in. And there's certain types of environments that trend following other tactical techniques do really well in. The same way you diversify assets, why wouldn't you diversify your process of managing risk? With you. All right. So let's be specific. As I'm reading through this, I have questions.

So effectively, the index is going to hold three different equity buckets, U.S. international emergent markets, and then there's going to be two fixed income replacements, intermediate and short term? Yes. Okay. So the index employees four methods for calculating momentum scores. And effectively, is this momentum or this is momentum not trend? So it has both momentum and trend. Maybe what would make sense, take a step back and just explain the very simple decision

tree here. We just had this conversation with Jack and West. It's like, okay, what's momentum? what's trend? What's growth? So I'd love to hear it from you. Yeah. So to me, what's always confusing to people about momentum and trend is that they're calculated the same way very frequently. But momentum is really, to me, a decision about trying to find opportunities for outperformance. It's a relative comparison. So I might say, what is the return of one asset class? What's the return of another? And Momentum says, we think the one that has been relatively outperforming its peers will continue to

relatively outperform. But that could mean both are losing money. It's just one is losing less. Whereas trend is comparing one asset to itself? To itself. In an absolute sense, is it positive or negative. So I look at momentum really as saying, how can I tilt towards areas of relative strength and try to outperform the sort of cohort that we're looking at? And then trend is really more of a risk management technique acknowledging I don't want to lose money in the absolute sense. All right. The index employs four methods for calculating momentum scores from adjusted prices. I had a question about that. Why adjusted prices? So in other words, you're including the effect of dividends. Why? Why not just look at price? I think it's probably easier to take it to an extreme area like high yield bonds, where if you were to exclude any income, you would actually see a negative price return on high yield bonds because all you have is credit loss. So I think it's very obvious in that sense why you would want to include the total return stream you're earning. Okay, that makes sense to me. So you're looking at horizons ranging from 21 days, which is basically a month of trading. through 378 days, which is a year and a half. The way that you describe this, or maybe it was

the folks that resolve, is not a light switch, but a dimmer. So how does this dimmer work? Let's maybe take a step back and explain very simple decision tree of how this type of strategy would work. So at the high level, what we're going to do is we're going to compare global equities and ask, do they have a positive or negative trend? If global equities have a negative trend. We're then going to go down one side of the decision tree and say, okay, we don't want to hold global equities. Let's hold either short or intermediate term U.S. treasuries. And that's where we're going to apply momentum and say which one has outperformed and we'll hold that one. If equities are positive, though, that's where we're going to go down the other side of the

decision tree and say, okay, do we want to hold U.S. international developed or emerging markets? And we'll use momentum there. It could be a combination of the three? It's just one. Got it. So very simple decision tree. And then the question becomes, okay, in theory, we're using trend and then we're using momentum. But how do you actually measure that?

So our good buddy, Meb Faber, wrote a paper back in was it 2006 where he said, hey, look, 10-month moving average is great as a trend-following technique. Tons of evidence that supports it. And then a couple years later, AQR writes a paper. It says, you want actually a 12-month total returns are a great trend-following technique. And then you start to read all the literature and you realize, well, you could use moving averages. You could use total returns. You could use these crossovers.

There's all these different ways. And if you really get into the weeds, you actually find out they're mathematical cousins of one another. They're intrinsically linked. And so the choice of one creates what we call a lot of specification risk. You're choosing only just one way of trying to implement this idea. And they could have big differences on returns. Big differences.

So last year was a perfect example where if you use 12-month returns versus just 11-month returns, which doesn't sound that difference, you can have hundreds, if not thousands of basis points of performance difference in this very simple type of strategy. I think in September 2018, we looked at this, whether you used the 10 month or the eight month literally could have meant the difference between a down 16% month and not. Absolutely. So you don't want to hit your wagon to just one horse.

Right. And so over the long run, there's efficacy, it seems, in all these approaches. And if you can take a super long run approach, pinch your nose, just choose one and stick with it, you're probably okay. But as we talked about a little earlier, that's hard. So what we basically do is we say, well, why wouldn't we use all these? different approaches. How do you balance all of this with keep it simple versus how do we not get too complicated where everything gets watered down? So I think the idea of complex and complicated

to me is really all about adding bells and whistles. So it would be adding more signals, more complexity, different indicators, edge cases, more sort of nodes on the decision tree. What we're doing is saying we have a very simple decision tree. And then what I do is I take that decision tree and I implemented a whole bunch of different ways. So the easiest way to think about this is you and I are sitting here and let's pretend Ben's here and Josh is here and Barry's here. And I say, I'm going to use a 12 month total return. And you say, I'm going to use a 10 month moving average. Ben says I'm going to use a six month moving average. And everyone has a slightly different way. And we all follow our very simple process. And at the end, I say, I'm voting for

US equities. You say, I'm voting for U.S. equities. Ben says, you're both wrong. It's intermediate term Treasuries, Josh says, you're all idiots. It's actually international equities. What we would then do is say, all right, U.S. equities got two votes, intermediate term treasuries got one vote, international equities got one vote. We're going to hold those equities in proportion to the number of votes they get. So we're not creating this incredibly complicated process. What we're trying to do is take a very simple process. Perfect it to the extent that you can. And incorporate diversification. The same way you could say I think equities are going to work in the long run and not just buy one stock. I'm saying, I think this process works in the long run, but I don't want to buy just one implementation of it.

So people diversify across asset classes, across strategies. This is diversification within the strategy. Within the strategy. And so to your question earlier about how is this like a dimmer switch, if I just had one implementation, let's say, in or out. In or out, if I just said I'm going to just look at, say, the 12-month trailing return, I would say, okay, my one vote is for U.S. equities. all-in U.S. equities. And that creates a very big all-in, all-out decision that can have huge specification-related impacts. You could be just slightly wrong. Let's say U.S. equities were outperforming international equities by 0.1%. You're making a very big all-in, all-out bet on a very tiny signal difference. It could also close five basis points above the 10 and but below the 11.

Exactly. To me, there's not a lot of humility in that choice. There's not a lot of recognition that at the end of the day, these are models. Models are not always right. And so what we're trying to do is diversify that, access the general style of momentum and trend without having to choose at any given time, which one will necessarily be the right choice. So again, something I asked of Wester Jack, I'd be curious to hear your answer. You do so much research. How do you look for new things and how does new information manifest or get implemented within your investment philosophy? Or do you think you're like, I've seen it all? How do you think about that? So I think when you're an active manager, you need to sort of think about the types of edges

you're going to pursue. Mobison talks about the four different types of edges you can have. You could have a truly structural edge. You could have an information based edge. You could have an analytical edge or you can have a behavioral edge. I don't think my firm has the ability to compete on structural edges necessarily. We're not getting access to certain markets other people aren't. Do we have an informational edge? I don't think we have any different information than other people are operating with. Do we have an analytical edge? Maybe you might be able to argue that there's some models that we build that look at things slightly differently that give us an edge. But certainly I think most of the major factors and style premium and quantitative techniques

we talk about sort of fall into the behavioral edge that can we get people to stick with this when other people are going to fold. And for us, then a lot of time has to be spent researching on the craftsmanship side. How do you build a portfolio that people can actually stick with? How do you avoid the unnecessary and unintended risks when you're implementing this stuff? And this goes to some of the conversations around choosing one particular model, understanding when to implement from a timing perspective and the sort of luck that can go along with that. And we spend a lot of time in those weeds to try to build a portfolio that has greater certainty in achieving its outcome than just taking it to its simplest possible implementation. So I hear you on the simple stuff, but let me just

challenge you on this. 21 sampling frequencies over 357 look back horizons for a total of 29,988 momentum calculations. Why? At the end of the day, it's sort of the same question of do you really need a thousand stocks in your portfolio versus 50 versus 100? Is the marginal benefit of that thousandth stock really that much better? Probably not. At a certain point, it doesn't matter much. But if it doesn't cost you anything more, if you're trying to just buy the market and it doesn't cost you anything more to have 500 versus 1,000, from our implementation perspective, as a it's not any harder for me to run 500 models versus 1,000 versus 20,000. It's all the same sort of, again, very simple decision tree. I'm just making tiny little changes. Got it. So on the website,

and we'll share all of this. This is, it's extremely transparent, which is, I think, what you all are all about. You provide monthly returns and the allocation so people could look back and say, this is what it would have done. I always joke that the worst 10-year performance for a back test is the next 10 years. How do you think about what sort of expectations people can have going in? So in the back test, the max drawdown was 16.6%. Is that a sort of realistic expectation to have going forward? like how bad could a whipsaw be? Yeah, whipsaws can be pretty bad. I think there's two types of drawdowns. There's

the drawdowns from the assets you're holding. And then there's the drawdowns that occur because of the active decisions you're making. So I think 2015, 2016 was a period where the market went sideways and trend following strategies created their own drawdown because they got whipsawed. And I think if you go through a prolonged environment where the market goes sideways and you get mean reversion, you can see that those whipsawls will compound. Again, the whole idea. here is not that risk can be destroyed. I have this philosophy that risk is never destroyed. It's just transformed. When you do a buy and hold portfolio, you're making a conscious decision to manage one type of risk, which is you're not going to be active. And so in a sideways market, you're not getting

in and out. In fact, you might even benefit if you're rebalancing by capturing some of that meaner version. But the cost is in a bull market, you're over allocated to fixed income. And in a bare market, you might be over allocated to equities. Something like what we do with the trend following techniques might do better in that bull market or that bear market, but it's going to suffer, the give up is going to be in those sideways markets. So I think from an expectations perspective, it's all about acknowledging which sort of environments you can do well in, which ones you can't. I think in environments like a 2008 or a 2013, a strategy like this should do quite well, should participate very meaningfully in a 2013 or a 2017 and should be able to sidestep those

prolonged drawdowns. It's not going to work in the 1987, a very sudden large sell-off. If we are 100% in equities and the market just drops 30% a day, well, there were no trends. Trends didn't change. It was just a big drop and we're going to suffer that loss. So it's very hard to say precisely what type of drawdown can you expect. To me, it's about how is your portfolio allocated today, what type of environments do you expect it to do well in? What type of environments do I expect this type of portfolio to do well in? And is there a combination of what you do today and this type of tactical portfolio that can lead you to greater certainty in the types of outcomes you're trying to achieve? So one thing that I keep hearing from you, and I think this is extremely

important, and you do a good job making this point, is that you can't view this in a vacuum. Where does this fit within your other assets? And that is really the way that you have to look at all of these alternative strategies. I think it's the way you have to look at any investment strategy and not just in the context of how does it work within your asset allocation or how else you're building a portfolio, but very much what is your objective? What are you trying to achieve? If you are a young investor who has a very long horizon doesn't need the money, I would argue you probably don't need a strategy focused on risk management. It doesn't make a lot of sense because you're going to pay some sort of implicit or explicit insurance premium. In this case,

if you're someone who's 100% invested in equities and you take on a tactical equity strategy, you're going to be giving up some upside if the market goes up in the long run. So if you're 20 and you're saving and you've got a long time to earn money and you don't need to touch that money, I would argue this might not be a prudent strategy for you. If you're 65 and you're retiring and you're looking at holding a lot of fixed income in your portfolio, that's only going to give you a 2% return over the next decade and you think there's a chance the market might continue to appreciate, then this type of strategy might makes sense, not as an alternative, but as a compliment to what you're doing. Fantastic. Anything

we missed? I think we hit it all. Awesome. Thank you, Corey. Appreciate it. Been a pleasure. Thank you.