The Derivative - BLNDX[ing] Trend Following and Global Equity with Standpoint’s Eric Crittenden

Episode Date: July 16, 2020

How do you get investors to stick with an asset allocation that’s good for them in the long term, but maybe doesn’t taste so good over shorter timer periods?  Today’s guest has designed a new mutual fund to attempt just that, giving investors the whole meal instead of letting them fumble around with the ingredients. Eric Crittenden, Co-Founder and CIO of Standpoint Funds joins us today to talk about Standpoint’s new $BLNDX fund. We’ll be getting into the weeds on this unique fund, as well as talking about Witchita State basketball, a zero sum game, 2,554 days of surfing, building Standpoint from the ground up, a “mystery asset class,” the new ETF dilemma, structural risk premia, losing money on purpose, open interest, a fundamental death of trend following, averaging correlations, moving in a mutual fund vs private funds, the antithesis of mutual funds, never playing golf, and Star Wars character Salacious B. Crumb.  and Follow along with Eric on LinkedIn and check out the Standpoint Funds website. And last but not least, don't forget to subscribe to The Derivative, follow us on Twitter, LinkedIn, Facebook, and sign-up for our blog digest. Disclaimer: This podcast is provided for informational purposes only and should not be relied upon as legal, business, or tax advice. All opinions expressed by podcast participants are solely their own opinions and do not necessarily reflect the opinions of RCM Alternatives, their affiliates, or companies featured. Due to industry regulations, participants on this podcast are instructed not to make specific trade recommendations, nor reference past or potential profits. And listeners are reminded that managed futures, commodity trading, and other alternative investments are complex and carry a risk of substantial losses. As such, they are not suitable for all investors. For more information, visit www.rcmalternatives.com/disclaimer

Thanks for listening to The Derivative. This podcast is provided for informational purposes only and should not be relied upon as legal, business, investment, or tax advice. All opinions expressed by podcast participants are solely their own opinions and do not necessarily reflect the opinions of RCM Alternatives, their affiliates, or companies featured. Due to industry regulations, participants on this podcast are instructed not to make specific trade recommendations nor reference past or potential profits, and listeners are reminded that managed futures, commodity trading, and other alternative investments are complex and carry a risk

of substantial losses. As such, they are not suitable for all investors. Welcome to The Derivative by RCM Alternatives, where we dive into what makes alternative investments go, analyze the strategies of unique hedge fund managers, and chat with interesting guests from across the investment world. You don't need artificial intelligence or machine learning or any of these complicated topics for that. What you need to do is figure out who is willing and able to lose large sums of money in the futures markets. And hopefully,

who is actually economically better off for having lost that money in the futures markets? And if you can identify that those people exist and consistently exist, and you can participate in the markets in such a way that you're providing liquidity to them in their time of need, then it's reasonable to conclude that some sort of a risk premia will flow from them to you over time. Hello, you're back on The Derivative live from my house as we continue the coronavirus lockdown here in Chicago. And today we're covering all things trend following with Eric Crittenden, co-founder and CIO of Standpoint Funds and their mutual fund, BLNDX, the Standpoint Multi-Asset Fund. Welcome, Eric. Thanks, Jeff. Glad to be here. Great. So Eric's been designing and managing investment strategies in and around the managed future space for over 20 years. And

Phoenix-based Standpoint Funds is his most recent venture focused on providing an easier way to stay invested in a globally diversified portfolio. So I'm excited to hear what it's like designing a mutual fund from scratch and what sorts of models make this fund unique. So, Eric, thanks again for joining us. You're based in Phoenix, right? Technically, we're in Scottsdale, which is a suburb of Phoenix. Yes. Okay. What's the situation like there? You guys are in lockdown? It's not too bad, actually. I think Arizona is a little bit behind the curve in terms of testing and locking things down. It does look like a ghost town out there,

but there's still people in the parks and walking their dogs and the restaurants are closed, but people getting takeout and riding bikes and whatnot. It's not too bad. So some people would think of that the other way of it. It's really bad if you're behind the curve that it hasn't hit yet, but you're saying from a life standpoint, it's not too bad. So far. That's good news.

And then you're originally from Kansas? Yes, I was born in Kansas. I grew up on a hog farm. One grandfather was a hog farmer. The other was a wheat farmer. Nice, quiet, boring little existence down in southeastern Kansas. And so you didn't go down the farming route? No.

I was a military brat for the first 10 years of my life. So I ended up living in about six different states. I think I went to seven or eight different elementary schools. So that took me out of the, out of that pathway and towards something else. What, uh, what branch was your, who was in the military? Uh, my father was a airborne Rangers army. Oh, great. Um, so yeah, I love, we're actually at RCM in the ag side of the business quite a bit, helping people hedge crops and herds of cattle and pigs and whatnot. So it could have been a separate life of that side of the business, which is

interesting. And did you actually ever work the farm or do any of that stuff? I did when I was very young. I don't have memories of it, but I was told horrifying stories about how early we had to get up and how hard we had to work. I thought you were going to say like, uh, silence of the lambs types, type stories. That's further North up in Iowa. The, um, and so then what, you went to college there in Kansas? I did. Um, after moving around to different States, um, I decided to move back to Kansas to go to Wichita State University. That was in the mid-1990s and stayed there for a while after college and then ultimately came out here to Arizona.

The shocker. So you're a March Madness fan or you watch the basketball program at all? Yeah, I would consider myself a fan. Of course, there's nothing going on this year, but when I attended Wichita State, the team wasn't particularly good. Right after I left, that's when they became famous. Yeah. Who's the coach now? Gary Marshall, maybe is his name? He wears those glasses that have the Wichita yellow on the stems or whatever you call them, on the earpieces. They take the basketball program very seriously in the city of Wichita now. Those glasses are very popular.

How big is Wichita? It can't be too big, right? It's actually the biggest city in Kansas, although that's not saying too much. I believe the metro area is a population of about 400,000. Okay. Bigger than I thought. Then you're at Wichita State. How did you get up, end up in this world of investing and trading and managed futures? in economics and fell in love with the dynamic nature of price data and econometric data.

I really like nonlinear complex models. That's what attracted me to public health in the first place is where preparedness is rewarded and unintended consequences are important to understand. And there's a lot of parallels between what you get in the public health discipline to what you see in the capital markets or financial markets discipline. So you would have almost been in super high demand here in the coronavirus if you had the public health side and the mathematical modeling side? Yeah, well, I left public health for the same reasons that you're seeing a lot of the chaos in the world right now, the political component of the decision making. It turns out that

the math takes a backseat to politics. And that's kind of what drove me away from that major when I when I stumbled upon finance, and I knew nothing about the stock market or the derivatives markets in 1994. When I realized that you could separate politics from the data from the analysis from the work, and you could get rewarded for prudent risk taking. That's when I found my calling and decided to switch to finance and computer science. Right. It seems like public health, you'll get shamed for prudent risk-taking, right?

Or you'll get always like, hey, we're taking a risk by, or we're trying to control risk by getting everyone out of Florida before this hurricane might strike. Like, it seems like there's a lot of blowback on people being too careful in public health. Yeah, there's that. There's also this phenomenon where offending the wrong people at the wrong time is career suicide. So that's more important, the politics component than making good long term decisions. Got it. And so then stumbled upon finance in college. And what was the path after

that? There was a moment in my studies where I learned something that I think is an advantage that will resonate with you having so much experience in the CTA world. I was in a class, I don't remember which one it was, it might have been the derivatives and futures class, where I was tasked with building a mechanical trading system that we would run for the duration of the semester and your grade would be a function of its risk adjusted returns and also your logic from constructing it. So being an idiot back then, I designed a system that bought 52-week lows and sold 52-week highs. Just like every other normal human being would attempt to do, right? Perfect.

And I back-tested this on several different asset classes. And the back-test looked beautiful. And I ran it for a semester and lost a tremendous amount of money on paper, of course, not real money. But then the back test still looked great at the end of the semester. So that forced me to look under the hood and rip this thing apart and figure out, why does my back test say I'm making money, but my statement says I'm losing money? And that's when I learned about things like survivorship bias and post-ictive error and how system developers can easily fool

themselves if they don't understand these really important databasing concepts. And you quickly learned there's not just one 52-week low in a year. It can make many more. Yeah. The first 52 52 week low oftentimes leads to 15 more 52 week lows on your way to a 90% drawdown. Exactly. I'm impressed that they had a derivatives and futures class at Wichita State back in, it must be, they have ag roots and they're trying to teach people hedging and whatnot. Yeah, Wichita State is an underrated school if you want to study economics, specifically agricultural. It's a very good accounting school. Finance is good. Koch Industries, the Koch brothers, K-O-C-H, is down the street from the university and they

donate a lot of money. There's a tremendous amount of farming, hedging, manufacturing, airplane manufacturing. There's a lot of business that goes on in the Wichita area. So I was able to leverage that environment. I started a club on the campus. It's probably not around today, but back then, before there were terms like data science and quant and whatnot, we created our own club of people that had an interest between an intersection between computer science and derivatives trading and stock trading as well. And a lot of the people that worked at Koch Industries that were foreigners that got recruited to come over from other countries because they had PhDs in physics or finance or economics or whatnot. There's not a lot to do in Wichita. Culturally, Kansas has its

own culture and it's not particularly consistent with people from Europe and other places. So we had this eclectic mix of people from different countries that all had a common interest in derivatives and systems. And that's where I learned about commercial hedgers and how their desire to participate in the markets leads to very different results. They're not profit seeking. They're looking to hedge away risks in their core business. And that was a big eye-opening moment for me because the futures markets are a negative sum game. And if you're going eyeopening moment for me because this futures markets are a negative sum game. And if you're going to make money, it has to come at the expense of someone

else. So if you can find people that aren't profit seeking and provide a valuable service to them, then you should expect some sort of risk premium going forward. So I feel like I got lucky in meeting these people and analyzing the models that they built. I got two quick questions. One, isn't it a zero sum game? Why do you say negative sum transaction cost? Yeah. So the NFA has to get paid, the SEC, the exchanges, the broker, you guys have to get paid. So after trading expenses, it's a negative sum. Got it. And then my more important question is, where was this club meeting? Were you guys going to Ratskeller, having a couple beers and talking models, trading models instead of model models? Or were you in the computer lab,

totally geeking it out? Both, actually. We started off, we sequestered a particular classroom in the sub-basement of the Barton School of Business. And we got kicked out of there for a while and we relocated to a spot in the library. And then we started hanging out at a local Barnes and Noble in town. So it depended on when and who was showing up. Where were the drinks? I wanted the drinks to be part of that story. The drinks? I'm envisioning like some german guy who can't talk stats without a beer there were a few uh serbians and croatians which was interesting because that was during the civil war over there so they didn't get along very well but they were the ones that did most

of the drinking uh sometimes that was in my backyard you had a backyard in college? Yeah, I was a homeowner. I was a homeowner in college. Yeah, I had a house. You still own it there in Wichita? No, I sold it for $50,000. That's how much a three bedroom, two bathroom house on a quarter acre lot in Wichita costs. What do you think it costs today? 65? No, it's probably up to 110, something like that. This was back in the mid-90s. Yeah. Cool. So then you, somewhere in there, you've left college. Tell us what's the journey after that. So I came to Arizona. I was actually moving back to Silicon Valley. We skipped a bunch of parts that I won't go into, but I lived in Silicon Valley for seven years and I left there to go back to Kansas.

There's a surfing part in there somewhere, right? Yes. My mother moved us from Oklahoma to Los Angeles when I was 11. And then three days later, I was in the ocean and I went surfing every day of my life, except for one day when I had the flu for the next seven years. Nice. I grew up in Vero Beach, Florida. So we used to surf quite a bit. Waves were much smaller, but still fun. Yeah, I've heard of that place. So there's some parallels between surfing and the markets as well. Again, nonlinear system, unintended consequences, lots of variables, the tide, the swell direction, the wind speed, the wind direction, glassiness of the water. All these things are changing, creating different conditions and whatnot. So surfing appealed to me because I

like these complex puzzles where there's lots of interaction and counterintuitive results. I bet you were the only surfer out there thinking of it in that manner. Maybe Meb Faber, if you ran across him out on the waves yeah we talk about that from time to time i never ran into him he's up in uh la county so got it uh so then from there back to phoenix you're saying no from there i moved up to silicon valley uh in the san jose area uh and i was there for seven years so i would drive over the hill to go to Santa Cruz and go surfing, which is a lot colder, a lot rockier, very different environment. I wasn't a very good student back then. I spent most of my time surfing, not studying. Yeah, what's the big break

there called in Mavericks close to there? That's a little further north, I guess. Yeah, that's up in Half Moon Bay, about 30 minutes north of Santa cruz that was unknown at the time actually if you read that guy's biography i think he was surfing it by himself back then which is completely crazy it's an enormous and very dangerous break but yeah i was unaware of it at the time i wasn't a big wave guy i'm not going to pretend to be that brave no those guys are have a couple screws loose. All right. So then San Jose back to somewhere. Phoenix? From San Jose, I went to Kansas, went to school, got out of school. I worked for a pretty large family office for a couple of years. Learned a lot about people that make a lot of money fast and lose money. I learned a lot about the psychology of

how people deal and change when they're in a drawdown, when it's their money. And ultimately left that firm in 2001. And no, actually, yeah, it was 2001. I was just here to visit. My mother had moved to Phoenix. And I just, I was on my way back to Silicon Valley. I was just here to visit. My mother had moved to Phoenix and I just, I was on my way back to Silicon Valley. I was just stopping to visit and that was in April of 2001 and I'm still here. So I haven't left yet. I returned the U-Haul, but I'm still here. So I decided to stay. I've lived here longer than anywhere else now. I love this place. It's sunny, it's warm. So I ended up working on a trade desk at a local hedge fund, Lins and Capital Partners for a while. That was a great experience. Each one of these was a new

experience seeing, you know, the different players in the ecosystem and how they are rewarded and how they experience pain and how they make money and lose money and whatnot. The trade desk wasn't for me. It was a, it was too exciting, too fast moving, not longterm enough. So I ultimately left and helped co-found a company that was a fund of funds that allocated to CTAs and systematic global macro managers. And we ran that company for, I think about seven years, and then helped co-found Longboard Asset Management, which is a mutual fund company that has two mutual funds. We created a managed futures mutual fund

and a long short equity mutual fund and had a lot of success. Our AUM got up to almost $700 million at one point. I left that firm a couple of years ago, went back to school, studied some of the newer machine learning, artificial intelligence topics. Where was that? There in Arizona? No, this was an online school, Saar University out of Germany, that had a very impressive, at least to me, computational finance machine learning certificate that I thought was a good fit. How old are you at this point where you decide to go back to school? That's kind of a big move.

I was probably 46 two years ago. You're doing the school from home. It was an area of interest. It was pretty consistent with the stuff that i learned in the 90s you know all this machine learning and ai stuff it's not new it's just possible now it's the same concepts we were going over in the late 90s uh we just didn't have the computing power to do um and i feel like it's now just people are more willing and able to talk about it right like in the past, people's eyes would have glossed over. And now you're like, well, no, that's how Uber knows how to get you here through that route or whatever.

It's starting to become socially acceptable. I don't know how much of a difference it's making for what we do, but it's definitely in the lexicon now. For sure. And then quick question. How does one get these great jobs at a family office and a hedge fund sort of recently out of school? And especially not coming from a big Ivy League or with a huge resume coming out of Wichita. Yeah, I don't have a great answer for that.

They found me in Kansas. I was a good student when I was in college in Kansas because there's no surfing in Kansas. And I knew my stuff and I really understood what they were looking for, which was options pricing theory, computer programming, linear algebra, trading related topics. So I was a good fit for what they were looking to do. When I came to Arizona, just persistence, opportunities, they fell in my lap and I jumped on them. And beyond that, I've had to build things myself. So standpoint is kind of a, we built it from scratch. There's five of us total, all equity partners. No lucky breaks there. Build it. Got it.

And so what was the impetus to kind of go out on your own and build Standpoint and see what you can do? I'll tell you, you'll understand this. When you are delivering pure managed futures returns to people difficult for regular retail investors and financial advisors to hold on to. They don't like uncorrelated returns when it means that you're underperforming the core positions in their portfolio like stocks and bonds. So that is just a huge uphill battle and no amount of education or talking about it seems to change anything. I've tried for 15 years. I know you have. And

I have utilized a lot of your research. I've never paid you a penny. I probably owe you several hundred thousand dollars because a lot of your research that you guys did at RCM was extremely valuable and no one else did as good a job as you guys did in that regard but it still was not enough when when the performance differential went on long enough or the magnitude of it became great enough people just can't hold on to alternative investments and i've done hundreds of client calls and you don't need a degree in data science to ferret out what's happening here. It's the statement risk phenomenon.

It's that people don't like feeling like they're being left behind. And if stocks and bonds are a 60, 40 portfolio is doing better than a more balanced portfolio, people can only hold on for a couple of years, three at the most. So old, old, old piece called the problem with alpha is it lacks beta, which is basically the people, right? They can't understand why am I making money? Why am I losing money? They want that herd comfort of, okay, if I'm losing, as long as everyone else is losing, I'm fine. But if I'm making and people are making more, I get super upset.

So the epiphany that I had, or at least think I had is stop fighting with people and stop judging them. They're just being people. And if I didn't have the insights that I have, I would behave, I'd be interpreting it the same way they are. That's all they have is they can just look at the report card, their statement, and that's all they have to go on to judge whether you're doing a good job or you have their best interest at heart. So what I found, and this was kind of a slap in the face to me, what people really want is how I invest. They want us to actually do the work for them. They want us to blend in the appropriate amount of managed futures into a portfolio of traditional investments. And if you do that, then all of a sudden they look at it and say, job well done. It's okay to underperform a little bit at times and outperform a little bit at times. I don't feel like I'm getting completely left behind

and people's feelings actually matter if you're considering their financial decisions because they're going to make those decisions emotionally. There's no amount of effort we can put into forcing people to be rational or objective. That's not how the world works. Right. I feel like we're always trying to point out behavioral biases and you have this, you're not seeing it rationally and you're not seeing this. So you kind of said, stop fighting that and just roll with it.

Yes. Much like a parent would, if instead of trying to get their five-year-old in the morning to eat a big chalky multivitamin, they just give them a gummy bear vitamin. Everyone wins. The kid loves it. The parent loves it. And everyone wins. It's well, you can big chalky one the uh flintstones vitamins i don't know that was growing up i did and they weren't very good but i'm talking about like a big graved flavorless it tastes like chalk or something yeah um you know and it's you you could try to reason with the kid and say look you know after 30 years you'll be in much better condition if you take this kid doesn't care So do you want results or do you want to be right? Right. It's like as an investing public, they've all failed the marshmallow test.

So then you started standpoint with this direct vision to be this answer for the people of, hey, I've blended it for you. And that's, by the way, why it's named BLNDX, the ticker of the mutual fund? Yeah, that's correct. That's correct. I did that because during my time off, after I finished up the, after going back to school, I started doing an experiment. It wasn't very scientific, but it was very convincing to me where I would sit down with financial advisors and I would show them a spreadsheet that had the calendar year returns of the U.S. stock market going back to 1970. And they all knew what it was. They could tell. And then next to that, I would put the calendar year returns of some sort of a managed futures index and let them scroll through it and look at the relative performance year by year by year.

And then I would ask them, how would you feel about making a 5% allocation to managed futures? It's a small allocation. And I estimate that 9 out of 10 people said no way. And they all gave the same reason. They said, look here, it was down when the market was up three times and it underperformed 11 times and so on and so forth. And there's no way that my clients could have stuck with that. I would lose clients if I did this.

So not going to do it. And I would say, really? Not even a 5% allocation? And their response would be, well, 5% is not enough to make a difference, but it is enough to cause a problem. So the answer is no. So then I would trick them. I would remove the managed futures,

and I would create this mystery asset class. And all this mystery asset class was, was a 50-50 blend of stocks and managed futures rebalanced annually. And I would stick it up there, but it wouldn't be titled. There'd be a question mark at the top. And I would repeat the experiment. I'd have them go down the list and look at the different years.

And then now all of a sudden, nine out of 10 people said, yes, this looks great. What is it? I'm very curious, but I wouldn't tell them. At this point, I would say, so a 5% allocation is okay with you? And nine out of 10 people said, sure. As long as it's not something crazy, this is exactly what I'm looking for. I'd say, okay. Now I was tempted to reveal what it was at this point, but I took it a step further and I said, what about a 10% allocation? How would that feel to you? And the answer I got, the primary answer was sure. If it's not something crazy, this is the kind of alternative results I'm looking for. Sure. 10% should be fine. So then I revealed to them

that it was a 50, 50 blend of stocks and managed futures. And I don't remember a single person not being shocked. Everyone was blown away. Heads exploding. What? And then I told him a 10% allocation to this 50-50 blend is mathematically identical to the thing you rejected, which was a 5% allocation to peer-managed futures. So what does that tell you?

Yeah, it's the old uh behavioral problem right of would you rather have a 50 chance of making a hundred dollars or a 50 i can't remember what that thing is but basically it's the same expected return but everyone chooses to like not lose the hundred risk so they were seeing it just from a career risk standpoint not necessarily the actual performance numbers. Just I don't want to have to explain this extra column to my clients. Right. But at this point, everyone can be honest with one another. We see it for what it is. It's the statement risk issue. Now, at this point, as the manager, me, do I want to be in conflict with these people and tell them, look, this is where you've gone wrong and you need to change? Or do I want to roll out a blended product that happens

to be the way I invest personally and give them that gummy bear vitamin so we can all win? That's the question. And I don't understand why more people don't approach it this way. Yeah. I think of it more as the Tropicana putting the calcium in the orange juice. Same concept. Gummy bear vitamin might be more tasty. Might steal the orange juice thing from you. Yeah, take that. So let's dive into the strategy a little bit.

You gave us the broad stroke. So the mutual fund. So this concept, this rough experiment you were doing, that became the actual fund. So you're this concept, this rough experiment you're doing, that became the actual portfolio. So you're doing 50% equities, 50% trend following. It is 50, 50. The first time I looked at this was back in 1996. It was another class at Wichita state where the project was to write computer code. I think it was Fortran back then to build the efficient frontier, basically implement modern portfolio theory. And the professor gave us latitude with respect to how we would go out and get the data. And I had friends that had Bloomberg terminals

and whatnot back then, or the equivalent, I think it was Reuters back then. And I was able to get data on all kinds of different asset classes, some of which I didn't even know what they were back then. And one of them was a global macro index. And when you- That's hard to come by even today. Yeah, it was available. And I remember looking at the underlying constituents, and I think it was Bridgewater and Soros and some other guys. And I think John Henry was in there. But anyways, I didn't know what it was at the time. It was just another series of a giant database of data points. And I built this mean variance optimization program and unleashed it on the data. And it came back with a huge allocation to this global macro index. I think it was 40%. And my professor though, and so the Sharpe ratio came back at a really high number, something like 1.2 or something, which in real life is a high Sharpe ratio. Meanwhile, if you limited your scope to just stocks, bonds, and real estate, the sharp

ratio was somewhere in the 0.6 or 0.65, something like that. So when I turned it in, the professor pulled me aside and he said, how did you get a sharp ratio this high? What did you do? Um, I said, I don't know. I didn't know anything back then. Um, so we started going through it and he's like, ah, here's the problem. What, what is this a global macro thing?

And I said, I don't know. It's an index of these things. Uh, no. And he's like, well, we can't use that. You know, it just needs to be stocks, bonds, and real estate. So kick it out, redo it, and then turn it in. And that's why. Yeah, I did. I tried a little bit and I asked questions, but the funny thing was, is he wasn't interested in any questions and neither were any of my the other students in the class. Nobody cared. They just wanted to get, you know, get an A or a B or whatever. You just identified the core reason for like institutional think and like, no, it's always

60, 40. Why? Well, I don't know. That's what I was taught in school. Well, who taught you in school? Like, it seems like a never ending cycle of just that's the way it is. That's the way it should be. Well, what was eyeopening was the deterioration that I saw in the results when I kicked out the global macro index and the deterioration in the subsequent Monte Carlo simulation, because I was doing Monte

Carlo simulations on the day two. And it really widened up in the spectrum and the dispersion of potential outcomes. And it just created a terrible result relative to what I had. And I showed it to people and nobody cared. And I thought, wow, this is interesting. Why do I care and no one else does? And so that was one of my first introductions to this nagging curiosity I have that a lot of other people don't seem to have. So that stuck with me forever, even to this day. So you asked about what's the allocation? Why is it 50-50? Well, back then, the optimal Sharpe ratio allocation was almost exactly 50-50 using that index and those other asset classes. I redid essentially, I recalibrated.

You're optimizing for the sharp, you're saying? Back then I was. Yeah. So today I use multiple different ways. So 50-50 approximately, it was 50, it was 49, 51. I don't remember which way it leaned back then. Um, but I redid all of this analysis or at least attempted to, uh, a year and a half ago.

Um, right after I finished all those data science courses and I redid it all in Python this time and the optimal allocation hadn't changed. Wow. From 96 to 2019 to 2018, it hadn't changed. Wow. From 96 to 2019? To 2018, it hadn't changed. It was still approximately 50-50. And then I looked at how that portfolio zigged and zagged over the last 25 years. And I thought, wow, most people would be ecstatic with those results given all the chaos we've had. And this was before the chaos we're having right now with the coronavirus. This is 18 you're saying.

That's interesting. And that was with the same global macro index? No, I actually can't remember exactly what it was, but I have access to about 10 different CTA and global macro indexes. And they're all almost, they're very, very similar. There's a couple of them I don't trust. They're too good. They suffer from survivorship bias. So I kick those guys out, but the rest of them, there's four or five of them that I think are intellectually honest. And they're very, very correlated with the global macro indexes that I feel are intellectually honest. So I'm

comfortable that I'm looking at the same structural risk premia today as I was back then. Yeah. And I, which I've told people for years, it's not magic. You're not trying to like capture this guy's brilliance, um, trend following in particular, right? You're just bracketing the market. You're catching all these breakouts.

If they're true breakouts, you make money. If they're false breakouts, you lose money money but lose much less than you'll make um so with that structure right they're gonna do what they're gonna do regardless of basically who's in the index and and whatnot there'll be differences around the edges based on how you know their time frames and whatnot but essentially they should provide the same profile yes there is a beta structurally. Yeah, mathematically put versus my narratively put. So the 50-50, so what the 50% equity is, what's going on inside that half? So I spent about a year studying the microstructure of the ETF world because ETFs are very alluring because

they're convenient but I didn't trust them until I really did a deep dive into the structure of how they work and in-kind distributions and how it all works underneath the hood today I'm very comfortable with the ETF industry, and I see the benefit of using ETFs to get the equity exposure that we want. I could spend a week talking about it, but I won't. It's too boring. But these big ETF shops do a great job of just slamming all the costs down to almost zero.

In fact, I like to argue that you get paid to own an ETF because they're lending out the shares of the stocks they own underneath the hood, collecting short interest credit and rebating it back to the fund. And I think the number that they're collecting exceeds the management fee you're paying a couple times over. So you're actually getting to invest for free if you look at it that way. Where do you stand on a lot of people are thinking that all the money flowing into passive indexing via ETFs might someday cause a problem for the ETFs. We saw some dislocation between NAVs and the ETF price and the coronavirus crash with the junk bond ETFs, I believe. Do you have any worries or what'd you find out in your research in that regard? Yeah, I have some strong opinions about that particular topic that aren't consistent with some of the popular concerns. With respect to

things like the junk bond ETFs, where there's a mismatch between the liquidity in the ETF and the liquidity in the primary market, a lot of people look at what's going on in the ETFs and see it trading at a discount to NAV and say to themselves, this is a problem. You know, we need to fix this. I don't think it's a problem. I think that that's actually fair value if you want to transact and you want to clear the market because you're able to trade in the ETF world at a discount. If you actually transacted that business in the primary market, you'd probably get an even bigger discount. So the ETFs act kind of as a bucket shop derivative outside of the primary market that allow people to clear the market, transact with one another without disturbing the primary market where the bid-ask spreads are certainly going to be a lot wider. And then that's going to trigger margin calls

and a bunch of other stuff. So I see the ETF mechanism, even when you get premiums and discounts, being an effective market clearing mechanism that allows people to transact in a tax efficient exchange regulated manner. Yeah. And I don't even understand. Some of the concerns are like that people would redeem faster than they could sell the underlying assets. I think it's one of the concepts. So that is a flaw. I think it's a flaw to allow people to believe that there is daily liquidity in the kind of volumes that just aren't possible, that rush for the exits phenomenon. So the review is mixed on some of these things, but it's really just an education thing. If you want the convenience of an ETF structure that's participating in illiquid markets, you have to understand that if everyone wants to exit at the same time, the ETF is going to start to trade at potentially a very large discount to the primary market. But that doesn't

mean anything's wrong or broken. The primary market simply can't facilitate all of you getting out at the same time. As long as you understand that upfront, then you invest accordingly. Right. it's like if all the we work employees were trying to dump their private shares when all the shit was hitting the fan right there would have been a huge discount to what the reported number was for what the value is and that discount doesn't mean something's gone wrong it's just a discount it's the current price right yeah and Yeah. And everything you're doing is not these that we're talking about that have potential problems. You're talking SPY or

something of that nature. Yeah. So everything we're doing is at scale. I like large cap. I like market cap weighted indexes. I like GDP weighted global equity investing. I'm not passing judgment on any of this other stuff. It's just not for me. So I don't want to have to deal with those issues. I like things that can scale. I like the concept of keeping taxes to a minimum. I like the concept of keeping fees to a minimum and scale. So everything we do, whether it's on the future side or on the equity side,

is going to be with an eye on scale and keeping costs manageable and no eyebrows going up over any of that stuff. Yeah. And I think all those ETF issues, if they're real, they're going to show themselves way earlier in an illiquid side than on the as liquid as it gets equity side, especially US equity. Yeah, I've thought about this a lot. And on the ETF side, in what we do, we'll never sell our ETFs. You know, we are buy and hold investors on the equity side. I mean, we would have to sell if we had outflows, sure. But we're collecting the equity market risk premium on the equity side of the portfolio. And that means you have to be there during the good times and the bad times. It's your job to absorb the volatility and the losses. I mean, that's why you get paid to be an investor.

All the tactical stuff is on the managed future side. Got it. And then I, so you were going into how you get the equity exposure with the ETFs, but what does that look like in terms of, are you allowed to share the name of the ETFs or what the foreign US blend looks like? Yeah. So it's 60% US and it's the big names that everyone's familiar with, Vanguard, Schwab, BlackRock. And then the balance 40% is going to be split almost equally between developed Europe and developed Asia. So I'm just looking to collect the equity market risk premium from developed global equity markets on half the portfolio. So you're not dabbling in frontier markets or

African something or other. Developed Europe is basically the G20 countries of Europe and same for Asia with the Asian countries. Correct. Correct. I spent a lot of time and I'll admit agonizing over whether I should include emerging markets. At the end of the day, they're just not big enough or significant enough in the global context when you're looking at things on a GDP-weighted basis to worry much about.

I also liked having equal representation on the futures side, meaning if we've got a lot of France in the equity portfolio, well, I've got a lot of France in the CAC 40, you know, French futures market portfolio. So I wanted balance. And at the end of the day, 90% of global GDP, by my estimate, comes from these developed nations. So if I don't have to deal with Argentina or Brazil or, you know, Zimbabwe or any of these challenging places, then I'd rather not. What did I just read the tweet today?

That Argentina defaulted on its debt for the 13th time today or something? Yeah, the easiest prediction you'll ever make. Yeah, mind-boggling. People will keep – I think they sold 100-year bonds too, like a couple years ago. Not to me um yeah me neither so and is china china's not part of the asia no i i'm not a believer in china um it's a communist country most of those equities are primarily owned by the government uh i can't i can't go down that road just can't i't. I mean, if China goes on to lead the world

and be an economic miracle machine, they're just going to have to do it without me. So even if they become, which could be in the next few years, the largest economic power, right? Are they number two now behind the US? For now. Yeah.

So even if they're number one, you're saying stay away? I mean, the volumes in their stocks aren't close to number one. I don't know what they are, but probably. I just don't see it as a fair market with an actual price discounting mechanism working. So if, you know, let's say they were number six in the world, my answer would be absolutely not. So the fact that they're number two by some people's metric, my answer still needs to be absolutely not. That doesn't mean I won't trade their futures markets when they open up. That's

a different animal altogether. Futures markets are risk transfer vehicles. It doesn't matter if they're a communist country. Those risk transfer vehicles should be efficient. If they're not, then I won't participate. But if they are, which I expect them to be, I will as soon as they become available. But on the equity side, if the government there owns most of those corporations, then I just don't see them as... The equity market risk premium argument doesn't hold water

if the government owns the corporations. Yeah, and they just had... What was it? I want to say Dunkin', but it wasn't Dunkin'. Luckin'. Luckin' Coffee was in the news the past. Yeah. And they just had, what was it? I want to say Duncan, but it wasn't Duncan Luckin. Luckin Coffee was in the news the past couple of weeks. It's kind of a huge fraud. They said they had 10,000 stores and they had a thousand or something. So you're trying to avoid those pitfalls. I'm trying to avoid investing in the DMV. I wouldn't do that. That's a mean thing to say, but at the end of the day, I think a lot of those are going to be zombie companies

and look, it's a freak, it's a free country. Someone else is going to do it. I thought about it and I, it was a tough decision and I said, no, I'm just going to go with my instinct here. I don't want to participate in Chinese equities. Just don't want to do it. Got it. And I think that comes back big to statement risk. Like you were talking about before, I think you'll find more RAs that agree with you on that than don't. Yeah. And if they want China exposure, there's a million different ways to get it.

Got it. Just not here. So any other comments on the equity side? It's pretty standard. Yeah. I wanted it to be super low fee, tax efficient, easy to understand and liquid and scalable. So after that research project where I compared using these ETFs versus using futures contracts versus going out and buying the common stocks myself and managing that portfolio and looking at custodial costs and taxes and tax treaties and all that other stuff, the weight of the evidence was very much on the side of using these ETFs and they're almost free in terms of management fees. So that made it real simple. Half the money goes into a globally diversified portfolio of these

ETFs. All right, let's dive into the other half, which is the trend following approach. So unpack that. What kind of model is it? I'm assuming, well, I'm not assuming anything. Tell me what kind of model it is on the trend following side. It's interesting. A couple of years ago when I sat down to start building this program, I had a blank slate and I had a lot of experience having done

this a couple times in the past. And I, you know, I got out of the data science school and had brushed up on my machine learning and artificial intelligence skills and quickly realized that those are not going to be very helpful in building what it is I want. What I want is something that's very durable, that is simple and enduring. What I mean by enduring, I mean something that if I applied it to data from the 60s and 70s, it would produce results that were consistent with reality, um, results that weren't shockingly different from what I would have expected. Um, you could apply it to data from the eighties, nineties, two thousands, and hopefully into the future. So enduring means,

um, I'm zeroing in on some sort of a structural risk premia that's always been there and should always be there in the future. So you don't need artificial intelligence or machine learning or any of these complicated topics for that. What you need to do is figure out who is willing and able to lose large sums of money in the futures markets and hopefully who is actually economically better off for having lost that money in the futures markets. And if you can identify that those people exist and consistently exist, and you can participate in the markets in such a way that you're providing liquidity to them in their time of need, then it's reasonable to conclude that some sort of a risk premia will flow from them to you over time. And so people hearing that would say like, what are you talking about? You're crazy.

Nobody wants to lose money on purpose. So give us an example. Who wants to lose money? I don't. Right. That's exactly what I would have said a long time ago, too. But it turns out that more than half of the dollars in the futures markets are not profit seeking. More than half of the open interest, by my calculations, comes from commercial hedgers in most futures markets, not all, but most. And commercial hedgers, of course, they'd like to make money on their futures trades, but really what they're trying to do is hedge off specific risks in their core business. So what's more important to them is that this trade that they're establishing be negatively correlated with a risk on their balance sheet or on their income statement in their business. And we're talking like Southwest Airlines hedging their oil costs. Yeah, corporate farming conglomerates, pension funds, energy companies, energy consumers,

people that buy wheat, bakeries, people that produce wheat. So to make a long story short, what I've found is that the evidence is very strong to suggest that commercial hedgers primarily sell rising markets to lock in prices, to lock in profit margins and continue to sell as they go up. Meanwhile, other commercial hedgers buy declining markets to lock in low input costs, again, to give themselves certainty of profit margin going forward and vice versa. So they step in front of declines and start buying on the way down, which I believe pushes the derivatives price, not the cash market, not the spot market, but the derivatives price to be higher than its intrinsic value. And these people control a lot of money. So they fade trends. And then on the upside, they sell markets that are rising to lock in those profit margins and they push the derivatives price below its intrinsic value. So now who's on the other side of those trades? Who in their right mind wants to buy things that are hitting

52 week highs? I don't know anybody who likes to do that. Just sit around and watch a market soar and go up day after day after day. And then it hits a 52 white high. And then they say, all right, now I feel great about this. I want to buy it. Buy it. Except all the Tesla chasers back at the end of last year. Yeah. Well, it's a lottery like payoff. And if if you take 100 people in off the street and you set them down at Bloomberg terminals and you give each of them a million dollars and say, start trading,

none of them are going to do that. None of them are going to wait for a 52-week high to buy or a 52-week low to sell. They're going to do the opposite. Quick aside, I was working with this guy who was doing some option new startup that you could like click on the chart and see different option prices. But he had a different idea of shoot all these chart patterns out to thousands of people, like pay them a dollar a click or something. And just basically be like, would you buy or sell here?

And build this huge big data repository of like the human brain of how it reacts to all these different chart patterns, which was kind of interesting. He never did it. It sounded expensive. But the idea is great of like, okay, here's how the human brain actually reacts to this chart pattern, which I would guess, yeah, 9 out of 10 are going to be like, yeah, I sell that. That high. It's gone too high. It's at the top of the screen. I got gotta sell it

one of my co-workers had the greatest idea ever he said um let's go to a frat house at asu arizona state university which is world famous for their frat houses yeah full stop or there's more to it yeah and we're we're gonna do is hire the most aggressive loudmouth frat guys that we can possibly get and stick them all in a room with a bunch of computer terminals and give them trading accounts. And these guys have no experience in the markets, right? But on the other side of the wall, we're just taking the opposite sides of their trades because you know they're going to blow up. And I thought, yeah, I don't know if legally you could do that, but that would be a very interesting behavioral finance experiment.

But we never got around to doing it. Yeah, in the futures world, you can't do that. But that is basically the equities world. Everyone pays for the naive order flow, especially in the options market. Right. Those prop firms buy that flow and trade off of it all day long. Yeah, and you can get a very high arithmetic mean doing that, but it's not very

scalable. So all this soul searching and you're trying to look for, okay, what's basically you're saying, I wanted to know that there's someone on the other side of these trades so that I'm comfortable with a simplistic standard approach. Like I don't need to add machine learning and all these bells and whistles to make sure I know how to make money. I just want to know there's a basically a beta to this trend following approach. And then I'm going to get the best replicator of that beta. I think it's a fair characterization. And I'm not saying that I'm right and other people are wrong. So I'm not going there at all. And we're just, look, all of us have to look people in the eye and justify our results long term. And I have to be able to sleep at night.

And the business person in me says that's what's important. I do not understand how other people can build mathematical models and backtest them and then unleash them on the markets and make or lose money going forward without understanding why this should work in the first place. So for me, I look at the hedgers and understand that they are willing and able to lose money on their trades. It's a negative sum game. The returns can't come from anywhere else. And this idea that I'm going to be smarter and faster and more skilled than the other speculators in the market, that gladiator mindset doesn't resonate with me.

I think it's misguided. It's likely to be untrue. And even if you could figure out a way to outsmart the other speculators in the market, the other trend following firms and futures trading firms, they're terrible customers because what do they do after they lose money? Well, they start betting smaller. They start going away. If they lose money for two years, they get redeemed. Their clients fire them. So that's, I call that the pawn shop model. And even if you can figure out a way to outsmart everyone else, they're not going to stick around and keep paying you. Yeah. It's a short live, short live, short live edge to be sure. Yeah. And that it's, it's more glory based. whereas I look at it as a symbiotic relationship between trend followers and hedgers. Hedgers lose money on the derivatives positions, but that's the best outcome that they could have looked for because that's negatively correlated with their core business.

So, of course, they want to lose money on something that's negatively correlated with their core business. They're just using the derivatives as a form of dynamic insurance to control their total exposure at the firm level. So if you provide a service to them, then it is realistically possible that you can compound wealth over time at a reasonable number. And so tie this all back into the 50% trend following. So that's why you chose the model you chose, or that just lets you sleep at night knowing that's the model I chose? Yeah, I would say that that guided my attempts to build what ended up being a relatively simple model. So that's why I think it doesn't need to be that complicated. I was amazed. One thing that really jumped out at me in the last couple of years is I sat down and I built many different models. I built dozens and dozens of models over the years, some complex,

some simple. Um, some of them have worked great. Others have been mediocre. One of them didn't do very well at all. Um, but the ones that have done the best were the simplest. And this model that I use now, I call it the maximum capacity program where it's just open interest weighted participation in 75 different global futures markets with a portfolio heat target of 20 percent it was supposed to just be the baseline model you know kind of this is the beta of managed futures from my perspective but all of the complex things that I built around it or on top of it, they added more model risk, which I don't want, and didn't really improve the results. And I kept looking at this baseline model, which I think of as the S&P 500 of futures.

It's just real simple. Participate on an open interest weighted basis. Take every trade. Control your risk. Wash, rinse, repeat. Don't ever break discipline. It works great. And at the end of the day, that's exactly what I want. That's what I want to use. And there's benchmarks out there like SockGen trend indicator or there's like S&P has one, I believe, trend indicator. So it's essentially similar to those indicators or indoor indices? No, I wouldn't say it's similar to them at all. I've looked at what they're doing.

I feel like a lot of those things have special rules. Like some of them have special rules that say we won't short energy, or we won't use leverage, or we won't use stock indexes. I don't view those things as a good proxy for trend following. The SG trend index is a good proxy for trend following because it's an equal weighted index of the biggest trend following firms out there. So I think that's a fair proxy for managed futures trend following returns, but I haven't seen

too many others today. They've changed over the years that I would put into that camp. Yeah. But this whole concept is a lot of the banks and big firms have gone down this path and said, hey, institutional client, you can get this trend following beta right here at my shop in our risk premia department. How much do you want to put into trend risk premium, momentum risk premium? So it's a similar concept there, but I would agree they have different bells and whistles and, or leave it up to the client to choose those bells and whistles. And they might shoot themselves in the foot and be like, cool, I want this, but I don't want short energy, like you're saying, or something of that nature. True. And I've, I've been disappointed in some of those

products I've looked at, at least in the results. I think a lot of those are very short term in nature relative to what I've chosen to go with. So I'm not sure. I like what I've come up with. I really do feel that it represents the beta, at least my idea of what the beta is of trend following, at least on an open interest weighted basis. So that's what I ended up going with. And tell me a little bit more about that because that's a little bit unique

on the open interest weighted basis. Yeah, so it kind of dovetails with what we were talking about earlier, where I really think that the commercial hedgers are the source of any sustainable at the end of the day. So, my perspective is that hedgers can't hide. They've got to show up in the open interest. So, I view that as a proxy for any profit potential on a market. So just like if you're looking at a stock and you're float weighting or market cap weighting your participation in an index, which is very efficient, tax efficient,

results in very low friction rebalancing, you can take those same concepts and port them over to the futures industry if you simply pay attention and migrate with the open interest. And that means trading the whole futures curve, not just the front month, and weighting your positions according to their current level of open interest, knowing that that's going to change over time and adjusting to those changes in a slow, pragmatic manner. So give me an example of that. So I would assume like energies are some of the biggest open interest bond futures. What are some of the top 10 in the portfolio based on the open interest? Yeah. So it would be the 10 year treasury, S&P 500, gold, Brent crude, the corn markets big, you know, every sector has got its leader and then its second place and then third. And then it really starts to drop off after that.

And then are you saying you're actually looking at like December 21 corn and measuring its open interest and if it's viable, it might get a single contract and June 20 corn has huge open interest, so it might get 10 contracts. Yes. Well, that's how we will scale the program as it gets bigger. It's not necessary when you're small. But if you want that capacity to be there, once you start to scale, especially in the soft

commodities and the grains, you need to start trading the deferred contracts on an open interest weighted basis. And then you guys seem to outperform some of the other managers who are doing similar things here in the March sell-off. Do you think that was because you have more in energy and you were short the energies? I suspect so, yeah. I think a lot of managers, for some reason that evades my understanding, choose not to participate in

energies on the short side. And they also choose not to participate in bonds on the long side when they feel that interest rates can't go any lower. And I've argued with several of them over the years talking about contango and term structure and how much the role yield factors into the profits of a long-term trend follower and how that is to some degree immune to the argument that they're making that the price can't go any lower. So yeah. And we have proof last year, a lot of trend followers were long German boons at negative rates.

Well, sorry about that. If you could hear that. Right there, long boons at negative rates. Like, that makes no sense. But it went more negative and they made money on it. So there's a bit of a disconnect of like, hey, not only can it go through the zero bound and we can get negative rates, it can even go more negative. Price is higher, rate is lower. Back in 2015, I talked to some clients that I had about interest rates

potentially going negative someday. And I think I lost business because of that. One client accused me of wearing a tinfoil hat. The idea that interest rates in a real country could go negative was so absurd that he couldn't listen to me anymore. So yeah, it's, you know, we're in uncharted waters. There are things happening. I mean, crude oil, I think had a negative print in some province in Canada a few weeks ago. So, and I've heard a couple of smart people that aren't crazy talking about negative crude oil

prices. And I'm not predicting that, but it is possible if the implied storage costs exceed the intrinsic value of the underlying toxic waste in the barrel, the price could be negative. So we are in this Corona virus, like they ran out of places to put the jet fuel, the unused jet fuel, right? So yeah,

they got to pay someone to either build new storage or pay someone to take it off their hands, which would be a negative barrel. We're going to pay you to take this barrel. Yeah. And that's what I love about futures markets is that they're very counterintuitive. So when a market goes into full carry, like a lot of these energy markets are now, you'll see the contango get priced into the curve. And if you try to unwind that contango and say, why is the contango, you know, $7 a barrel? What you'll find is that part of that term structure is a function of estimated interest rates,

a little bit of expectations, but most of it is the cost of storage. And the cost of storage is a fascinating thing because it's linear for a while until you start to come close to capacity. And then it goes non linear and there's no limit to the cost of storage because there are government laws against toxic waste and whatnot. So now if you're a short seller in the energy space, when a market's in full carry

like that and the storage facilities are full and you keep rolling a contangoed market and making all your returns from a roll yield over and over and over again, shorting at 20, closing at 15, short at 20, close at 15, you know, and you're just rolling down the curve, November, December, January, February. And then you do an honest assessment of why did I make this money? Well, you were a dynamic synthetic storage provider during that period of time. When you, when you shorted the contract, you gave someone else the price certainty that they needed. Had they not been able to contract with you, they would have needed to have gone out and paid for that storage. So all of a sudden you went from being

a future speculator, trend follower, whatever. You're just providing another valuable service that happens to exist for some different reason. You're a synthetic storage provider. Who thinks about stuff like that? That's fascinating to me. Why would that be correlated with the equity markets or with the bond markets? I agree. I like that. I'm going to get some shirts made up for you.

Synthetic storage provider. Only in a full carry market that's going down. And explain what you mean for the listeners by full carry market. Well, that's when. And explain what do you mean for the listeners by full carry market? Well, that's when the whole curve is, you know, the spread traders are active. The open interest is full and it's all being locked in. There's some papers that I really benefited from. You'll probably recognize the author Holbrook working.

Yeah. Yeah. He wrote a bunch of papers and it's the best futures coverage I've ever read. And they're all from the 1930s and 40s, I believe. Very timely today. Just super interesting. So I don't know if that's helpful to people, but it was definitely helpful to me to at least try to understand this ecosystem of the futures markets because they're very different from the other markets. And you see this with like Glencore and huge commodity traders, right? If they have like oil they own on a ship and they're, no, they don't want to get the price they're going to get. They

just hold it in the tanker and wait for the higher prices in a few months time, which has its own risk, but there's, yeah. So there's all those dynamics too, of the cash players in and out of the market. Yeah. That's a, that's a different discipline. You know, there's arbitrageurs cash and carry all these other participants and whatnot. And I know my place in the ecosystem and that's to provide liquidity to some of those commercial hedgers in their time of need and do this uncomfortable thing that people don't like to do by breakouts, sell breakdowns, close your position out if it goes against you significantly and control your

risk. There's a place for us in that ecosystem and it's actually quite profitable and it's beneficial to a portfolio because it's uncorrelated with stocks and bonds. So let's talk a little bit. A lot of people have gotten so super frustrated with managed futures over the last nine years, especially trend following articles that trend following is dead. The volatility is so low. All the markets are correlated. You can't diversify across markets. How would your, this simple model have performed during that time?

Just in general, general terms, but then also what are your views on can trend following ever die? It seems like you're saying no, but what are your views on can trend following ever die? Seems like you're saying no, but what are your views on all that? I do think trend following can die. There is a way for trend following to die fundamentally. And that would be if you get so much vertical integration in all these different markets, which is possible, I'm not ruling it out, that there's no more risk premia for an outside participant to collect. So what I mean by vertical integration, that's where someone like Amazon

starts buying all the downstream, you know, suppliers and whatnot. Basically they can do all the hedging internally, meaning, you know, they're both the consumer and the producer of some of their own goods and they control the whole ecosystem. Yeah, they don't price it at the end point. Yes. They have the customer relationship. Right. They have all pieces. So they'll just say, this is the price.

I don't need to hedge anything. Yeah. Imagine if one giant corporation owned the airline and the energy company that supplied the airline and then whoever else, you know, is in that ecosystem. But if they owned all of it, then the hedging, the contracts could be intra-department or inter-department back and forth. So there's no need for external people. You don't need to lay that risk off onto an exchange. So that's possible. The banks all try to do something like this as well,

to kind of get rid of the CME and create their own interbank exchange where they just offload their risk between each other and not pay the CME billions of dollars a year. Right. Yeah. If it's a single company and Amazon's probably the best candidate for this dystopian future we've ever had. Yes. And like I said, I'm not ruling it out, but if it does happen, it'll correspond with plummeting open interest levels on the exchanges. And since I'm open interest weighting everything, I'll just naturally kind of get muscled out and have to go do something else in my life. But yeah, I think we're a long way away from that.

And hopefully you never see anything like that. I put the odds at, you know, five to 10% chance of that dystopian future happening in my lifetime, which again, it's not a non-trivial amount. The other issue with trend following is a lot of people have looked at the nominal returns of trend following and correctly concluded that they have deteriorated significantly from what they were in the 80s and 90s. I think they've incorrectly diagnosed this as a problem, however. I don't think it's a problem.

I think it's completely natural for two reasons. One, almost all of that deterioration can be explained by lower interest rates. So what people don't understand is that a CTA, a managed futures manager, sits on a ton of cash. So if you give a CTA a million dollars and you say, hey, go run me a futures program, they're going to take about 100 grand of that or maybe 15,000. I'm sorry. Let's just say it's a million dollars. So 150,000, they're going to post it as margin. The rest just sits in cash, which they're going to then invest in treasury bills. And they're going to collect the risk-free rate of return, and that's going to show up in the performance. Well, the 50-year average T-bill yield is 4.6%,

but it's not 4.6% right now. It basically went almost to zero right after 9-11, bounced up a little bit, and then went to zero again in 2008. It's been hovering at really low levels ever since. So if you were to credit that back, you would see much less deterioration. So that part's out of the CTA's control. The risk-free rate of return is zero. It used to be 4.6%. So you should expect to see about a 4% lower annualized return for your typical CTA on a fully funded basis. I would add to that whole argument that the CTAs these days have many more institutional clients, pensions, big clients that don't want as much volatility. So in your example, a million 150s used as margin back in the eighties and nineties, they probably that million dollar investment had six 50 in margin or 500 grand in margin.

So they both had the, the bump from the interest rates, but they were also putting more money, more of the money to work and more volatile to the upside and the downside. And so now they've, they've de-levered and there's less interest. Yes, that's true too. So in order to answer the question, have the returns, quote unquote, returns deteriorated, you have to define what you mean by returns. So what I like to do is strip away the interest rate component.

So we're comparing apples to apples, but you also have to strip away the thing you just brought up. You have to normalize the variance. So you're looking at risk apples to risk apples. And when you do that, you see considerably less deterioration. You still see some, and it's meaningful, but it's not eye-popping or off the charts. Let's talk about that deterioration for a minute. A lot of people in our industry see that as something to be ashamed

of, something that's bad, something that you want to run away from. I don't view it that way at all. I think it's completely natural. And I expect it to continue up to a point. And I think it's natural in any market. As markets scale and become more mainstream and more liquid and more accessible and convenient, any of these excess returns, this alpha component is going to deteriorate down to a sustainable level. Eventually it's going to floor, it's going to turn into an asymptote and floor. And that's just a natural part of growing up. You know, I'm not as fast and limber as I used to be now that I'm 48. Doesn't mean I've done anything wrong. It's just a fact of life. So I think that the sustainable

risk premia from managed futures or trend following is probably what we've seen. I don't think it's going to be, certainly it's not the 20% a year that CTAs made in the 80s. And I don't even think it's the 15% a year that they made in the 90s. It's probably on par. My calculations show that it's very close to what the equity market risk cream is, which I estimate to be about 5% a year over risk-free. It's just totally uncorrelated. And if I had to guess, if you put a gun to my head and said you need to be right over the next 20 years, that's the number I would pick. So similar return, but totally different how they get the return. Yes, which is covered.

Yeah. Which is very important. So one study I used to show people is over a certain period of time, the stock market compounded at 10 and it was like a 30 year window and an intellectually honest index of CTAs compounded at 10 and they both had 15% vol. So 10% return, 15% vol, identical sharp ratio. But when you blended them together, the return went up to 11 and the vol dropped to nine and the drawdown went from 50 to 20. Wow. That's amazing. Yeah. Because a lot of times these efficient frontiers, I'm like,

I get it. It looks nice on the chart. Then you look at the scale and the standard deviation went from like 9.8 to 9.4. Right. And you're like, I don't really want to go through all this work to get a 40 bps reduction in, in annual volatility. Especially when the standard, standard error is 300 basis points yeah exactly yeah um but that's isn't that what we get paid to do that's what they taught me in business school they just then turned around and said don't actually do it in real life so portfolio math diversify uh different risk premia uh diversify as much as possible uh so i'm actually doing that i'm actually following through and doing that and trying to help people do that with their portfolio as well and last thing I'll mention on the trend point piece so

it's gonna ideally zig when it zags not guaranteed but it's gonna be in there in a crisis not by you know what I say by structurally because it's gonna as you were saying those new 52 week lows it's gonna make new new new lows and you're to be involved in that. But the whole concept of the whole thing is I'm going to blend these two together. When the market crashes, I should be involved in that on many different asset classes, not just stocks. And when the market's chugging along higher, I'm going to do okay. It's a dangerous topic. I have really strong opinions about this topic uncorrelated doesn't mean what a lot of people feel it means it doesn't mean that you never go down together so if you have two uncorrelated assets i think it's reasonable to expect that they'll both go

up together 25 of the time and they'll both go down together 25 of the time and then they'll oppose each other one's up the other's down 25 of the time and then you both go down together 25 percent of the time and then they'll oppose each other one's up the other's down 25 percent of the time and then you flip it the other one's up the other one's down 25 percent of the time that's a better kind of mental model yeah for the relationship between ctas and stocks so in the crash of 87 i think most ctas were down that month there were a few high profile paul tududor Jones and some other people that you know became legends from being short But I've looked at the data and I've talked to people that were trading back then most people were long Yeah, they couldn't they couldn't get out right so you can go down the same time the market goes down So it is not a guaranteed hedge

But it's still what I said earlier, 10% returns, 15% fall, blend them together and you get a higher return. The geometric return goes up and the vol is offset to a large degree. That's a true thing. If the correlation is low, sometimes the correlation is negative 10, sometimes it's positive 10. It can swing around and there'll be times when you lose money on both managed futures and stocks at approximately one quarter of monthly data points, that's true. So. Agreed. I've been hammering that point for years that it's non-correlation. I say it's the average of all the correlations. So sometimes it's going to be

positive, sometimes negative, as you're saying, what the non is, is the average, but we all know, right? You can drown in a river that's two feet deep on average. There's going to be periods in there where it's deeper, more correlated than you think. Right. Briefly, tell me structurally. Is there anything you can't do in the mutual fund that you would have done in a private fund or different? Or can you access the full suite of what you're trying to do in the mutual fund? Well, you certainly can when half the money is in equities.

So if you look at it at the fund level, it looks like we're running a very low-fall managed futures program because half the money is dedicated to equities. So the short answer is yes, you can do everything that I would want to do. Uh, the regulations are suitable, uh, for running a real managed futures program and a mutual fund. You couldn't run a super aggressive one on a, on a dedicated basis, meaning a pure managed futures program. And you wanted to run something like a Mulvaney or, you know, one of these guys that has really high heat that really goes for it, that wouldn't work too well.

You'd have to do a lot of dancing around some of the leverage restrictions. And essentially you can't have more than a quarter of the portfolio in, in levered products. You can't have more than a quarter of the portfolio in in illiquid products and your your futures account for trading commodities is considered illiquid even though it's not it just for anything that can be physically delivered I believe right yes yeah so but that's probably triple what we would need so we're well under the limit. So yeah, we don't have any issues. I'm very pleased with how simple the regulations have gotten relative to where they used to be.

Back in 2011, there was a lot more hoops you had to jump through, but the NFA and the SEC have done a good job at harmonizing and clarifying what you can and can't do. And I'm happy with the, the guide, the guard guardrails. And what's it been like starting the new mutual fund company? So hard, easy. Um, you know, somewhere in the middle, I, uh, more towards easy in terms of, um, it's easy when you know who you are and you, you know what your message is and you know what you're not and you know who

you don't want to do business with. We want to do business with prudent financial advisors that want a real balanced portfolio and they respect kind of the, uh, the intersection between realistic expectations, um, discipline preparedness. Uh, and, and they, my, my message of kind of mutualistic behavior resonates with them. They know that you don't get something for nothing. I'm not out there saying I'm smarter than anyone else,

that we're faster or more gifted or we're using machine learning. It's more of a, we understand why these markets do what they do, like why they were set up and where the risk premium are. And we're going to do the things necessary to capture that risk premium. And it's not fun. You know, we're not in this for fun or excitement. We're providing a service to the marketplace that's valuable. And we're going to collect this risk premium. And we can show you how much of a difference that makes in different market environments, inflation, deflation, youlation, Goldilocks scenarios and whatnot. And then just allow people

to calmly and intelligently assemble the portfolio that they want. And then hopefully, hopefully it's a little bit of fun. Well, it's fun for me. I use that almost in a sarcastic manner that I've come across a lot of traders in the last 25 years. And a lot of them get into this business for the wrong reasons. They see it as a way to get rich and for excitement. And those two things do not work very well. Those aren't the attributes that you want. So what I'm saying is we're running this as a business, collecting risk premium for providing a service. We're not glued to our screens and watching the markets and trying to have fun. Right. And it seems like you're the antithesis of what I think of a mutual fund company. They're like all suited up walking into a tall building in Boston or something and analyzing fundamental stock research or something. Right. So you guys are a little bit on the different side of that. Yeah, I'd say the old school guys are, but there's a new breed of up and comers,

guys younger than me that are doing some really good work out there. So don't write off mutual funds yet. I think there can be a renaissance, especially in the alternative mutual funds. Yeah. And we didn't talk about that. A lot of people would say the mutual fund world is dead or dying and everyone's going to switch over to active or passive ETFs. I think you're showing there's a need for this. Well, think about what I'm doing. I put half the money in passive ETFs for a reason. I actually believe they're a very efficient way of capturing the equity market risk premium. But then I'm marrying it to 50% active management and alternative investments. So I think you can do both. You don't need to pick one camp or the other. Got it. All right. Any other things on the strategy or we can go into our

favorite section and close it up here? No, we didn't get too much into the strategy, just that it's a plain vanilla, long-term, medium-term trend following, old school, the same stuff that the chairman of our board of directors, Tom Basso, was doing back in the 80s. And I believe in that stuff. I think it works for a reason. So we haven't reinvented the wheel. We're just doing it in a very efficient, transparent manner. And we expect that that's going to give us the beta that we're looking for, which is

that trend following beta, pair it up with ETFs, get the equity market risk premia, you know, keep an eye on taxes, keep fees low, and that's it. It's not complicated. And the goal of it is to let people be comfortable, right? Like not have to make these decisions, not have to say, okay, should I get into stocks now? It lets you be always long stocks. Yes. Well, we didn't talk about the rebalancing between futures and stocks. One of the beautiful things, and this is great, even I succumb to this one. When you have enough managed futures in your portfolio, when it comes time to rebalance into stocks, you do it with confidence. So if stocks go much lower here, I'm going to be rebalancing into stocks. I'm going to be buying more stocks. Who wants to

do that right now? Everyone's looking for ways to get out of stocks, but if the market's down, you know, 45% or something, I'm going to be getting signals to liquidate some of the managed futures and to put more money into stocks. So having two uncorrelated return streams in the portfolio puts you in a position to actually buy low and sell high rather than panic out at the bottom and panic back in at the top, which is what people do when they have unbalanced portfolios. And that's on a day by day basis or on a monthly basis? It's evaluated every single day. And we have rules for that. All right.

Let's jump into our favorites. Not my favorites, your favorites. So thank you again for joining us today, Eric. Going to end out this episode with our quickfire favorite section. You ready? I'm ready. All right. Favorite Arizona national park.

Don't have one. Don't have one. Don't have one. Well, I'll give you a choice. Grand Canyon or Sedona? I don't like either of those actually. Okay. Yeah. Let me think about this for a second.

There's a park just north of Fountain Hills that has awesome trails if you like mountain biking. Can't remember what it's called. We'll look that up. Sorry, we've gone past my time. All my notifications are beeping. Favorite investing book? Fooled by Randomness. Fooled by Randomness, one of my favorites.

It seems like your whole portfolio is geared towards that of being anti-fragile. You removed a lot of the fragility in the simplistic trend following model. Yes. I'd say that's a paramount importance to me. Less model risk, more durability. I like it. Favorite investing blog. Favorite blog, uh, flirting with models. I was teeing it up for you to say RCM's blog.

Yeah. Well, RCM is the one I've gotten the most mileage out of and you guys do a great job, but the recent I've been reading them, they're kind of new. Yeah. Yeah. He's good. Uh, are you a golfer? Nope. Never played golf in my life. Really? And you're in Scottsdale. It's a shame. The, uh, favorite you, so you don't have a favorite golf course there in Scottsdale? I wouldn't know a name of a single one. Desert Mountain. Talk to Tom Basso.

He probably has played them all. All right. We'll talk with him next. Do you listen to podcasts? A little bit. Generally. Favorite podcast? No, I don't.

Not yet. I've just recently started listening so i've listened to some of yours and and uh neil's and uh moritz uh haven't and meb favor too like it uh and last but not least we were talking offline you don't watch a lot of movies but we asked everyone their favorite star wars character so hopefully you saw it somewhere along the line. Favorite Star Wars character. So I remember the movie from 1977 and Jabba the Hutt had this little creature that cackled like a maniac. Yes, I know his name embarrassingly.

Oh, what's his name? Salacious Crumb. Salacious Crumb is my favorite Star Wars character by far. I like it. That's a good one. I think he dies. Maybe he runs away when Jabba gets killed. Look, we all die, but that guy made history

because that stuck with me since 1977. I think that was Jim Henson did Yoda as the puppet and was like, hey, give me another character here. They're like, okay, you can have this little guy because he was kind of muppetish all right eric thanks so much for your time and best of luck with the mutual fun and uh we'll talk to you soon you bet thanks a lot take care all right you've been listening to the derivative links from this episode will be in the episode description of this channel follow us on twitter at rcm alt and visit our website to read our blog or subscribe to our newsletter at rcmalt.com if you liked our show introduce a friend and show them how to

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