Episode #389: Eric Crittenden, Standpoint Asset Management – The Market Owes You Nothing
Guest: Eric Crittenden is Chief Investment Officer of Standpoint Asset Management. He has over 20 years of experience designing and managing investment strategies, with an expertise in systematic trading in both mutual funds and hedge funds.
Date Recorded: 1/26/2022 | Run-Time: 1:15:09
Summary: In today’s episode, we’re talking with one of the true systematic investors out there. We start by discussing the potential impact of inflation on investors’ portfolios. Then Eric shares what led him to start a new firm focused on giving people what they need in a format they want – a mix of trend following and global equity beta. We touch on diversification and why Eric’s a true believer in trend following.
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Links from the Episode:
- 0:40 – Sponsor: The Idea Farm
- 1:09 – Intro
- 1:48 – Welcome back to our guest, Eric Crittenden; Episode #225 & Episode #14
- 2:46 – Episode #2 Tom McLellan, The McLellan Market Report
- 3:59 – The stealth bull market as told by copper
- 4:56 – Eric’s view on how inflation can impact portfolios
- 6:20 – What’s good to know about the 1970’s in regards to inflation
- 9:00 – The volatility of today’s markets given valuations at all time highs
- 11:48 – What Eric means by “the market owes you nothing”
- 21:29 – The false assumption that bonds are always a good diversifier for stocks
- 23:14 – The risk of stagflation
- 29:40 – Why Eric likes trend following
- 37:54 – Eric’s decision to pair equities with managed futures
- 45:02 – Eric’s view on commodities
- 57:21 – What percentage advisors allocate to these strategies?
- 59:00 – Episode 368 – Return Stacking
- 1:07:02 – What else has Eric curious as he looks out at 2022
- 1:10:29 – Spending time diving more into computer science
- 1:11:36 – Learn more about Eric; standpointfunds.com
Transcript of Episode 389:
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Meb: What’s up everybody? Today we’re bringing back a fan favorite for the third time. Our guest is the Chief Investment Officer at Standpoint Asset Management, an investment firm focused on bringing all-weather portfolio solutions to U.S. investors. In today’s show we’re talking with one of the true systematic investors out there. We start by discussing the potential impact of inflation on investors’ portfolios, then he shares what led him to start a new firm focused on giving people what they need in a format they want, which is a mix of trend following and global equity beta. We touch on diversification and why he’s a true believer in trend following. Please enjoy this episode with Standpoint Asset Management’s, Eric Crittenden.
Meb: Eric, welcome back to the show.
Eric: Thanks for having me back on, Meb.
Meb: It’s good to see you, my friend. Last time we had you on it was back in 2020, which seems so much more recent. Maybe you and I just caught up. Where do we find you today?
Eric: Safely at home in Scottsdale, Arizona. Sunny Scottsdale.
Meb: And as well as I know you, I know that you’ve just been prepping all week to watch and trade-off the Federal Reserve press conference. Right? Isn’t that your style?
Eric: Anything but I didn’t even know it was a fed day until a couple of hours ago.
Meb: It would have been a great bet. Does Eric know there’s a fed meeting today? I’m the same as you. It’s a little bit of theatre, but there’s good Alison Krauss song, one of my favorite singer/songwriter, is a bluegrass and she’s got a song, the name of it’s “You say best if you say nothing at all.” People love to try to divine every single word, and space, and sentence, and response to what people mean by some of these fed meetings. It’s funny because I posted a Tom McClellan, another old podcast guest, chart. And I said, “You know, wouldn’t it be funny if the fed just goes to these meetings, drink some beer, watch “Seinfeld” reruns, and just pegs the fed Funds rates to the two-year?” Because if you look at fed funds rate against a two-year, they’re not exact clones, but they’re pretty close. And all this time people spend prognosticating and pulling their hair out is really just an exercise and nothing. Hopefully, Jay Powell saw that. I don’t know.
Eric: I couldn’t agree more. I’ve looked at that lead-lag effect between fed funds rate and the two-year and it definitely seems like they just follow that thing around and gravitate towards it. If I had a nickel for every person I’ve known that blew themselves up trying to trade on fed days, I’d be richer.
Meb: Speaking of nickels, I wonder how Kyle Bass famously bought, was hoarding and storing a bunch of nickels back in the day, because the melt value is worth higher than the actual nickel. Do you remember this? And it’s a big problem with telling people this. Which is the same problem of telling…if you’re Jay Powell, telling people you would peg it to the two-year because then people would start to know that you’re pegging it to the two-year. But the nickel thing is illegal, the meltdown currency. So I think as soon as you tell people you have $20 million in nickels, what are you supposed to do with it anyway? What’s going on with copper right now? Been going sideways for a little bit, but it’s pretty darn near all-time highs, five bucks, I think. Isn’t that a copper resistance that’s never been breached, or am I way off base here?
Eric: I’m not sure. It’s not in our portfolio. It hasn’t done much, like you mentioned, over the recent history. And we’re trend following at heart, so it’s just not in the portfolio. But I’m going to take a look right now, see if there’s truth to what you’re saying.
Meb: It’s been kind of sideways for the past, I don’t know, six months, or a year even. But it had a huge run in 2020 and isn’t consolidating. But if you look back, all the way back to 2011 maybe, it hit this four and a half range.
Eric: You’re right. It’s not that far away from an all-time high, or at least going back to 2003, which would be an all-time high. So yeah, that’s kind of a stealth bull Market that not a lot of people are paying attention to. Another piece of evidence for potential inflation.
Meb: You’re a systematic guy. So I’m drinking tea right now, but a happy hour sort of conversation. What’s your kind of general view on inflation and what’s going on in the world right now? Heading down to Miami in a couple of weeks, and I was trying to book a hotel and half the hotels were $1,300. And I was like, “Oh my God, what is even happening?” You got any off-the-record insight into how you think about inflation and how it impacts portfolios keep you up at night, or is it something you don’t think about at all?
Eric: Yeah, it’s a complex topic. I have a lot of opinions about inflation. But I think before you get into those, you have to ask the person you’re talking to what’s their definition of inflation. You ask 10 different people, you’ll get 6, 7 different answers. So some people will say it’s CPI and other people will say no, it’s the prices that I pay for the goods that I consume. It’s not owner equivalent rent and whatnot.
So the truth is right now we don’t know if the deflationary pressures are going to come back, the demographic deflationary pressures, and then this ends up being transitory. Or if it’s sticky and the debts getting monetized and you have negative real yields, and this turns into something meaningful like the 1970s, we don’t know, I don’t know. Which is why we invest the way we do, disciplined and tactical. And if it turns into something sticky, that sticks around, we’re comfortable with that, we’ll roll with those punches. If it turns out to be transitory and we go back to deflation, we’re comfortable with that reality, too, going forward. But I can’t tell you which one we’re going to get. I don’t think anyone can.
Meb: The beauty of having the trend-following approach and being systematic is those two outcomes are pretty different. You harken back to the days, the ’70s and inflation, and most traditional portfolios just really sucked when. If you look at our old asset allocation book, unless you had some real asset exposure or were actively trading, almost every buy-and-hold portfolio was challenged. And then flipside is you have a deflationary Japan scenario on the other side, that’s hard too. And no one seemingly wants any fixed income treasuries where they are here, but you have that sort of world that’s a pretty interesting asset to have as well.
Eric: Let’s talk a little bit more about the 1970s and inflation. As my co-workers like to point out to me, because I’m so buried in the empirical data, and have a scientific process to investing, they always remind me to be open-minded about getting an environment like nothing we’ve ever seen before. That guy, Mike Green, over at Simplify comes up with these elaborate, well-thought-out scenarios about how we might be going into an environment where there is no historical precedent. So like you said, it could be inflation, it could be deflation, it could be something in between, or both at the same time in competing sectors. We truly are in very different times. I’ve been doing this for 25 years, I’ve never seen anything like the current environment.
Meb: What does that mean?
Eric: If you look at valuations and stocks, they’re definitely not low. You look at the real yields and bonds, they’re deeply negative. You look at the fragility in the system and the sentiment, there are some parallels. The other day when Netflix blew up, that felt like a lucid moment to me. Do you remember when Lucent blew up in 2000?
Meb: Actually, that was a stock that I used to own. And I remember being an intern at Lockheed Martin. And the way you’d check quotes back then, you just read the newspaper. They were in fractions. Pulled the business section. “Oh my God, Lucent’s up another $2 LU.” So I have a very fond tax loss carried for a long time from Lucent.
Eric: I worked for a big family office in Kansas. And I was next to all the traders that work there. And then the patriarch of the family, when the earnings news came across and they saw Lucent was down 50% in the aftermarket, and they owned an enormous amount of that stock, it was gut-wrenching to look at the psychological reaction to losing 50% in half a second. That was a learning moment for me to see all these people and their reactions. And in hindsight, that was the peak in 2000. I call it the Lucent moment. Then there was the Bear Stearns moment, I think it was 2007. These moments, and maybe Netflix was another moment or maybe not, you never know. You know after the fact when the dust settles. But right now we don’t know.
Meb: You did a tweet, I think it was last year actually. Let’s pull it up. You said something along the lines of, “This feels like one of these environments where you blink, look around and wonder, ‘Man, when did all these high-flying expensive stocks go down 80%?’” Look at a lot of the tech stocks and there’s an absolute carnage over the past year, seemingly peaking around Feb, March of almost a year ago, with the broad cap-weighted markets being at all-time highs, which is an interesting differentiation. You see a lot of people tweeting or talking about how much they’re struggling, and their portfolios are down so much. But at the same time, you see the market-cap-weighted stuff shrugging it all off and still chugging along. And that’s a reminder that indices are not necessarily what people own. And the Lucent example, I think is a great one.
Eric: That’s another observation of things that have happened in the past that are not particularly bullish. Were you trading in ’98?
Meb: Yeah. So I would have been in university. And I tell a lot of stories about this because my engineering professors would straight up be trading stocks in class. This is more ’99, 2000, you would see them checking quotes. And E-Trade was the Robin Hood of the day back then. And so I remember getting some of these IPO allocations and a lot of very seared-in-my-memory experiences from that period, good and bad.
Eric: I had a finance professor, she’s probably the best finance professor at my university, constantly buying puts on Amazon in ’98, and just losing gobs of money and just couldn’t figure out why these valuations make no sense. But my point though is that the average U.S. stock peaked in ’98, didn’t peak in 2000, small-caps, mid-caps, the breath in the market. The market-cap-weighted index has carried the market to a new high, I think, in what was that? March of 2000. But the average stock peaked approximately a year and a half, two years before.
Same thing happened in 2008. I was running a long-short program and a futures program in 2008. And I remember looking at the breath in the spring of 2008, when the long-short program was really starting to deleverage and get out of the stock market. But the stock market was at a new all-time high, but the average stock had been deteriorating for three quarters. And then by the time Lehman blew up, most stocks were down meaningfully off their highs. It didn’t look anything like the market-cap-weighted indexes.
So here we are, again, today kind of the same phenomenon. You just brought it up that a lot of these high-flying tech stocks have been struggling for over a year now. Yet, the market-cap-weighted indexes really aren’t much off their all-time high. So these parallels are interesting to me. I don’t make investment decisions off of them. Like you said, we have a systematic rules-based process. But still, these things jump out at you infrequently, you know, once a decade, once every 15 years, it’s hard to ignore them.
Meb: You see these spreads in the performance, sometimes you’ll see the market cap, so S&P 500 versus, say, small-caps or micro-caps, or value versus growth, or U.S. versus foreign. People love to talk as if there’s just one market everywhere, TV and Twitter, that are seeing the market. And usually, that’s referring to S&P 500. That’s the default. But at the same time, it’s like talking about PE ratios. I got into getting ratio’d on Twitter the other day, because I did a tweet about PE ratios and I said the 10-year PE ratio. And all the responses were talking about some other PE ratio. There’s like 10 different PE ratios. You have to have the common language or else you may not be talking about the same thing. And it goes back to your original comments on inflation, too, you can have inflation and say higher education, but deflation and TVs or whatever. It’s not one uniform market as people talk about. Unless they’re just talking about the S&P.
Eric: Right, which they usually are. Okay, so I went off on a tangent there. But your question was about a statement that I evidently made that the market owes you nothing. So I don’t recall making that statement publicly. But I say it all the time, even when no one else is in the room. So I guess we should cover it.
Meb: Well, because people expect… I’m not sure, what do you mean they owe you nothing? People expect 10% returns on stocks, pension funds, expect 7%, 8% returns on their pensions, and that’s both public and private, corporate as well. The pensioners expect their pension to be there. What do you mean? What are you telling me that the market owes me nothing? It owes me 10%, 8% returns.
Eric: So this concept’s important to me because I think that it’s important to understand the ecosystem in which you’re participating, why it actually exists. There’s valuable knowledge and potentially wisdom in understanding what this whole thing is set up for, you know, why it exists in the first place. When I look at the stock market, what I see is a capital formation market. It’s a place where people can go and sell equity and raise capital in order to go out do a business with the kind of risk structure that they want, limited liability or they can do preferred, or convertibles, or whatever.
It’s nothing more than that. It’s not a utility that was designed to give you 8% a year. It doesn’t have to go up. It can go down 50%, as we’ve seen. It can go down 90%, as we saw in the Great Depression. It doesn’t need to be consistent and it hasn’t been. There’s been decades where it’s been 25% a year and there have been other decades where it’s zero. So all the empirical data comes back and says that if you want a consistent, smooth return, the stock market is not the place to get that. And there probably isn’t a place to get a smooth, high consistent return. I’ve not seen one.
Meb: What do you mean? It’s all these private real estate interval mutual funds that, you know, they check your balance once a year and they report 4% vol. And same with private equities. Private equity is the savior for everyone, Eric. The pension funds all have been taking their cash balance down and putting it in private equity because you only check once a year. There are no drawdowns there.
Eric: None that you can see until they happen and then there’s nothing you can do about it. But yeah, that’s just the Titanic iceberg risk. The risk is there, you’re just not seeing it. The fact that you’re not checking the temperature of the risk doesn’t mean it’s not there. And yeah, the industry is plagued with products and programs that are designed to obscure the risk you’re taking so that you are less afraid. And that actually works to some people’s benefit, because they won’t sell prematurely. But the risk is there. Risk cannot be created or destroyed, just transformed. So the fact that you’re not seeing it does not mean it’s not there.
So the markets owe you nothing. So there are two kinds of markets in the world that I concern myself with, capital formation markets, that’s stocks and bonds. That’s where you go to essentially sell a piece of your business to someone else or borrow money at some sort of a structured or at an interest rate with on covenants and whatnot. And they don’t owe you anything. And if you get 8% a year from that, that’s great but you’re not guaranteed that. And they’re not set up for you, they’re set up for the person that wants to sell equity, and someone else that wants to buy equity. And their job is to clear the market, to bring those buyers and sellers together at a price where they can both agree. And that might be 30% higher, it might be 50% lower, it might be yesterday’s close. It is what it is. It’s supply and demand. And that’s all these markets were designed to do.
We become accustomed to everyone just putting their money in there like it’s a bank and earning a return. And that’s okay. It’s okay to invest like that. But just realize that these markets weren’t designed for you. Therefore, there’s going to be times where they do stuff that doesn’t make you happy. And that’s not something to sue someone over or get angry or be confused about. They’re just not designed to be utilities for you. It’s not like your stove, when you turn it on the natural gas is supposed to flow.
Now, the other kind of market is what I call a risk transfer market. Those are the futures, forwards, swaps. They’re designed also to bring buyers and sellers together, but not for capital formation purposes, for risk transfer purposes. It’s a place where hedgers can go and eliminate or lay off certain risks that they don’t want to take that may be redundant with what’s on their balance sheet and their income statement and then their core business. So those are the two primary kind of markets that I concern myself with. And neither one is designed to conveniently and safely deliver you the return that you want over time. If you want that, you have to build a strategy and participate in these markets in a way that’s accretive to those markets. Especially in the risk transfer markets, if you want to earn a return, you need to participate in a way that’s beneficial to the marketplace as a whole.
And I bring this up because it may not be important to other people, but it’s very important to me to understand the ecosystem and what the rules are. And how you can create a situation where any returns that you get are actually justified.
Meb: A conversation I was having with an adviser yesterday. And by the time this drops, it will have been published on the podcast. Whitney Baker, she has a nice chart of household net worth and household income, both relative to GDP. And it’s at the highest level it’s ever been for both. But the second-highest was the ’20s. And the reason talking about it is that anytime you have money, it sort of resets your expectations. So as anyone knows, with this hedonic adaptation of a new salary, where if you get inheritance, whatever happens in your life where you come into some money, athletes are a great example, you have this honeymoon period, maybe it’s three months, maybe it’s six months, where you’re probably a lot happier. And then you kind of adjust and you start, most people, spending money on bigger houses, and nicer cars, and fancy vacations, and better dinners, on and on and then you kind of readjust back to normal happiness.
But he was talking, he says, “You know, I’ve been in this business a long time. And one of the problems of bull markets last a while is the expectations ratchet up.” And we see these with the surveys all the time where they expect stocks return more and more and more as the market goes up and up and up. So some of the crazy ones last year were north of 15% on stocks and portfolio. But they say it also creates some interesting behavioral challenges. So he says you see a wave of retirees, or people all of a sudden see their investment portfolios get to a certain point, because they’re always heavy in equities, particularly in the U.S.
And then the US has had this run and then they get to a point where they’re, “Oh, I can retire now, I’m fat and happy.” They retire and then they have one of the normal bear markets, which happens all the time, it goes down 20%, or 40%, or 50%. And it creates a huge behavioral problem because they get to the point of the whole, “I can’t take it anymore. I’ve retired. I can’t lose this all,” on and on and on. And so the sequence, which you and I used to talk about 10 years ago, I think, of returns comes a big behavioral challenge, particularly at turning points in the big bull markets.
Eric: Yeah. I mean, it’s the bane of every financial adviser’s existence, right? It’s the constantly repeating whipsaw of client emotions, and expectations being a function of the recent performance. A nonlinear function, too, meaning the longer it goes, the more entitled people… This applies to all of us. Our brains are all basically hardwired the same way. If something’s been working for seven years, you don’t want to bet against that. It’s irresponsible.
You and I have talked for over a decade about ways to deal with this. I think the big mistake that a lot of practitioners make… And this is just my opinion, I’m not an expert on the subject matter. But it does seem apparent to me that the big mistake is they try to change the investor’s behavior and the investor’s psychology. And that’s a one-to-many relationship.
Let’s say you have an adviser and she has 600 clients. So that’s 600 really tough conversations where you’re swimming upstream and going against the grain. And everyone talks about it, everyone’s bright-eyed and bushy-tailed when they get their CFP, or they get some other designation and they go out and they’re going to change the world. And then check back with them 10, 15 years later, and they’re just worn out and having the same conversations with clients over and over and over. Then they start using the word education a lot. “I need to educate my clients,” this type of thing. I’ve been hearing that from people for as long as I’ve been paying attention, and they take that phrase all the way to their grave, and pretty much don’t make a dent. It’s just, look, we’re hardwired that way. That’s our software. It’s entrenched. It is what it is.
I think that a better approach, though, is to actually build products that have the cyclicality diversified out. And then just trying to do business with people that are enthusiastic about having realistic expectations. Because they’re out there. That’s actually the majority of people. They get carried away at times, sure. But it’s not that hard to talk someone down off the ledge if you have a credible alternative to the roller coaster, something they can actually believe in. So if you can diversify away the cyclicality, in my experience, it’s not that hard to talk sense to most people.
Meb: It seems like the nightmare scenario that we talk a lot about as a potential that I think everyone assumes can’t happen. And we’ve been talking about this for over a decade. But the thing that would really, I think, inflict the most pain is a scenario where both U.S. stocks and U.S. bonds do poorly. And a lot of people just assume that U.S. stocks and bonds are always negatively correlated. And so in the bad times for stocks, bonds will do okay and vice versa. Is that a dangerous assumption? 60/40 has crushed just about everything, including a lot of the biggest, smartest institutions in the world the past decade. What sort of problems does that cause? And then let’s start to move toward what can we do about it?
Eric: I think the assumption that bonds will always bail you out when stocks go down is the most dangerous assumption in the asset management industry. And that’s why I think the 1970s are such an important decade to familiarize yourself with and wrap your head around. A lot of my peers say that was an aberration anomaly and not something to be taken seriously. I think they’re wrong. I think it’s a very valid data point. I think stagflation is a very real risk, and that it’s terribly irresponsible to not have a plan for dealing with it. Because I think it’s actually a very likely scenario. I’m not saying 90% or anything like that. I’m just saying that I look at the algebra of the central bank balance sheets, the demographics, the valuations, the bond yields, the real yields, I look at the algebra of all this and say, “Like water, it’s going to go to its lowest common denominator. It’s going to sink and it’s going to find balance somehow.” The path of least resistance is stagflation. It’s a decade of stagflation. Again, I can’t guarantee that’ll happen.
Meb: Explain to the listeners what stagflation is, if they don’t know.
Eric: Depending upon who you ask, you’ll get different answers. But to me, stagflation is something along the lines in the 1970s where the stock market does not generate a positive return and it has severe downside volatility, a couple of 40%, 50% drawdowns. And basically, you’re right where you started, say, 12, 14 years ago. So I think in ’82, you were right where you started in 1968. That’s a long time to make no money in stocks, and to have a couple of 40% and 50% drawdowns along the way. But at the same time, bonds don’t work for you either. And in fact, the bonds go down the same time the stocks go down. That’s what we saw in the 1970s.
And you can feel those same correlations creeping up in today’s environment. We see days, even today, I think stocks and bonds were down at the same time. Meb, sometimes bonds are the problem, not the solution. It’s infrequent. It’s kind of like that iceberg risk we talked about earlier where it is infrequent, but it is terrible when it happens. And I’m not predicting it will happen, but I’m not going to be the least bit surprised if we get a meaningful bout of stagflation. And it could drag on for a long time. And I just don’t see any reason to be proud of not having any preparation or any thought that goes into dealing with stagflation, considering that it’s such a horrible experience. And it would be the worst possible experience for baby boomers and people that are going into retirement right now. The last thing that they need is drawdowns and no diversification right now. And my fear is that not very many people are prepared for that, and it’s very possible.
Meb: I remember maybe a year ago when bonds were plumbing the lows on yield and you’re pulling your hair out and showing me some simulations. You’re like, “Meb, there’s just basically no way possible bonds can have a positive return over the next five years, even if they go hard into negative yields.” We kind of went through all these simulations and it was a fun chat. Similar analogue, I think, is during the pandemic, if I recall, a lot of the foreign sovereign yields in a lot of these countries were already zero and negative. And when the coronavirus panic happened and it hit the fan in a lot of these countries, their sovereigns didn’t really help. If I recall, they didn’t provide much cushion to the equity markets getting pummeled in those countries. They did in the U.S., but the U.S. was a relatively higher-yielding bond market at the time. So this assumption that treasuries will always hedge a market puke, I think, is problematic if you’re relying on it to outperform.
Eric: Yeah, and I would echo those thoughts. I remember looking at some of the German, UK debt markets and seeing that they didn’t bounce much at all, when the stock market was just ripping off huge losses. And in the U.S. they bounced a little bit, but not like what people were expecting. I know. I was long treasuries during COVID. And that’s not what saved us during COVID. Not at all. It was being short energy, and longs on flight to quality currencies. We made a little bit of money being long treasuries, but not the kind of money you expect to during a risk-off event like COVID.
So this has been happening for a while now. Here’s my point, if we get a really bad outcome going forward, let’s say we get five years of really bad results, no one’s going to be surprised. They’re going to look back, and it’ll be very easy to say, “Well, the correlations between stocks and bonds had been steadily rising. Bonds hadn’t been paying off on down days for years. What was everyone so confused about?” That’ll be with hindsight, but that’s the conversation people will be having if we do get serious risk-off market environment.
Meb: Before we start talking about solutions, I love being devil’s advocate. And people always ask me, they say, “Okay, Meb, how do stocks do 10% for the next 10 years, if you could wave a wand? How does this possibly happen?” What needs to happen for 60/40 to be okay, or this be a decade in the 2020s where things work out and it’s not meager returns, but we do hit 8% a year, or I’d say 5% real on stocks and bonds, 60/40 for the next decade? Can you envision a world where that happens?
Eric: Yeah, we’ve been in that world, actually, for quite a few years now. I don’t think it’s realistically possible to get a positive real return from government bonds going forward. I’ll extend that to corporate bonds as well, those are a little harder to model. That simulation that you referenced, I did that video I think it was in August of 2020, maybe September, where I just shared the results of a Monte Carlo simulation that took the mathematics of bonds and basically extrapolated the amount of 3,000 different future scenarios, and showed that I think out of 3,000 possible scenarios, only 1 had a positive real rate of return.
Meb: That’s the whole plot of “Avengers End Game” when Dr. Strange is like, “I did a million scenarios and there’s one that worked.” And look what happened with the Avengers, it worked out for them. One could be the possible path. Let’s hear what happens in that path.
Eric: Well, the weight of the evidence strongly suggests that a reasonable person who’s informed about bond math shouldn’t expect a positive real return. They could get it, but it’s pretty unreasonable to expect it going forward, at least over the short and intermediate-term. One way it could happen is if you get negative yields. You can make money from capital gains and bonds if yields go negative. And I’m not ruling that out, it is possible. You do have the demographic fuel for negative yields. But they literally have to go to negative six on the 10-year for you to get the normal, I think, 7% return a year from 10-year bonds that people have been accustomed to over the last 40 years.
So if the 10-year goes to negative six, people are going to be eating each other in the streets. Like, that’s going to be a real bad environment. So I don’t think it’s a good bet. I think it’s a bad business decision to expect that. But still bonds have been holding up. I mean, they haven’t been doing well for the last year and a half. But over the long-term, they have held up really well and no one does the analysis. And we don’t have a problem until we feel the pain. That’s kind of the mentality. But you ask the question, how does the 60/40 portfolio make 5% real over the next 10 years? Well, I think based on what I just said, most of that’s got to come from the stocks. I don’t think you’re going to get any real from bonds. Possible, just very, very unlikely. So if 60% of your money’s in stocks and you need 5%, you just do a little bit of algebra and you need a certain return from stocks over the next 10 years. And is that possible? Yeah, it’s a lot more possible than bonds getting out a real positive return. Is it likely? No, it’s not likely.
Meb: I had a tweet about this, but Oracle had put out an expectation for the disruption companies they invest in to go from a market cap currently, I think, of a 10 trillion to 200 trillion at the end of this decade. And I scratched my head and the current market cap of global equities is 100 trillion. So their expectations was that this group of innovation across the five or six sectors they look at would compound the market cap by 37% a year and the rest of the companies outside of that is minus 8% or something. And it’s one of these things you look at and you say, “Look, is it a possible scenario?” It is. Is that the probable outcome? It’s hard to see, at least in my mind, that sort of outcome happening. But you got to think about these things. Because as a student of history, we’ve certainly seen weird things happen plenty of times and trend following, from one trend follower to another, at least lets you ride along with these possible crazy outlier scenarios, both up and down, good and bad, right?
Eric: Yeah, totally. I was going to talk about that. I may sound like an overly pragmatic person that’s stuck in the textbooks and the fundamentals, I’m not. The disciplined trend-following approach just drags us along into whatever is working, no matter how crazy it seems. And you apply some risk management to it, and a guy like me can sleep at night. So I’ll give you an example. One of our biggest winning positions over the past of couple years have been carbon emission credits. Now, while everyone’s talking about Ethereum and Bitcoin, and all these other things, carbon emission credits are the best performing market in the world, from what I’ve seen, over the last two, three, and I think four years and no one’s even talking about them. It’s a huge market, deeply liquid, a lot of open interest in volume. It’s an interesting story. And it’s the best performing market that I’ve seen, and no one’s talking about it. And it’s correlated with nothing.
We were buying this thing a year ago, I think it was around five. Now it’s it at 88. I mean, that’s a big move for a deeply-liquid futures market. And we won’t go into the details about what it is, but briefly, the EU has capped the amount of carbon emissions that are allowed, and then they issue credits to people. And if you want to admit more, you got to buy credits from someone else. If you become efficient, and you can cut your emissions, then you sell your credits to someone else. It creates a supply and demand. It’s going to reward people that are cleaner and penalize people and they have to pay more if they just can’t get their stuff together and reduce their emissions. No politics involved, it’s just risk transfer market that I’m trading.
Meb: The philosophy of trend following that I’ve always been drawn to is so many investors are intentionally or not, leverage to certain market outcomes. So they’re either tied to inflation, or deflation, or U.S. assets performing well, or value stocks. The beauty of the trend is it will often lead you to places that you may not go otherwise and have exposures as these markets get out of whack. So if U.S. stocks keep going up market-cap-weighted, you’ll be invested despite our feelings of nervousness about that possibility. And ditto with all these other markets and what’s happening. Talk to us a little bit about okay, so you’re a trend follower, you do it a little different now, you got a couple of mutual funds, some of my favorite tickers, BLEND-X and RIMIX. Tell us a little bit about how you guys put together your strategies, because it’s not pure-managed futures in the traditional sense of what most people would think. How’s it all fit together and why?
Eric: We consider ourselves to be rules-based macro, and totally global in nature. So we track the 75 most liquid futures markets around the world. And then we use cash equities, particularly ETFs, for our equity exposure, both domestically and internationally. So we care about taxes. And we structure our products, we think, in an intelligent manner to minimize the tax bill and to minimize the fees and the acquired fund fees that you pay and whatnot.
So from a trend perspective, after I left my last firm, I had to take about a year and a half off. And that was great, because when you have a non-compete, you need to move away from the industry and just take time off. I don’t know that I ever would have had the ability to stop participating in the markets for a year and a half. And that’s valuable. In fact, I would recommend that people do this. It’s like fasting or something like that where you just have a different perspective on life when the pressures, and the stress, and the expectations, and the routine deadlines that you have when you’re actually running money. When you don’t have that your brain works differently. Creativity is different.
So I decided to go back to the drawing board and retest every assumption. Every nugget of wisdom that I thought I had, I wanted to retest it. And when you take a year and a half off, you have time to do that. I also went back to school and for the second time, studied some of these concepts like artificial intelligence, and machine learning, and all that other stuff. So I learned a couple of things that were inconsistent with some of the prior beliefs that I held. So it was actually quite a humbling experience.
The first one is that I was highly biased towards what I call the small-cap premium. And I still am, it’s just part of my software and hardwiring. I naturally assume that if it’s hard to do, there must be more risk premia there, more upside reward. If it’s small and limited, it must be valuable. If it’s scarce, it must be valuable. And I think that’s just human nature to feel that way. So I wanted to trade obscure markets like Malaysian palm oil and Japanese platinum in these tiny markets. And I wanted to trade synthetic markets and go where a seemingly wasn’t crowded. I thought that was a source of alpha and return. And there are many people out there that will argue forcefully that it is. It’s a prominent thing in their programs.
But when I objectively looked at this and said, “All right, I’ll play devil’s advocate and take the other side,” what I found is if you just concentrate in the most liquid markets, you still diversify, you’ve got energies, you’ve got grains, you’ve got livestock, you’ve got bonds, you’ve got currencies, you’re still diversified, but you’re just going to focus on the most liquid markets in each sector, there is literally no deterioration whatsoever. And I run my simulations back to 1970. So I want to cover most plausible market environments, I think it’s important to include the ’70s. And it’s because you have much lower slippage, market impact, transaction costs, and your scale is 10, 20 times greater. I just had to admit that I was wrong. There’s just not that much alpha associated with going into these obscure markets, even though they’re uncorrelated with the core markets.
So I thought about, well, why would that be true? And it got me back to my thesis about the risk transfer markets being a negative-sum game, and the source of the returns that trend followers collect it comes from the hedgers. It can’t come from anyone else. They’re the only ones that have the deep pockets that are both willing and able to lose money in the futures markets. It’s got to come from somewhere, and that’s it. And they’re not participating in a meaningful way in these tiny markets.
And the other thing I did is I looked at who the really big boys, the people that have been doing this for decades successfully, they’re all managing $10 billion to $40 billion. So they can’t be trading in these tiny markets, not in any kind of size that’s meaningful. So that was a liberating experience for me, because I thought, “Well, I’m an empirical guy. Yeah, I’ve got my biases, but I’m not a slave to them. So I’m going to build something that is durable, reliable, and scalable this time around.” And that’s what I did. So it’s pretty simple. Like I mentioned earlier, I studied AI, machine learning, neural networks, genetic algorithms, all that stuff. And I found that there’s just no need for them in this space for what I want to accomplish.
I am not crapping on what other people are doing. But at the end of the day, the risk premia I’m looking for, you can’t manufacture it. It’s not alchemy. If it doesn’t exist, you can’t collect it. You can’t go out and create it. And the risk premia that I’m looking for from the hedgers is thick, it’s available, and it’s not complicated to extract from the markets. I’m not saying it’s easy, but it is simple. Psychologically, it’s not easy at all. Nobody likes trend following in practice because you’re buying things that are up and you’re selling things that are down, and you’re laying out risk after a drawdown. Psychologically, it’s not fun. But boy, is it effective, especially when you pair it up with risk assets like global equities or corporate bonds.
Meb: The decision to pair traditional equities with managed futures, remind us…we talked about this last time, but give us a quick overview of what the decision was there, and then a quick review of how you do the manage future side, the trend-following side of the portfolio in general, long, short markets traded.
Eric: Why did we not just build a good global trend program, or managed futures, or global macro, whatever you want to call it? Part of that was just business where the managed futures industry shoots itself in the foot because it’s so uncorrelated to equities. People can see the math. When you bring in a good, even decent trend-following program into a portfolio, it adds a lot of value. The same way bonds add a lot of value. Because it tends to be uncorrelated, especially in hostile market conditions. And a lot of the time, historically, makes money when everything else in the portfolio is going down. So it adds a lot of value.
But that doesn’t translate into happiness because there are times when the stock market’s soaring and your alternative investments, whether they’re managed futures or global macro are going sideways, you’re losing money. And it just drives a wedge in between the adviser and the client. And it requires all these conversations. And it’s just crappy business to be in. And you end up not helping people because they buy you when they’re scared, and you’ve been going up, and then they sell you when you’ve gone sideways for a couple of quarters and the stock market’s going up. And they end up being worse off for the allocation. It’s the way it’s always been with human nature.
So my team and I, we sat down and said, all right, is there a responsible creative way that we can solve this problem? And think back to our conversation from 20 minutes ago where I said, you can just keep yelling at people, and having all this education, and keep going and going and going, but it just doesn’t really make a dent. Even if you can bully people into being educated in dollar-cost averaging and rewarding diversification, it’s not in their nature to be happy about that. It’s in their nature to be envious of relative performance. They just want all their money in the best-performing asset class.
So is there a better way? And what we found is that yeah, there’s a better way. You handle the diversification internally. Do it inside of your own fund so that they don’t have to deal with a line item risk and see these things moving in different directions. So in other words, you build the optimal portfolio and offer that as a fund. Make sure there’s enough managed futures or trend in there to make a big difference. But don’t force them to deal with what we call the statement risk or line item risk. And then everyone can be happy.
But what really sold me mad was one of my co-workers said to me one day, and he said, “Eric, what do you do with your own money?” He already knew but he was asking me. And I looked and said, “Well, I run a blend of our managed futures program and global equity beta.” And he said, “Why do you do that?” I said, “Well, because that’s the optimal portfolio.” And he said, “What’s your definition of optimal?” And I said, “I want to put myself in a position to compound at a reasonable rate with the least amount of iceberg risk through any kind of market environment that we get in the future, any plausible market environments.”
And he said, “And what about taxes?” And I said, “I like it because it’s reasonably tax-efficient.” “Fees?” And I said, “Yeah, it’s pretty fee-efficient, too.” And he said, “So why are you not building a business around that? Don’t you think that other people would appreciate something like that?” And then it hit me that I’m an idiot and I just need to stop, put my ego in a closet and say, “I don’t need to create the best-managed futures fund in the world, or macro, or whatever. I just need to offer something I believe in and find out if there’s a fit in the marketplace.” And so far, I think the marketplace has said, “Yeah, this makes sense to us.”
Meb: An interesting setup could potentially be, and you could walk us through how much this would happen, global equities going to a downtrend. Presumably, the trend side could short equities. Is that true? And then how much of the equity exposure would that take down? Would it take down half of it, all of it?
Eric: It’s a great question. And that is what keeps trend followers up at night when you convince them to put some dedicated long exposure in their portfolios. Because they all think the next Great Depression is right around the corner, or a crash of ’87, or a 35-year bear market like the Nikkei. So here’s how I sleep at night. I look at the dedicated equity exposure, which is generally about half our money. Half our money goes into low fee, low tax global equities. That’s allowed to oscillate. So it can go as high as two-thirds or can go as low as one-third. If it gets down to one-third, we don’t rebalance back to half. Because that’s kind of an extreme thing to do. Because you know how dangerous it is to rebalance on the wrong day.
In 2008, I know a lot of people that were rebalancing right before Lehman. They just bought a bunch of stocks because the market was down and then they just got buried. And then it happened to them again the next February where they bought a bunch of stocks and got buried. So there are responsible ways to rebalance. You can tranche it up and do one-twelfth every month, or one-fifty second every week, or whatever, there are responsible ways. But anytime that you’re rebalancing, you’re creating a counter-trend effect. And that’s okay, if that’s the risk you want to run. And there’s a reason that it’s worked historically.
Well, we found a way to essentially regulate the amount of long-only exposure in the portfolio without binomial, large transaction rebalancing. And that is just to enforce those guardrails. If it goes below a third, we will buy to keep it at a third and not let it go any lower than that. Likewise, if there’s a huge bull market and our equity exposure goes all the way up to two-thirds, we will sell, tiny sell transactions to keep it from going any higher. But if it’s going to go from one-third to two-thirds, or two-thirds to one-third, it’s got to do it on its own.
And the reason I like this approach…because I simulated every kind of rebalancing strategy I could come up, with calendar-based, standard deviation based, the whole bunch of different strategies. And you probably already know this, but they all basically get you to the same destination. The only difference is the path travelled and the turnover. The approach that we use in the fund right now is 90% less turnover than the median rebalancing approach, but basically gets you to the same destination. So not paying taxes, not churning the portfolio, transaction costs, those are all real costs.
So you asked the question, though, what would happen if we went into a vicious bear market and you are holding it steady at one-third of the portfolio? You’re right, on the trend side, the same indexes that underlie the ETFs that we’re holding are in the futures program. It’s the exact same indexes. And in a runaway bear market, you’re almost certainly going to have meaningful short positions on those same indexes. And that’s going to go a long way towards offsetting that dedicated long-equity exposure in a way that doesn’t require you to sell your equities and generate capital gains or losses.
So is it one-to-one? No, but it’s pretty close to that. It’s enough to offset it meaningfully. And same on upside, too. You could be doubling up on your equity exposure. That happened for us over the last couple of years. Doesn’t mean that you’re using leverage or going more than, say, 70% or 80% net long, but you can be stacking on top of the exposure that you already have. And that’s the beauty of a trend-following program is that it’s completely indifferent to fundamentals, sentiment, it’s just going to get in line with whatever the current trend is and calibrate your risk to the volatility of that market. Wash, rinse, repeat.
Meb: That’s a great way to think about it. I like to think about it’s like a tactical or dynamic neutralizer or market-neutral approach that you want the equities, but it can take it down to a near probably zero beta. But if you think about the ’70s, and you think about all these potential outcomes, one of the things that a lot of portfolios have zero allocated to, and I’m not going to say emerging markets, listeners, because I know you guys don’t have any of that anyway. But mainly, it’s a relative of the real asset trade, which a lot of asset classes can rhyme.
So whether it’s dollar down, or emerging markets up, commodities, REITs, tips, they may not correlate all the time, and they may correlate at different points. But we consistently do polls, and we ask people if they have anything allocated to real assets, and it’s almost always negligible. With the exception of my Canadian and Australian followers, probably, they got a chunk in gold or miners. But is that a potential savior? If we go through the ’70s as a commodities and things like that,
