Alternative Strategies Fund 10-Year Anniversary Q&A
To commemorate the anniversary, co-Portfolio Managers Jeremy DeGroot and Jason Steuerwalt have penned a Q&A retrospective on the fund and the category at large. MORE
Interviewee: Andrew Beer, DBi
Interviewer: Jason Steuerwalt
Date: April 4, 2023
Mike: Hi, everyone! Thanks for joining us today for our client-update webinar on the IMGP Alternative Strategies Fund. I’m Mike Pacitto with IM Global Partner.
This is the first of two client webinars we’re doing this month. This one, today, features Andrew Beer of DBI. Andrew is the cofounder of DBI. He’s also the co-portfolio manager of the DBI Enhanced Trend Strategy, within MASFX.
As some history, we did add this sleeve in 2022, to add diversification and lower correlation of the fund to traditional stocks and bonds. We were happy with the fund’s low beta and low volatility. We wanted to bring those correlations down, while still maintaining the opportunistic absolute-return profile of the fund.
Andrew’s going to be discussing his strategy, and markets, broadly, with Jason Steurwalt. Jason is the head of alternative strategies, and he’s also the co-portfolio manager of the fund.
I mentioned earlier just now, and also in the email that we sent out to clients, that we’re going to be doing another client webinar, later in April. That one is going to be on April 19th. On that one, we’re going to be talking specifically about fixed-income.
Many investors in MASFX use this strategy as a core-alternatives fund. But many others use it as a bond-diversifier. On that webinar, that is going to feature both DoubleLine and Loomis Sayles in one single call. We’ll make sure that all clients get an invite to that, soon. That should be a really good call, with both of those strategies.
In terms of the agenda for today, here it is. I’m going to touch on performance. Then I’m going to hand it over to Jason. He’s going to talk about positioning and opportunities within the various strategy sleeves of the fund. Then we’re going to have the interview with Jason and Andrew. Then we’ll take your questions. In terms of questions, just enter them into the q-and-a on the Zoom, and then we’ll take those, as they come.
On to performance.
This is going to be relatively short, but I’ll do kind of a broad overview of performance, here. On the next webinar we do, we’ll be able to include Q1 2023 performance. Q1, the fund is up around 1%. You can look some of that stuff up; it’s public. But we’ll get into more details of the drivers of performance in that April 19th call.
For this call, I wanted to just kind of give you an idea of where we are on a year-by-year basis. Because of compliance and issues around the quarterly calendar, these are the kinds of charts that I can show you, at this point. They’re going to be through 2022.
Now, as we mentioned in our email invitation to everyone, the fund had its worst year in 2022. It was down around 9.75%. That was nowhere near as bad as the draw-down of around double-that for equities, as measured by the S&P. It was also ahead of bonds, as measured by the Barclays Agg – by around 3.5%. Net-net, despite beating those two broad benchmarks, we still weren’t happy about 2022 performance.
There is some good news, here. We think it’s twofold.
The first is that the fund continues to outperform bonds – the category and the hedge fund index – as you can see on this chart. Secondly – I think this is the most important part, in terms of people who are in the fund – as you’re going to hear from Jason, we think that the fund is really positioned nicely, going forward. Across all the portfolios.
In fact, we think it’s as good as it’s been since the fund was first incepted in 2011. We’ll get into that in a little bit.
Just quickly, in terms of clients that are using the fund to immunize their fixed-income allocations – we’ll see that the fund has done its job really well, here. Downside-capture, less-than a quarter of the downside of bonds, since inception. Simultaneously, getting most of the upside of sustained bull-markets.
Lastly, here – just talking about now, and going forward. On this slide, it’s just like in 2011, when we launched this fund. You’ll see that we’re overweighting one particular sleeve of the portfolio, based on the very compelling opportunity that we see, there. That opportunity is in DoubleLine.
We’re overweighting DoubleLine’s Opportunistic Income by 7%. 20% is the strategic allocation. 27% is the tactical-allocation. We’re going to stay overweight there, as long as we see this to be a compelling opportunity. Just like we did in 2011.
On that note, I’m going to hand it over to Jason. You can talk about not only how compelling that opportunistic income sleeve is, but also how the rest of the portfolio is positioned, across the strategies. Then we’ll get into the conversation with Andrew. Jason? You’re up.
Jason: Thanks, Mike.
As Mike mentioned, we added 7 percentage points to DoubleLine. That’s now 27% — the largest allocation in the fund. If we advance to the next slide, Mike, you can see from the stats on this page how attractive the DoubleLine portfolio is. Hopefully, you’d agree, and you’ll see why we made the decision to tactically overweight it, relative to its strategic-allocation of 20%.
We wrote about this move. You can read about it on the fund’s website. In short, we’re really trying to take advantage of the opportunities created by the upheaval in fixed-income markets last year.
Pretty much all investors experienced that pain in some form, to varying degrees – depending upon which parts of the market you were in. It was definitely difficult; there’s no getting around that. But the silver-lining in the dislocation of that magnitude, of course, is that it creates really tremendous opportunities.
DoubleLine’s yield-to-maturity, when we decided to make this move, was over 11%. As you can see from the stats here at the end of February, it was still over 10%, with a duration of about 5. At the end of last week, it put the yield in various [inaudible] slightly higher, but still fairly close to the numbers we show here.
We think there’s still a lot of value to harvest from this portfolio.
As a point of reference, the last time we saw yields in this ballpark from the DoubleLine portfolio, which was over 10 years ago – the returns over the next year were in the neighborhood of 20%.
We obviously aren’t making predictions or saying that’s what’s going to happen again. But we do think it’s illustrative of the type of strong performance that can happen when you have fixed-income portfolios priced like this – which is quite rare.
This should go without saying, but the portfolio obviously has more credit-risk than the Agg. It’s not the core fixed-income portfolio. It has a little bit less interest rate risk. Not core bonds.
We do think we’re getting more than appropriately-compensated for that, however. As Mike mentioned, you can tune in to the second webinar of the quarter – April 19th – to hear the PMs from Loomis and DoubleLine talk about opportunities in fixed-income markets in more detail.
Just to get back to the decision, quickly –
When we looked at the potential impact of making the change, we ran some numbers – to estimate what we thought various managers’ performance would look like in different scenarios. There was a lot of subjectivity in the assumptions, of course. We know we’ll never be exactly right, when we’re making point estimates. But we wanted to at least have a rough idea of the sensitivity around our base case.
As a result of the changes, our 12-month base-case return-estimate of the fund increased by over 70-bps – while our downside return-estimate decreased by only about 20-bps. Importantly, it was still positive. We had a really hard time getting to a negative 12-month return, from the starting points we were looking at. Not to say it can’t happen; of course, it could. Just trying to give people an idea of what our prospective-returns in the modeling were.
The upside return-estimate increased by almost 1.5 percent. Importantly, even when we adjusted the assumptions significantly, the positive asymmetry was still consistent. That’s what we want to see when we think about making tactical changes.
Getting to results –
One quarter is hardly enough time to judge. So far, the change has added value — in the neighborhood of 30-bps to 40-bps. In Q1, 5 to 6 managers were positive – led by FPA, up about 4.5%. DoubleLine was next, at almost 4%. DCI, Loomis Sayles and Water Island were also contributors – between about 60-bps and 2%-and-change. Those are all approximate gross-of-fees returns, I should note. DBI was the only detractor, as it was a really challenging quarter for managed futures, which comprises the majority of the strategy that they manage for the fund.
I should also note here that, based on our modeling of the DBI strategy and the fund’s returns, if we’d added the strategy at the beginning of last year, it would’ve improved the fund’s returns very substantially. I’m sure compliance will want me to talk about specific numbers, but very substantially, you can look at the returns of managed futures last year, and get a rough idea, yourself – without too much trouble.
Unfortunately, DBI wasn’t on the fund since last January. By the time they actually went live, in September, it was closer to the top of performance for the strategy. Not that we were trying to time it, in the sense of making a tactical move – based on what we thought returns would be – but it really was unfortunate timing.
Regardless of that, we considered DBI a really attractive addition to the fund. We expect it to make the fund more robust, across different market environments. That, obviously, includes dramatic market dislocations, like the one we looked through last year. We’ll talk to Andrew, to hear more about that, in a minute.
First, I’ll give you a quick overview of the other sub-advisors.
I’d say nothing is dramatically different than what we talked about late last year. But we’ll have more detail in the webinar in a couple of weeks.
Starting with Blackstone Credit – formerly known as DCI – they were up over 2% in Q1. The elements that contribute to an attractive environment for the strategy are all in place.
Namely, a decent level of absolute-credit spreads. This has over 500 spread on high-yield. We’re under that, now. Not by a ton, so it’s not an amazing spread environment. But it’s decent. There’s a healthy level of difference between the model’s fair-value estimates and what the market is pricing. And really significant differences in the actual performance of the underlying corporates that the model looks at.
We see that attractive environment reflected in the high-gross exposures in the strategy, in the long-short CDS portfolio. Not quite as high as they were a couple of quarters ago, but still well-above average.
I’d note that this strategy did quite well last year – up over 4%. We expect it to be one of the best performers in a negative environment, although that’s not required. The strategy did quite well in 2019, which was a good year for markets, generally.
If we turn to FPA, they were up about 4.5% in Q1. They have one of the highest-quality portfolios they’ve had, at attractive valuations. I’ve kind of characterized it before as a blend of franchise-type, really-high-quality internet and tech-related companies, and more classic-value names like industrials and financials on the other end, that are reasonably good-quality — at very good valuations.
They also own some special situations in both equity and credit – including a small basket of busted-converts that have quite a high yield.
Then they’ve also got the optionality of about 25% cash. That also now has the virtue of earning something above zero. That’s a nice feature.
If we go to Loomis Sayles, on the next slide – they were up about 1.7% in Q1. Also, a really nice portfolio, as you can see. The numbers here are as of the end of February. But they’re still very close to that, as of last week.
Loomis isn’t as focused on securitized credit, as is DoubleLine – and it has lower-duration, as well — so it has a lower yield. But it’s still very attractive, on a risk-adjusted, prospective-return basis. We’ll hear more from Loomis in a couple of weeks.
Water Island was up about 60-bps in Q1, after [a quarter went well] – a positive return. Assuming good deal-selection, they should be poised to generate nice performance, going forward, as well. We’ve got this really harsh regulatory climate, so there’s more risk for merger deals – especially politically-sensitive ones. Then, obviously, higher short-term rates, among other factors. That environment has created a pretty healthy deal-spread – where you can see the annualized first deal-spread in the portfolio is north of 20%.
Obviously, deal-extensions and deal-breaks do happen. That will reduce returns. But that’s historically quite a strong starting point.
I guess after that quick review of the rest of the fund, let’s turn to DBI. Despite the challenging start that I mentioned, we’re very excited about adding the enhanced-trend strategy. As Mike mentioned, in adding DBI, we wanted to lower the correlation to traditional assets, and add downside protection, while retaining the fund’s traditional focus on being opportunistic. Trying to take advantage of market-dislocations – and delivering long-term attractive performance.
We worked with DBI to customize the strategy. We think it’s a really great complement to the fund’s existing portfolio.
I’m joined by Andrew, who’s going to take us on a deeper-dive into DBI’s approach in the strategy. As Mike mentioned, he’s the founder of DBI, a managing member and co-portfolio manager of DBI’s strategies. He’s been in the hedge fund space for about 30 years, focusing on replication strategies for the last 10-plus, of those.
Andrew, thanks a lot for joining us, today. Let me turn it over to you for an overview of DBI, your philosophy and the approach, generally. Then hopefully we can get into some specifics, after that.
Andrew: Terrific! Thank you, Jason and thank you, Mike. Thank you, guys, for inviting me on the call. Can you hear me okay?
J: We can.
A: Okay. Just in case anybody had any confusion, I’m definitely the guy on the left, in the two pictures. The guy on the right is my partner. We’ve worked together, actually, for 15 years.
Our sole focus as a business has been –
Do you mind if we go to the next slide, please? I could walk through a little bit of what we do.
As Jason mentioned, my background goes back to the early-to-mid 1990s in the hedge fund industry. I started working for a very-well-known hedge fund manager named Seth Klarman, who is famous for writing a book called, “Margin of Safety,” but who also runs one of the earlier-generation hedge funds.
About 15 years ago, Mattias and I basically tried to really, really tackle one issue. That was, for certain hedge fund strategies, can you replicate them?
What do we mean by “replicate?”
In a strategy like equity long-short, sometimes they generate a lot of alpha by picking individual stocks. But it translates into, say, an overweighting of growth-versus-value. Or value-versus-growth. Or lesser equity-risk or greater equity-risk. Or dialing into emerging markets in the BRIC boom.
We’ve tried to identify where there are sources of alpha within hedge funds, where we can identify contemporaneously. If we can identify it contemporaneously, then we can – in a sense – invest in the same exposures, ourselves.
The whole idea is that that gives us the opportunity or the ability to deliver hedge fund alpha, but with lower fees. Daily liquidity. Sometimes we can build in customized strategies.
The exercise for this fund was really to try to build a strategy that was complementary to the other elements of the fund. Often, when people look at what they do, they come to us and say, “We want you to help us build something that’s another piece of the puzzle that we have difficulty finding in the markets.”
That’s why I have a slide here, where Mike and Jason talk about building a strategy that wasn’t previously available in the market – and building it themselves. In a sense, this is really just an extension of that philosophy.
In terms of the strategies we replicate –
One thing we always tell people is that there are plenty of hedge fund strategies you cannot replicate. What Water Island does with merger-arbitrage cannot be replicated, the way we do it. Illiquid, event-driven – illiquid-credit-focused strategies – you can’t replicate.
But there are three core strategies that can be replicated well. If you look at the upper-right of this slide, we and others have demonstrated that you can replicate the broad hedge fund industry. It tends to have more [inaudible], long-bias toward equities.
We started in 2012 to demonstrate that you could replicate equity-long-short. Then in 2015, the majority of our assets come from replicating managed futures.
As of today, we manage about $2 billion in AUM. We’re very, very focused on a handful of these key strategic relationships, where we can build products that they can use in their institutional portfolios. With the delivery mechanism being something that then takes this institutional quality of products and brings it out to a broader wealth-management audience.
Next slide, please.
What we sought to do here was basically combine two different strategies. The ethos of it is that when you look at strategies that are complementary to stocks and bonds, I’ve been hard-pressed to find a more compelling strategy than trend, on a stand-alone basis.
Basically, it’s a strategy that tends to do somewhere between stocks and bonds, over time. It tends to have much more muted draw-down characteristics. It’ll definitely go down in periods like what we’re experiencing right now, but they tend to be kind of contained. You don’t have these long, drawn-out down-30% or down-40% periods that you see in something like equities.
They tend to have zero-correlation to both stocks and bonds. In fact, recently, negative correlation to bonds. By the way, it tends to do best in years where there’s a major broad-market crisis.
When you take those four characteristics together, the strategy is incredibly compelling to put into a broader portfolio.
One of the issues with the strategy, though – it can be difficult to hold or maintain through an entire market cycle. The idea there is that in periods of time when traditional assets are doing well and equity markets are rising, et cetera – you can often see periods of sustained underperformance by managed futures as a strategy.
Going back to last year, when Jason approached us about helping to build a sleeve for this fund, we were trying to identify two different sources of alpha that we could bring, in the right mix. But then, also to deliver it in a low-cost, liquid fashion that could be incorporated into the overall strategy.
Our ultimate conclusion was that we wanted to have 75% of the portfolio allocated to this true shock-absorber. This trend-following strategy. But we also wanted to have 25% allocated to an equity-hedge strategy.
Let me talk a little bit about the nature of the alpha-generation on each of those two sides of the strategy.
In equity-long-short, as I mentioned, alpha-generation comes primarily from factor-shifts. Over time. What do I mean by that? I mean that in 2004, when hedge funds start looking at individual companies and they see that there’s all this growth in emerging markets, and [Chris Hahn] is talking to Cemex about their order book, and they have an order book that goes out 10 years –
What shows up in his portfolio is basically – or a lot of hedge fund portfolios – is a very, very significant overweight allocation to emerging markets. Over the subsequent several years, emerging markets outperformed developed markets by 30% a year. If you have a 30% weight to something that’s outperforming by 30% a year, it’s 1,000 bps of alpha. I mean it’s a huge driver of outperformance, over time. Without taking more risk – because that’s the nature of alpha.
If you can shift into markets that are sufficiently cheap, then you’re rewarded with extra return, without taking more volatility and more risk – that’s alpha. Within the broader equity-hedge universe, that’s a source of alpha that we can identify. We can identify what’s driving it, and we can replicate it with low-cost liquid instruments.
If you look at that column on the side, what we do is very, very different. We don’t build our own hedge fund strategies. We don’t try to invest in other hedge funds. Rather, we study hedge funds. In this case, we take 50 of the largest equity-long-short funds in the hedge fund database. We basically analyze their recent performance, and we drive it through what’s essentially a risk model, to figure out how they’re positioned, today.
Were they reducing risk in the first half of 2022? Did they make a pivot from growth to value stocks?
We’re trying to deliver something that, over time, will have about half of the risk of the equity markets, but – if we do it right – we’ll pick up maybe 100-bps or 200-bps of alpha or excess-returns. If you do that, then you can deliver somewhere between 2/3 and 3/4 of the returns of equities – but only half the risk.
Like a lot of this business, it’s a business of advancing the ball and pushing it a little bit forward, for longer-term-focused investors.
J: Andrew, let me jump in there and play devil’s advocate. I’m sure some of the people on the call are thinking you’re rebalancing monthly, and looking at monthly returns. Not too slow to pick up what these geniuses that are getting paid millions of dollars are doing on a shorter-term basis – reacting to things?
A: Not in the equity-long-short space. When you sit down with these guys and say, “Show me your portfolio today,” and then, “Show me your portfolio six months ago, and a year before that,” it’s often surprisingly similar.
The way these guys are set up – most of the guys that we’re talking about are very, very fundamentally-driven. They could spend years looking at a company before even deciding to buy a share. But, when they buy it, they’re often planning to hold it for five years.
The way we often think of this – it’s almost like a tanker in the water. What we’re doing is analyzing the wake behind it, with a satellite. We can’t tell you how many containers they have. We can’t tell you what’s in the containers. We can’t tell you the name of the captain of the ship. But we can tell you with great accuracy how fast it’s moving. Is it accelerating – decelerating? We could even tell you, probably, if it’s sitting heavily in the water, or not. We can infer a lot from it.
The key is, when you’re doing a strategy like this, where you are only rebalancing once a month, you need something that’s slow-moving. By contrast, trend-following is not slow-moving. If you were looking at the past 14 months in trend-following, you would have no idea how they were positioned, today.
What we had to do, when we went down that path, was to adopt the models. The same risk-model idea that we have on the equity-hedge side – and apply it to much-faster-moving funds. It might not be a jet-ski in the water, but it’s much more of a motorboat, cruiser or something that will turn more frequently.
On that side, every week, we basically look at an index of these funds that consists of the largest, flagship trend-following hedge funds out there. We try to infer if they’re long- or short-gold. Are they long or short crude oil, and how much? Did it change from last week? Are they shorting equities? Are they long equities? If so, do they have the bet on non-US equities versus US equities?
Trying to identify the big trades in their portfolios.
When we identify it, on Monday, essentially what our model then does – our process – is then to simply invest in futures contracts that give us similar exposures.
The idea is not to do what each one of these guys does, down to the precision of their individual positions, but rather, to capture their major asset-allocation decisions. What we’ve been able to show, if you look at the last bulletpoints here, on the equity-hedge side, when these guys make 10%, the clients often get 5% or 6%. Our general idea is that if we can get 8% or 9% — not 100% of what we do, but to charge less –
We just tend to do better, over time.
On the trend-following space, we can often get 100% of what they do, and charge less – and do better.
It’s just a very different approach. These were really designed as asset-allocation tools. By putting them together, we’re trying to deliver a blended return that would be very, very complementary to the other [legs] of this portfolio.
There would be this residual factor – equities – we call it strategic-alpha on the equity-hedge side. And it’s tactical alpha on the trend-following side. I think, given what’s happened in the markets, it’s pretty clear that no one really knows what the world’s going to look like in six months, a year or two years or five years. To have a strategy in it that will adapt, based upon what some of the best investors in those spaces are doing – it can be very valuable as a complement to a portfolio. Provided it’s delivered in a package that’s also user-friendly.
Let me ask you another question about the trend side of it. We show ten futures here on the page. We talk a lot to managers, as you know, that have dozens or hundred-plus individual contracts. How are you able to do this with a very limited number of contracts?
A: It goes a little bit back to the history of the managed futures space. People that have gone into the managed futures space tend to like complexity. There’s a reason they go into this space. If my job were to go out and build managed futures models and try to optimize everything, I’d want as many factors as I could invest in. Just from an external perception of diversification, it can look really valuable to say, “Hey. I’m trading this exotic currency over there.”
Our approach is very different, because we wanted to keep this as efficient and fee-efficient and trading-efficient as possible. It turns out that actually in most hedge fund strategies, it’s the big trades that matter. When we’re looking at big hedge funds, last year – if you got crude oil right – the dollar-versus-yen and treasuries right – that explains the performance of managed futures hedge funds. You didn’t need the bund. You didn’t need German bonds instead of treasuries. You didn’t need natural gas instead of crude oil.
It’s often really, really, the big trades. For some people, that’s considered to be a very radical idea. What we’ve been able to show is that with about a 90% correlation over time, we can on-average pick up about 100% of their returns.
A metric we often use is, because the fees and expenses of this space are high, just by using 10% of their instruments, 90% of the time, we can capture what they’re doing. There will be times when we won’t. We study it closely and see if the world has changed, in some fashion. But we’re very much believers in finding the simplest, most-efficient and most-logical way of getting as much as we can. Not adding complexity, unless we feel very confident it’s going to improve results, over time.
J: Can you dive into that a little bit more? I know you guys have looked at a number of different potential assets to add to the model. What have you found, in looking at some things, specifically?
A: There are always times when you look at it and say, “I wish I’d had that.” Right?
In September of 2021, I remember that was a month we underperformed the index by about 200-bps. We got to the end of the month and said, “What do we do?” Well, wait a second. What happened? What did we miss?
When you’re outperforming consistently by 300-bps or 400-bps – by cutting out fees, over time, you’re going to expect month-to-month variations in performance. That’s to be expected. But we want to know why.
When we looked at it, we realized that yes, if we’d had natural gas – we don’t have natural gas in our portfolios – we have crude oil and gold. If we’d had natural gas, it would’ve been about a 7% allocation at the beginning of the month, and it shot up. It went up 34% when not much else moved.
It was crazy weather patterns or a short squeeze or whatever it was.
The process that we do is to look at it and say, “All right. Let’s first of all, for the tenth time, go back and say –
“What if we’d started with natural gas back in 2000? When would it have helped and when would it have hurt?” Is there an argument that it makes our results consistently better? The answer is almost invariably, “No.” You don’t need it.
Then we ask ourselves a further question, which is, “Is there something we’re not seeing in the markets?” Has the world changed from where it used to be?
This was a more recent example – back in 2021. People kept asking us, “Why don’t you use crypto?” There wouldn’t have been evidence, historically, going back to 2000, as to whether crypto would’ve helped or hurt, because we didn’t have data on it.
But you can also ask the question of people who are invested in these funds – to people who manage these funds. To say, “Guys, there’s a lot of talk about crypto. Are you doing it meaningful size in your portfolio? I just read something in the FT about it.”
The answer was no. Maybe they had little accounts over here.
There’s always our bias, which is to always try to keep the number of instruments as narrow as possible. It keeps our trading costs incredibly low. It reduces our risk. As long as the results and the strategies support that decision, then we stick with it.
It’s very unusual in the quant world not to keep turning dials and changing things.
J: Yes, that’s very true. It sounds good, and people can make improvements over time. I know your model has made marginal improvements over time, that make it better. Big shifts are not what it’s really about.
A: I just want to ask the question – why didn’t you change it before? I gather you’re changing it, now.
Our goal is for these things to work. If they continue to work as well as they’ve been working, you’re not going to see much change in these things over the next 5 or 10 years.
We got a question that came in. I think we’ve basically addressed it, but –
Evaluating models, to determine if new factors should be added. Has that work been done? Could new factors or futures be expected?
You basically got to the philosophy of it, but maybe have you added anything new recently? Is there anything on the drawing board that might happen?
A: I’ll tell you the area that I’m intellectually focused on. But we haven’t found any evidence that it’s a change we need to make. It’s a thing we’re looking at.
We have a US-centric portfolio. We like trading US-exchange-traded futures contracts. They’re the most-liquid contracts in the world. They close all at the same time. They’re incredibly efficient to trade. There are lots of reasons we like them.
In January and February, it looked like those markets – often, those are the markets that are less-risky than the other marginal markets. In January, because of this obsessive market-wide focus on whether the Fed is going to sneeze or not sneeze, et cetera – those markets were actually a bit more volatile. It actually looked like we were losing some diversification by not having German bunds. Having more risk in German bunds, as opposed to treasuries. That may have the same underlying bet, but in an expression of differentials.
We look at this stuff every which way from Sunday, and we’ll continue to monitor it. I could see us moving into more of a multipolar world, where we do need to expand our factor set. It’s going to come down to a judgement call. Mateus and I will study it and we’ll think about it. We’ll talk to people. If we do it, we’re going to do it carefully and incrementally. Not spontaneously and reactively.
We have to keep our minds open to the fact that the one constitutes the world has changed, and we need to be aware of that.
J: When we see Dogecoin as 20% of the portfolio, we should panic; right?
J: You started to touch on it and went through it a bit, but can you talk about why the strategy performed so well last year? What worked? And then transition into – as I mentioned – our timing, getting us up-and-running live, was suboptimal. What changed? How do you see things, currently?
A: First of all, nobody on planet earth has figured out how to time this strategy. Some of the most sophisticated investors in the world, who’d held this strategy through a very difficult period during the 2010s, got out just before it took off.
I think the way we always talk to people about it is, you should think about the diversification benefits of the strategy, measured in a decade to two decades. Not quarter-to-quarter or month-to-month.
Sorry – I lost your first question.
J: Just talk about what drove performance last year, and then what changed? And then where we are, now.
A: The source of alpha-generation in trend-following is really interesting. I think about it a little bit differently than a lot of the practitioners in this space. A lot of those guys have this view that most investors are these kinds of flighty, neurotic people that are troubled by all these heuristic biases. They panic and they buy things, and it’s like they’re all those people in the scene in, “Trading Places.” Getting whipsawed, back-and-forth.
I actually don’t. That hasn’t been my experience. My experience is that most investors — both institutional and wealth-management, et cetera – their portfolios are designed to move slowly.
Since the 1990s, as the world of model portfolios has grown, the ethos is, “Don’t act rashly. Make long-term bets. Make long-term strategic allocations. Don’t sell them at the bottom. Don’t try to time things.”
It goes back to the 1990s. It started with equities. Jeremy Siegel’s, “Stocks For The Long Run.” It’s recently become true in bond portfolios, as well.
In early 2021, inflation started to come back. For the next 18 months, it was a very, very contrarian trade. We had the ports were going to be solved. It was going to be transitory. The Fed was going to let the economy run hot. You had all these narratives.
What they reflected was the fact was that even if you, as a typical portfolio manager were concerned about inflation coming back, you had low-rated bets throughout your entire portfolio. It was really, really hard to change, over time. You needed to see the data come in.
That’s an ideal time for trend-following. What it basically reflects is the asset-management industry will move slowly. But sometimes the world moves faster. When it moves faster, that’s a shining moment for hedge funds. There are hedge funds you’re reading about – an article on hedge funds getting hit really hard in March, in the Financial Times. A very good friend of mine wrote the article.
I sent him a text and said, “I think you sort of missed the point.” If a guy was up 100% last year and he’s given up 20% in March, that’s not a problem. That’s actually –
You don’t get one without the other.
What happened is, until last fall, the inflation-trade was still very contrarian in trading. But as we got into last fall, people had turned their votes. They’d reduced a lot of duration risk. This is on the long-only side. Actually, Mike and I were in Boston on November 13th, with long-only investors, when the first signs that inflation maybe was slowing down came into the markets.
We were seeing a lot of reversals on the managed-futures side and on the trend-following side. But we could also see it in the anxiety of long-only investors. They realized that their benchmarks were running away from them. They weren’t exposed to tech stocks, anymore, and tech stocks took off.
What you have had since then is a very, very difficult tug-of-war. January was great – February was horrible. March was – at least in terms of traditional asset classes – it goes up. Those sorts of oscillating markets tend to be very difficult for a strategy like this.
Now, what you’re seeing is basically – what the strategies do is –
I sometimes joke that nobody built these models to hold onto positions with a white-knuckle grip. By that, I mean there are no Kathy Wood models. Where somebody is going to be long disruptive stocks – no matter what they do – for as long as this person lives. It’s just sort of wired into her. As a credit to her, she held them through very difficult periods, and did spectacularly well through other periods; then terribly, in others.
They’ll shift and change their positions.
I think now what we’re seeing is kind of the tail end of the full-throttled inflation bet. That drove all of these things to levels that we couldn’t possibly have imagined at the beginning of 2022.
Rates went up much higher than people expected. The dollar got much stronger than people expected. Oil, at the beginning of the year, went up much more than people expected. Those periods where you have a lot of the unexpected tend to be really good for the strategy.
Today, you sort of have to ask the question. We’re coming off of a bad month in March. This hasn’t been a good year, so far. But now, I’ve asked the question of people, “Given the fact that we now have Jamie Dimon and Larry Fink and Mohamed El-Erian and all these other faces saying, “We’re in for years of rolling crises,” in the banking and financial services industries, we could be in for a hard recession. That was clearly not on the table a month ago.
All of these things make me think that actually in the moment right now, when you’re looking at very recent performance, it’s very frustrating. You feel like you’re on the wrong side of it. Then the portfolios pivot, and a new opportunity set arises.
I think, as a longer-term investor, we will see plenty of opportunities for these kinds of strategies to capitalize on. Who knows? Rates could go back down to 2% in 18 months. Well, guess who will then flip to be long treasuries – and ride it all the way down? Trend-followers.
J: That’s an interesting point. I remember a lot of talk when trend-following wasn’t working well for a lot of the last 10 years. You can’t make money with rates at zero and rates increasing. Obviously, that was disproven last year, as it was a great strategy to work.
But we’ve had a lot of volatility with the banking issues. Historic moves in rates, which hurt [those] still short bonds, to a large degree. As you mentioned, if we see an extended move in those, trends will benefit, then. In the meantime, maybe you can talk about this a little bit more. I think generally, we’ve seen gross exposures come in. There has been a lack of clarity. I know we can’t predict the future, but if we do see that recession, how do you expect the portfolio to act?
A: I use a crazy example. Let’s say six months from now, we’re in the middle of WWIII. We’re stockpiling bottled water and ammunition or something.
It doesn’t happen overnight. It happens. As you’re heading toward that event – whether it’s a deep recession or – more or less sardonically, maybe a deep recession or another round of the global banking crisis –
People fight the narrative. There’s always somebody who’s saying, “It’s true. I believe it.” They sound like [inaudible]. Then other people say, I’ve been doing this forever; don’t worry. It’s going to come back.”
There are always these kinds of opposing views.
It takes a while. But what happens – the way trend-followers – the way it would likely happen –
Rates would go down. Then people would say, “Well, they can’t really go down any further, because inflation is still at 6%.”
Then it goes down a little bit more. There’s going to be this period of disbelief. Trend-followers will tend to – there will be some people who reposition capital, as trend-followers will follow it. They’ll probably be long bonds, going into it.
They could be aggressively short equities. I suspect that if crude oil is on its way to 30, they’re probably going to be short crude oil.
It’s going to be all of those things where we’d look back six months from now and say, “My God! I can’t believe oil’s at 30, and the 10-year treasury’s at 2.5.” “Can you believe that Mike Wilson at Morgan Stanley was right, and equities are retested at the lows of 2022?”
Those are the kinds of things that are so hard to imagine, today – for us, as human beings, thinking in this framework of the world. Those tend to create the best opportunities for the trend-followers.
I’ve written about things like –
Last year, markets you’d not normally think about – like the dollar/yen – the move of the dollar/yen was considered impossible, by human strategists. It was like the Nasdaq dropping 80% in a year. Like just in terms of statistical measures.
It’s very, very hard with a strategy like this, because you don’t have a fundamental barometer, where you can say, “Here’s intrinsic value and here’s its historical cheapness,” or whatever. It tends to be much more about the opportunity set, going forward. Then how they end up positioning for it.
J: You hit on this a little bit, also. But why has replication – and it changed, recently – but through most of this year-to-date –
Why did replication struggle, relative to the index? Where, over time, you – as you mentioned – added several hundred bps a year, but in shorter time periods, it could be one way or the other?
A: We actually underperformed in January and February. But we’re right inline, in March. They were down a lot and we were down a lot. Almost identically, with them.
January and February were more interesting, in that I think we were under-diversified, in that. I don’t think we were slow. I think we were under-diversified.
I think the markets that we were in happened to be more volatile. There’s always that, plus an element of randomness that goes with it. We underperformed by maybe 300 bps, or something.
March, on the other hand, should be the proving ground. This is when you should – if you’re going to be too slow, that’s when it’s going to be. When everybody de-risks, overnight. If there are other esoteric hedging instruments that are not doing as badly as the 2-year treasury, which supposedly has a 13-standard-deviation move – which I don’t think even exists, statistically –
Then we’re right inline, in that.
You never know with perfect certainty. But I think it has to do with the first couple of months of the year being one of those times where guys that are running these hedge funds — and who were investing in a lot more esoteric and different markets than we were – were picking up better things to invest in than we were.
Most of the time, the value they generated from that doesn’t cover the additional costs and expenses associated with it. But 10% of the time, it does. And it happened to be – I think – in January and February.
J: Mike, maybe if you could go to the next slide and kind of get an illustration of that, long-term.
A: This is basically a representation of the trend-following space. You see that each of these lines is an actual investor in the space. If we came to Jason and said, “Hey, we’re going to build our own trend-following model,” and Jason is saying, “Boy – what I really want –
“I can see 20 years of returns of this strategy. And I can see its diversification benefits.” It’s like saying, “I really want to add emerging markets to my portfolio,” but then you have to pick one stock to do it. You just don’t know. You may do really well. You may do better than the emerging markets index. But you don’t really know, in advance.
We start with the premise that we’re trying to replicate. First of all, we want actual hedge funds. Hedge funds tend to do a little bit more than mutual fund versions. We start with the actual hedge funds. We take an index of these hedge funds. You can’t see it very clearly, but imagine there’s a kind of line going through the middle of these lines.
These lines show you the constituents of the index. One year, one guy does well. Then he falls off. Then another guy’s doing poorly and he rebalances. It’s a very difficult space to invest in.
We take the whole group of them. In the second slide, you can see that there’s a target of funds that basically represents the average of the whole pool.
The way we try to outperform – every single line you see, including the pool, is net-of-fees and expenses. They don’t tell you how much they made before fees and expenses – how much they took in fees – and then, “Here’s what’s left for you.” They just tell you what you get.
There’re often 300-bps of fees of expenses at the hedge fund level. There’re also a lot of trading costs. We seek and have sought to do since 2016 to basically try to replicate the average. But, before fees.
What you see at the bottom is a very different approach. We’re not trying to build the car that’s going to race around the track at 200-mph and then conk out on the next lap. We’re trying to build something that just consistently outperforms, over time.
What happens, if you’re a long-term investor – the appeal of it is, you have this predictability versus the index. But you just kind of steadily outperform, over time. You kind of climb up in the lead tables.
The idea of what we’ve always tried to do with our three strategies is, if you talk to guys at a pension plan that pick hedge funds for a living, they don’t really think in terms of getting exposure to the category. They want to buy each of the individual pieces or components, themselves.
With a strategy like this, it’s very difficult to find the fund that’s going to always necessarily do better, because there’s a lot of randomness in it. We’re trying to get to what we call, “an index-plus solution.” But getting there by cutting out fees and expenses. Interestingly, we’re doing this very much at the wealth-management retail level. The other guys that are doing it are all the way are with the largest investors in the world who do this. Like sovereign wealth funds will come in to these guys and say, “Hey. We could give you $500 million. But if 1-in-20 comes out of your mouth, we’re walking out the door.”
They get special deals. They buy a bunch of these guys, so they get diversification. They get their own special deal. Then, guess what? They do better than the index, over time.
We don’t have $10 billion to allocate to this space to drive hard bargains on fees. We try to do it synthetically. Based upon people I’ve spoken to in this space, we actually do roughly the same as they do.
J: That’s a great point. It’s one I think is very relative for individual investors’ portfolios. But also, for our fund. There’s very little persistence of performance, specifically in managed-futures. I think you have a chart that is not in here, but the [quilts] table of the best-performing one-year. It very often ends up in the bottom half or bottom quartile, the next year. Because of the randomness of different specifications of peoples’ models and portfolio-construction.
But if you do that average over time, and then cut out fees, it works a lot better. I’m just thinking last year, specifically –
In an ideal world, if we’d had this strategy on the full year, it would’ve helped the fund quite a bit. But, if we had picked one manager with one specific model, and it had been not very well-tuned for the environment, it could’ve ben a much uglier result than if we had just an average, including full-fee.
That’s one of the things we really like about what you guys do, and adding it to the portfolio. The same with –
A: Just to put some stats on it, the top-performer of hedge funds that we tracked was up 60. The bottom-performer was down 35. The mutual fund space – the top guy was up 58. The bottom guy was down 13.
There’s a clustering in the middle, as you might expect. But it’s an extremely difficult space. My friends that are in the business of trying to pick which one of these guys is going to do better call it, “Soul destroying.”
It’s really rough.
J: I’d agree with that. That’s why avoiding that single-manager risk is huge.
A: We like consistently above-average.
Interestingly, you mentioned this point about the difficulties of 2010. That was really caused by three factors. The first – we’re earning 4% on cash, right now. You talk about this period where the space did roughly zero, but they really did cash. They did maybe a little cash-ish, over that time. But volatile cash. Occasional 10% draw-downs.
If cash were earning 4%, people wouldn’t have complained as much about it. Your hedge would’ve been earning 4%. Second thing, we had the Fed. In a deflationary world, the Fed was definitely afraid of losing control of deflation and then becoming Japan. Their tools became effectively below-zero on inflation.
They were paranoid about a wealth-effect bringing down markets. That would have then caused a downward spiral that they couldn’t control. They, themselves, were stepping in. The Fed put was basically a volatility-suppression mechanism. The crises that should’ve happened for 10 years didn’t happen.
By the way – interestingly, one market they didn’t care about was the oil market. Back in 2015, what was a very good year – 2014/2015 – for these guys, it was because the oil market basically went from 105 down to 20, at one point.
The last was that when people talk about returns in this space, it’s after 300 bps of fees.
My argument was that when they say, “Oh, no – the strategy didn’t make any money for five years,” “No – you didn’t make any money.” These guys were fine! They were fine!
I think, going forward, we think about this strategy in general in two regimes. 20% of the time, it’s your favorite strategy. It does 50 to 70 points better than equities. Everything else is going down. It’s just knocking the cover off the ball.
The rest of the time, given the way we do it by cutting out fees and expenses, our hope is that it’s a cash-plus-3, net-of-fees. Somewhere in that range.
The idea is to structure it so you can weather the lower-return periods. Remain invested, so there’s no question that you actually have the right allocation at the time when it really hits. I often say to people that if you develop an earthquake detector that can tell you exactly when these things are going to hit, then by all means, first of all, call me. Let’s go into business together, because it sounds like a great idea.
In reality, you have to own it. You have to have a strategic allocation likely, in order to have it at the right time.
J: Exactly. You can’t time it, as you said. I’ve said it since we’ve been invested in this strategy on our private-client side for a number of years, and I’ve answered a lot of questions about it.
To that point, I think worth touching on it for the last couple of minutes – that’s part of the reason why we added the equity-hedge component to it, as well. As you mentioned, you get a lot of benefit in cutting out a lot of the fees. You actually do significantly better when it’s not working.
Then the equity-hedge piece is really complementary to the trend side. Especially, I think, for our portfolio – where we have tended not to pick up the big factor-rotations in equity, as dramatically as something like what you’re doing does. Maybe could you talk about  performance with your equity-hedge strategy? We had a good year, but I think the equity-hedge component would’ve made it even better.
A: Yes. Totally. Equity-hedge – hedge funds, from what we saw, were actually headed for a good year, last year. We were down modestly. A handful of percentage points, on the equity-hedge side. Again, relative to what the S&P was doing, it was very, very good. Why?
The first thing is, we picked up on a rotation into value stocks, going back toward the end of covid. Basically, a lot of fundamental managers said, “Okay. I bought Apple. I loved it, here. Now it’s 3-x and it’s 15% of my portfolio.” They were kind of dialing back as meta and tech stocks and everything went up during the covid crisis. They were dialing those back and putting them into things that had been slaughtered in the middle of covid.
That actually helped, going into last year. It helped in higher-rate environment. But they also cut back some equity-risk. We had some hedges in place in things like being short treasuries or long the USD. That helped to mitigate performance.
The idea is to have some equity-beta. It’s perfectly fine to have. That’s okay. But you want it in a controlled fashion. You want it delivered in a way that is sufficiently dynamic. Not all equity markets are created equal, at any point and time.
Even today, if you look at the assumptions amongst a lot of Wall Street banks or capital-market assumptions, everybody is expecting non-US developed markets to outperform the S&P. Like double-the-performance of the S&P, over the next 5 or 10 years. They’re saying the same thing for emerging markets.
A traditional allocator that’s benchmark-centric has a really hard time moving meaningfully into those markets. Hedge funds can go up to their gills in those markets.
If you think about it, Nasdaq went up 425% during the 2010s, while emerging markets went up 50%, with comparable levels of risk. If somebody gave you a crystal ball and said, “Pivot into tech stocks, at the beginning of the decade, and just hold it for the decade,” you were[n’t] taking additional risk. [But if every dollar] you’d taken from emerging markets.
The whole idea here is –
I think actually, the opportunity set going forward, is going to be much, much more favorable to these guys. One of the problems is that people don’t get really thrilled about having their hedge fund managers buy the same stuff they have in their index funds. There really is –
It’s great. 2014/2015, a lot of really smart hedge funds figured out that FANG stocks had these incredible business models, and would grow longer and father than Wall Street. It’s a little annoying to pay them 1.5-and-20 to pick the same stocks you’re getting for 6-bps, over here.
I think in a higher interest rate environment, and in a world with a resetting of these valuations, the opportunity set will be richer for them. We’ve seen that in this portfolio. On the equity-hedge fund replication side, we’ve seen episodes of really meaningful alpha, since covid.
We’re just about at the end of the hour, here. Any closing thoughts you want to leave us with?
A: I think March was the weirdest month. We had about –
On March 8th, we had this raging debate. Was the economy going to be slightly too hot, so the Fed would have to go to 50 bps and possibly peak at 6%, to bring it down? To – whether inflation would gently drift down and give the Fed room. Without going into recession, to give the Fed room to refill the punchbowl in the second half of the year. That was the debate, for four months.
Then we had a banking crisis. Overnight, basically two weeks later, we were talking about global recessions and global banking crises. Rolling crises. Then by the end of the month, everything had recovered and it was like it had never happened. Stocks and bonds were both up 3%.
On the trend and other side, I think in a sense, it’s somewhat –
At a moment like this, you always think it’s over. But I think the incredible thing about the banking crisis was, we went through two years of hiking – far beyond what anybody expected. But we always could take for granted that the banking system was safe. Dodd-Frank had worked. Regulations had worked. Banks were just these sleepy utilities. At least we don’t have to worry about that. We don’t have to worry about the plumbing. We can instead worry about Ukraine. Gas rationing in Germany. Covid in China. All of these. The nickel markets. Crypto. All these kinds of things.
Then we had this kind of two-week period where all of a sudden we were staring at the underlying chassis of the markets. There’s just been a remarkably fast acceptance that the Fed and treasury and ECB and Swiss banking authorities will just neatly have this under control. It seems to sort of contrast with what the guys that are running firms like JP Morgan and Blackrock and Allianz or El-Erian are saying.
It feels slightly surreal. Like this moment, to me, feels slightly surreal in the market. It’s going to just be fascinating to see how it plays out.
Back to your point, I think this is where you want diversification. It’s really hard to predict, right now, what the world’s going to look like in three months.
J: I hope you’re not saying this in the Bear-Stearns MBS hedge funds moment, when things started to unravel and then we had the summer that was kind of okay and then –
A: I don’t think so. I think the Fed and treasury – what they signaled early-on in this – more so than what people expected –
They really don’t want to solve inflation with a banking crisis. They want to do it on their terms with their tools.
You’ve already got people who are blaming them for having created a banking crisis, in the first place. People are talking like it’s the worst policy mistake in decades, basically.
I think that there is this idea. I do believe that there will be a series of –
The longer rates stay high, there will be a series of cascading issues that happen. I think they’ve demonstrated that overnight they effectively guaranteed all deposits above $250,000, without even a discussion.
Governments haven’t really stopped spending. There hasn’t been an impact of higher rates on government finances. There haven’t been corporations who have never had to deal with higher rates and refinancing and tighter conditions. All of that seems like it’s going to take years to play out.
I don’t see it, myself. But I do think I’d be surprised if it were smooth sailing. It’s always going to be something annoying, like Silicon Valley Bank. It got killed overnight by basically chat groups. It’s just –
Then Credit Suisse was killed overnight. That was a long, protracted –
I used to say it’s incredible they’re still alive. These are big deals. We’re almost anesthetized to these big deals, at this point. We’ll see.
J: A lot to think about. thanks so much for joining us. We really approach the conversation and [inaudible].
A: Thank you guys, and thank you, everyone whom I didn’t get to see, today. I appreciate your taking the time.
J: Mike – any closing words?
M: I’ll close it up, Jason – unless you have anything you want to close with.
J: Nope. Go ahead.
M: Okay. Great. Then everyone who joined us, today – thank you. Thanks for your continued confidence in the fund – of course, as well.
April 19th – I’ll make sure everyone gets an invite. If you’d like a copy of this deck, just let me know that, as well. I’ll send it over.
With that, I guess I’ll say, “Until next time.” Take care!
J: Thanks, everyone.
To commemorate the anniversary, co-Portfolio Managers Jeremy DeGroot and Jason Steuerwalt have penned a Q&A retrospective on the fund and the category at large. MORE
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