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Transcript It’s About What You Don’t Do

With: Jeffrey Gundlach, CEO and CIO, DoubleLine Capital Portfolio Manager, Litman Gregory Masters Alternative Strategies Fund

Date: November 14, 2019

Jeremy DeGroot: We talk about at Litman Gregory how someone is “wired,” as an investor. Not everyone is wired well as an investor. Clearly, you are.

I wanted to have you talk a bit about the key foundational elements of your investment philosophy and maybe how it may have evolved over time as you gained more experience and as markets have evolved. But just starting with, “How would you define your investment philosophy and the key elements of that?”

Jeffrey Gundlach: Very much a coward. Culture cowardice, I’d say. We’re looking for every risk that we could possibly find. Probably finding ten risks for every three that really exist.

That’s kind of the way I think why we’ve done well in the fixed-income world. It’s very much a negative science. In fixed-income, you make money very slowly and you lose money very quickly.

So, it’s very important to avoid fatal risks. I mean this is the logo of DoubleLine. This area is basically defined by these double lines. This blue is what you don’t do. It’s not what you do; it’s what you don’t do.

In fixed-income, there are risks that are fatal. Managing other peoples’ money, you have to be really careful about drawdowns. That’s what I’ve learned over the years.

With my own money, I don’t really care very much. I mean I don’t care if I buy something and it drops 30% if I think it’s going to go up 200% over the next 30 years or something. But with other peoples’ money, you have to learn that there’s a finite tolerance for negative results. Whereas –

One of the first things I did in this industry was, I was tasked with the idea where this fellow had a thought experiment. It was, “What if we had perfect foresight in our asset-allocation process?”

How we defined that was, we just took a historical return series of every asset class we could think of. Stock, bond, commodity real estate and everything. We just pretended that at the end of the year, we knew which should be the best-performing sector. Because we were looking at an historical data series over the next five years.

We wondered what benefit that would be.

We came to the conclusion that in the institutional business or managing other peoples’ money, it actually would be of no value to have perfect foresight of what would be the best thing for the next five years. Because so frequently, the thing that was the best-performer for five years was actually a terrible performer for the first two.

The conclusion was, you’d be fired by the time it was really going to shine.

I think one thing I’ve built into my investment process and philosophy is a horizon that’s about 18 months to two years. The longer your horizon becomes, I think the greater probability of success that you have.

The problem is, you have to be right fairly soon, based on that perfect-foresight idea. So I came to the conclusion that most people when they’re managing other peoples’ money, are way too short in their time horizon. They worry.

I hear people talk about weekly strategy meetings. To me, that’s a very bad idea. You’re focusing on the weeds and minutia, and you’re trying too hard to get the wiggles and jiggles. What really matters is trying to have more conviction and a long-enough period of time for it to play out.

Loss-mitigation – avoiding fatal risks – and having longer horizons than most.

Our strategy meetings for asset-allocation – we have a weekly discussion – but the real action meeting is once a month. I think that’s pretty helpful. I encourage the team to think about, “Don’t worry about next month. Let’s worry about 18 months to two years from now.”

That all kind of fits together into my philosophy.

Jeremy: Have fixed-income markets become more efficient? And is that something you’ve had to adapt to?

JG: They’ve certainly changed. They’re efficient until something blows up. Then all of a sudden, you have to change what you’re doing.

We’ve been in a long economic cycle here, and things have been pretty much arbitraged out. The Fed (Federal Reserve) and the central banks have manipulated rates down to levels that have forced all kinds of arbitrage behavior and strange risk-taking.

But our process really has never changed. My involvement in it has changed, because when I started out, I did everything. It was two guys and a Bloomberg. Now we have 300 people. Our investment team is very big. It’s about 150 people, now.

The process is one that I basically developed 30 or 35 years ago. That has to do with scenario analysis. That’s really the key. That is to try to figure out if the world goes “this,” way, what will happen to this asset mix if the world goes the “other” way? What happens?

That’s very different. A lot of people think that in the investment business, the process is about figuring out what the future is going to be. Get super-high conviction and bet the ranch on it. That works until it doesn’t. It’s like the roulette wheel does come up on 00 sometimes. So red-and-black aren’t always going to be winners.

It’s kind of like figuring out what your view is and what the maximum probability of the future is. But at the same time, to stress it for, “What if you’re wrong.”

Because our hit-rate in terms of getting things right versus wrong is pretty high versus the average in the industry. It’s about 70%. That’s pretty high of, “Right versus Wrong.” But that’s still 30% wrong.

So there is plenty of “wrong.” I’ve been at this for 35 years, as i said. So I’ve been wrong for over 10 years.

Jeremy: I’ve got a few of those to talk about.

JG: Thank God they weren’t consecutive, or else –

Jeremy: And magnitude matters, too. Right?

JG: Magnitude matters, too. That’s right.

But magnitude is about the scenario analysis. Because it’s like, “If I’m wrong,” then what is going to be the hit here?”

It’s one thing to be up 8 when the market’s up 10. It’s not great, but I don’t think anyone’s going to be too excited. But if the market’s up 8 and you’re down 10 – now, that’s a big problem. That’s what you have to avoid. I think people that don’t really stress-test or become overly fond of their base-case projection of the future can be blindsided by those times when they get it wrong.

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Curve Steepener A strategy that uses derivatives to benefit from escalating yield differences that occur as a result of increases in the yield curve between two Treasury bonds of different maturities. This strategy can be effective in certain macroeconomic scenarios in which the price of the longer term Treasury is driven down.
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A Leverage Ratio is any one of several financial measurements that look at how much capital comes in the form of debt (loans) or assesses the ability of a company to meet its financial obligations. 
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The Purchasing Managers’ Index (PMI) is an index of the prevailing direction of economic trends in the manufacturing and service sectors. It summarizes whether market conditions, as viewed by purchasing managers, are expanding, staying the same, or contracting. 
Quantitative Easing (QE) is a monetary policy in which a central bank purchases government securities or other securities from the market in order to lower interest rates and increase the money supply.
Quantitative tightening (QT) is a contractionary monetary policy applied by a central bank to decrease money supply within the economy. 
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Yield Curve: A line that plots the interest rates, at a set point in time, of bonds having equal credit quality, but differing maturity dates. The most frequently reported yield curve compares the three-month, two-year, five-year and 30-year U.S. Treasury debt. The curve is used to predict changes in economic output and growth.

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