Inside the Regime-Adaptive Portfolio | Systematic Investor | Ep.377

Summary

Niels and Alan explore how a fragile macro regime reshapes systematic investing, from a politicised Fed succession to widening …

Transcript

Imagine [music] spending an hour with the world's greatest traders. Imagine learning from their experiences, their successes, and their [music] failures. Imagine no more. Welcome to Top Traders Unplugged, [music] the place where you can learn from the best hedge fund managers in the world, so you can take your manager due diligence or investment career to the next level. Before we begin today's conversation, [music] remember to keep two things in mind. All the discussion we will have about investment performance is about the past and past performance does not guarantee or even infer [music] anything about future performance. Also understand that there's a significant risk of financial loss with all investment strategies and you need to request and understand [music] the specific risks from the investment manager about their product before you make investment decisions. Here's your host, veteran [music] hedge fund manager Neil's Krup Larson. Welcome or welcome back to this week's edition of the systematic investor series with Alan Don and I Neils Castle Larsson where each week we take the pulse of the global market through the lens of a rulesbased investor. Alan, it is wonderful to be back with you this week. Hope you're doing well. How are things in Dublin? All good to hear you. Great to be back on. Nice uh summer winter sunshine I should say. Yeah, getting very festive and pretty cold but but nice around. So looking forward to uh our discussion today. Plenty to chat about. >> There is actually plenty to chat about uh with a couple of world exclusives. Uh so I'm told uh one um thanks very much to you um a new paper that we will be talking about today. And the other world exclusive I think um is courtesy of uh Sockgen actually which we'll get to a little bit later. So, needless to say, we've got a very solid uh lineup of topics uh today, but as usual, before we even get into any of that stuff, uh I'm always curious to know what has been on your radar recently. >> Absolutely. Well, you know, one of the big talking points in markets is the next Fed chair, and it's been um something I've been monitoring for a while. I wrote a paper back in the summer about it, and at that stage, Chris Waller was the favorite according to the betting markets. the likes of Poly Market in the US. But we've seen some very interesting moves in the last few weeks. Um Kevin Hassad has gone from being kind of second or third in the running to being the clear favorite now. So according to the uh poly market uh betting market, you know, the likelihood is about 70% that he well it's touched a high of 70% or sorry 80% now it's about 70%. So clearly money talk. So the suspicion is somebody who has information um is betting on him becoming the next Fed chair. I would guess that he would be a bit more uh dovish. He's obviously a cheerleader for the administration and he has been on the record saying he believes in the productivity boom and the disinflationary uh implications. Um so certainly um it's something to monitor and that's going to probably going to continue to be on my radar for for the next few weeks. >> Yeah. Know I mean it's a great it's a great topic. Do we I mean I don't know uh his background. Is he uh well known? >> He is well known. I mean he is well regarded amongst uh serious economists. You know he has the proper academic training. He did write a book back in 1999. He co-authored a book called Dow. I think it was 36,000 at the time which of course he was eventually right but it just took a little bit of time to to get there. It you know it it fell in in half first. Um but no he is regarded as a um as as a serious uh supply sideoriented economist uh with with proper academic credentials but obviously he's been very close to the administration and and these days you know if you turn on CNBC you'll see him every second or third day it feels like um you know defending um the the administration's policies which I guess is part of his job but yeah that's the suspicion that he's been so close to the administration that uh can he truly be independent if he takes on the job of Fed chair. >> I actually had this point um further down in our conversation today. So, I did a little bit of research uh or at least I saw a headline about it. My understanding is that we are now promised that we'll know who it's going to be um no later than the 25th of December. >> Um so that will be interesting for sure. So on my radar, nothing nearly as exciting except if you are in in the crypto space. There's a little bit of good news. There's also a little bit of bad news. Um I think so. The good news is that Vanguard um who is the second largest asset manager in the world, they've decided that ETFs and mutual funds that primarily hold cryptocurrencies can now be traded on their platform. Um and that is kind of changing a longstanding position that they've had uh on this. I guess that's good news for the for the space um and for people uh looking to invest in these uh products. May maybe the other maybe the the bad news so to speak that's um and we know that probably from our own industry when when when markets go down or performance go down and and people um rack up a few losses um it makes the headlines and of course um micro strategy also now known as strategy is making headlines and you would think it's only because they're down substantially from their highs in November 2024 fall. But actually what caught my attention is that they're now facing some pressures over the positioning uh that Msei is um likely to take where it will um remove them from their benchmark. Um I I haven't, you know, studied the details as to why uh they wouldn't want to uh have the included. Um but there are some speculations that that may have a negative impact in terms of people who just simply need to redeem or sell the stock if uh if in fact it's no longer part of that index. So that was a little bit um of what um I I noticed uh this morning. Now, we're going to do something slightly different this week because we had a couple of questions via LinkedIn. Um, which I think is kind of the main platform people find you at nowadays. Is that right? >> Generally, yes. Yeah, that's so I put it out there this week to see if there was any uh topics or suggestions and >> we had two um two uh suggestions thankfully. >> Yes, absolutely. Well, we had one from Paisley who is uh an industry colleague. um I I think is fair to say. Um and she writes, "I'd love to hear your thoughts on how trend following can weather this storm of constant political shocks from the current US administration. Seems like another few years ahead of us of shifting focus and policy pivots that could cause trouble for trend." It's an very catchy headline actually. Trouble for trend. >> That's true. And it's obviously a very topical question and we've seen this this year obviously in the um early part of the year around the Trump uh liberation day. We we've nearly forgotten the name of it now. Um announcement very choppy and you know I've certainly got this feedback from investors that you know could we be in this environment where we'll have policy being announced and then being retracted etc and leading to choppy markets. And um I think it's it's definitely a valid concern. Um I mean you can take two ways of answering this. The blunt answer is yeah it's possible. We don't know. We never know what the future holds. Um at the same time I think there are um um other perspectives we can take. We we have seen instances in markets like this before um when trend following has been in draw downs. You know, if we go back to the 2012 2013 period, 2012 in particular, it was very much a risk on, risk off was was the term people were using a lot to characterize markets. And it felt like we were always going to be in this kind of um onoff type of risk cycle. At the time, it was very much related to the European debt crisis and would it be solved or not? But ultimately, what do we see? we saw a change in the fundamentals at at at some point where we saw um weaker economic growth and a breakout in European bonds and a sell off in the euro and and a breakout in in oil prices. So typically that's what you see markets go through these choppy phases and ultimately they can be um you know testing for investors particularly investors in trend following but eventually uh you know in the past we have seen breakouts or new pieces of information coming into the market. The other example would be you know we had a tough period in in in the latter part of the last decade. Performance did start to improve around 2019 but then we had co which was kind of a new jolt for markets and knocked the economy out of secular stagnation and into a new regime. So I think um you know there there is a an old expression I don't know where it comes from and this too shall pass. So I you know I think we got to hold on to that and and and say yes it is tricky um in you know with these kind of policy reversals. Yeah you could definitely make the argument that it will continue but equally we have seen this type of thing in the past and eventually it has passed and we have seen um better conditions for trend followers. >> I would add two things to that. Um, one is that uh you would think that the environment that uh Paisley is referring to might be great actually if you're a short-term manager because it's um you know the moves are generally you know shortterm and and there are quite a few um quote unquote uh changes in direction and so on and so forth. But actually this year has turned out to be a pretty horrible year for short-term strategies. So I think that's an interesting takeaway uh from investors because I think the intuition is that it should be the opposite way around. Um, so I think that's one thing that um people should be um aware of. And the other thing that I kind of take away from your comment where you mentioned specifically like periods around liberation day in my conversation last week with Andrew um he's always a great uh sport um when when he's on he um he did mention that most of the outperformance that they have seen in their strategy this year came around liberation day where potentially they were either too slow just that was the fact that they were too slow to react or they were you know quote quote unquote in the right markets and didn't get hurt by some of the uh the movement. So I thought I mean those are just very interesting um observation. I think it doesn't necessarily take anything away from trend. Um but it does suggest certainly that there will be specific events in a year that can either go you know against you or or in your favor. Um and and and that's obviously why people need to take the long-term view. All right. So, appreciate um the question, Paisley, and also I do appreciate all the likes that you give us uh on uh on LinkedIn and other social platforms. Um love the support. Thank you so much for that, Eric. Um and I'm I'm deliberately not saying their last name. I have no permission necessarily to do that, but Eric is also a long-term um friend and listener of the show. Um but he has a question that I think might be a little bit difficult for us to answer. He's writing if you have time. How are managed futures in generally positioned for a yen carry unwind? >> Yeah, I mean it's um difficult one to answer in some senses because you know we we haven't had the unwind yet. So I mean the yen is a little bit stronger the last few days. I think clearly trend followers are short yen. It's been a trend for a while. I think it's actually quite an interesting trend if you look at it particularly for the yen crosses and markets like euroy yen Swiss yen I mean these have been very popular um you know bearish calls from from market commentators you know Swiss yen in particular was you know Japan's going to be hiking Swiss are going to have to cut Swiss yen goes down I've heard this argument I mean so many times in the last two years and yet it continues to trend higher so yes you know if if we have a yen carry on wind I would expect it to be negative for for for trend followers in those markets. As ever, you know, the the the full impact will depend on the speed of the move and and the context of what else is happening in in in the world. But on on the FIB side, you know, um trend followers have definitely participated in that yen weakness, which has been much more persistent and prolonged uh than I would say most people have expected. >> Yeah. uh and but maybe you could even suggest that u most of the exposure is not necessarily in outright in the end but it might be in JGB's um at the moment. So uh that's another twist uh in in that story. Great stuff. Okay, let's move on to the trend following update since we've kind of touching on this already. Uh my trend barometer finished yesterday at 39 which is on the weaker side and it is kind of suggesting a neutral to a little bit weak start to December which I think is also what we're going to discover in the um in the performance numbers uh in a couple of minutes. Um but since we just finished November I was always I'm always interested in hearing kind of your thoughts when you look at the landscape. Was there anything that stood out to you um in the month of November? December is a little bit too young so to speak to uh to have had any meaningful um stories I I think. >> Not really. No, I mean we've obviously had a tough start to the year in trend following and then a recovery and a bit of flatlining I think um uh since then. So, you know, I mean um for many managers now it's shaping up to be not certainly not as bad as it looked a few months ago. Um but but no I mean nothing um apart from what we've kind of previously discussed I'd say. >> Yeah. No I mean one thing I will because it never really gets mentioned but if I look at the landscape I would say many trend following managers at least the ones that I keep an eye on I think it was like the fifth or sixth consecutive positive month maybe the fifth pos consecutive positive month. That doesn't happen too often. Um we talk about the the difficult start to the year but there's been a lot of um you know decent uh performance um following uh the first half of uh of this year. Now from a performance point of view as of Tuesday the 2nd of December um and by the way I think yesterday was a pretty okay day for most CTAs. Um but as of Tuesday 50 was down 22 basis points for the month up 1.22% for the year. Stockgen CG index down 35 basis points for the month, down 1.64% for the year. The stock trend index down 27 basis points uh for the month, up 19 basis points for the year. And the short-term traders index down eight basis points um so far, but down 5.41% uh in 2025, which is, as I've mentioned before, based on its volatility, it's a reasonably big number. Um on the other hand, um Msei World continues to move higher, up 11 basis points so far in December. Uh up 20.72% as of last night. The S&P US aggregate bond index down 11 basis points, but up 7.1% so far this year, having a good year. And the S&P 500 um pretty flat, three basis points to the positive as of last night. Up [music] 17.84% so far this year. >> [music] >> All right, I mentioned we have two world exclusives. [music] Uh, one is coming because that is your um new wonderful paper. The other one is actually that sock genen um very kindly allowed me to share the tentative 202026 um lineup um and the aum cutoff levels they're looking at in order to qualify uh for the indices and I'm focusing on the sock gen CTA index uh which is the broader index and the socken uh trend index which is more narrow uh has fewer earned constituents. So if we look at the broader the sock gen CTA index the cutoff level for 2026 looks like it's going to be around 1.9 billion in the program. Um that means we have a few uh new people joining that index. Uh one of them is uh our friends CFM their is trends program. So that would have seen a a a decent uh significant increase in AUM I would imagine in the last 12 months. Uh congratulations. The other one is a new name for me. Um F sorry AFBI. Um never come across that name before. It turns out um that you have but also it turns out that it is uh almost a a local uh from a Don Capital perspective because they're also based in Florida. Um, so I maybe I should have known them. Um, but it is a multi-manager firm. That's probably why it hasn't been on my radar. Um, and a third program that is qualifying for the uh stock NCT index for 2026, it looks like is the cradle advanced trend program. So that's a great effort. Um it's also a little bit interesting to me because um for those of us who've been around for you know three decades more we know Crabel as for one thing and that is being uh one of the premier short-term managers but now as far as I can tell their largest strategy is no more short-term it is actually their trend following program and I think it tells you something about um the long-term viability of short-term versus long-term strategies. That is my own uh words. Of course, um they may not agree with that, but I think it's an interesting development. Now, we have some people that came into the index. That means we have some people who will be taken out of the index due to this um AUM um criteria. So we have Epistine um that is uh being removed from the index. We have another crab program. So that is their not the shortest one they have but the shorter one which is Crael Gemini. That program is being removed. Uh we have Graham tactical trend but that was more to avoid the duplication um of the Graham quant macro program um which from my understanding is have some overlap in terms of allocation to the same trend model. So um I think that was a call um that made um which makes total sense. All right, then we have the socken trend index and boy has it become difficult to be part of that exclusive group because the cutoff level I actually don't know if this is higher or lower than last year but the cutoff level uh for 2026 looks to be $4.64 billion in one strategy. That is not an insignificant amount of money in a strategy. And that means one change coming into the uh index is PIMCO trends program being removed uh is a firm that's very well known in our industry and that is systematica actually also Swiss-based um leaders firm. So um little bit of a I don't know what's your what is you what are you most surprised about? What are you most excited about Alan when you see these uh names going in and out of the index? would be pretty sad if I got excited about you know new entrance into the sock gen CTA index but I am yeah a little bit little surprised AFBI I am familiar with them I always sort of more multistrat as you say multi-manager they kind of um they're not not multi-manager as in external managers but yeah multipm model obviously um haven't been around in this current current iteration in for that long um so maybe they've just grown sufficiently in terms of AUM to to to warrant justification but certainly would be more in the uh kind of quant macro side. Um as you say you know Crael is so is multi-product not in that at all um because historically that would be obviously the the product most associated with with Crael. Gemini obviously has had um some some diminished assets lately. So probably not surprising to see that moving out. But yeah, I mean um it is interesting as you say. I mean the the AUM threshold is is very interesting that it is at such a high level this year and I guess speaks to you know how we're seeing maybe the largest trend followers getting bigger and and just consolidating um their their position in in in the index. >> So I'm not going to go through the whole CT index. That's too many names. But I can mention the 10 names that will or looks like I should stress uh looks like to be in the socken trend index that's obviously closest to my heart. Um it looks like it will be alpha simplex managed futures. It looks like it will be AQR managed futures aspect core trend graham tactical trend is vector links program man AHL alpha pimco trends trans trend DTP and the winon trend program. So, those are the ones we need to keep an eye on if you're uh in the space. Um, but hopefully also some of the names that did not make the index um this year. All right. Now, which is something we normally do a little bit earlier in our conversation. So, I'm excited about having it now after the trend following uh segment. It is your current macro view, Alan. Um there's there should be enough to focus on as a macro uh observant. Um but what have you focused on? >> Yeah, a few things I wanted to touch on. Um just obviously in the context of moving into December, a lot of focus on the Fed expectation now that we'll see a rate cut. Um maybe going back 2 3 weeks, there was a lot more uncertainty about it, but expectations have definitely tilted. Then you know obviously it is interesting that we're seeing the Fed cutting rates at a time when inflation has settled very much above target and the the kind of trajectory towards 2% the momentum has has slipped and there is a clear split within the Fed as well between those saying no this this is not really the way to go forward because you know inflation has proven stickier than expected and uh and and maybe the the the governor's There's um Waller and Williams and um and probably Powell is is ironically probably more in in the Dovish camp. But um one thing that that I saw that was interesting was the San Francisco Fed had a research piece out looking at the impacts of tariffs. Um so they did a cross uh at um sectional study uh over 40 years across different advanced economies looking at what has been you know from a purely economic perspective looking at the hard data. How have tariffs impacted uh unemployment and inflation historically and obviously the historic um changes in tariffs have been much smaller relative to what we're seeing now. But it is interesting all the same that actually what you've seen historically is um unemployment tends to to rise um straight away when tariffs come in. Consumers seem to take a step back. Actually inflation tends to fall in um but then in the year after in the subsequent two years tends to rise to a reasonable degree. So I mean it's certainly plausible. I mean a lot of commentators have been arguing uh that we could be seeing a delayed impact of the tariffs in the US economy. you know obviously wholesalers importers may have taken the hit on the on the tariffs. So I think from that perspective there is a little bit of of comp maybe complacency around the markets with this uh you know I think the Fed probably will cut but but cutting in this environment where you know you know inflation is already above target and there is still that residual uncertainty of the impact of the tariffs. Um I you know I think I think there's certainly complacency from that perspective but I think taking a step back you know just thinking about the bigger picture is interesting. You know obviously we've transitioned we've also into a new macro regime um and I think one of the things that is evident that in that regime is is the change in bond markets. And if you look at bond markets outside the US you touched on JGBs already but you know JBL's yields have been rising steadily. We've seen the same thing in in European markets, German 25 year yields up to their highest levels in in in a number of years. So, so the bond market is telling us something here I think which is interesting and and and I think it's system symptomatic of that change in regime where we've gone from this excess capital world you know when we had negative yielding uh government bonds all over the world to now this world of more positive yields and and the trend higher in an environment like you know European bonds yields trending higher without much news uh behind it and Japanese markets continuing to trend um from a yield perspective. So I think that is telling us uh that that um there are there is more competition for capital. Obviously we've had the uh extreme um you know investment in in in data centers, AI etc. and that is fueling demand for capital to an extent and on on the public side rising defense spending. But all of that together is telling you that the kind of the the the savings investment um relationship has shifted more towards you know stronger investment demand uh pushing up uh pressure on yields versus the old regime where we had excess supply pushing down yields. So I think that is a risk factor in markets. We haven't really seen it hitting the US market yet. You know tenure yields still around 4.1% or so. So the US has probably been the outlier. But certainly um certainly that is is is one thing that that that I'm focused on. And I think the other thing that I think is interesting at the moment is we we've had this a lot of people I talk to draw a parallel between now and the and the mid to late 1990s >> and say you know look at the markets tech boom um it's a productivity boom um you know um does that mean that the equity market can keep going on for another few years before we see a turn down and I think clearly there are parallels between tech stocks doing very well um but there's you know, there are differences as well. And I think even on the AI, you know, productivity side, the '90s was quite interesting because, you know, as we got into the mid to late '90s, we had the development of the internet, but that wasn't what was fueling productivity at the time. What was fueling productivity growth at the time was more use of personal computers. You know, that technology had come in previously. So you had this coincidence of an an old technology that that was starting to permeate permeate the economy and you were getting the productivity benefit on that side on the supply side but also you had the the the demand side of more uh spending on on the internet infrastructure. So if you if you compare that to today, we're seeing the impact of AI from a demand side h in the sense that there's spending on chips, spending on data center and that's actually pushing up GDP arithmetically you know that spending as part of GDP >> but the other side of the the the equation is is well are we seeing the productivity gains yet and there's mixed evidence. So there's two studies. McKenzie have done a study on this recently, the state of generative AI adoption and basically saying a lot more a lot more triing than actual use so far. Uh and there was also a a study out from um the St. Louis Fed as well looking at well are we seeing actual gains from productivity and again similar some some some gains at the margin but I think you know the people kind of sometimes misinterpreted that that kind of distinction between the demand side and the supply side yes we're seeing the demand influence but bit early to say h we're seeing the the uh supply side benefits yet um you know different views on that um so I think you know that this parallel with with 1990s is a bit superficial and the other big thing in the background and we we'll talk about a little bit later because I touch on this it's critical point in in my paper death levels are much different than they were in the 1990s. You know the debt GDP level in the US is is double what it was uh in 1999. In 1999 2000 there was a fiscal surplus in the US. So that's a dramatically different we're in a much more unstable environment now when we have this confluence of elevated um equity valuations and high debt levels. So yeah interesting that people draw that parallel but I think we're in a much more unstable and riskier macro backdrop now than we were in in that kind of mid to late 1990s period. Yeah, I mean two one observation, one question for you. Uh, regarding the AI, one of the things that kind of stood out to me was uh, exhibit one in the McKenzie uh, which I'm sure you know by heart um, in the Mckenzie paper. It was just it it looks at the um, kind of the the use of AI by the responders to their survey. And in 2017, 20% um, responded yes, which actually to me that's is surprisingly large back then. you you wouldn't have thought that but I mean today it's like 88%. I mean it just really shows you how how um how much the penetration of of at least the use of AI I mean even I would fall into that category because I do use that GBT from time to time. Anyways the other question I had and I can't remember if you answered it um because I I do find it very interesting what you say about the longer term rates and how they're not really coming down. In fact, they're creeping up and in parts of the world, they're really creeping up. I mean, do you think that a lot of that is driven by just fiscal dominance that we have now that this is what they really fear uh the market participants that politicians will simply do whatever it takes from a fiscal point of view to get through their agendas and and as you say just leave the economies um even worse off uh from a debt point of view. Yeah, I think it's a number of factors. I mean, as I said, you know, the economic explanation is long-term bond yields reflect the um, you know, supply, sorry, savings versus investment. And that this was the reason why, you know, the conundrum in Greenspan's era, you know, why were bond yields going down all the time? Because of this excess savings from from Asia and then in the 2010s, bonds went negative. Why? because there was so much capital around and the view was the technology uh firms didn't need a lot of capital you know software isn't something that that is capital intensive but now we've moved into this AI economy where there is huge capital being deployed in data centers and spending on chips and then on the public sector as you say you know we've got rising defense spending whereas was previously we had a peace dividend you know in the in the 2000s and um you know every time there's a problem you know cost of living goes up we need more fiscal support not less >> um so the political environment is uh is such that there's no appetite for uh austerity or fiscal restraint um and that's I think that's what we're seeing in that that trend hiring bondules >> yeah cool all right now let's get to the second world exclusive thanks to you again Alan um because you I've been busy uh working on uh a really terrific paper. Um I very much look forward to talking about it and I really do hope people will go and and uh download it which we'll come to later on. If you don't mind um I would like to start out by just reading two quotes that you uh start out your paper with. Uh one by a guest that I hope you will get for your uh series and the other one by a guest that you already had on your series and who's returning uh very soon. Um so uh the first one the first quote is what is the biggest single mistake investors make? It is that they conclude that the way things are today is the way it'll always be and the things that have been happening will continue to happen. That is of course Howard Mark's uh wise words. The other one is from um William White or Bill White and he says in his quote that you use these systems always break down. The lesson is be prepared. And then you and I I'm not going to steal your thunder. You uh actually also have a very very good introduction u that kind of sets out the um the backdrop um and why this paper is really something. It's a must readad uh without a doubt. Um so I think maybe it's better for you to um start out. I will uh hopefully be able to um ask a few relevant uh questions along uh the way but um I don't want to steal any of your thunder here. >> Sure. Well, maybe I'll just set out why I wrote this. I mean rather than go through it, it's a lengthy enough paper so I won't go through page by page but I'll give you a sense on why. I mean when I'm working with investors um and and whether it's family offices or institutions or high netw worth individuals there's been a few themes I think that have been recurring of late um you know things like clearly we're in a new macro regime. So does that require a different in approach from an asset allocation perspective or from a portfolio construction perspective. That's one thing you know a second thing is then you know what's the right way to think about integrating alternative investment strategies like trend following macro alongside traditional investments and then more recently we've had the growth of concepts like return stacking portable alpha um etc and how how do we thinking about incorporating those very often they're positioned as building blocks but but but what should an overall portfolio look like? So, um, these were all topics that I think I'm hearing a lot of. Um, I wanted to set out a framework for how to think about that and particularly for how to think about the the very changed macro environment. And when I talk about the the changed macro environment, it's been, you know, very apparent as we were talking about the change in the in in the bond markets. But if you take a step back, we've had we had a 40-year period of of disinflation. Um starting in the 1980s when when Vulkar raised rates and and and caused a recession, inflation has been trending down because of there was a confluence of of positive factors. There was China coming in into the world trade system. There was the Soviet Union, the fall of the Berlin Wall, you know, there was an acceptance of neoliberalism and free markets and free trade. Um there was an acceptance of the need for central bank independence and inflation targeting. And all of these things were disinflationary forces um which led to to to lower inflation and more stable inflation uh and and more stable economic growth as well. We had what was called a great moderation. Now clearly we've transitioned out of that into a new uh regime since 2020. We've had shocks with respect to co uh the Ukraine war. But not just that. There's a sense that you know inflation is going to be higher and stickier. um uh and and this is uh I suppose been reflected in a change in the bond equity correlation and all of that is is well known but I think there are other vulnerabilities in the system which I touched on earlier particularly this this uh coincidence of high debt levels at a time of high equity valuations and why is that significant well I don't hear a lot of people joining the dots on this you know but if you think about it the worst thing that can happen from a debt perspective is if we get another recession. Why? Because you need to spend more. Tax revenues goes down. You get a big fiscal deficit. And if you look at the trajectory of the US jet debt GDP ratio over the last number of decades, every time you've got a recession, you get a a step change higher. So, if you get another recession now, and why why might you you know, we've got an increasingly financialized economy. Um, you know, US households own about I think it's about $40 trillion of equities. Um so if you had a a correction in equities or a bare market of the magnitude that we saw in 20202 you know that that you know the the the former IMF chief economist was suggesting that could knock 20 trillion dollars of wealth uh alone. So you can have a much we're much more levered into the uh equity market than we were in the past. And also debt levels are already at the point of um concerns about fiscal sustainability. So that could be the the straw that breaks the the camel's back and that that increases the risks of what you're talking about from a fiscal dominance and financial repression perspective. So the question is we're into an environment where you know yes the bond equity correlation is less stable more positive. You've got a risk of uh greater risk of tail outcomes whether it's runaway inflation or or even you know a deleveraging disinflation or deflation. And at the same time you know the policy framework has changed you know central bank independence under threat etc. And all of that just underpins this um idea of uh uh you know the risk of fiscal dominance financial repression etc. So what I wanted to address in the in in the paper was one that macro change, two what are the problems with kind of the traditional approaches um the and then what's what's a new framework I mean just briefly the problems with traditional approaches are you know categorizing assets and strategies using blunt labels like alternative or traditional public private you know why you you know something like credit is also often and seen as a diversifier but actually it it it has a low correlation to equities when equities are going up but it doesn't have a low correlation it tends to be positively correlation when equities are going down so is it really a diversifying asset so um what I wanted to set out was not just the the kind of the shortcomings of um the traditional approaches but also make the case for for a stronger allocation to what I call adaptive strategies trend following being one of those. So strategies that that can respond to a more changed macro environment um systematically in the case of of of trend following obviously the likes of discretionary macro is the same and also I wanted to address um maybe a misconception maybe that's a little strong um trend following is often positioned as crisis risk offset you know crisis alpha risk mitigation so you often have portfolios where you have you equities for growth, bonds for defense, and and trend following is more in the defense category. But actually, the way I see it is they're more like the the midfielders. You know, trend following can be proactive. It can be progrowth, pro- risk at times when when the equities are trending higher. They have the flexibility to to add risk in those environments. >> But when conditions change, they have the the ability to to reduce risk and uh play more defense. So I know we you you talked about the total portfolio approach before. So basically they act in that way that the total portfolio approach is trying to achieve of pushing risk into those sectors where the opportunities are greatest. Um so in in my paper it it sets out to do two things. One set out a framework and then a portfolio suggestion for this era. And where the portfolio I suppose differs from many of the conventional approaches is it looks at things from a risk perspective. So I'm thinking um in terms of uh risk contribution not capital uh amounts and and the framework has a 40% allocation of risk to growth 40% to adaptive strategies and 20% to diversifying assets and strategies and also uses uh tools like return stacking and and leverage. Um and obviously places a primacy on adaptiveness as a key driver as opposed to thinking about trend following and adaptive strategies as just purely diversifiers. They they f they they're the mechanism by which the overall portfolio tilts its um uh risk uh posture. So within the paper there's a the chart showing you know the uh rolling equity beta of a uh of this adaptive portfolio which swings much more dramatically uh from from kind of negative to over one than say a 60/40 portfolio which has a pretty consistent 6 uh equity beta. So um I mean it came from I suppose those uh the the reason for for writing a paper emanated from I suppose those investor questions. Um I have been running a portfolio like this for my own money for a while and I've had some queries around that. So I wanted to set it out in a framework as well. Um but I do think we're at a point where you know investors are looking for an alternative framework and an alternative approach but haven't uh formalized yet that yet. So so this is really setting out to to achieve that. >> Okay. So I mean quite a lot even in that little um introduction so to speak quite a lot to uh to to dig into but I know we we have a lot more to to cover but a few things that kind of um came to mind as I was hearing you uh talking about it. We often talk about this regime change and we often talk about the changes in the absolute level of say interest rates for example. Um but even also the correlation change that we've we've noticed um which obviously you can go back uh 125 years worth of data and every time interest rates uh go above 3 4% uh the correlation tends to uh go positive. So, it's obviously nothing new, but there's one thing that I wanted to ask you, and I don't know if you've done any research on it or just maybe your gut feeling, because I think what we don't talk so much about actually the changes in inflation and inflation expect changes, meaning going from this stable, predictable inflation to this more unpredictable uh inflation environment. To me that strikes me as being quite a large challenge not just in in ordinary business planning and all of that. Um but also in in the investment world. Um, and oddly enough, I think that uh although it may not show up this year, but it could well be something that I think trend following tends to do better in those kind of environments um where inflation may not be high, but it's not stable at least. So, I don't know what what you think about that. >> I think a few things to say on that. One is given that we've already had this inflation spike um in 202122 consumers market participants everybody's more sensitive to inflation now than they were 5 years ago. You know it wasn't it wasn't a talking point in 2020. So now if you do get higher inflation people remember we had this before. So there's an an increased risk of of inflation expectations being deankered. And this is something the Fed has talked about. They've said they don't see it as a risk at the moment given that unemployment is rising, but it is something that that they see as theoretically something to be aware of. The fact that you've had that inflation episode means there's a heightened sensitivity, you know, and and obviously what what's the the the big talking point in US at the moment? It's all about affordability. Prices have stayed high even though the inflation rate has has has moderated. So So I think that's that's one thing. In my paper, I do look at instances where inflation was uh 1 percentage point above its its two-year average and 1% below. And as you say, trend following is one is the one strategy that very much stands out when you get those inflation surprises. So, I think that's definitely uh part of it. And I think as as we've touched on earlier, you know, uh the inflation fighting credibility has been squandered somewhat. I mean it was it was hard one you know Vular Greenspan in that era but now we're at risk of of throwing it out and and and the reason uh central bankers fought so hard for for independence and lower inflation was because once it became embedded in the system in the 70s it was so hard to ring out. So I think that's a very big risk and that complacency. Another question. You mentioned the total portfolio approach which we've talked about um the last few weeks on the uh on the show because of the changes happening at Kalpus. Um is there a large different from the way you think about it in your adaptive approach rather than the total portfolio approach? And if if there is, is there a way for you to kind of narrow that down and say, "Well, this is how I see this being a little bit different to um to what they're doing uh over in California." >> Yeah. Well, actually it's something I looked at um because in my and I referenc it in the paper, but the portfolio I run this adaptive portfolio um it basically uh is equivalent to kind of using a 6040 as a as a benchmark but with about an 8% tracking error whereas Kalpers are looking at about a 4% tracking error versus their benchmark which is I think 7525 right >> so I mean it's I suppose it shares that philosophy or you can view it from that total portfolio perspective but obviously with a lot more flexibility around uh you know and obviously the 640 isn't a benchmark. I'm just looking at the historic performance relative to that. >> Um so I mean the the issue with with total portfolio and I mean I think it's a good development you know it's all positive and makes sense. So I think it really just reflects the shortcomings of how large institutions were set up previously and how they did um strate strategic asset allocation. But they still start off with a with with with a um with a reference portfolio. Where does that come from and what justifies that? So um you know it's still kind of embedded in old ways of thinking up to a point albeit it gives them a certain amount of flexibility but you could have much more flexibility to deviate from from from that kind of reference. >> Yeah. The other final thing and then I'll let you uh dive even deeper into your your paper, but the other thing that I noticed you you bring up uh early on uh in your paper and that is this that you use the words traditional and alternative and and you reference them as being the labels we've become used to. And I don't know if you intended to do it or whether it's just me um reading into it, but I think there is room to really question what traditional is in this new environment, what what you know what and if you and I, which I'm sure we will in 10 years time be talking on on top traders unplugged. Um maybe we have a completely different um narrative around what is traditional in a portfolio. Um so I don't know if you intended to open that debate. Um but um and and feel free just to jump in where you want to go in terms of your >> I mean I think that's a it's it's absolutely a valid point. Um I mean the point I was making is sometimes you put a label of alternative on something and then people assume that means okay it is very diversifying. So the point is >> you know you've got assets like private equity venture capital they're they're alternative growth they're not diversifiers. So, you know, we we talk about and again public public versus private there there is this almost a kind of um insinuation that the private is diversifying but no it's not it's just a private expression of um the the same risk that you're getting in in public markets just there may it may be better or worse but it's in in a private >> um so that's why I think you know um you can have too many labels so I've I've brought it down to to growth diversifying assets and strategies but but the the But the the threshold to be regarded as a diversifier is is higher. Um and then I suppose I see adaptive strategies as a unique form of diversifiers that have that flexibility to tilt in in their risk posture. But I I think um you know one of the things I wanted to to talk about in the in in the paper is um not just the the the kind of the mislabeling but but why you know as well investors struggle to hold these pure diversifiers. Um and you know we've talked about it before. Uh JP Morgan Asset Management and GIC you have done a study on um if you are optimizing a hedge fund portfolio by itself on a standalone basis you get a different outcome than if you optimize a hedge fund portfolio in the context of a broader traditional port you know with traditional portfolio with with bonds and equity. So if you if you if you construct it on a standalone basis, you get more into convergent market neutral long short equity equity market neutral type strategies. But you're already picking up um factors that that you already have in your your uh traditional side of your portfolio. Whereas if you take a total portfolio perspective, I guess it naturally points you to the pure diversifiers which are things like global macro trend following. they actually vent commodities as well. >> Um I know David Dredge, our friend has done a lot of work in this, you know, extending it to to volatility as well. So I think that's one thing that you know this this kind of behavioral bias of viewing the portfolio in isolation or viewing the hedge fund bucket in isolation and not thinking about it in the context of the overall portfolio. But to your point, I think something that we will see a shift is we we tend to think in terms of you know buckets like um you know equities, bond, multiasset but but now we're increasingly seeing hybrids. You know we've got where you'll have portfolios including traditional assets but also alternative strategies. >> Some with leverage, some without. So how do you classify these? What's the right classification? Um and I think that's something that um you know the the current labels maybe don't account for. Um but coming back to the point to kind of the the behavioral question um I think another reason why we've seen an underallocation to these strategies historically is um is because of of the capital constraint because for a lot of people if you want more risk that naturally means more equities just to get the volatility up but as soon as you have the flexibility to use futures for for leverage or to allocate to high volatility strategies that changes that and and and don't forget Marovit's optimization was based on the idea of you find the best risk adjusted return. You blend based on the on the best asset allocation. That's what you do first and foremost and then you decide the level of risk. Do you need to borrow to lever up or do you delever to find out what level of risk? So that's that has been somewhat lost in the industry towards this just blanket oh you want more risk in your portfolio. Well, that's an 80% equity portfolio. You want less. That's a 40%. And that's not the way way it should be. So part of the what I address in the paper is one about building balanced resilience and then about thinking uh what's what's the the right risk level. Um and I think when you take it from that perspective, it's easier to see the merit of having diversifying adaptive strategies. Um and and and another shortcoming here is people often judge these strategies from the perspective of the last 15 years when we've had a you know a fantastic equity bull market which you know >> you know based on on current uh equity valuations you'd say well returns are probably going to be less going forward. So I think there's a number of factors there. Go ahead. >> Yeah. No, I was just going to ask and just maybe in a sense um putting what you just said and trying to put it into the context of what we discussed earlier on the global in in terms of the global macro. I mean what do you think the result is if I can put it that way of this structural underallocation to the let's call it the true diversifiers or the strategies that are adaptive given where we are today. What what what do you think the if you're going to characterize what what the consequence maybe the consequence is a better word of that underallocation is as we sit in towards the end of 2025 given all the global macro forces that are at play. Um what do you think the worst consequences might might be? Well, I think the obvious consequence is what you see in portfolios is a concentration in assets uh to a risk factor exposure that is tilted towards growth and stable inflation. So as I point out in the paper, if you take your typical institutional portfolio that you often see, say whether it's a US endowment or pension fund and they're they've got exposures across public equity, private equity, venture capital, private credit, maybe some hedge funds, but they might be more multistrat or equity market neutral and then they've got credit etc. They might have 10 11 12 buckets but actually if you break it down into how much of the portfolio is linked to growth it could be 80%. In risk terms it could be more than 90%. Then how much the portfolio is prepared for higher inflation. Well they might have some real estate and commodities and over the very long term equity should be uh should be able to withstand inflation but but you know as we saw in the 196682 period we had higher inflation but equities got derated amid much more macro volatility. So I think the consequence is that that that it comes back to the Howard Marx quote that you've mentioned there assuming things will always be this way that we've had this long trajectory of disinflation and steady economic growth >> but not just the issue isn't just the change in the bond equity correlation. So that's that's a key point. It's that the tail risks are underpriced. Um that that there's what are the scenarios? Obviously much higher inflation I think is is obviously a clear risk and and you know uh I spoke to Morris Obseld another former you know IMF chief economist and he was blunt saying that when a you know a major economy like this US start behaving like an emerging market runaway inflation is the obvious risk but also you know if you get a boom and and like that and then if if they eventually then hike on the on the brakes you could get a an asset deleveraging deflation and that's something that definitely portfolios are are not clear um prepared for. So I think it's those tail risks that that are that are uh the obvious uh and and it's not just um those type of institutional portfolios. If you look at you know a typical wealth management multi-asset portfolio it's always kind of the same you know 50 60% equities 20% fixed income some hedge funds but not enough small amount of gold. So it's it's about rebalancing portfolios and re reorienting them and coupled with with using the tools like leverage. >> So maybe kind of you could give us a brief overview of um so what does these allocations look like in your view? Um and of course this is obviously hypothetical returns when you've gone back and you've done your research. What do the returns look like? How are they different? um you know let's let's let's put some numbers. So yeah, I mean from a from a balanced perspective in in um the the framework that I set out, I have 40% of the exposure in growth assets in in risk terms and 20% in diversifying assets uh in risk terms and 40% in in adaptive strategies in risk terms and the reason for that is it is a growth oriented portfolio over the long term but you diversification for enhancing the risk adjusted returns and then a high allocation reflecting the changed macro environments and the risks I've been talking about actually that it the portfolio outperforms the 6040 over going back since I look I look back since 1990 >> it looks it outperforms you know uh quite a decent amount in in total returns when you compounded over time the benefit comes from the notably lower draw downs you you see in the portfolio because >> the adaptive strategies have that ability to respond during the major crisis uh such we've seen 2020 2008 and that's where you get the the the long-term benefit from a compounding perspective because in those tougher times the draw downs are limited and then when markets recover you can compound then from a higher base whereas obviously equities suffered a 50% draw down in the financial crisis something similar maybe not as strong 2020 60 was down whatever depending on the level of duration anywhere between 20 to 30% in 2022. So, it's in those environments that really impacts your long-term compounding by having having that balance and adaptiveness helps mitigate those draw downs and compound at a higher level. So, that's one important point. I mean, the second important point is that the the strategy doesn't outperform in every period or not even in every 5year period. So, you know, 2015 to 2019 was was particularly good for 6040. obviously was the year years when bond yields went to their lowest level. So you it's not about building a portfolio optimized for any particular uh scenario but it's one about thinking about what makes sense for the next 10 years when you don't know is it going to be good for equities bonds gold or trend but you know we don't know which one of those the environment will favor or will it be runaway inflation or not or just you know a return to secular stagnation but balancing all of the risks and and building in sufficient allocations to strategies that that that can respond. So, ironically, you know, the the approach has done better historically even during that kind of disinflationary period, but you would expect it's a more robust methodology for thinking about the future outcomes. >> Yeah. The other thing that I think is quite important if you think about it with a a very large lens um you know the stability in the returns that you uh show um will I think be even more important uh going forward given the fact that we have such a large uh generation of people who are getting very close or in their uh phase of retirement. So um because the worst thing that can happen as you enter retirement is that you get a big um draw down in in your portfolio. So um that in itself I think is is also very makes it very relevant uh for people to uh to take a closer look. I'm sure they can get many more details uh if they engage with you directly Alan in terms of how do we get these wonderful uh returns. if we were going to make a few conclusions and of course do not forget to tell us uh where they can download the paper. Um I'm sure there's going to be a long delay because it's such an exclusive pro announcement on on the on the top traders unplugged uh podcast but it could it be ready right after people listen to this conversation of course. But um but before we get to that um what what what should the main takeaway be from people who have been listening to us uh today would you say from from this um new way of thinking and building uh portfolios and and is it something you would consider setting up so that people could just buy the ticket from you? That's yeah I mean I think first and foremost it is a it's it's a proposed architecture a proposed framework for thinking to to to to challenge I I guess the consensus around the traditional labels etc. So I mean that was part of my motivation for for sure. So, so to think more in terms of risk terms, not just uh notional allocations, to think about the the building blocks that are available in terms of you know uh futures or return stack type products or portable alpha uh and to think about you know um if you can combine um adaptive strategies within a portfolio, you can overcome some of those behavioral biases that that make it difficult, you know, for practical reasons for for investors to hold them. So I think that that that's the really the um the uh call to action I guess to to investors. So the paper will be on uh the archive capital website archivec capital.ie. So have been heavily motivated to get it finished cognizant that we we would talk about it today. So it'll be on the website uh from from when this is released. And um yeah I mean I've had some interest uh in this approach. So it's certainly something that uh we're exploring uh in terms of executing as a strategy. So um you know certainly keep tuned uh we we may have more on that in time. >> Fantastic. Good stuff. Now you mentioned just before we wrap up completely, you just mentioned uh in passing um you know return stacking or portable alpha strategies and I couldn't help uh watching um or or reading uh briefly a note uh on LinkedIn um by uh another great uh industry participant Cory Hoffine um who and I'm not an expert in this area. it's not an area that really affects me directly. Um, but it has become very popular these return stacking portable alpha products. And then he mentioned that a small change in name or labeling by the likes of Morning Star has actually had quite a large or could potentially have quite a large impact on these uh products. I don't know if you read the note uh that Cory wrote um but it has something to do with how some of the authorities um uh rank or or or how should I say view these products when you uh when you use quote unquote leverage. And if you put the word leverage into the um labeling, then that becomes a problem for many platforms to even carry those products on their uh on their platform. So maybe you have a better way of describing what I was trying to say here. I just had a read of it as you sent it to me. It sounds like um I hadn't been aware it was an issue. Um so morning links are have come up with a new category it seems for for for products like return stacked uh products um uh I think it's levered multiasset or something like that um which you know we all know the label leverage can have negative connotations uh for for some investors even though there's leverage in lots of places um that you know um you get operating leverage from certain companies you know it's not an issue you get to different degrees, you know. Um, so I think um what I what I what I thought was fair is from Morning Star's perspective is is I do think the labels need to be reconsidered. But maybe something like unconstrained multiasset might be a better reflection of what um these types of strategies seek to do in the sense that you know multiasset traditionally in a European sense would be more often long only you know long equities, bonds, property etc. Once you start to integrate alternative strategies with traditional assets you're you're getting long and short dynamic exposures and leverage. So I see that as being more unconstrained multiasset. So admit that's my suggestion for Morning Star. >> Just again listening to you talking about that um going back to uh our very first part of our conversation uh with the company strategy which we know is not really known for being an IT company anymore but actually a 3x levered version of Bitcoin um as far as I know. I mean I could be wrong about the the the leverage amount but anyways um I wonder how Morning Star classifies that. uh is it just classified as an equity or is it classified as something with leverage? Uh which I'm pretty sure um people would say that's probably what's going on in here. Um anyways, um interesting an interesting uh post that uh Cory had about that and the quote unquote kind of uh uneven treatment of some of these products perhaps uh in when it comes to labeling. Well, I think that wraps up a wonderful uh conversation. Um Alan, so first of all, let me just um encourage everyone listening to really show their appreciation for uh not just uh you writing a paper that they should go and read um but also just um all the preparation that goes into these conversations. So um you can do that by going to your favorite podcast platform and uh find the podcast and leave a rating and review and say of course how great Alan is as a co-host. Um, and in fact, he's so great that he's going to come back next week and he's going to host uh the uh the the the the show um along with Mark. He's going to be joined by Mark because I will be traveling to um to Florida next week. And so um yes, that's going to be another great uh episode for people to tune into. Um I think that's going to wrap up what we um had planned for today. Thanks ever so much from Alan and me. Thanks ever so much for listening. We look uh of course forward to being back with you next week. And as usual, as always, in the meantime, take care of yourself and [music] take care of each other. Thanks for listening to Top Traders Unplugged. If you [music] feel you learned something of value from today's episode, the best way to stay updated is to go on over to iTunes and subscribe to [music] the show so that you'll be sure to get all the new episodes as they're released. We have some amazing guests lined up for you. And to ensure our show continues to grow, please leave us an honest rating and review in iTunes. [music] It only takes a minute and it's the best way to show us you love the podcast. We'll see you next time on Top Traders [music] Unplugged.