2024-03-13

Secrets of Private Equity, Cocoa Trends & Optimal CTA Portfolio Weights

Overview

This episode is a must-listen for anyone interested in investment strategies, financial market structures, and the intricacies of futures contracts.

Key Topics

Return Stacking, Managed Futures, Diversified Alternatives

Introduction

In this episode, the team is back with Corey Hoffstein, CIO of Newfound Research, Adam Butler, CIO of ReSolve Asset Management Global, Michael Philbrick, CEO of ReSolve Asset Management Global, and Rodrigo Gordillo, President of ReSolve Asset Management Global. They delve into a myriad of investment topics, providing valuable insights into the world of finance.

Topics Discussed

  • Discussion on the structure of pre- and post-2008 alpha and its impact on financial markets
  • Exploration of the dynamics of private equity and hedge funds in institutional portfolios
  • Insights into the replication of Managed Futures with nine contracts
  • Understanding the total return vehicle of futures contracts and the embedded cost of financing
  • Examination of the impact of the inverted yield curve on futures and stacking
  • This episode is a must-listen for anyone interested in investment strategies, financial market structures, and the intricacies of futures contracts. Tune in to gain valuable insights and strategies to navigate the complex financial landscape.

This episode provides valuable insights into the concept of return stacking and its potential in enhancing portfolio returns. It is a must-listen for investors interested in diversification strategies and the future of investment management.

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Summary

In the world of finance, risk allocation plays a crucial role in shaping the success or failure of a trading strategy. Quantitative Trend following managers employ a strategy where they allocate risk budget in a quantitative manner, leading to smaller position sizes as market volatility increases. This approach can contribute to diversified risk and better risk management during years with no clear market Trends. However, during years with strong Trends, it may limit profit potential compared to a concentrated portfolio. Take for instance, the Cocoa trade. Large percentages of Q1 returns were driven by the Cocoa industry, providing significant profits for firms like Mulvaney. While traditional Trend following managers would allow their investment to grow as long as the Trend persists, quantitative managers would react to the increased volatility by reducing their position size. In such instances, the open interest in Cocoa could hamper exit efforts due to the substantial slippage resulting from holding more than 10% of the daily volume of Cocoa. The debate on the allocation percentage towards Trend following strategies in a traditional 60/40 portfolio is a contested one. Some suggest a 63% allocation for effective risk management and offsetting losses in years with unclear Trends. Yet, strong Trends can yield significant profits from concentrated portfolios. Importantly, the size of the investment universe can also impact the performance of Trend following strategies. Larger funds may have more room for diversification while smaller ones might see substantial effects from a single trade. Trend following strategies can complement a traditional 60/40 portfolio, especially if the allocation mechanism is adjusted to maintain a balanced risk profile as the portfolio grows. However, implementation can be challenging due to behavioral vulnerabilities and the potential for significant drawdowns. Additionally, the choice between classical and quantitative Trend following strategies can influence outcomes, as each approach has its strengths and weaknesses when dealing with market volatility and trade exits. In the aftermath of the 2008 financial crisis, institutions have been shifting from equity to private equity. This shift allows them to introduce portable alpha without managing leverage in their portfolios, effectively stacking alpha. Private equity offers volatility laundering and leverage without the associated risk, allowing for greater freedom in capital allocation to hedge funds. However, it’s worth noting that private equity may lack the same level of liquidity and transparency as publicly traded securities. In conclusion, Trend following strategies can significantly enhance portfolio performance, but careful risk management and consideration of factors such as position sizing, investment universe, and the potential for drawdowns are essential. The shift towards private equity offers opportunities for leveraging without managing it directly in portfolios, but concerns remain regarding liquidity and transparency. As with all investment strategies, understanding the dynamics of the markets and the nuances of various trading strategies are key to making informed decisions and managing risk effectively.

Topic Summaries

1. The impact of Quantitative Trend following on portfolio allocation

Quantitative Trend following managers allocate risk budget in a quantitative sense, resulting in smaller position sizes as volatility increases. This can lead to more diversified risk and better risk management in years with no clear Trends. However, in years with strong Trends, having a concentrated portfolio can generate significant profits. For example, Mulvaney profited massively from the Cocoa trade, with a large percentage of their Q1 returns driven by Cocoa. Classical Trend following managers tend to allocate a certain amount of capital to a trade and let it grow, while quantitative managers allocate a certain amount of risk budget. As Cocoa’s volatility increased, quantitative traders reduced their position size. The open interest in Cocoa also played a role, as some Trend followers held more than 10 percent of the daily volume of Cocoa, making it difficult to exit the trade without significant slippage. The dispersion between classical and quantitative Trend followers is evident in their drawdowns, with classical Trend followers experiencing larger drawdowns. Diversification across more markets can be beneficial in years with no clear Trends, as it allows for offsetting positions. However, in years with strong Trends, having a concentrated portfolio can lead to significant profits. The allocation of Trend following strategies in a traditional 60/40 portfolio is a topic of debate, with some suggesting a 63% allocation to Trend following.

2. The role of diversification in risk management

Diversification across multiple markets can help offset losses and manage risk. In years with no clear Trends, having a diversified risk budget can be beneficial. However, in years with strong Trends, a concentrated portfolio can generate significant profits. For example, having a few markets to trade, like Cocoa, can result in substantial gains if the Trend is in the trader’s favor. Classical Trend following managers tend to allocate a certain amount of capital to a trade and let it grow, while quantitative managers allocate a certain amount of risk budget. As Cocoa’s volatility increased, quantitative traders reduced their position size. The open interest in Cocoa can wreak havoc on the dispersion of funds within an index, especially for funds with a small investment universe. Large Trend followers with a limited number of markets or a large size are constrained in the amount of capital they can deploy to any single instrument. This constraint minimizes the impact of a single trade on a large index. However, for smaller Trend followers or those trading their own PA, conviction weighting and a larger tolerance for drawdowns can lead to alpha generation. In years with no clear Trends, diversification across more markets can help offset losses and find positions that offset the P&L. On the other hand, in years with strong Trends, having a few markets to trade can result in the majority of profits. The portfolio as a whole operates with offsetting positions that can dramatically change as market dynamics change.

3. The value of Trend following strategies in a portfolio

Trend following strategies, such as managed futures, can provide alpha and complement a traditional 60/40 portfolio. Allocating around 63% to Trend following in a 60/40 portfolio has been suggested as an optimal allocation. For example, the ‘Honey, I Shrunk the Trend Following’ article recommends a 63% allocation to Trend following in a traditional 60/40 portfolio. Trend following strategies have been found to outperform Trend indexes in terms of alpha, especially for smaller portfolios with a high tolerance for drawdowns. As portfolios grow larger, the allocation mechanism needs to be adjusted to maintain a balanced risk profile. The performance of Trend following strategies is influenced by various factors, including exposure to bonds and commodities. The SocGen Trend indicator, for instance, has shown that long positions in the energy complex and gold and silver have contributed significantly to portfolio returns. While Trend following strategies may appear to have concentrated positions in certain assets, the risk is often offset by other positions as market dynamics change. Overall, Trend following strategies have been shown to enhance the performance of a traditional 60/40 portfolio and can be a valuable addition to an investment strategy.

4. The challenges of implementing Trend following strategies

Implementing Trend following strategies can be challenging due to behavioral vulnerabilities and the potential for significant drawdowns. Investors may allocate to Trend following during market peaks and then panic and sell during drawdowns. This can result in significant losses and missed opportunities for profit. The dispersion between classical Trend following and more quantitative Trend following strategies is also a factor to consider. Classical Trend following managers tend to allocate a certain amount of capital to a trade and let it grow, while quantitative managers allocate a certain amount of risk budget in a quantitative sense. As a result, quantitative managers may scale back their position size as volatility increases, which can help manage risk. On the other hand, classical Trend followers may experience larger drawdowns and have difficulty exiting trades when they become too large. The size of the investment universe can also impact the performance of Trend following strategies. Funds with a smaller investment universe may be more affected by the performance of a single trade, such as the Cocoa trade mentioned in the discussion. In contrast, funds with a larger investment universe may have more diversification and be better able to offset losses. Overall, implementing Trend following strategies requires careful risk management and consideration of factors such as position sizing, investment universe, and the potential for drawdowns.

5. The use of private equity to introduce portable alpha

Institutions have found a way to introduce portable alpha without managing leverage in their portfolios by shifting from equity to private equity. Private equity returns can be equivalent to levered equity returns, providing volatility laundering and leverage without the risk. This shift has allowed institutions to allocate freed-up capital to hedge funds and effectively stack alpha. The insight is that post-2008, institutions were able to move from equity into private equity, shrinking down the equity piece and allocating that freed-up capital to hedge funds. By doing so, they are effectively reintroducing portable alpha in a structure that allows them to stick with it. The ability to allocate to private equity gives institutions implicit leverage, which they can then use to allocate to hedge funds. This strategy allows them to stack the hedge fund alpha in the same way they were able to pre-2008 with portable alpha. The key is that private equity provides the liquidity and transparency that institutions desire, allowing them to make their bets as liquid as possible. This is in contrast to illiquid investments that may not offer the same level of transparency and liquidity. Overall, the use of private equity as a means of introducing portable alpha has allowed institutions to optimize their portfolios and allocate capital in a way that aligns with their investment goals.

6. The importance of liquidity and transparency in investment strategies

Investors and advisors should prioritize the liquidity and transparency of investment strategies. The discussion highlights the importance of considering these factors when evaluating different investment options. One aspect discussed is the allocation of institutions to hedge fund strategies and private equity. It is noted that institutions have shifted a significant portion of their equity into private equity post-2008. This move allows them to effectively introduce leverage without managing it directly in their portfolios. However, private equity investments may lack the same level of liquidity and transparency as publicly traded securities. Another point made is that private equity returns can be seen as equivalent to leveraged equity returns, but with reduced risk. This volatility laundering and risk reduction make private equity an attractive option for institutional allocators. However, it is acknowledged that the ability to have liquid and transparent investments is preferred by skilled investors like Swensen. The discussion also touches on the importance of competitive market forces in driving hedging trades to parties with access to cheaper financing. This highlights the role of cost of financing in investment strategies. Overall, the conversation emphasizes the need to consider liquidity and transparency when making investment decisions, particularly in relation to private equity and other alternative strategies.

7. The pricing and replication of futures contracts

Futures contracts are priced based on the cost of replicating the underlying asset. The pricing of futures contracts is determined by the principle of replication, where the price of the derivative instrument is derived from the price of its replication. This means that the price of a futures contract is not influenced by the market’s view of the future, but rather by the cost of replicating the trade. For example, when pricing a 10-year U.S. Treasury note futures contract, the cost of financing is embedded in the futures price. The larger the coupon, the lower the value that a buyer would be willing to pay, as the coupon will be earned in the price return of the futures contract. Similarly, the cost of financing in S&P 500 futures may be higher due to the uncertainty of dividends. The pricing of futures contracts is influenced by competitive market forces, with the trade being driven to parties who can execute at the cheapest cost. For Treasury futures, big banks with access to overnight repo can offer cheaper financing, resulting in lower financing costs for these contracts. In contrast, the cost of financing for S&P futures may be higher due to the challenges of executing the arbitrage trade. Overall, the pricing and replication of futures contracts are based on the cost of replicating the underlying asset and are influenced by competitive market forces.

Transcript

[00:00:00]Corey Hoffstein: All right. Here’s my hot take. So if you look at private equity returns, they are basically equivalent to 150 percent levered equity returns, with all the beautiful volatility laundering and all of the leverage taken away from the risk. If you look at how institutions are allocated, on average, they still hold seven to like 15 percent in hedge fund strategies, alternative hedge fund strategies.

But a huge swath of equity has gone into private equity. I am of the view that post 2008, they were able to move from equity into private equity, shrink down that equity piece by holding private equity, which is giving them the implicit leverage, and allocate that freed up capital to hedge funds.

And if you unwind and look through, they’re effectively stacking the hedge fund alpha the same way they were pre-2008 with portable alpha. It’s just, they’ve come up with a structure by which they can stick with it.

[00:00:56]Rodrigo Gordillo: I mean, the insight is bang on. I sincerely…

[00:01:01]Corey Hoffstein: I’ll go get my tinfoil hat.

[00:01:03]Rodrigo Gordillo: … that it was done explicitly.

[00:02:23]Rodrigo Gordillo: Alright everybody, back again. The whole team, Episode 2 of what we are now calling the Get Stacked Investment Podcast. Today we are joined with Corey Hoffstein, CIO of Newfound Research, Adam Butler, CIO of ReSolve Asset Management Global, Michael Philbrick, CEO of ReSolve Asset Management Global and myself, President of ReSolve Asset Management Global, and we have a lot of interesting topics, Return Stacked topics to talk about today. How’s everybody doing?

[00:02:51]Corey Hoffstein: First topic of the day, Rod, where did the name Get Stacked come from? Who, which one of you geniuses was that one?

[00:02:58]Rodrigo Gordillo: Of course, like, are you kidding me? Mike, show me your biceps.

[00:03:04]Mike Philbrick: Yeah, okay, you can see the upper pecs right through the shirt here. Come on.

[00:03:07]Adam Butler: That’s…

[00:03:08]Rodrigo Gordillo: It’s got to be from…

[00:03:09]Corey Hoffstein: I feel like that’s an attack at…

[00:03:10]Rodrigo Gordillo: … professional football player.

[00:03:11]Mike Philbrick: By the way, how is your pec tear doing?

[00:03:12]Corey Hoffstein: Yeah. For those who don’t know, I tore my pec off about three months ago. I, you know, it’s still not there, so…

[00:03:19]Mike Philbrick: Oh, no, well…

[00:03:20]Rodrigo Gordillo: So it’s still not there, meaning it was supposed to, it’s supposed to kind of grow out again?

[00:03:25]Corey Hoffstein: Oh no, it’ll never…

[00:03:26]Rodrigo Gordillo: Like a lizard?

[00:03:26]Corey Hoffstein: I am permanently impaired. My bodybuilding career is over. I cannot get stacked.

[00:03:32]Rodrigo Gordillo: Awesome. Speaking of competition, one of the big topics that came up in the last month or so has been how are the Trend replication CTAs competing against Cocoa and that massive run up that we’ve seen, as well as the Bitcoin run up, right? Those two markets really took the world by storm in the first quarter of 2024, and I think the big question is, Trend replication seems interesting. Seems like it’s a thing that would work when you’re dealing with major asset classes, pretty fantastic. But what if your best market or the best markets of the deep traders ends up being the only P&L that you see?

So anybody have, I know we’ve all kind of talked about it and tweeted about it. But Corey, you wrote up some of this content. Why don’t you start us off with your thoughts in that space?

[00:04:26]Corey Hoffstein: Yeah, first let’s acknowledge, I mean, firms like Mulvaney who are profiting massively from this trade, I mean, I think they’re up, correct me if I’m wrong, north of 120 percent in Q1, a huge percentage of which is driven by Cocoa. And I think it shows the dispersion between classical Trend following and more quantitative Trend following or classical Trend following. Managers tend to allocate a certain amount of capital to a trade and let that trade grow, whereas quantitative managers allocate a certain amount of risk budget in a quantitative sense. And so what you’ve seen is as Cocoa went to the moon, so did its volatility, which meant for more quantitative traders, that position size got smaller and smaller. And if you actually look at the open interest in Cocoa over time, it peaked and has since declined, even though that Trend got stronger.

And so I think you can see a lot of quantitative traders haven’t necessarily captured the fullness of the Trend because they didn’t do what more classical Trend followers have done since the seventies, you know, really doing that sort of outlier hunting type trade. So I think it just highlights again, in theory, we’re all Trend following, but the ways in which Trend following is done can lead to massive dispersion.

And one of the questions we received all throughout Q1 was, well, if you’re missing these trades like Cocoa, or I think Wheat was another really big short in Q1 that played well, or long Crypto. You know, if you’re not trading those markets, can you still replicate the performance of the industry at large?

If you’re looking at returns like the Barclays top 50 or the SocGgen Trend Index or the broader SocGen CTA Index. And I think the results are an emphatic yes. One of the simple tests I did is I said, well, rather than seeing whether the process works from, you know, there’s a lot of statistical noise, but like if I just had a crystal ball and I could look forward in time and use just nine key futures markets, things like U.S. Equities and Gold and Oil and sort of the major markets, and I wanted to replicate the future returns of something like the SocGen Trend Index, how close could I get? Because in theory, that SocGen Trend Index is made up of players who are trading things like Cocoa. And the answer was with the crystal ball, with just nine factors, you could get very, very close to replicating those returns. So, you know, I think there’s a lot of potential reasons why that’s the case, which I’m sure Adam probably has a…

[00:06:57]Adam Butler: Well, what does that mean when you get close to replicating the returns?

[00:07:00]Corey Hoffstein: Yeah. So basically, like as a very simple test, what I did is I said, well, February was a month, for example, where Cocoa, spectacular returns. I looked at the SocGen Trend Index, daily returns of the SocGen Trend Index, and I said, let me formulate one portfolio. Looking at those four returns, let me use these nine futures markets and come up with a replicating portfolio that I’m going to assume I’m going to hold constant throughout that whole month, just to try to track that Index closely. And the daily returns were very, very close. The daily correlation was spot on. The total return of the period was very close.

In other words, you know, suggesting there wasn’t a huge amount of change in the replicating portfolio over that period of what it took to track that Index, but also that you didn’t need to trade anything more than these nine major contracts to have actually replicated the returns. Again, if you had a crystal ball, we don’t always have a crystal ball, or if you do, mine’s pretty cloudy, but it wasn’t like not having Cocoa was not meaningful, in terms of not being able to realize the result.

[00:08:04]Adam Butler: Yeah, so I mean, one, first of all, it’s like one month, right? So it’s one major Trend breakout, Cocoa

[00:08:12]Corey Hoffstein: The way, I should mention March was the same. So February and March, same, same.

[00:08:15]Adam Butler: Two months and I think this also illustrates that you know, most of the, keep in mind, right the Trend Index and the CTA Index are both, they track the largest managers. Several of these managers are in the billions of AUM, right? And so, and, you know, they may trade a smaller number of markets. You know, not all large Trend followers trade 400 markets. Some of them trade much less, like, you know, Dunn is on the record as trading a more limited universe of markets, right?

But when you trade a lot of markets, or when you’re a very large size, you’re going to be constrained in the amount of capital that you’re going to be able to deploy to any single instrument in the portfolio, right? So it’s just not going to, on an isolated basis, have that much impact on this large AUM-weighted Index, right? Obviously going to wreak havoc on the dispersion of the funds within the Index over that timeframe, because there’s going to be some funds that have relatively small investment universes. You know, they trade only a couple dozen securities, for example. Like, Mulvaney is kind of on the record as, they only trade like less than 30 markets, right? Cocoa is one of them. Well, if you trade less than 30 markets, and one of the markets you trade has a bonanza Trend, and like you say, you don’t scale back your risk as the vol of that Trend takes off and as that position in your portfolio begins to represent an excruciatingly large amount of the total portfolio, you can envision, over two or three months with a Trend as large as the Cocoa Trend, you put the Trend on at a certain level of risk, two weeks later, three weeks later, the position has grown massively, relative to all the other positions in the portfolio. It may even represent like, be larger than the portfolio was before you put it on that single position. And now that position is completely wagging the dog of the entire portfolio, right?

So you’ve got managers like this that, they happen to trade the market that broke out, they caught the Trend, they didn’t scale back the risk. And then you’ve got these multi-billion dollar funds that may trade Cocoa, one of a few hundred positions, or because they’re so large, it actually can only be a very small proportion of their total portfolio, et cetera, and that will dictate the relative performance within that Index in that time period, right?

[00:11:05]Mike Philbrick: So there’s a lot of luck.

[00:11:05]Adam Butler: … the surface.

[00:11:06]Mike Philbrick: There’s a lot of luck in there. And I think something that’s tragically underreported is the fact that Cocoa before this occurrence, didn’t Trend. It is one of the worst Trending assets for consideration. So how many people were still getting their face ripped off trying to get a Trend in Cocoa when it didn’t happen? And what were the deleterious effects of getting chopped and sliced and diced while trying to follow a Trend following situation in Cocoa for 20 years? It’s quite possible you just made back all of the money that you lost over a couple of decades of trying to follow a Trend in Cocoa and have been losing two, three, four, five, six percent a year, hidden in the context of your other assets, right?

So when you look at Cocoa, and you look at the personality of Cocoa, it had not Trended for a couple of decades, and so there was an albatross that those funds that were using Trend on that particular asset class carried. And some of that they got back. And some of that may have been profit above that. We don’t really know. It’s great when lightning strikes though and everyone wants it and it becomes a topic of conversation.

[00:12:25]Rodrigo Gordillo: It’s a great question.

[00:12:26]Mike Philbrick: Before we get into, I’ll just, one last thought…

[00:12:28]Adam Butler: Really good …

[00:12:29]Mike Philbrick: … out to you guys, is this also gets into the dispersion around the asset managers and replication, versus trying to pinpoint managers. So I’ll throw that back to you guys to…

[00:12:38]Corey Hoffstein: I got some numbers here just to, can I throw some numbers out? All right. So Mike, to your point, going back, so one of the things I actually love to look at is the SocGen Trend indicator. I’m not sure people are aware of what the SocGen Trend indicator is, but it’s a replication Index that SocGen created, that’s a very simple rules-based indicator. And you can look up the SocGen Trend Indicator on Google, and it will take you to a page that shows you all the things they’re trading with are long and they’re short. And you can click on each contract and it will tell you the cumulative P&L over time, and they take it back to early 2000s.

And Mike, to your point, from 2000 to 2022, Cocoa had not made any profit. It was down. Now it was a contribution to the total strategy. The cumulative contribution was negative 250 basis points. It then, from the bottom of 2022 until March this year, finally got back to break even, and I think is now at plus 1.5. So it took, you were underwater for 22 years and going lower. That was all unwound in a year and a half. So to your point, this was one of the worst Trending commodities markets, I think ever.

[00:13:49]Rodrigo Gordillo: And in fact, I know some, so talking about who’s benefited from this and who hasn’t, there has been a handful of CTAs that booted Cocoa out, because it clearly had some sort of seasonality, according to them, that didn’t lend itself to Trending.

[00:14:03]Mike Philbrick: I wish I had never fallen prey to that.

[00:14:05]Corey Hoffstein: Yeah. Who I wish never used seasonality as the lesson there.

[00:14:09]Mike Philbrick: I wish it, it’s not even seasonality. It’s just, this is a hard behavioral thing.

[00:14:15]Corey Hoffstein: So, let’s talk about the traditional Trend followers versus the Quants here. So shout out to Scott Phillips on Twitter, Because he wrote about this, and I think this is a really great point where he said, in the last year, Cocoa’s prices, when he wrote this on April 8th, so two weeks ago he said, Cocoa’s price is up 4X on the year. Cocoa’s vol is up 40X, right? So think about that. If you’re a Quant trader, the position size you would have put on a year ago, if you did not unwind that position at all today, the position size is now a hundred and sixty times what the initial position size would have been that you would put on today on a vol-adjusted basis.

Like, if you were saying for the same risk size, it’s a hundred and sixty times what you would put on today, right? Mulvaney, right? So this trade that keeps growing and growing and growing, Scott sort of backed out Mulvaney’s position size. If you assume that most of the profit in March came from Cocoa, which he’s an allocator to Mulvaney, and he said the majority of it looks like it came from Cocoa. He said that their position went up $109 million for the month. Basically means that the entire notional value of Mulvaney’s Fund right now is in Cocoa. That position size has gotten so big and they hold more than 10 percent of the daily volume of Cocoa. Like, their ability to exit this trade is very limited.

There’s a significant amount of slippage that would happen if they tried to liquidate. So again, you know, like you have a great win. Kudos to them, up and up 124%, but funds that tend to operate like that also, and there’s a great RCM article about this, about the sort of classical Trend followers tend to have much more significant drawdowns than the more quantitative Trend followers who again called…

[00:16:06]Mike Philbrick: The momentum, there’s the drawdown at the end of the Trend, at the, it’s, there’s…

[00:16:10]Corey Hoffstein: Yeah, you know, Mulvaney, EMC, Dunne, Chesapeake, all great Trend followers, all except for actually Chesapeake. I think their max drawdown is around 30. The rest, drawdowns between 50 and 60%, you know…

[00:16:23]Mike Philbrick: I mean, and to some degree that’s for the allocator and advisors to see a position size that’s doubled, and to now reweight that within the portfolio, spreading that across the other Trend followers, or spreading that across the other asset classes. That’s the right thing to do here. You have something that’s gone up that and that much in the portfolio now represents more risk in the portfolio. So allocators should not, well, I will leave it to the allocator to decide, but in a rebalancing scenario, you would rebalance back.

[00:16:54]Corey Hoffstein: But think about if all of a sudden, Mulvaney starts to get a bunch of people who are saying, well, I want to rebalance, right? That’s, the curse of winning is that’s where the capital comes from. So you get a bunch of redemptions because you won and they have to start cutting their position size.

[00:17:07]Mike Philbrick: Rebalance early.

[00:17:09]Corey Hoffstein: Right.

[00:17:09]Mike Philbrick: And advisors, rebalance early. You don’t want to be…

[00:17:12]Corey Hoffstein: All of a sudden, they’re going to impact the Cocoa price because they have to start selling some of that position off.

[00:17:18]Rodrigo Gordillo: What’s been interesting about all of this too, is that when we talk about Cocoa, there’s actually two Cocoa markets, right? There’s London Cocoa and there’s U.S. Cocoa. And one of the things is we dug deep into this is what we found is that U.S. Cocoa tends to not have auto-correlation, or has not exhibited autocorrelation for this whole period of time. But yet London Cocoa does have positive autocorrelation. So if anybody was, yeah, and they do look similar if you just kind of eyeball it, but you’re, you are able to find a positive P&L. In London Cocoa, using traditional Trend models in a way that you wouldn’t with U.S. Cocoa, and that tends to what we, when we did some analysis, we found that the 30 percent, around 30 percent of the variance between U.S. Cocoa/London, or the difference has to do with, it can be explained by seasonal effects, which we’re going to dig deeper into in our research. But I thought that was also interesting, right, that it wasn’t that one, it, one has worked and one has not in a traditional CTA sense.

[00:18:19]Adam Butler: I think that the take home, because it can sound a little bit like we’re beating up Mulvaney, I have to say, I would not have the risk tolerance for that. That’s way outside my comfort zone, but kudos. Everyone that invested in Mulvaney, presumably understood the way that they invest, and they absolutely hit it out of the park and, you know, should be congratulated, but it does serve to highlight some of the major differences in construction and the randomness that’s involved in the results of different Trend strategies from month to month, year to year, et cetera, right, which makes it just really hard to judge what was skill and what was luck and over, even very long stretches of time. So, emphasizing again, the importance of having a deep understanding of process and expectation, rather than trying to make decisions based on past performance. Yep.

[00:19:25]Mike Philbrick: And you can allocate to 20 different Trend followers and reallocate and rebalance between them, that’s one set of circumstances. If you’re a registered investment advisor and has, wants to put some Trend in, and wants to think about getting something that’s going to capture the kind of meatiness of that muscle movement, right? I want to be kind of in the middle of distribution. I don’t want to be on the high end and I also don’t want to miss the whole thing. So thinking through that process, you’ve got to kind of pick your products slightly differently, or your allocation mechanism.

Sorry, Rod…

[00:19:59]Rodrigo Gordillo: Yeah, no, I was just going to emphasize, I was going to say a similar thing, that we’ve got to define what the value of the different approaches are. When I talk with, there’s a few Trend followers that just trade their own PA, let’s say, you know, a few million dollars of their own PA, they’re not constrained by any sort of quant risk management necessity. They have a large tolerance for drawdowns. They will be conviction-weighted often, and they do exhibit some alpha. When I’ve looked at their performance, they are still 90 percent correlated to the Trend Index, but they do outperform it from an alpha perspective. Now, as you get bigger, you can still do that, especially if you’re able to trade different markets or look at different types of Trends, blah, blah, blah.

But when you’re looking to, when you’re looking at Trend replication strategies, what you’re really trying to capture, like you said, Mike, is that kind of big muscle movement, the thing that is something that is, does it have a positive risk premium? Why is it non-correlated? When you need it to be the most non-correlated, does it provide that offset when it does, and largely speaking, the big handful of asset classes within a Trend following strategy is likely to be able to capture that going forward, right?

It doesn’t need Cocoa in order to provide those characteristics. And so yes, you can find alpha, it’ll be in the smaller end, it’ll be the guys that trade different markets. And then sometimes when it’s, not all of them, but I’ve seen condition-weighted very CTAs make a lot of money over time doing…

[00:21:25]Mike Philbrick: Hell yeah. That’s super hard when it’s that…

[00:21:28]Rodrigo Gordillo: … to get an allocation,

[00:21:29]Mike Philbrick: When it’s that hard, try to keep an allocation through, you know, 20 years of minus two and a half percent contribution of Cocoa, like it, those are, I definitely believe they have premium, because that’s hard as, that’s hard AF.

[00:21:44]Corey Hoffstein: I just, to add a point on the replication front though, because there was another piece of research I wanted to highlight that came out in Q1 from Quantica, which is another Trend firm. And I thought they had some really fascinating research on this idea of like how many markets do you need to trade? Are you a better Trend follower if you’re doing 15 versus 25, versus 50, versus 100 markets. Now the way they did this was they had very generic Trend following rules and much more of the quantitative style of Trend following, much less of the Mulvaney. By the way, I certainly didn’t mean to be dismissive of Mulvaney.

They, talk about absolute iron stomach to sit through that risk. I couldn’t do it. But, so what they did is they said, let me come up with these generic Trend following rules, and then let me run those same rules using a 15 market approach, a 25 market approach, a 50, a 100, and how does the performance compare in different years?

And the lens with which they looked at it, at that performance through, was based upon what they called the number of independent bets driving the P&L. So let me give a concrete example of what that means for, you know, in 2022, we saw that short bonds and long the dollar were both very profitable trades. The U.S. dollar were very profitable trades and Trend following, but they were pretty much perfectly correlated trades. It’s kind of two sides of the same coin.

So what they use is they use the statistical technique to say, well, those, yeah, they were different markets, but it was actually just one trade being expressed two different ways. We’re going to call that one risk factor. And so they use this statistical technique to do it. If you read their Q1 paper, they talk about how they do it. And what they found is really interesting, which was, in the years that are driven by just a few strong independent risk factors, one, those tend to be the years of the highest return of Trend followers. So years like 2022, where there are very strong Trends.

And two, if you have just, if you’re trading just 10, 15 markets, you likely captured it and captured it well, because more of your risk budget ends up going to those Trends, versus if you’re trading a hundred markets, and 90 of the markets that you’re trading are unrelated to that short-bond or long-dollar trade, you’re eating up your risk budget with stuff that’s not necessarily the meatiest trade of the year,

[00:24:08]Rodrigo Gordillo: Well, it’s yeah, go ahead.

[00:24:11]Corey Hoffstein: So just to finish, where all those extra markets seemed to matter more was in the year where there were no clear Trends, and you weren’t getting chopped up in just a few Trends that weren’t working. You had more of your risk budget diversified across more stuff, and we’re likely to find things that offset those, you know, the P&L.

And so it was more, it actually seemed to be, from a risk management perspective, the diversification was better, but in those years that like the SocGen Trend Index really ripped, those are the years that just having a couple of markets to trade got you the vast majority of the returns.

[00:24:50]Rodrigo Gordillo: So can I just clear something up? Do you mean that the best performing years were the ones where there were the least amount of independent bets, and an overweight of one or two of them. Yeah. So that’s exactly, I mean, we’ve done principal component decomposition as well. And I remember it was years ago. So Adam, correct me if I get this wrong, but within the managed, which within the future space, you get on average around 13 unique bets, but it could be as low as three and as high as 20. I just don’t know what the correlation between having a lot of bets or versus…

[00:25:24]Corey Hoffstein: Yeah. So that’s exactly, they’re sort of ran between like five and 50, I think. And what they found was, those years that had five, those are the years of really strong CTA returns. In the years of 50, not very strong CTA returns. It was just that the CTAs that were trading a hundred markets tended to do better in those environments than the CTAs that were trading 10 markets, because they just didn’t have any diversification, nothing was working, and they were in sort of the, they just had more risk concentrated and stuff that wasn’t working.

[00:25:55]Mike Philbrick: Yeah. S&P 500 stocks, but it’s one market. There’s one set of institutional buyers and sellers. There’s a set of flows that come from the various sources of capital. Now think about a managed futures portfolio of Cocoa, Wheat, the energy complex, precious metals, also stocks, bonds, currencies.

So when you roll through the independent bets and the independent market participants that are responding to the independent factors of each market, did we have a drought in Wheat? Do we have too much Wheat? Where are we in the Wheat side of things? So the number of independent bets to diversify a portfolio is incredibly important. And I think Adam, you always have that formula measured as to how much you can improve the Sharpe ratio of a portfolio with the independent bets. Maybe you can you pull that out of your brain?

[00:26:49]Adam Butler: The fundamental law of active management, right? Which is just that the alpha is a function of, or information, coefficient information ratio is a function of the information coefficients of the skill of the manager, the degree to which your bets correlate with being on the right side of the market, times the breadth, where breadth, the good proxy for breadth is the number of independent bets in the portfolio.

And I was going to say that a lot in that analysis, a lot depends on how the portfolio is constructed. If you’re constructing it naively, like if you’re just holding all of the markets in equal risk, for example, right, then you could easily have a portfolio that has a lot of equity markets, a lot of bond markets, a lot of currency crosses versus the dollar. And those from a risk standpoint in years when macro kind of defines a major Trend or two, one or two major Trends, then obviously those portfolios are going to have massive loadings on those, this small number of factors. If you take a more thoughtful approach to portfolio construction, you will never allow your portfolio to load too heavily on those concentrated bets, right? So if you were to even weight by equal risk contribution, or some kind of robust mean variance optimization, then presumably you would see a lot less of that, because you just would never be allowed, or the portfolio would never be allowed to have such concentrated positions in those single factors.

[00:28:26]Rodrigo Gordillo: Right. Yeah. And look, and speaking of diversification, another topic that we wanted to touch upon on the CTA space was in the last quarter, we saw a lot of the CTA space load heavily on equities. And equities have been doing well, especially from the concept, from the perspective of Return Stacking, it feels like a scary thing to have a hundred percent, let’s say in equities, and then on a Trend following strategy that has a big loading on equities and the big fear was like, you’re just doubling up on the S&P 500 risk.

But the reality is that it’s really tough to discern the impact of a single security or set of securities in a well diversified CTA portfolio, if you don’t understand where all the other bets are pointing, right? And so in spite of that being true, and also the second thing that people forget is that if it does get it wrong, you know, these systems have stop losses and they have the ability to get out and turn it around fairly quickly.

And I, we saw a lot of that in during COVID, where they were caught offside, and then were able to get out quickly, but from the perspective of, hey, I see a big position here, therefore, if X happens, then you will lose. It’s much, it’s a much more complicated view. So since then we’ve had a drawdown, and we haven’t seen the carnage that people expected.

So what were the elements that we saw? The diversifiers that we saw take the opposite side of that bet in this, in the last four months, Corey.

[00:29:51]Corey Hoffstein: I’m just going to add a number here for you, Rod, just looking at some SocGen data. So over the last month, the S&P 500 is down a little over 5%, and despite carrying a pretty significant position in equities, long equities, the SocGen Trend indicator is up 5, CTA Index is up just under 3, and the Trend Index is up just under 3. So to your point, yes, it did look like we were, we and other CTAs were carrying a lot of equity, but there was other stuff that worked, right? Short bonds has been a very profitable trade over the last month and commodities and currencies, right? So I’m looking, month-to-date for example, at the turn was like right at the 29th. So if I look month-to-date at the SocGen Trend indicator, equities are about a 200 bip drag.

Basically being long the dollar has been, added a hundred bips. Short bonds has added 50 bips, and a variety of commodity exposures, right, long, the energy complex and long Gold, Silver has added about 300 bips in the SocGen Trend indicator. So there’s, right to your point, the portfolio operates as a whole, and very often you can see a concentrated position. Oh, it looks like you’re carrying a lot of equities on a single day. But you’ll have a lot of other positions that from a risk perspective can be dramatically offsetting, as the market dynamics change.

[00:31:15]Mike Philbrick: I think that’s a good segue into the one article I wanted to make sure we highlighted, which was Honey, I Shrunk the Trend Following, by Man, which just went through the, I put it in the Slack channel too, if you guys want to pop it up. I know, I’m pretty sure we’re all pretty familiar with it, but you know, went through, hey, Trend following what it does do to a 60/40 portfolio, and they sort of stacked it on top as well, which on Return Stacking Radio at night, we’re happy to see a stacked portfolio with Trend following on top of the traditional 60/40 and the complementary nature of that. And, you know, obviously we will get asked all the time, what’s the allocation to Trend following in a traditional 60/40. And in Honey, I Shrunk the…, it’s 63%.

[00:31:59]Rodrigo Gordillo: So again, going to get into the proper weighting of a Trend following strategy? We’re going to get, it was some…

[00:32:05]Mike Philbrick: I’m just saying, you know…

[00:32:07]Rodrigo Gordillo: … in other podcasts about that.

[00:32:09]Corey Hoffstein: Is it, is this my chance? Is this my chance to go at Andrew Beer?

[00:32:12]Rodrigo Gordillo: Yeah, that’s right. I will bring what, Andrew’s waiting on the silence. I’m…

[00:32:16]Corey Hoffstein: Yeah, I know he is.

[00:32:17]Rodrigo Gordillo: … him, Andrew, come on in, tell us what you think, but it was, for those who are interested in what we’re talking about, the, it’s, yes I think, … speaks big about an unrealistic allocation to Trend following from an behavioural perspective, and in a recent podcast, better understanding of this space, Andrew Beer was asked what an ideal position would be. And, you know, I got to say, I know that we talked about optimality and behavioral optimality. I think he was talking about a very low position, especially for those uninitiated, right, the advisors, looking at a 4 percent allocation I think is what he recommended. Understanding that’s, he’s not going to get more than that. And then, forget the host’s name, but he pushed back and said, that’s crazy. That’s, you know, Neil is like, that’s crazy. That is absolutely not the optimal thing.

[00:32:57]Corey Hoffstein: Well, when you got someone like Neil, who has a hundred percent of his portfolio, his Trend following, having Andrew say 4%. All right. But to Andrew’s point, the average U.S. financial advisor, I think if dollar weighted, their allocation to managed futures is like sub 20 basis points, right? Now that means there are some that have quite a bit, and the vast majority have none. Andrew’s point is if we can get everyone off zero, all of us Trend followers are going to be very happy, right?

Now again, let’s start with the behavioral aspects here. Do you, does it mean, does someone want to manage a 1 percent position? No, it’s not going to benefit you, and it’s only going to make, raise eyebrows. So you need it large enough for it to make a difference. Not so large it’s going to drive your clients crazy. And especially if you’re not stacking it, right? Not so large that it sticks out for a very long time when it stops behaving like stocks and bonds, and stocks and bonds do well.

[00:33:54]Rodrigo Gordillo: Yeah, I think that’s bang on. I think the, look, when you’re looking at it from a, as a diversifier, it’s tough to make an argument for a 4 percent position, right? You’re just not going to reduce the volatility of the drawdowns. This is not going to add, but it is a…

[00:34:08]Adam Butler: … way too gentle, 4 percent is ludicrous. Why bother?

[00:34:14]Rodrigo Gordillo: … point.

[00:34:14]Mike Philbrick: Why bother? No. I think we have the behavioral aspect, right? We have the behavioral aspect. So I, we’re making a lot, laid that down to

[00:34:21]Adam Butler: The behavioral aspect.

[00:34:23]Mike Philbrick: But the problem is the behavioral aspect, is a function of, okay, you have a bunch of people that are subject to hurting. They are succumbing to the behavioral vulnerabilities in their portfolios. I’m, you know, can’t help them, but we should not shy away from the fact that the allocation to this type of strategy should be far larger, especially with all the baby boomers and the accumulated assets that are going through decumulation.

Being in decumulation and having a higher, more volatile portfolio is extremely deleterious to the amount of money that you can take out. We have investment stewards who are well educated and are underexposed to this. We see it through the growth and shrinking of the CTA complex in and of itself, bad performance, less allocation, good performance, more allocation. That’s at an institutional level. So we’re not just talking to RIAs here. This is kind of like, come on guys, get with it.

[00:35:25]Corey Hoffstein: I like the hand raising.

[00:35:26]Mike Philbrick: Yeah. But I’m just saying, so are you going to be someone who succumbs to the behavioral vulnerabilities or are you somebody who’s going to get off zero to a more meaningful position? Yes, you’re going to have some tracking error. Those are things that you have to think of as a professional to keep your job.

But again, Rod over to you.

[00:35:45]Rodrigo Gordillo: Well, look, I’ve recently been re-reading The Three Body Problem because of that Netflix series. I want to freshen up before I see how good or bad it was, but it’s this, from a game theoretical perspective, you know, I want to, I kind of feel like Andrew’s, from a game theoretical perspective, this is not a single game, right?

You meet with an advisor. You want a 20 percent allocation. And so you bid for that 20 percent here. You’re breaking minds. You’re not bending minds, right? And if we play this game forward a decade or two, if you think, first of all, that you think about a decade back, how many wire houses would allow advisors to have a big alternative position? That’s gone from 5 percent to 10 percent to 20 percent to 30 percent, is now allowed to be an alternative strategy. So the long game is that pie is going to grow. You’re competing with other alternatives, like long/short equity, like private equity, private credit. So if you want a piece of the pie, let’s say a quarter is four. You don’t want to break minds. And with the hopes that you keep on pushing the agenda, we’ll, without talking about it too hard, so that 10 years, 20 years from now, 50 percent of the portfolios are alternatives. And that four grows into a reasonable amount.

[00:36:53]Corey Hoffstein: And in fairness, hold on. And in fairness to Andrew Beer, he was not just saying this is a 60/40 investor that’s going to put 4 percent in managed futures. The expectation here was, with a 4 percent, was part of a larger allocation to alternatives. It was, and that was going to be alongside things like equity long/short, and private equity and private credit.

And we can have all the discussions we want as to what is actually an alternative and what matters and what should be sized up or down, but it was not, hey, take your 60/40 and add 4 percent to managed futures, and you’re good. Now that said, let me defend Andrew here. I like round numbers. I’m just going to say five. Four is an arbitrary one. You know, let’s just say five. If I’m meeting with someone who’s never allocated to alternatives ever, and they have a 60/40 for their clients, it would be so irresponsible of me to convince them to go to 20 immediately, right? I have to just say, for their business, because they will not have the confidence to stick with it, I am very convincing. I will, I bet I could get them there and within six months they will blow out of their position and lose.

[00:37:58]Mike Philbrick: We’re going to have to move you out of sales immediately. We’re going to have to, I mean, in Kahneman’s book, God rest him, he said, you know, when you have some facts and someone throws at you some nonsense, you throw the table over because you can’t even entertain the ridiculousness of the 4 percent allocation because it’ll pollute your mind. We need to be thinking about this through the mind.

You know, do you want to manage some stuff and be the guy who’s in the seat? I get it. You need to keep your job, your Vanguard salesman, low fees, 4%. That’s fine. I get it. We’ll push the envelope on that. I’d like to make the argument that Trend following is like the Dennis Rodman of the Chicago Bulls.

Yeah, it’s different. Yeah, the guy shows up late. Yeah, he does things to a different drummer. But boy oh boy, when those rebounds come in, when your portfolio, when your equity portfolio is getting slaughtered and you’ve got something to rebalance to, your Trend following is doing exceptionally well.

And you take money off the table there to buy those betas that you thought you loved in 2000, and then had a 12 year bear market when you could buy when things were cheap. I think we’re underestimating that. I don’t want people to, you know, get caught up in the hey, everybody’s doing it. Like, you know, this, is that what you tell your kids? Well, everybody’s doing it. You should just own the S&P 500. I don’t know.

[00:39:20]Rodrigo Gordillo: So look, that’s what education is for. I think there’s two things here. I think you can say exactly what you said in this medium, in this format, in white papers, in studies where people can see the North Star and say, okay, I want to get there, but I agree with Corey because we’ve experienced it. I a hundred percent agree with Corey and because we’re good, we’ve gotten people to allocate 20, 30%, sadly at peaks, often because that’s when they’re motivated to do something, to then see them shit their pants for the next six months, and then sell it all. And it was one of those things for like a careful, you know, with great power, with great sales power Corey, comes great responsibility. I think Corey has realized that. And so we can anchor high appropriately.

[00:40:01]Mike Philbrick: If we had great sales power, we’d get them to buy in the drawdown. We’d get them all to buy down.

[00:40:06]Corey Hoffstein: I’m teaching my son to swim. He’s just as likely to drown in the deep end as the shallow end. I’m still starting him in the shallow end. Like, it’s not like I’m just tossing them in the deep end.

[00:40:16]Rodrigo Gordillo: No, you got to, they have to look, the first of all, it’s a difference between faith, and like, faith in the person versus faith in the strategy, right? When you sell somebody, they have faith in the person who articulated the idea. When you take, give them time to look at it, to feel through it, to understand it, to be able to articulate it to clients, to come up with a conviction, and that takes months, if not years.

[00:40:40]Corey Hoffstein: It can’t be rented. You can’t rent conviction,

[00:40:43]Rodrigo Gordillo: And…

[00:40:44]Mike Philbrick: … rented conviction right now when U.S. security…

[00:40:47]Corey Hoffstein: That’s called performance chasing. I, well, that’s all I’m, and by the way, we all generally agree on this. I’m just representing another side of this.

[00:40:55]Adam Butler: I’m still stuck back on the fact that you guys said private credit and private equity are alternatives.

[00:41:01]Corey Hoffstein: Oh, I was trying to avoid that.

[00:41:03]Rodrigo Gordillo: Yeah. Just if anybody…

[00:41:05]Adam Butler: I haven’t gotten over that yet.

[00:41:06]Corey Hoffstein: Adam, I, you’ll like this. Did you catch my no, I hear you go. This is my recent thing on Twitter that I said, private credit and really more private equity, was the way for institutions to reintroduce portable alpha without having to manage the leverage in their portfolios. So here’s my take.

[00:41:23]Corey Hoffstein: All right. Here’s my hot take. So if you, if you look at private equity returns, right, they are basically equivalent to 150 percent levered equity returns with all the beautiful volatility laundering and all of the leverage taken away from the risk of the actual institutional allocator. If you look at how institutions are allocated on average, they still hold seven to like 15 percent in hedge fund strategies, alternative hedge fund strategies.

But a huge swath of equity has gone into private equity. I am of the view that post-2008, whether they did it knowingly or not, they were able to move from equity into private equity, shrink down that equity piece by holding private equity, which is giving them the implicit leverage, and allocate that freed up capital to hedge funds.

And if you unwind and look through, they’re effectively stacking the hedge fund alpha the same way they were pre-2008 with portable alpha. It’s just, they’ve come up with a structure by which they can stick with it.

[00:42:25]Rodrigo Gordillo: I mean, the insight is bang on. I sincerely…

[00:42:29]Corey Hoffstein: I’ll go get my tinfoil hat.

[00:42:32]Rodrigo Gordillo: That it was done explicitly, right? Because you know what’s funny? So I tweeted this, and I had some people who were institutional be like yeah, there was definitely a little bit of it, was by a few people who knew what they were doing. We’re like, yeah, we actually are doing this on purpose, I think the vast majority definitely.

Okay. So that’s a good point. That’s awesome. I love that. And I think for the most part, this idea of when you allocate to private equity, number one, you’re getting a positive equity risk premium that’s levered 1.5 at a high quality. And sometimes you just, you have some high quality. My, what I can test is that when private equity gets down to the retail level, whether it’s for these interval funds or whatever, that the quality of private equity that you’re getting for the retail space is even going to match after fees and transaction costs, even going to match the S&P.

[00:43:21]Corey Hoffstein: I will not even entertain this conversation. I don’t even want to go here. Yeah, I agree. I agree. I wouldn’t, I will not invest. I will not invest in any private equity fund that’ll take my money. That it’s that old. Like I won’t be in any club that’ll have me. Like, no, if a hedge fund will take my money, it’s not exclusive enough.

[00:43:40]Rodrigo Gordillo: That’s right. At this…

[00:43:41]Adam Butler: I’m still stuck on the fact that you think it’s great that they moved from zero to seven percent hedge funds and think…

[00:43:47]Corey Hoffstein: Listen, man, you got, it’s higher than 4%.

[00:43:50]Adam Butler: …a…

[00:43:52]Rodrigo Gordillo: … of The Three Body Problem, man. You got to think decades ahead. You’re thinking too nearby. This is going to take a while. It’s going to…

[00:43:59]Mike Philbrick: Well, I think each investor should reflect on the facts and make their own decisions, and advisors and allocators should do the same. And you know, Swensen, when he was making these changes all along the career, of his career path was alone. All right. And then he became popular and then he changed. So if you’d like to be alone, then you would do more. If you’d like to be with the crowd…

[00:44:24]Rodrigo Gordillo: I think that also speaks to the fact that the way we’re getting, they’re getting structural alpha is from the types of structures that have the liquidity for these big pools of money to give to, if you were to grab Swensen and say, hey, I want you to do your best work with this $200 million portfolio, what are the chances that he’d be allocating in the same way? The truth is that the ability, if you give somebody as smart as Swensen the ability to have all of their bets as liquid as possible, versus all of their bets be as illiquid as possible, they would choose liquidity and transparency every single time. It’s the fact that you can’t do that at that level of AUM that you…

[00:45:06]Mike Philbrick: First of all, Swensen pioneered the endowment model and private investing when multiples were a quarter of what they are today

[00:45:15]Rodrigo Gordillo: Yeah no. All of that too.

[00:45:17]Mike Philbrick: So, valuation is gravity. It determines future returns. And so we have a lot of people chasing the endowment model and laundering volatility and doing all the things that we’re talking about, but they ain’t doing it at two times cashflow.

[00:45:29]Rodrigo Gordillo: Right. So, there’s definitely a valuation model, but my point is, you know, I think a lot of people look at the endowment model and say, I want that. I want to have that so bad. I want to be there. And then I can go and pitch that, but you don’t want that. You have the ability now, especially with this concept of Return Stacking, you have the ability to get non-correlated stacks and have all the liquidity, and just be able to know what’s going on at all times, right?

[00:45:53]Mike Philbrick: But only do 4 percent of that though.

[00:45:54]Rodrigo Gordillo: Well, let’s just talk about, speaking of education and ongoing education, let’s talk about that concept of using futures to stack, and what you’re going to get for stacking, right? So one of the topics has been coming over up again. There’s two areas here. It’s what does a futures contract give you, for real, right?

Like what you, I buy a 10-year Treasury. What am I actually going to get at the end of the year for that? Am I going to get the price return? Am I going to get the total return? Am I going to get the total return plus …? Like, what if I were to use just the futures contract. What am I actually getting? I think people are confused by this. When we talk about even stacking the S&P on top of some sort of bond ladder, what are you getting? So can anybody try to decompose that for me. Yeah.

[00:46:43]Adam Butler: The sins he’s committed here already on this show, Corey should have to answer that question.

[00:46:47]Corey Hoffstein: Wait, what are the, what’s three?

[00:46:49]Mike Philbrick: Private equity, 4 percent is fine. Those two were obvious.

[00:46:53]Corey Hoffstein: I think, I’m just, this is what happens when I show up as the only Newfound guy on an all…

[00:46:57]Adam Butler: The third one was saying that you can replicate managed futures with nine contracts. Things are going to be, we’re going to, it’s going to get heated, dude.

[00:47:05]Corey Hoffstein: I said in that month, you could, doesn’t mean every month. Okay. Yeah. This one comes up a lot, you know? So I think the intuition people have here is, if I buy a Treasury note futures, a 10-year U.S. Treasury note futures, well, that future isn’t paying me a coupon. So it must be giving me the price return of the bond, not the total return. Or if I buy S&P 500 futures, well, I’m not getting paid the dividend, right? So it must be the price return of the S&P 500, not the total return.

And in fact, it is the total return that you are receiving in excess of the embedded financing rate that the futures are charging you for the leverage that you’re getting. And the intuition here, my opinion requires recognizing that the way futures work, the way they are priced, has really nothing to do with the market’s view of what’s going to happen in the future. One of the core principles of financial markets, especially derivatives markets, is this idea that quote pricing is replication, that if I can replicate a trade, the price of that replication gives me the price of the derivative instrument I’m trading.

So what does that mean with futures? Well Rod, I’m going to pick on you and use you as an example. Let’s say you wanted to buy from me a 10-year U.S. Treasury note three months from now, for a certain amount of money. What amount of money should we accept? Should we both accept that you’re willing to pay and I’m willing to receive, to give you that U.S. 10-year, U.S. Treasury note? Well, you and I could just think of some numbers, or I could go back to my desk and do some math and say, well, how would I hedge this trade? How would I ensure that I can deliver that bond? Well, let’s assume 10-year Treasury notes are trading at par, 100 face. So I will borrow a hundred dollars and buy a 10-year U.S. Treasury note. Over the next three months, I’m going to collect the coupons. And at the end of three months, I’m just going to hand you that Treasury note. You’re going to pay me whatever that money is. And then I’m going to go back and repay that initial 100 borrow, plus any interest I owe.

So the P&L of that trade is whatever you agreed to pay me, plus the coupons, minus the 100, minus interest. And if markets are efficient, P&L of that trade should be driven towards zero, right? And you can sort of rearrange those terms and say, well, all that has to equal zero. Well, that means that that amount you’re willing to pay me should be equal to that $100.00 minus, plus the interest, minus coupon, or I’m thinking I’m doing that backwards in my head. Minus coupon, excuse me, the plus interest, minus coupon. And what’s important there is that again, none of that has anything to do with the view that we have, right, and it has everything to just do with what is the cost of replicating. And the important points are that that interest is the interest that’s embedded in the futures price.

That’s the interest, the cost of financing the futures. But the larger that coupon is, the lower that value that you’re willing to pay me. Why? Because that value is going to roll up the futures curve towards spot, and you’re going to earn that coupon in the price return. And the same thing happens with the futures.

Equities and dividends a little bit different, because dividends are getting forecasted out three months, and you may be right, you may be wrong. So maybe you have to charge a little bit of a risk premium there, depending on how certain those dividends are. But the idea there is that those yield elements are actually being captured in the return of the futures contract itself.

And so it is a total return vehicle minus that embedded cost of financing. The last thing I’ll say then is, all right, what is that cost of financing? Well, again, assuming competitive markets, people who have access to cheaper financing are going to be able to do this trade and capture more profit. And so competitive market forces will typically drive this hedging trade to the parties who can execute at the cheapest, those who can trade the underlying the cheapest. Those who have access to the cheapest borrow for something like Treasuries. That’s going to be big banks who have access to overnight repo. And so the overnight repo rate is actually the embedded financing rate in Treasuries, which has historically looked a ton like one-to-three-month US Treasuries.

[00:51:27]Rodrigo Gordillo: Yeah. It’s just, if anybody ever kind of questions where those return drivers come from, all they really need to do is do, okay, I can buy a futures contract. What will a futures contract delivery in three months give me? Okay, now what do I need to do mathematically? If I go to my bank and I need to borrow money, I need to buy a security, I need to understand what the future price of that is after coupons or dividends, if you’re doing equities, whatever it is.

If you do that math and you get a number that’s different from the futures contract, then you have an opportunity to arbitrage, right? So, you’ve figured something out. Great. I’m going to go to the market. I’m going to grab what I did here with the math. I’m going to borrow the money from the bank. I’m going to buy the contract and I’m going to do the opposite trade with my futures contract, and I’m guaranteed for that to come in. Now that does happen. And it happens by every market participant that is playing that trade. Any high frequency trader, any prop trader, they’re constantly playing that game.

That makes the rest of us who are just simply assuming that we’re getting a fair price in the futures space, to get a fair price in that future space most of the time, right? So that’s, I think, when it comes to a futures contract, all in all is that what you’re going to get, just to answer my own question from the beginning, is you’re going to get whatever the return of that contract. Let’s say the Treasury note minus the cost of financing, that’s what you’re going to get in the futures contract. And that financing cost is going to be the cheapest financing cost you can get. You can’t get your bank to give you better pricing than that. And if you do, then there’s an arbitrage opportunity there.

[00:52:55]Corey Hoffstein: And what you typically find is in instruments like the S&P, for example, S&P futures, the cost of financing is a little bit higher than the cost of financing and something like Treasury futures, and historically, it’s because it’s harder to execute that arbitrage trade. It costs more to accumulate all the S&P 500 stocks, and those dividends are less certain.

So that yield that we’re for, you know, we have to come up with a price today. But that dividend yield in the future. Well, you could run into a 2008 and all those dividends could get cut in the next three months. Like, they’re not all necessarily declared with certainty. We have a much more certainty about Treasury coupons.

And so there’s going to be potentially a little bit of risk premium baked in there. And so those sorts of things mean we can be thoughtful about how are we trying to achieve leverage in the cheapest way possible. Treasury futures have historically been one of those markets where we can get leveraging in some of the cheapest borrow you can find on the planet, in my opinion.

[00:53:51]Rodrigo Gordillo: Perfect. So look we didn’t get through everything we wanted to talk about today. Sadly, I have to get going. And we have an hour. So we’re going to try to keep this under an hour for the most part. Next time we have, I think one of the key things that we’re going to talk about next time is the inverted yield curve and how that’s affecting futures and stacking and you know, why we should still or not be stacking based on the futures yield curve. So stick around for next month. Make sure you are Liking, Subscribing, make sure you’re getting that feed when we publish the next podcast. In the meantime, anybody else have any announcements, anything else to say today?

[00:54:26]Corey Hoffstein: I…

[00:54:27]Adam Butler: Get after that 4 percent man.

[00:54:29]Corey Hoffstein: I feel like I need to apologize to Adam and repair our relationship here. I’m, not sure he’ll talk to me until we, until next time we record.

[00:54:35]Rodrigo Gordillo: Yeah, you guys can hug it out after the recording. All right. Thanks all. And we’ll see you next time.

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