Talk Your Book: A Tactical Strategy That Actually Works

0:00Today's Animal Spirits Talk Your Book is brought to you by Potomacomac Funds. Go to Batnick and Ben Carlson as they talk about what they're reading, writing, and watching. All opinions expressed by Michael and Ben are solely their own opinion and do not reflect the opinion of Ritholtz Wealth Management. This podcast is for informational purposes only and should not be relied upon for any investment decisions. Clients of Ritholtz Wealth Management may maintain positions in the securities discussed in this podcast.

0:43Welcome to Animal Spirits with Michael and Ben. And on today's show, we're joined by my friend Dan Russo. Dan is the co-CIO at Potomac. Like, rewind 10 years, maybe even more at this point. Gosh, time is going by then. Like 2012, tactical strategies were all the rage. Particularly, there was a whole new category called Black Swan Funds. Anything that did anything to sidestep, did I just say anything twice? Any strategy that managed to sidestep? Introduce myself. Any strategy that was around that managed to sidestep part of the GFC and even new funds that launched up, investors love to fight the last war, was all the rage.

1:27How do we avoid the next shoe to drop? The problem is most of the time, the market is biased to go up, right? 74 % of the time, 73, 75, whatever it is, it goes higher one year later. And the problem with a lot of these tactical funds or these bear market strategies, and I know those are not the same thing, is that a lot of them can't survive the upside. And if they can't survive the upside, as we've learned over the last decade plus, then they're no good to investors. And so the conversation today with Dan gets into one of the unique things that they've been able to do is actually keep pace with a rising market.

2:04What a concept, but really hard to do. And they've done it. Yes. Protecting the downside volatility is a lot easier if you take the upside off, right? And that's what a lot of those funds did. And a lot of people realized that in the 2010s, after they rushed into all those strategies and products, then they got out because it's like, hey, this is no fun. If there's no downside volatility, this thing's worthless for us, right? And yeah, that's the hard thing is like trying to play both sides. And the great thing about Dan, and I think a lot of quantitative investors, is that he's a straight shooter and he tells you, like, this is the good stuff, this is the bad stuff.

2:40Straight shooter. I do love that. I do love that. Upper management written all over him. And so we get into all that, and I think that's the – I think the pros and cons of a quantitative strategy is that you just have to kind of let go of the steering wheel and let God take control, right? It's like, because you have to trust that this thing, this signal or this strategy or this move is not always going to work, but most of the time it's going to work. And that's a hard thing for a lot of people, right? Yes, trusting the process and not always the outcome. So fun conversation. We get into all this stuff, how the strategies work, the pros and cons, the situations where it won't work, why other tactical strategies haven't worked as well.

3:16So here's our conversation with Dan Russo from Becoming Funds.

3:24Dan, what's up, man? Dan, it's good to see you. Good to see you. Thanks for having me. All right, I'm excited for this conversation. Let me give you a proper intro. Dan, you are the co-chief investment officer at Potomac Funds. You've been there for how long now? Coming on five years, marginally five years. Okay. I'm pretty sure, I could be wrong, but I'm pretty sure that you are one of the, this could be one of the first conversations we've had with a truly tactical manager. There might've been one more, but either way, it's been a minute. And the reason why is because doing tactical well, and when I say well, I'm just talking about performance.

3:59It's really hard. If you look at the Morningstar category of tactical, it really sucks. What is unique about you guys is that your numbers don't suck. And we're going to get into all of that today. Maybe let's just start there. Like why is tactical? And there's a million answers. Why do you think tactical has been such a difficult category for investors? I mean, I think you can start right from the beginning by saying it's hard to define tactical. I think people look at tactical a lot of different ways. You know, I mean, in theory, if somebody can move from, say, fully invested to 75 % to 50%, that's kind of tactical, right?

4:40At Potomac, we can, will, and do move our portfolios 100 % to cash if our composite model tells us that that's the right move. And we'll obviously get into that a little further. I think that we are one of the few firms that do that. Actually take the portfolio 100 % cash and kind of happy to let the market play out and then let probability dictate for us when it makes sense to get back in. So at its core, I think it's hard to define tactical. There's a lot of different definitions and a lot of different ways to implement tactical. And I think one of the things that helps us is the fact that we have this willingness and ability to go to cash.

5:20Well, here's how I think about it or define it. A tactical model or a tactical strategy is effectively a market timing strategy. Now, within that, there's a million different variations, definitions. And timing the market is really difficult. I'm not going to say it's impossible, but it is certainly difficult. It's impossible if you're winging it. It's impossible if you're using your intuition. I know that a lot of the work that you do is leaning on not intuition, not how you feel, but probabilities, quantitative inputs. So how does – and listen, I think that investors want to have their cake in it too.

6:00They want a tactical strategy that gets a lot of the upside and doesn't have to deal with a lot of the downside, which is obviously - I mean, that's what we're trying to deliver, yeah. I know that's what you're trying to deliver. So just that premise is, what are you talking about? How is that possible? So what are you trying to deliver? I know you have four strategies and we'll get into them, but how are you trying to create this alchemy? So we're doing it with quantitative technical analysis. We have a composite model that is made up of individual trading systems. Right. And we kind of view it as almost like we are the general manager of a sports team.

6:41Right. And we kind of date ourselves a little bit when we when we talk to people and use, you know, the 90s Chicago Bulls. Right. And I'm not even a basketball fan. I don't know why we do this, but we do. And but, you know, you've kind of looked at the 90s Chicago Bulls. First of all, Jordan was there for what, about seven years before they really did anything. Right. So you have this kind of you have a superstar, but you need the players around him. You need Scottie Pippen, you need Dennis Rodman, and that's the extent of my basketball knowledge. I'll throw in Ron Harper. Fair. That's how we view it.

7:12Each of the different trading systems is a player, and the composite model is the team. As I said, all quantitative technical analysis. We're doing technical analysis, but it's not lines on charts and randomly attaching fib retracement somewhere. where all of the individual systems are tested on their own and then in combination with each other. And then we take the systems and we combine them to create a composite. And the composite basically answers the question, do you want to be invested? And if the answer to the question is yes, we have four individual 40-act mutual funds, which are used as the vehicle to buy and sell our investments.

7:53And each one of those funds is run to a specific risk profile as measured by drawdown. And then we take those four funds, combine them in different weights to create strategies which are available to financial advisors. So you say you have your composite. Does that mean that it's one rule you're looking at? Or do you have multiple rules within each fund where you could be invested like you're 60 % risk on and 40 % risk off? Or is it all or nothing? The composite model is all or nothing. Now, in fairness and in practice, we have more than one composite model. So a fund could be kind of 50 % invested and 50 % out of the market, depending on what the different composite models are doing.

8:30But what's important to understand, I think, is that we do not have, you know, one rule that gets us in, one rule that gets us out, and that's it, right? It's kind of the theory that when all you have is a hammer, everything looks like a nail. You know, for instance, I like to use trend following, and I love trend following. I think it's, you know, I think it's an interesting strategy. But if you're a trend follower, what do you do in a market that's not trending, right? That's moving sideways. Your strategy is going to get, you know, death by a thousand cuts. You're going to get chopped up. Market's going to go nowhere, maybe plus or minus 3%.

9:01And all of a sudden you look up and you're down 15 or 20, right? Because your trend model got cut up. Like 2022 was a really difficult year for trend following because there was a lot of bear market rallies where the market fell, you sold, the market bounced, you bought back in. Oh shit, it rolled over again. Yeah. So 2022 is an interesting year and it's one that we actually use a lot in examples for our composite model because our composite is designed, like I said, a lot of different inputs. The trading systems, the individual systems themselves tend to be uncorrelated with each other. So it's designed to be regime aware.

9:35So we have this concept of a base system and then trigger systems. And if we think of the base system, think of the base system as Jordan, right? The base system kind of dictates the market environment that you're in. If the base system is on a buy signal, you're probably in a pretty bullish environment. And if the base system is on a sell signal, you're probably in a bearish environment. Now, our base system was mostly on a sell signal in 2022. But we recognize that markets don't go down on a straight line. We recognize that you want to have different ways to get in and out of the market. So we have these counter trend trading systems that are designed to fire in a bearish type environment.

10:14So we actually were able to take advantage of a lot of those bear market rallies throughout 2022. So even though the environment was weak, the individual trading systems are designed to recognize opportunities across different regimes. So I'm curious how advisors are using you. So let's just look at, I'll call this your flagship, but you could correct me if I'm wrong. The strategy or the mutual fund with the most assets is the Potomac Defensive Bull Fund, correct? So this is just one of your strategies and we'll get into it. But what's remarkable about what you've been able to do in this, and I want to here, how you combine it with the other strategies for advisors, is you've been able to not only keep pace with the market, and I'm talking about the S &P, because when people say the market, I know on fair affair, that's what people measure.

11:11Over the last five years and three years, you've outperformed the S &P. And that's incredibly difficult, not just for tactical, for anybody in this type of market where the leadership has been narrow. It has all been in tech and communications. And you've been doing that in a way in which you're not fully invested. So there have been periods of time where you've been 100 % out of the market. So the fact that you've been able to keep up is remarkable. Now, within that particular strategy, there have been drawdowns. And that's fine. It's beating the market. So how does that strategy fit into the overall strategy?

11:49And how the hell have you beat in the market? All right. So I guess we'll start with how the strategy works and how it's implemented. So I said earlier, our composite model answers the question, do you want to be invested, right? And then each fund has a specific profile. For that fund in particular, if the composite model fires a buy signal, we have concentrated exposure to a broad index such as the S &P 500. So that fund will run at, when it's invested, that fund will run at about a 1.6 beta to the S &P. Now, when it's obviously, when it's not invested, we'll move into money market or cash-like products.

12:26So the beta drops to zero. So what that allows us to do is actually de-risk the model because when we run the fund at about a 1.6 beta, we are able to spend more time in cash, right? Our composite model on average is in the market about 60 % of the time, give or take the year. So by spending roughly 40 % of our time in cash. We can wait until probability dictates via our model that it's a good time to be invested. And then once we get in, that concentrated exposure at about a 1.6 beta allows us to outperform if the trend persists, right? But it also allows us to give the trend time to develop, right?

13:11We're not trying to catch the bottom. We're not trying to catch, you know, sell the top, by getting in at about a 1.6 beta, we are able to let the trend develop, let our signals tell us that this is a healthy trend confirmed by, you know, breath work and confirmed by intermarket analysis. Now we can get in with that concentrated exposure and catch up and hopefully get ahead of the broad index pretty quickly. So you're using, you're getting that 1.6 beta through leverage, obviously. Through different products, right? So it's a combination of futures and ETFs that allow us to get that beta in a cash-efficient manner, right?

13:54So by using futures, we don't have to tie up massive amounts of capital to get the exposure we want. And then adding in ETFs brings us to that 1.6 beta. So I call it leveraged exposure. We're not borrowing money, right? It's not a$2 billion fund where we go out and put three turns on it so that we could put$6 billion to work a lot of hedge funds. We're actually putting less money to work in the market, pure capital, to obtain the exposure we want than we would if we were doing everything with individual equities or even all with ETFs. So this is obviously a quantitative strategy. Yep. How much of it is rules-based versus like your discretion to say, all right, in this environment, this input is not really working or it's out of favor or whatever.

14:47Like how much manager overlay is there? So the discretion comes in the research process, right? When we're designing the individual trading systems, when we're thinking about how to combine them, that's where the discretion comes in. Once we've kind of done all of the testing and we're confident that what we have is going to add value, there is zero discretion. And again, 2022 is another great example because I'm kind of known as – I'm not a perma bearer, but a hater. And so a year like 2022, I'm super happy, right? The market's getting wrecked. The NASDAQ's down 40%. We can go through the psychological reasons of why I am the way I am.

15:29We've discussed it. But in that environment, you know, as I said earlier, our base system was mostly bearish, but we're getting these countertrend signals, right? We're looking at things like the VIX to tell us, hey, we've gone down too far, too fast. And that fires a buy signal. So, you know, we come in, we run the models, you know, either at night or early in the morning. And our CEO, who's also co-CIO, Manish Khada and I, we'd be going back and forth with each other, you know, like, hey, we have a buy signal here. I hate buying here. But we don't ignore the signal, right? And I think there were six or seven of those in 2022.

16:03And all but one was actually a winning trade. Now, those trades in that environment are going to be different than the trades that you see in a bullish environment. In a bullish environment, the triggers that get us in are likely to keep us in longer. The market does have a natural upside bias, which leads me to believe that I should not be a hater, but I just am. So the signals that get you in in a bearish environment are going to be kind of these quick hit trades. Maybe you're in for three or four days at a time. And then you get out of the way again. But we do not override the signals. You know, if we have a signal, we don't override it.

16:36Because honestly, you know, we pitch ourselves as quantitative managers, systematic and rules-based. The second we override a signal with our own discretion, we've stopped delivering what we promised our clients we would deliver. Dan, in 2014, Josh and I took a meeting. And I highly doubt this manager is still around. They had like 32 different inputs. And Josh and I were like, all right, so it's rules-based. He goes, yeah, but like, you know, if we'll do what we have to do if we, you know, like if we have to, and I was like, wait, what? Look, yeah. Listen, I think, you know, at the end of the day, you know, we all have our experiences and we all, you know, if you've done this long enough, you have your view, right?

17:16And I certainly do, but that doesn't mean we're going to override the signals, right? We're big believers in data over feelings, right? Probability over prediction. These are all, you know, taglines that you'll see on our website, but we don't override it. I mean, if you think about it, if we were able to do that, we wouldn't have made one of those trades in 2022 because, you know, Dan the hater hates the market. The market was clearly in a downtrend. You could make every argument to not take the signal, but you do, right? Because that's the product we're delivering. And because we believe in the data and we believe that we've built a robust system so we don't ignore it.

17:51You mentioned that you have some like drawdown limits on each of these funds. I'm curious what your risk parameters are and like what you're comfortable with and what's the range of outcomes you're willing to accept. Do you have certain drawdown thresholds that like, listen, below this level, like there's something wrong or the portfolio gets out? Like what are your risk profile? What's your risk guidelines? Yeah, no, that's a great question. So, I mean, we test all the individual trading systems, like I said, on their own as well as in combination with each other. And the key metric that we look at for any of the different systems as well as for the composite model in general is maximum drawdown, right?

18:22As if an individual system or the composite model starts to approach its maximum drawdown, we'll take a look at it and try to understand what's going on. Did something really change in the market? Does the data that we're using no longer make sense for the current market environment? Does the data we're using no longer exist? So max drawdown is our key risk metric, right? To just have this hard and fast number, say if a system is down 10%, we're going to pull it, or a system is down 15%, we're going to pull it, doesn't make a lot of sense because volatilities change over time. It's kind of similar to the concept of using stop orders.

19:01People use stop orders, and they arbitrarily pick 5%. Well, why 5 %? You just kind of pulled that number out of thin air. Volatilities change over time. Sometimes 5 % might be a lot. Sometimes it might be a little. So maximum drawdown is the key metric that we focus on. The strategies and the strategies that you're running have a lot of moving parts. They require a lot of education, a lot of handholding, a lot of communicating. You guys have had a tremendous amount of success working with advisors to deliver these strategies to end clients. What's your AUM up to and how have you been so successful in translating these strategies to advisors and their clients?

19:39Yeah, so we are over$3 billion in AUM across the funds and strategies. And just as a frame of reference, I joined here in March of 21. We were just under$500 million. So that growth has been fun. It's been a lot of fun to be on this ride. You're right, though. It is a handheld sale, right? I think anytime you willingly choose to look different from the benchmark, you are going to spend a lot of time explaining yourself. So we have, in the past couple of years, really been diligent and focused on building out our sales and education team, both out in the field and here internally. Like you all, we're big believers in content.

20:18Our new home office here in Bethesda, Maryland, has a studio in it where we do a lot of content. We believe in education, however people want to consume it, whether it's written, whether it's video, whether it's audio such as this. But it's really just been kind of getting out there, telling the story, making people see that the way that we're doing things makes sense and that it adds value to, you know, strategic portfolios that a lot of people are currently using. We're not going in there and saying, hey, you should rip out your strategic asset allocation portfolio and add us. We kind of show people how we're a complement to what they're currently using by trying to maintain the upside of the S &P 500 while delivering an experience that has a lot lower drawdown.

21:11And one of your research pieces you sent us, you talked about the bear market and diversification. I'm just curious how you frame that for advisors and how you try to position your funds to complement those strategic allocations. Dan wants the AI bubble to pop so badly. Maybe. He's not alone, I don't think. I honestly, well, before I answer Ben's question, I go on record as saying I don't think there's an AI bubble as measured by the MAG-7. Because if you look at the MAG-7 relative to the S &P 500, over the past 12 months, it's an inline performer, right? So I would think that, I mean, massive runoff the April low is fair.

21:49So you're not a hater, Dan. I'm not a hater. Oh, yes, yes. The data doesn't point to me being a hater right now. See, data over feelings. But Ben, to answer your question as it relates to a bear market and diversification, we just think that the traditional diversifiers that people go to to diversify their equity exposure, they all have their limitations, right? Number one. Number two is they all work at different times, right? And if we think about things like, you know, whether it's bonds, whether it's gold, whether it's commodities broadly, you know, whether it's a balanced allocation, like a 60-40 portfolio or managed futures, none of them is perfect.

22:28But what you have to give up in all of these, to us, the juice is not worth the squeeze, number one. Number two is, as I said, they all work at different times, right? 2022, we keep coming back to it as a great example, right? For the first time in, what, 20 years, bonds failed to diversify your equity exposure. Now, based on our work, we think the key differentiator as it relates to when correlations are going to shift is inflation. Now, if you think you can get the inflation call right, by all means, you know, rotate amongst the different diversifiers. You know, you're a better person than me and you're a better person than the Fed because the Fed can't even get the inflation call right.

23:05So that's number one. Number two is, you know, if you want some level of return, you know, a 60-40, 70-30 portfolio that kind of gives you a decent return, the drawdowns there are still pretty steep. And, you know, a 60-40 portfolio runs at about a 97 correlation to the S &P, right? So are you really diversified there? Probably not. And then so as you go down the correlation scale to things like the ag, right, roughly 23 % correlation, but 10-year annualized return of about 1.3%. Okay, fine. You go a little bit further out on the risk spectrum in the bond space to something like 20-plus year treasuries via an ETF.

23:48Well, the TLT has a drawdown, a max drawdown of about 45%. So an equity-like drawdown for your risk-off diversifying asset, right? Right. Commodities broadly, almost no return over the past 10 years, about 3 percent with a 76 percent drawdown. Right. So there are these tradeoffs. The things that give you a little bit of return still have decent drawdowns and are highly correlated to the S &P. Right. Look at, like, say, the ACWI, you know, 55 percent drawdown with a 98 percent correlation to the S &P. Right. So to us, the bear market and diversification is these massive tradeoffs and what you have to give up to get true diversification.

24:29Then you have to have the ability to time which product to use. So and then to top it all off, you know, you've had this kind of just set it and forget it bull run in the market for the most part. You know, a true diversifier has kind of been a drag to portfolios. So we add all that up. We think that there's this bear market and diversification. And we think that that sets us up, you know, because of how, you know, how we're investing. We're trying to kind of give you that return profile while running lower correlation, right? Over time, if you kind of look at our composite model, the amount of time it's invested, the amount of time it's in cash, and you blend that out, we get to about a 0.5 beta, a 0.5 correlation.

25:10relation, equity-like returns with drawdown mitigation. So when advisors work with you, they're like, all right, I get the story. I like that it's rules-based. I see that it has a place in my portfolio for clients. We'll take some from stocks. We'll take some from bonds. We'll put it in this sleeve over here. How does it work in terms of like, all right, so you've got four different funds. They all have different risk parameters. Are you helping them come up with, all right, we think it should be 60 % this fund, 20 % this fund 10 and 10? How does that process work? Traditionally, what we've done is we've taken the four funds that we have.