Talk Your Book: Back to the Futures Market

0:00Today's Animal Spirits Talk Your Book is brought to you by CraneShares.com. to craneshares.com slash KMLM to learn more about the Crane Shares Mount Lucas Managed Futures Index Strategy ETF. That's craneshares.com slash KMLM. Welcome to Animal Spirits, a show about markets, life, and investing. Join Michael 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.

0:38Clients of Ritholtz Wealth Management may maintain positions in the securities discussed in this podcast.

0:46On today's show, we speak with Jerry Pryor. Jerry is the COO and Senior Portfolio Manager at Mount Locus, which created the OG Managers Index. I did not know that. I have heard of the MLM Managed Futures Index before. I never put two and two together. It was Mount Lucas. No spoilers, but interesting origin story. Yes, that's credit to you for knowing what he was talking about. I heard that and I thought, I've heard of that before. That's, you know, I've read some books. It retains some knowledge. PTJ. So one of the things that he said today that stuck out to me that I had never thought about with respect to Managed Futures was, what did he say?

1:24Stocks and bonds are negatively skewed. Is that what he said? Yes. The point was basically probability is in your favor that gains happen more often than losses. Okay. But with this kind of strategy, the losses may happen more than gains, but you have the bigger chance of a home run when you need it, I guess, is the idea. I think lower. So, okay. What I took out of that was because, and the particular trend or managed future strategy that we're talking about today, which uses trend following as its main input, it's commodities, bonds, and currencies. So no equities in here. But yeah, and I guess the other point just is that if you're looking for an uncorrelated strategy, you want that ability to have things swim against the current, which is exactly what a strategy like this did in 2022.

2:11Yeah. And that's the way it happened. But unfortunately, as we get into this show, a lot of times that means people fight the last war and get into this kind of strategy after the fact. And you have to set the expectations up front that this thing is going to zig when other things zag and zag when other things zig. And it's going to look like relative crap in an equity bull market, especially something like this particular managed future strategy that doesn't have the ability to go long equities. Right. Right. So it is truly, truly a diversifier, non-correlated for better and for worse. When people hear non-correlation, they say, okay, good.

2:41In a bull market, I'll do fine. In a bear market, I'm going to be negatively correlated. No, no, no. That's not what it means. It cuts both ways. It just means that you will not be directionally tied for better or for worse to, say, the S &P 500, for example. So, all right, enough of an intro. Here's our talk with Jerry Pryor from Mount Lucas.

3:03We're joined today by Jerry Pryor. Jerry comes from Mount Lucas Management. Jerry, welcome to the show. Thanks for having me, guys. Nice to be here. Okay, tell us who Mount Lucas is and what you guys do. Sure. So, Mount Lucas is, we're in the business of managed futures. It's a diversifying strategy. It's been around since the 1970s, 1980s. I actually was thinking about this the other day when, you know, thinking about, you know, where managed futures came from and how to think about it. I think about like two guys sitting around in the 1970s or 80s saying, you know, the one guy being, hey, I've come up with this new asset class.

3:42You know, it's a great diversifier to stocks and bonds. The other guy said, you know, what's it called? He goes, managed futures. That's cool. What do you do? Well, I invest in the futures markets. That sounds great. You must be really good at predicting futures prices. The other guy says, no, not at all. I think the best way to do this is we're going to follow futures prices. We're going to trend follow and we're not going to predict them. All right. Well, then if it's managed futures, you must have guys really doing a good job managing those positions. No, no, we're going to we're going to system we're going to systematically do this.

4:17This is going to be a quantitative strategy. And what are we going to call ourselves? How about commodities trading advisors or commodity pool operators? Oh, that makes sense because you guys are only trading commodities. Oh, no, no, no, no, no. We're doing FX and bonds and equities and a little bit of everything. So kind of a bizarre name for an asset class. But that's what we do. Yeah, it stuck around. I think I talked to a lot of people. I had a range of people that either have never heard of it, have heard of it, know a little bit, or people that know a lot about it. So the conversation is always interesting to have.

5:00Jerry, as you gave that intro, I was reminded of the scene from Office Space. What would you say you do here? Yeah, exactly. Exactly. So I'm looking at the fact sheet and this stuck out to me, stood out to me. It got stuck between stood and stuck. It stuck out to me. $300 billion in assets and managed futures, mostly in private vehicles. This has traditionally been a strategy for family offices or high net worth investors. Correct. 30 % portion of CTA industry assets under management and managed futures. What's the other 70 %? Because in my mind, CTAs and managed futures were synonymous, but obviously I'm not correct.

5:40So what's the other 70 %? I think it would be more multi-strats of people not doing managed futures specifically. You're using futures as part of multi-asset portfolios. So what exactly is the difference? Is this just like a potato-potato? Yeah, it's more diversified hedge funds. Managed futures is pretty much, at least the way I think about it, is primarily accessed through systematic trend following. I think that's the best way, or historically has been the best, most effective way of earning the risk premium in that asset class. I think actually you just nailed it. It's the systematic part of it.

6:22It's the trend following nature. It's the, I don't really need to know what the Bank of Japan is doing or might do. Most of that information, of course, today's an outlier. But generally speaking, all of the information, all of the analysis that anybody could do boils down to price. And if you follow price, if you follow trend, you're usually on the right side of the trade. Not always, of course, but over time. Yeah. I think the best way to describe it and the way I talk about it a lot is that the futures markets exist for an entirely different purpose than bonds or equities and credit. If you think about sort of traditional asset classes like equity and credit, they're built for businesses and companies.

7:04They want to raise capital from investors. Investors hope to earn a risk premium over time by participating in that wonder that is capitalism so that those businesses and companies grow, pay out their future earnings, of your own capital appreciation. The investment risk premium in stocks and credit is very well understood. In the futures market for the investor, it's entirely different. Futures markets exist, have existed for over 150 years, and they exist so that those same sort of businesses and companies can transfer exogenous price risk that they don't want, that hurts their margins and could materially affect the way they operate their business.

7:47They go into the futures markets and they want to get rid of that price risk. Where we sit as investors, where managed futures managers sit in that marketplace is we're acceptors of price risk. We are taking and we expect to earn a premium over time for that. So if you think about a corn farmer who is planting corn in the in the spring. He thinks, you know, if, you know, I can get the corn in the ground for two bucks in the current price of corn is three bucks. I'm going to make a buck a bushel, but not, but not if the price of corn falls over the next six months. So he's going into the futures markets.

8:24He wants to lock in his price. He wants to run his business. He wants to worry about his business of farming, not what's going on in the price markets. And that's the risk transfer that he's trying to accomplish. Now this in futures markets that exist on both the long and the short side of the market, right? So for every corn farmer out there, there's General Mills who needs, who is a purchaser of corn, has to have corn in order to put it in their cornflakes. And they're also worried about the price of corn and big changes in price materially affecting their margins. Same thing exists in companies in the FX markets, interest rate changes, banks trying to manage that process.

9:06So the whole point is, you're almost like the investment bank that's taking risk off of someone else's book. They want to lock in their price now so they know what it is, they can plan for the future. And you're taking the other side of that in terms of the volatility and the time horizon and all that stuff. So you're taking the risk off of their table. Correct. And where we earn our premium as an asset class is when markets are moving. There's price dislocations across markets. We tend to do really well when that's happening across a lot of markets all at once, which tends to happen in sort of the high stress, you know, inflation, inflationary markets, deflationary markets, sort of after the tech bubble, after the GFC or during the GFC, you know, COVID, you know, 2022, all really good periods for our asset class.

9:55But it's no surprise that it works that way, right? The way we invest through trend following, the price is moving up. We get long and we stay long as long as it keeps going. Typically, trend followers have a moving average or some sort of close stop behind that. And the more things are moving, the more volatile things are, that is good for our business. That is good for our asset class. And typically, those are bad periods of time in the equities and credit markets. When you get those really big stress periods, that's bad for stocks and bonds, good for us. And that's sort of where we fit in the portfolio.

10:41Within the futures market, do you know how much of it is, I would assume that the vast majority is dominated by actual commercial hedgers, whether you mentioned General Mills or these giant multinationals that are hedging, whether it's commodities or interest rate risk. How much of it is – are the CTAs just a small portion of it or is it maybe bigger than I think? Are you big enough to move the price? As an industry, I would think yes at times, but not when the markets are coming unglued. Ultimately, the fundamentals of these things are going to win out in short periods of time on a day. or, well, I'll tell you, let's look at what's going on in the markets today, where we have, we've seen sort of a map.

11:32Yeah, today's a slow day out there. You know, quiet day in August, which I thought would be a good day to schedule a podcast. Well, I think this is actually, I think with an asset class like this, setting expectations is really important. So maybe we could use the current environment to sort of set expectations. So timestamp this, we're taping this Monday, August 5th in the afternoon. Markets have sold off pretty heavily the last week or so that, as I say on the financial news, intensified today. I'm curious how you view the pivots because there was a certain set of trends, and I'm not going to say I know how everything was working in every commodities market, but stocks were trending in one direction.

12:09Bonds were kind of, I don't know, trendless, I guess you would say. How does a strategy like this pick up inflection points like this? How long does it take for this stuff to realign in a strategy like yours when there is a big change and a fork in the road? Trend following is, as the name implies, we are following, so we're not predicting. There is a lag for us to hop on, hop onto a trend. I always tell people, you know, particularly the way we approach the market, in general, most trend followers approach the market. We use a longer term look back period. You know, we're slow to get in, slow to get out.

12:46But because over the fullness of time, being sort of slow to get in, slow to get out, you don't get chopped up as much along the way. You don't want to be jumping in and jumping out all the time. Correct. Yeah. So to me, this move starts around July 10th. What's going on now, that was sort of the top of, depends how you look at the currency. That was the top of the weakness of your, we'll call it the bottom of the yen price, at least in futures terms. You know, you had a couple of currency interventions kind of go, fail, you know, because you have a wall of carry working against those currency interventions.

13:25But then we really saw the yen start to strengthen and the carry trade start to start to unwind. You add in, you know, sort of the Fed, the non-action of the Fed last week and then together with the unemployment report. And we just poured gasoline on the carry trade. which created sort of a systematic global de-risk environment. Is trend following going to catch that? Well, we certainly didn't catch the yen trade because we were short the yen. It's been a great trend forever. You had zero rates in Japan. You had 5 % rates in the United States. Guess what happens in currency? It gets weaker and weaker and weaker.

14:07Trend following rode that trend all the way down. Now that has rapidly unwound, so that in our sort of parlance, that's what we call a trend reversal. It takes us time to get on the other side of that. But what's also happened with that is it's also created flows into bonds. We've seen a big sort of big long bond move here, which has been good for at least some of the trend followers. At least for us, it's been decent, or at least over the last couple of days. As we are long held short and bond positions have started to, we had started to move into long bond positions probably in the last month or so.

14:49So some of the some of the loss in the yen is getting picked up by the gains and bonds. But ultimately, what you got, you're sort of getting from trend following is that you're hoping in these periods, you're getting sort of non non correlated type of returns. I sometimes explain to people that if you think about in terms of a first responder, second responder, historically, bonds have been a really good first responder in an equity sell-off. Trend following is that second responder. Bond gives you that initial protection. It works pretty quick, but then it doesn't continue to protect. You almost look at today, you go back to Friday, we had that big equity sell off and bonds were there.

15:36You had a really big positive bond move to protect your portfolio. Then you get today, stocks are still down, but bonds aren't helping you at all today. Now, let's give it a few days, a few weeks. Let's see how these markets play out. But trend following, like you saw in the GFC in 22, as time progressed, trend following gets on the right side of things and it allows you to earn returns or continue to diversify the portfolio after that initial impact. As Ben mentioned earlier, expectations are really important, especially when it's for something that's not as simple as, all right, bonds, I know that in a drawdown, which bonds are still in, I know that eventually, just arithmetically, I will get my money back.

16:22It sucks. It's not fun. I wasn't supposed to lose money in bonds, but I hold my bonds. I'll get paid back. Stocks, not quite the same arithmetic relationship, but generally speaking, if you had the mindset of, I will hold my stocks and I will ride out the storms, they've treated you well. Managed futures is a little bit different because it's a trading strategy. And it's one of the most effective diversifiers to a total portfolio. But one of the challenges with real world investors, which is what we're dealing with, is that it's a line at them. And when it's uncorrelated in the way that you don't want it to be uncorrelated, you're like, well, what is this?

17:02Why am I short sugar or soybeans or whatever? So how do you talk to investors about the ups and downs and how it fits and how you should look at it within the context of an overall portfolio? I think what you said about real world investors is true and the line items is true. I mean, I think that's the biggest challenge for our asset class. You know, if you look at an optimizer or if you're a CFA or an asset allocator and you're taking a stock bond portfolio and you're running managed futures returns through it. Guess what? The optimizer always wants managed futures. Optimizers love managed futures because they don't have any behavior bias and they don't have, you know, they don't say, oh, you know, maybe I shouldn't rebalance here.

17:43Maybe I shouldn't. Harry Markowitz would have loved managed futures. Is that what you're saying? Absolutely. Absolutely. Every time you look at it in a portfolio, it helps. It helps lower portfolio risk. It helps lower portfolio drawdown. Almost every time you put it in a portfolio or through a backtest or anything like that. The problem with managed futures is, I don't care, it's a problem. It's either a bug or a feature. It's a feature. Feature, not a bug. Yeah, it depends on your perspective. It's a positively skewed strategy. Sounds nice, right? You know, stocks and credit are negatively skewed strategies, right?

18:21So what does that mean sort of as a real life investor and how I live with this portfolio on a day to day basis? In a negatively skewed thing like stocks, you have more observations above the mean than you do below the mean. But the ones below the mean are your left tail events. But they only happen every once in a while. Now, on a day-to-day basis, you are getting patted on the back for owning stocks all the time. You have more good days, more days above the mean than you do below. It feels really good. You're getting constant or consistent reinforcement that you've made the right decision. A positively skewed strategy is different.

19:05It has more days below the mean than it does above the mean, except that it tends to have really positive tail events. That's sort of what Managed Futures is trying to deliver to your portfolio. It's why it diversifies stocks and bonds so well. You're pairing up a negatively skewed distribution with a positively skewed distribution. But on a line item basis, it doesn't always feel good to own that positive distribution. It can be frustrating. And your tail events are few and far between. So you spend a lot of time going, guy, this thing just is not doing, you know, my stocks go up every day and this thing just sits there.

19:47You don't have to go back that far to see the tail event. So I'm looking at, so your strategy, which we haven't even mentioned yet, the Crane Shares, Mount Lucas Managed Futures Index Strategy. Take care. ETF. KMLM? Correct, correct. Not going to lie, it kind of sounds like an airline. Is that fair? Maybe, yeah. I will say that the MLM is for the name of R for Mount Lucas management. What's with Mount Lucas? Is that where you guys are located? It's a good story behind that. I'll do it quick so it won't burn too much time. So we were founded in 1986, and we spun out of a firm called Commodities Corp, which goes back - Oh, wow.

20:22Paul Titter Jones. Correct. Yeah. So one of the founders of Commodities Corp was a guy named Frank Vanderson, who came out of Princeton. He had done his thesis in the wheat market. He got together with this guy, Helmut Weimar, who had done his thesis in the cocoa market. They were working in Nabisco in the hedging department. Thought they could go manage money and got together with a bunch of other traders and started Commodities Corp. And Commodities Corp was based in Princeton, New Jersey. Frank was there. a guy named who's our chief co-chief investment officer Tim Rudderow came to work for him in 1979 as a soybean analyst Frank and Tim were working at Kamais Corp in 1986 East Makota expansion plan had come to Kamais Corp to run a managed future strategy that was an ERISA plan you had to be an RIA Kamais Corp didn't want to do it Frank and Tim said hey let's you know let's let's spin off we're going to do this business.

21:24We're going to take managed futures to the institutional world. We're going to get registered with the SEC. What do you want to name it? Commodities Corp sat in a farmhouse outside of Princeton on the corner of Mount Lucas Road and Poor Farm Road. And if you want to start a commodities trading advisor, you don't name it Poor Farm. So it's Mount Lucas Road, Princeton, New Jersey. So that's where the Mount Lucas comes from. So back to the tail. So I'm looking at your returns of this strategy. And so in 2022, when stocks were down almost 20%, depending on what you're looking at, bonds were also down double digits.

22:03That was the worst of all years for stock and bond portfolios, right? They were both down. Bonds didn't hedge. Your strategy was up more than 30%. So in that tail event, that is the outlier, and to your point, the diversifier. and then the next year, the stock market comes back and your strategy is down 5 % or so, so it kind of lags, but you have that counterbalance. I'm curious, the behavior, after a really good year like 2022, did you see a bunch of inflows into your fund because you had a good year? I'll say, Ben, his investors, they'll give you 2023. All right, a great year, a bad year, but in 2024, they paid to the ass again.

22:40Right, right, and that's where that positively skewed distribution comes in, right? But do you see investors jump in after the fact that you have a really great year in 2022? Do people see those returns and go, ah, I should have invested that? And then they pour money into it? We do. I mean, clearly, 22 was a tailwind for us raising assets for sure and for the industry in general. We, you know, for what we in our space call the sort of lost decade was the teens for us. You know, you had a really low, volatile, zero interest rate environment, you know, during the teens. not a great space for people that are generally long volatility like us you know having been through this cycle so i'm i'm in my 27th year with mount lucas mount lucas has been clearly around like four decades we've seen the you know sort of the cycles of managed futures and you know clearly we're you know i'm a true believer so you know i believe more than most uh i'm very careful about how I described a strategy.

23:38I spend a lot of time, you know, helping people understand when should I expect managed futures to make money? When should trend following make money? When shouldn't? When there are trends. Yeah. When there are trends, when there's more volatility in the market. And guess what? When these things are happening across a lot of markets at once, you're going to see our best performance. But what you get from us is the ability to perform in different types of environments. Bonds worked great for 40 years. It diversified every single time the stock market went down until we had inflation. And then all of a sudden, most people's investing lifetimes, they hadn't seen a world like that.

24:20I haven't been around long enough, but the guys I worked for had been around long enough. We knew that Managed Futures was going work in an inflationary period because we go back to the 70s and 80s. Why? Because you could short bonds? Because you could short bonds. Yeah. I mean, that's the big thing. If you look at anybody's portfolio, what has the ability to short bonds? What asset class can short bonds? It's not much. And the long commodity simultaneously. Correct. Yeah. So we do actually show, I don't know if we show a chart a lot, It might be in the fund presentation, but you look at how we made money in 2022.

25:01We were short bonds, long commodity, short bonds, long to dollar through that period. If you look at the index that our strategy tracks and you run it back to 2008, in 2008, we were short commodities and long bonds. So it's that sort of ability to access two sides of the district in long and a dollar during that period as well. But it's that ability to access two sides of distribution across these big liquid asset classes. One of my partners always says that managed futures tends to pick up crash flows, right? So when the world's crashing, those sort of events are flowing either. Sometimes they're led by other asset classes, but they are flowing into the currency markets, they're flowing into the bond markets, they're flowing into the commodity markets.

25:51And what Managed Futures does is sort of pick up those cash flows. Well, Jerry, this is obviously not something that you can control. You do the best that you can to put the message out there to let investors know that you should probably invest not before. I mean, sorry, before and not after Managed Futures goes on a great run. But listen, you do what you can and investors do what they do. So I say that to say that at the beginning of 2022, there was give or take$30 million in the ETF. And then, you know, you were the umbrella in the rainstorm and the assets 10x in just one calendar year. Yep.

26:27Yeah. And that's the way it goes. I believe in the strategy, but right place, right time helps too when you're raising assets, right? So I give, you know, another thing I talk about is, you know, we had just come out of a period in the teens of pretty mediocre performance at best. Again, you know, zero interest rates, bonds aren't moving around. There's no interest rate differential between central banks. Currencies aren't moving around. It's not a great trending environment. But, you know, from a portfolio construction standpoint, you're winning because your stocks and bonds are just going. They're just marching up every single day as they as they were.