Talk Your Book: Compounding Machine

0:00Today's Animal Spirits is brought to you by Standpoint Asset Management. On today's show, Ben and I spoke with Eric Crinton, who's been around for a while, does some great research. You might have heard him on Meb Faber's podcast a few times. He's a really smart guy. They talk a lot about systematic trend following, all-weather investing, why it works. We spoke briefly about this, but I just wanted to enhance it or double-click on it because he was pretty modest about the returns. But past performance, obviously, et cetera, et cetera, no guarantee. You did the double-click thing. I did. Yeah, sorry.

0:34Sorry. I'm a podcaster now. It's official. This all-weather strategy that they run completely missed any sort of drawdown. Missed in a good way. Very little drawdown during the pandemic. Very little drawdown in 2022 when stocks and bonds got clobbered. And the reason why I'm harping on this is because it's not like he got lucky with guessing. Now, maybe there were some, you know, fortunate circumstances, whatever, whatever. But it's not like he made a market call, right? That's not what they're about. That's not what trend following is. He has a model. And of course, it ebbs and flows, good times, bad times.

1:09But man, time leaves everything. And this thing is absolutely destroyed in a good way since inception at the end of 2019. And you and I looked at a ton of alternative funds in the 2010s. And a lot of them had a really, really bad decade. And you would wonder, the bond market did OK. The stock market was lights out. how are all these funds missing completely on the one big trend? And it's really hard for an alternative investment to survive a bull market like that. And you don't have to match the stock market in that kind of run because that's impossible if you're running some sort of alternative program.

1:48But keeping up at all, it seems like that's the sweet spot that this fund is trying to get to. It keeps up, but it also gives you with less volatility and the drawdowns. And the point you made on the podcast was great. I won't step on it too much, but there's so many really smart people who have quantitative strategies that are just like, look at all this beautiful stuff I did in a computer that creates this wonderful model. I'm just going to sit back and the money's going to pour in. And the investment industry does not work like that. You have to consider how it's going to impact the end client or financial advisors who are going to be the ones putting it in client portfolios.

2:23And it seems like Eric has really been very thoughtful about that, where some other managers just didn't go that extra step. Yeah, and the proof is in the pudding. They actually have done an incredible job raking in assets. So, all right, don't want to step into the conversation, which I hope you enjoy. This is Eric Quinteton from Stampede. 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.

2:56This 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.

3:10We're joined today by Eric Crintenden. Eric is the Chief Investment Officer at Standpoint Asset Management. Eric, excuse me, Eric, welcome to the show. Thank you. Thanks for having me. So we're going to talk today about all-weather portfolios, about trend following. And why don't we start there? So you're a fan of systematic investing. How did you come about? There's got to be an origin story to how you discovered the fine art of trend following. Yeah, there's three on-ramps for me. I say the first would be in college. I did a project where this was in, I think, an investments class where the project was to implement modern portfolio theory by writing the code ourselves.

3:57And at the time, I was going to Wichita State University. There's a lot of commodity trading and agriculture going on in Wichita, Kansas. So I had access to Bloomberg terminals, Reuters terminals. I knew people that worked on hedging desks. So I got a lot of hedge fund data. In college, you knew those people? Yes, yes. Well, my degree was computational finance, and there's not a lot to do in southern Kansas. So anybody with that interest would hang out at the university. I even started a club for quant finance before quant finance was a thing. So I had access to this whole world of hedge fund returns, commodity returns, all kinds of different alternative investments.

4:35And I used that data in my project to implement modern portfolio theory. and one asset class stood out from all the others and really added a lot of value to a stock and bond real estate portfolio. And back then it was called, oh, it's changed over the years. Some people call it managed futures. Some people call it systematic trend, systematic global macro, whatever. They're all close cousins. But the data I was using added a lot of value to stock and bond portfolios. So during that project, that's what got me interested in the space. And if you look under the hood, come to find out, you know, 80 % of the managers, of the successful managers, tend to be either 90 to 100 % systematic in their approach.

5:17So that's what first intrigued me. And then I became an acquaintance of a guy named Tom Basso. You may be familiar with the name. He was profiled in the book, The Market Wizards. I think it was the second version of the book. The New Market Wizards. Yeah, The New Market Wizards. Excuse me, you're right. And became friends with him. And I learned a lot vicariously through him and met other people in the industry. And I just saw all this, what I consider to be success, non-correlated, positive, absolute returns from an industry that didn't get a lot of press and that was highly diversifying in nature when combined with stocks or bonds, but most importantly, stocks and bonds at the same time.

5:58And then the third one was, it just fits my personality. I was in college when those first two on-ramps happened. And then I grew up and entered the industry myself and found that a disciplined, slow-moving, risk-managed systematic approach is completely consistent with my personality. And I think that's important. And I think Tom would reiterate that too, that however you're investing, at some point, your feet are going to be held to the fire and you better be doing something that's consistent with your value system and your belief structure. Otherwise, you won't be able to stick with it. So what about guessing?

6:33No, it's no good. Not a good strategy. How much do you think things have changed in your own personal strategy and then in the managed futures sort of quant space since you were in college? Because I've got to imagine the computational power, the competition, all this stuff. How much has that changed and how much have you personally changed that philosophy? Yeah, so I'm going to be pretty controversial in my response there because I'm completely on the other side of the spectrum. Most people are going to tell you everything's changed, everything's faster, everything's more complicated. There's so much more going on.

7:05And that's all true if you make it true. But the structural risk premia that exists for extraction in the markets hasn't changed at all, at least at a medium and long-term frequency. Where all the change happens is in the shallow, bloody waters with all the sharks with the short-term trading, mean reversion, spread trades, short-term supply chain issues, stuff like that. Yeah, that's very dynamic, very exciting. But it's not where I play because you need a structural advantage. you need size, you need a network in order to play that game. So there's been a lot of change there, and that's what gets all the press, and that's what people read about and whatnot.

7:41But the plain vanilla old school trends and risk premia that you collect by providing liquidity to hedgers at a medium and long-term frequency hasn't changed since the days of Holbrook working back in the 1920s. I'm so glad you said that. Ben and I were talking last week about the zero days to expiration option phenomena, where they're like 50 % of all option volume or something like that. Crazy. And does the fast-moving markets require you to go quicker? And I said something like, no. If anything, you should probably go slower. So I think there's probably a lot of market dynamics that have changed intraday.

8:13Markets might move faster. But if you look at something as very blunt as just a 30-day rolling standard deviation or price change of the S &P, going back to the 1920s, it looks how it looks. Stocks are volatile. They always happen. They always will be. So it sounds like the lessons and discoveries that you had in, I'm guessing, the 90s have not changed dramatically till today. Two points. They haven't changed dramatically at the frequency that I'm looking at them. They have changed, like you mentioned, on an intraday frequency. Certainly, there's been a lot of changes there. But it doesn't affect me or my firm at what I do.

8:54So it's not that significant. I would say, though, that the lessons I learned in the 90s were not good lessons. The 90s were an unusual decade. The lessons I learned were the lessons from the 70s and the 80s and the 2000s. So I think it's very important, or at least I would attribute success and preparedness to being a student of markets throughout history. Look at what your strategy would have suffered or benefited from in the 60s and the 70s and the 80s because it's more likely that we're going to get environments like that going forward than we're going to get a repeat of the 90s. How do you explain managed futures to someone who's never invested in the strategy before?

9:33I try not to. So, well, a couple things. Managed futures is - So do you think it's hard to convert people to this type of strategy? Well, to the managed futures component of it, yes. But we are not a managed futures firm. We come from a managed futures background My background was long short equity And then managed futures And now all weather absolute returns So what we try to do is Extract the useful attributes Out of managed futures strategies The ones that matter the most And combine them with equities And fixed income products To offer more of an all weather portfolio So I gave up Trying to convince people to use Meaningful amounts of pure managed futures because it's not what they want.

10:20It causes too many psychological problems for their clients. So I have a saying that you can give people what they want or you can give them what they need. They won't buy what they need if they don't want it. Bingo. Yes. So what we've done, or at least the standpoint's an experiment. We know what people need, or at least we believe we do, looking at all the weight of the historical empirical evidence. They need more trend. They need more diversification. They need assets that aren't dependent upon rising GDP and falling interest rates. That's what they need. They need these things. And these things exist, but they don't want it until after it's too late.

10:59So there's two ways to tackle this problem. One, you can try to educate people to help them finally start wanting what they need. Now, that's a massive uphill battle riddled with bodies. I mean, I have not seen very many people be successful at that. Or you can take the easy way out and the smart way, I would argue, out. reformat, repackage what it is they need into a format that they want. So basically create the Reese's peanut butter cup. Nobody wants to buy chocolate from you. They don't want to buy peanut butter from you. You can't break into those industries. Margins are razor thin. Mix the two together and you got a whole new industry, blue ocean, huge margins and no competition.

11:37So that's one idea. Or just put some wheels on the bottom of the luggage. Do something. Deliver what people need in a format they want, you can do business. So that's the standpoint experiment. So I am aggressively nodding my head. I agree with everything that you said. I want to come back to the differences between managed futures and all weather. But before we do that, can we just start out with something basic? What is trend following? Why did trend following work in the 50s? Why does it still work today? What is it behind the nature of trend following that is immutable, for lack of a better word?

12:09Great, great triage of questions here. So in practice, this trend following is tracking a diversified basket of uncorrelated assets, hopefully global in nature. So you're looking at metals, grains, energies, bonds, currencies, you know, all the global liquid markets. And you're making sure that you hold positions long in markets that are rising and that you hold positions short in markets that are falling and that you have some sort of a a risk budget for when you're wrong on your position so that you can calibrate the degree to which you're going to lose money, and some sort of a stop loss or a sell discipline to get out of positions that turn negative before they grow into a serious problem.

12:56So you're buying strong markets and holding them for as long as they remain strong. You're short-selling weak markets and holding them for as long as they remain weak, and then managing the transition process from weak to strong and from strong to weak. That is, in the simplest form, just a rules-based trend-following approach. There's millions of different ways to do it. You can be a short-term trend follower, a medium-term. You can use moving averages, breakouts. You can do all kinds of really complicated stuff. But at the end of the day, if you look at the returns of profitable trend-following firms, if you look under the hood and audit those returns, you'll see they made money from basically the same markets.

13:30They're long energy right now. They're short bonds right now, they're long stocks right now, they're short grains, so on and so forth. One of the reasons why this strategy works to the extent that it does is because it's systematic in nature that goes against all of our human biases. In other words, people, I've been guilty of this, I'm sure a lot of listeners have, have a tendency to pick a bottom or to call a top, right? And it's very difficult to let your winners ride, whether they're going up or down or you're long or you're short. But trend following in a systematic way completely removes all emotion.

14:05At least the model is not emotional. As the manager, you might be emotional. But the underlying decisions and structures of the model have no feelings. Yeah, it's a very productive robot, almost sociopathic in nature. It's designed to be a compounding machine and to hold winners ruthlessly for as long as they win. And these things, if you look at the empirical data going back to, say, the 1950s or 60s, you can see these markets have a tendency to go up more than you expect when they first start breaking out and to drag on longer and longer and longer. And then when they reverse and go back the other way, they have a tendency to blow right through the stop and just keep going down and down and down.

14:43Not every time, but enough to blow you up if you don't have rules to govern the process. And a trend following system just simply forces you to hold your winners and to cut your losses. Eric, I wasn't like you where the trend idea made sense to me immediately. It took me some time to kind of understand it and figure out because it kind of went against my own biases. But I understand it now and I am a believer. But how do you get over the fact that you can get so caught up in the minutiae here and like the details and not like the big trend piece, like you said, is the big thing without figuring out like and torturing the data and going.

15:19well, if we did a six-month here, but a seven-and-a-half month here, how do you avoid getting caught too much in the details when the big trend, to your point, is all that really matters for most of it? Yeah, a couple things I'll say about that. You're talking about model risk, where a six-month breakout system looks great over the last three years, but a five-month breakout system was a license to lose money. Yeah, so you could look at it and go, well, we're going to change it now because it would actually look better if we would have done this instead of that. Right. So we diversify across different models.

15:50We have short-term models, medium-term models, and long-term models. That way, we always have something that is not terribly out of favor. I'll give you an example. So from 1970 to current, our medium-term model is by far the most profitable, much more profitable than the short-term model, and moderately more profitable than the long-term model. However, since we launched Standpoint at the end of 2019, the short-term model has been absolutely lights out. It's been the Atlanta Braves this year. I mean, it has just been on fire. And the medium-term model is just, eh, it's kind of, it's doing okay.

16:23And the long-term model, I think, has dramatically lagged. So just like you diversify across stocks, different bonds, different asset classes in the trend-following space, it's important to diversify across models because they do go in and out of favor. The other thing I would share is that if you have a model that is fragile, meaning like a five-month breakout is great, but six is terrible and seven is great, that's a really bad sign that you're on the wrong. You've got a fragile system that's not durable and robust. Because if I see that, what that means is you haven't zeroed in on a structural risk premium in the marketplace.

16:58You've curved fit to some spurious nonsense. And now it's just luck that decides whether it's going to work going forward. So that's something you throw out. And Michael, this gets me back to, I didn't answer your, you asked three questions and I answered one of them and then we jumped off topic. And that is, why does this even work in the first place? Is that fair? You asked that question, right? Yep. Yeah. So in practice, trend following on futures and forward contracts is basically, like Ben alluded to, the exact opposite. What you end up doing is the exact opposite of what would make you feel comfortable on a day-to-day, hour-to-hour basis.

17:34Your human emotions would say, why do we want to buy something that's at a 52-week high? Why didn't we buy it earlier? And why am I selling it now that it's gone down by nine ATRs or nine standard deviations? Why didn't I sell it earlier? Every single thing you're doing is basically the opposite of what makes you feel good right now. So it takes a strange personality to be able to say, I don't need positive feedback. My emotions are not the prime consideration here. I definitely need positive feedback. Yeah, well, I mean, most human beings get worn down by this, and that's why people can't stick with it.

18:08Because underneath the hood, it's basically you're doing the opposite. It's like being a professional poker player. You're not a hero. You're a grinder, right? And it is not fun. That's why most people can't do it. Now, investing is not gambling here. And this is the point, a really important point I want to make. In practice, trend following tends strongly to trade opposite hedgers. Hedgers love to buy declining markets, and they love to sell rising markets. So production hedgers like to buy declining markets to lock in lower and lower input costs. And I'm sorry, consumption hedgers love to do that.

18:45Production hedgers like to sell rising markets to lock in their profit margins and their output prices. Why? Well, it's because they're using the futures and forward markets as a form of insurance to manage the risks on their balance sheet and their income statement. I know this from my days of living in Kansas and having family members that were hedgers and working with people that worked on hedging desks and looking at how they trade. They're basically pure counter trend on a dollar weighted basis. So who's on the other side of that trade? Who wants to buy rising markets and short sell declining markets?

19:19Not very many people. It's just the systematic trend followers. So if these people are using the markets as a form of insurance, a valuable form of insurance, which really reduces their cash flow variability, which in turn lowers their bankruptcy costs, which in turn lowers their own debt financing costs, they can issue bonds at a much lower interest rate because they're a much more stable business because they hedge. That's very valuable, and it's an inverted form of insurance. Now, in what world is that insurance free? It makes no sense. It should not be free. So what ends up happening, and this is a theory, and this is my theory, and I can't prove it, is that the risk premia that they pay flows from them to the trend follower over time.

20:01And because they're notionally trading and trend followers are trading on a leveraged basis, that 2 % can easily become 6%, 8%, 10 % depending upon how you're calibrating the risk in your portfolio. And that is a symbiotic, sustainable relationship. And that's structural, right? Those hedgers don't leave the market. No, they're the reason the market exists. Yeah, these markets were not designed for investors. Yeah, sugar futures, that's not for retail. That's for literally people. That's for Domino. Yes. Yeah, it's commercial hedgers. And then you've got the speculators and large participants on the other side providing them liquidity.

20:42So you mentioned earlier about managed futures, which might be what people need, but not what they want. And I couldn't agree with you more. I was looking at, so I'm a fan of trend following in almost all forms. But I was on a quarterly call with an asset manager just checking out their managed futures. This is probably like 2018 or so. And it had been a really, really rough decade. And one of the biggest drivers of underperformance for that particular quarter was a short sugar trade actually. And that example always stuck with me. if you're trying to explain to an end client why they're having a rough time and you point to a short sugar trade, it's like, whoa, whoa, why am I shorting sugar?

21:22Now, I understand the non-correlation diversification benefits fully, but if you can't at least even remotely survivable market, now, if the S &P is up 11 and you're up nine or eight or even seven or six, that's not what I'm talking about. But if the S &P is up 9 % a year for a decade and you're flat, I don't care how sophisticated your end client is, you're just not staying with it. That's fair. Yeah, I mean, that's the empirical observation. Now, whether they should is a completely different argument, but it's true, right? People can only handle so much relative performance envy before they have to move on.

21:58And so how did you come to the conclusion that, all right, managed futures, maybe that's the pinnacle of what I'm trying to do. But again, human beings are the buyers of this. So let's do the next best thing, which is an all-weather strategy. Can you talk about some of the differences between the two? Because in my mind, they're synonymous, but obviously they're not. Well, let me take a step backwards and say, I don't think all weather is the next best thing. I actually think it is the best thing. So in that project that I did back in 1996 at the university, the maximum Sharpe ratio portfolio and the maximum Sortino ratio and the maximum Calmar ratio were all about the same portfolio.

22:35It's about equal risk contribution from pure trend, managed futures, systematic global macro, whatever we want to call it, at global equities with the cash balance going into treasury bills. And that was from 1970 to 1996. So if you run it again from 96 to now, same weightings. It's the same portfolio. That is the optimal compounding vehicle when you limit yourself just to scalable asset classes. I'm not talking about some weird asset classes that don't have a lot of liquidity. So I view the all-weather as the appropriate balance between a managed future strategy, global equity, risk premium that you're collecting, with the balance going into T-bills to try to keep up with inflation.

23:20So I view that as the best, by my definition, the best, which is I want a stable, reliable compounding machine for a very uncertain future. So, sorry, I didn't answer your question. Well, what's the biggest difference? Yeah, I'm curious how you differentiate. Between managed futures and all weather? Yeah. Yeah, well, it's not very meaningful. So we run a managed futures program that's diversified across 75 different markets around the globe. Currencies, grain, soft commodities, energy, bonds, so on and so forth. and when you run a futures program let's say you guys loved my futures program and you gave me a million bucks and said Eric go run your program I only need a hundred grand to run the program that's it, that's the way futures programs work all you have to do is put up the margin deposit and a hundred grand is twice what I need for the margin deposits to control all the futures contracts on a one million dollar program so what do I do with the other$900 ,000 where a typical managed futures manager is going to just stuff it all into T-bills.

24:28That's all they're going to do to get that yield. We take about half that money and put it into globally diversified market cap-weighted equities. So basically the MSCI World Index, leaving us with still about 40%, 45 % sitting in cash. And we take most of that and we put it into a laddered treasury bill portfolio, leaving us with about 5 % to 10 % sitting in pure cash. And that, my friends, is an all-weather portfolio. And it has about equal risk contribution from global equities and the managed future strategy with a nice little kicker from the T-bills, or at least today we're getting almost 5.5 % from T-bills.