Talk Your Book: How to Eliminate Negative Alpha

0:00Today's Animal Spirits Talk Your Book is brought to you by Longboard Funds. Go to longboardfunds.com to learn more about the Longboard Fund, which is a trend-filing strategy we were talking about on the show today. That's longboardfunds.com. 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.

0:34Clients of Ritholtz Wealth Management may maintain positions in the securities discussed in this podcast.

0:42Welcome to Animal Spirits with Michael and Ben. On today's show, we are joined by one of the OGs in trend following, Cole Wilcox. Ben, I love the idea of systematic investing, trend following, removing the emotion, if only I could follow it. I mentioned this on the show that I sold Netflix and and meta, I don't know, both 50 % ago. Why? Because I doubled my money and I was out. That is obviously not the right way to invest. But I guess I need to learn that lesson 10 ,000 more times before I finally follow the trend. But what I'm attracted to about what they do is there's no emotion. They don't get scared that the profits are going to go away.

1:23There's a trend, there's a system, and they follow it. It's also probably one of the reasons that trend following is not in concentrated positions either, Right. Most trend following strategies are diversified because they don't want to be in the position of holding a handful of stocks. And then if one or two of them goes right or wrong, it totally screws everything else up. Right. Like you'd you'd have to have a more of a bigger basket of stocks of Netflix's and Facebook's to do that strategy. My favorite part, my favorite point that he made in the conversation today, not to step on too much of it, was listen, it's not that like the trends are necessarily predictive.

1:55it's that they're systematic so that you don't have to decide is now the right time to sell because obviously that's impossible. And again, not that there's anything magical about trend following, but you're not going to shoot yourself in the foot. And so we, Cole works for longboard funds and it's a company that we've mentioned on our podcast and our blog, I don't know, eight, nine, 10 years ago. And their work looked into the distribution of stock market returns that It sounds like it kind of was a motivation for Hendrick Bessenbinder, who we've also mentioned before, that shows like the top 4 % of stocks accounts for the large majority of the gains.

2:29It is not a bell curve. No, not at all. And so we get a little into that research, and he's got a new fund out. So very interesting strategy. And plus the trend itself, there's so many different ways that you can take it and ways that you can think, put it on this or that asset class or this security or that. It's very interesting. So we get into all that with Cole Wilcox. founder and chief investment officer at Longboard Asset Management.

2:56So Cole, you've been doing this for a long time on your website, Longboard Funds. It says optimizing alternative investments for financial advisors. Alternative investments are like all the rage these days. So I'm curious, what does alternative investing mean to you? Like when you hear that word, what do you think about? It's a big category. For us, we think about It's really anything that can be that third leg of the portfolio outside of stocks and bonds that is designed to provide additional diversification, lower the risk, correlation, etc. So you have a more balanced portfolio. And obviously, there's a lot of ways to access that, whether it's public vehicles, private vehicles.

3:39It's quite a big category to kind of dissect with alts. You're an OG trend follower. Like I said, you've been in the game for a while. I'm curious because we've never spoken before. Just like a 30-second background. How do you get to here? What's your background? Background is we've been doing this 25 years now. Originally, I started as a private asset manager. We ran a hedge fund fund of funds that specialized in allocating money to trend following managers, managed futures, whatever you want to call it, and macro hedge funds. And that was kind of how we got into the space originally. And through that process, started to do our own research and development on our own internal strategies, which kind of started in 2005 and led to the publication of a lot of pioneering research that we did in that 2005 to 2007 publication time.

4:40So one of the research pieces that Michael and I have used, I think in our blogs over the years, we might use it in Affirm too, just you did this distribution of returns for the stock market just to show that it's just a very small number of stocks that account for the majority of the games from a market cap perspective, which I think when it came out was kind of mind-blowing to a lot of people. You would think, well, half the stock's too good and half the stock's too bad. What did that research in conclusion tell you about trend following? What was it about that stuff that made its way into your work?

5:11Well, that concept of the vast, we're not in an equally distributed world. It's not a bell curve the way that it may be with indexes. At the individual stock level, most companies and most stocks are actually very, very bad investments, and a small minority are driving all of the market's cumulative returns. So another way of saying is that power law kind of concept is very, very real and is a fundamental law of the stock market and capital markets, sort of like it is in venture capital returns. A small minority of deals end up generating all of the returns. It's the exact same outcome in public markets when you dissect this.

5:53What we saw was that being able to predict winners and losers, after the fact, it's easy to say, oh, this 7 % of stocks made all the returns, everything else was garbage. But being able to predict which is going to be that 7%, which ones is going to be the winners, I mean, if we knew how to do that, we'd all be billionaires pretty quick. Trend following doesn't have a predictive advantage. It doesn't know which companies are going to be winners and losers, but it does have the advantage of a systematic process of holding your winners and folding your losers as markets kind of evolve and play out.

6:30So it's very, very naturally positioned and predisposed to be able to benefit from that power law distribution that exists in markets. So Cole, I blame you. I blame Hendrik Bessenbender, who you inspired. And I blame JP Morgan's The Agony and The Ecstasy of Stock Picking. What do I blame you for? Showing me the light and making it so that I can't hold my winners because I know the math of how most stocks are not worth holding for the long run. But I also, I should have taken your advice and do a better job of riding my winners. So for example, I sold Netflix, I don't know, a couple of months ago, I sold Meta last year.

7:09After I make a double in a stock, I'm out. That's like my upper bound. I can't get a 10X because I'm afraid that the gains are going to be ripped away from me. But instead of being driven by my emotions, I should just follow the damn trend. But it's so easy to say, and it's so hard to do, which is why I am really drawn to the idea of systematic. To your point, it's not that it's going to know for sure, but it eliminates the emotional aspect of riding winners. It's hard, right? Because a lot of these winners have big drawdowns. And so you want to stay invested, but you also don't want your gains to be ripped away.

7:45So I'm rambling here, but it's important. The systematic part of it, I think, resonates with a lot of listeners. Yeah, I mean, I would not be able to do what we do and capture the kinds of gains that we capture on individual positions if this was a discretionary strategy. I'm a human. I understand my natural biases just like everybody does and the desire to book winners and hold on to losers and kind of all of the psychology that exists out there. I'm not immune from that. But by being aware of it and then designing strategies and systems that can eliminate the negative alpha that comes from your human failures and put it into a process like this and allow this insight around what is the real distribution of the markets and what is the real human psychological flaws that we end up screwing things up and put it into a process that can hold your winners, cut your losers, and have that repeat kind of over time to successful opportunities.

8:44outcomes in a very disciplined way is why we do what we do in our strategies. From a 10 ,000-foot view, trend following seems relatively simple. It's cut your losers short and let your winners run, right? But if you get into the weeds and the details, there's a lot of different ways that people interpret trend following. Some manage futures funds, will invest in dozens, if not hundreds, of different futures commodities and rates and foreign exchange and all this stuff. Some people use trend following to do an asset allocation switch. They'll go from owning stocks to owning bonds or cash or something like that.

9:19Other people will use trend following on individual names. Where do you fall in terms of trend following and how you implement your strategy? So in our strategy, we do something unique and different where we specialize on trend following on individual securities. So our investment universe is quite broad. It's the entire Russell 2500 index of US companies. So there's 2 ,500 companies that we start with, and we're analyzing the long-term trend and performance behavior of every stock that is inside of that index. And then we're going to bottom up build that portfolio by whatever the breakouts are that are making new highs.

10:02We're going to own every single one of those securities in our portfolio. And every stock that is breaking down in trend to new lows is going to be eliminated from the portfolio. So we constantly just own the cream of the market through every evolutionary cycle. And we're constantly eliminating tax loss harvesting and exiting the majority of stocks that are ultimately a big drag on performance at the index level. So this is basically like a mid-cap strategy. It's Russell 3000 minus the S &P 500. Correct me if I'm wrong. Why no love for the large caps? It's not that we don't have a love for large caps.

10:46If you think about on average, most stocks are small and mid-cap companies. So we do own some large cap in our portfolio, but it's the minority 90 % of the portfolio is small mid-cap exposure, or it's 10 % is large cap. It's really just due to the fact that we like to have the whole universe and catch those big winners. There is more 10-baggers and 50-baggers that come out of the small and mid-cap universe relative to a mega-cap universe. It's hard for Facebook today at its current market cap to become a 50-bagger from where it's at today. But a stock like Sprouts Farmer's Market is an example of a company we made a lot of money in over the last few years.

11:35Maybe it becomes as big as Walmart someday, but it still has a lot of runway and a lot of growth in front of it. So you see those growth opportunities and these big opportunities for huge multi-bagger winners that are naturally predisposed to trend following that come out of that small and mid-cap space. It's interesting, too, to look at the opposite of that, because the stat we always hear is, I don't know, 40 % of Russell 2000 stocks have no profits. Is it just as important to avoid the losers in this space, too, because there are probably so many smaller and mid-cap companies that don't make it or languish or potentially go out of business?

12:09So is taking off that side of the tail just as important as finding the winners? It's more important than anything. I would say the biggest source of alpha is taking out the losers. But how do you take out the losers is what's important. There's a huge amount of performance drag and a huge amount of opportunity cost in owning those junk stocks that exist inside of the Russell. But just because a lot of companies are junk, that doesn't mean that every company is junk. It cuts both ways. And so being able to sift through that and only own the top performing companies that are with inside of that, you have to do both.

12:53But a huge part of the alpha is eliminating the performance drag of just garbage that's in the Russell. So the 50 baggers or the 20 baggers, whatever, correct me if I'm wrong, they don't go up in a straight line. They have drawdowns. And a lot of them have severe drawdowns. So how do you – I guess it's like a push-pull. How do you ride the wave and avoid the 35 % drawdown or whatever it is that's almost inevitable? How do you do that? Well, one, you kind of understand that those drawdowns are natural kind of ebbs and flows. I mean, Bessenbinder did another paper where he analyzed the average drawdown of the biggest winning stocks over a decade period of time in the previous decade.

13:40So if Amazon was the biggest winner in this decade, you went back the previous decade and What kind of volatility did you have to suffer to hold? I think the average drawdown was like 50%. So big winning stocks have huge, enormous drawdowns in their life cycle, and that's just kind of a reality. For us, it's also the recognition that these big trends, they play out over multiple years. We are not talking about capturing short-term momentum in something. Our average hold time on a position is going to be measured in years. In a highly profitable position, it's going to be measured in multiple, multiple years.

14:19So by being patient, giving these positions room to run, and not being overly aggressive in how you calculate your stop loss levels is kind of where our focus is at. More of a very long-term approach versus the kind of the short-term trend speeds that we don't focus on. So if you have a stock that you've held for three years that's up 4 ,500 % or whatever, do you give that more room to run or more room to draw down? Because if you were to zoom out, a stock that's up 30x could have a 40 % drawdown and the long-term uptrend can still be very much intact. So do you have a different set of criteria for different stocks or is it universal?

15:05No, our criteria is universal. And it's not rocket science or necessarily even proprietary. We just published a paper this week on SSRN called Does Trend Following Still Work on Stocks? where it pretty much fully disclosed the entire logic of what we do, how we get in, how we get out, the calculations around that. But it's a universal entry-exit kind of criteria that self-adapts to the volatility of each individual stock. So a stock that has a lot of volatility, you're going to give it more room. A stock that has less volatility, you're going to give it kind of less room. But their volatility kind of like neutral between one another.

15:49Does that make sense? So I guess the hardest thing about most trend-filing strategies is the pivot and the turn, right? Going from an uptrend to a downtrend. and no strategy is perfect in catching those turns. If it was, as you mentioned, we'd all be billionaires. If you could get out of the top, get right back into the bottom. Most trend-following strategies, you know, obviously are going to miss like the exact peak and the exact bottom. But you have this table in your presentation that shows the five worst quarters for the Russell 2000 since inception of your fund, which is kind of funny because it only goes back to 2018 and there's been some really nasty Russell 2000 quarters, right?

16:27It was down 30 % plus for that first quarter of 2020, for that first two months or whatever. And you show your performance in there for your fund, and it outperforms by a ton in those quarters. So how quickly does going from an uptrend to a downtrend turn in your stocks, and how quickly can you get out? And then do you just go to cash, or what happens in those events? I mean, how quickly is very much dependent upon the market cycle and what happens. I mean, in COVID environment, we de-risked the portfolio in a matter of weeks. But that was also the macro environment was it was the fastest decline on record that we had had.

17:05And our strategy is going to naturally self-adapt to that massive increase in volatility. Your stops all get hit. And what we do is, unlike a lot of other people that are trying to move money into gold or some other kind of low-correlated asset, we want absolute stability in a moment of crisis. And what we have found in our research is that the most reliable source of non-correlation in a market crisis is short-term treasury bills to provide stability, capital preservation, and a source of non-to-negative correlation. So that's the asset that we go to in a risk-off environment is to hold more treasury bills and weather the storm until the next kind of trend bull market cycle emerges in the future.

17:53Is there anything inside the structure of the market that you've seen a noticeable change on over the years where trend following used to work really great in, I don't know, the 04 to 06 range, and it's a little bit trickier now given whatever XYZ, or have you noticed no change at all? When it comes to trend following on individual stocks, we have not seen any change at all. There's actually in the paper that we just published a stability of alpha section where we answer that question. Has there been any change or any kind of stuff? And there hasn't. In fact, last year was actually one of the most successful alpha-producing years for trend following on stocks.

18:38What I have seen, but it has nothing to do with trend following, is obviously the huge performance dispersion between small and mid-cap stocks and large-cap stocks. So everybody kind of knows that the S &P 500 has been driven by a handful of companies, and they've really substantially outperformed their small and mid-cap cousins by a wide margin relative to history over the last decade. So obviously, a strategy like ours, if you benchmark it against the Russell, which is our universe, we produce a lot of positive alpha, and it looks great in terms of the raw returns and the risk-adjusted returns.

19:21But if you looked at it against the S &P, you'd be like, eh, S &P outperformed you, right? But it's like, well, the S &P has outperformed everything. Everything and everyone. Yeah. So, you know, if we had been running trend and it was only on those S &P stocks, right, well, then we would have much better performance performance because you'd have more trend in these stocks that had turned out to be these huge winners. But I have not seen anything there in the individual stock side of it that there's any deterioration that is specifically trend-related. In the multi-asset trend stuff, I would say probably for sure you started not—it's come back in the last few years, but there was that period of time from like 2016, 17, 18, you know, 19, all that pre-COVID thing, government intervention, you know, there was a, there was a, it was hard to make money in currencies and other kinds of trends.

20:18Managed futures had a really rough 2010s, right? Managed futures had a very, very rough, difficult period of time because you just didn't, you know, you didn't, the macro environment of what was going on with central banks and the rest of stuff just didn't in the compression and interest rates, eventually it blew up, right? Like post-COVID, now you saw inflation, huge moves, and that's been very, very beneficial. And there's been a resurgence in the performance of those multi-asset managed futures kind of stuff. But there was a period, a minute there, where you would have been a very, very unhappy investor in those kinds of strategies for quite a while.

20:54So for setting expectations for a strategy like this, if you're like a financial advisor and you want to put your clients in this strategy as an alternative. Are you setting expectations of, hey, you should expect the Russell 2500 returns, but with much less volatility and lower drawdowns? Or are you saying, no, this is positioned to outperform? Or how do you position this in terms of setting expectations? Setting expectations and just, you know, performance, we, you know, we've been fortunate to be able to match or exceed the returns of like the Russell successfully, like net of all fees. So I think that's a reasonable, you know, expectation.

21:28I certainly don't expect to outperform the S &P 500 because it's not the appropriate benchmark for us. But against the Russell, it is. And to do it with substantially less volatility and substantially less drawdown and meaningfully lower correlation and meaningfully lower beta. But the way that the fund and the strategy is best used, and this is kind of what we focus on, is not so much providing a fund, but providing optimizing alternative sleeves for financial advisors and how our fund fits into that sleeve and the right use case for it. Because we have incredibly low correlation to any other alt strategy that's in the market.

22:12But we also happen to have, right now, I think, of the top 20 alt funds, like the third highest nominal rate of return. So we can add returns into an alt sleeve without blowing up the diversification value or the risk profile of that sleeve. And that's where we find kind of the most success is helping advisors dial in and optimize the performance of their overall alt sleeve and how our strategy kind of fits with inside of that. We don't position this as like, you should replace your small cap exposure in your small cap beta with this. I don't think that's the right use case. I like how you talked about the potential upside here.

22:58Because I came from the institutional space where one of my biggest problems with hedge funds that all these large endowments and foundations were in is that they were never set up to keep up at all in a bull market. and trend following to me seems like a much more logical way to hedge because you have the ability when things are going down to get out or to go short or whatever you're going to do but then when things are going up you're going to ride that wave I'm curious what you think about the hedge fund structure and how that space has performed versus just a simple trend following model For us we're in the hedged equity category and that's kind of where people put us I don't like a lot of the products in that category for long-term holds because they tend to look more like buffered strategies where you're giving up a lot of your upside.

23:47If it's some covered call type thing, it'll reduce volatility. I think the largest fund in that category is the JPMorgan hedged equity strategy. And the issue with it is that over the long term, it's not going to give you anywhere near the rate of return of the S &P 500 because every time there is an up move that's outside of the option collar that they have on, you're giving up that upside. And that upside is incredibly important to the long term distribution and return of being an equity investor. In our case, we want our cake and eat it too. The ability to have trend-following hedge on the downside and reduce volatility and reduce drawdowns, but still be able to be fully invested and capture your full upswing when the trend is there is what we prefer about this approach.

24:40And then relative to hedge funds, what you said is you also need to be in a structure or something where the fees are fair. If you're taking management fees and performance incentive fees and maybe taxes on top of that, if you have an inefficient kind of structure of what you're doing, those things really start to eat into the returns that the investor actually ends up receiving in their wallet and what they can kind of eat from. And that's something that we're very sensitive to is making sure that our fees, our taxes, and the net of everything that we're delivering is actually really adding value to our shareholders.

25:21What's the worst market environment for a strategy like yours? What are some things that investors need to be aware of as they consider allocating to this? Well, I mean, the average person, I would say probably over the last 10 years, that's like the worst environment for us because our universe has sucked so bad compared to what everybody thinks is the general market, right? Like, oh, you look at us versus the S &P, and we're like, oh, you're not very good. And I'm like, well, we're actually great, but it's the wrong frame that you're looking at it through. The other part of it that's worst would be incredibly markets that go to new highs and then go to new lows and then go to new highs and then go to new lows.

26:04But I'm talking about maybe the 1970s kind of period of time where you have these big, wide channels of ups and downs can potentially be challenging for the absolute returns. The relative returns may still be better than less volatility and whatever. but for actually just making net money if the market truly just goes nowhere for an extended period of time. And not the market, but like the underlying components of the market, right? Because that can be, you know, difficult. But the truth is, because we have such a wide universe and we're covering everything, we generally usually can find something somewhere, you know, that's working.

26:47Like an example of that was in 2000, 2002, you would have said, oh, you were in a bad bear market. And it was for the NASDAQ and tech. It was just terrible. But underneath the market hood, there was small and mid-cap value was just raging and doing quite well. So if you had a more diversified universe like we do, you were able to find all these positive trends that were working, even though your average investor out there was just getting hammered in the tech wreck. How often does your fund go to cash? And then maybe what is an average percentage where the fund is in that risk-off mentality? Well, the question about how often it would go completely to cash or treasuries is very, very rarely.