[REPLAY] Eric Peters – Trading and Evolution at One River (First Meeting, EP.18)

24:32We have five funds now, and maybe over the years that will grow as we figure out really good things that we can do. The irony is we converted to this model. We ended up getting six or seven really notable global endowments. A couple of the largest U.S. corporate pension plans were approved by a couple really notable U.S. consultants. Now, our whole world just changed after having made that transition. Now we have some of the strategies that we can recombine in ways that I think will be a really fun part of our business over time. So what are some of the strategies and themes you have in these vehicles today?

25:08So we think in terms of strategies, themes would be embedded into our discretionary strategies. It's just kind of how we think about the world. So we have a dedicated long volatility fund. So it's a discretionary fund that looks across asset volatility globally and looks for what we think are the best opportunities to be long vol relative to what's happening in the world, relative to what we think are the potential catalysts. And so that's a fund that we run. We run a fund called Dynamic Convexity, which is also long volatility, but it is a purely systematic long volatility fund and only equity.

25:45So it doesn't trade cross asset of all. Dynamic Convexity, we talked a little bit about quantitative investing earlier on. It's super exciting from my perspective and a career perspective because it's taken three different investment approaches that we've had in owning equity volatility that we have traded for years and it's codified them into something that's purely systematic and not only puts risk on, but takes it off and takes profit and crystallizes those profits based on what we think is sound trading logic. And so that's a great allocation for people to make that want to have some type of really thoughtfully constructed, systematic convexity solution next to maybe the risk premium portfolio or next to their equity portfolio, or quite frankly, next to their trend portfolio.

26:29So it works really well together. So those are the two long vol strategies. We have an RV volatility strategy. So it's purely market neutral. And it is market, it's flat on the air. But we're looking for cross asset, idiosyncratic opportunities in the vol space. And I think coming out of this crisis, it's gonna be a very target rich environment for a strategy like that because there are so few players left in it. And whenever you start dislocating markets like this, the people who can manage the risk well through the difficult times, I think really, and rightly so, get rewarded on the backside of that.

27:04So those are the three volatility strategies we have. And then in trend, we've been running a systematic trend strategy, which took me back to those early Chicago days. And something that was really exciting for us is one of our largest Australian superannuation clients last year came to us and said, we like your approach to trend. And everything we do, we think, has really thoughtful risk mitigation embedded into it, including trend, where we have certain stop loss methodologies that get us out of the way of really big market reversals. And so they said, we like what you're doing. If we gave you$100 million, could you apply your algorithms to alternative markets?

27:38And we had been doing research on that for about a year and a half. We knew it would be one of the products that we would want to do. And so we were able to launch that last year. And so that's our fifth strategy. So we have core trend that's outperformed the industry, and now we have one of the few alternative market trends out there. And because we've been trading macro our whole careers, a lot of these instruments are just pretty straightforward for us to trade. And so that's been a really nice addition. How do you think about what your edge is or competitive advantage in these trading strategies?

28:06I think we apply what I would say is just a lot of common sense to what we do. We want to always understand why we're getting paid to do something. for instance in trend i absolutely respect guys who can make money in short-term trend trading i don't understand why they're getting paid to do it i think that we get paid to trade long-term trends because the world is always changing and there are certain times in history it's changing more dramatically and perhaps quickly than others but the world is always changing and it's difficult for humans to wrap their heads around change. And so that is often why trends extend well beyond what people can really contemplate or imagine.

28:48And markets and economies and innovation and politics all move through cycles, and they don't tend to be super short-term cycles. They tend to be longer-term cycles and weather and everything I observe in nature moves through cycles. And so I think that the reason you get paid is because the world does move in cycles, and yet people struggle to understand the breadth and magnitude of change. And so if you can ride a trend for a long period of time, there's a good chance that a lot of people, even if they're super smart, will have gotten in it, but get out of it way too soon. For instance, when 10-year treasuries got to three and a quarter yields, I can't tell you how high the percentage of friends that I had who are discretionary traders, and I am as well, who thought they probably don't have a whole lot of upside, but they have a lot of downside from you.

29:35yields could fall a long way. And they were short above 3%, and they were typically out at 275 or 280 and declaring victory. And now we're whatever we are, 70 basis points. And I've watched people blow up over the years with the JGB Widowmaker, where you just couldn't believe that rates could go as low as they have. And so these are just examples of things. So we trade in medium to longer term trend because we think we understand why we get paid there. And yet the trade-off there is that if you're trading longer term and you have major market reversals, you can get really profoundly hurt. And so I don't like that.

30:11I just don't like losing a lot of money and being vulnerable like that. And I hate negative convexity. And so we have embedded stop losses within everything that we do. And that gets us out of the way. We got out of all of our equities in the second half of February. And so we thank God. But that's why we've built things the way we've built them. Now, one of the challenges for us is it limits our capacity. So our big competitors, they've made the choice that they're going to build strategies that can manage 10 or 15 or$20 billion and they can't get out of the way. But my view is I'd be very happy to build a business where we're great fiduciaries and we have good risk mitigation, but we're not as big as the other guys.

30:52In vol, we've been doing it for a long time. They're very complex markets. And I think we're very cognizant of risk. I think that we work very hard to understand all the flows. That's helpful. I think we're super curious. I think one of the things that's underestimated in investing is just how important it is to have an open mind and be really thoughtful and curious about what are the things that maybe you don't understand that well and what are the potential risks embedded in that. You can go through long periods of time where that's not super important and then you get to a period of time like this and if you're not those things, you get wiped out.

31:25you lose your business, you lose your money, you lose your investors money, you might lose all of it, or you might just be so impaired that you can't be around to play again. Those edges are really underappreciated until you have these periods. And then I guarantee you in three or five years, people won't be that worried about stuff like that anymore. We're going to take a short break from the conversation so I can tell you a little more about today's sponsor, Adam Finance. It's an investment research platform built by a former hedge fund allocator who wanted to be able to use the kind of institutional research tools he had at his fingertips at a certain expensive terminal in the past.

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32:42So you can get these alerts on markets, on your stocks, company news, and upcoming earnings announcement dates. You can try all this for free today at adam.finance. That's A-T-O-M dot finance. And make sure you download the Atom Finance app on your mobile device as well. Cool. Let's get back to the conversation. I want to turn to this last couple of weeks and period of time. So as we sit here and it's Wednesday, what are you seeing in the markets? I just think what's happening in the world is utterly fascinating right now. The thing that's most interesting to me is humans just have a very, very difficult time processing rapid change.

33:25And I'm not immune to that, but I think that creates opportunity because what we had is we had a very rapid equity market decline that I think was entirely justified. Number one, because I think equities were just enormously overvalued to start with. And then we had this chaotic decline that the Fed stepped in to try to mitigate. and in the absence of what the Fed and what the government have done with this, I think the equities would be down 30 % to 50 % from where they are right now. Now, the Fed has done what they've done and this government package is in place and I think that they're material and they're meaningful.

34:05But when I look at it, I think we now have a whole range of second order effects on society and on the economies and on markets that are extremely difficult for people to process. And I think that's where some of the really good opportunities are going to come from. And then once we get through the second and third order type shifts that are going to happen, then investors are going to look at their portfolio. And then you have this whole new round of challenges. How do you build a 60-40 portfolio when the Fed has taken the whole curve to zero or close to zero and doesn't move. I don't know. Go ask the Japanese how well that's worked out for them.

34:43We haven't had to confront that in the West because we've had an actual curve. Even if rates have been low, there's been some ability to have your treasury investment offset some of the risk in your equity portfolio. And that's allowed people to take lots more risk to hit the magical 7.5 % pension return. There's no way pensions are going to be able to even come close. They're not even to be able to pretend that they can anymore. And so what are the repercussions of that? So there are a lot of things that I'm kind of just starting to think through. In terms of the market here and now, I think we're a lot closer to the ceiling in terms of equity prices here than we are to the floor.

35:20I think it's highly likely that we'll be a lot lower in equities before this is over. And there'll be pockets of opportunity in vol. Equity vol could still go up from here, but the real convexity is behind us in equity vol. But there is a lot of convexity still in certain currencies. And then I think some other things that we're looking at. So as you look out past that period of time, say two years, three years, whatever it is, you mentioned pretty significant effects on the economy, society, and markets. Why don't you walk through your thoughts on each of those? Let's start with just quickly what got us here.

35:56I think what got us and why we have been calling for market fragility when I think a lot of others have been relatively sanguine. What I've observed over the course of my career is that crises are always different and policymakers are always fighting the last word. And people say that a lot, but I don't think that they appreciate how important that is. And it's important because if that's true, then you can rest assured that the next crisis is always, it's just going to look different. And so I think what happened after 08 is that people concluded that the banking and financial sector just got way over its skis and it facilitated this huge run-up in property prices.

36:33So we have to stop that kind of behavior from ever happening again. And we have to just rein in these banks. And if we can do that, then we're in good shape economically and market-wise. And so you'll notice that over the last few years, whenever central bankers are talking about the overall market structure, like, well, look, the banks are well capitalized. And largely speaking, everything's okay because the banks are not engaging in risky behavior and the private sector can handle losses if they do something stupid in ETFs. But the central bank, if they could have prevented the worst crisis since the Great Depression in 2008, then surely as long as the banks are healthy and the Fed is there, there's no way we're going to have a really disrupted economy.

37:18And so I think what has happened is that our entire corporate sector and investors have geared themselves toward really low levels of economic volatility, because the view was that if the Fed was able to save the economy from 08, and if that was truly the worst thing that's happened since the Great Depression, then what else could happen? And so when you have everyone gear themselves to low economic volatility, what are some of the things that that means? Well, it means that the corporations look at their balance sheet and they're like, well, if we have relatively stable cash flow coming in and we think that the Fed is going to be able to mitigate any real economic disaster, then why don't we just go out and borrow as much money as the market will let us and then buy our stock back?

38:03And so that's what they did. And investors did the same thing because they're like, well, look, we got to earn 7.5 % a year. Otherwise, I'm the state of, you come up, you name the state. Otherwise, we're insolvent and we can't be insolvent. So we got to make 7 % a year, at least pretend like that. And we can't only own equity. So let's just go into credit and private credit or let's do private equity. And every single one of these things has been fueling and funding this leveraging and financialization of the US economy. And the common factor is low economic volatility. So here we go. Boom. We have this tail event.

38:34And by the way, it could have been any number of things. This outbreak happens to be, I think, the worst conceivable tail that could have hit because it just stopped the cash flows to all these guys that have over levered. Everyone's over levered and private equity guys. They're the worst in terms of this. But investors have put their money into private equity because they get a levered equity return to try to hit their seven and a half percent target. They don't have to market, not as aggressively. And so no one has been a bad actor, but the pressures that we're all under led to this leveraging of the economy.

39:09And so now that's over. So the question I think you have to ask yourself is, will we go back to that type of financialized, leveraged corporate sector and investment portfolio? And I would say that it's pretty clear to me that is not happening. OK. And so if that's not happening, that means the economy runs on a less levered basis, which makes it more resilient, but less dynamic, makes it more resilient, but slower growth. OK. Investor portfolios, they're going to run in a less levered way. And that just means that they're more resilient, but the potential return is lower. And that's going to create this cascade of effects because that's just going to make our pension system not only insolvent, but obviously insolvent.

39:53I think people pretended otherwise for a while, and we're going to confront that. So those are examples of things that I see unfolding. What do you think portfolios will look like? Pick your time frame, five or 10 years out when this washes through and people have the time. Some of these investments just take time to recycle and shift allocations. This is the kind of thing that may make me look foolish. I think private equity is done. I think that it will always be an investment style like it has for over the course of my career. It was just LBO investing when I started, I guess. Now it's private equity, but there will be people engaging in that.

40:30But I think the private equity guys are going to come out of this looking terribly because when we finally go through this and really go through the analysis, people are going to say, holy cow, all these guys went out and bought whatever the number is. You know better than I, 25 % of all the private companies in America, they bought them. They put how many turns of leverage on this? They borrowed all this money. They pulled that money out for themselves. Of course, also their investors as well, but those investors won't get the scrutiny. So the guys who run those firms pulled all that money out themselves.

41:03Look at how wealthy they got. And then what happened? The economy stumbled. They all went broke. They fired everyone or almost all the people. And a lot of these companies didn't survive, but they kept on their money. So in that environment, I think to imagine that you're not going to have a lot of new rules, taxations, regulations, I think we will. That's going to be something that looks different. But in terms of big picture around how investors, what their portfolios look like and how they'll invest, I think it will inevitably be with less leverage. The portfolios, my guess is they'll be less complex in lots of ways.

41:43I think one of the other mind tricks that we played on ourselves over these numbers of years is that, and I'm going to exaggerate this, but imagine everyone went to the same university and studied the same book on portfolio theory. And everyone came to the same conclusion, which is there's no free lunch other than diversification. And so everyone tried to enhance their portfolio through diversification, but they all end up doing exactly the same thing. Again, this is a stylized exaggeration of the marketplace. And if everyone does the same thing and thinks that they're diversified in the same way, which is people are trying to create an enhanced return by diversifying their portfolio in such a way that their risk systems make it look less risky so that they can apply more leverage to it.

42:31I think we're going to find that the portfolios that applied that logic to the greatest degree are the worst performing. And so that behavior will be significantly curtailed, whether it's through regulation or whether it's through investment committees and endowments and corporates. I just think that it's going to look different in that way. It feels like you have a lot of these conversations that for the last 10 years, people in those seats felt like we were in a low return environment. And part of the reason we've seen that extension into private equity and private credit is exactly as you said.

43:05What you're painting is going forward an even lower return environment. And so there's this question of what alternative do people have if they get simpler than they're left with choices that clearly aren't going to meet their spending needs? Yeah, I think people have thought we've been in a low return environment, but historically, I'm not sure that that's been true. It's been low relative to what the targets that they've set for themselves and the targets that they've set for themselves have been relatively arbitrary. And I think it's a function of what do I need to deliver to make sure that I'm not insolvent as a pension and or maybe what did I get used to earning and I want to continue to earn that.

43:45I think the problem is there's just too much capital in the world. We haven't had a real cycle of capital destruction. Historically, that's what wars do. They literally destroy capital. We haven't had a depression. In the Great Depression, you got to a point where people were knocking down office buildings and homes because they couldn't get tenants. And the property tax that they had to pay because there was a structure on a piece of land was so uneconomic, it made more sense to knock the building down. And so there are lots of ways to destroy capital. I think we haven't had a real capital destruction cycle.

44:21And so when there's just too much capital in the world, and I think that there continues to be, there's obviously a lot of destruction that's happening right now, but there's not destruction of plant and equipment yet. I think that that's coming, by the way. I think that there's going to be enormous capital destruction globally over the next five years or so. But until you get real capital destruction, there's just too much money in the world chasing too few streams of return. I think it literally is that simple. And what the Fed is doing and the Treasury is they're saying, let's just make sure that no one goes broke and let's make sure that none of this capital gets destroyed.

44:56And so I don't see how that doesn't lead to a long period of really low returns. Now, what people do about that, anyone who has relied on investment returns to fund their future obligations has a real problem. And this is going to amplify it because as a society, we clearly have made the choice that we do not want to see capital destruction on a large scale. We want to keep, just like Japan, we want to keep everyone in business for as long as possible. And I get it. Who wants to see capital destruction? I just think the consequence of that is that investment returns that are available, if there's too much capital because it hasn't got destroyed, those returns go down.

45:36And we have a major, major issue around that. It's not the happiest thought, but it's certainly one case. One of the things I wanted to chat with you about, you for a long time have written what you call weekend notes. and it is a fascinating perspective and style of some of the very bright minds you talk to. And I was wondering if you could talk through what you view the weekend notes to do for you and then how you go about it. I've been formally writing weekend notes for a decade now. It's been one of the most wonderful things in my life and career, for sure. And it's just been tremendous in that I write it throughout the week.

46:18It forces me to do an enormous amount of reading. And I try to speak with people that I've cultivated relationships with throughout the industry and throughout policy and strategy groups globally. And then I really try to think about what are the most interesting things that I learned that week and that I thought about and that I assimilated that I'm thinking about for our portfolios and questions that I'm asking. and it is a very succinct piece, which is a good discipline as well. I hate things that are unnecessarily long. And then I publish it and it's been great because it allows people to understand what I'm thinking about.

46:58And it allows me to walk into almost any meeting in the world with policymakers or investors and share ideas, but get them to speak. It's wonderful to have that exchange. And so it's helped me enormously understand the world of investing, not just from a hedge fund perspective, but an allocator perspective, but also policy perspective. And so it's grown a lot. And a lot of the top policymakers and central bankers in the world read it every week. And a large percentage of the CIOs at the biggest investment firms, both on the hedge fund side, but also the allocator side read it every week. Any longtime reader will be familiar with names like Mara and Charlie and Connor.

47:36How have you thought about where you keep it personal and where you make it professional? Well, Mara, my wife, she was the youngest editor at the New York Post and the only woman editor at the New York Post when I first met her. And she's an incredible partner. And we have four kids. And she's always pushed me to just be as real as possible and as transparent. and things I think about at work also affect the way I interact with my family and things that I learned from my children and observations I have apply to what we do. So it's nice to blend those together and personalize and it's helped me enjoy what I do even more actually.

48:14On that theme of personalizing things, I want to turn to a few closing questions. So why don't we start with what's your favorite hobby or activity outside of work and family? I just love the outdoors. I played college sports and so I love sports. I love coaching our kids, which I do and love coaching other kids in town. But I really, I just like getting out in the mountains. The thing that I miss having moved back from California, the East Coast here is the mountains, but there's a lot of beautiful outdoor spaces. So hiking, running, riding through the nature, that's my thing. What's your biggest pet peeve?

48:47Petty people, pettiness. It's just, none of us are on this earth for very long and people who take themselves too seriously and are just petty, it drives me crazy. How about your biggest investment pet peeve? I think there are a lot of people who are very arrogant and just not introspective when it comes to investing. And investing requires huge amounts of curiosity. And the best investors that I know are that by far, they're humble. Maybe they put on a little bit of an air in front of a big group of people. But when you really sit down with them, they're super, super curious and passionate and humble, and they recognize that they've gotten a lot of things wrong in their career.

49:28Maybe they've gotten more wrong than they've gotten right, but they've sized the things that they got right at the right times. And so you just come across real arrogance. What do you do for self-growth? I think writing has been the greatest gift. It's a blessing that occurs just because there's a lot of work that goes into it. For sure, it makes you have to organize your thoughts. And there's a lot of pressure when you have the kind of audience that I have with this. You hit send and you're putting yourself out there in front of a lot of really, really smart, critical thinkers. And you just want to be your best all the time.

50:02What teaching from your parents has most stayed with you? I'm the oldest of eight kids, so it was just hard work. I always had to earn every dollar that I ever made. and was just very self-reliant. And just by definition, that's kind of what happens. And so those are good things. All right, last one. What life lesson have you learned that you wish you knew a lot earlier in life? That's easy. Maybe starting from my mid-30s, I started realizing how little I knew and how much I could learn from people who just were much more successful than I was and much smarter and just had been through different kinds of life lessons.

50:44And then I think Mara did an amazing job of just helping me understand that in order to really engage with those people, I really needed to be transparent and just true about how I feel about things and what's going on in my life. And I really invited some wonderful relationships into my world that are, if they're not direct mentorship relationships, They're just, they're wonderful relationships where we all get something out of it. And I've just learned how to conduct myself in ways that I was just ill-equipped when I was younger. And had I learned that earlier, let me put it this way. I actively coach my kids to help them figure out how to develop meaningful relationships with coaches and teachers and other adults, because I think it's so important.

51:31And I just think that reflects how badly I wish that I had done that earlier. Yeah. Great. Well, Eric, thanks so much. Thank you. It was really nice. I appreciate it. Thanks for listening to this episode. I hope you found a nugget or two to take away and apply in your investing and your life. If you'd like what you heard, please tell a friend and maybe even write a review on iTunes. You'll help others discover the show. And I thank you for it. Have a good one and see you next time.

52:04This podcast is for informational purposes only and should not be relied upon as a basis for investment decisions. All opinions expressed by guests on the show are solely their own opinion and do not necessarily reflect those at their firm. Manager's appearance on the show does not constitute an endorsement or investment recommendation by Ted or Capital Alligators.