You're about to join Niels Kaastrup-Larsen on a raw and honest journey into the world of systematic investing and learn about the most dependable and consistent, yet often overlooked investment strategy. Welcome to the Systematic Investor Series. Welcome and welcome back to this week's edition of the Systematic Investor Series with Alan Dunne and I, Niels Kaastrup-Larsen, where each week we take the pulse of the global market through the lens of a rules-based investor.
Alan, wonderful to be back with you this week. How are things in Dublin? Things are good, Niles, good to be back. Interesting times as ever, but all good here. How are you? Yes, absolutely all good. But you know, the year is really off to a flying start in so many ways, the markets included. So yeah, it'll be interesting times ahead, no doubt.
Andof course, speaking of interesting times, before we dive into a lot of the topics you brought along (and thank you for that), I was wondering what's kind of on your radar at the moment, at the beginning of 2025? Well, there's obviously lots going on. US politics is as interesting as ever. But the one thing that I've been monitoring and kind of talking about in this segment, the last couple of times, has been Germany and some of the challenges in Germany.
And we've talked about the problems at Volkswagen, and that theme continues to be on my radar, I'd say. Wehad the German GDP data for last year released this week showing a second year of contraction in the German economy. And if you go back to December, the Bundesbank were forecasting growth of just 0.1% for this year. Butcrucially, that was before you factor in any potential adverse effect from Trump's possible tariffs.
And the Bundesbank were saying they could knock 0.6% off growth in Germany. So, if that came to pass, that would be the third year of contraction for the German economy. I haven't looked through the data going back in time, but I'm sure you have to go back a long way to see that level of that kind of prolonged slump for the largest economy in Europe. So,we've got elections coming up in February in Germany.
So, I do think they're shaping up to be quite a defining moment for Germany and maybe even Europe in general. So, you know, obviously in Europe, we're used to policy moving at a fairly slow pace. But you know, potentially this is a possible game changer in terms of a new direction. Certainly, it's needed. But I mean, when you see that level of growth, it really has been very stark for the German economy. Just a couple of questions on that. I'll come back to the German election in a second.
But when you think about it, and you put on your sort of macro hat, what do you think are the main reasons of this change in the German economy? Which of course coincides with probably Ukraine, more or less, the beginning of that. So, are we just down to energy, the failing policies and the price levels or…? Energy is part of it for sure. Obviously, they had a big dependence on Russian cheap gas.
Some of the industries like chemical production, when the gas price went up so much, they were literally unproductive and uneconomical. So, that's been a direct hit for some… The costs have been rising. Andat the same time, obviously, China which has evolved from being an export destination for German goods, particularly capital goods that were used in manufacturing, to now, obviously, China increasingly competing with Germany in middle tech and higher value industrial goods.
So, think about solar panels EVs as a classic example. Obviously, Volkswagen we're talking about. So, certainly it's been that evolution of the Chinese economy. Ifyou go Back to the 2000s, China was a manufacturing powerhouse in lower value goods but still imported a lot of capital goods, machines, et cetera, to assist them in the production of those goods from Germany. So, Germany really benefited from China growing on one hand and then cheap gas from Russia on the other side.
Nowon both sides they're getting hit now. Then coupled with that, we've long talked about the demographic challenge in Europe and Germany which is certainly at the forefront of that. But we're at the point now where that's actually starting to bite. Ifyou look at the dependency ratio, which is kind of the ratio of workers to dependents, that's been creeping higher for the last number of years, and it's forecast to grow even more.
So, you have a problem where there's not enough workers for dependents. Atthe same time, you've got, you know, this surge in the polls for the AfD who have very much an anti-immigration stand. So, people don't want foreigners coming in but at the same time who are going to do, particularly, the lower paid jobs in the restaurants and in the service industry. So, there's a number of problems there.
Youknow, the CDU, which is the kind of conservative party there, are leading in the polls, so likely to be the main party in the next coalition. But will it be with the SPD, or the Greens, or who? That remains to be seen. And it remains to be seen, what can they do? Andthen the big thing is that they've had this debt break policy. So, the Germans have always had this fiscal conservatism, don't want to borrow, balance your books, fiscally conservative.
But arguably, they're in a better place than most people to invest in new technologies. Debt to GDP levels are 60%, so not high by international standards. And German 10-year yields, okay, they're not negative anymore, but 2.5%. Surelyyou could borrow at 2.5% and find productive uses for capital. So, it's partially external factors, it's partially internal factors, and partially politics and policy. So, we'll see.
Certainly, there are obvious solutions there, but will we actually see them coming through? That's the question. Yeah. So, a couple of things spring to mind, actually. So, I know we often hear this argument about gas prices, and I don't follow gas prices per se. But from memory, I mean, we've had high energy prices before.
And frankly, right now, and maybe this is very different for gas, I don't know, but if you look at oil, oil is not specifically high at the moment compared to before the Ukraine invasion. So, I don't know how much we can continue to just blame it on that. For sure, in the beginning, people were hurt in that sense. Youmentioned the German election coming up. And of course, it is notable how Elon Musk has come out supporting the AfD.
And I was wondering, because you said this thing about, well, they're not very immigration friendly. And I was thinking, I saw this video from a BMW factory and the robots there, which actually look like these robots that Elon Musk is building, humanoids or whatever they're called. I was thinking, well, maybe he's supporting it so that he can sell all these robots to the German industrial complex. You never know. He seems to always have an economic angle to many of the things he does.
Youknow, when I think about Germany, there's one thing that kind of strikes me and that is how far behind they are in terms of digitalization. I mean, I think, anecdotally I've heard that in some instances, maybe it's in the public area, you know, sometimes you have to even send some stuff by fax. Okay, right. Yeah, so maybe that's an extreme example. But it certainly seems, I think, reasonable to say that compared to other countries, they're far behind.
And again, it just seems like policy has been very poor in predicting either trouble with dependency, and also the lack of digital infrastructure. Andthen thirdly, you mentioned China. I mean, what were they expecting? We've done everything we could to include China in WTO and other things for two decades. Wouldn't they expect, at some point, that they were going to compete with their own, you know, industry? So, it's like, wow, what a surprise.
And that strikes me as very disappointing that you have leadership that actually, and not just leadership, but I mean all the surrounding experts that, you know, help leaders make policy, that just seems to be a complete miss with the fairly simple trends. No, you're right.
I mean you could say that around the world there was a bit of naivety with WTO, you know, that the view that when China came In, back in 2000 or so, the view was that Chinese economic growth will propel the country towards more liberalism, politically, and that will open up the markets. You know, that was the view in the US as well. Obviously, in retrospect, China hasn't gone down that route and it was just very… They just became very good at producing stuff, right?
Yeah, they've been very good at producing stuff and not really allowing foreigners into the Chinese market, you know. So yeah, that's the way it's planned out. It's, as you say, been a bit naive. Germanyobviously has arguably made errors as well in terms of energy policy, you know, closing down nuclear plants as well. It's been a policy. So, there have been a number of missteps.
Andas I say, this kind of fiscal conservatism has definitely constrained public investment in things like, as you say, digital economy. But even things like the railways, you know, people who went to the Euros, that's what I heard coming back, the trains look outdated and running late, etc. So, I think that there's huge need, for a catch up in terms of investment there. I can think of a few other European countries where you could say the same about the railroad, but we won't go there today.
Alan. Okay, all right, very good, very interesting. A good place to start. So,I'm going to throw two things at you in terms of what's been on my radar besides Greenland, which we're not going to talk about, but that's always on my radar at the moment. Thefirst thing is something that I really, really hope people will take the time to tune in to the episode that I'm publishing on Wednesday with Cem and Dave Dredge.
So, we do this annual conversation, and last year's conversation, I think the topics were pretty spot on with Japan as being a focus for 2024, and we saw that over the summer anyways. But there was this throwaway sentence that Dave came up with and actually, the credit for the sentence is probably one of our other co-hosts, Hari Krishnan, I think, who may have said it or written it somewhere.
Ithinkthe wording is something like, “risk is about vulnerability, not predictability”, meaning that a lot of investors, they have a long list of beliefs, and they make a sort of portfolio construction based on the risks that they want to mitigate, and so on, and so forth. But rarely do they talk about what they're doing about all the risk they haven't thought about. Which could be an extreme rally that they're not participating in.
It could, of course, be in a bear market that they're participating in way too much, and so on, and so forth. Andnow, maybe we will go back a little bit to Greenland because I was thinking about it. What about a place like Denmark? I mean, two weeks ago this was a country that probably did not have on its radar that you could get these confrontational statements made by a friend and an ally of the country.
And so, this is like one of these kind of a little bit of a gray, maybe a black swan for Denmark. But this is just an example that is very top of my mind at the moment. Butit's this idea that investors often have strong opinions that they build their portfolio towards. But they never do something about all the things that they haven't thought about. And I thought it was a very interesting point to make, and that investors probably should think about these things as well.
We may have a strategy that actually is very good for that, Alan, but you never know. Fully enough, I thought it was heading that way. But no, I think you're right. I mean it's the classic known unknowns versus the unknown unknowns. And as you say, things have politically ramped up a notch and we don't know where that's going to go. So. Yeah, how do you deal with that? Iguessthe problem is.
Yeah, it's that people in our industry have long been advocating for diversification, resilient portfolios, et cetera. But we've had 10 to 15 years where you haven't really needed it. If you haven't bothered with any of that, you've gotten away with it. So, that's maybe part of it. Andas you said, maybe people do hedge some risks, but they're not thinking about that we can have different types of a world that we haven't even envisaged. So, I agree with that.
Yeah. And I think we'll get to this maybe a little bit later on our conversation because, of course, some people think they are diversified, but actually they're not. They just put the word private in front of your investment and then they think, oh, this is completely different to what else I have in my portfolio. Okay,fine, we'll leave it there. The other thing I thought, and this is like a little bit unfair to throw at you on a Friday afternoon, but it was a comment.
I published an episode with Moritz this week where I had a really great conversation with Bill Gebhardt from 10Dynamics. And Bill mentioned or questioned, I think, whether or not there really is a trend following beta. Andwhat was interesting about it, for me, was that I think people have thought of trend following as being something that's easy to do. It's kind of a commodity now. So, there must be this is kind of a beta you can get for free.
But he was, I think from recollection, kind of questioning that, because when you look at all the underlying managers, the dispersion and the returns between managers are very different. So, how can there be a beta if people are so different? Do you know what I mean? Yeah. So, I was just wondering whether you ever kind of thought about that, whether you had an opinion about it.
Yeah, I think it's a tricky one in the sense that it's, I mean, mechanically, when we normally think of beta, we're talking about equity beta. So, if you look at trend performance versus the S&P, it's largely alpha because the beta is close to zero over the long term. So, from that kind of statistical perspective, it's more alpha. Butthen you get to the view, well, everybody, it's easy to do trend following and just say you can do it on the strategy. So, it's not an alpha strategy.
It's become more commoditized. I don't think you can dismiss that completely. Obviously,you can get trend type exposure more cheaply now, but at the same time, as you say, the dispersion around the mean is very high. So, how can that be beta then? So, I think it's something that requires maybe different language. I haven't come up with what the language is, but maybe it's not alpha, maybe it's not beta, it's something else.
But yeah, so it's become more mainstream, possibly easier to do, but beta is maybe the wrong word for it. Now, before we get to trend following, we need to, as always, hear a little bit about your sort of big macro picture, your thoughts about where we are. So very curious to hear your thoughts. Yeah, well, I just wanted to focus in on what was, arguably, the main talking point in macro at the moment, which is bond yields and government bond markets, and just give a bit of context on that.
And what is the recent move saying about things more generally? Andwe've had this rise in yields and this unusual situation where the Fed have cut rate by 1% and long-term yields have risen by 1%, give or take a few basis points. So, what's behind that? And talk of, is it an inverse conundrum or reverse conundrum? Youmight remember in the 2000s, Greenspan was wondering, he was raising rates and bond yields were going down and this was a conundrum.
So, if that was a conundrum, is this a reverse conundrum? So, what to make of all of that? So,I mean, it's interesting, if you take bond yields, you can kind of decompose bond yields. There are kind of a couple of ways of doing that. The first thing is between real yields and nominal inflation, sorry, to take nominal yields and split them between real yields and inflation expectations.
And if you look at what's happened in the bond market since September, I mean, inflation expectations have gone up a little bit. So, if you say nominal yields have changed by about 1%, inflationary expectations have probably increased by about a third, and then two thirds of it is down to an increase in real yields.
Andthe higher inflation expectations reflect the fact that inflation is generally… The inflation numbers in September, October, November, December were higher, a bit stickier, but it's largely been real yields. So basically, the main difference, or the main driver from that perspective is a reassessment of the economy. So,bear in mind, like it's only last August. (I remember it was the bank holiday here), the market was in a tailspin.
Jeremy Siegel was on the TV saying the Fed has to cut 75 basis points immediately and guarantee another 75. Andthen suddenly the data improved over the next number of months. And okay, the Fed still cut, in September, 50 and still did two more. But you know, the economic outlook has improved quite a bit since then. The SAM rule got triggered back then. Now unemployment has just stabilized around 4.1%, 4.2%. So, recession fears were very elevated at that point.
So,if you look at kind of the short-term, the software futures, or the Fed funds futures, there's been a shift in expectations there of about a 1% or 1.25%. Rates were expected to be down to, I think, 3% by the end of this year. Now they're expected to be back to around 4%. So, a recession was basically priced in and that's come out of the market and that's a big reason for it.
Theother thing I would say is that you can also decompose bond yields in terms of looking at the full average rate over the full 10 years and the term premium. So, the term premium is kind of the residual. You can't observe it. So, there are various models that economists use to try and estimate what's the term premium? Intheory, the term premium is the compensation you get from holding long-term bonds, the fact that they're volatile, et cetera.
Now, we've had very low term premium for a number of years. The term premium basically reflects supply and demand. So, if there's very strong demand for bonds, term premium is low. And there was very strong demand for bonds. The argument was there's a lack of safe assets and there's a lot of savings around. But now the term premium is rising. So,is this the crucial points that we're reaching?
Because obviously we have been worried about the trajectory of the deficit in the US, 6%, 7% debt to GDP levels, et cetera. So, all of that. So,the fact that we are seeing rising term premium is a worry, I would say. I mean, it hasn't risen to catastrophic levels but about 50 basis points. Term premium is now built in, which is more consistent with what we've seen historically. Nowsome people say, well, foreigners can't be too worried about the US because the dollar is still strong.
But actually, I did see some interesting data during the week pointing to foreign central bank holdings of Treasuries have been declining, and parking their money on repo has also been declining. So, there is some evidence of a little bit of a shift there. And,of course, it's possible that, okay, the dollar could be strong but the composition of buyers of dollars could be changing if it's all kind of short-term spec money that's holding up the value of the dollar.
Meanwhile, foreign central banks are getting out, Well that would obviously be a worry for the dollar. So, I do think there are some warning signs there for bonds. Thatsaid, as we got towards the end of the week, economic data got a bit weaker and bond yields have come off their highs. You sent me something from Ray Dalio around debt crisis, and he's writing about that. We could talk about that.
Whatwe're in, at the moment, isn't a classic, like some of the big debt cycle crises that he talks about in his book. If you think about some of those things like the Asian crisis, or the global financial crisis, very often in those instances, when you get a really big problem is when you've got big debt and credit growth alongside asset bubbles - credit fueled asset bubbles. Now we have, you could say we might have asset bubbles in some markets, but I don't think they're credit fueled.
It's not like what we saw in 2000-2007. So,I think this is more of a fiscal challenge. And yeah, we could see strains in the market for sure at some point. But I think, ironically, the higher bond yields go up in the short term, the more likely they will reverse back downwards later on because obviously higher bond yields have a direct impact on the economy.
So, if you get a big spike in bond yields that could probably push the economy into recession which would in turn then alleviate the strain on bond markets. So, bonds are funny in that way. Yeah, pause there. Curious to get your perspective. Yeah, I mean, yeah, it's funny how we should all be cheering for a recession, right? So that the bond market doesn't collapse. Yeah, a bubble, obviously, yes.
But, I mean first of all, I, I don't know, but the other things, we talk about the term premium and all that. I mean, the other things that I note is that there is a hell of a lot of refinancing that's coming, even in 2025. I think it's $10 trillion, most of it short-term, which of course could have been avoided if they had funded themselves long-term when interest rates were ultra-low. But only Austria I think did a 100-year bond. But there we are.
It hasn't been a good investment for the investors though. So that, that's one thing. Butanyway, so, I mean, lots of things going on. I'm Kind of, I guess deep down, I've always felt that interest rates would go higher.
I know I came out with this outrageous prediction in our group chat, but that was more maybe fun to say that, okay, we're going to have some kind of AI driven miracle and interest rates are going to go much lower, etc. etc. Butyeah, I've always been worried about yields and maybe, to some extent, I'm a little bit surprised that equity markets have held up so well given the fact that yields have gone up quite a lot.
So, I don't know, I don't have a strong opinion where what we do from here, but I wouldn't dismiss higher bond yields. Andsomewhere, even though some people would say, well, you don't have to really worry about debt and certainly not if you're a reserve currency, that just doesn't sit so well with me that you can just kind of say, well, it doesn't really matter. It's almost like when the MMT people, a few years ago, said, oh, that doesn't matter, inflation is not going to come back.
And then two years later it really came back. I agree. I think there is a valid point that there's no reason that the US should default on its debt because they can print their own currency and pay with that. But that's not the whole picture. Obviouslyif it comes to that, you have to print a lot of dollars to pay or the Fed has to keep buying Treasuries, then at some point you can get a loss of confidence. And I think that's the point.
And that could either translate into higher inflation domestically, in the US, or a weaker dollar. Imeanthe question is, at what level of yields is required to entice people to buy a U.S. treasury? So, I think at the moment, that yield has been going up, it could go a bit higher. Butyeah, I mean I think it's not just a binary default or not. It's more of an if you have excessive debt, does it undermine confidence in the currency?
And ultimately, could you get too much money printing in response that? Which could obviously, obviously push up inflation. So, I think that's the medium term to longer term risk. Yeah, all right, cool. Okay, let's quickly talk a little bit about trend before we dive into some of the other topics. I mean the year started off pretty strong, I would say for trend following. Actually, my trend barometer has been certainly reflecting that all year, there has been very strong readings for that.
However, I will say, the last week or so has been a bit more challenging mainly due to, and very apropos what we just talked about, corrections in fixed income. Imean,there was definitely a push higher for in yields but they have cooled, certainly this week, and the latest inflation number from the US also helped a lot. So, trend followers will certainly have given up some of the early gains in the fixed income markets.
Also,the yen has found some strength, maybe as a reaction to the noises coming from the BOJ about future rate hikes, and that also impacted Asian equities. Nikkei and Hang Seng, I think they've been a bit of a challenge for trend followers and also, perhaps, some of the energy markets have been a little bit difficult. But it's still a positive start for the year. So, that's kind of how I see it. Any insights from your vantage point? Nothing much outside what you're saying.
I mean, obviously, bonds was a big tricky market for some medium-term trend followers last year and I would guess managers are kind of heavily short now or decent sized short. So obviously, that worked well for a while but we've seen a bit of a correction. So,if you look at kind of 10-year or 2-year yields, they've basically been oscillating in a big range around kind of a central point.
So obviously, from a trend following perspective you'd like to see it either break out one way or the other or it's going to be painful. But I mean, we are seeing opportunities elsewhere as you say. Yeah, yeah, yeah. So anyways, quickly a run through of the numbers. It's very easy because month-to-date and year-to-date is the same. So, I'll just do one of them. BTOP50up 1.25% so far this year. SocGen CTA index up about almost 1%, 93 basis points.
SocGen Trend index is a little bit softer actually, only up about 40 basis points. And this is as of Wednesday by the way. And the Short-Term Traders index up 81 basis points so far. Bridge Alternatives up 52 basis points. That is a trend following index that is also worth mentioning. Andin the traditional world, MSCI World Index Equity Index is up about 1%, and the S&P 500 Total Return is up about 1%, 95 basis points as of yesterday.
And the US Treasury bond with a more than 20 years maturity, that index from the S&P is down 56 basis points so far this year. Allright and we're going to talk about something that kind of ties into the early part of our conversation. And you and I have found a few articles that were interesting, you may have read them a little bit more carefully than I have, but I'll do my best to, to keep up.
ButI think the first one you wanted to talk about, and correct me if I'm wrong, it's kind of like one of those Cliff Asness specials where he's produced a paper which, it's funny, it has a serious side to it as well, but it's written in a very, at least to me, entertaining way where he pretends to be an allocator assessing sitting in the year 2035, so, 10 years from now, looking back to 2025 and kind of making an assessment of different investments that he's made and what he learned from it.
Sothat was also one of the papers you wanted to quickly talk about. So, what were your takeaways? Yeah, I think it's, obviously it was written, maybe largely, for entertainment purposes, but it is an interesting perspective to take the backward-looking perspective from the future. I think, what he describes is basically all of the things that you might expect over a 10 year period based on current maybe elevated valuations in some markets.
So, it's basically saying, the gist of it is, looking back from 2035, public equity performance in the US was a bit more mundane - I think cash plus 2% as a valuation is kind of adjusted. Bonds did okay. Inflation ended up being 3% or 4%. Bondswere kind of about 1% real. International equities, which a lot of people have been kind of saying you shouldn't diversify from the perspective of US investors for a long time, hasn't worked. It ends up that it does work over this 10-year period.
And then, obviously, private equity, which has been a bug bear of Cliff Asness, in particular, underperforms in this period, as does Bitcoin. Interestingly,the multi-strat seemed to do fine. So, that was one thing that continues in the current trend and liquid alts, generally. So, they do well.
Trend following gets, you know, I think in his humorous way or in their kind of hypothetical portfolio, they get out of trend following just before it starts to do well, but it continues to do well in this tough period.
So,I mean he paints a picture of a decade that would be okay, maybe not quite as severe as the first decades of the 2000s, but of a more challenging one for equities ,and better one for diversifiers, and a tough one for some of the kind of the hotter areas of the market at the moment like privates; private equity, private credit and crypto. Yeah, absolutely.
I'll comment on it in a second, but I will just read to you just to give people a sense and why they should go and download the paper on the AQR website, when he gets to the private equity, one of his comments are, “sadly and totally unforeseeable it turned out that levered equities are still equities even if you only occasionally tell your investors their prices, and when you do you don't need to move prices very much.” So, it's kind of really, yeah, super good. Anyways,I agree with you.
I think the takeaway for me is that, and this is something that I also spoke with Cem and Dave about, I think a lot of investment portfolios, you may know this better than I do when you talk to the allocators on your series, I think a lot of people are allocated and invested based on what how things have worked in the in the last 20, 30 years. Which is not uncommon. Of course, let's be realistic here.
However,I think the reliance on certain relationships, certain correlations, are reflected very heavily in these portfolios. And I think what I take away from reading between the lines, and this is not maybe what he meant to say, but for me at least it is, we should all (and we've mentioned this before) imagine the unimaginable.
WhatI see this as the beginnings of, and we saw that already back in 2022, but some of the relationships, some of the correlations that people have been relying on were breaking down. And we're even seeing a continuation of that. I mean, first of all, bonds and equities have been generally positively correlated. Now, that's actually normal in the long run, but it's not normal for the people sitting at the helm of these big investment portfolios because they've only been there for 20, 30 years.
In that period they've been mostly negatively correlated. Butother relationships are breaking down. I mean gold is going up along with the dollar. That's not something we normally see and, and so on, and so forth. So, my takeaway is that he kind of, in this pretend allocator scenario, he kind of invested based on simple historical return and relationships and surprise, surprise, it didn't work out going forward. And I think that's, for me, really important to stress.
Ithinka lot of investors are potentially allocated incorrectly for this uncertain future which must be clear by now to everyone that the world has fundamentally changed compared to five years ago. I don't disagree. Yeah, I mean, it is natural for people to struggle to kind of envisage radically. Can you imagine US unexceptionalism, or whatever the opposite is? It just seems hard at the moment. ButI remember back to 2000, and it was a similar thing.
It was like you'd had a decade of, okay, you had the productivity boom. It seemed impossible to imagine, you know, the US not having a strong economy. And then obviously you had the dot com bust and then you had the global financial crisis. So, you've got to be open to all of these scenarios. You started out by talking about the German economy.
I'm sure 5 years ago none of us would have thought that we would have had, potentially, three years in a row with negative growth from the world's largest exporter and the engine of the EU and maybe a bigger part. So again, time will tell, and people should be aware of it. Allright, well, moving on from that, there is another article. Also another one which, of course, is always well written because it's from Howard Marks, and he does a great job.
So, I'll let you guide the conversation from here and I'll see... Well, I mean, it's consistent with what we're talking about because he's reflecting on bubbles. I think it's called Bubble Watch. And he's saying it's 25 years. So. Yeah, I'm talking about 2000. He's saying it’s 25 years since he wrote a piece called Bubble.Com, which was kind of… Well timed. I think it's funny.
Yeah, well timed and, interestingly, in the piece he mentions that, I think, he'd been writing for 10 years or something and this was the first time he got kind of feedback from investors. So, obviously his profile has increased a lot since then because everybody kind of downloads and reads his research these days. ButI mean, I like what he writes about. He has a couple of kind of interesting nuggets in there.
He's not saying we're in a catastrophic bubble, but he's saying there are signs, and a couple of things about bubbles, he says, you get bubble thinking in bubbles, that people kind of disregard rational thinking. And he says, what is the main reason for that? What is it about it? And the word he has his ‘newness’. Andwhen you get something new, that is the thing that excites people. And obviously we've got that newness with respect to AI in particular, but arguably crypto as well.
And it's very hard to say, it's hard to argue against it. Who's going to argue against AI being transformational? Okay, you can definitely debate crypto, and we've had that debate for a while but certainly on the AI side. So, it's that kind of newness. There's no history, there's nothing to temper the entire thing. This time is different, Alan. This time is different, yeah.
And he makes the comparison with the Nifty Fifty (which were the high-flying stocks back in the ‘70s) and even with the high flying stocks in 2000. He looks at what were the biggest stocks in the S&P 500 and how many of them are still there now? I can't remember, it’s four or five that are maybe still in the top 20. So,he's saying, investors are betting on persistence, they're betting on Nvidia's persistence.
So, a bit like what we're talking about, you know, people can't envisage different versions of the world. People can't envisage Amazon, Microsoft, Nvidia, Meta, that these won't still be the biggest companies in the world in 5, 10 years’ time, but they probably won't. Some of them will fall by the wayside. So, I think that they are all good points.
Andthen, within his piece also, he says, just as he was about to send, that there's always some other piece of information that he really has to include. And this time it was a chart from JP Morgan Asset Management, which I've seen floating around on social media. It basically shows current valuations P versus plotted against them kind of forward 10-year returns.
And they're pointing to and in-line with the Cliff Asness view because valuations are elevated now, forward returns for the S& P. I can't remember exactly what JP Morgan are saying, but kind of flat, or 2%, or could be real term but very much lower than we've had is the implication. Soalso, I mean I like what he writes because right at the end he kind of sums up the arguments. But then he gives the counter arguments which is, you know, the PE ratio for the S&P 500 is high but not insane.
It's true, you know, definitely we saw it higher in 2000. The Magnificent Seven are incredible companies so their PEs could be justified. Youknow, this is the argument that these are new, their moats are so established, they’re cash cows and are generating so much cash, you know, that they're dominating the world. Elon Musk is meddling in UK, German politics. Where's all that going? He's saying I don't hear people saying there's no price too high.
So,I remember in the Dot Com there's certainly these talk of stocks that you have to own no matter regardless of the price, you just had to own them. It feels a bit like that with Magnificent Seven, but he's saying he's not hearing that. Yeah,in markets, while highly priced and frothy, they don't seem nutty. So, I think that's a fair comment. Valuations are high, but maybe relative to the tech boom in particular, sentiment isn't so extreme.
So,it's pretty good and nicely summarized in terms of all of the arguments and reasonably balanced as well. But it is still pessimistic in terms of return expectations. I mean it's always nicely written, of course, but not in a way where you go away saying oh yeah, I know exactly what I'm going to do now. Because as you say, there's always two arguments here. Acoupleof things, you know, when he mentions this, like you said, in the 2000s people were just buying regardless of price.
And, and maybe we don't hear that spoken out loud, so to speak. Yeah. But I wonder whether we hear it anyway, through passive investing. Because there is no price too high for passive investment flows. That's true. And so, I think that that's an important little thing to be aware of.
Now, the other thing that Dave mentioned during the conversation with Cem, and that's also actually the title of his new paper which is out on LinkedIn and people should read it, is that, for him, it's kind of deja vu that we may have forgotten that the period of 1995 through 2000, the S&P was actually compounding at something like 28%, five years in a row - the best five-year period. Iknowwe just came out of the best two-year calendar period for the S&P for a number of decades, maybe ever.
But he says, well, there was actually an instance where that just continued. So, I think it's fair to bring up the Bubble Watch. It feels that way, but who knows? Imean,again, this goes back to this, what are people doing about the risk that they don't think about? And maybe there is a risk that you're getting too cautious. It's not always about becoming you know, risk mitigation. I mean, that's also a risk.
If you say I'm going to follow the pessimists and exit here, and obviously we've made that point about trend following before, it's not just the ability to help you manage your risk on the downside, but if you're trend following in equities, it's keeping you invested. No, it's true. Imeanif you go back to the ‘90s, like Greenspan's famous speech about irrational exuberance which was in December 1996, the market was up massively. It was up 20% plus in ‘97, ’98.
We had a wobble in Q4, ‘98 with the Russian debt crisis and then it was up again in ‘99. People were expecting issues with Y2K and the Fed kept policy easy. So, if you exited because Greenspan was worried about irrational exuberance, you missed a huge run up. So that's why. Yeah, it's hard to know. Itfeels a bit frothy here. There are certainly parallels between now and the 1990s. It remains to be seen if the productivity story is really as big now as it was back then.
But time will tell, you know, so yeah, there are risks in both sides, as you say. And it, of course, leaves investors with a big question and that is what to do with their asset allocation? And luckily, we have another paper, also thanks to AQR and the team over there. And this is the one where you probably have had more time than me to go into the details. So,if you wouldn't mind, guide us through what it’s about, and the key takeaways that you found interesting, and so on.
So, the paper is on broad strategic asset allocation, and I think it was maybe last September it was out. So, it's dealing with, I suppose, quite an interesting topic. It kind of starts off by saying, if you have a blank piece of paper and you're going to construct a portfolio, how do you go about doing it? Andnormally a lot of this analysis starts from the perspective of a 60/40 portfolio, maybe with cash, what's the optimal allocation?
But now, as we've been saying, you've got alternatives to consider. So, how do you think about incorporating liquid and illiquid alternatives all together in one portfolio? AndI mean, they start off by saying, in theory, if you were to take the theoretical view on strategic asset allocation, mean variance or portfolio theory, portfolio theory tells you that everybody should hold the same portfolio. There's one optimal portfolio that's tangential to the efficient frontier.
And then you should hold that portfolio. And then, depending on your risk appetite, if you have more risk appetite, you lever that up. If you have less risk appetite, you hold cash and that portfolio. But in theory that's the optimal portfolio that everybody should be holding. Obviously,in reality, that's not the case. There's a couple of reasons for that, obviously. One is that kind of theoretical analysis is based off a certain level of expected returns.
And obviously, for the various asset classes, everybody has different views on the expected return. So, some people are saying Cliff Asness returns are going to be more muted, others would be more bullish. So that's one thing. Buta second reason is, and this is kind of an interesting way of framing it, they say that really in real-life, real-world allocation decisions are largely driven by beliefs and constraints. So, the beliefs I've talked about, so different beliefs.
But the constraints are very important too, if you think about it. So,you know, what are the typical constraints that investors face? Well, one is, so for example, leverage, as I said, in theory with all the optimal portfolio and lever up or down. But in reality, if you're say, running a private wealth portfolio or for retail investor, there's no real leverage available. You can't go and say I'd like to lever up my portfolio.
Maybe the bank will lend to you, but probably not, and probably at a level that wouldn't make sense economically. Leverage, that's one kind of thing. And then liquidity is another one. So,people have different requirements around liquidity. So, you know, it may not be optimal say, for an endowment for a university, or something, to hold too much private markets if they have to kind of fund or pay out. So, that's another thing.
Butthen they also mention this kind of peer conventionality and benchmark risks, which I think is an interesting one. And this is all around the area of, you know, people don't want to fail unconventionally (to use Keynes expression), and complexity as well. Thisis sort of what it comes down to, we often ask, why don't people allocate more to trend following and manage futures?
If you do the basic analysis, encore strategies, positive expected return, combine it with equities, improves the Sharpe, so what's wrong with that? Butthen, obviously, some people don't have a background in futures, and they say, oh, that sounds risky, or I don't understand quant, or I don't understand trend following, it doesn't make sense, why would that work? So, all of this kind of complexity is a constraint, I guess, for some people as well as the peer comparison.
So, it's kind of like a career risk, I guess. You don't want to invest in something and then it not work out. You get questions from your board or investment committee, and benchmark risk. So, they're all relevant constraints as are fees as well. So, I mean, some people don't want high management fees, some people don't want any performance fees. And that can constrain what you can access.
Andthen, I guess, they don't mention vehicles, but I guess vehicles could be a constraint for people as well. You know, if you can only invest in UCITs and then not all the strategies are maybe represented or are represented optimally. So,what to do then is okay, to run an optimization we need kind of risk and return expectations. So, they go through a process of kind of first defining the building blocks.
They list 10 different asset classes and they categorize them called traditional investments, liquid alternatives, and illiquid alternatives. So, on the traditional side, equities, bonds and credit, basically high yield bonds, on the liquid alts, commodities, diversifying long/short and risk mitigation. So,diversifying long/short, they are the kind of group macro and kind of multi strat, quant multi strats within that.
And then risk mitigation, they actually use trend following to represent that completely. And then on the illiquid side it was private equity, real estate and infrastructure, they were grouped together and private credit, so three on the illiquid side. So,that's kind of their building blocks. But then you could group those according to their kind of drivers, in terms of their factors, like equity rates, credit as well. So that's another way of looking at it.
Butthey're basically the 10 building blocks that they use; the nine I mentioned, plus cash, to kind of formulate different portfolios. And they construct volatility. So, the measured correlation based on history, based on various indices that they use to represent that, and then volatility measures and return expectations. Now,obviously, with all of this stuff with portfolio optimization you can always kind of quibble with assumptions.
So, for example, for private equity they use a composite of, I think it's 1.2 times the Russell 2000, 50% that and 50% a private equity index to proxy. What it comes out at private equity is at 20% volatility. So, in contrast to public equities, which is, I don't know what, maybe 15% vol or something like that. So that's the capture (yeah, 15% vol), so that's to capture the kind of the riskier profile or private risk markets. Thereare other bits in there.
So, they basically assume for a lot of the old strategies that the Sharpe ratios are 0.3. Yeah, for the asset classes it's 0.3, and then for commodities, the long Sharpe is 0.24. For risk mitigation, as mentioned by trend is 0.24, which seems very conservative, but interesting for diversifying long/short they have it 0.36, which is higher. So, you might say, okay, is that valid or not?
So,I mean, basically what it comes out with is they have various long-term geometric returns, equities, which seem a little bit on the low side in some instances. Equity 6.9, private equity 7.5, risk mitigation 5.4. Andthey put all of this into the optimizer, and they start off from the perspective of okay, if you relax certain kind of constraints with respect to fees and with respect to say tracking error to a benchmark, what does that mean?
So, at a basic level, unsurprisingly, once you allow for this broader array of asset classes and based on the assumptions, you get a more diversified portfolio. So,for example, at the same level of volatility of the 60/40 portfolio, but allowing a 4% tracking error and allowing higher fees, you basically get like, what is it, 11% allocation to commodities, 15% to long/short, and 16% to trend following. And then coupled with a 12% allocation to private equity, that's a 54% alts allocation.
So, I mean that doesn't shock anybody, I don't think. ButI think what's interesting is what's relevant here is we've heard all of this, that we're moving from 60/40 to whatever. Is it 40/30/30 or 50/30/20? But putting a number like 20 on alts misses the most important question nearly, what's the composition of the alts? Sothat's what this is kind of more interesting in saying, given a framework to think about, not just an alts element but whether it's liquid or illiquid, interesting.
There are a few things that looking at, I mean there's a lot of different variants around this. I thought it was interesting that kind of long/short Sharpe is higher. That's one thing, whether we would agree with it or not. I suppose maybe they're including multi strats within there, that might make sense. They're kind of more consistent return profiles but more positively correlated.
Theother things that are interesting is they also show, in different examples, the idea of if you ease the leverage requirement and if you allow leverage then you would naturally, even at that same level of volatility, you would borrow about 50% and you would ramp up. Actually, in that instance you would ramp up more fixed income exposures but also some of the other ones.
Butit also highlights the point that we've talked about before, that if you can't leverage by borrowing, another way to do that is to leverage via allocating to higher volatility managers. So that's another thing that investors kind of overlook.
So,I think that the key thrust of the point of the paper is that with kind of reasonable return expectations, and as I say you could debate those a little bit, you could easily get to a point where alternative are 40%, 50% of the portfolio and you can have relatively high allocations across different types of alt strategies. So, I mean I would definitely be in the view of it's very hard to say, is trend at 0.3, 0.4, 0.5 Sharpe? It’s the same thing about long/shorts.
So, from a robustness perspective I can see a case for it for blending a number of different strategies. Butcertainly, it does come back to the point that we're talking about which is based on why we have this compelling kind of rigorous, I wouldn't call it academic, but kind of theoretical data to support the case for being much more diversified with much more higher allocations to liquid alts. But why don't we see it? Imean,the complexity is another point that they make.
And theoretically, I suppose, what are investors in? They're basically penalizing that Sharpe ratio for some of these strategies because of their maybe uncertainty about what the true Sharpe is or because of complexity. That's the theoretical way you can get to the point to explain, I suppose, the underallocation to these strategies. So,I think it's quite a nicely done paper. As I say, it’s broad strategic asset allocation.
It's hard to go through it all in one cut, but it's more about just the framework that it gives you for trying to understand, well, does your portfolio make sense given your view of the world? If that makes sense. So, a couple of thoughts, and I hate to go back to my conversations over the years with Dave Dredge, but I remember one of the first conversations, when he was first on the podcast a few years ago, he talked about this analogy about a race car.
There are two kind of two ways you can drive. One way to feel safe would be to generally, on average, drive slowly and you don't have to worry about all the different corners that you get on the track.
AndI think that's kind of what you're saying is here, that a lot of the diversification in the portfolios, it feels safe, but it's also slowing down the car and it's not going to win the race, but it's going to complete the race, at least under normal circumstances, I guess, in an environment where interest rates are coming down. I'm not so sure about when interest rates are coming up.
But it just seems to me that a lot of people have done that in their asset allocation by prioritizing things like fixed income. Imean,in certain European countries, you still have not 60/40 like we think about in the US but 60/40 or even 80/20 in favor of bonds or fixed income. And in an inflationary environment that is devastating to your portfolio and to the pensions or whoever you're managing the money for.
So,of course, in his view, and that's obviously something I support completely and that is, well, the other way of doing that is to build portfolios that allow you to drive faster because they have good brakes. Andthat's what we would obviously argue that things like trend following would be in a portfolio context, something that can allow you to have meaningful equity exposure because it tends to help out and mitigate risk when you have problems in that area of your portfolio.
There may be one or two other things that could act as good brakes but also still allow for a positive return. ButI agree with you. And this is what I tried to say, maybe in a different way earlier on, about I fear that a lot of investors are allocated the wrong way for the environment that we are going into, where they probably should have a completely different construction of their portfolio.
And more in line with what AQR is writing about, but more in the philosophy of saying, yeah, we can drive fast as long as we have something that's going to help us when things get a little bit dicey, instead of always trying driving slow and just tick along and know that we're underperforming year, after year, after year, because that compounds as well. Yeah, I think you're right.
I mean, I think there were a couple of… On that point, so, the last part of this paper, they kind of translate the building blocks and the typical exposure you get to those different asset classes into kind of factor exposures. And basically, what it shows is most institutional portfolios are heavily influenced by equity risk. Ifyou think about it, public equities, private equity, even, obviously, private credit will do well in a positive equity environment.
Will it do well in a severe tail environment? So, I mean, people have this view, you add 10 asset classes together, I'm diversified. But actually, you're not. You might be heavily loading on the same factor, particularly when you adjust for volatility, etc. So that's one thing.
Imean,I thought it was interesting, the outcome from this paper, if you compare it to, we discussed the paper that was written by GIC and JP Morgan Asset Management last year that looked at optimal hedge fund portfolios in the context of a 60/40 portfolio. And they were pointing out that, when you integrate the hedge fund portfolio, that decision into the wider portfolio, you end up allocating much more to risk mitigation type strategies.
So, you don't want the other kind of ‘steady eddy’ type strategies because you're already picking up that kind of type of exposure from your 60/40. Butwhat you really want is risk mitigation. Now you don't get that kind of analysis coming through as strongly from the AQR paper that's based on kind of the assumptions that they are making. Andtheir analysis is, it's high level in the sense that they're just putting numbers into an optimizer.
They're not looking at the tails, they're just saying, well, what's the optimal in terms of mean variance optimization? They're not saying, okay, let's look at what's the worst drawdown type scenario. And they're not kind of plugging it into the past history. So,I think from that perspective, from a robustness perspective, that points you more towards having that higher weight to risk mitigation alongside your growth drivers.
Whereas with this approach you're getting more of a blend of more strategies. Just as we kind of slowly start to wrap up. NickBaltas, one of our good friends and co-hosts on the show, of course, he wrote a paper a number of years ago that I've discussed with him, maybe you have as well, where he talks about, well, one of the challenges of getting enough trend in these bigger portfolios is the tracking error that it might lead to, and people are, you know, very fearful about that.
And it's kind of conventional wisdom right now that as we say, well, you shouldn't be too far away from your benchmark. That's not good now. Andthis is a bit of a stretch, I will admit that. But, you know, another kind of conventional idea we had, not long ago, was that, yeah, ESG is the way forward, this is how portfolio should be built, and so on, and so forth.
I don't know if you read that news story recently where a portfolio manager, I can't remember the firm, or what the circumstances were, but actually someone got into really big trouble for having favored ESG in the portfolio at the expense of returns and kind of broken, as far as I remember, broken his fiduciary duty to investors of focusing on returns, not on other things.
AndI've always wondered, because we know the empirical data is there, the evidence is there, that when you blend trend with these traditional return streams (fixed income and equities) you get simply a higher return over time. That's at least based on all the evidence.
And I was just wondering, I mean, could we even, and going back to this, imagine the unimaginable, could we even imagine, one day, that someone would be successful in making the claim that portfolio managers, pension funds, whatever, who have not allocated enough to trend, or let's call it, these risk mitigation strategies, are in breach of their fiduciary duties? Because it's clear, the evidence is there. It's not difficult to calculate.
Now, as I said, it's a bit of a stretch, but… But you know what? I did not expect this about ESG either. It's true. Yeah, yeah. I mean, definitely the direction of travel in the US is very much… I think the case you're talking about was a US, it might have been a pension fund. I read the article as well. I can't remember exactly. And equally, BlackRock are withdrawing from whatever climate change group that they were part of. Moving into trend at the same time, Alan.
Moving into trend at the same time. So, they're really taking their fiduciary responsibility seriously, aren't they? So,yeah, I mean, it's definitely the trend. But I wouldn't say in Europe, the ESG mindset is still there if you talk to investors, in continental Europe is my impression anyway. But certainly, from a US perspective, a huge shift. But the other thing, not that we are going to go on, but it’s just, again, this unpredictable thing.
I mean, five years ago it was certainly not in fashion to be investing in bullets and bombs and military stuff. Right? Yeah. Look at how that's changed in the last five years. So, who knows? Absolutely. I mean even, you know, Meta is throwing out their (was it a meta?) diversity policy. All of this stuff is now up for… Fact checking apparently isn’t a thing anymore. No need to do that. Of course. Yeah. All right, Allan, this has been fun.
Next time I'm going to see you is, actually, I think in the US because we're both heading over there. But, kindly, you're helping out next week. You're actually going to be hosting next week's episode with Mark. So that's going to be fun. Ifpeople have any questions that Alan should bring up with Mark, as always, you can email them to info@toptradersunplugged.com.
And if you want to say a big thanks to Alan and all the other co-hosts for all the work they put into this, I suggest you go to your favorite podcast platform and leave a rating and review for the show. We love it. It certainly feels nice that when we see people appreciate the content we put out there. That'sit for this week from Alan and me. Thanks so much for listening. We look forward to being back with you next week. And in the meantime, take care of yourself and take care of each other.
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