FM: I thought Mandelbrot proved that wrong 30 years ago.
LP: That’s true.
FM: Do you see that view of managed futures changing?
LP: It is changing. You are seeing some leadership in that direction. People are going back to some core principles of diversification. How we ever got to a 60/40, pushing 70/30, mix of stocks and bonds in the wake of everything that Markowitz and Bill Sharpe and Eugene Fama were doing in research 50 years ago is beyond me. It is really the hope that capitalism will be victorious over the long run and greed is good. That sort of drove everything from the first Wall Street movie until now.
FM: Break down your allocation in your current portfolio.
LP: We have a 40% allocation to equities: 20% to developed market equity, 5% to emerging market equity, 5% to high yield and 10% to private equity so it is only 40% of our overall allocation and I have a 35% levered position in Treasury futures on top of 5% unlevered. My 40% allocation to growth oriented basket comprises 68% of my risk budget and that huge allocation to these diversifying strategies which includes a 40% allocation to treasuries, a 10% allocation to emerging market debt, 10% to global macro and CTAs (divergent strategies) and 10% to relative value strategies. That 70% allocation of dollars only represents 18% of my risk budget. A 40% allocation can cannibalize two thirds of a portfolio and a 70% dollar allocation doesn’t even get up to a fifth.
FM: Are some of the risk measures used to analyze the appropriateness of certain investments, causing mistakes in allocation?
LP: Yes. The over reliance on more naïve optimization without thinking about what drove it and most of these things are not right or wrong. There is nothing wrong with standard deviation, there is nothing wrong with value at risk or estimated short fall. All of those are useful statistics but what is often not appreciated is that when you are looking over particular periods of time where a risk factor was not present then to expose the portfolio to that historical period without thinking about other periods of history that might not have been in your sample set is what causes bad decisions. For example, if we built our portfolio over the data set that we had ending in January of 2000 for the prior 10-year period, well we were in a particularly benign period that was marked by a soft spot in 1991 then from there we had a disinflationary period, high productivity, high credit creation, an overall increase in investor risk sentiment and positive government relation on a global economy (you had people globalizing and deemphasizing regulation).
If you had built your portfolio around that 10-year period you would come up with a result that was not at all diversified because it did not consider what would happen in a re-regulatory regime, or in a high inflation environment or a deflationary environment or an environment where credit creation was not the watch word of the day but credit contraction and debt deleveraging were the watch words of the day. That’s the fallacy more than anything else. People don’t really understand what is driving the results of these asset classes, these big moving global macro factors that are affecting the economy.
FM: Are some strategies designed to produce positive risk measures as opposed to providing diversification to an overall portfolio or positive results?
LP: Yes. Beware of high information ratio strategies. Credit is a perfect example, particularly higher grade floating rate credit. Bank loans were a perfect example of this and I like bank loans. The original concept of bank loans was a nice clean asset. Then people started levering them and then the underwriting got to be worse and worse as the banks quit retaining the risk and started syndicating 100% of the risk so the market changed. What historically looked like an efficient asset class with a high income relative to the volatility of the underlying no longer had those fundamentals as it evolved. Unlike that, I look at trading strategies that on their own only have an information ration of .2 but they have such a low correlation with everything else that when you collect 10, 15, 20 of these strategies and bring them into a portfolio and you can turn low information or Sharpe Ratios of 25% to Sharpe ratios of 1.5 times. That is what is attractive as opposed to being short this option… that makes credit look like an efficient asset class. …If you are going to use shorter term data series you have to look at something else other than the traditional statistics for credit strategies and convergent strategies. [For] divergent strategies, it is easier to use traditional measures.
FM: In our Markets piece, analysts are pretty split as to the direction of equities. They are even split in terms of defining the current markets environment. Are we in a bull or bear market and where do you see equities heading in the next six months?
LP: I don’t see a big rebound in six months. My five-year forecast is a pretty flat market even vs. where we are today. And it is because of several headwinds the global economy is experiencing. I think on a cyclical basis stocks are a little cheap just looking at cash yields and earnings yields. Long-term we are in a debt deflation economy where consumers are saving and not spending here. In Europe, countries are starting to save and not spend. You already have a lot [stagnancy] built into the economy and now through traditional measures the central banks are tapped out. I don’t think they can raise interest rates or get into a more aggressive position any time soon. There is tremendous slack in the economy, the output gap is massive. This is the worst trend deviation we have had in GDP since 1945, so post world War II this is it, we are more than two standard deviations off trend and you are in a re-regulatory environment so everything that fostered financial innovation, credit creation and leveraging of the consumer balance sheet is all working against you now because they want to recapitalize the banking system but put in tighter standards, which there are people that recognize that was part of the error of the Hoover administration in the 1930s so hopefully we are not going to go too far in that pendulum swing but it is a policy risk with some downside to it. I just see a lot of risk to the economy. The component of the economy that was built on finance, which was 30% to 40% of S&P earnings depending on how you treat homebuilders, most of that is not coming back so the earnings per share number we were experiencing in 2008, that is gone, that component of the economy is not coming back.
FM: What are the most important fundamental factors traders and investors should be watching right now?
LP: The unemployment statistic and the regional unemployment statistics — California had the highest marginal propensity to spend — that is pretty important because until you start taking the slack out of the labor market. I don’t think that you are going to have a meaningful sustained rebound in consumer spending. It is really the government stepping in and spending money and perpetuating consumer spending.
FM: Are we going to run out of money or see a real recovery come first?
LP: Well I am watching the dollar. I don’t think they are going to run out of money because they can print it. The problem is, the money multipliers are not increasing, they are decreasing, so bank reserves are still high and you have undercapitalized banks. You have to have an expansion of monetary policy and for velocity to stabilize. The Fed is not in the mode of increasing the monetary base and at the same time everything we have seen since the recession in 2008 is that velocity has offset all of the increase of money supply the Fed has put into the system and then you have this hording of bank reserves at the same time so there is no real expansion of the monetary base. It is not trickling through to consumers. Banks aren’t [returning] to the risk appetite that they had so all of those things have to get traction. You have to see unemployment go down and you have to see some real credit creation before this economy is going to have any sustained recovery. If it does, I’ll be the first person to come off of my bearish view. It is just that until I see some evidence of this turning, it is hard for me to buy into it.
FM: It is difficult for retail investors to get access to alternatives, particularly divergent strategies like CTAs. Should the retail investor have more access to those return streams?
LP: I think they should. I think that having commodity pool operators and CTAs should be more mainstream, just like a Fidelity, makes a lot of sense. Everybody should have some exposure, a minimum of 10%. Retail portfolios are far worse than institutional portfolios. Retail portfolios are almost 100% stocks.