FM: Haven’t the expectations changed? Managers aren’t shooting for huge returns like they used to.
JS: What is possible has gone down, [especially] with the zero interest rate environment. If you have 6% or 7% interest, that adds to your return. So the zero interest rate counts against your return. You look at the long-term trend followers who have been around for a while, those that started in the 70s and 80s and even early 90s they had one type of return and then if you look from the mid-90s on it has been a different story. Trend following still works but it certainly doesn’t deliver the return to risk as it did in the early days.
FM: You most often write about hedge funds and CTAs, do you consider managed futures a hedge fund subset or a completely different asset class?
JS: I consider it kind of a subset, but there are some very important distinctions. One of them is liquidity. It is the most liquid part of the investment universe. That also means something else very important. It means that CTAs are the only group that is probably immune from the correlations going to 1. At the end of 2008 you had all these strategies, which at times might be significantly uncorrelated yet during the crisis of 2008 and 2009 start to behave extremely similarly. That is true because everybody is on the same side of the fence; everyone is trying to get out. However, CTAs by virtue of the ability to get out of any position on the same day and as importantly go short, they are not vulnerable to the losses [related to] correlations going to 1; and in fact they may be in a situation to take advantage of those factors. If they are smart and good, they can not only not be long but they can be short and make some money out of that crisis.
FM: The CTA space has become more institutional. Managers are shooting for 10% instead of 50%. Is this a good thing?
JS: What a manager targets is totally irrelevant. I say that as an allocator. I don’t care if a manager is targeting 5%, 10%, 20%, 40% whatever. Why? Because you can take a guy who is targeting 5% and then decides he is going to target 40% and his risk goes up by a factor of 8. That’s fine; I’ll just invest one eighth, so it is irrelevant. If you invest in a managed account you are going to decide what notionalization you are going to use.
FM: Your new book attempts to debunk the Efficient Market Hypothesis — for those who still subscribe to it. Why do you think this has persisted despite all the evidence to the contrary?
JS: That is easy to answer. Because the efficient market hypothesis and underlying assumption of normal distributions and so forth, the whole academic finance structure, there is one great thing about it. It allows you to quantify, it allows you to give precise answers. It may be the wrong answer but it is precise. If you take away that normal distribution and that markets are efficient, then you can’t really answer the questions: ‘How do I allocate my portfolio? What percent should I put in stock and bonds? What is my best allocation?’ You can’t answer that question, but you can answer it exactly if you use portfolio optimization, which assumes a normal distribution. I would argue that the answer is not only wrong, but it may be worse than random. People like it because you can quantify and give pat answers. It allows for definitive conclusions. My view of markets is that they are influenced by fundamentals and there are times when the markets will act [efficiently], but the really big moves come where emotions play a very large role. We call those big moves bubbles and the collapse of bubbles. That model describes the world accurately but as I like to say: market moves begin on fundamentals and end on emotion. The only [problem] with that is there is no way of quantifying emotion. The Nasdaq stops at 5,000 plus, it should never have gone to 5,000 plus and it could have just as easily stopped at 4,000 plus and still have been way overbought or it could have gone to 6,000 or 7,000. [The Efficient Market Hypothesis] may be the correct way to explain the world, but it does not allow a way to define how far is too far. There is a large amount of chaos and randomness to it.
FM: I have profiled many managers who cite your books as the reason they became interested in trading. What do you think when a manager you are interviewing tells you he was inspired by a profile from one of your books?
JS: This may sound a bit self-serving, [but] almost everyone I interview cites my books. It is extremely common for managers I interview to tell me that my books got them involved [in trading]. Quite often they talk to me because my books got them interested so they feel some sort of an obligation even though they have no reason to. In "Hedge Fund Market Wizards" I actually had the problem that my books came up so often in interviews that I became self-conscious of the material. I decided to take out the reference if I didn’t think it was necessary.
FM: What is your opinion of the trend toward manage futures funds? Do you see this moving to a point where it will be normal for retail investors to have an allocation to trend following strategies in their portfolios?
JS: I have mixed feelings. On the positive side it is preposterous to think that mutual funds of stocks are OK for regular people and conservative investments whereas mutual funds of CTAs are risky and shouldn’t be allowed for average investors. It is absurd because if you go by track records, returns are probably similar and they are much less volatile and risky in the CTA world. There is a complete bias unsubstantiated by any [analysis] and that flies in the face empirical evidence. So there is a reason why mutual funds of CTAs should be perfectly fine and provide diversification. All of those reasons [show managed futures] are absolutely a legitimate product and everyone should have it in their portfolio. However, here is the problem. If too much of this goes on, the traditional investment world is too large and the industry can’t absorb it. If it becomes successful, it is going to kill the industry. Returns will be driven down where there just won’t be satisfactory returns. The biggest risk to the industry is if it becomes too popular.