The Armored Wolf in pursuit of alpha

John Brynjolfsson successfully has traded alternative real assets for more than 25 years. And, in 2009 he traded his career at PIMCO, Newport Beach, Calif., for his own firm, Armored Wolf, Orange County, Calif., which trades a global macro strategy emphasizing real assets. The unusual firm name is the translation of Brynjolfsson from the Icelandic Brynjólfur, or Brynjúlfur, or made of brynj-, from brynja “coat of mail, armor” and úlfur (-ólfur) “wolf.”

Brynjolfsson’s experience includes trading commodities, global inflation-linked bonds, event-linked catastrophe bonds, as well as asset allocation and risk management. We talked to him about trading, including the career move from a big traditional asset management firm to his own firm, along with his pursuit of alpha.
 

Futures Magazine: Your trading career cuts a broad swath across commodities, global inflation-linked and event-linked catastrophe bonds. This trading experience gives you a unique perspective on the markets. You spent 19 years launching and building PIMCO’s Real Return platform from $0 to $80 billion in third-party assets, including launching and managing PIMCO’s second, third and fourth largest public funds before establishing your own firm.  Tell us about the evolution of your career as a trader and the various instruments in which you are expert.

John Brynjolfsson: Going back as long I can remember, certainly to my undergraduate and graduate school days,  I’ve been driven deep down by answering the question “In what way  can I best serve society?” My answer has been to be part of the infrastructure that allocates capital to its best and highest use.

Though my answer, allocating capital to its best and highest use, is somewhat abstract and impersonal, I think this desire to do good is a powerful motivator that has kept me engaged.

[At] the most superficial level, that function (allocating capital as an investment manager) might be most overt in  areas like venture capital, stock picking or perhaps high-level asset allocation. [But] my quant training, and opportunities in the job market, convinced me that managing huge portfolios of fixed-income securities, and transforming risk in innovative ways using futures, derivatives, options and structured products, where often a basis point or two was material, was not just significant but the most, certainly in aggregate terms, socially redeeming role for me.

Fleshing this out, I’ve always been attracted to the challenge that the markets provide. There’s a unique combination of big-picture thinking relating to politics, property rights, globalization, sentiment, macro flows and valuation, as well as bottom-up details, ranging from delivery specifications, contract construction and counterparty risk that all come together.

My career got a jump start when I got hired because of my quant background. I hold Math and Physics degrees, and was a MIT Finance PhD candidate, so I had the world of fixed income ahead of me. Ironically, I tried my best to distance myself from those aspects, though I was not entirely successful. My entrepreneurial instincts drove me to listen to clients and think about their needs.

FM: Which commodities have you traded? What are you currently trading and why?

JB: My professional introduction to financial markets really began with crude oil futures, going back now more than 25 years. Much of my early research at MIT, and for a company called Charles River Associates that consulted for the U.S. Department of Energy (DOE), was into the nascent oil futures market. My positions offered me a front-row seat, and some involvement in terms of doing policy research, to the DOE’s efforts to manage the SPR (Strategic Petroleum Reserve). My role allowed me to explore how the DOE could use oil futures both as a temperature gauge of tightness in the oil markets, and possibly to assist in implementing SPR policy.

It was some years later that I got involved in commodity index investing. A luminary in that industry, Robert Greer, at the time was promoting how more traditional investors could best get exposure return and hedging qualities that commodities provide. Ultimately Bob joined me, and together we launched and built out one of the largest commodity franchises in the world. The major indexes were constructed to focus on the largest most liquid commodity futures. Though our “trading” was done mainly on index baskets, using derivatives and structured notes, my broader experience provided me with extensive exposure to financial futures: Bonds, equities, currencies, you name it. In particular, one of my first roles in the business involved me writing state-of-the-art, circa 1995, delivery models for valuing all the major bond and note contracts around the world.

FM: You’ve seen the evolution of the catastrophe (CAT) bond. How have these grown and changed over time? What’s your outlook for this market?

JB:  CAT bonds sit at the nexus of two huge markets. One of those markets is the reinsurance market, which attempts to underwrite and diversify catastrophic natural hazard risk, or “perils.” The other, even larger market, is the global capital market.

I hold some pretty strong opinions about how CAT bonds can serve investors. Succinctly put, there’s a certain segment of the natural catastrophe market, the super-catastrophic, parametrically modeled, peak-perils, that all large institutional investors should strategically and tactically participate in, via CAT bonds.

FM: You are the co-author of “Inflation-Protection Bonds” and co-editor of “The Handbook of Inflation-Indexed Bonds” and once were responsible for trading $160 billion in TIPS [Treasury Inflation Protected Securities] for PIMCO.  As an inflation expert, what’s your outlook for the near- and long-term?

JB:  Obviously the global economy is, and has been for five years, in the midst of one of the toughest deleveraging cycles of the past 100 years. This, combined with unprecedented monetary policy, not just at the U.S. Fed, but at all major central banks globally, puts inflation at a knife’s edge.  I suspect that inflation in the near term will remain contained, and there is even a risk of disinflation. However, my concern is the huge amounts of “dry gunpowder” in terms of excess reserves in, and lagged effects of, negative real interest rates globally, that speak to inflation risk on the upside and that would be difficult to control.

FM: You’ve written extensively on the U.S. Federal Reserve’s actions over the past few years. Would you share your current economic overview and outlook?

JB: The two-trillion-dollar question is “exit strategy.”

The Fed is capitalized with $55 billion of  “paid-in capital.” The actual number may be much larger or much smaller than this, [because] implicitly the Fed has the backing of the Treasury and taxpayer (Yup, it’s too big to fail!), and also has implicit obligations [that] are unstated. But, I like to begin at least with the “facts” as they are stated, in this case on the audited financials of the Federal Reserve System. So by any measure, $3 trillion of assets on the Fed balance sheet is a lot of leverage. What leverage does is amplifies swings, or puts entities on the knife’s edge. That doesn’t per se speak directionally to inflation or deflation. What it speaks to is the following:

Low volatility “great moderation” is obviously behind us, as 2008 proved. However, it also is likely that the low volatility, inflation pegged at 2%, current environment will not endure. Markets are too complacent if they think interest rate moves are measured in basis points and inflation ticks up or down 0.1% a month to peg inflation at 2%.

Disinflation is certainly a possibility, as monetary policy is largely pushing on a string, and fiscal policy (with debt-to-GDP in the United States and most developing countries at over, or near, 100%) is hamstrung. Therefore there is little ability of the economy to respond to a negative macroeconomic shock.

Right now the United States seems to be motoring along, with pent-up demand and low interest rates, being roughly offset by headwinds created by fiscal tightening, the combination of tax hikes and spending cuts.

China, Japan and Asia more generally face headwinds to growth and are slowing. In China, secularly, we are seeing slowing from [an] historic rate of 10% to 12% being recalibrated toward a more sustainable 6% to 8%. But within that secular range, we are seeing inflation flare up, from 1.8% last fall to 3.2% now. That has triggered policy tightening in various forms, and in this sense is running somewhat counter to cyclic and policy dynamics elsewhere. Japan is facing slowdown, though it has a new, almost experimental, radical policy easing being promised and implemented at this time.

Europe is a basket case, and has already experienced a recession characterized by negative real GDP growth, falling inflation and rising unemployment among young and old, periphery and core. The macroeconomic challenges, an uncompetitive exchange rate, combining with dysfunction of the labor and capital markets brought about by befuddled policy, are being strained by political challenges. The uncertainty created by political forces,  both those centrifugal forces pulling the Eurozone apart, and the domestic forces within nations created by the wealth disparities, unemployment, and austerity imposed on large populations, make capital formation almost impossible.

Inflation, longer term, that once started, accelerates and is difficult to harness is the biggest risk I see. The geometry of the situations is multifold, but with every aspect pointing to higher inflation.

First, you have a fundamental backdrop of growing demand, particularly in emerging market nations, for a finite supply of raw materials. Food, minerals, land, even fresh water. As these populations migrate to cities, urbanize and increase their incomes from current subsistence levels, their demand for commodities personally, and in their industrial efforts will multiply, while supply grows arithmetically by a percent or two, if not shrinks.

Second, you have extremely easy monetary policy, for unprecedented periods. The ease is measured by the real Fed Funds rate. Normally, the Taylor Rule, history and other models of real interest rates, suggest that a “neutral” real Fed Funds rate is +2%. So the Fed Funds rate may be 4%, inflation may be 2% and the difference, the real Fed Funds rate +2% would be considered “neutral.” During periods of overheating, typically a +4% real Fed Funds rate has been required to “put the brakes on” and cool an overheating economy, or accelerating inflation. During periods of weakness, when inflation falls, unemployment rises and real GDP growth hovers around zero or less, a stimulative real Fed Funds rate of 0% is required. Over the past four years the real Fed Funds rate has gravitated down to –2%, and QE (the balance sheet expansion of the Fed, and other central banks) has amplified this by extending the negative real money market rates out the curve into the seven-, 10-, and even 30-year sectors of the bond market.

Third, you have the difficulty in exiting. Fighting accelerating inflation is always hard. You have the normal political pressure (from presidents, senators, representatives and other politicians up for election) to accept the bargain of short-term gain through easy policy, at the expense of much greater long-term pain associated with high inflation. But currently the huge balance sheet, unprecedented not just in size, but [also] in the maturity and low coupon of the fixed-rate securities holds. On a mark-to-market basis, these could wipe out Fed capital with a small rise, 40 basis points or so, of market yields! Though not marking to market is optically preferable, it doesn’t change the reality. In particular, the mark-to-market simply quantifies the ongoing cost of carry securities with low, long-term, fixed coupons. Similarly, whether the Fed exits by selling securities, or instead finances them at somewhat higher short-term rates (needed to offset the inflationary effects of the Fed continuing to hold large quantities of long-dated Treasuries on its balance sheet) the cost is roughly the same. The challenging financial position that the Fed will be put into by these dynamics will erode [its] political independence, at best. As an investor, I think it prudent to register the increased inflation risk associated with this unusual situation, particularly because current policies only increase this dynamic.

FM: You successfully have made the transition from a large, traditional asset management house (PIMCO) to a successful global macro hedge fund firm (Armored Wolf), with in excess of $1 billion in assets under management.  You launched Armored Wolf in 2009, arguably one of the most difficult periods in which to start a fund. You’ve seen some tough markets in which to raise capital and trade. Tell us about your strategy and how it has evolved and changed since inception.

JB: Our launch was driven by two interrelated super-secular forces. The first was the end of disinflation, and the second was the end of benchmark-driven management fees.

The end of disinflation we felt would mean the end of the free money created by falling yields and rising p/es.  By 2008 we were in the 28th year of a bull market for financial assets. We saw equities essentially peak in 2000. Though they’ve ground higher since, the combination of volatility, inflation and taxes suggests that any gains since 2000 are essentially illusory. Given the end of disinflation, we felt traditional forms of investing, equities and bonds, had seen their best days. As such we focused on building Armored Wolf’s “intrinsic firm capital” by focusing on talent acquistion, infrastructure and solutions that would do well in sideways or rising inflation environments.

The other aspect involved benchmark-driven management fees. Though there have been fits and starts, with 2008 being a rather large fit, increasingly quantitative approaches to markets have characterized the past 50 years. Recently, this has made the cost of getting benchmark exposure, particularly at the institutional level, essentially zero. Not only would fees for such services, including [those] embedded within broader products, gravitate toward zero, but markets themselves would become more efficient. We no longer could assume simply that “stocks for the long run” would work. There would be no frictions, or disequilibrium  conditions, that would allow this heuristic to apply going forward.

FM: What was it like to make the transition? What were the hardest lessons you learned?

JB: It was a profound luxury [that] I fortunately could afford. In particular, it was a reckless tribute to the entrepreneurial desires I had always harbored, and [that] led me to drop out of my PhD program decades earlier. While I rely heavily on both my senior partners who help me run Armored Wolf, and my other colleagues who both ply their trade and support me, I enjoy both the weight upon my shoulders and the breadth of challenges I face.

FM: What advice would you give new managers starting out?

JB: The landscape is competitive. The most expensive cost one will face is surely denial--denial regarding one’s strengths and capabilities, or denial regarding one’s weaknesses.  Ultimately, passion and desire are the only rocket propellants that will get one into orbit.

FM: Your firm embodies the convergence between traditional and alternative investments. For about a decade, traditional firms have been trying to get into the alternatives space, while hedge funds and other alternative managers have been trying to launch mutual funds. Meanwhile ETFs have become all the rage. Can you flesh out this landscape, and Armored Wolf’s role in it?

JB: Yes. At [PIMCO], though I ran the some of the largest mutual funds in TIPS, commodities and the asset allocation space, my approach was decidedly quantitative, relying heavily on a concept called “portable alpha,” in which alpha became the centerpiece of my efforts, and the benchmark took a backseat. So analytically speaking, my ability to allocate across specialist managers and manage portfolios myself, was seamless.

In terms of clients and mandates, our firm spans the gamut. Our people and infra-structure, starting with my co-founder Mohan Phansalker (former CLO for PIMCO, now Armored Wolf’s COO & general counsel), span a variety of structures, regulatory frameworks and asset classes seamlessly.

Currently our clients are Eaton Vance: Armored Wolf serves as sub-advisor for the EV Commodity Strategy Fund; Curian Capital: Armored Wolf serves as a sub-advisor providing ETF model portfolio for Curian’s retail separate account product; OFI: Armored Wolf serves as sub-advisor for the OFI SSP-Armored Wolf Euro Inflation-Linked Bond UCITS Fund; James Alpha: Armored Wolf serves as advisor for the James Alpha Global Enhanced Real Return Fund; and Armored Wolf is the manager of various institutional separate accounts and privately placed funds (hedge funds) in the high-yield and absolute return arena.

FM: So coming back to the current investment environment, and synthesizing both your background, and your investment process, what can you tell us about the current outlook?

JB: In terms of inflection points, I’m drawn to commodities generally, and the tensions embodied therein.  In the energy market, you have rapid innovation transforming: The supply side, transportation infra-structure,  and via conservation and substitution, the demand side. This innovation, or these productivity enhancements, are keeping a lid on energy inflation. In the metals, and precious metals, you have a different and much more bullish dynamic going on.

Pricing for commodities, and metals in particular, is based on three intimately interrelated markets. The first and foremost of these is the long-term market, where ultimately supply and demand fundamentals intersect. The second is the spot market, where at each instant for every buyer there is a seller. The third, the glue that ties these first two together, is the market of storage, or inventories. Inventories are the “time machine” by which spot sale of current production is in effect delayed, as the material is transported into the future.

With the global economy experiencing “a new normal” sub-par rate of growth and industrialization, for five or more years as Reinhardt and Rogoff describe in their sarcastically titled book, “This Time is Different,” the spot market for many metals is relatively glutted. Don’t be fooled however.  The longer term fundamentals could not be stronger.

I don’t expect this to endure. For some commodities, those that are difficult to store, this disconnect will simply endure, until gradually the passage of time will resolve the discrepancy. For metals markets, the cost of storage is low, so the spot market and the long term market remain linked. Low interest rates further facilitate this arbitrage.

Precious metals are of course the most direct way to play this, with platinum, at a discount to gold, providing both fundamental, and relative value. 

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