FM: Do you still allocate to other managed futures programs?
LP: We do. When we are allocating to outside managers, we think about that with the same hat that we are wearing when we are managing our own strategies. We ask, “is the manager providing something that is purely systematic that isn’t a classic definition of skill?” If they are, we don’t want to pay the incentive fees because we as the asset owner are housing that risk so we don’t think the incentive fee structure is appropriate. The second thing that is key when allocating to outside managers [which goes counter to traditional thinking] is we prefer more volatile managers in the portfolio. There are two reasons for that: You have to have a reasonable amount of volatility to have any impact on your overall risk budget, particularly with a strategy like managed futures that is going to show no correlation to your principle risk factors in a portfolio. The second thing, and it is just as important, is if someone is charging a 1% to 2% management fee and they are running at 5% volatility, it’s much more difficult to make that math work than if you are running at 10% to 15% volatility, where the fee to volatility level is running much lower.
FM: Has the entire investing process been distorted by the love affair with the Sharpe ratio?
LP: The Sharpe ratio is a good tool at the portfolio level. You are not as interested in the Sharpe ratio of each component of the portfolio on a standalone basis, what you are really interested in is the marginal impact that a particular strategy will have on your overall portfolio Sharpe ratio. If I have [strategy] A or B, which one has the biggest impact on my risk adjusted returns or absolute returns? Maybe it is a strategy that has a lower standalone Sharpe ratio. Let’s say manager B has a [better] Sharpe ratio than manager A. However, manager A--because it is negatively correlated with everything else in the portfolio--can have a more positive impact on the overall portfolio Sharpe ratio despite the fact that it looks inferior to manager B if all you are looking at are those two managers on a standalone basis. The point is that Sharpe ratio is not really a bad measure; it is that people are misusing it. They are using it as the single measure of success for each individual manager in their portfolio and that is absolutely the wrong thing to do.
FM: Is there a risk that once bonds reverse its long bull trend, managed futures will lose its non-correlation to equities?
LP: In the 1970s when you had this rising rate environment, stock and bonds were much more correlated with one another. Right now people have come off of this 20-year period where correlations were at its lowest level for the whole century. People say, if you were long bonds it drove the negative correlation in the strategy but in reality if you get into an environment like the 1970s when stocks and bonds are very correlated, then having a long position in bonds may not be lowering correlations, it may be increasing correlations where a short position in bonds can actually be the source of diversification in your portfolio. There are so many different outcomes that managed futures can take advantage of that it is hard to predict how it is going to play out.
FM: Where do you see interest rates going?
LP: Yields have come down since the high of last year. The 10-year note/30-year bond spread had a high of 155 and now we are at 80. That is almost an 80 basis-point move in the 10/30 spread over the last nine months. This is all while the Fed has withdrawn $40 billion in purchases of mortgages and Treasuries, so the long end is telling you something. The Fed really wasn’t the one driving down interest rates, they were actually the ones adding inflationary concerns to the long end of the curve and now we are in an environment where the economy is going to have to stand on its own. And you are seeing this great rotation in central bank activity where now the Fed is more hawkish and the Central Bank of China and a lot of Asian countries are becoming more dovish (See “is the Fed pushing or pulling,” below).
FM: Is the market now moving off of fundamentals instead of every Fed move?
LP: That is what is going on right now. The question will be whether the Fed keeps their hand off of the trigger. We know Janet Yellen as a dovish Fed Governor, but she was there in 2003-2006 for all the increases that crushed the subprime market. She had shown herself to be pretty heavy handed in that episode. It will be interesting to see what happens if we hit a soft patch. How much tolerance for pain will be exhibited?
FM: Equity based alternatives have performed well. Are the folks at AQR doing something right or are the simply collecting equity beta?
LP: First of all AQR is doing something right but whether or not its beta or alpha or alternative beta, I don’t know. They can have a better exposure to fundamentally market based returns and still have a big advantage. AQR had a bit of a soft patch in 2007 on their quant equity funds but they are very smart and very adaptive so they learned a lot from that experience. AQR’s thinking--a lot of the quant equity guys’ thinking--has continued to evolve and they differentiated vs. other players in the market where they are all not doing the same thing in the market so there is less of a tendency that they all run to the exit door at the same time.
FM: Do you create your own program because you could replicate systematic trend following and just select more discretionary managers to allocate directly to?
LP: Absolutely. We think of ours as being alternate beta and we look for guys that we really think have an information edge over the market and those are almost all discretionary macro.