Managed Futures, Short and Long Volatility, E-Minis
Tom O’Donnell is a principal and a managing direction at 3D Capital Management. Tom began his career at the Virginia Retirement System where he pioneered the use of alternative investments to mitigate portfolio risks.
Since then, Tom’s 30-year career has been devoted to reminding investors that markets move in two directions: up and down. Tom has been finding and using alternative investment strategies to reduce risk and enhance returns across the business cycle.
In today’s conversation, we talked with Tom about this history of the Managed Futures industry, the relationship between returns and assets under management, and how investors should think about combining short and long volatility investments.
In the interview, Tom mentions a financial instrument called the e-mini. The E-mini is a commonly traded futures contract that is worth one-fifth of a full S&P futures contract, but for the purposes of our contract, it can just be thought of as a S&P contract.
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Have comments about the show, or ideas for things you’d like Taylor and Jason to discuss in future episodes? We’d love to hear from you at info@mutinyfund.com.
Transcript for Episode 9:
Taylor Pearson:
Hello, and welcome. I’m Taylor Pearson, and this is the Mutiny Podcast. This podcast is an open-ended exploration of topics relating to growing and preserving your wealth, including investing, markets, decision-making under opacity, risk, volatility, and complexity.
Taylor Pearson:
This podcast is provided for informational purposes only, and should not be relied upon as legal, business, investment, or tax advice. All opinions expressed by podcast participants are solely their own opinions, and do not necessarily reflect the opinions of RCM alternatives, Mutiny Fund, their affiliates, or companies featured.
Taylor Pearson:
Due to industry regulations, participants on this podcast are instructed to not make specific trade recommendations nor reference past or potential profits. And listeners are reminded that Managed Futures, commodity trading, Forex trading, and other alternative investments are complex and carry a risk of substantial losses. As such, they’re not suitable for all investors, and you should not rely on any of the information as a substitute for the exercise of your own skill and judgment in making such a decision on the appropriateness of such investments. Visit www.rcmam.com/disclaimer for more information.
Taylor Pearson:
Tom O’Donnell is a principal and managing director at 3D Capital Management. Tom began his career at the Virginia Retirement System, where he pioneered the use of alternative investments to mitigate portfolio risk. Since then, Tom’s 30-year career has been devoted to reminding inventors that markets move in two directions, up and down. Tom has been finding and using alternative investment strategies to reduce risk and enhance returns across the business cycle.
Taylor Pearson:
In today’s conversation, we talk to Tom about the history of the Managed Futures and CTA industry, the relationship between returns and assets under management, and how an investor should think about combining short and long volatility investments.
Taylor Pearson:
I also want to say, Tom mentions a financial instrument in the interview called the E-mini. The E-mini is a commonly-traded futures contract that is worth 1/5th of a full S&P futures contract. But for the purposes of our podcast, it can just be thought of as a S&P contract. With that, let’s get to the interview.
Taylor Pearson:
Tom, I’d love to just hear you start and speak a little bit about your background and how you got into the philosophy that brought you to 3D Capital, where you are now. Now, I know you worked at Chesapeake Capital and the Virginia Retirement System, which are different businesses, different career tracks. So how did you get to 3D, and what was the career trajectory that took you there?
Tom O’Donnell:
Sure. Thank you, Taylor. So I started my investment career at the Virginia Retirement System in 1987. The stock market lost 22% in a single day that year. The lesson that that single day had on my career, what it taught me were two things. Number one, the stock market moves in two directions, it moves up, and it moves down. And two, the down moves can be violent.
Tom O’Donnell:
So armed with that knowledge, my career or mission was born, literally that day, find a way to participate in the stock markets upside without suffering the painful downside. And when you work at a public pension fund, you can’t pay retirement benefits with negative returns. So the question then is, well, how? How do you mitigate that downside risk? And for us, again, back in the late ’80s, early 90s, we were drawn to the concept of diversification, that diversification was the first step.
Tom O’Donnell:
So back in the late ’80s, early 90s, the magic of modern portfolio theory, efficient frontiers and, of course, our fiduciary responsibility, it consumed our thinking. We embrace the idea of diversifying into non correlated assets as the best way to achieve the best risk adjusted returns, and to avoid the risk of large losses.
Tom O’Donnell:
We conducted a bunch of research and due diligence on everything we could get our hands on, first, expanding our domestic equity program into international equity, and later, emerging market. And then we set our sights on alternative investments. And within the alternative investments, and within public pension funds in general, we actually were considered a pioneer in the alternative investment space. Some of the alternatives we invested in more private equity. We did market neutral, which is quite a long short equity but we did it with an S&P futures Overlay, and we did manage futures.
Tom O’Donnell:
We were actually the first public pension fund to invest in a meaningful way in the managed futures industry. And managed futures was, based on my experience, it was the best single investment for achieving broad market diversification because the managers we employed. The CTA, those that were, they were investing in a global portfolio long and short in stock indices, interest rates, currencies and commodities. So the amount of market diversification was significant. Everything was going great until we encountered one of the downsides of diversification, which is the human factor.
Tom O’Donnell:
And the human factor of diversification goes like this, we have all these non correlated to negatively correlated investments. When the equity market is doing exceedingly well, people get more bias into thinking the equity market might be the only thing they need to be invested in. This comparison, of course, is unfair for obvious reasons. However, it’s an easy trap for investors to fall into since the equity market tends to get a free pass, and it is considered a mainstay in most investors portfolios. So, when equities are doing great, investors can get lulled into thinking they don’t need diversification.
Tom O’Donnell:
The VRS decided to dial back their diversification in managed futures. I was still overseeing the global equity program, which was about 10 billion in size at the time, and I felt that we needed additional ways to diversify that equity basket. I subsequently left the Virginia Retirement System and joined Chesapeake Capital.
Tom O’Donnell:
Chesapeake was one of the CTAs that I uses in the managed futures program at the Virginia Retirement System. They fit into the category of broadly diversified long term trend follower. Then I went on to work for Newedge, which was, at the time, one of the largest futures commission merchants in the world. And then later The Bornhoft Group. And The Bornhoft Group is a multi manager CTA firm.
Tom O’Donnell:
These firms were involved in the things that mattered to me. I was working in the managed futures industry with my buy side institutional investor brain and my sell side suit. And these opportunities to add value helping to carry the managed futures torch, were very rewarding, and I always enjoyed the opportunity to share the knowledge that I’ve learned over the years.
Tom O’Donnell:
As The Bornhoft Group was winding down, Rich Bornhoft had just won the Lifetime Achievement Award in the managed futures industry, and he was retiring from the industry. I was still seeking this opportunity to combine my global equity experience and my managed futures experience. And I do actually remember praying for that opportunity. And then in the summer of 2017, I was actually contacted on LinkedIn by a complete stranger named Eric Dugan. And Eric Dugan is the founder and Portfolio Manager of 3D Capital Management.
Tom O’Donnell:
He, of course, identified himself as a CTA, and since I’ve been in the managed futures industry for nearly three decades, I’m always happy to help CTAs. And so I asked him, I said, “Well, what markets do you trade?” He said, “Well, I trade the E-mini S&P futures contract.” I said, “Well, what other markets do you trade, because most CTAs tend to be very broadly diversified across many markets?” And he said, “That’s it. That’s the only market I trade, is the E-mini S&P.”
Tom O’Donnell:
So if you talk about an answer to prayer, here is a manager that is a CTA in the managed futures industry, but what this manager has dedicated himself to is managing equity market risk, specifically, and head on every day. He went on to say, and this is even more interesting is that the way 3D trades the E-mini is with a short bias. So think about that.
Tom O’Donnell:
Most equity managers, most equity market investors rather, are long the stock market. They buy the stock market, hoping that it will go up. And this is where the buy and hold mindset comes from. But they’re all vulnerable to the downside. The mouse trap that Eric built, the product he built is specifically designed to mitigate that downside risk. So, it is literally designed to provide the deep end that the longing the stock market investors desperately need.
Tom O’Donnell:
Well, interestingly enough, he’d been running this program since February of 2011. So he has this live track record that exists during this historic bull market. And as a former institutional investor, when you analyze any strategy, one thing you’re hopeful for is that the strategy you’re analyzing, you hope somewhere in the track record is an environment where you would expect the strategy to do poorly. Well, clearly, an equity strategy that has a short bias would be put to it’s greatest test during a bull market. And that, in fact, after I studied his track record, Eric was succeeding during this bull market, shorting it profitably.
Tom O’Donnell:
So I know we’re not supposed to talk about returns on this podcast, but it’s especially important to evaluate a manager when you expect the manager to be doing his or her worst. I had done that. And past performances, of course, not indicative of future results, but how someone performs in the worst possible market conditions gives you some indication as to how that manager will perform in favorable market conditions.
Tom O’Donnell:
So, one of the other things I always look for is the objective of the program. So, the objective of the program, the investment objective of the program is to primarily short the stock market when it’s going down and stand out of the way when the market is rising so investors can enjoy their long own the stock market gains. And again, it was just an answer to prayer for Eric and I to come together. In the summer of 2017, I joined the firm, moved all my licenses, my futures licenses, over to the firm and started officially working full time towards the end of ’17, beginning of 2018.
Taylor Pearson:
I’m interested, I think, the managed futures, CTA space’s, obviously, grown a lot over the last… I guess, since you’ve been in it. [inaudible 00:12:16] could you just, for the listeners, what are managed futures and CTAs? And I want to just talk a little bit about the history when you… I think you got started mid ’80s. So you were really there at the very beginning, and as we’ve seen it evolve over time.
Tom O’Donnell:
Yeah. That’s exactly right. In fact, the approximately $500 million that we allocated to CPAs in the early ’90s, not only were we the largest public pension fund doing it, we were one of the largest investors. And I throughout my career, I’ve met many CPAs who have come up to me at conferences and things, and said, “Oh, yeah, you were our largest client, Virginian was our largest clients, et cetera, et cetera.” So yeah, there is some history there.
Tom O’Donnell:
I think one of the things that has changed a little bit here, more recently, in the managed futures industry is a lot of the institutional investors that are getting into the space seem to be 100% focused on trend following. Trend following is, of course, one of the most popular styles/strategies in the managed futures industry. But there is an inordinate amount, in my opinion, an inordinate amount of attention being placed on just that one style. And often the assets get aggregated or allocated to a lot of the same managers. And many of those managers are more highly correlated with each other, et cetera, et cetera, et cetera.
Tom O’Donnell:
So if you’re really looking for diversification, I think you need to be looking beyond one style because there are multiple styles and strategies within the managed feature space and beyond, what would you call it? The trend following, and or just the broadly diversified trend followers and making that the medium, the longer term space. If the industry has tremendous depth and extend skill that moves way beyond just that category.
Taylor Pearson:
Correct me if I’m wrong here. Managed futures, just need to know, and an active manager in the futures space. And then as you mentioned, those managers themselves are be referred to as CTAs, and [inaudible 00:14:42]. A lot of people that are familiar with managed futures, CTAs seem to think of it as just trend following because that’s maybe the most popular strategy in this space. Is that a fair summary of it? Where do you see it on the other… what are the… I guess, if you’re not doing trend following, what are the other prominent strategies used in managed futures and CTA space?
Tom O’Donnell:
Well, so basically, I mean, you do have… On the one hand, you’ll have systematic rules based managers, and then on the other hand, you’ll have more discretionary approaches, you’ll have managers that trade within different time frames, anything from minutes to hours and days out to weeks and months in duration, for trading time frame, and different markets, of course. 3D Capital happens to specialize in the short term space, but within the E-mini S&P, there are other managers out there that trade sectors like maybe just the energy market sector, or they might be more broadly diversified.
Tom O’Donnell:
So it’s not a category of investments that, in my opinion, can be boxed in to just one specific category or niche. There is tremendous diversification to be had within the managed futures industry. And if anyone is just simply more narrowly focusing on one of those strategies, I think they’re missing out on a lot of additional diversification and additional returns.
Jason:
Tom, I think one of the most interesting thing you said, we can talk about managed futures, CTAs, alternative investments, et cetera, the most interesting piece to me is the skin in the game, right? At Virginia pension, you were putting hundreds of millions of dollars by [inaudible 00:16:35] that, when you left there, you took the career risk and skin in the game that you decided this was the path forward for you and your life and your lifestyle. And that I think speaks more volumes than anything else you could possibly say.
Jason:
But going back to what you’re saying not to derail us too much is, if you put your marketers hat on, you were saying that it’s typically been called managed futures and under that CTAs anyway, does broad brushstroke to this trend following, but within futures and options, there’s so many unique, smaller capacity constrained strategies you can do. So how do we… Our co managers at RCM are trying to maybe call it alternative investments. Do you have any other ideas of specific nomenclature or ways we can rebrand these very unique strategies using the cash settled futures markets?
Tom O’Donnell:
Yeah. I think, in general. So, in my nearly three decades of being in the investment industry as an institutional investor, there really aren’t any new asset classes, okay? So in my mind, the global portfolio of exchange traded listed market to market assets are equities, interest rates/no fixed income currencies and commodities. I mean, those are the asset classes.
Tom O’Donnell:
So managed futures happens to embrace all of them in one product or in one industry. But it does, I think oftentimes, get treated like there’s some double standard because those managers, by virtue of their diversification, are perhaps less well understood. But let’s for a moment, just take the word, the phrase rather, or the label, CTA, Commodity Trading Advisor, that of course was born out of the fact that the first futures contracts that were traded were commodities. So, at the very inception of the industry, managers traded, if they were trading, traded commodity contracts, and then later in the ’90s, the equity indices and interest rates and other markets became available, so they became more broadly diversified.
Tom O’Donnell:
But I think what is always impressed me most about the managed futures industry is that the most successful managers are the ones who have the best risk controls. Right? The mandates that I handed out at the Virginia Retirement System where I gave somebody a benchmark and said go beat the S&P 500, that manager is able to hide behind that benchmark. Because if that benchmark is down, as it was in 2008, down 38 and a half percent, if that manager, the equity manager I gave the money to, his only down 37, they look like a hero. But in the managed futures industry, as you get into all the alternative investment industry, down 37 isn’t going to cut it. So you tend to get into more absolute return oriented, which always appealed to me. I can’t pay benefits to a public pension fund with negative returns. Okay?
Tom O’Donnell:
And my actuarial rate assumption as the public pension fund back when I was doing this, like I said 30 years ago now, it was approximately eight and a half percent. But these actuarial rates have been coming down, just averaging today about 7%. But remember the actuarial rate of return, the overall objective for the pension fund is generate a positive return. Well, every long-only investment that I’m familiar with, is vulnerable to the downside.
Tom O’Donnell:
So, again, every investor should, I think, be taking stock of the fact that they have great investments in their portfolio, but you always need to be looking at the vulnerability of those investments, and long-only investments, in particular long-only stock market investments are vulnerable to the downside. You only make money in long-only stock market investments when they go up. You lose when they go down. That, I think, is the risk that needs to be addressed. And in the case of 3D Capital, through our defender program, we built the product to address that. And the managed futures industry also has other solutions for that.
Taylor Pearson:
You mentioned earlier the human factor element, I’ll come back to that because I think that’s important. I’m curious to know… I think it sounded like maybe one of the things that happened with Virginia Retirement System was, after a period of a long bull market everything seems to be… Maybe the firemen, the policemen, the people you’re dealing with are looking at the stock market on CNBC or the newspaper, they’re seeing what the S&P is doing, and they’re going, “Why is it my pension fund doing…” I’m curious, how you saw that play out and then how you sort of… What do you say to that person, to someone with that sort of thinking about maybe why they should think about it differently?
Tom O’Donnell:
Right. Well, I mean, we also had at the Virginia Retirement System, an investment committee comprised of investment professionals. But when you get into kind of a group think discussion that human factor is that everyone is entitled to an opinion. And maybe again, this could get all the way down to just families, families that are considering how to manage their own retirement, so how to manage their own wealth.
Tom O’Donnell:
The bottom line is that you’re going to take risks in order to generate returns. And what I always wanted to know when I was allocating to a manager is I wanted to have a reasonable expectation as to what I should expect. So, in a simplistic way, if I’m going to take on equity market risk, I know going in that I have the potential, on average, to earn 8%, 9%, maybe 10%, on average over a long time period. But in that timeframe, there could be significant downturns. We know there have been two recent 50% corrections, one in the tech bubble and then in 2008. So we have to figure out a way how to mitigate that.
Tom O’Donnell:
And I think this is, again, where managers that have the ability to survive are the ones who manage risk, investors who have the ability to survive are the ones who understand and appropriately manage risk. And the risk I’m talking about is the risk of losing money. Right? You want to avoid losing money. So you need to be invested in the stock market, no question about it. You need fixed, no question about it, but you also need to embrace that markets move in two directions.
Tom O’Donnell:
And again, that was the genius behind whatever Dugan built in the 3D defender program, because he recognized early on in his career. In 2008, in fact, he recognized that everybody on the stock market are vulnerable, and he knew that he could predict with a high degree of accuracy, the daily price activity in the S&P, and in 2008, and he set out to create the firm.
Jason:
And like you said, the most important thing is survival, or sometimes we talk about finite and infinite games. We’re playing an infinite game here. And this just happened this morning, so I’m curious. As I was walking through the airport, I’m seeing the TVs in the airport saying the stock market’s up over 20% this year, and I’m like… in my mind, I’m just kind of like… my brain kind of froze up and I’m like, “It’s up over 20% on some arbitrary time horizon that you chose, as like, January 1, 2019. It’s actually [inaudible 00:25:00], if you take the draw down from Q4, 2018.” So I’m just curious how you think about time sequencing, and that kind of stuff. Just don’t lose money, but you got to… you need to compound at a better rate over the longer term.
Tom O’Donnell:
Yeah, that’s exactly right. So I think, again, just fairly recently. So let’s look back to what is, I believe, the fastest stock market retracement minus a correction is last year. So January of 2018, the markets were going great. And then in February in three days, the stock market, in February of 18, in three days, had lost 11%. Once again, underscoring, it moves into directions.
Tom O’Donnell:
Fast forward to the fourth quarter of 2018, Eric Dugan actually was on Bloomberg, October 3rd of 2018, and he was asked, he said, “Well, what should investors be thinking from here?” And he said, “Based on what I’m saying, I’d prepare for markets to go down.” I think he might have said even a sharp sell off. Well, in the fourth quarter of 2018, the stock market was down approximately 14%.
Tom O’Donnell:
Now, here we are in 2019, and as you just said, the stock market is up 19%. The stock market clearly has the ability to add value. Nobody is saying you shouldn’t invest in the stock market, it is an important investment, but it can’t be your only investment because if it is your only investment based on what we’ve just discussed, you’ll be experiencing feast or famine throughout your entire life. And to the extent, anybody wants to achieve better risk adjusted returns, diversification is certainly something that needs to be embraced, and service hedging. That is the idea of hedging stock market risk. And that is where, our program, we tend to call it a smart hedge, because it’s managing stock market risk on a daily basis.
Taylor Pearson:
And I’ve heard you make the point that, especially today, a lot of investors are optimizing for low fees and can be missing the point in some way. If you’re optimizing for any strategy that has a negative 50% drawdown, if you’re minimizing your fees, it’s not necessarily the right way to think about it. I guess, the common knowledge or common belief, I should say, is that lower fee strategies can outperform over the longer run. How do you respond to that? [inaudible 00:27:46] Is it a behavioral thing? Theoretically, that’s true, but people tend to buy high and sell low. Is it a business cycle thing that you have a portfolio does that over the course of business cycle? How do you sort of think about that?
Tom O’Donnell:
I think what I’ve heard in your question had to do with fees. And one of the things that I’d like to remind investors when it comes to fees is the old saying, “You get what you pay for.” The least expensive, when it came to fee negotiation, the least expensive investment that was at the Virginia Retirement System where our index funds. So our long-only stock oriented index funds cost us one basis point, so 0.01%. They were the least expensive. And mind you, this is going back decades. I think Charles Schwab today, if I’m not mistaken, they might even give some indexing away for free.
Tom O’Donnell:
So the beta component is cheap. You can get market returns for very low cost, but you should be prepared to pay a little more than that, or to pay more than that if what you’re actually trying to do is to mitigate the downside associated with those least expensive investments. Because again, in 2008, losing nearly 40% in your index funds, even though it has the lowest fee doesn’t sound as palatable all of a sudden, right? You get what you pay for. Was that the question I heard you asked?
Taylor Pearson:
Yeah. I think, when we have these conversations with investors, yeah, I think the essence of that… the common belief is like, “Well, yeah. It was down 40% in 2008, but look how much it has come back. And if you look over the long history…” If I’m a relatively young individual, I’m in my 30s or something, should I care that it’s going to go down 40% if it’s still going to do well over the long run? How do you speak to… What are your thoughts for that type of person?
Tom O’Donnell:
Yeah. Well, again, I mean, there’s two ways to do everything. One way is to do it in a more protected fashion, and one is to do it in a more risky fashion. So maybe the analogy is this. I know how to swim. Okay? But if I am in water, [inaudible 00:30:25] above my head and has the potential to be above my head, would I be better off wearing a life jacket? If I’m at all concerned about safety, my own safe, I think the answer is yes.
Tom O’Donnell:
So now think about your portfolio. If your portfolio is subjected to market risk, and this feast or famine type of environment, it’s just a question as to whether or not you want your portfolio to be as protected as you yourself would likely want to be if you were in turbulent water. So I think we would all agree that if we were out in the ocean, and in rough seas, wearing a life jacket would be a better idea than not wearing one at all. And I think for investors portfolios, I think they’d be hard pressed to refuse a life jacket for their portfolio, or to refuse diversification.
Tom O’Donnell:
I mean, at the end of the day, you can make a whole bunch of money in the stock market, but like I said, February of 2018, 11% of it disappeared in three days. And in the fourth quarter, 14% of it, right? And then this year, you’re now up 19 again, but this is the longest and strongest bull market in history. You need to be long in the stock market. I would suggest being long the stock market, and protected would be something that you should consider. But everybody has different risk aversion and palate. I mean, some people, I guess maybe they enjoy losing, I don’t know, because eventually the market does retrace. And if there’s an easier… If you can create a smoother equity curve, I think people should always consider that, better risk adjusted returns.
Taylor Pearson:
Yeah. I think that makes sense. We have those conversations a lot, so I’m curious. I think we often touch on one just the behavioral component. It’s really easy to feel like you’re going to have equanimity and all that stuff, and then sometimes when things start going badly, very quickly, you can can make poor decisions in the moment. And then I think it’s true also to returns across the business cycle when markets tend to go up, and markets tend to go down. And combining something that goes up with something that… Suddenly goes up when markets go up, and suddenly goes up when markets go down can be a sort of better form of diversification across that business cycle. I’m curious, given your investment experience, how do you personally think about combining short equity and long equity beta?
Tom O’Donnell:
Right. So specific to 3D’s program, or specific to just anything that’s negatively correlated?
Taylor Pearson:
I think we can maybe start more broadly, anything that’s negatively correlated. Then, yeah, I’d love to hear how it’s related to 3D’s program, how y’all think about that.
Tom O’Donnell:
Right. So things that tend to be not correlated, the way I look at it in an asset allocation perspective, is the first place I like to look is under the hood. I want to see within the product, does it have multiple asset classes, multiple return drivers, multiple markets that are long and short? If the characteristics look like that, that would tend, in my mind, to have me thinking about it as an alternative investment. And usually in the alternative investment category, investors allocate 5% 10% or 15% in order to move the needle as it were.
Tom O’Donnell:
With regard to 3D’s program, when you look under our hood, the only thing we are investing in is the S&P 500. And we’re doing it with a short bias. So it can be considered, and is often considered an alternative. It can also be considered a capital efficient overlay to the equity portfolio, because the only risk that we are managing is in fact equity market risk.
Tom O’Donnell:
But it’s very important that you get into the program with a reasonable expectation and a reasonable time period to hold it, because you don’t want to fall victim to that human factor where equity markets just constantly make money, and you think there’s no downside to it. Because if you get lulled into that thinking, the likelihood of experiencing a negative outcome is just in front of you, in my opinion.
Tom O’Donnell:
I mean, I can’t forecast an environment where the stock market will not continue to move in two directions. And the stock market today, I think does represent the biggest risk in most investors portfolios.
Tom O’Donnell:
One of the things I’ve witnessed over my career is that those other long-only diversifying baskets have actually, I think, become more highly correlated. And so when we hear the pundits or just your research reports refer to this concept of one correlation go to one, all those non correlated long-only baskets start to look and behave in a similar way. So you really need to be thinking beyond some of the original diversification, which includes things like international equities, emerging markets, et cetera, et cetera. Because when you look under the hood, those investments, they’re equities, but they’re just equities by another name. And given the global economy that we live in, I think that has a lot to do with why correlations go to one in many of long-only investments.
Taylor Pearson:
Yeah. I was going to ask you… Go ahead.
Tom O’Donnell:
Yeah. Go ahead. No, no, you go ahead. That’s fine.
Taylor Pearson:
Yeah. I was going to ask, why do you think that those correlations are coming together? What have you seen change over the course of your career that makes you think that all those long-only equity investment or is it just you’re looking at the actual correlations going up from, there’s something systematic, cyclic systemic that you’re looking at?
Tom O’Donnell:
It’s not anything in particular that I’ve studied or looked at. I mean, it is[inaudible 00:37:20]. And I think the phrase is that have come into… The talking point is this concept of risk-on. And risk-on is this environment where you buy and own assets hoping they appreciate, they go up and down. That describes a risk-on environment, whether it’s bonds or equities or gold or any anything that you think is going to provide diversification because it has a different name than the stock market. But risk-on is where you see all these assets going up in value. And then when you hear a risk-off environment, you see these assets going down in value.
Tom O’Donnell:
But the one thing all those assets have in common is they’re long-only. You’re buying them hoping, or it’s buy and hold, as I like to say, buy and hope that they go up in value. And we all know when any chart or Google any chart, they move in two directions. Taking advantage of that, I think is one of the keys to success. Availing yourself of investments that embrace the fact that markets move in two directions, I think is a key.
Jason:
Tom, I don’t want to put words in your mouth, but it seems like the overarching idea, what you’re saying too is, we don’t have to be that smart, right? If we have risk-on investments paired with risk-off investments, we don’t have to really predict the future, we can just compound at a better rate of return. It doesn’t need to be that sophisticated. It’s just pairing actually risk-on with risk-off instead of just having only risk-on baskets.
Tom O’Donnell:
Correct. And you’ve got to hope that the manager’s skill is maintained, or how you deploy the assets, that those managers continue to do what you’ve hired them to do. That’s certainly a great screening criteria. Are they remaining disciplined to their systems? But yes, ultimately, this whole risk-on, risk-off, I mean, one of the things that I found a bit frustrating, and maybe some of your listeners have heard these people on the radio and on TV. But there are those out there who seem to prescribe and describe gold as being like this godsend, which, okay, fine, maybe gold is a great thing to own. But the only thing you ever hear the person on the radio say is to buy gold, buy gold, buy gold, buy gold. I encourage all of your listeners to go look at a gold chart. It’s just like the S&P. It moves into directions. Why does the guy on the radio never tell you to sell gold?
Jason:
Is it time risk? You could never know exactly when you have the market time that sell.
Tom O’Donnell:
Correct. And that’s the same thing in the equity market. So we’re all advised to own the equity market, because over the long term, the stock market goes up. And I agree. I absolutely agree. It is the reason, and it is why I own long-only stock market investments. But the part that’s disturbing is that those same pundits telling us to own the stock market long-only, I actually posted something on LinkedIn recently where I touched on this.
Tom O’Donnell:
So the study I was reminding them of was, why they all end up hearing the reason you’ve got to own the stock market for the long term is because if you missed the 20 best days in the S&P from January of 2002 to September of 2019, nearly a 20 year period, your annualized return in the stock market, if you just missed the 20 best days, over a nearly 20 year period, your return would have gone from 8.33 annualized to -0.52. Now that in and of itself is compelling.
Tom O’Donnell:
But the part that’s inconsistent is that the person telling you that doesn’t tell you or fails to tell you what missing the 20 worst days would have done to your returns. And in my LinkedIn post, I reminded the reader that if you missed the 20 worst days, over the same 20-year time frame, nearly 20-year time frame, your annualized returns would have gone from 8.33 to 18.82, which is of course even more compelling.
Taylor Pearson:
Hey, this is Taylor jumping in real quick from the editors booth. I was speaking with Tom after he had this interview, we realized there was a slight miscalculation and the numbers he just quoted. So the correct numbers are, if you had been in the market every day, the annualized return of the S&P, from January 1st, 2000, through the end of September 2019 was 5.65%. If you had missed the 20 best days, it was -0.35%. And if you’d miss the 20 worst days, your turn was 12.54%. So the tales are still very fact, but the numbers just slightly off due to calculation.
Tom O’Donnell:
So this underscores that market, the stock market will rise higher, and it has the ability to sell off sharply. Managing that risk is critical in my opinion. And you can either do it yourself, or you can go hire others to do it for you. But I do think that that risk-off, risk-on type of a mindset environment, et cetera, I think that’s something to at least generate hopefully meaningful conversation between investors and advisors or different product providers.
Jason:
And as you just alluded to, you need to… If you’re doing risk-off, protecting your portfolio, like you said, you could go do it yourself, or you need to hire people that can do it. I’m curious to your thoughts, this is a recurring theme on this podcast. It’s nearly impossible to DIY this. And so like you were talking about it before, “You get what you pay for,” it’s interesting when you’re have any sort of risk-on or short-vol trade, anybody can put that on, setting buy button. But for all of these risk-off, these very dynamic protection strategies, it requires very active dynamic management and therefore you have to get what you pay for. You have to find the best of breed managers. I’m curious at to how you think about that, as well as, why does… When you look to protect yourself, all of sudden, it creates a much more difficult puzzle to solve than it is when you’re just long-only.
Tom O’Donnell:
Right. Well, this is a long-only crowd, like back to the feast and famine comment, right? So there are moments in time where the long-only crowd is the only crowd out there. There’s a place to be. And then there’s the [inaudible 00:44:33] company when the long-only crowd experiences a down market, or a significant down market. But then all of a sudden, the wisdom that they get, even though in hindsight, they would have preferred to avoid the downdraft, now the wisdom is, well, I’ve already lost all that money, so I just have to stay in, right?
Tom O’Donnell:
So it’s an interesting psychological game. I think maybe a better way to go about it would just be to try to identify what they believe their maximum risk of loss is or whatever they want their maximum risk of loss to be, and maybe manage to that, identify strategies. And again, I know past performance is not indicative of future performance, but identify strategies that provide a reasonable expectation of what should happen during different volatility regimes in the strategy. You know, with certainty, what is going to happen to your stock market investments, you can stress test that.
Tom O’Donnell:
If the stock market were to a 5% decline, what does my overall portfolio look like? Okay? If it experienced the 10% or 15, or 20, et cetera, all the way down to 50 or go even north of 50, whatever you want to do can be stress tested. You can then go investigate strategies, you identify strategies that have a different investment objective. Strategies, for instance, like 3D’s, which was built specifically to manage downside risk in the stock market. That’s what it does. It manages downside risk in the stock market. It’s a volatility based strategy. When vol spikes historically, it tends to do remarkably well.
Tom O’Donnell:
But it does well, because the way it was built, historically, the way it was built is to take advantage of the weakness in the stock market, because the investors already got investment that take care of the strengths. So again, past performance is not indicative of future performance, but you can look at the overall investment objective of a program and determine when it should do well versus when it should not do as well. And when these diversifying strategies aren’t doing well, there’s a greater likelihood intendance for your long-only equity market investments to be doing quite well. I think you need a blend of both.
Taylor Pearson:
But, Tom, one thing I’ve heard you speak about is the relationship between investment strategies that produce accurate results and capacity constraints. I’m curious, what do you see is the relationship between results and capacity constraints, and why does that exist?
Tom O’Donnell:
Right. Yeah. I’ve not come across a manager yet in my career that can manage infinite sums of money, because that’s the underscore, and be the best manager within his or her style category. Best, meaning, top four collar or top decile. Certain strategies do in fact, in my opinion, have capacity constraints. And that’s another thing that investors should be mindful of.
Tom O’Donnell:
When I joined 3D capital with this concept in mind, I asked Eric Dugan, and I said, “Well, do you want to be the biggest manager, or do you want to be the best manager? And he said, “I want to be known as the best S&P trader on the planet.” I said, “Okay. Well, if you want to be known as the best best S&P trader on the planet, what’s your capacity constraints if I have this bias that I don’t think you can manage infinite sums, and still be the best year in and year out?”
Tom O’Donnell:
So 3D Capital does have a capacity constraint. And when we get to that level, or as we get close to that level, we would expect to do a soft close and then ultimately a hard close and reestablish and determine whether we think there’s additional liquidity for us to properly execute our strategy, and achieve our targeted risk adjusted returns. But I think that’s true of all managers across all strategies. I think these markets are very, very, very liquid. But how quickly the manager execute their strategy needs to be factored in, because if they need liquidity and liquidity isn’t there, that’s going to potentially result in a bad outcome.
Taylor Pearson:
Tom, I think that’s all have for you. It was great to have you on, and chat with you.
Tom O’Donnell:
Okay. I know we’re probably still being recorded, but did you have any… did you want me to spend any time talking about the global relay race or anything like that?
Taylor Pearson:
Yeah. We can get… If you have a few more minutes. I just want to be kind to your time. I know we said we’d wrap up with the hour, but yeah, I’d love to just… if you want to [inaudible 00:49:54] the global relay race, we can do one more on that.
Tom O’Donnell:
Okay. So let’s see.
Taylor Pearson:
Let me ask the question the question.
Jason:
Do you want me to ask him a question? Yeah, question for him.
Taylor Pearson:
If the last encounter, not to dispute your opinion on is the global flow relay race. I know that’s a concept… You have talked a lot about, I’ve heard a lot about. What does that mean in terms of your trading philosophy?
Tom O’Donnell:
Right. So basically, the inside and the genius of what Eric has brought to bear in our 3D defender program, our short biased S&P program, 26 years ago, Eric worked for one of the legendary hedge fund managers by the name of Monroe Trout. He’s featured in the book New Market Wizards. And what Eric learned in that experience because Eric was overseeing trading in the Asian markets, and then later the Europe markets. He started to see these patterns, and these inter market relationships that were developing or that he could just like see and unfold over time.
Tom O’Donnell:
So we refer to our investment philosophy and what it taps into as the global relay race because the trade day actually begins in Asia. And for any of your listeners to be reminded of this, when they first wake up in the morning and put on one of the TV channels that is showing market activity, they’ll see, across the ticker at the bottom of the screen, the Asian market. And if they watch long enough, they’ll then see the European markets, and then when the U.S. markets open, the U.S. markets.
Tom O’Donnell:
Well, our investment philosophy takes full advantage of how global markets interact with each other. We refer to that as the global relay race and whether or not the baton is being handed from Asia to Europe, to the U.S., and then it just keeps going.
Tom O’Donnell:
So that, again, from my point of view, having allocated money into a broadly diversified global equity portfolio, I’ve never encountered an S&P only, a domestic manager that’s using the globe to identify the daily price activity in the S&P. But I think because there’s this systematics, the rules that Eric follows and the discipline with which he executes these rules, they follow three things. The rules are logical. They make sense. The rules are symmetric. They have the ability to make money on the long and the short side and they’re persistent. These rules that Eric follows work in all volatility regimes.
Tom O’Donnell:
The Defender program has been biased to the short side to provide what we think is the greatest vulnerability to the long-only stock Market investor, and that is that they’re guaranteed to lose when the stock market goes down. So, we have a unique approach to managing that risk. And I’m thankful to have it in my portfolio, and I’m also thankful that I get to share it’s success with others.
Jason:
Tom, one quick last ancillary question. What do you think it is… What’s in the water in Virginia that seems to breed such great traders and then having great managers domiciled their funds there? There might be confirmation bias on my side from small sample size, but there’s something about Virginia it seems like.
Tom O’Donnell:
Well, yeah. And by extensions, and 3D is actually headquartered… 3D Capital Management is headquartered up in Basking Ridge, New Jersey, but with respect to Virginia, yeah, they’re just have been… There have been some really successful money managers in Virginia along with some of us too, back in the day, were pioneers at identifying them and allocating to them. I don’t know if there’s anything in the water, but it is certainly something to pay attention to because there are some… as you said, there are some very talented managers in Virginia. And, again, as I just mentioned, I’m really fortunate to be working with one of our really, really talented managers up in New Jersey.
Taylor Pearson:
Well, Tom, thank you so much. This is fun.
Tom O’Donnell:
Excellent. Thank you gentlemen.
Taylor Pearson:
Thanks for listening. If you’d like more information about Mutiny Fund, you can go to mutinyfund.com, or better yet drop us a message, taylor@mutinyfund.com, and Jason is, jason@mutinyfund.com, and we’ll get back to you. You can find us on Twitter @MutinyFund, and I am, @TaylorPearsonME.
