Q: Would you give an overview of the fund?

As the name implies, this is a multi-asset fund. It is not just stocks or bonds or commodities but many different asset classes. It is designed to be a true macro fund, relatively conservative, risk averse, and one that avoids significant volatility, yet provides steady returns above what investors would get in normal fixed income. We accomplish that by using individual stocks, individual Treasuries, and exchange-traded funds (ETFs). 

Its benchmark is 60% fixed income, using the Barclays Capital U.S. Aggregate Bond Index, and 40% equities, using the MSCI All Country World Index (ACWI).

Although the fund has existed for about five years, I’ve been using the strategy behind it for 25 years. 

Most all-asset funds have some kind of asset allocation, but still try to pick individual securities. We don’t do that. History shows that, in an all-asset fund, individual stock and security selection has the smallest impact on performance. Getting asset allocation is primary; size, style, and geography, for example, are secondary performance drivers. 

Q: What is your investment philosophy?

We look for correlation among asset classes. Correlation, like statistics in general, can be manipulated into saying whatever you want, by changing time horizon or periodicity—using daily, weekly, monthly, and quarterly data. We smooth out correlation. We look at secular correlations—correlation trends, rather than actual numbers at any point in time—because trends in correlations don’t change much over time. 

We have certain themes we want in the portfolio, equity or fixed income-type themes, and the asset allocation is based on how those themes correlate to other asset classes. 

Contrary to public perception, diversification is not achieved by owning numerous asset classes. You can have many asset classes in a portfolio, but if the correlations are high, where is the diversification? Many portfolios today have five or 10 different, but highly-correlated asset classes, misleading investors into thinking they have a well-diversified portfolio. If people were properly diversified, financial crises like 2008 would not scare them. 

Internally, we don’t classify assets by name or category, only by correlation. Take high-yield corporate bonds, which are generally categorized as fixed income. Not by us. We categorize them internally as equity, because high-yield corporate bonds historically correlate more closely to equities than Treasuries. They may pay a high coupon, encouraging people to treat them as fixed income, but the total return correlates more to the equity market. 

Accordingly, if we consider investing in high-yield corporates, we want to know how we can get a bigger bang for our buck, while providing greater diversification. In other words, high-yield corporates are low-beta equities. Should we instead have a higher equity weight and have more Treasuries, which have a negative correlation to equities and better offsets the risk? That’s how we think, which is markedly different from the mainstream. 

Also, the main portion of attractive high-yield corporates comprised energy- and commodity-related junk bonds. Should we be thinking about energy- and material-related stocks to get more for our money? We can invest less in those sectors and get higher total return because of the sensitivity to the effect we seek. Right now, we have no weight in high-yield corporates, but we are overweight energy and material stocks, and have a fair amount of mid cap and some small cap energy and material stocks to achieve higher beta with less weight. 

Another thing we do differently is x-ray our ETFs. While externally, our clients see us as holding a specific ETF, we load its holdings individually into our risk models, making it appear internally as if we hold hundreds of securities, because we want to identify correlations and our weights in different sectors or asset classes. That can be misleading if you simply say, “I own ETF ‘X’.” 

Q: What is your investment strategy and process?

Although wholly macro-based, it differs for equities vs. fixed income. We look at three factors: corporate profits, liquidity, and sentiment. 

Corporate profits move equity markets, not GDP. People are still baffled why emerging markets underperformed so dramatically in the last 4–6 years when their GDP growth exceeded that of the U.S. The reason is because corporate profits growth was miserable in the emerging markets. Companies in emerging markets consistently disappointed, relative to profit forecasts. They led the world in negative earnings surprises for the nearly every quarter during the past five years. Corporate profits affect equity markets, not GDP. 

Similarly, in the U.S., people wonder why we’re in a bull market when the economy has been so slow, assuming the Fed is responsible. Certainly the Fed’s liquidity helped, but the bull market is also attributable to corporate profits becoming the largest percent of GDP ever in U.S. history. 

Liquidity has many different measures, including yield curves. We look at yield curves in 40-plus countries, which tell us where liquidity needs to be added to the financial markets, where it’s available, and where it’s drying up or being reduced or removed from a particular market. We want a situation with more liquidity vs. less, from both the point of view of economic growth and corporate profits and the degree of liquidity available to invest. 

In terms of sentiment, we do not look at short-term trading measures of sentiment, which, when tested, have demonstrated zero predictive capability because they change too rapidly. Short-term sentiment is like flipping a coin. Instead, we look at long-term views of sentiment, including valuation. We actually consider valuation a sentiment measure. There will never exist an overvalued asset that everybody hates. Neither can there be undervalued assets among those enjoying popularity. 

Using these three factors, (profits, liquidity, and sentiment) we determine how and where we want to structure our portfolio. We do a lot of quantitative work, but figuring out where to get the biggest bang for your buck is not quantitative—it’s an art. Is it in a call of growth and value? A geographic call, more of an asset allocation call, or a currency call? While it’s an art form, a lot of the underlying data we use is quantitative. 

Q: How do you apply your process—regionally, or by industry or sector?

Using those three linchpins of profitability, liquidity, and sentiment, we look at it all—40-plus countries, at regions, industries, and sectors all around the world. We look for places where all three factors are good. If we can definitively say better, the odds are we will invest there. The big question for us is whether things will be better or worse 12 months from today. 

Now, it does not mean fundamentals have to be “good” per se. Markets do not care about good or bad; markets react to better or worse. So if things are improving and will be better a year from now, that’s attractive to us. If we find situations where we think fundamentals are worsening, even though absolute growth rates might be quite high, we don’t want to invest. Too many people look for good, even when the good is slowing down. Rarely do assets outperform in that environment. 

Sentiment in the U.S. is one of our driving factors right now. People are incredibly bearish on U.S. equities. I have never seen anything like it. Equities are starting to outperform fixed income and yet the flows out of equity, ETFs, and mutual funds are startlingly high, bigger now than in 2008/2009! 

U.S. corporate profits are getting better. The profit cycle troughed in the fourth quarter of 2015 and although profits are not good, they are recovering, making it a good time to invest. If you wait for it to be good, you’ve missed your opportunity.

Q: How does your strategy work for fixed income?

We look at spreads as valuation and do similar analysis looking for sentiment, etc. What I find interesting is the recent attitude toward interest rates. Three or four years ago, everybody was convinced rates would rise. Now that rates are down, people are saying lower for longer. 

We think inflation expectations troughed last February, which means these massive flows into bond funds are likely a mistake. 

Currency is also important in fixed income. Generally, we prefer to invest in foreign equities vs. foreign fixed income because, as total-return investors, we want the biggest bang for our buck—we do not necessarily care about coupon. 

Q: What is your research process and how do you look for opportunities?

We start with regions: our big four, the United States, Europe, Japan, and emerging markets. If we see something particularly positive or negative, we drill down. Generally, if we get the regional view correct, that’s 90% of the game. 

If we see the European profit cycle heating up, we drill down to try to figure out why, looking for consistencies with an embedded theme. 

For example, with Brexit, the pound fell about 10% to 15% and has not rebounded. That’s good for multinationals in the U.K. We looked at that and profitability, saw a theme emerging, and took positions in U.K. multinationals. 

Vice versa, we saw our indicators in Japan uniformly looking terrible a while back, couldn’t find anything promising, and punted our entire Japan exposure. 

Q: How do you identify new indicators? 

Any indicator we use has been tested through multiple cycles. We do rigorous testing to ensure we avoid standard or forward-looking biases, or incorporate data unavailable at the time. We then examine the economic rationale for that indicator. 

If we find an indicator but cannot determine any economic justification, we won’t use it. The economic justification is what reveals the indicator’s implications concerning profits, valuations, sentiment, liquidity, and such. 

This rigor means we do not come up with many new indicators, a couple of years at most. Probably 1% of all possible indicators make it into our process. 

Q: What is your portfolio construction process?

Right now we are quite bullish, despite this being a relatively conservative fund—probably 60/40 relative to the fund’s 40/60 benchmark. 

We construct the portfolio to hold assets for roughly 12 months, with a 40% to 50% historical turnover. We don’t do a lot of trading. Our process is more plodding than nimble, which we prefer. As you extend time horizon, your probability of losing money goes down and you invest more for fundamentals, paying less attention to noise. Although “nimble” sounds good, nimble strategies often increase turnover and tax liabilities without benefiting returns.

Our equity portfolio generally has 300-plus securities in it. Every week we check for stock risk, and over 90% of the equity risk we take is macro-factor risk. Less than 10% is stock-selection risk. If we were stock pickers, we’d take stock-specific risks for over 90%, with little macro risk. That’s not what we do. 

Fixed income stems primarily from where it negatively correlates to equities, mainly Treasuries over the past decade, as they are ballasts to equity market volatility, but they can also present opportunities. Several years ago we saw markedly wide spreads on high-yield (junk) municipals. Everybody was convinced U.S. municipalities were all going bankrupt. At one point we had 20% of 25% of the fund in high-yield municipal bonds through ETFs, but that is now around 13% to 15%, as what the flows in bond funds has done to fixed income valuation and spreads has made it less attractive. 

Q: How do you define and manage risk?

We do not define risk as volatility. Volatility is an academic definition of risk. The practical definition of risk is return falling below some acceptable level. We view risk as having an asymmetric behavioral response, as losses invoke greater reaction in investors than comparable gains. 

One way we define risk numerically is the probability of a severe loss or drawdown—and not volatility—within a 5-year period, and not even the probability of a negative return, although we do a lot of work on that as well. In some cases it might be the probability of a severe drawdown, say, -10% or -15%. 

Diversification is an insurance policy against one’s view of the world being wrong. If I am bullish, I diversify in case the market goes down. If I am bearish, I should be diversified in case the market goes up. Although people were bearish on Treasuries long before the lower-for-longer attitude, we found it the only asset class negatively correlated to equities and the cheapest hedge for this portfolio. The problem with insurance policies is that you have to pay for that protection. 

Diversification means holding assets you hate, assets that directly contradict your view of the market’s outcome. And the price you pay for true diversification is lower returns. 

Yes, we could juice up the portfolio, and maybe five years from now, after the roller coaster ride, we might have great returns, or 10 years, or 20 years, but the point of an all-asset fund is to manage the interim volatility because it is so difficult for investors to do themselves.