Eric Crittenden of Longboard Asset Management talks about the two unique strategies that they are employing: their long/short equity strategy and their managed futures program including the kind of market conditions in which they work best.
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Longboard's Long/Short and Managed Futures Strategies
Hello and welcome to Strategic Investor Radio on OCTalkRadio.net where we bring you investment strategies you are not hearing elsewhere. Very pleased today to be talking with Eric Crittenden with Longboard Asset Management. Eric is on the phone with us from Phoenix, Arizona, their headquarters. Eric, welcome to Strategic Investor Radio.
Thank you, Charley. It's good to be here.
Eric, you're the chief investment officer there at Longboard. You guys have two mutual funds. Give us a brief history of Longboard, will you?
Sure. Longboard was started back in 2011. Our CEO, Cole Wilcox and myself, we left the hedge fund industry because we saw that there was a big unmet need in the marketplace for uncorrelated alternative returns in the retail financial advisor industry. We started Longboard Asset Management and rolled out some mutual funds that were wrapped around strategies that we've been running in the hedge fund universe for a long time. Again, our goal is to compound, have a reasonable rate of return in a way that's not related to stocks and bonds.
Explain that a little bit, in a way that's not related to stocks and bonds.
Two strategies are run. One is our long/short equity strategy. It's primarily a ruled based trend following approach applied to all the stocks in the Russell 3000. It's long and short, meaning that we're essentially vetting on the performance of the strong stocks relative to weak stocks. This performance itself is spread between those two groups, it's generally uncorrelated with the beta of the stock market itself. In that sense, this program can deliver returns that don't necessarily track those of the stock market or a 60-40 portfolio.
Let me stop you for a minute. It's a long/short strategy but it's built on trend following. Most long/short strategies that I have followed have been fundamentally based. Yours are not fundamentally based?
That is correct.
You're following a trend, and typically the key to trend following is what time period you select. Do you like three weeks, three months, a year and a half? What kind of time focus do you use in your trend following analysis?
We focus exclusively on ultra long term trends. Regardless of which program we're talking about, our average hold time on a winning position is in excess of sixteen months. We're talking about very long duration trends.
Do you do stocks only or do you also do sectors and indexes?
In the long/short equity program, we only do stocks. Every stock is in the Russell 3000. We trend follow on those stocks and then we go short by shorting index futures.
Let's go over that again here. I'm a bit confused. You go long stocks but you go short indexes?
That's correct. Shorting indexes is very efficient, cost effective and scalable. Shorting individual stocks has a whole host of problems and issues associated with it. Essentially, what we want to do is be long a subset of the Russell 3000, whatever the strongest stocks. Then we want to hedge out most of the market correlation beta by taking short positions in liquid, easy to trade index futures.
You do that through sectors primarily?
No, we trade the three big index futures. You've got the S&P 500 large cap, S&P 400 mid cap and the Russell 2000 small cap.
I see. You have about how many stock positions that you invest in, stock positions do you invest in long?
Right now, it's about 700. It usually oscillates between 600 and 900, depending upon how the good the breadth is in the market and the market conditions themselves. If we're in a bull market, we generally will have in excess of 800 long positions. If we're in a bear market, that could be down around 400 and 300.
I'm sitting here in shock. How do you keep track of hundreds of positions like that?
That's the power of computers. We use computers as tools to help us manage a portfolio of that scope and to manage risk. For a computer, 600 stocks, no more complicated than six stocks.
Is this rules based where they're automatically sold when certain things occur?
Yes, everything we do is completely rules based. Discipline is everything in this business. There's no subjectivity to the day to day operations. The subjectivity and the qualitative component went into the construction of the original rules years ago. On a day to day basis, we just maintain discipline, put one foot in front of the other and follow the rules.
How do you determine what degree you should be net long or net short?
We let the market condition, the breadth in the market and how many stocks are hitting new high and the volatility of those stocks dictates to us what our exposure should be. If we have a lot of stocks hitting new highs and the volatility is low, then our exposure will be big. However, if the volatility picks up, our exposure will come down. Or if the breadth starts to deteriorate, then likewise, our exposure will come down.
I've got to congratulate you here, Eric. This is a very unique long/short strategy. This is not at all the typical, "Hey, we go long fourteen positions and short six positions here." Do you make these determinations of what degree you're going to be net long or net short daily or weekly or quarterly or what?
Every day, the portfolio is reevaluated. We pull in all of the data from the different exchanges, collect all the dividend information, divestitures, mergers, spin-offs, corporate actions. Clean all that data up and then run that through our models and then it gives us an optimal portfolio. We compare that to the actual portfolio. The differences between the two creates a trade blotter that we send to the broker in the following day, in the morning. It's reconciled and re-balanced on a daily frequency.
I see. You're probably making changes most every day if you've got that many stocks?
Pretty much every day there's some trades. I don't want to give you the wrong impression though, the program itself will hold a winning position for about a year and a half. It'll hold a losing position for about six months. But at the margins because there's so many stocks, you're really buying three, four, five, eight stocks each day and selling two, three, four stocks each day.
How does that play into the expenses of the fund?
The expenses are pretty reasonable. I've been running this program for over eleven years now. I'm always surprised at the end of the year when I do an audit of all of the transaction costs, even though it seems like it's pretty active, we're just moving a little bit of inventory off of each side, closing some stocks out that are broken down, adding some new stocks in that have broken out. By and large, the 99% of the portfolio is static each day. There's not that much trading going on on a dollar weighted basis.
Your evaluation of the trend that you're using here, is it fairly simple? Does it have 47 factors or does it have two or three?
The evaluation of the trend is as simple as it can get. We collect the data on all these stocks and then we factor in the dividends and we get the total return stream for each stock. If that total return stream is hitting a three year high, then we will buy the stock the next business day. It's that simple.
I see. Again, this is very, very unique here. Then you short simply on a market basis, basically.
The goal of the short is just strip away three quarters of our beta in correlation to the overall stock market. What ends up happening is, we own all these stocks that are in the Russell 3000. Right now, we own about 800 of them. We go short these three index futures, which collectively are essentially the Russell 3000. We're actually shorting the same stocks that we're long, but we buy enough of the stocks we want to own to more than offset their exposure inside the indexes. What ends up happening is we end up being net long all the stocks that are trending higher and then synthetically net short all the stocks that aren't trending higher, giving us a nice, balanced, diversified, efficiently priced long/short portfolio.
What can I say? This is very, very different and it really sounds intriguing here. Because again, I've looked at and talked to many, many long/short strategists but they have a very different strategy. If it does what you say it does, then you are in the positions that are trending higher and you're out of the positions that are trending lower.
That's a good way of saying it. I should write that down.
This is very, very interesting. Before we finish, we're going to want to get involved in your managed futures strategy as well. Eric, you guys basically have a strategy where you go long those stocks, US stocks of the Russell 3000 that are in an uptrend or have a certain amount of momentum. Then you short that same market through indexes so that in essence what you're doing is you are seeking to be long those with momentum and to be short those without momentum.
That is correct.
Why do you not just take the same criteria to determine those that are in momentum to identify those that are not in momentum and short those? Is it because it's just such a hassle to short that many stocks?
We modeled all that out years ago and have continued to look at the costs associated with shorting individual stocks. They can be exorbitant. There was a time it cost 90% annualized to borrow Tesla shares. That caused to borrow changes on a daily basis. Then this terrible thing happens. When you're short a stock and it really starts to go down and you think, "Wow, I'm glad I'm short that stock." The broker pulls it away from you because the owner of those shares wants to sell it himself. It's hard to hold the borrow when the short's really paying off and then the cost of borrow is a high number potentially and is variable through time. When you use index futures, none of that's an issue. The costs are rock bottom and your ability to hold the position is unquestionable.
Can you be net short?
In this program, no. We don't go net short in this program. It can go to zero exposure. When Lehman filed bankruptcy in 2008, prior to that we had about 4% net long exposure. We were pretty close to having zero exposure. But no, we did not go net short.
You could be almost market neutral but not quite?
Are you considering being able to go net short, given where the market is and PE ratios and other things?
No, once we design something, it takes us a long time to come to a consensus internally. Once we design something, it's very important to us that we not succumb to any kind of peer pressure, social pressure to change it. We're going to leave it as is. We may design something in the future. I'll tell you this Charley, from my experience, I've known a lot of people who tried to make money shorting the market. None of them have been able to compound at a positive rate for an extended period of time. There's just something about short selling that it may add value to a portfolio but we're in the business of compounding long term. There's so many other ways to make money and that we're just not interested in dedicated short strategy.
Are you guys looking at moving to other markets with this strategy? You're only doing, as you have mentioned, the US domestic Russell 3000. Are you looking at doing any commodities or any international or into bonds or anything like that?
Actually, the long/short program is a minority portion of our business. Our flagship program is our managed futures program. That's where 80 plus percent of our assets are. We are in the commodity space, currency forward, metals, grains, livestock, things like that.
Tell us about the managed futures strategy. Does it use the same core evaluation system and methodology?
It uses the exact same risk management computer code and philosophy. The entries and the exits are a little bit different for futures than they are for equities. In the managed futures program, that's both long and short. Futures are different than equities. Equities are a capital formation market and the risk premium is typically a one way street. In the futures markets, they're more symmetrical, the risk transfer market. You have to be willing to go both long and short if you want to be on the right side of risk premiums long term.
Do you go short markets? Do you go short individual positions? How do you do your short side?
In the managed futures program, we're trading the 140 most liquid futures market around the globe. We'll go long or short. We're completely agnostic to market direction. If the market's trending higher, then we will go long. If the market's trending lower, we'll go short. We use the same entry criteria on either side.
You use different evaluation criteria to determine where the momentum is going than you do on the long/short?
Yes, we don't wait for three year highs. In the futures program, we're looking at five quarters worth of data. We're essentially trying to align our interests to those of commercial hedgers because in the futures markets, that's where the risk premiums come from. You need to be providing liquidity to commercial hedgers if you want to compound at a positive rate in the futures market long term. Five quarters is the general time frame that commercial hedgers will look at in order to estimate intrinsic value of a market, try to get a baseline, a price to lean against. We look at the same thing. Then if the market is trending higher and it goes up to the 99th percentile over the last five quarters, that to us is an uptrend and we will initiate a long position. Likewise, if the market's weak and it's trending lower, it goes all the way to the first percentile over the last five quarters, then we'll initiate a short position there.
You mentioned, you're in how many markets throughout the world?
We track 140 global futures markets.
Are you in every one of those every single day, short or long or just some of them?
Just some of them. We're either long, short or flat. If you pick one particular market, let's say Japanese kerosene. You go back to the beginning when that market first started trading, I believe it was 1980, and you apply our methodology to it. What you'll see is that we're long about a third of the time, we're short about a third of the time and we're flat about a third of the time.
Very, very interesting here. This is all in a mutual fund, correct?
Yes, it's in a standard plain vanilla mutual fund with 1099 tax treatment. It's just like any other mutual funds from the investor's perspective.
Both this and the long/short fund are in a mutual fund?
What are advisors concerned about in getting into this managed futures fund?
A few things. One, there's an education component. Most people are comfortable with stocks and bonds and real estate. Alternatives like this, there's a high bar for educating people as to why it works, what to expect, how to explain it to clients. There are going to be times when it loses money, how to explain that to clients. We have our work cut out for us. We take that part very seriously and we try to make it consumable because the education is new. We've got 140 markets in 25 different currencies. There's different continents, different time zones. Some of them are priced in different languages. The learning curve can be steep but we make that as easy as possible for people.
You basically have created this strategy with the evaluation factors and you have applied all of this into your algorithmic systems in a quantified way and it basically runs itself on a rules based system.
That's a fair characterization. I will say this though, that it's completely rules based. It's very disciplined, but under no circumstances do the computers send orders to the brokers. There's always a personnel in between our systems and the brokers. I might myself have gone through ever trade that we've ever done for the last eleven years. I'm a big believer in a human being taking a look at what's going on. Because every now and then, the exchanges can get the prices wrong or they can move the decimal place or whatnot. There's room in this process for the judgment of an experienced human being to review everything before it actually gets sent off.
Are you guys using leverage? Are they hedged positions in any way in the managed futures plan?
Leverage means different things to different people. Futures contracts are leveraged by design. They're designed to be efficient tools to use for risk management. That means that we leave your capital alone, we'll give you the exposures you need but on your end, you need to manage the risk. Depending upon who you're talking to, leverage can mean economic leverage, legal leverage, obligations and whatnot. In the managed futures world, a lot of the terms have different definition than in a traditional investment world. I can tell you this though, our managed futures program has one of the lowest margin to equity or leverage utilization rates of any managed futures program out there. That's because our hold period is so long. We don't need to put large positions on because we're not trading very frequently. We're holding directional trends hopefully, for one, two or three years. Does that make sense?
Yeah. I accept that the commodities marketplace, most managed futures programs trade much more frequently than that.
Most of them do. That's correct.
The longer trend, you're comfortable with that?
I am. In fact, I know a lot of the operational research people in this industry. I've corresponded with them for years. One of the things that no one ever really brings up but it's still true is that 80% of the returns for the managed futures industry comes from 20% of the trades. The Pareto Principle. The bulk of the profits, they come from the long term trend following model. The rest of the models, the short term, the neural networks and all these things, they're really just an excitement factor to get people excited about paying fees and whatnot. Things haven't changed. The big lumpy risk premiums are captured with a durable robust long term trend following models. We just avoid all of the exciting stuff on the left end of the curve. It doesn't add that much value.
Are you guys commodity trading advisors also for other clients besides this mutual fund?
Yes, we are registered with NFA as a CPO, commodity pool operator.
I see. This again is fascinating stuff, Eric. I've got to congratulate you guys. You've created something here and put it in a mutual fund wrapper that is just very, very interesting. Like you said at the very beginning, these have very low, if any, correlation with US equity and bond markets, correct?
That is correct.
Eric, a question we like to ask all of our guests here is, what keeps you awake at night?
The one thing that costs me a little bit of sleep is the potential unintended consequences of all of the government intervention that we've seen over the past eight to ten years. We are in uncharted waters in a lot of ways. I think I just have a feeling that the unintended consequences are going to make themselves known on my watch during my career, maybe starting very soon. That is something that has me thinking long and hard about counterparty risk, liquidity, things like that.
No question about it. You are not the only one that has concerns in those areas. Question number two we like to ask all of our guests is, what book on investing would you recommend for our listeners?
There's two books in particular that I recommend to people. One is called Poor Charlie's Almanack by Charlie Munger from Berkshire Hathaway. It seems a little odd that people view us as quantitative investors. Really at the end of the day, we're all value investors in one form or another. The way Charlie Munger thinks about things where he likes to invert concepts and work from right to left in addition to left to right has really helped me a lot over the last 25 years see things that I otherwise never would've seen. That's one book. Another one is The Alchemy of Finance by George Soros and his theory reflexivity. That made a big impression on me when I was in college, back in the mid 90s and really allowed me to think about things like unintended consequences and how hard, brittle things that have been in effect for a long period of time can crumble overnight. It's the adaptable that survive, not the strong. Those two books, I don't think someone could go wrong by reading both of them.
Hey Eric, thank you very much. We've had a couple of hundred interviews, asked that question every time and nobody has recommended those books. Thank you very much for that. Eric, give us, for our listeners who want to find out more, give them a website and contact information, will you?
Sure. You can go to LongboardFunds.com. We have two websites, another one is Longboard-AM.com, that's our corporate website. You can find out all about us and our strategies and our philosophy at either one of those sites.
Final words for our listeners here, Eric?
This is the kind of stuff that you want to be talking about. Your radio show is very interesting. You're talking to people that think outside box, thinking about alternatives, thinking about constructing portfolios that aren't just the necessarily convenient ones that are offered essentially for free. We are in uncharted waters. Now is the time to I think be conservative and be prudent. But don't give up hope because even though we've had a lot of challenges over the last ten years, if you look back historically, times like that are usually followed by times of opportunity.
We all certainly hope you're right here, Eric. Eric, thank you very much for joining us today from Phoenix.
My absolute pleasure.
Again, we've been talking with Eric Crittenden, chief investment officer of Longboard Asset Management out of Phoenix, Arizona. You've been listening to Strategic Investor Radio on OCTalkRadio.net. We'd love to hear from you, info@StrategicInvestorRadio.com. Go to our website to listen to podcasts of all of our interviews and shows, StrategicInvestorRadio.com. I'm Charley Wright, wishing you an enjoyable week and productive investing.