David: Welcome, everyone, this is David McAlvany, the CEO of the McAlvany Wealth Management, and today we have a variety of people joining us on the call, a combination of institutional investors and clients, as well as individual investors. When we get to the Q&A there will be a wide range of questions, some of which are highly technical in nature and relate to tax reporting for a particular institution and insurance company. Others will be more appropriate for an individual investor.
We hope to cover as much ground as we can today, and if you find that there is a nuance that you would us to add to, or if your question wasn’t fully answered, feel free to reach out to us directly. I will be happy to get on the phone with you, or any member of the team. Always contact us at the following email address: firstname.lastname@example.org, and just mention the Tactical Short and, specifically, how we can help you, that is, you are interesting in moving forward and opening an account, or have further clarification that needs to occur.
Just to have the flow for the day, we will be taking a few minutes to explore what our investment process is and what the key elements are of the tactical short, and Doug Noland will be covering that for us. Then we will also look at the Q&A for the remainder of the time. We are going to target about an hour for our call today, and if we can finish early we will. If it goes a few minutes beyond that, and you have scheduling constraints and need to come back on to listen another time, we are recording this for your convenience, to come back and listen again. It will be posted online at our website so that you can review anything that you might have missed if there are any scheduling conflicts as we get toward the tail end of our discussion today.
Doug Noland joins the Wealth Management Team starting in 2016, and we are very excited to have him as a part of what we are doing. We feel like the team continues to grow in terms of adding to the talent base and the mental capacity, if you will, the decision-making capacity here at McAlvany Wealth Management. Dough Noland’s educational background is an accountant, as a CPA. He finished business school with an MBA and spent time as a treasury analyst, as a hedge fund trader, as a mutual fund portfolio manager for about 16 years, and of course, has been a writer and analyst on all things credit-related since the mid 1990s forward. If you are not a routine reader of the Credit Bubble Bulletin, I would encourage you to do so. He has been writing that since 1999. You can find that on our website, and hopefully, that becomes part of your weekly routine as you look at the changes that are happening in the financial world.
That is a lot of what we are going to be talking about today, in addition to the processes that we go through in finding an opportunistic short in the marketplace. There are things that represent a backdrop for us that are very important. GDP, at both the global and domestic level, has been decelerating. We have corporate profits, earnings growth, revenue growth, which are concerning to us, to say the least. Industrial production numbers of the last 6-12 months have been soft. World trade is not exactly supportive of continuation of a growth thematic and continued moves higher in the U.S. stock market, certainly, but selective global markets, as well.
We look at the world from many perspectives, including a political and geopolitical perspective, and we see, not only divided and divisive electorates here in the United States, but you see that mirrored in Europe, with many things that are going to be determined in terms of even the viability of the European Union in the next 6-12 months.
And I think one of the things that we are all very interested in is the results and unintended consequences of the massive monetary experiment that we came to know as negative interest rate policies, zero interest policies. What will the implications for that be as we move past the monetary policy experimentation phase, and into, perhaps, a new phase? Will we see rising rates? What are the implications for indebted individuals or countries?
The backdrop issues are very important, and I am going to leave most of those to Doug today, but suffice it to say, at least, here, domestically, in the United States, with cumulative 375% debt-to-GDP when you are looking at U.S. public and private debt, borrowing costs do matter, and if we begin to see very much of a move up in interest rates, it has massive implications for pockets within the financial market.
What we have put together is, I think, the appropriate tool to be able to approach the markets winsomely, intelligently, carefully, and in a very risk-aware way, so that when we see those pockets of weakness the MWM Tactical Short managed by Doug Noland will be able to help you, not only hedge, on the one hand, but profit, as well, on the downside.
So, how it works – yes, we do have investors that I think will come to us, specifically, because they are looking for an opportunistic short, profiting on the downside, but I think with some institutional design and with an audience that is institutional first and retail investor second in its orientation, this is designed to lower volatility across all your financial market assets. If we can reduce downside vulnerability, if we can simultaneously create liquidity, when we have these market disruptions, and that may be a small disruption and a small pocket within the market, that puts you in a position to have a more impressive P&L at the end of the quarter, at the end of the year, reduced volatility, and as I say, add to liquidity at the same time.
I have introduced Doug. I hand it over to him, and Doug, tell us a little bit about your approach to the tactical short and how you have thought of this in structure and design from your 25+ years’ experience being short in the market. And then, having distilled that into this particular product, the best offering you have ever put together.
Doug: Thanks a lot, David. Good afternoon, everyone. We believe we are putting together something special here, and I very much appreciate your interest in jumping on the call this afternoon. So, let’s get right to this. Exactly what do we do? Here is the short answer – we short securities. That is stocks, ETFs. We will also buy liquid, listed put options. In shorting, we position to make money when stock prices decline. This strategy is designed for separately managed accounts, SMAs. We are not opening a fund. Tactical Short is not a mutual fund. It is not a hedge fund.
As a manager of short exposure for 25 years in the hedge fund industry during the 1990s, and also, as David mentioned I was at the Prudent Bear Fund for 16 years, we received a lot of questions regarding hedge funds. We specifically chose not to structure a tactical short as a hedge fund. And frankly, we don’t share the typical hedge fund mentality. 2 and 20 is the industry fee standard. They charge 2% management fee, take 20% of investor returns. Naturally, this arrangement has hedge fund managers focusing on reward first before risk. When I wake up in the morning I think about risk and risk management. We won’t be out swinging for home runs, but rather, we will be focused on singles and doubles, and a consistently solid batting average over time.
My experience convinces me that long-term success on the short side is predicated on a disciplined and determined daily focus on risk management. There are no shortcuts. What we do is tough. And I love it. We believe our offering is a better mousetrap, with important client advantages over existing short products in the marketplace. More about this in a moment.
What is the objective with Tactical Short? To provide a professionally managed product that reduces the overall risk in a client’s investment portfolio while providing downside protection in what we view as an especially uncertain and high-risk global backdrop. We see Tactical Short as an integral component, a 5-20% allocation in a well-diversified investment portfolio.
As David mentioned, we are not recommending big, bearish bets against the market, but we do believe strongly that it is time to re-focus attention to risk and management. And while we anticipate there will be environments where we move aggressively to seek outsized returns, this strategy will generally endeavor to have less volatility, a lower portfolio beta, in the U.S. equities market.
Let’s take a deeper dive into shorting, more generally. This is important. Shorting entails risks unlike those on long investments, and it is certainly not for everyone. In theory, risk is unlimited. On the long side, stocks can fall to zero. Losses on the short side don’t have this constraint, so effective management of short market risk demands experienced, active management.
A quick explanation for how shorting works. To begin with, there is a big difference compared to long investing that can be confusing. Buying on the long side uses cash versus shorting stocks that doesn’t use cash. Let me provide an example. Let’s say an investor wires cash to fund a new tactical short account at our broker custodian. We ensure that funds are promptly invested in treasuries or government money market funds. This holding, then, provides collateral for shorting. Next, to establish short exposure, we will borrow securities from the broker’s stock loan department. We then sell these borrowed securities into the marketplace in a normal transaction. The proceeds from this short sale then flow into a restricted account at the broker where our investors receive a cash return, typically the Fed funds rate less 25 basis points.
Let’s briefly differentiate what we do from competing products. Let’s start with cash. Others go for yield. They will sacrifice safety and liquidity. We will not. In fact, many so-called bear funds invest cash in third-party derivatives. And for short exposure, some bear funds don’t even short securities. They instead get market exposure through third-party derivatives. There are important reasons why we do thing differently. We care greatly about, and manage around, systemic risk. What happens if the markets tanks, or even crash, like 2008 or 1987?
Other short products risk liquidity and counter-party issues, as unfolded back in 2008. For our client accounts, when market declines create gains on our short positions, cash is simply transferred from that restricted account to our client’s brokerage account. If securities were already sold, it is just a matter of a funds transfer. I want everyone to know that in my 25 years I have never had a situation where I was unable to honor investor redemptions in a timely manner. In developing this new product, we have pulled the most investor-friendly aspects from various products and strategies I have worked with over my career. This is a unique offering. There is nothing similar in the marketplace. Tactical short was designed with key characteristics for the benefit of investors – liquidity, transparency, flexibility, and low fees.
First – liquidity. Our long holdings will be predominantly in cash. Our short exposures will be highly liquid, and as a money manager, I need to be tactical. That is why we included the name, Tactical, for our offering. I appreciate that investors may have to be tactical, as well. There are no gates here, no redemption restrictions. You want out of the market, and or your money returned, I assure you this will be done in a timely manner.
Transparency. We have chosen the SMA structure with a broker/dealer/custodian that offers a comprehensive plan interface. You will have online access to monitor positions, trades, and account value. Fees will be transparent. You will have access to an impressive menu of customized reports, and I will regularly update clients on portfolio strategy.
Flexibility. Flexibility is so important. We will have the capability to short stock sectors, the broader market, the S&P 500, various asset classes, and international markets around the clock when necessary. We will have the flexibility to cautiously buy liquid put options on stock sectors or the markets. We will have the flexibility to vary our exposure and portfolio beta, depending on the backdrop. We will strive to short what is working, go where the action is, so long as there is a favorable risk/reward calculus.
The SMA platform allows for some customization. We will have the capacity to cater to individual portfolio needs, and to customize based on a client’s risk preferences and tolerances. And low fees. We are coming with a 1% management fee because we believe low fees are an important contributor to long-term performance.
In conceptualizing this new product, I didn’t sit around contemplating a strategy to make Doug Noland rich, that is for sure. The focus was on a void in the marketplace and the opportunity to create a unique product that would benefit investors for years to come. Our goal is to have tactical short as a long-term fixture in clients’ portfolios. We would love to find clients to be partners with us for the next 20 years.
Our investment process. I have to admit to being anal when it comes to process, and I apologize in advance for going granular on this, but it is just really important. Few investment vehicles offer the potential rewards available for shorting individual stocks, with one caveat – only when that type of analysis is working well in the marketplace. Think back to 1990, 1994, 1998, 2000, 2001-2002, 2007-2008. Those were all exceptional years for stock-picking.
The problem – there can be long stretches when stock shorting doesn’t work. Much of my career I had to remain short-stocked. There were prospectuses and mandates. But we are going to ensure that we have the flexibility to short company stocks when risk/reward is favorable, as well as the broad mandate to avoid them when it is unfavorable. Often, and I have seen this repeatedly, there are more attractive risk/reward opportunities, shorting sectors, segments of the marketplace, different asset classes for the general market. We strive to be opportunistic.
Our process of melding macro and micro, for analyzing risk versus reward, is a key competitive advantage. Most bear products are 100% short all the time. Well, this is risk indifference, and risk indifference on the short side doesn’t work. Our sound analytical framework drives our daily decision-making.
How short do we want to be? Generally, overall short exposure will be between 50% and 100% short, but it could be zero. The composition of our short exposure? We will short individual company stocks. We will short sectors, such as retail or financial, for example. Themes, leverage companies, bond proxies could be examples. Other assets classes, fixed income, emerging markets, currencies. The broader market – there will be times we will want to short the mid caps, the small caps. We will short the S&P 500 index. We will buy listed put options on stocks, sectors, and the market.
Importantly, we will carefully manage overall portfolio beta for the volatility of the accounts. We must anticipate position correlations and short squeezes. Our philosophy for managing overall exposure. We will build short exposure when risk/reward is gauged to be favorable for shorting. We will build winners, add exposure when things are working, but we will reduce exposures when losing money, or when risk/reward is unfavorable.
While challenging, position timeliness is key. We would rather be a little late than too early. We are not aggressive traders, but we are, instead, disciplined risk managers. We regularly re-balance short exposure. This is an important part of managing short exposure, to guard against becoming more short in an unfavorable rising market, or less short in a favorable declining market. But we will rebalance with highly liquid instruments to keep transaction costs to a minimum.
Several questions addressed what drives our daily decision-making. We use a mosaic and indicators for gauging risk versus reward in the marketplace. We focus on 1) gauging overall financial conditions, and 2) gauging market dynamics. This is from a top-down perspective.
First, gauging overall financial conditions. Indicators include the monetary policy backdrop. Is it loosening or tightening? Credit availability, which includes lending conditions, debt issuance, market demand for securitizations and derivatives. M&A activity. We monitor, closely, credit growth. We want to know the prevailing types of risk intermediation. We follow closely the dynamics of asset inflation. We follow investment in speculative flows – inflows or outflows. Where are they coming from? Where are they going?
Various credit spreads and risk premiums. Our framework pays special attention to corporate credit availability. In sum, are conditions loose, or loosening? Tight, or tightening? And then, we are gauging market dynamics. Is the backdrop generally leaning risk-on, or instead, risk-off? Is the market embracing risk, or is risk aversion gaining a foothold? Is the speculator community adding leverage, or are pressures mounting for de-leveraging?
We closely monitor the performance of various fund strategies, especially in the hedge fund arena. We monitor the performance of various bear funds, and a lot of favorite short positions. We closely monitor option and derivative pricing. We want to recognize early market signals from the perspective of both risks and opportunities. We are looking for changes in trends and potential vulnerabilities, inflection points, and critical junctures.
The core versus periphery analysis offers valuable insight. Companies, industries and countries at the periphery. The marginal borrowers are the most sensitive to changes in financial conditions and market dynamics. They act as early indicators. We give special attention to the junk bond market, small caps, and EM, emerging markets. They often provide good canaries in the mine.
The financial sector is closely monitored. We view the marketplace akin to a huge card table and we methodically study each card, seeking to discern the nuances of the other players and the game, itself. We are disciplined, intensively focused on comprehensive analysis, market probabilities, risk versus reward metrics and execution. When managing short exposure, a sophisticated framework and investment philosophy really boil down to, “You’ve got to know when to hold ‘em, when to fold ‘em, when to walk away, and when to run.”
I am a top-down, bottom-up, fundamental analyst, but long ago I learned to respect technical analysis, so our investment process incorporates a technical overlay. If our fundamental analysis is wrong, and we are not timely, then we have our technical analysis to fall back on. I have used the same outside technician now for over 20 years. Every position will be score technically on a weekly basis. The market and many of our market indicators are scored regularly. We want to avoid being short stocks that are technically strong, and we would rather not short a strong market.
Who are our ideal partners? When we conceptualized our new product we had institutional investors in mind, but tactical short could, as well, be appropriate for qualified individual investors. We would like to develop long-term relationships with family offices, pension funds, financial advisors.
And with that, I will pass it back to David.
David: Thank you, Doug, for giving us an overview of how we approach this, and we will dive right into the questions that have been asked, a wide range of them. We will just click through them as quickly as we can, starting with:
What is the minimal investment MWM is willing to accept?
This is a two part answer. One, the individual investor – the minimum account size for the tactical short is $100,000. The minimum for an institutional investment is $1,000,000. Just to make that distinction, an individual is the smaller of the two. The institutional investment would be at $1,000,000.
The second question is put to us this way:
I have positioned myself and my investments to be 95% gold, silver, cash. Being a student of economics, I believed after the very first quantitative easing that inflation was coming. I did not know at the time, more QEs were coming. I am a very paranoid investor and I don’t trust Wall Street, which is why I own tangible assets. For those of us who have stayed away from investing in the marketplace for the past few years, why is now the time to get in, but on the short side?
Doug: Okay, David, I’ll field that one. I have written as much, I believe we are in the late stages of a historical, multi-decade credit bubble. I will just throw out my definition of a bubble. It is a self-reinforcing, but inevitably unsustainable inflation. I believe zero rates and trillions of QE have made things much worse. They have inflated lots of things and created deep, systemic addictions to monetary stimulus. Last year we saw global bonds markets in a speculative blow-off, and this year we are seeing similar dynamics unfold in equities risk markets more generally.
We have watched money flood into equity index products, a lot of these passive indexes. Investors’ confidence and complacency are at extremes. My view is that the election set off a final major short squeeze in speculative market blow-off. But from my global perspective I believe we are at peak monetary stimulus. So, again, we look at the backdrop and say it is time to revisit risk, and we believe we have the best offering to help in what we expect to be an increasingly difficult market environment.
David: Dough, another question:
Is your strategy going to focus on U.S. or foreign listed securities markets?
Doug: Our primary focus will be securities and trade here in the U.S. There are often issues borrowing securities globally, although today, with so many different types of products that trade here in the U.S., we can certainly get foreign exposure through trading ETFs, ADRs, and other instruments here in the U.S. And there may be occasion where we will look through our broker custodian relationship and potentially borrow securities overseas, but our main focus is on U.S. securities.
David: The next question is:
I’m not a market timer, but if we end up experiencing another 1, 2, 3, or more years of up markets, how will that affect this portfolio, or this product?
Doug: That is an excellent question. A lot depends on just the path of the market’s advance. If it goes straight up, we get out of the way, and then we will just minimize losses by not being short. We are hoping, even in an up market, that there are pockets that we can play. That might be a time period. Last year, 2016, which was an up year in the market, provided a very good opportunity in the short side at the beginning of the year. So, someone who was opportunistic, who took advantage of that, and then mitigated risk in the rising environment, could have had money made on the short side last year.
We don’t know what is going to happen over the next few years. I think we are prepared to deal with whatever the market throws at us. One of my cardinal rules is, we don’t try to pick market tops. We are going to have to play this cautiously, but be ready to be opportunistic.
David: I think you addressed this in your earlier comments, but maybe you could say one more thing about lock-out periods. The question is:
Are there any lock-out periods before we can liquidate after getting in, that is, for new investors?
Doug: No way. As I mentioned earlier, we are going to be highly liquid. Accounts will have large cash holdings in liquid short positions. Of course, we are hoping investors will stay with us for years to come, but if you decide you want your money back, it will not take long.
David: One question:
Is this a stand-alone product, or one that may be incorporated alongside an existing securities portfolio?
I think be design, what we were assuming was that this is a complement. This is not intended to be everything in your financial universe, your very last investment dollar, but again, you are either looking at this as an opportunistic short to compliment other things that you have in your financial universe, or as a means of off-setting risk and volatility. So, in that sense, we would be accompanying you, or we would be right there alongside your other portfolios.
Another question for you, Doug:
Does your confidence level justify selling other assets and investing them into this strategy?
Doug: Difficult question. I have done this long enough to know that predicting near-term market direction is really tough, if not impossible. But I will also say, we would not be launching this product right now if we did not have high confidence in its success. If I though the market was going to go up for another eight years we would not be here today. I am not familiar with your particular situation on this question. Everyone has their own individual portfolio characteristics. But I would say, in general, it is time to look at one’s portfolio of assets and take some risk off the table. We would certainly like to be part of your other strategies for preserving and enhancing wealth.
David: In addition to that, is this a long-term investment strategy, or something just to take advantage of, of a short-term trend of market correction, or what have you?
Doug: This is definitely a product that we are launching today to offer something to investors for years to come. We think this is very valuable to investors over various market cycles, hopefully, over the next few decades. I have an eight-year-old son at home, and David has young children, and both of us would like to create something that they could get involved with down the road if they choose. But at the same time, we would be happy for investors to profit from an unfolding sea-wave that, if it is a typical sea-wave, that would be nasty (inaudible 32:18).
David: Another question:
Doug: That’s a good issue that needs to be addressed. First of all, to short, we need to borrow securities. I mentioned earlier, we will go to the stock loan at the broker to borrow securities so we can sell them, so we can short them in the marketplace. This arrangement, by design, requires a margin account, but we will not use a margin to borrow cash. We will not borrow cash to leverage security holdings. As I mentioned, to short stock it does not take cash.
For the most part, we will keep short exposure below 100% of account assets. In some situations, we might have overall short exposure above 100% in a declining market environment, and that would be when we include what is called a delta exposure, a market exposure of the liquid put options that we hold. Especially in a declining marketplace, if your puts go into the money, then you can get significant market exposure from your put options. As far as leveraging, we won’t leverage.
David: Yes, I think that is a critical question to linger on because oftentimes we are critical of the levels of total margin debt. Today, it is about 528 billion. That is 50% above the peak level of 2007, which would imply to us it is not a question of if, but instead when, we have a major market correction or crash. We are not talking about having margin associated with the account that allows us to leverage up, or buy more than what we should in the account, it is just a function of being able to borrow that stock that requires a margin account. So, as you are opening an account, just to be clear, it is not to go above that 100% level except on the rare occasion, which you have just described.
Maybe you can explain sector, or stock selection, strategies.
Doug: Our perspective on this is very much where macro meets micro. This sets us apart from other shops that might only focus on analyzing financial statements and looking at individual companies. We like to short sectors and companies where I see a high probability for disappointed expectations. We like to see elevated expectations. We like to see environment. It could be a macro environment, something specific to a company, or an industry, where we see a near-term, high probability of disappointment.
I look for fundamental deterioration, but I also want to see stock under-performance. I want to see the marketplace begin to adjust to these deteriorating fundamentals that we are analyzing. Fundamentals can vary very much, depending on the individual company or the sector, but generally, I am not looking to short Wall Street darlings. I much prefer to short what the Street is falling out of love with in a backdrop of tightening financial conditions, and that is something I am waiting patiently for.
I love to short companies in sectors vulnerable to tightened credit conditions. That means weaker, bloated balance sheets, over-aggressive expansion plans, over-zealous management, short maturity liabilities, the traditional types of things we would look to from the short side. After going on nine years of ultra-loose financial conditions, my view is, when finance begins to tighten, this will really open up opportunities for shorting individual company stocks, in particular, but certainly also sectors in the market.
David: So, with ultra-loose financial conditions being in the backdrop, the next question is:
Would you ever suggest shorting gold stocks?
Doug: I have never been fond of shorting hard assets. I am kind of a hard asset guy. If I am looking to short a hard asset company I feel like there is usually a better opportunity elsewhere. Especially as things are unfolding, if you start to have any type of crisis of confidence in central bank policy-making, I would want to be long hard assets and short financial assets, definitely.
David: The next question is:
Could you give us your best-recommended mutual fund for a strategy like this?
Doug: (laughs) Not easy.
David: (laughs) Which is kind of why we started this particular offering.
Doug: That’s true, David. If I could recommend a mutual fund strategy we wouldn’t be coming to the listeners today with a new short offering. I have been in this space a long time. I am very familiar with the bear mutual funds, and it is not my style. I’m not here today to criticize them, but each of them has, at least, a very serious weakness. For starters, most are 100% short all the time, which, as far as I am concerned, is a flat approach. That can work on the long side, index on the long side, 100% on the long side, 100% long on the long side. That’s fine. Doesn’t work on the short side. You have to be able to get out of the way.
Other funds use nothing but third-party derivatives, which I have a serious issue with in regard to being a hedge against systemic risk. We want to be a hedge against systemic risk, so we’re not going to invest in things that we think could have a problem during the next financial crisis. One of the large bear funds has page after page of derivatives, including credit default swaps, interest rate swaps, and even “swaptions.” For me, it is kind of nutty, but that’s what they do.
There is another fund that only shorts stocks. We don’t want to only short stocks. Another has become a long/short fund, and that’s not our strategy either. Our investments can find their long products elsewhere away from tactical short. We are just going to focus on managing short exposure. And as I have discussed, tactical short will do things much differently, and we believe provides a superior offering through – I will call them competitors – these other bearish or short-sided mutual funds.
David: I will take these next two questions. The first is straightforward:
Can this be used in a trust portfolio?
The answer is yes, you can use that in a trust portfolio.
The next one is from an existing client on the Wealth Management side:
I want to know if Mr. Noland will be involved in the investments that we already have with you, or if this is a separate strategy that will not be used with existing funds?
That is correct. This is a separate strategy not used with existing funds. It is a unique offering separate from the MAP or S portfolio strategies.
The next question is:
Do you recommend taking put options on SPY or specific stocks, and which sector do you think is best for this strategy?
Doug: I have been trading in puts professionally now for 25 years. I am assuming that puts led to a lot of this grey hair. I know that shorting has led to a lot of them. But between the two I don’t have any brown hair left. These are really tough instruments. They provide some benefits in shorting strategy, and we will definitely use them in tactical short. There are characteristics here that we like. We can well define a potential loss on a position. We can buy a put, that we know if the market declines that is going to increase our exposure in a more favorable environment. If the market goes against us, again, our loss is capped.
So, we like these. But we trade them with caution and discipline. That is the only way to approach these. A lot of put options or derivatives, generally, have worked great in theory – often challenging to execute. But for the most part, unless someone has a lot of experience trading options, I tell folks just to stay away from them.
The tactical short, though, will back-put options on stocks, sectors, and the markets. It just depends on where we think we will get the best bang for the buck. If there is something company-specific, but the risk of shorting is too high, puts offer us a way to position bearishly on this stock with a clear limit on potential losses. If our focus is, instead, on the market, I will tend to gravitate to the cheapest S&P puts available. I tend to like to pay extra and have more time because things generally take more time than I anticipate to unfold, so I always want to gravitate toward longer maturities.
I am also very disciplined, in that if you get a market break and these puts go into the money, and I am going to capture gains on these puts, I am going to roll my strikes down, extend my maturities. This is, perhaps, a little sophisticated, but the point is, these have to be managed carefully. In the past, if my focus is on some unfolding systemic development, I will look to financial sector put candidates, and that is a real opportunity if you can get ahead of the market, anticipating not just risk-off, but a liquidity market event in the market, that is a place we will look.
So, to answer this question, I didn’t answer it that well, but it all depends on the backdrop, and how you are positioning, and looking at the relative pricing of the options.
David: This next question I will take it because it is concerning mechanics:
Can we use traditional IRA or Roth IRA funds?
The answer is no, because those accounts do not allow you to have a margin component in them, which is necessary and prerequisite to being able to borrow securities.
The next question, not necessarily tongue-in-cheek:
How long do we have before a crash? Or the crash?
Doug: You know, I have no idea. At this point, nothing would surprise me. I fear there is certainly a lot more risk of a major market dislocation in the complacent marketplace views today. But I don’t know.
David: Fair enough.
The next question reads:
I absolutely agree with your conclusions on this great credit bubble. My concerns are whether this increase in currency expansion and interest rates will cause hyper-inflation, or will buckle the economy and lead us into a depression. How will the tactical short hedge its risk against these two very different outcomes?
Doug: Excellent question. First of all, this is very important. This is part of our broad mandate here. If we have to get out of the way, we will get out of the way. I often say, my job is not to predict, but to react, and to have the framework to be able to react, to be prepared. Clearly, this could unfold in different ways, and we have to be prepared for various scenarios, as well as the unexpected. I would like to think that no matter what scenario develops, what the market throws at us, we will be able to find company sectors and markets that are under-performing. More specific, hyper-inflation would cause a lot of grief throughout the economy. It would certainly lead to a spike in interest rates. In general, higher interest rates would significantly benefit the tactical short strategy. We sit on cash, and we also receive a return on our proceeds from the short sale. So, higher interest rates help our strategy tremendously, and we are actually excited now that the Fed is raising rates. That helps us.
In a depression that would have profoundly negative effects on asset prices, generally, creating enormous short opportunities. Over my 25 years, going back to 1990, we have seen these bouts where the market fears a deflationary scenario and that is the best opportunity. The best opportunities presented for shorting stocks is in that scenario.
David: The next questions is:
Measuring risk, i.e., standard deviation of the investment. Can you address that?
And the second part of the question is:
Accounting for fees and costs associate with the investment.
I think we have covered that, but if you want to add anything, feel free, but for sure, focusing on that measure of risk and standard deviation.
Doug: Another good question. This is something we monitor very closely. We will measure the volatility of our accounts versus the S&P 500, and we expect to generally run a portfolio strategy with a beta below the market. In my experience, low beta is preferred to high beta, except for those market opportunity periods where we want to build our short exposure.
But our neutral position is that lower beta is preferred to high beta, with the expectation of pushing beta up, with shorting, not only our short exposure, but also the volatility of our different short exposures, and therefore our put options, because we want to capture more in the inverse of the S&P in a meaningful decline. We can’t do that day-to-day, but if there is a meaningful decline in the market, we want to be able to get our exposure up and capture more than 100% of the S&P’s decline, and hopefully, we can be tactical and significantly mitigate risk during rallies.
David: The next question:
Accessibility to non U.S. residents.
The answer to that is yes, in most instances. There are some exceptions, and for a variety of reasons. Some of those have nothing to do with international relations with the United States. Some of them have to do with domestic concerns about capital mobility and what have you. I would say in 9 out of 10 instances when someone has asked us, “Can we open an account from the U.K., from Canada, from other locales?” The answer has been yes. We just take that on a case-by-case basis. So, feel free to inquire. Again, if you have a specific question related to that moving forward, email@example.com, and we are happy to look into that for you. I will be happy to research that for you, have our team do so.
Doug, the next question:
What would make it different (our tactical short) from buying, say, a highly-leveraged short ETF?
Doug: I have a real issue with these high-leveraged short ETFs, and I think folks he come to appreciate that they are dangerous in the marketplace. I just kind of mentioned, our neutral position in the marketplace is a beta below the S&P. Some of these that are running a beta of -2 or -3, if the market rallies, let’s say a 10% rally, and we saw that after the election – that can happen quickly – some of these products lose 20-30% of their investors’ money.
The way it works – let’s say if you lose a third of your money on the short side, the way the math works, you have to make 50% just to get back to break even. So, especially in a volatile market environment, you do not want a leveraged ETF because if the market rallies, let’s say 2-3%, you will quickly lose 4-5%. You just don’t want to take those kinds of losses. So, our product is a lot different than a leveraged short ETF. It is actively managed, it varies its beta, and only in rare instances would it really press its beta much above 1%.
David: This is an interesting question:
What work or research is involved for the personal investor on a weekly basis who is involved in the tactical short? What is required to maintain the discipline and flexibility?
Let me just address that. What we are attempting to do is, actually, with the nature of the tactical short, remove the trading pressure from the individual. Doug, that falls to you. That is your role, as opposed to the investor’s role. Looking at some of these other passive products like the leveraged ETFs, it is absolutely incumbent on the investor to maintain their own research and discipline in getting that done on a daily and weekly basis. That is what we are shifting, actually, to you, Doug, in the context of the tactical short.
One other question here, I will take before I pass it back on to you:
Someone wanting to know if we would ever accept smaller accounts below the minimums, and what that would look like?
I would say this. Down the line, it is certainly my desire to take the best work that Doug has done and mirror that is some form through a mutual fund for ease of accessibility, and in making his best efforts in the marketplace and his success there to be available to anyone. That is not going to happen right away, but that would be sort of a preview of coming attractions.
One more that I will take because it is a little bit into the weeds. The question relates to tax accounting, and I will state at the front end, I am not a CPA and this should be qualified and verified, but the question is:
How will the tactical short, the fund, if you will, report for investors who use STAT accounting, that is, for insurance companies, and what have you? Do we receive NAV, Net Asset Value, on a daily or monthly basis? What type of asset would a separate account investment in the tactical short be considered? Would we use the Schedule D, Schedule DA?
Let me just give you a brief introduction, and then a referral if you need this. Because we are dealing with bonds, stocks, and ETFs, most of your investment schedule filing, which occurs year-end, would be D-1, D-22, and predominately, BA on the exchange-traded fund side. To get better clarification on that, and as you are finalizing your year-end filing, if you are an insurance company, pension fund, or anyone needing to stay consistent with the STAT accounting, the National Association of Insurance Commissioners is incredibly helpful and I could refer you to someone that I know there who could answer every specific question for you.
Again, firstname.lastname@example.org. I am happy to put you in touch with our resources there that for reporting purposes in the context of an insurance company will clarify that. We have been in touch with them and they are happy to review what we have, who we are, as well as how that works for you in terms of your consistent and predictable filings.
Doug, the next question:
What would be the main difference between your short fund to, say, a short fund like SQQQ?
Doug: As I mentioned, we believe, if you are going to play on the short side you want an active manager. These other products are 100% short all the time. They force the investor to be the market timer, and we don’t necessarily think that is such a great idea so what we are doing is very different. We are changing our exposures depending on risk/reward. We are very focused on risk/reward in the marketplace, and positioning based on our perception of the predominant opportunities or risks in the marketplace. You don’t get that with an index product.
David: Let’s tie that into the next question, which is:
Looking back at the calendar years from 2007 to the present, there was really only one full year, 2008, when it was highly profitable to be short. In the other nine years, looking back, I believe a strategy other than being short would have been more profitable. For those periods when the risks of being short, especially the risk of losing capital are great, and correctly appreciated, what portfolio strategy would pursued by the manager of the tactical short in those separate accounts?
Doug: Excellent question. I have lived through long bull markets, and on short side, it has not been easy. But I think back to 2007, actually. That was a year the market was up, and that was a very good year for stock-picking. We started to see things unfolding sub-prime, Fannie and Freddie, the financials, consumer discretionary. It was a very good period for stock-picking, even with, I think, the market S&P ending up 10% higher, or something. But we are hoping more years like that.
If we get years of just enormous QE and zero interest rates, that is highly unfavorable, and we are not going to have much short exposure if that unfolds. That is why we are structuring this product that way. We want to be prudent about this, we want to be opportunistic, but also we know that if central banks keep printing money, if we go back to QE4, that is going to be a real challenge that we are going to have to mitigate with risk control, and we are ready to watch that unfold and we will respond accordingly.
David: Dough, the question is:
How do you best protect the tactical short from gross government intervention like, number one, trading stops, or number two, making shorting illegal on certain stocks?
Doug: Another good question. This has been a concern of mine as a professional bear going all the way back to 1990. I had to deal with a moratorium on trading financial stocks back in 2008. I remember on the day that was announced financials stocks were up almost 10%. So, the best way to protect investors is, you have to manage anticipating these types of things might unfold. You need a variety of highly liquid instruments. You need to be relatively diversified. You need to be very disciplined, and not to have too much exposure in one area. You have to be one step ahead of policy-making, and that could be from the Fed or the Treasury.
But if the government banned shorting – let’s say they banned all types of shorting – the entire market has a huge problem. The derivative players have a huge issue. How are they to hedge the derivative that they have written? But I will say, in the worst case scenario, we cut our shorts, we are going to be liquid, and we will return money to investors. That is the worst case scenario. The thing is about shorting, again, you have already shorted that security. The cash from that sale is sitting in a restricted account. So, you unwind your short and then send the cash back to investors.
David: Another question:
How will the tactical short protect a portfolio with a mid to long-term hedge, or portfolios or long-term stock dividend plays?
Doug: Yes, this is an interesting question. Over the years I have often been asked to recommend a percentage allocation to a hedging strategy. Someone will say, “Doug, how much should I use to hedge?” My response is always that it really depends on the risk profile of your portfolio. If it is a high-risk portfolio, you need more hedging. If it is a really low-risk strategy, less hedging, perhaps even no hedging necessary.
My old response – I can’t today. We have watched enormous amounts of money flood into these perceived defensive strategies such as the now very popular long-term dividend plays. But today I believe such strategies are excellent candidates for a tactical short hedge, when they might not have been in the past. Why? Because I think there is a much, much greater risk in the so-called low-risk conservative strategies than we have ever had in the past, just because of the way market dynamics have unfolded under the Fed policy.
Our strategy can be valuable because rather than to sell long and generate taxable gains, one could look to the tactical short as a hedging strategy to add downside protection without having to liquidate other things.
David: You mentioned that cash positions would be primarily treasuries and government money market funds. Is that correct? The question here is:
Will cash positions include previous metals?
I am assuming that is absolutely not the case. It would be short-term treasuries.
Doug: Yes. Our focus will be to keep our cash liquid and safe. There may be a point in time when we could look to other assets as a potential safe haven other than cash. That is down the road, and this would be well communicated. Perhaps we could invest part of those cash proceeds in safe overseas foreign currency-denominated cash positions to hedge against a dollar crash, for example. But that is not our thinking at all today. Today the focus is keeping that cash liquid and safe.
David: This is kind of an interesting market dynamic for years. Any minor dips in the market have been shallow, have been bought aggressively. So, what is the tactical approach when gauging whether to cover versus to let a position run?
Doug: That sounds like a question for someone who is shorted in the marketplace because that is the holy grail, and there is no easy answer. It is a question that demands a lot of attention on a daily basis. What we do – it is as much as art as a science. Every positions becomes stored. For example, let’s say a position starts to go against me, I am looking at, what is the beta of that position? What is the short position of that position? What are the other companies in that sector? How are those stocks performing? Is that stock in a hot sector? What are the dynamics behind that rally?
The same is when I have a highly profitable position. And of course, there are the occasional rallies. The question is, do you take money off the table and cover a position, or do you stick with your winners? No easy answer. Again, a lot depends on the size of the short position, the individual dynamic of that position, but also, what is happening generally in the marketplace. No easy answer, and that is what makes this a challenge, but that is also our competitive advantage of having done this for 25 years. We hope to have an edge over others.
David: I will do just two more questions. The first is:
Is the tactical short still applicable as an allocation which is not meant to be a hedge for stock holdings?
Doug: David, I am assuming this is like a directional bet on the market?
Doug: Yes, some may play it that way, and that is the way we look at it. We much prefer to be part of a greater risk management strategy for the overall portfolio, but we will play an account like that just as we do the other accounts.
David: I think you have talked about this already, but the question is:
What portion of a person’s assets would be prudent for allocation to the tactical short?
I am assuming this is liquid financial assets.
Doug: Our standard answer will be 5-20%, but it is very specific to the risk profile of that portfolio, and the risk tolerances of the account-holder. That is why we look forward to having discussions with folks and seeing how a tactical short best fits in their portfolio investment.
David: As we wrap up, just reiterating that what we have designed is what we consider to be the best in the marketplace to approach an actively managed, daily re-balanced, short exposure in the stock market, one that gives us the flexibility of pressing in when it makes sense to be short, and also gives us the tactical flexibility to be completely out, and not get run over by a market that wants to go up.
We have structured it, in terms of fees, to be very attractive, both at the institutional and retail level, for a long-term relationship, something that you can have as a complement to an existing portfolio, and add value day-in, day-out, not necessarily waiting for a market to crash, but looking for pockets of weakness and being able to add value, identifying those opportunities day-in, day-out, week-in, week-out, year-in, year-out.
So, what Doug and I have discussed and put in motion is that very complement, something that is designed to go the distance. We can certainly look at today’s current issues, whether it is, as we mentioned earlier, margin debt being at 528 billion dollars, whether it is a deceleration in global GDP, the transition from monetary policy dependence to now, hopeful expectations that fiscal policy will deliver more and more of the goods to deliver economic growth.
These are backdrop issues which we are constantly appraising, and as Doug has brought into focus, factor into the mosaic which he is looking at every day to make decisions as to whether or not we are zero percent short, 25% short, 50% short, 100% short, for your benefit. He is right in saying, it is very hard work, but it is very intellectually rewarding work, and it is something that he loves, and we are very, very proud of what we are bringing to market. I do think that the timing is impeccable, not that we are trying to time a market top, but we have what is in the makings, I think, an immense opportunity to be structuring a portfolio to lower risk, to lower volatility, and we think we can help you do that.
Join us in this endeavor. We hope you will. We would love to be in contact with you over the next few weeks, and if you would like to reach out to us, the best means of doing that would be the email address, email@example.com, and we will know exactly how to respond to you. If you are calling in to our office, keep in mind we are coming into tax season and the most effective and the quickest way for us to respond to you would be to get in touch with us by email, firstname.lastname@example.org. Feel free to reach out to us and we can schedule a conference call, a committee presentation, or whatever your needs may require.
Thank you for your time today. We will end it there. We would look forward to serving you in any way possible in the years ahead. We hope you have a wonderful day and we will go ahead and wrap it up.
Doug: Thanks, everyone. Good luck out there.