#64 - David Varadi - “Managing Risk is Absolutely Critical"

53 minutes

In Episode 64, we welcome David Varadi from Blue Sky Asset Management.

David tells us a bit about himself before he and Meb jump into investing. Meb starts by referencing a quote from Blue Sky’s website:

“Unlike endowments, investors do not have an infinite time horizon. For this reason, we believe that a traditional strategic asset allocation approach based on modern portfolio theory is suboptimal. It makes more sense to adapt to changes in the economic environment. We favor a dynamic approach to asset allocation using market information to guide our investment decisions. Most importantly, we believe that a systematic, quantitative approach is necessary to avoid emotions and biases in decision-making.”

Meb’s a fan of all the ideas in that quote, so he asks David to expound and discuss his general market framework.

David tells us how it’s easy to be a buy-and-hold investor when market is going up; much harder so when the market is falling – especially when nearing retirement. Significant drawdowns can be devastating. So David tells us that “managing risk is absolutely critical.” Investors need to be able to adjust their strategies to handle a wide variety of market scenarios – bear markets, varying interest rate scenarios, and inflation. And “if you have a dynamic asset allocation, you have the ability to be more in tune with the market regime that is currently going on.”

Meb asks David to dig deeper – what are the rules and frameworks in place that make his models dynamic?

For David, much goes back to fundamentals, trend, momentum, and volatility.  David starts with a strategic allocation that reflects longer-term assumptions. But what’s interesting is how David uses volatility in concert with trend/momentum, helping him know when to be in the market versus cash. Most people think time-series momentum is a binary decision, but David brings probabilities into the discussion.

Meb then asks about the challenges a retail investor faces when trying to implement the strategies David has been discussing.

A big challenge is tracking error. The more dynamic you are (moving away from buy-and-hold indexing), the more potential tracking error. Another issue is how often you trade. David tells us that the investor has to ask himself what is most important – does the investor want to reduce the drawdown in a 2008 scenario, and if so, is he willing to take the tracking error associated with that?

Meb echoes this tradeoff between buy-and-hold versus active. It’s very hard to look “different” than the market and/or your neighbors when you’re underperforming.

Next, Meb references a chart from one of Blue Sky’s white papers that shows the most successful asset managers (presented in our show links). The top three are all quant/trend guys. Buffett is at six. Meb asks why, then, everyone knows Buffett’s name, but most average investors aren’t familiar with the trend asset managers.

David gives us an interesting answer, referencing how trend is less known, as well as the behavioral challenges of its implementation. But he tells us that a big reason why many of those trend investors are on the chart is because “when you stay in tune with what’s actually happening in the market, you’re much more likely to survive over a long period of time.”

It’s not long before the guys switch to a fascinating new topic – using equity option data to select stocks. In essence, looking at the implied volatility between puts and calls to get a feel for which equities are more likely to climb. David is searching for “high implied skew.”

Next, Meb brings up another Blue Sky whitepaper, this one about retirees and risk. David hits the high points, discussing the challenges of volatility in retirement.

There’s plenty more in this episode, including the new areas David is researching… David’s most memorable trade (one involves put options, the other Bitcoin)… And David’s one piece of investing advice to listeners, involving three mental “buckets” for your asset allocation.

What are they? Find out in Episode 64.

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