MLM Index: Why no equities?

The MLM Index™ (see www.mtlucas.com for a description of the MLM Index™) does not include an allocation to equities. Many of our trend follower competitors do include them, and as a result we get asked all the time the reasons behind excluding them. As we have written about in previous posts (Portfolio Symmetry and Commodities are not Stocks), we believe that commercial markets like commodities, currency and interest rates are fundamentally different than equity markets, and need to be accessed in a different way, matching the economic rationale for the markets existence. Equity markets exist to fund the growth of capitalism and transfer capital from savers to businesses to be invested profitably. That’s a long only rationale in our mind, as the market participants are overwhelmingly one way. We think this is borne out by the tendency of equity earnings and prices to generally rise over time as economies grow. It also means that there isn’t a natural investment pool short the equity markets – no one has a business model that relies upon falling equity prices. One way you can see the differing utility functions is in the options market – implied volatility on puts trade at a premium to calls, as the demand for protection of a long investment book is much greater than the demand for call protection on a big real money short portfolio.
Commercial markets are different – they exist for businesses to hedge operating risks, the economy as a whole has hedging needs on both the long and the short side. If commodity investors only invest on the long side, that’s great for E&P companies as they can sell all their production to lock in prices giving certainty for their operations, but lousy for airlines, that would be unable to buy protection from markets to hedge the damage rising fuel costs would do to their business. As we wrote previously, we believe investors are wildly underexposed to this risk premium and combining these approaches makes a lot of sense in a portfolio – you can read more here.

Given many investors are underexposed to the trend following risk premium and overexposed to the investment risk premium, we think the trend following investor should want the commercial market exposure, as it’s a great diversifier to the equity and credit led investment portfolio they already have. Why add more equity? In a portfolio context, you count on the trend following diversification to provide a return in times of instability when the rest of the portfolio is getting hurt. Adding more of what you are trying to diversify away from muddies the water. The real juice comes from capturing the flows on the other side, as instability drives commercial prices in currency, fixed income and commodity markets.

So why do our competitors do it? We think there are a few reasons. First, it makes for a better business for the manager, as historically equity markets do go upwards, and it makes sense for the manager to maximize the expected return of his product, offering a one stop shop. In our mind, this higher expected return is coming directly from the portfolio or plan they seek to help, and dilutes the value of the product to investors. When you are looking for hedges and diversifying return streams, what you want is convexity, adding equity trend following to us reduces that convexity. The second reason is that the equity markets are very large, and trend following managers need large markets so that they can grow large, which means that they add equity markets in order to trade bigger funds, which again is for the benefit of the manager at the expense of the investor.

We made a similar argument against long always commodity indices, which were not matched to the underlying economics – those returns weren’t durable over time. Adding equities to the MLM Index™ is the easy thing to do. Having conviction in the economics that drive the underlying risk premium – that is the hard thing.

While Mount Lucas does not include traditional equity securities in the MLM Index™, Mount Lucas does trade a substantial amount of equities as part of its other investment strategies and products and, with respect to these, also files Form 13F with the Securities and Exchange Commission on a quarterly basis.