JAKE MERL: Welcome to Trade Ideas. I'm Jake Merl, sitting down with Louis Llanes, founder of Wealthnet Investments. Louis, great to have you on the show.

LOUIS LLANES: It's great to be back.

JAKE MERL: So, we're here today at the CMT Symposium in New York City. And viewers at home actually may be familiar with you from our Tech Trader series. But before we get into our topic for today, can you please go over your background, who you are and what you do?

LOUIS LLANES: Sure. So, I'm an investment manager, and we manage money for private clients. I like to tell a little bit of a story about how I got involved with technical analysis because I consider myself to be like a roundtrip technician. And I want to explain what by that. If you think about the concept of a roundtrip, if you're a trader, you've heard that term before- that means you bought a stock, for example, and it goes up in price. And then it comes all the way back down to what you bought it at. And you take this roundtrip.

That was my experience in the investment world because I got involved 27 years ago with technical analysis. I was watching FNN and John Ballinger was on and I was like, I became in love with technical analysis. So, what I did was I read every single book I could possibly read. And on my own, I was in college at the time. And so, I really got involved with that.

But then I got a real job, my first real job out of college in 1994, managing money, and I was completely indoctrinated in fundamental analysis, got to Chartered Financial Analyst, and really went to the bottom-up money management style. And it was interesting, because during that time, we had this big bull market that started happening, right? And by 1998, we had a completely overvalued situation, right? All by any metric that you could look at, the markets were overvalued. And so, in our process, we were like, we got to pull back, we got to buy more defensive stocks, buy more high cash flow, high dividend stocks, and we were completely underperforming.

And not just us, all the value managers were underperforming, because you could look at like Berkshire Hathaway was down 50% during that period of time from that 1998 to the peak in the market in 2000. And I learned a valuable lesson. In fact, I will tell you, I got my CFA at the peak in the market in 2000. And I learned as a market crack that fundamentals only matter when the market recognizes it. If the market doesn't recognize your fundamentals, it's completely useless.

So, there's a few different examples of what you'd tend to see if you only look at fundamental analysis. One would be you don't understand why a stock continues to go up, even though the value is overvalued. Another example would be like, well, why is this stock breaking out and taking off when the fundamentals look horrible? But then you find out that there's an amazing new development. Or you might have something like I remember MCI that was just cracking and falling down but the fundamentals look great. So, like what is going on? Everybody on Wall Street was telling you why you should own MCI, but yet the technicals were saying you shouldn't.

So, I learned a valuable lesson about really blending those two philosophies of fundamental analysis, because they're different lenses, and they give you a different view of the market. So, that's why I call myself a roundtrip because I started with technicals, got into the fundamentals and then found myself in a situation where I got more holistic, saying you know what, we could use both of these.

JAKE MERL: So why not just use fundamentals? And why not just use technicals? Like why are you using both right now?

LOUIS LLANES: I'll tell you. The main reason is why is because I learned the lesson that you have two opposing views, right? With a pure fundamental analyst- I think is almost like saying, it's like the most arrogant situation you can be in. Why? Because I'm saying, as a pure fundamental analyst, my view of valuation is the only thing that's real. And the market doesn't matter. Price doesn't matter. So, therefore I'm right, right? And the market knows nothing.

And then the opposite end of the spectrum is the pure technician who says only price matters. And you can only- prices are the only thing that pays. And that's like what I call the complete ignorant phase, not ignorant in a bad way, but you choose to be ignorant. You say, I'm just going to only look at price. And I know money managers on both extremes that are extremely successful, pure fundamental and pure technical. But I believe that what happens is you get a worse reward risk ratio, because you're not getting a full picture about what's happening. And I call that the arrogance, ignorance continuum. And so, and most managers are somewhere in between. And I tend to be like, right in the center.

JAKE MERL: So, what is your process? What do you do to gain an edge?

LOUIS LLANES: Well, when I think about an edge, and I always ask this question when I'm talking to students in the MBA, when I help teach a class and I asked the class, what is an edge? And inevitably, they give us this really esoteric answer, statistical type answer. And I heard one time that an edge is just the probability of one thing happening over another. So, I think that's where I'm coming from when I'm talking about an edge.

And what we're trying to do in the investment management world is we have a very unique situation, we're not like dealing with science, right? Because we're dealing with human beings. And with human beings, there's always fuzziness and randomness. So, we have, if you can imagine, like a Venn diagram, on one side of the Venn diagram, you have the randomness of the world. And then on the other side, you have this- the quality of our decisions. So, it's our goal to make strong quality decisions in this element of randomness. And when they coincide together, that's when we have really good outcomes.

So, we have to focus in on the quality of the decisions. So, in my process, what I do is I have come up with a systematic way over the years, to deal with managing fundamentals and technicals together and blending them together so that you can actually take actions. And let me give you a little bit of a background, I used to be a Senior Portfolio Manager for a very large bank, we managed billions of dollars, and I was on the asset allocation committee. And me and one other gentleman were the only people on the team that also had technical backgrounds, the rest was all pure fundamental.

And we were always fighting an uphill battle to move the needle on decisions on the asset allocation for this big firm. And I found out that the reason why is because we didn't speak the same language. And so, what I've done over the years is made it so that my company, we speak the same language. We basically put a process together where we define the risk profile of the portfolio. But then we select our factors that we're going to look at from a fundamental and tactical standpoint. And we break them down into three main categories- return, risk and correlation.

So, when we're dealing with the technicals, we also are dealing in those same three terms as we are with the fundamentals. And then from there, then we bring ourselves down, and we go through this whole process where we're really- I keep saying this, but speaking the same language, and that language actually leads to actions.

JAKE MERL: So, whether it's technicals or fundamentals, we all know, managing risk is extremely important. Can you talk a little bit more about that?

LOUIS LLANES: Managing risk is the most difficult part of our job. But when you risk profile, that is like the number one thing you have to do, like what is the total risk that we're going to have with this portfolio that we're managing? So, when we do that, we basically say okay, we need to first define risk. What is it? How are we going to define it? Is it standard deviation of the portfolio? Is it drawdown? What is it?

And in our estimation, drawdown is the most powerful statistic to use for risk management to define the overall portfolio because most investors remember where they were at the highest peak, and they look at where they are right now. They don't think about standard deviation. They think about drawdown.

So, when we think in terms of drawdown, we start with that number and say, okay, how do we risk budget? How do we break that down to the position level, to the sector level, to the group level? And then from there, then we say, okay, now we have a risk budget for every opportunity that we're going to invest in.

Now, how much of that risk budget are we going to use? Well, that's based on the opportunity score, and that opportunity score can have fundamental work in it and technical work. So, if the opportunity score is 100, then we're going to use 100% of our risk budget, because it's got the maximum, based on our factors that we think are most important, we're going to have 100% of our risk budget.

Now, I want to bring up something more macro about risk management. Because in the risk management world, a lot of guys tend to think about modern portfolio theory and all that. And one of the things that really blows those models up is this concept of converging correlation. And, gosh, 15 years ago, I wrote in a book called The Handbook of Risk, published by John Wiley, I wrote about converging correlation and market shocks, because you have this tough period of time where diversification doesn't work, right? And all the correlations moved to one. So, everything moves together.

So, one of the things I did in my research is I found the common characteristics that you tend to see when that's about to occur, so that you can be more proactive and bring down your risk ahead of time. And when we have to do that, there are some common characteristics that I've identified. And I could list a few of those if you'd like. And one of them is, is if you have a lot of leverage in the market, there tends to be a higher probability that you're going to have some market shock or an event that's really not going to sidelines you.

Another one would be if you have a small number of institutions that are controlling the liquidity or responsible for liquidity for a big group of investors, if any one of those small, those few institutions actually affect that liquidity, you can have massive dislocations in the market. So, that's one thing I'm always looking for. Another thing is a real simple one is what's the Fed doing? The probabilities of a big event really increase when the Fed starts changing policy, especially when they're raising?

So, there's a list of these things that we're looking at. So, managing risk from a macro perspective is also really, really important. You can manage the individual portfolio positions. But if we have no perspective on the overall asset class level and their interrelationships, then your management of risk is limited. And so, if you're trying to manage to a drawdown, there must be at least in our process, some view that is related to the macro as well, not just the micro stock level.

JAKE MERL: So, alongside risk management is position sizing. So, what's your process for that?

LOUIS LLANES: Well, first of all, position sizing is just as important as determining what you're going to invest in. And that's one of the things that I always like to bring up, because if you look at the formula for portfolio contribution, which is basically a formula that says what moves the needle in your portfolio returns? You see that the actual number of what you put in is just as important as how much.

So, in terms of how much, basically, we use a very disciplined process that looks at both fundamentals and technicals. And it starts with the risk budget. So, first of all, we say, okay, what is the risk budget on every opportunity? And it's going to be different for each position. But the position that you're looking at, you have to say, okay, based on the risk of the fundamentals, what does it look like?

Now, the fundamentals, maybe it's not something that you can measure, it could be things like the quality of the management, it could be the competitive advantage period, things like that. Those are things that you can't necessarily quantify. And on the technical side, though, you can really quantify these things. You can say, okay, what is the volatility of the instrument? What technical indicators are there that are indicating that volatility will increase or decrease? And what does that mean for my position sizing?

So, if we're going to risk budget, say, 1% of the portfolio, well, then what does that mean from an empirical standpoint, from the technicals? And what does that mean from the standpoint of the fundamentals? Like, that's the thing that's always more nebulous. People go, well, the fundamental says the risk is whatever. But what we do is we say, okay, we're going to have to quantify this, and we're going to speak the same language, right?

So, we're going to put it in a scale from one to five. What does that mean from one to five? If technically a fundamental, we put that together, then we have a common risk score, if you will. And from there, we say, okay, now we know what our risk budget is, right, how much we could put at the maximum. Now, how much are we going to use right now? Well, that depends on what the opportunity score is. What is the evaluation of it? What do the technicals say? Combine those together, and then that tells you what percentage of the overall risk budget you can use in that opportunity.

So, it's really bringing those two things together. But then there's another filter on top of that. And that filter has to do with diversification. Because if we have a lot of things that are looking really good, for example, in one sector, let's say it's the energy sector, well, we're only going to take a certain amount of that. We're not going to just let it go as far as it can go, vol everything saying you need to own bunch of energy, because then, we're outside of our risk budget.

So, we want to look at return, risk and correlation. And that goes back to our last discussion about the overall portfolio process, but risk budgeting starts with the like how much you can do at max, return tells you how much of it you're going to use, diversification limits that so that you don't get outside of your overall portfolio objectives.

JAKE MERL: Louis, that was great. Thanks so much for joining us.

LOUIS LLANES: You're welcome. Glad to be here.

JAKE MERL: That was Louis Llanes of Wealthnet Investments and for Real Vision, I'm Jake Merl.