How Game Theory Can Reshape Portfolios

Steve Cucchiaro talks about a new approach to building portfolios from the asset class up.

Reviewed by: Matt Hougan
Edited by: Matt Hougan

Steve Cucchiaro is a legend in the ETF industry. As the founder of Windward/Windhaven, which he sold to Charles Schwab, Cucchiaro pioneered the concept of an ETF strategist—an institutional-quality asset manager that would provide high-quality ETF portfolios to other advisors.

After leaving Windhaven in 2014, Cucchiaro took some time off to “head into the lab” (in his words) and think about how to reinvent portfolio management for the modern age. The result is recently launched 3EDGE Asset Management, which uses game theory to interpret and react to today’s turbulent world.

Cucchiaro, who is delivering the closing keynote address at the forthcoming Inside ETFs conference, taking place Jan. 22-25 in Hollywood, Florida, recently sat down with Inside ETFs CEO Matt Hougan to discuss what he’s working on.

Inside ETFs: What is 3EDGE Asset Management, and how did it come about?

Steve Cucchiaro: During my time off, I had a chance to reflect on the changes taking place in the world, particularly the unprecedented monetary stimulus that’s come into the markets.

That’s affected the markets in ways we’ve never seen before. It’s unprecedented, and there’s no historical analogy. So that got me thinking about ways to understand and model portfolios that don’t just rely on the past, as there’s no past to rely on in this case.

We found that the best approach to understanding this new world was to apply multiplayer game theory to better understand how some of these new players like central banks and fiscal policy stimulus would interact with the markets.

Then we use those insights to build portfolios using ETFs, to take advantage of the fact that while stock picking is a very efficient process, asset classes continue to be inefficient, with regular mispricings.


Inside ETFs: What is multiplayer game theory, and how would it apply to the Fed or the new Trump administration?

Cucchiaro: The thinking goes like this: We’ve never had the kind of monetary stimulus we’ve seen since the financial crisis, and we’re likely to see significant fiscal stimulus as well soon.

Thinking about how to manage portfolios in this world, we realized we needed to learn how central banks were impacting the markets, how the markets were impacting central banks, and so on.

The application of multiplayer game theory is similar to what military planners do when they simulate a war that’s not like any war that’s happened in the past. They make an assessment of the state of the battlefield, they look at the players involved, they look at their resources, and they play a war game.

They look at how one action causes a reaction, and they play two to five rounds. By playing successive war games with different assumptions, they get a much better understanding of what’s going to happen in such a complex environment.

That’s something we’ve carried over into the financial markets. We’ve actually played different roles and war games, and played them over many rounds, and that’s informed the algorithms we use to drive our portfolios.

Inside ETFs: What are the inputs you’re considering right now? [Editor’s Note: The interview was conducted in December]

Cucchiaro: No. 1, the Federal Reserve is looking to embark on a policy of tightening. The question is how much more tightening they telegraph over the next several months, even as other central banks are still easing. We see the contrast between the tightening of monetary stimulus and the unleashing of fiscal stimulus as a critical contrast to consider.

So we’re looking at the impact of tax reform and infrastructure spending on the market. Rising interest rates and deficits could be fine if growth rises to a sufficient degree to justify those higher rates. But if that growth doesn’t materialize, it could lead to stagflation and a very different outcome than most people are anticipating right now.

One of the failures of the recent monetary stimulus is that, while it succeeded in raising asset prices, it didn’t create the growth people hoped for.

Now the hope is that fiscal stimulus raises our animal spirits and drives growth forward. We’ll be measuring whether or not that’s true by looking at money velocity, which fell sharply after the financial crisis and never recovered. If we see a significant growth in money velocity, that’s a sign growth will be robust and it’ll all work out.


Inside ETFs: I’m hearing a lot of notes of caution and concern in your position. Are you just naturally cautious, or are you more cautious than in the past?

Cucchiaro: Equity markets have been in trading range for a long time, and recently broke to the upside. Sometimes when that happens, you get a behavioral response with people piling in because they don’t want to be left behind.

There was a lot of cash sitting on the sidelines, and we could see this equity market benefiting from all that cash coming into the market. We’ve been anticipating this rally that we’re enjoying currently, and we’ve described this first phase after the election as the “hope phase.”

But we anticipate there will be a “reality phase,” when we get to see if all these expectations for growth are true, and if we get enough growth to justify the higher interest rates.

It’s hard to say when the reality phase will kick in—there’ll likely be some honeymoon phase after the inauguration. But by looking at things like money velocity and other signs of growth, we hope to have a sense of the timing of that reality phase.

We’ve been looking at the prospect of an equity market meltdown if that growth doesn’t materialize, because at the end of a long bull market, valuations can become very stretched.

Inside ETFs: Is it a real possibility to get through this whole phase of massive quantitative easing and have no significant negative repercussions?

Cucchiaro: If I were to paint the best-case scenario, it’d be that these so-called animal spirits kick in and corporations truly pick up capital investment. That would be a big departure from what we’ve seen over the past few years, and 3-4% growth would be a wonderful way to offset the rise in the deficit that we’ll see down the road.

Skeptics will say, however, that given the demographics we have, it’s a dream to say we’ll get growth rates of 3-4%. From studying market history, I know that sometimes psychology actually can help change the real economy. So there is a possible route where it all turns out great. We don’t think it’s the most likely scenario, but we do think it’s a possibility.

Inside ETFs: You said earlier that asset-class mispricings are more likely than individual stock mispricings. Why is that?

Cucchiaro: I think this really justifies why ETFs are so important. It goes back to research I’ve done over decades. Markets are micro-efficient but macro-inefficient. There is so much information about individual stocks these days and so many people are using it; that’s why it’s become harder and harder to beat the market through stock picking over time.

On the other hand, the markets themselves are part of a complex nonlinear dynamic system, and it’s much harder to understand the behavior of such a system. Like any complex system found in nature or physics, the market fluctuates in different stages of disequilibrium, going from overvalued to undervalued and back and forth as it gets buffeted by different market factors and economic factors.


Because it’s so much harder to understand the dynamics and feedback loops and time delays in the markets, you’re much more likely to find mispricings and therefore alpha than you are trying to pick individual stocks.

That’s something I felt strongly about many years ago, and others—Paul Samuelson, Robert Shiller—have published papers coming to the same conclusion.

That’s why I’ve always believed asset classes and market indexes are the way to build portfolios and not individual stocks. That will be true until there’s no one left picking individual stocks.

Inside ETFs: With the massive political trends we’ve seen—Brexit, Trump, etc.—is that creating more uncertainty and opportunity than in the past, or does it just feel different because we are in the moment?

Cucchiaro: Sometimes people have a tendency to think that we live in such an uncertain time. But you can go back to any time in history and so many things have happened that are even more uncertain—World War I, World War II, the Great Depression. It’s good to keep some context in mind when you think about that.

That said, the part that’s really unprecedented is that we have this major experiment with central banks and low interest rates and massive balance sheets. That hasn’t happened before, and that’s created a real level of uncertainty. Thinking about how central banks—and now governments—will impact the markets in this environment is something we’ve never had to do before.

Inside ETFs: One last question from the “this time it’s different camp”: How should people be thinking about bonds in their portfolios today versus how they thought about them over the past 30 years?

Cucchiaro: We think right now there’ll be a lot of surprise from investors who over the past 30 years have lived in an extraordinary time for bonds with falling interest rates. We think that period ended this summer.

If you’re used to bonds being a safe source of income because not only did they have fixed income but they had principal appreciation, all of a sudden this’ll be turned upside down.

As people look at their statements and see the principal value of their bonds decline, I think they’ll be shocked that they could lose so much in a bond portfolio. With interest rates so low, they don’t have the interest income to make up for it.

People have to learn that the next 35 years won’t be like the past 35 years, and bonds won’t necessarily be that safe a source of income.

In 1981, at the end of the last rise in interest rates, no one wanted to be in bonds even though yields were in the double digits. At the end of this bull market, everyone wanted to be in bonds even though yields were not much above zero.

We see the mirror of what happened in 1981 happening in 2016. We think people should be cautious about what to expect from bonds.


Inside ETFs: If you were an advisor looking at the year ahead, what are the hairy awful things lurking on the horizon that you should be worried about, or is the next year going to be OK, as we are still in the hope phase?

Cucchiaro: There’s no guarantee the hope phase is going to last too many months, so I think there’s a significant chance for a lot of upset. Because the central banks have provided so much monetary stimulus since 2008, I think they pulled returns from the future to the present, hoping that would create economic growth that never materialized.

We believe that, over the next several years, we’re facing a low-return world, and that a portfolio structure that might have worked well in the past—relying on the stock and bond market to produce returns—might not work so reliably going forward.

The good news is the markets fluctuate from overvalued to undervalued, as I said, and there’s an opportunity to still do well in a low-return world by focusing on asset classes that are not only undervalued, but poised to appreciate due to a potential catalyst. If you can build an ETF portfolio that takes advantage of those opportunities, you can get a decent return even in a low-return world.

But there’s a lot to be worried about. The bond market could continue to suffer; we could have an equity market meltdown; we could have a bear market. We have a lot of geopolitical uncertainty.

China has a housing bubble that’s worse than any housing bubble we ever had. You have trouble in Italy with an election crisis, and in France. As these countries become more nationalistic and remove themselves from the euro, there could be big instability in Europe that could cause ripples through the economy.

There are certainly lots of black swans out there to worry about.

Inside ETFs: Any hints about what appealing undervalued asset classes we should be buying today, or do we have to wait for your talk at Inside ETFs on Jan. 25?

Steve Cucchiaro: I look forward to giving you our best ideas at the upcoming Inside ETF conference, and thanks again for speaking with me.

3EDGE Asset Management works with individuals, advisors and institutions in an effort to deliver strong portfolios. For more information, check out

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Matt Hougan is CEO of Inside ETFs, a division of Informa PLC. He spearheads the world's largest ETF conferences and webinars. Hougan is a three-time member of the Barron's ETF Roundtable and co-author of the CFA Institute’s monograph, "A Comprehensive Guide to Exchange-Trade Funds."