Episode #17: Michael Philbrick, Adam Butler, and Rodrigo Gordillo, ReSolve Asset Management, “It’s About Risk Allocation, Not Capital Allocation”
Guests: Michael Philbrick, Adam Butler, and Rodrigo Gordillo run ReSolve Asset Management. Mike has over 20 years of experience in investment management, including 6 years as a Portfolio Manager. He is responsible for investment decisions, coaching, and strategic leadership, and has co-authored several whitepapers. Adam has 10 years of experience in investment management, including 7 years as a Portfolio Manager. He is primarily responsible for research efforts related to the management of investment portfolios. And Rodrigo has 10 years of experience in investment management. He’s responsible for investment decisions, business development, and has co-authored several whitepapers and research.
Date: 8/25/16 | Run-Time: 59:18
Summary: Episode 17 starts with the guys from ReSolve discussing how they view asset allocation and top-down investing. They start with the global market portfolio which is the aggregate of what every investor in the world owns, yet interestingly, nearly no individual investor allocates this way. They then adjust the global market portfolio by striving for balance, specifically, risk parity. They discuss how leverage enables an investor to scale risk and target a specific volatility level, therein equalizing the portfolio. Risk parity gets you to start thinking about risk allocation instead of capital allocation. And this is helpful as “you’ve always got something killing it in your portfolio…and always got something killing you.” The topic then moves to valuation. The guys from ReSolve tell us how they see today’s market—near the peak of a cycle and expensive relative to history. What does this mean for returns over the next 10-20 years? They think 1-2% real. This leads to a discussion about the Permanent Portfolio and its pros and cons in various markets. Then Meb doesn’t miss the chance to bring up gold, as he suggests Canadians love their natural resources (ReSolve is based in Canada). Next, Meb asks the guys their thoughts on currencies. Here in the U.S., it’s rare that we factor currencies into our investing decisions, but it can be more of an issue for many non-U.S. investors. The conversation circles back to risk parity, this time in the context of bonds, and where yields might be going over the next 5-10 years. There’s plenty more, including managed futures, assorted risk premia, and an announcement from the ReSolve guys about a new service offering. What is it? Listen to episode #17 to find out.
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Links from the Episode:
- Free Resources
- Risk Parity Solution Brief
- The Importance of Asset Allocation vs. Security Selection
- Adaptive Asset Allocation – Butler, Philbrick, and Gordillo
- Trading Front
- “The Asset Allocation Debate” – Vanguard
- ETFs May Actually Make Weak Players Weaker – Econompic Data
- This IS the Global Market Portfolio – Faber
Running Segment: “Things I find beautiful, useful or downright magical”:
Transcript of Episode 17:
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Disclaimer: Meb Faber is the co-founder and chief investment officer at Cambria Investment Management. Due to industry regulations, he will not discuss any of Cambria’s funds on this podcast. All opinions expressed by podcast participants are solely their own opinions and do not reflect the opinion of Cambria Investment Management or its affiliates. For more information, visit cambriainvestments.com.
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Meb: Welcome to the show, everybody. This is another summertime episode. We have an interesting and different episode today where we have three different guests in two different locations in a separate country. Welcome to the show Adam, Michael, and Rodrigo.
Michael: Happy to be here.
Rodrigo: Great to be here.
Meb: So for the listeners, today we have…you’ll be familiar with them through either their blog, GestaltU, or company, ReSolve, and their website is investresolve.com. But Adam Butler, Michael Philbrick, Rodrigo Gordillo are the managing directors, founders, CEO, president, all that good stuff of ReSolve. And I’ll tell you what, why don’t you guys…one of you all maybe give us a quick background on your firm. How you came to work together, why in the world you’re in cold Canada? And then we’ll get into the good investing stuff.
Michael: Cool, I think, really, the idea in conceptualization of ReSolve was born out of the 2008 financial crisis. And it was the realization that certain things work and are very important, and certain other things aren’t. And that really set us off on the path to do more what worked and really think about that very deeply and approach that from a very quantitative perspective.
I think that launched us through a path of a number of different firms which eventually let us to be our own independent firm about a year ago. In fact, our one-year anniversary is September 1st.
Meb: Congratulations, very cool. And are you guys all from Canada, originally Canadians, from different places, and where are you now?
Rodrigo: No, we’re not. Rodrigo, of course, a Latin American name. I’m Peruvian and I’ve spent half of my life in Peru and the other half over here in Canada. The immigration policies here were much easier than anywhere else. And I think you could say that Mike and Adam are from Canada, but I don’t know if like, you know, a farm boy from Niagara-on-the-Lake and a new fee from the East Coast would qualify as an average Canadian?
Michael: Doesn’t get any more Canadian.
Adam: Between, that’s for average.
Meb: All right. Well, I expect a lot of friendliness out of this conversation. Well, look, let’s go and start diving in. You guys have been famous and you put out a lot great content including the book “Adaptive Asset Allocation: Dynamic Global Portfolios to Profit in Good Times – and Bad.” And typically y’all’s focus is on what we called top-down investing. And what that means for the listeners is investing based on asset class levels or sectors or industries rather than bottom-up investing which maybe picking individual stocks and whatnot.
So why don’t you guys start with kind of thinking about, and you’re talking about in your book, you know, starting from kind of the basics of a 60/40 portfolio which is 60% stocks, 40% bonds, and then the global portfolio, and then kind of how you guys think about top-down investing in general, and then we’ll segue probably into little more of the dynamic tilts, etc.
Adam: The basic fundamental recognition is that asset allocation completely dominates long-term portfolio outcomes, right? There’s a pile of research out there, most of it is really misunderstood. For instance, study’s [SP] a perfect example where the original research claimed that 90% of returns were explained by asset allocation, then everybody came aboard and said that asset allocation is responsible for 90% of performance. And then it is when the CapLinked came out and blasted a bunch of those myths.
But I mean, anyway, a slice in asset allocation is the dominant theme whether it’s 50% or 2/3rds or 90%, whatever. Asset allocation is what matters to long-term portfolio outcomes, right? So that was number one. So once of you realized that, then it’s okay, well, how do you effectively move into asset allocation.
And, you know, once you start really digging into some of the more advanced asset allocation techniques and realizing that 60/40 works really, really well in some economic environments but really struggles in others, then you start to wanna broaden your scope and you wanna think more globally. And so that was really the starting point for our journey.
Meb: If you look at the Global Portfolio almost no one invest in the Global Portfolio, the global market portfolio, which is roughly, and I’m gonna paraphrase here, around 50% global stocks, 40% global bonds, of which a chunk is corporates, so you could actually say maybe it’s 55/45 and then maybe 10% other. But it’s pretty darn close to 50/50 stocks bonds but with a tilt towards stock. No one invests in that and there’s probably reasons why. You guys talk a little bit about this, maybe you could speak as to your ideas there and also the inherent biases that people have and how they implement it.
Michael: Yeah, that’s an interesting one. I love the whole idea that the global market portfolio is the combination of all the world’s bias, right? Every country on the world suffers from a pretty significant home country bias and that combines into a global market portfolio which no one is tracking towards.
So I think one of the main reasons no one uses it is because of the massive tracking error between what they might think is their goal or what their friends are doing versus what that portfolio is achieving. And that leaves, I think, a pretty substantial opportunity for investors. So when you think about considering all the asset classes out there, I’m pretty sure most portfolios don’t include things like emerging market, sovereign bonds, or, you know, international real estate as pieces of a well-diversified portfolio that will add benefit in the long-term.
Meb: And so do you guys start with that as, is your starting point the global market portfolio? How do you think about starting to construct these global portfolios? And two, you may wanna talk a little bit about, you know, our buddy Jake at econompick [SP] wrote an interesting blog post recently that has been widely circulated. Do you all wanna go down that alley?
Adam: Sure, I’ll take a crack at that. So let’s start with where we start with the asset allocation process. As you say the global market portfolio is the aggregate portfolio of what everybody owns, but no single investor actually owns it. So it’s this strange concept. But the way we think about the global market portfolio is as the only passive global portfolio. Literally, the only passive true expression of a passive, efficient market view is this global market portfolio. And it is, from that perspective, really the only passive benchmark as in not active benchmark for a multi-asset solution. So we actually use that as our benchmark for all of our multi-asset strategies.
Meb: You guys need to pick an easier benchmark, that’s a…no one in the mutual fund world picks a…that’s actually a tough benchmark to be. You guys need to pick like LIBOR plus 100 basis points or something.
Adam: That’s so true. And so many people choose like U.S. 60/40 or some people actually just choose S&P 500 as their benchmark for a global diversified tactical strategy. And then it just means you’ve got five years of massive tracking your…and probably massive underperformance especially, for example, over the last six or seven years. Anybody, any tactical or global strategy that’s picked the S&P 500 as a bogey has been taken out back and shot, right?
But, you know, we just tried to pick a benchmark that was truly reflective of the opportunity set. Right? These are all of the assets that are available to investors to allocate to, and we just take the average allocation of everybody’s views and that becomes our bogey. And then where we deviate from that in a systematic way, then we expect to earn an edge on that. So that seems fair.
Meb: So let’s talk a little bit about your process about how you do deviate because if someone wanted to just go by the global portfolio, they can do that for very cheap, what people will consider to just be global beta.
How do you actually…you know, you’ve done a lot of research reports that we’ll link to some in the blog, but one in particularly that I liked recently about risk parity. Can you explain a little bit about the thoughts about how you now construct these portfolios, also talk a little bit about the theory of what risk parity is in general for the listeners that aren’t familiar?
Rodrigo: So going back to the global market portfolio, the first thing you got to do is say, “Okay, this isn’t a passive benchmark. Any deviation away from this is an active bet.” So how do we best make those active bets? Well, that 55/45 portfolio, it may seem that it is contributing the same amount of risk to the client’s portfolio. But in reality we know that the equity side of that dominates the volatility of the other portfolio.
In fact, when you measure it, you know, depending on who you’re citing, the equity side represents 90% to 98% of the volatility of that portfolio. And the bond side of the equation offers very little in terms of diversification benefits. The global market portfolio, the first thing that it does is it allows you to get exposure to a broad array of risk premium, global asset classes that will do well in different market environments.
So you may own some gold, some commodity, driven economies, you’re gonna have some bonds, government bonds that are gonna do well in a deflationary environment, so that’s step number one. And then step number two for risk parity is to make sure that there’s balance. And balance happens when you observe the volatility of each asset class and their correlations to each other.
All right, so the tradition of risk parity methodology looks at long-term estimates correlations and volatilities and gives a higher waiting to those lower volatility and more diversified asset classes than the riskier asset classes like equities and so on. So if you look at a traditional 60/40 portfolio and if you wanted to risk balance that, you’d look at something like 80% bonds and 20% equities. And then depending on what return you’d want, you would then lever that portfolio up.
Meb: Let’s talk a little bit also, maybe comment on leverage. And if you go back to investment theory that’s been around 57 years, and talking about the efficient frontier and the capital market line, the best way that people want to invest is defined the highest essential sharp ratio portfolio, which will often be these risk parity type portfolios. And I think Bridgewater used to talk a lot about this, is that there’s no reason to accept asset classes prepackaged the way they are.
So if you wanna go buy the S&P 500, you get, you know, let’s call it…we’re rounding up at 8% return, 15% volatility. There’s no reason to accept that. You could say, “Well, I want stock exposure, but only at half the volatility so I’m gonna put…I’m going to de-lever that down.” So I’m gonna be targeting say 4% returns, but it’s 6% volatility. Or you could leverage it, and the same thing with bonds. And so one of the things about risk parity was equalizing either the volatility so you’re gonna say, “I’m gonna target 10% volatility for all asset classes.”
And so once you start to think that way, it’s a very fundamental shift for a lot of people, then you can design the portfolio and then lever up or down the entire portfolio to whatever desired level of volatility or risk you want. So maybe talk a little bit about how you all think about leverage in constructing these portfolios, and then we can also talk a little bit about your dynamic shifts or tilts as well.
Adam: The thing about leverage is that it just allows you to scale risk. And so the fundamental shift that a person goes through when they begin to think in terms of risk parity, is they begin to think in terms of risk allocation instead of capital allocation. And this is a fundamental shift and how you think about every aspect of portfolio management. And it’s so critically important for such reasons that Rodrigo highlighted, right? Because you wanna have an allocation to this wide variety of different global risk premium that behave differently in different economic environments.
So you’ve always got something that’s killing and eating your portfolio because it’s really perfectly aligned with the current economic environment. You’ve always got something that’s killing you in the portfolio because it’s exactly the opposite of what would thrive in the current economic environment within the balance of the portfolio as it’s chugging along normally as if nothing’s irregular. You get this sort of steady performance through thick and thin. But the problem is that all these different, you know, diverse asset classes have very different risk characters.
So if you think about them on an equal capital allocation basis, then what ends up happening is that the more volatile assets, that by the way also tend to be more highly correlated with one another, end up completely dominating the risk of the portfolio. So the portfolio ends up being completely susceptible to the economic environment that, for example, equities do well in.
The other asset classes that do well in different regimes have no opportunity to exert their benefits when those regimes actually manifest. So it’s this risk interpretation instead of a capital interpretation that really defines that transition to risk parity. And then we actually view all asset allocation methodologies through this risk glance.
Meb: You know, one of the things I think is the big challenge for people, one, is they don’t necessarily have a large appreciation for history particularly if they’re younger. So a lot of people aren’t thinking about, particularly in the U.S., highly inflationary environments, and so often have under allocations to asset classes. They did great in that sort of rising inflation environment or even a rising bond [inaudible 00:15:45] environment which hasn’t happened here in 30 years.
Canadians in general, you all tend to think about natural resources a little bit more than I think Americans do, but trying to build a portfolio that can respond in any environment, I think, is critical because what happens with a lot of people is, you know, an asset class will do great for a few years, or terrible, and so emerging markets and commodities in the last three years have done horrible. And then they abandon those asset classes when it [inaudible 00:16:11].
So talk…and you guys do a little bit, it’s not that just you’re allocating to a risk parity portfolio, you’re actually dynamically managing that or actively management. Can you talk a little bit about your process moving away from the buy and hold?
Michael: I think it’s also, just to finish up on leverage. One of the things that everybody is told is about the avoidance of leverage, right? You can own the S&P 500 which has got a debt-to-equity of 2 to 3 and that’s okay, but God forbid, you lever a well-diversified and balanced portfolio. Which is, I think, one of the key things to consider as well as a persistent edge. There are willing losers who would rather contaminate their portfolios with more equity in order to try and achieve a return rather than lever a diversified portfolio. I think that’s a key point to the way we think about leverage as well.
Building on that to think about the idea of how we might dynamically overlay some thought process on risk parity in order to improve their returns. We think about that from the perspective of what Adam mentioned earlier and the idea of if you’re really well-diversified and you’ve got assets exposed to all of these economic regimes that can manifest, you’re gonna have something that’s killing it and you’re gonna have something that’s killing you.
And now you wanna overlay a process in which you think about those really negative returns that are very serially correlated and persistent where you’ve got an asset class that just not persistently goes down, and you wanna just think about a way in which you could back away from it. Not eliminate it from the portfolio, but just reduce the exposure to it overtime and have a process that is not an on and off process, but more of a…I’m thinking about it in the probabilistic way what might the positive returns be, what might be the magnitude of those. And if they’re going to be…let’s say it’s a 70% chance that those returns are not gonna be positive, you would reduce exposure to that asset class by 70%. And that’s the way we think about dynamically overlaying a process in the portfolio that improves the result.
Rodrigo: And that’s where the…so the risk parity methodology is dynamic and the fact that we’re looking at an absolute momentum filter like Mike described. But we’re also, versus other more traditional risk parity approaches, we understand that the correlation and volatility numbers change drastically from month to month and they deviate drastically from the mean.
So we also observe volatilities and correlations consistently and adjust the way it’s based on those changes, and then we deemphasize asset classes in a consistent negative trend. Our flagship solution actually does an even stronger tilt and it’s looking at a relative momentum. So instead of always been invested in all asset classes this is a…our adaptive asset allocation framework actually eliminates asset classes altogether while still keeping the asset classes that we hold keeping them in balance by observing the volatilities and correlations.
So we’re just looking at the universe more often and we’re applying momentum factor on both, and then maximizing diversification by optimizing for risk parity.
Meb: All right guys, interesting. This shifts to how often are you guys looking at these portfolios to make changes. Is it daily, weekly, monthly, quarterly? What’s the kind of updates that you all implement?
Michel: Depending on the mandate we look at it in different ways, right? So we have an ETF that we launched in Canada that…just for operational reasons. And you know what, the statistical difference between looking at something daily and trading daily is very small, but in this particular product we look at it on a weekly basis. And we balance as necessary. We’ll rebalance, but it’s not always necessary. A risk parity is much slower moving.
The fund that we run in Canada and the mandates that we run in the United States in separately managed accounts, we’re observing that universe more often on a daily basis. But again, we don’t trade unless…then you suggested allocations that are statistically significantly different than the old ones, right?
So there are some times we’re not trading all for a month, a month and a half, and some times where we’re trading a few days in a row if things are changing quite drastically.
Meb: Maybe we’ll shift gears a little bit here, but in your book you guys also talk a lot about valuations. So my first question is does valuations come into play at any point in your portfolio construction process? And then two, would love to hear a little bit about how you guys construct your valuations for, say, for U.S. equities and any global equity market, and then what those estimates would say now.
Adam: Meb, let’s face it, you’re sort of the king of updating these global valuation metrics and I follow your publications on that every time that comes out, it’s great. Especially with the CAPE stuff. And valuation is such a contentious topic. You know, everybody is using valuation or mostly will use valuation basically just to confirm whatever their market view is, right?
So, you know, you’ve got these studies that come out from some of the investor banks with 12 or 13 different valuation metrics, but most of them only go back to 1986, right? You know, you’ve got sort of 30 or 40 years of data where…like, people need to remember that in 1994 the market went into a complete phase transition, right? Where we had never observed market valuations in history prior to 1994 like what we observed after 1994. And then once it busted through that top in ’94, it just kept going and going, and doubled and doubled again. Right? And so, of course, at the peak of 2000 we had the most expensive markets that we’d ever seen in the U.S. The most expensive markets to my knowledge in the last century were in Japan in the very late ’90s, the peak of their bubble.
Our study showed that if you use a very long history for U.S. stocks, and I think your analysis confirm this too, that stocks go through these very long cycles where the price-to-earnings ratio or the price-to-book or whatever, the valuations, the multiples rise, rise, rise for 15 or 20 years. We go through this secular multiple expansion, and then we peak, and then we go through this long secular multiple contraction that rise and fall of the valuation multiples actually account for the vast majority of the variance in returns from year to year and from decade to decade, right?
And so all we did is we say, “Okay, well, let’s look at these valuation multiples. Let’s find ones that have very long histories,” like the cyclically adjusted P/E ratio from Shiller that you always talk about, the Q ratio that you can actually get from the Fed’s at one rapport [SP], the market cap to GDP, few other things. And then look at them on a variety of different scales and a variety of different forecast, horizons, what have you.
See what seems to work about the best and then when you put it all together, you get what you kind of expect which is we’re at near the peak of a cycle, stocks in this…especially in the U.S. are expensive relative to history. And we know that valuations versus returns are kind of like a see-saw, so you get expensive valuations, you get lower future returns. Right?
Now, it doesn’t mean that the market is gonna crash tomorrow, probably it doesn’t. But over the next 10, 15 years for those who are trying to put together capital market expectations for retirements, a sustainability of institutional corporates etc. Well, they can use these to inform their expectations and budget accordingly.
Meb: And so y’all’s composite valuation metric I think has one of the lower expected return projecting’s…what are you guys projecting right now for 10, 15 years, U.S. equity market, and I don’t know if you track it for other markets. You can comment there too if you do, but for U.S. what are you expecting a nominal or real base is next 10, 15 years?
Adam: Well, we’re actually in the process of updating it. We’re gonna automate the report and we’re probably gonna publish it every quarter. We actually haven’t updated it since [inaudible 00:24:32] 2014. You know, I’m gonna guess just based on where we are relative to then the fact that earnings have continued to rise a little bit while valuations have…or sorry, the price of the S&P has stayed relatively the same, maybe a little bit higher, that we’re looking on the order of sort of 3% or 4% nominal, 1% or 2% real over the next sort of 10 to 20 years.
Meb: Okay. Well, that’s not too doomsday-ish. Do you guys calculate this for any foreign countries at all or put in the plans?
Adam: No, it’s tough to do the foreign countries because you don’t have the same length of data. So it’s even for the U.S., if you take a cyclically adjusted P/E ratio that uses a 10-years smoothing factor and you wanna then forecast for 10 years, well, if you’ve got a 130 years of data going back to 1880, then you’ve really only got 13 independent samples, right? So the statistical significance of your forecast is actually not very strong, just gives you a general direction. There’s not a lot of precision in the estimate. And then if you’re using data that only goes back to the mid ’80s or ’70s or what have you to find the equilibrium value for other countries, then, obviously, the forecast becomes statistically meaningless.
You could use the U.S. equilibrium, but there’s pretty good arguments to be made that different countries that don’t have the reserve currencies won’t have the same equilibrium valuations that the U.S. market will have. And so there’s all these extra variables that you’d have to account for. So we just don’t bother, we figured the U.S. market is whatever, 50% will go to the market cap so it’s pretty indicative of what investors should expect generally.
Meb: It’s interesting because if you think about these really long-term secular moves in valuations, etc., and the Japanese example you gave is spot on and, you know, in the ’80s, Japan hit the highest CAPE ratio we’ve ever seen and at a value of almost 100. Whereas the U.S. was a measly 45 in ’99, and it’s back down to 25 now, so, of course, much lower.
One of the cool things about studying history, one of my favorite charts in your book is that you examine asset allocation models. And we actually talked about this in the last podcast where we say one of the most sacred rules in investing people assume is that equities were outperformed bonds. But there’s been very many periods of 20 to 40 years in the U.S. where equities don’t outperform bonds. And there’s a couple of markets right now where over the past, I believe, 20 years, Japan being one, Canada being another, where bonds and stocks have roughly the same return.
But the chart you have in your book is…you say, “Look, let’s apply some asset allocation models in Japan.” And again, Japan is the second largest economy in the world, now maybe third, but it demonstrate how they would have performed, because, you know, most traditional asset allocation models in Japan would have done horrible over the past 20, 30 years. But you showed something like using a more global approach and the permanent portfolio. Maybe you talk a little bit about that and the kind of Japanese playbook because it also looks like the U.S., and a lot of the world is starting to look a lot more like Japan over the past few years.
Adam: Absolutely, you know, the Japanese model, the experience of Japan over the last 30 years, I don’t think it can be discounted that the developed world is in the process of experiencing some very, very similar dynamics as Japan. And that’s why we felt the Japanese example was maybe more relevant today than many people would like to admit.
I mean, you’re right, the permanent portfolio which includes both cash and gold and then…so just to rehash, right, permanent portfolio classically from Harry Brown was 25% cash, 25% gold, 25% treasury bonds, and 25% stocks. Of course, Japanese stocks over the past 30 years or more are down about 60% or 70%, but the permanent portfolio delivered positive compound returns over that period. So, again, just another example of where thinking about diversification from an economic regime standpoint can really pay off.
Michael: I think it’s worth stating though, that is the diversification that you like. And if you think about the permanent portfolio from an American’s perspective over the last, I don’t know, 5 or 10 years, that’s the diversification you don’t like. And it’s a strange thing because you have this opportunity to be diversified in a permanent portfolio and we highlight Japan, but an American investor today looking at that type of diversification may have shun that because their 60/40 has done so, so well.
Meb: It’s been almost everything. You know, it’s funny, if you look at permanent portfolio in our book, we examine all these different portfolios and permanent portfolio is one of the most stable. It was one of the lowest performers if not the lowest performer, but that’s to be expected because it has half the portfolio and cash and bonds. I wanna hear what’s your-all’s perspective on gold? Most of the Canadians I know are up there with…our friends in India, they love gold, you know, more than anything. Is this something…one, what’s your-all’s perspective on, and you included in the portfolios…anyway, what do you all think about gold?
Michael: I think Canadians first of all, you know, if you ask a barber for a haircut, he’s gonna tell you you need a haircut. And a Canadian economy based largely on resources will, if you ask Canadians, will largely tend to skew towards wanting to be bullish on resources. We’re global in nature so we don’t think that way at all.
Meb: We, as in ReSolve?
Michael: Yeah, we, as in ReSolve. But I think we were all probably chuckling as you mentioned gold. And I think from the perspective of the permanent portfolio, the reason it was included was just to be true to what Harry Brown had laid out.
Adam: Yeah, and yes, and Canada, I would say peak oil theory, hyperinflation, the world is gonna come to an end and commodities and gold seemed to be a strong storyline. And especially now that gold’s revived itself a little bit, it’s getting…all the old guys that hadn’t said much for a couple of years are now starting to pipe up again.
Meb: Well, I’ll be giving a speech here in Vancouver in about a week or two so I will pleasantly see what kind of polls I can have on the ground there. But, yeah, it seems, my experience when I go skiing or chat with my fellow Canadian…or friendly Canadian. Sorry, not fellow…is similar. All right, let’s…
Michael: Let’s just…We think of gold as a unique return stream and a diversifier. So that’s how we think of it. We have loads to talk about it as Canadians, because everyone will remember what we said and they will just sit on the edge of every word on gold and tosses it. If it adds diversifications has a good return and trend, it will be in the portfolio. If not, it will be out of the portfolio. Though, you know, talking about it just is a losing conversation.
Rodrigo: You should see how happy the Canadian advisers we were talking to are now when they asked how much gold you have in your portfolio, and we just have 20% allocation, we just added a 20% allocation. They couldn’t be happier, even though it could be gone tomorrow.
Meb: It’s one of the more polarizing asset classes because you have on one hand someone like Buffett who talks about it being a pet rock, and then someone like Ray Dalio, largest hedge fund in the world, who talks about…he’s like, “If you don’t invest in gold, you don’t understand history basically.” So it’s…of all the asset classes it’s one of the more polarizing, you know, and it was one of the few that really helped in the ’70s. I mean the ’70s sucked for investing with stocks and bonds unless you had a lot of inflationary assets like commodities, emerging markets perhaps, if you could even allocate to them then, or gold in particular, the ’70s was really tough.
One of the things you guys talked about is…there’s a couple of more topics I wanna touch on that I thought was interesting, is you talked a little bit about portfolios but also the sequence of returns and particularly for retirees. And this is a topic that our investors are very interested in, and we haven’t talked much about. Maybe you all could touch a little bit on, you know, your topic in the book of sequence of returns and how and why that matters.
Rodrigo: It’s interesting to think about the average investor, risk taking investor that has the majority of their money in equities. You know, I think they’re generally prepared to take some volatility and some underperforming years in order to achieve something close to a long-term expected return.
But the problem is that those negative years or negative periods can last a lot longer, a lot longer than what they normally think they would. And in fact, we outline a period from 1966 to 1997 where the Dow Jones annual is at 8%, right, on average? But from 1966 to 1982 the returns were 0, and from 1982 to 1987 returns were around 16%. All right, again, on average it’s like having your head in the freezer and your feet in the fire, right? In the middle you’re just right. On average rate what you have these very different periods. And somebody that retired in 1982 without even trying would have left a huge estate. Somebody retiring in 1966 would have run out of money within 7 years. Right?
So these are the things that happen when you concentrate your portfolio in a single asset class. My father concentrated all his portfolio in a single asset class which was cashed in the safest bank of Peru in 1988 right before inflation went from 20% to 7,200%. I mean, he could have used some gold there, he could have used some U.S. equities, some other asset classes.
All right, so the point we’re trying to make in the book is that you need to…one of the reasons you need to move away from a single asset class is because you’re gonna reduce the amount you lead to luck by simply being diversifying the [inaudible 00:34:42].
Meb: I think that’s pretty powerful. It’s worth buying the book alone just for that chapter. How do you guys think as Canadians…you know, a lot of our U.S. listeners are used to the U.S. being half the world’s portfolio, being the reserve currency. How do you guys think differently as Canadians about your portfolio and currency exposures?
I mean I traveled the world and, you know, Americans, God bless them, think less about currencies than anyone else because usually they don’t have to for the most part, but almost every other country, one of the first topic is always what’s going on with their currencies. And you just mentioned a very relevant example of inflation and hyperinflation. How do you all think a little bit differently than perhaps your American counterparts?
Michael: Well, you have to consider what is the home country that someone is spending in. But other than that you still need to think about your portfolio from a global perspective, maximize the opportunity for diversification to prevent those large drawdowns, and to reduce the opportunity that you go through one of those long periods of no returns and lots of volatility like the 1966 to 1982 period.
And so when we look at our portfolios, we actually consider the Canadian Dollar, U.S. dollar relationship sort of like another asset class. It moves dynamically. It’s informed both by the cross rate of the currency as well as what the current portfolio holds. That’s something that is unique to Canadians. Canadians, Australians, South Africans, all of those countries around the world who’s not the reserve currency…the U.S. dollar is not the reserve currency.
I think if I’m an American, I really don’t have to worry much about it until it’s not the reserve currency of the world. It probably provides an opportunity of some kind from a portfolio perspective, but I think it would be somewhat limited, most of the return…well, not most, in a portfolio you get the return from the asset class that you’re considering as well as the currency, so the Japanese stock market is a combination of Japanese stock returns in the Yen, as an example. And those due benefit portfolios from a return and diversification perspective.
Meb: One of the biggest criticisms of risk parity is, you know, that it’s had a large tailwind from global interest rate. It’s moving from, you know, double digits down to the single low digits now or even negative. And I imagine your dynamic models is the answer to this, but how do you think about risk parity sort of portfolios that usually by definition end up putting you more in fixed income investments than traditional portfolios? Is that something you guys think about, what’s your solution to that, is it something you don’t worry about? What’s your thoughts?
Adam: Well, I’ll tell you, not one conversation comes up about risk parity where we don’t talk about the fact that it overweights bonds, and that we’re at, you know…but depending on how you measure it, millennial low rates, right? So there’s a couple of different considerations. The first is the tailwind that bond investors have experienced over the past 30 odd years, 36 years, has also benefited every other asset class with cash flows, right? Because when you value an asset class, any asset class anywhere, you value it on the basis of the discounted value of future cash flows. Well, the discounted value is based on a discount rate. Well, the discount rate is the treasury rate.
Now, the different asset classes have different durations, and you’ll use different terms of treasury markets to discount, but at every term the discount rate has steadily dropped for the past 30 odd years. And so every cash flow market around the world has had exactly the same benefit from that tailwind as bonds have themselves. And so that’s another reason why we think that returns going forward are gonna be a lot lower because, you know, this very, very low discount rate has been priced across all different asset cases.
The other thing to think about is that risk parity, although it has a large capital allocation to bonds, is no more sensitive to interest rate risk or inflation risk than to any other type of risk. That’s the whole concept of risk parity, right? You got an equal…you’ll do equally well in a deflationary growth environment as you do in an inflationary stagnation environment. Just because you’ve got this large allocation of bonds doesn’t mean that risk allocation in the portfolio is heavily weighted to bond. Instead what happens is, you know, a very good year for bonds might be, like a 10-year treasury bond, might be up 10% or 12%. A very bad year might be down 10% or 12%.
But when bonds go down 10% or 12%, then something else on the portfolio will also have a good year. Well, a good year for gold is up 30% or 40%, or stocks is up 25% or 30%, right? So those other asset classes will provide ballast to the bond side if, in fact, we do go into a period of steadily rising rates. And you know, of course, there is no guarantee, not by a long stretch, that we’re gonna see rising rates anytime soon, you know, for the next 5 or maybe 10 years or longer.
Meb: Here’s a good example on that, and by the way, it’s very clear that you’ve heard that question before. It may touch a nerve. But a fun example, there’s two parts to this. One is that, you know, we say once Japan went below 2% nominal yield which was, I believe, in the late ’90s, they haven’t gone back above, you know, it’s been below ever since. And the other example was, I was reading article by Seth Klarman the other day, the manager of Baupost, called…it was in “Forbes” or “Fortune,” called “Don’t Be a Yield Hog,” or “Don’t Be a Yield Pig,” where he’s basically saying, you know, people are chasing into yield, don’t chase into yield.
That article is from the early ’90s. And so it’s good example of people, you know, how long have people been saying, you know, “Bond yields can’t go lower. We got to protect our portfolio against the rising rate environment.” Well, shit, that might not happen, and you know…I mean, who knows? It could happen next year, it could happen 10 years from now, it could happen 20 years from now. And so a bond portfolio we’ve always found even in certain rising rate environments can be a great buffer, like you mention, to the other asset classes.
All right, a couple of other topics. You guys, I believe, recently announced a new initiative partnered, I think, with one of our buddies we’ve had on the podcast. You guys wanna talk about that?
Adam: Yeah, sure. You know, we built out ReSolve and then started garnering some interest from both U.S. advisers and U.S. individuals. Now, for the advisers, it was pretty easy because we could partner up with them directly in one way or another. But for the individual investor there wasn’t really a clear solution.
Now, luckily this quant space is pretty small and as we search for a delivery mechanism in one of our conversations with Wesley Gray from Alpha Architects who I know you’ve had on that podcast before. Awesome dude, great gut leader in the quant space. He introduced us to the Robo-Interface that he and his partners had developed. I think they’ve now since spun that business of into its own entity called TradingFront. But the brilliance behind this interface is that as a quant manager like us, we need to be able to offer that institutional execution and on the trading side.
And we need that to deliver the solutions in a robust way for smaller accounts as well, and the only way that we can do that is through Interactive Brokers as a custodian. The problem with that is that Interactive Brokers while it’s great for trading and it’s great for fees, it’s not necessarily great for client on-boarding and reporting. So this marriage between the TradingFront user interface and Interactive Brokers institutional trading and razor-thin fees allowed us to really provide something that is of value to the American investor. So within a couple of weeks we’ll be able to provide access to our product lineup, and it will be based on an individual’s risk profile which mandate we will recommend. And, of course, for those individuals qualify for the use of leverage will be able to hit different risk profiles using our core mandates with intelligent leverage.
Meb: And so you guys…let’s expand on that to the extent you can. So you’re not gonna just be offering one portfolio, you’re gonna be offering multiple solutions. And if you can talk about it, how you’re going to actually be doing the leverage because I think people find that particularly interesting?
Adam: Sure. It is a tradition of Robo and that they’re gonna have to answer…individuals are gonna have to answer a questionnaire. And based on how they answer they’re gonna be bucketed into different risk profiles. And risk parity without leverage is a 6% bulk product so it actually makes sense as a core solution for low risk individuals.
And then we move up to our database allocation framework which takes more concentrated positions and asset classes, and that one would be for a medium risk investor. And then we also have this tactical equity mandate that excludes some of the lower returning asset classes intakes and more concentrated bet in the highest risk premium asset class, which is equities, but reduces a tail risk by an absolute momentum filter. Right? So they will fall into one of those three buckets. Then they’ll have the option in saying, “Well, you know, I’m okay with leverage.”
If that happens and they qualify for leverage and we’ll be able to use our flagship product and use direct leverage from…so we will borrow directly from Interactive Brokers. Whatever amount is needed in order to hit the volatility target. And of course, that 12% volatility, which is a balance portfolio volatility, we’ll be able to use leverage only when it’s appropriate to do so, right? So when diversification is really good and the optimal portfolio has little volatility, we’ll use leverage and lever into that 12% target.
And when volatility starts to spike, we’ll actually reduce leveraging, even go into cash in order to keep that daily volatility experience that the client signed up for a consistent. And the same thing would go for a 16 volatility target profile.
So we’re really trying to bring the idea of a noble price, the idea of the capital market line, the efficient frontier and apply leverage to high/short portfolios that eliminate…that reduce tail risk much more than what you would get from being 100% invested in equalities in order to give the investor a better chance of surviving in the low return environment.
Meb: And are you guys doing that thing you mentioned with ETS, are you doing it with single stocks, are you doing it with…what’s the underlying portfolio look like?
Adam: Our building blocks are exchange-traded funds. They are the most liquid, cheapest, exchange-traded funds in order to get access to the asset classes that we need to.
Meb: You know I like to hear that. Interactive Brokers, by the way, for listeners, one of the most criminal practices of a lot of traditional brokers is if you look at, even the big names, Fidelity, Schwab, probably E-Trade, and look at their margin rates for investors to borrow. It’s often just…I mean, it’s like 8%, 9%, 10% in a world of 1% interest rates. Interactive Brokers is often fed funds plus, you know, 50 or 100 basis points, whatever it may be, it’s much more reasonable. So if you’re using leverage, by the way, investors, at a traditional broker, please go look up what the margin rates are because it is often atrocious.
All right, maybe one or two more questions and then we’ll start to wind down. Do you guys think about Managed Futures at all? Do you allocate to that sort of asset class, and if you don’t, any other ideas you’re working on in the current research cue?
Michael: That’s funny. Yeah, we are big fans of CTAs or Commodity Trading Advisors and their funds. We generally like the trend following versions that are quantitative in nature and we do allocate to one here in Canada for our client portfolio. So we’re big fans. And, you know, we were having a discussion today about, you know, what would have more evolved [SP], a 60/40 balance portfolio, or a 60/40 portfolio of 60% stocks, 60% CTAs…
Rodrigo: Forty percent CTAs.
Michael: Forty percent CTAs. And then thinking about what would the correlation between stocks and CTA have to be in order for it to have a lower [inaudible 00:47:39] in the 60/40 stock bond. Anyway…
Rodrigo: There’s no doubt that the big benefit…there’s no argument that the tail risk will be much lower, right? CTAs have a tendency to do really well when everything else is doing really poorly, when trends are really strong. We really like trend as a factor and their ability to short which is something that we don’t do ourselves, so we’re big fans.
Meb: Anything else you guys are working on in the research cue that we have to look forward to or any other studies in the blog, any more…gonna do any more books, anything on the brain?
Adam: We’re gonna be digging more into this sequence of returns issue that we talked about before. Is it talking about actual case examples where the risk parity concept, even a simple implementation like a strategic implementation, and then, of course, we’ll also walk into some of the more advanced methodologies as well. But just this concept of true diversification and balance can have a profound impact or the probability of a positive financial outcome, right? The probability that clients can edit his or her financial goals.
And I think there’s also a lot of need opportunities in the future space either a complement to the existing strategies that we run or as completely new solutions. We’ve taken the view with our strategies, because we’re all long only, right? We’re asperities [SP] long-only, adaptive asset allocation is long-only. I know you guys run long-only strategies as well. And by impaction what we’re saying really is that we believe fundamentally that these asset classes that we’re allocating to will have or should have long-term positive risk premium. Right?
We should expect positive returns from these assets over time. Whereas the Managed Futures strategy takes the view that the…they’re agnostic, that they don’t think that there’s any higher probability of earning a higher return, or a positive return, or a negative return on the assets that they allocate to. So, you know, if we do an attribution analysis on the type of global tactical asset allocation strategies that we embrace and that I know you embrace, Meb. What you see is about half of the returns come just from exposure, this long exposure to the underlying risk premium, and then the other half comes from the systematic factor bets, the momentum bets, or the value bets, or how do you at a multi-asset level that we put on, right?
So I just think it’s important for investors to have a grasp of what their implicit…what implicit beliefs they’re expressing by investing in the solutions that they invest in. And you got to…that’s the starting point. And then once you’ve…you understand what you believe and then how to best express that, figure out what the weather in AF [SP] and how you might wanna deviate from that in an intelligent way.
Meb: Cool. Well, guys let’s start winding down. We always ask our guests, and there’s three of you, so I don’t know if you want one answer or three, but something that others may not have heard of that you find beautiful, useful, or somewhat magical. You all have anything for us today?
Michael: All right, so I tried to think about things that have really changed or enhanced my life. And one of the things that I can’t live without anymore are my Bose noise reduction earphones, so these are the ones that sit inside the ear, and they are the only version of a noise reduction headphone. If you travel on any kind of subway to and from work, you’re probably not gonna throw a big headphones over your ears. And these ones work fantastically well, even when you don’t want the noise reduction, the clarity and the detail that you can hear in your music is a huge enhancement. So that has been life-changing for me.
Meb: Are these traditional wire or are they Bluetooth yet? Are you still wired into your…
Michael: They’re wired in. They’re not Bluetooth, and that…maybe we should send a letter to Bose to get them to do a wireless version.
Adam: You know they’re on it already. You know they’ve been working on it for five years, right? They just need to get it exactly right.
Rodrigo: Mike likes them so much, he likes them so much that he buys a new set every two weeks that loses it.
Michael: Yes, and before any listener goes out and buys them, there’s different versions for Android and Apple.
Meb: Good to know.
Michael: [inaudible 00:52:12] in the right one which I have made. And they’re like 350 bucks, so, yes, I have multiple pairs.
Meb: Good to know. Anything else from you guys?
Rodrigo: Yeah, I have a cheaper option. You know, I’m a father of two girls, four-year-old and a two-year-old, and a lot of what we do requires us to read, right? So I tried to find time in my day to manage the team and also go back home, take care of the kids, take care the wife, and read the material that I need to read is nearly impossible. So I’ve taken to, you know, audible and podcast like yours, which I love, but there’s an app called Natural Reader where you can…it has a built-in browser.
So whenever you’re browsing, if you’re reading an article or a blog online, you can just let it read it to you while I’m driving or, you know, if I’m cooking for the family, I have it on my earphones, it reads it out to you. White Papers, you put a PDF in there, it reads it all out to you. So, you know, I’m an audible learner, and I think anybody that has an inclination to that should pick it up. So Natural Reader is an app on the iPhone.
Meb: What do you listen to that on?
Rodrigo: What do I listen to that on, what do you mean?
Meb: Your Bose quiet comfort?
Rodrigo: No, I can’t afford it. I lose my stuff every two days.
Meb: And can you select like Canadian accent on that?
Rodrigo: You can actually.
Meb: Latin, Peruvian accent.
Rodrigo: You can select different voices, male, female, different accents, yeah, yeah.
Michael: It [inaudible 00:53:40] in there too.
Rodrigo: That’s right.
Meb: Anymore, is that a third or are you finished on that side?
Adam: Yeah. Mine was a nerdy one and I’m not even gonna spend any time on. But I think open-source programming has been the single greatest life changer for me over the last three, four years. Just learning R and Python and all the different packages and functions and stuff that other people produce to do all kinds of really cool shit is absolutely mind-blowing. We make use of it in every single dimension or our business, not just from the perspective of development and strategy deployment, but for reporting, for dynamic updating of reports like this expected future returns report that we’re gonna develop every quarter now. We’ve just got a script written in R that’s gonna aggregate data from all the different sources and automatically generate it with no human intervention and it just gets posted. It’s just amazing.
Meb: That is literally my worst nightmare. I had sat through about one semester of C++ in college and it was the most physically painful course I’ve ever taken. So kudos to you, but programming for me is so incredibly difficult. I admire those that can do it.
All right, well, mine is a little bit different. I went skiing in Japan this year which very few know has some of the best powder in the world, you know, Canadians may take that personally, but they get a ton of snow. And returning from Japan almost feels barbaric. And then they have the most amazing toilets in the world. So were talking heated seats. They have like 19 different functions that anyone that has been over there can remember, but there’s a particular brand I believe called TOTO, and you can get a little off Amazon and…not an adjustment, you can get a little kit to put on your toilet. You need an electrical outlet, but it is a life-changing situation. Once you’ve sat on a heated toilet seat, you’ll never go back. So that’s slightly weirder, but a huge suggestion.
All right, guys. So look, a lot of fun today. I wanna encourage you to keep cheering for the Canadian Dollar to go down. I really wanna go to the Powder Highway. It’s like top on my bucket, Whistler, Revelstoke, and Kicking Horse and some of the resorts around there. But where can people find more about you guys? If they wanna read more, where is the best places?
Rodrigo: Just as in aside before we do that, just so you guys know, we almost named our company Revelstoke Asset Management so that’s…
Meb: Oh, cool. Have you all skied there?
Michael: At Kicking Horse, yes, Revelstoke, no, Whistler yes.
Meb: All good spots.
Michael: I have been out there, yeah. It’s awesome. Yeah, you’ll love it.
Michael: You can reach us at investresolve.com. You can also connect at the blog, gestaltu.com. We also have a designated site to learn more about risk parity at riskparity.ca.
Rodrigo: And reach out to us on Twitter, we’re all there. Just look us up, Google us, and we always answer everybody’s questions.
Meb: You guys should have hit me up about five years ago when I was selling the riskparity.com domain name.
Rodrigo: That was you?
Meb: It went for a lot more. That’s a good story for another time. I would have sold it for the price of a surfboard which was their first offer for like 500 bucks, and it’s in anonymous bidding process. And I ended up selling it for a decent five-figure amount because rightfully so thought it’s either some yahoo that just wants to buy it for a blog, or it’s a probably big-money manager and they ended up hitting the…they ended up paying for it. So for something I probably would have sold for $400, ended up selling for a lot more. Good story.
But now I own risk parity if you want that, maybe risk party. Anyway, all right. All right, guys, look, it’s been a lot of fun. We’d love to have you back on in the coming months or years. For the listeners, you can always find the show notes, we’ll link to a lot of these links for their website as well as a lot of the papers in their book “Adaptive Asset Allocation.” You can find that at mebfaber.com/podcast.
If you liked the show, please suggest it to your friends, leave a review on iTunes. And you can always send us Q&A and feedback for the episodes at firstname.lastname@example.org. Thanks for listening and good investing.
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