Episode #231: Julian Klymochko, Accelerate Financial Technologies “The Democratization Of Alternatives, It’s Happening, But It’s Something That Does Not Happen Overnight”
Guest: Julian Klymochko is founder and CEO of Accelerate Financial Technologies, a firm delivering institutional-caliber hedge fund and private equity ETFs ranging from absolute return strategies to private equity replication to arbitrage.
Date Recorded: 6/17/2020 | Run-Time: 1:13:09
Summary: In today’s episode, we’re talking liquid alts and democratizing alternative strategies that have been tapped by the world’s largest institutions for decades.
We get into the current state of liquid alts and hedge funds, and the standardization and commoditization that has come with increased competition. We talk about merger arbitrage. Julian offers a story about a 2014 trade that went awry when he was running his first hedge fund, adding color to some of the mechanics and risks inherent in the strategy.
We key in on private equity, dig into the lack of mark-to-market appraisal of holdings, and how this strategy can be replicated in public markets. As we wind down, we discuss the opportunity in the future for flows to work their way from complex, high fee alternatives, into low-cost liquid alts.
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Links from the Episode:
- 0:40 – Intro
- 1:40 – Welcome to our guest, Julian Klymochko
- 5:38 – Current state of liquid alternatives
- 8:33 – Beat the Market: A Scientific Stock Market System (Thorp, Kassouf)
- 10:48 – Blog and twitter (@JulianKlymochko)
- 10:50 – The Art of SPAC Arbitrage (Klymochko)
- 13:03 – Accelerate’s arbitrage strategy
- 16:07 – SPACs
- 21:49 – The Ivy Portfolio: How to Invest Like the Top Endowments and Avoid Bear Markets (Faber, Richardson)
- 22:40 – Merger arbitrage
- 22:52 – The First Time I Lost $1 Million (Klymochko)
- 28:13 – State of M&A in 2020
- 30:35 – Accelerate’s approach to private equity
- 31:46 – Yale Endowment Report
- 33:28 – Replicating Private Equity with Value Investing, Homemade Leverage, and Hold-to-Maturity Accounting (Stafford)
- 39:57 – Illiquidity premium
- 48:42 – Should Harvard’s Endowment be Managed by a Robot? (Faber)
- 48:56 – Long-short equity hedge fund
- 52:43 – How conversations with advisors typically go
- 58:20 – Other topics that Julian is fascinated by: crypto
- 1:05:01 – Most memorable investment
- 1:07:22 – Favorite strategies over the next 12 months
- 1:08:06 – With Markets At Record High Valuations, This One Investment Strategy Can Help Diversify Your Portfolio (Klymochko)
- 1:11:41 – Best way to connect with Julian: twitter (@JulianKlymochko), accelerateshares.com, medium, seeking alpha, Absolute Return podcast
Transcript of Episode 231:
Welcome Message: Welcome to the “Meb Faber Show,” where the focus is on helping you grow and preserve your wealth. Join us as we discuss the craft of investing and uncover new and profitable ideas, all to help you grow wealthier and wiser. Better investing starts here.
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.
Meb: What’s up podcast listeners? We got another good show. Our guest is the founder and CEO of Accelerate Financial Technologies, a firm delivering institutional calibre ETFs, ranging from absolute return strategies to private equity replication to arbitrage. In today’s episode, we’re talking about liquid alts and democratising alternative strategies that have been tapped by the world’s large institutions for decades. We get into the current state of liquid alts, and hedge funds, and the standardisation and commoditisation that has come with increased competition. We talk about merger arb. Our guest offers a story about a 2014 trade that went awry when he was running his first hedge fund, adding colour to some of the mechanics and risks inherent in the strategy. We key in on private equity, dig into the lack of mark-to-market appraisal of holdings and how the strategy can be replicated in public markets. As we wind down, we discuss the opportunity in the future for flows to work their way from complex, high fee alternatives, into low-cost liquid alts. Please enjoy this episode with Accelerate’s Julian Klymochko. Julian, welcome to the show.
Julian: Thanks, Meb. Happy to be here.
Meb: Where is here? Help our listeners place you, where in the world are you today?
Julian: So I’m up in Calgary, Alberta, Canada. It’s a pretty chilly day here.
Meb: Did they cancel the Stampede this year?
Julian: Yeah, unfortunately, I think the first time since one of the world wars and that’s a huge advent, gets tons of tourists, and a big blow to the city but definitely understandable with the whole coronavirus pandemic. But I’m fortunate because it’s a hell of a good time.
Meb: You could probably do some safe distancing at Cowboys. That’s the big bar. I was at the Stampede a few years ago for a bachelor party. Everyone got to play Canadian cowboy, dress up for the weekend, and it felt like a Canadian Colorado to me, honestly, similar vibe to Denver. It reminded me a bit. You’re from there originally?
Julian: No, originally from Winnipeg, Manitoba, which is right in the middle of Canada, north of North Dakota there. So moved out here back in the big bull market of 2007. Perfect time to go through the first financial crisis of my career, which was a great learning opportunity before I had too much money to lose.
Meb: Yeah, my only ski day this year would have been at Lake Louise. It wasn’t this year, I guess it would have been in 2019 but a beautiful country up there. I want an excuse to get back for sure one of these days. All right, we’re gonna talk a lot about a lot of fun stuff today. Lot of thing alts. Give us a little origin story real quick before starting your current company. Where’d you come from? You said 2007 was a good vintage. Give us a little background.
Julian: I grew up in Winnipeg, Manitoba. Pretty normal childhood, solidly middle class, grew up skateboarding and things like that, snowboarding for what we could do in the prairies, which wasn’t a lot. So I was keen to get out west because I was really kind of passionate about snowboarding, had some family living out here as well. Finished up University, studied electrical engineering and finance, and got a job with one of the main Canadian investment banks. So I started out as an investment banking analyst working the 90, 100 day weeks. One time I actually did stay up three days in a row working on a file in Beijing, China. So it was quite the formative experience and I guess, actually warped my vision of work-life balance. But nonetheless, I thought it was a great experience, a great place to start the career. So did that for a couple of years, the analyst program there. And after that, went to the buy-side to a little kind of startup hedge fund here in Calgary, it’s called Ross Smith Asset Management, and rose to the ranks, became Chief Investment Officer, ran a number of strategies there on behalf of credit investors, institutions. Specifically, we ran American mutual fund for 10 years, multi-strategy market neutral, which I could get into that, ran an arbitrage fund for six years and also in 2017, started the country’s first cryptocurrency fund, which was an interesting experience as well. So always been involved in the alts space, then 2018, launched Accelerate, so looking to do something innovative in the alternative investment management sector.
Meb: Awesome. Well, we’re gonna dive into all those things here in a bit and starting a north of the border Canadian ETF shop. I’m excited to hear about that. One of my favourite games to play, I used to have a Canadian roommate back in the day would be kind of, like, the how dumb is the American friend, relative to our neighbours to the north where we play? How many of the Canadian provinces and territories can you name? Is there, like, 12? Is that the right number? Ballpark?
Julian: Yeah, I think you’re right. It seems like they’re changing it all the time with what’s going up at the territories up north…
Meb: Right on. Most Americans could usually get about two or three. That’s not what we’re gonna talk about today. Today, we’re gonna talk about alternatives, in general, and you spend a lot of time I think, being a lonely voice on Twitter, almost, with a lot of your strategies, which many investors I think would find esoteric words like market neutral, event-driven arb, SPACs. First of all, what’s kind of the current state of liquid alts hedge funds in 2020? Give us a broad overview of kind of how you’re thinking about the industry. And then we’ll start to dive into some of the specific strategies as well.
Julian: That’s a great question. And alternatives, in general, have really grown over the past, say 30 to 40 years. If we go back to way, way back, Warren Buffett running Buffett partnership kind of in the 1950s, 1960s, then he kind of had a decline of the hedge fund industry in the 70s. Then the 80s, things really picked up with the emergence of private equity, the leveraged buyout, which really came to the forefront in the late 80s. You had hedge funds coming to the forefront back then as well. And over the past kind of 30-ish years, we see a standardisation of specific alternative strategies where you can really kind of bucket risk-reward expectations of a specific mandate. For example, leveraged buyouts, they’re expected to beat the market, i.e. the S&P 500 specifically because it’s generally more leverage small-cap and value names within the leveraged buyout sort of bucket. So you can expect higher returns but higher risk, higher volatility. Then there’s about kind of 10 main hedge fund strategies which have really become standardised, for example, merger arbitrage. It used to be a really niche strategy executed by a handful of specialist firms, and they could earn generally very high returns because it was kind of secretive back then, not many knew how to conduct that sort of strategy.
But as we’ve seen is kind of this democratisation over the past number of decades, specifically over the past 10 years, where in the U.S., you have now, I believe, three merger arbitrage ETFs, and you do have a passive merger arbitrage index by S&P. We launched an arbitrage fund up in Canada. So that’s there now. And it’s really just merger arbitrage portfolios across different hedge funds. They’re not all that different. Then if you look at long-short equity, that’s fairly standardised as well. Many, many firms doing sort of multifactor long-short, which is what we do also in the absolute return space. You can kind of say the same thing for market neutral, we feel like a convertible arb, that secret’s been out for quite a while. If you look back when “Beat the Market” came out, which was, like, a really, really influential book on the street which got investors interested into convertible arb, warrant arbitrage. And back then, you didn’t even have the Black Scholes formula in terms of pricing optionality. So how one would trade warrants and how one would trade convertible securities, convertible bonds, convertible debentures, was really secret. And the guys who could figure out the secret back then, just made an absolute boatload of money. If you remember, the firm that started trading convertible or warrants and convertible bonds, I believe…what were they called in Manhattan? They were out of California.
Meb: I mean it’s even Thorp’s firm, Newport…?
Julian: Oh, yes, Newport. Yeah.
Meb: Oh, Newport something but I don’t think they even ever had a down quarter.
Julian: Yeah, exactly. So he basically figured out the secret to trading warrants and convertible securities, basically figured out the Black Scholes model on its own prior to getting published and they could just mint money during convertible arbitrage. But now, you look at their returns back then, 25% annualised, and as you indicated, super, super consistent, rarely, if ever, having any sort of down periods. And now you look at convert alt funds these days, you need to use just an absolute ton of leverage 7x, 8x, even 10x leverage, just to squeak out moderate single-digit annualised returns, just because it’s become standardised and extremely competitive. And you see that all across the alternatives space, bucketed strategy that many, many people know the secrets and therefore, competition has increased. And with competition, once things get to a certain point, the last sort of frontier in terms of competition is on the fees. And so that’s why you’re seeing ETFs and other sort of liquid alternatives come out with these specific strategies and compete on fees because the secret on how to execute these strategies, it’s out there. Like, it’s known by people like myself, and it’s becoming even more popular because I write about all of this on my blog and my Twitter feed. I put out a post over the last month that’s become quite popular. It’s called “The Art of SPAC Arbitrage.”
And I guess people read it and kind of have their eyes open to this interesting new field that they didn’t know existed, that kind of used to be sort of secretive, but it’s out there and people know it, and it’s pretty cool. I’m a big fan of the Warren Buffett quote, he says, “Teach a man to fish, feed him for a day. Teach a man to arbitrage, you feed him for life.” There’s just a ton of cool investment strategies that go above and beyond just your standard 60/40 equity and bond portfolio. So there’s a lot more to investing than just, say, buying Apple or Microsoft or these days, Tesla and Nikola. So the other thing that’s kind of a high growth industry these days is liquid alternatives. So if we look at where the growth is, you know, it’s certainly not in the mutual fund side, which is kind of a sunset industry, but ETFs is growing like crazy, alternatives, still growing like crazy. However, it really depends on the specific segment. Obviously, if you’re running a short only fund, real tough business ever since 2009, you had a just a wicked bear market specifically for U.S. large-cap equities. So it’s been a real tough time being just a straight-up short seller. However, we are seeing significant growth in a number of different alternative mandates. And if you marry that growth with the growth of ETFs, you can have this liquid alternatives market. And really, that’s where we’re focusing our efforts, is the democratisation of this space, making it really easy to use, liquid, transparent, and ultimately, low cost.
Meb: There’s a couple comments on some of the things you mentioned. By the way, the name of the Thorp fund was Princeton Newport, I looked it up real quick. But you also commented on Buffett. And it’s funny because everyone always assumes Buffett just buys these high-quality companies and holds them forever. But if you look at his history of investing, I mean, it’s been derivatives, and currencies, and…
Meb: …options, arbitrage, all these other strategies that you would say, “Wait, that sounds like a hedge fund.” And people just aren’t that familiar with kind of his history. So kinda the arc of what you’re talking about with hedge funds, in general, seems to be, and this is the way that it should be, of course, is that it goes from being kinda secret high alpha to as it becomes known about and more competition, it gets commoditised. And the challenge with that is it often pushes down the curve of fees from 2 and 20 or if you’re still a medallion, 4 and 40, all the way down to kind of more reasonable fee structures. Let’s get into a few of those strategies. So I’d like to talk about all the ones you guys manage. Pick one first, maybe the simplest we can talk about, and then we’ll kind of get a little more esoteric as we go. Your pick. What’s a good one to start with?
Julian: Yeah, I think arbitrage is kind of a crowd favourite these days. It’s a really intriguing strategy. It’s been around for many decades. As you brought up, Warren Buffett was a practitioner for many, many decades before Berkshire ultimately kind of became too large to execute on that sort of strategy, where he sort of pigeon-holed himself into large-cap equities. But if you go back and read the Buffett LP letters, he was conducting a significant amount of arbitrage. And that’s ultimately where he earned his highest returns in percent basis. And if we go back even further, to the Ben Graham days, he was conducting arbitrage as well. So it’s a strategy that’s been around for a long time. And me, I started out my career doing closed-end fund arbitrage, which is a really interesting trade. The way that it works is a lot of closed-end funds trade at discounts to the value of their underlying holdings, their net asset value, and so you can effectively buy the closed-end fund, short all the underlying securities and hope to earn that spread in Canada. And this is different than in the U.S. is that generally closed-end funds offer a redemption at net asset value at least once per year.
So that’s kind of, like, a rock-solid arb, where we could earn great returns even throughout the credit crisis of 2008. And our market neutral fund that was stuffed with closed-end fund arb opportunities, it’s one of the few funds that’s actually up this year. So closed-end fund arbitrage is one sort of arb. We don’t have it in our current arbitrage fund, but that’s one. The main sort of arbitrage strategy that we conduct is merger arbitrage. And the sort of little brother of that strategy is SPAC arbitrage, which is pretty new to the market, the emergence of SPACs, which are special-purpose acquisition companies. It’s now a $33 billion asset class. It’s kind of becoming significantly more popular these days. If you look at a number of high flying stocks, such as Nikola, then there’s that DraftKings, that betting company, and the space one, Virgin Galactic, those all started out as SPACs, and they’re becoming more and more popular. Social Capital has now done three of them. So, Chamath, the founder of Social Cap…
Meb: Just to interrupt you real quick, explain to the investor essentially how a SPAC works? What that means.
Julian: The way that a SPAC works is they do an IPO, Initial Public Offering, where they raise typically anywhere between 50 million at the low end. Now, some SPACs are going out at a billion dollars. There’s actually media articles on Bill Ackman potentially coming out with a billion dollar plus special purpose acquisition company. So they call them blank check companies. They raise a bunch of cash, and then they have a timeframe to do a business combination, i.e. buy a private company, which effectively takes this private company public. So typically they had between one to two years to do a deal. And then they just keep the cash in short dated treasuries, typically 180 days. And so as a SPAC investor, the IPO is for units, and units consist of common shares, plus warrants. And then where the arbitrage comes in is that either at the end of the light, they’ll liquidate, pay you the cashback plus accrued interest. So basically if you’re buying an arb, you get yield of treasuries. If you can buy below NAV, then you get treasury plus that spread or upon yield completion. When they announce the acquisition of a private company, say, when the Social Capital announced the acquisition of Virgin Galactic, there’s a vote. And at that point, you could redeem your shares for cash. But in a hot deal like that, it’d be trading way above its net asset value.
So as an arbitrager, you’d likely sell there, but if you subscribe to the units with the IPO, you get common shares and warrants. You can redeem the shares if the deal goes through, then you have this warrant upside. So it produces some really interesting risk-reward dynamic, such that you basically have downside of treasuries, and equity upside, assuming you buy at the right price. Now, that’s where kind of the expertise and experience comes in because it is a new market and the bid ask spreads in these things can get pretty wide and some crazy stuff can go on. Requires close monitoring. So it’s a strategy that’s fairly labor intensive, I’d say. And then your standard merger arbitrage is also something that’s super labor intensive, but it can get more stressful just because if you look at, especially what’s going on in the current recession coronavirus pandemic, you have an elevated number of M&A deal breaks. So traditional merger arbitrage. You’re really kind of walking on eggshells and you really got to be careful in terms of your asset allocation and security selection to make sure you don’t invest in one of these deals that blow up. If we look at one just last week, Cineplex and Cineworld, that deal fell apart on the traditional merger arbitrage side and now a couple of names are heading to court. If we look at, say, Taubman and Simon in a mall deal, or Advent and Forescout in a private equity buyout deal.
So, merger arbitrage typically has higher returns than SPAC arbitrage but higher stress, higher volatility, just with ups and downs. And SPAC arbitrage, it’s really like a very low-risk strategy that you can get some big wins if a hot deal is announced. And I really think that’s a huge growth area. Over the past three years, SPACs have been growing like crazy. And I made a joke on Twitter that in the next year, so we’ll see 99% of VCs, hedge fund managers, and private equity firms launching their own SPAC. And now you see basically the next week, Bill Ackman potentially coming out with one, Third Point and Dan Loeb, they have one, Social Capital has one. And we’ll see more and more of that where you’ll have different hedge funds, VCs, and private equity firms launching their own SPACs because for the founder of the SPAC, it can be extremely lucrative. I can get into those mechanics as well. And so when the SPAC is founded, all the funds in which investors subscribe to the IPO, typically, it’s $10 per share, that goes into trust and the SPAC cannot touch that capital. And so what the founders do to provide working capital is they subscribe to warrants that are typically struck at $11.50. So you have the IPO at $10, warrants at $11.50. If they don’t get a deal done, that at-risk capital goes to zero because it’s used to fund the SPAC until it either gets the deal done or liquidates.
However, where the prize comes in, and this is actually like a massive prize, and it doesn’t get nearly as much attention as it should, and it’s also the main reason why you’re seeing a lot of enterprising investors such as hedge fund managers, etc., get into it is because they’re awarded these Class B shares effectively for free. It’s like at a fraction of a penny. And the class B shares convert to basically 20% of the proform of company once the business combination is completed. So if they get a deal done, then they’re rewarded with a 20% stake in the business, which something like Virgin Galactic, or Nikola Motors is now likely worth in the billions of dollars. So it’s basically nothing to billions in a couple of years, which, no wonder they’re becoming so popular.
Meb: It’s funny you mentioned Ackman, because I’ve long been an observer and commenter on the big discounts in the closed-end fund world. And I mean, going back to my very first book, we were talking about closing fund discounts. And for the most of the time, they’re not that interesting, but usually, in massive crisis, the spreads can often blow out. And we were tweeting and writing about this in March. And I almost never disclose individual positions. But we were talking about how Ackman’s, for example… I mean, I think it got to, like, a 40% discount to NAV. And part of that, I say there’s somewhat of an Ackman NAV discount. I don’t know what it is just because I feel like he’s often, with the public, not that likable. I don’t know what the right word to describe it is. He kind of gets in his own way…
Meb: Yeah, he goes on CNBC. He starts going crazy every couple of years. Anyway, he’s had an amazing run this year with some of his hedging traits. Anyway, it’s a great example of how these things can get to huge spreads. But this back world is interesting. And you started to talk about M&A a little bit. So talk to us about merger arbitrage. I mean, the basic mechanics of it, the long and the shorting. And then also, you mentioned the risks. And you had a great article I read on your blog about the first time you lost a million bucks, maybe still too painful to talk about, but you just closed it so maybe we could touch on that story too.
Julian: Yeah, I’d love to chat about it. It’s always good to have this painful experience and learn a lesson from it. And so that specific investment was one that had a formative influence on how I conduct a merger arbitrage operation and we do it very systematically. And after that experience, which I’ll get into, we implemented one of our rules. And that rule is, never get into a merger arbitrage trade that has a buy-side vote. And by buy-side vote, I mean a vote on the acquire side, because that acquire side vote effectively puts the acquirer in play. So if you’re long in target, short in acquire, and the acquirer catches a hostile bid, while now, you know, short is absolutely skyrocketing, and ripping your face off, not only that, but your long is now plummeting, just given that deal has likely broken. So that’s something to consider because when the acquirer has to put the target acquisition after a shareholder vote, what are they gonna vote for? Are they gonna vote for the acquisition of a target and issuances of shares, in which likely when that was announced, the stock might have been down 5%, 10%,15% as they usually do, or are they gonna vote for a 50% premium take out?
And so an example of that happening was the first time that I kind of got my face ripped off on that sort of trade was back in 2014. And so I was running an arbitrage hedge fund, kind of roughly $30 million fund at the time, had a decent position in a pharmaceutical merger. And at the time, if you go back to 2014, ton of pharmaceutical consolidation, if you remember, Valiant, Endo, Tax Inversions. Tax Inversions were a trade that were very hot at the time, but Tax Inversion was, and it was really popular amongst pharmaceutical companies, was they were merging with a non-American company to ream domicile offshore as basically a tax arbitrage. Allergan did it, Valiant did it. Valiant became a Canadian domiciled company. Endo did it. And so this trade that was announced in 2014, was Auxilium, a U.S. pharmaceutical company, announced the acquisition of QLTI, which was a Canadian domiciled kind of smaller cap pharma company. So the trade was, it was an all-share deal, you know, long TI, short Auxilium and you hope to earn the spread as the deal progresses, and ultimately flows is fairly healthy spread in the double-digit, probably kind of mid-teens range, which you’d judge as to be an attractive spread. However, Auxilium had to issue so many shares in order to get the deal done that they required a vote of their shareholders. And as I indicated, when you have that buy-side vote, it provides an opportunity for a potential hostile acquirer if they had that company in their sights, perfect opportunity for them to go hostile. And so put on the trade for a decent size.
And I remember my analysts told me after market one day, he’s like, “Oh my God, Endo has come in for a hostile bid on Auxilium at a 50% premium.” And you hear that, and your heart just kind of sinks. And you look at the price action after hours and, of course, Auxillium’s is absolutely skyrocketing and QLT… To remind you, Auxilium is the one that we’re short. And so if that doesn’t suck enough, then the target stock, QLTI, which were long is plummeting. So once the deal is broken, and that certainly broke the deal, Endo went on to successfully acquire Auxilium, you get your face ripped off on the short and you lose a good chunk of cash on the long. And so that’s kind of a rule that we never get involved in that sort of trade again. And after that, I saw a number of other trades blow up hedge funds. If you looked at Williams Partners, WMB, a number of years ago, probably about four or five years ago, they tried to buy their MLP back. And then Energy Transfer Partners, Kelcy Warren, came over the top to buy the acquire. So some arb hedge funds just got roasted on that. And I think about 10 years ago, it happened on a Canadian mining deal. It was Primero and North Gate. So that’s something… If someone is going to run a merge arbitrage operation, that’s a rule that I like to live by. I’m not saying it happens often but 1 out of 100 or 1 out of 50 times it does happen, then it’s pretty painful. And I’ve lived through it. I lost a good chunk of money on that one and you learn from these experiences. That’s really kind of where expertise is built is just doing it, operating this type of strategy, learning from your mistakes, and just improving and getting better.
Meb: And it’s also important to know things like position sizing. I mean, listeners hearing this are probably like, “Oh my God, you lost 30% or 50%.” But because there’s position size, you ended up not losing that much of a percentage-wise.
Julian: Like 3% loss, but that’s still enough to get clients yelling at me for it.
Meb: Painful but not devastating.
Julian: Yeah, exactly.
Meb: All right, so you run a couple of other strategies. Are we done with M&A? Is that kind of we got a good idea of… What’s the state of M&A in 2020? And then we’ll move on to some other ideas.
Julian: Yeah, it’s really interesting. So I touched on SPAC arbitrage, which is growing like crazy and perhaps the best I’ve ever seen it. You still have decent spreads and just a ton of issuance through the coronavirus pandemic, basically 75% of the IPO’s respects. However, on the merger arbitrage, that one’s super, super interesting because we had a big boom up until late February. And then ever since then, there’s been a dearth of deals really not much going on at all, aside from a small handful of biotech deals in the U.S., and a decent chunk gold miner consolidation in Canada. So you really gotta pick your spots. And on the deals outstanding, it’s been a fairly perilous environment. So with the market getting crushed in March, basically all markets, equities, bonds, etc., merger arbitrage wasn’t really spared. You had targets trading down significantly, which opens spreads as wider. You could drive a truck through most of them. And many of them have closed, which were a great money-making opportunities. And April was one of our best months in arbitrage ever, just given the closing of super, super wide spreads.
However, we have seen elevated deal breaks. And a number of really unique situations, the ones that I spoke of, Advent/Forescout, a private equity buyout which the buyer walked away from claiming a material adverse effect. And then Simon/Taubman, same thing, they’re both heading to litigation. That’s really precedent-setting in terms of what is a material adverse effect? How are merger agreements gonna be structured in the future? And can buyers just walk away if the target has a missed quarter or the market is down? So there’s major implications in that market. Other than that, that basically summarises things. We really haven’t seen a bounce back in M&A yet. However, over the past week, I think we did see about three new deals. So it’s kind of we see nature recovering and things coming back to normal a little bit in the merger arbitrage market. And that’s basically a pretty good summary of what’s going on there now.
Meb: Another area you guys talk a lot about that is very near and dear to my heart is private equity. And I’ll just pass you the mic and the floor. Talk to me about private equity, y’all’s approach to it, how you think about that space because it is a monster, monster. When you talk about hedge funds, you talk about endowments institutions, everyone loves private equity. My God. Still loves paying super-high fees. How do you think about it?
Julian: Exactly. And you really nailed it on the head there, Meb, just with massive growth, enormous demand for private equity, even though since 2006, and this report just came out a few days ago, I read it in the “Financial Times” that private equity has not outperformed public equities since 2006 Netta fees. However, as you indicated, these institutional investors, endowment funds, pension funds, etc., are just absolutely starving for private equity. Most endowments now allocate north of 50% of their asset allocation to alternatives of which private equity typically is a large chunk of that. I looked at the Yale endowment report this morning that was north of 10% allocated to leveraged buyouts. And if you look at CalPERS, one of the largest pension funds out there, if you remember a quote by their CIO, Ben Meng, a number of months ago, they’re so desperate to reach their 7% return target. That is telling people that they need private equity, they need more of it and they need it now, just because those types of institutional investors view private equity as this panacea where they can reach these return targets. If we go back to say, 1995, you could earn that 7% to 8% with a relatively conservative portfolio, that was bond heavy. But now with the 10-year yielding, what 70 basis points, it gets quite a bit more difficult, meanwhile, before yielded 7%. So when it goes from 700 basis points to 70 basis points and returned targets of those institutional investors, don’t come down, in fact, stay kind in the 7% to 8% range.
They really, really have to crank up the risk. And there’s no strategy riskier than private equity. However, private equities’ real secret, and this is something that I can kind of wax poetic on all day, is the kind of market to model nature. And I was just kind of laughing at a number of private equity funds that came out with their Q1 results and they’re stating they’re down, took write-downs of mid-single-digit. Meanwhile, the Russell 2000 was down north of 30%, I believe. And so our involvement in private equity really spawned from a landmark paper that came out of Harvard in 2015. And that was on private equity replication. The crux of the paper indicated that private equity can be replicated with liquid public securities and that private equity is based on a three-factor model, and that’s value, size, and leverage. And that’s really where the outperformance comes from, is basically the harvesting of those three factors. So if we look at size, there’s what’s known as the size premium where historically back over the past 90 years, small-capitalisation stocks have outperformed the market. So if you look at the average leveraged buyout, they’re typically buying small and mid-cap companies substantially smaller than the average S&P 500 constituent. And the second-factor value, value factor, which most investors know and some of us love, unfortunately, in this environment, but if we look at value stocks, i.e. those with low multiples, what we like to look at are enterprise multiples.
So based on ED enterprise value to EBITDA enterprise value, to operating income or ED to free cash flow. But typically, leveraged buyouts are done off the EBITDA multiple. And over the past, say, 90 years or whatever your time frame, low EBITDA multiple stocks have outperformed the market. So you have this value factor effect. And then the third factor, it’s not really a factor, but it’s more an effect is that leverage that really provides the secret sauce of leveraged buyout. So you combine the value factor, the size factor, and leverage, and you can get private equity returns, however, replicating it with liquid public securities. The one downside to this, like, you can do it in a systematic and quantitative fashion, which is what we do with our private equity replication strategy, however, we actually have to disclose our returns on a daily basis to investors. And we’re at the whims of the market. And when you’re running a leveraged small-cap value strategy, you can imagine how volatile that is. And that’s been quite a painful trade over the past year or so, because as investors know, small-cap value stocks have been crushed. And when you apply leverage on that, leverage magnifies returns. So it’s making things even worse, where traditional private equity, their sort of secret is that they get to have a market to model. They don’t have to mark-to-market their portfolios every day. Like, if we go back to Thursday, when you had the big drawdown in the market, S&P was down about 6%, small caps down even more. The average private equity portfolio would have been down 10%. But investors are generally oblivious to that.
And the funniest thing is if you look at some of the private equity indices, whether it be the Cambridge private equity index, I believe there’s some others as well, they’re actually claiming a volatility that’s lower than the S&P 500. If we look at public equities, typically 16%, 17% vol, they’re saying the vol of private equity is 10%, which is as crazy. We run private equity replication, and the volatility is kind of north of 30%, which is what you’d expect with leveraged small-cap value stocks. And we run the numbers and we can kind of match up the returns to the traditional private equity index and other firms have kind of done this as well. If you’re looking to factor research, they produced the same stuff, other firms operating similar strategy. Verdad, I believe they are doing something similar as well in the private equity replication side, utilising liquid public securities. But that secret really comes from private equities market to model. It leads to an unrealistic smoothing of returns.
And a guy like Cliff Asness has good reports on this as well, where institutional investors become quite comfortable because there’s so much less career risk if the marks are coming back, and for Q1, you’re showing down 5%. Meanwhile, if you did this in a private equity replication strategy, which will likely get you the equivalent long-term returns or perhaps higher because the fees are a fraction, they don’t have to suffer that career risk of coming in with a big markdown for a specific quarter or a specific month. So the traditional private equity model keeps investors oblivious to the true underlying volatility, and then they’re getting that artificially smoothed returns, which really helps keep investors in the fund not redeeming, because if we look at specifically in Q1, and really, I believe this deserved a lot more press than it actually got.
As I indicated, private equity firms are coming out saying, “Oh, we’re marking down our portfolio a bit, maybe mid-single digit.” Meanwhile, the market was down like 20% at that time in April. And if we look at certain public entities, specifically the business development companies, now business development company, they’re publicly traded, and they typically own leveraged loans to fund these leveraged buyouts and most of the large private equity firms have their own business development companies, Carlyle, Apollo, etc. You can actually see what the real mark-to-market is on the private equity loans, i.e., the more senior securities, typically the secured loans backing these leveraged buyouts are held by business development companies. And some of these were down 50% to 60%, that’s 60% in the first quarter, so how do you think the more junior subordinated equity would perform compared to the loans? Like, it’s not gonna be down 10% when the loans are down 50%. It makes sense to me, but really, no one was talking about it. And they just kind of chose to remain oblivious to the inherent, significant underlying volatility within private equity. So that’s kind of the positives and negatives of private equity replication. You can do it cheaply, significantly lower fees. However, you do need to actually deal with that true underlying volatility, which is significant. I mean, you don’t put together a leveraged buyout fund, where the average LBO is leveraged six times EBITDA, compare that to the S&P, which is about one and a half times. So you’re talking about kind of four times as much leverage. How do you think that’s gonna perform from a volatility standpoint on the equity side?
Meb: There’s surprising, actually, that the SEC and FINRA did a lot of these, like, interval funds in the U.S. where I saw an ad the other day that claimed their volatility was 4%. And it’s billions of dollars invested in this fund. And it’s so misleading that the SEC or FINRA should almost require, hey, this invest in stocks, which have a volatility of this because this only marks at four times a year, they claim this, it’s so misleading, but this whole wink nod. And it’s funny because investors always assume the institutions, the endowments, the CalPERS of the world are the really smart money. And as you mentioned, private equity has had somewhat of a transition. The argument before at least 10 plus years ago was that, “Hey, you have to be in the top decile, quartile of funds. If you’re not, the rest is out S&P-like or worse. So there’s no point in doing private equity. However, we’re capable of picking the top funds.” And that was the argument is that we can be top core tile. But the problem is that there used to be persistence in those funds. And in the past 10, 15 plus years, all the research shows that persistence is now gone. And on top of that, you alluded to Dan and the work that Safra has done at Harvard, and we’ll post the links in the show notes, there used to be a pretty large valuation spread between the private market stocks and the public. But that’s now almost totally gone or inverted, essentially.
Julian: Yeah, exactly. And so that brings up this notion of illiquidity premium. As you indicated historically, if you go back to the 80s and 90s, leveraged buyouts were getting done at kind of 4 to 6 times EBITDA. Meanwhile, the Russell 2,000 was trading at 8 to 10 times EBITDA. So if you could acquire a bunch of private companies, roll them up, you can play that multiple arbitrage. And the way that is explained through traditional corporate finance is the notion of the illiquidity premium. If an asset is illiquid, you require a higher return. And that return is manifested through the lower multiple, the lower valuation that you pay when getting into it. So you could capitalise on this illiquidity premium that was displayed through lower multiples. But as you indicated, you’ve had this massive flood of capital into private equity chasing these returns. As things get more competitive, you have 100 PE firms in a bidding war for one asset, that’s gonna be priced pretty damn efficiently. And then you’ve had this kind of flip flop, such that it’s so competitive now that this illiquidity premium has now turned into an illiquidity discount, i.e., private asset multiples are now at a premium to public equity. And it’s really interesting because you see a big private equity shop like Brookfield. They’re actually now spending a ton of capital into public equities because that’s where they’re seeing the deals. And this liquidity premium, i.e., higher multiples, which if you look at the theory that valuation ultimately drives returns, what you get with higher multiples, is lower returns on a go-forward basis. But perhaps from a theoretical perspective, this makes sense.
And Cliff Asness alluded to this in one of his research reports, in that perhaps, institutional investors are now willing to accept subpar returns just for that market to model kind of smoothed return profile because it does in fact produce career risk if they’re not taking those big kind of mark-to-market hits. If you look at one controversial scenario that happened in the pension fund space this year was actually income. The local pension fund manager in Alberta, they were effectively during this short volatility trade, which dealt with liquid securities, the market plummeted, and they lost kind of $3 billion on that, basically providing insurance to banks on volatility. Hedges had a role for that. It was in all the media, all this terrible coverage. And you had the media saying, “Oh, these guys don’t know what they’re doing. They lost $3 billion, a big mark-to-market loss.” Well, look at how many kind of bankruptcies are happening in private equity space, but that doesn’t really get a lot of coverage because the mark-to-market volatility, it really gets masked just by the structure, the way that it gets market to models. So I believe that we’re in a new sort of paradigm for private equity, where returns are gonna be subpar. However, that’s acceptable because this is trade-off to get this smoothed return profile. But you can still attain those traditional private equity leveraged buyout returns through private equity replication.
Like, if we look at our portfolio, the average multiples four-and-a-half times EBITDA for a diversified portfolio. And I’m sure you’ve read some of the rate research come out these days by a number of firms on the valuation spread. It’s never been wider. I think it’s wider than even the peak in 2000. The difference between the beaten-down value stocks trading at four to five times EBITDA, and then the sort of rock star can never do anything wrong, superstar stocks that everyone wants to own with incredible sentiment, their large-cap growth stocks where there’s this massive, massive premium on growth or even a perception of growth. And if it’s a four times EBITDA multiple stock, no one wants it. And those have really never been cheaper. So it really harkens back to the old kind of 1980s leveraged buyout days, where you can actually get these sort of great LBO candidate type stocks in a liquid form, but I don’t think they’re seeing all that much of those in the private assets basis because it’s become incredibly competitive. You put up an asset for sale, everyone seems to think they have these proprietary deal flow channels. But at the end of the day, 10 million EBITDA company will likely get looked at by, like, 100 mid-market PE shop. So how inefficiently is that gonna be priced? Is someone gonna be able to buy that at four times EBITDA? I don’t know, I think that’s unlikely.
Meb: It’s such an interesting area because if you look at the state of the world today, project out the next decade, I love the concept of these, what I’ll call, investable benchmarks. So, private equity, massive, massive industry. And all of a sudden, you have a fund like yours that as it starts to get some seasoning and vintages under its belt, and you have the CalPERS of the world, and all these big institutions that put forth these massive hundred-plus person teams, spend all these time focusing on private equity, the complexity, the fees, everything involved, and pretty soon you’re gonna start to see the returns roll in and you say, “Wait a minute, we can’t beat this little ETF over here. What are we doing? Like, what the F are we doing with all this?” And you’ve already seen the stressors of so many of these big real money institutions. And as this starts to happen, and as all these guys don’t hit 3% return targets in the coming decade, I think you’re gonna start to see a massive flow from these highly complex, high fee setups, to things that more resemble what you’re doing. It just makes so much sense. And it just seems so obvious. But it sounds like we’re preaching to the choir here.
Julian: Yeah, exactly. But I mean, it takes a long time to convince people of the merits. I mean, look how long it took for institutions to be accepting of hedge funds and private equity. They used to be strictly kind of government bonds and started incorporating corporate bonds. And then if you go back, what is it? 1940s 1950s, even stocks were deemed too speculative. So, these sort of regime changes really take time. And I think the democratiation of alternatives, it’s happening, but it’s something that does not happen overnight. It’s gonna take many, many years for people to kind of really wake up and smell the coffee on, “Wow, we can save how much in fees?”
Meb: It’s a lot too. The bigger challenge too of so many of these institutions, it’s cultural. There’s so many competing interests. If you look at the struggles with Harvard, so well-documented between the alumni, and the students, and the faculty, and people that work there. There’s just so much friction between the mandate and what they’re trying to do. Some endowments and institutions like Yale have a hall pass but it’s also not an indefinite hall pass too. Anyway, we write a lot of articles called, “Shouldn’t XYZ be managed by a robot?” and it just seems like a lot of these structures are pretty fragile. Anyway, are we done with all your strategies? Did I miss any yet? Do we cover them all?
Julian: Yeah, we have a number of other strategies. So one’s, like, our flagship long-short equity hedge fund, systematic. And the way this works is we’ve built this multi-factor model that we’ve kind of developed and run over the past 10 years, really harvesting various, they’re known as, alternative risk premia, which is kind of a nerdy word. I prefer just long-short factor investing. So we’re looking at various kind of proven factors, factors that are proven both academically and with real money. So we’re talking about value, price momentum, operating momentum, quality, trend, things of that nature, that kind of proven to be effective. And so we have a systematic, long-short hedge fund, that’s an ETF, really systematically harvesting those factor premia. What you’ve seen over the past sort of five years is the emergence of smart beta. And what smart beta does is it’s looking to have factor tilts to kind of have a lot of beta but introduce factor premia into it, say, you have a value index or a quality index. Momentum and quality have really been doing quite well lately, value have been getting crushed. But over the long-term, we can expect these factors to lead to a performance. So, smart beta has kind of been doing that on the long side. We basically took that a step further such that we’re harvesting factor premium, not only on the long side but also on the short side. So, effectively systematising what a human hedge fund manager would do.
So basically going long, high-quality stocks at attractive valuations, good price momentum, solid operating momentum, and a nice share price trend. And then we’re going short, the exact opposite. So, low-quality stock, ridiculous valuation, terrible price momentum, poor operating momentum, and a bad share price trend. So, really, looking to harvest those factor premia on both the long and short side, but the goal is about matching market returns, but really mitigating the downside, given the large short book. It’s not market neutral. It’s like about 110 long, 50 short. So it is directional. However, that short book does kind of come into play, especially in Q1. I mean, it really helped cushion the downside and cushion that volatility. So in addition to a long-short hedge fund, we run something with a similar model just on Canadian stocks. We call this alpha plus beta. So I think alpha plus beta is a type of strategy that it’s really kind of frontier alternative strategy that I think will become significantly more popular in the future. So instead of kind of taking your index and doing factor tilts, we provide exposure to the index. And our fund, specifically, it’s the Canadian index, the TSX 60. Then we add a long/short alpha overlays with 50 long, 50 short Canadian stocks. Really harvesting factor premia, so overweighting your best index longs and underweighting or outright shorting the worst stock.
So the end result is you track index performance relatively well, the correlation is about 0.9. However, we do expect to outperform over the long-term and the outperformance comes with mitigated downsides. So, less drawdown, less volatility, just given that 50 long 50 short alpha overlay. So alpha plus beta is really interesting strategy that I think could become more and more popular in the future because the beta component helps people stay invested because if their portfolio is not keeping up with the market, then they typically ditch it at the completely wrong time. So that beta component helps keep them invested in the alpha component, helps leading to outperformance.
Med: Talk to me a little bit about how your conversations are with advisors, particularly in Canada, which I assume are most, how some of these strategies fit into a portfolio. You mentioned on one hand that some of these top institutions can have 50%, if not more, and a lot of these alternative strategies, we tend to be pretty weird and that we have way more allocated to non-traditional sort of strategies than most. I joke with most of my Canadian friends that all the portfolios of investors we talk to up there as barbell strategy of junior miners of cannabis, which both seem to be having a pretty good year this year. So it might be tough marketing. How does all this work together? How does it all fit in? What’s the narrative you’re having with investors as they look to add some of these to their portfolios?
Julian: It’s a good question. And so the financial advisors, wealth managers are really our main target market with some institutional and kind of do it yourselfers as well. In our pitch to financial advisors, we’re really providing the tools needed to access that endowment style as allocation. And we don’t advise anything nearly as aggressive as, say, the Yales and Harvards that have north of 50% allocated to alternatives. But with equity valuations, near all-time highs, specifically U.S. equities, which most are allocated to, bond yields at basically all-time lows, the return of a 60/40 portfolio likely won’t be that sort of 8% that we’ve seen over the past decade. So many advisors are cognisant of that. And so we say, instead of your standard 60/40 equities and bonds, perhaps you should consider something 50/30/20 equity bonds and then that 20% is your diversified alternatives bucket. And you can either do this through traditional alternatives or liquid alternatives. And so the advisors who have already kind of keyed on to this, of which many have, they’re typically allocated to traditional hedge funds, charging 2 and 20. If we go to them and be like, “Look, we have a track record of success running hedge funds on a 2 and 20 model,” which I did for 10 years, won five awards from the Canadian hedge fund awards. And so we can compete in that space, but we have those same strategies, however, we offer them with as ETFs.
So they have intraday liquidity, full transparency, and ultimately fees that are a fraction of what the traditional guys are charging. And you don’t have to deal with all the paperwork, subscription agreement, redemption form, and all that nonsense. They can really wrap their head around that and be like, “Look, we think it’s a better mousetrap.” So that’s an easier sell if they’re allocated to traditional alternatives, paying 2 and 20 perhaps dealing with the illiquidity, sometimes getting gated, which would really anger an investor rightly. So if they can get that in an easier to use cheaper form, who wouldn’t make that trade? So that tends to be the easiest pitch or it gets more difficult if they’re stock pickers. Many advisors cannot pick stocks themselves or more traditional, perhaps they’ve been burned on a hedge fund in the past. And that’s something that presents a challenge to managers is some just have a negative view on the sector. Perhaps sentiment is bad for them because they allocated to one hedge fund. It could have been a levered long mining fund. When I started in this business, mining was super, super hot. However, we went through a nasty bear market where all the mining funds blew up. I remember in 2010, we were running a market neutral fund that had great returns, kind of positive every year. And fund of funds were talking to us, they were like, “Yeah, market neutral is okay, but do you have any mining funds?” We don’t do mining and so they’re really hot for mining, and they made those allocations, and those funds, like, basically all blew up, and you don’t find mining funds anymore because they’re basically levered long, these junior miners and perhaps that gave some advisors and investors bad experience.
But my main sort of warning or disclaimer to investors when investing in alternatives, you really need to do your due diligence and know exactly what you’re getting into, know exactly how the strategies function, and what is the expected risk-reward? Because if you look at the spectrum of alternatives, it basically runs massively different, everything from short only, which is negative beta to zero beta, kind of your market-neutral arbitrage strategies to levered beta on the private equity side. And everything in between, say, long-short equity is 50.5 beta, so they really need to know on the entire menu of alternatives, which is quite extensive which meal they’re ordering. Is it the chicken salad or the filet? And if you don’t know that those two are different, then you have some learning to do. So it’s really important to kind of look at the menu of alternatives and say, “What’s the expected risk? What’s the expected return?” And allocate that way and really demand transparency see from the alternative manager that you’re investing in. Because if you don’t get that transparency, really don’t invest. And that’s where the problems come from is if there’s no transparency, they don’t know what’s going on, all of a sudden, they wake up and things have gone brown on them. We see that happening in the private asset space, specifically, a lot of nastiness happening in the private mortgage fund space, private debt space. So lack of transparency is always a huge red flag for me and leads to bad experiences. And that, in turn, leads to more difficult marketing for guys like us in the future.
Meb: So you spend most your time now building a young and growing ETF company. What else has got you excited or confused or interested these days? It could be new strategies. It could just be the state of finance or geopolitics of the world. What’s on your brain these days?
Julian: Well, a lot of the stuff that we touched on, like the value growth, I don’t call them growth, I call them glamour. So the value of glamour disconnect, that sort of valuation spread between the cheapest decile of stocks and the most expensive decile of stocks has never been wider. And if we look at what happened post-2000, you really had that spread reversing, leading to tremendous outperformance of small-cap value and huge underperformance of kind of these large-cap growth stocks. And that really nailed it for hedge funds back then, because a lot of them were long small-cap value, and short large-cap growth. And that was really the golden era. So what’s on my mind, is that going to happen again? Are we gonna have a replay of the 2000s in the market? Obviously, I’m hoping for that and kind of positioned for that, but thus far on a day-to-day basis, hasn’t necessarily been going that way and kind of been going worse. So that’s one thing that I’m definitely paying attention to. Obviously on the private equity side, just the lack of a slowdown there and just voracious appetite that seemingly gets greater and greater every year. That’s another thing that’s on the radar. And another space that is sort of dealing with the same dynamics is on the private debt side. You’re actually seeing a tremendous growth in shadow banking. I think it is a large growth area. It’s kind of sketchy, in my opinion, because it does come with significant illiquidity, lack of transparency. And you are seeing some bad behaviour.
Specifically, in Q1, I saw a number of private debt, private mortgage funds throw out the gates. Meanwhile, they’re disclosing to investors a steady increase in NAV. So, in March 2020, if you’re claiming your NAV went up, you’re getting investors, I think that’s a no, no, in my opinion, and I’m surprised that the regulators aren’t going after that. So the private asset, private lending space certainly is a large growth areas specifically with banks kind of pulling back. The other thing that I’ve really liked for a number of years was cryptocurrency. And as I indicated, I kind of launched the first cryptocurrency fund in 2017, which was also the best performing fund of that year in Canada because we thought that we could bull markets. Our timing was great on that. And if you remember 2017, was really just the peak of the sort of rabid speculation within cryptocurrencies. You had all these sort of all coins, which all seem to be scams. The one that I generally do like is Bitcoins. So I’m doing some stuff in that space. I believe it’s only a matter of time before a Bitcoin ETF comes out. We haven’t tried that. Thus far. I’ve seen about 15, 20 firms try. It’s been nothing but millions of dollars in legal fees, it seems. So right now that seems to be a headbanging on the wall exercise. However, I would love to see a Bitcoin ETF trading the futures at some point. I think it’s an asset class that perhaps deserves some exposure in portfolios.
And some exposure I mean, you know, max kind of 1%. So I think the Bitcoin space has room to grow in the future as an alternative asset class, if you think that it’s analogous to gold or something of that nature. It seems like each and every year, Bitcoin is still there. It’s sticking around. It’s maintaining its price, near 10,000 bucks per coin. And each and every year that happens, where it doesn’t go to zero, the naysayers are proven wrong, it becomes further legitimised, and it’s only a matter of time where you start seeing this kind of being introduced first in more enterprising institutional investors, and then it sort of trickles down, like any new asset class does. Go back, hundred years, Triple-A bonds or investment-grade bonds, government debt was really the only investable asset class and then slowly you had corporate bonds, preferred shares, stocks were too speculative, but now they’re okay. And then you had all sorts of weird asset classes, whether it be the VIX ETF, which people seem to like, inverted ETFs, and all sorts of weird things that people seem comfortable trading, speculating on. But it takes a while for that to enter the common lexicon of investors and then ultimately become accepted as a normal asset class that is deemed appropriate for a portfolio. So, it’s not there yet, but I think it will be at some point.
Meb: It’s interesting to me because like you mentioned, there’s a gazillion people trying to launch a fund in the U.S. There’s some funds around the world. There’s a couple of the… It’s not credit scale. I’m blanking on the name. There’s some Swedish funds. They all consistently trade at premiums and net asset value as a funny example…
Julian: Yeah. GBT…
Meb: But I used to always joke, I was joking on Twitter a couple of months ago, I said, “Why wouldn’t an operating company, you could even do it through a SPAC have a private company…?” I said, “If they just wanted to convert to a proxy crypto tradable, you just put your balance sheet in crypto, and then voila, you have a tradable fund.” I don’t know. It’s a pleasant distraction to me.
Julian: Yeah. A couple of funds tried that in Canada, where they had, say, like, a mining shell that had some cash. They did, like, a crypto fund, like, an RTO, sort of backdoor crypto fund. And what the Ontario Securities Commission did is like, “Yeah, okay, well, you’re never gonna be able to do an equity financing. So you’re always gonna stay small because we’ll never approve that perspective.” So they kind of closed the door on that. And I suspect that’s kind of the case with the SCC as well. Now, like, any sort of backdoor shenanigans such as that, but, you know, I think it’s only a matter of time before an ETF gets approved. But who knows when. Back when they were running our crypto fund, I thought the advent of Bitcoin futures, I’m like, “Oh in 2017, 2018, we’re done. ETF is gonna come out right away given the Bitcoin futures.” And three years later, it still hasn’t happened and doesn’t look like it’s gonna happen anytime soon.
Meb: And you’re not allowed to say the one we already talked about but what’s been your most memorable trade over your career? X the one merger arb we discussed earlier?
Julian: That’s an interesting question. Most memorable.
Meb: It can be good, it can be bad, just the one that’s seared in your brain.
Julian: One that’s been memorable, just for the experience is two years ago, I started a capital pool company on the TSX Venture, which is somewhat similar to a special purpose acquisition company. However, they are significantly smaller. The way that they work in Canada is they have small-cap companies going public on the TSX Venture, which is kind of a small-cap exchange. The capital pool company does a small IPO, where you raise a few hundred thousand dollars, and then you’re up and trading, and you basically looked to do a business combination with a private company, and which we announced earlier this month, a business combination. And we’re out there kind of searching for nearly two years to do a deal, and finally got one announced in terms of the LOI signed. So that’s pretty exciting.
It was cool experience being CEO of a small public company and having to go through quarterly financials and dealing with your stock trading, and being on the board of directors. And in terms of the trade and once this closes, which we expect over the next few months, it’ll be really cool being a part of a new public company that is high growth and really looking to dominate an industry. I think that is a super cool process to go through and just that experience of being the founder of a CPC. It is a lot of work, you don’t get paid for it. It’s worthwhile if you do a good deal and your stock appreciates. So it’s really pay for performance. You’re a major shareholder of the capital pool company. Your goal is to do a good deal, and then have the company do well on a long-term basis because their shares are locked up for a long time. So that is a really interesting experience. It’s really difficult to sort of mimic that learning experience with standard going to your Robin Hood account and day trade a stock. It’s a lot different when you have the reins of the company and you’re driving asset allocation and making a major decision for shareholders that will really drive shareholder value and growth on a go-forward basis.
Meb: You mentioned Robin Hood, and I’ve seen you tweet a little bit about it, as I spent a lot of time thinking about the catalyst for what may be the return of value. I saw a half-joking tweet that was talking about when sports eventually return shortly, all of the attention will divert back to other types of gambling rather than financial markets. You got a favorite ideas for the next 12 months, strategy, any best ideas as far investments over the next year?
Julian: I’ll tell you, the worst idea is buying bankrupt stocks. So throw that out there if you’re thinking about buying Hertz or Chesapeake, or things of that nature. So I put out a post in January talking about record-high valuations, specifically with U.S. equities, telling investors to perhaps lighten up, look at some more kind of market neutral strategies with lower beta than say, S&P 500, and then had a 35% drawdown into March. And now we’re back to kind of where we were, near record-high valuations on the S&P 500. And specifically, large-cap growth. And, Meb, you talk about this a lot is diversifying beyond just U.S. equities. I can see over the next 10 years, international equities, emerging markets, Japan looks cheap, Europe looks cheap. However, I’m not allocating at this point. Canada’s certainly quite a bit more cheap than the U.S. And so, I think international diversification can make a lot of sense. And obviously what we kind of focused on over this podcast are various alternative strategies, some good, some not so good. I’m a huge fan of arbitrage, been doing that for basically my whole career. And that’s a strategy that I think personally perhaps in buys, but I think it serves perhaps a small part in any investor’s portfolio, just because it has low correlation and can really improve the risk-reward dynamics.
And as investors should know, they say diversification is the only free lunch in investing. And the more uncorrelated assets that you can add to a portfolio, the better. And this is really… And if you bring up a guy like Ray Dalio, he’s always looking to add uncorrelated assets to his sort of global macro strategies. And that’s really how they run their all-weather strategy is this risk parity with uncorrelated assets. Well, they couldn’t kind of even build on top of, say, risk parity, where they’re assuming stocks and bonds have low or even negative correlation. If you add additional uncorrelated assets on top of that, you’ll only improve the risk-adjusted returns. And we’ve talked about a number of different asset classes over this podcast. So that’s what I’m kind of keen on seeing is the introduction of additional asset classes to average person portfolio. Like you said, you don’t need just the barbell strategies of junior miners in Cannabis Stocks, or cryptocurrency, or whatever it is. Further diversified in a portfolio of 30 cannabis names isn’t necessarily diversified. By true diversification, we’re talking about asset classes with low correlation amongst each other. So that’s really what we’re all about is promoting that diversification. You see it somewhat in more so institutional portfolios. We are starting to see that trickle down into standard retail portfolios and it’s nice to be a part of that.
Meb: Yeah, you mentioned Dalio. I think he calls it the holy grail of investing is getting all the different zigs and zaggers together. And it’s important also, from the standpoint of at least surviving, look, it’s totally great if you have a long only equity portfolio. We’ve seen some articles recently in the journal and elsewhere, talking about individual investors, the doctor in his mid-60s, there was some stat, it was like a third people in that demographic at Fidelity sold out of their entire equity exposure in Q1. And so if you have these other strategies, even if they’re sub-optimal, that help you get to the finish line and survive, then by themselves, they’re worth it. And so it’s always heartbreaking to see the people that behaviourly do the wrong thing at the worst wrong time. But it’s what happens with markets.
Julian: The best allocation is the one that you can stick with, right?
Meb: Yeah. Julian, where do people find out more about you, what you’re up to, your writings, your funds? Where do they go?
Julian: So I’m kind of all over the internet. You can check me out on Twitter, The People’s Hedge Fund Manager at @JulianKlymochko, K-L-Y-M-O-C-H-K-O. And I’m always putting stuff out on my website, accelerateshares.com. I’m also on kind of Medium, Seeking Alpha. Those are kind of the main spots. I also have my own podcast, “Absolute Return Podcast.” Check that out if you’d like going over kind of whatever’s going on in the market that we’re focusing on M&A, IPOs facts, things of that nature. And I’m always trying to put out fresh content. So give me a follow if you wanna hear more.
Meb: Cool. Julian, thanks so much for joining us today.
Julian: Yeah, thank you, Meb. Always a pleasure and best of luck for investors. Hopefully, I can add some value, and they can take a look at alternatives but whatever you do, don’t go long the bankrupt stocks. Hopefully, that’s one lesson. And the other thing, never go long a merger arbitrage with a buy-side vote.
Meb: Perfect ending. Thanks so much.
Julian: All right, cheers.
Meb: Podcast listeners, we’ll post show notes to today’s conversation at mebfaber.com/podcast. If you love the show, if you hate it, shoot us firstname.lastname@example.org. We love to read the reviews. Please review us on iTunes and subscribe to the show. Anywhere good podcasts are found. My current favourite is Breaker. Thanks for listening friends and good investing.