Episode #457: Damien Bisserier and Alex Shahidi on Risk Parity & Investing for All Market Environments
Guest: Damien Bisserier and Alex Shahidi are the Co-CIOs of Evoke Wealth, a $20b+ billion RIA. In 2019, they launched the RPAR Risk Parity ETF. Damien previously worked at Bridgewater and Alex worked at Merrill Lynch.
Date Recorded: 11/2/2022 | Run-Time: 1:19:45
Summary: In today’s episode, we’re talking all things risk parity. The guys share their approach to portfolio construction, which focuses on risk management and while still seeking an attractive expected return. We also talk about what true diversification looks like, something many investors are learning in a year with both stocks and bonds down, and the benefits of utilizing the ETF structure.
Sponsor: AcreTrader – AcreTrader is an investment platform that makes it simple to own shares of farmland and earn passive income, and you can start investing in just minutes online. If you’re interested in a deeper understanding, and for more information on how to become a farmland investor through their platform, please visit acretrader.com/meb.
Comments or suggestions? Interested in sponsoring an episode? Email us Feedback@TheMebFaberShow.com
Links from the Episode:
- 0:38 – Sponsor: AcreTrader
- 1:51 – Intro
- 2:39 – Welcome to our guests, Damien and Alex
- 3:16 – Defining what being long term investors means
- 16:30 – One of the worst years ever for the 60/40 portfolio
- 21:06 – Their philosophy on portfolio construction and managing risk
- 27:31 – Balanced Asset Allocation; Deciding what actually makes its way into one of their portfolios
- 39:10 – Pushback they tend to get about non-traditional long-only assets
43:49 – Market sentiment around ETFs and the fat tax bills of mutual funds
49:26 – Whether or not they incorporate any crypto assets into their portfolios yet - 50:45 – Moving beyond long-only and assessing strategies to incorporate for diversifying
- 58:22 – Which of their diversifying strategies are their favorites
1:04:20 – How they decide when it’s the right time to abandon a strategy - 1:08:42 – What is on their minds as 2022 winds down
- 1:11:50 – Their most memorable investments
Transcript:
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.
Sponsor Message: Today’s episode is sponsored by AcreTrader. In the first half of 2022, both stocks and bonds were down. You’ve heard us talk about the importance of diversifying beyond just stocks and bonds alone. And if you’re looking for an asset that can help you diversify your portfolio and provide a potential hedge against inflation and rising food prices, look no further than farmland. Now, you may be thinking, “Meb, I don’t want to fly to a rural area, work with a broker I’ve never met before, spend hundreds of thousands or millions of dollars to buy a farm, and then go figure out how to run it myself. Nightmare.” That’s where AcreTrader comes in.
AcreTrader is an investing platform that makes it simple to own shares of agricultural land and earn passive income. They’ve recently added timberland to their offerings, and they have one or two properties hitting the platform every week. So you can start building a diverse ag land portfolio quickly and easily online. I personally invested on AcreTrader, and I can say it was an easy process. If you want to learn more about AcreTrader, check out episode 312 when I spoke with founder, Carter Malloy. And if you’re interested in a deeper understanding on how to become a farmland investor through their platform, please visit acretrader.com/meb. That’s acretrader.com/meb.
Meb: Welcome, my friends. We got a fun show today. Our guests are Damien Bisserier and Alex Shahidi, co-CIOs of Evoke Wealth, a 20+ billion RIA. They also entered the ETF game in 2019 when they launched the RPAR Risk Parity ETF. In today’s episode, we’re talking all things allocation and risk parity. The guys share their approach to portfolio construction, which focuses on risk management and while still seeking an attractive expected return. We also talk about what true diversification looks like, something many investors are learning in a year when both stocks and bonds are down. As we wind down the show, we discuss the benefits of utilizing the ETF structure compared to mutual funds or separately managed accounts. Please enjoy this episode with Damien Bisserier and Alex Shahidi.
Meb: Damien and Alex, welcome to the show.
Damien: Thanks for having us.
Alex: Great to be here.
Meb: Gentlemen, where do we find you today?
Alex: In rainy Los Angeles. We don’t get to say that very often.
Damien: Yeah. Those are two words you don’t hear next to each other very often.
Meb: Well, it’s a sign of the end of times, raining in L.A. It’s also Fed Day, and you guys aren’t the type that are going to be sitting here, day-trading in this during the conversation, right? Or do I have that wrong? Are you going to be doing some futures on every announcement, every tweet? What’s the process over there on Fed Day?
Alex: We’re definitely long-term investors, so things like this aren’t major events for us.
Meb: So what does long-term mean? That’s, like, a week, two weeks, month, quarter.
Alex: Yeah. I guess, to most, that sounds like long-term, you know. We’re looking at data every second, and the news flow is constant. You know, over the short term, it’s hard to predict where things go. In some ways, it’s easier to predict long-term. You get this reversion to the mean. So the longer, the better. And we’re always fighting with our clients in terms of, to them, shorter is long, and for us, very long is the way we think about it.
Meb: Yeah. You know, we often say that, you know, people are…on their investing landscape, they say they have a long-term horizon, but they really act on a, I don’t know, one- to two-year, maybe, if even less. That’s the way they think things should play out, should work out. You guys chat with direct clients probably a lot more than I do. Is that an accurate statement, or what is the kind of feeling you get from…? And this isn’t the, like, indoctrinated people that have been with you forever but kind of newer clients, people you talk to. What’s the mismatch, if any?
Alex: You know, the way I think about it, and I’ll let Damien jump in, in a second, is there are two voices in your head. There’s the logic, and there’s the emotion. And you can think of it as the two people on your shoulders, you know, shouting at you what they think you should do. And logic tends to be longer-term and more rational and more well thought out, whereas emotion is something that we feel over a shorter-term period. And what’s interesting is most people make decisions based on their emotion. So I think people who try to be more rational, try to offset some of the pressure that comes from the short-term emotion by saying, “No, I know I’m feeling this way, but logic tells me to go that way.” But most people respond to their emotions, especially if the logic isn’t as sound and as thought out and as experienced. So our sense is that people who tend to be less sophisticated are going to react to their emotions more because it’s not as well grounded, and vice versa. So that’s just my experience working with clients.
Damien: I just don’t think humans are wired to think in long-term increments, and also, in our business, it’s counterintuitive. Unlike any other service that you receive where you can evaluate the outcomes over short time frames, you know, you go to the dentist. It’s pretty clear whether your dentist knew what they were doing, and so you make the decision based on that one outcome whether or not to go back. Whereas, with your financial advisor or when you’re looking at market outcomes, there’s so much noise in terms of any particular outcome relative to whether something is working that it just drives people to make decisions on the short-term basis, like they do in every other aspect of their lives. And that’s very reasonable to, basically, do the thing that’s working in every other aspect of your life. In our business, if you simply do the thing that’s working and avoid the thing that’s not working, you end up with the worst possible outcome, right? And so that is just a very hard thing, I think, for most people to do in a disciplined way.
Meb: You know, as we talk about emotions, does that play into your investment methodology at all? So what I’m talking about is, like, you know, sentiment. I feel like I spend a lot of time talking about sentiment and a lot of people on Twitter or just the shoeshine indicator, the magazine cover indicator. We look at sentiment indicators. Is it something that plays into your process at all, or is it something more that you bake into how do you talk to clients and kind of provide them with expectations and a base case? What influence does it have, if any?
Alex: I think it definitely has an influence because it’s related to how people respond. And the way we think about client portfolios is, you know, on one end of the spectrum, you have what we think, just thinking of it from a math and purely, you know, model-driven approach, what an optimal portfolio looks like, and on the other end of the spectrum, there’s what the typical portfolio looks like, and we can get into that more. And we think you should be a lot more diversified than what most people have. But somewhere in the middle is how much the client can handle, and depending on how emotional they are, how biased they are to the way other people invest to whatever their experience has been, we can’t go all the way to what we think is the best portfolio, because if they can’t handle it, they’re going to sell it at the wrong time. And so emotions and behavior play a significant role in figuring out what the optimal portfolio is for that specific client. And so education is part of it, how emotional they are is part of it, and our job as advisors is to find the right point along that spectrum to basically get us diversified as they can get without veering too far off what their comfort level is. And so we have to, in some ways, play psychologist to try to understand what that means.
Meb: And so ignoring the portfolio composition aspects, which we’ll probably spend most of the time on today, are there any sort of hacks, being the wrong word, but insights you’ve garnered over the years talking to investors and educating them that really helped, you know? And part of what I’m thinking about is, you know, we don’t do a great job educating people in personal finance and investing, in general, you know, through schools. And so a lot of people come to a blank slate. There’s a lot of emotional shame that surrounds money and personal finances, investing, as well as a lot of other emotions, you know, wrapped up. Is there anything that, as you talk to people or educate them, that…and the first thing that pops to mind is, almost always, it feels like investors, if given the choice, behave poorly when they take on more aggressive risk exposure than less. I rarely hear people say, “Man, you know what, I really wish I had taken on a lot more risk.”
Damien: Whatever strategy you end up pursuing, in our experience, the clients that do the least amount of tinkering end up with the best outcomes, which is interesting. You know, that’s tough for business owners, right, because business owners, typically, are in control of their businesses, and they want to make changes to their businesses to optimize the outcomes. And if you try to do that with your portfolio in a very active way, you know, sort of responding to information and making determinations on the basis of that incoming information, you end up, oftentimes, resulting in or, you know, producing a worse outcome. And so a lot of our clients that paid the least amount of attention that have the most sort of stable approach, you know, whatever that approach is, whether it’s 60-40 or whether it’s a more balanced approach, you know, the key is not to sell low and buy high.
You know, back to the point about emotions, there’s a tremendous emotional pull to do that because it’s validating for whatever your belief is around what’s working and not. But actually, if you can just stick with an investment plan and be disciplined and rebalance on a regular basis and really focus on the things you can control, which is identifying things that are reliably different, incorporating them in a way that is prudent into a portfolio, and diversifying as much as you can, and just sticking to that plan through time, even in times when it’s tough. That is generally the formula to the best long-term success in investing. It doesn’t sound very sexy, and it’s certainly not what you hear about on CNBC, where I think a lot of people get their investment information, but it actually is, I think, the secret to producing the best long-term outcomes.
Alex: The other thing that I think has been helpful is trying to be as transparent with clients as possible. So oftentimes, I’ll tell them, “Ideally, your portfolio should look like this, but we’re not going to go all the way there, and it’s because you may not be able to handle it.” It’s kind of like “A Few Good Men,” you can’t handle the truth, if you remember that. And so they’ll say, “Well, what do you mean I can’t handle it?” Well, it’s because there’s going to be periods where certain assets are going to do poorly relative to whatever your reference point is for most people to stock market. And on a relative basis, it’ll look like it’s underperforming, and you’re going to want to sell it, and then you don’t benefit from the strategy if you do that.
So we’re going to test to see how you respond as the environment plays out. And they’ll say, “Well, of course, I can handle it,” and it almost becomes a challenge. And so kind of putting it out there in terms of in our experience, clients have a hard time with this because, you know, something is zigging when they think it should be zagging. And we just want to see how you respond to that. And then, if you pass that test, then we’ll move closer to what we think is a more optimal mix. So that opens up the conversation about how emotion can drive behavior and then makes it more obvious to them that they may be susceptible to that, at least, you know, with the experience that we’ve had with other clients.
Damien: Relating back to the point you made, Meb, about the risk, that’s why I think it’s important that clients have a risk level that they can tolerate, because if you experienced a significant loss, you’re very likely to want to make a change to the strategy at the worst possible time. Whatever strategy it is, you know, typically, the best returns follow the worst returns. And so if you make the change after the worst returns, then you’re likely to go, basically, pursue something that’s been working, and then you sort of invest in that after it’s been up a lot, and then that does poorly. And so you’re on this hamster wheel. And I even saw it when I worked with institutions that consultants would always come in, they’d run a manager search, and they would never recommend the manager that was in the bottom quartile. They’d always recommend managers that were in the top quartile performance. And lo and behold, after you hire those managers, they’d always be in the bottom quartile, or they’d be significantly worse than they had been, you know, prior to getting hired.
And actually, the best strategy is to find the managers you think are really smart and really great who have just gone through a terrible outcome and hire those managers. And that’s just very hard, emotionally, to do. But kind of on your point, I think, if you can develop an investment strategy that produces your desired outcome with the least amount of risk, you’re most likely to stick with it in the bad outcomes. So because your losses won’t be so great that they’re intolerable and will force you emotionally to make a decision to change course, so that’s why I think you could say, “Well, I’m an investor for the long term. I just want to take the most amount of risk so I can generate the highest return,” and in reality, most people can’t survive trough. They can’t hold through the trough because they see a third or half of their life savings evaporate, and they’re going to want to make a decision because, you know, it’s a very reasonable response to that outcome. If you can produce something that never has that type of a loss experience because it’s better constructed upfront, then you’re much more likely to hold through the trough. So that’s another aspect that’s been our experience.
Alex: And this is an intersection of a lot of topics we already covered, which is, when you go through a drawdown, looking backwards, the numbers look terrible. Most people make, you know, forward-looking decisions based on, you know, recent performance. So the emotion there is, “I need to sell.” Then, at the same time, the outlook for whatever that is, whether it’s a market or a manager, is going to look really bad, and so you’re thinking that bad performance is going to continue. And so that’s forcing you to sell. And all of that in an environment where, most likely, it’s probably the best time to buy. And we all understand, you know, buy low, sell high, but your emotions force you to buy high and sell low. And those emotions are at a peak, most likely, right before that inflexion point. And so those are things that just drive behavior and constantly cause investors to shoot themselves in the foot.
Meb: I used to have this conversation a lot. You know, I sold everything in 2009. I didn’t invest. I didn’t get back in, so 10, 12, 14, 16, 18. You know, I heard this all the time. It’s really sad. But they say, “Okay. All right, I’m ready to get back in,” or, “Hey, I just sold a business.” Let’s use the more often business scenario, just sold a business. But what do I do? Do I put it all in today? You know, that feels very scary to me. And I say, “Look, the optimal/correct answer is, yeah, like, statistically speaking, you probably put it all in today.” But psychologically, “Hey, you want to put in, scale in over the course of a year, every quarter, two years, like, fine, you know.” Like, because the hindsight bias of, “Oh my God, I can’t believe I didn’t wait three months,” or “Look how much better it would have been had I done this,” is a lot more painful than, you know, the average of the possible outcomes. And you know, 10, 20 years from now, it’s not going to matter. But for your short-term mental health, if you blow up your investing plan because of that hindsight bias, it will matter.
Alex: Yeah, especially if it causes another reaction to that bad experience. But also, that questions, what I found is most people think about getting in or getting out is the stock market, that’s how they’re thinking about it, and that’s a volatile ride. So your timing actually matters a lot, and obviously, you don’t know if it’s a good time or a bad time. But if your portfolio is much more stable than the stock market and has a lot less volatility, you know, loss likely to have a bad decade, less likely to have, you know, 40% or 50% drawdown, then your timing matters less, because you’re not jumping on a volatile ride.
Meb: We’re now having one of the worst years ever for 60-40, to a traditional portfolio, stocks, bonds, and oddly kind of coming into this… I tweeted about this the other day, I said, “You know, if you were to come into this year…” Alex and I were on a panel. I can’t remember when it was, maybe first quarter, but we’d been on a panel last year, and I said, “Okay, I got a crystal ball, and I’m going to tell everyone that this is going to be the worst year ever for traditional portfolios.” It doesn’t feel like people were freaking out that much, at least to me and at least people I talked to, where I’ve predicted it’d be a lot worse. What’s the vibe like? You all’s phones ringing off the hook? What’s going on? Can you give me a little insight into what this year feels like so far?
Alex: You know, what’s interesting about this year is, if you came into the year and said, “You know, I’m really concerned about the markets. I’m going to be very conservative. I’m putting my money 100% in fixed income,” you’d be down 15%. And you know, the worst year prior to this year was -3. So you’re 5x the worst year. So I think part of the reason that we’re not seeing, and I don’t think, generally, you don’t have people panicking, is because…what could they have done? Nobody wanted to hold cash earning zero. If they were all in bonds, they’d be down 15%. So I think that’s part of it.
Meb: There’s no envy on your neighbor. Like, it’s like, everybody just got kind of smashed. I think there’s the element of shell shock too after, like, coronavirus, everything going off. There’s a couple of people…people are just like, “Whatever,” like.
Alex: Yeah. I think that’s part of it. Another part of it is there is actually good news. You know, bond yields are the highest they’ve been in, like, 15 years. So prospectively, you can actually earn something. You can hold, buy T-bills and get 4%, right? That hasn’t existed for a long time. So if your target return was, let’s say, 6% to 8% a year ago, that was a lot harder to achieve long-term versus now when you can get 4+% from cash. So now, as long as you survive that transition from low rates to more normal rates, your long-term expected return has actually gone up. So I think there is some good news in what’s happened. And then the third thing is my sense is people respond to the bad news they hear in the news and, you know, economic downturn, things like that. Nothing’s really even happened yet.
The only thing that’s happened this year, the big surprise has been, you know, rapidly rising interest rates. The economy seems to be doing fine, inflation’s higher than, you know, most people feel comfortable, but there’s nothing crazy happening. So I think that’s largely why you haven’t had, you know, a big negative shock so far.
Damien: Yeah. And stock markets have generally held in much better than I would have expected. If we were all sitting around at the end of last year and said, “Hey, in Q4, inflation’s going to be running at 9, and the Fed’s going to be on their way to 5, at 4% interest rates,” I think all of us would have said the stock market will be down more than 15%, which is kind of extraordinary. So you haven’t really experienced the degree of pain that I think is possible in the stock markets, and so that, I think, also influences the mood. I think there’s still a hope, which I think is low probability, but a hope for a soft landing that the Fed can engineer a slowdown in inflation without a vicious recession. But our view is you’re likely to see a pretty significant fall in growth and fall in earnings, and that hasn’t yet been discounted in stock markets. And so most of the pain has been felt in the bond markets.
But you know, as Alex said, I think the bond market pain, even though it’s been awful this year, and I think a lot of people have been surprised by it, it’s a little easier to tolerate, because, prospectively, you’re getting a lot higher interest rates. I was just talking to a core bond manager the other day, and they said their current yield is 6%, you know. That’s extraordinary. If you think about the last several years, we’ve been getting, you know, 1% to 2% from core bond managers. So I think there’s a little bit more of a tolerance around that in bond markets, but the pain likely is to come, in our view, in the stock markets, and that’s when I think you’re going to get the real panic.
Meb: Yeah. We like to say, like, glass half full, half empty on sort of the fixed income landscape. I say, you know, the good news is you’ve reset to this, like, much higher income level, which is great from a yield perspective but also from a potential capital gains reversal if interest rates come back down. All right. So we’ve talked a lot about 60-40, traditional, all sorts of stuff so far, but that’s not what you guys do, right? Traditional 60-40 is not in your bag. So let’s open the kimono. How do you guys think about portfolios in general? And how do we put the pieces together?
Alex: I mean, to us, the most important thing is managing risk. I feel like we’re in the risk management business, and risk is one of those things where you don’t really think about it until something bad really happens. And then, all of a sudden, it’s the most important thing. It’s kind of like your health, right? Your health is always priority number one, but you know, oftentimes, you don’t even think about it until something bad happens, and then, all of a sudden, it becomes priority number one again. So I feel like one of our responsibilities is to always be thinking about risk and the things that can go wrong rather than just jumping on the ride and, you know, going up and down along with everybody else.
So when we think about it that way, you know, to build a diversified portfolio, you just need a bunch of different return streams that are individually attractive but reliably diverse to one another. And if you can do that, you can effectively get an attractive return, just like you would if you were to invest in a single risky asset class without taking the risk. And then think of risk in three components. There’s, most importantly, risk of catastrophic loss. You can’t do that. And if you’re over concentrated, that’s how you take that risk. Think about the Japanese stock market. It’s still down from its high 30 years ago, right? The U.S. stock market, in the last 50 years, has had 2 lost decades. In the 2000s, it was a negative for 10 years, and in the ’70s, an underperformed cash for a decade. So the risk is not low. So avoid catastrophic loss, and you do that by just being less concentrated.
Number two is minimize the risk of lost decade. I mentioned, you know, the U.S. stocks have had two out of the last five. So taking a bad year and then recovering is more tolerable than doing poorly for 10 years. That’s really hard to come back from. And then, finally, there’s volatility. So try to minimize the volatility for that same return, and you do that by just being diversified across, you know, individually attractive return streams that are diverse.
Meb: And so what does that mean? You know, I think a lot of people, when they think of opportunity set in the U.S., it’s U.S. stocks. So when they think opportunity set in different return streams, they’re thinking, “Is it S&P, or is it Dow, or is it the Qs?” And if it’s bonds, is it the agg, or is it 10-year, or maybe if they go a little crazy, munis? But it’s like a grocery store. It’s like going to Costco. It’s a world of choice. What do you guys consider to be the main ingredient?
Damien: Those are two of the ingredients, but there are a lot more that you can use to build your menu. And as Alex said, you know, really the goal is to find lots of individually attractive return streams that are reliably different. So within the public markets, you can expand into things like inflation hedges, which are important, because stocks and bonds do very poorly, traditional bonds. Fixed-rate debt does very poorly in a rising inflation environment, and even worse in a stagflationary environment, which would be accompanied by weaker growth. So the ’70s was an awful time to own a 60-40 portfolio. So you’d want inflation hedges, which would do much better in that type of environment. That could be commodity exposure. It could be inflation-indexed bonds, which we actually think is probably the most attractive asset out there today, with, you know, really yields north of 1.5%. So they’re paying you 1.5% plus realized inflation. You know, those are government-guaranteed securities that are paying you probably high single-digit returns. That’s pretty good.
Alex: It’s like a high-yield bond without credit risk.
Damien: Yeah, yeah. Where you can envision a lot of scenarios where, you know, you could do very well. So that’s in the public markets. Now, you’re pretty limited in the public markets, frankly, in terms of buy-and-hold strategies. So you can also incorporate really high-quality active management or alternative betas, so things that are more uncorrelated return streams. You know, these could include different types of hedge fund strategies where the managers are market neutral over time or fully hedged. There are a number of different types of strategies that would fall into that category, equity market neutral, you know, certain types of long/short credit, you know, could be trend following, or things that are kind of almost like alternative betas. There’s all different types of strategies where I think you can make money in an uncorrelated fashion to being long risk premia. So we’d want to incorporate those in a thoughtful way where you build in a diversity of strategies and you have high conviction in the individual managers or the strategies.
And then the third category would be private markets, and in the private markets, there are all sorts of return streams you can access. You can oftentimes access them with a high component of active management, because these are just inherently less efficient markets. Think about an apartment building and how the average apartment building is managed versus the very best-managed apartment building. You know, there’s a lot of NOI accumulation or net operating income accumulation from just being conscious of your costs and making sure you’re turning over your apartments and making sure you’re leasing, you know, in the best possible way. And so that’s alpha, in our view, and you can apply that to private equity, private credit, all different types of private markets.
And so, in those categories, in the private markets, you can access things that are truly uncorrelated as well, things like healthcare royalties, life settlements, litigation finance, all sorts of things that then can further augment the number of ingredients in your cake that you’re baking when you’re thinking about baking that portfolio. And the more you can layer in things you can be confident and that are reliably different that perform differently in different environments, the better your overall portfolio outcome is going to be, the more stable that’s going to be, and the lower your risk is going to be. And that’s really what we seek to achieve for our clients.
Meb: This episode is brought to you by Cambria, a global asset manager. Unhappy with your portfolio’s performance this year? With one of the worst starts ever for traditional U.S. stocks and bonds, is there a better way? Cambria thinks so. Cambria provides investors with global market exposure and low-cost, differentiated, quantitative-driven strategies, like deep value and trend following. Join over 100,000 current Cambria investors today. To learn more, email us at the following address, info@cambriafunds.com, or if you’re a financial professional, check out the Contact Us page on our website and reach out to your local representative today.
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So that’s a lot. Alex, I was just reflecting. You know, I read your book. It’s almost a decade ago now, “Balanced Asset Allocation.” And how do you, as a chef, portfolio chef, how do you start to think about, this is for both of you, guys, the menu? Meaning, like, all right, you just named, like, 20 things that could go into a portfolio. And on one hand, you have this sort of long-only beta exposures, right, so stocks, bonds, real assets, etc., and then you have this kind of bucket of other where it’s active return streams that are probably not as easily accessed through ETFs or something. How do you kind of walk down that path of deciding, you know, what goes into the actual recipe from this, like, limitless, I mean, there’s tens of thousands of funds out there, menu? Is that a daily constant iteration? Is it something you kind of review once a year? And how have you come to the final recipe that you’ve settled on to date? This might be a really long answer, so.
Alex: That’s a career-long endeavor, because the way we think about it is you’re constantly trying to uncover new return streams, new gems. And simplistically, the way you can think about it is you have equities. To us, that’s one. Okay. There’s a lot of flavors of equities, but for the most part, they go up and down together. So that’s one. So if you have 10 different equity strategies, that’s really, like, 1 strategy, 1 return stream.
Damien: Which, by the way, you mentioned tens of thousands of funds. The vast majority of those funds are doing very similar things. And so they, more or less, move up and down together.
Meb: Yeah. I mean, the good example, we use the phrase mutual fund salad, and I’m sure you guys see so many portfolios that come to you, and they’re like, “I’m diversified. I have these 10 mutual funds.” And you look at them, and it’s large-cap growth, large-cap value, small-cap growth, small-cap value, big-cap growth, big-cap value. I’m like, “Congratulations. You just bought the S&P or Wilshire 5000.” But that’s not what you guys are talking about, right, when you put together this menu. That’s, like, one entry, which is just stocks.
Alex: That’s right. Now, you can make it more diversified, but you got to understand what…think about your building exposures. Each of these return streams, it’s like a package that you buy, and it gives you certain exposures. And for the most part, you can think of it as what’s the exposure to growth, what’s the exposure to inflation. Those are the two big drivers of, at least, asset class returns and, you know, how growth plays out versus what was discounted, how inflation plays out versus what was discounted. Think of it as the big surprises. That’s what moves the markets. So in the 1970s, the big surprise was inflation was higher for longer than anybody thought. So that path for stocks and bonds, so they both underperformed cash. That cause-effect relationship, that linkage, is very, very reliable and predictable, but you don’t know what’s going to happen in the economic environment. So you’re going to be diversified based on that.
So think of stocks as one bucket. You can think of bonds as another bucket. What’s interesting about bonds is that the Sharpe ratio of bonds is about the same as it is for stocks. So most people, when they’re shopping in the grocery store, they see low-risk/low-return bonds, high-risk/high-return stocks, and that’s their main menu that they’re choosing from. So they calibrate how much risk and return they want by going, you know, allocating between those two asset classes. And what ends up happening is that’s a very poor menu to choose from because the more return you want, the more concentrated your portfolio becomes, and you violate that first principle that I described of you become over concentrated, now your risk of catastrophic loss is too high, risk of a lost decade is too high. That’s just a very bad framework. So because those two have a similar Sharpe ratio, meaning same return per unit of risk, all you have to do is adjust the risk and you get a similar expected return as equities.
So one of the numbers that I threw out there that really surprises even investment professionals is, if you go back 100 years, and let’s say you have 2 choices, you can invest in stocks or you can buy treasuries, which one would you choose? And you were holding it for 100 years. And you know, 100 out of 100 would say stocks beat bonds. But those two have about the same Sharpe ratio. All you have to do is hold bonds at about the same risk as stocks, and over 100 years, they have about the same return in risk. And so now, if your menu isn’t, you know, high-risk/high-return stocks, low-risk/low-return bonds, instead it’s high-risk/high-return stocks, high-risk/high-return bonds, that is a much better menu option.
You can do the same thing with things like inflation hedge assets like commodities or gold. You know, gold has underperformed equities by about 1% over 50 years and has about a 0 correlation. And that’s basically when we came off the gold standard in 1971. That’s a pretty attractive asset class. It’s diverse, and its return over 50 years has been just, you know, barely shy of equities. Inflation-linked bonds, they’ve only been around 20+ years, but in the 1970s, they probably would have done really well. They tend to do best in a stagflationary environment.
So there’s actually a lot of good options within public markets that are heavily underutilized because most people think in that 60-40, you know, framework that I described. So just changing the way you think about these things gives you the opportunity to get really well diversified within public markets. Some people term that risk parity framework, but that is a lot more robust than the traditional framework. And I think, in a period where the risk of, you know, prolonged inflation or weak growth is more present, the benefits of that will come through a lot more than, let’s say, in the last 10 years, when all you had to do is buy equities.
Meb: The comment you made, I think, is such a critical insight because it’s hard to see the world the same afterwards, which is you don’t have to accept assets prepackaged the way they’re offered to you. And what I mean by that, so you talked about stocks versus bonds, and stocks, historically, I don’t know, 18% volatility. Bond’s a lot less. But you got to remember, stocks, on average, these companies have debt, yada yada. So theoretically, you know, you could say, “Well, instead of accepting the S&P 500 100% in my portfolio, maybe I like stocks, but maybe I’m 60% stocks and 40% cash,” and you alter that sort of stock sort of path. It looks different. And the same thing with bonds. Like, you don’t have to accept bonds at a 10-vol, or whatever they are, and you can lever them up. And so once you start to think like that, it changes the menu to not just “Hey, here’s your three choices,” but “Hey, there’s sort of infinite choice on how you put these together,” and it becomes much more of a question of correlations and opportunity. So, and maybe this is a Damien question, but as you look at the main offering of what people have, so let’s say they’re crazy and they actually have global stocks, global stocks, bonds, of the buy and hold sort of beta exposure, what are the things that people really are the big muscle movements you think are important? Is it gold, TIPS, commodities, REITs? Like, what are the big things that you think make the difference?
Damien: I think you mentioned the main ones, which is…I think the biggest gap we see in client portfolios today on the public market side, on the buy and hold, you know, capture public market risk premia side, is inflation hedges. Investors are just not prepared for it because we haven’t worried about inflation for so long. You know, it’s been decades since inflation’s been a real concern until the last few months. And so you’re starting to see a little bit of an inching towards more inflation hedges, but we’re amazed, for instance, that investors wouldn’t want to hold more inflation-indexed bonds relative to fixed-rate debt today. Like I said, if you look at it on just a yield perspective, it’s offering higher yield than high-yield, and it’s got this really unique characteristic of, basically, paying you inflation plus a premium, which is quite attractive.
So there are these portfolio tools that are not complicated. You can access them in a very low-cost fashion by either buying securities directly or buying any number of ETF or mutual fund strategies that hold these things, you know, for virtually nothing, you know. I think there’s a Schwab fund that’s five basis points, you know, so, where you can just buy the TIPS market. And so that’s something we would encourage investors to really think about today. It can be a really helpful diversifier for portfolios.
Same I would say for commodities, you know. For long-time commodities, I think we’re kind of the dog-inclined portfolios. We took a lot of heat from clients for having them in our client portfolios for a number of years, you know. It was a lonely road to walk down to have commodities in your client portfolios, but I think they serve a very valuable role, in particular, in these types of inflationary environments, and you know, commodities have actually been one of the only things that are up this year.
Gold is another one. I kind of think about that differently. So when I say commodities, I’m thinking more about industrial commodities, the things that sort of feed the growth engine. Gold is really a currency. And so you can think of that as, you know, you have paper currencies like the dollar and the euro and the yen, and then you have gold, which is the world’s oldest currency. And unlike the supply, paper currencies cannot be manipulated in the same way, so there’s a finite amount of gold. And so, this year, it’s not surprising that gold’s done poorly, and actually, it’s only done poorly in dollar terms. If you’re a Japanese investor, a European investor, you know, a UK investor, actually, gold is up. So gold’s actually, you know, I think, done surprisingly well in an environment that should be terrible for gold this year.
And the main challenge with gold, of course, is that it is a currency that pays you zero, and you’re in an environment of tightening dollar liquidity, which means the supply of dollars is shrinking and the rate of yield on dollars is increasing at the fastest clip ever in 100 years. And so that is an environment where you’d expect a currency like gold to do poorly relative to dollars, and in fact, that’s been the case. But actually, gold has held in there pretty well because you have a lot of savers in the world that are viewing that as an attractive way to save assets for the long term. And we do think, over a longer-term time frame, it is something that can be an important part of preserving wealth. It is one of those currencies that cannot be manipulated in the same way that paper currencies can.
And we think, eventually, you’ll get to a point where that growth-inflation trade-off is such that central banks will stimulate again, and when they stimulate, they’re going to print dollars, they’re going to print euro and yen. And that is…I guess the Japanese are still printing yen. But they’re going to print these currencies, and you’re going to see gold, most likely, go up a lot in that type of environment. And so it’s a really valuable diversifier in that sense. We think about it as a hedge to monetary inflation, the debasement of paper currencies.
And so those are the ones that you mentioned that we would focus most on. REITs, I think, there is some value, but the public REITs tend to trade in a very correlated fashion with stocks. And so we don’t see as much diversification benefit there. And there’s also, I think, within real estate, there’s obviously the benefit on the top line in terms of your rent growth being strong in inflationary environments, but financing rates are also going up a lot as a function of the inflation, which is, I think, a headwind for real estate markets, generally. So you’re seeing cap rates expanding. And so that also…it’s not as clear of a hedge to different inflationary outcomes that the other assets that I mentioned would be.
Meb: I know this is time-varying, so the answer is “depends on what’s currently doing terrible and what’s performing well.” Like you said, it’d be different to have this conversation about commodities a year or two ago than today. What pushback do you guys traditionally get the most about when it’s the non-traditional long-only assets, of those? Is it gold? What’s the vibe?
Alex: You know, the story with gold that we share with clients is it’s part of your catastrophe insurance. It’s like one of those assets that you don’t necessarily want to do well because that means it’s a probably bad environment. And you have…it’s kind of like fire insurance on your house. You hope you never use it, but you got to have it because it protects you against that catastrophe. So think about the 1970s. Gold was up 30% a year. That would have been a great time to have that asset. And then, in the ’80s and ’90s, when you didn’t need that catastrophe insurance, gold was negative for 20 years. But it is part of that diversified portfolio. So gold has a decent story attached to it.
I’d say probably the hardest one is treasuries, and people look at that and say, “This is a dead asset.” That’s less of an issue now because yields are at 15-year highs. But the way to think about treasuries, especially long-term treasuries, which have gotten killed this year, but the way to think about it is it’s another…you can think of it as it’s not really catastrophe insurance, but it’s more about a recession insurance or a downside growth insurance. And that’s really a big part of a balanced portfolio, especially those portfolios that are overly allocated to equities. They’re taking a lot of growth risk and of growth surprises at the downside, which it often does, and that may be the next big surprise we get here in the U.S. You want something that goes up enough to offset the downside that you get in that volatile asset, you know, that we call equities. But that’s the one that we probably get the most pushback on.
Even though it’s treasuries, these are government-guaranteed securities, it’s a hard thing to own, especially longer duration, because people don’t associate government-guaranteed safety with, you know, high volatility.
Damien: It’s also hard in this environment when you can get 4.5% yield on a 1-year T-bill to want to invest in 30-year treasuries that are yielding just north of 4% or 4%. I’ve never, in my career, had so many clients call me and say, “Let’s buy T-bills, you know. That sounds good, you know.” So that’s a new thing. You know, I don’t normally have that request until this year.
I think there is another important aspect to incorporating these diversifiers into a portfolio that relates to structure. And this isn’t as exciting as talking about what’s likely to happen to these things, but I think it’s critical for investors to think about how do you access these things in a low-cost, efficient, tax-efficient way. And I think, you know, you have certainly built your business around taking advantage of these things. We are also in the creation of an ETF taking advantage of these things.
But there is this inefficiency that exists for most investors, you know, particularly taxable investors, when they’re going out and they’re accessing these multi-asset class portfolios in a mutual fund structure or on a bespoke basis, in the act of rebalancing, they’re having to realize gains. And when you wrap these multi-asset portfolios into an ETF structure, you can defer the gains. And that is a really powerful compounding benefit where you can basically wait to pay, you know, the realization of the gain, pay the tax associated with the realization of the gains for when you actually exit the ETF.
That is a really powerful underutilized technology, frankly, that exists, you know. You look at iShares or Vanguard, in most of the vast majority of the ETFs they have are, you know, very narrowly defined, you know, cloud computing, or U.S. stocks, or large-cap stocks, etc., and you don’t get much of the benefit of diversification across the underlying components. And so there’s not that much of a rebalancing benefit there. But when you put together reliably diverse return streams that are volatile in a package, in an ETF package, you actually can rebalance across the components and generate a higher return than the underlying components would offer you, which is interesting. It’s an interesting portfolio benefit, and you can avoid having to pay those capital gains taxes that so many investors are going to be experiencing in their portfolios, as they normally rebalance those portfolios.
So that’s a really powerful concept that has to do with just being thoughtful around structure. So it’s not just identifying the right things to hold, but it’s then structuring those in a thoughtful way. And that is, I think, something that ETFs offer that is just generally underappreciated.
Meb: Yeah. I mean, look, we talk ad nauseam on this podcast and elsewhere about portfolios and construction, and all this stuff, which is, of course, important, but we say, you know, investors always overlook the really big things that matter often. ETF structure, on average, and we’ve been saying this a long time, there’s nothing necessarily unique about the ETF structure that guarantees a lower cost, but on average, they’re a lot lower cost because part of that is it’s devoid of all the legacy conflicts of interest and fees that are associated with mutual funds, 12B-1 platforms, mutual fund supermarkets, on and on and on. So the average ETF is, like, 75 basis points cheaper than the average mutual fund. And then the tax implications, our ballpark estimate for strategies with decent turnover is an annual benefit of around 70 basis points, which is significant, right? So when you add those two together, and right there, just because of the structure alone, you’re talking about 150 basis points, on average. And so we always tell investors, like, your base case is ETF, and you need to come up with a reason for it not to be an ETF. And it’s not true for everything, of course, but for the starting point, it should always be ETF.
That conversation here in 2022, I’m happy to report, is a lot more well-understood than 5, 10, 15 years ago, you know. Fifteen years ago, people were like, “EFT, what’s that?” But now, I think it’s starting to make its way into the vernacular, and you’re really seeing the dam break with a lot of the mutual fund to ETF conversions, which I always thought ETFs would overtake mutual funds, but this year, that’s the biggie.
Damien: I’m guessing this year, people are going to be shocked at the realization of capital gains in their mutual funds, because one, you’ve had a lot of sort of people exiting, two, you’ve had a lot of these positions that mutual fund managers have been holding for many years that they’re now rotating because they’re in this dramatically different environment. So I think even though a lot of these mutual funds are down a lot, they’re going to be distributing gains this year, which, you know, probably is a good opportunity for somebody who’s been sitting in something for a while, you’re going to get a big capital gains distribution. You can sell before that, you know, to avoid that capital gains distribution and maybe move into something that is more tax efficient.
Meb: I’m going to re-say that again just so investors can get this, but if you own a mutual fund and you’re probably down 20%, 30% this year, no matter what you’re in, we looked it up the other day, and it’s, like, 90%, 95% of funds are down this year, if you exclude leveraged and inverse funds. So you’re probably down, so don’t feel bad. But what’s worse than being down is getting a fat tax bill on top of it. Like, it’s the most preposterous situation. It’s just like a giant, pardon my technical term, but kick in the nuts twice. And so if ever, like we always say, the money leaves these high-fee tax-inefficient funds, there’s so much inertia in our world, so money stays put, but divorce, death, bear markets, and then fat tax distribution, this is my favorite time of year to retweets all these…Morningstar puts out all these mutual funds that have these huge tax bills. Oh, man. But I don’t think you ever go back. Like, that happens to you once, and you’re like, “Oh my God, what am I thinking?”
Alex: One of the biggest lessons that I’ve learned, you know, doing this for a long time, is investors, even professional investors, are overconfident in so many things. And one of those is their ability to predict the future. And so you always hear these prognostications of “This is what I think is going to happen. Therefore, you should buy this.” And they’re going to be wrong a lot. And the thing that they probably undervalue the most are these structural efficiencies that are highly reliable. So, like, all the resources and energy go towards predicting what’s going to happen next with low hit rates, as opposed to spending time and thought in “How do I build the structure…” you can think of it as structural alpha, understanding there’s tax advantages here. I’ll take that, you know. That is guaranteed, you know, excess returns. I need to bank that. Diversification, we think, is one of those things, where you basically get, you know, a higher Sharpe ratio by being more diversified, and you can manage what that risk level is. To us, that’s much more reliable than predicting what’s going to happen next.
So you wrap all the stuff together and bring it to where we are today, and you look forward. The economic volatility that we’re experiencing is probably the highest that any of us have seen in our careers. And for many, many years, for probably 30 years, inflation hasn’t really moved very much. And now, it’s as volatile as it’s been in, you know, 40, 50 years ago. And so where the environment goes next in terms of growth and inflation, both are highly unstable. For a long time, inflation was stable, growth was a little bit more volatile. Now, they’re both volatile. The range of outcomes is wider than we’ve probably ever seen, you know, in the last 40, 50 years, and people are probably less diversified now than they certainly should be. And so there’s more guessing now, the odds of being wrong is probably higher than normal, and there’s less taking advantage of these clear, you know, structural alpha options that are available.
So that’s it. There’s a huge mismatch there, and I’m concerned that people are going to learn those lessons the hard way. And part of it is just the tax discussion that we just had later this year, but I think part of it is also going to be how the environment plays out and these big surprises that are coming up next and the lack of diversification in portfolios that it’s going to…you know, all that is going to surface.
Meb: Yeah. We like to say better to be Rip Van Winkle than Nostradamus, which is seemingly what everyone wants to do all day. I imagine you get this question less now than a year or two ago. What’s the framework do you guys incorporate? Any crypto assets yet, or is it something you keep an eye on, or is that a hard no?
Alex: You know, it’s so funny. We get that question whenever it goes up 100%, and we don’t get the question when it drops 50%. So this is the second or third round of that. So you know, a year ago, a lot of questions about crypto. Now, not a single person is asking. And our response…so we don’t have that, and our response has always been, “It’s more of a speculative asset.” Maybe somewhere down the line, it becomes more institutionally owned, more established, less, you know, risk on/risk off type of trade and more like a currency. And maybe it’s like a digital gold. But it doesn’t feel like we’re really there yet. And the other aspect of it that I personally just have a hard time is I get concerned when something has the risk of going to zero, either because it’s regulated away or it gets replaced. And if there’s a risk of going to zero, it doesn’t fit into a model well, because you don’t know what the risk of zero is. If there is a risk of zero, that raises another, you know, concern about catastrophic loss and all those things.
Meb: You guys talked a little bit earlier about sort of your standard menu at the restaurant and then here’s your specials or here’s the alt-menu. Once you move beyond sort of the standard offerings of long-only, and you can correct me, this tends to be kind of more like the ETF structure. But once you kind of move into some of these dozen other ideas that help diversify as well, I’d love to hear a little bit of the framework for how you assess, you know, these strategies, because I think it requires a fair amount of homework and due diligence. And then, also, what’s kind of, like, the client response to that? Do they tend to want something that’s, like, simpler? “Look I want this ETF. I kind of understand it,” or, like, “No, actually, I want the full menu with the varied ingredients.”
Damien: Well, I guess the answer to your second question is that it depends on the client. So some clients want something that’s simple, more public-oriented, highly liquid, low cost. And then some clients, I’d say, probably the majority of our clients want to access some element of the alternatives that we’ve identified and make available on our platform. And the simple reason is that those things are really valuable as diversifiers, and so they help us build a better portfolio for clients. And they’re hard to access, as you alluded to, for clients on their own, you know, whether because there are high minimums or the strategies are closed or they’re just hard to understand. We can do the diligence on our side.
So we have a whole group, and I lead that group, where we evaluate these strategies, and we get to know these managers, usually, over the course of years. Because unlike trusting that there’s a risk premium in stocks or risk premium in bonds, you know, this is a leap of faith. You’re trusting that this manager can generate alpha or active management return, and there’s no guarantee of that. You know, it’s a zero-sum game. So you have to be really confident in the edge that the manager has, in the culture that they’ve built, in the integrity of the people making the decisions that are stewards of your client capital. So it takes a long time to build that trust and to build that understanding and to see that edge and be confident in that edge. And then thinking about how it would fit into a broader portfolio.
So we go through this process constantly, evaluating new opportunities, new strategies, evaluating existing strategies to make sure that they’re continuing to perform as expected. And you can think of it as a menu that we then can provide to clients where they can select these things, and we would help guide them in that process of figuring out what’s the right fit for them. And it comes back to those three categories. You got the public markets, which, as you said, the goal there is diversify and keep costs and taxes low. Then you have we call them hedge funds that hedge. So these are strategies that are lowly correlated, high component of active skill, managers that we have high conviction and that we’ve known sometimes decades, and we provide a means to access those.
So for really large clients, you know, multi-billion-dollar clients, they can access them on a direct basis, but for most of our clients, we actually create a vehicle to access these managers in a diversified way. And many of these managers are closed or, just frankly, inaccessible to retail investors. So it is a very compelling offering. And the outcome of combining those managers in a diversified way is you get something that we think, you know, generates a risk level that’s more like bonds but with the potential return level that’s more like stocks in an uncorrelated fashion or a very lowly correlated fashion from the public markets. That’s a really valuable diversifier, and something that, you know, is really unique.
And then we have a third category, which are these private strategies, and that is, you know, frankly, where I spend most of my time because you have to underwrite every single fund offering, and you know, they are mostly these drawdown vehicles where it’s private equity style, you get the capital committed and called over the course of three to five years, and then that’s invested. And then, as they exit the positions, the clients get the capital back. And so, at any point in time, you look at our menu of offerings there, and you might see, you know, 10 to 15 different options to access across private equity, credit, real estate, some uncorrelated categories as well. And that’s, basically, you know, a seasonal menu based on what we think is compelling, what managers we have confidence in, you know, when they’re open and raising capital. And we continually try to build that out so that there are more and more strategies on offer where we have conviction in the underlying asset class in the different verticals and where we think the manager that we’ve hired or accessed is best in class or one of the best in that space.
And then the other thing that we do is we use our platform scale, because, you know, we manage over $20 billion. We’re the size of a large college endowment. We can really negotiate fees and terms to the benefit of our clients. So unlike one of the large broker-dealer platforms, the banks, where they add all these extra fees to access the alternatives, we actually provide access to those alternatives, usually, with a discounted fee structure, and that all gets passed along to our clients. And then any benefits we can achieve through our scale, you know, both with regards to access and lower fees, that gets passed on to our clients. So that, you know, I think, from a lot of our clients, is a really compelling offering. And it actually builds upon itself.
So a lot of our clients are asset managers who, while they are really good, you know, at what they do, they don’t have the time or the bandwidth or, you know, frankly, are able to access a lot of these strategies in these other verticals. And so they utilize us as a way to gain access to those other really compelling alternatives and return streams and help them think about the overall portfolio structure. And then they can be a resource for us. So they can help us uncover things or diligence things, you know. Nobody is going to understand these things as well as somebody who’s lived and breathed it for their entire careers. So we’re evaluating a new multi-family manager. We can talk to our multi-family clients and say, “Do you know this person? Have you done business with this person?” And so that’s really, I think, an integral part of our value add and the access and the diligence that we can provide. And sort of it’s self-reinforcing positive in terms of, you know, the more really smart, really exceptional clients we can have, the more we can access these really great strategies for our clients and be able to evaluate them in an appropriate way.
Alex: And, Meb, if we zoom out a little bit, as co-CIOs, one of our big decision points, and I think a lot of investors face this, is, how do you allocate your time and your resources? And when we look at those three categories of public markets, you know, hedge funds that hedge, and private markets, we tend to allocate less to public markets and more to those other two. And the reason is those other two are, frankly, easier to underwrite because you’re kind of underwriting, almost underwriting, like, a business, and there’s more opportunity there to add value. In public markets, if you go back 50 years ago, maybe there was more opportunity to add value. Now, you’re competing with computers, millions of investors. Creating alpha is just really hard in that space. Over there, structural alpha is more reliable, like we talked about. So figure out ways to do that really well, and then reallocate the resources in those other areas, private markets and hedge funds, where your due diligence and your underwriting can actually add value. And at the same time, you become more diversified doing it that way. So I think a lot of this is just reorienting the way you think about constructing a portfolio, and most people spend all their time in public markets, trying to uncover the next manager. They’ll hire them after they have a five-year good run, they fire them after they underperform, and they repeat that process.
Meb: I would love to hear, and you can’t…I’m not holding you to it, it doesn’t have to be your favorite, because these are all interesting. But like, of those strategies, which ones really speak to you guys, as including, in this mix to, you know, diversified traditional portfolio? And I know there’s a lot of descriptions. But are there any, like, really, like, “You know what, I got a soft spot for aeroplane lease finance,” whatever it is? Anything that comes to mind?
Alex: The way to think about it is what is diverse to, you know…so you mentioned RPARs, so the risk parity. So that’s stocks, you know, treasuries, commodities, and TIPS. So the question is, what’s diverse to that? What can give you, you know, an attractive return that is going to be reliably different from that? And so that fits within those other categories that we described, and then, more specifically, Damien can give you some answers.
Damien: Yeah. I mean, I’d say the major categories that we would…if you came to us blank slate today and say, “I got RPAR. What else would you recommend that I invest in?” I would throw it into a few general categories. So one would be low correlation, active management strategies, you know, the hedge fund portfolio that we’ve built for clients, because that is a pretty liquid exposure. It’s quarterly liquid. It allows you to, I think, diversify against the one thing you can’t really diversify against in public markets, which is a terribly intense tightening, right? So that is one thing.
No matter…you can’t hide out in any public market, I mean, other than being in cash, but as far as if you’re taking risk in public markets, there’s nowhere to hide in an aggressive tightening. You know, it is the worst environment for assets, generally. But what you can do is you can incorporate high-quality active strategies, low correlation strategies where your hedge, things like global macro, or quantitative strategies, etc., where they can actually make money in this type of environment by being short some of these asset classes, because they can anticipate what’s happening or they can take advantage of trends that exist within markets. So that is one category which we see as important, you know, as a semi-liquid exposure but relatively liquid.
And then, within the private markets, we would have a meaningful allocation to private real estate. We think it’s a very important asset class. It’s got characteristics that are attractive in terms of income, and that income is quite tax-efficient, in most cases, because you can depreciate your assets and shield a lot of that income from taxes. So it’s a nice way to fold income into a portfolio that is tax-efficient. It’s got real asset characteristics, so inflation hedging characteristics, because it is a real asset, you own the property. And so real estate…and there’s a lot of alpha potential, in general. So if you think, like I said earlier, in terms of, you know, a great multi-family manager or an industrial real estate developer, etc., there are ways to add alpha in that asset class that we think is compelling and reliable. And so when you add that all together, we think it should be a very meaningful allocation for every client. Typically, for us, it’s, you know, in that 10% to 25% range for clients, and so that’s a big piece, the private real estate.
And then, within the other categories, we really like different types of secured credit-oriented strategies. So things where you have underlying high-quality collateral, whether it’s real estate or businesses, or hard assets, like inventory or equipment, or healthcare royalties, or any type of underlying collateral, we can get our arms around where the lending that’s happening is secured against that collateral at a low loan-to-value. So you know, in a terrible scenario, you’re still going to recover your principals plus penalty plus interest, and in the meantime, you can generate a nice high return stream, you know, high-interest return stream with that collateral protection behind you. That, in our view, is a really robust return stream, and there’s lots of ways to do that. Like, I mentioned a lot of different types of collateral. But that’s something that can hold up in good times and bad and can be a great diversifier for client portfolios and, frankly, be a lot more compelling than what you see in public credit markets.
So that’s the other category which we think should be a material exposure in your portfolio to help diversify the public markets. So I’d say probably those three categories would be the things that we would focus on first. You know, there are other compelling things to do in private markets. Like, for instance, private equity, etc. But that’s probably more similar to things you already own on the public side than the things I mentioned.
Alex: And then, also, bringing it back full circle, one of the advantages of the private markets is you don’t have that mark-to-market. And from an emotional standpoint, that dampens volatility of your total portfolio. And we all know there’s a lag, but that actually makes a big difference, because clients feel better about the total portfolio because there’s less realized volatility. And that makes it less likely that they’re going to react to that downturn, and it gives them, you know, more likely.
Meb: We have a joke, we’re just going to wrap all of our ETFs into a private fund and only report on it every once in a while.
Alex: You know, it’s funny. That would actually help investors. You can’t do that, obviously, but that’s a good thing for investors, because it forces them to zoom out a little bit, you know. We’re all zoomed in, looking at a day-to-day, you know, reacting to what we hear in the news, connecting that to the performance that we see, and you feel like you have to do something about it. It’s, like, outside of the investment world. Everywhere else, you know, bad performance in the past is a precursor of bad performance in the future, right? If we have an employee underperforming, you don’t go to them and say, “Oh, I’m going to buy low.” You’re going to say, “No, I’m going to sell low. You’re out, and I’m going to hire a high performer.” So everywhere else, our intuition has been built around our real-life experiences of you sell underperformers. But in the markets, it’s the opposite. So it’s very counterintuitive. And you tie in emotion and your real-life experiences, and it forces you to do the wrong thing at the wrong time. So it’s very challenging.
Meb: Yeah. On the discretionary side, this is a hard question for me. As you guys look at a lot of these private offerings and fund managers, you mentioned that you’ve been investing with for a long time, in many cases, and you said earlier, like, often, the best time to be allocating or rebalancing to many of these strategies is when they’re doing poorly. How do you decide when to finally let them go?
Alex: Well, a big part of it is you have to look at what did you buy, right, the people. So obviously, people change. That’s more obvious. But what return stream did you buy, and how should it react to different environments? And you have to analyze it through that lens, which is, “Okay, you know, it underperformed.” Does it make sense why it underperformed? Did it underperform because of an environment that transpired that we should have predicted it would underperform if that had happened? So in other words, you know, you’re buying a path, you’re buying, you know, a return stream path, and that path will include downturns. Is this downturn understandable? And does that mean that an upturn is coming? Or is there something, you know, happening that is beyond what you would have expected? So a lot of it is just understanding the context of why it’s underperforming and whether that makes sense or not.
Damien: A related point is that you should never invest in anything that you can’t hold through the trough. So every strategy, no matter what it is, will go through periods of underperformance. And if you can’t understand when those periods might occur and for what reasons and be convicted in the long-term efficacy of the strategy, even though there will be periods of underperformance, you shouldn’t invest in it, because you won’t hold on, and you’ll get a bad outcome. Because every strategy will eventually underperform.
Alex: And related to that, the odds that that bad period is coming is a lot higher than you realize. And it’s because you didn’t typically hire them after the bad period. You hired them after a long stretch of a good period. And a bad period is inevitable for every strategy. So when you go in as a buyer, you should already assume a bad period is coming, and you need to ask yourself, “Am I willing to hold on through that trough? And do I understand that’s going to be coming soon, regardless of whether the manager believes it or not or expects it? And do I have the conviction to stay the course?” Because, otherwise, you’re going to be on this repeated cycle of you buy your outperforming manager, you’re going to fire them underperforming, and you won’t get a good return over the long run.
Meb: You know, we often say, we talk to people and say, portfolio managers, I don’t think I’ve ever heard someone ring me up or email me and say, “You know what, Meb, we invested in your fund last year,” two years ago, five years ago, whatever it may be, “and it’s done so much better than expected. We’re going to have to fire you,” right? But they have said, plenty of times, “Hey, this is doing worse than I thought. We’re going to fire you.” And the same on the institutional level, right? Like, people, if the fund is better, the strategy is better than expected, they ascribe it to their brilliance, “Oh, man, I was smart picking that strategy,” or manager. If it does poorly, it’s the manager’s fault, and you know, they fire them. And it’s a very odd setup because, you know, we did all poses. Like, if you have…to be an investor, you have to be a good loser, because asset classes spend, like, 2/3, 70% of the time, in some form of drawdown. It may not be much, maybe a few percent, maybe a lot, but that’s kind of the base case is, like, you’re not at an all-time high.
Damien: Ideally, you’d want to be adding. If you’re convicted in the strategy, you’d want to add to it when it’s underperforming.
Meb: Yeah. Part of this, you know, and much of this is solved by an advisor or having a process, a written process, which no one does. But we love to ask polls on Twitter, and one of them was, you know, do you establish your sell criteria when you make the investment? And it was like 90% say no, you know, where they just buy something and then wing it. And you see why that’s a problem. It’s a problem not just for funds and strategies but on individual levels for investments because, if you have an investment that goes down, what are you going to do? But also, if you have an investment that does really well, what are you going to do, you know? And that’s a good problem to have but one that’s, either case, winging it. It doesn’t seem like a reasonable strategy.
Alex: No, you’re more likely to respond to your emotions, in that case.
Meb: As we sort of wind down 2022, what else is on you all’s mind? Anything, in particular, you guys are thinking about, excited about, worried about, brainstorming about?
Alex: Yeah. I mean, for me, I’m excited about higher yields. I think that’s very positive long term. The thing that I’m most concerned about is what the next big surprise is. You know, as I mentioned earlier, it’s the surprises that move markets. You know, the only surprise this year has been the Fed tightening more than expected. You know, coming into the year, very little tightening expected, and instead, you got one of the fastest rates of tightening in history. So that’s a big shock. So what we do know is that’s going to have some economic impact, that it’s going to be on a lag. We don’t know what the impact is. We don’t know how sensitive the economy is to a rapid tightening like this. But when you look at what markets are discounting, it’s, effectively, we’re going back to the trend line for growth and inflation by next year. Inflations are going to come down to 2% to 3% or so, and growth is going to be, you know, reasonable. That’s what’s discounted.
So there’s a lot of room for a surprise, and our sense is the big surprise is weaker growth, potentially very weak growth versus what’s discounted, and higher inflation for longer. And both of those are bad for equities, and that’s kind of like the 1970s scenario. If you look at the headlines in the early ’70s and you remove the names and the numbers and the dates, it’s a lot of similar topics that you’re reading about today. And so, if that repeats, that’s bad for 60-40. That’s bad for both stocks and bonds. And, to me, that’s one of the biggest concerns is that most portfolios have very little inflation hedges and these other, you know, return streams that are diverse. To me, that’s, like, the huge disconnect between the concern that people have about a recession, the concern they have about inflation. Those are the two big topics if you just scan Google or watch CNBC or, you know, read “The Wall Street Journal,” yet portfolios don’t reflect those risks. And so I think that’s going to play out over the next probably 6 to 12 months.
Damien: Yeah. I think it’s just fascinating watching this tectonic shift in markets as we move to a very different type of inflation and interest rate regime and thinking analytically about what it is that is likely to perform well in that environment, try to incorporate those things in meaningful ways into our client portfolios. You know, that’s an exciting challenge and I think one that, you know, we’re better suited for, frankly, than most because we have access to so many interesting compelling return streams with really high-quality managers. So that’s what we’re focused on as we continue to build that resilience into client portfolios, focusing on things that can really add value in what’s a very challenging market for the traditional stock and bond portfolio and, hopefully, differentiate ourselves relative to others so that we can continue to help clients weather this very challenging environment.
Meb: Yeah. We’ve held you guys for a long time. I know you want to get back and trade, the new Fed announcement, and adjust portfolios by the end of the day. But most memorable investment, good, bad, in between, both of you. What’s the most memorable investment for both?
Alex: For me, it was going back to 2011, so go back 11 years, and that was the first time we started to put on a long treasury position for our clients. And for those who remember, that was the time when there was concern that treasury was going to get downgraded, which it was. That was a point when the Fed was going to stop buying bonds, and so everybody was saying, “Interest rates are going to skyrocket, you know, downgrade, and nobody is going to buy these bonds anymore.” And so that was a time when we thought, “I don’t think that’s really what’s going to happen. If they stop doing that, you’ll probably get an economic downturn, and rates will probably fall.” So we always wanted to move towards a more balanced mix, which includes things like long treasuries for that downside growth, and we saw that as a good opportunity to make that shift.
And so we went to our clients and recommended, you know, long treasury position in a small piece. And they push back, like, “What do you mean? Everybody else is selling this.” Literally, everybody else was selling this. And I said, “Well, first of all, when you hear that, that’s when you know it’s a good time to buy. So that’s number one. Number two, let me walk you through a rationale.” And so we started to build this big position in a long treasury Vanguard ETF. And Vanguard even called me and said, “You know, we think you may have made a mistake here. This is…you know, of all the funds in our arsenal, internally, we think this is the least attractive. Don’t you know everybody’s selling treasuries? You know, downgrade. Yields are going to skyrocket.” And I thought, “Oh, that’s really interesting. Let me tell you why we’re buying it.” And what’s interesting is that ETF was up 50% in 6 months. Now, we didn’t know that was going to happen. It basically played out as we expected, economic downturn.
Meb: Can I get the number of your guy at Vanguard so I can text him?
Alex: Well, he called me back, and he said, “Oh, now we understand why you bought this fund.”
Damien: So I spent a large chunk of my career at Bridgewater, and Bridgewater focuses on public markets. So I think, for me, probably, one of the most memorable trades or investments that I engaged in was one of our first private fund allocations, which, after I left Bridgewater, I joined Alex, and we started an RIA together. There was a healthcare royalties manager in New York called Oberland Capital, and this was, for me, an eye-opening experience to understand the power of accessing these really unique return streams in the private markets. You know, what Oberland does, essentially, is they provide financing to biotechs or inventors in exchange for the royalty payments on certain life-saving or standard-of-care products. So it could be a liver disease treatment or an oncology treatment. And they’ll structure it, you know, with debt-like characteristics where they essentially receive an interest payment plus royalty participation.
And you know, there’s components of it that, you know, were highly structured where the underlying collateral, these royalty payments were completely uncorrelated from the broader markets. They were based on the patent protection and the science and the competitive landscape, and all these different characteristics. There’s certainly risk in that, but it’s just a completely different set of risks from anything I’d been exposed to. And they have this really unique position where the banks don’t underwrite the risk, and so they’re one of a dozen firms that provide this type of financing. And you know, it was complicated.
So I spent a lot of time understanding this, and it was, like, the light bulb went off for me as, like, “Wow.” It’s like, “Here’s a return stream where it’s just hard for me to see how this is not additive to client portfolios, because these guys are very good in underwriting the risk. They’re very good at structuring. You know, the return stream is such that you’re sort of receiving quarterly payouts that have nothing to do…it’s floating rate plus royalty participation.” So it has nothing to do with, you know, what inflation is, what the economic growth story is. You know, it really is very idiosyncratic based on these underlying treatments and the structure they put in place. And for me, that was just very formative to say, “Wow, you know, the more that we can incorporate these types of things into client portfolios, the more robust and the better our client experience is going to be.” And so that was, you know, I think, kind of one of the more memorable things that I worked on, just because it was so eye opening.
Meb: Yeah. I mean, the private side is so fun, but it’s a giant rabbit hole. There are so many…and I love the weird strategies. Like, the weird ones are my favorite. Like, I could just spend all day reading about some of these…and many of them don’t scale to, you know, giant size, which is why they’re fun to uncover, but it’s a sort of endless sea of opportunity and landmines, of course, too, but that’s what makes it fun. Gentlemen, it has been a whirlwind, a lot of fun. Love to have you back next year. Where do people go? They want to find out more about you guys, invest along with you, what’s the best spot?
Alex: Well, our website is evokeadvisors.com. We post a lot of insights on there. We’ve done interviews with money managers that are recorded and placed there, with their market outlooks. And then our ETF is rparetf.com that they can go to and check out the Risk Parity ETF.
Meb: Very cool. Gentlemen, thanks so much for joining us today.
Alex: Thanks, Meb.
Damien: Thanks, Meb.
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 feedback at feedback@themebfabershow.com. We love to read the reviews. Please review us on iTunes and subscribe to the show anywhere good podcasts are found. Thanks for listening, friends, and good investing.
