ReSolve Riffs on Maximizing the Rebalancing Premium

This is “ReSolve Riffs” – live on YouTube every Friday afternoon to debate the most relevant investment topics of the day.

As US equities and bonds continue their apparently unstoppable rally, their expected return over the coming years grows vanishingly small. Especially if markets are faced with anything other than the goldilocks environment of growth, deflation and abundant liquidity that has ruled the past 12 years.

Readers of our research (as well as any student of history) will know that stocks and bonds can go through prolonged periods of synchronized underperformance, while Risk Parity can navigate virtually any form of inflationary or growth shock. But when executed properly, with periodic rebalancing, Risk Parity can benefit from a substantial tailwind, as we showed in our recent paper – Maximizing the Rebalancing Premium.

Our discussion of the rebalancing premium and its implications for investors included:

  • The traditional thinking on rebalancing is likely outdated – adjusting for drift is not enough
  • Defining the rebalancing premium and how it can be maximized
  • The benefits of rebalancing for different implementations of Risk Parity
  • Why buy-and-hold investors are paying this premium
  • Risk Parity vs the ubiquitous 60/40

The debate also delved into the importance of reducing volatility drag to smooth out the path portfolios take and improve geometric returns.

Thank you for watching and listening. See you next week.

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TRANSCRIPT

Adam00:00:00When I share my screen. It’s right in the middle of my screen, a big yellow dot. It’s the big yellow dot that you get from Teams. You know, when you press a button in Teams and a yellow dot comes up to a live screen.

Mike00:00:14We’re live. Cheers, gentlemen.

Rodrigo00:00:16Cheers. What does everybody got today?

Adam00:00:20I’ve got to be an official at a swim meet later. So they don’t like it when I’ve been drinking first.

Rodrigo00:00:26Yeah, I upped my game this time.

Mike00:00:28You know what I saw what was so funny, if you’ve ever watched the Bad News Bears, and you watch the old movie with, is it Walter Matthau is the lead guy. So this is hilarious, because he is the coach of the basketball team, obviously, or the baseball team. And he’s coaching these kids. And he’s constantly walking around with a stubby beer, he has one of those old stubby type beers, and he’s coaching kids and he’s drinking, the parents are coming up and yelling at him. He’s walking around, he’s having a brew. While he’s coaching him like that just those things just don’t happen anymore today. I don’t know what kind of world we’re living in, where.

Rodrigo00:01:10Were we raised to take over the world.

Out With the Old

Mike00:01:14So on that note, so we’re going to talk about the Rebalancing Premium today. And just as everyone knows, we’re going to have wide ranging conversation, anything that’s investment related, you should get serious professional help on, not from The Three Musketeers on this particular call. And, I am really excited, though, to talk about this. I think this paper potentially shifts the tectonic plates of how practitioners should think about the idea of different asset classes, and the idea of how one rebalances them. You know, typically, you have this sort of old format of thinking that a balance or a rebalance is a, you know, a deviation from target. So one has some asset classes that they’ve allocated to, there’s a deviation from the target that may deviate one’s risk tolerances, and thus, you know, you should come back to your previous allocation. And that’s certainly one very simplistic way that it’s, that it’s often done. But it misses the point, right. There are several sources of, sort of setting the table, I think there are several sources of return that practitioners can harness, sort of the risk free rate, the risk premia that come from various betas, maybe the risk premia that come from various factor exposures, and then potentially the alpha of manager skill that sits on top of that. But what that misses, and I think what the Rebalancing Paper demonstrates so wonderfully, is the thoughtful pursuit of beta, what betas, making sure those betas are differentiated. And then the discipline nature in which you would think about rebalancing those, being aware of their volatilities and correlations, brings a whole new layer of potential excess return to the table. And it’s absolutely not being capitalized on. And when we think about those sort of three or four dimensions of how you might garner some excess returns, the first one I mentioned, the risk free rate is at zero, potentially, in some cases, less than zero. And so rather than focusing on you know, sort of traditional betas, traditional factors, and just looking at the rebalancing process, as a process of simply coming back to some, I’ll call it somewhat arbitrary target allocation, and not always arbitrary, but some target allocation. Rather, it should be thought of as a way to pursue excess returns across the entire portfolio. And I think this is where, you know, a lot of times the idea of the asset classes themselves, and then the rebalancing are viewed separately. It’s better when the process is fully integrated. And I think I’ll stop talking, I’ll turn it over to you, Adam. And you…

Integrated Balancing

Adam00:04:13No. I think that’s actually or your last comment hits it right on the nose. Because I think what we tried to do with this series of papers, keep in mind that this paper on Rebalancing Premium was an addendum or an appendix to the original paper on Global Risk Parity, right. And I think the idea is look, we like why do we like just not to continue to beat the same dead horse we beat all the time. But why do we generally like risk parity, because we don’t like being vulnerable to a concentrated exposure to equities, when we know that equities do well exclusively during periods of benign inflation, stronger than expected growth and abundant liquidity. What we want is a portfolio that is resilient to other economic conditions. Obviously, the last 10 years has been dominated largely by conditions that have been especially favorable to US equities.

Rodrigo00:05:11US growth equities.

Adam00:05:12US growth equities, hundred percent. But we know as we look back decade by decade by decade, back to 1900. And we’ve got we’ve got data series from provided like global financially that go all the way back to the 1700s. And in some cases for, you know, British stocks and Dutch stocks back to the 1300s. Right. So we’ve got very long history. So we know that economies go through periods of unexpected shocks, both positive and negative to growth, and unexpected shocks, both positive and negative to inflation. And that equities are only really fundamentally designed to do well, in a couple of the four potential quadrants. And US equities, especially are only really expected to be the top performer in one of those quadrants, right. And we’ve been in one of those quadrants, typically, you know, sort of disinflationary growth quadrant for the past decade, which is a reason why US equities have completely dominated every other asset class. But there’s no reason why we should expect that to happen going forward over the next 10 years, or over the next five years, or 20 years. So the first principle is, we want to diversify, because we want to eliminate or minimize our vulnerabilities in any particular economic environment, right? So that’s where we get to risk parity. And one of the big objections to risk parity, there’s a couple. One is, it typically leans towards a higher fixed income allocation on average, as a proportion of the portfolio than you get from, say, a 60/40 portfolio, right? But obviously, only 40% of the portfolio is in bonds, and 60% are in equities. Well, now we’re saying, well, we want to have closer to sort of 70% of the portfolio 65% to 70% of the portfolio with fixed income, and then the balance is going to be allocated to a mixture of equities, which everybody loves, and commodities, which can be scary, right? Like, is there a risk premium in commodities? Why? How large is it? And so this larger than expected allocation to fixed income, and this allocation to commodities that typically ring sensitivities for investors, right. So one of the great things about this appendix on the Rebalancing Premium is it showcases one of the benefits of having access to all these commodities. Keep in mind, there’s like 35 different commodity markets there. They span across grains and softs and metals and energies. And so they’re going in different directions for different reasons, at different times. It creates a lot of independent sources of return. And when you’ve got a lot of independent sources of return, that is an opportunity to maximize this thing called the Rebalancing Premium, right. And so that’s how we sort of come full circle. When you have all these different bets in the portfolio, some of them are scary, especially sort of commodities and maybe higher concentration to bonds. But if you can get over that, you’ve got this opportunity for this, you know, 2 or 3%, maybe even higher Rebalancing Premium that comes from this extra diversification. And you get this 3% Premium without any expectation of higher risk.

Rodrigo00:08:36And I want to differentiate this concept of diversification for it not to mean line items in your portfolio, but rather true idiosyncratic sources of risk. Right. I think, I don’t know probably a year, a year and a half ago, we published a piece just going through how much diversification there are in different universes of investable assets. And we started with the S&P 500, then the S&P sectors, just traditional kind of, you know, gold, equities, just some of the asset classes you can glean from exchange traded funds, and then you got the futures and you got there, you got a lot. So what do we see, when we threw all of the equities in the US market, the amount of idiosyncratic bets. I can’t remember off the top of my head, but it was something like 1.2, 1.4. Right, and then it went up from that to sectors to around two independent bets. So even though you may have 5,000 stocks, because the idiosyncratic risk is all based on growth expectations for equities, you’re not going to get that diversification benefit. What needs to happen, what needs to exist is not a thousands and thousands of line items in your portfolio, but rather enough line items in your portfolio with completely unique sources of risk that you’re able to capture divergent returns in different times, because of the underlying realities of those asset classes that you invest in. Gold being different than TIPS, being different than softs, being different than energy, and equities and so on. Right? So I just want to lay that out.

Adam00:10:14Yeah, I’m going to share my screen because I actually have that image up here. So I’m just gonna share it. Let’s see what.

Mike00:10:25While you’re looking for that, I think it really is the essence of I think good investing is to think about how you might source these different areas of return and pursuing these different. And again, it’s the difference that makes all the difference, I suppose.

Adam00:10:51Apparently, I’m not allowed to share my screen. So maybe I’ll flip it to you guys. And you can share.

Mike00:10:56I think maybe Ani can help with that, potentially. But as you were commenting too on the overexposure, supposed overexposures to bonds, well, that’s the cash allocation. The risk allocation, again, is digging a little bit deeper scratching the surface, okay, well, yeah, bonds have a volatility of six, they’re just, they’re going to require more capital exposure in order to provide that type of risk to the portfolio, which is very different than the risk that would derive from commodity markets, or from precious metals markets, or from emerging markets or, you know, developed markets. And so, you know, the objection that it’s a bond portfolio is false. And it has an allocation that is similar to the allocations of risk that are otherwise associated with the portfolio. And so we hear that, you know, as we talked about, there’s a few sources of return probably for, the risk free rate is one, we don’t have that risk free rate anymore in bonds. And so, you know, what are the potential for returns there, that is also built into all the other asset classes that are discounted cash flow assets, though. I think that’s another miss in people’s sort of overconfidence driven by the recency bias of the sort of the recent performance of those, you know, sort of US growth stocks. Anyway, over to you on the graph Adam.

Adam00:12:19No, but I want to make sure that’s not lost, right, because I think everybody focuses on the fact that bonds have ultra low rates. But they’re not accounting for the fact that those ultra low rates are built into the expected returns for all other markets.

Mike00:12:30Correct.

Adam00:12:30Because all of them are discounted at the same rate. And so if the expected returns on bonds are low, the expected returns on all other markets are also low. And if that’s not true, then you’re expressing the view that markets are not efficient. And if markets are not efficient, what are you doing in a passive cap weighted stock portfolio in the first place, right. So pick your goddamn poison. Either you think markets are efficient, in which case, you believe that all markets everywhere have low expected returns, because many global markets, many global benchmark bond markets are trading at negative yields, and benchmark Treasuries are trading at 1%. And everything else is discounted off that, therefore it also has low yields. Or you believe that markets are not efficient, in which case you need to make take other steps to modify your portfolio to express the actual optimal portfolio given your new views. Right. So just to reinforce that point. And again, to sort of close the loop on this, this is a chart that we included in one of our presentations, but I’m just going through the opportunity for diversification, again. Not the number of stocks or sectors or line items in the portfolio, but the effective number of uncorrelated sources of risk in the portfolio. So, you know, to the far left, if you put 10 industries in your portfolio, because they’re so highly correlated, you only get about 1.6 effective sources of risk. You’ve got 10 line items, but only 1.6 uncorrelated sources of risk, right? Move a little further along if you want to go to sub industries. So the 49 industries, and this is just from a download from Chris, but 49 Industries, the returns give you three effective bets from 49 Industries, right? Because, again, most of them are so highly correlated. All the stocks in the S&P 500 during a period when stocks are highly correlated, like for example, over the year through March 2009, you’ll remember that was the global financial crisis. Stocks tend to become more correlated during crises, so there were fewer bets than normal. So across all 500 stocks over the year of returns coming into March 2009, there were only four and a half effective uncorrelated bets. Now during a calmer period. I believe I made this chart in 2017. In 2017, got about 10 effective bets over the previous year, overall 500 stocks. But still 500 stocks, only 10 effective bets. And if you go to 40 futures markets, you get up to 13 effective bets on average, right? So just the power of adding all the markets in futures to this universe. And what that means is diversification.

Rodrigo00:15:18I want to point out something as well here that there’s a blue bar and a yellow bar, right? The traditional way of thinking about things is the blue, it’s okay, you got 10 industries, if I equal weight them, how many effective bets do I have. 10 industries equal weight is 1.4. But then there’s a thoughtful process by which you actually want to maximize the impact of diversification where each individual bet has a maximum opportunity to express their diversification benefits, right. So if we move over to the S&P 500, and we do an equal weight S&P 500 portfolio, we see that there’s 2.3 bets in the blue. But if you weight them more thoughtfully in order to take, you know, different weights and account for correlations and volatilities you can create as much, you can allow, you can weight certain securities that have higher correlate, non-correlation characteristics, you can weight them in such a way where you can express four and a half unique bets. So it’s not just about identifying a universe of differentiated risks, but you have to weight them in a way where you maximize your opportunity for diversification. Later on we’re going to address what that, being able to do that what the portfolio impact in terms of expected returns, will have on it. And just going all the way to the futures, the 42 futures markets, equal weighted 42 futures markets at 5.4. A well diversified maximum diversification weight approaches 13.2. Right. So massive improvement by thoughtful portfolio construction.

The Diversification Premium

Adam00:16:55So just that was good. And just to sort of segue, and again, I don’t know why I can’t share my screen, but Rodrigo, maybe you could share Figure One in the new paper, because it just dovetails so perfectly with that chart. Just talking about the diversification premium that you can generate from investment universes with more independent bets, right? Just to prime people for what they’re going to see. We just said, let’s assume we’ve got random assets. So we’re just going to create a random time series. And so to the far left, we’re going to create three random time series. And we’re going to rebalance back to equal weight for those, just think about them as, as markets, right. But instead of actually having real returns, we just created random returns. So you put those three markets together, they’re uncorrelated by definition, you rebalance back to their target weight. And then you can set a target compound return on average across the three markets. And as you increase the drift in the markets, your Rebalancing Premium also goes up a little bit, right. So just at the far left, you can see for three uncorrelated random markets with zero, where all the markets have zero returns, even though the markets on average themselves produce zero returns, the portfolio delivers a compound return of point 8%, because of the fact that you’re rebalancing. So you’re selling losers, buying winners every time you rebalance. And that rebalance effect creates a 0.8% compound return over time. If you go all the way to the other end of the chart. And you’ll recall right, the futures universe had 13 effective bets. So here you’ve got 13 effective bets, again, 13 uncorrelated markets, even if all those markets have a zero return, you’re still generating 2.2% a year in Rebalancing Premium. If they happen to have 3% on average compound returns, now you’re generating two and a half percent per year in Rebalancing Premium. And God forbid they all have 6% returns, now you’re into the 3% per year. So I mean, it’s astonishing what you can generate by just having a group of diversified markets, and making the effort to find the most diversified way of constructing a portfolio of those markets to maximize the number of bets.

Rodrigo00:19:36And just to put things into perspective. And I may be wrong here. But when you look at traditional long only factor investing, versus the underlying S&P or whatever the underlying benchmark is, what type of excess return do we see from having those tilts on there.

Adam00:19:51I mean, that’s a really good question, actually. And I meant to go there, I’m glad you reminded me. But so the global equity risk premium since 1900, is about 5% a year, that’s the global equity risk premium. To earn that premium, you need to suffer a volatility of about, depending whether you measure it monthly or daily, somewhere between 16% a year and 20% a year in annualized volatility, okay? All of these returns in this plot are what you get at 10% volatility. So, if you get 5%, I’m just gonna keep the math simple. If you have 5% at 20% volatility, it means you get two and a half percent at 10% volatility. What I’m showing you here is you get the same premium, just from rebalancing as you get from the equity risk premium, when you scale it to the same volatility. That’s how powerful this effect is, when you apply it across such a diverse basket of markets.

Rodrigo00:20:51And what I also want to emphasize is that traditional equity selection type of factor investing, the excess return above the S&P 500 tends to be 1%, 2%, 3% in, back testing without transaction costs and the like. This competes with that, without getting fancy, right? This is a simple matter of the benefit of the rebalancing risk, that excess juicy return you can get without taking excess risk.

Adam00:21:24So that’s a really good point. Because what it also says, if you sort of flip it around, it sort of says, This is the opportunity cost from concentrating, right. This is what you’re giving up, in order to express active views. In other words, to take a confident stand that one market is going to substantially outperform another market. If you create concentrated portfolios that lean heavily into certain markets, then you are by definition, giving up the opportunity of diversity and this diversification premium. So there’s a trade off based on your level of confidence that is, you know, if you’re. You’ve got to be really, really confident to want to give up this, what is essentially a free premium that you get just from diversity.

Rodrigo00:22:14That’s right. That’s a great point. That is like it is the point. Because what is that threshold? Right? If you want to concentrate? What do you actually have to have a level of confidence of achieving, and executing on what VIG, what excess return do you need, in order to be able to say I don’t need that basic stuff. I want to do this advanced stuff that’s going to give me that much more benefit. It’s a big leap to make, right. One is about again, risk parity, going back to the concept is, it’s all about preparation. You don’t have to make a prediction of which asset class is going to work in the future. The only assumptions you need to make is that these asset classes will continue to have idiosyncratic realities based on their underlying fundamental features, right. And we all need to get behind that. Or some may not. But I think we can make a strong argument as to why gold will continue to be different than for TIPS and so on. That’s the assumption you need to make. After that you don’t need to predict, you just get that, right. And that’s it. That’s it, everything else requires you to have a little bit of prediction emphasis and prediction confidence.

Adam00:23:23Exactly. And the same goes in the other direction, right? Like when you emphasize one market, it’s the same as de-emphasizing other markets. And so we hear all the time about people that don’t like risk parity, because of the –  and Mike addressed this from a risk weighted standpoint, but a lot of people don’t get that. What they see is a concentrated allocation to bonds. And so when you’re concentrating, when you’re saying I don’t want to own bonds, what you’re doing is you’re eliminating the opportunity for diversity, right. You’re eliminating a variety of independent bets. And so that is a strong statement, you’re saying I want to be concentrated in all of the other things, instead of holding some bonds, right. And it’s, I think, tying together what Mike said about the fact that if you look at a portfolio in terms of its capital weights, you can’t really get a good sense of the diversity of the portfolio. I mean, if you know that bonds are substantially less volatile than stocks, and you understand the dynamics of risk contributions, you might be able to sort of intuit it. But once you go past two assets, or three assets, it gets essentially impossible. You’re trying to visualize a 13 or 60 dimensional space. So like, there’s just there’s no way to do it, no way to intuit it. So, you sort of have to trust the math that you’re gonna get diversity by not aggressively saying, I really don’t want to own any of these, or I really only want to own this, right. I only want to own equities is the same statement as I don’t want to own any bonds. Right? So it’s a very strong position to take with a potentially large opportunity cost.

Rodrigo00:25:10Well think about it. I always use the example of the German Bunds, right? This belief right now that you’re not going to get any yield from treasuries whatsoever. It’s a why have it? As we speak with advisors, they’re reducing their Treasury exposures, or eliminating them altogether, because they see that the only place that they’re going to be able to provide value to their clients in terms of meeting that 4% threshold in retirement is through the best performing market, regardless of the risk you’re gonna take. But what if they’re right, let’s assume that they are right. And over the next 10 years, equities do well, but it takes eight years for that to manifest because some reason the central governments do, you know, continue to push the yields down, we go from one percentage point yield on the Treasury to negative three, and that takes eight years. And then it all unravels. And you have this massive equity recovery, where you make that 4% annualized return. Well, you just gave up eight years of Rebalancing Premium in order for your view to be correct. Right. That’s a lot to give up.

Mike00:26:16There’s, there’s an extension there, Rodrigo, that keeping in mind diversification, risk management are all about managing the arithmetic stream of return, and helping it approach the geometric rate of return to smooth that. And now we’re at a point where baby boomers are retiring. And most assets that are, that are being put to work are actually flowing cash. They’re not receiving income, they’re giving income. And what you articulated there, Rodrigo, is even more detrimental to a portfolio that’s in decumulation that have this very, very high level of volatility in its annualized returns. And that accentuates, it’s actually the inverse of dollar cost averaging of putting money into volatile assets, and you get an excess return. But when you’re taking money out of volatile assets, you actually get a lower return. That’s that difference in the geometric and arithmetic calculation. That is incredibly important. It is the actual quintessential center point of diversification as a way to try and lower that difference. And then the rebalancing side of it is it’s so powerful, when you can think about sourcing those different betas. Let’s not talk about adding value yet in an alpha sense, let’s not even go there. Right? Let’s, you got the risk free rate, that’s zero. Now we’ve got to get some risk premia from some betas. Well, that in of itself, just as the paper shows, is a very thoughtful process that can be implemented to source those differences. Where are we going to find them? How might we incorporate them? And then, of course, you’re going to have tracking error. Yes, there’s going to be tracking error. Yes, this is going to take discipline. You know, they say diversification is a free lunch, I kind of think people pay. They pay for that free lunch.

Adam00:28:24It’s not free if you’re concerned with tracking error instead of downside deviation.

Rodrigo00:28:29Well, that’s a good question on the free lunch of things, right? Because this is what we’ve always said diversification is free lunch. Rebalancing is the benefit. That’s where you get your free lunch. We were kind of discussing this the other day, Adam, but every way we think about capital markets, we talk about what is, who’s the willing loser on the other side, right? What is somebody giving up in order to get something else? In the case of this premium, what model can we attach to it? Who is giving up something in order for the rest of us to capture that 3% Premium, in a you know, moderately performing well diversified portfolio?

Winners, and Winners

Adam00:29:13Yeah, so this is where you know, and I want to say hi to people that are here by the way, and especially Brian, how you doing? But also Matt, Breaking The Mark has been really inspirational in this regard. And also Taylor Pearson And Jason Bock for Mutiny shared some really great content. And one of the one of the pieces that they shared was this was this video. Maybe actually, you could drop that in the chat, Rodrigo, that video in the chat, which is just incredible. Because what it demonstrates is that when two parties rebalance against one another, you know and extrapolate it out to multiple parties or you know, all investors. When they rebalance against one another, it just, it actually grows the total pie at a faster rate and a more stable rate than not rebalancing. And it makes everybody’s wealth more resilient over the long run. So it’s one of these situations where no one has to lose in order for everyone to win, which is a truly remarkable and astonishing recognition, right? I mean, how often in markets do you get to participate in an effect where if everyone else were to participate in it, everyone else would do better? You know, usually you need to take a premium, you know, it’s Sharpe’s Arithmetic, right? If you’re taking $1 in excess returns from the market, someone else must be losing it. Here’s a situation where that’s not true. Which is remarkable.

Mike00:30:51In fact, the long term single asset holders pay. Right? The long, if you’re a single asset holder, you experience the Sharpe ratio of that asset. You don’t transport liquidity to other assets when you have excess liquidity in your particular domain to capture the excess return that comes from an asset that’s going through a liquidity squeeze, you don’t get that. You just stay in your one lane. And you only get that

Adam00:31:20And why is an asset going through a liquidity squeeze? It is because a certain class of investor is having a bad time, right? Like let’s face it, like people are poor sellers, so something is having a liquidity squeeze. And the people who are rebalancing are stepping in and offering a helping hand during that time. And you know, that situation will reverse eventually. Right. And that is where you generate this long term mutually beneficial and mutually reinforcing type of dynamic.

Mike00:31:53It’s like the value investor, he doesn’t invest today because he foresees prices being lower in the future. The rebalancer is similar, he’s looking at some set of assets that he’s balanced, and he’s looking for that opportunity for something to happen to cause him to say, oh, here’s an opportunity to provide the liquidity I have in these four asset buckets to this other bucket that’s going through this period of time. It’s kind of like this transportability of liquidity that is provided to that which attenuates the downside in that other asset and attenuates the upside in the asset that needs to be sold. And this yin and yang provides less. So when we think about this in the way the market is headed, with the you know, sort of popularity of market cap, the popularity of the US, the 10 stocks in the US that are dominating the market cap in the S&P 500. When you think about that, you have a setup here where, you know, certainly we have high valuations, we have very low interest rates, the risks are higher, the possibility of correlation spikes is higher. All of these things are higher, and maybe they’re higher, because there is more concentration in these assets. But this is a time to be thinking a little bit ahead. Where’s the puck going? Not where’s it been? Each decade seems to have its own sort of persona. And if we think of, you know, the 90s were quite different than the 00’s, the 00’s are quite different than the 10s. Here we are at the beginning of the 20s. Now that doesn’t obviously work out each decade is unique to the year. But we go through these regime shifts. And so if you, certainly if you think you can predict them, you know, that’s the alpha, that’s that excess return, we did cover that in one of the things.

Rodrigo00:33:41It’s totally fine, you just know what the hurdle is now, right.

Surprises

Mike00:33:45It’s very high. So I wonder if we could shift gears a little bit, we’ve certainly beat this diversification horse to death. I’d like to know, Adam, you were sort of deep into this. What were the things that surprised you? What were some of the things that, you know, I know, you and I talked about a few things. I’m like, oh, that made me go hmm. But for you, what were some of the things that sort of, “this is a little bit different or this is better than I thought what were the key”?

Adam00:34:07I was surprised by the number of, the amount of diversity among the commodity markets. I mean, if you look at the risk allocation, the average risk allocation within the sort of most diversified risk parity portfolios, you get a lot more allocation to commodities than you would expect. You know, you think about a more traditional global risk parity, where you target equal risk to an equity cluster, a bond cluster in a commodity cluster. But the commodity cluster is typically weighted by production. Or you know, you can imagine the Goldman Sachs Index weights by the dollar value production of these of these commodities, that sort of thing or the Reuters Index equal weights commodities, right. But you’re not getting the maximum amount of diversity, like just going back to Rodrigo’s chart that he was showing earlier. And I may get the numbers not exactly right. But he gets sort of four or five bets from equally weighting all of the futures markets, but you have 13 bets from maximizing the diversification using an appropriate optimization, right. And so the ability to allocate to a commodity cluster, in a way that is aware of and maximizes the diversity in that cluster. And then acknowledging the optimal diversity of all of those different commodity clusters against the different financials, against the different equity markets, and against the different bond markets, when you put them all in together. I was astonished at how large the premium was. I went into it thinking, well a three asset permanent portfolio, I’d seen some papers that shows that the Rebalancing Premium was on the order of about 1% for them. And I validated that in the paper. But a three or three and a half percent Rebalancing Premium, at a 10% vol, of the portfolio, I was astonished at the magnitude of that. And so it just made me rethink the value of commodities in the portfolio. Certainly, they serve a role as an inflation hedge. I mean, that is originally why we wanted to have the assets in the portfolio in the first place. But there’s this sort of niggling concern that they’ll be a bit of a drag to returns. It turns out because of their diversity when you rebalance them, there is a material premium in commodities, just from rebalancing among all the different bets.

Rodrigo00:36:39Just from having them there. Yeah. No, 100%. That was shocking to me as well. But it does. It makes absolute sense, right. And this is the problem, though, I think, from the perspective of these, the Rebalancing Premium, what you need to make sure you have as your value system is the ability to stick to an asset class or series of asset classes that may go in decade long periods of downward drift, but volatile, right. You have to. Because as long as they’re different, and they’re moving in different ways, you’re getting that Rebalancing Premium, number one. Number two, you never know when they’re gonna start having a massive 10 year long recovery, like we saw from, you know, treasuries from 1941 to 1981, followed by some of the best performing, one of the best performing, if not the best performing asset class the following 20, 30 years, right. The moment that you sign up for this, you give up your willingness to want to predict. You have to, you have to, like believe in the process of rebalancing and constantly being the farmer harvesting that Rebalancing Premium. And we wrote a piece a bunch of years ago called the Shannon’s Demon that showed just that, two asset classes that both lose money, but are non correlated and have X amount of volatility, create a positive Equity Line. I’m actually putting the link in right now in the chat. I think that speaks to the point of why have any gold in there? Why have any commodities? Why have any treasuries right now? They’re low, it should be 100% equities. Okay, here’s why. But it’s tough. Again, it’s a really tough thing to do.

Adam00:38:21Mike, I remember we had a conversation, but you had a couple of, you sort of came at it from an acute angle. And what were some of the things that you had sort of identified as particularly curious.

Mike00:38:30We showed some of the actual portfolio constructions that actually provided a negative rebalancing. And you and I were sort of talking about.

Adam00:38:41I was gonna suggest that we show figure six actually to illustrate that. I agree. That was it. That was another one that really. Because I know that for example, the hierarchical risk parity method has gotten a lot of attention. I apologize for the windiness, I thought I’d try to be outside today. But it is more windy than usual. But yeah, the hierarchal risk parity gets a lot of attention. And it does have some interesting properties. But one of the things that we observed is that because the traditional formulation of hierarchical risk parity, inverse variance weights, the final clusters, it doesn’t quite work like this, but it’s effectively like this. The final weighting between the clusters is inverse variance weights. And bonds have such, so much lower volatility than the other assets in the portfolio, it ends up just really massively emphasizing bonds. And you know it.

Mike00:39:43Go to figure six. Figure six really kind of, down I guess. South America goes.

Adam00:39:55No, no, no. That’s the right one us out. Yeah.

Mike00:39:58The other one is the one that summarizes. Is it advanced or otherwise you bought pages and pages on this thing?

Adam00:40:03Agree. Yeah. So all I did here is I bootstrapped the returns to all of the different markets. So randomly grab, you know, 30 years of returns with replacement. And then run all the different optimizations and observe the Rebalancing Premium, right? And then do that 10,000 times. And that’s the distribution that we observed, the distribution of Rebalancing Premium. So you can see that the max diversification, the maximally diversified risk parity portfolio consistently generates a higher premium than the other methods. In contrast, the hierarchical risk premia, sorry, the hierarchical risk parity method consistently generates a zero premium. And it’s because of the extreme concentration in fixed income. Now, I mean, if you sort of scroll up, I actually think we should go up to figure four, because it does show that. There it is. Yeah, it does show that the performance of the HRP of our portfolio is, over the long term, long term average portfolio return compounds at around 10%. It’s competitive, but it’s competitive, because bonds did so well in sample, right. It emphasized bonds, and bonds happened to be the highest Sharpe asset class, right? So it delivered reasonable returns through concentration. But that same concentration makes it extremely vulnerable, and especially right now, right. Whereas the max div style portfolios had a much smaller allocation to fixed income on the order of about 25% of risk on average, and about the same in equities. And over 50% of the risk was allocated to commodities, because there’s so many diverse bets within commodities. So you have a situation where these maximally diversified portfolios, generate the returns without such a heavy reliance on a high equity risk premium going forward, or a high fixed income risk premium going forward, which makes them even more attractive?

Rodrigo00:42:08How far back did you use? Did you test.

Adam00:42:10It goes back to 1985?

Rodrigo00:42:12Right. So it would have been a whole different story, if you would have been able to get back enough, like previous 40 years.

Adam00:42:17Oh, God. Yeah, I mean, if you’ve gone back in the 70s, then the HRP var would have been absolutely demolished.

Rodrigo00:42:22Yeah, like just from a first principles perspective, the idea of risk parity is over long, very, very long, like 100 years, you’re going to get similar Sharpe ratios. But even over 30, 40 year periods, you will have certain asset classes outperform. And in this case, it happens to be the one that has a lower volatility that gave the best result. Right, and of course you’re gonna get that.

Adam00:42:46Exactly.

Mike00:42:47We’re just talking about this often too, Rod, you know, the last number of years, well, 1982 to 2000, people would talk about, you know, oh bonds did this and the, you know, 18% rates of return. You also had an allocation to gold. Gold went from $2,000 to $200. And you had, you carried that risk weighted allocation to gold, commodities. Oil bottomed at $9. This happened ‘99 and 2000, those were part of the risk parity portfolio during that whole period of time.

Adam00:43:17And as you say, we see this quantitatively. That gold, when you are emphasizing diversification, gold does stand on its own, and apart from the broad commodity cluster, right? So many commercial risk parity implementations, they sort of bucket commodities together, because they don’t really know what to do with them. So they bucket them all together, like I say, like, the Goldman Sachs index, or equal weight them or something, or maybe inverse variance weight them or something, or inverse vol weight them. But it doesn’t account for the diversity of clusters in there, you know. If you look at the energy cluster, a lot of the energies, if you look at WTI crude versus Brent crude and RBOB, and like, these are very highly correlated, you know, like, they’re not. You can’t allocate within the energy cluster and get the same diversity that you can get by allocating between the different clusters. Right. And so having an awareness of that, of the broader relationship context, really allows you to emphasize and far more bets emerge.

Sourcing Betas

Mike00:44:23And that’s a great point to dig into. Because I think, you know, as I think about this, from the standpoint of the different sources of return that we have, and that we have to prioritize the sourcing and finding of these different returns and how do we do that. And that hierarchal process, maybe you can go into a little bit of that of how that actually gets done in order to make sure that you can source these betas, and when they’re, you know, oh, they’re acting together, they will change the bucket that they might be in. Do you want to talk a little bit about that?

Adam00:44:56Yeah, sorry. I we got a question on that from Rahul. So thanks. For that question, Rahul, but, um, yeah. I mean, the way that it’s typically done is that you, because correlations and covariances change through time, you’re observing the covariances locally. Because typically, what we’ve observed most recently ends up being the best estimate of what we should expect in the recent future. So if you’re rebalancing, monthly or even quarterly, you know, typically, these regimes last for a little while. And so you want to have, you want to be observing the covariances over the past, you know. If you want a relatively fast moving model, over the last 60 days, or you can use some sort of exponentially weighted covariance estimation, but even if you’re estimating over rolling windows, if you’ve got monthly data. We’ve just read some analysis using very long or monthly data, and rolling for 36 month horizon, you know, even that can be very effective, right. And some combination can be even more effective, because you get different mean reverting and running dynamics at different time horizons. Actually, which reminds me of another point that I wanted to make, which is when you think about managed futures. So managed futures allocates across all these diverse markets, clearly, they’re allocated across all these financials, bonds and equity and all these commodities. Typically, historically for most managed futures programs, they like to keep it simple, right? If you talk to managers, futures manager, CTA, they hate covariances. They don’t want to talk correlations. Correlations aren’t unstable, right. But they give up a lot from that, right? If you acknowledge that there’s, yes, covariances are unstable, therefore, you need to use shrinkage and you need to use robust estimation methods, you can still generate an enormous number of bets out of sample, and we show a chart of the true out of sample number of bets you can generate from this diverse futures portfolio. But if you think about a managed futures manager, it actually. If you recognize the benefit of having all of these bets in the portfolio, then you want to actually make it more difficult to not have a market in the portfolio on, right. Like if all the markets were perfectly correlated, then there’s no benefit to having more markets on at the moment, right. But if you’re acknowledging the diversity in the investment universe, then you want to make it harder for like, for example, a market may have a slight negative expected return based on your trend model. But if it’s sufficiently uncorrelated with the balance of the portfolio, it may still generate a higher, create a portfolio with a higher Sharpe ratio, but continue to harvest this Rebalancing Premium.

Rodrigo00:47:57That Gestalt is what’s missed when it comes to CTAs. Right? Because a lot of CTAs come from the old school Chartists, right. They’re looking at an asset classes and asset classes. And it’s not like Momentum where you’re trying to do your rank best to worse. You’re actually every single asset class is its own thing. And you’re either above trend or below trend, you’re going long, or you’re going short. So what happens in a situation where the only thing above the trend is 100%, like a bunch of equities. And everything else is kind of hovering in your equity line, and you’re not neither short nor long. Well, you have all of your risk there. And you have no risk in anything else, right? That is a highly concentrated, single bet. You’re not, you don’t have 10 different equity markets you’re betting. You have one bet on growth. And so if you do have anything that’s balancing it off, and you take into account the correlation between those two, what ends and happening as you, if you care, if you’re a CTA that cares about balance as well as that direction, you give yourself an opportunity to increase the Sharpe ratio, in spite of that negative returning asset class that you think may not be there. And we shown, we’ve done this analysis on trend. How by doing this, by thinking about risk parity plus trend, just by thinking about that the balance side, you can increase Sharpe ratio by as much as 50%.

Adam00:49:18Oh, totally. I mean, it’s just amazing. And we can give this away now, because we wouldn’t touch this with a 10 foot pole. But this method, where you can. Just imagine a simple trend system, whether it’s a moving average system or time series momentum system or whatever. And you’ve got up you’ve got a set of markets. And based on your trend signal, either you want to be long, or short, or maybe neutral, maybe this other signal is either a one, a zero or a negative one. You’ve got many markets and all of them have a signal of one zero or negative one. Well, instead of just inverse vol weighting them, so the ones that are on get inverse vol weighted or whatever inverse ATR some other stick. The ones that get on get one vol unit, the ones that are short get one negative vol unit, the ones that are zero get zero vol units. Instead of that, instead of you plug those return estimates into a robust max Sharpe optimization. And now you have a trend portfolio that is aware of the trade off between the desire to maximize the exposure to trend, and the benefit of diversification. Right, and as you say, and we’ve sort of, we’ve circled the drain on this without sort of going into a white paper on it or whatever, in several research pieces. But, as you say, using the same simple trend signals, regardless of what they are, you get about a 40 – 50% boost to the risk adjusted performance of your models by using this diversification aware approach, rather than using a more naive approach that, you know, abhors correlation.

Rodrigo00:51:04Where it’s 100%, about prediction, and diversification just is a secondary afterthought. You know, it just happens to. I mean, the original trend managers would just allocate whatever, oh, that one’s long. I like that one. I’m going to give it more conviction weighting. I think more modern CTAs do inverse vol I think. Right. But there’s that step.

Adam00:51:24And some of them do ERC weighting. And there’s been some good papers on that. And ERC weighting improves it over just inverse vol, or inverse ATR. And like this, you get closer, but everybody avoids a true mean variance optimization, right? Because they’ve been fed this line about error maximization. And I mean, which is itself is total nonsense.

Mike00:51:46Damn you, Carver?

Adam00:51:47Yeah, no, yeah, but Carver gets it right. Like, if you use straight mean variance optimization in with a lot of assets, where many of the assets are very highly correlated, you can get overly concentrated, right? But I mean, Mark Kretzmann has written some great articles. Yes, you get two, you allocate between two markets that are highly correlated, a very small change in mean might cause you to go 100% in asset A, zero in asset B, and another very small change in mean might cause you to go zero in asset A, and 100% in asset B. But the reality is, if the change in mean is very small, then the actual mean variance expectancy of the portfolio is exactly the same, whether you want a 100% asset A or 100% asset B, right? Optimally, you don’t, 50% in A and 50% in B, because there’s idiosyncratic risk that you’re not capturing in the optimization, right? That’s what a robust optimization will deliver, right? So you can do that using regularization, using a bootstrapping, there’s a variety of different ways to achieve that outcome.

Rodrigo00:52:54Make sure that 50/50 like, approach. This is it, they’re right? I mean, nobody’s saying you’re not wrong, and that small changes can lead to drastic shifts in allocations. But from a risk parity lens perspective, those allocations are identical.

Adam00:53:11Well, yeah. But from a mean variance perspective.

Rodrigo00:53:31You’re either from 100% in NASDAQ and 100% in S&P, right. It doesn’t really matter, if you’re one or the other. Like you said, there’s idiosyncratic risk, you want to have both. But if you kind of play that out and let it all and assume no transaction costs, then it’s kind of, it ends up being the same portfolio in spite of those drastic changes in allocations across asset classes.

Adam00:53:31Well, even with transaction costs, it’s the same because you’re either gonna trade two units of one or one units of two. Right, so it’s the same. So you know, I think that’s missed so often. And it’s just another example of how people miss this opportunity cost of diversification.

Rodrigo00:53:51Well, the loathing of mean variance optimization is just astounding to me. And it makes a lot of sense, because I think one of the first papers we wrote back in 2012 together, talked about GIGO, garbage in garbage out. So I think the industry has used mean variance optimization, assuming long term volatility expectations of equities and bonds and long term correlation of equities and bonds. And if you are just using those and applying mean variance optimization, and doing whatever, your capital market expectations based on what they’ve done over the last hundred years, then yeah, you’re probably going to hate mean variance optimization, right? But it’s just come such a long way. And that remnant of you know, people leaving wire houses and saying, I’m never gonna use that again. It just, you can’t breed it out of them, They don’t understand the benefit of it.

Mike00:54:40It might be a similar situation with rebalancing. What is rebalancing? When you talk about rebalancing for most people, what is it? It is either calendar based or threshold based. And it’s based on those two dynamics on the most popular asset classes called 60/40. You’ve seen this constant degradation of any exposure outside of that. So I think that the vast majority of people would probably pass on the paper, just breeze over it, because they’re thinking of it in a very simple dynamic and not understanding the true implications of. Well, first, you’ve got to find and source the different return streams that are firing in different times, and understand that that’s not a stationary thing, that those things do evolve and move. And you have to have some mechanism in order to track that, in order to monitor that, and adjust to that. I forget which figure, figure four, right in the rebalancing papers shows how the number of you know out of sample independent bets changes, right. They do cluster.

Adam00:55:48In response to changes in the covariances.

Mike00:55:49Yeah, and which is a function of the regime shifts that is occurring. And so, you do need to pay attention to that. Now, you know, something like a permanent portfolio goes a long way. It’s super simple, but it doesn’t quite maximize the opportunity. And so I think that’s something that from a rebalancing perspective, you know.

Adam00:56:09Well, here’s an interesting point, like, right, so we know a lot of people who run a permanent portfolio individually, because they’re like, I don’t want to pay fees. And I can, this is super simple. I can run it myself, I don’t need to pay any fees right. Now. Well, the Rebalancing Premium on the permanent portfolio is 1% a year. The Rebalancing Premium on the maximally diversified risk parity portfolio is 3% a year. Which to me says you can pay 2% in fees, and be neutral. And most of the risk parity strategies that I see commercially offered, you don’t pay 2% fees.

Mike00:56:48We certainly don’t charge that.

Adam00:56:49The Rebalancing Premium is a lot larger, it’s close to like two and a half percent a year.

Rodrigo00:56:55So let’s, I want to just touch upon one thing you said, Mike, which is that, you know, there’s this idea that the markets move and they evolve. You know, we’ve touched, we’ve talked a lot about the market dynamics leading to alpha going away when there’s too much money going into a methodology, overcrowding and the like, right? So we’ve written a ton on that. It’s one of the reasons why we do, we try to avoid the crowd through our machine learning process. But taking it to this basic rebalancing that earlier on, we said, well, it’s there, it’s always going to be there. It’s a free lunch. It’s just the dynamics. What type of overcrowding can exist here? And how can overcrowding possibly minimize or reduce the Rebalancing Premium in the future? Everybody listens to our podcast, everybody buys into risk parity. They like what we’re doing, slight differences, what happens then?

Mike00:57:52I think you’re seeing that right now. You’re seeing 10 stocks dominate the returns of global equity markets everywhere. That doesn’t mean that there’s not an opportunity for…

Rodrigo00:58:02But we’ve seen massive divergence and correlations between those 10 stocks and bonds, in the worst of it, right. And gold is now significantly lower correlation. And so if I’m an asset class level, I take your argument, because I have, it’s happened to me before.

Adam00:58:15If everybody rebalances, then the aggregate wealth of everybody increases. And you also create a portfolio that is much more, much less ergodic. In other words, you’re much less vulnerable to a major catastrophic outcome in a single asset class. Right, I mean.

Rodrigo00:58:32Yeah, so everybody, less people take concentrated risks that leads them at the margins in panic, to take aggressive action that leads to increased or decreased liquidity, which leads to lower volatility of single asset classes. And that lower volatility leads to a lower rebalancing premium. Am I getting it wrong?

Adam00:58:52Well, I think you’re assuming that everybody’s like, that there’s this aggregate amount of capital that sits in the market and none ever leaves and no one ever goes in. Like, there’s always going to be investors that are flowing funds into the markets and flowing funds out of the market that are going to, they’re gonna buy and sell, you know, like. And they’re gonna buy and sell at different times for different reasons and take concentrated risk.

Rodrigo00:59:20Totally that is likely the outcome. But what if, what if everybody’s buying the risk parity maximally diversified portfolio?

Mike00:59:25So let’s observe. Do you think that that’s happening? We know that the global.

Rodrigo00:59:33No. Listen, I’m gonna play devil’s advocate.

Mike00:59:35No, it’s a great advocacy for the devil. Let’s look at the global market portfolio. Right? So the true passive equity portfolio, just let’s say equity, let’s ignore all the other asset classes that would be sort of an ACWI  weighted benchmark to equities, and that everybody in the world should own that. In fact, everybody in the world collectively does own that. That’s how the market cap manifests. But they all own it from a significant home country bias, all of them. And so I don’t see.

Rodrigo01:00:07Yeah, you would need to eliminate home country bias. Right? Right, you would need to eliminate the need to feel like you can predict. You would need to eliminate the industry as a whole believing that they can predict the future. Like it’s just there’s so many hurdles for this to go in the. You know what my biggest one is where I think there, as a Peruvian and who’s seen this happen is capital controls, where like we saw it in gold. Gold was at a certain level. There was zero volatility for gold in the majority of its modern history. And so all that Rebalancing Premium that we have from gold, it doesn’t exist.

Mike01:00:46Hold on a second, there’s a zero observed gold. The black market for gold was very different. So, right.

Rodrigo01:00:56Portfolio. That’s the case, as long as you can transact. One of the key tenets of risk parity is that you need to be able to be liquid, you need to invest in liquid stuff, right. It doesn’t work for VC, it doesn’t work for real estate.

Adam01:01:07But you get a Rebalancing Premium by rebalancing between stocks and cash. Cash has no volatility, but rebalancing between stocks and cash produces Rebalancing Premium. So if you’ve got several markets that don’t trade, but that are sufficiently liquid that you can get in and out of them, and you’re able to trade other volatile markets, you’re still able to generate a material Rebalancing Premium.

Rodrigo01:01:24Yeah, I think there will always be opportunities, what I’m discussing is the reduction of what we’ve seen in situ by a despotic series of leaders, having capital controls on commodities, having capital controls on gold, having capital controls. I mean, one might say that we have some very big fears of capital controls and yield control in the Treasury market. Right. So those are the things I think when you look at the overcrowding discussions we’ve been having over the last few weeks. I mean, nobody’s immune to it, I just think this process is the most immune to it.

Adam01:02:01This is what this always devolves to. But – but – but you know, it has these flaws, without recognizing that all of the other potential ways you could invest have much, much more hair.

Mike01:02:12Oh, yeah.

Rodrigo01:02:13They have seven buts.

Adam01:02:14So I know, we all want to be intellectually honest, and whatever. And I think that that’s important that we try to go in. We try to discuss things from all different angles. But reductio ad absurdum is also. I don’t know how helpful it is because, you know, people are resistant to new ideas in the first place. And they want to keep doing what they’re doing. They want to keep doing what their friends are doing. And they don’t need any more. And they’re going to see the flaws in something new with much brighter colors, with greater, more vividly and with much louder noises, than they see the flaws in what they’re currently doing and what they’re currently being advised to do. And so, you know, I agree that there are some potentially non-zero probability, future trajectories that could result in some of these weird situations. But I would argue that this global risk parity portfolio is still the best position, even though we may compromise some of the.

Rodrigo01:03:16So one that has the highest structural barrier to arbitrage.

Mike01:03:19And again, I think what you what you outline is a point that is very important too, Rodrigo, is that the markets are reflexive. And that if everyone does adopt this particular protocol, then that has an effect on the markets. As Adam says, the study of physics doesn’t change physics. But in fact, it does. If you light a wave or a particle, well if it’s observed, it changes. It’s a very interesting thing. But in most domains.

Adam01:03:49It doesn’t change so much as it just expresses a state.

Rodrigo01:03:53Or somebody’s gonna to read that white paper.

Mike01:03:54Having said that, the observation of things doesn’t change things as much. But that’s what we’re here for. We’re not espousing this as being, “this is what you should do forever”. I think it’s a very, very solid protocol that one has to look very carefully at if we think about, Okay, what are the sources of return that we’re going to have, we have the risk free rate, we have risk premia from betas, not just the equity risk premium beta, not just the value factor premia. Right, and then you’ve got the opportunity for skill. Well, let’s cover off the first two really well, you know, like risk free is going to be zero. Okay. What about the potential for a diverse basket of risk premia betas? What about the opportunity to rebalance those appropriately? Then, let’s talk about more. And I would say therein lies some skill in that for sure. Analyze some discipline, analyze the ability to tolerate tracking error. So there’s going to be a price paid for those investors who take this particular path. But you know, I think given what the paper talks about, these are substantial excess returns. Like these are returns that are on the order of risk premia excess returns, and they reduce risk at the same time.

Rodrigo01:05:14And look, one thing that we haven’t talked about, that comes hand in hand with risk parity is that risk parity, because it’s so diversified could lead to a very low vol portfolio. And so you have the benefit of using Nobel Prize winning concepts from Sharpe, using leverage in order to increase your total return. So we talked about a 10% volatility risk parity portfolio that has an excess return of 3% if done right? What happens if you run a 20 vol product, because you’re used to having 20% volatility as an international 100% equity investor, and you can handle that volatility and that drawdown? Well, all of a sudden, you increase, maybe not double because you have to pay for leverage. But you’ve all of a sudden increased your Rebalancing Premium quite a bit with…

Adam01:06:06Well, keep in mind, our study was on futures. So increasing leverage is no particular…

Rodrigo01:06:11Yeah, exactly.

Mike01:06:14Well, I think from it from a nominal notional perspective, from the average investor, they might perceive it that way. But I’m with you.

Rodrigo01:06:20But the point is that, you want more return, I want more return. So I have to, the default is I have to be predictable. I have to use prediction. What I’m saying is that, well hold up a second. Before you go there, first, assess what your maximum risk you’re willing to take, see what the Rebalancing Premium offers you at that level, and then say, I need more, great. Are you ready to go down the machine learning rabbit hole, right? Or you know, some of the stuff that we do. But there’s even more of a hurdle. Remember going back to the original point of if I haven’t predicted, if I can concentrate in equities and try to pick better equities? Well, your equities have a vol between 15 and 25 average. Okay, so let’s get that risk parity Rebalancing Premium up to your vol, and recognize that now your hurdle got even higher. Anyway? I think Matt asked a question.

Adam01:07:13I just want to acknowledge, Breaking The Market, Matt, I’m just focusing the lens on the fact that so long as we’ve got a group of investments that are uncorrelated and sufficiently volatile, there will be a Rebalancing Premium. I think that’s what we sort of triangulated on with Rodrigo’s comment, so 100% agree. Yeah. So what is supposed to happen when something changes from liquid to controlled? Yeah. So I mean, if something can no longer be traded, then it no longer represents an opportunity for an uncorrelated bet. So for sure, but control doesn’t necessarily mean that it’s not liquid, right? They could just, you could just set a price.

Rodrigo01:07:52You can still have it in your portfolio, you just don’t have the volatility to necessarily rebalance.

Adam01:07:56Yeah. Hong Kong has pegged its currency against the dollar for many years. The Swiss Franc pegged for a while to the Euro, you could still buy and sell Francs versus euros and Hong Kong dollars versus US dollars, etcetera. It’s just that the price doesn’t change, as long as you’re able to, you’ve got other volatile assets, and you’re rebalancing into and out of the non volatile assets, you’re still able to generate a premium.

Rodrigo01:08:21And proxy assets that are not controlled might have even more volatility that you can harvest from that, right. So there’s always a pressure valve that needs to be released.

Mike01:08:28I think in this case, when you have something pegged, don’t trade the pegged item. Right, trade the non pegged item.

Adam01:08:37Well, no, the point is. Oh, yeah, I mean, but if you can trade it, then trade then using it as an. Again, right? You can generate a Rebalancing Premium by rebalancing between cash and a volatile asset, right? So you still want to trade it, it’s just that it won’t generate any volatility. So you may need to trade the rest of your portfolio at a slightly higher exposure to preserve your target volatility and preserve that or achieve that rebalancing.

Mike01:09:01I guess, what I’m suggesting is what happened with the euro and Swiss franc was a particularly large event. So if both assets were behaving the same because of a peg, the one that can unpeg, the smaller of the two that unpegs and has some 20 standard deviation.

Adam01:09:21I see what you’re saying. They’re 100% correlated now. So why are you trading both of them?

Mike01:09:25Why are you trading both of them? Yep. So you trade to one that is the more freer trading one of the two, but those get down sort of deep into decisions that have to be made in the trading of different assets and portfolios, and things like that? Well, that’s run an hour and 10 minutes, and I know you’ve got a swimming meet to get to Adam. And I know Rod’s got some kid’s stuff to do. What do you think we should. Shall we wrap it there?

Rodrigo01:09:51I think we covered everything.

Mike01:09:55I also do want to ask everyone out there if you can certainly Like these things, subscribe to them on YouTube, it helps us a lot. If you leave a review or you have it in the comment sections, it’s really great. It helps us grow, the opportunity to share things with everybody, it helps us grow the opportunity to have great guests on as well when it’s not just the three amigos if you will. And we appreciate all your support. And well.

Adam01:10:20That’s a really good point, Mike, because and hopefully I know Matt’s on here and several others probably listening were tremendous helps in editing and bouncing ideas off for these papers. And those contributions are enormously valuable, and really appreciate all the engagement and sharing etcetera, of all the content. And just absolutely just keep it up. The more engagement we get on these shows, then the you know, the more guests we’re able to attract more easily and more quickly and the more interesting the conversations, the more valuable conversations get so.

Mike01:10:56What do we have next week?

Rodrigo01:11:00That’s a good point. I just want to say that I’m shocked that it’s been an hour and 10 minutes and Adam hasn’t dropped this favorite line. Diversification is indistinguishable from magic.

Adam01:11:10Sufficiently advanced diversification is indistinguishable from magic. Exactly, yeah. Bastardizing that are.

Rodrigo01:11:14Mike. You know that but the cue was not coming out, I had to bring it out. Anyway, gents, great chat, as always. Everyone out there.

Adam01:11:23Thanks to Matt Faber, actually for canceling this week and giving us a chance to riff on this paper.

Mike01:11:27Oh yeah, so Wayne Himmelstein is with us next week,which is really interesting, right? Because now you have, so you have a Rebalancing Premium across different asset classes. But now let’s talk about the idea of detail. And how does that impact the opportunity for diversification through a portfolio? This is a very, very, I think, complimentary discussion to what we talked about today. So to truly get a robust portfolio, that’s going to be a bit of fun.

Rodrigo01:11:59Absolutely. Agree. Thanks, guys. Have a great weekend. Thanks for your listening. Everyone.

Adam01:12:03Have a great weekend. Yep. See ya.

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