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

It is, without a doubt, the most logical starting point for any portfolio that seeks both global diversity and risk balance. Preparation before prediction. First, do no harm. Yet there is a wide range of ways to structure and deploy Risk Parity – as always, the devil is in the details (for a deeper dive check out our recent whitepaper). We had the pleasure of speaking with Alex Shahidi and Damien Bisserier (co-founders of Evoke Wealth and ARIS Consulting), creators of the popular RPAR ETF, on topics that included:

  • Their history and journey before joining forces
  • Multiple definitions and iterations of Risk Parity
  • The consistent mispricing of global diversification benefits (why Risk Parity works)
  • Why the investment industry is wired to overweight prediction and underweight preparation
  • Behavioral hurdles and the real struggle with FOMO

Of course, it wouldn’t be a true Risk Parity debate without addressing the role of bonds in the current zero-bound environment and the importance of duration adjustments on bond holdings, as well as the role of currencies and different ways of obtaining exposure to commodities. A true Risk Parity primer.

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

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Alex Shahidi
JD, CIMA®, CFA®, CFP®, CLU®, ChFC®

Managing Partner, Co-CIO

Alex is a Managing Partner and Co-Chief Investment Officer at Evoke Wealth and ARIS Consulting, a $19 billion registered investment advisor. Alex has 21 years of experience as an investment consultant managing multibillion-dollar portfolios. He began his career at Merrill Lynch, where he led one of the firm’s largest institutional consulting groups, advising more than $10 billion in assets with an average client size of approximately $300 million. After Merrill, Alex co-founded ARIS, where he, along with co-founder Damien Bisserier, oversaw the firm’s research and client service efforts. 

Alex focuses on advising large pension funds, foundations, endowments, and ultra-high-net-worth families. He works with his clients in a variety of financial areas including developing investment policy statements, managing asset allocation, selecting managers, monitoring portfolio performance, and creating financial plans. 

 

Alex is a Chartered Financial Analyst (CFA®), a Certified Investment Management Analyst (CIMA®), a Certified Financial Planner (CFP®), a Chartered Life Underwriter (CLU®), and a Chartered Financial Consultant (ChFC®). Barron’s magazine has repeatedly ranked him as one of America’s Top 100 Independent Financial Advisors, Top 1,200 Financial Advisors and Top 1,000 Financial Advisors.

Alex graduated cum laude from University of California, Santa Barbara, with degrees in business economics and law. He earned a JD from the University of California, Hastings Law School, and is a licensed attorney in California. 

Alex is a prolific writer. His book titled Balanced Asset Allocation: How to Profit in Any Economic Climate, was released in late 2014. The article introducing the premise of the book was recognized with the IMCA 2012 Stephen L. Kessler Writing Award as well as in the Wall Street Journal, Market Watch, Money News, Fidelity.com, and Wall Street Daily. 

He has been interviewed on Bloomberg Television and BBC as well as for articles in the Wall Street Journal, Barron’s and other publications. Alex has also contributed articles on asset allocation and long-term equity market cycles to Investments and Wealth Monitor, a national publication of the Investment Management Consultants Association (IMCA), and Advisor Perspectives, a leading publisher for financial professionals.

Alex Shahidi
JD, CIMA®, CFA®, CFP®, CLU®, ChFC®

Managing Partner, Co-CIO

Damien is a Managing Partner and Co-Chief Investment Officer at Evoke-ARIS, a $19 billion registered investment advisor. He has over 19 years of experience advising some of the world’s leading institutional investors and financial companies on investment and risk management issues. Damien began his career at Oliver Wyman, a premier financial services advisory firm. As a consultant, he focused on risk management at global banks and insurance companies.

After Oliver Wyman, Damien spent nearly a decade as a Senior Client Advisor and Senior Investment Associate at Bridgewater Associates, one of the world’s largest hedge fund managers. In this role, Damien was responsible for managing relationships across more than 50 North American institutional clients – including endowments, foundations, pension plans and family offices – ranging in size from $1 billion to $100 billion.

Damien advised institutional CIOs on a range of investment topics, including portfolio construction, manger selection and asset-liability management. While at Bridgewater, Damien participated in the rigorous Investment Associate program, a requisite for Bridgewater’s senior investment professionals, which included ongoing testing and education around the global economy and financial markets. In 2014, Damien co-founded ARIS with business partner Alex Shahidi, with whom he oversaw ARIS’ investment research and client service functions. 

Damien graduated cum laude from Princeton University with a BSE in operations research and financial engineering.

TRANSCRIPT

Rodrigo:00:00:00And are you guys? Sorry Alex, I missed it. Were you were you from there originally?

Alex:00:00:05Yeah, I grew up in Orange County. And I’ve been up and down the coast my whole life and kind of still up and down the coast. Try to stay close to the water, just in case, you know.

Rodrigo:00:00:17Very cool.

Adam:00:00:18I get that. I was born on an island and have always craved living close to the water, though. Not the North Atlantic so much, but certainly warm oceans and beaches. So okay, we’re live. Welcome, everyone. And welcome, Alex and Damien. So, today we are speaking with Alex Shahidi. And Damien. Is it Besserier, Besserier?

Damien:00:00:46Besserier. Yeah, that’s right.

Adam:00:00:47Besserier? Alright.

Alex:00:00:48Like Perrier.

Adam:00:00:50Got it. Yep. I think us Canadians we’re maybe a little bit better equipped to pronounce those names, the French derived names. But, so yeah, the progenitors of the RPAR ETF. Of course, that’s not the entire story. And we want to get a much more comprehensive view of both of your stories today. I guess before we get going, maybe our chief comedian and compliance officer can say a few words about what everyone should expect from this episode.

Rodrigo:00:01:22Can I just have a sip of my alcohol?

Mike:00:01:23Well, yeah.

Rodrigo:00:01:25I’m drinking my red today.

Mike:00:01:27Sure.

Rodrigo:00:01:27Did you guys get the memo that this was a drinking interview? Maybe not.

Damien:00:01:33At the very last minute, so I don’t actually have anything besides my coffee, which is not as exciting.

Adam:00:01:39You know, you could have just lied and said there’s whatever rum or whiskey or…

Damien:00:01:42I guess I could have said that.

Rodrigo:00:01:44Well, you’re from the west coast, I guess there might be other things available. Other party favours that you can’t talk about. So alright, Mike, take it away.

Mike:00:01:56Well, just a warning for everybody that we are going to discuss lots of topics, they’re very wide ranging. Some of them may include investing topics, and that you should take any advice that you receive from this particular venue and not use it in any way shape or form. There is no advice as it were, and that you should consult a professional in executing anything that you might find interesting from this conversation. And with that, let’s roll.

Backgrounder

Adam:00:02:24Well said so I mean, obviously, Alex, Damien, we have a shared interest in asset allocation, particularly risk parity. So we’re going to certainly talk about your new ETF RPAR, but I think we’d all like to know a little bit more about your respective careers and how they culminated in a partnership on this project.

Alex:00:02:43Sure, Damien, you want to kick it off? Yours is a lot more interesting than mine.

Damien:00:02:49So I grew up in LA and then moved back east to go to college and worked in financial services. Spent most of my career actually at Bridgewater, it’s a large hedge fund in Connecticut. And when I was at Bridgewater I met Alex. He was actually one of our largest clients and he was overseeing an institutional consulting practice at Merrill Lynch, probably the largest at the firm. So he had some multibillion dollar clients’ pension plans that were investors with Bridgewater. So actually a funny story, he was in the office meeting with my boss, Ray Dalio back in I think was maybe it was 2009. And they had a good conversation. And afterwards, Ray grabbed me in the hallway and he said, “That guy I was talking to he’s got good common sense, we should hire him,” which is not, you know it’s a little atypical after meeting someone for the first time for Ray. That was pretty high compliment. And so I called up Alex and I basically offered him the opportunity to move cross country, because he was in Los Angeles.

Alex:00:03:51No way.

Damien:00:03:52And he basically said, “You know, can I move my, you know, can I do this from Los Angeles?” I was like, “I’ve been trying to convince Ray of that for years. It’s not happening.” And so he said, “Well, while we’re on the topic, would you ever consider working with me? So that was when we first started talking.”

Rodrigo:00:04:08Well, I’m going to say, you do have some common sense. That’s some common sense right there.

Damien:00:04:12Yeah. So yeah you know, we talked about it for a number of years. And then my wife and I decided to move back to LA to start a family and that was back in 2014. So I left Bridgewater and Alex and I started the business.

Rodrigo:00:04:25And what were you focused on in Bridgewater? I mean, there’s many roles that one takes there. Was it the risk parity side for you?

Damien:00:04:31Well, so, at Bridgewater it’s a lot of generalists. So I mean, there’s obviously different departments. So I started in research. I was in their investment associates program, and then you have the opportunity to choose different paths and I really enjoyed working with clients. So one of the unique aspects of Bridgewater is that they put investment professionals in the seats of client relationship managers, and the goal was to deepen the relationship beyond just the return train. We wanted to be a partner to our clients to help them think through their strategic challenges like asset allocation. And so All Weather it was kind of core or risk parity was kind of core to how we approached a whole range of strategic issues related to asset allocation. That was our philosophy around how you should allocate assets. And so I was in that role of basically providing that advice and that strategic help to, you know, endowment CIOs and pension plan CIOs and those types of investors, and Alex is one of those. So actually, he’ll talk about his background, but one of the first things that he did, after we introduced that philosophy to him was, this is an indication of the kind of person that Alex is, his response was, “Oh, that’s interesting. Let me do my own work on that.” And so he went back and did a bunch of research on the topic. He ended up writing a book that was published by Wiley, the first book that I know of that really elaborates on that philosophy in any detail, because he thought this was such a wonderful thing that every investor should have access to that knowledge base. And, you know, and actually, it was only available to a few institutional investors who’d embraced the concept. So that’s it.

Rodrigo:00:06:13Yeah. I remember reviewing it before it came out. It was a, I read it a couple times just to round things off. I mean, we’d written a book that touched it, but nothing as detailed as Balanced Risk. Is that what’s it called?

Adam:00:06:26Balanced Asset Allocation.

Rodrigo:00:06:28Balanced Asset Allocation. So how many electrodes did the average employee get hooked up to at Bridgewater on a daily basis? Like, what was the routine there? How many buttons were you pressing? And then telling you.

Damien:00:06:41Well, the buttons and electrodes increased over time. So when I joined, it was 200 people. Ray hired me.

Alex:00:06:46Oh, wow.

Damien:00:06:47So there were no electrodes. There was just Ray in his watchtower, you know, and then over time, you know, that you can’t scale Ray. And so he decided that, you know, the same way that he approached investing, which was to systemize his investment thinking, he wanted to systemize his management process, and so that he could essentially build a management infrastructure that implemented the same type of management style that he was implementing on his own. And so then the electrodes came, and all the other things came along with that.

Rodrigo:00:07:17Interesting. Alright, so Alex, why don’t you give us your background?

Alex:00:07:23Sure, I, you know, I grew up in California, up and down the coast, went to college in Santa Barbara. And then I went to law school in San Francisco, and while I was in law school, the first thing I realized is I didn’t want to be a lawyer. And so I still went through. I finished, I graduated, took the bar exam, and a week later, I started at Merrill Lynch as a financial advisor. And what’s fun about that experience is you arrive, and they say, “Welcome, here’s a computer and here’s a phone, go get clients.” And it’s really interesting to do that when you’re at the top of the market, which is in the late 90s. So my first three years in the business, the market fell 50%. So it’s not the headwind you’re hoping for when you’re launching your career, but what it did, what it taught me is the value of protecting principal, and trying to achieve a steady return. And so all those, that was kind of instilled in me early in my career, you know. Obviously, I wasn’t managing very much, but it gives you the, you realize how important it is to protect and then also the behavioural biases of people and, you know, this whole, you know, selling low and buying high and so all of that was instilled early in my life and in my career. So, I was at Merrill Lynch for 15 years. In 2014, I felt it was time to move to the next chapter. Damien and I have been talking for, felt like, almost 10 years, you know, we move slow in our business. And, you know, all the stars aligned, and it was time to leave and, you know, launch our own firm, which we did in 2014. And I think within a month is when the book got published. So I was working on that at the same time. And since then, we’ve been embracing this risk parity concept, implementing it in client portfolios, and always looking for ways to incrementally make improvements. And the launch of the ETF is kind of a continuation of that process. And I think we’ll probably talk about that, but you know our mission is “Keep improving the investment process.” And so all the resources that we bring in, all the people we talk to, we’re always looking for, you know, people who are smarter than us. That’s why I thought it was good for Damien to join me. He’s, you know, he doubles our IQ average. And so if you keep doing that, and you look forward 10 to 20 years, your portfolios will be better than they are today. So that’s you know, that’s the lifelong objective that we’ll never get to, you know, the ultimate, but we’re always going to get better. That’s it. That’s, you know, that’s who I am.

Adam:00:09:58So currently, today you manage a private practice that’s mostly high net worth. Is it also institutional? Is it a combination? What does the practice look like?

Alex:00:10:08It’s a combination. So we advise about 18 billion in assets. And it’s for institutions and high net worth. It’s like 50/50 in terms of assets. And, you know, the portfolios are, you know, our goal is slow and steady wins the race. And, you know, that’s the way we manage it.

Adam:00:10:29So we’ve been talking for several years, mostly, I think, on the topic of risk parity. So my understanding is that you have been employing a risk parity concept, whether it was an allocation to All Weather or your own internal risk parity formulation for a while. How do you articulate it? I mean, our, the people that listen to this podcast, and all of our other content, I think are sick of hearing how we articulate it. So I’m always curious to hear how other people think about it, and describe it and make it understandable and approachable.

Articulating Risk Parity

Alex:00:11:03Sure, Damien, you wanna start?

Damien:00:11:07Sure. So I’m going to take it a step back, actually, and talk about, in our view, how to build a great portfolio, which I think is, you know, this is very much an implementation of how to do that, but it’s a limited implementation in the sense that it’s just focused on things that are easily accessible. So public markets. And so our view on a great portfolio is lots of individually attractive return streams, let’s say return streams that offer you equity-like or better returns, but that are reliably different from one another. And that second part is the part that is probably the most under appreciated aspect of investment management. The vast majority of portfolios are full of lots of line items that are very closely related to one another, they’re equity oriented line items. And so they tend to go up and down together. There isn’t a lot of diversification, reliable diversification, in most client portfolios, or most investor portfolios generally. And so risk parity is our attempt to look at what’s available in the public markets and try to build something that is as consistent as possible by taking advantage of those diversification benefits. So that’s how I’d say. And then we can get into the mechanics of risk parity, but I think it’s important to start there because it’s just not how people think about investing when it actually in our view is very common sense.

Adam:00:12:33So what are the fundamental assumptions for, that in forming a risk parity portfolio, that are different from how many investors think about forming portfolios?

Alex:00:12:48Yeah, I mean that. And a lot of this sounds intuitive, but the way most people invest is they look for things that they think are going to go up over time. And they look for things that they think are attractive returns, and they just allocate to those. And then if those things are too risky, then they’ll own bonds or other things that control the risk. And so when you approach it from that framework, you basically end up with a portfolio that has a lot of stocks, and maybe high yield bonds or corporate bonds, because the assumption is the expected return of those is higher than it is for, you know, higher quality bonds. And so if you’re a longer term investor, if you’re more comfortable taking risks, you should own more of those things. And if you’re less comfortable, or have other concerns or needs, you own less. And you scale up and down based on your risk profile. So that’s the way you know, that’s the way.

Rodrigo:00:13:42Return based, return expectations based asset allocation.

Alex:00:13:45Yeah, exactly. Right. That’s a simple way to say it. Thank you. Okay, so that’s the way most people think. The challenge though is that if you follow that path, you could end up with a portfolio that is not very balanced. And balanced to us means something that is not highly dependent on any single economic environment. So a portfolio that is equity centric, or credit centric, will do well when the economy’s doing well and will do poorly when the economy’s doing poorly. And it also is not the great inflation hedge, so like in the 1970s, it would have done really poorly. And, what’s really interesting is because most portfolios are positioned that way, when bad times come and you lose money, you look around and everybody you know has lost money too. So it feels like that’s the way it is and we’re all in this together, we’re down together, everybody just hold on, it’s gonna come back. So that’s the philosophy, but there is a better way and it’s reliably better over the long run. And so, but you have to dismiss the traditional way of thinking, the conventional wisdom.

So the way we think about it, which is I think a different approach, is rooted in what Damien described, which is, look for return streams that are attractive, that are different from one another, as opposed to what you just said, which is focusing on just the returns. And what is really surprising is you can take these traditionally lower risk asset classes, and you can scale them up to give you a comparable return on risk. So I’ll give you a couple of data points, which I think might surprise a lot of people. So if you look at the last 50 years, global stocks have earned 8 to 9% a year for 50 years. Long term treasuries, you know, the thing that nobody likes today, has had about the same return for the last 50 years. And you think about philosophically, conceptually, how can that be? How can a government guaranteed security have the same return as stocks, which are really risky? And it’s because you’re basically, you can extend the duration and you can increase the risk. So stocks have a higher return because the risk is higher. And bonds have a lower return because the risk is lower. But you can equalize them. And you can do the same thing with things like gold or inflation linked bonds, or commodities. And if your menu of choices isn’t just, you know, high risk stocks and low risk bonds, if your menu is a bunch of things that have similar returns and risk, then your framework for building a portfolio is a lot more advanced. And you can end up with a portfolio of asset classes that go up and down in different environments fairly reliably, that have all have high expected returns, and you end up with a lot less risk. So that’s the way I think about it and the framework that I hope makes sense.

Adam:00:16:31The interesting thing about this conversation is that Rodrigo and I get to play a role on the other side asking questions.

Rodrigo:00:16:39I got 50 questions.

Adam:00:16:41Yeah, that’s right, that we hear all the time as challenges. One of them, of course, a timely challenge is the fact that government bond rates are a fraction of what they were 30 or 40 years ago. And so, why should investors think that the next, that the returns to bonds, or the risk adjusted returns to bonds rather, over the next 10, 20, 30, 50 years, are likely to be similar to the risk adjusted returns on stocks? How do you respond to that?

Alex:00:17:20Yep. So that’s a question I’ve been getting for about 10 years. Right? So rates have been low for, I mean rates have been falling for 40 years, right? You go to the early 80s. And, and you know, 10 years ago, they were too low, they can’t possibly go any lower. Nine months ago, they were too low, there’s no way they can go any lower. And look at where we are now. Right? So if you just look at US rates relative to the rest of the developed world, they’re actually high. Right? So they can certainly go lower. So that’s point number one. Number two is rates falling has, it has benefited bonds, it’s also benefited stocks, it’s benefited all asset classes. And looking forward, the expected return of all of them is lower. Right? Because when cash is, you know, I remember when I started in the late 90s, cash was yielding 6%. Right? So you could just buy cash and earn 6%. And, you know, in stocks, you would expect a much higher return than that otherwise, who would take the risk of stocks to get something less? But today, cash is zero, right? And over the last hundred years, stocks have outperformed cash by 4 or 5% a year. That’s where you get those, you know, 9 to 10% returns, when cash is zero, the expected return on stocks is low. So, you know, it’s a challenging environment because cash is at such a low rate. Right. So then, you know, so the third point, and I’ll let Damien jump in, is that the real question you have to ask isn’t whether rates are going to go up or down. You have to ask what would cause that to happen? Right? So let’s say, you know, we’re looking at the next 12 months, if I told you that the economy was going to suffer, you know, a devastating hit, more so than what’s already happened, there’s a good chance rates are gonna fall further. And if you don’t own that bond, right, you’re gonna, you don’t have balance in your portfolio. And likewise, if the economy does really well, rates will probably rise and that bond will get hurt, but your other assets will do well. And so rather than trying to guess, because it’s really hard to do that. I think 2020 is a perfect example of the difficulty in predicting, you know, the markets and even the economy. It’s, in our view, it’s better to be balanced, and especially in today’s environment.

Rodrigo:00:19:33Yeah, I think I use the example of what did German advisors say to their clients in 2015 when yields were .75 for German bunds? What’s the point of owning these? They’re only going 75 basis points. Who would own these? Who would own such things? Fast forward three years, and if you held a portfolio of German bunds, a 10 year, you would have annualized at just under 6%. Right? So these are, this is the challenge is everybody, I remember ’09 there’s nowhere else to go but up in terms of yield, and here we are today. So…

Alex:00:20:04Right.

Adam:00:20:04I wonder though.

Rodrigo:00:20:05 Certainly it’s easier to liquidate.

Damien:00:20:06I do think you need to make some adjustments though, because if, you know, if you’re holding just very short term bonds, there isn’t much more room to fall. And so one thing that we’re conscious of is we want to make sure that in a downside growth scenario, you’re actually getting meaningful diversification from the bond portfolio. That’s the role of the Treasury exposure, is to provide a hedge to that downside growth scenario, when equities are likely struggling. And so one thing we have done is we’ve moved further out on the curve, where there’s a lot more room to fall. So 30 year bonds in the US are 1.4%, which doesn’t sound like a whole lot. But if we go the way of Japan and Europe, which, you know, is not an unreasonable assumption, those rates could be much closer to zero. And so that type of a rally with long duration bonds would have a meaningful return impact on the portfolio. And so that’s one thing we’ve done is we’ve moved further out of the curve. And then the other thing that I think is relevant in this environment, is we’ve also increased our exposure to gold. And so if you think about monetary policy, traditionally, it was to lower interest rates to stimulate the economy, that is a tool that has minimal, maybe no effectiveness at this point. And so now, the way that central banks manage their economies, the way they stimulate is to print money. And initially, it was to print money and buy assets, and now it’s to print money and then turn around and have the government fiscally stimulate. So it’s a print and spend policy. And so that environment I think gold in many ways has become a barometer for a stimulus that’s likely to come in a weaker growth environment. And I think it can function in that way as a complement to the Treasury exposure, where you don’t have any sort of upside cap on how high gold can go. And in this environment, I think, it’s hard to envision a scenario over the next decade or two where you don’t get a lot more printing from global central banks.

Rodrigo:00:22:10Can I just go back to your first point on going up the maturity? So in your implementation risk parity, in lieu of levering up the bond portfolio, you’re going up the maturity curve? So you’re not choosing to lever up the short term cash rate?

Damien:00:22:26Yeah.

Rodrigo:00:20:27 Is there an advantage? What is the advantage or disadvantage of choosing to go up the maturity curve versus levering? Is there, have you guys put any thought into that?

Damien:00:22:39We have. I mean, if you look historically, the shorter term bonds have a higher Sharpe ratio than the long term bonds. So I guess on, if you were to look at that narrowly, and you say that the future is gonna be like the past, you’d say I’d rather lever up the shorter term bonds. The challenge is, of course, that shorter term bonds are offering you virtually no yield. And I think there are also challenges with managing a higher degree of leverage in the strategy, which, you know, also in a 40 Act context, that also gets challenging. So I think, as I think about the future, because we’re trying to manage this portfolio for the environment that we’re in today. Again, we come back to this notion of why are the bonds in the portfolio? They’re in the portfolio obviously to deliver a return, but also to provide outperformance in certain environments that are challenging for equities, and namely, a downside growth scenario. And so, in our view, that 30 year bond offers you much more potential return, because they’re just physically, you know, for the same amount of duration at the 30 year point versus the 10 year or the five year point, there’s just so much more room for that rate to fall. That it’s possible that, you know, you get better returns on a prospective basis from those bonds than you do from the shorter duration bonds, which, you know, may not be able to.

Rodrigo:00:23:56Do you feel like you get more convexity from the 30 year than you would from the levering up of the short end?

Damien:00:24:02That’s right.

Rodrigo:00:24:03Okay. So it almost becomes, because that’s another thing that I wanted to ask you guys about, is the idea of risk parity is that you have balance across these different regimes, right? High growth, low growth, low inflation, high inflation. And yet empirically, we see that when there is a big growth shock, risk parity doesn’t do so well. So, one of the ways that you guys are looking into reducing that is by looking at high convexity options on that bond side. And I guess, increase gold side as well. That would definitely.

Alex:00:24:36Yeah, I mean, the question you really have to ask is, if you get a downside growth surprise, what’s probably going to do well? And that’s the question you should always be asking. So let’s say hypothetically, the 10 year Treasury is at zero. And you asked that question, what’s going to do well when, you know, the economy experiences a downturn? The 10 year is probably not gonna move very much because it’s near, maybe it goes negative, but it has limited room. The 30 year has a lot more room. And then you also, you know, in an environment where the Fed can’t lower rates anymore, maybe they go negative, but they’re near the bottom, they’re probably going to print money. And that’s good for gold. So those are the I think, if you ask yourself those questions, without having to guess what’s going to happen, you know, it’s like an “if, then” type of, you know, series of questions of downside growth, upside growth, downside inflation, upside inflation, what’s probably going to do well, and you just own those assets, and you risk balance them. That’s how you get a solid portfolio.

Rodrigo:00:25:32Can I push back just on that point? I want to, I haven’t thought it through, really, is, you said something that there isn’t a lot of room. With the fore guidance from the Fed, you know, really taking that zero bound out of the equation and allowing things to go negative. Can we truly say that there is less room? Is it more of a politically, it’s untenable, and therefore there’s less room? Or is this a kind of a mathematical reality of some sort?

Alex:00:26:01Well, I mean, there’s less room than it was 15 years ago, 5 or 10 years ago, or even one year ago. So yes, you can go negative but there’s limits as to, you know, at some point, when you’re too negative, people just hold the cash. Right? You just run out of room, literally. And you’re seeing some limits globally. I think the lowest negative I’ve seen was negative 70 bips or 75 bips. So there is some lower bound, we don’t know exactly where it is, you know, maybe it’s zero, maybe it’s slightly. Right now, they’re telling you, we’re never going to go zero, but that may change in a crisis. Right? So I think, but you are, you’re getting there. We don’t know exactly where the line is, but we know we’re a lot closer to it than we’ve ever been.

Rodrigo:00:26:47Got it.

Return per Unit of Risk

Adam:00:26:48So one thing that I’ve always struggled, a question I’ve always struggled to answer, which comes up a lot, especially in conversations with institutions. So I’m actually really curious how you approach this problem. But it’s the question of capital market expectations for a risk parity portfolio. Because it seems to me the intuition around the efficiency of the portfolio is relatively tight, you’re making very few assumptions at a general efficiency or equilibrium model to form the portfolio, but then how do you approach the question of how much return you should expect to get per unit of risk? Right? What is the slope of the capital market line after you form this portfolio?

Alex:00:27:41Damien, you want to take that one?

Damien:00:27:43Sure. So it’s interesting. So you can go asset class by asset class. So you know, with regards to the treasuries and the TIPS, you know, there’s both the yield, but there’s also rolling down the curve, which is an aspect of investing in bonds that people don’t appreciate. But you actually do get an increase in valuation, which is a portion of your return, as rates come down, as you essentially roll down the curve.

Alex:00:28:16 That’s even with negative real yields?

Damien:00:28:19That’s right. So you know, you could have negative nominal yields in the, you know. In Europe, you know, you can get, you can still get positive returns, like, you know, so. So anyway, so  that’s a little bit of a distinction. And actually, the way we allocate to treasuries here is we use futures. And so futures actually, they’re not the total return of bonds, they’re actually just the excess return of bonds. So it really is just a function of how bonds do relative to cash, you know, and that ultimately determines your return profile there. And so that’s how I think about the bonds. So we think you can get close to equity-like returns, if you’re holding them longer duration, you use some leverage, meaning it may not be literally levered. So in the TIPS context, we just hold more than we do in commodities and equities. And then the way we solve for that on the commodity side is that commodity futures, I think there’s an argument there around what is the return of commodity futures? Is there an excess return or risk premium? And so we actually approach that differently. We actually hold commodity producer equities, where we’re much more convicted in the risk premium. You know, historically, there’s been a very persistent risk premium. In fact, commodity equities over the last 50 years have outperformed traditional, you know, broadly diversified equities. And so that’s how we’re generating a lot of the return there, reliable return, equity like return on the commodity side. And the goal of, you can argue, you know, there’s probably not a risk premium there. But it’s interesting, if you look at the 50 year return of gold, it’s actually almost spot on the 50 year return of equities. So that’s maybe an indication of how, you know, what it’s like to have a fiat currency regime, because it’s basically since the end of the Bretton Woods and when we came off the gold standard. But I think you can certainly imagine a scenario over the next 10 or 20 years where gold has a similarly attractive return profile, because central banks are just printing and printing and printing. So, we don’t necessarily think there’s a risk premium there. But we do think there’s an attractive return profile just by virtue of the supply of fiat currency increasing that could be quite competitive with equities.

And so when you get down to it, we still think you’re getting similar return contributions from the different components. And then there’s another piece here, which I think is really under appreciated, which is the rebalancing benefit. So when you have a portfolio of low correlation line items, and you’re constantly buying the thing that underperformed and selling the thing that outperformed, so you’re buying low and selling high, you do that over and over again, the average return of the portfolio is actually higher than the average of the underlying components on a standalone basis. And in a portfolio like this, we looked at this over long timeframes, it’s about 1% of incremental return you get at the portfolio level relative to the average of the underlying returns. And that’s why.

Rodrigo:00:31:03How often do you guys do rebalancing in your situation?

Damien:00:31:06Quarterly. And then this gets to another really interesting feature of ETFs, which is that you can do the rebalancing in an ETF without triggering any tax consequences. And so it’s really powerful from a portfolio management perspective, because, you know, I can tell you as a financial advisor, we run into this all the time that you want to rebalance, but you don’t, because things are appreciated, and clients don’t want a tax bill. And so inevitably.

Alex:00:31:31Well that and people have a hard time selling high and buying low.

Damien:00:31:35That too. Yeah. Because you’re telling them to buy the thing that just did terribly so. And so in the context of the ETF, we can do that programmatically. But then importantly, we can do that in a tax efficient way. And so it adds incremental returns to the portfolio. And so that’s why, you know, we think we have a good shot at being competitive with equities.

Mike:00:31:51So on.

Rodrigo:00:31:53Sorry, go ahead, Mike.

Mike:00:31:54Good, I was just gonna ask on that note, so you’ve got sort of precious metals, energy and non energy commodities. So you’ve decided that commodity exposure through the equity assets. But as you say, you don’t necessarily have to anticipate a positive risk premia to benefit from an enhancement in the geometric mean of the portfolio if there’s a rebalancing opportunity. So did you ever think that, was the limitation for commodities other than gold, those that you are doing through the equity piece? Was that ever a consideration? Was it a structural limitation of the ETF that sort of steered you away from the sort of non gold?

Adam:00:32:36The direct commodity exposure.

Mike:00:32:38Yeah, the direct commodity exposure, rather than the equity based equity exposure.

Damien:00:32:43So the equities have a couple of attractive features. So I talked about one which is a higher expected return. But obviously, there’s a negative that comes with that too, which is that it’s more equity like. And so the way that we solve for that, well actually, I would say, the other big positive that you have to factor in is there’s a tax advantage to it. So if you’re going to hold commodity futures, you would have to do that in a way that utilizes derivatives, you know, most likely, you’d have to hold that through a Cayman subsidiary.

Adam:00:33:10Right, you’ve got a blocker so there’s.

Damien:00:33:11And that’s gonna generate income, that’s gonna generate income, and there’s nothing you can do to shield that income. It’s going to, so if it goes up, it’s going to generate income for your portfolio. And so that’s far inferior to managing it in the context that I just described, which is to basically defer all your capital gains. So that was a big piece of it as well. And then what we did was on the commodity side to solve for the negative that I mentioned, which is that it’s more related to the equity markets is we created our own basket, which was as close to the underlying commodity price as we could get. So we redefine the commodity universe to just identify companies that were pulling it out of the ground, essentially. So we don’t include refiners or even like steel makers, because that is more, you’re taking iron ore as an input. And so in the mining and energy space, it’s very directly related to those pulling it out of the ground. And then agriculture is a trickier one because there’s not as direct of a link. So we chose companies that were, you know, logically connected to the price of crops. And so, you know, it would be, you know, fertilizer companies or, Deere machinery, agricultural machinery companies. And but that’s a smaller allocation than the other two. And then we did include things like clean energy and water as well. And clean energy, I imagine might grow as a piece of this as fossil fuels become less utilized. But that’s how we did it.

Rodrigo:00:34:35So they’re like securities rather than energy sector ETFs and the like.

Damien:00:34:42Correct. Yeah, we actually created our own index, which also has a cost advantage. So if we’re using an ETF, we have to pay another layer of fees. We hold it in the fund just on a direct basis. It’s less expensive, and that’s why when you look at the holdings, you might be confused, like, why do they hold a bunch of resource stocks and then a bunch of ETFs? It’s because for broad market exposure, the Vanguard ETFs are very efficient and low cost. But for tailored exposure, it made more sense for us to build it ourselves.

Mike:00:35:07Right. And so the basis for this that you experienced.

Adam:00:35:10Go ahead.

Mike:00:35:11Through the basis risk you experienced through the proxy of the equity is overwhelmed by the fact you get these tax advantages, and all of these other sort of structural advantages in the ETFs that flow back to the investors, which is a very thoughtful construction actually.

Damien:00:35:28There’s two more things actually.  So one is you can basically dissect a commodity equity into equity and commodities exposure. So you can bake that into how you build your equity allocation, so you don’t get over allocated there. So that’s one component. Just think of it as two. And actually, there’s some leverage there, too, so that’s efficient. So it’s not like a commodity equity exposure is 50/50, stocks and commodities, it’s more like 60/60, or 70/70. And so you can bake that into how you build a portfolio. And then the other piece is that we have a larger allocation to gold, than, you know, than is probably typical in a lot of these risk parity strategies. And part of it is related to gold helps hedge some of that equity risk that’s embedded in the commodity producer equities.

Mike:00:36:15It really does. That’s actually, I think, maybe an unknown point that the correspondence with gold and inflation is not as, the correlation rather, is not as great as the correlation between gold returns and volatility, which seems to be a nice offset in that sense. So now do you do? So do you do the gold exposure via stocks, or is that via both or, the commodity? How do you, you may have covered that.

Damien:00:36:40Only the commodity. Yeah, so we.

Mike:00:36:42Only the commodity for gold?

Damien:00:36:43We just hold one of the Grantor Trust ETFs that give you exposure to the physical bullion.

Mike:00:36:50Okay.

Alex:00:36:51Yeah, the other thing about gold is that, you know, we’re always looking backwards and seeing what worked in the past and trying to formulate a portfolio looking forward. But gold has a very interesting place today, when you, you know, we’ve never had interest rates this low in the US. And, we haven’t had monetary policy like we have today, where you’ve got a, you know, you had a trillion dollar deficit before COVID. And now you’ve got a multi trillion dollar deficit after, and, you know, with promises to keep it going as long as possible. And so, you know, part of the idea is balance. And you have to, you can’t just look at the past, you have to consider that we’re in very unique times. And gold is one of those assets that it, you know, it’s been around thousands of years, right, it’s a store hold of wealth. And ultimately, you’re trying to achieve a return for clients that protects them in a terrible environment and gives them some upside, and gold could participate in both of those. And you’ve seen that this year. Right? It was up, you know, in the beginning when the market collapsed, and it’s up, you know, 20 plus percent year to date. So, part of this is forward thinking as well.

Mike:00:37:56I think, Adam, you wanted to say something?

Adam:00:38:00No, I mean, I just wanted to, I know for sure that a good friend of ours, Dave Cantor, I wonder if he’s listening, is going to want me to press the point on how you come up with capital market expectations? And I know you started going down that path, but I’d love to be able to close that loop because I think.

Capital Market Expectations

Damien:00:38:16Alright, so, okay. So what we do is we assume a similar Sharpe ratio across assets. So we actually don’t believe in CAPM. CAPM doesn’t actually reflect reality in any shape or form. So as a great example, inflation index bonds have a negative beta to the stock market, but they do not have a negative excess return. And so CAPM depends on all of these assumptions that just don’t hold in practice. It assumes that every investor has the same objective function, it assumes everyone can leverage. You know, you have a, it’s just not reality. And so this is, I think the reason why risk parity works is that people don’t price for diversification benefits. So theoretically, a CAPM, the reason why the market portfolio is the efficient portfolio to hold in theory is that assets that offer you diversification benefits should have their price bid up to the point where they don’t have any excess return or negative excess return. But that’s not the reality. You know, bonds have outperformed stocks over the last 30 years. So it doesn’t. So in  practice, what we find is that assets actually give you a much more similar return relative to risk than would be implied by CAPM. And so maybe it’s not perfect, you know, and nobody knows what it’s actually going to be. But empirically, that’s what’s been the case, is that they all give you an excess return above cash. And so we go into this assuming that we can get similar returns relative to risk for each asset class, understanding that maybe in practice on a prospective basis, bonds don’t do quite as well. That’s okay because they have really powerful diversification properties and we’re also picking up some return in the rebalancing. And, you know, maybe gold, you know, you don’t have the same argument for risk premium. But I think there are other logical arguments there for why there should be a positive expected return. And that definitely doesn’t fit CAPM. Right? And so that’s how I’d answer that question directly.

Mike:00:40:20Thank you. Go ahead.

Adam:00:40:21As I look across the different asset classes, I mean in an effort to answer this recently, I mean, one thing that we can calculate up to a fairly high degree of certainty is the expected Sharpe ratio on bonds, because you’ve got a generally, even a decent estimate of the roll yield, you know, the starting yield, you know that there are really good simple formulas for forecasting expected bond returns over a horizon equal to twice the duration of the bond for a continuous contract. We sort of start there for a 30 year bond, maybe you’re looking at, you know, let’s say the bond has a 15% fall. Its expected return is 1.5%. Sorry, yeah, about 1.5% a year, so you’re looking at a Sharpe ratio of about .1, maybe less than that, because you want to sort of build in excess returns. So if you had.

Damien:00:41:15Yeah, I mean, it’s probably a little higher than that. Like, if you look at investing in long term bonds in Japan, over the time, like, if you just look at, if you started buying long term bonds in Japan after they fell below 2%, it was literally the best Sharpe ratio on the planet of any asset, you know? Because it’s a steep curve that was controlled by the Central Bank, you just roll down the curve every year. And volatility actually was nowhere near what you’re describing, because they’re intervening in their markets. And so that’s the challenge of trying to use some sort of precision with this assessment, we don’t really know. I think there’s a, you can make an argument that it’s a terrible investment. A lot of people say like, this is the worst investment on the planet. But then you have to think about, okay, in what scenarios are they thinking about? And how would the other assets in the portfolio do in those scenarios? And ultimately, we’re trying to construct something that’s like a finely tuned engine, right, where there are components that would do well in any scenario you can envision, and treasuries, like them or not, is one of the, it has a very specific role. And I don’t think that, you know, even with low rates, that role changes meaningfully. I do give, I would give on the point that I do think the expected return, the Sharpe ratio, is certainly lower than what we’ve experienced, you know, because you just don’t have that tailwind of falling rates. But it doesn’t mean it’s not attractive. And if you’re in this sort of conflict, you know, deflationary type of environment that we’re in today, you know, it could still be a great performing asset class, we don’t know.

Adam:00:42:36Keep in mind, I agree with you. I think that we are big believers in the risk parity portfolio, it’s just getting, a lot of the pushback we get is how do you, what are the expected returns on this portfolio, right? So if we’re expecting all of the assets with the possibly, the same diversification adjusted Sharpe ratio in the portfolio, then, you know, if we know what that Sharpe ratio is that we’ve got the slope of that line, and we can tell them, give them some sort of forecast about the expected return that they can get per unit of volatility. So it’s just, what the slope of that line is, at the moment, I think is pertinent to institutions. I mean, it’s funny, because we talk to institutions and large investors, we talk to the principals at AQR, for example, we understand that, you know, this is a core, their risk parity strategy is a core holding for many of the principles that’s very difficult to sell outside the firm. Institutions don’t generally buy into it. Major challenges, it’s really hard to come up with capital market expectations. And if you do come up with capital market expectations that are fundamentally aligned with the principles of the strategy, then you end up having fairly low expectations at this time. Right? So I just think it’s very.

Damien:00:43:55I do. I agree on the bond part. You probably have lower expectations than you did historically. But you do have the same problem on the equity part.

Mike:00:44:04Amen! Amen!

Damien:00:44:04I mean, equities are historically high evaluations. So it’s not like it’s in isolation that the expensive problem exists. It exists everywhere, in every public market asset and probably market access, too, right?

Rodrigo:00:44:16That’s the thing that’s very difficult to get across for any investor, right is that you’re coming in with this, as you said, fine tuned machine, that it’s trying… What we say here is that this is about preparation, and it’s not about prediction, right? And everybody else in our industry is designed to think about prediction before preparation. And that’s a big problem, especially in a period like right now, where you said, look, you got expensive bonds, you got expensive equities and, you know, there’s no point in investing in something that’s going to consistently invest in those two things in equal risk. Like why on earth would I do that? What if it goes to shit? Well, it didn’t. It hasn’t. But let’s push that aside. Why? When is a period where both bonds and equities go down together? It’s a period of rising or unexpected inflationary shocks, right? When was the last time we saw them? In the 70s. Well, what happened to that gold component in the 70s our a commodity component, our TIPS component that had existed. Well, it turns out that the returns for that asset class were way outside of expectations, you know, huge right tail event that tended to offset the losses of the other two so that your expected Sharpe ratio is within normal expectations of a well fine tuned machine like risk parity. So there is that, the hope here, or if we think about this problem appropriately, is that one of the components, one or two of the components, is going to have ridiculous positive returns when the other ones suffer. But the problem that we all fall into is every time we think we know what the returns are going to be and what our worries are going to be next year, we’re always wrong. Right?

Mike:00:45:49Yeah. Well, the whole point.

Rodrigo:00:45:50Yeah, but you have to get that across. Hey, listen, you got to be okay with losing money in two components and sticking to it because we have this other thing. And not then have your committee say, well, why don’t we just own a bunch of gold right now? Maybe, because maybe tomorrow it goes to shit. Like, it’s a different conversation.

Alex:00:46:07Just go back. Let’s just rewind 12 months. So if we were sitting here 12 months ago, what, one we wouldn’t be on video, right? I mean in person, but two, who would have predicted where we are just 12 months later? Not a single person on earth. Right, that, you know, unemployment rate would quadruple in a couple of months that, you know, the whole world would be on shutdown? I mean, who would have possibly expected that? Right? And then who would have expected that the market would go up during that time? I mean, good luck trying to figure these things out. Right? And so, you know, I remember nine months ago, very few people wanted to own, you know, long bonds or long TIPS. I mean, that was like, that’s what, you know, it’s a crazy thing to buy. Gold, there were some people. There were some gold bugs saying, yeah, gold is a good thing. But, you know, hardly anybody expected it to go up that much that fast. So it, you know, I think a lot of people and you look at, you know, what’s on TV and the news, it’s all about predicting what’s going to happen next. Everybody has a crystal ball. If you actually, honestly tested the accuracy of those, they’re very poor. Right? Not much better than that. … perspective memory and you know, … predict, right? And so, and obviously, you know, most people think they’re good at it because they forget the things that they completely missed and you know, only remember the things that they were right about. And so, what’s shocking to me is after the experience we just went through that there’s, you know, people aren’t really understanding that these things are really hard to predict.

Mike:00:47:43I think the one thing that, Damien, you said that I wanted to come back to is this idea that we don’t know the future Sharpe ratios. Right? So in 1980 to 2000, there was a pretty significant stagflationary set of assets in a risk parity portfolio that were a tremendous drag all the way into the bottom of oil at $9 a barrel in 1999. And gold at $200. There was a massive drag. You’re always going to have somethin,in a portfolio killing it, and you’re always going to have something killing you. The point is that you want to keep those bets in balance, harvest all that risk premia, and you just don’t know that future Sharpe ratio. And so, the Sharpe ratio of gold for the next 20 years could be two and a half. We don’t know.

Damien:00:48:33Right. We don’t know.

Adam:00:48:34So this is what I always say to people, right? This is, and you know, I have this back and forth with all the consultants all the time, well, what capital market expectations should I declare for my pension client for this portfolio that you’re recommending that their actuaries need to stamp? Right? So this is why I keep pressing this point, because I keep saying I have no idea. I could tell you that I think that this is the most efficient portfolio, but I cannot tell you with any reliability what the expected Sharpe ratio on this portfolio is. And this is somehow unsatisfying. So this is why I keep pressing the point.

Damien:00:49:06Yeah. Well, I think you can take a pretty simplified approach, which is just to say, the return you expect from assets is the return of cash, plus an excess return. And so cash is easy, right? We know what that is. And then the excess return is going to be a function of the Sharpe ratio. And again, we don’t know what it’s going to be, but it’s probably positive. You know, for capitalism to work, you need to assume you can get a better return by taking risk otherwise, you’re just gonna leave your money in the bank. And so central banks are very clear about their mission to avoid that scenario. It might happen for short periods of time, which is, by the way, one of the scenarios where this underperforms because that’s when all assets fall, is when people want cash.

Mike:00:49:49The discount rate. The discount rate contingent.

Damien:00:49:51That’s right. And so but over time, you know, they have to engineer a situation where you get positive excess returns. And we don’t know what those excess returns are going to be. It’s not that important. You’re not all that dependent on how, you know, because one’s probably going to shoot the lights out, and one’s gonna do terribly. And you don’t know which is which. And if you have your, if you basically spread your bets, you don’t worry about it, right? And then you also, as I said earlier, I would not discount this rebalancing benefit, it makes a big difference. And then I’m much more convicted that that’s beneficial to you. I know that that works relative to the Sharpe ratio, because again, it comes down to the structural diversification here. These assets are different not because of a correlation we measured, but because the way they’re constructed, they have very reliable outcomes in different economic environments. You know, when there’s a collapse.

Mike:00:50:44Yeah. They’re structurally connected to the economy in ways that causes them to act in these ways.

Damien:00:50:49Right. That’s right.

Mike:00:50:50Keep going. Yeah.

Damien:00:50:51And so one of the really interesting things is when you concentrate on one asset class, you subject yourself to these very prolonged periods of underperformance that are devastating.

Adam:00:51:03We should just end it there.

Rodrigo:00:51:04And on that point.

Mike:00:51:06No, he’s gonna be hanging right on! What is he trying to say? What is he gonna say? I don’t know what he’s gonna say.

Rodrigo:00:51:13So just for those listeners, we’ve had a, we got a freeze frame here.

Adam:00:51:17I bet Alex can pick up where Damien left off.

Alex:00:51:20Yeah, so other than taking the risk of going through a lost decade, you can, you know, diversify across things that you know, are very unlikely to all do poorly at the same time.

Rodrigo:00:51:30Like when we’re rebalanced ….

Mike:00:51:31Everything’s back in perspective, right. The 70 stagflationary perspective, if you’re in a balanced portfolio, you experienced basically a 20 year period, where you just didn’t have any positive returns.  Now add on decumulation, as baby boomers are decumulating their savings, this is amplified dramatically in taking a bet on any one specific economic regime, manifesting through stocks and bonds.

Rodrigo:00:51:58Yeah. I want to go back to the rebalancing premia. I think we wanted to finish it up, is that this idea that you don’t get that premium when you’re focused on a single asset class, right? And I think a lot of the reason as to why people don’t even talk about it is because when they’re thinking about rebalancing premia, they’re thinking about rebalancing across 500 equities, right? Is there any rebalancing benefit across 500 equities? Well, no.

Damien:00:52:19A little bit.

Rodrigo:00:52:20Because they’re not correlated, right?

Alex:00:52:22A little bit, but not much.

Damien:00:52:23It’s proportional to the correlation. So the lower the correlation and the more volatile the assets, the higher the benefit.

Rodrigo:00:52:31Exactly. So if you have created I mean, Adam is about to publish something on this. But if you’ve created out of all the portfolios you can create with public markets, right? The one that provides the highest level of rebalancing premia is the one that structurally creates the biggest distance between those assets that you create. So if you can find, if Elon Musk goes to Mars and creates a colony there, that’s completely non correlated to the, here, I want to have that part of my portfolio, because it’ll allow me to have even a higher rebalancing premium, right?

Damien:00:53:02That’s exactly right.

Rodrigo:00:53:04People ask, one of the things that people ask all the time is like, why would I invest in risk parity because it’s going to have no returns? You got bonds and that.  Well, let’s assume that that’s true, and that gold isn’t going to do anything. The rebalancing premium alone will hedge a lot of that risk. And it’s something that needs to be discussed a lot more.

Adam:00:53:21It’s good to hear though that you guys came to the one,  because I get 1% as well on the portfolio in general that you guys constructed? What is interesting is if you add more granularity within some of the asset classes that you can get to more bets. And the rebalancing premium per unit of volatility is a function of the number of bets that you are able to extract from the portfolio. It’s a bit of a trade off because you’ve got to get, have a little bit more commodity exposure in there in order to get some of those other bets. So you maybe are injecting assets with a slightly lower expected premium. But on the flip side, you’re able to extract a higher rebalancing bonus. So for example, if I look at a permanent portfolio, that’s just, you know, basically stocks, bonds, gold and cash. Then at about a 10% vol, I get maybe one or one and a quarter percent rebalancing premium. But if I create the most diversified portfolio of 65 or 70 different futures markets across a bunch of different equity indices, bond indices, and a wide variety of commodities, I get up into, I can almost double the number of bets and I get up into the sort of two and a half to 3% a year in this rebalancing bonus at the same level of volatility. But again, there’s trade offs there as well. But I do think that this volatility premium is profoundly under appreciated. And what’s so great about it is just, it’s a mathematical, it’s not a certainty. There’s an error term there. But the mean of that is actually a lot higher than anybody expects. And if you do it properly, that even if the underlying assets deliver a near zero real return over the next 5 or 10 years, the rebalancing premia, if you do it properly, may take that excess return up to the 2 or 3% range.

Alex:00:55:24Yeah.

Currencies

Mike:00:55:25Can I? And I know we only have Damien for five more minutes or so. And there’s two questions that I really want to have hit. One is, what role do currencies play as another asset class in a risk parity framework? And two is, and I know Cory Hoffstein is going to want to ask this, who’s paying this rebalancing dividend or bonus? Is it that we’re transporting liquidity across these asset buckets? And as we transport liquidity, we take it from where we have liquidity and the market doesn’t. So we get some equity premium or some risk premium for that. Who’s absorbing it? Who’s paying it? Like, what are your thoughts on that? So two things before Damien has to go.

Damien:00:56:07That’s… The second question is a really good one. I actually don’t know if I have an answer, but I’ll try to think through it.

Mike:00:56:11Make one up, just make one up. You’re credible. People will believe it …

Rodrigo:00:56:18If you can answer that one, I have a second question after you answer the first one.

Damien:00:56:22Sorry, what was the first question? Maybe I think that was there.

Mike:00:56:23Oh just to see, what role currencies play?

Damien:00:56:25Oh, yeah. So currency. So you can think of currency as, it doesn’t generally have an expected return. You know, it’s a relative price between two economic regimes in the form of an exchange rate. And so because it doesn’t have an expected return, it’s incremental risk for the portfolio, even though it’s uncorrelated. So in general, you know you probably don’t want too much currency because it introduces an uncompensated risk. At the same time, you have to think about the objective of wealth preservation, and ensuring that you have exposure to assets that can preserve wealth in a dollar collapse, because again, we want to generate as consistent of a return as possible, we don’t want to be overly influenced by the problems in one economy. And so we do have exposure to non-US assets in a pretty large size in this portfolio. Gold is a 17 and a half percent allocation. That essentially is another currency. It’s a non-US dollar currency. We also have of the 25% in equities, half of that is non-US. So it’s EM and developed non US. And then we also have a component of the commodity producer equities that are international as well. So when you add all that up, you probably have, you know, 40% of the portfolio in non US equities. And then if you broadly defined commodities as another, you know, way of preserving, you know, real returns, then, you know, maybe that bumps up to 45%. So it’s a pretty meaningful portion of the portfolio.

Rodrigo:00:57:57 So here’s a question I want to ask.

Mike:00:57:59Wait, wait, so I want to hear the rebalance premium. Speculate. I want to know where the bonus comes from. I want to hear the speculation. Sorry, Rod.

Damien:00:58:06Yeah. So I mean, look, it exists because there’s mean reversion and assets. Who pays for that? I’m not exactly sure. I mean, I think probably you have some element of just overreaction to things. And so maybe, you know, investors through just behavioural biases, you know, essentially pay that. But I’m not exactly sure, you know, why this exists like.

Adam:00:58:35But what’s amazing is it actually exists in a Wiener process. You don’t even need that, you know, specifically mean reverting process.

Damien:00:58:41That’s true. It’s more of a mechanical thing, which is why I never thought of it as …

Mike:00:58:48I didn’t know he’s gonna say that.

Rodrigo:00:58:50Dave would say Wiener. He calls you that all the time?

Mike:00:58:54He loves that process.

Rodrigo:00:58:56We always talk in risk parity about the two axes, right, the growth and the inflation shocks, but we rarely talk about liquidity shocks. And it seems to me that risk parity does really significantly better when there’s positive liquidity, and there’s a lot of money going into everything.

Damien:00:59:09No question.

Rodrigo:00:59:10And then during growth, acute growth shocks, there is a point like you saw this year, risk parity held in there, held in there, held in there. There’s gold, treasuries are going up and then all of a sudden, in three days, everybody just said, I want cash. And liquidity dried up. You saw this gap, it went down. And so we’ve had a bunch of speakers on our circuit here that are, they say there’s only one asset class and it’s volatility. And yet, in risk parity we would only talk about volatility as an asset class. Is there room for some sort of volatility allocation, some sort of tail protection or if not, how do you guys think about this issue?

Alex:00:59:51Yeah, I mean, the challenge is, you don’t have an expected return. Right?

Rodrigo:00:59:55Yep.

Alex:00:59:55Sort of throwing things in there that don’t have an expected return. And over time…

Damien:00:59:59Or negative expected return, actually, because you’re paying a premium.

Insurance

Alex:01:00:01Yes, insurance. It has a cost. So the way we think about it is, if you can, so set that aside. If you can build a portfolio that has assets that are biased to do on different environments, such that  it’s hard to imagine an environment where you have sustained losses and you know, see significant drawdown. It might be for a short period where there’s a liquidity squeeze. And that’s hard to protect against, as you mentioned, because cash outperforms all assets. So as long as you can protect against a material downturn, then you don’t need to pay the insurance. Right? So you know, you’d be basically self insuring, without paying that extra premium. And you know, maybe that, including that will help on the downside, but you’re going to give up over the long run. So that’s the trade off.

Rodrigo:01:00:46Right. That’s how you get the premium. That’s the premium that you need to pay for the excess return.

Damien:01:00:54Yeah. So that’s a really important point, which is for anyone who’s thinking about embracing this concept, it’s not risk-less. There’s risk here. What we do is we try to mitigate the risks to the things that we can mitigate, which is big shifts in economic environments. We can mitigate that risk by designing the portfolio in a better way. What we cannot protect against is these type of tight liquidity environments, which can be either caused by the Central Bank tightening faster than expected. That’s like a ’94 example, a ’79 example, a 2018 example, oh sorry. Two thousand.

Mike:01:01:28Four.

Damien:01:01:29Yeah, 2018 example.

Mike:01:01:302004 example.

Damien:01:01:31Yeah, there’s a few of them. That 2013 was a big one because of the temper tantrum, a taper tantrum that Bernanke key kicked off. And so those are environments where a balanced collection of assets will underperform because there’s this headwind of tightening liquidity, there’s also. So those are the ones that are sort of Central Bank engineered. And then there are the panic selling environments that you reference. So March was a perfect example. 2008 was a good example. Now the reason why we’re okay with that risk, and number one, we have to be because that’s just the risk of investing in markets. In a lot of those scenarios that I described, particularly the panic selling scenarios, you’re going to be better off in a balanced portfolio, because at least there are some things that are going to hold in there like treasuries, then you would be in a more conventional equity oriented portfolio. But then more importantly, these environments tend to be short lived, because central banks cannot allow them to exist. You know, they will respond. And they will do that, by any means necessary to avoid that scenario, because it’s devastating. It will destroy the social fabric of the country if you allow that to persist. And so because capitalism doesn’t work in that environment. And so we’re comfortable with that risk because we know it’s going to be short lived. It will be painful for some period of time, but it will be short lived. And the thing you get with risk parity, that I think is the biggest takeaway that I want people to think about, is that you don’t get, well I think it’s very unlikely you will see bad decades. And the reason for that is that you can have any single asset class dislocate for a decade. You had that the equities were negative for the duration of the 2000s for over a decade. And it’s because you came into the 2000s with these wildly optimistic assumptions of what the future was going to be coming out of the tech bubble. And then what you actually got was the slowest rate of growth since the Great Depression. So that disconnect of what was priced in to start and then what actually happened was devastating for equities to the point that they were negative for a decade. And yet, if you look at a balanced portfolio like this, you wouldn’t notice any difference between the 2000s or the 2010s, or the 1990s. It’s because you had assets in there that were in bull markets. Bonds were in bull markets, commodities were in bull markets. And so that’s the benefit. And when you think about having liabilities or trying to save for retirement, or whatever your objectives are, you can afford a bad year. You cannot afford a bad decade.

Mike:01:03:49Precisely.

Damien:01:03:50And even though everybody likes to talk on TV about what’s going to happen, nobody really knows we’ve established that. And so that’s why we’re so convicted in the strategy, which we believe should be the core of every investor’s portfolio. This is how you should hold assets, because you can avoid, in most scenarios, a bad decade and that makes sure that you can achieve your long term objectives.

Mike:01:04:10Start here. This is the do no harm portfolio. If you want to have Tilts in bets, then you would bet against this portfolio because you feel you have some edge or advantage to predict the future. But you start here. You don’t start with, well, I’m not going to own any bonds because I think this.

Alex:01:04:28Right. And if you’re going to do that, if you’re going to try to make alphabets, then be honest about your ability to successfully achieve that.

Mike:01:04:36Handicap them.

Rodrigo:01:04:37Don’t mask them behind beta. Don’t say.

Damien:01:04:40I gotta go.

Rodrigo:01:04:41I know Damien you gotta go.

Damien:01:04:42I know. I’m sorry. I’m having a good time.

Mike:01:04:44Damien, get out here.

Damien:01:04:45Alright. Thank you.

Mike:01:04:47He’s got a real happy hour to. He’s probably actually got a real happy hour.

Rodrigo:01:04:49How are you doing Alex for time because I had a few other questions and thoughts?

Alex:01:04:53Yeah, I’m here.

Adam:01:04:56I was curious. I mean, we talked about how we all agree that risk parity is a logical core for a long term portfolio. And I’m just wondering, what are some of this? I know that that’s, you practice what you preach there. But what are some of the satellites that you consider? And how do you think about allocating to the sort of alpha sleeves?

Alex:01:05:17Well, there’s also other beta sleeves, so you can own real estate. You know, there are other asset classes that are diversifying to what’s in a core risk parity portfolio. But basically, you’re looking for other return streams that are different. So you know, one thing we look for are market neutral hedge funds. Because you know, call them hedge funds that hedge. You know, most of them don’t. They basically go up and down with stocks. And if you can find some that are truly uncorrelated, you know, where they’re market neutral, or they’re market neutral over time, that can be additive, because it’s low correlated, attractive returns when you put them together. That obviously gives you similar return. You get a rebalancing benefit there too, with less risk. And also private assets. I think if you start navigating towards less efficient markets, there’s more alpha potential there. Obviously, you have to think of it net of fees. And if you’re, you know, a tax one investor, net of taxes, which is a high hurdle. But those are areas where you can try to achieve.

Mike:01:06:20What do you think Alex about? So we’ve established, hey, we’ve got risk parity. This is our do no harm portfolio. We have these events that occur from shocks. What about a tail protection strategy as an adjunct, this is going to be non correlated, it’s gonna have a different series of returns, what do you think about that as an adjunct to the risk parity type solution?

Alex:01:06:42Yeah, the challenge with that is, as we mentioned before, it has a negative expected return. Okay, so basically what you’re trading off is risk for reduced return. So you’re basically scaling down a little bit. If you’re… What I think is a better approach is to start with risk parity, add less correlated returns. And if you do it well, you can actually achieve a total portfolio that has a relatively low risk, if you execute on that, where you don’t need to add those tail hedges. So basically, you can self insure without experiencing a negative return, you know, an addition to the portfolio.

Adam:01:07:21Apologies on the call, who are going to be grinding their teeth at this particular …

Mike:01:07:28Well, I mean, there’s the assumption first is there’s a drag. The other thing is, in those moments where you could rebalance to assets, you get a shock, the risk parity shock happens. You have a tail event that allows you to rebalance back to that. It really is a function of the drag. The lack of diversification, the opportunity to get more assets into long term growth assets in a risk parity framework. So there’s a couple of assumptions that you have to make. They’re all valid. You know, a lot of the folks that we talked to, do a lot of work in order to, you know, sort of minimize the drag in order to have that optimality. And that moment of failure when everyone’s going to be calling you, right? You have your, hey, everyone’s gonna call me. So I might think of that as a way to hedge some of those calls. You’ve got something in your portfolio doing well. Everybody calm down and relax. Anyway. That being said.

Alex:01:08:20Yeah. I mean, you also have. And whatever your strategy is, you have to factor in the behavioural biases that we know exist. Right? And, you know, when we, you could just take any fund that’s been around a long time, and you look at its time rate of return versus its dollar rate ofreturn, and then the dollar rate of return is a few percentage points below the time rate of return, meaning people buy high and sell low over and over and over again. So one of the issues that I’ve seen with tail risk hedging strategies is they’re very popular after a bad event. And they, you know, the optimism towards those fades as the bad times fall further in the rear view mirror. So that’s, I think we can’t. As humans, we can’t ignore that we have this natural bias. And so you have to factor that in on top of just the math equations.

Mike:01:09:11Yeah. You’re speaking of tail, sorry, Adam. You’ve also had the positive tail. Right? So you’ve got risk parity. And if you have a period like we’ve had with US equities or NASDAQ, if someone has that proclivity from a behavioural aspect, right, you might say, just, hey, just buy that. Buy that thing so that we can hedge your behavioural bias with a particular asset that satiates that. The vast majority is going to be a risk parity construction. And oh, you know, here’s some other things around the edges. Private equity and whatnot. Anyway, sorry, go ahead.

Adam:01:09:44Well, no, I mean, I was just gonna, you mentioned private equity, real estate, marketing tool hedge funds, and I’m sure there’s other alpha sleeves. Am I right in assuming that you think about allocations to those in the context of risk parity as well? So they’re just other sleeves that  you want to add to a broader conceptualization of the risk parity portfolio? And then somebody asked, which I think is a good question. How do you think about risk in the context of, you know, building a risk parity portfolio, but when you’re also allocating to private assets that don’t have the same sort of pricing frequency, for example?

Alex:01:10:25Yeah, the way I would describe it as the framework is, you want a bunch of returns that are attractive and low correlated to one another. And you can really break it up into three categories. There’s public markets, right, which we think of risk parity. There’s private markets, right? And those are, they come as a package of alpha and beta. Right? So those are typically together. And so you want to think about what your equity exposure is within those, you know, beyond what the numbers show, right? You just need to understand fundamentally how, where the returns come from. So you have public assets, private assets, and then you have what we call hedge funds that hedge and which should be uncorrelated. Because if you have a hedge fund that is highly correlated to equities, you’re paying a lot of fees, and it’s tax inefficient, and you have bad terms for something you already get. Right? So if you look across those things, and you’re really thinking about your exposures from a kind of a high level of what is my exposure, you know, in what environment will this hedge fund do poorly and in what environment will it do well? If it’s truly uncorrelated, that’s totally different from equities. Right? It could be down when equities are down, it could be up when they’re down, you don’t really know. But that’s diversifying. And then the private assets, the less correlated they are, the better, right? And so I think the framework is just thinking about it from a risk parity framework from the top down, which is things that are uncorrelated to one another, are low correlated to one another, and just don’t over expose yourself.

Adam:01:11:53So just to put a pin in that, for example, real estate, you would look at the real estate or REITs or REIT portfolio or private real estate portfolio, and you’d say, well, the loan to equity ratio is, whatever, 30% or 40%, and therefore, you’ve got a short bond portion of that real estate portfolio. And the beta of the real estate to equities is, whatever, .4 or .5 and you would you would seek to sort of neutralize or account for those relative betas in the broader context of the portfolio to preserve that risk parity spirit, even though you know that you don’t have precision, but you want to approximate that in general.

Alex:01:12:35Yeah, and the way I would describe it is one step further. So zoom out a little bit more, which is, in what environment is that real estate going to do well? And in what environment is it going to do poorly? Even setting aside the beta exposure, even the short bond exposure. It’s that asset that you own, what is its bias to the economic environment? And so you put that into that bucket, and then you add up all the buckets for all the assets, and then alpha is separate from that. And then you just see what your exposure is.

Adam:01:13:03Yep. I like that.

Mike:01:13:05Is there any? Speaking of just leveraging how high you might target the volatility of risk parity strategy, where’s the limit? Where does it kind of move from, you know, sort of signal to noise or just fall apart? Where is the fraying around that sort of lurking closer. You know, there’s this point where the arithmetic means can converge the geometric and then they. Any insight into that?

Alex:01:13:29Yeah. Also, the more vol you have, the bigger the difference between the time rate of return and the dollar rate of return. Right? Because volatility is, the more volatile something is, the harder it is to hold on. So I think you’re trying to optimize because ultimately investors earn their dollar rate of return. That’s the actual dollar return. And so if you have too much volatility, theoretically, it might make sense, especially when you can borrow at near zero. It might theoretically make sense, but investors can’t hold on. So to us, the way we think about it is, how much can people hold on? You know, at what vol level can people hold on? So the way we’ve structured it is, it has something like 60/40 expected volatility, and you know, equity plus type returns, which I think is something that most people can hold on to. Now we’re, you know, thinking about, well, maybe we can come up with another version that has a little bit higher volatility. We have some limitations. And especially when you can borrow, you know, what’s interesting, we talked about all these asset classes being expensive. The one asset class that is actually really cheap is left.

Mike:01:14:35Cash.

Alex:01:14:36Right. You can borrow near zero and lever up, you know. This is what the Fed wants. They want. They’re telling you cash is going to be zero for a long time. We’re going to keep it there. We might make it negative. I mean, we want you to take, we don’t want, we want you to take the cash and borrow or spend or you know, buy things. Don’t hold cash. So if you don’t want to fight the Fed, one thing you could do is borrow, but you don’t want to overdo it. Right? So if you can do it in a responsible way, and responsible has to factor in what investors are likely to do.

Mike:01:15:09Right. And what do you think the a… there’s an earlier question. What do you think about it in the number of non uncorrelated bets that you can create in a portfolio? Or is it sort of you’ve got structural sort of the viewpoint. So there’s four, there’s five, or there’s three. Obviously, if we could all get 20 uncorrelated bets streams, it would be great. What do you think there actually are? Are there new ones coming? Is Bitcoin one? When would you think an asset class might cross the chasm to, you know, frontier, to being included? Any thoughts? That was a lot of questions, I’m sorry. Just answer the first five.

TIPS

Alex:01:15:49The last big one was TIPS. And I was. You know these things were relevant when I was, you know, 20 plus years ago. You know, I saw a question earlier, which is, how many uncorrelated bets are there? Asset classes, you’re limited. They’re not really even uncorrelated. They might be uncorrelated over time, but they may be correlated for a decade at a time. So finding these uncorrelated assets is a lot harder to do than to, you know, my team, you know, so I would think of it as you know, if environment A transpires, what’s likely to do well? And so when we do that, go through that process, we get to maybe four or five, if you think of gold as a separate asset class versus commodities. Maybe real estate could fit in there, you know. And then you’re starting to move into alternative asset classes that are not as, maybe not as liquid, not as well understood, hasn’t been around long enough, but we’re always looking.  But you need a positive risk premium, right? You want some liquidity, you want some history, and you want a clear economic bias. And that just takes a long time to collect all that data.

Mike:01:17:00For sure. Well, it takes a long time for the structural sort of implications of that, of an asset class. Like think about TIPS, right? So you have to, the government has to manufacture them, they have to start trading, there’s all the infrastructure that’s involved with trading. And so there’s a lot, there’s a lot to that, from that perspective. So.

Alex:01:17:17Yeah, but if you can jump in early, you can actually benefit. So TIPS, for example, since their inception, their Sharpe ratio blows everything else away. I mean, they’ve actually outperformed stocks since they came out by a few percentages a year.

Rodrigo:01:17:27Why do you think that is? Why, what’s unique about TIPS that make them, that has made them work as well as they have?

Alex:01:17:37I think part of it is they’re widely misunderstood. You know, it’s really interesting when you see how they behave, oftentimes, it’s not what you expect, initially. And then they behave exactly as you expect. There’s obviously, there’s less liquidity there than in treasuries. And that liquidity has been increasing, and I would suspect, there’ll be more issuance there. You know, obviously, limited history. So investors take a long time before they buy. So maybe the first 10 years it did exceptionally well. Obviously, you had falling real yields during, you know, its inception. So that’s helped. But what’s remarkable is you’ve had such great returns in TIPS without inflation, right? Inflation actually has been falling, which gives you a sense of how well it could actually do, especially if we live in a world of negative real yields for an extended period.

Rodrigo:01:18:29Well, in your book, you mentioned sect TIPS into, you know, them being a hybrid between inflation protection and growth shocks. Right. So it’s kind of like a little bit of a 10 year Treasury and a little bit of gold, but it’s actually more directly correlated, well it’s directly correlated to the CPI. And so its ideal place is when there is negative growth shock and positive inflation shock, right? That’s when they kind of will do better than either of them.

Alex:01:19:03Yeah. Which is the exact opposite of equities. So if you told me, hey, you only have two assets to build a diversified portfolio, you just buy equities and TIPS because their bias is the exact opposite. And in, like a perfect example is in 1970s, right, that we didn’t have TIPS at the time, but that probably would have rivalled gold. Gold earned 30% a year for 10 years. Right? It probably would have been up there.

Rodrigo:01:19:29I actually think that’s the reason why risk parity get such a bad name. I think that people may have heard somebody say, look, a good risk parity portfolio, some TIPS and some equities, and then they just hear bonds and equities. And then they say, well, revenues are correlated to each other. You know, it’s just amazing how pervasive that view that it’s just those two asset classes, is. In your rounds of talking about risk parity, how often do you have to deal with that objection and disabuse people of that?

Alex:01:20:02Quite often. The other part of that that is pretty interesting is there’s a, I think, an over focus on correlation. So people will say, oh, the correlation of, you know, X and Y were high recently, and you’re assuming that they’re gonna be low. And so that, you have a failed assumption there. And it’s not about correlation. Because, you know, you can take any two asset classes, and that they could all go through periods of high correlation or even negative correlation. It’s about the economic bias, you know. So you just look at stocks and bonds, right? In the 80s. And 90s, they were highly correlated, right? Because you had falling inflation, and they’re both biased to do well in that environment. And in the 70s, they were highly correlated, because you had rising inflation. But in periods where it’s growth that’s really moving, like the 2000s, you know, that was the real driver. Inflation didn’t really move very much, but growth was all over the place, the correlation was negative. Right?  So correlation is just the manifestation of the environment. Right? And so I think there’s an over focus on.

Mike:01:21:02Such a good point.

Alex:01:21:03On the specific numbers. You have to think about the economic bias. And most people don’t think in that framework.

Mike:01:21:10It’s kind of the relationships that manifest over much longer time periods, than this sort of, oh, there was correlation for 10 years. No, no, and you don’t even have to know the correlation in the short like, just know that they’re sort of generally not correlated in the longer term. And all the error terms that are happening in the short term, they’re going to kind of offset, they’re going to do some funky stuff. But like, that’s one of the things you’re right, people will be very precise about, oh, well, they’re correlated or not over a decade or five years. And they’re just like, hand to forehead, I’m like.

Alex:01:21:43Right. With all this computer power, there’s a sense of obligation of trying to fine tune the machine.

Mike:01:21:52Right. And be precise.

Alex:01:21:53And you can’t fine tune it. Like the market is so peculiar because when you try to fine tune it, it’ll literally work against you because that’s how it prices, right? It discounts what the inputs are, or discounts what the consensus view is. And so you’re much better off zooming out, and forgetting the details and forgetting the noise, and just looking at the fundamental relationships that you know are true. Even without being you know, even without studying the data. You just know that, you know, if the economy weakens, rates will fall. And it’s because of what the Feds are gonna do. There’s these natural relationships that are far more reliable than trying to guess what the Sharpe ratio is or what the expected return is, or the expected risk or the correlation. You know, all the inputs into an optimizer. Right? There’s, you’re trying to create precision out of something that’s not precise.

Mike:01:22:46Right.

Pro and Counter Cyclical

Rodrigo:01:22:49I have one other question that often comes up is when people, you know, the concept of risk parity equal risk balance, everything that we discussed, they kind of all makes sense. But there are definitely two major ways of implementing risk parity that have been created. The pro cyclical and the counter cyclical, right? The pro cyclical one being that you’re creating a risk parity portfolio, and you’re constantly measuring the volatility of that portfolio and either increasing or decreasing your exposure in order to hit a target. And kind of the Bridgewater approach, which is, listen, we expect these relationships, these are structural relationships across these asset classes, and we’re going to create weightings based on those structural relationships. How do you think about that problem? What is the way that you guys prefer to implement?

Alex:01:23:35Yeah, we don’t assume we can be precise about these things. Right? So part of, and I think this goes back to what I just said, which is this objective of trying to be more precise. So a lot of funds, what they do is they try to target a certain volatility, right? And there’s maybe too much science in this where they’re, and basically, the way it ends up is when market volatility is low, they have more leverage. And when market volatility is high, they have less leverage, because they’re trying to target a certain volatility, because that’s, their perspective is that’s what risk parity is supposed to do. And the challenge there is you can get whipsawed. And it happens all the time, because oftentimes periods of low volatility are followed by periods of high volatility and vice versa. And if you’re trying to fine tune that way, we saw this this year, a lot of these funds lost a lot on the downturn, cut their leverage near the lows and then didn’t rebound as much. And you know, our little ETF that isn’t very active, and it just holds you know 20% leverage all the time, it went, it was down 4% in Q1 and is up 10% now. And there’s nothing fancy about it. There’s no trying to fine tune and target volatility. We just know what these relationships are over time and we just hold it. It’s actually very simple.

Adam:01:24:53When I look through the, because you guys publish the index, right? It’s the Advanced Research Institute Risk Parity Index, which is great because it provides some ability for analysis and a good sort of illustration of what one might expect in general in terms of the character of risk parity strategy. But one thing that did stand out as I just did a quick poke around at the index was that it does seem to have a rather high strategic beta to Treasury risk, higher than what we observe in some of the other indices. And I’m just wondering, is that strategic? And I mean, like going all the way back, right, so you can look at a rolling basis, or you can look at it on an average basis, but certainly, it does have an, and obviously that was very, very helpful in the more recent episode where having a larger allocation to fixed income, obviously, was very useful. So what are the risks and benefits in your mind to having that larger strategic beta to Treasuries?

Alex:01:26:07Yeah, so I think it’s a little misleading. So the exposure there is very similar to the ETF. And the reason there’s a difference in market value is because in the index, we’re just buying ten year treasuries, whereas in ETF it’s 10s, and 30s. So that’s limitations with the index and having a long track record, because it’s back tested to ’98. So that’s why it’s there. But the duration exposure is very similar in the ETF. So it is risk balanced. It’s not, it just looks that way because of the allocation, it’s just lower. It’s a little bit shorter duration than the ETF.

Adam:01:26:46Right. Sure. Okay. Yep. Makes sense. Good.

Rodrigo:01:26:51All right. Look we’re at an hour and a half, almost.

Mike:01:26:55So I’ve only got five more questions.

Alex:01:26:59This is fun. We’ll do this every Friday. This is fun. Good for you.

Mike:01:27:05Oh, we’ll have you back on, too.

Alex:01:27:06Talk to people.

Rodrigo:01:27:08Yeah, it’s a lot of fun. And we’ll definitely have you back on because I want to know what Mike’s five questions are.

Mike:01:27:15It’s a great thing I saved mine. I actually have them on. I just wanted to save them.

Rodrigo:01:27:18Ask them. You have it.

Mike:01:27:20Well, that was the first set of five. I got.

Alex:01:27:23Five sets of five.

Mike:01:27:24Five sets of five.

Adam:01:27:26The conversations are usually more contentious too. I mean, we’ve been racking our brain about how to like poke and prod on a subject that we’re all in violent agreement on.

Rodrigo:01:27:39Everybody nod for the rest of it. I mean do you guys have another half hour? There are some questions that I want to ask.

Adam:01:27:45That’s right.

Crossing the Rubicon

Mike:01:27:46It’s been helpful, though, to understand how you and your group cross the Rubicon, help people understand. We’re always struggling with that, you know, the discussion. We’ve had so many times with, you know, the idea of treasuries and you know, risk parities, levered bonds and, you know, it’s sort of like saying, hey, risk parities is levered gold in 1980. It’s just,  it’s not, it’s an eye view. And, but it’s really hard to get people over it. And I think, you know, I’d love to, in the next time we get together, I want to hear more about how you get, how do you? Well, I wouldn’t mind knowing now, actually, we could give you two minutes for now. But how do you get  that, you know? Adam was poking and prodding on this earlier, but how do you get the institutional client over the hurdle on this? Or is it that they’ve come over the hurdle already? And so they’re looking for expertise, and they’re ready to buy or do you ever convert them? Are they kind of like, you know, real estate investors trying to convert them to public markets? That’s just never gonna happen.

Alex:01:28:49Yeah, I mean, it’s easier to convert people in their thinking when it’s doing well than when it’s doing poorly. Right? Let’s start there. Okay. So people are more interested in things that are doing well.

Rodrigo:01:29:02ETF had just launched something like this at the right time that I’ve ever met.

Mike:01:29:07Congrats.

Alex:01:29:09Yeah. I mean, normally, when you launch an ETF before a global pandemic, that’s not a good time. Right? It’s like starting a business before like, you open a restaurant, January, it’s probably not the best.

Mike:01:29:18You’re gold.

Alex:01:29:19Right. But in this case, you know, you have this philosophy of how things are supposed to work. And you’ve got this, the real life stress test in both scenarios, not just the downside scenario, but in the upside scenario, right? And then the turn, which timing that turn is nearly impossible, right? So, and let alone predicting it. So you got it, you actually got the test on both sides. So that helps obviously. So when you tell the story with that backdrop, you know, you get a lot of nodding of heads. So I think you have to think of it in an environment where that’s not happening and how do you convince people? So I think the first thing is the way people are trained to think about investments is, I think environment A is going to transpire, therefore, I want to own asset A, right? As opposed to, I don’t really know what the environment is going to be. And I need to recognize that if it’s environment A, asset A is the thing to own. If it’s environment B, then asset B is the one to own. If it’s C, then, and recognizing that you don’t know what the environment’s gonna be. And part of that, that bridge, is understanding that if your view of what the future looks like is a consensus view, that’s not insightful, because that’s already in the price. So not only do you have to guess what’s going to happen, you have to guess relative to what’s already discounted. So those are the steps. So that’s like, you go from A to B to C. And if you can make that connection, that logical connection, then they recognize, wow, I really don’t know what’s going to happen relative to the price. And if I don’t know, and then I know that if A happens, it’s good for A, if B happens, it’s good for B, then you start, you basically get them to tell you how they should invest without you telling them the way to do it.

Rodrigo:01:30:59Okay, but that’s. Let’s talk about that a little bit, right? Because I think I am genuinely curious as to whether it’s people coming to you that have already been converted, or if you’ve ever actually been able to convert anybody. Because if you’re dealing with institutions, with the CIO’s job is to pick winners and drop losers, whether that is from a security selection perspective, or from a strategy selection perspective, or from future assumptions of returns and asset allocation. Their job is that, and you come in there and saying, let’s go to the point A then point B, then point C. You see how you’ve been useless and everything you’ve done up to this point has been wrong. Are you with me so far?

Alex:01:31:40Yeah.

Rodrigo:01:31:41Just in that risk parity. So I just, I’ve never been able to convince anybody that hasn’t completely lost faith in their abilities. I mean, and you need to get people from like the depths of hell, when they’ve there. They’ve never been able to get it right. They finally admit it.

Mike:01:31:58They’re despondent. … You get fired.

Alex:01:32:03Yeah. So the short answer is yes. Been able to convert people. A lot of it is from the book. That’s actually one of the reasons I wrote the book, because I spent so much time explaining the concepts. But I said, you know what? I should just write this down. And somebody who’s really interested, read the book, and then let’s talk. Okay. And so that helps. When you invest the time to go through it and see the data and all that, you’re much more likely to, you know, for the lights to turn on than a short conversation. And then the other thing is the big key is recognizing their relationships, of environment A and asset A, and environment B and asset B. Because those relationships happen even over shorter periods of time, right? You get a small downturn and, you know, Q4 in ‘18. And you can see what the assets do. And so that logic gets embedded in your brain, you view it in markets, and you’re now thinking from that framework, and you see it happening. And that builds confidence over time, even if you haven’t invested yourself, but you start to see the relationships. It’s kind of like, it’s like the Matrix, right? You’re kind of in that zone, and you can see these things that kind of move in slow motion. And then it reinforces the belief. And then that leads you down that path. The other…

Adam:01:13:13It’s interesting because. Oh, no. Didn’t think you have another point. Go for it.

Alex:01:13:16The other way to think about it is you don’t have to go from I know the future to I have no idea. Right? There’s a middle ground, which is I think I do but I’m not always going to be right. So maybe my hit rate is 60%, or 70% if you’re overconfident. And so in that environment, or in that framework, maybe risk parity is your core in maybe your neutral portfolio, right? And then you tilt around it. And the more confidence you have in your ability to tilt either yourself or by hiring active managers, then you have less risk parity and more of the other things. And the less confident you are, you have more risk parity. But to not have it at all is making a huge assumption that there’s no way you can plausibly make.

Rodrigo:01:34:59Yeah. I like that part when you use the hubris.

Mike:01:34:01Preach it.

Rodrigo:01:34:03The humility hubris.

Alex:01:34:04Frame.

Adam:01:34:05Scale.

Mike:01:34:06Violent agreement.

Rodrigo:01:34:0875? Well, that percentage is a good heuristic.

Alex:01:34:12That’s right.

Rodrigo:01:34:13To risk parity.

Adam:01:34:14It is interesting, though, because we are, our experience because we, I think, communicate in the same way and position in the same way. And our experience is often that the CIO will invest his personal account with us and the endowment will not have anything to do with it. Right. And so that’s an interesting, that happens almost all the time.

Alex:01:34:37Yeah. Career risk is real, right? You can’t ignore it because, and that goes into the dollar rate of return as well. Because, you know, if you, if career risk is at play, and it always is, then you may not be able to hold on for the ride. And if that’s the case, then you shouldn’t do it or you should minimize your exposure. So it’s really those who have the complete buy in, where they’re basically setting aside the risk of looking like an idiot for an extended period of time and potentially getting fired or shunned. Right? Those are the ones who embrace it more. And then the ones that maybe really embrace it personally, but at that institutional level can’t implement it for those challenges, maybe they just do less. So I think of it as like a sliding scale. And you know, as an advisor, I think there’s a spectrum. On one end, it’s a really well balanced, diversified portfolio. The other end is what everybody else does. And our job as advisors is to play psychologist in some ways, and find the right point along that spectrum for each client where they can go as far towards the diversified balanced side as they can handle. And so we test them. So a lot of times I sit down with a client. And I say, look, this is what everybody else does. This is what we think is ideal. We’re not going to put you in the ideal portfolio because you can’t handle it. Right? … You can’t handle the truth, right? So we’re going to test you, and we’re going to start a little bit over in that direction. And then there’s going to be a challenging environment, it’s going to come in the future, I don’t know when, or how it’s going to transpire, but it’s going to come and then we’ll sit down, we’ll talk about it again and see how you feel. And then we’ll do that again. And every time you pass a test, we’ll go further and further. And if you fail, we’ll take a step back, and we’ll work our way in this direction. So that’s, and you tell people.

Adam:01:36:22I like the language, the pass, fail, you can’t handle it. These are good. These are really good ways to position it for these types of events.

Rodrigo:01:36:30This is what you’ll get – you can’t have that.

Alex:01:36:33Yeah, yeah right.

Rodrigo:01:36:34You’re not brilliant enough guys. If you’re brilliant, you will have it.

Mike:01:36:37Did you just say I can’t have something? What?  You know who I am?

Alex:01:36:42And usually we’re dealing with people who are very confident, successful, so they’re gonna say, no, no. I’ll prove you wrong. I can do it.

Mike:01:36:49Fantastic. Well, that was one of, I’m gonna keep all my other questions for later, but that one, I want to get that one.

Rodrigo:01:36:56Awesome. All right. Well, Alex, it’s been many years that we’ve been interacting. I’m glad we finally got you on the podcast, and got to chat about our joint passions. But we’ll definitely have you and Damien in here again to.

Alex:01:37:11Appreciate that.

Rodrigo:01:37:12Or maybe we’ll bring some other guys that have contentious views.

Alex:01:37:15That’d be even better.

Rodrigo:01:37:16I got to feel it like Schindler, Jason Buck and Shahidi, Damien thing would be. And we’ll just drop them in that podcast and walk away.

Mike:01:37:28Thunder dome? Do you want to thunder dome them?

Adam:01:37:31Yeah, we need someone who just wants 100% US equities too, like we need Rick Ferry on this too.

Mike:01:37:36Yeah Rick Ferry will get us in here.

Rodrigo:01:37:38Hugh Henry. Hugh Henry. Let’s put him in there.

Adam:01:37:41Right.

Mike:01:37:42Madman. Well, thank you for being so generous with your time now.

Adam:01:37:44Thank you, Alex.

Mike:01:37:46It’s been amazing. Looking forward. If you’re in the Caymans, drop by. If we’re in LA, we’re definitely gonna knock on your door. So.

Alex:01:37:52Sounds good.

Mike:01:37:54Cheers. And thank you very much. And everybody remember that, just smile and nod like the penguins in Madagascar while Ani takes us off of this podcast a little bit. Everyone stay here and smile and nod.

Rodrigo:01:38:06Our best though, go ahead Ani, take us.

Adam:01:38:08That’s a wrap Ani.

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