Mike:00:02:30Yeah, in advance of that, just so we can have a far wide ranging conversation, that is not investment advice at all in any way, shape, or form, and should not be taken as such. Please remember, it’s a Friday afternoon on YouTube. So, three guys on a YouTube channel is not the place to get your investment advice, or I don’t know, maybe it is, but go check it with your advisor anyway. And with that, let’s roll Bobby Elliot.

Bob:00:02:54How’s it going?

Mike:00:02:55BobEUnlimited.

Backgrounder

Adam:00:03:00Actually, I’m pumped. I missed last week’s Riffs. And so this is kicking off the year for me. Last week’s was actually fantastic. But you know, we’re really cranking it up here. So, we’ve got Bob Elliott, ex Bridgewater, recently launched a hedge fund replication firm and a new ETF. And we’re going to talk about all of that, as well as the current macro picture, which I’d say is pretty well ambiguous and complicated and uncertain as we have seen in quite a long while. So, we got a lot of ground to cover. I think it probably works for you to start us off with a bit of background about yourself, Bob. How did you get into this crazy business? What did you do with the early part of your career and what are you hoping to do now?

Bob:00:03:48Yeah, yeah. I mean, my background, I guess 20 years as a systematic investor is what I always like to say. The vast majority of that was at Bridgewater Associates where I was there for just a little under 15 years, and did a whole bunch of different things while I was there. Built Systematic Investment Strategies across all the major asset classes, many of which were used in the flagship Pure Alpha Fund. I also ran Ray Dalio’s investment research team for a decade, ghost wrote a lot of what he has put out since, during that time and since, and was part of the small handful of investors that sort of brought Bridgewater from being a bit of a niche player back in the early 2000s to being, you know, what it is today. To being the incumbent, I left in 2018. I spent some time running a $125 million venture fund which use big data to identify early consumer opportunities, which kind of like, systematic in the venture space.

And then over time, sort of recognized that the two and 20 world in general is pretty good for the manager and not great for the investor. And that’s because even though the managers are pretty good at generating alpha, they’re also pretty good at charging fees. And that is, that leaves investors not much better off than they could do on their own. And so I sort of had this idea, this sort of inspiration that could we sort of create diversified low cost index funds in the two and 20 space, the same way there are Vanguard funds in equities and bonds and all that. But recognize that it was going to be a little harder to do that, than traditional investing like that. And so have been working for a while now, building a technology that allows us to look over the shoulder of managers, see what they’re doing, infer what they’re doing, and replicate it and put it in that investor friendly form of the ETF, which is great, has all sorts of advantages, particularly for US-based taxable investors. And so that’s what we’ve done.

We launched HFND three months ago, which seeks to replicate the gross of fees returns to the hedge fund industry at that much more modest 95 basis point management fee versus two and 20. And it’s been the number one — number one growing, independent, actively managed ETF launch in 2022. So, 55 million bucks in it, it’s been a ride for three months. And also sort of getting — I mean, you guys, we’ve met over on Twitter and I bet some of the people who are on here, know me from Twitter, that our thought was, make the return streams available. Also make macroeconomic understanding and research available. And that was what I spent a lot of my career doing. And it’s been fun getting back to that. And Twitter has just such a great platform to do that stuff. You know, it’s really — anyway it’s been a lot of fun.

Adam:00:07:02Yeah, yeah. And you’ve definitely made a success of it, and quite rightly so. I mean, you’re very active, you post a lot of incredible content, lots of really great analysis and context and charts to make your case. And I’ve really enjoyed following the journey. And congratulations on your — the launch of your ETF and your early success. That’s fantastic.

Bob:00:07:25Thank you –

Bridgewater’s “Daily Observations”

Adam:00:07:26And I mean, as fellow nerds and quants and systematic managers, I’m super keen to hear how, you know, dig into some of the details of how you’re executing your replication and your research journey and all that kind of stuff. But before we get there, I want to talk a little bit about your time at Bridgewater. I understand that you spent some time, many years I think, if I understand correctly, writing Bridgewater’s Daily Observations, is that right?

Bob:00:07:53Yes. Yes, yes. I was — there were five or six authors that were regular authors on the daily observations, and I was one of them for five or six years. So, writing between one and two of those, there are two sections, a morning and evening section, one or two of those sections a week, every week for years, which was a lot of fun. I think many of the things that — some of the things that when you think about Bridgewater as an institution, obviously, it’s become sort of the incumbent. I think many people fail — many people sort of look at the return stream, and sort of say, oh, that’s a pretty good return stream, like that makes sense why people might be interested in it.

I think they don’t necessarily appreciate that what makes — what has made people, particularly institutional investors, stick around for a long time through the good times and the bad is that thought leadership and that partnership of working with clients to understand what’s going on in the macro economy, and help them navigate in aggregate. It’s not just about the product, it’s about the overall partnership, and doing that through content. And the daily observations are just, I mean, they were sort of the premier way of doing that content and creating that relationship. It’s incredible. You know, it was a ton of work.

Adam:00:09:19No, we are … aware and we’ve been long-term admirers of Bridgewater’s marketing strategy through that Daily Observations and recognizing very directly how it builds trust and long-term relationships with clients to support whatever’s going on in the background on the investment side. So, I was kind of wondering, though, like, to what extent — I mean, I understand Bridgewater is for all intents and purposes, 100% systematic, maybe not systematic in the way that many people think about systematic, it’s more sort of macro systematic, the way I understood it anyways. But the — to what degree to what’s going on and the thinking in daily observations either overlap or inform, or synergize, with what went on in the back end on the investment side in terms of the types of data that you were feeding into the machine, the types of relationships that you were — that act as Bayesian priors on whatever the forecasting engine is. How did that synergize between research and that marketing activity?

Bob:00:10:24Yeah, yeah. I mean, I think the thing that — when we say, systematic, I think, often people will think about it like traditional quant and I wouldn’t quite describe — it’s not — it was not, it is not a traditional quant-y type process. It’s more systematic in the sense of like, using data and logic and decision rules to determine what position should be across markets, and then building – views and portfolios and things like that. And so that’s really kind of what it is. And I think the process of developing a systematic approach to managing money is, in a lot of ways, what you do is you use systemization, to help create leverage. So, instead of coming in every day and saying, well, the Yen’s PPP is this and interest rate differential is this and the… Instead of having to, like recalculate that in your mind every day, which is stupid, because computers are pretty good at that.

What you could do is you could just take that data in, process it based upon your, by and large your existing understanding, and start with something that is a pretty good representation of how you would think about what’s going on in the world. And then I think the main thing that — and that — there’s all sorts of reasons why you want to do that, because it creates discipline and it removes the emotion and you’re not getting hung up on the news of the day, and all those things, all those things that are frankly, like intellectual… There are problems of human nature that can be — that need to be resolved through discipline and systemization is an effective discipline, right? That’s — most of — it is leveraging and discipline. And those are the two most effective things that it does.

But necessarily, there’s always things the world is evolving, your understanding is evolving, your thinking is evolving. So, there’s always things that are incremental that could get better in that understanding over time. And that’s really what that process is, which is, you see what’s going on in the world, you see how you think things are playing out, then you see how they are playing out, and then you’re constantly going back and forth and observing things you may have missed, you may not have understood, things like that. And that generates questions and from questions become ideas of what are the other decision rules that should be used, and from other decision rules that we can use, presuming you know, they’re good.

Which to be clear, the vast majority of people’s intuitions are bad, they’re not good; just so that people have that understanding. Particularly if you rigorously assess it, it is bad, like 80% is bad. Like, if you have a 200 or 300 hit rate on incremental ideas of how to trade markets that are good, like you’re a world-class investor, just to have that in your mind. And so that’s what that process is. And the observations and the writing of the stuff, in a lot of ways is just talking about the discipline of trading. It’s also the discipline of wrestling with whether the views make sense or not. That’s what the writing is, right, is that discipline of saying, I am actually going to sit here, I’m going to look at that stat. And I’m going to look at what I think is going on. And I’m going to compare those two things and I’m going to say in line with what I think, out of line with what I think, incremental insight or understanding about it.

And that’s a lot of what you see me do on Twitter, like, in some ways, it’s like a little boring, which is like University of Michigan Confidence Survey comes out. I think it should look like Transitory Goldilocks. Okay. What does it say? Well, it ticked up and the, essentially the growth part of it ticked up and the inflation part of it ticked up. Okay, check, consistent with my understanding, put it aside, move on, right. That’s what the process really is all about.

Mike:00:14:11I suppose there’s also a huge benefit in the consistency of the dashboard, if you will. You’ve got a dashboard of instruments that you’re attuned to and paying attention to. And I would imagine there’s a small migration of maybe new things or incremental understandings, that’s coming and going from that larger dashboard of inputs with which you’re trying to sort of screen the world through. And then you’ve got this consistency, though of the bulk of those types of pieces of information coming at you that your dashboard’s fairly consistent through time. And so you know, your insights, probably grow, your intuitions grow because you’ve got this consistency of that dashboard of indicators, if you will.

Bob:00:15:00Yeah, and I think one of the things that people so often fail to appreciate is how much easier it is to start with a high quality foundation, a high quality levered foundation. And so that dashboard, like as an example, there was like a book that got printed every week that had a thousand pages in it, right. And it just basically had all the charts of everything that you’d want to see going on in the world. And it was the same every week, being able to come back and look at that and say, this is the holistic understanding I have. What isn’t working consistent with my holistic understanding, what is working with my — consistent with my holistic understanding?

And what it does, I mean, systemization, it is like freeing, because it frees the mind from having to, like, rebuild the understanding over and over again, like, that’s the thing. The discipline and the leverage are the things that are so valuable about systematization. And those far outweigh the fact that it’s going to be imperfect, right? So, often people get kind of confused, like, well, a systematic approach is an imperfect approach. It’s like, well, like damn straight it’s an imperfect approach. But it’s a whole heck of a lot better than an approach where you’re trying to like mentally reprocess everything with all of your emotions every single day, right? Like that is a way worse approach and a much more taxing approach than a systematic one.

Adam:00:16:27Now, I view that — I view the dashboard as being something more than a dashboard and providing more like PPP for the Yen is this, expected inflation in Japan is this, economic growth is this, the Nikkei has done this over the last three, six — whatever, like a basket of kind of reasonable sort of intermediately moving or evolving indicators. And then a system that provides kind of an outside view of here’s the conditional probability of certain outcomes, given some number of combination of these different meaningful indicators that you’ve got some sort of theoretical rationale for why these indicators should be explanatory of the economic machine and how markets should evolve in response to the economic machine, right?

So, it’s not just like a bunch of dials and dashboards. Am I right, that there’s also, along with those dashboards, a variety of sort of conditional inferences that represent kind of Bayesian priors on look, if you want to be short the Yen here, if this constellation of indicators typically is suggestive that we should — that the probability is that the Yen is going to appreciate over the next six months. So, that should skew your or temper your enthusiasm to go against that — or to you know, coalesce that thesis. Is that a decent intuition, or?

Bob:00:18:12I think, any good, I’d call it systematic process, what it’s doing is it’s just, it’s taking your logic, right, your intuitions, going through a process of saying, are those intuitions good intuitions are bad? Meaning like, how much goodness do those ideas have? And then giving — …

Adam:00:18:31Like a calibration process.

Bob:00:18:33Calibration process, which is important, because there are certain things that have better goodness, and other things that have worse goodness, and other things that have no goodness or negative goodness. So, like, I mean, this is just like a simple thing that has come up on Twitter, like everyone’s focused on the ISM non-manufacturing survey, and you know, the fact that it plummeted. And it’s like, okay, well, let’s talk about that. That’s basically an attempt to have a real-time indicator of services demand. Well, actually, that’s — that 20 years ago or whatever, in the past was pretty good. And actually, it’s deteriorated in quality, to the point where it’s actually not a good indicator of anything right now. It’s been essentially zero correlated to actual activity in the sector over the course of the last, basically post financial crisis.

Like that’s such a good example of like, if you go on the Twitterverse, everyone is running around, looking at that stat without contextualizing its goodness, without contextualizing its goodness on an outright basis, its goodness on a relative to other indications basis, on all of those different things. And that’s the beauty of a systematic process, which you could say, hey, look, anytime I’m looking at something to be an indicator of growth, I should see whether it’s related to the thing that it’s trying to measure. And if it’s unrelated to the thing that it’s trying to measure, then I should start to weigh it less than if it becomes more related to the thing I’m trying to measure, right, or I should downplay it relative to other things. And that’s the thing that the mind, that the individual’s mind is so frankly, like bad at is weighing in a disciplined way all the information that comes to you in a real-time basis.

The way to do that, I mean, there’s like nuances of how exactly to do that but you’d be surprised. Like, you have the power. Like it’s not grand novelty in terms of thinking about how exactly these things should work, the idea of like, you should look at an indication of growth relative to what it’s trying to measure. You know, there’s nothing like that insightful about what I just said. But the value is the discipline and the process and the rigor of actually evaluating that in a first class way. You know what I mean? And that’s what systemization brings and it doesn’t — and taking away the emotions, the emotions that I did or did not eat lunch, and therefore, I overreact to the ISM non-manufacturing.

Adam:00:21:06Yeah, yeah, for sure. No, that’s a really interesting characterization of systematic thinking, right? I mean, we skew much more the other way. There’s always discretion, right? You’re always making decisions, what indicators are you going to use? What research framework are you going to apply? What markets are you going to trade? Like, there’s an infinite number of decisions that you make, even if you’re a purely systematic quantitative manager. But you’re sort of taking that idea of systematic to a slightly higher level of discretion, right, where the systematic component is to constantly improve calibration of the information you’re using to make decisions, and you know, how well your analytical process in combination with the data you’re using is calibrated to positive forecasting over time. And then learning and adapting in response, right?

Bob:00:22:04Yeah. And I think that’s — I think, often people will immediately sit there and say, oh, well, you’re just like running a big regression or something like that, against everything. And like you’re just kind of like, like the — that there’s no, there is — even in thinking and investing in a systematic way, there’s tremendous art. There’s a tremendous amount of decisions that have to be made in constructing the approach, in evaluating the approach, and frankly, in running the approach on a day to day basis. And saying — …

Adam:00:22:38Oh, yeah, for sure.

Bob:00:22:39— what’s right, what’s wrong, how confident am I? Like, you can’t, that’s why you can’t — so often people are like, well, I’ll just like gin up an indicator of something, and then just like, run it off the cliff, and it’ll be fine. And like, that’s not how it works. Like, you got to — systemization is a way to create leverage and discipline in running money, but running money is what you’re doing. And so like, it’s important to recognize when you’re hiring people to — when you’re investing in people, even people who have a systematic approach, you’re hiring the people.

So, it’s important not just to look at the approach, but also look at the people and see if you can be confident that the people are going to manage your money well. Do they have the skills, experience, expertise, perspective? Because I don’t know, if you hired somebody five years ago, they would have had to navigate through COVID. Like, do you have someone who’s just going to run it off the cliff in the middle of COVID? Or do you have someone who is going to like, manage the money? You know? You can’t get away from managing the money. That’s the thing that’s always important to recognize.

Adam:00:23:45Yeah. No, that’s a really, really good insight. Absolutely. And even the most systematic managers need to intervene on occasion because there are certain things that the system just does not know that, for example, there’s a peg on the Swiss franc to the euro, right? Should you continue to trade the franc, right? Like it just — or the Bank of Japan is instituting full on yield curve control, they’re not going to let it go beyond a certain level. Now you’re creating an asymmetric risk. These types of things need to be accounted for, you need to be constantly watching the market for things that your systems don’t know.

Bob:00:24:29Right, right. And that’s why when you’re looking at people, like managing money is not a part-time profession. You know? Like, you got to be in the game. And so that’s actually like, one of the things I think is kind of — people don’t realize, like, the — like, I’m producing this content. The reason why I’m producing the content in a lot of ways like I’ve got to do this anyway, right. To run money, I have to have that level of understanding of what’s going on, on an ongoing basis. Now, obviously, we all know, like, writing something more formally is different from sort of like scribbling some notes. Although in a lot of ways actually might, I even, like got on Twitter because I just was going to like write notes about what I was thinking was going on in the world. And then like, share, it with some friends and then I don’t know, I became Bobby Unlimited, the Twitter …

Adam:00:25:17You’re sharing with 50,000 friends and growing. Exactly.

Bob:00:25:20Exactly, exactly. Which it’s kind of funny. I didn’t — I honestly, I had no idea that people would be so interested. But it’s cool, you know?

The Re-birth of Macro

Mike:00:25:28Yeah. Well, I mean, you’re coming into the rebirth of macro, too, I think, from the perspective of the implications that this sort of scarcity global economy now faces versus the economy of free trade and optimization …

Bob:00:25:47And liquidity.

Mike:00:25:48And liquidity, right. Exactly. Yes, precisely, precisely.

Bob:00:25:51The era of cheap money is over. That is very, you know, it’s been 15 years since that’s been the case, right?

Mike:00:25:58Yeah.

Adam:00:25:59Well, it seems like it’s taken the market a long time to internalize that fact, I’ll tell you. There’s a good question in the chat from my partner Rodrigo. We struggle with this internally about how to effectively make use of macro data because the frequency of the data is so low, right? So, you’re looking at monthly data, you just don’t have enough data points or enough full economic cycles, or what have you to be able to draw strong statistical conclusions and make strong statistical inferences for forecasting purposes. So, maybe close the loop on that for us. I mean, I think that you’ve answered some of it. But just …

Bob:00:26:40Yeah, yeah. Well, I think I take two — I’d approach it or answer it two different points on that, which is one, I actually, I recently was writing about this in the context of the employment report. Like most people, they look at the US employment report and what they’re trying to do is they’re trying to find the thing that tells them what’s going on, right? The indicator, the series, the whatever that is leading. And the thing that’s very interesting about, I think, the most sophisticated macro investors, and what they’re actually doing, is they’re processing all of it. Right? They’re basically saying, let me look at all the different indications of this, assess its …, and put together a comprehensive and probabilistic picture of what’s going on. That’s what you’re doing.

And so part of the way that you beat the dearth of data points problem is by looking comprehensively. Like, if the question is what is going on with the labor market in the US? The answer is, there are hundreds of different ways to look at that problem, that together, I think, paint a — you can synthesize a picture together on it. And so that’s part of the way that you increase real-time, sample size, and some are more timely and less timely and like, there’s a lot that you can do there to increase your resolution — to create — You’re never going to have certainty, you’re going to have a probabilistic sense of the range of what’s likely happening, right? That’s what you’re going to get to, but you can get a fair amount of information about that. And then when it comes to the through time part of it, which is a big part of it, how do you know? People talk about the yield curve to trade stocks, right, the yield curve for recession, right? You got like seven instances. There are people who, like have won Nobel Prizes inferring what’s happened with seven data points, which …

Adam:00:28:28Yeah, right.

Bob:00:28:29Like, a real quant looks at you and you’re like you got to be kidding me. Like, what’s the statistical significance of this? And the reality is that in macro in particular, there’s not enough statistical significance to be able to run traditional quant models. And so what you have to do, this is the art and the science, is you have to balance that idea of intuitive fundamental understanding with what you think, how you think it should work with an observational testing, to say is that actually how it plays out. And that is actually part of — there’s a big — there’s a real discipline you have to have there to basically say, I’m not — what I’m not going to, I’m going to in a very disciplined way, say, here’s how I think the world works, then I’m going to go test that.

What I’m not going to do is if that ends up being false, or not a particularly good indicator, I’m not going to like tweak the optimization to get myself to a point where it’s going to be better and better, because you’d always with seven cycles post-war or whatever, I promise you, I can find a million things that look great, that test great, look great, whatever. And part of the discipline is saying no, the thing that will be durable is the thing that’s rational and intuitive about how human nature and how people should react and respond. And for those things that are good, like yes, that I can have confidence. Like, if I have good intuition, and I have empirical evidence that’s pretty good, it doesn’t have to be perfect, but pretty good, then I could be confident in that. And if it doesn’t work out, like, you throw it away and you don’t cheat. You can’t cheat. That’s a big thing. No cheating.

Adam:00:30:11Yeah. I mean, I think you — I totally hear you about the ensembling of a constellation of a wide variety of different data sources that are viewing the economy through, from slightly different angles. Right? We make abundant use of that same technique. What’s always stumped me was just again, that if you’ve got a limited number of cycles trying even to determine which indicators are strong, or weak, or relevant, or irrelevant, or inverted, it’s tricky. Right?

Bob:00:30:44And I think that’s part of the other thing is in macro at least. You know, I’m going to separate that maybe from other places. In macro, the best macro managers, the most — the absolute best macro managers in the world are 60% right, 55 to 60% right in any trade in one market in one month. Just think about that. Like, at a high level, that’s not very good. That’s actually pretty bad in the scheme of things, right, relative to, like, what the world considers expertise. And so part of what you have to do because macro is so imprecise, right, since your signal to noise is so low, is what you do is you have to create a lot of bets. Because if what you do is you have 20 bets that are 55/45 with a reasonable amount of reliability 55/45, actually, you can build a 1 to 1.5 gross of fee Sharpe ratio. And if you do that, you’ll build the biggest institutional asset manage, you know, the biggest head front in the world. Right? Like, think about that. That’s what it takes. But the — …

Adam:00:31:51Fundamentals asset management. Absolutely. Yep.

Bob:00:31:54Right. But the trick, the trick is diversification. Like, that really is the trick in the macro sense, which is, you know, I was trading currencies. There’s 50 major liquid exchange rates that are out there. And, like, the idea was, try to get yourself to 55/45 or even 53 or 54. If you get yourself at that point and get enough diversification, enough balance, enough things like that, you can actually do something that’s pretty good. But if you looked at any one of the things, you kind of be like eh, kind of garbage-y. Right? Like, not that good.  And so that’s kind of the, you know, just get that coin in your favor.

Adam:00:32:37Yeah. Yeah. No. No. We hammer that drum all the time, that most — if you look at any of the individual edges that we use, that the size of the edge is vanishingly small. If you look at all of those edges applied to a single market, it’s marginally better. It’s only when you apply all of those edges across all of those markets at a trade frequency, a sufficient trade frequency that balances your edge against the friction, right, the cost of having a trade, that you actually are able to generate the 1, 1.52 Sharpe ratios that everybody is looking for and so few can deliver. But diversification is such a huge part of that. Yeah.

Bob:00:33:24It’s a huge thing. And I feel like the — I feel like the Twitterverse or the popular media, like, everyone is like, I don’t know. Is the Fed going to pivot in June or not or whatever, July? Like, that’s one bet. Like, genuinely, that’s how I look at that. It’s like you know, I don’t know. I think probably not. But, like, that’s about how good it is. It’s like one bet. You know, one bet of ideally you know, hundreds of bets that you’ll have on over time. And so, like, also on the flip side, whoever calls that bet that right, like, recognize that the odds that they got lucky are at least 45%. Right? The odds that they got lucky because if there’s, you know, if they were the best in the world, the odds that they got lucky were 45%. Right?

Adam:00:34:18Yeah. Right. Right.

Bob:00:34:19More likely the odds that they were lucky are something closer to 50%. And so also, it’s about looking at the process, the process, not the, you know, to get — to understand whether if you run over enough sample size, you’re going to get something that actually works through time.

Adam:00:34:37Yeah. No, that’s so critical. I also just scratch my head constantly how everybody is so obsessed with the S&P or just equities in general. You know, it’s literally — you’re trying to time one bet. Right? You’ve got, like, you’ve got 80 — we trade 80 markets if you orthogonalize them, it represents maybe depending on where correlations are at the moment, between kind of 10 and 20 different independent bets. Right? 10 and 20 versus one, right? So, everyone’s trying to find the guy that can time the S&P. That’s why I marvel at these — the obsessed with long-short equity managers or what… Like, it just seems such a narrow focus. It all seems so absurd to me, but this apparently is where everyone wants to focus all their time.

Mike:00:35:25I also think that’s a function of the timing, the last decade in that particular asset class. There’s been — if you look over many cycles there’s this myopic focus on whatever’s, whether it was the previous cycle and the BRICs or emerging markets or natural resources and the S&P was not as popular sort of 2000 to 2009, ‘10, ‘11. And now we’ve got constant fascination, and we’ve got the buy the dip crowd that this is human conditioning that’s going on, and it has a lot of eyes focused on it. So, everyone has a lot of it and so now they want to try and manage it. And some of that — Which goes across this idea of not only are you trying to get your dashboard to feed you the information, but then you’ve got initial conditions to consider, right. This dashboard in a different — looking like this with a different set of initial conditions, will have very different outcomes, both short, medium and long-term. And so there’s a whole lot. Go ahead.

Bob:00:36:32Yeah. I was going to say, like, part of the reason why everyone’s so focused on the S&P 500 and if it goes up or not, right, is because for some reason, everyone’s sitting around with all of their assets in the S&P 500. Like, that is crazy. You know?

Adam:00:36:53Agreed. Could not agree more. Amen. Preach brother.

Bob:00:36:56Right. Like, why — like okay. So, like, why are we living in a world where that’s the, essentially, the only asset that anyone’s holding, not just like in, like, the fact that they are holding — they just hold stocks. They don’t even hold international stocks. You know, they basically effectively only hold stock risk. They won’t even hold international stocks. And then let me tell you, like, let me try and mention gold to somebody and whew, I’m like a crazy person.

Mike:00:37:25Yeah, yeah. Probably the most polarizing asset.

Bob:00:37:30But, like you know I’m saying, hey, maybe you should buy a diversified portfolio of assets across countries. Gold is one of the many things you could consider, and it’s like, hold — …

Adam:00:37:42Get out of here you wacko. Go to hide your bunker.

Bob:00:37:44Right? Like, you gold bug crazy person.

Mike:00:37:47Yeah. Keep it beside my guns and my beans.

Diversification

Adam:00:37:50That’s right. We’ve been hugely influenced actually by a lot of the research that Bridgewater’s published on their All Weather portfolio. And obviously, they’re not the only ones that published on sort of risk parity. But I mean, we couldn’t agree more. All of our products, we’ve got some products that are just alpha and others that have a core beta component. The core beta component is a global diversified risk parity portfolio, right, motivated in large part by 10 or 12 years ago that early research that Bridgewater published. And it just makes such amazingly duh sense when you think about it. Right? You know, stocks and especially developed market and US equities really only work in a certain kind of economic environment.

Now we’ve had an economic environment that is kind of Goldilocks for that from 2009 to the end of 2021. Right? So, I think a lot of the consternation at the moment is, holy crap, what’s happening here? Like, the last 10 years this was an easy game. I thought this was an easy game. And people are having to think about diversification in a very different way. So, I mean, how did your stint at Bridgewater just cause you to think about the idea of kind of strategic asset allocation relative to how most people invest?

Bob:00:39:13Well, I think the most important thing is, like, diversifying. And there’s lots of different ways for you to diversify and there’s lots of different approaches to diversification and there’s risk parity and there’s other solutions. There’s other solutions to the problem. But, like, one of the things — Sometimes I worry that people feel almost like it’s too much. Like, I can’t replicate risk parity. It’s like, fine. Don’t replicate risk parity. Just risk match your stocks and bonds. Let’s start there. Right? Like, not that complicated, like, buy TLT instead of, you know, VGIT or the equivalent of it. Right? Just, like, buy some more duration against your stocks. Or just buy 10% in BCI, a diversified commodity portfolio. Just don’t stress too much. Buy 10% and you’ll be better off than you were the day before.

Like, there’s lots of different — it’s a journey, right? It’s a journey, not necessarily a destination. I think there are lots of good solutions. Like, I basically run R-Par in one way or another, which is the risk parity ETF for my personal strategic portfolio, like, that’s what I holds R-Par. And then over weighted towards tails outcomes and higher inflation because those are the two essentially risk of ruins for an investor. And so in the spirit of, I hold 10 or 15% of my portfolio in gold, which people think is crazy, you know hold more commodities than the average Joe. But, like, that kind of gives you a sense of it. It’s like you know, a little bit of, like, find diversification and then protect yourself from the tail risk. Because I think I probably spent too much time studying very terrible outcomes.

Mike:00:41:10I think we all have. It’s one of …

Adam:00:41:12Or examining the full distribution of potential outcomes. Right?

Bob:00:41:15Right. Right. Right. Right. Right. Yeah. I mean, probably too much time studying Weimar and Argentina and Turkey and — but it happens more than you think as a …

Mike:00:41:29Yeah. You think that now because that hasn’t happened for a while.

Bob:00:41:30Right, right, right. Yeah.

Mike:00:41:34And the other challenge with all of the things you’ve mentioned and I think the sort of the general direction of the investing public at large, this includes both retail and institutional, has been to … diversification because it has not paid, especially pre-2021, where your commodities dragged you down, gold dragged you down. And investors tend to look at things of six months, 12 months at a time, and they say, well, why am I hauling this albatross around my neck when I have these other things that are doing so well, and they just sort of continually through a full market cycle, tend to both through drift in the portfolio. Right? So, there’s a drift that occurs in the portfolio. If we go back to that 2000, 2008-9, I mean, the commodity side drifted up just because of pure performance of it. So, you get more there.

And if you’re not rebalancing and doing the exact opposite where you say, well, I’m going to get rid of these things because they don’t seem to be doing much, you end up in the situation, I think, where we are now. And I think, is it Portnoy who coined the, diversification is just always having to say you’re sorry. Because something in the portfolio, right, just something in the portfolio is always going to be acting to one of the other quadrants. Right. And so if that particular deflation or stagflation is not occurring, you’re just hauling what you view as a dead asset. But again, if you look at this over decade long periods, which by the way is the timeline, you inevitably will have a risk like ruin type scenario. Because your timeline is long enough that you are going to have one of those scary situations happen, and it’s going to leave a big dark hole in your portfolio. And that is going to have some challenges for whether it’s your own portfolio or for the constituents of the portfolio that you’re managing on behalf of, if you’re an allocator or an endowment or pension fund.

Adam:00:43:44Yeah.

Bob:00:43:45Well, that’s really uplifting to everyone.

Adam:00:43:46Well said, Mike.

Bob:00:43:48It’s those terrible risk of ruin moments, which are, will inevitably hit you before your death. So, just be prepared.

Mike:00:43:59Well, you sort of pay for it along the way or you pay for it all at once.

Bob:00:44:03Or you pay for it when it happens. Right.

Adam:00:44:05That’s right. That’s right.

Bob:00:44:07Or you know — Or you get lucky.

Mike:00:44:09Or get lucky. Right.

Adam:00:44:11Like, investors have for the last 10 years for sure, not including the last year maybe.

Bob:00:44:16Like all those people — all those people who retired in 2019, right? You know, who were, like, levered up in, like, illiquid, high beta strategies and retired in 2019, they’re like, I killed it. I’m the best investor that existed. Ah, those other people. They’re the ones who screwed up the portfolio.

Adam:00:44:35Yeah, that’s right.

Mike:00:44:37And I think you mentioned the TLT, or extending duration to try and get that bond side of it up, when I think over the previous sort of 10 years, at least the last five from ‘16 to ‘21, people were reaching for yield in the credit space. Right? Again, expanding that equity exposure rather than saying let’s get some yield, but let’s extend duration in sovereign bonds, which will have largely, didn’t quite work out in 2022. But over other cycles, you have a better hedge to your equity portfolio than loading it with a bunch of credit and or high yield credit, things that actually are much more responsive to the growth impulse rather than inflation. They just compound your equity exposure. Anyway.

Evolving Macro Variables

Adam:00:45:24Yeah. Well, we saw the implications of what happens when you’ve got a two legged stool, right, in 2022. So, Bob, of course, I really wanted to have you on because you’ve produced such incredible commentary and analysis as we’ve come along this journey through 2022 and now into 2023. And obviously, the macro variables have evolved with gyrations and amplitudes along, certainly along the inflation axis and in certain other dimensions of the economy that we just haven’t seen in decades. So, I’m sure that people listening are going to want to hear your thoughts on what you’re currently seeing in the market. As you say, everyone’s obsessed with the inflation numbers and the Fed pivot. So, what are you seeing? I’ve obviously been following some of your tweets and your charts. You’re making some really good nuance points. Where are you at the moment with your views?

Bob:00:46:28Yeah. I mean, I think we’re — The first thing – I’d just like taking a step back for folks like, a big part of what I did is I taught sort of the introductory macro course at Bridgewater for a long time, and I kept, you know, this is during — a lot of it during post GFC. And I kept bringing the students back to studying cycles in the 60s and the 70s and they’d all look at me and they’d say, “Oh, do we have the study the cycle? What will it tell us? Like, inflation is dead? Like, why are we doing this?” It’s like, a lot of what we’re experiencing. Like, I’m getting the thank you notes now in terms of navigating an inflationary cycle. But, like, a lot of what we’re experiencing is a flavor of inflationary cycles. So, in some ways, like, a pretty boring traditional inflationary cycle now is a little different. There were supply shocks which created, obviously, like, inflation shock, which kind of kicked off the inflationary side and we had large fiscal stimulation globally that also supported the spending and kind of got us into that inflationary cycle. So, that’s a little different than a sort of traditional 60s or 70s version of it.

But look, the big picture was we’re in an inflationary cycle. Some of those things, some of those shocks are getting resolved in a transitory way in a sense of used cars went up and then they went down because it’s being resolved to some extent. But what’s happening is, in general, the sort of baseline structural inflation is being driven by wages, labor markets are tight. When labor markets are tight, in general, wages remain relatively elevated, wage growth remains relatively elevated. And that’s very typical in an environment where you get the sort of inflationary shock with a tight labor market or an elevated economy, an easy monetary policy, you often get basically an inflationary cycle. So, that’s what we got right now.

The question is for where are we on that version? A year ago, it was, like, inflationary cycle and the Fed is, like, out to lunch and has, like, left the building and have forgotten that that matters. I’m sorry about the alarm here. This has been going on all afternoon. I apologize. I’ll just keep talking through it. But then you got through the year and you had the typical monetary tightening response to that inflationary cycle. And kind of, we’re at this point of saying, where are we in that cycle — where are we in that process? Like, it looks like, to me, we’re in the sort of six months, let’s call it, of what I’m calling transitory Goldilocks. Which is because some of the supply shocks have been resolved, some of the issues — we’re switching from inflation to disinflation amongst a couple of different core sectors of the economy.

That is bringing overall reported inflation down. That’s supporting real incomes which is supporting real spending. And as a result, we’re getting moderately good growth in a relatively tight labor market. But we can have moderately good growth with okay inflation, like, fine inflation at this point in the cycle as that disinflationary impulse comes through. But eventually, it will no longer be sufficient to offset the services inflation, etc. And so therefore, what will happen is we’ll come back, we’ll find ourselves six to 9 months from now in an environment where inflation is probably more elevated than what we expected and the Fed will probably have to do more. That’s my guess.

If that’s the case, the bond market is totally mispriced. Right? Because the bond market is saying cuts in the second half of 2023, massive recessionary cuts. So, if we get to that point where the Fed has to do more, that’s going to create — that’s not priced in the bond market. At the same time, if you look at the equity market, and the equity market is sort of saying, there’s not going to be an earnings recession. Everything’s fine, which makes, one possible outcome is that the Fed has done enough and when all these dominoes flow through, the economy will weaken in something like six months from now. Right? It will start to get — feel like recession six months from now. At which point, the stock market is totally mispriced. Because if we’re going into a recession, like basically, earnings expectations on a level basis are higher than they were a year ago. Right? The equity market is actually more expensive today than it was a year ago.

And so one of the things is happening, like, the stock market’s mispriced, the bond market’s mis-priced. They’re both kind of implausible. And at the same time, what’s being priced into the commodity inflation side of the market is basically a return to perfection. Right? Like, we are absolutely getting to 2% and it’s going to be perfect and spot on and stuff like that. And that also is totally, like, that is likely implausible in the sense of if we were going to go below it, the Fed can ease and support the economy. So, if the risks are skewed to the upside, then the Fed hasn’t done enough on it. And so you basically have transitory Goldilocks combined with asset markets that are basically pricing in totally implausible scenarios in one form or another. And that actually creates a lot of opportunity in terms of positioning through this dynamic.

Adam:00:51:49Yeah. Well said.

Bob:00:51:50I kind of yammered on there. I apologize.

Adam:00:51:52No. No. That was great.

Mike:00:51:54That’s spot on. Right? Somebody, in the way assets are priced and asset classes are priced, there’s an incongruity with the potential outcomes that is noticeable. And that is being largely ignored by investors as they kind of look through the last 10 years of what their habits have been and their reactions have been to these types of things. And thus, you have an opportunity in active management to have much further dispersion created, which creates the opportunity for active management to provide excess returns, and in particular, at a time when passive portfolios, whether they be risk parity or otherwise, may sort of struggle. And you know —

Bob:00:52:39Yeah. I mean, this is going to be a very challenging experience and that this transitory Goldilocks like what we’re seeing and what we’ve seen in the beginning of this year is like, the beginning of this year 60/40 has been doing great. Right? And you could imagine what happens is we get the circumstance where the growth is okay and the inflation comes down and everything looks okay and 60/40 does great, but it’s not a durable circumstance. And so you could easily have people levering into assets in the 60/40 and they get royally hammered if either outcome happens, which is either the economy topples over unexpectedly or the Fed has to tighten more. Like a combination of those two things is really bad and you could as a strategic investor, you’re not well positioned for that path.

And so what can you do? You can either increase your diversification, which is, like, if you’re just a strategic investor, like, increase your diversification, try and put your, you know, hold more cash, lower your risk, increase your protection against elevated inflation, don’t be a hero, bundle through this year, and it’ll be okay. That’s what I would do if you were just like, hey, I want to put on a portfolio and not worry about it. Or what you’re going to do is you’re going to have to find the most sophisticated asset managers because this is going to be hard. Like, let’s be honest. Like, this is going to be a doozy of a year, is what we’re going to experience here. And I think — …

Mike:00:54:10Right. And I think — Go ahead. Keep going.

Bob:00:54:13And so like the beta guys are not, like, they’re going to get ruined by this thing. Like, you need those sophisticated people to help you.

Mike:00:51:21And so that’s the other thing I think you touched on that not many people are kind of putting their finger on. Previous to 2021, bonds are a great offset to stocks. So, your portfolio vol is just lower, ambiently. You move into this scenario and as you lay it out, that’s neither a good situation for bonds or stocks. And so now you’ve observed an increased correlation between these two assets, which means your portfolio level of volatility is much higher, which would say to you, I should probably own some cash.

Bob:00:54:55Right. Yes. That’s totally right — the same vol, you should hold 30 or 40% cash if the correlation is flipped from negative 0.5 to positive 0.5. Right?

Mike:00:55:05Exactly. Yeah.

Adam:00:55:08What’s interesting …

Bob:00:55:09… something —

Mike:00:55:10That’s the other thing. Yeah. A year ago, it was bupkis. Now it’s sort of whatever three to four and a half even on a trend. And if you do get rates higher, well, your rates are going to ticking up, depending on what your duration is and all that sort of stuff. But holding that cash means it happens instantaneously. Right? You’re getting higher cash rates as that happens. And so if you’ve got this 30% cash, you’re dampening the portfolio vol, you’ve got dry powder to look at things when they become more attractive, and you’re getting a pretty good yield on that.

Bob:00:55:49Yeah. And that’s a — I actually had not heard many people frame it in the risk taking context, the correlation flip to the risk taking context. I think it’s a very insightful point and paints a very compelling picture for why — even if you’re just — you’re like, I like 60/40 for whatever bizarre reason you like 60/40. You’ve got to be holding more cash relative to what you were doing before to de-risk. It really is a good point.

Adam:00:56:17Agreed. Another point that I think is often missed is that several hedge fund categories actually hold a lot of cash on the balance sheet. Right? Like macro strategies who trade futures, market neutral strategies, they hold a huge amount of cash already. Right? So, if you got a — if you want to own cash, but also at the same time get exposure to strategies that may be able to more effectively navigate or diversify against your strategic holdings in stocks and bonds over the next few years, while also delivering a yield, these macro funds, CTA funds, market neutral funds, other types of hedge fund strategies that hold a lot of cash, they might hold 80% of their assets in cash strategically against their futures positions or against their long and short stock position. And they’re generating a yield on that cash.

Whereas two years ago, you’re getting no yield on that excess collateral. Now you’re getting 4 or 5% on that excess collateral, which is going a long way towards overcoming whatever the excess fees are. Right? So, the benefit of some of these great structural diversifiers is A, they lower volatility because they’re either zero or in some cases negatively correlated to your core strategic portfolio. And you’re getting the yield pickup from the large cash allocation on the balance sheet.

Structural Factors

So, I want to pick up at the point that you made about why you think we’re in this kind of transitory Goldilocks. But then what are the structural factors that are extant in the current market that you think are going to pick up again in six, 12 months that many market participants aren’t seeing. Right? Like, how has the economy structurally changed so that when we cross this transitory chasm, we move back to a higher level of average inflation, do you think?

Bob:00:58:31I think the key question is where do wages and incomes in a nominal basis settle? And for decades, basically, wage growth was 2%. Like, I can remember creating models where I just typed in 2%, you know. Like, as if it was sent from heaven that wages and inflation shall be 2%. Right? But that’s not the circumstance that we necessarily have on a forward looking basis. For a variety of reasons, labor markets across the developed world are actually relatively tight. A big part of that is that even though growth is not that strong in an environment of low productivity and in an environment of negative demographics; what you have is you have a circumstance where you have even like a muddling economy, actually can create some labor tightness.

Now if we didn’t have, I think, the inflationary shocks that existed a year or two ago, my guess is we would have seen more of a Japanese-y type outcome, which is kind of this, like, everyone kind of accepts that wages grow very modestly even though the labor market is relatively tight. But what that has done is in some ways and this little unsatisfying is, like, it has inspired or created a reason why labor can negotiate — an immediate reason for why labor can negotiate for higher wages. You even see that, like, very tactically, like, to get, like, real weedy. Like, if you look at the Atlanta Fed wages amongst hourly high school educated workers, what you see is that in that spike in gasoline prices in June that spiked up and then spiked down June and July, you actually saw wages, wage growth increased right in line with that.

So, you can see, you can tangibly see how people are like, I need more money because I need to put gas in my car. So, I have a — and the labor market’s tight, that’s important too, and the labor market’s tight. You can’t find anybody else so you better give me a little bit more dough so I can do this. And so that’s created a higher rate of nominal incomes, and that higher rate of nominal incomes then allows for a higher rate of nominal spending. Right? The higher rate of nominal incomes maintains. It’s not a spiral. There’s no spirals. Right? It’s just — it’s a maintenance. If I keep getting paid, my wages grow at 5 or 6%, I’ll keep spending growth nominally at 5 or 6%, and we’ll just keep plodding along with that. Right? And I think that’s the key question is, are we going to go back to the world of 2% inflation, or are we in this because of a structurally tight labor market, a more persistent 5 or 6% type wage outcome?

And if we are, that’s the thing that Powell, and it’s not just Powell. It’s also Lagarde and others when they talk about what they’re worried about. That’s the key question that they’re worried about. I’d say the jury’s still out, but it’s, my guess, having looked at things that look like this through time, is we’re going to see higher than what most people expect, longer, in terms of inflation than it’s currently priced into the bond market or into inflation swap markets or things like that. Like, that’s my guess is where we’re going. And so that’s why I’m squinting at these things, you know, like, the Atlanta Fed wage thing comes out. Like, let’s get the spectacles on and start squinting at it. It’s important. Because where that settles will be the determinant of how this whole thing plays out. It’s very important and it’s and it’s ambiguous. I don’t know. And anyone who tells you that they know is blowing smoke. They don’t really know. Right? This is the art, this is the ambiguity of the macro environment. Right? You got to deal with that.

Mike:01:02:35And are those wages sticky? Like, once they rise, do they not, like the gas prices dropped, did the wages drop immediately? And… Or are they a little bit more stickied? Right.

Bob:01:02:49The growth slowed. And so that’s kind of the question. Like, the levels you have an adjustment up in levels and then the question because inflation is the change in prices and so that connects to the wage growth, right, the nominal wage growth. And so the question is how fast does the nominal wage growth go? And it looks like it’s persistent. That’s the thing. It looks. But you could envision let’s just say everyone gas prices went from I don’t know $3 to $5, everyone had a level reset in their wages and then we all carried on. Like, I agree that would then return us back to a zero or whatever low inflation dynamic.

The issue is, you know, because it’s discontinuous, right? Like the inflation happens and the person negotiates and the — you know, and then the spending happens. Like, that, it’s not — it almost necessarily doesn’t create an immediate adjustment. Right? It’s a dynamic that interplays with itself rather than an immediate dynamic, an immediate readjustment.

Mike:01:03:56Feedback loops over and over again through a number of durations.

Adam:01:04:02Is part of this Goldilocks thesis due to just absurdly high year over year comps? Like, we’re just coming into a period where obviously inflation growth readings were really, really high during Q1 and Q2 last year. And therefore, as we’re comparing year over year moving through Q1 and Q2, it’s going to look like inflation is moderating, but really it’s still persisting at a dangerously high rate.

Bob:01:04:40No. I mean, this — some of this is sort of real in the sense of, like, if you look at the I, you know, this is the sort of thing, like some people look at year over year, like, I think probably the best thing and what the Fed would look at would be kind of a smooth monthly, I don’t know, three months, six months, something like that. And you’re seeing it in those measures as you’re — it’s not just a back end thing. Like, it’s real. Like, used auto prices are falling, like furniture prices are falling, like stuff’s coming down, oil prices are falling, things that are connected to oil prices are falling, like airline fares and things like that. Like, it’s not like a technical issue. It’s like, no, prices are falling. Or there’s a subset of prices that are falling. Right. And so that’s a real thing.

But the issue that people often forget about is in order for inflation, you know, inflation — let’s just say labor or services inflation is running at 5%. That’s basically what it’s running at, just draw that line, just draw across. In order for aggregate inflation to remain at 2%, what you have to have is the prices of all the other stuff have to keep falling at the same rate on and on and on and on again. And that’s just not like how it works. As an example, there’s a big disinflationary impulse from oil falling but, like, it’s not like oil falls 20% a month. Right? Because then we’d get to zero real fast. Right? That’s not how it works. And so the fact that oil prices are stabilizing and actually slightly increasing at the current levels means that you’re shifting from a disinflationary impulse from falling oil prices to an inflationary impulse of falling prices and that’s going to necessarily create a positive impulse on inflation.

And so that’s the cycle we’re in is we’re in the cycle of going — of getting that disinflationary impulse that’ll flow through, that’ll eventually revert. And we’ll get back to that structural inflation, that structural labor inflation, which is the thing that matters. Like, that’s why we got to be laser focused on understanding what that is, because that will make or break. And that’s what Powell, that’s what Lagarde, that’s what they’re focused on, that’s what they’re really thinking about. They don’t really care if used auto prices are going up or down. Like, they’re not buying used autos. And it’s not the thing that matters to people …

Adam:01:06:56Yeah. How important is the reflexive relationship between the Fed’s desire to raise risk premia, slow, or at least moderate economic growth in order to moderate wage pressures and pressures in certain parts of the economy, maybe the housing market, etc. play out against the animal spirits, right, in equities, in credit, and in the rates markets? Right? It seems like the risk takers are determined to play chicken with the Fed. Right? They’re — …

Bob:01:07:37I know. Amazing. Right?

Adam:01:07:38How do you think that dynamic plays out? How is the market perceiving the potential reflexivity there? You know, just generally, what do you think of that dynamic?

Bob:01:07:50Well, I think part of what we’re — I think we’re seeing we’re seeing a couple different things playing out, like, in this like, why are we getting to chicken? Right? I think part of what we’re seeing is frankly, there still is this hangover of liquidity in the market in one form or another. And it speaks to the fact that how many people, how many things have you read out there that is, like, the Fed is engaged in the greatest monetary tightening in the history of time, and the economy will go to shit as a result. And the answer is, like, well, first of all Paul Volker raised interest rates 1,200 basis points in 6 weeks. So, like that’s a tightening.

Mike:01:08:36You call this a tightening?

Bob:01:08:37Yeah, you call this a tightening? That guy knows how to tighten. But anyway but, like, this idea of, like, yes, money is tighter than it was before, but also there have been trillions of dollars of QE. There’s been zero interest rates for forever. There’s been low bond yields for forever. There’s the secularly low mortgage rates on average for households that have locked in. Like, there’s all of this hangover effect of liquidity that just, you know, and as a market participant, it’s like, you don’t exactly know exactly where it’s going to, like, pop out here or there. But, like, it is interesting to kind of see it. It’s kind of everywhere. Right? You know? It’s kind of constant there all the time. You know what I mean? Like, you kind of see it everywhere that you go. And so that’s part of what’s driving the dynamic. Does that make sense in terms — You know I think that that is — …

Mike:01:09:33Well, it does make sense, but I suppose that does wear off over time, right, as — …

Bob:01:09:38Right. Right. And it’s slowly but surely wearing off. I think that’s the, you know, that’s the issue is that it’s slowly but surely wearing off. But I think the big question that is on everyone’s mind, I mean, certainly that’s on my mind, is that where — like when does that roll off? Right? Like and I think it’s a bit ambiguous when that rolls off. And I think there’s a lot of people who will sit there and say, oh, well, it’s certain that it’ll roll off on this day or it’s dead this day. And part of the big picture uncertainty that exists out in the market right now is that there is uncertainty …

Adam:01:10:21You’re breaking up, Bob. Sorry. You’re breaking up.

Bob:01:10:23We don’t really know all… Oh. Sorry. We don’t really know what all those sensitivities are in the market. Right? That’s the thing that’s so challenging to understand is that there’s cross cutting forces, debt levels are higher. But at the same time, there’s been all this liquidity. And so when we talk about — there’s lots of people who will have very confident answers in exactly how this is going to play out in terms of the sensitivity of the economy to interest rate hikes or the sensitivity of the economy to other — to interest rate hikes or to QT and all that stuff. They’ll very confidently say it is like this or it is like that. And the real answer, and the amazing thing is people are very confident that it’s going to be a disaster and very confident that the economy can withstand it. Right? Like, as evidenced by the stock and bond market. Right? The bond market is very confident that there will be a recession, and the stock market is very confident we’ll be A okay. At least for a while. Right?

And the answer is you don’t really know. And that, and we don’t really know. And that is such an important thing when you’re navigating. Recognizing that you don’t know what the sensitivity of the economy is to monetary policy, is critical to being able to navigate through this market. Because then, like, this is not the time to be a hero. Like, be prepared, any of these things could play out. It’s very uncertain. And I have my view of where it’s tilted. I think it’s tilted towards the cycle moving slower and the Fed needing to do more. But I also wouldn’t go whole hog into saying that it’s impossible that the economy could start to deteriorate relatively rapidly. Like, you got to be prepared for both plausible outcomes.

Mike:01:12:11Well, and I think that’s where the macro then starts to move into that you got to manage money, and the recognition of these other positions that you have are diversifying, they’re considering the probable outcomes that could occur. And just because you’re saying, well, maybe it’s all Goldilocks. There’s a 30% probability that doesn’t mean you weigh your portfolio with a zero allocation to the assets that would do well in that. Right. If you’re well-calibrated, you would have a probabilistic weighting to some of these outcomes as you navigate and continue to course-correct going through the uncertainty.

Bob:01:12:52Right. Right. That’s exactly right. You want to be able — you want to be careful to not go all in on one of these outcomes. Like, that is the most prudent way to manage through this cycle, is not all in. And the other thing I would really emphasize is it’s not just not all in, but also, because you’re uncertain. Like, why are you taking full, like, whole hog leverage? Like, whole hog risk? Like, you don’t have to. Like, it’s as if people don’t recognize, like, hey, you just hold cash. Like, cash is fine. Like if it helps you sleep better at night, it’s fine. It’s fine to de-risk. It’s fine. You know, we look at what hedge funds are doing and they’re positioning and stuff like that. And hedge funds right now are running the lowest risk that they’ve run-in 25 years outside of crisis environments. And like, those are the most sophisticated — they could do whatever they want right now. And their answer is, it’s pretty uncertain. Let’s look run low risk. Let’s be reasonably balanced. Let’s try and tactically tilt in ways that kind of give us a bit of an advantage. But let’s not go whole hog, frankly, on anything. And that I think is actually reflective of a very prudent way of managing money in this particular environment.

Adam:01:14:21Yeah.

Mike:01:14:22Yeah. Endorse.

Replicating Hedge Funds

Adam:01:14:23Exactly. And is a good segue, Bob, to your core business at the moment, right, which is analyzing and replicating hedge funds. Right? So, maybe if you don’t mind, just give us a brief description of the objective of the fund you’ve launched, what is it, and maybe we can get into how you’re thinking about building it, what you’re trading inside of it to try and replicate the hedge fund. Let’s go into that.

Bob:01:14:52Yeah. Yeah. I mean, I think you know, what our thought — You know, what occurred to me and for those of you who are at sort of the top of the — haven’t necessarily listened since the top of the podcast is, you know, my basic thought was is there a way to kind of bring this idea of diversified low-cost indexing from beyond bonds and stocks and bring it to the world of two and 20. And I think the approach to that, you can’t just, like, invest in the funds themselves. Right? Like, the way you can, you know, Vanguard just sees S&P 500 and goes and buys it. It’s not that complicated. Right? And then they compete on price. If you tried to invest in the products themselves, the good ones wouldn’t take your money, most and plus you’d get charged two and 20 fees, which is kind of the problem, plus you’d have to pay yourself and then you have fees on top of fees and top of fees.

And so our basic idea was, well, what if what we could do is look over the shoulder of the managers, kind of understand what they’re doing, sort of see what they’re doing in close to real time and compare and take that understanding and package it up in an investor friendly form of the ETF. And that is kind of the core idea, which is creating a imperfect, but pretty good replication of what they’re doing using our years of — decades of experience and running hedge fund style money. Right? Kind of get a pretty good replication of what they’re doing. And then charge a lot lower fees to create fee alpha, which there’s no more durable alpha in the world than fee alpha. And then also put it in the ETF structure, which is a much more tax efficient structure for many investors. And so that kind of idea is like imperfect diversified, imperfect replication of two and 20 strategies at a quarter of the fees and half the taxes. Right? That’s kind of the idea. And so that’s what — that’s the essence of HFND, which is the first product, is to try and replicate the gross of fees returns of the hedge fund industry, but do it at that much more reasonable 95 basis point management fee rather than do two and 20 style management fee.

Adam:01:17:06Okay. And so, presumably, you don’t have any insight or at least you’re not using any direct information about hedge fund positioning from a source that actually aggregates what all the hedge funds are holding. Presumably, that’s not what you’re doing. So, you’re needing to sort of infer what they’re holding from daily returns of the different investment categories of the index or whatever. How do you think about that?

Bob:01:17:35Yeah. Yeah. So, there are some reporting, like, 13 … and stuff like that, which for those who are in the industry know that that’s incomplete and not very good and sometimes even manipulated. So, what we’re doing instead is we’re — what we look at is the returns. And the reason why we look at returns is returns are comprehensive and they’re the truth. You can’t lie about your returns or you go to jail. That’s the nice thing about returns. Right? And so embedded in returns is understanding of how managers are behaving, right, in a holistic way. And so what we do is we take the overall hedge fund industry. We break it down into the individual sub-strategies, like global macro, fixed income, arb, etc. Each one of those different sub-strategies has a different plausible set of exposures that they could have on at any point in time.

A global macro manager, a global macro set of managers is very different from equity long/short, which is very different from managed futures let’s say, if you put all those different things together. And so because we kind of know what exposures each one of those sub-strategies has, we can look at the returns and compare those returns to a portfolio of plausible exposures and essentially solve for what portfolio best describes the returns that we’re seeing in close to real time either daily or there’s good information relatively quickly into the subsequent month, and basically solve for what that portfolio is and then use that understanding and translate it into positions. And the critical thing to understand is you could sculpt any one month’s returns or set of days returns with any portfolio could give you some crazy, crazy outcome. Right? You know, you’d always find an optimization for something.

But I think the thing that it’s important to recognize is because positioning is path dependent, there’s actually a lot more information value in the pattern of returns than many people realize. Because what you could do is you can understand today’s returns in the context of what positions determine today’s returns, but that is in the context of the returns yesterday and the set of plausible exposures that determine the returns yesterday, and the day before, and the day before, and the day before. These ideas are continuous, these positioning is continuous. It’s not discontinuous. And so there’s — we use sophisticated machine learning techniques basically paired with our experience running money in these strategies, to basically curate or design a systematic process that allows us to infer what they’re doing, based upon that pattern of turns and the plausible exposures.

Adam:01:20:28Okay So, — …

Bob:01:20:29Take that for a Friday afternoon.

Adam:01:20:31Yeah.

Mike:01:20:32Beauty.

Adam:01:20:34Now we’re really down the fairway. Now we’re really where we wanted to get to.

Mike:01:20:39We’re off the tee.

Adam:01:20:41Yeah. So, what set of markets are you using to replicate? Like, what are you able to trade? Are you trading individual stocks? Are you trading ETFs, futures?

Bob:01:20:51Yeah. Yeah. So, this is a good example of let’s call it the art as well as the science. Right? Like, one of the key questions in this sort of approach is where is there that nice balance between signal and noise. Right? So, we could create single security optimizations or replications using single securities of single hedge fund performance. And I bet I could show you something that looks really good. Like, really, really good. And I’d say it was big data and I’d say it was great and we really understand this and it would be total garbage. Right? Because you’d have no confidence that you’d actually be inferring what they’re doing.

And so instead, what you know, this is a choice, a design element, is we basically said we think that the sort of wisdom of the crowd is at these sort of fund strategy levels. Like everyone might pick a specific security, but in general, you’d find global macro managers are long bonds or short bonds and kind of how that nets out is insightful. And so we think that they kind of look at it at the sub strategy level, like the all the equity, long/short or, all the global macro managers, and look at the exposures that they could have at sort of that, I don’t want to call it macro, but sort of that aggregated level, which is, like everyone has a view on. Is it Tesla or is it you know, this tech stock or this tech stack or this tech stock.

But when you aggregate it, are they basically long tech stocks or are they short the tech stocks. And that’s really the idea there in terms of curating it at that level. So, what we trade is we trade 50 of the biggest most liquid markets, the major stock-bond, equity indices, geographies, factors, sectors, things like that. We sort of trade all of those things. Our universe is a universe of 50 ETFs, to start off. That’s what we’re rating as long and short positions in low cost index ETFs. We may add futures or swaps over time depending on what makes sense and what’s the lowest cost and highest liquidity. And so that’s the basic idea is you sort of put that, you curated it kind of at that level. And that’s where you can be sort of confident that you’re actually getting signal instead of noise.

Adam:01:23:12Okay, great. So, and you’re able to go short as well. So, what’s your, I guess, is there a maximum level of total aggregate short that we can be in the fund?

Bob:01:23:20Yeah. I mean, there’s, I don’t know, like, I don’t know how ETF nerdy folks are here on this platform, but there’s some regulatory constraints that actually — a number of things that actually increased flexibility that came out during COVID, that allows you to run more sophisticated strategies as long as you implement, frankly, like, common sense, risk controls; things you should be doing anyway even if you weren’t in your niche yet. And so we run the strategy, like, well within those tolerances. We have constraints that mean that we’re never going to close to those tolerances structurally. And it’s fine. We get enough risk on using a very modest amount of leverage, like 50 long side and negative 30 or 40% short side, and that’s fine. We’re not — there’s no issue with that.

Adam:01:24:18And if you — well, yeah, because I was thinking if you’re including indices like equity long-short, they typically run at kind of a long bias anyway. Right? So…

Bob:01:24:27That’s right. I mean, that is true that those funds have — that have some bias to them, some beta in them. And I think the thing — if you look at the allocator community, the allocator community, part of what we’re doing is not replicating the individual sub strategies, but we put them together in HFND aligned with the AUM and the different sub strategies. And part of that is frankly a reflection of leveraging the allocator community’s understanding and weighing of where alpha exists and what is that good — we all know that there’s a balance between pure risk and alpha return and there’s always a balance between alpha and the goodness of alpha and consistency with beta, in order to create a more consistent return stream. And so that overall portfolio that, let’s call it the aggregate gross of fees returns of the hedge fund industry, that has a little bit of beta in it in aggregate, you know. Like a.. …

Adam:01:25:27Yeah. That beta has been increasing over time too. Right? I think, like, there was a time a while ago when the beta of the HFRI index was close to 0.9 or something on the S&P. Right? So, there’s definitely some beta embedded in the index.

Bob:01:25:46Yeah. It depends on which index you’re looking at and stuff like that. The aggregate index on a gross of fees basis, the beta is like 0.25.

Adam:01:25:53Oh, okay. Yeah. So, that’s lower than I would have expected. Yeah.

Bob:01:25:56Yeah. It’s not, you know, it’s that. You know, like —

Adam:01:26:01Yeah. Yeah. Yeah.

Bob:01:26:03Is that low? That’s what it is.

Adam:01:26:05That’s what it is. Exactly. Yeah. What about market neutral, obviously? You’re not able to then include market neutral in your basket of…

Bob:01:26:12Well, I think it’s important to recognize that because, what we’re doing is we’re putting all these strategies together. And so things like market neutral strategies, we can put together and we can pair with other strategies because we could do cross strategy netting. And so what we do is we essentially, a universe of securities that would be appropriate for hedge funds or long/short equity strategies that have beta in them, we can pair against neutral strategies and basically net those two sets of positions out and be able to run that portfolio in that way. And that really is one of the advantages.

I mean, structurally, like, one of the advantages of this approach of HFND is any one of these sort of sub-strategy approaches, like manage futures or global macro or equity long-short, any one of them is like pretty good. They’re not unbelievably good. You wouldn’t only hold those strategies in a portfolio. So, each one of them is kind of pretty good. And part of the idea is you put them all together and you get a much more consistent return stream over time, than betting on any one particular one at any point in time.

Adam:01:27:25Yeah. No, I mean, I love that idea. I was just thinking for market neutral that presumably they’re targeting a high level of idiosyncratic risk, right, at the stock level. But you can certainly tease out different beta tilt, different sector tilts — that kind of stuff, right?

Bob:01:27:40Right. Right. Across funds, it’s true. Any one individual manager will have individual stock selection. But, again, that’s part of the idea is to say, but then there’s sort of the wisdom of the crowd, which is all of them together, and do they like tech or do they not like, or do they like healthcare?

Adam:01:27:58Yeah. Yeah. There’s sector indices for — yeah, for sure would be…

Bob:01:28:01Right. And there’s real — I think there’s real alpha in their understanding at that level. Like, they’re at the industry wide or at the sector or the strategy level, that wisdom of the crowd as an example for — is a hedge fund managers, equity, long/short managers are like way smarter than mutual fund managers in aggregate. Like, an even median gross of fees hedge fund manager is like hundreds of basis points better than mutual fund manager. Right?

Adam:01:28:37Yeah. Yeah. Yeah. On an alpha basis, for sure.

Bob:01:28:40On an alpha basis, they’re just, like, way smarter. And that’s very consistent through time.

Adam:01:28:45You’re muted, Mike, or something.

Mike:01:28:47I would say, yeah, it’s structural as well. Right? The structure of a mutual fund, the objectives that you would have in there would dictate a limit of the alpha that you could provide. It would be very poignant to the area that your risk that you’re managing, the index that you’re going to be tracking, all of that stuff. So, I mean, they’re probably smarter, but there’s also a lot of structural issues that would impute a mutual fund manager from having the flexibility to compete with the hedge fund space. What’s your expected sort of long-term volatility on the portfolio?

Bob:01:29:22Yeah. Yeah. I mean, hedge fund, I think it’s — often people hear hedge funds and they’ll be like, oh, well, their returns are only so-so and, like, isn’t the S&P 500 better and stuff like that? And I think what that speaks to, is the fact that hedge funds have a fee problem. They actually don’t have a strategy problem. They have a fee problem. They charge people too many darn fees. Right? That’s the problem with hedge fund. And so hedge fund returns gross of fees are like a hundred basis points better than stocks over a long period of time. They have about half the volatility on a monthly basis and about a third of the drawdowns. Like, that’s what hedge — that’s what hedge fund returns look like, gross of fees And if you can get access to that or something even close to that, that’s a great strategy. You want that in your portfolio. Right? And that’s the basic idea

And the way that the hedge funds do that, I think, is also important, which is during more challenging market environments like what we’re seeing right now, to be blunt, they’re relatively conservative with the risk taking that they engage in, in order to preserve capital. And then there are times where their confidence is higher and they take on more risk and that’s when they deliver a pretty good return. And the thing that’s so interesting about it is if you can limit the drawdowns and deliver a pretty good return in other times, you actually end up getting a return stream that is a fantastic return stream. Right? Like, that’s you know, it’s the — it’s boring.

That’s the thing. Like, we’re trying to develop a product that will gently deliver equity-like returns that you don’t have to think too much about. You know, it’s kind of boring. No one’s going to call you and complain about it. Right? It’s not going to go way up and way down. Like a nice, boring, moderately, moving up into the right return stream that’s well diversified. That’s what we’re trying to do. That’s what we’re trying to deliver with HFFD. And frankly, that’s what hedge funds are pretty good at doing. You know, they’ve shown a very long track record of being able to do that.

Adam:01:31:38I think maybe also where you were going with that, Mike, is that one of the problems that hedge funds have is that they operate at too low vol. Right? So, your typical market neutral fund might operate at a six vol, your typical long/short equity fund might operate at a 10 or 12 vol. You’re just not able to generate the dollar alpha necessary to overcome your fees at that level of volatility, even if you’re running at a one or one and a half Sharpe. But if you’re running at a six vol, you’re generating 9% pre-fees, you know, your performance fee take is not that high, but it’s high as a percentage of the total return. Right? So…

Bob:01:32:21And even there, right, what is it? 3.4%. Right? Like…

Adam:01:32:27Sure. Sure. But, I mean, if you’re delivering 6% of alpha, then that 3.4% is less of an issue than if you’re only delivering 3.4% of alpha, then you’re consuming all of the alpha in fees. Right? So —

Bob:01:32:42And that literally is — that is the problem is that the hedge fund managers consume all their alpha in fees. And so if you can cut fees, like, instead of hedge fund managers taking all the alpha, and they don’t actually consume all of it. They consume, like 60% of it or 70% of it for themselves, and give clients just enough to make it worth their while, but not too much. And imagine the idea of saying, hey, look, instead of the split being 70/30 or 80/20 to the manager, what if what we did is we flipped it and we made it 20% to the manager and 80% to the investor? And then the other thing from a US perspective, US taxable investor perspective is like the hedge fund managers put these things for taxable investors, put these things in these structures, which suck for the investor, right?

Like, you put it in an LP structure, it’s taxed at ordinary income, you get distributions each year. You actually have to pay the taxes even if you don’t sell out of your position. Like, you have a bunch of paperwork, you have to file extra things, they send them the paperwork to you late. Like, I know these sound like very practical issues that you have to face. But if you’re an RIA in, you know, the middle of the country and you have moderately sophisticated investors and you’re looking at that thing and you’re saying, God, that looks like a pain. I mean, combined with the fact that you can’t get into the good ones. Right? They won’t even take your money. Like, you look at that story and you say, I’m essentially locked out of getting anything close to the quality of returns that an institutional investor can get into it. And that’s really what we’re trying to do with HFND, which is look, this is not a perfect replication.

It’s not — it is a pretty good replication. It’s pretty darn good replication. But it has a lot of other advantages, which is it’s much lower fee. It’s much more efficient tax wise. You don’t have to fill out any paperwork. You could buy it on your platform tomorrow. You know, you just click the button. Boom. You buy it. Right? You buy it across client accounts without paperwork. And just to, like mostly get — let advisors get access to something that’s pretty good in a way that currently they’re totally locked out because of the practical realities of …

Adam:01:35:07Right.

Mike:01:35:07And so how do you, when you’re chatting with RIAs, the question that we get all the time is how much, how much can I get in? How much should I have in my portfolio? How do you think through that as you’re talking with the growing client base that you have? And part of my question was if it is lower vol, I mean, it’s this great sort of core thing that’s going slowly from the lower left to the upper right. But it’s not really a crisis alpha thing or is it just to stabilize the rest of the strategic portfolio, if you will. And then how do — you then run into some compliance departments, I suppose too, where they’re looking at these things. Are they core? Are they not core? How have you found navigating all of that?

Bob:01:35:52Yeah. I mean, the thing that I found at least so far is that most RIAs I talked to are, first of all, they’re quite sophisticated. Like they’re sophisticated as any institutional investor. If anything, they’re actually, like, more sophisticated and entrepreneurial than traditional institutional investors. As part of that sophistication, what they recognize is that alternatives have a good — a very, very useful place in their portfolio. And they’re already actively looking at something like 20% of their portfolio in alternative assets in one form or another, in one shape or another. And that mostly what they’re doing is they are sitting there going, God, it sucks to have to go through this.

You know, like — I talked to a guy who is running a $5 million midtown Manhattan, a nicer office than I’ve ever sat in my life. And he sits there and he goes, like, I want allocation to alternatives. I know my clients want it. They’re sophisticated enough to understand it, it improves the overall portfolio outcomes on a strategic basis. But I’ve got 200 clients and I can’t get them to fill out the darn paperwork. You know? And that is just an — like, it’s just impossible to get busy people filling out the paperwork and dealing with all of that. And that — I empathize, like, I know what it takes to run a business and all of the things that it takes that are not the core of the business. I’m sure you all appreciate that as well.

And so those sorts of things are the things that you need to, like, cut out of your life in order to make it more efficient and spend times on the good stuff. And so typically, they’re already allocated in that 10 to 20% range in alternatives. And so we’re often — the conversation starts with how are you a good alternative to the things that I’m already looking at in that bucket, in that alternatives bucket. And that ends up being a pretty productive conversation. You know, because what we’re trying to do is hit the main pain points they have. You know, that’s — they obviously have pain points and we’re trying to create a product that’s helping address those pain points.

And I think also I’d say, most big strategic asset allocators, like, that’s kind of what they allocate to all alternatives. Right? All alternatives mean liquid markets, hedge fund style strategies, 10 or 20%. Like, it’s not a science, but 10 or 20% is about that balance of, you have some confidence that it will be better than your traditional liquid markets portfolio. But you don’t — you’re not certain, so you don’t want to go all in on — you want to bet the farm on alpha. You want to be care– you know, you want to put some of the farm in alpha. Right? Because it might — they might not have edge, they might not work in beta as … ratio, but more liable, you could be more confident.

Adam:01:38:47Yeah, that makes sense. Well, I could certainly poke and prod at some of the technical details of the model. Are you the quant that built it or you’ve got a team that kind of helped out or what’s your…

Bob:01:38:59Yeah. Yeah. It is the two of us. My partner, Bruce McNevin was at a hedge fund for many, many years, 30 years as a data scientist before data science existed as a thing, and professor of econometrics at NYU. And so he is a core part of building the model. I also have built these strategic models for a long time. And so that’s a big part of, you know, the two of us together are the hands on keys. You know? Some people ask, like, how could you have built this model. The answer is, well, we’ve done it for 20 years, and so we’re building the model. Like, what do you want me to tell you?

Adam:01:39:49 Awesome. Awesome. Well, Mike, should we let him — let Bob go to his Friday evening? Or — …

Mike:01:39:54Yeah. I think we covered — …

Bob:01:39:56Yes. This has been super fun.

Mike:01:39:58Yeah. We’ve covered a lot of stuff. We did the macro. We did the history of Bob. And probably Bob, why don’t you let everybody know where Bob E Unlimited can be found and where people can find your products, your websites, your twitters, etc., etc., so that …

Bob:01:40:14Exactly. Exactly. Well, you can find me @BobEUnlimited on Twitter, and I’m happy to — I’m very often on Twitter and so very active. So, check me out there. Or you could check out what we’re doing with HFND at unlimitedfunds.com is probably the best place to check it out. So, thank you so much for having me on. I really appreciate it.

Mike:01:40:34Thanks for joining us.

Adam:01:40:36Amazing first conversation of the year for me. I hope they all live up to this standard. Really appreciate your, like, you spend a lot of time with us, so I really appreciate your generosity as well.

Bob:01:40:46Oh, no. Thank you so much for having me. Really appreciate it.

Adam:01:40:49Love it. All right. Well, we’ll find you online and have you on sometime later in the year. All the best of luck.

Bob:01:40:55Great. Talk to you guys later.

Adam:01:40:57Thanks. Have a great weekend.