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

To help us make sense of this market we invited Chris Schindler back to discuss:

  • Why the next 10 years are likely to be very challenging and different from the past 10 years
  • Why investors should set very low return expectations for virtually every major asset-class
  • The power of recency bias and lottery-ticket (wishful) thinking
  • The role of commodities and how to use them effectively in a portfolio
  • Portfolio construction as a source of both risk and possible alpha
  • The dangers of mispricing risk of private investments and assumed negative correlations

We also discussed how Risk Parity is a) disastrously mis-specified by most investors and b) held to a much higher standard than almost any other investment approach, even though it is still the most coherent starting point for a global diversified portfolio.

Thank you for watching and participating with your questions. See you next week.

Check out Chris Schindler’s previous appearance at Gestalt University Podcast:

Chris Schindler: The Alternative to Alternative Risk Premia

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Chris Schindler, CFA

Chris Schindler was responsible for a variety of roles during his 18 years at Ontario Teachers’ Pension Plan. He started in the Research and Economics team where he worked on the Asset Liability Model before transitioning to the asset management side of the firm as a founding member of the newly formed Tactical Asset Allocation group.

Over the next 12 years, he was responsible for researching and managing a wide variety of systematic programs as head of the Global Systematic Investing group. Notable programs included an internal CTA, risk parity portfolio, alternative risk premium program, quantitative cash equities and the enhanced beta strategy, all of which were launched between 2005 and 2007, as well as a large number of pure alpha strategies (models not highly correlated to traditional alternative risk premiums). He and his team were also responsible for evaluating and hiring external managers in the systematic space.

In 2016 Chris joined the newly formed Portfolio Construction Group (PCG) as head of Asset Allocation and Portfolio Management. PCG was responsible for making recommendations to the CIO on Total Fund asset allocation decisions, including risk factor balance, asset class composition and weightings, FX hedging policy, tail mitigation strategies and constrained resource allocation. Chris is in the process of setting up a relative value systematic futures hedge fund with a planned launch date of Q1 2020.

Transcript

Adam:                         00:00:03          Welcome. We missed last week but we are back and badder than ever this week with ReSolve’s Riffs. We’ve got Chris Schindler, who I’m pretty sure was our most popular guest in terms of podcast engagement over the last six months or so. And, Chris, I think we spent about an hour and a half, maybe a little longer than that with you in our initial podcast, Rodrigo and I and then there’s like another hour afterwards of kind of post mortem on that conversation and then lots of grist to the mill since then. So we’re really tickled to have you back on. For those who have been hiding under a rock and don’t know Chris, maybe Chris, give a brief overview of your professional journey.

Backgrounder – Chris Schindler

Chris:                           00:00:46          Sure. So I spent 18 years, a bit over 18 years at Ontario Teachers where I started in the asset liability modelling group, joined a nascent little team called TAA, which turned into Tactical Asset Allocation which turned into the Capital Markets Group. While I was there, I founded the macro systematic team and ran that through to 2016. That was sort of a risk parity, CTA global macro risk factor, and alternative risk premium equity quant volatility kind of stuff. So like anything, it was a very broad mandate, anything liquid and systematic. And we also had, it was pretty cool sequence. I also invested in managers through a good chunk of that starting in late 2008. So that was a really cool seat. In 2016, Teachers created a new portfolio under a new department called portfolio construction group, which sort of took over ownership of total fund oversight or at least kind of shared it with the board whereas before the board completely owned it and said, we work closely with the new CIO, a total fund issues which we’re going to talk a little bit about today, I guess.

And then in 2018, I resigned from Teachers and I took some time off and I spent the last little bit working on putting together my little personal project which is trying to start a business and a hedge fund.

Adam:                         00:02:19          Right, which is where you are today. Right? So you’ve spent the last few months, you built this suite of strategies over the last few years, you’ve been refining that and building structures and getting seed assets and all that kind of stuff for the last little while and launching your own fund. That’s great. So we named this podcast, what was it?

Mike:                           00:02:48          Navigating An Impossible Market.

Richard:                      00:02:49          Navigating an impossible market. Exactly. For sure.

Mike:                           00:02:57          Okay. We all, you got to do what you got to do.

Adam:                         00:03:01          But we were briefing before and Mike and I had like an hour long conversation about this exact topic earlier today, we spent a lot of time, probably half the time over the last several Riffs addressing some of the reasons why this market is really hard in terms of trying to achieve required returns. And so, we were briefing before this about some of the ideas that you’ve been bringing to pension boards and others who are interested in how to think about this market and how to, like let’s go back to basics. How can we think about optimal portfolio construction and capital market expectations and filling some of the holes. I don’t know, do you want to try and take us through that narrative arc to get us going?

Optimizing Portfolio Construction

Chris:                           00:03:46          Sure. So I wasn’t expecting to come in and monologue but-

Adam:                         00:03:51          Don’t worry, we won’t interrupt you.

Adam:                         00:03:53          Okay. There you go. So I had this presentation-

Rodrigo:                      00:03:55          Cheers for the end of portfolio managers on this episode.

Adam:                           00:04:04         That’s sweet. I’m drinking my wine in a party glass.

Mike:                           00:04:08          Oh, I love the wine. The Italian wine glass got there. That’s fantastic.

Chris:                           00:04:14          I saw you guys were all wearing blue plus I thought I would spice it up-

Mike:                           00:04:17          Shake it up.

Chris:                           00:04:18          Here we go. So cheers guys. Great to do this.

Mike:                                 00:04:20      Cheers Chris. I love, is that salmon? Is that the colour you got on today? Is it salmon?

Chris                                   00:04:27     Yeah, it’s like it.

Mike:                           00:04:28          I think it’s a nice pink. Salmon, just an upscale pink. Totally.

Rodrigo:                                  00:04:33          I literally almost wore the exact same shirt and the exact same brand.

Mike:                           00:04:37          There you go.

Adam:                           00:04:42         Okay, it looks better on Chris man.

Chris:                           00:04:45          Okay.

Adam:                         00:04:46          We have to do that every time.

Chris:                                 00:04:49        So literally as we were talking about today. And you guys have already taken some really juicy topics like leverage and tail mitigation and it’s like I can either throw my two cents it on those pieces but I did give this presentation a year ago, so the data is a year old, but it’s okay. It’s 100 years of data. So not much has changed. And I thought there’s some concepts in here, which I think highlight the difficulty. And that’s it like this is a challenge, like this is not going to be an easy, I don’t think it’s going to be an easy next 10 years for a CIO. And I say that it’s not impossible. It’s not the impossible markets. But it’s not going to be as easy as the last 10 or 15 years have been. And I don’t think anyone looks back at the last 15 years and man, that was easy, but I think when we look at this, you’ll say it was easier than is going to be. And so there’s a couple things about that. And the first piece I think we got to say is like look from today’s starting point, and we’ll talk a little bit why we are where we are today starting point, but I’m going to argue expected returns are quite low from today’s starting point on almost every major asset class.

And so that makes it really hard from a portfolio construction perspective when you see equities here. Do you like bonds here? Do you like infrastructure? Do you like real estate? Do you like private equity? What do you like here? And it’s a small set. And then you say what else strategies? And you said, well, like all those quivers in our like all those arrows in our quiver over the last 10 to 15 years are also starting to look pretty attacked because man, there’s so much money all chasing and doing the same things. And I’d say, here’s the problem with investing, if you do the same thing as everyone else, at best you can expect median returns. So you can only expect to do as well as everyone else. If you do the same thing as everyone else and you get there late, you should expect below average returns. The only way to outperform the market is to get there early or to do different things and-

Mike:                           00:06:42         But not too early. You can’t do that too early.

Chris:                           00:06:45          Not too early and not randomly different. Nine out of 10 different things are going to lose money like at the end 50% were going to. But at the end of the day that’s the challenge. And this is the classic. What got you here isn’t going to get you there because the last 10 or 15 years will not repeat. And the games that we learned and the games that worked over the last 10 or 15 years will not be as good over the next 10 to 15 years. What do you do? It’s not impossible, it’s just harder. And that’s why I think that the proper foundation starting point is paramount. And then building up on it is also super important. And, it’s a different challenge for a trillion dollar pension plan, or half trillion dollar than it is for a $20 billion pension plan, or it is for a billion dollar family office, and it is for someone who’s just trying to invest a million dollars and obviously, there’s different challenges across the board. And I’m going to say there’s a sweet spot in the middle there, where the opportunity set doesn’t look all that black. And you certainly have a competitive advantage probably for the first time in your life as a relatively smaller investor, where you can still do a lot of this stuff where the big guys are, as they are forced to fall back to the more beta investments. It’s going to be a little bit more difficult for them.

Adam:                         00:07:53          Yeah. All right. Do you need to share your screen?

Chris:                           00:08:03          So, and by the way, this presentation is a year old. So it doesn’t include any of the craziness from this year. But I think the story still holds up. And the point is, on one hand, you think of the CIO’s challenge. I got to make 5% real over the long term, it’s four and a half percent real 6% normally. Everyone’s got their certain numbers, but they’re roughly speaking, I got to make 5% real. And I got to do that in perpetuity. And that doesn’t sound so hard, does it? I don’t know, it sounds maybe not so bad. And this is my definition of risk. This presentation, by the way, has no equations, and it is the least technical presentation I’ve ever given in my life. And I’m going to say and I’m going to define risk, because I don’t want to blow up along the way. And what is a blow up? Blow up is different for everyone, a blow up is I didn’t meet my funding obligations, it means I couldn’t pay my cash flows. It might mean for me, I got fired. Everyone’s going to have a different definition of what a blow up means but as a CIO or as a CEO, however you define risk, I got to make that 5% real and I don’t want to blow up. And as I said, this was a year ago. That’s certainly true today as well. There’s nothing really obviously cheap and easy right now. There’s probably pockets of relative valuation, but I don’t think anyone looks and says, relative to 10 years ago, that’s a steal.

                                                            And I’m just going to argue that the typical and I know you guys spend a lot of time on risk parity on the 60-40 portfolio, the typical 60-40 equity centric portfolio is way riskier than people think it is in the long run. It is not nearly as safe as people think it is. And that’s where I think this is probably less intuitive. And I’m going to do a massive cheat here. And I’m going to say 60-40, let’s just call it equities for a second, because we forget the amount of bonds, the types of bonds and we get that discussion for a second say and a 60-40 portfolio is basically, it’s like instead of putting all your money in equities, you just put like half your money in equities. And so, it’s just think of a de-levered equity portfolio. In fact, I just said let’s just take an equity portfolio, scale it to about 10% volatility which is about the equity piece of the 60-40 and just say that’s what a 60-40 portfolio. So I’m not going to include bonds in any part of this discussion for a second here. And let’s just look when you say most investors, it’s not just pension plans, most retail, most high net worth, most people have had their wealth tied up in equities. And they will do well when equities do well, and they do badly when equities do badly, but they go that’s great because don’t equities pay you 10% a year or 12% a year, what’s your expectation? And they certainly have been paying a ton recently. I think part of that is because this is US equities. Starting with $1 in 1926 and going through to today and it’s like, okay, so I guess the 2000 to 2010 looks a little ferocious, but just keep buying, keep going. It always works out and man look at that run recently. And I think especially into 2000 did it ever look amazing. And the problem with this is this is the exact same data, the exact same chart. It’s just an arithmetic instead of  geometric. I think this is log form but basically the point in this, this is actually the equity process, a 30% poll in 1929 looks the same as a 30% poll in 1975, looks the same as a 30% poll in 2008. These are real returns, just scaled to 10% volatility. And that’s what equities look like.

And okay, I lied because there’s one equation in this whole presentation, and you just got to know the Sharpe ratio is, and it’s just to say, if we’re running around 10% risk, roughly how much returns you make in this case, if the Sharpe ratio is around 45? That means you make 5% real. Well, amazing. Isn’t that all we have to do as a CIO or CEO is make 5% real? Why don’t I just do a 10% D-levered equity portfolio? Super easy. And the answer is and I’m just going to leave full caveat here. This is statistically bunk. I completely made up this statistic. But if you look at the top, all I did was I took that arithmetic growth curve and I just filled in the high watermarks with like red ink says like this giant red water. And that red water is the pain of equities. Because you think there’s two pain points when you own something. The first is like it drops a lot. So you can see each of those things from, if you put all your money in 1929 well, in 1931, you’ve lost 35% of your money, at 10% volatility. But you’ve also pain as either the amount of the loss or the length of the loss. Because wherever you’re trying to make 5% real, if 15 years later you’re flat, well, you’re so far behind what your actuarial projections are, that you’ve blown up. And so the problem with that is you can see when you glance at this and US equities over the last hundred years, is they make way more money than you need them to, for big pockets of time, and they do way worse than you can afford for them to do for also large pockets of time. So equities alone and the equity risk factor just doesn’t survive that second piece of the equation. I want to make 5% real for the long term but I don’t want to blow up because they will blow you up. They have like absolutely demonstrated like blowing people up over and over and over again and we’re very spoiled by the last 10 years and arguably 20 years. So-

Adam:                         00:13:13          How can you leave a guy hanging?

Mike:                           00:13:12          Well, while Chris is going back online I just want to take a moment to point out that everything on here is for entertainment purposes only, and should not be used for your own investment advice. So just like Chris said, most of it’s just made up. So I mean, that’s-

Adam:                         00:13:31          And it will be used against you in a court of law.

Rodrigo:                      00:13:34          I like the angle he’s getting after. Every one of our presentations has that fact. That 60-40 portfolio is actually 90% equities, 10% bonds, but just to say, okay, given that it’s 90% equities, let’s just call it equities. And as we speak with pension plans, I mean, the 60-40 is just such a powerful thing. I want to believe that I that I use that as a trope, that I use it as like something that used to happen 10 years ago, and it worked so well for communicating with others that I keep on using it. But time and time again, when I sit down with institutions, it is the same thing. And the only thing that may have changed is that they’ve gotten more private equity on their books.

Adam:                         00:14:13         So that’s more equity centric.

Rodrigo:                      00:14:15          More equity. So it’s no longer nine-

Mike:                           00:14:16          And decrease their liquidity. I think another thing that’s important that I don’t know if Chris was going to allude to this at some point, but he’s talking about a portfolio that was funded with one cash flow at one point. And so what you’ll have is an endowment, the reason you want five real is because most endowments pay about 5% and you’d like to maintain the purchasing power of the endowed asset. So that that endowed asset provides 5% in perpetuity, or maybe can grow a little bit, sometimes it’s four or 5%. So, once you introduce the, the income aspect whether what if it is an endowment in fact, and there is just distributions happening? Those red areas become progressively-

Adam:                         00:15:03          Catastrophic.

Mike:                           00:15:04          Incredibly catastrophic. So how does a Yale or how does an endowment from a hospital or for some sort of cancer funding or whatever, how would they? So you’re going to fund, you’re going to have the ability to fund and grow for a 15 or 20 year period and then you’re going to have an a period where you can’t fund the university, you can’t pay for the tuitions, there’s just a decreased amount of potential opportunity to fund and so you’re just going to get fired in those situations or someone else is going to come in and do something else. Did we reach out to Chris at all on a cell phone and all this?

Rodrigo:                      00:15:43          Just give me a moment I’ll try it now.

Adam:                         00:15:46          I think the point though is that what most people don’t realize because we are so myopically, and this is both cognitive and emotional salience. We’re so myopically focused on recent experience. The recent experience has been if you invested in equities, especially US equities, essentially you won the lottery. I mean, this has been one of the best, if not the best, notwithstanding whatever the reason, a couple months. But prior to that the best 10 year period for US equities in history and US equities are the best performing global market over the last 120 years. So even the best period for the best market in history over the last 10 years, this is what sets investor expectations, and it’s what makes it so difficult to stress the importance of diversification. This whole feast or famine. Literally US equity investors won the lottery in the last 10 years. There’s a lottery ticket, they won the lottery. If you go back to the 1966, you’ve got it back to 2000. There’s lots of examples where 10 years, even 20 years, you get flat real returns in equities in general but especially US equities because there are macroeconomic regimes where foreign equities completely dominate US equities. Obviously, the knots were a really good example of that. We’re emerging market share if he were so good.

Rodrigo:                      00:17:03          I just kind of continue on the same point that Chris was on a couple of    slides that I just recently created. Let me know when I’m sharing on it. And the truth is that- Are you seeing it?

Mike:                           00:17:22          Yeah.

Adam:                         00:17:24          Yeah.

Rodrigo:                      00:17:24          What you have now is just, we kind of all know this but not only is it difficult when you have a portfolio, it’s 90% equities, but it’s more difficult when you have 90% equities and you’re in North American markets that are the most expensive in the world. And when you’re just looking at the 60-40 portfolio, ie: the 90-10 portfolio, these are the real returns from 1900 to today. Or well, maybe not today, but 20 years of not making money, 20 years, 14 years and so on. So, it is a problem to just depend on that one premium that provided that return when I show here is this is the-

Adam:                         00:18:09          Hold on. Now you’re stealing Chris’s thunder

Chris:                           00:18:16          When did you lose me?

Mike:                           00:18:17          I was tired.

Rodrigo:                      00:18:18          We lost you when you were about to give us the answer to all of our problems.

Adam:                         00:18:22          We lost you out after-

Chris:                           00:18:28          Well, we lost the answer. All your problems are solved.

Adam:                         00:18:35          I mean literally you were just talking about-

Chris:                           00:18:38          I will end this monologue in like two minutes.

Mike:                           00:18:41          You we were talking about the deep reds. That’s where you were at. The pain check.

Chris:                           00:18:48          Do you see my slide? I guess you don’t see it.

Mike:                           00:18:51         Ani can you share Chris’s screen?

Adam:                         00:18:53          Listen Chris, your monologue was interrupted for five minutes, man. So it’s no longer a monologue. You got lots of time. I don’t get through this. It’s so good. I want to make sure we get it at all. No, now you’ve jumped so far ahead. We’ve got the like, no we were at the draw down chart for equities.

Mike:                           00:19:10          For the pain train, the red pools.

Chris:                           00:19:16          Okay. Let me rewind. I really was talking to myself there for a while. We’re like before this?

Mike:                           00:19:21          Now get it back.

Rodrigo:                      00:19:23          There we go.

Richard:                      00:19:24          That’s one. Yeah.

Chris:                           00:19:25          Okay. So, let me quickly pop through this piece. In the top right in the box, there’s about four statistics. One is the Sharpe ratio. That’s just like saying it makes 4.7% yield per year. Not bad, almost what we need, but the next piece is like as important the 9.6%. There’s a one in 10 chance that if you put money in the S&P today, that five years from now, you’ll be below where you started today. And I don’t think people appreciate at any starting point.

Adam:                         00:19:51          Unconditional, not accounting for valuations – any starting point.

Chris:                           00:19:54          Yeah, and certainly not accounting for valuations. That is just on average through time. There is one 17 year period where you don’t get your money back in real terms, and then this number, this 97 is just my made up statistic, literally is the area of that pain. And that’s just saying length is a problem, depth is a problem. I guess like length and depth together, volume is a problem. So area is a problem. So you look at that and go that’s equities. And I think it’s fair to say that it makes the returns you need almost, it will blow you up along the way. So equities alone cannot in a 60-40 portfolio alone, cannot solve your…and I don’t want to blow up along the way. Problem as the CIO and CEO. And so I guess there’s a lot of hope here, I mean in this world I got it, just hope it doesn’t happen to me in my lifetime. And I think that’s there’s that piece. Okay, so here are bonds, I created a roll bond process on US 10 years. It also scaled to 10% vol, it’s not really, let’s not focus too much on exactly how it’s built but just to say like equities bonds also seem to be make more money than you need for you need for extended periods, way less than you need for extended periods. They also have their own pain points. Interestingly, if you look at the top right, actually a bit better than equities, except has a slightly lower Sharpe ratio, but has a better set of other definitions of risk than equities, which is interesting because Sharpe ratios is a definition, like volatility is a definition of risk, but not the only definition obviously.

                                                            Anyway, so this is now the classic stock bond risk parity story. And so you take your equity risk, and you take your fixed income and you put those guys together, maybe you can average out some of that growth risk. That’s a major source of risk in equities. And so we build that balanced portfolio of stocks and bonds and you get that stock bond risk parity, which is the risk parity that the vast majority of investors in pension plans and investors are sort of attacking and they’re probably not going fully here, but then at least they’re moving towards this.

Adam:                         00:21:49          So I just want to make sure everybody understands what you’re talking about here. So you’re talking about equal risk to stocks and bonds, not 50-50 in stocks, bonds, but equal risks of stocks and bonds.

Chris:                           00:21:58          Which is roughly 80% bonds 20% equities but then leveled up.

Adam:                         00:22:01          Exactly.

Chris:                           00:22:02          So you can probably call it 40% bonds and you know, sorry, 160% bond. And so there’s leverage and then we can get into that discussion.

Mike:                           00:22:09          Is it 90-60?

Chris:                           00:22:12          Yeah, maybe.

Mike:                           00:22:15          Ish ish.

Chris:                           00:22:16          So here’s the thing. If some, like incredibly impressive individual in 1929 went, you know what, I’m going to build a stockpile and repair the process and invest in it. I mean, well, they’d be a genius, they would have absolutely crushed it, the Great Depression becomes a bit of a nothing but it recovers almost immediately and just goes off to the races. If you compare it to the equity curve, it’s just an absolute no brainer. It absolutely kills it. And probably you could totally hit someone in 1965. We’ve done this for 30 years, patting ourselves on the shoulder and we’re like, who is better than me? I solved there, I broke the markets. And then this happens. You go, Oh my God. And you heard there is clearly a major problem with stocks on risk parity. There’s a huge hole in it. Because like that’s even worse than just equities. And so if you look at just like the once again, the statistics and you go, it’s actually got a higher Sharpe ratio now. So apparently this is less risky than either stocks or equities or has more return for the same amount of risk. But the area under the curve measure says differently because there’s a massive pain point. And let’s just be clear, and no one, if anyone’s portfolio today of 60-40 goes through that again, none of us are in our jobs and our pensions are not met. And we call this a failure of complete never proportions, like our actuarial assumptions cannot survive five years of this. So just to say there’s a hole in risk parity, and all the people who are just running straight risk parity are bearing that risk.

Adam:                         00:23:43          Hold on, there’s a hole in stock bond risk parity.

Commodity Protection

Chris:                           00:23:46          There’s a hole in stock bond risk parity. And this is now, and this is I think a pretty well-known framework, but the issue is, yes, stocks and bonds, balance on growth risk, but it turns out they’re both exposed to exflation risk. And so if you look at that you say your risk parity, your stock bond risk parity process, it’s got a hole in it, and like, you really you need another asset, or another asset class that somehow can handle the inflation piece without adding too much growth risk. And you say, maybe we can try and solve this a little bit. And thank goodness, mention that I’m not going to call it as an asset class, or at least they’re not necessarily a positive risk premium, but we can say there’s at least something we can invest in, that sits on the other side of this equation. And it allows us to somewhat build a portfolio that’s now kind of ish, like diversified or immunized are protected from growth risk, and the same time protected for inflation risk. So this stock bond commodity risk parity process, if you want to see how it looks like, that looks pretty good.

                                                            Now we call this a factor balanced attack because we’ve certainly got the two major factors and so we’re kind of moving out of the asset class space and talking about risk premiums and asset classes and just for a second, just think this thing is roughly balanced between growth and inflation. And it’s a significantly stronger process. Now we only have to go into 1945, that’s when we have the basic quality data. But this is just long Ico and a package of commodities. And equal risk for stocks and bonds. And it’s a significantly better process. And if you look through the statistics of it, it’s got a 20% higher Sharpe ratio, either stocks or bonds, and it’s about half that area under the curve. So it’s a significantly better process.

Adam:                         00:25:29          So there’s some question. No, you keep going.

Chris:                           00:25:32          No. Ask the question, please.

Adam:                         00:25:34          No, I mean, I think there’s a lot of people who are scratching their heads and wondering whether commodities represent a risk premium. And in our discussion before we went live, we had some discussion around that. And I just think it’s worth sort of, I’ve wondered this too, and to what extent can we rely on commodities, diversified commodities risk premium, and I think that if you’re rebalancing between commodities, or maybe some sort of positive direction of rebalancing, just like the mathematics of rebalancing stochastic portfolio theory. But even then I also wonder whether or not the idea of a risk premium is even the right way to think about it. And really, it’s you’re buying insurance against certain conditional payoffs. So in an inflationary regime, on the condition of an inflationary regime, you’re buying an insurance policy that will produce a massive payoff in that situation. If bonds you’re buying an asset, or whatever an insurance policy, that will have a massive payoff in a disinflationary regime. Stocks, you’re buying an asset with a massive payoff in a growth regime. So if you don’t frame it as a risk premium, but more like I’m trying to hedge against all these different risks and I’m buying payoffs with structurally different payoff profiles, that may be a better or another way of thinking about it.

Chris:                           00:26:56          100%. So I absolutely agree with what you’re saying from a factor perspective, we’re not actually talking was printed off, we’re just saying we want to say like, and the interesting thing about commodities, even the definition I use here, I’m going to argue they don’t have much of a risk premium. But they are a positive paying hedge. And you’d be crazy not to take advantage of that. Now, the other thing is, if you actually look at it and say everyone starts with risk parity going stock bond risk parity, because we’re trying to cover growth risk, I hate bonds, because of inflation risk. A very interesting and equally compelling package is a commodity bond risk parity process and turns out you and I can get them. Can get the risk premium of bonds without the deflation risk.

And, of course, the two of them together those two packages into this three package, these three asset two factor package. Looks pretty good. It is a significantly better starting point. It’s not perfect. It’s not ideal. And just a run into it. This is the commodity process that I showed you. It does exactly what you needed. From 1962 to 1978 and in that inflation shock, it did really, really well. But from 1980 to today, the real return in commodities is very, very close to zero. And the question is why? Because weren’t we all told that there was an equity like risk premium in commodities doing really well, the commodities pay money and the answer is not really. Not really. There are risk premiums in commodities for sure. But they’re not the same as stocks and bonds where the risk premiums just buy some stocks and the risk premium is still a long side and buy some bonds and the risk premium it’s the long side. In finding commodities sometimes the risk premium is the long side, sometimes to the short side and is conditional and constantly changing.

Adam:                         00:28:30          And that is going to come back. Because I think again, we’ve experienced this long disinflationary growth process. So if we had experienced a stagflation reprocessing, extended stagflationary process, then obviously commodities or not, obviously, but I would submit that commodities would represent, I mean, we would look back and say, Wow, commodities have a really strong premium.

Chris:                           00:28:55          Possibly, it just depends on the source of inflation. So and you can define inflation in lots of different ways, and people do and then you get debates and like what is the definition of inflation? Is it an increase in monetary supply? Is it an increase in the price level? Is it the increase in the price of commodities? And there’s at least Bridgewater has four definitions of inflation risk. I would say, if it’s a commodity driven inflation risk, yes, then commodities should cover it. It may not cover a monetary edge like inflation risk and-

Adam:                         00:29:26          Certain commodities, they help, right?

Chris:                           00:29:29          May not. But just to say, but that also speaks less to a risk premium or more to the concept of a changing discount rate value to a certain extent. The question is, do they do they pay if you just sat long this thing? Would it pay you money over time? It is a different statement than, could it be worth more or less through time, depending on different outcomes?

Adam:                         00:29:48          Okay, fair enough.

Chris:                           00:29:50          And I would say, if you look at commodities there’s a couple of things to pay attention to. They do cover that inflation or they did cover that one type of inflation risk that we certainly cared about in the 70s and late 60s, and 1980 but they have pretty bad drawdown characteristics. I mean, this is it goes off the bottom of my chart here. And sometimes they lose money at the same time as equities as everyone found out in 2008. So you go, is it a perfect diversifier? No. But is it a really good playground for a quant? And the answer is absolutely, because first of all commodities as a thing is a complete misnomer. It’s like saying stocks and bonds, like commodities is at least four or five pretty independent sectors, almost asset classes that almost have nothing to do with each other. So there’s more in here than just one thing and you say like, and from that there’s also a really different characteristics about like where are the risk premium is at different points in time. And so this is-

Mike:                           00:30:43          Chris, before we move off, we have a question that I think it’s related. So Dan P. asked, can you effectively hedge the inflation risk for your equity bond portfolio with inflation tail risk positions like calls or gold or gold miners or out of the money puts on bonds, et cetera? And I think that probably the drag there is probably significantly more than what you’re seeing in your commodities. But can you elaborate at all? What are your thoughts?

Chris:                           00:31:12          Sure, because it’s certainly true that. And gold is certainly part of your commodities. So when we’re thinking about commodity protection, whenever you think about commodity protection, say like I said, I think there’s three different types of inflation, right? So you can say that there’s monetary inflation, there’s price inflation, there’s underlying commodity inflation, which then flows through you know call it like-

Mike:                           00:31:34          There’s Price Index inflation.

Chris:                           00:31:36          Yeah. And so it’s kind of like a ball. You can attack those and defend against those in different ways. But you can say like, maybe gold is a pretty good protector against monetary inflation. It might be like, at least, and gold’s interesting, because gold is actually an inflation hedge. And it’s inflation hedge. It’s an inflation hedge, and it’s a shit show hedge. And that’s why people kind of mess up because when you actually measure the correlation of gold to inflation, it doesn’t look great because you’re actually realising that it’s not a linear relationship at all. But if you measure like the correlation of gold to inflation, and then take away like the downside, the deflation piece, the correlation comes up significantly. So gold is a decent inflation hedge, but not a perfect deflation edge, not even close. If you want to price it, the easiest way to get those real return bonds or break evens. If you want to really isolate the inflation piece, and if you want to talk about, well, if it comes from the commodity side, you probably have some commodities, and the main source of that tends to be the energies but like that flows through quite quickly with the eyes and you can see it so you can basically see at least three different types of inflation goes like if you want to hedge inflation, you should probably have a basket of stuff that kind of attacks it from those three directions. Just to say like you want to make sure you’ve got to kind of covered.

                                                            Now, can you do gold miners? Well, there’s a ton of business risk in that and now you’re going to do some equity risk into your inflation hedge. Can you buy calls and puts? And you go yes, absolutely. That was a classic form of insurance, but you’re going to be paying a lot of money for it. The beauty of this approach is that these are all positive pay negatively correlated on expectation. And so, yes, and you can start to think about mitigating risks if you feel you have a particular source of risk you want to cover, but in general, we’re going to try and build the portfolio. And when I think of risk parity, and this is how I’ve tried to explain to people, doesn’t have to be a static portfolio. You don’t have to only do this. You could, in fact, you want to add lots to it. But I think of trying to build a portfolio, I think, a factor balanced. I’m trying to build the portfolio that I would want to have 10 years from now. We talked about this in the podcast I think. This is distinctly different than the portfolio I want to have over the next 10 years, is the portfolio in 10 years, because I can tell you a certainty. No one has a view about whether stocks are going to outperform bonds in 10 years, or whether commodities are going to outperform bonds at 10 years. No one has an active view 10 years from now. What is the portfolio that is as best as possible, active view agnostic? That’s your starting point. Now you can put access however if you want to. But how do you define the most passive you can get away with getting without getting like ridiculous. So this is a definition, I think of a pretty good definition of passive. It’s like, I have no active views. This is the thing-

Rodrigo:                      00:34:15          A do no harm portfolio, right?

Chris:                           00:34:18          First and foremost these guys protect each other. That’s a great starting point. So, now as we said though, commodities, here’s the thing. They did really great till 1980 and from 1980 to today, zero real returns. And so can we do better? In fact, if you had a wish list of the perfect asset to hedge your stocks and bonds, you say, I want to have inflation hedging protection. I want it to like ideally, not have these terrible draw downs, and maybe not drawdown at the same time as equities. And so you could do this wish list of like, what would be the perfect like balancing asset for stocks and bonds and you go, I mean, probably sounds ridiculous. And you say, can we build that now? I’m going to make a giant leap here and say, yup, we can, I think we can build it. And this is a very dumbed down simplistic sort of like simplified version of the types of things you can do. But just to say that we’re going to call this an enhanced commodity process. I’m not going to talk about how it might be done, but let’s just say there’s ways that you might want to do this. It’s got some nice characteristics. And let’s just pretend, just go with me for a second. Imagine we could build something kinda like this. If you build a balanced portfolio of equal risk portfolio of stocks and bonds, and this enhanced commodity process, and that’s what you got on the right and compare it to just your equity centric portfolio, which you have on the left, you can see it’s night and day.

                                                            Now, it’s say for the same monthly volatility, it makes about twice as much money. Or the other way you can say that is, if you want to, you can run that half the rest and make the same amount of return. But the real key feature is that it’s got like less than one third of that pain that the equity centric portfolio has. And so I think it’s fair to say this is a clearly better starting point than an equity centric portfolio. And so now I’m just gonna say, it looks great. Why don’t we just put all the money in this and just go golfing for the rest of our lives? And the answer is because I cheated, like so badly in this in a bunch of different ways. And there’s a really, really important cheats, because everyone’s commits like some part of these cheats. And I gotta tell you, the reason you can’t just do this and go, and the reason is not going to be that easy. First of all, I just showed you US stocks and US bonds over the last hundred years. The US is the top performing stock and bond market in the world over the last hundred years. And I guess it kind of goes without saying if I would say of the 16 major indices that have been around from 1900 to today, the US is by far the best. In fact, if you look at the next slide, I think the US has got a four and a half percent real. I think the next best is like two and a half percent real. So you say what do equities owe you? What should you expect out of equities over the next 10, 50, 100 years. Unless you can tell me that of the 16 largest countries today, the winner is going to be, you put all your money in that. It doesn’t tell you what the winner paid you over the last hundred. It’s probably more like what the medium paid. That’s like 250 basis points real, it’s not as good as it looks.

The other problem with that is I set up 16 countries that survived. But if you look at the biggest countries in 1900, a bunch of them went to zero. If you put your money in Russia, or Egypt, or Argentina, like countries that surprisingly were like very large. Germany,

Mike:                           00:37:37          Russia and China both went to zero. And they were large economies back when they went down.

Chris:                           00:37:42          So just to say, if you follow the winner the whole way through, and if you do the median, adjusting for survivor bias it’s more like 150 basis points and that’s really generous. So we’ve got a real sense that equities owe us a lot more than I think they will ultimately pay but I’m pretty sure that risk of them is an accurate representation of the risks. And that’s the long term. That’s not talking about today’s starting point. So this is a difficult time.

Adam:                         00:38:12          We haven’t even got there yet. Exactly.

Chris:                           00:38:14          Okay, and so the next thing is, obviously, I showed you a commodity model. So if I could have done this in 1965, look how great it was. And I said, Just trust me, I can do this. Of course, I would not have known to do that in 1965. So there’s a whole bunch of, and we started doing similar things back in 2003, 2002. And they continue to work but you have to have a really strong argument as to why this is a persistent risk premium as opposed to just, hey, if I know what to do this thing gives. And you’ve got to hold people’s feet to the fire to defend that.

Capacity

                                                            Fourth thing is it requires leverage which a bunch of people can’t do and a bunch of people just refuse to do. And at the end of the day, they would rather sit on that incredibly risky equity portfolio than build a more diversified process that requires some leverage because they somehow feel that that is risky while this isn’t and so because I think once again, they’re caught in some survivor bias US centric essentialism of research problems. And then the last one, capacity. Not everyone can do this. If you’re a trillion dollar pension plan, it’s impossible to get enough inflation protection to cover your stock bombers. And in fact, you probably don’t have enough bonds either. And so you probably just running by an equity process. And now your challenges as a CIO is to optimize that portfolio given the constraints you have, because there’s a whole ton of constraints into that optimization.

                                                            If you’re too small, becomes a bit hard to do but there’s an absolute sweet spot where you can actually probably like literally for the first time so I think I have a competitive advantage over the big guys, because I think I can still do this because I think it requires a certain amount of sophistication but it’s doable.

Rodrigo:                      00:39:45         Is that like capacity on the inflation hedge probably could do probably the reason why Bridgewater works with the US government to launch the Treasury inflation protected securities?

 Chris:                          00:39:57          It could be. For sure they would have be looking for their inflation protection absolutely.  I assume as capacity the fact is, there’s just not enough commodity futures out there for everyone to like, for even a very small percentage of people.

Rodrigo:                      00:40:11          If you limit let’s say what any one entity can own on that.

Mike:                           00:40:13         

Chris:                           00:40:14          And so the banks will give you swaps around it, but it’s somewhere sooner or sooner or later there’s a limited amount that you can do, because there’s not many people to get on the other side of that trade.

Mike:                           00:40:25          Even swaps end up back in the futures market.

Positives and Negatives

Chris:                           00:40:28          Of course, unless somehow you found an offset. And then you kinda  go. So you have to come at it in different ways. And like I said, real return bonds is a pretty good one. Now, the problem with real term bonds, the challenge of them is the breakeven part, the inflation hedge part has got a negative expected return. So it’s not a positive pay. It’s just like negative pay. That’s not bad, probably still worth doing. So we say well, gold is a positive, probably a positive expect return at least real neutral, probably real plus something and it’s got that nice deflation hedge too. So you probably want some gold in your process. And so you have to be a little bit creative about coming at it from the especially the inflation has started, because-

Mike:                           00:41:05          We’ve got one other question here too and I think it’s relevant. And it’s just, how does this work in those pinch points where the correlation of assets and the drift from historical positions? Well, basically, you’re going to get some sort of liquidity contraction like we had in March where there just isn’t an asset. Even your long dated treasuries or your shorter dated treasuries have liquidity pinch points.

Chris:                           00:41:36          Sure. So how does it work? Because like I said, I did this last year, I couldn’t show you his exact numbers. Is it bulletproof? Does it never lose? No, if you look at on the bottom right, it’s not volatility. What it doesn’t have is clusters. In fact, it’s much more normal process. The 10% vol you’ll see some 20s you’ll see some 10s, you’ll see some 15s, you’ll see a 25. It’s a much more normal process. You should run away scared from any process that says 10% vol. It doesn’t have peak to trough close a 15 to 20% every three to four years because it means it’s not random walking. And when something doesn’t random walk, it’s almost always because the volatility has been hidden in higher order risks . And so you can do that. You can always take something reduces volatility and increases skewer kurtosis.

Mike:                           00:42:23          Yeah. Selling vol has been a predominant feature of doing exactly that.

Chris:                           00:42:26          From vol, a lot of credit, a lot of insurance and securities are things that it takes a full cycle to realize the risk. And so it looks like a Sharpe ratio of two until there’s a minus four in there and it balances out at point five. But that looks more like equities, to be honest. You want a normal random walk process whenever you can. And you need to see those peak to trough, you need to see losses. How does it do it do in March 2013? I’m not exactly sure but what this isn’t and what this one isn’t, is a short term vol targeting dynamic vol process. This is a long term. I mean, I did this monthly. I’m just trying to roughly get the positions right. I’m not trying to deal with vol clusters in a way that you would probably do in the short term. It’s an interesting question, we can always check. My guess is okay. But the fact is, you can’t judge a process by one or two weeks. And I would also say man, equities did not do well in that period either. So it’s better than equities, is probably a fair statement.

Scrutiny of the Quants

Adam:                         00:43:22          Actually, it’s interesting. We’ve constantly commented on internally how the scrutiny of quant or systematic based strategies is so much higher than it is for more traditional strategies. If you’ve got a traditional manager who comes in to pitch his discretionary value, Quality Strategy, he tells a nice little narrative, he describes it the pitch for four or five stocks that he really likes right here, and why they’re the largest positions in the portfolio. And the CIO feels really good and this guy knows what he’s doing and it maps to whatever he learned in his MBA, but when you go through a quant process that everybody really begins to drill down to the details, it’s like, yeah, but what are the tails? And yeah, but how to do here? And yeah, but what do we expect here? And what are the go forward expectations? And what are the capacity constraints? What’s your trading costs? Like, it’s amazing how when you empower people with more data, that what it does is it prompts for questions.

Rodrigo:                      00:44:25          And you know what it is? This well that really busts me, is the view that risk parity, everybody’s waiting for this risk parity to blow up, and when it has an inevitable 15%, 20% drawdown. See I told you that we’re going to blow up. I told you it was going to blow up. There was nowhere to high risk parity isn’t real, what happens when everything correlates? And there were like three days that it correlated in March and everything down together when your leverage that hurts, but it was a perfectly reasonable drawdown for a 10% volatility a well constructed 10 ball risk parity product cruised through this year. Yet in the headlines its risk parity blows up. How do you think risk parity did that doesn’t really know?  They all blew up. It’s astounding the standards that we are expected to meet.

Chris:                           00:45:15          Sure. I think you’re absolutely right. First of all, everyone starts off, like 99% of investors and stuff and end up thinking themselves like I am a Warren Buffett, I invest like Warren Buffett, I want to buy low and sell high, I want to buy good things cheap. And because it’s so intuitive, it doesn’t mean it’s easy to do. And it doesn’t even mean that’s the reason you’re making your money. It’s very intuitive. So I think the problem a lot of quants have is they don’t properly explain the intuition or they can’t explain the intuition and it becomes much, much harder as a selling feature. I think that’s the first thing. I think the second thing is this is so anathema to how people think of what their role as an investor is. My role as investor and we always talk about the Sharpe ratio is returnable risk, and they’ll say my role as an investor is to try and time things. I want to pick the winners, I’m trying to improve the return. And what we’re saying is hold on a second, you can do a much, much better job by improving the risk and keeping the returns constant. And then using a bit of leverage. And so it turns out, it’s much easier to come at it from the risk side, but that’s not what investing is, portfolio constructing. I always think of portfolio construction as putting the pieces together as risk.

                                                            And a lot of people are portfolio construction is about returns. TAA is about returns, maybe. But at the end of the day, I really think like this is why I really think the portfolio construction is like I want my starting point that I can do my active stuff around. But what is my starting point, and the fact is risk is more stable. Correlations, in fact, are more stable and they’re easier to predict this result and they are something that you can put pressure on about the future. If you want to make predictions about the future risk and correlations risk in particular correlations are hard. Risk in particular deserve weight, because a two year bond tends to have less risk than a 10 year bond. And that’s pretty straightforward statement that your Eurodollar futures tend to have less risk than gold. That is something you can pretty much go to the bank and it will always be the case. But it’s enough to add value in the future. It’s very, very hard to predict returns.

                                                            Most people destroy value trying to predict returns. And I would say at the end of the day, start thinking about risk from the risk factor portfolio construction side, and then start to think, well, how can I add some alpha? How can I then start to choose the returns on it?

Adding Alpha

Adam:                         00:47:23          Okay, so let’s go there.  Let’s go there because I think we all kind of agree on the risk parity as the neutral starting point. And we I think all agree, we call this the impossible market or navigating the impossible market. You say, okay, not impossible, but it’s highly challenging. So let’s go to that challenge. So we’ve got a well-diversified portfolio we’ve taken a good crack at managing the risk of all these major economic environments. But this risk parity portfolio, given capital market assumptions, probably is not going to do it. It’s not going to hit the required return chart. It’s not going to give you 5% real over the next 10 years in the way that gave you more than 5% real over the last 20 years, at the same level of vol. So, you mentioned earlier we can raise levels a little bit that helps a little bit. But when the expected return is one or 2%, on your risk parity portfolio, there’s a maximum of Kelley leverage that you’re going to want to hit before your expected compound return begins to decay. And so you’ve got to add other edges to the pile in order to be able to pile on to get to your 5% required return target. How do you, how do you think about that?

Chris:                           00:48:42          So there’s two bits, and so the first one is, beta’s returns are probably lower today than they were historically. And you just said that as a statement. I think they’re only one or 2%. But you got to defend that statement. I think a little bit and you’re saying why they are lower today? And the answer is they’re lower because the price of everything is high. For a given set of Cash Flows if you’re willing to pay twice as much for those cash flows now as you were five years ago, your expected returns come down as a result. And so when prices are high, for a given set of cash flows, you can think of that discount rate as the IRR, but like the lower the discount rate, the lower expected return. It sounds really obvious, but the problem is right now the discount rate across the board for everything is as low as it’s ever been. You cannot escape the fact that expected returns are also as low as they’ve ever been.

Adam:                         00:49:28          So let’s break it down. Let’s put some numbers on it. So what’s the 10 year yields? What is 60 basis point range? And the equity risk premium is in the- and like short term rates are in the I don’t know zero range. And the equity risk premium. If you look at the median, the median is in 150 basis point range. Let’s be generous and call it 200 basis points. And commodities, notwithstanding some sort of overlay let’s call it zero. So the expected return real on 60-40 is obscenely low on risk parity, is obscenely low risk parity is going to give you the same return for probably a lot less volatility. I think you could argue that there may be some kind of rebalancing risk premium in risk parity that you don’t get for 60-40. But notwithstanding all that, you’re in this sort of two to 3% range max real and usually below that.

Chris:                           00:50:25          So the one thing is, you got a couple points there and you’re right, everything’s low. We could talk about why they’re low because it’s super important to understand. But just because yields are low in bonds, doesn’t mean the risk premium in bonds is low. And I think we’ve talked about the bond risk premiums and deals with like, that’s actually not the right way to think about it, like the yields are on a bond, but you have to understand what we’re talking about bonds. And if you want to compare, a bond is not an asset class, a bond is a thing that you put your money in a 10 year bond and one year from now it’s a nine year bond and five years now it’s a five year bond and the statistical characteristics I think, are constantly changing until it turns into nothing. If you want to compare perpetuity which is equities, to a perpetuity of fixed income, you have to start thinking about a rolled bond process. And if you really want to get right you probably have to talk about a funded roll bond process.

                                                            So if you want to compare a perpetuity of equities to perpetuity of bonds, you got to look at levered role bonds that is a completely different asset class than a bond.

The Futures Contracts

Rodrigo:                      00:51:20          The futures contracts.

Mike:                           00:51:22          For futures contracts or swaps are like when you think about a funded levered process, and so like what does a futures in bonds look like? Well, futures in bonds is arguably now a perpetuity. And so you think we want to compare apples to apples, you should probably think well, what are the characteristics of the futures in bonds in the futures in equities we got the big characteristic of levered bonds is two of them, is that when the yields come down, the short rate tends to come down even further. And the top performing asset class almost on the planet over the last 30 years has been US, sorry has been JGBS, Japanese bonds. When their yields fell below 100 basis points they got better, why? Because the short rate was zero to negative and the carry was still very good and you can have 4% yield and 3% short rates and you’re only making 100 basis points and carry, you can still be making your hundred basis points and carry at 100 yield.

                                                            And so it doesn’t mean that they will be always. It doesn’t mean they’re not enormously risky. But there’s lots of caveats to all this always. But there’s a massive mistake people…The other thing I think the real knock on bonds that people tend to think of them in terms of their yield, no one knows what the price attendance because you can’t talk about the price attendance –  doesn’t make any sense. But you can talk about the yield. The yield is like saying the PE and people go the yields only 100 basis points. So bonds are worse. So bonds are quoted, like kind of differently than equity. Equities rise in value, people go, oh the better, because they don’t look at what’s my forward looking return. Bonds rise in value of the forward looking returns lower because the yield’s lower and so like, there’s a real mistake in there. The other thing about levered bonds is that they are a shockingly good global diversifier.

So, if you think about why do we do it, every … in the planet is trying to diversify your nationals. Everyone’s trying to get into Asia, trying EM and trying to get in, let me go. Why? Because we need some diversification for equities. The diversification on the equity side is okay, there’s a little bit like maybe it’s a 70, 80% correlated and maybe you got a five or 10% increase in your Sharpe ratio in your equities maybe. Global bonds are incredibly good diversifies because of that short rate, which is driven by the local central banks, and those tend to be relatively uncorrelated with each other. So, you’ve got this feature where like the diversification benefit across global bonds is actually significantly better than it is a across global equities. And central banks tend to drop the short rate when equities are doing badly. So global levered bonds are better diversifiers against equities. So you’ve got to make sure you’re defining bonds properly.

Currency

Mike:                           00:53:43          How does currency work? Continue with that but come back to how currency works into that as well, if you don’t mind.

Chris:                           00:53:50          So typically, when you’re using futures, you can just think you’re thinking there’s a local currency, you don’t really have to worry about that. But I would say very much. As a Canadian investor, you should be super aware of your currency exposures. And there’s two lines of thought on FX hedging. And one is, FX has zero expected return and there’s a cost of hedging, so why would I bother? And so you certainly might as well have a completely unhedged portfolio and might have a deliberately unhedged portfolio, I might have a policy where it looks like reverse like hedges that they were to show up because I want to be unhedged. And so you look at that, you say, well, like what have I done? You say, well, I imagine a pension plan in Canada that goes out and buys private assets in Brazil or Chile or anywhere and you end up with a whole bunch of short Canada long somewhere else from an FX perspective. And if you don’t hedge it, you can end up with a very very big, short Canada long exposure and so from a Sharpe ratio investor who only cares what return you got. Why should I bother. Why should I bother hedging? From a Sharpe ratio investor cares about risks you go, Oh my God, I got this giant source of volatility with zero expected return.

Adam:                         00:54:58          Yeah, the tails wagging the dog.

Chris:                           00:55:00          I’ve got this thing that it’s just noise and that is Sharpe ratio destructive that is like that is the worst use of an active risk budget you can imagine. I’m given a certain amount of risk to spend, I want to get the most return for the risk I’m given. That’s what I am as an investor, why would I put it in something with zero expected return? For sure, you should hedge your currencies, but you have to be really careful. And this is the CIO’s challenge part two is, I even if I knew how to build the maximum Sharpe ratio portfolio, I knew exactly what to do. I’m in a world of constrained resources. And my major constraint of resources is my balance sheet, is my leverage. In looking at this and say where am I spending my cash? And if you go and you hedge away your FX exposure, you have to set money aside to defend that because there’s a world where the stocks are falling and the FX is moving against you and you got to come with money and if you don’t, you can get really caught in liquidity space and a couple pension plans. Doing the right thing hedging currency but probably over hedging and not properly defending them clear that their cash on it got themselves into a bit of trouble in 2008.

                                                            So, do you currency hedge? Absolutely. But you have to think of that money as it’s doing something. It’s money I’m spending to improve my Sharpe ratio like hiring an active team. And in fact, I think when we looked at it, we figured that if we currency hedged ourselves completely at Teachers, the increase in Sharpe ratio was equivalent to the entire active management of Teachers. So it’s just to say it’s taking away the source of risk and if you replace that risk with better return.

Mike:                           00:56:29          I like that. What about currencies as an actual asset class themselves? Did they live into this structure?

Chris:                           00:56:38          Clearly, when we say that commodities don’t necessarily have a long side risk premium. Obviously, FX by definition does not have the long side risk premium because it’s not going to long side. … long Canada long …. But are the risk premiums within commodities just like their risk premium within FX just like they’re risk premiums within commodities? Absolutely. Because all you need for risk premium is a willing payer who’s willing to pay money to someone else? Because it improves their position, they’re paying that money because they’re getting something beneficial out of it. You got a payer, you got to payee. That’s exactly what the equity risk premium is, what fixed income premium is and those exist all over the place, and for sure, FX is still a great place to invest. But I would say you should not ever…but you should be very careful about the extra risk you take on. It kind of came as the baggage associated with another investment. But it’s got a cost. And to think that the cost is only an expected return side is not to realize the risk is a cost. And risk isn’t really cost, absolutely yes. You could have taken that risk budget and put it into equities or put it into bonds or put it into this diversified portfolio. Absolutely risk is a cost. Because you’re risk constrained. Someone somewhere said you’re only allowed to take X amount of risk and your job is make the most return you can for that risk.

                                                            Now, do you have to hedge all your FX? No, because when you have this giant source of risk and it’s literally an overarching source of risk. You don’t have to drive to zero for it to disappear into your portfolio, you just have to take it from a loud roar down to a dull roar. But once it’s a dull roar, like the math of diversification starts to take over and it starts to become a smaller and smaller contributor to the total portfolio. So there’s a tipping point where you want to get below that level. And then just be careful, if you’re going to FX hedge, make sure that you’ve set that money aside. Now, there’s one final debate and all of this, which is what if you really believe the correlation between Canadian dollars and equities is negative? And then you say, if I’m long US and short Canada is that not a great trade in 2008? It’s like do I not think the Canadian dollar is going to get smoked each and every time the stock market falls? The answers is, it might. But you got to be very, very careful making investments. That’s a real correlation. Correlation is a super noisy, super unstable, very hard to predict. Not very dependable-

Rodrigo:                      00:58:51          Kind of different in 2020. Took a long time for it to start working.

Chris:                           00:58:52          Yeah, and it won’t necessarily in an inflation crisis. It won’t. I would say that they’re the reason why every big US hedge fund on the planet doesn’t hedge its equity risk with short CAD is because that would be insane. It would be a crazy additional source of risk. But I think the same-

Mike:                           00:59:12          It’s so great, it’s so great that you drive across the border. Literally just fly your plane 30 miles across, land in Niagara Falls – Fort Erie and have the same discussion about how you should be currency hedging, and it’s a totally different ballgame. Like it’s just not even the same fishbowl anyway.

Chris:                           00:59:28          Fair enough. It should be.

Mike:                           00:59:33          That’s the point. It should be just like you said. No other asset manager on the planet would do that, except for a Canadian asset manager would think about that. I digress.

Chris:                           00:59:43          One probably can slightly argue for a slight leaving it a bit behind because there probably is a slight negative correlation there. But I just like, be careful building a portfolio around an in sample look back that says hey, guess what these things were negatively correlated … because yeah, that is a super dangerous thing to do. You should probably be careful with ever building a portfolio around assumed negative correlations.

Rodrigo:                      01:00:09          Right. It’s probably most appropriate to think about it is a different source of risk that you have to manage and doing 100% of it is probably not a good idea.

Chris:                           01:00:15          I mean, like in our portfolios, what we are investing in is risk, and we’re trying to make as much return as possible for the risk we’re investing in an asset class, that or an exposure that has zero expected return. And lots of risk is very costly. It’s quite literally, and since it’s very cheap to hedge, typically I think it’s easy, doesn’t mean you completely hedge. It doesn’t mean you hedge everything, but just be aware that there are tricks in there. But it does get to the CIO’s challenge of going where do I spend my bullets? Because if you-

Spending Bullets

Adam:                         01:00:48          So where do we spend the bullets?

Chris:                           01:00:49          Well, at the portfolio construction level to start for a second ago

Rodrigo:                      01:00:54         

Adam:                         01:00:56          Jesus Christ. All this currency is shit.

Mike:                           01:01:01          How many bullets do I have?

Chris:                           01:01:03          Not that many. So the question is, first of all, let’s see, what’s your? Not right now maybe, but on average of the launch of the biggest source of risk, outside of equity risk for most pension plans is actually their liability string. Instead, we have this giant short bond project with a discount rate. He said, you know, the discount rates come down, that’s a real source of risk because your contribution rates go up, you may have to change your benefits, you can certainly fail just as easily from a discount rate move as you can from an equity fall. And so you should certainly be aware there’s a giant source of risk. So the first thing where you might want to spend that bullet, oh, man, I got the source of risk that’s got zero percent return, maybe I should hedge it. Well, that’s it, it’s LDI. So liability driven investing is the sort of the modern approach when we want to dampen that a bit. If you want to fully immunize your liabilities, you’re going to need leverage unless you’re fully funded and then you can use the rest to try and generate a little bit excess money but assuming you’re not fully funding others not, you’re not quite literally using your risk free rate as your actuarial discount rate and you haven’t which no one is, you’re not fully funded. So you can’t fully immunize without leverage. And so there’s your first thing, I’ve only got so much balance sheet, I can only do so much leverage. And I can only do so much LDI.

                                                            Where else? What else is demanding on my balance sheet? Well, your capital markets team, your FX hedging, as we said, all your derivatives programmes, and competing for that cash are your privates. Because you take that money out, and you do FX hedging, but you don’t set the money aside, you go spend it on something illiquid. You can’t have both of those. And so, this is the constrained resource that makes like really difficult because even if we all agree, we should probably should that we’re trying to get towards this maximum Sharpe ratio portfolio. There’s only so close you can get to it given all your constraints, and that is the part of the CIO’s challenge. Like, okay, I don’t think beta is going to pay that well. It’s not going to pay as well as it did the last 15 years. It’s impossible to pay as well as the last 15 years because the entire driver of the return wasn’t cashflow surprise on the upside, very little cash flow surprises upside. Your real estate didn’t go oh my god. Way more real estate than I expected because I guess I because my cash flow surprised, your infrastructure didn’t surprise in the cash flow side, it’s just that someone was willing to pay more for the same cash flow as five years later. That is a discount rate falling, you got paid on your privates from the bond side, from the discount rate side.

And so you look, we don’t like bonds here. And people don’t like bonds here for a variety of reasons. But you can’t really love a lot of the privates as well for the same reason. Because the price is very high relative to the cash flows you’re getting right now, historically high. And so that’s a challenge as well. And so this is the classic what got you here isn’t necessarily going to get you there because it’s not going to be as easy as, I hate this term, like greater full theory, but it’s not going to be as easy as just finding someone willing to pay more than you paid five years from now going, who’s better than me, because at the end of the day, that’s not going to continue forever. And that’s this falling discount rate which does raise prices. Because it leads to the present value of future cash flows, goes up if you take a discount rate down so the central banks came in discount rates are all down prices are up.

                                                            The problem with that is your forward looking return, all you’ve done is taken your future returns and paid them to yourself today. So literally your prices are higher, we feel that much richer now. But going forward, our expected return is proportionally lower, we are no better off.

Pricing Risk on Privates

Adam:                         01:04:16          So how are the institutions pricing risk on privates? It’s like it’s a major problem.

Chris:                           01:04:26          That’s a very tricky thing to do. So you say like how do institutions price risk and obviously, it’s in the news right now with IMCO. And to a certain extent, I’m unsympathetic, and to certain extent I’m very sympathetic because their risk system almost certainly did not look back 35 years and so they would have shown zero chance of this happening according to every system. I don’t think anyone’s institutional risk system really looked back that far. Now, that doesn’t mean that when the dealer came to you because like, a friend of mine in the business, said the dealers would come to me every six months with this trade, do this Cap… risk-off … and then this kind of Sharpe ratio 15. And it did have a Sharpe ratio of 15 and kudos to him because sometimes it’s the trades you don’t do not the trades you do. But yeah, it’s got a Sharpe ratio of 15 in the last 30 years, actually, it’s got a Sharpe ratio of minus two over the last 31 years. And that’s a crazy trick. Now the thing is kudos for not doing because it’s super, super tempting to put the trade on that, only once every 30 years blows you up? Because probably not going to happen in your lifetime. And you can look like a genius in between. So that’s a problem. It’s a real system problem. It doesn’t mean that it was a terrible trade to do if you size it right. Like it may still be a positive expected return, but clearly it has to be sized right? But it doesn’t mean like we haven’t got risks. It doesn’t mean we have the privates risks either on average, because I don’t think anyone’s got the 35 year private model either. You’ve only got like a 10 or 15 year look back on privates. They also look very low risk.

                                                            And so you see a lot of private models that okay, so we know for sure they’re smooth because they’re basically value counts and they’re lagged. If you could just take the S&P 500 and just lag it six months that would look like a brand new asset class at the annual level, like it really quickly to be uncorrelated be zero correlation. So like technically, that’s amazing. It’s like I would call it two assets instead of one, my Sharpe ratio goes up by like 40%, if all I did was just lag something about six months, but that’s the one year level, the three year level, of course, the fact that there’s six month lag starts to show up at the five year level, they’re 100% correlated again. It’s artificial. So lagging looks good. At the one year level, it looks good. At the two year level, it’s a bit artificial over that, the smoothing is artificial as well, because while the volatility is not showing, of course, it is trending a zero correlation and that’s almost the definition of it. So it still has the same or should have the same peak to trough.

Now it may also have a grind up slowing down dynamic where it only shows us risk every 10 years and you go this becomes a really hard thing to risk and it becomes a trap. Because what you see is a really good diversifier, really low risk, never blown up. And so you can imagine why someone might think, oh, maybe infrastructure is like as risky as a Canadian bond you can’t be because it has all the discount rate risk. But also at the end of the day, the reason these assets, the reason real estate or infrastructure, or the privates are paying more than the risk free rate is because they have equity risk.  They have business risk in them.

                                                            And so this is what you will see I think in a COVID strike, is you’ll start to see the business risk in a bunch of these assets. Because there are businesses risks, that’s what you’re getting paid for. And so it’s a bond and it’s paid like a bond, and so on the way we never saw the cash flow hit and so there’s no risk in the cash flows. Well, of course, there’s risk in the cash flows. And then there’s the danger of leveraging something up too much. If you take an asset class and you take an asset levered up eight or nine times it only takes a small decrease in cash flow  before you get yourself into some trouble. So I’m sympathetic to IMCO because I don’t think their system would have caught it. I don’t think many pension plans risk systems would have caught it. I think pension plan risk systems have also misdiagnosed risk in a lot of assets, maybe possibly underrepresented risk in some asset classes. But the problem with that, so this is sort of the I don’t know, this is a good analogy or not, but Nassim Taleb has this definition of fragility, and he’s got a really good example. I really like it. It goes like 50 years, 100 years ago, and I’m totally butchering the story, but go with the jist of it. But 50 years ago the power grids were all localised. And so you had your local power generator, and they were brownouts all the time, because these things would constantly go down and every single time one had a problem, you’d have a local brownout, and it kind of sucked.

And fast forward 50 years, you got this incredible process of overflows and dependencies and you’ve got this extremely optimised process, but it’s incredibly fragile now. And so what happens if one squirrel in a transistor or whatever like, in the East Coast, it takes down the entire East Coast grid. And so you go from like, a large number of relatively unimportant brownouts to a catastrophic blackout. And I kind of think that’s how I think about risk, because if you think about like, what the public markets show you is they constantly show you their risk. There is no hiding the risk of a public market, there’s no hiding from March in 2020. There’s no hiding from 2008. The risk is there, it’s in your face. And so you see it, you know it.

                                                            The privates hide their risk, the risk is there, and it will show up and it shows up over. Unfortunately, 2008 didn’t show up, because it was so fast that by the time they had to start working in 2009, it was already coming back. 2000, 2003 will show up in 1965 to 1975, it will show it. And so at the end of the day, I think we got like we potentially have this fragile system, because we haven’t seen the risk and we think that it’s not there and because it’s been hidden away to a certain extent. And we’ve taken short term volatility in local brownouts, and we’ve turned it into bigger, probably more catastrophic type explosions, much less frequently. So that’s the challenge of privates.

Rodrigo:                      01:09:52         So we’ve covered all the keys. We covered the equities, the bonds, the private equity. We’re now in the Zero to 2% land territory going forward. You’re about to say how can we improve this as quants?

Improving as Quants

Chris:                           01:10:07          Well, this is like, I can’t get into this too much. But I would say, I want to say first of all set up the how we could have solved it 15 years ago. And this is a chart look completely made this up. So and I can walk through that, just to say when you look at what the world looked like in 2016, you said like how did most institutions invest, we have some stocks, we had some bonds. And that confidence, I’ve always like I created this chart, and I kind of have confidence to me is not how high the Sharpe ratio is, but just that it’s positive. I think that these things pay money over time. I don’t know how much like I said, like who knows what equities owe you for real over 100 years, but I think it’s positive. I think credit is a mixture of stocks and bonds with some vol selling and some liquidity is probably positive too. And so pension plans played in that stock bond credit, that alpha I think is where a lot of pension plans played as well, but stock picking alpha like trying to add value above and beyond the portfolio.

                                                            I tend to think of that as being a zero sum game. So like how confident is going to be positive? You think that you’re skilled, you think that you’re above average skill, you think that maybe you should be able to produce positive, but then so does everyone. Let’s just call it zero for a second, doesn’t mean you can’t add value there. But it’s harder to think that it owes you money. And then I would say, there’s all those liquid alts right, and I think these were mostly overlooked by pension plans in 2006 and in 2005. Like I said in the podcast that, as you started trying to say, like, how can we build a diversified portfolio of alternative risk premiums and what did that look like? Part of the pushback is always, look, if it was this good, and this easy, why wouldn’t everyone do it? And so most people didn’t. But there was a ton of other tools in your toolkit that you could have added. And I would say the key to investing for sure, is to avoid the crowds. If you can anticipate and get in front of the crowds that could work for a while, but a crowded trade by definition, just by definition, if more people have bought it that should call that crowded, it’s price gets bid up and it’s expected returns come down as the result.

Adam:                         01:12:01          So do you agree with, I’ve been playing with this framework for the last couple of years, which is basically that to the extent that a strategy or an asset class or a methodology becomes well within the Overton window, it is accepted by academia, it’s accepted by institutional allocators. There’s such a good story for why it should work. Literally, the expected return is inversely proportional to those dynamics. Like, to the extent that everybody accepts that this is something valid, that is sustainable, that has persisted that has an attractive risk premium. The fact that enough people accept it to be true, invalidates it or if it totally diminishes the Sharpe ratio to the point where it’s no longer serves a function that you want.

Chris:                           01:13:22          And so the analogy I always sort of mention is the alchemists dilemma. You’re an alchemist, you spend your entire life trying to figure out how to turn straw into gold. Because if you do, man would you ever be rich, without realising that if you figured out how to turn straw into gold, you wouldn’t be rich, you would just make gold useless and worthless. So at the end of the day you go like, like, these things are only good if not everyone can do them. And that doesn’t mean that they shouldn’t be still in your portfolio, I still think they’re positive return, and they should absolutely still be in your portfolio, they won’t be as good as they were because they’re crowded, but so is infrastructure, so is real estate. So as private equity, everything’s crowded, the returns going forward are going to be a lot harder than they were over the last 10 years. So that’s the thing. And so I would just say that this was sort of the point of this chart was to go fast forward to 2018. And of course, I totally made this up again, but I’d say like those things that used to be considered hedge fund alpha, and really sophisticated and really not what people thought about doing in house or exposing themselves to in house more and more pension plans, bit by bit they started to include them in house and as a result their returns pinned out. And so you got two issues, the returns get compressed where people do it. The correlations come up as more people do it, the risk goes up, you’ll do it and go net, it’s a worse trading. And you also have this other massive problem in all of this when things get crowded. It’s not just the pension plans, but it’s the banks, the hedge funds, a lot of people pursuing the same strategies. And what is the natural, why would you think there’s any correlation between the cash flows produced by commodity backwardation, contango, and FX carry? There’s no reason, they should be correlated. They are 100% different things. But at the same multistrat is doing both of them and is forced to de-lever at the same time, they will both lose money at the same time, the more people are doing the same thing, the more giant multi strats trade all these strategies, the more they just become correlated by the flows in and out of them.

                                                            And so not only the returns get driven down, and the individual risks come up, but the correlations have had this capacity to spike and if you see a grand  de-leveraging or liquidity event, the diversification benefit you’re used to seeing sort of disappears. That is the major challenge in this space right now. And I think it goes back to your question like, why do people really, what’s one of their fears about systematic and make a little part of it is what happens if the future is different than the past? And there’s always that risk there. And I think there’s a natural sense of maybe the things that worked, well won’t necessarily and there’s a shift there. But it’s also the problem. Like the beauty of these things and the neat third part to them where people can do them is because if you build a CTA, and I build a CTA, our CTAs are going to be like 80 or 90% correlated, not maybe. Maybe that’s maybe like your basic trendline would be and it’s up to you to try and improve it. But the fact is, a lot of people have a general sense of how these things work, and they’re all kind of doing the same thing at the same time. And that you don’t have that risk with a discretionary guy as much they all could, they all could do the same thing. But this has an extra risk of man, they could all lose at the same time, all your strategies at the same time. And also like when people get too big, it becomes harder for them to make money. And when people get too successful, other people start to copy them. And that is more of a risk in systematic than a discretionary.

Jason:                          01:16:08          It feels like the risk avoiding behaviors of a systematic investor. We all share that in common, we identify the same risks, and we try to avoid them in the same way versus a discretionary manager is more opportunity seeking, which generally or may not always involve the same bets. And certainly it’s a hook into individuals. People like to talk more about opportunities seeking than they to do risk avoiding.

Rodrigo:                      01:16:36          Welcome Jason. I saw you…

Jason:                          01:16:40          I saw you drinking and I came away.

Mike:                           01:16:43          It’s happy hour yet. So I think it’s fine.

Adam:                         01:16:45          Exactly.

Chris:                           01:16:47          So, I think so. It doesn’t mean that they can successfully do it, but it’s soon too. And I would say, it just comes down to what the systematic guys have been constantly doing and trying to do is that they’re trying to get off to the right out of the crowd into the non-crowded space. I think like that is honestly and the problem is that complexity and sophistication curve of the world is constantly moving like as it should, that’s a great thing. But you have to stay off to the right of it. So you can’t be doing what you were doing back in 2006, in 2018. You can, but you don’t expect the same returns. Now, I would still say, I don’t expect the same returns from anything in 2018 that they would have given you in 2006. Infrastructure in 2006, a small number of really big sophisticated players pursuing a deal. And in 2018, 50 sophisticated big players pursuing the same deals, it’s very hard to imagine that you can get the same deal now that you could have gotten them. It just like this is it. It gets harder and harder and harder. And so really the onus and the challenge for the alpha investor is how do we get away from the crowd? How do we avoid the crowd? How do we do stuff in front the crowd, and that’s ultimately certain stuff that I’m working on. And I think what everyone should be working on as well.

Adam:                         01:18:07          So it’s, I mean, we completely agree. But I think it’s this incredibly rich, psychological challenge because you’ve got this situation where you need to be so far ahead of the curve, in order to be able to capitalise on innovations and inefficiencies that the rest of the market hasn’t recognized yet. But until it goes into the Overton window, until it has an explanation that people can get behind and understand, until a sufficient number of your peer group, embrace the same thinking that you don’t get the assets in it. It’s this incredible paradox. Like, the innovation happens out here where it’s uncomfortable, where your peer group don’t understand it. They’re not allocating to it. It’s strange-

Mike:                           01:18:56         

Adam:                         01:18:59          It’s complicated. It’s complex, it’s using new technology, new ways of thinking about it. Maybe machine learning is a bad example. But it’s an example of this where the tool set’s different, most people aren’t trained in it. And so it’s out of the Overton window. People don’t know how to evaluate it. And so it’s uncomfortable, but that’s where the alpha is. And no one’s willing to go there…

Mike:                           01:19:26          Which girl is going to be perceived as the most beautiful girl? Like it is. This is the Keynesian beauty contest. 100%. You have an Overton window, you have to guess where that window is going to go, which is what’s the prettiest girl in the room? Not by you, but by everybody around you.

Adam:                         01:19:45          So I think what you’re saying is that you’ve got a group, it’s not enough to have a group of strategies or strategies that are effective, they also have to be strategies that you could describe using language that a sufficient number of investors can connect with and say, yeah, I get that or like, there’s a papers on that from credible sources that I respect and-

Rodrigo:                      01:20:09          You can have this for six months now. And you’re looking at other factors that have an explanation in your audit that you’ve come up with that have explanations. But the moment that you explain I think you said there’s like 20 different factors that you’ve identified beyond what’s well documented and academic. I always find it interesting. I’m curious to hear how it’s been for you as you’re as you’re pitching this, when you can’t actually describe it, because then your IP will go away.

Chris:                           01:20:38          Well, so first of all a surprising number of investors ask you to just describe it. And so then you’ve got to be very careful because if your entire thesis is I’m doing stuff other people aren’t, it’s pretty hard to go and let me tell everyone what I’m doing. So there’s always that I don’t think this is a terrible now to get you in trouble. Like a said , forget. Anyway, I would say you have to be able to describe the intuition behind the thought process. And you have to be able to demonstrate that it’s not black box or it’s not quant it’s not data mined, but that there’s that there’s something you’re approaching and your approach the way that you’ve always been approaching it. And what it is, without a doubt, it’s very hard for most investors to be proper contrarian. And like I said, you want to buy when people are selling you want to sell when they’re buying, you want to avoid the overcrowded stuff, and you want to find the other kind of stuff and you want to get there early. Everyone thinks they’re Warren Buffett. Everyone thinks of that person, but no one-

Adam:                         01:21:39          No but I would argue that in fact, most quants think they’re AQR. Like because AQR created a model, which is we’re quant but we’re going to fully disclose everything that we’re doing so that you can understand it. We’re going to create an economic intuition. We’re going to write white papers on it and by you getting intuition and understanding the narrative and then showing us what is essentially back test results and support. That is how we’re going to get assets in the door because that combination of things of people getting comfort with the narrative, then seeing the back test is what allows big money to commit and it-

Rodrigo:                      01:22:20          It’s fascinating because when you look at our pitch books, when we talk about risk parity, we have 45 slides, because we can talk about every aspect of it. Then you get into kind of like the risk parity plus factors. We’re looking at 30, 35 slides and then now we’re doing, we got the machine learning thing and I like it’s five slides, because there’s not much more we want or can say. So you have you know, individuals that that are willing to go there.

Chris:                           01:22:49          Totally good. Selling is not easy. It’s not people’s natural predilection on how we think about investing and a lot of investors hate it, like you’re not just like, hey, you’re not going up against like someone has no real view. A lot of this is not what investing is. Investing is understanding the name and doing the research and so like, I think that’s a bit of a challenge. I think you have to think like AQR has obviously done an amazing job of selling it. So like, I think they’ve done a very good job of telling the story and of showing the back tests and so you have to be careful, I mean, like anyone can show up with a back test. I’m very sympathetic to the investor because it’s really hard for an investor because most investors in the space haven’t actually invested in the space and so they can’t tell a good story from that story. And that’s the problem. And it’s different. Different is like nine out of 10 different things will lose money, it has to be different but it has to be believable and it has to have some hook in behind it where you’ve got to be dependable. I guess is a piece of it.

                                                            And ultimately a lot of that comes down to it’s people typically want to see you up and running with a track record. Of course they should. And absolutely, that makes absolutely tons of sense. People, they want to hear you explain it in a way that makes sense to them. And you have to get to that too. And you’re right, this is a significant challenge, because no one has to tell you I buy low and sell high, I look for good value. Like even I buy shopping malls. It sounds obvious that it might take 100 pages to even start to describe all the risks that you might potentially expose yourself to when you buying an airport, but those are not easy and simple things. But you don’t have to explain why. And so is less defensive and for better for worse as the space we’re in. I think a lot of the time and the other part is obviously we have to keep moving always.

                                                            And so I think like the other part of the why this is the part I focus on a little bit. You can’t guarantee returns, like you’ve got these 20 different things and each one of them back tests as well as a CTA there in. This would be great if they all did that. I don’t know how they’re going to do another sample. You can just say like there’s a little bit of I’ve done this for a long time and there’s a robustness behind the process and the thought process, but nothing is guaranteed in the return side. But what I can spend a bit more time focusing on is the correlation side. Because the correlation of risk is where I think I actually can bit by bit, produce something that I think I can defend.

And so if I say like, I can’t tell you, I’ve got 20 things that all make money. In fact, I can pretty much guarantee that at any given point in time, two or three of them, if they’re independent processes will be losing money, because that’s just the way it goes. But I can say that they will be relatively independent to each other into other things. And that’s when like, if I said like, what would I want as an investor it’s like, I’ve got this stuff here. I’ve got the stocks, I got the bonds, I got the liquid alts, I can get these all like relatively cheap now, I’ve got the global macro. I’ve got all this stuff. I’m looking for this other stuff. I don’t want it to be correlated the stuff I already have, because that becomes a massive portfolio construction headache. What I need is different and uncorrelated and that I think is in that to me anyway is the pitch I would want to hear. I don’t typically pitch to myself and there’s obviously different targets, different audiences and different levels of sophistication but I’m very sympathetic to the investor who hears the same story nine times because everyone’s story sounds the same. Sales people are very good and you hear a good story, it will get repeated over time.

Rodrigo:                      01:26:23          And so one of the challenges I think is like you said, they’re thrown back to us all the time. They look fantastic. But there’s also the added level of a lot of these people throwing back tests to the investors believe strongly that what they’ve done is real. There’s a lot of low sophistication in order to be able to go on. What was that website that that people throw at us all the time ETF and ETF back testing website?

Adam:                         01:26:53          ETF Replay.

Rodrigo:                      01:26:55          ETF Replay. That anybody can have go to this tool, back test anything they want, what visors, asset managers and ETFs providers they create an index out of these back tests, and they believe it, they believe it in that belief that they have while they’re pitching it, that passion gets to the other side, they believe it, they go live, they lose money. … story from a bad back test, because they’re not bad people that put those back tests in front of them. They’re just novice quants that haven’t gotten there yet.

Chris:                           01:27:29          Yeah, I totally agree. And model building and systematic model building is a skill set. And this is where like, you think about well, how big does your team have to be? Because you can imagine a team of 70, like a lot of geez , three or 4 hundred and you go with a team of three or four. And I always prefer a smaller team, because I think the skill set is in the building of a model. So I don’t think you need to have, I build models in commodities. I build models in FX or I’m a subject matter expert in this one those small area because I think the danger of that is you end up data mining that one little piece of material where what you’re really trying to find is common ideas that work across the board. If you have a model that you get to very carefully, you see this all the time, we have a model that it works in FX and doesn’t work in commodities. And if you’re just an FX person –  done, but you’re someone who only works on half the things I tested, no. And so like I think there’s a real value to say my expertise is in model building, not in the asset class. And if you want to show something and you’re trying to capture some sort of process, you have to demonstrate that you can capture broadly across the board. Like there’s a lot to the skill set of model building and risk control portfolio construction and putting together and that’s why people want to see a history. And have a sample process. You’ve gone to work somewhere and you’ve done it for a long time. Something that says I haven’t just picked up a mistake, and I haven’t just started data mining and so what the problem is. It’s hard for an investor to tell the difference without balance, without some sort of backup and so like it’s hard and getting harder to get started.

Adam:                         01:29:04          Yeah. Because the only people that can evaluate what you have there are the people that can already do it themselves.

Rodrigo:                      01:29:09          People that can that can start teasing out what you’re doing and saying, Oh, I got it. I’m good. They’re the other quants. It’s like walking into Teachers. Could you imagine walking into Teachers with your quant model? 20 people in the room? What are they going to do? Invest in you?

Chris:                           01:29:26          I don’t know, what you’re saying. So obviously, Teachers, external manager group, the vast majority don’t invest themselves, and they just invest in managers. We were a very unique team and we would start every conversation just so you know, I run a quant shop internally. And start with that, and I’m here to talk about risk, portfolio construction, thought process because I’ve got your returns. I’ve already correlated against my returns. I see you’re doing something different. I want to think about how you think about model building. But I think it’s an atypical approach. And I think it’s a hard approach. And so I guess it’s hard for investors to invest and they get burned.

Adam:                         01:30:15          Qualify to be able to do that because you built your own internal models. Those who don’t run their internal prop desk, they don’t know what to ask, they don’t know what to look for. Like it’s a catch 22 and I agree. We call it quits all the time. We’re very sympathetic to the bigger picture.

Chris:                           01:30:32          It’s, you won’t stick your finger in that socket over and over again. But you seem to be more comfortable with like, okay, that discretionary guy was no good, but get me the next discretionary guy ready to go, the next one or there’s like, certain, I’m not picking on credit, necessarily, but your credit as an asset class is great because it’s a mixture of stocks, bonds, and vol selling, it’s a lot of betas. There’s not a lot of alpha in credit and stuff. There’s relative value credit you can do, but typically, like if you think of as an asset class, Just as it blows up, everyone loves it the most. It’s like, well okay, we just got smoked in this thing but look how good the spreads are now. And so it’s one of those things where even the S&P 500 people go, oh, it just got killed, but I love it more now.

Jason:                          01:31:16          Like bank stocks in March, right? We can’t all for sure.

Chris:                           01:31:19          Yeah. And so I think on the systematic side, some of these models got too crowded. Some of them got too common, too many people are doing them and I think there might be a rebalancing, where bit by bit, some of the money comes out, and I think they will start to work again. They probably will never be as good as they were when not many people are doing it. But I think at the end of the day, there’s room for new stuff. There’s always new stuff.

Jason:                          01:31:42          So, how big is that new stuff? Like it seems like a lot of investors are using it as a shortcut capacity. They want to find these strategies that have low capacity because they believe that’s where the magic must be, which can make sense because as the intelligence spreads and the weaponry is shared amongst all of the quants out there. We all have lots of weapons and lots of brains. So the only place to go may be these small capacity strategies.

Execution

Chris:                           01:32:13          So my answer that is a little bit of Yes, a little bit of No, you got to be careful. But the question is what small capacity? You can run anything at any size, unless you literally eat up the entire market. But like, what you’re really saying when you’re saying small capacity is your transaction costs at some point or your market impact overcomes your alpha process. And so there’s two answers to that. And the first one is, well, where do you have market impact or high transaction costs,? A lot of small capacity is either very illiquid or EM, or on the less you got some guys who just trend following pretty illiquid and pretty small stuff. The challenge with that is that you’re trading your cost of trade is significantly higher. And so you’ve just got to make sure the pressure that moves away from a signal or moves, it moves in addition to a signal to really talk much execution. And it’s like this by the way execution I can go on for hours but I’m just to give like a quick…execution is extraordinarily important for everyone.

                                                            And the discretionary guys don’t, they typically don’t intuit it. And I’m going to take a one minute story, we had a hedge fund manager, who had all these say like 1000 different alpha managers used to making stock picks. And these stocks picks were like six months to one year hold, they’re not high turnover, they’re not really like massively diversified portfolios like five to 10 games, and you’re just doing a very concentrated process. And they asked them, first of all, none of them really thought transaction costs matter that much for them. And the answer is, well, why? And they said, what do you think you’d make for trade? And the answer was between all 1000, the lowest was 400 basis points, 4%. And the highest was, I think, a thousand basis points around 10%. The expectation is if you’re making between four and 10% portrayed on expectation, you’re not buying Microsoft with the expectation of making two basis points. What does it matter if I trade for 15 basis points or 25 basis points in cash equity. It doesn’t. Because I’m making 10,000, I’m making so much. And the answer is when they went through this entire set.

And by the way, for this number to even be positive, it means that you’ve got alpha, at the very, very least. But like across all them, the answer was 51 basis points. And because there’s this massive intuitive flaw in what they’re doing, because they’re like, how much do I expect to make if I get it right, without realising their hit rate is like 51, or 52%. Of course, they can have the trades wrong. It doesn’t mean that you ride it all the way down. But if you don’t, if you stop it out early, it means that you actually have more losers than winners. But like long story short, if you have like a 52% hit rate, and you make 400 on the upside, but it it’s 400 to the downside, you’re not even 50 basis points in that story. And so then, is it 15 or 25? Is like oh, my God, that’s a quarter or half of my alpha. And so, does it matter? It absolutely matters. And it matters for long term hold discretionary guys and does it matter for systematic guys? It matters way more. And so which is why we talked about this in the past, you have to demonstrate strong signals and strong processes. Independence and portfolio construction risk. And you also have to demonstrate, or you have to focus and pay attention on execution. And I think execution typically means it doesn’t mean because you can spend a billion dollars a year, more and more on execute, or you’re not making that number up, because like there’s high frequency shops that you can spend enormous amounts, you don’t have to, I think the key is to not be the worst. Not be the fish that’s constantly getting killed, your job is to just kind of do okay, but it’s a hard world because you’re up against the smartest, the best resource, the richest people on the planet when you’re going into execution land. And that is a very significant and very important focus. And so I would just say, the problem with just to come full circle, the problem with those low capacity trades, what you’re really saying is expensive or hard to trade trades. Or you’re trying to run into a size where it becomes expensive how you’re trying to go. Maybe, but you’ve got to be super careful your back tests in that world and you’ve got to be like really, really properly, not going near the top end of those capacity because you’ll start to push it. You can really start to get yourself into trouble.

And then you’ve got to hope that there’s no other people also going into the same time as you in a similar manner. And that’s obviously the quant’s real challenge is, well let’s say it’s once again it’s a prisoner’s dilemma. For me the right thing to do is to run this thing and $500 million of assets because above that it starts to degrade risk. And then some of the gorilla comes in and runs at a 2 billion and kills it for both of you like well, I guess I should have taken it while I could have because at the end of the day, it doesn’t do me any good to be the good corporate citizen when someone else was going to come eat it all. And of course that leads to a very quick destruction of the comments and so that’s ultimately, it’s very hard to know that it’s being that thing that you found that isn’t also being overrun.

Rodrigo:                      01:36:42          So gents, you guys can stay, my wife just called me three times so clearly I’m needed to have further drinks with the neighbors. But-

Chris:                           01:36:53          Conversation

Rodrigo:                      01:36:57          I made promises man. We’ve done a five on average. And I told her Schindler was on the call. So it’s gonna be probably another half an hour and now going into 40 minutes.

Chris:                           01:37:08          Done. Excellent.

Adam:                         01:37:10          I think it’s great because we spent all this time talking about all the ways that you’re not going to hit 5%. So, there’s a whole other podcast on how you can actually-

Rodrigo:                      01:37:21          No. We spent the way to do it is to go out to do things that nobody else is doing.

Adam:                         01:37:25          For sure you’re right, go find the stuff that we can’t tell you about. That we can’t describe to you but where you’ve got smooth operators that you can trust.

Rodrigo:                      01:37:36          Or buy gold.

Adam:                         01:37:38          That’s right.

Chris:                           01:37:39          A lot of gold.

Mike:                           01:37:40          20% Gold and zero percent allocation.

Adam:                         01:37:44          You just gave Philip like 20 more minutes of conversation.

Mike:                           01:37:48          Yeah. I think we should zero out our S&P allocation that should always be zero. Your optimization for next 15 years should just zero out the S&P in the NASDAQ and put it towards gold, you’d be fine. We’re kidding. We’re just kidding.

Adam:                         01:38:07          All the S&P goes straight up for the next like what?

Mike:                           01:38:09          100% could happen yeah.

Chris:                           01:38:12          So it’s a tricky world, this is ultimately why portfolio construction is this and this and this not or like I … because I think that gives you the best fighting chance of because you don’t know. Portfolio construction is about giving yourself as many ways to win and giving yourself the least number of ways to lose. I think that’s the end of the day. And that’s what you guys are focusing on is what happens the thing you don’t expect to have happen happens. Do I have something in my portfolio that does okay in that world, and that’s the thing you know, if you come full circle, that’s ultimately what you’re trying to do at the at the aggregate level. And alpha’s hard.

Rodrigo:                      01:38:49         Amen.

Mike:                           01:38:50          Stealin’ lunch man. Tough game.

Chris:                           01:38:55          All right, good luck to the CIOs.

Rodrigo:                      01:38:58          We’ll have more. We’ll have more online for them as we go along. We’ll have you back again in about six months?

Adam:                         01:39:02          That’s right. That was wonderful as usual, thanks a lot for sticking with us for an hour and 40 minutes.

Chris:                           01:39:09          Two people left

Adam:                         01:39:14          Enjoy your weekend.

Jason:                          01:39:15          Good weekend.

Mike:                           01:39:15          See yah.