Episode Transcript
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SPEAKER_01 (00:00):
All we have to do is
go back to the 1970s.
That that's probably the closestanalog to what we've already
experienced so far in the lastfew years.
The Fed was raising rates, butthey were behind inflation.
So nominal rates went up a lot.
During that decade, you know,the stock market underperformed
cash for 10 years.
Um, and it wasn't a straightline.
SPEAKER_00 (00:32):
I'm your host,
Melanie Schaefer.
Welcome to Lead Lag Live.
Now, the the U.S.
government is officially inshutdown mode after Congress
failed to pass new fundinglegislation, which has many
investors treading cautiously.
My guest today is Alex Shahidi,managing partner and co-chief
investment officer at EvokeAdvisors.
(00:52):
Alex is the co-architect behindthe RPAR risk parity approach,
and he brings deep insight intohow we manage risk, growth, and
portfolio construction,especially in volatile markets.
Alex, thank you so much forbeing here.
Thanks for having me.
So let's begin withdiversification.
There's been a lot of talk thisyear about how well
(01:15):
diversification works.
How do you personally approachthe concept of uh
diversification in yourportfolio management framework?
SPEAKER_01 (01:24):
Uh the the way I
think about it is uh from a high
level, the future is alwaysuncertain.
Uh we, we it's, you know,there's periods where it's more
uncertain.
And I think now is one of thoseperiods.
You know, you we really have noidea where inflation is going to
go.
We don't really know wheregrowth is going to go.
Everybody has an opinion, but inreality, nobody really knows.
(01:46):
Um, and and so I think of in anenvironment like that, it makes
sense to be well diversified.
Um, and the way I think aboutdiversification, to answer your
question more directly, is uh ifyou take a look at asset classes
and what really drives ourreturns through time, the the
two big forces are growth andinflation.
And more specifically, it's howgrowth and inflation transpire
(02:09):
versus what was expected.
And in other words, it's thesurprises that matter.
And that is a hard thing tofigure out which way growth and
inflation are going to gorelative to what's discounted.
Uh, because you you not onlyhave to guess correctly, but
your guess has to be differentfrom the consensus, which is
what's already reflected in theprice.
And and we all know the oldadage, diversification is the
(02:30):
one free lunch and investing,and don't put all your eggs in
one basket.
Yet when you look acrossportfolios, given you know the
great uncertainty that Idescribed, and you look at how
most people invested, they'revery concentrated.
Uh, most portfolios own a lot ofstocks.
They own a lot of U.S.
stocks, and even the US stocksare highly concentrated within
just a few names, all of whichabout compete with one another.
(02:52):
So uh, so there's a like a bigdisconnect between how investors
should think about beingdiversified and what their
portfolios actually look like.
And and again, it goes to justbe diversify across growth and
inflation.
And there's no long-term cost ofdoing that.
You can just own assets that dowell in different growth and
inflation environments prettyreliably, and you uh balance the
(03:15):
portfolio across those assetsand then you rebalance, buy low,
sell high programmatically.
It's actually relatively simple.
And and I think that is one ofthe biggest uh oversights of
investors today.
SPEAKER_00 (03:27):
So just to follow up
on this uh a little bit more,
you often point out that justowning the S P 500 isn't enough
for many long-term investors.
Why should long-term investorsconsider options beyond simply
holding uh the S P 500?
SPEAKER_01 (03:41):
Yeah, it's an easier
conversation after a bear market
than it is during the uh thebull market.
And and I think to see thepicture more clearly, you have
to zoom out.
And if we just take the SP 500as you as you referenced, uh,
you know, you go back about 100years and you've basically had
about three really stronglong-term bull markets and about
(04:02):
three long-term bear markets.
And think of it as it goes upsignificantly for 15 to 20
years, and then it's about flatfor 15 to 20 years.
Um, and so here we are 16 yearsin a really strong bull market.
It's averaged about 16% a yearfor 16 years since the GFC lows.
But people forget the priordecade, the SP was negative.
(04:24):
It was actually one of the worstmarkets in the world and
negative, you know,underperforming cash.
And the same thing happened inthe uh mid-60s to early 80s.
Uh the SP underperformed cash asinflation became a problem.
And back in the 30s and 40s, uh,the SP earned zero for 20 years.
Um, so so the big risk if youput all your eggs in one basket,
and and the popular basket todayis the SP because you're on the
(04:47):
tail end of a really strong bullmarket that seems it'll never
end.
Um, uh, and it will at somepoint.
We just don't know when.
But when you see, when you seethose numbers, it's easy to
forget the long-term uh uhtrajectory and and uh cycles of
of this market.
Um and and so that is it becomesmore challenging to talk about
(05:10):
diversification in a in a periodlike that.
There's a recency bias that thatwe all face.
Um and so it that can be a partof your portfolio.
But if it's if you're puttingall your eggs in that basket,
that could be a really riskybasket, especially when you're
you know at valuations where weare and you've had this
long-term trend that uh we allknow is going to reverse at some
point.
SPEAKER_00 (05:29):
Yeah, and you
mentioned inflation, which has
stayed above target for morethan four years.
With that persistence, how doyou think investors should
navigate the continuinguncertainty around inflation and
its impact on portfolios?
SPEAKER_01 (05:40):
Yeah, I think this
is an area that is probably
underappreciated.
Uh, and all we have to do is goback to the 1970s.
That's probably the closestanalog to what we've already
experienced so far in the lastfew years.
Uh, during the decade of the1970s, uh inflation continually
surprised to the upside.
You know, the Fed was raisingrates, but they were behind
(06:02):
inflation.
So nominal rates went up a lot.
Real rates actually fell duringthe decade to give you a sense
of uh the Fed being behindinflation until Volker came in
and uh significantly hiked ratesto kill inflation uh uh
ultimately.
Uh but during that decade, youknow, the stock market
underperformed cash for 10years.
Um and it wasn't a straightline.
(06:23):
And so oftentimes you could bein a bear market and not realize
it until the the period is over.
Uh and bonds underperform cash.
So if you have a portfolio thatis uh heavily invested in stocks
and you can also throw uhnominal bonds in that category,
and we do have inflation uh thatcontinues to surprise us to the
upside, uh then you do riskunderperforming cash for an
(06:47):
extended period of time.
And the simple uh resolution tothat is just own inflation edge
assets, own assets that do wellduring uh inflationary
environments.
In the 70s, gold was up over 30%a year.
Uh commodities did really well.
Uh tips didn't exist, but theywould have done well as real
rates fell, as I as I mentionedearlier.
So owning these assets as partof your diversified portfolio
(07:09):
makes a lot of sense,particularly given the
uncertainty that we face interms of inflation.
SPEAKER_00 (07:14):
Yeah, and just uh,
Alex, I want to go back to sort
of the intro where I mentionedthat you use risk parity, risk
parity framework in your work.
Can you explain how risk paritydiffers from traditional
investment approaches and why itmatters, especially in times
like these?
SPEAKER_01 (07:28):
Um yeah, it's it's
an important question.
So let's start with thetraditional investment approach
and just the investmentframework.
So I think the way most peoplethink about it is uh you have
high-risk, high return stocks,low risk, low return bonds, and
investors allocate betweenstocks and bonds depending on
how much return and risk they'retrying to achieve.
(07:50):
And the longer your time frame,the more stocks you own, and the
more concerned you are aboutrisk, the more bonds you own.
And there's a trade-off betweenreturn and uh risk.
And so that's a typicalframework, which makes a lot of
sense.
But the challenge is that's nota very well-diversified
portfolio.
So the simple math is a moderaterisk portfolio using that
(08:11):
framework is 60-40, um, 60%stocks, 40% bonds.
That portfolio is 98% correlatedto the stock market.
And and the reason that is isbecause you have 60% in
something that's very volatile,40% in something that doesn't
move around very much.
And so the total return isdominated by the overweighted
asset that's also significantlymore volatile than the
(08:32):
underweighted asset.
So that's 98% correlated.
By definition, that can't bediversified.
You can't have a portfoliothat's 98% correlated to the
stock market and consider thatconsider that to be balanced or
diversified.
So that's the traditionalframework, which I believe is
highly flawed.
And the reason it matters isbecause when you're 98%
correlated to the stock market,you're effectively putting all
(08:54):
your eggs in that basketdirectionally.
And if you go through a lostdecade, like we've had multiple
times, as I referenced earlier,then you're probably going to
have a bad outcome.
And that's a big deal.
You know, if you're 50, you wantto retire at 60 or 65, and you
put all your eggs in the stockmarket basket, it may seem like
it's not a huge risk todaybecause you're looking
backwards.
(09:14):
But if you do end up with a lostdecade, then it's a huge risk
looking forwards.
So uh that's a traditionalframework, which I feel is
flawed.
Uh, the risk parity framework uhis just a more balanced
allocation.
Um, rather than just putting allyour eggs in the stock market
basket, you spread it acrossequities, commodities, uh
inflation link bonds, nominalbonds.
(09:37):
And that is, to me, a morerobust allocation, more
resilient through time.
Uh, it should generate moreconsistent returns through time.
Uh, it'll go through badstretches, just like the less
balanced portfolio.
But those bad stretches aren'tgoing to be because of growth or
inflation.
Uh, it'll be because you get amassive tightening like we saw
in 2022.
(09:58):
That's that's your main risk.
But 2008 isn't a huge risk.
Uh the the uh uh the globalfinancial crisis.
Um, you can go back to the 70s,that's not really a big risk.
Uh, even COVID, uh our ETF RPAwas down 4% in the first quarter
when the stock market was downover 20.
So you're not risking growth andinflation surprises.
(10:19):
You can diversify that, but yourmain risk is uh massive monetary
tightening, which doesn't happenas often as those other things.
So to me, that's a more uhrobust framework.
And that's uh especially in intimes like this.
SPEAKER_00 (10:33):
Along those lines,
Alex, what are some common
misconceptions about risk paritythat investors should be aware
of?
And what are the things thatoften trip people up?
SPEAKER_01 (10:41):
Yeah, I think the
the main one is there's just
this view that risk parity isabout leveraging bonds.
And and uh, you know, why wouldyou want to leverage bonds,
especially after they've beennegative for the last five
years?
Um, so I don't think of it thatway.
I think of it as it's just abalanced portfolio.
Um, and and so I think of itthere's there's two steps.
There's pick diverse assetclasses.
(11:04):
So we think of it as equities,commodities, uh tips, and
treasuries.
That's a very simple uh startingpoint.
And you don't have to introduceany leverage to have a risk
parity portfolio.
All you're doing is matching therisk.
And so think of it as equitiesand commodities, including gold,
have more volatility.
Treasuries and tips have lessvolatility.
(11:25):
So to balance, you own more ofthe less risky assets and you
own less of the more riskyassets.
And that effectively balancesyour risk to growth and
inflation outcomes.
Um, and and so you could have anunlevered risk parity portfolio.
You're just pairing the risk andyou're owning more of the less
volatile assets.
And that is a balanced startingpoint.
(11:46):
Then from there, you can say,well, I have a balanced
portfolio of assets.
I expect these assets to beatcash over time.
They won't beat it every year,but they they should beat it
over time.
That's why capitalism works.
And so you could effectivelylever that entire portfolio.
And if you do it through the useof futures, which is what we do,
your cost of financing iseffectively cash.
(12:08):
So think of it as an unleveredrisk parity portfolio.
You can lever that a little bitto have a levered risk parity
portfolio where you'reeffectively levering the whole
portfolio.
And that should beat anunlevered risk parity portfolio
over time, assuming balanced mixof assets beats cash.
And then you can lever that atdifferent degrees.
Um and the more leverage youintroduce, the more volatility,
(12:29):
same sharp ratio.
It's the same uh uh exposure,just more leverage.
And as long as a balanced mix ofassets beats cash, then that
portfolio outperforms over time.
Um, and and that is just a morediverse allocation than the 6040
or uh an equities uh centeredportfolio.
So I think that's uh that'sprobably the biggest
(12:49):
misconception, just reallyunderstanding it's all it is is
just a balanced allocation.
SPEAKER_00 (12:53):
So, Alex, for
investors who have been
following on and who aremotivated to improve
diversification, what are somepractical first steps that they
could take to strengthen theirportfolios in the beginning
without overcomplicating theirstrategies?
SPEAKER_01 (13:06):
Yeah, the the main
thing is just own, start adding
diverse assets.
So you can add things like goldor commodities or uh uh tips,
treasuries.
Tips and treasuries have beennegative the last five years.
That's the highest yield they'vehad in about 15 years today.
Um, and those tend to do wellwhen you get an economic
downturn.
(13:27):
And, you know, nobody isexpecting an economic downturn
today.
That's usually the case.
Usually those downturns aresurprise.
Uh, and typically what happensis you get a fall in rates and
those assets tend to do well.
Uh so start adding more of thoseassets and have less equity
concentration.
Uh, a very simple way to do allof that is uh through our ETFs,
(13:48):
RPAR and UPAR, um, that are uhrisk parity ETFs.
Uh RPAR has a little bit ofleverage, 20% of leverage.
UPAR is 1.4 X RPAR, so it's alittle bit more leverage, same
exposure.
And so if you imagine you have a60-40 portfolio, you want to
take one step towards being morediversified.
You could own a little bit ofRPAR or UPAR, depending on your
(14:09):
risk appetite, and take awayfrom stocks and moms or wherever
else you own, and you take an uhone more step towards a more
diverse allocation.
And the and the more you do, themore diversified you are.
So I think those are easy stepsthat investors could consider.
SPEAKER_00 (14:23):
Alex, just but uh uh
before we wrap up, where can
investors go to find more aboutyour research and to connect
with you uh directly?
SPEAKER_01 (14:30):
Uh sure.
Uh so our website for the ETFsis RP uh it's uh rparetf.com,
rparetf.com.
Um, there's a lot of informationabout both those ETFs, RPAR and
UPAR.
Uh and then our advisory site isevokeadvisors.com.
Um I write white papers, uh uh Ihave a weekly podcast that we
(14:53):
post there as well.
Uh so those are some places uhuh investors and advisors can go
to.
SPEAKER_00 (14:58):
Fantastic.
Well, Alex, thank you so muchfor joining me.
And thanks to everyone forwatching.
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