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Episode Transcript
Available transcripts are automatically generated. Complete accuracy is not guaranteed.
Speaker 1 (00:00):
Since most people will baseline against the S&P.
You know, and valuations becomesort of somewhat of an anchor
that when valuations are verystretched for some prolonged
period of time, diversificationreally starts to kick in, Like,
I mean, the benefits of it, thealpha that comes from it.
Speaker 2 (00:20):
I think that's right.
But again, the inflection pointis hard to know.
So stretch valuations can getmore stretched.
They can last longer than thepatience of most investors.
So you can use it as a precisepoint of inflection.
But generally speaking, if youjust looked at the valuation of
the stock market and I'll usethe US stock market as an
(00:42):
example here and you'reprojecting 10-year returns, it's
a and you're projecting 10-yearreturns.
It's a pretty good predictor of10-year returns.
When valuations are high,10-year forward returns are low
and vice versa.
But it's a very poor predictorof one-year returns or probably
even three-year returns.
Speaker 1 (01:06):
I have not had a chance to breathe, but I'm going
to take in a lot of things thatAlex Sheedy has to say here
during this conversation, sowe'll have a good back and forth
.
Looking forward to this, giventhat markets are confusing, I
think, for a lot of people and,with geopolitics now back at the
forefront, I'm sure there'ssome interesting things we're
going to talk about here.
Let's get right into it.
My name is Michael Guyatt,publisher of the Lead Lag Board.
(01:28):
This is a sponsoredconversation by Evoke Advisors,
one of our clients at Lead LagMedia, the man himself, mr Alex
Shahidi, who I've interviewed afew times over the last several
months.
Let's talk aboutdiversification, because it does
seem like we might be in a bullmarket for diversification.
Finally, for a lot of reasons,but I want to get into just kind
(01:48):
of in here now because it'srelevant to the headlines how do
you think about asset classperformance, dispersion of
returns, diversification broadly, when you're in an environment
where there's a risk of broader?
Speaker 2 (02:04):
war.
Well, there's a risk of a lotof things.
So I think the high levelthoughts on it is we're in
highly uncertain times andthere's a wide range of
potential outcomes, both growthoutcomes, inflation outcomes,
geopolitical outcomes, and alsothe risk of extreme outcomes is
(02:24):
probably greater than it's beenin a long time.
So all of that, I think, speakswell to an environment where it
makes sense and is prudent tobe well diversified, in other
words, own things that do wellin different environments, so
that you don't have to guesscorrectly what environment's
going to actually transpire andthe idea there is.
(02:44):
Don't take huge bets in anydirection because it's highly
uncertain which way we're goingto go, and I think, generally
speaking, it's always good to bediversified.
You talked about the bull marketand diversification.
I don't know if there's such athing.
To be honest, I think you knowI wrote an article last year
called the bear marketDiversification, where
(03:05):
diversification didn't do youmuch good for a long time about
a decade or longer and that'swhen the S&P did well and just
about everything else did poorly.
That's pretty unusual.
Most of the time,diversification doesn't get you
the best returns, but it getsyou stable returns and resilient
returns through time and, as weknow, the key to investing and
the way you make money over timeis to stay invested and stay
(03:27):
diversified so you can benefitfrom compounding.
And I think we're justbasically going back to those
core principles and in anenvironment like this, it just
makes a lot of sense to spreadyour risk across a lot of
different things.
Speaker 1 (03:40):
I guess, is it a bull market in diversification or a
bear market in FOMO?
Fear of missing out, right,Because you can argue that the
reason people don't diversify isbecause of that fear of missing
out.
They see some asset classrunning away from them, some
stock, and that makes themconcentrate, yeah.
Speaker 2 (03:53):
I think that's exactly right and it's the same
dynamic we saw in the late 90sand it's a common dynamic during
the late stages of a bullmarket.
I mean, I don't know if we'reat the late stages today,
probably, but you don't know,you won't know for years.
But that's typical.
When you're looking, we can'tsee future returns, we can only
see past returns.
So when you're lookingbackwards and you see certain
(04:16):
asset classes doing really welland let's say you exercise
patience and you say you knowwhat, I know this is going to
turn, and then you don't buy,and then it keeps going, and
then it keeps going and it keepsgoing.
Eventually you get pulled in,along with most other people,
because we're all human and wehave these emotional biases.
Then you start going in andthen maybe it pays off.
(04:39):
For a while it reinforces thatresponse to FOMO and then you
get to a point where markets areoverbought and then you get the
cycle reversing.
And you could just look athistory, particularly in US
stocks.
We can see these cycles persistand they take a long time long
bull markets, long bear markets.
We've had a bull market for 16years.
(05:01):
The prior bear market was abouta decade.
Speaker 1 (05:03):
The S&P was negative and these kind of alternate and
you just never know when thatinflection point is, but you
could see some signs that maybewe're near there today Is there
anything in your research thatsuggests that, since most people
will baseline against the S&P,you know and valuations become
somewhat of an anchor that whenvaluations are very stretched
(05:28):
for some prolonged period oftime, diversification really
starts to kick in.
I mean the benefits of it, thealpha that comes from it.
Speaker 2 (05:37):
I think that's right.
But again, the inflection pointis hard to know.
So stretch valuations can getmore stretch.
They can last longer than thepatience of most investors.
So you can use it as a precisepoint of inflection.
But generally speaking, if youjust looked at the valuation of
the stock market and I'll usethe US stock market as an
(06:00):
example here and you'reprojecting 10-year returns, it's
a pretty good predictor of10-year returns when valuations
are high.
10-year returns it's a prettygood predictor of 10-year
returns when valuations are high.
10-year forward returns are lowand vice versa.
But it's a very poor predictorof one-year returns or probably
even three-year returns.
But again, when you look at thecharts, it looks very obvious,
(06:20):
right?
Every bull market started withlow valuations and ended with
high valuations.
And every bear market startedwith low valuations and ended
with high valuations.
And every bear market startedwith high valuations and ended
with low valuations.
And the chart is very clean.
But again, you just don't knowwhen you're going through that
inflection point, until yearslater, when it's obvious that
the high was a year ago, twoyears ago, five years ago.
(06:41):
Then it starts to become moreobvious.
Speaker 1 (06:43):
I know we've talked about this before, but I do
think we should framediversification properly for the
audience.
People think 60-40,.
They think stocks, bonds, theythink maybe throw some
commodities.
They don't even think about howto weight things.
How would you definediversification in its purest
form?
Speaker 2 (07:01):
It's a really important question because just
in my experience 26 years in theindustry I feel like most
people don't really fullyappreciate what diversification
is.
And I'll give you a quick story.
So this was probably 10 or 15years ago.
I was having lunch with aretired portfolio manager who
was managing a quote unquotebalanced fund and it was a 60-40
(07:26):
strategy and he was activelymanaging around 60-40.
And he'd had a strong career,did really well for his
investors and he'd recentlyretired.
And at lunch I asked him I saidI have a very simple question
for you.
Why do you call it a balancedfund if it's not balanced?
And he said what do you mean?
It's not balanced?
Of course everybody knows 60-40is balanced.
And I said it can't be balanced.
And he said what do you mean?
It's not balanced?
Of course everybody knows 60-40is balanced.
(07:46):
And I said it can't be balanced.
I said 60-40 is about 98%correlated to 100% stock
portfolio.
And he said well, that can't beright.
You have 60% of one asset, youhave 40% of another asset and
the two, on average, have zerocorrelation to each other.
So the correlation of 60-40can't be almost 100% to one of
those assets.
It just conceptually doesn'tmake sense and he was missing a
(08:09):
very simple concept and I thinka lot of people miss because
it's not that widely discussed.
The 60 is a lot more volatilethan the 40 is, and so you're
overweighting the more volatileasset.
It might be three or four timesas volatile.
So the direction of yourportfolio is almost 100%
dependent on how the 60 does,not the 40.
The 40 doesn't really doanything.
(08:30):
It just dilutes the ups and thedowns.
It just reduces the volatility.
It doesn't have much to do withthe direction of the portfolio,
and correlation is all aboutdirection.
So 60-40 is almost 100%correlated to 100% stocks.
That can't by definition.
The math says that is notdiversified.
You can't be diversified ifyou're basically putting all
(08:51):
your eggs in one basket.
The first rule of investingdon't put all your eggs in one
basket.
Most people violate that.
60-40 violates that, and that'sgenerally considered a balanced
portfolio.
So right there, that tells youthat the market as a whole
doesn't really appreciate whatdiversification is.
So then you take a step backand then how do you diversify
(09:11):
then?
And it goes to what I saidearlier own assets that do well
in different environments sothat you're not overly
influenced by how theenvironment transpires and more
specifically, I think of it interms of growth and inflation.
Those are the factors the Fedtries to manage reasonable
growth, reasonable inflation.
(09:32):
But about half the timeinflation surprises the upside
and half the time to thedownside.
And same thing with growth it'srelative to what the market's
discounting.
The surprises are what matterand different asset classes
behave differently based on howgrowth and inflation transpire.
So own assets that do well indifferent growth and inflation
environments.
It's a very simple concept 60-40has no inflation hedges.
(09:54):
Inflation is all of a sudden aproblem the first time since the
early 80s and most people ownvery few inflation hedges.
A balanced portfolio shouldhave about half of its exposure
to inflation hedge assets, whichare commodities, tips, gold,
potentially real estate, otherassets.
So if you diversify across allthose assets, then you're
(10:16):
effectively reducing the risk ofgrowth and inflation
meaningfully impacting yourreturns.
And then you can also go intoalternatives.
There's all these other things.
You can own all these returnstreams that are truly diverse
and then you balance them basedon their volatilities, meaning
assets that are more volatileyou own less of and the assets
that are less volatile you ownmore of, so that the risk
(10:37):
contribution is roughly equalacross different growth and
inflation environments andconceptually that's a much more
diversified portfolio.
You can look at the history.
You can see that portfolio is alot more resilient during
periods like COVID or 2008global financial crisis.
The decade of the 2000s was alost decade for US stocks.
(10:57):
It was a great decade foralmost every other asset.
If you were diversified, youdid great.
The 70s was the same thing.
Us stocks and bondsunderperformed cash during that
decade as inflation surprised tothe upside for a decade.
If you were diversified, youactually had your best decade in
the last 50 years.
So I think there's a lot oflessons to be learned by
studying history and justunderstanding conceptually how
(11:19):
to build a diversified portfolio.
Speaker 1 (11:20):
Do you think people overcomplicate things, like
they're thinking too much aboutthis or that individual security
stock versus?
These are the asset classeswhich move the most differently
to each other.
Speaker 2 (11:33):
For sure, and I think the media has a lot to do with
it.
I think us being humans has alot to do with it.
It's not very exciting to say,look, I'm going to build a
diversified portfolio, I'm justgoing to set it and forget it,
and I'm not going to payattention to the news.
I'm not going to pay attentionto that voice in my head that
says I knew that was going tohappen or I know this is going
(11:53):
to happen.
But if you remove all of thatand you just look at the data,
diversification is the one freelunch in investing.
We learned that in investing101.
And most people don't takeadvantage of that free lunch.
So over time, if you're superdiversified, you get a higher
return to risk ratio and overtime that wins Now over shorter
(12:16):
times, and shorter could be oneyear, three years, five years, a
decade.
That doesn't feel short, but ininvesting terms it is short.
In the rest of the world it's avery long period of time.
That's one of the challenges.
So you have to be able towithstand those long periods and
to do that you basically haveto avoid everything you see on
TV, what you read about in thenews, your emotional impulses,
(12:40):
and that's really hard to do.
So the concept ofdiversification, I think, is
simple.
Understanding how to build adiversified portfolio isn't that
difficult, but actuallyimplementing it in practice is
hard, because you have toexercise patience and a deep
understanding of the benefits ofstaying on that.
Slow and steady wins the racepath and I think that's
(13:02):
basically the hard part.
So I just spent a lot of timeeducating people and trying to
share those perspectives,especially during bull markets.
During bear markets, it's easy.
You know the conversations arein.
Bear markets are very simplebecause you know our clients are
doing well.
They're, you know, roughlysteady and that's easy.
But during the bull markets,fomo sets in and,
(13:23):
counterintuitively, those aremuch more difficult to withstand
.
Speaker 1 (13:26):
Of course that's not to say that somebody shouldn't
feel comfortable tilting one wayor another.
Right, Just have more of a core.
That's a true diversified mix.
Speaker 2 (13:34):
Yeah, and I think the other way to think about it is
if you focus on the alpha, youknow, trying to add value, that
is a very tough game.
You know, on average alpha zero, after fees, after taxes, it's
negative.
So if you're average at that,you'll lose.
If you're above average, maybeyou break even.
If you're exceptional, maybeyou make a little bit, but it's
(13:56):
a very tough game.
So if you're focusing all youreffort and energy on trying to
do that, the odds are stackedagainst you.
It's it's just the odds arestacked against you.
It's doable, but the odds arestacked against you.
If you focus on beingdiversified, then the odds are
in your favor and that wins overtime.
So it is a little.
(14:17):
To me it doesn't make much senseto focus all your effort on
being and trying to add value.
Yet your starting point is nota well-diversified portfolio.
The simplest way to think aboutit is if you had no views about
the future, if you were kind ofneutral on everything, what
would your allocation look like?
What's your neutral portfoliomix?
That starting point should bevery efficiently allocated.
(14:39):
So it should be reallywell-diversified.
That free lunch and investinghigher return to risk ratio.
So if that's your starting point.
Then you can try to tilt fromthere based on your views.
But one of my golden rules isdiversification always trumps
conviction, because you have tohave greater confidence that
diversification adds value overtime than your conviction on any
(15:01):
single trade or any single viewof the markets, because it's
just a tough game, that's justthe math.
So it's a little off to focusall your time on trying to add
value, but your starting pointis completely off, and so that's
part of the point of thisdiscussion is to re-examine what
that starting point is.
And, going back to the firstquestion you asked, this is
(15:22):
probably a very good time to dothat, because diversification is
probably more important todaythan it's been for decades.
Speaker 1 (15:30):
And perhaps today is the least prevalent portfolio.
Right yeah, let's face it, it'sbeen an environment of like
nothing but S&P, nasdaq up andto the right needs anything else
just passive equities?
Speaker 2 (15:44):
Yeah, I think that's right.
I think if you were to ask mostprudent investors, is this an
environment you'd rather be morediversified or less diversified
?
I think most people would sayit's a crazy world.
I want to be more diversified.
But if you look at theirportfolio, it's probably less
diversified today than it was 10years ago, and so most
(16:04):
portfolios have more stocks thanthey did 10 years ago.
They have more US stocks andthe US stocks are more
concentrated within them withthe max seven and tech exposure,
and so that is a byproduct ofwhat's worked well looking
backwards.
And so you've had US stockssignificantly outperform just
about everything else otherstocks as well as other asset
(16:27):
classes and as a result, theybecome overweighted.
And then there's some challenge, because these stocks go up a
lot.
If you sell them, you have topay taxes, if you're a taxable
investor, so you hold on andholding on has benefited you.
So you keep doing that untilyou get to a point where you're
completely out of balance, and Iremember it used to be 60-40
was considered a neutralportfolio.
(16:49):
Now it's 70-30.
All of a sudden it's shiftedbecause US stocks have done so
well.
But that is not awell-diversified portfolio and
we all know there are marketcycles and one of the lessons in
history if you go back and youlook at the market leaders of
each decade over the last 100years, they're constantly
changing.
The market leaders are notpersistent.
(17:10):
Competition comes in,valuations get high, there's
over-optimism in the price,there's cycles and cycles
persist because people overpayfor great stories and maybe
today's giants will continuelonger than past giants, but the
(17:32):
odds are stacked against them.
If you just studied the data,so you're right.
There's probably much lessdiversification today and then.
So I talked about the allocation, but also the inflation hedging
component I think is importantto bring up.
We haven't had inflationproblems for decades and finally
, inflation is a problem.
We had a spike post-COVID.
It kind of came down.
(17:52):
It was transitory, it just tooka couple of years, not a couple
of months, but still it'shigher than our comfort level
and that has meaningfulimplications on the Fed's
reaction function.
It has meaningful implicationson people's spending, on
investor psychology.
It's a very different worldwhen inflation is elevated and
(18:14):
not coming down than what we'veexperienced the last few decades
.
So you could definitely see theenvironment shifting.
Speaker 1 (18:21):
If that persists, all right elevated and not coming
down than what we've experiencedthe last few decades, so you
could definitely see theenvironment shifting if that
persists, all right.
So let's talk about thosediversifying asset classes,
right, and in the context ofthis thing called risk parity,
so I think of risk parity asthere's.
Speaker 2 (18:32):
I think of it as two steps and I, you know,
personally I just don't love thename because I think it has a
bad reputation, because I don'tthink it's that well
misunderstood.
I've written two books.
One of them is called RiskParity, just because it's such a
popular concept in terms of thename.
But I think of it as a balancedportfolio and I think of it as
(18:54):
there's two steps.
The first step is pick diverseasset classes and then the
second step is how do youstructure those asset classes?
And that's a very distinct step.
So step one which asset classes?
And I think it goes back towhat I said earlier growth and
inflation are the big drivers ofasset class returns through
time own assets that do well indifferent growth and inflation
(19:14):
environments.
So I think of it as globalequities commodities, which
includes commodity producerstocks.
I prefer that over commodityfutures because commodity
producer stocks have a higherexpected return, higher
historical return.
There's a risk premium thereand their price is heavily
influenced by the commodityprice and it's also more tax
(19:38):
efficient.
And then gold, as a part ofthat commodity basket, which is
a very different commodity thanall the other commodities, it
tends to do well when growth isfalling.
So in Q1 2020, when COVID hit,commodities got crushed and gold
was up.
Same thing happened in 2008.
Gold was up and all the othercommodities fell.
So global equities thatcommodity basket of commodity
(20:00):
stocks plus gold, and then tipsand treasuries, tend to do well
in different inflationenvironments.
So tips are better wheninflation is rising, treasuries
better when inflation is falling, and so those two are good
diversifies to each other.
They both do well when growthis falling and commodities and
(20:20):
equities do well when growth isrising.
So between those four buckets,you can basically cover all the
different growth and inflationenvironments.
So that's step one pick diverseasset classes.
You're already ahead of mostpeople.
If you just pick those assetclasses, the weighting is really
important, which is step twopeople, if you just pick those
asset classes, the weighting isreally important, which is step
(20:41):
two.
So I mentioned earlier you wantto overweight less volatile
assets, underweight morevolatile assets.
So the challenge that comes tomind is most people think of
equities as where returns comefrom.
All the other asset classes aregood diversifiers, but they
lower return.
They have a lower expectedreturn than equities, so there's
a trade-off.
If you want more return, youwant more equities.
(21:02):
If you want more risk control,you own less equities and all
the other diversifiers.
So you don't have to do it thatway.
You can actually structure eachof these other asset classes,
these diversifiers, in a waywhere their expected return and
risk are similar to equities.
And so that sounds a littlecounterintuitive because it's
(21:22):
not what we were taught inbusiness school, but it's
actually not that difficult todo.
So I'll walk through each.
With commodities I mentionedearlier commodity producer
stocks plus gold.
That basket of commodities hasa similar historical and
expected return as equities,similar risk.
They have a similar Sharperatio, and so you could quickly
(21:45):
go from just equities to getreturns to commodities and gold
plus equities to have similarreturns.
And all of a sudden, you'remore diversified.
Those two asset classes were upin 2022 when equities were down
a lot.
They were up a lot in the 70s.
(22:06):
In the 2000s, they were up alot.
So right there, you increasediversification and haven't
given up on returns, tips andtreasuries.
Most people think of that as lowrisk, low return assets, but
what's interesting is theirreturn to risk ratio is similar
to equities over the long term.
So all you have to do is raisethe risk and mathematically you
raise the return.
And there's two ways to raisethe risk.
One is longer duration.
(22:27):
So longer duration treasuries,longer duration tips, have a
higher expected return and morerisk than shorter duration.
And then you apply a little bitof leverage and you can get the
same return out of those assetsas you do equities.
So if you go back a hundredyears and look at the S&P 500
and look at long datedtreasuries with a little bit of
leverage and over a hundredyears, they have about the same
(22:47):
return.
And so that is reallyinteresting because it's very
counterintuitive.
It's not something we weretaught.
So now you've got four diverseasset classes were taught.
So now you've got four diverseasset classes.
You match the risk that's wherethe risk parity part comes in
and you structure them the way Idescribed and you put it all
together and now you've got anequity-like expected return with
(23:08):
less risk than equities,because it's more diversified
than equities.
And that's a very simplestructure.
It's passive, you don't have topredict the future, it's more
diversified and it's, to me, amore reasonable starting point
for your allocation.
Speaker 1 (23:22):
And the nice thing is that you have a fund that does
just this with our part.
Let's talk about the history ofthat fund, the sort of
reception, the environment it'sbeen in, just kind of riff on
the vehicle.
Speaker 2 (23:31):
Sure, yes.
So this concept has been aroundfor a long time, for decades,
and about six years ago wefigured out it made sense to
create an ETF that didn't exist,to take advantage of these
concepts inside of a singlevehicle.
It also gives you some taxefficiencies, and one of the tax
(23:53):
efficiencies is when you ownmultiple asset classes, it's
important to rebalance acrossthem.
And if you think about it, ifyou have, let's say, four asset
classes equities, commodity,that commodity basket, tips and
treasuries and if you'vestructured them in a way where,
over time, they have similarreturn and risk and you
regularly rebalance, it's aprogrammatic way to buy low,
(24:16):
sell high.
So when something'soutperformed you sell a little
bit, when something'sunderperformed, you buy a little
bit and over time.
If you do that, you should beable to add some returns to your
total portfolio, because you'rerepeatedly buying low, selling
high and most people, as we know, do the opposite and if you do
it inside of an ETF wrapper, youcan effectively postpone the
capital gains associated withselling high until you sell the
(24:38):
ETF.
So, from a conceptualstandpoint, it's a very
efficient way to not only have abalanced portfolio but to do it
very tax efficiently.
And if you think about publicmarkets, they're relatively
efficient.
There's a lot of players inthat market.
It's hard to add value, unlikeprivate markets where it's
easier to add value.
So public markets is relativelyefficient.
So there you focus on low fees,low taxes, high diversification
(25:02):
and most people are activelymanaging public markets.
So their fees are higher, theirtaxes are higher and their
diversification is lower.
So the ETF RPAR risk-paired ETFR-P-A-R is a symbol, is
effectively a way to get lowerfees, lower taxes and high
diversification with a singlevehicle.
(25:23):
And the way we think about itis as a tool in your toolkit to
manage a portfolio and the morebalanced you want to be, the
more of that you own and you caninclude it as maybe part of
your liquid alternatives and youhave a portfolio let's say it's
even 60-40.
And you want to take a steptowards being a more balanced
allocation.
You could do 55-35-10 and 10 inRPAR and now you're raising the
(25:49):
expected return because you'reswapping some stocks and bonds
for something that has a similarexpected return as equities,
maybe even a little bit more,because of that rebalancing
benefit that I described.
So expected return goes up,diversification improves and
it's more tax efficient than a60-40 is because it's all inside
of that ETF wrapper.
(26:10):
So I think of it as a tool toget more diversified and to
improve some of those otherareas.
Now you also asked how has itdone?
So?
It's interesting.
So its return is dependent onthe asset class returns because
it's not actively trading.
It's a passive exposure to abalanced mix of asset classes
(26:31):
and it rebalances back to thatbalanced mix.
So since we started in December2019, right before COVID it got
off to a really strong start.
So 2020 hit.
Covid was the issue.
The economy collapsed in Q1 of2020.
The stock market was down 21%.
(26:51):
Our part was down 4%, and it'sbecause stocks and commodities
got crushed in Q1 of 2020.
Gold, tips and treasuries werein a bull market and that netted
out to minus four and then itfinished the year up almost 20%.
So really strong start.
The assets really grew fast.
As we know, people chasereturns and it was off to a
(27:15):
fantastic start.
2021, it had average returns.
It was up about 7.5%.
So nothing special there andthat's because you had asset
classes perform kind of onaverage.
I think gold was actually downat that time.
Treasuries were down a littlebit.
Tips did well.
That's when inflation started tofirst become a problem Big
(27:36):
diversions between tips andtreasuries, as you would expect.
Then 2022 happened, and that isthe perfect storm.
So what happened in 2022 wasthe Fed all of a sudden raised
interest rates from zero to 5%and the market started to
discount a massive increase ininterest rates.
So that is effectively theworst type of environment you
(27:57):
can experience for a diversifiedportfolio, because it's hard to
diversify against cash all of asudden going from zero to 5%.
We saw the same thing in theearly 80s when Paul Volcker came
in and rapidly hiked interestrates.
That is really hard todiversify against and it's
because it's not growth andinflation that are the big
driver of returns, it's cash allof a sudden becoming much more
(28:18):
attractive.
And as an investor, youbasically have one choice you
can hold cash or you have twochoices you can hold cash and
get the risk-free return, or youcan invest in risky asset
classes and earn the riskpremium that comes from taking
risks in those asset classes.
I think it makes more sense tobe diversified across those
asset classes than be lessdiversified.
(28:40):
That's the whole context of ourconversation.
But basically you have thatchoice Take no risk or take risk
, and you can take riskefficiently or inefficiently.
Now, when cash is earning zero,then a balanced portfolio might
have an expected return of 5%or 6%.
Let's say cash plus 5% or 6%.
That's what equity risk premiumhas been for 100 years.
(29:01):
It's cash plus 5% or 6%.
So when cash goes from zero tofive all of a sudden very
quickly, earning five or six outof risky assets is not worth it
anymore because I can just getfive from a risk-free asset.
So all those assets have toreprice.
The price goes down at the sametime.
Hard to diversify against that.
And then what happens is theprice goes down until the
(29:25):
forward-looking return iscompetitive with the new rate of
cash.
The new rate that's risk-freeand that makes perfect sense.
And the reason you can't reallydiversify against that in
public markets long publicmarkets is because every asset
is competing with cash and whencash goes from zero to five it's
a headwind.
So our par is down 23%.
As you would expect, it has alittle bit of leverage, so it
(29:46):
did a little worse in equities.
But then what happens?
When that tightening phase ends?
Then the expected return ofeverything is higher over time.
And actually over time you'rebetter off going through that
downside because now you'regoing to compound at a higher
rate and at some point there's abreak even and you'll come out
ahead than if rates never rose.
So that's basically what'shappened.
(30:08):
So you had a big drawdown.
You had a big recovery In 23,.
It was up about 6%.
Last year it was about flatStocks particularly US stocks
did well Most other things didnot and this year it's up about
6% or 7%.
And this year is a normal year.
Us stocks are doing poorly, buteverything else is doing fine.
So it kind of goes back to bediversified.
(30:31):
You're not making a single betand the outcome is, however a
balanced mix of assets performs.
Speaker 1 (30:36):
I'm going to tee you up for this, obviously.
But then why not just leveragerisk parity, more than just the
leverage that's needed for thetreasury side?
Speaker 2 (30:44):
So you know the way I think about it is risk parity
doesn't have to be leveraged atall.
Okay, so so think of it as solet's start with those four
asset classes equities,commodities, tips and treasuries
.
You can be balanced acrossthose four with no leverage.
So I think that's a misnomer tothink risk parity requires
leverage.
I think of it as a balancedportfolio.
(31:05):
You can be balanced withoutleverage and basically you own
more long data tips, long datatreasuries, then you do equities
and commodities and you have abalanced portfolio.
So think of that as like anunlevered risk parity portfolio.
Now you could take thatportfolio and lever the whole
portfolio and you can do it veryefficiently because you can use
futures to get the exposure tothose underlying asset classes
(31:28):
and the implied financing ratefor futures is cash.
So think of it as you can levera balanced portfolio and your
cost of financing is cash.
So if a balanced mix of assetsbeats cash over time, then a
levered risk parity portfolio isgoing to outperform an
unlevered risk parity portfolio.
By definition Now, cashsometimes outperforms we saw it
(31:49):
in 2022, but over time it'llunderperform a balanced mix of
assets, and it's because that'show capitalism works If cash is
king for 10, 20 years.
Capitalism stops.
People won't invest in assetclasses.
So those periods where cashoutperforms are relatively rare
and short-lived and over timeasset classes be cash.
(32:11):
But it's important to bediversified because equities
could underperform cash for adecade they did in the 70s, they
did in the 2000s A balanced mixof assets much less likely to
underperform cash for anextended period.
So I think of it as unleveredrisk.
Parity is a balanced portfolio.
You can lever that cost offinancing is cash and you can
lever it to different degrees.
And what's interesting aboutthat is you can basically take
(32:36):
the same sharp ratio, the samereturn to risk ratio, with no
leverage.
Lever it a little bit, you canlever it a lot and at every
point of that leverage yourreturn to risk ratio is the same
.
It's the same portfolio.
It's just levered up, and thatis much more efficient than the
way most people increase thereturns of the portfolio.
(32:56):
They just get more concentratedin stocks, portfolio becomes
less diversified.
So there's a trade-off If youwant more return, you own more
stocks.
That's what most people do andthen the portfolio is even less
diversified and the Sharpe ratiogoes down over time.
And so a levered risk-readyportfolio is a very efficient
way to get asset class exposure.
(33:16):
And so we have RPAR that's 20%levered.
And then we also created UPAR,ultra risk parity.
That's RPAR times 1.4.
So it's 1.4x RPAR it's 40% morelevered.
So I think of RPAR asequity-like expected return with
risk that's like 60-40.
And then UPAR is equity-likerisk with an expected return
(33:40):
that's above equities, and bothof those can be tools used in
your toolkit to build aportfolio.
Speaker 1 (33:46):
I try to always frame things for the audience in ways
that I think they can mayberelate to.
So is it fair to say that ifyou're bullish on the idea that
we could be in a lost decade forequities, that you should be
ultra bullish on a risk parityframework?
Speaker 2 (34:07):
I think that depends on your starting point.
So if your starting point isI'm heavy in equities, then it's
natural to.
If you think that equities aregoing to go through a bad period
, then you want to be in a lotof other things, and risk parity
gives you that option.
The other way to think about itis if you just don't know, you
want to be diversified across abunch of different things, and
(34:28):
especially if you don't have togive up returns to be more
diversified, then why would younot want to do that?
So I think that's true what yousaid, but I would add to it
that you should just bediversified all the time and
then also keep in mind thatwhether you're bullish or
bearish, you're going to bewrong a lot and the timing is
highly uncertain.
(34:50):
I know a lot of people who arebears for the stock market and
have been bears for a decade,and they've been dead wrong for
a long period of time and I'msure they're going to be bulls
during the next bear market.
So it's just low likelihood ofbeing accurate.
Even the best investors, thesmartest investors, if they
honestly assess their ability topredict markets, they might be
(35:12):
right 55% or 60% of the time andthese are the best of the best.
So again, I just put a lot lessweight in those predictions.
And diversification, I think,always makes sense, and when you
have great uncertainty itprobably makes even more sense.
Speaker 1 (35:27):
You've got to love tilting though a little bit for
yourself, right?
I mean I know you're a bigadvocate, obviously, of
disparity and everything you'resaying makes sense, but I mean
it's kind of like it goes backto that whole thing about Burton
Malkiel I think it is right whowas on the random walk and when
he was asked he's like I stillactively trade, I mean, for you.
I'm just curious, you're waybetter at talking about this.
Do you have something?
Speaker 2 (35:48):
Well, I think there's a couple ways to do that, and I
think there's a coupleperspectives that I have to
share on that One is I don'tfeel like I can add value by
actively tilting.
Just the math doesn't support it.
Not that I'm bad at it, but Ijust know how hard it is to be
(36:10):
good at it.
So, knowing that, that's onepoint I have clients that I work
with.
A lot of them want to hear myviews, so I share my views, but
I always give them thedisclaimer of, yes, this is what
I think is going to happen, butI'd only apply 55% or 60% odds
of that actually happening.
So you take that with what youthink that insight is actually
(36:33):
worth.
And then there's another way todo it, which is you can have a
passive allocation and then youcan hire active managers who
express views, and there aremanagers that invest across a
lot of different asset classes,so they can express.
Those markets are lessefficient, so you can express
views probably more consistentlyin those markets.
(36:54):
And so I think there's variousways to express views and tilts,
and I do a little bit myself,but I rely a lot more on people
(37:16):
who are in the weeds in thosevarious markets to express their
tilts that way as well.
Speaker 1 (37:22):
I know we've kind of framed it a little bit as an
alternative.
But why not just have an entireportfolio, just be that, set it
and forget it and go to sleep?
Speaker 2 (37:29):
Well, you could do that.
The numbers would support it.
A risk parity portfolio overthe long run has had similar
returns, if not better, thanequities, with a lot less risk.
But it's not that simple to doso.
On paper it's easy to do, it'svery understandable, easy to get
(37:54):
your arms around it.
You can understand how it'sperforming and why it's
performing as it is.
But in practice and I'm justtalking from personal experience
doing this for 20 years or so,even before the ETF was launched
, using this concept in practiceit's really hard.
And the reason is what I callthe reference point problem,
(38:14):
which is most people noteverybody, but most people will
compare their performance,either of their portfolio or
whatever they're invested in, tohow the US stock market is
doing.
And what's interesting is, whenyou ask somebody how the market
is doing, they're only talkingabout the US stock market.
(38:34):
When somebody asks me how themarket is doing, I always start
with what market are you talkingabout?
There's US stocks,international emerging, there's
bonds, there's tips, there'sreal estate, there's commodities
, there's gold.
There's a lot of asset classes.
Which one are you asking meabout?
And I know what they're talkingabout.
But I think it's reallyimportant to think in a
(38:55):
different way because we can getso pulled into.
It's about the US stock market.
When you turn on CNBC, they'retalking about US stocks.
When you read the paper, it'sUS stocks.
When you talk to friends atparties, they're talking about
US stocks.
That's the focus and thatbecomes the reference point and
it's constantly dripping on you.
So it's hard to escape.
So the challenge with sayinglook, I'm just going to buy a
(39:18):
risk-free portfolio and forgetit, is that you can go through
years, five years, 10 yearsthat's what the last 10 years
has been, where you would havebeen better off being not just
in the S&P but an S&P focusedportfolio, even 60-40.
And that's too long of a periodfor most people because they
don't just invest in a portfolioand not look at it.
(39:40):
For 30 years, they invest in aportfolio and look at it
constantly, and the time horizonis probably getting shorter as
the data is just readilyavailable in front of us.
So it's hard to not payattention.
You have to be very intentionalabout not paying attention,
because otherwise it just comesto you.
So I think that's the realchallenge and so you can
overcome that by being bettereducated about it, by having
(40:04):
complete buy-in, by recognizingthe flaws and focusing on the
reference point.
And the real challenge is thatif that's your true reference
point is the US stock marketwhatever you invest in that has
a low allocation to that becauseit's more diversified.
You can stay with it when USstocks are doing poorly.
(40:25):
But when US stocks are goingthrough a bull market,
eventually you're probably goingto sell that portfolio and go
into the US stocks and then,when stocks are doing poorly,
you'll go into that balancedportfolio.
And when the balanced portfoliois doing poorly relative stocks
you'll go back, and you'llalways do it after the fact, and
at the end of the day, 30 yearslater, you'll look back and you
would have been better offholding one of those other two
(40:46):
and not going back and forth.
So that's the challenge is justthe practical steps in that
direction.
Take a less diversifiedportfolio, add some risk parity
to get more diversified, to gaincomfort, to gain kind of
appreciation for how it behavesthe good and the bad, so that
(41:09):
you don't overreact to eitherone and then over time maybe you
gradually shift in thatdirection and then that's a
winning combination over timebecause it's just more
diversified.
Speaker 1 (41:19):
For those who want to learn more about RPAR and
Evoque broadly.
Where'd you went to?
Speaker 2 (41:24):
A couple of places.
Rpar has its own website,rparetfcom, so we have a lot of
information there.
We do quarterly webcasts,that's all.
The replays are posted there.
Evoqueadvisorscom is our RIA.
We manage about $26 billion forinstitutional high net worth
clients.
I'm one of the co-CIOs and sowe have a lot of information
(41:47):
there.
I write some insights that wetalk about various topics it's
not just risk parity and thenalso I have a weekly podcast
called the Insightful Investorand it's on Spotify, apple,
youtube and also theinsightfulinvestororg website
and there I interview guests andit's weekly and it's usually
(42:08):
pretty big names in thefinancial industry.
It's not about risk parity,it's just about investing in
general.
But those are all the placespeople can find us.
Speaker 1 (42:17):
Appreciate those that watch this, learn more about
RPAR and obviously reach out toAlex if you're curious for more
information.
But pretty in-depth here andhopefully we'll see you all in
the next episode of Lead LagLive.
Thank you, Alex, Appreciate it.
Thank you, Cheers everybody.
Since most people will baseline against the S&P.
You know, and valuations becomesort of somewhat of an anchor
that when valuations are verystretched for some prolonged
period of time, diversificationreally starts to kick in, Like,
I mean, the benefits of it, thealpha that comes from it.
Speaker 2 (00:20):
I think that's right.
But again, the inflection pointis hard to know.
So stretch valuations can getmore stretched.
They can last longer than thepatience of most investors.
So you can use it as a precisepoint of inflection.
But generally speaking, if youjust looked at the valuation of
the stock market and I'll usethe US stock market as an
(00:42):
example here and you'reprojecting 10-year returns, it's
a and you're projecting 10-yearreturns.
It's a pretty good predictor of10-year returns.
When valuations are high,10-year forward returns are low
and vice versa.
But it's a very poor predictorof one-year returns or probably
even three-year returns.
Speaker 1 (01:06):
I have not had a chance to breathe, but I'm going
to take in a lot of things thatAlex Sheedy has to say here
during this conversation, sowe'll have a good back and forth
.
Looking forward to this, giventhat markets are confusing, I
think, for a lot of people and,with geopolitics now back at the
forefront, I'm sure there'ssome interesting things we're
going to talk about here.
Let's get right into it.
My name is Michael Guyatt,publisher of the Lead Lag Board.
(01:28):
This is a sponsoredconversation by Evoke Advisors,
one of our clients at Lead LagMedia, the man himself, mr Alex
Shahidi, who I've interviewed afew times over the last several
months.
Let's talk aboutdiversification, because it does
seem like we might be in a bullmarket for diversification.
Finally, for a lot of reasons,but I want to get into just kind
(01:48):
of in here now because it'srelevant to the headlines how do
you think about asset classperformance, dispersion of
returns, diversification broadly, when you're in an environment
where there's a risk of broader?
Speaker 2 (02:04):
war.
Well, there's a risk of a lotof things.
So I think the high levelthoughts on it is we're in
highly uncertain times andthere's a wide range of
potential outcomes, both growthoutcomes, inflation outcomes,
geopolitical outcomes, and alsothe risk of extreme outcomes is
(02:24):
probably greater than it's beenin a long time.
So all of that, I think, speakswell to an environment where it
makes sense and is prudent tobe well diversified, in other
words, own things that do wellin different environments, so
that you don't have to guesscorrectly what environment's
going to actually transpire andthe idea there is.
(02:44):
Don't take huge bets in anydirection because it's highly
uncertain which way we're goingto go, and I think, generally
speaking, it's always good to bediversified.
You talked about the bull marketand diversification.
I don't know if there's such athing.
To be honest, I think you knowI wrote an article last year
called the bear marketDiversification, where
(03:05):
diversification didn't do youmuch good for a long time about
a decade or longer and that'swhen the S&P did well and just
about everything else did poorly.
That's pretty unusual.
Most of the time,diversification doesn't get you
the best returns, but it getsyou stable returns and resilient
returns through time and, as weknow, the key to investing and
the way you make money over timeis to stay invested and stay
(03:27):
diversified so you can benefitfrom compounding.
And I think we're justbasically going back to those
core principles and in anenvironment like this, it just
makes a lot of sense to spreadyour risk across a lot of
different things.
Speaker 1 (03:40):
I guess, is it a bull market in diversification or a
bear market in FOMO?
Fear of missing out, right,Because you can argue that the
reason people don't diversify isbecause of that fear of missing
out.
They see some asset classrunning away from them, some
stock, and that makes themconcentrate, yeah.
Speaker 2 (03:53):
I think that's exactly right and it's the same
dynamic we saw in the late 90sand it's a common dynamic during
the late stages of a bullmarket.
I mean, I don't know if we'reat the late stages today,
probably, but you don't know,you won't know for years.
But that's typical.
When you're looking, we can'tsee future returns, we can only
see past returns.
So when you're lookingbackwards and you see certain
(04:16):
asset classes doing really welland let's say you exercise
patience and you say you knowwhat, I know this is going to
turn, and then you don't buy,and then it keeps going, and
then it keeps going and it keepsgoing.
Eventually you get pulled in,along with most other people,
because we're all human and wehave these emotional biases.
Then you start going in andthen maybe it pays off.
(04:39):
For a while it reinforces thatresponse to FOMO and then you
get to a point where markets areoverbought and then you get the
cycle reversing.
And you could just look athistory, particularly in US
stocks.
We can see these cycles persistand they take a long time long
bull markets, long bear markets.
We've had a bull market for 16years.
(05:01):
The prior bear market was abouta decade.
Speaker 1 (05:03):
The S&P was negative and these kind of alternate and
you just never know when thatinflection point is, but you
could see some signs that maybewe're near there today Is there
anything in your research thatsuggests that, since most people
will baseline against the S&P,you know and valuations become
somewhat of an anchor that whenvaluations are very stretched
(05:28):
for some prolonged period oftime, diversification really
starts to kick in.
I mean the benefits of it, thealpha that comes from it.
Speaker 2 (05:37):
I think that's right.
But again, the inflection pointis hard to know.
So stretch valuations can getmore stretch.
They can last longer than thepatience of most investors.
So you can use it as a precisepoint of inflection.
But generally speaking, if youjust looked at the valuation of
the stock market and I'll usethe US stock market as an
(06:00):
example here and you'reprojecting 10-year returns, it's
a pretty good predictor of10-year returns when valuations
are high.
10-year returns it's a prettygood predictor of 10-year
returns when valuations are high.
10-year forward returns are lowand vice versa.
But it's a very poor predictorof one-year returns or probably
even three-year returns.
But again, when you look at thecharts, it looks very obvious,
(06:20):
right?
Every bull market started withlow valuations and ended with
high valuations.
And every bear market startedwith low valuations and ended
with high valuations.
And every bear market startedwith high valuations and ended
with low valuations.
And the chart is very clean.
But again, you just don't knowwhen you're going through that
inflection point, until yearslater, when it's obvious that
the high was a year ago, twoyears ago, five years ago.
(06:41):
Then it starts to become moreobvious.
Speaker 1 (06:43):
I know we've talked about this before, but I do
think we should framediversification properly for the
audience.
People think 60-40,.
They think stocks, bonds, theythink maybe throw some
commodities.
They don't even think about howto weight things.
How would you definediversification in its purest
form?
Speaker 2 (07:01):
It's a really important question because just
in my experience 26 years in theindustry I feel like most
people don't really fullyappreciate what diversification
is.
And I'll give you a quick story.
So this was probably 10 or 15years ago.
I was having lunch with aretired portfolio manager who
was managing a quote unquotebalanced fund and it was a 60-40
(07:26):
strategy and he was activelymanaging around 60-40.
And he'd had a strong career,did really well for his
investors and he'd recentlyretired.
And at lunch I asked him I saidI have a very simple question
for you.
Why do you call it a balancedfund if it's not balanced?
And he said what do you mean?
It's not balanced?
Of course everybody knows 60-40is balanced.
And I said it can't be balanced.
And he said what do you mean?
It's not balanced?
Of course everybody knows 60-40is balanced.
(07:46):
And I said it can't be balanced.
I said 60-40 is about 98%correlated to 100% stock
portfolio.
And he said well, that can't beright.
You have 60% of one asset, youhave 40% of another asset and
the two, on average, have zerocorrelation to each other.
So the correlation of 60-40can't be almost 100% to one of
those assets.
It just conceptually doesn'tmake sense and he was missing a
(08:09):
very simple concept and I thinka lot of people miss because
it's not that widely discussed.
The 60 is a lot more volatilethan the 40 is, and so you're
overweighting the more volatileasset.
It might be three or four timesas volatile.
So the direction of yourportfolio is almost 100%
dependent on how the 60 does,not the 40.
The 40 doesn't really doanything.
(08:30):
It just dilutes the ups and thedowns.
It just reduces the volatility.
It doesn't have much to do withthe direction of the portfolio,
and correlation is all aboutdirection.
So 60-40 is almost 100%correlated to 100% stocks.
That can't by definition.
The math says that is notdiversified.
You can't be diversified ifyou're basically putting all
(08:51):
your eggs in one basket.
The first rule of investingdon't put all your eggs in one
basket.
Most people violate that.
60-40 violates that, and that'sgenerally considered a balanced
portfolio.
So right there, that tells youthat the market as a whole
doesn't really appreciate whatdiversification is.
So then you take a step backand then how do you diversify
(09:11):
then?
And it goes to what I saidearlier own assets that do well
in different environments sothat you're not overly
influenced by how theenvironment transpires and more
specifically, I think of it interms of growth and inflation.
Those are the factors the Fedtries to manage reasonable
growth, reasonable inflation.
(09:32):
But about half the timeinflation surprises the upside
and half the time to thedownside.
And same thing with growth it'srelative to what the market's
discounting.
The surprises are what matterand different asset classes
behave differently based on howgrowth and inflation transpire.
So own assets that do well indifferent growth and inflation
environments.
It's a very simple concept 60-40has no inflation hedges.
(09:54):
Inflation is all of a sudden aproblem the first time since the
early 80s and most people ownvery few inflation hedges.
A balanced portfolio shouldhave about half of its exposure
to inflation hedge assets, whichare commodities, tips, gold,
potentially real estate, otherassets.
So if you diversify across allthose assets, then you're
(10:16):
effectively reducing the risk ofgrowth and inflation
meaningfully impacting yourreturns.
And then you can also go intoalternatives.
There's all these other things.
You can own all these returnstreams that are truly diverse
and then you balance them basedon their volatilities, meaning
assets that are more volatileyou own less of and the assets
that are less volatile you ownmore of, so that the risk
(10:37):
contribution is roughly equalacross different growth and
inflation environments andconceptually that's a much more
diversified portfolio.
You can look at the history.
You can see that portfolio is alot more resilient during
periods like COVID or 2008global financial crisis.
The decade of the 2000s was alost decade for US stocks.
(10:57):
It was a great decade foralmost every other asset.
If you were diversified, youdid great.
The 70s was the same thing.
Us stocks and bondsunderperformed cash during that
decade as inflation surprised tothe upside for a decade.
If you were diversified, youactually had your best decade in
the last 50 years.
So I think there's a lot oflessons to be learned by
studying history and justunderstanding conceptually how
(11:19):
to build a diversified portfolio.
Speaker 1 (11:20):
Do you think people overcomplicate things, like
they're thinking too much aboutthis or that individual security
stock versus?
These are the asset classeswhich move the most differently
to each other.
Speaker 2 (11:33):
For sure, and I think the media has a lot to do with
it.
I think us being humans has alot to do with it.
It's not very exciting to say,look, I'm going to build a
diversified portfolio, I'm justgoing to set it and forget it,
and I'm not going to payattention to the news.
I'm not going to pay attentionto that voice in my head that
says I knew that was going tohappen or I know this is going
(11:53):
to happen.
But if you remove all of thatand you just look at the data,
diversification is the one freelunch in investing.
We learned that in investing101.
And most people don't takeadvantage of that free lunch.
So over time, if you're superdiversified, you get a higher
return to risk ratio and overtime that wins Now over shorter
(12:16):
times, and shorter could be oneyear, three years, five years, a
decade.
That doesn't feel short, but ininvesting terms it is short.
In the rest of the world it's avery long period of time.
That's one of the challenges.
So you have to be able towithstand those long periods and
to do that you basically haveto avoid everything you see on
TV, what you read about in thenews, your emotional impulses,
(12:40):
and that's really hard to do.
So the concept ofdiversification, I think, is
simple.
Understanding how to build adiversified portfolio isn't that
difficult, but actuallyimplementing it in practice is
hard, because you have toexercise patience and a deep
understanding of the benefits ofstaying on that.
Slow and steady wins the racepath and I think that's
(13:02):
basically the hard part.
So I just spent a lot of timeeducating people and trying to
share those perspectives,especially during bull markets.
During bear markets, it's easy.
You know the conversations arein.
Bear markets are very simplebecause you know our clients are
doing well.
They're, you know, roughlysteady and that's easy.
But during the bull markets,fomo sets in and,
(13:23):
counterintuitively, those aremuch more difficult to withstand
.
Speaker 1 (13:26):
Of course that's not to say that somebody shouldn't
feel comfortable tilting one wayor another.
Right, Just have more of a core.
That's a true diversified mix.
Speaker 2 (13:34):
Yeah, and I think the other way to think about it is
if you focus on the alpha, youknow, trying to add value, that
is a very tough game.
You know, on average alpha zero, after fees, after taxes, it's
negative.
So if you're average at that,you'll lose.
If you're above average, maybeyou break even.
If you're exceptional, maybeyou make a little bit, but it's
(13:56):
a very tough game.
So if you're focusing all youreffort and energy on trying to
do that, the odds are stackedagainst you.
It's it's just the odds arestacked against you.
It's doable, but the odds arestacked against you.
If you focus on beingdiversified, then the odds are
in your favor and that wins overtime.
So it is a little.
(14:17):
To me it doesn't make much senseto focus all your effort on
being and trying to add value.
Yet your starting point is nota well-diversified portfolio.
The simplest way to think aboutit is if you had no views about
the future, if you were kind ofneutral on everything, what
would your allocation look like?
What's your neutral portfoliomix?
That starting point should bevery efficiently allocated.
(14:39):
So it should be reallywell-diversified.
That free lunch and investinghigher return to risk ratio.
So if that's your starting point.
Then you can try to tilt fromthere based on your views.
But one of my golden rules isdiversification always trumps
conviction, because you have tohave greater confidence that
diversification adds value overtime than your conviction on any
(15:01):
single trade or any single viewof the markets, because it's
just a tough game, that's justthe math.
So it's a little off to focusall your time on trying to add
value, but your starting pointis completely off, and so that's
part of the point of thisdiscussion is to re-examine what
that starting point is.
And, going back to the firstquestion you asked, this is
(15:22):
probably a very good time to dothat, because diversification is
probably more important todaythan it's been for decades.
Speaker 1 (15:30):
And perhaps today is the least prevalent portfolio.
Right yeah, let's face it, it'sbeen an environment of like
nothing but S&P, nasdaq up andto the right needs anything else
just passive equities?
Speaker 2 (15:44):
Yeah, I think that's right.
I think if you were to ask mostprudent investors, is this an
environment you'd rather be morediversified or less diversified
?
I think most people would sayit's a crazy world.
I want to be more diversified.
But if you look at theirportfolio, it's probably less
diversified today than it was 10years ago, and so most
(16:04):
portfolios have more stocks thanthey did 10 years ago.
They have more US stocks andthe US stocks are more
concentrated within them withthe max seven and tech exposure,
and so that is a byproduct ofwhat's worked well looking
backwards.
And so you've had US stockssignificantly outperform just
about everything else otherstocks as well as other asset
(16:27):
classes and as a result, theybecome overweighted.
And then there's some challenge, because these stocks go up a
lot.
If you sell them, you have topay taxes, if you're a taxable
investor, so you hold on andholding on has benefited you.
So you keep doing that untilyou get to a point where you're
completely out of balance, and Iremember it used to be 60-40
was considered a neutralportfolio.
(16:49):
Now it's 70-30.
All of a sudden it's shiftedbecause US stocks have done so
well.
But that is not awell-diversified portfolio and
we all know there are marketcycles and one of the lessons in
history if you go back and youlook at the market leaders of
each decade over the last 100years, they're constantly
changing.
The market leaders are notpersistent.
(17:10):
Competition comes in,valuations get high, there's
over-optimism in the price,there's cycles and cycles
persist because people overpayfor great stories and maybe
today's giants will continuelonger than past giants, but the
(17:32):
odds are stacked against them.
If you just studied the data,so you're right.
There's probably much lessdiversification today and then.
So I talked about the allocation, but also the inflation hedging
component I think is importantto bring up.
We haven't had inflationproblems for decades and finally
, inflation is a problem.
We had a spike post-COVID.
It kind of came down.
(17:52):
It was transitory, it just tooka couple of years, not a couple
of months, but still it'shigher than our comfort level
and that has meaningfulimplications on the Fed's
reaction function.
It has meaningful implicationson people's spending, on
investor psychology.
It's a very different worldwhen inflation is elevated and
(18:14):
not coming down than what we'veexperienced the last few decades
.
So you could definitely see theenvironment shifting.
Speaker 1 (18:21):
If that persists, all right elevated and not coming
down than what we've experiencedthe last few decades, so you
could definitely see theenvironment shifting if that
persists, all right.
So let's talk about thosediversifying asset classes,
right, and in the context ofthis thing called risk parity,
so I think of risk parity asthere's.
Speaker 2 (18:32):
I think of it as two steps and I, you know,
personally I just don't love thename because I think it has a
bad reputation, because I don'tthink it's that well
misunderstood.
I've written two books.
One of them is called RiskParity, just because it's such a
popular concept in terms of thename.
But I think of it as a balancedportfolio and I think of it as
(18:54):
there's two steps.
The first step is pick diverseasset classes and then the
second step is how do youstructure those asset classes?
And that's a very distinct step.
So step one which asset classes?
And I think it goes back towhat I said earlier growth and
inflation are the big drivers ofasset class returns through
time own assets that do well indifferent growth and inflation
(19:14):
environments.
So I think of it as globalequities commodities, which
includes commodity producerstocks.
I prefer that over commodityfutures because commodity
producer stocks have a higherexpected return, higher
historical return.
There's a risk premium thereand their price is heavily
influenced by the commodityprice and it's also more tax
(19:38):
efficient.
And then gold, as a part ofthat commodity basket, which is
a very different commodity thanall the other commodities, it
tends to do well when growth isfalling.
So in Q1 2020, when COVID hit,commodities got crushed and gold
was up.
Same thing happened in 2008.
Gold was up and all the othercommodities fell.
So global equities thatcommodity basket of commodity
(20:00):
stocks plus gold, and then tipsand treasuries, tend to do well
in different inflationenvironments.
So tips are better wheninflation is rising, treasuries
better when inflation is falling, and so those two are good
diversifies to each other.
They both do well when growthis falling and commodities and
(20:20):
equities do well when growth isrising.
So between those four buckets,you can basically cover all the
different growth and inflationenvironments.
So that's step one pick diverseasset classes.
You're already ahead of mostpeople.
If you just pick those assetclasses, the weighting is really
important, which is step twopeople, if you just pick those
asset classes, the weighting isreally important, which is step
(20:41):
two.
So I mentioned earlier you wantto overweight less volatile
assets, underweight morevolatile assets.
So the challenge that comes tomind is most people think of
equities as where returns comefrom.
All the other asset classes aregood diversifiers, but they
lower return.
They have a lower expectedreturn than equities, so there's
a trade-off.
If you want more return, youwant more equities.
(21:02):
If you want more risk control,you own less equities and all
the other diversifiers.
So you don't have to do it thatway.
You can actually structure eachof these other asset classes,
these diversifiers, in a waywhere their expected return and
risk are similar to equities.
And so that sounds a littlecounterintuitive because it's
(21:22):
not what we were taught inbusiness school, but it's
actually not that difficult todo.
So I'll walk through each.
With commodities I mentionedearlier commodity producer
stocks plus gold.
That basket of commodities hasa similar historical and
expected return as equities,similar risk.
They have a similar Sharperatio, and so you could quickly
(21:45):
go from just equities to getreturns to commodities and gold
plus equities to have similarreturns.
And all of a sudden, you'remore diversified.
Those two asset classes were upin 2022 when equities were down
a lot.
They were up a lot in the 70s.
(22:06):
In the 2000s, they were up alot.
So right there, you increasediversification and haven't
given up on returns, tips andtreasuries.
Most people think of that as lowrisk, low return assets, but
what's interesting is theirreturn to risk ratio is similar
to equities over the long term.
So all you have to do is raisethe risk and mathematically you
raise the return.
And there's two ways to raisethe risk.
One is longer duration.
(22:27):
So longer duration treasuries,longer duration tips, have a
higher expected return and morerisk than shorter duration.
And then you apply a little bitof leverage and you can get the
same return out of those assetsas you do equities.
So if you go back a hundredyears and look at the S&P 500
and look at long datedtreasuries with a little bit of
leverage and over a hundredyears, they have about the same
(22:47):
return.
And so that is reallyinteresting because it's very
counterintuitive.
It's not something we weretaught.
So now you've got four diverseasset classes were taught.
So now you've got four diverseasset classes.
You match the risk that's wherethe risk parity part comes in
and you structure them the way Idescribed and you put it all
together and now you've got anequity-like expected return with
(23:08):
less risk than equities,because it's more diversified
than equities.
And that's a very simplestructure.
It's passive, you don't have topredict the future, it's more
diversified and it's, to me, amore reasonable starting point
for your allocation.
Speaker 1 (23:22):
And the nice thing is that you have a fund that does
just this with our part.
Let's talk about the history ofthat fund, the sort of
reception, the environment it'sbeen in, just kind of riff on
the vehicle.
Speaker 2 (23:31):
Sure, yes.
So this concept has been aroundfor a long time, for decades,
and about six years ago wefigured out it made sense to
create an ETF that didn't exist,to take advantage of these
concepts inside of a singlevehicle.
It also gives you some taxefficiencies, and one of the tax
(23:53):
efficiencies is when you ownmultiple asset classes, it's
important to rebalance acrossthem.
And if you think about it, ifyou have, let's say, four asset
classes equities, commodity,that commodity basket, tips and
treasuries and if you'vestructured them in a way where,
over time, they have similarreturn and risk and you
regularly rebalance, it's aprogrammatic way to buy low,
(24:16):
sell high.
So when something'soutperformed you sell a little
bit, when something'sunderperformed, you buy a little
bit and over time.
If you do that, you should beable to add some returns to your
total portfolio, because you'rerepeatedly buying low, selling
high and most people, as we know, do the opposite and if you do
it inside of an ETF wrapper, youcan effectively postpone the
capital gains associated withselling high until you sell the
(24:38):
ETF.
So, from a conceptualstandpoint, it's a very
efficient way to not only have abalanced portfolio but to do it
very tax efficiently.
And if you think about publicmarkets, they're relatively
efficient.
There's a lot of players inthat market.
It's hard to add value, unlikeprivate markets where it's
easier to add value.
So public markets is relativelyefficient.
So there you focus on low fees,low taxes, high diversification
(25:02):
and most people are activelymanaging public markets.
So their fees are higher, theirtaxes are higher and their
diversification is lower.
So the ETF RPAR risk-paired ETFR-P-A-R is a symbol, is
effectively a way to get lowerfees, lower taxes and high
diversification with a singlevehicle.
(25:23):
And the way we think about itis as a tool in your toolkit to
manage a portfolio and the morebalanced you want to be, the
more of that you own and you caninclude it as maybe part of
your liquid alternatives and youhave a portfolio let's say it's
even 60-40.
And you want to take a steptowards being a more balanced
allocation.
You could do 55-35-10 and 10 inRPAR and now you're raising the
(25:49):
expected return because you'reswapping some stocks and bonds
for something that has a similarexpected return as equities,
maybe even a little bit more,because of that rebalancing
benefit that I described.
So expected return goes up,diversification improves and
it's more tax efficient than a60-40 is because it's all inside
of that ETF wrapper.
(26:10):
So I think of it as a tool toget more diversified and to
improve some of those otherareas.
Now you also asked how has itdone?
So?
It's interesting.
So its return is dependent onthe asset class returns because
it's not actively trading.
It's a passive exposure to abalanced mix of asset classes
(26:31):
and it rebalances back to thatbalanced mix.
So since we started in December2019, right before COVID it got
off to a really strong start.
So 2020 hit.
Covid was the issue.
The economy collapsed in Q1 of2020.
The stock market was down 21%.
(26:51):
Our part was down 4%, and it'sbecause stocks and commodities
got crushed in Q1 of 2020.
Gold, tips and treasuries werein a bull market and that netted
out to minus four and then itfinished the year up almost 20%.
So really strong start.
The assets really grew fast.
As we know, people chasereturns and it was off to a
(27:15):
fantastic start.
2021, it had average returns.
It was up about 7.5%.
So nothing special there andthat's because you had asset
classes perform kind of onaverage.
I think gold was actually downat that time.
Treasuries were down a littlebit.
Tips did well.
That's when inflation started tofirst become a problem Big
(27:36):
diversions between tips andtreasuries, as you would expect.
Then 2022 happened, and that isthe perfect storm.
So what happened in 2022 wasthe Fed all of a sudden raised
interest rates from zero to 5%and the market started to
discount a massive increase ininterest rates.
So that is effectively theworst type of environment you
(27:57):
can experience for a diversifiedportfolio, because it's hard to
diversify against cash all of asudden going from zero to 5%.
We saw the same thing in theearly 80s when Paul Volcker came
in and rapidly hiked interestrates.
That is really hard todiversify against and it's
because it's not growth andinflation that are the big
driver of returns, it's cash allof a sudden becoming much more
(28:18):
attractive.
And as an investor, youbasically have one choice you
can hold cash or you have twochoices you can hold cash and
get the risk-free return, or youcan invest in risky asset
classes and earn the riskpremium that comes from taking
risks in those asset classes.
I think it makes more sense tobe diversified across those
asset classes than be lessdiversified.
(28:40):
That's the whole context of ourconversation.
But basically you have thatchoice Take no risk or take risk
, and you can take riskefficiently or inefficiently.
Now, when cash is earning zero,then a balanced portfolio might
have an expected return of 5%or 6%.
Let's say cash plus 5% or 6%.
That's what equity risk premiumhas been for 100 years.
(29:01):
It's cash plus 5% or 6%.
So when cash goes from zero tofive all of a sudden very
quickly, earning five or six outof risky assets is not worth it
anymore because I can just getfive from a risk-free asset.
So all those assets have toreprice.
The price goes down at the sametime.
Hard to diversify against that.
And then what happens is theprice goes down until the
(29:25):
forward-looking return iscompetitive with the new rate of
cash.
The new rate that's risk-freeand that makes perfect sense.
And the reason you can't reallydiversify against that in
public markets long publicmarkets is because every asset
is competing with cash and whencash goes from zero to five it's
a headwind.
So our par is down 23%.
As you would expect, it has alittle bit of leverage, so it
(29:46):
did a little worse in equities.
But then what happens?
When that tightening phase ends?
Then the expected return ofeverything is higher over time.
And actually over time you'rebetter off going through that
downside because now you'regoing to compound at a higher
rate and at some point there's abreak even and you'll come out
ahead than if rates never rose.
So that's basically what'shappened.
(30:08):
So you had a big drawdown.
You had a big recovery In 23,.
It was up about 6%.
Last year it was about flatStocks particularly US stocks
did well Most other things didnot and this year it's up about
6% or 7%.
And this year is a normal year.
Us stocks are doing poorly, buteverything else is doing fine.
So it kind of goes back to bediversified.
(30:31):
You're not making a single betand the outcome is, however a
balanced mix of assets performs.
Speaker 1 (30:36):
I'm going to tee you up for this, obviously.
But then why not just leveragerisk parity, more than just the
leverage that's needed for thetreasury side?
Speaker 2 (30:44):
So you know the way I think about it is risk parity
doesn't have to be leveraged atall.
Okay, so so think of it as solet's start with those four
asset classes equities,commodities, tips and treasuries
.
You can be balanced acrossthose four with no leverage.
So I think that's a misnomer tothink risk parity requires
leverage.
I think of it as a balancedportfolio.
(31:05):
You can be balanced withoutleverage and basically you own
more long data tips, long datatreasuries, then you do equities
and commodities and you have abalanced portfolio.
So think of that as like anunlevered risk parity portfolio.
Now you could take thatportfolio and lever the whole
portfolio and you can do it veryefficiently because you can use
futures to get the exposure tothose underlying asset classes
(31:28):
and the implied financing ratefor futures is cash.
So think of it as you can levera balanced portfolio and your
cost of financing is cash.
So if a balanced mix of assetsbeats cash over time, then a
levered risk parity portfolio isgoing to outperform an
unlevered risk parity portfolio.
By definition Now, cashsometimes outperforms we saw it
(31:49):
in 2022, but over time it'llunderperform a balanced mix of
assets, and it's because that'show capitalism works If cash is
king for 10, 20 years.
Capitalism stops.
People won't invest in assetclasses.
So those periods where cashoutperforms are relatively rare
and short-lived and over timeasset classes be cash.
(32:11):
But it's important to bediversified because equities
could underperform cash for adecade they did in the 70s, they
did in the 2000s A balanced mixof assets much less likely to
underperform cash for anextended period.
So I think of it as unleveredrisk.
Parity is a balanced portfolio.
You can lever that cost offinancing is cash and you can
lever it to different degrees.
And what's interesting aboutthat is you can basically take
(32:36):
the same sharp ratio, the samereturn to risk ratio, with no
leverage.
Lever it a little bit, you canlever it a lot and at every
point of that leverage yourreturn to risk ratio is the same
.
It's the same portfolio.
It's just levered up, and thatis much more efficient than the
way most people increase thereturns of the portfolio.
(32:56):
They just get more concentratedin stocks, portfolio becomes
less diversified.
So there's a trade-off If youwant more return, you own more
stocks.
That's what most people do andthen the portfolio is even less
diversified and the Sharpe ratiogoes down over time.
And so a levered risk-readyportfolio is a very efficient
way to get asset class exposure.
(33:16):
And so we have RPAR that's 20%levered.
And then we also created UPAR,ultra risk parity.
That's RPAR times 1.4.
So it's 1.4x RPAR it's 40% morelevered.
So I think of RPAR asequity-like expected return with
risk that's like 60-40.
And then UPAR is equity-likerisk with an expected return
(33:40):
that's above equities, and bothof those can be tools used in
your toolkit to build aportfolio.
Speaker 1 (33:46):
I try to always frame things for the audience in ways
that I think they can mayberelate to.
So is it fair to say that ifyou're bullish on the idea that
we could be in a lost decade forequities, that you should be
ultra bullish on a risk parityframework?
Speaker 2 (34:07):
I think that depends on your starting point.
So if your starting point isI'm heavy in equities, then it's
natural to.
If you think that equities aregoing to go through a bad period
, then you want to be in a lotof other things, and risk parity
gives you that option.
The other way to think about itis if you just don't know, you
want to be diversified across abunch of different things, and
(34:28):
especially if you don't have togive up returns to be more
diversified, then why would younot want to do that?
So I think that's true what yousaid, but I would add to it
that you should just bediversified all the time and
then also keep in mind thatwhether you're bullish or
bearish, you're going to bewrong a lot and the timing is
highly uncertain.
(34:50):
I know a lot of people who arebears for the stock market and
have been bears for a decade,and they've been dead wrong for
a long period of time and I'msure they're going to be bulls
during the next bear market.
So it's just low likelihood ofbeing accurate.
Even the best investors, thesmartest investors, if they
honestly assess their ability topredict markets, they might be
(35:12):
right 55% or 60% of the time andthese are the best of the best.
So again, I just put a lot lessweight in those predictions.
And diversification, I think,always makes sense, and when you
have great uncertainty itprobably makes even more sense.
Speaker 1 (35:27):
You've got to love tilting though a little bit for
yourself, right?
I mean I know you're a bigadvocate, obviously, of
disparity and everything you'resaying makes sense, but I mean
it's kind of like it goes backto that whole thing about Burton
Malkiel I think it is right whowas on the random walk and when
he was asked he's like I stillactively trade, I mean, for you.
I'm just curious, you're waybetter at talking about this.
Do you have something?
Speaker 2 (35:48):
Well, I think there's a couple ways to do that, and I
think there's a coupleperspectives that I have to
share on that One is I don'tfeel like I can add value by
actively tilting.
Just the math doesn't support it.
Not that I'm bad at it, but Ijust know how hard it is to be
(36:10):
good at it.
So, knowing that, that's onepoint I have clients that I work
with.
A lot of them want to hear myviews, so I share my views, but
I always give them thedisclaimer of, yes, this is what
I think is going to happen, butI'd only apply 55% or 60% odds
of that actually happening.
So you take that with what youthink that insight is actually
(36:33):
worth.
And then there's another way todo it, which is you can have a
passive allocation and then youcan hire active managers who
express views, and there aremanagers that invest across a
lot of different asset classes,so they can express.
Those markets are lessefficient, so you can express
views probably more consistentlyin those markets.
(36:54):
And so I think there's variousways to express views and tilts,
and I do a little bit myself,but I rely a lot more on people
(37:16):
who are in the weeds in thosevarious markets to express their
tilts that way as well.
Speaker 1 (37:22):
I know we've kind of framed it a little bit as an
alternative.
But why not just have an entireportfolio, just be that, set it
and forget it and go to sleep?
Speaker 2 (37:29):
Well, you could do that.
The numbers would support it.
A risk parity portfolio overthe long run has had similar
returns, if not better, thanequities, with a lot less risk.
But it's not that simple to doso.
On paper it's easy to do, it'svery understandable, easy to get
(37:54):
your arms around it.
You can understand how it'sperforming and why it's
performing as it is.
But in practice and I'm justtalking from personal experience
doing this for 20 years or so,even before the ETF was launched
, using this concept in practiceit's really hard.
And the reason is what I callthe reference point problem,
(38:14):
which is most people noteverybody, but most people will
compare their performance,either of their portfolio or
whatever they're invested in, tohow the US stock market is
doing.
And what's interesting is, whenyou ask somebody how the market
is doing, they're only talkingabout the US stock market.
(38:34):
When somebody asks me how themarket is doing, I always start
with what market are you talkingabout?
There's US stocks,international emerging, there's
bonds, there's tips, there'sreal estate, there's commodities
, there's gold.
There's a lot of asset classes.
Which one are you asking meabout?
And I know what they're talkingabout.
But I think it's reallyimportant to think in a
(38:55):
different way because we can getso pulled into.
It's about the US stock market.
When you turn on CNBC, they'retalking about US stocks.
When you read the paper, it'sUS stocks.
When you talk to friends atparties, they're talking about
US stocks.
That's the focus and thatbecomes the reference point and
it's constantly dripping on you.
So it's hard to escape.
So the challenge with sayinglook, I'm just going to buy a
(39:18):
risk-free portfolio and forgetit, is that you can go through
years, five years, 10 yearsthat's what the last 10 years
has been, where you would havebeen better off being not just
in the S&P but an S&P focusedportfolio, even 60-40.
And that's too long of a periodfor most people because they
don't just invest in a portfolioand not look at it.
(39:40):
For 30 years, they invest in aportfolio and look at it
constantly, and the time horizonis probably getting shorter as
the data is just readilyavailable in front of us.
So it's hard to not payattention.
You have to be very intentionalabout not paying attention,
because otherwise it just comesto you.
So I think that's the realchallenge and so you can
overcome that by being bettereducated about it, by having
(40:04):
complete buy-in, by recognizingthe flaws and focusing on the
reference point.
And the real challenge is thatif that's your true reference
point is the US stock marketwhatever you invest in that has
a low allocation to that becauseit's more diversified.
You can stay with it when USstocks are doing poorly.
(40:25):
But when US stocks are goingthrough a bull market,
eventually you're probably goingto sell that portfolio and go
into the US stocks and then,when stocks are doing poorly,
you'll go into that balancedportfolio.
And when the balanced portfoliois doing poorly relative stocks
you'll go back, and you'llalways do it after the fact, and
at the end of the day, 30 yearslater, you'll look back and you
would have been better offholding one of those other two
(40:46):
and not going back and forth.
So that's the challenge is justthe practical steps in that
direction.
Take a less diversifiedportfolio, add some risk parity
to get more diversified, to gaincomfort, to gain kind of
appreciation for how it behavesthe good and the bad, so that
(41:09):
you don't overreact to eitherone and then over time maybe you
gradually shift in thatdirection and then that's a
winning combination over timebecause it's just more
diversified.
Speaker 1 (41:19):
For those who want to learn more about RPAR and
Evoque broadly.
Where'd you went to?
Speaker 2 (41:24):
A couple of places.
Rpar has its own website,rparetfcom, so we have a lot of
information there.
We do quarterly webcasts,that's all.
The replays are posted there.
Evoqueadvisorscom is our RIA.
We manage about $26 billion forinstitutional high net worth
clients.
I'm one of the co-CIOs and sowe have a lot of information
(41:47):
there.
I write some insights that wetalk about various topics it's
not just risk parity and thenalso I have a weekly podcast
called the Insightful Investorand it's on Spotify, apple,
youtube and also theinsightfulinvestororg website
and there I interview guests andit's weekly and it's usually
(42:08):
pretty big names in thefinancial industry.
It's not about risk parity,it's just about investing in
general.
But those are all the placespeople can find us.
Speaker 1 (42:17):
Appreciate those that watch this, learn more about
RPAR and obviously reach out toAlex if you're curious for more
information.
But pretty in-depth here andhopefully we'll see you all in
the next episode of Lead LagLive.
Thank you, Alex, Appreciate it.
Thank you, Cheers everybody.
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