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Diversification: The Free Lunch Nobody's Taking with Alex Shahidi
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Since most people will baseline against the S&P. You know, and valuations become sort of somewhat of an anchor that when valuations are very stretched for some prolonged period of time, diversification really starts to kick in, Like, I mean, the benefits of it, the alpha that comes from it.
Speaker 2:I think that's right. But again, the inflection point is hard to know. So stretch valuations can get more stretched. They can last longer than the patience of most investors. So you can use it as a precise point of inflection. But generally speaking, if you just looked at the valuation of the stock market and I'll use the US stock market as an example here and you're projecting 10-year returns, it's a and you're projecting 10-year returns. It's a pretty good predictor of 10-year returns. When valuations are high, 10-year forward returns are low and vice versa. But it's a very poor predictor of one-year returns or probably even three-year returns.
Speaker 1:I have not had a chance to breathe, but I'm going to take in a lot of things that Alex Sheedy has to say here during this conversation, so we'll have a good back and forth. Looking forward to this, given that markets are confusing, I think, for a lot of people and, with geopolitics now back at the forefront, I'm sure there's some 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. This is a sponsored conversation by Evoke Advisors, one of our clients at Lead Lag Media, the man himself, mr Alex Shahidi, who I've interviewed a few times over the last several months. Let's talk about diversification, because it does seem like we might be in a bull market for diversification. Finally, for a lot of reasons, but I want to get into just kind of in here now because it's relevant to the headlines how do you think about asset class performance, dispersion of returns, diversification broadly, when you're in an environment where there's a risk of broader?
Speaker 2:war. Well, there's a risk of a lot of things. So I think the high level thoughts on it is we're in highly uncertain times and there's a wide range of potential outcomes, both growth outcomes, inflation outcomes, geopolitical outcomes, and also the risk of extreme outcomes is probably greater than it's been in a long time. So all of that, I think, speaks well to an environment where it makes sense and is prudent to be well diversified, in other words, own things that do well in different environments, so that you don't have to guess correctly what environment's going to actually transpire and the idea there is. Don't take huge bets in any direction because it's highly uncertain which way we're going to go, and I think, generally speaking, it's always good to be diversified.
Speaker 2:You talked about the bull market and diversification. I don't know if there's such a thing. To be honest, I think you know I wrote an article last year called the bear market Diversification, where diversification didn't do you much good for a long time about a decade or longer and that's when 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 gets you stable returns and resilient returns through time and, as we know, the key to investing and the way you make money over time is to stay invested and stay diversified so you can benefit from compounding. And I think we're just basically going back to those core principles and in an environment like this, it just makes a lot of sense to spread your risk across a lot of different things.
Speaker 1: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 is because of that fear of missing out. They see some asset class running away from them, some stock, and that makes them concentrate, yeah.
Speaker 2:I think that's exactly right and it's the same dynamic we saw in the late 90s and it's a common dynamic during the late stages of a bull market. I mean, I don't know if we're at 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't see future returns, we can only see past returns. So when you're looking backwards and you see certain asset classes doing really well and let's say you exercise patience and you say you know what, 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 keeps going.
Speaker 2:Eventually you get pulled in, along with most other people, because we're all human and we have these emotional biases. Then you start going in and then maybe it pays off. For a while it reinforces that response to FOMO and then you get to a point where markets are overbought and then you get the cycle reversing. And you could just look at history, particularly in US stocks. We can see these cycles persist and they take a long time long bull markets, long bear markets. We've had a bull market for 16 years. The prior bear market was about a decade.
Speaker 1:The S&P was negative and these kind of alternate and you just never know when that inflection point is, but you could see some signs that maybe we're near there today Is there anything in your research that suggests that, since most people will baseline against the S&P, you know and valuations become somewhat of an anchor that when valuations are very stretched for some prolonged period of time, diversification really starts to kick in. I mean the benefits of it, the alpha that comes from it.
Speaker 2:I think that's right. But again, the inflection point is hard to know. So stretch valuations can get more stretch. They can last longer than the patience of most investors. So you can use it as a precise point of inflection.
Speaker 2:But generally speaking, if you just looked at the valuation of the stock market and I'll use the US stock market as an example here and you're projecting 10-year returns, it's a pretty good predictor of 10-year returns when valuations are high. 10-year returns it's a pretty good predictor of 10-year returns when valuations are high. 10-year forward returns are low and vice versa. But it's a very poor predictor of one-year returns or probably even three-year returns. But again, when you look at the charts, it looks very obvious, right? Every bull market started with low valuations and ended with high valuations. And every bear market started with low valuations and ended with high valuations. And every bear market started with high valuations and ended with low valuations. And the chart is very clean. But again, you just don't know when you're going through that inflection point, until years later, when it's obvious that the high was a year ago, two years ago, five years ago. Then it starts to become more obvious.
Speaker 1:I know we've talked about this before, but I do think we should frame diversification properly for the audience. People think 60-40,. They think stocks, bonds, they think maybe throw some commodities. They don't even think about how to weight things. How would you define diversification in its purest form?
Speaker 2:It's a really important question because just in my experience 26 years in the industry I feel like most people don't really fully appreciate what diversification is. And I'll give you a quick story. So this was probably 10 or 15 years ago. I was having lunch with a retired portfolio manager who was managing a quote unquote balanced fund and it was a 60-40 strategy and he was actively managing around 60-40. And he'd had a strong career, did really well for his investors and he'd recently retired. And at lunch I asked him I said I have a very simple question for you. Why do you call it a balanced fund if it's not balanced? And he said what do you mean? It's not balanced? Of course everybody knows 60-40 is balanced. And I said it can't be balanced. And he said what do you mean? It's not balanced? Of course everybody knows 60-40 is balanced. And I said it can't be balanced.
Speaker 2:I said 60-40 is about 98% correlated to 100% stock portfolio. And he said well, that can't be right. You have 60% of one asset, you have 40% of another asset and the two, on average, have zero correlation to each other. So the correlation of 60-40 can't be almost 100% to one of those assets. It just conceptually doesn't make sense and he was missing a very simple concept and I think a lot of people miss because it's not that widely discussed. The 60 is a lot more volatile than the 40 is, and so you're overweighting the more volatile asset. It might be three or four times as volatile. So the direction of your portfolio is almost 100% dependent on how the 60 does, not the 40. The 40 doesn't really do anything. It just dilutes the ups and the downs. It just reduces the volatility. It doesn't have much to do with the direction of the portfolio, and correlation is all about direction.
Speaker 2:So 60-40 is almost 100% correlated to 100% stocks. That can't by definition. The math says that is not diversified. You can't be diversified if you're basically putting all your eggs in one basket. The first rule of investing don't put all your eggs in one basket. Most people violate that. 60-40 violates that, and that's generally considered a balanced portfolio. So right there, that tells you that the market as a whole doesn't really appreciate what diversification is. So then you take a step back and then how do you diversify then?
Speaker 2:And it goes to what I said earlier own assets that do well in different environments so that you're not overly influenced by how the environment transpires and more specifically, I think of it in terms of growth and inflation. Those are the factors the Fed tries to manage reasonable growth, reasonable inflation. But about half the time inflation surprises the upside and half the time to the downside. And same thing with growth it's relative to what the market's discounting. The surprises are what matter and different asset classes behave differently based on how growth and inflation transpire. So own assets that do well in different growth and inflation environments.
Speaker 2:It's a very simple concept 60-40 has no inflation hedges. Inflation is all of a sudden a problem the first time since the early 80s and most people own very few inflation hedges. A balanced portfolio should have about half of its exposure to inflation hedge assets, which are commodities, tips, gold, potentially real estate, other assets. So if you diversify across all those assets, then you're effectively reducing the risk of growth and inflation meaningfully impacting your returns. And then you can also go into alternatives. There's all these other things. You can own all these return streams that are truly diverse and then you balance them based on their volatilities, meaning assets that are more volatile you own less of and the assets that are less volatile you own more of, so that the risk contribution is roughly equal across different growth and inflation environments and conceptually that's a much more diversified portfolio.
Speaker 2:You can look at the history. You can see that portfolio is a lot more resilient during periods like COVID or 2008 global financial crisis. The decade of the 2000s was a lost decade for US stocks. It was a great decade for almost every other asset. If you were diversified, you did great. The 70s was the same thing. Us stocks and bonds underperformed cash during that decade as inflation surprised to the upside for a decade. If you were diversified, you actually had your best decade in the last 50 years. So I think there's a lot of lessons to be learned by studying history and just understanding conceptually how to build a diversified portfolio.
Speaker 1:Do you think people overcomplicate things, like they're thinking too much about this or that individual security stock versus? These are the asset classes which move the most differently to each other.
Speaker 2:For sure, and I think the media has a lot to do with it. I think us being humans has a lot to do with it. It's not very exciting to say, look, I'm going to build a diversified portfolio, I'm just going to set it and forget it, and I'm not going to pay attention to the news. I'm not going to pay attention to that voice in my head that says I knew that was going to happen or I know this is going to happen. But if you remove all of that and you just look at the data, diversification is the one free lunch in investing. We learned that in investing 101. And most people don't take advantage of that free lunch. So over time, if you're super diversified, you get a higher return to risk ratio and over time that wins Now over shorter times, and shorter could be one year, three years, five years, a decade.
Speaker 2:That doesn't feel short, but in investing terms it is short. In the rest of the world it's a very long period of time. That's one of the challenges. So you have to be able to withstand those long periods and to do that you basically have to avoid everything you see on TV, what you read about in the news, your emotional impulses, and that's really hard to do. So the concept of diversification, I think, is simple. Understanding how to build a diversified portfolio isn't that difficult, but actually implementing it in practice is hard, because you have to exercise patience and a deep understanding of the benefits of staying on that. Slow and steady wins the race path and I think that's basically the hard part. So I just spent a lot of time educating people and trying to share those perspectives, especially during bull markets. During bear markets, it's easy. You know the conversations are in. Bear markets are very simple because you know our clients are doing well. They're, you know, roughly steady and that's easy. But during the bull markets, fomo sets in and, counterintuitively, those are much more difficult to withstand.
Speaker 1:Of course that's not to say that somebody shouldn't feel comfortable tilting one way or another. Right, Just have more of a core. That's a true diversified mix.
Speaker 2:Yeah, and I think the other way to think about it is if you focus on the alpha, you know, 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, maybe you break even. If you're exceptional, maybe you make a little bit, but it's a very tough game. So if you're focusing all your effort and energy on trying to do that, the odds are stacked against you. It's it's just the odds are stacked against you. It's doable, but the odds are stacked against you. If you focus on being diversified, then the odds are in your favor and that wins over time. So it is a little.
Speaker 2:To me it doesn't make much sense to focus all your effort on being and trying to add value. Yet your starting point is not a well-diversified portfolio. The simplest way to think about it is if you had no views about the future, if you were kind of neutral on everything, what would your allocation look like? What's your neutral portfolio mix? That starting point should be very efficiently allocated. So it should be really well-diversified. That free lunch and investing higher return to risk ratio.
Speaker 2:So if that's your starting point. Then you can try to tilt from there based on your views. But one of my golden rules is diversification always trumps conviction, because you have to have greater confidence that diversification adds value over time than your conviction on any single trade or any single view of the markets, because it's just a tough game, that's just the math. So it's a little off to focus all your time on trying to add value, but your starting point is completely off, and so that's part of the point of this discussion is to re-examine what that starting point is. And, going back to the first question you asked, this is probably a very good time to do that, because diversification is probably more important today than it's been for decades.
Speaker 1:And perhaps today is the least prevalent portfolio. Right yeah, let's face it, it's been an environment of like nothing but S&P, nasdaq up and to the right needs anything else just passive equities?
Speaker 2:Yeah, I think that's right. I think if you were to ask most prudent investors, is this an environment you'd rather be more diversified or less diversified? I think most people would say it's a crazy world. I want to be more diversified. But if you look at their portfolio, it's probably less diversified today than it was 10 years ago, and so most portfolios have more stocks than they did 10 years ago. They have more US stocks and the US stocks are more concentrated within them with the max seven and tech exposure, and so that is a byproduct of what's worked well looking backwards. And so you've had US stocks significantly outperform just about everything else other stocks as well as other asset classes and as a result, they become overweighted. And then there's some challenge, because these stocks go up a lot. If you sell them, you have to pay taxes, if you're a taxable investor, so you hold on and holding on has benefited you. So you keep doing that until you get to a point where you're completely out of balance, and I remember it used to be 60-40 was considered a neutral portfolio. Now it's 70-30. All of a sudden it's shifted because US stocks have done so well.
Speaker 2:But that is not a well-diversified portfolio and we all know there are market cycles and one of the lessons in history if you go back and you look at the market leaders of each decade over the last 100 years, they're constantly changing. The market leaders are not persistent. Competition comes in, valuations get high, there's over-optimism in the price, there's cycles and cycles persist because people overpay for great stories and maybe today's giants will continue longer than past giants, but the odds are stacked against them. If you just studied the data, so you're right. There's probably much less diversification today and then.
Speaker 2:So I talked about the allocation, but also the inflation hedging component I think is important to bring up. We haven't had inflation problems for decades and finally, inflation is a problem. We had a spike post-COVID. It kind of came down. It was transitory, it just took a couple of years, not a couple of months, but still it's higher than our comfort level and that has meaningful implications on the Fed's reaction function. It has meaningful implications on people's spending, on investor psychology. It's a very different world when inflation is elevated and not coming down than what we've experienced the last few decades. So you could definitely see the environment shifting.
Speaker 1:If that persists, all right elevated and not coming down than what we've experienced the last few decades, so you could definitely see the environment shifting if that persists, all right. So let's talk about those diversifying asset classes, right, and in the context of this thing called risk parity, so I think of risk parity as there's.
Speaker 2:I think of it as two steps and I, you know, personally I just don't love the name because I think it has a bad reputation, because I don't think it's that well misunderstood. I've written two books. One of them is called Risk Parity, just because it's such a popular concept in terms of the name. But I think of it as a balanced portfolio and I think of it as there's two steps. The first step is pick diverse asset classes and then the second step is how do you structure those asset classes? And that's a very distinct step. So step one which asset classes? And I think it goes back to what I said earlier growth and inflation are the big drivers of asset class returns through time own assets that do well in different growth and inflation environments. So I think of it as global equities commodities, which includes commodity producer stocks. I prefer that over commodity futures because commodity producer stocks have a higher expected return, higher historical return. There's a risk premium there and their price is heavily influenced by the commodity price and it's also more tax efficient. And then gold, as a part of that commodity basket, which is a very different commodity than all the other commodities, it tends to do well when growth is falling. 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 other commodities fell. So global equities that commodity basket of commodity stocks plus gold, and then tips and treasuries, tend to do well in different inflation environments. So tips are better when inflation is rising, treasuries better when inflation is falling, and so those two are good diversifies to each other. They both do well when growth is falling and commodities and equities do well when growth is rising. So between those four buckets, you can basically cover all the different growth and inflation environments.
Speaker 2:So that's step one pick diverse asset classes. You're already ahead of most people. If you just pick those asset classes, the weighting is really important, which is step two people, if you just pick those asset classes, the weighting is really important, which is step two. So I mentioned earlier you want to overweight less volatile assets, underweight more volatile assets. So the challenge that comes to mind is most people think of equities as where returns come from. All the other asset classes are good diversifiers, but they lower return. They have a lower expected return than equities, so there's a trade-off. If you want more return, you want more equities. If you want more risk control, you own less equities and all the other diversifiers. So you don't have to do it that way. You can actually structure each of these other asset classes, these diversifiers, in a way where their expected return and risk are similar to equities. And so that sounds a little counterintuitive because it's not what we were taught in business school, but it's actually not that difficult to do. So I'll walk through each.
Speaker 2:With commodities I mentioned earlier commodity producer stocks plus gold. That basket of commodities has a similar historical and expected return as equities, similar risk. They have a similar Sharpe ratio, and so you could quickly go from just equities to get returns to commodities and gold plus equities to have similar returns. And all of a sudden, you're more diversified. Those two asset classes were up in 2022 when equities were down a lot. They were up a lot in the 70s. In the 2000s, they were up a lot. So right there, you increase diversification and haven't given up on returns, tips and treasuries.
Speaker 2:Most people think of that as low risk, low return assets, but what's interesting is their return to risk ratio is similar to equities over the long term. So all you have to do is raise the risk and mathematically you raise the return. And there's two ways to raise the risk. One is longer duration. So longer duration treasuries, longer duration tips, have a higher expected return and more risk than shorter duration. And then you apply a little bit of leverage and you can get the same return out of those assets as you do equities. So if you go back a hundred years and look at the S&P 500 and look at long dated treasuries with a little bit of leverage and over a hundred years, they have about the same return.
Speaker 2:And so that is really interesting because it's very counterintuitive. It's not something we were taught. So now you've got four diverse asset classes were taught. So now you've got four diverse asset classes. You match the risk that's where the risk parity part comes in and you structure them the way I described and you put it all together and now you've got an equity-like expected return with less risk than equities, because it's more diversified than equities. And that's a very simple structure. It's passive, you don't have to predict the future, it's more diversified and it's, to me, a more reasonable starting point for your allocation.
Speaker 1:And the nice thing is that you have a fund that does just this with our part. Let's talk about the history of that fund, the sort of reception, the environment it's been in, just kind of riff on the vehicle.
Speaker 2:Sure, yes. So this concept has been around for a long time, for decades, and about six years ago we figured out it made sense to create an ETF that didn't exist, to take advantage of these concepts inside of a single vehicle. It also gives you some tax efficiencies, and one of the tax efficiencies is when you own multiple asset classes, it's important to rebalance across them. And if you think about it, if you have, let's say, four asset classes equities, commodity, that commodity basket, tips and treasuries and if you've structured them in a way where, over time, they have similar return and risk and you regularly rebalance, it's a programmatic way to buy low, sell high. So when something's outperformed you sell a little bit, when something's underperformed, you buy a little bit and over time. If you do that, you should be able to add some returns to your total portfolio, because you're repeatedly buying low, selling high and most people, as we know, do the opposite and if you do it inside of an ETF wrapper, you can effectively postpone the capital gains associated with selling high until you sell the ETF. So, from a conceptual standpoint, it's a very efficient way to not only have a balanced portfolio but to do it very tax efficiently. And if you think about public markets, they're relatively efficient. There's a lot of players in that market. It's hard to add value, unlike private markets where it's easier to add value. So public markets is relatively efficient. So there you focus on low fees, low taxes, high diversification and most people are actively managing public markets. So their fees are higher, their taxes are higher and their diversification is lower. So the ETF RPAR risk-paired ETF R-P-A-R is a symbol, is effectively a way to get lower fees, lower taxes and high diversification with a single vehicle. And the way we think about it is as a tool in your toolkit to manage a portfolio and the more balanced you want to be, the more of that you own and you can include it as maybe part of your liquid alternatives and you have a portfolio let's say it's even 60-40. And you want to take a step towards being a more balanced allocation. You could do 55-35-10 and 10 in RPAR and now you're raising the expected return because you're swapping some stocks and bonds for something that has a similar expected 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 a 60-40 is because it's all inside of that ETF wrapper. So I think of it as a tool to get more diversified and to improve some of those other areas. Now you also asked how has it done? So? It's interesting. So its return is dependent on the asset class returns because it's not actively trading. It's a passive exposure to a balanced mix of asset classes and it rebalances back to that balanced mix.
Speaker 2:So since we started in December 2019, right before COVID it got off to a really strong start. So 2020 hit. Covid was the issue. The economy collapsed in Q1 of 2020. The stock market was down 21%. Our part was down 4%, and it's because stocks and commodities got crushed in Q1 of 2020.
Speaker 2:Gold, tips and treasuries were in a bull market and that netted out to minus four and then it finished the year up almost 20%. So really strong start. The assets really grew fast. As we know, people chase returns and it was off to a fantastic start. 2021, it had average returns. It was up about 7.5%. So nothing special there and that's because you had asset classes perform kind of on average. I think gold was actually down at that time. Treasuries were down a little bit. Tips did well.
Speaker 2:That's when inflation started to first become a problem Big diversions between tips and treasuries, as you would expect. Then 2022 happened, and that is the perfect storm. So what happened in 2022 was the Fed all of a sudden raised interest rates from zero to 5% and the market started to discount a massive increase in interest rates. So that is effectively the worst type of environment you can experience for a diversified portfolio, because it's hard to diversify against cash all of a sudden going from zero to 5%. We saw the same thing in the early 80s when Paul Volcker came in and rapidly hiked interest rates. That is really hard to diversify against and it's because it's not growth and inflation that are the big driver of returns, it's cash all of a sudden becoming much more attractive.
Speaker 2:And as an investor, you basically have one choice you can hold cash or you have two choices you can hold cash and get the risk-free return, or you can invest in risky asset classes and earn the risk premium that comes from taking risks in those asset classes. I think it makes more sense to be diversified across those asset classes than be less diversified. That's the whole context of our conversation. But basically you have that choice Take no risk or take risk, and you can take risk efficiently 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 premium has been for 100 years. It's cash plus 5% or 6%.
Speaker 2:So when cash goes from zero to five all of a sudden very quickly, earning five or six out of risky assets is not worth it anymore because I can just get five from a risk-free asset. So all those assets have to reprice. The price goes down at the same time. Hard to diversify against that. And then what happens is the price goes down until the forward-looking return is competitive with the new rate of cash. The new rate that's risk-free and that makes perfect sense. And the reason you can't really diversify against that in public markets long public markets is because every asset is competing with cash and when cash goes from zero to five it's a headwind.
Speaker 2:So our par is down 23%. As you would expect, it has a little bit of leverage, so it did a little worse in equities. But then what happens? When that tightening phase ends? Then the expected return of everything is higher over time. And actually over time you're better off going through that downside because now you're going to compound at a higher rate and at some point there's a break even and you'll come out ahead than if rates never rose. So that's basically what's happened. So you had a big drawdown. You had a big recovery In 23,. It was up about 6%. Last year it was about flat Stocks particularly US stocks did well Most other things did not and this year it's up about 6% or 7%. And this year is a normal year. Us stocks are doing poorly, but everything else is doing fine. So it kind of goes back to be diversified. You're not making a single bet and the outcome is, however a balanced mix of assets performs.
Speaker 1:I'm going to tee you up for this, obviously. But then why not just leverage risk parity, more than just the leverage that's needed for the treasury side?
Speaker 2:So you know the way I think about it is risk parity doesn't have to be leveraged at all. Okay, so so think of it as so let's start with those four asset classes equities, commodities, tips and treasuries. You can be balanced across those four with no leverage. So I think that's a misnomer to think risk parity requires leverage. I think of it as a balanced portfolio. You can be balanced without leverage and basically you own more long data tips, long data treasuries, then you do equities and commodities and you have a balanced portfolio. So think of that as like an unlevered risk parity portfolio. Now you could take that portfolio and lever the whole portfolio and you can do it very efficiently because you can use futures to get the exposure to those underlying asset classes and the implied financing rate for futures is cash. So think of it as you can lever a balanced portfolio and your cost of financing is cash. So if a balanced mix of assets beats cash over time, then a levered risk parity portfolio is going to outperform an unlevered risk parity portfolio. By definition Now, cash sometimes outperforms we saw it in 2022, but over time it'll underperform a balanced mix of assets, and it's because that's how capitalism works If cash is king for 10, 20 years. Capitalism stops. People won't invest in asset classes. So those periods where cash outperforms are relatively rare and short-lived and over time asset classes be cash. But it's important to be diversified because equities could underperform cash for a decade they did in the 70s, they did in the 2000s A balanced mix of assets much less likely to underperform cash for an extended period. So I think of it as unlevered risk.
Speaker 2:Parity is a balanced portfolio. You can lever that cost of financing is cash and you can lever it to different degrees. And what's interesting about that is you can basically take the same sharp ratio, the same return to risk ratio, with no leverage. Lever it a little bit, you can lever it a lot and at every point of that leverage your return to risk ratio is the same. It's the same portfolio.
Speaker 2:It's just levered up, and that is much more efficient than the way most people increase the returns of the portfolio. They just get more concentrated in stocks, portfolio becomes less diversified. So there's a trade-off If you want more return, you own more stocks. That's what most people do and then the portfolio is even less diversified and the Sharpe ratio goes down over time. And so a levered risk-ready portfolio is a very efficient way to get asset class exposure. 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% more levered. So I think of RPAR as equity-like expected return with risk that's like 60-40. And then UPAR is equity-like risk with an expected return that's above equities, and both of those can be tools used in your toolkit to build a portfolio.
Speaker 1:I try to always frame things for the audience in ways that I think they can maybe relate to. So is it fair to say that if you're bullish on the idea that we could be in a lost decade for equities, that you should be ultra bullish on a risk parity framework?
Speaker 2:I think that depends on your starting point. So if your starting point is I'm heavy in equities, then it's natural to. If you think that equities are going to go through a bad period, then you want to be in a lot of other things, and risk parity gives you that option. The other way to think about it is if you just don't know, you want to be diversified across a bunch of different things, and especially if you don't have to give up returns to be more diversified, then why would you not want to do that? So I think that's true what you said, but I would add to it that you should just be diversified all the time and then also keep in mind that whether you're bullish or bearish, you're going to be wrong a lot and the timing is highly uncertain.
Speaker 2:I know a lot of people who are bears 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'm sure they're going to be bulls during the next bear market. So it's just low likelihood of being accurate. Even the best investors, the smartest investors, if they honestly assess their ability to predict markets, they might be right 55% or 60% of the time and these are the best of the best. So again, I just put a lot less weight in those predictions. And diversification, I think, always makes sense, and when you have great uncertainty it probably makes even more sense.
Speaker 1:You've got to love tilting though a little bit for yourself, right? I mean I know you're a big advocate, obviously, of disparity and everything you're saying makes sense, but I mean it's kind of like it goes back to that whole thing about Burton Malkiel I think it is right who was on the random walk and when he was asked he's like I still actively trade, I mean, for you. I'm just curious, you're way better at talking about this. Do you have something?
Speaker 2:Well, I think there's a couple ways to do that, and I think there's a couple perspectives that I have to share on that One is I don't feel like I can add value by actively tilting.
Speaker 2:Just the math doesn't support it. Not that I'm bad at it, but I just know how hard it is to be good at it. So, knowing that, that's one point I have clients that I work with. A lot of them want to hear my views, so I share my views, but I always give them the disclaimer of, yes, this is what I think is going to happen, but I'd only apply 55% or 60% odds of that actually happening. So you take that with what you think that insight is actually worth. And then there's another way to do it, which is you can have a passive allocation and then you can hire active managers who express views, and there are managers that invest across a lot of different asset classes, so they can express. Those markets are less efficient, so you can express views probably more consistently in those markets. And so I think there's various ways to express views and tilts, and I do a little bit myself, but I rely a lot more on people who are in the weeds in those various markets to express their tilts that way as well.
Speaker 1:I know we've kind of framed it a little bit as an alternative. But why not just have an entire portfolio, just be that, set it and forget it and go to sleep?
Speaker 2:Well, you could do that. The numbers would support it. A risk parity portfolio over the long run has had similar returns, if not better, than equities, with a lot less risk. But it's not that simple to do so. On paper it's easy to do, it's very understandable, easy to get your arms around it. You can understand how it's performing and why it's performing as it is. But in practice and I'm just talking from personal experience doing this for 20 years or so, even before the ETF was launched, using this concept in practice it's really hard.
Speaker 2:And the reason is what I call the reference point problem, which is most people not everybody, but most people will compare their performance, either of their portfolio or whatever they're invested in, to how the US stock market is doing. And what's interesting is, when you ask somebody how the market is doing, they're only talking about the US stock market. When somebody asks me how the market is doing, I always start with what market are you talking about? There's US stocks, international emerging, there's bonds, there's tips, there's real estate, there's commodities, there's gold. There's a lot of asset classes. Which one are you asking me about? And I know what they're talking about. But I think it's really important to think in a different way because we can get so pulled into. It's about the US stock market. When you turn on CNBC, they're talking about US stocks. When you read the paper, it's US stocks. When you talk to friends at parties, they're talking about US stocks. That's the focus and that becomes the reference point and it's constantly dripping on you. So it's hard to escape.
Speaker 2:So the challenge with saying look, I'm just going to buy a risk-free portfolio and forget it, is that you can go through years, five years, 10 years that's what the last 10 years has been, where you would have been better off being not just in the S&P but an S&P focused portfolio, even 60-40. And that's too long of a period for most people because they don't just invest in a portfolio and not look at it. For 30 years, they invest in a portfolio and look at it constantly, and the time horizon is probably getting shorter as the data is just readily available in front of us. So it's hard to not pay attention. You have to be very intentional about not paying attention, because otherwise it just comes to you. So I think that's the real challenge and so you can overcome that by being better educated about it, by having complete buy-in, by recognizing the flaws and focusing on the reference point.
Speaker 2:And the real challenge is that if that's your true reference point is the US stock market whatever you invest in that has a low allocation to that because it's more diversified.
Speaker 2:You can stay with it when US stocks are doing poorly. But when US stocks are going through a bull market, eventually you're probably going to sell that portfolio and go into the US stocks and then, when stocks are doing poorly, you'll go into that balanced portfolio. And when the balanced portfolio is doing poorly relative stocks you'll go back, and you'll always do it after the fact, and at the end of the day, 30 years later, you'll look back and you would have been better off holding one of those other two and not going back and forth. So that's the challenge is just the practical steps in that direction. Take a less diversified portfolio, add some risk parity to get more diversified, to gain comfort, to gain kind of appreciation for how it behaves the good and the bad, so that you don't overreact to either one and then over time maybe you gradually shift in that direction and then that's a winning combination over time because it's just more diversified.
Speaker 1:For those who want to learn more about RPAR and Evoque broadly. Where'd you went to?
Speaker 2: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 for institutional high net worth clients. I'm one of the co-CIOs and so we have a lot of information there. I write some insights that we talk about various topics it's not just risk parity and then also I have a weekly podcast called the Insightful Investor and it's on Spotify, apple, youtube and also the insightfulinvestororg website and there I interview guests and it's weekly and it's usually pretty big names in the financial industry. It's not about risk parity, it's just about investing in general. But those are all the places people can find us.
Speaker 1:Appreciate those that watch this, learn more about RPAR and obviously reach out to Alex if you're curious for more information. But pretty in-depth here and hopefully we'll see you all in the next episode of Lead Lag Live. Thank you, Alex, Appreciate it. Thank you, Cheers everybody.
