Ep. 48 Adam Butler, Resolve Asset Management

Risk Parity is the answer. What was the question?

Adam and Pierre focus their discussion on diversification as a combination of “diversity” and “balance”. Diversity is about holding investments that are designed to thrive in very different market environments, and for different reasons. Balance has the objective of ensuring that investments are all able to express their unique personalities.

Risk parity is the ultimate expression of diversification. Sadly, many investors are misguided about the concept, and focus on the wrong things. We drill to the heart of the idea and illuminate why a risk parity portfolio should be the starting place for most investors.

Originally recorded June 3, 2020

 

Transcript:

Rodrigo Gordillo: (00:00:06):

Welcome to Gestalt University hosted by the team of ReSolve Asset Management, where evidence inspires confidence. This podcast will dig deep to uncover investment truths and life hacks you won’t find in the mainstream media. Covering topics that appeal to left brain robots, right brain poets, and everyone in between. All with the goal of helping you reach excellence. Welcome to the journey.

Speaker 2 (00:00:28):

Mike Philbrick, Adam Butler, Rodrigo Gordillo, and Jason Russell are principals of ReSolve Asset Management. Due to industry regulations they will not discuss any of ReSolve’s funds on this podcast. All opinions expressed by the principals are solely their own opinion and do not express the opinion of ReSolve Asset Management. This podcast is for information purposes only and should not be relied upon as a basis for investment decisions for more information, visit investresolve.com.

Adam Butler (00:00:55):

This is Adam Butler, chief investment officer at ReSolve Asset Management. I had the pleasure of sitting down for an interview with Pierre Daillie, managing director and chief editor at Advisor Analyst. For those who’ve been camped under a rock for the last five years Advisor Analyst is one of the best aggregators of research and articles that are relevant to investors and advisors. And we’ve had a great relationship with Pierre for many years. He is very proactive in the education of advisors and investors. And, today, we specifically focus on the best form of diversification, which is a global risk parity portfolio, and why that’s relevant for advisors and investors today, probably more than ever before. Talk about how risk parity managed the turbulence so far this year with the COVID crash and the prospects for risk parity going forward, and how investors should think about it in terms of behavioral challenges, et cetera. So, it’s a wide ranging interview. I think it went really well and appreciate Pierre’s insightful questions. I hope you enjoy it. Without further ado here is Pierre Daillie interviewing yours truly.

Pierre Daillie (00:02:14):

So it’s nice to meet you, Adam. I’ve done different things with Mike and Rodrigo, and it’s nice to actually finally meet you.

Adam Butler (00:02:23):

Likewise, yeah, it’s great. You guys have been producing some fantastic and aggregating some fantastic content for many years. It’s great to see Canadian publishers and advisors. I know there’s been a few Canadian groups that have launched some really great podcasts recently, so nice to see. We typically are a couple of years behind our more adventurous Southern neighbors in adopting technologies and new concepts. So, obviously, this is an idea whose time has come for Canada. So it’s great to see.

Pierre Daillie (00:02:53):

Yeah, it’s funny. They seem to be more gung ho south of the border, but it’s funny yesterday I was looking at some of our older videos and listening to some of our older podcasts. And, compared to today, I feel like we’ve come a long way. And that was only a year and a half ago.

Adam Butler (00:03:09):

It’s true. I mean, especially the last few weeks, things have certainly been changing quickly. It’s amazing how standards have been relaxed in terms of noises in the background and what people are wearing and where they’re situated. Obviously, norms are changing by the day,

Pierre Daillie (00:03:24):

For sure. So, Adam, what are we talking about today? I think we’ve got risk parity on the radar. And anything else that we can talk about, I guess, what have we got an hour?

Adam Butler (00:03:34):

Yeah. And I’m happy to go for as long, or as short as the conversation goes organically. I think, risk parity is a particularly timely topic because we’ve just come through this crisis, and it’s been a really great way to … I mean, as Warren Buffett says, we get to see who’s been swimming naked when the tide goes out. And, obviously, the tide went out and has very rapidly come back in. It’s almost been what we observed with tsunamis, where you’ve got the tide is sucked way out to sea and then crashes back in, in this overwhelming crescendo. And that’s exactly what we’ve observed in some markets more than others. But it’s really great to see the concepts that risk parity espouses play out in real-time in this crisis as we’ve analyzed it in other crises before that had a slightly different character.

Pierre Daillie (00:04:31):

I’ve had many conversations over the last month or two. And then, do you think investors, I mean, it’s kind of like the conversation about alternatives because I think, for the most part, I think investors have number one, they’ve either been ambivalent about these types of strategies, like risk parity, and they know they exist. They don’t know what it is, they don’t necessarily understand it. I think and number two, I think the subject of risk parity sounds very technical to a lot of investors. And I mean, when you actually end up having a conversation about it, you find out it just makes a lot of sense. And it’s the thing that we should have been doing all along. But haven’t been because really the last 40 years, which is a very long time to have a recency bias sort of build up, but the last 40 years have been really in favor of 60/40 traditional portfolios. And so, for a long time, subjects like gold or assets like gold, putting gold in your portfolio was considered like a gold bug’s dream.

Adam Butler (00:05:34):

As Buffett calls it, a barbarous relic.

Pierre Daillie (00:05:37):

Yeah, exactly. People have had 40 years to sort of divine the answer to why, why would I do that? Not withstanding the fact that gold has had several periods of great performance in hindsight, you wish you had owned it because it had provided that ballast to portfolios that investors long for it, but never reached for in terms of when they should reach for it.

Had a great conversation the other day with Mike and Rodrigo regards to risk parity. And we talked about all the things that …

Adam Butler (00:06:10):

The pandemic portfolio, the sort of crisis portfolio, or how to create a portfolio that’s resilient to even the most stressful market environments.

Pierre Daillie (00:06:19):

The surprising thing is that that was what we were going to talk about, and we never actually got to it because there was actually a million things to talk about. And so, that’s what we hope to do today, I think, is talk about the pandemic portfolio that you guys have put together and sort of get into the nuts and bolts of that.

Adam Butler (00:06:35):

Just to sort of back up because I think there will be many listeners of this podcast that are probably not intimately familiar with risk parity, even on a high level. But the idea of risk parity, risk parity is sort of a fancy way of describing a portfolio that prioritizes balance. And my partner, Mike, likes to say that risk parity is about preparation rather than prediction. And preparation in an investing context is a combination of two things. It’s having assets in the portfolio that are sufficiently diverse, and they’re diverse structurally and fundamentally so they’re designed to thrive in very different economic regimes. They respond very differently, positive or negatively, to the dynamics of growth or inflation shocks. So, this is the idea of diversity hold a wide variety of assets that have very different properties. And then, balance is the idea that if you’ve got a really diverse set of markets that you’re trying to include in the portfolio, just structurally, some of those markets are going to have very different risk profiles than others.

So, for example, government bonds are going to be much, much less risky from a volatility expression standpoint than emerging market stocks or crude oil contracts. And so, when you create a balanced portfolio, you want to make sure that all of the constituents of the portfolio have an equal opportunity to express their unique personalities. And to contrast that, a traditional balanced portfolio, which is typically thought of as sort of a 60/40 portfolio, and even more narrowly typically considered to be sort of a US 60/40 portfolio. So US 60% in the S&P 500, for example, and 40% in maybe 10 year treasuries or high-grade bonds.

This is highly unbalanced because even though the capital is 60% in stocks and 40% of bonds, bonds are so much less risky than stocks that about 95% of the volatility of that portfolio, in other words the magnitude of the daily fluctuations, is attributable to the stock component. And the bonds, even though they respond fundamentally differently to different economic shocks they play almost no role in the portfolio as a diversifier because their impact is completely overwhelmed by the stock volatility. So, it’s marrying these properties of diversity and balance that brings you to the risk parity concept.

Pierre Daillie (00:08:57):

Exactly. So, even at 40%, the risk contribution of bonds is insufficient to offset the volatility. I mean, that doesn’t even come close to offsetting the volatility from stocks.

Adam Butler (00:09:09):

Depending on how and when you measure it, and this is probably a little technical for where we want to go in this, but consider the fact that depending on how, and when you measure the volatility contributions of a 60/40, the 40% attributable bonds may actually have a negative risk contribution. It’s a very strange concept to wrap your head around. It’s overwhelmingly dominated by equities. And so, the idea of risk parity is let’s get away from having a portfolio that is only fundamentally designed to do well in a specific type of environment, specifically an environment dominated by positive growth shocks, abundant liquidity and benign inflation. That’s when, specifically, domestic equities are designed to do very, very well. And if you’ve got untamed inflation or a major contraction in liquidity, or a major negative growth shock, then you experience equity returns like we’ve seen in February and March, what we saw in 2008, 2009, what we saw in the 2000 tech bust where equities can do very poorly and they can do very poorly for years.

Pierre Daillie (00:10:17):

I think when we were talking the other day with Rodrigo and Mike, one of the things they pointed out was that the risk parity portfolio was down 10%, while the traditional 60/40 was down in the teens, and the equity sleeve was down, I mean, for the US if you were S&P 500 beta was down minus 35%, and Canadian equities down 40. The point of those statistics is that, obviously, most investors can withstand a 10% shock to their portfolio, but when you get into the 20s and 30s, and even 40s it gets a lot harder. And the idea, of course, of having a portfolio is that you keep it, not that you somehow, when these exogenous shocks, like COVID-19, come along you abandon it. That’s, by far, the biggest behavioral mistake. It’s not the market’s fault. I mean, maybe it is the market’s fault that you abandoned it at that point but it’s not.

Adam Butler (00:11:15):

Well, it’s just a mismatch, it’s a misalignment of objectives and risk tolerance with the portfolio that you’re invested in. I mean, you’re exactly right. The risk parity portfolios really came through this year in the same way as they’ve come through in other recent crises. And I mean, Rodrigo’s got a terrific webcast where he goes through the character of risk parity over 90 years. And we’ve seen this time and time again, that risk parity by virtue of how it’s designed is able to prove resilient and deliver the returns that investors need regardless of economic environment.

And I think if could just share my screen, I think that we manage some risk parity mandates, and I think it’s worthwhile just sort of showing the performance of these risk parity mandates this year. It’s actually, I think really interesting. But, for example, and just let me know, I can’t tell if you can see my screen. Can you see it?

Pierre Daillie (00:12:13):

Let me see. I’m going to try, one second. I’m wearing these reading glasses to begin with.

Adam Butler (00:12:19):

I think you can. So this is, for example, the risk parity strategy in 2020. So, you can see even in March, now this is a 6% target volatility strategy, so it’s designed to be fairly low volatility. But even in March, March is down 3%. April, it’s up 1%, it’s down 1.6% on the year, which obviously compares extremely favorably against a typical 60/40 portfolio, which through the end of March may have been down 20 or 25%. but it’s not unique to the 6%. Even the 12% volatility target strategy did extremely well in this period. I think the 12% strategy is only down 5 or 6% in March and is only down 2 or 3%. And I’m not sure why the page isn’t loading, but anyways.

Pierre Daillie (00:13:11):

That’s okay.

Adam Butler (00:13:12):

It’s just been extremely resilient in this environment just demonstrating the merits of the concept in live trading.

So, you mentioned behavioral issues and I think that’s a really critical factor to consider because it’s easy to sort of point to how a risk parity portfolio performed in certain crisis periods, or even the period that wasn’t very kind to, for example, US equities from 2000 to 2010. That was like a full decade where us equities had almost no returns and risk parity had double digit returns per year. Obviously, those are periods that are very easy to commit to a risk parity style of portfolio. But there are, obviously, other periods that make it more complicated.

The past decade where the US 60/40 portfolio in particular has had the best run in history. In fact, we tried to model the performance of US equities over the past decade, not withstanding the current couple of months. But through the end of 2019 we tried to model it by simulating thousands and thousands of potential monthly paths from historical monthly data on the S&P. We actually could not create an environment randomly that was as strongly positive with as little risk as we’ve observed over the past decade.

Obviously, when a certain narrow sector of the market is doing very, very well for years on end it makes a mockery of the things of the principles that risk parity stands for. It makes a mockery of diversification. Any attempt to deviate from US equities in the US 60/40 portfolio over the last decade has made you look foolish.

Pierre Daillie (00:14:59):

Absolutely.

Adam Butler (00:14:59):

So, obviously, diversification means investing in things other than a specific narrow index. That looked foolish for the last decade. There have obviously been short periods over that time horizon that risk parity has really shone. And it’s shone, on average, at appropriate risk levels that are comparable to the risk you take with US 60/40. But it’s just hard to stick with when your simple, basic US-focused 60/40 portfolio is shining year and year out, diversification is harder and harder to commit to.

Pierre Daillie (00:15:32):

Quote, Mike and Rodrigo, I think the best portfolio that an investor can own is the one that they’re going to keep owning. And, without blowing too much smoke, I’ve learned more from our conversations than I think from any other group of professionals than you guys in terms of what these ideas mean. What they mean for investors, I mean, and what they actually do. And the idea of creating a portfolio that saves investors from making those behavioral mistakes is more valuable than winning by owning five or six tech stocks, or owning the S&P 500. But then withstanding these periods where draw downs are 30, 40, 50% like we had in ’09. When the market’s winning, like it has for the last 11 or 12 years, everybody’s happy. But soon as you have a draw down like this year’s, February, March draw down where stocks are down 35%, I mean, if you’re working with $1 million in equities, you’re down $350,000, that’s not an easy situation to just absorb emotionally.

Adam Butler (00:16:43):

It’s not. That’s a really good point because it’s not just how much you’re down, but it’s the proportion that you’re down relative to a, your annual income and b, the number of more years that you have to contribute to your portfolio. If you’re working person you’re working to save towards retirement, you take this hit it’s way harder to take that hit later in your career for two reasons. Number one, because the value of your portfolio is such a larger multiple of your annual income. And number two, because you’ve got a much shorter horizon with which to make it back.

Pierre Daillie (00:17:16):

It’s supposed to be the source of your future liabilities, your future income. And so, if you’re down one of the things that always comes up, and we’ve got a number of contributors in Advisor Analyst who talk about this repeatedly, but it seems to be forgotten. And it’s great to remind investors that if you’re down by a third, by 33%, in order to come back from that you have to make 50%.

Adam Butler (00:17:38):

Exactly.

Pierre Daillie (00:17:39):

In order to come back from, let’s say you have $1 million and you’re down to 667,000. To come back from 667,000 back to your break even where you were at the previous high, you have to make $333,000 back, that’s 50% of the 667,000. So, the proportions are much larger on the recovery than they are on the draw down.

Adam Butler (00:18:04):

People have a lot of trouble conceptualizing, or emotionally internalizing the mathematics of compounding. And you’re absolutely right. I mean, a 50% loss is exactly the same as 100% gain.

Pierre Daillie (00:18:17):

Exactly.

Adam Butler (00:18:18):

And volatility on its own, even daily, your weekly or monthly volatility, is actually a drag on the compounding process of a portfolio, which is another thing that many investors don’t intuit. And even if a portfolio is not subject to periodic crashes, the volatility of a portfolio when you’re in withdrawal, so if you’re a retiree or you’re a pension plan, and you are taking money out on a regular basis, all things equal, a lower volatility portfolio will allow you to take more out at each regular increment, than a higher volatility portfolio, even if they both have the same expected return. These are concepts that are not well understood. They’re not well understood by many advisors either. And so, that’s one reason why advisors are not more motivated to seek out strategies that preserve the opportunity for long-term gains while also minimizing week-to-week, and month-to-month volatility and being designed to be resilient against major economic shocks.

Pierre Daillie (00:19:23):

I think part of the problem is what happens in the beginning when you engage a new client because of all the talk of beating benchmarks, and the talk around the subject of SPIVA annual results, where the discussion sort of circles around the idea that active investors can’t beat the benchmarks. I mean, that issue actually doesn’t even matter in reality. It does matter statistically, obviously. How’s the market doing? But personally, when it comes to discussing goals with the client and risk tolerance in the true sense, not in the sense that the industry has historically sort of talked about the idea of risk tolerance, where you’re doing a KYC form, where you have to tick off a box, that box, whoa, hold on a second.

Adam Butler (00:20:14):

Everybody focuses on picking the best mutual fund or picking the best stocks. Meanwhile, we actually did a really interesting study a couple years ago. It’s in one of our papers on the importance of asset allocation over security selection or stock picking. And we analyzed the performance of mutual funds that are focused on three different markets. One was US equities, one was foreign developed equities, and the third was emerging market equities. And what we wanted to demonstrate is that no amount of stock picking skill can overcome the choice of the wrong market.

So, for example, over the five year horizon that we were examining, I’m going to pick numbers out of a hat, but they’re directionally correct, US stocks were up 10% a year, foreign developed stocks were up 3% a year, and emerging market stocks were down 2% a year, let’s just say. And we examined the top 5% of fund managers who were focused on foreign developed markets. So, they were only selecting stocks in foreign developed markets. And we saw were those 5% top stock pickers in foreign developed markets able to outperform the worst 5% of stock pickers in US markets? And the answer was no. And the top 5% trying to select stocks in emerging markets couldn’t outperform the worst stock pickers in foreign developed markets.

The point is that the choice of the market you’re investing in so profoundly overwhelms anything else you’re doing at the stock picking level that, for most people, it’s completely irrelevant. And yet this is the item or the level at which most advisors purport to add value in selecting funds by better security selectors, and where most investors are …

PART 1 OF 4 ENDS [00:22:04]

Adam Butler (00:22:00):

… they’re security selectors. And where most investors are most fascinated, what sector or what theme, what individual stocks are going to rise or fall. And it turns out that those decisions are almost immaterial if you don’t get your asset allocation correct. And so that’s why we spend so much time on trying to give deep thought to getting the asset allocation correct. And then if you want to delve a little bit below the surface and within whatever your appropriate US equity allocation, you want to deviate, you want to layer on some factors or you want to take a different portfolio construction approach, like minimum variance or something like that, go ahead, you’re not going to get in much trouble. But if you don’t give proper thought to the asset allocation, then the forest can be burning down while you’re trying to choose the best tree. It doesn’t make any sense.

Pierre Daillie (00:22:52):

I think what happens is that if you’re sitting down with a client for the first time, and you’re talking about markets and investing and the basic sort of superficial conversation is going to revolve around, “Oh wow, US stocks had a great year last year. Bonds had a decent year coming into this draw down this year. Stocks were down 35%, but they’ve rebounded.” I think the problem is expectations. If somebody says to you… If you start a conversation off with the historical returns for the equity sleeve, and you say, “Well, for the last X number of years, it’s been 12% or 13% a year or more,” whatever the measurement period is, and then you get into the subject of building a portfolio that has a return profile of let’s say six or seven percent, that’s almost disappointing to the investor.

So right off the bat, well, I want to make 14%. I want to make 12% a year, because with the rule of 72, I’m going to double my portfolio every six years. But at 6%, it’s going to take me 12 years. I think the problem is that is the sort of maybe there’s a fear of getting into the weeds about something like risk parity or any sort of optimal portfolio. It almost feels like a disappointment at the outset. And so maybe many advisors, the reason they won’t get into the subject of risk parity is number one, they haven’t allowed themselves the time to get into a full blown discussion about it and to understand it. And number two, they’re afraid that talking about it with their clients, with their prospective clients or with their existing clients, is a step down. It’s like an emotion from what they normally talk about in more interesting conversations. Because it’s more interesting if you have a conversation about how US equities have made 12% a year than a portfolio that makes six or seven percent a year. There’s almost like the way you talk about how bonds have a disproportionately low risk profile to stocks in terms of volatility, in terms of the contribution of risk, the conversation about risk has a similar profile in meetings with clients to the conversation about returns.

Adam Butler (00:25:10):

Absolutely.

Pierre Daillie (00:25:11):

So you get five times the contribution of risk from equities versus bonds, but in conversations, you get five times the contribution of returns versus risk. If you’re talking 80/20…

Adam Butler (00:25:25):

Well, part of this is an issue with regulations. So for example, in the US regulatory regime, if you manage a 40 act mutual fund, then you are so severely limited in what you can disclose in terms of context around how the portfolio is constructed, empirical evidence for how the techniques you employ have performed historically, even if they were not employed within this fund, any sort of even educational material that might be construed as relating to or implying promises about the fund in question are strictly off limits. And so you’re left with a situation where investors sadly have very little alternative but to focus on historical returns, and even worse, the risk of the portfolio is not published anywhere in most disclosure documents. Offering memorandum or the prospectus disclose certain qualitative risks, the risks of foreign stocks, the risks of derivatives, this type of thing. But the actual empirical risk of the portfolio isn’t disclosed anywhere.

You have the rare manager that describes the average drawdown profile or the expected value at risk, or even the standard deviation. But most of it’s just the returns. And all you’re obligated to disclose is the historical returns. And sadly, that’s what investors use to make their decisions. Advisors know this. And so in my observation, it is very common for advisors to simply create portfolios from back tests of managers that just happened to have performed well over the past five years or the past 10 years and bucket that together as though that’s their model portfolio. Their model portfolio changes every six months, depending on which managers have performed best recently. And that’s what’s pitched to clients as though that’s what they’re going to receive going forward. When we know that we know empirically and every conceivable study, it’s on every disclaimer, past performance is not indicative of future returns. It’s literally pretty well the last thing you want to look at in terms of determining the relative merits of an advisor, of an approach, of a strategy. And yet it’s the only thing that most clients lean on. And there’s an enormous regulatory hurdle for them to get other information that might help provide context. It’s a major conundrum.

Pierre Daillie (00:27:51):

The investor, the client brings up the subject of past performance is no indication of results when you’re March 24th, 2020, and you’re down 35%, or you’re the end of December, 2018, and you’re down 20%. That’s when the topic comes up. It doesn’t come up often enough beforehand.

Adam Butler (00:28:13):

Well, Pierre, look, we know that nobody goes to God on prom night. They only go to God during times of crisis. Crisis necessitates change. It’s not like people, and I may be the cynic among the three of us, between Mike and Rodrigo and I, which is saying something, but if you look at when people actually make change, they don’t make change with their portfolios rocking. That’s when they should make change, but it’s not when they make change. It’s precisely at the point where you’re most confident in your approach that you should have maximum doubt. But this is so counterintuitive for people that nobody ever behaves this way. And the great thing about the current situation is that the markets have given investors a Mulligan. So you’ve got, and I know Rodrigo and Mike, used this-

Pierre Daillie (00:28:55):

We had this conversation. We talked about the Mulligan. And we did a podcast just a few days ago, which we’ve now shared out there, about the Mulligan. Don’t waste your Mulligan. And that’s not the first Mulligan, actually. It’s actually the second Mulligan. Because the first Mulligan was last year. Although in hindsight, 2019 was a terrific year for markets, as you’ve mentioned, for both stocks and bonds. So if you were a 60/40 traditional investor, you’re very happy about 2019, but you’re certainly not as happy now. Although given the V-shape bounce and the fact that several markets and or sectors year-to-date are above water for this year’s drawdown, Those investors who stayed the course are very happy. But those investors who around the third week of March capitulated, not so happy.

Adam Butler (00:29:51):

Yeah, we talked to a lot of advisors who spent March talking clients off ledges. And we’ve had lots of conversations with advisors who were ready to jump off ledges in late March. And it’s just amazing talking to these guys and everything seems obvious in hindsight. They say at hindsight capital, it’s always a banner year. And this is such a great example. I know everyone was terrified, cleaning diapers in late March, and now feeling really smart for having stayed the course. And obviously in retrospect, it makes sense, but I do think it provides an opportunity for investors and advisors to take a close look at the types of risks that their portfolios are exposed to and determine whether or not they’re sufficiently diversified for whatever the future holds. If anything, the recent episode has continued to highlight in big, bright, neon letters, this idea of uncertainty. And the only way to manage uncertainty is through proper preparation, diversity, and balance. And that’s what the risk parity portfolio is designed to do.

Pierre Daillie (00:30:58):

Let’s draw the same analogy. We talked about how there’s five times more risk contribution from equities as there is from bonds in terms of volatility draw down, the bad kind of volatility. No one’s balking at up days of 3% or more. But when it comes down to a draw down of 35%, those drawdowns are five times more emotionally charged than all of 2019’s gains. In the end, the advisor and the client relationship is going to get hurt by the pain felt from drawdowns like we had earlier this year, and obviously historically all drawdowns. So if you can lessen the blow on the draw downs and even out the returns… It kills me because this is what all advisory relationships hinge on is this idea that we’re going to get the most return for the least amount of risk. And as Mike puts it, we’re going to get the most risk adjusted return. And the idea is that it all hinges on proper construction of portfolios. I would much rather as an advisor be in the seat where the market’s down 35% in equities and portfolios down 10%, then oh my God, I’m panic stricken, what do I do, and I have to talk you off a ledge.

Adam Butler (00:32:27):

It’s true. But I think it ignores the reality that clients don’t exist in a vacuum. Well, maybe less right now, but they’re going to dinner parties. They’re watching the business news. They’re reading the newspaper. There’s not all time highs, but stocks were up in April, up in May. And if you’re not participating, even if you’ve managed some of the downside, there’s just this itch to participate. You’ve got your friends who are gloating about the fact that they bought this or that near the bottom, they bought this bank or that utility or this tech stock. And you don’t want to look like a fool. You don’t want to be left behind. There’s this fear of missing out. And that can’t be understated.

Pierre Daillie (00:33:06):

Is that like a different kind of Me Too?

Adam Butler (00:33:09):

Absolutely. Yeah, it’s the Me Too on the upside of the stock market. And there’s a few different ways to think about a drawdown. A drawdown can be, like you say, a peak to trough absolute loss in wealth. But from the perception of how clients feel, it can also be a delta or a difference between what their emotional benchmark is, maybe it’s a TSX or maybe it’s the S&P or whatever it is, whatever the performance of that emotional benchmark, if you’re lagging that, that’s also a drawdown that they feel very acutely. And so in designing a portfolio that clients are going to stick to, you need to balance off the fear of missing out against the fear of loss. And the ultimate challenge is that the intensity of those different fears changes profoundly through time in the context of the market environment.

Obviously, for the first quarter of this year, everybody was really focused on absolute drawdown, absolute loss in their portfolio. In the next little while if we begin to continue to grind higher, that will flip on its head, and now everyone will start to have this fear and focus on their inability to participate on the upside. So it’s one thing to say the logical approach is X, but that’s not how clients make decisions. I’ve been around this so long that I could care less what the portfolios are doing relative to the benchmarks. If they’re up or down or whatever, I could care less. But I do know that that’s what clients are watching and that needs to be taken into account. So I don’t know how you get that across.

The compliance regime is also a problem. If you wanted to put an entire client’s portfolio into a risk parity product, a client at a major bank will be offside their compliance department. What type of risk profile does that engender? Are there derivatives involved? Is there leverage? You’ve got all this commodity exposure, what’s that about? It’s just so outside the Overton window of what is conceivable in the typical compliance regime that many advisors and many advisory businesses, especially the biggest ones, can’t get their head around it from a regulatory and compliance standpoint and that’s also a major hurdle.

Pierre Daillie (00:35:20):

Yeah, absolutely. I think being able to explain it, I think there’s potentially a huge market for products that delegate the responsibility of making these day-to-day decisions. There’s a huge market for that. But as you say, there’s a big barrier to explaining these products to compliance and then profiling them in terms of the investment policy statement and risk tolerance.

Adam Butler (00:35:46):

And I sympathize. I sympathize with compliance departments. I sympathize with advisors. I say risk parity. It may be something completely different than what another manager says when they describe risk parity. Bridgewater’s All Weather espouses a counter cyclical approach. So their asset allocation is diversified across the different exposures to growth and inflation, but they’re mostly static through time. So when stocks go down and bonds go up, they rebalance out of stocks and into bonds. Whereas many other types of risk parity strategies are pro-cyclical. So as volatility increases in stocks relative to bonds, they’re scaling out of stocks, even if stocks are declining relative to bonds. So that’s an important dimension. What asset classes are you holding in it? Do you hold credit or not? When credit is subsumed by exposure to rates and equities. Are you hedging out your currency exposures? Do you include currency exposures directly or are they included indirectly through exposures to global markets? What is your algorithm? Are you trying to divide your risk across latent risk factors, across markets, across asset classes, across economic regimes?

You do open this Pandora’s box. Are you using cash-funded instruments like ETFs or are you using futures or are you using both? So it does require a higher level of expertise and time commitment by the compliance team and the advisor to be able to really get their head around what’s going on under the surface with these products. And that’s why we write so much and talk so much and really put ourselves out there and try to educate. But it does require effort on behalf of investors and advisors and a real interest in understanding in order to be able to find common ground to be able to move forward.

Pierre Daillie (00:37:32):

I think it’s valuable what you guys are doing. I think the fact that you’ve actually not only published a very detailed, well thought out, very thoughtful book on the subject of adaptive asset allocation, you guys have written many, many papers on the subject of risk parity and risk sizing. An advisor will have to make a concerted effort to educate compliance. In a way you’re spearheading an effort because most advisors aren’t going to take the time that they should take in order to get everybody onside, not just their investors, their clients, but the bureaucracy and the business onside with the subject. And again, it’s because there’s all these associations with what the subject matter means and the ignorance around things like derivatives and the ignorance around different strategies that employ those instruments that are considered superficially to be high risk, but in fact provide the ballast for a portfolio sort of a holistic view.

It would be great. We talked about, Rodrigo used the term do no harm, creating a do no harm portfolio. And it would be great. In the medical profession, if doctors weren’t always reacting to symptoms rather than treating illnesses, here are the illnesses that around the subject even of alternatives, there’s a lot of solutions that are now available in the marketplace that investors aren’t partaking of that, let’s say, wealthy investors have always partaken of at the very sort of high level, high net worth management level, where people have discretionary assets managed by large firms. Those things are happening for those folks. And when the markets are experiencing these massive drawdowns, they’re in those strategies.

And it’s not because they took the time to learn it, it’s because their managers are employing those strategies at a discretionary level. But when you’re dealing with individual investors and you have to explain it to them, unless you’re a discretionary portfolio manager, which for the most part most advisors aren’t yet, but eventually as they realize that that is a important way of navigating around the subject that we’re talking about today, then you’re going to have to spend time to inform the people who care, the people who look at these investor profiles, who look at these know your client profiles and try and determine are you doing the right thing for your client? You actually have to convince them through education that you are doing the right thing for the client, that what you’re actually proposing to a client does put them in a much better position in terms of weathering risk through difficult periods like this year.

Adam Butler (00:40:28):

I don’t think you’re going to convince anybody of anything. Honestly, it’s amazing, Pierre, I’ve delivered this general concept through every conceivable channel, video, podcast, webinar, face-to-face presentations on this concept of risk parity and its extensions, which we can get into, and it’s amazing to watch people nod along, advisors, institutions, individual investors. They nod along. It’s impossible to argue with from a logical standpoint. It’s impossible to argue with from an empirical standpoint. They nod along, they nod along. And at the end, when the time comes to say, “Okay, great. So we’re going to move forward with this?” They just can’t seem to do it. And I think a part of it is just what’s just different, part of it’s they don’t understand it, the way they think that they understand a typical equity allocation. And a part of it’s just, “I don’t want to deviate from what my friends are doing.”

The cost or penalty of potentially looking stupid is so large, looms so large relative to the benefits of doing the right thing, then most people just cannot take the leap. So I don’t know what the right answer is. But you talked about the fact that, and we both mentioned it, that people follow benchmarks. They think about benchmarks. Sadly, the investment industry has put forth benchmarks like the S&P 500 or the TSX. These are completely meaningless benchmarks for most investors’ objectives. They’re completely arbitrary. The appropriate benchmark should be the most diversified global asset allocation portfolio. In the 1960s, Bill Sharpe proposed the idea of the global market portfolio, which is just the portfolio that holds all global markets in proportion to their current value. So I would even espouse that as a reasonable starting point. If you want to say, “Markets are efficient, I just want to lean on the votes of every market participant. The market in average gets it right. And therefore I want to embrace a passive approach and just free ride on that free lunch,” That’s fine. But a passive approach means owning every global asset class. It doesn’t mean be passively having a 100% of your assets in the S&P 500 or the TSX.

So if you’re not prepared to do that, then what exactly is the rationale for having 80 or 90 or a 100% of your risk in some mix of US and Canadian stocks? It just doesn’t make any sense at all. Let’s at least decide on and agree on a benchmark that espouses and expresses the true opportunity set that’s available and embraces the most fundamental tenets of investing: diversity and balance. What exactly are we doing here anyway?

Pierre Daillie (00:43:19):

Have you ever looked at the average speed on your car, the average driving speed? Have you ever looked through all the screens and clicked through, and then you get to the screen where it says, “Average speed traveled”?

Adam Butler (00:43:31):

Yeah, yeah, okay.

Pierre Daillie (00:43:32):

We’re Canadians. We like to drive pretty fast. 140 when you’re on the highway. A hundred when it’s a little bit of traffic. You’re driving in city streets, sometimes it’s 20, sometimes it’s 50 or 60, whatever. But whatever it is, speaking of getting from A to B, like investors getting from the beginning of their planning to the end of their planning cycle or an objective cycle, if you look at the average speed, no matter how fast or how slow you’ve driven, I was curious because the first time I looked at it, it-

PART 2 OF 4 ENDS [00:44:04]

Pierre Daillie (00:44:00):

While you’ve driven. I was curious because the first time I looked at it, it came out at like 50.1 kilometers an hour. So no matter how fast I drove from here to there, from A to B, in the end the average speed over the life of the driving was 50.1. Then six months later, I checked again and it was like 50, it was like 50.2. And I thought, let me see if I can raise the average. You can’t, because in the end no matter how fast you drive over the life of the car, the average speed for the whole life of the car is 50. So I think you can apply that to the same thinking with portfolios, is that yeah, there’s times when equity markets make 20%, 25%, 30%, 15%, those are all exciting numbers. And there’s times when they’re down 20%, 30%, 40%. We’ve all been through those periods, but in the end, what do they actually do during the entire time that you hold them?

Adam Butler (00:45:04):

Yeah, the ride matters, absolutely. I want to circle back if you don’t mind, because you did mention that there are a variety of alternatives available. They’re mostly available to qualified investors, accredited investors, which are above a certain wealth threshold or above a certain income threshold. And I do think it’s important to explain, or raise the fact that the idea of risk parity extends beyond just stocks, bonds, and commodities. What you really want in a perfect world, you would want to have exposure to as many reliable sources of return, where each of those sources of return are derived from a completely different source of risk. Whether it’s inflation, high inflation, high growth, low inflation, low growth, or some intermediate combination of those, or some other source of risk. You really just want to add to the number of diversified sources of expected return as possible.

And what we see so often in these high net worth accounts, is that when they have the opportunity to allocate to alternatives, they overwhelmingly allocate to private equity and private credit. And just in the spirit of risk parity, which is about diversity and balance, this is such an incredible conundrum to me. Because the idea of adding more equity to a portfolio that is already mostly equity, because don’t kid yourself, private equity is equity. It just happens to be private equity that gets to be marked to whatever some private business valuator wants to mark it to.

Pierre Daillie (00:46:39):

It’s not liquid.

Adam Butler (00:46:40):

It’s not liquid, they mark it slowly over time. And if the market drops by 50%, then the private equity valuations will drop slowly over several months.

Pierre Daillie (00:46:51):

Kind of like high yield.

Adam Butler (00:46:52):

Unless high yield reprices immediately, like it did in the current crisis.

Pierre Daillie (00:46:56):

There was a couple of days there where they were marked down by 50%.

Adam Butler (00:47:01):

Very substantially in a day, a hundred percent.

Pierre Daillie (00:47:03):

Just because there’s no bid, there’s nobody there to buy it from you if you want to get out of it.

Adam Butler (00:47:08):

There’s no bid in the primary market, and there’s no bid in the secondary market and they completely break down. But it’s important to just think-

Pierre Daillie (00:47:15):

Having said that I’m-

Adam Butler (00:47:16):

For people to be aware-

Pierre Daillie (00:47:18):

I don’t want to give investors the wrong idea. Sorry, Adam. Before you continue, Adam.

Adam Butler (00:47:21):

No problem.

Pierre Daillie (00:47:22):

There is a distinctly good opportunity on an ongoing basis in high yield, but it’s just at those times where liquidity is completely dislocated because there’s no movement on the other side. You have to be aware of those times, but having those components of fixed income, of credit in your portfolio, does work.

Adam Butler (00:47:46):

Well on a default and recovery adjusted basis, I would highly recommend, it’s a very short book, it’s a great book by Eric Falkenstein, it’s called The Missing Risk Premium. And he goes through a wide variety of different so- called asset classes, one of them is credit. And what he finds is that anything below double B credit, once you adjust for costs, defaults and recoveries, has virtually no longterm risk premium. So credit is not even really an asset class, it’s rates, selling a put option on the corporate structure. So anyways, we could go on about credit forever. We completely stay away from credit, I don’t think it has any value in a portfolio to be candid. But I just wanted to highlight that there are other things that, other true alternative strategies that investors can allocate to, but that get overlooked because of the shiny bright object that is private equity.

Keep in mind, a disproportionate number of wealthy individuals are wealthy because they owned a private business for many years, and they generated this wealth by operating this private business. And so they believe that the best way to continue to maintain wealth is to invest in private businesses. But in fact, there’s no demonstrable evidence, especially over the last 10 or 15 years, that private businesses garner any excess return over public businesses, in other words just buying public stock indices, after accounting for the risk. So there’s just a lot of myths out there. And I would just suggest that people who want to seek diversification, they look for genuine diversifiers like trend strategies, or carry strategies, or skewness strategies, or something genuinely disconnected from an equity risk, in order to continue to build out this risk parity framework to as many uncorrelated sources of return as possible.

Pierre Daillie (00:49:41):

Before time gets away from us, let’s talk about the pandemic portfolio. Just before you do that, I wanted to say something. With private equity, that’s the main reason, I think the one that you stated is the main reason why private equity is attractive to high net worth investors and wealthy individuals.

Adam Butler (00:50:00):

That’s not the only reason. It’s also because they can play around with their internal rate of return calculations. So there’s so many games they could play.

Pierre Daillie (00:50:08):

Because it’s not liquid, there’s the benefit of not being… It’s like when Warren Buffett talks about, “If I went to sleep for 50 years,” or whatever the amount of time is that he said, the rip van Winkle story. “If I went to sleep and the market closed, I wouldn’t care as long as I thought it was going to be there when I woke up, and it was going to be there when the market reopened again.” Is that part of the benefit of-

Adam Butler (00:50:30):

Totally, the benefit of not having the assets?

Pierre Daillie (00:50:34):

Yeah, not having the day to day pricing. Yeah, exactly.

Adam Butler (00:50:37):

This is not unique to individuals by any stretch. If anything, institutions have bought into the private equity snake oil more than individuals have. And it’s just, this is a demonstrable and stated preference, is that it’s nice to not know where the portfolio is trading every day, or every week, or every month, because it’s emotionally painful to know where it’s trading. But Cliff Asness actually goes so far as to say that the benefit of not having to mark to market, should actually represent a premium, so that private equity should produce a return lower than that of public equity’s, precisely because investors don’t need to see those daily marks that causes them excess stress.

And I think over the next little while, we’re going to see, because private equity is so awash in liquidity, I saw it quoted that private equity firms came into 2020 with $1.5 trillion in pent up cash, that’s just ready to be called and deployed at any minute. With that much cash chasing those few opportunities, the expected returns are just going to be abysmal from here. And really, like you say, the only real benefit is, A, that’s sort of the glamor of an individual investor feeling like they get access to these private equity deals, and the fact that institutions especially don’t have to look at the daily, weekly, marks on these things. Which would cause them, I guess, undue stress.

Pierre Daillie (00:52:12):

I mean emotionally, I can see the upside of not knowing on a day to day basis, what my private equity holdings are worth. That’s a phone call, “What’s happening?”

Adam Butler (00:52:22):

Agreed, a hundred percent.

Pierre Daillie (00:52:23):

It’s not on CNBC. They’re not talking about what private equity is doing today.

Adam Butler (00:52:27):

And they don’t realize that private equity is just a small value, these days it’s more of a small mid cap fund. So you just look at your average small value fund or your average small mid cap fund. That is the true mark on your private equity portfolio, even if that’s not what’s reflected on your statement.

Pierre Daillie (00:52:43):

Let’s talk about the pandemic portfolio. What does that look like? If I wanted to get into a pandemic portfolio, what do I have to do, assuming I’m sort of a traditional 60, 40, I’ve got equities and bonds for the most part in my portfolio, or as Rodrigo put it, a hundred stocks, mostly Canadian. How do I transform my portfolio now? How do I reconstruct, now that I’ve got this mulligan, the market’s rebounded, equities have rebounded, bonds have even provided a nice return with fallen yields. Now what do I do, now that I have this second chance, where do I go from here given that I’ve got this breather, and by the looks of it there’s time. But let’s assume there’s no time like the present, and let’s assume, what do I have to do to the 60, 40 portfolio in order to make it into more of something that resembles risk parity?

Adam Butler (00:53:40):

So not withstanding our product suite and our solutions, the first thing to do is to look at your portfolio from the perspective of how much stocks, government bonds, and anything else you might have, and say, “Am I sufficiently diversified? Do I own stocks which will do well in a deflationary growth environment? Do I own bonds which will do well in a deflationary bust? Do I own commodities which will do well in an inflationary environment? Am I exposed to the economic opportunity set that’s available to me from owning the companies of different geographies, emerging markets, foreign, domestic, US? What are my currency exposures? How should I manage those?” So just think about your portfolio in terms of its diversity, and then just how well balanced is my portfolio? If I’ve got 50% stocks and 50% bonds, that really is about 80 or 85% of the portfolio is levered to stock risk. Does that represent the right level of balance?

There’s some simpler ways to do this. I mean, you can kind of proxy it or use heuristic versions of this, if you just want a static portfolio of ETF’s. I would have a look into it, but I’m going to say that it’s approximately 65%, call it 10 year treasury bonds, and then the other 35% divided equally between a global stock portfolio and a diversified commodity portfolio. But then there’s more sophisticated versions. Sadly, there are very few offices in Canada. We do run a global risk parity ETF, it runs at a fairly low volatility. We’re in the process of transforming that to preserve its global risk parity properties. But add in, remember I talked about the opportunity to add other sources of return that are uncorrelated with either stocks, bonds, or commodities. Stuff like trend, carry, seasonality, skewness, there’s a variety of others.

Pierre Daillie (00:55:33):

There you’re talking about factors.

Adam Butler (00:55:35):

Correct.

Pierre Daillie (00:55:36):

You’re talking about introducing factors to the portfolio that haven’t been there yet. I mean, just in terms of breaking apart the equity sleeve into these factors is what you’re talking about.

Adam Butler (00:55:49):

You can add factor tilts as part of your Longley equity sleeve. That’s one way to do it.

Pierre Daillie (00:55:54):

So you don’t have to break apart your existing portfolio, you can just start to slowly introduce… Well, I don’t know about slowly, but you can just start to introduce, I don’t want to get into timing. I think the idea is to sort of embrace the idea that you need to start to introduce these other factors to the portfolio that provide the offsets, the lower correlation, or the uncorrelated balance that you’re talking about. I think what you call balance and what people think of as balance are two entirely different things. And people don’t look at risk balance, they look at asset balance, they think, “Oh, I’ve got,” let’s say, “Half in equities and half in bonds, that’s balanced,” but it’s not actually balanced, because if you’re only looking at the asset prism, maybe it looks like balanced, but if you’re looking at the portfolio through the risk prism, it isn’t balanced, it’s completely unbalanced. I think that’s, just to get to a very simple point, that’s actually the most-

Adam Butler (00:56:53):

That’s the crux of the matter, yes.

Pierre Daillie (00:56:54):

Yeah, that’s the part that’s completely wrongly identified or misperceived.

Adam Butler (00:56:58):

Well coming full circle, it’s about diversity. So you want to make sure you’ve got all of these different asset classes, and as you say, potentially factor exposures, that derive their returns from completely different sources of risk. Preferably that are not just levering on top of your existing equity risk. And then you’ve got to risk size those appropriately, so that all of those different bets have an opportunity to express their unique personalities. And most contemporary portfolios have neither diversity nor balance, and you need both in order to truly have a portfolio that is designed to be prepared for, to thrive in whatever economic environment that we may face going forward. And the uncertainty right now has got to be greater than at almost any other time in the last 50 years.

Pierre Daillie (00:57:48):

I think, and I think you think, that the subject of diversification, when it’s done right, when it’s done according to risk parity or similar modeling, it’s exciting.

Adam Butler (00:58:01):

Obviously, I get very jazzed.

Pierre Daillie (00:58:03):

We get excited by these topics, but the problem is that, how do you get everyone else excited about it? I mean, ideally you don’t necessarily want everyone to be excited, because then everyone will be doing it, and then the whole thing will get sort of flattened by everyone doing this.

Adam Butler (00:58:21):

There are feedback dynamics that need to be accounted for if a sufficient number of market participants decide to allocate in a certain type of risk parity. Just like any other strategy.

Pierre Daillie (00:58:35):

We don’t know what that is. But personally, I speak for myself, but I think for the remainder of my life, I would rather have a steady return with ups and downs, and with bumps and bruises here and there, not big ones, but I would be able to withstand six, seven, eight percent, forever. As opposed to years where sometimes you make 25%, and years where you lose 25%. I think I would rather, personally, I think most people who have worked their whole lives to save these assets would also rather have that.

But do you think that maybe the superficial conversation that happens at the outset of advisor relationships is actually more damaging than productive? Because it gets into all these areas of benchmarks, and beating, and let’s do better, or I can do better than the benchmark, or my managers can do better than the benchmarks? I think the problem is that clients slash investors come into meetings with all these ideas in their heads, and then they introduce them as questions.

Or sometimes it’s the advisor that has these ideas, because they want to impress or they want to win the business. That’s also a big part of the battle is winning the business, winning the client into your practice, and sales, and gathering assets. But I just have a distinct feeling that if the subject matter started from scratch as a flat… But I don’t want to say flat, but I mean, just a plain discussion about what the objective returns are for the client’s target dates down the line. Whether they’re 10 years out, or 30 years out, or five years out from their target objective date, whatever that retirement or that liability date is. It definitely makes more sense to have a less charged discussion about returns.

Adam Butler (01:00:27):

I agree a hundred percent. I think we all share some of the blaming with that. I think clients share some blame, they bring baggage to the conversation, they bring cynicism and that desire for a level of simplicity that just doesn’t exist in a complex dynamic domain.

Pierre Daillie (01:00:43):

It’s like trying to make mathematics exciting. It’s not, it’s not exciting unless you make it exciting. How do you make, when I say exciting, I mean interesting and engaging, I don’t mean exciting like Shopify or Amazon, I mean exciting like I want to make it to my goal. I want to get there, and when I get to that date, 2025 or 2035, I want to have my family’s wealth intact. And I want to be able to have the option of either selling my business or continuing, and it doesn’t matter. I want to be able to have all the options at my feet, and be able to say, “This is what I want to do,” or, “This is what I don’t want to do.”

I think that’s the ultimate objective for someone who has accumulated wealth and wants to keep it. When you’re 25, you don’t think that way, but when you’re 55 or 60, you do think that way, and you think I’ve made it this far, I don’t want to screw it up by making some bad decisions. I’m going to talk to 10 advisors, or five advisors, or I’m going to talk to the three best advisors that I can find on the street, and I’m going to see what they say.

Adam Butler (01:01:48):

How do you even judge? As a client, how do you judge what’s a good adviser?

Pierre Daillie (01:01:52):

It’s so subjective.

Adam Butler (01:01:53):

I use this analogue all the time and Mike can’t stand it, but I’m going to go for it anyway. If you’re really sick, if you’ve got some sort of potentially mortal disease and you go to see one specialist in this disease, and then you go to see another specialist in this disease, and it’s a rare disease and it’s a complicated disease, and you’ve got two guys, two experts who tell you completely different recommendations about what treatment protocol or path you should pursue, how is a layman going to decide? How does that happen?

Pierre Daillie (01:02:25):

I speak for myself when I say that at that point, if I was faced with that dilemma, I would want to be the best informed as I possibly could be, going into that situation. And so, as an investor looking for a suitable advisor, I would want to be the best informed. I love the fact that you guys do this, I love the fact that if I’m looking for these types of strategies, I can find you easily. If I put in risk parity, or get into the subject that you guys have written extensively about, and presented extensively about, and I’m eventually going to find you, whether it’s right away or as I’m continuing to look.

But going into that situation that you just described, I would want to be the most informed person in the room. Only then, I’d be able to decide whether this physician or this physician, this specialist knows what they’re talking about. Because I think we’ve all encountered situations where we feel like, I don’t think he knows what he’s talking about, when you go and you see any kind of professional, if you’ve taken the time to do your homework.

And I think people who have spent their lifetimes accumulating wealth, and we should give them more credit, they’re smarter than we think they are. Even if it’s at an intuitive level or an intellectual level, they know-

Adam Butler (01:03:42):

It’s not about intelligence.

Pierre Daillie (01:03:42):

No, it’s not. But I’m trying to cover off that base, which is to say intellectually or intuitively, they know whether someone knows what they’re talking about or not, and they know whether someone understands risk or not. And I would say that if I had spent my life accumulating assets and I came to you with $20 million, for example, and I said, “Adam, what can we do? How can we get from here to there in five, 10, 15 years? How are you going to do it?” And then if you don’t cover off what I think are the most important subjects of the discussion, then I’m going to walk away.

Adam Butler (01:04:18):

That’s fine, except that so often those conversations lead with, “I’m focused on good quality companies with high dividends,” without recognition that that is a complete red herring.

Pierre Daillie (01:04:30):

Maybe I’m just assuming that everybody who has worked-

Adam Butler (01:04:32):

Well, the challenge is that again, if you became wealthy by successfully managing and operating a business for many, many years, then you think that the secret to keeping wealth is to manage or own high quality operating businesses, and that’s the way. But the way of maintaining and sustaining wealth that you’ve already accumulated is polar opposite from the way that you accumulate great wealth in the first place. And so it’s very difficult, there’s maybe in my experience, maybe five or 10% of ultra wealthy individuals are able to wrap their head around the fact, that just because they have an expertise and an experience in something that made them extraordinarily wealthy, it doesn’t mean that they have experience, or talents, or education in ways to maintain or sustain wealth over multiple generations.

They’re completely different sets of skills and expertise, and they, in fact, don’t even really overlap. There is some portion of investors who are able to get over that hump, who self-educate and come to those realizations on their own. Those are the ones that often become our clients, or the clients of others who think like us. But there’s obviously going to be a majority that are just never going to come to that conclusion, because their own personal experience is so vastly orthogonal to those realities that they can never cross the chasm.

Pierre Daillie (01:06:01):

So, when you guys sit down with a new client-

PART 3 OF 4 ENDS [01:06:04]

Adam Butler (01:06:00):

… that they could never cross the chasm.

Pierre Daillie (01:06:01):

So when you guys sit down with a new client, someone who’s come on board and you’re onboarding them, or in advance of onboarding them, you’re having these conversations. How much time are you actually spending to uncover their biases? I think that’s what you were just talking about.

Adam Butler (01:06:17):

It doesn’t even happen for us anymore. Because we only take on individual clients who have found us by reading our research or from hearing us on TV or multiple podcasts or whatever. So they come to us already understanding at a pretty meaningful level, what our values are. So if our values, which we’ve expressed clearly, and over and over again, don’t resonate with you, you’re unlikely to call us up and ask us to go into our approach in more detail. And to come in and have a more fulsome conversation where you share your situation, your experience, and together, we come to a strategy on how to get you to whatever financial objectives that you express. So it’s a self filtering process. We don’t market the way that most advisors market, by referrals or what have you, or getting referrals because we’re employees of Royal Bank. Our engagement comes through our content and through our education, and therefore we get the right type of clients coming to us organically. And so that obviates a lot of those preliminary discussions that don’t go anywhere.

Pierre Daillie (01:07:29):

It’s very advantageous. I think one thing I’m surprised you have as ReSolve Asset Management, you have your own shop. You have the ability to do all that you want to do in terms of educating, in terms of doing webinars, in terms of publishing papers, in terms of… Again, we circle back to the compliance landscape. A lot of advisors seem to not have the willingness or the courage to invest their time in educating clients and investors, prospective clients.

Adam Butler (01:08:06):

It’s very difficult for advisors. I mean, that’s the major reason why we knew that we needed to go out on our own. If we were going to express our values and educate investors on our views in an uncontaminated way, then there was no way to do that at a major investment dealer under their compliance regime. And also, then that broker dealer risks us saying something that stands in contravention to what other advisors are saying. And it’s very difficult for clients to deal with that level of cognitive dissonance, between advisors of the same firm. There’s a lot of complexity that just makes it impossible for, well not impossible, but much more challenging for independent thinkers with strong moral backbones to be able to under that regime. And I think it’s going to motivate a lot more people to become independent over the next few years, just as we’ve observed in the United States. Where obviously the last decade has seen an enormous migration of advisors from the major broker dealers into an independent state.

Pierre Daillie (01:09:18):

Circling back to the pandemic portfolio, I imagine you have a really good understanding of what a traditional portfolio looks like across the advisor universe in terms of ball parking. What’s one major area that’s really lacking in that traditional portfolio that you think could dramatically, or meaningfully rather, improve the outcome of a portfolio over an extended period of time? What could advisors do, who don’t have the discretion that we’re talking about? I mean, other than obviously they could just start to allocate more and more to sort of one ticket solutions, where the day to day running of strategies is being done for them within an ETF or within a fund. But let’s assume that they’re not going to do that sort of thing.

Adam Butler (01:10:11):

I mean, one simple thing to do is reduce your equity beta. And you can reduce your equity beta by lowering your capital allocation to equities, but you can also reduce your equity beta by constructing your equity portfolio in a different way, or buying products that construct your portfolio in a different way. So for example, instead of owning a cap weighted portfolio, own a global minimum variance portfolio. A global minimum variance portfolio has about half the equity beta as a market cap weighted equity portfolio. So you immediately dramatically improve the risk balance in your portfolio, simply by shifting your equity allocation from a cap weighted strategy into a minimum varying strategy. That’s one step.

You could also reduce your equity exposure in favor of adding global government bonds, and adding exposure like strategic exposure, to a commodity index or ETF. There are several well constructed commodity ETFs. There’s one listed in the US called PDBC, Peter, David, Bob, Charlie, that obviously Canadian investors can buy, and allocates to a diversified basket of commodities that optimizes for positive carry. Which is important in allocating to commodities. And then you can see genuinely diversified alternatives, which sadly in Canada are rather sparse. Most tend to be oriented to sort of small cap or resource oriented. There’s some long short equity. There’s a lot of credit.

Credit looks like it’s uncorrelated to equities, except when you need it to be uncorrelated most as you’ve seen with a lot of these private credit funds. Especially recently, which are going to see massive write-downs. Most investors don’t even know that yet. So you’ve got to be really selective. But to the extent that you can get allocations to truly uncorrelated alternatives, I think that there’s an argument to be made for that. So there’s some simple steps that investors can take. Obviously, we’ve got a line up of products and separately managed account strategies that very directly express this perspective, and these approaches. But if you want to sort of take it into your own hands or advise your advisor on different preferences, then those are some baby steps that you could take.

Pierre Daillie (01:12:31):

I don’t know that I’d want to take it into my own hands. I think having read quite a few of your papers, and being part of many discussions with the three of you, with you and Mike and Rodrigo, that’s not exactly something that I’d want to undertake on my own. When I’ve read through… You mentioned Cliff Asness. When I’ve read through Cliff Asness’ papers and articles and blogs. I think the decision making landscape has become more complicated. Definitely it’s very complex. I would say less so in equities, but more so on the other side, on the side of assets that balance against equity risk. I think that’s where the landscape is more complex. And I think it’s more essential and more necessary to investigate the different areas that are worthy, in terms of balancing off that equity risk, so that you get that ballast in your portfolio, that bonds provided for so long.

Adam Butler (01:13:31):

There’s never been an argument, a better or more persuasive argument for investment advice. I always find this to be the strangest experience. No individual thinks that they should be charged with removing their own appendix, or defending themselves in court, or devising complex tax strategies. And yet everybody thinks that they could single handedly be the next Warren Buffet, or even just take a basic investment plan into their own hands. It’s absurd. If anything, the investment environment is one of the more complex professions, and it has the potential to go very, very wrong for people who don’t know what they’re doing. And yet everyone, or a great majority, seem to presume that they can navigate these stormy waters on their own. I mean, I think there’s never been a better argument for advisers. There’s always a challenge of finding advisors with the right set of values and morals and integrity and expertise, who gets it with a differentiated experience that’s worth their fees.

But there is no shortage of those advisors out there. With a little effort, you can absolutely put your finger on one. There’s probably one in your neighborhood if you do a little digging. So nothing I’ve said argues against the need for financial advice, it does argue for the need to be more discerning about where you’re getting that advice from. About how much you pay for the value that you receive. About thinking about the problem differently. But 100% people should be focused on getting financial advice, and leaning into that. Not leaning away.

Pierre Daillie (01:15:07):

I mean, I have to admit, I’ve been really at odds with this whole industry of do it yourself and robo advisers. And I think the problem is that… In a nutshell, what I’ve realized is that the more I learn about this business, about the industry, about markets. Let’s say about markets, because the more I learn about markets, the more… And I keep repeating this. I find myself repeating this point over and over again. But the more that I learned about investing, the more I realized how little I know. And it’s not getting any better. The proportion of knowledge isn’t changing, it’s just getting wider and wider. Because as I read more, as I learn more, I realize wow, I’ve never heard of this. Or I didn’t even know that this segment or this idea even existed.

Adam Butler (01:15:56):

Are you familiar with the Dunning Kruger effect?

Pierre Daillie (01:15:59):

Not by name. No. But go ahead. You’ve got my curiosity.

Adam Butler (01:16:03):

Dunning Kruger, they demonstrated the phenomenon where if you don’t know much about a subject, then you don’t know enough to know what you don’t know. You haven’t interfaced with the subject matter enough to see how vast the domain is. You’ve only had this small narrow glimpse. So the less you know about a subject, the more likely you are to think that it’s simple, because you don’t know enough to know how vast the total domain space is. And so this is true of every domain, not just investing. But the more you learn about a subject, the more you realize that you don’t know as a proportion of what there is to know. And unfortunately, if you don’t know about a subject, then everybody is in a position of thinking that they know a lot more than they really do. And I think you’re right. That that motivates some very bad behavior.

Pierre Daillie (01:16:55):

Or, it makes you realize that as an investor, you would really benefit from having a good advisor. A suitable advisor. Someone who has the knowledge, enough knowledge, to take you to where it is you’re trying to get financially.

Adam Butler (01:17:11):

Agreed.

Pierre Daillie (01:17:12):

When I left the business, I realized… I don’t know how long it was afterwards. But I realized, not too long afterwards, that I literally, I knew nothing about the bond market that I thought I knew. I had no idea how complex it was, or how vast it was. And when we started advisor analysts, well over 10 years ago now, 11 years ago, that was one of the areas that we spent a lot of time focusing on. It also coincided with the GFC, with the great Global Financial Crisis. At the heart of it, was the credit market, the bond market. And at the heart of all the Fed’s rescue and remedies, was the bond market that came first. And realizing that the bond market came first, it was really sort of at a precedent to the equity market. That if you didn’t look after the bond market, the equity market was going to have a hard time moving forward smoothly.

And same thing has happened again here, I think. That in 2020 with the shutdown of the economy and the sort of seizing up of credit at the outset of this crisis, with the shutdown, the Fed stepped in to remedy the bond market, and stepped into remedy the credit market, and is still sort of working through it. But if that wasn’t done, then the system potentially falls apart. And so again, everything seems to always come back to this 80-20 rule, or Pareto. Which is that, that’s 80% of the market really, is understanding what’s going on in the bond market helps. And that’s why the question always comes up, who is right? The bond market or the stock market.

Adam Butler (01:18:52):

And they’re often at odds, at turning points.

Pierre Daillie (01:18:54):

Yeah, like right now. I mean, there’s a lot of concerns about the economy. That Mulligan, that we’ve talked about this last week, is so valuable right now that even just saying, “Don’t waste your Mulligan,” under plays the value of that Mulligan. The fact that investors have a second chance to reposition themselves for whatever comes next, whether it’s in the near future or over the next 10 years or longer, you’ve got a chance to get that money that you could’ve lost in March.

Adam Butler (01:19:28):

You’ve got much of it back, and now you get a chance to-

Pierre Daillie (01:19:31):

Keep it.

Adam Butler (01:19:32):

And better decisions, and have a much better chance going forward. Agreed.

Pierre Daillie (01:19:37):

It’s not just about keeping it, obviously. Keeping that million dollars break even from early February, or whatever your balance is. It’s not just about keeping it, it’s about continuing to keep it and continuing to make it grow without giving up the insurance. Maybe the takeaway from this is that advisors are more valuable than ever.

Adam Butler (01:19:59):

Certain advisors, certainly. A good advisor is, I think you’re right, more valuable than ever. Absolutely.

Pierre Daillie (01:20:05):

So if you aren’t up to speed on topics like risk parity, or diversification at the level of the discussion of risk parity and other methodologies and processes, make it your business to get up to speed on that. Because you have the second chance now, assuming your portfolio is intact. You have the opportunity now to keep it intact, and you have the opportunity now to take it into the future. We covered a lot of ground in our discussion today. Anything else, Adam? Any other takeaways?

Adam Butler (01:20:41):

No. I mean, I think again, you’ve got a chance to make better decisions without having experienced material harm. That doesn’t happen very often. So Carpe Deum, there’s no time like the present. We’ve got tons of material, a great starting place for learning about better portfolio diversification at riskparity.ca. And obviously, as you’ve mentioned, we’ve got dozens of articles and papers on our blog that deal with asset allocation and other topics that we’ve covered today, and a variety of other topics that we can maybe cover in future episodes.

Pierre Daillie (01:21:17):

That’s at GestaltU.com.

Adam Butler (01:21:20):

investresolve.com.

Pierre Daillie (01:21:21):

Investresolve?

Adam Butler (01:21:22):

Yep. And like I said, riskparity.ca.

Pierre Daillie (01:21:24):

Have you done away with GestaltU, or you haven’t?

Adam Butler (01:21:26):

No. It’s still there. That’s the blog I started writing in 2009. And we’ve migrated most of the new content to investresolve’s blog site. And the research papers are there, and all the podcasts and webinars and videos, et cetera. So, that’s just a way better portal to find the full cross section of our educational suite.

Pierre Daillie (01:21:47):

Now, Adam, you evolved. I mean you and Mike and Rodrigo, you guys kind of evolved to where you are today, because you couldn’t find the right place, and you’re always looking for the right landscape in which to solve the problems. And eventually starting ReSolve is the result of that search, that quest.

Adam Butler (01:22:06):

Exactly right.

Pierre Daillie (01:22:07):

It was a very long quest. I know you guys have been in the business for a very long time, and to have gone from one place to another in search of the right home for that, has probably been the biggest challenge of your lives. I mean, in terms of finally making the decision to start your own asset management firm.

Adam Butler (01:22:25):

It’s a huge risk. But I mean, really there was no other choice. We could not make the dent that we wanted to make under someone else’s shingle, so we launched our own. Thankfully we had both the qualifications –  I mean, in Canada, it’s not easy to launch your own investment firm. And in the US, all you need to do is fog a mirror you can launch an RIA. In Canada, you need a CFA, you need a bunch of years in a compliance role, you need a bunch of courses, and you need requisite capital. It’s expensive. There’s lots of legal fees, both to startup and ongoing. So we had a critical mass of clients, and we had a critical mass business size. We had a critical mass of partners with diverse skillsets, but a shared vision and shared values.

So, I’m just overwhelmingly grateful about the partners that I have, and the ability to make a dent while preserving the moral fabric. That really sets us apart, in how we think about the problems. So it’s been a great journey. There’s been some ups and downs, as you’ve said, but I wouldn’t have traded it for any other path. That’s for sure.

Pierre Daillie (01:23:34):

I mean, I’ve certainly enjoyed getting to know you guys. And I know you and I, we just met today, but I’ve been talking to Mike and Rodrigo for years now. And I have to say, it’s been highly educational for me, because you guys walk the walk and you talk the talk. And you guys are so passionate about what you do. I have to say, it’s hard not to get enthusiastic about what you do when I’m talking with you guys, because first of all, I love the business. I love investing. I love the business of investing and everything around it, and to do with it. Maybe not everything, but I do.

Adam Butler (01:24:15):

It helped to keep you excited

Pierre Daillie (01:24:16):

I’m enthusiastic about it. But you guys have brought this other dimension to it, that I think even some of the most seasoned people even south of the border who were doing it, like hedge fund managers, you guys have already made it more exciting or more interesting, because you have that passion. There’s nothing like being around people who are passionate about what they’re doing, and who are true believers in what they’re doing. And so, that’s what I think about you guys. I feel like you guys are so far ahead that way. You eat your own cooking. You’re excited about what you do.

Adam Butler (01:24:50):

Well, look, it takes a pack. We’re just unbelievably grateful to be part of a pack that includes you and Advisor Analyst, and you’re out there trying to fight the good fight. And I think you bring such enormous value to the audience in terms of divergent viewpoints, and an abundance of research from a variety of different sources. And just really the pursuit of truth, which I think we’re trying to get to, and you’re trying to get to, and it takes both sides. It takes guys who are looking to ask questions and ready to put themselves out there and publish and aggregate research. And it takes guys who are willing to put themselves out there in terms of doing research, and having tough conversations, and putting their stake in the ground, saying we stand for something. And so I think it’s been a real good experience. We’re lucky to have one another in the community that we built. So we just need to continue fighting the good fight.

Pierre Daillie (01:25:38):

Well, thank you, Adam. I don’t know what to say. I’m not going to be able to go out and get groceries today. I’m not going to be able to get out. But I think when people who are passionate respectively about what they’re doing, meet up with other people who are passionate about what they’re doing, it’s incredible what can happen. Like in terms of the conversations, the things that we have in common are really amazing.

Adam Butler (01:26:02):

Agreed.

Pierre Daillie (01:26:03):

Adam, thank you so much. Thank you for having me. And it’s been really a great conversation and I hope to have many more. I think we only got onto the tip of the iceberg here, and there’s so much more room for expansion-

Adam Butler (01:26:16):

Agreed.

Pierre Daillie (01:26:17):

On everything that we’ve talked about. Yeah.

Adam Butler (01:26:19):

It’s endless. Grist for the mill, and this has been a lot of fun. And you know that the three or four or five headed monster that is ReSolve, is always ready and willing to evangelize and challenge the consensus, and also listen to great ideas. So thank you for providing a forum and asking great questions and seeking truth.

Pierre Daillie (01:26:40):

I hope I asked some good questions.

Adam Butler (01:26:42):

That’s great. Appreciate it. Thanks Pierre.

Pierre Daillie (01:26:45):

Adam, thank you.

Adam Butler (01:26:46):

All right.

Speaker 3 (01:26:47):

Thank you for listening to the Gestalt University podcast. You will find all the information we highlighted in this episode, in the show notes at investresolve.com/blog. You can also learn more about ReSolve’s approach to investing, by going to our website and research blog at investresolve.com, where you will find over 200 articles that cover a wide array of important topics in the area of investing. We also encourage you to engage with the whole team on Twitter, by searching the handle @investresolve, and hitting the follow button. If you’re enjoying the series, please take the time to share us with your friends through email, social media. And if you really learned something new and believe that our podcast would be helpful to others, we would be incredibly grateful if you could leave us a review on iTunes. Thanks again. And see you next time.

PART 4 OF 4 ENDS [01:27:43]