Animal Spirits Podcast - Talk Your Book: Portfolio Premortem

Episode Date: September 19, 2022

On today's show, we spoke to Fabric Risk Co-Founder, Rick Bookstaber about identifying risks for advisors, lifestyle characteristics and risks, the MSCI factor model, scenario testing, and much more. Find complete shownotes on our blogs...  Ben Carlson’s A Wealth of Common Sense  Michael Batnick’s The Irrelevant Investor  Like us on Facebook  And feel free to shoot us an email at [e-mail] with any feedback, questions, recommendations, or ideas for future topics of conversation.  Learn more about your ad choices. Visit megaphone.fm/adchoices

Today's Animal Spirits Talk Your Book is brought to you by Fabric. Go to FabricRisc.com to learn more about their system that helps advisors manage risk in client portfolios. Welcome to Animal Spirits, a show about markets, life, and investing. Join Michael Batnik and Ben Carlson as they talk about what they're reading, writing, and watching. Michael Battenick and Ben Carlson work for Ritt Holtz wealth management. All opinions expressed by Michael and Ben or any podcast guests are solely their own opinions and do not. not reflect the opinion of Ritt Holt's wealth management. This podcast is for informational purposes only and should not be relied upon for investment decisions. Clients of Rithold's wealth

management may maintain positions in the securities discussed in this podcast. Welcome to Animal Spirits with Michael and Ben. Michael, I think it was back in early to mid-2000s reading a Ryan holiday book. I think it was called Obstacle as the Way. It was really my first introduction to the whole idea of performing a premortem. You've heard the post-mortem where you look after the fact and say well, it went wrong. Pre-mortem is, let's go ahead of time and figure out what could go wrong in advance before we even start. That way, you don't have to go back after the fact and be totally surprised. I loved this idea in terms of portfolios and thinking through, because we've mentioned before, like things that never happen seem to happen all the time in financial markets

because we really don't have that long to go with it. I think that's something that advisors could probably help with clients more than they think is preparing people for a wide range of outcomes and drilling it in their head over and over again. And I think that's something you can do qualitatively and quantitatively these days. The platform that we're speaking with today is something called Fabric Risk. And we've had Rick on in the past to talk about the platform. And I would encourage anyone who's interested to go directly to the site and do a demo because it's one thing to talk about risk, even though it's something that's quantifiable, just, it's a little bit squishy when you're talking about it. But seeing this come to light was really eye-opening

for Ben and I. So like, for example, one of the things that this platform does, and it does a lot of things, is it shows you sort of like a tolerance ban of where the portfolios are in terms of where you want it to be and rebalancing. And I've never seen anything that at a glance, like color codes it so effectively for the advisor, whether a portfolio manager or the trader. Basically, any advisor is going to have dozens to hundreds to thousands of client accounts and being able to see it all in one place to understand whether that client is within the range of potential risks or outside of it is great because that's not only warrants a conversation that could warrant some sort of change in the portfolio. So we get into that

and more with Rick Bookstabber. Rick's got a crazy background in risk management for a bunch of different hedge funds and foundations and endowments and institutions. So here's our conversation with Rick Bookstabber from Fabric Risk. We're joined again today by Rick Bookstaber. Rick is the co-founder of Fabric Risk. Rick, good to have you back on the show today. Great. Thanks for having me back on.

So you have a storied background. You spent your whole career looking at risk in different ways. Why don't you tell us a little bit about your background and why you thought that now is a good time to bring this product to the marketplace? My career really has been in risk management. I was in charge risk management. the first risk manager really at Morgan Stanley, then moved over to Solomon Brothers, which maybe a lot of people now don't remember, but at the time it was the biggest trading firm

in the world and then became part of Smith Barney and then Citigroup. And at that time, I moved from the what's called the sell side. I moved from the broker-dealer and banks into hedge funds. And so I worked at a bunch of hedge funds. The last one I worked at was Bridgewater. and then after 2008 went and worked at the U.S. Treasury. After that, I went to University of California and was the chief risk officer there. And really, that path actually is related to the whole genesis of how I ended up doing fabric.

When I worked at the U.S. Treasury, I was there to help improve the risk structure of the financial system after the 2008 crisis. And from my vantage point there, I saw all the focus was on banks while the pain was with individuals, the single mother in Des Moines losing her job or the young couple in Las Vegas losing their house. And so I turned my focus there. And that's the reason I went to the University of California because the CIO there,

Jack Debt Botcher, and I sort of shared a vision for developing top grade risk management tools for asset owners. So I joined him as the chief risk officer at the UC Pension and Endowment, which is nearly $200 billion endowment and pension. And that's where I formed the foundation of Fabric. And University of California actually is a part owner of Fabric. What did you actually take from all those experiences with basically the institutional world and now you're trying to bring it to advisors?

What is it that you're trying to do for advisors and how are you trying to help them manage that risk? So where fabric sits is basically fabric's a platform for what I'd call risk-aware portfolio design. What I wanted to do is build fabrics or advisors could have access to the portfolio and risk technology that up to now has only been available to institutional investors. And what I mean by risk-aware portfolio design is that, first of all, when you look at the advisory community, when you're looking at the advisor, community about portfolio management. It's mostly performance reporting or trade execution. And these are important, but they're not really leading to building a portfolio that's the best

for a particular client's objective. That's efficient and scalable. A lot of times, advisors go to TAMP's to outsource this. So what I've done with Fabric is create a technology that allows advisors to do it themselves in a way that's more customized and risk-aware. and it's the risk-aware part of the portfolio design that matters. It's building, maintaining a portfolio by understanding risk first. As an example, as I mentioned, I worked with Ray Dalio Bridgewater. The key product there is the all-weather fund. And the starting point there is basically having a risk-aware portfolio design.

So, Rick, as I think about risk, there are all different ways to quantify it. It could be mathematical, it could be emotional. And like, for example, risk can be just standard deviation. How volatile is your portfolio? Risk can be drawdowns or historical drawdowns. What are the likelihood that I can experience a 12-month decline of X percent that's more than my stomach can handle? Or a bigger risk, perhaps, is what is the risk that I cannot hit my financial objectives?

If I am 45 and I've got this bucket of money that I'm contributing to, assuming these different rates of return, will I be able to live the sort of lifestyle that I want to live? When you're thinking about risk, which of these or other buckets are you looking at this through? This is the key thing that what you're pointing out is that for advisors, risks a lot different than if you're a hedge fund or a trading desk at a bank. This are more layers to the onion. So you always do start with market risk, and you always do take market risk and see what that

means for a portfolio, and you get them to the numbers that you're talking about. And it could be value at risk, volatility, your standard deviation of risk, maximum, draw down, all these things you're talking about. And that's a good start, but risk is more than a number, especially for an individual, because you then move into plan risk. And plan risk includes changes in risks in the individual's life. So it's not only about returns. If you only look at the portfolio returns when you're talking about individuals, when

advisors look at their client, it's like you're kind of clapping with one hand. You also have to look at those risks in the context of the individual's goals and objectives. And there's a lot of ways to look at goals and objectives. We can have a whole conversation about that. but there too. That's not a number. The individual's risk is not like risk tolerance. You can't do that because individuals care about security. They don't want to end up out on the street. They care about lifestyle. They want to be able to maintain their comfortable lifestyle through retirement. They have aspirational goals. They want to be able to save to maybe get a second home. I really love

the work of Ashven Chahabra, who wrote a book on this. topic called the aspirational investor. That's the way that I kind of think of objectives. And the thing is that all these risks feed off of each other. For example, your plans and your objectives are going to change based on your wealth. The other thing, too, that matters for individuals when it comes to risk that you don't get kind of when you're doing risk for hedge funds or portfolio managers is people have a longer time frame than a portfolio manager has. It's years rather than months. So the risk that matter are different. There's some things that a portfolio manager cares about that amount to noise if you have that long-term time frame of an individual. And there's some things an individual

cares about that build up too slowly or really even catch the eye of the portfolio manager. The problem is that despite these sorts of distinctions and differences, the legacy systems of risk management have ended up being kind of airlifted into advisor applications. I second your a recommendation for that book. I actually read that one to the aspirational investor. I liked his thoughts on like personal risk and aspirational risk and market risk, all that stuff. It was very good. Michael and I actually had a chance to run through fabric. I want to get into some of the details now of the product. Michael and I actually had a, from your colleague, Gavinda, gave us a nice little tutorial of it. I'm just curious because I think a lot of advisors are concerned about career

risk and clients leaving them. So part of it is you want to be able to bring in new clients and show them that you're a great advisor. The other thing is you don't want to rock the boat too much with your current clients and show them that you're weak or you miss something. And so one of the things we were wondering about with your program is basically you can use all these quantitative tools to show whether some of your model portfolios look good from the sort of risk that you're trying to suss out for clients. How do you straddle the line between trying to show advisors how to potentially improve their models or their portfolios? And also, unfortunately, be telling advisors that the portfolios they've been using, maybe are taking on too much risk

or they just don't know some of the risks that reside in that portfolio. How do you sort of straddle that line? That gets to really, all this is something the advisor has to do. So we're providing tools. We're not providing the distinct answers. And so really, what does the advisor do with the tool? So people talk about what's actionable, which is basically what do you end up doing with it. What can you do with it and what do you do with it? What does it do for you that you might not think about otherwise? So if you think about the things you can do, and then you can ask the question of, do I want to do this? How do I communicate it to the client? The typical use cases or the ways that you can use it is, first of all, a natural immediate starting point

is which portfolios are deviating from their intended goals for clients. And that can either be because the nature of the market's changed or the goals have changed. And that's why really you need to look at risk in context, in the context of the individual. And then you want to know how will investment recommendations impact my client's portfolio. And it might be that you're in a world where you don't believe in investment recommendations. you're not trying to generate alpha, but sometimes those recommendations are implicit, even if they're not explicit. If you bias the portfolio away from some benchmark, so you want to sort of know if I'm doing

things that are outside of some notion of model portfolio, first of all, do they really matter? Are they even moving the needle? If that's not the case, life's easy. You don't have to bother. It's one less thing to worry about with your client. On the other side of things, are there certain things that we're doing with portfolio that kind of conspire with other biases? So they add fuel to the fire so that if there's a specific shock that

occurs, things will be even worse than what we might otherwise expect. Kind of related to that, just more generally, is how will the portfolio be affected by a bad market environment? This is looking at scenarios. Like, let's put in a scenario, what if, of stagflation. How is that going to feed through to objectives? And given their time frame, is it something that matters? And can I change their exposure to better face those sorts of uncertainties? Rick, as advisors bucket this out mentally, is this more portfolio management and analytics? Or is this financial plan management?

Like, does it incorporate both aspects of the ledger? What we're doing is not financial planning. but we take the information that would come from a financial plan and put it into a cogent system for portfolio design and one that respects the risks that are inherent both in the financial plan and in the market and have those entry late. So really the advisor would work with the client in any number of ways to try to get an assessment of the sorts of buckets of objectives they have. And those will change over time.

So, like, think of security lifestyle aspiration, again, the Chihabra buckets. Security is going to mean a different thing to a 30-year-old, then it will mean to that person as a 33-year-old when they're starting a family, which will mean a different thing to that person as a 60-year-old when they've had a successful career and have a lot of wealth to support them. The same with lifestyle and with aspirations. There's probably not a whole lot of aspirations on the table. If you're 32 years old and have four kids that you have to worry about getting through

college, if you're an individual in your 40s and you don't have those responsibilities, you might put more into the aspirational bucket. So those are the sorts of things that the client and the advisor has to deal with sort of the lifestyle characteristics. But once you've done that, now you can structure portfolio that meets each of those. And the part of your portfolio that meets each of them is going to be different. You're going to hold different things to address security than address lifestyle. You're going to be willing to reach more in terms of risk to deal with aspirations.

So we're kind of taking over in the portfolio design and doing it in a way that understands and deals with the risks once the financial plan is done. One of the lightball moments for Michael and I when we were going through the demo of your system was just the whole. dashboard of different clients. And is your hope for advisors, because there's advisors out there who are managing dozens or hundreds, maybe even thousands of clients, is the hope for your system for advisors that use it simply that there will be some sort of red flag that you can monitor client portfolios and understand when things get out of whack and when they're taking too much or too little risk that advisors can then go to those clients and have conversations around the portfolio or around their goals? Is that the idea? Well, that's one of the functions. If you're doing risk

management. The first thing you do is see if anybody's gone over the trip wire and try to deal with that. But that's why I distinguish what we do. Rather than calling it risk management, which is a component of it, which is very important, that's why I call it risk-aware portfolio design. So you're not just trying to find times that somebody really is kind of out ahead of their skis. you're trying to find out how what they're holding is going to meet their objectives, but also you're also looking for the potential that some light will flash red. And this gets to the scenarios. You want to look at things that could be a concern in the market,

stackflation being an obvious concern right now. And you want to be able to pre-arm your client, sort of rehearse with your client the implications, if that sort of an event occurs. So you're not having to sort of walk them off the ledge when it's happening. The last thing you want to be doing as an advisor is having to feel panicked phone calls from clients because the market is misbehaving and they're wondering, what should I do? What should I do?

And a lot of times for them, what's happening in the market is just noise. If you've got a 30-year perspective, a tech blow-up, unless you're really super exposed to tech, A technology blowup is a flash in the pan for you. So the risk system would flash red once that's occurring. The ideal is the client has been trained to understand that before it occurs so that when it happens, sort of like, yeah, I've seen that movie already. I get it. I can work through this thing.

Rick, one of the exciting things about markets for better and this year for worse is that things that movies that we haven't seen before are always coming. onto the big screen. So, for example, if you were to model out the risk of a balanced 6040 portfolio, nowhere in their history would you see 2022. From January through August, through the end of August, the 6040 portfolios down almost 15% year to date, which is significantly worse than any start to a year since 1976. As new information becomes available, how do you update your own risk models? There's two things going on. There's what can you do to divine to understand understand these sorts of extreme events. Usually people think of the bonds as sort of a

moderating component. And here it's just exacerbated. People don't realize that a 10-year bond actually can drop 10 and 20 percent. Now they do. Yeah. The only time it has low risk is if it's matching your liabilities, if it comes due when you need the money. But what we're seeing now is a pretty extreme case. But first of all, risk systems, I would say universally, have gotten it wrong because of a couple of things. One is, as I mentioned, they look at risk just as a number. And risk isn't a number. It's an ongoing narrative. It has dynamics. There's a richness to it, especially when you put in the context of an individual's objectives. The second thing is the markets are dynamic and the risk now is different than it's been

over the last few years, but most risk systems take the last year or two, look at how much the market's bounced up and down, take that volatility, and apply it to look at risk today. And we all know that doesn't really make sense. I mean, you know, there's this mantra. We all know past performance is not indicative of future results. Well, people talk about that in terms of research. returns, they also should realize it's true with risk. And so one thing we do is we look at the nature of the market today. We look at the vulnerability of the market. Is there a lot of leverage? Is

there illiquidity? Is there high concentration? And we paramedize our models to take that into account, and then the risk model that we use itself allows for dynamics within the market. I think this is especially important. Look, if I only care about risk over the next three days, like if I'm a trading desk at a bank, maybe I can look at the last year or two and say, okay, for the next three days, that's probably okay. If I'm an individual looking at years, you know for sure what's happened in the last couple years is not the way things will unwind in the next while. So that's kind of a critical component is knowing what you can learn from the past, but not depending too much on the past in looking forward. So thinking of something like

crypto, which is essentially a new asset class, obviously, I don't know what the, depending on what you use, maybe the stock market has 60 to 100 years of decent data people can use. And you mentioned you're not specifically relying on the past. But if you have a new asset class like this that is, I don't know, call it 10 years old or whatever, how do you begin modeling something like that into your inputs? If you have an advisor who has maybe some younger clients who have a big exposure to crypto, how does that process even begin for a new asset class? It deals with crypto. First of all, our methods right now can deal with a lot of different assets.

Equities with ETFs, fixed income, and also illiquid and private assets, private equity, hedge funds, liquid assets, illiquid assets, and so on. And we can do this because we use a factor model from MSCI that's really broad and what it can do. Crypto is another matter. And I'll tell you the way I think you can look at crypto for risk management. But first off, crypto isn't an asset. It has no basis for value. I mean, should crypto be worth $500, $20,000, $500,000, and why? What is the basis for valuing it, it makes you money if you find someone who's more enamored with it than you are. Basically, it operates on the greater fool theory. And so if you have a position, if you have, I'll call it an asset, if you have an asset like that,

that has sort of no visible means of support, then when it comes to risk, what can you do? Just say, okay, be careful. I don't know. But given that, I'll tell you how I think you should deal with crypto if you're going to hold it from a risk standpoint. At least for now, crypto looks like leveraged equities. It really has marched right along with the NASDAQ. That's not the idea, but that's the way it's been. And who knows how long that will persist. But in any case, given that, the bottom line is that if you're going to hold crypto, you should think of it as another equity-like asset, as like a stock. And one that's

pretty correlated with the broad portfolio of equities. So then from a risk standpoint, you just have one question to answer, which is how much of any one equity would you hold? And I think for most people, the answer will be something along the lines of two or three percent of your portfolio. So if you're going to hold crypto, given its characteristics and so on, especially given that it has no tethering to the real world, in my opinion, I think you should hold it like you with any other equity. And that suggests a pretty modest exposure, something like 2, 3% of your portfolio. Rick, it's one thing to hear you talk about risk. When Ben and I took the platform for a spin, it was a much different experience to actually see what it does as opposed to

just talking about it. So maybe let's just transition to talk about the relationship with advisors. What does that look like when advisors come to the platform? The objective of our platform is to have a lot of horsepower under the hood, but have it be easy to operate and very intuitive. So when people come to use the platform, it doesn't look like something from outer space. It doesn't have a lot of flashing lights and dials. It gets very much to the point.

And when you do it well, risk management and portfolio design is not like, well, I was going to say it's not like rocket science. Let's put this way. there's rocket science under the hood, but the actual operation of what you have to do is pretty clear, especially when you operate using risk factors like we do. So an individual advisor first has to load their client's portfolios, and that's pretty easy to do. We're tied in with black diamond, with Adipar. We can actually use the same tags they use. So there's nothing different there. And then you can see fairly clearly what exposures are in any number of

different dimensions and various levels of granularity. And you can do that by looking at things asset by asset or by asset classes or really importantly, you can see it in terms of the factors that are threading across the various assets. And then you can ask the questions, like I was mentioned before, how does my portfolio compare to some benchmark or, say, a model portfolio that my firm has given me? how do I want to alter my portfolio given concerns my client has or given changes in their objectives?

Is this something that advisors put in front of their clients or is this something that they're using on the back end to better manage these portfolios? The ideal, of course, it's up to them how they want to do it. My view, and it's designed for being able to put it in front of a client. And this is, again, why it's not dazzling. It's pretty clear. The reason is that, I think I mentioned that the way we look at risk, this is the way I really think risk is, it's a narrative.

It's like a story that has twists and turns down the road. And you want to communicate that with the client. It should be a basis of communication conversation with the client. And the application helps facilitate that. And that gets back to the idea that then the client is kind of pre-armed and understands what might occur, so they're not sort of caught unawares if something surprising happens. They understand the conversation to have if their life's changes. So it's really up to the advisor. But in my mind, the ideal and the design, therefore, of what we're doing is to be

able to sit down with a client to go through things. I have a potentially geeky finance question here. You mentioned that you came up the institutional world and that you're using a factor model here, and it's using the MSCI-BARA factor model. I was in the institutional world for the better part of my early career, too, and that seemed to be the preferred method for a lot of risk management tools is using this barra-MSC factor model. I guess I never asked the question back then. Why is that the gold standard? What is it about those models and those factors that make them so amenable to using in a risk management tool like this? So risk factors, and MSCI is kind of the king of risk factors in my view, and we're really lucky to have a partnership

with them to use their factor model. The key is that risk factors are basically the elements of risk. They're the things that go out there that vary with risk. And any individual asset is composed of exposures to various risk factors. Risk factors deal with different industries and sectors. Risk factors deal with exposures to various countries. And it doesn't mean that you're in the stock of that country. people, of course, know this, that you can have a made-in-USA equity that actually has a

high exposure to the China risk factor. And risk factors also go into styles. Momentum's are really hot style right now. You can have a lot of exposure to momentum stocks, value versus growth and so on. But the key thing about factors is, first of all, they thread across assets to uncover shared risks, factors are really stable. Asset correlations can go all over the place. Factor correlations tend not to bounce all over the place. Factors are concise and intuitive. What I mean by the threat across assets is they're kind of common elements which represent the common risks across assets. So you may have different assets that don't naturally seem to relate to each other, but in fact all have some risk factor in common. And because they're the

elements of risk, they're kind of stable the way that chemical elements are. Just like compounds built from oxygen and nitrogen and carbon and so on can really go crazy. But the underlying elements don't. The other thing about factors is because they're concise, they boil down a lot of risk. So you might have a thousand assets in your portfolio. But it could be that 10 factors, factors make up 90% of that risk. So you then need to talk about, discuss, do narratives for 10 factors rather than 500 or 1,000 assets, which means you can have a much more intuitive sense of your portfolio, both because you're looking at fewer things and because each relates to a common sense sort of risk. So basically, bottom line, it's a more accurate way to

see risk. And it's a natural way to connect from the market risk to the portfolio risk, and then from that to the individual's objectives to their plan risk. So maybe that's a good enough geeky answer. That works. If advisors want to learn more about your system and take it for a spin, where do we send them? Well, we have a website called fabric risk.com, and an advisor can go there, click on the link to set up a demo. And, I mean, seeing it's believing, I I can sort of explain my philosophy towards risk what I think is important. But like you guys saw the application, and I think having seen the application, the sorts of things I'm talking about now are a little more in vivid color. And so I'd encourage people to look at it and see ways

that it can help them. It's very illuminating. It's not, I think it's really, I mean, people can tell me, but I think it's not intimidating, but it's illuminating. I would second that. It's one thing to hear Rick talk about it, but to see the application really brings it to light. So if you're interested in learning more, check out FabricRisk.com. Rick, thank you so much for coming on today. We appreciate the time. Oh, thanks. It's my pleasure.

Thanks to Rick. Remember FabricRisk.com to learn more for your advisor. And send us an email, Animal Spiritspot at gmail.com. Thank you.