Invest Like the Best with Patrick O'Shaughnessy - Bob Elliott - A Macro Tour - [Invest Like the Best, EP.302]

Starting point is 00:00:00 This episode of Invest Like the Best is sponsored by Canalyst. Canalyst is the leading destination for public company data and analysis. Founded by a former byside analyst who encountered friction sourcing, building, and updating models. Canalyst is now used by over 400 institutions, including the largest money managers globally and by a number of guests on the show. With detailed company-specific models and data on virtually every public company, panelists clients are able to ramp up faster, update models instantly, and incorporate the highest-quality fundamental data into any workflow. If you're a professional equity investor and haven't talked to Canalyst recently, you should give them a shout. Learn more and try Canalyst for yourself at canalist.com slash Patrick. That's C-A-N-A-L-Y-S-T-com slash Patrick.

Starting point is 00:00:42 Today's episode is sponsored by Brex, the integrated financial platform trusted by the world's most innovative entrepreneurs and fastest growing companies. With Brex, you can move money fast for instant impact with high-limit corporate cards, payments, venture debt, and spend management software all in one place. Ready to accelerate your business, learn more at brex.com slash best. That's berex.com slash best. Hello and welcome, everyone. I'm Patrick O'Shaughnessy and this is Invest Like the Best. This show is an open-ended exploration of markets, ideas, stories, and strategies that will help you better invest both your time and your money. Invest like the best is part of the Colossus family of podcasts, and you can access all our podcasts, including edited transcripts, show notes, and other resources to keep learning at join colossus.com. Patrick O'Shaughnessy is the CEO and founding partner of Positive Sum and the CEO of O'Shaunicee asset management.

Starting point is 00:01:42 All opinions expressed by Patrick and podcast guests are solely their own opinions and do not reflect the opinion of positive sum or O'Shaunacy asset management. This podcast is for informational purposes only and should not be relied upon as a basis for investment decisions. Clients of positive sum or Oshonancy asset management may maintain positions in the securities discussed in this podcast. My guest today is Bob Elliott, the CEO and CIO of Unlimited, which creates low-cost index ETFs for alternative investment strategies that typically cost two and 20. Prior to co-founding Unlimited, Bob was the senior investment executive at Bridgewater Associates, where he served on their investment committee and led Ray Dalio's personal research team for a decade. His breadth and depth of experience makes him a great person to assess the current macro landscape. We discussed the relationship between rates, inflation, and asset classes. Bob's approach to identifying data with the most signal and finish with his view on quantitative strategies in private markets.

Starting point is 00:02:41 Please enjoy this great discussion with Bob Elliott. Well, Bob, I've been so looking forward to this conversation, mostly because of your extremely unique background across both breadth and depth of different asset classes and strategies. for investing inside of those asset classes. So this is going to be sort of like a tour, if you will, across all that experience. But I found, I think, a very interesting place to start our conversation, which was based on something you shared publicly, which was that you could really learn an incredible amount from a paper called the Economic Organization of a POW camp. That definitely popped off the page of me as sounding very interesting. Maybe you could describe how you came to that paper and walk us through the key lessons that you take from it. First of all, thank you for having

Starting point is 00:03:26 me. It's a real pleasure. I've been listening to your podcast for a long time, and it's great to finally join you here. The economic organization of a POW camp, I think, is one of the most interesting core pieces when you're thinking about anything to do with the creation of financial markets, the macro economy, or frankly, just how people live their economic lives. There's something so nice about a constrained environment to look at how people at their most fundamental level organize themselves. Now, obviously, that is not to say that I appreciate that there were POW camps in the past, but it does give a very unique lens into individual behavior and how that individual behavior then creates collective behavior, and then how that collective behavior then

Starting point is 00:04:23 creates markets and how that collective behavior creating markets then creates natural economic cycles that you would typically expect to see then back in the big picture macro economy that we live in our day-to-day lives. And so I think it does a really nice job of sort of capturing all those individual pieces. A level down, when you think about how it does that, it really helps you understand the individual's behavior. If you think about the global macroeconomy, all it is is billions of people engaged in a bunch of individual behaviors which collectively lead to macroeconomic outcomes. And so in many ways, if you want to understand the macroeconomy, your best lens is to understand the individual and what the motivations are of the individual,

Starting point is 00:05:15 what the behaviors are of the individual. And then from there, you can start to see how things play out. So an individual gets a kit of different goods. Some goods they like, some goods they don't like. Some goods are perishable. Some goods are not perishable. And naturally, you can imagine what happens with that is that they start to think about, I really want the treacle, but I don't want the butter for whatever reason. Or I want tea instead of coffee. That's a very classic example in there. And then they start to trade in order. to improve their behavior because what they have is different from what they want. And so they trade their goods for goods that improve their overall quality of life. And then, of course, from there, naturally, what comes about is that one person's trade or preference of tea versus coffee, let's say, is different from another person's trade of tea versus coffee. Their pricing of those two things is different. And so then how do you create a system where that price starts to get discovered? Well, the first thing that happens is there's a bunch of different prices that get discovered that happen,

Starting point is 00:06:26 different market prices that emerge. And then over time, what happens is there are arbitrageers who notice that over here, the T versus coffee trade is at a different price than the T versus copy trade over here. And they function as a market maker, closing that arbitrage between trades in one place versus trades in another. And then eventually people start to recognize, actually, there's information value if we bring all the people together and we start to determine a fair market price of the T versus coffee trade and that that starts to create exchanges. At its core level, that's a lot of what everyone is doing in the macro economy every day, which is they have what they can provide, they have their preferences, they're trading what they can

Starting point is 00:07:08 provide for their preferences. And we're going through this process. each day of uncovering what the value of the preferences versus what the value of the provision is and creating more and more price discovery, essentially, over time. I love it as a simplified version of the key elements that drive market economies. Maybe you can say a bit more about the role that the simple model of supply and demand in reaching some sort of equilibrium price play in your thinking about investing across asset classes because obviously if there was perfect arbitrage everywhere all the time, all prices would reflect everything they needed to and there would be no opportunity. Yet there is opportunity all over the

Starting point is 00:07:49 world kind of all the time. Talk about supply and demand. What role does that play in the history of your thinking and behavior as an investor? How should people out there think about that simple model in a productive way? It really comes down to you can think about any financial market as basically a set of buyers coming into that market and a set of sellers coming into that market. And where those two groups clear is essentially what determines the value of the asset or the price. In the same way, you can think about the number of rations that people have, being the money essentially that they are bringing to a market. And on the other side, you can start to think about who is supplying or what is the demand for the different

Starting point is 00:08:36 products. That's the demand side of the market. And you can see how those things intersect with each other. In many ways, this toy economy, the toy economy of the POW camp, really highlights what you want to do is you want to get back to the core buyers and sellers of any market, understand what their motivations are, what their sources of money are, what they use their money for. And if you can get down to that level of understanding, without preconceived notions, mostly just try and get in the head of every single buyer in a market and get in the head of every single seller in the market and what motivates them and what drives them. That really creates a very generalized framework that you can apply to any asset market, whether you're thinking about venture capital or whether you're thinking about the

Starting point is 00:09:25 price of oil. That basic framework works everywhere. And then the hard work, to be honest with you, is just to roll up your sleeves and get down to understanding what those motivations are, what people are thinking about, what constraints they have, what capital they have available. That's the sort of nuts and bolts of the mechanics that you have to do in order to be successful at really understanding what's likely to play out. But at its core, it's that same basic framework that sits in the economic organization of the POW camp that applies to every single asset market, every single goods market that's out there in the world today. If we were to take a step back, do you have what I could describe maybe

Starting point is 00:10:02 as like an investing world view? Is there some lens through which, no matter what you're doing, you are always looking through this lens to understand a given situation set of opportunities? I think the most important lens is a dispassionate view of the data. And that's all there is to it. I think a lot of people come to investing with particular world views or particular ideas about how things ought to be. That type of strategy can often cloud your judgment about what is true. So in a lot of ways, if you think about what my real passion is, is that sober, dispassionate look at the data. You can take that sober, dispassionate view of the data. and build up from there an understanding of what's likely to transpire for all the different

Starting point is 00:10:58 investors or sellers in a market. And that creates the clearing price or what's the fair value or how the macro economy is likely to play out. And then from there, that provides opportunities. You see how that's going to play out relative to what's priced in. And from that, you can start to see where there are big divergences between what is likely to play out, what's priced in. Those are the opportunities to invest. And that's how you find those things. but it all starts with this, frankly, rather boring view of the data of what's likely to happen. Macro-economics is not an exciting business if done well. It is a analytically driven, data-driven approach to thinking about invest.

Starting point is 00:11:47 Maybe let's take today's environment, since it's so juicy and interesting and is so macro-indexamined. in its nature, which really hasn't been the case as much for the last decade, let's call it, since the global financial crisis. You've been sharing a ton of different data series, data points from all different sorts of places to sort of make sense of the current landscape. How do you decide what matters? Like I saw you sharing credit spreads as an example recently, just as a sense of like economic stress or financial stress, and it seems fairly muted still.

Starting point is 00:12:17 We're in, this is Halloween that we're recording this at the end of October 2022. How do you decide what matters? If it's all about the data, what data has signal versus doesn't? Because there's a lot of noise in data, I know, from 15 years of building systematic strategies. Talk to us about the current environment and that lens of this data matters and this one doesn't. I think it starts with a real good understanding of how the macro economy works. So it's not just, I guess, the sober look at the data, but it's also the sober look at the data in the context of how the individual pieces of the economy add up to get to the total of what we're seeing and how those different connections

Starting point is 00:13:00 work through time. So in a lot of ways, if we look at today's dynamic, what you see is that we're big picture transitioning from this world of significant monetary stimulation, everything's going up, that was really a post-GFC type dynamic to one where the era of cheap money is over. And that is an overriding dynamic that's playing out in a whole bunch of different places. And so when you start with that sort of overriding macroeconomic cycle dynamic, longer-term cycle dynamic, and then from there, what you do is you carefully think about, given that big picture overriding dynamic, where are all the place? that I want to look to see how that's playing out. What are the big things versus the small

Starting point is 00:13:52 things? And what are the things that lead versus don't lead? And so as an example, in that overall picture, money in the future will be tighter than money has been in the past, pretty much no matter what. The question is, how fast are we moving towards this era of easy money to tight money? So in order to understand that, because that really is the big overriding dynamic that's driving a lot of what we're seeing in financial markets today, you have to understand what the Fed's reaction function is. You have to understand what the inputs are to that reaction function. And when you do that, that's what gets you to very squarely looking at what are the things that the Fed's looking at to make their determination about whether or not monetary tightening is likely to continue or likely to pause or likely to reverse. And from under that, you start to look at the macroeconomic variables that they're looking at, as well as the financial stress variables that they're looking at. And that gets you to looking at credit spreads as an example of being the most compelling or effective way of understanding the type of macroeconomic variables or financial market stress variables that the Fed would look at to consider whether they need to curtail their path towards tightening, given what they're seeing in the financial markets, which right now.

Starting point is 00:15:06 Now, as the point of recording this, I don't really see a lot of indication of stress in the financial markets that would cause the Fed to pause or slow their actions relative to what we're seeing in the macroeconomic dynamics, which is squarely aligned with meaningfully tighter monetary policy for a long time. So at this point, when I'm thinking about what's the input into their reaction function, the financial market stress point isn't that relevant, but it could become relevant. So given that it could become relevant, you have to keep an eye on it because it's a critical input into their dual-tier decision-making process on a board-looking basis. Could you give us a crash course in the major implications of an easy money regime and a tight money regime? Everyone's kind of talking in these same terms, and it seems sort of obvious on face value, but maybe you could take us a few clicks deeper in each of those general macroeconomic environments

Starting point is 00:16:04 as to what they mean for economic actors? Any business is just a series of future cash flows. When you think about a series of future cash flows and that's any business or any loan or a bond, it's just a series of future cash flows. And when you think about that series of future cash flows, you want to think about that in the context of those cash flows relative to what you could get for free, like if you just a bank deposit during the same time period. And that very simply is the discount rate of future cash flows, which determines your decision

Starting point is 00:16:41 today between taking risk and investing in a company or making a loan where the future cash flows are ambiguous relative to staying in cash and just getting whatever the cash rate is over time. We were in an era for a very long period of time where the tradeoff between cash and investing was pretty clearly tilted towards investment in all sorts of different ways. If your baseline expectations for cash is zero for a very long period of time, then basically anything that could plausibly create positive cash flows over the future is a good investment. And it's not just the things that create the positive cash flows over time,

Starting point is 00:17:26 but because you could essentially borrow close to zero, you didn't actually need to create cash flows relatively quickly because the cost of not creating cash flows today relative to creating them in the future was very low as well. So you didn't pay much to delay creating cash flows and you didn't have to create that many cash flows in order to justify getting money relative to holding a zero. And so what you ended up having is a huge set of business activities. they were basically built on the back of that core economic arrangement. And that's the big thing that's changing is we're shifting from a world where that's true

Starting point is 00:18:05 to a world where, as an example, today, you can buy a five-year treasury inflation index bond and get a 2% or roughly 2% real yields, depending on the day, plus inflation. What does that look like relative to all the different investment opportunities? that are out there, it means all those other investment opportunities have to deliver something that's meaningfully better or be priced at a much lower price, reflecting the fact that this tradeoff between cash and assets is now much more heavily traded towards cash rather than assets. And that's basically what we're seeing. If you look through basically all asset prices today, mostly what you've seen is a repricing of the present value of the future cash flows. That's mostly what you're

Starting point is 00:18:55 seeing. Mostly people are reflecting a higher discounting because they expect cash to be higher over time. And that's bringing the value of assets down because the cash flows that they were receiving look a lot lower when cash is much higher than when cash was zero. And that's an important point when you think about where we are in the cycle because that's the first stage of a cyclical dynamic, a cyclical type, which is this move of interest rates from being low to elevated. But that doesn't, and so far, hasn't really meaningfully affected what actual cash flows. Most companies are producing. Earnings are still relatively elevated.

Starting point is 00:19:38 Nominal earnings are actually growing fine. They're not incredible, but they're growing fine. That in the cycle, that creates the next leg of the macroeconomic cycle during a typical inflationary peak and downturn, which is next we're going to see not just the repricing of the cash flows to be lower than what they were, but we're going to see how the higher cash rate and higher borrowing rates start to affect economic activity. And that starting to affect the economic activity will flow through and start to affect what the expected cash flows are. So that is when you're going to start to see the second leg down in this dynamic where we're not

Starting point is 00:20:18 just repricing what we already expected or what we have been expecting, but we're going to start repricing what we expect to happen in addition to how we discount what we expect that. If we walk back the chain of causality all the way back to the start for the specific cycle, it's hard to avoid inflation. I'd love you to just talk about the variable of inflation, how you interpret the story of how it was created in such rapid order here. And what's being done about it or should be done about it. I would just love you to riff on the role of inflation because it seems like without that variable, a lot of what we're talking about today, tighter money conditions, et cetera, wouldn't be there or wouldn't be as extreme. So I'm curious if you agree with that.

Starting point is 00:20:59 More than anything, I just would love your same crash course again on inflation that you gave us on easy versus tight money. Were we not in this point in having an inflationary cycle, we probably wouldn't be experiencing this bigger shift from easier money to tighter money and all the second and third are consequences that are coming with it. What do you think about what got us to this point in inflation? It's a, I'd say a long, meaning many decades long, complicated set of circumstances that got punctuated in a very typical fiscal stimulus. which put money in the pockets of people, which then allowed them to spend, which then allowed prices to rise. Production didn't keep up with their spending, which allowed prices to rise, or which created a price rise, which then created a feedback loop to wages, which then creates

Starting point is 00:21:58 a feedback loop to spending in prices. At some level, what we're seeing in the inflationary cycle is a very, very typical inflationary cycle. Having taught an intro macro course for years, I remember year after year I would teach students about a typical inflationary cycle. The economy is growing well. That leads to a tightening of labor market conditions. That leads to a tightness in supply conditions,

Starting point is 00:22:26 which then naturally creates a rise in prices, which then feeds through to wages given the type labor markets, which then feeds through to prices. that is like teaching basic macroeconomic cycles from like the 50s and the 60s and the 70s. All the students for a decade in the 2010s would sort of look at me and say, oh, yes, that's back then. The way it works now is the Fed does QE and then doesn't do QE and asset prices move. And that basically drives the cycle. And they're the big disinflationary forces.

Starting point is 00:22:57 And so inflation is basically that we never have to worry about it. The only thing that matters is growth. And I kept saying, okay, but what we're going to do is we're going to go back and look at the 60s and the 70s and the 50s and you're going to go look at those cycles and see what they're like because there will be a day when we get back to those cycles. And that's exactly where we are today is we're back to very old school macroeconomic business cycle that frankly, no one around us, no one in the investing community has really experienced in their lifetime. So the only way that actually understand the cycle that we're in is to go back

Starting point is 00:23:31 can understand those previous cycles and have like a visceral feel of those cycles because those cycles are the ones that are going to give you a sense as to how these things typically play out. And then what we're seeing from the Fed is basically the totally generic response to a typical inflationary cycle. And what we're seeing in asset prices, frankly, is a pretty generic response to a totally typical cycle. It's just not typical in our mindset today. Maybe you could give us the so what of those historical lessons around a traditional inflationary cycle then. So when you go study those prior periods that lots of us haven't experienced live in our investing careers, what do you see? What are the most common next couple of years going to look like if history is a good guide

Starting point is 00:24:19 with all the caveats that it's always different this time? You can sort of think about it at two levels. The first is how we expect the macro economy to play out. then for investors, what also matters is how that then affects asset prices relative to what's priced in. Starting with the macroeconomy side of things, traditional cycles are very bored. And that is something that investors, I think, don't really appreciate. They're boring in the sense of it takes years to play out. And the linkages that eventually create the turn in the business cycle, take a long time to play. Most of us in our investing career, we've basically experienced two main core business cycles. And those are 08 and 2020. Those are the two major downturns that we've

Starting point is 00:25:09 experienced. Some folks have experienced the 2000 cycle. But the most visceral thing in our minds over the last 20 years is those two cycles, those were crisis cycles. And so what you saw very much was a V-shaped recovery. You saw, for whatever reason, a sharp hit to economic activity in financial asset prices, whether it was the housing bust or COVID, that created a sharp downturn. You got a very reactive fed, all things considered in both cases, which reflated the economy and it created that sharp upturn. And all in all, the cycles we were talking about were very short in terms of their acute drawdown and their acute rise. But a typical macroeconomic cycle, even take 2000. The stock market peaked in early 2000 and bottomed essentially in 2003.

Starting point is 00:25:59 Three years. A three year stock market cycle is not in most people's minds as something that could play out, but it is a very normal set of dynamics to play out. And the reason why that is, is because the macro economy and the linkages in the macro economy, they take time to flow through. So as an example today, the basic problem we have from the Fed's perspective is nominal spending is too high. Nominal spending growth is too high, and that's relative to production and growth, which is creating inflation. So how do we slow nominal spend? That's what the Fed's trying to do. Well, the first thing the Fed does is it raises interest rates. That raising of interest rates starts to change credit costs, which starts to change the desire to borrow, and on the margin

Starting point is 00:26:48 starts to slow borrowing-related spending. But post-GFC, frankly, we haven't had a lot of borrowing finance spending across much of the economy because balance sheets are in much better shape and the need to borrow in order to spend is much less important today than it was, say, back in 2001. So that'll have an effect, but it'll take some time. If that borrowing side of the equation isn't going to meaningfully adjust or meaningfully affect spending all that much. Then you've got to have a different lever, which is that increase in interest rates has to affect asset prices. When you have that effective asset prices,

Starting point is 00:27:27 asset prices have to fall in order to change individuals' preference to basically spend versus save. When people change their preference to spend versus save, then what they have to do is that demand starts to affect company earnings, top line revenues. which affects their earnings. Then companies have to recognize that it's affecting their earnings, and they have to start to cut their labor costs in response to flagging demand on the top line. And that deterioration of labor market begins to ease wage pressures, which were the core thing financing the original demand.

Starting point is 00:28:07 Think about all of those steps and think about how long they play out. That's why I say this cycle is going to be very boring. If you go back to 2000, it took a long time. If you go back to the 50s or 60s or 70s, it takes a long time much longer than we've become used to. I think the second point is around asset prices, which is a bit unique to the inflationary cycle, which is different than most of the economic cycles, growth cycles we'd seen, which is in inflationary cycles, the types of assets that typically outperform are very different than the types of assets that we've come to expect. to outperform during traditional sort of growth cycles.

Starting point is 00:28:49 And what that means is over the last 30 years, bonds have been a great diversifying element to stocks. Portfolios have been built on that core concept, 60, 40 portfolios, that the bonds are cushioning the stock declines as you start to see a downturn in the economy. But in inflationary cycles, those bonds don't help you because what's happening is people are not just repricing the value of stocks, but they're repricing the value of cash, the value of money in a meaningful way. As a result of that, the bonds are selling off as much as the stocks are, which is really compounding, creating a pretty bad outcome for traditional 6040 investors.

Starting point is 00:29:29 But if you look back through other inflationary cycles in the 70s and not just in the U.S. But across countries and across time, what you see is in those cycles, things like commodities, things like gold typically do well and have done all things considered pretty well through this cycle, certainly relative to bonds and stocks. So for investors that are going through this cycle right now, in a lot of ways what they're learning is that they are poorly diversified to an inflationary business cycle and really should be looking to add commodities and gold to their portfolio of stocks and bonds, and they'd be in a much better position than they have experienced through the cycle. Maybe you can say a bit more about those last two.

Starting point is 00:30:14 I've always had this view of when I went to study in my 20s, I was curious about all these asset classes. And I remember studying gold, like, in great detail because it's this amazing, like, play thing for the investor that's really curious. There's no E, there's just sort of P. It's just a great, interesting asset to study. And my conclusion back then was always, I'm just not interested in stuff that doesn't have future cash flows.

Starting point is 00:30:34 I would rather just own T-bills now or tips or something basic and understand that maybe I'm not optimizing, but I'm sort of preserving liquidity and optionality in an environment like this versus something like gold and commodities that, again, just seem like this weird trading instrument more than like an actual security. Maybe react to that. Like, I'm curious why these things ever might belong in someone's portfolio, given that they don't actually produce or yield anything back to the investor. I think I would separate gold from industrial commodities or energy commodities.

Starting point is 00:31:10 I think industrial commodities and energy commodities are very compelling an inflationary cycle environment because often it's those physical goods that have the most clear constraints on supply relative to elevated nominal demand, which creates the squeeze on those products and basically creates a lot of good upside skew for an investor, who adds those assets to their portfolio. And the reason why industrial commodities are valuable in an investor's portfolio is because you can't create new supply instantaneously. You have to build mines.

Starting point is 00:31:44 You have to build pipelines. You have to build all the different things. The lead times are crazy now. The lead times often are a decade long. And so as that nominal demand happens, it creates that upside skew. And that's very different from, say, I don't know, services, which, So, like, you can work an extra hour. The supply of services and things like that is just a lot more flexible or you can run three shifts instead of two shifts than a manufacturing center.

Starting point is 00:32:11 Like, the copper mines that we have running today are the copper mines we have running today. And there's basically nothing you can do about it, right? So that's why they create a nice, diversifying property in a period of high nominal span. Now, let's turn to gold. Gold is a very different asset than industrial commodities. And think about gold. gold is non-interest-bearing money. At its core, that is what it is. So you see a couple of attributes of gold that are important to reflect on. What it means because it's not interest-bearing is in periods

Starting point is 00:32:45 of rising interest rates, gold typically underperforms. And the reason why that is is because if you hold money, cash, you are getting a positive interest rate or a positive real rate in this case versus holding gold for which you get no yield, as you mentioned, which he has. which is a drag on gold. That being said, what gold's real value is not, let's say, inflation between zero and 10. That's not really where gold is going to outperform. Gold's real value is on the tails. And the reason why that is, is it's very plausible that, say, the Fed acts in a way that is

Starting point is 00:33:25 less tight than is necessary to contain the rising inflationary pressures. We saw it in the 70s. Lots of countries have experienced this to greater or lesser degrees. And when you start to get to that more uncontrolled inflation, where the income you're receiving on cash doesn't look good relative to the way prices are rising, then actually gold starts to look a lot more attractive because it is a, even though it's non-interest bearing, it is a real storehold of wealth relative to cash. which is not necessarily a real storehold as well.

Starting point is 00:33:58 And then on the flip side, during depressions or deflations, gold is a good asset to hold because the way that you resolve depressions and deflations is by lowering the value of cash in order to stimulate demand. And so again, in that circumstance, what happens is gold typically holds its value and cash depreciates the value. It might be income earning, but it has to depreciate value in order to create an increase in nominal demand. And so gold has a smile.

Starting point is 00:34:27 Its smile is in extreme deflations. It does well. And in inflationary environments, it does well. But it doesn't necessarily do all that well when things are sort of pupsing around as sort of a normal inflationary cycle. And so that's basically what you're buying with gold is a hedge on the tailed outcomes. It's something that doesn't deserve 50% of your portfolio by any means. But the plausibility of those tailed outcomes, certainly if you look across the world, through time, it certainly happens. And you're in a lot better shape if you're buying and

Starting point is 00:35:00 holding gold as a strategic asset allocation entering those periods of very high or very low inflation in terms of building your overall portfolio. If we go back to our supply and demand lens on everything, one of the most fascinating to me and friends have been talking about it lately is the world of housing. You've got this unique situation where maybe not like a copper mine, but like some of the commodity stuff, you can't just like snap new homes or apartments into existence. So there's some constraint on new supply. And then you got this other weird phenomenon where you go on whatever your Zillow is right now and there's just nothing for sale. And the reason, in part, is because if you got a mortgage like so many people did in 2020 and 2021 at like 2% or

Starting point is 00:35:39 something, and now to go to a new house, you've got to pay seven whatever percent, just nobody's moving. You're just locked into this much more advantageous, fixed rate, long-term mortgage. It just seems like a perverted, strange supply demand picture in housing, but something that matters a lot to people. It's usually the number one asset and therefore investment. How do you think about housing today? Because it just seems like a great example back to your POW camp, like the basics of what individual people are choosing to do. Talk us through housing. Probably the best way to describe what's going on with housing right now is it's exhibiting typical frozen market dynamics, which is that you have a collapse in supply as individuals are not happy with the prices that they may receive if they sell their house on the market today.

Starting point is 00:36:30 And you have a collapse in demand, which is caused by the fact that the price of credit is much higher today than it was before. What you've basically done is you've basically taken out a big chunk of supply and a big chunk of demand. And what ends up happening is actually the marginal buyer and the marginal seller in the market has shifted a meaningful degree relative to where we were before. If you go back a year or two years, the marginal buyer was the person taking out the ADLTV loan at the 2% mortgage rate in order to bid for the house that was probably slightly larger than what they could afford. And the marginal seller was either the builder or the existing homeowner who said, this is a good time to sell, let me get it out there. And that's kind of how the market worked. And those were the two people clearing the bit. When you look at housing today, all those people are out of the market.

Starting point is 00:37:21 So now you have a collapse in activity at, I don't know, 50%, maybe even less of what the previous activity was. And the composition of the buyers and the sellers are just totally different. And this is very normal in a housing market. On the buying side, the composition of the buyers will now shift towards less credit sensitive buyers, who aren't necessarily particularly influenced by the shift in the mortgage rate on their ability to buy. That's a big chunk of the housing market. 40% or so of homeowners own their houses outright, mortgage rate doesn't affect them. They could take their money and they could effectively trade for a different house as a function of that.

Starting point is 00:38:02 And so they're less affected by the mortgage rate relative to who the previous buyers were. That's like 40% of the market. And then on the selling side, there's no real estate. there's no reason to sell your house at a lower price today, as long as you're living in it. You're just basically live in that house, pay your 2% mortgage. The debt servicing costs is actually quite low relative to history. Assuming employment remains even relatively good, that will continue to happen for the vast majority of homeowners.

Starting point is 00:38:29 And so the only people who are really selling are the people who are basically forced sellers, not like the financial prices where they're forced sellers because there were foreclosures, because, again, most houses were bought at low LTVs and reasonable incomes and docs and things like that. So there's not a lot of forced sellers financially forced sellers. So most of the sellers are just forced sellers in the traditional job switching, moving, retiring, just sort of that natural flow that represents a few percent of the housing market each year. Just that's how the world works is that there are people who are moving for all sorts of different reasons naturally. And so you have this sort of trickle of supply coming into the market against a demand,

Starting point is 00:39:12 which is of these low credit cost sensitive buyers. And so you sort of have this very shrunk market. And then where that settles, frankly, is not where it would settle if the only buyer was the previous marginal buyer who had to borrow. Where that price settles is something that is not nearly as extreme because the cash buyer might see value in a house that's down 25% relative to peak and not be so credit sensitive and come in. And so what you typically see in this market is very low activity.

Starting point is 00:39:44 It takes a long time for price discovery to happen because there's so little transaction volume. So we'll probably see in the housing market, let's say 20, 25% declines, which all things considered is not that big a deal given the current level of house prices and LTVs and things like that. And you'll sort of see that play out and it'll take a few years to play out. And that's kind of how the whole market works. Again, going back to what we were talking about before, that's very boring.

Starting point is 00:40:13 Very standard. Everyone wants a crisis and that's not going to happen. And instead, what we're getting is a very boring typical housing downjury. And it's going to take years to play out. It's a good, simple example of how these markets, and how the macroeconomy takes a lot of time to play out in a way that is actually quite different from what is in our head and in our experience. If we shift the same lens to the labor world, which I think is so interesting for so many reasons,

Starting point is 00:40:48 because it is incredibly tight. Everyone knows how incredibly hard. If you run a blue-collar business, it's been basically impossible to staff your business. If you run a software business, it's been impossible to hire engineers. You've got to pay them unbelievable amounts of money and let them work two days a week. Everywhere you've been looking, labor's been incredibly hard. Is this yet another example of like a boring rebalancing versus a labor crisis? How do you think about what might happen in labor?

Starting point is 00:41:14 Right. I mean, labor markets, if you look across the labor market today, we're basically at secularly strong levels. And we can all sort of squint at this wiggle or that wiggle or this announcement or that announcement. But the big picture is we have unemployment that's basically at secular lows. We have job claims that are basically at secular lows. We have wages which are rising at close to secular highs.

Starting point is 00:41:40 This is the best labor market that has existed in many decades. And that circumstance is very important to recognize. It's very self-reinforcing on the overall economy because the tightness of the labor market is driving the increase in wages. And in particular, if you look at the increase of wages, you see it strongest, actually, at the lowest quintile earnings groups. And that's important because the spending percentage, spending versus saving percentage for those lower income cohorts, is typically higher than it is for upper income cohorts. And so the higher wages for the lower income cohort creates more income, which then creates more spending,

Starting point is 00:42:27 which then supports the overall cycle and the expansion of nominal demands. Now, it's not necessarily keeping up entirely with prices, and that's actually quite normal, that you have negative real wage growth during a period of inflationary dynamics, and that's because prices can typically be adjusted quickly, and wages, it takes a little while for them to reprice, resetting your hourly wage, et cetera. There's a friction there, so it takes some time. But the point is that the tightness in the labor market creates the income, which creates the spending, which creates the demand, which creates the tightness in the labor market. And we're in that, in the labor market today, we're very much in that overall, very positive cycle.

Starting point is 00:43:14 And then that's further supported by the fact that there was a significant number of transfer payments that particularly lower income households received as part of a variety of different stimulus during and. after COVID, which enhanced their overall savings position, which means that they can endure a bit of negative real wage growth and continue their demand, which is exactly what we're seeing. We're only about a third of the way having worked through that savings that those lower income households put away during the COVID period. And so that's even further increasing the dynamic. And so when you see this dynamic in the labor market, that is a very subtle. reinforcing dynamic, which takes a lot to stop. I think that's a very important thing. If you think about

Starting point is 00:44:06 given where wages are, given where demand is, what do you have to do to get people to stop spending, what has to happen for the lowest income quartiles to stop spending? And the answer is it's pretty hard to stop that cycle of wage growth to spending growth in that cohort. the way that's going to have to work is in the same way it had to work on the upside. What the Fed had to do on the upside to get spending to happen is they had to inflate asset prices a ton to get the highest income quartiles to start spending, which then created demand and wage income for the lowest income quartiles that started to then spend. But think about it.

Starting point is 00:44:50 Stock prices for a decade, they had to go up 2x, 3x in order to get, frankly, going into COVID, with pretty modest growth. The same is very much true on the other side of the equation, which is how do you slow down an economy that has that self-reinforcing labor, wage, spending dynamic? Well, you're going to have to cut the spending of the groups that are the highest borrowers or the highest income earners through declines in asset prices. But to do that, you really have to have pretty significant asset price declines to impact their spending to have it flow through to this overall cycle. When we talk about sort of a boring cycle that's going to take a while, part of it is just

Starting point is 00:45:34 understanding the elasticity of what it's going to take for asset prices to decline before you start to meaningfully hit the spending before it actually flows through to the overall cycle. And then even then it takes a very long time for labor markets to play out. If you go back to that 2000 cycle, stock market peaks in early 2000, the unemployment rate basically is fine through the course of 2000 and starts to start to. rise in 2001. And so that's a 12-month period where things were basically fine. And even into 2001, the labor market wasn't in that bad of shape. And the economy wasn't in that bad of shape. So that's 18 months. And probably now the sensitivities are even lower than they were then.

Starting point is 00:46:14 And so could it take 18, 24 months before we start from the beginning of this year, basically, to the start of seeing meaningful deterioration of labor market? Yeah, that's very possible. That would be a very normal outcome given where we are. We haven't talked much about the rest of the world. And in the spirit of your idea, everyone's looking for a crisis or wants a crisis and what they're getting is this boring cycle playing out. What about the rest of the world? So I'm interested here in currency is one interesting lens to view this through. But also just it does seem, if you zoom in on what is most unique about this time versus some of the historical examples that you've taught us about and have learned from,

Starting point is 00:46:53 And maybe you zoom in on something like geopolitical conflict or the energy situation in the world. I'm just curious as you zoom out to the whole world away from just the U.S., what you're most intently focused on with maybe geopolitics and currencies as two subcategories. At a big picture level, there's an inflationary dynamic happening everywhere. The root causes of which can be slightly different in certain places, more energy organized in Europe, but basically inflation exists everywhere. in one form another. And that, in part is because the decade plus of monetary stimulation that

Starting point is 00:47:32 you saw in the U.S. was not just really a U.S. phenomenon. It was a global phenomenon of very easy money everywhere, filtering everywhere, creating a lot of strong economic activity everywhere. So what you're seeing then is maybe slight differences. I mean, there were meaningful differences in terms of the sensitivity to the commodity side of things. So in the U.S. were a little more labor and wage-driven inflation. And in, let's say, Europe and the U.K., more commodity price-driven rather than labor market-driven.

Starting point is 00:48:03 But the same basic dynamic holds in many ways, which is that you have nominal growth or nominal spending that's too high relative to your productive capacity and that that demands a response from monetary policy in order to curtail that so that you don't get the self-reinforcing dynamics related to inflation that cause longer-term instability. I think the thing when I scan across the world that's very interesting is how a number of these sort of secular or structural dynamics different economies in the world. So if you go and you look at the U.S., a big part of what I've talked about a lot is that the U.S. has much strong. stronger balance sheets than it did prior to the financial crisis.

Starting point is 00:48:55 It's basically a big push both from a regulatory standpoint and also, frankly, from a private sector standpoint, having learned the lessons of the financial crisis, that everyone needed to lengthen their duration and reduce their risk on short-term interest rates or short-term financing needs. And basically, everyone refinanced into the world of 2% interest rates, very low interest rates, very little debt coming due, et cetera. and whether it's the housing market, as we talked about, but also the corporate market, et cetera, there's low interest costs and not a lot of demand for borrowing in an immediate sense.

Starting point is 00:49:30 The rest of the world is very different in that context because a lot of the rest of the world, for a whole variety of reasons, has a lot more short-end sensitivity. So whether you're talking about mortgages in Australia or Canada or the UK, what you see is most of those mortgages are short-term in nature and get repriced much faster in response to monetary tightening than, say, it does in the U.S. So those cycles are very not boring because what happens is the rise in interest rates immediately affects not just the incremental supply and demand, but it immediately affects everyone in the market, paying more interest income, extracting demand, which then creates a circumstance with those means are much more sensitive to monetary tightening

Starting point is 00:50:18 than the U.S. is. So that creates a big global divergence that we're seeing in the world. That's number one, the structural sensitivity to interest rate changes. And then the second thing, which is very interesting, is the differences in the structural sensitivities to commodity prices. The U.S., if you go back 15 years ago, was a major commodity importer, along with much of the rest of the developed world. That has radically changed over the course of the last 15 years. The U.S. is now in net energy balance, whereas the UK and Europe and Japan are commodity importers, energy importers. And so they're meaningfully, uniquely affected relative to the U.S. when it comes to these rising commodity prices and commodity price sensitivity. So what you see is basically a U.S., which is,

Starting point is 00:51:07 for a variety of reasons, structural reasons, commodities and the structure of the credit markets, much stronger and much less sensitive to either commodity price rises or to interest rate rises than the rest of the world, which is much more sensitive to commodity price rises and interest rate rises. And that's basically what we're seeing globally is a massive divergence between the energy importing interest rate sensitive developed world and the U.S. And that then translates in all sorts of different ways in terms of relative bond market moves. It translates into relative economic conditions, which are weaker in the other economies versus the U.S. And it translates into foreign exchange moves where we've seen the massive rise in the dollar really is around these two core concepts, which is U.S. energy independence and U.S. low interest rate sensitivity.

Starting point is 00:52:02 And so you're seeing those dynamics basically flow through into the relative asset price moves across all these different economies. And that creates a lot of interesting cross-cutting global opportunities for investment primarily around this U.S. versus developed world divergence. Before we get to some of the what I'll call portfolio opportunities, if we had to go to like the scariest part of the world for you, away from this, okay, this is going to be one of these boring traditional rebalancings. What most keeps you up at night or what wiggle of the charts? Like you talked about wiggles earlier, what wiggle is the most interesting in the concerning. bucket to you? On a global basis, most of us, most of us as investors have cut our teeth in a world of globalization and integration.

Starting point is 00:52:51 And we're moving to a world of de-globalization and de-integration. And I think most of us don't fully understand how that's going to play out, partially because it's quite unfamiliar with us. And partially because there's just a ton of. of things that are unknown in terms of how that will manifest itself through time. And so in that sort of overall cohort of things, we have things like how Russia and China are interfacing with the West, which frankly, as a macroeconomic investor, I know I don't have a good, differentiated opinion on the political dynamics that will lead to a particular set of outcomes.

Starting point is 00:53:42 And that's important to recognize. And I think actually far too often what investors think is that they think that they have knowledge or insight about that or are implicitly or explicitly making bets on exactly how that will play out over time. I have no idea. So one of the most important things is to make sure that you're balanced to whatever plausible outcomes will emerge, given that set of dynamics. So as a simple example, we don't know how the constraint in commodities is likely to play out. Just coming into this podcast, there was the most recent constraint of Russia exporting grain. It's a very simple, concrete example that would have been hard to predict one way or the other.

Starting point is 00:54:26 certainly as a, from my perspective, as a macroeconomic investor, I don't really have a differentiated opinion on that. So instead, it's critical to be diversified to either outcome, whether the grain or oil supplies more constrained from Russia or whether the grain and oil supplies get less constrained from Russia. So in general, I think if you look at most investors, how they're positioned, because they're positioned in stocks and bonds, they're positioned for low inflation outcomes. And right now, the main uncertainty is around whether we're going to have high inflation outcomes or not. And if you look at that range of outcomes, basically totally unprepared for if that geopolitical dynamic ends up in a more highly inflationary environment rather than an environment that gets diffused

Starting point is 00:55:11 and as a low inflationary environment. That's for the typical 6040 investor. For me, as an investor in particular, it's about constantly looking at where am I position. And do I have an implicit or explicit bet on those geopolitical dynamics playing out? Because I've emphasized again, I don't know how they will play out. And the reality is nearly every investor doesn't have a differentiated opinion about how they play out. And if you don't have a differentiated opinion, you have to be prepared for any of the range of outcomes. And you have to be diversified and balanced to those range of outcomes.

Starting point is 00:55:46 And right now, people are not diversified and balance to the range of outcomes. They're making an implicit bet on one set of outcomes versus another. And that is a very risky proposition that I think investors already are feeling the effects of in the first half of this year and very well could feel further effect. All those comments make me obviously jump to the concept of Bridgewater's All-Weather portfolio and sort of a balanced approach to all different sorts of growth and inflationary regimes. Given your long tenure there as an investor and on the investing committee, if you had to rebuild that all-weather portfolio,

Starting point is 00:56:21 meaning the components of it, the things that you would be diversified to, maybe touch on what was in the original conception of the all-weather portfolio, and then anything that you think, given the circumstances and everything you just described, might need to be added to like what you would call a properly diversified global liquid portfolio today

Starting point is 00:56:39 for investors out there. The core concept of the all-weather portfolio is that there are two main drivers, of asset prices. Those are how growth conditions come in relative to expectations and how inflation conditions come in relative to expectations. And those two different drivers have very clear and distinct effects on asset prices. For instance, stronger growth is supportive to equity prices, weaker growth is detrimental to equity prices. And you can build a portfolio, a carefully constructed a portfolio that balances you to either a rising growth or falling growth environment or rising

Starting point is 00:57:18 inflation or falling inflation environment. I think for the everyday investor today, maybe that's holding 60, 40 or something that looks similar to it, that lens sort of gives you a sense that you're basically tilted towards inflation coming in below, how it's currently priced, and you're kind of balanced to growth conditions, pretty balanced to growth conditions. And basically what we're seeing play out for most of those portfolios. those where inflation has come in above expectations for the year is we're seeing what you'd expect given that dynamic. So if you're a little more balanced towards inflation outcomes, you would have been a much better position than if you simply were in a position where you were only holding

Starting point is 00:58:00 assets that basically outperformed when inflation was coming down. I think for an investor today, I look at that overall portfolio. There's a lot of merit to it. If anything, it pushes is there's only one free lunch in investing. That is diversification. And that portfolio pushes investors further along the trend to diversification. That's great. It's a great thing to do to be pushing investors towards that. It has two key gaps that we're seeing in the market today. I think the first is that most investors are more inflation sensitive than they realize. And so, a portfolio that is maybe balanced to inflation isn't necessarily the best portfolio that the every day investor should be holding because they're not just thinking about their assets,

Starting point is 00:58:54 but they also need to think about what they're going to spend their money on and the value of those assets relative to the value of goods and services, which is why you save the money is for goods and services. So if anything, what it highlights is that even a balanced portfolio to inflation probably is underweight inflation protection for the everyday investor, which would tilt you more towards commodities, more towards inflation index bonds, and more towards, frankly, gold in the extreme measure than even that balanced portfolio would do. So I think that's an important thing. And we're so far away.

Starting point is 00:59:28 6040 is so far away from what would have protected investors this year against rising inflationary pressures. It's a radical difference between those two things that I think investors are really missing out on. I think the other big thing, a balanced portfolio on the surface, can miss is the role of active management. And for a period for a decade plus of monetary simulation, active management didn't seem like it mattered that much, right? It wasn't that hard to generate decent returns, which is you just buy the assets. They go up. You have a good return, and that's great.

Starting point is 01:00:07 And frankly, that dynamic happened for so long. It became so ingrained in people's minds that that was the way to invest, to achieve good outcomes, which you just passively hold indexes, and you'll be fine. You'll look brilliant because you will have paid less fees than if you had active management. But when you get to cycles and parts of the cycle where you have a shift from easy money everywhere to the end of the era of easy money and much tighter money, and you have much more complicated macroeconomic dynamics than everything is going up, active management has a real place in most investors' portfolios, and they've really shunned that active management. Now, there's a question

Starting point is 01:00:52 of how much you pay for that active management relative to the quality of it, which is always a question around active management. But truth be told, active managers today have weathered this year, a lot better than index investors. The aggregate hedge fund index is down, let's say, 8%, 7 or 8% for the year at a time when equity indices are down 25. Like, you sure would have preferred to have had that 7% down return rather than 25% down return. And this is really where active managers often deliver their best returns is not necessarily when everything's going up and they just lever up. It's when conditions are much more volatile, when conditions are much more challenging, they prudently navigate through those dynamics, ensuring that they maintain

Starting point is 01:01:44 capital rather than just stick to the index and let it ride. And so that's really the other thing. Active management and the role of active management in a portfolio through more challenging economic conditions is something that I think frankly isn't getting enough of the conversation today, even relative to some of the other points around balancing your beta portfolio. Part of the beauty, of course, is that the instruments or the technologies or the tooling around beta are just so ubiquitous and easy and effectively free. You can get whatever beta exposure you want. How to manage those, of course, is a more difficult question. But everything is effectively free to access, which is amazing for investors out there of all types.

Starting point is 01:02:24 When you start talking about active, then what you're buying is some sort of skill. you are making a bet. Let's take the extreme case of a hedge fund that's market neutral and has no beta exposure. Maybe it doesn't even have factor exposure or something. You're making the bet that the manager has some sort of skill and you're buying a stream of alpha rather than beta. There, the tooling is non-existent. This is a notoriously difficult problem.

Starting point is 01:02:47 It's easier to identify alpha. After the fact, extremely hard to identify before the fact. What has your career taught you about that? about finding what I'll call like the most talented, skillful, smartest people that might actually have a chance to deliver alpha versus just like looking at past returns and identifying it after the fact. There's two things that really stand out in my mind when you're thinking about alpha and finding alpha. The first, which is critical, is a function of what you just said, which is it is very hard to understand what alpha and what manager is likely to be successful in the future.

Starting point is 01:03:29 Very easy to understand in the past and very hard to understand in the future. I think the general thesis or the general idea that sophisticated asset managers, hedge fund managers are in aggregate better at managing money and their strategies are better at managing money than passive indexing makes intuitive sense. and also is borne out by the data if you look through time and you look at the quality of the strategies before the fees, let's say. What you see is that those managers do very, very well, much, much better than holding index investments.

Starting point is 01:04:01 The issue is that too often investors are trying to find the one manager that's going to do great or the other manager that's going to do great or the strategy that's going to do great. And too often they're looking backward looking at the strategy that has done great and hoping that that will do great in the future or the manager that has done well and hoping that will do well in the future. That will lead to persistent underperformance. And that's exactly what you see, which is in all sorts of different ways, investors of diversified hedge fund type managers have meaningful index drag because it's very hard to pick which ones will do well and which ones won't. There's a solution to that problem, a very straightforward solution of that problem,

Starting point is 01:04:43 which is build a diversified portfolio of those managers. And those strategy. You don't know what's likely to succeed. You believe in aggregate they're going to go up and manage money better than index investing over time, invest in a diversified portfolio. That is the solution to that problem. And so too often people are looking for the one that will be successful and forgetting the core investing principle that diversification is certain and it is effective and it is the only free line. And so that's the first thing I'd is diversification because you don't really. The second point I'd say is it's all about the fees.

Starting point is 01:05:24 I think in general, as I look over the next, let's say, decade of asset management, there is today something like a trillion dollars a year of active management fees being taken from investors by a whole variety of asset managers, trillion dollars. And frankly, at prices that are like not that much different than what they were 10, 20, 30 years ago. 2 and 20 is still the standard in hedge funds or in venture capital or private equity.

Starting point is 01:05:53 And even equity mutual funds have come down, but not that much. Or your financial advisor still charging you 1% they have for a long time. So there's a trillion dollars of fees. And the question is rationalizing those fees. Because the thing that you recognize, the thing is that there are many, plenty of asset managers that do better than index investing, do better than what is, as you described, but they're charging you too much for it. So I think the second point is to say it's not just build a diversified portfolio, but build a diversified cheap portfolio. Because if you can find a diversified cheap portfolio relative to the alpha that you're getting, what you're going to end up seeing is you as the investor are going to get a much bigger share of that alpha

Starting point is 01:06:41 than if you're invested in much more expensive assets. And that cheapness is, certain. Cheapness is the most durable alpha that exists out there in the world. If you can deliver a lower cost product with a similar top line return, that is something that can persist for a long time. And so when you're looking at that portfolio, when you're looking at how do I find the alpha, you basically want to be diversified and you want to be cheap relative to what you're getting. And if you do those two things, you can find assets that are going to be highly complimentary and beneficial to the current portfolio of data that you have out there. Say a bit about the world of private markets.

Starting point is 01:07:22 You had such an interesting pit stop in your career, managing, I'll call it, like, a systematic approach to venture early stage, high growth, venture style investing. That is such an interesting experience to me as someone that does a lot of that, personally, with a lot of my time. What lessons did you learn there? like trying to apply the incredibly data-intensive, rigorous, systematic type thinking and approach to that world. And I'm also curious just how you think about that world now with everything else that we've talked about, like how it gets affected by, you know, its prices were amongst

Starting point is 01:07:54 the craziest in 2021 of anything. So riff on the lessons you learned in that chapter and the backdrop and how it affects that world. I think the early stage consumer space is such an interesting investment area because you've got the private markets dynamic of investing in those companies, but you have so much big data. It's like you're looking at a public markets set of information. The public markets like set of information for a private market's investment. And I think the thing that I saw through that lens that was very compelling is that investors can meaningfully improve the quality of their decision making. by being systematic and being quantitatively oriented.

Starting point is 01:08:42 And so through, frankly, a set of important decision rules, but not unduly sophisticated, we're talking about common sense, quantitative decision rules, you could very easily identify outcomes that would be meaningfully better, multiples better, than if you simply used your discretionary view of things. When you think about systematic or quantitative investing in general, I think it's very important to recognize you're not trying to get perfect at all. That's not what you're trying to do. What you're trying to do is use information to give yourself a little bit of an edge. What you do is you give yourself a little bit of an edge over and over and over again, and you can place enough bets on that over and over and over again. Then what you can do

Starting point is 01:09:30 is you can start to get better and better outcomes. I always like to say, the best hedge fund managers, example are right on their positions 55% of the time in any one month. 55%. You were wrong, 45% of the time, which, by the way, anyone listening to this should recognize that I am probably wrong at least 45% of what I just said, right? Right. But if you can take that 55% and you can place 100 bets that are slightly weighted in the coin in your favor, you actually can build a portfolio that is very, very good,

Starting point is 01:10:00 that is very reliable, quite reliable, and you can build a great business. So when you look at the venture space, the thing I thought was so fascinating is there's data and you can create edge and you can go out and build diversified portfolios of these bets. And any one particular one might work or might not work, but you can give yourself edge over and over and over again. And if you can do that effectively and build that diversified portfolio, you can generate high quality returns that, frankly, are a lot better than the typical structure. The typical venture structure, if you think about it, is, let's say, an early stage consumer is like, eat the yogurt, tell me what you think about it.

Starting point is 01:10:41 Stare the founder in the eyes and tell me what you think about that founder. And like that relative to using quantitative and systematic strategies is terrible. That's the reality. I hate to say it. I think the whole world of whether it's venture or private equity, there will be a reckoning someday in the same way that public. Public markets investors had a reckoning 30 years ago. 30 years ago, most people traded stocks on their gut because they looked at the management teams in the eye, so to speak, and said, oh, well, you know, I like this guy's strategy. I don't like this guy's strategy, et cetera.

Starting point is 01:11:17 And those people went out like the dinosaurs. But there hasn't been a reckoning like that in the private markets. They're using the same strategies. They're sort of looking over the table, staring at the person, looking in their eyes, looking at their resume. like why are we still in that world versus a world where you're using, by and large, data to create edge in all sorts of different ways. And it doesn't mean you have to have all the rigorous, incredible transaction data that we had in the early stage consumer space, but even very simple things like the odds that a founder

Starting point is 01:11:53 will be successful if they're in their 40s or 50s are multiples higher than they are in their 20s. If it's three times better, think about that. you take that bet and you put it on over and over and over again, you build a portfolio of lots and lots of bets, that actually will do you well over time rather than do you poorly. Or as an example, whatever, a second time founder is better than a first time founder. And you could imagine how you can construct common sense decision rules that meaningfully raise your probability of success investing in the private side just in the same way that you do it in the public side. And we're going to see that. 20 years from now, it's going to be computational strategies that will be identifying the most

Starting point is 01:12:34 successful companies through a variety of different data attributes, the most successful founders, the highest probability founders. That will be where this industry is going. Why do you think that hasn't happened yet? Because if you go ask this question of benchmark and Sequoia and all the big, most successful by scale and sort of IRA, early stage investors, they'll say like none of that matters. At the earliest stage, it is the backstory of the founder and their relationship to the problem they're solving. The answer may be as simple as there literally isn't any product data yet.

Starting point is 01:13:07 So until you have that, you do have to rely on a different set of things. But why do you think there hasn't been like an iconic early stage technology investing firm that is primarily driven by systematic approach or strategies? I mean, I saw this tension very literally. in running a systematic venture book. And I think a lot of it starts with the narratives and the assumptions that institutional investors have about how investing in the private markets should work, which then relates to their expectations of the types of outcomes or the types of strategies that they should see,

Starting point is 01:13:50 which relates to who they give money to who they don't. in a lot of ways, I think it really starts there, which is that the providers of the capital are not demanding that the allocators of capital are using strategies that increase their probability of success. And instead, what they're doing, I think, is falling into a very classic fallacy, which is they are pursuing those investors, or they're pursuing putting money into those investors where they can't tell whether the outcomes are a product of randomness or skill. Because you mentioned a few companies. Obviously, if you look back through time, you see their success, you see the outcomes of

Starting point is 01:14:34 their returns. Maybe that's because of skill. Maybe it's because of randomness. But nobody can answer the question of which is which. That I think is a very interesting question. And so naturally, almost by certainty, there is a set of investors who invests. in the private markets that have done very well. The whole industry did very well if you go back to the age of easy money.

Starting point is 01:14:56 The whole industry did very well because of the age of easy money. Everyone's vote was lifted there in general. And then on top of it, there's a distribution and a randomness of which ones you pick versus which ones you didn't. And there's always going to be a right tail of the best outcomes. No matter what you do, there is always a right tail of the best outcomes. Solely because of randomness. This is the thing.

Starting point is 01:15:19 This is the thing is a public market's investment. investor is obsessed with constantly thinking about are the outcomes I'm seeing a function of randomness or a function of my skill? They're constantly obsessed with that key question and is it repeatable and is it repeatable? And you don't see any of those sort of frankly core foundational skill sets or ways of thinking about investing that is so common in the public markets in the private market space. I don't mean to take out the whole industry and say anyone who's been successful is random. Instead, what I'd say is, I don't know, and I don't think any allocator really knows what of the outcomes we're seeing are a function of randomness and what of the outcomes we're

Starting point is 01:16:03 seeing are a function of skill, because they can't quantify or really understand which one is which. Well, Bob, I just looked at the clock and realized we're already past our time. I can't believe how fast they went by. I mean, just incredibly fun tour of ideas and of the world through the lens of an investor and thinking about market economies, it's been so much fun. I ask everyone that I talked to the same traditional closing question, what's the kindest thing that anyone's ever done for you? My career was sort of built in the two and 20 business. And starting unlimited, I wanted to basically create a product that was accessible for the everyday investor and got really interested in thinking about ETFs as a structure and really innovative and investor-friendly

Starting point is 01:16:48 tax-advanted structure. And when I started thinking about building the business around creating ETFs, I didn't know a thing about ETFs. I was starting pretty much from scratch. And the thing that has been incredible is coming into the ETF community, really, and just how incredibly supportive and helpful, the ETF community has been in general at helping a new entrepreneur in the space. I think so much of the hedge fund space is behind closed doors and competitive and trying to prove that you're better than the next person and the next person and the next person. And so much of the ETF world is about seeing a new structure, a new security that is better for investors, and being super supportive.

Starting point is 01:17:39 to all the different ways in which that can play out because I think in many ways the success of the ETF structure, particularly against the world of traditional LP and 2 and 20 structures, is going to be radically better for investors and all of us in the business will benefit. So what's the kindest thing that people have done? Frankly, dozens of people throughout the ETF ecosystem who have basically kindly given their time to help me, even understand where to start, who to talk to, what are the right vendors, what are the risks, what are the key things to focus on. Incredibly thankful for the whole community along the way. And even people who ostensibly, you could say, are competitive products being helpful along the way,

Starting point is 01:18:26 reaching out and being supportive to what we're trying to do. It's a breath of fresh air after decades in a much more competitive cutthroat environment. And honestly, one that really makes me enjoy coming to work and carrying my small share of the mantle of the ETF revolution that's coming. I don't think that there's been many people who've got your experience in macro hedge funds systematic, who have then tried to apply this to the world of ETFs. We already talked about how ETFs have made so easy to access beta instruments. To this point, they really haven't made easy to access alpha instruments or active instruments. And so it'll be just fascinating to see what you and unlimited funds together do in this space. I'm excited to watch it. And I'm really

Starting point is 01:19:11 thankful for your time here today. Great. Thank you so much for having me. It was really enjoyable knocking around all sorts of different topics, a whirlwindure, so to speak, and would love to come on again as this boring cycle plays out. Thanks again, Bob. If you enjoy this episode, check out join colossus.com. There you'll find every episode of this podcast complete with transcripts, show notes, and resources to keep learning. You can also sign up for our newsletter, Colossus Weekly, where we condense episodes to the big ideas, quotations, and more, as well as share the best content we find on the internet every week.

Invest Like the Best with Patrick O'Shaughnessy - Bob Elliott - A Macro Tour - [Invest Like the Best, EP.302]

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