Investing Billions - E224: Ex-CIO of Northern Trust: The Next Decade Belongs to Bonds, Not Stocks

Episode Date: October 10, 2025

If “fixed income is broken,” what are investors actually missing—and how should they rebuild the 40% to protect and compound through drawdowns? In this episode, I speak with Thomas E. Swaney II, former Chief Investment Officer of Global Fixed Income at Northern Trust Asset Management, who oversaw more than $600 billion across global fixed income. Thomas explains why traditional bond allocations fail when it matters most, how to separate duration from credit risk, and how to use notional leverage to target true diversification without sacrificing liquidity. We explore the structural flaws in 60/40, how to design a fixed income portfolio that actually offsets equity drawdowns, and why the future of bond investing depends on better risk budgeting—not higher yield.

What I learned early on was having all the answers wasn't the secret. Nobody has all the answers. It was really about knowing what questions to ask. So many firms want to do something differently. They want a different outcome, but they want to do things the same way they did yesterday. I think now is the time for fixed income. I think over the next 10 years, the returns from bonds is probably going to rival the return from stocks.

The problem is the 30-year treasury is the least efficient asset on the planet. There's not enough duration there. And the duration you do get is more susceptible to changes in inflation. inflation expectations as opposed to a response to a negative growth shock. Swenson was right in having a liquid long duration instrument that was more volatile. The problem is the returns weren't commensurate with the level of risk. Fixed income requires that you know a lot about a little. And in fixed income, when you know a little about a lot, you just know very little. So you've had a prolific career starting as a PM at Ellington, followed by being a CIO at Northern Trust. So maybe we could

start there. Tell me about your experience being CIO at Northern Trust. Sure. I think, anytime I think about my own career, I think about how fortunate I've been to be surrounded by talented people. More importantly, talented people who modeled the behavior they wanted to see in others. So I started my career at a small fixed income boutique that was ultimately purchased by Morgan Stanley. It was a private firm. It was run by investors, for investors. Everything was about investment process and performance. It was about doing a original research and using that research to outperform. It translated to putting the client first, and the firm really had what I call investment integrity. It just did everything with the end

client in mind. So the firm also had like an open debate team format. So debate took place openly and honestly, really and routinely. It was just done in a way that I can learn so much without having skin in the game. And I can still remember early days in my career when team members were really going at one another and I could learn so much just by watching. So what I learned early on was having all the answers wasn't the secret. Nobody has all the answers. It was really about knowing what questions to ask. And I learned how to become a systematic thinker there. So I kind of learned the importance of saying, I don't know, being secure enough with what you do know to say, I don't know, but I'll find the answer. It's something I try to model today as a leader and

something, you know, a trade I look for in those around me. So those things really stayed with me early in my career. And that kind of brings me back to the Northern Trust piece, which you can imagine that, you know, working at such a firm, they would generate a tremendous number of leaders who had great careers as CEOs or CIOs at major asset management firms. And one of those leaders became CIO of Northern Trust. And after he was in his position for about six months, he called and asked me to consider coming to Northern. Honestly, I didn't know much about Northern from an asset management perspective. I knew they were large. They were a $1.2 trillion asset manager. And I know the importance of scale and fixed income where at the time they managed over $600 billion. And so

combining that scale with leadership that appeared to want real change, that was really attractive. The first firm that you mentioned when you were at Miller Anderson shared a small boutique, you had this open debate culture akin to the Bridgewater, the Ray Dalio approach of everybody basically speaking truthfully to each other. A, how is that institute? B, tell me about the tradeoffs in that kind of culture. Bridgewater will describe itself as a deliver deliberately developmental organization or what they call it it becomes they've systematized a lot of that at the time none of this was systematized. It wasn't about trying to build algorithms to, you know, to, to measure things the way Bridgewater does. Instead, it was really just about modeling the kind of behavior you wanted to see in

others. And by being really open and honest and sort of breaking down some of those layers, so many people are so protective of they don't want to be wrong in front of others. And when you have the leaders of a firm demonstrating, again, and modeling the behavior they want to see, that was really great because they would ask questions and be asked questions in front of others. And that created a vulnerability and a trust, I think, that made them think more critically about things. Because, again, when you can meet with people and you know that you can trust one another and you have the end goal in mind, it's the same goal and you're not about outdoing one another, there's no doubt. I think that delivers better investment results. No, there is a downside to that, I guess, there always is, you know, to most anything.

But I think the downside is there's just certain people, they might take a little bit more time to organize their thoughts or they might be, you know, personality fit might be difficult for some to participate at the same level. But I think if you can recognize those people that need a little bit more time and call on them and, you know, as a leader, incorporate their thoughts more and try to incorporate as much as you can, I think that is you can make up for some of those shortcomings. So for me at the end, I think having that open debate is critical to getting a good result in when you're managing other people's money. Is there a real trade-off there that some people can't stomach it and that it polarizes some people away from the culture? And why don't more organizations embrace this open dialogue?

I don't know why more don't embrace it. I think when you think about, you know, I hate to use, you know, introvert, extrovert as the, you know, as the, you know, what we call it. But I do think there are certain people that, you know, gain their energy from being around others and certain people that, you know, really simply like to think more independently and on their own. I find the value to be more about what I call like sort of pulling the string. Oftentimes, you don't know where a discussion is going to end up. You don't know what critical decisions really need to be made. And by talking things out openly and getting people to think more critically about the prospect of being wrong and having people think more critically about every aspect of their investment and doing so

publicly. And in my opinion, it's not what you think independently that really matters. It's about how others thinking influences your thinking and where you end up. And I think on average, you end up in a better place. I think the reason why more managers may not do this is it takes time. You've got to invest in that. You've got to really cultivate that culture. You've got to have people that model the behavior. And there's no shortcuts because when everything is done publicly, people can kind of see that you're taking shortcuts. So I think it requires managers in that kind of environment to really be always engaged and always looking to, you know, get the best result possible. It's counterintuitive given the current school system in the U.S. where it's all about

having the right answers. It's not about asking questions. It's not about iterative progress. It's not about improvement. It's about absolute correctness the first time. And you can't be more correct than 100%. So there's also kind of a limited upside. There's also obviously this evolutionary psychology where when we were in tribes and you were wrong and you didn't show strength that you could have been banished from the tribe. I think there's some evolutionary aspect to that as well. I think about my mind is like an LLM, a large language model. And I'm constantly trying to improve the LM and fine tune it, which is why the podcast is such a value for me. I'm able to put out what I believe to be the correct truth and then have other people essentially iterate on it and improve my

thinking so that I'm more closer to ground truth. And I really have rewired my thinking into thinking, oh, you know, I say something, somebody corrects me. And that's like a blow to my ego. And I'm very excited, especially if it's around the right people. And I know that they're really fine-tuning my L on. That's something I value so much is having people with complementary skills. And our business, you know, at least in investing, the people that tend to lead are those that were great investors. And oftentimes great investors don't make great leaders.

And so I think knowing what you know and learning more about what you don't know is really important in that kind of environment because that's the way you can grow and you're going to be better together than you will in isolation. So I love that structure and I couldn't agree more with you. perhaps it's very obvious so apologies of so but why don't the best investors make the best leaders at organizations i hate to boil it down to one thing but i think ego plays a major role i think in order to make investment decisions um it's it's difficult right you're managing other people's money the hit rate is is you know you mentioned 100% right if you could be 55% right in in

most investments it's it's a good thing and so ego uh is difficult in allowing people to grow and allowing people to become the decision maker that you were when you're when you're when you're pushed into management oftentimes you want to you want to keep that same role and you know you may have used expert power you may have used you know other you know ways to to manage yourself and when you're starting to manage others and to be able to bring them on you really have to take you know a back seat and step aside and oftentimes lead conversations with questions and not necessarily all the answers as you might have, it might have done on the other side of the tables. It's just difficult because, again, there's very little training in our

business as well. I mean, it's not like you get into this role and there's a lot of training for you. You tend to model the behavior you saw in others. And there's been a, you know, decades of bad leadership and asset management. So it's very few people that you can learn from as well. when you started at Northern Trust it was 100% non-institutional and as a CIO you sought to change that and to enter the institutional market what was your thesis and how did you go about implementing that thesis this was probably the most compelling reason I found the CIA role in order to be attractive change is difficult in the asset management business when you build a successful institutional business and fixed income. The existing clients have bought into the people, the

philosophy, the investment process. And that investment in performance becomes kind of a necessary but insufficient condition for asset growth. Because you fit into a client's portfolio not only for what you deliver, but how it compares to other managers in the stable. So it's difficult. And when you're a new investment leader and you want to make changes, you've got to be very careful. The changes need to be measured. They need to be incremental. And they need to be messaged very carefully to clients or you risk losing the assets that you spent years building. And also, when you think about the distribution side of the business, the institutional distribution team, it can demoralize them because any kind of change derails the prospect of building assets in the near

term. So you've got to be so, so careful when you take over an existing institutional business. But to have the scale of Northern Trust, which I mentioned was about $660 billion in fixed income when I took over and to not have a meaning. institutional business, it meant that change could come not only more quickly, but most importantly, it becomes more of an internal exercise. And usually that increases the likelihood of success. So, you know, if you think about the limitations, you know, the real limitations for change generally come from outside the organization. And yet here was this opportunity to take something substantial and make changes quickly. And that was exciting.

Is there kind of this innovator's dilemma, the Silicon Valley idea that there's always disruption from the incumbent by because of stagnant organizations. Did you find that Northern Trust that was very difficult to change the culture and the focus of the entire organization, even from the CIOC? Without question, yes. I think, you know, someone said it, I don't, you know, I can't attribute the quote, but that, you know, culture, you know, each change for breakfast. And it, so many firms want to do something differently. I guess I should say they want a different outcome, but they want to do things the same way they did yesterday. So it's so hard to get the entire organization energized and thinking more critically about, you know, how to change.

And no matter how much from the top down, you know, even the support you have, no matter how great it is, it's still so difficult because change is hard. And I think particularly in the Midwest, there's a culture of sort of just being openly nice and, you know, change. oftentimes isn't nice. It's difficult. And you've got to say difficult things and those things need to be received in a way that is as if we're in something together and it's not critical. It just, you know, change is difficult. The biggest part for me in taking over Northern Trust was just when you inherit something that, again, wasn't really designed for to be managing institutional assets. They had an entirely different investment model when I got there. So the way

I would articulate it is, first, I was kind of global CIO, and yet the team, we had an investment team in London and our central location was Chicago. But this team in London was great. They were underutilized. So the first thing I did was to try to break down the geographical barriers and stop thinking of ourselves as being different teams. But the main thing that I did was I went from what I call a generalist investment model to one that was very different. The generalist investment model is kind of where the existing team was organized by product and not by skill set. So what I would say is you might have someone responsible for short duration strategies. You might have someone else responsible for core fixed income or high yield.

And that type of structure requires someone to know the aspects of each type of fixed income security and the underlying strategy. That's difficult. What's different about fixed income is that securities need to be decomposed into their respective risks. So that means that you have to understand the nuances of interest rate risk, credit risk, spread risk, prepayment risk. These things require like a very specific expertise to truly understand. And the generalist model that I inherited meant that we knew a little about a lot. And in fixed income, when you know a little about a lot, you just know very little. Fixed income requires that you know a lot about a little.

And you really want to just know as much as you can about this one thing. And so I think that is essential. that you organize yourself the right way. And third, I think and arguably the most important thing I did was to hire ahead of portfolio construction. It's so difficult to go to a prospective client and suggest that somehow you've hired better people, right? That's a difficult claim to back up with any evidence.

But if you've got a clear investment philosophy, if you've got a well-defined investment process, and you're thoughtfully organized to sort of perform both fundamental and quantitative research on those risks I just mentioned, all you need is a robust portfolio construction process. And that's where all the tradeoffs are explored, risk, relative value, the efficient use of capital. They all come together utilizing cutting edge tools. And I think for me, at least, portfolio construction really is kind of the secret sauce. In my opinion, it's what separates average investment teams from exceptional ones. And I think to me, at the end of the day, if you do all those things I just mentioned, it doesn't guarantee success.

But at least you have a real chance to build an institutional business. Before Northern Trust, you were at PM at Ellington. Tell me about that experience and how did that shape you as an investor. Ellington was the first firm I worked really since that fixed income boutique where I began my career that was really centered on investment integrity as I defined it. The quality and nature of the research, the people, the process and the data all come together was impressive. The firm's highly focused on a small number of things.

and they have what I call investment excellence, not asset gathering as their primary objectives. What they've done with their publicly traded REIT, EFC, the way they managed through COVID, they did such a great job of rotating in and out of assets that offered better relative value. They maintain modest leverage and they kept powder dry for more opportunities. It's a pretty impressive place. For me to work again with that caliber of investor was exciting. I managed derivatives strategy. It was meant to outperform several U.S.

U.S. and European credit benchmarks, whether they'd be investment grade or high yield. And that credit strategy was utilized in tandem with investments in residential and commercial mortgage-backed securities. So whereas many multi-asset credit businesses focused on bringing together high yield and bank loans, you know, those two things tend to be very highly correlated, particularly in times of stress. And what we were doing was really innovative. We were combining those credit investments with more residential, more residential, more

and commercial mortgage-backed securities that in times of stress, tend to be more diversifying. So it created a different way of thinking about relative value in a multi-asset credit strategy and something that they still do well today. Maybe you could break it down to investor. Why would investor want this kind of exposure? And how does this fit into a, let's say, an endowment's overall investment strategy? Yeah. So this interesting about fixed income.

So the more you seek higher return. in fixed income, the more you tend to have to go down on credit quality. And the more you go down in credit quality, the more highly correlated you become with equity markets. And so the very reason why you got into fixed income in the first place, which is usually diversification, it tends to get compromised. And so there's this real dilemma. And so what you want to make sure you can create in a multi-asset credit strategy is one where you can earn higher returns than what I would call core fixed income, but you can do so in a way that doesn't compromise the correlation with equity. So you want to do something where, yes, you can still earn higher returns, yes, you can

still get modest amounts of income, but what you really want is something that's still going to hold up well in times of stress. And so the endowments and foundations, you know, they love these kind of strategies for those very reasons. More and more people are starting to think more critically about not just fixed income as a sort of a label for everything, you know, but more so how it actually behaves in times of stress. And I think the events of, you know, obviously COVID, you know, an exogenous shock like that, or you look at, you know, 21, 22 with the breakdown and correlation between stocks and bonds. I think more and more clients are considerate of not just diversification in normal times, but diversification in times of stress, which is

actually the only thing that really matters. Bring it down to basic 60-40 portfolio. You have 60% equity, you have 40% bonds. The reason you do that, the reason you don't do 100% equity and maximize on returns is because you want diversification. So in that 40%, you not only want the best returns, you also want to be non-correlated to 60% or else you might as well be 100% equities. So in that 40%, you don't want these low-grade bonds, these junk bonds that are basically correlated to stocks. What do you want? So tell me about what investor could consider in that 4%? 40% bucket. Let's say that's using the Yale endowment approach. So the Yale model was really about the need to increase the amount of private assets in a

diversified portfolio. I think Swenson, the one thing he did was he realized that he wanted to capture that illiquidity premium. He wanted to make sure that his portfolio would be lower in volatility, just given the nature of private assets and how they're marked and get that liquidity premium over time. So he wanted to capture all of that, you know, excess, you know, spread, if you will, that comes from investing in private assets. The difference, though, is that in his, you know, 15 to 20 percent, the fixed income component, he didn't believe in having fixed income other than treasuries. And he believed only in 30-year treasuries because he wanted something in his fixed income portfolio to be liquid enough and volatile enough to provide value. So let's

me describe what that means. So if you were to think about where most of the value comes from in terms of asset allocation, it's not the standard asset allocation. So it's not whether you have 60, 40 or 70, 30. What matters is that you can rebalance dynamically after periods of stress. So think about this. You were in 2008, you've got a 60, 40 portfolio. What you want to have is you want to have something in that fixed income portfolio that's gone up in value. At the same time your equity portfolio has gone down. And then you want to be able to quickly sell that fixed income component, that fixed income component so you can then rebalance and capture the outsized gains from equity markets that we're obviously going to, you know, during your rebound are going to

be there after the fact. So it's that ability to rebalance that's essential. And so that's why you need to have your fixed income portfolio be negatively correlated with equities in times of stress and be liquid enough that you can efficiently sell it and rebalance in enough time to capture the value. on the back end of that. It's interesting because there's this cult of diversification, but no one really asks, why is diversification important? They assume that it's important because then when things go up, things go down.

But if you never have to sell, that wouldn't be important because equities would still outperform. What matters is to your point, A, is can you avoid taking the wrong action at the worst possible time in the market? So the worst possible time in 20 years to sell, can you avoid selling in that time? And two, as I guess to your point, like version 2.0 is can you not only avoid making a serious mistake, can you also be opportunistic about it and sell the fixed income that has gone up and double down into the equities at the lower, which takes a lot of a lot of gumption. But if you could just avoid that decision to sell, that's, I would argue, is the main point of jurisdiction outside of the need for liquidity.

If your endowment, you have to pay 5% every year for operations. You can't afford it there to be too much of a drawdown. But for an individual, that doesn't need to touch that money. The main thing is almost behavioral, not rooted in just traditional finance, behavioral finance. You know, there's been many studies that detail this. It's, you know, retail investors tend to make the very worst decision. They tend to do the opposite of what they should do. And so I think any time you can have an asset allocation that sound and then return to that asset allocation and rebalance dynamically,

many firms have what they call a bare market playbook. Well, they'll even go beyond that. So if you had a 70, 30 portfolio and had a major correction, maybe you'd go 75, 25, and allocate even more toward equities to capture the outsized gains that usually, you know, will come after periods of underperformance. I had the CIO of Calster, Scott Chan, and they ran this competition.

What is the best trade? What is the best idea internally in all of Calsters? And what won was what to do during the next recession, in the next drawdown, like basically almost this war games of, okay, this is going to happen. These are our, this is our playbook. This is exactly what we're going to do. And then lo and behold, you had in 2022 markets went down and they ran this playbook. I don't know for a fact, but I'm sure they were ready for the tariff drawdown as well.

So it's not something that human beings are wired to handle just in time. You really have to have a prepared mind for that kind of market downturn. And to your point, it's what matters is the reason. for the market decline. So if you were to think about a typical market decline, you know, a typical run-in-the-mill recession where you have a drop off in aggregate demand, that might be one playbook. But, you know, when you have an exogenous shock like COVID that was supply chain related, obviously you don't have a Fed that can do much with that aspect of it. So you can, you know, whatever you do with rates is sort of meaningless when you've got supply chain issues.

So I think whether there's growth or negative, you know, what I would call like just, you know, negative growth in some way or some kind of exogenous shock, that's one thing. But I think when you have the presence of realized inflation or you have a change in long-term inflation expectations, that can change what that playbook looks like because the correlation between stocks and bonds is going to change based on that one component. It's like you said, it's important to not just think about things on average, but to think more specifically about the reason for the, decline in growth and those those playbooks can differ greatly depending on what the source of that

risk is how many different types of market downturns are there i'm sure you i'm sure the answer is theoretically infinite but are there patterns over time over a hundred years do you see these like two three types of market downturns and what have you found studying history bridgewater does this really well bridgewater will talk a lot about markets being in equilibrium and When markets are in equilibrium, you tend to earn the long-term risk premium associated with that market. And when markets are out of equilibrium, you tend to have either a fiscal policy or monetary policy response. And so I think it's really critical that you understand whether growth and inflation expectations are changing, whether they're increasing or decreasing, because that will sort of influence how you respond. I've been in this business, you know, almost 30 years now.

And so for me, it's different in that I've started to focus more not just on fixed income and isolation, but how it complements other parts of a diversified portfolios. For many people, they worry about the Fed now and it's independence, and that's valid. But when you look at overtime and you mentioned the last 100 years, which is appropriate, a lot of people will look at the average correlation between stocks and bonds. And to me, that's irrelevant. What you need to look at is how has the 10-year Treasury performed when the S&P 500 is down 10% or more? So let's only look at how well bonds do when equities are underperforming, because that's when you really care.

And what's interesting about that is prior to sort of 1990, we were in a different regime where the Fed actually was not countercyclical in its policy, but actually exacerbated shocks. When you look at things sort of, you know, since 1990 and you look at sort of the dual mandate of the Fed, they've been very direct in terms of their communication. They've been very clear in terms of what that response function is likely to look like. And so because of it, they've engaged in countercyclical policy. And so that's done something magical in a way because it's meant that the correlation between stocks and bonds in really down periods has been decidedly negative. So there's been a real benefit.

And I don't see that benefit going anywhere, despite the fact that we might have higher risk premium out the curve because of higher levels of debt, maybe even higher levels of inflation expectations just modestly that are going to raise the term premium. I still believe that fixed income and bonds in particular can provide that real insurance aspect, if you will, in times of stress. And I think that that's going to be hugely valuable going forward. So let's just assume a 60-40 portfolio just to demonstrate, just for simplicity. If I had 60% equity and 40% in bonds, double-click on what is a good potential strategy for the bond part of my portfolio.

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Barclays aggregate bond index would represent that. Its returns are just about 3% and its annualized volatility is about four. So here you have the S&P 500. which is, let's call it 60% of your portfolio, just being simplistic about it, and it's got a volatility of 15%. Then you've got this 40% that only has 4% volatility. So they're completely out of balance. And so when you think about risk parity strategies and what they were designed to do, this is kind of almost exactly it, which is they didn't want to make these allocations based on nominal dollars. They wanted to make it based on contribution to risk. So what we really need in our fixed income portfolio is we need higher levels of volatility, only we don't

want to compromise by going down in credit. We want to actually maintain the credit, but we want more volatility in the portfolio because that's going to be what benefits the overall portfolio in times of stress. And that's a very difficult conversation to have, but that's what clients need more of the same in terms of default risk and more high yield bonds and bank loans. What they really need is more high quality duration, but that has more volatility to counteract the vol from equities. So is the answer, perhaps smaller allocation and leverage? What's the answer to that? The answer is to understand the parts of a bond. When I think about investing, I think, you know, and people will talk about fixed income, but to me, there's no such thing as fixed income.

Fixed income is a pretty broad umbrella that can encompass everything from, you know, treasuries to investment grade bonds to high yield, to bank loans, to CMBS, to residential mortgage-backed security. So you have all of these labels. And then even within that, there's multiple credit ratings and you have different duration profiles. So some have durations of close to 30 years. Some have durations that are in line with T-bill. So the generic sort of fixed income you know, moniker doesn't, does it, doesn't do anybody a benefit. And there isn't one thing. And so what I like to do is to decompose the securities into the respective pieces. And I'll, I'll take a corporate bond as a good example of this. So a regular corporate bond will ignore any swap,

spread component. It really has two pieces. It's got a credit component, which is obviously a function of the underlying credit quality, if you will, of the underlying issuer of the company. like take a Ford Motor, for example, Ford Motor might issue at 100 basis points or 1% relative to an equal duration treasury. So if they're issuing a five-year bond, let's say the five-year treasuries at 3%, they might issue at 4%. So only 1% is attributed to that credit component. The rest is from an equal duration treasury. What's interesting about an investment-grade bond is the volatility of those two pieces is actually roughly the same. It's what makes an investment-grade bond such a great asset because in times of stress, that credit component and that duration component, they

tend to be negatively correlated. And so in theory, investment-grade bonds are almost the perfect asset because they're in perfect balance. And that balance is what creates resiliency. And that resiliency is what translates into having something that can actually be diversifying in times of stress. So if you understand the pieces of a bond, no matter what you're looking at in fixed income, you can probably, I hate to use the word sophisticated, but you can have more of a more sophisticated approach to asset allocation. What are some tools that I would use to implement in my portfolio or an institutional investor might implement into their bond portfolio to both maximize return, but also maximize diversification

against their equities. Leverage gets a bad word. And I think anytime you're borrowing financial leverage, that can pose real risks. I think using notional leverage, though, sensibly, is a way to get at the goals of asset allocation. And by notional leverage, I'd simply mean, if you think about using treasury futures, for example, to increase the duration of your portfolio, you could do that using, futures and do it in a way that's extremely efficient.

and efficiency is a big part of this because at the end of the day, that's really the problem that we're trying to solve is how can we be more efficient in the capital that we're using? And what made me think more critically about this really is the amount of private assets now in portfolio. So if we were to take what we just talked about and said, hey, look, I agree with him. You know, it makes sense that we have the ability to dynamically rebalance a portfolio. now think about having 30, 40 percent of your portfolio and private assets that you can't even rebalance, right? Not only can you not sell them because they're liquid, but they're not even marked.

They're marked with a lag. So, you know, whether we have private equity or private debt, if you get a 2008, the value of those things might actually go up for a couple quarters before you start going down in value. So there is this denominator effect that obviously impacts, you know, institutions and people like that that's one thing. But what really is the problem with having a high degree of private assets is that you don't have the ability to truly rebalance the way you should. And to me, that's where you have to be more critical and more thoughtful about the public side of your portfolio, the liquid side of your portfolio, because you can't do the same thing there that you've done

historically when now 30, 40 percent of your portfolio is private. I wrote an interesting paper earlier this year. Kind of a interesting, it was just an empirical research, so it was nothing amazing. But everyone focuses so much on what you get from the private side. And we agree. We think, you know, that liquidity premium is 150 to 200 basis points while going down probably is still meaningful even in private debt. But we did something really simple. We took two portfolios. We said, look, let's look at a 70, 30 portfolio. So 70% equity and 30% bonds. And let's assume it's all liquid. The other portfolio we said was, look, take a 50% equity portfolio, put 30% in privates in the remaining, you know, in fixed income. And when you looked at those two portfolios,

the cost of that portfolio with 30% in private assets actually ranges between 145 and 165 basis points a year. That's because if you can't dynamically rebalance and capture those outsized gains from public markets, it really compromises your portfolio. So while everyone, one's focusing on what they get in private assets, more and more people need to think about what they're giving up. And I think the more they're going to think about critical ways to complement the modern portfolio that has greater degrees of private assets. And what's that paper called? Called private asset convexity. And convexity really is a key aspect of this because public assets are convex, whereas private assets are not.

Set another way to reframe what you're saying if we use the Kaplan Shore Index, created by Professor Steve Kaplan, who was previously on the podcast, private equity might have 350 to 400 points of outperformance, but its illiquidity also has 150 basis points or so of negative factors that should be factored into that 350 to 400. Exactly. And that's not even considering the denominator effect. That's not even considering other difficult aspects of having a mature private equity portfolio. So you're Exactly right. I think there's many investors out there that recognize these convexity differences. I just think we've done a poor job of creating products on the liquid side of markets to address this, you know, this dilemma. I like to define terms because it makes it easier to operationalize these strategies. So rebalance, balancing your portfolio, what you're saying is when the market goes down, if you're

fixed income portfolio will go up. That means selling the fixed income and buying more equities. Is there anything else that goes into this rebalancing procedure? No, no, but you're hitting on something, which is that two things. One is that fixed income component needs to be negatively correlated or uncorrelated with your equity portfolio. And it needs to be liquid enough that you can sell it to redeploy that capital in public market. So that is, so that is the very definition of convexity in this context. To me, the idea that public equities are more convex than private assets relates to how their return profiles respond to changes in market conditions, and particularly in the tails of the distribution. So, for example, in 2008,

when markets where public equities were down, you know, 30% plus, there was no way you were going to get the 40, 50% rebound type of returns from private assets that you could get in public assets. So they've got a very different or asymmetric return profile after periods of stress. And that's what convexity really means in this context. Perhaps you could define convexity. So what makes these bonds and this type of fixed income convex? Convexity refers to like the nonlinear relationship between risk and return at extreme. So the best way to put it is in private assets, you're going to get this premium. And on average, you will earn more, right, right? Then they're their public counterparts. But

that doesn't say that in periods of stress that you don't want the ability to go further into public assets because that's where you're going to get the outsized gain. So again, I get plans, even, you know, we're even seeing this in retail and we're getting this push even in 401Ks to allow greater degrees of private assets. And I'm all for that in theory. I just think that, again, we need to address the liquid parts of our portfolio for these convexity differences. and whether that means you leave powder dry, right? So your asset allocation, as you get more, you know, as you get at more extremes and valuations,

you want to create ways that you can take advantage of these outsized gains in public equity markets that simply don't exist in private markets. So I don't know if you're purposely avoiding implementing leverage or talking about leverage, but I really want to distill. Talk to me about leverage. How would you very specifically implement leverage

into a portfolio like that? What is important is that you may. maintain the balance. So this balance that I mentioned between credit risk and interest rate risk, what you want to do is when you look at the factor exposures of those bonds, right, and you look at what they have in them, if let's say you're fine with 5% volatility, then fine, you take it as it is. But if you say to yourself, boy, I'd love to have a fixed income component that generates 15% volatility. Well, then you need to do some sensible things using notional leverage to make sure you get that same balance, but you get that balance at a 15% val as opposed to a 5% vol.

And that generally involves using a combination of what they call index CDX. You know, it's a very liquid investment grade credit default swap index and then you use Treasury futures. So you can take the leverage, if you will, again, no borrowing. There's no financial borrowing, just notional leverage. You can take that up and down. depending on the level of volatility that you're intending to create. And that notional leverage is a synthetic type of leverage.

It is. And, you know, again, you need to be sensible about the capital that you set aside. So, for example, at factor two, we put 40% of that capital aside to meet any of the needs. So we don't, we, the goal is not to compromise anything using notional leverage. The very idea here is to meet the demands. of today's modern portfolios and to do so in a way that is more efficient in the use of capital. So if I were to take you back to that Swenson model, the problem with Swenson wasn't that he wanted a 30-year treasury. In fact, in theory with the tools he had, it was the best portfolio that he

could create. The problem is the 30-year treasury is the least efficient asset on the planet. It's sharp ratio historically is only around 0.16, whereas other assets are 0.4 and 0.5. And so the return to risk ratio for 30-year treasuries is decidedly low. And so it's because you don't get enough sort of bang for your buck, if you will. There's not enough duration there. And the duration you do get is more susceptible to changes in inflation and inflation expectations as to responses as opposed to a response to a negative growth shock. So Swenson was right in having a liquid long-duration instrument that was more volatile.

The problem is the returns weren't commensurate with the level of risk. And so the idea is let's look at making an investment-grade bond just that much better, make it have volatility closer to that of a 30-year treasury, but in a much more efficient manner. Let's say you took this 30-year treasure and you wanted to give him or her a makeover. What would you do to Swenson 30-year treasury that would turn it into more efficient bond that has a better sharp ratio. As you go further out the curve, though, when you get beyond, particularly beyond 10, that 30 year, that 10 to 30 year part of the curve is largely driven by inflation and inflation

expectations. So there's a sweet spot in that 5 to 10 year part of the curve where the response function, if you will, the change in the 10 year and the change in the 5 year to negative growth shocks is extremely positive. And so the curve tends to steepen, right, as the Fed cuts short rates. And so you get a pretty good bang for your buck in the belly of the curve. And so there you get sharp ratios that are more in line of 0.4, and you get the same level of duration.

You just get it at a different spot on the curve. And so that one simple thing alone could improve the risk return ratio of your portfolio just by altering where on the curve you get your duration exposure. You're the founder and CIO of Factor 2 capital management. What is Factor 2 trying to do and what problem are you trying to solve? It's almost the perfect time, I guess, to answer this because we've talked about so many things. Factor 2 is really trying to solve the problem of capital efficiency. There are not many options out there for investors to get the level of volatility they need

without compromising and going down in credit quality or going further out in duration where you become more inefficient. And so to me, that's really what we're solving, is we're solving the capital efficiency problem. And I mentioned risk parity before as a concept, but risk parity addresses capital efficiency by optimizing how capital's allocated across asset classes based on risk contribution rather than this nominal dollar allocation. But what we're doing is it's not entirely different, except it's not how capital is allocated across asset classes, but instead how capital is allocated within fixed income. And so instead of contribution to risk, we're examining the factor exposures of a number of fixed income through securities. And we do it through the lens of a technique called PCA or principal components analysis. It's just a really unique way for us to understand the level and source of systematic volatility in a number of fixed income securities. And I think the results of our work would be surprising to most investors because, again, everyone thinks of,

fixed income as being sort of ubiquitous in this one thing. I think your listeners would be surprised that, you know, treasuries obviously share very little systematic risk characteristics with equities, but other things such as high-yield bonds and loans from a PCA perspective, they look exactly like equity. So the idea for us is how can we take these factor exposures, maintain them, and make it look just like an investment-grade bond, but do so at a higher level of volatility. And that's what we spend our time doing. Perhaps it's obvious. Volatility sounds like a bad thing, but it's somehow correlated to higher expected values. And tell me about that relationship. Risk and return go hand in hand. So the key is, again, this also goes back to,

to me, what you really want out of your asset allocation. And to me, I think so many people focus on, focus on the averages as opposed to focusing on the extremes where the real value comes from. And so for me, I don't care about averages. I want to know if equity markets are underperforming, do we have a portfolio that's going to do well in times of stress? And it kind of goes back to the question you asked me earlier about the types of downturns there can be. And so to me, there's only one difference in the type of downturn that you get now. It's either inflation related or it's not. And the only thing that can change the sign of the correlation between stocks and bonds, in my opinion, because it influences

the response function of the Fed, is this notion of whether that, you know, whatever the shock is, is it inflationary or not? And because as long as we are not in an inflationary world and inflation and particularly long-term inflation expectations don't become unanchored, I think we can really rely on the countercyclical nature of the Fed's, you know, monetary policy response. I think the presence of inflation changes that. And so for us, we're so concerned about understanding what's driving the volatility and then making sure we're putting together a portfolio that can be valuable in times of stress to our clients because to me at the end of day, if we don't do that, we have no value proposition.

We have no reason to exist. You're building a fixed income portfolio for clients that specifically performs during a downturn or something that is also optimal during regular years and has this optionality. on downturn, how would you explain that? Yeah, it's exactly the latter. It's during normal times, you'll get exactly what you expect. We run volatility anywhere between 8 and 12 percent with a sharp ratio of about one. And so the returns are commensurate with the level of risk.

And the idea there is to really just have a goal of making sure that in normal times, we perform decently well. But then there's this optionality that when markets deteriorate, when you get this 10, 15% equity market correction, that we can do two things. One is that we can outperform in those times and two, that we can maintain our liquidity because we want clients to sell us down and go by equities and rebalance. And that really is the key is to be, again, to be able to dynamically rebalance a portfolio in times of stress. And that means we need to provide liquidity. And that's essential. I'm assuming you've backed us of this over many years.

And how would this have performed in the tariff slowdown? How would it perform in 2022? How would it perform in the global financial crisis? Anytime you get a regular, again, regular recession or exogenous shock, it performs extremely well. The one downturn or the one negative associated with a strategy like this is when you get a high degree of correlation between stocks and bonds in a downturn. So in 2022, the strategy, when you, you get a high degree of correlation between stocks and bonds in a downturn. So in 2022, the strategy, when we backtested, it was down about 16 and a half percent, not very different than other fixed income, you know, products of like duration.

So that at least feels, you know, makes us feel better, if you will. But the key is to understand, again, what the source of the risk might be and whether it's, whether it's inflationary or not. So there are many things we can do, obviously, when we backtest something, it's systematic in nature and we can't alter it. But, you know, when I look at, when I was at Northern, I look at the positions we had vis-a-vis duration in 2022, we would not have realized that. You know, it's hard to talk to prospective clients about that. But I think at the end of the day for us, we want to make sure that, again, we're cognizant of what is likely to drive volatility. And if that volatility is likely to come from inflation or inflation expectations, we can change where we're investing.

So one of the things we might do, for example, is to actually go and buy tips with some of the underlying assets. So that will obviously give us some protection against inflation, realized inflation. And so I think that's a real important aspect is that we can alter the underlying to address the type of downturn that we see coming. Two themes in the fixed income market. One is the independence of the Fed. The other is the long-term federal deficit. In terms of the independence of the Fed, how does that? incorporated into your model and how do you account for that that's a that's a difficult one i mean i

think when i when i think about the institution that is the fed and i think about its dual mandate i'm i'm it sort of gives me a certain level of you know i don't want to say assurance but there's a there's a certain level of the the institution itself and what it is meant and the nature by which they've designed it to actually accommodate varying degrees of opinion and yet still have the institution to fall back on. So it is concerning, to say the least, that we've got a president that is altering that. I think he's going to be very limited in what he can do. I think the markets will police this fairly well. I think any real attempt to change the independence will be met with higher term premium across the curve. The same goes for the amount of

leverage at the federal level. I think more and more now you're seeing markets react in the form of term premium to these kind of behaviors. They both think and hope that the markets will be the barometer by which the president can ultimately make, you know, try to attempt some of these changes. And I think that going forward, there is a, there's a misunderstanding to me. I think that's critical. And I don't want to make this political because I don't think it is because I think it's across the board. But I think many people think that lowering short rates is the answer to some of the problems we see in the economy. And so few people are actually influenced by short rates, both the overall sort of what I call the corporate world and particularly retail

investors, the number of people that have fixed rate 30-year mortgages that are in the threes is about 80%. And no matter what the Fed does to lower rates, whether that, you know, to obviously accommodate a slowdown in employment or in growth, I don't think that's going to do much to change the term premium. So mortgages are based on the 10-year treasury and a spread to that. So if we have 10-year treasuries that are higher because term premium is higher, you could cut rates all you want. And it's not going to spur on the housing market one bit. You still have people that are unable to move because they're locked into a mortgage that's three, three and a half percent. And the best mortgage they can get now is six, six and a half. And even if you change

that to five, it's not going to meaningfully change the behavior of, you know, or anything in the housing market. So I am a little concerned that people think that monetary policy is the elixir for everything and it's not. I think the truth is that we have, to me, a very, like an economy that's actually performing quite well, despite things slowing down. And the biggest risk to me would be what you mentioned, that somehow the independence of the Fed or spending continues to go out of control and that term premium continues to rise despite the Fed cutting rates. Given up on the goal of avoiding politics. To quote Leon Trovsky, you may not be interested

in politics, but politics is interested in you. I do not think it is possible to be a good investor without understanding the political environment and how it relates to the macro environment. On that note, this has been an absolute masterclass on fixed incomes and bonds. What would you like people to know about you, about factor two, capital management, or anything else you like to share? The one thing I'd say, to be honest, is that maybe this will be a little provocative, and maybe it's even selling my own firm, if you will.

But I think now is the time for fixed income. I think over the next 10 years, the returns from bonds is probably going to rival the return from stocks. And I think it's going to do so with much less volatility. We could argue about a lot politically, you know, since you mentioned the political angle. And the truth is the one thing that it's doing, it's increasing uncertainty. And it's increasing uncertainty for a number of reasons. And I think there's some volatility that's good volatility in the form of deregulation. But I think there's a whole.

another set of things, whether it be our institutions, whether it be the response function of the federal government in times of crisis, I think there are a number of things that you can think through now moving forward that volatility should be higher. And the one thing you mentioned at the end, I thought the quote was great, except I'd say that I think financial markets do a really poor job of understanding the political landscape and it's simply, you know, it's in the ramifications on financial market. So I think the market is usually a pretty good discounting mechanism. I think it does a really poor job with politics. And so I think it's very, the markets are very complacent. And I think again, over the next 10 years, I think a lot of this uncertainty is going to manifest itself in lower

returns from stocks. And bonds will be not only an insurance policy, but a fairly good return and, you know, much more much, much more stable income than you get from stocks as well. So that's probably not as a great of an answer as I could have. I wish there was something more that listeners would like to know about me, but I think now is the time for bonds. The most interesting kind of takes on markets and policy that I've seen is using prediction markets as a way to put forward policy. So let's say we cut taxes from 35 to 30 percent. What effect will that have on GDP? And then people bet on it and then use market wisdom as a way to actually set policy. I think using the wisdom, of crowds to actually end the fish of markets to cut through the politics and into policy,

I think is one of the best ways to use markets that today is not being used. Yeah, agreed. Well, thanks so much for jumping on podcasts. Much more for me to learn and I look forward to continuing conversation soon. Great. It was great to be with you. Thank you. Thanks for listening to my conversation.

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