Troy Gayeski — Allocator Series — October 11th, 2023

[00:00:07] Troy

One way or the other, curves are going to steepen. In the mini-banking crisis that we had, it was a bull steepener. The last six weeks, it’s been a bear steepener because inflation expectations have become more elevated and the higher for longer regimes are being priced into global fixed income. So we think there’s tremendous risk-reward there, and that’s an area that we’ve traded around quite substantially.

Again, it’s not speculating on duration. It’s just saying the probability of the yield curve steepening is excessively high and you’re at some of the most extreme levels of inversion in history other than the ’70s, early ’80s.

[00:00:46] Intro

Imagine spending an hour with the world’s greatest traders. Imagine learning from their experiences, their successes and their failures. Imagine no more. Welcome to Top Traders Unplugged, the place where you can learn from the best hedge fund managers in the world so you can take your manager due diligence or investment career to the next level.

Before we begin today’s conversation, remember to keep two things in mind. All the discussion we will have about investment performance is about the past, and past performance does not guarantee or even infer anything about future performance. Also understand that there’s a significant risk of financial loss with all investment strategies, and you need to request and understand the specific risks from the investment manager about their products before you make investment decisions.

Here’s your host, veteran hedge fund manager, Niels Kaastrup-Larsen.

[00:01:41] Niels

For me, the best part of my podcasting journey has been the opportunity to speak to a huge range of extraordinary investors from all around the world. In this series, I have invited one of them, namely, Alan Dunne to host a series of in-depth conversations on the topic of what it takes to be a world-class allocator. In today’s world, portfolio construction is fast moving to the top of the agenda of many investors as they try to analyze and understand the riskiness of their portfolios.

With ever-increasing uncertainty around the globe, being well-diversified across many different strategies and themes in your portfolio can mean the difference between ruin and survival when the next crises emerge. The aim of these conversations is to try and understand the experiences that have influenced these highly specialized allocators and the processes they follow to harness the best returns for their clients so that we can all become better-informed investors. With that, please welcome Alan Dunne.

[00:02:44] Alan

Thanks very much for that introduction, Niels. Today, I’m delighted to be joined by Troy Gayeski. Troy is Chief Market Strategist at FS Investments. FS Investments is a global alternative asset manager. The firm manages over $75 billion in assets for a wide range of clients, including institutional investors and individual investors. Troy is Chief Market Strategist and is responsible for research generation and conveying the full suite of alternative investments at FS Investments.

Prior to joining FS Investments, Troy was an allocator in a variety of different roles running fund of funds and institutional separate managed accounts and he’s also been a frequent contributor to Bloomberg and Fox and Yahoo Finance and CNBC. Troy, great to have you with us today. How are you doing?

[00:03:32] Troy

Doing great, Niels, doing great. There’s actually good swell going on a Rhode Island so I’m excited to surf tomorrow morning.

[00:03:39] Alan

Good stuff. Well, thanks for taking the time out. So maybe we always start off by just getting a quick intro on people’s background and how they got involved in markets. What was the route to your current role?

[00:03:53] Troy

Yeah. I think for me, I grew up in Northeastern Pennsylvania. Fortunately, I was good in math and science in school, but finance was like a checkbook. Nobody knew anything about hedge funds or asset allocation. So I went to MIT, studied chemical engineering, quickly figured out that I liked people far too much to be in a semiconductor fab all day or a lab.

Fortunately, quite a few of my buddies in undergrad went to Sloan and then got these great jobs at hedge funds or prop desks. I always thought it was fascinating how they could apply a lot of the analytical skills that you learn in school, like MIT, to capital markets and have very thoughtful, productive careers. So I kind of think I got into this business through the back door.

I started out doing engineering. I was fortunate to transition to a small fund of hedge funds back in 2001 which was in the middle of the great dot-com bubble implosion, so kind of a good time to learn that markets don’t always go straight up, although I don’t know anyone that studied market history that believes that. But every now and again, you get these periods of time where people still do believe it.

The gentleman I worked for was a real student of market history, so whether it’s guys like Marc Faber or you think about Charles Kindleberger, just trying to understand market cycles and then trying to figure out which strategies make the most sense throughout those cycles. I was fortunate to manage assets in better times. I don’t know if you’d call the ’04 to ’06 bull market, “’03 to ’06 bull market the greatest time”, but it was a more normalized environment. Then we obviously went through the global financial crisis.

The thing people forget about the GFC is you already had a test case for it. It was long-term capital management. But the GFC was long-term capital on steroids. Hey, this X is bad. And then, of course, we got into this environment where so much of market outcomes were driven by just Fed largesse and hyper loose monetary policy and ridiculous levels of asset inflation. I think we all know there’s a variety of indicators to focus on in markets.

But over time, it became very clear that money supply was a factor that even the Fed continues to ignore today, which is bizarre, but it had become so important in driving asset inflation. The relentless oversupply of money really helped drive all asset prices to unsustainable levels and it would take some type of inflationary period to finally cause that to the end.

As the incredible stimulus that was necessary originally, coming through the pandemic, really was just extended too far, it became very clear that we would have some type of real economic inflation and the Fed would have to tighten and they’d have to prick an incipient asset bubble. So I think, from a background standpoint, it’s really important to understand market history, try to understand where we are in a market cycle, try to figure out where the best risk-reward is in asset classes given the new regime you’re in.

At a basic level, a lot of macro research, a lot of investors kind of throw their hands up in the air when it comes to macro analysis because it cannot matter for years and then really matter. Even with the best analysis, you’re probably only right two out of three times because there’s so many paradigm shifts. But our thoughts are that the most important part of macro is really to try to understand what type of regime you’re in.

Are you in a green light go environment where you want to embrace as much risk as you’re comfortable with like ’20 to ’21, or are you in more of a yellow light caution, orange light extra caution environment where the reality is you’re just not getting paid sufficiently to take directional risk? We’ll get more into the bigger macro viewpoints in a bit but bottom line for us is we just stick with the current cross-currents going on.

Obviously, with significantly elevated recession risk, a Fed that’s still tightening aggressively, it’s very critical to err on the side of caution and what we refer to as risk-on strategies that are in the northwest quadrant of the efficient frontier, where you’re going to take that risk.

[00:08:39] Alan

Maybe before we get into that, it may be useful to give a sense, and obviously FS Investments as a large $75 billion asset manager, can you give us a little bit about what the focus is of the firm in terms of the types of clients you serve and strategies you run?

[00:08:53] Troy

Yeah. So I think what’s different about our business than most asset management firms is we like to say we’re not arrogant or naive enough to believe we can do every strategy, best in class, in-house. So what we mean by that is whether we’re looking at senior secured commercial real estate lending or middle market corporate EBITDA-based lending or our multi-strategy fund or our interval fund that is focused on security credit, we’re trying to find the best partners that can complement or amplify our own investment expertise and consistently deliver upper quartile performance in the strategy. You can’t do everything all the time and do it well. So we’ve tried to be very selective in how we build out the platform.

Originally, the firm was focused on middle-market corporate lending, evolved into broader asset classes, senior commercial real estate lending, multi-strategy, tactical asset allocation. What we’re trying to figure out is, should we run strategies solely in-house, like we do with our tactical asset allocation fund run by Ryan Caldwell; should we have 50/50 partnerships, like we have with Rialto and KKR in different lending strategies; or should we rely more upon in-house expertise, like we do in our multi-strat?

In some cases, the end game is a combination. Our acquisition is an example there. We were looking for years for a growth solution. Most of what we’ve done at the firm is income-oriented, grind-it-out returns, low vol, but we’re clearly not going to build a PE franchise from scratch or a VC franchise from scratch at this stage of the game. So we started discussions on partnerships with a firm called Portfolio Advisors. They are an institutional middle market PE shop with right now a heavy focus on secondaries because there’s so much going on there.

As the discussions evolved, we ultimately acquired/combined with them. That was the best way forward. So we’re really excited about that because now we have a growth solution. As you know in markets today, liquid markets, we’ve been through another period of rampant asset inflation. It’s very hard to find growth at a reasonable price anywhere. So middle market PE, with a focus on secondaries, is one of the few areas that you can rationally articulate that case. So whether we build it, we partner, or we acquire/merge, it’s sort of an all the above strategy to provide top tier outcomes for clients.

[00:11:36] Alan

Okay, very good. Well, you mentioned where we are northwest in the investing compass at the moment. It’s been an interesting cycle. Obviously, rates have gone from zero to 5%, 5.5% with a little bit of a wobble note, no major accident yet. So maybe just to get firstly, from a top-down macro perspective you say northwest, does that mean you’re starting to position portfolios with an eye on a potential economic downturn and even recession? How are you assessing the landscape?

[00:12:12] Troy

Yeah, so I think when you think about the end of 2021, it was pretty clear at that point that the Fed was behind the curve there, there’d be finally real economic inflation. They’d have to tie in certainly more aggressively than ’15 to ’18. Although to be clear, at the end of ’21, we didn’t think they’d be hiking to this degree this fast. We knew they would have to drain their balance sheet. The question at that point was, how fast, how aggressively?

As you know, they ended up draining the balance sheet at a target pace of roughly four to five times the last QT. So we knew at that point you really had to focus on protecting capital, moving to northwest quadrant strategies. We were exiting what was one of the greatest greenlight go risk-taking environments in history, 2021. By mid-April of ’20, it was clear between monetary stimulus and fiscal stimulus, primarily monetary stimulus, markets were going higher or assets were going higher.

So our mantra since the end of ’21 is, when you look at client portfolios (obviously, there’s typically a larger allocation to equities, a larger allocation of fixed income), that whatever your allocation to alternatives or cash (to be fair) was, it should be larger. So for smaller investors, that might mean taking 2% to 5%. For larger asset allocators that embraced alternatives for longer, it might be going for 20% to 25%.

That’s one of the really cool stories about last year, and even to this year, is there has been a handful of alternative strategies that have really shined: senior course real estate lending, multi-strategy funds, in an environment where obviously 60/40 last year got completely torched. This year, you’re getting some love from the 60. Equities have reflated from 15.75 times earnings, last October, to now 19.4. But the 40 is still a struggle, right? No matter how many times the bond crowd says, “Recession is going to happen tomorrow, recession is going to happen tomorrow,” it doesn’t make it sell.

So a lot of the use case for alternatives has been to replace fixed income since 2017. Now that markets have reflated again, we’re seeing more capital rollout of equities just through natural rebalancing. Locally (just to hit your question head-on), the difference between the end of ’21 and today is recession risk is materially higher. There was no risk of recession in ’21. There is very little to de minimis risk coming into this year.

Fortunately, for those that are overweight equities or credit, there is a path now to where you could see the Fed being able to thread the needle, from an economic standpoint; the combination of state and local government spending, the Inflation Reduction Act which is obviously driving more construction and more business fixed investment, you have housing which has been a drag on GDP for six quarters is now flipping to a contributor.

There is a path to getting there. So, we’re in this period where you’re going from extremely elevated inflation to a more manageable number. But along that path, as you look forward, recession risk is dramatically higher today than really any time with a forward view since the pre-GFC. So that obviously will work to the detriment of equity markets. Instead of getting 10% to 14% earnings growth, you have a 10% contraction that tends to not be a good outcome.

In the background, the Fed is still draining their balance sheet aggressively. When they announced QT in ’22, I literally almost fell off my chair because they were articulating moving at four to five times the pace of the last QT and we know how that turned out with Q4 of ’18. They obviously had to take a brief holiday from that during the bank rescue period because of the bank failures in the US, but they’re back at it.

You look at the balance sheet every month, it’s $80 to $120 billion coming off and so the probability of a liquidity accident continues to go up. Also, bank lending has completely stagnated as you know. It’s very tough to grow an economy without bank credit creation. The yield curve is not as inverted today as it was six weeks ago, but we still have a massively inverted yield curve which really destroys the incentive to create credit for any long or maturity long. So a very tricky environment there.

You have the combination of continued tightening plus elevated recession risk, which just means again, when you’re thinking about your asset allocation today, anyone that’s been overweight equities has enjoyed not a magical levitation but a substantial levitation in those valuations. When you think of it theoretically, are we more expensive in equities today or the end of ’21? At the end of ‘21 we had slightly higher multiples, 1.8 multiple turns higher, but risk-free was zero.

Look at it today, we’re 1.8 multiples cheaper absolute, but risk-free is 5.25, 5.5 and could go higher. Obviously, the 10-year no longer has a one-handle on it, it’s got a four-handle on it. So from a relative basis, we’ve only been more overvalued in the dot-com bubble. From an absolute basis, we’ve only been this rich in 2021 and obviously the dot-com bubble.

[00:17:45] Alan

Interesting. So if you were to summarize all that, obviously you’re advocating more alts and more cash. But it sounds like that in a model multi-asset portfolio, that might be funded more out of equities now, whereas if you went back a couple years ago, it might have been funded out of fixed income.

[00:18:04] Troy

That’s 100% right. You know this, Niels, from your rich career. From really the early 2000s to really 2016 to ’17, and so much of this was driven by the lost decade. You had a lost decade, couldn’t make money in equities. Most of the allocation to alternatives came from equity risk. The idea was to sacrifice some return and greatly reduce volatility. Then by ’16, ’17, the risk-reward of fixed income had gotten so lopsided that a lot of the use case was as a fixed income replacement. That’s continued through today, although clearly, there’s much better risk-reward in cash as well as the back end of the curve.

So with this more localized rally since October, we’re seeing more flows come from just again natural rebalancing. That’s the way it works in asset allocation. You should be able to rebalance your equities, your fixed income, but also your alternatives. That’s one of the nice things about the asset class becoming democratized is even though there’s limited liquidity, there’s some liquidity to allow people to rebalance.

We saw that pretty significantly in the real estate market where in ’21 to ’22, we launched the role of the capital structure campaign just urging investors like, hey, if you have risk in real estate and a lot of it’s in the equity part of the capital structure, and you’ve enjoyed not only a tremendous bull market but now a hockey stick like move, it might make sense to rebalance and take some of that risk and roll up the capital structure to not only reduce risk but also increase return because senior lending rates are going higher.

[00:19:45] Alan

I guess one of the interesting features we’ve had, from an investment asset allocation perspective in the last 18 months or so, is last year every article you read on asset allocation was all about the end of 60/40 and how it’s dead and all of these models have to be adjusted. Coming to this year, obviously, 60/40 has done pretty well, as you say, driven largely by equities. So let’s talk about the end of 60/40.

Now, most sophisticated investors are not running 60/40, but it’s maybe a derivative of it. Do you think now, given the overall landscape, there is structurally, there is a case for more alternatives? Within that, people talk about alternatives but the label alternatives is so wide-ranging. If you’re positioning a model portfolio asset allocation approach to clients, do you have a way of talking about it? Is it 40/30/30 now or is there some kind of derivative around that?

[00:20:44] Troy

Yeah, so there’s a lot to unpack there. I think that, from an actual math standpoint, so much of it depends on the starting point for the client and how far they are along in embracing alternatives. We’ll get into the different types of alternatives in a bit. But what we see is that the larger institutions, larger QPs that embraced alts for years are more in that 40/30/30 model. In some cases, obviously, if it’s an endowment that’s well funded, they might lean more heavily into fixed income because all they need is to clear their spend rate.

Obviously, older clients that are more concerned about protecting wealth than growing it, and then the flip side for those that are younger in their careers in life. But for some clients, particularly credit investors, remember it’s really only in the last five to seven years that a lot of these strategies that sovereign wealth funds or Yale’s endowment had embraced decades ago could actually access right and access in a way where the investment outcome didn’t deteriorate to some extent because of the structure.

So we still run into situations where clients have very little alternatives. It might be two or three and that might be REITs or MLPs or things that you and I are like, “That’s not an alternative,” but in a wealth management framework, it is an alternative. So just getting them to 5 or 10.

I think that, just stepping back again from an asset allocation standpoint, one of the best ways, we think, to think about this environment from a forward return expectation for equities or any asset that had been driven to very high valuation levels (principally by Fed largesse but also by lower and lower interest rates over 40 years and globalization, particularly China’s entry in the WTO and that tremendous labor shock that not only helped suppress inflation but helped boost corporate profit margins in S&P from 5.5% to over 13% recently), is this concept of galactic mean reversion.

When you look at a 30, 40-year history, labor market – sideways, median wages – sideways (real median wages), nominal GDP substantially lagged asset inflation, overall, almost every relevant time horizon (whether you look back 5 years, 10 years, 20, 30, 40). So you had rampant asset inflation while nominal GDP chugged along and the labor market stagnated. So, when you think about three of the key factors that drove that, up until the end of ’21, one was money supply growth.

The Fed consistently grew money supply faster than nominal GDP in the post-global financial crisis period. That provided the liquidity to drive asset prices higher. Of course, it wasn’t just a Fed, it was every central bank in the world. So that’s clearly been a headwind since they announced QT and rate hiking and really will remain a headwind until we have either a hard landing or some type of market accident. We all know, when unemployment goes to 4.2, the Fed isn’t going to panic and cut rates to zero, they’re going to be high fiving each other, like mission accomplished on inflation.

They’re not doing QE again anytime soon unless there’s some type of market catastrophe. So that’s been a huge tailwind that’s now a headwind as far as I can see. Look, interest rates are not going to be the headwind going forward, meaning higher interest rates that they were last year when 60/40 got torched. But they’re certainly not going to be the tailwind they were from 1982 to 2021. We can all factually say that the 10-year is not going from 16% to one handle anytime soon. It’s not going to be the strong headwind it was last year, but it’s certainly not going to be a tailwind.

Then when you think about globalization, look, we’re still trading, it’s not like trading is over. But China’s entry to the WTO was so profound in helping to suppress inflation and allow efficient supply chains to build and help boost corporate profit margins, because as you remember when they first entered, there was a 32 to 1 labor arbitrage with US, and that’s gradually gone down to roughly 3 to 4. So what that means is it doesn’t mean we’re going to have a lost decade or a 1964 to 1982 period where the Dow was flat. It just means that you have to readjust your forward return expectations for every asset, particularly those that are dependent upon Fed largesse and economic growth.

The flip side of that is that, in duration-related assets, you fortunately have much higher yield than the last 5 to 10 years which gives you some recession protection, and cash is yielding a rate that I don’t think anyone foresaw even 18 months ago. But the Fed, again, assuming the next terminal rate stop, in a mild recession, is 3 plus or minus, it’s not like the 10-year is dropping from 6 to 1 or 5 to 2. You’ll probably get the 10-year back to 3 and a 3.25 assuming the FOR at 3.

So forward return expectations for 60/40 are dramatically lower, now, than over most of our investment careers. It’s not that we’re going to have a lost decade, but it’s going to be harder to make a buck. That goes back to that northwest quadrant efficient frontier. If you can generate high single digit returns with far less volatility, more importantly, far less risk of loss, that’s something that should be embraced. So depending on the client’s risk appetite, how comfortable they are with alternative allocations, whether it’s 5, 10, 15, 20, it should certainly be higher than it was five years ago.

[00:26:39] Alan

You touched on nobody expected rates to get up to this kind of level 5%, 5.5%. Are you seeing that in terms of investor reaction? It strikes me as soon as the NASDAQ starts to rally again and the hype around Nvidia, etc., people are jumping on that trade and risk sentiment comes back pretty quickly. But as you pointed out, those multiples have to be viewed in the context of that kind of 5% to 5.5% threshold.

But are you seeing that in terms of investor behavior, people saying, “You know what, that looks like a pretty good return for us for the moment so we’re actually going to shift more tactically, defensively?”

[00:27:18] Troy

Yeah, Niels, great question. So when you think of flows and you look at flow data, there’s really been only two major shifts this cycle, and by major, trillions of dollars, not like, yeah, sure, alternatives have grown and there’s been money deployed there but it’s tiny relative to global flows. So the first is to cash. You think about money markets up by about 2 trillion since pre-pandemic, 2 trillion-plus. So there’s been a huge embrace of cash.

Look, bottom line is investors should have more cash exposure now than they’ve had when we were in the zero interest rate or reserve policies for years. So that’s been a huge driver of flows to cash. Also, T bills, we often meet with advisors or clients who are like, we’ve been rolling more T bills than we ever have. I never thought I’d be a T bill buyer but that’s what I do for a living now. The second of course, and this is more recent, is the flows of capital and cash from regional and community banks to big failed banks given the unfortunate situation with some of the less stellarly run banks that had problems with their duration.

So what can happen though is there’s this concept of inertia, and there’s a lot of inertia in asset allocation, like slow moving, backward looking, making changes after the fact. That can cause folks to freeze up like, hey, you know what? Cash is yielding of 5.25, 5.5, why do anything? Again, you should look at a higher cash allocation, but you should use this opportunity to look forward and try to figure out which strategies make the most sense in this galactic mean reversion period and at least start to nibble on them or leg into them.

Even though we’ve always been in the higher for longer camp, I think we do all include now (and by all I mean rational, non-biased market observers and economists) that there’s now a path where the Fed can keep rates meaningfully higher for longer. We still think it’s unlikely. That just means that floating rate lending strategies, for instance, are going to be able to generate more return. Floating rate lending strategies that roll the portfolio returns over very rapidly, like senior secured commercial real estate lending, for instance, where there’s three-year average term, those also have floors. So every new loan that’s done is a floor that, roughly, it’s sold for minus 100.

So the way I refer to it as the dare-to-dream scenario, where if you’re a floating rate lender, the front end is going to be higher for longer, you could throw off more income, we can avoid recession (which again we still think is unlikely but could theoretically happen), and every month that goes by, you have more and more floor protection for the next Fed cut cycle. For those involved in private real estate lending or middle-market corporate lending, that’s the dare to dream scenario.

So we’re hopeful that happens but we’re realistic that more likely than not that we, again, will have a mild recession, nothing catastrophic like 2008, much more in tune with what we had in ’01 where GDP only contracted by 70 basis points peak to trough. That was more of an asset bubble implosion period, which obviously we have very similar echoes to today.

[00:30:43] Alan

So you mapped out a pretty good rationale for bumping up alternatives, and as we said, the alternatives come in many shapes and sizes. I guess what you see with a lot of asset allocators, you may have allocations to, is as you say, private equity, VC, real estate, private credit, etc. Sometimes it strikes me you’ve got a lot of shades of equity risk wrapped up in different ways. So how do you look at the alts space and differentiate between the different types of strategies within alts? Is it public versus private? What’s your kind of framework for analyzing the space?

[00:31:25] Troy

So certainly public versus private is one of the ways to break down the space. All strategies that focus on liquid securities, where risk premia evolve driven by factors that sometimes you can predict, sometimes you can’t, are by definition subject to more mark-to-market volatility. So managing that volatility whether it’s through a multi-strategy framework, trying to generate that consistent return up from expressions that have the best risk-reward, is very, very important. In the private space, obviously you’re not marking things daily.

In most cases, you’re marking things monthly. But there, I think the big differentiation now is, do you want to be in the debt part of the capital structure or the equity part of the capital structure? I think, as usual, it depends. When you think about real estate as an example, from really 2012, ‘13 to the end of the hockey stick like move in Q1, Q2 of ’22, if you were in the equity part of capital structure, not only did you enjoy an attractive income, but you enjoyed steady appreciation, and then you captured that hockey stick like move.

But it was very clear at that point that unless something completely unrealistic occurs, every asset class was going to give back some of the hockey stick like move. Equities did obviously last year kind of reflated, real estate was going to roll over. So it became very clear that if you’re going to have exposure, you want to be senior in the capital structure where you greatly reduce risks, you don’t have the downside capture to beta moving in the wrong direction, and you actually increase your income because the Fed is continuing to hike.

So broadly, if you think about real estate, if you have real estate risks, you have to be in the senior part of the capital structure. You mentioned, back to client experience, what we found is the clients that are more involved in real estate, they come to that conclusion much more rapidly than those that are maybe less familiar with the asset class and the cycles it can go through. Then you think about corporate middle market EBITDA-based lending, let’s just say again, I think a reasonable expectation, equities annualize 6% the next 10 years.

So not a lost decade, but certainly not what we experienced from ’09 to ’21 when equity multiples went from 9 to 21. We know that’s not happening again because we’re at 19.4. So let’s call it 6 plus or minus. If you can start out with a 10% income stream and have minimal risk of loss, that’s at least a competitive return stream, potentially better in the senior part of the capital structure, which by definition, you have less risk of loss. Yes, you’re not going to capture the upside in equities in years like this, but you’re not going to have nearly the downside.

Actually, one of our clients came up with a great phrase for this. I came up with dare to dream, by the way, and galactic mean version. But their term for this environment is “Give me liberty or give me debt.” They happen to be based in DC so that was pretty apropos. You know what they’re going through in all their client discussions is, given where the front end is (and these are floating rate exposures) and the income that you can realize (total return you can realize), let’s have a heavy emphasis on senior lending the next several years, whether it’s commercial real estate or corporate EBITDA-based.

That’s a very different phenomenon or environment than we were in for years because people forget that if you were a floating rate lender, you had these two headwinds for years. The Fed never hiked then barely hiked, then cut by 75, then cut to zero and stayed there too long. So you got no love at all from the front end of the curve, like no love, no love from the Fed.

Then because you had so much liquidity because M2 was growing consistently faster than nominal GDP, spreads were tighter than they would have been otherwise, LTVs were higher, and now we’re in an environment where LTVs are materially lower, spreads are wider, and you’re getting tremendous love from the front end of the curve, which can persist at least for another year if not longer.

[00:35:51] Alan

Interesting. So obviously, commercial real estate and corporate lending (two kind of credit-based strategies, I guess), obviously, you’re highlighting the potential attraction there from an income perspective. Obviously, within commercial real estate, we’ve heard of challenges, withdrawals etc., BlackRock fund. Presumably, you have to be selective in that space or is it that valuations have adjusted now and there are attractive opportunities? How are you thinking about real estate from that perspective?

[00:36:24] Troy

Yeah, so I think big picture if you think about, first of all, you have commercial and residential, which are similar but different markets. The residential real estate market is much more homogenous, single-family homes. Yes, there are price differences and affordability differences driven by geographic regional differences in the country, but they all tend to move in lockstep. You also have a financing market for residential real estate that’s dominated by the agencies with implicit and explicit support.

So particularly in the QE era, you had artificially manipulated low mortgage rates, and now that the Fed is doing QT and no one in their right mind is stepping in front of that freight train, you have extremely elevated mortgage rates. So a much more homogenous market. Effectively what’s happened, it’s really bizarre, as affordability has dropped lower and lower, we still have an artificial floor into residential housing because no one wants to sell their home and move from a 3% mortgage to 10% percent mortgage.

Now, clearly, in a mild recession, if rates come down even modestly, that’ll unlock some supply which should lead to another leg down in residential. If you look at commercial real estate, very different because you have much more heterogeneity of sector. There’s obviously a huge difference between major metro blue state office towers, which are going through a slow-motion train wreck, a complete destruction of equity value. There will be some losses that bleed into senior loans.

Fortunately, it’s manageable from a banking system standpoint and from an insurance company standpoint. But lodging is on fire right now. Lodging got crushed in the pandemic and then came ripping back. It’s a sector that’s basically flat to up or down 2% for the last 12 months. Then of course you have multifamily, you have bricks and mortar retail, you have industrial, which these days is mainly talking about distribution centers. So in general, when we think of commercial real estate, for let’s call it 4 to 4.5 major sectors, we’re going through a healthy, higher borrowing cost, higher cap rate price decline.

In some cases, there’s a small imbalance between supply demand at the local level. But inevitably, when you have that hockey stick-like move up, you’re going to come back and we’re right back on trend, there’s probably 5% or 10% more price declines to come but we’re getting closer to bottom. And then in major metro-boosted office towers, it’s just it is what it is. You’re down 30% to 50% in price and the probability of recouping that anytime soon is extremely low.

So you have to be obviously very selective by sector, by geography, by quality of borrower, and then you hone in on what’s the appropriate LTV, what’s the appropriate spread SOFR to lend that in the current environment. Because you have this dramatic retrenching of bank lending, banks are still lending, but they’re just much more cautious, you have materially lower LTVs and wider spreads now than certainly last May prior to some of these unfortunate occurrences in the banking system taking place. So that looks really, really good right now.

But ultimately, there still will be more price adjustment in the equity part of the capital structure. You can’t have an asset class go up by 20% to 30% that you’re levered to and then drop by 10% to 15% that you’re levered to without having some degree of NAV hits. So that’ll play out over the next year or so.

[00:40:01] Alan

Okay. In terms of institutional allocators, obviously, prior to 2022, the preceding number of years, the big theme was around this wall of money into privates and particularly private equity, maybe VC to an extent, private credit as well. After last year, obviously, these allocations are not as fast to adjust and reprice. But presumably, allocators have got a little bit overweight on these sectors and have been looking to trim. How do you see that dynamic playing out and is that presumably then offering opportunities in secondaries as well?

[00:40:38] Troy

Stepping back, when you think about how alternatives have been democratized historically, it was always about taking an institutional strategy and packaging it in a way that the average investor could access without deteriorating the investment out. That was the mission. Easy to say, hard to do. But for a variety of strategies, the industry has gotten there.

In private equity secondaries, particularly in evergreen structures where you don’t have the J curve, particularly focused on middle market because there’s far more inefficiencies in the middle market in PE than there are in the mega-cap size, this is the first time we’ve ever seen slower-moving smaller investors be able to pick off larger investors.

When we’re trying to evaluate the forward size of the private equity secondary opportunity, there’s a variety of ways to get in there. You could just look at it flow in the last few years and extrapolate that out forward, you can look at the size of the market and put rough percentages over what has to transact. It basically gets to around 500 billion to 750 billion. The reason for that is if you think of a $5.7 trillion asset class, 70% of all the capital that was ever allocated to private equity came in the last five years, much of it driven by institutions.

So what’s happened is because the 40 in particular has gotten torched and hasn’t come back, 60 got torched last year, it has come back most of the way but not fully. If you were allocated 10% to PE, it might be 12% or 13% now. If your investment policy statement says 10, well, obviously you have to sell down secondary volume to get there. But you have to go a little further because if you want to embrace any new or vintage exposures, you need some freedom in your asset allocation limit.

So what we’re seeing is in LP-led secondaries, tremendous volume at 10% to 30% discounts. Even in GP-led secondaries, you can transact at discounts to NAV, which is a rare thing because there’s so much positive selection bias in GP-led secondaries. So if you’re investing in an evergreen structure, you don’t have the J curve, you are in a very unusual situation where you’re picking off large institutions that got over their skis and can source secondaries at significant discounts to NAV and then you immediately enjoy that appreciation.

So we think in the next two or three years, that will be a very rich opportunity set and it will normalize. There will still be volume, but we won’t have the pricing inefficiencies we have today. That’s one of the reasons when you’re looking at an evergreen PE structure, you want to make sure it’s full cycle. There’s been a lot of assets raised recently in secondary-only funds and that’s great. Go for it. But think of those as more satellite exposures.

As your core exposure, you want a full cycle fund so you’re not forced to rebalance or redeem three years from now and that opportunity goes away. Because oftentimes, these inefficiencies last two to three years and then they go away, and they may come back or they may never come back. So think full cycle middle market where you can monetize the secondary opportunity set for the next several years.

[00:44:03] Alan

Okay. Within the rest of the private equity VC space, obviously, there’s been a mark down in valuations. There’s always a debate as to have the price declines been fully recognized in the valuation? What’s your sense on that? Do you think that’s still an unfolding process or has it largely been done?

[00:44:27] Troy

The process, it’s underway, but remember, it’s a moving target. When you think about it simplistically, in 2021, you had rampant asset inflation for every asset, but particularly in public markets. So you didn’t have nearly the same distortions to the upside in private assets, which are typically marked based on EBITDA flow or LTV or spread, etc.

You didn’t experience the same degree of price declines last year, but you certainly experienced price declines. Because you never had the dramatic multiple expansion, you didn’t have as multiple compression. And then wouldn’t you know, here we are eight, nine months through this year, I guess, eight full months to this year where public markets have reflated again.

So in a valuation process, you need to look at EBITDA, cashflow, and comparable multiples valuations. Obviously, the valuation multiple continues to evolve first dramatically up and then dramatically down, and now once again, dramatically up. So I think there’s always a lag in how private markets are valued and it’s a challenge to get it to the screws. But the better firms have very thoughtful processes now.

If you think of simplistically, if you were in a middle-market PE fund that was focused on secondaries in a year like last year and you made 9%, well, some of that came from the fact that EBITDA grew faster than multiple compression, but some of it came from secondary exposure as well, being able to take positions in secondaries, write them up from a 20% or 30% discount to NAV.

So in general, I think in PE, we’ve seen less multiple compression last year, but also less multiple re-multiple expansion this year. And then we’ll obviously get into discussions on more liquid markets where things are priced much more frequently, and that conversation goes completely out the door.

[00:46:32] Alan

Well, that’s good. That was my next question. In the liquid space, obviously, you have a whole plethora of possible strategies from global macro to managed futures trend following, volatility trading, market neutral strategies. So how are you thinking about, one, what do you think about the opportunity set for those types of strategies at the moment, and how do you position those within a portfolio alongside the private market allocations?

[00:47:01] Troy

Yea. So obviously, a lot of it’s dependent upon the mandate of the strategy. So if you look at a multi-strategy fund, whether it’s a hedge fund or something wrapped in a daily liquid wrapper, the mission is typically to generate consistent returns, high single digits, low volatility, low beta, low to no duration, and just grind it out. You brought up managed futures, managed futures are a very different mandate. Those are really there to provide explosive performance when you get massive trends in markets, and you typically get some trends in markets during regime shifts or bear markets.

I think the last 18 months, hats off to managed future because not only did they do a great job last year but this has been a very different type of environment to last year but they’ve generated positive returns this year as well. Within multi-strategy, a few of our favorite themes this year, one has been the return of another secular slowdown in prepayment or refi activity in the US residential housing market.

When you go back and think about the last time there was a tremendous secular slowdown in prepayment activity, it was coming out of the global financial crisis where you had a housing bubble and home prices collapsed, and that drove already elevated LTVs, 60 LTV goes to 90, 80 goes to 110, 90 goes to 120. So even though rates dropped dramatically, the front went to zero, 10-year went to 2 briefly, it was very difficult to access the refinancing capability unless you kicked a lot of equity into your home or wrote a big check.

So we had a multi-year period where prepayment speeds were very slow, tremendous cash flow. Markets eventually recognized that new regime and priced it in and you had wonderful spread tightening. So still arguably the greatest trade I’ve ever seen because you could study it, you could analyze it. It wasn’t like the subprime short where you had to be there and then within 12 months, it was over and you had some ugly, short squeezes throughout the period. So this time around, it was clear we were having another hockey stick-like move in housing. Affordability was dropping like a stone.

At some point, when affordability met or exceeded the ’06 lows, you were going to get some degree correction. So we were lining this up for a while. We wanted to make sure home prices had peaked because from April 2020 to Q1 of ’21, prepayment sensitive RMBS is one of the few areas that actually didn’t make money (like try to find something that didn’t make money in that period), and the reason was home prices were screaming higher so the cash out refi machine was cranking again.

Also, you had mortgage rates that were still artificially compressed by QE infinity. Fast forward the clock to today, the main driver of refi’s collapsing is that mortgage rates have just gotten to levels that are just ridiculous. There’s no incentive to refi at all anytime soon. On top of that, you have had a modest correction in home prices which could act as a brake in the event that rates drop further.

So that expression is really cool because the core asset that we own are interest-only strips, and those have negative duration, tremendous positive cash flow, benefiting from slow refi activity. And then because we don’t want to speculate on interest rate direction, we buy back duration through agency pass throughs. If you paid any attention to the long-only fixed income crowd, they love agency pass throughs, because spreads are as wide as they’ve ever been other than the GFC period where we had garbage credit quality, no one really knew if the agencies were solvent, and of course they weren’t without a government bailout.

Now you have great credit quality, there’s no concerns about a 40% drop in home prices, and you have slow speeds. So it’s an interesting setup because we love the core asset, the cash flow, and we also really, really like the hedge. As you know, so you can make money on both sides. They’re both positive carry and there’s room for material spread tightening in both. We don’t think the spread tightening is happening anytime soon because of QT. But in the meanwhile, you’re earning a very attractive non-correlated carry stream.

On an even more liquid expression side, we’ve been big fans of yield curve steepeners coming into this year. The central thesis has been, okay, when have we been this inverted before? Oh, yeah, the ’70s and early ’80s. What’s the probability that we go into or we enter a ’70s-style outcome? It wasn’t zero, but it was very, very low. The Fed was cooling originally, they got religion, they tightened aggressively, massive QT. So one way or the other, curves are going to steepen.

In the mini-banking crisis that we had, it was a bull steepener. The last six week, it’s been a bear steepener because inflation expectations have become more elevated and the higher for longer regime is being priced into global fixed income. So we think there’s tremendous risk-reward there and that’s an area that we’ve traded around quite substantially. Again, it’s not speculating on duration, it’s just saying the probability of the yield curve steepening is excessively high and you’re at some of the most extreme levels of inversion in history other than the ’70s or early ’80s.

[00:52:44] Alan

Maybe more generally, obviously, they’re two very specific trade ideas, which make a lot of sense. If somebody was coming to you saying, okay, I wanted to build out a diversified liquid alts portfolio, how would you think about that or what would be the components that you would include in it?

[00:52:59] Troy

I think if you’re starting on liquid space, you still want to focus, to some extent, on hedge funds. One of the issues with let’s call it the platform hedge funds is that it’s all about supply demand, and there’s so much demand for that very unique exposure and there’s just not that much supply that the terms have become very, very investor unfriendly, not just in terms of fees, but in terms of liquidity profile. Tax treatment is poor because of the exemptions that are used to not be subject to short selling and wash rules. So those platforms have become very hard to access. But if you can get some supply, it makes sense to take some of that down.

Managed futures, another area. You don’t want to make it a large allocation but something at least meaningful enough that you can protect on the downside. Then where you can find more user-friendly multi-strat exposures that might not necessarily perform to the same degree as some of the well-known platform hedge funds but can generate 6% to 10% returns with very low volatility, low beta, that are super user-friendly. that’s something that you can access. Then you can rebalance in the future, where imagine you have a private equity allocation and you have a bunch of capital calls coming, you can make an allocation, you can make it a strategic allocation of 5% within your overall asset allocation and never touch it, just allocate and forget about it. It’s the last thing you worry about in years like last year, obviously, it lags equities this year but once again outperforms fixed income and cash.

So those are some of the tools in the toolbox right now. The first is very hard to access, the last is very easy to access. Within managed futures, you still have to focus on the sub advisor or the manager’s ability to at least perform in line with the asset class and hopefully add some alpha on top of that.

[00:55:13] Alan

Okay. Where does the old-school global macro fit within all of this now do you think? Has that been kind of replaced by the rise of the platforms and the multi-strats?

[00:55:23] Troy

So macro is still, as a strategy, a viable choice. But they’re much more volatile, similar to systematic trend followers. Systematic trend followers are just easier to scale. So if you think about the great systematic trend followers, there’s been a more scalable strategy. Whereas in macro, if you think about it, in some years, you get no swings at the plate. There’s just nothing to do; like nothing to do. In years like last year, where we have such profound shifts in inflationary expectations and interest rates, there’s a ton to do and they kill it.

And then you have years like this where they get bulldozed by bear market rallies or the start of a very short, cyclical bull market, and a lot of the more bearish expressions in rates just didn’t work out earlier in the year and then they gave up on them. What did you know? We finally get a bear super soak. So I think macro as a strategy still has a place, it’s just there’s far fewer options there as an allocator. Like all volatile asset classes, it’s not just timing entry, it’s also timing exit. You’ve got to time them both.

If you time the entry well, cool, but you’ve got to be ready to harvest some gains, and that’s very, very difficult to do for anyone repeatedly. Again, imagine we’re in this galactic mean reversion environment, rates are pegged higher for longer, equities appreciate but very modestly and yeah, dollar weakens, dollar strengthens, dollar weakens, dollar strengthens. It doesn’t matter how smart you are, how great your team is, there’s just nothing to do.

I think in general, the allocators have preferred more consistent return strategies that they don’t have the time entry and exit perfectly.

[00:57:16] Alan

Very good. Maybe just conscious of time, just one topic I wanted to get your thoughts on briefly. Obviously, AI has been a big driver of the equity run-up in Nvidia and tech stocks recently. What’s your perspective on that? Are you seeing that as something AI related strategies obviously within the managed futures quant space, do you see that to an extent? Are you seeing more machine learning type strategies or is that still a little bit down away in terms of something being really interesting as an allocator?

[00:57:47] Troy

Yeah, so I think for AI just from its impact on markets, obviously, it was one of the fundamental fuels of this recent rally, meaning you have this transformational technology. As we know so far, really Nvidia is the only company that’s been able to monetize it in a big way. But there’s obviously lofty expectations for the rest of the Magnificent Seven somewhere or the other profiting from it.

Just an anecdotal observation, what’s interesting about this period is when you see a new technology, you have those that start to try to explain market price action by like hey, AI is going to add 120 basis points to the US total factor productivity, and it’s like really, like that was greater than electrification or the locomotive, but sure. I know where you’re coming from. I know you’re trying to justify valuation, so come up with your pie-in-the-sky theory.

But I think when we think about it simplistically, if you’re more in the like this is going to be truly transformational, then you’re more in the 8% equity return range going forward. If it adds modest productivity, you’re more at six, and if it turns out to be a dud and if you don’t expect it, it’ll be more like four. But in terms of strategies, it’s really being embraced, as you articulated, by more of the quant side as one would expect. It’s still I think a to-be-determined how transformational it has been because that’s one thing that I think we all probably gloss over too much when you think about the systematic trading strategies. They’re constantly innovating, constantly innovating.

The trick to them has always been to innovate enough in real time that you’re recognizing which factors are actually important in this market regime without data fitting. Data fitting is the death of all quantitative strategies. That, again, sounds easy, but very, very hard to do. So AI gives those firms one more tool in their toolbox to help evolve in real time maybe more rapidly, and it’s certainly an arms race there, just like it is wth the platforms for major talent.

Just like it’s an arms race or a land grab in penetrating retail alternatives, there’s a multitude of kind of arms races and land grabs going on right now and AI is certainly a small part of that. I wouldn’t consider it the begin all and end all, but certainly, it will be more important over time.

[01:00:27] Alan

Good stuff. Maybe just to wrap up, we always ask our guests any brief advice for people starting off in the industry in terms of things to read, things to do, things that have been a big influence on you and your career.

[01:00:40] Troy

Yeah, so I think from just a career building standpoint, if you, obviously, have a quantitative background or some engineering experience, you’re probably a good problem solver. You probably know how to use basic quantitative tools to help enhance your investment process. I think it’s very important to go through the CFA program. I’m a little biased because I thought it was very challenging. It definitely demonstrates that you can work super hard at your core job and have the time commitment to broaden your understanding of even basic accounting or maybe areas of finance that you’re less familiar with from your undergrad or even your MBA.

I think market history, as I alluded to before, is so important to understand. I’ve always thought that Charles Kindleberger’s Manias, Panics, and Crashes is a must-read for anyone. That doesn’t mean every day you wake up, here comes the next panic or crash or mania, but these patterns repeat themselves; having some framework; one of our expressions is “every cycle is different, but every cycle is the same.” There are different drivers of euphoria, there are different drivers of panic, there are different drivers of corrections or bull markets. But ultimately, price action is pretty similar.

We talked about it before we started. The global financial crisis was the worst thing that just about everyone had seen. But the long-term capital management, the failure there and the Russian defaults, you ended up with very similar price action just driven by different factors. Now, obviously, the GFC was long-term on steroids. And in the pandemic, you had basically 18 months of GFC price action in like 6, 8, 10 weeks, depending on the asset class. So having that understanding of market history is very, very important.

I’d recommend to everyone to read Manias, Panics and Crashes just to have a level set on how cycles work and that every time people think something’s different, well, it’s partially because things are different, but it’s the same general market behavior.

[01:02:56] Alan

Very good. Well, this has been a great conversation, Troy. Thanks very much for joining us today. Make sure to follow Troy’s work because as you know, it’s a quite an uncertain environment we’re living in today, so very important to know how to allocate capital and be well-informed on global macro developments. So from all of us here at Top Traders Unplugged, thanks for tuning in and we’ll be back soon.

[01:03:20] Ending

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