How to Build a Future-Proof Portfolio ft. Bob Elliott

[00:00:06] Bob

Most people holding the 60/40 portfolio have a huge bet on peace and globalization. It’s been the truth in the past, but it’s not necessarily the norm in the future. So a critical thing is to create a diversified portfolio that helps protect against less globalization and more global conflict is not an exercise in projecting that it might happen. It’s recognizing and having the humility to understand that you don’t know what’s going to happen. So it’s much more important to be prepared for a lot of different outcomes than for any one particular route.

[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.

[00:01:42] Niels

Bob, welcome to the podcast. Thank you so much for joining Cem and I today for what I’m sure will be an insightful and fun conversation as part of our Global Macro series. Now, since this is your first time on the show, I do want to ask a little bit about your background. But since I’m sure many of our listeners already know of you, I would like to ask them in a slightly different fashion.

You spent 13 years at Bridgewater, and you write on your LinkedIn profile that you were Ray Dalio’s right-hand man for a decade. Now, this must of course have given you unrestricted access to Ray. I wonder if you can talk a little bit about what you learned from him and what you’ve taken with you in setting up unlimited funds, and perhaps also what you did not want to bring with you.

[00:02:28] Bob

Great questions. Thanks so much for having me on the podcast. I’ve really enjoyed listening to this podcast over time, so it’s fun to make my small contribution to it. My time at Bridgewater, for me it was a great place to develop that core foundational fundamental understanding of how the macro economy works, how markets work, and then take that understanding and translate it into systematic investment strategies.

If you ask the question what were some of the biggest things that I learned from working so closely with Ray for a long time, I think the core idea that what happens in the macro economy and financial markets is not random. It’s driven by a set of fundamental cause/effect linkages and the sort of things that you can intuitively understand, you can write down, you can measure, you can assess on an ongoing basis, often in quantitative ways, not exclusively, but often in quantitative ways.

You actually get a lot of advantage from basically taking your collected wisdom of how the world works and how markets work and writing that down and systematizing it so that what you do instead in your day-to-day is not focused on rebuilding your understanding every day, which is what traditional discretionary traders essentially do. But instead, to focus on the questions that you don’t know and you don’t understand, and incrementally ask those questions in order to compound your learning and understanding over time.

The ideas of fundamental systematic macro are not like building GPS – drive it off the cliff. It’s like, get leverage in a commonsense way, which is you don’t have to rebuild your understanding every day.

[00:04:23] Niels

I think that’s interesting. Before we pivot into some of the global macro topics that we’re going to talk about, I was wondering as I was listening to you, I would say that description may not necessarily be unique to Bridgewater. A lot of people have quantified stuff. I come from the trend following world where everything is rules-based, but not everyone is Bridgewater, right? Not everyone became so successful.

I’m just curious really for personal interest. What do you think made it so successful? What was the secret sauce, if you know what I mean, in becoming so successful? Not necessarily the secret sauce of the strategy, but how it all turned out.

[00:05:11] Bob

I think the idea of systematizing macroeconomic understanding was more novel 20 years ago than it seems today. You’re totally right. Over the course of the last 20 years, essentially, if you walk down the street in New York and go to one shop after another, essentially, everyone has done some amount of macroeconomic and market systemization. The reason why that is, is because you have to do that to keep up with all the other folks.

But 20 years ago, the concept of macro systemization, trading macro markets in that way, macro was the world of the big bets, big discretionary bets. So the idea of saying, look, we’re not going to take big discretionary bets but we’re going to have hundreds of small bets that are driven by systematic understanding, in a lot of ways I’d say, similar to the insights of the trend followers – the trend followers really had those insights decades before that in terms of a way of managing money.

It was a different type of approach in terms of what was being measured and how the views were created and things like that. But it was in a similar vein and similarly novel. I think one of the challenges with it is that, in a lot of ways, much of the world caught up mostly. Much of the most sophisticated asset managers in the world caught up to that understanding.

So in order to continue to be outperforming the rest of the world, you have to keep evolving and innovating. I think there’s room to do that, lots of different ways that that can be done. But that’s the core challenge. That moat of novel insight and way to manage money decays over time the way it decays for all asset managers. So innovation then becomes key and a commitment to continue to innovate over time becomes key in order to stay in the lead.

[00:07:17] Niels

Very interesting. Fascinating stuff. Thank you for sharing a few of the insights. Since I now understand that you and Cem, on a regular basis, speak about these things, before you get into your jive, I will throw the first question, and that’s just really maybe as a starting point. Perhaps you could share your big-picture assessment. I know we’ve got lots of data coming in at the moment, even today. But big-picture wise, how do you see the global macro framework right now?

[00:07:47] Bob

Well, I think the biggest dynamic that’s going on that I think is confusing a lot of folks is that we’re experiencing an income-driven expansion. That sort of expansion, an income-driven expansion rather than a credit-led expansion, is very different than the business cycles that really have existed over the course of the last 30 or 40 years.

So what’s happening is that interest rates are rising, and that is on the margin slowing credit creation as you’d expect and increasing debt surface. But it’s not anywhere near a big enough drag to overcome the consistency of income growth that is translating to a consistency of spending growth that is actually quite durable and sustainable. So if you were to very simply describe what’s going on in the macro economy today, wages and salary growth of households in the US is growing between 5% and 6% in aggregate.

Nominal spending growth is growing between 5% and 6% in aggregate. The savings rate is by and large flat. It wiggles month to month, but by and large, flat. That is a dynamic that can persist for an extremely long period of time. Because unlike credit creation, with credit booms you get unsustainable debt buildups that can’t continue. Income dominance, let’s call it, is the sort of thing that can continue. If I spend $100 and hand it to you and you earn that $100 and then spend a $100 and hand it to me, we can go back and forth.

There’s no reason why that can’t persist for an extended period of time. There’s no debt. There’s no liability. There’s no excess. Nothing is built up that’s problematic in that process. Folks kind of fumble around and are confused. If you look at how the Fed describes it, they’re confused. Read that Kashkari essay recently. He basically is like, “I am confused. Interest rates seem high, but nothing seems to be going wrong in the economy. I am confused.”

It’s because he has a debt-driven mindset on what’s going on with the economy rather than an income-driven mindset. Similarly, I think people are trying to find is it interest income which is relatively de minimis in the grand scheme of an economy that’s booming. They’re searching for the fiscal without recognizing that actually we’ve had a fiscal contraction over the course of the last three or four years at the time when GDP is booming.

So people are fumbling around for the things that they know versus going back and looking at this cycle through that income dominance lens, which to be honest is much more similar to cycles of the ’50s and ’60s. So if you go back and study those cycles, this actually looks very familiar. It’s just none of us have lived through a cycle that looks like this in our professional lives.

[00:10:46] Cem

Yeah. You and I, Bob, have been fortunate to be out in front of the higher for longer thesis. You and I have talked about this at length now. I think it’s going on a couple of years since we’ve been talking about it, but I know we’ve both been on top of that. We have broadly similar views. I agree that it is income-driven to a great extent. It is because we’re driving a demand-side economy versus a supply-side-driven economy.

You send capital, you lower interest rates, and you do QE, send money to the top and you send it to capital and supply. But if we start doing fiscal spending, that goes to people on the bottom, and that ultimately is a demand-side economy. I think this is the most important aspect as you highlight, what’s happening to the cost of money in interest rates.

I’d love to hear your thoughts on, how long is ‘higher for longer’ and how high is ‘high’. Let’s get into the details. Where do you see this going and why? Hold your feet to the fire so we can measure this down the road as well.

[00:11:58] Bob

Well, the current state that we’re in, with interest rates let’s say at 4.5% and income growth the way that it’s growing… Basically, interest rates have been here roughly for the last two years, give or take, 18 months, two years. So we’ve had elevated interest rates for an extended period of time. Nonetheless, we’ve had seven quarters of at or above potential total domestic demands getting around the wiggles of the way that GDP is accounted for.

So what I’d say is, in many ways right now, in this current environment, we’re in a bit of a stasis, a sustainable stasis environment where you can continue to have income growth the way that it is, interest rates are high enough to create enough of a drag on the economy to slow down spending, to slow down asset prices. This can continue for an extended period of time.

The main issue with this current environment is not growth. Growth is fine. The main issue is inflation is too high, and that the amount of nominal spending that’s occurring in the economy is just too high relative to the amount of productive capacity growth in the economy. So while we’ve made a lot of progress on inflation relative to the supply chain driven inflation that happened a couple of years ago, we’re stabilizing, we’ve seen, over the course of the last six months.

We’re stabilizing at a rate of inflation that’s too high and is inconsistent with the feds mandate. So when I think about this problem and how long can it persist, it’s less about a timeframe, a calendar timeframe, and more about a set of linkages, what needs to happen in order to create a slowdown and in order to curb inflation. What needs to happen there is that if we have an income-driven expansion, then what has to happen is spending needs to slow.

Well, what will cause spending to slow? What has to happen is asset prices have to shift, so households have to become more fearful. Right now, if you’re a household, you’re like, “My 401K is booming, my house is booming, my stock account is booming. Why should I save more?” So what has to happen is assets have to start to decline in value in order to shift away from spending out of existing income.

The question is, how do you get asset prices to fall? Well, it basically has to happen one of two ways. Either you get an exogenous unexpected shock that none of us are planning for, or you have to have a sufficient tightening of financial conditions to start to drag on asset prices. So that means either the Fed has got to do it or essentially the bond market has to do it on its own.

So that set of linkages, it’s less of a temporal thing and more an order of the linkages which is first yields rise, then asset prices fall, then spending slows, then earnings slow, then you get layoffs and decreases in wage income, and then that creates the negative spiral that eventually brings inflation down to target.

But so far, the Fed certainly doesn’t seem to be doing the work. The long end of the bond market seems to be constrained a bit by the Fed not doing the work as well as the fact that there’s easing in global jurisdictions. So that’s creating pressure, dragging the US bond yield down relative to the strength of the domestic economy.

[00:15:31] Cem

But what you’re speaking to are really the cyclical effects, right? This is what the Fed is in charge of essentially, controlling money supply and trying to manage the business cycle. Agreed, at some point, if they push hard enough, they will make it tough enough for assets and assets will decline, as you mentioned, and the economy will slow. This will happen. This is what’s happened for 40 years.

But this is, as you mentioned yourself, how every Fed governor, how most people thought about inflation and how it works. But the reality, as you mentioned, and we both know, is there’s something going on under the hood that’s not just about the business cycle. There are structural effects that are tied to fiscal spending, deglobalization, all the things that we’re seeing, that are driving structural inflation. That’s why this is different this time around in my view.

Let’s say that kicks in, in the next year. After the election, interest rates have been held long enough, there’s a lag, they’re forced to raise because inflation picks up, and eventually, things roll over, assets come down, etc. Okay, inflation CPI comes down for a bit, maybe it gets down to 2%. But then what? Then we pivot away from the 5.5% interest rates or whatever it is at that point. And then there’s a ton of pent-up demand for real estate, and there’s a ton pent up for money.

When that happens, we’re going to likely have these same structural effects continue in my view. Do you agree with that? If so, is inflation here to stay? Do you think once we finally prick inflation here and it comes down to 2%, 1%, we’re going to solve this and get back to where we were?

[00:17:26] Bob

Well, I think a lot of the core structural dynamics that were persistent over the course of the 40 years before COVID, that drove disinflationary pressures, are mostly gone. You touched on a few of them. We basically went from a period of not particularly well globally integrated to very globally integrated, China entering the WTO being a big part of that.

We went from a period where we had a billion people working on the farm and now they have moved into the factory across Asia, and that’s massively increased their productive capacity. We had a period, I think it probably doesn’t get talked about enough, of an unusual period of peace globally. If you looked at, for instance, the loss of life in global conflicts over the course of the previous 40 years before the Russia-Ukraine conflict, it was basically at 1000-year lows.

So that’s the sort of thing that you wouldn’t necessarily expect to persist, and I think that there’s certainly indications that it is not going to persist on a forward-looking basis. War is inflationary structurally. Peace is disinflationary, war is inflationary both because of the destruction of material involved with it but also because it creates a pullback of globalization trade, all the big disinflationary pressures that exist.

I think more structurally, a lot of the deep-seated disinflationary forces that existed in the US economy that really created that risk of deflation in the post-GFC period have mostly been resolved in the sense of household balance sheets are in fantastic shape. Fifteen years ago, they were in terrible shape. Business balance sheets are generally in great shape. Particularly big business balance sheets are in great shape. They were in real trouble 15 years ago.

So that confluence of things, deglobalization, increased conflict, the resolution essentially of the deleveraging dynamic and the debt overhang in the post-GFC period, all of that points to higher inflation ahead rather than lower inflation head relative to what we experienced pre-COVID. I think the main risk, the main question, I should say, is the Fed basically has one tool to resolve that issue, which is to constrain domestic nominal demand.

So if we’re in a period where inflationary pressures are persistent, then the question is, do they respond to that by reducing domestic nominal demand in order to contain inflation or do they choose not to respond to that and essentially allow inflation to run hot for an extended period of time? That’s a big question that has yet to be resolved.

I think each day, we so incrementally learn a bit of information about it, but I think that’s the real outstanding question. Because if we’re in an environment where not only do we have those higher inflationary pressures, but the Fed is accommodating to those higher inflationary pressures, that’s going to be a very different long-term macroeconomic environment than we’ve seen in the last couple of decades.

[00:20:47] Cem

I couldn’t agree more with that last comment. That’s the big question still. The Fed has yet to come out and say they’re okay with that. I don’t know that they ever will, whether they believe that or not, just because if they do, then they lose control of the long end of the curve, and that makes inflation worse. We’re now on transitory 3.0, I think is what I call it.

They keep saying inflation is transitory. But the reason they do that is not because they think it’s transitory. It’s because they want to try and convince the market that it could be, and so they keep the long end of the curve down. At some point, I think the market doesn’t keep falling for that trick. That’s what we saw in the ’70s. The market was like, okay, we believe you, you can control inflation until they couldn’t, and then it just took off.

Again, it remains to be seen, but I agree with your points. I think we broadly agree that there’s a structural element to this inflation, and that is trying to be controlled cyclically. They can control it short-term cyclically. We can look at CPI coming down. But they have a stagflationary issue at the end of the day. They’re dealing with inflation and the economy slowing at the same time, and at some point, they’ll have to choose. Whereas for 40 years, they basically didn’t because they were in a structurally deflationary period. That’s a big deal.

So what works in that environment? I know you’re big on commodities and gold. Talk to me a little bit about what you see asset allocation, how it should look in the years ahead?

[00:22:33] Bob

I think the outstanding question, for what it’s worth, is whether or not they actually are going to give up or are giving up on the inflation mandate at 2%. I think there are a lot of folks who casually say, “Well, they’re political, so they’re just trying to stimulate the economy,” or, “Oh, they’re just giving up on it.” I’m not sure that that’s right with this composition, this Fed composition.

When I look at how they’re behaving, which is to be clear, they’ve said lots of times they’re going to cut and have done nothing for the last nine months. Likely, we’ll see if they do nothing and if inflation remains where it is today. You look at their commentary about trying to understand what’s going on, it looks more like they don’t understand what’s going on and are too concerned about a credit style cycle and that that would hit growth.

They look more concerned about that than they do about being okay with inflation being where it is. You get that sense where they consistently are kind of like surprised that inflation is rising relative to what they expected rather than saying, “Hey, look, it’s fine. It’ll come down eventually. Don’t worry about any of this stuff. It’s totally fine.” I think people are attributing political motives to a lack of understanding, and I can understand why. It looks like the behaviors look very similar, but I think that’s what’s going on.

So I’m not yet giving up on this Fed having given up on the 2% inflation mandate yet. To be clear, that could change. We could have a different administration. They could put different pressures on the Fed. The Fed’s independence is not a guarantee. It certainly hasn’t been a guarantee. Part of the story that existed back in that ’70s period was actually very close coordination between the Fed, Treasury and the president putting pressure on keeping monetary policy persistently easy relative to financial conditions. So it’s certainly not a given over the course of the next 10 years.

What I would say is big-picture, the odds that the two-asset portfolio, the 60/40 portfolio of stocks and bonds, both of which highly benefit from a period of secularly disinflationary strong growth are likely to be the best portfolio on a forward-looking basis where we’re likely to have weaker growth and higher inflation, that’s not going to happen. So most investors are not going to be particularly well prepared for an environment that’s different than the last 40 years and what they learned.

What that means is looking for diversification to protect yourself against the possibility of higher for longer inflation, more persistent inflation, and driving a bigger share of what’s driving assets on an ongoing basis. What that means is, basically, it’s about gold and commodities. Those assets are assets that no one seems to hold in their portfolio but are critically important diversifiers if we’re moving into a period of higher inflation.

[00:25:46] Niels

Can I throw into question to both of you just on this topic and the previous topic in particular. You talk about these structural changes and what’s going on and people not being able to really explain this. I’m sure Cem and I talked about this before, and maybe you as well, Bob. But how do you see the demographic factor play into all of this? Because my suspicion is that might have a very pivotal role in, one, not being that easy to explain because we haven’t really seen the demographic shifts before, at least not for a long time.

Actually, this will take a long time to play out even though a lot of people have talked about it coming. I can’t remember when Harry Dent started talking about demographics, but it was a long time and nothing happened. Maybe it’s happening now but at such a slow pace that we don’t really know how to measure it and model it and so on and so forth. I’d love to hear your thoughts about that both of you.

[00:26:47] Bob

I think the demographic story, big picture level, we’re pulling workers out of the economy, productive capacity essentially out of the economy, and those workers are continuing to spend to some extent. Their production value is zero once they retire and their spending on houses and goods and services is certainly not zero. So, if you were just to look at that, on the surface, you’d say, hey, look, that looks like on the margin inflationary pressure, primarily through the fact that that demand would likely continue to keep labor markets relatively tight given that demand continues and labor supply is more moderated.

I think people get confused because they look at Japan and they say Japan had terrible demographics for an extended period of time, and therefore, it must be a deflationary force in the economy. I think they confuse the fact that you have to think about the demographic environment in the context of the monetary policy environment. The reason why Japan had a big deflationary environment is because their monetary policy was way too tight for 20 years, 30 years even. So it’s a question about whether it’s too tight even today on a secular basis.

So the effective outcome will be a function of the inflationary dynamic that comes from labor losses relative to the monetary policy and the acceptable amount of nominal demand that the Fed implements. If the Fed basically says, hey, look, we’re going to have the same amount of nominal demand, I think that’s basically what’s happening right now. The Fed is like, we want good nominal demand, 5% to 6%, nominal demand growth. But the labor force goes from expanding at 1% and 1.5% a year, the way it was back in the ’90s, to zero to negative.

Well, very simply, you can’t have those two things work out. You can’t have the same rate of nominal demand growth and significantly less people unless you have an incredible productivity boom (which is possible, certainly, that’s a possible option), or higher prices. That’s just the way it works out. Or you have to get labor supply from somewhere else, which we’ve gotten a little bit of that and it’s kind of offset excess retirements and so it hasn’t been as acute as it would have been otherwise.

That’s how those figures have to work out. So it’s really that interplay between the demographics and the Fed that will determine whether it’s inflationary or deflationary ahead.

[00:29:36] Niels

Cem, you’ve studied the ’50s, ’60s and ’70s. You’ve written about it, and you refer to it often as the last time we had real inflation. I was wondering, in doing that research, obviously, the world and the Western world, we lost a lot of young people after World War Two, and so there’s a lack of young people coming into the ’60s and the ’70s. Do you think that played a big role in why it played out the way it did back then?

[00:30:04] Cem

I think the part that we don’t talk about that relates to demographics is it’s not just about the number of people, it’s about the mentality of the number of people. So it’s scale and magnitude. We all have a collective memory of what happened during our collective childhoods and periods that we were around. As a generation, we are different than other generations as a result of that. This seems very soft and qualitative, but it’s actually critically important and is a primary driver to cycles.

I’ve talked about this before, but we, for 40 years, have sent money to capital and that’s created a difference in inequality. This is a measurable thing. We know this. We know Gini coefficients have gone from 0.34 to 0.45 in the US. We’re starting to go the other way after the last couple of years, but a long way to go. What that’s done is that it’s made people who are labor on the bottom unhappy. That’s important. It’s not just stratification. You can turn that stratification on its side.

The bottom in labor is when you come out of college, you’re labor; and when you retire, you’re capital. So the younger generation, millennials, have a collective memory of underperforming. They are 40% of the wealth creation and household formation of baby boomers at this point in their generation. So yes, they’re the new bubble, smaller than the baby boomers. But that collective bubble now is growing to political dominance and they have this collective memory.

So they want different things. They want labor rights. They want protectionism. They don’t want the same thing that the last generation had. So, yes, importantly, to Bob’s point, the older generation is both retiring and dying off and the younger generation is coming to. That difference in labor supply makes a big difference. But even bigger than that is the fact that we’re closing our borders to China, as Bob referenced. The protectionism that comes with that populism is massive.

Again, Bob spoke to war. The fiscal spending, the deglobalization and protectionism, all those things are connected. we had lower interest rates for a while. We got inequality and now we want to protect it and send money to the people, and that populism is what’s important. So I think demographics is critical, but not just in terms of numbers. But the numbers matter as well.

So gold, I agree with you, Bob, by the way. Commodities gold was the best performer during that ’60s and ’70s period until ’82, but it was very volatile. Commodities, broadly, perform very differently. Yes, broadly, commodities did well, but do you have a certain way you like to own gold or different types of commodities in particular that you look at that you think are going to be particularly great performers? How would you trade them?

[00:33:06] Bob

When I think about building a strategic portfolio, I think you don’t want to get too cute about exactly what you’re investing in. You want to build a diversified portfolio that is going to be able to handle a wide range of different circumstances, and in particular, I’d say something that you don’t have to think about. Like a good savings portfolio, you don’t think about. Maybe you rebalance once a year or something like that and then that’s it. Then you wait another year before you think about it again.

So in that context, I always lean more towards diversification rather than trying to be specific. I think gold, there’s a lot of different ways that people talk about holding gold. I think some of the challenges, people say, “What if I hold the miners or I hold physical and stuff like that?” For 99% of people, buying gold ETFs is by and large fine and gets you the exposure that you need, and you don’t have to stress too much about it. You can do it in your portfolio.

When you think about broader commodity assets, lots of easy ways to be able to invest in those. Again, I would be more inclined to diversification. How many people who are out here were pounding the table saying that cocoa was going to go through the roof in the ag space over the course of this year? Nobody bet that.

Partially, that speaks to the fact that you don’t necessarily know from a strategic perspective which particular commodities are going to do well or not, and which are squeezed, and which are going to meet significant production increases and things like that. So you’re much better off buying a diversified balanced portfolio, not one overweight oil, but there’s lots of different types of options that are out there if you want to buy a CRB-type index, a diversified index of commodities.

That way, you’re prepared for a lot of different outcomes in terms of what in particular gets squeezed as part of the overall dynamic, the overall higher nominal growth dynamic and protecting yourself from those outcomes.

[00:35:25] Cem

I agree, especially given some of the volatility that happens in these cycles. The interesting thing about the word diversification is it means a lot of different things to different people. Some people think they’re diversified by being in diversified equities in the S&P 500. We’re trying to bring up an interesting point that if you need diversification in strategy, you diversify away from beta and equities and bonds even.

What you’re trying to do with your ETFs, and again, you worked in the hedge fund space, is also to bring other diversified alternatives. In our wealth advisory business, we have an allocation of about 30% to 35% into alternatives. When I say alternatives, I’m not even talking about private equity, which I think is correlated to beta. I’m talking about hedge funds, non-correlated returns, event-driven, arbitrage strategies. We can go on and on about them.

What do you think when you say diversification broadly? Let’s move away from commodities broadly. How do you look at diversification and how do you think people should be allocated broadly across their portfolio?

[00:36:38] Bob

When people were struggling basically with the 60/40 back in 2022, I had a client come to me and basically say, “If I’m trying to build a long-term savings portfolio, what do I build? What should I go do?” I was working through it and I came up with this thing I call a simple game plan, the set-it-and-forget-it portfolio.

What that starts with is you want to start with beta. When I mean beta, I mean holding risky assets; not holding cash, but holding risky assets because you’d expect assets to go up relative to cash over time. That’s very valuable to have in your portfolio. That’s a very reliable return. You just want to hold that in a very diversified way, and there’s lots of different ways to think about that.

But even something as simple as just holding equal risk weight between stocks, bonds, gold and diversified commodities gets you 90% of the way there in terms of structuring a good beta portfolio. The problem right now is most people say you hold a 60/40 stock-bond mix, that’s 95% driven by the stock market given the relative volatilities of the two different types of assets.

So build that diversified beta portfolio, and then what I’d say is, tilt it towards inflation protection assets. The reason why that is, is because the real risk for most investors is not that assets go down, it’s that inflation goes up relative to assets. So what you’re trying to create is you’re trying to protect purchasing power or real wealth over the long term and compound real wealth over the long term.

So you naturally want to be tilted towards inflationary assets, they are assets that do well in inflation like TIPS, gold, commodities, relative to assets that don’t do well during inflation like bonds. Instead, what the world is tilted towards is towards bonds and not inflationary assets. So they’re doing the exact wrong thing to create a long-term real wealth portfolio.

I’d add on top of that the ability to add diversified alpha to your portfolio. I think there’s lots of different ways to do that. Honestly, some of the easiest ways is just add some trend following to your portfolio and you’re going to be in pretty good shape. The amount, something like 10% or 15% of your portfolio allocated to trend following has very high bang for the buck, works pretty well.

There’s lots of different easy ways to do that for most investors. The advent of all these great ETFs that are out there, a great way to do it, very efficient. You can put it in your portfolio. That combination, the reason why you want to add that is because sometimes, assets don’t do well relative to cash. Sometimes, certain assets do better than other assets. If you’re running your diversified portfolio, look, we all sit around and do this all day.

We’re following what’s going on in the markets. We’re trying to deliver alpha on an ongoing basis. That is challenging in and of itself and we spend all of our days focused on trying to do this. As a retail investor or a traditional saver, you cannot compete with what’s going on with the more sophisticated investors in the world. So you’re much better off, much, much better.

I mean that by retail investors, I mean that by financial advisors. Financial advisors aren’t spending enough time to be able to reliably create edge. So what that means is find ways to systematically get edge into your portfolio, get that agility into your portfolio. So you focus on what you need to do, whether it’s your day-to-day life or whether it’s building great relationships with your clients and get away from trying to do it yourself because you’re never going to do it as well as the people who are spending all day every day focused on creating that alpha return stream.

So that’s the overall portfolio which is basically diversified beta tilted towards inflation protection with about 20% allocated to diversified alpha strategies in one form or another.

[00:40:48] Cem

I agree. I think the only thing I would throw out there is there are long periods where, again, ’68 to ’82, the last time we saw bottom left to top right interest rates. I’m not just picking that number out of the air. We had a 65% decline in real terms of equities, like 65%, 14 years you invested, you lost two-thirds of your money, this idea that stocks for the long run, buy and hold, doesn’t work for long periods of time. Not only it doesn’t work, it is a quick way to the poor house.

I think there’s a broad assumption, because of the last 40 years and because interest rates have gone top left to bottom right, again, it is that simple that equities should be the core part of your portfolio. By the way, this isn’t the case across the whole world. This is a really US-centric, Europe, Western kind of phenomenon. The question is, is it right for the long run? I don’t know that it’s necessarily right.

Now, businesses should make money over the long run. If you find businesses that make money over the long run that outpace inflation, you will do well. I agree with that concept, obviously. But I think you really have to be thoughtful. I think you need to invest in the economy and not in the market. I think that kind of Warren Buffett way of investing when you look at DCF will work.

But if you’re just indexing and doing 60/40, I think that’s a problem. We need real diversification. I agree with a lot of what you’re saying. I’d love to hear a bit about how you think the average person should get, you mentioned it a little bit, but access to alternatives. I know you’re trying to make it cheaper for people to do that and easier for retail investors to get access to alternatives. Again, I said I think you should have 30% to 40% exposure to alternatives.

Other than your own products, how does somebody do this? Maybe speak a little bit about what that approach would look like.

[00:42:54] Bob

I think the main thing with alternatives that you have to be laser-focused on whenever you’re thinking about them is the trade-off between the alpha that you’re getting and the fees that you’re paying, and I should say also for a taxable investor, the taxes you’re paying. So I think one of the challenges of the world of alternatives is that most of the alternatives that are out there and a lot of what is being promoted in the financial advisory space are traditional LP positions in 2 and 20 style funds.

So, if you just think about that and you think about what does that mean for the end investor? Just take a traditional LP structure alpha fund in some way, shape, or form that’s targeting 10% returns. Well, you take that 10% return, gross returns, and you charge 2 and 20 fees, now we’re down to 6. Then what happens is you have to of course pay the government. If you’re in those funds, you’re probably at the top marginal tax rate. So maybe we’ll call that 50% to over-simplify it, and now you’re at 3.

And then of course you have to pay your financial advisor that comes after you pay your taxes another 100 basis points. That puts you down to 1. You probably, in a lot of these circumstances, have to pay some sort of platform fee, maybe 50 basis points, maybe 100 basis points. Now you’re down to like 1% to 2% returns.

Everyone in the world has gotten paid. The tax man has been paid, the asset manager has been paid, your financial advisor has been paid, the platform has been paid, and you get nothing, essentially nothing. You’re much better off having a bank deposit than having all of those risks.

So I think that’s the core challenge in the alternative space. It’s not the alpha. Managers are great at generating alpha, fantastic at generating. The problem is they’re also fantastic at keeping it for themselves. Uncle Sam is not helping along the way, as well, in terms of how these things get structured. So when you’re thinking about alternatives, what you want to be focused on is how many fees am I paying and what’s the tax structure?

If you turn your attention to those things, what you find is that a significant number of particularly ETF-style alternatives are really effective in that way because they are almost always much lower fee in structure and they’re almost always much more tax efficient than what you typically experience with an LP position.

So you put that together, and let’s say instead of that 10 becoming 1, we have a situation where you’re charged only 100 basis points and a circumstance where you’re paying mostly capital gains rather than marginal income tax, and where you’re not paying platform fees, and where you can do it yourself instead of paying a financial advisor 1%. Well, that then puts a lot of alpha back in your pocket.

That’s really what investors care about. What’s the alpha that they get net fees, net of taxes, net of financial advisory fees, net of all that stuff? The biggest problem in the 2 and 20 space is the fees. So that’s what you’ve got to be laser focused on.

[00:46:23] Niels

If you listen to the podcast, you probably know that we’ve had some heated conversations on the trend following ETF replicator side of things. I have mixed feelings about some of this because when I hear you talk about this, it almost sounds like yeah, okay, here’s a way you can save 9%.

It doesn’t quite show up in the numbers as replicator funds producing 9% better returns or 4%, or as we have in the trend following space where, initially at least, it was claimed that oh, yeah, 3% or 4% will do better than the industry no problem, and it turned out it wasn’t so easy.

By the way, the industry, at least in my experience, it’s not really 2 and 20 anymore, but it’s what it’s known for. But that’s not really what we’re able to achieve. But you came from the side where clearly it was difficult to invest. I’m sure Bridgewater was not the cheapest to fund. I don’t know what the fees are.

But I’m interested in what made you want to suddenly almost go the opposite way and say, “Listen, don’t invest with people like Bridgewater anymore, come to me, and we will replicate and we’ll give it to you much cheaper at a much lower tax.” What drove that inside of you? I’m curious about that process.

[00:47:53] Bob

During my time at Bridgewater and actually running a venture fund, a $125 million venture fund afterwards, I got a chance to basically work with some of the biggest, most sophisticated asset managers in the world. I think the thing that I increasingly realized was, first, they allocate a ton of money, a ton of their portfolio to alternatives, something like 50% of their portfolio.

Cem says, hey, look, 30% goes to alternatives. Well, if you’re a big institutional allocator 50% goes to alternatives. So I think that’s a pretty interesting portfolio decision. The vast majority of investors don’t allocate anything close to that in terms of alternatives. The second thing, which is very interesting in terms of what they do, is if you’re some of the most sophisticated asset managers, what you do is you invest in dozens of funds across all sorts of different strategies.

In that process, because you have a lot of capital, you beat down the fees. So you’re right. If you’re a top sovereign wealth fund, you’re not paying 2 and 20. You’re certainly not paying 2 and 20 on a platform fee the way a retail investor would, or a lower AUM qualified investor, something like that, or accredited investor. What you’re paying is something that’s a lot closer to 100 basis points on average than it is to 400 or 500 basis points on average.

So what are these big institutional investors doing? They’re essentially creating low-cost index funds of alpha strategies. The genesis of the idea was to say, hey, look, if we can create (the biggest institutional investors in the world) low-cost index funds of alternative investments. How can we do that thing but do it for the everyday investor so that they can start to build portfolios that are much closer to what institutional asset allocators are able to do rather than the options that they have available?

So that really was the inspiration. Personally, I found that, and I continue to find that to be much more interesting and compelling. Anyone has proprietary views, you can hang your shingle, charge 2 and 20, run a nice little business. But that doesn’t meaningfully influence and evolve the way in which the everyday investor is able to invest their money and build wealth over time. So that’s what’s really compelling to me.

I love the fact that, at least in the ETF space, you can invest $20 or you can invest $20 million. The access is the same. That is a huge deal when we think about how can we get everyone to be able to build better long-term savings portfolios, not just the very wealthy or the institutional.

[00:50:54] Niels

I agree with that. I think that has been one of the things where I definitely think there is a big advantage in the replicator funds, that it has given access to people who would not otherwise do. But I will say, I don’t want this to be… I want to go one more global stop before we wrap up.

But I will say, my concern is though, that those for the most part who would actually benefit from this are also the ones who don’t quite understand the difference and the risks. Because I hear the argument about, “Oh, yeah, but we’re removing manager risk because one manager could be great one year and the next…” Yeah, but you’re introducing another manager risk, and that’s the replicator. That algo, if that goes rogue, what happens then?

So, it’s a very interesting debate and I’m sure we’ll have you back, Bob, to talk about more about replication and what we’re going to do today. But I want to ask one question to both of you. It’s trying to summarize a little bit this idea about the environment we’re in right now but also the environment that we’re heading towards, and it may already have started.

Again, I’m not an expert in Bridgewater or Ray Dalio, but I read some of his stuff and he seemed to be very well-connected with China. So I have a feeling that maybe, Bob, you also know more about China than I do. In 2021, Xi Jinping gave a speech where he said the single most important word to describe the world today is chaos, and that this would be in China’s favor.

Cem and I are actually going to speak with someone who’s written a book about China in a month or so and some of the risks that he sees, but it almost sounded like they were the instigator of chaos, and maybe in conjunction with his friend, Putin. If that is the case, which if you look back the last three years, it certainly would suggest that the world is moving into a much more chaotic state than what we’ve seen before, then this could last for a very, very long time.

I just wanted to circle back a little bit maybe to hear whether you have any thoughts on this, but also to the point that you made earlier, that the majority of investors are probably invested in the wrong way because that is not the environment that the 60 portfolio was created for.

[00:53:24] Bob

The key thing, when I hear that sort of perspective or speculation, is to have humility about whether or not that is true. I think what causes macro investors to get out over their skis is where they start to project the fact that they have understanding of how macroeconomic systems work to how political systems work. Two very different things. A skill set in one does not connect to a skill set in the other.

So as an investor, it’s very important to understand what your edge is, where that is and where that ends. For me in particular, geopolitical perspectives is not an area where you should listen to what I have to say because I don’t have an edge in projecting what is likely to happen.

What I can say is, from a macroeconomic perspective, various geopolitical outcomes have various macroeconomic consequences let’s say. Those consequences, the question is, do you want to be prepared for a wide variety of those different consequences given the uncertainty, or do you want to be concentrated in a particular set of outcomes?

That’s where I’d emphasize most people holding the 60/40 portfolio have a huge bet on peace and globalization. It’s been the truth in the past, but it is not necessarily the norm in the future. So a critical thing is to create a diversified portfolio that helps protect against less globalization and more global conflict is not an exercise in projecting that it might happen. It’s recognizing and having the humility to understand that you don’t know what’s going to happen. So it’s much more important to be prepared for a lot of different outcomes than for any one particular outcome.

[00:55:30] Cem

I’ll say one thing. One response to that is the world did 60/40 and didn’t diversify away from that outcome for 40 years and it worked out really well. So I do think getting it right broadly is very important. Now, to your point, I think if we just diversify for all outcomes, you may end up with 50% of your portfolio in 60/40 and losing two-thirds on your portfolio.

So I hear you, diversification matters. But at some point, you also have to back up and look at the big picture and see where things are more likely to go and bet more heavily in that way. I do agree 100% with you that alternatives are a great way to do that. Again, very non-correlated. There are embedded advantages in rising interest rate environments to particularly hedge funds because of derivatives and the ability to both get your higher yield and use that collateral for other outcomes and to have it more efficiency capital.

So similar to a lot of institutions you talked about, I think that’s key. Even though you may not get all those benefits from simplifying and making it available to all, I do think there are benefits to that still to a broad range.

[00:56:51] Niels

We’re coming up to the hour, but I want to give both of you a chance to bring up any topics that you think we should also touch upon before we wrap up, anything we left out. There are so many things we could have talked to you about, Bob. We tried to cover as many of them as possible, but we may not have covered them. Anything else that you find in particular interesting on your radar right now that we haven’t brought up, Bob?

[00:57:14] Bob

Well, we haven’t really talked about what’s going on in the global exchange rate markets, which I think, from a macro investor’s perspective, is always top of mind. I think when you look at what’s happening globally, we basically the last five years have been a pretty correlated period, particularly across developed economies, but really globally, it’s been pretty correlated, probably China being the main outlier.

I think increasingly what we’re seeing in the fundamental conditions is divergences, divergences that are functions of policy divergences. In particular, I think people talk about US exceptionalism as if it’s manna from above rather than simply a function of different policy choices in terms of how the economy is running in different structures of the economy.

But this idea that the US economy continues to have higher levels of inflation, stronger nominal growth rates which will likely lead to higher for longer monetary policy, whereas other economies, Europe in particular, and also Japan to some extent, are likely to have easier monetary policy for an extended period of time given their both structural and cyclical dynamics, is the sort of thing that will likely put pressure on the dollar to continue to be strong relative to the rest of the world.

I think cuts really counter to this general theme that’s out there in the market right now that we’re going to have a US sovereign debt crisis or whatever at the time when the dollar basically hasn’t been this strong in decades. I think that divergence in policy driven by macroeconomic conditions diverging from each other will continue to emphasize the dollar relative to other developed exchange rates, which will surprise, I suspect, a lot of people over the course of the next couple of years.

[00:59:28] Cem

Yeah, I couldn’t agree more. Actually, historically, in these types of periods, what I do primarily is trade volatility and look at volatility markets. The volatility during that period in FX and gold, which by the way are I think more similar than gold is to oil even, are the assets that are the most volatile during those periods and represent the most opportunities too.

So, it couldn’t be more historically that that definitely is in line. People think that, broadly, all commodities are volatile during this period, because they think about OPEC in the ’70s. But the reality is oil was actually not very volatile. It had a very clear upward trend and didn’t have a ton of volatility over the ’70s and was underpinned by OPEC. So that was like a Fed put essentially on oil which really reduced volatility.

So there are a lot of other assets that had volatility priced into them which are kind of false. Whereas FX, and again, gold are areas where I think calls in particular in gold and other types of hedges in FX are wonderful opportunities.

[01:00:44] Niels

I want to wrap up this conversation. Unfortunately, Bob, I have to leave the last question with Cem because our audience were once again treated, a couple of weeks ago, from a very important call by Cem over the last OpEx, in particular, a period around the beginning of May that we called out on the podcast, or Cem did. So I can’t help just asking you, Cem, because I know the audience will be very interested. Is this playing out the way you see it? Any color you can give to our audience?

[01:01:23] Cem

The reality is these flows day-to-day, we’ve been talking about macro, these are monthly, quarterly, annual. The big macro picture is much more annual, right? But in the short term, it’s all about flows. It’s all about the short-term moves as long as the Fed comes in and underpins, doesn’t start shaking things up and is supportive, as Bob has said.

They’ve been broadly choosing, in the context of a bigger picture, between inflation and growth to underpin growth. The machine is at work, and that means puts decay every day, hedgers have to buy those back, companies buy back their stock, and the wheels keep turning. So we have gained the support we need in what would otherwise be a potentially risky period going into June. I think it’s pretty smooth sailing.

This is an election year. Bob and I didn’t get to talk about that this time, but an election year matters, particularly during a populist period. This populist period means more spending. We’re seeing it in ways that you wouldn’t expect, but fiscal policy is alive and well.

There’s talk about Fannie Mae and Freddie Mac releasing second mortgages out to people. That’d be $7 trillion in liquidity, something that most people are looking at. At the Federal Trade Commission, there’s a sweeping federal rule to ban non-competes. If that gets passed, that is really good for labor and that’s really inflationary. Whether that’s good for earnings and whatnot is another story.

But in the meantime, the fiscal spending and the support is here. We’re seeing that in lots of ways, so I wouldn’t get in the way of this in an election year.

[01:03:18] Niels

Good stuff.

Bob, this has been a tremendous conversation. I thoroughly enjoyed it. Thank you so much for doing this today. By the way, make sure you follow and subscribe to Bob’s work. As you can tell from today’s conversation, we are living in a true global macro driven world, and it is perhaps more important than ever before to stay well-informed.

From Cem and me, thanks so much for listening. We look forward to being back with you as we continue our Global Macro series. In the meantime, take care of yourself and take care of each other.

[01:04:38] Ending

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