Tobias Carlisle (00:02:48):
The premise I think is right. That’s the general idea that you want as many different uncorrelated return streams as you possibly can so that your savings generally grow over time, whatever kind of environment you can front. If it’s a 70 stagflationary gold running, equities getting smashed to pieces, bonds getting smashed to pieces, then you want to have something in that portfolio that’s keeping your purchasing power at least up with. And then, got other scenarios where you’ve got a late 1990s bull market or the bull market that we’ve just seen inequities. All those things are unpredictable and so it’s good to have those return streams.

Tobias Carlisle (00:03:26):
That said, I don’t do that because I’m an equity guy and I’ve only run equities. And I’m only going to be exposed to equities because I eat my own dog food. So I’m only invested in the things that I do. So I think it is a very good idea. I think it’s probably a better idea. It’s probably more important as you get older and further into your investment or into your saving career. But I think that early on, it’s all right to have a little bit more exposure to the things that you think you’re going to work a little bit better and to concentrate, figure all that sort of stuff out. Probably, Wes is your man for uncorrelated return streams.

Wes Gray (00:04:05):
Imagine to speak to that because I used to teach portfolio theory back in the day and I didn’t even know what I was telling these poor students but, going back to basic portfolio theory, the whole concept like Harry Markowitz and then leading to cap end and all that follows is that, yeah, you just pull a bunch of uncorrelated stuff together and even though they may all individually go all over the place, when you pull them all together, all the randomness goes away and you just make free money. And if you can use leverage, it works even better.

Wes Gray (00:04:33):
But there are two key assumptions that everyone learns. One is, it requires leverage. And then the second one is that, when the world blows up, the correlation structure stays the same. But as we’ve already learned and people always relearn is, leverage is not stable because you don’t have access to it anymore. And also when S-H-I-T hits the fan is, a lot of things that weren’t uncorrelated become correlated. Now, there are really two asset classes. Chris Cole, who’s Toby’s buddy, he’s very good at explaining this. It’s either you’re the short ball, you’re winning when things are stable or it’s the long ball. It’s losing when things are stable, but when the world blows up, it tends to go up.

Wes Gray (00:05:19):
So I’m a big fan of diversification across two asset classes, short volatility asset class, which things that work when the world’s doing okay. And then long volatility asset class, which is things that usually don’t work, but work pretty well when the world’s on fire.

Jake Taylor (00:05:37):
I’m coming live this week from Capital Camp. So I’ve learned that the only real asset classes are NFTs, blockchain, Levi, that’s a very popular topic at the moment. And I think that the other part of, I totally agree by the way with what both Toby and Wes said but I think another interesting way to reframe the question is, do you know what you’re buying or not? And, if you are a know-nothing investor and you don’t plan on wanting to figure out what you’re truly owning, then I think trying to find diversified streams as much as you can make sense.

Jake Taylor (00:06:09):
However, if you want to understand what you own, the businesses, or whatever product it is, I think that then diversification often ends up becoming diversification. And it’s just a different mindset and a different way to… There are lots of ways to do this game smart. It’s just, you have to match up your personality and what you want to work on with the particular portfolio and not trick yourself into thinking you’re doing one thing and really you’re playing a different game.

Stig Brodersen (00:06:37):
I think you bring up a good point, Jake, because like I mentioned before most people have the vast majority of their wealth in their home and that’s something they understand and it makes sense. And it’s a different standpoint than say, Ray Dalio, where I don’t know how many homes he has, but it’s probably a very small proportion of his net worth that’s tied into his home. So I can definitely agree with that, but if I can throw it all back to you Toby, and you said, you’re equities only. And I think a lot of people feel that way, perhaps they have their home in pure equities. I think even Warren Buffet said he would put 90% in the S&P and then 10% in treasuries but are you at all worried that we’re going to have a say, 1929? And it took 25 years to recoup that loss just because your analysis was wrong. 25 years is a huge price to pay for being wrong in opportunity cost. Is that something that you’ve considered?

Tobias Carlisle (00:07:33):
There’s a huge risk that equities, particularly US equities, are the most overvalued asset class in the world. And that the consequence of that overvaluation is a very extended period. I think when I look at the S&P 500 if I used that Hussmann method, I know that you’re not allowed to say his name, but I like his method for valuing the S&P 500. He says, “Let’s assume that over a decade we go back to the long-run average valuation, and still get the underlying growth, which is about 6% a year. And you get dividends on top of that. Where you end up in 10 years if you follow that method.”

Tobias Carlisle (00:08:09):
And at the moment, the last time I looked, it was predicting Ford returns of about 0.8%. And that includes 1.3% of dividends. So that’s a negative 0.5% on the index compounded annually for the next decade. Now, it’s been predicting very low returns for a while, and none of those have eventuated. So you can do what everybody else does and discard those. Or you can look at the reasons why that has happened. And that’s largely that the multiples have expanded faster than earnings have grown for a very long period of time, an unusually long period of time. And often, when you get this overvaluation, the consequences are lower returns and more volatility. So, yeah. I think that’s a very real risk and I think it’s probably a pretty good bet that at some point that’s exactly what’s going to happen.

Stig Brodersen (00:08:56):
Over to you there Wes. Assuming that you wanted to diversify away from away that Mark awaited it, called a global fund. Let’s just not say that it’s just our home country. So we’re already global. Which investing strategies would you follow or which assets would you add to your portfolio if you bought into this holy grail of investing type of thinking?

Wes Gray (00:09:16):
Going back to the, what’s short volatility? What’s long volatility? On that short volatility, the book is, what are things that do well during normal times? Well, that’s your house, that’s your human capital, that’s your stocks, that’s your, pretty much everything most people own, right? So within that bucket, I like to own cheap stuff and I like to own, right now in particular, just because I’ve been in the weeds of it, value, in my opinion, is evergreen, right? Buy with the margin of safety.

Wes Gray (00:09:48):
So I would not want to buy passive indices right now, because if you look at whether it’s a US index SPY, it’s probably got an operating income yield of 5%, which is crazy. And then international markets, maybe it’s 6%, and EM maybe it’s seven. All of those are extremely expensive if you just buy the market cap indices, which is fine. But if you go into the cheap stock world, in the US market, you could probably get stocks that are still 10 to 12%, even at yields, their operating income yields. But if you go into dev markets or EM markets, you could get 15 to 20.

Wes Gray (00:10:28):
So there’s two times as much bang for your buck opportunities in the value world out there in international markets. So I just think there’s a lot more opportunity. If I’m going to own short volatility, I own things that blow up when the world blows up. At least I want to own things with the margin of safety that I feel have higher expected returns. So that’s what I do. Buy cheap stuff in the States and globally, and then buy… We like momentum stocks as well because I got a hedge against the fact that, maybe value stocks do get burnt to the ground. So I just buy cheap stuff and buy winners across the globe for the short volatility book.

Tobias Carlisle (00:11:10):
Really stocks are like a smoking, smoldering rubble that you think they can burn down further from there.

Wes Gray (00:11:16):
I mean, I don’t think so, but as you know, I’ve learned enough in my lifetime to not believe in only one religion because sometimes religion is just wrong. And so I just diversify against the religions. Obviously, I believe in a margin of safety, I believe in fundamentals, I believe in free cash flow, I believe cash is king, but I also understand that Jake’s at a conference where they’re talking about NFTs. They have nothing to do with cash flow and dividends and fundamentals and net present value.

Wes Gray (00:11:50):
So I don’t know. Maybe we’re in a world where, and I get, I think this is crazy, but maybe we’re just in a world where people don’t care about valuation, they care about flipping it like Ponzi schemes, basically. Flip something that’s shiny now that’s going to be even shinier in the future to someone else who wants to buy it at a higher price, also a valid investment approach. And so, I’m with you Toby and that’s why I like value but there’s a risk that maybe fundamentals just won’t matter for a lot longer than anyone can expect. I need to hedge against that basically.

Stig Brodersen (00:12:26):
Jake, let me throw it to you. I always know what Toby’s going to say because he’s an equities-only guy, right? So-

Jake Taylor (00:12:32):
He’s a broken record.

Stig Brodersen (00:12:34):
He’s a broken record.

Tobias Carlisle (00:12:36):
Man with a hammer.

Stig Brodersen (00:12:37):
Right. Jake, are there strategies, or do you have any specific type of asset classes that you would add to your portfolio?

Tobias Carlisle (00:12:45):
I’m kind of drawn more towards trying to keep things as simple as possible. I structure things for my clients actually, where it’s basically if you’re going to need any money within the next five years, we’re not going to invest that part of the portfolio. And anything after that tends to be equities. I would be open to bonds if I found things that made sense, but it’s just in my lifetime. Well, early in my life, I think there were probably bonds, but I wasn’t doing a lot of trading as a toddler, but for most of my professional life, bonds have seemed to be high priced to me. And especially relative to what equities would offer over a long-term holding period.

Tobias Carlisle (00:13:24):
So I tend to end up with a barbell strategy where there’s a lot of cash and liquidity for any needs that a client would have in the next five years from that portfolio. And then everything else is eligible for a long-term hold equity type of investment. And that’s just the way that makes sense to me and is simple. And if you have more than five years, let’s say, until you would ever need to draw on that portfolio, all of it would be theoretically available for equity deployment. Now, we can argue the timing or not with that cash and the pitfalls of that. But, yeah. So I tend to have a fair amount of cash and not a lot of other more esoteric assets.

Stig Brodersen (00:14:04):
It’s interesting that you would talk about that Jake. So I had Toby on the show here not too long ago and we talked about having a cast position, we talked about inflation and how we might think differently about inflation. I don’t want to put words in Toby’s mouth whenever I’m saying this but I sure think differently about the opportunity cost than whenever I started. Well, I was taught at the church of Buffett and Munger that I’m supposed to have a ton of cash around and then I would then invest whenever that brilliant opportunity came along.

Stig Brodersen (00:14:33):
Not a lot of brilliant opportunities really came along. And so I kind of also felt I paid a higher opportunity cost with everything we see now, not just in the macro landscape, but just in general with the market right now. You already said that you have a fair amount of cash, is that 10%, 30%? And how do you think about inflation when it comes to that?

Jake Taylor (00:14:52):
I kind of view this as a poker game in a lot of ways where the amount of cash I’m holding is the chips in my stack and then there’s an anti that is, the blindness comes around to me and I have to pay and that’s the inflation. And I’ve been very, very thankful that the blinds have been low for a long time of this poker game. It hasn’t been that painful granted, the opportunity cost has been big. But even then, I mean, it’s not like value rip and I didn’t, it’s not like most of the S&P 500 didn’t really do anything. It was only a handful of things that have really done it. And I was not in a place to appreciate those businesses. And so I didn’t really deserve to get the gains from those. So there’s always going to be things I don’t understand. Those do well then, that shouldn’t really bother me. So I’ve just been very, very thankful that the anti of this game has been, or the blinds have been low.

Stig Brodersen (00:15:44):
Wes, I remember we talked about this some time ago in terms of ETFs and you generally want to be fully invested. How about you, in your private portfolio, are you sitting on a pile of cash?

Wes Gray (00:15:58):
To Jake’s point, cash is fine. In my opinion, it’s a costly insurance vehicle and there are potentially better alternatives out there that achieve the same in-state really. Because what cash is doing for you is it’s creating optionality to be money good when the world’s on fire. But the cost is, you got to sit in the bank account and you have the opportunity cost of capital and inflation, all this other stuff. And so the ideal situation is, how would I get access to insurance cheaper? And I’m not saying that there’s only one way to do it, but I’m just a huge fan of using, obviously trend following techniques where maybe you only put down insurance if we’re in a bad trend. There’s a lot of times you can buy different, long volatility products in the options world where you can find people that, yeah, they’re going to have some costs to carry, but it’s not that high, but when the world blows up, you get paid. And so now, it’s like buying insurance, but the insurance premium is not that high.

Wes Gray (00:16:59):
So I’m just a huge fan of trend following in general, managed futures, which is specifically trend-following managed futures, just straight up long volatility like owning puts but smartly, I could see working, and cash is also fine too. So I would say you probably want to do a mix of all those different things as a way to counterbalance your all-in equity book. So that’s what I do personally. I don’t have cash sitting around, I got managed futures. I got, I’m not going to mention it, but I own this fund that does long volatility and I do trend following. But for the most part, I’m long and strong our funds on the equity side like Toby does. So I don’t hold cash in big quantities.

Jake Taylor (00:17:47):
I think the other part that’s important for me is that most of this game for me is trying to control my own psychology. And I really do feel like it’s melting, it’s myself often and the cash is a way to really help me to stay patient. And there’s a comfort to it that I think makes me a better investor. And so even if it’s suboptimal, the simplicity of it, I believe in those things too, Wes. I mean, I think tail risk funds, things like that. They make sense to me, but oftentimes I’m trying to keep things simple so that my mind can rest at ease and I don’t have to do as many. And then I can really focus on trying to really understand the businesses.

Wes Gray (00:18:23):
Yeah. I mean, you’re doing it the right way. 99% mental game, 1% what you actually do. So if you’re controlling the 99%, I think you’re going in the right method.

Stig Brodersen (00:18:35):
Let’s talk about trend following. You’ve just mentioned it there, Wes. To me, I’ve never invested in anything that was trend following, but I read up a bit on here lately and it seems to me to some extent to fit the bill of the holy grail of investing. I don’t have 15 or 20 different revenue streams. It would be great if that was the case, but that’s not the case for me. And I was thinking whether or not trend following would really fall into that pocket because over a long time period, it’s not correlated with the stock market, it follows a lot of different and uncorrelated markets if it’s set upright, and yet you can achieve stock market-like returns and you can invest in smaller funds. You don’t need to put down a down payment, that’s good for your house.

Stig Brodersen (00:19:16):
And one of the things that might make this appealing is that perhaps it doesn’t matter if we are in the biggest bubble in history. Some people think we are, other people would argue that we’re not. But in case we are wrong, the strategy appeals to me in the sense that, you can make money in a direction the market is going. Obviously, you would then be very much long right now because of what’s happening to [inaudible 00:19:39] right now. So if the stock market would crash tomorrow, you would still see a significant drop in your trend following portfolio, but you could then make money on the way down whenever that trend has shifted. So my question is whether or not you considered investing in trend following.

Tobias Carlisle (00:19:55):
I like Chris Cole’s version of the world where everything’s long vol and short vol. As I pointed out to Cole, when you long vol, you still got to figure out which one of the long vol assets you want to be in. It’s not quite as simple as that, but he knows that too. He’s written some good papers on that but I like the way he thinks about the world.

Tobias Carlisle (00:20:11):
The idea of trend following is just that, well, the simplest version when you apply it an equity world is that when you get that precipitous drop, which you do, which is like the tail-end of most bears when you get that big gigantic sell-off that ends it, that you’re magically plucked out and you’re hedged through that period. And you can find lots of examples that work really, really well. You can run S&P 500 back and use the simplest version the 200-day or the 10 months, which is the one that everybody recommends. And you can see how well that’s done. Apply that same methodology to Japan. The beauty of it was that it kept you invested the whole way up the Japanese bubble as it ran up to 1990, and then it just plucked you out at the top. And as Japan was absolutely devastated, you survived and you’ve done much, much better than anybody else in Japan by following these things.

Tobias Carlisle (00:21:02):
The problem I have found with them is just the implementation of them is very difficult. And it’s not a total solution in the sense that you do have these, trend-following hasn’t been a great strategy over the last, Wes would know better than I would. But it has been a great strategy over the last short period of time in the market because we’ve been whipsawed quite a few times as the market goes down, you put the hedge on, the market goes back up your hedge, take it off. That’s every single trend following strategy that I have a look at Corey Hoffstein’s dashboard, where he tracks these things.

Tobias Carlisle (00:21:36):
Any of these risk-managed strategies like buying some fall, trend following, being a value guy, holding cash, everything has underperformed for the last 10 years because the market’s been very, very strong. And the longer and harder you’ve been through this whole period, the more likely you’ve outperformed and any kind of risk management has hurt you. And so it’s always at this point where people are like, “Well, I’ve been doing this for 10 years and now I’m underperforming. I’m going to give it up. And I’m just going to be long and strong. I might even leave it long.” And I kind of get the feeling that, and I’m going to buy some other stuff too. I’m going to buy NFTs, and I’m going to flip those and Bitcoin.

Tobias Carlisle (00:22:17):
I don’t like assets where the basis of the valuation is what the next guy pays for it. I like assets where the basis of the valuation is something that I can individually just go and have a look at the underlying business. And then if the mark gets changed tomorrow by 50%, but the underlying business is the same. And even though on paper, 50% poorer, I know that the underlying business is still great and that might be a good signal for me to buy some more.

Tobias Carlisle (00:22:42):
I approach it like that rather than… And I’m at the point where I just want to simplify my life. I don’t want vault and I don’t want trend following. I don’t want other things in there, I’m just trying to get to. Because I’m okay with a 50% drawdown in the market. I’m happy with my investible assets going down by 50% because I’m not using them for at least 25 years and probably longer than that.

Jake Taylor (00:23:04):
That brings up a really good point Toby. A lot of these things are like Wes said, they’re insurance products, right? And one of the things that you’re insuring against is quotation risk. Like having the prices move on you, and then you not being able to handle it psychologically, maybe making an unforced error. Well, if you know what you own, and maybe you have a lot of cash that you feel good about deploying at that time, which softens the blow of watching your other holdings going down, right? You can get excited about the new things that you’re buying for cheaper, and you can stomach the volatility and the quotation, you could self-insure that quotation risk.

Tobias Carlisle (00:23:41):
Both directions too. Up as well as down.

Jake Taylor (00:23:44):
Yeah, right. I think that’s how I view it as I’m trying to self-insure that risk rather than look for someone else to insure it for me.

Stig Brodersen (00:23:52):
Whenever people are hearing trend following, perhaps they’re thinking, which five stocks have spiked here recently, or they should run out and buy that. Or, I’d like to debunk any kind of myth.

Wes Gray (00:24:03):
It’s like a lot of things like, oh, I’m a value investor. What’s that mean? Do you own Amazon? You could be a value investor… So it’s really important to define what you mean, which is basically your question. So there are a million flavors of trend following. And I’ll talk about two that are the most important. The first form of trend following is just long-term trend following for risk management, get out of the way of the car wreck trend following. And that’s where the basic idea is, and we’ve studied this on every asset class that you could possibly get data on and it works everywhere, in some sense, where what you’re going to do is you look at a risk asset class. If it’s in a long-term trend, own it. If it’s in a long-term downtrend, get out of the way, that simple.

Wes Gray (00:24:55):
Why do you do that? Well, almost all left tail events of 50% type drawdowns are going to occur obviously in situations where this asset cost is in a poor long-term downtrend. And so you can apply that on every single market, over every single dataset, across time, we’ve done it, we got all kinds of posts about it, but we have a really important post called trend following. The epitome of no pain, no gain, because to Toby’s point, if you think value investing is hard or momentum investing is hard, how are you going to feel when you’re running like a trend fall to equity strategy and you’ve underperformed for 20 years, not that great, right? And a lot of times you’re in cash while your uncle’s like, he’s doing high fives on how the S&P is up like five times, right? You’re going to feel like an idiot.

Wes Gray (00:25:46):
And trend-following is the most painful trade possibly that I’ve ever found on the planet earth but it also is the trade that I have the most confidence in for long-term survival. Follow trends is a good way to survive because by definition if something’s working, you’re in it and if not, your gut is now away. So it’s really hard to lose your ass, basically, in just general trend following. That’s one form of trot. Tread following is very simple, you could apply it on your equity book or whatever, easy to implement.

Wes Gray (00:26:20):
The other form of trend following would be things that are supposed to deliver what they call crisis alpha. So where the prior form of trend following, which is just long-term super simple trend following is for risk management purposes. It’s not going to prevent you from losing money. It’s just the ideas that may prevent you from losing over half your money and maybe only lose 20 or 30%, but it’s just risk management.

Wes Gray (00:26:44):
Crisis alpha trend following is much more high frequency, usually runs long, short, and goes across the commodity complex, bond complex, and everything else under the sun. Those systems are designed to, in general, on average, you don’t do anything. You just get chopped up to debt and frictional costs, and you may make a little money and may lose a little bit of money, but they’re designed to actually make money in the stock market. I mean it’s why they call it crisis alpha. And that genre of trend following systems, which is generically called managed futures is, you may be daily rebalancing or weekly rebalancing, you’re going to use much shorter time window trends, maybe do 100-day, look back as opposed to 250 or 300-day.

Wes Gray (00:27:32):
And again, those are designed not to make you money, but just straight-up insurance, right? And they work, we run them, they go up when the market totally blows up. But the problem with those of course is you get destroyed in frictional costs, they’re super hard to understand. If you don’t know what you’re doing, to Jake’s point, you probably shouldn’t be invested in it.

Wes Gray (00:27:55):
So I’m a huge believer in managed futures for crisis alpha as well. But I would also, I’m a huge believer in behavior drives everything. If you don’t understand what you’re getting into, if you don’t know why and how it works, you should just put money in cash or bonds and do your diversification in that method.

Wes Gray (00:28:14):
Those are the two types of trends. Long-term trend-following for risk management, keep it simple. And then, high frequency, more complex, trade a lot trend following that’s usually deployed across tons of assets in a long-short context. Also, cool but not for everybody.

Stig Brodersen (00:28:31):
Could you provide some numbers if you’ve done some research on it? Like, how different portfolios have done with say, trend following taking up five or 10% of a portfolio. And then also, perhaps, a few thoughts on, should you diversify within trend following if you do allocate say, 10% of your portfolio into trend following?

Wes Gray (00:28:50):
In general, for the risk management form of trend following. Let’s say you want to own equities, but you don’t want to get your face ripped off at some point, anytime you deploy long-term trend-following rules, they don’t trigger that much, right? So de facto, you’re basically a buy and hold in the asset class, but it’s only in protection for extreme events. Usually, when you look at those time series, whether it’s Japanese stocks, Australian stocks, or whatever, it doesn’t really matter. You’re going to typically achieve close to the same expected returns with half the drawdown. However, that’s just backtesting.

Wes Gray (00:29:27):
I always tell people, “Listen, you’re buying insurance. So you probably shouldn’t have an expectation that over a long-term cycle, you’re going to get the same expected returns with half the drawdown.” We say, “Hey, you’re probably going to get a lot of the expected return, maybe 80, 90% of it.” And yeah, you probably well protect against the big kahuna drawdown, but you’re going to be eating massive behavioral pain because of the relative performance saying because there are no free lunches.

Wes Gray (00:29:55):
So that would be my expectation for a long-term trend. It’s basically bought and hold with an airbag, right? And you’re going to probably get half the drawdown with, maybe 80, 90% of the upside. Now, on real trend following, the more high-frequency crisis alpha version, where you’re trading whole commodity complex, gold, silver, palladium, blah, blah, blah. The more complicated managed futures products. Those strategies I would say are not going to be able to contribute. I mean, they do in a backtest sense. A lot of times that comes from the historical benefit of you put the cash in a T-bill that used to make money, now they don’t make money anymore.

Wes Gray (00:30:34):
What I always tell people is, I would not expect a high-frequency crisis alpha-focused managed futures fund to make a lot of money. If you get flat, that’s awesome. But if it provides that insurance where it goes up 10, 20%, when the world blows up, that’s insanely valuable. And if you’re not making anything, if you’re basically getting insurance and you don’t have to pay for it, that’s awesome. Is the best way to think about these things.

Wes Gray (00:31:01):
Now, as far as allocation, what I always tell people is, “Okay, you got 80% of your book in stocks, and you’re going to do a 5% trend following allocation.” Well, if 80% of your book is in stocks and they go down 50% and you put 5% in managed futures and you expect it to really do anything, you’re just insane. And so the weirdest thing, and I actually personally run my book like this, even though it’s totally insane is, managed futures exposure should be a massive component of your book because you need to counterbalance the equity book, right? Because if you’re 80% stocks and 20%, let’s say, your aggressive managed futures player, you’re realistic, you’re still 80%, 90% of your risk is the short ball and you have a little bit of protection. But if you really want to truly balance the chaos, you really need to be more 50, 60% managed futures program and then 50, 60% inequities. But no one does that.

Wes Gray (00:32:04):
So in my opinion, a 5% allocation to trend-following or managed futures are just a waste of time. You might as well just put it in cash and feel warm and fuzzy. Anyone can understand cash. I would say it’s either go big or go home trade. You either believe it and you do it or just hold money in cash and move on. But that’s my personal opinion.

Tobias Carlisle (00:32:25):
There’s a lot of implementation. I think of it like crisis alpha and I think crisis alpha… I think the trend is following, correct me if I’m wrong Stig. But the trend following that, you’re talking about that 200-day, using it as a hedge against a big drawdown, and then comparing that to something like crisis alpha, which is someone who’s long vol in the futures of the options. And on the big drawdown, it’s going to give you the big payoff. And you’re hoping that roughly they achieve the same thing.

Tobias Carlisle (00:32:51):
The two things to watch out for, if you’re exposed to that, the crisis alpha particularly, if you have that big drawdown, as Wes points out, these things mostly just break even over long periods of time. Well, that’s a great manager. He gets you to break even over time. The advantage of it, the reason that you do it is that you have that monster drawdown, all of a sudden, your third pocket appears, and it’s got a whole lot of money in it, but then to take advantage of it, you have to be able to get access to that capital and redeploy it long and rebalance your book back to that starting setting. And if you can’t get there, then it hasn’t performed its function, it’s popped up when the market was down and you felt good, but you didn’t achieve anything. It didn’t get you any further ahead.

Tobias Carlisle (00:33:31):
The trend following, the longer-term risk-managed stuff, you have to understand what the thing is and you have some implementation risk in that as well. In the sense that when the, like March 2020, I don’t know which ones worked and which ones didn’t, but there will be trend following funds that if they’re very long-term and they’re checking in once a month, are we on or off for this month? And there’s nothing wrong with that. If you do it more frequently than that, you might find that you…

Tobias Carlisle (00:33:56):
The challenge is always, how much of your cost over time, how much of your burning on premium, or how much are you burning, getting whipsawed versus your payoff? And you have to decide, you may be able to do a 5% allocation, but you got to recognize that 5% allocation so you give it to someone like Mark Spitznagel. Mark Spitznagel is probably going to burn your 5% allocation over a month or so and you might have to re-up again for the next month or two with another 5% allocation because that’s what those things do. They’ve got this extreme positioning that the premium bleeds off really quickly and so-

Jake Taylor (00:34:33):
I think it’s more than two to 3% per year.

Tobias Carlisle (00:34:35):
I’ve tried to do it with long vol options on futures, balanced against the value book. That’s a terrible idea because you can have this period of time where both sides of your book are underperforming. And if you don’t get the big payoff, then you’re just burning premium for a decade and you end up with that, you’ve achieved the same outcome where you’re down 50%, but you haven’t had the big drawdown.

Tobias Carlisle (00:34:55):
I’m sort of with Wes in the sense that there are no free lunches. You just have to get comfortable with your own personality and the function and implementation of the tools that you’re using and recognize what they do and know that there’s always a risk that you get, you do all this risk management for a decade, and you get to the same point that you would have been being down 50% of underperforming by 50%. All that said, that’s why I’ve gone back to just trying to simplify my life as much as I can.

Jake Taylor (00:35:21):
Do we have time for a quick story of one of the best third pockets I’ve ever heard? It naturally comes from the GOAT, Mr. Buffet. It’s the depths of the 2008 drawdown, and everybody’s losing their minds, right? The world’s coming to an end. Warren sells puts, $5 billion worth of puts. He gets the money that second that he can go do whatever he wants with. And those put the way they’re structured, no collateral required, no European style option, and the average duration is 13 and a half years from 2008.

Jake Taylor (00:35:53):
So even if the S&P was down, I think 40% from there, right? And this is all nominal as well, right? So 3% inflation alone, and even retained earnings is going to carry you well above probably wherever it is flat for that 10 or 15-year period. The cost of capital, at that point, for him would have been about 4%. And that’s if the S&P was at 40% below in 13 years from 2008. I mean, just one of the absolute all-time amazing third-pocket plays that I’ve ever heard.

Tobias Carlisle (00:36:24):
And he didn’t have to pay for it beforehand.

Jake Taylor (00:36:27):
Nope. Money in the door that day, while prices were the best that at least I’ve probably seen in my lifetime.

Wes Gray (00:36:35):
One thing I wanted to add here real quick is, Toby brought up a genius point that most people forget is if you’re going to do diversification, you’re going to do crisis alpha, you’re going to allocate these long-haul things. You have to rebalance into the world that you own that blew up. I’ve noticed this time and time again people are like, “Oh, I just sell them 60% of this, 40% of that, buy and hold.” No, it doesn’t work like that. The whole point is, you got to be able to actively rebalance and take advantage of your third pocket or your cash. And if you’re not willing to do that, it’s an even worse idea.

Wes Gray (00:37:14):
I’m sure Jake here, he’s got his cash, but he’s got a plan and a program and a system that when the world blows up, he’s ready to use it. What most people do, is they have their crisis alpha, they have their cash, the world blows up, “Oh, I just need to hold that cash.” Unless you have a plan to actually take action to implement on the whole point of owning crisis alpha, it’s also a waste of your time, which is something that Toby brought up, which is hugely insightful and important to reiterate here. It’s not buy and hold. You have to actually do stuff when the world’s on fire. Otherwise, it’s just going Vanguard funds, have a nice life.

Jake Taylor (00:37:55):
Yeah. Wes is totally right. There’s this idea of a Ulysses contract, and if you remember, Ulysses was this Explorer and he was sailing, this is mythology so it’s not a real person. And he would sail past the sirens and of course, they’re singing, withdraw the captain of the ship to steer into the rocks and crash, right? And that’s how all the sailors died. So what Ulysses did was, he tied himself to the mast so that he could still hear the sirens, but he couldn’t turn the ship. So you need to probably create some Ulysses contracts with yourself about, if something gets down to this price, I’m going to buy it. I even prefer to do it for myself with valuations. I like this company. If I ever see it at 8X, whatever multiple, I’m going to buy it, right? And I keep track of that.

Jake Taylor (00:38:38):
And I think that’s really, make these plans while you’re sober, while there’s not headlines filling your mental space, while it’s quiet and easy to think about it, and don’t wait until you’re in the heat of the battle. I’m sure Wes, that saying about, the more I sweat in peace, the less I bleed in war, right? I’m trying to sweat right now while it’s peaceful so that I don’t have to worry as much about it. And I just stick to the plan. I know it’s a good plan because I put it together while I was sober, right? Don’t wait until you’re in the middle to come up with, “Okay, what do we do now?”

Stig Brodersen (00:39:10):
Guys, I think this is a good segue here into the next topic about active and passive investing, emotions, or things that come with that. So it seems like these days that there are more active retail trading than ever. Let me just start by giving you some stats here. So in 2019, we had 59 million Americans who had accounts with one of the seven largest brokers. And that number has since surged. We are around 96 million and 20 million of them were just opened here in 2021.

Stig Brodersen (00:39:41):
And so if you look at the total trading flow retail is at an all-time high with 4%. So still with all that being said, we still see passive investing on the rise. If you look at the S&P 500, 18.5% of that is held in passive ETFs and mutual fund indexes. So we’ve seen what looked to be a singular trend for decades. And so even despite this surge in retail trading, we’ve seen more money be invested passively. So is that an advantage or a disadvantage? Let me throw it to you, Jake. If you have a large increased share of the other funds being invested passively, and I ask you because you pick individual stocks.

Jake Taylor (00:40:21):
I mean, a couple of things. I think I’m very ambivalent about the rise of all the, call it Robinhood effect for lack of a better term. On the one hand, I love the idea that young people are investing, taking an interest in owning businesses and saving money, and putting it to use. And I think it’s terrific and I want to encourage that. However, I can’t help but feel like a lot of it resembles gambling may be by design as far as some of the dopamine hacking that happens. And I find that to be very distasteful.

Jake Taylor (00:40:57):
While I like the idea of encouraging people to invest, the execution of it thus far in a lot of these apps, I find it to be disappointing. As far as once the money comes in from outside and may be less sophisticated is passive or active, I think for most people unless you have a real active interest in wanting to get into this stuff and live it, I think passive is totally appropriate thing for you to do.

Jake Taylor (00:41:22):
Now, if you are into it, then I think it’s active, it’s still very reasonable. And granted, this is motivated reasoning for sure, because it’s like what I like to do, but there are two sides to the debate. There’s the flow debate, which is, God, if everyone’s going into passive, they’re just buying all of the S&P 500, let’s say, therefore, that’s the only thing that’s going to ever work and move. And if you’re out of an orphaned stock, that’s not in an index, that’s getting passive flows, well, good luck to you ever being able to recognize good return.

Jake Taylor (00:41:55):
I think that that is true in the short run but a total advantage in the long run. And you have to have the faith that what I’m buying today, even though it is an orphan and not part of indexes, the underlying business value is accruing. And the fact that no one is looking at it because they’re just all passively indexing, is an absolute Godsend for an active investor. So I think that both sides of the debate right now have framed it as if, call it, Mike Green’s melt-up theory of, we’re just going to keep going up and it’s because there are just passive flows all the time.

Jake Taylor (00:42:28):
Yeah. I think over a short time period that’s absolutely true. But over the long period, you couldn’t ask for a better set up as a stock picker because if no one’s looking at all of these businesses and no one’s bidding them up, that’s my dream come true. I think it’s just, again, it’s always about coming back to setting what is appropriate for your psychology? What game are you playing? And then picking the strategy that fits with what you’re trying to accomplish and where your strengths and weaknesses are.

Tobias Carlisle (00:42:53):
The two questions are, passive in the sense that, you’re just investing into an index fund and you’ve thought about your allocation beforehand, and you’re getting some exposure to all the right things, you’ve got your asset mix. That’s going to be perfectly fine. You’ve already recognized that there are risks and S&P 500 has a risk of going down 50% at any time. International stuff’s in the same basket. The bonds might underperform if we get some inflation or interest rates to go up. There’s no, just to keep on saying Wes’s this favorite line but 100% endorse it. There’s no free lunch. There’s no way to protect yourself against everything or outperform everything.

Tobias Carlisle (00:43:28):
The other argument is about passive distorting the market or destroying the market. I’m with Jake on this and I’ve been saying this for a while, this scenario is not you. You can find there’s a Piper Jaffray article from 1999 called The Endangered Species List. And they followed it up later with another one called Darwin’s darlings. Basically, they were just pointing out, “Hey, look, with all this tech stuff going on, there are all of these Russell 2000 companies. So that’s the smallest 2000 of the Russell 3000. And that some of them onto the bottom and pretty small.

Tobias Carlisle (00:43:57):
Look, there are companies that are growing their earnings or revenues like 30% a year, and that you can buy them on an EV multiple of five. And this is crazy. And they were just pointing out the fact that this existed. And then from that, there was that activism and private equity boom in the early 2000s where they all got taken private, or they got approached by activists to have them do some value-enhancing maneuver. And then all of the action started happening in those smaller companies.

Tobias Carlisle (00:44:23):
And so, for a period of time, everybody in the market was a value guy and an activist. And that then value did extremely well. And it attracted a whole lot of guys, probably like me and probably like Jake too. I don’t know how he found that out but we talked about it at the time where I was like, “Oh, value works all the time and it does really well. All you got to do is stomach the tech boom, like the late 1990s. And they never come around very often. And here we are in another gigantic tech boom with people trying to justify why it’s going to go on forever.

Tobias Carlisle (00:44:54):
I think that when there are opportunities out there, you just got to take them, even if the market doesn’t recognize them for a long period of time afterward. So I think it’s a good thing from a selfish perspective. Whether it’s good for the market as a whole, I don’t know. That’s a slightly different question to the Robinhood question, isn’t it? I don’t know if we… Did we get off topic there?

Stig Brodersen (00:45:13):
No, let me throw it over to you here Wes, because we do have a Robinhood question here, the next one to go. But before we do that, I know you’re really in the trenches with your funds. So I’m sure you thought about this question and it’s something that is an advantage or disadvantage to the active investor that we now see this secular trend. It looks like it’s going to continue.

Wes Gray (00:45:34):
Yeah, I mean, I think in the end, investing boils down to dollars and cents, not whether it’s labeled passive or active. So the things that matter always matter: fees, taxes, and frictional costs. And so even though the best action strategy might be able to crush the soul of the worst passive strategy if the fees, taxes, or frictional costs are managed, you still might be better off doing passive, right? So that’s something we always want to be concerned about on any investment approach. What are we doing? What’s the net benefit of it?

Wes Gray (00:46:07):
But I certainly agree with these folks here. And it’s something that Ben Graham talked about 70 years ago. In the end, it’s a weighing machine. The facts matter. It’s not a Ponzi scheme. At some point cash flow and actual business matter. Now, that it means that-

Jake Taylor (00:46:26):
When is that point, Wes? When is that? I’m waiting.

Wes Gray (00:46:30):
Just the market is crazy for another 20 years but at some point the weighing machine matters. And so that’s something to consider whether you’re active or passive. It’s not whether it’s active or passive it’s, what are you buying? And fundamentally right now, what you’re buying when you buy passive is a bunch of extraordinarily, expensive, high gross prospect, high sentiment, it’s got to be perfect to work investments. If you’re cool with that, go for it. If you have a horizon, you have discipline, you believe in the weighing machine and you can access the exposure, cheap, efficient after-tax, blah, blah, blah.

Wes Gray (00:47:09):
I personally think that we’re in a situation where the opportunity inactive is actually enormous, but the cost of exploiting it is enormous in the form of behavioral problems because there’s very likely that anyone who tries to do something cute is going to have to sit for 20 years when your five-year-old cousin is like, “Why don’t you just buy NFTs, dude?” I mean, that’s the trade-off. To Toby’s point, there’s no free lunch. I think it’s all an age-old debate that people have forever. The weighing machine matters in the end: after taxes and frictional costs.

Stig Brodersen (00:47:46):
Gents, I’ve really looked forward to asking this question. Charlie Munger has said of the commission-free trading app, Robinhood. Yes, it is one of those episodes where we’re talking about Robinhood. And so he has said, “It’s a gambling parlor masquerading as a respectable business.” So let me just tee up to you, Charlie, tell us how you really feel, right? Jake, do you agree with Charlie? And is there a silver lining?

Jake Taylor (00:48:13):
I tend to directionally probably agree with Charlie. The silver lining, I think is, it’s true. Like Wes just said, lowering the fees on any product like that should hopefully leave more meat on the bone for the investor. Now, whether the hidden fees of front running or whatever it is that how by selling order flow, what that actually takes a bite out of the meat that’s there for the investor, I’m not sure I even know what the answer to that is. I don’t know how much that skim costs and it does feel a little disingenuous to say that it’s commission-free free trades, which, okay, that is true, but it’s not free trades. Those are two different things. So don’t say free trades, that’s not true. It’s commission-free trade.

Jake Taylor (00:48:58):
But yeah. I mean, as I said already, it’s certainly, and this is my own bias-speaking of how I see the world and how I want to do this, but it does encourage a short-term behavior, I think. Probably too active of trading relative to probably what the research would suggest is a good cadence.

Tobias Carlisle (00:49:16):
Yeah. It’s a modern-day version of the bucket shops that were around in Jesse Livermore’s day. But you basically, you can get access to margin and they’ve simplified it. So do you think this is going to go up then buy this thing, which is an option, which, up over what period? A week, a month, a year, 10 years. There are some businesses that I feel reasonably confident will be bigger businesses in five years’ time, whether that stock price is going to be higher at the end of the quarter or not. I flip a coin, I’ve got no idea. And I don’t think that there are very many other people who have figured it out either. Maybe Jim Simons figured it out, but I don’t think there are very many other people who’ve figured out that short-term stuff.

Tobias Carlisle (00:49:56):
I don’t really like the way that they set it up to encourage people to overtrade because I think that it’s people who, a lot of them are in desperate straits and they’re looking for some way out and they’re using that as their way out. And I think that ultimately they’ll probably get hurt. And then the silver lining might’ve been, well, it’s drawn all these people into the market who wouldn’t otherwise be in there, but if they get burned really badly, are they going to come back or are they just gone forever?

Tobias Carlisle (00:50:21):
Ultimately, you’re better of viewing it as a savings vehicle that you save into overtime and you get growth in the underlying assets over decades, not weeks or months or quarters or even years. So I don’t want to rain on anybody’s parade. If you’re having fun doing it, then have fun doing it. But just recognize that there is also a downside. And we haven’t seen one since March 2020, when a lot of these people have come in post that.

Stig Brodersen (00:50:45):
Wes, you don’t come off as the stereotype of the person sitting on your phone all day, trading 14-days options on Robinhood. I’ve seen you nod there with the criticism of Toby and Jake. Is there anything positive to say about this development we’re seeing right now?

Wes Gray (00:51:05):
I usually explain to people like, “Hey, investing is 99% behavioral, 1% operational.” And on that 1% operational, this stuff is amazing, right? If you’re an investor, your fees, your taxes, and your fictional costs are insanely low via these brokers, ETFs, what have you. However, you have a huge benefit on the 1% of investing, but on the other 99%, the behavioral side, the costs have been magnified, right?

Wes Gray (00:51:37):
You can now trade for free, you can trade seamlessly. Anyone can access the information, which just encourages decision-making and activity. And so I think on the net, it’s probably going to be the most painful, atrocious, money-losing exercise that a lot of people ever go through for the rest of their life, unfortunately. But it-like probably would be a good lesson. I used to do that, I used to gamble all the time and now I learned not to do that. So everyone’s got to touch the flame sometime. And I encourage people to do that when they’re young and broke because if you get some resources, you don’t want to start doing that because then you lose the whole kitty. So there are costs and benefits to everything.

Jake Taylor (00:52:23):
I think one of the reasons that real estate has been traditionally a pretty good wealth-building vehicle for a lot of people is that because the transaction costs are so high and it’s hard to get in and out of. And I think for the average person who, they can make their mortgage payment and it turns into a forced savings vehicle then. They basically, borrow $300,000 and then pay it back over time and you get $300,000 at the end. So this is very much the opposite of that.

Jake Taylor (00:52:50):
I mean, like you said if you’re diligent and I view that I’m building my little empire every single day and the fact that I can create and pare down my empire and whatever the image is in my head of what it should look like, for almost zero cost, anytime I want to do it is an absolute, amazing thing for an investor. But like any tool, it can be used for good or for not evil, but not for your benefit. And so you just have to be very careful just like you wouldn’t give a two-year-old because, sure, we do surgeries with scalpels, but you could also disfigure something. And I think that these tools now are very powerful in a similar way and can be terrific if used correctly, but also dangerous if abused.

Stig Brodersen (00:53:33):
Well said, Jake. For the last question here of this round, I want to throw it over to Toby and Wesley. Perhaps starting with you Toby because often on the show, we talk about individual stock picks. We don’t talk a lot about ETF investing. So I wanted to ask you now that we have both of you here, what’s the best and the worst thing that has happened for retail ETF investors in recent years?

Tobias Carlisle (00:53:55):
The change from, this is a technical thing, but the passive ETFs had a capital gains tax advantage over active ETFs that got removed in the last year. So an active ETF can now be run with the capital gains tax exemption, which, it’s the main reason that you run an ETF or one of the main reasons it has this liquidity, which is fantastic for investors so they can get in and out multiple times through the day if they want to. And then the trades of the manager don’t create capital gains tax implications for the person holding them. They make their own decisions about when they incur those capital gains taxes.

Tobias Carlisle (00:54:31):
So I think that stuff is fantastic. It makes them, I think the best vehicles. I think that makes them better than mutual funds, they’re better than LPs, they’re better than managed accounts that from that perspective, they’re great. And I think that the active change will see a lot more managers who had been in mutual funds or even managers who’ve been in LPs. And I know a few who are doing it, who are transitioning across into ETF structure, which means that anybody would be able to get access to them where previously you needed to have some sort of asset level to be in an LP that was going to charge you a carrier, which a lot of these guys want to do. You need to be an accredited investor, which is, they’ve just changed the threshold recently, but it’s like millions of dollars in investible assets, which most people don’t have.

Tobias Carlisle (00:55:12):
But you’ll be able to get access to managers through ETFs like Kathy Wood, a great manager. She’s run that portfolio really well, run it up and there’s $50 billion worth of money invested with her. So a lot of people have participated alongside her. I think that there are lots of value guys who are probably starting ETFs now that I think that there’s one of them will have a, or a few of them will have a really good run over the next few decades. And the average investor will be able to participate alongside them. I think that, even though that’s a technical change, the practical implications of that are huge for the average investor.

Tobias Carlisle (00:55:45):
As for the worst thing, it might be that there’s all of this new competition coming in value ETFs from these new managers, some of whom are going to do really well. And I like it. It’s more of an exclusive club selfishly that… I’m joking, but I think it’s a great vehicle. And so I think it’s all good.

Wes Gray (00:56:01):
I literally do three or four calls a day with people that want to launch ETFs now because we’re a manufacturing business, we help people get to market. And to Toby’s point, there are some amazing talents coming to market. Where normal in the old days that have been a hedge fund, tax-inefficient, high fees. And now you’re going to be able to access these great talents at low fees, global access, tax-efficient, right?

Wes Gray (00:56:30):
So it’s amazing. ETF’s great for investors, but to our prior conversation, what is so terrible about ETF? Well, it’s the same thing that’s terrible about access is, now you can trade it every day. You can move in and out of it every day. That’s the issue, it’s a behavioral problem. So even though the investment opportunities and the cost to access them came dramatically down, it doesn’t matter because people are going to screw it up by day-trading the value managers now. I start to feel like Jack Bogle here. People screw things up because they’re people. You could bring the horse to water, they don’t drink it. They just avoid your advice and go eat cyanide, I guess.

Jake Taylor (00:57:15):
Maybe you guys could cite the CGMs mutual funds results from 2000 to 2010 as an indicator of how bad that behavioral friction is.

Tobias Carlisle (00:57:27):[Cross-Talk 00:57:27]. Yeah.

Jake Taylor (00:57:27):
Yeah.

Tobias Carlisle (00:57:28):
That’s in quantitative values and it was like the fund outperformed by 18%.

Jake Taylor (00:57:32):
Yeah, that’s why I’m teeing it up for you guys here.

Tobias Carlisle (00:57:34):
The fund was at 18% a year and the individual investor in it was, 11% a year negative because the fund was volatile and had this gigantic run-up at the end. And so most people just traded it the wrong way. When it was up, they sold them, when it was… Sorry, the other way around. When it was up, they bought it. When it was down, they sold it. Turned an 18% compound into 11% negative.

Wes Gray (00:57:54):
Ben Johnson, I think he’s one at Morningstar, has a cool study where they look at over a 10-year period, the best performing funds. And then they look at how the Morningstar rankings and all of that stuff go. And literally, the top-performing funds, that usually it’s the case that only two out of three years they outperform the market. So that usually in a 10-year window, they have seven years of egg on their face. But that’s how it normally works. In order to outperform, you have to do crazy weird stuff and have a horizon. And so there’s just a trade-off. If you want to win and be the best over the long haul, you got to do weird stuff and it’s got to be unique and you got to be ready for the stats say, seven out of 10 years. And that’s not fun for a lot of people, which is the fact of the marketplace.

Stig Brodersen (00:58:44):
All right, gents, this has been a great conversation as always. We never have a chance to hang out with you. Before I let you go, I’d like to give all of you an opportunity to let the audience know where they can learn more about you. Wes?

Wes Gray (00:58:57):
alfaarchitect.com. And if you want to launch an ETF, etfarchitect.com. Pretty simple.

Stig Brodersen (00:59:04):
All right. Jake?

Jake Taylor (00:59:06):
My investment shop is farnam-street.com. Got a book: Rebel Allocator on Amazon. Kind of fun podcast with Toby every week, Value: After Hours. And that’s, yeah. Just say hi on Twitter at farnamjake1 and not too hard to find. Well, I should probably try to be harder to find someday.

Tobias Carlisle (00:59:25):
JT undersells his book. Charlie Munger read Jake’s book and liked it so much, he gave him a call. He called him up and had a chat with him and he’s trying to help him make it into a movie. So if you haven’t read that book, you should go and read that, it’s a good book and you should come to acquirersmultiple.com, which is my website where the podcast that I do with Jake is hosted. You can hear the man who spoke to Charlie Munger and hear what he has to say.

Tobias Carlisle (00:59:49):
I run two funds. One is called the Acquirer’s Funds ZIG, that’s mid-cap and large-cap US equities, US value, deep value style, and Deep, which is small and micro, the same strategy just in a different universe with a little bit more diversification. And I’m on Twitter at greenbackd, G-R-E-E-N-B-A-C-K-D. I think that’s it.

Stig Brodersen (01:00:11):
Fantastic. All right. As always, make sure to follow us. If you’re watching this on YouTube, make sure to subscribe. And gents, I guess I’ll see you next quarter.

Tobias Carlisle (01:00:20):
Sounds good.

Jake Taylor (01:00:20):
Thanks, Stig.

Wes Gray (01:00:21):
Look forward to it.

Outro (01:00:23):
Thank you for listening to TIP. Make sure to subscribe to Millennial Investing by The Investor’s Podcast Network and learn how to achieve financial independence. To access our show notes, transcripts, or courses, go to theinvestorspodcast.com. This show is for entertainment purposes only. Before making any decision consult a professional. This show is copyrighted by The Investor’s Podcast Network. Written permission must be granted before syndication or rebroadcasting.