The 60/40 Portfolio Is DEAD — Here&#39

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Transcript

Welcome And Guest Background

SPEAKER_01 0:04

But I always like to talk to Alex, and I think this is gonna be a well-timed conversation because uh a lot of people are talking about stagflation and maybe a return of 2022, which would be hell if that's the case. We'll uh we'll get Alex's thoughts on that. Um, and again, folks, uh feel free to comment. So uh Alex, you and I have done these lead live episodes for a while. Uh I know a lot of people have seen them and are familiar with you, but maybe a quick uh bio and background on you, on your funds, uh, and then we'll get it right into the conversation.

SPEAKER_02 0:31

Uh sure. Uh our firm is Evoke Advisors. Uh, we manage about$20 billion for ultra-high net worth and institutional clients. Uh, I'm one of the co-CIOs and I've been an advisor for 27 years. Sounds like a long time when you when you say it out loud. And uh and we created two uh risk parity ETFs, uh, which is a strategy that I've been using with my clients for 20 plus years, but about seven years ago we figured out it'd be more efficient to take that strategy, wrap it inside of an ETF vehicle. And and so we have RPAR and UPAR, which is a more levered version of RPAR uh available.

Stagflation Risks And The 1970s

SPEAKER_00 1:11

Okay, let's get right into it.

SPEAKER_01 1:12

Um actually just I'm gonna put out a piece in the next hour on the lead lag report, arguing that uh stagflation when you're starting point for US government debt of around 40 trillion doesn't really work that well. Um and there's a lot of concern around a stagflationary environment based on the very short-term dynamics of what we're seeing with oil and stocks and bonds. Uh, first of all, I want to get your historical perspective on prior stagflationary cycles, what that means for asset allocation, and if you yourself personally think uh there's a real parallel to today.

SPEAKER_02 1:43

Well, the closest parallel is the 1970s. So that was an extended period of stagflation. And and during that decade, if you look at the entire decade of the 1970s, I think what's really instructive is the stock market, global stocks, and the bond market both underperform cash for a decade. So if you're trying to diversify with stocks and bonds and you do experience something similar to the 1970s, which is the classic stagflationary environment, there's a decent chance that you'll be disappointed. And so I think there is a reasonable chance that might happen. Uh growth has been pretty resilient for an extended period of time. So there is some downside risk to growth. Um, and there's some concern about AM may have a hand in that. Uh, we don't know. Uh inflation has been low and stable since the early 80s. And in uh 2020, we had COVID, we had massive stimulus, inflation spiked for the first time since the early 80s, and then it came back down. Um, it ended up being transitory after a couple of years. Um, but still it's above target and it's been above target nearly five years. And if you and you mentioned the the deficits and the uh ballooning debt, you know, the least painful way out of your debt problems is especially if you're the world's reserve currencies, to print more currency and inflate your way out of your problems.

SPEAKER_00 3:04

Uh discount counted inflation for the next decade is only a little bit above 2%.

SPEAKER_02 3:16

So it seems like if you just take a snapshot today, what are the odds that inflation surprises to the upside for the next decade? I think it's probably above 50%. And what are the odds that growth surprises to the downside? It may be 50% or more. If those two both coincide, that's stagflation. And uh if we go back to the 70s, not great for stocks and bonds. Um, and then we can get into well, what do you do if that actually transpires?

SPEAKER_01 3:46

I know it may not be exactly um something that we can relate to uh your risk parity ETFR part, but I am curious to hear um your thoughts on how that interacts with the disinflationary dynamics of AI. Uh, you know, I have talked about this before. I've you know been preactive uh using perplexity in particular to automate things. This is the year of agentic AI. I fully believe that now, given the automations I'm doing, um, and it's gonna be disinflationary, even though there's obviously a cost in setting up the AI side of a business. Um rising oil is inflationary, although I would argue that depends on the speed of oil, because it could be a growth shock if the more it spikes, versus the disinflationary impacts of AI. Uh, we've never seen a cycle quite like that, no?

SPEAKER_02 4:29

Uh I I think you're right. Also, you know, we had an extended period, decades of globalization, and that has shifted into reverse, and we're probably in more of a structural de-globalization phase, and that could be more inflationary. So you you have these massive cross currents. You mentioned AI, uh, obviously uh oil prices more recently, um, and then the structural shifts of uh de-globalization. And also remember, there is this incentive to create more inflation, however way we get it, uh, because we have these massive debts and the debt service is becoming you know a very high percentage of our total spending. So uh how it all nets out is hard to know. Uh, but at the very least, I would say it's relatively clear that there is risk that inflation surprises the upside because the market isn't discounting much inflation.

SPEAKER_00 5:24

It's supposed to be the case that stocks are uh certainly more of an inflation hedge than bonds.

SPEAKER_01 5:30

Um that was not the case in 2022, was also not the case in the 70s. Um how do how do stocks historically perform in in conditions like that?

SPEAKER_02 5:40

Well, there are different types of stocks. I I'd say the the overall global stock market, if you just look at the data, has historically not done well during uh periods of heightened and extended inflation like the 1970s. I mentioned underperformed cash for a decade. I think that's a pretty clear case because it was a long enough period where maybe short-term impacts beyond inflation uh net out. So I think that was a pretty good case uh of inflation being a negative for stocks. But there are components of the stock market. So, for example, uh I separate out uh commodity producer equities, you know, the companies pulling the commodities out of the ground. Their price is heavily influenced by the commodity price. So in the 1970s, that subsegment of global equities actually did pretty well. Uh, it did well in 2022, it's doing well this year. Um so I think of I basically take equities, split them into two. There's commodity producer stocks, and then all the other equities. And you can just take like the index. And because I think those two are actually diversifying to one another. Um, so I think that is a that's an important component of diversification, is think about what drives returns of these assets. In general, inflation isn't great for stocks because the cost of things is is higher. And not all of that can be passed through to customers. So you'll you probably get some shrinkage of uh margins.

Gold As A Currency Hedge

SPEAKER_01 7:00

Speaking about AI, it's not to have AI uh very quickly produce this chart for us to talk through. Look at asset class performance from 1973 to 1982. Uh, there might be some hallucinations in this, folks, but I think this is largely correct. Now it can can verify given he wrote a whole book literally on uh risk parry. But um let's let's talk through this a little bit because um certainly gold has performed quite well, right? Maybe in anticipation of this. Small caps, not housing, debatable what happens going forward. But I look at this and it doesn't quite look like you know an exact parallel to what's happening right now. Um yeah, I think I think that's right.

Why 60/40 Breaks In Inflation

SPEAKER_02 7:34

Uh you you mentioned gold. Uh, you know, one thing that I think is really underappreciated by gold, because people talk about it now and and how it's how well it's done. You know, last year was the best year since 1979. You know, maybe the market is telling us something there. Um, but since we came off the gold standard in 1971 when it became free-floating versus the dollar, the return of gold for 50 plus years is near the return of global stocks. Uh, that might surprise a lot of people. Um, and it did exceptionally well in the 1970s, up over 30% a year. And then the 80s and 90s, when we had disinflation, falling interest rates, strong growth, almost the opposite of the 70s, gold was negative. Um this decade so far, it's been the it's outperformed equities, it's outperformed equities, it's outperformed the SP 500 since uh the turn of the millennium, you know, 25 plus years ago. Um, so it is an interesting asset class. And and I don't even think about it because there's concern about things like gold where it has no cash flows, it doesn't have much industrial use, it's just a shiny yellow metal. Uh, how can this outperform the best companies of the world? I don't think of it so much as gold going up. I think of it as paper currencies going down. And there is a great incentive for paper currencies to go down, especially in the developed world where there's all this debt. Um, and and I think that changes the dynamics. And again, that feeds into what does it mean to be diversified? Um, it it is it is a different world today than it was 10 years ago. Um, and it's not just what's happening, you know, currently, but just structurally, we're seeing these shifts. And so I think all of that has to factor into your thoughts about diversification.

SPEAKER_01 9:10

And and you know, you can't talk about diversification without talking about a 6040 framework. Um, and it seems to me, correct if I'm wrong, that um if there is going to be one parallel to 2022, it probably is that 6040 is not the the optimal place to be.

SPEAKER_02 9:26

Yeah, and a parallel to the 1970s. So the 60 and the 40 underperformed cash for a decade. Uh 22 was a tough period because you had massive tightening uh over a short period of time. So that's more akin to 81, 82, when Volcker came in and hiked interest rates uh massively. Um the 70s, we had this extended period where inflation kept surprising to the upside. It was a gradual increase in rate, a gradual increase in inflation. Um, and what's interesting about the 70s is nominal rates went up significantly, but real rates actually fell for the decade because inflation was rising faster than interest rates. Um, I think something like that could easily happen again. And the reason that's important is when inflation is a factor, you know, remember for decades it was not a factor. Inflation was low and stable, so it didn't really move very much. So what moved was growth. Yeah, growth surprises to the upside, growth surprises to the downside. 6040 is depending on stocks and bonds being diversifying. They are diversifying when inflation doesn't move very much, and growth swings around because they have a different bias to growth. So it they are diversifying in that regard. But in periods where inflation is uncertain, volatile, um, and can move around a lot, both stocks and bonds have the same bias to inflation. So stocks and bonds were more correlated in the 70s than they were like in the 2000s, for example. So, in that type of environment, when inflation is uncertain, especially if it's surprises to the upside, because they both do poorly in that environment, uh, it is important to have inflation hedge assets as part of your framework for building diversified portfolio. And that's one big shift that I think investors are starting to recognize.

Diversification Without Giving Up Returns

SPEAKER_01 11:06

Hedge is always an interesting word because obviously it assumes that I think um if uh the hedge is constantly a hedge. Uh and the reality is you and I both know correlations change. Hedges of old may not be the hedges of the future, or at least not be as effective. Um I want to talk about how to think about portfolio construction, uh, maybe not from the same point of hedging, but factors, right? Um let's start with the risk parity framework here.

SPEAKER_02 11:32

Uh so there, I think a really important point here, which is the my sense is the assumption about the concept of hedging is that it costs you returns. And and what I mean by that is the framework most people use for constructing a portfolio is they start with a critical assumption, which is returns come from stocks, especially US stocks. That's been the focus more recently. Everything else is diversifying, but it has a lower expected return. And so you sacrifice return. So there's this there's a viewpoint of there's a trade-off between returns and diversification. So if you want, if you want to control your risk, you add all these other diversifiers, but you have to you have to almost accept the fact that your return will be lower. So that's the that's the traditional mindset. And I think that's not accurate. Um, over time, a lot of these assets actually can generate returns that are competitive with equities. Uh, so non-U.S. equities, emerging market equities actually have a comp can have a competitive return with U.S. stocks. We've just seen US stocks outperform, but people forget in the 2000s, US was one of the worst countries to invest in. The last time we had a technology boom and bust. Um, I mentioned gold, competitive with equities. Commodity producer stocks are diversifying. They've actually outperformed global equities for over 50 years. Um, even assets like treasuries and tips uh that have different biases to uh inflation uh versus one another, and they're both good downside growth uh assets. I think people would be surprised what the returns have been over a very long period of time. Um, we know they've been negative the last five years, but yields today are the highest they've been in about 15 years. So you you put all those assets together, the they don't negate each other. So you don't get it like a zero return. You actually get the average return of all those assets. And I think a lot of those assets have generated returns that are competitive with equities. And you put all that together, and the hedges, quote unquote hedges, may actually increase returns. If you look at, if you look at where most people are overly concentrated, it's US stocks. You look at valuations of US stocks. A great predictor of long-term returns is starting valuations. And today starting valuations are among the highest we've seen in 100 years. So there's a reasonable chance that the SP over the next 10 years won't generate anything near what we've seen in the last 10 or 15 years. And if that's the case and you add all these other diversifiers, they could actually lower your risk and increase your returns. And I think that's why it is something that is of great interest today.

SPEAKER_01 14:03

You're hitting on um something which is important, which is uh nominal versus real, right? So you could have conceivably stocks e positive, but to your point about the incentive of government is to always print more, uh, they may print more than the stock market returns, which means you're actually losing.

SPEAKER_02 14:20

And that's basically what we've seen in the last 25 years. Um, and it's very possible that continues. If you think about it, when you have excessive debt and you're spending more than you're earning, there's only so many ways to get out of that problem. And especially if it keeps getting worse, that you're kicking the can down the road, but eventually you're going to reach the can. And it seems like the market is for the first time starting to push back on this uh, you know, the fiscal uh spending and overspending. And you can you can default, uh, you can try to grow your way out of it, and maybe AI provides that productivity miracle that allows us to grow out of it, but that's a long shot. Uh, we hope it happens, but it'd be a risky bet to put it all on that. Uh, but in inflating your way out of it is the least painful way. That's much less painful than a default, even though it's effectively the same thing because you're basing your currency.

SPEAKER_00 15:20

Um, but it is the least painful way.

SPEAKER_02 15:22

And and so at the very least, you want to quote unquote hedge against that. And the way you hedge against that is non-dollar assets, real assets like commodities, gold could be a great hedge against that because it at the like the ultra currency that is a countercurrency and has no uh counterparty, it's the oldest currency in the world. And again, it it's you're betting that currencies go down, paper currencies go down versus something that is a real storeholder wealth. And then putting all that in your portfolio is just a way to allow yourself greater probability of compounding wealth through time and not putting all your eggs in one basket, which is what most investors do in the US equity basket.

SPEAKER_01 16:39

Okay, let's talk about um construction. Um, some people have heard of the permanent portfolio, right? 25% across all these various asset classes. Risk parity is different in that um you're weighting it based on the historical volatility. So talk through that that first of all, the the the the very idea behind it, why that matters and um maybe why that's an opportunity.

SPEAKER_02 16:59

Well, let's start with the one of the big flaws in 6040, which I think is really misunderstood. You have 60% in an asset that's very volatile, 40% in an asset that doesn't move very much. And so you're overweighting the more volatile asset. As a result, 6040 is about 98% correlated to 100% stock portfolio because you're overweighting that more volatile asset. So directionally, the success or failure of 6040 is going to depend almost entirely on whether the stock market has a good period or a bad period. And those good and bad periods could last a decade or longer. We mentioned the loss decade in the 2000s, the 1970s was a loss decade where cash is better than stocks. You could easily get a loss decade the next 10 years. So volatility matters. And the reason it matters is because you have to think about what drives the returns of your portfolio. And the whole point of having diversification and having a balanced portfolio is you're diversifying the drivers so that one type of environment doesn't determine whether you have success or failure. So I think of a risk parity as synonymous with a balanced asset allocation. Uh, I don't think it's any more than that. And I think of it as there's three steps of how you construct a risk parity portfolio. Uh step one is pick diverse assets. So uh so for our PAR and UPAR, we use uh global equities, uh, commodity producer stocks, gold, tips, and treasuries, long data tips, long data treasuries. And it's because they have very different biases to growth and inflation. That's the real thing you want to diversify again. So that's step one. Pick diverse asset classes. Step two is you have to risk balance them. And what I mean by that is some of these assets have low volatility, some of them have high volatility. You have to overweight the less volatile assets, you have to underweight the more volatile assets so that you have equal risk contribution. And it doesn't have to be precise. Some you just know are more volatile, some are less volatile. You just own more of the less volatile, own less of the more volatile. It sounds counterintuitive, but that's how you balance the risk. That's how you balance the exposure. So that's step two. Uh, and then step three, because now you have a balanced portfolio, that portfolio may not have the return target that you're seeking. Now you can lever that balanced portfolio to whatever degree you want. Um, so one of the challenges with 6040 framework is if you want more return than 6040, you go 8020. Now 80 20 is even less diversified than 6040. Whereas with a risk parity framework, once you have that balanced mix, you can lever it to different uh levels of return and risk targeting. And that diversification is the same, whether it's lower risk, moderate risk, high risk. The sharp ratio is the same, the return to risk ratio is the same. And that's a much more efficient way to try to achieve returns because you're just taking advantage of one of the first principles of investing.

SPEAKER_00 19:46

Don't put all your eggs in one basket, stay diversified, and that's the framework that allows you to do that. I mean, that could be an entire portfolio, obviously, right?

Leverage A Balanced Portfolio

SPEAKER_01 19:58

Um, as a core uh framework. Some people looking at risk parity may have it as just a fund or an allocation, but I mean that's that really is sort of the idea behind the whole portfolio. Now, in order to achieve that um that kind of diversification, you may need to actually use leverage, which is a little counterintuitive, um, because people think about leverage in terms of uh taking concentrated bet as opposed to you know diversifying port.

SPEAKER_02 20:20

Yes. And and I don't think of it as levering any single asset class. I think about it as levering a balanced portfolio, which is very different from levering something concentrated. Because something concentrated can experience a significant drawdown, it can underperform for a decade or longer. And a balanced portfolio that's properly balanced, the risk of a significant drawdown or an extended period of underperformance is much lower. And so if you're levering that and you have obviously proper collateral and significant cushion, that is if you, especially if you can lever it with the and the cost of financing. Like in our par it's cash because we use futures to get the leverage. And so if a balanced mix of assets beats cash over time, then a levered risk parity portfolio should outperform an unlevered risk parity portfolio. That's the math. Um, it doesn't, you know, cash doesn't always underperform a balanced mix of assets, like 22 was an example. Um, but in the 70s it did in every decade 80s, 90s, 2000s, 2010s, so far this decade, uh, even this year. Um so so I think you have to think of it that way. Um and and the leverage, you know, the problem with leverage is when you do when you leverage something that's highly volatile and concentrated, you can just you you you can be forced to sell when it's when it's at the lows. Um when you're levering a balanced portfolio, it is obviously you're there is always a chance, but the risk is uh materially reduced.

SPEAKER_00 21:49

So you've got these two funds, you've got RPAR, RPAR, and then UPAR.

SPEAKER_01 21:53

Uh talk about the differences there. Um and if you were gonna be yes, they're both your children, but if you're gonna be more optimistic on one over the other in this environment, uh, which do you think uh is the most interesting?

SPEAKER_02 22:07

So I think of RPAR and UPAR as tools in your toolkit as an investor to build a more diversified portfolio. Uh so you so you mentioned something earlier, which is absolutely true, which is it could theoretically be the entire portfolio. I think that's unrealistic in practice. So I think you know, I always divided it up into what does the math say? And the math I think is be diversified. There is a higher return to risk ratio, it's a more efficient way to take risk. But in practice, it's hard to do it because a balanced, a truly balanced portfolio like a risk clarity portfolio, is not going to zig and zag with the stock market. It's going to look different from a traditional allocation. So there is some, good, there's going to be significant divergence between what the typical reference point is. And so people may go through stretches where they feel very uncomfortable with it, they sell it, they go back to a less diversified portfolio. And then when that does poorly, they go back and forth. And you're not going to do very well over time by following that discipline. So I think of RPAR and UPAR as tools in the toolkit to take a step towards being more diversified. So I think you have to try to understand what it means to be more diversified, appreciate that it's hard to do in practice, and take whatever your strategy is today, and you can add some RPAR or UPAR, if you want a more levered version, to take a step towards more diversification, see how it goes, understand, try to uh understand the behavior of that type of portfolio. And over time, maybe you gravitate towards more diversified allocation. And the only difference between the two is RPAR, we think of it as an equity-like expected return with 60-40 type risk. And UPAR is equity-like risk with an expected return that is uh maybe a couple points above equities. Um and it's in directionally, they move almost uh in locksteb, um, but uh UPAR will be more volatile. Uh so it depends on your risk appetite. And and you ask which I favor this environment. I think of both of them as basically the same thing, except one is more levered. So if you think that that a balanced portfolio will beat cash, then RPAR should beat an unlevered RPAR and UPAR should beat RPAR. That's the math behind it. And my my thinking is over time, I have pretty high confidence that a balanced mix of assets will be cash. And so I generally prefer UPAR, but the caveat there is you have to be willing to hold on for the ride. It's vol it's equity-like volatility. So you have to fasten your seatbelt. And if you're prone to uh jumping out at the lows, then it's probably not the right investment for you. It's probably RPAR and maybe some combination of RPAR and cash or something, lower volatility. Uh, for me personally, I can I can handle the ride because I've I I've seen it through a very long period of time. Um, and so I would favorite uh the more volatile one, but that's uh personal preference.

Links, Webinars, And Closing

SPEAKER_01 25:01

I like as you were saying that I heard like a car revving in the background. Yeah, if I there you go. Uh Alex, for those who want to learn more about the funds, where would you appoint them to?

SPEAKER_02 25:09

Uh our website, rparetf.com. Um, and uh so there's a lot of information there. We do quarterly uh webinars to uh provide an overview of the strategy and a recap of performance. So that's uh uh the replays are available there. Uh and then invokeadvisors.com is our advisory website. I also have a weekly podcast. We don't, it's not just about risk parity, you talk about a lot of other things called the Insightful Investor.

SPEAKER_01 25:37

Uh, which I encourage everybody to uh to subscribe to on that podcast and of course learn more about RPAR at rparetf.com. Uh stay tuned, folks. Uh, gonna be uh back to back with another podcast being live very shortly. Uh as always, I appreciate the time here with Alex and hopefully uh all of you enjoyed the perspective. Uh thank you Alex, appreciate it.

SPEAKER_00 25:53

Thank you. Cheers up