Jay Hatfield, InfraCap — Income, Infrastructure & Covered Call Strategies

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Transcript

Live Setup And Market Backdrop

SPEAKER_01 0:05

Morning, everyone. Uh, give me a second, as always. I gotta make sure we are streaming live. Uh the challenge with um this big AI pivot I've done is I've got like 70 agents running at the same time while interviewing people uh on Lead Lag Live, which is live, so that means if any of you have any questions as if you're watching this, feel free to post them on X, LinkedIn, or YouTube where this is streaming. I'm happy to uh bring that up here. Um I have been traveling nonstop the last six, seven weeks, so I am a little bit delirious. But the good news is uh Alex is not delirious, and he's gonna go through a lot of things when it comes to uh the current cycle and the current environment. We just went through a hell of a rebound on a very short-term basis. Uh, and uh, if you haven't noticed, oil is still making making higher highs, and I think stagflation's on everyone's mind. So I think uh this will be an interesting conversation to talk about uh where we are in terms of the cycle, how to play it, and risk parity as a framework, which those who've seen Alex before know that that's his uh his main thing. So, with all that said, my name is Michael Guiatt. I'm the publisher of the Lead Lag Report, founder of Lead Lag Media, and overall, uh uh I guess somebody who just does not relent and just keeps on grinding out. Uh I've got Mr. Alex Heedy of Evoke uh with his ETF RPAR, which is having a nice run, and I think as a framework is one that's definitely worth thinking about. Let's um let's get into that cycle question, Alex, for a little bit here. Um, because that's the sort of topic du jour. Uh I feel like we went through the stagflation concerns in 2022, then we went to growth, and now we're maybe back into a stagflationary uh narrative. Uh first of all, I think we should define what exactly stagflation is and what are the risks of an environment like that.

What Stagflation Really Means

SPEAKER_00 1:37

Uh sure. Uh stagflation is not something we've really talked about since the 1970s at length, but it's basically weak growth and persistently high inflation. So it's like in that in the 1970s, growth was relatively weak for an extended period of time. Inflation just kept going up and up and up. The Fed was raising rates, but one thing that people don't recognize is if you look at uh the movement of interest rates from January 1970 until early 1980s, it just kept going up and up and up. But real rates actually fell. And what I mean by that is nominal rates were going up than the number most people focus on, yet inflation kept outpacing that. So real rates actually fell. So, and the reason that's important is because that is a very different type of environment from what we've been used to the last four decades, where inflation wasn't really moving around very much. It was basically low and stable for an extended period. Uh, and the reason it matters is what uh what is cons what works in terms of diversification in the in a period where inflation is uncertain is very different from what works in terms of diversification in other periods. Uh so in the 1970s, as an example, the stock market, global stocks, and the bond market both underperform cash for a decade. So if the two tools you use to try to build a diversified portfolio is stocks and bonds, you probably wouldn't have done very well in the 1970s. And you're seeing some of those uh examples arise again uh more recently. Um, and and so I think you have to really think about are you actually diversified? Um and uh that's something I think is worth uh exploring further.

SPEAKER_01 3:19

Is it fair to say that um 60-40 fails the most in a stag inflationary environment?

SPEAKER_00 3:26

Uh I don't know if it's the most, but think about the 60 doesn't really protect you in a rising inflation environment, and the 40 doesn't really protect you. As I mentioned, both of those did worse than cash. So you would have been better off just holding a money market fund in the entire decade of the 70s, which I think is the most relevant example for what may come in the future,

Why 60 40 Can Fail

SPEAKER_00 3:46

uh, or at least there's a risk of that uh transpiring. And it I think it's very instructive to recognize that stocks and bonds have the same biased inflation. They tend to do better when inflation surprises to the downside. And you really have to think about the surprises. That's what really moves markets. It's not what it's not the level, it's not, it's not uh where things transpire. It's what happens versus what was expected. So, so part of the reason the 70s stocks and bonds and worse than cash is because inflation wasn't expected and then it happened. And then in the 80s and 90s, you had a historic bull market for both stocks and bonds because people were expecting inflation to be high for an extended period of time, and instead it just kept dropping and dropping and dropping. So, so where are we today looking forward? Inflation expectations are not very high. Despite the fact that inflation has been above target for the last five years since 2021, the market still is placing a lot of credibility in the Fed and its ability to fight inflation. And yet we're still above target. Uh, so uh so that is, I think, a really important point, which is if you think inflation may surprise to the upside, or you think there's a meaningful risk of that, the natural next step is well, I need to incorporate assets that do better when inflation surprises to the upside. Stocks and bonds are not those. So if if that's a concern, you should incorporate other inflation hedge assets into your portfolio. And that's just to get to neutral. You know, so if you think the odds are 50-50 inflation surprises to the upside, you should have a neutral allocation to inflation hedges. If you think it's greater, you should have more than neutral. Most people think of neutral as zero. That's not actually a diversified

Inflation Surprises Drive Returns

SPEAKER_00 5:28

portfolio.

SPEAKER_01 5:31

I think part of this is also sort of um the nuance of uh a demand shock uh versus a supply shock, which is shock is another way of saying surprise, right? Um this is arguably uh the concerns around a supply shock, right, with with oil. Although that's even that's nuance because the supply shock you know more impacts Europe than it does the US, conceivably, because we have much more oil being produced here. But um how does a how does a how does diversification uh alter based on those types of surprises, or does it not matter whether it's a supply shock or demand shock?

SPEAKER_00 6:00

Yeah, I just think of it as is inflation higher or lower than what was expected? And so far it's been higher regardless of the cause. So if you get a supply shock and it's deemed to be temporary, maybe the price comes back down. Uh that that's what happened in uh 21, 22, 23. Um, but you just don't know. You don't know what the long-term impact is, you don't know where the where the price is going to go, you don't know what the how long the shock is gonna last. Um so there's just a lot of variables. And I just think of it as you're trying to build a diversified portfolio. Recognize what drives the returns of all these assets. Some assets do better when inflation surprises to the downside, and others do better when inflation surprises to the upside. Geopolitical tensions are elevated. Uh, this is just another example of what we're going through today, but we've seen it uh you know in prior years, and we may see more in future years. So if the risk is elevated, it just to me it doesn't make sense to not have any exposure to those assets that tend to do better in those environments. So I think of this year and particularly first quarter as another example of that.

SPEAKER_01 7:12

Okay, let's talk about um risk parity in

Diversifying For Supply Shock Risks

SPEAKER_01 7:15

that framework. What exactly risk parity is? Um and and if risk parity maybe has a uh a better time in quotes in stackflationary environments.

SPEAKER_00 7:25

Uh so the way I think about it is there's basically I think of risk parity as just a balanced portfolio. Uh I prefer to call it a balanced portfolio rather than risk parity. I think it's easier to understand. But balanced portfolio has been, in my opinion, misused for decades, where 60-40 is considered balanced and it's not balanced. It has no inflation hedges, uh, and it's 98% correlated to stocks. So that points to two major flaws. Uh, the first is it doesn't have a diverse mix of assets. So uh you should own inflation hedge assets that's part of that diversified portfolio. So that includes you can own stocks and bonds, but you need to own other things like commodities, including gold, uh, which is kind of different from the other commodities, uh, and then also inflation link bonds. So I think you need to incorporate those into an allocation and then you need to risk balance them. And this is really important. And basically what that means is you own more of the less volatile assets and own less of the more volatile assets. And the reason you do that is because if you so 6040 has, you know, 50% more in the more volatile asset. And it's not just a little more volatile, it's a lot more volatile. So the total return is almost entirely determined by how the more volatile asset does. In a good period, 6040 does great. In a bad period for stocks, it does terrible. Uh and it's just that it just mutes the returns of equities. Uh so if you have a more balanced mix of assets, including inflation hedges, and then you own

Risk Parity As True Balance

SPEAKER_00 8:54

more of the less volatile ones, own less of the more volatile ones, uh, then you get to roughly equal risk contribution. There's no precision here, just be just directionally. And then now you have a balanced portfolio. And then to and then you think about returns and risk, and then you can effectively lever that balanced portfolio to different levels. And that's a more efficient way to achieve the risk premiums inherent in uh public market assets going long, as opposed to trying to uh own stocks, diversify with lower return, lower risk bonds. And then if you want higher returns, you have to own more stocks, which makes you even less diversified. So I think it's just a flawed framework. And in periods where uh inflation isn't a problem, you can mask the flaws because you you don't really necessarily need the inflation hedges. But in a period where inflation volatility is real, there's a lot of uncertainty, discounted inflation is low. So the risk that inflation surprises the upside is greater. Uh, for all those reasons, it makes sense to be more diversified. And if you do it appropriately, you're not necessarily giving up returns by being more diversified if you follow the framework that I just described.

SPEAKER_01 10:04

So I know you're not a fan of predicting.

SPEAKER_00 10:07

Um there's a reason there's a reason for that.

SPEAKER_01 10:10

I know as as as the old Yogi Bearer quote goes, uh predicting is hard, especially about the future. Um, which I think is accurate. And I always try to frame things in terms of conditions making the probabilities of something higher or lower, but even that probability is always changing, nobody knows the exact number. So even that's a little wishy-washy in fairness.

SPEAKER_00 10:26

And the probabilities are never really high to begin with.

SPEAKER_01 10:29

Yeah, I think that's right.

SPEAKER_00 10:30

And and especially over the near term. I think the probability of guessing where the market's gonna go over 10 years is probably easier than over one year.

SPEAKER_01 10:39

That's probably right, yes. I would I would tend to agree with that. Um but still I'm gonna ask you this question. Um what do you think the um the biggest danger is right now? Or maybe I should frame that as what's the narrative tell you is the biggest danger right now.

The Biggest Danger Is The Surprise

SPEAKER_01 10:54

Uh is it this concentration risk in equities, right, with the top names driving so much of the SP? Um, is it duration risk in bonds given inflationary concerns? Although I will say it's interesting that I would expect yields to have been a lot higher despite oil doing what it's doing, but yeah, maybe it's a gross slowdown scare. Uh or is it um that maybe the other risk is the one that nobody thinks is likely, which is some kind of deflationary shock?

SPEAKER_00 11:18

Um so I'll I'll give you two answers. I'll I'll give you what I think is the real answer, but I don't think it'll be satisfactory. So I'll give you a secondary answer. So I think the real answer is it's none of the above. It's a thing that nobody's thinking about, which I can't, I don't even know what that is. So so I think of like the biggest risk is the risk that isn't on people's minds. That's usually the thing that surprises the markets the most. Uh, and again, it's the surprises. So, like what I what I've learned through you know many decades is that it's the thing that really moves the markets is the thing that most people weren't thinking about because that's the surprise. So, like, for example, if everybody's expecting a recession, you get a recession, it really doesn't move markets very much because it's already discounted or it's at least thought of, it's on the radar. So I think the real answer is nobody knows. So so that's the real answer, but I don't think that's satisfactory. So so I think that, you know, uh it uh in general, I feel like we're in a highly uncertain environment. Uh there's a lot of unknowns. So there's major factors at play. So there's geopolitics, uh, there's the impact, both positive and negative, of AI. Uh, is it inflationary in the near term because of all the spending? Is it deflationary in the long term? Is it deflationary because it lowers the cost of doing things? And is it also deflationary because it puts people out of work? Um, so that's a big, big factor. Uh, what is the impact of going from a world of globalization to deglobalization? I would think structurally, that's more inflationary, as there's less of a priority of lowest cost versus uh what's more resilient and trying to do things in-house rather than uh uh bringing it from wherever is the lowest cost producer. So that's probably more inflationary. Um, obviously, geopolitical uh shocks and inflation shocks, those are all inflationary. Uh so I think you have major forces at play. And how it all nets out in terms of growth and inflation uh is highly uncertain. I think the Fed is you're seeing evidence of that. They don't know which way to go. They're gonna cut rates, now maybe they're gonna raise rates. We don't know. There's just too much uncertainty. So I think all of that uncertainty, plus the risk, I'd say, of outsized outcomes, you probably have a greater risk of extreme outcomes today. So all of that, I look at that world and I say, really hard to figure out where we're gonna go. You should be super diversified. And then I look at where are most people? They're probably less diversified today than they were 10 years ago. There's a greater allocation to equities, and largely because they've run up a lot. There's a greater allocation to US equities within the equity complex. And then there's a more greater concentration within US equities, you know, across the Max 7 or Max 6, whatever you want to call them. So I look at the world, probably good to be really diversified, and I look at portfolios very concentrated. To me, that is a huge risk, where it's the concentration that can destroy wealth. It creates wealth, but it can also destroy wealth. And that's probably the greatest risk that I see.

Concentration Risk And Extreme Outcomes

SPEAKER_01 14:27

Let's talk about um RPAR here, your ETF uh on a risk parity uh basis. How's it constructed? How do advisors use it? You know, what's the case for it right now?

SPEAKER_00 14:38

Um well, I think the case is what I just described, which is it makes sense to be diversified. And diversify and and also I think it's important to understand what it

How RPAR Is Built And Used

SPEAKER_00 14:48

means to be diversified. I think a lot of people feel like they are diversified, but it may, they may have the wrong reference point. Diversification, by definition, you have to have inflation hedge assets in your portfolio. Uh, inflation is all of a sudden a concern. It's right in front of us. And when you look at portfolios, the vast majority of them are underweight inflation. You could argue half of the portfolio should have inflation hedge components in it, um, just as a neutral allocation. So uh so I think of I think of having those exposures as being critical. Um, taking steps in that direction are positive. So if you so I think of it as there's a spectrum. On one end of the spectrum, you have what everybody else does, call it a traditional 60-40 portfolio framework. On the other end of the spectrum, you have what I think is a much more diversified portfolio. So I think risk parity is one step in that direction. You can add alternative investments that are uncorrelated to uh public markets, and you can build a really diversified portfolio. Think of it more like a college endowment type style portfolio, much more resilient. Uh you don't have to have as much in private assets, but just a more diversified allocation than 60-40 that's 98% correlated stocks. So think of a spectrum. On one end is what everybody else does, or most people do. It's more familiar, but it's more concentrated. On the other end of the spectrum, you have a more diversified allocation, but it's less familiar to most. So I think of taking steps from more concentrated to more diversified is a positive move on average. You your sharp ratio goes up. It's and it probably makes sense in an uncertain world, especially one where inflation is a risk. So taking steps in that direction is probably a good move. And so, but you can't go all the way because it's too unfamiliar and you you you almost have to take baby steps to get there. I think of RPAR as a tool to move in that direction. So we created it uh uh over six years ago because, and it's something I've been using with my clients for 20 plus years, the framework. I think of it as a very efficient way to take steps in that direction. You just you can buy the ETF, it has all these uh uh diverse asset classes within it, uh, and that basket is probably easier to hold over time than the individual components. Uh, you know, gold, everybody loves gold today, but you know, three or four years ago, when you should have bought it, uh before it went up a lot, uh, it was harder to own. Uh if you own it within an ETF wrapper, it's always there. And and you don't necessarily have to time the ins and outs. Uh so I think of RPAR as just a tool to move towards a more diverse allocation.

SPEAKER_01 17:28

Does anything kind of keep you up at night when it comes to things about risk parity? I mean, yeah, short-term versus long term. You've got to sleep short-term, right? In fairness. Uh long-term risk parity might be fine. But yeah, when you think about sort of uh you as a product developer and advocate for this way of approaching things, what what worries you?

SPEAKER_00 17:43

You know, I I think of it as it's a balanced allocation. So that worries me less than a less balanced allocation. So uh so it's not necessarily the portfolio and it's resilience that that concerns me. Uh what concerns me is more of a of a uh relative performance. Um so so for example, you know, our par could be up 5% and 6040 is up 15%, and people look at our par and say, you know, this thing is lagging, it's not doing very well. You could have this, you could have the opposite environment where 6040 is

The Real Challenge Is Relative Performance

SPEAKER_00 18:17

down 15% and RPAR is up the same five, and people look at that and say, wow, this is brilliant. You know, this is doing so well. And I look at it as, no, yeah, you're the reference point is wrong. You're you're comparing something that is more stable through time because it's more diversified to something that's more volatile through time. So it so, but that's the way most people think about it, because the reference point is the US stock market and you know, equity-centric portfolios. So what keeps me up at night is the relative performance, not necessarily the absolute performance, because it's just a more diversified allocation. Uh and that is, you know, in some ways it's irrational, but in some ways that's just reality. So uh so that is, you know, so I guess that's what I think about. Um, and I'm much less concerned about the even the short-term uh volatility of the of the fund. Uh, I understand environments where it does poorly, like 22, that's understandable. That's probably the worst case scenario. Um, periods like 2008, I would expect it to hold up better. It's more diversified. Q1 of 2020, I would think it would hold up better. Uh, it's really a tightening environment where cash is king, that's the risk. So I understand that. So when that happens, it I don't lose sleep over it. Um, but uh, but it's so it's it's more psychological than anything else.

SPEAKER_01 19:35

There's this term out there, um, all weather portfolio, which sounds really uh sexy from a marketing perspective, right? It's like, oh, it's pretty for all conditions, right? So of course there's always nuances because conditions are short-term, long-term. But it is is it fair to say risk parity is an old weather portfolio, or are there problems with that terminology?

SPEAKER_00 19:53

Um I think that probably that terminology may promise more than you actually receive, because when you say all, you know, you could say most weather portfolio, but all weather is too too um comprehensive, I think, because there are environments

Why All Weather Can Mislead

SPEAKER_00 20:11

where I wouldn't expect it to do well. I I've written a couple of books about this. There's a whole chapter devoted to the environments where you shouldn't expect it to do well on an absolute basis. Relative basis, it'll swink around because if you're comparing to something volatile, there'll be probably half the time or more relatively underperform. That's to be expected. But on an absolute basis, uh, I don't think of it as all weather because there are environments where we don't expect it to do well. And in particular, it's a massive tightening environment, like we saw in 2022, when interest rates go from zero to five percent uh quickly uh and unexpectedly. We saw the same thing in the early 80s when Paul Borker came in and tightened rates uh significantly. And that is to be expected. These are asset classes that compete with cash. When cash is zero, you you should you can expect maybe five or six percent out of risky assets. That's what stocks have earned above cash over time. And if all of a sudden cash goes to five, you you can't expect that people are gonna buy the same uh stocks at the same price, price to get you five or six percent when cash is five. So those assets have to fall. And that applies across all asset classes, they all compete with cash. So if you get a massive tightening, then you should expect losses, and then you end up in a in a better place post-tightening because they expect a return where everything is higher. So so if you if you I guess if you exclude that type of environment, then you could argue maybe all or mostly all uh weather. Um, but uh, and obviously there's things you can own that diversify against that environment. So that goes beyond the ETF and other asset classes, other investment strategies, you know, other approaches. Um so I think in in total, you could probably build a portfolio that's almost all weather. Um, there's always you know the corner case. But within a narrow uh universe of public markets, that you you should recognize there are environments where it would underperform.

SPEAKER_01 22:10

Okay, so the nice thing about ETF um like RPAR is that you can see the holdings daily. You're legally required to disclose that as an ETF issuer. Um which of course means if you're an investor, you can mimic exactly what uh the ETF is doing or any ETF is doing if you just look daily. Um why can't investors just do that? Why why use RPAR versus do that?

SPEAKER_00 22:30

Sure. Uh you don't even have to look at it daily. We we tell you what our target allocations are. It's roughly 25 equities, 25 commodities, including gold, 35 treasuries, 35 tips, and rebalance back to that every

DIY Replication And Rebalancing Friction

SPEAKER_00 22:44

quarter. So it's not an active strategy. We just go to those targets every quarter. So you could basically do that outside. There's a little bit of leverage there, so your cost of financing may be more than ours. Uh, but you could mimic it. But the challenge is what I said earlier, which is it's actually really hard to do in practice because a couple things. One is you have to own these assets all the time. And what happens when you remove the wrapper, all of a sudden the line items are right in front of you. And some of those assets are gonna be doing poorly, like tips and treasuries have been negative the last five years. You would have had to hold on this whole time. And there's gonna be a period, I don't know when, when they're gonna be probably the best performers, and you would have had to hold them at those allocations before that happens. So it's really hard in practice, and I'm and I'm speaking from experience, you know, doing this over 20 years. Uh, so that's number one. Number two is you have to rebalance, which means you have to sell a little bit of the winners and you have to buy a little bit of the losers regularly. And that is difficult for two reasons. One is psychologically, it's hard to sell the winners because you feel like they're gonna continue to be the winners. And you may do it in quarter one. And then in quarter two, you look back and say, you know, I wish I wouldn't have done that, but I'm gonna stick to my discipline. You'll do it in quarter two. And after three or four quarters, you're gonna give up and say, okay, this is not working. So that discipline is critical, and you can see it in the numbers long term. So that's hurdle number one, psychology. And by the way, it's hard to buy the losers because you think they're losers for a reason and the outlook is usually negative. Uh, and then hurdle number two is when you sell the winners, uh, if you're a taxable investor, there's usually capital gain associated with that. So not only are you selling the winners and overcoming the psychological hurdles, you actually have to pay taxes. So your portfolio declines a little bit. So those are some challenges. Um, and then also the the leverage. Uh so we use uh Treasury futures to get the leverage in RPAR. And if you're doing that yourself, it might be a little bit more difficult to do that. So uh so I was doing it on a separate account basis for for you know over 10 years, and then we figured out for us it's more efficient inside of an ETF wrapper. You get the tax benefits of rebalancing without generating capital gains uh that are distributed, and you get the cheaper leverage, and you can become more diversified because it's all within a wrapper. So so, yes, you can do it yourself. I think it's more efficient to do it inside the ETF, uh, not just uh mathematically, but also psychologically.

SPEAKER_01 25:08

Yeah, let's face it, people like to be lazy. But um, and then uh maybe a final question here, and then again, folks appreciate those that are watching us live. Um how should people learn more about RPAR?

SPEAKER_00 25:23

Uh our website, uh rparetf.com, um, and then uh our advisory site, evokeadvisors.com. Uh, and then also I have a weekly podcast called the Insightful Investor. The website for that is insightfulinvestor.org. Uh, it's not just about risk parity. I interview guests every week on all sorts of topics. Um, so if you're looking to learn more, any of those resources could be helpful.

SPEAKER_01 25:50

Like I said, uh Alex

Where To Learn More And Wrap

SPEAKER_01 25:52

always puts me at ease uh because uh nobody can tell you what tomorrow brings. Um so if you don't know what tomorrow brings, don't worry about tomorrow. Uh just consider risk parity. Uh so with all that said, appreciate those that watch this. It's gonna be a busy day. I got a number of these podcasts coming up as I'm catching up. Thankfully, hopefully less travel and uh learn more about RPAR. I'm a big fan of Al Shahidi and his firm and everything he does and his mindset. So uh give him a uh give him a like and also on LinkedIn. I see more posts from you on LinkedIn, by the way. I gotta give you some credit. You're uh you're putting more kind of thoughtful, almost provocative types of questions.

SPEAKER_00 26:20

Uh which is I'm I'm trying to catch up to you.

SPEAKER_01 26:22

Oh no, you'll never catch up to me.

SPEAKER_00 26:24

I know that.

SPEAKER_01 26:26

So thanks everybody for watching. Cheers.

SPEAKER_00 26:29

Thank you.

unknown 26:33

Okay.