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What's the Alternative? | Episode 14 | The Smoothing Effect featuring Cliff Asness
33 Plays3 months ago
Welcome to Banrion Capital Management’s What’s the Alternative Podcast! Join host Shana Orczyk Sissel, the “Queen of Alternatives” Founder & CEO of Banrion Capital Management, as she interviews leaders in the alternative investment space. Learn more about their firms, their passions and about the many different ways investors can use alternative investments to add value in their investment portfolios.
In this episode Shana sits down with legendary hedge fund manager, Cliff Asness, to discuss how advisors can best evaluate alternative investment strategies whether public or private.
Cliff is a Founder, Managing Principal and Chief Investment Officer at AQR Capital Management. He is an active researcher and has authored articles on a variety of financial topics for many publications, including The Journal of Portfolio Management, Financial Analysts Journal, The Journal of Finance and The Journal of Financial Economics. He has received five Bernstein Fabozzi/Jacobs Levy Awards from The Journal of Portfolio Management, in 2002, 2004, 2005, 2014 and 2015. Financial Analysts Journal has twice awarded him the Graham and Dodd Award for the year’s best paper, as well as a Graham and Dodd Excellence Award, the award for the best perspectives piece, and the Graham and Dodd Readers’ Choice Award. He has won the second prize of the Fama/DFA Prize for Capital Markets and Asset Pricing in the 2020 Journal of Financial Economics. In 2006, CFA Institute presented Cliff with the James R. Vertin Award, which is periodically given to individuals who have produced a body of research notable for its relevance and enduring value to investment professionals. Prior to co-founding AQR Capital Management, he was a Managing Director and Director of Quantitative Research for the Asset Management Division of Goldman, Sachs & Co. He is a trustee for the American Enterprise Institute and the Atlas Society. He is on the governing board of the Institute of Mathematical Finance at NYU, the ambassador board of the Journal of Portfolio Management and a board member for the Q-Group. He is a member of the board of trustees and the investment committee for the National World War II Museum. He is also an advisory board member for the Adam Smith Society.
Cliff received a B.S. in economics from the Wharton School and a B.S. in engineering from the Moore School of Electrical Engineering at the University of Pennsylvania, graduating summa cum laude in both. He received an M.B.A. with high honors and a Ph.D. in finance from the University of Chicago, where he was Eugene Fama’s student and teaching assistant for two years (so he still feels guilty when trying to beat the market).
Notable Contributions- Received the James R. Vertin Award from CFA Institute in recognition of his lifetime contribution to research.
- Five-time winner of the Bernstein Fabozzi/ Jacobs Levy Award and two-time winner of the Graham and Dodd Award for his research.
- Vaughan Executive in Residence at the University of Missouri's Trulaske College of Business.
- Member of the governing board of the Courant Institute of Mathematical Finance at NYU.
- Named one of the 50 Most-Influential People in Global Finance by Bloomberg Markets magazine.
Learn More About AQR Capital Management: AQR
Connect with AQR on 𝕏: @aqrcapital
Connect with Cliff on 𝕏: @CliffordAsness
Read Cliff's Research: Cliff's Perspectives
Learn More About Banrion: Banrion Capital Management
Connect with Banrion on 𝕏:
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Transcript
Introduction to Alternative Investments
00:00:02
Speaker
Welcome to Bonnie and Capital Management's What's the Alternative podcast. Joining host Sheena Orsik-Sicil, the queen of alternatives and founder, CEO of Bonnie and Capital Management, as she interviews leaders in the alternative investment space. Learn more about their firms, their passions, and about the many different ways investors can use alternative investments to add value in their investment portfolio.
Meet Cliff Asness: AQR's Journey
00:00:31
Speaker
Hello, everyone, and welcome to another episode of What's the Alternative? Today we have a fangirl moment for me. One of my favorite follows on Twitter, but also somebody that I've known for a long time. I first saw him speak at Schwab Impact in San Diego, what feels like a million years ago, but it might've been like 2009.
00:00:57
Speaker
And he talked about value and growth versus value and momentum, and I found it very compelling, and I started following his work and then several years later I had the opportunity to work directly with his team.
00:01:12
Speaker
about emerging market funds and a quant fund that I was doing due diligence on and ultimately ended up using when I was with Mercer. So I think I've like tempted you all enough as if you don't already know this is Cliff Asness. He is the founder.
00:01:30
Speaker
of AQR, he is a legend in the industry, and I am so excited to have him on the podcast. Thank you so much, Cliff, for agreeing to be on the podcast. It's awesome to have you here. Oh, thank you for having me. And legend just means I've been around for a while. That's true, but that's not a bad thing. The fact that you've been able to be around and you haven't been canceled yet is something to celebrate. Still looming out there, but so far so good.
00:01:59
Speaker
People have tried and failed. You know, I don't care and that's the best part. That's why I like you so much. But, you know, let's get into it.
Why Hedge Fund Strategies in Mutual Funds?
00:02:08
Speaker
I was really excited to have you on the show because I wanted to talk to you about
00:02:15
Speaker
this move to liquid alternatives. AQR in particular was one of the very first asset managers out there that began to offer hedge fund like strategies in a mutual fund wrapper and also one of the few that has had any success in doing so. And I wanted to get your thoughts on why doing that and launching those type of products was so important to you and why you were such a trailblazer in that area. Sure.
00:02:41
Speaker
I think almost every good story in business is some marriage of a business opportunity with something that can actually help people.
Alpha and Long-Short Strategies Explained
00:02:51
Speaker
I mean, you're doing this thing, what does the market want? What can we do? But it also fulfills a need. And what we saw out there, which I think we still see today,
00:03:04
Speaker
is the vast preponderance of most portfolios get the vast amount of their return from markets, from beta, if you will. We were believers, as we still are today, that there is alpha. Don't ask me to define that where people get in huge fights. So what risks do you take out? How do you risk adjust it?
00:03:30
Speaker
But we are believers that there is alpha. We are believers that alpha can be delivered and we do it in many cases in long only traditional formats, but we think it's best delivered in a long short, what you might call more of a hedge fund format. There are a lot of reasons for that. A great example is right now. If you're a long only equity manager, everyone talks about the concentration level, the lack of breath in the market. That is a bit of a problem in a long only portfolio.
00:04:02
Speaker
The huge stocks dominate so much that they're the only ones who can really underweight in any significant amount. In a long short portfolio, we don't notice things like that. There's alpha to be had expected alpha, I should say. We think it has worked out positively a lot more than negatively, but I don't want to say alpha as if it always works.
00:04:28
Speaker
Today's market doesn't affect that. Market direction. Anyone in alts, anyone who's in true alts, which I define as trying to have a fairly low correlation to markets, has experienced a very long period where the stock market has actually dominated everything else. If you had well-constructed alpha-oriented alts, they still have improved the risk-adjusted return.
00:04:55
Speaker
of a portfolio over even this period. You had to stick with them.
Sticking with Alpha-Oriented Investments
00:05:00
Speaker
We can talk about that. They've had their rough patches and that's always an implied caveat that any investment, traditional or non-traditional, that you're gonna sell after it's really tough period, you're probably not gonna be very happy with full cycle. But if you did stick with them, they've improved the risk adjusted return. And in anything unlike the last post GFC period of a bull market,
00:05:25
Speaker
There is not just going to be risk adjusted return. They're going to improve the top line in our opinion also. So we think there was a real need out there. We thought we were in a good position to supply it. I guess there's one other subtlety.
AQR's Merger Arbitrage Experience
00:05:40
Speaker
early in our experience. We had a very rough technology bubble. This is now a quarter century ago. I know, I feel like I have great gravitas when I refer to things as a quarter century instead of 25 years. It just sounds better to me. It just made you sound more experienced, that's it. And pretty early on, we realized that, you know, the famous hedge fund two in 20 or whatever,
00:06:10
Speaker
model. It's occasionally justified. There's certainly been people who've made that work and ended up being a good deal for clients. But more often than not, we think that's just too much. We think that there's less magic to some strategies.
00:06:29
Speaker
I'm calling magic unique alpha that the manager has. For any of the non-initiated on the call, it's not true magic, but it's as close to it can be for a portfolio. A lot of strategies though are about doing some known thing very well, well executed, low transactions costs, well hedged
00:06:54
Speaker
Two and 20 is not really justified for that. One of the earliest things we experienced with was merger arbitrage. We go back to 2001, looking at the work of Mark Mitchell and Todd Pulvino who've worked with AQR ever since then, where they looked at merger arbed, classic strategy of a deals announced, you buy the target, you sell the acquirer. Most of the price compresses here. If the deal goes through, you get the rest.
00:07:24
Speaker
and if the deal doesn't go through, you lose a lot. Kind of an ugly pattern in any one investment, but if you do it enough, you're kind of the insurance company. I should say, I hope I got the sign right as to what to buy and sell. In these kind of talks, I get the sign right about 90% of the time.
00:07:42
Speaker
I'm like that with risk on, risk off. I have to think about it for a second. It's like, which one is it? Forget ladder and former. I got to think that through every time I've ever said it or heard someone say it. But no, in real life, we get the direction right when we put the trades on. But I'm only at about nine out of 10 and speaking about it. But the work of Mitchell and Pulvino many, many years ago,
00:08:05
Speaker
showed that merger arm seemed to be a really good strategy. You got paid an insurance premium that was more than enough compensation for the bad periods. You just got it by doing pretty much all the deals. You could put some risk control on top, some diversification requirements. You know, if all the deals were in one industry at one time, maybe you treat it a little differently, but mostly it was doing all the deals.
00:08:30
Speaker
And we looked at it and said, that's just one example of many, but we said, that's a really good strategy. People should have some of that in their portfolio, but the world's charging two and 20 for it.
00:08:41
Speaker
and you can approximate it by blindly buying one of each, the Jack Bogle approach to merger art. I was friends with Jack, he'd probably take great offense to be labeling a hedge fund strategy, the Jack Bogle version, but it kind of is in a way, right? It's saying, this is a good idea, let's do everyone. That's extreme. Even we in merger art don't do everyone. We have some views. A lot of the other things we do are somewhere on that spectrum.
00:09:08
Speaker
But we also realized that we thought these things should be more transparent and cheaper. And one of the things I'm very proud of, I don't think we single-handedly move the industry, but I think we helped nudge it along to where there are a lot more.
Push for Transparency in Hedge Funds
00:09:22
Speaker
Not everyone, and again, some may justify the very high fees. When we do
00:09:28
Speaker
all of our strategies at very high aggressiveness level, we charge higher fees. By and large, I think we were pioneers in kind of pushing the transparent, this is what we do. There are a few things we won't tell you about, because yeah, we do think we've developed some alpha, some true alpha over time, but some of it is exposure to great strategies that you should have for a third of a hedge fund.
00:09:50
Speaker
what a hedge fund is charging. So it was a nice confluence of events. We thought people needed it. We thought we were good at providing it. And we were willing and more willing than able because most people are able to cut their fees, but we were willing and able to say this should be done in a different price point. So it was an exciting time. I think it's still an exciting time. But that's that's how it got started.
00:10:13
Speaker
Yeah, I think getting started as early as you did was a benefit. A lot of folks didn't jump into it until the SEC changed more of the rules, relaxed more of the rules in like 2007, which was timing wise, not the best time. Cause we were on the cusp of, you know, this warring of bull market where as you pointed out earlier, alts didn't do great. I love your framing of diverse of alts being low to no correlation because
00:10:42
Speaker
We often talk about it in the advisor world as anything that's not long only public equity or long only public fixed income. But that ends up throwing things like private equity and private debt into the mix. And those are actually high correlation.
00:10:59
Speaker
They actually are highly correlated to their public market counterparts. So they really aren't diversifying alt as I like to say they belong in your equity or your fixed income portions and then it becomes a discussion about liquidity and other things.
00:11:15
Speaker
Which I think brings me to my next question. When advisors look at those things, and you're very outspoken about this, and we're going to keep you a little bit on the leash so your compliance department doesn't get mad at me. I like upsetting them on occasion, but let's see what happens. All right. Well, I want to make sure that the podcast can get out without having to edit it too much.
00:11:36
Speaker
What I wanted to ask you was when you look at the framing with private equity and private credit, you can kind of make a case those are less efficient markets, right?
Private Equity, Credit, and Market Dynamics
00:11:46
Speaker
And that there is some value to
00:11:49
Speaker
taking or having an allocation to the private side. But it's become less and less in recent years. And there's this idea of they look better because they don't price every day like traditional equity does. And that results in a smoothing effect. So as advisors are considering
00:12:11
Speaker
this vast array of what we call alternatives. We have this diversifying hall bucket, which is the one that I think that advisors in particular should really pay attention to. It's the one that really does add value to the portfolio is everything you just talked about. But then there's this other side where clients want this opportunity. And now there's finally an opportunity for a lot more people to get access to it. But there's things that advisors need to be aware of. And you are very vocal about it. So I'd love to get your thoughts on
00:12:41
Speaker
If an advisor is considering, say, private credit or private equity, the smoothing effect, the pricing, all of these things, what are the kinds of questions they should be asking when they're evaluating these things?
00:12:51
Speaker
Sure. Well, to start, I like your summary because you did assume that privates are very correlated to their public markets. That is not an assumption everyone makes in that world. The same smoothing of volatility reduces the appearance of correlation, but we don't have to fight about that, you and I, because you said it already. Nope. The way I like to frame it is you can think of any investment as return over risk.
00:13:21
Speaker
And we can shed a lot of blood fighting about how to define risk. Is volatility a good measure? When is it not? Let's not go, let's just keep it very general, return over risk. The reason for me to invest in private markets is the numerator, the return side.
00:13:45
Speaker
And what you just said about perhaps there being less efficient markets, perhaps it attracting some of the most skilled stock managers and credit managers. I find that very plausible. Then I'll leave this fight to other people. They tend to charge very high fees. So does that skill and market and less efficient market, what's the net to the client of that against a very high fee?
00:14:15
Speaker
That's going to be a bespoke case by case basis. One fight I've managed to avoid is the fight about the average return on private equity over the last 20 years. There are some professors who write that it's much less than people think. People write defensive pieces.
00:14:33
Speaker
go there. The reason to think about these things is accessing a less efficient market and what may be a more skillful manager, and how do I weigh that against the cost? I tried to coin an economic law many years ago, but the world refuses to name after me, but I keep trying. It's that there's no investment product that's so good that there's not a fee that can make it bad.
00:15:01
Speaker
It's kind of obvious when you think about it, you charge 100%, you're probably not gonna make money afterwards. But we are getting up when you think of the fees and the fees on fees, that's the decision I think an investor has to make. Is there gonna be alpha after all that? What worries me is that I think a fair amount of investors in this are about the denominator, about the risk.
00:15:26
Speaker
And they actually, for maybe some good agency theory kind of reasons, prefer the smoothing. It actually helps them.
00:15:36
Speaker
Well, from a behavioral finance standpoint, it makes clients feel better because they don't see the volatility. You know, there's something to be said about like clients who are a little bit antsy seeing the ups and downs, it makes them nervous. So from a behavioral perspective, like Daniel Crosby would absolutely say, like from a behavioral perspective, they're more likely to stick in with it and liquidity and even though it's a liquid and things of that nature. Yes, I agree with that aspect.
00:16:03
Speaker
No, I agree with that too. As a practical matter, it's obvious that they do like this property. I do have, as you can imagine, a full war chest full of sarcastic comments to make out of it. Like, for instance, if you only check on us every five years, we look pretty much the same. We look nice and smooth and the downs have been very small and all that, and we wouldn't look very correlated. I like to say,
00:16:33
Speaker
There are at least two ways, let's go to two extremes, how to value any investment. You can value it at what the market will pay today, or at the other end of the extreme, you could value it at what you think it's worth. Why one of us gets to live in one world and one gets to live in another, I cannot understand because it is far from impossible
00:16:58
Speaker
to have a private manager tell you every day, all right, if I had to sell the portfolio today in an orderly fashion, I'm not saying a fire sale, what would I get? And I promise you, these are honest people. If the market's down 10%, they're gonna tell you down 14% because most of the time these are somewhat levered investments. On the other hand, we have the ability all the time to tell you what we think the portfolio is actually worth.
00:17:27
Speaker
In March of 2000, when we had a terrible start in the tech bubble, when short everything expensive and short everything cheap was not working out, I could have told you, we're down X for real if we sold it today. Or I could have told you, when the market returns to the valuation, I think it's more reasonable. We're going to be up. Why?
00:17:50
Speaker
Why one gets to do one and one gets to do the other is kind of an institutional, accounting, legal, market structure quirk. And then the question becomes, so what's the harm? What's the harm in smoothing? Well, there are two possible sources of harm. One is if you actually believe it. I'm trying not to make it off call or comment about believing your own, you know what. But if you,
00:18:19
Speaker
If you say smoothie makes life easier, particularly in a world, what I called agency problems before where you're not the final investor you have to report to someone else. I do find for final decision makers smoothing is a little less important than someone who knows that decisions are going to have to be reviewed by somebody else.
00:18:37
Speaker
because they're not just concerned about their own ability to stick with something, they're concerned about it down the road. But if you approach this and go, I know that Shannon and Cliff are right, that this is really volatile stuff, that's very high beta, and if we hit a 10-year bear market, God forbid, or even a 10-year disappointing market, this is gonna be disappointing. Fine, then it's all about the numerator, it's about whether you found good managers.
00:19:07
Speaker
if you didn't listen to us, which is always an error, but if you didn't in this case, you might have found you had far more equity, credit, beta in a bear market, even an extended disappointing market versus some other alternatives than you would have thought. So if you're gonna
00:19:29
Speaker
use fictitious risk numbers, and I will call them fictitious. Well, they are. You're just making it up. They are. If you're going to, I sometimes, again, sarcastically say lie to yourself with open eyes. At least be paying attention. If you actually believe those numbers, you can get in some very big trouble. The second worry is more speculative.
00:19:56
Speaker
and it's going forward, and here's the only comment I will make about the numerator, about the expected return. Imagine we go back 30, 40 years ago, when David Swenson at Yale was kind of pioneering using alternatives and particular privates at Yale's endowment. It was extremely easy to believe.
00:20:19
Speaker
I should say it is extremely easy to believe. Saying it was is saying that he wasn't a genius. No, he was. He saw it before other people. But it is extremely easy to believe that that was a very inefficient market where privates had a very large illiquidity premium. They paid you a very high extra expected return for being willing to take that illiquidity. That says illiquidity is a bug. It's something nobody wants to bear.
00:20:46
Speaker
That traditionally, by the way, you know, you go through academia, you go through even, you know, if you said to the casual person, is it a good thing or a bad thing that you're locked into this forever? Most would say, even if they end up using that degree of freedom poorly, they'd say, no, I don't want to be illiquid, all else equal, I'd rather be able to make my choice whenever I want. Well, if illiquidity used to be a bug, it makes sense that you got paid a big return premium for being in it.
00:21:17
Speaker
If illiquidity is now a feature, meaning enough people value the smoothing itself, that on net they prefer illiquid assets for the same,
00:21:29
Speaker
expected return. Then they're going to bid up those assets. And then paradoxically, that expected return advantage is going to be at the very least reduced. At some point it could go away. And if you talk to private managers anecdotally, I've spoken a lot more private equity than private credit managers, but I think they'll tell you they pay multiples that are a lot closer to public markets these days.
Private vs. Public Market Valuations
00:21:54
Speaker
And I think that's fairly consistent with this idea that illiquidity is not viewed as a bug, at least directionally it is viewed much more as a feature and maybe even on net a true feature.
00:22:06
Speaker
And that could mean, and I stress that it's speculative, that both the numerator and the denominator are off now. Because you're looking at a history when this was considered a bad thing and you needed to be paid to bear it, but now if everyone wants it for that feature, they will pay in the form of lower expected returns and higher prices.
00:22:27
Speaker
Higher fees, too. It's interesting you say that. One of the things I look at with this illiquidity thing is, and even private equity and private credit, how the alpha is degraded over the years recently, I would suggest that some of that is what you're talking about, but some of that is also the proliferation and the availability, right?
00:22:50
Speaker
Because the more investors you have out doing, you know, price seeking and the markets become more and more efficient, right? Because there's more folks out there doing the discovery. When there's less people, then there's much more opportunity for arbitrage, the small cap argument, right? The micro cap, small cap argument.
00:23:11
Speaker
Absolutely. When there's a lot, and with private equity and private credit, there's more availability now with interval funds and people doing things of that nature. Would you say that that also plays a role? Yeah, absolutely. And I think they kind of go hand in glove with each other. When the world wants a feature like smoothing,
00:23:31
Speaker
The marketplace will provide that feature for them in many varied ways because this will shock your audience, but money managers like to make money. So you will, they were almost saying the same thing. If this is now a feature, it's going to be really popular.
00:23:49
Speaker
and more people are gonna get into it. As an aside, the very bull market you and I have been talking about, and this one, you could call it a mega bull market for 30, 40 years. And you think of a better environment to be, in particular, private equity, private credit is somewhat of a newer phenomenon, but then a market where even with the backup in interest rates over the last few years,
00:24:12
Speaker
It's been a one-way period down for interest rates. It's been almost a one-way period up for equity market valuations. Imagine delivering a levered form of equities in this bull market while getting to report risk numbers that understate how risky you are. There is a reason this has gotten so popular. But one thing- I mean, the cost of leverage is so low.
00:24:36
Speaker
Yeah. And I've been on the right side and the wrong side of this. There is no strategy that is not susceptible to too many people doing it. And I don't know. This is why I say it's speculative. I don't know where that line is crossed.
00:24:53
Speaker
I do know, almost by definition, that when something is much more popular, and as you say, many more people are doing it, when anecdotally it is quite obvious, I think, I don't think you need to run stats that what used to be a bug is now a feature, that it can't be what it was.
The Future of Hedge Funds
00:25:09
Speaker
And as a quant, I love it when history repeats. What do quants do? We look at history and we try to apply some judgment as to whether it will repeat. If you have a name data mined model, yeah, you probably don't think it'll repeat. So I don't love the world too when history doesn't repeat, but I think it's a very good chance looking at the last post GFC and even the last 30, 40 years.
00:25:36
Speaker
that this has been a golden age of reported, of realized return and reported risk that neither of which maybe are quite correct as assumptions going forward.
00:25:48
Speaker
I think you could say the same about hedge funds in like the 90s. But coming out in the 90s, hedge funds lost their lure because there were more of them, more people doing long short, being able to do long short in different types of products. And then having the kind of bull market we did was not great for anybody who was short anything for a long time and much more difficult to kind of make the case for the higher fees.
00:26:12
Speaker
Every time you talk about fees, I will leave the manager nameless, but you definitely know him personally. I remember sitting in a meeting with him in 2011, maybe, and he said his fees were 5 and 50. And I almost died, because yes, very famous guy, again, will remain nameless.
00:26:37
Speaker
But five and 50 really, I'm a big proponent of saying like, I don't worry about fees, because I'm always worried about net of fees how things do and that's how I look at everything so I'm not really paying that much, but five and 50. I don't if you are doing well after five and 50 net of fees you're definitely not doing something on the up and up.
00:26:58
Speaker
So I walked out of that meeting. I was like, I'm never investing in this guy. But every time we mentioned fees, I think I want to remind our audience, these types of strategies just inevitably tend to have higher fees because they're just more expensive to execute, but within reason, folks.
00:27:15
Speaker
I think within reason is fair. And when I was touting our horn for cutting fees and lowering the fees in the industry, we didn't cut them to index fund levels. We cut them substantially below what other hedge funds were charging. Yeah, five and 50, if you're not named, unfortunately just passed away, Jim Simons, then I'm calling me skeptical.
00:27:41
Speaker
I can't be skeptical about Jim when you do it for about 30 years. Eventually, I will bow to the empirics. But your sarcastic comment, which I've made myself, that if you're justifying those fees by a large margin, usually I'm going to accept Jim Simons from this concept.
00:28:00
Speaker
you're doing something sneaky. It's probably right more often than it's not. I don't want it to sound like a hater. There are some people out there who maybe have figured out Jim Simon's like things and I'm just jealous that I don't, I have it. But all else equal, I'd have a lot of trouble getting myself to the point where I'd invest in a five and 50 product. For one thing, those managers that do that almost always price it to the point where it's pretty good at the end, but it's no longer life changing.
00:28:29
Speaker
They're keeping most, I mean, Jim ultimately went the whole nine yards and kicked all the investors out. Five and 50 is kind of going halfway to that. It's saying you can have some return, but it's going to be pedestrian.
00:28:44
Speaker
A lot of those funds also that do attempt that aren't very tax efficient. So often you're charging some giant fee on something with a lot of ordinary and short-term gains. So yeah, again, I'm leery of sounding just like a jealous hater as someone who's never been able to charge five and 50 and has never tried. I'm skeptical, I'm with you on that.
00:29:09
Speaker
Yeah, don't be jealous of this particular person. You have no reason to be. You will tell me who this is after the podcast. I will. I will totally tell you after. But you touched on private equity, but you also touched on private credit.
Role of Private Credit Post-GFC
00:29:23
Speaker
And I think private credit's an interesting place where I don't know if it has that
00:29:28
Speaker
um premium that's being paid for illiquidity in the same way that you see in private equity because private equity is sexy in a way uh you know you have the movies you have walls private credit is getting pretty sexy well it is getting sexy but i think what makes private credit a little bit different is because it really is sort of a newer thing
00:29:47
Speaker
that came out of GFC, right? Because non-bank lenders became more and more important, and businesses weren't able to tap into traditional credit markets as much. So they actually serve a really important purpose in a way that I think is worth a second look, but with the caveat that they're still fixing them.
00:30:08
Speaker
They're still part of your fixed income allocation. They are not diversifiers. They're just providing you with an opportunity to maybe get better yield at a slightly better credit than say high yield would, in my opinion. What are your thoughts? Yeah, a bunch of things. First of all,
00:30:27
Speaker
I wouldn't consider myself the world's biggest expert on private equity. Most of my comments on there come from the ingenious observation that prices move. But I know a lot more about private equity than private credit. Not a world I've spent a ton of time in. One of my colleagues named Pete Hecht has done some work in it and said the average private credit manager is pretty well approximated by
00:30:57
Speaker
and a similarly high yielding diversified credit. So I do think it's probably in that same ballpark of you need to believe your manager is particularly good. I don't think there's a whole lot of reason to do these things if you don't think you have a very good manager, but it becomes more about evaluating your particular manager. I think if you, not that I would ever suggest this, but if you bought one of each out there, I think you're going to get,
00:31:24
Speaker
pretty much the credit market return, perhaps a higher gross alpha and higher fees. But the ability to perhaps find those managers is there. I would absolutely agree with you. It doesn't make it a diversifier. It's credit. If you have a credit crisis,
00:31:44
Speaker
There's only so long you cannot mark something for. I do worry about the world discovering that these things are, it's Casablanca. I'm shocked to find gambling is going on here. I'm shocked to find my own credit. It's called private credit.
00:32:03
Speaker
right um your point that there's more of a case that they've perhaps taken over for the banks that's absolutely fair that makes it harder to just look at the growth in assets in private credit and roll your eyes because that very well i don't know where that math comes out i don't know if it's more or less a full substitution uh but that's a fair point but again much like private equity what i really beat the drum on is the risk side um i um
00:32:32
Speaker
I become on the, on the Twitter, uh, financial Twitter that you and I both enjoy. I've become kind of the go-to person or cynicism about private. So I get tagged on a lot of things that then, believe it or not, some of them, most of them even I ignore, but one of them, I got tagged on a, uh, tear sheet for a private credit fund that at the bottom that realized sharp ratio 10.0.
00:33:04
Speaker
You can't send that to me and expect me to sit in my chair. Which the person who sent it to me absolutely did. That makes me question what index they used to create said sharp ratio. I think it was basically the yield over an almost non-existent volatility. Okay. So it's plausible that was their realized sharp ratio in terms of literally how they marked the portfolio.
00:33:32
Speaker
I didn't look, but I'm sure this has the requisite disclaimers at the bottom that these are, but this should not be a disclaim thing. This should be a laugh that thing. Anyone putting out something, if I ever put out something that says the realized sharp ratio is 10, it's gonna contain long paragraphs as to why it's really not. Either we can't measure the risk, we really want to, but we can, here's why. Or it's a very, very short period and something do come in extremely high.
00:34:01
Speaker
If you ever see something from me without giant, top-of-the-line, bold, 72-point disclaimers that says sharp ratio 10, I'll, I don't know, I'll eat my hat. Do people still say that? I don't wear a lot of hats.
00:34:18
Speaker
I've heard it, my dad says it, not to make you feel old. Yeah, oh yeah, there you go again. A quarter century. I actually remember the tweet you're referring to and I know exactly what firm it was. And it's a firm that actually is very focused on the advisory market, which is why having folks like yourself on this podcast is so important to me.
Educating Advisors on Diversifying Alternatives
00:34:36
Speaker
You know, our mission here at Bondrian is to educate advisors on the space. And I feel like what happens with advisors is they get sucked in oftentimes to this, you know, you know,
00:34:48
Speaker
world that's not real because of some of the things you just referred to, they buy into these products, they don't do what they thought they would do, and then they get burned because their clients start asking questions they don't know how to answer and they're like, forget it, it's too complicated, I don't want to do it anymore. But that takes away from the actual true benefits that do exist when you add diversifying alts into your portfolio and diversifying alter
00:35:13
Speaker
The things we talked about those hedge fund like strategies that you can put in a mutual fund or ETF wrapper. They may not have, you know, I would argue sometimes that they may not have the ability to generate as much alpha, just because of the restrictions that the regulators put on the public products.
00:35:30
Speaker
in terms of leverage and things of that nature. So I always say, if you have a client that's accredited, you might want to go into the private product versus the public product for that reason. But they still have diversifying benefits. And I think sometimes that gets lost in this discussion. And I should say, this tear sheet with the 10 sharp ratio, at the end of the day, this could have been a dynamite fund. I'm not evaluating. I'm not saying it's a bad investment.
00:35:56
Speaker
I'm saying anyone's hackles should get up in this industry when they see 10.0. And frankly, the 0.0 bothered me as much as the 10. Yeah. The idea that we know it's precisely 10.0. But it may be a great investment. I don't want to disparage it beyond the ridiculousness of saying it's absolutely non-volatile.
00:36:18
Speaker
One of the key things we keep getting back to is both you and I think of true alternatives as things that at least plausibly have a fairly low correlation to traditional markets in actuality, not just in marketing. In actuality matters if the market stays down, if you're trying to gauge the right amount you invest in something. I do think, and this is extremely self-serving comment probably for both you and I,
00:36:44
Speaker
But I think when you talk about popularity cycle and that the world is on average off, almost by definition, people are most in the most popular thing when it's the most expensive and the most overdone and the most arbitrage away. I think I've seen several points in my career where I thought hedge funds were perhaps oversold. I think they're undersold at this point. I think truly had strategies.
00:37:10
Speaker
Um, a market neutral equity strategy where you're long and short a very similar amount of, of beta. Right. And you're trying to make the money on on the alpha. Um,
00:37:23
Speaker
I don't think anyone's going to play violins for our industry. It's still a pretty strong industry, but it is unpopular where private are wildly popular. And if you want to take a just five to 10 year magazine cover indicator kind of view of this thing, I would be willing to bet that true alternatives.
00:37:47
Speaker
are going to matter a lot more in the next 10 years than the last. Again, even the last 10 years, they've raised risk adjusted return, at least the way we measure it. We're not measuring the whole world. We're obviously measuring our own stuff. Going forward, I think it could be both. Your point about volatility or aggressiveness or how much you can move the top line.
00:38:10
Speaker
I think it probably can be done a little more aggressive than many realize, even in mutual funds. With that said.
00:38:19
Speaker
Yeah, LPs can probably go further. And in particular, I have a piece, I keep saying it's coming out. It's been about five months where I've been almost done with this piece. So I get scared mentioning it, because it could be a year from now till I actually finish it. But the tentative title is something like, in defense of high volatility alternatives. And it's arguing that if you've decided, an alternative manager, a true alternative manager,
00:38:49
Speaker
is a good addition to the portfolio. Within reason, reason being bankruptcy risk. Negative 100% is not fun for everyone. You get headlines and various, you know, bankruptcy's bad. But within reason, higher volatility alternatives are usually shunned
00:39:08
Speaker
because they're hard to stick with. They are hard to market, unlike privates, and high volatility means what it says. There will be some very tough periods. It's a far more efficient way to build a portfolio. You can put far less
00:39:22
Speaker
in to move the dial, keep your money if you want and something absolutely safe. If you're more aggressive, you can actually even take on beta, because more of your money is generating uncorrelated alpha and something aggressive. So I think it's a real yin and a yang. I think high vol makes things harder to stick with, but it also means it's actually making the portfolio better in a more extreme way.
00:39:48
Speaker
Um, so I will have a piece trying to defend this, uh, whether I convince anyone, I've been trying to convince people of this for about 30 years. Um, when we, I'll tell you a quick story, when we launched our first fund, this was mid to late 1998, right before the dot com bubble, we were targeting intentionally uncorrelated
00:40:13
Speaker
but fall in the low 20s. So, you know, a third more ball than equities. So this was not for the faint of heart. And we were quite clear with people, the ball we were targeting. Unfortunately, we didn't get to not market to market. So we told people, yeah, it's going to move around like crazy.
00:40:32
Speaker
When we did a road show, we spent about six months before we launched both building systems at home and going out and talking to potential clients. If you weren't a mere child at the time, we would have been pitching you on it. I wasn't a mere child. I actually died in the industry right around there, so I don't believe you. But the number of meetings I had where somebody said,
00:41:00
Speaker
this 20 some odd percent vol you're going to take. We don't need that. Half or a quarter of that would be fine. We want something tame. We don't think we can live through the ups and downs. I responded in a very flip manner, which anyone who has paid any attention to me finds it's very easy to believe, I assume.
00:41:22
Speaker
If someone said, we want a third the volatility, can you do a tier class for us or something? I said, no, just give us a third the money.
00:41:32
Speaker
I agree with you wholeheartedly. And I don't know how you feel about crypto. And I don't know if I want to go on this with you. But Bitwise, the folks over at Bitwise, who I think are excellent at being honest and transparent about the space, have this great slide in one of their decks where they talk about adding a 1% position in Bitcoin, even though its volatility is insane. The difference it makes in improving your returns is so substantial.
00:42:00
Speaker
with no or very limited increase in your risk number because of exactly what you're talking about and I think sometimes people miss that because they they're so worried about the ride and not the outcome. Well if you think about it this is the exact flip side of when we talked earlier about how
00:42:20
Speaker
smoothing has behavioral positives, right? High ball has behavioral negatives. But to continue the same theme, things that are behavioral positives, you probably pay for. Things that are behavioral negatives, you probably are doing something other people can't do as easily. And I think you all people are probably adding more value. Doesn't mean it's actually valued anything. You have to prove that separately.
00:42:47
Speaker
But all else equal with true alternatives, I think most investors don't always want a double of all half the dollar investment. Of course, we had a terrible first year and a half. The dot-com bubble is very similar to 2019 and 20, where we are not just want value, we care about quality, we care about a bunch of other things. The whole thing was thrown out. And the dot-com bubble, it was not just
00:43:17
Speaker
expensive stocks, but very low quality stocks. Typically negatively correlated things, but they were both going crazy. The number of times over that period, I had wished, I had acquiesced to my investors and given them the one third, one quarter ball version.
00:43:41
Speaker
because I think they would have had a much easier time sticking with it. So I think everyone should look at this as, you know, one positive way to look at it is, hey, I get paid to do the tough things, and I think I get paid more to do tough things like accept the actual volatility of things, to invest a smaller dollar amount in higher vol assets, because it's a more efficient portfolio. And I think if you can stick with it, that's a real true alpha you're adding. It's hard to do.
00:44:11
Speaker
The world ends up being kind of fair. What's hard is what gets paid. What is easy tends not to get paid. I agree. I think people would actually just prefer to stick something somewhere and not hear about it for years in that smoothing effect versus see the volatility every day. I always say it's not necessarily the outcome.
00:44:35
Speaker
I think that's the wrong way to look at things. So I'm totally with you on that. Well, I know we're coming up on time and I, you've been very generous with yours. So, you know, before we close out, you know, what is top of mind for you today? Like what is most interesting to you in the markets? What are you paying attention to? Um, and you know, you know, what gets you excited about going on in the future and what AQR is doing? You know, we've touched on,
00:45:01
Speaker
a lot of it. But I do think we went through this post-GFC doldrums for alternatives. In 19 and 20 it was particularly bad for any kind of market neutral equity. Other ones were like trend following, went through a 10-year block period. A lot is not as bad as really ugly.
Endurance and Optimism in Investment Strategies
00:45:27
Speaker
But 10 years is a lot longer than two years. So you come to me for these deep quantitative insights. 10 is bigger than two. Well, as the total aside, one thing I've determined over my career is every real life investment strategy, you joked about it before I did, every honest one that is truly mark to market is going to have a tough period. If you had told me when I was a young PhD student that the magnitude of a tough period
00:45:57
Speaker
might be less important than how long you had to endure a tough period. I would have rolled my eyes at you. I would have said, no, people are rational. Magnitude is what matters. Turns out, positive returns, but that are desultory compared to equity returns for a decade, even if the whole point of an investment, like trend falling, is to make okay returns in normal times and to do really well in poor times, that can be a killer.
00:46:27
Speaker
Time and length matter as much as severity and magnitude. So I do think we've come up, and for firms like ours and many others, we've managed to survive it and even prosper. But we've come up a period that has generally been unfavorable to what we collectively do. So this is not something, when you say you're excited about, this doesn't get fixed tomorrow.
00:46:55
Speaker
Unfortunately, the world does not wake up one day and say Shannon Clifford Wright. They'll be very cathartic. But also mean we'd have one good day and then be back to normal. So I think we could be in for quite a long period where offering true alternatives, because they market them to market, they'll still be ups and downs. But I'm actually quite bullish on them being a vital part of a portfolio over the next decade.
00:47:22
Speaker
And I'm ready. I got about one more decade left in me. So this is perfect. Well, I'm with you on that. That's been a retirement announcement, by the way, get myself in trouble at the firm.
00:47:33
Speaker
Okay, well that's good. And like, are you going to be one of those people that never retires? Because I feel like I'm going to be one of those people that never retires. That would be the case. My wife tells me she's afraid I'll never retire. Because most years have been good. And in good years, you're having too much fun. And when you go through bad years, you feel too much responsibility. Right. But she's like this notion that you'll ever find a time where it's not fun, but it's not lousy. Just doesn't
00:48:02
Speaker
probably doesn't exist. But there's a good chance you and I are reprising this in another quarter of a century. There you go. Well, thank you so much for your time. It has been an absolute pleasure. I so appreciate your thoughts. I'm a huge fan. And I really appreciate you coming on the podcast. I will put some links in our show notes where people can find you if they haven't already followed you on Twitter. But you are a great follow. But above and beyond that, you also write some great research.
00:48:32
Speaker
I want to make sure people know where to find that on the AQR website. So thank you so much for your time. Remember, folks, if you like this episode, make sure you follow and like. And if you have ideas or if you have guests that you think would be someone you'd want to hear from, let us know. We always appreciate that. So until next time, thank you so much. Thank you, Shana. This was awesome.
00:48:59
Speaker
The opinions expressed on the What's the Alternative podcast are for general informational purposes only and are not intended to provide specific advice or recommendations for any individual or any specific security. This is only intended to provide a presentation about the financial industry,
00:49:17
Speaker
To determine which investments may be appropriate for you, consult your financial advisor prior to investing. Any past performance discussed during this podcast is no guarantee of future results. The guests featured on this program are participants on Bonran Capital Management's platform. As such, Bonran may receive payment for their participation as a platform partner. Any indices referenced for comparison are unmanaged and cannot be invested into directly.
00:49:43
Speaker
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00:50:04
Speaker
charges and expenses, this and other important information is contained in the fund perspectives and summary perspectives which can be obtained from a financial professional and should be read carefully before investing. statements attributed to an individual represent the opinions of that individual as of the date of the published podcast and do not necessarily reflect the attainment of bonding and capital management or its affiliates.
00:50:27
Speaker
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