Christopher Cole | The Hundred Year Portfolio: How to Grow & Protect Generational Wealth

Christopher Cole | The Hundred Year Portfolio: How to Grow & Protect Generational Wealth

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and join our amazing community. And with that, please enjoy this week’s episode. What’s up everybody? My guest today is Christopher Cole, the founder
of Artemis Capital Management, whose core focus is systemic, quantitative, and behavioral
based trading of volatility and derivatives. Chris’s research is highly influential in
derivative and macro trading circles and widely quoted by the financial press. His 2012 research paper entitled “Volatility
at World’s End” was credited with repricing long-dated volatility and named one of the
best macro economic thought pieces of the last decade. Chris, welcome back to Hidden Forces. Thanks. It’s great to be back. It’s been about two years and it’s really
good to be back on the show. It’s actually, I think, been almost three
years. Yeah. That’s right. You were our episode five, that’s right. And I was telling you that I was so excited
when we first started the program and it was also so exciting having you there and having
you fortuitously in person. Some people know this because I’ve mentioned
this on one or two podcasts that I had first met you and come across your work in 2012
at Grant’s fall conference. And actually me and Jim talked about this
recently. He was recently on the program and I think
you had presented at the time, was it Volatility at World’s End? Was that the paper? That’s right. Volatility at World’s End and how many investors
were hedging the wrong tail effectively was the theme of that presentation at Grant’s. Well, they were hedging for deflation when
in fact they should have been hedging for inflation because inflation was much cheaper. Or at least hedging for asset price reflation. Right, right, right. I also want to say for anyone listening, nothing
I or Chris say today can or should be viewed as financial advice. All opinions expressed by me and my guest
are solely our own opinions and should not be relied upon as the basis for financial
decisions. So, how did you first get into writing these
research papers? Well, I think there’s a power, obviously managing
money is a process. I’m a quantitative investor and a systematic
investor. The way we trade volatility is really looking
at identifying mispricings in volatility and identifying opportunities and using computers
to do that. However, I think when you’re trying to formulate
your views on the world, it’s very, very powerful to sit down and put a pen to paper and think
through the logic of why you believe certain things, why you’re designing strategies in
a specific way. And I think that really helped. It’s a therapeutic process, but it also is
a rational process that helps you understand, does this make sense? Because if you can’t explain it to somebody
else, then you don’t really know it that well yourself. So I think by creating a paper and putting
those ideas out to the world, it really is an ultimate test that you’ve thought through
your process in a very robust way. You always seem to embed these papers into
allegories or popular stories as metaphors. Where did that come from? Has that always been something that you’ve
done when you’ve tried to convey information to a lay person or to a crowd? Yeah, I think part of that is, first of all,
I’m a visual thinker. I think in terms of visual allegory, so to
that extent it reflects the way that I see the world and I think of the world. But at the same time it is a lot easier to
convey complex ideas to people in a narrative or in a visual image. We can talk about how there’s tremendous gamma
exposure in the stock market today and how that gamma exposure and the dealer re-hedging
impacts the way that the flows work. I can talk ad nauseum about that, but it doesn’t
click until you show somebody a snake eating its own tail as a metaphor for that type of
flow action in the stock market and then suddenly people can understand that on a very visceral
level. So I think it is a powerful communication
tool, but it’s also just sort of a natural byproduct of the way that I think personally. So that metaphor of the snake, that first
appeared in Volatility and the Alchemy of Risk, or Ouroboros. That’s right. As I mentioned, it’s been about six years
since you published Volatility at World’s End, which was a really big paper. It had a wide reach in terms of readership. Actually not six years, what am I talking
about? Eight years. Eight years, yeah. And it’s been three years since Volatility
and the Alchemy of Risk. Where does this paper, the current paper fit
in the continuum of research that you’ve been putting out over these years? And I should say that you might want to give
the name of the paper to our listeners. Well, the latest paper is called The Allegory
of the Hawk and the Serpent: How to Grow and Protect Wealth for 100 Years. This paper by far is the most broad reaching
paper that I’ve written and I think the most relevant paper, not only to the average investor,
but also to the way that we think about retirement savings, entitlement programs, pension programs. It by far has the broadest reach. The purpose of this paper, it really starts
with this kind of baseline question that’s posed to the reader. Imagine you have the opportunity to grant
your family great wealth and prosperity for 100 years. That opportunity is subject to one final choice
and the choice is, you must decide what assets to invest in and maintain that allocation
for an entire century without changing it. The question is, what do you invest in? What assets do you choose that will ensure
that your children’s children have that money at the end of 100 years? And so we looked at a wide variety of data. I back-tested financial engineering strategies
going back 100 years and really came to some shocking conclusions about what it takes to
manage money in a way that sustains wealth and grows wealth through different periods
of secular decline and secular growth. In this sense, answering this question was
a great education process for myself. I hope it’s a great education process for
the reader and it’s entirely driven by an analysis of data over 100 years, not based
on any macro views, not based on opinions, but truly just a presentation of pure data
to understand, how can we rethink the process of portfolio management and help people. Every paper you’ve written, it is sort of
a continuum. You mentioned the overpricing or underpricing
of risk between the tales that you highlighted in Volatility at World’s End. Some of these concepts or obviously repeated
with respect to the hawk and the wings. But this paper has the most direct line with
your previous of any other paper I’ve read, specifically because you overlay the hawk
on top of the Ouroboros, the self-devouring snake, which again that was what was in the
paper Volatility and the Alchemy of Risk. And I’m thinking maybe it would be helpful
for listeners to get a sense of what that paper was about, where you were intellectually
when you wrote it and what you were hoping to convey with that paper. And then maybe we can use that as an entry
point into this one. Definitely. Well, the paper I wrote in 2017, the Alchemy
of Risk, it used this idea of a snake devouring its own tail, a symbol known as the Ouroboros,
as a metaphor for what’s actually happening in the modern stock market. Essentially that there is now, in equity markets
alone, 2.5 to $3 trillion plus of financial engineering products that simultaneously exert
influence over, but also use volatility as a proxy to generate excess yield. In this idea that if you’re using volatility
as a source of returns but also as a measure of risk, you end up in this cycle of self-reflexivity
where buying pressure generates more buying pressure but then selling pressure at a certain
point can generate more selling pressure. You’re referring to short volatility strategies. This is exactly, these short volatility strategies
and either implicit or explicit. There are strategies that are actually going
out there and shorting options. Those are about $200 billion worth of overriding
strategies and those strategies are actually using derivatives. But then there are other strategies like for
example risk parity or vol targeting funds that actually replicate some of the risk exposures
of shorting volatility and actually result in the same self reflexive flows. And so, in culmination you have all of these
strategies that are essentially reliant on the expectation of stability in order to make
money but become increasingly unstable in the event that there is any volatility, either
internal or external to the market. Of course, one of the largest components of
this is the trillion dollars worth of share buybacks. Where, I mean, in almost purely literal fashion,
the S&P 500 is self cannibalizing itself by issuing debt, using that debt to then retire
shares in what is now become a massive trade. So, if we go back and we think about some
of these reflexive Ouroboros, of course the snake eating its own tail, it believes it’s
nourishing itself. But this is an illusion because eventually
it will kill itself. These self-reinforcing strategies, they will
reinforce stability until they suddenly become unstable. Until the snake runs out of its own tail,
there’s nothing left to eat. Out of its own tail. That’s right. And a lot of people congratulated me on the
2017 paper because it correctly foreshadowed the demise of the short volatility ETPs, that
was the XIV product that blew up. And we in explicit detail outlined why that
was going to happen both in the 2017 and 2015 paper. However, that’s just the smallest component
of this trade. Back during the 1987 crisis in the stock market
where the market dropped 20% in one day, the reflexive strategies which were in essence
short gamma strategies like portfolio insurance, those were only 2% of the market and contributed
to a 20% one day decline in the stock market. Today, these short volatility products are
upwards of eight to 10% of the total market. So it’s quite powerful, especially in a market
that’s being dominated by passive investors. You’re equating people that are buying volatility
as buying insurance, the equivalent of buying portfolio insurance in this analogy. I think in this analogy it describes any strategy
that continuously applies leverage based on the assumption of stability. This is, and I highly suggest for listeners,
I mean, it makes more sense with you than almost any other guests we’ve had, for people
to get a copy of this latest paper, I have a link to it in the rundown and I pull from
your latest paper in formulating the material for this rundown and for the questions. But there’s a great image, you always have
these beautiful images. One of them is the same image, actually you
have it both in your paper from 2017 as well as this most recent one, which is the self-eating,
the tail eating snake. And on each of these scales you’ve got things
like risk premia, CTAs, VaR rebalancing, risk parity. These are all volatility suppressing mean
reverting strategies and aspects of the market. Is that why you’ve included them there? That’s right. And if we take a step back, I mean, this can
be done on a micro level, right? The snake eating its own tail is done on a
micro level in the 2017 paper because it talks about individual financial strategies. But if we go out on a more macro level, the
snake devouring its own tail represents entire secular periods of the overall market. During an initial stock market boom, an initial
stock market boom becomes driven by usually some sort of combination of legitimate growth,
favorable demographics and technology. That elicits an initial growth period and
expansion of the stock market. But then as that growth goes on, as it goes
on, in order to generate consistent growth in corporate earnings, year over year, we
run out of fundamental drivers. Either the demographics don’t look as good,
the technology becomes commoditized or overvalued or just fundamentally there’s not enough drivers
to keep growth going. When we enter that late stage, we start to
rely on financial engineering and debt and then all of a sudden the availability of credit
and debt expansion and valuation, multiple expansion, start driving the growth cycle
rather than fundamentals. This is very deceiving because if you look
at secular cycles, this can occur for many years at a time, certainly in the late 20s,
obviously we saw this in the mid 60s, we saw this during the late 90s and we’re in that
stage today where now, at least according to the Bank for International Settlements,
it takes 11% for every initial dollar of debt, you’re getting 11% less growth than you got
several years ago. When economic expansion becomes driven solely
by debt creation, central bank actions, credit availability, and multiple expansion rather
than anything fundamental, you enter into this dangerous stage where it becomes a snake
devouring its own tail. And then if we take that to the micro level,
you then look at different financial engineering strategies that have proliferated such as
short volatility selling in which where people are selling volatility because they can’t
get enough yield, there’s really a way of leveraging the stability of the stock market. You see that in the US, you’ve seen that in
places like Japan with the structured notice showing some of the Uridashi products. So, if you can’t find growth, you start to
introduce financial engineering tricks in order to create the illusion of yield and
the illusion of growth. And this is where you get into this destabilizing
process where the snake is now devouring itself. That can go on for a while until some sort
of either internal shock or external shock in the sense what I’ve shown as the hawk. The hawk represents the forces of change that
come down and attack the snake and disrupt this perpetual but decaying growth cycle. So that’s the overall metaphor there. I want to ask you about that imagery of the
hawk and the snake for listeners to really get it. What you’re saying is that there is increasingly
a disconnect between financial markets and the underlying economy. I think one of the interesting things about
your point about debt to GDP of the bang for the buck, that there’s a diminishing return
on every dollar, that suggest to me that there is this powerful deflationary force at the
center, this force of pulling markets to the left tail. But policymakers are simultaneously pushing
it to the right tail and this has been a debate that was raging in the early years after the
financial crisis and which I imagine will come up again. How do you think about that in terms of the
way you think about these tails and these wings in terms of the hawk? How do you think about that and how do you
imagine that expresses itself? Sure, definitely. Well, if we go back to this metaphor of the
hawk attacking the serpent, which really is. I mean, this is on the Great Seal of the United
States of America. It’s on the coat of arms of Mexico. It was an omen in the Iliad. It’s in Greek, Egyptian, Indian, Aztec mythology. But really this allegory talks about this
conflict of opposites. You have the serpent which represents the
lower self, which is vital, but the lower kind of self-replicating self; and then you
have the enlightened mind of the hawk. In economics, I see this as, the serpent represents
this period of secular growth, fueled by value creation, rising asset prices. And that starts by some combination of good
demographics, technology, globalization, prosperity. But as the secular boom matures in a cycle,
it’s corrupted and it’s corrupted by greed, fiat devaluation. And then eventually debt expansion replaces
fundamentals as a critical driver of those gains. But the hawk comes down and it represents
the forces of secular change that can destroy that corrupted gross cycle of the serpent. But there are two wings to that hawk and that’s
what makes them difficult. The two wings, there’s the left wing which
represents the deflationary path. The deflationary path, and we’ll talk a lot
about this, this is where you have an aging population like they’ve had in Japan, like
they have now in Europe and like we have coming on up. That drives low inflation, faltering growth,
and then debt default. But then you have this right wing of the hawk
which represents inflation, fiat default and helicopter money where you in essence devalue
the currency and create inflation to deal with your default. You can default on your debt in two ways. You can default on it or you can devalue money. The two wings of the hawk represent these
different avenues. The point that I want to make is that it’s
almost impossible to predict what avenue we might go to. Typically what we’ve seen historically is
that you have these powerful forces pull you to the left wing, you have this horrible deflationary
asset price crash, and then finally you have devaluation of the currency and an inflationary
kind of crisis that occurs thereafter. It’s impossible to tell necessarily what wing
of the hawk we’re going to get at any point in time and a lot of it is dependent on policy
choices that are impossible to fully predict. But the point that I want to make is that
if you’re a fiduciary or if you’re a retiree, you can build a portfolio that has elements
of the hawk and serpent that can thrive no matter what happens. And that’s what’s really important, and I
think the message of that portfolio is incredibly important right now because I think as we
will show in this paper, and we can talk about a lot of the way that entitlement programs,
pension systems are run right now, they’re almost entirely geared towards the assets
and the performance of these or the expectation of the serpent areas of secular growth. And if we don’t get a repeat of those growth
areas, most of the entitlement programs in our country right now are already below 50%
funded when you take into account lower growth rates, and that means that an entitlement
default and a financial and social crisis is almost certain if we don’t actually rethink
the way portfolios are organized and balanced. That kind of touches on a little bit and maybe
we can discuss it, it touches on what has been this need for yield that is well above
and beyond the risk free rate, 5%, 7%, maybe even higher depending on the money manager,
depending on the portfolio. How important has this need for yield, not
just the desire for it but the need for it been in driving the risk taking and how important
do you think it’ll be in fomenting or driving the policy options that will be deployed by
policy makers in the years ahead? Well, thirst for yield represents what I will
say is a recency bias and a delusion. It’s a delusion as to what we could actually
expect from yields. I will say right now that recency bias is
a major systemic risk. It is a systemic risk. And what do I mean by recency bias? Recency bias is the expectation that the past
that we’ve experienced is likely to continue on in the future. I want to throw out some stats, I think, which
are quite scary. The average investment advisor is 52 years
old. They entered the industry in the early 1990s
and they were a kindergartener during the last stagflationary bear market of the 1970s. So that means the average financial advisor
cut their teeth in this period between 1984 to today, which by all measures of financial
history was one of the greatest and most significant periods of asset price growth ever, ever! So, if we go back and we look at 200 years
of history, a remarkable 91% of the price appreciation for a classic equity and bond
portfolio over the last 90, 100 years comes from just 22 years between 1984 and 2007. It’s amazing. 91% of the gains. 94% of the gains from domestic equities, 76%
of the gains from bonds and 72% of the performance in home values were also from the period of
1984 to 2007. That period alone was responsible for those
percentages of gains over the last 90 years. How do we think about those in real terms
when comparing, for example, to the 1920s? I mean, if we go back and you think about
this, right? The silent generation hated the stock market. They were afraid of buying homes. They were afraid of buying the stock market. Imagine you are a GI coming back from World
War II, that year is 1946, and you come home, you marry your sweetheart, you want to have
kids and family and you get some advice to say, “Go take your savings and put it in the
stock market and buy a house and leverage it.” All you could remember, the stock market went
through 17 years of declines. 17 years, declines; home prices, 17 years
of declines. You’re saying before 1946. That’s right. The period between 1929 up to 46, you would
not have made your money. You would not have made your money. In fact, Japan has actually experienced this
as well. The period of 1989 to 2003, someone would
have lost over 50%. If you’d invested in the Japanese stock market
in 1999, you’d be down 50% by 2003. That’s incredible. Well, they still haven’t made back. They still high, right? Exactly. They have not. That’s exactly right. You’d still be waiting to make back your gains. And so, the GI who saw his parents invest
in the stock market, who saw his parents lose their home would say, “Why would I want to
be in stocks or real estate because it’s been almost 20 years and my parents still haven’t
made their money back. I’m going to go put my money in a certificate
of deposit.” Recency bias was quite dangerous at that point
because obviously the period between 46 and the 1950s was a tremendous period of economic
growth as you had a dynamic where the US became the only last standing power, was rebuilding
the world, and there’s a tremendous demographic boom. Well, it’s the exact opposite logic today. Recency bias is now the exact opposite where
the largest generation in American history, baby boomers, entered the workforce in the
early 80s, they began plowing money into stocks, bonds, and real estate, interest rates dropped
from 19% all the way to zero. And the baby boomers, their flows kept flowing
into markets as the world became more globalized, inflation was under control, there was a major
technological change and it was all fantastic. And so, we had this incredible period of growth
between 1984 which really technically ended in 2007. As interest rates fell, boomers came to power
and began saving and we had a lot of globalization. Well now, after this incredible four decades
of growth, we now have the highest corporate debt to GDP in American history. Close to $17 trillion in negative yielding
debt globally. It’s difficult for taxes to go much lower,
and we haven’t a historically high income disparity. And this is at a point where now the baby
boomers are not putting money into the stock market. They have to draw it out. There’s $28 trillion of retirement assets
that are going to have to come out of the market at a certain point in time. So, all of these factors, all of these secular
factors are now turning against us. But unlike the opposite of what happened in
1946, everyone has the sugar high, this four decade sugar high because they’re only looking
at returns over the last four decades of seeing, “Wow, look at what equity markets did. Look at what real estate did.” But the returns that we’re expecting over
the last four decades are very unlikely to be repeated over the next decade or the next
four decades. And I think the net result of this is people
expecting, the average US pension system is expecting 7.25% returns. If they can’t get that return, what they’re
doing is they’re turning to financial engineering products that short stability, doubling down
trying to get those returns, and as a result of that, they’re adding on more risk. They’re adding on more debt. We are now a snake eating its own tail searching
for yield. But this is not a solution. It’s actually going to be part of the problem. I think a key thing you would think, boy,
okay, the average USD pension system, they need to get 7.25% on plan assets. Back in the 90s you could get that on high
grade corporate debt, but now it’s very difficult to get 7.25% on plan assets. Well, the average system is about 70% funded. But in the event returns are just 2% lower,
that average pension system falls from 70% funded to under 50% funded, and over one third
of the state pension systems will have a funding ratio below 30%. The total underfunded pension liability will
expand from $1.4 trillion to $3 to $10 trillion. Conservatively, it could be four times the
cost of the bail out of the banking system in the great financial crisis, or that $3
trillion is pretty much the entire forward year tax revenues of the US government. So, we’ve based our assumptions on returns
over the last four decades. But if you look back over 100 or 200 years,
those last four decades were one of the most incredible periods of asset price expansion
ever, not just in US history but ever. And if we don’t replicate that, if we’re unable
to replicate that and by any rational person looking at the data would say it’s very difficult
to, a default in the pension and entitlement system is inevitable; and that will set up
a generational, financial and social crisis. A lot of questions have come up for me while
you’re talking. One of them that I want to explore next, although
I want to interject with another one, but I want to say it quickly, is a continuation
of this point about recency bias because you’re highlighting the cultural component of recency
bias. But I do want to ask you what time series
asset managers are looking at and testing their strategies against and how that factors
in. But before we explore that, you mentioned
this cyclical drop in interest rates or secular drop in interest rates from early 1980s until
the financial crisis or up through today. How much does this account for the anti-correlation
between bonds and equities? Because you’ve pointed this out before, that
historically bonds and equities actually spend more time correlated than not correlated. So how much does this play a role? Yeah. Well I think to… and I’ll answer that question. I really want to let people know though that
this is not doomsday. It doesn’t have to be doomsday because there
is a solution to these problems. But the solution is actually creating an allocation
that balances offensive asset classes like stocks and real estate with defensive allocations
that profit from periods of change like volatility investing, like gold, like commodity trending. One of the things that we’ve shown is that
it’s not about being afraid, it’s about being prepared. And that if you’re an institutional investor
or you’re a retail investor, if you look at different portfolio allocations that have
large allocations to asset classes that are uncorrelated to stocks and bonds, that is
the key to a portfolio that can last 100 years. And we’ll get into that in a little bit more. But to kind of answer your question on things,
I think there’s been four key trends that have driven the outperformance of traditional
asset classes like stocks and bonds over the last four decades. So we’ve actually recorded multi-generational
lows in stock market volatility and asset price volatility. That’s been a key one. More importantly that is not looked at very
much is the fact that asset price trending is very close to multi-decade lows. What do I mean by asset price trending? What I mean by that is, what is the propensity
for the stock market to continue a trend in the event that very low asset price trending
or high mean reversion means that if the stock market was down yesterday, it was very likely
to be up today. We’ve seen a lot of that behavior over the
recent years. By the dip mentality. By the dip mentality. Exactly. But in the past actually it wasn’t always
the case. If the stock market was down yesterday, it
was more likely to be down today and down the next day or vice versa. So that’s really interesting. Another thing we’re seeing is obviously a
secular low in interest rates. Obviously rates at one point it’s almost unimaginable
to think, but there were at 19% and have been dropped all the way down to zero and in the
US are likely to go back down to zero again. Obviously in Europe we have negative interest
rates. That’s been a huge boon to the… just for
our listeners who may not be familiar, that’s a boon to bond holders. If you’re holding bonds and rates are perpetually
dropping, the price of your bonds go up, so it’s a great investment. Yes. It’s a great investment. One of the things that people think about,
the average investment advisor says, “Okay, you should be in stocks and bonds, and bonds
are going to be a hedge to your stocks.” Okay, that’s true most of the time. Certainly if interest rates are at 6%, policymakers
have a lot of room to lower interest rates, and every time they lower interest rates that
results in additional gains on top of the coupons for bonds. Well, the problem is that given where interest
rates are today, in about 150 basis points, for you to get the same type of return on
your bond portfolio, US rates would have to go to negative 1.5% to get the same type of
return that you got in a rate. And that’s because rates are starting from
a much lower base. Obviously moving rates down to negative 1.5%
could have other social ramifications. So it’s just, you’re not going to get the
same type of return from a bond portfolio that you did when interest rates were at 5%
or 10%, it’s just math. It’s also a question of, and this I hope we
can kind of try get to it or navigate it when we talk about the hawk and the left and the
right tail and the left and the right wings, but there’s really a question of, how low
can you take rates? How much money can you create before you begin
to meaningfully deface the value of the currency in which the bond is denominated? We haven’t really seen that up until now. Perhaps we’ve seen it just generally in terms
of asset prices, but we haven’t seen it in many other ways that people worried about. But please continue. Yeah. If we talk about some of these dynamics as
they interrelate to one another, obviously the lower volatility goes, the more people
feel comfortable shorting volatility as a source of yield, and that comes in a variety
of different ways, either implicitly or explicitly. Obviously the more interest rates drop, the
more incentivized people are to use financial engineering to find ways to generate excess
yield. The fourth factor I didn’t quite mention was
liquidity. We’re actually seeing very low liquidity in
markets. So what this means is that the less liquidity
there is, the more there is danger for air pockets. And then finally, the more that there’s mean
reversion in asset price trending that impacts both volatility and liquidity as well, the
more that asset prices are likely to mean revert, the more you are willing to take an
opposing bet on stability. Let’s talk a little bit about a popular retail
strategy that I would say is implicitly short volatility. This is a great example. This is the strategy of buying on dips, a
very popular strategy that many investors have done. What this simply means is that if the stock
market was down yesterday, you buy it today expecting it to go back up and mean revert. This strategy is not technically shorting
volatility in the sense that you’re not shorting a derivative or shorting a put option. But the strategy, if executed systematically,
actually has an exposure to short volatility because it’s a short volatility exposure dynamic
because in essence you’re doubling down every single time the bet moves against you. So it actually ends up replicating and has
replication to a shortfall position. Money rushes in to douse the fire. Or to alleviate the air pockets, money comes
into the market, is your point. That’s right. This condition of buying the dip. Exactly. So someone might think, I’m not shorting volatility,
but if you’re buying the dip, you are in essence creating an implicit short volatility position
that’s actually highly correlated to a strategy like selling pullets. That strategy has returned buying dips; every
time the stock market’s done, gone down, that has generated a 10% return over the last decade. Not bad, right? Wow, that’s great. Wonderful returns over the last decade. Well, if I go back and I test that strategy,
going back 90 years, I see something very different. I see a strategy that has gone bankrupt. I mean, literally you lose all your money
three times over 90 years by systematically buying every single time every day the market
is down. This is an example where people are attenuated
to doing something. If you go on these message boards, you go
on Twitter, everyone says, “Buy the dip, buy the dip, buy the dip,” I don’t think most
people realize that systematically applying a buy the dip strategy over 90 years is a
recipe for bankruptcy. So how many asset managers are testing their
strategies against time series that don’t go back before the 1980s? Yeah, I’d say practically none. Why is that? I mean, I think what’s quite interesting is
that some of the largest quantitative managers in the world, and there’s many, many strategies
like this, there’s not that great data going back past the 80s in different markets like
options. So you have to make some assumptions. And in our paper we go at great lengths to
explain the assumptions we make. But essentially what a lot of people say is,
well, if it can’t be executed, literally executed, and if you don’t have tick by tick data, then
we’re not going to back test it. And if he can’t back test it, then we’re just
going to ignore that that data history exists. So most of these modern asset managers are
big, big managers running hundreds of billions of dollars in strategies, we’ll simply say
that, well, if we can’t get a good assessment on what it would have done if there wasn’t
a specific market prior to 1986, we’re not going to run our back tests over that any
longer history. And so, they’ll extol these incredible back
test starting in the 80s or 90s or early 2000s without any realistic assessment of how these
strategies would have performed over 90 years. So what we did is we actually at Artemis went
to great lengths modeling out each of these independent strategies with very defensible
assumptions and tried to, in a very honest way, understand how they would have performed. There are some strategies that I actually
think perform better than I would have anticipated. For example, risk parity is a strategy that
legitimately I think did better than I thought it would have done in different other regimes. Can you explain what risk parity is for those
of our listeners who may not know. Risk parity in a nutshell is a strategy that
seeks to equalize risk adjusted returns across different asset classes in a way that effectively
it ends up being a strategy that leverages bonds. You have, usually bonds, stocks and commodities,
but compared to a classic 60, 40 portfolio, the risk parity portfolio is going to apply
some leverage to the fixed income component of the strategy. But overall you’re rebalancing the risk adjusted
returns of these different asset classes based on some rolling period across time. So in order to make up the yield that you
would have if you were more fully invested in equities, you just leverage up the bond
portfolio a little bit more. In practice that’s what you end up seeing
a lot of the time. Effectively what they’ll find is that even
though stocks have a higher return, US treasury bonds have a higher risk adjusted return. Using a different mathematics, you would come
up with a different weight that might leverage the fixed income component of the portfolio
and to balance out the risk weightings between stocks, bonds, and commodities and to have
that reweight itself every quarter or every six months or every year. That strategy, very popular strategy, there’s
about $500 billion worth of that strategy in US equities alone, but that strategy didn’t
do terribly over 90 years. I think it does a lot worse during the 1930s
than most people would imagine because as we talked about, you’re not getting much return
out of your bond portfolio. When bonds are at the zero bound, they lose
their anti-correlation to equities and they don’t perform as well. There are some strategies I think that really
did shockingly bad to a point that I think people should be aware of. Many pension systems are doing these short
volatility overlays. This might include selling puts or it might
include covered call strategies where you have exposure to the stock market and you
sell calls against these strategies. We found that these strategies at best had
90% draw downs over the years. You’re talking about selling insurance to
the market. That’s right. These strategies not only underperformed,
they represented complete impairment of cash. This is what XIV was doing, right? I would say XIV was a levered version of this. There’s a lot of investors that are, for example,
one of the most popular would be just call over writing where you have a portfolio of
stocks and you sell calls against that. You think that seems really safe. You’re doing that for excess yield. That seems really safe in theory. If you go back-test that to 1986 you’d say,
“Okay, that’s done pretty well. This seems like a great portfolio.” Well, if you go back-test that over 90 years,
you see a very, very different reality. Was it one of your points when you presented
at Grant’s in 2012 that at that time it was actually in your favor to sell insurance to
the market, that it was actually a profitable trade to make. Let me explain this for a second. It’s not that selling volatility is bad all
the time, right? I’m not somebody who’s going to sit back and
say that it’s always bad. It’s something that when it’s done tactically
and when it’s done on a discretionary basis, you say, “Okay, we believe that the risk premium
that the market is charging at this point in time is too expensive. So, we’re going to put on a tactical trade
in order to sell volatility to harness that.” This isn’t what these institutions are doing. They’re systematically selling insurance regardless
of the price. It’s a strategy that people put on continuously
expecting it to be- They’re depending on things staying the same. Back to your point about the Ouroboros, they’re
expecting a reversion of the mean, they’re betting on no change. Constantly as a form of yield, as a consistent
systematic strategy. And there’s entire institutions that are built
on this. I guess one of the things that I’ve talked
about in this paper is that those strategies, they will go bankrupt over 100 years. Even some of the most innocuous ones, the
one that’s most innocuous is selling upside volatility on the stock market. You own the stock market and you sell the
gains for excess yield. Well, what could possibly go wrong? And I could say, “Well, let’s look at the
period leading in the 1932.” The stock market drops 80% between 1929 and
1932. You lose 80% of your money, but you’re making
a little bit of yield on the insurance that you’re selling on the upside. Then we have the Banking Act of 1932 and the
market goes up 70% in literally 1.4 months. A month and a half, the market goes up 70%. It’s incredible, right? Well, imagine this. You’ve realized the brunt of the declines
on your portfolio, but all the way down, you’re selling insurance on a market rebound, then
the market rebounds massively high, and as a result of the insurance that you’ve been
selling for excess yield, you don’t get to realize that 70% gain. In fact, you’re realizing a loss. So boy, I mean, something as simple as a covered
call strategy. Now, this is one example. I mean, that’s just one of the episodes. I mean, we can get into… there’s so many
other different examples of that. And this is why timeshares is so important,
right? I mean this really highlights the point. It depends on what you’re looking at. How big is the data set that you’re examining? If it’s just from 1980, you get a very different
set of results than if you look at the dataset from 1920, right? That’s right. Or the 1970s is very different. The problem is that we’ve been in this one
regime where baby boomers came into the stock market right at a period where the world began
globalizing. All these capital inflows came in, interest
rates dropped from 19% all the way to zero and we think this is normal. We’re expecting returns to match that reality
and it’s not possible for us to get the type of returns you get when taxes are cut from
extreme highs in the 70s all the way down to where they are today. Interest rates drop. You have one large generation in American
history enter the prime earning years right at the point in time the world globalizes
and this is your baseline expectation. Anything that doesn’t match that expectation
will represent underfunded liabilities. And if you can’t get that expectation, you’re
willing to plow on more debt and take additional financial engineering risk to try to match
those ridiculous expectations. So, we need to rethink the entire way we think
about portfolio management. Effectively what’s been happening is that
investors have been seeking excess yield to solve their problems when in fact that is
a recipe for crisis. This is where I’ve wanted to get to, right? Rethinking portfolio construction, and that’s
where we’re going to go. But before we do that, I have one more question. In the paper at one point you write, “To seek
our fortune, we must first understand our place in history.” This goes back to the point about, how big
is the data set that you’re looking at? Where are we… in that larger open ended
data set that hasn’t taken into account what’s going to happen yet, where do you think we
are today in 2020? I think we’re at a very similar to where we
were in the early 1930s, very similar to where we were in the 1960s, going into late 1960s. We’re at a point of transition from secular
growth to secular decline. That can take many different forms. Effectively we’ve had a long period of excess
returns, a long period of demographic inflows and we are now transitioning to a period of
likely lower returns, demographic capital outflows, globalization breaking down into
more individual interest of countries and nationalism and then finally a shift from
capital creation to income redistribution. So, when you go from a period of secular growth
to a period of secular change, it’s very difficult to understand how that will cut. It can cut to either wing of the hawk. You can have a deflationary collapse, I think
that’s what a lot of people are afraid of. Or you could have a situation where they do
helicopter money, they devalue the currency and you get a very different type of volatility
where asset prices are sustained, but you eat away at your debt with inflation and income
redistribution. So, on one end of the spectrum, you have the
standard portfolio that is just dominated by these assets that are linked to secular
growth. The standard portfolio as your average retiree,
it’s most of the pension systems out there. It’s most of the entitlement programs out
there, which currently have an allocation that’s 72% allocated to equity linked products,
72% allocated equity and equity linked products. If there’s any type of downturn, these institutions
are very susceptible to that type of risk. But it also goes in tandem because if you’re
a retiree or if you’re someone who has a job, you’re likely to lose that job in an economic
downturn right at the time your portfolio is going down. Their portfolios and their jobs, everything
is implicitly short vol. Yeah, implicitly short vol or another way
of saying there’s long instability. And then if you’re an institution or a state
pension system, well, you’re relying on tax receipts. Well, all of a sudden if there’s an economic
downturn, your risk assets do really badly and the tax receipts go down. And people, if you try to raise taxes, people
are going move out of your state. So this all compounds the problem. So in essence, all of these risks are correlated
to one another. And people who are in these secular growth
portfolios, much like the serpent, they lack the self-introspection to understand whether
they’re genuinely eating something that is fundamental prey or if they’re just devouring
themselves on accident. And it’s very easy to be like, “Well, you’re
alarmist. Look at the last two years, I’ve made X percent,”
not realizing what a period of secular decline can do. But there’s another spectrum to this. The other end of the spectrum is the overly
defensive investor who says, “I don’t want to be in stocks. I’m afraid of stocks.” These are the investors that hoard gold, they
hoard cash and they buy a bunch of portfolio insurance. The problem is that these portfolios really
fail to participate in any secular growth. If they’re all in cash, they can underperform
if there’s any type of fiat devaluation. And definitely if you’re a portfolio advisor,
you’re going to get fired by your client if that portfolio is not timed perfectly to the
business cycle. They bleed out. You bleed out. Yeah. So, I think the thing that I found is that
if you want a portfolio that consistently does well through every single decade, that
compounds through every single decade, you need to rebalance these two juxtaposed forces,
the force of the hawk and the force of the serpent. The forces of secular growth and the forces
of secular change. That is the key to a portfolio that grows
consistently over 100 years. And it’s so painfully obvious when you look
at the results. To that effect I talk a little bit about this
power of duality, the idea of opposing and complimenting energies, and this is like yin
and yang, winter and summer, male and female. There’s so many examples of this in nature
and in life. One of the ones I really love is Dennis Rodman,
the basketball player who’s the lowest scoring inductee in the Basketball Hall of Fame. I grew up being a Rodman fan in Detroit. Rodman couldn’t score consistently outside
of five feet. So he was a terrible score. He couldn’t shoot. But counterintuitively, when Rodman was put
on the floor with other basketball players, the offensive efficiency of his team improved. It was incredible. It shot through the roof. He added convexity to their portfolio essentially. That’s right. One of the reasons this happened is that Rodman
was so good at one skill, is that he rebounded the basketball. He was six standard deviations better at rebounding
than anyone else in the league. It was absolutely incredible. So, when another player missed a shot, Rodman
would get the rebound and give them a second chance and sometimes a third chance. All of those extra chances dramatically enhanced
the scoring ability of his teammates. And it turned an average team into a good
team and it turned a good team into a great team. And that’s one of the reasons that Rodman
was a key contributor on five championship teams. There’s some great analysis that Rodman, based
on wins over replacement metrics, was one of the 20 greatest players to ever play the
game of basketball simply because he was so good at rebounding. In asset management, it’s the same thing. If you have two asset classes that are correlated
to the growth cycle, those two asset classes, you say, “Okay well, I’m going to put them
together. I’m going to get a better portfolio.” Yeah, you’ll get bigger returns, but you’ll
get bigger draw downs and bigger crises during periods of declines. Actually a portfolio that’s a better portfolio
on both an absolute return or a risk adjusted basis is taking a growth asset, combining
with an asset that maybe doesn’t make any money but is anti-correlated to that growth
asset. And when you put that portfolio together,
you get better overall returns and better overall risk returns than adding two asset
classes that are correlated with positive returns. I want to move from this general conversation
about portfolio construction to specifics because what I think is notable about this
most recent paper is that, and you mentioned Dennis Rodman, of course you wrote a paper
where you used Dennis Rodman as a metaphor for adding convexity to your portfolio. But to my knowledge, this paper is the most
specific in terms of portfolio construction and what asset classes and strategies you
should deploy in tandem in order to achieve the most balanced high yielding portfolio
over 100 years. I want to discuss that in the overtime, Chris. For regular listeners, you know the drill. If you’re new to the program or if you haven’t
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RSS overtime feed with your favorite podcasting application of choice. Chris, thank you so much and stick around. We’ll be right back for the second half of
this conversation. Today’s episode of Hidden Forces was recorded
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5 Replies to “Christopher Cole | The Hundred Year Portfolio: How to Grow & Protect Generational Wealth”

  1. Have read Chris's latest paper twice and always get something out of his interviews, including this one. Good stuff. Speaking selfishly, though, I wish he could bridge to the retail investor who self-directs his own investments. That said, his insights into risk are of value to everyone.

  2. Thanks for another great interview. Chris is always very insightful and I always like to listen to him speak. Thanks again, great work.

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