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Excess Returns
$1 Trillion AI Bet. $10 Billion in Profits | Bob Elliott on the AI Income That Isn't Coming
01:00:14
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- [00:02]
Host 1
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- [00:11]
Bob
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Host 1
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Bob
Call of Duty Black Ops 7, available now. Rated M for mature.
- [00:30]
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- [00:40]
Bob
That's right, ma'. Am. You have rooms 201 and 709.
- [00:44]
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- [00:46]
Host 2
Eh, the doors have double locks.
- [00:48]
Bob
They'll be fine.
- [00:49]
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- [01:00]
Bob
There's a disconnect in some ways between what you see in the financial markets, which are essentially pricing in strong outcomes across, you know, particularly across the equity market. And at the same time, we're seeing weakening sort of real economy conditions, probably the weakest of which is in the labor market. If you ask the techno optimist, you say, you know, they'll say, hey, look, this is going to cut, you know, a huge amount of jobs and lead to great margins. And then you ask them, okay, well, when those people lose their jobs and they don't have any more money, who's going to spend on the company's outputs? And that, like, ads explode and they have no answer. People aren't necessarily looking at this and saying, are we making more money? So, like, even in your own life, if you look at how do you use ChatGPT, is it saving you some time so you can engage in more leisure? Not that helpful, right? Because you're making the same amount of money, not gdp, beneficial. Right?
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Host 1
Bob, welcome back to Excess Returns.
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Bob
Thanks so much for having me.
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Host 1
We always love when you join us and talk to our audience about a bunch of different things. And today what we wanted to do with you is kind of break this discussion up, I think, in two different parts. Although they'll be related at the hip, I think. But, you know, first kind of talk through some of the macro environment, what you're thinking about, what you're paying attention to in terms of rates, inflation and, you know, various asset classes that may look attractive and some that may look a little vulnerable here. And then in the second half, it'll be good to sort of talk through the Unlimited ETF lineup. There's some new ETFs recently launched, which we're excited to learn about and sort of talk through how these are designed and how they fit sort of into portfolios and allocations. So this will be a great discussion and I know our audience always appreciates it when you come on with us. So thank you.
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Bob
Sounds great. Looking forward to it.
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Host 1
And for those that want to learn more, you can go to unlimited etfs.com, which is the ETF site, which has more on the ETFs that Bob's firm runs, and then also Unlimited funds, which is the advisor site, which has some more content and learning material and stuff like that. So always want to make sure we're supporting our guests because they're giving us this valuable time. So to start, let's kind of just get your where are you currently on the economy right now? Like, what are you, what are your overall thoughts on where we stand economically?
- [03:32]
Bob
Yeah, I think we're in. We're in, in many ways a very typical late cycle environment. And by that I mean we had a strong economy, very strong economy coming out of COVID Inflation was too high. The central bank tightened. That tightening helped slow economic conditions to some extent. That's also been compounded with the new administration pursuing a series of negative growth policies like curtailing immigration and increasing tariffs. And that has slowed economic growth relative to what we saw in the previous years. And we're kind of in this. And that has then led to, particularly because of the weakness in the labor market, led to the Fed starting to ease a little bit into that. And when you look at what's going on right now, there's a disconnect in some ways between what you see in the financial markets, which are essentially pricing in just strong outcomes, particularly across the equity market. And at the same time we're seeing weakening real economy conditions, probably the weakest of which is in the labor market. And that sort of divergence between high expectations and weakening reality is very common in late cycle environments. And I think the challenge with it is being agile enough to not fall behind as those expectations continue to be high, and also being agile enough to shift at the point in which maybe those expectations come back down to reality.
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Host 1
Has there been anything with the government shutdown and obviously the data not coming out?
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Host 2
Is there any.
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Host 1
What are you looking at specifically without sort of some of this government data? I think one of the things that the market might be reacting to a little bit today, it's down today, but I think it was a Fed, one of the Fed, one of the Fed governors Made a point yesterday that, you know, because of this, they don't have the data, you know, they may not cut in December, something like that, something along those lines. So the market might be kind of reacting. So just curious as to what you're looking at when, when the data isn't there.
- [05:42]
Bob
Everything I can get my hands on is the reality. And I think this is, this is a period where it kind of separates the macro tourists from the, the natives, let's say. Because, you know, if you're, if you're in macro all the time, you recognize that you constantly have to be triangulating official government reported data with all the sort of variety of different sources that you can get your hands on. And so, you know, in some ways we lost, we lost sort of the gold standard data, but the reality is we still had a pretty good understanding of what was going on when you pieced together all these other sources. So, you know, we know since the time of the shutdown, the last reported data, that the labor markets have remained relatively soft, you know, basically zero job growth, give or take. We also know that, you know, wage growth has continued to moderate a little bit. And we also know that demand has been not nearly as strong as it was during the surge over the summer. And so, you know, those are all incremental pieces of information. They're not nothing, nothing that happened during the data blackout was game changing. It was all more sort of incremental and consistent with the sort of gradual economic slowing that we've been seeing of late.
- [07:03]
Host 1
So inflation has sort of been trending down, although it's kind of hovering around this maybe 3% range, although not down to the Fed's 2% target. What's your view on where we stand with inflation today?
- [07:20]
Bob
Inflation was looking like it was going to settle a bit above the Fed's 2% target, somewhere between modestly and moderately above the Fed's 2% target, depending on how you like to parse the words. So something in the sort of 2 1/2 ish range and the introduction of the tariffs has had an inflationary effect that has more than offset some of the other disinflationary pressures in terms of measured inflation, things like rents cooling a little bit. And so the result is we've gotten a pickup in inflation, whether it be core or headline, back up to that sort of 3% level. It's kind of hard to say exactly how much more tariff driven inflation pressures there's going to be, but probably a few tenths more and more. You know, none of this Particularly on the inflation side, none of it's particularly game changing. It's just probably the biggest impact that it's having is that it's creating a drag on consumer spending. The fact that you have various goods prices rising relative to where they were before means that there's just less money available for overall real spending. And that's why we've seen some softness in real spending in the last couple of months.
- [08:43]
Host 1
Do you have any thoughts on why sort of the tariffs didn't. It didn't seem like it flowed all. I mean, I guess companies like absorbed the hit. Is that effectively what happened and didn't pass the higher costs onto consumers?
- [08:59]
Bob
Well, I think there's a lot of different ways that you can answer that question. I think the short story is I think there's sort of this nagging feeling like, oh, we thought tariffs were going to be a huge deal. They ended up being something, they've so far been something like a 1 to 1.25% of GDP tax on the economy, which is meaningful, but not an enormous drag. It's meaningful. Part of the reason why that is part of the reason in terms of the disconnect is that the, the actual collected tariff rate has been quite a bit below about two thirds of what the statutory tariff rate is. And that has to do with a number of the frictions in terms of literally collecting the tariff and duty revenue. We implemented the greatest tariff hike in modern economic history. You know, we all know what it's like to go to the dmv. Like imagine trying to implement that for the government. Like of course the actual collections get delayed and you know, there's not the right paperwork and the people and all that stuff that, that has, you know, means the actual tariff collections have been more modest, that may gradually rise and there'll probably be some lost income relative to the statutory rates that will exist for a while. So that's part of the reason. And then part of the reason is it's taken them time to flow through to actual prices that households are seeing. Depending on how you calculate it, probably the most direct effect, households are absorbing about 60% of the tariff increase and US business is about 40% and foreigners zero. Depending on how you think about it, if you include related domestic goods which have also seen price rises, that number comes out closer to 100% of the tariff impact being absorbed by US households. So look, it's like a 1% drag on consumer spending which matters, but is not in any one month. You would never notice it. Right. A 1 to 1.5% drag nominal on an annual basis. It matters, but it's not game changing.
- [11:11]
Host 1
What are your thoughts on where the Fed stands here? On the one hand you have above target inflation. You obviously have some, like you said, maybe there's some flow through a little bit more left from the tariffs. We have a weakening job market to some extent, labor market. So what are you, what do you think the Fed and Fed did cut and they kind of has have signals this rate cutting, you know, initiative, policy stance. But just how are you viewing sort of where the Fed stands today?
- [11:42]
Bob
I think a big part of the lift of all financial assets that we saw in the last couple of months really came from the transition from over the summer. There's a question about whether the Fed would deliver meaningful cuts in the near term. And by Jackson Hole, Powell confirmed that basically they were going to not care at all about what was happening with inflation numbers. So we're going to look through that. They were going to solely focus on the labor markets. And so you've gotten, you know, a pretty good rally in the short end, in the long end, all reflecting the expectations that we're going to have a reasonable number of cuts, you know, a reasonable cutting cycle over a couple of quarters. The challenge with that is that that, you know, by lowering the discount rate it lifted all asset prices to some extent, created more mania and speculation in the market of around the Run it Hot story. The challenge is repeating that is very difficult for the asset markets because in order to repeat that gain you have to have easing that is greater than what is priced in. And that's the challenge. And I think it's part of the challenge right now. I was writing about that earlier this week about there's a fair amount of cuts being priced in. And at the same time what you're seeing is the Fed is signaling that maybe even December is off the table. Both Powell at the presser and then I don't know how many speakers came out in the last two weeks to basically repeat the same thing. And in some ways what we're seeing in the markets the more recently like today is a bit of an indication that maybe that December, those December cuts are off the table. And if that's the case, that certainly is going to disappoint those who are expecting Run It Hot to be the dominant driver here.
- [13:33]
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- [14:29]
Host 2
I'm going to go back to the Fed in a second, but I want to ask you about the economy because one of the things I learned from like your initial appearance with us is this whole idea of the income driven cycle versus the debt driven cycle and that everything kind of moves slower in that, you know, all of us are waiting for the crash. The crash doesn't come. It's like this barge. I mean, is that kind of still where we are? Like things are slowing down but like, I mean you hear things still these days, like the cracks in private credit are going to, you know, we're going to have a 2008 from that. Like, do you think we're still kind of just in this slow moving thing?
- [14:55]
Bob
Yes, it's the short story, like credit, private credit picked up. But it's really like the big picture is like credit is not a primary driver of this cycle expansion. And just now a year ago, two years ago, three years ago, it's basically not been the primary driver of the expansion. It's been income finance spending by households as well as income financed capex and spending by businesses out of their free cash flow. That's basically what it's been. And so as those things adjust, that's what leads to adjustment in the overall growth rate. And I think the thing that you see recently is in a very gradual way, household incomes are cooling. And if you look at what's going on, if we basically say the household math of this in terms of their spending power is there's zero job growth, wages are growing at three and a half percent, give or take wage growth per worker and prices are rising about 3%, which means that households have 0 to 1% real spending power growth. That's the reality. And in any one month or quarter they could spend a bit above that, which is what we saw over the summer. They can also spend below that, which is actually what we saw early in the year. But that is their spending is something like a 0 to 1% real demand. And if that's the case from a structural perspective, then basically something has to change in order to meet sort of expectations of 2 or 3%. In part, what met that close that gap in expectations this year was the AI investment boom. But now there's only so much that those hyperscalers. Overall that spending represents 1% of the economy. So it can influence GDP for a quarter or two, but it's not going to drive the whole economy over time because they're going to run out of cash to be able to do it. And you're already seeing that because they're starting to borrow or you've got to see something that indicates labor markets or wages picking up and you just, it's not there. There's no evidence that there's a meaningful rise in labor markets or wages. And if that's the case, we're kind of stuck in this late cycle economic malaise that you know, is kind of, what do you call it? It's a slow session. Right. It's not, it's not a, it's not a recession, it's not a crisis. It's just a slow session for now.
- [17:28]
Host 2
So Justin, just as a note to self delete the YouTube crashes cover coming cover that we created for this. We're gonna need something else for this one. I wanted to ask you, did you listen to Jack Farley's interview with Steve Mirren?
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Bob
I, I didn't. Although I've read enough of the, I feel like I've read enough of the commentary about the podcast.
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Host 2
Yeah, yeah, you probably, you probably know.
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Bob
But I probably haven't thought or two about it.
- [17:51]
Host 2
Yeah, I just wanted to ask you about that case because I mean that, that seems to be the case. People are making for more cuts. You know, one is shelter inflation is lagging and you know, the actual shelter inflation is much lower. So inflation's not as high as we think. Other things, you know, around, like we're just mismeasuring inflation. Things like asset management fees, the market's going up, so it's making inflation go up, but that's not, you know, necessarily the real inflation. And then the idea that the Fed is significantly restrictive now so the risk is to the downside. So the Fed should be cutting because they're significantly restrictive. We need to get back to kind of normal. That seems to be, I think, I don't know how well I summarize it, but that seems to be the summary. The summary of that case. Like what do you think of that case?
- [18:28]
Bob
Well, I think first of all I'd say that when you listen to, for instance, Powell talk at the presser and he says we have a circumstance where measured inflation is elevated, where labor markets are soft and where the unemployment rate is stable or not rising that fast because of supply side considerations, like that's a, that's a tough mix of different things to weigh as a central banker and that, and that essentially there are very reasonable thoughts that could look at that set of circumstances, very reasonable folks who could look at that set of circumstances and say maybe we should be a bit tighter, meaning like we should hold interest rates roughly where they are. There's also totally reasonable data driven thoughts that say, hey, look, I'm a little more worried about the downside. Let's cut into this sort of environment and essentially hope with good reason that the inflation, the elevated inflation is transitory to some extent. And so in that sort of range of different views, Myron is on the more dovish end of things. I think a lot of people will say all sorts of nonsense that he's a political junkie and all that stuff and he's just pursuing the President's policies. I don't think that that's, I don't see significant evidence of that. Like he has a data driven view of what he believes is, should be policy ahead. It's a bit, it's an outlier, meaning it's like marginally more, it's probably one step easier than the rest of the committee. And about half the committee right now is basically saying, you know, when we balance those pressures, it doesn't make sense for a December cut, maybe a touch more than half at this point. And so that's kind of where the committee is settling. And so I just think about Myron's view as kind of being the most dovish interpretation of the actual data that's being seen.
- [20:32]
Host 2
And it seems to me like, I mean, we all want to criticize the Fed, but it seems to me like they're in one of the more challenging situations they've been in, like since I remember in my career. I mean, inflation's never been a problem before, so they've never had to worry about it like it seems like it is. There are like, to your point, I mean, we may have different views on it, but there are cases to go in both directions right now. And it's challenging. I mean, we'll know in retrospect, but it's hard to know right now.
- [20:50]
Bob
Well, I Think the biggest challenge, and this is a challenge that always exists for the Fed, is if they had any skill at predicting what was likely to transpire, then the outcome would be clearer about what they should do. But the problem is they don't have any skill in predicting, predicting. And given that they have no skill at predicting, they're kind of stuck in this backward looking data challenge. And given that, essentially I think.
- [21:26]
Host 2
If.
- [21:27]
Bob
You were just looking at the data on the surface, you could break either way depending upon essentially what do you think is going to transpire in the future? I'm actually personally a bit sympathetic to the idea that the inflation pressures, the measured inflation, will peak at a little over three and will fade as the tariff policy moves through the system. And that probably the labor markets and demand side is actually quite a bit weaker than many people are realizing. And it that circumstance, you probably do want to cut into that rather than hold your firepower because you don't want that self reinforcing negative dynamic to emerge with asset prices falling and layoffs and things like that. And you're kind of close to a knife's edge on that. I think. I'm sympathetic to that. My personal policy sympathies are irrelevant to trading markets. What matters is what the Fed's actually going to do. But I certainly think that there's, it's a very reasonable case to make that there should be proactive and easing in this environment.
- [22:43]
Host 2
As you know, I'm kind of a macro tourist, so I can ask enough to be dangerous in terms of asking questions, but I don't know that much below the surface. So I wanted to ask you about this whole thing about the Fed stopping qt, because one of the things I've seen going back to the YouTube thumbnails is I've seen stuff about crisis in the money markets and things like that, and then that being related to the Fed stopping quantitative tightening. So can you just explain like what's going on there and why they're doing what they're doing?
- [23:06]
Bob
Yeah, yeah. First of all, quantitative tightening was going to end soon, kind of no matter what. And it was just a matter of exactly what quarter month, whatever it had fallen, it already slowed to $5 billion a month in treasuries and you know, relatively modest MBS roll off. And so the stopping of QT, I feel like it gets a lot of headlines. And it's like the difference between 5 and 0 is literally a rounding error in markets that are $30 trillion in size. So this is not a big deal in the Scheme of things. But I think part, there's two reasons why the Fed has transitioned to stopping the balance sheet rundown. The first with a monetary policy element. They won't say it, they wouldn't say this explicitly because for some reason there's some taboo about using the balance sheet on the tightening, you know, to be, to be tighter than what's implied by interest rates. But basically they went from selling a fair amount of assets to selling very little assets, which on the margin went from tight, you know, tighter than tighter policy than implied by interest rates to, you know, policy that's essentially applied by interest rates. And that was appropriate given we went from environment of elevated inflation to less elevated inflation. So that was kind of the first step. Now the question is basically what should. The second step is basically what's called balance sheet normalization, which is basically say, look, the Fed's balance sheet shouldn't be, you know, bloated unnecessarily like the Fed's balance sheet should be, you know, at the size that is necessary to have smooth functioning economic conditions and financing conditions, particularly in the banking system. And where exactly that level is, is like, you know, anyone's guess really. And the Fed will say that, they'll say, ah, you know, we, they have a concept they like ample reserves. Like well, what's it, what is the number for ample reserves? It's like, well, you know, it's like, it's like pornography, you know, you know it when you see it. They don't say it that well but you know, it's like that's, you know, it's like that's kind of how they talk about it. Right. And, and I, and I get why that is because it is uncertain to know exactly how much liquidity needs to happen. Because it's important to recognize, recognize in the banking system liquidity is not evenly distributed. Some banks hold more reserves, some banks have less, some are tight, some are not tight. What we've seen in the last couple of weeks is we've gotten to a point in terms of the overall liquidity level that a few banks, a very small number of banks have run into a bit of a liquidity problem. And so you've seen a little bit of an increase in short term interest rates and financing which an overnight rate going up 10 basis points, important to recognize if you're financing for one night at 10 basis points higher. The impact on your nim as a bank is the third or fourth decimal percent in terms of overall impact. So it's not a big impact. These aren't big jumps. And it caused the Fed to bring in a bit of liquidity, about $20 billion or 0.1% of the overall banking assets to ensure that that rate got normalized. And that's basically what's happened. And the Fed looked at that and they basically said, look, it seems like we're basically at this ample reserves level. We probably don't want to drop it meaningfully below this because more than just a tiny number of banks will run into trouble and we might get more challenges. And there's no good reason, there's no reason. There's no positive outcome from having friction in the interbank lending system. Like, no, no value in that. Right. Just banks should have ample reserves. And just in the same way, banks should just be well capitalized and that way we don't have to stress about it. And, and so they kind of came to that conclusion that we're basically there and that's what's happened. Which is far from very boring relative to thinking there's some grand crisis.
- [27:08]
Host 2
Justin. Delete crisis in the money markets as well. Gotta take that one down, hopefully by the end. Bob, you got a crisis for us somewhere. Is there? This is probably a dumb question, but I mean, obviously since 2008, the balance sheet has gone up a lot. Is there any reason like they want to get that way back? I mean, obviously it's not going back down to where it was before that. But is, is there any negatives of it being that big or are there any reasons they'd want to eventually get it way back down?
- [27:30]
Bob
I mean, theoretically banks having more liquidity available could lead to increased risk taking relative to if liquidity was a bit tighter. But the primary constraints on the banks are not liquidity or reserves or anything like that. It's mostly, I mean, from the bank's perspective, their supply constraint is mostly when it comes to capital. And banks are better capitalized than they've essentially ever been in all of history by like 2x. So capital isn't really a constraint. The main constraint on banks lending right now is a demand constraint. That's why there's no borrowing from banks, because people look at, you know, the interest rate or businesses look at the interest rate and they say it's too high relative to what they want to do with the money. And so they're not borrowing. So I don't think that there's like a, a meaningful lingering risk that exists in the system on the margin. There is an influence on treasury yields to the extent that the Fed is holding A lot of duration assets, meaning like if they hold a bunch of long duration bonds, the market is clearing, most likely at a lower interest rate than otherwise would occur, which probably doesn't matter that much. But it is a distortion in the treasury markets and the duration markets. And so that's why we've also seen the Fed say they're slowing, they're basically stopping qt, meaning they're stopping the runoff of the balance sheet. But they still intend to transition their overall balance sheet composition to be more aligned with the overall composition of treasury debt outstanding, the duration of treasury debt outstanding, which is a few years of duration shorter than their current holdings. And that would make them sort of like a neutral market participant in the overall treasury markets on the margin, they'll probably take five years to do to make that transition and who knows what crises we'll have in between now and then. But if they make that transition on the margin, that is a modest tightening in terms of financing conditions or asset prices as they sell duration and buy slightly shorter stuff, which is something actually Myron brought up in that, in that podcast.
- [29:50]
Host 2
So when we take your economic outlook and think about the stock market, I think you probably are feeling like it's priced pretty optimistically relative to what you think, where you think we are and the way you think things are playing out.
- [30:01]
Bob
Yeah, I mean, in some ways it's a pretty simple thing which is like if you just, if you sort of look through the tariff tantrum and you look and sort of where that went down and back up and you sort of start there, what you see is that stocks, the aggregate stock market has outperformed similarly matched bonds by about 20ish percent over that period, which is relative to risk matched bonds, which is a good indication of how markets are pricing in growth conditions. And that is strong. Those are very elevated growth conditions. I think the thing when, you know, a macro folks always sort of hesitate to get into the micro dynamics of the market. But at times it is necessary when there are such meaningful micro dynamics that are driving the macro outcomes in the markets. I think under the hood, what you basically see is you see the sort of real economy stocks which you kind of like very simple cut through and get a read of looking at something like the equal average S&P 500. What we see with those is they're basically flat for the last year, which is basically in line with the economy. Right. Because you'd normally expect those to be growing, you know, prices to go up 8 to 10% a year and they're basically Flat which means like not a great year for stocks, for equal weighted stocks. So what that highlights is that basically all of this rally is coming from a small number of large cap stocks, tech stocks, mag7, etc. That are basically driving the whole rally on what I'd call AI mania. And so that is. So the question is really not just, you know, it's not really a total growth outlook because I think that's actually being reflected somewhat reasonably. The question now becomes is the AI mania appropriate or not appropriate given the likely realities?
- [31:55]
Host 2
Yeah, I think it was Michael Sembla, she probably saw this as well, that had that data on like how much of the stock market rally, but also how much of the fundamentals are being driven by AI? I mean basically everything is AI right now.
- [32:05]
Bob
Yeah, I mean a lot of the incremental, whether it be the incremental growth rates in the economy in terms of, you know, what sort of boosted growth, despite the fact that household consumption has slowed, what has kept growth less weak than it otherwise would be is, you know, significant AI related spending. And so, and similarly when you look at the, at the equity market, basically it's AI oriented profits that are the primary driver of the outperformance and of the growth. And I think a lot of that, if you get into the internals of that, a lot of what's happening there is a lot of what I'd call self referential activity, meaning you have open, you know, Microsoft giving money to OpenAI, who's buying Amazon cloud services to do their activities and those sorts of things. They can exist for a while, particularly since they can be financed by, you know, mag sevens which have good cash flowing businesses. You know, I call them, you know, I call them old cos, right? They have good cash flow flowing old cos that they can use. They can basically light lots of money on fire to do all this AI investment and spending, etc. Etc. But the real question ultimately is going to be is there any real world income driven by any of this AI stuff that is going to meaningfully change the needle, meaningfully move the needle in the real economy? And there, I think certainly the jury's out, there's a lot of techno optimists who will make a case that this is likely to be the most radical productivity transformation in the history of humanity. I look at the data and I see nothing, basically nothing in terms of no impact on productivity, very little impact on real economy earnings or sales. I think Meta is actually a great example because Meta, the good thing about Meta as an individual Company. Again, I'm not an individual company analyst, but sometimes you got to look at the companies to really get a sense of it. Meta is an advertising business and a whole bunch of AI Capex, right? So if you look at what they're doing, so all their income is driven by the real economy. It's just advertising, right? All the normal advertising that you get through their platforms. Their advertising growth, their revenue has gone up a couple billion dollars. Like it's. It was growing at a reasonable pace. They invested a bunch into AI and they've gotten a few billion dollars more than they probably otherwise would have gotten given sort of normal trend growth. Well, a few billion dollars more a year when they're investing $70 billion a year in AI capex is a terrible return, particularly when that Capex has a shelf life of something like five years for the high value components. So that's what's happening right now. And you look at Amazon AWS and they're doing the same thing. $20 billion a year more revenue in AWS sounds great when you invest $125 billion to get it sounds like a terrible deal, right? And that's kind of what we're seeing is that an OpenAI, I should say, which is probably the worst of all of them, claims that they need $1 trillion of investment in order to meet the compute needs over the course of the next two years. And right now they're earning $10 billion a year. Like how the heck are they going to off a trillion dollars of investment if they're earning $10 billion a year? Like they'd have to have some of the most exponential growth that has ever existed in the history of companies in order to make that make any economic sense.
- [35:55]
Sponsor/Ad Voice
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- [36:25]
Bob
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- [36:56]
Host 2
Yeah, it's interesting. This has been so challenging for me because we just had Kai Wu on, he wrote a great paper about this talking about how if you look back at the railroads, if you look back at the Internet, like these companies that were building the infrastructure, it typically, it went, it went pretty poorly for them and maybe the benefits carried other way in other places. But also like I think about just, you know, you're great to talk about the overall economy and like, I can't translate what I'm seeing. I'm seeing efficiency in my own life here, but I can't translate that in any way in terms of what that means for the economy in five years. And to your point, the techno optimists will tell us stuff about like, the world of abundance is coming. Um, we're all going to be sitting at home and I guess there's going to be massive income and it's going to be redistributed or however it's going to work and like we're going to have everything we want. And it's hard for me to separate those things and think about like, what is the actual economic impact as I think like something like five years out.
- [37:40]
Bob
Yeah, I. One of the key challenges that I think many folks, I'd say there's sort of two key challenges many folks struggle with when they're thinking about the macroeconomic effects of these sorts of technologies, technology adoption. I mean, the first is how much does that technology adoption lead to making more money. And I know, you know, not to be crude here, but like the only thing that matters to GDP is making more money. So for instance, you could use ChatGPT to save you some time, you know, so you have more leisure. Right? That's consumer surplus. You can use ChatGPT to learn something new that you had never learned before, but you probably wouldn't pay for it either. Right? That's a consumer surplus. And so we see a lot of consumer surplus. And of course there's more extreme versions of consumer surplus in terms of the areas and fields that ChatGPT is happy to an OpenAI is happy to move into. Those are all consumer surpluses that are not related to people paying. I mean, there's subscription fees for OpenAI and stuff like that. But like, that stuff is de minimis relative to having a meaningful effect on the real economy. Right. Like if it OpenAI ends up being Netflix, who cares? I mean, whatever, it could be a fine company, but like, who cares? It's not a macroeconomically significant driver of productivity in the economy. Right. It's just another, you know, entertainment provider people spend some money for and get some, some value out of. And so I think that's the challenge is people aren't necessarily looking at this and saying, are we making more money? So, like, even in your own life, if you look at how do you use ChatGPT, is it saving you some time so you can engage in more leisure? Not that helpful.
- [39:31]
Host 2
Right.
- [39:31]
Bob
Because you're making the same amount of money, not GDP beneficial. Right. If it's, or is it actually making you more money? And my guess is you'd look at it and you'd say, nope, I'm not making more money. I'm not making more money from this.
- [39:47]
Host 2
I mean, if it's making me more money, it's because we're getting out more podcasts. But as you can imagine, Bob, the, the podcasting business is probably not a. He's not a podcast. Probably not contributing that much to G. To GDP.
- [39:56]
Bob
Exactly, exactly. Those, those YouTube fees, they certainly, you know, YouTube will buy you a sandwich every once in a while, but that's, that's about it. Unless you're Mr. Beast.
- [40:08]
Host 2
That's what I think a lot about is I, I think, like, forget about the hyperscalers. I think about like your average business out there. Like you talked about, like, the average S and P stock is not doing nearly as well as the S and P itself. Like, how do those businesses harness AI to make more money and whether they can do it. I mean, to me, that's, that's a really important question. I don't know the answer to it, but I think that's huge in terms of, like, what AI ends up being.
- [40:28]
Bob
Well, I think that then connects to the other point of this that I think a lot of people miss. So there's a question of like, can they make more money on the top line? And then the, the underlying question is, you know, often people will say, oh, well, who cares if they make more money, they'll be more profitable. And it's like, okay, so let's talk about profits. Because there's a relationship between technology and profitability and income, which I think gets lost. That sort of, sort of old hat from a macro perspective. But get lost by. Is lost by the techno optimist. And the very short story of that is what happens to the people that you fire if you get higher productivity or you get job savings from AI, what happens to them? What happens to their stuff?
- [41:14]
Host 2
They spend less money.
- [41:15]
Bob
They spend less money.
- [41:16]
Host 2
They spend less money because that is.
- [41:18]
Bob
The conflict in the economy is that one person's, a business's spending on employment is a person's income, which leads to their spending, which helps businesses top line. And so I think the story of saying, you know, if you ask the techno optimist, you say, you know, they'll say, hey, look, this is going to cut, you know, a huge amount of jobs and lead to great margins. And then you ask them, okay, well, when those people lose their jobs and they don't have any more money, who's going to spend on the company's outputs? And that like heads explode and they have no answer. I mean, I'm serious, like I've yet I've bring on the techno optimist who can answer that question. Because right now nobody has answered that question. And the reason why they can't answer that question. Well, first of all, they're not particularly familiar with the macroeconomic dynamics. But second of all, because the answer to the question is that spending falls, so unless aggregate productivity increases and that aggregate productivity flows into real wages, you don't actually see a benefit to GDP and to company profits.
- [42:33]
Host 2
I just have one more on the ETF space before we. Justin will talk about what you're doing in the ETF space, but I want to talk about something you're not doing in the ETF space, which is it seems like we're all of these private fill in the blank after them type of things are now going to be brought into the ETF space. And I'm just wondering what you think about that. Like the idea. Well, first of all, what do you think in general about the idea that your average person should be in private equity, private credit should be in those types of things. And this is something where rich people are making a lot of money and your average person doesn't have the ability to make that money. And this is something that should be brought to the masses. Like, what do you think about that idea?
- [43:04]
Bob
Well, first of all, rich people aren't making any money on that stuff, right? Just, just so that we're all clear on that, like, if you compare, it's actually a great piece that just came out by Pitchbook, who went back over the last 30 years and looked at all these private, what I call sort of alternative assets, private equity, venture capital, et cetera, and looked at how, what the returns looked like relative to public Market comps, the returns were negative, net of fees. Just remember negative returns relative to public market comps. So rich people aren't even making money. So let's start there. Rich people aren't making money. So man, if rich people aren't making money, are we really sure we want to be bringing it to people with more moderate incomes? That's the first point. The second point is I think the real challenge in these things is around information asymmetry. And what I mean by that is there's a lot of things in the world, in the world of financial markets where people can invest in stupid things, but everyone's on the same playing field in terms of their ability to access information. They may not at all access it, but like if you're trading Microsoft stock, like the filings are public, like you can see all the information that you need. The challenge with these sorts of products is that often there is undisclosed information that's held by a small number of folks that can advantage certain investors relative to others. And the challenge with the sort of everyday investor is they can't go through the process. They literally cannot go through the process of evaluating those things necessarily in the same way an institution can. And so given that, I'm not sure. And that creates, I should say, and that creates an opportunity, creates an opportunity for those folks issuing those securities to sort of the common man to take advantage of them. Whether it be duff crap assets into those products that the retail investor doesn't understand, doesn't know in order to advantage the institutional investors or even worse. Some of these things that I see are outright lying about what's going on. So a great example is, is dxyz which is sort of a venture capital access to venture backed businesses in a closed end fund structure for all investors. Right? It's a retail product. On their website, go to their website, it says management fee 2.5%. Read their most recent semiannual update. Total fee load 7 1/2%. 7 1/2 percent. So tell me who have you guys ever read page 38 of, of a semiannual update of a closed end fund? No. I mean you guys are in this industry, you know, like so I mean that's a perfect example of just, just, just fraud. Just plain and simple fraud. I got some threads on DXYZ if folks are interested they can look me look at those threads up on Twitter. But it's just such a good example of how it is, just creates such a market for grifters because of the asymmetry of information and the Ability to hide information from investors.
- [46:31]
Host 1
The thing that I struggle with too is you have like all these major institutions like seem to be bringing this stuff into 401k plans and kind like sort of like indirectly. I mean by offering it to investors, they're sort of like giving their stamp of approval because it's on their platform, it's in their ecosystem. So the two things sort of are like at odds. Like I agree with everything you're saying, but then at the same time you have, you know, major banks and advisory platforms rolling this stuff out to clients, you know.
- [47:02]
Bob
Yeah, I thought actually I had an interesting interaction with the, the portfolio manager of PR I V which is the, the PRI private credit etf, which is a little bit of a. How that got through the naming rule I don't really understand because it's less than 15% private credit. But anyway, let's leave that aside. And for those who are not familiar, the way it's set up is that because ETFs basically have to hold primarily liquid assets, basically only liquid assets, there's a backstop. So Apollo provides, identifies assets, private credit assets that go into the CTF and what they agree to do is they agree to offer a bid on those assets at any point in time that in which liquidity is needed. And so the way that that's structured, it means if there's redemptions to that product and they need to liquefy those illiquid private credit assets, the fund manager would go to Apollo and say I need a bid on these assets. Now to be clear, what it says in the prospectus is a bid. A bid could be a single pennant. And so you have actually two areas in which there could be conflicts of interest, obvious conflicts of interest that could befall the retail investor. One, Apollo could choose crap assets and sell them to the ETF at elevated prices in order to dispose of the worst of their institutional portfolios. And number two, if that product got into trouble, they could have an off market low bid and basically take advantage of investors to create the liquidity. And when I proposed this to the portfolio manager of this product and I said, what do you have to say about that? He says, yep, that's what we can do. No shame, no hesitation, totally fine screwing the retail investor. And so I mean such a good example of again that's, you know, those mechanics are in, you know, page 97 of the 150 page prospectus, which I'm sure no one is getting to except the real nerds like myself. But it's such a Good example of, you know, even institutional grift, known, known institutional grift that exists in the market.
- [49:24]
Host 2
Just as a really quick aside for Justin asks the next question like this is, this is so important because one of the things that happens when you put private things into an ETF is you have to hold mostly public things for liquidity. Right. So even if you're a believer that like you're going to get a great return from private credit, you're not going to get that much of it in these products because they have to by definition hold something else in order to provide the liquidity drop.
- [49:45]
Bob
Exactly, exactly. And I think, you know, Apollo was trying to, they were trying to be cute in this product to kind of get around those liquidity requirements. And I'm a little surprised that the, the SEC was cool with that. But, but you know, it creates all of these challenging incentives, one might say.
- [50:08]
Host 1
Let's talk about the new ETFs that are part of your ETF lineup. So maybe to start, walk us through. I think you've launched three new strategies this year. One in April and then two in July. So they're newer on the market, although I think they have long term, you know, back tests and solid rationale behind them. But talk about those strategies. Bob, what are you actually doing here?
- [50:30]
Bob
Yeah, so you know, for those of us who are familiar with our, our my day job, so to speak, you know, we've at unlimited, we've built, you know, our goal is to build, you know, Manager diversified 2 in 20 strategies at low cost for every investor. And we started in the hedge fund space and a few years ago we, we built our, our hedge fund replication technology which we've been using for a few years to track overall industry returns in our multi strategy product and approach. And, and that's gone, you know, consistent with what we expect pretty well. I think the challenge is it was really, you know, it's been really targeted at, at tracking hedge fund industry returns for institutional investors. And institutional investors are typically looking for bond like risk or lower and are looking for returns or strategies that are kind of like what I call cash plus. So they're looking for cash plus 300 basis points or something like that. And those strategies have performed in line with that expectation. It's just that those sorts of returns are a bit subdued relative to what a lot of advisors are looking for. And also some of those strategies, some of them are more correlated to asset markets and some of them are less correlated to asset markets. And so when we went, you know, a lot of ways we stood it up as a proof of concept to basically say, hey, look here, here's what we can do. We've developed this replication technology. Here's a product that shows that it's doing what it's supposed to be doing. But what do you want? And this is actually kind of, this is kind of the fun thing about working with, with so many advisors is, you know, they're pretty open about what they want, what they need, how you can help them. And so after getting a bunch of input from advisors, what they said to us is sort of two things that they wanted. One, they wanted the individual hedge fund strategies broken out so they can think about how they can complement them to their in to their portfolios. And number two is they want a more cash efficient product, meaning higher target returns, something more like equity index risk and targets rather than something like bond risk and targets. And so what we did this year is we took in all that feedback, talked to hundreds and hundreds of advisors and said, okay, what we're going to do is we're going to launch the individual sub strategies, so equity, long, short, global, macro, managed futures, those individual strategies and then target them at a equity index like risk level so that they're more cash efficient when folks are implementing them in their portfolio.
- [53:08]
Host 1
Yeah, so that's nice. So you have the, the core initial one and then you've kind of split out the different strategy so you, you know, you can get more targeted with what you're looking to accomplish. And by the way, I know from talking to you in the past, in past episodes, the vision was for always for you to launch other strategies. And I think as an ETF shop, you know, you never know, you know in any given year or two years what strategy might just do really well. And it might, that might be the one that investors get into. Hopefully they don't chase performance, but it's just the reality of the ETF business. So that's a good. Yeah.
- [53:42]
Bob
And I'm consistently, you know, the old adage is if you've talked to one Ria, you've talked to one Ria and I really, that is really true. And so we talk to folks and everyone's, everyone's looking for something different. I mean a lot, I think a lot of folks that we talk to, you know, they're sort of in this process of transitioning from like the 60, 40 portfolio to something that's closer akin to 50, 30, 20 where that 20 is alternative asset classes like private credit and some alternative strategies like for instance hedge fund Strategies like what we're, what we're working on, but each one is slightly different and I think it's, it's exciting because, you know, now we can have a really nice strategic conversation with a lot of these advisors. What are the gaps? What are you looking for in your portfolio? What are you missing? What do you wish you had? You know, whether it's a more cash efficient managed futures exposure or maybe it's a more sort of through cycle alpha strategy like a global macro, or maybe it's an active equity replacement where long, short equity actually looks quite compelling relative to a lot of the active products that are out there. So we're having those conversations and everyone's different and it's great that we can service kind of a wide variety of interests.
- [55:00]
Host 1
Now I'm going to do what we tell everyone not to do on this podcast, but I'm going to become a performance chaser here. And I was kind of blown away by the, and I know, you know, you can't talk performance specifically, but the global macro strategy, which, you know, I'd like you to kind of explain that, but I mean, just out of the gate here it's like kind of ripping, which is, which is crazy, but just explain sort of what, how you're building that strategy with this replication technology that you built.
- [55:29]
Bob
Yeah, so we, we have developed. Replication's been around for a while and there's lots of products that are out there related, you know, that our replication. I'm sure regular listeners of this podcast will be familiar with the various managed futures replications that are in the market. What we're doing is, I like to sort of call it third generation replication is. So instead of using sort of rolling regression type approaches, we're using a Bayesian machine learning process which allows us to infer positions on a more timely basis than using sort of rolling regressions with longer back ends. And as a result, we believe allows us to capture more of the tactical alpha that that's causing position shifts. Because, you know, knowing what hedge funds you global macromanagers have done on average over the last few years is not that helpful. Knowing what they're doing today and how they're shifting their positions over time is much more useful and allows you to capture the alpha. And so we use that understanding, you know, on, every day we get incremental information, performance information, and we use that performance information to infer how those managers are positioned in close to real time. And then we take that understanding and translate it into long and short positions in, in our etf products. And I think a lot of folks have looked at the macro strategy. I think it's, it's a very interesting, you know, macro hedge funds, if you look over the course of the last 10 years or post GFC, it's interesting to see the two periods that they performed the best were 2022 when all assets went down and this most recent period when all assets went up. And so when you think about that, what that highlights is that those managers really have the flexibility to go long and short in different times means that you can generate good returns in negative market environments, in positive market environments. And that's, you know, that's playing out in real time.
- [57:27]
Host 1
Yeah. And that particularly is important if you have like you said, a period of like 2022 where stocks and bonds are going down, but you have something in your allocation that's going to go the other way, that's just going to help overall staying the course, diversification, good things for clients and all that stuff.
- [57:43]
Bob
Exactly. And particularly from my perspective, and this kind of ties back to the beginning of the conversation when you get to these sort of late cycle environments, it's a very challenging environment. And the reason why that is is because expectations can remain elevated longer than, than you might think. And so if you're only, you know, if you're. And at the same time dynamics can shift faster than you can respond. And so it really is an environment that advantages tactical positioning. So the ability to basically respond to that Jackson Hole speech where Powell endorsed essentially ignoring the inflation side of the mandate and only focusing on the labor market, super important to take advantage of that, to be able to go long all assets and chase that basically benefit from that rally, but then be able to start to shift away from that. To the extent that we start to see, you know, the macroeconomic environment deteriorating.
- [58:48]
Host 1
Do you, are there other strategies in the hedge fund universe, other hedge fund strategies that you have your eye on possibly replicating in the future?
- [58:58]
Bob
Yeah, so we replicate a wide range of them in our multi strategy product and we launched the three that I mentioned this year because to be honest, they're the most complimentary set of different strategies and they sort of, you know, together kind of meet 80 to 90% of the demand. The folks that we talk to and we might, we still have our eyes on a couple of additional ones, whether it be event oriented strategies or fixed income oriented strategies, they're certainly still around and we're thinking about when is the right time to, to launch those. But kind of in light of our conversation about privates we're now starting to explore whether we can bring that concept of low cost indexing over the world of alternative assets, things like venture capital, et cetera. And so that's a key area of focus that we have right now and hopefully we'll have some interesting things to talk about in the new year.
- [60:06]
Host 1
Yeah, and by the way, just in closing, I think it's important to point out that, you know, all of your ETFs are, you know, unlike a hedge fund that might charge 2 and 20 or 1 in 20 or whatever the fee structure is and the performance fee, you know, your ETFs are replicating strategies that are getting similar types of return, but you're doing it with, you know, very cost effectively within the ETF wrapper.
- [60:31]
Bob
Yes, that's exactly right. I mean that this is really, when it comes down to it, the question is how do you generate differentiated performance over time? And I think a lot of folks, a lot of folks spend their time in the hedge fund universe trying to pick managers, right? Trying to find the best manager. And if you look at all of the data that's available and you do a rigorous analysis, what you find is that there's no single manager outperformance persistence amongst institutional quality hedge funds. And so if that's the case, if you take that for granted, to be clear, lots of people speculate that they can have edge in picking, but they've not brought me the goods in showing me the data that they can. Then if that's the case, then what you really want to do is you want to manage or diversify and you want to focus on lowering fees. The best way to outperform the index in hedge fund space is lower fees. And the beautiful thing, the beautiful thing about lower fees, lower fees can be persistent, right? You could always, it's very easy to be cheaper than other people like that. That is, that is what we call a durable alpha as being cheaper than other folks. And, and you know, when you start to talk about, for instance, a strategy that is, you know, targeting sort of 2x the target returns of the typical hedge fund strategy and is also charging, you know, less than 1% in terms of fees, you're looking at bringing down the overall fee load of those products by about about 85%, 85, 90% relative to a typical hedge fund, not to mention, you know, other things like tax advantages, liquidity, transparency, better regulatory infrastructure, all of those other things that are also advantageous to an ETF wrapper.
- [62:24]
Host 1
You know, you're where the goods sort of comment made me think of like, where's the beef? But then I think it would be more like where are the potatoes? Right.
- [62:32]
Bob
Exactly. Where are the potatoes?
- [62:34]
Host 1
That's a little inside joke. So anyways, hey Bob, listen, thank you very, very much.
- [62:38]
Bob
We appreciate it.
- [62:39]
Host 1
I know what audience does too, and we'll see you again soon.
- [62:42]
Bob
Thanks so much for having me on.
- [62:43]
Host 1
Thank you for tuning in to this episode. If you found this discussion interesting and valuable, please subscribe on your favorite audio platform or on YouTube. You can also follow all the podcasts in the Excess returns network@excess returnspod.com if you have any feedback or questions, you can contact us@xsreturnspodmail.com no information on this.
- [63:03]
Host 2
Podcast should be construed as investment advice.
- [63:06]
Sponsor/Ad Voice
Securities discussed in the podcast may be.
- [63:08]
Host 2
Holdings of the firms of the hosts.
- [63:11]
Bob
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- [63:40]
Host 2
Hey, Ryan Reynolds here.
- [63:41]
Bob
Wishing you a very happy half off holiday because right now Mint Mobile is.
- [63:46]
Host 2
Offering you the gift of 50% off unlimited. To be clear, that's half price, not half the service. Mint is still premium unlimited wireless for a great price. So that means a half day.
- [63:59]
Bob
Yeah, give it a try@mintmobile.com switch upfront.
- [64:03]
Sponsor/Ad Voice
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