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Excess Returns
Show Us of Your Portfolio II: Larry Swedroe on Alternatives and Interval Funds
01:06:44
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- [00:00]
Justin Carbonell
Welcome to Excess Returns, where we focus on what works over the long term in the markets. Join us as we talk about the strategies and tactics that can help you become a better long term investor.
- [00:11]
Jack Forehand
Justin Carbonell and Jack Forehand are principles at Validity of Capital Management. The opinions expressed in this podcast do not necessarily reflect the opinions of Valida Capital. No information on this podcast should be construed as investment advice. Securities discussed in the podcast may be holdings of clients of Validity Capital.
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Justin Carbonell
Hey guys, this is Justin. In this episode of Excess Returns, Jack and I do round two of Show Us yous Portfolio with Larry Suedro.
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Larry Suedro
Please.
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Justin Carbonell
Prolific author of multiple investing books and head of financial and economic research at Buckingham Strategic wealth from investing in interval funds to a wide array of alternative assets, Larry walks us through his personal portfolio and his quest to have a highly diversified source of returns that can power his portfolio for the long run and produce desired outcomes in many different market environments. Larry takes a disciplined, evidence based and first principles approach that all investors can learn from. As always, thank you for listening. Please enjoy this discussion with Buckingham's Larry Swagrup.
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Larry Suedro
Hi Larry, how are you? Thank you very much for joining us again.
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Great to be back with you, Justin and Jack.
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We sat down with you earlier this year and you were kind enough to join us on one of our Show Us your portfolio episodes and we were really interested in talking to you about your personal approach to investing. You kind of take an evidence based approach, but then there's a lot of other asset classes. What we learned actually during that conversation, there's a lot of other asset classes and return streams that are sort of feeding into your portfolio. And in that discussion, as we sort of uncovered this with the way that you manage your portfolio, it was kind of funny. Like during the conversation you were like, you know, if you guys want to explore that either now or in the future, we can do that. And then after we had a great 60 minute conversation, you know, Jack and I ended and we're like, okay, we got to have Larry back on to talk about all this other stuff we weren't able to talk about. So that's going to be great and that's what we're going to tackle today.
- [01:54]
That was good.
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Before we get into some of that though, we wanted to kind of just frame up the discussion because I think where a lot of investors start with their personal portfolios is around stocks and bonds. So when you think about the performance of equities and the performance of fixed income given where rates are today, and you think about the future long term returns relative to maybe what the past 40 years of returns have been, let's say, up until the end of 2021. How do you, how do you think about that?
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Yeah, well, first I, I want to make clear here that you want to distinguish, I think, and you were distinguishing between public stocks and public bonds. And there are also equities and fixed income investments that can be private. Doesn't mean they're not equities or fixed income, they're just private. So we want to make that clear. The one good thing for investors which has changed from when I last wrote my complete guide to a successful and secure retirement in 2020, was that rates were at zero and valuations were high so that the expected return to stocks goes going forward or much lower than the historical 10% expected return. A good example that we might look at is the best predictor we have of future equity returns, or at least as good as any we have, is the earnings yield. Whether you take the Cape one or the Cape ten doesn't make too much difference. They both have about roughly a 40% explanatory power. So the Cape 10 was by memory serves, was in around 30 or so. And so that gave you a 3% or so or 3.3 expected real return and expected inflation was, call it roughly 2. So you were expecting 5 or 5 and a half, something like that for equities, which is about half of the historical return.
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Unknown Speaker
And bond yields were in the 1%.
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Larry Suedro
Kind of range, one and a half maybe, and so versus maybe the 4 to 5 that they had gotten historically. So investors who were building traditional portfolios really had to make a tough adjustment if they were going to be realistic. And if they didn't, they were likely to underperform and not achieve their financial goals. Today, valuations for bonds certainly have come way up and that's helped across the board for any balanced portfolio. Equity valuations are kind of bifurcated. And by that I mean if you look at the big market cap indices, which, because their market cap weighted and dominated by a few stocks, the top 10 in the S&P today account for 35%. That might be a record high. And so their valuations look high. Their market PE is something in the low 20s, maybe today versus lower historical number. But if you look at the rest of the market, international stocks are trading more at the 12 and 11 for emerging markets and develop and small value stocks around the globe, at least for the funds of families that get deep factor exposure like Avantis does, you're talking in the sevens and eights, which is like a depression scenario. So those seven and eights are predicting much higher expected returns reflecting what the market perceives as the risk in those areas. So you can't broadly make statements about equity valuations. You have to look at the various segments and see what your portfolio is exposed to when you forecast returns.
- [06:10]
That's a good, good point. And especially up through about a month ago, you know the market was basically being led by that handful of large cap sort of high growth tech stocks that you're talking about. It's brought, it's broadened out recently but I mean that is the one thing that was happening for most of this year is large caps doing awesome and everything else kind of being left behind.
- [06:29]
Yeah. And I think it's worth noting that while what I'm about to say isn't the forecast because my crystal ball is always cloudy, we can learn from history and there's only been three other times that we've seen this kind of concentration in and valuations. And each time that happened, the Nifty50 was the first case. The DoT com boom around the end of the 90s and now and the other two cases, those high valuations crashed while the rest of the market didn't do anywhere near as boiling.
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Unknown Speaker
After that.
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Larry Suedro
So it's at least it's a warning to investors to who have their portfolios concentrated and making bets usually driven by some story. In this case it's an AI story. They tend not to be fulfilled and long term expectation reality tends to be less than the expectations and valuations tend to come crashing down when those earnings don't get realized.
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You gave me a good idea for my YouTube cover image. It's going to be a picture of you looking into a cloudy crystal crystal ball. I'm just kidding. I'm just joking.
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I'm always humble about making market forecasts. Anyone who is a legend in their own mind. That's all.
- [08:02]
Exactly. Yeah. I wanted to ask you about, you talked when we first talked to you about your personal portfolio, you had this idea of equally distributing risk and I just thought before I hand it over to Jack to talk about some of these alternatives, sort of if you could just explain how you actually think about that or do that in practice.
- [08:21]
Yeah, this is really good starting point. I have what are basic called first principles. The things that matter most when you think about building portfolios and they follow some pretty simple logic. And this is the way I think all investors should think. First of all, all of your principles should be based upon academic evidence. Based peer reviewed research. And the first thing we know is that while the markets are not perfectly efficient, there are lots of anomalies that go unexplained. Investors are best served by acting as if the market is highly efficient using systematic, transparent replica strategies like index funds. But index funds have some negatives which can either be minimized or eliminated through intelligent design. So I use all strategies that are systematic, transparent or replica. I don't own a single index fund. So my starting point is you should be systematic, transparent and replica. Some people use the word passive to represent. I don't think that's descriptive enough. So I use those three words. If you believe markets are highly efficient, then it must follow that all risk assets have very similar risk adjusted returns, not similar returns. Riskier assets should have higher expected returns to compensate for that risk. And risk is not just volatility. It has to consider other things like.
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Unknown Speaker
How fat are the tails, what's the.
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Larry Suedro
Skewness and kurtosis using the technical terms. And in addition, you want to also look at things like liquidity. Neither of those things are captured in things like Sharpe ratios. So people who need liquidity, you know, have to give up and can't earn an illiquidity premium. But for someone like the Yale endowment, which spends say 5 or 6% of their endowment every year, they can load up on illiquid assets. And for them, that illiquidity premium is as close to a free lunch as you can get. I'll take the opportunity to point out that I've asked our over 100 advisors. We manage $26 billion ourselves and collectively all the firms in the BAM community. There are over a thousand buyers.
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Unknown Speaker
I've asked them all.
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Larry Suedro
I've never heard one yet say it doesn't mean it doesn't exist. I've never heard one of our clients say they're taking more than their RMDs from their IRAs, which means even at age 90 you're not taking 10%. So most people vastly over, sorry, under invest in illiquid assets because they're missing the opportunity for whatever the reason they think they need liquidity when the reality is they don't, at least for a significant portion of their portfolio. So if you believe that all risk assets have similar risk adjusted returns, why would you concentrate your portfolio in any one factor or unique source of risk? And the typical 60, 40 stock and bond portfolio has 85, 90% of the risk in market beta when we know there are lots of other sources of risk?
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Unknown Speaker
So the Harvards and Yales of the.
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Larry Suedro
World have been addressing this for decades and by building more of what are called risk parity type portfolios. And while even our clients only typically hold 10 to 15% in alternatives, the Harvards and Yales own 50, 60% and most individuals own close to zero. I think the numbers should be much closer to that of the Harvard's and Yales, especially those clients who actually don't need a lot of liquidity. My own portfolio I've been moving over the years up and up. I'm in the mid-40s now and probably moving a bit higher and I've moved higher as private vehicles which are less liquid have become available that are much cheaper if not cheap and are still but they're much cheaper than the 2 and 20 fees that typically prevailed up until a few years ago. And so assets that I would have liked to invest in, but the management firms were capturing all the value and so I didn't. Unless you were Yale and Harvard and could negotiate much lower fees. But today that world has changed and the fees, while not low compared to index funds or other systematic strategies, are now much slower, allowing you to capture a significant portion of that excess return.
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Unknown Speaker
We're going to talk about a variety of alternatives, many of which investors probably may not have heard of or may not invest in. But first I want to talk about your framework. When you're looking at these types of alternatives, what are the criteria you use to decide whether you might want to invest in it?
- [13:54]
Larry Suedro
Great question. I highly recommend your listeners pick up a copy of what I think is the seminal book on factor investing that Andy Burkin and I wrote, your complete guide to factor Based Investing. And in that book I'm really proud. We established five criteria that were required in addition to showing evidence of a premium that a factor or a investment strategy had to meet, all of them before you consider an investment that can apply to other investments, not just factors. So those criteria were the premium. And it had to show evidence that it was persistent because very long periods of time. So wasn't just a lucky good period of good economic times.
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Unknown Speaker
It had to be pervasive around the.
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Larry Suedro
Globe across industry, sectors, countries and regions, as well as of course, asset classes, if that was appropriate. It had to be robust to various definitions. So value works whether you look at price to earnings, cash flow, EBITDA to enterprise, value momentum works whether you use 30, 60, 90, 120 days, etc. It had to have intuitive risk based or behavioral explanations for why you think the premium will persist. Now, important to recognize I greatly Prefer risk based explanations because they cannot be arbitrage the way can arbitrage away the excess risk of stocks versus T bills. Right now, the premium to stocks can go up or down depending on how optimistic and pessimistic investors are.
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Unknown Speaker
But it should never be odd away.
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Larry Suedro
Behavioral explanations can be odd away, but we do know that there are some significant limits to arbitrage, including high risk and costs of shorting. So if you can recognize these limitations to arbitrage, then you can consider it. And lastly, they have to survive transactions costs. So if the size premium, for argument's sake, looking at micro cap stocks was 4%, but it costs you 5% to trade it, it doesn't do you any good at all. So what I do is one, any investment must meet all those criteria.
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Unknown Speaker
But some I have stronger evidence than others.
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Larry Suedro
So I feel more confident I will not use an equal weighting or risk parity strategy. I will put more weight on that factor or strategy. And I have more confidence in risk based strategies than behavioral ones. So for example, I will put more weight and more of my assets in value strategies than I will in momentum. But every fund I invest in on the equity side incorporates some momentum strategies in their construction rules. So that's how I think about it. Whether it's reinsurance or life settlements, it doesn't matter. It has to meet all that criteria.
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Unknown Speaker
Many of the things we're going to talk about today, or at least some of them, are going to be available through what's called an interval fund, which I think is a pretty new vehicle in terms of being available to investors. So before we talk about them, I just want to talk about that structure in general. Like what is an interval fund and how does it work?
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Larry Suedro
Yeah, that's an important question because that innovation, when the SEC allowed interval funds, really opened up asset classes that would not be available to investors otherwise. First of all, an interval fund, just to set the record structure rate, cannot be owned in 401k retirement plans, those types of things. You have to have daily liquid investments like stocks and Treasuries and corporate bonds, publicly available securities that are highly liquid, of course. So an interval fund, what it does is it holds assets that are not perfectly liquid, but the SEC requires them to be able to make a minimum of 5% withdrawals every quarter. So that could get you 20% a year. So they to keep that liquidity, they typically will own some portion of highly liquid assets, whether it's treasury bills or even high yield corporate bonds. If it's a private credit fund they could do that. They can use credit lines to help meet those requirements. And so, just so investors could understand, let's say you put $1 million into an interval fund and it's got $1 billion. Okay? Of assets, 5% would be 50 million. If you're the only one who requests your million dollar redemption, you want entirely out. No one else requests out. You get your full million. If more than 50 million was requested, you would get a pro rata share.
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Unknown Speaker
As would everybody else.
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Larry Suedro
Unless the fund decided it could meet and was willing to, as Stoneridge did with its reinsurance fund, it paid out more than it was required to. So by enabling funds to hold assets that weren't liquid, it enabled investors to invest in these less liquid asset classes like private credit, like reinsurance, like life settlements, other things. So I'll give you one good example to help people think. So this is just a concept idea. So Jack, let's say you have an opportunity to invest in one of two assets. Okay? So think of, you know, Citicorp. Let's just use them as a bank. And it's got a big credit card business. The credit cards are yielding 20%. They expect 9% losses, not guaranteed. Of course, it could be much worse or much better. And it costs them 1% to service it. So their expected return is 10%. Now, let's say in theory you could buy that asset alternatively. Now Justin comes along and he says, I want to take a new credit card out and borrow. But the chief financial office says, we don't have any more capital to set aside. We can't do that business with Justin.
- [21:03]
Unknown Speaker
Now Justin's going to pull his corporate.
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Larry Suedro
Business and everything else they want to service them.
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Unknown Speaker
So what do they do?
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Larry Suedro
They take a portion of their assets, go to the capital market, securitize it and turn it into what's called an asset backed security or abs. It gets raided by Moody's and portions of it will be triple A and you know, etc. And sliced and diced and, you know, and now it's fairly liquid. Now, because it's fairly liquid, the market says we only require a 7 1/2% yield. Now you're sitting with your money and you're not near your retirement date. You have absolutely no plans to take money out of your ira and you have other liquid assets you could get reach in an emergency, some safe bonds in your portfolio.
- [21:54]
Unknown Speaker
Would you rather own the seven and.
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Larry Suedro
A half percent illiquid investment with exactly the same interest rate risk and credit risk, or the 10% you'd probably want.
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Unknown Speaker
To own the 10%. I would guess not.
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Larry Suedro
Probably, yeah, no brainer. Now, you have to meet that criteria right now. So that's basically another good example is reinsurance. You can't have reinsurance in a daily liquid fund, at least on what are called quota shares, where you're buying a book of the insurer's business or reinsurance, because you signed the contract to take that risk for a full year. So you say three months after you.
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Unknown Speaker
Invested in it, you want your money back.
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Larry Suedro
Well, too bad that contract is out there. So you give up that liquidity for a year. But Stoneridge says, all right, we'll buy these contracts and we'll hold, say, 5% or 10% in either cash.
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Unknown Speaker
Borrowing, credit.
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Larry Suedro
Lines from banks, or it might even own a cat bond, which is daily liquid. But that's highly concentrated in US Hurricane risk, where the quota shares can have global risk and earthquake, hurricane, wind, all kinds of other risks.
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Unknown Speaker
Much more diversified.
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Larry Suedro
Guess which one yields more.
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Unknown Speaker
Well, the one that's illiquid because people like liquidity.
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Larry Suedro
And so if you need liquidity, you own the daily liquid asset. If you don't need it, you can capture those large illiquidity premiums, which tend to be in the range of, call it one and a half to 3% or more, depending upon how illiquid it is.
- [23:49]
Unknown Speaker
So, like a rubber plantation in Indonesia.
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Larry Suedro
Is going to be highly illiquid and should have a huge premium there. And that's why the Harvards and Yales of the world invest in those kinds of things.
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Unknown Speaker
So the idea in terms of preventing, like a cascade where, you know, everybody pulls their money and suddenly the illiquid assets have to be sold. Is that 5% limit you were talking about before? So you can't. Everybody can't run for the door at the same time. It's got to be spread out over periods of time.
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Larry Suedro
Yeah. So you have to have conviction and a faith and a belief that the premium will last for a long time. The strategy is good. You have to really do your due diligence on the fund manager to make sure they're trustworthy, long record of performance, all of those things. Because it's possible you may need five years to get out entirely of your investment, and that's what scares a lot of people. But in my opinion, it should not if you're either able to do that due diligence on your own or you have a trusted advisor who could do that for you. But you have to make sure that that investment meets all of Those criteria that I laid out to give you the confidence to make that investment and then you need the discipline to stay the course.
- [25:09]
Unknown Speaker
So I want to work through some of these individually because these are all really interesting and many people may not have heard of these. So when I list each one, can you just talk about what the return profile is, what you think the investment case is for each one of these? And the first one is private credit, right?
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Larry Suedro
Okay. So you have public credits, investment grade assets. Okay. And then you have private credits, which tended to be a relatively smaller part of the market up until the great financial crisis. Crisis, mostly smaller, maybe mid sized companies. And the bank serviced even those markets very well. The great financial crisis caused banks who needed to desperately raise capital pull back and private credit stepped in. Now private credit raises capital from investors like you and I and the Harvards and Yales of the world and they make loans directly to those companies. And they can act much faster typically than banks which go through big committees. It could take months and months to get approval.
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Unknown Speaker
Private credit tends to react much quicker.
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Larry Suedro
And private credit, if done properly, actually has a far superior credit history to public credits of similar background. So mid sized companies, 150,200 million EBITDA. If you look at for example Vanguard's High Yield Fund, last time I looked it was yielding about eight and a half percent. It's got something like a six or seven year maturity. Now the Cliffwater Interval Fund, their private credit fund, the is cclfx. It's all floating rate debt. And that's something I wanted to avoid was maturity risk when yields were so low because I thought the risks were, you know, asymmetric rates were not likely to go down much, but they could.
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Unknown Speaker
Go up a lot.
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Larry Suedro
And Cliff Water's fund is much safer than Vanguard's High Yield Fund. And credit is because it's very specific. The debt is all senior secured. There is no covenants that are often there in public credits. And it's sponsored by leading public, sorry private equity firms who will often step in if there's problems because if they don't step in to provide more equity and renegotiate a deal, guess what? They get wiped out totally. So it's not a guarantee. Of course they'll step in if something's in dire need and they can't see a way out. But these are companies that typically make long investments. So Cliffwater has an index of these types of credits that are senior and secured that goes back to I think now 20 years. Historical defaults are 1% losses, 1%. Cliffwater adds that it also has to be backed by private equity. That database isn't quite as long, but it does have a better credit history as you would expect because the private equity firms have done their due diligence too and are prepared to. They know it's possible they could have to pay quit more. Their credit experience is 25 basis points in credit losses. Now today that fund has a net yield of about 11 and a half or about 3% more with no term risk, which you should be compensated for, right? For taking superior credit profile. In March of 2020, the fund lost 3% where high yield debt got slaughtered. Why would you own the Vanguard High yield fund which has tens of billions in it over this fund? It's because it's illiquid. It carries that much larger premium. There are other well run vehicles, firms with 20 year, you know, 15, 20 year track records of, you know, strong performance as well. So that's one example where you can access private credit. Now, I will say these are not generally available interval funds to the general public. Most of these firms know that this is a limited capacity area. They don't want to deal with the general public directly because of all the education about interval funds and the flights that naive retail investors tend to engage in. So they tend to work with, in some cases even a relatively small number of advisors. Stoneridge for example, I think it's less than 100 Clifford or somewhere maybe in that range. So you have to work with an advisor who does have access.
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Unknown Speaker
This next one's really interesting because I know absolutely nothing about it. Can you talk about structured life settlements?
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Larry Suedro
Yeah, this is me as natural, simple explanation as there is, right? We know that life insurance companies, they make investments in policies with an expected return on their capital, right? So now, Jack, let's say just using as an example, you bought a policy and you've been paying premiums for 30 years and something unfortunately happens, bad health wise to you. You can't make your premiums anymore. The insurance companies love you. Because what happens is now you're going to take your policy, cancel it. So you can, because you can't pay the premiums anymore and use it to pay your medical bills. A very, very small percentage of life insurance policies ever pay off. Many of them don't pay off for reasons that I just gave you. Now if you're able to pay the premiums, great, then you get paid off and the insurance company didn't probably get their expected return. You died earlier, but that wasn't the case until fairly recently. Now, the regulations, and I think almost all states, if not all requirements, hire the insurance company to tell you that you can sell that policy. Now you see ads on TV all the time from firms like Coventry and others that they're willing to buy your policy from you, giving you the cash you now get to pay your medical bills, maybe live in your home with dignity and those things. And there's obviously going to be an expected return. The buyer of the policy is buying an illiquid asset. They don't know when you're going to die. They can only estimate it based upon a doctor's report, which is what a good firm will do. They'll have a doctor specializes in that disease to estimate. Look at the x rays or MRIs or whatever and say the expected life expectancy is three years and. And then you can make a price based on that. The expected returns to these go up and down. They were in the low mid to high single digits before the great financial crisis. Then liquidity became a big issue. They jumped into the high teens and the big hedge funds, many of them played there and now they come down into the high, or, sorry, the low double digits in the 10 to 12% range. And it's like the perfect asset because it's obviously totally uncorrelated to stocks and bonds and anything else has a high, relatively high expected return. And you're actually. No, you're helping people because you're enabling them to get the cash they need. And otherwise they'd have to let the policy expire. The same thing applies to other structured settlements. Say, Jack, your parents, if they're alive.
- [33:46]
Unknown Speaker
Someone gets injured in a car accident.
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Larry Suedro
And they get a settlement as an annuity of 100,000 a year. But they want the cash now. Okay, I'll step in and buy that for you at a discount rate. And I don't know how long you're.
- [34:01]
Unknown Speaker
Going to live to get that either.
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Larry Suedro
So I'm going to provide a risk premium over that. And so firms can not only combine life settlements, but other structured settlements. And similarly, there are other assets.
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Unknown Speaker
Same things can apply.
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Larry Suedro
Things like drug royalties, music royalties, you.
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Unknown Speaker
Can invest in those.
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Larry Suedro
And Clifforder has a fund that is called their extended credit fund that invests in things like that as well.
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Unknown Speaker
I'm just curious, before we get to the next one, I mean, do you think this is something you mentioned, this is only available through select advisors, a lot of this stuff. Do you think this is something that could become available to the investing public at some point or. There are too many issues Behaviorally, with people panicking and stuff that they just.
- [34:46]
Larry Suedro
Wouldn'T want to do that anything's possible. As we said, my crystal ball is always cloudy. But these are really limited capacity areas. And so the big guys like Vanguard 1 are almost certainly not going to play in that space. Who would make it available? Maybe they've got the staff and would do. We do it. And so these companies don't want to have big staff to accommodate working with the public, 800 lines and, you know, things like that and the expense and marketing to them.
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Unknown Speaker
So that's one.
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Larry Suedro
And they don't want the behavioral issues as well.
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Unknown Speaker
So the next one's another one I know very little about, and that's drug royalties. Can you talk about that?
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Larry Suedro
Yeah. So you're now an inventor and you've invented a new drug, spent decades of being poor while you try to, you know, develop the product, and now along comes Pfizer and says, we'll buy your drug and we'll pay you, you know, 6% royalties on this for the next.
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Unknown Speaker
30 years or whatever.
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Larry Suedro
You know, the probably, you know, the life of the patent, whatever. And so you say, great, but I want to move on and do my next drug and I don't have the cash. I can't wait. So I'll go and sell that to an investment firm and they'll pay you upfront a specified amount based upon their estimates of what the sales, etc. Will be. So it's exactly like a settlement in a lawsuit where someone was hurt in a car crash. Only here you're now having to make estimates instead of known amounts.
- [36:33]
Unknown Speaker
So that's an example, litigation finance.
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Larry Suedro
So, Jack, you're a lawyer and you want to pursue a case, but you don't have the money to fund it. People will come in and say, all right, we'll fund that in return for X percent of those proceeds. So you could do things like that. Obviously, that cannot be a daily liquid fund, which would make it available to the general public. And trying to explain all the complexity to the average person, I just don't see it as likely.
- [37:10]
Unknown Speaker
The next one's interesting because pretty much everybody pursues factor investing on a long only basis, or, you know, that's where the vast majority of the assets are. But you do it in a different way here, at least for this portion of your portfolio, you invest these long, short factor funds. So can you talk about why you do it that way and how you think about that in the context of your portfolio?
- [37:26]
Larry Suedro
Yeah, here is an example of one that is A daily liquid. So you don't need an interval fund. I invest in AQR's Style Premium Fund. The symbol is QS Pix for tax advantaged accounts and QSPRX for tax advantaged taxable accounts. It's just avoids commodities, which would make it more tax inefficient. So most people who invest in factors like value and size and profitability buy stocks that have those characteristics, but they don't go short the other side of the trade. So it's not a market neutral. You're also long market beta. Right. So in order to diversify the portfolio more, you can go long short. And now you have pure 100% exposure to the factor. And not only that, but in an AQS case, for example, with value, it's long short, so it's long value, short growth or long, cheap and short expensive, depending on the asset class, stocks, bonds, commodities and currencies. So I'm picking up unique exposures that have often nothing to do that are uncorrelated with what's going on with market beta, which dominates most portfolios. So that fund is long short value, momentum defensive, or you could think of it as quality and carry factors that meet all of those criteria. They're ones that Andy Burkin and I put in our book. Out of the hundreds of factors in the factor zoo, we identified only eight that we thought investors should consider. And those are four of the eight. And so I like that fund because it's totally uncorrelated.
- [39:30]
Unknown Speaker
How about just one more before we move on to some other questions I want to ask you about reinsurance? How do you think about that?
- [39:35]
Larry Suedro
Yeah, to me this is another obvious no brainer type of investment. We know the reinsurance business has been around for about 170 years and you know, obviously it's generated good profits return on equity for the reinsurers who buy risks from other insurers who don't want too much risk in one particular area. Well, they have the same problem. They want to service their insurance clients and they don't have an unlimited supply of capital. So how when you know, State Farm, for example, goes to Swiss Re and says I want to pass on some more hurricane risk in Florida, they don't want to turn them down because they may already have enough of that risk or they don't have any more capital, they want to keep that relationship so they raise capital and sell off some of that risk. That's what cat bonds do. They're daily liquid, but they're concentrated in hurricane risk. They tend to have premiums on over the risk free rate depending upon how much risk there been and how the losses have turned out recently. So obviously stocks going up or down have nothing to do with the risk of hurricanes or earthquakes or tornadoes or windstorms or all this other stuff. Windstorms don't cause bear markets, et cetera. So it's a great asset in that it has no correlation to either stocks or bonds and it's got a big risk premium that's persistent, pervasive, etc. You're just buying In Stoneridge's case it might be example they go to let's just use the name Swiss Reinsurance and we'll say so you can't cherry pick. I want to be your strategic partner. I'm going to buy 5% of all of your risks. So we know they Swiss re has been in business 170 years, great track record long term they like everything else, they go through periods of poor performance. That's the nature or there wouldn't be risk premiums that would be large. Right. So you live with that risk but those losses should be uncorrelated with the.
- [41:58]
Unknown Speaker
Other loss and you partner with them.
- [42:00]
Larry Suedro
And now you've got a portion of their book of business and you should earn very similar returns to what they earn on those risks. Now the reinsurance companies, I don't want to own their stocks even though I like that risk because why don't I want to own their stocks? Because what are the risks that are on their balance sheet?
- [42:22]
Unknown Speaker
They take those premiums and invest it.
- [42:24]
Larry Suedro
In stocks and bonds and real estate which I already have on my balance sheet. I don't want to duplicate it. So in 2022, for example, when reinsurance had a decent year, reinsurance stocks got crushed because their stocks and bonds and real estate assets got crushed. So I can isolate that risk by buying these quota shares or cat bonds and now I've got the right asset there and so that's why I like it. I will tell a very brief story. Reinsurance, the first few years that Stoneridge came out with the product had good returns and then the next three years were pretty bad. Double digits or close to that. Not 20% or more, but minus 12, minus 17, minus 5. And that fund which at its peak had 5 billion of assets so are the typical naive, even with advisors holding their hands dropped down to 1 billion. Now some of that of course was caused by a roughly downdraft of high 20% obviously but much of it was caused by people withdrawing.
- [43:40]
Unknown Speaker
Well last Year the fund was up.
- [43:42]
Larry Suedro
About 6% and this year it's up 43. So, you know, unfortunately, 80% of those investors or 70 didn't earn those returns because they did. Now those the same type of people maybe that bail out of stocks after two or three bad years, but we see this pattern that while they may not bail out of stocks because they understand it more, okay, or think they do, they will bail out of reinsurance or drug royalties or private credit. They just chase returns and think it.
- [44:20]
Unknown Speaker
Was a bad idea when the logic is perfect, perfectly there.
- [44:23]
Larry Suedro
And good example. Warren Buffett loaded up on reinsurance at the start of 2023 because he saw, guess what? After bad years, the premiums go way up, the underwriting standards go way up. So if you want hurricane insurance in Florida, it better be steel reinforced concrete, not, you know, wood based house. And if you want fire insurance in California, you can't have a tree within 30ft of the house and 30ft of.
- [44:55]
Unknown Speaker
The next tree and 30 more feet.
- [44:57]
Larry Suedro
Of brush that's cleared. And by the way, the deductibles went way up. So the risk is actually down, the premiums are way up, and yet people flee. That's partly why a lot of these firms will not take retail investor money.
- [45:16]
Unknown Speaker
No, that makes a lot of sense. What I really like about these is, you know, going back to your criteria at the beginning, like I always like to ask myself when I'm investing in anything, why am I getting paid to do this? And like all of these as you've gone through them, they have compelling reasons why you should get paid to do it. And so if you expect it to persist in the future, I mean, that's a good reason for it to persist in the future is there is, there's a good explanation in all these cases why you should make money by doing these things.
- [45:37]
Larry Suedro
Yeah. And exactly. And by the way, that's why you don't overweight anything. I mean, to me, the expected return.
- [45:45]
Unknown Speaker
To the reinsurance fund this year, this.
- [45:47]
Larry Suedro
Fund, Srriax, was in the low to mid-20s, turned out to be a much better year than expected. We didn't have any big hurricane or earthquake losses. There were some losses, but not a lot. So the losses were less. And last year the fund, the reinsurers vastly overestimated the losses from one of the hurricanes.
- [46:11]
Unknown Speaker
So the fund reported losses of -5 and a half.
- [46:14]
Larry Suedro
But this year, big gains about 10% were related to reversing last year's estimated losses. But you know, when you get a hurricane in October, you don't know what the payout will be till maybe the following year, at the end of the year like now, or maybe even a bit longer. So you make estimates now randomly, it'll be higher or lower than you expect.
- [46:40]
Unknown Speaker
Turned out to be.
- [46:42]
Larry Suedro
They estimated too conservatively. And so last year was about minus five and a half, this year up about 43 and a half. If they had guessed right, last year would have been up about 16 and this year 33. Now I saw that high expected return, so I added significantly to my portfolio.
- [47:06]
Unknown Speaker
Exposure to the fund.
- [47:08]
Larry Suedro
But I still only own like 3 to 5%. I don't remember the exact number. I spread my risk out across many different assets.
- [47:18]
Unknown Speaker
Just one more for me before I hand it back to Justin. I want to ask you about something that a lot of people are starting to invest more in now, particularly as it becomes accessible through ETFs and you know, more readily available for your average investor, which is managed futures. What are your views on managed futures? Do you use them in your portfolio and what do you think about them in general?
- [47:34]
Larry Suedro
Yeah, so here's the thing. Managed futures, which generally you think of as trend following, right? So momentum, but specifically time series momentum or trend following, you buy what's going up and you sell what's going down. All right, that was one of the factors that Andy Burkin and I in our book on factor investing identified met all the criteria how. However, as I said earlier, there is no risk based possible explanation, although people have tried to concoct them after the fact. But it is purely behavioral based.
- [48:13]
Unknown Speaker
But the evidence is strong so I don't ignore it.
- [48:16]
Larry Suedro
And as I said, every one of the equity funds that I invest in includes exposure to momentum. So for example, a value fund often will buy stocks that is falling in price. It was a growth stock, now got cheap and is now value or buy it. While the funds I own won't buy it even though it meets the criteria. If it has negative momentum, it'll stop buying or wait until that negative momentum ceases. And when it starts to go up and is no longer, maybe they have a cap at PE. I'll make this up of 15.
- [48:52]
Unknown Speaker
The PE goes above 15, they may.
- [48:54]
Larry Suedro
Hold it for a while longer until they see that negative momentum decline. At least maybe until the PE gets to 17. I'm just making up examples there. And the fund I own, I mentioned earlier, style premium is in momentum also as well. I did at one point in my life cycle of investing have a Trend following fund, AQR's fund which meets all the criteria. But then over the years they've started to become available funds that met my criteria. The much stronger risk based explanations. So the allo. And I think a much higher expected future return. Okay. And therefore I dropped that and added exposure to these other asset classes which I believe provide, you know, some good tail risk protection as well and have more logical risk based explanations and higher expected returns.
- [50:07]
Unknown Speaker
So I have no problem with someone.
- [50:09]
Larry Suedro
Including a trend following strategy in their portfolio. But they should recognize they should never be buying it to enhance returns. It should be bought to protect tail risk because it tends to do best when it's needed most in long periods of underperformance.
- [50:29]
Unknown Speaker
Right.
- [50:29]
Larry Suedro
Like 7342002 08, you know, lasted quite a while. But most of the time because markets go up, you're going to be trailing. Right? So don't expect it to do well. In fact, it could go a decade as it has done when it does poorly and then in one year it makes up for all of that and you're thankful you owned it, but only if you stayed the decade through poor returns. Most individual investors can't do that sadly, and so they miss out. So if you can't do that, then you should never buy it in the first place.
- [51:09]
Just one personal story from me and then there's a question on the backside of this. But I was always one of those people that like highly valued liquidity. So that's just how I kind of manage my investments. And then Jack and I both have a good friend who had done really well in real estate outside of the area where we live, we live in Connecticut. He had done really well with commercial real estate and private real estate and multifamily in Texas. But then they came up here and they identified a pretty decent size commercial deal that I ended up investing in. But the only way I was able to get comfortable with that illiquidity was I had to kind of see the asset. Like I had to sort of know what I was investing in because I knew the money was going to be locked up and they were honest with me and they said, hey listen, this is going to be, you know, a five to ten year investment distributions might not start right away. And so, you know, I earmarked whatever portion of my portfolio, a small, you know, portion of my portfolio and invested in that. And that has probably been, I'd say, the most successful investment I've ever made. But my son, that's the story. But the question is, how do you advise advisors or how do you Think investors should think about getting over this illiquidity thing because I was able to see the asset, I was able to go and touch it and know what I was investing in when a lot of investors sort of might not be able to do that. So what would be some strategies that you would advise people do that?
- [52:41]
The first thing, you should never invest in something you don't understand the nature of the risk unless you just have blind faith in your advisor that, hey, I've worked with them for 20 years, they know far more than me. I don't know anything about this stuff, but I know, you know, tell me the story and if it makes logical sense, anyone can understand the example Jack, I gave you on the credit card debt, for example, or private credit.
- [53:07]
Unknown Speaker
Here's the data.
- [53:09]
Larry Suedro
I've written 15 page papers on reinsurance and private credit. Look at the evidence. You should demand to see the empirical research, the evidence, the data. You should do your due diligence, see if the story makes intuitive common sense, which Jack, you said.
- [53:27]
Unknown Speaker
Yeah.
- [53:28]
Larry Suedro
All these things do. Right. You don't have to see something. In fact, Justin, that's actually to some degree a bad idea because. Yeah. And here's the reason why. Because if you become familiar with something, you become. You think it's safer. So a great example I'll give you is guess what? Stock people in Atlanta own a disproportionate.
- [53:54]
Share of probably Home Depot or maybe Coke.
- [53:58]
Coke, right.
- [53:59]
Okay, okay, yeah, Coke.
- [54:01]
To own Coke. Justin, the way. And if you live where you live or if you live in Atlanta.
- [54:08]
Yeah, no, no, no, we all have that bias of. Right.
- [54:11]
But there are lots of people employed there. They live there, they work there. Now what if you worked at Enron and you lived in Houston? You know, you load up.
- [54:20]
Yeah.
- [54:21]
Well, you're familiar. I work at the guy, I know all this stuff. Right. Familiarity breeds overconfidence.
- [54:29]
Unknown Speaker
That should not be a criteria.
- [54:31]
Larry Suedro
Now all it's doing is checking out to make sure that that building exists. These guys are real. Yeah, you can look at it, but it's much more important to understand the story there. And in every case that I've told you, and this is really important, I'm glad we got to this story. Actually. Whenever I invest, I avoid idiosyncratic risk. I only want to own the beta of that asset class. So Stoneridge doesn't. Unlike some hedge funds in reinsurance. Hedge funds will go in and say, now I like Florida hurricane risk because the premiums went way up. I don't like California earthquake risk I like this. Not that Stoneridge says, I want the.
- [55:14]
Unknown Speaker
Beta of the asset class.
- [55:16]
Larry Suedro
They go to 8 or 10 or whatever number of, you know, highly regarded institutional players and they buy these quota shares. I own thousands of different risk or hundreds of different risks across broad regions of the world. Different perils. The same thing is true of Clifforder. They buy from 10 different industries. The best managers who have long track records credit. And when they make a $200 million loan, Cliffwater takes 2 million of it. They've got, I don't know, 15 billion and 15,000 loans. One loan goes bad, it's not, you know, there's no impact on them. You never want to make that one single building investment. In my opinion, you know, that's taking huge idiosyncratic risk. If I want to invest in private credit, I do it through Blackstone, which has a B REIT product which is outperformed the public markets by about 3% a year since its inception. Because you're getting an illiquidity premium. It pretty simple, but it's highly diversified. So key, understand, do your due diligence, read, learn, make sure it makes intuitive sense.
- [56:37]
Geez, I'm going to have to have you on speed dial the next time I'm presented with one of those deals to make sure I don't do anything bad. That one worked out. But I think those are all, you know, fair points.
- [56:44]
That's the problem.
- [56:45]
Absolutely.
- [56:46]
That's the problem that works out. And then you think the next one will work out and.
- [56:50]
Right, exactly.
- [56:52]
With a smart strategy.
- [56:54]
Right, I guess. And it's sort of. It's not really along the same lines, but, you know, when investors incorporate some of these alternative investments, inevitably there'll be years where some of these will really be doing what they're supposed to be doing. There'll be years where maybe they'll be a little bit lackluster. And then, you know, many investors will turn around and compare their portfolios to a 6040 or maybe just a long only S&P 500 and say, wait a minute, you know, these things have detracted from returns and there's that behavioral tendency to want to, you know, abandon ship and go where everyone else is making money. So, I mean, how do you just think that investors should give themselves the best chance for success in investing in these types of things?
- [57:37]
That's unfortunately completely illogical way of thinking about it. Although it's done by most investors, they don't know it's illogical. But let's start with the premise. Why Are we buying these assets? What's the reason to consider them either Jack or Justin? You want to answer that?
- [57:58]
Yeah. I mean they're different. They're totally different return streams. I think they're going to diversify you. They're going to hopefully help limit risk when those assets come out exactly right.
- [58:06]
If they're totally unique, then you can't and shouldn't ever compare. You're buying it because you fully expect that they will look different and you actually hope that's the case. Now that means you have to accept there will be some years, maybe even a long period where that particular one will do poorly. But the S and P has underperformed.
- [58:29]
Unknown Speaker
T bills for as long as 17 years.
- [58:32]
Larry Suedro
Do you not buy stocks because of that? You know, from 29 to 43, 66 to 83 and 2012, that's 45 years. That's almost half of the life of the markets. Now the other times it greatly outperforms and it's earned a big premium. Well, the same thing must be true of all these other or you wouldn't get the premium. So you, the key is, what that means is you want to diversify. You must succeed. Accept this tracking variance to reduce the volatility of your portfolio, which is the objective.
- [59:10]
Unknown Speaker
And the only way to do that.
- [59:11]
Larry Suedro
Is to add these low correlating assets so you then can't compare it and complain when you got exactly what you wanted. These funds are always doing what they're supposed to be doing. It's just that sometimes you like the results, sometimes you don't. And the worst mistake that people make is, is they engage in what's called resulting. They judge the performance of a strategy by the outcome and not by the quality of the decision before you know the outcome, which you shouldn't do because we don't have clear crystal balls. It's like after, you know, Russell Wilson threw that interception for the Seattle Seahawks when everyone thought they should have been running the ball, they said that was a bad decision.
- [59:59]
Unknown Speaker
Well, the saber maticians went and looked.
- [60:01]
Larry Suedro
At it and analyzed it and found.
- [60:03]
Unknown Speaker
It was exactly the right call to.
- [60:05]
Larry Suedro
Make from a statistical perspective because Lynch, Marshawn lynch, the great running back had fumbled three times, if my memory serves, in that situation during the season. And Russell Wilson had never thrown an interception in that zone area the entire year. So is much more likely to be successful. The other team just made a great play, but people said it was a dumb decision. He was, you know, he was on, you know, the fans try to get him fired the same thing is true here. You cannot judge things by the outcome, but only by the quality of your decisions or you will be always chasing returns. You'll buy after periods of good performance when returns expected are low because prices are high and therefore premiums are low. And you want to not sell after bad periods because markets are self healing. When bear markets happen, valuations come crashing down and expected returns are now higher. That's when, like Warren Buffett said, you know, don't time the market but buy when everyone else is panicked and sell when everyone else is degree Same thing was true with reinsurance, which had three bad years, big deal right now it's had great years and you're gone and you never earn those returns. You have to be able to stay the course. And the only way to do that is to understand why you did it in the first place. Write it down and sign it and say, I'm going to stick with it.
- [61:41]
Unknown Speaker
Signed it in blood.
- [61:43]
Larry Suedro
One last question here and it's kind of a hard pivot off of the core of this discussion, but we wanted to ask you this and I think because you've seen many different markets, a lot of different innovation in the investment industry over time. And I'm just curious, from your vantage point, where do you think a lot of the innovation is going to come from in the future? And we talked about the crystal ball. I'm not asking for any hardcore predictions, but I'm thinking things like direct indexing. You know, you're seeing more platforms that are getting investors access to private investing opportunities, sort of decentralization of real estate, slices of assets. You have like masterworks and investing in arts and art now. And so you're seeing technology is sort of, you know, bringing a lot of these opportunities to investors. But I'm just interested from your viewpoint, where do you think things are going to get very interesting here?
- [62:39]
Yeah, I, I think exactly what you said. The interval fund structure has changed the nature of the game. Also the big private equity firms have recognized that private equity with the capital call structure, so you commit a million dollars and then you don't know when they're going to call 50,000 or 200. So you've got to keep liquid, really doesn't work well. And so they're moving to create something similar to an interval fund, although it won't be public, it'll be an evergreen fund. And you put your money in any time. Once a month you can make an investment, maybe it's on the between the 20th and 25th of the month and Then they have a redemption feature like monthly you can get out 2% a month or 5% a quarter, whichever is the lower of those numbers like B REIT has today. That's Blackstone's real estate fund. You're going to see many more illiquid assets being liquidized at least partially through these interval fund structures to allow individual.
- [63:53]
Unknown Speaker
Investors to invest in the same vehicles.
- [63:56]
Larry Suedro
That the big institutional players and hedge.
- [63:59]
Unknown Speaker
Funds have been doing for decades.
- [64:01]
Larry Suedro
And that's bringing prices down. So I think you're going to continue to see prices coming way down relative. I recently where I would never, I never invested in any transaction that had a 2 and 20, you know, kind of structure. Today you're seeing deals I've done some recently that were 1% and 10%, a 10% carry. And I've seen some deals that are even less than that. Interval funds with fees as low as roughly 1% as well, without any hurdles and no incentive fees. So I think you're going to see a lot more of that as well.
- [64:47]
Larry, always super solid, always objective, thoughtful and we really appreciate you coming on with us and sharing your wisdom with our audience. And happy holidays to you and your family. Thank you.
- [64:57]
Thanks very much, Justin and Jack.
- [64:58]
Unknown Speaker
Glad to be a help.
- [64:59]
Larry Suedro
Hopefully we can help get investors more comfortable so they can add these other assets to the portfolio. And in my book Reducing the Risk of Black Swans, which I urge them all to read, we show how adding these alternatives greatly improves your odds of success. You run Monte Carlo simulations, you'll see the odds of not running out of money go way up because of those low correlations. It reduces the potential dispersion of outcomes. Best example I can give you. In 2022, every single one of my alternatives was up. While stocks and bonds both got crushed in double digit losses.
- [65:42]
Unknown Speaker
So my portfolio net was only down.
- [65:45]
Larry Suedro
Or was about flat. It's actually was up slightly where most people had severe losses and maybe many of that caused many of them to.
- [65:55]
Unknown Speaker
Panic and sell because they were afraid.
- [65:57]
Larry Suedro
That the market could get a lot worse. I think it actually helps you stay the cost because your portfolio volatility will go down and that's key to avoiding sequence risk.
- [66:09]
Thank you, Larry.
- [66:11]
Take care.
- [66:12]
Justin Carbonell
This is Justin again, thanks so much for tuning in to this episode of Excess Returns. You can follow Jack on Twitter, Twitter @practicalQuant and follow me on Twitter @jcarbonell if you found this discussion interesting and valuable, please subscribe in either itunes or on YouTube or leave a review or a comment.
- [66:30]
Jack Forehand
We appreciate Justin Carboneau and Jack Forehand are principals at Bolivia Capital Management. The opinions expressed in this podcast do not necessarily reflect the opinions of Olivia Capital. No information on this podcast should be construed as investment advice. Securities discussed in the podcast may be holdings of clients of Lydia Capital.