You Can't Eat Risk-Adjusted Returns | AQR's Pete Hecht on Portable Alpha's Capital Efficient Edge

Summary

Podcast Summary: "You Can't Eat Risk-Adjusted Returns | AQR's Pete Hecht on Portable Alpha's Capital Efficient Edge"

Excess Returns • February 12, 2026

Episode Overview

This episode dives deeply into the concept of portable alpha, a sophisticated investment strategy that seeks to combine uncorrelated sources of alpha with traditional beta exposures in a capital-efficient way. Pete Hecht, who leads AQR’s North American Portfolio Solutions Group, breaks down what portable alpha means in practice, how it solves critical challenges for investors, especially in portfolio construction and funding, and why risk-adjusted returns matter less than we might think. The discussion covers implementation nuances, risk management, sources of alpha, the importance of turnkey solutions, and common misconceptions about leverage.

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Key Discussion Points and Insights

1. The Core Issue: Why Portable Alpha?

• You can't eat risk-adjusted return, you can't pay bills with risk-adjusted returns, you pay bills with total returns.
  – Pete, [00:28]

• Challenge for Investors: Many believe in diversification and uncorrelated alternatives, but are reluctant to give up stocks due to career risk and fear of missing out on equity rallies. Portable alpha solves this by allowing exposure to both stocks and alternative return streams in one package.
  – Host, [00:41-01:23]

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2. Defining Portable Alpha

• Pete’s Simple Definition:

  • Portable alpha is about achieving alpha via unconstrained long/short investing (not limited to long-only or just equities).
  • "It’s the benefits of unconstrained active management, packaged in a beta 1, benchmark-oriented manner."
    – Pete, [03:16]

• How it Works Practically:

  • Pairing a market-neutral (zero beta) alpha source with a liquid beta exposure (e.g., S&P 500 futures) so your overall portfolio returns the market with “special sauce” alpha added in.
    – Pete & Host, [03:45-05:24]

• Difference from Traditional Portfolio Construction:

  • Traditional portfolios just stack stocks, bonds, and alts, but portable alpha specifically overlays uncorrelated return streams onto core exposures rather than making binary allocation choices between them.
    – Pete, [04:36-05:51]

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3. The Funding Problem and Solution

• Funding Problem: Selling stocks/bonds to fund alternatives causes regret if stocks outperform (benchmark risk, career risk).
• Portable Alpha Solution: Maintain core exposures (like 60/40) while adding alpha—avoiding underweighting in stocks or bonds.
  – Pete, [07:12-09:24]

  "Portable alpha solves the funding problem because it allows you to maintain your 60/40 exposure...replace the equity beta one for one and then on top you get the special sauce from that uncorrelated alt."
  – Pete, [08:55]

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4. Implementation: Vehicles and Approaches

• Legacy vs. Modern Implementation:

  • Older: Limited partnerships, feeders, complex overlays mainly at institutions.
  • Today: More accessible through mutual funds (40 Act funds) using simple overlays (e.g., add an S&P 500 futures contract to a long/short alpha strategy). – Pete & Host, [09:35-11:07]

• Turnkey vs. Complex:

  • Turnkey Approach: Manager handles both alpha and beta overlays.
  • Complex Approach: Invest in alpha separately and manage beta overlay/cash management yourself (associated with more risk, e.g., operational errors, cash calls). – Pete, [11:07-13:22]

  "Most of the horror stories with portable alpha are associated with separating the beta overlay from the alpha manager...Turnkey really mitigates that."
  – Pete, [13:00]

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5. What Makes a Good Alpha Source for Portable Alpha?

• Requirements:

  • Liquid underlying securities
  • Long/short and market neutral (low correlation to core beta, ideally over both short and long term) – Pete, [13:46]

• Examples:

  • Equity Market Neutral (“most popular and easy to understand”)
  • Trend Following/Managed Futures (“crisis alpha,” positive convexity, protective in downturns)
  • Multi-strategy/Relative Value Arbitrage
    – Pete & Host, [15:42-18:50]

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6. Common Pitfalls: What NOT to Use

• Avoid Less Liquid/Long-Only Alts:
  • Private credit/private equity—already very beta-exposed and illiquid.
  • Problems: Price smoothing hides true risks/correlations (“volatility laundering”), making overlays unsafe.
    – Pete, [22:15-24:28]

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7. Leverage: Good vs. Bad

• Key Distinctions:

  • Long leverage (amplifies risk): e.g., using futures for S&P exposure, or real-estate leverage.
  • Long/Short leverage: Market neutral and can actually reduce portfolio risk by offsetting exposures. – Pete, [24:43-26:05]

  "You always have to understand the source of the leverage...long/short leverage is usually risk-reducing. Long leverage is an amplifier."
  – Pete, [25:27]

• Managing Leverage Safely:

  • Target risk and volatility, impose notional leverage limits, maintain ample free cash to avoid margin calls, and never mix leverage with illiquid assets.
    – Pete, [26:32-28:17]

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8. Risk Management and Stress Testing

• Setting Target Volatility:
  • Use risk models based on position-level volatilities and correlations; portfolio is “stretched” or “compressed” (like an accordion) to hit a pre-defined risk level.
    – Pete, [30:00-32:06]
• Scenario and Stress Testing:
  • Always stress test with imagination for historical and hypothetical shocks (e.g., GFC, COVID, 2022’s bond-equity drawdown, and others never seen before). – Pete, [32:52-35:02], [45:09-46:52]

  "A thoughtful manager uses imagination for scenario analysis—don't just model the past!"
  – Pete, [33:18]

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9. Risks and Costs of Portable Alpha

• Implementation Risk: Turnkey is safer; complex approaches can introduce operational errors at the worst times.
• Financing Costs: Overlaying beta using instruments like S&P futures introduces an ongoing “frictional” cost (about 70–80 bps).
• Manager Selection: Ensure the alpha genuinely exists and is not just hidden (or negative) beta. – Pete, [35:35-39:20]

  "You want to think about the financing friction embedded in getting that beta 1 overlay."
  – Pete, [36:49]

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10. Evaluating Portable Alpha Strategies (Fusion Funds Example)

• Metrics to Use:

  • Is it delivering on the promised beta (e.g., S&P 500)?
  • Look at active (excess) returns above the stated benchmark.
  • Analyze volatility, drawdowns, and, importantly, performance during stress periods. – Pete, [51:54-53:56]

  "If this is going to be a beta 1 benchmark-oriented mandate, you evaluate it in excess of the benchmark—hopefully it's exceeding it."
  – Pete, [53:52]

• AQR’s Fusion Funds: Designed as turnkey portable alpha solutions for different sources/types of alpha, explicitly tax-aware, and structured for capital efficiency. – Pete, [47:11-49:32], [54:07-54:54]

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Notable Quotes & Memorable Moments

• “Long only active management is like running a 100-meter dash as a world-class sprinter with cinder blocks.”
  – Pete, [00:28] & [06:14]
• “You can't eat risk-adjusted returns. You pay bills with total returns.”
  – Pete, [00:28] & [48:58]
• “Portable alpha solves the funding problem because it allows you to maintain your 60/40 exposure…replace the equity beta one for one and then on top you get the special sauce from that uncorrelated alt.”
  – Pete, [08:55]
• “Most of the horror stories...are associated with separating the beta overlay from the alpha manager.”
  – Pete, [13:00]
• “You always have to understand the source of the leverage. Long/short…usually risk reducing. Long leverage is an amplifier.”
  – Pete, [25:27]
• “A thoughtful manager uses imagination for scenario analysis—don't just model the past!”
  – Pete, [33:18]
• “Whenever someone expresses a view, always ask: is it already priced in to current valuations? Because if it is, it’s not an edge.”
  – Pete, [58:15]
• “Mutual funds are not for dinosaurs—they are a great way to access diversifying, attractive after-tax returns.”
  – Pete, [57:15]

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Timestamps for Key Segments

• [00:28] — The importance of total returns over risk-adjusted returns
• [03:16] — What is portable alpha?
• [08:55] — Funding problem and how portable alpha solves it
• [11:07] — Turnkey vs. complex implementation
• [13:46] — Characteristics of suitable alpha sources
• [22:15] — What strategies not to use (liquidity pitfalls)
• [24:43] — Good vs. bad leverage
• [30:00] — Setting and managing target volatility
• [33:18] — Scenario and stress testing best practices
• [36:49] — Real-world costs of overlaying beta
• [47:11] — AQR’s Fusion funds and their design
• [51:54] — How to assess these strategies
• [53:52] — Active return focus for benchmarked mandates
• [54:07] — After-tax considerations and AQR’s tax-aware implementation
• [57:15] — Mutual funds as modern tools for alpha
• [58:15] — "Is it already priced in?”: foundational investing lesson

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Closing Lessons and Final Takeaways

• On Mutual Funds: Mutual funds can be more innovative and tax-efficient than many believe—especially for complex alpha strategies.
• On Leverage: It is a tool—dangerous if not understood, but essential for many portfolio solutions when combined with risk controls and liquidity.
• On Implementation: Turnkey, manager-integrated solutions minimize operational risk and are preferable for most investors.
• Critical Investor Discipline: Always evaluate whether your investment view represents a true edge, i.e., not already priced into markets.

"Whenever someone expresses a view, always ask the question, is it already priced into current valuations? Because if it is, it’s not an edge."
– Pete, [58:15]

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This episode offers a thorough, nuanced walkthrough of portable alpha—covering theory, practice, risk, and current best practices for both institutional and retail investors.

Transcript

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[Pete]

I always tell people you you can't eat a risk adjusted return. You can't pay bills with risk adjusted returns. You pay bills with total returns. Long only Active management's like running a 100 meter dash as a world class sprinter with cinder blocks, you're just not.

[Co-host/Interviewer]

Going to do as well as if you took off the cinder blocks. There's been a lot of people I've talked to today who are like, I believe in diversification, I believe in uncorrelated alts, but I can't give up stocks because what, what if the even though equity valuations are high, what if they rip and then I'm out of a job because people think I made a poor decision? So that's a foundational problem that portable alpha solves. Whenever someone expresses a view, always ask the question, is it already priced into current valuations? Because if it is, it's not an edge.

[Host/Interviewer]

Hi Pete, welcome to Excess Returns.

[Pete]

Thanks for having me.

[Host/Interviewer]

We're excited to have you on. You head up AQR's North American portfolio Solutions Group and you spend a considerable amount of your time and effort developing and managing portable office strategies and other capital efficient approaches for your client base. And so given your area of focus and expertise, we wanted to have you on to have a a good discussion around what portable alpha actually means in practice and how investors should think about it from a funding, risk management correlation standpoint and talk about how it's being implemented, you know, now in today's market and over the long term for your clients. So this is going to be, you know, a subject that I think a lot of investors are going to be very interested in, but we want to kind of make sure that we, you know, at least up front sort of describe some of these terms here and what we're actually talking about. So I thought maybe to start just very basically, you know, a lot of investors hear the term portable alpha and there's a lot of different, you know, possible definitions for that. And so we want to ask you, you know, at the most basic level here, how, how would you define portable alpha and what type of Problem is it trying to solve for investors?

[Pete]

Sure. So I think there's two ways to look at it. So if you think of alpha best achieved through unconstrained long short investing. So if you, if you find a skilled manager, why would you only allow them to buy securities they like? Right. You should allow them to short securities they dislike.

[Co-host/Interviewer]

And why should you only restrict yourself to stocks?

[Pete]

Right.

[Co-host/Interviewer]

Maybe, maybe you can create alpha, this sort of idiosyncratic diversifying return source by.

[Pete]

By trading other types of securities, macro assets, for example. So I think of portable alpha is giving you the benefits of unconstrained active management, but packaged in a beta 1 benchmark oriented manner. So the way it typically happens in practice is you've identified that alpha manager, that long, short, unconstrained or less constrained active manager.

[Co-host/Interviewer]

And you say, I love your alpha, but I have this equity sleeve and you have zero beta.

[Pete]

And so what that person would do.

[Co-host/Interviewer]

In portable alpha is they would port over that alpha to a beta overlay, let's say to the S&P 500 and voila, it is now portable alpha because you've ported this alpha over to an.

[Pete]

S&P 500 futures contract that gives you.

[Co-host/Interviewer]

100% exposure to the equity market. Now it can sit nicely as a.

[Pete]

Core equity solution in your equity mandate.

[Host/Interviewer]

And how is that distinguished between or versus traditional like balanced portfolios that might just take something like stocks, bonds and alternatives and sort of stack them together.

[Co-host/Interviewer]

Yeah.

[Pete]

So if someone's like, oh, you know.

[Co-host/Interviewer]

I don't hold 100% stocks, I hold bonds because bonds diversify stocks. And then I bring in these uncorrelated alts that diversify stocks and bonds.

[Pete]

So we're all for that. Okay, so we're a big believer in that. But a lot of people have a huge equity allocation in their overall asset allocation and bringing in an alternative in.

[Co-host/Interviewer]

That bucket is not appropriate because the.

[Pete]

Mandate is 100% equity exposure plus special sauce if you can do, if you can do it. Okay, so what portable alpha is one of the problems it's trying to solve is it's saying I'm going to put.

[Co-host/Interviewer]

This ALTS strategy in your equity sleeve and I'm going to correct for the.

[Pete]

Fact that it's market neutral, let's say by adding in that S&P 500, for example, beta overlay. So it has beta 1 to the market like all of your other long only active equity managers. But it has a higher quality alpha associated with it. So that's how it's different. It's in that equity bucket and you're combining two sources of return, beta plus that unconstrained alpha for just one check.

[Co-host/Interviewer]

So, so the idea is if I have these unique sources of return, but I don't want to give up say my stocks and bonds, my beta to those. The that's basically what we're trying to do here, right? We're trying to set it up so I maintain my exposure to stocks and bonds and then I can sort of put these other things on in addition to that.

[Pete]

Correct? Right.

[Co-host/Interviewer]

And you could think of it again, there's multiple ways to think of it. Just saying, you know, there's all these.

[Pete]

People who have given up on active in their equity sleep for sure for us large cap. That's why the rise of passive and. And maybe if you told me you can only have access to long only active managers that have handcuffs, right. I always tell people long only active management's like running a 100 meter dash as a world class sprinter with cinder blocks.

[Co-host/Interviewer]

You're just not going to do as well as if you took off the cinder blocks. So what we're trying to do is, we're trying, we don't want portable Alpha.

[Pete]

To be a bell and a whistle.

[Co-host/Interviewer]

Like I'm trying to promote. It's a solution to a real problem.

[Pete]

That active management has been inconsistent and challenging in long only constrained space.

[Co-host/Interviewer]

And portable Alpha is providing that high.

[Pete]

Quality alpha from unconstrained active management, but again packaged in a beta 1 benchmark oriented manner using a derivative overlay, giving you that 100% equity exposure.

[Host/Interviewer]

What is this idea that you've written about that portable alpha solves the funding problem of diversifying strategies. What exactly do you mean by that?

[Pete]

Okay, great question. So think about a 6040 stock bond traditional investor, and let's say we went to them 10 years ago and said.

[Co-host/Interviewer]

You know, we can diversify, just like bonds diversify stocks. You can make your portfolio better by funding these uncorrelated alts by selling down stocks and bonds. And they say I'm signing up for that. This makes sense. I'm honoring Harry Markowitz, the father of modern portfolio theory. And then look what happened over the last decade. Even if that alternative hits it, hits it base case return stocks crushed it, right? And now all of a sudden there's this regret and people are getting tough questions from their clients and why I'm not in the s and P500. And so that's a real issue. If you feel like your explicit benchmark.

[Pete]

Or implicit benchmark is going to be.

[Co-host/Interviewer]

Just stocks and bonds. So when you go into alts, you.

[Pete]

Have to sell stocks and bonds and you're underweight that.

[Co-host/Interviewer]

So portable alpha solves that funding problem because it allows you to maintain your 6040 exposure. Right. If you want to make an allocation to this high quality portable alpha program that has an S&P 500 beta 1, let's say, plus this uncorrelated long short alpha, you would sell down your US large cap exposure. You would, it would invest in this portable alpha investment solution that has 100% S&P 500 exposure. You replace the equity beta one for one and then on top you get.

[Pete]

The special sauce from that uncorrelated alt. So that's how it solves this funding problem.

[Co-host/Interviewer]

And there's been a lot of people I've talked to today who are like, I believe in diversification, I believe in uncorrelated alts, but I can't give up stocks because what, what if the, even though equity valuations are high, what if they rip and then I'm out of a job because people think I made a poor decision? So that's a foundational problem that portable alpha solves.

[Host/Interviewer]

So, so how does it actually like work in practice? Like when you're looking inside one of these portfolios, what vehicles are being used to create a leverage exposure to some of these sources of beta?

[Co-host/Interviewer]

Sure. So, great question.

[Pete]

So today the, the great news is.

[Co-host/Interviewer]

Like I would say in the old world it was really done more in.

[Pete]

Like limited partnerships and was really restricted to more sophisticated institutions where a feeder was set up, etc. But today those old sort of legacy.

[Co-host/Interviewer]

Portable alpha structures still exist where.

[Pete]

A.

[Co-host/Interviewer]

Single manager, a hedge fund manager, can.

[Pete]

Set up a feeder where they put on the beta overlay to the S&P 500. I'm just using that as an example. You can choose any beta with a liquid derivative market and they hold shares.

[Co-host/Interviewer]

In the underlying alpha strategy.

[Pete]

Okay.

[Co-host/Interviewer]

But we also see in a 40.

[Pete]

Act mutual fund that people are providing.

[Co-host/Interviewer]

Portable alpha solutions by just taking that same long short alpha strategy that might already exist in a liquid alt and.

[Pete]

Adding one security to it, an S&P 500 futures contract. So I think it's across the board.

[Co-host/Interviewer]

And one thing I would say in.

[Pete]

The institutional market, more or more of.

[Co-host/Interviewer]

This limited partnership, there are two main.

[Pete]

Ways to do portable alpha that I think is really critical from an implementation.

[Co-host/Interviewer]

So you could just outsource the beta.

[Pete]

Management and the alpha to your alpha manager so that it's sort of turnkey portable alpha. I don't have to, you know, figure.

[Co-host/Interviewer]

Out how to do the beta overlay and the operational risk and cash management risk. But there are certain investors, portable Alpha 1.0 would say, you know what, I'm just going to make an investment in the alpha manager.

[Pete]

He doesn't even know I'm doing portable alpha.

[Co-host/Interviewer]

And then I'm going to put on the derivative overlay myself to get beta.

[Pete]

1 exposure and I am going to have all of the cash management and collateral management risk. So, so that's something that, like in the 40 act space where it's a single trading vehicle, where there's just one additional security. Again, I think of that as the turnkey approach where you have a single manager taking potentially something that could be complex and making it very simple for investors to access.

[Co-host/Interviewer]

How common are those two different approaches relative to each other?

[Pete]

Yeah.

[Co-host/Interviewer]

So I would say it's still the case in institutional that people do it.

[Pete]

The complex way where they separate the alpha manager from the person who manages the beta overlay.

[Co-host/Interviewer]

I would say the turnkey approach, which is something that we're a big proponent because there were a lot of people who loved the concept of portable alpha. But once they heard about like I got to manage a derivatives book or I have to hire an overlay manager and deal with wiring money and what happens if there's a cash need and I don't have liquidity. So we're big fans of turnkey. So there is a push on the institutional side to do more turnkey so.

[Pete]

That the main risk you have is just the risk of active management. On the mutual fund side, you sort of have to do it in the turnkey approach. And I would argue that is the only appropriate way to do it for a 40 act type investor who's less.

[Co-host/Interviewer]

Sophisticated, you know, to assume for you the turnkey is probably better from the perspective that you could pull all the different levers of the entire strategy. So you, you might be able to provide a better solution that way if you're doing it all yourself.

Correct.

[Pete]

I mean it like, like all the.

[Co-host/Interviewer]

Potential horror stories you've heard of portable.

[Pete]

Alpha, most of them are associated with separating the beta overlay from the alpha manager. And so most people are like, oh.

[Co-host/Interviewer]

You know, in 98% of cases it just doesn't matter because I won't run.

[Pete]

Into the operational risk and cash management risk.

[Co-host/Interviewer]

But we know investing is also about.

[Pete]

Thinking about the 2% probability event and that turnkey approach really mitigates that and again really just has you face the main risk. You want to Take, which is the risk of active management.

[Co-host/Interviewer]

What are the types of alpha strategies that work best with this? Like I would think, I would assume one thing is I don't want it to be that correlated with the market. So if the market's going down, my alpha strategy is not as well. But like what, what are the key characteristics of alpha strategies that work well in this framework?

[Pete]

Right. So one is liquid underlying. Right. So, so, so liquid securities as the underlying source of the alpha, in order to be idiosyncratic, it's going to have to be long, short. I would argue it has to be uncorrelated to the market over the long run. Okay, now there's a debate on whether.

[Co-host/Interviewer]

It needs to be uncorrelated to the.

[Pete]

Market over the short run. Let me give you an example.

[Co-host/Interviewer]

So let's say someone says equity market neutral, which is a great candidate for.

[Pete]

An alpha source and a portable alpha program, most equity market neutral managers would be market neutral at all points in time. Okay. So if that is one of your requirements, equity market neutral is great. Now let's take a macro strategy, a directional macro strategy like trend following.

[Co-host/Interviewer]

Trend following might be uncorrelated with the.

[Pete]

Market over the long run, but the.

[Co-host/Interviewer]

Way trend following makes money is over the short run. It's directionally long and short. Hundreds of markets and those markets that you're directionally long and short could be correlated in the short run, let's say with equities. Okay, now so, so I still think that's an appropriate strategy to consider. But if one of your requirements for.

[Pete]

The alpha source is it has to.

[Co-host/Interviewer]

Be uncorrelated in the short run and long run, then again you're going to.

[Pete]

Want to do something like equity market neutral or a market neutral multi strat.

[Co-host/Interviewer]

If you're willing to allow some of.

[Pete]

Your alpha to come from the the sort of tactical timing that that occurs in a trend following strategy, then then trend following would be a great alpha source to consider.

[Co-host/Interviewer]

And what's nice about trend following is by having that short term directional nature that gives it the protective properties, the.

[Pete]

Convexity that everyone talks about.

[Co-host/Interviewer]

So, so I would say equity market.

[Pete]

Neutral, multi strategy, trend following, they're all candidates. And which one someone chooses will depend on whether they're willing to take some short term beta that's informed by an alpha view. The other thing I would point out for like equity market neutral, let's say you're going to do portable alpha in your equity sleeve, there are certain organizations.

[Co-host/Interviewer]

That are like, well if it's going to Be in my equity sleeve.

[Pete]

The alpha has to come from stock selection. So then it's going to be equity market neutral. So that's why it's probably the most popular choice and I would think is.

[Co-host/Interviewer]

If you're willing to live with that short term potential, you know, beta, managed futures slash trend following is one of the better things to use in a strategy like that. Is that right?

Yeah, I mean it's great because people.

[Pete]

Are like, it's got crisis alpha and that's what I want.

[Co-host/Interviewer]

So and then, you know, if you also think about, you know, one thing with managed futures is sometimes, you know, when the volatility is low, there's very.

[Pete]

Few catalysts for markets to underreact to.

[Co-host/Interviewer]

Managed futures can look boring and if you're investing in it standalone, sometimes it's hard to hold on to it during those boring times. And then you Redeem Right before 2022. Right. And so actually packaging managed futures with equity beta actually sort of provides the patience to stick with the strategy that.

[Pete]

You know, you need.

[Co-host/Interviewer]

Are there other common strategies? We talked about equity long, short, we talked about managed futures. There are other common strategies that are typically used in this type of approach.

I would say besides equity market neutral and trend following.

[Pete]

It's going to be a multi strat.

[Co-host/Interviewer]

And the case for that is. All right, I love your equity market neutral. I believe in diversification. Why should I just stop it?

[Pete]

Stock selection, right. As my alpha source, let's add in.

[Co-host/Interviewer]

You know, some, some alpha sources from relative value macro. Let's add in alpha sources from arbitrage.

[Pete]

Merger arbitrage, convertible arbitrage.

[Co-host/Interviewer]

So for someone who has the flexibility.

[Pete]

And their sort of governance structure or is willing to do stuff outside of, of stock selection, who wants the most diversified source of alpha, they would go with a multi strap.

[Co-host/Interviewer]

And do you typically see it done that way? Do you typically see people using a lot of different alpha strategies or, or do you see people typically say I love managed futures and so that's what I want to use here.

Yeah, I see, I see different use.

[Pete]

Cases based on investor particulars.

[Co-host/Interviewer]

Right.

[Pete]

So again like I said, equity market neutral, if you feel like it needs.

[Co-host/Interviewer]

To be stock selection risk. Also some people find equity market neutral.

[Pete]

The easiest to understand because it's a close cousin to long only active stock picking. It's just you're allowing the manager to go short securities while some of the macro strategies, while you might be a little bit more complex.

[Co-host/Interviewer]

Right.

[Pete]

So, so that's maybe equity market neutral. And then for a multi strat Again, people are like, you know what, I want all of your capabilities in a single alpha source because that's going to get me the best return for a given level of risk. Because it sort of monetizes diversification the most. And the men for the people want crisis alpha. It's going to be managed, managed futures.

[Co-host/Interviewer]

But I will say sometimes the limiting.

[Pete]

Factor is, you know, I always tell people alpha is super hard to generate. So maybe the limiting factor is you.

[Co-host/Interviewer]

Being comfortable that you actually believe in.

[Pete]

A particular strategy's ability to generate alpha.

[Co-host/Interviewer]

You might not have the luxury to say, I know these are all great.

[Pete]

Alpha sources and I have five of them and now I'm going to pick the one that fits my mandate.

[Co-host/Interviewer]

You might only have one that passes.

[Pete]

Your rigorous underwriting process.

[Co-host/Interviewer]

You know, it's interesting, what you're talking about is something even dealing with retail investors you see all the time, which is the strategy that you believe in is the strategy you're going to stick with. And that probably applies here as well. Like the whatever source of alpha a particular investor feels strongly about, even if it's not perfect on the spreadsheet, that's probably the one that they should be using.

[Pete]

Yep, exactly. You got it. If you're not invested in it and you redeem at the wrong time, you might as well have not invested it in the first place. And so, yeah, you have to understand it, you have to believe in it. You need to understand when it might underperform so that you can distinguish is.

[Co-host/Interviewer]

It broken or is it bad luck?

[Pete]

Right. Like all those things are critical.

[Co-host/Interviewer]

How do you think about simplicity versus complexity here? Like I would think you could probably do something that would have a lot of alpha sources and maybe like that line between is, is it too complex versus is it adding value? Like how do you think about that line when you think about all the different options you would have with a strategy like that?

[Pete]

So the first one, you know, we talked about it briefly, is implementation. I would just say if it's not turnkey, don't do it.

[Co-host/Interviewer]

Because the, the last thing you want.

[Pete]

Is for your active managers to actually do well.

[Co-host/Interviewer]

But the program didn't do well because.

[Pete]

Of implementation screw ups. Right?

[Co-host/Interviewer]

So, you know, like I give the.

[Pete]

Example like, you know, you go to.

[Co-host/Interviewer]

The appliance store and you're going to buy a dishwasher and they have a licensed plumber on staff who will give you the, the standard installation and the white glove delivery, the turnkey installation. Or you could take it home yourself.

[Pete]

And do a custom installation. For your plumbing.

[Co-host/Interviewer]

And I know for me, you know, like while the custom might be a little bit better if I could actually execute on it, that the sort of white glove turnkey with the plumber who's the employee from the appliance store is.

[Pete]

Probably the best bet for 99% of investors. And that's why I think the turnkey is the most important part.

[Co-host/Interviewer]

Then when it gets to the alpha source again it's, everyone's going to come to the table with a different background.

[Pete]

In terms of if they're really only.

[Co-host/Interviewer]

Have been exposed to stock selection, active risk, then it really should just be.

[Pete]

Underwriting different sort of long short equity sources.

[Co-host/Interviewer]

If they have had experiences with managed futures, then you can, you can, you can bring that into the opportunity set. If someone has had experience also with.

[Pete]

Arbitrage and everything, they can look at a full multi strat. But it's critical that you understand to some degree. Obviously these managers are very sophisticated. It's not like we're asking you to be able to replicate their process, but.

[Co-host/Interviewer]

You need to feel comfortable and understand.

[Pete]

The process enough before you can actually make that investment.

[Co-host/Interviewer]

We talked about some alternative approaches that work well with this. I want to talk about some that don't. Like, like, I assume I don't want to bring my private credit into here. Like what, what are some examples of some alternative type strategies that don't work well in this type of approach?

[Pete]

Great point. So anything that's less liquid. Horrible.

[Co-host/Interviewer]

And, and one of the main reasons is those less liquid strategies like private credit and private equity, Those are already 100% actually they're more than 100% long.

[Pete]

Beta because they use leverage.

[Co-host/Interviewer]

Right. There is no notion of idiosyncratic alpha.

[Pete]

Standalone in those strategies.

[Co-host/Interviewer]

And so you wouldn't want to do portable alpha with a long only alpha.

[Pete]

Source because by definition that long only strategy has a ton of beta. So then you're just doubling down on beta.

[Co-host/Interviewer]

The second problem with these less liquid.

[Pete]

Strategies is so, so let's say you know, you thought you had identified a manager with alpha who's a little bit long biased.

[Co-host/Interviewer]

So you'd sort of need to have.

[Pete]

A view on what the embedded beta is of that strategy for you to figure out how much of a derivative overlay to put on. So like if the, if the Alpha.

[Co-host/Interviewer]

Strategy is a 04 beta, then you would put on a 06 overlay. 0.6 plus 0.4 is 1. The problem with less liquid strategies is there's price smoothing and so it's really hard to Estimate the beta and in fact you end up underestimating it. And, and you think this 04 beta strategy is actually uncorrelated because of the price smoothing. And that was one of the problems. People who ran into in Portable Alpha 1.0 thinking that they were in an uncorrelated strategy when it was really just wasn't marked properly. It wasn't because the manager was doing something nefarious. The nature of a private market or less liquid market is we just don't know the true price and inevitably there's price smoothing. So you understate risk, you understate beta.

[Pete]

And then it's a cascading huge problem in a portable alpha program.

[Co-host/Interviewer]

This is that whole volatility laundering thing that Cliff talks about all the time.

[Pete]

Yes, exactly. Volatility laundering, beta laundering, correlation laundering, all of it. You're going to have a harder time estimating and you're going to tend to underestimate the true risk, the true volume, the true beta, the true correlation, and all that's going to be critical in successfully implementing a portable alpha program.

[Co-host/Interviewer]

I think one of the most misunderstood words in investing is the word leverage. Because as soon as you say that word, people are incredibly, incredibly scared about all the things that can go wrong. So can you just talk about the good use of leverage versus the bad use of leverage and how that applies to what goes on with portable alpha?

[Pete]

Yeah, so a couple of things. So first off, let's just take the alpha strategy that might be using leverage. What's key to understand is the difference between long short leverage and long only leverage in an alpha program. So private equity is doing long only leverage.

[Co-host/Interviewer]

Or if I buy $100 of S&P exposure with only $10 down because I'm using an S&P 500 futures contract, I have 10x long leverage that is massively risky. You buy a house with 10% down, that's long leverage.

[Pete]

So most people think long leverage and long leverage really does amplify volatility.

[Co-host/Interviewer]

Now let me go over long short leverage.

[Pete]

Okay?

[Co-host/Interviewer]

So if you give me $100 and I go long $100 of Coca Cola and short $100 of Pepsi Cola, that's two times levered. But that's market neutral, that's beverage neutral. That trade has very little economic risk. But it still shows up on the leverage sheet is two times levered, like someone buying $200 of S&P exposure with only $100 down. So I always tell people, you always have to understand the source of the leverage. Is it Long, short leverage, where you're.

[Pete]

Long and short like securities, those are.

[Co-host/Interviewer]

Usually risk reducing trades.

[Pete]

Long leverage is an amplifier. Right, okay, so that's sort of one thing I would point to folks. And then within a portable alpha construction you are adding in the beta overlay. So that is a form of long leverage.

[Co-host/Interviewer]

And so what do we do to.

[Pete]

Try to sort of mitigate those risks or any serious manager is one you're.

[Co-host/Interviewer]

Going to want to target risk. Right? Because targeting, you know, leverage can be.

[Pete]

Used to take too much risk.

[Co-host/Interviewer]

And if you're targeting risk and targeting.

[Pete]

Volatility, you'll already have limits on how much leverage you can use.

[Co-host/Interviewer]

The second thing is you would do is you would say I recognize my.

[Pete]

Risk models are fallible and I'm just.

[Co-host/Interviewer]

Going to have some notional leverage limits and limits in each security and limit.

[Pete]

My exposure, you know, as, as sort of a belt and suspenders approach to managing leverage.

[Co-host/Interviewer]

Then the other thing to do is to make sure I never marry leverage.

[Pete]

With something that's less liquid.

[Co-host/Interviewer]

Because when you lever up something that's less liquid that you can't rebalance and.

[Pete]

Get out of, that's like watching a slow train wreck. So you always want to do leverage safely with more liquid underlying securities.

[Co-host/Interviewer]

Then the other thing that's relevant for leverage management is you'd never want to.

[Pete]

Be put in a place where you're, you're in a forced deleveraging.

[Co-host/Interviewer]

What does that mean? That means I don't have enough free cash such that if my trades go against me, I'm actually my prime broker is going to force me out of my positions and there's a margin call because I can't handle it. And so anyone who's serious about managing leverage strategies, they make sure they have a ton of free cash available to handle serious market stresses such that they're never forced out of their positions because.

[Pete]

They don't have enough free cash.

[Co-host/Interviewer]

So those are some things that someone who's really serious and thoughtful about managing.

[Pete]

A leverage strategy and that's what you.

[Co-host/Interviewer]

Would do also in a portable alpha.

[Pete]

Strategy to make sure you can withstand.

[Co-host/Interviewer]

Either drawdowns in the beta, you have enough cash or drawdowns in the alpha.

[Pete]

And so that's all part of a thoughtful, resilient, portable alpha program.

[Co-host/Interviewer]

Do you find institutions are less averse to this? Like I talked earlier about, like you to individual investors, you say the word leverage, they get scared. Like are institutions less averse to leverage and more understanding of using it in the proper way? Like this?

I think there's like we can bifurcate the sample.

[Pete]

There still are institutional investors that I come across where you mentioned the word leverage and they, and they, it's like they go to this bad place. They. I don't even get to the point of the difference between long short leverage and long leverage. They just assume danger.

[Co-host/Interviewer]

And then I have to sort of remind them, you know, using leverage is 1950s finance.

[Pete]

Harry Markowitz modern portfolio theory. This is not a driverless car.

[Co-host/Interviewer]

You shouldn't be cavalier about leverage. But like let's remember that it's actually.

[Pete]

Part of foundational finance and building better portfolios.

[Co-host/Interviewer]

And then there are institutional investors that.

[Pete]

Feel very comfortable with it. So, so I do think I see.

[Co-host/Interviewer]

The whole gamut in institutional everyone from super scared about leverage and shorting to people who understand these are real tools.

[Pete]

That allow you to better achieve your return outcomes. And in actually risk controlled manners.

[Co-host/Interviewer]

You mentioned target volatilities before and some of our listeners are probably not familiar with that. So can you talk more about that, like how that works, how you set target volatilities, what the typical target volatility you might run something like this at are just. Can you explain behind the scenes how all that operates?

[Pete]

Yeah, so, so let's say I want to provide a portable alpha solution that has beta 1 exposure to the S&P 500 and I want to add in an equity market neutral alpha engine. Let's say that's targeting 7% active risk. So think of that. Active risk is tracking error. So I'm getting S and p exposure with 7% active risk. That's the volatility of my alpha source.

[Co-host/Interviewer]

So let's say my equity market neutral.

[Pete]

Strategy is long a thousand securities and short a thousand securities. Let's say this is a manager who believes in diversification.

[Co-host/Interviewer]

And for each of those securities they will have a risk model that talks.

[Pete]

About what's the individual volatility of each of those 2,000 securities, what are the correlations between those securities? Cause that's going to be critical.

[Co-host/Interviewer]

And for any given positioning of what.

[Pete]

They'Re long and what they're short, that.

[Co-host/Interviewer]

Risk model can do the portfolio math and spit out, um, you're within shooting distance of 7% active risk. So when you do the sort of optimization, you sort of say here are my views on the securities.

[Pete]

I want to be long and short.

[Co-host/Interviewer]

Go long and short. Those views in a manner that gets.

[Pete]

Me to 7% volatility.

[Co-host/Interviewer]

You can think of it as like almost like an accordion, right? I have a set of views and Again, I'm, I'm trying to like, let's.

[Pete]

Just use some heuristics. It, there's obviously some nuance here.

[Co-host/Interviewer]

If I only need 3% active risk, my longs and shorts are a little bit less in magnitude, but I have the same views. But if you said instead of 3% I want 6%, I just, my longs go longer and my shorts go shorter. Right. It's just like an accordion. And my risk model can actually calculate.

[Pete]

When I've hit that 6% or 7% target.

[Co-host/Interviewer]

So, so it's not just, of course.

[Pete]

We'Re, there's a lot of, like I talked about before in managing leverage, there's a lot of belts and suspenders, things that you, you sort of put around a risk model to, to make sure it's safe. But, but it's really, you know, doing that portfolio math to get a sense of what the current portfolio, what that translates in terms of forward looking volatility.

[Co-host/Interviewer]

How do you think when you're running a strategy, how do you think about like what a safe target volatility is to run something at like, for instance, I would think like if I'm building a portfolio and I'm putting in all these uncorrelated return streams, I would bet in my spreadsheet I could probably apply a lot of leverage to that and it works out. But then in the real world, I'm thinking about all the things that can go wrong and so I probably use a lot less than that. I don't know, I don't know if I'm right about that. But I'm just wondering how you would think through that type of thing.

Yeah, you're right. Because remember when I brought up the.

[Pete]

Concept of free cash, you want to make sure you hold a lot of.

[Co-host/Interviewer]

Free cash and you might be like, well, Pete, how do you know that's enough free cash? Because you're assuming these strategies are all diversified. What happens if they're not? Right. So one of the stress cases we would run is what if the correlations break down, do I have enough free cash? Right. So, so I always tell people, you.

[Pete]

Know, you, you know, even as a.

[Co-host/Interviewer]

Systematic manager or like people like to call quants, we need to have an imagination and bring that to the table when coming up with stress scenarios such that we can then feel comfortable that the amount of free cash that we.

[Pete]

Have available can sustain all of those shocks, whether it's a market shock, a breakdown in correlation, so that things now all of a sudden are more highly correlated than we thought.

[Co-host/Interviewer]

So we're always going, a thoughtful manager is always going through multiple types of.

[Pete]

Of stress scenarios, not just ones that have occurred that were really horrible.

[Co-host/Interviewer]

That ones that could occur that would.

[Pete]

Be horrible for the portfolio.

[Co-host/Interviewer]

Yeah, I think that's a really good point because I think markets are littered with the graveyard of people who have said this could never possibly happen or this has never happened in history and where they didn't model it out and then that thing happened and it blew them up.

And one thing just on this point.

[Pete]

Now, this happened historically, but if you would have asked somebody at the end of 2019, there's going to be this pandemic that keeps everyone at their house for a couple of years. They'd been like, come on.

[Co-host/Interviewer]

Right. But Covid did occur. And what's great about COVID I always tell people is during that like two week period where markets were tanking, that is a great test of whether someone.

[Pete]

Knows how to manage a levered book.

[Co-host/Interviewer]

The global financial crisis was horrible too, but that was a lot of a slow bleed. There were some big market down, but.

[Pete]

It was sort of like, it was like two years of trauma.

[Co-host/Interviewer]

Covid was this fast shock. So if you ever want to know if a manager is offsides with their leverage is you want to have a fast shock.

[Pete]

Okay.

[Co-host/Interviewer]

So I always, I always tell people like, hey, of course you want to have that imagination about things that haven't occurred. But going back to what happened during COVID is a good test of whether.

[Pete]

The manager has a good process in place for managing long short levered portfolios.

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[Co-host/Interviewer]

If you had to talk about sort of the risks and costs of this type of strategy, what would you talk about? I know one is there's, there is some financing cost embedded in this, right? Like what are some other things you would bring up?

[Pete]

Okay, so the first thing is there.

[Co-host/Interviewer]

Can be a lot of implementation risk.

[Pete]

If you don't do the turnkey approach. The turnkey approach is a single manager doing the beta and alpha for you. Okay, so that is big, it can be big and it rears its ugly head at the wrong time.

[Co-host/Interviewer]

Then when I, let's say I found this equity market neutral strategy, I need S&P 500 beta 1 exposure and I do the S&P 500 futures contract. Now the S&P 500 is a really popular market and a lot of people want unfunded exposure to the S and P. So there's a lot of excess demand for that futures contract. So there's a financing cost above and beyond just the standard sort of overnight T bill rate.

[Pete]

Okay.

[Co-host/Interviewer]

And we call that a financing friction. And that friction today could be 70.

[Pete]

Basis points annually for the S&P 500 or 80 basis point.

[Co-host/Interviewer]

It fluctuates different markets. Like some markets in the Europe, that financing friction is maybe 25 basis points.

[Pete]

Okay.

[Co-host/Interviewer]

So you want to think about the.

[Pete]

Financing friction that's embedded in getting that beta 1 overlay.

[Co-host/Interviewer]

You also there's, there could be, just like with any investment vehicle, there could be some, some, some small operating expenses.

[Pete]

Associating with setting it up.

[Co-host/Interviewer]

But I would say the main risk.

[Pete]

You know, is that implementation. Whether you go turnkey or more complex, I encourage the turnkey. And then when you think about the.

[Co-host/Interviewer]

Main cost beyond just the manager's management.

[Pete]

Fee on the alpha is, is, is the financing friction that's going to be embedded in that beta overlay.

[Co-host/Interviewer]

Now I would argue again, same 70.

[Pete]

80, 90 basis points.

[Co-host/Interviewer]

Hopefully you're in an alpha strategy that's.

[Pete]

That sort of, it's not a close call. Like I wouldn't be doing portable alpha with a manager that I think has, you know, 100 basis points of alpha. Usually you're, you're looking at, you know, people are doing portable alpha for more bang for the buck. And so you're looking for something that's more in the neighborhood of 5% or more. Again, very.

[Co-host/Interviewer]

In terms of the financing costs using futures, this is one of the lowest financing costs out there.

[Pete]

Right.

[Co-host/Interviewer]

Just for people who are familiar with it.

[Pete]

Yeah, yeah. Futures, super competitive market. Right. Because, because there's people who can put on an arbitrage to keep that, to keep that in check. So futures market, very safe, super competitive. In terms of the financing rates, how.

[Co-host/Interviewer]

Do hire rates across the board? I mean obviously we've got a lot higher rates than we did years ago here with inflation coming up. Like how does that affect these strategies? I would assume it's probably double sided, but how does it affect these strategies?

Great, that's a great question because a lot of people are like, well if there's some use of leverage and interest rates go up, that's gotta be bad for these types of strategies.

[Pete]

And the answer is no. It's as your intuition suggested, it's a double edged sword.

[Co-host/Interviewer]

So when I'm financing my longs, that's Bad that I have to borrow money at a higher benchmark rate because interest rates are higher. But when I short securities, let's say I'm shorting stocks, I raise cash and my prime broker credits that cash with a interest rate and that interest rate is tied to the benchmark rate minus a little spread. Right. So, so when interest rates rise, it hurts me on my longs because my financing rate goes up, but the credited.

[Pete]

Rate for my shorts also goes up.

[Co-host/Interviewer]

So usually the sort of level of interest rates isn't going to be a big deal.

[Pete]

When thinking about the efficacy of portable alpha programs, one of the things I.

[Co-host/Interviewer]

Read in one of the AQR research papers is that many hedge funds tend to be a little bit more correlated with the market than many people think. I'm just wondering when you think about evaluating these types of strategies, like how do you think about separating the beta out of there and making sure we've got true skill in terms of what the person is doing?

Yeah.

[Pete]

So, so one is again, stay away from less liquid strategies because that they're more likely to sort of launder that volatility that could rear its ugly head. The second thing is, you know, there could be strategies. Think about trend following.

[Co-host/Interviewer]

People say it has protective properties, positive convexity. There are things that have negative convexity, things that on average pay off, but in, in, in challenging market environments actually do poorly. Right. And, and that you can think of is like, you know, providing some form of financial insurance. I'm selling out of the money put option. I'm not saying literally a manager's doing that, but you can think of that, that's a strategy that you get paid a premium on average, you'll make money on average, but every once in a.

[Pete]

While you're going to experience a major crash. Okay.

[Co-host/Interviewer]

And so, so I think it's important to try to like when you're underwriting strategies, is this a truly market neutral strategy?

[Pete]

Does it have negative convexity where it's effectively providing some form of financial insurance?

[Co-host/Interviewer]

That's why whenever you're underwriting strategies with.

[Pete]

Options, you have to really be at the top of your game. And I would even argue maybe with some of these portable alpha programs, if you, if you just want to stay clear of that risk is just don't invest in strategies that are using options. So, so that's something that I think is a, a, an important thing to consider to avoid this situation where everything correlates at the wrong time.

[Co-host/Interviewer]

And then of course, making sure you.

[Pete]

Move beyond just what's the volatility and.

[Co-host/Interviewer]

Correlations and the strategies we have had. 2022, 2022, horrible market for investors. Stocks and bonds bolt down because of an inflation shock. But if it turns out your manager has great performance, except 2022, that's a red flag. Like are they doing some form of hidden beta? Are they doing some form of financial insurance that I don't know about, but it's possible they just got bad. Like they experienced bad luck during 22 or it's a sign that you really.

[Pete]

Need to roll up your sleeves and go under the hood of the car and better understand this. And if you can't run, run, run away.

[Co-host/Interviewer]

It's funny how 22, a period like 22 can bring out stuff like that. You know, somebody, you think they aren't doing something but then you realize when you see a period like that, oh, there was a big problem under the hood of this thing that I didn't see the whole time.

[Pete]

Exactly.

[Co-host/Interviewer]

How do you think about the interplay between the alpha and the beta part of this? So for example, like if I'm using an alpha strategy and I determine that it maybe has a 0.2 beta, then I probably have to adjust the beta side of this.

Right.

So is that sort of a back and forth? And I was also thinking about like what you referenced earlier. Some things might have a beta that's higher in the short term than they do in the long term. So it seems like that's an interesting thing to try to, you know, get the B the balance between those two things.

[Pete]

Right? Yeah. So great, great point. So you're going to want to ask yourself what's the strategic long run beta of this alpha strategy? Okay.

[Co-host/Interviewer]

Because sometimes it's hard to find pure alpha.

[Pete]

Right. There might be a little bit of beta, but again equity market neutral, we know can be done without beta. But like what's the long run strategic beta? Let's say in your case it's 0.2.

[Co-host/Interviewer]

Then when you do portable alpha, the portable alpha manager, let's say it's the same managers, the alpha manager is only going to put on a point 8 beta overlay because point 8 plus point.

[Pete]

2 brings you to a 1.0 over the long run.

[Co-host/Interviewer]

If it turns out that again the strategics point to, but it's veering around that point to in conscious ways. It's actually the manager trying to add value.

[Pete]

It isn't just some random like you.

[Co-host/Interviewer]

Know, they like certain securities and dislike certain securities that leads to more beta. Like it's an unintentional thing. But it's like if it's truly intentional and you think that manager has skill, then you shouldn't override that manager's beta fluctuation around the two. Just like trend following the whole idea if someone were running a trend following.

[Pete]

Program and, and then in portable alpha.

[Co-host/Interviewer]

Well it looks like the trend program's more correlated with equities. Now we need to drop the beta overlay to maintain beta 1. You would be taking away part of the alpha within that, that, that strategy. So, so again get an understanding of the long run strategic beta of the alpha strategy and then you would take.

[Pete]

That into consideration when sizing up the.

[Co-host/Interviewer]

Beta overlay to get to beta 1.

[Pete]

Which is your benchmark and then any.

[Co-host/Interviewer]

Type of fluctuations around that are intentional or it's assumed to be intentional or you should be asking those questions like.

[Pete]

In a trend following strategy and you just see that as another form of alpha that you don't want to overrun.

[Co-host/Interviewer]

You mentioned 2020 before. Like how do you think about stress testing these types of things? I mean obviously we have things that have happened in the past, we have things that have not happened in the past. Like when you're putting all of this together, how do you think about stress testing it? And you know what, what thinking about what an acceptable amount of risk is.

[Pete]

Yeah, so, so again you're going to, you're going to go through first all the historical stress scenarios. So it could be gfc, it could be tech bubble burst, could be Covid shock, could be 22 inflation shock.

[Co-host/Interviewer]

Again another great thing about 22 is while we had drawdowns in the past, we hadn't had an inflation shock driven drawdown. And so everyone thought like government bonds are a great hedge against equities. Fixed, high grade, fixed income. Yeah, if it's a growth shock, not an inflation shock.

[Pete]

So it's great.

[Co-host/Interviewer]

22 provided some, some more richness to.

[Pete]

Our set of historical stress scenarios.

[Co-host/Interviewer]

And as we talked about before, you have to use your imagination.

[Pete]

You know, what if this happens, right?

[Co-host/Interviewer]

Like just come up with different scenarios using your imagination.

[Pete]

Shock.

[Co-host/Interviewer]

Any types of correlation assumptions you made, like we talked about shock, maybe volatility assumptions, you might say, well I think this strategy has an expected return of 8%. Well what if it had an expected return of zero? Right. Like and we experience these shocks now you don't have an 8% cushion, you're starting off at zero from the shock. So you're going to do all that, run through all the historical, and then.

[Pete]

You, you'll have a set of different.

[Co-host/Interviewer]

Macroeconomic shocks that could occur that you.

[Pete]

Can then filter down based on the portfolio you're holding on how the portfolio would respond. And again, use your imagination. Use your imagination. And that's what's gonna protect yourself from ever being in a situation where you're gonna be in a forced deleveraging or you're gonna run out of cash and have a margin call be forced out of your positions.

[Host/Interviewer]

Pete, I know that AQR recently launched a series of funds called the Fusion Funds that are kind of bringing these concepts to investors. So can you talk to this fund family and and sort of the different approaches at the fund level?

[Co-host/Interviewer]

Yeah. So think of Fusion funds is the.

[Pete]

ACH is sort of our version of turnkey portable Alpha to the 40 act space where we, you know, we talked about what are different type of alpha strategies. One could be long short equity, equity market neutral. One could be managed futures trend following. Another could be multi strategy.

[Co-host/Interviewer]

So we said, okay, here are different.

[Pete]

Alpha sources we should probably offer and we're going to put it in a beta 1 format.

[Co-host/Interviewer]

What's the beta? Out of all the equity betas that are out there that people feel like.

[Pete]

Long only active management's been the most disappointing. US Large cap, everyone's like that's the most efficient marketplace. So we decided on beta 1s and P500 exposure for that reason, out of all the different equity choices we could have gone with. And so we're providing that better way to do active management. Right, because you're getting access to an unconstrained alpha Source in a beta 1 benchmark oriented mandate. We've solved the funding problem we talked about earlier because now when someone says.

[Co-host/Interviewer]

Well how do I fund this? You sell US large cap. Why? Because these are going to replace the US large cap exposure one for one, you're not going to be underweight that, but you're going to get this really high quality alpha on top of it.

[Pete]

Right.

[Co-host/Interviewer]

The other thing I would also point.

[Pete]

Out is sometimes when people invest in uncorrelated alts standalone, everyone's like it improved.

[Co-host/Interviewer]

The risk adjusted return, but it didn't.

[Pete]

Improve the total return. That's what we call capital inefficient implementation of an alt.

[Co-host/Interviewer]

So what Fusion and other portable alpha.

[Pete]

Type solutions do is they not only improve risk adjusted returns, they also improve total returns. And I always tell people you can't eat a risk adjusted return. You can't pay bills with risk adjusted returns, you pay bills with total returns. So Fusion and portable Alpha solutions in general not only give you a better way to do active management in your beta 1 equity sleeve, solve the funding problem we talked about. They also solve this issue of, of making sure it's a capital efficient implementation that improves risk adjusted returns and importantly total returns.

[Host/Interviewer]

And would there be any sort of argument or opinion I guess on you know, strategies like this in today's market where you have you know, relative at least to history, you know, elevated valuations and you know where yields are. So in just in terms of stacking it up to how these sort of fit in today's market and these are all long term strategies but is there any thoughts on that?

[Pete]

Yeah.

[Co-host/Interviewer]

So equity valuations are elevated.

[Pete]

It's hard to call markets but like.

[Co-host/Interviewer]

People, people love their equity beta. It's always going to be part of.

[Pete]

Their strategic asset allocation. And doing portable alpha or doing Fusion is a great way of honoring that.

[Co-host/Interviewer]

But also providing some long short alpha on top that's not going to be.

[Pete]

Subject to the equity valuation stretched problem or index concentration or if the Fed chair gets replaced with someone where the market no longer thinks they have credibility.

[Co-host/Interviewer]

I always tell people it's so funny that like sometimes like talking to someone.

[Pete]

From aqr like on a macro views.

[Co-host/Interviewer]

Boring because we're all about diversification, all the things that keep most investors up at night. Is the equity market going to crash? Is there going to be an inflation shock? Is there going to be like those are things that impact long only investing. And so that's why people need this long short alpha, these idiosyncratic return sources where it's not feast or famine based on what happens with these, these, these large macro risks that could occur.

[Host/Interviewer]

Yeah, we're, we're always looking for our next big hot YouTube cover and title image. And you know the, it's, it's diversification works. Doesn't always, doesn't always get investors excited but it, it's kind of what matters most I think you know, over time for most investors. So how would you, how would you go about like evaluating one of these strategies from different risk and return like metric standpoints? Like if I'm an investor looking at these Fusion funds over time or other portable alpha strategies, they all have different mandates but, and are different underneath the hood. But like what types of things would you look at I. E. The Sharpe ratio, tracking error drawdowns, like how would you go about assessing?

[Pete]

Yeah, so, so one would be is it delivering on the beta one mandate that you're signing up for? Right. Because if I'm telling you this is a core equity Solution. Right. Because it's beta 1 to the S&P 500. You can confirm that whether I'm within shooting distance of that beta one. So that's one thing.

[Co-host/Interviewer]

Then I've told you this is a higher quality alpha. So you're never, you don't want to.

[Pete]

Look at the total returns of the overall program or the risk adjusted returns of the overall program.

[Co-host/Interviewer]

You want to subtract out the stated benchmark.

[Pete]

Right.

[Co-host/Interviewer]

If I tell you this is a better way to do beta 1s and.

[Pete]

P500 active management, then you would, you would, you would, you would look at the active returns. So you would subtract out the S&P.

[Co-host/Interviewer]

500 and then you would do all that stuff of like what has it been on average, what's its volatility, what did it do in 22 in other shock scenarios to get a sense, does.

[Pete]

It have tail risk?

[Co-host/Interviewer]

And so you're, you're doing the standard risk and return and tail risk analysis.

[Pete]

But it's all in excess of the stated benchmark.

[Co-host/Interviewer]

And I always tell, this is, this is critical. It's amazing.

[Pete]

You know where sometimes people are running a portable alpha program and let's say they do it the complex approach where they have a separate alpha pool and they're doing the, the derivative overlay and.

[Co-host/Interviewer]

They'Ll be talking about my alpha managers are generating alpha. And my view is I don't really care. I want to know the total return of the overall program versus the stated benchmark you had. Because if at the end of the day you're not beating the S&P 500 in this particular example, it's a, it's a failure. Even if your alpha managers produced alpha standalone because you're screwing up something with the financing costs or the implementation. So it's critical to always keep your eye on the ball. If this is going to be a Beta 1 benchmark oriented mandate, you evaluate it in a similar way.

[Pete]

You would do it in excess of.

[Co-host/Interviewer]

The benchmark, hopefully it's exceeding it.

[Pete]

And then you would do those standard risk metrics, including tail risk.

[Host/Interviewer]

Are these funds managed so they're relatively tax efficient? Like how do the taxes work in here?

[Pete]

Yeah.

[Co-host/Interviewer]

So in general a lot of managers.

[Pete]

Are tax agnostic and that's just a reality, it shouldn't be.

[Co-host/Interviewer]

Right.

[Pete]

So at aqr, we, we don't believe in that. We believe it's not how much you make, it's what you keep. So we focus on after tax returns. And so the fusion funds are implemented in a tax aware manner. Where we're not just trying to give you the best diversifying source of pre tax alpha, we're trying to give you the best diversifying after tax alpha. And that's something that's not only in the Fusion funds, it's a part of now our, our liquid ALTS platform in the 40 act space.

[Co-host/Interviewer]

And it's a disruptor, it's a game changer because every manager and investor knows.

[Pete]

It'S all about after tax returns. But we've been sort of the leader in really, you know, bringing that home and actually implementing it.

[Host/Interviewer]

Are there any new sources of alpha or implementation approaches that you guys are researching at a firm that have you excited?

[Pete]

Well, the first, the last one I just talked about is really exciting because we, we sort of cut out like last year was our first, first full year of implementing our enhanced tax aware implementation. So you can add a lot of value through that.

[Co-host/Interviewer]

Beyond that, like obviously we do the.

[Pete]

You know, all of the innovation that needs to be done in order to create new signals, identify new signals that help predict returns, doing all the research to help figure out how to combine those signals.

[Co-host/Interviewer]

I always tell people, I can give you the list of ingredients, but if I don't give you the recipe, you can't make my baked salmon. You need to know how much of each to put in and preheat the oven at 350. So they're, you know, so we're doing a lot of research and innovation both on the signal front, on the portfolio construction front. We're leveraging machine learning tools to help us come up with new ways to.

[Pete]

Create signals like natural language processing, et cetera.

[Co-host/Interviewer]

So we're really excited about all that.

[Pete]

Work and we're really excited about focusing on after tax returns.

[Host/Interviewer]

So we have two standard closing questions we like to ask all of our guests. And the first one is, what is one thing you believe about investing that most of your peers would disagree with you with?

[Co-host/Interviewer]

So I would say the, the main.

[Pete]

Thing is that I would say most of my peers in the industry, where I'd say my peers, other investment professionals is they would say mutual funds are for dinosaurs. It's all about ETFs. And I disagree with that. So why do I disagree with that? Well, one is if you really want access to an alpha strategy that has intellectual property rights that manager wants to.

[Co-host/Interviewer]

Protect, they're never going to give that strategy in a daily transparent etf. They're going to want some of the.

[Pete]

Protection of a mutual fund.

[Co-host/Interviewer]

And we think of ourselves as an alpha manager. And secondly, this notion that you can't.

[Pete]

Run a mutual fund tax efficiently, which.

[Co-host/Interviewer]

Is the conventional wisdom, right?

[Pete]

ETFs for tax efficiency for long short alts, that's just not true. And we've proven it with our track record. And if you look at our distributions, how we've been able to minimize the distributions for our mutual fund. So that I would say would be.

[Co-host/Interviewer]

A huge thing that most people disagree.

[Pete]

Mutual funds are not for dinosaurs. They are a great way with a talented manager to get diversifying attractive after tax returns.

[Host/Interviewer]

That's definitely a, you know, interesting non consensus view for sure. And then the, the, the, the, the last question is based on your experience in the markets. If you could teach your average investor one lesson, what would that be?

[Pete]

Whenever someone talks about a view, I was on a panel and, and they were, they were saying stuff about why they're bullish on the U.S. the U.S. they have, you know, when you think.

[Co-host/Interviewer]

About the talent pool in the U.S. it's great. They got a great legal system that.

[Pete]

Protects investors and the regulatory system. And you know, and that's why the.

[Co-host/Interviewer]

You know, the US markets is going to outperform. And my response is so that's an example of a view. So whenever someone expresses a view, always ask the question, is it already priced into current valuations? Because if it is, it's not an edge, right? It's always comparing your view versus what's implicit in current pricing. It might be the case that everything that person said is true, but the market has over baked it in such that you should be shorting the US market. And so that to me is the like foundational lesson that most investors forget. Oh, he said some negative things, we should be shorting that he said some positive things, we should be overweight and.

[Pete]

Go long, that it's always relative to what's priced in. So that's the discipline all investors need to have when assessing whether there's something actionable from someone's insights.

[Host/Interviewer]

Pete, thank you very much for joining us. I know our audience is going to get a tremendous amount of value from this discussion, so we really appreciate it. Thank you.

[Pete]

Well, thanks for having me. I really appreciate it. Anytime.

[Co-host/Interviewer]

Thank you.

[Host/Interviewer]

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[Co-host/Interviewer]

On this podcast should be construed as investment advice.

[Podcast Sponsor/Host]

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[Co-host/Interviewer]

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