#3 – Bob Elliott: Portfolio Construction, Outlook

Summary

Insightful Investor Podcast – Episode #3: Bob Elliott on Portfolio Construction and Market Outlook

Introduction

In Episode #3 of the Insightful Investor podcast, host Alex Shahidi engages in a deep and informative conversation with Bob Elliott, CEO, CIO, and co-founder of Unlimited. Bob brings a wealth of experience from his 13-year tenure at Bridgewater Associates, the world’s largest hedge fund, where he served as the right-hand man to Ray Dalio. The discussion delves into Bob's transition from botany to macro investing, his investment philosophy, portfolio construction strategies, and his outlook on current and future market dynamics.

Transition from Botany to Investing

Bob Elliott begins by sharing his unique journey from being a trained botanist to becoming a seasoned macro investor. His passion for botany, nurtured through high school and college laboratory and field research, gradually shifted as he sought a more engaging and impactful career.

“[...] I realized that botany was probably not my long term profession. I wanted to basically be more engaged in the world and with people...” ([01:41])

This shift led him to develop an interest in development economics and public health, ultimately steering him towards macroeconomics and macro investing. Bob emphasizes the role of markets as a mechanism to hold oneself accountable in understanding complex economic dynamics.

“It's like a scoreboard of whether you get what's going on or not.” ([03:48])

Experience at Bridgewater and Investment Framework

Alex probes into Bob's experience at Bridgewater Associates, highlighting it as a high-pressure environment conducive to developing a systematic and data-driven approach to macro investing.

“Bridgewater is a great place to develop a deep, rich understanding of how to think about the world from a macro perspective.” ([04:12])

Bob draws parallels between his scientific background in systematics and his approach to analyzing the macroeconomy, emphasizing the complexity and interconnectedness of economic systems.

“In many ways, the macroeconomy is very similar [to botany]. It's a complex system that has a bunch of different intersecting features that you can observe the outcomes of.” ([05:00])

Understanding the 52% Hit Rate in Macro Investing

A pivotal part of the conversation revolves around the seemingly counterintuitive notion that a 52% hit rate in trading can be highly profitable. Bob explains that in macro investing, consistent small edges are leveraged across a large number of trades to generate significant returns over time.

“If you can be 52, 48 on trades in any given month, that'll make you one of the best investors in the world.” ([08:02])

Alex underscores the rarity of appreciating a 52% hit rate as a success metric, noting that most people mistakenly believe they can achieve much higher accuracy.

Importance of Humility and Risk Management

Bob stresses the importance of humility in investing, acknowledging that failures are inevitable and essential for growth. He contrasts experienced investors who openly discuss their losses with overconfident traders who only highlight their successes.

“A serious investor, an experienced investor, will tell you the 25 trades that they've gotten wrong...” ([12:09])

Risk management is highlighted as crucial in macro investing. Bob advocates for diversification and careful portfolio construction to mitigate the impact of inevitable losses.

“Risk management, portfolio construction, thinking about the correlations between your different trades, that is as important in macro investing as is getting any particular call.” ([12:03])

Portfolio Construction and Diversification Strategies

The discussion moves to portfolio construction, where Bob outlines a framework centered on diversification and low correlation among investment positions. He likens building a diversified portfolio to a casino offering multiple unrelated games, each with its own slight edge.

“If you have edge, then you can bet that edge over and over and over again.” ([09:25])

Bob explains that by combining uncorrelated or lowly correlated positions, investors can reduce overall portfolio risk while maintaining positive expected returns.

“Find a number of uncorrelated or lowly correlated positions. If each one of those have a positive expected return, you can create a portfolio that meaningfully reduces your risk...” ([18:53])

Alpha vs. Beta in Portfolio Management

Bob distinguishes between alpha and beta as sources of returns in a portfolio. He explains that beta represents returns from holding risky assets (passive investing), while alpha involves making strategic trades to outperform the market.

“Beta strategies are going to give you pretty good consistent returns, so you really want to rely on that. But alpha can help protect portfolios, particularly in difficult times.” ([31:36])

Alex adds to the discussion by highlighting the zero-sum nature of alpha and the rising cost-efficiency of passive investing.

Fee Structures and ETF as a Vehicle for Democratizing Alpha Strategies

Addressing the barriers to accessing sophisticated alpha strategies, Bob introduces Unlimited's mission to democratize these investment opportunities through machine learning and ETF structures. By leveraging technology, Unlimited offers replication of hedge fund strategies at a fraction of traditional fees, making them accessible and tax-efficient for everyday investors.

“We can replace the PMs with technology, which allows us to basically do it at a much lower fee structure and also in a way that's much more liquid than typical LP positions and much more tax efficient.” ([47:56])

Bob advocates for ETFs as the optimal structure for distributing alpha strategies, citing their tax efficiency, transparency, and regulation under the SEC.

“ETFs are more tax efficient, more better for actively managed strategies than it is even for passively managed strategies.” ([53:18])

Macroeconomic and Investment Outlook

When discussing the current macroeconomic environment, Bob identifies it as a late-cycle phase characterized by low unemployment, elevated wage growth, and inflationary pressures. He notes the unusual volatility in asset markets, where stocks are at highs and bonds are pricing in significant rate cuts, signaling a disconnect that may present investment opportunities.

“Stocks are above highs, they're pricing in pretty good conditions. Bonds and in particular short rates are pricing a lot of cuts.” ([58:13])

Bob warns of the potential for economic reacceleration and rising inflationary pressures, drawing parallels to the 1960s and 1970s. He emphasizes the importance of understanding what is already priced into the markets to identify investment edges.

“Start with what's priced in, and then go to what's likely to happen is going to be very advantageous for investors.” ([73:23])

Government Deficits and Economic Implications

The conversation shifts to government deficits, where Bob discusses the challenges posed by high national debt. He outlines the primary methods for managing debt—through higher inflation, increased productivity, or money printing—and anticipates a painful transition as governments strive to reduce deficits.

“The first step is transitioning from an elevated deficit environment to a more constrained deficit environment. So less borrowing. And that's a painful transition.” ([70:39])

Bob predicts that governments may resort to inflation and money printing to manage debt, underscoring the global nature of this issue and its implications for the US dollar as the reserve currency.

Final Insights

As the episode concludes, Bob shares a fundamental insight for investors: understanding what is already priced into the markets is crucial for making informed investment decisions. He encourages investors to take stock of current market expectations before forming their own views.

“Which is why when you're thinking about markets, you have to start with what's priced in.” ([73:23])

Conclusion

Episode #3 of the Insightful Investor podcast offers a comprehensive exploration of portfolio construction, risk management, and the intricate dynamics of macro investing. Bob Elliott's expertise provides valuable perspectives on navigating complex market environments, emphasizing the importance of diversification, humility, and strategic risk-taking. His insights into democratizing alpha strategies through innovative ETF structures present a compelling approach for everyday investors seeking consistent and tax-efficient returns.

For those seeking to deepen their understanding of sophisticated investment strategies and market outlooks, this episode serves as an invaluable resource, bridging the gap between high-level financial theories and practical, actionable investment practices.

Transcript

[Alex Shahidi]

Welcome to the Insightful Investor Podcast, a weekly series that seeks to share industry, investment and market insights. We define insights as concepts that are counterintuitive, widely misunderstood or underappreciated. In other words, unique ideas that you probably won't hear elsewhere. I'm Alex Shahidi, the host of the podcast and co CIO of Evoke Advisors, one of the nation's leading investment advisory firms. Learn more about our [e-mail] I'm excited to have Bob Elliot with me today. Bob, thanks for being here.

[Bob Elliot]

Thanks so much for having me. Looking forward to this.

[Alex Shahidi]

Yeah, I've been looking forward to this conversation as well. Bob is the CEO, CIO and co founder of Unlimited, which uses machine learning to create replication of what are traditionally expensive strategies that typically come in the 2 and 20 fee structure. So that falls into the category of venture capital, private equity and hedge funds. And prior to Unlimited, he spent about 13 years at Bridgewater Associates, the largest hedge fund in the world. The right hand man for Ray Dalio and his investment team. So a lot of background to talk about. But before we get into Unlimited and Bridgewater, why don't we start from the beginning with botany. So tell us about botany and what led you to the investment world.

[Bob Elliot]

I always like to say that I was trained as a traditional scientist in the sciences and in the specific in botany. I got a passion when I was a kid getting into it and had the opportunity to explore it a couple times in high school and do laboratory and field research work which then continued into my time in college as well. But over time, probably it was the days upon days in the sixth basement of the biological laboratories using growth chambers that, that I realized that maybe research science wasn't gonna be the thing for me over time. I mean, I love botany and still to this day I grow plenty of things in my yard as a hobby. But I realized botany was probably not my long term profession. I wanted to basically be more engaged in the world and with people and talking to people and sort of in parallel. I had gotten really interested in develop economics in college and development economics and public health issues and realized increasingly that macroeconomic dynamics are basically what drives the core fundamental outcomes that happen at a country level or a cycle or a longer term perspective. And so that drew me to macroeconomics and macro investing as a way to sharpen my skills and my understanding of it. And really it's amazing. I look back, it's been 20 years and I've really enjoyed really getting being in the markets, being in the macro economy. It's not. Lots of people come to markets for different reasons. For me, I think markets are very much a way to hold yourself accountable to understanding and to push yourself to constantly deepen that understanding and question how much you know and ask the next question and the next question. It's like a scoreboard of whether you get what's going on or not. And so that's really what drives me to think about markets on a daily basis.

[Alex Shahidi]

Okay, and so you ended up at Bridgewater. So tell us about that experience. It's obviously a high pressure environment. So maybe talk about what lessons you learned from your experience there on working. And also maybe we can shift into the investment framework you've developed from your experience there.

[Bob Elliot]

Yeah, I mean, I think Bridgewater is a great place to develop a deep, rich understanding of how to think about the world from a macro perspective. And in particular macro, there's a lot of people who think about macro in a lot of different ways. For me, it was really developing that understanding of thinking about macro in a systematic way, in a data driven way, building systematic investment approaches. And I think it was a great example.

[Alex Shahidi]

As a scientist. Right. As a scientist, you approach it from that perspective.

[Bob Elliot]

That's right. And I think actually to be great in markets, you have to have non consensus views. And part of the way in which you can develop or I've seen lots of people who have high quality non consensus views is they come from areas that are not strictly finance, they haven't strictly learned the textbook. And that different way of thinking is valuable in thinking about the macro economy, just as it is thinking about a particular company or anything like that. And so I think my, my way, my development as a research scientist was really very important. In particular botany, I focused on systematics. So how does all the different pieces of the plant, phloem and xylem and stuff you probably remember or have forgotten from your high school days. In many ways, the macroeconomy is very similar. It's a complex system that has a bunch of different intersecting features that you can observe the outcomes of. You know, for the economy, it's markets. For botany, it's like whether the plant grows or doesn't or produces, you know, crop yield or doesn't. And so those two things are very related. And I think, you know, Bridgewater is a great place to develop that understanding of macro, have that historical perspective, which is obviously a very foundational way of thinking about the world from Bridgewater's perspective, but also that pursuit of constantly asking the next question and the next question, appreciating that there's far more to learn about what's going on in the macro economy than there is that, you know, at any point in time. And so I think that philosophy and that drive was also very important in terms of setting the foundation to become a great investor over time.

[Alex Shahidi]

That's more related to how the economic machine works. Right. And how markets work and the big drivers of shifts and trying to predict what's next based on understanding those drivers. Is that right?

[Bob Elliot]

Yeah, absolutely. It's really about developing that sort of fundamental understanding of how the markets work. And it's not, I think people can think about systematic investing and they can think, oh, well, it's right computer rules, and they sort of drive you wherever you go. It's less about that and more about understanding and thinking that there are fundamental cause effect drivers that drive the outcomes that we're seeing, and that those are not necessarily static. There are ways of thinking about it, and there are certain elements that are consistent over time, but that system is constantly evolving. And so you can't just say, well, for instance, I trade stocks using the yield curve. Sometimes that works, sometimes it doesn't. In the last 15 months, or it hasn't, yield curve inversion hasn't been a very good indicator of stocks. And so you can't just take those things on the face value. You have to constantly, rigorously assess. But the foundation is that there are fundamental drivers that are driving markets, economies, where they were and where they're going. And if you can understand those fundamental drivers in a way that is better than other participants in the market, then you have a better view of what's likely to transpire and you can reflect that view in markets.

[Alex Shahidi]

So I'm curious, do you say it's a fair assessment to conclude that there are no certainties or very few certainties? There's just. It's probabilistic. Right? Is that how you think about it?

[Bob Elliot]

Part of the lessons from being a macro investor is the humility of getting a lot of things wrong. In baseball, if you hit over 300, you go to the hall of Fame. In macro, if you can be 52, 48 on, you know, trades in any given month, that'll make you one of the best investors in the world. And so that gives you a sense as to just how hard it is. And so a lot of what you're doing in terms of if you're trying to generate alpha from a macro perspective is you're trying to get some edge, right? You're Trying to get that marginal edge and then try to bet that edge over and over and over again. So you have large sample size so you can create more consistent returns. Because anytime any macro commentator watch cnbc, someone says stocks are going to go up, stocks are going to go down. That's a 52, 48 kind of bet. And so given that edge is so hard to develop, what you want to do is you want to create that edge, but then you also want to bet it. And that's part of what systemization is really valuable for, which is it both allows you to have sort of these fundamental cause effect sort of rules in terms of how the world is working, but it also is scalable and allows you to apply that understanding more broadly across markets and in a disciplined way so you can get the most out of your edge.

[Alex Shahidi]

Yeah, what you said there is I think actually really insightful. For somebody who doesn't sit on our side of the business either managing money or involved in asset allocation and looking at markets every day, it may be counterintuitive to think that 5248 is great. I don't think most people would equate 52% hit rate to a 300 batter because they know if they went out on the and they were trying to hit 100 mile per hour fastball, they would never get 300. But I think most people think they can probably do better than 52% just on their own, obviously their selective memory and so on. But, but I think it is insightful to hear from you being in the industry for a long time, working at Bridgewater, one of the most resourced, experienced firms, and to conclude from all that experience at 52 is actually really good. And I agree with you. But I think that's something that is often missed.

[Bob Elliot]

The key thing in that process is having the humility to recognize 5,248. And I think in a lot of ways macro investing, it is not about taking big swings in highly concentrated positions. I know there's lots of lore about some guy speculated on the pound and made a ton of money. He very well could have lost all of his money as a function of. And he probably did before, and he probably did before. And it's why you see these single trade macro folks, they don't necessarily have consistency. So maybe you call one trade right, but you don't have the consistency over time. The person who called the financial crisis well, it's very hard to then call the rebound and the downturn, the rebound and the downturn, and keep calling them and so part of the key way of investing from a macro perspective is that risk management, because what you do is you have the humility to say, I'm probably going to be wrong a lot. Okay. Given that I'm wrong a lot, how do I make sure that no one bet is would put me in a position to unduly take risk? And so I think it's interesting, risk management, portfolio construction, thinking about the correlations between your different trades, that is as important in macro investing as is getting any particular call. Right. And so often the people who are lauded are the people who are talking about this view or that view, and the people who generate good, consistent returns are carefully constructing portfolios over time. That is reflective of the humility of how often you can be wrong.

[Alex Shahidi]

Yeah. And I guess that humility comes from prior failure or at least seeing others fail.

[Bob Elliot]

Oh, no. If you've done this long enough, you have failed so many times that I think is one of the things you can tell a person who's a serious investor from someone who, frankly, you probably shouldn't trust, who's overconfident. Because a serious investor, an experienced investor, will tell you the 25 trades that they've gotten wrong and will tell it to you in a way that is in detail and why and revisited it. And they will think deeply about all of the instances they got wrong and why and try and learn from it.

[Alex Shahidi]

And.

[Bob Elliot]

And the overconfidence trader will tell you all the reasons and all the trades that they got right. And that is the distinction. Right. That is the distinction that you can quickly see in terms of who has really done this for a long time and has the scars to show and who hasn't.

[Alex Shahidi]

Yeah. And part of that is also keeping an honest track record. A lot of people, they don't actually write down everything that they've done and go back and objectively assess, okay, what's my hit rate? So I think part of the humility comes from actually knowing what the truth is, as opposed to some fantasy that you feel is reality, but it's not.

[Bob Elliot]

That's right. It's very easy to remember to just lodge yourself for the good trades and forget the bad ones. And it's much harder to have real money on the line that over time tells you whether or not you're getting things right or wrong. And I think that's why, whether you're a small scale investor or a professional manager, the way to do this most effectively is you got to put the money on the line because there is no better or faster learning tool than putting your views out there and getting it right or wrong and learning as a result. And that's the beautiful thing about markets, right, markets investing is every single day you're getting feedback about whether your understanding of the world is right or wrong. And that's such a great way to hold yourself accountable, to constantly be pushing to better understand the world and markets.

[Alex Shahidi]

I'm curious, why do you think It Is that 52 is good? What is it about this industry that may be unique from other industries where if you're a surgeon, if you had a 52% hit rate, you're not going to be in business for.

[Bob Elliot]

You will be fired.

[Alex Shahidi]

You'll be fired. In most industries, the 52% other than baseball is not good enough. So what is it about investing that makes it unique in that, you know, a little bit better than somebody who knows nothing is exceptional?

[Bob Elliot]

It comes down to the ability to develop high sample size of that. So if you take that 5,248, you know, which is that weighted coin, and you flip it one time, who the heck knows, right? You know, I mean, like, you can't tell the difference between 5050 and 5248, you know, if you flip the coin one time. And part of the idea, the great thing about markets is if you are prudent with your risk management, what you have the ability to do is if you have an edge, then you can bet that edge over and over and over again. And it's not just about betting it at any one time across a bunch of different markets, but it's also about betting that edge through time. Because at any one month, any one bet in any one month is. It's very hard to necessarily know whether you have edge over time. But let's say you put that on 100 times and you do it over 100 months. Well, now you have orders of magnitude more scale in terms of the number of times that you've made those bets. And if you've made those bets enough and you have that edge, odds are you're going to be able to deliver a return that, that is more consistent, that generates alpha, that's more consistent than, say, just passive investing. But what I'd emphasize is that there's also limitations. So someone who claims to be 60, 40 or 75, 25 in their bets is probably lying, maybe not overtly lying in terms of. They may think that that's true, but it's almost certainly not true. It's like Sharpe ratios of 3 don't exist, they don't exist in the world. Sharpe ratio is the amount of return you get relative to the amount of risk that you're taking at any point in time. It doesn't exist in the world because if it did exist, people would find those opportunities and erode the alpha away. And so when you hear people talk about having exceptional track records, the real question is, are they lucky or are they good? And the more exceptional the track record, the more likely they're lucky rather than good.

[Alex Shahidi]

And oftentimes what I've seen is you have exceptional returns for a long period of time and then you take a massive hit because you had this underlying risk that didn't show itself until it did. And then when you look through the full period, you're just like maybe 52%.

[Bob Elliot]

That's exactly right. I mean, certainly you can construct bets and there's lots of implicit and explicit ways in which people sell options. The investment management industry today is chock full of people who are selling options. And in a low volatility environment, you don't have to pay out for them. But in a high volatility environment or a jump to volatility environment, you could have huge gap risk. And take losses, I mean, for instance, that are multiples of your capital. And so you're totally right. It's not only just looking at the winning percentage, it's also looking at how you're winning and the likelihood that you're going to be able to consistently do that. And one of the big risks in the industry is that there is a tilt towards strategies or desire to hold strategies that look like they're working over time. And then when they blow up, you're like, ah, well, everyone blew up. But that's a bad investment strategy, right? What you want to do is, you know, you don't want to create a return stream that looks like up and then down. You want to create a return stream that is as close to a line as possible. And the way that you do that is by having the humility to understand that you're going to get a lot of things wrong and use diversification and use other tools in order to create a more consistent return.

[Alex Shahidi]

Let's dive into that a little deeper. So assuming you appreciate and recognize that your hit rate is probably not very high, talk us through a framework for putting together a well diversified portfolio that seeks attractive returns over time.

[Bob Elliot]

Yeah, there's the old classic view that one of the ways in which you can create a good risk return profile of a portfolio is by finding a number of uncorrelated or lowly correlated positions. If you can find 5 or 10 lowly correlated positions or 0 correlated positions, you can create a portfolio. If each one of those have a positive expected return, you can create a portfolio that meaningfully reduces your risk relative to the probabilistic return that you'll see. And so that's really at the core what you want to do with a portfolio. When you're thinking about positions. I think all too often people think about positions as individual, discrete ideas and don't necessarily think about them in terms of how they interact with each other. And so often what you'll find in markets is there are times when you have two positions that are skewed, where your positive expected value outcome is actually with different macroeconomic realities. And that's actually really good for portfolio construction. Because if you think both of those positions have positive expected value based upon what's likely to happen, the probability of what's likely to happen versus how it's priced into the market, then you can have two positions which are tilted in your favor, but they can pay off under different circumstances. What you want to do is you want to build a portfolio of positions in a moment in time that is as diverse to the different possible outcomes as they could be. Positive expected value, diverse set of outcomes that generates those positive expected values. Then over time, if you think about portfolios as I mean portfolios or alpha is just, you can think about it just like alpha returns can be thought about, just like stock and bond and gold returns, they're just return streams, particularly as you think about this in a systematic way. And so what you want to do is you want to create returns, bets on markets, rules that allow you to bet on markets that are as lowly correlated as possible to each other. So you can create that portfolio together. So it's about a point in time balancing of your portfolio risk and trying to find those lowly correlated positions and a through time way of balancing your strategies, basically your investment strategies, in order to create the most consistent portfolio you can.

[Alex Shahidi]

It's kind of like if you're the casino and you have roulette that has a 52% chance of winning, and then you put that out there, and then you put blackjack out there because that has a 52% chance of winning and those two returns aren't correlated to one another, and you have millions of users, you're going to win over time. And you go to Vegas and casinos keep getting bigger and bigger and bigger.

[Bob Elliot]

I love that analogy. It's craps and roulette and blackjack, all of those things are totally unrelated to each other. And to be clear, the casino loses sometimes in any day. They might lose a blackjack, or they might, you know, somebody might bet roulette, might hit the particular number. But the idea is, over time, if you have that edge and you have a bunch of different ways to basically bet that edge, which is what the casino's doing, then you could start to create a much more consistent return than if you just had one particular game or one particular, you know, table.

[Alex Shahidi]

And obviously, the law of large numbers works over time. That's just math.

[Bob Elliot]

That's right. And that's why risk management's so important, is that if you have edge, the key to proving your edge, taking advantage of your edge, is sample size. And so what that means is in any point in time, you have to have good sample size. But it also means you have to make sure that over time, that you can bet that over time. And so that's a very important component. All too often, people become enamored in a particular view or position and put on so much risk that it can ruin their ability to generate returns, ruin their ability to continue to pursue those strategies. And so that's why it's so important. The best investment managers, hedge fund managers, most sophisticated managers in the world, they sort of get this view of being like crazy hotshots. The reality is most hedge fund managers are trying to generate a 10% return, a very consistent 10% return, because that's the type of return profile that's going to allow them over time to bet in, you know, to pursue those strategies. And it's the through time that creates lots of sample size for you.

[Alex Shahidi]

Yeah. The best way to compound wealth is not to lose it all in one day.

[Bob Elliot]

That's right. That's right. There's all too often people who, from the outside, look at giant returns, right, and say, hey, look, shouldn't we have giant returns? And the humble, experienced hedge fund manager person who's been investing money for a long time, look at those big returns, and they say, if you're up 100, you could have been down 75. And that is not a good way to manage money.

[Alex Shahidi]

The challenge is, I think most people zoom in a lot. So if you zoom out and you have two return streams, one more resembles a straight line and one is extremely volatile. And let's say they end up in the same place over time, through time, if you're zoomed out, you pick the straight line every time. But in reality, we're zoomed in, we're looking at the markets every day, we're reading the paper, we watch cnbc, we hear our friends talking about how much money they made. And most people are focused on the volatile line. And it's easier to be drawn towards that after the upswing and drawn away from it after a downswing. And so I feel like your emotions kind of pull you away from where logic would lead you. And so that makes it difficult to implement and practice. Even though on paper it's clear the straighter line is the right path.

[Bob Elliot]

That's right. And I think it really connects to the behavioral aspect of investors. There's this paper going around where these academics are like, why would you ever put bonds in your portfolio when you could just hold 100% stocks and get a higher return over time? And the answer, and then you read the paper and they're like, what this would require you to do is when you're down 65, 70% in your stock portfolio, you have to just hold it. Why would you do anything other than just hold your portfolio? And it's like, why would you do anything other than hold your portfolio? Imagine you're a retiree and you're getting close to retiring and all of a sudden your stocks go down 75%. That is a totally normal outcome. To be clear, that is totally within the range of plausible expectations. For those of us who've been doing this for a while, we've seen two instances in the 2000s and the 2008 circumstance where we had a greater than 50% decline in stocks. And we were on that path in 2020, in the matter of weeks for that sort of outcome to happen. We didn't quite get there, but we were on that path relatively quickly. And the problem is, like, people start to change their behavior when they start to see declines like this. And actually, I think it's been very interesting in the last two years where just the stock market decline that we saw in 2022 caused a lot of people to move to cash. Cuz they had too much equity risk. They moved to cash right around somewhere between July and September and have been too conservatively positioned for the rebound. And the reason why that is is because they responded to the conditions, it felt safe to move to cash because they had so much equity risk, because they had so much portfolio volatility, they felt they needed to do something to protect themselves. And what they actually did was hurt themselves in the future because of their behavioral response.

[Alex Shahidi]

Yeah, in my experience, when I talk to investors and I Say, you know, the markets are going to go down at some point. Most of them would say that's great, I'm going to buy at that point and I'm looking forward to that. But what happens is when you actually live through it, the news is bad. When that happens, the outlook is bad. When markets have declined and, and so people look at all that, they look at the historical return and it's bad. And they look at current conditions as bad and the outlook is bad, they'll say why would I invest? That sounds, that seems stupid to hold the money now. I'll come back when the outlook is brighter. Right? And markets obviously move in advance of the outlook. And so you can justify selling low. I mean you're supposed to buy low, sell high. You can easily justify buying high and selling low. And it happens over and over again. And I think the cycles are long enough where people, the lessons are lost and people are kind of doomed to repeat the same mistakes over and over.

[Bob Elliot]

And that's why no one has a negative reaction, a quick shift to try to preserve capital if their investment portfolio is down 5 or 10%. Right. Like, you know, we sort of all accept that that's part of the normal volatility. If you're trying to generate any returns 5, 10, even 15%, people are pretty good about navigating through those. It's when you move outside that range that people start to respond by preserving capital and rationally respond. I remember a very vivid memory in March of 2009 when if you remember the S&P 500 bottomed at 666 having a rational conversation, totally rational evidence based conversation where I said, well look, the outlook for stocks at that time could be earnings at 60 and PEs at 10. That would have been a totally plausible outcome at the time. This is not random people on cnbc. This is one of the biggest, most sophisticated institutional managers in the world. That was a, that was a reasonable outcome that could have penciled out the S&P 500 in March 2009 at 600. And so think about that. That is the mindset that you have and that what marked the bottom, right? And we had 15 years of incredible equity market performance since then. That is the type of mindset that exists. And so you have to recognize that, you have to say, hey look, how am I going to respond to that? And much more often you're better off targeting a lower return over time with less volatility because it's a plan you can stick to than targeting a higher return with more Volatility on a plan you can't stick to because you will fail at actually experiencing those higher returns.

[Alex Shahidi]

Paper doesn't translate to practice if you can't stay on the ride.

[Bob Elliot]

It's one of the reasons in alpha strategies why systemization is so valuable. Because part of the, part of the challenge is getting edge, but the other big part of the challenge is actually playing your hand as you need to play it in order to maximize that edge. And so one of the great things about systemization is that it creates discipline to actually operate in the way that you expect to operate. And so that means you're getting the most out of your, most out of your edge. Right? Whereas if you're trading in a very discretionary way, like, you know, I mean, there's all sorts of studies and things like about a judge before and after lunch, like you are that judge, like your trading is worse before lunch than it is after lunch. Just recognize that if you're trading discretionarily and the question is, do you want, you know, do you want your edge to be based upon your skill or do you want it to be based upon whether you just ate or. That's not a good, that's not. I know which one of those two I prefer.

[Alex Shahidi]

So let's go back to framework. I know we've talked about this before, but you think of the world as there's beta and there's alpha. So there are returns that are risk premium that you collect by holding risky assets. So this is kind of buy and hold. You have a positive expected return and then there are trades that you can make. And in a moment we'll get into your market views. But maybe just quickly summarize that distinction between the source of returns and then how you think about balancing those two. In a well diversified portfolio, when it.

[Bob Elliot]

Comes down to it, you can generate returns from three different sources. There's cash, the cash rate, essentially the central banks, what that is, you get it for free and with no risk in T bills and stuff like that. There's beta, as you say, passive investing. And over time you'd expect assets to outperform cash. And the reason why that is is that the sort of fundamental construct of markets is that you forego the riskless cash return to hand your money to someone, whether it's to lend or to invest. And you would expect a higher return as a result than holding cash. And it's a reason why, if you look back through time, very, very rarely over meaningful periods of time does cash outperform assets. In fact, over any one year time frame over any 12 month time frame, it's like 70, 30 that assets outperform cash. And so the choice to overweight cash is actually an alpha choice. And you have to be darn good at that timing in order to actually have conviction that you should overweight cash, since so often assets outperform cash. And then the last choice, as you say, is making bets in markets. And when you think about a portfolio, you want to think about each one of those different pieces in a different way. First of all, you want to think about your overall risk tolerance. We talked about can you absorb 75 or 50% drawdowns in your portfolio? Or say, for instance, you're getting close to retirement and you really want a lot of conviction about exactly how much capital you have for retirement. And so that sort of gives you the sense of what's the choice between cash and assets, right? The amount of risk that you're willing to take in order to generate returns in excess of cash. And so that's different for every individual. And you just want to think about that thoughtfully and proactively to target your return. And then when you think about assets, the real question is how much do you want to put in passive investing versus active investing. And there's an important trade off there, which is passive investing generally has lower expected returns, particularly relative to the risk that you're taking, but it's more consistent, more reliable. You would expect assets to outperform cash over time, whereas alpha, you have the opportunity probably to get a better return relative to the risk that you're taking, but the reliability is lower. And so how do you balance these things? I mean, the frank reality is there's no obvious way to do it because you have to take into consideration of a variety of different things, including how reliable you think one is versus the other, how much skill you think managers have. I think if you look at big institutional managers, they're allocating something like 80% of their capital to beta in one form or another, whether it's liquid or illiquid, and about 20% of their capital to alpha strategies. I think that basically is about right in the sense of, in general, beta strategies are going to give you pretty good consistent returns, so you really want to rely on that. But alpha can help protect portfolios, particularly in difficult times. And so you want to put something on it, but you don't want to go overweight it. So something like 80, 20 makes sense. Which, you know is the answer to Every. It's either 80, 20 or 50, 50. Those are the answers to all of life's weighting questions.

[Alex Shahidi]

Yeah, that sounds about right. And then I guess it's also, you know, alpha is a zero sum game, it's a negative sum game. If you add fees, you know, in a lot of cases maybe the managers can generate alpha, they can outperform, but they take that in fees and the investors don't get as much as they might otherwise. So I think you have to weigh that as well. And passive investing just heading to zero in terms of cost.

[Bob Elliot]

Right. And fees. The biggest issue for an investor is fees. And the reason why that is, is alpha is uncertain. Fees are certain. Right. Whatever the fee is, you know what that management fee, certain that pass through, let me tell you, it's certain and it's big. Those, those fees are certain. Whether you could generate alpha is uncertain. And so given that, I think one of the things, I mean one of the things that's core to what I'm trying to do right now is, is to, is to bring these strategies, these alpha strategies which are uncertain, but bring down the fees. Because if you can bring down the fees, you at least know that you're getting, that's a certain benefit to the investor. Whereas the alphas are very uncertain. And so absolutely there's a big difference between your net of fees returns and the gross of fees returns, which the managers see and I'd also add very important is there's also a big difference between what your outcome is before taxes and after taxes. And all too often people don't think carefully about how in particular alpha strategies are disadvantaged from a tax perspective. And so that adds even more difficulty to adding alpha to your portfolio unless it's in a tax efficient wrapper like an etf.

[Alex Shahidi]

Yeah, and we'll get into this in a second. But basically if you're trying to generate alpha, you're actively trading and that by definition is going to be less tax efficient than something that's passive.

[Bob Elliot]

Right. Just by definition you're going to have more turnover, more short term capital gains, which are, at least in the US context are less attractive from a tax perspective.

[Alex Shahidi]

So a couple of points you made is the 5248 I think is critical and recognizing that you want to be well diversified and you want to emphasize diversification in your portfolio so you don't take a massive hit at any point in time. Yet when we. So all that sounds very logical. Obviously as a scientist it makes perfect sense. As somebody who doesn't have a science background, I think conceptually it makes sense kind of the oldest rule in investing is don't put all your eggs in one basket. And what you're describing is basically how to do that in practice and then thinking of the world in alpha and beta terms and different streams of returns and how to put all that together. So that's like an engineering exercise. So all that sounds very logical. And I think when I talk about that with people, they say, yeah, that makes perfect sense. Logically, it makes sense to be, well diversified. Yet when we look at how most people invest, their portfolios are basically invested in the stock market. All their eggs are in the stock market basket. When you turn on cnbc, they're talking about the stock market. When you read the papers, they're talking about the stock market. Everybody's focused on the stock market. And you ask somebody, how's the market doing? They're not talking about any market besides the stock market. So why do you think there's a disconnect between what logic would suggest is being diversified and then when you look at actual portfolios, even a 6040 portfolio, almost all the risk is in the stock market. Why do you think that's the case?

[Bob Elliot]

A big part of it is that people's eyes are drawn to the more volatile thing. And so I think it's not surprising that the assets that get the most capital into them are the highest volatility assets that are sort of commonly available because those are also viewed as the highest returning assets. And I think that really is one of the fundamental fallacies of how people think about investing is they don't think about. They think about investing in assets as they come rather than as economic exposures. And obviously you folks have done a lot of work on this particular topic, but there's no, again, going back to that paper that says should be 100% invested in stocks over time, they say a big reason why that is is because stocks are higher returning than bonds. And the answer is like, why? Why would stocks be higher returning than bonds? Like, if you just hold long duration stocks, like, you know, or long duration bonds, you can have bonds that have, you know, excess returns that are equivalent to stocks. They can have access returns that are higher than stocks at a certain volatility. You can leverage them, you can buy futures. There's all sorts of different ways that you can unpackage these assets and think about them based upon their economic risks, independent of what your return or volatility target is for these assets. And so I think it is a bit of a fallacy. I bet if you ask the man on the street, they wouldn't. You mentioned leverage. You have to start to mention leverage to investors. Like, oh, I want nothing to do with leverage. Right. And the answer is like your stocks are levered two and a half times. What are you talking about? Right. You've got tons of leverage in your portfolio and it's hard for people to understand and break down those pieces and then put them back together. And so I think that's why folks are just drawn to the highest volatility, normal asset class. I think as an example, I think if, you know, I don't know, if Bitcoin had a volatility that looked like 5% a year rather than 500% a year, I don't think anyone would talk about it. Right. Because it just wouldn't be volatile enough to attract people's attention. Could be a good investment. It just wouldn't attract nearly the interest.

[Alex Shahidi]

Yeah. And I guess there's also a draw towards investing in companies, which makes sense. You think about investing. It's investing in companies. These are great companies. I want to own these. And X is a great company. Y is a great company. The index is a basket of great companies. How can you lose if you just buy and hold great companies?

[Bob Elliot]

That's right. And I think that unfortunately that desire or that view, for instance, that you have to have even productive capacity of assets in order and yield outcomes of assets in order to generate returns, I think closes the door to assets that could be highly beneficial to a portfolio like gold, that have attractive risk return and correlation profiles that are different from what stocks and bonds provide. And so I hear you, I think that that's right. Is that there's sort of a tangibility of a company and Nike produces the shoes that I'm wearing today. What does the US Government bond produce? It's kind of hard to get your head around.

[Alex Shahidi]

Yeah. And I'm curious, why do you think there's just so much. And maybe you disagree, but why do you think there's so much misunderstanding about how the economy works, how markets work? We're in a world where information is readily available. There's probably too much information. There's probably a lot of noise. Why do you think we're in a place where, you know, the average investor doesn't have a good grasp of these concepts?

[Bob Elliot]

If financial Twitter is any indication, there's certainly plenty of noise out there. So much noise. Very valuable to you get a lot out of it. But there's a lot of noise. You have to filter through things. I think at its core I think there's a real education gap that exists in understanding economics. And also I think there's a huge education gap in personal finance. Like, we're. I mean, as an example, like, we're teaching young kids about farm animals instead of how, you know, they should invest their paycheck. Like, that is, you know, like. And 100% of people will have to figure out how to manage their paycheck. And, you know, 1% of the employment in the U.S. is in the farming industry. And so, like, that is a fundamental gap that exists in our educational system. And so I think the macroeconomy is hard to be clear. Lots of things are hard. Writing a good essay is hard. Understanding physics is hard. There's lots of different things that are hard. But we don't spend time societally in prioritizing a deep, rich understanding of macroeconomics when it is a thing that affects everyone's lives every single day, which is kind of incredible in a way that you live your life and you make your personal decisions. When the mortgage rate goes down, any person in the market who's thinking about buying a house, which is 2/3 of the people in the US own houses, it affects all of those people, and yet we don't talk about it. And so I think that's a real gap, and I think it's particularly a gap that is harmful for those people who don't have access to this information. I think, you know, increasingly, it's becoming more available and understandable for, you know, in various channels, but there's still not a good canonical way in which we educate people in the way that we do biology, chemistry, physics, math. It doesn't make sense.

[Alex Shahidi]

Yeah, I mean, that's one of the reasons I'm doing this podcast is when I. When I look at the other information out there, I feel like there's just a lot of misinformation. It's almost like you. You would have been better off not hearing that because it could lead you down the wrong path. And I'm just trying to share some insights that hopefully are helpful to investors. Yeah, it's. It's a. It's just such a fascinating field. You know, if you think about, you know, the average person, they have to work really hard to earn money, and then they take that money and they put it in some investment, you know, to save for retirement or, you know, down the road. And all that hard work could be wasted on investing inefficiently, which, when I look at kind of the average person, their portfolio is really out of balance. It's basically one bet and it's kind of overly risky and it doesn't have to be that way.

[Bob Elliot]

I totally agree. And it's how you allocate your savings and then also all the different steps, all the ways in which you can allocate savings, like all the planning aspects, which are so critical, I mean, so, so critical to getting the best outcome that you can. And a place where, you know, if you ask the average person on the street, like, what do you do? What's the most efficient way to save your money? It is not obvious, right? We're not, we don't have these conversations with the everyday, you know, the everyday person about how best to save, how best to structure it, how best to create a great portfolio, all of those things. There's a huge gap in terms of the education, it's the role. I mean, the great thing is there's also tons of advisors out there who really understand this stuff well and are out there trying to educate their clients and put them in the best position. So I think there's a great force for good that's out there to do this in a better way. But there's still a huge gap between what the man on the street understands and what is actually available to them and how to best implement a portfolio.

[Alex Shahidi]

So talking about availability, why don't you spend a few minutes talking about what you're doing at Unlimited and kind of democratizing these return streams, trying to make them low fee. And also maybe spend a minute talking about why you selected the ETF structure.

[Bob Elliot]

At Bridgewater, I worked with some of the biggest, most sophisticated clients and pools of capital in the world. And what you see, we talked about a little earlier, what you see is they put about, let's call it 20% of their capital in hedge fund style strategies, the most sophisticated ones. And when you compare that to the everyday investor, they basically don't have access to those strategies at all. Because typically you have to be a wealthy individual. You know, you have to have certain levels of assets to even have the ability to invest in them. And then you have to have access to the funds to actually invest in them.

[Alex Shahidi]

And a lot of the funds aren't very good.

[Bob Elliot]

And one of the challenges, you know, one of the challenges for advisors who look at these platforms and things like that, first of all, how do you evaluate all these different funds? But also the negative selection bias, which is very, which is a big deal, which is, you know, the person who the fund that's taking your 100,000 doll check is probably not the best fund to be in and certainly not the best fund to be in. When it's tax structured in an LP structure and you're paying rack rate on fees, plus platform fees and stuff like that, you're talking about a very bad structure. So the biggest, most sophisticated institutions in the world, they invest in these strategies. They have a 20% allocation. The everyday investor basically has no access to these strategies. The other thing in working with these sophisticated investors you see is, is that when they invest in these strategies, they invest in a diverse portfolio of them. Because any one of these strategies, any one of these managers, they might be good, they might be bad at any particular point in time, but when you put them all together, they actually generate a pretty good return. And so these institutional investors are actually creating indexes, essentially creating index products that might invest in 60, 70 of these different managers, which is essentially buying an index, right? Whereas you know, with a lot more paperwork, with a lot more, a lot more paperwork. Whereas the individual investor, you know, if you're an advisor, you're directing folks to like one or two funds, right? There's not, there's not, you know, you're not investing in 70 funds. So they, they invest in hedge funds, they index those hedge funds. And then the last thing, which is a very important thing, is those institutional managers beat the funds down in fees. And so, you know, the idea of paying 2 and 20, if you're a big sovereign wealth fund, you don't pay 2 and 20, you pay a lot less than 2 and 20. And so what they've done is they basically created a low cost index fund of these alpha strategies. Now how interesting is that when you look at what's out in the market, you basically don't, there's nothing that looks like that low cost index fund and certainly nothing that's available for the everyday investor. And so that was the basic idea is we said, look, I bet we could take our experience as, you know, having built the proprietary strategies and all these different hedge fund styles, I bet we could take that understanding, build technology that allows us to replicate what those managers are doing. Not perfectly, of course, but in a way that's pretty good. And because we can use technology instead of investing in the PMs, we can basically do it at a much lower fee structure and also in a way that's much more liquid than typical LP positions and much more tax efficient. And the outcome for the investor is the investor cares about net of fees, net of taxes, that structure at a quarter of the fees and half the taxes is much more compelling than typical LP positions. And because it's diversified, it should create a more consistent return stream, manager diversified as well as strategy diversified. So that's really at the core of what we're trying to do, is use those principles, those principles that big institutional investors bring to the table in terms of how they manage their money and bring that to the everyday investor.

[Alex Shahidi]

Yeah, that makes a lot of sense. And that ETF structure has kind of. It's almost like a tax loophole in some ways.

[Bob Elliot]

I mean, almost like a tax. It's a tax loophole. I think it's one of the things. No reason to beat around the bush. There's a structure, it's been set up so that for the investor, it looks like a stock and has all the properties of an individual stock in terms of its tax structuring, which means, you know, typically if you buy it and hold it for more than a year, it's taxed at, you know, your, your capital gains rate rather than your ordinary income rate. That's a great tax loophole to have it. ETFs are also advantaged relative to mutual funds in that they have the ability to wash the capital gains in the securities underneath. And so therefore you don't get you. I mean, in the vast, vast, vast majority of ETFs, there are not capital gains distributions. Even for products that have moderate turnover, there are not capital gains. They're typically not capital gains distributions that you see in other funds. And so what that means is you pay the taxes when you want to pay the taxes, not when the manager has redemptions or when the manager rebalances. That's all very advantageous. And so it's just. And not to mention the fact that it's transparent and it's liquid and it's a 40 act product that's SEC registered and at arm's length and has independent custodians and independent board, which for hedge funds. How many times are you looking at hedge funds and you're saying, well, I mean, what's the probability of fraud? I'm not saying that there's lots of fraud, but that is a thing you have to worry about. Well, if the security in an etf, if the securities are held by an independent institution, I don't touch the money, right? I can't touch the money. It's an independent trust that holds the money, not me. It's an independent trust that is highly regulated by the sec. That's very advantageous from a consumer standpoint in terms of the risk of fraud or abuse that comes from a manager.

[Alex Shahidi]

Yeah, I've always felt if you could take your total portfolio, however way you invest and put the whole thing inside of a single etf, you'd be in great shape because you're basically putting that tax efficient wrapper around. This is obviously for taxable investors. You can put that tax efficient wrapper around the total portfolio. Obviously that's very complicated, not easy to do. So short of that, you can try to put an ETF wrapper around those return streams that make sense.

[Bob Elliot]

Most people think about ETFs as, as like low cost index funds because that's basically how they started. But the tax efficiency is actually the best with moderate turnover portfolios because you don't have to take the capital gains in and out. All right, you can put those all into a single wrapper and only basically take the taxes, only pay the taxes at the point of sale. And so actually the ETF structure is more tax efficient, more better for actively managed strategies than it is even for passively managed strategies, which is pretty neat. I mean, that's why I got, I always been in the LP structure with institutions, which is a whole different game. I looked at the ETF and I said, well, if you look at all these different pieces, it's actually far and away the best structure for the vast majority of investors.

[Alex Shahidi]

Which is also probably why it'll be around for a long time. Because it's for the average investor, it's not for the ultra wealthy.

[Bob Elliot]

That's right, yeah. I mean it's been, just think about it, actively managed ETFs last year they got about 25% of the incremental flows. They might get as much as 50% of the incremental flows here in 2024. That really speaks to the fact that. But even with that, actively managed ETFs only represent something like 5% of the overall ETF and mutual fund actively managed market. So there's a long way to go here in the evolution of actively managed ETFs. And I think people are finally starting to recognize the real advantages that the structure provides, particularly for those actively managed products.

[Alex Shahidi]

So why don't we transition to market and investment outlook? You're very active in sharing your views, your alpha views of what you think the future holds. We're talking about the kind of the 52, 48 conversation I'm curious about. What are some of your big themes that you're contemplating that you'd like to share with us?

[Bob Elliot]

Well, the first thing I'd say is remember 5248. So the probability that anything that I say at this point is right is about that. Right. So just I love having that conversation about humility. And then it's like, what are your views? Well, don't have too much confidence in any view that I have, but I'll give you what my views are. So take them or leave them. I think most of us in our professional lives have basically experienced two, maybe three cycles which were relatively acute experiences. So 2020, obviously, I mean, I don't know, that cycle was like three weeks from top to bottom to reflation 2008, which was the course of six months. And then the 2000 cycle, the equity bubble, population. And those cycles are not normal cycles. Normal macro cycles are very boring, very slow moving. That doesn't get any clicks on Twitter. When I'm like, the normal macroeconomic cycle is like watching paint dry. Stop listening to any of us. This is going very slowly, but that's very important to recognize. If you go back to cycles like old time cycles like in the 60s and the 50s and stuff like that. And so if you think about where we are in that cycle, we're late cycle. The unemployment rates at secular lows. There was a tightening, inflation was elevated, there was tightening. That tightening is very, very, very slowing, very, very slowly slowing the economy. But it's very slow moving. And what we've actually seen instead is that people's expectations of what's going on have whipped around that very, very slow moving moderation in the economy. And that whipping around has created a lot of opportunities. If you think about it, what have we done in the last year? We went, at the beginning of last year, we were going to have a recession immediately. Then we went to hire for longer, then we went to a banking crisis, then we went to an AI boom, then we went to hire for longer. Then we had recessionary dynamics. We've been through every macroeconomic state in the course of 12 months. And the reality of the economy is just so much more boring than that. Right. I should have shared what's been going on with the unemployment rates. Basically been the same for 18 months. You want to understand what's going on with the economy. There you go. Nothing. Nothing has happened. Nothing has happened.

[Alex Shahidi]

And inflation spiked and it gradually went.

[Bob Elliot]

Back down and then inflation spiked and came down. And there were obviously issues related to the COVID dynamics in the supply chain, things like that, but those things happen. And those are one off up and down. But the basic underlying fundamentals of the economy are very boring. Late cycle tight labor markets, elevated wage growth, inflationary pressures, tightening in response, moderation or slowing of the economy. And that's basically where we're at. And then more tactically, so that's the foundational space of the economy is sort of secular and growth is about a potential. And then on the margin, what we've had over the course of the last 10 weeks or something like that is one of the biggest easing experiences, short term easing experiences that we've seen in history, which stocks that are up 20% or more, bond yields have come down 120 basis points, a huge easing that's basically been injected in the economy. And what you'd expect, and that sort of level of easing is typical of recessionary environments, but not very typical of late cycle environments. And the reason why that happened was a variety of things related to Fed policy, Treasury policy and inflation coming down. But what it created was an effective easing in a late cycle environment. And actually what we're starting to see is a re acceleration of the economy. And that's a bit of a dangerous point because when you get a reacceleration of the economy at a late cycle moment with elevated wage inflation, the risk of inflationary pressures reemerging are present, particularly after a period where we had such idiosyncratic but nonetheless meaningful inflationary pressures that existed coming out of COVID And so that's kind of where we're at, which is we're like, you know, that's where we're at macroeconomically likely to have continued pretty good, fine good growth and very low unemployment and tight labor markets. But the thing that's very interesting is that the asset markets are pricing in wildly different outcomes. Stocks are above highs, they're pricing in pretty good conditions. Bonds and in particular short rates are pricing a lot of cuts. Now typically you wouldn't see an environment where you have the economy, unemployment at secular lows, inflation risks elevated and growth pretty good, and stocks at all new highs and 160 basis points of cuts priced in those two things are totally inconsistent with each other. And I think that's basically where we stand in the economy, is where in many ways it looks like we're back to things that look a little bit like where we were at the beginning of 2023, where people are coming into the year with big expectations of weak economic conditions that are really unlikely to be realized, which is likely to put pressure on the bond market and particularly the short rate market and the pricing of all of those Fed cuts that are currently priced in yeah.

[Alex Shahidi]

So in some ways, bond market pricing and stock market pricing don't really match. It's hard. It seems like one of those is probably wrong.

[Bob Elliot]

And that happens, right? Different pools of investors, different market views, different flows, different things like that can often create different pricing in markets. And so that's, you know, if you think about this, the question is where do you have edge? It's about looking at what's the macroeconomic conditions, how are they likely to proceed into the future relative to what's priced in? And right now we have a pretty good economy, pretty tight conditions, pretty good asset prices and bonds are pricing in a terrible outcome right now. If you look at the short rates December 24th, short rates are pricing in a roughly 30% chance of a lower than 3% rate in December 2024. That would be a pretty bad outcome. 250, 300 basis points of easing in the course of a year would be quite a bad macroeconomic outcome. But that's priced in at a 30% probability. That seems unlikely, doesn't mean it's impossible, but it seems like that probability is too elevated relative to the set of macro conditions that we're seeing today.

[Alex Shahidi]

I wanted to go back and clarify one point, the 5248. And then also macroeconomic conditions are slow moving. So when you talk about your forward looking expectations, I assume the odds of getting that right is more than 52%. And the 52% is more related to trading around those views. Is that accurate?

[Bob Elliot]

Yeah, that's right. So the thing about trading, which makes it fun and challenging is that to get the bets right, you have to be different from what's priced into the market and so and correct. And you have to be right. That's a good one. You have to be right and different from what's priced in. And so that's one of the challenges. That's why it's so hard to make money in markets. Because there's many times when everyone says, well, the economy is likely to deteriorate or the economy is likely to do well and yes, you're right, you can have much higher probability understanding of those things. Then comparing those outcomes relative to what's priced in and betting on the markets where you have to be not just right about what's likely to transpire with the macro economy, but right relative to what's priced in.

[Alex Shahidi]

When I look at what we've experienced the last five, 10, even in my career, 25 years, relative to what people had thought was going to happen, it seems like there's Been constant surprise after surprise after surprise. Yet when you talk to somebody who's a seasoned investor and they've been investing for 30 years or 40 years, they can look back and say, you know, I've seen it all. And they feel confident that they have a pretty good sense of what the future may hold. Yet more likely than not, they're going to be surprised. I'm curious when you kind of zoom out and you look at, let's say the last four or five decades, you had the inflationary 70s, the disinflationary 80s and 90s, the lost decade of the 2000s when growth was the weakest since the Great Depression, and you had this boom since 09, as you referenced earlier. And obviously Covid in the middle of all that, how do you just in terms of what you feel the next five to 10 years looks like, just from an economic standpoint, do you feel like it's going to resemble one of those cycles that we've seen, or do you feel like they're just very different dynamics now and it's maybe probably another surprise down the road?

[Bob Elliot]

Any one cycle always is some mishmash of a bunch of different experiences in history. And I'll say while I was not around in the 50s and 60s, particularly the late 60s, I think that's probably the right feel in terms of what's going on. And I think the reason why I say that is I think there's a lot of elements that are similar. Taking Covid aside as a sort of one off shock that has existed in the economy, which was unusual in its own right, the sort of foundations of the macro economy are very similar to the 50s and 60s periods in those cycles where during those times you had actually relatively significant healing of balance sheets after a debt problem you had, particularly as you get into the 60s, you have creeping in inflationary pressures, you have relatively significant deficit spending. You had periods of rising conflict, geopolitical conflict there in the late 60s and early 70s, obviously, which extended into the full 70s. And so you sort of see and you see the Federal Reserve response during that period being a bit behind the curve. So letting conditions run a bit hot relative to monetary policy. And I think a lot of the conditions today look like that. Now that doesn't mean you should trade based on lineup two charts from 1965 to 1975 and say we're in 1968, it's not that simple. But a lot of the dynamics are very similar to that. And I think it's notable how surprised people have been in the Environment, that cycle, that period, the late 60s kind of dynamics and early 70s is something that's sort of fallen out of the consciousness of the professional traders that have existed. Right. They've sort of aged out of having had that lived experience. And so it's not surprising to me that this macroeconomic dynamic feels very surprising given essentially no one has lived through a dynamic like that. And I think that combines with the fact that the high levels of information availability have created this circumstance where there's just constantly a flow of information where everyone is trying to catch the incremental turn, the incremental data that is the incremental turn. How many, I don't know how many people are listening to this, go on Twitter or whatever, but how many single charts, single line charts of this data point or that data point that has called now we were going to a recession? Because this particular data point, I mean, it's like every day dozens and dozens of charts in my feed look like that. And I think that that is creating this extreme whipping of expectations around a macroeconomic cycle that basically no one has seen who's traded in their professional lives. And that's creating a set of dynamics that are very interesting. I think it creates a lot of opportunities, particularly to fade extreme market pricing relative to that overall dynamic. But I think that's the feel that I have in terms of what we're experiencing today.

[Alex Shahidi]

Yeah, it's really interesting. I remember when 0809 happened, and it's probably closest to the Great Depression. And I remember very clearly in 06 07, there was talk of could the Great Depression ever happen again? The answer was no way, because we've learned from that. And we got very close to it happening again. And it's almost the same timeframe where. Where that escaped the memory of most investors at the time.

[Bob Elliot]

That's exactly right. And so it's why you have to really look outside of your lived experience when you're thinking about investing. You really have to be outside your lived experience. And I think one of the challenges is people too often rely on their lived experience rather than opening the scope to all the different plausible experiences. That was a big thing, you know, that helped navigate through the 0809 period that, you know, having studied in incredible depth the Depression and the dynamics there, that was critically important. And I think a lot of people were challenged by, in that particular cycle, the difference between sort of a recession, which is what they knew, and a depressionary dynamic that they didn't know. And I think today we sort of see the same thing where a lot of folks, you have never lived through this compilation of different cross cutting forces that are going to drive the macro economy over the next five or 10 years. And so going back to those old time cycles like the 50s and the 60s and the early 70s, not to say that it would be literally the same, but the dynamics are very familiar. I think it's very, very relevant to what's going on today.

[Alex Shahidi]

One notion that you alluded to earlier is the deficits. I think the way governments are supposed to work is when you're in a boom, you have a surplus, so you save for a rainy day and then you are in a recession and now you run a deficit to combat the reduced spending during those periods. But in the US we basically we oscillate between a little deficit during good times and a massive deficit during bad times. And the worse the times, the bigger the deficit. And obviously you're ballooning government debts that accumulates over time. I'm curious, how does this end? It seems like you're abusing the privilege of being the world's reserve currency. And this is one of those other things that's slow moving until you hit a tipping point. I'm curious how you think about that whole dynamic.

[Bob Elliot]

There's a lot of governments in the developed world have high levels of debt. And when you have high levels of debt, there's basically, you basically have to grow out of them in some way, shape or form and either grow out of them with higher inflation and essentially inflate away those debts or through higher productivity. And so when you think about that process, the first step is transitioning from an elevated deficit environment to a more constrained deficit environment. So less borrowing. And that's a painful transition. And I think we may see that sort of transition happen in a way that is countercyclical, in a way that could be challenging. When eventually we get to a downturn environment, we're probably not going to accept deficits at 15, 20% of GDP. It's not going to happen. And so if you have constrained deficits at a time of economic vulnerability, you could have a more significant downturn than maybe folks expect. But that's in the distance. But first you have to think about the stages, which is first you've got to constrain the incremental borrowing. Then what happens is you got to figure out how you get your way, how do you pay down that old borrowing. And there's basically, as I said, the three ways you inflate. You have higher productivity. The other option is you can just print money in the way that Japan has. And so my guess is we'll see some combination of those. The optimal way of doing it to pay down those debts is through higher productivity. May happen, may not. Wouldn't necessarily bet on it. More likely we're going to see more inflation and more money printing than maybe people expect in order to retire that debt or at least move it out of the hands of the private sector. And so that's, that's really the story. The good thing, I think, for the dollar as a reserve currency is that there's lots of debt problems everywhere. This isn't a US specific thing. Basically everyone's going to go through some form of that. And given the fact that the US has the deepest, most liquid capital markets, we may be ugly relative to things like gold, but we sure look pretty good relative to a lot of the other options that are out there.

[Alex Shahidi]

Yeah, that makes sense. Bob, you've been very generous with your time. I'm going to end with one big question, which is, in all your years of studying markets and your experience, what's the one big unique insight that you'd like to share with us and maybe many have not heard before?

[Bob Elliot]

It may seem incredibly obvious, but it's so often forgotten. Which is why when you're thinking about markets, you have to start with what's priced in. That is because everything that you do in terms of your investments and also whether or not you can generate alpha comes down to how you see the world in the future relative to what's priced in. And I always like at the beginning of the year, it's a good time to just take a minute, take stock what is actually priced into these markets. While it many times is the easiest thing to do because it can be relatively well known and measured, it's the thing that gets forgotten. And so particularly in this environment where we have these expectations whipping around relative to the reality, having a firm foundation there, starting with what's priced in, and then going to what's likely to happen is going to be very advantageous for investors.

[Alex Shahidi]

That's great, Bob, I appreciate it. It was great chatting with you. I love the insight that you share. So thank you for being here.

[Bob Elliot]

Yeah, thanks so much for having me. It was great.

[Alex Shahidi]

Thanks for listening. We hope you enjoyed this episode.

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[Alex Shahidi]

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