#29 - Karen Karniol-Tambour: Market Outlook, Portfolio Construction

24:54That's a traditional role bonds used to play in portfolios. They can actually play them again. You also have higher for longer, stickier inflation. You actually need to tighten a lot more than discounted, where bonds obviously don't help you with that. And then your best bet is to be somewhere else. Go to places where you're not invested. Go to places that are maybe on a different cycle of growth and inflation, like, for example, in Japan, which is less likely to have a sticky inflation problem you need to tighten much more aggressively into. So let's talk about portfolio construction. Obviously, asset allocation is the major driver of returns.

25:29And you just talked about your observation about how most portfolios that you've seen are currently positioned. But one of the first rules we learn as advisors and allocators in managing a portfolio is don't put all your eggs in one basket. Yet when you say 80 or 90 % is in US corporates, that sort of sounds like it's all in one basket. How do we get to that point? Well, I think the biggest thing that's going on is that there's still a lot of hesitancy to use leverage. So one of the clearest arbitrage that exists is that if you're not comfortable with leverage, then people just look at return levels, even if something is less risky.

26:09The perfect example is in the equity markets. I think there's a lot of academic papers and whatnot to say this is still true and a lot of evidence of this, that if you look at companies that are just less volatile, they just have less going on. They sell something that people just buy every year, no matter what, even when there's a recession. They tend to kind of have the same returns, even though they're a lot less volatile. So it feels like something is off. And the reason is, if you wanted to make the same return and have a less volatile thing, you'd have to leverage it. So people actually demand the same kind of nominal level of return regardless.

26:39You see it in what happens with attraction to, there's a lot of alpha in private assets, but there's also a lot of attraction to private assets because the leverage is sort of embedded. And so it's just the nominal level of return can just be higher than what you can accomplish by yourself. So a lot of what ends up is if you kind of start and say, I need 7 % return, I need 9 % return, I want some number return, but I don't really feel comfortable kind of dealing with leverage myself, you have to end up where you think that's the nominal return level, even if there are good risk premiums in other places.

27:08And that's sort of how you end up where you are. The second thing is that I think that market cap is a natural thing to look at, right? There's a vision mark hypothesis of this for a reason, et cetera. But it has gotten more concentrated. So that becomes your starting point. And tracking here is hard for people to live with. If you constantly have to justify yourself relative to what any index is, you're drawn to be more like the index or to kind of add something uncorrelated on top of the index. So if you have an index that kind of goes up or down, what you want is a straight line, you have to be able to live with the fact sometimes when you have a straight line, you feel like an idiot because what everyone else is doing is going a lot better.

27:48And other times, you feel like a genius. It can be a lot easier to live with. I'll take that not straight line. I'll take that up and down. And I'll just add something uncorrelated on top. So I'll always be needed by a couple percent, much easier to live with. And so that's how you end up that if market cap is concentrated and other people are concentrated and you can't take leverage, you're in US corporates. What you just described is a framework that many investors take is they back into the allocation based on the expected return and the tools in their toolkit to build that portfolio. Would you walk us through the way you think about constructing portfolios if you're starting from a blank slate?

28:22And if your goal is to build a resilient portfolio as close to a straight line as possible, walk us through your thought process for how you construct that portfolio. So first, I'd remember there's basically three sources of return you can have. There's the cash rates. There is beta or risk streams that you're earning, holding riskier assets than cash. And then there's alpha or your skill and timing. Cash was an irrelevant thing for a pretty long time. And so I think a lot of investors almost forgot to think about it, which made sense when cash was at zero, but cash is no longer at zero. And if you look at what cash is sort of priced to be over time, you can make a bunch of the returns you need just sitting in cash.

28:59And that's a big deal. And that means that, for example, if you're buying a bond, a lot of what you're doing is not really trying to make a risk premium. You're just trying to lock in that cash rate and say, I'm pretty sure I'm at least going to make this nominal return, which is primarily just what the Fed is going to do with the cash rate is going to be. So it kind of deserves new consideration. Then there's what risk premiums are you earning or your beta. And there, I think that you don't have to be confident that the world is going to turn to at least be skeptical that it'll be as good of an environment for earning risk premiums as it was.

29:29Because the 2010s were like a runaway success, right? Like the returns relative to cash were the highest we've ever seen in the decade. And that's the decade with the highest returns relative to cash, primarily driven by US equities doing so well. And so you don't have to really have a strong view to at least say I'm skeptical that repeat. I know that in the start of the 2010s, valuations were terrible. I just came out of the great financial crisis before that I had, you know, 1999 and that stock market blow up. I started with good valuations. And now I'm, you know, 10 plus years into an amazing bull run, a lot of success is already priced in, I at least would be skeptical that's going to repeat itself.

30:08And so I think you can look at what risk premiums you're kind of sitting and earning, at least with some more neutral view of saying, I know I'm positioned for what just happened. What's the best way position going forward? Where do I think there are in our risk premiums? And I think when you look around the world in a lot of places, it doesn't look like risk premiums look great. There's already a lot of optimism priced in. There's a lot of easing that's already baked in. So it doesn't take a lot to imagine tightening more than is already priced, being difficult for all risk premiums, et cetera.

30:36It's just probably not going to be a great place to make returns where it was incredible kind of the last period. And then you get to alpha. And the biggest thing I'd say about alpha is that in the environment we just had, alpha was almost... People almost didn't notice it because everything went up, right? And so you didn't really suffer if you had slightly worse or slightly better private equity or public equity managers because everything went up. The differences felt small. We're probably moving to an environment where it will matter and where differentiation gets a lot bigger and you actually have big opportunities.

31:07Just look at in the public equity markets how lowly correlated single stocks are to each other. That's telling you it's a time of big opportunities. The last thing I'll say in kind of building the portfolio is don't take anything for granted. For example, for a long time, people didn't even ask themselves, what am I holding in terms of currencies? It just kind of happened. So you've gone into these habits where, for example, most people hold their bonds hedged and their equities unhedged. Does that really make sense? No, just kind of what expertise has grown up like. It felt for a long time in equities that it didn't really matter what currency or equity was in.

31:40And in bonds, it was easier to see the impact. So you got more skill set on the bond side to deal with currency than in equities. That doesn't actually make a lot of sense. You're in a different environment now. And back to the alpha opportunities, when you start getting divergences, divergences also exist across countries. So you can actually get exchange rates moving. So in the last few months, the Japanese equity market is like the best in the world, if you hedge the currency, and not that good if you're exposed to the yen. And probably whoever was making that decision for you, didn't even ask that question about the yen or has no expertise in that space, that decision becomes more important, starting to split out decision and asking, where do I have alpha?

32:16Where do I have expertise? And where are the opportunities going to be? And it's interesting when you use that framework of where the returns come from, cash plus risk premiums or beta plus excess returns or alpha. And you look backwards, cash was zero, and beta was high, particularly in equities. And alpha was more challenged. And let's say over the next 10 years, it could be almost the opposite, where beta could be more challenged. Cash is a lot better than it's been for a long time. And there may be more alpha opportunities as you get divergences across the globe and across asset classes. Yet most portfolios are backward looking and have a lot of beta exposure and probably much less in the other categories.

33:01I totally agree. This is the fundamental flaw that probably the biggest flaw in investing and based on how markets price and why opportunities get created, which is whatever just occurred, there's just a bias to be expecting the same thing is going to happen. And it's natural. It's a natural human flaw in decision making. Whatever just occurred, it just feels to you like that's likely to happen again. What ends up happening is that that then gets into the price because everyone expects it's going to happen again. So by definition, what just happened can't occur again because now it's in the price and markets basically price relative to how things transpire relative to the starting price.

33:38And so people naturally get positioned for a repeat of what happened in the past, even though the future really can't look like the past precisely because market prices have incorporated that information and now already have that outcome in its pricing. And investors have been too late to build a portfolio that's appropriate for what's coming ahead versus what worked for them in the past. To me, that's one of the most fascinating things about investing. in that we can only see historical prices. We can't see future prices. So it's natural to extrapolate the recent past into the distant future because I think our minds have that blind spot.

34:16And what ends up happening, at least in my experience, is oftentimes the near future looks like the recent past. And so it can reinforce that belief and keep it going for an extended period because you have human psychology actually plays into markets. And I think that's part of why you get these cycles that go longer in both directions than they may otherwise. Well said. Very well said. And I guess this all kind of circles back to what you said in the beginning, which is what attracted you to Bridgewater is being able to separate out how the economic machine works, how fundamentally markets price, the cause effect linkages, and then overlaying on top of that human psychology and its impact on prices and trying to put it all together to come up with forecasts for the future.

35:03Yes. And at Bridgewater, for me, the two sides of the equation have been really fun. We're both one hand, just truly trying to get my best view of what's going to happen next. And that's really what kind of making alpha is all about, right? Taking in everything you see happening and trying to call like what's coming next and trying to stress test that thinking and live through it. But then the flip side of that, which is really fun from Bridgewater's kind of perch where we see whole portfolios and look at every asset in the market, is also being able to come into big portfolios and partner with them and say, okay, here are probably the flaws in your thinking that you're making and here are the dials that you could potentially turn that would make you better prepared for what you kind of see coming ahead.

35:45Speaking about portfolio construction and its goals as you're building a portfolio, I'm curious to see your thoughts about what I always feel that one of the primary goals and actually probably the primary goal for every portfolio should be to avoid a catastrophic loss. And I think of it as similar to one's health. It tends to creep down the priority list the longer you go without suffering some pain and until you have the next crisis and all of a sudden it's priority number one again. I'm curious how you think about this dynamic and how do you generally think about this risk? I agree. I mean, I would say that the right way to think about your goals in a portfolio is that people really should have four goals.

36:28One is the most obvious one everyone always wants, they want higher returns. Everyone wants higher returns. The second is the one you list, which is easy to be aware of when it seems like a big deal and not otherwise, which is avoid tail risk outcomes. And then the kind of less thought of ones are narrow the range of outcomes. Actually, it's a bigger deal than people sort of think about, especially when you do use your cash along the way, right? And so if you lose a bunch of money, it's not good enough that it's theoretically going to recover, you need to be able to potentially spend at that point and not be able to just reinvest it all.

37:03And so it's really is helpful to have more of a range of outcomes be narrower. And the second is avoiding sustained periods of underperformance, which again, over a very long period of time, you can say I can live with it, but sustained period, you have to use that money. It matters. It matters for the pattern. So in other words, people think a lot about the level. They don't think a lot about the pattern. If they think about the pattern, they usually think only about tail risk, risk of ruin, which is extremely important because you got to stay in the game. but you also want to think about what am I doing for the pattern and what can I do to basically get from a lot of ups and downs to something that feels more like a consistent straight line, which over time is going to compound your wealth a lot better, especially if you're planning on, you know, kind of using the money at different times.

37:44Everyone thinks of themselves as a long term investor, but the reality is we all have some timeframe on it. It's never a forever and it does matter how our wealth compounds along the way. And in markets, long term is a lot longer than it is in the regular world. Yeah. I mean, you look at what happens when you are in a place like Japan and you go through just a long period of equity underperformance, and it's not something you can tolerate, even if after many, many years, it's going to recover. You're much better off saying, what assets should I be in that avoid that outcome? We're seeing the same thing in China now where stocks have been a disaster, but actually it's been a great time to hold bonds because there is consistent carry there and a consistent need to stay easy.

38:25And so you keep having these cases where you basically say, I know that just being concentrated in the stock market has these outcomes sometimes. Sometimes I can get very long periods of underperformance. I've seen it. It happens over and over at different places. I know it hasn't happened recently in the United States, but I certainly know it can happen. I know it can have a very wide range of outcomes and very long periods of slow underperformance. And so you have to kind of at the same time get yourself a little bit of psychology of it's been such a good investment, and I have so much peer risk if I move away from just being in the stock market, am I really willing to sacrifice that for something that I think should be more resilient to a wider range of outcomes, even though I'm not necessarily betting on what the outcome is going to be?

39:07And there's always a narrative that supports the strategy. So for example, the S &P 500 has been on fire. It seems to never go down. Anytime it has a little blip, it bounces straight back. But people forget that the prior decade before this 15-year, 16-year bull market, S &P was negative, one of the worst places in the world to be, as it was grossly overvalued after the late 90s boom. But that narrative of these are the greatest companies in the world, they're growing fast, how can you lose by investing in them? That can be pretty self-reinforcing. Totally. And it can make being more diversified look like a bad decision for an extended period of time.

39:51Yeah, you know, I was talking to someone recently that was telling me how they had some things in their portfolio that were really intended to do well when the rest of the portfolio did badly. That was the goal of those things. And we were talking about how hard it is to live with things in your portfolio that that's their literal goal. and they were saying to me, I find myself sometimes rooting for the hedges. And I know it's illogical because it's just a hedge. So it means that my overall portfolio is doing badly. So I can't really want to root for this. I have to root for like the main horse, but I just wish I could prove better that the hedge matters and it's going to work.

40:25And it's a real, you know, it's a governance problem. It's a psychology problem. It's difficult to kind of live in those periods where at any point in time, one thing is going to be the best and you could feel bad that you're not in the single best thing. It's the hardest when other people are by definition, just harder at those times. And it comes back to, I think when you kind of look at what levers people can pull in some ways, the hardest lever to pull is to do the most diversifying thing because it's something that just doesn't stand on its own. You're adding something for the purpose of complimenting everything else you do.

41:01So that's kind of the most difficult decision. Easier decisions are to more gradually shift your portfolio asset allocation or look within assets and say, how do I do them better in a way that you can still kind of be able to evaluate that outcome with less of a sense of as extremity of just complimenting my issues. And one of the challenges that I've seen with investors and clients is this tendency to zoom in to more recent periods rather than zooming out. So you mentioned that straight, if you had a choice between investing in, let's say the S &P 500 over 100 years, and you can get a straight line S &P that gets you that 9 % or 10 % every year without fail, or the volatile S &P that swings up and down and ends up in the same place.

41:45If you're zoomed in, you may choose the more volatile one because over that period, it looks like it's doing better. But if you were to zoom out, it'd be very obvious what the choice should be. So oftentimes, people just get too zoomed in. And it's really hard to get them to zoom out, to see the bigger picture. And to remember that that's what it's supposed to look like, that's actually what success looks like. Like I had a couple of conversations recently with folks that had made attempts to take their equity allocation and say, my goal is a total highest ratio equity allocation. I want my equities to be more consistent, just like you're saying.

42:19I want to create an S &P that's more consistent. And you know that the goal of that is literally like the meaning it would be making a straight line. And you don't think that straight line is going to make you 20 % a year or even 10 % a year. That's not sensible. But that's the goal. And you know that that means that if you really succeeded, sometimes you'll be under the S &P, sometimes you'll be over, but over time, you'll have more of a straight line. And literally, they do it thinking, on average, I'll have the same return as the S &P. 50 % of the time, I'll be above, 50 % of the time, under.

42:46And they set that up. But now they're living through probably the biggest period of divergence ever. Because today, literally, the biggest thing that determines your quote unquote, tracking or difference to the S &P is how much you hold of just a few companies. And so living with that and saying, I know that goal, as you're kind of saying, Alex, if I zoom out, I know that's what I want. I chose it proactively, but it doesn't feel good right now because right now I'm under what would have been this really cheap S &P 500 exactly the way it is. And I think part of the issue is the reference point.

43:19If the S &P was down 20 and you're down five, you're doing okay. But if the S &P is up 20, then all of a sudden you look like you're not doing well. And it's that reference point. And the US stock market, at least for investors in the US, maybe for investors globally, is the kind of de facto the reference point, because that's what's talked about on TV. When you ask somebody how the market's doing, they're talking about the US stock market. And so I guess part of the issue is that's the reference point we all compare ourselves to. And so the question is, is that the right reference point? Is that just what it is?

43:54Or should investors think about it differently? It's hard to commit to really assessing what you're doing relative to absolute returns. But I think that's actually the right answer. The right answer is to commit to assessing yourself relative to absolute returns, or even better would be relative to cash. Saying cash is really the thing I don't control. I'm going to just assess my level of return over cash. So I'm just going to say, my goal is to make cash plus X, let's pick cash plus four, cash plus five, I'm just going to assess myself relative to meeting. That'd be kind of the right intellectual answer.

44:23Very hard to do. Very, very hard to do. And so I do think there's steps you can take that move you away from just purely looking at market cap and let you kind of, you know, go along towards that direction. Even things like, I'm going to create an equity index that's more geographically diversified, doesn't have limits how much is in any one company, does something that kind of helps me get in the direction of remembering that the right perspective doesn't have to be the random one that just happened to be set by the market cap. So the other thing I've seen people a little bit do is try to build portfolios to do the two extremes.

44:58And then you can see the two extremes. So you can literally say, okay, here is where I do the market cap and alpha overlay. So I'm just trying to beat the market cap. I'm gonna assess any manager there by whether they beat the market cap. That's just what I'm gonna do. And over here, I'm just gonna try to make cash plus four, cash plus five, or you pick your number. And I'm going to be able to see the extremes and I'm able to see what bias I'm getting by being attached to market cap. But like, again, sticking with the equity example, one of the things you see is if you tell a manager, I want to make sure that you beat the market cap, I'm going to assess you by whether or not you kind of outperform the market cap.

45:31And let's say that manager, for some reason, thinks that meta sucks. They think meta is a bad company. They have to put all their efforts now and all their focus on do I have alpha in companies somewhat similar to meta? Because that's the biggest driver of my deviation. I know that's how you're going to assess me. And so there's a lot of downside to that because whatever is that thing, that might not be their best source of alpha in returns. And they might think, oh yeah, I'm buying something for you. It's very similar. So I'm minimizing my tracking error or something, but actually it's not because that is just really fundamentally different and idiosyncratic.

46:05So you're kind of messing up your like, what's the best way to use your insight, but you're getting the benefit of making you comfortable to be able to say, I know I just want to make a market cap. I want to be able to compare myself and I'm going to just check ability to do it relative to that. So it's almost sometimes nice to say, I'm just going to do the two extremes, see what that's like, see what biases I'm getting in both and be able to use that to kind of assess where could I be and what can my portfolio do for me? And I know that my portfolio that's stuck with market cap is stuck with that.

46:31Its base is 90 % risk in US corporates. That's its weakness. And I guess perhaps most practically, somewhere in between those two extremes is probably a place to be in terms of being able to hold on when your peers are performing relative to that straight line and protect yourself during those periods of extended underperformance. Yeah. Karen, what would you say are some practical steps that investors can take to build a more resilient portfolio? I'd say first step is always step back and try to be honest with yourself about your goals and constraints. What are you really trying to achieve? What would be a big deal for you in your financial situation?

47:14What is an unacceptable loss for you? How much volatility are you really willing to take? Second, I'd say is reassess your asset allocation. You're probably stuck in an asset allocation that is not right for today. And the most obvious example I see in most portfolios there is people hold no bonds because bonds just had zero returns for so long that they really couldn't achieve any goals I talked about in that first step with zero returns. But now they can, they can actually achieve returns. But there could be other elements of your asset allocation as well. Then the third, I would say, is make sure each part of your asset allocation is working for you to meet the goals that you set in the first kind of step.

47:49And so as an example, a lot of the reason people are in equities to a large extent is they feel they have real alpha. They can get out of that space, make sure you really believe in that alpha. And it's not just kind of showing up as if you had alpha because you're in an environment where everything went up. In the bond space, a lot of people end up in allocations where when they look at the alpha, the way that they get, you know, kind of active decision making added to bonds is primarily through leaning into credit spreads. Well, that kind of negates the reason you have bonds in the first place.

48:20If what you're trying to do is, you know, get away from concentration in US corporates. And so think within each asset class, what you're really doing to kind of get the allocation you want. And then the last thing I would do is basically step back and say, here's where I am. Is there anything I can do that would directly mitigate the vulnerabilities I have left? And how much am I willing to take something kind of mismatched and different to remember that that's my hedge? Whether that's an asset allocation that is much more balanced to begin with, and you want to watch that and see how that does, something more like a risk parity, whether that's something like something you feel is more negatively correlated alpha, so you have good reason to think it tends to do better when things are bad, whether it's a geographic diversifier?

49:03You sort of say, this left me being places like Japan and Korea that just have a different cycle. What are things I can do that kind of directly mitigate whatever vulnerabilities I have left? And I guess part of that is also looking at assets that may do better during inflationary periods, because that's why I found that's missing in a lot of portfolios, because we haven't had inflation issues for several decades. I agree. Almost no one has almost any inflation protection. I think that, as you kind of said, It felt unnecessary because there was no inflation. And then even the last few years have given people, I think, some sense of false comfort because inflation rose to high levels, and yet people's expectations were that inflation would come back down.

49:45So you didn't get a repricing of all assets to account for inflation staying high. If you had said to me, kind of going into this period before it happened, you're going to see the kind of inflation numbers we saw. But don't worry, no one's going to believe that's going to remain. I never would have believed it. And it's actually back to the topic we talked about before with all the government debt. It's kind of magic for the government, right? Like you run high inflation, inflates away your debt, but no one believes it's going to stay. So you don't have to pay higher interest rates. It's kind of magical.

50:12But it has lent people with a lot of lack of inflation protection. And it means that there isn't a lot of value being put on those places where there is inflation to be had. And one example we've talked about recently is infrastructure assets. Some of them have a lot of inflation protection. Some of them don't. You don't necessarily see a lot of differentiation because a lot of investors aren't in there, again, remembering the goal of why they're in the asset class and trying to kind of prioritize that and what they pick. To me, it's amazing when you get a massive disconnect between if you ask somebody what their goals for their portfolio were, and you look at how they're positioned.

50:47And I guess every once in a while, you just got to reset, take a step back, ask yourself those very obvious questions, and reassess it, not relative to what you've experienced in the recent past, but what the future may help. Absolutely. And that's really what portfolio construction is all about. It's about those tensions of you can't see the future, don't know what's going to happen. You're trying to build resilience through whatever methods you have. And you've got to kind of trade off confidence. What are you really confident in? What do you have a strong view of how it's going to transpire?

51:20What alpha do you really believe is going to deliver with diversification and realizing you don't really know how the world's going to play out. You don't have to make a big, bold bet about the world in everything that you do. and you have to trade these things off. If you always buy just the things you're most kind of confident in, you will end up sometimes blowing up because you're going to be wrong. Even the best decision makers are wrong, you know, 40 % of the time, 45 at best. But if you over lean on just diversification, you're missing the chance to really take advantage of where you do have opportunities you can lean into, whether that's managers where you believe in your alpha, whether it's an understanding of where the world is going to go and trading those things off well is really what portfolio construction I think is about.

51:59Well, Karen, thank you for sharing your insights with us. I greatly appreciate it. And I know our audience does as well. Thanks a lot for having me, Alex. Thanks for listening. We hope you enjoyed this episode. Please visit our website at insightfulinvestor.org to access past shows and learn more about our podcast. If you have questions, feel free to email us at info at insightfulinvestor.org. And if you enjoyed the discussion, please subscribe to this podcast to ensure you don't miss future episodes. And don't forget to forward today's conversation to others you think would enjoy listening. This podcast is provided for informational purposes only and should not be relied upon as legal, business, investment, or tax advice.

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