#72 - Damien Bisserier: Bridgewater Lessons, Advising Families, Diversification

25:38And the bar just keeps going up the more of them you meet. And then what you're really trying to find are the ones that are exceptional beyond the average. And just the average is at a higher level because it's an industry that if you do well, you can get paid a lot. It attracts a lot of really smart people and it's brutally competitive. And I think that's one of the key learnings that I've had is after you meet with hundreds and hundreds and even thousands of managers, you realize how smart they are and it just raises the bar. And then you have to look at that as the bar that the next manager has to overcome.

26:12And then if they're that good, you got to figure out how to get capacity. That's right. Right. And then there's all the qualitative aspects of underwriting. So it's far more complicated than it may seem on the surface. This has to be an organization that prioritize not losing money. That's another thing we spent a lot of time on is how do they handle risk management and how do they think about that in all these different return streams that we're accessing, that risk management may take different forms. In some cases, it might be just having a lot of different unrelated positions. In other cases, it might be structural downside protections that can be built into contractual lending terms, for example.

26:49So we spent a lot of time trying to understand those things and really digging into what could go wrong, even if it hasn't gone wrong. Oftentimes, people will reference, oh, in the global financial crisis, X, Y, and Z happened as if that's the worst case. But then if you look at the current environment, for example, if you're investing in office, it's way worse than the global financial crisis. So there are always going to be surprises, always going to be things you haven't seen before. We're trying to invest with people that are thinking in those terms, and they're thinking about things that maybe haven't happened.

27:17And how do we protect investor capital? That has to be the very first priority in their mindset. So Damien, one of the oldest rules in investing, just to go back to basics, is don't put all your eggs in one basket. When you talked about your overall investment philosophy, it's about diversification. One of the things Ray taught you is be humble and be diversified. And that goes to don't put all your eggs in one basket, meaning be diversified. In your experience, do most investors actually follow this simple principle? It's quite difficult when the dominant exposure in most people's portfolios is doing so exceptionally well, which has been US stocks for the last couple of decades.

27:56In practice, it is much more challenging than it sounds. And frankly, if you're just looking at public markets, there aren't that many places to go. The other thing that has been challenged, I think recently, is that typically the main diversifier people use for stocks has been bonds. And we're in a bear market for bonds where the return of the Barclays aggregate has been negative for a number of years. It's starting to recover now, but it was a very painful adjustment to go from near zero interest rates to where we are today. So I think that has left people in many cases with very concentrated portfolios because they've stuck with what's worked.

28:35And that's a logical thing. You also have tax considerations for folks that have had success. I know a lot of clients own very large exposures to the MAG7 stocks because those stocks are great companies and they've done well. And so there's a comfort in having those exposures. But that's something that we've been actively helping clients figure out ways to diversify without taking a big tax hit. And it's pretty important because these things, again, they all move in cycles. So this wasn't that long ago, but many people might remember that the US stock market was negative for over a decade in the 2000s.

29:08And I'm sure, I don't know when it's going to happen, but I'm sure at some point in the future, there will be an extended period of underperformance from US stocks as there is in anything. And it will be critical, I think, for investors to find other return streams that are equally attractive over the long term, but that are different. And so that's what we spend our time trying to educate our clients about, and also helping them solve some of the challenges with diversifying, like dealing with you know, embedded taxes and such to help get them to a better place that, again, is more appropriate for their long-term risk and return objectives.

29:41A lot of those return streams that you just alluded to fall outside of public markets and fall into the world of alternative investments. But accessing high-quality alternative investments is limited for most investors. How do you address the access problem for clients? So we have, for a long period of time, sought to find these best in class managers across all these various verticals, across all these categories within private equity, private credit, private real estate, hedge funds. And as you alluded to, many of these managers that are exceptional, they have exceptional results, and they run out of capacity or they have very limited capacity.

30:23Our challenge is identifying them and then building long-term strategic partnerships with them, using our scale to be a meaningful partner to them, and also get discounted terms, so attractive terms and access for our clients. And this can take many years in many cases. And a lot of times with these managers, we start small, we grow that relationship over time. I think because we tend to focus on fewer higher quality relationships because we, again, we don't think there are that many exceptional investment managers out there. So we want to find the few exceptional ones that exist and then be good partners to them.

31:01And they like working with us in many cases. And so they then give us capacity and give us preferential terms because we've been a good partner to them. It's not something that happens overnight, but it's been built up over decades of experience working with these individuals and building relationships with these individuals. And over that time, if we're making large allocations is because our conviction has grown as we've gotten to know the organizations better. So I think our confidence also is it's grown in line with those larger allocations, which again, gives us the ability to access those things.

31:30So access, I think, is a big drawing. It's a big selling point for us with clients who want to access high quality alternatives because we're at a size where we can access things, usually with preferential terms, and be meaningful partners to these managers. And our rigor on the research side, which is something that you and I have in our DNA, I saw it with you. And in fact, you've written a couple of books on asset allocation. And I was sort of trained at a place, Bridgewater, where the diligence was incredibly deep. They produced some of the best research in the world on macroeconomic topics.

32:08And then I basically applied that same sort of rigor to building out our investment research function here. And I hired other people that have that same sensibility and that same drive to really understand things at a very deep level. So it's like the diligence and then building those long-term strategic partnerships that allows us to access those things for clients. And it's something I'm very proud that we can offer to clients. When it comes to diversification, which we obviously spent a lot of time talking about today, how do you balance what is theoretically optimal with what clients can realistically handle, both emotionally and practically?

32:43It ultimately comes down to understanding what a client needs and what they're comfortable with from an investment perspective. And so that's the initial conversation we have with clients to understand the types of investments they're interested in, what they're trying to accomplish, what their risk tolerance is, what their liquidity preferences are, what their spending is, or other liabilities that they have coming up. And all of that then gets reflected in a portfolio that we think is appropriate for their needs and their preferences. And then it's constant education. So we are providing information on a at least quarterly, but oftentimes more frequent basis.

33:23And we also produce a lot of additional content to help clients understand what's happening in the world and what's influencing our decision making. We also provide transparency into any of the alternatives that we're investing with, usually with some content that gives investors direct exposure to the managers themselves and the types of questions that we're asking and the types of things that have led to us having conviction. It's all of those things that I think translate to arriving at a point where clients are happy with what we're doing. And it's an ongoing process to make sure they continue to be well-educated and understanding of how we're approaching things.

33:59And to the degree that things are not proceeding as they'd like, we make adjustments. That's ultimately the challenge. It's not just building a portfolio, one size fits all. It's a really highly customized, highly interactive approach. One of the big differences between institutional and high net worth or family office portfolios is tax. So part of the optimization for those that pay taxes is tax minimization or after tax returns. Are there certain tools families use to improve after-tax outcomes? Yes. And I spend a lot of time advising families on this. For whatever reason, tax is a topic that gets people more excited sometimes than the actual investments themselves.

34:42Maybe because it's a little bit easier to quantify. Pick a great active manager, they may continue to outperform, they may not. It's a little bit of a probabilistic guess. Whereas if you can build a more tax-conscious portfolio, there is a certainty with the kind benefit you can get on the tax side that I think is valuable and people appreciate. So a couple of the things that we've been doing on the tax management side that I think has been interesting and something that I think we will do in greater size across the platform. One is implementing long, short tax loss harvesting mandates. So historically, you can hold an equity index in a tax loss harvesting mandate.

35:27This is the traditional way of doing it, where you essentially go out. There are many firms that do this, where you buy individual stocks to replicate an index like the S &P 500. And as individual stocks go down, you sell that and buy it back 31 days later. So you're still replicating the index, but you're capturing losses along the way. And in that traditional long only context, you will have losses that you're capturing for maybe the first five years. And if you're not adding money, you basically run out of losses after that. And you're capped with how much loss you actually can capture just because everything ultimately becomes appreciated in the portfolio unless you're adding new funds.

36:03There's been a step change in the technology of being able to harvest losses where today you can now add longs and shorts on top of the index replication, and it allows you to generate a lot more losses consistently, so a greater magnitude of losses, and then you never run out of losses. Because if you think about putting on short positions in a portfolio, as you close out those shorts, they tend to be closed out at a loss. And so you essentially never run out of losses. There are all sorts of ways this new technology can be applied to client portfolios. I alluded to this need earlier on. We have clients with a lot of concentrated stock positions.

36:36So you can actually use this approach to, in a tax neutral way, move out of a concentrated portfolio into diversified index replication. And there are other applications too. If you have a big capital event coming up and you're going to sell your company and realize a big gain, and you're already holding index exposure in the S &P 500, you can do that with greater loss capture in advance and that those losses then can be used to offset the gain that you have that's coming from the sale of your company and it will reduce your tax bill. And what that results in long-term is you still have that equity index exposure as part of your portfolio with very, very low cost basis stock.

37:12And you have planning ways to deal with that later on, whether it's giving it to charity or dealing with various considerations and how it passes to your heirs. But being able to defer those gains is powerful and something a lot of our clients are now implementing in various forms. So that's one exciting thing because it's this new technology you can use in lots of different applications. And there are a lot of providers to do this and not just one provider. So that's another thing that we take comfort in. It's an established technology now, and there are lots of different practitioners that we can utilize to do that.

37:42Another thing that has been something that we just have been growing on the platform is something called private placement life insurance. So it's the ability to take out a life insurance policy and basically use that as a wrapper around a portfolio of different investments, usually alternatives, less tax efficient investments. And it allows you to invest in those things and your portfolio value, your cash balance value in that life insurance policy will grow in line with those underlying investments. And there are no tax ramifications. So ultimately, the cash value will be your death benefit, which is paid out and doesn't carry any tax consequence.

38:22There are some estate tax consequences that you would have to deal with. So you can fund that out of a grant or trust, for example, and then you get around the estate considerations. But it's really powerful if you're thinking about building a portfolio that includes alternatives, you can wrap some of those alternatives in a tax efficient wrapper utilizing life insurance. So that's another area that we've been focused on. And we've seen a lot of clients express some interest in this. And it's a growing space generally. So we see a lot of firms doing this. And in fact, some of the opportunities we're seeing today are helping clients maybe improve what's happening within an existing policy that maybe somebody else put on for them, but they're unhappy with for whatever reason, we can now offer them a better solution.

39:02When we think about tax generally, it's a critical part of our diligence process. So whenever we're recommending things to clients, we're always thinking about what's the best outcome net of fees and taxes, we incorporate an understanding, a deep understanding of tax as part of our diligence process. So anything we actually look at, we're looking at what's the actual tax treatment for that and what are clients going to ultimately get after considering those taxes. And so that's something I think we spend a lot more time, frankly, on than a lot of others because usually you're not evaluated on the after-tax returns, but we know that's a really critical piece for our clients.

39:36So we spend a lot of time on it. We live in very interesting times, as you know. What are some investment strategies you find compelling in today's environment? Yeah, it's a tricky macro environment, to say the least. We've had a quite good economy for an extended period of time, and now we have these very dramatic policy shifts that I think are introducing a lot of volatility and a lot of uncertainty moving forward. But there are certain areas of the markets where we see a shortage of liquidity and a very attractive return relative to risk. And also, these are areas that can be complementary for a broader portfolio in terms of diversification benefits.

40:15So one area that we continue to spend a lot of time on is secondaries. It's essentially a strategy whereby you're buying existing fund interests from other investors. You're providing liquidity to investors who are invested in existing funds because they want liquidity before the end of the fund term. They are willing to sell that LP interest at a discount. And if that discount is large enough, we view that as a really attractive thing to harvest. Essentially, you're getting to provide liquidity and in exchange, you get a nice premium because you get to buy assets at a big discount. Now, in practice, much of the secondary market transacts at a very small discount, which is not interesting to us.

40:54But there are pockets of opportunity, whether that's in credit-oriented LP interests, where there isn't as much competition because they're complicated and they're harder to understand and there just really aren't many skilled players in that space. So the discounts are much larger there, sometimes 30%, 40 % relative to net asset value. And because it's credit, you get paid back pretty quickly. So it's a pure play on monetizing that discount. So that's an area that we continue to have an interest in. There are certain secondary buyers that focus on much smaller bite sizes. So if you buy from individuals who don't have a lot of options to sell these interests, they also are willing to accept a larger discount because they don't have a lot of buyers that are willing to buy a million dollar interest, for example.

41:38And so that's been an area as well that we focused on. Those are a couple of the niche, niche or sectors within secondaries that we think there's a real need for liquidity. and people are willing to pay a premium to get liquidity and we're happy to provide that. And that discount that we can capture is essentially an uncorrelated return stream that we can harvest in our client portfolio. So we like that. Another area in today's market environment that we feel better about, because again, it's a risky environment, the economy we think is likely to slow from here, is secured lending. So lending money at high interest rates, double-digit interest rates, but with collateral as your protection.

42:15So if the borrower doesn't pay you back, you can capture the collateral that is securing the loan and sell that. And many times you make more money on those defaulted loans than you do on the loans that pay off normally, because in the cases where there's a default, you have incremental fees. And sometimes you can foreclose on the asset, own the asset, and the asset's worth a lot more than what you're owed. And so with the right underwriters, with the right risk controls and people that have had a long-term experience and track record of being able to do this well, we can get comfortable with lending against various hard assets, real estate, inventory, equipment.

42:51That's an area that we've been spending a lot of time on. And I think it kind of takes advantage of a higher interest rate environment, gives you that added protection, and we think offers a nice return relative to risk. Everybody likes income in the current environment. So that's a way to harvest the income with good downside protection. Another area that I think is interesting and relevant geopolitically is energy. So there's been a lot of capital flight from energy for ESG considerations. And so there is generally a shortage of capital there. So today you can buy cash flowing oil and gas wells at yields of 15 % plus in many cases, and you get the land that's adjacent that you can drill for free.

43:31And so that kind of setup where you can buy a discounted cash flow stream that's attractive on its own, and then you have upside optionality to develop land that's adjacent, and you can hedge a lot of your principal, essentially protect your principal through hedging of the existing cash flows. That's an interesting configuration to us and very different than what the energy markets look like 10 years ago. And if you think about the geopolitical environment, one risk that's out there is an escalation of tension globally. And that's probably an environment in which energy prices might go higher.

44:02And so having that hedge in your portfolio, we think is pretty interesting. It's an environment where we really are focused on the downside protection. And we want to make sure we have things that can make money across the very broad range of environments we're likely to face here. Yeah, it does feel like diversification is, you know, it's always important, but in this world where you have a wide range of potential outcomes and greater risks of extreme outcomes, diversification is paramount. Would you agree with that? Absolutely. And, you know, I alluded to this earlier, but some people, you know, they think about diversification as in, well, I can own bonds and that's my downside protection, but there are a lot of other things out there that can be resilient in a tougher economic environment.

44:43In fact, the challenge, I think the last few years has been that fixed income hasn't been that downside protection. Fixed income was down double digits in 2022, and it really hasn't helped, added much of a buffer for portfolios for the last few years. And so we actually augment our lens. We look at things like low correlation hedge funds as offering some of the same kind of fixed income characteristics where you can get returns that are higher than fixed income in our of view, even on a post-tax basis. But with a well-constructed portfolio, because these are managers that aren't taking a lot of directional market risk and they're uncorrelated to each other, you get a portfolio that can actually have risk that's lower than the bond market.

45:26So just thinking about all these different return streams that we can access across the platform, you can actually build in a much more resilient portfolio than a more traditional equity fixed income orientation. The other aspect of diversification are inflation hedge assets. And if you just take a step back, we haven't really had inflation problems until very recently post-COVID for three or four decades. And all of a sudden, it could be an issue again. And when you look at most portfolios, at least in my experience, they don't have a lot of inflation hedge assets because they weren't really needed for a long time.

46:01What's your perspective? Absolutely. It's something I think we've been putting into client portfolios for a number of years. And there are certain environments like 2022, when it was essentially the only thing outside of some of the alternatives that were positive. We believe strongly that inflation hedges are an important part of a diversified portfolio. And given the risks around the dollar today, and a weakening of the dollar, which the current administration has explicitly said they want to achieve, you have a lot of these policies that I think are challenging the supremacy of the dollar and long-term, there's a clear path here where the dollar is unlikely to retain the sort of dominant status it's had.

46:41You want to have real assets, tangible assets, inflation hedges of various forms. We believe that's a critical part of portfolios going forward. Looking ahead, are there other perspectives or themes you think will shape investing over the next decade or so? Absolutely. I don't think that US equities will forever remain the dominant return driver in portfolios. So really thinking about how do you build portfolios that are resilient and diversified regionally, because we have a much more fractured world. This is a world that is moving away from the globalization of the past couple decades to something that is much more disjointed.

47:21And so I think you're going to see bigger dispersion in outcomes across countries, across regions, more diversification benefit from having different regional exposure in portfolios. As you said, having exposure to things like inflation hedges that can hedge against a weakening dollar, for example, that's critically important. One thing that we've seen in recent years is better access to alternatives generally. So more vehicles to access alternatives in an efficient way. I think that's going to continue. A lot of larger asset managers are looking for different ways to deliver their return streams to clients.

47:56So that's a positive thing that means you can access, I think, a broader range of return streams for all investors. We, in certain cases, will utilize those vehicles as well. But we also think it's critical to do all the things that we do in terms of the diligence of the underlying return streams. And so the alternatives, I would say, are not all created equal. As you move into the alternative landscape, there is a greater component of active management, and there's also much higher fees. And so you want to be very mindful of those things, fees, taxes, and being really convicted that what you're getting is active management and not just leveraged or really expensive versions of things you can get in the public market.

48:37So I think it's exciting that you'll be able to access more things, but I think it requires a greater scrutiny than maybe you might have with traditional index funds within equities and fixed income. Damien, the final question I'll ask you is, if you could give just one piece of advice to help listeners become more insightful investors, what would that be? Surround yourself with people that are smarter than you, because we don't know everything. Be humble about what you can predict. Recognize that you'll be surprised constantly. And try to build something that can be as resilient as possible across as broad a range of outcomes as possible.

49:20This has been great, Damian. I appreciate you taking the time to share your experiences and your insight with our audience. Thank you. Thanks for having me on, 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.

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