Ep 68: How to Generate Alpha in Volatile Markets with Jacob Miller of Opto Investments

0:00And one thing people do in a portfolio is they assume static correlation between stocks and bonds. That works when growth is a dominant factor. The stocks go up and the bonds are down and vice versa. But not in the world where we're dominated by inflation and Fed action. Because both of those assets are long-term in nature. And so they're going to be discounted by higher and higher rates, driving today's price down. And this was the 1970s. In the 1970s, stocks and bonds moved basically perfectly correlated. And so you have a moment where it's much more necessary, if you're going to have a healthy portfolio, to think about, what can I add that is actually different?

0:34I'm excited to introduce you to my friend Jake Miller today. Jake and I co-founded Opto together, a financial technology company. We're facing some really complicated financial markets, economic challenges, debt challenges in our government over the next decade. Jake has some great insights about how to navigate these times ahead, and he's a fascinating person to hear from. I'm Joe Lonsdale. Welcome to the American Optimist. Jake Miller, thank you for joining us today. Thanks for having me. Jake, you're the co-founder of Opto, and you're currently running Opto's advisory practice. We're here in Miami today.

1:03Where are you in Miami? We're here for the Nitrogen Conference. It brings together hundreds of RIAs and tech solutions to talk about how to improve the whole space for advisors and their clients. So, talking to hundreds of RIAs, obviously you want them aligned with Opto. Tell us about your background before we jump in. Where you grew up, where you went to school. Yeah. So, I grew up in San Francisco, which I think from an early age got me interested in investing. I saw our next-door neighbor go from driving a beat-up old Honda to a Ferrari back to a beat-up old Honda over the span of about 18 months in 2001.

1:32And I thought, that game looks fun, but I should learn how to play it better than him. So, I've been investing since I was about eight years old. Studied at the University of Chicago, or studied economics and classics. And then, right after college, went to work at Bridgewater Associates. Classics, huh? Yeah. Personal interest? Personal interest. And I often say, I think I learned more about investing in that major than the econ major. So much of academic econ right now is about solving for some global maxima using physics equations that really don't belong in our economy. where studying classics in history, just seeing how civilizations grow, thrive, and ultimately fall, has a lot more bearing on how markets are evolving day to day.

2:08What do you mean more about human nature and civilization is really what we're doing here? Well, that makes sense. You were at Bridgewater before, right? Yeah. What did you do at Bridgewater? So, I was an investor there. It's an interesting company. It's really only three roles. There's management associates, technology associates, and investment associates, outside of some of the core operational paths. Some raising money and stuff, too, probably. Yeah. Yeah. And wore a couple hats there, worked with some of our big clients, sovereign wealth funds, pensions on how am I going to meet my goals?

2:35What's my probability of success? How can I up that? So Bridgewater is famously a very unusual place. They ask you lots of questions transparently. They criticize each other openly. Did you learn any positive lessons from that? Did you learn negative lessons from that? Personally, it worked great for me. I loved it. I think it's how I act most of the time anyway. And so rather that being like, oh, Jake, he's kind of weird and speaking his mind too much. It was very much nurtured and appreciated. It's a culture where you speak your mind, you confront things that are broken. I like that. Were there any downsides to how it worked?

3:06So in terms of that culture at its emotional level, I really can't say anything but good things about it. Where I thought we missed the mark sometimes was just how it was implemented. There were a lot of tools and structures and red tape put in place, which maybe at the company that size, it's unavoidable. but it felt like too much of our time was spent on talking about how to talk about problems than the problems themselves. It's one of the biggest hedge funds in the world, if not the biggest. Biggest, yeah. It's done very well. Some people say it's kind of cultish how it works. Overall, you think it attracts really good people and has a transparent culture?

3:36I think so, and it's something we try and recreate at Opto, and I imagine it's true across top places in technology. Some people say Palantir's a cult, too, by the way, sometimes. So I guess people say that about things that are successful with their own cultures. They look too good from the outside if you throw some stones. But I think what it does a great job of is great people want to work with other great people. And organizations can really die when you have someone who's a star and they see other people around them underperforming and that not being rectified. If you don't get rid of the underperformers, the stars leave and then you can't have a great place.

4:09What can look intense and a bit inhuman and impressed is actually really positive. Because if someone's not going to work there or anywhere that has a really high standard, it doesn't help anyone to wait nine months. And it can be really hard for a culture to sustain those people. It's a tough lesson to cut people quickly that aren't working out. Yeah. And so, you said you were an investor from a young age. I actually was an investor in the 90s in high school as well. Bought a BMW with some of my tutoring earnings that I made money on in tech stocks. It's very lucky I bought that because then the tech stocks all crashed afterwards, obviously, with 2001.

4:40What kind of investing were you doing when you were younger? So, I started, I think, where most people don't. I think early on, most people focus on the equity markets, which was a ton of opportunity there. I was always much more interested in currencies and bonds, so became a student of macro, reading a lot of great thinkers there early. And I really like those markets, because in the public equity markets, everyone is there to make a profit. You're competing against every analyst and hedge fund. In bonds and in currencies, they're non-economic actors. You have the Fed, who's not trying to make money.

5:12You have people just trying to do currency transactions. You have big, dumb institutions that are forced to buy bonds. Exactly. You have people just trying to trade. Let's talk a bit about those markets. I obviously was in macro as well with Peter and Clarion and whatnot, and we had some good years there. It's very interesting right now. We have the long-term bond going up, I think, almost 5 % now, I believe, which is unprecedented for a very long time. A lot of people speculating China has been selling and slash not buying as many things in general with their troubles and also their antipathy towards us these days.

5:41It's actually quite scary. Our debt payments are having to go way, way up with these higher interest rates. I think it's$1 trillion now, but it gets to$2 trillion pretty quickly over the next few years, if we don't fix it. It seems like there's some danger of a spiral out of control where these rates can go a lot higher. Now, that said, the dollar's gotten surprisingly a lot stronger more recently. Maybe it's the strongest of a bunch of bad options, or what's going on here? Yeah, I think that's what's going on. At the broad picture level, it does look pretty bad for yields to go up from here, with a huge amount of fiscal issuance happening, fiscal spending, that's not really backed by increase in revenue on that side.

6:18It's going to be an expansion of the deficit. Combine that with pretty bad conditions for demand, where I think this is part of the dollar strength. If I can earn 5%, 6 % on the short end, why would I buy 10-year bonds right now? J.P. Morgan's paying me 6 % right now. Exactly. For risk-free. I was going to build a bunch of buildings near East Austin, where I was going to try to make an investment there. And the paper return, when we mapped it out, was about 3.8 % yield. Money sitting in the bank makes 6 % yield. This is what the Fed's doing. They're slowing down the economy and making it so people like me don't have the incentive to build because it's a waste of money.

6:48Exactly. And I think that also speaks to the dollar strength, where if I'm sitting in Europe, Japan, other places in developed worlds, I'm getting, at least in terms of getting dollars back, risk-free payments of that amount, it's hard to beat that really anywhere in the world at that level of risk right now. Now, the other half of this, and we have an expression in macro, in the end, they always print money. So, what's going to happen if we keep running up the debt like this? Eventually, you're going to have to print to solve that, and that will be inflationary. Who is going to buy all this debt?

7:17There's going to be a lot more,$33 trillion of debt right now, I believe, something like that. The deficit, each of which is the amount we're losing per year, is it a couple trillion now? Is it a couple trillion now? Is it a good way to understand? A couple and probably going up from there. Probably going up. It's something like our spending is like, back of the envelope, six-something, and our revenue is four or something. So, it's like about two. But then, like, of the six-something spending, over a trillion of that's debt. And that part of it's going to double, probably. So, you can't even cut that.

7:41You have to only go up. Entitlements can't really be cut very easily, I guess, especially not right now in D.C. I mean, where does this go? Do we just get into an emerging market like debt spiral and interest rates go way up and there's massive inflation, they print lots of money and gold goes up? I mean, this is like the silly gold bug argument we've been hearing for 20 years. Is it finally going to happen or what's going on here? Yeah. So, this is a prototypical long-term debt cycle. We talk about these a lot at Bridgewater. There's a short-term cycle, usually lasts three, five, seven years.

8:05And there's a long-term cycle, which lasts much longer. At the beginning of the cycle, debt levels are low. And so, it's easy to add debt. Interest rates can climb and you can still want to add debt. So, what's that longer-term cycle? What are the years you're talking about now? It takes about 30 to 40 years. So, kind of from the early 1980s, we had very high rates. And now we've been declining, and now we're at the bottom. The 2020 was like the bottom, basically almost 0 % for a long time. Of yields, but we're still dealing with basically the hangover effects of that. And so, the government replaced private spending in 2020.

8:34That's in large part why the economy kept growing, despite the contraction in consumer spending with COVID. Government gets spending. We're now getting into a place where, as you correctly mentioned, that debt service becomes a huge part of the deficit. And the Fed can either raise rates and increase the government's own spending on that each year, or cut rates and risk running inflation, which will drive that up even further. So, it's pretty lose-lose. Ways of getting out of it would be a significant restructuring of how we spend, but as you noted, seems unlikely. So, we need either political willpower to restructure how we spend, or crisis.

9:10Or crisis. It feels like we're on this path, and the path keeps getting narrower and narrower and narrower. And we've slipped off towards the inflation side, and then we're climbing back on. But then we're going to slip off the other side. Yeah. I'm not a golfer, but I usually describe it as putting on a ridge, which I hear is hard. You're trying to walk the Goldilocks path. And speaking of American optimism, I think that's the only way you can describe a really positive path out of this, which I think will need budget cuts. Well, there's other ways you could do it, too. I mean, AI could just solve everything, Jake.

9:43But you just pray to the AI gods and put our hands in the sand. This is apparently what a lot of my tech friends are doing. But unless AI spends money, it's not going to improve the deficit. You never know. You never know. It could. It could already be spending money. There's some pretty clever agents out there. Yeah. But AI aside, you either need to restructure spending completely, which actually I don't think it's that hard substantively. I can make a plan for how we're going to only spend$3 trillion or$6 trillion and deliver the same quality services by having confidence. and accountability and firing a lot of useless bureaucrats.

10:13But assuming that we don't put dictator Lonsdale in charge here, because that's not how our country works, and that these guys can't get their act together in D.C., then there's going to be a crisis. And so, what does a crisis look like? So, my guess is, and this is just a guess, and he lives by the crystal ball will eat glass, but that it looks more like a slow bleed out than one sort of imminent moment. Of course, there will be shocks. But I think what it looks like is for a protracted period, 12, 15 plus years, rates are higher than they would otherwise be because there's this big gap in demand for bonds and exogenous demand.

10:46So similar to your example of that housing development, if because the government is spending too much and not matching that to income streams for years and years, we have just elevated bond levels exogenously, that's going to really hurt the real economy. It might not happen all at once. It might. But I think it looks more like it's just a higher cost. Almost 5 % already on the 10-year long bond is already probably impacting things very negatively. Oh, yeah. No one has an incentive to refinance. It is very hard if you got a mortgage anytime in the last 15 years to think about moving right now.

11:17And housing activity is a major driver of economic growth. I guess some people will tell me, well, Joe, these are normal rates if you go back in time. Like 20, 30, 50, 60 years. These are normal rates now. But I guess the question is, do we blow through them and go to higher? But you think there's near-term crises, but you think this is a longer term. This is a 10-year thing. I think this is a longer term thing. There will be bumps in the road for sure. And we'll probably have more bank issues that will be symptoms of the disease. But I think the disease is much more long term in nature. So let's jump to Opto.

11:45Opto is a company that I'm involved with as well as chairman. And there's trillions of dollars managed by family offices in RIAs. Tens of trillions in the U.S. of dollars. And the majority of this money is mostly focused on the easier to invest in things, which is mostly public stocks and bonds. And there's some good things to do there. But there's this whole world of alternative investing, which is venture funds, PE funds, private credit infrastructure. And so, you're helping people build portfolios to access alternatives. And so, first of all, why is that a good thing for people to do now? How does this macro tie into that, like connect this to funds?

12:17Yeah. So, I think it's two-sided. One is, when you look at conditions like this that are really bad for stocks and bonds at the same time, one thing people do in a portfolio is they assume static correlation between stocks and bonds. That works when growth is the dominant factor. So basically, if you buy stocks and buy bonds, in a lot of worlds, the stocks go up and the bonds are down and vice versa. But not in the world where we're dominated by inflation and Fed action. Because both of those assets are long-term in nature. And so they're going to be discounted by higher and higher rates, driving today's price down.

12:46Yeah. So last year, people got crushed. Exactly. The only one on stocks and bonds that got crushed. And if this is a 10-year thing, there could be a lot of years where both of those happen. And this was the 1970s. In the 1970s, stocks and bonds moved basically perfectly correlated. And so, you have a moment where it's much more necessary, if you're going to have a healthy portfolio, to think about, what can I add that is actually different? If you don't want to lose on both sides of what you own, you have to have something that's less correlated. But a lot of people say, well, everything's correlated.

13:10Why is it less correlated? What are the things that are less correlated? How does this work? Well, so, the core thing to me is finding alpha. If I just went out and bought every private equity-backed company, or even all private companies in the U.S., I would expect that to look like a market return. Alpha, for the people listening, is the return over the expected return of the asset class. So, you're actually looking for real skill or real advantages of some sort. Exactly. Because in an environment of high interest rates, you would expect just beta returns, market capture returns to be lower.

13:39Beta is just the returns of the market, whereas alpha is the gap. If I walk down the street and I ask three business owners, how much can I invest? Or I want to give them a loan, average that over the whole economy, that's beta. Beta is just doing that on average. Got it. Yeah, and that thing will go down as the cash rate goes up, for the same reason we just talked about. Well, if I can get cash here, why would I do this thing? And so, in those environments, you really want to find alpha. And if you find it, it is by definition uncorrelated, because it's a zero-sum game. If someone's winning, it's because something else is doing poorly, which means that you're not looking like the market.

14:13Is that true? Don't people just create wealth sometimes? Is it because someone's doing poorly? So, when we apply the alpha framework to private markets, it does get a little tricky, because imagine you had two founders, they have a stellar idea. No one's funding them. Someone sees the opportunity, sees their potential, their skill as leaders and founders, and backs that. And it goes from pre-money of$10 million up to$5 billion. I think the sort of naive academic thing would be to say, yes, it's Alpha, the founders lost to the backer. But it was never going to get off the ground without them. Yeah, of course.

14:44So, yes, you don't really want to think of it as zero sum in the real world. But this is the useless academic equations that you were talking about earlier. Yes. So, we probably should just think of it as positive sum. I would think about it as positive sum, but uncorrelated. Because it's about an individual skill of a manager in picking those bets, backing the right people, having the network to find the best talent, which shouldn't look like overall economic conditions. So, overall, private markets have outperformed the public markets the last decade or two. Obviously, there's certain people who have better access in the private markets.

15:12So, I've noticed that first-generation entrepreneurs who've been successful tend to have networks, where they tend to get better access. things. That's not always the case, but then on average, especially in their industry, they're going to have access to the best things and they tend to outperform. You see a lot of Eric Schmidt's family office are iconic with all the tech guys in it. They have access to great things. And then there's other industries. If you want to invest in the very best alpha for energy markets, you probably are going to have a big advantage if you're one of the big Texas families and you know everyone there, things like that.

15:39And so, first of all, how do you get access to the best things? Is it through these different networks? What is it through? Yeah, so I have a really simple framework for outperformance. I like to make everything as simple as possible. I think there's really only four ways to outperform. You need to have a unique information, unique access, unique insight, or have luck. The first two are illegal in public markets, but they have a lot of private. This is a really important point. So in public markets, you're not allowed to have inside information. In private markets... Or unique access. Everyone has to have the same deal.

16:07Everyone has the same access and same deal. But in private markets, you can make your own deals, and you can know things other people don't know. And in fact, not only is it not illegal, if you're not doing it, you're probably left behind. If you're not doing it, you're not getting the deals. And so, it is the networks. And it's also the value that investors can bring to the table. So, to your example, if I'm a big Texas family and I have connections in logistics or oil, and I'm trying to work with a manager. Or political, of course. Of course. But we try and forget about that piece. Unfortunately.

16:38But if I'm talking to a private equity manager who does infrastructure in the oil and gas space, having them as an LP in my fund is going to be really additive to my portfolio companies. And so, that's another place where it really is positive sum, where that unique information that family holds can get used to build better companies tomorrow. And so, Opto is tied into these networks. And then, of course, I know one of the main things is you try to do it in an aligned way where Opto makes money, when your clients make money, because you take a very, very tiny bit of the carry, I guess, over a certain amount is the main thing.

17:06Exactly. When you look at the space today of who's been marketing to RIAs and how they're marketing, it's a brokerage-based business charging either a placement fee to the funds, and the best funds aren't going to pay the placement fee. This stuff drives me crazy. They're basically getting paid to sell them third-rate stuff. Yep. And they make money because they get paid more money by people who desperately need to sell their funds. Exactly. Who's going to pay 5 % placement? It's the person who can't hit their target. It's crazy to me. People would want to buy things that people are being paid tons of money to sell them.

17:34Because it's obviously investment-wise. You're just like, there's just a gap there. So, it's like you're leaving an animal table. And this is a big open space for us, because most of these platforms have been built for the brokers. And brokers just get a percentage of the transaction. And so, they don't really care if it's good or bad. Opto's a fiduciary. We manage these funds on behalf of our clients and are held to the fiduciary standard, not just fair dealing. Let's go back to the macro stuff briefly with Opto. I think this is one of the really interesting questions right now. So, we have this very scary 10 years ahead.

18:01You already have rates going way up. You have all sorts of challenges in the markets. What should you be investing in in alternatives based on a macro perspective? Now, Alpha, sure, we want to invest in the most skilled people, but which of those areas do you target? How do you think about it? Yeah, so I put it in the context this year. The Fed has raised rates significantly. And on top of that, banks have tightened conditions, both in the back of regional banking stress, and the Fed coming in and saying, like, get your house in order. The effective rate gain has been probably close to double digit now, when you combine those two factors.

18:31Explain this again. So, the Fed raised rates from near zero, a half percent, to five and a half percent. Five and a half percent. That's about one. That's five percent of rate hikes. And the banks take that, and they say, well, I need to earn a spread. So, I'm at least going to increase by that much. But also, risk in the economy has gone up. The Fed is telling me to raise standards. So, the spread they charge on top of that is going to increase. In that context, what we look at is what spaces are going to be most attractive and have best opportunities for investors as capital pulls back. And there's really three pieces that we are particularly excited about right now.

19:05One is, in the private credit space, when banks step back, more specialty lenders can step in. And they can step in at more attractive rates and better risk sanders than they could before. Now, there's a little bit too much hype in this space right now at an aggregate level. And a lot of these registered liquid products are being marketed to RAs and their clients. We think there's more risk in those than people assume. because once you're in a liquid product holding a liquid underlying, you have a lot of counterparty risk. That said, in more specialty areas of private credit, asset-backed finance, certain parts of the real estate debt market, you've had the big buyer of banks step out.

19:43And the folks who are stepping in are able to get really attractive rates of return. This is another big trend in our economy. Banks are regulated in whole new ways. It makes it really hard for them to do things. So, alternative credit can go in and do those things and get much better yields for safe stuff. Yeah, as an example, there's a firm we know of that was part of an Australian mega cap commodity producer. They spun out and moved to the U.S. Same business, profitable, great company with a long track record. They don't have three years of U.S. audited financials because they spun out last year.