Gold, Bitcoin, and Managing Investment Risk (w/ Raoul Pal & Dylan Grice)
DYLAN GRICE: How else do you think about that? Well, I said at the beginning, I don't have a problem thinking that the marketing go law, but still buying. The question is how do you buy? Suppose if you think that this is the bottom to the day, then you should go all in. You shouldn't be hedging your [indiscernible] now, just put everything in because it is the very bottom. If you're not sure if today is a bottom, if you're maybe 50/50, then you should put half of your available capital in. If you actually think that this is almost certainly not the bottom, and it's going to fall, it's going to crater by another 20% or 30% from here, and then maybe you would only put 10% of your deployable capital in. RAOUL PAL: Yeah, I totally understand that, that makes total sense. Now, you've got a set of opportunities, how do you filter, which set of opportunities takes priority in the portfolio with the amount of capital that you want to deploy at any one time? Because this is where the dark after portfolio management comes in? It's never that easy. DYLAN GRICE: Well, I think you're so-- this relates back to what we were just discussing about predictions about where we think this is all going to go. It's all very interesting. We all have a view on the future. We all have predictions, we all like to compare predictions. I think that it's easier to react rather than to predict. I think reaction is almost an easier, like the market will as you questions, and you can answer yes or no. Whereas when you're actually trying to predict and you're trying to figure out where it goes, then I think it becomes much more complicated. Were you reacting? I think these are the markets where you know you're in reaction mode. Do I like these prices? Do I like the price of this security? Do I like the price of this asset class? Yes or no? You answer those questions reasonably easy, reasonably easily. I think that it's too late to be looking for new investments here. You shouldn't be dusting down your file on that company you meant to have a look at six months ago, because it now looks quiet, it's too late. It's too late. Either you know it, or you don't. You should have been doing the work six months ago. You should have been doing the work when you have plenty of time, when it wasn't a fast market, when it wasn't such a rapidly moving situation. That's when you should have been doing the work, whether it was for a company, whether it was for a security, whether it was some slightly complex trade, or a manager, and now is the time to be pulling the trigger on the work that you've already done. In terms of how do you decide which one's which, well, I think the filter is very easy to see. Have I done the work, or have I not done the work? If I've not done the work then I'll leave that for later because right now, I'm pretty sure it doesn't matter which market you're looking at. If you are a credit trader, you will see there will be some credits which you know you don't need someone tell you, you know that these offer great value. Why? Because you've been trading this stuff or watching this stuff for years. If you're an equity trader or an equity investor who's actually seen it, you've already got your watch list. If you're a CLO trader, or if you're an allocator to different managers, you know what your universe offers you. I think that a time like this is the time to pull the trigger. It's not the time to be doing new detailed analyses, I think that was for-- that stopped in January. RAOUL PAL: Going down to the next level now, across asset classes, where offers the better opportunity? Another question as an addendum to that, is how the fuck do you deal with a portfolio where bonds don't work any longer, as well if you're constructing a multi asset portfolios? Anyway, the two questions is what asset classes look particularly interesting as we're drilling down and how do you deal with bonds that don't really work in a portfolio or potentially then? DYLAN GRICE: I think the one that stands out on a risk adjusted basis I think would probably be CLOs. I think that across the CLO capital, when you get a little bit more senior into the CLO capital structure, you get to BBs, you're getting a double digit return, you're 10%, 11% for BB. Obviously, that's their selfinvestment grade but the credit performance of CLOs versus the underlying credits has historically been incredibly good, far too good. You can normally, if you're willing to basically do your homework and accept the complexity that comes with CLOs, of assets, vanilla credit, you're probably going up a notch, maybe even two notches in credit rating in terms of the expected defaults that you're likely to sell for. 10% or 11% for in vanilla credit prevalent towns, BBB, maybe even A, I just think that that's a phenomenal value. As an all peak market, you need to know how to access that market, you need to know who the managers are. RAOUL PAL: And you need to understand it's not a simple market. DYLAN GRICE: It's not simple market, but I think again, as I said at the beginning, one of the things that I think very interesting are just these very deep principles which are true across all-- doesn't matter what you're doing. The principle for Jim Simons and the scientists at Renaissance technologies, before they're actually deploying a model, the principle, the fundamental principle which they are deploying is exactly the same as the fundamental principle that Buffett and Munger will be deploying when they're allocating to a new business. Do we understand this? RAOUL PAL: A lot of people don't ask that question. DYLAN GRICE: But they should be. One of my heroes is Sir Richard Feynman, the physicist, the Nobel Prize winning physicist, and he was talking about doing science and science, in essence is not so different from investing. It's trying to understand reality. What Richard Feynman used to say was just when you're doing science, just remember two things. Rule number one, don't fool yourself. Rule number two, you are the easiest person to fool. Always bear those two things in mind, and when you're doing investment research and seen that, yes, I see it was complicated, yes, they're not that obvious, but how much time do you need to spend to roughly understand the basics of what these things are, and what the risks are? It's not rocket science, a little bit patience, and a little bit of willingness to ask some dumb questions to people who know and people who trade that stuff. I think you'd end up in the same place. If you're going to look at catastrophe bonds or if you're going to look at life settlements, or if you're going to look at booking.com, or if you're going to look at Google or Exxon, you're going to have to get down and dirty with really understanding what the hell is going on under the hood, or if you're building algorithms for Jim Simons. You're going to have to do some pretty serious work, go down a bunch of dead ends, throw your hands up on multiple occasions. I don't understand this at all, and then eventually persevere, and you'll get there. I think that subject to a willingness to walk away if it's genuinely too hard, or you generally don't understand it, then yeah, I think that spending time understanding how different investments work is just a very, very good use of your time. It's a very profitable use of your time at times like this, when you get this dislocations, I think in pretty much any market you look at, you can see dislocations. RAOUL PAL: Going back to that bond question, treasury bonds and how that works in portfolio construction. Have you got any thoughts on that? Because a lot of people are just starting to scratch their heads and think about it, and do I substitute it with something else? Can I just put gold in its place? How does that world work? DYLAN GRICE: I think it's interesting if you go-- where do you start? Okay, I'll give you the simple answer, I think, is this, and by the way, I haven't properly done the work. RAOUL PAL: Yeah, I know, I'm just picking your brains on it because it's just come up very quickly for everyone. It was like, oh, shit, okay. DYLAN GRICE: It suddenly has, yeah, it's funny. If you look at the-- they've got, I think it's Deutsche Bank indices, but they actually have long index hedges so pretty hedge the indices. On Bloomberg, you can look them up, the bottom for the DAX, the CAC, the FTSE, I think the S&P. RAOUL PAL: It applies a certain delta option you buy every month or something of that. DYLAN GRICE: I think it is, from memory, I think is 5% out of the money which they roll quarterly, it will make the out of the money, but I think it was 5% that they roll quarterly. This is not going to protect you, you could do far better than this if you just spoke to your bank and got them to rebalance it weekly or monthly. Because obviously, if you're buying a put option into December, and then the market was up 20% in January, February, then your put option has-- it doesn't actually afford you that much protection for a march drawdown. Nevertheless, that's what these indices show. If you look at the total return for this index and compare it to the total return of the DAX index, which has the total index in there, the difference over the last 20, again, it was a few weeks ago, I looked at this, but I think it's around about 20, 25 years' worth of data. The difference between a fully hedged index, and just a naked index is 90 basis points. In other words, it only cost you 90 basis points to hedge with a put option. Now, if that's the cost of hedging, I feel comfortable with it. I think that I would rather have a portfolio, put some of my portfolio then add to hedge my portfolio then the 60/40. 60/40 basically just as dampened equity. I can download my equity-- RAOUL PAL: Because they're both correlated so you got the double kicker. It made everybody with an all-weather fund look like a hero for a while. DYLAN GRICE: Although historically, they haven't thought that correlation is not being stable. Now, it's really so that there is a potential disaster where actually you basically get this-- you don't get the hedge there when you need it from the bond market. If you've got the leveraged risk parity, then you're clearly in trouble and but if-- again, subjects do happen to actually broaden that type of analysis but that's quite promising. If it costs you-- it only cost me 90 basis points through the cycle to hedge 100% of equity portfolio, and with put options, with vanilla put options, I think that gives me the answer. That's what you do instead of bonds. RAOUL PAL: Yeah, it's super interesting. What's the variability of returns? Because it's very easy if you're in a family office to say, well, 90 basis points over that period of time is fine. If the variability of the 90 basis points is one year, you're lagging by 10%. In this stupid business, nobody will accept it. Do you know anything about that or not? DYLAN GRICE: I think the volatility with the last drawdown was lower. I think that the question you asked is such a good question and I think for any money manager, it's just if you had a-- answering that question is the holy grail, because it's not you're asking that question for that particular strategy, you could actually ask out for anyone who thinks they may outperform for a couple of years and I think that the answer is to the extent that there is one is two things. One, education, so be as crystal clear as possible with your investors about exactly what you're doing and exactly what they can expect so that when it does happen, you can tell them, and it's not a surprise. That doesn't guarantee you anything. I think it might buy you an extra year of underperformance, but that can keep you in business. The second thing is deliver what you promised. If you're trying to educate, you're trying to promise investors and say, look, here's what-- we really outperformed over the cycle, but there could well be two or three, if we follow this exact strategy, we will expect two or three years of underperformance every 10 years. I think if you can really get out, don't sell them something that's not attainable, don't sell them constant outperformance and without any period of drawdown, without any period of underperformance. This doesn't work and bizarrely, you do see people do it because I suppose it sells. This is the asset gathering strategy where you just you have like 20 bonds and you tell the investor that every single one, for every individual case, you say, oh, this one's going to outperform forever. This one-- and of course, most of them don't, but just statistically, one or two of them will do. They're the ones that get all the inflows. RAOUL PAL: And then they stop outperforming, yeah. DYLAN GRICE: Yeah, I don't have a bad answer, but education, delivering what you promised and grapple with it. RAOUL PAL: Let's get down to more specifics now, what are the areas that you're focusing on? CLOs, that's an area that takes, as we talked about more of the skill set, in equity terms, is there particular sectors that you're looking at, or very, very special situations, single name driven, how you're looking at this? DYLAN GRICE: What can interest me? I think that there's some of the emerging markets are interesting. I think that a lot of emerging markets were interesting before this happened, before we had this recent episode. I think Russia has been interesting to me for some time, I've been invested in some Russian equities. Sberbank in particular, I think is-- RAOUL PAL: What's interesting about Russia for you? Because it's a market that people fall in and out of love with. As far as I know, most people aren't involved any longer. DYLAN GRICE: Well, so that's already a part of the answer. RAOUL PAL: I figured that out. DYLAN GRICE: Russia to me, is not-- it's not a view on Russia as such. It's not a macro call on Russia. It's just that like any index, there are to be any degrees, but any equity index has got good companies and bad companies, and well run businesses and badly run businesses and Russia has some very well run businesses. Some, not [indiscernible], but it's got some well run businesses. One particularly I think they have one of the best run banks in the world, Sberbank, which is a fortress balance sheet, unassailable position in the Russian market. Without spending 20 minutes with that articulation of the investment thesis, I think this is about as bulletproof as you get as far as banks go. It's like the JP Morgan of Russia and you have a very rapid banking system. Every time there's a downtime, the banking system gets crushed. When people do pull the money out of banks, when there are runs on the banking system, they put their money into Sberbank, because it's the last man standing, it's the highest quality name. In terms of the structural problems that banks have, i.e. bank runs, Sberbank, if anything benefits in that environment get stronger in that environment. The other problem that banks have is this structural mismatch between their assets and liabilities, so they've got very short term liabilities in deposits, but they've got longer term assets in terms of mortgage loans. This often eats into equity when there's shifts in the relative interest rates. Most emerging markets and certainly Sberbank, they actually lend floating rates, so they don't have that mismatch either. They have a very, very robust business model, very, very robust brand in Russia. They have extraordinary margins, and emerging market bank margins are far wider than they are in developed markets, because you don't get the same competition from capital markets. Emerging market banks I think are different animals than their developed market counterparts. You've got a bank that's regularly handling an excess of 20% return on equity and it's trading at 20% discount to book value. I think that you're getting very, very good-- that's very, very easily, easily a double digit return in my view. RAOUL PAL: You come across the family office, I won't mention their name, that only does this. They only do emerging market banks. Amazing, I should introduce you. Amazing. It's a big family office, they've made a fortune. Basically, they only focus on emerging market banks. They were the Nigerian banks, the Indian banks, the Russian banks and all of this. When nobody else is looking at them and everybody's puking them, they're the guys who go in and figure out what-- because there's one trick that they know really well. DYLAN GRICE: Well, something that I discovered when I was at Calibrium, one of the analysts that I had, incredibly switched on brilliant analysts, brilliant investor. He was the one who recently educated me on emerging market banks. He'd come from an emerging market background. I think I had many of the prejudices that we all have about buying. The structurally unsound business models, structurally leveraged business models, you don't make a good business better with leverage that's just buying, always blew up during a crash. Of course, every single one of those things has now a truth to it, but it's not quite the same in emerging markets. RAOUL PAL: It's also what discount you got when you buy them and what the tailwind is? Many of these emerging markets have great demographic tailwinds, for example, and you think of the Middle East for example. DYLAN GRICE: Yeah, no, no, Russia. RAOUL PAL: Russia is the opposite, it's that demographic brick wall. DYLAN GRICE: Real problems, but yeah, they are not bad. Sberbank is something that we own personally in our own portfolio.