Karen Karniol-Tambour - All Things Macro - [Invest Like the Best, EP. 237]

My guest today is Karen Karniol-Tambour, Partner and Co-CIO for Sustainability at Bridgewater Associates. You will quickly understand why Ray Dalio described Karen as a “vacuum cleaner of learning” - our conversation covered a variety of market themes, and Karen goes deep on each of them. We touch on inflation, monetary policy, currencies, retail investors, ESG, and how each of these levers has become more important for investors to understand. Karen has a rare skill for making complex ideas seem simple, and I love the frameworks she uses to deconstruct big, important issues. She does such a good job of explaining what’s changed, why it matters, and what to do about it. I hope you enjoy my great conversation with Karen Karniol-Tambour. For the full show notes, transcript, and links to the best content to learn more, check out the episode page here. ------ Invest Like the Best is a property of Colossus, Inc. For more episodes of Invest Like the Best, visit joincolossus.com/episodes. Stay up to date on all our podcasts by signing up to Colossus Weekly, our quick dive every Sunday highlighting the top business and investing concepts from our podcasts and the best of what we read that week. Sign up here. Follow us on Twitter: @patrick_oshag | @JoinColossus Show Notes [00:03:39] - [First question] - How Bridgewater invests and the experiences that led her there [00:06:47] - What working with Daniel Kahneman felt like and learning his perspective [00:08:09] - An example of holding herself to accumulating and stress testing data [00:10:17] - Important variables to consider when seeking returns in large-scale bets [00:14:18] - What we should be thinking about in terms of inflation as we look to the future [00:20:07] - How she thinks about inflation and how she defines it [00:22:57] - Relevant asset classes that can protect or help diversify against inflation [00:26:14] - What still largely confuses her about inflation and its many facets [00:28:05] - Her philosophy and model for understanding the system of currency [00:33:21] - How investors should think about the US dollar [00:35:50] - Whether or not owning an unhedged global equity index gives you currency exposure [00:37:07] - The fundamental nature of equity markets and household balance sheets [00:41:37] - Ways the growing wave of retail investors will impact prices and returns [00:43:53] - How she’s evolved her valuation approach given our new investor landscape [00:45:43] - The good and bad roles ESG might play for investors going forward [00:50:36] - Potential concerns around the growing trend of ESG writ large [00:53:51] - Thoughts on the 60/40 portfolio and whether or not it’s still worth using [00:55:32] - Designing a default diversified portfolio in light of markets today [00:57:45] - Aspects of the global market economy today people should be talking about more [01:01:15] - Ways she investigates a new topic and how it has evolved over time [01:04:14] - Variables that matter in investment teams and company cultures [01:06:53] - How she would approach cryptocurrency and what’s interesting about them [01:09:08] - A rosey and gloomy take of what the world could look like in a decade [01:12:37] - The kindest thing that anyone has ever done for her

Speaker names marked ? are inferred from speaking time and the show’s known hosts — they are not voice-verified.

• 0:00Patrick O'Shaughnessy?

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• 0:43Patrick O'Shaughnessy?

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• 1:26Patrick O'Shaughnessy?

  just $300 per call, not the $1,000 or more that others charge. If you're curious about Teegus, call the top performing investment manager you can think of. They're probably already a Teegus customer and they'll point you in the right direction because customers, myself included, love Teegus. Visit teegus.co/patrick to learn more. To hear more about Teegus, stay tuned at the end of the episode where I sit down with Teegus customer Ben Clermont from Cove Street Capital to talk about how Teegus is part of his investing process. This episode of Invest Like the Best is sponsored by Eight Sleep. Eight Sleep's new Pod Pro cover is the easiest and fastest way to sleep at your perfect temperature. It pairs dynamic cooling and heating with biometric tracking to offer the most advanced solution on the market.

• 2:11Patrick O'Shaughnessy?

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• 2:37Patrick O'Shaughnessy?

  Hello and welcome, everyone. I'm Patrick O'Shaughnessy and this is Invest Like the Best. This show is an open-ended exploration of markets, ideas, stories, and strategies that will help you better invest both your time and your money. Invest Like the Best is part of the Colossus family of podcasts, and you can access all our podcasts, including edited transcripts, show notes, and other resources to keep learning at joincolossus.com.

• 3:03Speaker 01

  Patrick O'Shaughnessy is the CEO of O'Shaughnessy Asset Management. All opinions expressed by Patrick and podcast guests are solely their own opinions and do not reflect the opinion of O'Shaughnessy Asset Management. This podcast is for informational purposes only and should not be relied upon as a basis for investment decisions. Clients of O'Shaughnessy Asset Management may maintain positions in the securities discussed in this podcast.

• 3:29Patrick O'Shaughnessy?

  My guest today is Karen Carneal-Tambour, Partner and Co-CIO for Sustainability at Bridgewater Associates. You will quickly understand why Ray Dalio described Karen as a vacuum cleaner of learning. Our conversation covered a variety of market themes, and Karen goes deep on each of them. We touch on inflation, monetary policy, currencies, retail investors, ESG, and how each of these levers has become more important for investors to understand. Karen has a rare skill for making complex ideas seem simple, and I love the frameworks she uses to deconstruct big, important issues. She does such a good job of explaining what's changed, why it matters, and what to do about it. I hope you enjoy my great conversation with Karen Carneal-Tambour.

• 4:12Patrick O'Shaughnessy?

  So Karen, this has been a conversation long in the making. I'm excited to finally do it. We've had all sorts of disasters that have gotten in the way of us getting this on the books, but have been so looking forward to it. I think because we're going to talk about so many parts of the investing world, interesting topics, interesting parts of the economy, that it would be appropriate to start with sort of how your mind works and how the investing machine at your firm works. So maybe you could give us a thumbnail sketch of how you personally got to here, what were sort of the formative experiences that have formed your investment worldview?

• 4:45Speaker 02

  Let me give a couple of sentences about how Bridgewater invests, and then I'll talk about my journey into Bridgewater and why it spoke to me. I think the best way to think about Bridgewater is a firm that takes equally seriously being fundamental and being systematic. So, we're not going to make any investments unless we deeply understand the cause-effect relationships. So, all conversations start with, how does this work? What are the drivers? What are the cause-effect relationships that will determine whether or not the price is going to move, or the asset will perform the way it is, or the economy will work the way we think it does. But then, we don't want to rely on just an understanding that

• 5:27Speaker 02

  kind of happens in a conversation, the way it would between you and I. We want to be able to take whatever that is and stress-test it. Put it on a pedestal and be able to convey it as clearly as possible, so that others can kind of look at it, critique it. So, it's not reliant like it's in Karen's head, so if I had a bad day, or I'm in a bad mood, or I'm gone, no one knows it anymore. And by actually writing it down as clearly as possible, you can stress-test it. So, you can say, where else did this ever happen? How's this different in other cases? And so on and so forth. And then that gives you tremendous power to be very diversified, because now you can look all over the world for any case that looks like that set of cases from its pricings, and do what's most attractive. So, that's kind of the investment philosophy. For me and how I got into it,

• 6:10Speaker 02

  I definitely didn't come from any background where I had any particular interest in investing. Bridgewater hired me straight out of undergrad, out of Princeton. And when I was at Princeton, I also didn't know I wanted to do investing or anything. I was interested in the world broadly, took a very wide range of classes, ended up doing my thesis, which is a special Princeton thing, that you write a thesis as an undergrad, with Danny Kahneman. I think the luckiest thing for me, honestly, was just getting to see him up close, and think through different ideas, and sift through them. Came into it not knowing for sure what I'd write the thesis about, and so we got to go back and forth, go through ideas, and I got to really... See how his mind works and how he thinks them through. But the core lesson of a lot of his work about human bias and judgment and decision making definitely stuck with me.

• 6:53Speaker 02

  So what drew me to Bridgewater was the mix of the fundamental interest in sort of how does the world work? As soon as I started talking to people at Bridgewater, I realized how many important things about what made the world tick, I didn't know anything about because I didn't understand the economy and markets. Combined with that deep appreciation for what makes human decision making and judgment flawed and how to move from you can feel really smart in conversation to something you should really rely on.

• 7:19Patrick O'Shaughnessy?

  What was the way it felt to work with Danny when you were doing that thesis? How would you describe the way that he attacked a conversation or a problem or something that you were trying to figure out? What did his lens feel like to you?

• 7:33Speaker 02

  Now, I'll give my take, but I highly, highly recommend the Michael Lewis book about Kahneman and Tversky's relationship. It is such a great book because even if you're not interested in the topic, it actually captures a lot what great work relationships are like because it talks about their relationship and how each of their work independently was never as good as together. So I think really useful for basically anyone in business. But I'd say what I really loved about how he approached problems. I mean, there's definitely some parallels and some differences to Ray, who I didn't have to work with a lot at Bridgewater. He always, no matter how much expertise he had, could look at it with a fresh perspective and say, forget everything I know, let's start first principles, let's start from scratch.

• 8:13Speaker 02

  And he was never afraid to kind of re-question ideas and past work he had done, start looking into new things. So unbounded curiosity, a sense that he was fallible and he shouldn't believe the first ideas that he had and a desire to really build something that made sense to him and incredible creativity. One conversation, cross 10 different topics to discussion, crisscross them, see connections between them and get to something you hadn't talked about before.

• 8:41Patrick O'Shaughnessy?

  Because of this joint importance of the fundamental and the systematic or quantitative as sort of the lens through which a lot of the rest of our discussion will unfold, could you give one tangible example of how that works in practice? Because I think oftentimes, it's easy to say that, right? But it's probably really hard to actually hold yourself to always going and getting the data, you know, doing that kind of hard work part. Once you've formed the fundamental view to stress test it, as you described, could you give one example, recent or otherwise, that would sort of nail home that point? Because I really do think that's the lens through which everything else we talk about will be passed.

• 9:15Speaker 02

  I think maybe a really easy one to start with is central banks, because the Fed just tells you their function. They tell you what their inflation target is. So they care about employment, they care about inflation, they tell you that. So in some sense, that fundamental discussion upfront can feel really easy. They told you they care about these two issues. So it should be pretty easy to just go and measure that and be able to say, okay, if that's what they care about, then that's what they're going to do. And I should be able to turn that into a literal rule that says, do I think the Fed is going to tighten or ease? And how much relative to what the market says they're going to tighten or ease to make money? In practice, though, people that fundamentally follow the Fed are often listening to what the Fed is saying and thinking how their reaction function is changing.

• 9:57Speaker 02

  And so at a time like today, when the Fed says, I think about my mandate differently than I used to, I'm willing to think about inflation more symmetrically, maybe it's okay if inflation is kind of above my target for a while because of what's been like the last 10 years, or I care about shortfalls in employment. So maybe that unemployment rate overall looks okay, but there are pockets that are really don't have great employment prospects. So I want to find a way to address those to my monetary policy. That then becomes the stuff of real work, where you're saying, well, how do I measure that? How do I know when it's going to matter? And how do I move from a world where it's sort of Karen's opinion of I'm reading the tea leaves and it feels very voodoo and listening to Powell, to I'm measuring something and I'm going to know when that changes and I'm going to know whether or not this special

• 10:41Speaker 02

  set of circumstances that isn't just classic unemployment rate plus inflation, does it apply in Europe? Does it apply in the UK? That's the sort of really hard work I'd say that we do.

• 10:50Patrick O'Shaughnessy?

  How do you think about the most important variables in the world today? When you try to understand where returns may go or cluster in the major asset classes and spaces? Famously, Bridgewater makes a lot of large scale bets on equities in different regions or different types of asset classes. The all-weather portfolio, a lot of people listening will be familiar with. How do you start to go from those outcomes back to the variables that might matter today? Because it strikes me that you think a lot about these big levers that will drive major outcomes. What is that landscape today for you?

• 11:25Speaker 02

  Well, let's start with what landscape is like from a timeless perspective. So over time, if you're looking at any asset that you think is going to pay you a risk premium. I think that's a pretty important first question of is this an asset that has a risk premium? For example, if you have risk on whether or not the euro is going to go up, no one is paying you a risk premium for that risk. You are taking it because you want to and you should consider whether you want to. Other assets have a risk premium. You can understand fundamentally, you know, if I'm in a capitalist economy, there's a good reason why I might get paid for instead of having my money under the mattress, giving it to a company, I should be getting paid for that risk. So if I'm looking at an asset with a risk premium, I'm expecting to make some risk premium on it. One way to think about that risk premium is to draw a classic discounted cash flow model. So to think, well, what are the earnings of that asset?

• 12:10Speaker 02

  In the case of a bond, maybe they're fixed, maybe they're not fixed. What am I going to get paid? And then how do I discount that to today in a cash flow model? And what you'll find is that what tends to drive the things that you're getting paid with, the earnings are basically what's the economy doing? What's the economy doing? You can divide into how large is the economy or growth? And what's the price of things in the economy or inflation? And then in terms of discounting the assets back to today, I'm going to say, well, if I have my money under my mattress the whole time, I could just go put it in the bank and be pretty safe. So I want to think about what's that free discount rate going to be over the next 10 years? I'm giving you money and I definitely want that. I don't want to make less than that. And I definitely want to make some risk premium above that, depending how risky the asset is.

• 12:55Speaker 02

  Or else why would I not just give it to the bank? And so. When you kind of then scale that up, you say, well, all assets, they have all sorts of things going on that are specific to that asset, and those can be really important. But all of them are going to be affected by whatever's happening in the economy, growth and inflation being kind of the size of the economic activity and what it's priced at. And every asset that has cash flows into the future, you're going to discount into today with that same view of what's the risk free rate or the discount rate and what's the risk premium. What you find is when you try to kind of extract that of different assets, what's being driven by each of these four factors and what's being driven by other things, usually at an asset class level, you can explain 90, 95% of the movements based on these four big factors.

• 13:39Speaker 02

  When you go to something like wheat, you could say, well, you have a planting cycle and so on. But when you kind of go at the asset class level, you really can use these four drivers to explain a lot of what's going on. What's the basis of our, what we call our weather portfolio, which is just meant to be beta portfolio, collect risk premiums efficiently through time, is the idea that some of those things are diversifiable and some aren't. And so the risk premium is very hard to diversify because you're going to get it on everything. And when people are just afraid to take risk, it's going to show up everywhere. But growth and inflation are actually easier to diversify because some assets are going to do really well when inflation is rising and some when inflation is falling. So you should be able to earn risk premiums more consistently by thinking really hard, how do you diversify your risk among them? So that's all along, for example, to say that's how assets generally work.

• 14:23Speaker 02

  But then obviously, at different points in time, different ones of these factors matter more and less. And today, we're in, I think, an extreme turning point from what has mattered in the last 20, 30 years of investor experiences and what probably will matter, probably the most commonly discussed element of that is inflation, where if you kind of look through time and through history at the four factors, I said, there are a lot of times where inflation is really, really important. And then it just hasn't been important for quite a while.

• 14:50Patrick O'Shaughnessy?

  So we have to dive in there because it's such an interesting shift. A lot of people's careers now, myself included, have gotten kind of long without really ever having to think about this variable. It's been very low, it's been pretty consistent, it's kind of a non-factor. So how should we, the audience, start to think about how this could play out? If you stand today in 2021 and look to the future, how do you sort of draw the spectrum of potential outcomes where inflation again becomes important? And where does it become important?

• 15:19Speaker 02

  I think the spectrum being broad is probably the most important thing for investors because that tells you, wait a minute, if I'm building a portfolio, I want to make sure I at least, either I'm taking a concentrated bet or I'm diversified against that is one of the factors you can't actually diversify against. But in terms of why the spectrum is broad, it's because you really see big pressures now in different directions. So if you kind of go through what I think of as the big pressures on inflation, you have what's called traditional cyclical pressures of really hot economy. So more people want stuff, so companies have got to produce more. Whatever way you want to measure really classic cyclical pressures on inflation in a lot of places, especially in the US, they're some of the biggest we've ever seen, more or less. Because, you know, the economy is roaring back, coming out of the pandemic lows.

• 16:03Speaker 02

  Then you have a big shift in policy perspective and goals, where you came out of this world where policymakers, central banks in particular, thought, well, controlling inflation is the single most important thing I need to do. That's really my mandate, saying, wait a minute, it hasn't been a problem in so long. And there are so many deflationary forces that seem to offset any problem of inflation going out of control. And if it's been below for so long, maybe it can overshoot for a bit. And still over the whole cycle, it'll be fine. So you have a different sense from policymakers of what their mandate is and what they should be doing and allowing inflation to get higher than it did before. Then you have a big shift in tools being used by policymakers, which is if what you're doing as a central banker is moving the interest rate up and down,

• 16:48Speaker 02

  the way you get inflation is the interest rate falls, you get people to respond to that, for example, by taking out a mortgage to buy a house because it's cheap, and then they go buy furniture and over time prices rise. If what you have is quantitative easing, it's even more indirect because now you're printing money, buying a bond and hoping that the person who used to have the bond gets the money and maybe they'll buy something in the real economy and maybe one day there'll be inflation. And when we had quantitative easing, we didn't see a lot of inflation. We saw asset prices go up because that's what they were buying. We didn't see a lot of inflation. To now, the tool is what Bridgewater has called monetary policy three, sort of the third generation where you're fusing fiscal and monetary. You're still printing money, but you're really relying on the government to be running deficits and effectively using

• 17:32Speaker 02

  that printed money because they're the ones selling the bonds into the Fed to go and give it to people. So now you have a much more direct distribution of that printed money. I mean, at the extreme, we saw people literally get checks in the mail coming out of the pandemic. But you know, if the infrastructure bill passes, that's very literally print money. You give it to the government, they build a bridge. That's somebody getting a paycheck every day and a bridge being built and straight into GDP. So that new policy tool, in addition to the policy perspective, is much more directly inflationary because you're literally spending into the real economy. So that's all the very inflationary things that creates that mix of potential for a lot of much higher inflation than we've seen. You're going to literally spend money and give it to people. Central banks are less

• 18:16Speaker 02

  worried about it. Very strong cyclical recovery. Then on the other side, I think you do have a shift in what's happening with globalization and automation that make it less clear. That actually says there could be deflationary things going on. So I think globalization's kind of in the middle. You had from 1990s, maybe 80s, but most of the 90s, tons and tons of global workforce coming online. And so you have people in poorer countries that just cost less to use them to produce things, to get connected into the global economy. So prices are going to fall if now you can go and pay them less to do things. And what you basically see is that almost every good physical thing that you and I use has already been highly globalized.

• 18:59Speaker 02

  The numbers are something like forty percent of global goods are cross-border, but that number understates the fact that if yours happens to be made in the US, it's not like the manufacturer can't go abroad. They just chose the US. In other words, the supply chains are open. You can go anywhere in the world and make that stuff. So that, to some extent, remains somewhat deflationary because it means that anyone that has a pocket of capacity, you can use it. So even if the US gets really hot, you have the ability to go, you know, use something else. And then you have the big potential for services to get more globalized, too. That connects to the automation point, which is, look, there's a lot of technology that's been accelerated in its development over the last 10 years. It hasn't really been picked up by businesses. If you look at any traditional business and say, could they be better in terms of using technology,

• 19:44Speaker 02

  especially in services, the answer is usually yes, but you need an impetus. You need to decide, I'm gonna go, I'm gonna invest, I'm gonna go, you know, switch over my accounting software to be more automated and get rid of the accountants, whatever it is. Historically, those things usually happened in big crises. So you get a big recession, you have to start rationalizing, why do I employ all these people? That's a good time to do it. COVID definitely might be one of those accelerants. When you talk to businesses and see surveys, a lot of them say, I'm gonna use this opportunity. So that's a big deflationary force that could be behind us and then mixes in with globalization to say, wait a minute, if I can get workers from anywhere and I can digitize, maybe I can send some of these scans to India, et cetera, et cetera. But we don't know exactly how big this wave is gonna be and how quick it's gonna be,

• 20:27Speaker 02

  but those are the deflationary forces on the other side that are very hard to size, like how fast businesses are gonna do this and just how deflationary they'll end up being and how they'll offset what are these once-in-a-generation inflationary forces.

• 20:40Patrick O'Shaughnessy?

  How do you think about how to actually define inflation? Because I guess my base case is always that this topic just confuses me. And I remember early in my career thinking QE must lead to inflation and then you didn't get it. And I had read so much about it and that was sort of like the straw that broke the camel's back for me. Like I was, this is not gonna be something that I can predict or really even understand despite quite a bit of trying. So how do you think about, just at a very basic definitional level, what inflation even means? Like, should that be a single concept? Because you see these charts that show some things have inflated a lot, others have deflated a lot in terms of their price. Just walk us through, because I think it's such a key topic, how you even define inflation in the first place?

• 21:23Speaker 02

  I think as an investor, the first thing you want to say is, what actual risk am I running? What's relevant to me? We have some institutional investors that know exactly, I have to pay every pensioner this much money. And that's tied to some number of the government publishes as cost of living. So I know exactly what my inflation risk is. I know I've got to pay these people this amount. And so I could look at my investments and say, there's a very particular kind of inflation that could occur where I would be screwed and I wouldn't be able to pay them. If you're a private citizen and you're just running your portfolio, it's not that different from that. You're saving your money because you want to use it. And you might want to use it all over the world, in which case you care a lot whether

• 22:07Speaker 02

  the dollar falls and foreign goods are expensive to you. You might want to use it for college for your kids. So you care about what that costs. But to some extent, like that's the type of inflation that you actually should care about as an investor. That's the risk you're actually running. And then you want to look at your assets and think, well, what are the assets that will do poorly if that kind of inflation occurs? So if you think about it that way, house inflation may or may not matter to you. You might think, I already own a house. I'm never buying a house again. I don't care about house inflation. Or it might matter a lot to you. Asset inflation is usually good for you because you own the assets. You want them to inflate. The thing that is really problematic for most people who are saving is classic, the consumption basket that you're going to have, that policymakers try to capture when they do CPI. It's not perfect. It has problems, but it's supposed to give a rough sense of what you're likely to actually

• 22:52Speaker 02

  want to spend your money on. And that's where, you know, take the simplest example, if I own a whole bunch of nominal government bonds rather than inflation linked ones, and they tell me they're going to pay me this size coupon and that coupon is in dollars. And now everything that I own is getting more expensive. Everything I want to buy is getting more expensive. I'm not going to be able to buy anymore. I lose real purchasing power. So to me, that's the only relevant definition of inflation for an investor actually thinking about their risk. And therefore, when you're thinking about what should I hold to manage that risk of inflation, you want to ask the same question, which is, well, what's dangerous to me? What do I want to get paid to make sure I can still do whatever I want to do with my money on the other side?

• 23:30Patrick O'Shaughnessy?

  I always love this idea that the only rational thing to do in the face of ignorance about something like inflation is to diversify. And I'm curious how you think about what the relevant asset classes are that do that diversification around inflation. So if everyone listening says, okay, I agree, it wasn't an issue. And now we don't know what's going to happen, but the spectrum of possible outcomes is probably much wider. And there's a chance that there's a lot more of it than we've seen in the past. Then what? Like, what are the things that I could consider as protection or diversification in the face of this wider spectrum of outcomes?

• 24:04Speaker 02

  I think it's good to think about what kind of inflation might occur. So I think it's underutilized to just exchange your nominal bonds for inflation-linked bonds, because that's just an asset class that's going to pay you that CPI index. So it's kind of nice. You've mostly saved and you just want to keep your purchasing power. You can get paid that, but you can also buy more levered. What you know is that you're going to get paid exactly what CPI is. Then augmenting that, commodities are, I think, somewhat of an underutilized asset class by a lot of investors, because those are literally the raw materials that get squeezed when the global economy picks up. And so it's the most literal manifestation of inflation. And it's not like you're literally going to go consume aluminum yourself, but it's

• 24:48Speaker 02

  in a lot of the things that you consume, and it's the best kind of reflection of supplies literally tight relative to demand. There's also good reason to think that you can still get paid a risk premium doing it, but that's somewhat different in every commodity in terms of what it's like with what producers want to get paid for. And most investors mostly do it poorly because if they have that exposure, they have it very concentrated in oil, which we could talk about, but has lots of idiosyncratic issues around it and politics around it versus having a broader basket of the type of commodities that are relevant to your life. And then I would definitely be thinking about gold and generally what your currency exposure is, because most people listening to this podcast both probably want to spend some of their money abroad at some point. So the dollar falling is one of the more serious inflation risks in terms of being

• 25:33Speaker 02

  able to afford things outside the country. And there's a lot of imported goods here, so it does flow through inflation anyway. And gold gives you Exposure to type of inflation where basically you just devalue the currency. So if the currency is just getting devalued, you hold the most real store hold of wealth that you can. And the other a little bit underappreciated thing is just think about what currencies you have exposure to. Cause you're probably not getting paid risk to hold those currencies. And partly because inflation has not been volatile in the last 20, 30 years. It just hasn't mattered that much what currency you held. And so if you look at people that held European stocks and Japanese stocks and UK stocks. The reason they didn't do as well as US stocks because US stocks outperformed. That was the big thing. It wasn't an issue really of what currency you picked.

• 26:16Speaker 02

  You look back at the seventies and eighties and the single biggest determinant often was did you had your currency or not? That mattered a lot more than what each stock market did. It was did you had your currency? So if you think you may be moving into a world where you have bigger differences in inflation across countries. And one country could get a lot of inflation because for example, for them, the cyclical pressures or policymakers. The policies they run are more inflationary than another country. Then you want to start thinking about your currency exposure. And if you don't have a lot of perspectives on it, maybe get rid of the exposure you don't need if you're not getting paid to hold it.

• 26:47Patrick O'Shaughnessy?

  You've obviously thought a lot more about inflation than I have. What still confuses you the most about inflation? Like it's such an interesting topic. It's so complicated. There's so many variables. What still kind of has you like throwing up your hands like, God, this is hard to figure out.

• 27:01Speaker 02

  The psychology parts are really difficult because at the end of the day, prices go up. When somebody who chooses how to price things decides to price them higher. And last time we had big inflationary shifts in the seventies and eighties. The structure of the economy was really different. Like you had unions and collective bargaining. And now you're in this case where like, who really chooses to go give higher wages? Who really chooses to go raise the price of an iPhone? And in the last few months, you've read really funny stuff that I think breaks textbook economics. Where you have companies saying, a lot of people want my products and I can't give them all a product. Because there's a supply bottleneck, but I'm not going to raise prices to ration that. Why would I do that? That doesn't make sense.

• 27:46Speaker 02

  I'm just going to hope it passes. And you're like, but wait, any economics would tell you, you would never do that. Right? You would say gorge the prices. If I only have a hundred of these things and a thousand people want them, let's have highest bidder. Let's charge whatever I can for it. That's how inflation is supposed to happen. And then you get to the same point with inflation psychology, which is you know that when you see inflation spirals and study them in places like Latin America that had big inflation spirals of the Weimar Republic, psychology becomes a big part of it, which is people start expecting inflation. So prices rise partly because it's expected and that's how you get a spiral. And you say, how does that really start? It's hard to study the psychology that way. And can you ever get a spiral if you have the kind of psychology I just talked about, where even in the face of shortages, you don't raise prices? How's this going to work?

• 28:28Patrick O'Shaughnessy?

  So it literally is like animal spirits. It's one of these things that could go because of human psychology very differently than you would draw it up rationally, which just makes it so fascinating. You mentioned currencies and the dollar. I feel like this is another area that most people, most investors, even professional ones, haven't had to think too much about in the last X period of time. And I'd love your sort of take and maybe we'll even start at the high level, like what is sort of your philosophy of currencies? Like, how does this, if it's a system, like any of this other stuff, how does the system of currencies itself work? And maybe we'll emphasize the US dollar, since that'll be the most relevant to most listeners. How do you think about trying to begin to understand currency? What's your model for it?

• 29:09Speaker 02

  In every single market that we trade, probably the most important thing that we do is we think about who are all the buyers and who are all the sellers in a very deep way, because at the end of the day, you can have all the theories you want, but the price only moves if there are more buyers than sellers. And that can sound very vague to people on some markets. But when I talk about currencies, it usually sounds very obvious to people like, well, of course, that would be the case. I say, that's the most important thing we do is we literally think, well, what's going on? Who are all the people that need to swap dollars for yen? And who are all the people who need to swap yen for dollars? And what are their motivations? One of the reasons that's so powerful in currencies is that when you're thinking about like Apple stock, not that many people are trading Apple

• 29:52Speaker 02

  stock for reasons that have nothing to do with Apple. Like, sure, there are some indexers, but a lot of people are thinking about Apple and the company. When you're thinking about dollar yen, the bulk of people are not thinking about it. Like when you're buying a Toyota, that is 100% not what you're thinking about. It's maybe one choice, part of your choice, whether you want a Honda or not, is how it's priced. And a little bit of that's the currency, but it's not a big part of what you're doing. You're not trying to move the dollar yen when you're buying a Honda. So for an investor, I think it's such a great market because it means that most people in the market are the opposite of professional managers. They're people living their lives, engaging in trade, buying things. And when they're doing that, they move the currency. And at the end of the day, if you know, Americans want more yen than Japanese one dollars, you get a shift in the exchange rate.

• 30:37Speaker 02

  So that makes it a really, really great asset class, I think. We try to really go through who are all the people that are doing currency transactions and why? That's probably the most important kind of perspective we have on things. And at times, those people change very rapidly. So you get something like COVID where tourism just dies, just doesn't exist anymore. And for some countries, that's a major part of how they clear their currency balance, which is usually called the balance of payments. And so balance of payments is a little bit of an academic term, but I think it's easier to think about as just, that's the academic term for, at the end of the day, if you're Turkey, how many lira are going in, how many lira are going out? Market has to clear. And if you're Turkey, people wanting to buy lira because they want a vacation in Turkey

• 31:21Speaker 02

  was actually a really big part of what happened to your currency. And then in a day, out of nowhere, no one came to Turkey anymore. It was just done. And so that's a pretty big deal. So COVID actually changed a lot of the composition of buyers and sellers in some of these currencies in terms of who was transacting in it for reasons that again, had nothing to do with currencies. The other thing that happened over the last, I don't know, 10, 15 years is you got a lot of sophistication that didn't exist before with different buyers around the world, less than in the US, thinking hard about issues of currency hedging. So people that in the past, every time they bought, for example, a US Treasury bond, they would just buy it and they'd end up with dollar exposure. Suddenly we're like, wait a minute, I can hedge this in all sorts of ways. And so you have to start thinking about what buyers were still in the market, not in the market, how they were doing the hedging, if they were hedging it through all sorts of instruments,

• 32:06Speaker 02

  who then had to hedge that. The composition of buyers and sellers and currencies is just changing a good amount. And the other thing I would say about currencies is back to this idea of it's a national kind of account of balance of payments, is you could also think about it more fundamentally as the price that you're paying to be in that country. So there's a real value concept of, if you go back to Turkey, which is easier to think about, is it cheap or expensive? If you go there, and we've all been in these situations where you go to a country and you say, wow, I could pay somebody so little to do X. Obviously, you have to adjust that to, well, is it impossible to get to their house because there's no road there? And if so, you got to pay to put it on the road. But at the end of the day, economists try to do is McDonald's index. You should be able to take similar goods and say, is this just cheaper in one

• 32:49Speaker 02

  country versus another? And then when you take that kind of starting cheap and expensive, that has a couple levers it can get adjusted by. It can get adjusted by literally the country itself changing internally. You can get tons of inflation in a country that changes the pricing of things. You can get the interest rate there luring money in or out, or it can change via the currency. So we also think about it that way in terms of how cheap or expensive is a place, how cheap or expensive is the currency? What are all the levers at play that will determine how it will shift? And then what part of that pressure go into the currency? And so if you are, for example, the UK or actually the US today, one of the really important things to know about the dollar right now is the US needs to attract money in all the time. It's

• 33:34Speaker 02

  our deficit. We need to attract money in in order to have the dollar not fall. That said, a lot of people want dollars because they're looking and saying, wow, the US companies are really attractive. There's tech revolution here and so on and so forth. So a lot of what we do when we trade currencies is both think about who those buyers and sellers are and think about what are all the levers that might clear that imbalance?

• 33:53Patrick O'Shaughnessy?

  So one of the things about the US that's so interesting now is our generally, on a relative basis, low reliance on global trade. We're a country that can produce so many things that we need ourselves. And obviously, there's been a lot of globalization and we use global labor force and maybe more and more services. But relative to a lot of countries, we don't need the global system as much as others. If you just look at like imports, exports as a percent of GDP or something. Through that lens, how should people think about the dollar? What else is interesting about it? You mentioned we need people to want dollars, but lots of people do want them. How should investors think about what the dollar is, represents, whether or not they should diversify away from it? Kind of like gold, it seems like something people just haven't thought about in a while and have taken for granted.

• 34:34Speaker 02

  The dollar is a very unique global currency because in most cases, the main use of a currency is people of that country using it. So, you know, I gave the Turkey example. No one's really looking at the lira or using it for any reason, except for people going in and out of Turkey, doing trade with Turkey. The dollar is a strange one because it is really widely used around the world. It's the world's reserve currency, as many say. So when people are saving around the world, they think of the dollar as the safe way to save. When people are borrowing around the world, especially in a country that hasn't historically had the most stable currency, they're often borrowing in dollars. So there's a lot of activity happening around the world in dollars. That means that both what happens with how freely dollars are available, if that's printing a lot of them or not, actually affects a lot of people outside the US.

• 35:19Speaker 02

  And the dollar gets affected by buyers and sellers that are not typical currency players in other cases of other currencies. I think the most important thing for investors to reflect on is just that a long-term risk to the dollar's value is that its role is disproportionate. If you just thought about it and said, look, what should that safe currency be? You wouldn't say it should only be the dollar. It should be nothing else. People in the world should only use the dollar and no other currency. And so, not surprisingly, alternatives are coming up to that, whether it's cryptocurrencies, whether it's the Chinese trying to develop their own sense of, can their currency be used? Even issues like post-Brexit, will the UK currency ever be used? I just think that we don't know exactly what the answer will be, but the idea that such a big percentage of world trade,

• 36:04Speaker 02

  capital flows, borrowing, lending will all happen in dollars, disconnected from the US, doesn't seem realistic. The US should probably, the dollar should have roughly the share, would be a little higher, of the US's size of global activity. And so, as we move towards that, that's kind of a long-term bearish pressure on the dollar.

• 36:22Patrick O'Shaughnessy?

  You mentioned that in the 70s and 80s, whether or not you hedged your currency exposure, let's say in international equities, was like a huge part of the return, good or bad. Do you think that the simplest way to think about getting exposure to currencies is to own like an unhedged global equity index? Because ultimately, you're getting exposure to companies around the world and the currency effect is sort of imputed in that index, if you wanted to simplify this?

• 36:46Speaker 02

  Yeah, I think if you're buying international equities and they're unhedged, you're holding a lot of those. But I think for most investors, the more important thing to think about is you probably have currency exposure you haven't realized that you have. And the more important question is, where do I have it? And should I hedge it? Is that a risk I want to take? People used to get compensated a lot to hold currencies of emerging countries. Now, less so, meaning the quote-unquote real interest rates are lower in those countries. And so I think it's more wise for investors to wonder where is that hiding they haven't even thought about than to seek it out? Because usually you're not getting compensated for these kinds of risks. If you're just saying, what do I want my kind of neutral spot to be? It probably shouldn't be all dollars. Your neutral spot should be a little more global.

• 37:30Speaker 02

  Often, it's going to think about gold as a currency because you can kind of say, well, I don't know exactly what currency I want to be in. I don't just want to be in the dollar. At least have something that's a stable store hold of wealth through time.

• 37:39Patrick O'Shaughnessy?

  There's two other things that maybe if we think of our conversation so far is what the world is changing to in terms of variables that matter that maybe haven't mattered as much for, let's say, the last couple of decades. There's two others that are, I think, worth exploring. The first is just the fundamental nature of equity markets. Is Robin Hood going public today or next couple of days? So kind of an appropriate time to ask the question. This big boom in retail exposure, you know, we've invested in companies that are going to allow other countries to build sort of the Robin Hood of, let's say, Turkey. That's actually a real example in this case. And then so the first is equity market fundamentals. And then the second is household balance sheets. I'll let you decide which one to take first. But I think these are also two big variables for investors

• 38:22Patrick O'Shaughnessy?

  that are changing pretty significantly or have changed in the last couple of years. And would love to hear your summary and take on each and why they matter.

• 38:29Speaker 02

  Let me take them together because I think they're actually pretty related. Because what kind of happened in the US and a lot of countries over the period of QE was that wealth got really concentrated. So wealth is getting concentrated pre QE, don't get me wrong. But the period where the main policy tool was to buy financial assets meant that most of the wealth gains were made out of people that already held some financial assets. They can benefit from the rise, which tends to be a pretty small percentage of the economy. And the reason for that was historically, it was not actually that easy to just buy stocks. There weren't necessarily tools to do that. It wasn't necessarily the culture to do it. You had a unique period of that in the US kind of tech bubble. But generally speaking, it's not like all around the world. That's how people save small amounts of money.

• 39:12Speaker 02

  And if you didn't already hold stocks, it was hard to benefit a lot over that period from stocks going up. And now, first of all, you have this huge shift to all around the world, you see household balance sheets are a lot healthier than they were pre-pandemic. And that can feel somewhat counterintuitive because obviously households had a really hard time during the pandemic. But financially, governments all around the world, and the US most extreme, tried to stop the bleeding from most of societies. I like actually splitting households to bottom 60%, top 40% because then you're saying it's more than half the economy, but you're not including any of the really upper-class households. Not just not 1%, but not even top 20%. So top, bottom 60 or bottom 80%.

• 39:54Speaker 02

  In most parts of the world, but especially in the US, governments found a way to make sure they kept getting a stream of money. So even if they couldn't work, they would get some stream of money, whether that was unemployment insurance, or in the case of the US, like they also got literal checks on top of it. And there wasn't that much to spend on, like we were all kind of stuck at home. And so the savings rates of households actually went up a lot. They were able to build up households. You see this in credit card down payments. There's this excess saving that kind of got built up over the pandemic. And then you couple that with big tech innovation that basically said, wait a minute, and Robin Hood was really one of the pioneers of this, this idea of fractional stock ownership of you don't have to be upper-class to buy a stock. I'm going to make it really easy for you. You can buy it with $10.

• 40:38Speaker 02

  You can buy it with almost no money because you can buy it fractionally. And I'm going to make it gamified. I'm going to make it fun. You can buy it on your phone. You could make it feel like you're doing it with a friend and post about it and read about it and stock tweets and all this kind of stuff. And so that's a pretty, that's leading to a pretty big change in composition about who is in the stock market, both because households have all these dollars and now there are all these tools to let them get in the game. And as an investor, you're both looking at a world where you shifted from a long decade where that extreme inequality meant that all the money was sloshing around with kind of the same people to money's moving downstream and then those people are actually using it in the stock market. So you get a stock market that can have somewhat more boom-bust cycles, individual investors

• 41:22Speaker 02

  just invest somewhat differently. And the other big trend is Robin Hood has really pioneered letting people do a lot of it through options because that's an easy way to use a very small amount of money to get a big exposure. So that really changes the structure of markets because when you or I buy an option on Robin Hood, that doesn't just sit there. Someone takes that and hedges it and there's a whole Backpipe of the financial system that handles how do you swallow up that risk? I may be putting $5 down, but we both know the risk behind that is not $5 of risk. So the infrastructure sort of has to swallow that up. So we've done a lot of work trying to study that question of what's happening since we're so obsessed with buyers and sellers? Who are all these new buyers? How are they going to behave? And what about all the ecosystem they're bringing behind them of people to deal with all the risks they're putting on like options?

• 42:05Speaker 02

  To make sure that we understand how the buyers and sellers composition is sort of changing.

• 42:10Patrick O'Shaughnessy?

  What is sort of the so what of this change? So it seems like maybe a permanent thing, right? Like there's going to be more tooling, more access, more democratization of whether it's options or equities or whatever. Like more people are going to be able to buy more stuff and do it really easily. What is the so what? Like, is it kind of like inflation where what it does is just kind of widen the spectrum of future outcomes? How do you think about where this actually will impact prices or returns in a way that's different than Robinhood not existing? Or none of these tools existing?

• 42:39Speaker 02

  It basically gives you the potential for bigger boom bust cycles. I mean, if you want to see a really extreme version of it, you can look at the Chinese equity market where most of the volume is actually individual investors. And so you do get a tendency to boom bust cycles that are bigger. And that's why Chinese policymakers that like to have a perspective on these things don't want that to stay this way. They don't like having a market that's 80% individual investors. In addition to that, you also have a world where let's call it money managers, people who are more skilled, more likely to think about this in a more broad way. Make a lot of excess returns in China relative to what they would in the United States because they're not the bulk of the market. In the US, you kind of said, let's take all the money managers and say, how much do they add value versus the market? They're going to be about zero because they are the market.

• 43:24Speaker 02

  They basically are the market. In China, they're really not the market. They're like 10% of the market and everybody else is retail. And so I'm not saying we're obviously not there yet, but that's the direction of travel or at least moving towards. It's a very different composition than it's all professional money managers. You're moving towards a direction where you have a lot of indexers and a lot of retail. In addition to that, not only is the retail behavior more likely to exacerbate boom bust cycles, but if a lot of it's done through options, depending on exactly what that mix of options is, sometimes you're going to end up positioned in a way where the process of kind of hedging those options and swallowing them up will really reinforce market moves and cause bigger boom bust cycles and sometimes not. It just depends how those options are sort of configured. And so these are just new considerations. It's not like.

• 44:09Speaker 02

  I'm telling you this, therefore you should definitely buy the stock market to sell it as much as you're going to get different dynamics. And at the end of the day, most investors are seeing signals to decide, do I want to go buy or sell and why? And it means that some of the things they used to see in the past are not going to be indicative in the same way and vice versa, when the dynamics of who's buying and selling have changed.

• 44:25Patrick O'Shaughnessy?

  I think it begs a question on valuation, because maybe the boom-bust cycle being higher peak to trough or something with more retail participation says a little bit about their valuation insensitivity, that they're often not trading on like, what's the intrinsic value of Apple? It's more just like, how much money can I make, you know, in the next week on this options contract or something? All of a sudden, you get this scenario potentially where maybe over the long term, it doesn't matter, but in the shorter term, valuation and price could really have these weird swings. So you started the conversation by talking about owning stuff that has risk premium, and you want to value that risk premium and compare it to price. How do you evolve your understanding of how to price something

• 45:07Patrick O'Shaughnessy?

  or value something in light of this changing market structure?

• 45:12Speaker 02

  I always thought about it that it's easier to think of the two independently and consider both when you're deciding to make an investment. Meaning, one of the really nice things about having a flows perspective of who are the buyers and sellers is that by definition, it's kind of fundamentally has no reason to be correlated with your value read. If I want to have a view on the market, I prefer to have multiple uncorrelated perspectives. Tell me it's a good view to have on, rather than a case where you're kind of mixed. And so I think it's great if you could have a strong independent sense of what is the value of the asset? Do I think this is an asset worth owning relative to the price? Like, what do I really believe? And then totally separately, do I think people are going to buy it rather than sell it based on flows, knowing that there's no good reason

• 45:56Speaker 02

  for those things to align? But you feel a lot better about the trade if you both like the value and think people are going to buy it. And if you're looking at and say, I love the value, but I really think a lot of selling is coming, it's not the best day to go do that trade. To me, investors should be encouraged by the possibility of having different differentiated perspectives on an asset.

• 46:15Patrick O'Shaughnessy?

  Another huge trend that I know you've thought a lot about that impacts prices directly is sustainability and ESG. I think that this went from something everyone talked about that didn't really seem to actually impact anything for a number of years to all of a sudden being absolutely central in how boards are having conversations at the company level, how policymakers are thinking about the future and what they're going to control for. It's clearly an important thing. How do you think about the role that ESG will play? Maybe give us the good, the bad, and the ugly from your perspective of how this may impact things for investors going forward?

• 46:49Speaker 02

  Well, I'll tell you my journey to it because I think that's useful in that perspective, which is first be doing my regular job, thinking if you have everything you think matters for markets as written down as you can, your job is to think, what are the new things that matter for markets that are not well captured? And before the label ESG was really crossing my mind, I realized that the environment we're in led a lot of the new important things for markets that I was working on with the big team at Bridgewater, trying to write down, systemize, understand, were things that had to do with environmental and social outcomes because of the way the world was changing. We were kind of in this interesting place. We talked about a shift to needing to use fiscal policy, for example. Fiscal policy is inherently a distributional game. You don't just say, I'm going to lower interest rates. Let's see who

• 47:34Speaker 02

  takes it. You're actually going and choosing who's going to get the money. Do I want to go build bridges? Do I want to go green buildings? Do I want to go tackle inequality? Look at the Biden plan. The whole thing is social or environmental. You can't really understand today's environment, not thinking, well, what is going to be done to address social or environmental issues? It's going to be a big part of what just drives policy landscape. Same goes for when you hear the Fed talking about these issues. What are the shortfalls in employment? They're bringing in social considerations. We started doing this research, which is hard to do, but I thought really interesting, basically saying, look, why is this happening? Well, through a lot of history, if you just looked at the stats we're used to looking at, market people. Growth, retail sales, whatever.

• 48:17Speaker 02

  If the stats look good, that was a very good proxy for people's life experience and quality of life. So you look at those stats and then if they were good, pretty much quality of life is going up. That was true for a very long time. I think it stopped being true at some point. I don't know, a decade ago, two decades ago, it stopped being true. And any measure you look at of quality of life started radically diverging with the expansion after the financial crisis being most extreme. It looked great on all financial numbers and pretty much any broader quality of life measure you pick looked really terrible. And so you get that divergence and you're going to get pressures building up to say, well, maybe that's not exactly how we should be running our economy anymore. Maybe there are issues underlying this.

• 48:58Speaker 02

  And so that became a big topic of research before I'd say the word ESG was really, I didn't even put the word on it to realize this is just things we need to be looking at, examining and thinking about whether they're important and why. So I'd say that's kind of the area of people can call it ESG, but like, why would you incorporate these things as an investor? Well, they just matter in the world right now and you'd be silly not to. And then the other thing that brought me to this is just the realization that more and more people, I'd say of different perspectives, whether it's roles, like are they running other people's money? Are they pension fund managers? Are they endowment managers? Or generations of these individual investors that are young, older, started thinking more, wait a minute, markets have had a great run, obviously. I really want to make my money in a way aligned with the kind of world I want to live in.

• 49:42Speaker 02

  And I think it became pretty clear that would become a more prominent view on things. And so I thought the intellectual question of can you do that and still have a good portfolio was really interesting. Both from a perspective of can you actually have impact as an investor or are you wasting your time? And from the engineering perspective of, well, if you just take the simplest math, if you start removing all sorts of things, you know mathematically you're making things worse. There's a mathematical answer to you remove stuff, you make stuff worse. Can you make up for that? Can you still do great? What's that like? So I think those questions really drew me into that. And I think at this point, you're in a place where a whole lot of investors around the world are increasingly saying in different words and tones,

• 50:23Speaker 02

  in different ways of emphasizing it, that they don't think their only mandate is to make as much money as possible for as little risk as possible. They see they have a mandate beyond that. It sounds different in different places and in different ages, but people see a mandate beyond that. The way of enabling that is becoming very, very important. And then they're going to start having effect on prices. I don't think they've had that much effect on prices yet. When I look at like, what are the biggest bubbles we've seen? For example, with really retail popular stocks, they don't look like the classic ESG stocks. And if you start thinking, you know, if you have a couple percent a year, people switching to think I have a mandate beyond just making money. I want to alongside making money contribute to social environmental outcomes. You can get pretty big effects on prices.

• 51:09Patrick O'Shaughnessy?

  One of the most fascinating things I came across in recent years was one of the largest institutional investors in the world, CDPQ in Quebec, evaluates all of their investing through risk, return and carbon on equal footing. So just to put an exclamation point at the end of your point, this is something that one of the largest allocators in the world has put on par. It's one of the ESG, it's the E issue, but it's on par with risk and return in their investment decision making. And it flows throughout the entire organization. So to ignore it doesn't seem to make any sense. I do think though, that there is like any trend in investing, people sprout up to supply strategies, ETFs, funds, whatever, with the letters ESG attached to them as sort of a marketing or sales strategy.

• 51:54Patrick O'Shaughnessy?

  Do you think that there's any perversions there or any signs of a, maybe bubble is too strong of a word, but anything that we should be concerned about as people sort of react to this trend?

• 52:04Speaker 02

  My prediction is that more money will move towards the type of ESG investing where you're really trying to be proactive, but where you're putting the money. That today, a lot of the things I look at and I say, look, quote unquote perverse, to use the word you're using. What they're really doing is saying, can I make as few changes as possible and qualify for ESG? Can I do as little as possible? And that's helpful for them because they're thinking about tracking errors. They're thinking about like, I just want to make this look exactly like my other thing. And people have been very successful in creating things called ESG that are really, really hard to distinguish from the original. My guess is that's going to go away. Meaning whatever they're doing will just be considered the minimum standard of incorporating

• 52:46Speaker 02

  ESG and people who actually think about it the way, for example, you gave the example of CDPQ, who are doing great work in the space, will require to say, I don't need to make it exactly the same. I actually care about impact, whether it's carbon or other types of impact, as much as I care about risk and return, so I can shift my holdings more. So I'll take the example in the equity market, which is, look, there are thousands of equities around the world, right? There are thousands of companies. You don't need to hold every single company in the world to get an exposure that looks like equities. That's just not how diversification works. The marginal benefits of diversification are pretty rapid. If anyone has ever managed a concentrated equity portfolio knows this, which is, you do not need thousands of stocks to end up having equity market exposure.

• 53:26Speaker 02

  But most ESG equity indices in the equity market look almost exactly the same and still have all those companies there. So when we started doing work, I had this challenge to my team, which I said, can we create allocation of only the 50 best stocks on environmental and social impact? Will it look just like the stock market anyway? If you're like 50, that's so little. I'm like, I'm not saying we're going to do this. Let's just see how far you can go. And the answer is you can go very far. If you're clever about engineering it, you do not need thousands of stocks. You could pick your favorites. So I believe that money will start moving in that direction of saying, instead of trying to replicate what I used to do before as closely as possible and still call it ESG, why can't I just lean in if I really think that I'm providing capital to companies I

• 54:10Speaker 02

  want to be going to a smaller number? I can do that. And that way, you take as seriously the impact part of your mission, whether it's carbon or social or broader impact mission, as the risk and the return. And it can be done because the diversification opportunities are there.

• 54:24Patrick O'Shaughnessy?

  So we've talked about, I don't know, five or six major, major things that seem to have really changed. We'll call COVID sort of the line of demarcation, not always caused by COVID, but convenient line to draw. In light of all of that stuff, what do you think about the 60-40 portfolio as a sort of baseline for how people think about allocating their money?

• 54:43Speaker 02

  I think that baseline is kind of dead in some sense. You know, it's like, the 60-40 portfolio worked because rates were not zero and growth was the dominant influence on cash flows. So you basically said, if growth pauses, if growth is good, obviously my equities are going to be great. And if growth pauses... Central banks can lower interest rates and my bonds will do well. And that's where my diversification is going to come from. And now you're in a world where you're saying, wait a minute, rates are already really, really low. I mean, look at the decline in bond yields we just had. That happened with not exactly a disaster in growth. So if you actually get a large decline in growth, how much do you think bond yields are going to fall? How much are you going to get diversification?

• 55:25Speaker 02

  And you're in a world where inflation is just more likely to become a factor for all the reasons we talked about. You don't have any inflation protection. That's all you have is equities and nominal bonds. I think investors are going to have a great need to shift out of that paradigm and stop thinking of that as a base. And investors I speak to that have some of the hardest time are ones where that's more enshrined. Because that's the benchmark you have to manage against. You have to explain every decision against that. And you're kind of stuck in this world where you're going to be comparing every decision to this a little bit arbitrary benchmark. When you're not constrained by that, I think you just think, what do I want to hold in today's environment and be diversified? You're not going to find yourself looking a lot like a 60 40.

• 56:05Patrick O'Shaughnessy?

  Maybe just list the four again that you started the conversation with, the big four factors that tend to drive returns. And then with those in mind, describe what do you think the replacement of 60 40 should be? Like if you were to design sort of a default diversified, simple portfolio for investors going forward, what does it look like in light of those four factors and how they're changing?

• 56:24Speaker 02

  So the four factors, there's how you discount the cash flows to today. The risk free rate can't control it. It's low. The risk premium, I just want to earn as much of it as possible. So I want every asset that earns a risk premium in my portfolio. And then growth and inflation, I just want my assets to be a diversified mix such that I have assets that are in risk premiums and do well when inflation goes up and when it goes down. And then the same with growth. And so when I look at that, I think, okay, if I could only have two assets in the world, I could do nothing else. I would say, give me equities and give me inflation linked bonds. And let me lever those inflation linked bonds to have about the same risk of equities. And now I'm in this kind of nice place where I have inflation linked bonds that are levered, that are going to give me half my risk.

• 57:07Speaker 02

  And so if growth is terrible and inflation is strong, I do well there. And I have equities that don't particularly pay me inflation that well, do great when growth is strong. I feel really good about that. That'd be such a great mix. Now, in practice, I could get more diversification than that. I could probably do better than that. And so I can start adding more inflationary assets. We talked about commodities. We talked about gold. That helps me handle different types of inflations that might occur. And I could add some nominal bonds because lots of people don't issue inflation-linked bonds. And so that lets me have more diversification of different places, different monetary systems. And I can handle what I'm missing on inflation from the commodity side. And I think I end up somewhere like there. And then the last thing I could do, which is a little more complicated, is I can actually go within the equity market

• 57:51Speaker 02

  and think, what is my best way of earning my best risk-adjusted returns? If I do care about impact, there's a lot of impact to be had by deciding what companies you hold there. But you can also engineer a lot of different return streams, particularly if I think that I'm lacking the inflation protection in some of these other places. I can be looking inside the equity market and I can basically not live with whatever it is the market is just giving me as the market index, which can end up being really concentrated in a couple of companies or one or two sectors.

• 58:17Patrick O'Shaughnessy?

  We've talked obviously a lot about, I love that advice, a lot about the big issues that are clearly big issues, but also ones that people are aware of. People are talking about inflation. They're talking about ESG. Are there aspects of the global market economy today that you think people really aren't talking enough about and should be thinking about more that you are?

• 58:38Speaker 02

  I find that most things that are really important, somebody is talking about. But often the people who care about one thing are really disconnected from where it matters and vice versa. You get kind of these pockets that don't listen to each other very well and are lacking a part of their worldview, a part of the universe of what matters because they haven't seen the other side. I'll give a really silly example, which is the oil market. If you talk to oil traders, they can tell you a lot about the buyers and sellers. So they know all about suppliers. They know all about OPEC psychology. They really, really understand it. But they actually know shockingly little about this huge thing going on in the world, which is that every government in the world has signed on to say we're going to phase out oil and never use it over the next 30 years.

• 59:22Speaker 02

  And basically I've said your industry is going to be obsolete, but we don't know how. And then if you talk to those guys, they often sound like climate activists and they're talking to you about all this beautiful, like we're going to make the world a better place, but they often really lack the basic understanding of what are the incentives that people involved in the oil industry? It's not like they're just going to stop drilling oil. Why would they? How is this actually possibly going to work? And so I find that like both sets of knowledge are there, but they're often not very well connected. And so people in oil often under weigh how much they have a very serious risk to governments taking this idea very more seriously and saying, wait, I signed on to this. I should really do something to actually get people to phase out of oil.

• 1:00:06Speaker 02

  And folks on the more classic ESG side often have strategies that a little bit understate what would really happen. So I'll give you an example of the last year, which is in the last year, US shale producers took a lot of supply out of the market. And so US oil production is less than it was pre-COVID. It hasn't recovered yet and a lot of it has nothing to do with anything like ESG, just they wanted to be more conservative since they had debt issues before, et cetera, et cetera. So you have people on the climate side that are like, any supply being taken out is so great, which on the margin, they don't want oil to be supplied. They want to phase away from oil. That makes sense. But what actually happened this year is it made no difference to how much oil was consumed in the world, the fact that there was less shale production, no difference at all, because you have OPEC and they have spare capacity and they want to maximize how much money

• 1:00:50Speaker 02

  they take home because that's how they fill their budget deficits. And so they basically looked at the situation and said, okay, we're going to increase supply on the other side of that and we're going to make sure the price stays at a reasonable level to avoid giving any kind of incentive for people to move away from oil. So you have this actually really important dynamic in the oil market where you can't really do much just by cutting supply. The idea of you cut supply, it just gets so expensive that people are like, I've got to move to something else. Doesn't quite work, given just who the players are. And even these US shale players, they're not in this for just the love of the environment. They're going to see oils really profitable. They might come back in. While at the same time, understanding those dynamics and how they really work tends to be somewhat

• 1:01:33Speaker 02

  underappreciated by those really trying to engineer the climate answer. And the oil side often underappreciates, okay, well, if policies do really come that make a big difference, for example, by highly taxing the oil or highly subsidizing the other side, it could make a very big difference.

• 1:01:47Patrick O'Shaughnessy?

  Just even this perspective on this one little small topic of oil makes me wonder how you personally learn about something new. You mentioned at the beginning, this like joint focus on the fundamental and the systematic or the quantitative, kind of how I think about it. When you're tackling something that you know nothing about, how have you honed that learning process? It seems like you've gotten very good at investigating something new. How has that process of learning and investigation evolved for you personally?

• 1:02:15Speaker 02

  I definitely like starting by making sure I have enough of a solid grasp of the fundamentals. And so that's just a childlike, curious, ask questions, don't afraid to appear stupid, and try to understand the very, very basics. There's a lot of topics where people are really scared to do that. If you start talking to people about, for example, we talked before about Robin Hood has more people doing options. A lot of people you talk to, it's not super fast and intuitive to them to say, oh, this is exactly how a call works. And then if you wanted to hedge it, that's what the delta would do. But they're afraid to sound stupid, so they're not really going to say that to you. But if you really want to think of that issue, you got to go really slow through the mechanics and you got to go through every Greek of the options and say, okay, how does that work? And if you were hedging it, what would you do? You got to take your time.

• 1:02:59Speaker 02

  And so take your time, build up a slow fundamental understanding, read as much as you can, talk to people and listen to people that know something about it, try to build up your base. But you're right, to make it systematic, you have to be able to go from that slow understanding you've built to say, how do you measure that? How do you go from these basic intuitive things you're learning and measure them? So what usually happens to somebody who's immersing themselves in a new topic and reading and hearing and learning is they start forming all sorts of intuitions of, okay, it kind of feels like this is what's right and this is what's wrong. But those are very gut-like intuitions. And oftentimes they're totally right and oftentimes they're totally wrong. And so that second process is, okay.

• 1:03:41Speaker 02

  Whatever my gut is today, how do I start putting that down on paper? Well, so other people can evaluate it. And that really comes down to making yourself really open to the feedback. That's a certain mindset I find of realizing right now I'm new to this. I'm putting down my gut feelings. Feedback will really help me. It'll really, really help me for people to not be scared to tell me what they think and tell me if my gut intuition sounds stupid to them. And that quantification, which helps you be able to say, well, how do I test that? And is that really right? So a lot of times you hear someone say something, you read something, it sounds really right. But if you actually look at the numbers, it's not really right. Or you're looking at it with any perspective, that number is high relative to last year, but not relative to the last decade. So I think that's sort of the steps for me.

• 1:04:23Speaker 02

  Learn slowly, really focus on fundamentals and how do things work? Try to open yourself up to a lot of feedback when you're trying to form those gut intuitions. And then try as much as you can to put it down into real numbers and measures and quantification of what you are coming up with. To be able to actually stress test it and see it across chases and also get that feedback. But it's almost like you're getting feedback from numbers and markets rather than people.

• 1:04:46Patrick O'Shaughnessy?

  In God, we trust everyone else bring data. I always loved that concept, which seems to be definitely true in your process. What have you learned about investment cultures and teams? I think that this is something where the way a team is structured, how things are digested, how decisions are made. Obviously is incredibly important, especially at the scale that you're doing it with, you know, enormous asset base. What have you learned about effectively building investment teams and sort of the variables that? We talked a lot about variables that matter in systems. Like what are the variables that matter in investment team culture and systems?

• 1:05:17Speaker 02

  I can't emphasize enough how much actually having a culture of open back and forth and feedback makes a huge difference. Because I don't think it's random that a lot of investment managers end up in silos. Meaning you have lots of portfolio managers, each run has their little pod, they do what they're doing and they're competitive with the others. It gets a lot harder to have one book and one kind of view of the world. You either do that purely by dictator, or you have to have a team that talks to each other. The biggest fear is that people just prefer to be nice, which is if you're on a big investment team and person A is like, I'm gonna start making these trades and they show you, you know, here's what I've come up with and here's my back test and whatnot. You know, they've spent

• 1:06:01Speaker 02

  a lot more time on it than you. You know, they've poured their heart and soul. They might've spent months on that thing, maybe they spent a year on that thing. And you don't want to be the person who's like, this sucks. You don't want to be that person. Everyone wants to be nice. But the problem is if you don't, then you're back in that pod structure where you don't really know what the hell that person is doing. You're just kind of saying, yeah, okay, no worries. That sounds good. Glad you're working hard on that. If you actually want to have a team that the whole team manages the AUM in some sense, even though obviously there's expertise and people develop different things, you have to have a culture where people can ruthlessly say what they think and go back and forth. To me, that has to come from a place where you really, truly believe that you're gonna get quality input, that you're better off as that person

• 1:06:42Speaker 02

  that spent a year and their heart and souls in that thing. You have to really believe these are other thoughtful people. We all want to be successful together. I know they know less than me. I know that I've spent a year on this and they haven't. This is gonna get better. My stuff is gonna improve and I'm gonna trade better. I'm gonna make more money from hearing all these people's views. So if you have that culture, that's the only way to kind of build one team that invests and not break up into the pieces. And I think most people want to be nice and it helps to have those personal relationships where both you know the person, so you know the person's trying to help you, and you have the track record of saying, I know my stuff, even if it hurts in the moment to hear tough criticism. I know my stuff just gets better when these smart people actually take the time and give a good feedback.

• 1:07:26Patrick O'Shaughnessy?

  I saved a fun topic for us for last because I know you've thought about it and are curious about it, but maybe don't know where the world's gonna go, which is cryptocurrencies. How do you personally tackle something? Like you seem like the perfect person to approach this topic, which is a big, potentially macro topic with lots of complexity and global implications and and and, maybe a role in a portfolio. You mentioned gold before. How do you begin to approach something like crypto, which I think is such a fascinating topic?

• 1:07:56Speaker 02

  I'll be totally honest, I just haven't. Like, I think the process I described should probably work, but I just personally haven't. I've seen great people start to do that process. I just don't personally think I've done it yet. I haven't spent time.

• 1:08:11Patrick O'Shaughnessy?

  How would you think about doing it? So broadly familiar with sort of what they are and the concepts. To you, what would be interesting to dive in on to begin the process of understanding how they work and what their implications might be?

• 1:08:24Speaker 02

  I'm really drawn to the question of what do regulators see as the advantages and disadvantages in them? Because I have some inkling that you have a real chance that the move to quote unquote crypto will actually be a regulated form where center banks totally control it. And therefore, in some ways, it's just easier to understand and have your mind around. And so my mind goes first to, is that thesis right or wrong? Is that something that's just likely to occur and be the way that this market goes? I don't know if that's the right intuition that I have, but I'm certainly drawn there. I'm also drawn to, if you basically think, why do I feel like I'm just not knowledgeable with the topic?

• 1:09:09Speaker 02

  A lot of it is about the foundational, how do they work from a tech perspective? And what are the advantages, disadvantages, and possibilities over time? I feel like I'd have to know that better to have more perspective on the topic. Because otherwise, you're kind of stuck in a, well, they're very volatile. And so obviously, I could tell you a lot about the role in the portfolio today, which is it's a very, very volatile assets. So I think you have to have more perspective than I possibly do on the foundational tech and on where the advantages and disadvantages might be going.

• 1:09:40Patrick O'Shaughnessy?

  One more fun closing one for you before my traditional closing question. I talked a lot about spectrums of outcomes. And obviously, I know a lot of your thinking and you and the firm's work is about you can't predict, but you can prepare. I always liked that Howard Marks line, that diversification can be really powerful. As we close and think about the spectrum of where the world could go from here, it would be fun to hear your, what I'll call like rosy and gloomy version of the world, say, 10 years from now. So you've talked about all these big variables and how things are changing. As you think about the world a decade hence, what do you think is that kind of rosy scenario? And how would you paint the story of the gloomy scenario from here?

• 1:10:17Speaker 02

  I think that something really important is happening with how people who hold capital want to align it with impact on the world. And with the mandate that governments seem to believe that they have in a world where standard of living haven't kept up with just plain economics, and they feel they have a mandate from citizens to change social and environmental outcomes. And so I think you could see a world where a lot of capital goes towards really making foundational investments in new technologies, new types of businesses, whatever it is that create better environmental and social outcomes. It's easiest to have a roadmap for that on environmental issues where you basically say,

• 1:11:02Speaker 02

  okay, you have governments agreeing to reduce carbon. You have a sense of what are the areas of technology and different types of business models that can support that. Every business feels like, wow, money's being thrown at me to transition away from carbon, whether that's rebuilding my building or redoing my factory or whatnot. We meaningfully change environmental and social outcomes. People's standards of living improve in a way they haven't, and there's sort of renewed faith and excitement about capitalism as a system that not only creates value in that invisible hand kind of way, that the best private sector solutions to problems win, but that there is more of a hand directing what are the solutions that we're trying to create? Are we trying to create solutions that solve how to create more misinformation?

• 1:11:45Speaker 02

  Or are we trying to solve a problem like inequality? And I think that there's a lot of seeds there to suggest that both governments and investors want to deploy capital and move the capitalist system in this direction. I mean, I think the gloomy one is easy to paint as well, but sad. Meaning there's a lot of hot air and discussion about solving climate change, but we're not really doing nearly enough of what's actually been announced. And there's political deadlock in lots of countries. So the kind of experiences we've had recently of bad weather becoming more lethal, a bigger part of our daily life, and a much bigger deal in terms of people's lives and livelihoods in poorer countries becomes real. The world changes in ways we can't believe, and it goes quicker than we think it's going to.

• 1:12:30Speaker 02

  And we're not even on time to handle adaptation well. That creates huge refugee flows. That makes political systems in rich countries more destabilized than they already are, which means.

• 1:12:42Speaker 02

  More disinformation, more mistrust, more of a loss of narrative for each country. Like, who are we as a polity? What are we trying to do? And that the way that the degree of inequality of so much money at the top gets solved is more violent. And you lose a lot of the value that's been created through capitalism through means that none of us hope it gets lost, which is either natural disasters or political upheavals.

• 1:13:09Patrick O'Shaughnessy?

  I like it as a closing frame because it's so important that we bend the curve towards that rosy outcome. I have so enjoyed talking to you every time that I've talked to you. I love the way your mind works. I just think it's so cool how you approach problems, are interested in the big issues, think probabilistically. It's been so fun doing this with you here today. I ask everybody the same traditional closing question. What is the kindest thing that anyone's ever done for you?

• 1:13:34Speaker 02

  I feel like it's almost cliche, but I really feel that Ray, Bob and Greg, who are kind of sort of founders, the fact that they were never afraid, ever that they would like quote unquote, hurt my feelings. And from day one, were willing to spend the time. And I think in some ways, when you're new in this, spending the time to mentor someone is the kindest thing you can do for someone. Spend the time, but also say it like it is, give me really harsh feedback and honestly continuously push me into harder and harder jobs. They saw me as a lot more capable faster than I ever saw myself. I think that is the kindest thing, set of things you can do for someone.

• 1:14:19Speaker 02

  Spend the time, mentor them, give them real feedback and see the potential in them they don't even see in themselves yet.

• 1:14:26Patrick O'Shaughnessy?

  It's amazing to me how often the answer to this question is some flavor of that, of betting on someone, giving someone early on the confidence that maybe they don't yet have, investing in them when you don't need to. Hopefully everyone listening like gets the impetus to go do that for somebody else. It's not an easy thing to do, so we shouldn't take it for granted. There's a reason that's always the answer. But I love it as a closing thought. Karen, this has been such a pleasure. Thank you so much for your time.

• 1:14:50Speaker 02

  Thank you so much for having me, Patrick.

• 1:14:52Patrick O'Shaughnessy?

  This episode is brought to you by Tegus. In this five-part mini-series, I sit down with Ben Clermont, a Principal Portfolio Manager at Cove Street Capital, to talk about Cove Street's investing process and how Tegus differs from other expert networks. In this week's episode, Ben and I discuss Cove Street's history and the lessons Ben learned from transcribing the Berkshire shareholder meetings. So Ben, maybe you can begin by just giving us an overview of Cove Street itself. What does the firm do? What does it focus on? Once you describe the firm, I'd love to also hear your backstory.

• 1:15:22Speaker 03

  Yeah. So Cove Street was founded almost exactly 10 years ago. And the starting principle was, and from the very beginning, to be a concentrated value manager focused on public equities in the US and take a three to five-year time horizon on all our ideas, do a lot of due diligence on our ideas, kind of the Buffett punch card of 20 ideas, where you concentrate on your best ideas and you don't take too many swings. It's been a fun ride over the last 10 years. We've enjoyed value being, let me put it this way, not particularly well, performance and value not being particularly good. And the other thing is we've seen the headwind of passive taking share from active. But aside from that,

• 1:16:07Speaker 03

  it's been an incredible journey for myself. I started in the commercial real estate business. I went to a school, a bit undergraduate business school, but didn't pay a whole lot of attention in my finance classes because I was focused on real estate. And so it was after a few years of working in the commercial real estate business where I got handed a copy of Ben Graham's book, Intelligent Investor, and that really changed my life and it changed the trajectory of my career path. And you know, it's cliche to some degree, but since then, I've been tap dancing to work because I love investing and I love learning about companies. I love talking to management teams. I love the competitive aspect of trying to beat a very difficult market. So went to business school after working on the buy side for a little bit, started a blog called The Inoculated Investor,

• 1:16:51Speaker 03

  which was my way to stay in the game while I was in business school. And I was lucky enough through the blog to get connected to our founder, who was leaving another firm to found this one. And so it was a really seamless transition where that firm was sold and my boss basically spun off with a track record and some assets and hired two analysts. He wanted to have fresh eyes on the portfolio. And that way of thinking, that philosophy of... Hey, I want two new people to come in and rip my portfolio apart. Tell me what I shouldn't own. Just give a fresh look at everything we own. That really translates to our current process today.

• 1:17:31Patrick O'Shaughnessy?

  Can you say a little bit about the experience of transcribing all the Buffett stuff in the early days before that was freely available online and why you did that and what it taught you?

• 1:17:40Speaker 03

  The first thing it taught me is that you should use a computer because the first year in 2009, when I did it, I did it by hand and my hand was literally about to fall off. Why did I do it? I have a passion for investing and I had this sense that there are a lot of smart people investing. There are a lot of very articulate people who are investing and there are a lot of people with a lot more experience than me. And so to be able to, I knew that after business school, I was going to need to find a job on the buy side because that's really what I wanted to do. And I had this sense that if you did something that no one else was willing to do, you could really stand out.

• 1:18:22Speaker 03

  And I just thought that it was a shame in a lot of ways that there was no transcript for the Berkshire meetings. And I'll just be honest with you, I don't know that I have that many talents, but I learned through that process that I had the ability to listen, process and transcribe at a really fast rate. So really what I learned is that hard work and being willing to do something a little nutty can be really beneficial for your career. I'm going to give a keynote at a conference and the topic of the conversation is 10 lessons from 10 years. And one of the 10 lessons is be willing to be a little bit nutty to move forward in your career. And so that was a good lesson for me.

• 1:19:01Patrick O'Shaughnessy?

  If you enjoyed this episode, check out joincolossus.com. There you'll find every episode of this podcast complete with transcripts, show notes and resources to keep learning. You can also sign up for our newsletter, Colossus Weekly, where we condense episodes to the big ideas, quotations and more, as well as share the best content we find on the internet every week.