WEBVTT - What Investors Should Know About The Correlation Between Bonds And Stocks 0:00:10.440 --> 0:00:14.040 Hello, and welcome to another edition of the Odd Thoughts Podcast. 0:00:14.120 --> 0:00:18.720 I'm Tracy Hallaway and I'm Joe Wisenthal. So, Joe, I 0:00:18.800 --> 0:00:22.160 think you're going to enjoy today's episode because we're going 0:00:22.239 --> 0:00:26.440 to talk about one of the most intractable, most difficult 0:00:26.720 --> 0:00:30.760 problems in all of finance and investing. It starts with 0:00:30.840 --> 0:00:34.720 the ce Do you know where I'm going? Yeah. If 0:00:34.760 --> 0:00:36.720 you hadn't told me it was going to start with 0:00:36.800 --> 0:00:40.680 the CEA, then my mind was not. I didn't totally 0:00:40.720 --> 0:00:43.160 know what you were about to say, But I think 0:00:43.200 --> 0:00:46.680 I'm pretty sure with that letter hint. Okay, So I 0:00:46.760 --> 0:00:49.400 just gave it away, which wasn't my intention. But today 0:00:49.440 --> 0:00:54.160 we're going to talk about correlations. Uh. And correlations historically 0:00:54.200 --> 0:00:59.080 have been quite difficult for banks and investors to model. 0:00:59.200 --> 0:01:02.800 And there's one correlation in particular. It's sort of the 0:01:02.840 --> 0:01:05.360 grand daddy of them all, and it tends to underpin 0:01:05.600 --> 0:01:08.560 a lot of investing. And over the past few years, 0:01:08.600 --> 0:01:11.839 we've seen more and more people start to question whether 0:01:12.080 --> 0:01:15.480 or not it actually exists in the way that we 0:01:15.520 --> 0:01:17.959 think it does, and whether or not that correlation, that 0:01:18.040 --> 0:01:22.319 particular relationship is going to hold true in the future 0:01:22.440 --> 0:01:24.920 and now I definitely know that you know what I'm 0:01:24.920 --> 0:01:28.800 talking about. Right. Of course, a lot of people have 0:01:29.000 --> 0:01:34.720 portfolios consisting of some slug of equities which are perceived 0:01:34.720 --> 0:01:39.360 as being risky assets, and some chunk of safety assets 0:01:39.400 --> 0:01:42.760 like bonds, and over the long uh, well, over the 0:01:42.800 --> 0:01:45.600 short term, you sort of expect them to move in 0:01:45.680 --> 0:01:49.200 opposite directions, and so on days when people are scared, 0:01:49.240 --> 0:01:52.600 your safety ssets rise and your risky ssets fall, and 0:01:52.880 --> 0:01:58.040 vice versa on bullish days. But none of this is guaranteed. Basically, 0:01:58.080 --> 0:02:01.120 just because for some period of time two different assets 0:02:01.120 --> 0:02:05.240 may have behaved and had some relationship does not necessarily 0:02:05.280 --> 0:02:09.920 mean that that relationship will persist forever. And hence a 0:02:09.960 --> 0:02:13.639 good portfolio is not a easy thing to achieve. Right, 0:02:13.720 --> 0:02:16.320 So you think about a standard portfolio, and the thing 0:02:16.360 --> 0:02:19.959 that usually comes up is sixty forty, right, that particular 0:02:20.000 --> 0:02:22.640 breakdown between bonds and equities. It's supposed to be a 0:02:22.680 --> 0:02:26.239 diversification play. The two asset classes are supposed to move 0:02:26.320 --> 0:02:29.560 in different directions. But we have actually seen a couple 0:02:29.560 --> 0:02:32.440 of times this year where they didn't do that, where 0:02:32.639 --> 0:02:35.760 bonds and stocks fell in tandem, And of course a 0:02:35.800 --> 0:02:38.760 bunch of people started asking whether or not this was 0:02:38.800 --> 0:02:42.840 the start of a historic break in that relationship. So again, 0:02:42.960 --> 0:02:46.840 this is probably one of the most important correlations in 0:02:46.880 --> 0:02:51.400 all of modern investing. Early February we saw that where 0:02:51.400 --> 0:02:54.560 we saw stocks and bonds get sold off together and 0:02:54.680 --> 0:03:00.800 basically people who thought of themselves as being prudent diversified 0:03:01.000 --> 0:03:04.200 investors were left with nowhere to hide. It was just 0:03:04.320 --> 0:03:07.640 right across the board. Since then, things have mellowed out 0:03:07.840 --> 0:03:11.160 and diversified investors have done a little bit better, but 0:03:11.280 --> 0:03:13.600 it did. It does make you wonder whether that was 0:03:13.720 --> 0:03:17.280 a warning or at least a message there. Just because 0:03:17.360 --> 0:03:21.359 you are seemingly diversified does not mean that some part 0:03:21.400 --> 0:03:24.280 of your portfolio is always going to work or heade 0:03:24.280 --> 0:03:28.080 against the other parts. Absolutely, So we are going to 0:03:28.120 --> 0:03:32.080 dig into both those concepts, correlation and diversification, and we 0:03:32.120 --> 0:03:34.520 have the perfect person who's going to talk about it 0:03:34.520 --> 0:03:36.880 with us, a guy that's been doing a lot of 0:03:36.880 --> 0:03:41.040 research on this exact topic. His name is for Ruke Javraj. 0:03:41.160 --> 0:03:44.600 He his head of investment Strategies research over at Barclay's. 0:03:54.240 --> 0:03:57.200 For Ruth, thanks so much for joining us, Thanks for 0:03:57.240 --> 0:04:00.600 the invitation. So did we get it right? In our intro, 0:04:00.960 --> 0:04:05.960 is correlation that difficult for people to model? Is it 0:04:06.120 --> 0:04:11.200 a sort of ongoing intractable issue in finance? That's exactly right. 0:04:11.280 --> 0:04:15.720 I mean, fundamentally, correlation, irrespective of where you're measuring and 0:04:15.760 --> 0:04:20.520 across asset classes or across stocks, et cetera, is time varying, 0:04:20.680 --> 0:04:24.559 and I think we're all very familiar with the fact 0:04:25.000 --> 0:04:30.640 now that it varies through time. Historically, there was an 0:04:30.640 --> 0:04:34.680 opinion about in particular, between the correlation of stocks and bonds, 0:04:34.720 --> 0:04:38.279 that they were positively correlated, and over the long run, 0:04:38.360 --> 0:04:41.560 depending upon the sample of data that you're using, you 0:04:41.720 --> 0:04:45.040 can't find that they were positively correlated during certain periods. 0:04:45.080 --> 0:04:48.360 But you know, post then there was almost a structural 0:04:48.400 --> 0:04:52.560 break between the relationships of stocks and bonds and they 0:04:52.600 --> 0:04:57.280 became more negatively correlated. Bonds were seen as almost flight 0:04:57.360 --> 0:05:02.120 to quality asset when risk was off the table. And 0:05:02.160 --> 0:05:06.560 so ultimately we are seeing that there's more variation in 0:05:06.560 --> 0:05:10.400 that correlation number through time, which means that it's harder 0:05:10.440 --> 0:05:14.760 to model, it's more difficult as an input into your 0:05:14.800 --> 0:05:19.719 portfolio construction methods, and there's because of the increase in 0:05:19.760 --> 0:05:23.159 the market participation, so there's more investors who are trading 0:05:23.160 --> 0:05:26.200 stocks and bonds in the market, from institutional through to 0:05:26.279 --> 0:05:30.600 retail investors, there's just more noise around estimating this correlation, 0:05:31.120 --> 0:05:34.159 and so it's a becoming an even more sensitive parameter. 0:05:34.200 --> 0:05:37.520 I would say, in particular, as you mentioned, between stocks 0:05:37.520 --> 0:05:39.960 and bonds. I want to go back a little bit 0:05:40.040 --> 0:05:43.839 because diversification within a portfolio is one of these mantras 0:05:43.880 --> 0:05:45.960 you always hear, but you always hear it's like, oh, 0:05:46.000 --> 0:05:49.760 you should be diversified. Maybe some people know what that 0:05:49.920 --> 0:05:54.440 means to be diversified, others don't. It's a fairly modern concept, 0:05:54.560 --> 0:05:58.040 isn't it. This idea of diversification in the last several decades, 0:05:58.279 --> 0:06:03.400 and this idea of having portfolios with distinctly different behaving 0:06:03.560 --> 0:06:07.839 asset classes has not always been something that the investment 0:06:07.880 --> 0:06:11.640 community understood. I think that's a fair assessment. I wouldn't 0:06:11.640 --> 0:06:16.240 say diversification is a modern concept. I think at least 0:06:16.240 --> 0:06:18.560 I've come from a very academic background, having done my 0:06:18.640 --> 0:06:21.120 PhD in the topic of stop one correlation, by the way, 0:06:21.160 --> 0:06:23.640 so this is the subject that is very close to 0:06:23.720 --> 0:06:29.400 my heart, and ever since returns, risk and the relationship 0:06:29.480 --> 0:06:33.360 between assets have been looked at by the academic community. 0:06:33.839 --> 0:06:36.400 The principles of diversification have been well known from a 0:06:36.440 --> 0:06:39.280 theoretical perspective. I should say, when I met Madern, I 0:06:39.320 --> 0:06:45.039 met like the last sixty yeah since yeah, okay, so 0:06:45.160 --> 0:06:51.440 not so. Modern investing has been around for hundreds, but 0:06:51.480 --> 0:06:53.880 it's really only since the mid nineteen hundreds that people 0:06:53.960 --> 0:06:57.120 have rigorously approached this idea of what it means to 0:06:57.200 --> 0:06:59.680 have a diversified part. That's true, and it's become more 0:06:59.720 --> 0:07:02.760 in focus, you know, as of the last you know, 0:07:02.920 --> 0:07:08.000 several decades. In particular, for instance, commodities is being seen 0:07:08.120 --> 0:07:11.400 as an asset class which can truly diversify your stocks, 0:07:11.480 --> 0:07:15.920 your bonds, your f X exposure, mainly because it just 0:07:16.040 --> 0:07:19.280 operates in a completely different way to the traditional asset classes. 0:07:19.360 --> 0:07:24.040 So I mean, diversification as a concept is very well 0:07:24.120 --> 0:07:26.520 understood and intuitive. Of course, you want to know, not 0:07:26.600 --> 0:07:29.800 put all of your eggs in one basket, but how 0:07:29.920 --> 0:07:32.800 do you go about doing that is the crux of 0:07:32.840 --> 0:07:36.200 the problem, and correlations are very much at the focus 0:07:36.280 --> 0:07:38.320 of how one goes about doing that and the course 0:07:38.360 --> 0:07:40.600 of that estimation or trying to get it right. In 0:07:40.760 --> 0:07:45.160 terms of forecasting, correlations is the most important question, and 0:07:45.200 --> 0:07:48.160 that's that's really where the crux of the issue is. 0:07:48.280 --> 0:07:51.640 I e. You know, historically we can look at the 0:07:51.680 --> 0:07:55.280 realized correlation between asset classes depending upon how we look 0:07:55.280 --> 0:07:57.720 at the data, and we can see that at various 0:07:57.720 --> 0:08:01.120 three time. But does that mean what we're inferring from 0:08:01.240 --> 0:08:04.400 history is going to apply going forward. So there is 0:08:04.440 --> 0:08:09.280 a kind of mismatch between realized and then expected future correlations, 0:08:09.400 --> 0:08:12.560 and that is, you know, where most of the research 0:08:12.640 --> 0:08:17.040 currently exists in trying to really forecast what those correlations are. 0:08:17.800 --> 0:08:20.360 So I have a variation of Joe's question before we 0:08:20.400 --> 0:08:26.440 dig into forecasting correlation, but why did the bondstock split 0:08:26.560 --> 0:08:31.960 or bondstocks diversification become the sort of standard portfolio model, 0:08:32.000 --> 0:08:34.319 Like why didn't we have people say I'm going to 0:08:34.400 --> 0:08:40.840 have stocks and commodities of some sort for instance. Yeah, 0:08:40.960 --> 0:08:42.760 I mean it's a good question. But stocks and stocks 0:08:42.760 --> 0:08:46.760 and bonds are the two fundamental asset classes that investors 0:08:47.160 --> 0:08:51.120 used to use in order to manage their assets and 0:08:51.160 --> 0:08:55.880 have growth on over time. So stocks are clearly obvious 0:08:55.960 --> 0:08:58.920 people are looking to participate in the growth of corporate 0:08:58.920 --> 0:09:03.200 profits and related economies, and bonds is because that's the 0:09:03.240 --> 0:09:06.280 other side of the financing equation stocks is equities, bonds 0:09:06.400 --> 0:09:09.280 is in essence, you know, you're lending money for either 0:09:09.360 --> 0:09:13.679 government or companies to use it to invest in capex projects. 0:09:14.000 --> 0:09:16.839 And so there are two sides of the of the 0:09:17.000 --> 0:09:19.600 you know, I would say investing coin and those are 0:09:19.600 --> 0:09:24.040 the two fundamental sides, and they're linked intrinsically by ultimately 0:09:24.120 --> 0:09:28.720 you know, macroeconomics um and what economies together with sectors 0:09:29.280 --> 0:09:31.360 and regions are doing. And so that's why stocks and 0:09:31.360 --> 0:09:34.640 bonds were looked at as the first asset classes to 0:09:34.640 --> 0:09:38.480 combine together. You mentioned that in more recent times there's 0:09:38.480 --> 0:09:40.960 been a lot of interest in commodities as a source 0:09:40.960 --> 0:09:45.480 of portfolio diversification. What is your view on that, because 0:09:45.600 --> 0:09:50.600 in addition to sort of being uncorrelated as a key 0:09:50.600 --> 0:09:54.040 preconditioned to adding from positive diversification, you also have to 0:09:54.080 --> 0:09:57.040 have some sort of positive expected return because you could 0:09:57.040 --> 0:10:01.959 add a source of uncorrelation like say betting on baseball games, 0:10:02.120 --> 0:10:05.080 which won't be tied to the background economy, but that's 0:10:05.080 --> 0:10:07.679 probably going to be a dragon your portfolio if you're 0:10:07.920 --> 0:10:12.400 average gambler. So in your view, do commodities fit the 0:10:12.400 --> 0:10:16.480 bill where either sufficially uncorrelated and be you can assume 0:10:16.559 --> 0:10:20.040 that they will add money to your portfolio over some 0:10:20.120 --> 0:10:23.240 period of time. Yeah, So I mean that's a good question. 0:10:23.320 --> 0:10:27.720 Commodities is a very i would say interesting asset class 0:10:27.880 --> 0:10:33.600 because it evolves basically based upon the applied demand dynamics 0:10:34.200 --> 0:10:40.560 of individual commodities that are being produced, and so it's 0:10:40.640 --> 0:10:47.000 almost operates independently because as individuals and societies, we actually 0:10:47.040 --> 0:10:52.080 have a demand and let's say natural resources, gas oil, 0:10:52.240 --> 0:10:56.000 et cetera. And you know that's almost separate from how 0:10:56.360 --> 0:11:00.920 participants or individuals interact with financial markets. So you have 0:11:00.960 --> 0:11:06.720 these two different segments of society that people are looking 0:11:06.800 --> 0:11:11.800 or investing or consuming, and in essence they're not intrinsically linked. 0:11:12.280 --> 0:11:15.160 Now they've become more so through time as people have 0:11:15.360 --> 0:11:18.760 looked more to commodities markets to include into their portfolios, 0:11:19.360 --> 0:11:22.200 as you can imagine. But that's initially why there was 0:11:22.200 --> 0:11:25.600 a motivation to include it. But you know, as of 0:11:25.640 --> 0:11:28.360 the last let's say, you know, five to seven years, 0:11:28.480 --> 0:11:32.280 our commodities as in focus as they were the last 0:11:33.000 --> 0:11:35.560 twenty years. No, and that's mainly because we saw the 0:11:35.559 --> 0:11:38.959 big commodity rise and then crash and as subsequent kind 0:11:38.960 --> 0:11:43.360 of For instance, the relationship with gold and oil after 0:11:43.440 --> 0:11:46.960 the global financial crisis has meant their investors haven't naturally 0:11:47.040 --> 0:11:49.280 used them in the ways that they have done historically. 0:11:50.000 --> 0:11:52.520 So it's a very interesting asset class that you know 0:11:52.760 --> 0:11:57.559 involves almost independently of others, whereas things like credit, for instance, 0:11:57.559 --> 0:12:02.000 are very much equity like and so those are kind 0:12:02.000 --> 0:12:04.920 of seen, as I would say, another way to achieve 0:12:04.960 --> 0:12:09.040 equity light returns. But the average returns historically have been 0:12:09.120 --> 0:12:12.600 higher in certain regions, and so that's why, you know, 0:12:12.679 --> 0:12:15.560 commodities were seen as kind as outlier that could be 0:12:15.559 --> 0:12:19.600 included in the portfolio for diversification. Right. I just got 0:12:19.600 --> 0:12:22.480 a flashback to a circa two thousand nine when we 0:12:22.520 --> 0:12:26.480 had a bunch of commodities funds launching that specifically were 0:12:26.480 --> 0:12:30.640 aimed at providing uncorrelated returns for investors. But of course 0:12:31.320 --> 0:12:34.760 those uncorrelated returns turned out to be negative and a 0:12:34.800 --> 0:12:39.000 bunch of them closed shop soon after. Moving on to 0:12:39.360 --> 0:12:44.839 the bigger question what we're discussing earlier, why does correlation 0:12:45.240 --> 0:12:49.040 tend to vary over time? What are the prevailing theories? 0:12:49.840 --> 0:12:52.680 What I will say is that from my perspective in 0:12:52.720 --> 0:12:55.559 the research that I've done. There are almost two different 0:12:56.080 --> 0:12:59.679 forces at work, the first being kind of a Macari 0:12:59.800 --> 0:13:03.400 kind of story. So, in fact, one of my first 0:13:03.880 --> 0:13:08.080 papers for my PhD was looking at the time variation 0:13:08.200 --> 0:13:14.000 between the correlation of stocks and bonds using macroeconomic variables, 0:13:14.040 --> 0:13:15.960 and I did it in a very theoretical way to 0:13:16.040 --> 0:13:20.080 show that you know, through time there are kind of 0:13:20.480 --> 0:13:25.480 new information on cash flows two companies, interest rates, and 0:13:25.800 --> 0:13:28.839 the kind of risk premium i e. You know, what 0:13:28.920 --> 0:13:31.480 return should be delivered for the risk that you're being 0:13:31.520 --> 0:13:35.760 exposed to. That cause for the change in the relationship 0:13:35.840 --> 0:13:40.360 between stocks and bonds, and these macroeconomic forces, together with 0:13:40.440 --> 0:13:46.120 interest rates and inflation, cause the variation to to really 0:13:46.280 --> 0:13:51.360 change through time. Now that's one side of the story. 0:13:51.800 --> 0:13:55.000 The second is more of a kind of more pragmatic 0:13:55.120 --> 0:13:59.240 market practitioner approach. And this is what I was alluding 0:13:59.240 --> 0:14:01.640 to earlier in that, you know, I would say pre 0:14:02.240 --> 0:14:05.520 eighties the way the investors interacted with markets is very 0:14:05.520 --> 0:14:11.880 different from posties and nineties, where almost financial markets were 0:14:11.920 --> 0:14:17.480 opened up to everyone, retail investors, mom and pop investors 0:14:17.480 --> 0:14:20.560 on the street, et cetera. Through the creation of et 0:14:20.720 --> 0:14:24.960 F vehicles and so now the way that market participants 0:14:25.040 --> 0:14:27.680 interact with markets is very different from what it was 0:14:27.920 --> 0:14:32.160 thirty fourty years ago, where it's mainly institutionally driven, and 0:14:32.200 --> 0:14:35.920 as such that is causing a change in the relationship. So, 0:14:35.960 --> 0:14:39.680 as you mentioned earlier in February of this year, you know, 0:14:39.720 --> 0:14:41.960 we saw the stocks and bombs sold off at the 0:14:42.000 --> 0:14:44.840 same time. Now, that's a very short time frame to 0:14:44.960 --> 0:14:48.920 evaluate the relationship. But the point being is it happened 0:14:49.400 --> 0:14:52.520 we've observed that in practice. Now would we have seen 0:14:52.560 --> 0:14:56.360 that dynamic if people weren't actively trading the market so 0:14:56.400 --> 0:15:00.560 frequently as they are now, Perhaps not. But point being 0:15:00.680 --> 0:15:03.239 is there are these two forces at work, the macroeconomic 0:15:03.280 --> 0:15:07.000 story as well as the kind of market participants story. Yeah, 0:15:07.160 --> 0:15:10.200 I feel like this market participation story and the ease 0:15:10.280 --> 0:15:13.720 with which people can access these asset classes is probably 0:15:13.760 --> 0:15:16.480 something we don't discuss enough when thinking about big trends. 0:15:17.000 --> 0:15:21.280 I'm thinking about how a lot of big institutions, some 0:15:21.360 --> 0:15:24.360 of the college endowments, they've been very big into by 0:15:24.480 --> 0:15:28.920 forestry and timberland as basically another asset class that could 0:15:28.960 --> 0:15:32.960 be offered diversification. But if I can access the same 0:15:33.000 --> 0:15:35.080 thing now, you know, at one point I imagine people 0:15:35.120 --> 0:15:38.000 had to take flights all around the world to inspect 0:15:38.040 --> 0:15:41.240 a forest and actually sort of make a deal with 0:15:41.320 --> 0:15:44.240 someone about whether they would get some royalties. Now, I 0:15:44.240 --> 0:15:47.920 could probably just go onto my brokerage account and invested 0:15:48.000 --> 0:15:51.880 some forestry e t F and if in February of 0:15:51.960 --> 0:15:55.120 this year I'm panicking and worried, I'll just sell that 0:15:55.360 --> 0:15:58.040 along with my stocks and my bonds because I need 0:15:58.080 --> 0:16:02.360 to pay my bills. That's a pretty fundamental change in 0:16:02.480 --> 0:16:04.960 the sort of flows in and out of this market. Yeah, 0:16:05.000 --> 0:16:07.680 that's right. I mean that's a function of financial innovation. 0:16:07.960 --> 0:16:10.800 So you have more people looking at creating products linked 0:16:10.840 --> 0:16:13.520 to things that perhaps are liquid, like forestry or even 0:16:13.560 --> 0:16:18.520 private equity, And you're right, that ultimately changes the dynamic somewhat. 0:16:18.560 --> 0:16:22.720 It creates this perception of, you know, something's happening in 0:16:22.760 --> 0:16:25.400 the forestry market or the private equity market that we 0:16:25.440 --> 0:16:28.240 can observe from market variables like an e t F 0:16:28.280 --> 0:16:31.600 there is linked to a index that is used to 0:16:31.640 --> 0:16:35.720 try and replicate the exposure to forestry of privorate equity. 0:16:36.040 --> 0:16:38.680 But you know, is it genuine, is it true? You know, 0:16:39.040 --> 0:16:42.760 is it really linked to the underlying fundamentals of that 0:16:43.000 --> 0:16:47.880 particular asset class quote unquote asset class, and so, you know, 0:16:48.000 --> 0:16:52.640 it does change the way that investors think and ultimately 0:16:52.680 --> 0:16:56.280 add exposures into their portfolio. Certainly, so it sounds like 0:16:56.320 --> 0:16:58.760 we're saying that because of the way that the market 0:16:58.840 --> 0:17:02.920 has evolved and developed, that correlation regimes have the potential 0:17:03.120 --> 0:17:07.479 to change more quickly than they had in the past. 0:17:08.000 --> 0:17:10.959 But you still kind of needed a trigger in the 0:17:11.040 --> 0:17:14.600 form of, I guess, a change in the macroeconomic environment. 0:17:15.080 --> 0:17:18.800 So what should we be looking out for when it 0:17:18.840 --> 0:17:21.720 comes to, you know, those sorts of triggers in the 0:17:21.760 --> 0:17:25.520 correlation regime? What have you found to be most valuable? 0:17:26.240 --> 0:17:29.280 The first thing to say, and it's said by pretty 0:17:29.359 --> 0:17:33.520 much everyone, correlation is not causation. And that's why I 0:17:33.560 --> 0:17:36.000 alluded to the fact that the you know, in my view, 0:17:36.040 --> 0:17:38.320 there are these two forces at work, the macro story 0:17:38.359 --> 0:17:41.400 as well as the kind of market story, which are 0:17:41.440 --> 0:17:45.520 the causation reasons for why we see correlation changing through 0:17:45.560 --> 0:17:49.160 time and how they interact is obviously a very complicated 0:17:49.200 --> 0:17:53.119 and interesting thing to observe. But you know, what should 0:17:53.160 --> 0:17:56.000 we be looking for? That's a good question. I think 0:17:56.840 --> 0:18:01.679 ultimately this is certainly probably informed with the work that 0:18:01.760 --> 0:18:05.160 I've done with Bob Shiller, who's one of our partners 0:18:05.160 --> 0:18:09.600 on the Barclays COS platform, in that the more data 0:18:09.800 --> 0:18:13.960 that you have, the better. I mean, his research work 0:18:13.960 --> 0:18:16.360 with John Campbell goes back to the eight hundreds where 0:18:16.359 --> 0:18:19.800 he has a data serve SMP back to seventy one, 0:18:20.520 --> 0:18:23.639 and I'm a big believer now that we should obtain 0:18:23.800 --> 0:18:28.440 as much data as possible because then we can almost 0:18:28.440 --> 0:18:33.040 infer structural relationships between asset classes where we have that data. 0:18:34.080 --> 0:18:37.440 And as such, if we are then able to monitor 0:18:38.280 --> 0:18:42.120 correlation through time on a real time basis. Now because 0:18:42.160 --> 0:18:45.080 we have daily observations or intra day observations, we can 0:18:45.080 --> 0:18:48.879 see if there are structural dislocations versus what we've observed 0:18:48.920 --> 0:18:53.800 in the past. If we observe that, okay, it's a flag, 0:18:54.320 --> 0:18:56.720 and then we start to look closer at well, why 0:18:56.800 --> 0:18:59.400 is that happening? And if we can justify it from 0:18:59.400 --> 0:19:03.640 a macrec normic perspective or a market participant perspective, then 0:19:03.680 --> 0:19:06.119 I think we can be comfortable about the changes and 0:19:06.160 --> 0:19:09.959 the volatility in the correlation numbers that we're seeing, and 0:19:10.000 --> 0:19:12.919 as such, it then is still a very good and 0:19:12.960 --> 0:19:17.639 fundamental input into our portfolio construction techniques, if you will. So, 0:19:17.680 --> 0:19:22.639 I think knowing well or feeling that we understand what 0:19:22.760 --> 0:19:27.679 the relationship has been between assets historically and trying to 0:19:27.760 --> 0:19:31.399 justify why we're seeing changes now is the big part 0:19:31.480 --> 0:19:34.359 of our kind of the challenges that we have for 0:19:34.400 --> 0:19:37.560 the investing space, and that's how I would approach that 0:19:37.640 --> 0:19:41.119 particular problem. So in light of that, going back to 0:19:41.320 --> 0:19:46.239 the starks bonds portfolio correlations, it's been really nice for 0:19:46.480 --> 0:19:51.320 investors that inflation has generally been on the decline for 0:19:51.359 --> 0:19:55.560 almost forty years because a starks have gone up, but 0:19:55.960 --> 0:19:58.720 disinflation is just good for bonds, and bond has become 0:19:58.760 --> 0:20:03.520 more valuable as flation goes down. In light of the 0:20:03.640 --> 0:20:07.000 longer term data that you've looked at, how much is 0:20:07.040 --> 0:20:10.960 the durability of this portfolio and the strength of say 0:20:11.040 --> 0:20:14.760 sixty forty portfolio, how much is it a function of 0:20:14.800 --> 0:20:18.560 this very banangn macro environment that we've seen. Ultimately, the 0:20:18.600 --> 0:20:23.360 sixty forty portfolios designed where it was suggested as a 0:20:23.440 --> 0:20:28.600 route to diversify equity risk into fixed income risk, and 0:20:29.800 --> 0:20:34.000 inflation eats ultimately at the real returns that you earn 0:20:34.080 --> 0:20:37.480 on your portfolio. And so generally the portfolio has helped 0:20:37.840 --> 0:20:41.919 by inflation coming down through time. So that's obviously a 0:20:41.960 --> 0:20:46.080 benefit to the end investor in that particular respect, but 0:20:46.160 --> 0:20:50.399 also inflation, arguably it is the super interesting variable because 0:20:51.359 --> 0:20:54.840 at least from my perspective, it's managed far more closely 0:20:54.920 --> 0:20:57.680 now than it has been done historically. If you think 0:20:57.720 --> 0:21:02.120 about central banks, pretty much, they have an inflation target 0:21:02.600 --> 0:21:06.520 and everything revolves around hitting that target these days, and 0:21:06.560 --> 0:21:09.080 they use all of their tools at their disposal to 0:21:09.160 --> 0:21:13.160 try and do that. And so you know, going back 0:21:13.200 --> 0:21:15.080 to a place where you know we're going to have, 0:21:15.359 --> 0:21:19.199 you know, these high inflation numbers I think is I mean, 0:21:19.240 --> 0:21:24.480 it's always possible, given especially given the period of quantity 0:21:24.480 --> 0:21:27.400 of easing that we've gone through in the developed economies, 0:21:28.160 --> 0:21:30.800 but you know, there's so many other forces at work 0:21:30.880 --> 0:21:34.240 these days, then I'm not sure we will end up 0:21:34.680 --> 0:21:38.159 going back to those levels. And so that's something that 0:21:38.280 --> 0:21:41.520 is of I would say a good thing for the 0:21:41.600 --> 0:21:45.280 end investor when it comes through to their their overall portfolios. 0:21:46.720 --> 0:21:49.479 So we've made it this far talking about bonds and 0:21:49.840 --> 0:21:54.480 stark correlation without mentioning risk parity, but I'm going to 0:21:54.600 --> 0:21:58.720 ruin it now, so whenever people talk about market correlations, 0:21:58.800 --> 0:22:02.880 or even whenever they talk about sell offs recently, risk 0:22:02.960 --> 0:22:05.920 parity always seems to come up. And there's this notion 0:22:06.080 --> 0:22:10.240 that risk parity these are strategies sort of balanced portfolio 0:22:10.320 --> 0:22:14.639 strategies stocks and bonds, where they apply leverage to the 0:22:14.880 --> 0:22:19.000 bond the fixed income portion of the portfolio to boost returns. 0:22:19.720 --> 0:22:23.119 There's a notion that risk parity is either in great 0:22:23.240 --> 0:22:27.000 danger if the correlation regime ever shifts, or that risk 0:22:27.080 --> 0:22:32.160 parity is somehow going to exacerbate market volatility by sort 0:22:32.200 --> 0:22:36.399 of messing with correlations in the market. How do you 0:22:36.480 --> 0:22:40.480 view risk parity and what is its susceptibility and its 0:22:40.520 --> 0:22:43.840 relationship with correlation. I mean, that's a good question in 0:22:44.000 --> 0:22:49.440 terms of its relationship with the correlation. But before answering that, 0:22:49.800 --> 0:22:52.920 it's good to step back and think about why risk 0:22:52.960 --> 0:22:57.960 parity basically became into favor and you know what it's 0:22:58.000 --> 0:23:01.800 being used for now. So risk party, as a let's 0:23:01.800 --> 0:23:06.760 say concept, was ultimately a way to increase your exposure 0:23:07.440 --> 0:23:12.200 two bonds versus stocks, and in essence allocating let's say 0:23:12.280 --> 0:23:17.240 six to bonds and stocks, so dialing stocks down further, 0:23:18.080 --> 0:23:21.280 and it's a function. Ultimately, you know, the weights that 0:23:21.320 --> 0:23:24.360 you're applying the asset classes, or the way that you're 0:23:24.359 --> 0:23:28.719 applying leverage is a function of, in this case, estimating 0:23:28.800 --> 0:23:31.240 the risk from the asset classes. So of course, the 0:23:31.359 --> 0:23:34.680 risk parity is known very well as the fact that 0:23:35.320 --> 0:23:38.000 fixed income has a lower risk than equities, so we 0:23:38.080 --> 0:23:43.000 overweigh equities, sorry, fixed income more versus equities so that 0:23:43.040 --> 0:23:47.479 we balance the risk contribution coming from each individual asset class. 0:23:48.520 --> 0:23:51.120 And as such that meant that your overweight bonds relative 0:23:51.160 --> 0:23:55.840 to equities. Fundamentally, now, ris parity funds did fantastically well 0:23:56.040 --> 0:23:59.879 during the yields collapsing because obviously bond did well. The 0:24:00.040 --> 0:24:03.439 returns to bonds what up. So you know, up until 0:24:03.720 --> 0:24:06.879 the point where you know, yields are their lowest that 0:24:06.960 --> 0:24:10.119 we've ever seen historically. For a persistent amount of time 0:24:10.320 --> 0:24:13.920 since the global financial crisis, there has been this concern 0:24:14.080 --> 0:24:16.760 that risk parity funds and approaches are not going to 0:24:16.800 --> 0:24:19.960 be good going forward because we're overweight bonds, but expected 0:24:20.000 --> 0:24:23.280 returns are lower than they have been historically because yields 0:24:23.320 --> 0:24:26.639 have to rise. So with that being said, there's a 0:24:26.720 --> 0:24:31.359 huge debate on Okay, we understand the popularity of risparity, 0:24:31.400 --> 0:24:35.520 but we don't necessarily understand the forward popularity of respiraity 0:24:35.640 --> 0:24:40.440 or the efficacy of that approach going forward. And that's 0:24:40.560 --> 0:24:43.680 also a function of the fact that the correlation dynamic 0:24:43.760 --> 0:24:47.720 has changed through time. So historically, you know, the correlation 0:24:47.840 --> 0:24:52.000 between you know, stocks and bonds was positive. If you 0:24:52.040 --> 0:24:54.760 could put a little bit more weight on bonds with 0:24:54.880 --> 0:24:58.240 deals collapsing, you'll earn more returns. That's great, But now 0:24:58.280 --> 0:25:02.080 they've become negative. So in essence, they're more diversified as 0:25:02.080 --> 0:25:06.600 asset classes. But risk parity ignores the expected return component, 0:25:07.240 --> 0:25:10.040 and they expected return component on bonds in general is lower. 0:25:11.000 --> 0:25:13.920 So is it sensible to overweight your portfolio to bonds 0:25:14.280 --> 0:25:18.399 now given where we are most saying no? And so 0:25:18.480 --> 0:25:22.600 that's why this is an interesting question, because correlations will 0:25:22.600 --> 0:25:25.240 inform us that it's good to be diversified across docks 0:25:25.240 --> 0:25:29.159 and bonds because they have a somewhat negative relationship at 0:25:29.160 --> 0:25:32.400 the moment, but again vary through time. But the expector 0:25:32.440 --> 0:25:37.320 returns are not great for bonds, So what does one 0:25:37.359 --> 0:25:40.920 do and in a risk parity setup that's not really 0:25:40.960 --> 0:25:44.919 accommodated for And that's why risk parity is something that 0:25:45.080 --> 0:25:48.560 is it's certainly a very interesting concept. It's been used 0:25:48.600 --> 0:25:51.840 successfully in the past, but we really need to question 0:25:52.040 --> 0:25:55.879 if that's the right approach going forward for our stock 0:25:55.920 --> 0:25:59.399