Episode #363: Rick Bookstaber, Fabric, “Risk Is The Other Side Of The Coin From Opportunity”
Guest: Rick Bookstaber is the co-founder and Head of Risk for Fabric, which provides factor-based risk management applications for investment advisors. Rick has held Chief Risk Officer roles at Morgan Stanley, Salomon, Bridgewater, and the University of California pension. He also worked at the U.S. Treasury post-2008 and helped write the Volcker Rule. He’s the author of The End of Theory and A Demon of Our Own Design.
Date Recorded: 9/29/2021 | Run-Time: 1:05:09
Summary: In today’s episode, we’re talking all about risk with someone who’s held Chief Risk Officer roles at Morgan Stanley, Solomon Brothers, Bridgewater, and the University of California pension, and if that wasn’t enough, he also helped write the Volcker Rule while working for the Treasury. Rick begins the episode by walking us through his framework for assessing risk and why the three keys are leverage, liquidity, and concentration. He also shares the lessons he’s learned from surviving the 1987 crash, 2000 tech bubble, and 2008 housing crisis.
As we wind down, Rick shares what led him to start his newest venture and how he plans to assist advisors with risk management for client portfolios.
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Links from the Episode:
- 0:40 – Sponsor: The Idea Farm
- 1:35 – Intro
- 2:29 – Welcome to our guest, Rick Bookstaber
- 3:04 – Rick’s framework for assessing risk
- 4:29 – What makes markets vulnerable and typically prone to crisis?
- 6:31 – The Four Horsemen of the Econopocalypse; The End of Theory
- 13:06 – Parallels and themes between market events over the past few decades
- 15:25 – What the world looks like to Rick today in regards to risk
- 19:52 – How to be conservative with the market at all time highs
- 27:20 – Will crypto ever be able to succeed? Are their prices a sign of a bubble?
- 30:14 – General takeaways on risk and protecting yourself against today’s markets
- 34:08 – Are negative yielding bonds aligned with their intended purpose?
- 38:04 – The origin story of his new startup, Fabric
- 43:18 – How Fabric works and, the use case for financial advisors, and the levers it pulls to analyze your risk exposure
- 52:47 –-Fabric’s launch date
- 55:18 – Rick’s most memorable investment or market experience; A Demon of Our Own Design
- 1:01:11 – Learn more about Rick; fabricrisk.com; LinkedIn
Transcript of Episode 363:
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Meb: Hey, hey, everybody. Today we have a mega episode. Our guest is the co-founder and head of risk for Fabric, which provides factor-based risk management applications for investment advisors. In today’s show, we’re talking all about risk with someone who’s been there, done that and held chief risk officer roles at Morgan Stanley, Salomon Brothers, Bridgewater and the University of California pension. And if that wasn’t enough, he also helped write the Volcker Rule while working for the Treasury. Our guest begins by walking us through his framework for assessing risk and why the three keys are leverage, liquidity, and concentration. He also shares the lessons he learned from surviving the ’87 crash, 2000 tech bubble, and 2008 global financial crisis. As we wind down, our guest shares what led him to start his newest venture and how he plans to assist advisors with risk management for client portfolios. Please enjoy this episode with Fabric’s Rick Bookstaber. Rick, welcome to the show.
Rick: Thanks. I’m glad to be here.
Meb: I can say live from New York City. You in Manhattan?
Meb: Going to ballet, walking around town, seeing fall time there. One of my favorite times in New York City. I miss it.
Rick: Yeah. It’s like the city’s 80% back to life now.
Meb: I’m going to one of my other favorite places this weekend, which is Colorado, Telluride specifically. So hopefully it’s all the leaves changing this time of year. So, for listeners recording this, the very end of September. It all seems calm and copacetic in the world. Let’s talk about your favorite topic. You probably have one of the more absurd resumes and curriculum … over the years with some of your stocks. I mean, I have to look at it. I mean, Bridgewater, More Capital, Salomon, Morgan Stanley, FrontPoint, on and on and on, University of Cal. You’ve seen a lot of different setups and a lot of different markets. You’ve written a few books on this topic. I love them. Talk to me a little bit about how you think about risk in general as to lay a little bit of concrete foundation and then we’ll start to get into all sorts of weird topics.
The first thing is risk is the other side of the coin from opportunity.
So, anybody who’s looking at opportunities in the market, anybody that’s focused on Alpha, if they’re not looking at risk in the same context, they’re kind of missing half of the equation. But at the same time, risk is fairly complex. You can’t boil it down to a number. You cannot look at it based on what you’ve observed historically. It’s sometimes kind of dynamic, just like the markets are dynamic. And so, you need to know what’s going on in the market today, what are the things that you’re worried about, and if one of the things you’re worried about occurs, how does that interact with the vulnerabilities of the market to create potential problems. One way to put it is it’s not a simple topic. It’s not one-dimensional, otherwise it wouldn’t be very interesting to be in the area.
Meb: Talk to me a little bit about markets. Is there something that makes them particularly prone to crisis?
Rick: When I try to understand the vulnerability of the market…and any risk is really a combination of two things. It’s some event that occurs which people thing of scenarios but it’s also how vulnerable is the market to that event. So, a starting point is how vulnerable is the market. And I look at three things as a start for them, leverage, liquidity, and concentration. If you want to look at the market today and ask the question, is it more or less risky than it’s been, say, a year ago or whatever, just ask the question, is it more leveraged? Is there less liquidity? Is it more concentrated?
Meb: Has that been a general trend? Is that something you look at kind of, like, a short-term sort of situation? Is it more of, like, a long-term build-up? So, I’m thinking about some of these types of ways of thinking of that and sometimes it feels like these things can go on for a really long time before it reaches sort of a terminus event. How do you wrap your head around sort of that challenge?
Rick: That’s one of the things about being in risk management, you’re wrong a lot more than you’re right because you can have a market that’s set up for problems but that doesn’t mean the problems occur. I was worried before 2008 about the level of leverage and some of the innovations that were out there, collateralized debt obligations and things went along for quite a while before they became realized.
So you can be, you know, concerned about something and the markets can be vulnerable but things can still go on for a long time.
And so, I don’t like to talk about the markets being in a bubble or the markets set up to crash. I’d rather just say the markets are vulnerable right now and I can explain why they’re vulnerable and that doesn’t mean that you should sell everything and walk into bonds tomorrow.
Meb: Bonds are an interesting topic we can get into in a little bit too because I feel like that’s a headscratcher for a lot of people on how to think about bonds in general. You talk about “The Four Horsemen of the Econopocalypse”. That’s a big word for me this early in the morning. I haven’t had enough coffee. And you talk about sort of the four dominant influences at play. You want to touch on some of those ideas there?
Rick: I wrote a book with Princeton University Press a few years ago called “The End of Theory”. There’s a lot of hutzpah in that title. I’m surprised they let me get away with it but basically, the idea is that if you want to look at markets, especially markets during times of dislocation or times of high crisis, economics and the standard methods that you’ve learned in finance don’t do the trick. Mathematical models don’t do the trick. Looking at history doesn’t do it. And there is a number of reasons why this is the case and these are the four horsemen…instead of Four Horsemen of the Apocalypse, I call them “Four Horsemen of the Econopocalypse.” But the key components for all them is that if you have a market that’s complex, it moves along in a way that is difficult to set down in a set of equations. It becomes a narrative. It’s like a story that’s unfolding and it’s got its twists and its turns, certain surprise endings. And if you try to encapsulate that either by just saying, “Well, I’m going to look at the last couple of years and whatever happened then. Probably is a good guide to the future.” If you try to put it down into a bunch of equations or an econometric model, you’re going to miss the point because when one thing happens, it feeds into the other.
The interaction of leverage, liquidity and concentration is a great example of that. I have an analogy that I like to give a sense of these dynamics. I think about a nightclub. And if you’re a fire marshal and you’re looking at a nightclub and you’re trying to figure out what’s the vulnerability of that nightclub to a fire, you look at three things. You look at the means of egress. How easily can people get out? How many people can get out per minute? You look at how crowded the nightclub is, how many people are there who will have to get out. And then you look at the combustibility or the flammability of the space. How much time will they have to get out? How crowded the nightclub is? It’s like the concentration of the market. How many people are really active in that part of the market?
The liquidity is the exits. How liquid is the market? How quickly is it for people to get out? And the flammability is leverage. Basically, the more leverage there is in the system, the more quickly people are going to have to leave if something goes wrong. The reason this gets complex is it turns out that if there is the fire, things don’t work the way that it does if you just sort of watch the typical night in a nightclub where people are going in and out. Suddenly, the exit gets slammed. People can’t get out, they’re crowding, they’re sort of going over each other. You can’t model that if you look at the world in a day-to-day world. The same thing with the markets. You can’t look at the markets day to day and say, “Okay. Everything’s fine.” If something goes wrong, people just exit because I know this is how people can get liquidity.
The basic idea in the End of Theory is encapsulated in that concept that you have these complex dynamical systems at work and what you see day by day does not give you a really good handle on the sort of risks that you really care about which is the risk of things really go bad.
Meb: Yeah. And so, as we think about it, I can think the first answer is just don’t go to the nightclub or watch movies at home. But for most investors thinking through this, is it a scenario where you say, “Okay. Well, if I’m not going to use…” And I don’t want to put words in your mouth. You said it wasn’t a situation where you said don’t look at history but it said how do you think about the possible outcomes? You’re like, “All right. Well, I see I don’t want to be in a crowded nightclub when it’s a ton of kindling in there.” How do I think about avoiding those situations? Is it a kind of constant monitoring? Is it through diversification? What would a fireman say if he was looking at that nightclub?
Rick: Well, it really is don’t go to the nightclub but the thing is in the markets, it’s not an either/or. It’s make sure you’re not too much into the nightclub. So where is the market vulnerable? Where is their concentration? Where is their potential liquidity? Don’t go into that in a lot of space or if you do, you better feel like this is really a great opportunity because the risk is high as well. A good example of that now, it’s kind of like…this is no secret. If you look at the concentration in the market right now, thing and related stocks, technology is where it’s at. And people have more in that nightclub, so to speak, than they may realize because…I mean, this gets to diversification. You may say to yourself, “Hey, I’m in a broad-based index. I’m in CVSMP or I’m in some ETF like the S&P. So, I’m diversified.” Diversification means have a lot of different stocks that aren’t highly correlated without a lot in any of those particular stocks. Well, if you’re the S&P, 25% of your capitalization is in 10 stocks and 40% of your exposure’s in the technology sector. So, you are crowded. You’ve made a bet even though you didn’t intend to. You’re not diversified even though you may not realize it because you are in this really crowded space. So, the first step is to understand where am I in a crowd and do I really want to be in that crowd.
Meb: Let’s rewind in history a little bit and then we’ll talk a little bit about the current day. You’ve been through ’87, 2000, Tequila Crisis, Asian Crisis, Flash Crash, on and on. Pandemic, forgot about that one recently, global financial crisis. Do these guys have some rhymes? Are they all different? Are there some common themes that you’ve kind of learned and appreciated over time or is each one a new surprise box?
Rick: There are common themes to them. It can only go so far with those common themes because obviously people learn from past events. Different innovations come to the fore. I think right now we’ve probably learned a lot from 2000 and the Dot-Com era. I think of big market events as different types. There is obviously ones that are just related to recession, right. The economy does bad. If there’s expectations, the economy will do bad, the market does bad. Then there are the periods that are fundamentally driven, periods like what Greenspan called irrational exuberance where people just get out ahead of their skis in terms of the view of fundamentals and there’s always some excuse for why this time it’s different. With Dot-Com it was all the accounting measures of earnings don’t matter anymore. Right now, the argument for high PEs is low interest rates mean that you don’t discount forward earnings as much. You know, whatever. But that’s kind of the fundamental component and people finally wake up.
And then there’s what I would call the market-driven events. Really, 2000 had a bit of that. One of my favorite examples even though it didn’t hit the broad market is LTCN in 2008 where it’s not so much the fundamentals that are the trigger. It’s high leverage, it’s the market technicals that are the trigger. Something happens and people have to sell, and when they sell, market prices drop. Now when market prices drop, more people have to sell. 1987 is a great example of that. In one day, the market dropped. The S&P dropped over 20% because people were selling and then because they were selling the market dropped and you’ve got this incredible cascade. There are certain themes or certain types of events you can look back at. I am not a fan of overrating what’s happened over the last couple of years as a basis for looking at risk, but I do believe that you can look over the large span…even going back to, like, post-World War II. Look at all the situations where we’ve had major downturns and use those to kind of inform the way the market works and the odds that we’ll have things looking forward which…by the way, if you’re a long-term investor, that’s, I think, the most important thing to look at.
Meb: You always see the disconnect certainly and this is partially why it plays out probably the way it does between what people say their intended horizon is. Almost everyone says they’re a long-termer, you know, investor. Then you look at the timeframe in which they analyze positions and make changes. I was trying to think of this concept to being wrong and what does it mean to be wrong. And so, I said how long are you willing to “be wrong” on investment? And I said wrong means, in this case, underperformance versus a benchmark or your expectations. Nothing is otherwise changed. So, the manager didn’t die. There wasn’t a major structural shift or government regulation, aliens or whatever. And you’ll probably understand where this is going. Twenty percent said that they would give it a year and then 52% said up to five years. The remaining 10%, 20% said longer than 5 years, 5 to 10, over 10. And despite saying they have a long-term time horizon, the concept of the two don’t align. That’s also the fact that we’re human. Probably line up to see so much of the crazy behavior, and bad behavior, and emotional behavior over and over again.
As you talked about the nightclub, I learned a new word this past couple of weeks which was murmuration, which is the starlings, right, the birds moving and that’s kind of the analogy I love to make is that, like, the history gives you some idea of what’s happened in the past but things are always a little bit different in the way they move. But looking back, I mean, you talk about 1980 story of silver with the Hunt Brothers. As we look at today, what does the world look like today to you? Any rhymes, particular risks? Does everything look warm and fuzzy?
Any time things are moving along really swimmingly, risk is building under the covers.
And we’re seeing it happen. Leverage is very high right now by a number of measures. Margin debt, less free cash balances is at an all-time high. The percent of household wealth and equities is at an all-time high. You may not think of that in the same way in terms of leverage but basically, people are out above their normal risk tolerance. You see this high concentration as I mentioned before. If you look at the size of the largest stocks or the technology sector, it’s a time that even though volatility does not seem particularly high and things are doing nothing but going up, there is a basic vulnerability in the market if something goes wrong. So, then you have to ask what could go wrong and that’s where you get into scenarios. The three that I think about and I think most anybody thinks about right now…it’s not like there’s a million of them out there. One is inflation. Another one is the possibility of…I’ll call it a tech bubble. Basically, then we get a hard landing because technology is at such an extreme various measures or thing, stocks…everyone to look at it. And the third is some type of a macro event. It could just be tapering or it could be a COVID resurgence leading to recession. So, marry those types of possible events with the situation in the market and that’s where I would focus risk because what really matters for most individuals…to your point, if something goes bad for six months or a year, fine. You know, if you’re a hedge fund manager, that’s a problem. But if you’re an individual, you’re looking out to retirement, even if you’re 10, 20 years out, you can live with it. But if you have a 2000 recur, it took us 13 years from 2000 to get back to where we were at the peak. So, if you have a timeframe of 10 or 20 years, that type of an event really matters to you and it’s even worse than it seems because the market dropped. It finally got back to where it was in 2000 but, you know, that’s 13 years that you didn’t have positive returns. If you expect…and it’s a reasonable expectation based on history that equities will return like on average 7% a year, you actually were down 50% from where you should’ve been, so to speak, if things were normal. So, when you look at these sorts of events, it can matter to you for a period longer than the event occurs. So those are the three that I really focus on.
Meb: We have a pinned Twitter thread that gives a nod to my southern mom and grandma where it’s called what in tarnation and it’s just a bunch of charts demonstrating some of the weirdness going on, particularly in U.S. market cap weighted stocks. A lot of the co-inherited sort of indicators. And it’s interesting because if you look at things like valuations, if you look at things like sentiment, if you look at things like the percent equity allocation which you referred to which is, I think, at all-time highs in the U.S. which on one hand, for me, is great. Americans are finally all starting doing stocks but on the other hand, it has, like, an amazing negative correlation with future returns. But all three of those in particular have a huge overlap in correlation. They look like the same chart. So, sentiment, valuation, percent in equities. And the reason being is because on aggregate, people just own more stocks the more they go up, and they go down, they own less and they own more. But the problem is that’s backwards probably of what it should be. They should own less when valuations are high and more when valuations are low. They should be more pessimistic when valuations are high and more optimistic when valuations are low. You know, Buffett talks about this but that’s not how it works. People get excited when they’ve made money, not when they have lost money.
So simple things like rebalancing the course helps that or being valuation conscious. But it’s hard when everybody’s making hay. Rick, when your neighbors are going to Tahiti. I guess they’re not going to Tahiti on travel bans but they’re buying cars. Buying houses, that’s what everyone’s doing now, buying new houses. What should people do? How should they think about it in a way that is sober, and sane, and realistic?
Rick: There are two sides to this and they both have to do with thinking that you have a well-diversified, maybe even passive portfolio. So, let’s ignore people who are trying to make bets. Let’s think of people who have the bulk of their equities in something that more or less is a big index. And that’s where most people are. There are two things going on. One is without realizing it; they’re in a momentum trade. Because of market capitalization, the more things go up, the more they own. So, you’re momentum trading and so you better realize that maybe you actually don’t want to be momentum trading.
And the second is, getting to my previous point, you think you’re diversified and you’re not. You’re making…because of that momentum trading, you are making an outsized bet in certain sectors, in this case, in technology. So, I think the first thing to do as you mentioned early on is know that you have that style implicitly even though you think you’re passive. Know that you have that bet implicitly even though you think you’re broadly diversified. And the first thing I would do, I wouldn’t even get to have too much exposure because that’s kind of risk 101 is do you now have, because of the run-up in equities, more equity exposure than your risk tolerance rule would normally say. And if things start to go the other way, are you going to say, “Oh, my gosh. What’s going on?” And start to sell right into it. But the other is to move away from these characteristics that are embedded in most indices because they’re cap weighted and move more towards a well-diversified portfolio, which would imply some notion of equal weighting. Not literal equal weighting. You don’t want to hold an equal amount in every stock because then you get into another problem, which is that some sectors have a lot more stocks than others. There’s a lot more stocks in basic materials than there are in banks. But kind of move more in that direction so you get better diversification and so that you’re moving away from momentum. To me, that’s kind of the sort of risk 101 first steps to be taking.
Meb: Yeah. I mean, the market cap weighting was an amazing innovation 50 years ago and we talk about this on the show and I say…but it’s a curious investment strategy. Like, what it enabled which is low-cost investing is amazing but now we live in a world…you can implement low-cost investing and other investing strategies and styles. The problem with the market cap weighting is when things go totally bananas and you live through…certainly the Japan is my favorite example but there’s been plenty of other times when smaller markets have gone nuts. The most recent, India and China pre-financial crisis, the BRICs 2007. Valuations I think were even crazier than the U.S. is now. The market cap weighting exposed you to that because it gets concentrated. And so, a simple answer, equal weighting is certainly one but at least breaking that market cap weight and ending in anything else to me. The hard part for a lot of people I think is they want to be Nostradamus, right. They want to forecast the futures. They’re always worried about what the exact catalyst is going to be. Everyone’s like, “What’s going to cause this to end? Is it inflation? Is it the Fed? Is it aliens, pandemic?” And I think what’s so great about your work is it gives you a framework thinking, “Look.” I’m not putting words in your mouth. This is my interpretation, so let me know if I’m off base. Is this like you don’t necessarily know what the exact catalyst may be but you can understand when things are getting riskier and problematic where you’re starting to see enough of the kindling sitting around to where it could be a problem.
What do you think about some of these other developments? Is this a sign of the times? Is this something else? I’m thinking about NFTs, crypto, SPACs.
Rick: Oh, yeah. Yeah, don’t get me started. So, this last point to sort of close this out. You mentioned earlier there’s no mystery here. You can line up charts whether it’s PE ratio or level of leverage or…go through them. So many of these are…two things significant. Near or at all-time highs and they mirror very closely what the world looked like in 2000. I hate to say that because, you know, you never want to pin something back to another event but in 2000, the market was down was 50%. Technology was down over 70%. And again, it took 13 years to get back where we are. I don’t want to overweight that but you can look out there and sort of see whether that will happen. Who knows? But you should at least understand that that’s there. And then the other thing that’s important to know and this gets back to past events. Nearly every decade from the ’50s on we’ve seen drops of over 35% in the market. In 1970…I don’t even have to go through them. If you believe what people always believe which is we have a normal distribution, you would see over 50…the odds of seeing 35% down events in 50 years is less than 1% probability. So, we’re really living in a different sort of a rule than what everybody puts in their mind.
I think level setting in that way is useful and, again, I’m not saying sell everything but at least understand that there is another side to what’s going on in the market.
Meb: Before you move on, I was relating very personally because I graduated college in 2000. So, got to see first-hand a lot of the boom on one side and then the bust on the other side because all my friends from about ’98 to ’03 had moved to San Francisco which was the land of milk and honey, right. And we’ve kind of seen the echoes again. So, got to see the crazy fun times but also the decimation afterwards. Like nuclear winter of the internet bust where you go on Craigslist and buy entire company’s furniture for…like, they’re just like, “Dude, just come pick it up. We got to get out of here. We’ve defaulted on our leases.” So got to see both sides.
Rick: Well, it’s funny. Then people have ’08 also. So, it’s not like we’re devoid of experience. How many people remember ’87? That’s another issue but 2000, 2008…so anyway, getting to this stuff with crypto and NFTs and so on, I feel like crypto is…I can’t understand what’s going on. There are so many people, many very smart people who were on that bandwagon and my argument has been for quite a while…and now we’re seeing some evidence for it being a reality. That no government is going to cede its monetary authority. If crypto is successful, it will be shut down because no government wants people to be able to do an end run around the monetary authority. And we’ve now seen that happen with China. We’ve seen glimmers of it occurring in some other countries. And it may be that we see digital currency or digital versions of currency. We know a number of countries including China are looking at that but that’s a different thing. For a country to take its currency and put it into a readily usable form, namely digital is not the same thing as cryptocurrencies.
The other problem with cryptocurrencies is what’s the value of cryptocurrency. Think Bitcoin. Could be 5,000, 50,000, 500,000. I don’t know. There’s no basis so…
Meb: Or five million. You never know.
Rick: Yeah, or five million. Yeah. So, this is sort of a tangent but I think that when you look at crypto, when you look at NFTs, when you look at SPACs which now has sort of run their course to some extent, you’re seeing innovations that may not be at the core of damaging the markets the way that, say, collateralized debt obligations and so on were before ’08. But they’re kind of canaries in the coalmine. People can get so wild about things. In my mind, if you sit back and think a little bit, you say, “Okay, well, whatever. I’m not going to go whole hog into this.” It is sort of a measure of euphoria and a measure of people kind of putting a certain set of reason to the side.
Meb: Yeah. I want to hear about your new, awesome start-up in a second but what’s, like, an investor to do? You’ve consulted to some of the biggest, well-funded institutions in the world. You’ve been at various funds. Our traditional sort of wheelhouse listener is a financial advisor, independent, registered investment advisor. We have institutions and we also have a lot of individuals. What are the general takeaways from sort of number of decades in the markets as we think about putting this all together with the portfolio but also where we are today?
Rick: I think that in terms of the mindset looking at risk, a simple starting point is to recognize that risk is not a number. Risk is not looking at the past and pushing it forward. That it’s space for your dynamic narrative. And so, if you’re an advisor and you’re talking with your client, it’s a source of discussion. It’s not just saying, “Oh, you know, risk is whatever.” It’s a living sort of a thing. And if you’re looking at scenarios and things to worry about, there’s a story to think about. There’s specific parts of the market that will matter. So, for example, with inflation. It’s not just, “Oh, there’s inflation. Maybe the market will drop.” You know that certain risk factors will matter more than others. If there’s inflation, smaller companies will be hurt more because they can’t adjust their costs as readily. Companies that have to borrow short-term will be hurt because rates will go up and so on.
So, I think a starting point is to look at risk more as a narrative to understand the right way to do it. And just to give you an example of that getting to all the places where I’ve worked. When we’re concerned about some risk and it doesn’t have to be, like, a cataclysmic thing but, you know, we’re thinking about something. We get together in a room around a table much like an advisor might with a client. And we basically would talk through stories and scenarios and how one thing might happen and how it could lead to something else and what does that mean for our positions. But the big difference that I would add to that for an advisor is it’s more than positions. An individual working with advisor has two characteristics that make the standard approach or risk management that I’ve used through my career wrong or incomplete. One is their timeframe is not the same timeframe as a bank or a hedge fund or an asset manager. They can bypass a lot of the risks. Basically, a lot of what they read about and a lot of what people worry about in the press is noise if you’ve got a timeframe measured in 5, 10, 20, 30 years. You also aren’t leveraged. You’re not in a situation where you’re forced to get out. You don’t have clients who might pull the plug and redeem. So that’s one thing.
The other thing that’s really important is that risk comes from two sides for an individual. An advisor kind of has to look in two directions at once because you have the portfolio on one hand and there’s risks to be concerned about there but you have the client’s goals and how those goals might change over time and as the market changes on the other. So, it’s like you’re cutting with a scissor rather than a knife. You have to worry about both of these things. So, it’s a really complex problem and I think this is sort of interesting that we think of super sophistication residing in hedge funds or whatever. The real sophistication, the real depths of issue is an advisor working with a client because they have to worry about a longer timeframe, they have to worry about not just returns but goals. And that’s why it’s actually a very rich area to be focused on.
Meb: What does the framework lend itself to bonds? Bonds is sort of a weird asset class that used to offer a fair amount of income in a traditional sense that now for the most part does not in some parts of the world. Certainly, does not. It’s negative yielding. Is that business as usual? It’s an inflation sort of real rates question in your mind or is it something else going on where it’s a potential risk as well that people maybe haven’t thought about for the past, I don’t know what, 30 years in the U.S.
Rick: Yeah, so the thing with bonds is if you hold a bond that doesn’t match your liabilities, you’ve got risk. If you’re concerned about paying for your kids’ education in 6 or 7 years and you’re holding a bond that has 10 or 20 or 30 years, you’ve got risk. So, a bond without adding the issue of duration and the timing of when you’ll need that money is also risky asset. And it’s riskier now than it has been for a couple of reasons. One is inflation. The nominal yield is one to one with expected inflation. And the other is we are used to rates being so low that it’s like in our mind, we don’t conceive of rates maybe being 4% or 5%. When I first started in the markets…let me back up even more. When I was younger and building my first house, I had a construction loan that was 21%. And my mortgage was 13.5%. And I was looking back at my parents and their mortgage which they had early on and it was 3.5% and it was like, “What world was that?” Three and a half percent mortgage? You know, we were in a different realm.
And by the way, in the mid-’80s when rates got back down to 8%, we had a trader in the bond desk who printed a trade and kept the print, when it hit 8% because that was like, “We’re back to normal.” So, we don’t have a lot of perspective maybe. I’m not saying the rates will go back to 13.5% for mortgages but really, to think that the level that we’re at right now is kind of it is missing the raw potential for risk. And bonds I think can be riskier than people may realize. And the only way to really control for bond risk is to hold bonds that sort of have a maturity or duration that’s comparable to your timeframe.
Meb: Yeah. To put it into perspective, I was, again, querying the users, Twitter followers on a poll and my thought process in an article I wrote was that bonds on a real basis are not risk free. I mean, people see T-Bills and low duration bonds as sort of a risk-free investment as they’re “safe money” and my point was after inflation, there’s been periods, certainly not really that much in the past 40 years but prior to that where that was a money losing asset. And I said, “What do you think bonds’ largest drawdown was in history?” And almost everyone said like, “Less than 5%.” And it’s up north of I think 50. And so, it’s a different asset, right. It’s like a slow decay usually because of inflation versus stocks, which tend to fall off a cliff at times versus bonds, which tend to be more of an erosion of wealth.
Rick: You see, that’s kind of an important point that the risk profile for bonds is closer to the goal profile of individuals than is risk profile for stocks. They still are lower risk than equities and if you hold them to maturity, sure enough you get your principal back. But if you are in a position where you may have to sell it between now and then, you might be selling it for less than what you paid.
Meb: Let’s roll into Fabric unless there are some other topics that we skated over. Anything else that we missed that you wanted to hit before we chat a little bit about your new venture?
Rick: No, I think we can go there. I think a lot of what I talked about is sort of encapsulated in either why I started Fabric or the characteristics I’m trying to deal with there.
Meb: Well, let’s hear it. Let’s hear the origin stories. Despite the various stops you’ve made in your career, you said, “I’m not done yet. I got an entrepreneur start-up in me at this point.” Let’s hear about it. I’ve met some of your co-founders, Boulder based. Tell me the origin story.
Rick: Headquarters was in Boulder, Colorado which is, like, one of the most livable cities in the country right now but, you know, as we mentioned, I’m sitting on the Upper West Side in Manhattan.
Meb: That’s a good barbell approach. That is a good risk manager approach is you have some city life, some country diversification as well. It’s a smart way to go about it.
Rick: That’s right. Finally, I’ll be able to take advantage of that. I got to Fabric and I’ve been in charge of risk management at banks, hedge funds, working at the Treasury and then at University of California pension and endowment. And the basic pivot for what I’ve done started when I was working at Treasury after the financial crisis because it was clear that the people who were hurt by the financial crisis, the place for risk management was missing and was most necessary was with individuals. I went to a quasi-individual focused role by being at University of California because a pension fund is asset owners. So, a pension fund represents individuals in much the same way that an advisor represents individuals although at a larger scale. And then while I was there, through Govinda Quish who is the CEO of Fabric, we realized that the natural move to take would be to take some of the work that we did for University of California for the pension world and bring it to advisors where there’s much more of a close relationship to the issues that individuals have. What are the issues they have? The things I mentioned, longer timeframe. Risk becomes not just from the market but from their objectives and changes in their behavior. So, what we’ve done is built an application that takes really institutional level risk management capability. And I can get into what I mean by that in a second. But put it in a form that advisors can use in working with clients. And working with clients, again, getting to one of the points I made is not just integrating their goals with their portfolio but being able to operate in the human sphere. Risk basically in the market or for individuals, it’s not just numbers being craned down in a computer. It’s as human by nature. That’s one of the points actually we didn’t touch on very much but in my mind, the human component…that’s human plus machine. That’s where you have to look at risk. And so, you can take the risk approach that we have and the application we have and put it in the context that’s easy to use, that can be used for narrative, for interaction with a client. So, the key thing is what it means to have it be institutional level is it, first of all, doesn’t just look at history and assume, “Okay, that’s what’s going to happen in the future.” It doesn’t just look at some scenarios and say, “Oh, if this happens, the market will be down 20%.” There’s a lot more going on with those things but another thing that we do is we use a factor-based approach to look at risk. Which is kind of the standard approach that’s used now for any sort of institutions and we have a partnership with a firm called MSCI which is not only the grandfather of using factors but it’s the standard approach now. So, you can look at a client’s portfolio, not only in terms of what are its assets and how those assets interact to create their risk but what are the factors. Things like…you can have sector factor exposure like technology. You can have country factor exposure like exposure to China. But not just a China stock but China through this supply chain effects on other stocks that you have. You can have the factor approach to value versus growth.
And these sorts of exposures, these risk factors kind of thread through a portfolio. And so, you can have a portfolio with hundreds of stocks but ultimately it might be 5 to 10 factors that really govern what’s driving the risk of those stocks and you can intelligently talk about those, whereas it’s hard to intelligently talk about this whole portfolio. So that’s kind of the basis of what we’re trying to do. Take a lot of these characteristics that won’t really matter for risk management. Put them in a human framework and in an application that really you can just use. I mean, it’s not like it’s rocket science.
Meb: Yeah. I mean, the human framework comment is really important, particularly when you’re dealing with individuals because there is so much jargon in our world. I feel like it’s always hard to distinguish between what is truly relevant and what is just a distraction. And so, what’s the best way to think about kind of what you guys are doing? Is it like an X-ray into a portfolio? Is it like an event study where you’re like, “Hey, this is…FYI, here’s how we’re set up. Here’s how you’re going to probably end up. Here’s how you could end up.” Like, what is the main sort of levers that when you sit down with an advisor who’s armed with this technology that is going to kind of get spit out? What’s the input and what’s the output of this sausage?
Rick: It’s both an X-ray and an event study, you know, to use your words. The starting point is the person’s portfolio. The goals and risk characteristics of the individual who’s holding that portfolio. The inputs are really pretty simple. The outputs also are pretty simple. The outputs are, were you exposed or maybe once you look and you say, “I don’t really want to be exposed.” Where does your exposure lead you versus the client’s goals? And how can I express that exposure in a way that’s kind of plain English? And that’s where the factors come into play. So, for example, to take an event study or scenario, let me use inflation as a case study because I talked about that earlier. Okay, so you’ve got your portfolio. You may look and say, “Okay. I see your portfolio. It’s kind of S&P, right, but it kind of differs a little bit from the S&P in different ways.” Does the way that it differs or does the S&P itself matter for you versus where your goals are going if you really worry about inflation? And maybe you’re worried about tech and recessions. You’ll be fine. We’ll start with inflation. Well, the first thing that we can say is inflation is…as I said before, it’s not just a matter of, “Oh, if inflation occurs, rates will go up and stocks will drop.” Some things drop more than others. Low cap smaller stocks will drop more than high cap stocks. Brick and mortar companies with a cost structure will be affected more than tech companies that have intellectual property. Companies that have to fund themselves that are highly levered and they have to fund themselves short-term are going to be really in a bad situation because their cost of funding will go up.
Fine. Let’s look at the leverage factor, the value factor which is sort of brick and mortar oriented versus a technology factor. What is your exposure there? Let’s look at your high cap versus low cap. Let’s look at those factors. And home in on those to see what your risk would be in this event. And then we might say, “Gee, I know you love value and I know you really love to push in mid cap. So, on a factor basis, you tend to be there but geez, if you’re worried about inflation, maybe we should kind of reposition what you’re doing.” The other thing is what’s your timeframe versus what would happen with inflation. It may be that with inflation…it’s not like boom. These scenarios occur and that’s the end of that. If we have inflation, it’s going to have a long glide path. So, depending on your timeframe, you may be more worried about inflation than you are about tech because when a bubble bursts, it’s violent but it doesn’t, like, last for a long time. So, the glide path of the risk of one thing versus another may matter to you depending on your goals. And then the advantage of this is…so I don’t know which of these things might happen. I don’t know exactly how bad they’ll be but now we can have an intelligent conversation before they happen sort of do a premortem, kind of worry ahead of time so that if this does occur, you’re not sitting there as my client on the phone wondering, “Oh, my gosh. Oh, my gosh. What’s going to happen now? What should I do?” We got it. We’ve trained for this fight. We know how it’ll hopefully go. We can monitor and see if it deviates from what we thought. Save a lot of consternation for you as a client and save a lot of time for me as an advisor having to walk you through it.
Meb: It’s interesting because setting the expectations and sort of laying the groundwork for when the bad times will happen and expectations is the classic value add behaviorally of a financial advisor. And it’s also historically, like, one of the biggest challenges because people…when the bad times hit, it’s particularly unsettling if you weren’t expecting it or you had expectations that largely deviate from the outcome. And that applies to everything in life, not just certainly investments but if anyone watched “White Lotus,” the difference between your expectations of a hotel and then if you get a bad room, a relationship that doesn’t work out, on and on. Like, that’s where the emotional factures happen. And so at least saying, “Look. Here’s the past of the portfolio. Here’s how this works together. Here’s how the future could play out in these different scenarios.” Realizing it’s, you know…always be different. I think it’s incredibly useful. A lot of people often kind of want to gloss over it and their role just says, “Look, you’re fine. Let me take care of it.” But that’s sort of delaying the conversation to another day when the bad times are happening.
Rick: And it might be that you’re not fine. But so like look, “Look, you’re not fine now but we kind of knew that if this sort of thing happened, you wouldn’t be fine. But we have talked about ways to deal with it beforehand.” To your point, we have issues like this throughout our lives. Some of them…like with relationships. It’s a tough one. You can’t model it. But the nice thing about finance and investments and that part of our lives is we can sort of get some handle on what’s going on. An advisor at least can in that sphere give people some…maybe not total peace of mind but certainly some peace of mind.
Meb: How much do you expect this to be used by advisors that will actually result in advisor portfolio changes operationally where, like, they didn’t know. You, like, send this through the Fabric X-ray and software and they’re like, “Oh, wait, crap. I didn’t know this is how we’re positioned.” I imagine that’d be a pretty material use of the platform too.
Rick: Yeah. I think it’ll be…one thing is being pre-armed for what might happen and understanding how that could affect your goals and then the next question was, “Okay. What can we do about that?” So, if you’re worried about inflation, I know the direction we need to go. If you’re worried about tech, geez. Even without looking twice, you’re really having…exposed to…and the factors approach would show that we’re just saying, “Hey, I’m in an ETF that looks like the S&P. We’re good.” But the thing is that I wouldn’t expect people to do major reshufflings of a portfolio because by and large, advisors and individuals get it. They kind of know, nobody’s totally crazy. I mean, maybe some people are but people get it. They do have to be diversified and then you sort of make adjustments or biases around the edges. It’s not like I’m really into China. I’m going to put 90% of my portfolio in China. You’ll be sort of in a broad-based portfolio and then you’ll buy a China ETF. But the first thing to do is realize, “Wait a minute. Maybe I’m in China without even realizing it as things stand because so much of the supply chain of the companies I hold comes from China. At least I know that. I want to bet on China. Hey, I got to bet on China.” If you want to bet on technology, hey, you already have that bet. You may want to move a bit around the edges and here I can go back. When I was at University of California, we had $170 billion portfolio. But you take away zeros and it’s like…well, it’s not quite actually like what you do as an individual because we have private equity and stuff but the point is we start with the base case of a benchmark and then we move away from that deliberately. When we move away, it’s plus or minus 2%, 3%, 5%. We don’t go crazy. But we know the ways that we’re adjusting.
So, I wouldn’t expect when somebody takes our application, they’re going to say, “Oh, my gosh. Where am I? You know, I’m totally off the wall.” But they might say, “You know, incrementally, we actually have this and that imply that we don’t really want. We should adjust somewhat on the margin for that.” Or it might be that incrementally I know that you as an individual have a very strong sense or affinity towards whatever. So, we’ll incrementally move to that or believe it or not, you already are incrementally moved to that because that risk factor’s already implicit on all your positions. So, this is sort of a long answer maybe to your question but I think it can be valuable for rejiggering the portfolio but I don’t think people are going to just sweep everything away and start from scratch.
Meb: What is the runway look like for you guys? Are you out in the market yet? Are you launching in 2021? What’s the plans?
Rick: The timing is really good because we just now this week are bringing our application to market.
Meb: Wow, congrats. That’s awesome.
Rick: Yeah. So, you know, it’s been developed for a while. We’ve been preselling it. If you go to our website which is fabricrisk.com. So that’s an easy one to remember. It’s a very easy website. You go fabricrisk.com. There’s a button to push. Put in your email. You get a demo. I mean, we can set up a time to show you a demo. And if you like it, you can get it. There is also…I have a little video there but you won’t care too much about the video because if you’re listening to this, you got it already.
Meb: I just want to watch your little animation video. I want to turn that into my screensaver. It’s mesmerizing.
Rick: Yeah. So that’s kind of the Fabric. So, when we first came up with the name, people were saying, “What? What is Fabric? You know, like, shirts?” And we’re saying, “No, no. It’s the fabric of the market, like, so the fabric of time and so on.” And so, we have this multi-colored moving thing that is…first evoke not so much a shirt but the fabric of space and time.
Meb: It’s like the murmuration of the starlings.
Rick: Oh, yeah.
Meb: It looks a lot like it. All right, so target market is financial advisors. You know what would be fun at some point? Would love to run…we could almost do, like, a whitepaper or study running some of our allocations through y’all’s system and come up with an output report. Demonstrate to all the listeners, all of Meb’s weird intended and unintended portfolio bias that we have, input it into the strategies we run. I know what it’ll say.
Rick: We’ve actually done that obviously for some people already and yeah, it’s interesting because again, people may already realize it but it’ll be there. From risk factor basis, there’s some exposures that sort of weave their way through…to use fabric as an analogy, weave their way through the portfolio but what’s interesting is sometimes they say, “Yeah. I see that. And I kind of thought that would be there.” So, it can either be a big surprise or a confirmation.
Meb: Yeah. Rick, if you look back on your career, what has been the most memorable…you can answer this one either way. Investment of yours but also you could also just say memorable market or experience at any of these various funds and times. I mean, man, there’s got to be a list of 20 you could talk about but is there one that’s seared into your brain more than anything?
Rick: The ones that naturally are seared into your brain are the momentous ones and I was at Bridgewater at the first part of 2008 crisis. Then I was at Treasury. And one of the things I thought was exciting there in both cases was working with younger people. And to me, younger is, like, 35 and under. Like, realizing you are in the middle of, like, a hopefully once in a lifetime event and you’re living it, to sear in your brain an experience that can help you going on. So that’s sort of an experience it’s hard to replicate. The two that really hit me and were the basis for my doing the first book I did, “A Demon of Our Own Design” which came out right before the financial crisis was ’87, October 1987, when we had the market drop 20% in a day and I understand the dynamics behind that partly because I was part of what created that crisis. And you can go through the book. I have a whole chapter on it but the short story is I was involved in what was called portfolio insurance. And that really got the ball rolling then.
And then the other which is just not a footnote now is LTCM, long-term capital management which was considered the most brilliant people in the world hedge fund run by these guys and blew up spectacularly in 1998. And the reason that was so valuable is first of all, it showed the nature of hubris in the markets that you don’t ever really have it figured out and it showed the interactive dynamics. Getting back to the “Four Horsemen of the Econopocalypse” in my book, “The End of Theory.” The hubris that people had led them to take actions where those very actions were their literal downfall because they took such positions because they were sure the markets would react in a particular way but their actions led to the market not reacting that way and led to the cascade that resulted in their failure.
So, a lot of the lessons I have or how I look at the market and manage risk today really come from those two experiences.
Meb: I feel like one of the weirder beliefs we have today…you referenced one earlier that we’ve talked a lot about on the show which is people justifying equity prices in the U.S. due to low interest rates. And we could go on for an hour about that. So, despite the fact the rest of the world has much cheaper markets despite much of the rest of the world having lower interest rates than the U.S. There’s a belief amongst participants…and I don’t know how ironclad this belief is but certainly, you hear people justify why the market’s going higher is one of the reasons that the Fed will save them. And to me, that sounds like such a strange thing to be counting on because I don’t see outside of a pandemic that being something that I would ever want to put my bet based on, right. Is that something that you hear much?
Rick: Yeah. I mean, the Fed did save us in March. Whatever is going on now with Powell. What he did then was breath-taking and courageous, to take the level of aggressiveness on such a short timeframe when markets were really on the throes of disaster…you know, the Treasury market. One of the days in March, the Treasury market traded $250 million. This is the most liquid market in the world. And so, the Fed did pull us from the precipice then. But don’t bet on it. That was, like, hopefully once in a lifetime event. I don’t even know what it would mean for the Fed to pull us back from just the market moving down and moving down and moving down back to kind of fundamental levels that were reasonable in the past. That…why would they do that? The thing about the PE ratio and interest rates…the basic idea is if rates are low, you’re discounting earnings 20 years out and 30 years out and the present value is pretty high because you’re discounting a low interest rate. Well, if you are in your finance 101 class and you’re looking at the Gordon Growth Model or Dividend Discount Model, yeah, that’s how that works. You take earnings going out 10, 20, 30 years, discount them back, you get the price. But nobody in real life does that. Nobody in real life, when they’re looking at a company and they’re evaluating a company…prices project out what the earnings will be like in 20 years and discount it back. Because you know the world’s going to change and that company’s going to be different. So, the whole premise that people are using in relying on low interest rates to justify a high PE is not consistent with the real-world approach to valuation and I think the common-sense approach to valuation. And I think it’s just as simple as that that PEs are high, things are maybe overshooting fundamentals and people are trying to find an excuse for why what they’re seeing, and what they’re holding is reasonable to hold.
Meb: Some of those sentiment we…chatting the other day at some of the threads where people seem downright angry at the possibility that stocks are expensive and I think you’ve seen the recent expectations, surveys where people are expecting 15%. So best of luck to you, friends.
Rick, this has been a whirlwind tour, man. Listeners, check out his books online, on Amazon. We’ll post links in the show notes at mebfaber.com/podcast and check out best place to find what you’re up to, Fabric Risk. Where else if people want to find out your musings? Is there a good home base? Is Fabric the best place?
Rick: This is, like, a longer-term process than I ever thought it would be to build a website. We have an interim website which is the raw, what you need to know to be able to sign up. We now are about to add into it another page that’ll have things that I’ve been writing. So, there’ll be a lot there. I tend to write things in LinkedIn. I’ve written…tend to come out with various articles in different places. Mostly places focused on where the financial advisors would look at things, but if you visit the website, you’ll be able to find a lot of the things that I’ve been talking about and writing recently.
Meb: Well, I’m excited for your journey. I look forward to following up and kind of see how this offering works out. We’ll definitely check it out and hopefully we can run some studies on our end as well. Rick, it’s been a blast. We’ll let you get back to the beautiful autumn in New York City. Thanks for joining us today.
Rick: Thanks for having me on.
Meb: Podcast listeners, we’ll post show notes to today’s conversation at mebfaber.com/podcasts. If you love the show, if you hate it, shoot us feedback at email@example.com. We love to read the reviews. Please review us on iTunes and subscribe the show anywhere good podcasts are found. Thanks for listening, friends, and good investing.
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