DR 164: Risk Parity Portfolio Construction with Dar Sandler

Dar SandlerIn his book, Money–Master the Game: 7 Simple Steps to Financial Freedom, Tony Robbins describes what he calls an All Weather Portfolio. It’s very heavy in bonds, commodities, and gold, which makes it a questionable approach to investing. Yet it’s loosely based on an investing approach called risk parity that’s used by Ray Dalio of Bridgewater Associates.

Robbins interviews Dalio for his book. While the term risk parity is nowhere to be found in the book, that’s exactly the approach taking at Bridgewater. How do I know? Because before I read Robbins’ book, I interviewed Dar Sandler.

Dar is a former hedge fund employee at Bridgewater and the current owner of the investment advisory firm, Appian Road, LLC.  At Appian he is trying to bring to the masses the same risk parity model used at Bridgewater.

We also talk about other topics, like robo advisors, and how regular folks should invest if we don’t want to go down the path of risk parity, why he thinks risk parity is a better way to invest, and how he actually goes about executing that investment philosophy.

There’s a lot of mystery surrounding how hedge funds operate and what they do, and Dar has shed a lot of light on this.

What is it that Hedge Funds Do?

Dar explained that hedge fund investing is essentially the ability and process of investing in “anything they deem will make money for the client” in an attempt to beat the market. It’s something akin to an actively managed mutual fund, except that hedge funds are relatively unregulated.

The client base is different too. A client needs to be an accredited investor, which means that they are deemed to be more sophisticated investors, and in a better position to absorb financial losses.

Risk Parity

This was a major part of our discussion. Risk parity involves holding various asset classes in proportion to the risk they carry. So if stocks are deemed to be twice as risky as bonds, then there would be risk parity in a portfolio that contains – roughly – 30% stocks and 70% bonds. That’s the simplified version, and you’ll have to listen to Dar’s full explanation in the podcast to understand the concept fully.

Four Investment Buckets (or Sub-Portfolios) That Will Grow in Any Economic Scenario

Dar explained that there are two general forces that guide the economic world – growth and inflation. Within those two forces, you have to be prepared to invest in four economic scenarios:

  • Rising growth
  • Falling inflation
  • Falling growth
  • Rising inflation

At any given time, the economy is experiencing at least one, and often two, of those outcomes in combination. His strategy is creating a portfolio that is risk-weighted in each of those economic scenarios. In theory, it will do well in all four scenarios. Right now, he sees us in a period of rising growth and falling inflation, where stocks do well. But one of the real surprise revelations from Dar is that real estate investment trusts do even better, since they have less volatility than stocks.

Dar covered a lot more – risk parity is a complex topic by itself. He also discusses investment strategies that are unlike anything the average investor sees on a day-to-day basis, and it’s fascinating stuff – especially the part about using leverage to increase your return without sacrificing diversification. Listen to the podcast if you want to get the full scoop, this is some deep stuff.

Transcript of Interview with Dar Sandler of Appian Road, LLC:

Rob: Dar, welcome to the show.

Dar Sandler: Hi.

Rob: You and I have talked a lot in advance of this interview about how you guys invest folks’ money so I’d like to start off with you and your background then we’ll jump into how you invest because it’s very new to me. It took awhile to wrap my mind around it and I really do want to get to it, but let’s start with you first. Tell us about yourself.

Dar Sandler: Sure. I am Israeli originally. Born in raised throughout the world but for the majority of my life I grew up in Israel where I completed my high school and military service which is a requirement (for those who know Israel). After that I went to U Penn for my undergraduate degree and from there transitioned into a consulting world. I worked for a number of consulting companies for 3 or 4 years. Then from there I transitioned to a hedge fund by the name of Bridgewater Associates and was there for a couple of years. Then I started my own firm, Registered Investment Advising. That’s kind of the ‘nutshell’ of who Dar is.

Rob: How long were you in the military?

Dar Sandler: I was in the military for three years. Men are required to be in the military for three years and women are required to be in for two.

Rob: Alright. What was that like?

Dar Sandler: It was, looking back at it, really interesting, fascinating and a great development kind of experience for me. It really took the spoon out of my mouth, so to speak. It was a difficult experience when I was going through it. Transitioning from high school to the military is never easy, but at the same time, looking back at it, I think it was a good opportunity for me to mature, get some discipline and have that kind of scrappiness mentality.

Rob: Yeah. I ask because my son just graduated from the Marines Recruit Training, so we’ve been all military here, recently and I know it can be a very difficult thing to do. I can’t imagine what it’s like in Israel. You think it helped you develop some discipline? I guess that’s pretty common.

Dar Sandler: I would say it’s more— again I want to be careful with the words I use— but, I think the largest things that came out of it for me are discipline, a certain kind of attitude slash maturity and just an appreciation of a lot of things, whether it’s the small things at home all the way to the bigger important things in life. That’s kind of the big themes that came out for me in the military. Also, the sense of leadership and leading people. I was a sniper instructor towards the end of my service. I had a group of soldiers under me for a large amount of time and I had to lead those soldiers through difficulties whether it’s personal issues, military difficulties, challenges, physical challenges. All these different things come with that and I took a lot out of that.

Rob: Right, and today you’re in the U.S.?

Dar Sandler: Correct. I was actually born in the U.S. I have dual citizenship. I was born here and I have Israeli citizenship, as well.

Rob: Okay, and you said you went to U Penn for undergrad?

Dar Sandler: Yeah, I went to Wharton, one of the schools for U Penn for my undergrad studies. Correct.

Rob: So how do you go from that to a hedge fund?

Dar Sandler: Good question. I went from Wharton, first off, kind of the standard typical path from Wharton, if you kind of follow the river, is into New York and into the Goldman Sachs and Mackenzie’s of the world. That’s kind of what your inundated with there. I actually went to a consulting firm from there. I went to a small company called Diamond Consulting which got bought out by PwC later, but I was there for a number of years. I didn’t know any better. Consulting seemed, to me, the path, because if you don’t know any better, you can be a consultant and learn a lot about a lot of things. Then, from there to a hedge fund. Well, we were consulting to a hedge fund, Bridgewater, up in Connecticut so one thing led to another. I was one foot out the door with the consulting company because I was considering going to do my Master’s in financial engineering. I was very interested in the space of finance and there was an opportunity in Bridgewater for me to kind of, instead of going the educational, academic route, I could go into Bridgewater and I made the flip from the consulting world to them— to my clients which is very common in the consulting world.

Rob: Yeah. You mentioned a Master’s in financial engineering.

Dar Sandler: Correct.

Rob: What is that?

Dar Sandler: That is a degree that enables and teaches you to understand the kind of intricacies of the mathematics behind a lot of the financial products. If you think about a bond, for example, how is that price of a bond really determined? There’s a lot of math involved. A lot of subtleties and how do you price that? That type of degree usually leads you to the space of either risk management in the financial space or even nonfinancial space, and/or quantitative trading. So if you think of high speed, frequency traders are a subset of that where you look for small arbitrages. That’s just to give you a nutshell of what that degree is and where it leads to, usually.

Rob: Yeah, that sounds like fun to me. Okay.

Dar Sandler: Yeah, it’s something that peaked my interest a lot and it’s something that I considered pretty heavily during the time.

Rob: Okay, so you didn’t go that route. You went to a hedge fund. We hear that term a lot; it’s in the news. What exactly makes something a hedge fund?

Dar Sandler: The technical definition of a hedge fund is basically an institution that takes a client’s money and buying in a large— again I’m saying this because I’m going to use it as a base comparison to a mutual fund or other things— is relatively unregulated and is able to invest in anything they deem will make money for the client. That’s sort of the big, theoretical definition. In reality, what they do is, a hedge fund typically takes a client’s money and comingles it with other clients’ money, like mutual funds, and is looking to create alpha. Alpha is basically a fancy way to say “beat the market”. That’s the idea.

Rob: Well there are actively managed mutual fund. I assume they’re trying to beat a market, too.

Dar Sandler: Correct.

Rob: So, what’s the difference between a hedge fund that’s trying to beat the market and an actively managed mutual fund that’s trying to beat the market?

Dar Sandler: Good question. A mutual fund has a lot more regulation. In order for you to—I’ll just give you an idea of the difference. Because of the difference in regulations, the type of clients is also very different. To invest in a hedge fund, you need to be a credited investor. I think that a credited investor, nowadays, could have to have a $400,000 salary or two million dollar assets. Those are a few different qualifications. Where, in a mutual fund you can quite literally, there’s a minimum and some things, but by in large, buy it from your fidelity brokerage account. That’s one key distinction. The reason for that is because of difference in regulation.

Rob: Do hedge funds typically invest in private companies as well as publically traded companies?

Dar Sandler: Absolutely. Again, it depends on what the hedge fund style is. Bridgewater, where I worked, was a macro-hedge fund. They would not have invested in private companies. But there are definitely many hedge funds that go the private route, as well.

Rob: If we were to walk into a hedge fund’s office space, is it just typical office space? Is there a trading floor? Are there people screaming and yelling buy orders? Or is it people with their Dunkin Donuts coffee in front of their computer who wouldn’t know the difference between a hedge fund company and an insurance company?

Dar Sandler: I’m going to give you an answer that’s probably not as sexy as you’re hoping. It really depends. The hedge fund of quantitative trading, they call them the ‘algos’ I would assume is more like the latter, although I’ve personally never been in one because of the high frequency of trading and of the constant activeness of it, it’s more like the classic look and feel of the boiler room from the past. Again, not with the legality of them but more with the action, the shouting, screaming, the intensity. Although most of it (to be fair) is done on the computer these days. Then, the other side of that spectrum, also more the world I was in is the more thoughtful, longer term, medium term type of investment where there’s a lot more thinking. And the trade guard is just mechanic execution opposed to the actual algorithms. Does that make sense?

Rob: Yeah, I mean it makes as much sense as it is probably going to make for me.

Dar Sandler: I’m trying to give you a sense. It’s more the Dunkin Donuts, classic office environment, in the more traditional sense. The more quantitative, algorithmic ones are more the ones you have in your head of the action packed, spill coffee everywhere, shouts and screams.

Rob: What did you do for the hedge fund?

Dar Sandler: I worked in a macro hedge fund where it’s a lot more thoughtful, bigger picture type of an office. When we see macro we look at how the world works in regards to different shift models. For classic example, monetary policy or interest rates in the world. Things of that nature. What my specific job in this hedge fund, which, right now, I think is the largest hedge fund in the world, was data analyst. So, what does that mean? I literally was the person for a particular team in the hedge fund. My responsibilities were to gather, clean and synthesize various data that were very important input into the various models that we had.

Rob: Okay, what kind of data?

Dar Sandler: The data could be anything from equity markets in the Philippines to pension funds in Europe. It’s large swatches of data like that or all the way down to specific assets within a company. Usually, it was a large amount of data, which required a large amount of cleaning and massaging and making sure that it’s consistent and then synthesizing that. What’s the conclusion? What’s the “so what?” of that?

Rob: So, when you were at Bridgewater— this may sound like a silly question, but I’ll ask it anyway— when you were at Bridgewater as an employee, was there a 401k?

Dar Sandler: Absolutely.

Rob: Did it invest in the hedge fund?

Dar Sandler: Good question. Actually, you were not allowed to— it’s actually regulation. It has nothing to do with Bridgewater, but one of the stipulations (I’m not sure of the details of it) is the 401k is not allowed to invest back into itself. I presume that has a lot to do with Enron cases in the past.

Rob: So you picked mutual funds for a 401k to invest in while you’re working at the world’s largest hedge fund?
Dar Sandler: It’s kind of like an irony in a way, but yes.

Rob: Could you invest in the hedge fund or would you be treated just like any other investor and you have to meet all the requirements and everything else?

Dar Sandler: I would most likely have to meet the requirements. However, Bridgewater specifically— the clients are only institutions. So even if I wanted to invest in the hedge fund, I wouldn’t be able to, regardless. That being said, I’ll answer your question more conceptually. There are definitely hedge funds which allow their clients to invest in it and it is part of the incentive. Let’s say I’m part of the hedge fund and I’m also trading for the hedge fund. They’d give me rights to invest because it puts my money where my mouth is. It’s mixed incentives in there. For my purposes I was not allowed to.

Rob: Okay, so how long were you at Bridgewater?

Dar Sandler: I was there for just under a couple years.

Rob: Then you left and you started your own investment advisory firm where you are, today.

Dar Sandler: Correct, Appian Road, LLC..

Rob: How do you spell Appian?

Dar Sandler: Apple, Peter, Peter, Indigo, Apple, Nancy. So, two P’s. It’s based off the road in Rome.

Rob: Alright, why did you do that? I mean, that’s a very competitive business that you’re in now and you left a hedge fund to start your own business in a very competitive industry. What were you thinking?

Dar Sandler: First off, from the personal aspect, frankly, I was just fed up. I always had this kind of itch I needed to scratch to start your own company. A lot of us have that dream or that vision. And, from a personal perspective, where I am in my life—no kids yet, so the risk is relatively lower. I wanted to go after that and scratch that itch. That was kind of the personal reasons. I’d had enough of the bureaucracy of corporate America. From a professional reason, the opportunity that we saw was one of the ideas that Bridgewater pioneered called, risk parity. But it’s not their own idea. It’s well known in the industry. It’s something that’s not so prevalent in the individual space, in the retail space. My partner Davide De Micco and myself saw an opportunity to bring this concept of risk parity to the individual. We saw an interesting opportunity here because we thought it made sense from a business perspective. That’s kind of the personal and professional reasons.

Rob: When you left Bridgewater, did you roll over your 401k into a IRA at your new company?

Dar Sandler: Absolutely.

Rob: Okay. I figured you did but I thought I should ask.

Dar Sandler: All my savings and investments are through Appian Road. I put my money where my mouth is.
Rob: Let’s go down this rabbit hole. Let’s start— tell us what risk parity is.

Dar Sandler: The notion of risk parity— and I’ll start with it in the traditional sense… The traditional sense of investing is a dollar weighted approach. In other words, you have $100 and you dollar weight that. So, if you want 60 percent in stock, you put $60 in stock and $40 in bonds, assuming the world has two assets. The risk parity approach says, if you do that you’re not really 60 percent of your stock and 40 percent in bonds because you’re actually 80 to 90 percent in stock and 10 percent in bonds. The reason for that is that stocks are a lot more volatile than bonds. Therefore, they dominate the risk weight of that portfolio. So risk parity says let’s risk balance those and then transition those into dollar weights. A risk parity portfolio of just stocks and bonds would be about 20 to 30 percent stocks and about 70 to 80 percent bonds. Again, it’s very simple. I’m making big assumptions at $5,500 for stock and we’ll do the entire U.S. aggregate for bonds—that would create a risk parity of a 50/50 risk attribution between those two assets.

Rob: Let me stop you there and make sure I understand what you said. First of all, when we’re talking about risk we’re using beta or volatility?

Dar Sandler: Absolutely, good question. We’re using volatility to measure risk.

Rob: Alright. Of course, stocks are more volatile than bonds in the long term. They go up and down more than bonds, right?

Dar Sandler: Correct.

Rob: So, when you talk about risk parity and having roughly 30 percent in stocks and 70 percent in bonds or something around that, is the idea of that 30 percent in stocks— the risk of that is measured by volatility would be comparable to the 70 percent you have in bonds?

Dar Sandler: Correct. That’s making the very simple assumption that stocks are two to one as risky as bonds.

Rob: Right. Bonds, in themselves, aren’t as risky as stocks. When we put 70 percent of our assets in bonds, yes, it’s lower risk. But, times that by 70 percent and that comes out to be roughly as volatile as the riskiness of stocks times 30 percent.

Dar Sandler: Exactly.

Rob: Okay, so that’s step one. I think we got that. I’ll turn it back over to you. Where do we go from here?

Dar Sandler: The idea is that this establishes a much more risk balanced portfolio. That’s kind of the first ingredient. The second ingredient is how do we think of all asset classes? How do we think about the world? The way we think about the world is driven by two forces. One force is inflation as measured by changes in CPI and growth, changes in real GDP. The idea here is that we break up the world into four economic scenarios. One is rising growth, falling inflation, falling growth, falling inflation and so forth. It’s four kinds of scenarios. The idea here is that you want to create a portfolio that is risk weighted in each of those economic scenarios. Now, let me take a step back. The reasons for those economic scenarios is that we believe all asset classes (and this is where our portfolio hinges on) are driven by expectations of real growth and inflation. I want to be very careful with the words I use its expectation, not actual. So if growth comes in above expectation, GDP in the U.S. is three percent and it’s expected to be at three percent next quarter and it comes in at two percent, that’s falling growth. It’s all relative to expectations. The idea here is you want to create a portfolio that is relatively agnostic to what the economic scenarios of the world are.

Rob: I get the idea that the two things you’re looking at are inflation and growth. Inflation measured by CPI, growth measured by GDP.

Dar Sandler: Correct, real GDP.

Rob: What does that mean. Real GDP?

Dar Sandler: There’s nominal GDP and there’s real GDP. There’s two ways to measure the economy.

Rob: It takes into account inflation I take it?

Dar Sandler: The idea of nominal has inflation in it. Whereas, real doesn’t.

Rob: Alright, so you have real GDP and inflation. With those two factors, you can have four quadrants, right? One in which they both go up. One in which they both go down. And then one where one goes up and the other goes down. And then the reverse of that. So, you’re looking to build a portfolio that will effectively do well in all four of those scenarios?

Dar Sandler: Correct, and risk weighted. If we recall what risk weighted is based on ingredient number one, that’s the way we do it.

Rob: Okay, so, we’re a long way away at this point (in my mind) from investing in three Vanguard funds. But that’s okay. I’ve got step one, the idea of risk parity. I’ve got step two, these four quadrants that we want to build a portfolio that is agnostic, if you will. And as you said, that will do well in all four of these scenarios. Now, how do we do that?

Dar Sandler: Now that we have those four scenarios, you can think of it as four different sub-portfolios. The portfolio of rising growth, falling inflation which is kind of the world we’re in right now. What does well in that world? You look at different asset classes. Stocks do very well in that world. Let’s keep it simple. So stocks would be the asset class that we would put in that bucket. REITs do really well in that world, so we would put REITs in that bucket. Within stocks you can say there’s European stocks. There’s Japanese stocks, but let’s keep it simple. Let’s just say those are two asset classes that you would put into that bucket. Then, within that bucket how do we create a risk parity portfolio? We’d say, REITs are more volatile than stocks are so we would put more stocks than REITs. That would be that sub-portfolio. We’d do the same thing for each of the other three portfolios and then each of those sub-portfolios would just simply be 25 percent of the weight in our big portfolio.

Rob: In the first bucket, you talked about rising growth, lower inflation, you said stocks and REITs do well in that example. Stocks are more volatile than REITs, so in that bucket you’re going to have more REITs than stocks?

Dar Sandler: Yes, if that’s the case. I’m just giving you hypothetically.

Rob: I understand. That bucket of stocks and REITs will comprise a total of 25 percent of the portfolio?
Dar Sandler: Correct. With the assumption stocks don’t fit in any other bucket. They might also be in another bucket which makes a little intersection. But conceptually, you are right. You can imagine some asset classes perform well in various asset classes.

Rob: Like what?

Dar Sandler: Bonds, you can think perform well when there is a deflation in the environment. Whether or not growth has gone up or down, you can argue, the longer bonds. So they might be in both of those portfolios.

Rob: Okay. So to explain that, at least as I understand it, in a deflation area environment, interest rates tend to go down. When interest rates go down, the value of existing bonds (which are at higher rates) tend to go up?

Dar Sandler: Correct. And usually on the longer end of the curve, on say a 10 year or 30 year bond.

Rob: Okay. So those sorts of bonds could do well in both buckets where inflation measured by CPI is going down?

Dar Sandler: Correct. It is irrelevant to where growth is. Now, obviously growth has a factor in something but as a subtlety that we think about in terms of that relationship. But on a conceptual level, that’s how we bucket things.

Rob: How do you go from what you just described, to actually building a portfolio that you use for your clients?

Dar Sandler: We are constantly searching the world for asset classes which we can invest in, meaning that they are liquid enough, cheap enough expense wise and they give us another level of diversification. In an ideal world, anything we can lay our hands on in this world that would fall in the buckets and add any diversification to it we would take in and literally add into that sub-portfolio. And again, risk weighted accordingly, as we described— S&P 500, MSCI Euro, bonds for Europe, bonds in the U.S., inflation link bonds, commodities and all these different asset classes that are readily accessible, usually via ETFs that are cheap and liquid enough. Usually the Vanguard ones are cheapest (or the Schwab ones) so we stick them into a kind of blender and see where they fall out in terms of risk in each bucket. And from that we create the weight for the individual client.

Rob: How do you determine the risk for each class?

Dar Sandler: Good question. So, first off, we do this experiment with creating a risk parity. Meaning that, assuming you put $100 in, without taking any leverage, what is the base risk for that? If I have $100 and I invest $100 in our portfolio, what kind of risk level would I obtain? Risk levels can be defined by volatility. I know we kind of lingered into the third ingredient but without getting there yet, we take the $100, stick it in the portfolio with different weights, invest 100 percent of it and the risk that comes out is the risk of the unlevered portfolio.

Rob: Yeah, but that’s what I want to figure out, is how you determine risk. Are you effectively using standard deviation?

Dar Sandler: Oh, yeah, sorry. We are. We are using historical standard deviation. All these portfolios are over three to four years.

Rob: So, how much historical data are you using to determine the standard deviation of each asset class?

Dar Sandler: As much as we have. For example, S&P 500 we have since 1960. Inflation link bonds which are the shortest, we’ve had since 1999 when they came out. That’s kind of the spectrum. Let’s say from 50 years to 15 years.

Rob: Alright, and how many different asset classes have you identified that you use in your clients’ portfolios?

Dar Sandler: About 15 to 16 different ones.

Rob: You have one or more ETFs for each of the asset classes?

Dar Sandler: Give or take. The reason I say give or take is that sometimes— for example, a bond, ETF, will include a few different risk factors. We don’t think of them as asset classes. We think of them as risk factors. It might include a few different ones within one. It’s not a one-to-one method. For example, I’ll give you a very simple one… You have a 10 year nominal bond, a U.S. government bond. There are two components to that. One is the real rate and one is the break even and inflation rate. Those two different rates move differently in different environments. So holding that bond, you have two different factors which could be in two different buckets. Do you get what I’m saying?

Rob: Conceptually, I do. Alright. Well, let’s get to the fun stuff then, because you mentioned the third ingredient is leverage. So, you’re borrowing money. How and why do you do that?

Dar Sandler: Correct. You can imagine the output of this portfolio is a relatively lower risk portfolio than what the clients’ would want. Risk is obviously mapped one-to-one with expected return. It’s well known in the financial industry that the more or less risk you take, the more or less return you’d want to achieve. You can imagine that, given that there’s a heavy dose of bonds or fixed income (which is less risky) we have to up the weight amount; you can imagine the overall portfolio risk is relatively lower than what the appetite of our clients want.

Rob: Now, let me just stop you there so we’re all on the same page. Let’s go back to our simple example that we started with, with 70 percent in bonds and 30percent in stocks. You set it there because it made the risk of each similar. But as you’ve pointed out, a portfolio of 70 percent bonds probably doesn’t generate the returns that most investors are looking for.

Dar Sandler: Correct. And it depends on the goals of the investor. Let’s stick with that simple example. Assume the world is just two simple asset classes, for now. We have 70 percent bonds and 30 percent stocks. That investor says, “Listen, I understand you’ve got it risk weighted. I understand diversification but I have a long timeline and I’m okay with taking on more risk. I don’t need this money for the next 10 years.” That’s a classic situation. With that in mind, how do we then up this portfolio? You’d mentioned Vanguard earlier, or the traditional, the traditional approach would say this client wants more risk, let’s add more stocks to this portfolio. Swing the pendulum, let’s put 80 percent stocks, 20 percent bonds. Correct. That investor now has more risk, potentially greater reward. However, what that investor now has lost is diversification. So what we suggest is, why change the underlying song? Let’s keep the song the same. Let’s keep the portfolio composition the same and let’s lever the portfolio. Keep the same ratio of 30 percent stock, 70 percent bonds and then increase it through the use of leverage. Not a lot of leverage but a tiny amount. When we talk about someone wants a 10 year portfolio, we leverage that portfolio, 80 cents to every dollar. That means, for $100 we’d be buying $180 for that portfolio. Therefore, the individual investor—

Rob: Sorry about that, we got disconnected. You were telling us about leverage. For every $100 you might actually leverage it up so you can invest $180. How do you do that? What are the mechanics of adding leverage to a portfolio? How does that work?

Dar Sandler: Sorry, before we talk about that, I’m not sure if you got the final point. Instead of using the traditional sense of increased risk which is weighting more in the riskier asset, what we do is simply use leverage up or down. The key to diversification benefits to the portfolio is that the composition never changes, just the risk level. The risk appetite changes. Now, to answer your question. How we actually achieve leverage is, there’s two mechanisms. One mechanism is through the use of a margin account. Quite literally, the account goes into negative and the assets they use against the margin are the assets themselves. I invest in S&P 500. I only have $100 in my portfolio. I invest $140. You’re going to see negative $40 in the account and the bank uses the S&P 500 as collateral against that loan.

Rob: Okay, here’s my question to all this. Why is this approach, which, to my way of understanding seems far more complicated, why is it better than simply having 80 percent stocks and 20 percent bonds?

Dar Sandler: The bottom line is diversification. That’s the way I’d give you a very simple answer. Eighty percent stock and 20 percent bonds are not diversified. Yes, you’re getting more risk. However, you’re making a very particular bet. If you go into the way we think about the world framework, about how we think of the world in terms of risk in terms of growth and inflation, stocks do really, really well when there’s rising growth and falling inflation. But what if the world is not like that? What if the world comes in a little differently? What if the next three years are deflationary, falling growth? Unless you want to be in that world, where you want to make a bet, why make these bets on the world? It just doesn’t make sense to me. So, keeping those very well diversified portfolios are the bottom line.

Rob: Do your portfolios perform and generate greater returns with less volatility than a comparable, traditional asset allocation?

Dar Sandler: Yes.

Rob: That’s after fees and taxes?

Dar Sandler: Correct.

Rob: So, can you give us some sense as to the numbers and why you think that is?

Dar Sandler: I’ll give you the reason why it is. The reason why it is, is because of diversification. Over a long period of time the market is about 50 percent right in regards to whether we have higher growth or falling growth, or higher inflation, falling growth. That’s just the reality of the world. So, if you’re diversified, you’re going to do better conceptually over the long term than you would making a particular bet on one of those scenarios. Now, how are the numbers different? We have about a 20 to 30 percent higher sharp ratio than if you look at the 60, 40. If you look at the 60/40, which is kind of the classic— When I say 60/40, I mean 60 percent MSCI world, 40 percent bonds of the world—the most classic and using Vanguard which is the most classic stuff with subtleties and all that, versus that type of portfolio, we have about a 20 to 30 percent better risk return ratio.

Rob: You mentioned the sharp ratio. Why don’t you describe what that is?

Dar Sandler: Sharp ratio is just a financial term that is very standard to use in the beta space which is the longer term, passive investing. It’s not so useful in the alpha world where you’re trying to beat the market. Short term volatility can really skew that ratio, but basically all that is, is excess return on the numerator— so your return of the portfolio minus the interest rate, divided by the standard deviation.

Rob: Let me play the devil’s advocate here. If what you’ve described is the better approach, why don’t the Vanguard’s and Fidelities and Schwab’s of the world offer an ETF or mutual fund that approaches investing as you’ve described?

Dar Sandler: Good question. On the institutional world, risk parity has been prevalent for many, many years and has been very, very successful. Bridgewater, HQR, INVESCO and a few other companies that are very, very successful in the institutional space. On the individual space, my best guess… This is my hypothesis. I don’t have supporting evidence or data behind this so you’ll have to take it with a grain of salt. But, I think the Vanguards of the world have not entered into this space yet because what they have is selling very well. They’re very good at it. It’s a very simple product to sell. It’s a lot easier than what we just went through. I can explain the 60, 40 approach a lot easier than what we just went through. And I bet even what I explained to you is probably not enough for most people to understand. I think the simplicity of it is one thing. That’s just the reality of it. When something’s easier to explain, it’s easier to sell. The last thing is, leverage is scary. Leverage is scary. We just kind of grazed the surface here, but lien and collapse have a 40 to one leverage basis during potential crisis. It scares a lot of people. And when you use that word, it pushes back a lot of our people that we try to sell to and people that we talk to. That’s probably the two big reasons why that is.

Rob: How do you deal with the risk? You talk about avoiding the risk of, I guess you’d say, “The lack of diversification from a traditional portfolio,” but you’re sort of introducing a different risk, and that’s leverage. How do you deal with that risk?

Dar Sandler: That’s a good question. Hold on one second— the risk of leverage, obviously, on a conceptual level, the portfolio return—if I lever a portfolio up and the leverage costs me more than I would potentially gain, then obviously it’s not worth levering up. Obviously, the returns are higher with the leverage than they would be. In terms of the risk, obviously leverage increases the volatility. The swings, up or down, are a lot sharper. Therefore, how do you manage that risk? You manage it in two ways. Number one, the bank that we use in contracted brokerage manages that risk by having a mechanism that stops or forces a sell if it breaks some sort of margin requirement. So, if I have $100 in my account and I lever it up 1.8 to 1, which is $80 and the portfolio loses, let’s say 30 percent, then the contracted brokers will force a sell, a mechanism that will sell it, the S&P 500, automatically, and pay it back. We never get to a point where the portfolio goes into negative, where the client owes money. That’s the bank mechanism. Our mechanism, on top of that, is that we rebalance the portfolio, quarterly or when there is a sharp up or down turn to manage that risk. It’s always at the risk level of the clients.

Rob: How have you done as a practical matter in marketing this investment?

Dar Sandler: It’s one of the challenges. It’s also one of the reasons I’m speaking to you, Rob. It’s a challenge. I think, probably one of the main reasons we do not succeed in making this a big company is because how do you explain a concept that is as intricate as this to the average person? We’re finding it very challenging. One of the things is to have things like we’re doing right now, to explain it. We have marketing materials. We have conversations with people. We go to schools to speak about this to MBAs, etc. It is challenging. We haven’t cracked that egg yet, frankly.

Rob: Have you thought about trying to get institutional clients that may have more of a stomach for this sort of approach?

Dar Sandler: We are. It’s definitely something that we are considering, probably more in the medium term than in the short term but it’s something that’s definitely in the front of our minds. However, with institutional clients, there’s a lot of leg work that needs to happen. It has to be, usually, a hedge fund or a mutual fund type of structure which has a lot of costs involved with that. There are a lot of checklists that you need to do which is a third party auditor, legal things, etc.

Rob: Yeah. What are your assets under management?

Dar Sandler: We’re getting close to the $6 million mark, right now.

Rob: What’s your cost?

Dar Sandler: With assets under management, we charge 1.35 percent assets under management.

Rob: It’s interesting. I think you have a couple different challenges. One, it is a very complex way to invest. And as you said, it’s not the approach that big firms like Vanguard are marketing. People are used to thinking in a risk parity, leverage way. Then, the costs, right? You can go get an ETF for 5 or 10 basis points.

Dar Sandler: Absolutely. I think you’re hitting the nail right on the head. Well, we think about that cost, the 1.35 percent— when compared to the average person who’s investing out there for you, they are charging you between one and two percent on average. That’s based on our market research. If it’s lower than one, it’s usually because that person is getting a kickback from the company that they’re investing in. For example, someone who works at Edward Jones might charge you .75 for a $2 million but the mutual funds that he’s putting you in, which are charging you one percent or more, he’s getting kickbacks from. So you need to be careful with those investments. However, to your point, if you’re in the most simple Vanguard traditional approach, yes, you’re paying 10 to 15 basis points. That’s the best you can get. Actually, our advice to people is, if you’re not going to go with this risk parity approach, do not spend any more than 10 to 15 basis points in your investment. It should be a Vanguard target retirement or whatever the 60/40, whatever matches your risk, in a traditional sense. And do not give anyone else any more money.

Rob: I’m curious. If I understand you, you’re approach generates excess returns, risk adjusted returns so the cost is justified. But, for someone to just put you a traditional portfolio, why would you pay them to do what you can do for virtually free at Vanguard?

Dar Sandler: Correct, and that goes directly to the Betterment’s of the world. It goes to all the fancy funds out there and all that. When we talk to clients who are debating whether or not to invest some of their assets with us, one question is how much are they wanting to invest with us. The rest of the assets that they don’t invest with us, for whatever reasons, our big advice to them— we usually give them the Vanguard equivalent of whatever they have, which is usually a quarter of what they’re paying.

Rob: What I was going to ask you about, robo-advisors. You mentioned Betterment. There’s Wealthfront. WiseBanyon’s one that’s actually free, what are your thoughts? If someone wanted to go the traditional route, what are your thoughts on those sort of automated investment services?

Dar Sandler: We actually just literally wrote a blog about it. It’s going to come out soon on our website so you can check that out in a month, but our perspective is do not pay for those guys’ fancy websites. You do not need it. You can get the same thing from a Vanguard. Open a Vanguard account. Get the same mutual fund and pay a quarter of what you would pay those guys. You don’t need the fancy charts and graphs. And frankly, Vanguard’s interface is very nice. It’s nice enough. My bottom line is, I don’t think people need them. And I think millennials are attracted to them just because of the look and feel.

Rob: Yeah, interesting. Well, a related question is when you go to a Betterment or Wealthfront, they slice and dice a portfolio, but they take a different approach. With betterment, they include small cap value and mid cap and different kinds of bonds and what not. I’m curious on what your thoughts are on that kind of portfolio where the number of different sub-asset classes versus, as you mentioned a minute ago, a Vanguard target date retirement fund, which doesn’t do that. Those funds are usually just comprised of four funds; a U.S. total market, foreign total market, total U.S. bond market and total foreign bond market. That’s it.

Dar Sandler: I think the question is, do the value of adding all those sub components, like breaking up the U.S. large cap into small cap, medium cap, micro-cap and all these different components add more value, even with additional costs that they incur? Because Betterment charges— and also those funds are usually a bit more expensive than a standard Vanguard. The honest answer is they’re probably equivalent over the long term, based on our own research. But the bottom line is, it’s just so much simpler and easier to have it in one fund. It’s just cleaner. It’s easier to get your mind around. It’s easier to explain it. It’s easier for tax purposes and it’s just so much simpler. Unless you’re in that world, which most people are not, I still recommend the Vanguard. I don’t see the added benefit to all the slices and dices that they do.

Rob: That’s kind of where I’m headed. I haven’t been a crazy investor with tons of sub-asset classes but I have had small cap exposure and a few other things. As I’ve tried to simplify everything in my life, I’m slowly coming to the conclusion that you just laid out. The thing I liked about talking to you, including the many conversations we had before this interview, was that you really believe in your approach and I think it’s very different than what most people have heard of. I kind of wanted to introduce it to the folks that follow this podcast. Obviously, what I’ll do, Dar, in the show notes, is leave a link to your site so that if people want to follow up with you, they can. You’ve also, over time, sent me a number of different resources. I will link to those, as well. If you have anything else that you’ve created since the last time you sent me things, which was probably a couple of months ago, if you send them over, I’d be happy to include that because I think it would help folks that want to understand this risk parity approach to investing. It’d help them understand better.

Dar Sandler: Absolutely. And to the listeners, I highly recommend, read, read, read. Learn. Educate yourself and ask a million questions. If you’re not going to go with risk parity (which might be too complicated for most people) simplify and go with… I highly recommend— I don’t work for Vanguard, but just do Vanguard. It’s the simplest, easiest approach. Don’t over complicate things. Investing should be boring. That’s how I think about it.
Rob: Yeah, they’ve heard that from me a few times.

Dar Sandler: It should be like watching paint dry. I’m a big believer in that. If you want the action, take $100 and go to the casino, get your free drinks and that’s it.

Rob: Dar, listen, I appreciate your time today. As I said, it’s taken me a while to really wrap my mind around. I think, conceptually, I’ve finally gotten there, but it wasn’t easy for me. Anyway, I appreciate your patience in walking me through this multiple times before we did this interview and then again today. I will include links to all of the information you sent me so folks can check it out if they’d like to. I really appreciate you taking the time to talk to us.

Dar Sandler: Absolutely. Anytime. Any questions, we’re always open. We love the skeptics. We love the critics. We love the feedback as well.

Rob: Okay, great. Thank you.

Dar Sandler: Take care.

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8 Responses to “DR 164: Risk Parity Portfolio Construction with Dar Sandler”

  1. Very Interesting episode. I just have one fundamental question. Assume I have 80% or a high proportion in bonds as suggested to reduce risk. Say the yield on that portion is 3%. I am also levering my portfolio with Margin accounts with interest rates between 7.75% – 10 %, why is this such a smart thing to do?

    Because something is more complicated and takes about an hour to explain, does it automatically makes it a better thing?

    • I think that he is talking about professional margin rates, not retail ones. So we are talking about probably something like .25% + Federal Funds; which right now means < 0.5%. So not those crazy margin rates you are mentioning that you get at Schwab, or other retail brokerage firms.

      Also, I think he mentions that they also use derivatives to lever up. In that case, the cost is just the federal funds rate.

      Both methods are how hedge funds use leverage for risk-parity strategies, and have been very successful at it in the past 20 years.

      The federal funds rate will always be lower than any other bonds rate and in general provide a lower return, because if that weren't true – no one would invest in anything except government tbills.

        • Mike Cohen

          I would be careful comparing a solid elite strategy like Risk Parity that has been applied successfully at the Institutional Level for several years (20+) against a theoretical approach outlined on one paper by one company.
          There are really no tangible credible, realized returns to back those claims against really anything. To my knowledge no big player is implementing this Sharpe Parity strategy (actually not really anyone) as opposed to Risk Parity, where you have very reputable companies like AQR, Invesco, JPMorgan and Blackrock.
          I also took a look at the paper you mention and there are several shortcomings/fallacies. Including claims that risk-parity doesn’t take into account things such as credit risk, which is completely untrue. Modern risk parity strategies, isolate each risk factor and risk balance it. So things like Credit Risk, Term Premium, Emerging Market Debt Spreads, etc. are isolated and risk balanced appropriately.
          Furthermore the paper claims that volatility isn’t a good measure of risk as it could preclude recency bias and goes on to claim that a better approach is one where “sharpe ratio”is considered instead. What that really means is that you are now considering RETURN as well as VOLATILITY. But there couldn’t be anything more biased towards recent events than return. So you are actually super biased in sharpe parity. In all intense and purposes this sharpe parity theoretical strategy is a momentum strategy, where you just follow trends. Which could do really well, don’t get me wrong, but it doesn’t balance risk better than risk parity. Volatility is a much more appropriate measure of risk in the long run than return (or sharpe ratio). If you look at any asset class you will see that volatility doesn’t change much over the past year, vs the past 3 years vs 5 or 10 years. While Sharpe Ratio significantly does, making it a lesser measure of risk.

  2. Jeremy

    Interesting show, thanks for doing this one. Were you going to post some materials from Dar? I looked at their website and they only have 4 blog posts and the latest is from Jan 2014. Maybe they are working on other things, but I’d think they’d want to keep it more up to date if they are trying to get customers.

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