Prevent Your Portfolio From Blowing Up Using Micro Risk Parity

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During his recent interview with Tobias, Nicholas Pardini, Managing Partner at Davos Investment Group discussed Micro Risk Parity. Here’s an excerpt from the interview:

Nicholas Pardini:
I mean, you can make money speculating on bonds going up or down the short term, if they go, say, negative, but I just think in terms of, from the perspective of an investor, it’s not a good place to be right now. But in terms of commodities and FX, I try to look if there’s any catalysts that will change the existing narrative or trend that’s coming, and once I see it, I’ll put on a position when my risk models permit and let it ride. In terms of how I manage risk, I use volatility to manage risk. I size positions depending on volatility. So, if it’s something that doesn’t move very much, say, like, I don’t know, FX pair, a much bigger percentage of my book, say, 20% of my book in an FX pair, even though it’s only worth maybe 25 basis points at risk, because the difference between my entry point and my stop is 25 basis points. But since currencies don’t move very much, you can have a much bigger position. Then, on the other side, something like, say, Tesla stock, which moves $20 a day often, you have to have a much smaller position adjusted for volatility.

Nicholas Pardini:
And I call it, in a way, micro risk parity, in the sense that, every one of my positions is worth the same amount in terms of risk. And I do that to prevent blowing up. I think the biggest risk that a lot funds make the mistake of is, apart from shorting gammas, mis-sizing positions without factoring in volatility. They’re just on pure blind conviction. I mean, I may feel like I have more conviction in something more than another in terms of the theme, or even a specific company, but historically, those intuitions don’t line up with the results. You have to look at it while … I mean, like in sports betting, where you just have even sized bets on every portfolio, because every game, because you don’t know which one is going to be the one that’s going to win. At least, I mean, I haven’t gotten to that point in my career where I can say, “This is by far my highest conviction trade, and the results reflect that.” I don’t know if you’ve had experience for your experience like that, in terms of sizing positions, but that’s how I do it.

Tobias Carlisle:
I find it difficult to size positions properly, so I tend to equal weight, but I’m in a equity world, long short equity world, so the volatility isn’t that different from position to position, although there’s a lot of difference between Berkshire Hathaway and, to your point, Tesla, speaking of which, do you have a view one way or the other?

Nicholas Pardini:
Yes. I mean, I have a bearish view on Tesla, and I have a short position in Tesla. I mean, I was kind of ignoring it until recently, but it’s already back within 20% of its all time high, even though I think you’re going to see a major demand crunch for cars in the future.

Tobias Carlisle:
With this quarter.

Nicholas Pardini:
Yes. I mean, they’re the company that changes brands on just pure momentum. But that’s the thing with the market right now, generally, which is making it a little bit challenging, with everybody writing off 2020 as just, this is just going to be a bad year because of COVID, and two months being shut down, maybe more. Fortunately for you up in LA. And therefore, we just are not going to have any guidance, we’re just going to write it off, we’ll forget about it, and let’s just hope 2021 is back to normal. But we have no idea if it’s actually getting back to normal, because nobody knows what’s just a temporary change, or if it’s a structural change. And so, the market with a lack of fundamental anchors, and with the possibility nobody knows who’s going to get bailed out by the Fed or companies who are going to give more favorable financing because they’re hoping that the Fed will help them if they get in trouble, that it’s basically, it’s pure emotion. Every stock is Bitcoin now, to a certain degree.

Tobias Carlisle:
Not the stocks I own. They seem to be pricing in a lot of COVID based disaster.

Nicholas Pardini:
Well, I mean that in the sense that, it’s moving the same way as Bitcoin. What I mean that more in the sense is that, there’s little to anchor it to. I’m not a big fan of crypto currencies just from a conceptual basis, but the, really, role of them is that it’s the most pure beta out there. You have no earnings, reports are nothing to be accountable on that. There’s no cash flow or interest rate expectations, so you can’t peek at zero rates, because you’re not expecting a cash flow anyway. And unlike other commodities, there is no storage cost, so you don’t have to worry about what happened with oil a month ago. So, if you want just a pure animal spirit beta, risk on, risk off, Bitcoin is the trade, because the only thing driving it is sentiment and emotion.

Nicholas Pardini:
I mean, actually, I used to be a really hardcore gold bug, and I still like gold from a structural point of view, just given its historical role of money, but how I started to see crypto, the arguments in favor of cryptocurrency merge with the arguments for gold, has made me more skeptical on precious metals, to a certain degree.

Tobias Carlisle:
So you don’t think gold will serve that same money function, or risk off function that it has in the past, and maybe that goes to crypto?

Nicholas Pardini:
I think they’re both trading similar in that way. I think crypto is more aggressive version of gold. Crypto is like … A lot of people argue that it’s digital gold. I think it’s more just pure beta. Gold is a mix of … It seems like the narrative of gold is continually changing. When I first was trading, gold was known as the inflation hedge, as a way to protect … But then you don’t see inflation, and gold goes up, and when you have inflation, gold goes down, but I think, really, gold is the proxy for real interest rates. The more negative real interest rates go down, gold should go up. It’s the inverse of real rates. And that’s, in essence, I think, real rates are structurally going to remain lower. I’m still positive view on precious metals.

Tobias Carlisle:
Let’s talk a little bit about Coronavirus and the market. You seem to be saying that the market is untethered from what is actually happening underneath, or people are just assuming you can write off the front month of the DCF, and then you look further out and your terminal value’s not changed. So, it makes sense we’re back to where we were before the shutdown. How do you see it playing out? What do you think about the way the market is now?

Nicholas Pardini:
Well, I think the market is pricing in a few possibilities here. If the base case that they give you, just as if this is a normal market economy, and the recovery is like a typical recovery from a contraction of half of the magnitude of this one, then the asset prices need to go down across the board, especially in some of the more overvalued, speculative names with a lot of leverage. People think tech all is clean balance sheet. There’s plenty of tech companies that have debt to equity ratios well over one, and that’s probably if you want to go short where your opportunities are with little to no profit and high levels of debt. So, you’ve got …

Nicholas Pardini:
That’s probably the basics that the market will catch back down to the economy. And, you could see a little bit of recovery in the short term, because going from zero to reopening, and a lot of people have to [inaudible 00:34:17] as there’s some pent up demand. I bet a lot of people in California really need to get a haircut now.

Tobias Carlisle:
Yes, I’m one of them.

Nicholas Pardini:
I’m one of them too. And that will probably make things look good, and in the shorter term, I think that’s starting to get priced in, but unless if this Coronavirus was just a complete hyperbole overblown, which there is a possibility that everybody was just wrong, and this lockdown is unnecessary. And this is no … I mean, this is just like a more potent version of a flu, then things could catch on a little faster than expected. I think that’s not the most likely scenario, but I think that’s a possibility. The other arguments to the bull case are, that this is the beginning of the major inflationary crack up from an Austrian perspective. And, really, the argument for that is, look at what gold and crypto are leading the way higher, and how you’re seeing things that actually require structural demand not recover as fast.

Tobias Carlisle:
What things require structural demand?

Nicholas Pardini:
Travel, transportation, industrials, and also you’ve seen REIT’s, like office buildings, not [inaudible 00:35:41], those are facing the work remote, but even residential REIT’s too. The basic things involved in the production of goods and services are lagging, whereas the stuff that’s leading the way is a lot of inflation hedges, along with health care, precious metals, and also the lagging of non US equity markets too, are the other thing on that side. The third argument is that the market is starting to price in basic income, and these … I’m just going to start these are the bull arguments. And I think, though, you see what’s going on, is that a lot of this stuff that’s leading the way higher is stuff that people will buy on an income that’s enough to keep them alive, but not enough to really live a life of luxury, or have a family or anything like that. So things like video games.

Nicholas Pardini:
Video game stocks are one of my favorites on the long side, because there’s a few reasons for that. One, going long, video games just short the earnings prospect of American and Western men generally. If you have a down economy, then video games are the one of few affordable forms of entertainment. I mean, as a younger guy, I know from my experience, the poorer I’ve been, the more I play video games. I don’t know if that’s the same with other people you know, but that’s-

Tobias Carlisle:
It’s certainly been a feature of this shutdown that there’s been an explosion in video games being played, so that …

Nicholas Pardini:
I mean, Animal Crossing sales … Nintendo stock has shown you what’s going on with that, but video games are big. They’re the new staple, I think. A lot of the old staples such as cigarette companies, and alcohol companies, and junk food, due to health choices were fading out, but maybe in a basic income, they have a chance of coming back. But fast food has been another leader on the way higher. Chipotle is back at all time highs. McDonald’s is close. You’ve also seen health care be a leader of that, because that’s a basic service that would be provided by government. And, you’ve seen a lot of internet entertainment, stuff like Google for YouTube, Netflix for streaming, et cetera, and you got eCommerce. So, those are telling me that the market is pricing us, and gold rallying too, is that, it’s going to be, central bank finance basic income is, I think, the most bullish scenario for markets, even if it has societal implications that aren’t so great.

You can find out more about Tobias’ podcast here – The Acquirers Podcast. You can also listen to the podcast on your favorite podcast platforms here:

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