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The Fed has hiked interest rates multiple times this year, but inflation remains stubbornly high. So are current housing prices unsustainable? If so, when will a housing market correction occur (and how deep will it be)?
Cullen Roche, founder and CIO of Discipline Funds, joins the show to discuss what real estate investors should expect going into 2023.
Watch On YouTube
- Insights on the Federal Reserve’s political considerations (and why the Fed may be “trapped” into destructive policy decisions in 2022).
- How a housing correction in 2023 would likely look different compared to 2008’s housing crash.
- Cullen’s prediction on the extent to which housing prices could fall in 2023-2024.
- Why real estate investors should maintain a long term investment philosophy.
- Details on the Discipline Fund ETF (DSCF), the model behind it, and why the “fund of funds” ETF model is so tax-efficient.
Featured On This Episode
- Pragmatic Capitalism (Blog)
- Pragmatic Capitalism: What Every Investor Needs To Know About Money And Finance (Amazon)
- Three Minute Money (YouTube)
- DSCF – Discipline Fund ETF (Morningstar)
Today’s Guest: Cullen Roche, Discipline Funds
- Discipline Funds – Official Website
- Discipline Funds ETF Site
- Pragmatic Capitalism – Official Website
- Cullen Roche on LinkedIn
About The Alternative Investment Podcast
The Alternative Investment Podcast is a leading voice in the alternatives industry, covering private equity, venture capital, and real estate. Host Andy Hagans interviews asset managers, family offices, and industry thought leaders, as they discuss the most effective strategies to grow generational wealth.
Andy: Welcome to the “Alternative Investment Podcast.” I am your host, Andy Hagans. This is Part 2 of my interview with Cullen Roche of blog and book “Pragmatic Capitalism.” So, Cullen, in our last episode, we were talking about inflation versus disinflation versus deflation.
You know, where we are likely to be heading going into 2023. It looks to you like inflation probably did peak, you know, whether it was four, six months ago, but the Federal Reserve has to look at that backward-looking data. And so, we’re likely to see some further rate hikes, I think. Would you agree with that?
Cullen: Oh, yeah. It’s kind of interesting the way this actually flows through the market, you know, the Fed is technically…you know, the actual Fed funds rate is much lower than what, I would say, the economy is reflecting. So for instance, the two-year treasury bill is, you know, as of right now, like, three and a half, three and three quarters.
And so, the policy rate is much lower than that right now, but the Fed, and this is part of what I was talking about earlier with open-mouth policies, that the Fed has communicated to the market that they’re basically going to 3.5% to 4%, something like that. And so, that’s what the market is basically pricing in right now. And it’s why you’ve seen this, you know, sort of front running of the Fed in the 2-year and even the 10-year.
But it’s interesting. It’s starting to get, you know, kind of screwy because the back end of the curve now is inverted relative to the front end, which is generally indicative of an environment where the market now expects that the Fed is going to have to walk some of this back in the future. So, inverted yield curves are typically consistent with, you know, if not recession, certainly economic slowdown, which, I think, is pretty obviously apparent at this point.
But the bond market is starting to say to the Fed, you know, “Hey, you know, 4% is probably the threshold here where you can’t really afford to be too much more aggressive.”
Andy: Yeah. But is the Federal Reserve saying, “You want to bet?” I mean, you know, like you said, that their entire profession was scarred by the 1970s, right? I mean, are they really going to be able to relax until the CPI is under 4%?
Cullen: It seems like they want to see the economy bleed some before they really step off the gas on the interest rate side of things. So they, I think, want to see…you know, it’s kind of weird that this is their perspective because this was also their perspective back in 2021, was that they wanted to wait to raise rates until they saw that the unemployment problem was definitively solved.
And so the Fed was very clear that they weren’t going to start raising rates until the unemployment rate came down to about 4%. And unemployment and just employment, in general, is a huge lagging indicator. And so, you know, they’re waiting on this lagging indicator to basically trigger whether or not the job is done.
You know, they wanted to make sure that the recovery was fully intact, basically. And that was…they were using the unemployment rate as their barometer there. Now they’re using the unemployment rate rising a little bit as their barometer that inflation has started to moderate to some degree. They want to see demand basically start to moderate. They want to make sure that there isn’t a wage-price spiral, like there was in, like, the 1970s.
And so, they’re, again, looking at the unemployment rate, and the interesting thing with that is that…let’s say that I think the unemployment rate fell a lot faster during COVID than a lot of people expected, which is, in part, why the Fed kind of found themselves backpedaling to some degree.
Because they were waiting for unemployment to come down to 4%, and then it came down really very quickly in 2021. And then they were kind of like, ‘Whoa, this is a little bit surprising. And inflation is rising a little bit faster.”
Andy: I mean, wasn’t a lot of that policy driven? I mean, basically, folks leaving the labor forces basically had nothing to do with the Fed’s actions in terms of political policy, or transfer payments, or just other…
Cullen: Yeah. Well, you could get into a whole other complex debate about how much Fed policy and, you know, inflation and interest rates even has a trade-off with unemployment. So, there’s the old Phillips curve model, is basically the idea that there’s a direct relationship between inflation and the unemployment rate, which for 10, 15 years before COVID, looked like totally bunk economics.
Because unemployment was low and inflation was low, which really, you know, that shouldn’t happen, according to the textbook model. So, you know, again, to some degree, it kind of looks like they’re working off this old-school textbook model that, you know, my worry now is that you could find yourselves in an environment here where the unemployment rate actually starts to spike a lot more.
You could start to see cracks in the foundation of, like, the financial system and the economy, and especially the housing market that makes the Fed really, really uncomfortable. Where you’re going to get inflation that starts to peel off much faster than they expected at some point. And then they’re going to be caught flatfooted again, which would be crazy, to me, to see the Fed get it basically completely wrong in both directions, you know, by basically being too accommodative too far into COVID and then being too restrictive coming out of , you know, the flip side of it, which is just…
Andy: Well, I mean, honestly, that makes total sense to me. I got to take the other side of that call, and its…
Cullen: It does, honestly. For them to get it completely wrong, it would be…I don’t know. It would be impressive to me if they got it that wrong on both sides, which is…it looks increasingly like there’s a really high probability of that happening here because they’re looking at this data in a way that is just sort of, I don’t know, mind-numbingly rear-view mirror looking.
And I get it because I think they’re so scarred by the 1970s, but I just…you know, in my model, my framework, the odds of a 1970s was just…it was never really a very high risk in the…
Andy: I mean, but I would argue they’re scarred by 2021, I think. Again, in my opinion, they’re willing to make a mistake. They just don’t want to make the mistake that they just made. So I think I agree with you that then the risk is that you just make the different mistake.
Cullen: Well, that’s what’s interesting, is that, you know, they could be causing…or I don’t want to say causing recession, I think there was going to be an economic slowdown no matter what. I mean, a lot of stuff just got way ahead of itself, whether it was real estate, or the silly stuff in crypto, or the meme stock boom, like, frankly, there was a lot of really stupid speculation going on for a lot of the last two, three, four years.
You could argue that a lot of, you know, the market, the stock market, and even the real estate market was frothy before COVID. And so, then getting this huge boom, you know, on the back of COVID that kind of made everything even more frothy, to me, you created an environment where frankly, like, if you imagine that COVID didn’t even happen well, you know, the COVID boom was basically just the blow-off top of, like, the big, long trends that were going on for the last 10 years.
And so, to some degree, you’re getting a giveback here that was much needed, you know? And this is part of the thing that makes investing in economics really, you know, difficult to kind of navigate, is that nobody likes going through these sort of short-term downturns, but to some degree, when you get these short-term booms, you need a giveback to some degree, you know?
The stock market, for instance, is an entity that it can’t go up 20% every single year because the underlying entities don’t actually grow 20% per year. So, if you get periods where the stock market goes through big, big booms like that, because of, in part, due to speculation and, you know, growing multiples and things like that, well, you should expect a giveback at some point.
And that’s part of the healthy process of any, you know, capitalist economy, growing, and booming, and busting over time.
Andy: Yeah. And, you know, I’m a real estate investor, and I’m a homeowner, and it’s like this assumption that higher housing prices are always good. And I’m like, “Hey, look, I could talk my book and say, ‘Yeah, I want real estate prices to go up,’ but you could also say, ‘I want home affordability to increase.'” Right? Like, so it kind of depends who are you asking.
Are you talking the home sellers or the homebuyers? Because for home buyers, these higher asset prices are terrible, that you can’t afford a home.
Cullen: Yeah. Well, and it’s interesting, especially for your listeners in the alternative space, where it’s like one of the reasons to use alternatives is to buffer the really high-growth parts of the economy. So, the stock market or something like the…especially like the growth areas of the stock market, like the technology space, or like the venture capital space, things like that, these are inherently really high-growth segments.
And sure, you could go 100% into those spaces, but you’re going to go through these big, big gyrations. And, you know, one of the values of adding diversification in the alternatives is that you basically are building in buffers around, you know, that really sexy high-growth component where you’re basically dampening the volatility of that component.
And, you know, that’s a good thing, in my opinion, is that I think most people would much prefer to have something like a 5% average annual return with a low rate of volatility rather than, say, a 10% rate of growth where you’re going through these huge booms and busts where, yeah, in the long run, you end up with probably a much higher balance, but in the short term, you go through just really painful, you know, ups and downs and these busts that, you know, frankly, are the components that behaviorally make investing really, really difficult.
Because these short-term busts, they’re really psychologically testing for people, where you might, in theory, have a 30 or 40-year time horizon, but behaviorally, I think most people have probably about a 30-day time horizon psychologically, where they can’t really go through big drawdowns and really painful periods for any sort of prolonged period.
Andy: Right. So, okay, let’s talk about real estate and alternatives. Because even as prices were going up in the past year, we saw large asset managers, the largest asset managers purchasing single-family homes, continuing to invest in multi-family, just investing in real estate in general.
And we see those inflows continue into 2022 and, I’d assume, into 2023. But I think… Actually, I don’t want to put any words into your mouth. Do you think the housing market is going to correct in the next 12 to 24 months?
Cullen: I do not see how the current imbalance with interestrates versus prices, I do not see how it can sustain levels of demand that I think put some downward pressure on prices. I think this is a very, very different environment than, say, 2008, in large part because you didn’t get the really low-quality speculative borrowing that you got in the run-up to the financial crisis.
I mean, that was the thing that…and this is the thing, frankly, that makes any boom turn into a crash, or any bust turn into a crash, I mean, is that, you know, you can get a kind of garden-variety downturn, but then at some point, in a panic, in a real market crash, you get forced selling. And that typically is the thing that you get margin calls and things like…you know, during the financial crisis, you had a lot of forced sellers of real estate, so a lot of delinquent borrowers.
And, you know, even in the investment banking space and the retail investing space, you had a lot of people that were forced sellers of equities in real estate in that environment, which is the thing that really made that environment incredibly scary because you get these sort of waterfall types of declines at times. Whereas, this environment doesn’t really have that low-quality aspect where you could end up with a really big forced selling downturn.
So, it’s very different in terms of quality, but the problem right now is that you’ve got a big supply-demand imbalance still where…and this is mostly coming from the imbalance coming through interest rates, where the affordability is still very, very low, prices are still very high, but now, you just have very low demand because interest rates are so high that it’s very difficult for most people to afford to buy at that new price with this existing interest rate.
And so, I think there’s got to be some sort of giveback. It’s either…you know, my guess is it probably happens on both sides, that you probably get, eventually, lower interest rates and lower prices, but there’s going to be something that has to come back into equilibrium to create the demand that’s consistent with, you know, rising prices, again, just because you don’t have enough demand at current interest rates to sustain the current prices.
So, I don’t think it’s going to be a big downturn. My guess right now is that you’re going to see something probably like a 5% to 10% downturn, something that’s kind of more consistent with, like, the 1991-style real estate downturn. So not a big, big, you know, waterfall crescendo-style downturn, but something that is still a, you know, 10%, maybe 15%, 20% maybe in some sort of much more speculative markets.
And I think that in the long run, that’s probably a good thing because I think, frankly, the real estate boom in the last 10 years was just in a lot of ways like the stock market boom, where it was just unsustainable trends to some degree, where the pricing got a little bit too far ahead of itself.
And I think some moderation in pricing is probably a good thing in the long run, that by 2023, 2024, we probably find ourselves in a legitimate real estate recession where, I think, the Fed will have clarity on inflation. And they’ll come back to a position where they say, “Okay, maybe the Fed funds rate can come back into 2%, say, because we’ve done the job on inflation and the real estate market has softened enough.”
And that’ll create more of an equilibrium between mortgage rates, where maybe mortgage rates come into something like 4.5% to 5%, something like that, where people then look at especially the relative rates, and they say, “Okay, well, I’m refinanced at 3% back in 2019, but I’m happy to buy a house that’s now at a 10% discount relative to where it was in 2021 with a 4.5% mortgage rate.”
Andy: Absolutely. Okay. So, you know, should investors wait it out? I mean, because it seems to me…what’s the technical…the trader term, capitulation? It seems to me like the asset owners, the sellers right now, haven’t really capitulated, you know, and to your point, they’re not being forced to, right?
Like, back in 2008, there was a lot of forced selling. So, I guess if you have the wherewithal, whether as an investor, as a homeowner, and you can just sort of, you know, hold, then maybe you will rather than take that loss. But you think that there may be…the new pricing will sort of…I guess it will be forced on the sellers who have to sell maybe in Q1, maybe in Q2.
And, you know, maybe we start to see some real price movement in the first half of next year.
Cullen: Yeah. I think that’s a reasonable view. You could start…not a lot of forced selling, but certainly, anyone who wants to move, I think, is going to come face to face with this reality that the demand in a lot of markets just isn’t going to be there for those properties. And this is probably more so true in, like, the middle-tier, upper-tier markets, where you don’t just have all cash buyers and the super wealthy that are able to come in regardless of what the mortgage rate is.
So, but yeah, I think that, in general, you’re going to get some softening of the market until you kind of find this equilibrium point with mortgage rates that, you know, creates more of a…we had, I mean, what is it? About 100% increase in the cost of a mortgage in the last year or so. Which is, compared to…look at something like disposable incomes.
I mean, disposable incomes only went up about 15% since the beginning of COVID. So, either…maybe I’m wrong, maybe people just value housing so much more after COVID that they just are willing to spend more of their income on housing now and what looks like exorbitant cost of a mortgage right now.
But I don’t know. I mean, here’s the thing that makes this tricky, housing is a big, big slow-moving animal. I mean, I remember back in 2006, the yield curve inverted in late 2006, and you didn’t really get pressure in the real estate market for really a couple more years, basically, you started to see some softening, but it didn’t really materialize for several years.
And that’s part of the thing with housing, is that housing is a big, big slow-moving industry. And so even when it starts to look like it’s obvious that things are going to slow down, well, you know, people are stubborn about their houses, first of all, and it’s just this big slow-moving industry where things take a long time to materialize.
And so, you might not see all of this play out for several years. And that’s why I kind of keep telling people all through this year, when you’ve got a real estate slowdown that’s in progress, well, these aren’t the type of economic environments that just sort of end.
There isn’t, like, a beginning and an end. This is just sort of a process of…it takes a long time for…think of it like a big ship making a turn. I mean, this isn’t something…it doesn’t just pivot. It takes a long time for this to make its way around. And that’s the situation that we’re in that makes this a really testing environment for a lot of people, especially from a short-term psychological perspective, is that this isn’t going to end in some sort of crescendo.
It’s just going to kind of slowly, it’s going to be a slow-economic downturn that takes time to play out. And the next 18 to 24 months are going to be, I think, the time period over which this sort of pricing or repricing of everything materializes. And it’s not going to be…I don’t think it’s going to be a 2008, where you get this sort of, like, crescendo downturn.
It’s just going to be more of a process, like a more traditional sort of housing downturn where, like 1991, it takes several years for this to materialize and play out before things really find their footing and people are able to come back in and feel really comfortable about the environment again.
Andy: Yeah. So, without that catalyst to make it happen quickly, it might just be sort of a slow and painful asset reprice that plays out over multiple years. The thing I think is interesting is I think you mentioned 5% to 10% correction in housing prices possibly, or maybe even 15% or higher, but if that happens over 24 months and inflation is 7.5%, let’s say, in the correction over 24 months and the housing market is 15%, isn’t that just going to be flat in nominal terms?
Cullen: Yeah. So, I think it’s going to be…I think we’re going to see a real nominal decline, or sorry, we’re going to see a nominal decline of 5% to 10%. So I think that in real terms, you could get something that looks and maybe even feels to a lot of people like something much larger.
Cullen: But you’re going to get still…it’s going to occur during a disinflationary period, I think, in all likelihood, which is, you know it, by the end of 2023, if the rate of inflation has declined in disinflationary terms down to, say, 3%, it won’t feel that bad relative to, say, like, a 2008 where you get a nominal decline that is really, really significant.
Andy: Got it. Okay. Interesting. So, you know, anything else that real estate investors should be thinking about going into 2023?
Cullen: Well, I think it’s important to maintain a long-term perspective with real estate. I mean, real estate is inherently…part of the reason why it’s this big slow-moving entity is because it’s a very, very long-term asset class by definition, basically. I think the average American stays in their house something like 9 to 10 years now.
I built what I call a duration model for all asset classes in a recent paper that I wrote called “All Duration Investing,” where I calculated real estate as basically being a 25-year instrument. So, residential real estate is a 25-year instrument in that model, which is consistent with, obviously, very, very long time horizon.
This is longer than…I mean, I only calculated the equity market at 17 years or so. So, real estate is an even longer duration instrument than the equity market is. And so, I think that when people go into investing in real estate, I think you always need to have this sort of long-term perspective because it’s just…you know, even when you look at the cost inputs, things like commodities.
Commodities are very, very long-term instruments by definition as well in my model. They’re actually closer to, like, e a 40-year instrument inside my model, so.
Andy: Oh, wow.
Cullen: And that’s because the cycles over which these instruments tend to perform very predictably is just very, very long-term cycles. And so, I don’t think there’s a lot of use in getting caught up in the guessing game of is there going to be a short-term downturn. I think if you’re a sensible long-term real estate investor, approaching things from sort of a dollar-cost averaging perspective is the right perspective.
You should always have your book of business, I think, being reinvested into. And sure, maybe there’s environments where you can have certain thresholds where, sure, maybe right now you don’t want to be as aggressive as you might have been in, say, like, a 2009 or 2010 type of environment when pricing starts to look very, very attractive again.
But I’m not a big advocate of this sort of approach where you sort of move all in and all out of asset classes in a manner that’s more consistent with, like, the way you might try to play poker. I mean, that’s not the game that we’re playing when you’re investing in real estate. And the one thing that’s especially, I think, sort of beneficial for a lot of real estate investors in this environment is that the rental market is going to remain, I think, very, very robust throughout any sort of downturn.
In fact, I think the rental market is going to put sort of a floor under pricing to some degree because people have to choose to live somewhere. And so, if you’re a landlord or a residential real estate investor who’s trying to find renters in this sort of environment, well, you’ve got a lot of pricing power regardless of what’s going on.
And sure, your balance sheet might be impaired if prices were to fall a lot, but I think that if you work your way through all of this, even a downturn like this, you’re going to find yourself on the other side and still with a lot of pricing power relative to what renters are looking at.
Andy: Yeah. And, you know, the spike in real estate asset prices was a lot more pronounced than rent growth, you know, much more pronounced. So, really, you know, I think those two things, they need to…
Cullen: Yeah, they need to converge. It’s part of what makes the Fed’s job pretty difficult right now, is that you’ve got upward pressure from rents, which, you know, again, it’s definitely a rear-view-mirror-looking indicator inside of, like, the CPI or the PCE.
But rents are really, really sticky prices. I mean, the likelihood of seeing a big, big decline in rent prices is extremely unusual. And so, rents tend to put sort of a floor under real estate prices to some degree. So, but yeah, those two prices, and it is one of the things that’s somewhat disconcerting about where both prices are, is that the discrepancy between both right now is much larger than it was in 2008.
So there’s this sort of outlier scenario that I’ve been thinking about where, well, if my, say, 10% estimate for prices is wrong, I mean, you’ve got…I can’t remember exactly what the number is, but the difference between, like, the owner’s equivalent rent and actual home prices right now, I think it was something like 35% during the financial crisis, and it’s much closer to, like, 50% right now, I think, something like that.
My numbers could be totally wrong. But the number is substantially bigger. And so, if you’re going to get this compression between the two or sort of mean reversion in the two, the downside in my model is that you could get more of the pricing, more of that mean reversion could come from the house price component, in which case, you know, that’s one of the arguments for a more bearish position, probably.
Andy: Absolutely. Well, I know that you have to run soon, Cullen, but one thing that you mentioned talking about dollar-cost averaging in and that long-term investment approach, I did want to ask you about Discipline Funds and the model that your ETF uses. So, when did you launch this ETF? And could you tell us a little bit about the model behind it?
Cullen: Yeah, so, basically, what we did with the ETF that we launched was we really…I built a very boring, plain-vanilla stock bond type of fund. And my beef with multi-asset index funds has always been that, you know, like, we call a 60/40, for instance, we call it a balanced index fund.
And the problem with a 60/40 fund is that a lot of people don’t realize that 85% of the volatility in that fund is coming only from the 60% component. So, from a risk perspective, your risk really isn’t very balanced at all. It’s almost coming exclusively or it’s coming primarily from the equity market. And you see that even in a year like this year, where even when the bonds are performing really badly, you’re still getting a huge skew in the downside variance of the portfolio because you’re just much more overweight stocks than you really think in terms of, like, a volatility perspective.
Because the global stock market’s down something like 21% this year, whereas the bond market is down 11%, which is awful for the bond market, but still, on a relative basis, it’s a much smaller decline relative to the equity market. And so, the thing that exacerbates this, though, that I always found really interesting is that multi-asset index funds, they’re not market cap weighted.
So, when you look at something like the S&P 500, you know, the traditional idea of passive investing is just to…you follow the market cap weight. The market does what the market’s going to do, and you just always rebalance back to that position. And the screwy thing with something like a 60/40 is that the relative market cap size of the stock versus the bond market, it changes a huge amount every year.
So, for instance, in the early ’90s, it was 35% stocks. It grew to 50% by 1999. It busted down back down to 35% by 2003. And that’s a lot of what’s happening in the underlying components, is that you’re actually really buying…when you buy something like a 60/40, you’re buying something where the 60% component isn’t just from a starting position riskier, but when the underlying market cap booms, that 60% component actually becomes even more risky.
And so you find yourself coming into a year like this year, where you’re not just overweight based on a volatility perspective, you’re overweight based on the underlying market cap. And so I always found it odd that Vanguard or any sort of passive investing shop never started a true market-cap-weighted multi-asset index fund that just tracked these components.
And so, what the Discipline Fund actually does is it takes these market caps and it essentially inverts them. So, coming into a year like 2022, our model is actually underweight the stock market. So we’re closer to, like, a 40/60 index fund right now. Whereas if the stock market were to fall a lot, let’s say, the market caps busted back down to that 35% level, our fund would overbalance in the other way, where we would become a 60/40, except we would do it when the market caps actually contract, when valuations actually contract.
And so, I called it the Discipline Fund because the goal really was to create an index style, something that’s actually closer to a market-cap-weighted fund that helps investors navigate these markets in a manner that’s much more consistent with the way that we actually perceive risk so that we’re not just always overweight the stock market at the worst possible times.
Andy: And so, it follows an automated model rather than being actively managed?
Cullen: It’s fully automated, it’s interesting, we can get into the legal debate about what an active index fund is and what isn’t, because when you go through the regulatory process, you know, we’re deemed technically an active index because our index is dynamic. We don’t just rebalance back to, like, a…
Andy: Ah, I see. Yeah.
Cullen: So, because our index is dynamic, we’re called, technically, an active index, which is…you know, it’s kind of screwy because I would actually argue that since our fund is much, much closer to the actual underlying market caps of the stocks and bond markets at any given average time relative to, like, a 60/40, I would argue we’re much more passive in that sense than something like a 60/40 is.
But because our index is dynamic it’s technically an active fund. But it’s a low fee, it’s 39 bips for…you’re getting 8,000-plus global stocks and bonds in one holding. And the secret sauce of an ETF and a fund like ours is that it’s a fund of funds. And so, it’s kind of weird the fund-of-fund space in the ETF world is still really, really small, which is fascinating because fund of funds are incredibly tax efficient because we can rebalance over time.
Like, if we rebalance back to our 60/40 weight at some point in the future, we’ll do so without kicking off capital gains, which is something that a mutual fund essentially can’t do. And that’s because we’re using a fund-to-fund structure where we’re able to rebalance underlying positions inside of one ETF. And that’s the secret sauce of ETFs really, is that they rebalance in kind and in a much more tax-efficient manner than mutual funds do.
Andy: Absolutely. I know tax efficiency is top of mind for a lot of our listeners, and viewers, and RAAs, and wealth managers. So, we’re going to make sure to link to that ETF in our show notes. I want to go check out and learn a little bit more about this. So, it’s actually global, it’s not just U.S. stocks and bonds. It’s global stocks.
Cullen: It’s global stocks. The actual bond component deviates based on just the domestic bond market. So, there’s a lot of inefficiencies in owning foreign bonds. And, in fact, I view foreign bonds in a lot of ways, like, you know, foreign junk bonds, for instance, are basically just equities in drag, in my view. So, to get away from the tax inefficiencies of that and the higher costs and the more equity-like component, our benchmark is basically the aggregate bond index.
But the benchmark changes based on the credit market cycle to adjust for…for instance, right now, we have no credit risk in the bond component. So, when it rebalances, it’s rebalancing in this countercyclical way that it actually adjusts for how much credit risk is in the underlying bond market.
So like right now we would argue that there’s very, very high risk in, like, the high-yield bond market. And so, we want no exposure inside of the bond component. So it’s all treasury bonds, basically, and government bonds. So, there’s no credit risk, which, unfortunately, we still have duration risk, we still have interest rate risk.
But that is a trade-off that, in our opinion right now, is worth it relative to having a lot of underlying credit risk that makes your bond portfolio look a lot more like an equity portfolio, basically.
Andy: Absolutely. Absolutely. And bonds should be balanced. At least that’s what Ben Graham said in his book. So, that’s been a classic in my library. I got to pick up your book as well, and I’ll be sure to link to that in the show notes. So, Cullen, I really appreciate all your time.
For our viewers and listeners, in our previous episode, we covered inflation, deflation, disinflation, and then continuing that conversation in this episode about the housing market and about your ETF. Really fascinating stuff. So, all those links will be in our show notes. And I also want to remind our viewers and listeners to subscribe to the show, so you can be sure to receive our new episodes as we release them.
Cullen, thanks so much for joining the show today.
Cullen: Awesome. Thanks for having me, Andy.