Episode #496: Phil Bak, Armada ETFs – Masterclass in (Liquid) Real Estate Investing
Guest: Phil Bak is the CEO of Armada ETFs, which provides investors broad access to the real estate asset class. He has previously served as Founder/CEO of Exponential ETFs, an ETF issuer and sub-advisor acquired by Tidal ETF Services in 2020.
Date Recorded: 8/9/2023 | Run-Time: 59:24
Summary: In today’s episode, Phil gives a masterclass on real estate investing. He covers the residential real estate space, the problem investors have come across this year with private REIT strategies, and why he has a solution to their problem. Then he shares how he’s using AI and machine learning to the REIT space through his long-only hedge fund.
Sponsor: Future Proof, The World’s Largest Wealth Festival, is coming back to Huntington Beach on September 10-13th! Over 3,000 finance professionals and every relevant company in fintech, asset management and wealth management will be there. It’s the one event that every wealth management professional must attend!
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Links from the Episode:
- 0:39 – Sponsor: Future Proof
- 1:14 – Intro
- 2:00 – Welcome Phil to the show
- 2:25 – Navigating the realms of entrepreneurship and investing
- 5:39 – REIT overview
- 13:30 – Narratives drive flows, flows drive performance
- 15:47 – Challenges for Private REITs
- 30:57 – Creating PRVT ETF to replicate private REIT strategies with lower fees and liquidity
- 34:18 – Exploring the HAUS ETF
- 36:12 – Applying AI & machine learning to REITs
- 43:08 – Phil’s most memorable investment
- 48:11 – Changing market dynamics due to shifting Fed actions and evolving REIT landscape
- 51:37 – Lessons from investing in baseball cards
- 54:37 – What investment belief Phil holds that most of his professional peers do not
- Learn more about Phil: Twitter; Substack; Armada ETFs
- Twitter thread on issues with BREIT
- Thread on the worst back-test
Transcript:
Welcome Message:
Welcome to the Meb Faber Show, where the focus is on helping you grow and preserve your wealth. Join us as we discuss the craft of investing and uncover new and profitable ideas, all to help you grow wealthier and wiser. Better investing starts here.
Disclaimer:
Meb Faber is the Co-Founder and Chief Investment Officer at Cambria Investment Management. Due to industry regulations, he will not discuss any of Cambria’s funds on this podcast. All opinions expressed by podcast participants are solely their own opinions and do not reflect the opinion of Cambria Investment Management or its affiliates. For more information, visit cambriainvestments.com.
Sponsor Message:
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Meb:
Welcome my friends, we have a really fun episode today. We welcome our old friend, Phil Bak, CEO of Armada ETFs, which provides investors broad access to the real estate asset class. In today’s episode, Phil gives a masterclass on real estate investing. He covers the residential real estate space, the problem investors have come across this year with private REIT strategies, and why he has a solution to their struggles. Then he shares how he’s using AI and machine learning to the REIT space through his long only hedge fund. As much as Phil loves the real estate space, he’s a true entrepreneur with a curious mind and would be my first call if I ever started a VC fund. Please enjoy this episode with Armada ETFs’ Phil Bak.
Phil, welcome to the show.
Phil:
All right, great to be here. Thanks Meb.
Meb:
Where do we find you today?
Phil:
I’m in Detroit, Michigan.
Meb:
I had a blast hanging with you there. Is this your first time on the Meb Faber Show Phil?
Phil:
This is my first time, and I have to say it’s really an honor to be here. I have learned so much. I’ve been listening to your show for years and the amount that I’ve learned from your guests and from you putting this out there, I just want to say I really appreciate it.
Meb:
All right. Well, some smart psychology there. You’re trying to butter up the host. But it’s funny because you’re one of my favorite people in the world to talk to. You and I sit down over food or a beer wherever we are in the world, and it’s just like a two-hour-long brainstorm. And usually what I sit down to talk to you about I’m thinking, “Here’s what you’re doing now,” there’s like four other things we both get deep into. So we’re going to go down a few of those rabbit holes, alleyways today. I was trying to think about this. Are you, in one word, is it more entrepreneur or investor?
Phil:
That’s a great question. I think I identify as an entrepreneur. It’s actually a very key part of how I ended up in REITs because I’m an entrepreneur, but I love markets. So there’s something to me, markets are magical. They’re beautiful, they’ve got natural patterns, natural cycles, and there’s this tug of war between order and chaos, and I love markets. And I started my career mostly doing some smart beta stuff with different ETF insurers, product development, and structuring. Came to do a lot of capital markets work with the NYSE. And the thing is at the end of the day, the further I get from markets, the less happy I am. The idea of being in a market, thinking about capital preservation, thinking about how to harness the energies of the markets and create better outcomes for investors is ultimately what really drives me.
And I’ll just tell you, I’ll just jump into it and tell you a little story, which is over the last few years I’ve been raising capital for different company [inaudible] ETFs. I tried to do something on NAV trading of ETFs. I was working for a fintech for a bit and various different ventures of different levels of success. And there’s this idea out there, and as you talk to VCs and you talk to even some allocators and advisors, there’s this poisonous idea out there that asset management is commoditized and anything is good enough. It doesn’t really matter as long as you have a good story or if you’re cheap or whatever it is. There’s not a lot of value to the asset management process.
And as I’m going through, at the end of the day as an entrepreneur, you need funding to start a business. You need some sort of capital. You need a capital base that is the gatekeeper. And it’s this big joke like everyone thinks, “Well, I don’t want to work for the man, I want to work for myself. I want to be independent.” But you’re never really independent. Either you have clients that you answer to, or you have capital that you answer to. And in my case, I was seeking capital and I was hearing from those sources of capital that asset management doesn’t matter. The markets themselves don’t matter. Look for some technological advantage, some structural advantage, the markets don’t matter.
And that just didn’t sit with me. I looked at a few things. At the end of the day, there’s something about the markets that’s magnetic that really just draws me. So I would say, yeah, I’m an entrepreneur but an investor too because I do love the markets. And that’s really what brought me to REITs and what I’m doing now to the REIT opportunity is the idea that there are some very overlooked issues and areas in the capital markets now that aren’t getting the attention that investors would be wise to give them.
Meb:
Real estate is something that I feel like for most people is the wedge into personal finance and investing world. Everyone kind of gets housing as an investment. It’s not as esoteric as a lot of what we do in our world. So most people get the concept of real estate. And so, alluding to kind of what we were talking about earlier, it seems like this would be a well-established asset class, that there’s not enough room for innovation, but what sort of drew you to this was the wedge on Haus, H-A-U-S, the ETF first there or what brought you in?
Phil:
So like I said, I was doing some soul-searching and thinking deeply about asset management and innovation and fintech and where things are. And the thing about REITs, they’re very tangible. Every REIT owns real estate and you can visit the properties, and I have, and the valuations could fluctuate, but there’s a baseline, there’s an intrinsic value. There’s a family that has a roof over their head. There’s a business that’s operating out of a warehouse. It’s real. It’s something that you can feel and smell and touch. A very transparent asset class, you know exactly what’s in it, you know what they own. They have very strong balance sheets, people don’t realize that. They have very strong balance sheets. They predictable cash flows.
And of course, being backed by the asset, there was something very kind of secure as I think I’m seeing so many of these just hot theme of the day and so many people chasing just as the winds are blowing around from this trend or that trend. And I was looking for something that felt more real, that felt more permanent and secure, that could be a tool for capital preservation. And I know people could talk about where we are right now in a cycle and REIT valuations and we can do that. But there was something about the REIT that to me was very comforting, that I felt like it was very real and it couldn’t disappear one day to the next. There can’t be that many shenanigans when you know what they own, when you know that the real estate is there, when the real estate itself has value.
So I’m thinking more longer term. I’m not thinking about a six-month business. I’m thinking what do I want to spend the next decade of my life building? And I start looking closer at REITs, and a couple interesting things. One is a REIT is not real estate. And I had always assumed that real estates are more or less fungible. A REIT is a REIT, more or less they’re going to give you real estate exposure. And what I started to see was no, a REIT is actually a tax treatment. The correlations between the different REIT subcategories is actually very low. And just because a hospital elects for the REIT tax treatment as does a data center, there’s nothing about those two assets that’s correlated.
In fact, when you look at what’s driving the data centers and the cell towers and some of the other REITs, they’re almost as highly, not as much, but almost as highly correlated to technology as they are to the real estate sector. So when you look at market cap weighting, and we can go down that wormhole and talk about indexing, but when you look at it specifically in REITs, right now VNQ is 70% of all REIT ETFAUM. And when you add in the I shares, you’ve got about 85% of all REIT ETF assets are in market cap weighted indexes. And for REIT specifically, that means that people are investing blindly into assets that are kind of technology, kind of healthcare, kind of real estate, real estate-ish. There’s a lot of real estate there, but it’s not a perfect bogey for real estate, not even close.
So when you look at what’s coming now with the sub-sector correlations are even dropping, they’re getting lower, there’s a lot of chaos and movement within the space, geographical dispersions. We’re looking at sub-sector dispersions. There’s a lot going on in this space, which means that there’s also opportunity and there’s also a way to do things better for investors. And that’s what we saw. That’s what we’re doing. We’re trying to provide a better outcome for investors than just investing in either the market cap weighted REIT index funds or the private REIT funds, which have a whole different set of issues that we could talk about.
Meb:
Yeah, I always scratch my head, and we probably had this conversation over the years, it is always strange to me much like the sectors within the U.S. stock market, tech, and utilities, but looking at real estate is probably even more varied. I mean talking about you have commercial, you have residential, you have data centers, you have healthcare, on and on and on and on, malls, shopping centers that have very different return profiles and you’ll see the spread some years where the performance is, I don’t know, 30 percentage points different, especially during COVID times. So do you want to talk a little bit about residential in-house or do you want to move straight into the death star of BREIT and everything going on there?
Phil:
Well, let’s start with house and exactly what you just said where the return profiles are quite different, not only that, but the factors driving that performance, the reason why you might make a bet for or against one real REIT sub-sector is very different than the others. So for example, REITs, what’s driving REITs? Interest rates, of course, rate sensitivity, economic impact absolutely, but also supply/demand imbalance. And by the way, the supply with Fannie Mae says we’re three million units short right now of supply of housing in the U.S. That supply is constrained further by rising rates. The REITs that we own are all existing, they’re already financed, but their competition, the supply saturation that would otherwise come in, they can’t get finances at higher rates.
What else is driving REIT valuations? Migration trends, demographic trends. These are things that are not captured by a top-down equity model or certainly by market cap weighted or by fixed income models. REITs need to be valued as REITs, right? You’re looking at occupancy rates and vacancy rates, right? You’re looking at a totally different set of factors, and I think too many investors are just saying, “Well, it’s a small percentage of the portfolio. We don’t have to think too deeply about it,” and we believe that they do need to think deeply about it or they need to rely on a REIT asset manager or us or someone else that is thinking deeply about it because if they’re not taking demographic trends and geographic trends, if they’re not taking these factors, occupancy rates, if they’re not looking at that in their analysis, they’re going to be behind the curve.
Meb:
Well, as you know, and you mentioned, and we can’t spend too much time on this because we’ll lose the thread, but everyone, if they do real estate at all, they just lob all their money into the market cap weights on the public side, right? You mentioned VNQ as well as the other biggies there. What’s the problem with that? Why shouldn’t we just be buying market cap VNQ, and ditto with SPY, if this isn’t a trigger point for you? What’s wrong with market cap weighting? Why is that not optimal?
Phil:
Well, it’s certainly performed well, there’s no question. And if you have a time machine, then I would say absolutely do so and use the time machine, go back to a global financial crisis and put all your money in mega cap tech and cap weight, which is essentially momentum factor, and you will do quite well. And I don’t think it’s the worst way to invest on a going forward basis. Certainly you could do it for free and it’s quite efficient. There’s a natural cycle to things, right? There’s a natural cycle to companies. Companies come and go. There’s no company that goes in one direction forever. And there were times where the railroads were invincible. They were the mega cap tech monopolies of their time. There was a time not long ago when Nokia was indestructible, right? There are companies that come and go. There are cycles that come and go. And this idea that while the FANG monopoly valuations are so high, there’s nothing that could stop, they’re just going to go forever. Amazon is going to trade to infinity. The PE doesn’t matter. It could just go forever.
Meb:
It’s not PE anymore. It’s now like PE has been supplanted with price to revenue. So it’s not even earnings. It’s like what used to be crazy at 40 times earnings is now 40 times sales, so we got to readjust our metrics.
Phil:
I mean it’s wild. Valuation doesn’t matter, but it will. And at the end of the day, what I believe is that narratives drive flows and flows drive performance. That’s what I’ve seen from the market for the last decade. Fundamentals and valuations haven’t mattered. I think they will matter again, but I don’t know when, I don’t know how. The narrative, the Vanguard narrative of, “Just buy whatever, buy low cost, the market’s been up,” has been very powerful and it’s driven flows into cap weighted indexes, cap weighted funds, and that has driven in large part the performance of such in a self-fulfilling prophecy. That narrative will one day one run dry, right? Nothing goes forever in these markets. There’s no factor. There’s no narrative. There’s no story that goes forever. In a market where investors have been getting such good returns for so long with so little volatility with the belief that the Fed is going to support markets no matter what, then yeah, there is complacency and indexing will do you just fine. You can buy the S&P for three basis points. It’s done quite well.
The narrative, the story about active managers underperforming, it’s a great story. Of course most of that data comes from a time where either active funds were in large part index hugging, they were expensive, and when they were the dominant force in the market, it’s a zero-sum. You take out fees, of course they’re going to underperform an aggregate, right? But now we’re getting to a different cycle. Now we’re getting to the end of a bull run. And look, it could continue. We might go sideways and not down. I’m not calling a crash here, but I’m saying that the complacency that investors have and this idea that market cap weighting is good enough is certain to fail. They will run out of gas eventually. These stocks cannot go on an indefinite timeline for mega cap to outperform then small cap forever when there will be technologies that we aren’t yet aware of that are going to uproot what the monopolies are doing. There will be insurgent companies, there will be antitrust issues from the big guys. Things change over time. And that will happen now, this time is not different. That will happen again.
Meb:
I told you guys, I can’t get Phil started. He is very passionate. But my favorite graphic about this, my favorite statement, is the problem with mark cap weighting and there’s no tether to valuation, and so when things go nuts to the upside, you get most of the weight in the things that went nuts and are usually extremely expensive, which in the future becomes a drag. And most people, I think if you were to ask, certainly most retail investors, and I would say a decent amount of pros, to describe passive investing, market cap investing, I don’t know that they would get it right, that it’s just the stock price that determines the entire portfolio weighting of the company. So in the REIT space, which is a subsector of the whole market, market cap weighting still problematic. But the simple answer to that of course is you can just go into private real estate, which solves all these problems. You don’t have to worry about market cap weight and private real estate, right, in that solution?
Phil:
The private real estate fund market, it’s the most incredible thing I’ve ever seen in my career. And again, I came at this recently and I started looking at this and the first thing when we started building a REIT asset manager, “Okay, let’s do a competitive analysis. Let’s see what’s working and what’s not.” And I saw the success of the private refunds, in particular Blackstone’s BREIT has been the most successful. And this is a fund that was bringing in at its peak $3 billion a month in inflows. They got up to about $70 billion in assets. It was a little bit leveraged, so about $110 billion in real estate. And it just seemed like this was like they had done a remarkable job. And they did. In some respects, very smart group. They’re incredible at sourcing capital, at deal sourcing, very efficient managing properties. They’ve bought tremendous properties, really excellent properties. They’re great capital allocators. They’ve told a great story to investors.
I think their success on the way up was very well-earned and very well-executed and have a lot of respect for what they’ve done. You get to a point though, it’s classic-
Meb:
Comma, but.
Phil:
It’s a classic victim of your own success, right? Success breeds hubris and hubris breeds disaster, and here we are. And you’ve got a situation now where these funds, these private REIT funds, there’s a Blackstone, there’s a Starwood, there’s a KKR, and on and on and on, these private REIT funds had been the largest buyer of commercial real estate. And it’s not exactly their fault that investors pile in at the worst possible time. They always do. So investors are chasing performance. They’re coming in at peak valuations, and they have to put the money to work so they start buying at peak valuations.
And you’ve got this perfect storm almost where the largest buyers of commercial real estate had been these private REIT funds, all of a sudden when everything turned, it turned so fast, the largest buyers became the largest sellers. And not only the largest sellers, but they’re forced sellers at a time, specifically at the time, where there is no liquidity in the commercial real estate market. And everything happened at once. And it’s not a surprise that everything happened at once because those factors that would turn these tremendous inflows into redemptions and those factors that would freeze the liquidity of the commercial real estate market and those factors that would drop the value of that commercial real estate are all the same thing, obviously.
And you can see it in hindsight, but nobody thinks about these things on the way up. Everyone assumes there’s so much liquidity on the way up. Everyone assumes that liquidity will be there on the way down in every asset class. And commercial real estate was no different. So on the way up, they have all this money coming in, they’re putting it to work at these peak valuations, and all of a sudden the market turns. And now what do you do? You have redemption requests that exceed the amount of cash they have. They can’t meet the redemption requests. They gate the fund, which in their prospectus it said they can, but I don’t think anybody believed they would or wanted them to. And all of a sudden now there’s a scramble for liquidity.
So we’re watching this thing and we predicted, by the way, I predicted on Twitter ahead of time that they would have to gate the fund before they did. And they did. And we start talking to investors about it and everyone’s like, “Well, they’re so smart. They’re fine, they’re fine, they’re fine. This is going to pass. This is just a couple months.” They had some Asian redemptions that everyone’s like, “Well, that doesn’t really count,” for some reason. I don’t know why that wouldn’t count. But it’s not resolved, and they had to give a preferential waterfall treatment to UC for one quarter for four and a half billion of liquidity, which kind of kicked the can down the road. They’re starting to sell properties. They’re selling the best of what they own, not the worst but the best, the most desirable. And they’re selling it at so far reasonable prices, but prices are coming down.
But here’s the amazing thing. The miracle here is that the NAV of the fund hasn’t moved. The NAV hasn’t budged. Now, if you look historically and you take private REITs versus public REITs-
Meb:
It’s not true, NAV’s up this year.
Phil:
The NAV is up. It’s a miracle. It’s incredible. Not only is it up, it’s up following the hurdle rate of their fees. It’s sub net of fees, which we can get into. But basically depending on the year because of the performance fee, depending on the class because of the selling fee, but net net it is by and large about a 300 basis point hurdle rate that they have to exceed compounding year after year. Nobody’s that good. I’m sorry, nobody is that good. 300 basis points in fees every year compounding.
Meb:
Well, so I mean the initial attraction to private REIT asset class or private real estate, I think for most advisors up till now, I can kind of sympathize with the advisors that may have done it in the past because they said, “Look, I don’t want to deal with these clients. They’re a headache. Let’s put them in this fund that you wink, wink, nod, nod, handshake, has a 4% volatility.” We get these email marketing all the time, and I usually respond to the email marketers. I’m like, “FYI, you shouldn’t send this to me. This is the wolf in the hen house and if you send me something really sketchy, I’m going to tweet it probably.” I do this many times where I’m like, “You shouldn’t, but you do and it’s public and you’re spamming people with it.”
But being able to claim something like the private real estate market has a 4% vol. So the listeners who aren’t as familiar, stock market volatility, high teens, right? REIT volatility, it’s usually in the 20s. I think REIT’s decline what, 70% in the financial crisis, 80% or something. It is a very volatile asset class, and that’s on aggregate. Anyway. But people say just because we only look once a year, once a quarter, same thing with private equity in general, and we can kind of smooth the returns, we’ve magically transformed this. And Cliff obviously talks a lot about this with volatility laundering, the ability to transform a very volatile asset class into a not volatile one just through the magic of only looking once a year is a pretty questionable practice. And I’m actually surprised the regulators haven’t come down on that yet. I think they will because it’s really just kind of very misleading at best.
Phil:
The way the NAV is set in these funds is appraisal base. The appraisers come by once a year. They can adjust it on a monthly basis. But there are several factors. One is just what you have with every private fund where because the NAV is set more infrequent that it seems to be a little smoother of a return ride than it would be if it was market to market daily. You also have a human bias. When you bring in the appraisers, people are anchored to their previous marks, and it’s harder for people to say, “Well, I said this property was worth $50 million last month and now I think it’s worth 40 because the market’s down.” People are very reluctant to do something like that.
So the unfortunate thing about this, and it really is sad, is that there’s been so little volatility in this fund. When you look at the performance, it’s almost a linear line up and to the right. There’s been so little volatility in this fund that it has been marketed to and optimized into portfolios as a bogey for fixed income and something appropriate for the proverbial widows and orphans, for the least risk tolerant. And that is a lot of the people who are in this fund, the least risk tolerant. And we can get to the valuations, but we think they’re sitting on a 40%. We think they’re overvalued relative to the public market comps when we normalize for Blackstone’s ability to deal source and their efficiencies are running, when we normalize for property type, when we normalize for class, when we normalize for geography, and when we normalize for sub-sector, we believe that they’re sitting on a 40% valuation gap by cap rate and by FFO. 40%. So investors are sitting there thinking that they own this, they’re paying a fee at the NAV, in most cases they’re getting their dividends paid out as dilutive shares at the NAV so you could say also potentially inflated.
And it’s really tragic because these are investors that don’t think they’re in an instrument that has the ability to drop 40%. These aren’t people who are buying the leveraged arc ETF. These are people who think they’re buying something that is steady and safe and it’s not.
Meb:
Well, I imagine a lot also have come through advisors. I mean this fund was up 8.4% last year as well as being up this year. And you mentioned, I looked it up where we’re talking, while the NAV is $68 billion, the total asset value is $122 billion. That’s a darn near 50% leverage ratio, which is pretty astonishing. I imagine that’s gone up as they’ve had to have some liquidity. So if they continue to hit, there was an article I think last night or yesterday or last couple of days that was talking about BREIT still where it was talking about they want kind pivot to AI data centers. Did you see this?
Phil:
Yeah, I did. Yeah.
Meb:
And I wonder if that was a marketing move to try-
Phil:
Narratives. With $122 billion in real estate, even with the gates, they have to provide 5% liquidity per quarter for redemption requests. That’s a lot of real estate to sell, right? And there are two ways that they could do it. They can sell the real estate or they can attract enough inflows, enough people buying into the fund, that are essentially the exit liquidity that they can use to offset the redemptions. And they’ve been on record saying that they believe that the performance of the fund, performance you could put in quotes, but the performance of the fund has been so strong that that will attract the investors to offset the redemption request, which I would submit is a little bit concerning. That tells you an incentive not to say that they are intentionally mismanaging the marks, but that right there is your incentive.
The other way to do it is to sell real estate. Well, if you sell real estate, you can’t fake the marks on a sale. You’re going to bring in cash. And the value that you’re bringing in is where NAV for that asset at least has to be written. This idea that well, they can kick the can down the road and they can keep the marks elevated for the NAVs indefinitely, they can’t. They can until they have the redemption requests are such that they have to start selling properties. When they sell the properties, they start marking them down to the cash value that they were able to bring in. And that is what kicks off the downturn in the NAV, and that’s when investors are going to start to feel the pain.
Meb:
So what’s the most likely scenario for how this kind of plays out? Is it that they just continue to have the withdrawal requests and then they try to trail the market, the public comps, for the next couple two years and eventually it kind of catches up? I mean there’s obviously a death spiral scenario where real estate continues to get pounded, in which case they get into I imagine some deep trouble because it moves the other way. What are thoughts?
Phil:
Yeah, we’re calling it the liquidity death spiral, right? There is the potential for things to go completely haywire where the redemption requests force them to sell properties in a fire sale, which means that they get appraised downwards. There’s a NAV draw down, investors get nervous, they put in more redemption requests, and it goes on and on and on like that. That is a possibility. That’s not necessarily a guarantee. That’s not necessarily going to happen. They can buy time, they can buy quite a bit of time. They have some access to liquidity through CMBS. They can do more deals like they did with UC. They can attract investors. All of those things will buy them time. But eventually, it doesn’t change the fact that there will be a convergence between the public REITs and the private REITs.
So over time, if you look at historically, there’s always this divergence and convergence. It’s actually pretty regular, a divergence and convergence between the value of real estate through publicly listed REITs and private REITs. And they’ve diverged in the past, they’ve diverged significantly, but always eventually they converge again, and it stands to reason. The building itself is worth what it’s worth. The building doesn’t care if it’s owned by Blackstone in a private REIT or if it’s owned by Prologis in a public REIT. It doesn’t matter. It doesn’t matter to whoever would be appraising or buying that building in a fair free market.
So we’ve made our bet. We think that right now, at this point in time, public REITs are significantly better for investors. Forget about the transparency and the liquidity and the lower fees. Forget about all that. Just on a valuation basis. We can buy these things at a 40% discount, 40%. By our calculations by FFO and by cap rate, at a 40% discount to what you’d be paying if you bought into Blackstone. And by the way, if you put money into Blackstone, into BREIT, that money’s not going to buy real estate. That money’s going to pay out the dividends and the redemption requests of others. And I think there’s a name for that when you use people’s investment money to go and pay out other people.
So I think investors need to be very-
Meb:
Rhymes with Ronzi, if you look at just last year alone, Blackstone’s fund did almost 9%. VNQ as a benchmark did minus 26. So there’s a 34 percentage point gap, and maybe it’s all alpha, but 34 percentage point gap last year in performance, which is quite a bit.
Phil:
It’s literally unbelievable.
Meb:
All right.
Phil:
Literally.
Meb:
Okay. So if you’re in the fund, I assume you’re just kind of stuck, right? There’s nothing you can really do at this point, right?
Phil:
Yeah, that’s right. Again, you can submit your redemption requests. You have to resubmit them every month. I would advise people to do so. You’ll get some of the money out, it’ll trickle out. Like I said, the current gates allow for 5% redemptions every quarter. Get that 5%, start getting your money out. And if you’re allocating into the asset class going forward, which I think is a prudent approach, and I think certainly on an ongoing dollar cost averaging way, I would suggest finding more efficient methods to do so.
Meb:
You wrote a paper, which may or may not be out yet, if it is out we’ll link to it in the show notes, that was very spicy. I’m sure we talked about most of the points here. If there’s anything left out, feel free to let’s talk about it. But you got some ideas and some solutions on how to think about investments and trades around this concept and including a new fund, PRVT, private.
Phil:
Yes. What we’re trying to do, we’re saying that, “Look, we agree, we acknowledge that Blackstone and Starwood are the two primarily that we’re looking at, that they’re master capital allocators, that they’re very good at selecting properties, at selecting asset classes. And we think investors should be able to allocate those ideas and those geographies and those property class types and from a fundamental standpoint, those allocations. But is there a way to do it without paying the private read valuations, without being gated and locked up and having liquidity issues, without the high fees? Is there a way to do it?” And we think we’ve created just that. So private real estate strategy is the name of the ETF. We’re using their strategies. We’re replicating what they’re doing from a fundamental standpoint via liquid REIT. So we’re just using liquid listed REITs. We’re doing it in an ETF vehicle. Our expense ratio is less than half of theirs, but we also have no embedded selling fee, no performance fee. So significantly net of fees. It’ll be significantly better for investors. There’s no liquidity gating or anything like that that can happen. And we’re buying into the real estate at what we believe is a 40% discount, so I mean that’s a hell of an arbitrage.
Meb:
How does one go and replicate private real estate in a public vehicle? That sounds like magic.
Phil:
No, it’s not magic. They publish in their 10Q and they’re 10K every quarter. They publish what they have. We are a real estate company. Our sister company and our backers are all real estate people. We’re very aware of what properties are out on the street that they’re trying to sell. And we’re able to get out in front of those trends. And right now they’re in industrial and residential, they have some data center stuff. We’re able to replicate that. They’re on all class A, we know the geographies that they have. And we’re able to replicate that based on the information that we have and give people, it’s not going to be exactly precise, it’ll be pretty close from a fundamental standpoint, from the factors that we’re trying to replicate.
And I know you’ve had some people on the show talking about statistical replication of hedge funds, and I think there’s a lot of viability to what they’re doing. That was the original plan. We went down the path of doing that in this case, but it didn’t work. Why didn’t it work? Because there’s no volatility. When you look at the NAVs and the reported NAVs that have come out in this thing, there is zero volatility. In fact, we were told by one of the leading factor replication firms out there who I was talking to about this, “Just buy levered treasuries if you want to replicate BREIT,” which is hysterical. And look, we all know risk is not backwards looking. Risk is forward looking, right? And these things, these systemic issues and how this fund was created and the liquidity issues right now, that can’t be modeled using the historical dataset. We needed to approach it this way.
I think what we have is going to be far more efficient for investors that are concerned about liquidity, that are concerned about what valuations are being marked at and where the money’s going in right now. So hopefully investors will heed the call.
Meb:
So if you’re an investor in BREIT, it sounds like no offense, sucks to be you, you’re stuck. That’s fine. Whatever. You can’t get out. You can get out if you can. I mean this is more targeted at someone who’s like, “Look, I want something similar to BREIT, but I don’t want to get stuck. And I want the same exposure. I want to try to …” You had a tweet thread by the way, which I haven’t seen many people outpace me on length of tweet threads, I have a four-part series once that was like 120 something, you have like a 50 banger, but was kind of on this concept of replication and backtest, and we’ll link to it in the show notes because it’s worth reading.
But so really this is for the person that would want something like the private read is either burned or has seen the headlines like, “I don’t want to deal with these headlines to my clients.” Because I think the worst case scenario is the financial advisor that allocated with the assumption that there would be liquidity, needs it, and is stuck. That is a terrible situation. If you invest knowing full well you might get gated, it’s like a private equity fund, you invest knowing full well you may not get your money for 10 years, okay, that’s one thing. But if you invest all your clients’ money in these funds and didn’t really say, “Well, that’ll never happen,” and then it does, you’re up Schitt’s Creek. So this is kind of target for them. Is that kind of a decent overview?
Phil:
That’s exactly it. If you want Blackstone and Starwood’s fundamental allocation and how they’re looking at real estate, this is we believe a more efficient vehicle for you. If you want Phil Bak’s view of real estate, then privately we’re managing through our AI technology. We just merged with an AI development company and we are looking at things a little bit differently, and we can get into that. And if you want pure play, if you want pure real estate exposure, you want the rental incomes from residential housing, then we have an ETF that tracks that, the Haus ETF.
Meb:
All right, check it out. H-A-U-S, P-R-V-T, both those pretty cool ideas. There’s a quote from Seth Carmen where he says, “Be sure you’re well compensated for illiquidity, especially illiquidity without control because it can create particularly high opportunity costs.” Well said and even probably understated in this sort of scenario. All right, you alluded to machine learning, AI, REITs. What does that mean?
Phil:
So AI, it’s really fascinating. A lot of people are talking about AI as a category. To me, it’s a tool, right? And what we’re trying to do is identify how can we get better REIT returns, better REIT allocations, how can we provide smarter and better REIT exposure to investors? So AI to me isn’t a category, it’s just a means to an end. The end is the same thing it’s always been. Machine learning allows us to do the same things that everyone else is doing, the same things that we’ve done, but it allows us to run more calculations than we’ve previously been able to. So if you take a look at, let’s say you take every factor that you might use to value a REIT, and they’re different than equity factors, they’re different than fixed income factors. In some cases they’re the same. In some cases there’s overlap, but there are factors that are unique and specific to REITs.
With static data, you can only go so far. Over a time period you can run a regression analysis and say, “All right, here’s your factor exposures that matter the most and in what proportion.” But when you have dynamic data that self optimizes, it’s miles apart. Technology tends to be a one way wrench and once we make a breakthrough and go somewhere, we don’t often go back. And I don’t think we’re going to go back to what we’ve done previously with either fundamental analysis or smart beta analysis, which is essentially what we’re doing but in a static way. You take every factor. I mentioned there are 25 factors, so we have 25 separate machine learning models that are running simultaneously to look at how each factor impacts REIT. Some are technical, some are fundamental.
And each one, let’s take an example. Let’s look at our yield spread model. So when you take a look at the yield spread between a REIT and the 10 year, if you look at it as a static number, as just a static number, we have found no predictive value in the future price of that REIT relative to the category. You could say it’s priced into the market or whatever you want to say. But the machine learning model found for us that the change in the spread, when that spread gets repriced and more so the velocity of that change, becomes a flashing red signal about the future returns of that REIT. When the market decides on a spread basis to reprice a REIT, that is very predictive of the future returns of that REIT.
And I say we have 25 factors, each model is giving us second and third derivative effects of each factor in real time. So it’s really fascinating what you’re able to discover. And look, there could be a day where our spread signal stops working. That’s okay. The model is self-optimizing. The model will tell us this is no longer working and exactly what proportion it should be in terms of the overall factor mix. And when you look at the machine learning decision trees, the main thing is you can find relationships between factors that humans couldn’t do. There’s no way that a human and a static model can find the different variables of the different connections between the market environments and the different factors, the factors in each other. It’s just not possible to run that amount of data.
But now we have large sets of REIT data that we’ve cleaned, analyzed, we’ve customized it for REITs. We’re training the machine learning algorithms in real time. We continue to train them in an ongoing basis. We will always be training them so they are self-optimizing, they are alive, they’re not static. So they’re able to reprice the value of a factor, the value of a signal, even in an environment that looks nothing like the environment that the data was trained in.
Meb:
How much of this do you think on the output is finding new factors or is it reinterpretation of existing ones that you think may not have insights you may not have understood? Or is it something else entirely?
Phil:
I think it’s both. And again, the model, it’s the ability to build a model that can tell us whether there’s a new factor, an unexplainable factor, or a reinterpretation of the factor. So one of our factors, one of our models, is what we call the active passive regime, which just tells us the density versus dispersion of REIT trading at any given time. Because when there’s a lot of density, when these things are highly correlated, they’re training together, that tells us that our models aren’t even working. That says that this is a cap weight run. Let’s go back into indexing and then come back in with our factors when it matters most. So the important thing is to build the decision tree such that it becomes self-optimizing and it is telling us.
Now, the trick here is always what if the model tells you something that doesn’t pass the smell test, right? If I ran an unconstrained model on equities over the last 10 years, it would tell me that stocks that start with A are the highest expected return because Apple and Amazon, right? And that’s not a factor that you want in your model. So there does, on the model specification part and the build out part, you do need to have that level of understanding of REITs and that expertise understanding of the signal to be able to design it such that you can avoid noise and you’re looking at pure signals. And that’s another piece of the art of it. But once the models are trained and set to go, they go. They go where they go. And we’ve found some pretty remarkable discoveries, some that we thought would be big and the model tells us aren’t or changed or are changing over time, and some that are persistent.
Meb:
So what are you going to do with this? Is this a future ETF? Are you going to trade this on your own? What’s the kind of insights? Where does this work its way out?
Phil:
Right now we’re managing a small hedge fund, long only hedge fund with the data. We have the ability to customize it and do more. We think it works best when it is customized for specific outcomes, so be that downside volatility, be that absolute return, whatever the specific strategy is. But we’re working on that analysis right now. We’re open to partnering with asset managers. We’re open to working with people and creating customized solutions through SMAs on it. We may do an ETF, I’m not sure. We have two funds now, two ETFs out there. And I think between private and house, we’ve covered what we consider to be most of the investor needs for current allocation models. So we will see where the opportunity goes.
But for us, the main thing is that we’ve got the REIT specific trained data and the 25 factor models, but 35 models in total. Some are regime models, some are pattern matching models, and I think we’re ahead of anybody else in this space and we want to stay there.
Meb:
Is there anything where it’s really pointing towards big opportunities today as far as sectors? Is it like, “You know what, this certain area looks really attractive or really terrible,” or is it sort of a just muddled back security specific?
Phil:
I’ll tell you, I was saving this one in case you asked me. I know often you ask people what is their most memorable investment?
Meb:
Yeah, let’s hear it.
Phil:
So a lot of debate and discussion on our team about the key question that a lot of people that we’ve talked to, a lot of allocators, that we ask ourselves is what if the model spits out something that doesn’t pass a smell test? Do you override the model or do you go with the model? And it’s a very difficult question. We’ve got a lot of different opinions on our team and through our stakeholders.
And my feeling personally, and again, this isn’t necessarily the Armada consensus view, but my feeling is people are investing with us because they want the model output. If they don’t want to trust the model 100%, then they can split up the allocation to other managers. But our mandate is to provide the model exposure, and our job is to make sure that it’s built with the guardrails and the specifications such that we can’t get an outcome that we don’t think is right.
But I mentioned we’ve got fundamental and technical factors and indicators, and we’ve got these technical factors. I’ve never really been a technical analyst. A couple of weeks ago, the model flipped positive on office REITs for technical reasons. And I don’t want to own an office REIT right now, myself personally. And the model said, “Hey, we’re going long office REITs.” We had a lot of discussion on our team. What do we do? The model is saying it likes the technicals here, I don’t, nobody does. I don’t want to explain this to a client why I’m in an office REIT during the office REIT apocalypse.
Wouldn’t you know it? It was one of the best trades that we’ve had. It was a massive short squeeze. I’m not saying that the model’s always right or we can time these things on an ongoing basis. It was right in this time. But it was a very good reminder that, look, we built this technology, we’ve invested in it. Our partners at [inaudible] have been working on this thing for almost 10 years. We’ve got some of the top data scientists in the world that are working on this model. We need to trust the model. And what I can see in my limited view and my limited capability that yeah, office REIT’s bad, that limited view, is far surpassed by a machine learning algorithm that’s running 35 consecutive models with countless decision trees with probably the world’s greatest data source set for REITs that’s ever been put together. I need to trust that model and take a step back and let it do what it did, which thankfully we did, but it was a good reminder of that.
Meb:
Yeah, I mean I think if you get to the point in model building where you say, “Okay, we set this up, these are the rules,” you kind of in your mind have to account for the rare tail events on both sides. What happens if this spits out X, Y, Z? You have to account for that. Or what happens if it spits it out and then it goes down 80%? Or what happens if it goes up like a five bagger or a 10 bagger and all of a sudden it’s a huge part of the strategy or fund? That’s stuff to think about ahead of time. Once you have that all set up, really everyone knows as a systematic person, you really have no business mucking around with it.
Because I guarantee you every time without fail that I look at a lot of the portfolio holdings for many of our systematic strategies on the value screening side, I’m like, “Oh my gosh, we’re buying that. Are you kidding me?” But also on the trend side, there’s been so many times and people, it’s funny to watch them, when there’s been an asset that’s been performing great for a long time and then it rolls over, they really don’t want to sell. They don’t want the party be over. And I very specifically remember REITs in ’07 rolling over and people being like, “Well, you know what? I think this is a little balance. I’m just going to wait for it to actually confirm.” And then it was just like the rug had been pulled out and it was just an elevator down.
And ditto for assets. I didn’t want to be buying for our momentum and trend strategies a bunch of equities last year. I was like, “Oh man, this thing is not done yet. Are you kidding me? This is going to last. This is just the beginning.” And then sure enough, the signals are the signals and here we are. So I’m at peace with it now. It doesn’t bother me now. When I was younger, the signals, it took some practice for me to have a little zen mentality about it. Now I don’t even want to know what’s in the fund. I’m just like I just let it do its thing and I’ll just look at the aggregate rather than the individual.
Phil:
I think [inaudible] has a quote where I don’t remember if it’s exactly right, but something along the lines of, “The thing I’m most proud of is that I let the models run through the global financial crisis without overriding them.”
Meb:
So let’s pretend you and I are sitting down, it’s actually coffee time here in California, but let’s say we’re sitting down for a meal, hanging out. What else is on your brain? ETF industry, startup ideas, something got you particularly excited or angry? What do we got?
Phil:
I’m very focused right now on this, right, on trying to really wrap my head around where the opportunity is for investors. There’s a lot of anxiety out there with REITs. There’s a lot of anxiety out there with real estate. But this is not the global financial crisis exactly, right? It’s not the same factors. In our lifetimes, we’ve never had a downturn with inflation the way we have now, where you want inflation protected assets. We’ve seen the repricing of real estate to the upside in other countries and other geographies. There is this supply/demand imbalance. And I think a lot of people are very spooked about REITs because of the global financial crisis and because what they perceive as a coming market correction.
But I’m not convinced. I’m not convinced that REITs are a bad place to be. I think within REITs, like we said, there are a lot of different economies. The Jim [inaudible] short thesis on data centers, very convincing to me. I’m not expert enough to say for sure, but it seems to make sense when you look at the competitive threats from AWS and Microsoft and you look at the drag on the technology itself over time, very convincing. When you look at office REITs, we talked about, I don’t know that I want to still be in office REITs for the long-term. I know someone is going to make a generational buy, that some of these office buildings are going to be bought at prices that we’re going to look back 20 years from and say, “Wow, you could have bought this incredible office building in downtown Chicago and downtown San Francisco at that price in 2023.” Maybe it’s 2024, maybe it’s 2025. But that will happen. That price will happen, right?
So I don’t know, but I do know that we are in the zeitgeist shift. We are changing from this investor complacency, this never-ending trend of declining rates, this never-ending wave of QE coming in over and over and over again. And now that the Fed has finally been spooked by the idea that inflation is actually a real thing, it’s not a ghost, it will happen if they keep going, they have to rein it in. They finally have to rein in everything that they’ve been doing. And that means that the investing zeitgeist is going to change and the complacency that investors have is going to go away. And that means probably a return to fundamentals, a return to intrinsic value. The idea that liquidity is always going to be there, maybe that idea goes away too. And I don’t think that’s a bad thing at all.
I mean you look at the seasons. Every tree, the leaves fall off in the winter. Things die in the winter, they’re reborn in the spring and summer. It’s natural, it’s healthy. They’re natural cycles. And when you delay these cycles, when you have human intervention that interrupts the natural order of things, I believe you only make it worse. You’re delaying the inevitable, but you’re making it worse over time. And I think there is, what is it called, a creative destruction or a healthy destruction. There is the idea that old businesses do need to die and new businesses need to come in in their place, and old processes and cycles and market factors, all of these things will turn over. And I think we’re starting to see signs of that.
Meb:
You mentioned at one point your memorable investment, one of your worst investments, was trading baseball cards. What was that all about? I still feel like the collectible I most pined for was the Griffey upper deck rookie card. It’s just seared in my memory. What does this mean to you?
Phil:
We are roughly of the same age of the same vintage. I think for a lot of people in finance that I talk to that are our age, this idea of baseball cards as an investment when we were kids taught them a lot of lessons about investing. And I’m no different. And me and my brothers, baseball cards for several years when I was young, that was our life. And I’d babysit or whatever, I’d get 10 bucks. We’d go bike ride to the store, buy some baseball packs, open them up. There’s an element of luck and surprise. “Hey, I got a good card. I didn’t.” But they also had this idea that they would always go up.
And what I did was after collecting for a few years, I’d saved up a bunch of whatever for that age, a collection and some money. And I sold all my cards. It had these blue chip cards. It had a Roberto Clemente, not a rookie, but pretty good Clemente card. I had all these cards, and I decided I’m going to invest in this Greg Jeffries rookie, this new guy that came up to the Mets that was supposed to be the next big thing. And I mean you translate it now to stocks and it’s basically selling your portfolio and putting it all in your nephew’s startup because he’s got the best app that … It was so ridiculous, right? And the player, Greg Jeffries, didn’t really work out. He was okay for a few years, but certainly nothing special. All these cards that I invested in all went worthless. All the cards in general pretty much went worthless, especially those, there was a flight to quality. There were issues of liquidity, there were issues of saturation. There were a number of issues that came up just in projecting the players, right?
A lot of statistical and investing lessons that came out of that that still to this day are kind of seared into my memory. The reason why I talk about the baseball card thing is those patterns that you learn early, those patterns that showed up even with kids trading baseball cards, they repeat themselves constantly. They’re market cycles. They’re truths about the market. There are real patterns in markets and every market everywhere. This time is not different. And that’s the key thing that it tells you. This time is not different. And I don’t know, I can’t see the catalyst for Apple to suddenly start underperforming the broad market. Or Amazon. I can’t see that catalyst, but I know it does exist, right? It will. I don’t know what it’s going to be a competitor or some issue, some I don’t know, but something will happen. A stock cannot outpace. I mean, you play that on an infinite timeline or even 100 years of one stock or one theme outperforming the broader market or even the market itself outperforming GDP growth, any of these things, right? When you play that out indefinitely, you start getting to valuations that very quickly look very ridiculous. Nothing goes forever. This time is not different, and that’s the key takeaway that I got from the baseball cards.
Meb:
What investment belief do you hold that most of your professional peers don’t? And it doesn’t have to apply to actual like an investment belief, it could be investment industry belief too. But 75%, we sit down at the dinner table and you say this and everyone groans or is like, “Oh dude, that’s a terrible take. I don’t.” But what are you talking about? And you can name more than one, but what comes to mind?
Phil:
We talked a little bit about market cap weighting. To me, that’s the big one. The idea that index funds are better for investors, this consensus view that everyone has that just manage costs, costs matter. There’s no cost benefit. There’s no benefit side of cost benefit anymore. I think it is really silly, and I think the data on active funds, it’s been very conclusive that it favors the index funds, of course. But you’re lumping in all asset managers and you’re looking at it over a time where fees were significantly more expensive, even active fees, were more expensive than they are today. And we’re in the middle, like I said, of this kind of changing zeitgeist where we’ve gone from fundamentals driving stocks to now narratives driving stocks. And that could change. And I think that might change in an environment where there’s more of a liquidity demand and less liquidity than there has been for the last decade.
But this idea that stocks always go up and you can just buy a market cap weight is I think a very dangerous idea. And the idea that everyone can save and everyone can put money in a market, I think it’s very dangerous. And a lot of people are out proliferating this advice as if it’s a fact, as if it’s not an opinion. Everyone will say, “Well, past performance doesn’t guarantee results.” But then when it comes to this it’s like, “Well, look at the past performance,” right? And we’re coming out of a cycle really going all the way back to World War II, where there’s been American exceptionalism, where the U.S. market in particular has done better than global equities, where U.S. equities have done better than every asset class, and where passive investing has been just fine, done better than every other strategy.
So everyone’s kind of resting their hat on this data set of the S&P 500 and saying that this is settled science, this is the right way to invest. It’s cheap. You know what you’re paying off these, you don’t know what you’re getting on alpha. You don’t have to worry about global diversification because American exceptionalism and we’re the leaders and stocks outperform over the long term. And I think it’s a very myopic point of view, and I think it’s a very dangerous point of view. I think the idea that American equities are going to outperform global equities indefinitely is not going to last forever. I mean it can’t, it’s just not possible. Eventually, valuations get stretched to a point where you have to go elsewhere. We might be there now.
The idea that equities can outperform global growth in a broad way like GDP growth or inflation or however you want to measure that, if equities, which is the sum of all publicly traded companies, which is pretty much a bogey for the economy, if they outperform the economy by another measure, compounding over a long enough period of time, eventually you get a divergence here that’s not sustainable.
If you look at market cap to GDP, we’ve already reached a level that I don’t think we’ve ever reached before. And I think prudence is required. I think active strategies, specifically strategies that focus on capital preservation, downside protection, I think it would be prudent to start thinking about those and for investors to be less dismissive about active management when done the right way. Not to say active as a whole category the way it’s talked about, but within active management strategies that will accomplish those goals. And to think about global diversification and to think about asset class diversification, and maybe for the Fed and the Treasury to think less about this idea of pushing investors or pushing the public into being investors instead of being savers, that it’s a net good for everyone to be in the market, I think that too is a very dangerous idea, and we’re at a point now where everybody’s retirement is in the market, is in the S&P 500, everybody’s.
Meb:
Phil, where do people go to find you? What are the best places to see your spicy takes? Obviously on Twitter, what’s your handle? And then what are the best websites?
Phil:
Thanks, Meb. I’m on Twitter at PhilBak1, it’s B-A-K. I’m on Sub Stack, Philbak.substack.com, and our company’s Armada ETFs, the website is armadaetfs.com.
Meb:
Awesome. Thanks so much for joining us today, bud. We’ll do it again soon.
Phil:
All right, thanks Meb.
Meb:
Podcast listeners, we’ll post show notes to today’s conversation at mebfaber.com/podcast. If you love the show, if you hate it, shoot us feedback at the Mebfabershow.com. We love to read the reviews. Please review us on iTunes and subscribe to the show anywhere good podcasts are found. Thanks for listening friends, and good investing.
