January 6, 2023 – On today’s show we welcome special guest Phil Bak, CEO of Armada ETF Advisors. Phil has been innovating in the ETF industry for over 15 years. He has previously served as Founder/CEO of Exponential ETFs, an ETF issuer and sub-advisor acquired by Tidal ETF Services in 2020. Phil has also served as Chief Investment Officer at Signal Advisors, a venture-backed startup in Detroit and Managing Director at the New York Stock Exchange.

On the show, Phil discusses:

  • Characteristics of ETFs that make them a great tool for investors
  • Some major innovations in ETFs over the past 15 years
  • The bull case for residential real estate
  • What is happening in the private REIT space
  • The major risk investors face in private REITs
  • And more

Welcome investors to The Absolute Return Podcast. Your source for stock market analysis, global macro musings and hedge fund investment strategies, your hosts, Julian Klymochko, and Michael Kesslering aim to bring you the knowledge and analysis you need to become a more intelligent and wealthier investor. This episode is brought to you by Accelerate Financial Technologies. Accelerate because performance matters. Find out more at accelerateshares.com.

Julian Klymochko: Hey, Phil, welcome to the show. Hope you’re feeling warm out there in Detroit and Michigan. How are things these days?

Phil Bak: Doing good and definitely not feeling warm. It is cold as hell right now out here but doing well and thanks for having me on.

Julian Klymochko: Yeah, excited to get into it. Long track record in the market. Been focused on ETFs for a long time, one of the innovators, pioneers in the space. Prior to getting into all thing’s real estate, ETFs. Can you touch on a bit of your career trajectory, your background in capital markets for nearly the past 20 years?

Phil Bak: Yeah, yeah. Well, you know. We don’t always choose our career path. You know, sometimes our career path chooses us. And I think that was the case with me. I landed in ETFs. I I started off my career as a trader, and I did some, you know, just like momentum trading, scalping back when that was a thing. And that was my first foray into the market. And I ended up doing some FX work on an FX desk overnight and was doing a little writing, it’s kind of like a little this or that, you know, trying to find myself, trying to find my career footing. When ETF started to explode. And I was very lucky to land with an ETF startup. At the time, it was called XTF Asset Management. And I did a little bit there and jumped over to another, similarly named, but very different ETF startup called XShares Advisors.

And I was very lucky there to have a company that ultimately, the company wasn’t all that successful, but I had some bosses that gave me kind of free rein to come up with ideas and work with people on different products. And in the short amount of time, we did a lot of really interesting things. We did the first ever target date ETFs, a mixed asset etf. We did the first ever carbon credit fund called Air Shares that came and went. But I was very proud of you know, the work we did and the structuring we did on that. That was very early. That was back in like 08 or so. We did a number of other funds. We had a number of ideas that, you know, it’s kind of a shame that over the years since have become monstrous success in the ETF industry that we weren’t really able to execute on.

But, you know, that kind of gave me a little bit of expertise and credibility as a product structure in the ETF industry. Like I said, it didn’t really work out, I ended up going to a company called Rydex in the product management and exchange trade fund group. And, you know, that was really just another fantastic experience. There were so many people there that I worked with at Rydex that now are all over the industry, all over in all kinds of roles. Just a number of very, very smart people there. And I was a product manager on etfs, including some really interesting ones. Notably the Equal Weight ETF is one of them that came into play later when I launched the Reverse Cap ETF down the road.

That was kind of like the seeds for that. But, you know, long story short is, I did a lot of ETF product stuff and capital market stuff. I joined the New York Stock Exchange in 2010 and worked with ETF issuers and regulators and market makers and did a lot of market structure work there. And then in 2016, I had a very pivotal year for me. I had a pituitary tumor that was pressing up on my brain, required two surgeries, two brain surgeries to get it out. And ultimately it was obviously terrifying scare, but, you know, it worked out, it was very much a dodge bullet, and everything worked out okay. And I’ve had a clean bill of health ever since. But having that moment, having that like belly of the beast moment where you realize, you know, life can be taken away, life is short.

And I mean, all the cliches that people say because there’s a lot of truth to them. And that was a moment in my life where a lot of things changed. And up until then, none of you guys would’ve ever heard of me. I didn’t have a social presence. I didn’t really, you know, I was just some guy working at the exchange and, you know, upstairs in the office that nobody really knew. And when I came out of that experience, I had a very different approach to life. I had a very much, you know, it was very real to me that, you know, life is a finite amount of time and the things that you want to do, you just have to, you know, wake up and go do them. And, you know, I was in an unhappy marriage.

I got divorced. I was in a career path that was very fortunate to have. But I wanted to be an entrepreneur. And up until that point, I probably would’ve wanted to be an entrepreneur, thought I would’ve made a good one for the rest of my career while I sat in these corporate jobs for another three decades. But that really gave me the kick in the butt that I needed to go out and make things happen. And a number of other things, being more outspoken. And, you know, again, I don’t really, you know, have little bit of a social presence these days. I don’t really consider myself outspoken. I consider myself just calling it like, I see it, you know, and let the chips fall where they may, like, I’m not going to filter myself or be worried about what, you know, potential, you know, potential partners or other firms or what they’re going to think. I’m just going to say what I think is the honest truth. And I’m not always right. I’m not always, you know, sometimes I fall into something that resonates. Sometimes I don’t but it’s really just a question of being honest and out there and not hiding or filtering, you know what I’m saying? So, all that changed very suddenly around 2016. And at the time I was, you know, like I said, I decided, okay, I’m going to go do something entrepreneurial. I had two business opportunities. One was a hedge fund that used proprietary customer satisfaction data, which I wanted to convert into an etf. And the other was some IP around non-transparent ETFs, non-transparent active ETFs, which at the time had not yet been approved by the SEC, it’s kind of weighing the two.

I decided to do the customer satisfaction hedge fund, which was the start of what became Exponential ETF. So, we launched the ACSI ETF, which is still trading, and then we launched a Reverse Cap ETF. And then what we found was we were quite good at the portfolio management side of the business, more so than distribution side. So, we started outsourcing our abilities to manage ETFs as ETF sub-advisor. And we did that for a while with some success. We sold the company to Title Financial Group a couple years ago. And now I’m back at it with another ETF venture. I figured I didn’t get kicked in the teeth enough the first time around. So [laugh], I’m back for more. Back for more abuse

Julian Klymochko: [Laugh], yeah, it’s always fun and a truly inspirational story, how you made those major changes after a big health scare. But we’re all happy that you made it through to the other side. And you have this new venture that we’re going to get into. Prior to that. Etfs, you’ve been in them for a long time and you’re now just kicking off another round of it. You’ve done multiple rounds of different ETF concepts, product concepts. What specifically attracts you to this investor tool? What makes it a great tool for investors, specifically

Phil Bak: The promise of ETFs, the beauty of ETFs. Something Eric Balchunas at Bloomberg refers to as ETFs being the Silicon Valley of finance.

Julian Klymochko: Right.

Phil Bak: And, you know, everyone loves to use the buzzword, the democratization of this or that. And I think when it comes to ETFs, there’s a lot of truth to it. You know, it’s not free to launch these things. It’s not that easy to launch them but it’s not an insurmountable amount of capital or effort to get them done. So, you know, typically you’re talking about a quarter million dollars a year in operational cost you know, maybe 15 basis points. But you can get one of these ETF launched if you have a good idea and you have some, you know, some ways to distribute it, at least to a minimum level or some seed capital. And, you know, the idea that you can come up with a more clever twist on what people are doing now or you can come up with an NASA class that people aren’t currently investing in, that they should be, make it available. It doesn’t always happen, doesn’t usually happen but it can happen that you can hit scale and in an etf, the likes of which you can’t in other vehicles. So, you know, for example, hedge funds are far more profitable, even mutual funds are more profitable, but it’s harder to reach scale because they’re sold on a, you know, in a hand-to-hand combat way.

Julian Klymochko: Mm-Hmm.

Phil Bak: They’re sold kind of as one-offs. Whereas ETFs, once you clear, you know, liquidity hurdles, which are very difficult to do for a number of reasons we can get into, but if you do clear those liquidity hurdles, because so many people are allocating now by, you know, model portfolios or more broadly, you have these centralized home offices, if you can get something that catches on in those markets, you can create something that can reach incredible scale. So, it’s, you know, the promise of it is very tempting, right? For every Cathie Wood, there’s a number of active, you know, managers in the high beta space or whatever that don’t catch on, right?

Julian Klymochko: Mm-Hmm.

Phil Bak: But enough catch on that it’s the promise of, hey, I’ve got this great idea. I think if I can get the investment world to see it the way I see it, that I can have this, you know, permanent annuity stream of revenue. And it’s very tempting. It’s very interesting. So, you know, I don’t know. There are times I look over at, you know, some of the other vehicles or some of the other strategies people are using to distribute different investment thesis. And I get, you know, pretty envious because the amount of capital you need to raise into an ETF in order to make it just profitable on its own, let alone to make any money on these things, it’s quite high.

They work at scale basically. They don’t work unless you get them to scale. And getting them to scale is not easy. And it’s getting harder and harder because a lot of the centralized, you know, wire houses and different distribution avenues or closing those gates, there looking for, you know, hidden kind of, you know, ways where they can profit off the relationship that are still allowed. And there’s a lot of shady things going on there. So, it’s not quite a meritocracy the way, you know, the way it was or the way it’s advertised to be, but it is more of a meritocracy, I believe, than the other areas of finance. So, you know, that’s the temptation.

Michael Kesslering: And from an asset manager’s perspective, what are some of those key considerations that you think they should be looking at when they’re looking to launch a strategy? They have a strategy; they’re looking at an ETF structure versus closed end fund versus a traditional hedge fund or things of that nature. Many other different structures. What would some of those key considerations be for some of our audience?

Phil Bak: The key is accessibility. So, you know, if a strategy is not yet available and an ETF is a little bit hard to get access to, all of a sudden you can put in the ticker and buy it through an ETF, it becomes very simple. And a lot of ETFs that have exploded in popularity have done so for that reason. Like, the key example would be GDLG. It’s not like it’s hard to buy gold, right? You could buy gold at a jewelry store at the time, there were different derivative instruments. But for most investors who just want to have one portfolio, in their equity account where they have all their holdings becomes very simple that way. All of a sudden GDLD comes along and now it’s, you know, it’s a juggernaut. And there are different strategies that are, you know, more complex.

They’re hard to get to, they’re hard to implement. You know, increasingly we’re seeing other competing tools that also provide that access. And I think some of them are fantastic. I think direct indexing is very appropriate, certain instances. But the key thing with the ETF, many people will talk about the tax efficiency. That’s true. There are some, usually depending on the fund, usually there’s some cost efficiencies. It is a very consumer friendly structure. But I think, you know, at the end of the day, the thing that is really tempting for the sell side, for the asset manager is that you can make something very accessible with catchy memorable ticker trading desk to use it. And it could become ubiquitous with, you know, that strategy and really own a strategy.

Julian Klymochko: Now, Phil, you mentioned a relatively controversial figure, Cathie Wood of Ark Invest, who has a number of these innovation ETFs that are very popular with investors. And, you know, the numbers are the numbers in terms of performance hasn’t been awesome lately, but I was interested in your opinion because that firm has been tremendously successful in terms of growing to significant scale. What do you think are some of the keys to success that she has had in the wind behind her sales?

Phil Bak: So, you know, look, there’s a lot of ways that you can answer this. There’s a lot of different angles, right? Was her success from a performance standpoint, a function of, you know, high beta of, you know, a lot of tail winds of some tech trends, but a lot of, you know, friendly fed environment and different things kind of lining up at the same time? Yeah, there’s no question. There’s no doubt. But I am also a fan of hers and of the firms and what they’ve accomplished for a number of other reasons that are more kind of specific to our industry. I know you’re in the ETF industry as well. And, you know, for one thing, I think she has tremendous conviction in what she believes. I think she truly believes in the innovative capabilities of the companies that they invest in.

And she’s not a faker, I don’t think she’s a (Inaudible 0013:02). I think she truly believes in it. And over the long term, you know, maybe she’ll be quite vindicated by the success of some of these companies. But what I think is, as an industry, we’ve gotten very, very bland, right? And there’s this massive wave and push towards index investment. When I say index investment, of course, I mean passive market cap weighted indexing you know, smart beta is kind of, you know, ebbs and flows based on, you know, how market cap weight is essentially the counter to all those strategies, right? How that’s doing. We haven’t been in a value cycle for a long time. And you know, a lot of the very large asset managers have, I don’t know if I’d go as far as say they have closet indexing strategies, but you look at their strategies and they’re just not that bold.

Julian Klymochko: Right.

Phil Bak: Right, and if you look at top holdings of a lot of the large active funds, you see the same, you know, the same top holdings. Slightly, they tweak the weights. Maybe they, you know, they don’t like J&J, or they don’t like Google, but they basically have, you look at the top 10 of a passive cap weighted fund, and you look at the top 10 of any of the large mutual funds, they’re going to look the same.

Julian Klymochko: Mm-hmm.

Phil Bak: Right? Just from a cell test, from a high level. And here comes somebody who has their own thesis and truly believes in it and is investing in a very unique, differentiated way. And as commercial success, commercial success. So, for forgetting about the investment success or not, or whatever, but just commercial success as an independent coming up woman and a small team initially coming up against, you know, these gigantic asset management companies. And to me, it says a few things. It says that active management is not dead. It says that independence and you know, startups can succeed against these big asset managers. And it says that what you really need more than anything to succeed, yeah, you need performance, you need the right environment, but if you wait long enough, that environment will come.

Julian Klymochko: Mm-Hmm.

Phil Bak: So, what you really need is conviction and differentiation. And those are things that I really respect, and I don’t think we see enough of. So, kind of a long-winded, complicated answer, but I have tremendous regard or respect for what they’ve accomplished.

Michael Kesslering: No, and that’s a really good point in terms of the, she’s had a ton of commercial success and it’s through some structural changes to how we view ETFs. And so, with that in mind, you already, in your career, you’ve been a big part of some of these structural changes to ETFs. You mentioned before non-transparent ETFs, there’s now active ETFs. It’s not just passive. Moving forward, what are some of the innovations and changes within the ETF structure that you would like to see over say the next 10 years?

Phil Bak: I think we’re seeing them now. I think a lot of these derivative strategies are very interesting to me. I think, you know, the traditional 60/40 is, you know, famously, you know, in a bear market, all correlation, spike and et cetera, et cetera. I think a lot of people are rethinking some of those assumptions. And as they do, you know, different frameworks for asset allocation are popping up and a lot of them, you know, rely on, you know, rather than rely on diversification or rely on fixed income for downside protection, they have more direct, you know option strategies to achieve that, or they have structured outcomes and different things like that. I think a lot of those strategies are very, very interesting. I’m a big fan of what simplifies doing. I’m a big fan of the Black Swan Fund and that concept that Amplify has out, there’s a number of these strategies that are like, quite a bit.

So, I think, you know, for a long time, the use of derivatives in ETFs was very difficult to do. You had to go through this 19 before process on a product-by-product basis with SEC. Recently, they’ve kind of loosened some of those restrictions and allowed some of these different strategies to come. And I think it’s really interesting. I think it’s going to allow more creativity by issuers you know, by quant. And I think, you know, look, the way we invest in 20 years is probably not going to be the way we invest today. So, I think, you know, having a regulatory framework that allows issuers to stand the forefront of, you know, new innovations is really critical. And we’re seeing that now.

Julian Klymochko: Yeah, it’s great to see new innovations become accessible to investors. And I was just reading Howard Marks memo over the weekend, and he was speaking about starting out his career in high yield bonds, junk bonds. And when they first got created kind of late seventies, that nearly all investors weren’t allowed to touch them because they’re too speculative. They’re like, what? a non-investment grade bond. We can’t touch that. And now you look, there’s all sorts of high yield bond ETFs, junk bond, like basically everyone has junk bonds in a diversified portfolio. So, it’s a great just to see all these innovations and new asset classes come to the forefront and become accessible, low cost, easy to use, et cetera. Now, in terms of what you’re up to right now at Armada ETF advisors, residential real estate, can you tell us the bull case for that asset class?

Phil Bak: Yeah, and you know, it’s not, you know, we’re talking about these like, you know, complex, you know, super advanced ideas. This one’s the opposite. This one is, you know, really about dialing it down and keeping it simple. I think a lot of people in our industry think of a REIT as an afterthought and a REIT is a REIT. Like what’s the difference, right? And what’s happened is, really two things. One is the REIT structure, the unifying description of anything that’s a REIT is just the structure of REIT, which is basically a tax treatment. You don’t have to be in real estate, and you have all these different types of REITs now. You have, you know, cell towers, storage facilities, student housing, all these different things, and they’re all called REITs.

And what’s interesting to me, what really hooked me on this project was looking at the correlation matrix of the sub-sectors within the REITs and seeing that they were really quite low, lower, in fact, than you have as the correlations between, you know, your traditional, you know, growth value or large cap, small cap. There’s more diversification benefits or opportunities for trading within the REIT sector. Now, I had not been aware of that. I was one of those people, I just assumed, you know, REITs are REIT. So, you know, I’m looking at the REIT industry saying, wow, there’s really some opportunity here. Well, two things. One is, what do I want to own? And this macro environment going forward, and you know, obviously in a post covid world, you don’t necessarily want to own office buildings. Now, you might not want to own malls. And, you know, we’re kind of going through the cap weighted, the VNQ and the different cap weighted REIT ETFs. And there’s a lot here that I probably don’t want to own.

Julian Klymochko: Right.

Phil Bak: So, there’s real opportunity here for Alpha, and what do you want to do? Do we want, you know, create a multi-factor model? Do we want to create a rotational model? Like what do we winna do? And at the end of the day, what we saw was these residential REIT who basically investing in the rental income that comes with them. And, you know, when you look at the supply demand imbalance in housing here in the US, you look at the demographic trends, you look at the fact that in a rising rates environment, it’s harder for new builders to finance new construction, but the existing homes are already there. So the rental income, even in the downturn in real estate, tends to be a lot more stable than let’s say, you know, home prices or different things. So, if I were to put my money to work in the REIT space, where do I want to put it? You know, it’s pretty clear to me and my founders that we want to keep it in residential REIT. That’s the good stuff. That’s where you want to be. And in fact, we built this for [laugh], you know, for the chairman of our company to, for him personally, to put his money, he wanted to put, you know, a million bucks into a residential REIT and there was no ETF to do so. So, you know, we built this fund, we think it makes a lot of sense for this macro environment. And that’s, you know, that’s it. This is a pure play on residential REIT.

Julian Klymochko: I believe I heard a stat, someone said that residential real estate is the largest asset class in the world. And I always thought that was super interesting, just a massive market there. And I found it quite shocking that there wasn’t previously an ETF dedicated to that. So good on you for recognizing that opportunity. Now, with respect to the broad REIT sector, it’s been a bit of controversy there lately, and you really touched on it in a recent Twitter thread that I thought really nailed the issues. So, what happened was the largest private REIT showing exceptional performance year to date up 9.3% when a lot of its peers on the public side were down 20, 30 even you know, 40%. And so, some mismatch there then run into some liquidity issues. Can you break down that situation for us and what’s happening on the private REIT space versus the public?

Phil Bak: Yeah, and I said two things, I think I said that talked about the market cap weighted. The other, you know, big way that people have been getting access to this asset class lately is in these private REIT funds. So, there’s this Blackstone REIT Fund, there’s Starwood, there’s a number. Over the last three years, over a hundred billion has flown into this one asset. And it’s a scary thing when you think about, because the largest buyers of commercial real estate, by far, the largest buyer has been Blackstone through this BRE REIT fund over the last couple years. And we’re in an environment now, and I’ll kind of break down it and get to here, but we’re in an environment now where those largest buyers have become, not only sellers, but you know, possibly forced sellers.

Julian Klymochko: Right.

Phil Bak: So, you know, what’s happened is, we’ve got these non-traded REIT, which are basically just the same as REITs, except they don’t trade on the exchange.

So, you don’t get the benefit of, you know, transparency, daily mark to market for the pricing, which, you know, to me is a benefit. But to a lot of people, it could be perceived as the opposite because you know, what you have is a smoothing effect, which, you know, your listeners are probably familiar with. But in all private markets where you have you know, less frequent marks on the value of the underlying asset than, you know, you could be, depending on how you calculate it, you could be kind of deceived into thinking that it’s less liquid because you look at it less often, right?

Julian Klymochko: Yeah.

Phil Bak: But it’s not only the smoothing effect, it’s not only the fact that the marks are come in, you know, quarterly, they’re all based off these appraisal systems, which are even slower. So, there’s the appraisals, you have human appraisals, and the appraisers I’m sure are very good at what they do. However, they only come in periodically. And appraisers in general are less likely to, you know, to be more volatile in their assessment. You know, based on like macro, you know, trends or based on publicly traded comps. When the market turns quickly, which is what happened, market went, you know, from, you know, wildly bullish and peak valuations to something else. It takes a while for those appraisals to catch up, right? Because you only do them once a year on a property-by-property basis. So over time, over the course of a year, they all kind of catch up to the new environment after a churn. But it takes a long time. So, you have this massive Blackstone REIT Fund and Star War. There are others to, but let’s just talk about the Blackstone.

You have this massive REIT Fund which is still calculating their navs off of these lagging indicators, off of these lagging appraisals. So, you’re basically looking at it as if the value of the assets held by this fund are six-month-old when the market is dropped. Now in that time period, in those six months, publicly traded REITs have dropped by like 15% by a significant amount. So, there’s a huge divergence there. Now, in the past there’s been a divergence between public and private REITs, right? They have diverged, never to this extent, but every time they’ve diverged, over time they have converged, right? They kind of come back together over time. What stands to reason? You could say that Blackstone is really good at picking great properties, and I think they are, by the way. I think they do a very good job of that.

You could say that they’re so good at it that they’re going to outperform the public REIT. Okay, fine, maybe I’ll give you that. How much can they outperform by and for how long? And can that compound and stay and build forever? It’s not possible and the properties aren’t that much better. And you can normalize your comps based on, you know, property type and geography and a number of different factors to give you, you know, an apples-to-apples comparison. So, if you want to grant them, we can get into the fees later. But basically they have to overcome a hurdle just on the fee difference of over 3%. They have to be that much better than the baseline and the market. And then you want to say that they’re even better than that, than the public REITs. Okay, I’ll grant you maybe a couple percentage points because I’m nice because they seem so smart and everything. But once you start talking about 15, 20, 20 5% divergence between the public and the private REITs, you know that it’s going to true up. Now, it could chew up, theoretically could true up by, you know, the public REITs, you know, rebounding and coming up to meet the privates, or it could be something in between or it could be the privates coming back down earth. Now, like we see in a lot of close end funds like we’re seeing now with GBTC, just because a private fund isn’t being marked at a nav that is, you know, congruent with the publicly traded comps, it doesn’t mean it has too tomorrow. There’s no mechanism for it to true up. There’s no, you know, arbitrage mechanism or anything that will force it to come back to earth, except for one. Except if they have to start selling properties in the real world for real dollars from real buyers, well, they’re only going to get what they’re going to get.

And whatever the appraiser said a year ago about this property has no relevance of their ability to find liquidity today. Like I said, the largest buyer in this market has become a seller, right? And the real estate markets are generally frozen. It’s not a good time to be selling large commercial real estate. If they have to sell, then you know, the navs are going to reflect what they were able to get in the market, not what they think they’re worth. So, there’s a big risk here. Now I’ve got a caveat at this, right? Because they do have a lot of liquidity. They’ve got CMBS on the books, they’ve got credit lines, they have ways to get liquidity. And you know, what we think happened here, we’ve been watching this situation very closely. You know, they have in their prospectus, they have a right to gate and slow down these redemptions.

They are claiming they got a lot of redemption requests from, you know, some centralized Asian sources and may or may not be true. I think they underestimated the fact that by giving the fund, which in, you know, in their words, which is true, they had a right to do which I think they saw as a temporary thing to kind of wait to get some more inflows that can offset the redemptions or to kind of buy a little time. I think they underestimated the panic that that would cause that gating the fund would cause. And the fact that if I need liquidity on this thing and I can only get 5% out of quarter, well now all of a sudden, I have to put in a bigger redemption request for my clients. If they need liquidity, let’s say next year, the year after, they have potentially caused their own run on a bank with their own hubris that they can gate the fund and not cause a panic.

So even though they had plenty of liquidity, probably enough liquidity to meet whatever redemptions they had last quarter, the question is, did they cause a big rush for more redemptions? And are they going to be able to cover that without having to sell properties? And again, selling properties, I mean, we’re not talking about, you know, an FTX situation. We’re not talking about them, you know, defaulting on, I mean, you know, all the shares in the fund are represented by the properties that are owned. The problem with them having to sell properties in order to get liquidity is the price that they’re going to get on the properties is not even going to be close, not even close to what their marked at is now. So, the investors are going to have to take a huge write down if that happens.

Julian Klymochko: So, to provide some additional context to that, you provided a lot of details and insights there. Couple terms now: Gating, what they’re doing there. The private REITs tend to be what they call a semi-liquid. So, they allow a portion to be redeemed each quarter, each month. And gating means saying no must to redemption, say they’ve had too many and they can’t honor those like investors want. And obviously gating causes issues because it sort of sets off the alarm bells for other investors while it’s like shouting fire in a crowded movie theater. Everyone wants out at the same time. Now, Phil, I was wondering with respect to this dynamic, so you’re an investor who owns a private REIT rate right now. Like what are the major risks and what should they do?

Phil Bak: I mean, the major risk is being able to get liquidity when you need it. And again, let’s say it’s the Blackstone Fund, even if you think it’s a temporary issue, if there is a big rush to the exits and you have to get in line behind everyone else, that line is going to get longer and longer potentially. And you know, I talked a little bit about this in the thread, but there’s this idea of, it is similar to the Cathie Wood thing. When performance is really strong in an asset, we see more people chase that performance. It’s just human nature, it’s how it is. And you know, the performance has been really, really good in this fund. It’s been really good with very low volatility, and a lot of people have rushed in for that.

And if the performance turns and the performance gets worse because they have to write down the value of these assets because they have to sell them because they have to meet the redemption requests, well, guess what? That too, just like the run on a bank, you know, people afraid that they can’t get out. The turn in performance will also cause an increasing run on a bank. So, all of this, it’s the scenario that plays out on the way up. And then on the way down where, you know, people rush in, the flows drive performance, right? If people are buying something through a fund, intermediary or direct, everyone’s buying something, that itself pushes up the price and on the way out the exact opposite happens. So, you have this possible scenario where the whole thing feeds off each other and it creates a cycle where, you know, more redemptions, create more write downs, create more redemptions and it gets harder and harder to get your money out, and you have to wait longer and longer to get it out.

And while you’re waiting to get your money out, you’re getting, you know, write-downs. And I’m not saying that this will happen. I’m saying that this could happen. I think it’s enough of a risk that investors should be cognizant of it. If your money’s in there, the only thing you can do right now is get an queue to get it out. If you can get it out, or if you’re allocating new capital, I would suggest that the public REITs the valuations are significantly better without the same issues. And you know, one of the things I talked about also is the liquidity, you know, liquidity premium where like, you know, the idea historically is if something is, you know, you have to accept diminishing return, have more liquidity, or you have to get a better return in your expectations for less liquidity because liquidity is valuable and it’s all been turned on its head lately into markets where people feel like, well, anyone could buy an etf, anyone could buy a liquid asset.

There’s nothing special about that. But if I want something really special to my clients, I have to get something illiquid and I’ll pay a premium for that, right? So, you know, if I can get into a venture fund or if I can get into a private equity fund, or at least private REITs, that because there’s an heir of exclusivity to them, it makes it seem more valuable and they charge more fees. So, the less liquid it is, the higher the fees are, which is totally backwards, totally backwards. And I think we’re going to see now a return to common sense where people are willing to you know, pay more for liquidity. But here you have to pay less for liquidity. As you get more liquidity, and you get better valuations in the public’s right now at this point. That can change, but this one looks like today.

Julian Klymochko: Yeah, it’s very interesting. You noted the valuation, the dichotomy between valuations of the private REITs, which have remained elevated. They’ve basically taken, no write-downs haven’t adjusted the appraisals at all for clearly rising cap rates declining multiples amongst significantly higher interest rates. Obviously, interest rates drive real estate valuations for the most part and also a recessionary environment as well and created this potential bank run scenario that you detail. The other one that we can extend further with respect to the price differential is this quasi-arbitrage opportunity where you can basically, if you can get the liquidity from a private rate at a hundred cents on the dollar going to the public market at 70 cents on the dollars, the most rational thing an investor could do, right? Because there’s such a better deal in public markets. And ultimately when you think of what drives the return, that’s valuation. So, if you’re buying private REITs, it’s say, you know, 20 times FFO or funds flow and you can get it in public markets at 15, it’s like, where do you think you’re going to find the higher returns?

Phil Bak: Yeah, I would say it is an arbitrage if you can get liquidity at the privates. I mean, could tell you even before they gated the fund, before everyone was talking about this, we looked into swap exposure on some of these private funds. And no moss, nobody was making that offer. But if you can get that, then I believe it is in a perfect offer, but I think it’s pretty good arb.

Julian Klymochko: Yeah, if only you could short them and create a pair trading opportunity. Unfortunately, you can’t. And at this point, it’s really tough to discern why anyone would be using private REITs. I know they typically say, oh, these things are sold, not bought. And then there’s a whole, I believe Cliff Asness refers to it as volatility laundering. You mentioned return smoothing, which in the volatile market environment certainly helps to be oblivious to the underlying volatility and risks. But are there any reasons why you think people should be in private REITs or are you pretty focused on, you know, public REIT exposure being the better way to play it?

Phil Bak: Well, I think unfortunately the, you know, the bestselling point on these was the low volatility. And it’s a great story. They’re real properties. They exist, quality properties, like I said, they do a very good job, we think at choosing and managing the properties. And if you look at the volatility and you compare it to, you know, public options, it looks amazing. And you know what’s really sad about that? The reason why it’s sad is because the risk return characteristic of this thing, you know, because it’s considered very low volatility based on historical attracts an investor that does not have a lot of risk tolerance.

Julian Klymochko: Right.

Phil Bak: Right, so you’re talking about retirees and widows and orphans, proverbial, widows, orphans.

Julian Klymochko: [Laugh]

Phil Bak: But specifically, this fund got modeled in for investors who are the least risk tolerant. And, you know, we’re looking at a 15 to 20%, you know drawdown in NAVs or at least convergence to the publicly traded, that’s imminent. That’ll happen over the next year. You know, specifically it’s going to hit these investors that are least inclined to take on that kind of risk. It’s really unfortunate. It’s really sad. But yeah, they have been you know, the brokers have been incentivized to move this thing. There’s a very high selling fee associated with it. It’s high fee in general, but you know, it’s got a very good brand. And I think the business case for real estate is strong generally. And you know, there are definitely reasons to buy it. It’s just unfortunate that it’s been sold, not bought, and sold, you know, two investors with a pretty low risk appetite.

Julian Klymochko: And as we approach the holiday season, the analogy that I like to use for private funds, private REITs is that of Turkey. And if you look at the graph of the life of Turkey, it’s all smooth sailing, these private funds typically only show, you know, positive performance month after month after month, never any sort of drawdown. Comes Christmas Eve, and then there’s a massive drawdown. And who knows? That could be coming to these private REITs. As you indicated, the valuation certainly warrants some sort of adjustment there. I guess we’ll watch that and keep our eyes open for that, monitor that situation. Now, outside of real estate, Phil, just prior to wrapping things up here, what is your top investment theme or idea?

Phil Bak: I like uranium miners. I think from a macro standpoint, I think a lot of people, a lot of, you know, governments and you know, the idea that nuclear power is, you know, more efficient and probably more environmentally friendly than people had given it credit. I think that idea is kind of permeating and we’re going to see more power plants, nuclear plants built and that’s going to help uranium miners. I’ll go with that one.

Julian Klymochko: Yeah, and that makes a lot of sense because you look at all the regulations coming against coal power production, natural gas, even this whole energy transition. And there was a big news story on Fusion the other day. Saying, oh, we’re going to have endless clean power without emissions, but a lot of those features are available in nuclear power from Uranium today. There’s just this obvious negative sentiment, this negative bias against it given what happened decades and decades ago. So that would be great to see. I know there’s a lot of junior Uranium minor stocks that tend to be a bit sketchy I’d say as well. But definitely a huge growth area. In any event, Phil, thanks for coming on the show. Anything else before we wrap things up?

Phil Bak: Yeah, this is great. Thank you, guys and happy holidays and new year and thanks for, having me on.

Julian Klymochko: All right, thanks for coming and hopefully it warms up there in Detroit and wish you all the best.

Phil Bak: All right.

Julian Klymochko: Take care. Bye everybody.

Thanks for tuning in to the Absolute Return Podcast. This episode was brought to you by Accelerate Financial Technologies. Accelerate, because performance matters. Find out more at www.AccelerateShares.com. The views expressed in this podcast to the personal views of the participants and do not reflect the views of Accelerate. No aspect of this podcast constitutes investment legal or tax advice. Opinions expressed in this podcast should not be viewed as a recommendation or solicitation of an offer to buy or sell any securities or investment strategies. The information and opinions in this podcast are based on current market conditions and may fluctuate and change in the future. No representation or warranty expressed or implied is made on behalf of Accelerate as to the accuracy or completeness of the information contained in this podcast. Accelerate does not accept any liability for any direct indirect or consequential loss or damage suffered by any person as a result relying on all or any part of this podcast and any liability is expressly disclaimed.



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