*We experienced some technical issues with Episode #26. We’ve resolved them going forward. Thank you for your patience with the slightly reduced audio quality in this episode.
Episode #26: “You Should Be Hedged a Lot More Than You Are”
Guest: Jeremy Schwartz. Jeremy has been the Director of Research at WisdomTree Investments, Inc. since October 2008. He was previously the Deputy Director of Research at the firm from February 2007 to October 2008. Jeremy is responsible for the WisdomTree Equity Index construction process and oversees research across the WisdomTree equity family.
Topics: If you’re ready to dive straight into the deep end, Episode 26 is for you. The guys waste no time, starting off with complicated topic of currencies. Jeremy takes issue with the currency-stance belonging to some former, unnamed Meb Faber Show guests. Specifically, he challenges the idea that currency hedging is expensive. Not true, he says. It’s only “selectively” expensive. You can actually get paid to hedge certain currencies. He gives us more details, leading to his overall takeaway: You should be hedged a lot more than you are. Meb then asks about any rules that might be applied when using a dynamic currency-hedging strategy. Jeremy gives us his thoughts, telling us when we want to be hedged versus when we don’t, as well as two good signals to use – interest rate differentials and momentum. Where are we overall today? Well, Jeremy says that there is no country so cheap that his shop would take their hedge ratio to zero. Eventually, Meb switches the topic to factor investing. Jeremy gives us his take, noting that minimum vol is where things are most expensive. The guys then discuss factor investing as it pertains to the bond space – in essence, moving away from market cap weightings. Why is that important for bond investing? Well, do you want to give the most weight to the countries issuing the most debt? Unlikely, but that’s how market cap weighting works with bonds. Next, Meb steers the conversation toward liquid alts, specifically managed futures. That’s followed by a great discussion on corporate buybacks. Gotta watch out for that dilution from new share issuance. Interestingly, it turns out that buybacks are largely a U.S. phenomenon. Jeremy agrees, but points out some spots around the globe where that might be changing. As we near the end of the show, Meb asks about the opportunities Jeremy sees going forward. His response in a nutshell? “People are underinvested overseas.” There’s plenty more, including an asset class that is coming up on being down a whopping six years in a row, as well as how Meb hacked a VPN service that enabled him to watch the last Super Bowl from a tiny village in Japan. How’d he do it? Find out in Episode 26.
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Comments or suggestions? Email us [email protected]
Links from the Episode:
- Big Mac Index
- Dividends, Buybacks and the Prospect of Future Returns – WisdomTree
- The Forgotten Dividend Payers: Mid- & Small-Cap … – WisdomTree
- Three Approaches to International Small Caps: A 10-Year Retrospective
- The Right Time for Dynamic FX Hedging | WisdomTree ETF Blog
- DB Currency Returns
Beautiful, Useful, Magical:
Jeremy: No Wait App
Transcript of Episode 26:
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 www.cambriainvestments.com.
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Meb: Good afternoon, ladies and gentlemen. This is Meb. We have a special guest today live from a hotel room in Buckhead, Atlanta, Jeremy Schwartz. Welcome to the show.
Jeremy: Meb, thanks for having me.
Meb: It’s great to have you on. Jeremy, for those who aren’t familiar, is Director of Research at WisdomTree, a $40 billion or so ETF shop with offices all around the world. And Jeremy spends a lot of his time on planes, trains and automobiles. And so we’re lucky to grab him today. He also does a radio show. The only single reason I’m… Is it XMSirius radio?
Jeremy: SiriusXM, that’s right.
Meb: I’m a subscriber. With Professor Siegel, once a week on Wharton, highly recommend. All right, Jeremy we’re not gonna pull any punches today. So we are going to straight up cannonball into the pool probably with some areas to a lot of investors that may not be as familiar. So if you’re driving or working out, turn up the volume a little bit because this is gonna get esoteric pretty quick. Let’s start with currencies. This is an area that both you and I, I think, think a lot about. So why don’t you tell me a little bit about your perspective on currencies in general and we’ll move on from there. How do y’all think about currencies when investing in a global world?
Jeremy: Well, I love you starting right with this question because this is one that I’ve done a lot of commentary on, and I think this is actually one where in the industry, the industry has done people a very big disservice in, I think, propagating a lot of myths out there. And a lot of it comes from the act of managers, and I’ve actually heard a few people on your show, two people I actually really respect a lot, who have made statements that I just think are quite misleading.
Jeremy: And the statements are…one of them is, “Currency hedging is expensive.” This is a broad conversation that a lot of people say and the truth is it’s only selectively expensive. For Brazil, it’s a very expensive thing. Their interest rates are 14% and that means that’s essentially the cost to hedge. But for something like the ECB where they have negative interest rates, so negative 40 basis points in Europe, and we have positive 40 basis points, you get basically paid 1% to hedge the euro. You get paid to hedge the yen because they’re at negative 10 and we’re at positive 40.
And it’s not just today. You’ve been paid over the last 30 years, 30 years on average, you’ve been paid almost 40 basis points a year to hedge for our currency. So it’s not really an expensive proposition. What the question people say and what people say why they’ve been un-hedged for so long, you hear a lot of catchphrases, like currency’s a “diversifier.” And I really challenge that proposition. I say if you look at the data, if you look at MCI-EFA going back 40 years to the longest time period they have, if you look at the stocks by themselves, the volatility of the stocks by themselves, is 14.4 for U.S. investors.
If you look at the stocks, plus currency on top, the volatility becomes 17. So there’s about 260 basis points higher volatility to buy EFA stocks with the currency. And so I call that uncompenstated risk, that you’re getting this higher risk profile for no expected return. Sometimes the currency will help. Sometimes it won’t help. It’s basically like going to the roulette wheel. You bet on red or black. Sometimes it pays off. Sometimes it doesn’t, but it doesn’t mean you should always go to the roulette wheel and bet on red or black.
And so I say you should be hedged a lot more than you are and for broad international mandates, I think most people aren’t hedged. You know, WisdomTree was the first firm to start doing currency hedging ETFs. Now for Europe and Japan, I’d say roughly 30% of the assets are hedged. I think a lot more should be hedged, but I think for international benchmark like in EFA universe, nobody’s even started that yet.
Meb: This is really interesting and you guys were some of the pioneers here. I mean, currencies are particularly challenging I think for Americans. And you and I both travel a lot international and part of it is, “Look, we’re the reserve currency. We don’t have to think as much in terms of currencies.” But if you go travel to Argentina or Europe or Japan, people think and talk about currencies. Almost every investor I meet talks about currencies in these first 15 minutes of the conversation whereas most Americans don’t think about it. I was reading a book on currencies, I’m blanking on the name, and the intro says, “Currencies aren’t difficult. They’re just confusing.”
And I think like you mentioned, there’s a lot of misunderstanding on currencies in general. We had actually written a book or started to write one on currencies and kinda just threw up on our hands because we said probably no one’s gonna read this at all. So it’s an interesting…so there’s… Then you’ve got equity…
Jeremy: That’s actually where I got the idea. Sorry to jump in there, but it’s actually when I was traveling to Europe in 2007, 2008 and we would talk to pension funds, and they would say, “You know what? I invest in the U.S. I would never take currency risks. Why would I ever bet on the dollar?” We were saying, “Wow, the U.S. is so backwards when it comes to this.” We’ve always basically…maybe these foreign markets are smaller in our allocations, and we maybe will be 70, 80% in the U.S. and only a small amount overseas.
Now what’s interesting is when you talk to people about their fixed income allocations, “Oh, of course.” When I go to international fixed income, “Of course, I’m gonna hedge my currency. The volatility would just swell up my fixed income volatility.” It’s standard practice, internationally on fixed income, that we’ll hedge our currency. But for equities, where they’re more volatile, people just said, “Ah, that’s not that important.” Well, in the last three to five years, though, it can be very, very important depending on what happens, and you’re not guaranteed for the dollar to always go down or say that the euro will always go up.
So if you don’t think the euro will always go up why should you be betting on the euro? And so that’s really my main proposition. And then the Europeans, they definitely do a lot of currency hedging. What’s interesting, I was in Australia talking to Vanguard there, and half of Vanguard’s assets in Australia are done on a hedge basis when they go overseas. Now that’s a country that has very high interest rates so they get paid even more to hedge when they go overseas but it’s sort of interesting that we haven’t done that in the U.S.
Meb: You know, you see a lot of interesting investor behavior around the world when you start to travel that you may not think about necessarily in the U.S. For example, I was down in Buenos Aires…I think it was Buenos Aires…Buenos Aires and was at the marina. I think it was Buenos Aires. I’m blanking on this. Anyway, one of the nicest marinas I’ve ever seen with some of the nicest boats, the largest boats I’ve ever seen in my life. And I was like, “Holy cow. I live in L.A. This puts the L.A. marina just to shame,” and the guy who was with me he goes, “Well, Meb think about it. If you live in a country with high inflation and it starts to talk about currency risk and everything else, where do you put your money? You put it into the hard goods because at least you’ll have something when the currency depreciates or inflation takes it away.”
I’m getting a little off topic. So there’s a first step and there’s areas that I’m super opinionated on, and there’s areas where I’m a little more agnostic. And so you and I have talked about this many times over sushi or whatnot where I’ll say, “Look, currencies…with equities, I’m somewhat agnostic.” However, I always say that you need to pick one side or the other. You’re either going to hedge or you don’t, but don’t go back and forth. Then I follow that up with a caveat which is…and this was part of the book that we had written and the only fund we haven’t filed from our original filing many years ago was the currency strategies fund, which is you can actually apply some very simple rules to currencies that actually can tilt your exposure, just like in stocks, to a dynamic exposure that’s actually value-added.
And you guys have been, to my knowledge, one of the first that started to roll out some of these dynamically hedged currency funds. So instead of just being non-hedged or hedged, you’re actually adjusting the currency exposure. Maybe you can talk a little bit about that idea there.
Jeremy: Awesome, no, I think that’s absolutely right. So the one thing I tell people is that the only thing they shouldn’t be doing is being un-hedged all the time. So I could fully advocate a position that is, a U.S. investor, you should be strategically hedged all the time to just get the lower volatility profile of that EFA universe. But the question is, should be you be un-hedged all the time? And that’s where I say, “You should.” So the question is, “Can you actually figure out when it’s beneficial to add a currency exposure to take it down?” Or to say that differently, “When I should hedge or take the hedge ratio down?”
There is factors, like you’re saying. There’s a lot of factor investing in equities where you look at value, you look at momentum, and value and momentum have worked in currency. You probably read the paper, “Value and Momentum Everywhere” from Cliff Asness, and he talks about it in stocks, in bonds, in commodities, and in currencies. And when we develop a dynamic hedging index family in conjunction with a currency manager from London, we developed these indexes together, and value and momentum were two of our three signals.
The one signal we added on top of value and momentum that we actually found to work better than each of value and momentum was interest rate differentials. And that’s a simple, you know, when you’re getting paid to hedge like you are today for the euro, you hedge it. But when it costs you to hedge, like the Australian dollar, you don’t hedge it. And so the factor works fairly simply, the third based on interest rates, binary on or off, fully hedged, momentum on or off. You know, it’s either fully hedged or not depending on the trend. And we’re looking at a short-term signal like late as ten days versus a long-term signal with term 40 days. And when currency’s weakening, you wanna be hedged, and when it’s strengthening, you don’t.
And then the value, a PPP discount, you know, that’s a very long-term signal. It takes… It’s not like a short-term signal and we find that to become very cheap versus your fair value, your PPP type number before you would take the hedge ratio to zero on that. And that’s one where we do have a half signal on that. So what’s interesting today for the dollar, there’s nobody so cheap that our value ratio would suggest a zero hedge. So, basically, everybody is within our bands of reasonably… Some of them are cheap. The euro’s a little cheap but it’s not so cheap that we take the hedge ratio to zero on that.
The cost to hedge is mostly in your favor. You’re mostly getting paid besides for something like the Australian dollar, the New Zealand dollar. So most of them are hedged on the interest rate signal and then momentum, it’s sort of a mixed bag. This year you’ve been hedged on the pound and that’s been very, very effective. It’s protected from the Brexit using this dynamic signal. It’s been half-hedged on euro and yen this year. So you could say you’ve somewhat got part of the benefits from the yen appreciation. But the interest rates have obviously suggested it’s being hedged there. So momentum signal helped you there, but…
Meb: Well, you know, and so the nice thing about those signals too is just the same as combining, say, value and momentum in equities is they work holistically. So the first thing of power parity, which we’re talking about with a lot of investors, a good example of this is “The Economist” looked at the Big Mac index. So how much does it cost to make a Big Mac at McDonald’s all around the world? And it’s a good way of comparing currencies. So I mean, I remember I was tweeting years ago when I went to Australia, was at a little service shack in Byron Bay and was having a hamburger and beer. And I remember I was like, “Holy cow, this is incredibly expensive,” and that’s kind of like a generic man version of the purchasing power parity.
So the value, like you mentioned, plays out over very long periods. But combining value with, say, momentum or trend, which works exceedingly well in currencies…because typically these geopolitical forces often can take many, many years to play out. And the last one that you mentioned, the interest rate differential, which most people refer to as “carry,” is one of the best ones. However, carry, traditionally, is one of the worst diversifiers to a traditional portfolio. So a lot of the carry type of indexes, if you just sorted markets by carry, it got crushed in 2008 because typically a lot of the high-yielding countries tend to be more, in today’s world, more of the risky type of currencies or risky country that would be seen as sort of a risk on type of portfolio. And the funny thing is once you combine them, you end up with much more of a holistic scenario. I remember doing a post in the early days of the blog where we looked at just carry and carry worked great.
But the same sort of thing you’re talking about is if you looked at the valuation of the carry basket, kind of what a lot of people are talking about right now, with factor investing, we said, “Carry works best when the basket is really cheap that you’re buying and expensive that you’re selling, and it works terribly vice versa,” that maybe a good time to segue into thinking about some other topics.
Okay, anything else you wanna talk about on currencies while we’re here?
Jeremy: No, I think this is a great conversation. Thanks for bringing it up. I mean, I do think that we’re trying to challenge people, think more from this uncompensated risk perspective for your strategic options, but then I think this dynamic family is in some ways the future to try to help that value over on top of that.
Meb: I love it. I really do love it. So check it out, guys, WisdomTree’s website. And so we’re thinking about factors as well. You guys have been an early pioneer certainly with factor-based funds, moving away from market-cap weighting. What would you like to touch on first there? I mean, I know you guys have written some on low vol. You’ve written on factors internationally. Is there an alleyway you wanna start down first?
Jeremy: Yeah, there’s such a broad conversation. So I think just one for people [inaudible 00:16:08], we did pass our 10-year anniversary around our first 20 strategies [inaudible 00:16:13] dividend weighted family back in 2006. Now dividend weighting, when you look back… When we first launched in ’06, everything was maybe 300 ETF and $300 billion in assets. And today, what? It’s five, six times as many ETFs with closer to $2 trillion. The original concept was market cap weighting. It’s non-rebalancing. You could say in some ways it’s a momentum strategy. We just ride prices up and down and doesn’t try to add or subtract weight based on any sense of value. That was our first concept, was rebalancing back to these relative [SP] valuations.
We have a dividend family with 10 years history dividend earnings family. A year later, or maybe nine months later, that drives it back to earning streams. We referred to U.S., although we’d done some countries like India and Korea that are lower dividend countries. And so I think we started off with this broad dividend data as you would call it. There’s a lot of active dividend strategies that try to pick subsets of the dividend universe but you could say our broad index is really the dividend benchmark by owning the broadest cross section of dividend stocks.
And then we’ve recently gone in towards quality. I think that is a factor looking at the academics. Maybe three years ago, we launched a quality family that I think is interesting. I think that’s in the U.S. where the valuations are the cheapest, is in the quality side of the market. But the minimum vol, that is actually the place where I think the valuations are the most expensive. And when you look at what… There’s some interesting lines of thought coming out in terms of what are the embedded biases of these strategies. And there’s an interesting paper called “The Embedded Interest Rate Exposure within Minimum Volatility” and it sorts these low volatility portfolios into the [inaudible 00:17:57] from Fama-French.
It does some regressions on saying, “What is your interest rate factor exposure in these?” And I think you find the lowest volatility stocks tend to have, call it a 30% allocation into bonds, let’s say. And they’re the highest volatility index out there, more like being short bonds. And I had done a piece on our blog saying the other side of low volatility was Japan in saying that, what has actually for the first six, seven months of the year, Japan had been underperforming as interest rates were going down. Low volatility utilities were outperforming, in the first six months of the year, its exact opposite side. Then interest rates bottom July 8th and everything reversed.
So utilities had been underperforming. Minimum vol has been underperforming. Japan is in a way outperforming. So you’ve gotta think about what’s your embedded factor exposures within these factors. And so interest rate bets concentrating on within minimum volatility, you could say if you’re a conservative investor loading up on minimum vol, you’re actually concentrating your risk in bonds even more than you might’ve been. If you thought you were being conservative and already had a 75% allocation to bonds, now you’re actually increasing it even more.
Meb: You guys actually talked a little bit about that in…and we’ll link to a lot of these papers in the show notes… You talked a little bit about that in, “Intended or Unintended Exposures.” I think the piece was “Utilities versus Financials: A Rising Rate Story” where you talked about utilities over the course of this year through maybe June or July and whether or not people intended to do it through certain factor exposures, etc. Are we all in this sort of global rate trade? Do you wanna talk a little bit about that piece or that line of thinking?
Jeremy: Yeah, I mean it was basically just looking at utilities through July 8th and then utilities since July 8th and then look at what other sectors had done. And July 8th gave a strong and poignant report so that’s when rates basically bottomed and started heading back up. And you definitely saw financials were outperforming as the rates were increasing and utilities are under-performing there. So I think it’s part of that same thing of whether it’s utilities or it’s low vol. I mean, I think it’s definitely tied to interest rates. And so I think when I talk about… For us, I think one of our better positions I say is actually our small cap earnings strategy.
That’s been one, lower PE ratio stocks. It’s more tied to these cyclical sectors. It did well during the 2013 rising rate environment. It did well since July 8th. So if I’m looking at a U.S. strategy that’s probably my least sensitive to interest rates is small cap earnings stocks. If I’m saying what is actually my most negatively correlated to bonds, it’s actually financials, and Japanese financials in particular, which were down 40% through July 8th and now up, say 20%, 25% since July 8th. And so that’s actually one of the sectors that has really been benefiting from rising rates.
Meb: You know, and so I think the factor space in the U.S., it’s really interesting. It’s pretty well-developed for equities talking about all the different factors. And it’s good to see people getting a large amount of interest there. One of the areas that people don’t talk as much about factor exposure, we wrote a paper on it this past year or two that you guys talk a lot about as well, is talking about a factor exposure in the bond space, and maybe talk a little bit about y’all’s approach to moving away from the market cap weighting in bonds because I think a lot of people don’t really understand how bond indexes are weighted. And then once they hear about it, it’s kind of a revelation. They say, “Oh, geez, why would I weight it that way?” Do you wanna talk a little bit about that?
Jeremy: Yeah, and even within the ETF industry I still think bonds have been really one of the holdouts. I look at the flows towards ETFs and mutual funds, I’d say the last 10 years, there’s something like a trillion dollars into equity ETFs. And almost, when you take out a certain set of investors, like certain retirement accounts and other Vanguard oriented passes, mutual funds, the active funds have sort of lost a trillion dollars within equities over a certain 10-year period I was looking at.
But in bond world, the active funds have still kept a foothold. And when people say, “Do I wanna give the most weight to the countries or the companies with the most debt that’s outstanding?” You say, “Well, if they’re gonna try to pay back their debt, do you really wanna give the weight to the countries with the most debt?” So an international bond [inaudible 00:22:30] have been mostly to Japan which has the most debt and has low yields. And so is that really the problem that you want? And that’s why people say, “Yeah, I wanna use an active manager.”
But I think there is gonna be an increasing amount of ways to try to allocate towards these types of strategies without having to use an active manager to make those decisions. And so there’s a few different strategies we’d want. One is just essentially for the aggregate, the U.S. aggregate, which is one of the biggest allocations people tend to do in indexing world. The amount of Treasuries have been growing just because the Treasury keeps issuing more debt. And so it’s role within the Barclay’s agg keeps growing. It’s up to approximately 40%, I wanna say, up from 25% maybe 20 years ago.
And so instead of that, and those Treasuries keep getting lower and lower yields. Ao the question is can you sort of reweight the aggregate in a way like we reweight equity markets to try to enhance the yield? And so we partner with Barclay’s to create this yield enhanced agg index that shifts the duration. It doesn’t try to keep the duration constrained within a year, tries to limit tracking error to 35 basis points a month, but also tried to optimize that yield and get a higher yield. So you end up getting about 60, 70 basis points higher yield in your core sort of investment created fixed income with minimum duration pickup and that strategy is done very, very well over the year it’s been live. It’s doing well versus the active funds.
It’s doing well versus the passive benchmark, so I think that’s one optimized type of way where you put constraints, guardrails on what’s your tilts that you’re gonna make, but just sorta reweighting the agg towards yield, is one nice way. And secondly we launched a fundamental fixed income family that’s actually trying to do credit analysis in a way where you’re looking at factors. So in the high-yield bond market, one of the things we found is if you can just look at the fundamentals and the earnings statements, the cash flows, and find bonds that don’t have negative free cash flows, those bonds tended to outperform the bonds with positive free cash flows.
The negative ones underperformed the bonds with positive free cash flows, and that’s sort of a simple quality factor within the high yield bond market that we do think can increase the return profile. Definitely you sort of get a lower risk profile there. Then we try to reweight those bonds back towards incomes. If you just screened out those bonds of negative free cash flow, you can obviously drop your yield a decent amount. So we try reweight back towards income once we’ve screened out those negative free cash flow bonds. And so that’s another interesting approach.
We launched a few short-term, longer-term, high-yield bonds as well sort of investment grade appliance, and more methodology appliance quality factor, but reweighting towards income. So I think there is gonna be more core strategies within fixed income that are gonna be able to do these type strategies.
Meb: And so one more area that I think is really interesting that we’re big fans of what y’all do is a little bit on the liquid alt space. And historically there’s been a lot of very meager choices in liquid alt and ETFs, I think. I think it’s inning one, honestly, and I think it’s getting better and better. A good example is I think y’all do a little more self-indexing or bringing some of the partnerships in-house.
An area that is very near and dear to us, of course, is trend falling. And y’all have… Probably my favorite sort of strategy or index there in the EFT space which is the managed futures, and that is an area that you guys have a little bit different twist on the methodology than some do. Do you wanna chat a little bit about the managed futures kinda concept involved, y’all’s take on it?
Jeremy: So it’s interesting. We did have somewhat of a strategy change this year. So we were… When we launched…and WDTI is the ETF here, we launched that ETF and we had a partnership there with Alpha Financial Technologies and we were using the DTI indicator. It had a live track record on the index side before we had launched it where it was just going long or short, a basket of commodities, currencies, and interest rates. And it had done fairly nicely it’s in live inception. We launched it, I wanna say early 2010. I’m forgetting the exact launch date.
But it had been a little bit…the category had not done well since we launched it. Our strategy did just sort of a fair I’d say or maybe disappointing. So we looked at some capabilities we were developing internally. We’d hired my teams in building out. We’ve hired some Ph.D.s on our team and started looking at the data and saying, “Can we try to add some enhancements to the methodology that might help it perform in the future?” And we looked at what are the signals?
So in a trend system, you could say you’re obviously the universe that you’re selecting from is one of the variables that you can add value in and then your signal when you’re going long or short, and how much you will add into those positions. And so we looked at where can we try to improve? And we were looking at with the all DTI which is when you had the seven-month weighted exponential, moving average on the prices to determine your long short signal. We enhanced it to look at three different time periods, the short-term three month, medium-term six month, and 12-month signal. So that’s having multiple decision points on when you’re going long or short. Then we’ve scaled down position sides is when those three signals don’t agree, you don’t take a full position in that commodity, currency or interest rate.
So that’s one way I think we’re managing volatility a little bit. But second, we found if you look at the long-term data on these commodities, currencies, and rates, when there’s very high volatility in that commodity it tends to…trend following doesn’t work as well. So one of the things we’ve done is also screened out some of the commodities that have the highest volatility from our universe, and we think that potentially can improve some of those results going forward. And so that’s essentially some of the things that we’ve done is try to enhance the screening with multiple time periods, try to scale down the position size when the signals don’t agree, and then remove from our universe some of the commodities with the highest volatility.
Meb: Yeah, y’all do some pretty interesting work in a lot of liquid alts. We’re not gonna go down that rabbit hole too much today. But listeners, check out some of the liquid alts on the WisdomTree blog and website. Let’s shift a little bit. We’re bouncing all around and listeners are familiar with that, so they don’t mind. It’s standard. Y’all put out a great piece, maybe one of my favorites, over the past year called “Dividends, Buybacks and the Prospect of Future Returns.” You and I have probably rapped more about this topic in the many years than anything else. You wanna talk a little bit about that piece? Because this is a nice, long piece. Again, we’ll post it to the show notes you did it with Trip and Josh. You wanna talk a little bit about that piece?
Jeremy: Yeah, and this is something that we’ve been trying to revive. There’s really… When people talk about buybacks, they have this reputation that the press loves to hate on buybacks. And I think it is actually one of the key ways firms are starting, have increasingly used to returning cash to shareholders. For something like the S&P 500 today, my calculations show or our calculations show about a 2% dividend yield with a 2% net buyback. And so a lot of people have said, “Well, the S&P 500 looks expensive,” because if you look at the data from Bob Shiller, the average yield used to be say 4.4%, you know the average dividend yield. Now we have a dividend yield of 2%.
We’ve had a long-term dividend growth in the market. In nominal terms, they’d call it 5%, let’s say, since 1957 when the S&P 500 was started. And so people say, “Well, 2% dividend yield, 5% dividend growth, 2 plus 5 is 7. The market’s expensive. We need to lose 3% or 4% on valuations, compressing back to their average, so we’ll only get a 3% or 4% nominal return.” And I say that 5% dividend growth is likely not to be 5%. It’s more likely to be 7% because your 2% buybacks are actually locking in future growth. If their cash flows are the exact same, you now have went from 100 shares outstanding to 98 shares outstanding, your future dividend growth is likely to be higher in the future. So one of the things we try to take strides of is trying to show net buybacks across every index we have on a daily basis.
So on our website you can see the net buyback yields, the gross buyback yields every day. And I don’t think any other index provider has that information or actually publishes that information. It’s very tough to find. Now it’s really a U.S. phenomena so if I looked across our U.S. indexes on our earnings family, you could get 3% buyback yields. And our quality dividend growth that I talked about a little bit, 3.5% net buyback yields. The broad dividends [inaudible 00:31:56] more dividends than buybacks, maybe their buyback yields are 1.5 with a 3% yield. But basically, you get 4.5% to 5.5%, 6% buyback yields depending on the strategy. Those are actually good indicators of your real after-inflation return. You don’t need any growth on top of that.
If you get a combined dividend buyback yield of 6%, that’s a pretty good indicator of your long-term real returns which is not a bad place to be today given the overall market. So I think it’s something we’re trying to provide good data on and I think it is something that’s gonna lead to better dividend growth in the market or [inaudible 00:32:32].
Meb: [Inaudible 00:32:32]. I don’t think a lot of people understand that, and certainly reporters, I often pull my hair out, when I’m reading some of these articles on buybacks because what mostly the buybacks do is they simply shift the equation. So on the dividend yield, for example, you mentioned this again, historically, four or five down to two, but because the route of cash flow distribution has changed since the ’80s, that means the equation for the earnings growth it shows up somewhere else. So instead of distributing the cash or dividends, they distribute the cash through net buybacks and by net buybacks it changes the growth of the dividends. And that simple takeaway for a lot of people is sort of an aha moment and I think a lot of people really don’t understand that well for the broad market.
Now the interesting part, of course, is that once you start to divvy up the stocks or sectors like y’all do, and the information is notoriously hard to come by. I mean you can get it for stocks, even then, on only a few places. I mean, of course, on Bloomberg. We use white charts as well for individual stocks, but for sectors and industries…or sorry…sectors and broad country indexes, it’s incredibly hard to get. And I’ve been looking through y’all’s paper, and this is dated from six months ago. But it’s really useful because like you said, there are some indexes that have a 4% net buyback yield and there’s some that are negative.
There’s some where these indexes you’re getting diluted in…like any strategy like value or carry we talked about. We often say it’s just as important not just to be buying the stocks or the investments that are cheap or that are buying back their stock, but it’s also equally as important to be avoiding the expensive ones or the ones that are diluting you. And so you guys have some on this list that are minus 2% per year and those are just as detrimental to a market cap portfolio as [inaudible 00:34:34].
Jeremy: Let’s talk about what those indexes are. So what it is it’s the small cap stock, and so this is actually really… I thought this was one of the more interesting pieces of that paper was if you look at…and so you hear a lot about the Fama-French small cap value versus small cap growth. Small cap values are one of the best performing asset classes across time and you say, “Why is that?” We started looking at the buyback data. What’s interesting is it actually does show that firms do respond to incentives. That the most expensive companies issue the most shares. They’re in growth mode.
They’re trying to take advantage of their stocks being expensive and they issue shares. The cheaper stocks actually do more buybacks or they issue less shares. And so if you looked at just the Russell 2000 universe and you sorted it by PE ratio and you look… The lowest PE stocks in the Russell 2000 may do some buybacks or certainly are issuing less shares. But the most expensive stock in the Russell 2000 will issue consistently 5% shares a year, and so that’s a hurdle. That’s how much these companies just have to grow earnings just to break even. So you say, “Why is small cap value beating small cap growth?” They don’t have this 5% share drag that the growth companies have.
Meb: And I think we did a piece on the blog. I can’t remember the name of it but we’ll link to it in the show notes, in the last year or two, where we ranked every company in, I believe it was the top 2000 market cap and combined the dividend yield on buybacks or shareholder yield. And on the left side of the chart, about 80% had a positive, I believe, shareholder yield, but 20% had essentially a negative one. So whether they had zero dividends and negative share issuance or…and this happens more often than people would expect…a company that has a positive dividend yield, but the amount of shares they’re issuing swamps that dividend yield, we call these kinda the capital destroyers. And it’s an area you just wanna run away from.
And there’s a couple interesting point you touched on that I wanna come back to. One is that it’s interesting to me that you see the U.S. is kind of in the forefront of this buyback trend and the rest of the world is still very dividend-centric. Have you seen in your travels or studies any countries in particular that are starting to embrace the buyback sort of methodology or do you see it as something that’s still, for the most part, is largely a U.S. phenomenon?
Jeremy: So I mentioned we were calculating this across 80 indexes today. So I know it across all of our indexes. The U.S., if I look at the broad U.S. dividend index that we have, you get a 3% div in yields, 1.8% net buyback yield today on our website. If I look at that for the EFA market, so the broad international developed world, here are the dividend yields are a percent higher, so you get a 4% div in yield, but only a 28 basis point buyback yield, right? So if you just looked at dividends you’d say, “Well, international market’s higher div in yields.” But when you look at the total, so that 3% plus 1.8, you actually get a slightly higher combined div and puts buyback yield for the U.S., div and pairs compared to EFA’s dividend pairs which is interesting.
Now across the other countries though, so I if I looked at Europe or if I looked at the other regions, the only country that I really see as a stand out and it’s sorta interesting and something countries become more known for is Japan is actually starting to increase its buybacks as part of they’re focusing on, from [inaudible 00:38:21] data they’re talking about trying to target a return on equity. They’re trying to get companies that have better stewardship of capital, and they actually are increasing buybacks, one of the higher buyback yields, closer to a percent on the broad Japan markets. The Japanese financials are doing the most whereas U.S. companies might have this reputation of, “My stock’s going down. I’m gonna stop my buybacks.” The Japanese financials were down 40%, and they have 2% buyback yields, so they’re actually doing more buybacks. But it’s really not a broad international trend. It’s really a U.S. phenomena.
Meb: You know we noticed the same thing, and so I was kind of baiting you on that one, and I know as much time as you spend in Japan, we’ve noticed the same thing, informed about, that Japan has increasing amounts shareholder-friendly companies, which hasn’t really been the case over the past couple decades. But certainly, the weights, if you would do shareholder yield methodology are very high, tilted toward Japan, in particular internationally.
All right, so we’re probably starting to get closer to the end of the podcast than the beginning. Did you ever take your work hat off, and say what do you see as the main opportunities over the next five to ten years or even shorter, if you wanted to, and kinda how you would either construct your own portfolio or advise, not advise but talk to individual investors, is there any kind of 10,000-foot takeaways as far as what you see as big opportunities whether it be secular or cyclical, short-term, long-term, anything in between that you see kinda going forward?
Jeremy: No, I mean I think you talk a lot about good things, in terms of your philosophies. Do you wanna go…you know you look at the active managers. I loved your blog that talked about look at the asset allocations in London, and how many people are actually invested in the active world in their own funds. And so finding people who have conviction in what they do, eat their own cooking, so I loved how you’re using your own types of models for running your own personal money. And I am the same way where I develop a lot of our equity solutions, and I eat my own cooking and have sensibly just used our ETFs, and so I definitely believe in that.
I think in terms of where the opportunities are around the world, a lot of people say the U.S. market is expensive, and I’d say, “Yes, on an absolute basis it’s not a cheap market relative to your opportunity set, though,” and when you think about…and this is an important part of the thing…you can’t just say everything is relative to bonds in a way because bonds are when you think about finances, it’s assets are the present value of their future cash flows, and to get the present value, you need a bond rate. You need the risk-free cost of capital, and so as you look at the ten-year TIPS in the U.S., your inflation protected bond yields today are zero, and so if you’re gonna hold a ten-year bond, the ten-year TIPS, that you zero will return, just protection from inflation.
And if you’re not gonna look prices on a daily basis, if you’d say active buy a broad basket of U.S. stocks, however, you wanna construct it, whether it’s just the market data, whether it’s something in a factor-based world, like either one of our firm’s does, I think you’ll do better than the ten-year TIPS bond, and that’s I think a suggestion I would make. Now if I had to say if I’m constrained to just the. U.S., I would say people should not just constrain themselves to the U.S. I think it’s a global world, valuations around the world are cheaper than the U.S.
If you look at the developed world, compared to the U.S. it’s one of the worst times for say the EFA markets in the last ten years, compared to the U.S. It’s maybe a 90th percentile worst times for EFA markets versus U.S. So I do say if you can, I would actually be positioning overseas, compared to the U.S. whether it’s developed, whether it’s emerging markets, and I’d say you know and I always start a conversation with currencies. I do say still, “I don’t want to bet on the currency.” I’d say either slowly hedge or dynamically hedge or whatnot there. But I do say people are over-invested in the U.S. I’d say people are under-invested overseas.
Meb: Well, we agree with you on a lot of those statements. In particular, we always say mean aversion, one of the most powerful forces in investing, and looking at all this stuff that’s just been getting skewered over the global financial crisis, and emerging markets, and commodities still, for the most part, having a really hard time rebounding. You and I were joking a little bit about the bombed-out markets that have been down three, four, five years in a row in both emerging and commodities been down three in a row.
Some tiny sectors have been down five. We chatted about coal, and I tweeted about this today. And then a Twitter follower had brought up the fact that we’re getting ready to, if we finish the year now where we are, uranium stocks are gonna enter six down years in a row, if we finish where we are now. So we’ll reconvene at the end of December and see if uranium still getting bounded. All right, so we always ask our guests for one piece of interesting, beautiful, useful, magical idea that somebody may not have heard of. Do you have something for us today?
Jeremy: You know I thought you might ask this question, and a lot of your followers or your questions have gone towards the apps on the phones. And so I started looking through my apps and saying, “All right, so which one of these things might other people not have used before?” One of them is interesting. We both do a lot of travel. I think one of them is, actually, my wife had this idea of an app and then we started looking around, and actually they had developed it already. Of course, you always think you have the greatest ideas, and then you look and people have it.
But you go to these restaurants, and a lot of them have long wait times and you say, “They really should just have an app that you can book ahead of time, and so you don’t have to get there, and get in line for these long waits.” And in my area there’s a lot of these restaurants are already using this app, and I’m hoping more and more restaurants join it, so that you can put yourself in line, don’t have to wait in those long waits. But the app is called Nowait, and you can get in line, and then they keep track of your place in line. You can show up after you had an hour normally and something. So I think that Nowait app is actually an interesting one that we’ve been using a lot.
Meb: There’s two other in that vein that I use. One is called, I think, Reserve and if you’re not in one of the major cities in the U.S. it’s probably not gonna be that useful, but it’s kinda like a Uber of restaurant apps where it gets you a reservation, and you actually just have a credit card on file. You don’t pay. They bring you the bill at the end, and that’s that. Then there’s another kind of hilarious one that I’ve seen, and you see this in the bullish cycles where in your seven, eight bull market, and so you started to see a little silliness where I remember this in the late ’90s, all these apps that…or at that point it was websites, but you could sign up and get $30 for doing nothing other than signing up, etc.
There’s one called Hooch which just got funded for a million and a half that for $9 a month it allows you to go to any number of bars in your city and get one free drink a day and so you basically break even if you just have one drink, and if you’re an alcoholic this is an app for you. But it’s funny to me how in the world possibly that that could make money. But not only that, they have a guest feature where you don’t even have to sign up, but you just get one free drink a month anyway. And so I’ve been using it the last few months. If we find any restaurants or bars to go to in L.A. that we’d be going to anyway been using the Hooch app which is kind of funny.
All right, so the one that I have, again, it’s also an app and for those who like going to concerts, who like going to sporting events, this is particularly interesting right now in L.A. You’ve got the Dodgers, Cubs game tonight in LCS. It’s called SeatGeek and it aggregates all the other sporting event tickets. So instead of having to go StubHub and then Craig’s List and all these other places, this one aggregates all the values, so you can very quickly find in either a section or sorted by best deal, and it’s been incredibly helpful on being able to find a ticket for a good event or venue. Anyway SeatGeek, check it out.
Jeremy, before I let you go, on your travels right now, any particular what do you got on the docket for the rest of the year? Are you gonna be back home in New York? I know both of us are gonna be at the Josh and Barry’s Evidence-Based Investing Conference. I think it’s November 15th. You got any other travel or are you gonna mostly be home for the rest of the year?
Jeremy: A lot of travel still. November is certainly…October, November an interesting one. I’m going back to Australia, New Zealand area. My first time to New Zealand, but we’ll making a trip to Australia ahead of that, and then I come back, and I’m there that next week with you in New York, and then go home to Florida where I grew up, for Thanksgiving. Then December at least quiet for now, but that always picks up.
Meb: That’ll change quickly. Well, cool, listeners if you’re in New York, come out to this conference. We’ll buy you a beer at the Happy Hour on I, Meb, or Barry and Josh, whoever. Jeremy, thank you so much for joining us today. If listeners wanna find more info, follow your research or writing, or your twittering, where’s the best place to find out what you’re up to?
Jeremy: So www.wisdomtree.com is our blog that we do writing every day there. That’s probably the best place Wisdom Tree that is where they tweet out a lot of our thoughts on that as well.
Meb: And you don’t tweet that much, but we can find you on Twitter, I think Jeremy D. Schwartz, is that right?
Jeremy: Yeah, it’s tough for work reasons to do that personally, but…
Meb: Well, I was a little worried because the last tweet I saw from you, I think were in Medellin.
Jeremy: Yes, I was flying to…that was the first debate. I was trying to watch the debate. I was flying in just as the first debate was starting, and I listened to it on SiriusXM actually.
Meb: Oh, well, that’s funny. You know something that I learned and this may be useful to listeners, as well is that I was trying to watch the Denver Bronco game from Japan, the Super Bowl last year, and I was in a small village in Japan, and was kinda panicking because I was either gonna take a bus back to Tokyo to watch it or try to figure out a way to watch it in this village. It was in this small inn, and they had TV but I found out that it was gonna be, they would have the game, but it would be completely in Japanese, and I would have loved to have heard the broadcast, and CBS wouldn’t stream it internationally and so you were blocked.
I’m in some ways very tech savvy and in other ways just a complete moron, and so one of the guys I was with was a big tech guy. He says, “Oh, no, you just need to sign up for a VPN” and yada, yada. “What’s a VPN?” But it basically allows your computer to say that it’s in somewhere, and you get to choose the somewhere else, so I said, “Hey, I’m located in San Francisco.” Sure enough, got the most beautiful, glitch-free Super Bowl on my computer. It looked like you were watching on an HDTV in a tiny village in Japan, and only for about one second in the third quarter did it even glitch once. So that’s another great idea for listeners. If you’re traveling abroad, get a VPN service that’ll let you say you’re anywhere in the world. All right, Jeremy…
Jeremy: Easier to stay connected to these things from anywhere you want.
Meb: Yeah, it’s an amazing time to be alive. All right, Jeremy thanks so much for joining us. We always welcome feedback and questions for the show at [email protected] As a reminder, you can always find show notes, other episodes at www.mebfavor.com/podcast. Remember to subscribe to this show in iTunes, Overcast, any of the other podcast players and if you’re enjoying it, hating it, whatever, please leave a review. Thanks for listening, friends, and good investing.
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