Episode #52: “This is a Market Where the Average Human Tendencies Are Precisely the Wrong Thing to Do”
Guest: Jason Hsu. Jason is chairman and CIO of Rayliant Global Advisors and vice chairman of Research Affiliates. Based in Hong Kong, Rayliant Global Advisors is an investment management firm focused on smart beta strategies tailored to the Asian markets as well as Chinese equity strategies targeted at foreign institutional investors. Research Affiliates, a research-intensive asset management firm, is the global leader in smart beta and asset allocation, delivering investment solutions globally in partnership with leading financial institutions.
Date Recorded: 5/10/17
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Summary: In Episode 52, we welcome Jason Hsu, joining us all the way from Taipei. We start with a bit of background on Jason and his company, Rayliant, which is a spinoff off Research Affiliates. Listeners might recognize the name Research Affiliates, as it was co-founded with another Meb Faber Show guest, Rob Arnott. Rob and Jason decided to spin off Rayliant to enable Jason to focus on his investing passion, China.
As the conversation naturally led to China, Meb decides to run with it. He brings up how a prior Meb Faber Show guest (Steve Sjuggerud) is incredibly bullish on China. Meb asks Jason for a “boots on the ground” perspective. Does Jason agree with Steve’s bullishness?
In short, absolutely. Jason has two hypotheses as he evaluates China: One, as China continues moving toward, and eventually becomes, the world’s largest economy, investors will realize they’re underexposed to this market. Given this, there will be major rebalancing into Chinese equities; Two, Jason tells us that approximately 80-90% of Chinese daily trade flow comes from retail investors (here in the U.S. this percentage is significantly lower). This means more market inefficiencies, so the probability for “alpha” for managers is greater. Both these factors make China a market that should be on investors’ radars.
The China discussion dovetails into investor sentiment on China, and how emotionally-driven we are, which typically ends in underperformance. This leads Meb to ask pointedly, why are people so bad at investing?
Jason gives us his thoughts, which tend to reduce to “flow chases short-term performance.” He goes on to say how oftentimes, investors get crushed as they buy in at the peak of a style or asset class cycle.
Meb asks how investors should combat this. Jason has a classic response: “Whatever you think is a good idea… do the opposite and you’re going to be more successful.” The reason this tends to work is because “This is a market where the average human tendencies are precisely the wrong thing to do.”
This prompts Meb to bring up a study idea he wants a listener to undertake for him regarding historical news headlines and investor sentiment. Listen for the details. Anyone up for the project?
The guys stay on the topic of behavioral challenges, with Meb pointing toward one of Jason’s papers about how investors prefer complexity to simplicity. It’s a fascinating look into our wiring as humans and why investing is such a challenge for us.
Next, the guys move on to smart beta and factor investing. Meb asks Jason to provide an overview, and any main takeaways for investors implementing smart beta strategies.
Jason gives us his thoughts, including revealing his personal favorite factor: value. This leads the guys into a discussion of Warren Buffett and his true alpha being his ability to stick to his style and not abandon it at precisely the wrong time, as most of us do. The guys then discuss manager performance and underperformance, and the tendency to always be chasing.
There’s far more in this episode: Meb’s “forever fund” idea (which most people he’s discussed it with actually hate)… Why hedge fund lockups and opaqueness can actually be a good thing… The unique “values” which Jason created for Rayliant, and how they’re so different than those of most other money managers… Jason’s most memorable trade… And lastly, his final takeaway for listeners looking for better market performance.
What is it? Find out in Episode 52.
Links from the Episode:
- Jason’s bio and links to many of his papers from Research Affiliates
- Rayliant Global Advisors
- Research Affiliates
- 6:45 – “The China Syndrome: Lessons from the A-Shares Bubble” – Hsu
- 10:27 – “Timing Poorly: A Guide to Generating Poor Returns While Investing in Successful Strategies” – Hsu
- 18:58 – “The Confounding Bias For Investment Complexity” – Hsu
- 22:52 – “Institutional Investors Are Delusional” – Faber
- 25:30 – Research Affiliates Smart Beta Interactive
- 40:10 – “Does Blame Predict Performance?” – Hsu
Transcript of Episode 52:
Welcome Message: Welcome to “The Meb Faber Show” where the focus is on helping you grow and preserve your wealth. Join us as we discuss the craft of investing and uncover new and profitable ideas all to help you grow wealthier and wiser. Better investing starts here.
Disclaimer: Meb Faber is the co-founder and Chief Investment Officer at Cambria Investment Management. Due to industry regulations, he will not discuss any of Cambria’s funds on this podcast. All opinions expressed by podcast participants are solely their own opinions and do not reflect the opinion of Cambria Investment Management or its affiliates. For more information, visit cambriainvestments.com.
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Meb: Ladies and gentlemen, welcome to the show. Today we have a special guest here all the way from Taipei. Jason Hsu, welcome to the show.
Jason: Thank you for having me.
Meb: For those who aren’t familiar with Jason, quick background. Founder, chairman, CIO, Rayliant Global Advisors, which is a little bit of a spin-off and new company that Jason started. But some of those may be familiar with him in a previous life as one of the co-founders and vice chairman of Research Affiliates. If you guys recall, we had one of his partners, Rob Arnott, on in an earlier podcast. Jason has also been a professor, as well as publishing like 10,000 academic papers and being on a bunch of boards, and all that editors and good stuff for a bunch of academic papers. But one of my favorite things about Jason is he’s got one foot in the practitioner world, as well as one foot in the academic world.
So, Jason, let’s start with a super quick background. Maybe just give our listeners a quick overview, a kind of how you got to starting Rayliant. You know, it looks like you’ve gone to almost every university in the State of California for one degree or another, but why don’t we start there?
Jason: Absolutely. Meb you explained to everyone already that Rayliant Global Advisor is a spin-off from a firm that others are perhaps more familiar with, which is Research Affiliates, a firm that Rob Arnott and I started…wow, now it’s almost 16 years ago. The start of last year, Rob and I spoke and we decided to spin off Rayliant Global Advisors, which was previously Research Affiliates Asia, as its own independent separate entity that allows me to have a vehicle to really double down on a big [inaudible 00:03:06] passion of mine, which is the emergence of China and the necessity for investors to have exposure to that economy as a portion of their overall portfolio. So I’m hoping with Rayliant Global Advisors to be the very best provider of Asian equities to investors, you know, global institutional investors to retail investors, all the same.
Meb: You know, so I was actually gonna talk about China a little bit later, but let’s talk about it now, now that we’re on the topic of Asia, both developed and emerging as well. One of our other recent guests was super excited about the opportunities he sees in China and the given years, part of it being just sort of current macro backdrop based on lower valuations as well as…one of his biggest thesis, and I wanted to ask you about it, is there’s a lot of interest in Chinese stocks and particularly as they’re getting added to the global indices, and he saw this as kind of a sea change. The marketplace really hasn’t appreciated or factored in at this point. Is that something you agree with, disagree with? And what’s your general just kind of overview of, you know, kind of boots on the ground? What’s your what’s your perspective on [inaudible 00:04:24] area?
Jason: I wholeheartedly agree with that thesis. In fact, it really is sort of a two-hypothesis, and I think they’re no longer hypothesis, these are beliefs that I have. One is, as China begins to make its ascent to become the world’s largest economy by GDP and as i’s equity market and fixed income market get close to the size of the U.S., investors are gonna discover they’re underexposed. In fact, I guess you could say to under-diversify in the sense that they don’t have enough China exposure within their portfolio, be it on the duration side, be it on the on the equity side. And there’s gonna be a meaningful rebalance coming out of that realization. Now we’re already hearing a lot of talk about MSCI including China into its EM index, and I’m sure later on into the whole world index. Of course, FTSE has already done so two years back in a custom index for Vanguard. So there’s already awareness from the very biggest players about increasing exposure to China. So that’s one part, and that’s really what I would say the beta story, right? It is a diversifying beta, it is a meaningful beta if you wanna participate in global growth.
The other part is, of course, the alpha component. You know, the interesting thing about China is anywhere from 80% to 90% of the daily trade flow comes from retail investors. And this is literally people who have very little financial education, who exhibit all of the behavioral anomalies that, Meb, you documented in books and articles you’ve written. And so we’re talking about 85% on average of all trades are conducted by those individuals. And that means the probability for alpha for managers is just so much larger in that market versus, say, in the U.S. where 85% of all trades are done by, you know, hedge funds, robots, high-frequency guys, and the pros. So, anyone who’s seeking to find alpha, I think that’s got to be a market you spend some time fishing.
Meb: And we’ll link to all your papers on the show notes, but one paper that I wasn’t even gonna talk about today but now that we’re on the topic, I remember you were writing about kind of the mid-2000s bubble, and I think it was mid-2000s bubble in China and comparing it to some other bubbles and valuations. And it’s so funny to look at from someone like myself who is a quant and kind of distanced from this, but now that China in many ways is at much, much, much lower valuations, almost nobody is interested anymore. Is that the similar perspective, you know, from that side of the globe or have you…maybe talk a little bit about that paper and kind of educate the listeners what I’m talking about.
Jason: Sure, absolutely. You know, a spectacular run-up and collapse in the China stock market occurred around, I would say, the latter half of 2015, that’s the run-up phase, and then that bursted fairly quickly in the first half of 2016. And we’re talking about a run-up now 180%, followed by a collapse that was…you know, that destroyed about 65% of market value. So fairly large bubble that occurred over a very short period of time. And I think what most people remember from it was all of the interesting short-term policy interventions that were put into place, that cost a lot of people to, you know, lose some confidence in that market or in the regulators for that market.
So that’s kind of the backdrop of the entire event. But I think, Meb, the point that you made was, during the run-up, everyone was big on China. They thought of the run-up and the stock market as a validation from investors of the ascension of China into a major global player. There’s a lot of excitement about China reaching out to the rest of Southeast Asia in terms of what they call the “One Belt One Road” economic policy. And of course, just assume that the bubble collapsed, everyone stopped talking about that and the sentiment became very, very negative. And they saw about the incompetence of the policymaker and the fact that, you know, China is never really gonna become a true global player.
And all the same time, if you look at the underlying shift in fundamental, there’s, you know, some volatility but nothing out of normal. And it just goes to show the amount of retail sentiment that could turn on dime that’s driving the market volatility. And it’s not just true inside China. I think there’re a lot of global flows that were just as fragile in terms of its positive and negative sentiment for us. And I think this, again, remind us of, you know, the kind of behavioral swings that can occur at inequality [SP] with really the underlying fundamental volatility that we see in so many different markets. Well, we saw that during the tech bubble, we saw it again during the real estate and credit bubble in the U.S. I think this is just yet another reminder about the volatility in the investment psychology exhibited by retail predominantly, but also sometimes institutional investors.
Meb: Yeah, I mean, I think as institutions and professional investors we often, you know, can look down on the retail and say, “You guys are so crazy,” but you’ve actually written quite a bit of research and this is probably a good segue in general to talking about humans just being humans and doing really dumb things over and over. And in investing we have a paper in front of me called “Timing Poorly: A Guide to Generating Poor Returns While Investing in Successful Strategies,” and you have a bunch of papers and thoughts on kind of this whole concept of why are some people so bad at implementing simple ideas that they’re already on board with, and in many cases they’re simple concepts, why are people so bad at investing?
Jason: Yeah, as a graduate student, the one thing that we all had to buy into was that, you know, the market is pretty efficient. And why is the market pretty efficient? Well, because, you know, this is serious business, lots of money at play. Big institutions, big money. But when we look more and more at the data, what we discover is, this just ain’t so. For example, one of the, you know, greatest questions that I think whenever I run into bill shock that he asks are about, you know, smart beta and about… A fact of investing is, well, if these strategies are so reliable and make so much sense, why doesn’t everyone do it? And if everyone is doing it, how can it keep working? Right? Essentially he’s asking, “Who is the dumb dumb on the other side of your trade?” And that just take value strategy…and I’m a big believer, I think, Meb, you’re a big believer that a sensible buy low, sell high discipline value strategy could create excess return for investors in the long run.
Seems fairly straightforward, a lot of you will buy into it. We certainly hear Warren Buffett promoting the virtue of value investing constantly when he speaks, so why doesn’t everyone do it? And maybe everyone is doing it, and if that’s the case, how can we believe that there’s still any excess return left from that strategy? So I decided to explore that in the paper that you mentioned, to look at, “Hey, let’s study these very successful strategies that’s been documented in academic literature and see just how much alpha can we squeeze out of that lemon, and whether there is any more juice left over. And the big surprise that I saw was, when you look at how investors who invest in value strategies, and I generally want to, you know, argue that the value investors are probably the more financially savvy, they’re the ones who, you know, perhaps gonna be school and remember that the value factor outperforms, and you then try to be disciplined in buying value products.
But the way when we say buy value looks like the following. That is, they bought into value and then during the late ’90s, as they saw the growth outperforms against value, they quickly lose confidence, and by the end of 1999 they have completely given up, believe that what they learned from the textbook was wrong, switched over to being large cap growth investor, only to be hit by the class of tech bubble. They got back into the market and in a big way again in, say, 2004 and ’05 after a major value rally and where all the value funds are rated, Morningstar, five-stars, with their wonderful past three, five years track record. Again, massive close into value funds, only again to run head straight into the global financial crisis where all these bank shares are generally value stocks, lost a lot of money, and then you saw a lot of outflow in, say, beginning of 2009, only again to miss the massive value rebound in the following year and a half.
This is actually what we see in data, that is slow chase, short-term performance, and as a result of that no one is really a buy and hold investor as we sort of measure what investors are doing. They’re timing funds, they’re timing managers. Unfortunately, the way they time is quite counterproductive. That is, they get into a fund that’s done well recently and demand that has done well recently, and simply get hit and smack on the head as a buy-in at the peak of a style cycle over an asset class cycle. And that’s what I see, that we see exactly that for value investors. And so when you tabulate, the excess dollar alpha they should have earned, it’s actually quite negative.
Meb: You know, it’s funny. There’s a lot of people you’ve mentioned in your articles, Ruskin [SP] is a great one, and a number of others that talk about this gap and behaving poorly. And I can remember in one of your papers I read, some of your advice was simply, “Hey, forget your password to your investment account and just let it sit dormant,” which is ironically probably a great advice, but how do people combat this? Like, it’s so hard not to want to, you know, trade or update. But look, what’s your best advice? Like, what do you tell your grad students? What do you tell people that, you know, these huge institutions you’re talking to in Asia and everywhere else you say, “Look, here’s a sound investment plan,” you know, what’s your advice there?
Jason: My best advice to most of my students is whatever you think is a good idea, whatever you observe yourself doing or your classmates doing, just stop. Stop doing that, do the opposite, and you’re going to be more successful. The fact of the matter is, if you look at data, the average investor is not very successful, right? I think, all the data points to, if you’re an average individual trader, you’re a six and a half percent behind a passive index. If you buy at the funds and, you know, pick and choose, you’re two and a half percent behind just buying an equal-weighted blend of passive ones. So there are all these data that says, “Whatever it is that you think you’re doing that’s adding value is actually just de-tracking value, so just do the opposite.”
And so this just goes to show that this is a market where the average human tendencies are precisely the wrong thing to do and you have to recognize that, recognize that you, I, most of us are probably average, and we got to recognize, acknowledge that, and then, first of all, stop ourself, because if we don’t stop ourself, we’ll just get the average outcome because we’re not that special. And as best as possible, perhaps try to do the opposite. And I think the opposite often is, don’t check your stock codes every 30 seconds. Don’t trade when you feel like you want to trade because most likely you’re gambling rather than acting on good information. Whatever information you think might be private, proprietary, and valuable, it’s probably common knowledge and perhaps even stale. So if you can just argue the opposite of what you believe, you’re going to do much better.
Meb: Well, you know, it’s funny. One of these days, a study I’ve always wanted to run and maybe we’ll get a bunch of your UCLA grad students to do this…by the way I was just down at the UCLA Fink Conference this past week, but one of the ideas was to…I said, “I’m pretty sure how this works out but I would love to do the study, I’ll fund it.” So if there’s any professors listening, too, you guys reach out, let me know. I would love to go get all the copies of “The Wall Street Journal” or, you know, “Barron’s” going back to 1900. Pick out probably the 50 or 100 biggest global, you know, headline events and say, “Look, we’re gonna give this to the investor, you know, this date, this is Pearl Harbor got bombed, boomed, what do you predict the future one week, one month, one year stock returns are?”
And, you know, my guess, and I think you’d probably agree with me, would be that even if given tomorrow’s headlines today it wouldn’t make any difference to investor and outcomes. And so what people spend so much time thinking about, of course, is, you know, watching CBCs, the headlines, and what’s going on with Russia and FBI. You know, all this stuff. I’m of the opinion it doesn’t matter much. So if anyone wants to run that study, reach out, let me know, and I’d love to do it. But I don’t wanna personally sit in the bottom of the “LA Times” fishing out papers for a long weekend. You know, part of the thing behind this is probably along the lines…one of the reasons why…and, you know, our industry is guilty of it as well is, you talk about it in one of your papers and in pieces called “The Confounding Bias for Investment Complexity.” And so maybe talk a little bit about that as your thoughts are.
Jason: This article is really inspired by Daniel Kahneman’s bestselling book, and it’s a fantastic book that I suggest everyone go take a look. This is “Think Fast, Think Slow.” And so basically, what it says is that the human brain is very, very good at rationalizing. We make decisions that are actually fairly instinctual, mostly driven by emotions. And then, the rational part of our brain simply gives a good excuse to make us think, “We’re just making a really good, sound decision based on data,” when in fact it’s all purely driven by emotions. At least, you know, by and large, most of our decisions are that way.
And so as it turns out, when you look at financial products, you know, our industry is known for selling a lot of complexity because, hey, if you want someone to pay you, the strategy is really simple, so simple that the investor himself could replicate it if he had access to Yahoo! Finance and Excel spreadsheet, it’s unlikely you’re gonna get paid. So totally understand that the industry profit maximization strategy is to, you know, sell things that are complex that people would be afraid of trying it at home. Now the problem with that is that the complexity caused the investor to develop following belief, which is they are investing in an expert who’s doing something that’s very complex, that the investor himself doesn’t understand, and therefore he has to trust, and then he’ll reward that trust when he sees good performance.
Now the problem, of course, we know is in the short run, performance completely random. What that means is there’s about a 50:50 chance that come next 2 years, the investor will be disappointed, and instead of saying, “That’s just random noise,” or, “I made that decision,” they’ll say, “I trusted you to do this right, and now I am going to stop trusting you. And in fact, I’m gonna fix this problem and I’m gonna punish you for violating my trust.” And that almost is the script for our business, for how products are sold, and how investors and managers interact, is there is a cycle of, “Oh, I’m going to trust you to do something I don’t understand, and then I’m gonna get disappointed, I’m gonna fire you and feel vindicated that I have punished you for violating my trust.”
And then a result of this cycle is that people buy things they don’t understand, managers promise perhaps short-term performance that’s not possible, and people get disappointed, funds are fired, and no one can really actually be a long-term investor and see a strategy or see a manager through a proper market cycle. So this complex actually creates this really bad dynamics in our industry where the investor’s return on a dollar-weighted perspective is far worse than the manager’s printed results if you were only able to buy and hold that manager for a full market cycle. So that’s the issue with complexity in our market, is what helps with fees helps with selling, in the long run it’s actually been bad for everyone.
You know, simplicity, on the other hand, and, you know, we can really kind of point to the Vanguard and iShares type index investors, they tend to exhibit a lot less of that because what they’re buying is something that’s fairly transparent, it is not at all complex. So, the psychology then goes, “Hey, I don’t trust the manager, I trust myself, so I’m going to buy something on that decision.” And people are far more forgiving with that because what happens is, when the market goes down they say, “Hey, I think the market is gonna come back up. Being a solid long-term investor in the U.S. market is a good idea, so I’m gonna ignore short-term fluctuation.” And the result of that is, you see index investors tend to be able to buy and hold, and at least, and participate in the long run in the equity premiums.
Meb: There was a study that we talk a lot about where, you know, the name of the blog post we did was…it was called something along the lines of institutional investors are delusional, where it was a survey, and in the survey they asked these institutional investors, “How long would you give an active or smart beta manager underperforming before you would seek his replacement?” And 89% and 99% said two years. And so, you and I both know, and so also listeners, like, we laugh because one of the best probably time frames for mean reversion is that sort of two to five-year period, meaning you want the worst performers over the last two, three, four years. And so exactly what they’re doing is the opposite of what you should be doing. So simple advice of rebalancing, you know, Research Affiliates has talked about the concept of over-rebalancing, meaning, you know, you’re gonna tilt even more to what’s done very poorly over the last few years are very sensible things.
One of the things I’d like to…an example you used in this paper is you talked about fishing lures. And, you know, fishing for tuna where, you know, in many cases these very simple lures do just as good of a job, and I wanted to make a comment because I was reading that…and I’m gonna murder his name, Yvon Chouinard, the founder of Patagonia, older guy but one of the really pioneers in climbing and a true outdoorsman. He just published an article and he was talking about it where he’s been fly fishing all over the world for his whole life and said he went…I think it was over a year experiment where he just used one fly, and it was in different conditions. So it was in the ocean, it was in rivers, it was in lakes. And the only thing he changed was the size, and he says, “I have had just as much success with this…I think as a pheasant tail partridge, as I’ve had with these, you know, every local angler, and these tens of thousands of flyers I’ve used.” I thought that was a really interesting example, just about the complexity and simplicity as well.
I probably couldn’t possibly do a podcast without at least touching on smart beta and factor investing. It’s something that you and your team have been pioneers on and have talked about over the years, and you have some pretty interesting opinions on it, too. Research Affiliates had published some pretty cool, new interactive software that talks about expected returns and valuations of factors, and you’ve written particularly on, I think, I guess, how you give your speech on this, on trading costs and implementing smart beta factors. We don’t have a whole lot of time, but why don’t you give us an overview on kind of the main takeaways that you think are important for an investor that is considering or already implement smart beta sort of strategies?
Jason: Absolutely. I think the emerging consensus around smart beta is the technology behind it, you know, the finance theory behind it is things that we know for 30, 40 years goes back to the 1970s. For many of these factors, they’re now being baited to smart beta product. So the technology, the theory, they’re all tried and true. What’s different is now putting it into an index or index-like chassis so that low-cost product would be produced. So it’s really an innovation in terms of lower cost, greater transparency in the product. And so, you know, the way you wanna think about this is figure out what are the factors or the anomalies, because most of these factors, really, when you think about them, the lurcher understands them to be sort of behavioral anomalies, just systematic ways of capturing mistakes that the average investor make.
So think of capturing these anomalies that are academically robust, been vetted by, you know, different generations of scholars, and there’s the underlying economic motivation as to why they’ll continue to work because oftentimes, these behavioral bias are so ingrained, you know, it’s part of how we evolve as a species, that it’s unlikely to change over, you know, any intermediate horizon. So you’ve got to make sure that that theory and empirical data support is there. And then, you know, it’s not too complicated from that point on. Invest in a diversified handful of, you know, factors, or call them anomalies if that’s the language you prefer, and invest in them in as low cost of fashion as possible. So that’s likely going to be ETF type vehicles that access these behavioral anomalies.
And then, forget your password or, you know, tie your hand anytime you think about picking up your mobile app and trade. Just don’t that. Be a buy and old investor over a proper market cycle or two, and you’re likely to see better outperformance than doing something much more expensive, much more active. And so that, I think, is how I would summarize smart beta from kind of a theory and product perspective, and also in terms of my advice in how investors ought to go forth and execute on this.
Meb: Do you have a favorite of the thousands of factors you’ve looked at? What’s kind of Jason…what does your psyche sort of gravitate to? Are you momentum guy, are you a quality guy, are you value? What’s your personal belief there?
Jason: So, I’m pretty traditional. So I’m boring in this case. So I really like value, and that’s been around for a very long time. That just goes all the way back to grandma and dad. And that starts from, you know, the ’20s. But it’s really tried and true. And I’ve done a lot of research that convinced me that, yes, whatever is driving the value anomaly, driving the value premium, the mistakes that the people make creates a value premium, that continues to be made by individual investors, by institutional investors, the like. So I’m a big believer in that. And really, the story is an easy one to tell. You know, for whatever reason, people prefer to pay for growth. Growth is more exciting, growth is sexier, growth, in the short run, you know, can be successful. And that momentum is going to, you know, lure us into chasing it. So, when these behaviors are persistent, and if you can be patient, being on the other side is gonna give you success.
Meb: You know, it’s interesting. The example we often give is Warren Buffett. And we say, “Look, you know, Warren Buffett, what he’s been doing is pretty basic, It’s not that complicated. Value, quality, a little bit of leverage, etc.” But the biggest challenge, we say his alpha, historically, has not been his investment strategy, but it’s been rather him sticking with it and not deciding after one, two, five, eight years of underperformance that, “Oh, hey, I’m gonna become a growth guy now,” or, “I’m gonna go chase, you know, some other market.” And he currently…like we tracked this through 13Fs and say if he just replicated his stock picks, which by the way, an investor could do in like 20 minutes a year, so once a quarter, buy his top 10 stock picks, update it once a quarter, you’re done.
Historically, since 2000, that’s outperformed like five percentage points per year. But he’s underperformed, it’s something like eight…sorry, that portfolio has underperformed like 8 of the last 10 years versus the S&P. And so, we often say…we joke and say, “Look, if you blinded these results and showed these two Cowper’s,” not to disparage Cowper’s, but just an institution and said, “Hey look at this manager over the last 10 years, and he’s underperformed 8 of the last 10,” you know, no person on the planet would wanna allocate to that strategy despite the fact he would have beaten 98% of all mutual funds over the period. And that goes to your point of how these factors go in and out of favor, but not just factors too, you know, it’s countries and sectors. We talked about China, but other markets as well, and that’s the hardest part.
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Meb: We think a lot about the behavioral ways to try to keep people from being, you know, their own worst enemy, and one of the ideas we had floated this week was the concept of a really long-term lock up. And I said, “Look, what about the idea…” I said this is Cinco de Mayo, so I had a little tequila, I said, “What about the idea of launching a fund and saying, “You know what? This will be ultra low cost, but you got to choose between a 10 to 50-year lockup.” And I said that would be a great way to get people to really put, you know, their money where their mouth is, and people, in general, hated the idea. And they hated it because they said, “Well, what if I need to change my strategy?” or, you know, “What if what if the world changes?” So, anyway.
Jason: Well, Meb, actually you’ve brought up a really interesting point. So I met a private equity guy, a very successful one. Someone challenged him and said, “Hey, have you look at all these, you know, five-equity replication strategy that claims that a private equity is no more than a, you know, small cab exposure levered.” And the private equity guy says, “Well, you know, that’s probably true, but the one thing that I can provide my investors that a levered small-cap strategy can’t is that I can lock up my investor for 10 years so he can ignore or, in fact, he won’t see the volatility of that levered portfolio, so he’s able to write it and fully capture the premium associated with the strategy. Whereas if the investor had to replicate that himself and levered up a small-cap portfolio, you know, he would have bailed, sort of, you now, first sign of shock spike up in volatility and never would have been able to ride his strategy to sort of logical end and capture the necessary premium.” And I thought that was actually a really, really interesting way to think about the value of lock up in the presence of investor behavior.
Meb: You know, it’s actually really profound. And I hadn’t thought of that same topic until I heard a couple other podcasts. You know, it’s either Patrick O’Shaughnessy’s or Tim Ferriss’ maybe, but talking about a concept and saying, “Look, I think as Tim said, I’m a terrible public markets investor because I’ll muck around to do everything that all the biases, you know, say you’ll do. But the private equity, because I can’t sell, I just kind of forget about it, put away in a mental lock box, and one day, it either goes bankrupt or public, I’ll have an exit.” But the two ideas we floated I said, “Jeff,” he’s my co-host, Jeff, I said, “Jeff, we could either do a locked up fund where we charge a penalty that declines over time. So if you pull out in year one it’s 10% penalty but it declines over time.” Or, I said, “You could charge a 10% sales load upfront, put it in a sidecar, and at year 10 that money goes back to the investors. But anyone who had left, you know, their load goes in.” So the people that stayed not only get their own money back, they get the bonus.
Anyway, this may be a good grad project for us to, you know, give all the UCLA students to come up with a good structure here. We love brainstorming these ideas because we see it so much every day being both the individual account managers, as well as ETF manager, you know, the flows into our funds and strategies, it’s almost always the worst timing and the worst…and I’m sure you’ve seen that as well. By the way, along those same lines, so there’s been a lot of, you know, development in the U.S. with these robo-advisors and automated investing solutions. Well, I think they’re interesting. I think it’s gonna be challenging for a lot of them not having…you know, one of the biggest benefits of financial advisor is, you know, that wall in between, you know, you touching your own account and selling. And I think the automated, while designed fantastically, may run into that in a bear market. We’ll see, we haven’t had one in forever here in the U.S. Is there a culture of these automated solutions developing that you’ve seen in Asia at all, or is that something that it is probably a big opportunity that’s not really being tackled?
Jason: You know, anything that’s a success in the U.S. you’ll instantly find a lot of lookalike solutions in Asia and so on. It’s no different for robo-advisory. So a lot of robo-advisory type of technology, apps, and firms are starting to flood the market in Asia. It is really interesting to see because I think in the U.S. a lot of the robos are about user experience, it’s trying to take the complexity out of investing, and also, it’s trying to take a lot of the conflict of interest between advisors and clients out of the system by, you know, giving you a fairly templated standard advice, very, you know, transparent format. And a lot of this is no more than a diversified portfolio that rebalance regularly.
And so I really see that as a disruption to the financial advisory ecosystem, where you’re seeing clients being disappointed with the quality of the advice and with the conflict of interest that’s almost embedded in this advice provision. In China, we’re seeing some of the same thing, but there it’s sold much more as artificial intelligence, like super smart computers that will aggressively asset allocate for you, time for you, pick funds for you. Yes, it’s…you know, whether that’s ultimately successful, whether they’ll ultimately deliver goods remains to be seen. But, yes, you see robo-advisory in Asia but it’s operating under very different ethos. It’s about artificial intelligence, more so than trying to mend the issue of loss of trust between advisors and their clients.
Meb: It’s touching on two of your favorite topics. One, it’s kind of selling the dream and selling the complexity, too.
Meb: The old Chinese proverb, “Fish see the bait but not the hook.” All right, I’m gonna…we’re gonna touch on like a couple more questions. We only have you for about 10 to 15 more minutes and we’ll try to ask 1 or 2 of the Twitter questions that people sent in. One is the interesting area that’s not really related, it’s related because you’ve done some research there, but I thought it was really interesting, you know, a lot of firms, when you look at their websites, they’ll say stuff like, you know, “Here’s our qualifications. We manage this many billions of dollars. I’m a CFP and we’ve been in business 20 years.” And it’s kind of really about them, but I thought your values was a really interesting commentary. And I’ll read a couple of them and then maybe you can talk a little bit about a paper, the research you’ve done there about kind of the culture of blame. But a couple of the values you said, “We’re deeply opposed to manager ego and all it represents.” You know, and nicely on the flip side, you said, “We’re serious about our strategy and clients but we don’t take ourselves too seriously. We strive for authenticity and humility when we’re communicating ideas and building relationships.”
There’s a couple of others. “We’re motivated by purpose rather than money.” So maybe talk a little bit about that, but with a nod to kind of your research and thoughts into manager selection criteria. And there’s a quote, at one point you said, “Should be examined from a higher level of consciousness and responsibility.” What do you mean by that?
Jason: You know, as I’ve been talking to more institutional clients who are now doing more ESG and particularly paying attention to the governance part, they really care about the governance of the underlying company we invest in. But, many of them don’t seem to care very much about the governance of the managers that they invest in, that is why we want our, you know, our IBM and our Philip Morris to be more socially responsible, we don’t seem to ask of the same of our managers. And this is where I think, you know, investors have started to turn a little more sour these days about, you know, the big hedge fund managers sort of swagger and ego and the way it gets expressed in conspicuous consumption, so on and so forth.
Again, I don’t wanna be judgmental about that, but I think there’s something to be said about how that attitude of, you know, I deserve my 2 plus 20. You know, I deserve the incredibly large compensation package that I paid myself, despite the fact that over the long horizon I may not outperform the benchmark. Recall the famous bet between Warren Buffet and the Protege partners about that one. I think that’s an area where investors really could spend a little more time thinking about.
Are they okay with the values being expressed by the managers and their fee schedule, and by the managers and the way at which, you know, they seem to feel perfectly justified for the very asymmetric outcome where, you know, regardless of what happens manager win and over a long horizon and the fees, clients have actually been not well served by our industry and would have been much better had we all told them to go buy a Vanguard index fund or, Meb, one of your ETFs? I think this just does warn our industry and all of us practitioners to think about what value have we actually created, and can we really honestly say that we have created value.
Meb: I was listening to an interesting podcast with…and I’m gonna totally blank down his name, he’s the guy that wrote “Influence” and the new book “Pre-suasion.” He was talking about the brilliance in the Warren Buffett letters and he says, “Every Warren Buffett letter you’ll look at, you’ll notice he leads with one of his mistakes.” And he says that has a way of disarming people but also it’s honest and it’s genuine. And he’s saying, “Look, we’re not perfect. We’re not just gonna brag about what we do so well, but we’re gonna say, ‘Look here’s something we tripped up at and failed.'” And he said in some years when Buffett’s made no mistakes, he’ll go back and say, “Well, in 1993, I remember this mistake we made.” And it’s a great way, but it is a good example of the way that a manager thinks and culture.
And one of the biggest lessons that almost every investor learns at some point in their career, you know, is humility. And I think like nothing I see more and more than if you don’t have humility, you’re just kind of asking to get taken to the woodshed at some point. But thankfully, it happened to me a lot when I was poor and broke and didn’t have as much money to lose when going bankrupt. Let’s do a couple of quick hits before you have to go hop on a plane. Where are you heading, to by the way?
Jason: Heading to Hong Kong.
Meb: Cool. I’ve only been once, but absolutely loved it. I need to head back to Asia sooner than later. But I’m gonna ask you my couple of Twitter questions, some we’ve already covered on factors, and I’m not gonna ask you what your best long, short ideas because I know you tend to be a little more, like me, quanty. You can answer that if you want, but someone asked for your best long, short ideas. One of the questions was, have you noticed any difference, or is there any main takeaways for…or emerging markets any different at all than developed in the U.S. as far as factor investing, or is it things that…it just happens to be more inefficient? So the question is, what’s the main differences with factors for developed and emerging?
Jason: So it’s actually correct to assume, to say that the emerging markets are more inefficient. And so, you know, by deduction, the anomalies and the premium associated with these anomalies are just larger. But what is also true is that the bubble, as they form, or the deviation away from, you know, fair pricing that mean reverts later, they can extend for much longer period of time. So I do wanna remind every one of the famous Cain saying, that as the market can stay irrational longer then you have capital or conviction to stay in the market. So, that’s advice to everyone who is looking to, you know, invest in factors or quant strategies that you have to be even more patient and be able to withstand some meaningful draw-down before you see the really, really breathtaking recovery.
Meb: And is factor investing in general…one of the questions, is it embraced as much as it is in the U.S. in Asia or is it a little bit of a harder sell or education hill or what’s out there?
Jason: The educational work is definitely monumentous in Asia because it is still very much a nascent, immature market. The sophistication isn’t quite there, so the more quantitative and academical language isn’t as natural when you speak to clients and investors. So there’s a lot of education that’s required, I think, before people could fully embrace and execute on factor investing or smart beta. But I would say the intuition about that markets make mistakes, investors make mistake, and the type of mistakes they make, if you can put it in that language, I think, you know, perhaps in many ways the EM markets are more receptive and are natural believers of fact that there are a lot of investors who make a lot of mistakes.
Meb: Each year we have one theme question, 2016 was a little different. 2017, it is, what has been your most memorable investment? And it can be a good one, it can be a bad one, and it can be a trade, whatever, but the first thing that comes to mind when I ask that question and one you’re willing to share.
Jason: Absolutely. Investing in emerging markets the last five years. Now, that’s been a big overweight in my personal portfolio and it’s been a big overweight in many of the clients who bought into my strategy of Research Affiliates. You know, Rob and I created RAFI, and then RAFI has big overweight in EM, because EM became very cheap in the start of the last five years, and then that continued to underperform for much of the last five years. But very memorable because it was very painful for much of the last five years. And, you know, every conversation we had with clients was, “Well, you know, yes, there’s been some shock to the region, yes, performance has been bad, but look at how much cheaper it has gotten relative to rest of market, relative to the U.S.”
And that was a harder to harder conversation to have with clients. And the recent recovery, in some ways, felt like a vindication. But I think the big takeaway is, any time you choose to be a long-term investor, and I really do believe that’s where the advantage is, you know, it’s very, very hard for you as an investor to ride that out, and it’s even harder if you’re acting as a fiduciary, acting as an advisor, because your clients are naturally gonna doubt whether you got it wrong this time. They’re naturally going to be more prone to blame you and lose patience with you. And so it’s a hard, hard job to do right by your client, to get them to stay on, stay invested. And that’s just a lesson I keep relearning over and over again, how hard it is and how important it is to still make sure we do that and do that well.
Meb: And particularly, for investors, we used to do a chart and a speech when we’re talking about global valuations. And the left side of the chart would be the cheapest cape ratio countries and the right would be the most expensive. And we used to label the left side of the chart career risk. And I said, well, you know, it is the smartest thing for you to tilt wards value and away from the expense inside. But if you go buy Brazil, Russia, Europe, everything else in between, and you get it wrong, so 2014 or, say, you know, some of those years prior, you get fired. And you do well, maybe your clients notice, maybe they bring you a bottle of wine. But for the most part, they’ll forget pretty quick.
Then this has been the hardest environment to be an international investor, because what’s happened the U.S. has gone straight up for eight years, and one of the largest outperformances we’ve ever seen versus, you know, the foreign markets in general. But since maybe last summer, that seems to be changing or changing for the positive, but we’ll see. We’ll have you back on in a year, five years, and see what the world looks like then. All right, last question before you go hop on your plane. When you used to talk to UCLA students, you’re talking to, you know, the listeners on this podcast to, you know, the kind of number one piece of actionable investment advice. And maybe a little repetitive, because you’ve covered a lot of good stuff already, is there kind of one final takeaway, advice to investors across the board that really pops the forefront of your mind?
Jason: This is probably the simplest advice, and it’s really easy to get but it’s also really hard for people to remember, and that is what I call the first fundamental law of investing, which is outperformance, call it alpha if you may, is a zero sum game. Meaning, if you are going to win in a game of investing, if you’re gonna outperform, someone has underperformed. And that means you have to be trading against people who are less informed, less educated, less skilled than you are. What confidence do any of us have that the trade we place and that we make satisfy the condition, that is the guy on the other side is really dumber and less educated. And until you can convince yourself that, you really ought to stop trading.
Meb: I think that’s great advice. Let’s quietly end there. That was great. Jason, it’s been awesome. Have safe travels. Thank you so much for taking the time out today.
Jason: Thank you, Meb. It’s been fun.
Meb: Well, we’ll look forward to connecting again. One days when I’m in Asia, well, we’ll have to do a live recording. Listeners, thanks for taking the time out to tune in today. We always welcome feedback and questions for the mailbag at [email protected] As a reminder you can always find the show notes, we’ll link to all Jason’s writings research, new website, Twitter, even though he doesn’t tweet anymore, and other episodes at mebfaber.com/podcast. You can subscribe to show on iTunes. And if you’re enjoying the podcast, please leave us a review. Thanks for listening, friends, and good investing.
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