Episode #16: “Listener Q&A”
Guest: Episode #16 has no guest, but is co-hosted by Meb’s co-worker, Jeff Remsburg.
Date: 8/16/16 | Run-Time: 53:19
Topics: Episode #16 is another “Listener Q&A” episode. With Jeff asking follow-ups, here are a few of the questions Meb tackles:
- Given low bond yields, what asset would you suggest holding in a trend following strategy while in “cash”? Would you stick to short-term bonds, diversify with several bond funds, or actually hold cash?
- I struggle with a way to screen for quality. I just listened to your podcast with Pete Mladina and he alluded to profitability as a factor. Have you done any work here?
- Do you believe that the development of smart beta (momentum, value, low vol…) will kill the edge of these factors?
- It’s difficult to distinguish signal from noise when evaluating different indicators, such as forward PE versus TTM PE. What suggestions do you have for evaluating the myriad indicators out there?
- I just came into a lump sum of money. Is there any research on the best way to invest it into a pricey market? All at once? Average in? Buy on the pull-backs?
- Should your primary residence count toward your asset allocation and portfolio?
- What do you mean by rebalancing taxable accounts by cash flows?
There are many more questions that touch upon topics including currency exposure, tweaks to shareholder yield, and the effects of hefty fees. All this and more in Episode 16.
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Comments or suggestions? Email us Feedback@TheMebFaberShow.com
Links from the Episode:
- Morningstar Fund Screener
- Attain Capital
- “A Quant Approach to TAA” – Faber
- Timing Updates and FAQ
- “Finding Yield in a 2% World” – Faber
- “Profits for the Long Run: Affirming the Case for Quality” – GMO
- Piotroski F-Score
- “Where are the Cheap High Quality Value Stocks?” and “How to Identify High Quality Stocks” – Alpha Architects
- “Quality Minus Junk: Factors, Monthly” – AQR
- “Buffett’s Alpha” – AQR
- What Works on Wall Street – O’Shaughnessy
- “To Win with “Smart Beta“ Ask If the Price Is Right” – Research Affiliates
- Home Price Indices
- The Real Value of a Home – Zweig
- Bankrate Survey
- Median House Price to Median Income chart
- Stocks You Shouldn’t Own – OSAM
- Home Bias – Schwab
- “How Much are those Dividends Costing You?” – Faber
Transcript of Episode 16:
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: Hey, everybody. It’s time for another Q&A episode. We got Jeff Remsburg back in the studio. Jeff, how are you doing?
Jeff: Good, thanks.
Meb: So first of all, thanks for all of the feedback. Keep them coming. If you guys keep sending all these questions we could even start doing this as much as weekly. Send emails into email@example.com. Also, thanks for all the reviews, really, really appreciate it here. Keep them coming. If you haven’t left one yet, please leave a review on iTunes as well if you’re enjoying the show, pass it along with some friends. I think it’s been a lot of fun for us to produce and hopefully a lot of fun to listen to. So if also you have any suggestions, keep them coming as well. So after that, Jeff, I’ll turn it over to you. Fire away.
Jeff: Sounds good. So what we have this week is a lot of the questions have come in in similar categories so I’ve grouped them together, figure we can just knock them out subject by subject. A couple of things as well, if you wrote in, please note that I’ve annotated your question. I’m trying to trim it down a little bit. So, please, no emails that I’ve misquoted you.
Meb: Change the name of the innocent. So we’re not going to quote your name. If you have a really question you’re embarrassed to send in, send in anyways. Good chance, someone else has the same question.
Jeff: Absolutely. All right, let’s start off with some managed futures questions. First one, is there a cost effective way to get a 20% to 30% allocation to managed futures if you have a portfolio of $50,000 to $100,000? Bonus points, if you come up with the solution that’s available to European investors?
Meb: So as you remember, managed futures is an investment strategy. Typically, it means going long and short. A lot of different markets around the world. Most managed futures are trend following strategies although not all of them are. Let’s call it maybe 80% are. Another 20% are short term or arbitrage or high frequency. But in general, when we talk about managed futures we mean the [inaudible 00:03:19] strategies. Historically, these have been around since the ’70s. So famous names like John Henry, owner of the Red Socks, Dunn, Chesapeake, Campbell, Harding, HL, all of these are famous managed futures companies. Historically, they offered them through commodity trading advisers and CPOs, commodity pool operators.
So CTAs and CPOs, those are like the private versions, commodity versions of hedge funds. So traditionally they have been a 2 and 20 fee structure, 2% management fee, 20% performance. Well, as we’ve seen this sort of evolution in a publicly available funds over the past 10 to 20 years, you’ve seen a lot of these managed futures funds transition into mutual fund format. So there’s two types. One is a fund to fund type which when we talked in this episode with Eric Crittenden recently, he mentioned you’ve got to be really careful because they can be super high fee and in some cases he said up to 5% to 10% per year.
The other types is actual…a managed future…mutual fund manager who actually manages the fund. So you can buy, there’s a whole bunch of those. You can go to Morning Star, sort them. You got to be a little careful. A lot of them are pretty expensive but in general there’s a handful of good fund companies that…PIMCO has some. AQR, the Tech SIS, Longboard, they all have lower cost managed future strategies. There’s a few ETFs that do it. ETFs’ place isn’t as developed as we want to see it yet but hopefully that will change soon.
Jeff: Can you put some parameters around the universe of cost, that’s money you should be looking for from a low end to high end?
Meb: You’re not going to see Vanguard and Schwab. I mean I would love for them to enter this space but historically they’ve shied away from a lot of the managed futures area. So a lot of the traditional fee pressure shops don’t exist here. So you’d see a little higher fee. So I imagine, if I had to guess, the average mutual fund fee is one and a half to two for the individually managed funds. But there’s some that I believe are below one or pretty close. Then the ETFs are lower cost but they’re not…they’re based on indexes that I think are kind of first generation, kind of 1.0 index because they do some screwy things like they don’t short the energy complex. The reason being is when they had put out the index, energy had only gone one way which was up and, of course, what happened?
We all know is energy is going to destroy it since. So again, same rules apply. Try to pay as little as possible but it’s a little more challenging in managed futures. This is one asset class strategy. It’s not an asset class but a strategy where due diligence is rewarded. So you need to be really careful in looking into the fees, looking into the manager. But there are some pretty good shops out there. Then the traditional CTAs, too. The only challenge there, it’s a little harder to allocate to for an individual investor. Plenty of institutions can allocate to these but those typically come to 2 and 20 performance. But a lot of those guys had been around a lot longer.
There’s a good website, I think it still exists, iasg.com. We’ll put it in the show notes that ranks up under the managed futures managers. Attain Capital used to do it. Morning Star has some rankers. We’ll put some in the show notes for some resources, too.
Jeff: It sounds like a bunch of what you mentioned would be available to European investors but is there anything in particular you want to highlight?
Meb: No. I mean I don’t have a firm grasp of the European landscape that’s any better than what’s available in the US so I’m going to pawn it there. Extra gold stars for me.
Jeff: All right. Let’s move on to the second one. Given current bond yields, what assets would you suggest holding in a trend following strategy while in cash? Would you stick to short term bonds? Diversify with several different bond funds or actually hold cash?
Meb: So when we published our first white paper 10 years ago, it was crazy. Quantitative approach tactical asset allocation. We demonstrated a very simple trend following strategy which was along an asset, when it’s above its long term moving average, we use the 10- month simple moving average and out of the asset when it’s below, and so sitting in cash or T-bills.
One of the questions that we implemented in the paper in the following years was if you spend a fair amount of time in cash and…so that model, on average, spends about a third of the time in cash over the total portfolio, you’re really sitting 70% invested, 30% in cash on average or roughly around there. But at times it can be 100% cash and at times it can be fully invested like right now.
If you instead put the cash component or what people call the collateral component in 10-year bonds instead of T bills, you add a little over another 1% point of performance per year. Now the problem with that is that the vast majority of that period has existed during a bond bull market. So from the ’80s till now, you’ve had bonds go from double digit yields to low single, one and a half or whatever we’re at right now in the 10 year. Is that likely to repeat? So we went back and looked at the ’70s, of rising interest rate environment and said, “How would this have affected taking that extra duration risk for the cash in your portfolio?” It actually didn’t hurt.
So one of the takeaways could be, “Look, if you want to move out the yield curve to 5 or 7 or 10-year treasury, that’s totally fine. We also think it would be fine to add some global bond yields so it’s a global bond exposure. So if you had the cash portfolio and wanted to put half in US treasuries, half in global bond sovereigns, I think that’s totally fine. You know, when we showed in our white paper, even ranking global bonds on value and sovereign bonds works well, too, so that’s reasonable.
Jeff: But you’re speaking in general right now on a yield perspective, right? Not a risk perspective.
Meb: Well, it’s both. It diversifies. US Treasury play very particular roles of diversifier to risk-off type environment. You can’t count on it but historically most of the time they have. But global sovereign should as well. Now the problem with global foreign bonds, debt weighed or market cap weighed, it means you’re in the stuff that has an even lower yield than the US so there’s not a lot of cushion, some of them which are negative. So if I wasn’t going to go into foreign bonds, I would pick based on a carry strategy or like some of our funds that do it. What you don’t want to do is what Jon Corzine did in MF Global which was leverage up a bunch of European sovereign bonds and leverage it up a bunch and blow up his entire business, right?
So you never want to leverage the…this is supposed to be the safe part of your portfolio. So if you want super low vol, don’t want to take any risk with it, fine. Put in CDs, cash, T-bills, totally fine. If you want to eke out a little more returns, fine. Put in 5, 17-year bonds. If you want to diversify away from the US dollar risk I think it’s totally fine to put, say, half of your collateral into foreign sovereigns. But particularly, I would tilt away to the higher yielders. Then if you can think of other cash-like substitutes, I think that’s okay as well. This is actually…real quick. If you look at managed futures for example of historical returns, the collateral…and this is a little different because it’s futures. You’re using…most of the accounts it’s in cash or T-bills and then you go buy futures.
You only need to post about 5% or 10% of the overall account value as margin for these futures. Most of the accounts it’s in cash. Well, managed futures is a strategy. It’s something like half of the historical return is that collateral yield. A lot of people don’t know that. That was a big tail wind for managed futures when collateral was yielding 5%, 6%, 7%, 8% and now that it’s yielding 1%, you’re not going to see as much of that return from the collateral yield. So that’s why [inaudible 00:10:51] people do screwy stuff like what Corzine did. But in general our default is you want to take as little risk as you can with the safe part of portfolio.
Jeff: Well, there’s that growing percentage of people who are afraid about the 10-year market rolling over. Do you share that concern at all? Would that steer you closer to straight-up cash or anything?
Meb: I mean, who knows with bond yields? You never know. I mean the US is one of the higher yielding developed countries which is kind of amazing, at one and a half or whatever it is. But if you look at Japan for example, number two economy in the world, when they cross below 2% yield, I think it was in…I’m on a blank on this, ’97 maybe? It hasn’t gone back above since. The US, our most global developed nations, in for a period of 10, 20 years of just low interest rate environment. I mean that wouldn’t surprise me. It wouldn’t shock me. It just happened in Japan. The answer to trying to predict interest rates I think is foolhardy but rather say, “Look, if you’re more worried about volatility, just go a little vol. Buy T-bills and that’s fine or a 5-year, whatever. You could always add some sovereigns as well in foreign countries.
Jeff: All right. To wrap this one up, what specifically would you personally choose?
Meb: I would do a mix. I would do say mid-yield curve treasuries, so maybe 7-year treasuries. Then I would add a certain percent on sovereign high-yield bonds but I would not take that over 50%.
Jeff: All right.
Meb: I’ll keep it below 50.
Jeff: All right. Let’s go to the next one. I’ve been thinking about allocation to a trend following ETF. What about the increased fees from the increased turnover? I haven’t found a way to measure that.
Meb: So you can scratch the word “trend following” from that and just say any strategies. Traditionally, obviously, strategies with lower turnover have lower transaction cost. Buy and hold strategy that never rebalance isn’t going to have any transaction cost. A strategy, it doesn’t matter if it’s trend following, if it’s equity screening, if it’s a bond portfolio, if it’s a portfolio that base…trades based on the calendar. It doesn’t matter. All that matters is the turnover and liquidity in those markets. So markets that are highly liquid, US large cap stocks, futures markets have very low friction cost. Markets that are not that liquid, say, trading stocks in Columbia or foreign corporate bonds or even US corporate bonds that often on any given day don’t even trade, those markets are going to have more friction.
So, whereas, trading US large caps every time you make a round trip that’s only maybe a few basis points, trading some of these other markets, it adds up. So it’s really about what markets they’re trading. Trend following strategies, it depends on the style. You can’t just say any trend following strategy. The long term trend following is going to have a lot less turnover than short term. In general, the rule is yes. Lower turnover, the better but also the more liquid markets, the better. But then, of course, you get into a lot less of the really big money as trafficking in the emerging markets so there’s more potential for alpha there as well. So you’ve got to find the right balance, but yes, you have to absolutely be aware of transaction cost in any given market strategy.
Jeff: As a percentage of your total investment, how much would you personally be willing to pay in transaction costs?
Meb: I think it depends. I mean it’s more of a how much a…or is it a paid up application strategy? In that case, you want to say just, “I want to replicate this asset class where there’s a little turnover in cost as possible.” Or is it a real alpha generator that you think it’s going to generate three percentage points and extra performance per year? Then you can say, “Okay, this was on paper. How much of that is actually being generated and what is the reasonable amount?” Then you can compare the fund returns versus, say, the hypothetical index. Eric Crittenden talked about this in his awesome interview where he talked about back when he was in college, comparing a paper portfolio that he was tracking in real time to back-tested results. The back-tested results were amazing.
But in real time when he compared the back-tested results to the paper portfolio, the paper portfolio did terrible and the back-tested did great and the reason was because the stock database used for testing had huge survival bias. So it’s different problem but similar. If you were to say, “All right, I’m going to actually trade this,” look at the transaction cost versus this hypothetical. Yeah, I mean it’s a very real friction that a lot of people don’t think too much about.
Jeff: All right. Let’s move away from managed futures and head over to tilts. So question number one is, “I struggle with how to find a way to screen for quality. I just finished listening to your podcast with Pete Modina and he alluded to profitability as a factor. Have you done any work on quality?”
Meb: Pete’s is one of the most popular podcast and for good reason. Pete’s a really bright guy. If you ask any number of shops what their definition of quality is you’ll get different answers. But if you look up either O’Shaughnessy’s, what works on Wall Street book, AQRs, paper on Buffett, any of Wes’ work at Alpha Architects, all these GMO, those guys have done a lot on quality. They all talk a lot about quality and it means a number of different things but we’ll talk about a few. So one, you can think of the actual earnings growth. So look at a stock and say it’s a factor such as is there a decrease in profitability? Are earnings decreasing year over year or three-year earnings growth? Are there negative earning surprises instead of positive ones?
Jeff: Would you factor in like repurchases there since that can manipulate the EPS?
Meb: We do factor it in in our models but for pure quality, I would not. Here’s another…there’s another tangent. So financial strength is a good one. Change in debt is a good example of financial strength or the debt ratios or how much cashflow they have relative to debt. Those are all financial strength metrics. A company that’s buying back their stock traditionally is going to have more cash. There’s a lot of variables that overlap. Another one would be accruals and earnings quality. So there’s a handful of others. You always have to ask, do they work? Does it matter? I mean, total debt in general, that’s a…change in total debt is a great one. A lot of the people use quality not as an initial screen but as the skim off the crud at the bottom.
Say “Hey, look, we’re going to take the top quartile of our multi-factor model but we want to get away from a few of these maybe value traps that actually are just junky companies that otherwise look like good value companies.” You see a lot of people that do the screens, include it as kind of a junk sweep stage of the screen. But we use some of these metrics in our funds when we think it makes a lot of sense. It particularly makes sense when the bear markets happen because a lot of the highly levered junky companies get punished and we haven’t seen that in the last seven, eight years. So at some point we’ll have bear market again but who knows when.
Jeff: Okay. So for this listener who’s looking for sort of a way to begin his understanding of quality, are there one or two metrics that you would point them toward that you think are more effective?
Meb: I don’t know that I have any favorites. I mean in general for me it’s avoiding the high leveraged through debt. So you could do debt to equity, debt to total assets, change in debt. Those all to me are ones…Petrofsky talks a lot about all these steps in his…but we’ll point the readers to a few books in the show notes that are these quant factor screening bibles. But, of course, always start with one of the earliest and that’s What Works on Wall Street.
Jeff: All right, next question. Do you believe that the development of smart beta, specifically the factor-based smart beta ETFs including momentum, value, low vol, etc, will that essentially kill the edge of these factors?
Meb: So anytime more assets come into an asset class or strategy, if it’s an arbitrageable strategy, it, by definition, really reduces the returns of that strategy. So, yes, is value investing harder when there’s tons of flows going into…and we’ve always said that flows change factors. The good example we’ve been giving in the last few years is that all this money that’s rushing into dividends, that’s rushing into low vol, has changed the attractiveness of the asset class and now it’s not that of attractive of a factor to allocate to. Is that because of flows, already called smart beta and arbitrage? Yeah, I think so. There’s some strategies but, however, the funny thing about it is that it’s not like it’s a permanent thing. So for example, what’s going to happen?
Well, dividend stocks would do poorly for a few years or they’ll get crushed in the next bear market or whatever it may be. Then people will hate dividend stocks for a while and they’ll be interested in only solar producings, autonomous car stocks or emerging markets will come back in a favor and everyone will rush into investing in whatever the next version of the bricks or commodities or whatever it may be. It’s a wrench repeat. So it’ll get to the point where value stocks or dividend stocks get out of favor for 5, 10 years and then all of a sudden it’s a great time to be buying those again. So, yes, money washing in and out of any strategy I think will…Aaron [inaudible 00:20:07] talking a lot about this. [Inaudible 00:20:07] has been talking a lot about this on changing that the attractiveness of any given strategy.
But a lot of these underlying factors I think they’re timeless and universal over 50, 100 years. So if you were to bet on them for the next 50 years it’s going to work but there’s going to be absolutely various periods where any asset class or any strategy looks wonderful or terrible. What we’ve seen from all the behavioral research, people chase returns, be buying these strategies at the worst possible time the way we think about dividends and low vol right now and then, of course, when they’ve gone completely out of favor. The same thing happens with managed futures. Managed futures had something like three, four down years in a row, in the mid or the late 2000’s, early 2010’s. Everyone declared trend following is dead and what, of course, happened? They had some great returns after. So it happens everywhere but I don’t expect it to be a long term, permanent efficiency in any of them.
Jeff: It sounds a bit like fashion where certain styles go in and out and fade over the years and you see sort of the circular pattern. Have you done any studies as to maybe the rank or the order of these factors? Is there any sort of consistent history of, “All right, it starts off with value then it moves to low vol and then it moves to…”
Meb: So fashion is a good example, except for maybe you who’s been wearing fleeces for 30 years.
Jeff: I look amazing.
Meb: There’s two schools of thought currently. There’s the [inaudible 00:21:35] which is, “Look, there’s a bunch of factors. Find a bunch of them that don’t correlate, put together a portfolio and you don’t try to time it.” There’s Rob recently, he’s been talking about, “Look, I think it make sense to move away from some of these when they get really expensive or vice versa relative to their own history.”
I’m not totally decided yet. I want to believe that it’s possible at the time just because I want to think that it’s doable. But I think having a number of approaches that do zig and zag, I mean, the most two traditional ones: value and momentum. So, great example. They almost never work at the same time.
So you have periods where one is not working, the other is and you have the complimentary “one plus one equals three” by putting both end to the portfolio. But even the basic “do anything,” move away from the market cap portfolio then you’ll end up with better than just the broad index.
Jeff: You hate market cap.
Meb: Hate it, hate it. It’s been having a great run though in the US.
Jeff: All right, it’s sort of a good segue, into valuation. A quick question on this: it’s often difficult to distinguish signal from noise when evaluating different factors. For example, some say the forward PE is the way to go while others swear by trailing to a month PE. Still others say trailing to a month is useless. Do you have any suggestions for metrics, methods or insights to get a hold on how to start effectively using the myriad indicators out there?
Meb: So anytime you pick just one indicator you’re setting yourself up for a lot of these binary outcomes. Two, take a step back. One, you should also test to see if any indicator works. So there’s example of people talking about, “Hey, dividend yield is higher than bonds right now. Therefore, stocks are vastly more attractive.” Well, that was true for the first half of the century and just because it wasn’t true for the last 10, 20, 30 years doesn’t mean that it’s not going to be true again. So if you get a look at these factors, like the Fed model was in some Fed notes in Greenspan tenure. But it worked okay in parts of the later half of the 21st century or 20th century. It didn’t work at all for the first half.
So a lot of these indicators, one, does it work at all? The listener mentioned the number of valuation factors and if you apply them to, say, the US stock market, you would learn that a lot of the longer term metrics, whether its 5, 10-year PE ratios, work much better than the 1-year ones. It doesn’t mean they’re perfect but one of the things you can do and same thing for a trend following indicator, so say a 200-day moving average. It works great over time, however, the example we often give is going into 1987, had you had a 200-day simple moving average or lower, you would have been out during the black Monday and that was 20% drop. But if you had a 200-day moving average or longer length, you would have been invested during the…and both of them are trend following indicators, long term.
So one take away is that once you have some indicators you like or factors, you can also use the composite. So for valuation factors you could use a composite of, say, five valuation metrics because maybe PE is saying one thing and price and sales is saying something else, the enterprise value to IBIDA. Once you have this composite, it gives you a blended reading and I think that’s a lot more useful than any just one. In general, they almost always say the same thing when you’re at extremes. If a market or stock is really cheap or really expensive, they should all agree. One of the other, you also have a blended outcomes. So if you use, for example, trend following indicators and said, “All right, instead of just using the 200-day, I’m going to use the 50-day, the 100-day and the 300-day. I’m going to use a third allocation on each to go in and out of these markets as a way of timing so that I avoid the all-in, all-out emotional trauma of being in a market and being on the wrong side of it.”
There’s a couple of different takeaways from that. First being, I wouldn’t put any money based on just one indicator. You want a lot of confirming indicators but you also have to test if they work in the first place. Then also the nice thing about having a composite reading or using multiple indicators is you get more of a blended outcome.
Jeff: So maybe the way to think about it is stop trying to look for the one indicator that’s going to be correct by using the composite. In essence, you’re playing defense preventing you from having anyone that’s going to be decidedly wrong.
Meb: There’s a lot of hindsight bias and hand wringing that you’ll get from just choosing one indicator. Now that’s what most people want. Most people want that Holy Grail. They want someone to tell them, “You’ve got to sell stocks now. You’ve got to buy gold now,” and that’s just not the way that it works. There’s no magical indicator that works all the time. In fact, usually what you’ll have is one indicator that’s wrong, wrong, wrong and people declare it doesn’t work anymore. It’s the worst and then all of a sudden, it’s right again.
This is why it’s so useful to look back to history. A lot of the ones people talk on TV don’t work at all. In some cases, they work in the complete opposite direction. I can’t tell you how many times I’ve seen someone go on TV, talk about it. They’ll be like, “Wow, we like this stock because the X or Y or Z,” and in reality they’re using an exact 180 degree wrong fashion if history was any guide. I mean the most famous example of that is beta.
So if you look at the beta of a stock to the market, most of the original financial theory was that the more risk you are taking, the higher beta, the higher return. It was actually opposite, 180 degrees opposite of that. So you got to first, look to history as a guide but also in my mind is don’t bet the farm on just one magical indicator because that’s going to cause you a lot of stress.
Jeff: So people looking for one indicator that tell them exactly when to get in and out is actually a good segue into the next questions which are about market timing. We actually got several of these but I’m going to read just one since they all basically ask the same thing. “As a result of inheritance, we came into at least a million in cash. I’m wondering if there’s any research on the best way to put the cash into a pricey market. Put all of it in at once, average it in over three years, assume inevitable corrections and buy in on them.”
Man: And he’s referencing…Rick, excuse me, other people were questioning specifically the US market but let’s just talk about expensive markets in general.
Meb: So first of all, I would…if that person was a client, a potential client, I’ll have him come and say, “Okay, first of all, let’s take a step back.” First of all, I think you should have a diversified global portfolio. So yes, if there is one expensive market, usually some asset class elsewhere is going to diversify. They all zig and zag. So right now, the way we see the world we think US stocks are expensive. But US stocks are only going to make a fraction of this globally diversified portfolio that’s going on foreign stocks which we think are really cheap by the way. It’s going in foreign bonds. It’s going in US bonds. It’s going in real estate. It’s going in commodities. It’s going in managed futures. It’s going in on all these stuff.
Don’t focus on just one market though most people in their head always want to focus on US stocks for some unknown reason. So that’s one. You already, that takes the valuation question out of consideration. It’s just like you’re asking the wrong question. However, there’s two other questions embedded in this. One is, “All right, we got this lump sum of money, how should we invest it?” Let’s say they were going to invest in The Trinity Portfolio or at global asset allocation portfolio. That portfolio has positive expected returns overtime. So mathematically, the best thing to do would be invest today because you’re going to have positive expected returns over the next 1, 5, 10, 20 years.
However, and I tell almost everyone we talk to, I say, “Look, you want to avoid,” and we mentioned this a minute ago, “the hindsight emotional trauma of putting in this inheritance and one of the markets or some of them tanking in the next three months and you having a 20% draw down which will happen in any asset allocation portfolio.” You’re going to lose 20%, 25% at some point. So if you win all in and that happened in the next three months, what’s going to happen? That client is going to sell everything. They’re going to go find another adviser. They’ll sit on it for a year and then they go find another adviser, wrench, repeat.
Another thing you could do say is say, “Okay, look. Here’s my policy portfolio. I want to avoid the headache of whatever trauma of stress of my sister harassing me that I’ve invested this and it’s gone terrible. So I’m going to implement it and at dollar cost average in over the next year or two years or five years or a decade,” depending on your time frame. To me that’s completely reasonable thing to do. Mathematically, it is not the best thing to do. You could also have some things in place where you say “Look, we’re going to implement this. We’re going to keep 50% in cash and we’re going to put some in.” I mean whatever the rules may be, set them and then just be done with it. What you want to avoid is the looking over your shoulder and say, “Man, I wish I shoulda, coulda, woulda done this,” or “Wow, we shouldn’t have done this.” So dollar cost averaging helps to spread that out.
The last part of that question which I don’t really want to answer but people ask so much is that, “All right, if I have to invest in one market,” and I don’t know why you ever would, “but if I have to invest in US stocks and I know that they’re on the expensive side, what should I do?” We’re going to ignore all the other things I just said which is the good advice portion. But if you had to invest in US stocks I would say the same thing as I always do. I say, “Look, lower your expectations.” So we think US stocks will do 4% maybe over the next decade. Two, try to come up with an investing approach that adds a benefit over market cap investing so whether that’s our favorite shareholder yield or any other combinations of value, momentum, quality, etc. that we think will be better.
Or you could even try to do some long/short approaches or add some trend following approaches. All of those things are better probably than just a straight up buy and hold of the market cap index. But what you want to avoid doing is that timing. I’m going to sit in cash but I’m going to wait for the dip. That’s how big of a dip? 10%? 20%? 50%? 80%? Or what if you looked at your potential global asset allocation in distinct buckets? So this guy with the million bucks and he looks around and says, “All right, emerging market looks great over the next decade so I’m going to go and put my full allocation into emerging market. But here in the US we’re looking overvalued so I’m going to sit in cash, willing to sit in cash for up to three years waiting for the pullback.” You sort of give yourself a little bit more guard rails.
We’ve had a perfect example of that, rewind three years. A person that does this would have then sat out a three year run in US stocks. So they weren’t cheap then, they’ve gone up for three years.
Jeff: Was that based upon Shiller?
Meb: Yeah, but on any valuation metric. There’s no way you could have said they’re cheap. They’re not a bubble and they’re not crazy expensive but they’re on the expensive side. The rest of the world is cheaper. There’s no question in my mind. So had you said that three years ago, what’s happened? You would have invested in emerging markets that have gone down three years in a row. Same thing with commodities. You would have sat out US stocks going up. First of all, that guy would have done that for a year and then quit, or two years. Forget about three, absolutely. Then what’s happened? This year, of course, emerging markets are ripping. Commodities are doing well. Some commodities are doing well.
US stocks are doing okay but not as great performance as foreign stocks. The whole key in my mind is having a policy portfolio stick with and in a blended asset allocation is a great first step. Then The Trinity Portfolio is the same thing. We said you can add [inaudible 00:33:32]. It’s like value and momentum. You can add a trend following exposure which is a big one. So, look, if you’re uncomfortable and you have someone buy and hold, add some of the trend which should be doing something totally different a lot of the time and that’s a good portfolio. But then we stick with it, this kind of desire to predict the future and be able to guess when markets are going to be going up and going down. It’s just not the way it works.
Jeff: Remind me again what the net expected return is, the global asset allocation?
Meb: Historically, if you look at all of the asset allocations in our book, Global Asset Allocation, you get a free copy at freebook.mebfaber.com, the real returns, net of inflation, is that four to six band for all of those. Now they don’t include tilts. They don’t include trend following. That’s just buy and hold global asset allocation. If you remember, stocks’ historical return is five around the world. Bonds is one and a half and bills is a half. It’s actually four and half, one and a half, half. We round it up and call it the 521 Rule. It’s easier to remember. We’re optimist. US stocks were six and a half but they’re an outlier. So an asset allocation historically has been in that four to six range and we think that’s a pretty good guide for a portfolio going forward.
The thing is there’s not that much inflation around the world right now. So expected returns, take that 4% to 6%, add a percent, maybe two of inflation and you end up with a lot more mutual returns than the historical returns that I think a lot of people are looking for. But adding some of those tilts and adding trend following I think can actually help as well.
Jeff: It seems like a lot of this could be addressed simply by people adjusting their expectations some in terms of longer term returns.
Meb: Yeah, but it’s tough because there’s a lot of other things that come into play. So, example, your adviser’s fees and mutual fund fees. So adviser, average 1%. Mutual fund, average 1.25%. That’s no big deal when markets return 10%, 15% a year. You’re skimming off a tiny bit. If a market returns and they’re expecting in return 3% a year, that’s…each of those fees is a third of the return. So there’s a lot of unintended…so even if you do have lower expectations, there’s a lot of behavioral changes that start to happen and people think in nominal terms, not real returns and that’s unfortunate because they should think in real returns but it’s a lot harder. How many investment books are written with real returns? I can count them probably in a few hands. But comparing a return of 10% in the ’70s when inflation was 8% to a return in the 20-teens when inflation is essentially almost zero is totally different.
Jeff: All right. So it sounds like basically you’re telling this guy to put his money in and just let long term returns do their thing.
Meb: Well, come up with a policy portfolio that you’re comfortable with. I don’t care if that’s CDs. I don’t care if you put your money in whatever it maybe. Just whatever you can sleep at night and what works for you. For me, I mentioned many times, it’s similar to The Trinity Portfolio. Half in a global market cap portfolio and then invest in all global assets, tilts toward value and momentum and the other half in trend following strategies. That for me is sort of my perfect allocation. But for a lot of people it’s 60-40 and forget about it.
Jeff: Let’s move on now. We have a hodge podge of random questions. First one is should your primary residence count towards your asset allocation and portfolio? In my case, I have looked at the correlation between my house price in San Francisco in the S&P500; and found the correlation to be over 90%.
Meb: One of the beliefs that most investors adhere to that is wrong is that real estate is a good investment in your house, in housing. I don’t mean this specifically. This is someone who just pulled their hair out and probably crashed their car listening to this. So, obviously, real estate is local. Obviously, if you pick a really cheap house and fixed it up and have a lot of domain knowledge, I’m not talking to you. But, in general, on average, and that’s the same thing by the way as picking a really good stock instead of buying the stock market so if you’re a great stock picker, I’m not talking to you when I’m talking about index and S&P. Historically, real estate and housing has not been a good investment. On average, the real return is about 1% a year so that’s on par with bonds and bills. Way less then stocks.
Jeff: But again you’re just talking here…just to clarify, you’re talking about capital appreciation versus rental real estate that’s cash flowing, right?
Meb: Correct. So REIT, for example, maybe are a blend of equities and bonds. It looks more like a 60-40. Shiller has this going back I think to 1890. Total house price appreciation is about 1% a year. So, yes. So should you consider? A lot of people, their home is their one of the majority biggest portions of their portfolio. So yes, absolutely, you should consider it and the way that I would think about it, I would think about it as a blend of roughly 60-40 US stocks or if you include some REITs, if you’re a REIT investor I would consider reducing a little bit the REIT exposure but it’s the same. Different REITs look like 60-40 which our buddy, Modina, talked about. But I would like to add a comment because I saw this on our buddy, Morgan [inaudible 00:39:01] where he posted a link to a study on bank rate in a survey and asked people, “Which would be the best way to invest your money that you wouldn’t need for the next ten years?”
I’m going to tell you, 25% said real estate. 23% said cash which is savings and CDs. 16% said gold. 16% said the stock market. 5% said bonds and another 14% said none or refused to answer. That, with the exception of bonds, that is an almost perfect order, inverse order of historical returns. So stocks historically return the most and you can put gold, real estate, and T-bills in all that same bucket. They’re not historically…they’ve not been great investment. They’re not bad. I mean, it’s not a bad investment. I mean real estate, 1% a year is positive and if you can certainly add value to that equation by having some domain knowledge. Plus it’s a huge pain in the ass. There’s maintenance. You’ve got to fix it up. You’ve got to pay, include all the taxes you have to pay and property. It’s just, oh, my god.
Jeff: What do you think about this though? So if you’re talking about…
Meb: Spoken like a true renter, by the way.
Jeff: If you’re thinking about your primary residence, obviously, I think that affects your net worth. But if you’re talking about your portfolio, when I think of investments, I think of a certain amount of inherent liquidity, you can’t sell your home if you come into a crisis like you can sell a stock portfolio that’s only have cash available to pay down, the need for a new car or a child breaks a leg or something like that.
Meb: Also don’t forget that there’s a 6% transaction fee when you do want to sell it which is absurd by the way. Still, that hasn’t been arbitraged away by the Internet. It’s also absurd to me, I’ve never understood why housing price insurance hasn’t taken hold. That’s one of the strangest things to me, that that’s not a business that every time you buy a house you say, “All right, would you like to pay us some insurance on the value of the house?” That’s such an easy business. Shiller I think started one back in the day and it’s never taken hold. I don’t know why. This all having been said, real estate, not a great investment.
Jason Zweig has a wonderful article we’ll link to. I don’t remember the name of it but it’s basically like, “Look, the vast majority of the benefit of a house is not the financial returns. It’s the emotional attachment to that house or really that home. So whether it’s your family growing up or having a home base that you get very emotionally attached to in memories. That’s what’s important there. It’s not the investment side of it.” So, yes. Should you be smart about it? Of course. Don’t do just something really stupid. I think well, what’s the average…there’s a rule of thumb of what’s sort of property you can buy and I think it’s on average it’s been around four times income? Four, five times income. We’ll add a chart from that [inaudible 00:41:56] we can find it that listed historically.
This also shows you when you have the distortions of 2006, 2007 where all of these indicators went totally just bananas, saying depreciation for the past 10, 20 years is totally abnormal, all of these people reaching to buy stuff they can’t afford and the flip side happened after the crash. But it seems to be back at least here in LA, back into a crazy town again with the prices.
Jeff: Let’s move on to the next one. I’m sure this is an elementary question. What do you mean by rebalancing tax bullet counts by cash flows?
Meb: So let’s say you have global portfolio, Trinity Portfolio, whatever it may be. Typically, people rebalance it once a year just to keep it in line. So let’s say you had a 60-40, 60% stocks, 40% bonds. Stocks go up a ton, bonds go down. You rebalance it in the next year to keep it in line with the percentages you’re targeting and that’s fine in a tax exempt account. We even say you could rebalance it every two, three, four years. It doesn’t really matter as long as you rebalance it at some point but once a year is fine because it’s a nice timeframe to review your investments. Two is that if you’re in a taxable account, you have to be careful because everytime you make a transaction it creates potential taxable events. So, yes, you should still rebalance it back to targets yearly but try to be tax efficient about it.
So if you have…so let’s say you just got a big bonus and you want to invest it. Well, you should put it in the asset classes that are farthest from their tolerance band. So if your 60% in stocks has gone down to 50%, you would add it to stocks. The opposite is true. You’re going to go buy a car or a house. You want to take it out of your investment account. You want to take it out of the areas that will help you get back to that target. So if stocks have gone up to 80%, you’ll want to sell the stock portion. Of course, you want to do that tax efficiently. So, for example, if you’re going to be adding it to the one that’s dropped a bunch, maybe you’ll sell your SMP, ETF and then buy related total market or Cambria ETF hopefully, to replace it. So you’ll take the loss and then invest it and get it back up to target.
Jeff: How do you blend that idea with momentum and that if an asset class is rising, you don’t want to get out of it? You want to let it keep rising. You want to let it do its thing, make you money. It seems like you’re sort of cutting off your nose despite your face if you’re selling an appreciating asset to rebalance into an asset class that’s not doing very well.
Meb: Never heard that phrase before. I don’t even know if it makes any sense. Cut off your nose?
Jeff: Despite your face?
Meb: Yeah. Is that something people say?
Jeff: You’re just out of touch, Meb.
Meb: Yeah, but all of our trend following studies, we also include rebalancing as well or not. Again, it shows that rebalancing makes sense as long as you do it sometimes because otherwise things will get way out of whack. So a traditional 60-40, if you just let it drift eventually it’s going to end up almost totally in stocks because stocks return more in the US. Now, by the way, this is a great example. I was reading Annette Davis’ piece this morning, Japanese stocks over since 1985. So that’s going on 20 plus years.
Meb: No, thirty years. Japanese stocks since 1985 have returned 2.5% total so that includes the dividends. Japanese bonds, 4.2%.
Jeff: But this is total, not per annum.
Meb: Total return.
Meb: Per year.
Jeff: Okay. Just making sure.
Meb: Total return per year. When you say total return I mean including dividends. Sorry, annualized total return, 2.5% stocks, 4.2% bonds. That’s incredible and most people think stocks for the long run, right, that stocks…that’s 30 years that stocks have not outperformed bonds. In Canada, our maple leaf buddies, I was just up in Calgary. Canadian stocks and bonds, same return over the past 30 years.
Jeff: I mean it goes back to the other question. If you’re trying to wait and time markets perfectly, forget it. Just put your money in in a balanced global portfolio.
Meb: Agreed, I agree, I like that. Okay, so back to the rebalancing. Look, rebalancing, you just do it. At some point, it doesn’t really matter when and be smart about it, tax efficient about it. There’s a lot of automated services that can do it for you nowadays. You don’t have to worry about it but be certainly mindful of the tax versus tax exempt.
Jeff: Okay, two more questions and we’ll wrap it up. Second to the last: “Regarding shareholder yield, our firm is dividend oriented. Many clients like dividends and the regular cash flow. But if we begin by filtering down to only those companies that are in the top 20% to 25% of shareholder yielders then looked only at those that pay a dividend, would that make sense? I understand that this is not a pure play way to apply your strategy but will we miss a lot by attempting to implement it in this manner?”
Meb: Of course I think it’s fine. Second, shareholder yield by the way is combining dividends paid out, as well as net stock buybacks. So buybacks minus issuance and we’re a little different. We also include debt paydown as one of the few shops that do that. But shareholder yield in general, dividends and buybacks. So once you get to the top quartile which is what he’s talking about or quintile which is top 20% or decile which is top 10%, then yes. Can you add some…so once you’re there that’s already fine and then just selecting dividends I think is okay. But more importantly, what I would do is tilt towards value. So if you look in that shareholder yield quartile box and then chop that up into a further quartile or whatever it may be, quintile and there’s some good studies that we’ll post in the show notes, it shows that if you pick the best shareholder yield and the best value, it does much better than the best shareholder yield in worst valuations.
So I would certainly use value as a filter. We talked about value composites and using multiple value indicators but also momentum and quality. All three of those are great factor groups used once you’ve already determined the top shareholder yield quartile. I mean dividends, look, I think that’s fine. Excuse me, I certainly think that’s better than dividends alone. So you’re making one step in the right direction but I would also think about considering value and potentially quality and momentum as well.
Jeff: Okay. Sounds like you might also want to remind his clients about the tax ramifications of the dividends versus buybacks.
Meb: Yup, yeah. We talked about this on a post. I forget what it’s called but it’s something like the least popular post whoever’s going to write. But it was about dividends are always having to pay taxes every time you get a check. Whereas, for other methods of avoiding dividend stocks and potentially focusing on capital gains, for a taxable investor, can be a lot more tax efficient than dividends alone.
Jeff: Okay. Last question, it’s from an Italian investor who seems a little scared about currency risk. He writes, “As a European investor it’s hard for me to stick with the strategy that invests most of the time in US dollar-based assets. But at the same time, if I had indulged in home country buys over the last 5 to 10 years, the yield would have been disappointing. Can you suggest some theoretical or practical considerations that can aid a foreign investor?”
Meb: I love Italy. Italian stocks have been a big laggard this year. They’re definitely cheap. Greece and Italian stocks just can’t seem to get their act together. Look, I mean we’ve said this many times. It doesn’t matter where you live, you want to be global and it’s particularly important in smaller countries. So yes, even in the US we say half your assets should be outside the US, in foreign markets. The smaller you go for countries, you want to have a bigger global exposure. So not just having exposure to your home country stocks and bonds and currency but also global becomes even more important in a country like Italy who I’m guessing is what, 5% of world GDP? It’s almost entirely global and it’s hard to do personality wise but you really want to think in terms of a global allocation because you’re going to end up with a much better possible outcome I think than just picking one country or being majority dominated in your own currency and country.
Jeff: I’m not sure if this is what he was asking. I might be reading into it more but I took from this a question about if I live in a country that has a great deal more currency fluctuation than the US dollar, against the US dollar, what base currencies should I use for my investments? I mean that seems to add another complication to things.
Meb: Well, his base is always going to be Euro because he’s in Italy. I was going to say Lira. It’s been a while. It’s going to be in Euro because he’s in Italy, right? That’s his home country currency. But you want exposure to foreign currencies, ask anyone in Brazil or Russia or elsewhere you’ve seen their currencies in recent years just get crushed, right? If you’re in Venezuela and you have all of your assets in Venezuela, well, tough darts. I mean you just add…your currencies have just been getting destroyed. So you want to have a global currency and global exposure so a lot of your assets and foreign stock exposure is a great way to do it, foreign bonds, have a certain percentage. In his case, what’s the right answer? I don’t know. Half, two thirds, three quarters, four fifths. I think that’s totally reasonable.
His is the Euro so it wouldn’t be that high. But I mean I think, in general, at least half. I mean we recommend to our US investors it’s half. In currencies, I mean you’ve got to remember, currencies over long time periods, in general, they kind of booey and they seesaw back and forth in a fairly stable real returns. So they adjust for inflation over time. But over time can be a very long time period. So you want to have a global exposure and in his case, look, you want to have a lot in foreign currencies.
Jeff: Fair enough. That’s it for me. Anything else you want to add?
Meb: No, I’m tired of talking. It’s been about an hour today. But look, you guys keep sending in the questions. We love doing this. firstname.lastname@example.org. You can always find the show notes at mebfaber.com/podcast. We love the reviews. Keep them coming. We’d like to see any. Go to iTunes and view any other of the, what, 14 shows we’ve done. We’ve got a lot of great guests coming up. Thanks for listening friends and good investing.