Episode #18: “People Need to Ratchet Down Their Return Expectations”
Guest: Rob Arnott. Rob is the founder and chairman of Research Affiliates. In 2002, he established Research Affiliates as a research-intensive asset management firm that focuses on innovative asset allocation and alternative indexation products. He previously served as chairman of First Quadrant, as president of TSA Capital Management (now part of Analytic Investors), and as vice president at The Boston Company. He also was global equity strategist at Salomon Brothers. He has published more than 100 articles in journals such as the Journal of Portfolio Management, the Harvard Business Review and the Financial Analysts Journal.
Topics: Episode 18 is packed with value. It starts with Meb asking Rob to talk about market cap weighting and its drawbacks. Rob tells us that with market cap weighting, investors are choosing “popularity” as an investment criterion more so than some factor that’s actually tied to the company’s financial health. What’s a better way? Rob suggests evaluating companies based on how big they are instead (if you’re scratching your head, thinking “size” is the same as “market cap,” this is the episode for you). Is this method really better? Well, Rob tells us it beats market cap weighting by 1-2% compounded. Then Rob gives us an example of just how destructive market cap weighting can be: Look at the #1 company in any sector, industry, or country – you name it – by market cap. Ostensibly, these are the best, most dominant companies in the market. What if you invest only in these market leaders, these #1 market cappers, rotating your dollars into whatever company is #1? How would that strategy perform? You would do 5% per year compounded worse than the stock market. Now slightly tweak that strategy. What if you invest only in the #1 market cap company in the world, rebalancing each year into the then-#1 stock? You’d underperform by 11% per annum. Meb then moves the discussion to “smart beta.” Why is Rob a fan? Simple – it breaks the link with stock price (market cap), enabling investors to weight their portfolios by something other than “what’s popular.” But as Rob tells us, there are lots of questionable ideas out there masquerading as smart beta. The guys then dive into valuing smart beta factors. Just because something might qualify as smart beta, it doesn’t mean it’s a good strategy if it’s an expensive factor. Next, Rob and Meb turn their attention to the return environment, with Rob telling us “People need to ratchet down their return expectations.” All of these investors and institutions expecting 8-10% a year? Forget about it. So what’s an investor to do? Rob has some suggestions, one of which is looking global. He’s not the perma-bear people often accuse him of being. In fact, he sees some attractive opportunities overseas. Next, Meb asks Rob about the idea of “over-rebalancing.” You’ll want to listen to this discussion as Rob tells us this is a way to amp up your returns to the tune of about 2% per year. Next up? Correlation, starting with the quote “The only thing that goes up in a market crash is correlation.” While it may seem this way, Rob tells us that we should be looking at “correlation over time” instead. Through this lens, if an asset class that normally marches to its own drummer crashes along with everything else in a major drawdown, you could interpret it more as a “sympathy” crash – selling off when it shouldn’t; and that makes it a bargain. Does this work? It did for Rob back around ’08/’09. He gives us the details. There’s way more, including viewing your portfolio in terms of long-term spending power rather than NAV, the #1 role of a client advisor, and even several questions for Rob written in by podcast listeners. What are they? Listen to Episode #18 to find out.
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Links from the Episode:
- Research Affiliates
- RA Twitter
- The Fundamental Index: A Better Way to Invest – Arnott
- A few Arnott papers on SSRN
- Rob Keynote at UCLA
- Meeting of the Minds
- Too Big to Succeed – Arnott
- The Biggest Urban Legend in Finance – com
- Selection Bias – Arnott
- Why You Should Invest Based on Sustainable Spending – Arnott
- Sustainable Investing in a Low Return World – Arnott
- Why You Have Way Too Much Invested in US Stocks – Faber
- Lots of RA publications can be found here, and a short list is below:
- Mind the (Expectations) Gap: Demographic Trends and GDP¹ – Arnott
- Research Affiliates Asset Allocation Module – RA
- To Win with “Smart Beta” Ask If the Price Is Right – Arnott
- Beware of Rising Valuations in Smart Beta – RA
- How Can “Smart Beta” Go Horribly Wrong? – Arnott
- Rip Van Winkle Indexing – Arnott
- Are Stocks Overvalued? A Survey of Equity Valuation Models – Brightman
- Woe Betide the Value Investor – Hsu
Running Segment: “Things I find beautiful, useful or downright magical”:
Transcript of Episode 18:
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: Welcome, friends. We have a great podcast set up for you today and I’d like to welcome our special guest, Rob Arnott. Rob, hello, welcome to the show.
Rob: Well, thank you very much for the invitation.
Meb: Quick intro about Rob, for those who aren’t familiar. Rob, founder, chairman of Research Affiliates, started that back in 2002. Runs some funds for PIMCO All Asset All Authority. Rob’s background comes from all sorts of different shops. He’s familiar in the quant world, the First Quadrant, Salomon Brothers, now Citi, TSA Capital, now Analytic. Rob has literally written over 100 academic articles. I read about half of those catching up for this interview, and also has won numerous awards. He’s the co-author of The Fundamental Index: A Better Way to Invest, and got his BS from somewhat local up the street, University of California, Santa Barbara in econ, math and computer science.
So Rob, I figured we get started talking about one of our favorite topics we talk about on the podcast and in general, and that’s a little bit about market cap-weighted indexing. And this is a little timely. I saw Zweig had a nice article out about the 40-year anniversary of Mr. Bogle launching one of his index funds. Why don’t you start out with that? I saw your book, Fundamental Index dedicated it to a certain individual as some of the ideas that you started thinking about in the Fundamental Index books. But let me start off there, let you talk from why you dedicated that to George, who he was and then also let’s go down the road of market cap-weighted indexes.
Rob: Sure. George Cain has been a long-time friend, the organizations that he’s managed have been important clients of mine as well. He founded the Common Fund which manages commingled university endowments for schools all over the country, and has been a clear thinker on big investment issues for all of his life.
So back in about 2002, he approached me and he was deeply concerned. He sat on the board of New York State Pension and a couple of other state funds. He expressed deep concern that many, many tens of billions were indexed to the S&P 500 by these jumbo state funds who seems oblivious to the fact that they were tacitly loading up on bubble stocks which were savaging the wealth of the state by dent of savaging the pension portfolios. He said, “There’s gotta be a better way.”
So he and I and a couple of others including Marty Leibowitz who was then with TIAA-CREF and is now back with Morgan Stanley. We talked about the issues of cap weighting and the heart of the problem is a really simple one. Cap weighting weights company is in direct proposition to the price. If the price doubles, the weight in the portfolio doubles.
Now, common sense in investing says you want to have more of your money in stocks that are gonna produce higher returns. Okay, well, that’s the truism. Well, tacitly that means that with cap weighting, you are making a bet, an active bet that the companies that have doubled in price now have better return prospects than they did before they doubled in price. Well, that’s just nonsense. That just goes against any sensible view of the world.
I and my team viewed this as an interesting challenge, an interesting puzzle. Why bother weighting companies in proportion to their price? Now, cap weighting has some wonderful advantages, very low turnover, very low trading cost, vast capacity, representativeness spanning the macro economy. How could you capture all of those benefits without linking the way to the price? Well, it turns out it’s incredibly simple. Just weight companies according to how big they are. Exxon Mobil is huge, so give it big weight because it’s a big company not because it’s large market cap.
And the result is that you wind up with a portfolio that anchors on the company size and it concentrates against the market’s most extreme best. So if a company soars in price but the underlying fundamentals haven’t changed, fundamental index will say, “Gosh, thanks for the nice profits, let me bank those profits, sell the stock back down to its economic footprint, and reweight it back to the size that the company actually is.” Companies [inaudible 00:06:44] fundamental index will say, “Jeez, that’s disappointing to see it go down, but on the other hand, boy, that’s an interesting opportunity. Let me buy at these low prices and top it back up to its economic footprint.”
In so doing, if you’re trimming the gross stocks down to their economic weight and boosting the value stocks, the cheap stocks up to their economic weight, it tacitly has a value bias, such a value-tilted portfolio. But it spins the macro economy in a meaningful…economically meaningful way. It mirrors the look of the composition of the macro economy instead of mirroring the look of the market. And it has low turnover, and it has high liquidity, and it has vast investment capacity. And, oh by the way, you go back historically and you find that all over the world when you invest in this fashion, you beat the market by 1.5% to 2% per year compounded.
Meb: So I sat down with a friend of mine who’s an investor but not a professional and they said, “What are you reading?” I said, “Oh, I’m getting ready for this podcast with Rob, you know, we’re gonna talk about market cap weighting indexes and, you know, why they’re suboptimal.” And I said, “You know, are you familiar with market cap weighting?” And she said, “Yes.” And she said, “That’s investing in the biggest companies.” And I said, “Yes, biggest by what measure?” And it’s funny because she said…you know, took a pause for a second and she said, “Well, revenues or profits, right?” And I said, “No.”
It’s interesting because a lot of people think market cap-weighting is biggest by a lot of these measures. Like you mentioned book cash flows, sales, dividends, all these things. In reality, what you’re describing is fundamental indexing. And the question that I had for you, and this is more of a thought experiment. If we could go back in time 40 years to the ’70s when a lot of these, you know, Wells Fargo, Jack Bogle, a lot of these guys were developing what were the first index funds, my thought experiment is why do you think they picked market cap weighting as, you know, the first index fund? Why wouldn’t think about any other, you know, equal weighting or fundamental weighting? You know, if you’re an alien, like you mentioned, it seems counterintuitive way to build the first one. Any thoughts on why that was kind of the first iteration of index 1.0?
Rob: There’s a really simple reason, and that is that finance theory taught us that cap weighting is correct. A longer answer is, hey, it was already available and people were already using it because the S&P 500 was viewed as a broad market index indicating how the stock market was performing. And yes, that’s exactly what it is.
I love your thought experiment. I’m gonna take it back a couple more decades. Fortune 500 was launched in 1954, three years before the S&P 500. Fortune 500 was the 500 largest companies by sales. Let’s suppose Fortune had said, “You know, it would be really neat not only to publish a list of the 500 largest businesses in the United States, but also to create an index of these companies weighted by how big their sales are.” Well, if that had been done and S&P came along three years later and said, “Gosh, that’s not the stock market, that’s the business world. The stock market is weighted in accordance with the market value of companies. Let’s create S&P 500, the 500 largest market cap companies. This is the stock market. This is the index of the stock market. Fortune is the index of the macro economy.”
Well, roll the clock forward, again, from there to the time of Jack Bogle launching Vanguard, no one would have given a thought to indexing to market cap. Jack would have said, “Oh gosh, of course we’re gonna index according to the size of the business.” Just look at the relative performance over the last 20 years, you would have won by 2% a year compounded. Why on earth would you wanna weight by a company’s popularity?
So the essence of the issue is availability. S&P 500 was available, was used by everybody, not as an index to manage but as a measure of stock market performance. And secondly, finance theory was barreling down this path of market efficiency and you had Bill Sharpe ultimately eventually winning a Nobel Prize for his proof that you can’t beat the cap-weighted market. Cap-weighted market on a risk adjusted basis cannot be outperformed. Yes, the market is perfectly efficient, prices are all correct. If all investors have the same opinions on some companies’ risks and performance expectations, if all investors can trade free, no trading cost, no taxes, etc. Now, Bill would be the first to admit that the array of assumptions isn’t correct and therefore that the capital asset pricing model is an approximation of the real world, an idealized approximation that shows how the world ought to operate and is not in fact the real world.
But you had a lot of people saying, “Okay, well, we see this proof that you can’t beat cap weighting. We already have cap-weighted indexes out there, let’s just match those and get out of the stock-picking game altogether.” Fundamental index also gets out of the stock-picking game but it is in the stock weighting game because it reweights companies. Instead of weighting them according to popularity, it weights them in accordance to the size of the business. Instead of tracking the look and composition of the stock market, it tracks the look and composition of the publicly-traded macro economy. So that’s what’s cool about it.
Meb: And I think that’s great explanation. One of the best descriptions that I think to the broad audience as to why cap weighting is suboptimal is a couple of papers you all wrote. One, I think, was called Too Big to Succeed , another was called, I believe, The Winner’s Curse where you talk about some of the reason that cap weighting struggles and a lot of it has to do with some of the largest weightings within the cap weighting. Maybe you wanna talk about that real quick before we move on to some other topics.
Rob: Sure, sure. That was a fun paper. It’s an issue that gets, I think, less attention than it ought to get. In fact, you’re the first person interviewing me who’s asked about that particular paper. What’s interesting is if you go back historically and just look at the number one company, the top dog in any sector in any country in the world by market capitalization. What’s the biggest tech company in the world today by market cap? It’s Apple. What’s the biggest oil stock in the world today? I think it’s Exxon Mobil, but it might be Shell. And you go through the list and then ask the question, let’s say you want to invest sensibly with broad diversification, and let’s say you wanna be really simple about it and choose market leaders, dominant players. So I wanna just own the number one market capitalization company, the most dominant company in every sector in the U.S. stock market. Okay. Well, that sounds sensible enough. How does it do? “Well, it does 5% per year compounded worse than the stock market.” Five percent per year shortfall.
So you look at that and you think, “Gosh, what’s going on here? Taking the number one most popular, most beloved, most respected, most valuable company in each sector and I underperform by 5% a year. Good gracious.” When you think about it though, the companies that are number one in market capitalization are big companies that are also trading at high multiples. Big companies that are also popular and beloved, where they wind up having to perform brilliantly as a business just to justify their current price, never mind getting ahead and beating the market.
Secondly, the number one market leader in each sector has a target painted on his or her front, back, side, head, you name it, whether it’s regulators or competitors or the punditry. Everyone’s taking shots at them. Apple was golden and beloved until it became number on market cap, and then all of a sudden, it started to attract shots. It’s still gold and beloved, but the gold is a bit tarnished because people are starting to take shots at it. Well, that’s natural for the number one player.
So, of course, the number one market cap company is gonna be a big business in the sector, and of course it’ll also be one of the ones trading at a premium multiple because that’s what it takes to get number one market cap. And of course its price for perfection, it has to succeed at everything in order just to stay where it is, let alone to make further progress and to beat the market. We found that if you pick the number one market cap company in the world, just rotate into that number one market cap company as it changes from year to year because the number one company doesn’t stay the same for decades on end, it changes. And so you’re constantly owning the most beloved and then finding it’s less beloved and you have to trade back into a new company that’s the most beloved.
Okay. Suppose you do that, how does it perform relative to owning a broad global stock market? It underperforms by 11% per annum compounded, 11%. So the top dog is also…and we talk endlessly about companies that are too big fail. No, these companies are in many cases too big to succeed.
Meb: It’s really kind of astounding, but when you think about it, like you mentioned, there’s a lot of reason that makes sense in a capitalistic world and it’s probably the way that it should be. We often joke that there’s probably an ETF in there somewhere to just simply exclude the top few holdings or short them or combine them into an ETF. It’s a really fascinating area. It matters in the U.S. where, like, you’ll see these companies, I think Apple and a number of companies that have got to that kind of magic 4% of the stock market in the U.S., and almost every time they hit that 4% area, you know, the press takes over, “That’s gonna be the first trillion-dollar company.” But in reality say, “Look, this is actually probably not a good thing for them to be happening.” It’s even worse in a lot of foreign stock markets because they’re smaller and more concentrated.
I think you mentioned in some of your papers the percent of the market cap can get up into the double digits. I think you mentioned in one case it was like 30% of the index. But that’s one of the true flaws of market cap weighting, is when you have these big bubbles, the price…you know, back to the late ’90s, you mentioned this. A lot of the stocks that you had the biggest weight on were the most bubblicious type of names. The Ciscos of the world, they would really hurt your performance going forward.
I think that’s a good segue into a little bit of this topic of smart beta. You know, it’s a phrase that probably you’re dead sick of talking about but you’ve actually written a couple great papers recently. And we’ll post all these to the show notes. How Can ‘Smart Beta’ Go Horribly Wrong?” As well as another one. And I think there might be a third in the series, but why don’t you talk a little bit about smart beta? You know, as we move away from the market cap portfolio, kind of what does smart beta mean in your view? And then also talk a little bit about your ideas on, you know, factor valuations as well.
Rob: Well, firstly, let’s start with the label “smart beta”. It’s a clever marketing catch phrase. Who doesn’t wanna be smart? But I think looking back on the history of the label is kind of interesting. The inspiration for inventing the label smart beta was actually fundamental index, our work on fundamental index. The expression was invented by Towers Watson in London, and they liked the fact that fundamental index breaks the length with stock price. So the more expensive the company is, well, that has nothing to do with what your weight in the portfolio is. Your weighting company is more if they become more successful, not if they’re more popular and more expensive.
So they liked that, they liked the fact that it demonstrably adds value historically. And so they decided, “We need to encourage our clients, our consulting clients to diversify their beta exposure.” Yeah, use cap-weighted core equity if you want, but also use a strategy that can break the length with price. And so rather than just saying, ‘Split it between cap weight and fundamental index,’ they coined the expression “smart beta” and they broadened it to include equal weight, minimum variance, low volatility strategies, EDHEC-Risk Efficient strategy, TOBAM’s Maximum Diversification strategy, and so forth. All of these are strategies that weight companies in a fashion that is not controlled by the stock price. That if the price goes up, the weight doesn’t. Okay, well, that’s interesting. And that’s the common shared source of alpha for all of these. All of these strategies add value because they break the length with price. Fundamental index doesn’t add value because it’s smarter about fundamentals. No. Actually, that’s not the reason it adds value. It adds value because it’s weighting on something other than price.
So they coined the expression and it took off. Now, everybody wants to do smart beta, and every investment manager wants to say, “We do smart beta, too, look at this product.” So the definition of smart beta has been stretched to encompass almost anything other than cap-weighted broad market indexation. Anything you do that’s mechanistic, that’s objective, that is constructed in a formulaic fashion, people are branding it as smart beta. Now, if smart beta is broadened to encompass everything, then the term means nothing.
In our paper, How Can ‘Smart Beta’ Go Horribly Wrong?, we drew attention…the paper has been misunderstood. Some people think that one of the originators of smart beta is suddenly against smart beta. No, not at all. The essence of the paper is A, there’s some not very smart ideas masquerading as smart beta, and B, even good ideas in smart beta can be temporarily overpriced. So if you buy any strategy, it’s the same as buying a stock. If you buy a stock, do you buy it and not care what you’re paying or do you buy it and ask, “What price can I get this for and is that a sensible price?” Any sensible investor will do that, will gauge the price.
Well, the same thing holds true for me and it does for strategies, for asset classes. What’s cheap? What’s cheaper than its historic norms? And the same holds true for smart beta. There’s smart beta strategies that are trading at near-record valuation multiples relative to the market. Some low volatility strategies are currently trading at more than twice the market multiple. Well, if you buy low vol expecting downside protection, just expecting that low volatility means less risk of losing money, then you don’t want to be invested in stocks that are trading at twice the market multiple.
And so when low volatility which historically trades at a discount to the market at a 10% or 20% cheaper than the market, when it’s trading at twice the market multiple, oh my goodness, what happens if those stocks revert back to market multiples? You’ve just underperformed the market by 5,000 basis points. This is not to say that low vol is a terrible idea. I like low vol, we offer a low vol product. It’s to say that if people buy on strategy without asking, “Jeez, is trading expensive now or cheap now?” They may very well be buying something with great historical performance and lousy future performance.
Last observation on this is something very simple. What can we say about anything that’s newly overpriced? If it’s newly overpriced, it will have bad future performance eventually, and it will have wonderful past performance. So when people use past performance to pick their smart beta strategies, they’re making a smart beta 101 error. A very, very simple and very costly error.
Meb: And there’s some great examples you say in the papers. Again, we’ll put these in the show notes but talking about when a lot of factors got discovered. You were talking about price to book and the performance before and the price after. And an example you said was, “Look, you know, a lot of these academics and investors that were writing about these factors are only publishing them because they worked in the past. They wouldn’t certainly publish it if a factor didn’t work, but in a lot of cases, those factors didn’t have as good performance going forward.
But a lot of the reasons, I think, we’re seeing a lot of these value distortions go back to kind of the environment we’re in and flaws. And certainly when you have a lot of these flaws in the funds, whether it’s low vol, we’ve talked a lot about dividend yielders. I mean, the largest dividend ETF, I think has a higher valuation on every metric than the S&P and a lower dividend yield, ironically.
So, you know, our buddy Wes Gray who was on the podcast refers to one of the cheaper factors which I think you said the value factors in at least bottom quartile maybe even bottom decile as the value investor pain train over the last seven years. But I think it’s a very common sense approach and, you know, we think about it top-down as well. You know, going back to looking at say Japan in the ’80s. You know, at some point as an investor you have to say, “Look, this just doesn’t make sense.” Or, you can have a quantitative process to reduce exposure when the factors may be too expensive.
And we’ll kind of come back to ideas on how to do that in a minute when we’re talking about asset allocation, but we only have you for a limited amount of time. I wanted to shift a little bit into the return environment. So as we’re talking about valuation of factors, we can also talk about valuation of top-down markets in general. So the entire U.S. stock market as well as bond market and also investor expectations of returns. You’ve written quite a bit on this including a great UCLA speech which we’ll post, but maybe we wanna open that up to you and talk a little bit about the return environment from a top-down perspective.
Rob: We’ve written a fair amount about what we described as an expectations gap. Low investment returns aren’t a bad thing if you’ve got very low yields. It is what it is. The danger is if you’re expecting high returns and you get low returns, your plans get demolished. If you expect low returns and get high returns, well, gosh, your hopes are golden. If you expect low returns and you get low returns, then you’ll have done something very, very sensible. You’ll be spending less, saving more and planning to work a little bit longer. Well, that’s okay. That’s a whole lot better than running out of money when you turn 80. And we have vast swaths of the baby boom generation who are positioning themselves to run out of money at age 80 or even sooner. And they’re doing so by dent of having return expectations that are outlandishly high.
What do I mean by that? Most retail investors think, “Gosh, my stock should give me 8% or 10% a year or maybe even a little better than that.” No, that’s nonsense. The yield is 2%. So if the yield is 2%, how do you get 10% return? Well, you’ve gotta have either 8% growth in earnings and dividends or 8% per year rising valuation multiples. Valuation multiples are already stretched, so let’s toss that one right out of the window, it’s not very likely. Eight percent growth in earnings and dividends? How many people really think that in this slow-growth environment, that’s possible? GDP growth has slowed 2%, 3% per year. And that’s in nominal terms, not even real terms. If growth in GDP is 2% or 3% per year and you’ve got a 2% yield, well, maybe you should expect 3% or 4% return from your stocks. Jeez, nobody wants to expect that.
And if you’re getting zero yield from the bank and 2% yield on bonds, maybe you should expect zero return from your cash holdings and 2% from your bonds. People need to ratchet down their return expectations. Folks think that I’m a deep pessimist when I say this, but no, I think it’s just plain old realism, and the pessimism really relates to wanting to expect more than this and being told you shouldn’t.
Okay. Well, like I said earlier on, if you expect 2% from your bonds and 3% or 4% from your stocks, you’re going to be saving more aggressively for your future needs. You’re gonna be spending more cautiously and you’ll probably plan to work another two or three years, and if you do that, you’ll be fine. It’s that simple.
Meb: It’s reasonable personal finance advice anyway. I wanted to bring up a couple of points. One is if you’re reading any of Rob’s papers, you should always read the footnotes. There’s probably more information and references in the footnotes than in any of the actual papers. But one of them, he was talking about the Duke does a survey I think with CFOs where they estimate the returns of their plans and I think now, it’s at least come down to around six and a half. But that was down from a double digit return they were expecting at the worst possible time, which was the peak of the stock market in 1999. But at least they’re moving in the right direction. However, and Rob, you may have seen this study but it caused me to go red in the face. State Street did a recent survey of 400 institutions with over a trillion in AUM, and their projected response to this survey was, “Well, how much do you expect your portfolio to return?” And they said, “10.9%.”
Rob: Good Lord.
Meb: And not only that, they said their hedge funds…they expected that their hedge funds to return 13% per year which is obviously net, which means all these hedge funds are magically returning 20% a year gross in UA. It was one of the more astonishing surveys I’ve ever seen and these are supposed to be the smart guys.
Okay. So we have this low return environment particularly in the U.S. You know, you manage a multibillion-dollar asset allocation fund. What are some of the things that U.S. investors and investors around the world can do in general that would possibly make a more balanced asset allocation? I know you talked a little bit about the three pillars, but moving away from just U.S. stocks and bonds, what are some of the other choices out there?
Rob: Well, thanks for leading the conversion in this direction. Some of our discussion is about what’s wrong with forward-looking return expectations. But the flip side of that is, “Well, jeez, what can I do about it?” And there are things you can do about it. If you’re in a low return environment, you’ve got three tools in your toolkit. One, look for markets that are out of mainstream that maybe cheaper, that maybe priced to offer better forward-looking returns. Well, that turns out to be surprisingly easy. I’ve been described as a permabear because of my views on U.S. equities at current price levels.
And, yeah, I’ve had a negative view on U.S. equities for several years at this point, and ultimately wrong about it before the bull market of ’13 and ’14. But in any event, that caution was built on a foundation of terribly low yields and anemic macro-economic growth. So the only thing that allowed the stock market to do as well as it did was rising valuation multiples which is a non-recurring thing. You can’t count on that as a source of return year in and year out.
So step one, look outside of mainstream. Most investors have what we would call a two-pillar-centric approach to investing. First pillar is mainstream stocks, second pillar is mainstream bonds. Let’s diversify by using two pillars. Well, pardon me, but there’s another pillar available to us and that’s broad diversification outside of mainstream. Looking at markets that may get less attention and that maybe priced off of better forward-looking returns. You’ve got things like high-yield bonds, things like TIPS, inflation-linked bonds, commodities, emerging markets stocks and bonds, and the list goes on. REITs is another example.
Well, if you look around the world at this broader spectrum, you’re likely to find some good deals. Like I said, I’ve been described as a permabear, but that’s because of my view on U.S. equities. I’m a bull on international stocks, I’m a bull on emerging markets stocks. They’re cheap. Europe is priced at half the U.S. valuation multiple. You’ve got people on Wall Street saying, “Don’t worry about prices in the U.S. because there’s a zero yield on stocks. Where else are people gonna put their money?” Excuse me, because there’s a zero yield on bonds and on cash, people have to put their money somewhere. So any valuation for U.S. stocks is gonna be fine.
Well, if you believe that thesis, then the fact that U.S. cash is zero and U.S. bonds are 2% is a good basis for being bullish on U.S. equities. All right, if you believe that thesis, what about negative yields on cash and near-zero yields on bonds in Europe and Japan? Well, that should justify the sky is the limit valuation multiples for their stocks. But their stocks are cheap, they’re priced at half the U.S. multiple. So I look around the world and I see some markets are cheap, some markets are richly-priced. I wanna put my money in markets that are cheap and I wanna be patient because I have no idea how long it’ll take for the markets to adjust. Usually, it doesn’t happen immediately, and usually it doesn’t take too many years for it to happen. So I want to be patient and put my money where markets are cheap.
The two other ways to add value which we can get into or not as you like, are one, look for alpha. Look for ways to beat the market. Fundamental index is an example. And two, actively manage the asset mix. Ramp up your investments in markets that are rather favored, unloved and cheap and ramp down your exposure to markets that are expensive because they’re beloved, trendy and popular.
Meb: In one of the phrases that I heard from you in the UCLA speech which I have now adopted, so thank you, but one of the better descriptions, because a lot of investors I know struggle with systematically implementing this in their portfolio. It’s very difficult for them to add to markets that are declining and, you know, pair back markets that are going up. Like the U.S. has outperformed everything since the global financial crisis over the last seven years, U.S. stocks and bonds. And by the way, listeners, Research Affiliates, Rob’s company has a great software portal on their website that talks about expected returns. They have free CAPE ratios for about a dozen countries. But the phrase that I thought was such a perfect apt description is you said, “If you’re managing a portfolio and you have your policy portfolio is the concept of over-rebalancing.” And I wonder if you could talk about that just for a second about what you meant by that in the context of a portfolio and how individuals could adopt that philosophy.
Rob: We’ve all heard the words “buy low, sell high”. And most of us have thought about it and realized that’s a good idea. It’s a lot easier to say than it is to do.
Firstly, selling high, what does that mean? Take something that you’ve made a lot of money on, that’s been a source of great profit and joy and sell it. Sell it because it’s popular, beloved and expensive. That goes against human nature, but it’s nothing like the challenges you face buying low. Whatever is cheap, whatever is newly cheap has horrible past returns. It’s inflicted pain, it’s inflicted losses. Take those markets that have hurt you recently, that have inflicted pain and buy more. Point is that go against human nature. Our ancestors didn’t survive on the African veldt by running towards a lion. So it goes against human nature.
And when you think about it, what’s cheap is almost always cheap for a very good reason. It didn’t get sold down to bargain levels because there was nothing wrong. It got sold down to bargain levels because people were legitimately fearful. So you can always find a rationalization, a straight-forward and legitimate rationale for saying, “Hmm, this might be cheap but then again look at all the troubles they’ve got. I’d better wait for things to settle down.” If you wait for things to get better, the price will already have moved. You’ll have missed the opportunity. So you have to buy when people are selling, you have to buy what’s out of favor, unloved and legitimately creating fear.
One way to do this, a simplistic way to do this is to set a policy mix and just rebalance back to it. Let’s go with the classic 60/40. Stocks rally, you’re now at 65/35, stocks are 65% of your portfolio, bonds are only 35. Okay, so you’re gonna take some profits and trim it back to 60 and boost the bonds back to 40. All right, that’s rebalancing. It’s a built-in structural inherent buy low, sell high discipline. But it does it in a way that’s automatic and easy and not too painful and also not too profitable. It helps but not hugely.
What if stocks rally to 65% weight and bonds fall to a 35% weight? What if you decide, “Okay, whenever that happens, I’m not just gonna rebalance back to my target weight, I’m gonna over-rebalance. I’m gonna rebalance the stocks back down not to 60 but to 55. I’m gonna top up the bonds, not to 40 but to 45.” Over-rebalancing in that fashion roughly doubles the advantage of rebalancing. Over long periods of time rebalancing in a global portfolio can add about 1%. So over-rebalancing would add about 2%.
Now, if we’re in a low return environment and stocks are priced to give us a 3% to 4% and bonds are priced to give us 2%, so your balance portfolio, 3%, if you’re lucky. Well, over-rebalancing if it adds 1% or 2%, great, now you’re at least 4%. If alpha from fundamental index can add value of let’s say 1% to 2%. Great, now you’re at 5% or 6%. If an embracive out-of-favor markets, outside of mainstream, unloved, and more interestingly priced, if that can add 1%, now you’re up to 6% or 7% return, which I think most investors would agree is a lot better than 3%.
Meb: I think, you know, advisors that are listening to this, that’s a great reason to think about how to justify your fees. You know, most advisors out there, financial advisors charge a percent a year. Some of these value added ideas Rob is talking about are great ways to have conversations with your clients.
You know, it’s interesting, Rob, we’ve done a lot of studies in-house that look at some fun quant studies, but they’re so rare that I’ve always struggled on how to implement them. And a couple are looking at asset classes, sectors or industries when they’re down 60% to 90%. Or looking at asset classes that are down say three years in a row or sectors that are down five years in a row, which only happens about 1% of the time. And trying to come up with a meaner version portfolio was always pretty difficult as a standalone, because most of the time you’d be sitting in T-bills until…you know, as I thought about it and heard your speech, I said, “Oh, this is actually a great way to implement this when some of these rare events are happening, start to do this rebalancing where you have a policy portfolio and then have set parameters. Hey, when XYZ gets to this valuation or maybe when it’s down 80%, we’re gonna add a higher exposure.” And I think that’s a great advice.
I wanna talk about two more topics that are kind of tangential. I don’t think we’re gonna have time to get into demographics today. This conversation could go five hours and I’m sure you have other things to do. But two topics that I think a lot of investors don’t understand that would be interested in. One is as we’re on the topic of asset allocation, I was looking at an old paper you guys did I think on etf.com called Bonds: Why Bother. And it was talking about 2008 and 2009. And you said, “If 2008, 20009 teaches us anything, it’s the truth in the old adage. The only thing that goes up in a market crash is correlation.” And you talk about…you said, “Look, we track 16 different asset classes.” And I don’t know if you remember this paper, study, and then you talk about what happened in September ’08 and then what happened in October, 2008. Do you wanna comment on that or is this paper too old?
Rob: Sure. Sure. Yeah, the adage on Wall Street, “The only thing that goes up in a market crash is correlation” was vividly illustrated in September and October of 2008 during the market crash. Best of my recollection, the only thing that went up in price because it went down in yield is long treasury bonds. That’s it. Everything else, stocks crashed, commodities crashed, REITs crashed, credit crashed, even investment grade bonds crashed. Investment grade bonds were briefly trading at 5.5% spread over treasuries. God gracious. That hasn’t been seen since the depths of the Great Depression. So when you look at a situation like that, a lot of people fret that correlations go up and no matter where you put your money, you’re gonna get hurt.
There’s another way to look at this and that is correlation over time. If the correlation is normally low, that is to say if you find asset classes that are normally matched to their own separate drama and the correlation spikes during a time of market distress or market crash. Well, one response to that is to wring your hands and say, “Gosh, there’s no benefits from diversification.” The other is to say, “Well, gosh, these are normally uncorrelated. One of them crashed in sympathy to the other and shouldn’t have crashed and therefore is a bargain.”
And so in our own asset allocation work, we looked at the diversifying markets, emerging markets bonds, commodities, convertibles and so forth, and we realized, “Jeez, in a stock market crash based on some of the systemic risks that we’re looking at, some of these asset classes have legitimate merit and shouldn’t have crashed.” So we ramped up exposure to those diversifying markets and wound up by the fall of ’09 recouping the entire drawdown so that we were back in new all-time high territory by late 2009. Well, that was very satisfying but it came out of…in part, it came out of a desire for broad diversification and in part it came out of recognition that diversification works even if temporarily it doesn’t. Even if correlation soar in a market crash, that actually creates new opportunity.
Meb: Well, you had a great quote, I think it might have been in another paper. And this is kind of a quote that I think would…most investors would be surprised to hear someone say, but you said, “A balanced investor that’s disciplined about investing, the damage from bear markets is shockingly mild.” And maybe you wanna comment on that. But I think a lot of it has to do with the fact that most investors just think in terms of their domestic stocks and bonds and that’s it. But when you have one of these truly diversified portfolios, you know, the bear markets traditionally aren’t as bad as bad as the 60/40.
Rob: Sure. And factually, it goes beyond what you’ve just suggested. What’s the value of our portfolio? Is it the dollar value of the assets in the portfolio? Well, that boggles around quite a bit. Or is it the sustainable spending that the portfolio can deliver on a long term basis? If you have stocks today yielding 2%, let’s suppose we have a bear market and a year from now they’re down by half. Horrible bear market, and the yield is now 4%. What’s your income on that portfolio? Well, it hasn’t changed. You’re still getting the same income from the portfolio. It’s still in all likelihood producing income that grows with inflation.
And so if you take things from the perspective of sustainable long-term yield and view your wealth in terms of, “How much sustainable long-term income can this portfolio deliver to me?” You’ll find that the market volatility, you can just shrug it off. The crash in 1929 to ’32 was an 87% drop in the stock market. If you were a 60/40 investor invested in 60% in 10-year treasuries and 40% in the U.S. stock market, how much did you lose? You lost 65%. Ouch, two-thirds of your wealth gone, except that’s not your wealth. The wealth is a sustainable spending of the portfolio. If you were spending the income distributed by that portfolio, how much did the income fall in the greatest depression in U.S. history? It fell by 22%. Okay could we survive on a 22% pay cut? Most of us could. And it wouldn’t be pleasant, but that’s not a crash. What crashed was the price that people were willing to pay for a given dollar of income.
And so people forget that the bottom number on your brokerage statement that says, “This portfolio is worth X,” that’s not the best measure of how much wealth you’ve got. It’s something that’s very volatile and that’s not tied except indirectly to the long-term spending power of your portfolio. If people focus on long-term spending power, they’re gonna see, “Oh, gosh, I can improve that by going with assets that are abnormally high-yield offering more income than they normally do with assets that have become cheap, and I can benefit my spending power by over-rebalancing.” All of these things are wonderful ways to improve your long-term experience.
Let me just touch on one other point you made, and that’s the role of the financial advisor. The number one role of a financial advisor, I think, is Hippocratic Oath, “First, do no harm”. Why do I say that? Because if you help your clients to not lose money by chasing popular trends , by buying what’s gone up because past is not prologue by selling what’s been disappointing. If you can persuade them to not do damage to themselves, you’ve done a tremendous amount of good. A financial advisor who adds zero alpha is a big step in the right direction relative to most investors, a big step. And if a financial advisor can add a little bit on top of that, boy, they’re golden.
Meb: Yeah, Vanguard does a lot of studies there. You know, they estimated it’s three percentage points a year, half of which is simply the behavioral coaching, keeping people from doing dumb stuff over and over again.
All right. We’re gonna do a couple quick take questions and then start to wind this down. We’d love to keep you all day. One that came in from Twitter or email, I can’t remember which was, you know it says, “Look, we’ve read your papers on smart beta, this is really interesting about factor getting crowded.” He said, “How is there a good way to measure the amount of flaws that may alter a strategy? Or is there a reliable way for people to kind of monitor this sort of information? It’s not something that Morningstar readily publishes. Is there a way to keep an eye on it or what’s the best way to kind of be abreast of what’s going on with factor valuations?”
Rob: You know, in terms of how crowded space is getting, there are data sources out there. I’m not aware of which specific data sources would be best. The one, I guess, I’m most familiar with is Morningstar’s surveys of what they call “strategic beta” which is smart beta ripped large to include anything disciplined. And that gives you a sense for what the different kinds of strategies are seeing in the way of flaws.
The other thing you have to be aware of which is much more subtle is that different strategies have different capacity. Cap weighting, of course, has vast capacities. If a third of the global stock market was indexed to the global stock market, it wouldn’t hurt anything, it would be fine. We’re about half way there, by the way. If 1% of the stock market was invested in the momentum strategies, those momentum strategies would be ripped apart because they trade too aggressively all in the same direction. Okay. So there’s a different capacity for different strategies. And so one should do a little bit of homework on the strategies they’re looking at and ask, “Okay, what’s the capacity?” The capacity for quality strategies is pretty darn good, for fundamental index it’s vast, for cap weighting it’s beyond vast, for momentum it’s very small, for low vol, it’s a little small. And so these are differences that make a difference. I hope that helps.
Meb: It does. And I think the answer, of course, is for a lot of cases it depends on the asset class and strategy. If you’re trading Colombian stocks, it’s gonna be a lot less than U.S. large cap.
Another question that came in over the transom was…basically said, “You know, Rob, as someone who thinks about global portfolios and global tactical portfolios, what’s your opinion on A, tail risk strategies to diversify a portfolio and B, managed futures as a complimentary strategy?”
Rob: Yeah. Firstly, tail risk. It’s insurance. When you insure your home, you pay money for it. You expect to lose money on insurance. You hope to lose money on insurance. You expect to lose money on tail risk hedging. You hope to lose money on tail risk hedging, because if things are chugging along just fine, with tail risk hedging, you’re going to have a lower return. It really only helps when you have catastrophe strike. When catastrophe strikes, the cost of tail risk hedging soars, so once you’ve benefited from tail risk hedging, get rid of it because it’s now temporarily way too expensive. That’s very different from the way most people think about it. Most people think about it as a value added strategy, it’s not.
Managed futures are not an investment in any asset class. People think of it as a commodities investment, it’s not, it’s zero. It’s long some commodities, short other commodities. For most managed future strategies, what it really is is a momentum strategy that chases what’s newly beloved and has performed well and a bet on manager skill. And if you’ve got a great managed futures manager, it’s gonna be marvelous, and if you’ve got an average managed futures manager, it’s gonna go nowhere for you. It’s not an asset class, it’s a bet on whether the manager or the algorithm has merit.
Meb: Last question and then we’ll start to slow down. Someone asked in, they said, “How do you think about international bonds?” You know, a lot of investors in the U.S. that have a global market portfolio, it’s roughly half of the world’s market cap. And you’ve written some papers on, you know, bond indexing and the challenges with the same thing, with market cap indexing in the bond world which allocates most heavily to the countries that issue the most debt. So how do you think about allocating to international bonds? And then B, quick side question is, would you consider hedging the currency exposure or no?
Rob: Generally, I prefer not to hedge currency exposure. The reason for that is very simple. Hedging is not all that cheap. Like buying insurance, it’s gonna erode your long-term return. So I prefer to roll with the currency risk especially when the dollar has been stupendously strong. When the dollar has been rallying, the last thing I wanna do is hedge back into the dollar because past is not prologue. The dollar has just become more expensive. Why do I wanna buy a more expensive currency just to protect against that volatility that might otherwise have gone in my favor?
As for global bonds, I think the simple truism is that cap weighting in bonds means you were…if you’re a bond investor, you’re a lender, and if you’re cap-weighting, you’re lending in direct proportion to the debt appetite of the borrowers. The more they wanna borrow, the more you’re lending them. Why on earth would you wanna do that? It makes no sense at all. It makes more sense to weight bonds in accordance with the debt service capacity of the borrower. How much debt could they comfortably handle?
So for global portfolios, weighting the bond portfolio by GDP or even population or something like that to reflect inputs of production, the inputs of production are capital, labor, resources. You can weight the bonds in proportion to a blend of all three. That’s what fundamental index in bonds does. Well, that makes a lot more sense than cap weighting. You have the added problem, and this is primarily a developed world phenomenon, U.S., Europe and Japan, of financial repression. Pushing the real yields negative, pushing the nominal yields negative in some cases. Why on earth would I want to pay money to lend money to a foreign government? Why would I wanna do that? And yep, that’s what a negative yield implies.
So when I look at the international markets, I look at most international sovereign debt in the developed world as pretty darn interesting. U.S. ironically is just about the most interesting out there because it’s got anemic yield, it’s not zero yields. But can we do better? Oh, sure? Emerging markets that has got a 5% spread relative to the G5. Is there historical default rate anywhere near 5%? No, it’s about 1%. So jeez, that sounds like a pretty good deal. Do I wanna hedge the risk of default by buying credit default swaps? No, that’s another form of insurance and you’re gonna pay for it. I’d rather ride with the risk and control the risk by controlling the size of my exposure to that market and not having more in that market than I could afford to lose. So yes, they’re interesting opportunities in bond land, most of them are outside of mainstream.
Meb: And I think that’s a surprise to most investors because they hear so much in the news about Switzerland and Japan and negative yields, which is also just kind of a crazy world we live in, but that’s what they think of when they think of sovereign bonds. They’re not really thinking of emerging. And it’s funny because if you pull up emerging markets, you know, even the names that sound scary, you know, Brazil or a lot of these names, you diversify, you end up with a pretty nice portfolio. And even if you look into Vanguard’s holdings in some of the emerging markets they own, Iraqi bonds and Kazakhstan and everything else. So they go even more to the extreme.
All right, Rob. Look, we’re gonna wind it down. At the end of the podcast, we always ask each guest if there is something beautiful, useful or downright magical that most people haven’t heard of. Do you have anything for us today?
Rob: I could say that something utterly magical is our website and its tools for asset allocation. But that would be self-serving, so let me not say that. One of my weird hobbies is to chase solar eclipses. It takes me to all kinds of odd places around the world. And a total solar eclipse is magical. It is an amazing spectacle. I’ve seen people burst into tears of joy at seeing a total eclipse. Well, next August, I think it’s the 21st of August, there’s a total eclipse coming across the U.S. for the first time in over 30 years. Cool. Where is it coming? It’s going from Central Oregon to Central South Carolina, draw a line there between the two and be on that line on August 21. And I would urge the folks listening to this podcast to make plans and be somewhere on the centerline of the eclipse and take in some magic. It is just breathtaking.
Meb: It sounds like a good idea for the Research Affiliates 2017 annual meeting. You can hold it at 2:00 in the morning at one of these locations. I love it. That’s a great idea. For the listeners, a little-known fact, Rob was an aspiring astrophysicist. He says the reason he pivoted into finance was there wasn’t as much competition from the high-end math world as it was in astrophysics. I actually started out as an aerospace engineer because I came from a family of aerospace guys and until I took about one semester of college where I realized that aerospace engineering wasn’t becoming an astronaut, but rather taking classes like statics and dynamics which made me nauseous. So transferred quickly into biotech and moved on from there.
Anyway, all right, my useful magical idea is this is an article that was posted by the blog FiveThirtyEight, which for our listeners, many are familiar. It’s a quant blog, Nate Silver who writes a lot about politics which interests me very little as well as sports which interests me a lot more. But one of the staff writers wrote an article that was pretty interesting, because it took into account a couple of things. One, its quant screening and B, it takes into account kind of the status quo, what’s assumed. And the title of the article, this is a couple of years old, was Stop Playing Monopoly with Your Kids (And Play These Games Instead).
And so they went to a board game website called Board Geeks where people review board games and what they found out was…and they did this for each age bracket. They rated all the games and found out that a lot of the highest rated and most reviewed games were games most people had never heard of like Hive Pocket, Dixit. But a lot of traditional games like Candyland and Monopoly were very lowly rated. And so, I don’t have any kids, I’ve got seven nieces and nephews, bought a handful of these and took them to Denver last time I was in town and they loved the games. So check that, we’ll put it in the show notes. It’s a great idea for games.
Now, the only…what Rob would probably say or any quant listening is there is a little bit of selection bias there in that no four-year-olds or six-year-olds are logging into Board Game Geek and rating these games, but it’s probably the adults and parents. So a slight survivorship bias, but so far the games have been money.
All right, Rob. So you mentioned the website. Is that the best place for people to find more information on your writing and Research Affiliates?
Rob: That’s the best place. We just redid our website in a ground-up way, revamping it completely to make it pretty dramatically user-friendly, we think and hope. And of course we welcome feedback. So if you go to our website, you’ll see our asset allocation tools, you’ll see our articles, you’ll see our research papers, you’ll see links to organizations that run money using our ideas. Companies like PIMCO, Schwab, Invesco PowerShares, Nemorin [SP] and so forth. It’s a pretty powerful tool. Parts of it, the asset allocation page has gone viral. It’s had over a million hits since we launched it two years ago.
Meb: That’s great. You know, we send a ton of people your way because you update CAPE ratios for a couple dozen countries and it’s always fun to go on there and see just how cheap Brazil is relative to just how expensive the U.S. is. And I believe that update is quarterly, but a pretty nice interface.
Look, Rob, it’s been a blast. We’re gonna post all the show notes to the blog at mebfaber.com/podcast, including much of Rob’s papers as well as ones we didn’t get to talk about today. It’s kind of like getting a quick masterclass MBA in investing. So Rob, thank you for coming on the show. Listeners, thanks for taking the time to listen, we always welcome feedback as well as questions for the Q&A mail bag at email@example.com. Remember, you can always subscribe to the show on iTunes as well as Overcast and lots of other podcast players. And if you’re really enjoying the podcast, please leave a review. Thanks for listening, friends and good investing.
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