Episode #130: Eric Falkenstein, Economist, “I Think in the Long Run (Cryptocurrencies) Are Going to Work”
Guest: Eric Falkenstein. Eric was a TA for Hyman Minsky, which motivated him to be a macroeconomist. After grad school, he worked at KeyCorp bank in Cleveland, first as an economist, then he set up their value-at-risk system for their trading desk. After that, he led the development of their economic risk capital allocation across five major business lines, 23 secondary business lines, and 138 tertiary business lines. He’s been a portfolio manager, and has also written for academic journals and published two financial books: Finding Alpha and The Missing Risk Premium.
Date Recorded: 11/16/18
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Summary: In Episode 130, we welcome Eric Falkenstein. The show starts with Meb and Eric discussing ice fishing in Minnesota (where Eric is currently located). But then Meb asks for Eric’s origin story. Eric tells us about being a teacher’s assistant for Hyman Minsky, wanting to be a macro economist, the turn that pushed him toward investing, and a well-timed put option that made him a boatload in the ’87 crash.
Next, the conversation turns toward Eric’s interest in low volatility. He tells us about being one of the first people to study low-vol. He was early, and the broader investing community wasn’t ready for the findings. People dismissed the suggestion that high volatility stocks (with high risk) didn’t outperform low vol stocks. Eric tells us that given all this, “low vol” wasn’t enough of a selling point – you had to layer on another factor just to get people to pay attention.
Meb asks about the main value proposition of low-vol. It is a smoother ride? Better returns? And why does this factor persist?
Eric’s answer touches on CAPM, high beta, low beta, risk, various premiums, high flying stocks, and alpha discovery. This bleeds into a conversation about factoring timing relative to valuations. Eric tells us he tried factor timing, but didn’t find it to be too helpful out of sample.
The conversation bounces around a bit, with the guys touching on Meb’s paper, “A Quantitative Approach to Asset Allocation,” bonds and how the US is flirting with the top bucket of bond yields, whether low vol translates to global markets and different asset classes, and Eric’s take on risk parity.
After that, the guys turn to crypto. Despite the current pullback, Eric believes “in the long run, it’s going to work.” He believes that crypto will eventually replace Dollars as people will want an alternative to fiat currency, something not susceptible to manipulation by politicians. He tells us that he sees a tipping point coming.
There’s plenty more in this episode – Eric’s books, pithy quotes and maxims, how people often think about the specific investment they want, but not the “plumbing” such as the bid/ask spread of that investment, the volume, and so on… And as always, Eric’s most memorable trade.
Get all the details in Episode 130.
Links from the Episode:
- 0:50 – Welcome to the show
- 2:58 – A look at Eric’s early career
- 6:31 – Inspiration for his dissertation on volatility
- 10:05 – What the process was like for getting published
- 14:07 – What Eric learned about implementing funds
- 15:55 – Why the low volatility strategy persists
- 19:30 – Factor timing
- 22:41 – “A Quantitative Approach to Tactical Asset Allocation” – Faber
- 23:20 – The luck of predictions and timing
- 27:11 – High yielding sovereign bonds
- 28:08 – Does the low volatility strategy transfer to other countries and asset classes
- 29:22 – Building a portfolio around low volatility
- 32:20 – Wild claims that are pervasive in the investing world
- 34:45 – “Where Have all the Sharpe Ratios (over 1) Gone?” – Faber
- 37:37 – What attracted Eric to the crypto space
- 40:58 – How crypto will impact the future of investing
- 42:31 – History of Maxims: 700+ Profound Ideas – Falkenstein
- 44:55 – What piques Eric’s interest right now
- 46:13 – 12 Rules for Life: An Antidote to Chaos – Peterson
- 46:19 – Second most memorable investment (most memorable documented earlier in the show)
- 49:32 – How to connect with Eric; @egfalken
Transcript of Episode 130:
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.
Meb: Welcome, podcast listeners. We have an awesome show for you today. He’s been requested by many of you. Our guest has a background in academia, econ, fund management. He’s worked as an economist, set up valued risk systems for trading as a key core Bs, spent time managing money, starting his own funds, did a PhD, written a couple books. You may have read “Finding Alpha” and “The Missing Risk Premium,” and a whole slew of white papers. Welcome to the show, Eric Falkenstein.
Eric: Well, thank you, Meb. It’s a pleasure to be with you.
Meb: We’re tuning in from Minnesota, which it’s like one of the five states I’ve never been to. It’s on my to-do list. Are you an ice fisherman yet?
Eric: No. But the fun thing is my old firm, when the guys would come out from New York, you take them ice fishing in the winter, and then they would never wanna come back because they thought, like, that’s all we did. But if we thought, you know, if you’re gonna come out to Minnesota, you should do a Minnesota thing. You know, we’re not gonna take you to Buffalo Wild Wings. You can do that there.
Meb: My brother is a big ice fisherman. And I say, “Wayne, I’ll do it with you once every five years just to have a little brotherly quality time,” but they don’t do it quite the way that people in Minnesota do it. He’s in Colorado. I mean, it’s like a tent and a heater and that’s about it. The true pros have those, like, cabins with record player, and whiskey, and music, that’s the way I wanna do it. So anyway, but being at the cold and staring at a hole is not my favorite.
Eric: It’s really an excuse to get away from your wife and drink beer.
Meb: Yeah, all right. Well, I like that part. By the way, I gotta give you a great compliment. You’re one of the last holdouts of the bloggers out there that still use the old-school Blogspot platform. I think you still do, right? I think it’s Professor Damodaran from NYU. There’s, like, three or four others. I love it. Please don’t ever change. I have a very soft spot, we started out on that many years ago, so I love it.
Eric: Well, I don’t go much anymore. I’m not a big blogger anymore. The value isn’t there for me now, so it’s…
Meb: It shifted. See now, it’s on podcast. So you’ll get a lots of crazy responses that you would have used to get on the blog on the podcast. All right. Let’s start chatting. So let’s go back to the origin stories. I wanna hear a little about some of your early beginnings. You covered a lot of ground and kinda academia, why don’t we walk back there? Talk to me a little bit about your path of how you got into this sorta econ beginnings and the origins of what we’re gonna talk about the rest is talk today.
Eric: Well, you know, I went to West U as an undergrad. And I got an econ because I was a TA for Hyman Minsky and, you know, he was like my mentor as an undergrad and maybe wanna get a PhD. And so I thought he was really cool because he was really down to earth and he was really kinda clastic in the sense that he didn’t get along with the Keynesian, and he didn’t get along with the monetarists, and so I just found his attitude really fun.
And I still disagree with him on, like, a lot of things, but he did tell me one thing I’ll never forget, which is when I was, like, 20, he said, you now, “Just don’t think you’re gonna know everything until you’re at least 30.” And I remember thinking at the time, “Oh, what an idiot. You know, I almost know everything now.” And I didn’t realize that he could probably added 10 years to that. But he was really good. And so then I took that, I wanna be a macroeconomist because it predicts business cycles and, you know, he had his own little boom bust theory.
But as much as he’s like popular now, his basic idea that economies are endogenously unstable, I agree that’s true. But other than that you really…you know, he had this idea that basically you just lever more and more during the cycle. And it’s kind of true, but there aren’t any aggregates of that. And I found that that was true and everything in macro. Everything you tried didn’t really work. So I kinda jumped ship in grad school in Northwestern and got into finance because at least, you know, all I did was stock markets.
When I first got out of school in ’87, my first trade, because I had like $5,000 because my grandma died and so, like, I got $5,000. And so my first trade, I actually bought a put on SB-500 on October 16th, ’87. So, like, I hit a homerun. I made like $42,000 in two days.
Meb: That’s gotta be the most amazing origin story for anyone’s first trade. I mean, I…
Eric: Yeah, that was my first. So I thought that wasn’t really cool.
Meb: But also, that’s probably like the worst possible first trade that could ever happen to someone in their 20s. Now, you’re like, “I’m George Soros. I’m gonna soon be worth $500 million because…”
Eric: Yeah. If you love somebody and they go to Vegas, you want them to lose the first day. It’s definitely true. Yeah. Because then, you know, I realized after that, over the next year I said, “Oh, I’ll just do this full-time,” but, you know, the spread, and the taxes, it killed me. But anyway, you know, I just really hooked on, like, the markets and trying to figure that out. And, yeah, so I went to grad school and I tried the macro stuff, I found none of those guys know what they’re doing.
Even today, they’re still arguing about the same stuff. They can’t predict business cycles and they can’t predict long-term growth. It is, like, nobody predicted, you know, what is it the five Asian Tigers we’re gonna take off in the early ’80s. Nobody predicted West Germany would take off after World War II. And nobody knows why Haiti is poor and Iceland is rich. Economists disagree on that. So it’s kind of pointless.
So anyway, finances, I thought was fun. But then I got into that and then one of the first things I found was that, you know, volatility didn’t have a premium, and so I wrote my dissertation on that and said, “Hey, Highball stocks actually have a low and average return.” And, yeah, that’s my dissertation.
Meb: What was the inspiration for that as you’re just kinda kicking around reading about finance? Was there ever kind of a…you’re just playing around the numbers, because you were really early to this. So this is probably early mid-90s at this point, not a lot of people talking about this. What kinda of led you down that path? And was it something where you kinda scratch your head and say, “Man, I’m really on to something. This is really cool,” or you’re like, “Am I just an idiot and the rest of the world understands this and I don’t…” or, like, what was the general aha sort of process?
Eric: Well, I’ve always just said like that. I don’t know, I’ve been disagreeable in the sense that I always think like Minsky, you know, everyone else is wrong. And so, you know, that’s kind of a personality disposition. But, you know, I had the standard SaaS access to the crisp tapes, which all the PhD programs have, right? And so one of the first things you can do in SaaS is to do these like, you know, decile sorts and stuff. And so, you know, I calculated volatility, all these metrics, and I ranked from low to high, and looked at the monthly returns of the portfolios.
I remember, I found the momentum thing was one of the first things I found, and I was doing this in like ’92. And around that same time, Jagadish and Tippmann published the momentum paper, the first moment of paper. And I remember, I found it and, like, you know, a month later, you know, it was published, which means Jagadish and Tippmann probably figured it out two years earlier. But anyway, I thought was cool that I found something before anyone told me about it. So I thought, you know, I’m not seeing things.
And then I found this volatility thing. You know, I calculate volatility. The trick was, you gotta get rid of the small stocks because the little small stocks have really high volatility. And you get this weird bias to returns when you look at small stocks because they have crazy bid-ask spreads and such. You know, the whole thing that caused, you know, the size effect initially was thought to be around 15% annually. And it was all just because in these measurement issues with the bid-ask on the small stuff.
So, yes, I got rid of the small cap stocks. If you got rid of, like, the low price stocks really, the returns for high as well were lower than average. And I knew that didn’t make any sense. And so it was so new then, it was actually too new. You know, it’s sorta, like, you know, Apple in the Newton, you know? It’s good to come up with new ideas, but you don’t wanna have them be too new. In fact if I would have done this, you know, in the late ’90s after freakonomics and behavioral finance got hot, it would have been more…I don’t know, it would have been accepted better. I didn’t have a rational explanation for it.
And Northwestern is kind of like Chicago. Those guys are all, like, well, you have to have a theory. You can’t just find something because, you know, that’s just data dredging, and you’re just finding meaningless noise. That’s the way things are done now. But back then, it was, no, you have a theory. And, you know, if you just find something but there’s not a rational explanation, then you’re fooling yourself. It’s not real.
So I wrote up this story about how mutual funds are attracted to sexy stocks, and I got that published in the journal finance. But the asset pricing one, you know, was rejected because it just didn’t make any sense. And like I said, that was just too early, like, five years later, they already said, “Fine, if you found something, we’ll publish it,” but that didn’t [inaudible 00:10:04] them.
Meb: It’s funny because I was smiling as I read through a lot of your comments on the publication process and how kind of humorous that was, because, you know, when we published our first academic whitepaper, being someone that had never been through this, it was such an odd process to me. I mean, it had all the earmarks or something you wouldn’t expect out of a theoretical academic process where people totally came to the table with their preconceived notions, where there’s definitely an element of clubiness to it and all these other things that…and it’s changed a lot in the ensuing a couple of decades. But what was the process of trying to get this published? The idea, you know, it was just kinda universally shut down. Were people dismissive?
Eric: They’re all just very dismissive, you know, like, one guy said, you know, I’m trying to tell him that the world is flat or something, because they said, you know, it can’t be, and it was just in credulity. I mean, there was nobody high-profile. You need some big guy to, like, say, “Oh, yeah, that’s a good idea because otherwise the people okay in your paper are gonna feel stupid.” And I had no big guy backing me. You know, my dissertation committee was actually most of those guys were like game theorists. I had one finance guy but he was a junior faculty guy. So that’s why, you know, I could get my one paper done on mutual funds because it was kind of…it wasn’t that radical, but they were all totally fine, it was just too radical at that time.
You know, looking back, we see other people found it too but they would just kind of mention it parenthetically, like, Haugen, you know, had papers finding it and other people. But either they just mentioned it as an aside. I was emphasizing it, and they’re like, “Well, no. This can’t be true.” And so I was a perfectly fine with that because I thought, “Oh, great. I’ll set this up as a fund.” And so I got a job as an economist, but I was busy trying to, like, create my own fund. Well, the first thing I did and I tried to create this little vol fund in this.
But, you know, and I created the C Corp with just with my family money. So, you know, I put like a couple hundred grand in there. And then I would go to New York, you know, and try to sell it to some people. But the problem was it was just so simple. You know, it wasn’t sexy, because I just said, “Hey, low vol has you get another, like, 100 basis points, 200 basis points for, you know, low vol over the S&P, and you get, you know, two-thirds of risk.”
And that didn’t work for two reasons. One is that it was just say, well, this can’t be true because it was, true, everyone was doing it. And then another thing they would say is, “Well, basically…” I would explain it so well. They’re just figuring, “Well, you know, that’s nice, but now that you’ve told me kind of, like, the whole thing, I wouldn’t wanna hire you to do it, right, because there’s no…” So, yeah, it was just the massive failure on my marketing end.
You know, and then by the early 2000, you had people like Pim Bambly [SP] and, you know, Unigestion started funds around, like, 2004, you know? And they were just in the right place at the right time. You know, Pim just got lucky and had a good manager that allowed him to do his thing. And then they took off then became history. So I missed it by a big amount.
But I mean, I did, I tried to setup another fund later because I’d been in hedge funds by then in 2006. But unfortunately, my boss sued me for, I don’t know, violating a confidentiality agreement. And then, you know, after I got out of that, no one would touch me because it was kind of vague and no one wanna deal with the risk. So my second trial to start a fund when it really started to take off, that got whacked too. But, you know, then I applied it later. You know, I was doing low vol stuff at my last hedge fund, and it worked fine. But that fund, you know, outside of me, it was, like, $5 billion when I got there, and it went down just for other reasons. I was one of many PMs there, and they no longer exist.
Meb: Talk to me a little bit about some kinda what you learned about the practical implementation. So you kinda spent some time managing the funds. Did the results play out sorta as you would expect it to? And was there any sort of conceptual takeaways for running the strategy in the real world, or is it pretty much what you’d expect?
Eric: Well, you know, looking back, I think the essence of it…its value is really straightforward. It’s just low vol. And it’s a flat maximum. It doesn’t matter if you use daily vol the last six months or two years, or… That doesn’t really matter that much. And it works almost in every market, and I think it does work in every market.
But adding layers onto it, I found was always kind of like a red herring. It was kind of essential because if you just told someone you’re doing low vol and trying to arb stuff that way no one would, like, give you money to do that. So you had to add another factor even if it didn’t work. But that was all sort of a compromise you had to make in order to get someone to do it, because no one wants to do it just low vol.
Everyone has…AQRS got their low vol fund and it’s got, you know, like, what do they call it, defensive. And then, you know, Pim’s…at Robocall, they call theirs conservative. And, you know, he’s got extra factors. And, you know, but the extra factors are just…I’m not really a big fan of any of the other factors. I’m sure you’re aware that, like, values getting beaten up and, you know, it’s a tricky one, you know, how do you measure value.
And I don’t have a lot of expertise in those, and I don’t have lot of confidence in them. But to the extent that the low vol thing works, I think it’s just a really captured very well by the SPLV ETF. And so, yeah, there are ways to make it better by doing it internationally, I think, and diversifying. But other than that…
Meb: You mentioned a couple things I wanna touch on real quick. And the first is, you know, you kinda came up this research before many people did and understood it as you have seen in the ensuing couple decades. A couple of things, one, what do you see is the main value proposition? So is it behavioral? Do you think it’s smoother returns potentially better returns? But also, you know, why do you think it really persists? I mean, and this may tie into your first academic paper on people being attracted to lottery stocks. But what have you learned in the ensuing two decades that kind of tells the story in a way that makes sense to you as to why would this continue to persist, and why do people continue to do dumb things?
Eric: I guess the key is that, you know, the CAPM, when they divide it, everyone just thought it worked because it made sense. And when they first tested it, the real first test was when those guys at Chicago, you know, created the first crisp tape and they found out that, you know, equities had, like, 7% premium over bonds. And so they’re like, “Hey, this was, you know, 10 years or so after CAPM was developed,” or no, right around the same time the CAPM was developed. And so they’re like, “Oh, the explanation is, you know, higher beta stocks, you know, high-risk stuff gets us risk premium.” But it doesn’t generalize to anything else.
I mean, we know that the equities return more than bonds, and that’s a good example of a risk premium. But it’s like the only one. I mean, you have that and then you have the return of BBB bonds over treasuries or over AAA, but you don’t have a lot of other places. I mean, if you look in sports gambling and within stocks, it doesn’t show up. And my big thing is, people are more relatively oriented than absolutely oriented. So if risk is what everyone else is doing then, you know, and if you invest in stocks, the spiders are at low-risk. So tracking air is your risk. Your risk is not your absolute return. It’s your return relative to what everyone else is looking at.
And that makes just a lot more sense from an evolutionary standard standpoint. And it just seems to show up again and again that people are more relatively oriented. And if people are relatively oriented, then, you know, a high beta stock has risk, but so does a low-beta stock. So, you know, there’s no risk premium in that dimension.
And then the high beta stuff has all this extra sexiness that people like. I mean, people have a confident that causes you to apply your great alpha to the, you know, the high-flying stocks, not the boring ones, the people information cost. High-flying stocks are written about all the time. They’re generating news. There’s, you know, output discovery in the sense of, you know, if you’re gonna get into the game, you don’t wanna, like, pick Coke versus Pepsi, you wanna pick, you know, Facebook versus Apple or something, something that’s gonna move around a lot.
You know, and then generally, equity investors tend to be bullish because you wouldn’t invest in equities unless you’re a bullish. And conditional upon, the stock market going up, well then, you wanna be in high-risk stock. So there’s a bunch of sexy reasons why people are glom on to the high beta stocks, and there’s no premium for it. So that pushes those down. And the security market line is flat, otherwise, I think. And that gives the low vol stocks, not so much a premium. But because high vol stocks are part of the index, that means that the low vol stocks kinda just tend to outperform by a couple percent a year.
Meb: So now, we have kind of the low vol phenomena seems to be fairly well-accepted in the community. You know, there’s now a debate raging, would love to…raging is probably the wrong word. You can’t really have a raging quant finance debate. But if it was, that’s it. Where people have been talking about various factors like low vol investing, which historically works great, but the capacity to say that there’s times when this may work better, whether through regimes or research affiliates talks a lot about this, where they say, “There’s times based on valuation of the underlying stocks,” meaning, a factor can go in and out of favor such as the late ’90s, values out of favor, certainly in this period, values been getting pummeled by the pain train for this almost entire cycle.
What’s your thoughts in general on, you know, that concept of looking at factors through the lens of either your economist hat of different regimes or also potential valuations where they’re either in favor or out of favor? And do you think it’s possible to ever time those?
Eric: I tried that a lot because, you know, when I was applying this at various funds, you know, a lot of my bosses would say, “Well, why don’t you look at the price to book of your strategy now and compare it to earlier times?” And, you know, it makes a lot of sense, right, because if previously, you know, the strategy of going along low vol stocks had a relative value metric that made it different currently, it would make you weary.
But historically, I didn’t find it really worked. It didn’t help me time the cycle. There’s one exception of course which is the internet boom. You know, they are obviously all the metrics kinda like highlighted that, you know, the internet stocks were overdone and relatively boring stocks. But other than that period, that little, you know, period where it went way up and way down, trying to find those valuation metrics to time factor be it, you know, value or whatever factor, size, or momentum, or, I don’t know, whatever the cool factors are now.
I haven’t found them to work at a sample where you kind of like handcuffed yourself and come up with a rule where without looking forward, you know, you determine whether it’s high or low. Yeah, I never found any of those to work unfortunately. You know, and the same sense of like you look at CAPE, right? You can look at the whole sample, like, look at the…what do you have? Who’s that guy at Yale?? He’s got that…
Eric: Shiller, yeah. So he’s got as like Excel sheet, right? You can look at the PE over time. And you can just go through that Excel sheet and say, “Okay, what if I took, you know, if I had some dynamic rule to get in or out of the market based on the PE?” And if you can find that rule looking backward, it’s hard to create something that adds value to just being long. Oh, no, have you tried their exercise? I mean, like a play [inaudible 00:22:30].
Meb: Oh, yeah. We spent a lot of time with the CAPE ratio. And, yes, I agree. I mean, look, market timing is tough in general. I mean, you’ll smile at this, when we wrote our very first whitepaper, the original title of it was “Simple Approach to Market Timing.” And my God, you should have seen the reactions to that. People, every single person I sent it to just pulled out their hair, they wouldn’t read it.
And we we’re trying to get it published. And then we changed the title to, “A Quantitative Approach to Tactical Asset Allocation.” And it was literally night and day, Eric, you have no idea how people responded to it as if like… So, you know, in our world of investing in finance, like you mentioned, so much of it is just kinda how you frame the argument. So instead of calling it low vol, you call it conservative or whatever it may be.
So market timing, yes, I think there’s plenty of metrics that I think help. But in almost always, they don’t help the way that people think they help. Most people, individual, as well as a lot of institutions out there, you know, when they think of market timing, they’re looking for a magical elixir that’s gonna tell you when to sell at a market top and buy at a market bottom. But in reality whether using trend or whether you’re using valuation, they tend to be fairly blunt tools, and likely what is the net effects.
Yeah, they’ll probably reduce your worst case drawdown, but those drawdowns don’t happen that much, you know? It’s a kind of once in a generation sort of thing. But we have found value but, you know, it’s not the Holy Grail. You know, but it’s funny too because we say, “Wow, Shiller’s goes all the way back to 1880.” And then there’s global financial data just put an update for CAPE ratio back to, like, 1810 or something. And, you know, what did the world look like back then? Well, certainly, not what it does today.
So it’s a little bit of just trying to, in my mind, a lot of those rules come down to common sense, you know? And so you can apply CAPE ratio globally to countries like all the countries in the world, but it gives you more than anything an understanding of history. So saying, “Hey, did it make sense to buy Japan at a CAPE ratio of almost 100 in the ’80s?” And, you know, those things then don’t pass the small test. So it’s simply using value, or low vol, or some of these factors, I think, it helps. But certainly, the market cap weighted indexes are a high hurdle. Anyway, so, yeah, we could spend a four more hours talking about CAPE ratio, that tends to always…
Eric: Oh, I think it’s, you know, like, my old fund actually, they got really pushed up into the upper tier because a guy there I work with before, Steve Koon, he made a great timing call on treasuries in, like, 2010 and said, you know, that these mortgages actually are gonna rebound. And he was right. And you get one of those big timing calls, a big thing like that right, and you make a lot of money for people, and you get a lotta benefits.
But, you know, they’re so sui generis and they’re so infrequent. It really doesn’t say much about your alpha in general. It just means, you know, if you were right about mortgages coming back in 2010 when people thought they were gonna do a double-dip, great. But, you know, who’s that famous guy who was at Paulson or something? You know, he called that whole thing right. And then and I think, you know, he kept thinking the treasuries were gonna crash for the next eight years. He was wrong. And so, yeah. Those timing calls, they can make you a lot of money. But I think, to a rational that, like, extrapolate alpha from those.
Meb: We’ve had a couple good guests on the podcast that have framed it. You know, so many investors on the timing side wanna think in binary terms where, “Hey, you know, stocks are expensive and they’re in a downtrend. I gotta be in or out.” And the way we often tell people to think about in psychologically and behaviorally, it’s probably a lot easier to handle is, you know, somewhere in between where you’re either calibrating your portfolio or the fancy technical term we call going halfsies where, you know, you’re not necessarily going all in or out on some of these ideas, but rather you’re tilting away from. That’s the way we think about it. It’s really hard for people to think in binary terms, although almost everyone wants to because they secretly wanna gamble.
Eric: The timing call I would call now is that, you know, I do think it’s a bad time to be like long bonds, you know? I think interest rates have gone back up a lot in the last year, but they’re still historically pretty low.
Meb: It’s funny, if you look at bonds, and we’re talking about sovereigns, and you look at them globally, the U.S. is now interests its way despite not being that high versus history into sort of the top quartile of, I believe, of high-yielding developed market and emerging market bonds. And so it’s a bunch of emerging market countries like Greece, and Mexico, and Russia.
And the U.S. is in that bucket now, but that’s not as much a comment on the U.S.. It’s a comment on how crazy still the rest of the world is on these super low-yielding sovereigns of, well, below 1% in many countries around the world, which is probably being the biggest surprise in my career seeing negative yielding sovereign bonds as an economist that probably made a lot of your former colleagues scratch their head a lot. That’s kind of a…
Eric: Yeah. No one would’ve predicted that, especially for so long. I mean, you know, it’s got gone on for now almost 10 years now. It’s crazy.
Meb: You had a fun quote on one of your papers and I wanna use it as its kinda a transition point where it stood out. You said, “You need some sort of delusion focused on low volatility stocks that causes some investors to reach for the high beta assets outside of the standard model.” So I wanted to ask, is this something the general thinking and theory applied to low vol in the equity world? You mentioned very briefly in passing earlier global. So one, is it something that you see that translates well to global? But also does it translate to any other asset classes, so currencies, bonds, we just talked about commodities. Any thoughts there?
Eric: Yeah. You know, the idea there is, you know, you can get a flat relationship between risk and return. But to get the high vol stuff to have lower than average returns, there’s no rational way you can do that without just… And so you have all these irrational things like people being overconfident and stuff like that in risk loving and trying to show off. But, yeah, it does translate to a lot of different areas. You know, you have a little bit like options. They’re really out of the money options. You know, those things have horrible returns. If you look at those, penny stocks have horrible returns and those have really wild volatility.
Meb: Where do you fall on the extension? I don’t know the answer to this, but I haven’t heard you comment on it. But, you know, one of the big on a portfolio level conceptual theories is when thinking about volatility, is the concept of when building a portfolio, either normalizing levels of volatility, or trying to optimize on correlations, and then levering that portfolio, the main one that many would consider to be risk parity as an idea in the portfolio context. Do you have any thoughts on that? Is it a pass to, I think it’s interesting, not that interesting?
Eric: Yeah. I’m not only a fan of risk parity of stuff. You know, I just think within any asset class, you know, like bonds, but I would separate bonds and, you know, you have high-yield bonds, and then you have investment grade bonds. But within those universes, within junk bonds, you wanna be in the safest junk bonds because the higher volatility ones have no higher return and they have a lot more risk. Same is true within emerging markets, and the same is true, you know, within maturities on the bonds.
I mean, why go out 30 years when you can go out 5 years get the same return and that was volatility? You know, you can do the same thing on currencies, and everything else. You know, sports books obviously, you know, the 100 to 1 long shots, they have a low so compared to, like, you know, the two to one guy. Of course, if you’re betting, it’s for fun. So when I bet at the horse-racing, I bet on 101/2 because who wants to make 100% at the racetrack, right? You wanna make 10 times.
Meb: Well said.
Eric: You know, but that’s just play money. But, you know, within any grouping, I think it always pays to just go for the most boring stuff when you’re talking about real money because it’s not sexy, and because it shows humility. And, you know, humility is very important and most people don’t have it. It’s one of our big sins. We all think we’re smart and smarter than…it’s just like quants. You know, we all think we’re smarter than average because, you know, almost all the quants were probably better than average compared to our friends in high school. But, you know, everybody out, there’s lot of other smart people too, and everyone’s looking at the same data.
Meb: Believe me, I just got back from the world’s largest cannabis investing conference in Las Vegas where there was 25,000 people. And, yeah, I think pretty much everyone there is looking for in 1,000 to 1 long shot. There’s so much money sloshing around including I took a photo and posted it on Twitter of one booth that had a sign that says, “Money grows on trees,” which I thought was pretty good description of the current mood and vibe there.
Although, it was the first conference I’ve ever been to where was at the institutional investing session, on the table to my left was drinking beers, and the table in my right was smoking. So I think it’s a little different vibe than my normal quant conferences.
Eric: Well, you know, you say this all the time. You know, when people advertise, no one ever advertises and says, “I’m gonna outperform by something reasonable and feasible.” Like, “I’m outperformed by 3%. you know, with the same vol,” or, “I’m gonna have the same return but, you know, 20% less vol.” Those are very feasible outcomes, but it’s really hard to sell. And you see all the time, like The Motley Fool is always… I had one pop-up that said, you know, “Make 200% on your money over the past, you know, three years or something.” And, you know, they want the home runs and stuff.
Meb: The catnip. The Motley Fool has certainly gone down that rabbit hole pretty deeply that they’re advertising. They used to be kind of a very investor-friendly-focused platform. But, yeah, whoever is in charge of their offerings in advertising department, it’s getting pretty icky. But it’s funny, you know, even on the institutional side, you know?
I mean, I can’t tell you how many…despite not investing in private funds, how many fund offering docs we get that says, targeting mid-teens returns, targeting 25% returns. And I laugh because I said, “I’m gonna just have to change all of our marketing material to say we’re targeting some obscenely high number. We’re never gonna get it, but we’re targeting it.”
Eric: Yeah. It is kinda strange. You think an institution would be smarter than that because I left my old hedge fund because it was just floundering and so they ran out of money. And I thought, “Okay, I had a decent sharp there personally,” you know, and like 1.3, I was making money every year, you know, the average fund doesn’t have a 1.3 sharp. And, you know, I thought this would be great.
But every headhunter I talked to was like, “Nope, you need a two Sharpes.” And I thought, “You’ve gotta be kidding? You know, if two Sharpes the bar to get in, and these are individual PMs, then every hedge fund should have like a three Sharpe, and we know that’s not true. So, you know, why are you asking for sharpes that are not reasonable?” But it is what it is.
Meb: Sharpe ratio is the old-school sorta, if you’re not familiar listeners, it’s like risk adjusted return metric where asset classes over time have about a 0.2, 0.3, a good asset allocation portfolio. It gets you up to about 0.4, 0.5. And so really anything above one is, over time, world class and theoretically should put you sword in the ring of fame. And so two and three, by the way, is not sustainable.
And so we did an old post years ago called, “Where of all the Sharpe ratios of one gone?” This was for commodity trading advisors, but it applies that hedge funds as well, and looked at funds Sharpe ratios by age and how long strategy has been around. And so certainly after a couple years, you had some that had Sharpe ratios two or three. By the way the S&P can have a Sharpe ratio of two or three, you know, in short periods.
Eric: And in 2017, I think it had a daily Sharpe of two. It was high. But, you know, vol was so low and went up 17% I think in…
Meb: Yeah. First year in history, the stock market didn’t have a down month. But the funny thing about our study was as the years went by, as you went 1, 3, 5, 10 years, all the Sharpe ratios declined below 1. I think it was none that had a Sharpe ratio above 1 out past like 10 years or something, you know, because eventually, you know, that’s, you know, strategies. It’s tough to maintain an edge, but also markets…almost any strategy goes through periods of 2, 3, 5, 10 years where, you know, unless you’re Renaissance that they struggle.
Eric: It’s puzzling to me because I mean, these are sophisticated people at these big funds. And, you know, the hedge funds…I think I haven’t seen the data aggregate lately. But, you know, they do okay, but, I don’t know, how can they, like, higher PMS with this kind of delusion? I just wonder if maybe they’re just getting, like, they’re doing kind of the style momentum that is if your fund and you have, like, 30 different strategies, and, you know, whatever, it’s like pairs, and you have a volatility strategy, and something else, and something maybe is, like, momentum-based. And so if you just blow them on to, like, whatever is worked over the past two years and generated a two plus Sharpe, maybe that strategy tends to do okay. That’s the only rational explanation I can get for.
Meb: I think there’s a much more rational explanation and that’s the old Chinese proverb, “The fish see the bait, but not the hook.” And what these hedge hunters and fund managers, everyone sorta in on the secret of they’re out there selling the sizzle and this dream that I think it’s with the internet, you know, acting as the global disinfectant. It’s becoming harder and harder to sell that, you know, sort of dream, which is why hedge funds so many of them.
And the hedge fund is just a structure, so it applies to a lot of things, but have really struggled in this past…particularly this past cycle has been a graveyard for a lot of famous funds, but the challenge of are there…who said it? I think it’s very Ray Dalio said that, “Largest hedge fund manages the world,” said, you know, there’s not 10,000 good pilots referring to another 10,000 plus hedge funds. You know, by definition, it’s hard.
So anyway, there’s a couple other things I wanna talk about and we only have limited time, but I have three more pages of questions we’re not gonna get to. But one of the things I’d love to transition to is sort of the career arc, you know, now starting to think a little bit about the cryptocurrency space. Maybe talk to me a little bit about what attracted you to that world? It sounds like an economist dream that ever been a more fun experiment in crypto. I don’t know what it is. But talk to us how you kinda got interested in that world.
Eric: Well, yeah. I just started reading about it. And I had really got into the hole. First just the technology is really…it’s not only technology, the conception, that whole Diffie-Hellman key exchange, and the proof of work. And I was just thought that was just cool. I mean, it’s just kind of interesting if you’re a geek kinda person, a quant person.
And then, you know, I’ve always been a libertarian, so it jived with that part of me as well. And I also think that, you know, we’re gonna inflate all of our problems eventually, so, you know, it makes sense in the long run to get in these things, so all that stuff kinda came together. And then as I mentioned, I wanted to be, you know, apply my old strategy, but I was too honest and said, “Well I can give you a low one Sharpe.” And there was no interest in that. And so I said, “Well, I’d eventually find somebody who’d be interested in a low one Sharpe, but I never did.” And says, “Well, screw it, I’ll just get into this crypto stuff.” And it’s been fun.
You know, obviously, you know, right now, it’s going through a tough time, but I think a long run is gonna work. And I’m really working now. I’m just trying to find legal ways, you know, to do this because there’s so many constraints on setting it up as a fun because everyone is afraid of what, you know, all the risk, you know, and finding safe ways because, you know, it’s really safe but you forget your password all the time. Well, here, if you forget your password, you don’t get your money back. There’s nobody to call.
So you have to come up with mechanisms so that it’s both safe, but, you know, you’ll also never forget it. Actually, that’s a fun problem. But then coming up with ways to, you know, there’s so many horrible things out there. Unfortunately, our regulators thought they’re gonna save us by not letting us trade them, but, you know, if the regulators letting us short these stupid old coins last year, wouldn’t have the stupid bubble that it did, but you couldn’t short any of that.
So I’m still working on trying to figure out ways to do that because almost, you know, well, there’s a famous saying by that novelist that 90% of everything is crap. And that’s definitely true for this space. And so there’s lots of stuff that’s worth zero. And I’d love to short it. And I’m trying to figure out how just feasibly…because you can short this on various exchanges, but you can’t do it as a fun because it’s technically illegal for a U.S. person to do it, so you gotta figure out a way to do it.
What people generally do is they lie, and they go through VPNs, and pretend they’re living in Mexico, But you don’t wanna do that as a fun because that’s not legal. So anyway, yeah, just as a lot of fun. And I think, you know, in 30 years, it’s gonna be where you want to be because I think the dollar will be worth, you know, not much because I don’t see how else we’re gonna pay off all of our pension debts and all those, I don’t know, off-the-book liabilities without inflating our way out of them.
Meb: Talk to me a little bit about the future. So you mentioned 30 years from now, is this something…how do you think about how they change the landscape of finance? You know, is this become a staple of investor portfolios? Are people gonna use it mainly as contender in the currency space? What’s your general beliefs here as we look out of the horizon?
Eric: Well, yeah, it’s not gonna replace stocks, it’s just gonna replace dollars, I think eventually. Like, in 100 years, I think it’ll be crypto not fiat money because the governments will have…you know, they’re gonna blow up all their credibility. And you’re gonna wanna go to something that’s trustless that can’t be monkeyed with by politicians.
So in the long run, that’s the currency you wanna be in. But the companies are gonna still have to exist and always be a profit rate for companies because if there’s no profit, there’s gonna be no company. So in the profit rate in the U.S. has been kinda constant over the past hundred years contrary to what Marx thought when he thought that the profit rate would go to zero. So that’s just the equilibrium. And so they’re gonna make whatever the money is. But I think, you know, at some point, there’s gonna be a tipping point. It’s gonna be episodic. There’s gonna be some big events. And then Bitcoin, or Ethereum, or someone’s going to take over, and that’ll be the means of payment.
Meb: We’ll, just promise me when you launch your low vol crypto fund that you instead brand it as the
defensive or conservative crypto fund.
Eric: Yeah, I’ll do a tactical… Tactical is goo, a quant tactical crypto.
Meb: Well, we’re gonna bounce around. We’ve kept you long enough. A few more questions I think would be fun. One, you’ve published a few books, but I thought one of the more interesting was this concept of your book, “Maxims.” You wanna tell us what the history of that was?
Eric: Oh, yeah, it was fun. So my son was leaving to college. And it’s your kid and you want him like, “Oh, geez, what are some good things I want him to know.” And so, you know, I would think, “Oh, I should really have him know, you know, moderation in all things. That’s a really good thing to know.” And then I wrote down like some of my other, like, favorite ones. And I like quotes, so I kept, you know, a couple other quotes. And so then I thought, “Well, I’ll just put it in a book and give it to him.” And so it was just fun for him or fun for me.
And, you know, what you find is, you know, if you wanna understand life, it’s not, like, know one thing. You know, there’s like lots of things to know, you know? It’s not like, “Oh, all you have to understand is love, or know thyself, or, you know, whatever.” But no, there’s like a couple hundred things you should know and go to the easiest way to learn them. And so I put those in a book. And it was really cool because I could do it online. And there was, like, five bucks. And so I’m like, “Great,” you know, just something to make a way.
I was really worried, you know, if I got killed or something, and, you know, I wanted my son to, like, know, “Oh, it’s really important to know,” whatever, you know, and to be greatest, to be misunderstood, or knowledge can be communicated but not wisdom, or, you know, 90% of everything is crap, you know, it’s just…
Meb: I liked a couple of them, but under the purpose tab was seek above all for a game worth playing. I think that’s a great commentary on a lot of what you and I spend our time thinking about. And it’s deeper than the quote sounds, you know, but I loved it. So anyone else buy the book?
Eric: Yeah. No, I sold actually about 250 of them, so not bad.
Meb: Oh, that’s great. That’s awesome.
Eric: I just priced that it kind of like, you know, par, so it’s not a big deal. Yeah, it’s a fun thing to do for your family. Actually, it’s really cheap to do.
Meb: So for someone who’s got a curious mind, just thought about all sorts of different stuff in this career, anything else does you sit back in your chair that has got your brain worrying anything that you’re thinking about these days, whether it’s markets or anything else? I imagine a lot of it’s crypto-related, but what else is on your brain these days?
Eric: You know, just about that. You know, I became a Christian a couple years ago, so I spent a lot of time in Bible studies now and do a lot of that stuff, but that’s kind of off topic. I find that very rewarding. But I mean, I like to just read lots of stuff about science, and finance, and keep up on that stuff. But there’s always more books I wanna read than I can. And so there’s always…
Meb: Any favorites lately? I need some good inspiration. I’m in a law. I find myself more and more…in the last half dozen books I’ve been through really struggling with them. Any favorites of the past year or two? By the way this this question is impossible for me to answer, so…
Eric: Yeah. [Inaudible 00:45:55] at the top of my head of…let’s see. Yeah, doing a lot of the Bible study-type books which is interesting. Now, I don’t remember the ones I really likes, but…
Meb: All right. Well, if you think of any that were astonishing…
Eric: You know, I’m a big a fan of Jordan Peterson. I really liked his “12 Rules of Life.” I get it to my son too. That’s a good one for him I thought.
Meb: Perfect. I haven’t read it. So as you look back over your career, and I think we already did the punchline in the beginning of the talk, but you may have to think of number two. But we’d love to ask the guests, what’s been your most memorable trade or investment over the course of your career? And if the puts is number one, you have to answer what’s…is there another one that comes to mind? Anything in particular that really stands out?
Eric: Well, you know, after that, I remember I was a little overconfident. So I thought, “Oh, I’ll trade these things.” So I remember back then, I had to call on the phone and then I wanted to buy a put on or call on a specific stock because, you know, the Fed actually lowered interest rates right away. And so via the Minsky model where the Fed really kinda controls these things, I was confident that the market was gonna recover, which it did.
So I picked out a specific company because I figured…you know, so I remember it was bought, like, there are some retail company, like, May company and May stores, and I bought an out-of-the-money call, and it was treating it like a dollar and a quarter. And they said, “Oh,” you know? And they called me back five minutes later and said, “You got filled at a buck in three quarters.” And I’m like, “Oh, I got it just as it’s going up. Great.”
But then I realized, the price didn’t change. So basically the bid-ask spread was like, you know, you buy it for a buck in three quarters and you sell it for a buck in a quarter. What’s the transaction cost on that? That’s like, I don’t know, a quarter divided by true value is one and a half. So anyway, the spreads on those options back in late ’80s were so high, you know, just two or three trades and I was down like 40%. And the market didn’t move. And I’m like, “What’s going on?”
Meb: You know, that’s actually a pretty, I think, useful example a lot of people spend almost all their time thinking about, you know, the right investment. And so a little time thinking about the plumbing. I was getting into of a fees, and transaction costs, and all the boring stuff, taxes. I got into a bit of a Twitter fight this morning because I was giving a really hard time to this very hot startup that has, like, four million users that it’s a savings and investment app. And, you know, they make it sound like it’s a great deal because they only charge $1 to $3 a month. But in reality, the average account size is only 250 bucks.
So these people are paying 5% to 15% per year. And they’re registered as an investment advisor. So technically, fiduciary. And I said, “Look, you know, it’s great that all these…” Millennials hate going into branch banks anymore but, you know, in the meantime, you’re paying 10%, 15% a year on a savings account. So, you know? And man, you should have seen the reactions. Many of which were, “What are you talking about? I don’t pay any fees.” So the important stuff is often not necessarily the investment side but everything else.
Eric: Yeah. Free is always the most expensive way to do something. And when somebody says like, “Oh, I don’t measure my trading cost because I’ve got more bigger fish to fry.” It’s like, “No, you don’t.”
Meb: Eric, where can people find if they wanna follow your updates, writing, everything else? Is the blog the place? Where should they go?
Eric: Right now, I’m basically most active on Twitter. I don’t really update my blog much anymore. You know, you can go to @egfalken, Eric George Falkenstein, @egfalcon at Twitter, type in my name. But, you know, I’m pretty much off the grid now especially, you know, doing my crypto stuff. I can’t really talk about that too much because I am trying to create a fund. And so that’s, yeah, you know, there are all those restrictions on that and stuff.
Meb: I hear you. Well, look, we’ll post show notes links to your books, and papers, and the best places to get in touch with you, and people can pick fights with you on Twitter as well. We’ll post links. Eric, it’s been a blast. Thanks for taking the time to join us today.
Eric: All right, great, Meb. Nice talking to you.
Meb: Listeners, thanks for sitting in. We’ll post the show notes I mentioned on the blog at mebfaber.com/podcast. You can always subscribe on the various apps, Overcast, Breaker, Stitcher and leave us review, got over five-star reviews. I promise, we read every one of them, and loved it, and really do appreciate it. Thanks for listening, friends, and good investing.