Episode #181: Radio Show: Zero Trading Commissions…Valuations…And Trend Following
Guest: Episode 181 has no guest but is co-hosted by Justin Bosch.
Date Recorded: 10/11/19
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Summary: Episode 181 has a radio show format. We cover a variety of topics, including the new ETF rule:
- Major brokerage firms dropping ETF trading commissions to $0
- New ETF rule
- Market valuation
- Trend following
- Investment Process
There’s this and plenty more in episode 181.
Links from the Episode:
- 0:50 – Welcome
- 1:27 – The trend toward commission free trading
- 3:12 – How these companies make money off your accounts
- 6:04 – Use this news to get your accounts in order
- 7:14 – The ETF Rule and how its impacting the mutual fund industry
- 13:02 – Overview of the US stocks
- 17:53 – Global valuations
- 17:58 – John Hussman post on twitter
- 21:09 – How to use trend following in this market environment
- 22:53 – Recession risks and how investors should incorporate it into their strategy
- 23:24 – The Meb Faber Show – Episode #172: Cam Harvey, “This is a Time of Considerable Risk of a Drawdown”
- 23:25 – The Meb Faber Show – Episode #171: Raoul Pal, “Buy Bonds. Buy Dollars. Wear Diamonds.”
- 26:34 – Listener Question: Power Laws dominate investing and the difficulty in shorting
- 29:51 – Listener Question: How do you judge a manager
- 33:09 – How investors should evaluate a manager’s process
- 34:56 – What if 8% is Really 0%? Pension Funds: Investing with Fingers-Crossed and Eyes Closed (Faber)
Transcript of Episode 181:
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: Hey, podcast listeners, it’s been too long. We got a radio show for you today. And not only that, it’s almost the end of the year. It’s Q4 2019. In less than 100 days, we’re gonna have to start saying 2020. That’s a new decade. It’s a pretty good time to reflect. Today, we got Justin to join us here in the studio. Welcome.
Meb: How are things going? Are you ready for 2020? I’m not.
Justin: No, I’m still in 2019 mode.
Meb: It’s, kind of, creeping up on us. I feel like there’s not been a lot of talk about the decade ending but starting to see a little bit.
Justin: Yeah, I haven’t seen any talk on until I was speaking with you the other day about it.
Meb: So what’s going on in the world? What do you know?
Justin: Some big news lately. Why don’t you get into it with us? No commissions.
Meb: Yeah, man. So this is interesting where listeners if you haven’t seen it, and I’d be surprised if you hadn’t, a lot of the big brokerages have announced a move to no cost, zero commissions for online ETFs as well as stocks. And this is something that was really a long time in the making. If you look back a couple of decades ago when Dean Witter and a lot of these old school brokerages around, E.F. Hutton. I mean, Schwab used to charge $150 a trade plus basis points of the commission, right? So it ended up being hundreds of dollars of trades. They kept going down and down and down. I remember my first electronic online brokerage was E-Trade. And what happened was you had this startup, Robinhood, which many are familiar with. It really pioneered no cost trading. Then eventually, the other dominoes started to fall.
So, a lot of them were low cost already, so you had five bucks or maybe a penny a share. Well, you have Vanguard that announced no ETF cost trading last summer. And then Interactive Brokers was really the first of the majors. And then within the course of a week, you saw, and I can’t remember the exact order, Schwab, TD, Fidelity, boom, all zero. And this is awesome. And for the end investor, paying less cost is always a great thing. You know, it doesn’t mean it’s an excuse to go and trade your account a bunch and churn it. But anytime you have to pay less is better than paying more. So the first caveat is you should definitely be at a brokerage that charges nothing to trade.
But also this is a great time to look back and reflect because a lot of investors don’t realize that commissions are probably one of the lowest expenses to your actual account. And so if you have an account with one of these big brokerages, let’s use Schwab as an example. The way that Schwab makes money, so people said, “Oh, my God, I can’t believe they did this.” Well, Schwab only gets like 5% of its revenue from trading. So it’s, yeah, maybe it’s hundreds of millions of dollars to them, but the overall piece of the pie as a percentage, it’s no longer that material. They make half, half of their revenue from simply interest. So they’re basically a bank. And what does that mean?
So let’s say you have $100,000 in your brokerage account and you know what? You got a bunch of Cambria ETFs, but you, maybe, have 10% in cash. Well, a lot of people are like, “Well, that’s not a big deal.” But Schwab probably pays you zero on that. And there’s the competitors, whether it’s money market funds or anything else, you should be getting paid 1.5%, 2% on that and it’s totally protected. But a lot of these brokerages don’t automatically sweep you into those if you didn’t sign up for a certain fund when you open the account. I guarantee you we did a Twitter poll on this. Most people don’t know what the cash on their investment account earns. So the same thing extends to your checking account, bank account.
This is also getting pushdown. So, Wealthfront announced this, Betterment announced this and now a lot of the brokerages are trying to catch up. Betterment, you can go sign up for their checking and savings account and they pay 2% and it’s protected under the guidelines. I forget if it’s up to like a million, or what they have are the various rules because traditionally, it’s only $250,000 in cash. But regardless, this is the way that a lot of these brokers make money. That’s the way Robinhood makes money, one of the biggest ways. And then there’s two other smaller ways these brokerages make money. One is payment for order flow, meaning they sell your orders to a lot of these high-frequency firms. I don’t think that’s that big of a deal. Some people do, they consider it a cost. But if you’re using limit orders, and you’re trading liquid names, and you’re a long term focus, it doesn’t really matter.
And then the last would be if you have a margin account or you’re trading in an account that allows it, you checked a certain box, then these brokers can lend out your shares to short sellers, they earn interest on that. And unless you designated, they’re not going to share it with you. And we’ve talked about this a lot on the podcast before. That can be a very material source of revenue. We have some funds, all of our funds do this, but we have some that, we can’t promise it, but very well could generate 10, 20, 50 basis points of revenue and one in particular, probably our cannabis strategy could generate hundreds because they’re in demand, short companies.
So anyway, the whole summary of this discussion is, as you reflect at the end of this decade, first of all, make sure you have your house in order. The base case, starting point, if you’re an investor, is you should be paying zero commissions. You should be earning a reasonable amount on your cash balance. So I guarantee you go look up your Bank of America, it’s probably zero. You should be earning 2% on that. And some people listening have a very material cash balance. So some people we talk to have $1 million, $10 million sitting in cash. And by cash, they mean real cash, not cash earning 2%. And that’s just lazy and gets to be a very big cost. The others are less important. But as you take the year-end time to reflect, it’s important to look at all those things.
Now that has implications also for the brokerage industry. You know, we joked on Twitter that the brokerage industry is really a terminal short at this point because of the disruption going on. It’s going to be a really tough business in the future. But the asset management business too. And that probably leads into the other big piece of news, the ETF rule. I feel like I’m doing all the talking. But feel free to chime in at any point.
Justin: That’s okay. No, no, no. No, it’s good.
Meb: I have a lot to say in these topics.
Justin: Yeah, and I want you to. So give us a rundown of the rule.
Meb: So the ETF rule, I feel like a lot of the commentators picked up the first part, which is the ability to launch ETFs is really a patchwork put together over the years where you had to get an exemption and used to cost a million bucks then it cost us I think probably 200 grand. Now it doesn’t cost that much. But you had to get all these different…each one was unique. So, whether you’re active, whether you’re passive, yada yada, yada yada. SEC finally just said, “You know what? We’re going to streamline this.” So it’s way easier to launch a fund now. And that’s what the media picked up on. However, there’s a more important piece, and without spending the next two hours on the esoteric nature of this, the summary is that it allows active ETFs to have the same tax treatment as passive index ETFs.
Well, why does that matter? Well, if you have an active fund that trades 50%, 70%, 300% turnover, normally, that would generate a lot of capital gains transactions. And you see that with mutual funds. It’s like 60% of mutual funds have capital gains distributions every year when the number of ETFs is only like 6. So the ETF structure, now with active funds as well, allows ETFs, all of them, for…and we’re talking about plain vanilla, we’re not going to get into the weird stuff, plain vanilla stock ETFs to be vastly more tax-efficient than their mutual fund counterparts. And that’s important because the vast majority of the assets still in active equity mutual funds hasn’t been disrupted by the ETF structure yet.
And so this could be one of the final dominoes that’s starting to really put the nail in the mutual fund coffin because now, the average ETF is half the cost of the average mutual fund, and the average ETF in the equity world, my estimate, and there’s others that have given more and less, is about 70 basis points more tax-efficient than the average mutual fund per year. In 2019, I guarantee you, listeners, look out. So, beginning of November, you’ll start to get mutual fund estimates of capital gain distributions. And we have a big fat up year in U.S. stocks. And I guarantee you, you’re going to be shocked at the amount of distributions a lot of these mutual funds will distribute in capital gains when an ETF, it should be or usually, is near zero. I don’t think the SPDRs have done a capital gain distribution ever, all the way back to 1997.
So this is important and I think it’s interesting, you know, to me, going back to the base case, you should pay no commissions, you should be earning 2% on your cash balance, but the base case is also you should use ETFs. And anyone that’s owning mutual funds at this point, we did a tweetstorm about this, I said, you know, you better have a good reason why you own mutual funds because you have two major hurdles of fees and taxes that add up to 150 basis points, 1.5%-ish, right around there. Maybe it’s closer to 1.2%, so let’s say 1.2%. So your mutual fund manager has to generate 1.2% alpha just to get over the structural disadvantage. So it’s something that I think is it’s always useful to reflect that you’re in. It’s also useful to reflect a decade in as the portfolio you have. And most people we talk to, this goes back to our old zero budget portfolio. You know, if you pull out a white piece of paper, have a glass of wine, write down your ideal portfolio, and if it’s not the same as what you own now, there’s something wrong.
So, you know, these are part of the things that I think it’s important for people to look at year-in. It’s wrapped in this whole concept of, you know, what we’re talking about with what’s going on in the industry. And then for the ETF-industry folk out there, you know, I think this could be the dam that really breaks when you start to see a ton of flows. Because the funny part about the ETFs that are now commission-free everywhere is mutual funds still have to pay a huge toll, which is, I mean, my poor mutual fund friends, you know, Schwab has to publish this because it’s a public company, but they charge these mutual funds just to be on the no-transaction-fee platform, anywhere from point 0.4% to over 1% just to be on the platform and have no commissions. And so if you think about it, I used to laugh, because I said, half the ETFs out there, you know, they charge less in total fees than you’re charging the mutual funds to be on the platform. So the mutual funds are, kind of, hosed. And so there’s going to be this big fight coming up between mutual funds hopefully saying, “Hey, brokerage platforms, pounce in. We’re not going to pay these fees.” But Schwab makes a billion dollars a year from one source.
And so, you know, in both cases, this is the old guard, this is the dinosaurs, they have two choices. They can ride the gravy train for as long as possible. And plenty will. You know, if you’re 60 years old, 50 years old, 70 years old and you’re in that business, you say, “You know what? I’m not going to be around long enough for it to matter. We’re going to ride our dividends the next 10 years. Hopefully, we don’t get disrupted too quick.” And the flip side is that you got to disrupt yourself. If I was a mutual fund listening to this, I would, tonight, I would have done it yesterday, but tonight, I would transform my mutual funds into ETFs. And that’s doable. That’s actually not hard. The problem is you’re starting to cannibalize your own revenue streams. But the question is, will you survive otherwise? Anyway, we’re getting too deep in this for most people. But I think it’s really important these major tectonic shifts happening in the asset management world and I think at the end of the day, no matter what, it’s a great thing for investors across the board.
Justin: Agree. Agree. Well, let’s hop into some market topics. U.S. stock market, still expensive. Why don’t you give us a quick rundown there? And you have a few stats to support.
Meb: Yeah. Well, you know, I mean, look, listeners are probably bored to tears listening to me talk about this but we did a fun tweetstorm to put this in perspective. So if you’re just looking back and reflecting, again, you’re sitting in your lazy boy watching the Broncos this weekend, depressed about it, having a tea, having a beer, maybe sipping some champagne. Let’s call it year-end, December 31st. It’s New Year’s, you’re cheersing your loved ones and saying, “Man, what a great decade it’s been to be a stock investor.” And it’s been one of the top…if you go back to the last 11 decades, it was one of the top 5 best performing decades and we’re talking about after inflation. So real returns to equalize decades. One of the best top half decades ever. I think we did around 10% plus inflation that’s probably around 12. So monster returns. Obviously, we’re coming out of the global financial crisis, but one of the best return decades ever.
But perspective, so we said, “Let’s look back and see how that compares and if there’s anything we can learn from that.” So the average, after inflation per decade return for stocks has been 6.6%. And again, you add back in inflation, that gets you up to around the historical, almost 10% return to stocks. But 6.6%. The worst decade was -3.4%. A, that was post technology, internet bubble. So the 2000s ending, really at the end of the financial crisis. So pretty tough starting and ending points, but you also had about 3% per year. The best was a whopping 16.7%, nifty ’50s, 1950s exciting time and electronics. And so if you said, “Okay, well, let’s look at the three worst decades,” which would have been the 1970s, which got hammered by inflation, the 1910s, and 2000s, the average across those three was -2.6% per year.
And then the following decades, so that’s pretty depressing, right? You lost money over the decade. The future decade after those averaged 12.3%. So well above average, a double average, actually. That’s awesome. So, had you just followed this stat after the 2000s, you would have said, “You should expect double returns than average.” And you came pretty darn close to that. If you look at three best decades, the roaring ’20s, the nifty ’50s, 1990s, which I grew up in, just assume that was normal, average real return was 15.8%. So, again, plus inflation that puts you up close to 20. Future returns the next decade were only 1.1%, which is terrible. So what you’ve seen is this mean reversion after times of romping and stomping bull, followed by usually subdued returns and vice versa.
So, if you were, kind of, extrapolating and saying we’re ending the decade at 5th out of the 11th, you should expect slightly lower returns in the 2020s but still positive. You know, you could do all sorts of regressions but, again, you’re only using 11 data points, so you can’t extend too much. BUT, this is where my capital BUT…And there’s a famous saying, you should ignore everything that was said before the but and only listen to what’s said after that. It shouldn’t be any surprise to anyone that after the three worst decades, at the end of the decade, valuations were subdued, meaning after you had terrible returns, not surprisingly, valuation multiples contracted. So the average long-term P/E ratio of only 11.7. So if you think about that, that’s a great starting point. But after the three best decades, valuations on average ended at 28.3. So, over double, almost triple the low decades.
So where do we stand today? We have the fifth-best performing out of 11, but we have the second-highest valuation out of 11. This is a long-term P/E ratio of around 30. So, you know, the quick summary, and this is for super long-term perspective, obviously, celebrate the hell out of this great 10-year return, drink a bunch of champagne, be excited about the end of the 20, whatever we call these, 20 teens. But come 2020, sober up. Take your medicine and set expectations realistically and consider a decade in the future with very probably lower U.S. stock returns.
Now, of course, the caveat. Everyone knows here I love foreign markets better. I think they’re much cheaper. So a great way to tilt. And so there’s a little bit of subdued optimism. But for most people that are U.S. listeners, they have 70% to 80% in the U.S. market. So it may be a good time to really think about investing at least half in foreign markets.
Justin: And where do we stand on global valuations?
Meb: One more comment, by the way, because my good friend, Jon Huntsman had a post on Twitter about a month ago where, you know, every market is different. So if you look at the late ’90s, you can’t just say the stock market because you have thousands and thousands of stocks that make up the stock market. And the late ’90s was the biggest bubble we’ve ever seen. But it was fairly concentrated to a lot of the tech, and IT, and biotech. And so, a lot of the big stocks turned out to be tech too. But you had this crazy bubble where the P/E ratio of the overall market was 45. But it was really condensed to a lot of specific companies. And so if you had a value or a dividend approach, you actually did quite fine from 2000 to 2003.
Now, you have a scenario where if…he broke it into deciles, so 10 different deciles or buckets of the U.S. stock market and he did the S&P 500, so 50 companies each, the difference now is that everything is more expensive. That most expensive decile is not quite 2000 levels yet, but it’s more expensive than any other period. But everything else is more expensive than 2000. So think about it this way, it’s not a concentrated bubble like ’99, where it’s all in a certain amount of stocks, it just happens to be that the entire market is elevated and more expensive. So there’s probably what you would consider to be less places to hide.
And obviously, my takeaway is that if you look at the rest of the world, foreign developed is coming in at, sort of, the low 20s. So a totally reasonable valuation for a low inflation environment. For an emerging, which is my favourite, is probably around 15.An d then, of course, my real favourite, if you move beyond just main indices is the cheapest bucket is down around 11 or 12. Again, an interesting part is a lot of those countries are having a great year this year. So two of the best-performing countries in the world, Greece and Russia. It’s going to surprise everyone listening that Greece has the highest PMI in the world. So their economy apparently is doing great.
But again, valuation is a blunt tool. We don’t know when it turns, but in general, you know, as you reflect on this decade, but you know, again, I’ve been saying this for a few years, it makes a lot of sense, I think, to tilt away from the U.S. and towards the rest of the world.
One more thing that I think is important as you take all this information in about what I talked about with ETFs, what we talked about with commissions and your accounts, and you re-evaluate and look towards the future, one of the big benefits, of course, is also to be tax-aware. And so we always tell people if you’re using automated brokerage, Vanguard just announced, by the way, that they have an automated brokerage option, a true robo-advisor, which all in is gonna be 20 bips. They do a great job of tax-loss harvesting, but if you’re doing it on your own, it’s something to consider. And so with a lot of these funds, a lot of strategies, if you have some losers, you can sell them and replace the other funds, consistently bank ones. We just launched a cannabis fund which probably has the best tax-loss harvesting potential of anything because every single one of the other ETFs, including our own is at all-time lows. So it’s an interesting time to be thinking about that.
Justin: You’re a trend follower, wanted to get into this a little bit, kind of, on the subject of valuations as well. Something that, you know, everyone has, there’s all kinds of views on this, how to use it, what it really should look like. But in general, where do you see trend following stacking up, whether that be on its own or, or as a way to, sort of, look at triggers or signals when we see some of these very expensive or very inexpensive markets around the world?
Meb: You know, I mean, trend following is having a pretty good year. It obviously depends on how you define it, but the managed futures complex is actually having a pretty great year. But traditional trend following is doing just fine. The consideration is always that if you look at trend following bucketed per market or as an entire portfolio, you know, I think we go back to our old, very old discussion on trend in value in the U.S. stock market where we put it into four buckets. The best performing has always been a cheap uptrend. And the worst performing is an expensive downtrend. And right now, we’re in the second-best performing bucket, which is an expensive uptrend.
And despite, you know, I feel like the media, and Twitter, and everyone feeling like pulling their hair out. I mean, the markets up depending on when this publishes 15%, 20% this year. It’s had a monster year. So the trend has still been positive. It gets hairy when that trend rolls over. And whether that happens 2019, 2020, 2025, who knows? But that’s the nice thing about having that approach is its objective, you can have it rules-based. But as far as right now, the U.S. trend is up but, you know, that’s something to be wary about, particularly when markets are elevated.
Justin: Yeah. And let’s get into that a little bit. Some of the risks we have with these late-cycle situations or late-cycle moves, at some point, may not ever happen, I don’t know. But at some point, looking at history, we may have a recession coming down the pipeline. Risk we run, definitely holding expensive assets and at the end of cycles. So you had a couple of great conversations with some fairly well-known people in finance, Cam Harvey and Raoul Pal. They both had some warnings on their assessment front. Give us a little rundown of what they were talking about and what your thinking is on that, how investors, maybe, should be incorporating this thinking into their portfolio?
Meb: Yeah. I mean, you know, Cam, certainly the big yield curve guy, Raoul, the big PMI guy. I think both things are indicators that are worth being aware of. You know, if you look at stats, we had a Ned Davis stat that I’ll bring up as well. We were talking about interest rate cuts and how this all plays in. And the interesting part is after the first Fed cut, this goes all the way back to 1950, actually, over the next year, you had earnings down on average, it was about 8%. But you also had SMP up 14% on average. P/E ratio also went up. So, in other words, people, the multiple expanded. And so as far as the timing on a lot of this stuff is always, you know, who knows? Is it this quarter? Is it 2020? Which quarter in 2020? Who knows? And that’s the hard part. If you’re a subjective investor, which is why, of course, we use trend as our final determination.
But you’re seeing a lot of these signs. You know, you’re seeing where the PMI is really weakening in a lot of different places. They’re strong in a lot of places but there’s just a lot going on that I think gives people pause. But, again, I’m a trend guy and so until that final red light is flashing from yellow to red, it’s not the final say.
But you’ve also had a monster year this year too of bonds. Man, what a fantastic year they’ve had. Not a lot of people predicting U.S. bond yields going down as low as they have. I got an old tweet I retweet every once in a while, I said, “Wake me up when the U.S. bonds hit point 0.5%,” because we’re living in a strange world of negative interest rates in so many places. And who knows where they go from here? Certainly, I don’t.
But real estate has had a fantastic year too. I think the asset class that’s probably been the biggest laggard has been commodities. You’ve seen precious metals pick up a little bit. But some of the big shops we’ve tweeted out have particularly strong expectations for commodities going forward. Vanguard, of all people, I think said commodities would be one of the best-performing markets over the next 5, 10 years. So it’s an interesting…because you go back a decade ago, pre-financial crisis, and everyone wanted commodities. Oh, my God, that was the big diversifier and then most of the people have puked them out since. Anyone who allocated a big strategic allocation of commodities in the 10 years since has probably sold it, except for us, we still like them.
But at some point, that will turn as well. When? Who knows? But at some point, you’ll see an uptrend and strength there. But precious metals certainly have been doing well. Part of that is historically, gold seems to do great during negative real interest rates. So we’ll see. Who knows?
Justin: Moving on, we have a couple of listener questions. So, first off, “Meb, you’ve talked several times about papers that look into what percentage of stocks make up the most of returns, which find that it’s a small percentage and a lot of stocks fail to be T-Bill returns.” I think the conclusion most people reach is that since it’s such a small percentage, and it’s hard to know which stocks are going to be the top, then the best solution is to index. Also, I’ve heard many people say that shorting is very difficult since stocks mostly go up over time. But aren’t these two conclusions contradictory, if most stocks fail to beat the index and a significant percentage of them fail to beat T-Bills, then shouldn’t shorting be easier since the chances are that you short a stock that doesn’t even beat T-Bills? All of this before costs, of course. Obviously, it isn’t that easy, but I fail to reconcile the two conclusions. Would love to hear your thoughts on this.”
Meb: The reader hits on a very important concept of power laws dominate everything around us when it comes to investing. So talking about the stocks that return 10, 100 times your money, the McDonalds, the Walmarts, the Googles, the Amazons over time. And so if you index you’re guaranteed to own those, you’re also guaranteed to own the losers which are most stocks. And on the flip side, shorting, the difficulty with shorting is numerous. One is that, yes, on average, are you going to pick a stock that will underperform the index? On average, yes. But you’re also, on average, going to pick a stock that could be a 5, 10, 100 bagger, in which case, you’re going to lose all your money. And so it’s a position-sizing issue.
On top of that, it’s almost impossible for investors to short because of the cost of borrowing them, etc., etc. There’s a bunch of number of other considerations. And it’s also just a losing game. In general, you have a headwind of shorting that the market historically goes up almost 10% a year. So, what you do when you have concentrated portfolios is, again, you’re hoping that the characteristics you include in that portfolio gives you a better chance of outsized returns over time. And what that magic number is, there’s somewhat of a tradeoff where if you’re too small, you run too much risk of not having the right stocks in that portfolio. So if someone buys a portfolio that says 5 or 10 stocks, is that enough? That’s tough because if you miss the big winners, then you’re really going to underperform.
Now you may get the big winners, in which case you really outperform. But if you own 500 stocks out of the 3,000 out there-ish, is that enough or is that too many? Are you going to lose some of the benefits of having a concentrated portfolio? You know, we tend to settle on around 100 for us. Some of our friends like the Alpha Architect crew, I think does 50, some do more. And granted, we’re not a $50, $100, $500-billion shop, so we don’t have to worry about it. But in general, I’m comfortable with around 100 for enough breadth to capture the big winners, but also concentrated enough for it to make a difference. But again, the shorting side is hard. We prefer to short through indices and derivatives as a way to capture the short side of the book versus individual names, despite how much fun it may be.
Justin: So next question, “Meb comments there are a lot of managers that fail to meet their benchmarks, which is backed up by evidence. Meb also mentions you can’t judge a manager on the short term but need to stick with a strategy for a market cycle, say roughly 10 years. But he has pushed this out to 20 years recently. So my question is, how do I tell if the manager’s system is just terrible, broken, out of favor like value versus waiting for 20 years to realize they were wrong? If I work 40 years and waste half the time on a bad manager, I have to make that up on the backend if I have less time for compounding.”
Meb: You know, I think this is a great argument for why you shouldn’t be mucking around with discretionary managers. It’s so hard, you know, trying to pick stock pickers. Like all my friends that work at these big endowments or CalPERS, etc., who spend all day interviewing managers, I don’t envy them because, I mean, it is kind of fun, but I don’t envy them in the sense that, how do you know when that manager has just become complacent in their wealth? They’re not excited about going to work as much now that they have a hundred million dollars as they did when they had zero? How do you know they’re not going through a divorce? How do you know they’re not abusing substances? How do you know, you know, that they’re…or is it just their style is out of favour? Right? So these are really hard questions. And honestly, it’s a game that I just…I don’t particularly really want to play.
On the flip side, applying that to assets, asset classes, strategies, you know, I think it goes back to the old concept of process over performance. If you were to simply look back over the last 10 years, you would say, “You just put all your money in U.S. stocks. Why would you do anything else? That’s crazy.” But if you looked at the process, you would realize, “Hey, these asset classes go in and out of favour. And U.S. stocks had a terrible run 10 years prior and other stocks did great, or other asset classes,” excuse me, and there tends to be a season for all of them. So I think once you build in a good process, then it’s a scenario that I feel a lot higher level of confidence that it’s going to be repeatable. But so let’s say someone says, “Well, Meb, what about value? You know, at what point do you think value doesn’t work anymore because it hasn’t been great this past cycle?” Or whatever it may be. You know, to which I would say I would have a hard time disbelieving in the concept of value because what’s the alternative? Just to buy investments without any regard to valuation whatsoever? That seems crazy to me.
So, you know, you eventually, at some point, get comfortable with whatever your process may be. The hardest, certainly, is just handing over the keys to discretionary managers and saying, “Have at it.” You know, do I think those people exist? Absolutely, but introduces so many more potential fractures of where there could be failures in the whole process. And evidence shows, for the most part, people are really bad at timing the entry and exit points with these managers. Usually, they just chase performance, buy them after they’re hot, sell them after they’re cold. Reams and reams of evidence on that, you know, and so to me, I think it’s just much simpler to come up with a strategic allocation and just let it go on autopilot.
Justin: So I do want to ask, get into this a little bit deeper, if you can, how should investors be thinking about evaluating process? Because there could be somebody who literally has just a written process, there could be managers who have thorough processes that are rigorous in all kinds of forms, how should they be looking at it?
Meb: You know, it’s a personal question. I think we encourage people to develop a written investing plan. Most don’t. Vast majority of people don’t. I’d probably say 90% don’t, and to at least write it down and try to work out your thoughts. And that could be as simple as, “You know what, I do 60/40 rebalance once a year. That’s what I do.” “I invest in Vanguard’s automated digital robo-advisor.” “I dollar-cost average. That’s what I do.” “I buy top 20 dividend stocks.” You know, whatever it may be. I think it’s important to find something that really resonates with you and your personality. The challenge for a lot of people, they think they know what that is until they go through the hard times. So they say, “Yeah, I got this aggressive portfolio, I can invest a ton in stocks,” and then stocks go down 50%, like they do all the time, and they go, “Oh, my God, I can’t take it. I gotta sell. This is crazy.” You know, it just, it doesn’t relate to with what they thought they would behave like in the beginning.
And so, you know, having a thoughtful respect for history, studying how markets have done historically, stress testing them through different environments, but also realizing that the future is going to be different than the past, you know, I think is all important. And, you know, trying to come up with the base case expectations and what we tell people, you know, we say, “Look,” I still laugh at all the 8% expectations for pension funds and endowments and everyone else, they’re starting to come down a little bit. But I laugh when we wrote a paper on this called “Investing with Eyes Closed and Fingers Crossed,” something like that, you know, where historically, these strategic allocation portfolios have returned about 4%, 5% plus inflation. So if you’re in a no to low inflationary world, how are you magically expecting 8%? And particularly adding on the fact that bonds now are yielding 1%, 2% if you’re lucky. Half the world, they’re negative. So where are you gonna get that return? Well, if you’re expecting them from stocks, where U.S. stocks are expensive, it’s going to be tough sledding.
So, anyway, you know, I think all this comes to having a respect for history, having broad expectations that are reasonable as opposed to most who are unreasonable. Most investors expect 10% plus, and then just trying to think through it and resisting the urge and temptation to chase returns, urgent temptation to muck with the process because most of us want to. It’s very seductive and easy to do. Particularly now that commissions are zero. It costs you nothing to mess everything up. But in general, just think about the process and be wary of fees, taxes, everything else in between.
Justin: Great. Solid advice. That’s all I got today.
Meb: All right, good. Well, listeners, it’s been a while, we need some more ammo. Send us feedback, questions, we’ll add them to the queue, firstname.lastname@example.org. Enjoy hearing everything you have to say. Leave us a review. We love to read them. Maybe we’ll start reading some of the reviews on the air. Subscribe to the show on iTunes, Breaker, anywhere podcasts are sold. Thanks for listening, friends, and good investing.