Episode #210: Jonathan Treussard, Research Affiliates, “Be Aware Of The Cracks Under Your Feet”
Guest: Jonathan Treussard leads the Product Management group at Research Affiliates. He contributes at the intersection of investment research and business strategy, and is a permanent member of the Investment Committee and the Product Management Committee.
Date Recorded: 4/3/2020 | Run-Time: 56:11
Summary: We discuss what’s currently going on in the world around us and how rapidly things are changing. We cover the idea of “nowcasting,” and how it’s different from the type of forecasting and opinion that prevalent, often unhelpful, and sometimes downright detrimental to investment decision making.
We talk about Research Affiliate’s stance on valuations, emerging markets looking attractive, and having discipline when it comes to analyzing data to form a sensible guide to forward looking expectations. We get into factor investing, value investing’s underperformance, and the behavioral struggle investors have with it.
As we wind down, we chat ESG investing, and hear a candid take on the industry’s approach in helping investors prepare for retirement.
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Links from the Episode:
- 0:40 – Intro
- 1:50 – Welcome to our guest, Jonathan Treussard, and background on his early education and career
- 2:48 – The way the world looks to Jonathan, today
- 2:57 – The Meb Faber Show Podcast – Episode #18: Rob Arnott, “People Need to Ratchet Down Their Return Expectations”
- 2:58 – The Meb Faber Show Podcast – Episode #193: Chris Brightman, “Here We Are With Emerging Markets Again Trading At A Shiller PE Multiple Less Than Half Of The US Stock Market”
- 3:00 – The Meb Faber Show Podcast – Episode #52: Jason Hsu, “This is a Market Where the Average Human Tendencies Are Precisely the Wrong Thing to Do”
- 3:02 – The Meb Faber Show Podcast – Episode #172: Cam Harvey, “This is a Time of Considerable Risk of a Drawdown”
- 3:31 – Investment Research Retreat
- 3:59 – Oh My! What’s This Stuff Really Worth? (Brightman, Treussard, Ko)
5:03 – Nowcasting
- 6:58 – How Research Affiliates analyzes the market and forecast
- 11:58 – Expectations and global markets
- 16:40 – The state of value investing now
- 21:39 – Why do we struggle with value?
- 26:38 – The concept of “Top Dogs” in markets
- 33:06 – Top Dogs
- 34:03 – Allocating to equity managers
- 42:07 – Thoughts on ESG’s
- 50:02 – What Jonathan is looking forward to in the future
- 53:44 – Most memorable investment
- 55:32 – Best way to connect with Jonathan: Research Affiliates
Transcript of Episode 210:
Welcome Message: Welcome to “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’ve got an excellent quarantine show for you today. Our guests leads a product management group at Research Affiliates. He contributes at the intersection of investment research and business strategy and is a permanent member of the investment committee and product management committee. In addition, he oversees the content and quality of Research Affiliates publications which bring the firm’s insights to the broad investment community. Finally, he works with investors and partners’ firms around the world to ensure that research affiliates, products, and insights are accessible globally. On today’s episode, we discuss what’s currently going on in the world around us and how rapidly things are changing. We cover the idea of nowcasting versus forecasting. We talk about research affiliate stance on valuations, emerging markets looking attractive, and having discipline when it comes to analyzing data to form a sensible guide to forward-looking expectations. We get into factor investing. Value investing’s underperformance and the behavioral struggle investors have with it all. As we wind down, we check ESG investing and hear a candid take on the industry’s approach in helping investors prepare for retirement. Please enjoy this episode with Research Affiliates’ Jonathan Treussard. Jonathan, welcome to the show.
Jonathan: Thanks for having me.
Meb: You’re here from where? Remote headquarters in what part of the world?
Jonathan: Newport beach. I’m in my bunker.
Meb: Okay, nice. Not too far away. Up in Manhattan beach. Well, you went to school right down the road. You were a UCLA grad, right?
Jonathan: I did, and before that, I went to Santa Monica Community College. I’m a proud product of the community college system.
Meb: Awesome. I’m a public school guy too, but ended up Ph.D. as well. What’d you study? Were you an econ guy?
Jonathan: My Ph.D. is in economics. It’s interesting, actually. I thought it’d be a pure economist. And then in my second year of grad school, I met a professor, Steve Bodie, who was teaching at the school of management at BU, who as a matter of fact, became my father-in-law years later.
Meb: What? That’s a whole ‘nother podcast. Amazing.
Jonathan: Seriously. Right? But in the meantime, we started talking very early on in the semester and he said, you know, “Everything you like about economics, dealing with uncertainty and optimizing under-uncertainty, that sort of thing, that’s finance. So how about you focus on that?” That’s been an interesting path.
Meb: All right. So you’re now part of the Research Affiliates family. We’ve had a few of your coworkers on in past episodes. We’ll add them to the show links with Rob Arnott and Chris Brightman, and Jason Xu, and, of course, Cam Harvey. A lot of really wonderful episodes, but we got a lot to talk about today. The world is changing pretty fast. You’ve put out a lot of wonderful publications over the years and we’ll talk about a lot of them. Why don’t you give us just 10,000-foot overview of the way the world looks to you today. And sadly, we would probably be right around somewhere, the Research Affiliates conference right now that had to sadly get cancelled. Give us a review of what the world looks like today.
Jonathan: Yeah, no totally. And to your point about the conference, it’s interesting how quickly the world is changing. I’m part of the team that actually puts on this conference and three weeks ago, we were struggling with whether to hold the conference, not hold the conference. And it seemed like a big decision at the time. And, of course, it’s pretty quaint, a decision node relative to where we are today. So that’s how quickly the world was changing. Yeah. Well, I mean, look, in terms of what’s going on, I think it’s interesting, kind of setting aside the investment, kind of principles for a minute. A lot of it is how do you actually process information and what matters and what doesn’t matter and how do you prepare for something like this. We actually wrote recently about now-casting, and it’s interesting because this whole concept of it’s really hard to not interpret the recent past as what’s about to happen and it’s extraordinarily hard to actually look beyond the horizon and what we’re dealing with right now is basically this hurricane, right? It’s kind of baked in. The models are telling you it’s gonna be hitting the shores in two days or whatever it is, but you look out the window and you’re like, “It’s pretty sunny,” right? In the face of that kind of cognitive dissonance, what you’re seeing and what the world is telling you is gonna happen are very different things. How do you deal with it?
You kind of referenced my academic background, one of the things that I thought very early on as I was studying options and weirdly teaching myself bizarre versions of calculus to deal with that is it’s not just dealing with the uncertainty that matters, it’s dealing with the fact that uncertainty changes and what you’re worried about today may not be what you’re worried about tomorrow. Kind of makes me think about what Howard Marks often kind of references to in terms of second-order thinking and that sort of thing. So that’s where we are today from a societal perspective.
Meb: Explain a little bit. This was a great piece, what you guys mean by now-casting. I don’t know if a lot of people would be familiar with that phrase versus forecasting. Maybe just give a kind of little summary about some of the main ideas in that piece.
Jonathan: Yeah. So the term now-casting has a legitimate use and definition. If you think about economic prints, unemployment, that sort of thing, they come out on a particular frequency at particular dates and in the meantime, in between those dates, you’re kind of left in the dark if you don’t use other means of guessing what the numbers are gonna be. That’s what is legitimate now-casting. Unfortunately, there’s a whole other form of, whether it’s behavioral bias or honestly just kind of people hijacking the system, that are just putting out opinions, often predicated on what just happened yesterday and are projecting that as a proper prediction, and unfortunately, that’s just not one helpful. It’s noise and in a lot of ways, it can be super detrimental to how you make decisions. It’s one thing to be kind of now-casting on…well, the example we use in the article, of course, again, it feels like a millennium ago now, was the trade war. People say, “Well, hey Bob, you know, what’s going on with capital markets and what’s gonna be moving markets tomorrow?” And, of course, Bob, the talking head says, “Well, gee, trade war, that’s been a big deal and it’s gonna be moving markets going forward.” And you’re like, “Okay. Thanks, Bob. But how much information was in that statement, really?”
Had a colleague at Ziff Brothers in New York who was a very aggressive proponent of what he called active reading and he literally read anything, whether it was an analyst report or “The Wall Street Journal” with a sharpie in his hand and he would just sharpie out anything that resembled non-fact, non-information and opinion because his view was, generally speaking, you take all that opinion and it really doesn’t add much to your analysis. And in a lot of ways, it’s that kind of now-casting noise
Meb: That’s a great idea for a start-up is we’ll get almost like a DVR that lets you just bleep out any CNBC, any Bloomberg where it’s non-fact and condense it into about 30 minutes a day out of the 24 hours. But it’s tough, I mean, if you have a day like today and who knows when the market closes in a couple of hours, it’s up S&P’s up 8% already today, which normally is like an entirely good year in one day and vice versa, of course, what’s been going on the other side. But Research Affiliates has been one of the groups that’s been pretty, I don’t know what adjective you wanna use, logical or sober. Some people would say bearish, depending on what part of the world. Some people would say bullish, depending on the asset class. But you guys did another article, one at the end of the year and one more recently called like, “Oh my, what is this stuff worth?” Maybe give us a little broad perspective on kind of how you guys think about coming up with market expectations or ideas and concepts that have this sort of long-term view of what are things really worth at this point.
Jonathan: Yeah. No, absolutely. And again, it’s interesting you say that. I think there are a couple of things here in terms of how to think about that. First and foremost is, derive to the best of your ability and formed forecast and we put them on our website and all the methodology is out in the open. And so, I encourage people to go and visit. It’s free and readily available, so I’m not gonna go through the methodology documents. I think that’ll be putting people to sleep, which, honestly, maybe some people might need help sleeping these days. But if you think about it, we use the CAPE ratio, the Shiller, a cyclically adjusted PE ratio as a leading kind of valuation metric. And it’s interesting as you think about it, people were complaining a couple of years ago about the fact that the cyclically adjusted PE ratio uses 10 years worth of earnings and they were saying, “Well, we still have the prints from 2008 and 2009 in there and these were abnormal years and they’re not gonna happen again.
And as a result of that, a lot of people thought U.S. capital markets and equity markets, in particular, were probably cheaper than we thought. And it’s this whole thing where if you have the discipline of not ignoring the data, of not thinking that well, what’s happened before is impossible to happen again in the future, then you have a sensible guide. It’s not gonna be a perfect guide, but it’s gonna be a sensible guide to actually have forward-looking expectations. And in a lot of ways, this whole, “It won’t happen again, the world is different” philosophy is what fails us as investors. Beyond that, I think for us, and, you know, we’ve talked about it, particularly in this, “Oh My!” piece that came out, I guess about a month ago now, was this concept that, particularly, equity markets in the U.S. only had been pricing in the good news. They had been optimizing for the best of circumstances and I think that’s just not a reliable way to operate. As you think about it, and again, I love the great writers in finance and I mentioned Howard Marks before, and I guess this time I’ll mention Seth Klarman and in terms of thinking about the margin of safety, is just don’t do that. Don’t optimize for the best of circumstances, allow for the inevitable bad news to come out and impact prices. So that’s interesting to me.
What’s also very interesting and an analogy, I think, that is worth emphasizing as we were thinking about this at the beginning of the year is be aware of the cracks under your feet and be extraordinary. You know, part of it is also being subtle about that analysis. We were talking about, obviously, valuations being pretty stretched. We were talking about a lot of corporates really getting into trouble area in terms of debt loads and so on and so forth. So you have to be aware of the cracks. I come from a risk management perspective and my former boss always said, “Failure of risk management is failure of imagination.” But what’s interesting about that is don’t be mano tone about it. It might be cracks in the sidewalk, in which case you’re probably okay. It might be cracks on thin ice, in which case it’s gonna be a very different reality.
Meb: What you mention and one way I think about it is when you have these expensive markets, it’s almost like they’re more fragile in a way where for things to keep hitting on all cylinders, most of the things need to be almost perfect, and we had sort of almost that perfect storm of wonderful situation coming into 2020 as far as unemployment and inflation and the catalyst is always obvious in retrospect, in this case, it was a global pandemic, but other times it’s hard to see, but preparing for it. By the way, listeners, we’ll add this to the show notes. Research Affiliates has this awesome asset allocation interactive. We’ll put the link in the show notes so you can go and pull up all sorts of different assets, see what Research Affiliates’ expectations are. Bad news and the good news is the bad news is coming into the year, Research Affiliates had pretty low expectations for things like U.S. stocks and bonds, but other areas, emerging markets, a little higher expectations, but the good news is as prices have come down, I imagine some of those expectations have gone up a little bit?
Jonathan: Yeah. And I think that’s worth noting on a couple of fronts. One is, yes, we thought, based on the data and the evidence that we have that emerging markets were cheap. Now they’ve gotten a little bit cheaper, but again, if you think about that, emerging markets were not priced for blue skies and as a result of that, had more margin of safety going into this. The other part of it is, and I think we’re discovering this through this episode, is it’s pretty clear that emerging markets have had a history of recovering from crisis. We seem to not always have the muscle memory to do so as much. So, yeah, I think emerging markets are very clearly a case of really attractive valuations and therefore, attractive expected returns going forward and a reasonable belief that they have a good amount of muscle memory of this relative to us. That’s one thing to note.
And by the way, I think, again, there was an interesting article recently about, actually, I think it came out today, Jason Zweig was talking about this great cessation, which I think is a great description of what’s going on. We had a great depression, a great recession, and now we’re just kind of on hold and the implications for human capital and kind of thinking about your portfolio. And in a lot of ways, this is the best of time, and this is the worst of times because if you think about what’s going on, human capital, your ability to earn an income, has a certain amount of risk to it, a beta to it. Now, it probably isn’t linear, which I think is part of the whiplash that a lot of people are experiencing. Most of the time, your salary just kind of shows up and you’re okay, and, of course, there are these kinds of societal systemic events where waves of people find themselves unemployed or underemployed. You know, new graduates come online and the job market isn’t the same.
So if you think about what’s going on, it’s subtle, but for a lot of people that truly are credit constrained, this is a really challenging situation. I’m reminded of, again, when it was the good times, all of three seconds ago, people are saying, “Well, gee, the consumer is about two-thirds of the U.S. economy. The consumer’s doing great. We’re gonna be okay.” Never mind the fact that this isn’t an exact statistic, but I remember kind of reading all these kind of polls of people saying, “I don’t have $400 to cover the cost of repairing my car if it breaks down.” That’s gonna be an issue here because this isn’t about repairing a car, this is about sustaining a major blow.
And so, I have a great deal of sympathy for thinking about human capital and what Jason is talking about in terms of people are gonna need cash and now I think it’s particularly for financial advisors, I think this is a great opportunity to reinforce core principles to the extent that one can build a bit of a safety net for yourself, to the extent that you’re sensitive to these realities, don’t over-invest in risky assets in particular equities if your human capital has an equity component to it, which most of us, unless we have some form of, you know, tenured position, it’s gonna go up and down. So it’s gonna be really hard for some people, but I think what you’re gonna find is, on the other hand, the bleak forecasts that we had, as you said, for U.S stock markets and other such highly valued markets going into this, hey, maybe this is an opportunity to actually get decent, at least more likely, decent returns going forward. So there might be a silver lining there for people that actually can have the discipline and honestly, are in a position to take advantage of these prices.
Meb: You hit on a couple of great topics, one of which the bear markets and crisis and emerging markets have been numerous and very large over the past 20-plus years, say 25 years, so we can include the ones in the late 90s, any investor that’s lived through those has the scars to remember and there’s a certain playbook, the U.S. has been through such a long period, a decade since the financial crisis, of somewhat pretty mellow times. A lot of the younger investors, and this is particularly, I think, constructive for people who just haven’t been through it and also have a financial advisor, a young financial advisor is all the theoretical are now becoming reality of experiencing things like, “Hey, is this really my risk tolerance?” Can I really behave logically during times of stress where it’s not just portfolio stress but societal, emotional? If you’re quarantining at home like we are, family stress, spousal stress, all those at one time, it makes it tough and so, I think that’s a good comment on how to think about it, particularly, the long term.
One of the things you guys talk about quite a bit is value investing, and this has been something that Research Affiliates has talked a lot about over the years and has some pretty interesting opinions but would love to just hear some general thoughts. You guys have put out some various papers that you’ve co-written over the years. Give us your broad perspective on value, where does it stand today, is there opportunity, is it potentially misleading in a world of potentially uncertain future? Give us all your thoughts on the value.
Jonathan: Well, I mean, there are a couple of things. Value is among, if you look at empirical data, value is probably the grandaddy of factors as people talk about those things now. Though, again, I think value has a long and distinguished history in investing because it’s common sense that goes well earlier in history than when the factor conversation started. And honestly, it’s one of those things where the data telling you that value is among the most robust investing return drivers you can come up with is encouraging, but the data will never tell you the whole story. Part of it too is you have to think about does it logically make sense to you and in my view, and obviously, at Research Affiliates in general, the answer is obviously yes. In a world in which it doesn’t matter what you’re shopping for, whether it’s a car, or a sweater, or house, or groceries, everybody’s probably wired to think a lower price is a better deal. We live in a world where we get to financial markets and all that kind of obvious common sense goes out the window and people are chasing the most highly-priced companies and the most expensive assets because they’ve done really well recently. And so, it just kind of trips up your brain, right?
So first and foremost, is just start with the fact that the data are supportive of a value being the most robust factor that you can come up with. Combine that with just the ironclad logic that buying relatively inexpensive assets is a good idea just, as a matter of human experience, but more importantly, because the inverse of price is expected returns and so high price, low expected returns, low price, higher expected returns.
Now, clearly value’s been underperforming for a period of time and we’re clocking in 12 years-plus at this point. Under extraordinary circumstances, where basically, again, it’s been nothing but this kind of chasing the hot ticket kind of reality, if you think about what’s going on now, it’s one of those reset elements. It’s one of those times where people are saying, “Oh, gee, what am I holding? And what is it actually worth?” And that’s part of the paper that Chris, Amy, and I put out recently this, “Oh My!” piece, which is that’s the way human psychology works. People talk about Minsky moments, right? Minsky, of course, being an economist who kind of noted that basically during the good times, people just kind of overextend and a lot of it having to do with financial leverage of one form or another, but the truth is we’ve also over-extended in some ways through the economic channels. We’ve optimized supply chains and all of that thinking that nothing bad could possibly happen. We’re having a Minsky moment. People are waking up, they’re realizing that, by the way, in certain cases, the stuff they’re holding, there may not be a market for it and we’re clearly not there with capital markets, but I think about everything as an asset, whether it’s your human capital or your house or anything like that. How many people are going to open houses this weekend? How many people are actually gonna hold any job fares? And how many people are…
And so, through kind of the entire system, people are realizing they’re holding those assets that they may not be able to trade. And this is increasingly being tested in capital markets too. And so, all of a sudden you say, “Well, I’d rather be holding an asset that’s pretty inexpensive, has a pretty kind of robust and reliable stream of income going forward, not in the next three months, not in the next 12 months, in the next 5, 10, 20, 30 years out, and take it from there.” That’s the premise of why though we’ll never know if today’s the day where value begins to turn around. The data tell us that value grinds down in terms of underperformance and at some point, the world wakes up and in the early stages of a rally, value stocks tend to do extraordinarily well. And one of the expressions for that is…I don’t love it, but it kind of tells you everything you need to know, is this concept of a rally of the trash.
Jonathan: We had a quote, we blasted this in 2008 where it was a reference to I think the Great Depression where Templeton…this was an idea of doing a Templeton where he bought every stock on the stock exchange trading below $5, so we didn’t even use valuation. He just said, “Look, I’m gonna buy all of them. Some of them will go to zero. Some of them will return to, but similar concept, low price in that world.” Put on your academic or practitioner hat. I mean, this is a simple question, but so many people struggle with it wherein almost every other avenue of life, people get value in my opinion and when it comes to stocks, for some reason, it’s just hard where when things are going down it’s scarier, it’s emotional, they don’t see it as being an opportunity the same way they would see maybe a house next door or getting put on discount or going to the store and seeing 30% off. What’s the behavioral framing there that really you think people struggle with? You talk to a lot of institutions as well. I don’t think a lot of institutions are any better, many of them than some individuals are pros as well. Why do we struggle so much with this concept of value?
Jonathan: First, and I think this is a universal struggle, as you said, institutional and household and so, this is not casting blame. This is just recognizing we’re human beings and everybody’s trying to figure this stuff out. First and foremost, I think one of the issues with capital markets is we’re dealing in the abstract. We’re not very good at dealing in the abstract. To your point, the house, you can see it, you can go in, you can walk through it. Hopefully, the previous owners have removed the pictures in the frame so you can actually see yourself in the house. The point is there’s a very kind of raw and human experience to it. When you look at stocks and bonds and financial assets, you don’t have that. And so, I think it’s really important to start by saying, “Let’s not think about it as a stock or a financial asset. Let’s think about it as the business that it is. Let’s think about it as what it truly is in the physical world,” so to speak, as opposed to this kind of intellectual construct.
Okay. So then you can actually start having a little bit of a calmer reaction to it. The other part is we’re just not seeing the right numbers. On the screen on the statement, whether that’s the statement you get in the mail as an individual or odd packages if you’re an institution, we’re seeing the past prints, we’re not seeing a forward-looking expectation. We’re not seeing things that are actually informative and because our brain doesn’t know what to do with that information, if it has a big fat red number printed, you kind of assume, “Well, gee, this thing’s going down. Get me out of here.” Whereas if there was just a second column that just said, “Yeah. I mean, look, it’s been rough, man. Let’s not pretend.” But the good news is this asset, if not permanently impaired, and I think to your point about the example you used earlier, you know, some of these companies will go bust and all that. There’s no question.
But as an asset class, as a diversified portfolio, these are actually more attractive now than they were before. And we just never see the data. You ask me to look at it from the perspective of an academic, and there’s a word for that. You kind of call it the numeraire, the unit of account and the unit of account, it shouldn’t be past returns. It should be forward-looking expectations. It’s a little bit like if you’re planning for retirement, honestly, very clearly, if the account balance in your 401k plan and IRA matters, but what matters possibly more than that is what you can turn that dollar value, that numeraire, right? U.S. dollars into consumption units. And so, we just have a really hard time because it’s pretty abstract and because there is no kind of form of agreement, the past is the past and something’s down 8.37%, that’s what it is. Of course, the moment you start looking into the future, you have to have models and it creates uncertainty and discomfort and as a result of that, we just don’t look at the data we should be looking at.
Meb: Yeah. I remember back to my favorite bubble, which is the late 90s internet bubble, and I think it was Scott McNealy at Sun Microsystems had a great example where he was talking about his stock later and it was trading for, I don’t know, 7, 10 times sales. And he walks through this example. He’s like, “Are you serious, people? Like what were you thinking?” That means every single dollar of sales we have, you’re paying for seven years worth of that and that doesn’t even include us doing any R&D, any taxes, any expenses. Like at least like the concept of buying the cheap stuff is hard, but also equally as hard as avoiding the expensive, really exciting stuff too.
Jonathan: Yeah. And again, like I think right now I really sincerely believe that the market does oscillate between fear and greed and, of course, we’re in a fear component, part of the distribution, so to speak. But yeah, I mean, again, it’s in good times. Do you wanna own the dogs? I mean, no, you wanna own the stocks that have done really well, that are promising this bright future. And I think the example, I don’t know how many cocktail parties you go to, I don’t go to many, so I feel like the whole cocktail party example is a little overstretched, but generally speaking, it feels better to yourself and in social contexts to own the stuff that’s done really well. Period.
Meb: Yeah. Part of it is probably wrapped up in this whole concept of money is an emotional, very discussion for most the concept of, I think there’s a lot of other emotions wrapped up being shame, and embarrassment, or pride, of course, Buffet and Munger always talk about fear and greed and the biggest one being envy. So people will always wanna project the winners and the good ones and forget about the ones that have done terrible, but often the ones that have done terrible get priced to a certain level that is attractive. You guys have done well. Some of my favorite research on the planet that I cite a lot is this concept of as you’re building strategies, the way that many equity indices with market cap weighting starting in the 70s with Bogle and Wells Fargo, but even taking back to the 50s with the S&P, it is the market but as somewhat of a suboptimal exposure. And part of the reason you guys have described with a really great example is this concept of really the biggest of the big, the dogs, the global big dogs, I think, as you guys call them or something.
Jonathan: The top dogs. Yeah.
Meb: Top dogs. Could you maybe talk a little bit about that? Because I think it’s such an insight that when you hear it, you can’t unhear it, unlearn it. You know, and I think it’s a really helpful construct to think about markets and again, capitalism and free markets in general too.
Jonathan: No, totally. And again, before we get to the top dogs, because I think that’s just, as you said, kind of an eye-opener but if you think about just, generally speaking, market capitalization-weighted indices versus another way to look at it, which is fundamentally weighted indices, I think that kind of level sets in an important way. The construct of an index is a fantastic one. It allows you to have transparent, arguably low-cost ways to actually track asset classes. Fantastic. The problem, again, given the premise that we just discussed, which is basically behavioral biases and generally speaking, the way in which market participants become enamoured with the top-performing stocks and eventually reality kind of sets in is a capitalization-weighted index ends up owning more of the overpriced stocks and less of the underpriced stocks and when mean reversion, which is just a physical force, so to speak, relative to the hopes and dreams of investors. When that sets in, of course, that creates basically a return drag.
And generally speaking, if you look at really long stretches of data, the return drag is about 2% per annum relative to simple construct, which would be to basically say the same thing, “Look, indices are great, we’re gonna own the economy as opposed to the market and we’re gonna do it on the basic principle of weighing investments on the basis of your economic footprint in the economy at large.” You do that, you actually end up creating a bit more discipline for yourself relative to market capitalization indices by basically concentrating against the hopes and dreams of Mr. market, the average investor, whoever you wanna kind of personalize it as. If something’s gone up in value, fantastic, I love it. I’ll take my gains and I’ll trim my position. If something’s gone down in value, great. Better forward-looking type of bargain and let me kind of lean into that position a little bit more.
So people are like, “Yeah, that’s, I get that. That’s a pretty intuitive, but kind of theoretical construct.” And so, what we did is we looked at the top dogs because, again, the most expensive companies end up hurting you in a very big way when they’re also at the top of the charts, so to speak, when they’re among the largest positions in a passive cap-weighted index. And every generation, it’s almost without fail, every generation has them. Whether you’re looking again at 1999 and it’s gonna be a bunch of tech companies, by the way, some of which turn out to be great businesses. They were just incredibly expensive for the business. They were. Going back further in time, look at 1989 and the fact that if you looked at a global index, basically every slot among the top dogs, among the largest companies by market capitalizations would have been a Japanese company.
And again, now-casting set in and people said, “Japan is gonna take over the world” from a kind of a corporation and markets perspective. And, of course, that turned out not to be the case. It is almost invariably the case that you roll the clock out another 10 years and the vast majority of the chart-topping companies, the largest companies in the world just aren’t there the next decade around. Sometimes it doesn’t even take that long. And again, it doesn’t mean that those are bad businesses. It’s just the prices were out of whack and they tend to really, really hurt investors as those bubbles burst, basically. And sometimes a bubble is kind of this market-wide type of bubble and sometimes the bubbles are more contained to let’s just say this overexcitement about tech companies, this overexcitement about Japanese companies, so on and so forth. By the way, beyond bubbles, the same construct happens on the other side of the spectrum with anti-bubbles where there are these companies that are kind of untouchable, they’re so horrific, and those can turn out to be pretty good investments.
Meb: Yeah. You know, it’s funny you mention…I mean, putting the context, couple of points. One, when you’re talking about market cap, I think if you were to poll most investors, and this includes a fair amount of pros, they would assume…the base case assumption is most people would assume that the broad indices are, in fact, fundamentally weighted. When I talk to people, when I say, “How do you think the biggest indices are constructed?” And they’re like, “By size.” And say sure. And they would say, “What do you mean?” Well, you know the biggest by earnings and revenues and you’re always like, “No, no, no. It’s just stock priced.” I’m sure it’s outstanding. And I think that surprises a lot of people, and we’ll link to this in the show notes about some of the research you guys have mentioned, but the magnitude of some of the underperformance depending on sector or country, it goes from like 3 percentage points per year all the way up to almost 10, which is a huge drag and you could do it…
Jonathan: Well, it’s enormous.
Meb: … many other ways. But to me, once you understand that, it’s such a fundamental shift in how to think about markets and it’s fun to go back and look at the top dogs from prior decades, we’ll try to include it in the show notes links too and…
Jonathan: Yeah. No, absolutely.
Meb: It’s a lot of names that the older crowd of people listening will look back at with fondness and smile and say, “I remember that stock, whether it’s RCA or all the Panasonic and Kodak, all the companies that in my generation, maybe the Ciscos and Sun Microsystems that are still around but not the best performers.
Jonathan: No, it’s really to your point, and this is really kind of funny. Again, I’m kind of a recovering academic in a lot of ways and it’s incredible how we talk ourselves into these… We twist ourselves into pretzels when it comes to concepts, when kind of the common sense tells you like, “Why are you using market cap again?” That was never… And then you’re like…well, then you get into these kind of theological debates as to the heresy of not using market cap and you’re like, “But what about just common sense?”
Meb: Yeah. That’s a better branding. I’m gonna name some of my indices, the common sense indexes. Maybe that’s a better marketing angle. You guys talk a lot about too for being a quasi quant shop that does a lot of historical research. You’re nice because you talk about practical implementation too. And you guys did a piece on thinking about how people actually implement and allocate to equity managers. And you say, “One, we’re not necessarily that great at it. Historically, people love to chase performance.” And then you come up with kind of three main questions to ask as you’re thinking about allocating to people. Maybe you could talk a little bit about that paper or kind of walk us through what it’s all about.
Jonathan: Yeah. No, absolutely. And I think long shelf life principles will take you pretty far in a world that’s inherently complex and where, you know, people are… You know, I hate to say it, but our industry is prone to rent-seeking like every other industry that I can come up with. And I think complexity and just kind of smoke and mirrors is part of that rent-seeking kind of behavior. So, you know, I really do think that simple principles that allow you to stay on firm ground in the middle of this kind of storm of people telling you things and selling you things and all of that are really, really important. The principles, which I think I’ve highlighted at least hinted at some of them in the past, earlier part of this conversation, first of all, is the strategy something that makes sense? Is it intellectually coherent and does the historical record bear it out?
Let’s just start with that. Again, give an army of professors and grad students and professionals laptops and infinite access to data and they’ll come up with some pretty crazy concepts. And in some cases, the concepts will actually bear out in the data just because it’s a random pattern. But then you stop and you say, “Okay, so now I’ve got to control for that. So does it make sense?” And so, that combination of does it bear out in the data, but more importantly than that, does it bear out in the data and does it make sense? It’s gotta be a joint test and that’s number one. And you kind of look at that and you think to yourself, “Well, there are probably a four or five types of investment styles or factors that, you know, have a pretty decent historical record though you should haircut it, have a pretty solid intellectual construct behind them. And so, okay, let’s just kind of accept those.” Then you have to go back and say, “Great, so that makes sense. But where are we now?” That’s number two, right? Which is this valuation kind of filter, if you will, or test?
Every strategy, because again, it’s just the nature of capital markets, every strategy is going to have times in the cycle where it’s expensive and times where it’s cheap. And, by the way, it’s true of even value, which is kind of built-in to be cheap, but, hey, cheap can be dirt cheap and cheap can be cheap, but kind of inline. So all of this has kind of cycles to it. So once you found strategies that made sense to you and that were kind of borne out in the data, then you ask yourself, “Where are we now in terms of valuations?” And look, I think the idea that valuations ought to be a huge driver of allocations is probably overdone. There are cases where things are so cheap that they’re only priced for failure and it’s a pretty safe bet that it’s gonna beat your expectations going forward. There are times when strategies are so expensive that they’re only priced for success and there you should watch out.
But otherwise, you know, of the three, four strategies that you said, “Yeah, those generally make sense to me,” then allow valuations to gently kind of tilt your allocation over time because you also don’t wanna, one, presume that you have more information than you have and two, get yourself into this kind of decision kind of failure moment where, you know, you’ve been proven to be wrong because you will be proven to be wrong and you just kind of freeze in place and just say, “The hell with the whole thing.”
And then the last one is implementation. And again, that’s really important. One of the challenges, particularly with indices and passive investing, because I think most people that stop and think recognize that active strategies that are concentrated in a handful of names and probably are constrained incapacity. And you know that because if you’re in the world of hedge funds they’ll say, “No more. I can’t manage more assets and I’m plenty rich so I don’t need more” kind of thing and/or, “Well, okay, so I would need to put like a 51st position on the book. And honestly, my best ideas were the top 50, so the 51st position is just gonna be kind of a crummy one.” So in the active world, we all accept there are limits to the ability of managing assets. Somehow the world thinks that passive investing is like this frictionless plane, right? Where you can put infinite amounts of money to work and nothing’s gonna give. And, of course, that’s not true. It’s obviously the case that trading isn’t a frictionless activity now. You might have on your brokerage account, you might have commissions free trading, but at some point somewhere, someone’s paying the bid-ask type of concept. And you say, “Okay, so, that’s great, but I don’t see it because these index funds, they seem to be heading the index levels every day. So there is no slippage.” And, of course, that’s the great magic trick of indices that one has to be aware of, is the trading costs get baked into the index levels. And so, it’s very important to actually look at how the indices are built, and constructed, and traded, as a result, to ensure that that inevitable fact of life, that they will be a bid-ask, that it is minimized and that your strategy doesn’t kind of bake in this shadow underperformance.
It’s pretty clear that if you fundamentally wait, you retain a lot of the positive attributes of the more standard indices, which is you own more of the highly liquid stocks. If you don’t optimize and therefore you don’t have super high turnover in your strategies, that’s great because there is no sure way to reduce transaction costs than to trade as little as possible. But it’s all, of course, the world isn’t simple. It’s a trade-off because of course, well, you know what doesn’t trade is market cap indices but then you’re along for the ride with the ups and downs of market follies. So that’s how to think about it in three easy steps, is basically does your strategy make sense and does the data show that there is good reasons for this? Where are the valuations and have you thought about the implementation characteristics of your strategy?
Meb: It’s funny, the common sense one is so obvious, but I spend a lot of time looking at certain products and I just shake my head and I’m like, “That is the dumbest idea I’ve ever heard of in my life.” And it’ll raise like $10 billion, so I would say, “What do I know?” But also what you touched on, and I think this becomes often obvious in retrospect on actual index design is most people buy sort of the headline, “Hey, this sounds like a cool narrative,” and rarely actually get down to the prospectus level or indices and how they calculate what they do and only become surprised after something bad happens. And then the last one was that, you guys on valuation have a great tool. Again, I love this tool so I keep mentioning it, but where Research Affiliates talks about factors and shows kind of where we fall for that factor in its valuation relative to its own history. So whether it’s, hey, this quality or low vol or actually value itself, where does it fall? And I think that’s something that there’s a lot of debate about. It’s a great perspective. So really, three wonderful things to consider. Jonathan, we got limited time. I’m gonna give you a buffet choice. All right. Are you ready? There’s four topics, you can choose to talk about any of them. You’ve written about all of them, which ones do you think are most timely or interesting? There’s gonna be commodities, bonds, ESG, or target-date funds. Which one or two is particularly on the front of your mind or most interesting right now?
Jonathan: I’ll pick ESG, that they’re all kind of interesting and of course my first love was talking about target-date funds, which I did going back to my grad school day, so that would be a close second.
Meb: Good. Let’s talk about both. We’ll squeeze them in.
Jonathan: But on the ESG side of things, you know, again, I think if you go back to the principles of intellectual honesty and understanding that investors are people and people have preferences that go beyond kind of narrow risk and returns, the ESG conversation gets really interesting because it is my sincere belief that people actually care about the nature of their investments and the way in which their behaviour affects community at large, let’s just say. And I’m a big believer in that because we’re social creatures, we care about others. And with the exception of very few among us, how your behaviour and how your decisions impact the greater welfare and all of that kind of just plays a role into how you think about things. So, I think the ESG conversation is very real and we need to be able to help investors make decisions that are consistent with the preferences, without falling victim of intellectual dishonesty.
And I think that’s the great challenge. As I said earlier, I think our industry is, again, full of people and people are people and therefore, rent-seeking is gonna come into the equation. And if you think about what’s…I mean, it’s incredible to me that investment products are launched on the basis of surveys and test groups. And basically, the conclusion is if you want it, we’ll build it with no real, you know, no real sense of like, is it good or bad for your health? So, by the way, maybe we should start by putting ESG ratings on financial companies, so to speak. But all joking aside, can I tell you for sure that ESG investing is going to be a return driver? I can. First of all, start with the fact that, and you know you mentioned quality earlier, so let me draw a parallel between quality investing on which we wrote an article that actually was granted an award recently, which I think people might find really interesting, which is what is quality? And quality, unlike value, is one of these things where it can mean 1,000 different things to 1,000 different people, right? Is it a highly profitable company? Is it a company with little leverage up and down the line and ESG… And before I move to ESG, the thing about quality investing is it becomes such a broad umbrella that it’s almost like a meaningless umbrella and so you have to actually kind of drill into it and say,” What is it that makes economic sense and how does that translate to investment returns?”
With ESG, you start with three letters that basically cover the waterfront and aren’t a coherent set of constructs, environmental, social and governance. It’s a lot of ground to cover. It turns out the governance bit as investors seems to have decent legs, but again, there are so many ways to look at governance. It’s not a guarantee that the way a particular investment company might do governance would generate an excess return. Then you get into other kind of complicated constructs. And, again, we’re a pair of clear-minded. We want data, we need data to actually form a fully mature opinion. The E part is one of those where even if you gave me data going back 60 years, which tends to be what we like as empiricists on the E characteristics of companies, the capital markets, were just not paying attention to that 60 years ago, 30 years ago, 20 years ago. So all the data in the world will not tell you the answer. And I think that’s really important. So as a result, you’re left with basically this moment of great humility, which is can we deliver investment strategies that are true to the preferences of investors? And I think that’s really important. You know, along this journey on ESG, I’ve learned words like greenwashing and pinkwashing and just kind of this window dressing, you know, do the bare minimum. And I think that’s utterly unfair to those investors who care. So can you actually deliver on the specified preferences of your investors and do it in a way that is not detrimental to investment outcomes to the best of your knowledge?
And I think the answer is yes, it’s again, bake in, return drivers where you know them to be reliable, use fundamental weightings as opposed to cap weighting. Well, that’s gonna give you an edge. Things like that. If you’re going to be devising a governance score, lean into parts of the G that you think have robust evidence of outperformance in the data you have. It turns out you could remove fossil fuel companies. Well, you know, we can talk about a variety of things around that, you know, engagement versus divestment and all of that. But GMO, there’s some interesting work a few years ago, which I think is worth noting here where you can remove kind of any one sector of the S&P 500 and it’s definitely gonna give you a tracking error. It’s definitely gonna be the case that year over year you’re either gonna look really smart or really stupid, but over the longterm, it actually doesn’t make much of a difference. So you can do all those things. And again, like if you kind of get into the granular components of it, people talk about sin stocks and very quickly they say, “Well, gee, you look at those sin stocks, they’ve outperformed so surely if I remove the same stocks, I’m gonna left in the ditch.” And this is where some of the tools that we have at our disposal can be helpful.
It turns out if you look at the sin stocks, they’re not outperforming because they are sin stocks. It’s not like some kind of magical thing where all of a sudden you’re a sin stock and you’re on fire, but a lot of these businesses are adjusting to the reality of being in unsavoury lines of business and whatever, and they’re running pretty conservative businesses. They’re watching their expenses and they’re highly profitable, highly disciplined businesses. Okay. So all of a sudden you say, “Well, that’s something I can do something about because surely, it isn’t the case that only sin companies are the only companies in the universe that will be profitable and disciplined.” Now, a lot of companies turn out to be not disciplined. That’s the curse of being highly profitable. All of a sudden you’re like, “Well, let’s get on this empire-building kind of deal,” but you can find non-sin companies that have those characteristics and as a result of that, you can kind of balance back into non-sin companies that are gonna be profitable and conservative in their management. You can do all sorts of things that require a little bit of engineering to deliver investment strategies that are true to what investors want without basically being bad for their financial health.
Meb: This is close to home because my high school’s name was RJ Reynolds High School in North Carolina, so like the single best-performing industry of all time is probably tobacco companies. Pretty sure they would fail every single ESG category today. But that’s a problem also with ESG too, is that depending on where you’re from and your definitions and the way you view the world, the E, S, and G can be a little different too. It’s hard.
Jonathan: It really is. And again, it goes back to this principle, right, which is be respectful of your investors’ preferences. And preferences are broader than risk and return and be responsive to what those investors actually care about.
Meb: Yeah. We’re gonna save commodities, bonds, and target dates for our next conversation. But I do wanna ask you, a lot of stuff we talked about today is stuff you guys have been writing about for the past decade. Love to follow you guys. What’s got you curious today? What are you most excited about, doing research on? Anything that can give us a peak behind the curtain as you look on the horizon for the next 10 years, anything, in particular, that’s on your brain or you’re thinking about or interested in?
Jonathan: A couple of things come to mind and I’ll use it as a pivot back to target-date funds. I think we’re doing a pretty subpar job as collective to help investors get ready for retirement. I just think we can do better. You know, a lot of it again is we’ve talked ourselves into kind of corners. It’s making it harder for people like ourselves to kind of breakthrough the noise and ultimately kinda lead with common sense. So the big challenges will reveal themselves and I can’t tell you what they will be in the next 10 years. But it’s pretty clear that lifetime investing for households, whether it be through employer-sponsored plans or honestly in the cases where a financial advisor can be part of that solution set, how do we help investors and the people that they turn to and trust, how do we help them make better decisions at reasonable prices so that ultimately everybody wins? I mean, we’re a mission-driven firm. We really do wanna transform the investment industry for the better and for the benefit of investors, and that’s gonna be our North star and we’re just gonna have to figure that out.
Meb: So do you have any initial takeaways, prescriptions, diagnosis of the target date/main issues versus solutions or is it something you guys are just kind of workshopping on right now? How do we fix this all?
Jonathan: Target-date funds, I’ll give you the 32nd version. And I think, you know, and we’ve written about that. Again, a lot of it is just testing accepted, common wisdom, this concept that somehow having a bunch of equities early on and very little equities at the end of the journey, like somehow that has to be the right answer. Does it? The data is suggested that there are plenty of paths in which that’s, you know, that’s just a pretty…it’s a little bit like if you were driving and you weren’t allowing for, you know, kind of bumps in the road and just like you’re like, “Well, I’ve charted this course and that’s the end of that conversation.” It’s just the inflexibility and the presumption, the glide path, so to speak. The answer is well worth looking at. The other part of it too is, I think, generally speaking, the industry is not focused on the fact that ultimately this is about delivering academic talk coming your way, but units of consumption. This is not about dollars. This is about can you actually afford food and shelter and, you know, all the other necessities of life, decades into the future?
So that’s part of it. And on the other side of the equation, stepping away from target-date funds, we’re very actively looking at how to help financial advisors serve as their clients more effectively, kind of build-in, you know, some of these safeguards that we’ve talked about in terms of delegating decisions so that the behavioural biases don’t come into play and derail things and basically help people stay the course, react to opportunities without overreacting to fear and greed.
Meb: Well said. It’s a tough problem. We struggle being a public fund manager, watching people behave poorly in public markets all the time and not being able to necessarily prevent that. And even if you’re a financial advisor, the person could say, “Screw you, buddy. You’re an idiot. I’m closing my account.” It’s hard. We struggle a lot with it. So if you find the solution, let me know because we’ll certainly embrace it. We struggle with it all the time.
Jonathan: Sounds good. We’re all doing our best, is my suspicion.
Meb: Yeah. Jonathan, what’s been your most memorable investment over your career? Good, bad, in between? What’s the first thing that comes to mind?
Jonathan: Oh, God. When I finally got my Ph.D. which meant I was finally not poor, I bought a 1971 Z28 Camaro in honor of my mentor at UCLA, Earl Thompson, who only ever drove classic cars and, in particular, Camaros. It was a fantastic car. My brother-in-law, who’s also an investment professional, kind of made fun of me because he thought, “It’s an awful investment.” And I said, “Yeah, yeah, but there was a lot of consumption value here.” Neverminding the fact that, by the way, as far as kind of flashy cars are concerned, a 71 Camaro is pretty cheap relative to what you see, particularly on the streets of Newport Beach, right? I bought it when we were still in Boston. We moved to New York City. It became pretty impractical then I had twins, a 71 Camaro without seatbelts in the back didn’t seem like a particularly good investment, so I sold it years ago though. And I remember it fondly. I think the big lesson is when you buy something, you got to know why. I didn’t view it as a financial asset only. I viewed it as a consumption good, and you gotta be okay selling.
Meb: Some of my happiest purchases, despite what the normal financial advisor would say have been both. And I used to have a 67 Land Cruiser. Did same thing when my young one came along. Didn’t have any kid seats, the seats faced sideways, but I got it during a distress sale and I came this close to buying a 67 Camaro. The thing was beautiful, was maroon at a Palm spring auction. I went to one of those auctions, but I was way too scared to place a bid. Well, I’m a Quan and I’m also a cheap bastard, so the prospect of me raising a paddle and getting caught in an emotional bidding war sat on my hands. I was too scared. So almost, I was a Camaro owner, but ended up with the Land Cruiser instead. Jonathan, people wanna follow you, all your readings, all that’s going on. Where’s the best places?
Jonathan: Go to researchaffiliates.com, sign up for a newsletter.
Meb: Easy. Thanks so much for joining us today. We appreciate it.
Jonathan: Thank you.
Meb: Podcast listeners, we’ll post show notes to today’s conversation at mebfaber.com/podcast. If you love the show, if you hate it, shoot us firstname.lastname@example.org. We love to read the reviews. Please review us on iTunes, and subscribe the show anywhere good podcasts are found. The current favourite is Breaker. Thanks for listening, friends, and good investing.