Episode #322: Radio Show: Inflation or Deflation?…Foreign Stocks….Value and Momentum
Guest: Episode 322 has no guest but is co-hosted by Justin Bosch.
Date Recorded: 6/14/2021
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Summary: Episode 322 has a radio show format. We cover a variety of topics, including:
- Preparing your portfolio for the possibility of both inflation and deflation
- International stocks making a comeback
- Value and momentum factors
- Listener questions!
Links from the Episode:
- 0:43 – Intro
- 1:36 – Meb’s take on the inflation debate
- 6:31 – Meb on global valuations
- 10:38 – Stocks Are Allowed To Be Expensive Since Bond Yields Are Low…Right? (Faber)
- 14:00 – Grappling with the mental hurdles of making changes to your portfolio
- 17:19 – Worried About the Market? It Might Be Time for this Strategy (Faber)
- 20:31 – Value and momentum and thoughts on combining them
- 25:33 – Sponsor: Bitwise
- 26:23 – The 100 year portfolio
- 26:54 – Chris Cole, Artemis Capital Management, “You Want To Diversify Based On How Assets Perform In Different Market Regimes”
- 29:40 – Yale’s US stock exposure over time
- 31:44 – Mutual fund to ETF conversions; Jim Atkinson on Making History First Mutual Fund
- 35:20 – How to play defense in today’s market environment
- 39:12 – Developing discipline in your own investment strategy
Transcript of Episode 322:
Sponsor Message: Today’s episode is sponsored by Bitwise. You’ll hear more about them later in the episode.
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: Hello, friends. It’s been a month, so we’re back with a radio show, but first, a request. My birthday is coming up and all I’m asking for is a podcast review. Would love it if you guys went on to Apple iTunes, click to review, left us a short note, we read them all. I promise. It would mean the world to me. So in today’s episode, we start by brainstorming how to make your portfolio ready for the possibility of either inflation or deflation. Then we discuss international stocks making a comeback, not just this year, but this whole decade.
Next up, we talk about value stocks starting to catch that MOMO momentum. What does that mean for your portfolio? As we wind down, we touch on some listener topics, including playing defense and developing discipline. Please enjoy today’s radio show. What’s up, everybody. It’s radio show time. We committed to doing these once a month, so here we are today with my trusted co-host. Justin, welcome to the show.
Justin: Howdy. How’s it going?
Meb: Well, it’s almost summertime in here in LA, recording this in mid-June. It feels like the world’s starting to reopen. Are you starting to feel that vibe down where you are?
Justin: Yeah. Certainly feels that way. But it’s also one of those things that down here you say almost summer, but it certainly feels like summer. I mean, this time of year, the wonderful weather starts to show up, it starts to get hot. Beach is beautiful place to be.
Meb: You’re a Pacific Northwest guys, o this is probably already cooking. We don’t have air conditioning in my house, so I’m already feeling the effects of global warming. But I’ll tell you what, I’m also feeling the effects of is these reopening prices. And I know everyone talks about kind of Uber and Lyft going crazy again and plane flights, but man, I’ve gone out to dinner a couple of times and my goodness, my wife and 4-year-old child went out to a Mexican dinner the other night and somehow managed to spend $200 and I was like, “How is this even possible?” So you’re seeing it creep up in places, I think. You starting to feel it down in Orange County?
Justin: I notice it at the gas pump. And I know that there are different inputs here that are having an effect. I know they switch over to a summer blend of gasoline that has an impact, but this leads me into a point I wanted to cover today, was this whole idea of inflation post-COVID reopening. I’ve heard arguments on both sides. What do you think? I mean, we see it in commodities prices for sure.
Meb: Yeah. I mean the short answer is, of course, you never know forecasting. My favorite phrase being most investors be better suited being “Rip Van Winkle” than Nostradamus trying to predict the future. And so we always say you want to have a portfolio that’s resilient to either. I mean, inflation, deflation, everything in between. That having been said, the way that we traditionally build portfolios, it certainly gives a very thoughtful hat tip to the pressures of inflation. So if you look at kind of Cambria and the way we’ve always thought about a framework of putting together an asset allocation portfolio, it doesn’t matter if it’s the buy and hold stuff or the trend, but there’s a pretty heavy chunk in real assets, so real estate and commodities. And like you mentioned commodities really had quite a run this past year in different spaces, but they all seem to be accelerating.
We do a lot of podcasts on farmland investing, which people seem to really like and you’ve certainly seen prices on the farm move up as well. So there’s anecdotal evidence as well as the macro evidence, the trend following portfolios that we run that overlay momentum. Those also have had an outsized exposure to commodities and equities with commodity exposure over the past year, which they’ve benefited from. So I like the concept of, “Hey, we can go wherever the wind blows and if that happens to be inflation, we really want exposure to those assets.” Will it be transitory or permanent? I’m not sure. We’ll find out.
In the meantime, we’re no longer going out to $200 Mexican dinners. Have you tried my favorite food delivery yet? Purple Carrot? I’m neither an investor nor are they a sponsor, which I would love to be both. We got to hit them up. But they have… I’ve done probably a dozen of these at-home boxes and cooking, and all those sorts of things, and we’re going to have one of the most successful direct-to-consumer female-focused boxes coming up on the podcast here soon, FabFitFun, which, listeners, if you’re looking for a gift for a lady friend or for the few female listeners to the show, check it out. It’s an incredible service. On the flip side, I am both an investor as well as a consumer of that one, but Purple Carrot’s amazing. It’s plant-focused, organic. I’m not sure if it’s fully vegan. Anyway, I’m trying to save a little money there, but it’s odd because I feel like most of the food boxes and meal prep kits, most of the meals are like a solid six. Like they’re fine. This one has been consistently like eights and nines where you’re just like, “Wow. This is amazing.” Anyway, long tangent. What’s the next topic?
Justin: Well, I just… I want to wrap this topic up by saying I think that from an investor perspective, all this talk of inflation one way or the other is interesting, but I think your answer of, I don’t know, but let’s approach it with a portfolio that can be in a position regardless of what direction inflation goes. I think that’s a really kind answer. So I just wanted to kind of wrap that up by saying that’s sound advice, a sound answer. And my favorite one, but, of course, we never know. Another topic, we talk about this all the time, but valuations. They’re still high here in the U.S. at least, but international stocks may be making a comeback. Mike Venuto had a nice tweet on this. You want to get us up to speed here?
Meb: 2021, in my opinion, has been…there’s been a shift over the past year and whether people realize it or not, you can point to three different waypoints that we’ll look back on and be able to point to those as the actual regime change, the first being the pandemic bottom in March, the second being interest rates bottoming in the summer, and the third being the election. And with hindsight, we can all point to it and say, “Ah. That’s when it changed.” But there have been some very noticeable differences in markets over the past year. One big one is, of course, value has rebounded. We’ve talked at extreme lengths about value being a major opportunity versus the expensive stuff, which particularly the U.S. expensive names that spread.
My single favorite chart of 2021 coming into the year was talking about the value French pharma factor going back to the 20s, the value spread, going back to the 20s, it had its worst performance ever in ’99. So the peak of my favorite bubble, senior in college, called it fourth year at Virginia. Worst year for value, but guess what? The single best year was in 2000 after the bubble popped value shown brilliantly. That was until 2020. 2020 was actually worse than 1999 and said, maybe we’ll see the playbook workout again. And that’s what it looks like. So thus far this year value has been making some pretty significant moves, but I think you can trace it back to one of those three waypoints last year. In addition, you can put foreign stocks and emerging markets in that same category. I think that now this gets into back to Nostradamus territory, but if I had to bet, I would think you will see as the rest of the world trails the U.S. in reopening’s, that the value tray will spread around the world.
And so right now we find ourselves at a valuation in the U.S. long-term CAPE ratio of around 38. And that’s actually one of the more sober valuation metrics. There are plenty of others that are all-time highs already. You got Buffet’s favorite, the mark cap GDP, price to piece cash flows and EPS. You have, I just tweeted this today, Jesse Livermore’s favorite indicator, the stocks as a percentage of household assets. Hit an all time high in Q1. It’s delayed. So it’s probably even higher now. The highest peak before that was in ’99, where it hit, I think, 45% of household assets.
But remember, 10 years later at the bottom of the financial crisis, it was like 22. So here we are back above 45. And then you got the five other indicators. There’s tons of new IPO and SPAC supply, short interests. The shorts are now virtually extinct. Median short interest as percentage of market cap is at all-time lows. And then you have interest rates going up and the dollar, we’ll see what happens, but potentially going down. So you have all these things going on.
I tweeted out and got a lot of flack for this, but I said, if you go back in history, the time that U.S. stock market has closed a year at a CAPE ratio of 35 or higher on the main markets, so looking at U.S. stocks foreign developed and emerging, it’s only happened about seven times and the future 10-year real returns on average were zero. Now, if you were to go back to look at individual countries, it’s happened, I think, about 55 times and the same takeaway, on average, the future ten year real returns are zero. Now, about a third of the time, it’s still positive, but not a good indication as far as starting points with valuations.
And I asked radio show listeners, you want us to answer some of these questions on there, shoot us an email, feedback and the mebfabershow.com and somebody asked, “Is there a reason CAPE could be sustained high in the U.S?” And there’s really two. There’s the one that people think, which is interest rates being low. And we did a piece that kind of debunked that a few months ago called “Stocks are Allowed to be Expensive Since Bond Yields are Low.” And it turns out that wasn’t true, but we don’t need to get into that. We can point the listeners. We did a podcast, reading that entire piece. You can scroll back for a few months and find it. It’s probably in February or January, but that ties to inflation. So, yes, stocks can be a little more expensive when inflation is low in that sort of 1% to 3% safe zone, but takes the long-term CAPE ratio from around 17 to around 21 or 22, which has been the average for the past 40 years in the U.S. but remember, we’re at 38.
So unless there is some unforeseen, just absolute explosion in innovation and earnings, the likes we’ve never seen before in history, this is a pretty high valuation metric. So, again, what do you do? We’ve been singing the same tune for years now. The first is don’t take the risk. If you own too much expensive garbage, own less. Get to your sleep at night, threshold. Second are you diversifying the other assets, real estate, commodities, foreign stocks? We’ve mentioned many times that foreign stocks are quite a bit cheaper. So average foreign developed countries around 23. It’s got a double, the dividend yield of the U.S. U.S. is called one and a half if you’re generous, both foreign and developed are above three foreign developed and emerging, and then foreign emerging is that long-term valuation around 15. So downright cheap.
Next, you could certainly add value on any of those indices you’re using. So instead of using a market cap-weighted index in the U.S. you’d tilt towards value. Obviously, we love shareholder yield. I mean, that is a thoughtful investment strategy during any period, but particularly in times when things are expensive. So if you look at the valuation of a shareholder, you have a basket, and that strategy is having a phenomenal run, particularly this year, the valuations across the board are cheaper than the category and, of course, the S&P 500. And then if you look at obviously the foreign and emerging versions of a shareholder yield strategy, they’re cheap too, but having a quality business that’s trading a low valuations and returning high cash flows to shareholders, that’s a business you want to own in any time really, in my mind.
Of course, trend following is the next one, I think you can protect yourself. But as for now, I mean, we list all these concerns about the U.S. markets and we always say the trump card is trends. So everything is starting to line up, worrisome with the exception of trend and if and when that ever rolls over, I think you go from the…my 4-year-old would tell you from the yellow light to the red light sort of a game. And then lastly, of course, we’ve talked ad nauseam about tail risk strategies, we’ve had volatility recede from the pandemic, VIX highs of what, 80s down to background 15 today. So many of those strategies are quite a bit cheaper than they were to implement a year prior. So that’s kind of the four main steps I would take if I was… Most listeners to this podcast that have those extreme U.S. stock allocations to consider those four steps. Don’t take as much risk in the first place, diversify into other assets, real estate, commodities, foreign stocks, bonds even, three add value, or trend following strategies, and lastly, consider tail risk as well.
Justin: Yeah. I agree with all of that. I think that’s really sound advice and in a way, every single one of those points are really practical things that anybody can go out and implement in their own way. But the question I have, and maybe some others as well is what do you think the big hang-up is for people who don’t get themselves there when they need it? Or should I say when it’s appropriate, how do people grapple with that whole behavioral idea of making changes to a portfolio?
Meb: People love to buy what they wish they had bought. We got mentioned in the journal a couple of weeks ago because we were talking about an old study we did, which was influenced by an old Bogle study where he looked at the top-performing funds each decade and how they then did in the ensuing decade and not surprisingly they’d underperformed because the ideas, and strategies, and managers that have their moment in the sun, and this applies to asset classes too, often the script flips. And so we had published an article about looking at the top mutual fund managers of the 200s and I said, “How many of them outperform in the next decade?” And zero did. And the average under-performance was significant.
And so people love to chase what has been working. And so I think the challenge is, again, this is such basic advice, but having a written investing plan in the first place, then rebalancing it to your target weights based on time or tolerance deviations and then considering writing in rules that say, “Maybe we’ll over rebalance if things go a little crazy in one way or the other.” And my personality is such that I’m drawn to things, and we’ve tried to do this as a firm for the past decade. Haven’t always been great on the timing of it, but I particularly like launching funds when the idea of strategy is out favor. I think we’re probably the only company that was foolish enough to launch a real estate fund during the pandemic, a strategy, but we love that concept. And so we’ve launched a number of foreign funds over the past handful of years as foreign stocks have been, we believe out of favor versus U.S. stocks. And thinking about that, I think it’s important to consider. I mean, look, we have one strategy that we wrote a paper about a long time ago, and it’s so simple and it just buys value and momentum stocks. So cheap stocks that have good momentum. And for a long time, there hasn’t been a whole lot of overlap in those circles. If you were to do the Venn diagram, most of the momentum of the past decade has been in the growth-led names until very recently.
And you mentioned a Mike Venuto chart showing, as well as many others, we sent out an email piece to our email list, detailing sort of this value opportunity. And so you have this huge spread of the valuations of the cheap versus expensive but they haven’t had the outperformance until the last year. And so you’ve started to see all of these giant momentum funds start to rebalance away from the growthy names, the expensive high flyers to the cheap value stocks. And so it’s for once, you have sort of the value momentum overlap.
Now, we go an additional step that I think is thoughtful, and this strategy has been horrible for the past five, seven years in large part because those factors have been out of favor, but also anything that’s hedged during that time period has hurt because the market’s all dried up, but this strategy that we detailed in the white paper, and we’ll link to it in the show notes, it would add 25% hedges based on two buckets, one on overall market valuation. So not surprisingly, that bucket would be max capacity hedge because the market’s expensive, so 50% hedged. And then it would also hedge another 25% and 50%, so taking you up to 75% and then 100%, aka market-neutral based on trend.
Now, the trend has been up for a long time, so that hedge has rarely if never been on, but the underlying stocks similar to value and shareholder yield over the past year have had a really outstanding run. The thing is like I don’t think it’s even been more than a blip though. If you look at a lot of the value charts detailing the spread, it’s got a long way to go. So if you were to try to make an analogy, maybe the value is starting to outperform takes us back to year 2000 where this played out over three long years for the market cap-weighted indices, but a lot of other asset classes and strategies did just fine. Value stocks, dividend stocks, foreign stocks, real estate, all cruised through that sort of internet bust, but there were so many big, expensive names populating the market cap-weighted indices and if you were invested in any of the market cap-weighted indices, you really struggled in a 50% bear market during that period.
So circling back to the beginning of this discussion, you see a lot of similarities in actionable, I think, portfolio moves you can make that are thoughtful. I think everyone thinks they can add the tail risk before it happens, but often I think the opposite is more likely to be true, is that people don’t want the party to be over and they’re actually reluctant to sell a lot of their high-flying winners and they’ll kind of wait and wait and next thing you know, the market has passed you by. So whatever sort of strategy you have to implement these changes, the big key is to, in my opinion, detail ahead of time, write it down, codify it so you’re not trying to make these emotional shoot from the hip decisions when markets start to go bananas as they have over the past two years. You got the pandemic and then on top of that, you’ve had all the meme stocks and everything else going crazy this year. So that to me is, and particularly if you reference some of our polls that we consistently do, for example, on how long should people wait until they fire an acting manager, I’m like 85% of our respondents said like three years or five years. So I think that having the playbook ahead of time is a lot better approach than just showing up to the game having no plan.
Justin: Yeah. Agree a hundred percent. But I want to have you go down that value momentum rabbit hole just a little bit further. And I’ll kind of kick this off with the idea, Jack Bogle wrote about this recently, when you think about value and momentum, is it best to implement them combined or separate? That was really the premise of the piece he wrote. And it’s, I think, a really good question. It’s a practical question in my mind, because you think about these two independent, interesting, and I think very good concepts to follow and have in your portfolio, but there’s also this, when you combine them together, it actually could end up with slightly different results. What are your thoughts on that?
Meb: I thought you said Jack Bogle wrote about this recently and I said, “Really? You know, it’s…” Rip Jack, but Jack Vogel of Alpha Architects fame.
Justin: Yes. Of Alpha Architect. Precisely.
Meb: Yeah. One of our favorite writers. That firm is sort brothers from another mother. There’s a lot of topics we address on this show that I’m extremely opinionated on and there’s some where I’m mildly opinionated on. It’s pretty rare for me not to have an opinion. This case though, I’m sort of ambivalent and the reason being is that I’ve seen the research on both sides and I think the biggest muscle movement in the first place is moving away from market-cap weighting. So, all right, deciding to use value and momentum in the first place, I think, is more significant than how do you implement the value and momentum. And so, listeners, what Justin’s talking about is you could say, “I’ve got a portfolio of a hundred stocks.” One way to do it is say, “I’m going to find the cheapest 50 value stocks and then the 50 highest-ranked momentum stocks and there’ll be separate and we’ll keep it as part of the portfolio.” The other way, as you say maybe, “I’m going to rank all stocks based on two metrics, one, value, one, momentum, and I’ll take the average of those two metrics and take the top 100 stocks from that.” So you end up with a more of a blend. I don’t know that it matters over time. I think people will argue that you may get diversification benefits treating them separate, but, again, I think it’s sort of a declining utility versus the choice to break the market cap and use value and momentum in the first place. So I’m really open to both.
That having been said, I think it is extremely important to understand your methodology. A lot of people allocate to funds and I think conceptually just based on the name of the fund, consider that sufficient. And I think really drilling down even to a fact sheet or prospectus level is pretty important because in some cases you end up with funds that are totally different under the hood than with what you would expect from their name or their approach, and in many cases, the rigidity of an index. And this is why we say an actively managed index is far superior to a published index if you look at some of these giant momentum index funds that have tens of billions of dollars and have to essentially telegraph what they’re buying and selling. That’s a very real cost. We have plenty of hedge fund friends that just prey on those sort of rebalances all day long. I don’t know if they’d be described as the remoras, or the shark, or what, but it ends up being a cost to the actual fund.
But on the flip side, our buddy, Phil Bach, had a chart where…Phil doesn’t pull any punches, but he was showing basically three different ETFs from iShares. And not to pick on iShares. We used some of their funds, but one was, he said, “For three BEPS, you get the S&P 500. For 15 BEPS, you get the drive innovation by embedding sustainability risk into our active investment process and for 30 BEPS, you get a sea change in global investing.” And I don’t even know what three funds he’s referring to. The first one is the S&P, but he then shows their top 10 holdings and weights and they’re basically identical. So, for one, you’re paying 30 BEPS and one are paying three. I mean, this also reminds me on the amount of money that’s locked in EFA and EEM, which they have comparison funds that are literally identical for much cheaper, but people just don’t pay enough attention.
And so the whole point of, I think, all of this is you should always know what you own and not just on a superficial level, there’s so much closet indexing going on out there, and particularly, with the traditional mutual fund space it’s worse because you have someone who says they’re doing something extremely active and then it just…you look at it and it’s the S&P 500. Problem there is they’re charging you one and a half. With an ETF that’s starting at 30, it’s not as offensive. Still offensive, which is why we’ve always aimed when we launch our funds to be extremely weird and different. Say that’s kind of the whole point where in 2021 buy and hold investing as a commodity. Like it or not, you can get a global portfolio for 0% cost. So to be weird and different and charge more, you really have to, not just say you’re going to. Anyway, that’s kind of the end of my rant.
Justin: Fair enough. Fair enough. No, I appreciate the color.
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Justin: So let’s shift gears a little bit. I want to touch on this idea of portfolios being ready for various environments. So we talked a little bit about an inflationary environment versus not, but kind of looking back at history, it encompasses so much more than that. And you had a really interesting podcast with Chris Cole recently, and you guys talked a little bit about the 100-year portfolio. So can you expand on that a little bit and give us your thoughts on that conversation and kind of what that means more broadly for investors in today’s environment?
Meb: Chris is the man. If you missed it, go check it out. It’s the second podcast we’ve done with Chris. And he penned one of the best investment publications the last couple years, talking about his Dragon Portfolio and how do you survive 100 years of various market regimes. And it speaks exactly to everything we’re talking about today, which is you have to be prepared for any market environment. In the past couple of years, we’ve seen negative-yielding sovereigns. I don’t know how many people were predicting that a decade ago. We’ve seen markets go crazy, the upside and downside, and everything in between. So how do you prepare a portfolio that can survive during these different sort of markets we’ve seen in the past 100 years? And both Chris and the crew here, I think, have pretty similar views. Most people kind of opt for the 60/40, something like that, and kind of stop there.
And traditionally that’s with U.S. stocks and bonds, which has to be one of the worst opportunity sets in history currently. I think you’re looking at probably zero real on U.S. stocks and probably zero real on bonds. So if you say with inflation maybe you’ll get a few percentage points, it’s not great.
And so looking at other strategies, and we did a fun exercise where we kind of labeled the strategies, he loves to talk about Dennis Rodman and how these pieces of portfolio fit together where if you have five similar players, even if they’re amazing players, you may not have a great team, you need to kind of complimentary. And I’m saying this with a little bit of melancholy with my Nuggets, just getting booted out of the playoffs, but you need a complementary team, and so we were trying to identify who of the best Bulls team was different portfolio metrics.
So you have to listen to the episode to figure out where we fitted in Jordan and Pippin. But I think both Chris and all of us here would say, you need to be diversified globally stocks, bonds. He likes trend-following as well as we do. We’re big value guys here. He talks about commodities and the long volatility component, which has really been his specialty for the past decade. And we implement that as well too. So I think the challenge for a lot of people, particularly professionals is moving away from that comfy career risk sort of area. If you look at David Swenson, for an example, arguably the greatest asset allocator in history recently passed away, but one of his legacies was this concept of thinking differently, where I have a tweet that shows his U.S. equity exposure over the years and last time I tweeted it, it was like 4% to publicly listed U.S. stocks.
What other institution is going to have 4% in publicly listed U.S. stocks? Now he gets some of that beta, of course, through other investments, certainly private equity and VC has a lot of U.S. stock beta exposure, but from someone who adds investments and other things that other people never would, I think it’s a very important lesson. But most people are just going to be unwilling to feel that different, like it’s an uncomfortable place to be. So our universe for the Trinity Portfolios, the starting point is half buy and hold and half trend. And trend is having a fantastic year in 2021. I feel uncomfortable saying that. I don’t want to jinx it. It’s been kind of a, not a particularly distinguished past decade for trend, did really amazing during the financial crisis, but it’s really come back into its own. We’ll see if it lasts, but with heavy allocations to value and foreign in real assets too. So, to me, I’m comfortable with being weird and different, but I think a lot of people really struggle with that. And so that’s not always important if you’re allocating at various points in the past 20 years, there’s been plenty of times when U.S. stocks and/or bonds looked great. Just now is not one of those times.
Justin: Yeah. No it’s an interesting point. And I think thinking about portfolios in terms of various environments and different ways to be allocated, be ready for different things is so critical. When you were talking about that, it reminded me of your conversation with Vineer Bhansali of LongTail Alpha, was interesting to hear him talk about how there isn’t one single hedging strategy or tail risk strategy that’s perfect for every environment. So I think it’s important, no matter how you look at your portfolio, to really consider all the possibilities, consider that there may not be one silver bullet, but a multitude of things that kind of help a portfolio be greater than the sum of its parts, so to speak. So let’s shift to something I think you have a pretty strong opinion on, ETFs and fund conversions. This whole idea of fund conversions really coming to light. There’s a great podcast with Jim Atkinson on this. Let’s get into it, you know, the mechanics, the benefits, the tax efficiency, different things. Why are fund managers considering this whole idea of converting to an ETF?
Meb: Yeah. It’s all happening. I mean, look, we’ve been talking about this for a long time and in Barron’s, I famously predicted ETF assets would cross mutual fund assets and kind of got laughed out of the room. And the concept is simply, the ETFs have a better structural wrapper. Full-stop. Now, you could speak to why the mutual fund lobby let this happen, and they were really foolish for doing so, but that’s the case and that’s the way the world exists. The IRS could certainly, and SEC, legislate that mutual funds could have the same tax status as ETFs. There’s zero chance that happening, but that would probably be the right thing to do. But since they’re not going to do that, the quick summary is you have the fee advantage of mutual funds over ETFs. Now, that doesn’t have to exist. Mutual funds charge more for a lot of legacy reasons.
They don’t have to. There are certainly cheap mutual funds, but on average, they’re about twice the expense ratio, but the taxed one is the one that goes kind of unnoticed. Now, it doesn’t matter in a lot of places. Obviously, if you’re in a tax-deferred or exempt account, doesn’t matter. But if you’re in a taxable account and you own an active mutual fund or your advisor owns active mutual funds, frankly, they should probably be fired. It’s something like two-thirds of mutual funds have meaningful capital gain distributions and the percentage of ETFs that do is like 5%. And there’s been a lot of different estimates for what that annual drag costs. The one that I’ve seen and quoted the most is about 70 basis points per year of cost, simply by using an active equity mutual fund versus ETF.
So not surprisingly people are waking up to this and you have companies that are doing conversions from mutual funds and hedge funds to ETF structures. And kudos to them. And it’s not just little offshoots, little upstarts, DFA just converted like a $30 billion lineup to ETFs. So I was listening to that Guinness Atkinson podcast and they said the entire mutual fund space should convert. Now, look, I realize there are some areas that there’s not that advantage, so if you have some weird and liquid stuff, that’ll never exist in ETF structure, mutual funds are fine. I think if you have a lot of the retirement plans, again, you’re not going to have the mutual fund ETF taxable difference. They still charge a lot more on average, you got to be careful, but in general, you keep seeing cracks in the dam and if companies like DFA and the big boys start converting in mass, you could see kind of the final blockbuster moment. I talked about it for years. I was like, “I always wondered what the big catalyst would be for ETFs taking over.” And, of course, it’s something as boring as taxes, but, but rightfully so well.
Justin: Well, we’ll keep our eyes and ears on it and see how things develop. It’d be interesting to watch, that’s for sure. So let’s move on to some listener Q&A. We had some really good suggestions. Thanks, Peter. On a couple of topics, I think would be good to cover. The first being playing defense in today’s environment. How does one do it? You covered this a little bit, but if you were to kind of sum this up and give us sort of the baseline approach, how would you do it?
Meb: One of the biggest takeaways that I think people have learned a couple of times in the past decade is this concept of your human capital being highly correlated to the business cycle and GDP. So, what’s going on in the world? And if you think about, if you could say, “Look, my portfolio is going to do 10% a year,” but if you could actually design when it does better and when it does worse, ideally you would probably want it to do better during the bad times, because that means you get to buy more of the things that everyone’s puking out, you get to have some money available when the markets are in 20%, 50%, 80% drawdowns and there’s stress sellers, but that’s actually kind of the opposite usually of what a traditional portfolio does. A traditional portfolio usually does poorly when it’s all hitting the fan, so global financial crisis and pandemic two back-to-back illustrated this quite clearly.
So we’re outliers here, but we own a big chunk of tail risk strategies at my company’s balance sheet. So a lot of people have taken this corporate treasury balance sheet debate into the marketplace. Now, many people have concluded, they want to own crypto, but we said, look, it makes sense, I think, to own a global diversified portfolio. We do it with Trinity Strategies, but also with tail risk. And it’s specific to a firm like ours where we’re even more exposed to the business cycle because of we get paid based on fees as a percentage of assets, which, look, the odd thing about this entire conversation is nothing would benefit us more than the U.S. market doubling from here because most of our funds over time want exposure to this equity marketplace, but we’re also want to be honest and realistic.
I don’t think you necessarily need tail risk strategies, but for my psyche and for others, I think it’s a thoughtful allocation if it works for you. So that’s how I do it, but, again, we tend to be pretty outliers on this concept. I’ve talked to people in the ensuing few years who have implemented similar concepts, but it applies to everything in your life. If you’re a lifetime employee at a company, big multinational, and as I’ve seen this mistake so many times, your human capital is all tied up in that company and then turn around and these people invest all their money in the company stock. That is the opposite takeaway from this conversation, is you want to be diversified. And so think about your own human personal capital. If all your money in livelihood is wrapped up in commercial real estate, do you then go put your whole portfolio in commercial REITs?
Probably not the best idea. Ditto with almost any other concept and this bias applies to sectors where people overweight the sectors of their geography and what they’re located in. I mean, talk to anybody in Texas and some of those cities, the outlook rises and falls with the price of oil and others, natural gas, etc. So I think it’s useful to think about this concept of how do you hedge your human capital, not just for the arithmetic of the portfolio, but also for just your general well-being and emotional stability and also take advantage when times are bad, which happens. May never happen again, but in general, the bear markets are a normal functioning part of free markets.
Justin: Yup. Well put. This ties a little bit to that first theme, but how about developing discipline? For example, when you recognized you got lucky with an investment, the kind of discipline that it takes to actually recognize that, first of all, and then to actually do something about it, what are the things people can be on the lookout for and what sort of things can folks put into place to make sure that they have sort of checks along the way to make sure that they’re not piling into things on an emotional basis or something like that?
Meb: One way we talked about earlier, which is just trying to codify your rules. The second is to make it automated. Nothing is more beautiful in the academic literature than showing the effects of what Vail [SP] and others call these nudges, but having an automated set-up to take you out of even the possibility of a decision, so automatically investing part of your paycheck into your retirement plan or 401k, that’s such an awesome one because you never see the money. You can’t spend it. Most of us, if given the opportunity to spend the money, we will because we start seeing, “Oh. Look at this bank balance. I can’t just let that sit around. I got to do something with it.” So having that sort of dollar-cost averaging into whatever investing plan you have is such a wonderful way to do it and almost every investing platform lets you. Believe me, they want you to increase your balances over time so they get paid more. So they love to have that feature enabled, but it’s such a no-brainer one. And there are so many apps now. I mean, the Vanguard Digital Advisor, we have our own at Cambria. I’m partnered with Betterment, but plenty of great options out there that just simply let you do all this with simple software.
Another way, if you don’t trust yourself and don’t feel like you have the education or capability or just emotional fortitude to do on your own, that’s a pretty honest assessment, so good for you. A lot of us don’t. Plenty of people do really dumb things with money and if you don’t think you do, then certainly just look at your friends and family. I’m pretty sure you can shake your head and identify a lot of people that are absolutely atrocious with money and investing. Then hire an advisor, find a good partner, a fiduciary that can help you and hopefully they offer value, not just on the investing side, but also in other extremely value-added areas like taxes, and estate planning, and tickets to your local show. I don’t know. But financial planners can be worth their weight in gold if they have thoughtful approach to markets and ideals are aligned with what you want to accomplish.
Justin: Agree. Well, Meb, thanks for the time. I think that’s all I have today. Do you have anything on your mind?
Meb: No. I’m just sitting here drinking Ugly water. Listeners, if you haven’t tried Ugly Drinks, I recently made an investment. We put through more of these. They’re like the flavored sparkling beverages. We got to try to hit them up to be a podcast sponsor because this is one of my favorite investments. I kind of reserve a certain part of the angel portfolio and we’re trying to write a piece on this, which hopefully we’ll get out soon on kind of my angel investing journey. But the later stage Peter Lynch-style products, products I love. So anyway, I’m polishing off another Ugly Drinks and then yeah, I got nothing else on my brain. Oh, travel. I forgot to update. By the way, listeners, we used to do a million of these. It’s been forever, but will find myself this summer, let’s see. North and South Carolina. We’ll be in Northern California, but kind of wine country. We got a lot of pandemic weddings where the weddings already happened, I think, but they’re now just having a reception.
We’ll be in Colorado at some point and Seattle and potentially Hawaii in the fall time.
Meb: We’ll see. Last time we were, there was baby moon pre-child according to some podcasts from a chocolate farm, roosters in the background, but it sounds like everyone and their grandma’s going to Hawaii and having to rent new halls because there’s no rental cars anywhere. So we were thinking about waiting until the fall time when everyone’s back in school. So we’ll see. I’m pretty happy just to stay pretty local here in SoCal too this summer and do some local trips. So anyway, listeners, if you want to say hello, reach out, shoot us an email, and we’ll see if we can catch up in person.
Justin: All right. Well, thanks, Meb. Appreciate the time.
Meb: All right. Friends, listeners, we will add all these show notes links. We’ll throw in some of these charts and links we talked about today at mebfaber.com/podcasts. We’re going to commit to these once a month. Shoot us questions – email@example.com. Thanks for listening, friends. And good investing.