Episode #392: Laurens Swinkels, Robeco – The Global Market Portfolio, (Realistic) Expected Returns & Global Factor Premiums
Guest: Laurens Swinkels is Robeco’s Head of Quant Strategy at the Sustainable Multi-Asset Solutions team. His area of expertise is empirical asset pricing.
Date Recorded: 2/2/2022 | Run-Time: 1:01:01
Summary: In today’s episode, we walk through some of Laurens’ favorite research. We begin with the global market portfolio, how it’s evolved over time and where crypto fits in today. Then we talk about his research on factor performance dating back to the 19th century.
We also cover his framework for determining expected returns for all major asset classes and why he and his team decided to include climate change in that analysis for the first time this year.
Be sure to stick around until the end when we touch on sin stocks, ESG, and even the tokenization of real estate and other assets.
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Links from the Episode:
- 0:40 – Sponsor: MUD\WTR – Use code “FABER” for 15% off
- 1:35 – Intro
- 2:20 – Welcome to our guest, Laurens Swinkels
- 3:57 – Lauren’s research on the global market portfolio (papers here and here)
- 11:15 – Link to Laurens’ research
- 15:00 – Where does crypto fit in the global market portfolio?
- 21:22 – Laurens’ research on global factor premiums since 1800 (link)
- 28:09 – How investors should think about factor investing
- 31:15 – Laurens’ research into sustainable investing, ESG and sin stocks
- 42:38 – Robeco’s huge report on expected returns
- 52:18 – Other areas Laurens is researching
- 55:37 – His most memorable investment over his career
- 57:19 – Learn more about Laurens; ssrn.com; Erasmus School of Economics; Twitter
Transcript of Episode 392:
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Meb: Hey friends, we got a really amazing show for you today. Our guest is on Robeco’s Quant equity research team and one of my favorite authors. On today’s show, we walk through some of our guest’s favorite research including the global market portfolio, how it’s evolved over time, the performance, and where crypto fits in today. Then we talk about his research on factor performance dating back to not the 20th, but the 19th century. We also cover his framework for determining expected returns for all major asset classes, what he’s seeing today, and why he and his team decided to include climate change in that analysis for the first time this year. Be sure to stick around until the end when we touch on sin stocks, ESG, and even the tokenization of real estate and other assets. Please enjoy this episode with Robeco’s Laurens Swinkels.
Meb: Laurens, welcome to the show.
Laurens: Thank you. Thanks for having me, Meb.
Meb: You have a beautiful background. Where do we find you today?
Laurens: I’m at home in Oslo, in Norway.
Meb: Are you originally Norwegian? Where are you originally from?
Laurens: I’m originally from Netherlands, as you can maybe hear from my accent as well. But I moved here, I think, about 9 to 10 years ago. I moved to Norway, yeah.
Meb: And what’s the vibe? I’ve never been, it’s very high on my bucket list. I’m a skier, so I want to come over and ski. As soon as the world starts reopened and again, I’m there.
Laurens: Yeah, you’re welcome.
Meb: Are you a skier?
Laurens: I’m a skier. But in Norway, skiing is cross-country skiing and downhill skiing is, like, everybody can do because you just need to be able to stand and then you can go downhill. But the real effort is the cross-country skiing. So, I’m not good at it but I enjoy it. That’s the thing.
Meb: I see the problem is, like, everyone in my family does it but it seems like so much work. But that’s part of it, I guess.
Laurens: It’s an exercise in the nature.
Meb: I’m getting better at backcountry skiing. I want to do the hot route in Europe at some point one of these days. Okay, you are officially one of my favorite authors.
Meb: Yeah. Now the bad news is I like to read papers in print form rather than on the computer or Kindle. And so, the environment has suffered at your hands because I print all your papers. How many papers have you written at this point? Do you know?
Laurens: I think published, around 40 to 50, something like that.
Laurens: Yeah. But that means I’ve written many more, but that’s the ones that actually made it.
Meb: Right. Well, good, let’s cover all of them today. You’ve written some of my favorites, including arguably one of my very favorites of the past few years. So, I thought we just really just cannonball in right now and start talking about some of them because I think they’re really fantastic. The first one, which is I talk a lot about and partially because of your work on this, that I feel like is not something that the world really talks that much about until recently because they just didn’t have either the data or just kind of a way to talk about it, which is the global market portfolio. So, why don’t we start there? Tell us what that even means and then we’re going to kind of dig deep and talk about all parts of this portfolio.
Laurens: So, what it means is already…it means different things to different people maybe. I tried to do in the paper that you referred to, me and my colleagues often got the question like, “What is the markets?” Because capital asset pricing model, many people refer to it and often it’s S&P 500 or something, but what is the market? So, depending always on who you ask, you got maybe slightly different answers because well, one takes that data series, the other one takes the other data series and include this asset class or not, etc. So then, I said with my colleagues, “Let’s do it right for once, we spent a month of time on it and then we’re done.” And how it usually goes with projects that you think will last only a month, they can last up to a couple of years and that’s also how this went.
What we focused on is not the theoretical market portfolio where everything is in because if everything is in, then it’s very difficult to say what is in it. But we focused on the global invested market portfolio as we call it, which to us means that we put all financial investors together and see what kind of investments they hold that they could trade with each other. So, that means if an investor holds a private home, that’s not part of our invested market portfolio because that’s not something that’s another investor would easily be able to buy. And just to say about financial investors. So, there’s also many maybe strategic investors that hold the position because governments, for example, because they have some other wishes with a certain company, that’s all what we do not include. Only those that really we think are financial investors that will trade with each other. So, free flows, you could say, to some extent.
Meb: So, tell me, what are the main components? Or what are…you can say what are all the components, but what are the main components of this portfolio? And how big is it today here in 2022, ballpark guess? Not to the decimal point, but to the many trillions.
Laurens: I updated that last week because I do it once a year, I update that as a service to the community to see where we are because I wrote a paper about 10 years ago. Now it’s at about $177 trillion.
Meb: So, let’s call it 200. I’ll round it up, I’m an optimist, just to make the numbers easy. What are the big components of that? What fits into the pie chart?
Laurens: Obviously, a large component is global equities, listed public equities. That’s the big part of that pie. Other very large parts are the government bonds and investment-grade corporate bonds. Now I have to do it from the top of my head, but I think around 40% or so is equities, 45% maybe, listed equities. And I think the government portfolios are probably 35 in total or something like that.
Meb: So, you end up with this kind of global market cap portfolio. You alluded to this in the beginning but just to kind of restate it in terms of magnitude, what are the big missing pieces? You said it’s kind of single-family housing, which is pretty big. Like, I think if I remember in your paper, it’s like…I don’t know, what do you say? Was it 50 trillion, 100 trillion?
Laurens: I think that’s very different estimates that are really far apart of this but I think typically, what people say is it’s about the entire market portfolio, the same size of it, so in this case, it would be 200 trillion or so would be global private real estate or something. It’s about the same size as what this investable market portfolio. So, that’s obviously a huge part. And I think that maybe some innovations going forward that risk-sharing on that field is also going to be more possible or more likely, but I think that’s a big part that is missing. Other part that is missing is human capital. Of course, a lot of the capital that we have is human capital. I know that there are some people who try to approximate the value of human capital but that’s something that we didn’t go into. It’s possible, but it’s a huge problem to estimate that.
Meb: Paper number 41.
Laurens: Yeah, maybe, maybe. But I think those two components are probably going to be very important. And, I mean, when I say the private real estate, think on that also like the corner shop where there’s like a cell phones corner shop, we also don’t because it’s not listed equity. So, those kinds of shops, I think, of course, if you add all these together, that’s also going to be quite a substantial amount of equity that’s in that.
Meb: So, you include private equity, though, but that’s the listed. And these questions are so hard to answer, so apologies for making you do the math on the spot. But are private companies like private non-listed, is that a huge chunk? Would it be kind of a minority would you guess? Or was it like 20 trillion, 50 trillion? Because in some countries, it’s probably more, I would assume.
Laurens: Yeah, so I think this should be coming…if you look at the national statistics offices, they probably have something, like, for economic activity of these small businesses from. But I estimate it’s huge because I think…I forgot how much of the total, like, labor force is by small to medium enterprises. I think that’s huge, so I estimate that equity would also be quite substantial if you would add all those up.
Meb: Yeah. We talked about farmland too on the show, which is another one that’s hard to allocate to but it’s changing. Like you mentioned, a lot of these things are changing. We bemoan the real estate sector in the United States is so antiquated, but there’s a lot of businesses trying to disrupt that not just on the transaction side and servicing, but also the ownership and ways to kind of securitize and sharing that. Anyway, so the global market portfolio, roughly 200 trillion, 40/60 call it stocks/bonds ballpark. How much of a bear was that to get all the data and put it all together? I mean, did you just have a sea of interns and poor PhD students where you doing this or how hard was this?
Laurens: Actually, in some sense…so people, they talk these days about the data science, so I like to call myself a data scientist in the sense that I’m actually digging up a lot of the data myself and evaluating it myself. So, it’s different maybe than from AI and machine learning data scientists type, but now I got this data all myself. And the main problem was not so much to find what the current market portfolio looks like because the data for market caps of asset classes today is…well, there’s still things like real estate that is always a debate when I mentioned it, but that’s can be done. But we decided to go back to 1960 to also make a comparison over time of how the market portfolio had changed over time.
And if you go back to 1960…actually, before 1985, returns are still available for many asset classes but to get to market capitalization rates, it was surprisingly difficult. So, for corporate bonds, for example, it was extremely difficult. So, I went together with a co-author to the…I think they called it the stacks in the library, so that’s where normal people can’t actually go, but you need a special pass from the librarian to go down in the basement and then dig up books, make with our phones copies of the data, and then later type it in by hand to collect that data. So, I mean, that’s the historical part of how we actually literally collected it, yeah.
Meb: So, a huge pain in the butt but a worthwhile venture because it leads you to this paper. And by the way, you mentioned this, but listeners, Laurens has a very generous download that he does from his website. We’ll put it on the show note links where you can download a lot of the…not only papers but data that he talks about on his website. So, we’ll put it in the show note links. So, tell us how has it changed in history? Is it always been sort of 40/60 over the past 50 years? And then we’ll start to dig into how it’s performed too over this time period. Was that the second paper, or was that part of the…?
Laurens: That was the second part that we did, yeah. Because I think the 60/40 that you mentioned, that was kind of the…we thought it should be quite stable at 60/40 because everybody talks about 60/40, so that must be it. But when we actually did the time series, we saw that there were periods that’s actually it was, I think, 75/25 or so for stocks, but also periods where the amount of stocks, I think, went to…now I’m doing it from the top of my head, but to 45% or so. So, there was quite some depending on issuance, of course, but also on the price of the assets. If it’s market-cap-weighted, then that’s a big part of it. So, it’s not moving extremely fast. Well, if the prices move fast, then that also moves fast, but also the issuance and the part that becomes investable because, in the end, that’s also what is important, of course. When things become…if big markets become investable for international investors, then the pie also gets bigger on part of this global invested market portfolio.
Meb: So, it floats over time. And then talk to me about how’s it done.
Laurens: Maybe on the floats over time parts, maybe I could add something to that because it’s tempting to see through. Like, look a little bit from a distance on the picture, I think, there must be mean reversion. So, prices of this asset class will go up and prices of that asset class will go down, and it will mean revert to the long-run average or so. So, we’re a bit careful in the interpretation of that because that can be part of it, of course. If some asset class is overvalued, then you would expect it to go out. But there are quite persistent deviations from it. So, we also see that, actually, issuance or buybacks, that can also drive it and that doesn’t always add up to investor returns. If there are a lot of issuances, then investors don’t see that as a return. So, it can mean reverts without investors benefiting from it of predicting it incorrectly.
And the returns, that is actually the question that we often got as well. Now we know what it looks like, but how did they do? Again, over the past 10 years, it is relatively easy to find performance metrics for most of these asset classes but again, when you go back in time, that was quite difficult. For example, real estate, to find what the performance of real estate was in the ’60s…and we talked about global real estate, in the ’60s was quite cumbersome. So, we did a lot of going to the library, browsing online, looking for books on bookfinder.com to find everything out. In the end, we found real returns. I don’t know whether that’s real or excess, there were, of course, different ways to look at it, but it’s about 4% over this period from 1962. I believe we end our sample in 2017 or so, but adding one or two years to such a long sample doesn’t really change the average too much.
Meb: Four per cent, I mean, nothing to shake a stick at. That’s pretty good. Although in 2020…well, I would have said this maybe last year, after a lot of the tech stocks and expensive stuff is sold off, I’ve imagined the expectations are coming down. But there were a lot of surveys floating around last year that people were expecting north of 15% returns on their portfolio.
Laurens: And they didn’t ask me for an estimate.
Meb: Right. And also, you know, people always struggle with nominal and real, I think, in the surveys. So, 4% real, tacked on, I don’t know, 3% or 4% inflation and you get up to that sort of 7%-8%, that seemingly every pension fund or institution expects, ballpark speaking. A few other questions we’ll just pepper you with, one which would be a guaranteed listener question, when do you guys going to start to incorporate cryptocurrencies in the global market portfolio and how are you going to think about that in the coming years?
Laurens: Yeah, and one of the drafts of the paper on returns, we actually included cryptocurrencies. But as you know, as academics, we have to sometimes listen to what reviewers say and they thought it was distracting to put it in. So, then we actually took it out but now we got so many people that, by hands, force it in. So, I’ve seen many of the graphs of the market portfolio where somebody added a slice of cryptocurrencies that we’re now working on a new paper where the end product should be monthly returns because the previous one that we did on returns was annual returns, which is nice if you want to look at the long-run average and these kind of things. But if you want to do really, like, risk analysis or calculate a beta or something like that, then it’s better to have a monthly return.
So, we’re working on that and now we include also cryptocurrencies. It’s different from day to day but, let’s say, roughly, 1% or so of the invested market portfolio. But, of course, since the volatility is very high, it’s more important than maybe…it’s not at the percent of government bonds or something. Its volatility is much higher, so it would count for some of the volatility of the market portfolio, even though the weight is only 1%. So, in that sense, the question often becomes, “Is it an asset?” I don’t know whether the English word is agnostic for that. So, if investors invest in it, then for me, that is…it seems that there’s many people active in this field and invest in it, therefore, it has some value. So then, it has apparently some value to investors. So, I’m not to judge whether they’re rights and attach a value to it.
Meb: It’s just funny because everyone comes to markets with their own bias and people often ask about the crypto angle. And the least satisfying response on the planet is when I say I say…they say, “Meb, should I buy crypto or should I include this in my portfolio?” I said, “Look, if you’re struggling with that,” and this I actually say, you know, applies to most asset classes, I’m like, “Just allocate in line with the global market weight.” So, crypto, I mean, again, depending on what it’s doing today, is somewhere between one-half of 1% to 1%, and no one wants to hear that. They either want to hear, “Zero, I shouldn’t own any of this,” or they want to hear, “I should put half my net worth in this.” And it’s like the least satisfying answer but accurate, I think. It’s a good heuristic with which to think about all assets, “Should I include gold? Should I include farmlands?” Yadda-yadda. Anyway.
Laurens: To me, I often say as the starting point, so if you’re not investing in an asset, there can be many reasons why not to invest in certain assets but I think it’s relevant to know whether you’re underrate relative to the average investor that is investing in it or not. To me, it’s a good way to compare your own portfolio against what the average dollar is doing in the world and how they are invested, and there can be many reasons to deviate from it.
Meb: So, why doesn’t…considering that it’s a pretty nice performing portfolio over time, you could have it today in 2022 for, at least here in the U.S., darn near-zero cost, maybe 5-10 basis points, why don’t a lot of people or more institutions just buy the market cap portfolio and be done with it? What’s all this extra work for? And this may be a lead through into the next part of our conversation on factors, but what’s wrong with the market portfolio? And why shouldn’t everyone use it?
Laurens: Because it’s aggregated to what all investors do. So, I think it’s very difficult for me to say that that’s wrong but, of course, to get really the market portfolio, I think there are some of these alternative asset classes. You said, 5 to 10, I think, then you’re covering about 80% of the market portfolio because I think if you want to get exposure to private equity or high yields or something, it’s probably more difficult to get at the near-zero cost but this doesn’t have to be very expensive overall for the portfolio level. I think what’s many investors are doing is looking at whether all these assets are priced correctly, whether the market is rights in pricing it. I think there have been several studies. I got a lot of feedback when we did this study on the market portfolio.
Apparently, if you publish the market portfolio, then you should also think that markets are efficient and that the CAPM works. That is kind of automatically what people attach to that, but we think of it more as a starting point and I cannot recommend everybody to deviate. Because if I give the same advice to everybody, everybody should hold to market portfolio. So, in that sense, it’s a very strong…but given that I’m not convincing everybody anyway about my investment views, I have a preference that’s…well, in one of the papers that we did with even a longer horizon, have a preference for cheap assets and assets with good momentum. I think that’s for me better and then if you look at this historically, that’s the performance relative to the risk has been much better than if you would simply hold the market portfolio.
Meb: Yeah, we often say, “Look, it’s a pretty awesome benchmark.” I personally think that it’s going to beat, in a Vanguard sort of way, two-thirds of a lot of the portfolios out there. I also personally believe that you can improve upon it, which is moving away from market cap weights perhaps within each asset class, and we do that, we have a strategy that does that. But in general, I think it’s a great starting point. I think it’s a great starting point for a lot of sort of insights and lessons. One of the biggest ones we talk a lot about…and this applies to every country in the world.
We talk about it specifically in the U.S because we believe the U.S. is expensive right now, but it applies even more so in certain countries like Norway or Canada or Australia where they’re a smaller percentage of the world market cap. The Norwegian sovereign fund, without talking the other day in the “Financial Times” about some of these ideas, but this concept of home bias where people put all their money in their own stock market. And I often say, I’m saying, “Look, Canadians, you put all your money in these gold miners and cannabis stocks or whatever,” I said, “You’re only a small sliver of the world, a starting point should be the global market portfolio.” Then if you want to deviate, fine, but this as a starting point is usually a pretty great place to be. Anyway, end of rant.
Laurens: I think you mentioned the sovereign wealth fund in Norway. That one, of course, has the opposite of a home bias because they’re not even allowed to invest in any assets that are dominated in the home currency. So, to prevent that from happening…well, I have another friend that is doing only the home bias stuff, but they have separate managers for that but they only invest outside. And also even in the Netherlands, so I think the Netherlands is one of the other countries in the world that has the least home bias of all. So, I think many large investors from the large pension funds in the Netherlands, they have global benchmarks and the Netherlands is, what is it, 1.5% or something of their equity portfolio.
Meb: So, global market portfolio, pretty great portfolio, good benchmark, good starting point. Something else you guys have done a lot of work on and we talked about sourcing data for the market portfolio as one bear problem or challenge, but you guys took on a whole next level challenge, which was thinking about factors, but thinking about factors to the 19th century. So, let’s start to dig in. As we move away from the market cap portfolio to factors, explain to us what a factor is, talk to us about what a couple of the factors are, and then we can start to talk about this concept of factor investing for a long time in history.
Laurens: Yeah, so if you think about factor investing, I see it more as just like a systematic style of investing where you focus on a certain characteristic of an asset. I think the two most famous factors are value and momentum where you look at a valuation characteristic of an asset and you compare it with the valuation of other assets. In a very simple way, you could just rank all the assets based on which one on that metric is cheap and which one is expensive. The typical factor strategy would then take a long position in the ones that are cheap and a short position in the ones that are expensive. And that supposing that you can do a hedge factor, otherwise, if you are a long-only investor, you would only buy the cheap assets, basically, and you let go of the expensive assets.
For momentum, it is focusing on those assets that have performed well. Typically, people take the past year or so as a starting point. So, look at which assets have had the highest returns over the past year, sometimes risk-corrected, mostly just plain returns. And then you rank them on best return to low return and you buy the ones with the best return and sell the one with the worst return. That’s basically how simple it is. So, you can do that on individual stocks or corporate bonds, for example. All these strategies seem to work across asset classes as well. But what we did for the study that you are referring to is look at this from an asset markets perspective, so we are going to look not at individual stocks going back to the 19th-century but looking at markets. So, we treat the U.S. markets as one asset and U.S. government bonds as one asset, but also then German bonds and French bonds, like, the entire stock markets assets to do these factor strategies with.
Meb: So, what did you find? What are the takeaways?
Laurens: Well, what was very surprising to us…because many of these studies on the factors across different markets that I just described, they have been already published in the top financial journals. Usually, they were, let’s say, discovered on U.S. equities first and then people ventured into other developed markets, emerging markets to see whether this works, but then also across these markets itself. But there are still a lot of people, at least that I talked to, that say, “Yeah, it could be data-mined, how do we know for sure that that’s the case?” Then we said, “Well, let’s just look at data that hasn’t been looked at before because then you have a real out-of-sample study if you can do that.”
So, that’s what my two co-authors and I, what we did, we just say, “So, how much data is there before?” Then we went back and got all the data back, for some instances, to 1800. And we found that these Sharpe ratios that were documented in the, let’s say, more recent literature, typically somewhere from 1980s or so, that the Sharpe ratios reported, they were roughly 0.5 on these factors. And when we went back to 1800s, these Sharpe ratios were slightly over 0.4, so very close to 0.5 that were originally documented. So, in that sense, we were…at least I was surprised that it was so similar because, of course, we know the world was very different in those days, but factor investing somehow was pretty close to what, I think, the results from that as we saw on more recent periods.
Meb: I’m putting Laurens on the hot seat here, what would you say, if you had to, of all the factors, do you have any favorites? Or do you have ones that you say, “You know what? As a researcher, as an investor, I think there’s a little more justification robustness for this?” I know Robeco is a big low vol shop. Do you like all of them? Or do you think all of them have a shot in the future?
Laurens: Yeah, so maybe that’s not the answer you want but I don’t really have a favorite factor because I think…and that was also what we see, that factors don’t always work. There are periods that they don’t, and so it’s good to have the other factors. And just by saying I have one favorite, that implies that I would let go of the others and then have periods that can be 10 years’ long that you don’t see any return. So, I think, really, our results show that if you have this multi-factor portfolio, that that is way superior to picking one or two of those factors. Of course, I think if I think about underpinnings, what I like is if there is also not only, like, strong statistical underpinning, but that there is also a good story that is either done or whether it gets hardwired behavior or institutional effects that seem to be good ways to explain such anomaly.
I think for that…well, at least in the past, what is it, 20 years something that I’m doing research now, it always seems that people say, “Ah, momentum and value, it’s easy to arbitrage, it’s easy to arbitrage.” But when you’re in the markets, it feels not so easy to arbitrage these things. So, even though you know that these…or at least I believe that these factors are there on the long run, it doesn’t come for free and there are periods…well, I think we both suffered at least from the value for a little bit of time before the last year. So, you have to be quite strong to live through the underperformance of one individual factor.
Meb: Yeah. I mean, look, that applies to both factors. So, you mentioned value has its time in the sun or momentum, yadda-yadda, but also asset classes, people struggle with this just as much where the U.S. outperforms foreign or commodities are underperforming and, like, it’s really hard for many investors. And this isn’t just…people assume that institutions are somehow exempt from this but we see a lot of these big institutions, time after time, make similar mistakes as individuals where they chase returns and on and on.
Laurens: I had several presentations in, I think…what was it? Early 2009 for a client where the hypothesis on the table was the equity premium is zero and together with a colleague, we had to kind of say, “Well, no, we think the equity premium is positive.” That’s the beginning of 2009 and, of course, three months later, the market just came up for…no, I think it hasn’t really come down until last month. But I think that’s how easy it is to look at 10-year past returns and then just say, “Well, now…” Because in that time, of course, if you looked 10 years back, the performance actually was close to zero and, yeah, then many were contemplating just to get rid of their entire equity portfolio.
Meb: Yeah. It’s rinse-repeat, man. It happens every cycle over and over and you will see the flows and you shake your head and you say, “How can people be doing this again and happens over and over?” What do you think about, in general…one of the things you mentioned was 100 or 200 years of this data, but then as the factors become known, do you think it’s a scenario where they will continue to outperform in the future because of what we just discussed, which is the flows, chasing things, and people being human? Do you think the outperformance will be less because of arbitrage sort of concepts? What’s your general, like, guess as to what the future holds for…
Because in my opinion, I think anything but market cap weighting should have 1% or 2% tailwind just because there’s no value sort of link. Things can go just bananas as we saw last year too in the U.S. But what’s your take? How should investors think about factor investing? And, like, there are certain Quant shops out there that think it’s possible to tilt or time when some of these look better versus their own history? So, a lot of people were saying, “Value looks great, now it’s at an extreme spread.”
Laurens: I think for many of the returns documented, you’ve seen many backtests in your life as well, so to actually make money in real life on that, typically, I would not assume that in-sample…or even though you try to correct as good as you can for data mining or for data dredging kind of issues, it seems to be a prudent assumption to make that in out of sample, you would get slightly less than what you found in your in-sample results. But I think, given if you look at many of these…like, our study finds a Sharpe ratio of 0.4 or so over this long period, which is not 1 or 1.5 that you sometimes documented. So then, I would get a bit skeptical but I think 0.4, maybe it’s a little bit on the high side but I don’t think that’s exceptional and I think something like that would be possible also going forwards.
And the reason, indeed, is not that we don’t know about it, although I’m also a bit skeptical that people in the past didn’t know. There’s also several of these old writings where people are kind of hinting to value at momentum already 150 years ago, but, of course, now it’s much easier, accessible, and implementable in all these things. But to actually follow that course and keep doing it even though it hasn’t worked for three or four years, I think that is something that they will…especially value momentum, they will keep existing for that reason. And, of course, it can be if suddenly everybody becomes rational and switches off that fear and greed kind of mode, it could disappear. I’m not excluding that possibility. But given what I’ve seen over the past 20 years, I would find it surprising if suddenly that switch goes around and suddenly everybody starts to be more rational in that sense. That seems unlikely to happen.
Meb: Yeah, that’s the one thing we can count on is human irrationality, no matter what happens.
Laurens: And what you said, I think, is also important because I think that’s often said, “It must be the retail investor.” And I’m happy to say that they might be more irrational but it’s not only people who are pushing the buttons at institutions, they are also people and they also have their career risk and all kinds of incentives to maybe actually follow the same patterns as we see in the data that we call factors, yeah.
Meb: I mean, that’s a perfect segue into a pretty timely and impactful significant institutional topic. And there are two of them and we can kind of pick and choose which way you want to go here. But these topics of, A, sustainable investing, ESG, and within that is a little subset of what we call sin stocks or sin companies. Let’s dig into the actual data of kind of what you found in some of your research here.
Laurens: Yeah, I think it’s an intriguing question. So, there’s a lot being said and a lot being done, and I don’t know whether it’s always for the right or the wrong reasons. So, together with some colleagues, we said, “So, let’s just ask ourselves these questions and see what we can find sometimes in the data or sometimes on arguments in prior literature.” I think one of the things when you talk about these sin stocks, often the question that comes up is, “Do they get extra returns or not?” I think that’s something that often is at least what people have on their minds. I think excluding stocks, and it doesn’t have to be sin stocks, once you start excluding, if you exclude a few stocks off the global market portfolio, probably you’re still going to be quite well-diversified. If you start excluding more and more, suddenly, you’re losing diversification.
So, I think that’s one of the things that are in one of the papers that we studied. We just quantify also, “Well, if you’re less diversified, that is costs,” because you could be more diversified and you could invest more in equities, for example, because now you increase the risk of your portfolio, but you could have diversified it better and then decrease the risk of the total portfolio. So, there is a cost to it if you exclude a little, maybe not so big. But if you exclude more, then that’s going to hurt you. But it also depends, of course, on what’s the expected return of the stuff that you exclude.
And many of the sin stocks, they actually have what we would call favorable factor exposures. So, they tend to be these stocks that are value-like, quality-like, and therefore, they have a higher expected return than the market has. So, if you exclude them, then your portfolio has a slightly lower return than the markets. You could repair that, there may be other value stocks or quality stocks that you could buy instead of those sin stocks that you don’t want to have in the portfolio, so you can repair it to a certain extent. But if you just do it blindly and naively just exclude those stocks, you would get also a little performance drag out of that. And then I think the third question, which I think is most difficult to empirically assess is, “Is there a sin premium on top of this?” And that is a very difficult question.
I think that a lot of research and literature search, it’s not easy to kind of get that part out to disentangle it from all the other effects that we see because returns are so noisy, and what is considered sin can also be time-varying on top of that, so it’s not that easy. But on top of it, there could still be sin premium but I think the primary stance was that what was called a sin premium, until a couple of years ago, my colleagues found that this actually, for a large part, was quality exposure that is…well, that was only the Fama-French Three-Factor model at that time. So, but if you have this…now we have the five-factor model, we could actually kind of explain why this additional performance of sin stocks was there.
Meb: Yeah, I mean, I think part of this is challenging from the sense…you mentioned a couple of great points. One is perception changes over time, of course. Two, I remember looking back at the French-Fama industries, back to the ’20s and I think two of the top three or five performing industries of all time were tobacco and beer. So, what do people love? And you can have your own opinion if those are sin companies or not but a lot of people, the tobacco in general, sets them off for various reasons. But you had some insights, in particular about ESG, which applied to tobacco companies and kind of who owns tobacco companies and divesting. Do you want to talk a little bit about that? Because I think it’s fascinating and the message you have is often I don’t think what the assumption of the majority of the media thinks about this topic.
Laurens: I also know that you have…I don’t know whether you have a vested interest, but at least I know where you’re from. I think if I heard correctly from the previous talks that you did with other people that you have a background around the tobacco industry.
Meb: Yeah, I mean, look, I’ve never been a smoker when I was a kid. I used to hide my parents’ cigarettes. Like, I saw one of those ads from the ’80s where, you know, smoking is going to give you black lungs or something, and so I used to literally, like, hide my parents’ cigarettes. And like everyone of our parents’ generation, everyone smoked. But I grew up in North Carolina, partially in Colorado also, but in North Carolina, I certainly was exposed to the tobacco industry. But other than that, I have no real connection.
Laurens: Okay. But I mean, that’s what’s the background that I heard that you were talking about with some other guests. So, I can also talk, I am, in some sense, from a different area but I was also hiding the cigarettes from my parents but to no avail. And my dad also passed away on lung cancer maybe 15 years ago now. So, that’s my personal story. And my mom is still smoking a lot. I don’t want to recommend anybody to smoke, that’s the first thing I want to say.
Meb: Europe is much better about this where on the cigarette packages, they have, like, giant skull and crossbones, basically, they’re like, “If you smoke this, you’re going to die.”
Laurens: It’s written on it that you’re going to die from it and it has a picture. If you don’t read it properly, then you see like a black lung or the different things pictured on it. So then, the question becomes if a person who is smoking…because in one of the papers, we asked like, “Is this exclusion effective?” So, if you every day take up the back while your kids are trying to hide it for you, you see it kills, it has a picture of somebody who already died on it, and you still decide to smoke, is a pension fund that is going to exclude this from their investment portfolio going to be the tipping point to have that person stop smoking? It could be, but I’m not easily convinced about that argument.
So, I think if that’s the goal of excluding tobacco stocks, and this could be other sin stocks, then I don’t think that’s really going to drive it. If it’s a moral issue…so, for my mother, when I stopped by at the airport, I’ve come from Norway so I can buy tax-free cigarettes, but I don’t because I think it’s bad, you should stop. So, I don’t want to be involved in this activity, so I don’t do it, although I know it would be financially advantageous to do it. So, if that’s the reason that investors don’t want to be associated with it, well, I cannot say much.
If you don’t want, then that’s a preference that you clearly have. That’s at least is different than thinking that the world is becoming a better place because of it. And I think one of the main special things why tobacco also is an easy target is because, like, it’s bad and there are not really alternative uses that are so great. So, it’s easy to fit in this system. But tobacco companies, most of the trading, I think one of the main points that we want to make, always is the primary market and the secondary markets. And tobacco companies have issued shares a long, long time ago…
Meb: Explain primary and secondary for those who aren’t…
Laurens: Okay, so if some companies want to set up a new business, they need money, one way to get money is to ask investors, “Please give me money.” And that’s what I call a primary or an issue, you go to the stock market to get new money. But once you have sold your new shares to the markets and the market has absorbed them, at that point, the market is selling it to other people based on preferences and whatever, that’s what’s happening. But the company is not involved anymore because they already got their money when they sold the shares and they can set up whatever they want to do.
So, the effects that you have by selling them, maybe you will depress the stock price if enough people are selling a stock compared to other stocks that are not sin that will go down. But if you don’t have to go to the markets to sell new shares, you’re not really that affected by the stock price. And I think for tobacco companies specifically, they tend to have quite some cash because they have addicted customers. so they can’t really go anywhere. And actually, they’re buying back shares, many of them are buying back shares. So now, they’re buying back shares a little bit cheaper than they were otherwise doing.
There are industries…so, I think mining, I hear often that it’s more capital-intense and they might actually need to go to the markets to get new capital regularly when they open a new mine and so on. So, maybe there, the potential effect that you have as an investor is bigger. But you have to really look at it case by case because if the company that you’re trying to exclude doesn’t need any fresh capital, maybe not that effective to do it. So, that’s one of the things that we looked at extensively. So, we also looked at more in general because often, we think about the price as investors, so the return or the price of capital but also, we looked once at the quantity of capital.
And we also did one study, actually, specifically for tobacco companies but also in general, how many more capital flow to good companies like, I don’t know, green companies or…what’s the opposite of sinful? Virtuous companies or so than to sin companies. And actually, it looks like if you add this all up, the quantity is about the same that goes to green or brown or sinful or not sinful company. The conclusion is it hasn’t happened. So, if that’s what the world wants to invest more in better companies that have better ratings or are greener, then the world is not there yet because there’s some way to go. In the past 10 years, nothing much was effective there.
Meb: I was joking on Twitter of kind of getting into it, I said, “You know, for a lot of people who really are being champions to the cause,” I was like, “The probably better scenario is to actually be shareholders and then vote,” and to people, that’s, like, explodes their brain. I said, “If you would really want to make some impact? That is a potential way to do it.” And you’re starting to see some activist campaigns in this sort of genre that you wouldn’t normally see.
Laurens: Yeah, but it’s a bit difficult in the sense that, of course, you need to vote on behalf of many shares to have some impact on these companies, then you need to collaborate with other investors that have the same view. It also takes efforts to actually write up new proposals to kind of dig into it. So, I think some investors are more keen on saying, “Well,” for example, “The tobacco company is less likely to switch to become a good company, so I’ll put my effort in something else than to spend time on them.” If you find 51% of investors who agree with you that they should put, I don’t know, less nicotine or…I don’t know, but do things that are in the ends are better for the world, let’s put it that way, then you could influence the company by definition, but you need to gather enough shareholders to agree with you that this is the way to go.
There’s also all kinds of political issues, whether this is something that we should want but that can be a political issue, but you can, for sure, exert efforts. I think what is often missed here is that once the share is issued, often that’s it. You can vote, so you should. But bonds stay mature. Stocks don’t mature but bonds mature. Assuming that many of these sin companies also want to keep their capital structure the same, they need to roll the bonds every, I don’t know, 5 years, 10 years, depending on the maturity that they have. So, if you want companies to change and you’re a corporate bonds investor, you could all the time at least say, “Well, you change this incrementally, this is better. Otherwise, when you have to roll your next bonds, I’m not going to buy it.” At least that’s a fresh capital moment when new fresh capital can be directed to the company or to another company that behaves better. So, I think also for bondholders, that’s a bit underutilized maybe, that they have also some impacts in letting their voice be heard to the company management to do well and I think that’s something we will seem, yeah.
Meb: Yeah. I got this one more thing I want to ask. Robeco put out a monster 120-something page expected returns PDF and had a big climate angle. As you think about a framework for kind of constructing return expectations, talk to us a little bit about how you think about that? Does mean reversion play a role? Is climate is something we should be thinking about? How do you kind of think about the future being different from the past and what are the main levers most investors should consider?
Laurens: Yeah, that’s what I’ve been doing over the past…I think this was our…the last one was the 11th publication or so. So, every year we update it and we have kind of a five-year horizon on when we think about it. So, not too long, but also not too near term. But we do have a study on, really, particularly like equilibrium risk premia or something, so on the really long run where we use this 200 years of data if we have it for certain asset classes and we tried to use economic theories to get like a long-run picture unconditional or like a really long run picture. But then we believe that the market is not always in equilibrium and have exactly those risk premia that we have seen on the long run.
So, our second building block is valuations at the asset class level now, so we look at whether equities are expensive, bonds are expensive, corporate bonds are expensive, these kind of things. And that’s a very important component because I think we can say that the long-term interest rates on the long run should be 4% but if they’re currently 0%, then the yield we get is closer to zero to the 4%, that we think we get on the really, really long run. So, valuation is important. And then we have a component that is also trying to look at, “Is there a reason for this valuation?” So, a macro component, our macroeconomists look at, “Is this cheap for a reason?” so to say. Or expensive for a reason? Try to put this valuation into perspective and see whether that, like, it’s overly expensive or overly cheap given the macroeconomic outlook that we have. So, that is the main component we had for 10 years.
And last year, we also introduced a climate component, then we look, again, at the asset class level and not at whether within the energy sector, there’s winners and losers or something because that’s another level. But at that asset class level, which asset classes may be more affected by climate change than other asset classes? The first thing we actually went back to look at is to think, “Well, how can climate change return because it’s not maybe that obvious?” So, I teach also a class at Erasmus University in the Netherlands on Finance 1, so the basic principles. So, I thought, “Well, if I teach that to the students, I also put my basic formula of pricing in this report and look at what part of climate will affect the cash flows that we need to discount and what parts will affect the discount rates.”
Because, in the end, it’s cash flows that we need to discount that will determine the price of an asset and then the return of an asset. Because I hear a lot of stranded assets. I’m not sure whether that was a term that you hear a lot in the U.S., but stranded assets, that’s typically something that I hear a lot. To me, that sounds really like something that would be a cash flow effect because that means that there’s less cash flows than originally were predicted before we knew it were stranded assets or something. Once we realized that those assets are stranded, there’s a whole market looking at…they know what the oil reserves are and etc., etc. So, do you know better than the markets what a stranded or not? That’s the important question, I think, for an active manager then.
But once that is known and you have to take that out of the numerator, then the expected return is, again, the same because the discount rate hasn’t really changed. So, from that point on, the expected return is the same as for other assets. The other thing is if you think it’s more risky, these carbon-intense assets, you have to discount them at the higher rates, that’s also a possibility. If you do that, then the expected returns on brown assets is higher than on green assets. So, just consequences to kind of thinking about this way on what this means for investors.
So, we are putting this piece together and I think how we see it now is that the current discount rate and the one that we think that will be there in equilibrium or so if it’s properly priced, and we think that the discount rates can go up further for carbon-intense companies, which means that the bar doesn’t go up, that’s just not good for brown companies on average, right? Because then you start discounting against the higher rates, which means that the price is going down. That’s why we think that carbon-intense assets will do a bit worse than green assets or around here, you call it non-carbon-intense assets, which would be negative for emerging markets and high yields because they tend to be a little bit more carbon-intense than developed market equities and investment-grade corporates.
Now, of course, the big thing that is in between here is also the oil price because you can be carbon-intense but if oil price is going up, as we have seen in the past, then those assets through the cash flow effect will do very well because now the cash flows are streaming into these companies. So, that’s still, of course, also an effect that is there. But we try to…at least we try to put a little bit of more structure on the discussion because we hear a lot of discussion about it. Where are these expected returns are coming from and how this will evolve over time? That’s what we tried to do in that report that you are referring to.
Meb: So, what are the big returns, baby? Tell me what asset class that was going to do 20% a year for the next five years and what’s doing negative 10%? Anything in general that looks better than historical and what looks worse than historical for the next five years?
Laurens: So, since the starting point is actually quite low, yeah? So, because the risk-free rate is quite low, the starting point is so low that there’s actually not a lot that is looking better on the nominal terms than historically was the case. Our expectations for commodities are quite okay because I don’t know off the top of my head whether it’s exactly on the long-run equilibrium. But if it’s not, then it’s at least very close to it because also in the energy transition that we see, a lot of commodities are needed to build all those windmills to the electrification that we see and the car fleets, etc., etc.
There’s a lot of mining and other industrial metals that are necessary for that to happen. So, we think that commodities have also been lagging a bit. If you don’t take the last year into account, but, like, the 10 years before, commodities have been lagging a little bit on the prices but also on the investments from that side. There hasn’t been a lot of investment in new mines or new activity. So, we think that commodities are closest to the long-run average, like, have a quite high return. I think for equities, we are close to 5% or so in dollar terms. I’m not sure whether that is making you enthusiastic, I’ve heard you say you expect 0% for the next 10 years or so. So, maybe that is very optimistic to come up with five.
Meb: But to me, that’s just U.S. Foreign I think is very attractive, in particular, the emerging markets. But I think commodities…I’m sitting here and I tweeted the other day where I said, “In Los Angeles, we had…” I said, “I spotted $6 per gallon gas in LA last weekend,” which is really high. But as commodities are kind of ripping here and across the board with the exception, of course, of probably precious metals, it reminds me of the full cycle. You know, early 2000s, commodities were institutionalized, really, for one of the first times ever, broadly speaking, partially because they had a great performance.
And then every institution and their mothers started adding commodities, and then what happened? Commodities had a horrible performance for a decade, you started seeing all the institutions…many of them, not all of them, many of them start to divest and say, “Okay, well, that was a mistake, we don’t think commodities are a great investment”, just in time for commodities to have a nice run. Here, again, we’ll see how long it lasts but we poll people regularly just to kind of get a feeling and almost no one has any meaningful allocation to real assets in general other than their own house. So, REITs, commodities, TIPS, that area is often very under-allocated, it seems like.
Laurens: Yeah. And especially for…maybe, that goes even back to my Ph.D. thesis that I think I wrote back in early 2000s, where there was also a chapter on commodity investing where I think if you want to protect your asset against inflation, one of the sources of inflation is commodity prices. So, if you’re investing in that, then at least there is a partial protection coming from that part that you can at least protect some of your assets against inflation. That’s at least an attractive property of commodity investing. Apart from that, currently, we expected to also have a high return to correlate nicely with purchasing power.
Meb: Yeah. Circling back to the very beginning of the conversation, how do you handle commodities as part of the global market portfolio that’s notoriously a little squishy to weighted commodities? Is it based on production or economic use? How would you kind of slot them in?
Laurens: The one that I annually update, the reviewer demanded us to kick it out, which was quite special because that was also…in one of the first drafts, we made the estimates to put it in. But then in the later version when we do get the return, so part two of that project, and then we put it back in ourselves. Then, we looked again at financial investments and we think how we reason is that tankers of oil, that is not really financial investments. So, basically, it’s derivatives that you can see as a financial investment but derivative, somebody is long, the other one is short. So, zero, that is not. So, what we did is we looked at gold that is held for investments and silver and I think there’s a few more, platinum and palladium I think, so that’s the four metals.
And then we look at estimates of investors that hold commodity-linked investment products, so that are kind of long commodities on that side. Compared to gold and silver, that was not a very big part of that portfolio. So, I don’t know from the top of my head what’s the total share with us, but we included it in the last draft. And now we’re going to add cryptocurrencies to that same basket of commodities kind of, although, of course, it’s not a physical commodity. But mainly it’s gold and I think it’s fair because many investors do hold gold as part of their portfolio, like a long-only gold investment. I think that makes sense to have it into that. Yeah, and for derivatives, it’s just a bit complicated and we don’t want to put oil tankers in.
Meb: What else are you thinking about? What’s interesting to you? What’s got you confused? What’s got you excited? What’s got you depressed? All those emotions. What are you working on?
Laurens: You mentioned in the beginning real estate, because there’s so much going on in the crypto that I thought I also have to think a little bit more about it. But what I was thinking about is that you now see that real assets are being tokenized, not at extremely large scale now but there is tokenization of residential real estates going on in the U.S. specifically. The nice thing about it is that when it’s on the blockchain, it’s public. So, I was digging up myself, again, looking at the…what is it? Blockscout or whatever, to look up that data. So, I have a working paper on just that, on how investors that invest in tokenized real estates, what their portfolios look like, and whether houses worth $50,000, whether they are really kind of little fractional ownership because I think that’s the promise of the centralized financing that now you can own a few bricks of a house.
It seems that that actually is the case, so I was surprised that this market…at least in the initial study that I did and put out, that the market is living up to the promises. So, I expect more on that side but also thinking about the projects because now also stocks are tokenized so you can trade them actually 24/7, the tokens of these stocks, individual stocks that is. I recently heard that many of the stock return is earned during the nights rather than during the day. Now, we can also look at if we have two tokens that trade 24/7, we can actually look at what part of the nights these returns are made based on information or what’s going on?
Or maybe it’s just the opening that’s causing it. That could also be the case, of course. But I’m trying to look a little bit on the tokenized sphere, that’s one area I think is promising more than, for me, the NFTs, and so it’s not that interesting. I’m more into the real assets that can also be on the blockchain. And, of course, we already talked about sustainable investing. I think that’s something that is on my agenda…a big part of my research agenda as well. So, I’m thinking more now these days about impact investing also, so how can you not excluding but how can you have real-world impact with your investment portfolio? And I think that’s very exciting to think about but I don’t have any answers yet.
Meb: I was going to say, what’s the preview there? I don’t know.
Laurens: For example, when I think about governments, if you think about it in a, let’s say, ESG perspective, typically, the countries that come up that are very high on this ranking is, for example, Norway, the country I live in. I don’t think we are the ones that need the money the most in the world to actually make the world better. I think there are governments that need the money more to actually change part of the world for the real better. I think this current ESG framework, they are good to think about, “Who will pay me back? Who is responsible with my money?” But I don’t think that is where you have the biggest impact for every dollar that you invest.
So, I’m more thinking about how can we characterized countries where there is a big gap when you think about sustainable development goals or something else, like where there’s a big potential to make progress, and where it is likely that the money doesn’t end up in the wrong pockets but that you actually will have some positive influence on these countries. So, that’s what I’m now trying to get my head around on how to think about that and how to structure that in an investment portfolio. So, I think that’s exciting to think about, not only who will give the money back, but who needs the money to do something good. That is kind of the idea behind it, yeah.
Meb: What’s been your most memorable investment? You’ve been involved with anything good, bad, in between, do you remember, of course, in the span of your lifetime? Yeah.
Laurens: The thing is you talked to many CIOs on the podcast, now you’re talking to a researcher, so I’m actually not a PM where I’m choosing a lot of investments. So, one that I think is most memorable to myself is when I was, I think, probably 9 years old or something like that, maybe 10. It was on the news that the U.S. dollar…at that time, we had the guilders in the Netherlands, so this is pre-Euro time, that it’s fell, I forgot, 50% or something. There was a big drop, maybe it was in ’86 or something like that. And then I pulled two guilders out of my piggy bank, I think, you called it then, I went to the local branch of the bank, and I bought $1.
And at that time, everything was without commissions or anything, so I just went there to buy $1 because I thought the dollar was a value investment for myself. And I was very proud coming back home to actually show everybody that I was now into currency management. Of course, I think the dollar at this day is still about at the same level as it was when I bought it then but I thought that’s very fun. I came to realize that this is also something that’s kind of how this financial market work that from that moment already, I was sparked in my interest in financial markets, how it works, and what determines the value of certain assets, and so on. So, that’s what always stuck with me.
Meb: It’s a great lesson. Like, thinking about currencies, for many people, tends to be a challenging concept when you start to thinking about investments. But from a practical standpoint, we used to give away, you can find them on eBay, a lot of the hyper inflated currencies from Zimbabwe and other places. You can buy them and pick them up and it’s a fun reminder of how certain currency systems work, etc. Laurens, this has been a whirlwind tour from the global market portfolio to your piggy bank to ESG, the factors, and everything in between, we’ll definitely have to do this again sometime. But in the meantime, where do people go? Well, I had the show notes links, but best places to keep track of what you’re up to, your writings, what’s going on, what’s the best spots?
Laurens: The best spot is to look at the homepage from me at Erasmus University. When I have a new working paper, I post it there. But most of the working papers, in the end, end up at SSRN. So, if people are happy to look at SSRN, that’s where they will see it coming past as well. So, I think that’s the best spot to look at it for research on my side.
Meb: And you’re also fun to follow on Twitter. So, listeners, we’ll post your Twitter handle as well.
Laurens: Yeah, of course, and there I also promote other people’s work that I think is interesting to have a look at because it’s more than just the research that I do myself there, yeah.
Meb: Laurens, this has been a blast. Thanks so much for joining us today.
Laurens: Thank you for the invitation. Thanks.
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 feedback at firstname.lastname@example.org. We love to read the reviews. Please review us on iTunes and subscribe to the show anywhere good podcasts are found. Thanks for listening, friends, and good investing.