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Excess Returns
99.9% Focus on the Wrong Question | Victor Haghani on Why Static Allocation Fails
01:05:37
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- [00:00]
A
Investing involves two decisions. What are you going to own and how much of it? And like 99.9% of what we read and see if we're on in the financial media, if we turn on cnbc, it's all about what the what question. But this other question of how much is really, really important too because if you get that wrong in either, in either direction, it's so harmful. The whole 6040 portfolio is a total abrogation of duty. It's like saying, I don't know anything about expected returns. I'm going to be 60, 40, you know, for no good reason. It's pretty easy to see that companies buying back 3% of their stock could be pushing equities up 3 to 5% a year. While that's happening, I'm really worried about this level of low expected returns. I'm worried about the degree that investors are extrapolating past returns into the future. It's very difficult for corporate earnings to like totally break away from GDP growth the way that people have to be believing that to be the case if they thought about it.
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B
Victor, thank you for joining us and welcome to Excess Returns.
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A
Great to be here. Thank you.
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B
You are the founder and CIO of Elm Wealth. You're a researcher, you, you're an author, you wrote the book the Missing Billionaires A Guide to Better Financial Decisions. You guys also run an etf. And so we're excited to jump into a number of different, I think, topics and threads with you today. Part of it's going to be talking about investment process, things like dynamic indexing, how you think about expected returns, risk management and how sort of all this is incorporated in portfolio allocations and that you run for your clients. I'm just going to say right up front there is tons of valuable content, research papers, tools, little widgets you can play with on Elm Wealth's site. We encourage everyone to go there to learn more about sort of the way that you guys think over there, the frameworks that you've created and the way that you manage money and grow your clients wealth. So people can learn more@elmwealth.com and also learn more about your ETF@elmfunds.com.
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A
So with.
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B
That little intro, thanks again and yeah, Jack, let me kick it over to you for this to set up sort of some, some of the background here.
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C
Yeah, just to, to echo what you said about EL wealth. Like I had a hard time coming up with the outline, there was so much good stuff on there, so. But we'll definitely have to have you back sometime to, to cover all these various topics?
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A
Yeah, it'd be my pleasure, definitely.
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C
But one thing really stuck with me when I was doing all the research for this and that's what you see is there's many people in the investing world that think they can beat the market or think they have the greatest investment strategy that run complex strategies. And you were one of those, you were at Long Term Capital Management. And what you almost never see in those people is if something blows up or if they don't outperform the market and they get redeemed, they just think, you know, what the market was wrong, you know, or I made a mistake, but in hindsight I know the mistake I made. And they go and they continue to deploy those types of strategies over and over and over again. And you went a completely different direction after Long Term Capital Management, whereas now you run what I think is mostly a passive strategy. So you really have embraced those principles of simplicity and passive investing. And I'm just wondering if you could talk about that journey of how you got from there to here.
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A
Sure. Well, you know, I think one of the really interesting parts of, you know, my story, which I think is a really common story, is that, you know, I went to Wall street in 1984, started working at Salomon Brothers and then eventually was one of the co founding partners at ltcm. And you know, from the time I left university where I had studied finance, but from the time I left university until, you know, after the blow up of ltcm, I was taught and learned very little about personal investing. You know, that, that I got to Solomon and the training that I got at Salomon Brothers was how to be a valuable investment banker. On the sales. In the sales and trading area. In the trading area. And I was also in research and at ltcm I was also focused on learning and doing the best that I could with, you know, relative value hedge fund strategies that we were doing at the time. So when LTCM was over, I realized that I didn't, I hadn't really thought about how to invest my family's savings, such as they were after that. And, and then, you know, it didn't happen right away, but the, there was this evolution where the first thing that I did, you know, this is now going Back to like 2000, 2001, is I looked around me and what I saw was, you know, everybody was trying to follow the David Swenson Yale endowment model, you know, trying to generate alpha, trying to, you know, be this long horizon investor that could patiently earn Excess alpha type returns. And you know, it took me about five or six years to kind of to, to realize that this didn't work for an individual investor, even an individual investor like myself that was pretty knowledgeable about different investment strategies, that had a lot of micro market knowledge and understanding and experience. It just, you know, whether it works for Yale, you know, is, is, is, is another question. But I can tell you for sure it doesn't work for a person like me. And that's what got me thinking about going back to basics, going back to what I had learned in university and, and getting to a really simple diversified portfolio of public market equities and fixed income and just managing that and accepting that as the amount of excess return and risk that would be reasonable to take for the rest of my life and thereafter. And you know, I think also part of my thinking, or at least was, you know, that my thinking was furthered along by a couple of other things too. One of them was taxes. You know, as a US taxable investor that trying to beat the market is very, very tax challenged. Investing in alternatives tends to be very tax inefficient and, and being, you know, pretty frenetic in your trading is also fairly tax inefficient and difficult, especially as an individual. And then, you know, the other thing was kind of thinking about, you know, my kids and grandkids and so on. I have three children and you know, I was thinking, well, you know, what example do I want to show to them about what they should do if they have savings that they're investing? You know, should they devote a large fraction of their lives to trying to generate alpha? You know, is that a reasonable thing for them to do? And if they saw me doing that, you know, it would kind of set an example to them like oh, they should do that. And that was the furthest thing that I would want for them, you know, or any or any future family members or anybody around me also, you know, just, you know, lots and lots. I have nieces and nephews and all kinds of young people that I want to set this example to, of, of sensible long term investing. But really I think one of the most interesting parts of this whole story is like how, how you can go through 20 years at, you know, kind of leading edge institutions surrounded by brilliant finance professors and, and all these people and not really ever be taught about personal investing. And I think that's a real failure of our system that, that we would, we don't teach people more. And I'd love to talk about that Whole topic, a lot more. So anyway, that was kind of the journey from Solomon Brothers and LTCM Hedge fund, proprietary fixed income trader to index investor.
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B
Well, isn't there the famous Warren Buffett quote, you know, something along the lines like it's not the guy with 160 IQ that beats the guy with the 110 IQ, it's the guy that's able to control his temperament, you know, is the one that can be maybe more successful in investing. I don't know if that plays into how you guys think about the markets, but.
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A
Yeah, no, definitely. I think, you know, that's, I think you have to be realistic about your capabilities. You know that, that there are professional investors, there's alpha out there. We know that there's alpha that's out there. And you know, if you want to get out there and compete with, you know, Rentech's Medallion Fund or all these other, or Citadel, you know, you've got to take it seriously and compete with them. You got to have a chance of competing with them, you know, and realize what they're bringing to the table. And you've got to bring something similar to the table and you can't do that as an individual.
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B
One of the things that you've talked about when constructing a portfolio or building an investment strategy isn't really the decision on what to buy, although that's important. But you know, at Elmwealth, you guys are mostly focused on trying to get, you know, exposure to various parts of the market very, you know, cheaply through index funds and there's other holdings in there too. But that's kind of the main core of it, as I understand it. But just talk about the idea. It's not necessarily like it's, it's the how much of what you're buying that's important and how do you think about that in terms of position, position sizing in the portfolio and in, in terms of risk management?
- [09:45]
A
Sure. So yeah, that we, you know, we like to say that as has been said by many others, investing involves two decisions. What are you going to own and how much of it? And like 99.9% of what we read and, and see if we're on, in the financial media, if we turn on cnbc, it's all about what the what question, what should we buy? And that's really important. You know, you got to answer both these questions. I'm not denigrating the what question. We'll come back to that in a second. But this other question of how much is really, really Important too, because if you get that wrong in either, in either direction, it's so harmful. So if you know that if you decide I'm not going to invest in anything risky at all, even though I recognize that it has a positive excess expected return, that's really bad. And that, you know, really leaves you way behind where you should be, you know, versus a, versus a more sensible allocation to risky assets. But in the other direction, it's even crazier, right? Like if you take too much risk, then even if you have good investments, you'll go broke, you know, so even if you find stuff that has a 20% return, let's say you find stuff that has a 20% return and it has only a 10% risk per annum or something like that, you know, it's amazing. It's wonderful. Well, there's some degree of scaling, there's some amount that you could own of that where you will go bust, you know, just, you know, because you know there's going to be some period of time when the drawdown multiplied by your leverage, you know, wipes you out. And so that how much decision is as critical or more critical, in fact, you know that if you get the wrong decision on the what question, you kind of survive it. If you're, if you size things reasonably and you live to invest another day. But if you get the how much question wrong in the too big size, you know, then you get wiped out and you have to start over. And that's really painful. So the other thing is that the how much question is easier, you know, that the what question? Well, the what question. I'm sorry, the what question can also be easy. Like if you decide that you're going to go with something pretty, you know, pretty passive. On the what side? If you're going to invest in index funds, you make that decision, fine. But if you're searching for things that are going to beat the market now you're in the most competitive game in the world, and that's a really hard game to win. Whereas it's, and it's zero sum. The how much decision is not zero sum. I can make the optimal how much decision for me. You can make the optimal how much decision for you and we're all happy. My, my success is not your failure. We can all be successful in sizing at the same time, but we can't all be successful in invest on the what question unless we invest in something like index funds, you know, then fine, we can all be successful together, but you know, we're not. Nobody's beating the market. In that case, if you want to beat the market, you have to find somebody that you can, that, that, that, that is up for losing.
- [12:54]
B
And, and just like more tactically I guess, how do you think about that sizing? Is it like, you know, you're looking at how it fits into the overall portfolio and how it affects risk adjusted returns. Like just kind of walk through how you try to optimize that sizing question.
- [13:09]
A
Sure. Well, risk, risk should be viewed as having a cause. Like risk is, risk is like a fee. You know, the, the you're kind of charging yourself a fee is a, is a good way to think about it. And, and, and, and you can see what that cost of risk is by asking yourself the question of, of what would you accept as a risk free return in lieu of a higher risky expected return. So let's just say that I think about a portfolio of stocks and bonds and I say, okay, I'm going to be 70% in stocks and 30% in bonds. I think stocks have an extra 4% expected return above bonds. So I have an expected return of 2.8% above the bonds for my portfolio. Well, I can, I should ask myself, Vic, what would you accept? You're not allowed to invest in stocks. What risk free return like over the risk free rate would you accept to forego that expected return of 2.8% and be just as happy but getting a risk free return? And I should be able to answer that just by noodling on it. I don't need any kind of formulas or math or anything. I just can think about it and say, well, okay, I think, I guess I would accept 1.6% risk free in lieu of the 2.8%. So the 1.6% is my risk free return above the risk free rate. The difference between 2.8 and 1.6, that's 1.2%. That's the cost of risk. And what I want to do is I want to think about different amounts of equities that I could own and what amount of equities gives me the highest risk adjusted return. You know, what amount of equities will I answer that question with the highest number, you know, for my portfolio. And I just need to kind of think about that and search over that and think about that a little bit. And you know, that's, that's really all there is to it. Now. You know, we can bring in some, you know, we can bring in a little bit of machinery if we want to, you know, and kind of, you know, calibrate our risk aversion, you know, using a utility function, all that. But you don't need to do any of that. You know, you don't need to do any of that. You can just really interrogate yourself to come to the optimal sizing decision. And also we need to realize it was really important when it comes to optimal sizing, is that your risk if on the X axis it's like how much risky asset or how much equities do I own? And on the Y axis is my risk adjusted return, that the shape of this curve is very flat at the top. It's kind of parabolic. It's not like a mountaintop like that. It's not like the Grand Teton summit. It's really rounded out. And so what that means is that you don't need to hit it on the head. Like anything kind of in the vicinity is as good as anything else. So like if I would say okay, given a 4% excess return for equities and given, and given kind of a normal amount of riskiness for equities, let's say I would say my optimal, the optimal allocation I want to equities for me it's my personal preferences is 85%. Let's say I somehow I know that's optimal. Well, there's almost no difference between being at 75 or, or 92. You know, it's like almost going to be the same expected risk adjusted return. And that's really good. It takes the pressure off. But you know, as you start to get far away then the slope really gets big. So like if I would say, well I just, you know that my optimal is 85 but I'm just going to be at 20. Oh, but that's really bad. You know, I'm really losing out a lot. Or if my optimal is at 80 and I want to be at 160 and levered, that's really bad. You know, it's like I've given up everything then and maybe more. So that's how I like to think about it. Really simple, you know, just this idea of the cost of risk, risk adjusted return, expected return and just putting, you know, just thinking about those things.
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B
One of the things that is on a lot of investors minds right now is the market valuation. And there's a lot of different ways you can look at the market's valuation. But one of the more popular ways is looking at something called the Cape ratio or the Shiller pe. And as Jack mentioned before know, and what we appreciate at Elm wealth is There's a lot of like original thought and research going on at the firm. And so you guys are putting out research and white papers. And as I mentioned, you've written a book, but you published a piece on the CAPE ratio. But it's this P cape which I think is incorporating dividend payouts into the cape. And sort of you found that it helped improve some of the issues with the cape. So can you just talk to that? Because that's. This is going to be. A lot of. Our audience is very familiar with the cape. We just discussed it with Jim Paulson on our last episode, which he had some interesting thoughts. But just explain this concept to the P cape and sort of what you guys found.
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A
Sure. So, you know, thank you so much for saying that. We have a lot of original research. I mean, our feeling is that most of our stuff is, is actually not original in our whole, you know, and we're really happy to share it. We like, a lot of, some of what we do is original, but most of what we do is just trying to take sensible, sensible, well, you know, sensible kind of basic ideas in finance and make them really intelligible to people. So like everything around sizing is stuff that we've pulled out of old academic things that just never got enough attention. But thank you anyway for, I mean, I appreciate, I mean that. And every once in a while we do something a little bit original, but not too often it's original to me.
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B
But maybe, you know, but I, I certainly appreciate it anyways.
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A
And that's why we, you know, if it were really original, we wouldn't, you know, like, I mean, you know, in some ways, like we share everything because we think that, you know, it's, it's, it's out there and everything that belongs out there in the public domain to help people. Anyway, so first of all, the idea of cape. We like to think about CAPE not so much as a valuation metric, but really as a long term expected return metric. And in that sense what we actually need to think about is one divided by CAPE is the earnings yield. And so we like to, you know that we like to think about the idea that the earnings yield of equities is a good by itself long term expected return estimate for the market. And it's like you're buying a building, you know, you buy a building, it's fully rented out, let's say. And, and, and you look at the rental yield of the building and you say, well, the rental yield is 5%. And then you just kind of think, you know, it's 5%. I'm going to have to spend a little bit of money each year keeping it in good condition. But I'm going to grow the, I think I can grow the rent with inflation or maybe inflation plus a half a percent. And you just take that and now you've got the long term real return of that commercial real estate building. Well, with the stock market, kind of the same thing, like if we just say, well, the earnings yield of the stock market is 4% and if we think that companies would be able to grow those earnings with inflation if they paid out all the earnings as dividends, then, you know, on a long term basis that 4% is like a good long term estimate of the stock market's real return. And so, you know, there's questions then, okay, well, what earnings do we use? Do we use last year's earnings? Do we use next year's forecast of earnings? And you know, going all the way back to Benjamin Graham actually originally, you know, in the, whatever in the 40s, or 30s, you know, he said, you know, when I'm thinking about earnings, I like to average like the last 10 years. He just threw that out. You know, I want to average the last 10 years because, you know, there's some cyclicality in earnings. And what if last year's earnings were negative? I'm not, I don't believe the stock market or a company's earnings will be negative forever. It'll be out of business then. So, you know, this idea of like, yeah, let's average the last 10 years of earnings, just totally arbitrary, you know, why not 12 years or, you know, or seven years. A little more biblical. Anyway, so we, you know, so we kind of have this thing of 10 years. Then Bob Shiller and John Campbell came back to that and you know, so We've got this 10 year inflation adjusted average earnings that we use as an estimate of future earnings as a starting point. Well, you know, one thing, and Shiller, Bob Shiller has thought about this too, and other, other people have been thinking about is like, well, you know, when we go back and use earnings from five or seven years ago, you know, in this average to estimate, you know, the starting point for future earnings, you know, if the company hasn't been paying out any dividends, you know, we would expect that earnings are going to be higher because of all this retained earnings. So when we look back at earnings five years ago, we want to bring them to today. If they haven't been paying out a lot as dividends, we want to bring them to today, you know, average, you know, bring them higher so that when we're averaging, we're starting off at a slightly higher starting point for earnings. So that's the retained earnings adjustment. You know, Shiller has incorporated it into his freely available spreadsheet. With all the last 150 years of stock market stuff, he does it in a slightly different way. It's the same thing though, pretty much. And, and so what that does is, you know, especially in, in today's world where the dividend payout rate has gone down for U.S. stocks is quite low, is like, I don't know, 35, 40%, you know, ignoring buybacks. You know, what that does is it gives us a little bit higher earnings. It gives us a little bit higher estimate for the long term expected return of stocks. And you know, this seems like a reasonable thing to do when you look at it historically, it's a little bit better, just a little bit better. As a predictor, not hugely. You know, earnings yield is an okay predictor of the long term return of the stock market. I mean go back to 1900. Guess what? The earnings yield on U.S. stocks in 1900 was about eight, eight and a half. Eight, eight and a half percent. Well, U.S. stocks have delivered a 10% return over the last one hundred and twenty five years and almost all of it was predicted by that starting earnings yield. And then like a doubling or tripling of the multiple gives us like an extra 1% or something. So you know, over long, over 50 year periods of time, earnings yield has been a pretty good predictor of the long term return of the market. But it's just a predictor. You know, the market's always going to be higher or lower than that. I mean like when we think of the next 10 years and I mean everybody's seen the charts of like earnings yield or PE on the x axis and then kind of the average next 10 years real return. And how that's this nice upward sloping bar chart. It's hiding a lot of volatility in each bar. But you know, when earnings yield is low, the long term return of equities, we think it's going to be relatively low. And historically that's been the case. It makes logical sense too. But you know, it doesn't always happen like that. I mean, you know, the earnings Yield was low 10 years ago already. I forget what it was. If we go back 10 years in the last 10 years have been bumper US equity returns. But if we go and look at non US markets, it's been a lot better predictor over these last 10, 20 years. So we know that, you know, we're going to get higher or lower returns. That doesn't mean we should throw out the estimate. But, but we need to think about it, you know, but, you know, as we think about it, it continues to make sense. I mean, I think that companies really do have a hard time growing earnings faster than this notion of if you paid out all your earnings of dividends, you could only grow at inflation. That's kind of a weird, I think that surprises people sometimes. You know, it's like, what if I paid out everything in dividends? Shouldn't they be able to keep up with real GDP growth? And no, they need to reinvest to be able to keep up. They need to retain earnings to be able to keep growth going faster with real gdp.
- [26:03]
C
How do you think investors should think about expected returns in practice? Because that's the question we always get is all right, we've got these estimates of 7 to 10 year returns or whatever they are. How do I think about that in terms of how I'm constructing an investment strategy? And I think you get those even more these days because most estimates of expected return to what you just said been low for a long time now. They've been projecting lower returns than what we've actually gotten. And so people think about like, is this useful to me in practice? So I'm wondering, like, how do you think about investors? How do you think investors can use expected returns?
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A
Well, the first thing I would say is there's no alternative. You know, it's like, okay, you know, my expected return was a low estimate for the future. Well, okay, maybe you want to do something different with your, you know, maybe you want to think about why it was wrong. Is there something you should change? But we can't escape thinking about expected returns. I mean, the whole 60, 40 portfolio is a total abrogation of duty. You know, like, you know that it's like saying, I don't know anything about expected returns. I'm going to be 60, 40, you know, for no good reason. I mean, it's kind of a really weird, like we always need to be thinking, whatever we do, if we don't have an expected return, then I think that we can't do any investing at all. I mean, we also need a risk number. We need an expected return and risk. And so we need that. And so if somebody has a better idea for thinking about the expected return of the stock market, they should use that. They should come forward and use that Now One thing that's really interesting is if you just spend some, you could spend a half an hour, 45 minutes or just go to an LLM and say, please give me the long term expected equity return estimates from 25 of the most prominent investment firms in the world. And you know, like you can get that or you could do it yourself but you know, like perplexity will go out and just look at the capital market assumptions of BlackRock and Vanguard and Goldman and Morgan Stanley and Pimco and all these guys. And it's amazing that actually, you know, like if you go for 25 of them that like 23 of them are all in the same place. They're all congregated around earnings yield. They're right now they're all very low and there's, and they're all in consensus and they're all kind of thinking about a little bit differently. There's like one or two outliers, we won't mention them necessarily. There's one or two outliers and the outliers don't believe their numbers anyway because the, you know, like one of the firms that's an outlier is like constantly invested in equities even though they think they have a negative expected return. I mean they, they would be out of business if they believed their negative expected return numbers and put them into practice. But you know, 23 of these firms are kind of in consensus. They're also around earnings yield. And so I think that there really is a basis on which to say that there is an expected return out there. Now if you poll investors, if you poll, you know, when you poll retail investors, they have an expected return for stocks that's much higher at the moment, you know, and you know, so there's a lot of extrapolation by non professional investors tend to extrapolate the past. So you know, non professional investors and also, you know, some of the institutions like some of the pension funds and part of it is that, that you know, there's incentives I think out there for why some pension funds and others, you know, have, have overly optimistic and not, not realistic expected returns. But, but you need, but we need to, you know, we can't invest without expected returns and risk. You know, there's no way to do it. I'm just curious.
- [29:44]
C
On the topic of valuations, we've been talking about a lot recently and Justin mentioned our conversation with Jim Paulson. But if you look at that cape all the way back, you've kind of got two regimes. You've got a regime up to, I don't know, it was like 1990 or so where you had a much lower average. Then you've got a regime recently where you've got a much higher average. And then it also seems like the average is actually going up over time and continues to as well. So do you have any thoughts on that? Like on should we expect the market to revert back to historical valuations? Is that even useful to consider? Is something changed with the market where valuations are just going to be higher permanently? Have any thoughts on any of those issues?
- [30:19]
A
Well, I think so. So first of all, right, the, this 10% stock market, US stock market return from 1900, right, that this is, this is the basis of what academics have been calling the equity risk premium puzzle for a long time. So, you know, I don't think that we're going to go back to the first half of the 20th century kinds of valuations where there was just much less understanding of equities. You know, there was the, the whole, what do you call it, prudent man, prudential investor rules, where so many, so, so much fiduciary managed money was not viewed as being prudent to be invested in stocks. So I think we can like, you know, in terms of just thinking about what's, what's normal, I think we can throw out a lot of that whole history and thinking about things. The other thing is that we need to always be comparing the expected return of stocks to safe assets. And so, you know, you know, safe asset returns really vary a lot. I mean, there have been times, you know, like in the middle of the 20th century where real rates were really negative. And then of course, you know, a few years ago we had negative real rates, you know, now we have somewhat more positive real rates, at least in long term tips. And so, you know, some of this, some of what's happening, you know, is also a function of what's happening, what has happened and will happen with interest rates. But at some point, you know, at some point when the expected return of stocks is too low relative to safe assets, we're going to see a ton of equity issuance. You know, we're going to see a lot of companies, existing companies and new companies and private companies come along and say, hey, if I can issue if my cost of capital is equal to the U.S. treasury, right? Like we're not that far away from that right now, you know, U.S. equities is offering an extra 1 to 2% more than U.S. treasury bonds. Well, you know, if, if the, you know, if if expected returns drop another 1%, if P Es go up another 50%, you know, we're going to be at a point where a lot of companies are going to say, you know, this equity capital is basically the same as me issuing investment debt. You know, I'm going to issue a lot of this and, and other people will come along and issue, issue equity and, and a lot. We'll see a big move from private to the public sphere as well when and if that happens. So I think there are bounds on it. You know, I think that an equity, an equity risk premium of 6 or 7% just feels kind of high to me given, given the risk of equities. So, you know, I don't think we're going to see those really high levels. Maybe we'll see them briefly from time to time, as we did in the gfc. But yeah, I think going forward, the expected return of equities is going to be lower than it has been on average over the last hundred years. But probably for the US Market, I think it's going to be higher than it is today. I think there's not enough compensation in US equities today to warrant the risk. And you know, at the end of the day, you know, equity markets are real, true, systematic risk. You know, when equities go down big, you might lose your job at the same time and everything is terrible. And it's, it's a real societal risk that, undiversifiable, that should carry, you know, a relatively healthy risk premium. And, you know, I think that, you know, we're now at a point where it's starting to really feel pretty paltry.
- [34:00]
C
I want to get into how you think about constructing portfolios. But first I just wanted to ask you about buybacks because you had another great research piece on your site about buybacks. And just a quote from the piece, you said their rise since the 1990s may be one of the most underappreciated drivers of US equity market performance and warrants greater attention from academics, investors and policymakers. So I'm wondering if you just talk about what you found with that piece of buybacks.
- [34:20]
A
Sure. So, you know, I think that, you know, in some ways our buyback piece was more a piece about. About the elasticity of the stock market, of stock market prices, and about how investors are approaching asset allocation. Then it was, you know, I mean, it was also about buybacks too. And. But it was really this like, jumping off point to say, let's think about buybacks, you know, how much impact could buybacks possibly be having on equity returns. And we said, well, you know, I don't know. I mean, how, how do different investors do their asset allocation? Well, what if everybody just was going to be 60, 40, you know, or had some strategic asset allocation of x and 1 minus x in, in US equities? Well, the only way the buybacks could happen would be the market would have to go up a lot so people could still stay at their desired asset allocation. So, so buybacks, you know, if, if companies were buying back 3% of all outstanding equities each year, which is around where we've been, you know, the market would have to go up 5 or 6% just so everybody could remain so that, you know, the buybacks could happen and then everybody could still be at 60, 40 or 50, 50 or wherever they wanted to be in terms of a stock bond mix, assuming they didn't want to be at 100% in stocks, then there's no impact from that. And then we said, well, okay, that's interesting. What about, you know, some other investors, like some investors come up with their return expectations from extrapolating from the past, you know, that, that we've been talking about. And there's a lot of evidence that goes on. So when returns have been higher in the past, in the recent past, they want more equities, their expected return is higher and they want more equities. Oh boy, that's a problem. You know, now that exacerbates things versus the world in which we just had the guys that are the fixed asset allocators. And then we said, well, okay, let's bring in some other guys that maybe are looking at expected returns and they're willing to go when expected returns go down, they're willing to drop their asset allocation to, or their allocation to equities. Oh, well, that helps. And anyway, we just played around with all of that and we said we don't know who's who or how big these different players are, what their parameters are, but it's pretty easy to see that Companies buying back 3% of their stock could be pushing equities up 3 to 5% a year while that's happening. And that's really big. You know, that's like, that's a really, that's really sizable in the, in the scheme of things. And then we talked about other things with regard to buybacks. You know, like the fact that they're kind of a bit of a tax, their tax advantaged. And so the US treasury is losing out on tax revenue because this is happening. And you know, we brought up that question and brought up what's going on with indexing. You know, I think people misunderstood. This is a place where people misunderstand indexing because indexing is actually helping to smooth things out between buyback and non buyback stocks. Because index funds are like, here you go. When, when the company comes in to do the buybacks, index funds said, here you go, here's my stock. And then they go and buy back. They have to go buy the non buyback stocks and kind of push them up. So there's pressure on the buyback stocks to go up, but the index funds are helping to mitigate that a little bit. So anyway, we talked about all these things. It was a really fun article. But really in some ways what we were saying is that we think there's all this carping and I guess we'll talk about this at some point. There's all this whinging and carping out there about index funds. You know, index funds are worse than Marxism and indexing is ruining the world and indexing is terrible and all this. But you know, I would say that all of the things that we, the people, not me, all of the things that the index fund haters are complaining about are really explained by static asset allocator, static asset allocators and return chasers. Like, I think that's where the problem is, is that people are not approaching asset allocation sensibly and they've conflated and they've, they've gotten confused between stock picking, you know, and, and, and a dynamic asset allocation. They think stock picking is bad. And so also dynamic asset allocation is bad. Well, no, they're, they're totally different things. And you know, I think that, you know, what we're seeing is really being driven. What we're seeing with this market that just doesn't want to go down is the fact that so many asset allocators are not driven by forward looking expected returns. And I think that's really causing all the problems that people complaining about indexing are seeing and are misattributing to, you know, to market cap index funds in terms of stock picking.
- [39:14]
C
Yeah, that's really interesting. And if we get time at the end, we'll get into some of Mike Green's work on this because I'd like to talk about it. But I want to get to building portfolios and how you think about that because we had Rick Ferri on recently. We sort of started at a very basic level when we were talking about building a portfolio. I Mean, we've all got a bunch of assets we can choose from. There's way more now than there once were with all these new funds and everything that are coming out. But at a basic level, we've got stocks and bonds, and we have to take those and think about how do we construct a portfolio. So I'm wondering, and I know you primarily use stocks and bonds. How do you think about that decision in terms of what you want to own and how you want to put it together into a portfolio?
- [39:46]
A
Sure. So, yeah, So I think the first thing is, right, there's just this, like, multitude of things that we can invest in. And so you have to have some kind of a screen. You have to have some kind of a screen so that you narrow down what you're investing in. And so, you know, for us, and I think everybody needs to build their own kind of screen. But for us, we say, well, when it comes to risky assets, we want to invest in things that, that where there's a good reason that they should have a risk premium. We want the risk premium if it does, you know, that if we think that something should have a risk premium, we want to be able to verify it. So it's like trust and verify. We want to be able to calculate it. So oil is a huge, huge asset class, right? It's enormous. It's bigger than all the value of stocks in the world. The oil that's known in the ground, that that is owned by people and countries and companies. But there's no way to really come up with this expected return. You know, we don't know. You know, it's so difficult. You know, like, we believe it should have a risk premium, but we can't calculate it. So that would be an example of something that falls out because we can't calculate it. You know, then we want it to be something that's, you know, low fee. We don't want to pay a lot of fees for it. If it's in a tax, if we're going to hold it in a taxable account, we want it to be tax efficient. And in general, we just don't want anything that zero sum. So we don't want any kind of strategy or investment that's like a zero something where somebody's on the other side from for us to make money, somebody else has to lose money. You know, we don't want that. You know, but really it's these first, you know, these first three things of it's big and it should have a risk premium. We can see what the risk premium is and we can access it at very low fees. So that leads us to, you know, some, some low cost, broad market index funds on the risky side of things. And it leads us to diversified, you know, similar kinds of holdings on the safe asset side just that are low fee and liquid and so on. So, so we get down to. Then it's like, okay, well how granular do we want to go? You know, well, we want to maintain those low fees. So we break the world up into like 10 buckets. US equities, European equities, EM developed Asia, you know, we break the fixed income into a few groups of, you know, t bills, tips, nominal bonds, more or less. And you know, we have whatever, eight, nine, ten buckets altogether. And then we just, for the risky assets, we're just looking at their expected return and risk level. And we're, we have a baseline and relative to that baseline, we overweight or underweight if the expected return is higher or lower than where we pegged that for the baseline. And when the risk is higher or lower, we have less or more of that bucket as well. And that's how we build the portfolio. You could do it on the back of a napkin. There's no mean variance optimization. There's nothing complicated. I mean, you know, mean variance is good, but you can't do that on the back of a napkin. So you know, that's, we do it in a way where everybody, you know, where all of our clients can see and understand what we're doing and know what to expect. I think there's probably better ways to do it, but there's not any way that we found that's both better and as simple or nearly as simple. So that's how we build it up. You know, each client or product has a baseline and that baseline is, is defined by what's the expected return and risk in that, you know, that we've set that baseline at. So then we can go out in the world and see what are the expected returns and risks and then over underweight relative to that baseline. So baseline is not just a set of weights. It's a set of weights and a set of risk and return for each bucket. Which is, which can be arbitrary. It doesn't have anything to do with history. It could just be, it just is needed for the definition of what the baseline is that you have to define the baseline with a certain expected return and risk so that then when you go into the world you can say, oh well, this is what the expected return is today for My baseline, I had this. So I want more or less.
- [43:46]
C
One of the things I like to do with the podcast is to challenge some of the things I do with my own clients and my own portfolios. And you wrote a piece recently that does that because you challenged the permanent portfolio. And we don't run that exactly, but we run a version of that. And the theory of the permanent portfolio sounds great. You know, you've got your four quadrants, you've got one asset that's doing well. People talk about stocks and bonds having this one, you know, Achilles heel in terms of inflation and you're covering that. So I just want to talk you to talk a little about what you found in that piece and why you maybe think the permanent portfolio might be suboptimal relative to some of these other options.
- [44:15]
A
Well, first of all, the permanent portfolio is exact, has exactly the same problem is the 6040 portfolio is that it has nothing to do with expected returns and risk. I mean, it's like somebody just, you know, went like this a while ago, a long time ago and said 25, 25, 25, you know, so it has nothing to do with expect, so has nothing to do with expected return, risk and covariance among those different assets. So I think that if somebody says, look, I want to own global equities, I want bills, I want long term bonds and I want gold. I. That's, that's my, that's what I want my portfolio to consist of. If somebody said that as a starting point, fine, that's great. I mean, I just said, you know, okay, we're going to have stocks and bonds or we're going to have these bonds and we're going to have these stocks. Right? I just went through all of that. So you have to come up with what, what are your ingredients? And those ingredients need to be reasonable. And those ingredients are reasonable. You know, for me, you know, gold doesn't make it for me because I can't really come up with its expected return easily, but I could come up with an expected return. You know, I could see somebody coming, you know, somebody could say, well, I think gold is going to grow at per capita GDP growth rate, you know, above inflation, you know, or something like that. They could have a model for it. And that's fine with me. That's good. So now you have expected returns for the four pieces. You have risks for the four pieces and you're going to need some covariance for the four pieces or correlations. And then you get a portfolio out of that and the one thing that portfolio is not going to be is. Is never going to be 25, 25, 25, 25. I mean, it's just, you know, I mean, it might pass through that at some point, you know, but, like, the probability that it ever comes up at 25, 25, 25, 25 is pretty low. And if. And if there's a moment in time when it is supposed to be that great, you know, but two months from then, it's not going to be that anymore, you know. And so it just, you know, from that point of view, I think it suffers from exactly the same problem as just saying, I'm going to be 60, 40 forever. So, you know, and of course, you know, yeah, I think that's really the main, you know, kind of the main thing that I would say is like, we just need to build portfolios based on expected return and risk or covariance.
- [46:39]
C
I have one more. Before I hand it back to Justin, I would ask you about one, maybe taking things to a little more of a complicated level. You're seeing a lot more of these more advanced strategies being available to individual investors through ETFs these days. And you know, what I will say that we use for clients and I want to get your view on is managed futures. Because if you just look at it from a math perspective, and again, it may fail your expected return framework. But if you look at it from a math perspective, managed futures are good in that they're uncorrelated with all the other asset classes. They tend to perform well during big drawdowns. Like, they tend to create a smoother return when coupled with these other assets. And I'm just wondering, how would you think through an asset like that and whether it should be added to a portfolio?
- [47:15]
A
You know, I have a soft spot for managed futures. You know, I think that, you know, it can. It can be a relatively low cost. It's a very easy strategy to implement. It can be done at very low cost. And, you know, I think that there are, you know, reasons why that, you know, has performed pretty, pretty well over very, very long periods of time. You know, from, you know, from our point of view, we're trying to keep things simple. We're trying to keep to this sort of rubric of we want things where we can think about expected returns prospectively. And, you know, our. I think that our take on it would be like, for our clients is that, you know, this is what we're doing for you guys, clients. You know, we're going to put you into low Cost, diversified public market stuff. But you're going to have other investments away from us. And you know, if you wanted to have managed, if you wanted to ask us what we think of managed futures, we would say, you know, that's a, seems like a reasonable thing as long as you're doing it with somebody that's extremely low fee and you know, isn't too carried away in terms of getting into really weird, you know, illiquid markets. So, so yeah, I mean, I'm kind of somewhat positively disposed towards it. You know, it doesn't really fit with our, you know, with our five star. Right. Our five star thing. It doesn't fit in there because we can't, we can't really say what the expected return is, you know, except for looking at history number one. And number two, you know, it's, it can be low fee, but it's never going to be low enough fee for us. Like our portfolios have an average expense ratio of like 5 basis points. And you know, and we're kind of pissed off that there's not a low cost Canada etf. If Vanguard is listening, please, Vanguard, give us a low cost Canada ETF so we don't have to see 18 basis points from, from the Canada one.
- [49:07]
B
Everything up in Canada is expensive. Even the stuff down here that's Canadian is just expensive.
- [49:12]
A
Well, no, but the Canadian Vanguard has a Canada ETF is like three or four basis points, but it's only for Canadians. It's not. Oh, really?
- [49:21]
B
Oh, interesting. Ye.
- [49:23]
A
Yeah.
- [49:27]
B
Talk about. I wanted to, and maybe I think you've touched on it, but this idea of, and I think it's the strategy that you're using in the etf, so this dynamic asset allocation strategy and how this is being managed, you know, over time and how you guys actually construct, you know, walk us through the investment process of how you construct the ETF and what its long term objectives are.
- [49:56]
A
Sure. So, you know, we, we launched an ETF on the New York Stock Exchange in February. But it was the, it's a, it's the conversion of a fund that we had, a private fund that we had going back to 2011. So it's, it's been around and, and it follows our dynamic index investing approach. And so it starts off with a baseline, 75% equities, 25% fixed income, the buckets we talked about a few moments ago in terms of the different regional equity markets. And so that's our baseline. And then we look at the expected return or the expected risk premium in each asset bucket on the risk asset side, and we allocate more or less to each bucket, depending on how much above or below 4% those risk premia are. The residual goes into fixed income. I'm sorry. Also as part of the allocation is whether we're in a high or low risk environment. Instead of measuring risk more directly through something like VIX for US stocks and VIX equivalents for non US Stocks, we use one year moving average momentum. That's a pretty good proxy for risk. It's not always pointed the same direction, but it's pretty good. And so when for an asset bucket, if it's in a high risk state, we reduce its exposure by a third of the bucket size or we increase the exposure by a third of the bucket size when we're in a low risk state. And that's it, we add up all those risk buckets. If they're less than 100%, the residual is fixed income. If it's more than 100%, we would scale them all down so it equals 100%. No leverage in the ETF. And then in the fixed income bucket, we kind of split it between bills, TIPS and nominal bonds with a pretty heavy weighting towards, pretty low weighting towards nominal bonds. And we use a little bit of asset allocation there, but it doesn't really move the needle very much. But we use the risk level or momentum to overweight or underweight within the fixed income bucket relative to bills. So that's the whole thing. And we've, we've been running it like that. We rebalance it on a weekly basis, sometimes more frequently if the markets are moving. But the rebalancing that we do is like a slow moving rebalancing where we're like rebalancing a quarter of the way back to Target each week so that the turnover would, the turnover looks like we're rebalancing monthly, but we're actually touching the portfolio all during the month, you know, to smooth things out. But, but without getting all that extra trading activity that we would get if we were doing it more frequently. And we have about $500 million in there. The average expense ratio of all the underlying ETFs is about five or six basis points. And then the fee that we charge and then the fee that also goes to the series trust provider that we have, you know, it's like another 18 basis points between the two. So the underlying ETFs, RFE, the US bank's fee, it all comes up to 24 basis points, which is low for, for this kind of thing. And you know, it's like as far as we know, it's the only rule based, rules based, relatively low cost, dynamic asset allocation product out there. And you know something that's just amazing, right, is like that asset allocation ETFs are just tiny. I mean, the total outstanding amount of asset allocation ETFs is around $10 billion. And it's mostly three iShares ones. I mean, we're getting to be, we're probably the fifth, I don't know, fifth biggest one now at 500 million, which is tiny. But the asset allocation mutual funds, right, is like three or four trillion dollars. So there's three or four trillion dollars of demand for asset allocation mutual funds, but only $10 billion of asset allocation ETFs. And I think that anybody that's a taxable investor has to want the, the etf. It's more tax efficient. You know, it's the same thing. You should have the etf. You shouldn't own one of these Vanguard balance funds or target date funds. I mean, target date funds also are not, you know, I mean, I think a balanced, I would rather have a balanced fund than a target date fund anyway for most people, for many people. But anyway, it's kind of interesting, right? It's because of the whole 401k thing is like all based on mutual funds and everybody's going into a balanced, some kind of an asset allocation. I mean, so much money is going into asset allocation mutual funds through the 401k. And then in the taxable world, you know, or sorry, in the rest. Then for everybody else, there's like almost no investment in asset allocation ETFs. I think that'll change probably, but who knows when? Yeah. Yeah.
- [54:58]
B
Well, a lot of those investors that are, that are in taxable accounts in those types of strategies probably have like locked in embedded gains. They don't want to obviously sell and then have to realize. So I mean, but ties are, ties are clearly changing with the, you know, the wave of assets going towards etf. So I think it's just a matter of time. But 500 million is nothing to sneeze at either. So that's great. So congrats.
- [55:19]
A
Thank you. Yeah, yeah.
- [55:21]
B
As we get towards sort of the end, I have a couple more questions just I want to ask you. Do you think about or see the risk of, I mean, because you obviously have a big, you know, percentage of, you know, equities and US stocks make up probably a significant percentage of that. So what do you feel about sort of level of market concentration with the, you know, the big tech stocks making up as much as the market as they do. Does that, is that something that worries you at night or are you like, this is the way that market cap weighted indexes are and you know, I'm not going to lose too much sleep about it.
- [55:56]
A
Yeah, more the latter. Also looking at global, the global stock market, you know, those concentrations all look, you know, 40% smaller, you know, in terms of the whole thing. But you know, they're big companies with big revenues and you know, the whole, you know, the whole US stock market worries me much more than the concentration issue, you know, but that, yeah, I mean, I'm just really worried about, you know, yeah, I'm really worried about this level of low expected returns. I'm worried about the degree that investors are extrapolating past returns into the future. You know, I'm worried when I look at the Nancy Pelosi portfolio and see that and it's like, oh my God, you know, like this is how, you know, a supposedly intelligent person is doing their asset allocation. You know, it just is all, you know, it all makes me, you know, makes me nervous. And, and you know, I think that, yeah, I think that it's very difficult for corporate earnings to like totally break away from GDP growth the way that people have to be believing that to be the case if they thought about it. But again, you know, it's like all of the investment professionals are kind of saying the same thing. You know, we're all saying, okay, you know, US equities are going to give us, you know, 1 to 2% over safer assets. And everybody's kind of acknowledging that, you know, like blackrock's not out there saying we're about to get some massive earnings growth and you know, massive earnings growth to a new level forever. And so we're going to get 5% over safe assets. No, they're saying the next 10 years is just going to be 1 or 2% above treasuries. And that's what everybody's saying. And it's pretty scary in terms of how sustainable it is. Just some things change. We're getting one and a half trillion dollars of stock buybacks at the current time in the US but I don't know if OpenAI and, you know, and a few other private companies decide to come public, you know, all of a sudden that could be a trillion dollars of issuance or, you know, again, if, if at some point, if companies are like, I mean, isn't it amazing? Like, isn't it amazing that Oracle and Meta are buying their stock back and issuing hundreds of billions of dollars of debt. Like how can that make any sense at this, at these market levels? They need the money for the, you know, for their capex stuff, but they just continue to buy back stock and then issue debt, you know, 30 billion for Meta, 80 billion for Oracle. Google's doing what, 30 billion. And at tight spreads. I mean the whole thing just is really weird.
- [58:45]
B
It's a very interesting point. You know, like a lot of people have talked about how companies are staying private longer and they have these crazy valuations, but eventually those investors are going to want to realize, the investors behind those companies are going to realize, you know, the value and those massive companies like OpenAI and others in the future will come into the public markets and it's, it's just, you know, it's an interesting question. Is that going to create like this vacuum almost that the market, you know, the money is going to go towards them. It's going to have to come from somewhere. So how does that, how does that whole thing sort of play out? It's not a lot of people talk.
- [59:25]
A
About, yeah, it's the buybacks in reverse. So if buybacks are pushing stocks up 3 to 5% a year, we go in the other direction. And it's very pro cyclical the whole thing. Also companies basically stop buybacks, I mean really curtail buybacks at times of high uncertainty, volatility and economic slowdown. So in the financial crisis in Covid, buybacks came to a standstill and we got out of those periods through interventions and other things. But you know, it's, it's scary, right? I mean the buyback machine is not something that's going to be there forever. And at some point also we're just going to see, you know, we're just, we just have to see equity issuance. Even if companies don't want to issue stock, you know, other people are going to come along and say if I can, if I can raise equity capital, you know, if the demand for equity capital is like basically such that I could start a company and invest in Treasuries and that would be okay. You know, it's going to be right. I mean there's just trillions of dollars, you know, for, for that kind of thing or you know, so it's, it's a weird, right? It's like I'll, I'll create a company and buy, buy treasury bonds and wait until I find something good to do with the money and it's like if the market would be okay with that, which it effectively would be saying, you know, once, you know, once we get to a PE, you know, when we get to a PE of 100, which is just a doubling of the market from here roughly, or a PE of 80, you know, we're back into late 1980s Japan, and believe me, there's a lot of things that people will raise equity capital to do when the market is so is when the market is so excited about stocks.
- [61:19]
B
So we have two standard closing questions that we like to ask all of our guests. The first is, what's the one thing you believe about investing that most of your peers would disagree with you with?
- [61:32]
A
I think that, I think that in the investing, in the investing world in general, that, that people are not willing to change their asset allocations vary dramatically in response to changing expected return or expected risk, premia and risk. You know, there's this feeling that changing your asset allocation is market timing and market timing is bad. You know, I think market timing is what we mean by market timing is something different than this, that it's rational to change your asset allocation, but that, you know, for whatever reasons people have. I think a lot of people think it's rational. They just don't want it. They're just afraid to do it, or they're cautious about doing it. And they know how it, if they had done it, how it would have been, and they're cautious about that. But I think that's probably one thing that, that I think so many different investors are not really agreeing with me on, which is that we should be dynamic in our asset allocation and pretty, pretty dynamic, you know, not just a couple of percent here or there, but, you know, but fairly, you know, fairly big changes in asset allocation can be warranted by different conditions.
- [62:47]
B
And then lastly, based on your experience in the markets, what's the one lesson you teach your average investor?
- [62:56]
A
You know, Matt Levine, who's just such a great writer for, you know, for Bloomberg Money Stuff, he said that, that financial literacy should be boiled down to one question, you know, that people should understand. And that question, he wrote, is if somebody comes to you and offers you an investment that has a 20% return with virtually no risk, what should you do? A jump on it, because it's going to be gone in a minute, you know, if somebody else is going to do it, baby, you know, research it. And, and if, and if it is as presented, do it, or c, assume the guy is either lying or doesn't understand the situation and save yourself the time and walk away. And, you know, I think that people really have a hard time choosing C, you know, but I think that C. I think that this question kind of embodies like, all of the bad things that you can do in investing. Like if you don't see, like if, if you don't see that as an individual investor, that it is an excellent working assumption to run the other way when you hear that or when you think that, you know, I think I, I, I, I think that's like the one lesson that I think it would be so valuable for people to have. And I can't take credit for it. It's a Matt Levine thing. But yeah, I just, I just feel like that encompasses like everything. It encompasses that risk matters, it encompasses market efficiency. You know, it encompasses like all of the important, not all, but it encompasses so many of the important things that we should know as investors.
- [64:46]
B
You know, if you just would have told me that story, I would have then given you credit for another original idea, which you would have said, that's not original idea. But, but I love that response. But I love that response and I think it's spot on. So, Vic, thank you very much for joining us. Really appreciate it and enjoyed it and hopefully you come back again soon. Thank you.
- [65:04]
A
Yeah, me too. Thanks, guys. I really enjoyed that too. Thanks for giving me a chance to, to riff on all these things. Really, that was great.
- [65:10]
B
Thank you for tuning into this episode. If you found this discussion interesting and valuable, please subscribe on your favorite audio platform or on YouTube. You can also follow all the podcasts in the Excess Returns network at excessreturnspod. Com. If you have any feedback or questions, you can contact us at excessreturnspod. At gmail.
- [65:28]
A
Com.
- [65:29]
C
No information on this podcast should be construed as investment advice.
- [65:33]
A
Securities discussed in the podcast may be holdings of the firms of the hosts or their clients.