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The 4% That Drive All Returns | Larry Swedroe on What You're Getting Wrong About the S&P 500
01:05:04
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- [00:00]
A
There are very, very, very few, if any people have great forecasting track records. These legends don't exist. They're often made heroes in the financial press because somebody gets a particular forecast right. But no one ever goes back and look at their prior 20 forecast to show what their track record was. The markets are vetting. The winners will be the AI sellers. It may turn out to be the AI users. I don't think anything was more revolutionary than airlines. And airlines have been one of the worst investments over the last hundred years. There's only 4% of all the stocks that have ever existed that account for 100% of the equity risk. What are the odds you could identify the 4%? There are three periods of at least 13 years where the S and P underperform. Totally riskless T bills. And so that tells you you must or should logically be diversified.
- [01:06]
B
Larry, welcome back to Excess Returns.
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A
It's my pleasure to be back with you, Justin and Jack, great.
- [01:13]
B
Much of our audience will be very familiar with you, not just because you've been on our show multiple times, but also because of the extensive writing and your focus on investor education across books, articles and your substack, which I'll mention in a second here. You know, from my perspective, you've built a reputation for helping investors think clearly about the markets, evidence and risk. And you know, I know Jack and I have always appreciated how you kind of separate the data from the noise and think about long term investing. So I think this conversation will be, as it always is with you, a good one today. And even though you're not known for making macro forecasts, we do want to Talk through your Q3 sub stack that you put out a few days ago, which was kind of looking at sort of some important, important things in the market, tariffs, sort of immigration trends and the impact of AI, which we'll talk about all that in a minute. And then we also want to just as when we have you on, you know, exploring some of these broader topics that are important to the market, passive investing and its impact obviously factors, you know, private credit as an asset class and a bunch of other things that hopefully we have, we have time to get into. But just real quick, before we get into the first thing here, I do want to mention that your substack is Larry swedroe.substack.com if you search Google for that or if you just go on substack, you can subscribe and get updates on all the good, good research and articles that Larry is putting out. You can probably find Them on a lot of other places too, because I know you write other places, but substack is a great way to kind of keep up with one central place on where you're putting out research and materials.
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A
So.
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B
So great. So, so yeah, I wanted to. Let's just talk about this third quarter economic market review. And you kind of focused in on. On three things and you were working through not necessarily forecasting like where the market is going to go because of these things, but how investors should maybe be thinking about them in terms of risks. And the first thing, the first thing that you really highlighted was the tariffs. So can you just talk to sort of how you were articulating the impact of tariffs and what they might mean for the economy?
- [03:32]
A
Yeah, sure. Before we go into that though, I think it's important to talk about why I don't make macro economic forecasts per se. And that's because my advice, as you guys know from all my readings, is all based on the peer reviewed academic research, not my opinions. And the research shows basically there are very, very, very few, if any people have great forecasting track records. These legends don't exist. They're often made heroes in the financial press because somebody gets a particular forecast right, but no one ever goes back and look at their prior 20 forecast to show what their track record was or then look at future track records. Elaine Garzarelli is probably the most famous one and that she forecasted the 87 crash. They gave her big funds to run and she immediately crashed and lost lots of money for investors. And there's a famous story which I think really relates well to the world of investment. But it's important to note I was a trained economist. I worked at Citicorp in their investment bank. We sold economic and market forecasts on interest rates, exchange rates, economies as part of my job. And I tell people that when I got a forecast right, of course I took credit for my brilliant analysis. And when I got it wrong, I always blamed some unforecastable event that was a surprise and nobody could afford. So I was either a genius or unlucky. Well, eventually, if you're smart enough, you figure out that, you know, you're just random outcomes. The market in its collective wisdom is already built into current prices, its best estimate, what's likely to happen. And the famous story, which I try to get people to understand when they think about investing, has to do with A World War II general who asked for the weather forecast so he could plan whether he would have aerial support, et cetera, for his battle plan. And the forecaster said, general, we can't give you a forecast that's worth anything basically beyond three days. And the general said, I don't care. I need a forecast so I can plan, you know. And I think the same thing applies in investment. What I try to do is talk to people about what risks are out there. And if you are concerned about the risks and that's going to drive your behavior, then you should build portfolios that are, if you will, using Taleb's word, antifragile to that risks. If you're exposed to those risks in your portfolio or your life, your job, your labor capital and your portfolio should be tilted to protect those risks. So coming back to the issue, particularly tariffs, so let's ignore for the moment the issue of national security, which I think everyone would agree with is a reason to consider tariffs. We need maybe tariffs to protect we have some domestic steel industry so we could produce airplanes and bullets and, you know, machinery and everything else. Let's leave that aside. But financial economists have known for a long time that tariffs are not just a tax on imports, as American farmers are quickly learning. Yeah, there are also a tax on exports because people can't export to you your imports, they don't have the revenue to buy your exports. That's number one. And exports are, sorry, tariffs are just the tax on consumption. Right. So that's got to have a negative impact on the economy as well. And it could have an inflationary effect because you're driving up the prices of goods that are cheap, replacing them with more expensive, that could lead into workers demanding higher wages. And you get this cycle. So there is the risk, I think it's somewhat significant that you could have higher inflation, more than the market was expecting, more than the Fed is forecasting. And therefore if that is a concern, then a logical thing to do is shorten your duration and avoid long duration assets. Not mean I'm forecasting that the bond market is going to crash. It means I think the tail risk is greater that interest rates could go up because of tariffs than the odds. Even if it's 50, 50 or even you think the odds are greater, rates will fall. How much are they going to fall when you have, let's call it 2% GNP growth and at best 2% inflation, why should the 10 year be below 4% except if you're in the middle of recession? So my thought was tariffs are a risk. Combining that with the immigration issue, which was the second point, that's shrinking the supply of labor, if you shrink the supply of anything without changing demand. You push prices up so you could have wages going up. And so that's another risk on the inflation side there. And that could cause the Fed to, you know, keep rates higher for longer, which could mean slower economic growth as well.
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B
One of the, one of the things that really stood out to me is when in, in your piece when you, you know, you basically said, you know, 3,000 unauthorized immigrants deported daily, you know, assuming they're all working, you know, would result in like, roughly 1 million, 1 million people less in, like, the labor force. And when you start seeing numbers like that and how it could compound over time, you could clearly see how that sort of starts to transform the labor market quite significantly.
- [09:44]
A
Yeah. It also means that the economy is growing less because there's really only two factors, and I think we're going to get into this issue of AI and productivity. It's only two factors that basically determine how your GNP grows, and that's your population growth. And then you add productivity. Well, if you're contracting the population because you're stopping all immigration, U.S. replacement birth rate is less than 1 to 1. I mean, less than 2 to 1, which means you don't replace your population, means you're not going to get growth from that. And our historical productivity has been running generally under 2%. May boom, may change. That doesn't leave a lot of room for economic growth. And so that's one of the things we could see as an anomaly. You could see the economy be softer than expected because of that, but the unemployment rate not going up because you don't have a lot of population. Right. So that's an issue. And then you've got the other side. This AI boom could offset that because you're getting this massive spending which could increase productivity. We don't know. We'll see whether that's a boom that drives productivity and helps growth and helps fight inflation or not. These are all risks. And I would tell you there are no forecasts who can predict what is likely to happen. That's why I don't get too pessimistic or too optimistic that the AI boom is going to be the greatest thing ever and we'll have the next 20 years be another roaring 20s type in mind.
- [11:30]
B
So one of the charts you had in there was, you know, showing productivity has been above trend since, you know, late 2022, early 2023. And you were making the point, you know, the AI advancements probably don't have much to do with that yet, but maybe they're coming. But I just was, I thought it was interesting. Just talk through the implications of that. So you had three things. You had Federal Reserve flexibility, market support and real wage growth. So just quickly talk through the, those, the three things that higher productivity would result in, in those three things.
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A
Well, if you get a higher productivity, that means the economy can grow with less inflation pressure. Right? Because your input costs aren't as high, that allows you to keep prices down. So that means the Fed, if they are anticipating this productivity increase, could decide that they have more flexibility and could lower rates. And that of course can help stimulate the economy there. So that's really an issue. Nobody knows how this is going to play out. There are various opinions. You know, I think you've got people on both sides who think it's not going to have as big as impact. And we're going to see this massive spending, like we did say, to build the pipelines for the Internet and all that much of that spending, while it helped the users, it didn't help the owners of that. And a lot of them went bankrupt or had big difficulties. It was the usage of the technology that mattered. And we could see the same effects here. Again, so everyone's betting or the markets are betting the. Well, the winners will be the AI sellers. It may turn out to be the AI users in the same way. To use analogy, I don't think anything was more revolutionary than airlines. And airlines have been one of the worst investments over the last hundred years, but they certainly helped the economy grow and the users benefited, Right? And all the ability to use the Internet has certainly increased productivity and information in lots of ways. But the people who built the Internet, the pipelines, Lucent and others, many of them aren't even around. And the initial cell phones, which were changing, well, where's BlackBerry investors? I mean, and Netscape was going to be the dominant player. Very hard for people to predict which will be the winners. Even if you get the technology will be the winner there. It's hard to know who will win. So again, my answer, as you guys know, is always build a highly diversified portfolio that doesn't try to pick winners, but keeps faith that optimism is the right way and that you'll ultimately be likely but not certain to be rewarded for taking risk.
- [14:39]
C
When you think about having a highly diversified portfolio, do you think about these things at all? So I know you're, you're core answer is going to be these economic things, tariffs or whatever, I don't really care. But you mentioned earlier, you know, you may Want to avoid duration. So would you make like small changes around the edges because of things like this?
- [14:53]
A
That's exactly what I do. I like to use Cliff as Ness's line about sinning a little. So I have always thought the right way to think about fixed income is to take a balance of risk. You don't want to get too long duration, then you're betting against the risk of inflation rising. And you don't want to get too short because then you end up with reinvestment risk if you get deflation or very weak economies. And so to me the. And the sweet spot on the yield curve is tended to be in that two to five years, the best risk reward. The curve on average tends to be fairly steep historically in the first two years, then really flattens out. And beyond 10 years you don't tend to pick up too much. So an average duration of about five years seemed to be right. And what I would do is when the yield curve got steeper, meaning the longer end had much higher returns than historically, I would sin a little and extend my duration out to maybe six years, maybe seven if the curve got really steep. And when the curve got flat, I would shorten it from five to four, but maybe three and never really any shorter than that. There was a change every decade or twice. Once every 20 years I'll make a change to my basic plan because I think the rubber bands have gotten so stretched in valuations. So in 98 I moved my portfolio from about 2/3 value because of historical evidence supporting the value premium to 100% value because the growth end of the market had gotten very bubbly. Let's assume that the normal pricing on P Es was about 20 for growth stocks and about 12 for value. So the average for the market was 1670 while we were in 98, when Greenspan use the term irrational, exuberant. We were sitting on like 30s, 40s, even getting up to 50s for the growth end of the market. And value stocks were still trading at about 12. So I said that doesn't make sense. And I went to 100% value and have stayed that way since. And around five years ago I went to a much shorter duration and really just let my muni bond portfolio, which was running five years on average, run down. It's almost completely run off now. And I've moved everything down to the very short end of the curve. And much of it is now sitting on what I would consider the very high end, highest quality private, private credit where you have no duration, risk and a massive illiquidity premium going back to AI.
- [17:59]
C
What do you think are the biggest things we can learn from if we look back to the dot com and other technological booms, like it's, it's funny, like, I know basically that there were a small group of winners from that period and a lot of the companies, pets.com and stuff are gone. But I look back now and I'm like, Amazon and whatever other companies did really well. I'm like, I gotta be able to figure those out now because we're in this AI boom and we're going to look back in 10 years and there's going to be these huge winners from AI. Like, I almost want to convince myself I can find them, although I know it's really hard to do it.
- [18:24]
A
Yeah, probably the biggest human error, because it's the most common, is we're overconfident of everything. All the behavioral research, for example, there's studies done on asking people, are you a better than average driver? Well, we know it can't be more than 50%, but 80 to 90% of the people on any question like that say they're better than average. You can ask them, are you liked by others better than average? And 80 to 90% will say, but are you a better than average lover? Then you get the same answer. Well, it can't be. And we tend to think that we are better than average at picking who the future winners are when there's no evidence to support that unless you look in the mirror and maybe if you see Warren Buffett, but there's only one person who gets to do that and it's not you. So I think you're better off building diversified portfolios. And again, here's another thing that people don't know. And one of my favorite lines is what you don't know about investment is the investment history. You don't know. So if you ask people in a survey, and I do this anecdotally, what's the highest performing sectors over the last hundred years? And they all say one of two things, tech or health care. And the answers are tobacco and alcohol and gambling. I mean, they are the highest return. And the same thing is true. You go outside the U.S. right, and we can't predict which will be the winners. And as I said, even if you knew, right. That you know, search engines would dominate. Netscape was the original leader and Google took them out. Amazon almost, you know, stock price collapsed like 80%, 90%, I think twice before it eventually succeeded. Right. We don't know. Apple, you know, Almost disappeared a couple of times. Some of their price clock. Look at intel. Everyone thought intel would be the winner. And I remember in the mini computers, data general, digital equipment, these companies aren't even around anymore. I think it's absolutely foolish to believe you could pick winners. When we know thanks to recent research there's only 4% of all the stocks that have ever existed that account for 100% of the equity risk. What are the odds you could identify the 4%? So if you insist on playing that game for enjoyment or whatever I tell people, take 1 or 2 or maybe 5% of your portfolio, set up a separate entertainment account, pick your stocks. You won't get necessarily rich, but you may get really lucky and you won't go bankrupt either. The rest of your portfolio will be at work for you.
- [21:25]
C
Yeah, it's funny, in the moment it's so hard because you think like some of these moats are like impenetrable. Like so if I go back to myself five years ago and I look at Google and search, I would have said there's no chance anybody will ever challenge Google and search. And now we're sitting here with all these AI companies and Google scrambling like on search. So it's just interesting like when you know the fact, like the facts you know at the time it can seem like companies are invincible, but something always comes out of left field.
- [21:48]
A
Yeah, there's always the quote black swan that comes up. Google could have been, you know, split up by antitrust. Nobody can predict these things. And because we don't have clear crystal balls, the only logical answer in my opinion is to hyper diversify across as many unique sources of risk as you can identify. Because if you believe markets are efficient, okay, that doesn't mean perfect efficiency, but it's highly efficient. It means all risk assets have to have very similar risk adjusted returns. That must be the case. So for example, if you thought the US had higher risk adjusted returns and everybody else thought so too, than say emerging markets, then what will happen? Money will flee emerging markets, go to the us what does that do to expected returns? Well, you don't change the earnings of the emerging market companies when you sell their stocks. So it means their valuations go down, but the expected returns have to go up, paid less and you get the same earnings and so their expectorant returns go up. The reverse is true. In the US cash flows in drive prices up, which is what happened over the last decade or so. Right. And now your expected returns go down. And we see these cycles go for typically 8, 10 years, US outperformed in the late 90s, international outperformed the next decade. US has outperformed basically since 2016 by large amounts. And this year all the people are forecasting US is going to outperform its US Exceptionalism dominate in AI. I just looked at the Avantis or Dimensional International Small Value Fund, which I own for exposure there. It's up 40% or more, the S&P is up 15, and emerging markets are up in the mid-20s or something. I can't predict that. But for the last 10 years I've just been rebalancing my portfolio and actually about 18 months ago or two, it got so wide, widest spreads I've ever seen. Okay. I actually sinned a little bit and bought a bit more international merger. So I went from like 55% US to 50 and I raised my international a little bit. So I sin a little on the edges when I see massive shifts.
- [24:29]
C
You mentioned diversification. And one of the things many people who have diversified portfolios own is something along the lines of the S&P 500. And there's been a lot of talk recently about this idea. I mean, the market, I don't know if it's the most concentrated in history, but it's certainly among the the most concentrated in history. And is there a risk associated with that? And you have people on both sides saying, you know, these are the best companies in the world, I should own more of them. And then you have people on the other side saying, you know, no, this is not something you don't want that much of your weight in a small group of companies. So how do you think through that problem like this concentration is a risk to the market?
- [24:56]
A
Well, there are two things. One, go back to my first premise, which I think all investors should adopt, that markets are highly efficient. So, and then the second point I want to. Which means, you know, you can't predict what's going to happen and markets are pricing efficiently. The second principle is you should never confuse information with value added information or what I would call wisdom. If everybody knows that these US stocks are the best, their earnings are going to grow faster, et cetera, you should just ask yourself one simple question. Am I the only one who knows this? And the answer is obviously no. And therefore, since the smart guys at Citadel and Renaissance Technology and JP Morgan and all these big fancy money managers, they know it. And therefore that information must already be embedded in prices. And the only way you could benefit is if all these other geniuses are wrong and you somehow can interpret it better than them. That's the only way you should outperform. And if you believe they're the best companies and they're going to grow the fastest, are they safer or riskier?
- [26:12]
C
No, they're certainly safer investments.
- [26:13]
A
Well, then how do you make the case that you should expect high returns from them if they're safer? That's the most basic principle of finance, that risk and expected return must be related. So if you think that they're the safest, the only logical conclusion you should draw is, fine, I want safety. I'm willing to accept lower returns, and I want to load up on these stocks. If you want higher returns or think I should be more diversified, then I would avoid the S and P because it is highly concentrated in a small number of companies. And I can't see any logical reason to let a portfolio be dominated by any one country. Like Japan dominated the market cap in 1990, and the next 30 years was a disaster for investors. But Japanese investors and investors around the globe thought Japan was going to dominate for the next decades, and it didn't happen. Nobody knows what's going to happen. That should be your basic premise. So avoid concentration. Global market cap is a good starting point. So maybe 60% US or 55 or whatever the right number is. And then you can look at valuations and say, hey, I don't like this concentration risk. Europe and emerging markets are trading at historically cheap levels. I'm going to move 5% away from the global market cap, and I'm going to live with that portfolio and not question whatever happens, look back, and I'm just going to stick with it and rebalance and watch what happens and only act when you're in like the third standard deviation of spreads.
- [28:03]
C
Yeah. It's interesting. I've had this conversation with clients because in a lot of ways, I mean, the s and P500 is a good way to invest long term. I mean, people have done fine with it, but I've kind of argued to them, like, in the situation we're in, maybe you're becoming more diversified by adding some exposure to something like value or adding some exposure to some factors. Because to your point, we don't know the way the world's going to play out. We don't know if these big companies are going to keep leading. We also don't know if value is going to win in the next few years. So maybe a little bit of both might be good.
- [28:29]
A
Yeah. And so let me add this. You said, and most people believe the S and P has been a great way to invest. And over the long term that's true. However, as I love to point out, and I've written it in many of my articles, this shocks most investors, especially the younger ones who have seen only the S and P do great recently is there are three periods of at least 13 years where the S and P underperform. Totally riskless T bills, right? Which means they basically had no real return or minuscule. 15 years from 29 to 43, 17 years from 66 to 82, and just recently from 2000 to 13. In 2009, it underperformed by 39, 40% or some number like that that tells you you must or should logically be diversified. Because I don't know many investors, especially those who would do it yourselfers, who have investment horizons that would allow them to stay the course for 13 years and watch that do so horribly while other assets are doing great.
- [29:47]
C
I want to shift the passive investing because this is. We've kind of been talking about the s and P500, but you know, we all know the cost. The actual direct expense ratios of these funds are basically very close to zero right now. But there's been some research recently that's looked at the other costs because obviously these, these stock funds are getting bigger and bigger and bigger. They've got to move in and out of positions, at least to some degree. And you wrote about this. So I'm wondering if you could talk about this a little bit about what you found, maybe about the costs of these passive investing funds.
- [30:11]
A
Yeah, well, let's make a couple of points here. First, the points I'm going to make are not huge issues. They're not like saying paying 2 or 3% and 20% to some hedge fund. You're talking of much smaller magnitudes. And I'll touch on what the size of those magnitudes are, at least what the research shows. So most people, if you think about say an S&P 500 fund, and let's say it actually costs you zero because you can get one for zero, they think that's the only expense and their fund matches the return of the index. What's missing is they don't understand the way The S&P 500 is calculated. It's calculated the returns are based upon the prices at the last trade at the end of that period. Right. Now let's think about what happens if you're an index replicator, which all index funds basically do. Their sole goal is to replicate the index. So what they don't want you to know or don't tell you and don't educate you. And it's sad that nobody explains these things to people. And it's not a huge issue as I'll touch on. But the smart people know that the people who own an S&P 500 fund are going to wait to do their trades and bulk them in all on the last trade of the of that day. Why do they do that? To ensure they got the last price. That's their goal. Now when you trade, there are is a triangle of issues that you can deal with and you can only pick two as your objective. You cannot control all three. You can get the price you want by trading very slowly and not taking liquidity from the market. You can do it with speed, right? Okay. And you don't care what the market impact is. You're some active manager and you think a stock is going to crash, so you sell everything. Even if you take a big haircut on the price. Or you can look at the amount, you can get done. That's it, right? Price, speed and amount. You can choose two of the three, but not all three. The index funds say I don't care about the price, I want to get all of them done and they want it on that last trade. So speed. So what happens, all of the high frequency traders and everybody knows ahead of time what the indexers have to trade. They're going to buy the additions and sell the subtractions. And what the research shows is, is if instead of waiting till that last trade because it doesn't show up in returns, because of what I explained, if you own the fund with no expense ratio and the S and P index went up 10%, you're going to get 10. Because the cost that I'm going to describe happened in that last trade. The cost of that, if the researchers found, is instead of doing that, you had started trading in small amounts, say two weeks ahead of time, selling the stocks that are going to leave and buying the stocks that are going to enter, you'd be 40 basis points or so ahead. That's a real cost to these funds. And the bigger the fund gets in size, the bigger its market impact cost. It's going to have to move large amounts of stocks. Now what's interesting, and most people, especially the factor based funds which will go nameless for the moment, they don't want you to know when they get big, they face the same things because they've been telling people for decades, right, that we can take advantage of that, we can be a patient trader because we don't care about replicating. We can be willing to live with what's called tracking variance. So we see a stock enter our buy universe. Well, the index fund has to buy it, it pays the price, pays to get market liquidity. The factor fund could say, no, we'll start buying, we'll put in bids, and we'll try to minimize our trading costs, etc. Okay, so that. And when it stock is leaving, the index doesn't have to sell it immediately. It could start to slowly trade and it gives up speed. Right, to get the best execution. Okay, so the. When you're small, say you're managing 500 million, a billion, you could do that when you're at 20 billion, 30 billion, 100 billion. Now you're running to two problems. One, if you're either going to have to do bigger amounts, right, to get it done quickly, because if you don't get it done quickly, what happens? You're now owning stocks that you shouldn't own. Okay, so fund family might decide to minimize costs, we're going to not buy or sell more than 2% of the average daily volume. Now, if you're a $30 billion firm, from what I've talked to portfolio, it could take you two years to get totally into or out of a position. Which means if you want to buy a stock because it crashed and became value, you start to buy it and two years later you finally get to the position size you want in the portfolio, and now it's a growth stock and you got to sell. And here's one other interesting thing that nobody wants to talk about. So now you're a big fund family and you've got a small value fund, a small cap fund, a total market fund, core fund. You got all these funds and all of them buy small value stocks. So now you can say, all right, I only want to trade 2% of this small value's average daily volume. Which fund you're running, say five funds that own it. Which one are you going to give that small that first trade to? Well, you're going to give it to the one, I would assume that's the most important. It's the small value fund doesn't impact the others as much, so they may never even get to buy them. But. Or it could take months or years, whatever to get there. And those effects means you don't have the factor exposures that you want to have. Now that effect might be another 20 basis points or so. Okay. That inability to move quick enough or to trade bigger than you have Market impact cost, which could make it more so to me the smartest thing to do. Especially now when you could do 10, these 351 exchanges. You own an ETF when it's small and has a high factor exposures. Okay. And the smaller funds can get deeper loadings, which is what you want, so you have lower cost per unit of risk. And then when it gets really big, you go to Alpha Architect and put it into a, an etf, exchange it and gather it and then move on to something else, maybe in your portfolio. So diversify out of it over or stop reinvesting and move to another fund that can get you access that's now new or smaller. So these issues are things that none of the big fund families want people to know about. And I thought it was important that this should not be hidden. That doesn't mean the funds are bad. There's still great vehicles. But if they're going to tell you we're saving money by patient trading, they also should say, well, the fund is now large, we can't, you know, here's the negative side of that patient trading. It's going to cost us a little bit in our ability to gain factor exposures.
- [38:43]
C
Do you worry about this idea, you hear it a lot, that passive investing will get too big? I mean it's hard to figure out what passive investing is, but I think most people think it's maybe in the 40s or something like that of the market right now. Do you worry like it could get too big where we start to have bigger issues related to this?
- [38:57]
A
Well, I guess anything is theoretically possible. But here's the way I think about it. In the 1950s there was like 90% of the market was owned by individual investors with their stocks held in their individual brokerage accounts. That means very little that was run by these big institutions. There was only I think 100 mutual funds, active funds at the time because there were no index funds. And yet the market was highly efficient, nowhere near as efficient as is today. But still it was very hard to outperform in 98. By then the market had gotten much more efficient. Charles Ellis's famous book Winning the Losers Game was published and he wrote that only 20% of active funds were outperforming risk adjusted benchmarks. And that's before taxes. So add in taxes, maybe it's 10%. I know about you, but I don't like those odds where you got nine to one against you and there's no persistence beyond the random. So you can't know who the Future winners are likely to be. So you should have been a passive investor today. The percentage of people who are passive have gone from was only about 5% passive in the mid-90s and now it's 50% or so. And the market's so efficient that only 2% of active investors are in. I think because we have so much better trained investors running funds. Everyone who runs money today, it's got a PhD in nuclear physics or math certainly, and a PhD in finance if it's not math. They have massive databases, access to every bit of information. They're better trained, better equipment, better models, and yet it's so hard to beat the market. I think We've got over 10,000 mutual funds and over 10,000 hedge funds. The market could shrink by 99% so you'd have 100 of them and that would be more than enough to keep the market sufficient in price. So it would be difficult to outperform because these hundred would have the best information, the best data. And even if there wasn't a lot of people filing with then if you don't have a lot of trading, well, the bid offer spreads will be wide and if you could find an anomaly, it would cost you too much to exploit it. I don't think we're anywhere near the markets becoming inefficient because there's too much passive investment.
- [41:49]
C
Just one more thing before I hand it back to Justin. I want to ask you about value and interest rates because this is something you hear about all the time and it's something in theory that makes a lot of sense. You know, that in higher rate environments, you know, shorter duration value should do better and in lower rate environments, growth should do better. And it's kind of the way it played out, you know, in the recent couple decades. So people think that's just the way it works. But you look at the data to see how this actually works. And did you find any relationship between the performance of value and growth and interest rates?
- [42:17]
A
Well, all the data shows that stock returns are basically have no correlation to interest rates. They perform roughly the same in rising rate market, falling rate markets or stable markets. Roughly the same. And the same thing is now there's some evidence that value has outperformed in higher inflation. And for the reasons you said, I don't know that we have enough data points to really show that is the case. And more importantly, I don't think anyone can predict which environment we're likely to be in anyway. So I think you're better off diversifying. You want to Be a value investor because you buy the risk and the value is a higher cost of capital. Story invest for those reasons. The data I've shown, I've seen does show some evidence that value does a little bit better in higher inflation. But you have to ask yourself, gee, I can't be the only one who now knows that. It published papers, I write about it and once that information's known then if people are forecasting higher inflation then that should already be in value prices. So I would not make big bets based on that. The one thing I would say is this. When you get higher than expected inflation and I'm not talking about 2 to 3% but when you get above that to where the Fed really starts to worry, then you run the risk that the Fed could really tighten and contract and that could knock out all of the bubbly prices which are in growth stocks right now. So everything might come down but value stocks might move from a 12 PE to an 8 P E. I'm just making something up and value stocks can go from 40 down to 15. And so the growth stocks could get hit much more because they are so highly valued. So more of a defensive play because it's already cheap. Again I always tell people the markets are forward looking, you're not likely to be able to forecast better than anyone else. If you're worried about certain things then just design your portfolio to own more assets that are resilient to those things. So high inflation might want to own a little gold, might want to own commodities. Real assets like infrastructure, shorter duration assets should do better, right? So you could do that. If you're not worried about it then you don't have to do that.
- [45:02]
B
One of the recent articles you published was highlighting this recent piece of academic research where these authors looked at, they took four, you know, relatively simple value strategies. I think it was the Piotrosky F score, the acquires multiple green blast magic formula and then pimbong the lead's conservative stock strategy which these are all like, you know, pretty simple. What would be considered like quant value screens and that select stocks based on you know, a series of pretty easy sort of factors. I shouldn't say factors like variables.
- [45:43]
A
And.
- [45:44]
B
They looked at this, these, how these strategies performed or last I think like 25 years or something like that. And I was just, I think it's just interesting to like talk through what their findings were and then also like what maybe some of the recent performance has. So I'll let you kind of talk to first like what did these authors find in this, in this study of.
- [46:04]
A
Strategies, you know, they found that all of these strategies did provide good performance over the long term. None dominated really in one period. One of them does better than the other, and then they rotate around. But they all should work if you believe markets are efficient. And these factors or traits or characteristics are rewards for taking risks that other investors are not willing to bear. And so to me, they're all a version of a simple, you know, value, profitability, quality strategy. The academics have, if you will, reverse engineered Warren Buffett. So what did Buffett buy? He bought value stocks that were cheap, profitable, didn't have a lot of financial leverage. So they look like what we would call quality companies today. And the people at AQR wrote that paper. I think one of the more important ones on Buffett's alpha basically showed that Buffett genius had nothing to do virtually. Not exactly, but close with stock picking doesn't take anything away from what he accomplished. But he identified these traits or characteristics 60 years before everybody else. So he deserves great credit. But he hasn't outperformed for the last 20 years. Once we account for these factors. He's had virtually no alpha since then. So that's what I wrote about in my book with Andy Burkin, the incredible shrinking alpha, in effect, reverse engineering what the great investors had discovered or uncovered. And then it becomes beta. Because you could buy all these different factor strategies, use any one of them, and you would have been fine. But you also have to know, and here's the important thing, all risk strategies will go through very long periods of underperformance. That doesn't mean you should avoid the strategy I gave you 17 years where the S and P underperformed. Does that mean should avoid the S and P? I think most people would say no. You need discipline. You need to follow Buffett's rule of, you know, don't time the market. But if you can't resist, buy when everyone's panicking and sell when everyone's greedy, okay? And it means you should hyper diversify because your next 17 years, which might be your whole horizon, and, you know, for someone my age, for example, could be the one where beta is a horrible asset to own. So why would I want to concentrate and take that risk? And then you get this dreaded sequence risk could cause your portfolio blow up. So I want to hyper diversify, which is what all of those factor strategies are doing. They're not betting on value, profitability, beta, momentum, you know, whatever, individually, right? They're betting on them across factors that sort of you could say equal weighting and what the research shows. Interestingly enough, and this is true everywhere we look, not just in finance. A naive one over n strategy tends to be extremely difficult to outperform. So you could pick any five factors like that define value. Some people like EBITDA to enterprise value, other like price to cash flow. You could pick any one of five of the 20 that are probably out there, randomly choose five and just go one over and you'll end up with something that will look similar to the performance of all four of those great simple strategies. Same thing is true I think why you should own infrastructure, private real estate, private credit. You could own commodities, you want to own international, own us, you know, and have I own reinsurance as well. I own investments in other strata like litigation finance, hyper diversified, of course, assets that have nothing to do with inflation risk have nothing to do with economic cycle risk and then have other investments that have lots to do with those risks.
- [50:31]
B
Your, your comment about Buffett's Alpha made me think of and I'm pretty sure the name of the paper was Superstar investors from aqr. I think where they looked at. So the one you're talking about is called Buffett's Alpha. People can Google that. But then there was also this superstar investor where they tried to do the same thing across other great investors. So I think maybe Druckenmiller might have been in there. Peter Lynch I think was in there and there was maybe a couple other great investors and they tried to, you know, show like how much of their performance was just beta versus you know, alpha or relating to the specific factors. But where I want to go with that and I just thought of this and you know, if an investor wanted maybe, maybe you'll say they should just want it. But if investor wanted like growth exposure, like growth stock exposure, like how is there a way to get that in the factor world? Of course you have momentum, but momentum doesn't always, doesn't always correlate with growth. Momentum can go anywhere. It's just what's performing best in the intermediate term in terms of relative strength or something like that or trend. But how would you answer that on the growth side of things?
- [51:43]
A
I think the good answer to that is there are good growth stocks and bad growth stocks. The bad growth stocks are what the term I use is the lottery stocks. These are like the penny stocks that people are betting on. These meme stocks often could fit into there. So way to think about them. And there are lottery tickets, say 90% of them disappear. Have Returns worse than T bills, et cetera. And a small number of them end up hitting the lottery and provide spectacular returns. So it looks like that lottery ticket. Right. All right. The research shows, for example, that small growth stocks with high investment think AI now. Right. And low profitability think AI now. Right. Some of them. Right. Have returned worse than T bills. Why would you invest in that? So if I want to own growth, I would look at a more diversified approach that kicks out the bad stocks by using simple formulas that buys growth. But quality, maybe low volatility would be another way. So I'll have high, you know, stocks that have high prices to book or high price to earnings, but are lower volume, higher quality, not a lot of financial leverage, more stable earnings, you know, those kinds of things. And maybe aren't even high investment, although high investment and high ROE is a good thing. So that's where profitability would come in. So that's the way I would try to attack that. But I wouldn't recommend you do that. But you know, if you're going to do it, I think that's the best way to go about.
- [53:39]
B
Okay, just as we kind of wrap up here, we wanted to get some of your thoughts. I mean, private credit is something you've written about a lot. It's actually exploded as an asset class. I think it's being wrapped up inside ETFs. And I don't know, is it coming or is it alternatives coming to 401ks? I'm not sure. Like, you know, it seems to be this stuff is starting to ooze into, you know, a lot of different just options for investors. So I guess just generally like what are your sort of thoughts on the asset class? And then also do you think that wrapping this inside, you know, an ETF and making it available to, you know, any investor that's out there that has a brokerage account is a good thing or what?
- [54:20]
A
I think it's a really bad thing on both accounts as much as I like the asset class. So first of all, you should never take an illiquid asset and put it into a daily liquid investment. That's a recipe for disaster. You get a run on the bank, if you will, and then you get four sales and an illiquid asset. You must sell, right? So the bids are going to come way down. You have massive losses that become self fulfilling. You get margin calls and everything else and the whole thing implodes. The way these funds will likely try to minimize that risk, they can't eliminate it is own in. In the ETF a lot of daily liquid investments. So you know things like the assets you could buy, for example BKLN or SRLN to private credit funds that buy, you know, the daily, I mean the liquid portions of what was originally private credit and securitized. And it trades daily. Well, if you look at BKLN or SRLN versus the Fund I investment which is Cliff Waters private credit fund, it's underperformed by about, let's call it roughly 3% and that's the illiquidity premium. Now Clifford is fund only allows 5% per quarter as a gate. If there are more demand than that, they only have to return 5% so you can't force them to sell. And the asset is all is almost self funding because while the average loan is about seven years in maturity, typically when they're made, because these companies eventually get sold and the debt gets repaid and they don't want to sit with this high cost debt so they'll pay it off as quickly as they can. The average maturity of how long that should last is about three and a half years. So think about roughly a third of the portfolio is maturing every year. You're getting that cash, you're getting the interest payments which are now almost 1% a month. Right. And you're getting some new investor money. And Cliffwater, very intelligent focuses on the liquidity issue. So they'll pay like 80 basis points fee or something like that to get a guaranteed line of credit that they could use should they need to pull in more cash other than what's flowing now you do that in a public fund there's no, you know, not, no one's going to tell you about these risks. And you could get people demanding their money. But the first thing I'd ask is why do you want to own BKL? And when you're giving up to 3% liquidity premium so your earnings are going to be lower than the asset class. And now you still have all these problems, you know, with the run on the bank issue. Let me touch one last thing because you're going to see this now move to private equity. We're already seeing interval funds in private equity and I think most of the players are making a bad mistake and offering this 5 and 20 liquidity structure. Now tender offer funds like Blackstone's B REIT for example, which ran into a problem. They offer 2% per month but 5% per quarter. But a tender offer fund has the right to say we're going to shut it off so we don't have to Have a for sale interval fund. Can't do that. So to me, interval funds are a terrible place for structures that don't have the natural liquidity flow that short term private credit does. So I would avoid an interval fund that's offering 5 and 20. Clifford, in my opinion, did the right thing and said we're only going to offer 5 and 10, so it's only twice a year. And again they have backup lines of credit to help meet those demands and don't need to hold a lot of assets that will drag down the portfolio returns. Last thing I'll mention is if you're going to invest in an illiquid asset, you better understand that there almost certainly will be periods you will be gated and you need to be willing to stay the course, not panic and sell. And the biggest problem Justin and Jack, you probably know with investors is they think three years is a long time to judge performance. Five years, very long and 10 years, infinity. And so they panic and sell after three or years. Let me give you one just brief example to show why investors should avoid these types of things and why you have to learn to be a disciplined investor. One of my favorite investments of the last few years, I think it's been the best single investment around because so many people panicked and sold and got out of the asset class. So expected returns went through the roof as the self healing mechanism happens to be reinsurance. So Stoneridge has a reinsurance fund that they introduced I think in like 2014. And naturally a great asset. It's got a risk premium. Naturally people aren't going to sell insurance, doesn't have an expected return. It's bad because it has that big tail risk. You get a disaster, you lose a lot of money. But that demands what? A big premium. Just like equities demand a big premium because you have that big tail risk. So they go and it's a great asset because it's no correlation to stocks or bonds, has no inflation risk, no duration risk and bear markets don't cause earthquakes or hurricanes and almost always it's not going to be the reverse. So this asset class had an expected return of 5% of over t bills when I first started. It's a dream asset because 5% over T bills with no correlation. That's equity like returns. I invest in the first three, four years of returns, roughly that 5%. Then we get three horrible years in a row, loses about 35, 40% drawdown. Nowhere near as bad as the worst drawdowns for equities. Right. But 80% of the money disappeared. Now some of it of course, was the 35% or so drop. But the fund went from 5 billion to 1 billion as dumb naive retail money panicked and sold. So what happened? The self healing mechanism that works with stocks, right? When stocks crash, valuations go down, expected returns go up, which is why Buffett tells you to buy. When you get bear markets and credit, credit losses go up. What happens? Spreads widen, yield specter returns go up, underwriting standards get tighter reinsurance. What happened with the Cal fires? You can't get insurance unless there's no trees within 30ft of your house. You can't get wind insurance in Florida unless you can withstand 140 mile an hour winds. So the risk went way down. The premiums went up like 60% in a lot of cases. The next two years the fund returned 92%. And this year itself, despite the 10% loss from the largest fire in history in the U.S. anyway in California, it's still up like 18% this year and probably you'll end up if we don't get a big hurricane, which is less and less likely now over 20% again and next year I would expect it to be up 20%. But you should hyper diversify because you could lose 35, 40% in a one or even three year period. But if you stay the course, right, you are ultimately likely to be rewarded. So again, private credit, I think it's bubbly in some of the areas you're going to see loosening of credit standards. You're seeing it already in the largest trades, the biggest funds where the biggest competition because Blackstone and Aries and all these big guys have to put huge amount of money to work through. Owl, I would stay more in the smaller to middle market. They can't play there because a 5 or $20 million loan is not going to hit their balance. The spreads have not moved there that underwriting standards are if anything tighter than they were. That's not as true in the largest, what was called the broadly syndicated loan market. So this is an asset class that is highly differentiated. You want to stick with senior secured back by private equity. Average LTV in the Cliffwater fund is like 41% default history, average 1% actually or less. So to me that looks like a good investment right now. An expected return of about 10% and a volatility that's very low, not as low as publicized. But that's enough story for another day.
- [63:52]
B
Larry, thank you very much for sharing this time with us, for helping our audience and reminding our audience the importance of discipline, diversification, keeping a long term mindset and staying evidence based. So really appreciate your thoughts as always. Thank you very much.
- [64:08]
A
It's my pleasure. Be happy to come back anytime. We've always got all these great issues to talk about. There's always something new in investing, which is why it keeps me busy. Keep reading the research and hopefully helping people get educated. What I think is the most prudent way to invest, giving you the best chance to achieve your life and financial goals.
- [64:30]
C
Well, you're probably the most prolific writer in finance, so you're always giving us plenty of topics to choose from, so we'll definitely have to have you back.
- [64:36]
A
Thank you very much.
- [64:36]
B
Jack 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 xs. If you have any feedback or questions, you can contact us at Excess returnspod at gmail. Com.
- [64:56]
C
No information on this podcast should be construed as investment advice. Securities discussed in the podcast may be.
- [65:02]
A
Holdings of the firms of the hosts or their clients.