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- [00:00]
A
People debate whether prospect theory is real, that losses hurt more than gains. It's very real to me. And me, yeah, in good years, I'm like, well, there's a lot of randomness to this. I'm just, you know, I think we'll make money long term, but. But that was probably luck. In bad years, I'm like, I don't invest based on this. I'm pretty good about avoiding that. But I have every bad emotion that, that we attribute to investors. Losses hurt. They're not supposed to. You're supposed to just do the rational strategy and keep repeating. But we live in the real world. Foreign.
- [00:35]
B
Welcome back to another Infinite Loops. I'm Jim o' Shaughnessy and I'm thrilled to be joined today by my friend Cliff Asness. Cliff is the co founder and chief investment officer of AQR Capital Management, one of the world's largest and most influential quantitative investment firms. Please enjoy this episode with my friend Cliff Asness. Cliff Asness. Man, it is so great to see you. You had a great 20.
- [01:04]
A
It was very. It was very nice here.
- [01:07]
B
It must have felt really good, right?
- [01:09]
A
It feels about a third as good as the equivalent bad year feels bad, which is very good. But, you know, people debate whether prospect theory is real, that losses hurt more than gains. It's very real to me. And me, yeah, in good years, I'm like, well, there's a lot of randomness to this. I'm just, you know, I think we'll make money long term, but. But that was probably luck. In bad years, I'm like, I don't invest based on this. I'm pretty good about avoiding that. But I have every bad emotion that we attribute to investors. Losses hurt. And they're not supposed to. You're supposed to just do the rational strategy and keep repeating. But we live in the real world.
- [01:57]
B
Yeah. And one of the things I love about you, though, is you get more aggressive when you're having bad, bad year. Right. By the way, I did something when I was at osam, we did the same thing. I said to my people, I don't want you on the phone when we're a thousand basis points ahead of our benchmark. I want everyone, including me, on the phones when we are sucking wind.
- [02:22]
A
I remember there, we've had basically two and a half, three bad periods. There was the tech bubble. I mean, you and I are ancient now.
- [02:31]
B
I know.
- [02:31]
A
We are. So a lot of people listening. That's like, I think I read about that.
- [02:36]
B
I don't know about that, dad.
- [02:37]
A
Eddie Some of the things we do, not everything. During the gfc, individual stocks were fine. During the GFC it was. But there were some parts that were really annoying. And then two and a half years, from kind of mid 18 through the end of 2020, and we do get more aggressive in the sense of being out there explaining we'll do this in good times too. If people want to hear it, they just don't want to, don't need to hear it. Right. As much though I do vary a little bit. If we lose and by the way, we win a lot more than we lose, somehow I'm only focused on losing here. But if we lose for reasons that I think are, for instance, valuation based, where I think things are getting a little stupid, then I get more aggressive. Yeah, long term. We just did this, we wrote a blog on this about two years ago. The correlation of our strategies to, you know, what people think of as basic value, long, short, you know, fama, French, HML or.
- [03:41]
B
Yeah.
- [03:42]
A
Or somewhat more sophisticated versions than that. It's about 0.2. It's not that large. It's been negative for rolling three year periods. But there have been particularly the tech bubble and the period culminating at the end of kind of COVID Were value disasters. And when they're value disasters. Yeah. If the fundamentals are not why we lost, if it's just prices doing this, then I get more aggressive just because I believe in it. If we lost because of momentum or quality or more proprietary things, we do a lot of things. I will not talk. I'm sure you do too about I and the firm will explain what happened, of course. But I wouldn't get more aggressive like take more risk or even get more pugnacious in the world about it because you know, for instance, if you lost because of a momentum, then you just change your mind and apologize. And you know, we do believe if you do that over and over again, you win. And we think we've demonstrated that. But it's when you lose because the world goes mad. If you're right about that, that's the time we definitely get more, more publicly aggressive. You know, writing a million things. Look at this. This is crazy. And last time you and I spoke, we talked a lot about the value spread. Yep. It's. It's still high. It's nowhere near as high as it was. Right, right. Which is good news, I guess.
- [05:08]
B
Yeah. I think the point about the dot bomb is really illustrates that it's kind of good that we've been around as long as we've Been around because I remember I wrote a piece, I don't forecast right. I listen to the numbers and if they are like crazy, then I'll write something. Right. And so I wrote a piece called the Internet Contrarian in April of 1999 in which I said, I'm sure, I read it. 95% of these companies are either going to be carried out feet first or be 90% low, even the winners. And I used Amazon as an example.
- [05:47]
A
You got lucky there.
- [05:48]
B
Yeah, I did. Dead.
- [05:49]
A
Total luck.
- [05:51]
B
And it will be 90% lower. Cliff, the hate email consists of the beginning of email. Right. The hate email I got because What, I was 39 years old and they're like, why are you such an old fogey?
- [06:05]
A
You don't understand the new world. You're always called old if you prefer to pay a lower price for something.
- [06:11]
B
Exactly. But the mania that typified that time was like. It was all encompassing. It was like a mind virus.
- [06:21]
A
Yeah. I still think literally on the value spreads that we measure, the end of 2020 got a little bit crazier, which I never saw coming. And I admit this, a lot of my thinking has evolved based on saying we saw the craziest thing in 50, 60 years of good data in 99, 2000. If someone had asked me then, are you going to see something crazier in your career? I definitely, I don't know if I'd say definitely. No. That's a stupid thing in our business to ever say.
- [06:53]
B
Exactly.
- [06:53]
A
But I'd say it's highly unlikely. Right. This was the most extreme thing in 50, 60 years. People like Jim O' Shaughnessy and I will still be around the notion that if something happened 100 years ago, you can imagine the world forgets.
- [07:09]
B
Sure.
- [07:09]
A
But you know, I was, I was like 33 at the time of the tech bubble. I'm like in my career. So it's that 20 years later it's going to happen again. And it happened again now the value spreads got wider. I still think the dot com bubble was a little more extreme in a different way because the correlation of value and quality were different and the dot com bubble value spreads were here and they were all of the, if you'll pardon the technical language crap companies. Yep. In 2020, it wasn't terrible. It wasn't like you had to short the hell out of quality, but it wasn't on both dimensions. It was really evaluation, at least how we see it.
- [07:50]
B
We saw it exactly the same way during the dot com, because we would, when we would sort right Just on our value composite.
- [08:00]
A
Right.
- [08:01]
B
And there'd be names like Citicorp there. And without the quality filter, you'd go, you, you would have been backing up the truck for Citi.
- [08:10]
A
But when you put the quality factor.
- [08:12]
B
In, you're like, holy shit, I'm not touching that. Right. So yeah, it was a, it was a really interesting time. But then the 2020, like, I actually thought of you when I was watching those guys.
- [08:26]
A
The Gamestop guy.
- [08:27]
B
Yeah, the Gamestop guy.
- [08:30]
A
I've hear real name like 20 times. I watched the movie. I just don't remember it. It's more accurate than saying I don't know it.
- [08:36]
B
Yeah, but the reason I was thinking of you was like, even I maybe get agitated a little less than you do.
- [08:45]
A
It's pretty safe bet.
- [08:46]
B
But, but like I was agitated, I was watching it and like, because I was thinking this is going to fuck up a generation of young investors. They're going to think that this is the way you make money.
- [08:58]
A
Well, that prediction I would say is on its way to coming, to coming true.
- [09:03]
B
Bear markets are when stocks return to their rightful owners. And those guys were not rightful owners.
- [09:11]
A
I avoided watching the movie for a while because I knew it would make him out to be a little bit of a hero eventually. I had a. In fact I wrote an op ed on this was in the Wall Street Journal where I explicitly said I'm going to complain about this movie that I have not watched. I try to avoid using the meme stocks as like my complete example because it's kind of unfair arguing to take the most extreme example.
- [09:34]
B
Agreed.
- [09:36]
A
But as long as you remember that that's not a full argument. The most extreme is edifying. It can, you know, you would have to argue that nothing else. This is in isolation going on and I do think the meme stock phenomenon. Again, I'm going to sound like a very old man, but the, you know, gamified 247 electronic trading. I am, I'm fairly convinced there are a lot of. I'll use the term investors, but there should be air quotes around this who can't distinguish fanduels from Robinhood. It's just an app and they have their little systems. I read. What did I read this morning? I was reading about some, some, some person who gives their financial advice out for, for money and had a system that worked and this thing is. And they blew up. They're selling it. They lost this one actually around Christmas. Lost a whole bunch of money and they're like explaining, well, it was a Martingale system. And I'm like, I'm reading this and I'm having this internal dialogue. I mean, you mean the thing that's been around for like 400 years where you just keep doubling the bet and that's exactly what it was. And first of all, the guy sounded like he rediscovered it, like, oh, you never lose. And I'm like, yeah, with an infinite bankroll and an infinite will do.
- [11:02]
B
You got that?
- [11:03]
A
And it's just the old cliche, pennies in front of a steamroller, advocating the Martingale strategy. To the individual out there who has no clue, just saying you keep doubling and eventually you win and you make back your initial, your initial bet, they leave out the risk of ruin. And so pennies in front of a steamroller is literally being advocated. And that was just this morning. I don't know how widespread that one is, but that was my thing.
- [11:28]
B
I got very unpopular with folks who were using massive amounts of leverage on illiquid assets.
- [11:38]
A
That is the death combination.
- [11:40]
B
It really is. And I was at a club in Greenwich and talking to somebody who had been at long term during their heyday, so this is way back, and he got really mad at me when I pointed out that that amount of leverage, it isn't if you're going to die, it's when you're going to die. And it flummoxes me that we don't learn that lesson.
- [12:06]
A
Yeah, I mean, leverage is always such a difficult topic and I really doubt that we're in disagreement on this. But it can be a wonderful tool if you have a very diversified portfolio. If the bets truly aren't the same, it can, it can help you balance out your bets. You know, I always say the example we've been given for like 30 years is if you have equal skill at bond stocks and commodities, for instance, and you take the same dollar bets in each, you're a commodity trader who dabbles in equities and bonds are irrelevant. Right. But, but if you delever one and you got to do both directions and lever the low risk one, you create some balance. But we've always imposed limits on it. Like we've never done the so called basis trade, right? Buy off the run treasury, sell on the run Treasuries, it's, it's the best example because you literally can cash flow match the thing and it's the same government cash flows. And as nervous you might be about the budget deficit, the notion that they will default on only selected bonds, it's a little weird. So it's about as close as you can get to a true arbitrage in that sense. And it still rises up to kill people all the time. And exactly at the times you don't want to be killed. Right. So it's not a martingale, it's a different system, but it's very similar characteristic that it works most of the time, but. But when it ain't working, you know, here's another example. We have the arrogance, and I'm sure you share this arrogance. To think that in the last 30 years, since the early 90s, our measures of so called factors have gotten better than they were back then. And one thing that comes up is there's still a fair amount of indices, fair amount of people who trade kind of the old school ones. So why not go long ours and short there? The old school. Yeah, yeah, that you can do that to some extent, but not much because you got to lever the bejesus out of that trade. Because for instance, you know, if you're doing a momentum or a value strategy, you've taken out that part and you're levering up the idiosyncratic part, which may in fact be fairly high risk adjusted return if your measures are better.
- [14:27]
B
Yeah.
- [14:27]
A
And beautifully like uncorrelated with things in the world because you have value on both sides, momentum on both sides, you just have to lever it an uncomfortable amount. And so that's on my to do list to one day figure out how to do that without dying. But I haven't gone down that road yet.
- [14:45]
B
You know, the other real shock to quants was the global financial crisis. Right. We had a guy from who had what had been Lehman, but Barclays took it over. He was a consultant to quants. Right. And I'm sure you've met with this guy, I don't remember his name, but he came out right after and basically said to us that 68 and probably that's probably fucking wrong. But 68% of quants overrode their model. In other words, they freaked out and their model was overridden.
- [15:19]
A
Yeah, we didn't do that.
- [15:20]
B
Nor did we.
- [15:22]
A
You can always debate what is over. You know, every time you do research and you change your model. I agree it's kind of a philosophical. But at no point did we say, all right, take this all off, we don't know what's going on.
- [15:33]
B
And that was my follow up question because I said, well, you know, we're evolving these models all the time and when we find something that's better, we put that, we take out the old one that no longer works as well and we put the new one in. And I said but so what do you mean specifically by overrode the model? And he basically said what you just said. They were like we don't know what's going on. We're just.
- [16:00]
A
Yeah. Now if you discovered that you truly took too much risk, I will say In August of 07 we cut some positions in our most volatile places because we thought we had to.
- [16:13]
B
Yeah.
- [16:14]
A
There's a difference between. We actually think this is, this is crazy enough that we're hitting risk limits and we don't like the model. The vast majority of what we did, we did not do that in because we weren't particularly worried about survival. It was just a really painful week. Yeah, yeah. And the GFC in total was actually not that bad for quant equity selection.
- [16:40]
B
Yeah, I agree.
- [16:41]
A
August of 07 and those events get conflated a little bit. I think of August 07 as the kind of the precursor. The first maybe bad month for credit was July of 07. And I think a lot of people had added quant had no idea what it was.
- [16:58]
B
Right.
- [16:59]
A
So it's like the first thing you cut and you and I are cursed for doing very liquid things, which is wonderful as an actual investment property, but it does mean you're the world's ATM when they feel they need it. So August of 07 was a harrowing week. Mostly recovered in the following two weeks. Actual calendar year 2008 I think we were slightly, slightly up. It was not a banner year. Value went through a disastrous period in the middle, but bounced back a lot. But a lot of the memories of quant as we see it and you know, not every quant is exactly the same, but we do have, we do overlap was really comes from August of 07. There was no global financial crisis at that point. That was a little adumbration of what was going to, what was going to come.
- [17:44]
B
One of my theories is that quant also can be the canary in the coal mine. Because in my research, and I'm sure you've seen it in yours, I'll give you an example. This is one going up, but it works going down as well. And I can't remember the year it was. I think it might have been 2004 or 2005. And all of a sudden a bunch of tiny steel making companies start showing up in our growth portfolio and I'm like what the fuck is this? This doesn't make any sense to me. Right. And so we bought Them, right? Because the model said by them. Well, about seven months later there was a Fortune or a Forbes magazine about how China was building one Boston a month. And then I'm like, oh, they're buying all the steel, right. Do you see that you have a much broader portfolio than we were? Much more concentrated than you.
- [18:49]
A
If we're right about what we do. And again, I think the evidence is there. But I'll always say if you are picking up mispricings, maybe I briefly believe 35 PhD students at the University of Chicago, you have to be an efficient markets risk guy. But I wrote a dissertation on the early versions of the momentum strategy. And immediately we knew it's highly unlikely this is working because of rational risk space. Therefore, if you're picking up mispricings, they're going to be a ton of stuff like that. If you're concentrated, you have to worry about it more. Right. We're adding these steel companies. You don't want to change your model, but you're going to look at it hard just to understand what it's doing for us. We try to be industry neutral mostly not entirely. And we'll have a thousand longs against 1000 shorts around the world. But in more micro small ways, we're a really boring portfolio to actually talk about. I mean, when people ask me, do you own this stock? Which happens all the time because they're like this, you're a professional investor. We're at some party, I'm like, I don't know. And I love to say that because it just makes people's face go, you don't know exactly. And they give you something like, are you kidding? Are you grossly incompetent and negligent? I'm like, no. The bad news is occasionally when I do know about an individual name because we were not short gamestop, but it's more like you guys are short gamestop and you've lost a lot on that. That would be even that doesn't really happen.
- [20:24]
B
Little percent that you might own or.
- [20:26]
A
Short or be short. You know my story about talking about shorting a meme stock on tv?
- [20:31]
B
No. No. Let's see. Let's hear it.
- [20:33]
A
This is one of these things where I pretend I regret, but I'm actually a little proud of. Okay, that's actually kind of a go to move of mine. But. So this is May, maybe 2023. I could be off by, you know, the years. In my stories, I get increasingly confused. Same with me by particularly with COVID With COVID I have no idea if it happened before COVID Exactly. Different time. But we had a really rough two and a half years through like October of 2020. And then things were fabulous and they're. They've stayed fabulous for five plus years. And you know, we know five years of fabulous is. Plus two and a half years of pain is actually very good. But it doesn't make the pain any, Any more pleasant. Right. We shrunk a lot. That's this business. You shrink when things. So when things were provably good again, my team that does this stuff wanted me to go on TV and talk about it. And they usually we. I go on TV occasionally, but it's not a big thing for us.
- [21:30]
B
Yeah.
- [21:33]
A
So I was a little surprised. And they're like, no, it's time to tell people as gently as we can. We were right. So we're planning this segment. It's on cnbc. And you've done this a million times. You have a pre call not to script the whole thing, but just to make sure you have something to talk about. Right. They want me to give them some names, long and short. They know we do both directions. And I'm doing the standard quant explanation if that's kind of silly. I usually don't know them were betting on an idea that's working that cheap, profitable, you know, companies that have been heading up lately that are buying back their own shares, blah blah, blah.
- [22:13]
B
We were buying the same stuff. Yeah.
- [22:16]
A
But I don't know the names. And they're like, well, everyone in this segment gives us names. So it was kind of a deal breaker. And I'm like, all right, I'll give you names. So I asked my team to put together. I said through the US because, you know, it's a us show.
- [22:30]
B
Yep.
- [22:30]
A
I asked him for two criteria which may have been the null set, but one, some stocks somebody's heard of. It's not that fun to, to, to say, you know, blah blah, blah, Acme, whatever. That. No, no one's not going to resonate with anyone.
- [22:46]
B
Acme Pharmaceutical. Wiley Coyotes.
- [22:50]
A
Some microcap. No, exactly. Sitting on top of a rocket. A fuse. Second, let's look for ones that are bad on most of the things that we publicly talk about because I think it's easier to explain it's bad on the following six things than trade offs. Right. And there are some things you'd be short or long that are fabulously good or bad on four things and are quite the opposite on two. But that's a more subtle argument. So I'm like, try to give me ones as best we can.
- [23:21]
B
Subtle. On some cnbc.
- [23:22]
A
So buy, sell or hold TV in general. I mean, one of the shorts they gave me was amc. The moving company. The movie company. Not movie company.
- [23:32]
B
Remember this? I didn't see the segment, but keep going.
- [23:35]
A
And I know I brought it on myself because I was obnoxious. I was trying to be funny, which is how you get in trouble.
- [23:41]
B
You are funny.
- [23:43]
A
It's not mutually exclusive with obnoxious, though. So I. The deal I made with them was they got to give me 45 seconds to explain were quants that we could be totally right about this and still have a bad year. We could be totally wrong and still have a good year. These are six names. I don't even think I got to all three on both sides. AMC was a big meme stock. I didn't know that going in, but I didn't know. I had no experience with the depth and breadth of the Fever swamp. The whole GameStop Melvin Capital thing.
- [24:16]
B
Total cult.
- [24:17]
A
But I kind of watched it. It was not relevant to us. I know we're super diversified. You know, I don't particularly like investing death cults that go around just trying to hurt people because they don't like them. Yeah. But it was.
- [24:32]
B
I'm kind of opposed to them, too.
- [24:35]
A
But it wasn't. You know, to be blunt, it wasn't hurting my portfolio. So I was like, this is some crazy stuff out there. So I had an. I knew a little bit. So I go through. That was short amc and I went through like. It was. It was a beautiful example because it was just. It was super expensive based on the fundamentals that were actually measurable. It's not like it had earnings or something, but it was super unprofitable. They were issuing, not buying back shares. Every form of price and fundamental momentum was. It was not. It was super high beta. There's not a thing we liked about the stock. So it was easy to explain. But then at the end I said, but again, we're quants. So we're short a whopping 12 basis points of the portfolio in this thing. I just described that we hate. And then I added the line that I should not have added. So the crazies can't hurt us even if they're right or something. I'm paraphrasing and I think I'm throwing them a lifeline trying to explain that it could be bad on everything we know and there could be management that does something revolutionary, fixes it all. It was actually Quite the opposite in real life, of course. And you know, it's 12 basis points. As crazy as that stock is, it never doubled in a day. If we lose 12 basis points in a day, it doesn't show up on my radar screen. So I'm saying this, thinking I'm being funny, but it turns out one thing I misjudged, which was really you could have gotten right ex ante is people don't like being called crazy. I know, I know. It seems rather obvious after the fact. So I got a ton of hate email. We had weird phone calls where people were pissed. And also another. I've gotten better at this. Not perfect, but better. I have a bit of a problem in that I will at least initially respond to the crazy people on social media.
- [26:35]
B
Yeah, well, you and I have talked about that.
- [26:38]
A
Well, I know you've tried to. One of my many good friends who've tried to have an intervention with me on it. And I have gotten much better.
- [26:45]
B
You really have. I totally agree.
- [26:47]
A
I try to be nice the first time.
- [26:48]
B
I know, I know.
- [26:49]
A
I sit there and I go, look, you're yelling at me. I actually think I'm one of the people trying to help you. If you'll just listen for, for a second. I don't know. This stock is terrible. I tried to, you know, I would re explain that it's just statistics, it could work out for you, but I wouldn't. There'd be these sad things. People would be like, you're dissing this stock that I have, my kids whole retirement. Not retirement, college fund.
- [27:15]
B
Yeah.
- [27:15]
A
Which is terrible. And I'm like, you know, we're all careful. I can't quote, give investment advice on social media. But I'd be like, you just might want to think about that a little bit. And you know, not your stock in particular, but if you put your kid's whole education fund in any one stock, that doesn't strike me as, you know.
- [27:37]
B
That'S a bad idea.
- [27:38]
A
Yeah. But then they scared me a bit. It was one of the few times I've actually been like, there are some very angry, not to well adjusted people. And they're angry at me because I said I was short of stock.
- [27:56]
B
All 12 basis.
- [27:57]
A
All 12 basis points. I mean, I, you know, if, if I, if, if I actually shorted, you know, all of our money and that went down about 98%.
- [28:06]
B
Yeah.
- [28:07]
A
Since that point. So 12 basis points is actually quite disappointing.
- [28:09]
B
Yeah.
- [28:10]
A
Sometimes it hurts to be a quant.
- [28:12]
B
Oh boy, I feel you there. 100% there have been times where I'm like, we should maybe do more. We should do more here. But we never did because we have.
- [28:27]
A
One part of what we do that is a little less quantity. Is that a word? It's called AQ arbitrage. We do convertible arbitrage, merger arbitrage, when things are really apples to apples or as close as you can get. And these strategies all have leverage. They all have the peso problem that we talked about before. They're just not as extreme as the basis trade. So they're points on a spectrum. But we had on the Jim Chanos microstrategy trade, and it wasn't short bitcoin, it was long Bitcoin against MicroStrategy. And that's the one that last year just killed me because we did way too little of that. And that's our discipline. We're doing what we say. We don't take a big bet, even. But I'm like, yeah, but that one was a closed end fund selling for two and a half times what it owns.
- [29:25]
B
It's a layup.
- [29:27]
A
So I'm not supposed to be this guy. You and I are supposed to be the rational guys who don't do this. But I look back and I go, why didn't we put everything in that trade? You know, because our clients should fire us if we do that. It's not what we say we do, but totally agree.
- [29:41]
B
And yet I had kind of an existential crisis during the great financial crisis. I, for a year starting in 2006, was saying to anyone who would listen to me, if you can short your house, short your fucking house. And, like, I would give him the, but I did nothing.
- [30:01]
A
You should make that your social media profile quote, short your fucking house.
- [30:08]
B
But the thing is, I had so downloaded the discipline, the never do that. Right.
- [30:17]
A
And I'm not above. Maybe you're not above being ex post about these things. I think that discipline has probably stood both of us in pretty good stead over the years. But again, it's a version of prospect theory. We remember the bad more than we remember the good. I remember every trade I took off too early or didn't. We talked before about overriding a model. Yeah, we were never very bad at this, but I will. I have done it in my career, and I am fond of saying, which I've never actually tested because it's hard to formally test, but I'm pretty sure I'm at least directionally right. The times we've made a change that I think were motivated by losing money is the only negative 5 Sharpe ratio strategy I've ever developed. Sadly, I don't have any positive fives either. If you make a change and we've gotten really good, this is probably 20 years now at saying, all right, we will consider that change. But in six months.
- [31:17]
B
Yep.
- [31:18]
A
Because actually what we did, there's nothing in a model that's diversified that you have to do this second. Right. I wish we knew things that clearly that. So all of these things, they're hard to do in, in, in real life.
- [31:34]
B
Yeah.
- [31:34]
A
Or as the kids say, irl. They still say that. The kids probably don't even say that anymore.
- [31:38]
B
Yeah, I know.
- [31:38]
A
They, I think the kids are now my age.
- [31:40]
B
Yeah. I, I have six grandchildren and I look to them for all of the.
- [31:44]
A
New lingo and I, I don't have grandchildren yet, but I have 21 and 22 year olds.
- [31:49]
B
Okay.
- [31:50]
A
And I do, I could look this up, but sometimes I, I just email them an abbreviation like, so what's this one? And they're like, I can't tell you what that one is. I'm like, okay. It's one of those.
- [32:06]
B
Yeah. I had to get lectured on what based meant because a bunch of young people were on Twitter calling me based.
- [32:15]
A
Oh, you're based. I know this one. This is.
- [32:19]
B
I learned, I learned later. But I was like, what the fuck.
- [32:22]
A
Does this hybrid of cool and contrarian.
- [32:26]
B
I think, yeah, that's it exactly. Cool but highly contentious.
- [32:33]
A
You know, I hope to achieve this, but I'm certainly, I'm certain you have. You are more based than me sometimes. You could be too based for your own good.
- [32:42]
B
I agree. But like, you know, for a guy who's a quant, I live for the stories. And so, you know, on the thing where they were coming after you, I remember, you know, CNBC used to squawk box used to be a three hour program.
- [32:58]
A
I hosted it a few times 20 years ago.
- [33:02]
B
I did mark like every other week because we really got along. Right. But you could talk to a portfolio manager and really let them explain their thesis to you. And then the last time I was on cnbc, it was just like, yeah, we're going to give you the full five minutes. Oh, okay, great. And then you get there and it's two and a half minutes and I'm just like, you know, I'm out.
- [33:25]
A
And it's not even their fault.
- [33:26]
B
Oh, no, I agree entirely.
- [33:28]
A
These are market mechanisms. The market gets what it wants in general. And someone has figured out that long form quants like us are probably not the highest ratings killers. Yeah. Let's talk about leptokurtosis. Obviously I wish it would swing back a little. A little the other way. Yeah. I do think times affect this. I can't root for a bear market. First of all it's not in my financial interest. We run a lot of long only assets and I'm guilty about rooting for our clients money to go up because both for them and for us. Second, be careful what you root for. Right. You know people who are rooting for a crash. You find out you are collateral damage or during the gfc literally collateral damage. Our example there. I'm all over the place. I know but it's great was convertible arbitrage was very painful in the gfc. Actually round trip was wonderful because we added a ton to it when it got just beyond stupid.
- [34:36]
B
Yeah.
- [34:36]
A
But there was nothing wrong with that arbitrage. It's just people needed their. People needed their money. And I like calling it collateral arbitrage because collateral is like a mortgage. It was literally collateral collateral damage. Excuse me.
- [34:49]
B
Yeah.
- [34:50]
A
Collateral arbitrage should be a strategy.
- [34:52]
B
Things change minute by minute. Markets change second by second. Human nature has changed millennia by millennia. Arbitraging human nature is your last sustainable edge.
- [35:03]
A
Absolutely. And you can, you know the simple measures, obviously I think they could be made better. But I have this chart I still pull out occasionally of just the growth in Faman French's HML since 1926. And it's just a line going, you know, mostly up, but it has all these labels. Steamships give way to railroads, radio, rural electrification, space race, personal computers, Internet, AI. And I used to go do you think something like the world's simplest value strategy needs technology not to change? No. It does need humans to over extrapolate for instance and think this technological change implies infinite valuations. But if human nature stays the same and not enough people are willing to take the other side of that. Right. I'm basically saying that just are not enough gyms and cliffs in the world. In theory enough people agree with us. This could get arbed down. I just don't think we're. I see no signs of it.
- [36:12]
B
I think we're still a pretty.
- [36:14]
A
If I had a guess in my career I've seen the opposite move. I've seen it get a little stupider. So the, the notion that it's being arbitraged away that human nature. I think it's. I like to call things mildly backwards.
- [36:31]
B
Well that brings me to AI. I'm deeply into AI now but We're.
- [36:37]
A
You're a real person.
- [36:38]
B
Right.
- [36:39]
A
This is an animatronic.
- [36:40]
B
No, actually, real gyms back in Greenwich. Sound asleep in bed.
- [36:44]
A
That's coming.
- [36:46]
B
We're only doing investing for our family office. We don't have clients, which is liberating. But I agree.
- [36:55]
A
Yet I love our clients. I want that to be clear.
- [36:59]
B
You know I will second that. You really do. Of all of the asset managers I talk to, you talk more about your clients in a positive way than many. Many that I talk to.
- [37:12]
A
They've been good to us long term. Yeah. Again, I keep saying prospect theory. I am guilty of remembering the ones who left at the bottom. And that'll always happen. Right. That's kind of how you get a bottom. Yep. But by and large, our clients. I would sign for this in a heartbeat. In the next 26 years or so.
- [37:32]
B
I. Right. You basically said that you've been surrendering a little bit to the machines. Talk about that for a bit.
- [37:40]
A
Sure. Well, first of all, that is too extreme. You said it correctly. Surrendering a little bit. I said something along that lines. And again, when I say headlines, these are on top of the New York Times. This is the geeky stuff we read. So it's not like I walk down the street and people are saying, hey, that's the guy surrendering to AI. But in our small financial world, there were a bunch of AQR surrenders to the machines. And I'm like, this is a point on a spectrum. Yeah, we spent. And again I'm going to. I'm just going to guess we share this. A lot of years talking about how to bet on something. Call it a factor. A factor is just for anyone don't know, you sort stocks or any other asset on some characteristics and the. The high end tends to beat the low end. Do you believe it's going to happen going forward? What you have is two things going in. You have evidence from the past, a so called back test, which even though everyone loves to malign.
- [38:43]
B
Let me just interject there. Right. Because that's one that gets me hot. It's like yes, of course you can over engineer a backtest and do data snooping. Even honest minded monkeying with the backtest. But the value of a back test to me it's just like what other. It's like I used to get pissed off when the. Oh, I do what I feel like. I talked to my buddy and he hooks me up with a great stuff stock and I'm like, I'm sitting here with 45 years of data. Not only will I Show you the 10 worst drawdowns, I will show you the base rates. I will show you the fact that this does not win in every three, five, seven and ten year period. And people are just like, oh, yeah, well, but that's just a test. So that's my little rant. I'm a huge believer in base rates and back tests.
- [39:36]
A
Oh, you know, the, the classic criticism of a back test is it's like driving through the rear view mirror. And my retort to that is always, do you prefer to drive without a rear view mirror? I wouldn't want to drive through the rear view mirror, but I wouldn't want to drive without one.
- [39:53]
B
Exactly.
- [39:54]
A
Either. But the two things. So you have a back test that's pretty good, and then you have a story and story you have a reason why you think this works. And we always were very proud and we still are, but a little less so that we demand a roughly. And it's impossible to know. This is just a way of explaining it. Roughly 50% each. Do we think this makes sense? And how good have the historical results been? If you have a longer back test that can start to weigh more, shorter one, maybe you rely more. So it's, it's not an ironclad rule, but that's how we thought of what we do now comes along machine learning. And there are certain steps in machine learning where you just don't get as much intuition as you used to get. One of my partners, Brian Kelly, has written a paper. It's controversial, but Brian's 100% right. So I'll settle the controversy with that. Called the virtue of complexity.
- [40:58]
B
Yeah.
- [40:58]
A
Saying basically you throw more things in with modern ML and shrinkage techniques. It's not, it's actually a feature, not a, not, not a bug in that world.
- [41:08]
B
Yeah.
- [41:09]
A
Other things. One of the things, this is not a secret we use and it's not unique to us at all. Natural language processing, where, you know, you probably remember for a lot of years, some quants used it, some didn't. But the quant way to process textual information was a table of good and bad words and phrases. And it was bespoke. You made it up as you.
- [41:33]
B
Yeah.
- [41:33]
A
As you, as, as you went. And you know, if the word increasing is there plus one, and we know the downside of that. Right. If the actual sentence was massive embezzlement is increasing, you know, our bed on that one. But we also know as quants we got to be right 52% of the time. Right. So you're allowed to look stupid 50%, 48% of the time. So that was always something that drew me to quant.
- [41:58]
B
I get to look dumb 48% of the time.
- [42:01]
A
Exactly. It's a great way to view it. Natural language processing is taking things like. And there are a lot of other uses for it, corporate statements and saying, is this good or bad news? But the way it actually works is it expresses each statement as a vector of numbers. And then what you do is you test that vector and you look at linear or nonlinear, even nonlinear combinations of this vector and say, what predicts? And it turns out this is actually fairly correlated with these older measures. It's just we found the same. Better. Yep. The machine does a better job than me missing the word embezzlement in the thing. Not perfect. It's still a machine learning from the past, but it's better. And I think we understand a lot of the intuition around it. But if you ask me, or even much younger now, smarter people than me who actually write the code. Exactly what are those numbers? You tend to get a look like they represent the sentiment of the piece. Yeah, but what are they? And there is a certain element where you have to say, do I buy this technique? And if so, I'm going to be two thirds evidence now and one third story. We still, in that instance, basically require that. That it works. It's. It's very comforting, I should say, that it's correlated to simpler measures that should be getting at the same thing.
- [43:33]
B
Yeah.
- [43:33]
A
Because it makes us go, I think we're measuring what we think we're measuring.
- [43:38]
B
Yeah.
- [43:38]
A
But there's a step that I never would have been comfortable skipping 20 years ago, where I go, it's just doing its thing. And one way to view it. This just popped in my head at some point is I was complaining internally, you know, I come on these podcasts and I sound all confident, but internally, I'd be like, we have no fucking idea what those numbers are. Really? You want me to bet money on that? And it just struck me that if artificial intelligence, machine learning, if I understood every step of what it's doing, what's it doing, what's it adding to my world? There almost has to be. And this is not a mathematical theorem, but there almost has to be some opacity to it, or it's hard to believe we weren't finding it with simple, intuitive linear statistics before. So half comforting, but it got me halfway to saying, all right, if I'm going to use this at all, I cannot hold it to the same standard. So when I say, as you correctly quoted or paraphrased, we've moved a little towards surrendering to the machines. We have. Yeah, we have. And that's just if, if a technology gets better, you know, why do you change your mind? Well, because the facts change and you hope that's your reason. Yeah. So yeah, there are certain things we do that are, that are a little more data driven. I think modern techniques are better ML for what we do is still just statistics, it's just today's version. And there was some point where people didn't use ridge regression or generalized least squares or something. If you get better, you believe it.
- [45:25]
B
Yeah. I was into machine learning really early. I'm a journal keeper and I saw one from when I was 25 where basically the whole piece that I wrote in my journal was I can't wait. I didn't call it AI, but I can't, I can't wait. But, but the point is, you're right, there is an opacity there that a dedicated quant has got to really look very closely at. Because I brought on a guy who was a specialist, he'd already retired from one of the big tech firms, he was our machine learning guy. And so I nailing with all these questions and finally he says Jim, here's the thing that might be really hard for you to accept. I went what's that? And he goes no human can look at arrays, vector arrays of hundreds of millions of data points and find the five that go together. Right. And I'm like agreed. I never thought that that was possible. And he goes, let me continue. And he goes the problem that you're going to have is it might be able to tell you what and when. It will never be able to tell you why. And I'm like that's fair. That is a very interesting conundrum. But I like you agree. I think it is where quant is going. I think that there will be much amusement when people start blowing shit up because they don't take the care. But I definitely think it belongs in a quants toolkit in 2026.
- [47:10]
A
I absolutely agree, though I do fear it a little bit in only one way. The older simpler stuff. You never have fun when you're losing money, but at least you could explain it fairly straightforward.
- [47:26]
B
That was my problem.
- [47:27]
A
It's, it's not fun in a giant valuation bubble to be long value in your model and you will lose some people. Oh for sure. You actually do get to point to exactly what happened it resonates with people because they're, they're watching the same world. Yeah. So, you know, I'm just going to try to avoid ever losing money again because the opacity is going to be harder for people.
- [47:52]
B
Yeah.
- [47:53]
A
Because in our world it's not all the way there. We're a hybrid. We still bet on the old factors. We think that they do capture an aspect of human nature. In some cases we have ML versions of the old factors that we think are improvements in the value world. We use it classic ML. It's better at more parameters, which valuation measures to use, in which industries, whether that function should be linear or nonlinear, stuff we never did before because it seemed like overfitting ML makes it better. But there's still a core economics to what's going on. But it will be at least marginally harder to explain the next time there's a bad period.
- [48:34]
B
We're only investing for the family office now, so we don't have any, like, constraints. So it's not like we're putting a lot of money into these tests. But I just find them really interesting. And, but the opacity that is that one is hard because now I only have to explain it to a few family members. But I just think that there's some really interesting stuff on the horizon there. You know, one thing that we haven't been doing a lot is not with. But I've had this idea for a while. I'd be really interested in your view on it. So if we take the whole idea of the black swan can't be predicted. Right. I ask the question, well, okay, let's assume that's true. Let's just assume that is true. It might not be true, but let's assume. But can a black swan be confirmed?
- [49:31]
A
You mean after the fact?
- [49:33]
B
Or let's use oil when it went negative. Right. So black swan. But was there a point in that series of oil on its way to going negative where there could be some machine learning algorithm that could figure out, oh, this is a black swan.
- [49:58]
A
And then does it tell you if it's going to keep going well?
- [50:01]
B
Right, exactly.
- [50:02]
A
Yeah. And for me that's very akin to can you identify bubbles before the. Before the fact? Black swan might be much more short term.
- [50:12]
B
It is, it definitely is.
- [50:13]
A
But on the topic of bubbles, what I, I've written about this, there's no bright line test. No, I'm not gonna, I'm not gonna pretend there is. I basically screamed bubble twice in not even during the GFC wasn't smart Enough to do it on the John Paulson trade. He was probably right about that being a bubble. But you know, again.com and culminating in 2020. But in this piece where I said the 10 things I want to complain about in the Financial Analyst Journal, I really had to work to get it down to 10. I talked about overusing some words. I do think bubble in our industry and black swan to a similar extent, a little less well known than the term bubble get used too often, right?
- [51:04]
B
Yeah, you're probably right.
- [51:05]
A
Like the individual stock you think is too expensive. I tend not to say it about an individual stock. I may think it's overvalued. I may even think it's wildly overvalued. But it could turn out to be right.
- [51:15]
B
Yeah.
- [51:15]
A
You know your example of Amazon from the dot com bubble, I think that was a bubble. Yeah, but what. But if I said Amazon was in a bubble, I would have been wrong. Your prediction was correct. Even Amazon went way down for a while. But it was worth it. To me, a bubble is still subjective, but it's. I have leaned over backwards to put in every assumption that would make this price be too high or too low. A negative bubble make this price reasonable. And I can't come close. I remember the things I wrote very similar. When you were writing during the dot com bubble, I was just saying, all right, let's take Cisco Systems. Let's assume it grows more than any other company has ever grown ever for the next 10 years. And then gradually comes back to just growing fast. It still sucks. And then in that thing called bubble logic I wrote then I said, and I'm only using Cisco as an example. The entire NASDAQ 100 looks like one big Cisco. Turns out that one would have worked out for me because Cisco was like, I think I just saw a headline just passed its tech bubble. Not the last bubble. This is the 2000 just passed its.
- [52:33]
B
Its peak 26 years.
- [52:35]
A
People were right. It was a great company. It was just in proto social media, the message boards of the late 90s, early 2000s. I remember in general, I actually cleared this with compliance because can't just post on that. I said, can I ask this hypothetical question? And they're like, okay, just that question. Yes. That's not promoting something. That's not. I asked. It was a Cisco message board. And I said, all right, you know, we all love the stock, but at what price would you sell it? And I'm just trying to get somebody to think that these are actual cash flows to an actual company. And no matter how much you love it. And you may, you may think, may totally disagree with me and say the growth rate is going to be even faster.
- [53:25]
B
Yeah.
- [53:26]
A
There still has to be a price where you say this is not a good long term hold. I got like 30 irrelevant answers. But my favorite one, the only one who actually answered in terms of price. Yeah. Was one person said, well, if it went down by 50%, I'd be out. And I'm like, I was asking a value question. I got a momentum answer. You're not actually wrong that that could be a decent strategy.
- [53:51]
B
Yeah.
- [53:51]
A
Too. But I went like 0 for 30 on, on, on, on people responding who were like, I don't understand the question. I'm like, is there some price where it's too expensive? And it just didn't even compute for people.
- [54:04]
B
Yeah.
- [54:05]
A
I also used to carry around in my wallet. I'm sad I lost this eventually. Probably disintegrated. A quote from 2000. It was from a strategist and I think Prudential saying there are a set of stocks you need to own at any price.
- [54:20]
B
Oh yeah, I saw that piece too.
- [54:23]
A
And it's one of these things I would take out my wallet occasionally and it's in the credit card area. And I'd say, I remember that one. I hope I have that somewhere.
- [54:34]
B
The four horsemen of the investment apocalypse are fear, greed, hope and ignorance. And ignorance you can deal with or not. But people become religious about these things. Right. And I never could understand it. I like I talking about not knowing. Right. Whether you own a name or not. When I was reestablishing Oshaughnessy Asset Management after rolling out a bear, I suggested to my team, you know what, let's, let's take the names away. Let's give them the ticker has a number. And I got rebellion.
- [55:18]
A
We were trying to make it more dispassionate.
- [55:21]
B
Yeah. And they're like, will you just stop with this stuff? Like my head trader especially, she was like, I talked to these guys all day long and if you've got me having to translate numbers back into names.
- [55:37]
A
Well, she has a logistical point.
- [55:39]
B
I agree.
- [55:40]
A
The information flow, we didn't do it.
- [55:42]
B
We didn't do it. But I was just trying to make it even more dispassionate.
- [55:46]
A
Just a few days ago, I was explaining to one of my kids who has no interest in what I do, basically somehow currencies came up. And I'm explaining that some are quoted as the foreign currency per dollar and some as dollar per the foreign Currency. And I was admitting that doing this for 35 years still have to occasionally think which way do I want this to. To go? And they were like, isn't that a dumb system? And I'm like, yeah, so. And she was like, why don't you change it at your firm and you just do it the right way. I'm like, because we're going to trade it and do the opposite of what we intend. At some point if I say let's quote all these things as dollars per whatever. Yeah. Some point in the code, somebody's going to mess it up.
- [56:32]
B
Yep.
- [56:32]
A
So we're going, we're going with the world.
- [56:34]
B
Yeah.
- [56:35]
A
On this one. Even if. Yes, it is kind of. It is kind of silly.
- [56:38]
B
Yeah, I lost on that one too. And when, you know, looking at her point of view, I was like, yeah, you're right. Okay, I get it. What do you think right now is the most overcrowded trade from a like a factor point of view?
- [56:57]
A
We don't do. We do some factor timing largely on. On various trends, following examples. I don't think quant is particularly overcrowded at this point. You know, the valuation spreads are still wider than normal.
- [57:13]
B
Very.
- [57:14]
A
You know, everyone has their own measure. Us taking out the industry bet means ours have come in a little bit more, but they're 80th percentile versus versus history. So it's hard for me to call something crowded when it still looks cheaper than it normally does. I do think some of the. The kind of bleeding edge you could have short term things that look like black swans, you know, hopefully mini versions of August of 07. July of last year. Yeah, we saw a mini version of August of 07 and some of the more sophisticated stuff suffered along. Even more so to us than kind of simple old school Quan stuff. So I think there are a fair amount of people out there at places like that that are quicker to trade out of it than we are. This should accrue to our benefit. Long term. Trading out of it doesn't mean you trade out of it before the problem. It often means you're. You miss the comeback. But it does mean if pot shops with very tight risk limits are doing similar things to you. Again, it may not have been crowded in the sense of squeezing the juice out of the trade. The inefficiency you're trading on might be there, but in a different sense it's crowded in that you are subject to. You're always subject to anyone who overlaps with you and their actions.
- [58:34]
B
Yeah.
- [58:35]
A
So yeah, I worry about Short term events, you know, we do the same thing. When you look, I look back at August of 07 and it was weird because it was, it felt near death at the time and I'm like, really wasn't? No, it was a giant standard deviation event. But a one week standard deviation is not that big.
- [58:57]
B
Right.
- [58:57]
A
So we lost. It was painful.
- [58:59]
B
Yeah.
- [59:00]
A
But it wasn't life threatening. We weren't close to being forced to take down our positions or something like that. So, you know, living with some of that, every investor lives with some of that. You don't have to be a quantity. But that's probably overlapping with the pod shops is the closest where I come to being worried about being crowded these days.
- [59:22]
B
Yeah, Jeremy is. I don't know whether you follow Jeremy Grantham, but he's back to saying that he would have zero exposure to US equities. I try to be charitable. If you look at previous forecasts that he and his shop have made, he.
- [59:44]
A
Usually comes at things in mostly pure valuation sense. The notion that the US might deserve a premium. I think it's entirely possible. Again, we don't bet a whole lot on these grand themes to begin with. We've looked at and you've probably looked at similar numbers. We've written a bunch of things doing analysis like this. How much of the US depending when you want to measure it, is probably a 25 year drubbing of the world. It's probably since the Japan peak in like 89 or 90, partly because of the Japan debacle. But Europe, whatever, US has beaten pretty much everything. Yeah. Something like it depends on your favorite valuation measurement. But pick your favorite. It's going to be 75 to 85%. The US getting more expensive against the world.
- [60:40]
B
Yeah.
- [60:41]
A
That leaves 15 to 25% being genuine boots on the ground, fundamentals being coming in better. And you may or may not be willing to assume that's going to keep going. And I'm not going to fight about that. That's not my, my thing.
- [60:57]
B
Right.
- [60:57]
A
But to assume anything like the 75 to 85% that came from valuation. If you look at 1990 on most measures we look at the US look cheap to the world and it now looks very expensive against the world. So I say much milder things, but directionally similar to Jeremy, I say I would, I would probably expect the world to gain some of that back, but that's, that's betting on mean reversion at the very least. I would not assume it happens again. In my heart of hearts, do I think there's probably some mean reversion in that trade. Yeah, probably, but not so much that it's anything close to a high Sharpe ratio trade. Last year it actually worked fairly well. The world did beat the US for once. So I'm directionally similar but I'm a 2 out of 10 where he's an 11. He spinal tap on these, on these things. You know we think valuation over 10, 15 year Horizons is about the only thing that can guide you to, to how expected returns change. It's not perfect, doesn't have an R squared of one at your favorite horizon but it's not, it's not a very high risk adjusted return at any reasonable time horizon that, that you can live with in this actual world.
- [62:23]
B
Right.
- [62:24]
A
So we always tell people we do anti illman and my colleague is, been the king of this for many years. He, he does similar forecasts to Jeremy, you know, 10 year forecasts but he doesn't assume valuation changes. He just does it based on the yield effect. Essentially if you buy something at a higher price, all else equal, you make less money just because you're paying more for, for the cash flows.
- [62:45]
B
Yeah.
- [62:46]
A
So our versions are much more, much more muted and all I would use those long term forecasts for, I don't, I don't think I'd ever trade on them. If the long term forecast is things are all expensive and I think we'll make less going forward. If I'm thinking about retiring or if I'm a pension plan who formally needs assumptions. Right. I think it's useful to go, hey, we probably should expect less going forward. That affects how much you save, it affects when you retire. I spent my life, my dad had a little sheet of paper that was some number that he thought he needed to retire. It was probably, he was, believe it or not, he was, my mom was the math person. He was not mathematical so it was probably utter gibberish. But a number you need for that sheet is how much do you have, what are you going to spend and what can you make on your retirement savings? So I do think these forecasts can be useful. Yeah, but they're, they're terrible trading strategies.
- [63:45]
B
Yeah, yeah, I agree. And let's switch gears over to one of our mutual disdain is too strong a word. But we're, we're highly critical of private equity and I think for the same reasons. But give me, give me your version.
- [64:11]
A
Well, I like to say there are two fronts in, in, in this fight. One is what's its long term return been and its Prospective return going forward. The other is is how risky is it. I have opinions about both, but far more strongly about the risk side.
- [64:32]
B
We are very similar.
- [64:34]
A
So there are great debates on what the actual historical track record is kind of hard to get and their IRRs. And are you getting a real sample of these firms? And there's a. What's his name? I never pronounce his name right. There's long Italian name, academic who's kind of taken the fight to private equity and he claims it's much lower. And I don't have a horse in that race.
- [64:59]
B
Right.
- [65:00]
A
I get driven crazy. I coined the term volatility laundering.
- [65:04]
B
Yeah, I like that.
- [65:05]
A
The number of, of clients general media articles that that will do the equivalent. And you've seen this too. Here's an efficient frontier. You know, the X axis is risk. The Y axis is, is, is expected return. Public equities use volatility. Not a perfect measure, but 17% annual volume, private equity 6.5% and I'm like, no, it's not. It's not. I had my first fight about this in 1997. Private equity is a much smaller part of the world.
- [65:43]
B
Right.
- [65:44]
A
But I was at Goldman Sachs at the time and we had a private equity area. And again, this is something that only you and I on the podcast will remember, but the Asian debt crisis.
- [65:55]
B
Oh yeah, It's.
- [65:56]
A
It's like 17 crises ago and seems very minor by comparison. But at the time it was after a long positive low volume run on the S and P and the S and P was down about 7% on in a day. And I have other stories about this day. Our P and L system said we were like up 6%. We knew that was not true. We were at the time we were short the US and long Europe. And this is a mini version. As close as I ever came to private equity. Okay. Is you look like a genius when what you're short is open and crashing and what you're long is closed. Jon Corzine, the then head of Goldman Sachs, we were much lower tech at that point. It was an Excel spreadsheet that we had at F9. I had to get a P and L. And he. I had shown him this like a month earlier on one of these visiting dignitary tours. I was a stop show John what we're doing. So he was like wandering the firm to find where am I losing money today? And he looks at our screen without me there and it says we're up 6% reality. We thought we'd be flat you know, it's betas, who knows, there's randomness. But if Europe opens up consistent with its beta were about flat, which we thought was a home run. Yeah. Because we had made a lot of money in a bull market for three years. So flat in a crash was wonderful. You cannot take a man from thinking he's up 6% to flat and still make him understand. John was a brilliant guy, but you still can't make him understand, grasp and be happy with flat. So that was very disappointing to me. But then later in that same day, the head of our private equity, whose name I will excise from this nice guy, but I fought with him a lot comes by and I had learned, so I'm manning first the Excel sheet. We didn't always have someone sitting there back in those, in those days, just so this doesn't happen again. He comes by and goes, how are you guys doing today? And I said, I think when Europe opens tomorrow and all the dust clears, if we, if we end here, we're going to be, you know, about flat. And he was smart enough to go, that's actually really, that's, that's so cool.
- [68:08]
B
Yeah.
- [68:08]
A
And then he just goes, me too. He's the private equity guy. And I was not as nice to him as he was to me. I'm like, back up. If you went to sell your portfolio today, you would never sell a private equity portfolio in one day. But, but if you did once, you get a lot less than yesterday. And to his credit he said way less. But of course, you know what he said next, but I don't have to sell. And I said, neither do we. It, it's, it's. Private equity is active levered equity.
- [68:52]
B
Yeah.
- [68:53]
A
It's more than a beta of one. I'm almost certain different firms, they could have more low beta stocks. We. Yeah, yeah. But it's a, it's a levered active equity portfolio that they're just not marking the best argument that comes back to me on this and it's not a good argument. But the best one is something I've written about. I don't think markets are perfectly efficient.
- [69:15]
B
No.
- [69:16]
A
You know, Bob Shiller won a Nobel Prize for saying volatility is excess volatility in the world. That's probably part of the inefficiencies. I probably think they're less efficient than Gene Fama thinks these days and more efficient than the average person on Wall Street.
- [69:29]
B
Yeah.
- [69:30]
A
But the question of whether you have to sell like. Well, if you agree markets aren't perfectly efficient Then the prices we have where we move them less might be more accurate as a reflection of fundamental value. And I go 100%. But why do you get to do it and we don't? Right In March of 2000, the peak of the tech bubble, when we were down two standard deviation down a year and a half. As a statistician, you don't freak out about that when it's your first 19 months in existence. It's not very pleasant. But I could have, I practically did. But I could have told people when prices return somewhat normal, we are going to be actually up. That did turn out to be right, by the way. I'm just going to, I'm going to toot my own horn there for a second. But I don't get to do that. I don't get to say, I have not lost you money. Your money is in a bank I call short NASDAQ and it is simply waiting for you there. I get to tell them we're down two standard deviations. Here's why. I think it's going to roar back in the next two to three years and net make us money. I get to say that. But I don't get to tell them it didn't happen. Right? And then people be like, but we don't have to sell. You do. I'm like, no, I don't. I only have to sell if people foolishly make me sell. But we absolutely don't. So for long term investors, it's just not apples to apples, you know, in private credit, is this on steroids, people? I actually got, I think, I think this was me. By making fun of it in social media, I got somebody to stop saying they have a 10.0 Sharpe ratio. The best thing was that it was 10.0. I'm sure that's just where the number came out. But the over precision of that, I'm like, so an 8 would just suck. You would just have no interest in an 8. So private credit will literally use volatilities very close to zero, when again they may be good investments. But the notion that public credit moves around a lot but private doesn't is just madness. It's absolute madness. Now people will say, being this opacity again, this fact that we show muted makes it easier to hold these things. And in a world of imperfect markets where we all use behavioral tricks to get ourselves to do certain things, I'll give you that cliff screaming, look how much we lost is more painful than someone going, we're fine, even if it's totally not true. But here's where I jump in the fight about the numerator, the expected return a little bit. And this is, again, I want to be clear, a less strongly held view. These things are comparable, or actually probably, given that they're concentrated portfolios, individual private equity is going to be considerably more risky than a typical index fund, for instance.
- [72:43]
B
Right.
- [72:44]
A
That. I don't know if I'll ever bet the ranch on any one thing, but I would. I would. I would bet at least most of my ranch on me being correct.
- [72:55]
B
Yeah.
- [72:55]
A
That it's the. The expected return, though it actually filters in to this because if 40 years ago and David Swensen at Yale is credited and I think probably deserves it, pioneering these things for institutions. Go read his book Pioneering Portfolio. I haven't read it in like 25 years or whenever he wrote it.
- [73:13]
B
Yeah.
- [73:14]
A
Again, I'm not good with the dates, but he talks a lot about the illiquidity premium.
- [73:17]
B
Yeah.
- [73:18]
A
That you get paid for owning something that's illiquid. Why? Because you can't get the money when you need it that way.
- [73:25]
B
It was a huge part of his thesis.
- [73:27]
A
If you do have an opinion that maybe it's overvalued, there's nothing you can do about it. There's all kinds of problems with illiquidity. And that was fairly plausible. You get paid a lot to own it. Now, whether the historical track record, I'll leave to others whether the massive fees in that world ate up the illiquidity premium. Let others fight about that. Right. But the idea that. That certainly in growth space there should. You should make money. But if all these things about where they're telling me. No, it's a. It's actually a good thing because it's easier to hold. That means illiquidity is not a bug anymore, it's a feature. And in the markets, all else equal, you get paid for putting up with a bug that's undiversifiable. You all know that. And you pay for a feature that everyone would want. Yeah. So if these people's explanation is right, to me it's probably also a story why you should expect to make less, not more, on this going forward. Something easier to hold. And if you, you know, we both live in Tony or part of Connecticut, so we live with a lot of private equity people. I have a lot of, you know, you know, the old. This sounds like one of the classics. Some of my best friends are.
- [74:37]
B
Yeah.
- [74:38]
A
So I can't be a bad guy. Some of my good friends are Private investors.
- [74:43]
B
Same with mine.
- [74:44]
A
And I be perfectly comfortable investing with them because I tend to think maybe, maybe I overestimate my friends, but I tend to think there's probably some alpha there. Private equity. One thing I talk up about it is their ability to add value from. From changing the company. I wouldn't just assume everyone can, but that is a source of alpha unavailable to you and I in a quant.
- [75:04]
B
Totally agree.
- [75:05]
A
Portfolio. And it's a beautiful source of alpha too, because I don't think that's particularly correlated to most risk factors or markets. That's just whether they're good at that. So there are some things to. To talk up. Yeah. But if more of the world is buying this stuff because it's easy to hold, it's going to be priced to the wrong level. And the reason I brought up my friends in Greenwich is if you get a few cocktails into one of these people, they will tell you, yeah, we're paying much closer to public multiples than we used to. So it's very consistent with the theory. And it doesn't imply a disaster looming ahead. No, but it does imply lower returns than the past. And I think that applies to everyone. Something's popular and you ask me what's crowded. I think we're finding out private equity. A lot of people would like to sell some of theirs, but they don't like the prices they would get. That's a version of crowded.
- [76:01]
B
And the thing that always bothered me was, first off, regular people who don't have domain expertise, in my opinion, it's just an opinion. Are being misled with Mark to market with volatility, laundering. They literally don't have a clue. And that bothers me.
- [76:25]
A
No, I'm with you. The institutions, right or wrong, whether I'm right or they're right or somewhere in between, they're big people. The move to, quote, democratize private investing to bring it to the 401ks near you really bothers me.
- [76:43]
B
Me too.
- [76:44]
A
And I tend to be a very laissez faire, libertarian kind of person. So I'm a little bit of a hypocrite on this because I get all paternalistic.
- [76:51]
B
Yeah.
- [76:52]
A
Just saying. It's just not a very good idea. I mean, there are rules in 401ks. They don't do everything. There are all kinds of prudent standards, fiduciary standards. I think it's a pretty bad idea. And some of these places advertise we're going to let you trade your private equity. And I saw one. I Don't know if this ever happened. I've not followed it that closely, but was like, we're going to put it part of an etf. I'm like, okay, good, good luck with that. I actually think they risk killing the golden goose a little bit because the more they make it tradable, the more it's going to trade to real life prices.
- [77:34]
B
Yep.
- [77:35]
A
And again, I think we're just starting on this road.
- [77:38]
B
Yep.
- [77:39]
A
But also the 401k. The next time there's like an equity disaster, someone's going to sue, saying, you're still marking that private here in my 401k. When it's not, it's, it's, it's a bad idea.
- [77:53]
B
Yeah.
- [77:54]
A
There are things, you know, online trade trading, you know, single stocks on Robinhood. God forbid, single day options on Robinhood. I am not the authoritarian who'll say you're not allowed. My personal advice is it is a disastrously bad idea for you.
- [78:09]
B
Yes.
- [78:13]
A
Every libertarian in the world thought we should legalize marijuana for years. And now I'm an old man who walks around New York City going, why does this whole fucking place think of marijuana? Well, okay, somehow I got to marijuana here. I don't know how.
- [78:27]
B
I am older than you and still believe that marijuana and most drugs should not be criminalized.
- [78:33]
A
I am, I believe I agree with you intellectually.
- [78:38]
B
Yeah, but.
- [78:39]
A
And I would vote for that.
- [78:40]
B
I agree with you when walking around Union Square.
- [78:43]
A
I'm just saying I've become enough of a paternalistic where I'm just walking guy, where I'm walking around just going, that's a bad idea. It should be legal and you shouldn't do it. Same with sports betting.
- [78:55]
B
Yeah. Oh, we totally agree.
- [78:57]
A
The amount of, of 22 year old males who are spending half their life, I think it's ruining sports for them.
- [79:03]
B
Yeah.
- [79:04]
A
They don't root for teams anymore. They root for one guy on a team.
- [79:07]
B
Right, right. I agree. And I have the same, I had the same conflict with Robin Hood. Right. Like I am in favor of democratizing investing but not being idiotic about the whole thing. When I first looked at their app, I mean, honestly, I, I almost couldn't believe it.
- [79:29]
A
Little balloons come down at times.
- [79:31]
B
Yeah. And I'm looking at this and I'm like, this is a casino masquerading as an investment app.
- [79:39]
A
Now they will say investing is always a casino. It's really not. I don't exactly know where a bet becomes an investment, but positive expected return bingo is a small part of it.
- [79:50]
B
Yeah.
- [79:50]
A
And you know, it's ironic, a lot of the individual traders who love Robinhood will rant and rave about hedge funds. And do you know how rich they're making brokerages that facilitate their single day option trades? Sadly, I'm not the guy who does. Not my business. Right. But they're just, I promise you, they're handing a lot of their money to quote Wall street or a broad definition of Wall Street. The plumbing.
- [80:20]
B
Plumbing.
- [80:20]
A
The pipes paid a lot.
- [80:21]
B
The pipes are like, that's where the money is.
- [80:24]
A
You and I should have built pipes. We've done it. We've done okay.
- [80:29]
B
But in another world, I'm building the pipes.
- [80:31]
A
But what they really don't understand is two steps. It's how much money the pipes are making. I'll call them the pipes.
- [80:37]
B
Yeah.
- [80:39]
A
And the fact that that comes out of the pie. So you guys are losing.
- [80:43]
B
Yeah.
- [80:44]
A
And it's such typical stuff where you'll only hear about people's winners. Anyone who's describing this is, I bought MicroStrategy when it was here and I got out here, I'm like, I promise you that Citadel and Jane street are taking your money. I love both those firms, by the way. I mean, they're doing exactly what they should be doing. But I promise you and some people, longer term trades that are on the other side of your trades. This sounds terribly elitist and obnoxious, but retail loses long term. It's in the literature.
- [81:18]
B
I know. And that was like my big crusade when I was younger. Right. Like I did what works on Wall street and published it because I wanted people to have you pissed off.
- [81:28]
A
A lot of academics who thought they discovered that shit, by the way, because I was part of that world at the time.
- [81:35]
B
All of the bibliography, they all should.
- [81:37]
A
Have cited you, including me. I didn't know about your book.
- [81:41]
B
But the point is my book cited all of them. And then I had certain individuals who we will delete the name. Really get pissed off at me for talking about a factor that was my factor. And I'm like, I cited you in the bibliography of the book.
- [82:05]
A
Yeah. I don't know how someone complains about that if they're cited. I'm not above being petty if I think that stupidest thing in the world, the way the simple way on Fama French's website they describe momentum is the last year returns leaving off a month, which tends to be more contrarian. I did that in my dissertation. You probably did it 10 years before me, but I did that in my dissertation. That's the Version I and I'm the one who got them to adopt that. And whenever people. Not whenever, almost always. Here's my shallow story for the day. Mark Carhartt, brilliant guy who I admire, used Fama French's three factor model plus my momentum factor to analyze mutual funds. Discovering the mutual funds on average don't do so well, blah blah, blah. When I'm left off and someone says when Mark Carhartt created momentum, oh, that would piss me off. I'm sorry, Mark, I love you, but I did that part and I didn't even do that. Jack Keesh and Tippmann were before me. I created the specific form that became popular in academia. So I'm not above, not too often. Probably about eight times in my career have I sent an email to someone saying, you know, you might want to cite the 12 papers I wrote on that. But you know, you suffer from this more than me. You're more removed from academia. I started out in academia, right? But even me, who's quite close to academia came from intended to be an academic, you know, close to a fair amount of people there things that we've written, not just me in the more practitioner journals, the faj, the jpm. There have been several times the academics just rewrite the friggin paper and they don't feel they have to cite the practitioner.
- [83:51]
B
No, I know, papers.
- [83:52]
A
So not your pain, but I have felt a little bit of.
- [83:56]
B
I have a great story for you about this. So I always came at it from the point of view of a practitioner, right? But I'm a research junkie too. And so I read all French fama, I read all of the literature LSV like you, I read everything that was available and then kind of took my own take on it from the point of view of a practitioner. Right? So you and I agree about stocks with no liquidity, right? I would get into fights with academics who would say, yeah, but look at the smallest stock decile. And I'm like, you do understand that there's no liquidity there and if you tried to put a bid in that, it would skyrocket. And it's like the old joke about economists on a desert island. They find the crate of food and the engineer says, well, I can get it open this way. And the plumber says, I can get it open this way. And the economist says, let's just assume we had a can opener. And so that always bothered me. It's like I gave a guest lecture for Roger Urbison's class. Love his work. Absolutely. Think the stocks, bonds, bills, like somebody.
- [85:07]
A
Had to do it.
- [85:07]
B
Yes, somebody had to do it. And very important. Right. But so after class I'm like, you know, professor, does it bother you that this is back in like the late 90s, early 2000s. Does it bother you that your small stock index, that you hold the stocks for five years? And he's like, what's the problem? And I'm like, well, it's probably getting a lot of its performance. Like when you last rebalanced, how many of the stocks in that were actually large cap stocks?
- [85:40]
A
It rhymes with survivorship bias.
- [85:44]
B
And he like literally looked at me. But the story I wanted to tell you was I was up at Boston, won't say which university, but having a really great conversation with the academic guys, right. And they were on the committee, we were trying to get their endowment to invest with us. And we're at lunch and we're having a, like I'm talking about Mandelbrot, I'm talking about all of that kind of stuff, you know, standard deviation. Yeah, that's a good risk measurement. But don't people only freak out when stocks are going down? And do you ever look at the semi standard deviation below zero? Anyway, great conversation. And then one of the guys says to me, where'd you get your PhD? And I said, oh, I barely have a B.
- [86:34]
A
School of hard knocks.
- [86:35]
B
I barely have a ba Boom. Shut it down. Yeah, like literally over here. Boy, this guy's got a lot of really good ideas. Stupidest person on earth.
- [86:48]
A
We have one of our partners at AQR didn't graduate from college and I won't name this person for obvious reasons, but I love this. I'm not, you know, Peter Thiel level hatred of college where nor am I. He'll spend his own money to keep people from going to college. But the fact that someone is a brilliant guy, he's a polymath, he's great at so many different things and he, I think I don't even know his story about this, but I think he just probably would have found college boring. So yeah, credentialism go too far though. I think it goes both ways because nowadays we distrust experts too much also.
- [87:33]
B
Yeah, I agree.
- [87:34]
A
I like to say experts are on average, right. It's a disaster to assume they're always right, but it's also a disaster. Knee jerk.
- [87:42]
B
Yeah, they're always wrong.
- [87:43]
A
The pointy headed expert over there is just always wrong. Right. So you know, like almost everything in life there's some happy medium. I think we probably do they're doing both bad things at the same time now.
- [87:56]
B
Yeah. And like again, it wasn't that I didn't read all of the academic papers. I relied upon them and cited them. But I really was much more interested in. Okay, what can a practitioner really get out of this?
- [88:13]
A
Well, the small stuff you're just totally right about. First, we don't believe there actually is a small firm effect period. If you adjust for like 17 other factors. We wrote a paper on that. But if you just adjust for market beta, it doesn't outperform the original small cap studies.
- [88:30]
B
Right.
- [88:31]
A
Yeah. I think the was that 85 in.
- [88:36]
B
Journal portfolio Management a couple years earlier.
- [88:38]
A
Maybe it's come out then. Yeah, I remember. 82, 83.
- [88:42]
B
That might be right. That might be right.
- [88:44]
A
Like I said, I don't get the years right. Yeah, yeah. But some of that's been revised to a smaller spread because I think they assume too large a recovery rate. You always have. There's some, you're always doing some guesswork with empirics. If something gets delisted right, you know, what's it worth? So there's some, there's some guesswork in there. And I think they think they've upped the severity of or increased the severity of the recovery assumptions. But our big thing is the betas were always woefully underestimated because they don't trade all the time. Simple adjustments for that just make it go away. And then the question is, it is absolutely true that if you run the tests on small, most of anomalies factors look stronger gross, how much you get to keep? We trade small. We like small. But ignoring the implementation side of small is an utter disaster. And the small firm effect, almost all of it came from the first decile, which is just crazy.
- [89:47]
B
Yeah. One of my favorite strategies was a microcap strategy. Even though I've sold the company, I still let OSAM manage all my public equities. And I just love our microcap strategy. But it's adjusted for liquidity. It's adjusted for all of the things that would destroy you because the index itself is dog shit.
- [90:11]
A
You just can't buy it. Right.
- [90:12]
B
You can't buy it. And the companies, if you're doing a factor profile, the index itself, it's kind of dog shitty.
- [90:19]
A
There's no strategy in the world where you don't want to worry about the real life details, but there's some. You have to worry a lot more. Yeah, micro caps, you got to worry more than large cap equities. I Remember this goes back to 94, 95 when we're building our first, first models we built at Goldman Sachs were actually macro models. I had written or was still writing a dissertation on quant equity. But you know, you do what your employer asks you to do. So we had a backtest and it was still based on simple value and momentum stuff. So for currencies it was purchasing power, parity and carry and, and momentum. Yeah. And we spent time with the trading side, we were on the asset management side but we spent time with the sell side of Goldman, sat down with traders and kept asking what assumptions for trading costs should we. You know, we were young and stupid but we weren't morons. We knew we weren't going to trade for free.
- [91:16]
B
Right.
- [91:17]
A
So we want to estimate this. And I distinctly remember the currency traders said just use zero. What do you mean? This stuff is super cheap to trade. And that's never true. No, but it was also a communications problem because they were thinking dollar yen and as a fraction of the volume you're taking on, the costs are quite low. Yeah, but we don't think it's particularly high. Sharpe ratio trade. Right. When you have 25 currencies and you're relatively neutral on a lot of factors, you need more leverage and suddenly a fairly small trend and a lot of them are more expensive to trade than dollar yen. So we never assumed zero. We knew they were crazy. We also traded really stupid back then. Remember how things started, the way we trade? I don't know. I'm telling you all kinds of things. Probably shouldn't tell you. This is 27 years ago. So I think the statute of limitation.
- [92:09]
B
I think we're beyond statute of limitation.
- [92:11]
A
But we would go to one broker with a list of currency trades we want to do and we get fills from them. And we weren't again complete morons. We would, we would be watching Bloomberg and we literally would print screen on Bloomberg as they were doing it and we'd get some estimate of how far off of what we were seeing on the screens at the beginning of the trade we were getting executed at and we would occasionally move the business to a broker who did better on that scale. So not complete idiots. Yeah, but what a dumb way to trade.
- [92:42]
B
My God, we did exactly the same.
- [92:45]
A
Crime because you know what the broker did? They said we're going to screw these guys. How much can we, what's the optimal amount to screw them?
- [92:53]
B
But can we screw them?
- [92:55]
A
And still we're just giving them fills and they're going to accept them here. But if they're really egregious, they might not trade with us again. Right. So they were just literally saying, how much can we fleece? Yep. Goldman Sachs and Cliff's poor clients for. We learned pretty quickly. But, you know, you think back some of the things. It was a simpler time, but we.
- [93:15]
B
Were much, much simpler. And things have improved dramatically. We got most of our trading to as close to zero as possible. But that took us a long time because we did exactly what you did when we started out. Because we were dumb. All right. It was just like, oh, yeah. And maybe we shouldn't do it this way.
- [93:34]
A
And edges erode over time.
- [93:37]
B
Yep.
- [93:37]
A
And more people are out there. So it. Quite possibly. I'd actually argue it was. Was actually true. Was not as important to be super optimal on the trading when you were the first person doing a certain. That's right. Strategy. That's right. When something's part of everyone's toolkit and you got to measure it a little better than other people. And you got to trade more efficiently than other people. The. One of the. We could say the world's improving. It is. But it doesn't always make you better because it's improving for your opponents. Your opponents. At the same. At the same time. Yep. So, you know, don't get me wrong. I'm as chauvinistic about our strategies as everyone else. I. Of course, I think we're improving more rapidly than the average. But you got to keep in mind the world is always trying to take away your itch.
- [94:20]
B
Yeah.
- [94:20]
A
So sometimes you have to admit that you have to improve these to run in place.
- [94:24]
B
Yep.
- [94:25]
A
Which is great if you have a good strategy to begin with. Right. But it is sobering. You'd like to think every improvement is an actual improvement, not just defending your turf.
- [94:33]
B
Yeah. It's just defending the turf.
- [94:35]
A
But you got to.
- [94:36]
B
You've taken some heat recently for talking about needing beta in alternatives.
- [94:42]
A
I don't think of it as heat. Well, I wrote this up myself saying this will sound like Hypocrisy because in 2001, myself and colleagues wrote a paper called Do Hedge Funds Hedge?
- [94:57]
B
I love that. Thanks, by the way. Thanks.
- [94:59]
A
It was using some of the liquidity stuff I mentioned in Small Cap that people were underestimating the betas of hedge funds. And what we ended up finding was hedge funds with the publicly accepted data, which kind of sucks for hedge funds. But it was the same data other people were using to say, these are awesome investments. So we said, actually, there's about zero Alpha after fees. Which given the size of your fees guys, is actually pretty impressive.
- [95:25]
B
Yeah.
- [95:25]
A
But still not that helpful. So we were on the, on the bandwagon of the average hedge fund is not adding value to the client there. We would come up with hypocrisy, accusations or some of you. But you run things that you call hedge funds. I'm like, yeah. Any form of active management, not just a hedge fund, is an inherently arrogant act.
- [95:49]
B
Oh absolutely.
- [95:50]
A
Because Sharpe's arithmetic is diabolically powerful. My partner Lasse Peterson has written a piece. One exception might be new issues that have to be priced. It's going to be small. Lasse, if you're listening, Sharp's arithmetic says the average can't beat the average. Right. So the idea that active management on average loses. Yeah. Or best breaks even.
- [96:14]
B
But Right, right, right.
- [96:15]
A
But the idea that there are some systematic mistakes that you take the other side of, you have to believe you're, you're better than, than average to do that. And we live in a society. We're saying that out loud sounds obnoxious. But when you drill down, would you really want to invest with a manager who says we're just getting the average. Yeah. Here and the average. We're charging you a lot to get back to zero. No.
- [96:41]
B
So. But you know, I'm older than you.
- [96:44]
A
In the late gaining on you. Okay. As a, as a fraction, it's getting closer to one every friggin day.
- [96:52]
B
But back in the late 70s, early 80s, I started O' Shaughnessy Capital, my first company as a consultant and it was a quantitative consultant. And what I would do is build normal portfolios for pension plans. Right. So most people don't even know what a normal portfolio is today. So it's a portfolio whose factor profile and general directionally looks very similar to the manager. It's modeling. And do you know how many closet indexers I found back then, like I.
- [97:26]
A
Won'T name and that's only gone up over time.
- [97:28]
B
Oh, I know. And it's like when the first time, like I was a kid, I was 27 when I founded this company. And I'm like in front of this big pension plan and I'm like manager A is essentially the s and P500.
- [97:48]
A
But you asked about beta.
- [97:50]
B
Yeah.
- [97:50]
A
So this result and do hedge funds hedge? There was an implicit, maybe explicit, I don't remember the paper as well as I should saying they should hedge because the hedge funds had like 0 4.5 betas. And beta is not correlation. Right. I'm not explaining this to you, I'm saying. No, I understand, but they were about point 8 correlated to the S and P as a whole. A diversified portfolio of hedge funds. Because even if it's point, you know, people always think at a point four beta, how's it point eight? I'm like, well, imagine you invested 40% in the S&P 560% in cash. 100% of the variance comes from the S&P 500. So that would be a correlation of one and a beta of 0.4. So they are separate things. But at least if you built a diversified portfolio, A, you should only, this is a big leap. You should only invest in hedge funds you think are above average. That's the numerator. But I also think they should hedge. So being point eight correlated as an industry is kind of not the point. I still believe that. But I actually think I cost myself a bit on this because for so many years I talked about this that I almost forgot that beta is actually good long term. And when we say beta of one alternatives, we're really just talking about a portable alpha concept, right? Exactly. You know, portable alpha return stacking, call it whatever you want, but so imagine you have this fully hedged for truth, fully hedged positive expected return asset. When someone invests out of equities, as they often do, not always. If the expected return minus a little bit of diversification, compounding effects, we're going to ignore that if the expected return on the fully hedged good hedge fund is less than the naked equity market, you have improved your Sharpe ratio, but you've lowered your average return. So the old you can't eat risk adjusted returns, you actually can, but it's often practically true. The idea is, imagine you have a fully hedged process with a decent risk adjusted return, positive expected return, you should do two things. It should be run aggressively and it should be equitized often. And both of those are the exact same reason. It's not that it's always going to work. I'm not saying be aggressive for that reason. I'm not saying equitage because beta is always going to work. But if you now imagine investing out of equities into this thing, you are replacing the equity beta, you're not actually lowering it, you're simply adding the positive expected return. And then given that these things are generally done in small size, this is a battle I've been fighting for years that I've yet been to win. And we run a lot of alternatives at very low risk levels because that's what our clients want and it's good for them. But all else equal, they should give us less money at a higher risk level. It's just more capital efficient for them. And by the way, it fixes fees perfectly. When we originally launched our firm, this is a story I probably told you before. We only launched with one north of 20% volume product.
- [101:03]
B
Yeah, I remember.
- [101:04]
A
And that was theoretically correct and practically disastrously wrong because I made this argument to people we weren't doing portable alpha at that point, so it was hedging to zero. But I told people who would come and say 22% volume is crazy. How about a quarter of that? I'd say give me a quarter of the money. You. And I know I was correct on the math. I'm not going to apologize for that, but I will apologize for being wrong in the practical sense.
- [101:32]
B
Yeah.
- [101:32]
A
Because we weren't quite. We weren't down 40, but two standard deviations down times 22% is a very big number to most people. To a statistician it is still two standard deviations and just happens.
- [101:45]
B
Yeah.
- [101:46]
A
To a perfectly good process. Occasionally.
- [101:48]
B
Yeah.
- [101:48]
A
You throw in the world, our world's always going to be a little fat tailed and you're going to see bad events.
- [101:53]
B
Yeah.
- [101:55]
A
I was naive about the industry though. Certainly we survived. Some people stuck with us, but we lost some accounts. And I'm sure you've experienced this. The people who decided to invest with you are often not the decision makers. When you have a bad period and the decision makers one or sometimes even two levels up in the firm. If you're talking to the corporate treasurer trying to explain that you designed the thing to take 22% volume and this is actually not even that terrible. You're just an egghead who lost them 30%.
- [102:30]
B
I have had those conversations.
- [102:32]
A
So nowadays we will do whatever a client wants within reason. We won't run to any volume. There's a low enough volume where the noise of implementation would be more than we think is even worth it. But I will still tell people the theoretically optimal way to invest in us is as high volume as we're willing to run. And hopefully there's a lot of prudence built into that because you never want to have a forced sale. That's the main reason you would limit volume. Yeah. Or you hit a point where the dealers just won't give it to you. Yeah. And for most people, beta of one actually makes a lot of sense if you're funding it out of equities as they often do, because it Just replaces that it's.
- [103:14]
B
Yeah.
- [103:14]
A
I tell them don't think of this investment as a beta of one. Think of it as we're not charging you for an index fund.
- [103:20]
B
Right.
- [103:20]
A
Index fund prices are very low, are very low. They're not quite usually zero. Some big institutions can get actually negative when the securities lending whatnot. I say these things. I'm talking to you. Right. So I feel I have to dot every I. But it is quite efficient for you to equity. Think of it as just replacing your equity. Don't judge us on that. Which they will of course at some point but of course judge us on the. On. On the, on the alpha. And by the way, that should be as aggressive as we're both comfortable. Yeah. With because then you have to give us less money.
- [103:51]
B
Yeah.
- [103:51]
A
And you can put it somewhere super safe. Oh, I made a huge error. This is a 30 year old 20, 25 year old era. Occasionally when making this argument I would point out to people that if we lost more than 100% due to utter incompetence on our part or malfeasance, I ran off to Bolivia with it. I don't even know how I would do that. Could you imagine your firm telling your ops area? Yeah. Could you just wire all the client money to my Bolivian account? It's fine. It's fine. No. So not realistic. But not a good thing to even bring up as a hypothetical I discover. Right. But my point point was investing at four times the volume with a quarter of the money in the disaster case that I don't believe will ever happen, I will go out on a limb and say I don't think that's going to happen. It is far safer. You lost a quarter of the money. Right. Robert Vesco can only take. I'm really dating us now. A famous embezzler can only take the money that's there. So in all. In most cases it's the same risk if you, if you adjust the dollars in one hopefully wildly unrealistic but disaster state of the world, it's actually lower risk. Right. And I still have trouble more I convinced. Excuse me, I've convinced more people than I have in the past, but I still have trouble convincing people of this one because the sticker shock, it's the opposite of private equity. Right, right, right. We're going to add the beta visibly and then we're going to take a lot of volume that you're going to have to tell people.
- [105:25]
B
Right.
- [105:25]
A
About. I think it's the optimal, you know, suddenly being optimal and most People not being able to do it often go hand in glove.
- [105:33]
B
Yeah.
- [105:33]
A
The reason there's an edge there is most people can't, can't do it. Do it. So that's what I tell myself to get myself through some hard, hard nights.
- [105:39]
B
Yeah, I, I, I totally understand that. A, a strategy like that makes perfect sense. And trying to, because I used to just, I tried everything, trying to get regular people who weren't quants to understand. And what I ended up doing for the most part, because, you know, we were long only. Right. And, and so essentially, I ended up telling a bunch of stories. And I would start my speeches or if it was a pension or a wealthy high net worth around a table, I would start the pitch by saying, I'm going to tell you a bunch of stories about why you shouldn't invest on stories.
- [106:23]
A
That's great. As I've done many times in my career stealing that from you.
- [106:27]
B
Please. What is something that you believe, say, 10 years ago that you think is bullshit?
- [106:35]
A
Today I'm having trouble coming up with a good one. You got one?
- [106:40]
B
I do. And it wasn't that I had a strong belief in it, but I believed that directionally, it was important for our firm to offer it. And that was when we were building out canvas and putting a lot of emphasis on esg.
- [106:57]
A
See, I didn't have the guts to say that I should have.
- [107:01]
B
Well, again, I don't have clients anymore, Cliff, so I.
- [107:04]
A
It's much easier.
- [107:05]
B
It's much, much easier.
- [107:07]
A
Well, I, I got in. Not in trouble. I believe in if it's legal. And you think he could do it. Well, doing what your clients ask you to do.
- [107:18]
B
Yes, I agree.
- [107:20]
A
We run a lot of ESG money. We run a lot of money that's totally agnostic to esg. You give me a restricted list, you give me a rule. We're going to do what our client. As did we. I wrote a piece. I don't know. This was probably 10 years ago. Just saying the obvious. Something you've known in your bones forever, that you can't tell people, you're going to make them even more money. If you insist it's esg, that investment constraints have a max, the best they can be is zero expected value. And that's unlikely. Very unlikely. And I give the example that two different clients give us the utterly same mandate, but one says there's a third of the stocks you're not allowed to own. How can I look at the one who lets me own those and tell them, why you buying those? Because I think it's going to make the portfolio better. To a fellow Kwan, all you have to say is constraints are costly. Though I thought they would love me for this paper because I go on to explain and this is kind of similar to the private equity ideas of when something is a bug or a feature. Right. That the whole point of an ESG constraint and I'm talking the classic exclusion of stocks like so called activist stuff. That's not our world. So I'm not saying there's no form of ESG that this doesn't apply to or the classic form of ESG is you're not allowed to buy this stuff.
- [109:01]
B
Right.
- [109:03]
A
How is that supposed to make the world a better place? And the goal is noble. It's to make the world a better place.
- [109:10]
B
I agree.
- [109:11]
A
If it has any hope, and we can all debate how much hope it actually has, but if it has any hope, the only mechanism is by enough people not owning something. You're raising the cost of capital on that thing.
- [109:24]
B
Yep.
- [109:24]
A
You're forcing the people who are, who are ESG and perhaps morality agnostic, let's call them. I may or may not be one of these people. So it's not meant to be a total insult. But you're forcing them to own more than they would normally want because you won't own it. And the market has to clear for them to do that. They should. They should and probably do demand a higher expected return.
- [109:49]
B
Yeah.
- [109:51]
A
So the sad fact of ESG is the main way it can help the world be better. Now here's how it makes the world better. If the cost of capital is higher and you have traditional looking cash flows. We all know from old school NPV you can have weird shaped cash flows. But traditional project companies sitting there evaluating should we invest in this horribly environmental, unfriendly project? Well, we have to pay an extra 3% on our cost of equity because of these people. So when you have build your little spreadsheet that they taught everyone in business school. Yep. And discount the cash flows, fewer projects will cross the threshold.
- [110:29]
B
Exactly.
- [110:29]
A
And you will get less of the bad stuff.
- [110:31]
B
Yep.
- [110:33]
A
I'm not sure how practical this is, how much they actually move the. The dial stocks are fairly substitutable and fungible. So. But that's the principle. But to accept it, that means the ESG people on average are making a little bit less. Right. Because the higher expected returns is on the stuff that is starved for capital. They're. They're adding capital to the good places. Yep. That is how they make the World a better place. And if they believe in it, they should be proud of it. But they shouldn't just sit there and go, and of course you'll make more money. Right. Fewer people say that these days, but there was a point where a lot of people were saying, and it's to have your cake and eat it too. You could be a wonderful person, wonderful organization, and of course you'll profit from it. Yeah, you probably won't. I always give an exception if ESG is a trade, if somebody does it, because I think the rest of the world is going to move to esg and I want to be first.
- [111:29]
B
Right.
- [111:30]
A
That can work like any. It can work or not work like any trade. I also, a little nastily, occasionally point out the evil people will do that trade too. Right. You're not saying, I love ESG or ESG or I'm doing this. They're saying, you know, it's any trader. I think the world's about to buy a bunch of this. So. Yeah, you came up with the one I should have come up with.
- [111:53]
B
Yeah.
- [111:53]
A
Though I don't think I believed in it too much 10 years ago.
- [111:56]
B
Yeah.
- [111:56]
A
We do it again for anyone who wants it. I just won't tell people it makes their portfolio better.
- [112:02]
B
And back when I was still at the company, before we sold it, whenever we would have someone who was really interested, I was fine. But I had to be able to say what you just said. I had to be able to say, you do realize that by adding these restrictions, you're probably going to do less. Well, and like, the people who were like, that's fine. I want to make a difference.
- [112:27]
A
Of course people believe it too much now because there are a bunch of bad years in a row for most ESG tilted.
- [112:33]
B
Yeah.
- [112:34]
A
Portfolios. And, you know, even if I'll tell people you should expect less, I'll also tell them, I'm sure you do, that you don't want to look at three years and abandon your whole project either. Right. Because that's just what happened.
- [112:47]
B
Yeah. But the other thing that was really useful for me from my point of view, was it got me onto this stated preferences, revealed preferences. And, you know, it got me to guys like Todd Rose, who has a new way of doing polls that like, literally nail the actual mood. So, for example, I had him on a couple episodes ago.
- [113:14]
A
Does it involve physical torture?
- [113:15]
B
No, it does not.
- [113:18]
A
Does that might work?
- [113:18]
B
Yeah, it might. No. Abu Ghran robbed bad posing. But he was literally able to call before ahead of the traditional pollsters Trump this time around it's a tough call. Like months before really months before. And he has a very particular way of doing it. So it got me very interested in all that. So that's a net positive. We're running out of time. I always love talking to you and we end up talking for forever. We're going to wave a magic wand. We're going to make you the emperor of the world. But you can't kill anyone and you can't put anyone in a re education camp. That's my anti.
- [114:01]
A
That wasn't my immediate intention but okay.
- [114:04]
B
That'S my anti authoritarianism coming out anyway. But what you can do is we're going to hand you a magic microphone. You can say two things into it it and the next morning, whenever their next morning is the entire population of the earth is going to wake up and say I've just had two of the best ideas ever. And unlike all the other times, I'm actually going to act on these two. What are you going to incept into the world?
- [114:33]
A
Give you two things. All of our issues with government spending and taxation, they matter a lot. And the debt problem's a real problem. But I wish people understood most of the issue is what government actually does, whether it's funded as a deficit or a surplus. If it's a good idea we should do it. If it's a bad idea, we shouldn't do it. And I think that gets away and again this is not going to happen. I'm not going to be granted this power and the world listening is unlikely. If I was. But that's one the other one because I'm now I'm finally remembering you. You did ask me this last time, so I'm going to repeat myself. Okay. I think statistics should be taught in junior high.
- [115:16]
B
Oh, I completely agree with you.
- [115:18]
A
Much more than calculus for instance. I actually I'm geeky enough that I like calculus but for most people are not going to use that in their lives. Everything people read, all these crazy things you hear on the Internet, having even some knowledge of statistics, of randomness would help so much. I have my issues with Nassim Taleb. I won't go through them here. And when I say issues. Not a fan but his first book, Fooled by Randomness.
- [115:53]
B
It was a good book.
- [115:54]
A
It's a good book. Massively pretentiously written.
- [115:57]
B
Oh yeah.
- [115:58]
A
Self referential, all that goes without saying. But he's doing the Lord work there.
- [116:02]
B
Yeah, I agree.
- [116:03]
A
Making people understand how much of what they see is random and how much they over believe and want to give a reason for things that often don't have one. Each of his books had a real point. The Black Swan. Yeah, the world's fat tailed. I do think other people knew that. He likes to yell about my. One of my heroes, my professor, Gene Fama. Gene in the 60s wrote his dissertation.
- [116:29]
B
I read Gene's dissertation.
- [116:31]
A
I think Daley returns that they were fat tailed.
- [116:33]
B
Yeah.
- [116:33]
A
So. And he'll say things like, you know, Fama thinks everything's normally distributed. I'm like 1965 man. Before I was born he was doing this. You know, even the fragile book, he's right. There are things that are that like volatility and there are things that dislike volatility. I disagree with them in the options premium. But you don't have to read every book but a basic statistics class. I've told my own kids this. The more mathematical, the less mathematical ones. I've said, you know, to be a functional citizen and to have your vote actually be meaningful. Not in the sense that you're going to swing the election one way or another as one, as one vote, but have to be informed. Yeah, I would, I would love the world to understand a little basic statistics. Focusing most importantly on appreciating how random things can be in the. In the short or even medium term.
- [117:31]
B
Yeah, those are both great. Cliff, as always, I always have the best time chatting with you. Thank you for coming on.
- [117:39]
A
Thank you for having me. This was so much fun.
- [117:40]
B
Oh, thanks. Sa.