Bigger Extremes, Better Returns | Cliff Asness on the "Less Efficient Market Hypothesis"

[00:00:00] And so if that is true and markets are in fact somewhat less efficient, not grossly inefficient, but less efficient than they used to be, yeah, there might be more money to be made from someone who can stick with rational investing, but it will also be harder to stick with.

[00:00:15] You go back at the end of year three, it's pretty much you and your mom in the fund at that point, and your mom hasn't filed them yet, but she's filled out the redemption papers.

[00:00:27] Democracy is the worst system for governing ever devised, except for every other one that's ever been tried.

[00:00:34] And, you know, you might say the same about markets, but I've always been terrified that if I ever show up in anything like that, I'll be played by Albert Brooks.

[00:00:43] And nothing against Albert Brooks, he's hilarious, but that would bring out, you know, that would be the pure Jewish angst version of Click.

[00:00:50] If you need five more shares of NVIDIA at 2 a.m. on a Saturday, you might reconsider your whole investment plan.

[00:00:59] Welcome to Excess Returns, where we focus on what works over the long term in the markets.

[00:01:04] Join us as we talk about the strategies and tactics that can help you become a better long term investor.

[00:01:09] Jack Forehand is a principal at Validia Capital Management.

[00:01:13] Matt Ziegler is Managing Director at Sunpoint Investments.

[00:01:16] The opinions expressed in this podcast do not necessarily reflect the opinions of Validia Capital or Sunpoint Investments.

[00:01:24] No information on this podcast should be construed as investment advice.

[00:01:29] Securities discussed in the podcast may be holdings of clients of Validia Capital or Sunpoint Investments.

[00:01:35] You're watching Excess Returns right here on YouTube.

[00:01:38] I'm Matt Ziegler.

[00:01:39] Jack Forehand's here, too.

[00:01:40] We're about to perform some less than optimal qualitative research with the co-founder, principal, CIO of Advanced Quantitative Research himself.

[00:01:48] Author most recently of In Praise of High Volatility Alternatives and The Less Efficient Market Hypothesis, both of which we will dig into.

[00:01:57] An author, most favorably of mine at least, the papers that growth investors, are they cray-cray with the value spread, pointing out that the long run is lying to you.

[00:02:06] Or my personal favorite, size matters if you control your junk.

[00:02:10] A poet in finance, if ever there was one.

[00:02:12] That title was not my creation.

[00:02:15] That title was a co-author, Toby Moskowitz's creation.

[00:02:19] Probably wouldn't do it today.

[00:02:21] The world has gotten a little more sensitive to off-color humor.

[00:02:24] But it's funny, because of my reputation for saying more outrageous things, everybody assumes that was me, not Toby Moskowitz, tenured professor at Yale University.

[00:02:36] So I get either credit or blame, depending on whether you like or are offended by the title.

[00:02:41] Not me.

[00:02:42] We had Dan Villalon on, and we asked him, we were like, that has to be Clif.

[00:02:46] And he was like, no.

[00:02:47] He's like, I might not tell you who it is, but he's like, that actually was not Clif, even though you thought it was.

[00:02:52] As head of the firm, I feel I have the authority to out people at our firm on these things.

[00:02:57] That is our first footnote of the episode, Jack.

[00:02:59] We've outed Toby on the title of that paper.

[00:03:02] There will be many more footnotes to come.

[00:03:05] But before we get into your papers, we want to start with something.

[00:03:07] I was really excited that you gave all of us a little bit of hoax.

[00:03:10] So when I'm on Twitter all the time, I always hear that if I want to be really successful in life, I have to do a variety of things.

[00:03:17] And one of those things is I have to have a certain morning routine.

[00:03:19] That morning routine has to include some sort of ice bath.

[00:03:23] It has to include drinking something I don't want to drink.

[00:03:25] It has to include all these terrible things.

[00:03:27] And so I just want to thank you because you tweeted something that gave all the rest of us hope that maybe we can have a normal routine and be successful.

[00:03:34] So what you tweeted for people who are not watching us on video is you said, your morning routine is alarm goes off at 530 a.m.

[00:03:39] I text my trainer, not today.

[00:03:40] I sleep another hour.

[00:03:41] I awake and drink coffee and go into the office.

[00:03:43] Then I get mad about something.

[00:03:45] I'd recommend it.

[00:03:46] So thank you very much for from the rest of us for saying we don't have to do all those things.

[00:03:50] Yeah, there's a little bit of humor in there, but it's uncomfortably close to accurate.

[00:03:56] You know, some of these is a great example of correlation versus causation.

[00:03:59] Those morning routines may be correlated with very highly productive people, the same mindset that can make you wake up and do some wacko, uncomfortable, painful routine.

[00:04:12] But I don't I don't think it's as causative as people as people think.

[00:04:18] You know, Winston Churchill used to wake up in the afternoon and work in bed till the evening and then stay up till 4 a.m.

[00:04:26] Different things can work for different people.

[00:04:28] Yeah, I hope it's not causative because I wake up basically try to get a coffee in and then have my wife and kids tell me a bunch of things I have to do.

[00:04:33] So I certainly don't have any time.

[00:04:35] Well, you should do them.

[00:04:36] The key to survival right there in a nutshell.

[00:04:38] Let's let's let's go straight into this less efficient markets paper.

[00:04:41] Sure.

[00:04:41] At a high level, I guess most people probably think that the markets become more efficient over time due to technology, smarter participants, all the normal things.

[00:04:50] But you're saying that's maybe not the case.

[00:04:53] Break down what's in this paper for us.

[00:04:55] Yeah, I'm starting admittedly from two rather only two observations with a statistician never enjoys having two observations.

[00:05:03] But they were giant observations that were very anomalous given, you know, 75 years of history.

[00:05:11] And essentially it was the dot com bubble in the late 90s.

[00:05:16] And then surprising because, you know, it happened once and I thought to be honest, I thought it would probably be 50 years.

[00:05:22] So what happened again?

[00:05:25] Very similar event in 2019 and 20, where the difference in valuation between so-called growth and so-called value stocks.

[00:05:34] I prefer to call them expensive and cheap stocks because every once in a while, the cheap guys are actually growing pretty well.

[00:05:40] But the difference in valuations hit easily far and away a record level compared to history in the dot com bubble and then actually surpassed that during COVID.

[00:05:53] And I can't even blame COVID because it was getting right up there pre-COVID.

[00:05:59] And, you know, that led to anyone, you know, quantitative value strategies.

[00:06:05] But anyone who cared about price, I don't care if you were a a concentrated stock picking Graham and Dodd manager, you generally hated those periods to a level that was unprecedented.

[00:06:17] In both cases, they've massively recovered and the round trip has been fine.

[00:06:23] So the main challenge was holding on.

[00:06:26] But after the first one, it shaked my faith maybe in efficient markets a little bit.

[00:06:33] I wrote a paper called Bubble Logic during it that was a little sarcastic about about some of the valuations that that maybe was an odd title at that point for a Gene Fama disciple.

[00:06:43] I still love Gene, even if I get for at least on the spectrum of how inefficient the market is than than than he is.

[00:06:52] But then when it happened again, I sat back and I said, all right, I'm pretty sure there's something out there causing either general levels of inefficiency to be somewhat bigger or occasional massive bouts of mania to be somewhat bigger.

[00:07:12] So, you know, I was reasoning from data points.

[00:07:16] I didn't predict this.

[00:07:17] And then it's always more valid if you predict something and then it comes true than if you observe it and then try to come up with a story.

[00:07:23] But but with with that caveat, I do believe markets have gotten somewhat less efficient.

[00:07:28] I want to be clear.

[00:07:30] I don't think they're grossly inefficient.

[00:07:32] I don't have a better way for society to allocate capital.

[00:07:36] I'm fond of the Winston Churchill quote.

[00:07:40] It's my second Winston Churchill reference in six minutes.

[00:07:43] I didn't mean to do that.

[00:07:45] But he has this great quote about democracy.

[00:07:48] It's a good data for this quote.

[00:07:49] It's a good day for this quote, actually.

[00:07:52] Democracy is the worst system for governing ever devised, except for every other one that's ever been tried.

[00:07:58] And, you know, you might say the same about markets.

[00:08:01] But I'm gene Fama.

[00:08:03] I sat through his class three times.

[00:08:06] First as a student in two more years, full time sat in every lecture as the T.A.

[00:08:11] And he always tells the class about a few weeks in markets or after introducing the concept that markets are assuredly not perfectly efficient.

[00:08:21] And genes, you know, if anything, super intellectually honest.

[00:08:27] He admits perfect efficiency is ridiculous.

[00:08:30] Nothing's perfect.

[00:08:30] But once you admit things aren't perfect, how imperfect they are and how much that varies through time become a legitimate object to test.

[00:08:42] And if it's hard to formally test, to even speculate on.

[00:08:46] I think the intuition you mentioned that markets would get more efficient over time is largely based on technology.

[00:08:53] The speed of trading, the cost of trading has gone down, the ubiquity of information.

[00:09:01] But I think most of that is about speed, not about correctly processing information.

[00:09:09] I think it's almost it's almost a certainty that information gets into prices faster than 35 years ago, which is roughly the beginning of my paying attention to this stuff.

[00:09:21] Um, but I think the difference is 10 minutes versus 10 milliseconds.

[00:09:26] I you know, I'm old, but I'm not carrier pigeon old.

[00:09:30] We had Bloomberg's and we had phones.

[00:09:33] And, you know, when news would come out, prices prices would react.

[00:09:38] So, you know, it in information itself has to be processed well.

[00:09:45] And I then I advance a bunch of theories as as to why that processing might be.

[00:09:54] Less efficacious these days.

[00:09:56] How did you think about testing market efficiency?

[00:09:59] It would seem like that's that's probably a pretty difficult thing to do in the real world.

[00:10:02] How did you think about tackling that?

[00:10:03] Testing market efficiency is historically extremely hard.

[00:10:06] First, it runs up against something famous in academic circles, which is a bit of an oxymoron.

[00:10:13] It means famous among 11 of us.

[00:10:15] But that called the joint hypothesis problem.

[00:10:20] The efficient market hypothesis boiled down to one line says prices reflect all available information.

[00:10:27] Not included in the hypothesis is a model of how prices should reflect what information is relevant.

[00:10:36] You know, do you do you pay a lower price and expect a higher return for a more volatile stock, even if it's uncorrelated with the market?

[00:10:45] The capital asset pricing model would say no.

[00:10:48] The capital asset pricing model is a great example of a famous part of the joint hypothesis.

[00:10:55] You can test the joint hypothesis that markets are efficient and the capital asset pricing model is what's being used to set returns and prices.

[00:11:06] That test is wildly rejected.

[00:11:10] It's one of the great failures.

[00:11:13] You know, you know.

[00:11:15] 50 to 100 years of data across every country.

[00:11:19] No, the security markets line is relatively flat.

[00:11:22] It is it is not rewarding beta, as the cap M says.

[00:11:27] But then you have to step back and you go.

[00:11:29] So what went wrong?

[00:11:31] I had two hypotheses.

[00:11:33] Is the market trying to use the capital asset pricing model?

[00:11:37] But there are frictions and biases and mistakes people make that lead them to not succeed.

[00:11:44] Or is the market quite efficient and the cap M is just wrong that there are other elements besides market beta?

[00:11:52] And maybe market beta isn't that important if we had the true correct model or are both wrong.

[00:11:59] We almost never know the answer to that question.

[00:12:04] And some things when you find, you know, this is very rare.

[00:12:08] But when you find these strategies that for some period have incredibly high risk adjusted returns, you can say maybe it's implausible.

[00:12:16] There is an equilibrium model that in a joint hypothesis that would explain a three sharp ratio.

[00:12:23] And those usually go away pretty quickly.

[00:12:25] But if that exists, maybe you can start to say it's market efficiency that's suffering.

[00:12:30] But mostly you don't know.

[00:12:32] But one thing I took great latitude in this paper is this was an invited paper for the 50th anniversary of the Journal of Portfolio Management.

[00:12:40] I think they just did it by age.

[00:12:42] Whoever published first and was still alive gets to write one of the invited papers.

[00:12:49] And, you know, lucky for me, I'm one of both.

[00:12:55] As part of this, the publisher, Frank Frabosi, was quite encouraging about retrospectives, opinion, you know, wise old man kind of stuff.

[00:13:05] I've been around for a while and I admit at the very front of the paper, I will not be proving this assertion.

[00:13:11] Tests of the general level of market efficiency over long periods are still highly contentious.

[00:13:19] It's not an easy thing to prove one way or another.

[00:13:22] Therefore, tests of a modest to decent size change in that level over your career are going to be even harder.

[00:13:31] So there is a lot of opinion.

[00:13:33] I'm not making an excuse.

[00:13:34] It's a strongly held opinion.

[00:13:36] I stand behind.

[00:13:37] But this is a very long winded answer of saying, unlike many of my papers that are filled with T statistics and other formal approaches, I'm not going to be claiming I have a p value of 0.03 that I'm that I'm right.

[00:13:52] I'm going to be claiming I think I'm right because of what I'm observing.

[00:13:55] But it is more anecdotal and logical and opinionated than than my normal kind of work.

[00:14:01] Do you think the percentage of managers outperforming is a reasonable measure of efficiency?

[00:14:05] I read that somewhere that somebody had made an argument on the other side of this, like that's a relevant thing.

[00:14:09] Do you think that matter?

[00:14:10] Do you think that it measures efficiency at all?

[00:14:12] Actually, I don't.

[00:14:13] And I've heard that in response to my paper and I haven't gotten around to it, but I plan on writing a little something on this, probably just on my website.

[00:14:23] The Journal of Portfolio Management issue is just coming out now.

[00:14:26] And I do find it a little weird to write a defensive, no, it's not this to critics before the actual paper is out.

[00:14:36] You know, I can be thin skin, but that's taking it just a little a little too far.

[00:14:40] But here's the problem with that.

[00:14:43] It's always going to be the case.

[00:14:45] Bill Sharp's arithmetic is tyrannical.

[00:14:49] The average deviation from the market doesn't beat the market.

[00:14:53] And the average deviation from the cap weighted Jack Bogle style market loses to the market after fees and transactions costs.

[00:15:03] So the observation that the average person owning a active portfolio.

[00:15:09] Doesn't win.

[00:15:11] If it does win, your your measures are broken.

[00:15:16] You're not doing it right.

[00:15:17] You can measure subsets.

[00:15:19] Do mutual funds.

[00:15:21] Do Graham and Dodd old school managers.

[00:15:24] Do quants win on average?

[00:15:26] Because obviously they can be taking the there could be negative alpha to others and positive to some.

[00:15:32] But the general observation that the whole my argument is an extremely conceited one.

[00:15:39] It's that this this basic valuation driven approach.

[00:15:43] It doesn't have to be just quant value.

[00:15:45] It could be broader than that.

[00:15:46] It could be multidimensional value that considers profitability, you know, changes.

[00:15:52] It get moving in the right direction short term in terms of fundamentals, risk levels, beta of all.

[00:15:59] But my basic intention is those who follow that rigorously.

[00:16:04] Will do better going forward in a world of less efficiency.

[00:16:09] But you can never forget.

[00:16:11] And again, there's an arrogance to this.

[00:16:12] Any kind of active management has an arrogance because it says I can be the right side of Bill Sharpe's arithmetic.

[00:16:19] They are taking you're taking someone's money and now you're serving a purpose.

[00:16:23] You're making the market more efficient if you're taking the right side.

[00:16:26] That's what markets work.

[00:16:27] Everyone try.

[00:16:28] You know, everyone deviating from cap waiting is trying to take someone else's money.

[00:16:33] And that that leads to pretty good results if the market stay stay stay stay close to efficient.

[00:16:39] But the fact that the average doesn't win.

[00:16:41] Nope.

[00:16:42] And even looking at the subset I like, that's come way back.

[00:16:47] I had a really rough time in 18 through 20 made more than all of it back, which is which is nice.

[00:16:53] But the value spreads I focus on, I've been obsessed with since 99 with just tracking the spread between cheap and expensive.

[00:17:01] I usually publish very simple versions.

[00:17:03] I have also looked at kind of quality adjusted versions.

[00:17:06] They usually say about the same thing.

[00:17:10] The way we track it, that's that set a new record in late 2020, early 2021.

[00:17:18] Blue past the way we measure it, blue past the high of the dot com bubble, which, again, I never thought I'd see my career again.

[00:17:24] Admit I got that wrong.

[00:17:27] It's come way back.

[00:17:28] So it said a new hundredth percentile.

[00:17:31] I have made this joke many times.

[00:17:33] I apologize if your listeners have heard it already.

[00:17:35] But I took to calling it the hundred twenty fifth percentile, which was always fun to say that to an audience.

[00:17:42] And if nobody laughed, he knew you were in trouble because they well, actually, they might just not have found it funny.

[00:17:49] I have I have trouble accepting that.

[00:17:51] But if they might just think, oh, one hundred twenty fifth percentile, that's that's great.

[00:17:56] No, there is none.

[00:17:57] It's the new hundredth percentile.

[00:17:59] But the point is, of course, there's a fair amount wider than the prior one.

[00:18:05] Huge recovery.

[00:18:06] And I'll brag much larger in ways we measure value, which is much more balanced within industries, not tech versus everything else global, not just the U.S.

[00:18:18] In the U.S., the major value indices have continued to be crushed by the major growth indices.

[00:18:25] And that's a mag seven phenomenon.

[00:18:27] But those are cap weighted and have huge industry bets.

[00:18:30] If you do it more like an active manager and it's not unique to us and you do it very balanced, not equal weight, that's way too far, but closer to equal weight, many hundreds of stocks long and short around the world.

[00:18:43] We've seen a huge comeback.

[00:18:45] But we're only back to low 80th percentiles in that spread versus history.

[00:18:52] So if, you know, maybe we'll stay here forever.

[00:18:54] But if we eventually head back to historically normal, I still think rational strategies.

[00:19:02] You mentioned the long run is lying to you paper earlier.

[00:19:06] The point of that paper is when valuations are at extremes, asset classes, strategies, relative returns on different geographies.

[00:19:16] History will give us a poor guide to the future because it's really recording the valuation change, not something fundamental.

[00:19:23] So I think the wind has still net been in the face of what I call rational strategies.

[00:19:29] So, you know, I look forward to.

[00:19:34] To the future, because I do believe in this, I do believe it will be more lucrative to be on the rational side for at least the time being.

[00:19:42] The caveat to that, and I'm very clear about in this paper, is what inspired me to look at this were two wild, unprecedented episodes that were extremely painful for what I call rational investors that ultimately paid off for them.

[00:19:56] And so if that is true.

[00:20:01] And markets are, in fact, somewhat less efficient, not grossly inefficient, but less efficient than they used to be.

[00:20:07] Yeah, there might be more money to be made from someone who can stick with rational investing, but it will also be harder to stick with these periods.

[00:20:14] As we've seen, if my theory is correct, will be that you'll have to fight bigger extremes that last for longer.

[00:20:24] And I say in the paper, no one might care what I think is fair.

[00:20:28] I'm just throwing you my opinion.

[00:20:30] But this strikes me as kind of fair.

[00:20:32] Harder to do, but a bigger payoff if you can do it, is even within an inefficiency argument, is some type of efficiency.

[00:20:41] That strikes me as a fair tradeoff.

[00:20:45] I steal a line from my ex-professor, Ken French, who labels the market has, what does he say?

[00:20:51] And he attributes this to someone else, but I'm giving it to him, that markets have an efficient amount of inefficiency.

[00:20:58] And we could get into that.

[00:20:59] That gets a little geeky.

[00:21:01] But this strikes me as something that is fair going forward.

[00:21:04] I think the payoff to being the rational investor willing to take the other side of extremes will be bigger in the next 20 years than it's been in the last 20 years.

[00:21:13] But it will occasionally test you more.

[00:21:18] So there was a chart, I believe, out of that paper.

[00:21:22] And number one, what you just explained is beautifully pictorially represented in a chart that shows that too.

[00:21:28] But this five-year moving average of the value spread from Fama French.

[00:21:33] I think Jack can get it up on the screen for us in this too.

[00:21:36] Jack looks skeptical to his ability to do that.

[00:21:39] Let's see if he can do it.

[00:21:40] Well, I can do it for the people who watch the video after the fact.

[00:21:45] So from their perspective, it'll look great.

[00:21:47] I do remember the chart, so we're okay.

[00:21:49] I want you to just explain what's going on.

[00:21:52] And personally, I really want you to help walk me through what's going on in that late 70s through the mid-90s.

[00:21:58] Basically in the lulls of the chart, as much as we have this giant skew on the right side, it just picks up and up and up.

[00:22:04] So backing up, I vaguely alluded to it earlier.

[00:22:08] But the chart, formally using, in this case, it's Fama and French.

[00:22:13] So it's just their price-to-book measure.

[00:22:15] I'm not going to dis-price-to-book, but I'm also going to say it's not what most quants use.

[00:22:20] We use a wide variety of measures, some of which are well-known, some of which we've tinkered with for a long time.

[00:22:28] But as I show in the paper, more modern quant measures come up with very similar results.

[00:22:33] So why not stick with the classic that's been looked at a ton of times?

[00:22:37] This goes back to 99 during the dot-com bubble.

[00:22:40] We built this measure, which people have not looked at yet.

[00:22:43] I say that.

[00:22:44] People have not publicly talked about.

[00:22:46] I always want to be careful.

[00:22:47] Someone privately might have been doing it 10 years before us.

[00:22:49] We've had things at our firm we've been doing for 10 years that someone finally writes about publicly and we're like, darn, why'd they tell people?

[00:22:57] So I don't want to scoop people who are ahead of us, but we were the first to write about this.

[00:23:02] Where the prior tests, almost all the academic and practitioner research had sorted stocks on something like price-to-book, formed a portfolio of the cheaper versus the expensive, and just looked at the return differences.

[00:23:17] To our knowledge, none had asked the question, how big are those differences?

[00:23:21] Well, if you take the price-to-book of the expensive and divide it by the price-to-book of the cheap, that number better always be more than one.

[00:23:31] I'm fond of saying if it's not more than one, your code or your spreadsheet is broken.

[00:23:36] You've sorted the stocks, and you took the high divided by the low, and it's not allowed to be negative.

[00:23:42] So you're going to get a number bigger than one, but from 1950 to 1998, it had looked like a very well-behaved series.

[00:23:53] Either the straight series or the five-year moving average that you refer to looked, for an economic series, fairly well-behaved.

[00:24:02] It varied between about three and six, which means the top 30% of stocks was at the most about six times more expensive on this scale than the bottom.

[00:24:12] 30%, and at the tightest was only about three times more expensive.

[00:24:17] And then in the dot-com bubble, it exploded to, I don't know, I don't remember exactly, but 10-something.

[00:24:24] It looked like a broken chart.

[00:24:28] You know, the famous, the world has changed.

[00:24:31] At least on this measure, the world did change.

[00:24:33] I don't think ultimately the gravity of the world that would pull this back to normal went away, but there was a change.

[00:24:41] Um, then over the next 20 years, you saw meander around.

[00:24:46] I think those periods where it spends long periods around the median or below the median, those are kind of the normal periods,

[00:24:54] uh, where maybe even if markets are less efficient in extremes, um, nothing extreme is going on.

[00:25:01] What I'm talking about are really these bouts of crazy.

[00:25:05] Um, but the point of the five-year moving average, and I do it a few different ways, five-year moving average is, of course, going to be more extreme if the numbers are more extreme,

[00:25:13] but it also shows things lasting for longer.

[00:25:15] Uh, in the paper, I also quote, number of months, it's been above median, where when you have, uh, you know, big spreads, how long, and that's gotten radically longer.

[00:25:25] Um, and that's two form, there are two ways to hurt when you're underperforming, uh, intensity and duration.

[00:25:33] You know, how bad are your losses, be they absolute losses in, say, a long-short portfolio or relative losses to the market in a traditional portfolio?

[00:25:43] Um, how big are they and how long do they last?

[00:25:47] And one thing, uh, in my career, if you asked me at the very beginning of my career, um, you know, back in the stone ages, um, which of these two are more important?

[00:25:58] I'd say, oh, you know, you know, the magnitude, um, that's, you know, magnitude is what counts.

[00:26:04] If you write down formal utility functions, uh, maybe there is one, maybe some genius professors done it.

[00:26:10] I don't know any, uh, that have, uh, you know, duration of, of annoyance, uh, in, in them or duration of, uh, pain, uh, in them.

[00:26:20] In the real world, sticking with a strategy, even if the absolute size of the drawdown is two-thirds of the size, smaller,

[00:26:31] if it lasts three years instead of a year and a half, that's much harder to stick with.

[00:26:36] If, after year one, you go back to client who likes you, who chose you, and you're saying, this is what happened.

[00:26:43] This is why we like it going forward.

[00:26:45] You're usually okay with that.

[00:26:47] You go back after year two, they're like, you know, that's what you said last year.

[00:26:52] Uh, and you go, yeah, it just happened again.

[00:26:54] And this is why we like it even more.

[00:26:56] Some don't buy it.

[00:26:58] Many do.

[00:26:59] You go back at the end of year three, it's pretty much you and your mom in the fund at that point.

[00:27:04] And, um, and your, your mom, um, hasn't filed them yet, but she's filled out the redemption papers.

[00:27:10] Um, so duration, I'm exaggerating, of course.

[00:27:13] Uh, but, and my mom would have never redeemed, but that, that would have just been a Jewish mama sticking with her son.

[00:27:21] Uh, she would have lost total, total faith in my abilities.

[00:27:25] Um, duration counts too.

[00:27:27] Uh, but if markets, if that tether to reality is not gone, but weaker, which is pretty much what I mean by bouts of more extreme inefficiency, then they're going to do both.

[00:27:38] They're going to be bigger and they're going to last longer.

[00:27:41] I just think of it as gravity.

[00:27:43] Is the gravity pulling things back to, to fair?

[00:27:46] And if that force is weakened, you're going to see bigger and longer deviations.

[00:27:51] You mentioned a few hypotheses in the paper as to why this might be going on.

[00:27:54] And I want to focus on number one first, because this is something we've talked about a lot on our podcast, which is there are many arguments out there right now that passive investing is influencing the market.

[00:28:03] In that these large companies, there's a lot of flows going into them.

[00:28:06] If liquidity doesn't scale with market cap, you might see some influence there on the market.

[00:28:11] And I'm just wondering, what are your thoughts on those arguments in general?

[00:28:13] Um, there are a few different ways to take this.

[00:28:16] Um, first, I, I list that as one possible reason.

[00:28:19] I, um, I do think, uh, uh, the rise of, of, of passive and by passive, I mean, true Jack Bogle, market cap style passive.

[00:28:28] Every once in a while, someone will define passive as like rules based.

[00:28:31] So every ETF, no matter how anti market it is, would, would fall into passive.

[00:28:37] That makes no sense to me.

[00:28:38] Passive is owning what everyone else owns.

[00:28:41] Um, and I do talk about how the rise in passive and I'll get to why, uh, in a, in, in a moment, uh, but could help loosen that tether to, to reality.

[00:28:53] Um, I do think the general notion that the, that money going to passive radically distorts things in favor of the big caps is overdone.

[00:29:04] Um, um, you asked the exact right question.

[00:29:07] Um, what's the impact compared to liquidity?

[00:29:09] Um, yeah, and there's some evidence.

[00:29:11] I cite one paper.

[00:29:13] This research is in its infancy.

[00:29:15] Um, but the question comes down to like, if I bought 1% of Nvidia and 1% of a micro cap, do I have a bigger impact on the Nvidia price?

[00:29:25] Um, and you could tell different arguments.

[00:29:27] You could tell an argument that it should just be proportionate.

[00:29:30] You could tell an argument that ultimately dollars matter.

[00:29:33] Uh, that it's not just proportionate.

[00:29:35] Um, the, the initial evidence I've seen says dollars matter a little, uh, but not a ton.

[00:29:42] That kind of probably fits my intuition.

[00:29:44] Um, but more so when we, you know, I'm looking at it through my own lens, of course, but when we've done things like recalculate that value spread, throwing out the 5, 10 and 20% biggest caps, throwing out just the most expensive stocks, uh, throwing out some version of the magnificent seven and a more dynamic way.

[00:30:05] Like always looking for what was the closest thing at it, at its day.

[00:30:09] Um, obviously the magnificent seven 20 years ago, wasn't the magnificent seven.

[00:30:14] And this, the value spread.

[00:30:16] And I know I'm, I'm singing the same song, but the value spread historically comes out looking very similar and value performance comes out looking very similar, no matter how you're doing this.

[00:30:28] So to us, at least looking at it our way, somebody else might have a different way to look at it.

[00:30:41] Uh, uh, uh, uh, relatively balanced by industry with no nothing having a huge weight.

[00:31:01] So even if the mag seven are grossly out of whack, which you don't come to a quant for to answer that question.

[00:31:08] Uh, you don't, uh, quants don't answer questions about seven stocks.

[00:31:11] Uh, but even if they are, they, it, it, we knew this result even before running the numbers that it can't be driving the kind of spreads I'm talking about.

[00:31:20] They're much more pervasive.

[00:31:22] Now here's where I think the rise of passive can matter.

[00:31:27] There is one number when let's ask the question, what percent of the market could actually be Jack Bogle style passive?

[00:31:36] And still have some degree of an efficient market or not.

[00:31:40] Yeah, I don't know.

[00:31:41] Some, you haven't hit inflection point where it gets really crazy.

[00:31:44] Well, there's only one number we know for sure that can't be a hundred percent.

[00:31:50] This is something I joke in the paper that PhD students drunk at a 2 a.m.

[00:31:54] And then I admit it's one wine cooler at 9 30 p.m.

[00:31:59] Um, you know, it's almost like a cone, like a, like a, where you, how do you, how do you even think about a world where everybody is trying to free ride off everybody else?

[00:32:12] There's literally nobody doing the work of saying is NVIDIA worth more or less than the corner drugstore.

[00:32:18] We're all just assuming the other person did it and copying them.

[00:32:22] So let's just say that would be nuts.

[00:32:24] I don't know what it would look like.

[00:32:25] It's hard to think about.

[00:32:27] Um, we, uh, this is funny.

[00:32:28] We once had a Jack Bogle himself on a podcast we were doing.

[00:32:32] We did a podcast for a while because as you know, legally in America, everybody must have their own podcast at some point.

[00:32:39] Um, and I was lucky enough to be friends with Jack.

[00:32:43] Uh, it was an odd friend, 85 year old godfather of passive.

[00:32:48] And at that point, a 50 year old long, short active quant.

[00:32:52] Um, but Jack was a wonderful man.

[00:32:54] Um, I think the fact that his son was a long, short active quant probably softened everything about me to him.

[00:33:01] Uh, you know, I know anything one of my kids do.

[00:33:03] I'm predisposed to maybe think isn't the devil.

[00:33:06] Um, actually one of my kids, I would assume it was the devil, but I'll, I'll keep that to myself.

[00:33:11] Had Jack on the podcast.

[00:33:13] We got into this discussion and Jack like Gene Fama.

[00:33:16] I'm going to say this about another famous person.

[00:33:17] He's incredibly intellectually honest guy.

[00:33:20] He's like, of course, a hundred percent of the market can't be passive.

[00:33:23] I think my marginal recommendation to most investors to be passive is the right one.

[00:33:29] But a hundred percent, everything breaks down.

[00:33:31] He freely admitted that.

[00:33:32] And I said, Jack, so how much of the market can be passive before it starts to get weird?

[00:33:38] Um, and he said 75%.

[00:33:41] And I'm like, oh, that's really cool.

[00:33:43] That's, you know, where'd you come to that, Jack?

[00:33:45] Uh, and he just looks and goes and he gets a little twinkle in his eye and goes, oh, I completely made it up.

[00:33:50] And when you're, I don't know, he was 85 at the time and you're Jack Bogle, you can get away with that.

[00:33:55] I think those of us who didn't create Vanguard, um, and probably shouldn't make that joke.

[00:34:01] Uh, but, uh, but his point, even that has a point.

[00:34:04] No one really knows.

[00:34:05] Uh, a lot of people are very histrionic about this and think passive is the devil and everything has fallen apart.

[00:34:12] Um, I think it is unlikely to me that all the craziness that I admit happens at a hundred percent passive.

[00:34:20] Happens magically at 99.999% uh, passive and a hundred.

[00:34:26] Most things in life are some continuum.

[00:34:29] Um, so the idea that we're much more passive now than we used to be has contributed to maybe some, uh, some smaller tethered to reality.

[00:34:38] I find fairly intuitive, but assigning a magnitude to it.

[00:34:45] And particularly, you know, again, I think markets are less efficient than they, than they used to be, but I don't think I've proven they're inefficient to where you can drive a truck through.

[00:34:55] And just as the rational investor make free money all the time, uh, I don't think it's that far gone.

[00:35:00] Um, so I think passive is part of the story for the reasons I outlined, but I, I, I think, and I admit this is all as it's still in the realm of hard to prove.

[00:35:10] That putting a magnitude on it is difficult.

[00:35:14] And my instinct is those who are absolutely freaking out about it are overstating its role and have kind of made it their life's work to be kind of anti-passive.

[00:35:25] I want to just make sure we get the optioned rights for the, uh, as this Bogle, like bromance movie where you guys are hanging out.

[00:35:34] I'm just kind of picturing like a, uh, twins thing.

[00:35:36] Yeah.

[00:35:37] I've always, I might be, but your, your viewers might not remember him well, but I've always been terrified that if I ever show up in anything like that, uh, I'll be played by Albert Brooks.

[00:35:47] Um, and not, nothing against Albert Brooks.

[00:35:49] He's hilarious.

[00:35:50] Uh, but that would bring out the, you know, that would be the pure Jewish angst version of click.

[00:35:55] Um, so it'll, it'll, you know, Albert's a little older now, so maybe it won't happen, but they'll, they'll find someone similar if this ever happened.

[00:36:05] All right.

[00:36:06] We're optioning the rights for this.

[00:36:07] All right.

[00:36:08] Good.

[00:36:08] As soon as this podcast ends today.

[00:36:09] I just want script approval.

[00:36:14] Fair enough.

[00:36:14] We'll give you a script approval and free range on footnotes.

[00:36:17] The rise of passive creates this thing.

[00:36:19] And I'm thinking about David Einhorn and some of the comments he's made.

[00:36:22] Does this create new types of like obscure opportunities?

[00:36:25] Like this, this, uh, it's like a new flavor of inefficiency, meaning there's a new flavor of active opportunities that can work.

[00:36:32] Um, wait.

[00:36:35] Yes and no.

[00:36:36] One of the things it's doing.

[00:36:39] Again, I, I'll stop giving all the cowardly caveats, but in a paper, that's largely opinion.

[00:36:44] Um, as someone who often writes for more academic things, I always feel like I have to give the caveat every time.

[00:36:51] Um, you know, this is, uh, if this is right, I wouldn't say it's, it's a different, uh, opportunity, uh, in kind.

[00:36:59] Um, I would say it's just in magnitude.

[00:37:02] Um, markets have never been perfectly efficient.

[00:37:05] As Gene told us, they've always had deviations.

[00:37:08] Um, you know, uh, the factor that I wrote my dissertation on him, price momentum.

[00:37:13] Um, he's always been very generous in calling that the chief, uh, Jagadish and Tidman should get pride of place for finding.

[00:37:19] And I was right behind them.

[00:37:21] Um, but he always says that that's, that's the chief flow to their three and now five factor model and very hard to reconcile with market efficiency.

[00:37:32] So, um, in that sense, I, I, I think if markets have always been somewhat inefficient leading to opportunities for some subset of the market, not for all active management, I, I think it just loosens it.

[00:37:45] And they're generally bigger.

[00:37:46] Um, there's one I can think of specifically, um, uh, uh, uh, Rob Arnott, um, who I, I've had my run-ins with Rob, but I have great respect, uh, for him, uh, has recent work on, uh, on additions and deletions, uh, to, to, to passive indices, um, that shows some, uh, some, at least in my quick reading, uh, rather large effects.

[00:38:09] And that, again, I, I don't know the ins and outs, but it's very plausible that, that the larger role for passive would make that effect a unique and new thing that probably is driven by the specific role, larger role of passive.

[00:38:25] That's one I can think of, but mostly I think it's just further loosening the same bounds of rationality that have never been perfect, even if they've been pretty good over time.

[00:38:37] I want to touch on the third hypothesis you had in the paper, because I think that's the one you sided with the most, which is we have the effect of technology backwards.

[00:38:43] And this is an idea I think about a lot.

[00:38:44] You know, we have social media, we have technology, like, is it, is it making us all crazy?

[00:38:48] Um, and is maybe that playing a role in market efficiency?

[00:38:51] Yeah, that's my favorite of the three hypotheses in the paper.

[00:38:55] And it's my favorite for two reasons.

[00:38:56] The first is I just enjoy things that are counterintuitive.

[00:38:59] And we started out this whole discussion with that most of our intuition would be that technology makes things more efficient.

[00:39:06] Now, we often use that word efficient in very different ways, right?

[00:39:10] Um, in, in, if you're running a factory, efficient is how much you can produce with how many resources.

[00:39:15] Um, and there, I think technology clearly makes things more efficient, but we, we distinguish in market speed versus accurate processing of information.

[00:39:24] And this is a opportune week to use politics as an example.

[00:39:30] I will not be making any partisan statements, uh, but I would venture that most of the country would agree that our politics are somewhat worse because of social media.

[00:39:45] Um, that we have access to all the information in the world, but, uh, but 85% of it is false.

[00:39:52] Um, I, and please don't hold me to that specific number.

[00:39:55] I'm speaking for fun and hyperbole, uh, but some large number amount of it is false.

[00:40:01] Um, we're overloaded with us.

[00:40:04] We're subject to algorithms that, that by design reinforce our biases, confirmation bias, um, and push us to more extreme views.

[00:40:15] And if you're a believer that this has made our politics worse, well, markets are just voting mechanisms.

[00:40:26] They're votes where you count the votes by your dollars.

[00:40:29] And the final price is some weighted average of the votes.

[00:40:33] So why wouldn't it make our markets worse?

[00:40:36] Now, if I wanted to cheat, it's always cheating to point to the most extreme example, um, and, and act like that's the average.

[00:40:43] So I hope I'm not doing that, but just, you know, the extreme is fun to point to, uh, but I'm not saying this is the norm.

[00:40:51] Um, uh, the U S mean stocks would be an example of, you know, purely social media driven, um, kind of insane in their, both how they act and at times their valuations.

[00:41:02] Um, and I, I don't think many aside from some true believers, which are dwindling over time.

[00:41:08] Uh, I had my run-ins with, with, with this world when I, I won't say accidentally cause it was quite non-accidentally, but I mentioned we were short one on CNBC.

[00:41:18] Um, these are not people you want to, to do that too.

[00:41:22] Uh, I just, I discovered it's a much darker corner of the investing universe than I actually knew about, but call them the extreme example.

[00:41:30] Again, life in general and investing is more often a continuum than discrete.

[00:41:36] It's not, I don't think they're, they are themselves in a vacuum and everything else is just normal.

[00:41:43] Um, you know, and then throw in other things, 24 hour gamified trading on your phone, where when you buy, you get a smiley face.

[00:41:50] When you sell, you get a, uh, a frowny face or confetti cut confetti coming down on the screen.

[00:41:56] If you are up and you can trade it at 2 AM on a Saturday.

[00:42:00] Um, I, I don't know how old your kids are, even if you have kids actually,

[00:42:04] but when your kids hit teenage years, almost all of us eventually say something along the lines of nothing good happens after midnight.

[00:42:13] Um, and we mean in a very different sense, but if, if you need five more shares of Nvidia at 2 AM on a Saturday,

[00:42:21] you might reconsider your whole investment plan.

[00:42:25] Um, so I do think this environment has made things less stable.

[00:42:30] I think the first.com bubble coincided with the ride and, and the fellow graybeards listening to this will be the only ones who remember this.

[00:42:39] Uh, but coincided, uh, with, uh, message boards becoming extremely popular that call that proto social media.

[00:42:46] They were largely text.

[00:42:47] They looked very low tech today, but a huge amount of the.com bubble to my remembrance.

[00:42:54] I was watching it live seem to take place on these where Pete and it was huge confirmation bias.

[00:43:00] Um, one of the funnier things is I asked compliance at AQR back then a few times.

[00:43:06] Can I post on these?

[00:43:07] And they were like, that's not a good idea.

[00:43:08] Really bad idea.

[00:43:10] Finally, they let me post one purely hypothetical question.

[00:43:14] I, I, I was talking about Cisco systems, which was one of the darlings at the time they were selling huge cap, huge earnings selling for a hundred P.E.

[00:43:24] Um, you know, if you have micro earnings or no earnings, uh, infinite or super high P can be justified because you're at that stage, much harder to justify when your earnings are gigantic.

[00:43:36] Um, and so that was one of, uh, the examples of things I thought were very overvalued.

[00:43:43] I cautioned that any single stock could end up being worth it.

[00:43:47] You look at the.com bubble, Amazon ended up being worth it.

[00:43:50] Almost everything else didn't.

[00:43:52] So even Cisco could have ended up being worth it.

[00:43:55] I posted on a Cisco message board again, compliance approved hypothetical question.

[00:44:02] You all seem perfectly comfortable with this at a hundred P.E.

[00:44:07] at how much would the price have to change tomorrow for you to sell it?

[00:44:13] And I'm looking implicitly for, well, a hundred P.E.

[00:44:17] I have a model.

[00:44:18] I think it's reasonable.

[00:44:19] It would not be a reasonable model, but I can imagine someone making one up, but a 200 P.E.

[00:44:25] I'd be out.

[00:44:26] That can't be a good investment or whatever.

[00:44:29] Call it a thousand P.E.

[00:44:30] I was looking at a number.

[00:44:32] Only answers I got were the other direction.

[00:44:36] If, oh, if it's down 30%, I'd be out.

[00:44:38] And I was like, oh God, I asked a value answer and I got a momentum answer.

[00:44:45] So, you know, and this round certainly coincided and it's been around for a while, so it didn't

[00:44:52] start immediately.

[00:44:53] But a huge amount of the 19 and 20, in particular blow off top for expensive versus cheap, took

[00:45:01] place on the internet and in discussion forums and in Reddit.

[00:45:05] I spent as little time on Reddit as possible in my life.

[00:45:10] I think that's a good idea.

[00:45:13] But I think these are part of it.

[00:45:15] I think they've made our political discourse less rational and less rational.

[00:45:20] Again, I'm not being partisan in all directions.

[00:45:22] I think it's made it less rational.

[00:45:24] You're only talking to people who agree with you.

[00:45:26] You get more surprised by results because you're not talking to anyone who disagrees with

[00:45:31] you.

[00:45:31] And I do think the same forces have made our markets, again, not basket cases.

[00:45:35] Again, I only have a better way to allocate resources, but I think they've made our markets

[00:45:40] less efficacious, less efficient than they used to be.

[00:45:45] So is this like Yahoo Finance message boards?

[00:45:48] Yeah, but way back when that was the big one, I think.

[00:45:51] I've tried to block out that period mostly.

[00:45:53] So I remember my stories, but not the specifics.

[00:45:56] As I get older, I'm fond of saying I remember two periods well, the last two weeks and high

[00:46:02] school.

[00:46:03] Everything else in between is just a little bit of a blur.

[00:46:10] Well, I guess we're not going to find out what that sweet Yahoo Finance handle was then.

[00:46:14] Oh, no.

[00:46:16] No, no.

[00:46:17] I'm not going to share that.

[00:46:18] It was probably mildly embarrassing.

[00:46:23] It had the word bear in it.

[00:46:25] I'm actually trying to remember.

[00:46:27] It had something bear.

[00:46:28] I was trying to be honest about my views.

[00:46:29] There's like reasonable bear or rational bear or something along that line.

[00:46:35] Okay.

[00:46:36] That's a good thing to post a question like that on the Cisco boards.

[00:46:40] What about for like, and I'm thinking both from AQR's perspective, but also from shareholders

[00:46:46] and whatever else.

[00:46:48] How do you think about like pursuing factor investing strategies now in 2024?

[00:46:54] What does this mean for us?

[00:46:56] Is it just get comfortable with the discomfort and know what you just said?

[00:46:59] I think that's half of it.

[00:47:01] I think get comfortable with the discomfort.

[00:47:03] I think the more you talk about it, I have a presentation where I talk about, and in the

[00:47:08] paper, I talk about how to get more comfortable, how to, but it's hard, right?

[00:47:12] Because I'm effectively saying, you know, holy grail of finance is to get more long-term.

[00:47:17] And in some sense, I'm just saying, get more long-term.

[00:47:21] Don't obsess about the short-term as much.

[00:47:23] So it is far easier said than done.

[00:47:26] Mostly, I'm just trying to be honest with people.

[00:47:28] I think the payoffs are bigger and the extremes will be bigger.

[00:47:31] Though I do think the very act of discussing that up front, ex-ante, will make tolerating

[00:47:40] it when it, you know, I'm not predicting it happens again tomorrow.

[00:47:42] It could be 20 years again.

[00:47:43] It could be 50 years again.

[00:47:45] But we'll make, ultimately, if it does happen again, you'll be, you know, forewarned as

[00:47:51] forearmed.

[00:47:53] I think we've now seen two episodes of this.

[00:47:55] And as I've said in other forums, I'm keeping the receipts.

[00:48:00] You know, business-wise, it was still quite difficult.

[00:48:04] But for our own ability to stick with it and keep confidence in what we do, we were open-minded.

[00:48:11] We did listen to every possible story for why this time is different and it's never coming

[00:48:16] back.

[00:48:17] And ultimately, we rejected those stories, but not after taking them seriously.

[00:48:20] But having lived through the movie once before and seeing how it ended, it did make it considerably

[00:48:27] easier, at least for me.

[00:48:29] Maybe not emotionally every day, but in terms of keeping intellectual confidence.

[00:48:35] Yeah.

[00:48:36] The second time is easier than the first and the third time should be easier than the second.

[00:48:41] So I think number one is do everything you can to, before the fact, get more long-term.

[00:48:47] And one major thing you can do is look at history and say, you know, we've seen this happen a

[00:48:51] few times before and we've seen how it ends.

[00:48:56] I think the second is, I hope I don't sound like a hypocrite here, but we're also savagely

[00:49:03] pursuing things that would make us less dependent on this cycle.

[00:49:07] We think, and I'm going to do a little commercial for our stuff here, I apologize, but we think

[00:49:12] we've radically improved what we do in trend following, moving into very esoteric markets,

[00:49:17] fundamental and price trends.

[00:49:18] We think those hold up a lot better than pure rational investing at times when there's

[00:49:23] irrationality going on.

[00:49:25] We've moved more, like many quants have, into the realm of alternative data and machine learning

[00:49:32] and sometimes those two combined.

[00:49:34] And some of those overlap with what I've been calling rational investing, but some are considerably

[00:49:39] more short-term and idiosyncratic.

[00:49:41] So I am, again, I hope this is balanced and common sense, not hypocritical.

[00:49:49] But with one voice, I say, get more comfortable with discomfort, as you said, you will be paid

[00:49:57] for it.

[00:49:57] The other, I say, if you can make money in other ways, and I think we can, then a portfolio

[00:50:03] of the two can be better.

[00:50:06] And the first one can be easier to stick with during the downturns, because it's not your

[00:50:10] whole world.

[00:50:11] It's two-thirds of your world, half your world.

[00:50:14] So I am very optimistic about the future.

[00:50:19] But that doesn't mean I'm not hopeful that it will be my descendants at AQR who have to

[00:50:26] live through the next one.

[00:50:28] I've done my time in bubble land.

[00:50:31] As we move to the back part of the podcast, we just had a few different issues that we talk

[00:50:34] about a lot on the podcast we wanted to ask you about.

[00:50:36] And the first, since we're a nerdy quant podcast, we have to ask about a nerdy quant paper.

[00:50:39] But we want to ask you about this paper by Andrew Chen and Alejandro Lopez Lira.

[00:50:43] We've had them on the podcast.

[00:50:44] And this plays into the idea of, do factors have to be intuitive?

[00:50:48] And they looked at three types of factors.

[00:50:50] Factors with a risk-based explanation, factors with a behavioral explanation, and factors with

[00:50:54] no explanation.

[00:50:55] And they started, they tested them up into the 90s, and then looked at them out of sample

[00:50:59] and saw how they worked going forward.

[00:51:01] And they really didn't see a difference between the behavioral and risk-based ones and the ones

[00:51:05] that had no explanation.

[00:51:06] So I was wondering if you just comment on this idea, do factors have to be intuitive to

[00:51:10] work going forward?

[00:51:11] This is really interesting.

[00:51:13] I've only paged through the paper, but a lot of things, I'm lazy these days, and I'm

[00:51:19] old.

[00:51:19] So a lot of times I send this to, I have a literal macro email address called academics

[00:51:26] at AQR, of which we have quite a few, that I will occasionally say, give me the too long

[00:51:31] didn't read version of this paper.

[00:51:34] So I don't want to claim to be an expert on it.

[00:51:36] But it's a really cool paper.

[00:51:38] I think there's a lot more to be done.

[00:51:39] I'm not willing to throw away intuition tomorrow.

[00:51:43] But I will note, first of all, you have to remember, and they're very clear about this.

[00:51:48] So it's not a criticism of them.

[00:51:50] But you have to remember their factors without explanation were still dealing with economic

[00:51:56] data, returns, accounting information.

[00:51:59] They weren't sunspots.

[00:52:01] They weren't the famous data mining example at Max Darnell at First Quadrant.

[00:52:06] Max Darnell knows a different guy at First Quadrant.

[00:52:08] Did many years ago that butter production in Bangladesh helps predict, is the best predictor

[00:52:14] of S&P returns the next year or something.

[00:52:17] I always thought he might have cheated on that just to create a funny one.

[00:52:22] But, you know, so they're not dealing with ridiculous data, which would be much more extreme.

[00:52:29] I'm unwilling at this point to say we should throw out intuition.

[00:52:34] Intuition or guardrails around things.

[00:52:37] But I will say, separate from their findings, the rise of machine learning, even us building

[00:52:47] something we've done in the last five years, a far more systematic Bayesian approach to allocating

[00:52:52] among factors where we let the data speak more, has pushed us.

[00:52:59] These are made up numbers just as for a concept.

[00:53:02] But AQR has always prided itself on being, relying on both, economic intuition.

[00:53:09] And that's any good story.

[00:53:12] It could be behavioral.

[00:53:13] It could be risk.

[00:53:14] It could even be more common sense kind of thing.

[00:53:19] And data roughly equally.

[00:53:22] The rise of better statistical techniques.

[00:53:27] It's pushed us, I don't know, two-thirds, one-third data.

[00:53:29] Data, we're moving in the direction of that paper.

[00:53:33] And that is a little hard for me.

[00:53:35] When you've touted something for many years and you've got to go, no, our philosophy is going

[00:53:41] to change a little bit.

[00:53:42] But if the data science gets better at doing its job, our intuition and our theoretical

[00:53:52] models ain't getting better.

[00:53:53] So, you know, I think the old Keens, if the facts change, I change my mind.

[00:53:58] What do you do, sir?

[00:53:59] I'm unwilling on one paper to throw out intuition.

[00:54:06] But their paper is really interesting.

[00:54:09] And for maybe some different reasons, we have been moving at least a decent step in that direction

[00:54:17] anyway.

[00:54:17] I mean, there are some fascinating results, a day of the week momentum where the day of

[00:54:22] the week years ago that something has gone up seems to have efficacy for predicting the

[00:54:27] day of the week going forward.

[00:54:30] That I'm willing to admit the results are so strong that I'll do at least a little risk

[00:54:37] without theory.

[00:54:38] One way to think about 50-50, even in the old days, is 50-50 doesn't require both.

[00:54:45] 50-50 says if you don't have one, the other better be massively good.

[00:54:52] And, you know, if you create a strategy that's non-ridiculous, not super high turnover, butter

[00:54:57] production in Bangladesh, search everything, but it's based on economics and has incredibly

[00:55:03] high sharp ratios we can't explain.

[00:55:06] Yeah, I'd probably take a little risk on that, just not as much as if I had a story to go

[00:55:11] with it.

[00:55:11] Going the other way, to be honest, I probably wouldn't.

[00:55:14] You could have the best theory in the world.

[00:55:17] The capital asset pricing model might be one of the best theories in the world.

[00:55:20] Makes perfect sense that your contribution to risk of a portfolio, of a diversified market

[00:55:27] portfolio, not your idiosyncratic risk, should drive the required expected return.

[00:55:33] It just is a spectacular failure for 75 years everywhere it's been tried.

[00:55:39] So I'm willing to short that theory.

[00:55:41] I think we have good reasons.

[00:55:43] That's the famous betting against beta factor.

[00:55:45] I think leverage limitations or lottery preferences are actually a pretty good behavioral story.

[00:55:50] So that's not quite the example from this paper where there's no story.

[00:55:55] But it's always been a mix of the two.

[00:55:57] And maybe this paper pushes me even a little further, but only in a direction that we were

[00:56:03] already voluntarily going.

[00:56:05] And I'm a little mad at myself for resisting it for a while, but a little proud of myself

[00:56:10] that approaching 60, I can slightly change my philosophy.

[00:56:16] Slightly.

[00:56:18] Well, thanks, slightly.

[00:56:19] And so this, I want to go back to, you said this a little while ago, and now I'm asking

[00:56:23] you at approaching 60 and me approaching mid-40s here.

[00:56:27] Inflation is this thing.

[00:56:28] You said, I can remember stuff two weeks ago and when I was in high school.

[00:56:32] Inflation is barely two weeks ago in my life that I saw an uptick of it.

[00:56:35] Yeah.

[00:56:35] And it definitely wasn't happening when I was in high school in the 90s.

[00:56:38] Well, we went to a different high school.

[00:56:41] We went to a different high school.

[00:56:42] That's a different movie.

[00:56:44] How, as allocators, like how do we think about just inflation across asset classes and all

[00:56:50] that?

[00:56:50] Sure.

[00:56:51] Well, it is funny.

[00:56:53] Inflation was certainly, in elementary school for me, was huge.

[00:56:58] The price of comic books went from 20 cents when I started buying them to 65 cents when

[00:57:04] I stopped buying them, which obviously the comic book measure is the most relevant measure

[00:57:09] to most of America.

[00:57:10] That's the only number we recognize on excess return.

[00:57:13] Yeah.

[00:57:13] You know, the USA Today uses Big Macs.

[00:57:16] I use comic books.

[00:57:19] You know, let's also diminish expectations here.

[00:57:24] I'm not a macroeconomist.

[00:57:26] I'm not sure if I'm admitting that or bragging about it.

[00:57:30] But inflation, you know, predicting inflation and its effects are not my number one goal.

[00:57:36] When we build portfolios, they're at least in the individual stock world, which is still

[00:57:42] the single largest source of risk we take.

[00:57:44] We're trying to be pretty neutral to everything.

[00:57:47] You can never be perfectly neutral to everything, even ex ante, but certainly ex post.

[00:57:51] But we are trying pretty hard not to take a market bet, an inflation bet.

[00:57:56] So mostly what I do in my real life is run from having to have an opinion on this.

[00:58:01] But, you know, the inflation we saw at its peak.

[00:58:06] You know, after the Ukraine invasion, after the various monetary and certainly the giant

[00:58:12] fiscal stimulus, as we had seen, and everyone can fight about exactly what caused it and

[00:58:17] politics get involved, get involved there.

[00:58:20] You know, that was certainly abnormal and markets reacted quite poorly to it.

[00:58:24] That was 2022.

[00:58:26] The inflation we have now is still above the Fed's target.

[00:58:29] It's, you know, roughly three instead of two.

[00:58:32] But it was the inflation we had post-GFC that was abnormal.

[00:58:37] If abnormal is bad in some sense that maybe historical relationships won't hold, I think that's

[00:58:44] exaggerated too.

[00:58:45] I don't think inflation was the key driver behind crazy craziness.

[00:58:50] I think negative real rates for a while helped drive people crazy.

[00:58:54] That was actually reason two in my paper.

[00:58:57] And just to parenthetical that one for a second, I have no theory for that other than paying

[00:59:03] people negative real on their cash for an extended period drives them mad.

[00:59:08] They end up doing some silly things.

[00:59:12] But I think the inflation environment now looks a lot more like the last 100 years of history

[00:59:19] than the prior 10 years before the bout of inflation.

[00:59:23] I just think we all got used to zero.

[00:59:27] And zero is not normal.

[00:59:29] Three is pretty, this is a technical term, but three is pretty freaking normal.

[00:59:35] So I don't think it's, you know, another bout of severe inflation.

[00:59:40] Yeah, that's going to royal asset classes for a while.

[00:59:45] But I don't think it's that big a deal at this point.

[00:59:47] I think it's faded as an issue.

[00:59:49] And I think we're, you know, prices are still high.

[00:59:51] We saw that in the election.

[00:59:53] Obviously, people are, you know, a lot of individuals focus on the price level, not the change in

[00:59:58] inflation.

[00:59:59] And that's not entirely crazy, by the way.

[01:00:02] If you put me in 130 degree room and you stop raising the temperature and you tell me you should

[01:00:08] feel great because I've stopped raising the temperature, you're like, you know, you haven't

[01:00:12] lowered the temperature.

[01:00:13] So I get why people were upset about that.

[01:00:15] But as an investing environment going forward, I think, you know, and obviously with the change

[01:00:21] in administration, we could have a lot of weird things.

[01:00:24] We could have good tax reform.

[01:00:26] We could have lousy tax reform.

[01:00:27] We could have giant tariffs.

[01:00:29] There are macro events that could happen out there.

[01:00:32] But as of now, I see the macro environment is pretty good and pretty normal.

[01:00:37] With that caveat that I am not a qualified macro economist, I will tell you one anecdote

[01:00:43] about that.

[01:00:44] I don't think I'll do it again, but probably four times in my career, I thought I need to

[01:00:49] know more about macro economics.

[01:00:51] I have a PhD in financial economics and you pick up some of it, but I'm really macro adjacent.

[01:00:57] You're not an expert in macro.

[01:00:59] And I'd always go back and four times I've gone back and kind of cover to cover, read one

[01:01:04] of the famous macro texts.

[01:01:05] And I've done that across the political spectrum.

[01:01:08] Maybe the extremes being Robert Barrow on the right and Paul Krugman on the left.

[01:01:14] And at the end of a fair amount of work, I go, well, I've put in a lot of work for about

[01:01:20] a month and a half.

[01:01:21] I still don't understand macro, but I'm reconvinced that they don't either.

[01:01:28] So I'll end with a little cynicism on the whole endeavor.

[01:01:33] I want to ask you briefly about market concentration because this is something we've talked about

[01:01:36] a lot in the podcast as well.

[01:01:37] This idea that obviously the Mag 7 are a very large portion of the S&P.

[01:01:41] And if you go back historically and look at the top 10 companies in the S&P decade to

[01:01:45] decade, it usually changes a pretty good amount.

[01:01:47] But a lot of people are arguing now things are different.

[01:01:50] These companies have such a big technology advantage.

[01:01:52] They can invest in AI a lot more than other companies can, so they're not going to be caught.

[01:01:57] How do you think we should look at that?

[01:01:59] The idea that it has changed a lot historically and contrasted with this idea that maybe right

[01:02:03] now these companies have a huge advantage that other companies historically didn't have.

[01:02:06] Again, I will admonish you.

[01:02:09] You're asking a quant, a non-quant question.

[01:02:13] You know, seven companies is, it's not quite as bad as saying you're short AMC on CNBC.

[01:02:22] But I'll answer the question with that caveat.

[01:02:26] First, I'll recommend you, if your listeners are not following Owen Lamont of Acadian's blog,

[01:02:34] they should.

[01:02:35] You know, the last thing I ever want to do on earth is praise competitors.

[01:02:39] Now, I hope I'm actually pretty good at that.

[01:02:41] But it's incredibly insightful.

[01:02:43] He's a brilliant guy.

[01:02:44] And I'm going to trust him on this.

[01:02:47] Concentration is high today, but we've seen it before.

[01:02:50] And the effects of it are not disastrous and they're not clearly one direction or another.

[01:02:58] I think mechanically they're correlated with wide value spreads.

[01:03:03] You know, some things are being valued very high.

[01:03:05] It would be pretty odd if that were only showing up in seven stocks.

[01:03:08] So maybe that's not mechanical, but it's, I think they have been correlated with that.

[01:03:14] Regarding these seven specific stocks.

[01:03:16] Now, here's where I got to be very careful.

[01:03:18] I think on average, the success long term, the still success long term, even with the last few years of first pain and then huge comeback of value-based investing.

[01:03:31] I think the main explanation is behavioral.

[01:03:36] I think it's that some companies should be worth more, some companies should be worth less, but the market goes too far.

[01:03:43] I think it largely gets the direction right, but the magnitude wrong.

[01:03:47] One of the massive footnotes to my last paper looks at the predictive power of the cross-section of different valuation ratios for next three or five year growth.

[01:03:59] And it shows that on average, the expensive outgrow the cheap.

[01:04:03] Yet you still win by being underweight, the expensive on average, because they don't outgrow by as much as is in the price.

[01:04:11] Therefore, based solely on this, if you held my feet to the fire and said, I have to bet my life on the mag seven, I'd say on average, when people assume, as they've done many times, that this time is different and these firms will outgrow forever.

[01:04:28] At magnitudes enough to justify their already fairly massive valuations.

[01:04:35] I would take the other side of that, but I would bet a trivial amount of my portfolio on seven stocks.

[01:04:43] You know, I'm sorry if this is useless as a trading strategy, but if it's useful in a don't bet all of your portfolio on this sense, you know.

[01:04:53] So someone in compliance, by the way, in my in my year, if they were listening, which I don't think they are.

[01:04:59] I think they'll see it after the fact. They'd be thinking, don't tell people not to do it because someone's going to not do it.

[01:05:05] It's going to work out and they're going to sue you for telling them not to do it.

[01:05:09] So let's do the standard. This is not investment advice, even though we know it really is.

[01:05:14] No one should listen to me.

[01:05:17] I may be crazy. I probably am crazy.

[01:05:20] But all is equal. Again, if you held my feet to the fire, I would bet against them being as a portfolio of seven.

[01:05:27] I feel stronger than any one, but still not that strong.

[01:05:31] It's still only seven. So I would take the other side.

[01:05:34] But I would I would bet a very small amount of my capital on any seven stocks, no matter how crazy.

[01:05:42] You could have gone broke shorting Amazon at the absolute peak of the crazy.

[01:05:49] So be interesting. I haven't done the exercise saying if you'd equally weighted shorting seven, could you have gone broke?

[01:05:53] Where there are another six that that were good enough that they would save you.

[01:05:58] Maybe I'll go back and look at that.

[01:06:02] I'm really interested in the position sizing comment that you made in there, but I want to steer it into the context of the in praise of high volatility.

[01:06:09] Oh, OK.

[01:06:10] It was paper that you wrote.

[01:06:11] And I want to talk about this because I think especially for the asset allocators like watching this, that is a really interesting concept, both in praising high volatility, how you put it in, how you position size it and the rebalancing part.

[01:06:26] Sure.

[01:06:26] Talk a little bit about what's in that paper.

[01:06:28] Well, first of all, I have to say this paper is almost diametrically opposed to my prior discussion that it's going to be wilder and occasionally harder to do rational investing.

[01:06:41] Their pain is going to be larger and last longer.

[01:06:43] It's just, I think, going to pay you more long term.

[01:06:46] And now my next thing I wrote after that is you should invest in more aggressive versions of this would exacerbate all of that.

[01:06:53] So let me give the honest, strong caveat only if you think you can take it.

[01:06:58] But here's why higher volatility alternatives.

[01:07:02] And here I mean truly uncorrelated assets, attempted uncorrelated assets where you're long, a very diversified portfolio of attractive, short, a very diversified portfolio of unattractive stocks, whatever your model might be for attractive and unattractive.

[01:07:18] And you're trying to create an uncorrelated return stream from that by the longs beating the shorts, but uncorrelated because you're as short as you are long.

[01:07:28] As you know, I get my backup over alternatives.

[01:07:31] I think they should be some degree of really hedged.

[01:07:37] You might love private investing for a lot of reasons, but you shouldn't love it because it's uncorrelated.

[01:07:42] They're just beta of one or larger assets.

[01:07:45] So I'm talking about true alternatives.

[01:07:48] One critique of them has always been, yeah, even if they're good, they don't move the dial enough.

[01:07:56] They tend, most of the products that are being created are targeting modest fall, modest excess returns.

[01:08:05] They're probably doing that for the reason we've discussed, that these things can be hard to stick with when they're out of favor.

[01:08:10] Even before things getting crazier, they can be hard to stick with.

[01:08:14] If it's too modest, allocating to them out of, say, equities or even 60-40 doesn't necessarily raise and can even lower the expected return of the portfolio.

[01:08:29] If it's well-constructed and it really has a positive expected return with zero correlation, it should raise the Sharpe ratio of the portfolio.

[01:08:38] But the old adage, you can't eat risk-adjusted returns.

[01:08:43] I think there are ways to eat them, but this is not the way.

[01:08:47] Adding something that lowers expected return is often just not what people are looking for.

[01:08:52] It's nothing to sneeze at, by the way.

[01:08:53] Say, if you lower expected return but raise Sharpe ratio, that's lowering volatility more than you lowered expected return.

[01:09:02] Some might actually like that tradeoff.

[01:09:03] So I still think those assets have a role.

[01:09:07] But a higher volatility alternative.

[01:09:11] It's still trivial risk in terms of your whole portfolio.

[01:09:15] If you take normal numbers, I'm going to put 1-2% of my portfolio in this alternative asset that's uncorrelated to my main portfolio.

[01:09:25] Double the vol.

[01:09:26] It's still going to move the vol of your whole portfolio a trivial amount.

[01:09:30] If you're myoptically focused on this one-line item of this alternative, yeah, it'll freak you out occasionally.

[01:09:37] But if you're a cold-hearted Vulcan and you're just being rational, it's not changing your portfolio very much.

[01:09:46] Now, the reason rebalancing is important, particularly for high vol, is an example I use in the paper.

[01:09:54] Imagine you're offered a trade and you're never really offered this.

[01:09:58] So, you know, this is God coming down with a burning bush and telling you, here's the deal.

[01:10:03] Once a year, you can put as much of your portfolio as you want in a bet that two-thirds of the time doubles your money

[01:10:10] and one-third of the time you lose all your money.

[01:10:14] Well, I contend that a rational investor would not put 100% of their money in this portfolio.

[01:10:23] To put it a little facetiously, negative 100% returns tend to affect your lifetime compound returns for a long time.

[01:10:32] You could actually argue a lot of you get to start over, declare bankruptcy.

[01:10:36] I don't want to get into that.

[01:10:37] Negative 100 is something most people probably wouldn't risk.

[01:10:41] I think a rational investor would always put something.

[01:10:43] This is a wonderful risk-adjusted return.

[01:10:46] What they should do is figure out what the right number is, and I'm not going to tell them what that is,

[01:10:50] but put X percent of the portfolio in this, and then every year, reload.

[01:10:56] One-third of the years, you're going to be disappointed.

[01:10:58] Two-thirds of the years, you're going to make money.

[01:10:59] It's going to make your portfolio better.

[01:11:02] Reloading is rebalancing in this case.

[01:11:04] It's just going back to that same percentage.

[01:11:08] Alternatives, or traditional parts of the portfolio for that matter, but high-volal alternatives are at least starting to look like that direction.

[01:11:16] Sometimes they're going to go up 30% in a year.

[01:11:18] Sometimes they're going to go down 30% in a year.

[01:11:23] In both directions, it's not just a commercial, you know, stick with AQR when we're having a tough year.

[01:11:29] You know, no money manager ever enjoys a client taking their money back, but my favorite redemption on earth is, of course, you've made me so much money.

[01:11:38] You're too big a part of the portfolio.

[01:11:40] I'm taking it back.

[01:11:42] And I usually think that's still a bad idea.

[01:11:45] You didn't have enough to begin with because I'm a little biased to us, but that's a person who's thinking about it right.

[01:11:54] Right.

[01:11:55] So, you know, if you have a high-volal alternative and never rebalance, it's either going to zero in the portfolio or going to way too big an amount in the portfolio.

[01:12:04] Obviously, the hard part is to add when it's down, but it's absolutely what you should do.

[01:12:12] How practical this advice is and how many people can do it, that remains to be seen.

[01:12:16] And I'm quite clear in the piece.

[01:12:18] I know I'm asking a lot of people, but I think you want to start from what is mathematically correct and then ask the question, can I really do it?

[01:12:29] And if so, how much of it can I do?

[01:12:33] I think sometimes we let the investing cliches.

[01:12:37] It's better, you know, being early is the same as being wrong.

[01:12:41] The market can stay irrational longer than you can stay solvent.

[01:12:45] We let the tail wag the dog.

[01:12:47] We let the cliches let us out of the tough job of building and sticking with the best portfolio.

[01:12:54] So the cliches are cliches for a reason, but that shouldn't mean we abandon trying to do the right thing.

[01:13:01] And I'm just trying to start people at what I think is the cold Vulcan-like right thing and then work backwards to how much you can do.

[01:13:09] As we wrap up, we have a standard closing question we ask all of our guests, which is based on your experience in markets, if you could teach one lesson to the average investor, what would that be?

[01:13:16] Look at your portfolio as little as possible.

[01:13:19] Probably 20 of your other people have said the same thing, but that just means it's true.

[01:13:26] Particularly for what you call the average investor.

[01:13:31] I think there have actually been studies on this, but just intuitively, you know whoever looks at it more loses.

[01:13:41] I don't know what the right frequency.

[01:13:43] I can't imagine someone not checking once a year.

[01:13:45] How's it going?

[01:13:46] But perceive risk when you look frequently.

[01:13:51] By the way, I think dance is a little different for professionals.

[01:13:56] I have to look at how we're doing each day.

[01:13:58] It's just a little weird if one of my clients calls and goes, oh, big event happened today.

[01:14:02] How are you guys doing?

[01:14:02] And I go, I don't know.

[01:14:05] That's just a little odd.

[01:14:07] But I'm a hypocrite.

[01:14:09] I look at it all day.

[01:14:11] When I'm in the office, I look at it all day.

[01:14:13] When I'm out of the office, I'm actually much better.

[01:14:15] I can check it on my phone, but I just do it a lot less.

[01:14:20] But I will tell you myself, and if anyone should be aware of these biases, I'm up there with people who should be.

[01:14:30] I don't know if I'm going to tell you I'm not that good at it, which is embarrassing.

[01:14:33] But if we have a day where we've been up, we've been down, we've been up, we've been down, and we ended up flat, I feel like it's been a bad day.

[01:14:42] The downs hurt me more than the ups made me feel good.

[01:14:46] The formal term for that is prospect theory, and it applies intraday.

[01:14:50] My perception of how crazy the world is is probably larger than it really is.

[01:14:56] So to the extent people, you know, once a year make sure your money wasn't embezzled or something, that's probably a good idea.

[01:15:05] But much more than that, no one will probably get to that.

[01:15:10] But if you're looking daily, look weekly.

[01:15:12] If you're looking weekly, look monthly.

[01:15:13] If you're looking monthly, go further out the spectrum.

[01:15:17] Certainly the individual investor and most professionals, including me, don't have a lot of short-term predictive power.

[01:15:23] And their instincts are probably to do the wrong thing, to sell at the bottom and buy at the top.

[01:15:28] So look less would be my one-liner.

[01:15:33] Thank you, Cliff.

[01:15:33] This has been awesome.

[01:15:34] We really appreciate your time.

[01:15:35] Oh, I had a really good time.

[01:15:36] These were great questions, and it was a lot of fun.

[01:15:38] Thank you, man.

[01:15:38] This is Justin again.

[01:15:40] Thanks so much for tuning in to this episode of Excess Returns.

[01:15:43] You can follow Jack on Twitter at Practical Quant, and follow me on Twitter at JJ Carboneau.

[01:15:49] If you found this discussion interesting and valuable, please subscribe in either iTunes or on YouTube, or leave a review or a comment.

[01:15:57] We appreciate it.