Bogleheads® on Investing Podcast Episode 043: Eduardo Repetto on factor investing, host Rick Ferri

00:00:00.000 | [MUSIC PLAYING]

00:00:10.480 | Welcome, everyone, to Bogle Heads

00:00:12.020 | on Investing, podcast number 43.

00:00:15.040 | Our guest this month is Eduardo Ripeto, Chief Investment

00:00:19.600 | Officer of Advantis Investors and former Chief Investment

00:00:23.760 | Officer and Chief Executive Officer of Dimensional Fund

00:00:27.640 | Advisors.

00:00:30.120 | [MUSIC PLAYING]

00:00:37.560 | Hi, everyone.

00:00:38.240 | My name is Rick Ferry, and I'm the host

00:00:40.040 | of Bogle Heads on Investing.

00:00:42.080 | This episode, as with all episodes,

00:00:44.640 | is brought to you by the John C. Bogle Center

00:00:47.080 | for Financial Literacy, a 501(c)(3) nonprofit organization

00:00:52.960 | that you can find at boglecenter.net.

00:00:57.400 | Your tax-deductible contributions

00:00:59.280 | are greatly appreciated.

00:01:01.040 | The Bogle Heads investment philosophy

00:01:02.920 | is to keep it simple, and that usually

00:01:05.320 | means starting a portfolio with a total stock market index

00:01:09.560 | fund, a total international index fund,

00:01:12.920 | and a high-quality fixed income allocation of some type.

00:01:16.760 | For most investors, this is all they

00:01:18.640 | need to achieve their financial objectives.

00:01:21.880 | Sometimes I'm asked, what's next?

00:01:24.980 | What's beyond a total stock market and a total international?

00:01:28.680 | And my answer is, if you wish to take a little extra risk

00:01:32.200 | in your portfolio for the potential of a higher return,

00:01:36.040 | then look at small-cap value investing.

00:01:39.800 | But not just any small-cap value fund or small-cap value index

00:01:43.680 | fund.

00:01:44.200 | You want a fund that's low-cost and highly concentrated

00:01:48.560 | in small-cap value factors.

00:01:50.780 | The company that pioneered small-cap value investing,

00:01:54.480 | using concentrated factor strategies,

00:01:56.920 | was Dimensional Fund Advisors, more commonly referred

00:02:00.440 | to as DFA.

00:02:02.320 | Eduardo Rapeto, our guest today, was the chief investment

00:02:06.120 | officer and the chief executive officer of DFA until 2017.

00:02:13.440 | Then in 2019, Eduardo joined Advantis Investors,

00:02:17.880 | a new company by American Century Investors,

00:02:20.920 | where he became the CIO and continued

00:02:23.680 | to refine factor strategies for their ETFs, mutual funds,

00:02:27.720 | and directed accounts.

00:02:29.080 | Whether you believe in this or not,

00:02:30.600 | or whether you want to include it or not,

00:02:32.360 | this is a very interesting discussion

00:02:34.840 | as we go behind the scenes with one of the brightest

00:02:37.280 | minds in the industry.

00:02:39.080 | With no further ado, let me introduce Eduardo Rapeto.

00:02:43.480 | Welcome, Eduardo.

00:02:44.760 | I really appreciate you coming on the Bogle Heads

00:02:47.000 | On Investing podcast today.

00:02:48.520 | Oh, it's a pleasure.

00:02:49.400 | It's always a pleasure to speak with you.

00:02:51.640 | Thank you.

00:02:52.400 | We kind of go back a ways.

00:02:53.560 | I can remember being in your office at DFA,

00:02:56.120 | pleading with you to start ETFs at DFA.

00:03:00.080 | That was a few years ago.

00:03:01.760 | That's probably 10 years ago or something like that.

00:03:03.920 | I don't remember.

00:03:04.840 | It was a while back.

00:03:05.800 | Yeah, yeah, I remember.

00:03:07.680 | Anyway, now both DFA and your new company have ETFs.

00:03:12.680 | So before we go down that road, let's

00:03:15.440 | talk a little bit about your very interesting background.

00:03:19.040 | Go back as far as you would like to tell us

00:03:23.160 | how you got to go from where you started to where you are today.

00:03:28.600 | So yeah, I have a weird background.

00:03:30.800 | The first thing is I was born in Argentina.

00:03:33.200 | Argentina, if you know, was a developed market.

00:03:35.880 | Then it was an emerging market.

00:03:37.560 | Then it was a frontier market.

00:03:39.000 | And I don't think it's a frontier market anymore.

00:03:41.480 | It's not even that.

00:03:43.120 | But I was always a geek, so liking numbers and whatnot.

00:03:47.440 | I studied engineering, then I got a master's at Brown

00:03:50.680 | in engineering, mechanical engineering.

00:03:52.920 | And then I got a PhD from Caltech here in California

00:03:57.040 | in aeronautical engineering.

00:03:59.480 | Let me interrupt you because you didn't just get a PhD.

00:04:02.280 | You won the Ballhouse Prize for the best PhD thesis

00:04:06.320 | of the year.

00:04:06.840 | I mean, you were a prodigy.

00:04:09.120 | But sometimes you have to be lucky in life.

00:04:11.360 | Let's put it that way.

00:04:12.960 | OK, all right.

00:04:14.160 | Be modest, too.

00:04:16.400 | Yeah, I was lucky.

00:04:17.920 | Look, I have an amazing advisor.

00:04:19.520 | And I was in an amazing school.

00:04:21.360 | And so look, this was a long time back in '98.

00:04:25.680 | I finished my PhD.

00:04:29.800 | And I was doing things that were extremely interesting.

00:04:33.520 | But my heart was not to continue in academia.

00:04:37.960 | I used to have a boss back.

00:04:40.520 | He was a mathematician, a PhD in mathematics.

00:04:43.400 | And he went to research in just mathematics into Wall Street.

00:04:49.880 | And he always told me, hey, you will like this.

00:04:53.440 | You will like investing.

00:04:55.280 | And you will like the whole environment and the cutting

00:04:58.320 | edge science.

00:04:58.920 | Because a lot of the things that we study in science

00:05:01.920 | are very applicable in investment.

00:05:04.840 | And so I always had that bug in my mind.

00:05:07.520 | And so I had the opportunity to switch instead

00:05:10.600 | of continue being in academia and become

00:05:13.240 | a professor and whatnot.

00:05:15.200 | And I switched.

00:05:15.960 | And so I moved into finance.

00:05:17.920 | And I got a job at DFA in the research group.

00:05:23.160 | How did you link up with DFA?

00:05:26.920 | That's the most weird thing.

00:05:29.240 | A lot of things are random in life.

00:05:30.840 | So I was at Caltech.

00:05:32.040 | And DFA was looking for someone to work in research

00:05:35.600 | with Ken French and Jim Fama.

00:05:38.040 | And I applied.

00:05:40.040 | And you apply.

00:05:41.440 | And you cross your fingers.

00:05:42.800 | And I was lucky enough that they hired me.

00:05:44.880 | And yeah, DFA was small.

00:05:46.520 | I think that I was employee 107.

00:05:49.160 | And I think that at the time, DFA had around $25 billion.

00:05:53.600 | It was a great opportunity to work

00:05:55.600 | with some magnificent people in a small company

00:05:58.720 | where you were able to get involved in basically

00:06:01.280 | all the different aspects, not only research,

00:06:03.320 | but the legal aspects of what you were doing,

00:06:05.480 | the portfolio management, the trading aspect,

00:06:07.480 | the marketing aspect.

00:06:08.400 | So it was a magnificent opportunity.

00:06:10.240 | I was lucky.

00:06:11.760 | And interesting, though, that DFA would look at you,

00:06:16.160 | given your background.

00:06:17.120 | I mean, clearly, the forward thinking

00:06:19.400 | of the David Booth and Gene Fama, Ken French,

00:06:24.000 | who were both on the board of directors there,

00:06:26.360 | decided with you, with no financial background,

00:06:30.400 | really, that you were the guy who they were going to bring in.

00:06:34.480 | And they kind of overstepped all the PhDs in economics.

00:06:39.280 | - Well, I don't know who else was applying, to be fair.

00:06:42.120 | - Oh, okay.

00:06:43.400 | - I think you're giving me more credit than I deserve.

00:06:45.880 | Look, I was living in California.

00:06:47.280 | My wife is from California.

00:06:49.080 | And the job was in California.

00:06:50.520 | So it was a perfect match for me.

00:06:52.480 | And I was very, very lucky about that.

00:06:54.840 | And I was extremely lucky to work with talented people,

00:06:58.400 | like you mentioned.

00:07:00.160 | It was like doing a second PhD

00:07:01.840 | when you start working with Ken and Gene,

00:07:03.760 | because you have to read, read, read, and read,

00:07:05.920 | and do research.

00:07:07.480 | But that's what you are trained.

00:07:09.160 | When you do a PhD from a top university,

00:07:11.920 | no matter what's the field,

00:07:14.000 | the training is training how to learn

00:07:16.560 | how to get to the cutting edge of the science,

00:07:19.360 | and then try to push it a little bit more.

00:07:21.520 | That's a PhD program.

00:07:23.360 | And so working with these professors

00:07:25.560 | was basically the same,

00:07:27.160 | getting to the cutting edge of the science,

00:07:29.040 | and then try to help pushing it a little bit forward.

00:07:31.960 | And that's what I was doing.

00:07:34.320 | - And by 2007,

00:07:36.520 | you became the co-chief investment officer

00:07:39.800 | with David Booth at DFA.

00:07:42.440 | And I think, if I'm not mistaken,

00:07:44.120 | that's probably when I first met you back then,

00:07:46.480 | about 15 years ago.

00:07:48.440 | And then in 2009,

00:07:51.960 | you became the co-CEO.

00:07:55.640 | And at this time, wasn't DFA moving to Austin?

00:07:59.480 | - Yes, DFA opened an office in Austin,

00:08:02.040 | I think 2007, yeah.

00:08:04.800 | And so I told my wife, "Let's move to Austin."

00:08:07.880 | She agreed, so we went there.

00:08:10.240 | We have three kids.

00:08:11.080 | So I became, I was CIO,

00:08:14.840 | and then became co-CEO with David.

00:08:17.120 | What's a great honor, no?

00:08:20.320 | - Sure, absolutely.

00:08:21.560 | And you got on the board of directors,

00:08:22.920 | and you became a director of the mutual funds.

00:08:25.720 | But then in 2017,

00:08:27.960 | I've heard you use the word "retire,"

00:08:29.680 | you use the word "resign."

00:08:32.040 | I mean, you decided to leave.

00:08:33.720 | - Yeah, yeah, yeah.

00:08:34.560 | So my wife is from LA, no?

00:08:37.000 | Her parents are here, LA.

00:08:40.600 | So in 2015,

00:08:44.120 | before my oldest one started high school,

00:08:47.440 | the family wanted to move back to LA,

00:08:49.720 | because the grandparents are not getting younger,

00:08:52.320 | let's put it that way.

00:08:54.560 | And if we were staying in Austin,

00:08:57.560 | we would have to stay there at least for another 10 years,

00:09:00.480 | because we have three sons,

00:09:02.840 | and we didn't want to move kids

00:09:04.880 | when they are in high school.

00:09:06.800 | So the family decided to move in 2015 to Los Angeles.

00:09:10.520 | And so I was going back and forth to Texas,

00:09:13.680 | on top of going everywhere.

00:09:16.000 | I was putting 250,000 miles a year

00:09:18.640 | between going to Texas and going everywhere around the world.

00:09:22.760 | So you see, it was probably not the right balance.

00:09:26.720 | And I was never home, never seen the family,

00:09:29.640 | and so it was not the right balance.

00:09:31.400 | So I basically resigned without any job in mind.

00:09:36.280 | You can call it "retire."

00:09:38.600 | It was not a permanent retirement, I guess, but--

00:09:41.800 | - Well, you started doing research,

00:09:44.760 | one of your papers on value and profitability

00:09:48.640 | in international and emerging markets

00:09:50.800 | that you co-wrote during this period of time.

00:09:53.680 | But around the same time

00:09:54.720 | as it was being peer-reviewed and published,

00:09:57.080 | you then decided to take a job with Avantis,

00:10:00.400 | which was a new company.

00:10:01.600 | Now, did the company form because you were coming on board,

00:10:05.760 | or did it form and then you came on board?

00:10:08.840 | - So let me speak a little bit about how all that happened.

00:10:12.240 | I was not working, but like you,

00:10:15.200 | when you work a long time in the industry,

00:10:17.360 | you get to know a lot of people,

00:10:18.760 | and people have magnificent ideas.

00:10:21.200 | And some people at American Center Investment,

00:10:23.680 | you know, in Kansas City,

00:10:25.200 | that I know them for a long, long time.

00:10:27.800 | They wanted to start something new,

00:10:29.600 | something that is more systematic, low cost,

00:10:32.240 | because there is a big need

00:10:33.360 | for something like that in the market.

00:10:35.360 | And they reached out if I wanted to help them,

00:10:37.920 | and they were willing to do it based in LA, where I live.

00:10:40.600 | So that's great.

00:10:41.880 | And one of the things that I have as a condition

00:10:44.920 | is that the investment strategies,

00:10:47.720 | let's call funds, ETF, what they were going to be,

00:10:50.320 | they have to be low fees.

00:10:52.000 | That's what they wanted.

00:10:52.840 | They wanted to start something systematic,

00:10:54.480 | organized from day one,

00:10:56.960 | so that you have all the checks and controls on cost,

00:10:59.920 | so you can be low fee and still have a very good business.

00:11:04.040 | So I agreed to work together with American Century

00:11:08.160 | and start Avantis.

00:11:10.520 | So Avantis was going to be a standalone company

00:11:12.960 | where the people in Avantis own a piece of that,

00:11:15.880 | and American Century owns another piece of that.

00:11:19.360 | But we decided not to do that.

00:11:21.080 | Why?

00:11:21.920 | Because that was going to impose more costs,

00:11:24.760 | and that was going to make us have higher expense ratios.

00:11:28.920 | So what we did is we created Avantis

00:11:31.680 | as a unit inside American Century.

00:11:34.080 | So I'm an employee of American Century,

00:11:36.280 | but I have a business card that is called Avantis,

00:11:38.360 | because we manage money different

00:11:40.400 | than the traditional American Century manager.

00:11:42.880 | And I report to the CEO of American Century.

00:11:46.600 | So we're a unit that is a little bit outside

00:11:49.280 | of American Century, but we're part of American Century.

00:11:52.360 | But all our operations, legal, compliance, HR,

00:11:56.320 | think about all the support functions

00:11:58.400 | that you need to have a professional asset management company

00:12:01.520 | are done by American Century personnel.

00:12:03.760 | - Yeah, and where is the trading done?

00:12:05.600 | Is it done through American Century,

00:12:06.960 | or are you doing it on your own?

00:12:08.240 | - Depends on what.

00:12:09.160 | And you know, when you do ETF,

00:12:10.920 | you know, a lot of the trading happens in-kind, in and out.

00:12:14.400 | So if that's the part, we do it on our own.

00:12:17.800 | Whenever we need to trade stocks,

00:12:20.520 | we work with American Century trading desk

00:12:23.160 | that has segregated our trades

00:12:25.440 | in a different way of trading,

00:12:26.800 | that we think we don't have to demand liquidity to trade,

00:12:31.800 | and we can be very efficient.

00:12:33.680 | - And you have different products.

00:12:35.400 | I mean, most of your money, I believe, is in ETFs,

00:12:39.880 | but you also have traditional mutual funds,

00:12:43.760 | and you have private individual accounts.

00:12:47.840 | But can you break that down?

00:12:49.480 | You've got about 10 billion under management right now,

00:12:52.520 | which is great number,

00:12:53.640 | just getting started over a couple of years.

00:12:56.040 | How much of that is ETFs?

00:12:57.600 | How much of it is mutual funds,

00:12:58.960 | and how much are private accounts?

00:13:00.800 | - The vast majority of the money,

00:13:02.600 | but the vast majority of the money is ETF.

00:13:05.800 | And why that?

00:13:06.800 | Because for most investors, an ETF is a better vehicle.

00:13:11.680 | And you know that.

00:13:12.600 | - Well, I know that, but why do you know that?

00:13:14.840 | - That's an inside joke, by the way,

00:13:17.960 | between Eduardo and me, so it goes back a long, long way.

00:13:21.200 | Because I spent years

00:13:22.200 | trying to convince dimensional fund advisors

00:13:24.120 | they should have ETFs.

00:13:25.480 | - Both of us know that ETF is by far a better vehicle,

00:13:33.400 | not only because of tax advantages,

00:13:35.720 | but also because you save on cost of different kind.

00:13:38.600 | For example, in certain cases,

00:13:40.320 | you don't have to pay some taxation when you buy securities,

00:13:43.480 | like stamp duties when you buy securities in other countries.

00:13:46.920 | So ETF is a much better vehicle.

00:13:50.120 | But for some investors,

00:13:51.600 | let's think about 401(k) plans, yeah?

00:13:54.920 | The ETF really doesn't work because of operations,

00:13:57.720 | so the 401(k) plan is different.

00:14:00.200 | So it works for the brokerage window,

00:14:02.160 | but not for the default options.

00:14:03.880 | - Correct.

00:14:04.720 | - And our goal is to try to help everyone

00:14:07.280 | with the right vehicle.

00:14:08.600 | We have no biases.

00:14:10.040 | - But I have looked at the performance of an ETF

00:14:14.080 | and a mutual fund, same strategy,

00:14:17.240 | same, might be small cap value, large cap value,

00:14:19.560 | whatever it is, where you have an ETF

00:14:22.520 | and you have a mutual fund,

00:14:24.760 | and there are slight differences in return between them,

00:14:29.360 | but the fee is the same.

00:14:30.680 | So maybe you can explain why that is.

00:14:33.280 | - Yeah, yeah, that's a great question.

00:14:35.320 | If you were running an index fund

00:14:38.400 | and you have pre-described holdings,

00:14:40.640 | so you have securities and weights in both of them,

00:14:44.840 | the performance probably will be the same

00:14:47.520 | with small differences.

00:14:49.120 | But if you're running a strategy

00:14:50.480 | that is trying to use today's information,

00:14:53.240 | the performance will be slightly different between both.

00:14:57.240 | Why?

00:14:58.080 | Because a lot of the trading that happened

00:14:59.800 | in the mutual fund happened depending on

00:15:02.000 | when the cash flows come, you know?

00:15:04.000 | If you give me money today,

00:15:06.200 | I'm going to invest in the securities

00:15:08.200 | that are great to have in the portfolio today.

00:15:11.960 | But if I don't have money today, I have money tomorrow,

00:15:14.640 | I may have to wait for tomorrow to do.

00:15:16.200 | So you have the regular trading and rebalancing,

00:15:19.800 | but you have an effect of cash flows

00:15:22.360 | that forces more one direction than another.

00:15:24.760 | It's more, in a mutual fund,

00:15:27.320 | you always have to carry cash.

00:15:29.520 | Why?

00:15:30.360 | Because if you have a redemption in a mutual fund,

00:15:32.920 | I have to have cash to send it to you tomorrow, yeah?

00:15:37.800 | And I cannot sell securities tomorrow

00:15:40.320 | to raise money to wire on the same day,

00:15:42.960 | because settlement of those securities is two days later.

00:15:46.000 | So you have to carry cash in the mutual fund.

00:15:49.280 | And not much, but you have to have some cash.

00:15:51.600 | If that cash that you carry is not enough,

00:15:53.480 | you have to hit the line of credit

00:15:55.160 | in order to be able to wire the money.

00:15:57.000 | So even though the strategies are the same,

00:15:59.040 | there is more difference in how you have to manage them

00:16:03.520 | in order to deal with the different settlement

00:16:07.200 | of clients' transactions, yeah?

00:16:09.840 | And if you think about that, the ETF is way more efficient,

00:16:14.320 | because the ETF, when you purchase an ETF,

00:16:16.720 | I receive securities in kind.

00:16:18.280 | So I'm always invested.

00:16:19.600 | And when you redeem, you receive securities in kind.

00:16:22.000 | So the long-term shareholder don't have to bear the cost

00:16:24.880 | of the redemption.

00:16:26.840 | So there is always going to be a difference in performance

00:16:31.560 | between the ETF and the fund,

00:16:33.240 | but those difference should be small.

00:16:35.880 | Now, when can those difference become very big,

00:16:39.560 | or bigger, let's call it, when the market moves a lot?

00:16:43.440 | If you have a day that the market moves 10%, yeah?

00:16:47.080 | And you have a purchase that represents 1% of the fund,

00:16:52.080 | or 2% of the fund in cash flow,

00:16:55.680 | well, that money is not invested until tomorrow morning,

00:16:59.160 | yeah?

00:17:00.160 | So if the market moved 10%, right there,

00:17:02.760 | you can see that you have 20 basis points

00:17:05.200 | in difference in performance,

00:17:06.480 | because you are carrying cash overnight.

00:17:08.720 | - And it's not your cash.

00:17:09.640 | I mean, generally, if the investors are in it

00:17:11.240 | for the long-term, it's not their cash that's causing this.

00:17:14.600 | It's some other investor's cash that's causing this.

00:17:16.520 | - Yes, it's not the long-term investors.

00:17:19.080 | An ETF, the long-term investor is kind of protected

00:17:22.120 | from the actions of people coming in and out.

00:17:25.120 | In a mutual fund, no, you are commingling,

00:17:27.880 | and cash is coming in, cash is going out,

00:17:30.920 | so you are exposed to the actions of other shareholders.

00:17:35.760 | And that causes difference in performance.

00:17:38.440 | - Now, Vanguard has a unique structure,

00:17:40.400 | and I know they have a patent on this,

00:17:42.040 | but their ETF and their open-end mutual fund

00:17:45.960 | are just share classes of the same pot of money.

00:17:49.760 | And that patent, someday, I thought it was last year,

00:17:54.080 | but maybe this year, is actually gonna come off patent.

00:17:57.840 | In which case, is it beneficial or would it be beneficial

00:18:01.560 | for other fund companies to adopt that patent,

00:18:04.000 | where there's one pool of money,

00:18:06.680 | and then there's an ETF share class,

00:18:09.320 | and there's a mutual fund share class?

00:18:10.880 | What's the advantage and disadvantage

00:18:12.960 | of doing it the Vanguard way?

00:18:14.880 | - That's a great question.

00:18:15.800 | We thought about that, to say,

00:18:17.440 | do we want to have a big pot of money, big fund,

00:18:21.360 | where one share class is an ETF,

00:18:23.080 | and the other share class is a mutual fund?

00:18:25.560 | And we decided not to do it.

00:18:27.680 | Let's go through the logic.

00:18:29.680 | Let's suppose that you have a mutual fund share class,

00:18:32.400 | a mutual fund, yeah?

00:18:33.640 | Yeah, and with a mutual fund share class.

00:18:36.280 | And I decide to attach to that mutual fund

00:18:38.880 | an ETF share class, yeah?

00:18:41.360 | If you are the mutual fund shareholder,

00:18:45.080 | you are going to be very, very happy about that,

00:18:48.640 | because you have people coming in kind, in and out,

00:18:51.880 | dealing with your capital gains,

00:18:54.200 | and not imposing any cost on you,

00:18:56.920 | because they're coming in kind.

00:18:58.520 | It's not that they're giving you cash,

00:18:59.720 | and the portfolio manager had to trade,

00:19:01.680 | and the cost is spread out across all the shareholders.

00:19:05.320 | No, if you have a mutual fund,

00:19:06.600 | and you attach an ETF share class,

00:19:08.960 | the mutual fund shareholders will be ecstatic,

00:19:11.560 | will be very happy about that, yeah?

00:19:13.200 | - Right, I agree.

00:19:14.680 | - Let's go to the other case.

00:19:16.160 | I have an ETF share class,

00:19:19.480 | and I put a mutual fund share class on the side.

00:19:22.000 | Will the ETF shareholders be happy?

00:19:25.120 | No, they will not be happy.

00:19:27.560 | Why?

00:19:28.880 | Because people coming in the mutual fund

00:19:30.880 | are coming in cash.

00:19:31.920 | And who pays for those transactions?

00:19:34.000 | Everyone, even the ETF shareholders.

00:19:37.200 | So the ETF shareholders pay their way in,

00:19:40.000 | pay their way out,

00:19:42.160 | but they also have to pay a fraction

00:19:44.760 | of all the people coming in and out on the mutual fund.

00:19:47.480 | So it's not really fair to them.

00:19:50.480 | And so on top of that,

00:19:52.160 | if you have the shareholders in mutual fund

00:19:54.160 | redeeming a lot of money,

00:19:56.200 | the ETF shareholder may take a tax bill

00:19:58.560 | that they are not expecting,

00:19:59.920 | because there are cash transactions

00:20:02.440 | in the mutual fund share class.

00:20:04.800 | So what we decided is to have different pools of money,

00:20:09.800 | one for ETF and one for mutual fund.

00:20:14.160 | If you want a mutual fund,

00:20:16.120 | you know what you're facing.

00:20:17.440 | You're having a commingled vehicle

00:20:19.400 | and you're exposed to the actions of other shareholders,

00:20:23.760 | externalities due to other shareholders.

00:20:26.720 | But you trade at the NAB

00:20:29.200 | and for some people that's easier.

00:20:34.120 | In a 401k, as you said, you have to do it that way.

00:20:36.920 | In a 401k, you have to do it.

00:20:39.160 | If you go to the ETF,

00:20:41.200 | you're going to pay your way in and way out

00:20:43.840 | when you buy in the market based on spreads and whatnot,

00:20:46.960 | but you are going to be protected

00:20:48.680 | from the actions of other shareholders

00:20:50.880 | because of the in-time purchase and redemption mechanism.

00:20:53.880 | So by separating them,

00:20:56.520 | we give people a pure benefit of one or the other

00:21:00.000 | and they can decide what's better for them.

00:21:02.160 | They are not going to be blindly surprised

00:21:04.480 | by the action of the other pool of money

00:21:06.280 | that is coming in and out in a different way that they are.

00:21:09.800 | - Okay, let's go into a different topic

00:21:11.480 | and that has to do with how you invest money.

00:21:14.640 | You invest money using factors.

00:21:19.640 | You're a quantitative factor investor,

00:21:23.200 | but before we get too deep

00:21:24.760 | into all these different factors, what is a factor?

00:21:28.200 | - So the factor basically is a way to understand

00:21:33.160 | the performance of securities.

00:21:34.640 | For example, let's suppose that small cap securities

00:21:38.640 | have a better expected performance than large cap securities.

00:21:42.720 | So a factor is the difference in performance

00:21:45.200 | between the small cap securities and large cap securities.

00:21:48.880 | - Okay, well, let me stop for a second.

00:21:50.520 | Why would small cap have an expected higher return

00:21:53.040 | than large cap?

00:21:54.120 | - Well, that's a great question because I'm going,

00:21:57.440 | let's just pick another factor

00:21:59.240 | and then we go back to a small cap.

00:22:00.760 | - Okay.

00:22:01.600 | - A small cap is probably the one that you cannot justify.

00:22:04.680 | A company, because just being a small,

00:22:07.280 | should not have a premium

00:22:08.720 | because you can have a small cap company

00:22:10.720 | with extremely high price

00:22:14.000 | and that's not going to have a premium.

00:22:15.800 | So let's just speak about the value factor.

00:22:17.680 | That's easy.

00:22:19.240 | And what is the value factor?

00:22:21.280 | If you can buy a security that has low price

00:22:23.520 | relative to a fundamental,

00:22:25.160 | let's say the book value of a company,

00:22:27.560 | well, that company tends to have a premium

00:22:29.600 | relative to a company that has a high price

00:22:31.440 | relative to the fundamental, yeah?

00:22:33.480 | It's like you're buying something on a discount

00:22:35.960 | at a lower price, yeah?

00:22:38.360 | - Okay, but why?

00:22:39.200 | Why would a company with a low price to earnings,

00:22:44.200 | low price to book, low price to cashflow,

00:22:48.120 | low price to something or just low price,

00:22:51.200 | why would we expect that to have a higher rate of return?

00:22:55.680 | - That's a great question.

00:22:56.680 | So we have to start with the premise.

00:22:59.880 | It says we believe that the market

00:23:02.920 | is pricing all the securities

00:23:04.560 | and we cannot find a better price

00:23:06.560 | than what the market has.

00:23:08.560 | There's an assumptions of different kinds,

00:23:11.440 | but we also believe that there is no need for the market

00:23:15.800 | to put the same return for every security.

00:23:19.240 | Different securities will have different returns.

00:23:21.800 | Different returns will have different discount rates, yeah?

00:23:25.440 | - The discount rate is a factor

00:23:26.760 | of the perceived riskiness of a security, correct?

00:23:30.400 | - It can be risk or it can be something else.

00:23:33.800 | It can be behavior, you know?

00:23:35.680 | Some people just, for whatever reason,

00:23:38.240 | dislike a lot a certain set of companies.

00:23:41.920 | And if there is enough people

00:23:43.560 | that dislike a lot those set of companies,

00:23:46.080 | those companies will trade at a little bit lower price.

00:23:49.480 | And so that's a higher discount rate.

00:23:51.200 | - Let me push back just a hair on this,

00:23:53.440 | 'cause I wanna make sure I understand it,

00:23:54.640 | because there's this thing between risk and behavior

00:23:57.840 | that always goes back and forth with these factors.

00:24:00.280 | But to me, if it's true that there are a lot of people

00:24:04.040 | who just don't like these companies,

00:24:06.520 | they don't like them for a reason.

00:24:08.440 | And isn't it true that they don't like them

00:24:10.800 | because they see more risk there and lower returns,

00:24:13.720 | and that's why they don't like them?

00:24:14.920 | So isn't it a fundamental factor?

00:24:16.600 | - It may or may not be.

00:24:19.560 | But the fact that a certain client that moves away

00:24:23.920 | from certain set of securities

00:24:25.760 | certainly will push the price of those securities lower,

00:24:29.880 | and that suddenly you have a higher discount rate,

00:24:33.200 | because if the price is lower relative to the fundamental,

00:24:35.680 | you have a higher discount rate.

00:24:37.200 | But let's go a little bit deeper in why there is a premium,

00:24:41.120 | because you're asking is why certain securities

00:24:43.120 | have a premium, a higher return than others.

00:24:46.240 | - Right, okay.

00:24:47.080 | - And so let's think about that.

00:24:48.680 | Let's suppose that I give you two options to work.

00:24:51.280 | So you work with us for one week,

00:24:53.560 | and if you work with us for one week, I give you $100.

00:24:57.040 | That's option one.

00:24:58.480 | Option two is if you work with us for one week,

00:25:03.000 | I give you $0 or $200, 50/50,

00:25:07.400 | depending on the weather of the last day.

00:25:09.360 | So 50/50 probability gives you zero or 200.

00:25:14.360 | The expected payment for you is the same, it's $100.

00:25:19.040 | So in one, you get $100 for sure.

00:25:21.600 | In the other one, you get an expected $100,

00:25:25.440 | but you can get zero or 200.

00:25:27.400 | - Okay.

00:25:28.240 | - Will you take that deal?

00:25:29.800 | In general, you will not take the second deal.

00:25:31.960 | You will take the $100 for sure,

00:25:34.680 | because the other one, you can finish with zero or 200.

00:25:37.840 | So now I'm going to try to spice it for you.

00:25:41.960 | I'm going to give you zero or 250.

00:25:45.080 | So now the expected payment to you is not 100 and 100,

00:25:51.320 | it's 100 and 125, 50% zero, 50% of 50.

00:25:59.000 | So I'm incentivizing you with a premium

00:26:02.760 | to take the more risky outcome, yeah?

00:26:06.720 | At some point, if I keep on increasing the incentive,

00:26:11.720 | at some point, you are going to say,

00:26:15.480 | "I take the risky outcome."

00:26:17.960 | So whenever you have a risky investment,

00:26:20.960 | it's not that the expected outcome

00:26:23.360 | is the same as a less risky investment.

00:26:26.320 | The more risky investment will have a return

00:26:29.880 | that is a little beyond just the same expectation.

00:26:34.480 | You will have a premium,

00:26:36.200 | because that premium is what incentivize you

00:26:40.440 | to take a little bit of that risk.

00:26:44.320 | Because if you do a perfect risk adjustment

00:26:46.760 | and you have the same expected outcomes,

00:26:50.080 | you will never take the risky investment.

00:26:53.360 | So there has to be a premium, a little bit more return.

00:26:55.880 | So when you're speaking about security,

00:26:57.600 | how low price relative to fundamentals,

00:27:00.000 | and we're saying that's a value investment strategy,

00:27:02.920 | why there is a premium?

00:27:04.120 | Because not every security has the same expected returns.

00:27:07.720 | There is no need, there is no logic for that.

00:27:10.800 | So when you're looking for security

00:27:12.320 | at a low relative to fundamental,

00:27:14.320 | what you're trying to do is identify those securities

00:27:18.480 | that are having higher discount rate,

00:27:20.800 | higher expected returns.

00:27:22.760 | - And then put a diversified portfolio together

00:27:25.040 | of just those securities.

00:27:27.360 | - Yes.

00:27:28.320 | But you can see that when you were mentioning it,

00:27:31.400 | hey, you're saying low price relative to fundamentals,

00:27:33.960 | but what we're trying to do is try ways, systematic ways,

00:27:38.720 | mechanical ways, if you want to think about that,

00:27:41.800 | to identify what securities have high discount rates,

00:27:45.200 | because the discount rate is your expected return.

00:27:47.320 | So what security has these high expected returns?

00:27:50.120 | Now, every model is incomplete.

00:27:54.760 | The models don't describe reality.

00:27:57.080 | But what financial science has been doing over time

00:28:00.600 | is trying to make better and better models,

00:28:03.640 | trying to understand what variables matter most.

00:28:07.000 | And that's why you have so many factors,

00:28:08.880 | because people start looking at different variables,

00:28:11.160 | and they're saying, well,

00:28:12.000 | this variable explains something about returns,

00:28:14.120 | and this other variable explains about other returns.

00:28:17.000 | And I think you have like 400 factors now, yeah?

00:28:20.600 | I think there's a paper called "The Factor Zoo."

00:28:22.800 | - "The Vector Zoo," yes.

00:28:23.960 | - So the issue that we're facing now

00:28:26.560 | is there's so many factors.

00:28:28.520 | How we put all this together?

00:28:31.000 | And there are many, many different people

00:28:33.000 | put this together in different ways.

00:28:34.520 | Some people do optimization.

00:28:35.920 | So let's put all these factors, optimize,

00:28:37.920 | and we see what happens at the end.

00:28:39.720 | But you know, as well as me,

00:28:42.960 | whenever you put a big soup of estimated numbers

00:28:46.840 | in an optimization, you get very weird outcomes.

00:28:53.720 | So "The Factor Zoo," so we've got,

00:28:56.640 | I talked about large versus small,

00:28:59.520 | and that factor was strong decades ago.

00:29:04.520 | But it seems to me,

00:29:07.880 | since the proliferation of small-cap index investing,

00:29:10.720 | in other words, became much, much easier

00:29:12.560 | to invest in a big, massive mega-portfolio

00:29:15.240 | of small-cap stocks.

00:29:16.400 | It wasn't so easy 50 years ago.

00:29:18.640 | It's easy now to do that.

00:29:20.840 | And that led to the term,

00:29:24.720 | well, led to factor decay.

00:29:26.800 | In other words, it went away.

00:29:28.520 | It was easy to identify these small-cap companies.

00:29:33.080 | It was easy now to package them together

00:29:35.160 | into these index funds, mutual funds,

00:29:38.520 | extended markets, small-cap funds, whatever.

00:29:41.200 | And because of that, I believe,

00:29:42.960 | and I might be wrong about this,

00:29:44.200 | but I believe that caused this factor to decay

00:29:47.200 | to the point where there really isn't

00:29:49.440 | a big premium anymore, as you mentioned earlier.

00:29:53.120 | - What you're observing is absolutely right.

00:29:55.840 | Now, the question is not if it has decay.

00:30:00.520 | The question is, was it there on day one?

00:30:03.760 | - Oh, okay.

00:30:04.960 | - And why is that?

00:30:05.800 | Let's suppose that we go to the zoo one day,

00:30:08.040 | and we see that animals with stripes are zebras.

00:30:11.760 | That doesn't mean that every animal

00:30:13.440 | with a stripe would be a zebra,

00:30:15.360 | because a tiger would have stripes, yeah?

00:30:19.480 | So the fact that people observe that the small-caps

00:30:22.880 | up to '81, I think it was, have a premium,

00:30:26.720 | that can have been a random outcome, yeah?

00:30:31.160 | And the fact that we don't see much of that

00:30:35.040 | after that period, it may be because that's reality.

00:30:38.760 | And why I was pushing back in the small-cap premium,

00:30:42.240 | because when I was speaking about value,

00:30:45.400 | I was telling you, you have a low price

00:30:47.400 | related to fundamentals.

00:30:49.160 | You are looking for companies that have high discount rates,

00:30:52.720 | and any high discount rate will push the price down.

00:30:56.760 | So there is a logic there, yeah?

00:30:59.440 | - And just to clarify, a discount rate means

00:31:01.720 | you need to get a higher rate of return.

00:31:03.040 | It's a cost of capital.

00:31:04.160 | - Exactly.

00:31:05.240 | - The company has to get a higher rate of return

00:31:07.800 | for you to invest in that company,

00:31:09.200 | because you perceive, true or not,

00:31:12.640 | you perceive that there's more risk there,

00:31:14.360 | so you need to get a higher rate of return.

00:31:16.480 | - Yeah, if a company is going to produce

00:31:18.400 | a dollar in the future,

00:31:20.080 | you're not going to pay that dollar in the future

00:31:22.040 | with the dollar today.

00:31:23.840 | You're going to pay 70 cents today

00:31:26.320 | to get a dollar in the future,

00:31:27.520 | 50 cents today to get a dollar in the future.

00:31:30.000 | So the lower the number that I'm paying today

00:31:33.280 | for a dollar in the future is the higher discount rate,

00:31:36.320 | higher discount rate.

00:31:37.160 | So when you have a strategist that is trying

00:31:39.080 | to buy low-priced securities related to fundamentals,

00:31:42.320 | what you are really trying to capture

00:31:45.080 | is that high discount rate,

00:31:46.480 | that higher expected return due to the low price today.

00:31:50.800 | But if I tell you you are buying small caps,

00:31:53.600 | that is nothing that tells you

00:31:56.200 | that a small cap security can have a premium.

00:31:59.720 | If not, you can divide a large company

00:32:01.680 | in a bunch of pieces, and suddenly you have a premium.

00:32:05.600 | And more logically,

00:32:07.440 | let's suppose that you have a small cap company, yeah?

00:32:10.760 | If I have that small cap company,

00:32:12.560 | and that company has a very, very high price

00:32:16.360 | relative to fundamentals,

00:32:18.520 | that company should not have a premium

00:32:20.360 | because the price is too high related to fundamentals.

00:32:25.040 | So a small cap premium is highly debatable.

00:32:28.600 | Let's put it that way.

00:32:30.080 | - Well, let's go ahead and then move on

00:32:31.520 | to some other factors,

00:32:33.160 | because we talked about small cap

00:32:35.640 | potentially not being there anymore,

00:32:37.480 | or maybe it wasn't there to begin with.

00:32:39.240 | We talked about the value factor,

00:32:41.120 | price to book, price to some fundamental.

00:32:43.600 | You also, at your company,

00:32:46.280 | are looking at profitability as a factor.

00:32:49.240 | So tell us about profitability.

00:32:51.080 | - Yeah, that's a great question.

00:32:52.360 | So imagine that you are going to buy a company.

00:32:55.360 | How much you're going to pay for that company?

00:32:57.440 | You know, I'm buying Rick's company.

00:33:00.040 | How much I have to pay?

00:33:01.000 | Well, I have to pay for the equity

00:33:02.520 | that you have in your company, yeah?

00:33:04.800 | But I also have to pay for your cash flows.

00:33:07.720 | But since your cash flows are in the future

00:33:09.720 | and they're uncertain,

00:33:11.040 | I'm going to discount those future

00:33:13.160 | and I'm going to pay less today

00:33:15.120 | for those future cash flows

00:33:16.320 | than the value of those future cash flows.

00:33:19.520 | So the price that I'm paying for your company

00:33:21.480 | is your equity plus a discounted value

00:33:24.160 | of your future cash flows, yeah?

00:33:26.720 | So remember, what I'm interested is in that discount rate.

00:33:32.720 | Yeah?

00:33:33.560 | And what variables I know?

00:33:35.440 | I know the price

00:33:36.280 | because Bloomberg tells me the price every minute.

00:33:39.000 | I can have a proxy for the equity in the company

00:33:41.800 | and I can have a proxy for the cash flows of the company.

00:33:45.080 | And these three variables,

00:33:46.680 | because of the valuation framework

00:33:48.560 | that I mentioned with you,

00:33:49.960 | are related to the discount rate,

00:33:52.800 | to the expected returns.

00:33:54.880 | A company that has higher expected returns

00:33:58.000 | will have a lower price for the same equity value

00:34:02.000 | and for the same cash flow expectations

00:34:04.640 | than a company that has lower expected returns.

00:34:09.000 | So the higher the expected returns,

00:34:10.520 | the lower the price,

00:34:12.080 | keeping the other two variables constant,

00:34:14.600 | keeping the equity and the cash flows.

00:34:17.600 | So I need to take into account not only the equity

00:34:21.640 | that I can use book value as a proxy for equity,

00:34:24.520 | I also need to take into account

00:34:27.240 | the cash flows of the company.

00:34:28.320 | I have to take both set of financials,

00:34:31.360 | the balance sheet and the income statement,

00:34:34.160 | both set of financials

00:34:36.120 | to identify what companies have high discount rate,

00:34:39.840 | high expected returns.

00:34:41.280 | - When you're selecting the securities then for your funds,

00:34:45.040 | is it a fixed formula

00:34:46.560 | where you're using some percentage of book value,

00:34:50.760 | some percentage of profitability together in your model?

00:34:54.920 | Or is it a variable thing where it moves?

00:34:58.360 | - No, it's fixed, it's fixed.

00:34:59.760 | So look, there is enough uncertainty in life

00:35:03.080 | that if you have it fixed,

00:35:04.800 | it's already there is uncertainty

00:35:06.800 | to add a variable component.

00:35:08.720 | There is no way for us to have so much precision.

00:35:12.120 | So we want to use the main drivers of selecting securities

00:35:17.120 | that are how much money the company is making,

00:35:21.360 | what's the equity position of the company,

00:35:23.280 | what's the price related to these two variables.

00:35:26.360 | And once we have that,

00:35:27.720 | we have enough information to put together

00:35:30.280 | a well diversified portfolio

00:35:32.480 | that in our opinion has high expected returns.

00:35:36.520 | Trying to be more clever than that

00:35:39.280 | and just changing the weight of the security

00:35:41.520 | with market conditions or the factors

00:35:43.880 | or the components with market conditions

00:35:45.720 | or anything else,

00:35:47.120 | is just adding noise with not really known outcome.

00:35:52.920 | - So I'm gonna say one thing,

00:35:54.200 | but then I'm gonna move right on to something else.

00:35:55.640 | So what I was getting at was

00:35:57.600 | you don't do what's called factor rotation,

00:36:00.400 | where you're trying to go from one factor

00:36:01.920 | to another, to another, to another.

00:36:03.880 | - No, no.

00:36:04.720 | - Companies are very hot on doing factor rotation.

00:36:08.000 | And they're saying that,

00:36:09.120 | well, if we move at this time from this factor

00:36:11.600 | to that factor, to over to this factor,

00:36:13.400 | that somehow some way they're gonna get an excess return

00:36:16.440 | from rotating their portfolio around

00:36:18.600 | or highlighting different factors at different times.

00:36:20.560 | And you don't find any value in that at all.

00:36:22.720 | - No, that's unpredicted where the market is going to be,

00:36:25.120 | it's the same.

00:36:25.960 | If you can predict the performance of a given factor,

00:36:29.240 | it's the same as saying

00:36:30.080 | you can predict the performance of the market.

00:36:31.800 | Imagine who we could do that.

00:36:34.000 | That would be great,

00:36:34.840 | but the markets, that's not how it works.

00:36:37.680 | The performance of market is unpredictable

00:36:39.600 | because there are news that we don't even know

00:36:42.280 | that they're coming and they will come.

00:36:44.320 | I don't know what will be,

00:36:45.320 | but it will come, something new tomorrow.

00:36:47.960 | - So you have your list then,

00:36:50.040 | you come up with your portfolio

00:36:51.480 | of what you would like to buy.

00:36:53.640 | But there's another factor

00:36:54.720 | that we haven't talked about yet, it's called momentum.

00:36:57.560 | And this is looking at the price

00:37:00.000 | and seeing if it's moving down or moving up.

00:37:04.400 | And we don't wanna try to catch a falling knife

00:37:07.400 | is a phrase that we hear often with quantitative analysis.

00:37:12.240 | So could you talk about how you use momentum

00:37:15.120 | in your portfolio management?

00:37:17.760 | - Yeah, so momentum is fascinating.

00:37:20.280 | It's a little bit like a small caps.

00:37:22.880 | When I was telling you small caps,

00:37:24.240 | there is no logic for existing in small caps.

00:37:27.040 | There is a logic while the premiums are small,

00:37:30.280 | larger than small caps.

00:37:31.720 | Small, the value premium in small cap

00:37:33.840 | is larger than the value premium in large cap.

00:37:36.160 | There is a logic for that.

00:37:37.720 | But the existence of a small cap premium,

00:37:39.320 | there is no logic.

00:37:40.200 | For momentum, it's the same.

00:37:41.360 | Momentum is something that we observe,

00:37:44.200 | but we don't understand why it happens.

00:37:46.200 | And there are two competing visions of why that happens.

00:37:48.800 | So what is momentum?

00:37:50.400 | A security has extremely bad performance,

00:37:54.560 | will continue to have,

00:37:56.080 | for some short period of time, bad performance.

00:37:58.920 | And a security has extremely good performance,

00:38:01.560 | will continue to have,

00:38:03.040 | for some short period of time, good performance.

00:38:06.000 | So how do we use momentum?

00:38:09.000 | If we have a value strategy,

00:38:10.760 | we're buying security at a low price, yeah?

00:38:13.640 | How will the security becomes low price?

00:38:18.240 | One probability is because the price is going down.

00:38:20.560 | The security has very bad performance.

00:38:23.200 | Well, we can go and buy the security immediately,

00:38:27.240 | or you can say, wait, don't buy it now.

00:38:30.480 | Wait a little bit until the price stabilizes.

00:38:33.680 | And so that's what we do.

00:38:35.040 | We decide not to buy immediately,

00:38:37.160 | not to jump into this security

00:38:39.000 | that have extremely bad performance.

00:38:41.200 | And we decide to wait a little bit

00:38:43.080 | until the price stabilizes.

00:38:45.160 | And so we try to prevent buying securities

00:38:47.920 | in downward momentum, yeah?

00:38:50.160 | The opposite for upward momentum.

00:38:52.320 | If you have a security that is a small value, for example,

00:38:55.880 | and it's an upward momentum,

00:38:57.400 | we are willing to slightly overweight that security.

00:39:01.520 | And if the security starts going up in price,

00:39:04.080 | and instead of being a small cap,

00:39:05.520 | now becomes a mid cap security,

00:39:09.120 | instead of sell it immediately,

00:39:10.800 | we may be willing to hold it a little bit longer.

00:39:13.240 | Why?

00:39:14.080 | Because the momentum premium is very, very strong,

00:39:17.400 | but it's very short-lived.

00:39:19.160 | So if I can get a little bit of push

00:39:21.840 | because of upward momentum,

00:39:24.000 | just by holding the security a little bit longer.

00:39:26.960 | So we incorporate momentum,

00:39:28.760 | downward and upward momentum in our strategies.

00:39:32.280 | But we are very, very careful how we do it,

00:39:34.480 | because if you are not,

00:39:36.360 | you finish with a very, very high turnover.

00:39:39.120 | - Let me ask a question about factor premiums.

00:39:42.480 | Now you have a multi-factor model

00:39:44.280 | where you're using profitability and value combined

00:39:48.040 | to come up with what you expect to be a premium over beta,

00:39:53.040 | expect to be a premium over the market return.

00:39:57.160 | Do you have a way of determining

00:39:59.720 | what that premium should be going forward?

00:40:02.880 | What are we looking for?

00:40:03.760 | And a long only portfolio, not a long and short,

00:40:05.960 | but just a long only portfolio.

00:40:07.680 | - Yeah, no, long only.

00:40:10.320 | I don't think any one of us need a short portfolio.

00:40:13.440 | So we're all happy to have a long only, you know.

00:40:16.800 | This is a great question.

00:40:18.160 | So the question is,

00:40:21.200 | can we know at any point in time

00:40:23.920 | how much the market is discounting future cash flows?

00:40:27.840 | And the answer is no.

00:40:31.040 | And why not?

00:40:32.880 | That's where behavioral finance gets together

00:40:36.760 | with rational markets, yeah?

00:40:40.080 | In different periods of time for the same level of risk,

00:40:43.720 | people may be willing to take a lower price

00:40:48.240 | or a higher price.

00:40:49.160 | You know, we change.

00:40:50.480 | You know, the market change.

00:40:51.440 | You know, in periods of high anxiety,

00:40:54.080 | people are priced humongous discount rates.

00:40:56.400 | The price are very, very depressed.

00:40:58.280 | In other periods, the price is higher.

00:41:02.480 | And so the market is having lower expected returns.

00:41:06.200 | And you cannot really know at any point in time

00:41:09.240 | how big or how small is that premium.

00:41:11.960 | What you know is that it's a premium.

00:41:13.480 | But there is research that is very interesting

00:41:15.480 | that shows, look.

00:41:17.040 | Look at the long-term average of these premiums.

00:41:19.800 | That's probably as good as it gets.

00:41:22.400 | Now, some people say that if you look at the market,

00:41:25.840 | historical market performance

00:41:28.160 | relative to treasury bills, for example,

00:41:31.440 | probably was higher than what we should expect

00:41:33.800 | in the future.

00:41:34.640 | - I would agree.

00:41:37.000 | Some people say that because now the market,

00:41:39.640 | now more people embrace investing in the market.

00:41:42.280 | There is more of us that are buying securities

00:41:44.880 | than what there were in the past.

00:41:46.480 | And so if you have a higher clientele,

00:41:48.520 | there's more people willing to take

00:41:50.920 | a little bit of that risk.

00:41:52.160 | We're increasing the price

00:41:54.040 | and we're reducing expected returns.

00:41:55.640 | There is a logic.

00:41:57.160 | - I think another piece of logic is,

00:41:58.640 | are treasury bills correctly priced?

00:42:01.200 | If you're gonna use that as the risk-free rate.

00:42:04.160 | Based on where treasury bills are currently priced,

00:42:06.720 | I think that the premium could be high,

00:42:08.600 | but if treasury bills were correctly priced

00:42:10.760 | based on where the inflation rate is,

00:42:12.400 | I think that the premium might be a lot lower.

00:42:14.240 | So I don't know if treasury bills

00:42:16.080 | are the right risk-free rate to use,

00:42:17.760 | even though that's what's being used in the models.

00:42:20.040 | - Yeah, you are right about

00:42:21.360 | what is the risk-free rate is interesting.

00:42:23.720 | But we're not just speaking about short-term periods.

00:42:27.000 | We're speaking about long-term periods.

00:42:29.040 | And so if we think about that,

00:42:31.760 | expected returns of the market may be a little bit smaller

00:42:34.840 | than what we have seen in the past.

00:42:36.720 | There is more willingness of people to embrace the market

00:42:40.400 | and embrace market rates.

00:42:41.920 | And there is more people to do that.

00:42:43.520 | Then you would expect premiums to be a little bit smaller.

00:42:47.240 | Is that the same for value investing?

00:42:50.280 | And when I say value,

00:42:51.680 | I think a generalized ways of value, like what we do.

00:42:55.280 | I think that there is no information

00:42:57.560 | about more people embracing these than before.

00:43:01.240 | They may be smaller than historical premiums.

00:43:03.920 | They may be not.

00:43:05.520 | Now, the traditional way of defining value,

00:43:08.800 | like if you are looking low price to book

00:43:10.720 | without looking at the cash flows of the company,

00:43:14.560 | that probably is not the right way to do it.

00:43:17.680 | And so science has evolved from there.

00:43:20.480 | So I think it's better if people evolve from that.

00:43:24.480 | - Let me ask a question about US versus international,

00:43:26.920 | because you did this paper on using value

00:43:30.680 | and profitability in international markets.

00:43:34.200 | Is it different outside the US?

00:43:36.400 | Is it different in emerging markets than in the US market?

00:43:39.280 | And how do you have to change your formula?

00:43:41.720 | - Okay, so if you remember,

00:43:45.480 | I told you a story about the valuation of the company.

00:43:48.080 | So what is the value of the company?

00:43:49.760 | The price of the company is the equity

00:43:51.360 | plus the cash flows discounted by some discount rate.

00:43:54.440 | But I never told you that that valuation

00:43:57.440 | is only valid in the United States.

00:43:59.280 | But I think that that valuation was valid

00:44:01.400 | when the Babylonians were selling and buying donkeys.

00:44:04.640 | And probably it's going to be the same in the future

00:44:07.040 | when we are selling and buying water or oxygen,

00:44:09.520 | if we ever live in Mars.

00:44:11.320 | So this is an evaluation framework,

00:44:14.800 | the beauty of evaluation framework

00:44:16.240 | that is valid in all the different environment.

00:44:18.880 | It's different from a pattern.

00:44:20.720 | A pattern may be valid here and not somewhere else.

00:44:23.160 | So the way that we do things

00:44:24.920 | is based on evaluation framework

00:44:27.480 | to understand what factors or what matters

00:44:31.160 | in expected returns of a company.

00:44:33.520 | And basically it works all around the world.

00:44:36.760 | It works in the US, it works in international,

00:44:39.600 | works in emerging markets.

00:44:41.440 | So the research is very robust from that point of view

00:44:44.200 | because you have a research that you can apply

00:44:46.720 | with evaluation framework everywhere.

00:44:49.280 | Now, when you're speaking about the variables itself,

00:44:52.840 | you have to adapt to realities.

00:44:54.720 | For example, in the United States,

00:44:56.640 | companies report financials quarterly,

00:45:00.000 | but in some countries report only twice a year.

00:45:04.320 | And so you have to adapt with the data

00:45:07.160 | and try to make the best that you have

00:45:09.280 | with the data of the different countries

00:45:11.200 | in order to have the model

00:45:13.400 | use the right set of information.

00:45:16.000 | - Let me ask a question about small cap value funds.

00:45:19.440 | I personally have a small cap value tilt in my portfolio.

00:45:24.560 | I don't yet have an international small cap value tilt.

00:45:27.720 | And one of the questions I have is,

00:45:30.640 | why are there no global small cap value index funds or ETFs?

00:45:35.640 | - You know, I've been asked that many times.

00:45:40.200 | It's more, we may be thinking about doing one

00:45:42.680 | outside the United States, not for US investor,

00:45:45.080 | for outside in United States.

00:45:47.560 | And why we don't have one in the United States?

00:45:50.280 | We have, as you know, we have a US small value strategy

00:45:53.880 | and international small value strategy

00:45:56.600 | and an emerging markets meet and a small value strategy.

00:45:59.640 | And we do meet and a small together in emerging

00:46:02.400 | just because of how more liquidity

00:46:04.120 | and the number of securities.

00:46:05.320 | But we don't have one that puts the three of them together.

00:46:08.560 | - Correct.

00:46:09.400 | - Why is that?

00:46:11.040 | Because different investors

00:46:14.600 | want to have different allocation

00:46:16.880 | to the US versus emerging versus international.

00:46:20.160 | And if we put all together,

00:46:22.600 | then constrain the investors to decide which one to buy.

00:46:27.600 | Now, how to weigh them.

00:46:29.680 | Now, yeah, I understand, but think about this.

00:46:34.000 | When you buy an ETF, yeah?

00:46:36.480 | What is your fixed cost?

00:46:38.240 | Do you pay ticket charges?

00:46:40.040 | No, you don't pay ticket charges.

00:46:41.480 | So buying three ETFs is the same as buying one

00:46:44.720 | because you don't have ticket charges.

00:46:46.600 | So given that you don't have ticket charges,

00:46:48.840 | just buy three securities instead of buying one.

00:46:52.320 | And that gives you the freedom

00:46:54.280 | to decide how you want to weight them.

00:46:57.080 | - Okay, I will push back here

00:46:59.400 | because you have a global real estate portfolio,

00:47:04.400 | a real estate, but you just finished saying

00:47:08.680 | you should have a US small value

00:47:10.600 | and an international small value,

00:47:11.920 | but yet you have a global real estate fund.

00:47:14.840 | So explain why.

00:47:16.560 | - Yeah, that's a great question.

00:47:18.480 | So you say you can have a US real estate

00:47:23.120 | and international real estate,

00:47:24.440 | and I will tell, yes, you're right.

00:47:26.280 | We can have a US and an international.

00:47:28.120 | Now, an international real estate market

00:47:31.160 | is much, much smaller than the US real estate market, yeah?

00:47:35.920 | - 30% versus 70, so international versus US.

00:47:39.960 | - Yes, so an ETF for international real estate

00:47:44.280 | that will have a very, very small allocation

00:47:47.320 | in someone's portfolio, we say, no,

00:47:49.680 | let's put it all together in real estate

00:47:53.040 | and let's give that to someone

00:47:55.400 | because I, maybe I'm wrong, but we say,

00:47:59.120 | no one worries too much about how much US or non-US.

00:48:02.080 | So someone wants a full US real estate

00:48:05.560 | or they are happy to have a global real estate.

00:48:08.240 | So we say, let's provide global.

00:48:10.440 | The global real estate market has been developing.

00:48:13.360 | You know, UK REITs, I think they are 15 years old,

00:48:17.360 | JREITs, so it's developing.

00:48:19.760 | At some point, we may split it

00:48:21.920 | or have two versions or whatnot,

00:48:24.360 | but for now we decided global probably is the right decision.

00:48:28.280 | - I can give you the pros and cons

00:48:30.240 | of a global small cap value fund.

00:48:33.840 | The pros are, man, it's a lot more convenient

00:48:37.400 | than buying three funds.

00:48:38.600 | Just buy one small value, covers the world, I'm happy.

00:48:42.880 | What's the disadvantage?

00:48:44.080 | Well, the disadvantage is taxes and the foreign tax credit.

00:48:48.240 | If you're gonna put it in your taxable account

00:48:50.160 | because since less than 50% of the portfolio

00:48:53.160 | is gonna be an international,

00:48:54.400 | you don't get the foreign tax credit.

00:48:56.440 | So in a taxable portfolio,

00:48:58.000 | you still have to divide it up between a US small value

00:49:01.920 | and an international small value.

00:49:03.200 | So you get the tax credits

00:49:04.400 | on the international small value.

00:49:05.600 | But if this was gonna go into an IRA account

00:49:08.920 | or a Roth account of some form,

00:49:11.600 | which I could see a global small cap value

00:49:14.560 | into a Roth account, that it would make sense,

00:49:18.160 | at least from my standpoint as an advisor,

00:49:20.360 | where I get this factor exposure using one fund.

00:49:24.360 | There is a need for it, I believe out there.

00:49:27.400 | So I'm just plugging that.

00:49:28.960 | - You're not the first one telling us that, to be fair.

00:49:34.480 | But I also go through that saying,

00:49:36.480 | look, if you have three ETFs,

00:49:39.200 | you don't have ticket charges in custodians.

00:49:41.400 | - But you have three funds and I don't want three funds.

00:49:43.720 | I want something simple.

00:49:45.000 | Anyway, let's go to the next thing.

00:49:48.200 | You know, we've evolved, we have the factors zoo now, okay?

00:49:52.120 | We also have things like artificial intelligence

00:49:55.320 | and we have machine learning

00:49:57.120 | and behavioral finance can be thrown into that as well.

00:49:59.920 | Are you looking at these things to incorporate them

00:50:03.240 | into your world and how you do things?

00:50:07.080 | - You know, the whole thing of machine learning

00:50:10.440 | and neural networks and all this is fascinating

00:50:13.160 | because what it's trying to do,

00:50:15.040 | it's trying to emulate how the brain works in learning

00:50:19.240 | or a collection of entities works in learning

00:50:22.600 | in order to learn without having a predefined model, yeah?

00:50:27.600 | So, but isn't that what the market does?

00:50:34.000 | - Yeah.

00:50:35.040 | - The market is a big machine learning machine

00:50:39.320 | that does machine learning.

00:50:40.560 | The market is a network of this, you know,

00:50:44.200 | a loose network of people interacting

00:50:46.920 | in order to increase some benefit for everyone,

00:50:51.680 | collectively everyone,

00:50:53.040 | but individually, each one of the individuals,

00:50:55.720 | each one is just trying to incorporate the information

00:50:58.680 | that they come in order to come with prices.

00:51:01.200 | So the whole market is a big machine learning network.

00:51:04.920 | Now, if I were an acting manager picking stocks

00:51:08.680 | and I think that I can do better than the market

00:51:11.120 | and find what securities are underpriced

00:51:13.400 | and securities underpriced,

00:51:14.960 | probably I will invest a lot of money there and say,

00:51:16.920 | oh, I'm going to be better than everyone else

00:51:19.600 | and find all the undervalued securities

00:51:21.440 | and all the overvalued securities.

00:51:23.680 | That's not us.

00:51:25.360 | So I'm not going to dispute the market price

00:51:27.480 | and create my model and then I will say,

00:51:29.200 | my model is better than the market

00:51:31.200 | because the market is as good as it gets.

00:51:33.400 | No, whatever our model is,

00:51:35.040 | it's going to be subpar to the market, in my opinion.

00:51:38.400 | So the market gives us a price of the securities.

00:51:41.520 | What we do is try to use that price

00:51:43.920 | in order to identify what securities have been priced

00:51:47.240 | at higher discount rates,

00:51:49.880 | so they have higher expected returns,

00:51:52.320 | and what securities have been priced

00:51:53.720 | at lower expected returns.

00:51:56.680 | There may be things that are interesting

00:51:58.960 | in machine learning to apply even to what we do.

00:52:02.480 | And for example, we were speaking about finding factors

00:52:07.480 | or finding drivers of expected returns.

00:52:09.800 | You could have imagined that all this factor research

00:52:14.320 | could have been done with machine learning.

00:52:16.400 | So we can have a machine learning trying to find

00:52:19.560 | what variables that are related to valuations

00:52:22.320 | have different levels of impact

00:52:26.360 | in the expected returns of the security.

00:52:28.480 | And that could have been done,

00:52:29.720 | but that's what the professors and researchers

00:52:33.040 | around the world have been done in a loose way.

00:52:36.040 | So yeah, you can use it, but a lot has been done

00:52:39.520 | even we don't call it machine learning.

00:52:41.680 | - Let me ask a question that was posed to me.

00:52:45.520 | It has to do with ESG.

00:52:48.240 | - Okay.

00:52:49.080 | - So ESG is popular in Europe, for sure,

00:52:52.960 | and maybe becoming a little more popular

00:52:54.640 | here in the United States than in the past,

00:52:56.760 | but it's very hard to find a small cap value ESG fund

00:53:02.640 | for the people who want factors and want ESG.

00:53:06.800 | Any interest there?

00:53:08.080 | - We are getting into the responsible investment business.

00:53:14.040 | So we're going to launch a couple of strategies,

00:53:17.280 | three strategies that have high exposure to a small value

00:53:21.560 | in the near future, let's put it that way.

00:53:25.800 | - Let's get into the last topic

00:53:28.280 | and that has to do with fixed income.

00:53:30.280 | You do have a few fixed income funds

00:53:33.760 | and you do run a strategy based on the yield curve,

00:53:36.600 | trying to enhance the return based on yield curve.

00:53:40.000 | In other words, you say the yield curve

00:53:41.280 | is telling you something.

00:53:42.640 | Could explain your fixed income investment strategy

00:53:45.560 | and why there may be an expectation for a higher return

00:53:50.320 | than just doing a regular straight index fund.

00:53:53.760 | - There is a couple of things

00:53:56.200 | that are very, very interesting

00:53:57.480 | when you think about fixed income.

00:53:59.600 | Let's just speak first about indexing.

00:54:01.520 | You know how the index works.

00:54:03.240 | The index that an index managers follows in fixed income

00:54:06.320 | incorporates every bond as there have been issued.

00:54:09.560 | So you re-issue a bond,

00:54:12.120 | that bond is incorporated in the index automatically.

00:54:17.120 | Now, if you recap to issue a bond,

00:54:20.080 | are you going to issue in a way that increases your cost

00:54:24.040 | or reduces your cost of servicing that debt?

00:54:27.280 | You're going to try to minimize your cost.

00:54:30.000 | So you're going to issue in the condition,

00:54:32.240 | say duration or whatever it is,

00:54:34.280 | that minimize your cost, yeah?

00:54:36.680 | - Yes.

00:54:37.520 | - But if you are minimizing your cost,

00:54:40.080 | you're also minimizing my expected returns

00:54:42.760 | if I'm the investor in that bond.

00:54:45.160 | So the automatically inclusion of bonds

00:54:49.480 | is really a detriment for an index in fixed income.

00:54:54.720 | Now, you mentioned we use some scenario.

00:54:58.040 | We need to have like inequities.

00:55:00.280 | We need to have an idea

00:55:02.280 | what bonds will have higher expected returns than others,

00:55:06.240 | given the same credit quality and everything the same.

00:55:09.480 | And we do that by using the yield curve.

00:55:11.800 | So what do we mean by that?

00:55:14.080 | Let's suppose that you have a bond

00:55:15.840 | and you hold it to maturity.

00:55:17.720 | And let's suppose that the bonds of default, yeah?

00:55:20.360 | What is your expected return on that bond?

00:55:22.600 | Your expected return of that bond is your yield to maturity.

00:55:26.160 | - Assuming you can reinvest the income

00:55:28.600 | at the yield to maturity rate.

00:55:30.200 | - Let's assume that it's zero coupon.

00:55:32.480 | Life is easy.

00:55:33.440 | - Life is easy.

00:55:34.280 | Zero coupon.

00:55:35.520 | - Zero coupon.

00:55:36.800 | So your zero coupon bond

00:55:38.840 | that has a yield to maturity of 2%,

00:55:41.560 | your average return if you hold that bond to maturity

00:55:45.000 | is 2% a year.

00:55:46.480 | - Correct.

00:55:47.400 | - But your return from year to year is not going to be 2%.

00:55:51.640 | - That's correct.

00:55:52.760 | - Because if you have a three-year bond

00:55:54.720 | under the typical yield curve,

00:55:57.040 | the yield curve has lower yields to maturity

00:56:00.400 | for short-term durations

00:56:01.960 | and higher yields to maturity for longer duration.

00:56:04.880 | So if I have a three-year bond

00:56:07.400 | that gives me yield to maturity of 2%,

00:56:10.360 | one year from now,

00:56:11.880 | that bond will be shorter to maturity.

00:56:15.160 | So on expectation,

00:56:16.160 | we have a lower yield to maturity than today.

00:56:20.880 | So you can see the yield to maturity

00:56:22.960 | was the average return to maturity,

00:56:25.360 | but that doesn't mean that every year is the same.

00:56:29.440 | In general, the longer portion of that holding period

00:56:34.840 | will have higher returns

00:56:36.120 | than the shorter portion of that holding period.

00:56:39.200 | So you can use information in the shape of the yield curve

00:56:43.000 | to decide when that bond has higher than average returns

00:56:47.320 | relative to the yield to maturity

00:56:48.600 | and when it's going to have lower expected returns

00:56:52.280 | relative to the yield to maturity.

00:56:54.080 | And we use that information to create portfolios.

00:56:57.600 | - In geekish fixed income,

00:56:59.280 | what you're talking about is horizon return.

00:57:01.440 | - Yes.

00:57:02.280 | - If you're going to use it for two years,

00:57:03.880 | you're going to keep it for two years

00:57:04.920 | and then you're going to sell it,

00:57:06.280 | you're going to do what we call riding the yield curve.

00:57:09.080 | - Yes.

00:57:09.920 | - This 2% bond that you purchased

00:57:12.200 | because the last year,

00:57:13.320 | the yield to maturity on that bond

00:57:14.800 | might only be a half a percent,

00:57:16.360 | and you bought it at 2% as a three year.

00:57:18.800 | After the first two years, if you sold it,

00:57:21.880 | you're going to get a return on that

00:57:23.320 | that's much higher than the 2% yield.

00:57:26.120 | So the horizon yield might be two and a half

00:57:28.400 | or 2.7 or whatever it is.

00:57:30.600 | - Exactly.

00:57:31.440 | That's exactly what we're saying.

00:57:34.680 | - See, I remember from my CFA days all of that stuff.

00:57:38.160 | - That's exactly what we're doing.

00:57:39.920 | Instead of trying to get an average income to maturity,

00:57:43.440 | we are happy to get an income from some period of time

00:57:46.720 | and a capital appreciation

00:57:48.400 | due to the change in the shape of the yield curve.

00:57:51.040 | - And the convexity, as another geekish word,

00:57:53.120 | has a lot to do with this too.

00:57:54.280 | I mean, there are some bonds that this happens rapidly

00:57:56.960 | and there are some bonds where it takes more time.

00:57:58.680 | - Absolutely.

00:57:59.520 | And that's why the way we do it

00:58:01.240 | is we have an estimated yield curve for different issues.

00:58:04.640 | For every issue, we have an estimated yield curve

00:58:06.680 | depending on the sector, the credit quality and whatnot.

00:58:09.600 | Based on market information,

00:58:10.760 | we don't make predictions, remember.

00:58:13.080 | And then we use that estimated yield curve for every issue

00:58:16.240 | to compute the specter return of the bond

00:58:18.000 | for a horizon, like you mentioned.

00:58:20.160 | And then we use that information to create a portfolio.

00:58:23.000 | - Very interesting.

00:58:23.880 | Well, Eduardo, it's been fantastic having you

00:58:26.000 | on "Bogle Heads-On Investing."

00:58:27.800 | I thank you very much for your time today

00:58:30.320 | and wish you a lot of luck.

00:58:31.320 | And I know you just passed 10 billion

00:58:32.920 | and hopefully you get to 100 billion quickly.

00:58:35.720 | - Thank you very much.

00:58:37.280 | - This concludes "Bogle Heads-On Investing,"

00:58:39.720 | episode number 43.

00:58:41.560 | Join us each month as we have a new guest

00:58:44.040 | and talk about a new topic.

00:58:45.720 | In the meantime, visit bogleheads.org

00:58:48.520 | and the "Bogle Head" wiki.

00:58:50.200 | Check out the "Bogle Heads" new YouTube channel,

00:58:53.280 | "Bogle Heads" Twitter, "Bogle Heads" Facebook,

00:58:56.160 | and find out about your local "Bogle Heads" chapter

00:58:59.760 | and tell others about it.

00:59:01.200 | Thanks for listening.

00:59:02.400 | (upbeat music)

00:59:05.000 | (upbeat music fades)

00:59:08.080 | (upbeat music)

00:59:10.660 | [BLANK_AUDIO]

Bogleheads® on Investing Podcast Episode 043: Eduardo Repetto on factor investing, host Rick Ferri

Chapters