Bogleheads® on Investing Podcast 034 – Jason Hsu, host Rick Ferri (audio only)
00:00:00.000 | (upbeat music)
00:00:02.580 | - Welcome everyone to the 34th edition
00:00:11.620 | of Vogelheads on Investing.
00:00:13.640 | Today, our special guest is Jason Su.
00:00:16.280 | Jason is one of the smartest investors I've met.
00:00:18.960 | He has published more than 40 peer-reviewed articles,
00:00:21.960 | won numerous awards.
00:00:23.560 | He co-created the Fundamental Indexing Concept,
00:00:25.960 | and today, focuses on inefficiencies in Chinese stock.
00:00:29.500 | (upbeat music)
00:00:32.080 | Hi everyone, my name is Rick Ferry,
00:00:39.440 | and I'm the host of Vogelheads on Investing.
00:00:41.800 | This episode, as with all episodes,
00:00:43.720 | is brought to you by the John C. Vogel
00:00:45.640 | Center for Financial Literacy,
00:00:47.860 | a 501(c)(3) nonprofit organization.
00:00:51.360 | Visit us at vogelcenter.net,
00:00:53.760 | and your tax-deductible donations are greatly appreciated.
00:00:57.400 | Today, we have a special guest,
00:00:59.120 | Jason Su.
00:01:00.760 | Jason graduated with a degree in physics
00:01:03.420 | from California Institute of Technology,
00:01:05.840 | was awarded his Master's of Science in Finance
00:01:08.440 | from Stanford University,
00:01:10.240 | and earned his PhD in Finance from UCLA,
00:01:13.080 | where he conducted research on the equity risk premium,
00:01:15.980 | business cycles, and portfolio asset allocations.
00:01:19.100 | Jason has authored more than 40 peer-reviewed articles.
00:01:22.360 | He is the Associate Editor
00:01:23.780 | of the Journal of Investment Management,
00:01:25.680 | and serves on the editorial board
00:01:27.240 | of the Financial Analyst Journal,
00:01:28.900 | the Journal of Index Investing,
00:01:30.680 | the Journal of Investment Counseling,
00:01:32.680 | and the Journal of Investment Management.
00:01:34.960 | Professionally, Jason has been on the forefront
00:01:37.080 | of factor investing as one of the founders
00:01:39.880 | of research affiliates,
00:01:41.440 | and now has taken factor investing to a new level
00:01:44.960 | as he applies it to the Chinese stock market.
00:01:47.960 | So with no further ado,
00:01:49.740 | let me introduce Jason Su.
00:01:53.000 | Welcome to the Vogelheads on Investing podcast, Jason.
00:01:55.840 | - Glad to be here, Rick.
00:01:57.160 | - Well, it's great that you joined us.
00:01:58.520 | I've always been super impressed with your background,
00:02:02.960 | and all the things that you've done
00:02:05.480 | in the financial services industry,
00:02:07.600 | in the investment management industry.
00:02:09.880 | Been a very successful person.
00:02:12.280 | Although, I have to say, you kind of fly under the radar,
00:02:16.320 | in that you've done so much,
00:02:19.340 | and you've got so many awards,
00:02:21.440 | but you may have fortune,
00:02:23.600 | but you don't have the fame,
00:02:25.820 | which is a little bit odd in a way,
00:02:27.520 | given who you are and everything that you've done.
00:02:31.400 | And so maybe we'll elevate that a little bit here,
00:02:34.920 | at least among the Vogelheads.
00:02:36.120 | So I've been a big fan of yours for years.
00:02:38.520 | And before we get started,
00:02:40.940 | tell us, going as far back as you feel comfortable,
00:02:44.560 | a little bit about your background.
00:02:47.120 | - Well, going really far back, Rick,
00:02:49.760 | I came to this country really as an immigrant.
00:02:53.560 | No, you know, I arrived when I was 10.
00:02:56.720 | At the time, I spoke, I think, no English.
00:03:00.760 | But the country's been really, really good to me.
00:03:02.960 | I learned a tremendous amount.
00:03:05.520 | And eventually I found myself at Caltech,
00:03:08.480 | studying to be a physicist.
00:03:11.480 | - You got into California Institute of Technology,
00:03:16.480 | and you decided you were going to be a physicist.
00:03:20.800 | And you've excelled in that.
00:03:23.480 | You actually graduated summa cum laude in physics.
00:03:28.480 | What happened after that?
00:03:29.600 | I mean, you've made a pivot for sure.
00:03:33.320 | - Yeah, the one thing that I experimented with
00:03:37.240 | while at Caltech was I did sort of a weekend gig
00:03:42.240 | at a economic laboratory,
00:03:45.840 | where they had students play essentially market games.
00:03:50.680 | And we were the subject of the experimentation.
00:03:54.720 | And I was really good at those games.
00:03:56.960 | Eventually they prevented me from participating.
00:03:59.360 | And that's when I got to learn about markets,
00:04:03.160 | and about equilibrium, and also about market efficiency,
00:04:07.920 | and how competition leads to price efficiency,
00:04:10.440 | and how that generally leads to better outcome
00:04:13.440 | for everyone involved.
00:04:15.200 | - What year was this, when all this was going on?
00:04:17.960 | - 1994, so I was a sophomore.
00:04:22.960 | - And then you decided after you graduated
00:04:25.240 | to pursue a master's of science in finance
00:04:29.560 | at Stanford University.
00:04:31.280 | You've got some pretty good schools in your background.
00:04:34.160 | - Yeah, I decided to learn about financial markets,
00:04:38.560 | really be an economist and understand
00:04:40.480 | how this stock market thing work,
00:04:42.880 | how the capital markets work,
00:04:44.560 | how that's relevant to the real economy.
00:04:47.480 | And I guess to how society are shaped
00:04:52.480 | as a result of how these markets interact.
00:04:56.120 | - And then from there you went on to get your PhD at UCLA.
00:05:01.120 | - That's right.
00:05:02.880 | - And what was your PhD thesis?
00:05:05.680 | - So I was studying the differences
00:05:10.280 | between American households and Asian households.
00:05:14.280 | And the thing that I was trying to understand
00:05:16.720 | is why do Asian households save too much
00:05:20.240 | and American households save too little?
00:05:22.800 | And as a result, what you see is Asian households
00:05:25.480 | participate in the stock market very directly
00:05:29.160 | and very meaningfully, and American households do not.
00:05:32.480 | The participation is very indirectly
00:05:34.600 | through their defined benefit pension plans or 401(k).
00:05:37.760 | There's really very little of individual wealth
00:05:41.040 | outside of retirement plan
00:05:42.360 | that's committed to the stock market.
00:05:43.800 | So that was kind of the primary thing that I studied.
00:05:47.320 | - Well, it's interesting.
00:05:48.160 | And we're gonna get to this a little bit later on
00:05:49.560 | in the podcast, but it's interesting now
00:05:51.200 | that you've circled back to that with your new company
00:05:54.560 | in a way to try to capitalize on these individuals
00:05:59.000 | in the market as opposed to through institutions.
00:06:02.640 | I can see where you ended up going with all this
00:06:05.840 | is a little bit where you currently are right now
00:06:08.440 | and without getting too far ahead, is that true?
00:06:11.440 | - Yeah, I mean, I didn't know at the time
00:06:13.640 | that that was going to be of any practical usefulness.
00:06:17.080 | Really, I was very much set on pursuing
00:06:20.520 | a academic research career.
00:06:22.920 | It really was through a sequence of, I guess,
00:06:25.040 | happy coincidence that I ended up being
00:06:27.600 | more of a practitioner than a academic scholar.
00:06:32.200 | It's like a bigger accident that 20, 25 years later,
00:06:37.200 | it ended up being quite useful given the business I'm in.
00:06:42.280 | - But you did do a lot of academics.
00:06:44.000 | I mean, you were an adjunct professor
00:06:46.280 | and you were a visiting professor at various colleges,
00:06:48.960 | both here and in Asia.
00:06:51.440 | And you did get the feel for being an academic.
00:06:55.360 | - Yes, I did put my PhD to good use.
00:06:58.840 | - And you also wrote many papers.
00:07:01.600 | You wrote 40 peer-reviewed papers.
00:07:05.320 | And could you explain what the difference is
00:07:07.920 | between just writing something and having it published
00:07:10.960 | in a peer-reviewed paper?
00:07:13.640 | - Yeah, so it is now fashionable in our industry
00:07:17.400 | for firms to do white papers.
00:07:20.240 | And white papers feel a little less marketing and salesy
00:07:25.240 | and perhaps more educational and neutral.
00:07:29.880 | But frankly, oftentimes, the quality is suspect.
00:07:34.720 | And you can definitely see an angle
00:07:36.640 | where this is just a dressed-up marketing document.
00:07:40.480 | But when it's a peer-reviewed journal article,
00:07:42.840 | whether it's industry journals or academic journals,
00:07:45.640 | they're meant to be educational, right?
00:07:46.960 | You're supposed to do research
00:07:48.280 | that answers the important question
00:07:49.880 | and you're supposed to use methods that are robust,
00:07:53.400 | that is replicable.
00:07:54.960 | And the conclusion you draw from it has to be logical.
00:07:59.080 | And there's at least one referee, if not two,
00:08:02.120 | and the journal editor will also sort of vet the paper
00:08:04.840 | to ensure that it is truly educational and useful
00:08:08.720 | and then not sort of a sales document in disguise.
00:08:12.760 | So it's a much higher bar that's required
00:08:15.480 | in terms of rigor and the time committed
00:08:17.400 | to doing a peer-reviewed article.
00:08:20.760 | Most articles that are submitted to journals
00:08:23.280 | are actually rejected.
00:08:24.840 | And even the ones that get accepted
00:08:26.600 | go through two, three rounds of editing and re-editing.
00:08:31.480 | - You are also very familiar with getting articles published.
00:08:36.160 | Not only have you written 40 peer-reviewed articles,
00:08:38.440 | but you're also a member of the editorial board
00:08:41.640 | for the Financial Analyst Journal.
00:08:44.200 | You're a trustee for the CFA Institute Research Foundation.
00:08:48.800 | You're an associate editor
00:08:50.400 | for the Journal of Index Investing,
00:08:52.840 | an associate editor
00:08:54.080 | for the Journal of Investment Management.
00:08:56.880 | You could tell the difference, I think, if anybody could,
00:08:59.600 | between something that's a marketing piece
00:09:03.120 | and something that is a actual academic paper.
00:09:06.840 | - Yep, part of that is the PhD training,
00:09:09.160 | and part of that is also being on both sides of the table,
00:09:14.160 | writing something as a scholar,
00:09:16.880 | and of course, being a gatekeeper
00:09:19.040 | to ensure that only scholarly pieces sort of come through.
00:09:22.560 | And I've been doing that for about 20 years.
00:09:25.200 | - Yeah.
00:09:26.400 | You also have been in the field.
00:09:29.000 | You've got a distinguished career, not only in academics,
00:09:32.240 | but also you have a distinguished career
00:09:34.360 | in the investment management field,
00:09:36.800 | first as the co-founder of Research Affiliates,
00:09:41.800 | and co-founded that with Rob Ardott.
00:09:44.680 | Can you give me a little history?
00:09:45.840 | Because I know Rob, and I've known him for many years,
00:09:48.280 | and he's an interesting character.
00:09:51.160 | But I'd like to know how that all came about.
00:09:54.720 | - Yeah, again, as I mentioned, a very lucky coincidence.
00:10:01.120 | So I was at UCLA, really finishing up.
00:10:04.520 | That was my last year in a PhD program,
00:10:06.560 | and Rob had just sold and exited out of his last company,
00:10:11.560 | First Quadrant, and decided to volunteer
00:10:15.520 | at UCLA Anderson School.
00:10:17.960 | Of course, the dean was very excited,
00:10:20.920 | having someone who's so well-known,
00:10:23.080 | and who, at some point in the future,
00:10:25.240 | could be a very meaningful donor to the business school.
00:10:28.000 | And so we were put together to co-teach a class together,
00:10:33.000 | because, obviously, I'd been a lecturer at UCLA
00:10:37.120 | by that time for a number of years,
00:10:38.960 | and Rob, obviously, someone with great war stories,
00:10:42.640 | so the dean thought that would be a great pairing.
00:10:45.320 | So that's how we got to know each other.
00:10:46.960 | And Rob is someone, I guess at that time,
00:10:51.080 | still very young, had a lot of ambition,
00:10:53.080 | and had a lot more left in his tank.
00:10:54.960 | And he quickly decided, well, he said,
00:10:57.240 | hey, I'm gonna start something,
00:10:59.480 | and Jason, would you be interested in joining in the startup?
00:11:03.160 | And that's how we got started,
00:11:04.480 | literally two guys in a garage,
00:11:07.320 | 'cause we didn't have an office back then,
00:11:09.040 | and then a Bloomberg.
00:11:11.320 | - A living room and a Bloomberg,
00:11:14.400 | that's how I actually got started myself
00:11:16.040 | in the advisory business.
00:11:17.360 | So I understand where you're coming from on that.
00:11:20.080 | But that's interesting.
00:11:21.000 | And tell us originally about the focus
00:11:25.280 | of research affiliates.
00:11:26.440 | What is it that you were trying to do with that company?
00:11:29.640 | And then what did it evolve into?
00:11:32.360 | - Like many startups that eventually succeed,
00:11:35.720 | what the original founder set out to do
00:11:39.560 | is often not what ended up being successful.
00:11:42.680 | So I think when Rob and I first got started,
00:11:45.800 | a number of ideas we tried.
00:11:47.160 | Like we initially wanted to offer software, actually.
00:11:51.720 | And it was way ahead of its time.
00:11:54.280 | It was a smart software to help wealth management platform
00:11:59.240 | to manage rep accounts.
00:12:00.680 | So it would be very intelligent
00:12:02.800 | in terms of tax loss harvesting,
00:12:06.920 | crossing, offsetting trades.
00:12:09.680 | That great idea, probably ahead of its time,
00:12:13.760 | at a time when technology was a lot more expensive,
00:12:16.720 | a lot more unwieldy.
00:12:18.520 | So that didn't fly.
00:12:20.600 | But I still think it was a great idea.
00:12:22.240 | And later on, others have clearly done a much better job
00:12:24.600 | with that idea.
00:12:26.040 | We then set out to do a liability defeasement strategy.
00:12:30.560 | Again, a clever strategy that played off
00:12:32.840 | of the way the yield curve worked.
00:12:35.720 | And we thought there was gonna be great demand,
00:12:38.000 | but I think liability defeasement back in the early 2000
00:12:43.000 | was still a little too early for most pension funds.
00:12:46.120 | So again, a decent idea.
00:12:47.720 | I even got a seed investor to trial the program,
00:12:50.200 | but it didn't actually go anywhere.
00:12:52.480 | Was almost a side hustle,
00:12:55.000 | which was sub advising a asset allocation mutual fund,
00:12:59.160 | kind of a little pilot experiment for PIMCO.
00:13:02.680 | And that ended up taking off and became a runaway success.
00:13:06.120 | And then like, I think what most of you know us for,
00:13:09.720 | eventually we use the income from that product
00:13:13.320 | to develop fundamental indexing,
00:13:15.640 | which is what today research affiliates,
00:13:18.320 | but Rob and I are probably best known for
00:13:20.960 | and likely will be best remembered for.
00:13:23.760 | - I recall all of this because I was in the industry
00:13:28.160 | at the time and watching this happen.
00:13:31.080 | And to me, DFA, Dimensional Fund Advisors,
00:13:36.120 | had a real headstart on this factor investing,
00:13:40.520 | fundamental indexing strategy,
00:13:44.680 | but you did it in an exchange traded fund form mostly,
00:13:49.600 | and you captured that market fairly quickly.
00:13:53.560 | - Back in the early 2000, ETF was a very new concept.
00:13:57.560 | A lot of people didn't know what it was, right?
00:14:00.000 | This mutual fund at the time was the vehicle of choice.
00:14:04.200 | All the big ETF players you know of today
00:14:06.360 | didn't exist back then.
00:14:07.440 | And probably back then they didn't want to do ETF.
00:14:09.800 | They thought it was a stupid thing to do.
00:14:11.920 | So very early on, after we wrote the paper
00:14:14.680 | on fundamental indexing,
00:14:16.600 | we were contacted by Bruce Bond and Ben Fulton.
00:14:21.600 | They started PowerShares.
00:14:23.760 | And they said they are looking for innovative indexes
00:14:28.760 | on top of which they can create ETFs on.
00:14:31.480 | And they knew it wouldn't make sense
00:14:33.480 | for them to do an S&P and compete with the SPDR.
00:14:37.320 | So they really wanted something
00:14:38.400 | that was very differentiated.
00:14:40.400 | And they saw our research paper that was published
00:14:43.640 | in the "Financial Analyst Journal"
00:14:45.360 | and said, "This is it, this is it."
00:14:47.720 | And so we met one snowing afternoon in New York,
00:14:52.520 | agreed to a deal, found FTSE,
00:14:55.480 | had FTSE basically convert our fundamental index methodology
00:14:59.840 | into an index.
00:15:01.320 | - Just to clarify, FTSE is who?
00:15:03.760 | - Yeah, FTSE is one of the largest index calculators
00:15:07.080 | in the world, owned by the London Stock Exchange.
00:15:10.600 | - And they took your methodology
00:15:13.000 | and created an index out of it?
00:15:15.120 | - That's right.
00:15:16.600 | - It was one of the things that I looked at
00:15:20.120 | and I personally said, "Well, this isn't an index.
00:15:22.200 | "This is active management."
00:15:24.120 | (laughs)
00:15:25.280 | And that was really a debate back then.
00:15:28.680 | I know that ship has sailed
00:15:30.320 | because the SEC said, "Yes, it's an index."
00:15:32.760 | But back then, I can recall the mudslinging
00:15:35.520 | that went on between you or your company
00:15:38.080 | and Standard & Poor's as to what is an index.
00:15:41.720 | But I think that the SEC allowed all this
00:15:44.080 | to be called indexing and there it was.
00:15:46.360 | Much different than what the slang became
00:15:50.640 | and the slang became smart beta,
00:15:53.600 | which at first you embraced,
00:15:58.360 | but then later on,
00:16:00.080 | didn't seem like you were embracing it so much.
00:16:02.520 | - Yeah, so Rick, I gotta tell you the backstory to that.
00:16:05.560 | So we didn't come up with the moniker smart beta.
00:16:09.200 | We called our strategy fundamental indexing
00:16:13.080 | and we really were trying to play off
00:16:16.200 | of cap-weighted indexing, right?
00:16:18.160 | We think about cap-weighted indexing
00:16:19.680 | is market capitalization,
00:16:21.720 | which is determined by price times shares outstanding.
00:16:24.720 | So really, there's a lot of price indexing
00:16:27.520 | in that construct and we wanted to play off
00:16:30.720 | of price-based indexing against something
00:16:34.520 | that's not price, but still related to value.
00:16:37.040 | So we think of a company fundamental.
00:16:39.960 | So we said, okay, now fundamental indexing
00:16:42.440 | would be this play on word and it would contrast
00:16:45.240 | against say, cap-weighted or price-based indexing.
00:16:49.280 | And that's really how we came up with the name.
00:16:52.240 | And like you say, most people didn't think
00:16:56.520 | what we created was an index because everyone
00:16:59.320 | had by that time come to, except that the index
00:17:04.320 | should be cap-weighted because that's how S&P is built.
00:17:07.960 | And there's a paper by Bill Sharp and others
00:17:12.440 | that talked about the merit of cap-weighting
00:17:14.880 | as a portfolio construct.
00:17:18.240 | And so we were really swimming upstream
00:17:20.440 | against that established school of thought.
00:17:23.960 | And as we were talking to investment consultants,
00:17:26.800 | financial advisors, most people said like,
00:17:29.160 | you got an active strategy, it's not an index.
00:17:32.240 | So you really shouldn't be in the ETF space
00:17:36.040 | because ETF is really meant to track passive indices
00:17:38.560 | for people who believe in market efficiency.
00:17:40.720 | And so we actually had a lot of struggle
00:17:42.320 | in the early get-go.
00:17:44.280 | - And I think I was part of the struggle.
00:17:45.800 | I was the one that's sitting in the audience
00:17:47.120 | raising my hand, yelling at you.
00:17:48.760 | - That's right, I do remember that.
00:17:52.040 | - Well, anyway, it took a lot.
00:17:54.920 | Fundamental indexing, you know,
00:17:56.720 | I talked with Robert Knott about this.
00:17:58.320 | I think it's an everlasting term,
00:18:01.360 | but you know, the smart beta isn't
00:18:04.840 | because it kind of dirties the water
00:18:07.520 | and muddies the water, in my opinion.
00:18:09.880 | Okay, this thing takes off then.
00:18:12.120 | I mean, you start rolling like a steamroller
00:18:15.840 | with fundamental indexing due to great returns
00:18:19.960 | from value stocks after the tech wreck in the early 2000s.
00:18:24.960 | I mean, you're on the radar and things are growing.
00:18:28.560 | Can you just take us through that part
00:18:30.280 | of the growth of the company?
00:18:31.880 | - Yeah, absolutely.
00:18:32.720 | So from the initial get-go where, you know,
00:18:35.560 | people didn't even like the word indexing,
00:18:38.760 | to it being embraced by, I think it was first by,
00:18:43.240 | at the time, you know, Towers Watson, later on Mercer,
00:18:47.560 | and they coined the category name smart beta.
00:18:50.520 | And then, like you say, it just grew like wildfire
00:18:53.120 | once consultants sort of validated the concept
00:18:55.840 | with a category name.
00:18:57.760 | And we were the first, you know, off the board.
00:19:01.120 | Yeah, we just had momentum behind us being the first mover,
00:19:05.320 | being the claim to the original IP.
00:19:08.840 | We, yeah, we had a lot of, I would say,
00:19:11.960 | active-oriented pension funds who say,
00:19:15.640 | "Hey, you know, we heard about the merit of a lower cost,
00:19:19.240 | "more transparent index strategy,
00:19:22.600 | "but we're not ready to go full-on passive
00:19:24.920 | "into the S&P 500.
00:19:26.720 | "So going into a fundamental index
00:19:29.680 | "is kind of like halfway move,
00:19:32.120 | "going from full active to full passive."
00:19:34.600 | And then that was a good compromise
00:19:36.200 | for, I think, a lot of pension funds
00:19:38.320 | and their investment consultants.
00:19:40.760 | And similarly, I think we had a lot of people
00:19:43.480 | who already bought into the concept of indexing
00:19:46.760 | and love and understood the ETF chassis who said,
00:19:51.400 | "Well, you know, here is a index product
00:19:55.920 | "that could actually have some credible success
00:19:59.680 | "in delivering outperformance slightly more consistently
00:20:04.040 | "and slightly more scientifically."
00:20:05.600 | And so we kind of were attracting flows
00:20:07.440 | from both sides of the argument, right?
00:20:10.080 | Attracting flows from active investors
00:20:12.320 | and attracting flows from some passive investors.
00:20:14.760 | And that really, like you say,
00:20:17.600 | it sort of steamrolled through the industry
00:20:20.760 | and then put research affiliates on the map.
00:20:23.480 | - Yeah, I remember this whole period of time
00:20:26.280 | and I remember discussions with you and discussions,
00:20:31.280 | I know I had discussion with you, Rob, about this.
00:20:33.840 | It was, look, you're sort of barking up the wrong tree.
00:20:38.120 | This is initially, this is right at the beginning
00:20:39.760 | once you came out with fundamental indexing.
00:20:41.800 | I remember saying, you know,
00:20:43.600 | don't go after the cap-weighted index first.
00:20:46.720 | Don't go after them.
00:20:48.200 | I mean, that's not your market.
00:20:49.400 | Your market is active management
00:20:51.120 | because what you've done here
00:20:52.840 | is you've lowered the cost of active management
00:20:56.240 | and you've made it more consistent
00:20:58.560 | than what it was in the past
00:21:01.240 | because you have a set of rules.
00:21:03.240 | And that's the enduring part of what you're doing.
00:21:06.840 | So in my view, it was exactly what you said
00:21:10.920 | about a lot of these pension funds.
00:21:12.000 | Look, we're not ready to go from active
00:21:13.760 | to cap-weighted indexing,
00:21:15.760 | but what we're ready to do, at least partially,
00:21:18.240 | is to go from active to fundamental indexing
00:21:22.120 | and at least lower our cost and make things more consistent.
00:21:25.680 | When that shift happened,
00:21:27.920 | you know, that kind of the mental shift of marketing,
00:21:30.320 | if you will, happened,
00:21:31.160 | I think that really helped to propel
00:21:34.160 | the whole industry that you started.
00:21:37.040 | - Yeah, Rick, you're absolutely right.
00:21:39.360 | I think your prediction and your advice at the time
00:21:43.680 | turned out to be, I think, key.
00:21:45.360 | I think, ultimately, we attracted a lot more assets
00:21:47.840 | from the active camp
00:21:50.520 | who really haven't had that much success
00:21:53.240 | with active management.
00:21:55.480 | But, you know, I think it's going fully to pure passive
00:22:00.160 | took some meandering, I think,
00:22:02.480 | before they could fully sort of get on board.
00:22:05.200 | And, you know, going to fundamental indexing
00:22:07.600 | was kind of a safe middle way compromise.
00:22:11.200 | - And, like I said, it really cut the cost of doing it.
00:22:14.800 | And it was consistent.
00:22:15.640 | I mean, when you're following a strategy
00:22:17.120 | like you're following,
00:22:17.960 | and you have to follow a systematic methodology,
00:22:21.400 | you don't get manager whims don't get in the way.
00:22:26.400 | I mean, if you believe in the methodology
00:22:29.720 | and you look at the data and you say,
00:22:31.920 | "Well, it worked in the past
00:22:33.240 | "and this is why it worked in the past."
00:22:35.280 | And so we know that since it's a quote unquote index,
00:22:38.920 | that this is the methodology
00:22:40.000 | that's going to be used in the future.
00:22:41.240 | So we can rely on that rather than relying on the manager
00:22:43.880 | to do one day be a value manager.
00:22:45.960 | And the next day, they're not so much a value manager
00:22:48.720 | because that's just not where the momentum is at the time.
00:22:51.480 | That there was a lot of value to that.
00:22:53.840 | And I have to believe that that's continuing
00:22:56.840 | to be that way.
00:22:57.840 | Although it was a struggle, right?
00:22:59.280 | I mean, after the financial crisis occurred,
00:23:04.320 | value investing, fundamental indexing,
00:23:07.840 | although a lot of assets were going that direction,
00:23:10.320 | those factors didn't perform well.
00:23:14.040 | I wanna get into here a little bit
00:23:16.320 | that they're not always going to perform well
00:23:18.240 | and that there is a 25 year,
00:23:22.640 | I don't wanna say cycle or something,
00:23:24.320 | a wave to these things
00:23:25.760 | and that people who are in it need to be patient.
00:23:29.360 | - Yeah, Rick.
00:23:30.200 | I mean, I think what we saw in 25 years,
00:23:33.320 | probably going out 30 years,
00:23:34.800 | there are really two things happening in the background
00:23:38.160 | that's made it difficult to be a value investor.
00:23:41.920 | And given value is a big underpinning
00:23:45.360 | of the fundamental index methodology,
00:23:48.640 | it's been tough for value investors
00:23:50.160 | in fundamental index the last 30 years.
00:23:54.080 | And part of what's driving that
00:23:55.760 | is market has become more efficient, right?
00:23:58.160 | If you think of value as an anomaly,
00:24:00.840 | meaning you can buy good quality asset cheap,
00:24:03.440 | that's not supposed to happen.
00:24:04.560 | Good quality assets are supposed to be expensive
00:24:07.640 | and it's generally the risky stuff
00:24:09.400 | that's supposed to be cheaper.
00:24:10.440 | So you're generally supposed to see value stocks
00:24:13.520 | as more expensive, not cheaper,
00:24:16.760 | if they're truly high quality, right?
00:24:19.560 | So a lot of the value premium,
00:24:21.040 | you could say was an anomaly
00:24:22.320 | for whatever reason that it existed.
00:24:23.800 | But as the market gets more efficient,
00:24:25.600 | it's supposed to go away.
00:24:27.480 | So I think part of the diminishing value premium
00:24:31.280 | is related to the U.S. market
00:24:33.280 | becoming ever more institutional, ever more efficient,
00:24:36.400 | and any anomalies that's been documented historically
00:24:40.040 | is arbed out or just less relevant.
00:24:43.800 | But you also have, I think, the last few years,
00:24:45.920 | if you're looking at Reddit,
00:24:47.800 | you're looking at Robinhood trading,
00:24:52.920 | you're looking at prices for cryptocurrency
00:24:55.800 | and GameStop stocks,
00:24:57.440 | you also recognize that U.S. market
00:24:58.880 | has, the last few years,
00:25:00.000 | became probably more inefficient, right?
00:25:01.520 | I think retail trading's gone from 3%
00:25:04.080 | to closer to 30% now,
00:25:06.480 | and where exciting, sexy growth has done much better
00:25:10.440 | because that's where the retail sort of flows
00:25:13.360 | and retail trading have been concentrating on.
00:25:15.240 | So you got two things, right?
00:25:17.280 | One is market becoming more efficiently priced,
00:25:20.320 | which makes value work less well.
00:25:22.040 | And then more recently,
00:25:23.120 | the market's sort of kind of gone
00:25:24.960 | to a bit of a tech bubble,
00:25:26.720 | which has a further punished value.
00:25:28.280 | And when you combine those two together,
00:25:30.040 | it's been tough to be a value investor.
00:25:32.520 | - But has that been true internationally?
00:25:36.440 | And let's kind of work outside the U.S. now
00:25:39.040 | and look internationally at developed markets
00:25:41.880 | and then, secondly, emerging markets.
00:25:44.400 | Is it becoming more efficient?
00:25:46.360 | - Yeah.
00:25:48.400 | So generally, I would say,
00:25:49.840 | when you want to get a sense of efficiency,
00:25:53.360 | probably the best indicator to look at
00:25:55.640 | is the fraction of the trading volume
00:25:58.200 | that's accounted for by retail trading.
00:26:01.080 | Because I guess market efficiency is about price discovery,
00:26:05.320 | so it's about well-informed, analytical,
00:26:08.960 | rational, experienced investors making trades.
00:26:12.600 | And when you're talking about individuals,
00:26:15.040 | that's not what drives efficiency.
00:26:17.720 | So if you look at developed markets,
00:26:19.960 | by and large, are very institutionalized
00:26:21.880 | because they have giant pension funds
00:26:24.000 | and very developed mutual fund
00:26:27.480 | and wealth management industry.
00:26:28.640 | So most of the money's been delegated out
00:26:31.720 | and ultimately, the people who manage these assets
00:26:34.120 | are experienced.
00:26:35.560 | So it's basically super smart, experienced traders
00:26:39.360 | and PMs competing against each other.
00:26:41.120 | So markets tend to be more efficient.
00:26:43.200 | That's, by and large, not what you see in emerging markets.
00:26:46.880 | Many of them have underdeveloped wealth management markets.
00:26:50.840 | Their mutual fund industry is in their nascent stage.
00:26:54.480 | A lot of the trading are still just done
00:26:56.560 | by individual investors who are gambling in a stock market.
00:27:00.720 | And so as a result, efficiency is generally poor.
00:27:05.720 | And the funny thing is in the Asian emerging markets,
00:27:10.560 | I would say the efficiencies are particularly poor.
00:27:14.080 | Part of it, you might say, might be culture for gambling.
00:27:18.200 | A lot of the Asian investing is more gambling
00:27:21.880 | than really retirement planning or retirement saving.
00:27:25.440 | And also what you see is Asian households,
00:27:27.560 | like my dissertation found out, they save way too much.
00:27:30.680 | And some of that money end up going
00:27:32.560 | to the stock market unproductively.
00:27:35.360 | - So back to research affiliates,
00:27:36.720 | are you still associated with research affiliates?
00:27:40.040 | - I'm associated with research affiliate as an advisor.
00:27:44.520 | So I exited or I spun out of research affiliates in 2016
00:27:49.520 | to launch Rayleigh & Global Advisors
00:27:54.280 | to focus on basically China.
00:27:57.960 | We are now a specialty China manager,
00:28:02.040 | working with large institutions as well as financial advisors
00:28:05.440 | to help them get access to all things China.
00:28:08.400 | That's my new focus now.
00:28:09.760 | And it's because that's where I think as a researcher,
00:28:13.200 | as a portfolio manager,
00:28:14.680 | we could still create alpha consistently
00:28:17.720 | and reliably net of fees.
00:28:19.480 | - Research affiliates was a research shop.
00:28:21.640 | You actually didn't manage investment portfolios there.
00:28:24.880 | You were doing research and you were creating
00:28:27.000 | the methodologies for choosing stocks and weighting stocks.
00:28:31.480 | Is that what your company Reliant is also?
00:28:35.200 | - Research affiliates had a very small book of business
00:28:38.120 | that was running assets directly,
00:28:40.360 | but it was so small as to be not known by most people
00:28:45.360 | who've done business with us.
00:28:47.320 | Rayleigh & Global Advisors,
00:28:49.040 | we now are more like a traditional
00:28:52.800 | quantitative active manager.
00:28:54.360 | We both develop the IP, the strategy.
00:28:58.120 | And while we do license them out
00:29:00.320 | to other larger asset managers who wanted our research
00:29:04.560 | and our strategies,
00:29:05.920 | we also have a thriving practice
00:29:08.920 | in terms of creating our own funds.
00:29:11.640 | We have funds in China, in US,
00:29:15.560 | and we run segregated accounts for institutional clients.
00:29:18.920 | So we got a different business model now
00:29:20.880 | versus research affiliates.
00:29:22.920 | - So let's get into all of the research that you did
00:29:25.560 | on factor investing that was pretty much
00:29:28.600 | centered on US investors and the US markets
00:29:32.080 | with fundamental indexing initially.
00:29:34.080 | I know you expanded that globally,
00:29:36.400 | but you primarily started it in the US markets
00:29:39.240 | and a lot of the work that you did,
00:29:40.360 | a lot of your papers and so forth were on the US markets.
00:29:44.120 | You take these tools that you created, this research,
00:29:48.000 | you bring them to China.
00:29:50.320 | And now the first thing you do is take those
00:29:53.840 | and did you attempt to apply them to the Chinese market?
00:29:57.360 | And if so, what happened?
00:29:59.480 | - Yep.
00:30:00.320 | So first thing I did was to apply everything as is, right?
00:30:04.760 | So I've taken all of the anomaly factors
00:30:08.240 | that we documented in academia based on US data
00:30:12.960 | and say, well, do they work in China?
00:30:15.240 | And surprisingly or not surprisingly,
00:30:18.000 | they work in China and they work quite well.
00:30:20.800 | And when I thought about it, I go, oh, of course, right?
00:30:23.920 | A lot of the anomaly factors for the US,
00:30:27.480 | they sort of lived in the past
00:30:29.160 | and are sort of less effective or almost non-effective
00:30:33.640 | the last 10, 15 years because markets become so efficient,
00:30:37.120 | but they certainly work
00:30:37.960 | when the US market was less efficient.
00:30:40.400 | Now, if you're applying those same intuition to China,
00:30:44.640 | it being a much more inefficient market,
00:30:47.360 | these anomalies ought to be larger.
00:30:49.440 | And since these anomalies are often related
00:30:51.600 | to retail individuals and their behavioral biases, right?
00:30:56.600 | Mental accounting, loss aversion,
00:31:00.160 | preference for high volatility as sort of lottery substitutes
00:31:05.160 | but you see all of that in China in spades.
00:31:07.880 | So what used to work in the US
00:31:09.680 | that maybe doesn't work anymore are alive and well in China.
00:31:14.680 | - I listened to your podcast with Jeff Patak
00:31:18.120 | and Christine Benz on Morningstar Longview.
00:31:22.200 | And you were talking about a 9% performance gap
00:31:27.800 | between Chinese fund returns and investors in those funds.
00:31:32.800 | And just for some background,
00:31:35.640 | in the US that gap has been closing significantly
00:31:39.600 | over the last 10 or 15 years.
00:31:41.760 | And the gap between mutual fund returns
00:31:45.000 | and market returns and client investor returns
00:31:48.560 | has really narrowed down.
00:31:50.640 | In fact, balanced funds,
00:31:51.880 | which you're actually getting an alpha now
00:31:53.640 | by being in a balanced fund.
00:31:56.480 | But this is not the case in China.
00:31:59.000 | Can you elaborate on that?
00:32:01.160 | - Yeah, there are two things that are super surprising
00:32:03.240 | when you look at Chinese fund data.
00:32:07.560 | First of all,
00:32:08.800 | if you just track the average mutual fund in China,
00:32:12.840 | on a net of cost basis,
00:32:15.040 | they outperform by about 4% per annum.
00:32:18.960 | So this is adjusting for survivorship bias,
00:32:22.240 | obviously taking costs into account.
00:32:25.040 | So this is really net performance.
00:32:26.800 | And of course, that's not what you see in the US, right?
00:32:28.680 | In the US net of cost,
00:32:30.040 | the average mutual fund underperforms.
00:32:33.400 | So that's the first surprising thing.
00:32:35.080 | Now, again, if you think about it,
00:32:37.200 | just tells you US market very efficient.
00:32:40.240 | Therefore, even well-trained portfolio managers
00:32:42.480 | can't consistently beat the market.
00:32:45.280 | In China, it's very inefficient.
00:32:47.160 | So someone who's a trained money manager,
00:32:50.120 | he's basically extracting alpha
00:32:52.280 | from essentially retail gamblers.
00:32:54.720 | So that's the first surprising thing.
00:32:56.840 | The next surprising thing is,
00:32:58.680 | the mutual fund industry in China is very underdeveloped,
00:33:01.240 | meaning most people don't trust mutual fund managers
00:33:04.720 | enough to buy mutual funds.
00:33:07.320 | They somehow trust their own skill more
00:33:10.080 | or prefer to gamble.
00:33:12.160 | And so as a result,
00:33:13.520 | they speculate in the stock market
00:33:18.000 | to obviously great detriment of their own wealth.
00:33:22.440 | So that's another thing we see in China,
00:33:24.240 | despite the outperformance,
00:33:26.480 | mutual fund industry is in its very nascent stage.
00:33:30.040 | It's actually not grown very fast at all.
00:33:33.000 | - I was reading a research paper that you put out,
00:33:37.480 | "China's Got Talent, Fund Manager Skill
00:33:39.880 | and Alpha in Chinese Stocks."
00:33:42.360 | And you track the growth of the mutual fund industry.
00:33:47.360 | And back in 1999,
00:33:50.560 | there was a whopping 22 mutual funds for all of China.
00:33:55.560 | But by the end of 2020, you wrote,
00:33:59.480 | there was almost 8,000 mutual funds.
00:34:03.160 | So, and most of them were developed in the last,
00:34:06.600 | call it seven years.
00:34:08.840 | How do you think this is gonna affect the efficiencies
00:34:12.720 | of the market efficiency in China?
00:34:14.640 | - So usually I will be on the side of competition.
00:34:19.880 | I will bring about greater efficiency.
00:34:22.640 | As I study more time with the data,
00:34:25.440 | what I have discovered when I look at this proliferation
00:34:29.720 | of mutual funds are really two things.
00:34:33.000 | One is most mutual funds in China are very concentrated.
00:34:38.000 | So unlike the U.S. where most mutual funds
00:34:41.760 | are benchmark huggers, right?
00:34:45.040 | Where kind of, you're looking at closet indexers
00:34:48.760 | and therefore net of cause,
00:34:50.760 | it's very hard for them to beat the index.
00:34:52.280 | In China, most of the mutual funds are quite concentrated.
00:34:56.040 | They would have enormously large bets on a sector,
00:34:59.120 | sometimes on a single stock.
00:35:01.040 | And you kind of think about, well, why does that happen?
00:35:03.680 | Right, that goes against diversification,
00:35:05.360 | it goes against sensible portfolio management.
00:35:08.840 | The reason it happens is Chinese fund investors
00:35:12.240 | are very short-term oriented,
00:35:14.000 | meaning they look at mutual fund performance leaks table
00:35:18.160 | on a weekly basis.
00:35:19.680 | And they would buy a fund and if they see another fund
00:35:23.520 | that had the better performance,
00:35:26.560 | the next time they pick up a newspaper,
00:35:28.440 | they would be trading out of their last fund
00:35:31.240 | to get into this new hot fund.
00:35:33.080 | And as a result, if you're a mutual fund company
00:35:35.360 | and you want to not lose asset,
00:35:37.880 | or at least keep the asset within your family of funds,
00:35:40.200 | you've gotta constantly launch a new fund
00:35:43.800 | that's sort of flavor of day, theme of the day,
00:35:46.040 | and that's very concentrated.
00:35:47.320 | So when the theme is right,
00:35:48.680 | you have insane performances.
00:35:50.800 | And so that's largely what describes
00:35:53.400 | the funds industry in China.
00:35:54.800 | So this fund proliferation hasn't brought about
00:35:58.600 | better price discovery or better competition.
00:36:01.840 | It's really just everyone is creating
00:36:04.080 | more and more extreme portfolios
00:36:06.280 | trying to benefit from the volatility effect
00:36:10.320 | so they can randomly become the best performer
00:36:12.480 | and gather a lot of assets.
00:36:14.280 | - You know, it does remind me of the mutual fund industry
00:36:16.840 | in the United States, say in the '70s and '80s,
00:36:19.240 | there was a lot of that going on.
00:36:21.000 | I think that Fidelity would create a fund
00:36:25.760 | based on whatever, it didn't matter what it was.
00:36:27.680 | We're gonna create it and we're gonna launch it
00:36:30.400 | because people want it.
00:36:31.680 | And even though the owners of that company
00:36:34.200 | would never put a dime of their own money in it,
00:36:36.320 | it didn't matter.
00:36:37.440 | They were in the mutual fund business.
00:36:38.680 | And if this is what people want,
00:36:39.960 | then we're gonna give it to them.
00:36:41.480 | Now that's not so much anymore in the United States.
00:36:44.000 | I think it's become too expensive to do that.
00:36:45.840 | And it's thinned out as far as the amount of money
00:36:48.760 | that's available.
00:36:49.600 | So it's almost become almost prohibitively expensive
00:36:52.160 | to do that.
00:36:53.400 | You still see some of that perhaps in the ETF industry,
00:36:55.800 | but just not as much as they used to be.
00:36:57.720 | But it seems like in China, this is what is going on.
00:37:01.840 | - Yes, it is the mainstream practice.
00:37:05.400 | And so the fund proliferation really hasn't created
00:37:09.880 | a competition to lower fees or a competition
00:37:14.200 | toward sort of better practices in portfolio management
00:37:17.760 | that leads to them better price discovery,
00:37:19.960 | which then would lead to a more efficient market.
00:37:22.560 | So we're many, many innings away
00:37:24.560 | from getting to that outcome.
00:37:26.480 | - Now the market in China, if you wanna use an indice,
00:37:32.040 | I'm just looking at the China MSCI Stock Price Index.
00:37:37.040 | There is a beta there, although if you look back
00:37:40.960 | from 1995 through 2001, this market collapsed
00:37:45.960 | about, well, it looks like 95%.
00:37:49.600 | And then it came roaring back from 2002 up to 2007
00:37:53.480 | by I don't know how many multiples.
00:37:57.280 | And then it collapsed again during the financial crisis.
00:38:00.160 | And now it's been crawling back up again.
00:38:03.000 | Can you tell us a little bit about, you know,
00:38:04.760 | beta and people who say, well, I get what you're saying
00:38:08.440 | about the inefficiencies in the market.
00:38:10.280 | And then if I used an active manager that I might do better,
00:38:14.160 | but I wouldn't know, you know,
00:38:16.960 | one active manager from another, of course,
00:38:19.200 | without, you know, getting into your firm yet, of course.
00:38:22.520 | But, you know, what if you just bought beta?
00:38:25.440 | I mean, would that work in China?
00:38:27.400 | - So if you just bought beta,
00:38:30.560 | it would have worked out okay the last 15 years.
00:38:34.800 | Prior to that, not so much.
00:38:37.560 | Now the question is, well, is that just me
00:38:39.560 | cherry picking the last 15 years?
00:38:41.880 | Well, no, because prior to the last 15 years,
00:38:45.360 | beta is poorly constructed in the following sense.
00:38:49.880 | It was mostly state-owned enterprises.
00:38:52.480 | They weren't a lot of companies.
00:38:55.200 | And so when you kind of bought that beta,
00:38:58.520 | you actually really had just a very concentrated exposure
00:39:01.680 | to a few large state-owned entities.
00:39:04.080 | And then that I don't think is what you want to buy
00:39:07.400 | when you're betting on, you know, the growth of China,
00:39:10.520 | the transformation from being an export-oriented economy
00:39:13.280 | into a more consumption-based economy
00:39:16.600 | where you're hoping a very educated,
00:39:19.200 | hungry young workforce will drive productivity gains, right?
00:39:23.200 | That, you know, the 15 years prior to the last 15 years,
00:39:26.040 | you just couldn't buy things like that.
00:39:28.800 | So it's really the last 15 years
00:39:30.000 | that you're starting to have breadth
00:39:31.160 | where the listed market
00:39:33.960 | is more than just state-owned enterprises.
00:39:36.440 | Actually, a lot of interesting smaller cap stocks
00:39:39.760 | that were purely, you know, privately controlled
00:39:43.040 | became listed and were driving value
00:39:45.800 | and driving earnings growth.
00:39:47.920 | So I think, you know, the last 15 years
00:39:49.960 | was more representative.
00:39:51.480 | Still, last 15 years, of course,
00:39:53.800 | you still had, you know, the global financial crisis.
00:39:57.640 | You had the European debt crisis
00:39:59.720 | that had some spillover, like China.
00:40:02.080 | You had China's own crisis of the 2015
00:40:04.440 | with the credit crisis.
00:40:06.240 | But, you know, even through those ups and downs,
00:40:08.760 | the beta did deliver about a 11% return,
00:40:13.760 | compounded geometric return, which is not bad.
00:40:17.520 | So yes, the beta itself,
00:40:18.840 | even if you go purely passive, is decent.
00:40:22.280 | It is a lot more volatile than, say, the S&P 500.
00:40:26.080 | - I found some of your research
00:40:27.240 | that you did on state-owned enterprises
00:40:29.720 | to be interesting because you divide them up
00:40:31.760 | into big, mega, country-wide state-owned enterprises
00:40:36.760 | and then more local enterprises that are localized.
00:40:42.480 | And the research found that these localized
00:40:48.360 | state-owned enterprises were far less
00:40:51.480 | likely to produce profits.
00:40:54.880 | Could you dig into that a little bit for us?
00:40:57.120 | - Yeah, I think most of us,
00:40:59.400 | when we think about state-owned enterprises,
00:41:02.400 | we tend to have this very negative view, right?
00:41:04.800 | We don't think of them as actually companies.
00:41:07.760 | You just don't see them as very efficient,
00:41:09.600 | nor do they really care about, say, stakeholder value.
00:41:14.040 | And that is not entirely true, but it's true enough.
00:41:17.440 | So in the data set, when we look at just the sort
00:41:20.640 | of city-level, town-level state-owned enterprises,
00:41:24.080 | when you look at all the operating efficiencies,
00:41:26.120 | they're just not very efficient.
00:41:28.000 | You know, they have poor margins.
00:41:30.640 | They have a lot of debt.
00:41:32.800 | If you look at all the metrics for management efficiency
00:41:36.520 | and quality, just not very high-quality teams.
00:41:39.400 | And you're not surprised because they're really,
00:41:42.240 | you know, controlled and dominated by local bureaucrats
00:41:44.960 | and then subject to all the issues that occurs
00:41:47.240 | when a local sort of political power boss
00:41:50.600 | has his sway with everything in town.
00:41:53.840 | But when you look at the big Beijing-connected
00:41:56.840 | central state-owned enterprises,
00:41:58.680 | they tend to be, you know, well-oiled machines.
00:42:01.520 | The very best of the managers, you know,
00:42:04.360 | are in leadership positions,
00:42:06.880 | and their efficiency ratios are very, very high.
00:42:10.160 | And they actually tend to have decent performances
00:42:12.080 | over time.
00:42:12.920 | - You also did research on,
00:42:16.120 | and I found this to be fascinating, by the way,
00:42:18.320 | the China companies that list in the U.S. market,
00:42:23.200 | we are here in the U.S., at least I've always been,
00:42:25.640 | under the belief that, well, these things have to be,
00:42:28.200 | go through a certain level of scrutiny,
00:42:30.200 | and that the accounting has to be right
00:42:33.200 | before they can be listed on the U.S. exchanges.
00:42:35.320 | And there's a certain level of confidence
00:42:38.160 | that I would have in a Chinese company
00:42:40.200 | that lists in the U.S.
00:42:41.800 | versus just listing in the local markets in Asia.
00:42:46.240 | So I would be more inclined as a U.S. investor
00:42:48.640 | to trust those companies more.
00:42:51.040 | But your research actually shows the opposite.
00:42:54.680 | - Yep, I mean, I had the same intuition as you did, Rick.
00:42:57.960 | I thought, look, you know,
00:42:59.200 | if you are willing to expose yourself to, you know,
00:43:02.760 | New York, right, to the financial money center,
00:43:06.280 | and compete out here as a stock, right,
00:43:08.280 | you gotta be pretty good when it comes to, you know,
00:43:11.640 | dotting your I's and crossing your T's
00:43:13.360 | and having good governance.
00:43:14.720 | As I did more research,
00:43:15.560 | I realized it was actually the opposite.
00:43:17.160 | So the listing requirement and the level of scrutiny
00:43:21.040 | that you have to go through as a firm
00:43:24.520 | before you get listed in China is extraordinary.
00:43:28.640 | And it's because the regulator at the stock exchanges
00:43:32.840 | who, you know, is in charge of approving your listing
00:43:36.240 | has personal liability.
00:43:38.360 | If you list and it was discovered you made up numbers
00:43:41.800 | or for whatever reason you blow up later,
00:43:43.920 | that regulator has a lot of personal liability
00:43:47.040 | and his career is ruined and he might be going to jail.
00:43:49.840 | So they take forever to approve anything.
00:43:52.400 | And essentially they actually have this very cynical view
00:43:56.320 | about the underwriter,
00:43:57.880 | the investment bank that's helping you go IPO,
00:43:59.960 | expecting all of you to be in cahoots to defraud investors.
00:44:03.640 | So they actually have a separate underwriting process.
00:44:07.480 | Now in the U.S. it's not like that, right?
00:44:09.240 | In the U.S. our regulatory environment
00:44:12.880 | and our listing requirement
00:44:14.920 | is such that the consenting adults making trades, right?
00:44:18.240 | If you're willing to buy shares in a Chinese company
00:44:21.480 | that doesn't want to subject itself to independent auditing,
00:44:25.920 | hey, you know, it's in the disclosure.
00:44:29.320 | It's, you know, buyers beware.
00:44:30.960 | So you can't blame anyone if you invest in these companies.
00:44:33.520 | So as a result, our listing requirements
00:44:34.920 | are actually very low.
00:44:35.840 | And most Chinese companies who cannot qualify
00:44:38.720 | for listing in mainland China or Hong Kong
00:44:41.880 | have chosen to list in the U.S.
00:44:43.800 | - Sorry to interrupt Jason,
00:44:44.880 | but could you say that one more time?
00:44:47.680 | - So the listing requirement for the U.S.
00:44:51.720 | is substantially lower than the requirements
00:44:54.680 | for mainland China and Hong Kong.
00:44:56.560 | So as a result, a lot of companies
00:44:58.840 | who fail listing requirement in mainland China and Hong Kong
00:45:02.320 | actually choose to list in the U.S.
00:45:04.120 | - That's just fascinating.
00:45:06.760 | I would have never known that.
00:45:09.000 | You know, I mean, here I am, a U.S. investor, you know,
00:45:12.000 | thinking, oh, all these big companies
00:45:14.000 | that come over here to list,
00:45:15.200 | they must be the cream of the crop
00:45:16.960 | to come over here to the United States
00:45:18.320 | and list on the New York Stock Exchange
00:45:20.160 | or something like that.
00:45:21.000 | But I would have never guessed
00:45:22.560 | that it's much more difficult to list
00:45:25.080 | as a Chinese company to list in China
00:45:27.320 | than it is to list in the United States.
00:45:29.320 | - It's absolutely true.
00:45:31.240 | It's very strange, but it is true.
00:45:33.400 | - Okay.
00:45:34.880 | All right.
00:45:36.320 | So you set up the shop over there
00:45:38.040 | and you first started out with factor investing
00:45:40.760 | and that was in 2016.
00:45:42.640 | But I imagine you learned a lot very quickly
00:45:44.640 | and things are shifting for you.
00:45:47.200 | - Oh yeah, absolutely.
00:45:48.360 | So the first thing I learned was
00:45:49.960 | while many of these behavioral factors
00:45:54.200 | that we research and discover in the U.S. can work
00:45:57.640 | and then do work well in China,
00:46:00.440 | it is still a different market,
00:46:03.160 | certainly with a lot more retail participation.
00:46:06.000 | And also with accounting rules are different than the U.S.
00:46:09.240 | and then also a market structure that's quite different.
00:46:13.440 | It's still got a lot of state-owned enterprises.
00:46:16.400 | And as a result, you have to localize the research, right?
00:46:19.520 | You gotta take all these institutional features
00:46:21.920 | that's uniquely China and adapt your research.
00:46:26.720 | And so what we found is we found a lot
00:46:28.080 | of China-specific factors.
00:46:30.800 | So again, they're behavioral in nature,
00:46:33.160 | but they exist in China only
00:46:35.480 | because either the data is available in China
00:46:38.520 | and not available in the U.S.
00:46:39.880 | So there's just more ways to characterize
00:46:41.840 | that behavioral bias,
00:46:44.120 | or they're just sort of features of the Chinese market
00:46:46.360 | that allow for retail individuals
00:46:48.880 | to express more of their biases.
00:46:51.400 | So what we found is you've got to really have boots
00:46:53.920 | on the ground, know that market, learn the psychology.
00:46:57.800 | And if you do that, you'll discover a lot more factors.
00:47:01.800 | - Jason, a lot of investors are worried
00:47:03.480 | about the ESG factors,
00:47:05.880 | which are environmental, social, and governance.
00:47:08.640 | In other words, look, a lot of these are state-owned
00:47:10.800 | companies, they're not gonna report human infractions,
00:47:14.000 | they're not gonna report environmental infractions.
00:47:16.360 | People don't wanna invest in China
00:47:18.080 | because a lot of things are covered up.
00:47:20.560 | What is changing in China to make more disclosure?
00:47:24.360 | And can we trust it?
00:47:25.520 | - Well, today, if you want to apply ESG to Chinese stocks,
00:47:32.480 | if you hold them to Western standard
00:47:35.960 | by requiring them to be at the same level,
00:47:38.360 | clearly you're gonna eliminate so many of the stocks
00:47:41.160 | as to make the portfolio very concentrated
00:47:43.480 | and perhaps one that is unlikely to produce return.
00:47:47.920 | But if you wanna apply a rule,
00:47:50.000 | which is more about the slope,
00:47:52.440 | meaning the speed at which they're improving,
00:47:55.000 | you'll find many companies to be great ESG citizens.
00:47:59.760 | That's because they're starting at a low base
00:48:02.200 | and the increased global pressure
00:48:04.920 | and increased self-awareness in terms of why ESG matters
00:48:08.520 | has actually encouraged a lot of them to make changes.
00:48:11.360 | Part of that is because if society becomes more wealthy,
00:48:14.520 | frankly, there's very little difference
00:48:15.920 | between a Chinese parent and American parent, right?
00:48:18.880 | They all want better water, better air,
00:48:21.880 | better food safety, better work environment
00:48:23.880 | for their children, and they're gonna demand that
00:48:25.600 | as consumers and they're gonna demand that as regulators.
00:48:29.480 | So we're definitely seeing improvement,
00:48:31.600 | even though the level today
00:48:32.840 | is clearly not international standard.
00:48:35.720 | Now, the one thing that is additionally interesting
00:48:37.880 | is governance is certainly the one dimension of ESG
00:48:41.960 | that is highly correlated with return in China.
00:48:45.560 | It may be less so outside of China,
00:48:47.440 | but in China, it's very correlated.
00:48:48.720 | I think it's true for all emerging markets.
00:48:51.320 | I think people who are more short-term oriented
00:48:54.840 | in the way they evaluate stocks
00:48:56.640 | tend to not care about governance,
00:48:58.400 | but in the long run, it matters.
00:48:59.560 | So it's an underappreciated factor in China.
00:49:02.760 | And if you focus on firms with great governance,
00:49:04.840 | you often end up having great return.
00:49:06.720 | So even without requiring that,
00:49:08.480 | most portfolio managers in China,
00:49:10.880 | and ourselves certainly included in that,
00:49:13.760 | are very governance-focused,
00:49:15.480 | and that's critical in terms of driving portfolio value.
00:49:18.880 | - Without getting too into politics at all,
00:49:22.120 | there's been some real changes in things like tariffs,
00:49:26.040 | and that has affected some exports from China to the U.S.,
00:49:30.600 | that is, until the coronavirus hit,
00:49:32.080 | and then we all started spending our government checks
00:49:35.160 | on Amazon, and exports went up from China after that.
00:49:40.160 | But there's a shift, it seems, out of China now
00:49:45.080 | towards places like Vietnam.
00:49:46.800 | Are you thinking of expanding your search for companies
00:49:51.000 | outside of China to someplace like Vietnam?
00:49:54.360 | - Well, we're definitely sort of looking
00:49:58.840 | for other alpha reservoirs.
00:50:01.840 | Now, the thing with Vietnam is,
00:50:04.040 | it certainly is even more inefficient than China,
00:50:08.600 | because it's just an even younger stock market.
00:50:12.160 | But it doesn't have a lot of depth,
00:50:13.640 | and it doesn't have a lot of stocks.
00:50:15.440 | And then, of course, for a proper portfolio,
00:50:17.720 | it's gotta have some breadth.
00:50:19.640 | And of course, as a reservoir, right,
00:50:22.920 | to really be able to extract alpha,
00:50:25.760 | the reservoir has to be large enough.
00:50:28.200 | So for small markets with very little liquidity,
00:50:31.640 | and perhaps not enough wealthy household
00:50:34.280 | to enter the market to supply alpha,
00:50:36.880 | it's, even though there's inefficiency,
00:50:38.920 | it's actually not likely for managers
00:50:41.480 | to do very much with it.
00:50:42.960 | You're gonna be severely capacity constrained.
00:50:45.920 | So in a way, if you think about big alpha reservoirs
00:50:49.560 | that are available in the EM basket,
00:50:52.160 | really, it's China,
00:50:54.160 | and maybe a distant second would be India.
00:50:57.840 | - And that has-- - That's got the population.
00:51:00.320 | - And they have a trading mentality in many ways.
00:51:03.280 | - Yep, as that market becomes more wealthy,
00:51:05.240 | as sort of the per capita GDP starts to catch up
00:51:08.720 | toward the Western world, like China has,
00:51:10.920 | you'll see more of the household wealth
00:51:13.440 | enter the stock market.
00:51:14.560 | And that's when sort of retail trading
00:51:17.200 | as a fraction of the market,
00:51:18.320 | and overall market liquidity will go up,
00:51:21.240 | and then therefore making the opportunity more meaningful
00:51:24.880 | for someone who wants to sort of be actively
00:51:27.800 | on the other side of those retail trades.
00:51:30.760 | - Well, Jason, it's really been interesting.
00:51:32.920 | Let's get to your company,
00:51:34.640 | and if our listeners want to learn about your company
00:51:38.760 | and what they might be able to follow you,
00:51:43.520 | where should they look?
00:51:44.680 | - So while we've been running
00:51:48.400 | a lot of different Chinese equity strategy onshore in China,
00:51:54.000 | the success of that business has convinced us
00:51:56.960 | to explore that.
00:51:58.880 | So we've launched our very first active ETF in the US.
00:52:03.360 | So to find out more about that strategy,
00:52:05.440 | you can go to funds.ralian.com
00:52:10.440 | to learn about what it does,
00:52:12.720 | whether it makes sense for you.
00:52:14.760 | We're obviously looking to build out a whole family
00:52:18.400 | of different Chinese equities exposure
00:52:21.520 | and fixed income exposure and other alternative exposures.
00:52:25.760 | And our belief is most investors
00:52:30.720 | are underexposed to China.
00:52:34.080 | So the correlation is definitely going to come in
00:52:36.280 | as a major benefit
00:52:37.640 | in terms of making your portfolio more diversified.
00:52:40.680 | And insofar that you want to have exposure
00:52:43.720 | to a different currency,
00:52:46.160 | Chinese assets will give you exposure
00:52:48.760 | to another major currency
00:52:50.160 | that might be emerging and rivaling China.
00:52:52.960 | So you don't have to go to cryptocurrency
00:52:54.840 | to hedge against your dollar exposure.
00:52:56.760 | You can look at the renminbi based assets.
00:52:59.680 | And of course you want to buy more growth
00:53:01.200 | and it's differentiated growth.
00:53:02.360 | I guess China is just on a different part
00:53:03.800 | of the growth curve versus the US.
00:53:06.400 | This is a market where you can buy that growth
00:53:08.200 | and buy it cheaper.
00:53:10.640 | But of course, to find out more about our research,
00:53:12.280 | go to our website, ralian.com.
00:53:15.960 | And if you're interested in the strategy,
00:53:17.160 | go to funds.ralian.com.
00:53:20.240 | - Okay, that'd be great.
00:53:21.200 | I had to ask you one question
00:53:22.200 | because you brought it up,
00:53:23.640 | the cryptocurrency.
00:53:25.080 | China's central bank is rolling out a digital yuan,
00:53:29.040 | making it the first central bank
00:53:30.520 | to issue a central bank digital currency.
00:53:34.840 | What do you think about this?
00:53:36.280 | - Well, I think it's super smart, right?
00:53:38.360 | 'Cause as we're looking at cryptocurrency,
00:53:41.320 | we've often found two things, right?
00:53:43.520 | One is the technology, the blockchain technology,
00:53:45.960 | which is just a superior technology
00:53:48.400 | in terms of settling payment,
00:53:50.040 | tracking the flow of funds, it's safer,
00:53:53.360 | and it's just more technological advance, right?
00:53:56.000 | The existing settlement process we have
00:53:58.720 | came from 60 years ago.
00:54:01.560 | So China is pursuing that.
00:54:03.920 | It's pursuing the blockchain technology.
00:54:06.320 | The rest of the cryptocurrency
00:54:07.680 | is a combination of that blockchain technology,
00:54:09.680 | which is wonderful,
00:54:11.080 | with a currency that you're not sure
00:54:13.920 | if it's actually a currency
00:54:14.960 | 'cause it's not backed by anyone,
00:54:16.520 | not backed by anything.
00:54:17.680 | It's not really legal tender.
00:54:20.200 | So I think this actually helps investors
00:54:22.120 | in terms of really understanding
00:54:24.360 | what the blockchain technology can do for central banks
00:54:27.760 | if they wanna digitize their currency
00:54:29.760 | and improve the existing financial infrastructure.
00:54:33.440 | And then it helps us then understand,
00:54:35.840 | okay, if you take out the digital aspect
00:54:38.960 | and just have this new fiat currency
00:54:42.000 | issued by a non-central bank collective,
00:54:46.080 | like, is there really value in that?
00:54:48.240 | So I think what China has done is genius
00:54:52.440 | in terms of adopting a technology.
00:54:54.400 | Many central banks are likely to do the same thing.
00:54:57.240 | And as that happens,
00:54:58.440 | I think you'll find existing cryptocurrencies
00:55:02.120 | to sort of be left behind.
00:55:05.200 | - Well, I don't wanna upset too many of our listeners
00:55:07.680 | by getting into cryptocurrency.
00:55:10.000 | Discussions on cryptocurrency were just recently banned
00:55:12.880 | on the bogleheads.org website.
00:55:14.720 | But it's been a fascinating discussion, Jason.
00:55:16.880 | I mean, you've done so well in your career
00:55:20.000 | and we just greatly appreciate you being our guest today
00:55:22.720 | on the "Bogleheads on Investing."
00:55:24.680 | - Thanks, Rick.
00:55:25.520 | I'm so glad to be here.
00:55:26.920 | - This concludes "Bogleheads on Investing."
00:55:30.680 | I'm your host, Rick Ferry.
00:55:32.680 | Join us each month as we have a new guest.
00:55:35.360 | In the meantime, visit bogleheads.org,
00:55:38.720 | bogelcenter.net, the "Bogleheads" wiki,
00:55:42.120 | view our new "Bogleheads Live Speaker Series,"
00:55:45.920 | get involved in your local "Bogleheads" chapter
00:55:48.320 | or a virtual community, and tell others about it.
00:55:51.840 | Thanks for listening.
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