Bogleheads® on Investing Podcast 057: Dr. Derek Horstmeyer on multiple investment topics
00:00:00.000 | (upbeat music)
00:00:02.580 | - Welcome to the 57th edition of "Bogleheads on Investing."
00:00:13.840 | Today, our special guest is Dr. Derek Horsmeyer,
00:00:16.840 | professor of finance
00:00:18.040 | at George Mason University School of Business,
00:00:20.840 | who publishes a monthly "Wall Street Journal" column
00:00:23.440 | on interesting investment topics
00:00:25.520 | and also publishes for the CFA Institute
00:00:28.120 | and other major publications.
00:00:29.820 | (upbeat music)
00:00:32.400 | Hi, everyone.
00:00:39.520 | My name is Rick Ferry
00:00:40.360 | and I'm the host of "Bogleheads on Investing."
00:00:43.080 | This episode, as with all episodes,
00:00:45.600 | is brought to you by the John C. Bogle Center
00:00:48.160 | for Financial Literacy,
00:00:49.880 | a nonprofit organization that is building a world
00:00:52.760 | of well-informed, capable, and empowered investors.
00:00:56.340 | Visit the Bogle Center at boglecenter.net,
00:00:59.840 | where you will find a treasure trove of information,
00:01:02.520 | including transcripts of these podcasts.
00:01:05.960 | Before we begin today, I have two special announcements.
00:01:09.380 | The first announcement is the opening of registration
00:01:13.000 | for the 2023 "Bogleheads Investment Conference"
00:01:17.400 | to be held in Bethesda, Maryland,
00:01:20.400 | just north of Washington, D.C.,
00:01:22.480 | from Friday, October 13th through Sunday, October 15th.
00:01:27.180 | We've pulled together an action-packed agenda
00:01:30.260 | full of "Bogleheads" favorites,
00:01:32.340 | as well as well-known investment and personal finance experts
00:01:36.420 | who will be appearing at the event.
00:01:38.500 | This year, we have Charles Ellis, Paul Merriman,
00:01:42.700 | Clark Howard, Jonathan Clements,
00:01:45.580 | Michelle Singletary, J.L. Collins, Barry Ritzelt,
00:01:49.700 | and Wade Fowle to name just a few of our special speakers,
00:01:53.760 | along with "Bogleheads" favorites such as Mike Piper,
00:01:57.560 | Alan Roth, Christine Benz, Bill Bernstein,
00:02:01.380 | and I'll be there too.
00:02:02.720 | Go to boglecenter.net to see a full lineup
00:02:06.040 | and to register for this unique event.
00:02:09.200 | The second announcement is that there will be a guest host
00:02:12.640 | for this podcast for the next five episodes.
00:02:16.680 | Within the next week, my wife and I
00:02:18.360 | will be loading up the truck and the dog
00:02:20.360 | and hooking up the travel trailer
00:02:22.520 | and heading out for a five-month travel adventure.
00:02:25.560 | We'll head northwest to the Rocky Mountains,
00:02:28.140 | up into Canada, into the Yukon, over to Alaska,
00:02:32.520 | then turn north up to the Arctic Circle
00:02:35.160 | and keep on going until we can't go any further,
00:02:38.200 | and then put our toes in the Arctic Ocean.
00:02:40.280 | We'll then tour around in Alaska for about a month
00:02:43.140 | before heading back.
00:02:44.360 | And during that period of time,
00:02:46.120 | your guest host on this show will be John Luskin.
00:02:50.320 | John has a fantastic lineup of guests,
00:02:52.880 | including Nobel laureate William Sharpe.
00:02:55.940 | I'll be back as the host in October
00:02:58.400 | right after attending the "Bogleheads" conference.
00:03:01.320 | Our special guest this month is Dr. Derek Horstmeyer,
00:03:04.520 | a professor of finance
00:03:05.600 | at George Mason University School of Business,
00:03:08.480 | where he specializes in corporate finance.
00:03:10.840 | He writes a monthly column for "The Wall Street Journal"
00:03:13.080 | and the CFA Institute on cutting-edge research in finance.
00:03:17.880 | His work has also been cited in "Forbes," "Bloomberg,"
00:03:20.760 | "CNBC," "Fortune," and other outlets.
00:03:24.000 | He's a dedicated teacher.
00:03:25.640 | He helped create and lead
00:03:27.040 | the first student-managed investment fund
00:03:29.080 | at George Mason University,
00:03:30.700 | developed numerous programs at the college,
00:03:33.320 | such as the MS in Finance and CFA tracks,
00:03:36.740 | and currently serves as the director
00:03:38.960 | of the new financial planning
00:03:40.280 | and wealth management major at the university.
00:03:43.040 | One interesting aspect of the way Dr. Horstmeyer teaches
00:03:46.800 | is he encourages his students to do unique research
00:03:49.960 | and helps them get published.
00:03:52.140 | So with no further ado,
00:03:53.680 | let me introduce Dr. Derek Horstmeyer.
00:03:57.400 | Welcome to "Bogleheads on Investing."
00:03:59.520 | - Thank you, sir.
00:04:00.600 | It's great to be here, and please call me Derek.
00:04:03.080 | - Thank you.
00:04:03.920 | Well, you've written on a lot of topics,
00:04:05.820 | and what intrigued me about your writing,
00:04:09.560 | which I find all over the place,
00:04:11.360 | in the "Wall Street Journal" and CFA publications,
00:04:14.800 | I mean, your name is out there,
00:04:16.680 | is the depth and the range of different topics
00:04:19.760 | that you talk about,
00:04:20.600 | and a lot of them have to do with individual investors
00:04:24.040 | and things that we should be aware of.
00:04:26.400 | Whether we take action or not, we should be aware of it.
00:04:29.160 | But the other thing that I'm very impressed with
00:04:31.560 | is that you bring your students into the conversation.
00:04:35.660 | You co-author a lot of these articles.
00:04:38.720 | So could you tell me, first of all,
00:04:40.040 | a little bit about yourself, your bio,
00:04:42.760 | and then how you bring your own students into this?
00:04:47.000 | - Sure.
00:04:47.840 | Yeah, to start off, obviously,
00:04:49.360 | I'm a professor at George Mason University.
00:04:52.320 | I've been there for about 10 years now.
00:04:54.540 | Before that, I was a PhD student at USC
00:04:56.840 | and Stanford University.
00:04:58.480 | And yeah, it's been great.
00:05:00.440 | It really is just a great feature
00:05:02.920 | that you get to reach out to students,
00:05:06.040 | and they are enthusiastic to help and to do this data work.
00:05:11.040 | And not only that,
00:05:12.600 | I get employers reaching out all the time saying,
00:05:15.680 | "Did John Smith actually co-author
00:05:18.400 | "this Wall Street Journal piece with you?"
00:05:20.480 | And it really opens doors for the students.
00:05:22.700 | It really is win-win to have these students
00:05:24.960 | kind of help with this work and do the data work
00:05:27.000 | and have a phenomenal thing to have on their resume.
00:05:29.760 | - Outside of being a professor,
00:05:32.000 | you're also an avid swimmer and a squash player
00:05:36.200 | and a devoted fan to everything that is Reno, Nevada?
00:05:40.180 | (laughing)
00:05:41.760 | - Very true.
00:05:42.640 | Yeah, I am a squash player first.
00:05:45.880 | Obviously, your prime age for being a squash player
00:05:49.520 | is probably 25 to 30.
00:05:51.980 | So I'm a little bit over my prime there,
00:05:54.360 | but I still try and play as much as possible.
00:05:57.520 | But, whew, man, is that a hard sport.
00:06:00.480 | - I have a piece of advice.
00:06:02.120 | Try pickleball.
00:06:04.240 | - Oh, boy.
00:06:05.080 | - All of us over the age of 50 are getting into pickleball.
00:06:08.000 | So maybe you're getting there.
00:06:09.320 | - I'll probably be there soon.
00:06:11.320 | (laughing)
00:06:12.160 | - Okay, very good.
00:06:13.120 | Well, the way we're gonna do this today
00:06:14.880 | is I've broken down all of these articles
00:06:17.400 | that you've written in the Wall Street Journal
00:06:19.000 | with your students and the articles
00:06:21.440 | that you wrote for the CFA Institute
00:06:24.000 | and their publications.
00:06:25.220 | And there was literally dozens of them on your website,
00:06:28.840 | derrickhorstmeyer.com.
00:06:31.040 | There's just a laundry list of all these articles
00:06:33.600 | you publish, one a month in the Wall Street Journal,
00:06:36.760 | one a month for the CFA Institute, plus others.
00:06:40.120 | And I categorize them by individual investments,
00:06:44.520 | portfolio management, taxes,
00:06:48.200 | and then the last one I call investor behavior.
00:06:50.960 | So four different categories I put them into
00:06:53.420 | for this interview.
00:06:54.560 | And so I'm gonna start with investments.
00:06:57.520 | So under investments, they are individual
00:07:00.240 | investment categories, for example.
00:07:03.080 | And I'm gonna throw this out there
00:07:04.440 | because this is something that I have been big on
00:07:07.120 | for a long time.
00:07:08.500 | High-yield bonds.
00:07:11.680 | Do they belong in a portfolio?
00:07:13.520 | Do they not belong in a portfolio?
00:07:15.600 | On the Boglehead site, you will find the camp is divided.
00:07:20.600 | I am on the side of yes, they can add value.
00:07:24.360 | What did your research say about high-yield bonds?
00:07:28.120 | The title of the article was,
00:07:29.680 | do junk bonds pay off in the long run?
00:07:32.200 | And we found in general, yeah,
00:07:35.560 | they're basically in line with the Sharpe ratio
00:07:39.600 | that you would expect.
00:07:41.000 | The funds that we were looking at were mutual funds
00:07:43.960 | and ETFs that had the word high-yield or junk bond
00:07:47.640 | or other names like that in the title of the fund.
00:07:51.360 | So we didn't look at the underlying D rated or C rated
00:07:55.720 | or BBB minus rated debt itself,
00:07:58.280 | but the fund that was carrying it.
00:08:01.120 | And in general, what we found was comparable returns
00:08:06.120 | to the S&P 500 with a little bit lower correlation.
00:08:11.320 | So there is some diversification benefits here
00:08:16.120 | and a little bit lower volatility.
00:08:19.320 | So yes, it did seem on the whole
00:08:23.160 | that this could add some value to your portfolio.
00:08:28.160 | But again, don't expect that this is gonna be
00:08:30.840 | a groundbreaking investment
00:08:33.120 | that's gonna outperform the S&P by a significant amount.
00:08:38.120 | For instance, to quantify what I'm saying,
00:08:40.560 | what we found was over this 30 year period
00:08:43.640 | when we could study these things,
00:08:45.560 | the S&P delivered 7.8% and the high-yield bond fund
00:08:49.920 | delivered 7.1% with a little bit lower volatility.
00:08:54.680 | - Some people will say, don't buy credit risk,
00:08:58.400 | just buy treasuries and take your credit risk with equity.
00:09:03.400 | How do you feel about that strategy?
00:09:06.040 | - Yeah, that's an interesting point.
00:09:09.480 | So I think this research would highlight that, yeah,
00:09:12.840 | taking some credit risk in the bond market is appropriate
00:09:17.360 | just because again, you're getting near S&P 500 returns
00:09:22.060 | over the long run,
00:09:23.680 | but it doesn't have a perfect correlation with the S&P.
00:09:28.680 | So again, what it's doing
00:09:30.960 | is slightly diversifying your positions.
00:09:34.320 | We also noticed it had less crash risk.
00:09:37.960 | So we define that as did the S&P 500 drop 4%
00:09:42.680 | in a month or more?
00:09:43.760 | And we found that high-yield bonds had a lot less
00:09:47.760 | of these big drops on a monthly basis.
00:09:51.560 | - Interesting.
00:09:52.560 | Well, let's go into another area
00:09:54.320 | of mostly non-investment grade fixed income.
00:09:59.320 | And this is preferred stock.
00:10:01.120 | This is another thing that I personally own
00:10:04.060 | in a fund, in an ETF, an index fund.
00:10:07.100 | A small amount.
00:10:08.120 | I've owned it for many years.
00:10:09.840 | I also used to manage preferred stock portfolios.
00:10:13.120 | It's kind of unusual because it's such a small market,
00:10:16.200 | but I always felt that there was something there
00:10:18.880 | and there's not a lot of research on this,
00:10:20.620 | but you did do an article
00:10:22.400 | and you did do some research on this.
00:10:23.860 | So can you talk about it?
00:10:25.720 | - Sure.
00:10:26.560 | Yes, indeed.
00:10:27.380 | So again, you're right.
00:10:28.320 | There's not a lot of funds out there
00:10:30.640 | that are concentrating on this.
00:10:32.260 | And so we were able to look back at 10 years of data
00:10:37.140 | from basically 2010 to 2020 on preferred shares.
00:10:41.820 | And we found that in general,
00:10:45.300 | these came in around the returns
00:10:48.940 | and volatility of long-term bonds.
00:10:52.100 | So to put numbers to that,
00:10:53.740 | over the past 10-year period,
00:10:56.480 | long-term bonds delivered about 7%.
00:10:59.660 | Preferred stocks delivered about 7.2%
00:11:03.080 | and with a little bit less volatility than long-term bonds.
00:11:07.480 | So again, an appropriate thing to add to a portfolio
00:11:12.480 | and definitely to an equity portfolio.
00:11:17.000 | But again, we didn't see some strange
00:11:19.520 | out of equilibrium behavior
00:11:20.920 | where preferred stocks absolutely knocked out of the park.
00:11:25.080 | But again, I will say this caveat,
00:11:27.080 | all of this data that we were looking at
00:11:28.840 | was a 10-year period because again,
00:11:31.120 | we couldn't find any major funds
00:11:33.920 | that went back before the mid 2000s.
00:11:37.400 | - And one other thing about preferred stock
00:11:40.400 | is there is a tax benefit to it for taxable investors.
00:11:45.400 | Was that part of your,
00:11:48.120 | first explain what that is
00:11:49.320 | and then was it part of this calculation?
00:11:52.840 | - So yeah, very good point.
00:11:54.200 | We looked at pre-tax returns
00:11:58.480 | and we compared everything on pre-tax return basis,
00:12:01.440 | not with the post-tax benefit of preferred stock.
00:12:06.440 | - So when the other thing about preferred stock
00:12:09.160 | that I personally like is I own it in my taxable account
00:12:13.320 | and a lot of the dividend yield that comes in
00:12:16.720 | is treated as a long-term capital gain
00:12:18.760 | because it's a stock dividend.
00:12:20.800 | It may be more tax efficient than owning a corporate bond.
00:12:25.000 | And again, it's a complicated asset class,
00:12:27.080 | it's not widely followed.
00:12:28.880 | I do wanna say one thing before we move on
00:12:30.560 | is that all the things we're talking about today
00:12:32.760 | are not investment recommendations.
00:12:34.440 | We're just discussing these things.
00:12:36.680 | I don't want people who are listening here to get confused
00:12:38.840 | that we're actually making investment recommendations
00:12:41.000 | because we're not.
00:12:41.920 | - Of course.
00:12:42.760 | - All right, well, and then there was this one other area
00:12:45.160 | which I found very interesting.
00:12:47.160 | It affects a lot of people across a lot of different states
00:12:51.520 | and that is municipal bond performance by state.
00:12:55.640 | And I didn't realize how much of a difference there was.
00:12:59.920 | - Very true.
00:13:00.760 | Yeah, we were surprised by these results as well.
00:13:02.480 | We went out there and collected data on muni bond offerings.
00:13:07.480 | Obviously, we're focusing here on the big states
00:13:12.080 | that have muni bond mutual funds or ETFs.
00:13:16.360 | So we were able to get about 15 different state offerings
00:13:23.320 | and calculate returns based on these different state funds.
00:13:27.120 | And in some cases, buying a muni offering
00:13:32.120 | for a particular state makes sense
00:13:36.200 | over the past 10, 15 years of data that we have,
00:13:39.000 | even if you don't get obviously the tax benefit
00:13:44.360 | of living in that state.
00:13:46.280 | So for instance, to put numbers to this,
00:13:48.760 | Colorado and Missouri over the past 10, 15 years
00:13:53.760 | have averaged about a 4% rate of return
00:13:58.520 | over that time period.
00:13:59.960 | And Maryland on the opposite end returned about 3%.
00:14:04.640 | So there's about a 1% spread there.
00:14:06.360 | And again, this is pre-tax.
00:14:08.840 | Yeah, interesting to see that you get this big spread
00:14:12.960 | and it's not totally explained by risk
00:14:15.620 | just because we didn't see any significant differences
00:14:18.560 | between Colorado and Maryland
00:14:20.560 | in the volatility of these things.
00:14:22.920 | - Yeah, obviously it's not due to Colorado funds
00:14:26.080 | having lower fees than Maryland funds.
00:14:28.120 | I mean, you factored that, correct?
00:14:30.240 | - Yep, we factored that in.
00:14:31.760 | One idea that we had, and again, it didn't fully pan out,
00:14:36.400 | maybe it could be the age of the population.
00:14:40.200 | So you can imagine maybe there's a bit more wealth
00:14:43.720 | in places like Maryland and a bit older individuals.
00:14:48.000 | And so they all rush into the immunity bond offerings
00:14:52.280 | and push rates of return down.
00:14:55.780 | So that was one theory, but that didn't kind of line up
00:14:59.880 | with all the other states that we had in this data set.
00:15:02.920 | - And taxes, obviously, if you're in California
00:15:05.520 | and you're paying 13% tax versus Texas
00:15:08.600 | and you're paying no taxes, that didn't explain it either?
00:15:12.600 | - That didn't explain it either.
00:15:14.000 | From what I can tell, what we looked at,
00:15:17.120 | Florida was really high up on the return list.
00:15:20.840 | And so I think Florida had something like a 3.9%,
00:15:25.680 | something like that, rate of return
00:15:27.480 | over the past 10, 15 years.
00:15:29.580 | And to the best of my knowledge,
00:15:32.320 | Florida's a pretty darn low tax state.
00:15:35.200 | - That's why a lot of people move there.
00:15:36.920 | - Yeah.
00:15:37.760 | - And I'll ask one more question about this,
00:15:39.200 | and that is, is it a factor of the makeup of the portfolio,
00:15:44.080 | whether a lot of hospital bonds in Maryland
00:15:47.920 | versus general obligation bonds in Colorado, right?
00:15:50.880 | I have that backwards.
00:15:52.160 | - No, no, that's a great thing.
00:15:53.400 | We didn't dive into the actual holdings.
00:15:56.040 | But again, we did look at the volatility.
00:15:58.540 | The volatility was pretty close across the whole spectrum
00:16:02.080 | of 15 different states that we looked at.
00:16:06.240 | - So the volatility was the same,
00:16:07.480 | it was only the performance that was different.
00:16:09.720 | - The performance was, and we're not talking, again,
00:16:11.720 | about huge spreads, but a one percentage point spread
00:16:15.240 | per year is pretty big.
00:16:16.800 | And again, that's the top performer
00:16:18.520 | against the bottom performer.
00:16:20.720 | - Well, let's go into another topic,
00:16:22.720 | and this has to do with inflation.
00:16:24.840 | So we've had a bout of inflation here,
00:16:27.520 | and everyone is wondering where should I be putting my money
00:16:31.240 | if I want to hedge against inflation?
00:16:34.960 | And you've written a couple of articles about this.
00:16:37.840 | - Yes, it's always a fascinating topic.
00:16:40.560 | How do you preserve your money?
00:16:42.160 | Or how do you just have something
00:16:43.760 | that just correlates positively with inflation?
00:16:46.520 | Obviously, a lot of people piled into TIPS,
00:16:49.720 | Treasury Inflation Protected Securities,
00:16:51.560 | and then they had a horrible 2022
00:16:54.280 | because the ramp up in price happened
00:16:57.040 | at the very beginning of 2022, or even end of 2021.
00:17:02.040 | And so you think the things that are gonna protect you
00:17:05.760 | don't do as well.
00:17:06.840 | And so we looked at this.
00:17:09.040 | Not surprisingly, S&P does really poorly
00:17:12.880 | during inflationary periods.
00:17:15.200 | Again, we looked from 1970.
00:17:18.440 | So I should be very clear,
00:17:19.960 | this data came from 1970 to 2021.
00:17:24.160 | So before the most recent big bout of inflation.
00:17:28.720 | Something else we saw, not surprisingly,
00:17:31.360 | real estate actually hedges very well
00:17:34.480 | and did very well during high inflationary periods.
00:17:38.240 | This is tangible real estate, I should be very clear.
00:17:40.520 | Not REITs, but tangible real estate.
00:17:43.200 | And not surprisingly, oil, gold, and silver
00:17:47.040 | were the best performers
00:17:48.600 | over the high inflationary periods.
00:17:51.240 | And the two worst performers,
00:17:53.080 | the S&P 500 and intermediate bonds.
00:17:56.120 | - Well, that wasn't good for last year.
00:17:58.160 | - Exactly, yeah.
00:17:59.400 | So this data was up to 2020, 2021.
00:18:03.040 | And then obviously we saw it play out exactly like that
00:18:06.800 | or close to like that last year.
00:18:09.560 | - You know what's funny about last year,
00:18:11.280 | people who may have bought gold
00:18:14.920 | at the beginning of last year
00:18:17.280 | when inflation was coming back were disappointed
00:18:20.320 | that it didn't do well.
00:18:22.320 | And I think you had to look back
00:18:25.880 | and see what the price of gold did
00:18:28.320 | as soon as the pandemic hit.
00:18:30.680 | Everybody started hoarding gold.
00:18:32.280 | So the price of gold shot up $400, $500 an ounce.
00:18:36.440 | So as soon as the pandemic hit,
00:18:37.600 | and there wasn't any inflation.
00:18:38.800 | It was probably deflation during that period of time.
00:18:41.360 | And then when inflation came rolling around
00:18:44.320 | and gold didn't do anything, it actually went down.
00:18:47.560 | And I was telling people, well, you already had the gain.
00:18:51.200 | The gain occurred before there was even inflation.
00:18:54.680 | Not that people were anticipating inflation.
00:18:56.480 | They were just hoarding gold at that time too.
00:18:59.000 | Because of what was going on in the world,
00:19:00.720 | real estate does a good job of hedging inflation,
00:19:04.840 | but not if interest rates are also going up
00:19:08.080 | and you have a pandemic and occupancy rates
00:19:11.200 | start going down and you start seeing foreclosures
00:19:14.160 | and a banking crisis all at the same time.
00:19:15.920 | So it's period specific, but in general, in general.
00:19:20.920 | In general, yeah, you're exactly right.
00:19:23.160 | There's a lot going on in the past three years.
00:19:26.000 | And so we can't just isolate it to inflation.
00:19:28.680 | Let's go on to the next part of this,
00:19:31.200 | which we started to work on a little bit,
00:19:33.160 | which is portfolio management.
00:19:35.480 | And you've written a lot of articles
00:19:37.000 | about portfolio management, both active and passive.
00:19:41.280 | And I first want to talk about an article that you wrote,
00:19:45.520 | which I thought was very interesting.
00:19:48.120 | Is it better to roll your own, pardon my French,
00:19:50.760 | roll your own portfolio by buying
00:19:53.000 | a few broad market index funds
00:19:56.400 | than it is to use a one and done target date fund?
00:20:01.120 | As a lot of people would happily create
00:20:05.160 | their own index fund portfolio,
00:20:06.680 | or if it's easier, use a target date fund.
00:20:09.440 | I mean, what did you find there?
00:20:11.680 | Yeah, this obviously takes some effort,
00:20:15.520 | but we looked back and said, are you getting fleeced
00:20:19.040 | on your target date fund, for lack of a better word?
00:20:21.920 | And so we said, could you construct your own
00:20:24.080 | and do better here?
00:20:25.280 | And what we found was in general,
00:20:29.360 | you could construct your own
00:20:31.160 | for about 10 basis points less per year, right?
00:20:35.880 | So you're saving 10 basis points by constructing your own.
00:20:38.880 | And obviously that takes a bit of effort.
00:20:41.360 | So again, to put kind of numbers to this,
00:20:43.080 | we were looking at the average target date fund
00:20:45.840 | was charging you about 30 basis points a year
00:20:49.480 | and using the same fund family bond and equity holdings,
00:20:54.480 | you could create that same portfolio for 20 basis points.
00:20:58.320 | So they're charging you 30 basis points.
00:21:00.760 | You could go in there and using the same thing
00:21:03.900 | that they're using, you could do it for 20 basis points.
00:21:07.400 | So they're kind of taking 10 basis points from you
00:21:11.320 | for the management and for shifting it over time.
00:21:15.280 | That's kind of what we found.
00:21:16.400 | And we found that the longer you went out
00:21:19.080 | on the target date spectrum,
00:21:21.040 | say the 2060 target date funds,
00:21:23.920 | those are the ones where they were charging the most.
00:21:26.280 | Oh, really?
00:21:27.480 | Interesting enough, they're charging the young kids.
00:21:29.960 | More money.
00:21:31.160 | Yeah, more money to manage these things.
00:21:33.520 | And so this adds up over time.
00:21:35.720 | We kind of calculated if you did it yourself
00:21:38.400 | over a 10 year period,
00:21:40.400 | you would have an extra 3% return
00:21:43.520 | if you just did it yourself.
00:21:44.880 | Oh, wow, that's fairly significant.
00:21:48.320 | Yeah.
00:21:49.360 | Interesting offshoot of what you just said
00:21:52.520 | that the fund companies are charging you 10 basis points.
00:21:57.240 | Some maybe a little bit more
00:21:59.160 | to do the portfolio management.
00:22:01.400 | So you could go to a mutual fund company,
00:22:05.400 | a Vanguard or whomever.
00:22:08.000 | And for 10 basis points,
00:22:09.160 | you can get a pretty darn good portfolio managed for you.
00:22:13.680 | And I kind of tongue in cheek, look at that and say,
00:22:16.600 | well, why are investment advisors charging 100 basis points
00:22:19.920 | to do the same thing?
00:22:21.920 | Yeah, very good point.
00:22:23.960 | Yeah, you wonder how they stay in business.
00:22:25.760 | Well, they stay in business because people think
00:22:27.920 | they're getting what's called value added.
00:22:29.720 | But anyway, that's a different topic.
00:22:31.920 | All right, now we're gonna get into
00:22:34.680 | the active versus passive debate a little here.
00:22:39.160 | And you've written quite a bit about active management.
00:22:41.920 | And we have a three fund portfolio,
00:22:45.480 | Boglehead portfolios.
00:22:47.040 | You refer to them as lazy portfolios in your article
00:22:51.800 | versus what's called a valuation based,
00:22:54.720 | which if you could explain what that is,
00:22:56.720 | but it's active management.
00:22:57.760 | So how do they compare?
00:23:00.440 | Yeah, very good.
00:23:01.280 | So this was one that just came out a month ago
00:23:03.440 | for the Wall Street Journal.
00:23:04.480 | And it won't surprise anyone in this group
00:23:07.040 | that time in the market doesn't work.
00:23:09.520 | What we looked at this one
00:23:10.560 | was the age old Fama versus Schiller debate.
00:23:13.960 | They both won Nobel prizes 10 years ago
00:23:17.360 | for their work in market efficiency.
00:23:19.040 | Eugene Fama comes down on the efficient side
00:23:22.080 | and Schiller would always say,
00:23:24.240 | you could time the market based on the P/E ratios
00:23:27.520 | or his CAPE ratio.
00:23:30.160 | And so what we did was we said,
00:23:32.120 | well, does that still hold true?
00:23:34.040 | We looked at how the P/E ratio changes in our market.
00:23:38.800 | And we kind of followed his advice from back in the 70s,
00:23:43.160 | which said, if the P/E ratio is very high at 20 or above,
00:23:49.080 | you should be shift over to a bond portfolio.
00:23:52.760 | We used a 70% bonds, 30% equity.
00:23:56.080 | And if the P/E ratio for the market goes down below 12,
00:24:00.680 | then you should shift over to equities.
00:24:02.080 | And again, 70% equities, 30% bonds.
00:24:05.740 | And we tested the strategy.
00:24:06.880 | Does this work?
00:24:07.720 | Does this help you on a risk adjusted basis?
00:24:10.240 | - Relative to what portfolio?
00:24:12.040 | The passive, but what was the passive portfolio?
00:24:14.040 | - The passive portfolio was just 50/50.
00:24:16.400 | - Ah, good, okay, thank you.
00:24:17.840 | - It was just 50/50.
00:24:19.320 | So if you formed a 50/50 portfolio,
00:24:21.920 | how would you compare against this?
00:24:23.880 | And not surprisingly, hasn't done well.
00:24:27.440 | Interestingly enough, before 1950,
00:24:29.960 | this actually juiced returns a little bit,
00:24:32.060 | but since then, nope, you'd be underperforming.
00:24:35.560 | And again, I think to most people,
00:24:36.960 | this wouldn't surprise anyone,
00:24:38.260 | just because basically using this strategy,
00:24:40.760 | you would have been out of equities since 1995,
00:24:45.220 | for the most part.
00:24:46.060 | You would have been really out of equities.
00:24:48.120 | And obviously we've seen crazy strong growth
00:24:50.920 | in equities since 1995.
00:24:53.080 | So yeah, it was interesting.
00:24:54.200 | We also updated this and tried to move the valuation points
00:24:58.160 | so that it made sense in a post-2000 world.
00:25:01.640 | And still we saw no results.
00:25:03.840 | - Interesting.
00:25:04.720 | - Yeah, we kind of biased it and moved things up.
00:25:07.200 | Still no risk-adjusted returns.
00:25:09.240 | I follow this strategy that Schiller lined out
00:25:12.800 | and partially won a Nobel Prize for.
00:25:15.940 | - It's interesting that you said something,
00:25:17.940 | prior to 1950, it worked,
00:25:19.420 | because it seems like market structures do evolve.
00:25:23.120 | When Fama, French, came out with their three-factor model
00:25:28.260 | showing that the determinants of portfolio return
00:25:31.700 | were both the market beta,
00:25:33.980 | the size of the stocks in the portfolio,
00:25:37.820 | and whether they had high price to book
00:25:40.500 | or low price to book, basically.
00:25:43.240 | And since that time, at least the size portion
00:25:46.800 | hasn't really materialized.
00:25:49.040 | - Oh yeah.
00:25:49.880 | - Again, they looked at data going back prior to 1994
00:25:53.240 | and it worked really well.
00:25:54.300 | But then from '94 coming forward,
00:25:56.440 | it just hasn't seemed,
00:25:57.800 | at least the size premium hasn't worked.
00:26:00.440 | The value versus growth has been very difficult lately,
00:26:04.080 | but we think it should work, I think, in the long-term,
00:26:07.080 | because there's sort of a fundamental reason
00:26:09.040 | why it should work.
00:26:10.400 | But what's interesting is that the dynamics of the market
00:26:13.440 | do seem to change over the long-term,
00:26:16.800 | as taxation on buybacks change,
00:26:21.160 | and dividend structure change.
00:26:22.440 | I mean, all these things change,
00:26:24.220 | causing companies to react,
00:26:26.160 | and it causes changes in the marketplace.
00:26:29.440 | - Nope, very true, very true.
00:26:30.960 | Yeah, it's been a bad 15 years for small caps.
00:26:35.500 | Everyone swore that you could juice returns
00:26:38.280 | by going with small caps,
00:26:39.720 | and small caps haven't done well.
00:26:41.640 | And obviously, up until a year ago,
00:26:44.680 | value stocks obviously didn't do well.
00:26:46.880 | Growth had this great decade,
00:26:49.240 | obviously due to low interest rates and a few other things.
00:26:52.760 | - Well, talking about large and small,
00:26:54.120 | let's talk about another paper you wrote,
00:26:55.640 | which is, look, if I'm going to invest
00:26:57.640 | in a actively managed fund,
00:26:59.760 | should I invest in a large actively managed fund,
00:27:02.960 | or a small actively managed fund?
00:27:06.520 | Intuitively, I'd say, well, I want a small fund
00:27:08.680 | where the manager is maneuverability.
00:27:11.320 | But you did some work on this.
00:27:12.820 | - Yeah, yeah, it was interesting to find
00:27:16.240 | that your biggest actively managed funds
00:27:19.260 | actually did better than the small funds,
00:27:23.000 | on average, after taxes.
00:27:25.640 | This was a little interesting to us,
00:27:27.880 | 'cause we thought, you're right,
00:27:29.480 | you would go with the small fund
00:27:32.000 | just because it had more maneuverability, like you said,
00:27:35.080 | or ability to fly below the radar
00:27:39.360 | and maybe not have their strategies mimicked,
00:27:42.920 | and a big fund would just be kind of lumbering and bloated.
00:27:47.800 | But we didn't really find that.
00:27:49.360 | We found that small funds had more turnover
00:27:53.320 | and therefore were less tax-efficient,
00:27:56.020 | and while the big guys didn't trade as much,
00:27:58.460 | that actually worked to your advantage.
00:28:02.000 | - Well, go on to another way
00:28:03.000 | of picking actively managed funds,
00:28:05.600 | and this is, do we go with the fund manager
00:28:08.940 | who's been around for 35 years,
00:28:11.360 | or do we hire the fund manager
00:28:13.600 | who is right out of one of the Ivy League colleges,
00:28:17.200 | 30 years old?
00:28:18.320 | How does age and experience work in this marketplace?
00:28:22.800 | - Yeah, again, this is for active mutual funds.
00:28:25.000 | We looked at 20 years of data
00:28:26.760 | and looked at how did the short tenure managers
00:28:30.520 | compare against the long tenure individuals,
00:28:33.680 | and I don't think it would surprise anyone.
00:28:36.080 | The long-tenured fund managers were, on average,
00:28:40.640 | on a post-tax basis, a little bit better than your rookies,
00:28:44.640 | but they didn't have that right tail to their distribution.
00:28:49.560 | So in other words, they didn't hit a lot of home runs.
00:28:52.440 | They were just kind of steady eddies.
00:28:54.580 | They kind of just delivered you
00:28:56.520 | a very close return to the benchmark.
00:28:59.320 | Some would call that almost closet indexing.
00:29:02.280 | That's a term that people have thrown out
00:29:04.040 | at some active fund managers
00:29:05.880 | that are just trying to follow the index
00:29:08.760 | when they should be doing more active management.
00:29:11.320 | And then the rookies, on average, underperformed,
00:29:15.080 | but every once in a while,
00:29:17.560 | you had a rookie that just did very well,
00:29:20.800 | knocked out of the park, took on a lot of risk,
00:29:23.200 | but it worked out.
00:29:24.540 | So if you kind of want big and boring,
00:29:27.360 | you go with the individual that's long-tenured.
00:29:30.920 | If you want to take on some risk and maybe have a winner,
00:29:34.440 | then you go with the rookie,
00:29:35.360 | but on average, they underperformed.
00:29:38.000 | - We talked about a lot of investment strategies
00:29:40.040 | of the active managers versus the passive
00:29:42.000 | and how you might try to choose an active fund
00:29:45.680 | that might outperform experience of the manager,
00:29:49.400 | the size of the fund, valuation models,
00:29:53.740 | but how important, I guess the elephant in the room,
00:29:58.180 | is fees, fees.
00:30:00.380 | There's been studies out there.
00:30:02.080 | What did you find about fees?
00:30:04.580 | - Sure, it's not gonna surprise anyone, right?
00:30:07.160 | I should say that all of these past results,
00:30:09.640 | doesn't matter if you're a rookie
00:30:11.020 | or a long-tenured manager,
00:30:12.880 | you're still underperforming the benchmark
00:30:15.120 | over a 10-year period.
00:30:16.540 | Obviously, to this group,
00:30:17.660 | that's not gonna surprise anyone.
00:30:19.560 | Now, when we looked at fees,
00:30:21.140 | fees was the single determinant of long-run return.
00:30:25.420 | It's your turnover and then your fees.
00:30:28.500 | It's how tax-efficient you are
00:30:30.220 | and then what you're charging.
00:30:31.460 | And we looked at the most egregious mutual funds out there
00:30:35.740 | in terms of fees.
00:30:36.580 | Are they charging more than 1.5% per year?
00:30:41.180 | And these were just the worst performers.
00:30:43.660 | It's amazing these funds still exist out there,
00:30:46.940 | but there's quite a few of them
00:30:48.160 | that are still charging 1.5% or more to manage a fund.
00:30:53.160 | And not only did they underperform by 1.5%,
00:30:58.420 | they underperformed by about 2% on average.
00:31:02.460 | So not only do they charge you a lot,
00:31:05.500 | they did worse than their fee structure would suggest.
00:31:09.380 | - Interesting.
00:31:10.420 | - Again, obviously, I'm preaching to the choir here,
00:31:12.760 | but if somebody's charging you 1.5% to manage something,
00:31:17.260 | you just don't touch it with a 10-foot pole.
00:31:19.460 | - Yeah, I think that the people who are paying 1.5%
00:31:22.340 | probably don't even know they're paying 1.5%
00:31:24.420 | because it's not something that they pay attention to.
00:31:27.660 | - True, or these are being crammed
00:31:29.340 | in really bad 401(k) offerings.
00:31:32.100 | - Oh, is that right?
00:31:33.340 | - Yeah, I haven't written on this,
00:31:34.960 | but I have done some consulting work
00:31:36.620 | and looked at very small companies
00:31:39.820 | just get the dregs of the 401(k) offerings.
00:31:42.900 | And a lot of times these awful,
00:31:45.580 | awful offerings are crammed in there.
00:31:47.980 | - All right, now we're gonna get into a couple
00:31:50.700 | of controversial active management strategies.
00:31:55.300 | And it'll be the last two questions on this.
00:31:57.740 | ESG, environmental, social, and governance.
00:32:01.620 | A lot of information out there on this.
00:32:04.660 | Big fight in Washington, D.C. now over this.
00:32:08.060 | Is it alpha enhancing?
00:32:10.940 | Are they really helping the world?
00:32:13.420 | Is it just a fad?
00:32:14.820 | What did you find out?
00:32:16.260 | - Yep, the evidence goes back and forth.
00:32:19.700 | And in general, ESG funds are just gonna probably
00:32:24.180 | match the benchmark over the long run.
00:32:26.660 | I know energy has had a good year, past year.
00:32:31.360 | So ESG underperformed during that period.
00:32:35.620 | But we kind of looked at a different tact and said,
00:32:38.620 | what are you really getting with ESG
00:32:41.820 | in terms of your correlation coefficients?
00:32:45.180 | What is it moving with?
00:32:47.140 | Like what risks are you exposed to?
00:32:49.020 | And what we found was because when an ESG portfolio
00:32:54.020 | is formed, they need to cut something.
00:32:57.460 | They are obviously cutting energy.
00:32:59.340 | They need to add something to make up for that.
00:33:01.540 | And so not surprisingly, a lot of tech companies
00:33:04.420 | out there have good ESG ratings.
00:33:07.660 | So what we found was if you invest in an ESG fund,
00:33:11.220 | you have a higher correlation with tech
00:33:14.780 | and you have a higher correlation with the Russell 2000.
00:33:18.260 | You're taking on more small cap risk and more tech risk.
00:33:22.540 | - I see.
00:33:23.380 | - And because of that, you actually had
00:33:27.300 | close to the same level of correlation
00:33:30.180 | with the change in oil prices,
00:33:31.860 | which was kind of another thing.
00:33:33.940 | ESG funds were about the same level of correlation
00:33:37.060 | with underlying price of oil.
00:33:39.700 | - Correlated with the price of oil.
00:33:41.180 | So if the price of oil goes up,
00:33:42.740 | everybody's looking at alternative energies, right?
00:33:45.100 | So maybe some of these funds
00:33:47.700 | that specialize in that do better.
00:33:50.420 | - Yeah, yeah.
00:33:51.260 | So we found the S&P had a correlation of 0.22
00:33:55.020 | with a change in oil prices and ESG funds on average 0.23.
00:33:59.500 | Little bit higher correlation to oil.
00:34:01.980 | - Interesting.
00:34:03.980 | All right, we're gonna get into the last one
00:34:05.300 | about active management
00:34:06.980 | and it's the one on everybody's mind
00:34:09.060 | or I should say on everybody's computer.
00:34:11.420 | And that is AI, artificial intelligence.
00:34:15.820 | Is this the new active management?
00:34:17.820 | Is there hope for buying a fund that employs AI
00:34:22.820 | and this will outperform?
00:34:26.300 | Is this it?
00:34:28.100 | - We did a deep dive.
00:34:29.220 | We got access to one particular AI fund.
00:34:32.940 | Even the person that was running it
00:34:34.220 | couldn't explain kind of just said it's a black box
00:34:37.140 | and it's trained on this past data
00:34:39.140 | and I don't know what it's doing.
00:34:40.780 | And it would try and predict
00:34:42.020 | and move in and out of the market.
00:34:43.940 | And this particular one actually did an okay job.
00:34:47.300 | It had much higher risk.
00:34:49.620 | Sharp ratio was pretty comparable
00:34:51.740 | but it was moving in and out on a daily basis.
00:34:54.700 | We're trying to figure out what is going on
00:34:56.620 | inside this black box
00:34:57.740 | that's making it sell out on these days.
00:35:00.140 | And we got some insight, but we couldn't totally get it.
00:35:03.180 | - Well, you're not supposed to be smarter than humans.
00:35:06.660 | - Exactly, exactly.
00:35:08.740 | And so, yeah, this one was taking on excessive risk
00:35:11.260 | and it did pretty well.
00:35:12.300 | But again, on a sharp ratio basis
00:35:14.020 | kind of matched the S&P 500.
00:35:16.700 | But you're right.
00:35:17.540 | If AI is gonna work,
00:35:18.580 | then all the AIs will just be trading
00:35:21.140 | and then they'll--
00:35:23.620 | - Then it won't work.
00:35:24.460 | - Then it won't work, exactly.
00:35:25.540 | - Yeah, it works until it doesn't.
00:35:27.020 | - It works until it doesn't.
00:35:27.900 | There's an equilibrium, it has to be.
00:35:29.860 | - All right, let's get off of this topic
00:35:31.140 | of portfolio management
00:35:32.700 | and get into something that we all love and that's taxes.
00:35:36.660 | We've all just recently paid our taxes or did our taxes.
00:35:40.460 | So we've realized that funds,
00:35:44.700 | some of them distribute capital gains
00:35:47.700 | at the end of the year,
00:35:48.540 | even in years where the markets are down.
00:35:51.060 | We realize that some funds are distributing dividends
00:35:54.180 | and maybe some of the dividends are not too tax efficient.
00:35:58.260 | And we learn a lot about what we own
00:36:01.700 | if we really start to study our tax returns
00:36:04.340 | because it can really affect our after-tax returns.
00:36:08.260 | So you did a lot of work on taxes
00:36:12.180 | and mutual funds and ETFs.
00:36:14.460 | Let's talk first about turnover within a fund
00:36:17.260 | and how does that affect taxes?
00:36:19.180 | - Sure, I've always told my students this
00:36:22.980 | and I've always been told this.
00:36:24.140 | Well, you should just look to the turnover of a fund
00:36:27.620 | and that'll tell you how tax efficient it is.
00:36:30.540 | So we kind of took a step back and said,
00:36:32.900 | well, how true is that?
00:36:33.860 | Can you just look at the turnover
00:36:35.900 | of an actively managed fund or even an index fund
00:36:38.500 | and does that predict how tax efficient it is?
00:36:41.300 | And it was pretty much a muddled picture.
00:36:44.740 | Some funds were better and some funds weren't,
00:36:47.300 | but on average, it was kind of just a wash.
00:36:49.860 | And so what I mean by that was we separated
00:36:53.260 | within Ask Classes, we looked at high turnover funds
00:36:55.900 | and low turnover funds and on average,
00:36:59.020 | they kind of just have the same tax efficiency.
00:37:01.580 | And so, yeah, we kind of started thinking,
00:37:03.860 | there's a lot that's captured by a turnover measure.
00:37:07.220 | It doesn't separate out,
00:37:08.620 | are you trading short-term capital gains?
00:37:11.300 | Are you incurring long-term capital gains?
00:37:13.300 | Are you maybe trying to tax loss harvest?
00:37:15.980 | All these things that are going
00:37:17.420 | into the underlying turnover measure.
00:37:19.820 | And so that is kind of lost in one simple measure.
00:37:24.220 | And so that was kind of our ending conclusion.
00:37:27.460 | You can't really see that with a turnover measure.
00:37:31.260 | - Interesting.
00:37:32.380 | You did do work on the ETF structure
00:37:36.140 | versus the open-end mutual fund structure,
00:37:39.020 | the traditional open-end mutual fund structure.
00:37:41.660 | And you did come to a different conclusion
00:37:43.100 | about ETFs versus traditional open-end mutual funds.
00:37:47.100 | - Yes, indeed.
00:37:47.940 | Again, another thing that I've always been told
00:37:49.860 | is ETFs are more tax efficient,
00:37:52.420 | but I've never heard a quantifier,
00:37:55.020 | literally how much more tax efficient they are.
00:37:57.420 | And so we designed this pretty simple study
00:38:00.220 | where we looked at within fund family,
00:38:04.420 | so it had to be the same fund family,
00:38:06.660 | it had to be the same benchmark,
00:38:08.580 | the same expense ratio within two basis points,
00:38:13.020 | and the same underlying holdings.
00:38:14.980 | For instance, we looked at Charles Schwab,
00:38:17.220 | Charles Schwab S&P 500 ETF
00:38:20.940 | compared to the Charles Schwab S&P 500 index fund.
00:38:24.300 | I'm not sure if those two were in our study,
00:38:27.140 | but I'm just giving an example, right?
00:38:28.660 | So it's the same holding, same everything.
00:38:31.380 | - Almost identical.
00:38:32.740 | - Almost identical, same expense ratio, same everything,
00:38:36.140 | except one is a mutual fund and another is an ETF.
00:38:39.580 | And then we looked at, well,
00:38:41.220 | how much has their performance differed?
00:38:43.900 | And what we found was it differs by about 20 basis points
00:38:47.780 | to 25 basis points per year.
00:38:49.860 | - That's what the benefit to the taxable investor was?
00:38:54.860 | - Yes, on a post-tax basis,
00:38:57.580 | the ETF outperformed by about 20 basis points.
00:39:00.340 | - Wow, that's a lot.
00:39:01.620 | - Yeah, it's significant.
00:39:02.980 | And again, obviously this is due
00:39:04.540 | to the redeem-in-kind feature of ETFs,
00:39:07.580 | but that adds up over time.
00:39:09.900 | That 20 basis points,
00:39:11.940 | if you're holding that in a taxable account,
00:39:13.940 | that's a percentage point every four years or so.
00:39:16.940 | - Sure.
00:39:17.860 | Now, Vanguard is a little different.
00:39:19.260 | Their structure is different.
00:39:20.980 | Can you explain that
00:39:21.980 | and then why it really wouldn't fit into this study?
00:39:24.780 | - Sure, yeah.
00:39:25.620 | Vanguard was omitted from our study
00:39:27.220 | just because their ETFs and mutual funds
00:39:30.580 | have the same post-tax returns,
00:39:33.180 | net of the difference in the expense ratios.
00:39:36.340 | And that is, again, because of this patented system
00:39:40.860 | that Vanguard has,
00:39:42.180 | which basically gives the same benefits
00:39:45.620 | that an ETF has to the mutual funds.
00:39:48.380 | I believe that patent is, I've read, is expiring soon.
00:39:51.780 | - It is expiring,
00:39:52.660 | but it doesn't mean they're gonna stop doing it.
00:39:54.420 | It just means others don't have to pay Vanguard to do it.
00:39:57.940 | - Yes, exactly.
00:39:58.940 | Which will be good
00:39:59.780 | 'cause then other groups will have this same benefit
00:40:02.780 | and it'll be more tax efficient for all, hopefully.
00:40:05.420 | - You know, you would think though over the years
00:40:06.940 | that it was a really good idea back 20 years ago
00:40:10.300 | when they did this at Vanguard.
00:40:11.980 | You would have thought that if it was other fund companies
00:40:14.420 | would have just paid Vanguard some fee to use the patent.
00:40:19.300 | But I've heard all kinds of different stories
00:40:21.140 | about why that never happened.
00:40:23.460 | Some of it had to do with the fund companies
00:40:25.900 | not wanting to pay Vanguard anything.
00:40:27.740 | And then other times I've heard that Vanguard
00:40:30.140 | wasn't interested in leasing the patent to anyone.
00:40:34.660 | So, but it is coming off patent, I understand.
00:40:37.260 | And maybe, in fact, I have seen and heard of companies
00:40:42.340 | that are preparing to launch products
00:40:44.740 | where the Open-End Fund and the ETF
00:40:46.980 | are a share class of the same underlying portfolio.
00:40:50.380 | So they'd be treated the same for taxes.
00:40:53.580 | - Interesting.
00:40:54.460 | - Another section of taxes, tax loss harvesting.
00:40:59.460 | You did a lot of work on this.
00:41:01.860 | Now you did it with individual stocks,
00:41:04.260 | but if you've also done some work
00:41:05.580 | on just tax loss harvesting of ETFs
00:41:09.700 | within a taxable portfolio, that would be helpful.
00:41:12.140 | So tell me, what is tax loss harvesting
00:41:14.300 | and what's the benefit?
00:41:15.660 | - Sure, again, I should give the caveat here
00:41:18.420 | that tax loss harvesting is very unique
00:41:22.540 | to a particular situation.
00:41:24.860 | But we tried to capture how much could one individual
00:41:29.860 | juice returns by tax loss harvesting.
00:41:34.220 | So again, the idea here with tax loss harvesting
00:41:38.180 | is you sell loser stocks to offset
00:41:41.780 | some capital gains tax liability.
00:41:43.900 | And we did a lot of simulations here.
00:41:46.140 | We looked at past 50 years of data.
00:41:48.900 | And not surprisingly, during high volatility periods
00:41:53.900 | or strong down years, that's when tax loss harvesting
00:41:59.140 | could juice your returns the most.
00:42:01.580 | And on average, on down years or high volatility years,
00:42:04.500 | we saw you could add about 2% on that year
00:42:09.500 | by tax loss harvesting.
00:42:11.980 | But over the long run, kind of on average,
00:42:15.260 | you're looking about, I would say a percent or so return
00:42:20.260 | that could be added to your portfolio
00:42:22.500 | by tax loss harvesting.
00:42:24.180 | - To make it clear, you added it to your return
00:42:27.860 | because eventually you have capital gains.
00:42:30.700 | - Yes.
00:42:31.540 | - Because you're only allowed to write off $3,000
00:42:33.220 | as a year of losses against your income.
00:42:35.700 | So if you don't have any gains, but if you have gains,
00:42:38.540 | then you could write off these losses against those gains.
00:42:41.060 | So when you're talking about in the long-term adding 1%,
00:42:45.420 | you're assuming you're gonna have gains from,
00:42:47.820 | I don't know, the sale of a piece of property,
00:42:50.020 | the sale of a business, even the sale of your primary home,
00:42:54.140 | if it goes over the 250,000 or $500,000 limit,
00:42:58.220 | if you're single or if you're married.
00:43:00.220 | And therefore, this is how you make up that 1%.
00:43:04.140 | - Yes, yeah.
00:43:04.980 | So again, we're generalizing here to something
00:43:07.780 | that's incredibly individual-specific.
00:43:11.220 | Tax loss harvesting obviously is most beneficial
00:43:13.580 | when you're going to incur a very large taxable event,
00:43:17.860 | I don't know, a sale of a business or something, so.
00:43:21.740 | - Well, that breaks things into another question I have.
00:43:24.580 | And I don't know if you've written on this or not.
00:43:26.460 | I didn't see anything.
00:43:27.380 | It has called direct indexing.
00:43:30.060 | And this is where, instead of just buying the S&P 500
00:43:34.780 | or the total stock market index fund,
00:43:37.580 | you go out and you hire a company,
00:43:40.980 | and even Vanguard does this now,
00:43:42.460 | so it's widely sold out there, and I will say sold,
00:43:46.700 | is that you end up with a portfolio
00:43:49.860 | of 500 different stocks or 1,000 stocks in your portfolio,
00:43:53.580 | literally 85-page account statement every month
00:43:57.300 | of individual securities.
00:43:58.940 | But the program sells the losers, generates tax losses,
00:44:03.940 | and then rebuys or fills in or substitutes,
00:44:09.300 | or the different programs do it different ways,
00:44:11.620 | waits 30 days, rebuys it back,
00:44:13.620 | and you generate quite a bit of tax loss in a year or two
00:44:18.220 | when you might need it.
00:44:19.620 | In other words, you're gonna sell a business
00:44:21.340 | or you've got a big single security
00:44:24.780 | that you're gonna be selling,
00:44:25.620 | and there's a big capital gains,
00:44:26.900 | you wanna maximize the losses.
00:44:28.780 | - So that's how direct indexing is sold.
00:44:31.620 | On the downside, you have to pay fees on that
00:44:34.460 | pretty much for the rest of your life,
00:44:35.940 | because what are you gonna do with 1,000 stocks?
00:44:38.700 | My views of direct indexing might not be as rosy
00:44:42.860 | as the people who are selling this product,
00:44:44.300 | but what are your views on direct indexing?
00:44:46.940 | - Yeah, I was hearing so much about this about a year ago,
00:44:50.340 | and then it kind of dissipated.
00:44:52.980 | I wish I could say more about this.
00:44:56.020 | I just haven't dug into the data.
00:44:57.500 | I don't know if there is data availability yet,
00:44:59.860 | 'cause again, it's, to the best of my knowledge,
00:45:01.900 | it's individually created for a person.
00:45:04.820 | Correct me if I'm wrong, but it was,
00:45:06.500 | I remember hearing O'Shaughnessy,
00:45:08.420 | hopefully I'm pronouncing that name right.
00:45:10.420 | They were on TV a year ago really propping this thing up
00:45:14.620 | and saying how great it was,
00:45:17.060 | but I haven't heard much since then.
00:45:18.860 | - Direct indexing firms,
00:45:20.060 | if you had created the software to do it,
00:45:23.700 | became extremely valuable, the companies themselves.
00:45:28.020 | Wealthfront was almost sold to UBS
00:45:30.860 | at extremely high valuation
00:45:33.020 | because of their direct indexing products.
00:45:34.500 | I mean, these direct indexing companies
00:45:36.580 | were going for crazy multiples,
00:45:39.700 | and then it disappeared, you're right.
00:45:41.380 | I mean, last year, 2022, when the market went down,
00:45:44.580 | it all stopped.
00:45:45.420 | In fact, UBS backed out of the deal with Wealthfront.
00:45:48.420 | I will admit there are individuals who could use this,
00:45:51.340 | as long as there's some sort of an exit strategy
00:45:53.260 | to get out of it, so you don't, for the rest of your life,
00:45:55.500 | have a 85-page statement and have to pay fees.
00:45:59.340 | - Yeah.
00:46:00.180 | - Let's go on to the last phase,
00:46:04.100 | the last part of this, and that is investor behavior.
00:46:08.220 | And particularly, I think I wanna get to
00:46:11.340 | a little bit of performance chasing.
00:46:13.580 | We hit on this with the Fama-French three-factor model
00:46:17.380 | a little bit, when it first came out,
00:46:19.740 | Dimensional Fund Advisors adopted it
00:46:22.300 | and they started promoting three-factor investing,
00:46:25.780 | and then Rob Arnott and research affiliates
00:46:29.020 | came out with fundamental indexing,
00:46:30.900 | and all of a sudden, smart beta was the big thing.
00:46:35.300 | It didn't really pan out, as far as the performance,
00:46:39.220 | since it got to be really popular.
00:46:41.980 | Even though these things are academic-based,
00:46:45.260 | sometimes they don't actually work.
00:46:48.620 | And my question to you, as an academic,
00:46:51.900 | is how much weight should investors put
00:46:55.020 | on these new academic discoveries about investing,
00:47:00.020 | or should they wait to partake in them
00:47:03.260 | for at least 20 or 25 years
00:47:04.860 | to see if it actually works in reality?
00:47:08.300 | - Yeah, it's an interesting phenomenon.
00:47:10.460 | At Boston College, we've been writing a lot on this,
00:47:13.700 | and their name just slipped my mind,
00:47:15.940 | but they published a number of works
00:47:17.620 | that go back and look at anomalies.
00:47:20.140 | Anytime a anomaly is announced,
00:47:23.660 | it disappears pretty quickly.
00:47:25.260 | So there's a lot of writing in finance
00:47:27.780 | that goes and looks at an anomaly.
00:47:30.100 | This could be the, I don't know, January effect anomaly.
00:47:32.740 | It could be any of this.
00:47:34.460 | And as soon as it's published, it disappears.
00:47:37.460 | - Yes.
00:47:38.420 | - And that's kind of what we've seen
00:47:39.820 | with this five-factor model.
00:47:41.700 | For those who don't know about it,
00:47:42.940 | it isolates how do small companies do against big companies,
00:47:46.340 | how do high book-to-market do against low book-to-market.
00:47:49.780 | Three factors plus what we call a quality factor.
00:47:54.220 | All the factors really haven't done well
00:47:56.860 | since year 2000, except for the quality factor.
00:48:00.500 | - By quality, you mean quality of earnings?
00:48:03.460 | - Quality of earnings, yep.
00:48:04.580 | People have different definitions for this,
00:48:06.220 | but Vanguard has a quality ETF, a lot of others do,
00:48:10.020 | and it's companies that have positive ROA and growing ROA.
00:48:14.660 | - That has done well, but that's a later factor, right?
00:48:17.180 | I mean, that came out later on.
00:48:19.580 | - Yes, that came out really recently.
00:48:21.340 | That has come out in the past 10 to 15 years.
00:48:24.420 | - If I'm not mistaken, I think the fourth factor
00:48:26.980 | that came out was momentum.
00:48:29.500 | Cliff Asness did a lot of work on that
00:48:31.340 | at the University of Chicago, did his dissertation on that.
00:48:35.180 | I had him on the show.
00:48:36.900 | And then this quality, I believe, was the fifth factor.
00:48:39.700 | That came even later than momentum.
00:48:41.660 | Correct me if I'm wrong, but I think that's the linearity.
00:48:44.340 | - Definitely correct.
00:48:45.180 | That came out with a group of researchers
00:48:47.100 | at University of Rochester.
00:48:49.900 | - So it hasn't had time yet to go awry.
00:48:53.460 | - Yes.
00:48:54.300 | - I don't know, I'm just saying.
00:48:55.660 | It seems to me that even in the academic world,
00:48:59.340 | taking what's called evidence-based investing,
00:49:02.060 | this is a term that I never liked, but it's out there,
00:49:06.620 | and saying, look, here's the evidence from the past,
00:49:10.020 | therefore it's going to,
00:49:12.100 | I don't wanna say it's going to be the future,
00:49:13.580 | but there's evidence that it'll be there in the future.
00:49:16.180 | And I just never bought into that,
00:49:18.420 | but it's sold a lot out there, evidence-based investing.
00:49:21.460 | It's sold as being scientific, a scientific way to invest.
00:49:26.460 | And I don't know, to me, that's just marketing.
00:49:29.260 | What do you think?
00:49:30.180 | - Yes, yeah, I think it's,
00:49:33.340 | we always need a new marketing gimmick, like you said.
00:49:36.180 | - Smart beta.
00:49:37.220 | - Yeah.
00:49:38.740 | And then there was dynamically adjusted multifactor ETFs.
00:49:42.900 | - Yes, of course.
00:49:44.020 | - I haven't heard from those in a while.
00:49:46.140 | But you always need to come up with something
00:49:48.460 | that seems to fit the bill even better,
00:49:50.180 | but it disappears quickly.
00:49:51.940 | And again, if people are curious to read this research
00:49:54.580 | that really does go through the 200 anomalies
00:49:57.940 | that we've identified,
00:49:59.340 | it's a gentleman named Jeff Pontiff at Boston College,
00:50:03.540 | who's done a lot of work and chronicles,
00:50:05.780 | and shows you just how much,
00:50:07.620 | once something's talked about, it disappears quickly.
00:50:10.940 | So Jeff Pontiff.
00:50:12.740 | - All right, so, you know,
00:50:13.860 | Fogelhead's philosophy is buy a few low-cost index funds,
00:50:17.860 | broad market index funds, rebalance if you can.
00:50:20.980 | I mean, and you probably use your tax advantage accounts
00:50:23.940 | to do rebalancing, or new money to rebalance,
00:50:26.780 | so that you can be tax efficient, and stay the course.
00:50:30.220 | How does this sound to you as an academic
00:50:32.380 | who has studied all this other stuff?
00:50:34.500 | It's a loaded question, by the way.
00:50:35.940 | (laughing)
00:50:37.380 | - I've been part of this group for 20 plus years.
00:50:40.260 | It still seems to hold true in the data.
00:50:43.020 | You know, there's no magical solution here.
00:50:45.260 | Just being low-cost and tax efficient
00:50:48.540 | is 98%, 99% of what you can do over the long run.
00:50:53.540 | Doesn't matter if you're an active manager,
00:50:56.380 | and you think you can beat the market.
00:50:57.940 | Over the long run, you're gonna underperform.
00:51:00.220 | It's just a matter of time.
00:51:01.980 | The way I explain it to my students,
00:51:03.340 | 'cause they're always so gung-ho,
00:51:06.300 | and, you know, 'cause they read about,
00:51:07.820 | I don't know, renaissance technology,
00:51:09.460 | or some hedge fund out there,
00:51:11.220 | that we think has beaten the market.
00:51:12.660 | And I say, "Well, even if there are a few
00:51:15.260 | "that can beat the market, they don't want your money."
00:51:18.180 | Right?
00:51:19.020 | They're not taking your money.
00:51:19.860 | You're gonna have-- - That's right.
00:51:20.700 | - Right?
00:51:21.540 | If a hedge fund is asking for your money,
00:51:23.340 | you're probably gonna lose money with that hedge fund.
00:51:25.900 | So-- (laughing)
00:51:27.380 | - So true.
00:51:28.260 | - Yeah.
00:51:29.100 | So being tax efficient, low-cost is the best you can do.
00:51:32.220 | - And stay the course.
00:51:33.540 | - Stay the course, yeah.
00:51:34.700 | - Well, Derek, thank you so much
00:51:35.620 | for being on Bogleheads on Investing.
00:51:37.220 | I really enjoyed having you here today.
00:51:38.700 | It's always great to get these different perspectives.
00:51:41.300 | And I gotta give you a lot of credit
00:51:43.140 | for what you're doing at your school,
00:51:44.460 | getting these young people involved,
00:51:46.100 | not just having them do projects,
00:51:47.820 | but you being a real advocate for them,
00:51:50.260 | getting them published.
00:51:51.260 | I mean, that is so huge for them and their careers.
00:51:54.420 | Continue the great work.
00:51:55.980 | - Well, thank you for having me on this podcast.
00:51:58.020 | It's been great.
00:51:59.540 | - This concludes this episode of Bogleheads on Investing.
00:52:03.620 | Join us each month as we interview a new guest
00:52:06.380 | on a new topic.
00:52:07.420 | In the meantime, visit boglecenter.net,
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00:52:22.060 | Join one of your local Bogleheads chapters
00:52:24.940 | and get others to join.
00:52:26.300 | Thanks for listening.
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