Bogleheads® on Investing Podcast 027 – Cliff Asness, host Rick Ferri (audio only)

00:00:00.000 | - Welcome everyone to Bogle Heads-On Investing podcast number 27.

00:00:14.680 | Today our special guest is Cliff Asness, founder, managing principal, and chief investment officer

00:00:20.960 | of AQR Capital Management.

00:00:23.760 | Cliff has a PhD from the University of Chicago.

00:00:26.680 | Jack Bogle called him a brilliant academic.

00:00:39.020 | My name is Rick Ferry and this is Bogle Heads-On Investing podcast number 27.

00:00:44.400 | This podcast, as with all podcasts, are brought to you by the John C. Bogle Center for Financial

00:00:49.960 | Literacy, a 501(c)(3) nonprofit organization at boglecenter.net.

00:00:57.760 | Today we have a special guest, Cliff Asness.

00:01:00.680 | Cliff is the founder, managing principal, and chief investment officer of AQR Capital

00:01:06.120 | Management.

00:01:07.120 | At the end of 2019, the firm was managing over $186 billion of assets, in part on strategies

00:01:13.960 | that Cliff developed at the University of Chicago as a PhD student under Nobel Laureate

00:01:19.480 | Gene Fama.

00:01:20.480 | Cliff has received many awards, including the Bernstein-Fabozzi-Jacobs-Levy Award from

00:01:25.360 | the Journal of Portfolio Management, the Graham and Dodd Award from the Financial Analyst

00:01:29.920 | Journal, the James Verton Award from the CFA Institute, and probably his biggest award,

00:01:35.800 | Jack Bogle referred to Cliff Asness as a brilliant academic.

00:01:40.200 | I will warn you that some of this podcast is going to be a little geeky, so put on your

00:01:45.180 | math hat and here we go.

00:01:47.280 | With no further ado, let me introduce Cliff Asness.

00:01:51.840 | Welcome Dr. Asness.

00:01:52.840 | Thank you, Rick, but please call me Cliff.

00:01:58.440 | Doctor makes me think you want me to help with an appendectomy.

00:02:02.840 | Well, thank you, Cliff.

00:02:05.000 | It's a real pleasure to have you on Bogle Heads on Investing.

00:02:08.300 | You have a lot of followers on the Bogle Heads.

00:02:11.560 | All of your research and your background is really quite fascinating.

00:02:16.920 | But that's what I want to start out with.

00:02:18.960 | If we could start as far back as you are comfortable going, how did you get to where you are today?

00:02:27.200 | I was a very unmotivated high school student.

00:02:32.680 | My parents thought I was an underachiever.

00:02:35.400 | I did very well on standardized tests and very poorly relative to those tests in classes.

00:02:41.680 | Partially, back then you can get away with actually not doing your homework and I took

00:02:45.800 | advantage of that.

00:02:47.940 | When applying to college, my dad found this program at the University of Pennsylvania

00:02:53.360 | that was a dual degree program between the Wharton School and the Engineering School.

00:02:59.360 | I had not really given any of this much thought at all and it was my father who suggested,

00:03:05.200 | "Hey, why don't you study two things that both could help with a career because you

00:03:10.000 | don't know what the heck you want to do and you have no direction."

00:03:12.800 | So I really didn't start out going to school and doing that because I had a great love

00:03:17.860 | of finance or really wanted to be a computer scientist.

00:03:22.520 | It was more of a default.

00:03:24.440 | I ended up loving both those things.

00:03:27.120 | Little luck is always a good thing.

00:03:29.480 | You got to take advantage of good luck when you get it.

00:03:31.360 | You got to minimize bad luck when you get it.

00:03:33.440 | But if things work out well and you don't acknowledge the role of luck, you're just

00:03:37.400 | not telling the truth.

00:03:39.240 | So I went to this program, at one point, I started doing research assistant work for

00:03:44.880 | a few different professors, one of which is quite well-known now, Andrew Lowe of MIT.

00:03:49.520 | He was at Wharton at the time.

00:03:51.040 | He was a very young man.

00:03:52.560 | I ended up enjoying even the research assistant work and I think I said something to him kind

00:03:58.240 | of like, "I might want to do what you do."

00:03:59.720 | He was like, "That's cool.

00:04:00.720 | Why don't you think about where you want to go, see where you get in."

00:04:04.360 | I applied to a bunch of PhD programs, got in to Chicago, Stanford, and Wharton.

00:04:12.360 | Did not get into MIT, for which I'm still bitter about.

00:04:16.360 | But eventually, I'm on year 32 of being bitter about that.

00:04:21.840 | I think at some point I got to let it go, but I'm not quite there yet.

00:04:26.560 | They said something along the lines of, "We don't take people directly from undergrad,"

00:04:30.920 | but I think that was kind of like when someone breaks up with you and says, "It's not

00:04:34.120 | you.

00:04:35.120 | It's me."

00:04:36.120 | It probably wasn't because of your grades because according to the bio that I read,

00:04:40.680 | you were a summa cum laude in both engineering and economics.

00:04:45.800 | Yeah.

00:04:46.800 | There was a day where I was pretty smart.

00:04:50.120 | That day has faded and I couldn't do any of those things again, but sometime in the

00:04:55.680 | distant past, the brain used to work.

00:04:58.240 | Let's not dwell on the one school I did not get in, though I will one day extract

00:05:03.160 | my revenge upon the entire institution.

00:05:07.440 | I ended up ... Wharton's a great place, but it didn't stack up against Chicago or Stanford

00:05:13.400 | when it came to PhD programs.

00:05:14.920 | I'm not talking, of course, about MBA programs or whatnot, but PhD programs always have their

00:05:19.400 | own kind of unique rankings.

00:05:22.440 | I basically went around to 10 professors at Wharton, told them that I'm looking to get

00:05:28.120 | a PhD in this.

00:05:29.120 | I got in these three schools and almost to a man, they said, "Shut the door," largely

00:05:35.880 | because they were going to tell me not to go to Wharton.

00:05:38.960 | Again, no knock on Wharton.

00:05:40.360 | I love my alma mater, but that was how PhD programs ranked those days.

00:05:45.640 | Nine out of 10 told me to go to Chicago, and many of them had gone to Chicago themselves.

00:05:51.960 | One famous professor named Robert Litzenberger, who was the next Stanford professor, he suggested

00:05:58.120 | Stanford, but at that point in history, Chicago's where you want to be.

00:06:03.920 | As an aside, Chicago offered to fly me out, and Stanford didn't.

00:06:09.120 | I asked, and they said, "No, it's just not in the budget."

00:06:11.920 | I had no money at the time, so I took Chicago up on their offer, visited on one of the most

00:06:17.240 | gorgeous spring days Chicago has ever produced.

00:06:20.400 | For years, I am fond of saying that I am the world's only person to choose Chicago over

00:06:25.280 | Stanford on the weather, which turned out to be a bit of a bait and switch, but the

00:06:31.240 | school worked out well.

00:06:32.480 | Not only did it work out well, but you got to study under some future Nobel laureates.

00:06:41.720 | One of them was Gene Fama.

00:06:45.480 | You know what's amazing?

00:06:47.840 | Back then, we pretty much knew he was a future Nobel laureate.

00:06:51.160 | Frankly, I thought they gave him the prize 15 years after they should have, but you knew

00:06:57.200 | it at the time.

00:06:58.200 | He was an amazing man.

00:06:59.200 | Again, it was a lucky break for me to be at Chicago in the late 1980s when Fama and French

00:07:05.320 | were doing a lot of the early work on what we now call systematic value investing or

00:07:12.440 | factor investing.

00:07:13.440 | We didn't even use those terms back then.

00:07:16.560 | We were just a bunch of geeks running regressions and sorting stocks on different variables,

00:07:21.840 | looking at returns.

00:07:23.440 | The terminology came later, but I was lucky enough for Gene to ask me to be his teaching

00:07:29.280 | assistant at the end of the year, and I did that for two years, so it basically meant

00:07:34.360 | I kind of took his class three times, so I sat in on it pretty much every day for three

00:07:40.280 | years.

00:07:41.280 | I got to teach review sessions and got to know Gene.

00:07:44.920 | In PhD programs, getting good advisors, it's just a big part of it.

00:07:49.520 | Getting advisors who are interested in you, who think well of you, I think that work helped

00:07:54.520 | me get him and Ken French to co-chair my dissertation committee, which was quite wonderful.

00:08:00.360 | More luck.

00:08:01.360 | Professor Fama was a big efficient market guy, but your thesis really had nothing to

00:08:05.560 | do with efficient market or maybe almost to disprove efficient markets in some way.

00:08:11.160 | Oh, first of all, we never prove or disprove things.

00:08:13.640 | Oh, I'm sorry.

00:08:14.640 | We're statisticians, so we're cowards.

00:08:15.640 | I joke about the cowardly statisticians that we are.

00:08:20.320 | We don't disprove.

00:08:21.320 | We just say there's only a one out of 100 chance we're wrong.

00:08:25.000 | Oh, that sounds like a Wall Street analyst there.

00:08:28.760 | Yeah.

00:08:29.760 | Yeah.

00:08:30.760 | But it is.

00:08:31.760 | It's funny.

00:08:32.760 | It sounds kind of wimpy and cowardly, but it's also just intellectually true.

00:08:37.260 | Data can never prove something.

00:08:38.480 | It can just increase the probability of your hypothesis or against your hypothesis.

00:08:44.480 | If you see a 99 out of 100 event, it may be in fact that it's true, or maybe you've got

00:08:50.480 | a 99 out of 100 random event.

00:08:53.000 | But yeah, a big part of my dissertation, not all of it, but a big part was one of the very

00:08:57.720 | early pieces of work, Price Momentum Strategy.

00:09:01.920 | Pride of Place is first.

00:09:02.920 | It has to go to Professors Jagadish and Tippmann, who wrote the first big published paper on

00:09:09.160 | the Price Momentum Strategy.

00:09:10.960 | I was fairly concurrent with them, and I am proud that my definition, partly because Fahman

00:09:17.100 | French adopted it for Ken French's kind of data website and used it in their papers.

00:09:22.760 | It's kind of the most common one people use today, UMD, up minus down, for basically one

00:09:30.600 | year price momentum.

00:09:32.400 | I do remember very, very distinctly being nervous about precisely what you just said,

00:09:39.200 | that here I am.

00:09:40.200 | I'm lucky to have this relationship with the premier advocate for the efficient markets

00:09:43.800 | hypothesis in the world, and I have all these preliminary results saying that a fairly straightforward

00:09:51.160 | momentum strategy was effective.

00:09:54.240 | I distinctly remember telling him, "Gene," and I say Gene now, "Professor Fahman," certainly

00:10:00.560 | it took me 15 years after the program until I would call him Gene, even though he kept

00:10:05.120 | telling me to, "Professor Fahman, I want to write a dissertation on price momentum,"

00:10:10.640 | and then I mumbled the second part out of fear, "And it works really well."

00:10:15.000 | And he's like, "What?"

00:10:16.000 | I'm like, "And it works really well."

00:10:18.040 | And he thought for a bit, and he said something that has always stayed with me.

00:10:21.960 | It was actually in a weird, geeky way, almost kind of moving.

00:10:26.040 | He said, "If it's in the data, write the paper," which to me said, "Look, this might not be

00:10:31.840 | something I love.

00:10:32.840 | I might not love this result.

00:10:33.840 | I might consider it the exception that proves the rule," but data's kind of holy to him,

00:10:39.400 | and that kind of stuck with me, and it also allowed me to get on the path to graduation,

00:10:45.080 | which was nice.

00:10:46.080 | Though even then I was not crazy enough to say, "Gee, I found something better than your

00:10:51.600 | value factor."

00:10:53.600 | First of all, that would have been bad economics.

00:10:56.080 | They work better, if you believe both of them, they work better together.

00:11:01.160 | Systematic value can make money over the long term.

00:11:04.200 | Systematic momentum can, and they're fairly negatively correlated, which is a wonderful

00:11:08.720 | thing to have if both strategies make money.

00:11:11.360 | It would have been bad graduation strategy to tell Fahman, "We're going to do this instead

00:11:16.400 | of value," saying, "It's a compliment to your wonderful value strategy," was some sucking

00:11:21.800 | up I was absolutely willing to do.

00:11:23.480 | >>Corey: Well, let me ask just a couple of questions on what you just said.

00:11:27.760 | Did Fahman ever call what he did "value investing"?

00:11:30.600 | >>David: It's funny you ask that, because I keep meaning to go back and check the original

00:11:34.800 | papers.

00:11:35.800 | I don't believe so.

00:11:37.480 | It's certainly possible when the world started calling it that, that they eventually referred

00:11:42.060 | to it that way.

00:11:43.060 | I don't even know that, but I don't remember them calling it a value factor or whatnot.

00:11:48.360 | I think that was index providers and maybe other papers that did it.

00:11:52.960 | I think they were just looking at multiples and whatnot to sort stocks.

00:11:57.400 | I could be dead wrong about this, but from memory, I don't remember being at Chicago

00:12:02.120 | and talking about value investing.

00:12:04.280 | But certainly that label caught on, and I actually don't even think it's the best label.

00:12:10.280 | It creates tremendous confusion, because you're kind of Graham and Dodd, old-fashioned, concentrated

00:12:16.200 | portfolio, active management, value managers.

00:12:19.440 | People call themselves value managers.

00:12:21.560 | Get mad, because they look at the quantitative factor, and they say, "That's not value."

00:12:27.240 | Value is the price against fundamentals in consideration of things like which are better

00:12:33.880 | companies, safer companies, faster-growing companies, more profitable companies.

00:12:39.520 | The answer is quants don't think price divided by anything, books, sales, cash flow, earnings,

00:12:47.820 | is the only thing you should judge on.

00:12:49.720 | We agree with those managers, and we just call them different factors, things like the

00:12:54.760 | profitability factor, earnings momentum, low-risk investing.

00:12:59.480 | Those are all in the direction of the things that Graham and Dodd people want us to consider,

00:13:03.720 | but they just put the whole thing together and call a cheap company one that's cheap

00:13:07.960 | considering these other factors.

00:13:10.000 | We break it up and call them other factors, and 1,000 fights have been caused by that

00:13:15.720 | when they're really, through very different methods, concentration versus diversification,

00:13:20.760 | judgment versus systematic, but through very different methods.

00:13:23.960 | I think they're often looking for the same kind of things in the stocks.

00:13:28.360 | I always thought that beta can be agreed upon.

00:13:32.120 | You can take all the stocks on the market, weight them by either the shares outstanding

00:13:37.120 | in the public float or total shares outstanding, something, but we all can come to an agreement

00:13:42.320 | on what the beta of the market should be and that size, meaning large-cap stocks, mid-cap

00:13:50.960 | stocks, small-cap stocks, even micro-cap stocks, in general, all of the index providers can

00:13:57.040 | sort of agree what that is.

00:14:01.480 | They are all pretty close, but when it comes to value, I always say value is in the eyes

00:14:06.760 | of the beholder.

00:14:08.440 | Everybody has a different equation.

00:14:09.640 | Sure.

00:14:10.640 | First, I think that's fair, but let's talk about the value factor, what I would prefer

00:14:16.600 | to call the price factor, not the holistic considering other aspects, just price divided

00:14:21.160 | by some fundamental.

00:14:23.560 | You could choose price to cash flow.

00:14:25.640 | I could choose price to book.

00:14:27.880 | Someone else could choose a weighted average of how it looks on many different reasonable

00:14:33.640 | evaluation factors.

00:14:35.660 | You could do what we do.

00:14:36.660 | We wrote a paper on this in 1994 and tried to use this value factor to bet within industries,

00:14:44.960 | meaning we don't think it's very effective across industries.

00:14:47.160 | It's pretty hard to compare valuations.

00:14:49.480 | The standard work in almost all of academia and a fair amount of the indices allows very

00:14:54.600 | large industry bets.

00:14:55.880 | In fact, it always strikes me that the way we invest in value, we try very hard not to

00:15:01.360 | take an industry bet, and the way many speak about value is only in terms of industry bets,

00:15:07.460 | tech versus textiles.

00:15:09.860 | All of these things make your value possibly different than my value, but if we both use

00:15:16.260 | a handful of reasonable measures and have a portfolio construction technique, I also

00:15:21.500 | didn't mention how you weight them, can be different.

00:15:24.660 | Fama and French is a cap weighted.

00:15:26.620 | You could do a signal weighted where the degree of the valuation signal tells you your position.

00:15:31.600 | You could do equal weight, and of course, those will have somewhat different results

00:15:36.000 | and have somewhat different degrees of implementability.

00:15:37.920 | Is that a word?

00:15:39.920 | I think it's a word, implementability.

00:15:41.880 | Yeah, we'll call it a word.

00:15:43.880 | We'll call it.

00:15:44.880 | Yeah.

00:15:45.880 | It's our podcast.

00:15:46.880 | We'll write a paper on that when you get off this podcast.

00:15:49.840 | With that said, I do think if you create your favorite value strategy, and it's reasonable,

00:15:57.420 | deflating price by four or five of the major things out there, I might do it within industries.

00:16:03.660 | You might allow an industry bet.

00:16:05.580 | We're going to be, I'm making this up, don't hold me to it, we're going to be 0.8 correlated.

00:16:10.780 | What's amazing is over a couple of years, how different sometimes 0.8 correlated things

00:16:16.540 | can be.

00:16:17.540 | Yeah.

00:16:18.540 | That often surprises people.

00:16:19.540 | Some of the choices, they may not be provable which one's better, but over the short, even

00:16:23.820 | the medium term can matter.

00:16:26.320 | But 0.8 correlated says to me, you are right, there is no God-given way to measure value.

00:16:33.720 | But I think it matters a little less than people worry about, because price is the main

00:16:40.900 | thing driving the ship.

00:16:43.380 | Price compared to anything reasonable leads to at least fairly decently correlated strategies.

00:16:49.460 | I'd also say cap-weighted market, even that has a little degree of ambiguity.

00:16:55.500 | How deep do you go in the capital structure?

00:16:57.620 | You know, Wilshire 5000 versus S&P 500, size is actually even a little more complicated.

00:17:04.180 | I would agree still with your statement that size and the market are more common.

00:17:08.700 | If you and I both come up with a definition, we're probably going to be more correlated

00:17:12.300 | across those.

00:17:13.300 | But I still think of value, there's a concept that any decent value factor follows, deflating

00:17:21.140 | price by reasonable things and going long, the cheap and short, the expensive on that

00:17:26.700 | measure.

00:17:27.700 | And again, yours and mine, we might fight to the death over whose is better.

00:17:32.060 | We're kind of co-religionists who differ slightly in our dogma at that point.

00:17:37.020 | And as we've seen in history, those are some of the most vicious fights.

00:17:42.740 | But I don't think it's really...

00:17:45.140 | And I would include myself.

00:17:46.140 | I think, of course, after years of doing this, that our way is the best humanly possible.

00:17:50.300 | And I don't mean that arrogantly, I mean that in a sense of we would do it differently if

00:17:54.740 | we didn't think it was the best way to do it, and I'm sure our competitors would.

00:17:59.540 | But again, I think it's a great question.

00:18:01.460 | I think you're right directionally, but I think it is less...

00:18:04.480 | You didn't even say it was a problem, but I don't think it's a problem.

00:18:06.580 | I think most reasonable ways to come up with value will be more similar than you think.

00:18:11.380 | Some people believe that a multi-factor approach to value might solve the problem, at least

00:18:18.740 | for retail investors.

00:18:20.460 | In other words, instead of trying to pick which price to something is value, you just

00:18:26.500 | have a formula that takes a little bit of everything.

00:18:30.900 | I like that approach.

00:18:32.700 | We've written on that approach.

00:18:36.540 | Earning is going a little too far, price divided by, you know, you can imagine crazy things.

00:18:42.380 | I think I even used this phrase a few minutes ago.

00:18:44.540 | Price divided by anything reasonable.

00:18:47.120 | Make up your favorite four or five.

00:18:48.900 | Price divided by book.

00:18:51.000 | Price divided by trailing earnings.

00:18:52.580 | Price divided by forecasted earnings.

00:18:54.540 | Price divided by free cash flow.

00:18:57.380 | Price divided by sales.

00:18:58.820 | All reasonable.

00:19:00.340 | And I can tell you advantages and disadvantages to each one.

00:19:04.880 | I would prefer a stock that is the most attractive on a weighted average of those five more than

00:19:11.620 | I would prefer a stock on any one.

00:19:14.780 | I'm not smart enough and I don't know if anyone else is to pick out which of those five is

00:19:19.540 | actually...

00:19:20.540 | I'm saying five.

00:19:21.540 | It can be many more than that, of course.

00:19:23.860 | But I don't think we're really smart enough to figure out collectively.

00:19:27.180 | I don't think value is that, as you pointed out earlier, that well-defined a concept.

00:19:32.260 | I would rather take the average.

00:19:34.220 | So let's get to another debate.

00:19:37.580 | Is the value premium, at least historically, a result of risk or is it a result of behavior?

00:19:45.700 | Oh, you're going to get me in trouble.

00:19:48.860 | Oh, I am?

00:19:49.860 | I'm sorry.

00:19:50.860 | I like to put it this way.

00:19:53.220 | First, they both can have some influence.

00:19:56.460 | They both can contribute to a positive value premium.

00:19:59.660 | I know you've seen some of my work before.

00:20:01.420 | I'm not always a peacemaker.

00:20:03.060 | Sometimes I like to throw gasoline on a fire.

00:20:06.060 | In this particular case, I often throw water on the fire because I've been in academic

00:20:10.860 | seminars where I point out, you guys are arguing about this, but the real world is complicated.

00:20:17.300 | It could have a risk premium component and a behavioral component and just to really

00:20:21.860 | mess with everyone, those can vary through time.

00:20:25.300 | Right now, I think we're in a fairly crazy period and I'll go out on a limb and say I

00:20:28.780 | think there are more mispricings than normal.

00:20:30.940 | So maybe behavioralism matters more right now and maybe sometimes it matters less and

00:20:37.060 | it's more of a risk premium.

00:20:38.420 | I will tell you, and this is why I said you're going to get me in trouble, even though I

00:20:42.020 | wrote my dissertation on momentum as a Pharma student, I was probably two-thirds, one-third

00:20:47.420 | towards the risk story.

00:20:49.420 | Doing this live for now 26 years, going back to '94, I've certainly drifted more towards

00:20:55.060 | the behavioral story.

00:20:56.380 | I think living through about six cataclysmic events and at least three for value and being

00:21:03.420 | frustrated at those times, to be honest, a world I thought was going a little crazy has

00:21:08.980 | certainly pushed me.

00:21:09.980 | But again, I'm not dismissive of the risk.

00:21:11.900 | I'm probably two-thirds, one-third, the other way.

00:21:14.060 | Now, I'm not someone who feels intellectually confident saying we know the answer here,

00:21:20.100 | but at this point in my career, if I had to bet on one and couldn't split my vote, I would

00:21:25.940 | lean behavioral, though I warn you, I say that on the coast.

00:21:30.020 | If I'm ever in the Midwest and feel like Pharma is within a thousand miles, I change my story.

00:21:36.540 | It's kind of odd though that you would say that, and here's why.

00:21:40.140 | It's because there's been so much work done on behavioral finance and biases and everything

00:21:46.340 | that you would think that we would have resolved some of our internal human issues and that

00:21:52.780 | we would notice that, but what you're really saying is people are acting worse than they

00:21:57.900 | used to be, even though the research by various top Nobel laureate behavioral economists are

00:22:05.500 | putting this information out.

00:22:06.700 | People are reading the books, right?

00:22:08.180 | No, I think that's a fair observation and I have a few thoughts on it.

00:22:14.180 | I think it comes down to this.

00:22:16.500 | Value has been on a terrible streak.

00:22:17.820 | It's kind of a 10-year drawdown.

00:22:20.020 | I think the first seven years of that drawdown were very different than the last three.

00:22:23.500 | I think the last three have been far less rational than the first seven.

00:22:27.700 | Remember my distinction that behavioral can matter, but it's not always behavioral.

00:22:32.100 | But even a few years ago, not 10 years ago, even two, three years ago, maybe the most

00:22:36.860 | common question I got was along the lines of what you're saying.

00:22:41.020 | Not just value, but other factors too, but we'll talk about value here.

00:22:44.340 | If this is true, why doesn't it get arbitraged away?

00:22:47.500 | It could get arbitraged away by too much capital or people could learn and stop making these

00:22:52.860 | biases.

00:22:53.860 | The learning part, which is more where you're coming from, again, I don't see a whole lot

00:22:58.960 | of evidence that human biases are going away or even ameliorating around the world.

00:23:05.420 | We live in a little bit of a bubble where we're very well-versed in all these behavioral

00:23:11.220 | issues and we read all the literature.

00:23:13.800 | But I think, not to pick on them, it's become an easy punchline, but you go to your average

00:23:18.500 | Robin Hood trader, and I don't think we've gotten through on the arbitrage, why are these

00:23:24.820 | arbitraged away?

00:23:25.820 | Remember, strategy can go away for two reasons, it can go away for either demand or supply.

00:23:31.060 | Demand for strategy is too much capital chasing it, which even if there is a certain amount

00:23:36.320 | of bias in the world, you can't extract an infinite amount of money from that.

00:23:40.600 | You can only take the other side and close the gap on valuation.

00:23:44.340 | So if the first trillion dollars closes most of the gap, the second trillion dollars doesn't

00:23:50.660 | make any money.

00:23:51.660 | It's closed.

00:23:52.660 | No one makes any money.

00:23:54.580 | Or it can go away because of supply.

00:23:56.540 | And this is a little bit cynical, but this is behavioral, this is the supply of investor

00:24:01.700 | error.

00:24:03.100 | People have to continue to make errors and a limited amount of capital has to pursue

00:24:07.740 | them.

00:24:08.740 | So again, two and a half, three years ago, the question was, why do these things persist?

00:24:13.180 | After two and a half, three painful years to these strategies, the question I get now

00:24:19.140 | is more, how can anyone stick with these, even if they're great long-term, how can anyone

00:24:23.820 | stick with these?

00:24:25.060 | And I love to point out that these are, in a real way, the opposite question.

00:24:30.280 | One is saying, this is so obvious, everyone should do it and it should go away.

00:24:34.060 | The other is saying, no one can do it.

00:24:36.140 | And I think there's an element of truth to both.

00:24:39.860 | Real life strategies that can be done in large capacity, I mean a strategy like value that

00:24:44.500 | can be done at fairly large scale, is not a super high Sharpe ratio.

00:24:49.500 | I think it's real.

00:24:51.380 | And so a real positive Sharpe ratio, you can add to a diversified portfolio, that is a

00:24:56.060 | wonderful thing.

00:24:57.980 | But it goes through, as we've seen even before the last 10 years, we've seen horrible periods

00:25:02.620 | for value.

00:25:04.100 | And the very fact that it can be very hard to stick with drives a fair amount of people

00:25:08.460 | out, makes it hard to see the whole round trip.

00:25:10.820 | So you do have this kind of yin-yang.

00:25:13.220 | On the one hand, it should go away.

00:25:14.420 | On the other hand, it's really hard to stick with.

00:25:17.020 | And perversely, I think low Sharpe ratio, high capacity strategies that are a long-term

00:25:24.420 | investor's good friend, if you really can stick with them, they can improve a portfolio.

00:25:31.140 | And I think they don't go away precisely because they're at that kind of risk-adjusted return

00:25:35.500 | that's on the cusp.

00:25:37.140 | You can recognize it's good.

00:25:39.100 | Some people can stick with them.

00:25:40.980 | But a lot of people think they can, but can't.

00:25:43.780 | And so if something is real, but 90% of the people throw in the towel when it's had a

00:25:48.620 | bad three years, it's going to stay an opportunity, and it's going to occasionally really hurt.

00:25:53.340 | I think that the overwhelming interest in value investing that occurred in the early

00:25:58.660 | 2000s after tech tumbled and value just had an incredible run, small cap value in particular,

00:26:07.860 | created this wave of fundamental weighted ETFs and a whole range of other factor-based

00:26:15.260 | ETFs just came out of the woodwork, and people were inundated with this.

00:26:21.180 | Because of all this interest and because of all this new knowledge that people were getting,

00:26:25.500 | it seems to me made this value factor not work, but also not work for a longer period

00:26:31.140 | of time than normally would have occurred, perhaps.

00:26:35.020 | It's certainly possible.

00:26:37.500 | We certainly live in a cyclical business where people do, in fact, overreact to the prior

00:26:42.500 | big event, and it's possible.

00:26:46.260 | We all collectively did that at one point.

00:26:48.300 | I will say, ever since 1999, when we started our firm right before the teeth of the tech

00:26:54.260 | bubble really took off, we invented and have been tracking since then something that has

00:27:00.020 | come to be called the value spread.

00:27:02.860 | This was...

00:27:03.860 | All right, Fama and French and many others in academia sort stocks on some valuation

00:27:08.860 | ratio and they look at the spread between the cheap and the expensive in returns, but

00:27:13.580 | what was really missing, we couldn't find it anywhere, it's certainly possible someone

00:27:16.940 | privately had done it, but we didn't see it in the literature, was anyone who looked at

00:27:22.460 | and thought the information was interesting in the magnitude.

00:27:26.020 | How cheap is cheap?

00:27:27.900 | Imagine all of value is price to cash flow, and again, like we talked about before, I

00:27:32.220 | would much rather use many, but just to make it simple, you're going long, low price to

00:27:36.800 | cash flow, and short, high price to cash flow.

00:27:39.580 | The expensive ones will always be more expensive on your own metric, but how much more expensive

00:27:46.740 | and how much cheaper, what the spread is between them will vary through time.

00:27:53.060 | And we did this in the teeth of a very terrible value market and not surprisingly discovered

00:27:58.140 | that after it being terrible, that spread had blown out to record levels.

00:28:03.060 | That didn't have to happen.

00:28:04.440 | You can lose in a value strategy or any strategy and have it not get cheaper.

00:28:10.540 | Simplest example, imagine you bought a stock because it had a low P/E and the price fell

00:28:15.740 | 50%.

00:28:16.740 | A naive, simple approach to say, "Oh God, it got cheaper."

00:28:20.980 | But if the earnings fell 75%, your favorite metric, P/E doubled, it didn't get cheaper,

00:28:27.380 | it got more expensive.

00:28:28.380 | So you can actually lose in a strategy, if you lose because the fundamentals move against

00:28:33.340 | you, it doesn't necessarily get cheaper, so it was worth checking.

00:28:37.500 | And we did find it had gotten massively cheaper, which means most of what was going on in the

00:28:42.100 | tech bubble, actually, I think more than all, because I don't think these were high quality

00:28:45.420 | companies even, was from price action.

00:28:48.540 | It was not fundamentals.

00:28:50.860 | We've been monitoring this spread in many different ways in many different places ever

00:28:54.620 | since.

00:28:55.620 | Halfway, of course, it's symmetric, halfway to worry about periods like now, where that

00:29:01.140 | spread is back out to approximately record levels.

00:29:04.700 | If you're beaten up in value, is that money gone, meaning you lost on fundamentals, which

00:29:10.260 | you don't give up, you might continue with your strategy, but you don't expect to make

00:29:15.980 | that back.

00:29:17.500 | Or did you lose on price, where you may have an expectation that it's more attractive than

00:29:21.820 | normal now that the premium is larger than normal.

00:29:25.820 | But we didn't track this only for times like today.

00:29:30.020 | Maybe even more so we tracked it to see what if that spread ever compressed well beyond

00:29:34.900 | history.

00:29:36.100 | The only one I have memorized is price to book.

00:29:38.740 | And I think if you look at the standard Fama-French construction, the price to book of the expensive

00:29:43.260 | is 30%, against the cheap, call it 30%.

00:29:49.480 | It averages maybe five or six times.

00:29:52.380 | So the expensive are five or six times more expensive than the cheap.

00:29:56.100 | The low is maybe the high threes, maybe four was the low, and you've hit that a few times.

00:30:01.860 | And the high was about 12 in the tech bubble, 12 to 14, depending upon the precise measurement.

00:30:08.780 | And we are back to similar levels to that.

00:30:11.420 | But one reason we've monitored this forever is what if that spread smashes down to one

00:30:17.580 | and a half, to a compressed level where the differences in valuation are just not very

00:30:23.140 | large and in fact record small compared to history, and then stayed there for a few years.

00:30:30.340 | Your hypothesis that maybe the world has figured this out, maybe they're not making that error

00:30:35.300 | or maybe too much arbitrage capital has come in would be hard to argue with.

00:30:42.500 | You know, if a value strategy exists because there's a spread in valuations, if that spread

00:30:46.900 | in valuations is much smaller than it used to be, maybe the world has figured it out.

00:30:51.820 | And we've always felt monitoring that in case it was time not to do it was the case.

00:30:56.860 | And we've seen lower and we've seen higher, and we certainly see extremely high today,

00:31:01.700 | but we've never seen it smash down to levels that say, you know, value is never going to

00:31:06.700 | work again.

00:31:07.700 | The world has figured it out.

00:31:09.380 | It could certainly still happen in the future.

00:31:12.700 | Let's pivot back to momentum in a very short and eloquent, simple way.

00:31:18.220 | If you can explain the formula for momentum, that's number one.

00:31:23.140 | And then number two, you said that the momentum factor and the value factor are uncorrelated

00:31:30.420 | or at least low...

00:31:31.420 | No, negatively correlated.

00:31:32.420 | Oh, they're negatively correlated, okay.

00:31:34.520 | So if they're negatively correlated and you had them both together in the same portfolio,

00:31:38.100 | I mean, how does that reconcile or do you not have it in the same portfolio?

00:31:43.380 | The simplest measure of momentum I know is still the one I used in my dissertation.

00:31:48.060 | It is simply one year total return, leaving off some of the very recent returns.

00:31:54.140 | I didn't even use daily data, so I left off the last month in my dissertation.

00:31:58.460 | You don't really need to leave a whole month off.

00:32:00.020 | You need to leave off a few days.

00:32:02.620 | That could be because we see some true reversal at the very short term, liquidity provision.

00:32:07.580 | You know, if someone tries to trade a lot, they push a price and it's temporary price

00:32:10.860 | pressure or they're just some microstructure issues.

00:32:14.580 | If the last trade is at the bid, the price looks low and the momentum looks worse.

00:32:20.660 | But if the next trade is half at the bid and half at the offer, half the time, on average

00:32:25.480 | you get a bounce.

00:32:26.540 | So it creates a little bit of an artificial contrarian strategy.

00:32:30.780 | So I often shorten it to one year price momentum and leave off all the geeky stuff about having

00:32:35.900 | to be sure that you don't accidentally get that contrarian part that may or may not be

00:32:39.540 | real at the very short term, but call it simply one year price momentum.

00:32:44.620 | I actually call this the fool strategy when I presented it to Fama, and I think I was

00:32:48.900 | just currying favor there.

00:32:50.500 | I knew he wasn't going to like the momentum strategy, so I might as well be self-deprecating

00:32:55.860 | about it.

00:32:56.860 | But on the face of it, you can't get simpler, right?

00:33:01.060 | Buy a diversified portfolio.

00:33:03.140 | Again, you can do this.

00:33:04.300 | You can weight it in different ways, but buy a diversified portfolio of stocks with strong

00:33:09.060 | one-year returns and sell a diversified portfolio of stocks with weak one-year returns on a

00:33:14.700 | relative basis.

00:33:15.700 | It doesn't matter which direction the market has gone.

00:33:18.620 | Now, of course, I won't get into this, but just like value, you can do this in more complex,

00:33:27.840 | perhaps better, perhaps over-engineered, we can always debate that ways.

00:33:32.140 | You can take out the industry bet from this.

00:33:35.060 | You can look not at total return, but total return net of, say, a beta or multiple betas

00:33:42.900 | to different factors.

00:33:43.900 | What's the excess return?

00:33:45.660 | There are a lot of different things you could do, and people do pursue these.

00:33:48.420 | There are a lot of papers on tweaking the momentum factor, just like there is with value.

00:33:53.420 | Same problem and/or opportunity, depending on your perspective, that there's no one way.

00:34:00.100 | But I think the base way in academia is still this one-year price momentum.

00:34:04.460 | Now, negatively correlated strategies.

00:34:07.980 | The way I think about this is imagine your value strategy, long cheap, short expensive,

00:34:13.940 | has a 5% average return and a 5% long-term volatility.

00:34:19.780 | And imagine so does your momentum strategy.

00:34:21.880 | If they are uncorrelated, you take their volatility and you divide by the square root of 2.

00:34:28.380 | So if you put half your money in each, you get a diversification benefit.

00:34:32.820 | If they are negatively correlated, the volatility comes in even lower.

00:34:37.300 | An implausible negative correlation, you know, if you thought they were negative one correlated,

00:34:41.660 | they both can't have a positive mean.

00:34:44.020 | That's a perpetual motion machine, right?

00:34:46.260 | To say I have two strategies that are perfect hedges, perfectly opposite, but both have

00:34:50.980 | a positive average.

00:34:52.620 | That would be no volatility ever and making money every day.

00:34:56.980 | It's like going long the S&P 500 and short the S&P 500.

00:35:01.420 | Yes.

00:35:02.420 | It's an absolute negative correlation, but you don't make any money.

00:35:06.380 | Exactly.

00:35:07.500 | But in real life, value and momentum, and times it's higher, times it's lower, but call

00:35:14.180 | it a -0.5 correlation.

00:35:17.500 | And that is actually pretty reasonable.

00:35:20.540 | If you say it in English, what you're trying to buy, if you give, and I don't say you have

00:35:24.660 | to give half your weight to each and there are other things besides value and momentum,

00:35:29.500 | but if you gave half your weight to value and half your weight to momentum, the actual

00:35:33.580 | stocks you're trying to buy, forget the quant stuff, just think about describing the stocks,

00:35:39.060 | are cheap stocks that are not disastrous on momentum or even mildly cheap stocks that

00:35:44.820 | have good momentum that are getting better.

00:35:47.660 | I used to laugh and be kind of obnoxious when more traditional managers would all describe

00:35:54.380 | their process as we're looking for value plus a catalyst.

00:35:59.060 | And I used to roll my eyes and say, "You all say the same thing."

00:36:02.740 | And then a friend who was an active stock picker said, "Don't you do value and momentum?"

00:36:08.540 | I said, "Yeah."

00:36:09.540 | And he said, "Don't you think you can describe that as value plus a catalyst?"

00:36:15.460 | And I said, "Damn, I think I see where you're going with it."

00:36:18.740 | So just the mechanical math is if you have two strategies that are not unrealistically

00:36:24.940 | negatively correlated, but are decent.

00:36:27.540 | They're not perfect hedges, they just tend to move in the opposite direction, and both

00:36:31.620 | make money.

00:36:32.620 | I think that is both possible at a minus 0.5 correlation, and you create a better risk

00:36:37.300 | return.

00:36:38.300 | Any time you create a better risk return, you can take that benefit through getting

00:36:42.480 | basically the same average return at lower risk, or you can be more aggressive and try

00:36:48.020 | to translate that into higher returns for similar risk.

00:36:53.360 | But I think the idea that there are two strategies that can both make money and partially hedge

00:36:59.180 | each other, not fully because that can't work, but partially hedge each other.

00:37:03.460 | I just think is what's going on with value and momentum, and I think it's quite intuitive.

00:37:08.300 | All is equal if the price goes up, the momentum gets better and the value gets worse.

00:37:12.900 | So let me ask a question.

00:37:15.940 | Dimensional Funds does this.

00:37:18.020 | They first screen for their value stocks, the stocks they want to buy based on their

00:37:24.240 | value screens, and then they buy the ones that have good momentum.

00:37:30.640 | So in other words, value first, and then momentum.

00:37:34.200 | How does that work?

00:37:35.200 | Sure.

00:37:36.200 | You know, I mean, I have great respect, of course, for the guys at Dimensional, Fama

00:37:40.680 | and French still do a ton with them, and there's nobody in the industry I respect more.

00:37:46.060 | We do differ on this.

00:37:48.020 | Like I said, people of basically the same religion with small differences.

00:37:53.040 | You get your 30 Years War, you get your Shia-Sunni kind of thing, where essentially we agree

00:37:59.840 | on almost everything, but we disagree about this small point.

00:38:03.480 | Let's fight about that.

00:38:04.840 | So that definitely does happen.

00:38:07.120 | I am fond of saying momentum is very hard to reconcile with efficient markets.

00:38:12.400 | I think Ken and Gene would agree.

00:38:14.760 | My DFA using it as a screen, in my view, is very close to just using less of it than we

00:38:20.080 | do.

00:38:21.080 | You're giving it a say over when you trade, but that's it.

00:38:23.920 | You're not giving it any kind of equal status.

00:38:26.480 | So I think it's just a point on the spectrum.

00:38:28.800 | I think their philosophy started out more value-based.

00:38:31.960 | I think they recognize that momentum has been a real phenomenon, and they don't want to

00:38:35.100 | trade against it.

00:38:37.160 | We want it to actively contribute, not to dominate value, but to actively contribute.

00:38:42.480 | And you know, people who agree on a lot, who even like each other's processes and think

00:38:47.080 | each are good, can differ with where on the spectrum you would be.

00:38:51.600 | You know, if you and I both designed a process with similar data and similar empirical results,

00:38:56.000 | we wouldn't necessarily come out with the same weights.

00:38:57.840 | A screen is not technically the same thing, but I think it's pretty close to thinking

00:39:02.400 | of it as them believing in momentum, but less than we do.

00:39:07.720 | And I will say if they ever, you know, say something negative about momentum, I do make

00:39:11.720 | the "a little bit pregnant" joke.

00:39:14.040 | You've already showed you believe in it, you just believe in it less than we do.

00:39:18.440 | So I think we're more similar than we are different on this.

00:39:23.320 | But yes, clearly we would give momentum closer, not necessarily precisely equal.

00:39:29.240 | We don't have to weight these 50/50, but we would give momentum more weight than they

00:39:34.600 | would.

00:39:35.600 | Well, we sort of got off track a little bit because we're actually...

00:39:38.440 | That's my specialty.

00:39:39.440 | No, no, no, no.

00:39:40.440 | This is fine.

00:39:41.440 | This is perfect.

00:39:42.440 | But we haven't even gotten out of college yet.

00:39:45.000 | I mean, you obviously got your PhD, so they accepted your dissertation.

00:39:50.240 | Well, I'm more comfortable with the geek stuff than with the autobiography.

00:39:53.360 | Okay.

00:39:54.360 | But then you went to Goldman Sachs.

00:39:56.360 | I went to Chicago.

00:39:57.720 | I started a dissertation on momentum when I got an offer from friends who were at Goldman

00:40:04.080 | Sachs Asset Management starting up a... taking over.

00:40:08.360 | It was close to a startup, but taking over a fixed income area.

00:40:12.600 | Initially, I went for a summer, which was great.

00:40:15.840 | They then said, "Why don't you come for a year and see if you like this as compared

00:40:19.960 | to being a professor?"

00:40:22.600 | And I still thought I wanted to be a professor at that point, but I did recognize that free

00:40:26.440 | options are good things.

00:40:28.000 | They teach us that in finance.

00:40:30.400 | So I said, "Let me try this."

00:40:32.280 | I ended up being there about a year and a half, was working on my dissertation at night.

00:40:38.040 | That was an odd experience to be a portfolio manager, a trader, and a modeler in fixed

00:40:43.160 | income during the day and go home and work on quant equity at night.

00:40:47.480 | I was getting closer to... very close to being done.

00:40:50.720 | Fam and friends were great about doing my dissertation from afar.

00:40:54.480 | I went back to Chicago.

00:40:55.640 | I proposed it.

00:40:56.640 | I went back and defended it.

00:40:58.320 | They wanted me to go on the academic job market.

00:41:01.000 | I got, again, very lucky.

00:41:03.440 | PIMCO, the West Coast Asset Manager, wanted to start a quant research group.

00:41:10.000 | Quant was getting more popular.

00:41:11.480 | It was still a relatively new thing, believe it or not, back then.

00:41:14.920 | PIMCO ended up offering me that job.

00:41:18.280 | As an aside, the guy who took me out to lunch asked if sushi was okay.

00:41:23.520 | And I had never had sushi and hardly ever had fish at that point in my life.

00:41:27.800 | And being a cowardly 24-year-old, or whatever I was, something 24, 25, I said, "Yeah, sure.

00:41:34.400 | Sushi would be great."

00:41:36.160 | And one point when he wasn't looking, I did spit my food into a napkin.

00:41:40.800 | Gotta come clean about that.

00:41:42.440 | But I went to Goldman and said, "I'm thinking of doing this.

00:41:46.240 | This seems perfect.

00:41:47.240 | I'm trying to decide between academia and being a practitioner, and this seems to be

00:41:52.200 | the best of both worlds."

00:41:54.520 | And to be brutally honest, and I feel bad, it was kind of PIMCO's idea, and we ran with

00:41:58.680 | it.

00:41:59.680 | But Goldman swore to God they were looking to start the same group, and they were thinking

00:42:02.520 | of talking to me.

00:42:03.800 | Again, I made the odd life decision not to live, first not to live in Palo Alto, and

00:42:10.200 | then not to live in Newport Beach.

00:42:12.120 | I have managed to avoid good weather rather consistently in my career.

00:42:16.960 | But Goldman said, "Start this group."

00:42:18.680 | And I said, "Yeah, my family's from here.

00:42:21.040 | I like Goldman.

00:42:22.040 | They were treating me well.

00:42:23.040 | I'm an East Coast guy.

00:42:25.600 | Okay, let's start this."

00:42:28.080 | And I hired three people that gave me a budget for a four-person group.

00:42:32.000 | Two were fellow PhD students at the University of Chicago.

00:42:36.160 | One is still my partner today at AQR.

00:42:41.320 | We ended up both building direct quantitative processes to run client money.

00:42:49.700 | Over the course of the next three years, we ended up running probably just about $7 billion,

00:42:56.000 | about $6 billion in traditional kind of beat-the-benchmark, no leverage, no shorting, just regular stock

00:43:02.880 | picking, though in a quantitative manner, and about $1 billion in long, short, more

00:43:07.920 | hedge fund kind of work.

00:43:10.880 | To be honest, the hedge fund work, being less constrained, we think is a more pure version

00:43:16.440 | of what we do, but it's not that different.

00:43:19.080 | When our factors beat the benchmark, we tend to get positive return in a similar based

00:43:23.960 | hedge fund product.

00:43:25.280 | The hedge fund is kind of the alpha part.

00:43:28.040 | Life went well.

00:43:29.040 | This group, though, had much broader responsibilities than running money.

00:43:33.680 | We were also in charge of pretty much anything quantitative.

00:43:37.240 | We were like door-to-door quants.

00:43:39.880 | Especially before we were running money, we were desperate for someone to give us a task.

00:43:44.160 | So we were doing asset liability analysis, running efficient frontiers for their marketers,

00:43:50.400 | and while there's absolutely nothing wrong with that, it was good stuff, it was really

00:43:54.520 | awkward to be running a group that was running billions of dollars and growing and doing

00:43:58.300 | well and be in charge of the graphics for the marketing people for other people's products.

00:44:04.680 | Sometime, I think it was '96, I had one of my other partners, still to today, a guy named

00:44:11.120 | David Cabellar, started working on me, particularly on the hedge fund side, saying, "You know,

00:44:16.840 | we really could do this on our own.

00:44:18.400 | You guys are at Goldman Sachs, but you buy all outside data.

00:44:22.380 | You don't trade off Goldman Sachs as strategists.

00:44:24.680 | It's all self-contained."

00:44:26.800 | And there'd been various hedge funds, booms and busts, but that was a boom time, and he

00:44:32.080 | thought we could do it.

00:44:33.080 | And I spent the better part of '96 doing my Hamlet imitation, "Should I do this?

00:44:39.800 | Should I not?"

00:44:40.800 | Very decisive.

00:44:41.800 | Mid '96, I went to Goldman and actually said, "I'm thinking about doing this."

00:44:47.280 | It was very straightforward, thinking of going off on my own.

00:44:50.960 | They said, "What would it take to keep you and the whole team, not just me?"

00:44:54.560 | I said, "Well, certainly money is part of it, and I won't pretend it wasn't.

00:45:00.240 | We didn't even propose a deal where we'd make anything like if we ran our own successful

00:45:06.480 | hedge fund.

00:45:07.480 | But we proposed something in the middle, some kind of sharing arrangement."

00:45:11.800 | What was really odd was they certainly didn't jump at our first offer, but they met us a

00:45:16.880 | decent part of the way on the more crass issue just of money.

00:45:21.820 | But they were very insistent that we kept doing the support work.

00:45:25.480 | I ended up saying, "Yes, Goldman Sachs does many things well, but retaining employees

00:45:30.840 | they want to retain is something they are excellent at.

00:45:34.080 | Certainly you are sitting with John Corzine, then president of Goldman Sachs, multiple

00:45:38.840 | times being told how much they want to keep you."

00:45:43.280 | It turns your 20-something-year-old head.

00:45:47.660 | I ended up, along with the rest of the group, deciding to stay.

00:45:51.280 | Rick, do you ever have one of these giant decisions that as soon as you finally make

00:45:57.520 | the decision, after agonizing, you get a wave of relief, partly just because it's over,

00:46:03.920 | but partly it often seems obvious?

00:46:07.400 | What was not obvious when you were agonizing seems obvious after the fact.

00:46:11.040 | You're like, "Well, yeah, I don't know what I was agonizing about."

00:46:15.140 | I never got my wave of relief.

00:46:18.080 | About a month later I was still going, "We should be doing this on our own."

00:46:24.280 | David again, he was the Mephistopheles, the tempter in this story.

00:46:29.720 | About a month into it, he and I were talking and I said, "Is that still an option?"

00:46:37.760 | You don't say that to David.

00:46:39.960 | I gave away the whole ballgame at that point.

00:46:42.960 | We agonized for a few more months, but at the end of the year we did decide to go and

00:46:47.240 | do it on our own.

00:46:48.800 | The first time you try to leave when you're someone they want to keep, you get a full

00:46:55.440 | charm offensive.

00:46:57.480 | The second time you do not get the charm offensive.

00:47:00.500 | You get quite the opposite, largely because when you come back the second time, they know

00:47:06.080 | you're gone.

00:47:07.480 | The partner I reported to was not happy with me.

00:47:13.880 | One of the scariest things in my life was telling him I was resigning.

00:47:18.360 | I remember that.

00:47:19.360 | I was a total child.

00:47:21.400 | I played psych-up music on my Sony cassette Walkman in my office before I went down to

00:47:27.280 | the offices.

00:47:28.840 | I was not calm, but it worked out.

00:47:31.640 | Well, it sure did.

00:47:34.400 | You ended up creating an incredible powerhouse, AQR.

00:47:40.240 | By the end of last year, you had $186 billion in assets under management.

00:47:45.900 | That's a phenomenal number.

00:47:48.280 | Clearly you made the right decision, and of course to be congratulated.

00:47:55.040 | Your father would be proud of you.

00:47:57.800 | I hope so.

00:48:00.560 | I have just a couple more questions from the Bogleheads, and I've asked you some already,

00:48:04.440 | but I just have a few more.

00:48:06.320 | This has to do with things that you've wrote about over the years.

00:48:09.480 | One of the things you wrote about was the 60/40 portfolio, and is it a good solution

00:48:16.080 | going forward?

00:48:17.200 | Just realize that a lot of investors invest along the 60/40.

00:48:22.760 | What's wrong with 60/40?

00:48:24.120 | We hear a lot about this recently.

00:48:25.560 | What do you think?

00:48:26.560 | Well, first of all, pretty much ever since we and others have been saying that 60/40

00:48:31.880 | just chugs along, some wild volatility at times.

00:48:35.800 | Mid-March this year, it didn't seem like it was chugging along, but on net, it's continued

00:48:40.960 | to do well.

00:48:42.480 | My issues with 60/40, there are two, a long-term one and a conditional one on where we are

00:48:48.280 | today.

00:48:50.960 | The long-term one is there's nothing wrong with it.

00:48:53.560 | I think it's great to have that as a core of your portfolio.

00:48:56.720 | There's no magic to the particular weights of 60/40.

00:49:01.360 | Of course, like everything else, we pick kind of a benchmark, and then it gets holy over

00:49:06.120 | time.

00:49:07.120 | I don't think 65/35 or 55/45 is going to be any great sin, but the general idea of being

00:49:15.000 | diversified across stocks and bonds as a core is great.

00:49:19.400 | We do think you could do better, both in a traditional sense, you know, all the classic

00:49:23.640 | things we talk about, being global, at least to some extent, you can still have a home

00:49:28.080 | bias, but 60/40 is often thought of as the domestic U.S. portfolio.

00:49:34.800 | There are other ways to make it better, but if you believe that there is a value premium,

00:49:40.080 | there is a momentum premium, then you can just view that as another investment that's

00:49:44.760 | not very correlated to 60/40.

00:49:47.120 | We do think long-term you can at least somewhat improve the risk-adjusted return or the total

00:49:53.040 | return if you choose to take enough risk of 60/40.

00:49:57.840 | Today, it's a little more serious.

00:50:01.680 | These are very long-term phenomenon.

00:50:04.000 | We always, thank God, we caution, don't use this to time the market, don't use this to

00:50:08.520 | make a one-year forecast, but stocks, you know, pick your favorite measure.

00:50:13.640 | I remember when the Shiller CAPE was a brand-new baby in 1996, but it's become kind of the

00:50:18.760 | lingua franca in talking about how expensive the stock market, just like any valuation

00:50:23.680 | measure, it's not the only one by any means, there are a whole set of them.

00:50:27.380 | The Shiller CAPE, I think last time I looked, just a few days ago, it was about 32, it hit

00:50:32.560 | below 40s at the end, in '99, 2000.

00:50:37.040 | So if you graph it back, you know, 100 years, the only way it looks reasonable is if you

00:50:43.600 | squint and compare it to the tech bubble.

00:50:47.800 | If you compare it to the whole series, it's somewhere in the, again, don't hold me to

00:50:52.120 | the precise number, the 92nd percentile expensive versus history.

00:50:57.200 | And statistically, it's actually hard to say strong things about long-term returns because

00:51:02.200 | you don't get to observe enough, let's call it 10-year or longer periods.

00:51:07.900 | But what we do get to observe seems to fit with intuition.

00:51:12.680 | When you buy stocks more expensive, the average return is lower going forward and vice versa.

00:51:18.680 | So therefore, we'd expect positive returns out of stocks.

00:51:21.440 | We're not people who are forecasting giant mean reversion and a crash, but we do forecast

00:51:26.240 | a lower risk premium for long-term investors from here.

00:51:30.360 | And this is even easier because it fits intuition even more so.

00:51:34.960 | The same for bonds.

00:51:36.560 | When bonds are selling for near zero real yield against economists' forecast of long-term

00:51:41.680 | inflation, not many of us need great convincing that they're probably, probably from here

00:51:48.440 | in the next, call it 10 years, going to make less on their bonds than history in a real

00:51:54.320 | sense against inflation.

00:51:56.640 | If stocks are less than normal and bonds are less than normal, then you could do some very

00:52:02.200 | complicated math, this is stochastic calculus.

00:52:05.440 | You take 60% of your estimate for stock returns and you add it to 40% of your estimate for

00:52:11.400 | bond returns, and you get your estimate for 60/40.

00:52:15.400 | 4% is really what you're looking at, maybe.

00:52:18.840 | Nominal.

00:52:19.840 | We think it's about 1.5% real.

00:52:20.840 | Nominal, yeah.

00:52:21.840 | Yeah, no, you're dead on.

00:52:23.680 | And that, you know, I prefer real because it just adjusts for the environment, but,

00:52:28.960 | you know, that comes out to about 1.5% real right now.

00:52:34.000 | History is more like 5%, meaning if you could buy a diversified portfolio at a low transactions

00:52:41.800 | cost and a low fee, that's a big if, because there's a long part of history where you really

00:52:45.520 | couldn't do that.

00:52:47.380 | But if you could, you got 5% real just for showing up.

00:52:52.400 | We think you get 1.5, 2% real just for showing up today.

00:52:57.640 | And that's not negative.

00:52:59.200 | You can make it negative if you want to forecast big mean reversion, but that's market timing.

00:53:03.800 | That's saying we know these prices are going to drop.

00:53:06.160 | I don't know that.

00:53:07.160 | This could be the new normal.

00:53:09.760 | If the prices drop, it'll be even worse, but I'm negative enough at 1.5, 2%.

00:53:17.120 | If you do have alternatives that can make a portfolio better on average, I think they're

00:53:21.720 | more important when the core portfolio is offering you less.

00:53:25.160 | Let me ask a question about international stocks because I look at the international

00:53:31.240 | market and I look at the industry group weightings of ex-U.S. or international stocks versus

00:53:37.760 | U.S. stocks, and I see very different industry groups.

00:53:41.260 | And I see very-

00:53:42.260 | In the U.S. there's certainly more tech.

00:53:43.800 | And more healthcare.

00:53:45.720 | And now more communications.

00:53:47.220 | So it's a different makeup.

00:53:49.720 | It's like 50 years ago, we did everything in this country.

00:53:52.360 | Now we import all our desks and computers and just about everything I'm looking at right

00:53:56.920 | here in front of me.

00:53:57.920 | But my point is that if you look at the valuations of international stocks, just use the Vanguard

00:54:04.640 | Total International Index Fund.

00:54:08.200 | And I didn't know I was looking at the Vanguard Total International Index Fund.

00:54:12.520 | All I was looking at was the price to earnings ratio, the price to book ratio, return on

00:54:17.480 | equity, growth rate.

00:54:18.480 | I thought I'd be looking at a mid-cap value index.

00:54:21.920 | And then lo and behold, you pull the cover off and it's the international market.

00:54:26.720 | Can't people who are doing, say, a 60/40 portfolio, and to your point that a lot of people are

00:54:31.320 | thinking about just U.S. stocks, can't they diversify or maybe get some of the value premium

00:54:37.720 | that you're talking about as simply as adding, instead of having all U.S., having 40% U.S.

00:54:44.720 | and 20% international?

00:54:46.520 | Would that work?

00:54:47.520 | Absolutely.

00:54:48.520 | I would say you really don't have to choose one or the other.

00:54:55.240 | International versus the U.S., even when international is cheap, is not highly correlated at all

00:55:00.920 | to when value works as we do it within industries for picking individual stocks.

00:55:08.240 | The basic math of portfolios says you should do everything you believe in that's diversifying.

00:55:13.960 | You should just have a high standard for what you believe in.

00:55:15.880 | So you don't end up doing a ridiculous amount.

00:55:19.000 | But I don't think these are necessarily competitive solutions.

00:55:22.360 | I think they're complementary solutions.

00:55:24.640 | You could do half of what you would have done over each and have less risk of disaster if

00:55:29.640 | you're wrong on either one.

00:55:31.560 | But absolutely.

00:55:32.960 | I do think even if you adjust for the industry, a long, long time ago, we wrote a paper in

00:55:38.840 | the mid '90s showing that cheap countries with good momentum can outperform expensive

00:55:46.080 | countries with bad momentum if you just pretend the index is a single stock and add up the

00:55:51.280 | numbers for the underlying components.

00:55:54.560 | But years later, we did notice exactly what you are talking about, that of course you

00:55:59.200 | can get some very different industry components, particularly in some of the smaller countries

00:56:03.560 | where you don't have a very large cross-section.

00:56:05.840 | You go to Belgium and you get a ton of financials.

00:56:09.240 | You go to Australia and you get a lot of resource stocks.

00:56:12.800 | So this gets really geeky, and this is your fault, Rick, that I'm doing this.

00:56:16.960 | You brought it up.

00:56:19.000 | But years ago, we modified what we do in comparing countries.

00:56:23.520 | We still compare them straight out against each other, as you were doing, but we also

00:56:27.200 | do something where we look at a country's industry composition.

00:56:32.020 | We look at the global, including the U.S., total cap-weighted global industry, get its

00:56:37.160 | valuation, forecast based only on its industry composition what we think the valuation ratio

00:56:44.840 | of that country would be if everything was selling at an average for the industry, and

00:56:49.640 | then call it cheap or expensive only if it's lower or higher than that forecasted price.

00:56:56.840 | So it's kind of like a similar thing.

00:56:59.000 | Remember earlier I said we take our value bet without taking a whole lot of industry

00:57:03.660 | exposure?

00:57:04.660 | At least I think I said that earlier.

00:57:05.660 | I say that most of the time.

00:57:06.880 | Yeah, I thought you did.

00:57:07.880 | You said that.

00:57:08.880 | I did.

00:57:10.980 | But we found that makes the country betting a little higher of a risk-adjusted return,

00:57:16.360 | but we still do both.

00:57:17.360 | We give weight to both, and both will say, even adjusting for industries, we think the

00:57:22.720 | U.S. is expensive against the world.

00:57:25.780 | Like everything else, value alone, particularly for big decisions like U.S. versus global,

00:57:31.160 | it could be wrong for a long, long time.

00:57:32.980 | It's just a question of, is it a smart bet?

00:57:36.020 | And we do think it's a smart bet to have some outside the U.S., partly because we always

00:57:41.180 | think that, because we like diversification, but also conditionally, as you're saying,

00:57:46.020 | because it has more of a value tilt than it normally does right now.

00:57:49.100 | Well, since you agreed with me on the last point and made me look very smart, I think

00:57:53.220 | I'm going to end the podcast here.

00:57:56.780 | You're afraid one more question, and I'll disagree, and it'll all collapse.

00:57:59.820 | That's smart.

00:58:00.820 | Thank you.

00:58:01.820 | Remember Steinfeld?

00:58:02.820 | That's George Costanza, has learned that if he ever says something smart in a meeting,

00:58:06.780 | he excuses himself from the meeting immediately, and says thank you, and just claims victory.

00:58:12.580 | That's what I'm going to do.

00:58:13.580 | Cliff, thank you very much for being our guest, and we really appreciate your insights.

00:58:17.620 | It's been a real pleasure having you on the show.

00:58:20.360 | Thank you, Rick.

00:58:21.360 | I enjoyed it very much.

00:58:22.360 | Thank you.

00:58:23.360 | Thank you very much.

00:58:24.360 | This concludes Bogleheads on Investing, podcast number 27.

00:58:27.580 | I'm your host, Rick Ferry.

00:58:29.620 | Join us each month to hear a new special guest.

00:58:32.940 | In the meantime, visit bogleheads.org and the Bogleheads Wiki.

00:58:38.020 | Participate in the forum and help others find the forum.

00:58:41.740 | Thanks for listening.

00:58:42.500 | [music]

Bogleheads® on Investing Podcast 027 – Cliff Asness, host Rick Ferri (audio only)

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