Episode #68: Corey Hoffstein, “Risk Cannot Be Destroyed, Only Transformed”

Episode #68: “Risk Cannot Be Destroyed, Only Transformed”



Guest: Corey Hoffstein. Corey is the founder and CIO of Newfound Research. He’s a frequent speaker on industry panels and contributes to ETF.com, ETF Trends, and Forbes.com’s Great Speculations blog.  He was named a 2014 ETF All Star by ETF.com. Corey holds a Master of Science in Computational Finance from Carnegie Mellon University and a Bachelor of Science in Computer Science, cum laude, from Cornell University.

Date Recorded: 8/14/17

Run-Time: 1:12:44


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Summary: In Episode 68, we welcome Meb’s friend and Newfound Research founder, Cory Hoffstein (or as Meb refers to him, a “fellow nerd”).

Per usual, we start with Corey’s background, but then Meb jumps in by asking Corey to describe his general, 10K foot investing framework.

Corey tells us that a specific product and/or style doesn’t necessarily define him or Newfound. Rather, he believes in a consistent, well-researched process that takes into account the behavioral challenges that accompany any given investment strategy. This is because the journey is often just as important as the destination.

Meb asks where Corey starts when creating a portfolio. Corey tells us it’s about the balance of risk. This is because “risk cannot be destroyed, only transformed.” Therefore, when building a portfolio, there’s no single holy grail. You need to understand the goals and fears of your client, then figure out how to balance various strategies in order to find a robust, flexible portfolio that handles risk appropriately.

This dovetails into one of Newfound’s white papers, “Portfolios in Wonderland,” which tackles today’s investing climate. Corey tells us that we’re in a unique environment, whether focusing on equity valuations or interest rates. It used to be that stocks and bonds zigged when the other zagged. But in the 1980s, both became cheap. Today, we have the opposite: high equity values and low yields on fixed income.

This leads to a great discussion on bonds, including Corey’s rule of thumb for estimating future bond returns, and his research into the source of bond returns – how much was due to the coupon, versus declining rates and roll yield.

The guys agree that with U.S. equities richly valued, and bond yields so low, future returns of the classic 60/40 portfolio don’t look too appetizing. So, what’s the solution?

Corey likes the proliferation of asset classes that used to be found almost exclusively in hedge funds. Now, we can use them to diversify our portfolios and reach a solid rate of return. The conversation bounces around a bit here – how 8%-10% returns aren’t likely going forward unless you’re invested exclusively in emerging markets… how if you let a portfolio optimizer do its thing, you’d have almost no U.S. exposure in either equities or bonds… and how, behaviorally, most people couldn’t have 0% allocated to the S&P, so finding a balance between the best portfolio and the most realistic portfolio is needed.

Meb asks how much drag there is on returns when moving away from the mathematically “best” portfolio to a portfolio which investors can actually stomach. Corey tell us investors are probably giving up 50-100 basis points of return which, over the long run, is a meaningful difference.

It’s not long before Meb asks about new research Corey is working on. Corey tells us he’s looking at much complexity an investor should bring into a portfolio. Some small details can make a huge difference. This leads to a great discussion about “timing luck” when it comes to trend following. More specifically, when you choose to rebalance can make a huge impact on your returns. If you’re a trend follower, make sure to catch this part.

A bit later, the guys discuss another white paper from Corey, “Outperforming by Underperforming.” This leads into a conversation about the challenges of looking different with your strategy, as well as the right time-frame needed to evaluate any strategy. The conversation includes a great quiz Corey often asks his audiences regarding Buffett and how badly he has lagged the S&P at times. Chances are you’ll be surprised to hear what Corey says.

There’s way more in this episode, including answers to “Should we be holding more cash?” “Is dividend investing dangerous” and “How do you factor in various global interest rates when looking at a bond allocation?” There’s also how Corey constructs multi-asset portfolios… how value works across asset classes… the biggest concerns Corey is hearing from clients today… an idea Meb has for a “weird ETF”… and of course, Corey’s most memorable trade.

What is it? Find out in Episode 68.

Links from the Episode:


Transcript of Episode 68:

Meb: Welcome to “The Meb Faber Show” where the focus is on helping you grow and preserve your wealth. Join us as we discuss the craft of investing and uncover new and profitable ideas, all to help you grow wealthier and wiser. Better investing starts here.

Disclaimer: Meb Faber is the Co-founder and Chief Investment Officer at Cambria Investment Management. Due to industry regulations he will not discuss any of Cambria’s funds on this podcast. All opinions expressed by podcast participants are solely their own opinions and do not reflect the opinion of Cambria Investment Management or its affiliates. For more information visit cambriainvestments.com

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To learn more visit roofstock.com/meb. Again, that’s roofstock.com/meb. And now on to the show.

Meb: Happy summertime podcast listeners, we’re excited to have a rare in-person podcast guest, Corey Hoffstein, welcome on the show.

Corey: Thanks, for having me here Meb.

Meb: So we have a fellow nerd, I can say that because I was an engineer once upon…

Corey: Absolutely.

Meb: …a time. Corey did computer science?

Corey: Yes, computer science.

Meb: And computational finance?

Corey: Yap, that was the grad program.

Meb: That is double nerd. All right well, we’ll get on a second, but he runs Newfound Research based out of… you guys, kind of bi-coastal now, Boston mainly.

Corey: Boston mainly, trying to be out here on the West Coast a little more.

Meb: Not only that there’s also a Faber on the staff.

Corey: There is a Faber on the staff.

Meb: Are we related? Has he done a 23andMe ? Are we like second cousins?

Corey: We should check, because you’re originally from Colorado right? And he’s in the Denver area.

Meb: Oh no kidding. Well that’s probably a relative for sure. Is he good looking?

Corey: He is a good looking guy.

Meb: Well, good. Brilliant, and good looking that’s a good com-… all right, so for those who aren’t familiar with Corey, he is a prolific writer, he’s got a chapter in our new curated book, “The Best Investment Writing.” He does… is it a weekly column?

Corey: It is. It is weekly.

Meb: When does it come out, Sundays?

Corey: Monday morning.

Meb: Monday mornings, that is…really, to give you a compliment, one of the best reads of the week each week. But, I mean, it has everything from pretty generic-sounding titles like “Should We be Holding More Cash?” To the super nerds out there, “Combining Tactical Views with Black-Litterman and Entropy Pooling” I don’t even know what that means.

But why don’t we get started by…I mean, despite your somewhat young age you’re now just celebrating your third decade. Congratulations.

Corey: Thank you.

Meb: I saw a great post the other day that kinda listed some of your bucket list items from your 20s, and hopefully, we can talk a little bit more about what your bucket list items for your 30’s are and 40’s, which I just joined, regrettably.

Corey: Congratulations.

Meb: Thank you very little. But let’s talk a little bit about maybe, the transition to starting your own company at the depths of the bear market, and talk a little bit about Newfound, and then we’ll get into your investing framework and go from there.

Corey: Yeah, absolutely, so Newfound did get its start August, 2008. So we’re actually about to hit our nine-year birthday on Newfound, which as you mentioned was starting towards the depths of the Great Recession there. And I would like to pretend that we started with some grand vision, but we really just tripped and fell into this. I had been working on some model portfolios designed around ETF-sector rotation and the ability to go to cash. And I’m happy to go into how I even stumbled into that.

But found a portfolio manager in the Boston area, who was interested in licensing some data from me. And so at that time I was a poor college student. I was planning on going off to graduate school and said, “Absolutely.” So I created this company, Newfound Research, named it after a lake that I grew up on.

Meb: Where is that?

Corey: That’s in New Hampshire.

Meb: Oh, no kidding. I lived in New Hampshire briefly, not sure where. I was, like, two.

Corey: Not sure?

Meb: I was like two but I’m told I did a stint there. Okay keep going.

Corey: So again just named it after a lake I grew up on, no long-term plan on growing this thing. Was gonna go to graduate school, figured I’d end up at one of the big banks doing derivatives modeling or something like that. And found, after 2008, obviously there was a large appetite for tactical portfolios, risk management really became forefront for people.

Meb: Funny how a 50% decline will do that.

Corey: Absolutely, right? Everyone’s focus on it. Probably at the time they should have been piling in to risk-on assets instead they’re focusing on risk off. But regardless, we saw a large appetite, and so Newfound really blossomed from there. We spent the first several years not actually offering portfolios ourselves, but more sub-advisory-style roles. We would work with large RIA groups or institutions to develop custom tactical overlays, develop custom model portfolios. And then towards the end of 2013, ultimately ended up launching our own suite of products.

And where we really sit is what I would call a quantitative tactical asset allocation space. So we focus mostly on portfolio construction, tactical allocation, but everything we do is systematic. The conventional investment styles, momentum value, carry defensive trend. Sort of what AQR has made so popular, and that’s really where we focus most of our research endeavors.

Meb: Music to my ears. By the way, congrats. You won ETF Strategist of the Year, last year.

Corey: Thank you.

Meb: All right, so you got funds, you got separate accounts, you got some advisory business, you know, some folks [inaudible 00:06:40] individuals, institutions everything in between. What’s, kinda like, the general, 10,000 foot framework? And then we’ll kinda start talking about, you know, all sorts of different ideas and topics, but what’s ya’lls general…I mean when you say global tactical, I know you just did a recent paper on this, like “The Basics of GTA” or something like that?

Corey: Yeah.

Meb: Do I have that right?

Corey: Yeah, it was sort of “A Gentle Guide…”

Meb: “A Gentle Guide…” There we go, found it. Okay.

Corey: You know, I think a lot of firms in asset management define themselves as the product they offer. Right? So the, “We’re [SP], the small cap value guys,” or “We’re the dividend growth people.” I think what makes Newfound a little unique is we don’t tend to think of a specific product that we offer, a specific style defining our philosophy. We say that we like to invest at the intersection of quantitative and behavioral finance.

So our big philosophies are, a consistent well researched process. That’s the quantitative side. But the behavioral side is a recognition that even if you have the most optimal portfolio that you can design, one of the most important things is whether investors have the capacity and ability to stick with it over time.

Because if they can’t stick with it, if it’s gonna suffer that 50%, 70% drawdown before it returns 500%, most people are gonna end up bailing out. And so for us it’s that recognition of the journey being just as important as the destination, for achieving strong, long-term performance.

Meb: And then the challenge with this is, we talk so much about it, you can try to educate investors on that topic, but so many have to live through it till they, kinda, do it again. It’s like telling a child, you know, “Don’t touch the hot stove,” and eventually they touch it and they say, “Okay well, that was stupid, I’ll never do that again.” But, I mean, it’s kind of the same way with behavioral, and so quantitative behavioral, do you guys call it QB or am I just making that up?

Corey: Well, so we have a suite of strategic portfolios that we offer called QB, cube. Again, a blend of the quantitative and behavioral. The idea being that we are embedding a lot of the quantitative techniques, but explicitly taking into account behavioral biases that investors have, for a preference for smoothness of the journey, fewer drawdowns, more shallow drawdowns. An acknowledgement that most investors need some sort of home-market bias, which you’ve written about numerous times, acknowledging that while that might be objectively sub optimal, if you don’t embed those concepts, investors may not be able to stick with the portfolio.

Meb: And so what’s, kinda, your starting point? Is it, you know, when you’re thinking about all this, is your starting point when you’re talking to an advisor, an investor, is it you’re looking at their current portfolio and saying, “Hey look, here’s how you can overlay or add all of these concepts and ideas”? Or is it, you know, kind of a blank slate? You say, “No, no, no, here’s how you start from, kinda, the bottom up”?

So when you’re saying GTA or tactical asset allocation, to a lot of people that means a lot of different things. So it’s a for one shop if you look at, like, a lot of the banks they’ll say, “Okay our tactical is, we move from 60/40, then when we’re really bullish, we’ll be 70/30, when we’re really bearish we’ll be 50/50.”

So it doesn’t really move the needle at all, and some are totally different, where tackle means something completely opposite. What’s, kinda like, your general thoughts on that? You know, how do you guys approach tactical in general? Like what does that mean to you?

Corey: Yes, so I’m gonna have a completely cop out answer here for you. To me again it really depends on who we’re working with. There are a variety of needs when it comes to tactical. Our view is there is no holy grail. I like to say that, in this industry hubris tends to sell but humility tends to survive. People will say that they have the best investment product, that they have the best way of designing a portfolio, when in reality almost every investment style goes in or out of favor, at some point. And for us it’s all about balancing the risks.

So we have some portfolios that are highly tactical, we’ll[SP] go 100% invested, to 100% cash. And when we talk about those portfolios with investors, we would advocate them as a use of what we would call a completion portfolio.

Meb: What does that mean?

Corey: It fits as a niche within a larger, strategic allocation. It’s not…

Meb: Was that what some people would call, like, a core satellite?

Corey: Absolutely. Absolutely, so it would be more of a satellite. And then we have other products that are designed, in mind of being 100% of a client solution. So it’s more of a global balanced, balancing-risks type of portfolio that will likely be far less tactical. Maybe more around the fringes because we find again, behaviorally, that’s what people can stick with.

Meb: Interesting. So let’s say a $1 billion RIA came up to you, and said, “Corey I lived through 2000, 2008, I’m not really comfortable with my allocation. I’m gonna give you a blank slate. Here’s $1 billion dollars across client assets.” What would, kinda, be your starting point? Do you have one? Is that a tough question?

Corey: That is a very tough question.

Meb: I’m a $10 billion money manager, incentivize you. But, like, kinda, talk to me from the defaults or the two sides of your portfolios. You know, whether it’s the completion, whatever solution it may be. Is there, kinda, a default at all? I mean, is there something that like…you know, or maybe even go with some of the underlying thematics. You know, so whether is it value or trend following. Like, what goes into this stone soup sort of idea? What’s part of this?

Corey: So we’ve dealt actually, we’ve dealt with those situations where we’ve had large RIA’s come to us and asked to help rebuild their portfolios. And often, again, it’s very customized because, they’re often coming to us with preexisting philosophy. And so we’re trying to obviously merge with their preexisting philosophy, with some of our philosophies.

Taking a step back there is one concept to me, that is very foundational to Newfound, and it actually came from my time in graduate school. So you mentioned my degree in computational finance. I got that from Carnegie Mellon, and that is a degree that’s very focused on the construction of derivative contracts. So it’s all about pricing, and designing, and creation of derivatives.

And one of the things that I learned, that really changed my view on the industry, going through that program was that entire program was really less about return. Less about generating return, and much more about risk.

It was about the identification, location, extraction, pricing, and trading of risk. That’s really what, to me, a derivative contract really embodies. And I took that viewpoint and really that’s how I see the entire financial industry now.

So for example, to totally change the subject for a moment, a company raising capital, selling equity for example, is the founder trying to reduce the risk of going out of business, in the short term, and they’re willing to identify, extract, and sell that risk to someone else. And the investor who’s buying that equity, is taking on that risk, injecting some cash, but they’re getting the upside.

So this idea for me of everything being about risk, transformed into this catch phrase that we use all the time, which is, “Risk Cannot be Destroyed, Only Transformed.” And that to me is the very foundational underpinning of all the portfolios we build.

So to bring it back to your original question, when we start designing portfolios, for us it’s 100% about the balance of risk. The balance of a strategic approach and a tactical approach. The balance of value and momentum. In everything we do we are trying to acknowledge that there is no holy grail investment strategy. And how can we balance all these different types of approaches that may do well in different environments to create a more resilient portfolio?

Meb: So very Zen. There actually is the holy grail, but I won’t tell you where it is till you turn 40, so you’ve gotta go look for another decade.

Corey: All right, I’ll keep searching.

Meb: Good, well look, I have about 15 different abstracts in front of me, so we may dance around a little bit. But maybe a useful framework would be to talk a little bit about the way the world looks today, and then, kinda, go through potential solutions, or what it may look like.

You did a great PDF that we’ll link to in the show notes, if we’re allowed to. Maybe we’ll l have to put a link to your site, to download it because I think it’s for professionals only. But it’s called “Portfolios in Wonderland.” Which, when I first read the title I wasn’t sure if it was a reference to John Mayer or “Alice in Wonderland,” you know that my body is a wonderland?

Corey: Yeah, that would be a little harder to work into the presentation.

Meb: I don’t know. You may get a totally different demographic downloading this paper. Anyway, you start out by talking about the way the world looks today, and we’ve mentioned this a lot on the podcast. Where a lot of other quant shops and people… We did a tweet, I remember, where we said something along the lines of the historic real returns of equities in the U.S. since 1900 were like 6.7%, ballpark. And foreign, globally it was lower, it was maybe down around five something.

And then we looked at like five of the most famous investors, Jack Bogle, there was AQR, Professor Shiller, GMO, so [SP] Grantham and Hussman. All these people not a single one was close to the expected returns, historically. So they all forecasted lower, which I agree with. Part of me, of course, wants to be contrary and say, “Well maybe there’s something we’re really missing.”

You know, because that totally changes the framework in my mind where if the opportunity set isn’t always the same, that the famous…you know, is it a fat pitch? Is it something you should just wait on? And so you have this, like, 50-page document we can, kinda, go through. But why don’t you tell us a little bit about how you’re thinking about this concept, portfolios in Wonderland? And I’ll just let you riff from there, and then we can go down whatever dark alley we want.

Corey: Yes, so you sort of teed it up nicely. This idea that where we are today from whether it’s equity valuations or interest rates it’s a very unique environment. And, you know, one of the things that I think is important is…and I’m sure you see these every year Meb. I mean, firms publish these massive, glossy, market outlooks. Right? And they’re 70 pages long, and they’re filled with impressive data sets.

And the reality is it’s more, in my opinion, macro tourism than anything, than really practical advice for investors. But for the, you know, 99% of investors in the U.S., all they really care about is, how are U.S. equities likely to perform? And how is U.S. fixed income likely to perform?

And the reality is, in the short term it’s pretty random, you know. Predicting in the next year is very, very difficult. I’ve never seen a good model that could consistently do it. But when you start looking out 7 to 10 years, there are these guideposts. And valuation is one of the great guideposts that you can look at and say, “When equities have a high valuation, a high CAPE, or something like that, it tends to lead to lower expected returns.” Or, on the fixed-income side, when you look at there being low nominal or real interest rates, it tends to be, therefore, low future returns on fixed income.

Now historically, if you look at equity valuations, and fixed income valuations over the last, call it, 100, 120 years, typically one would zig and the other would zag. And so if you looked at a portfolio the valuation of, call it, a 60/40 or a 50/50, it was always pretty fairly valued. And then something changed in the ’80s. Both fixed income and equities got very, very cheap, and there is probably no better time to go passive.

So when I look at the history of Vanguard I say, “Wow, what a time to launch passive equity funds and passive fixed income because, really, just from a pure investment standpoint, you couldn’t do much better than just buying cheap beta.

But today you have the exact opposite, which is high equity valuations. We’re touching north of 30, and the projected return is much lower than the historical average, that most people have come to expect with U.S. equities over the long run. And you look at U.S. fixed income it’s even easier to project because, the yield you buy today is more or less the return you’re gonna get, over the next 7 to 10 years. And there’s some very simple rules of thumb that we can talk about there, and sort of predicting bond returns…

Meb: Go ahead. No, let’s pause. Like, what’s a good rule of thumb?

Corey: Yeah, so one of my favorites is this rule called “two times duration minus one,” and it’s a little complicated in name, but it’s a very simple idea. Which is, you take the current yield to maturity of a bond portfolio and you take the current duration, and you multiply that duration by 2, subtract 1. So let’s use a specific example. Let’s say the Barclays Aggregate today, let’s call it a duration of around 5.5. Double that, we’re at 11. Subtract 1, we’re at 10.

So over the next 10 years your expected return is the current yield to maturity. So if the current yield to maturity is around two and a half, two and three-quarters, well that’s what you can expect your return from holding the Barclays aggregate to be, over the next 10 years.

Meb: It’s not great.

Corey: It’s not great, and in real terms it’s likely even worse. Right? And so for most investors who maybe look at the last 30 or 40 years where they got, on average, a 6% nominal return in the Barclays Aggregate. A 60/40 was much more attractive than it is today, where you’ve got 40% of your assets in an asset class that, after inflation, might return next to nothing.

Meb: And you had a whole piece on this, on bonds. Where you guys said, did declining rates…because a lot of people would say, you know, you talk about risk parity, you talk about bonds in general, I’d say “Well, you had this 30-year bull market where the bonds just declined from double-digit yields in the ’80s all the way down to super-low digits now. And sure enough we’re gonna have super, runaway inflation, and bond yields are gonna from 2% to 5%, 10%. But you said, you had a piece, said, “Did Declining Rates Actually Matter Over the Last 35 Years?” And, kinda, what was the conclusion there?

Corey: Yes, so like you, you do this a lot. Is, there’s a lot of conventional wisdom on Wall Street that isn’t necessarily backed up empirically. And I actually started this piece by shooting out a tweet, I’m not as prolific a Tweeter as you are, Meb, but…

Meb: Mine is mostly a bot.

Corey: It’s good to know, that’s why I can’t keep up.

Meb: It’s the Jeff Remsburg bot, he just tweets away.

Corey: So what I wanted to do is, most of my following tends to be professional investors, I simply wanted to ask, “We hear this idea that declining rates was a really large contributor to returns over the last 30 years for fixed income. How much did it really contribute?” And so I asked out on Twitter, and I probably got about 100 responses or so, and said, “Did you think it made up 25% of returns? 50%? 75%?” And over 50% of people who responded, said it made up more than 50% of returns.

So then all I simply did was decompose returns, over the last 30 years, for the Barclays Aggregate saying, “Well how much actually came from the yield, from the coupon you earned from holding the bond? Versus, how much benefit did you actually get from declining rates, and rolling that portfolio, getting that roll yield? And what I found was, it was really the vast, vast, vast majority of the return. Whether you’re looking at Treasuries, or a broad portfolio like the Barclays aggregate, was due simply to the fact that there were high on-average yields. That your average coupon was about 6%, and that declining rates really only added a couple, 50, 60, 70 basis points per year. Nothing to sneeze at for sure, but it wasn’t the biggest driver.

And the flip side of that is for people who are very worried about rising rates, if your outlook, if your horizon is 10, 20 years, you really shouldn’t be that concerned about rising rates. What you should be concerned about is that the average yield that we’re starting with is so low, that that’s gonna be the big drag on return. So there’s just not enough yield to generate a meaningful total return.

Meb: Makes sense, and so… By the way I loved your phrase macro tourists. No one gets more in trouble than the equity guys venturing into macro, and if you have an equity portfolio manager who, all of a sudden is talking about gold, and macro, and the dollar. It’s like the biggest sell signal ever. Our friend, the stalwart at Bloomberg, Weisenthal, used to have a great phrase called macro bullshitters so we registered the domain. I said I was gonna give it to Joe and let him run with it, but…

Corey: Well it’s…

Meb: I said, “I want you to do a Bloomberg segment called macro bullshitters but…”

Corey: It’s hard because it’s attractive. Right? I mean it’s hard to not play in that macro space because it’s fun to think about all the things that can go right or wrong. But I think when you take a step back and say, well you read these papers, and they line up everything nicely like dominoes. Right? Or they say, this is what’s gonna happen in China, and that’s what’s gonna happen with oil, and it’s all nicely cascading into each other. And the reality is it’s more like chaos theory than dominoes.

Meb: That’s the secret to becoming a financial pundit. Is, as soon as you lead with QE and the Fed, and you can throw gold, and crypto currencies in there, all that good stuff. That’s what gets the good use.

All right, we’ll keep going. All right, so U.S. and equities and bonds, you show it’s like bottom decile for the 60/40 portfolio. It’s maybe even bottom 5%. So kind of [inaudible 00:24:41] returns going forward expected, what’s, kinda, the solution? What’s the next steps, for this sort of portfolio? Is there anything you do? Just put your head in the sand? The ostrich portfolio?

Corey: So that’s certainly not great news for financial planners who are, historically, reliant on U.S. stocks and bonds. I look at the last 10 years, 15, 20 years even, and say, “There has been a really positive trend though.” Which is, to me, the proliferation of asset classes that used to simply be in the hedge-fund space coming downstream, and coming downstream in a very cost-efficient manner. That advisors and investors can now use to build portfolios that are more well diversified and, potentially, can still hit a reasonable expected rate of return.

I don’t think the 8%, 9%, 10% return is realistic today unless you’re going 100% emerging markets, but I do think that if you’re willing to diversify away from traditional U.S. asset classes, that there are, a lot of places, a strong return.

Meb: Give us some examples. By what, do you mean?

Corey: So one of the things we pretty frequently look at is, we look at the published capital-market assumptions, and by that I mean expected returns and volatilities of different asset classes. From firms like JP Morgan, Research Affiliates, GMO, you named several. And we actually go through the process of building an optimized portfolio. Using that mean-variance framework, that modern portfolio theory framework, to actually say, “Well if we want a moderately-risky portfolio, what asset allocation would generate the maximum return?”

And what we see is that U.S. equities would almost be non-existent. That if you just let an optimizer do its thing, not knowing which asset class is which. Just simply focusing on return and risk, and how things balance each other out. You would almost have no equity exposure in the U.S. And you would almost have no traditional fixed-income exposure.

Instead, you’d end up with a lot of emerging-market exposure, you’d end up with a lot of alternatives exposure. Things like managed futures, and you’d end up with a lot of exposure in asset classes that we would probably put in, like, a credit category. High yield bonds, bank loans, emerging-market debt both local currency, and U.S. dollar denominated, things like REITs. All of which are available today, in ETFs that cost less than 50 basis points. I don’t think you could get that 15, 20 years ago. And they would make up a very large part, call it, 30% to 50% of the portfolio.

Now, again going back to okay that’s our quantitative direction saying these are the asset classes we need to focus on. Behaviorally, I recognize that very few investors in the U.S. could probably tolerate a portfolio that has 0% allocated to the S&P 500. But finding a balance to start incorporating some of these asset classes, we think, is important not only for their diversification benefits, but from their higher, if not equal, expected return to traditional equities.

Meb: You know, it’s funny. I always think about, kinda, the mean variance and think about ideas where, you know, a lot of these firms will publish these forecasts, and we always talk about being asset-class agnostic. You know, and trying not to get wedded to “I’m a gold bug,” or, “I’m a dividend guy,” or whatever it may be.

It’s such an interesting thought experiment to go through something like this, and if you say, “You know what? I’m just gonna blind all the asset classes and see what it kicks out.” Because what it kicks out is often something no one will invest in.

So like you mentioned, like, even if you use their own numbers it’s highly unlikely that all the firms you just mentioned are gonna totally exclude U.S. stocks and bonds, despite their own arithmetic because, there’s career risk there. And if U.S. stocks and bonds rip for another year or two, then they have, you know, hundreds of billions of assets coming out, then that was probably a really dumb business decision. Despite the fact their own math proves that they should be different.

So it’s kind of an interesting concept to… It’s almost like you could have a portfolio that’s like a lock box, but I’m not gonna tell you what’s in it till a year later, and then we’re gonna rebalance. And it’s we’re just gonna use your own math. But it’s hard for people. Right?

People often look at a lot of the stuff we do and they say, “Man, that’s unconventional.” And, I think when we’re at the Ritholtz Evidence-Based East Conference, I said along the same lines, I said, “Look if you’re truly evidence based,” and I was talking about managed futures, I said, “the allocator would spit out 5%, 10%, 50% of this asset class, or strategy.” Anyway. Okay, so you come up with a somewhat atypical allocation, but the behavioral part you’re talking about, meaning there’s still an anchor to that traditional world.

Corey: Yeah, I think that’s the next step, and you mentioned managed futures which I think is a great example. Yeah, the optimizer typically spits out for us, that you should have 5%, 10%, 15%. One of the things that the optimizer has been spitting out lately, is the idea of barbelling risk.

So I mentioned there’s very little allocation to traditional fixed income, in this sort of optimal portfolio, but that allocation that does exist, tends to be very long dated U.S. treasuries.

So you say to an investor, “I’ve got this optimal portfolio for you. It’s 10%, 15% managed futures, it’s 10%, 15%, 20-plus-year U.S. treasuries, zero U.S. equities, emerging market debt, emerging market equities.” And when you go through piece by piece it sounds absolutely insane. Right? No one would hold it.

But, when you look at it from the way the optimizer is seeing it, you’re getting a portfolio where risks are really being balanced. That, yeah, maybe the outlook for traditional 20-year fixed income isn’t great, but when you look at the assumptions of how it’s going to diversify risk, if things go bad on the equity side, well it makes a lot of sense.

That said, again going back to that idea that the investment journey is very important, investors need to be able to stick with the portfolio, first and foremost. What we do is then have a second step. And say, “This might be the optimal portfolio, objectively, but how do we actually try to build back in considerations for traditional benchmarks?”

We are willing to then say, okay, the optimizer may want us to have a 0% allocation to U.S. equities. That’s not realistic. Let’s build back in a meaningful-enough allocation to U.S. equities, and make sure that the optimizer takes that into account. Maybe have some sort of minimum threshold that has to be there, so that this portfolio doesn’t look so weird. That the second it does something strange the investor completely abandons it.

Meb: So the next question would be, you know, if you’re saying from whether it’s sharp or return versus risk, sort of, perspective, the best portfolio for investors may not be the one that actually has the algorithmic best returns.

I wonder how much, sort of like, behavioral drag there may be on that portfolio, you know, just to keep them from doing dumb things. So, like, you said the ideal portfolio right now is emerging-market stocks, long-term treasuries. Yada, yada. I wonder if you’ve ever looked at, modeled, the kinda, buffer of how much they’re giving up, just by having a more strategic, kinda, foundation?

Corey: Yes, so we have…it’s a little bit of an assumption you have to make to say, “Okay, how much do I have to buffer in?” Really, if we were a little more quantitative about it you’d probably say, “Okay what does the market really bear here? How different and weird can we get before people start abandoning it?”

But what we’ve found is, in an environment like you have today, you are probably giving up between 50 to 100 basis points of return, for us to still build a meaningful amount of traditional U.S. equities, large cap equities, in there. And a meaningful amount of traditional U.S., sort of Barclays Aggregate, fixed income.

And it doesn’t sound like a lot, you know, 50 to 100 basis points, but over the long run that is a really meaningful difference that can compound. So we think that there is, again, a big behavioral… I don’t wanna call it “drag,” but a big behavioral component, as to what makes a portfolio actually achievable, for an investor because a drag implies they’re giving something up. In my opinion that optimal portfolio is never actually achievable, for most investors, anyway.

Meb: That makes total sense, although I think maybe we should start an ETF called “The Weird ETF” and we’ll let you manage it, where it just has the totally unconstrained portfolio.

Corey: It sounds great.

Meb: We have to think of tickers[SP]. Listeners, send us tickers for “The Weird ETF.” Winner gets a free Idea Farm subscription. All right, so you do all this portfolio when you think of sort of the, a lot of these asset classes are long only, sort of, stuff, and you mentioned trend following. But what sort of actual…as we start to think of active, whether it’s rules based or tactical, sort of, tilts or implementations, what sorta categories do you look at other than, say, managed futures and trend? What else is out there? Value perhaps? What do you guys look at?

Meb: So there’s a lot of things you can look at, when we’re building portfolios like these we typically start from an asset-allocation perspective. And in the asset allocation that’s when we start to bring in things like value.

So, you can do these capital market assumptions I mentioned, with no concept of value. You can simply, for example, with U.S. equities you would look at your expected long-term growth rate, and probably the yield. On the other hand you could say, “Let me look at the long-term growth rate yield and some expected mean reversion, because CAPE is so high.”

We do the latter. So value gets built right in, in this sense, to the optimization and that’s part of what makes it look so weird today. That these valuations are so meaningfully different than they have historically been.

Once you get that asset allocation all set, then it comes down to actually implementation. And that’s where I think things like, when you look at equities how are you actually implementing that small cap exposure? Is it just pure small cap beta or do you look at some of the empirical evidence that suggests small cap is much better with a quality value tilt?

Do you look at U.S. large cap or international and say, “I think we should do multi-factor value momentum size quality tilt.” What have you. And so we sort of look at that across the board. There are some places where there simply is not product to implement some of these tilts, I think fixed income…

Meb: Like what? Let’s hear it?

Corey: I think fixed income is an area that’s still very nascent with a lot of these tilts. And I think it’s just harder from a research perspective to try to identify what’s effective in those areas. But you certainly see a massive proliferation of factor based on the equity side. And so you can get very low-cost factor-type portfolios, value, momentum, quality. That sort of stuff. On the fixed-income side you tend to still see a lot of more active management.

And then on the alternative side you are seeing some interesting product come downstream. I think AQR has had a lot to do with that certainly. But there’s still limitations on shorting leverage that really, sort of, limit the true diversification that some of the stuff can add to the portfolio.

Meb: We have a list in my office, a white board of, kind of, ideas we love, that the problem with a lot of ’em aren’t really that appropriate for a mutual fund or ETF structure, like catastrophe bonds. What a cool asset class that correlates to really nothing. But you can’t really put into a public fund that easy. It’s just odd, a lot of the inverse funds are still really expensive the short funds, and I don’t know why that’s the case, but opportunity for someone, not us.

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Meb: So what’s kinda your process? I imagine it’s like a constant evolution. Right? You guys are always doing research, looking at peer-reviewed stuff, adding it as it comes along. What’s that process like? Is it a little just, ongoing? You know, I know we struggle with it a lot here on just keeping up with all the new funds coming out, and all the new strategies etc., etc. I mean what’s y’alls approach?

Corey: Yeah, that’s a great question. Well, we’re skeptical. Let me just start there. Everything new that comes out we tend to be just very highly skeptical, as people. My fiancé would probably say I am a complete downer. But the reality is, in our view, there really isn’t a whole lot that we know, in the world of finance, for certain.

And what I mean by that is, in physics there are certain laws that may not be perfectly true but they are good enough. I can put my hand on the table and push as hard as I want and my hand’s probably not gonna phase through the table. Right?

Meb: This is a pretty cheap table actually, there’s a good chance you’d go through straight through this thing.

Corey: But in finance and in markets in particular there’s no holy rules. There’s sort of supply and demand and that’s about it. And everything else we have to look back at history, and try to determine whether past performance actually is indicative of future results, Right?

So every disclosure in the industry says past performance is not indicative, and yet everything we know about active management assumes just the opposite. Value, momentum, size, these are all based on things that have historically worked, and we’re gonna assume actually do work, going forward.

And I think there is evidence you can look at, but the thing about statistics is that it can never prove a positive. And so we can never prove, for certain, momentum works. We can never prove, for certain, value works, so there’s a certain amount of faith to it. So a lot of our research that we do is just ongoing exploration of, do we actually think there is evidence to support what we’re using? Does this apply in other areas of the market? You know, we hear U.S. sector rotation with momentum is such a great strategy. Well how many ways can we slice and dice this?

One of the areas that we focus a lot on is how much complexity should you really bring to building a portfolio? You can generically talk about something like value or momentum, but the way you actually implement some of the small details can make a huge, meaningful difference for the investor experience.

Meb: Like what?

Corey: Well, one of the ones…and I’ve talked with you about this Meb, but one of the small details that I think is really important is, in the trend-following space. So just as a very simple example, we’ll go back to your famous paper. That 10-month moving average. Where you will invest in an asset class at the end of every month. Right? If it’s above its 10-month moving average. And then if it’s below you’ll sell out.

That strategy has had, empirically, an enormous amount of success in improving both, sorta, the risk adjusted and total return for investors. But, in my opinion, it introduces a lot of what I like to call “timing lock” into the equation.

Meb: I like to call it “The 1987 example.” Right?

Corey: Exactly. Exactly. It doesn’t always work for protecting against your 1987s, but also it’s highly influenced by what’s going on in the market when you choose to rebalance. So we rewind a couple of years, January 2014 I think it was. Yeah, January 2014. If you recall the market sold off 5% or 6%, it was one of the worst Januarys the market has ever had. If you had a tactical strategy that was rebalancing at the end of every month, you might have chosen to de-risk at the end of the month.

February, the market immediately rebounded so if you had rebalanced at the end of the month you were highly subject to what the market had done. Fast forward a couple months, October 2014. Market sells off 6% or 7%, 8% mid-month. By end of month it was flat to positive. So if you were rebalancing end of month it was like nothing had ever happened. So when you choose to rebalance, actually makes a huge impact on your returns.

Meb: Simple answer, is just be lucky. You know?

Corey: Well that’s why I call it timing luck.

Mb: That’s one of the things, you know, a lot of these binary outcomes, and it applies to so many things buying stocks, shorting stocks, going long, short of market, and investors so often want to think in binary terms.

So I can’t tell you and I’m sure this is same experience views with you. So many investors, and advisors, and even institutions I talk to, the question is, “Yes, no. Should I be invested in gold?” And it’s never, “Should I sell… come up with a five-year plan to sell 10% of my gold each year?” It’s never, “I’m gonna have a system…” Like, you talk to a cryptocurrency investor right now, and I have so many friends that talk to me right now and they say, Meb “What do you think about Bitcoin? You know, should I buy some?” I’m like, “I don’t care if you buy some or not. What do you plan on doing after you have it?”

And it’s the same thing with almost any investment. Is it’s, like, they don’t have a system or a way of thinking about what to do on the other side. So there’s lots of ways to diversify, I think, this problem. Right?

Corey: Right.

Meb: So you could use multiple parameters. So like the 1987 is a great example, if you use something like a 200 day moving average or shorter you would have missed the crash. Longer, you would have been in. Big time outcome difference, but maybe if you used three different moving averages you would have had a blended exposure, and of course, using a lot of other markets as well.

Corey: Yeah, so I think that’s a perfect example. You can use different signals. Right? You can diversify your signals. You know, you can go big picture and say that’s why value and momentum work so well together. But if you’re just doing a trend following, and you see this in managed futures all the time. Using different signals to size your total exposure to an asset class. Our preference at Newfound is actually to dollar-cost average in and out. So it’s almost like running multiple portfolios under the hood. One that rebalances, for example, once a month, but on a different week of the month.

But you can just think of it as dollar-cost averaging. It all more or less has the same impact which is, it really reduces this impact of timing luck. But it cuts both ways. So you may not get the whipsaw, in something like a January 2014 because you’re not reallocating 100% of your portfolio at the end of the month. But because you are dollar-cost averaging, you may get more whipsaw in an October 2014.

And so what it means is there’re gonna be environments that you help mitigate whipsaw, and there’s gonna be environments where you might create a little more whipsaw. But over the long run, we believe that it more or less helps diversify out this timing risk.

Meb: You get the blended average.

Corey: Exactly.

Meb: And the problem with the end investor a lot of times is, the same thing with diversification, it’s same thing with this is, a lot of them simply like to gamble and so it’s nothing to cheer for. Like, they wanna be, “I’m out. I want the market to crash and I’m excited about it.” You know, in a diversified portfolio that owns these 30 different investments with active strategies that are blended, is a lot more boring.

Corey: It’s definitely a lot more boring. I also think the other hard part for most investors is they’re very used to the concept that the proof is in the eating of the pudding. That, what is more proof than returns? That if I say to you, “Over the long run I believe that this methodology is not just empirically superior, but mathematically provably superior.” And then I underperform the basic Meb Faber end-of-month strategy for the next three years, most investors would say, “Well clearly it doesn’t work.” And when you come at markets from a mathematical perspective, your definition of long run is 20, 30, 40 years. But again most investors don’t have the wherewithal to stick with something that long.

Meb: And that also doesn’t match up with the career risk of trying to stay in business. So talk to me a little bit about this. I know you had a piece called “Outperforming by Underperforming.”

We’ve had many conversations, we did this office hours with investors where they would say, “Meb, you know, can you tell me about your last three months performance,” and I would just kind of giggle. And they would say something like, “Well, how long should I use to evaluate your strategy?” And I said, “Well how about the next 5 to 10 years?” and they’d laugh again, then it’d be silence on the phone. And I said, “Well, serious, if you’re looking a long term approach…” And you guys actually touched on this as well, but the classic example of Buffett.

Where you had a great slide deck that showed, you know, underperformance, and outperformance and despite the fact he would have beaten, I think, 99% of all mutual funds since 2000 he’s underperformed like 8 or 9 of the last 10 years.

So talk to us a little bit about this piece and under-performance cycles in general, and kinda, the conversations you have with investors because, this period since 2009 has been really hard for most active-tactical people, that are anything other than U.S. 60/40. That’s crushed. Absolutely crushed everything else in the world. Give us some thoughts on that, open mic.

Corey: So Warren Buffett is one of my favorite examples because I think, most people know who he is, know his track record. He has provably outperformed the market. And so when you are offering a strategy, often people will be, perhaps skeptical of your performance. You mentioned it, you know, “Why have you underperformed over the last three months?”

You get those questions as a boutique asset manager. Whereas Warren Buffett sort of gets a pass because of his long term performance. So I love using Warren Buffett as my favorite example.

And you mentioned some of the unbelievable stats since 2000. If you go back even further since Berkshire Hathaway went public, and you compare the performance of Berkshire Hathaway’s stock to any other company that’s been around just as long, or any other mutual fund that’s been around. Again, he outperforms 99%, if not 100% of them, on a total return and risk-adjusted return basis.

So you mentioned that track record and then I always like, when I’m in front of an audience using the slide deck, before I flip to the next slide, I always ask a question. Which is, “All right, hands up, how many of you think Warren Buffett’s worst trailing performance, over any one-year period, to the market, was…the S&P 500, was worse than 5%? You know, so the market was up 10%, he was up 5%.” And a lot…most hands go up.

“All right, what about 10%?” Well, you know, can you really outperform by that much if you underperform by 10% at one point? You might get half the hands up. “Fifteen.” All right, you might have one or two brave souls. Then you get to 20% and everyone’s hands are down. There’s no way he ever underperformed by more than 20%.

The reality is he underperformed by 50%, 60% in a one year period, during the .com days. And not only was it 60%, it was the market was up 40% and he was down 20%. Right? And I always say his genius…well he has multiple geniuses, but permanent capital. Right? If he was running a mutual fund company he would have been out of business.

Meb: Gone, baby, gone.

Corey: Right? He just would have been gone. And that wasn’t just a one-time thing. Warren Buffett has underperformed the market by 30% or more over rolling one-year periods, five or six times. In fact he, almost every five years, has underperformed by 20%, at least once.

And so if you did this concept of, “Let me do a stop loss on my managers,” you would be getting out of Warren at all the wrong times. And for us what that brings us back to is, if you want to be different than the market, it means you’re going to have to likely underperform the market at some time.

That there’s, again, no holy grail. That if there were some strategy that could just always consistently outperform the market, what would happen is investors would flock to it. And if investors all flocked to that strategy, those assets, whatever it’s buying are gonna get all bid up. Their prices are gonna go up, their valuations are gonna go up, and it’s gonna drive their performance down.

Meb: And we have some very real examples of that. I mean, I think the one a lot of people talk about is, you know, some of the value anomalies getting published. The most famous probably being price to book. And then Dimensional Fund Advisors was…a gazillion other quant shops say, all right we’re gonna to start building portfolios based on value and use price to book. Next, thing you know DFA is a $500 billion shop and price-to-book has been one of the worst value factors for a long time.

Corey: Exactly. Exactly, so our view is..,and you’ve had the guys from Alpha Architect on the podcast, mention this as well. For something to work it’s gotta be hard. It’s gotta be so difficult that most investors don’t actually wanna do it. I mean, look at the performance of Berkshires and you say, “Wow, most people probably wouldn’t be able to stomach that under-performance. That performance difference to the broad market.” And Buffett’s ability to stick with his process during a period like 1999, really says something about his long-term ability to generate outperformance.

So when I talk to someone about, “Okay, you’ve underperformed over the last three months. Well using Buffett as the example, and saying, you really want to exceptional long term performance, you need to understand these things have to underperform. There is no strategy that can always outperform because it’s an arbitrage. If you always outperform the market, well I’ll just buy that strategy, short the S&P 500 and I’m printing money.”

Now, the inverse of that is, there’s never a strategy that should always be able to underperform, if you ignore costs for a moment. Because if a strategy always underperforms, you can short that strategy by the market, and you have an arbitrage.

Meb: Right, so even if you bought, like, a great example is buying expensive stocks have been a dumpster fire over the past, whatever, 60 years. And that’s easy to show, but that there are times if you were to short that bucket, you would have your face ripped off.

Corey: Absolutely.

Meb: You know, and you see a lot of the expensive stocks ripping over the past year or two. You know, your stocks that have price, earnings ratios 50, 100. But at times, and I think Greenblatt’s got the greatest example of that. People used to always ask him, “Why wouldn’t you use your magic formula long-short?” He said, “Because you would go broke.” You know, it’s too hard.

Corey: And that’s exactly right. That’s exactly right, and so when I say can’t always work, I mean consistently, day in day out, or even week in week out, month in month out. Things like value may work over the long run, but they can go decades. That’s right. You can go decades underperforming.

Meb: The only one that I know that would probably be a consistent safe bet would be taking the other side of Jeff’s option trades. We need, like, an automated service that will just, like, take the other side every time he places an option trade. Jeff loves option trading.

Let’s start to do some quick hits, doesn’t have to be quick. Start to ask [SP] some questions on various topics, various papers. We’ve got a few Twitter questions from people who wanted to ask you. We’ll go two or three of these, you can answer as long or short as you want. “Should We Be Holding More Cash?”

Corey: Yes, so that paper I wrote was simply a question of when you look at conventional modern portfolio theory the idea is you should hold what is the sharp optimal portfolio, and you should either lever it up, or you should put some cash in the portfolio to de-risk it.

And yet what you tend to see most investors do is, not actually include cash when they wanna be more conservative, they tend to actually do what is sub optimal and just go towards less risky asset classes.

And so my question was, should you really be taking this barbell approach? Riskier assets plus cash will actually give you a better return. Despite the fact most investors don’t want to sit on cash. And what I found was that, in today’s market, it really doesn’t make too big a difference. But just a consideration for the future, most people think of cash as being assets that they haven’t put to work. When in reality, if you can have that cash on the sidelines that allows you to invest in a riskier asset class, it might be better from a portfolio perspective.

Meb: Cash has a very real psychological benefit to a lot of people, of just the optionality of not being all in. You know, so many people they wanna be fully invested and then when things start to hit the fan, it’s really tough for them because they have no powder to work with. Right? So even if your return is sub optimal, having some cash I think, is probably good mental health.

Corey: I think it’s also hard for people, especially those people who work with financial advisors, to see their advisor sitting on cash and potentially taking a fee on that cash. And again, the use of cash in a portfolio even if it’s not just 2%. It could be 10%, 15%, 20%, may allow you to create a portfolio that has a better return and risk profile, but most people don’t want their advisor sitting on cash. So there is a very psychological aspect to the utilization of cash, and creating optimal portfolios.

Meb: The phrase, “That’s not what I’m paying you for.”

Corey: Exactly.

Meb: You hear that a bit. All right, next. is dividend investing dangerous?

Corey: So this was actually largely inspired by you Meb.

Meb: Good.

Corey: Because you talk about dividend investing all the time, and I think this post was really…you know, you talked about both dividends being sub optimal from a tax perspective. Really, the exploration was, what is dividend investing? Why invest in high-yield dividend stocks? And what we really found in this piece, was evidence that high-yield dividend stocks are just bad value stocks and drag. But there might be an argument for dividend growth. That those two are not necessarily the same.

That if you’re investing in dividend growth there may be, what you’re really investing in, is the re-investment factor and, sort of, a quality factor, and a profitability factor. But dividend yield, explicitly, as an investment methodology is just, sort of, bad value.

Meb: It has to be up there for me for an investment concept or brand, with the most assets with the most nonsense, in my mind. There’s probably not a fun complex out there of the top 20 that doesn’t have a dividend fund.

Corey: Yeah, and again I think dividends on their own, right? I would bucket the two. I would say there’s dividend yield and dividend growth. And I’m still mixed on dividend growth. I certainly understand the tax implications. So you have to have an asset location strategy there.

Dividend yield, just investing in the highest yielders, to me, yield might be something you can consider as part of your value strategy. But, as you mentioned, there’s much more efficient ways to get value, and probably much better ways to get value.

Meb: Well it’s like, the one, kind of, tell too, is that if you look at a dividend yield quartile, quintile, decile, when you have factors you in general wanna see a nice stair step. And dividend’s one of these wonky ones, where the top decile quartile is worse than the next, you know, bucket because you end up in these junky stocks that have a bunch of debt, and are paying out a ton of the cash flow as dividends. And they actually underperform the next bucket, which is rare. You don’t see many factors that don’t have that…

Corey: You get that nice monotonic increase.

Meb: Yeah, I don’t know why that is. All right. Let’s go to Twitter, let’s see what some of these tweets had to ask you today, usually we get a few nonsensical ones. All right. Ready. Ask, “How about whether to, or how to, incorporate country interest rates into global allocations.” Not really sure exactly what that means but you can take the question…

Corey: Country [SP] interest rates.

Meb: …and run with it.

Corey: Sure, I mean that’s…

Meb: I mean assuming… let me rephrase the question for Brad, and it probably means something along the lines of, you know, 1), in your bond allocation is it makes sense globally to allocate to carry. So are you looking at interest rates at all there? And, 2), is that a input to any of your equity valuation models? I mean, that’s probably, sort of, two different…I’m guessing. Do they play a role where if interest rates are 8% in Brazil does that change how you look at things versus, 2% here?

Corey: Right. So I was gonna mention immediately carry. Most of what we focus on when we build portfolios are the incorporation of strategies that already exist in some sort of packaged product. So there’s not a lot of vanilla carry strategies that are available. I think carry’s got a great track record as an investment methodology. I find it’s hard for most traditional investors to get access to, in some sort of very basic, you know, ETF or mutual fund.

So we don’t include it a lot, but I certainly recognize the strength of carry. From a asset-allocation perspective what we tend to see is most common, and again having a very U.S. perspective is, you don’t tend to get, “Should I invest in Japanese 10 years versus German 10 years?” You just get U.S. and non U.S. And in that non U.S. you do get a big blend of what are, sort of, global interest rates, but it’s less of a consideration of country by country, and more of a global perspective blending it all together.

Meb: Great. Next question I think you kind of answered. Oh, it’s funny. The second part of the question was, “Discuss risk-adjusted carry and use in bonds.” Part 1. Thoughts on valuation-based market timing for all asset classes. That’s a hard one by the way. Is, I think…

Corey: I’ll jump into it though that’s a deep end.

Meb: Going cross… Yeah that’s deep end. Cross asset allocation valuation is tough because, if you look at, just like, global stocks. You can compare them on valuation metrics. We sort of compare stocks to bonds, to real estate, to commodities. What do you think?

Corey: So this is actually another one I wrote about, a couple weeks ago I think, in a commentary. It is very difficult. Right? There’s a couple things you gotta address. First of all what does it mean to be cheap or expensive in fixed income? Versus, what does it mean to be cheap or expensive in commodities? Versus, what does it mean to be cheap or expensive in equities or currencies? Each asset class is gonna have its own definition.

Let’s say you do come up with that definition. Well then the question is, how do you compare across definition? So you might say, “It’s price to book, or price to earnings, or CAPE for different countries. But then on the fixed income side, it might be real yield.”

So now I have all these countries and their 10-year bond and I’m looking at real yield, and I’m looking at CAPE for equities. Well, how do I compare a CAPE of 30 to a real yield of 2%? Well, that’s not necessarily obvious. So then you have to solve that problem.

And then from there, even assuming you figure that out, you then have to take into account, you know, traditionally with factors you look at building long-short portfolios. Well, depending what’s on your long half, versus what’s in your short half, you’re gonna have a very varying risk profile. So if I go long stocks and short bonds, you are now actually, in an equal dollar amount, you’re way more allocated to equity volatility, than bond volatility. So you need to then take into account portfolio construction.

So it’s very non obvious how to do those three steps. What we tend to see is that you don’t build multi-asset factors the same way you build equity factors because a lot of that stuff is addressed. If I am talking about, call it “the value factor” where I buy cheap stocks and sell expensive ones. A lot of those things are already addressed.

The same measurements work across all stocks so I can just use price to book and it’s consistent, and it means the same thing. When I do dollar neutral long-short, for the most part, both sides have an equal amount of volatility that they’re contributing. So a lot of these things go away.

On the multi-asset side, what you tend to see is that you use these different factors to adjust the expected return of an asset class, and then you run some sort of optimization. Because one of the things you wanna be cognizant of is, when you’re building a multi-asset portfolio what is, sort of, your target risk profile, and what does it mean for diversification give up.

So to go back to, sort of, stocks, you’re buying a value portfolio, one way to think about that is, you’re buying the market plus a value long-short on top. If you have a 60/40 portfolio and you incorporate value you’re not changing your overall risk profile. You’re not changing your overall internal amount of diversification. You might be actually adding some diversification by adding that active risk component.

Going back to the multi-asset framework, you can really meaningfully change how much risk you have embedded. And that’s one of the things that I think makes global tactical so difficult. Is that, very often you’re explicitly foregoing diversification opportunities in pursuit of return. And you need to be constantly cognizant of, where are the risks that you’re taking? And, what extra risks are you adding in pursuit of these returns?

Meb: You know, and it’s something we were thinking about the other day. Is that, a lot of active managers, and this is natural when you’re looking at a strategy and it goes through a hard time. They’ll write an article or do something, basically calming investors saying, “Look we’ve seen this before. We’ve underperformed by this much before.”

But the biggest challenge in investing, there will come a point where we haven’t seen it before, and it gets worse. And a challenge I think for a lot of investors is, at what point do you cry uncle, give up with a strategy, say it’s broken, and what time do you over rebalance, add more to the strategy and say, you know, “This is simply a drawdown, and let’s put more in”? And I think it’s a tough question to answer. Do you have any thoughts on that?

Corey: Especially with value. Right? I mean value is such a long-term mean reversionary type strategy, that when you say to someone, “Hey, I think that there’s gonna be some mean reversion here, but it might take 7 to 10 years,” that can be very hard to place a trade on and stick with.

I’m gonna steal a phrase from Cliff Asness, where he said in a Bloomberg interview recently, he doesn’t “get excited about valuation-based trades until things hit their 150th percentile.” Which obviously isn’t a real thing. Right?

But his point basically being, look, if equities are in their 80th percentile historically, being expensive doesn’t really mean anything. That they not only need to be at the 100th percentile, but they need to be in weird new highs or weird new lows, for him to really wanna put on a meaningful trade.

So you look at something like equities in the late ’90s. Right? They hit that 100th percentile and I think they went up, like, another 100%, 150%, maybe even 300% from there.

Meb: I missed that bubble. That was such a great bubble. I loved…we need another good bubble. Hopefully, this crypto bubble will just keep expanding. It creates a lot of opportunities on both sides. I didn’t mean to cut you off, I was..

Corey: No, you’re absolutely right.

Meb: …reminiscing a little bit.

Corey: But long story short there’s, I think, valuation-based timing is very, very difficult. So when I say equities are overvalued, I don’t mean that to imply there has to be a crash, I just simply mean the evidence directs us to the idea that we should mute our expected returns a little bit.

Meb: Yeah, I mean, you think back to so many examples in history, and this is why I think being a market historian is so important. Like, the long-term capital is such a great example of people that were betting on spreads and leveraging it, and then something happened and you have spreads that had never seen before, and they go broke, but creates opportunity for other people.

And so many things in market history, you know, Russian stock market closing, world wars, you know, everything in between creates these sort of environments, 1987 we’d never seen before. And there’ll be [SP], that’s what makes this fun and interesting.

Corey: Yeah, you know, I think Brendan Mullooly had a great post the other day which was saying, “Look, it’s very easy to point out the asset classes that should mean revert, it’s very hard to know when they’re gonna mean revert.” It’s very easy to say right now, U.S. equities are overvalued. Historically, they are. Knowing when that’s actually gonna revert back to normal valuations is very, very difficult.

Meb: It’ll probably just go sideways for, like, 10 years and then just frustrate everyone on both sides to no end. If they just did, like, 3% a year, how one…

Corey: Wait for earnings to catch up.

Meb: Yeah. Couple more questions. I’m gonna have to let you go because it’s already been an hour. One, so you’ve done a ton of… I mean how many weekly pieces have you put out? Hundreds?

Corey: Yeah, I’m probably at 150 at this point.

Meb: So, probably do, what we need to do is start recycling the old material. Just start republishing stuff from 2008. Just kidding. What are you working on? So you’ve covered a lot of ground, what are you thinking about today? What’s, kind of like, on the back burner? What are you excited working about, thinking about, kinda, going forward? Any sort of projects that got you marinating on?

Corey: Yeah, absolutely. So again, a lot of what we did historically were those satellite-type portfolios, very vertical in a specific asset class, and that last question dovetails very nicely into a lot of the research we’re doing now, which is, How do you construct multi-asset factor portfolios?

How do you think about taking value and applying it not just within an asset class, but across asset classes? And how do you think about building unconstrained portfolios to incorporate these ideas, with the recognition that you need to maintain a consistent risk profile, for a balanced investor? You need to be cognizant of the diversification give up that you might be taking.

And so a lot of that is where our research is focused today. The application of value, momentum, carry, defensive, and trend styles, and their application to multi asset investing.

Meb: Looking forward to the next white paper. “The weird portfolio.” How to put it all together. We always ask this question. In your career personally, or allocating for clients, has there been a most memorable investment or trade? What do you do with all your money? Do you just park it in CD’s, or are you investing in, kinda, the same sort of things y’all publish? What’s been the most memorable?

Corey: Yeah. So the most memorable for me was when I was getting started. And I think when everyone gets started in this industry a very common theme I hear is, everyone reads some Warren Buffett, they read “Security Analysis,” they read, you know, “The Intelligent Investor” everyone fancies themself the next, great value-stock picker. And then they pick a stock and it absolutely goes up in flames.

So I had this micro-cap stock that I had found. Company was called, Deep Down…

Meb: Oh my God. Great name.

Corey: …and it did…

Meb: Wait, do you wanna guess what it does? Jeff, any thoughts? Deep Down?

Jeff: It’s a quilting company.

Meb: I’m going ocean exploration.

Corey: Yeah, it was similar to ocean exploration. It did a lot of the hardware for ocean exploration so…

Meb: Oh, chicken dinner.

Corey: Yeah, helping oil companies try to identify good areas to further explore, providing them with all the tubing, and that sort of stuff. And it was sort of a, industrials play, I guess. And it was $1. And I got in and it went up to $2 and I thought I was a genius. Doubled down and it went to 10 cents. And it was just one of those, you know, perfect examples for me of…

Meb: Were they based out of Utah or Vancouver? It seems like all the frauds that you end up… all these pink sheet companies somehow are or Utah or Vancouver.

Corey: And for me actually it was a reminder, and probably the last time I ever picked a stock. I went, from that point, 100% quantitative. My employees always make fun of me and say I am the most emotional person they know for a quant investor. And it’s one of the reasons I am quant. Is, I recognize that I’m not immune just because I know about all the behavioral deficiencies that we tend to have, when it comes to investing. You know, I’m not immune to them. And so I have found that every time we have a tactical-signal change and my gut is telling me to override it, I have been wrong 100% of the time, and it’s why we never override the signals.

Meb: That’s a good signal you can start incorporating the anti-Corey signal.

Corey: I have found the best signal I actually have is, when I get a large number of calls, of people concerned about the market, but that is almost always the exact bottom of the depth.

Meb: What are your investors and advisors… what are the biggest concerns today, do they have any? Promo [SP]?

Corey: Yeah, the biggest concerns actually, it’s really interesting, many advisors and investors that we speak to, are very cognizant of the valuation risk. Most of them expect lower returns. Their concerns are all about, “Okay what does that mean for portfolio construction? What does this mean for my retirement going forward?”

Meb: Well, you guys just published something this morning on withdrawal rates.

Corey: Yes, we did. We did. Looking back and saying, “Well, if you actually had lower, sort of, average returns over the last 100 years, what would that mean for retiring?” But not just that.

A lot of people are sitting on a lot of gains, and so there’s a lot of advisors we talk to who say, “I know I need to start transitioning my portfolio to incorporate things like managed futures, and maybe trend-following equity, and other means of managing risk. But how do I do this in a tax efficient way?” And, “How do I do this without upsetting my client, if I start to make the transition and the market keeps running for another three years?”

So most people that we talk to seem to be aware that they want more risk control in their portfolio. But actually getting from A to Z is actually not as easy as just pulling the trigger.

Meb: Yeah, I mean, that echoes almost the same conversations we’ve had. A lot of people say, “Look, I know stocks are expensive. I’m not sure what to do about it, you know, in general.” Who knows?

Well look man, it’s been awesome. Where do people go to find more info on ya’ll, your funds, your offerings, your writings, everything else. Where’s the best place to follow you?

Corey: Yeah, so the best place to follow us is, you can go right to our website thinknewfound.com. You can get a link to our blog there, you can sign up for our weekly commentary. I publish that every Monday morning 10 a.m Eastern and then you can find me on Twitter as well, choffstein.

Meb: @choffstein. @choffstein, thanks for stopping by today.

Corey: It’s been my pleasure. Thank you for having me.

Meb: Listeners, thanks for taking the time to listen. We always welcome feedback, Q&A, feedback@themebfabershow.com. As a reminder you can always find the show notes. We will hyperlink and add many of Corey and crew’s PDFs if they’ll let us, in other episodes at mebfaber.com/podcast. Subscribe to the show on iTunes, and please leave us a review, let us know what you think. Thanks for listening friends, and good investing.