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Episode 100: Prof. Kenneth French: Expect the Unexpected

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Who better to have on the 100th episode of the Rational Reminder Podcast than Professor Ken French? Ken has been a massive inspiration to us and has remained a guiding light for sensible, evidence-based investors over the last few decades! His work with Eugene Fama stands as the seminal work on the subject of passive investment portfolios and we are so delighted to have him on the show today as we talk through some of his thoughts on a variety of subjects. This conversation was recorded near the beginning of the coronavirus outbreak on this side of the world and although Ken does mention the crisis, the situation has developed considerably since then. We start with the basics, with Ken giving us some helpful definitions and perspectives on asset pricing models and active management before we dive into the current market volatility and familiar topics such as risk tolerance and equity premiums. We also get the chance to hear Ken's reflections on a number of his papers, home-country bias, and the value of a good advisor. Some listeners may be surprised to learn that Ken still relies heavily on a financial advisor of his own and he explains exactly what functions this person performs for him and why he values their help so highly! We also discuss better strategies for long-term portfolio allocation, sustainable investing options and more, so be sure to join us for this very special episode, it is not to be missed!

Key Points From This Episode:

  • Ken's description of asset pricing models and their importance to investments. [0:02:37.2]

  • Reasons why most people should ignore and avoid actively managed options. [0:04:50.7]

  • Why the same rules that apply to mutual funds apply to hedge funds too. [0:08:36.3]

  • Reasonable approaches to the market volatility we are currently experiencing. [0:11:01.7]

  • The potential impacts of the move away from active into passive investments. [0:18:22.2]

  • Realistic expectations for collecting a positive equity premium. [0:21:12.8]

  • The probability of negative premiums and the most helpful time horizons. [0:25:25.5]

  • Findings from the Fama and French paper, Value Premium. [0:28:47.4]

  • Better and worse ways of measuring value and Ken's personal preference. [0:34:06.7]

  • Factoring in the 'momentum effect' and keeping it in perspective. [0:37:36.1]

  • Defining and evaluating home-country bias. [0:41:06.5]

  • Ken's view of buybacks and the possible penalization of companies administering them. [0:43:50.4]

  • Environmental and sustainable investing and how this can play into a strategy. [0:46:02.7]

  • Who should business management work for? Shareholders or corporate stakeholders? [0:49:25.5]

  • Ken's valuable relationship with his own financial advisor! [0:52:41.8]

  • The most important factor that Ken considers in his investments: the unexpected. [0:54:27.2]

Read the Transcript:

Your asset pricing models have been transformational to the field of financial economics, which as an aside makes it really cool for us to be talking to you, but anyway. Can you describe what an asset pricing model is and why having a good one matters?

Yeah. An asset pricing model is basically trying to say what's the expected return on a stock or a portfolio or some other asset that you may be interested in investing in. Usually the way they work is the expected return on your portfolio is going to be a function of the characteristics of the assets you have in your portfolio. Most asset pricing models have to do with stock. The characteristics are typically, how does that stock move with some economic returns? So for example, we typically construct factors. One factor may be the overall market. So a portfolio that's really sensitive to the overall market probably has a higher expected return than a portfolio that's not so sensitive to the overall market. That's a simple asset pricing model.

And what's happened over the years is we've added more and more things like the market, other factors. So one factor might be how sensitive is this portfolio to the behavior of small stocks relative to big stocks? So if your portfolio is a portfolio of all small stocks, it's going to be real sensitive. And most of us think there's probably a positive premium associated with a tilt towards small. The more tilted you are, the more we would add to your expected return on your portfolio. Another factor might be a value versus growth factor. There's evidence that says the expected return on value stocks is higher than the expected return on growth stocks. And the value factor, your sensitivity to that is going to capture that difference in expected returns. And what you do is you just start adding up those pieces of the expected return, sum them all up and say, "Oh, this is the expected return on my portfolio."

So knowing what we know about how markets work, are there any good reasons to invest in the traditional actively managed investment strategies?

The short answer to that would be no. And the longer answer is it may be sensible for some people to try to invest actively with an active manager. But let me give you the simple reason why most of us should just ignore that problem of do I want to go out and pick an active manager? There's enormous amount of evidence. In the place where we really have good data, which has mutual funds, there's an enormous amount of evidence that says, if I just add up all those mutual funds into one big, huge portfolio, as a group, they underperform just a passive market portfolio. And the logic is simple if you say, "Okay, as a group, they can't beat the market, they're basically just picking stocks at random." Then you'd say, "Well, they're picking stocks at random, and yet we have to pay them to do that. So we should expect to underperform."

And it turns out that that's not a bad model of what the group of all active US equity funds are doing or equity funds around the world for matter. As a group, before fees and expenses, they deliver the market. After fees and expenses, it's going to be something less than the market. Now, that doesn't say there's nobody in that group that can beat the market, there may well be. The problem is twofold. First, you got to figure out who's going to be able to beat the market consistently. And second, is there going to be any of that extra return available for me as an investor? So suppose I discover there's this great manager. Well, my problem is I'm competing against all the other investors out there. And the evidence is clear, they tend to overreact to any ability of a manager. So that if there's a hint, just good luck, you'll see money flooding into that manager trying to chase those returns well before there's any compelling evidence that would say, yes, that manager really has skill.

So I'm competing against all these other people who are moving too quickly, which says, unless I'm superhuman, I'm not going to be able to get there before all my competitors get there and do more than consume it away, do more than compete it away. They actually drive the performance negative. They overshoot, if you want to think of it that way. And on top of that, there's so much volatility in the market, it's just incredibly hard to draw any inferences whatsoever. So first, it's hard to figure out who's going to consistently win. And second, even if I could figure out a manager that had great skill, it's not apparent that other investors would allow me to benefit from that skill because they basically are going to flood in and dilute whatever expertise that manager has.

You mentioned that people should ignore this problem, are there any cases where it would make sense for someone to pursue an actively managed strategy?

Not that I'm aware of. I always say most people because I don't want to be so arrogant to think there's nobody out there that can do this. I know there are some managers out there who can do this. The question is, do they leave anything on the table for any of their investors? And even if they wanted to leave something on the table for their investors, it's apparent investors won't allow them to. Again, any evidence that somebody may have some skill and money floods in and dilutes whatever expertise they have. And usually that evidence is really ephemeral, it's actually just the result of good luck, it's not really skill. But everybody overreacts to that anyway.

And the same goes for hedge funds?

The data there aren't clear enough to be able to say this definitively. I don't see any reason why people behave differently when we're talking about hedge funds than they would do with mutual funds. So the evidence is pretty clear when we talk about mutual funds, the evidence is really cloudy when we talk about hedge funds. But to me, people are people whether it's the hedge fund manager, who if I truly have a great hedge fund manager, they're going to be the scarce resource. And in economics, they capture the rents, why should they leave any of that on the table for their investors? And second, even if they wanted to, investors behave in it with hedge funds the same way they do with mutual funds, they're not leaving anything on the table themselves. I just don't think there's any reason to play that game.

And on top of that, the volatility that I spoke of earlier, there's so much volatility. It's going to be hard for me even after the fact to assess whether this manager has done a good job in some true expectational sense, that they've actually done anything for me or not. It's just too noisy to tell whether the outcomes are meaningful or just the result of either random good or bad luck.

And I guess we can see an anecdote maybe, correct me if I'm wrong, with the Renaissance Medallion Fund where maybe they have had that type of performance, but they've also closed down to outside investors?

Exactly. And not only that, but even if you're an inside investor, if you're one of the employees working for Renaissance and you're allowed to invest in their Medallion Fund, I understand the fees are somewhere around 6% of money under management and 45% of profits. Now, I may have those numbers are wrong, but they're of that magnitude.

Yeah, I think it's 5 and 40. I just read the book that was recently written about Jim Simons, they could have gone up though.

I'll take your numbers. I read the book too, but I don't remember the numbers.

Okay. Okay. Right now as we're recording this, I think this is a good question for any environment, but maybe particularly right now when we're having this conversation. The S&P 500, the US market as measured by the S&P 500 has dropped 25% in the last couple of weeks. And I think one of the pitches of active management, and this is a hunch that one of the things that continue to drive assets in active management is this idea that they can protect the downside. Whereas when you're an index investor, you're just getting the market return. How do you think index investors should think about and act in periods of market volatility like we're seeing right now?

The way to think about it, first, if you step back and ask what's going on in the markets. When you buy, for example, the Sand P 500, what you're buying is a claim on all of the cash flows from now till whenever a company liquidates when you buy a share of that stock. It's a long, long period that you're buying into. And what the market's been doing for the last few weeks is trying to figure out what are the implications of this coronavirus for all of the future cash flows that we used to have a claim to. I guess we could say we still have a claim to them, they're just a lot smaller than we expected them to be two weeks ago or three weeks ago. So our expectations are being readjusted as the market's expectations are being readjusted. The last several weeks, a few days, people's inferences have gotten a little more optimistic than they were the day before and prices have gone up dramatically.

But most of the time over the last three weeks or so, price has gone down dramatically as people have reassessed, "Oh gosh, this is going to be bad, and I see what's going to happen." So I'm sitting here at Dimensional Fund Advisors. And if it turns out there's problems with coronavirus here in Austin, Texas, they'll send people home to work. This sort of business where it's mostly people who type on computers, in this sort of business people can work at home. But if we think of a General Motors plant or we think of a plant that's up the road making computers at Dell, they can't do that work at home. You can't bring all your pieces of computer home with you and build up the computers that people are ordering and ship them. So it's going to be a real hit to productivity, a real hit to GDP. And people are trying to sort out what are the implications of that.

To ask, okay, now there's this active manager out there who says, "Don't worry, I can handle this." Unless that manager has some clairvoyance that the rest of us are unaware of that allowed her to forecast, "Oh, the coronavirus is coming, we should expect it four months from now. And I'm going to put that in my portfolio today to protect against whatever it's going to do to my portfolio." I don't know anybody who has claimed that foresight. An active manager who says they could have protected us against this huge drop, I guess the proof of the pudding will be in the eating. But so far, I haven't seen anybody put his or her hand up and say, "Don't worry folks, I'm the active manager who knew how to deal with this." It'd be wonderful if somebody does, then I'll know who to pay attention to next time.

One of the questions that I've gotten several times in the last couple of weeks is, doesn't it make sense knowing that all of this uncertainty is being priced into the market? Doesn't it make sense to just get going to cash and sit on the sidelines until we know what's going to happen? It seems intuitive when you say, well, the market's going to keep dropping, so let's just get out and get back in at the right time. Of course, who knows what the right time is? How would you respond to that line of thinking? If someone says, "Well, let's just go to cash until a better time to get in," whenever that may be.

Well, in your question, I think I'm going to quote you accurately. You said it seems intuitive when you know the market's going to keep dropping. Yes, absolutely. If you know the market's going to keep dropping, get the hell out. But if you know the market's going to keep dropping and you're not special with respect to that information, so does everybody else, and it's already impounded in prices. So it's not logical to say everybody knows the market is going to keep dropping. The reason one might want to adjust his or her portfolio at this point is because they've learned something about themselves. They've discovered that their tolerance for risk like this is lower than they thought. If that's really the case, then fine. With this level of volatility, if this is way more painful than you anticipated, then adjust your portfolio. But you probably should think of that as your new permanent portfolio.

It wouldn't make sense to say, okay, I used to think I was just like the market, like all the other investors in the market I want my fair share of the market. Now, I'm thinking, oh no, I am more timid than the typical investor, I better reduce my allocation to stock. Now, that you've discovered you're more timid, you probably ought to use that information later on when you're building your portfolio. So what I'm getting into here is my general way of thinking about portfolio allocations. I'm thinking about how people should construct their portfolios. And I always frame it by saying, I know the average dollar invested holds the market portfolio. How do I differ from the average dollar invested? If I look like absolutely the typical investor out there, then the market portfolio seems perfectly sensible for me as my portfolio.

But then I might say, "No, in fact, I am more timid. I have more risk aversion than the typical investor." Or go the other way, I'm less timid, I'm more adventuresome, I'm willing to take on extra risk in exchange for the equity premium, the positive expected premium associated with stocks relative to fixed income, relative to the risk-free asset. If I am not very risk averse, I have a daughter who is as close to risk neutral as anybody I know. That's a huge benefit to her. Why? Because she gets to capture that equity premium without suffering all of the concerns about, gosh, what's going to happen to my portfolio? It just doesn't scare her. By the nature of her personality, she's the beneficiary, she captures the equity premium for free. Me, I get paid, I think I probably do look like a typical investor in terms of my own risk aversion. So I'm getting a fair risk return trade off.

Somebody else who's at the other extreme, they're not going to get compensated enough to say, you really ought to be holding your fair share of the equity market. That doesn't mean they don't want to hold any, but they probably want to hold less. So now when I see all this volatility here, what I presume ... And I don't have the data to be able to prove it, the data are just too noisy to make a compelling argument on this with the data. But you got to believe everybody else understands this volatility, and people are demanding a higher expected premium to hold the volatility that we're currently experiencing. The point estimates say that in fact that is what happens. Expected returns do seem to go up when we're in these really turbulent economically pessimistic times.

Yeah. It's a fascinating way to frame the answer that you can't time the market and you don't know anything more than anybody else. But this might be a really good time for a gut check in terms of how risky your portfolio is.

Exactly. But you're learning about yourself, you're not necessarily learning about expected returns or anything like that.

There's been an enormous amount of money flowing to index investments over the recent couple of decades, I guess. Should investors worry about the impact that this might be having on the market's pricing mechanisms?

That's a great question. The short answer is maybe. And why do I say maybe, because it really depends on who it is that's moving out of active into passive. So if you think about any trade, there's some trades where people are just reallocating risk. Hold those aside and say what we're seeing in almost every trade out there. Somebody thinks a stock is priced too low, somebody thinks a stock is priced too high. One of them is, one of them is wrong. And I mean that in an ex-ante, I don't mean what actually happens. What actually happens is mostly unexpected stuff. But somebody really understands this stock should be priced at $87 and it's only priced at 82, I want to buy it. Somebody else says, "Okay, this stock is priced at 82, I think it should be 76, I want to sell it." One of them is right and one of them is wrong.

If the person who steps away and says, "Nah, I'm tired of playing this game. I've read all the academic studies, it doesn't make sense for me to do this active investing." If that's somebody who's systematically wrong and they step away, that makes the world a better price. And what I mean by that is that makes prices more accurate. So in my example, the price is 82, it should be 87. And the person who was thinking it was going to be 76 stop playing the game. Well that vote of 76 doesn't get cast anymore, and that's the way to think about it. There's somebody saying 87, there's nobody on the counter side saying 76. That's going to push prices up toward 87 closer to where we just agreed they should be.

On the other hand, if it was the smart person in the game here who systematically is right, I don't know why they would choose to quit. But if those are the people that are quitting moving to indexing, then we're getting prices less accurate. I don't think we really ever have to worry about nobody coming and making that bet. People tend to be so overconfident about their ability to do this stuff that I expect there'll be plenty of these disagreements going forward. People will be out there some of them saying, no, it's 76, and some of them saying, no, it's 87. But the more we can drive out the people who are pretty clueless, the more accurate prices are going to be.

You mentioned earlier that when you're buying stocks, you're buying the rights to future cash flows or earnings and buying them at a discount based on some level of risk. And I guess the investor would then expect to collect the risk premium. How confident should investors be over the long-term, say, 20, 30 years? How confident should investors be that they're going to collect a positive equity risk premium?

Your question's a great one. I work with a guy named Gene Fama. Gene and I have a paper on exactly this question. And the experiment we did, I think it's really interesting. What we did is we took all of the past returns from 1963, in this case we stopped in 2016 because we wrote the paper in 2017. So we have data from 1963 to 2016. And we took all of the monthly returns. And we just said, okay, if I think about pulling each of the returns for a sample of, let's say I'm working on 20 years. The question I'm trying to answer is over the next 20 years, what's the probability of getting a positive equity premium? And we just say, okay, let's sample from all of the past equity premiums. What do I have? 240 months, I'm going to draw 240 of the prior months.

I pull a ball out of this bucket that has all the months in it, look at it and say, "Oh, okay, that's the equity premium for the first month." I put that ball back in, I pull out another one and say, "Oh, there's my equity premium for the second month." I do that 240 times. And what's wonderful I know exactly the distribution of balls in my bucket. I know exactly what the average premium was, and I know what the volatility is, what the randomness in that bucket is. And so we do that 100,000 times, we do 20-year samples drawing balls out of the bucket, 240 of them. Calculate the equity premium, and then 100,000 of those experiments. So I get to look at 100,000 of the equity premiums from a true distribution I'm absolutely certain of. It's the one we experienced from 1963 to 2016.

It turns out if I'm looking at a 20-year horizon, I get ... Again, I can't remember the numbers here. Just about 8% of my 100,000 samples produce a negative equity premium. So what that says is I go to my financial advisor, my financial advisor tells me there's this positive equity premium. What that means is the expectation, if you played this game enough, on average you'd have a higher expected return or a higher average return if you buy equity instead of T-bills. That's what we mean by a positive equity premium. If have enough observations, you have a positive expected return on stocks relative to T-bills. What Fama and I show is almost 8% of the time, 8% of the universes if we have 100,000 parallel universes. If we look over the next 20 years, you will not get a positive equity premium.

So people will look at that and say, "Aha, there is no positive expected equity premium." In fact there is, but the realization can be quite different from the expectation. The realized return, that's the expected return plus the unexpected return. And the trouble with equity is the unexpected return, as we're living through the coronavirus right now, the unexpected return can totally dominate the expected return. Almost your complete performance over any reasonable short run period is going to be determined by the unexpected not the expected return. And even 20 years, 8% of the time you won't get a positive equity premium if the world looks exactly like it did from 63 to 2016.

The paper that you're referencing is Volatility Lessons for anyone listening. I mean, I probably reference back to that paper once a week. So thank you for writing that one with Professor Fama. Because you brought the paper up, you referenced it anyway, I want to ask one other question on this. We just talked about the equity risk premium. In the paper, you also looked at the small value and the market-wide value risk premiums. Can you talk a little bit about the probability of a negative premium for those and how that relates to equity risk premium?

I may call on you in a minute. If you've been looking at this paper, it's more frequently than I look at it, I assure you. But the likelihood that small value delivers a positive premium is actually a bit higher than the likelihood that you get a positive equity premium. Again, the likelihood of a market value or a big value, market value and big value are pretty similar here because the market's dominated by big stocks. The likelihood that you get a positive premium on big value relative to the market is a little lower than the likelihood that small value outperforms the market. But as we know from the last 10 or 15 years, that probability is not close to zero. If I were thinking about the 10-year premium, for example, I've forgotten the exact numbers and you can probably correct me. But my recollection is it's probably on the order of 4% that you get a negative premium over a 10 or 15-year horizon for small value. And it's even more likely to get a negative premium on big value, but I can't remember the exact numbers.

Yeah. That was the main takeaway for me was that there is a higher chance historically. Over that time period anyway, there is a higher chance of a positive premium for the other risk factors. Now, on this topic, one more question relating to the Volatility Lessons paper. If we look at five, say five-year performance for an asset class like the market or small value or anything, can we learn much about the expected risk premium from a period of time like that?

Five years is way too short to learn very much at all about any of the premiums we're looking at. Five years is also too short to learn much about any manager's performance other than an index fund. With an index fund that's truly supposed to track an index, I can tell pretty quickly whether they're doing that or not. But for everybody else, if there's much tracking error at all, it's going to be hard to say anything about what the manager's performance looks like over any five-year. I love that there's lots of institutions out there that focus on a three-year horizon. If you can't tell in five years, it's going to be really hard to tell in three years. Now, that's not to say you don't learn anything in three years and you don't learn anything in five years.

If you learned something with a million years, you must have learned ... I mean, if you learn a lot with a million years, you must have learned something with five years because lots of five years add up to a million. But people are crazy when they try to draw the inferences that they do from 3 or 5 years or even 10 years of performance on an asset class or any actively managed fund or a non-index fund. It's very hard to draw really precise inferences that people think they can. I think that's what supports a lot of the active that people are investing in out there. They see five-year track record and say, "Aha, I know I have a great manager here," when in fact you'll learn almost nothing about a manager's skill from five years of performance.

I have a question about another one of your papers. So in 2020, you and Professor Fama wrote the paper called The Value Premium, and you looked at the post-publication out-of-sample data for the US value premium. Can you describe what you found?

Sure. Gene and I wrote a paper, it was published back in 1992 that looked at data from 1963. It was July of 63 to June of 1991, which is a 28-year period. And recently we realized, hey, we have another 28 year period here. We have the in-sample 63 to 1991. And now we have 28 years of out-of-sample evidence from 1991 to 2019. And so we thought, "Oh, that'd be interesting. Let's take a look at what the out-of-sample period looks like relative to the in-sample period." Now, we do pay attention as we go along. So we knew that the out-of-sample average value premium wouldn't look as good as the in-sample average value premium. So 63 to 91 produced a higher premium the 91 to 2019. For us though, the interesting question was, could we tell the difference? Statistically, could we say that the expected return on value stocks has fallen relative to the market in the out-of-sample period after 1991?

The short answer was no, we don't have enough precision to be able to say, "You know, that expected value premium truly declined." And what I really mean by that is, yes, in fact the average premium from 91 to 2019 was lower than the average premium from 63 to 91. But there's so much noise. Remember that realized return is the expected return plus the unexpected, what I'm calling noise here. That noise is so important in the realized return that you can't tell that the expected return is different from the in-sample to the out-of-sample. Now, in the same breath, I want to be really quick to say I also can't tell that the expected premium in the out-of-sample period is different from zero. So I can't tell that it's positive nor can I tell that it's different than it was 63 to 91.

When I put both periods together, I can see, probably this value premium really has a positive expected value. But if I say, "No, just focus on out-of-sample," I can't say it's different from the in-sample, but I also can't say it's different from zero.

And has the international experience been similar?

The international experience is pretty robust. It's a bit smaller. I mean, we don't have any in-sample in quotes, basically the data we have internationally start roughly in 1991. The 91 to 2019 returns outside of the US are smaller than the 63 to 91 inside the US, but they're also bigger than the 91 to 2019. Think of the international in the period where we have out-of-sample data is stronger than the domestic in the period when we have out-of-sample data.

It's interesting to talk about the international data because it is so much more robust. I think there are some narratives out there talking about ... And I know this is one of the things that you were testing for or trying to test for in the value premium paper I think so. These narratives that the world has changed and companies are different, business is different, and it's this winner-take-all environment where the traditional value investing is no longer going to work. So seeing both results where the US, we can't tell if it's changed or not, whereas international, it still looks pretty robust is I think pretty interesting.

I'm not a big fan of this notion that it's a winner-take-all economy, this time is different. Anytime somebody tells me this time is different, I'm skeptical. I guess I'm old enough to have heard that many times and every time it turned out well, it really wasn't different. When I think about Amazon and Microsoft and Facebook, the companies where people are saying, "Oh, it's a winner-take-all economy," it's not plausible to me that the expected return on Amazon or Microsoft or Facebook is equal to what their realized return has been. I keep coming back to this theme that the realized return is the expected return plus the unexpected return. The astronomical performance of those high-tech companies, to my mind, that was unexpected.

Things turned out to be phenomenally great for them, but there's no reason to think, "Oh, now when I do my calculation, what should the expected return going forward for Amazon or Microsoft or Facebook be? It's not going to be what the average return for those stocks have been for the last 15 years. It's going to be something quite modest that reflects what their price looks like relative to their fundamentals, relative to their book value, relative to their earnings, or relative to their cashflow. And it's that same ratio that informs us both the combination of what's expected growth and what's expected return that I'm going to use as information about future expected returns.

Since we moved in this direction, I just want to ask one more question about narratives around those big growth companies. One of the other things that we hear about value investing is that using book to scale doesn't make sense anymore because all of these companies have all intangible assets and things like that. Do you have thoughts on whether or not book is still the right way to measure value?

I don't want to argue that book is the only way to measure value. The way I think about what we're trying to do when we look at book-to-market or earnings-to-price or any of the fundamental to price ratios, I would love to know future expected cash flows. If you gave me those, give me price, give me a future expected cash flows, I can easily calculate an internal rate of return, the discount rate that links those future expected cash flows to the current price. That is the long run expected return on that stock, it's a tautology. There is one number here that's going to link price to future expected cash flows. Higher expected return, lower price relative to the future expected cash flows. Low expected return, high price relative to the future expected cash flows.

And then the only argument here is, what's the best way to proxy for those future expected cash flows? What we learn is there's a lot of different ways to proxy for those future expected cash flows. Book tends to work well, earnings tend to work well. Cash flows, current cash flows work well. Dividends, it depends on whether companies are paying dividends. But if you give me international markets where we get most companies paying dividends, dividend to price works well, sales to price works well. Number of employees to price probably works well. I could probably use the size of the company headquarters to price. Give me something with price in the denominator, high expected return, low price relative to that measure of future expected cash flows, that proxy for future expected cash flows.

The reason I like book is because I care a lot about transaction costs. I don't want to have a portfolio that's turning over all the time just because my signal is so noisy. So if I'm basically capturing the same thing with book that I'd be capturing with some other numerator in my ratio, I'm going to go with book. And I have run this experiment lots of times, this is not the first time I've heard it's about intangibles. If you experienced 1999, for example, that was all about high tech, this time it's different. It turned out it wasn't. But when we ran the experiments and we looked at sorts, sorting on book-to-market was giving us essentially the same spreads in terms of characteristics as sorting on earnings, price, cashflow to price, all the other variables that people throw around.

And again, these things are so noisy that if somebody says, "No, you're absolutely wrong," I can't prove I'm right. It's a judgment call, and that's what it comes down to. What I do know is if I use something that's going to create lots of turnover, that's going to impose costs on investors. I know that. So then the question is, how should I design my portfolio given I'm trying to deliver an effective, efficient portfolio? Books seems like a great measure to me.

Yeah. I think that was a really, really good way to think about it and explain it. We've talked quite a bit about the risk-based framework for asset pricing. One of the things that's been observed empirically pretty persistently is the momentum effect, which does not fit at all, I don't think, well anyway into the risk-based framework for asset pricing. How do you think investors should approach momentum? Which again, is empirically robust. How should investors approach implementing that in their portfolios?

Well, first, I'm with you. It's really hard for me to reconcile momentum with a risk-based story, so I never argue prices. All prices are right, I think there probably are mistakes and prices. My trouble is I don't know which ones are too high and which ones are too low. So if I'm thinking about momentum, what I basically want to do is look at the last year, it's not quite the last year. If I look at last month, there are reversals. The companies that did really well last month tend to do poorly, and the companies that did really poorly last month tend to do well. Momentum's the reverse. Momentum says, okay, stocks that did really well last year, they tend to continue to do well for the next few months. Stocks that did poorly for the last year, they tend to continue to do poorly.

And so you can see if I've got this reversal going on last month, I can strengthen the momentum effect just by holding last month out. So that's what we do. We look from minus 2 to minus 12, and that's where we see persistence. What Dimensional does is say, "Look, we don't really understand what's driving momentum, but it's such a robust characteristic in the data, let's not ignore it." On the other hand, we know it's a high turnover strategy. If I really wanted to pursue an active momentum strategy, you're going to be turning your portfolio over a lot. That's going to cause transactions costs. We're careful, we don't want to impose transaction costs on our clients. So what we say is, "Let's not chase momentum, but let's use momentum if we were going to trade anyway."

So what I mean by that is suppose we have a stock that we'd like to sell. It was a small stock portfolio, the stock is now big, it doesn't fit in the portfolio, we'd like to sell it. Before we sell it, we look to see what happened from month minus 2 to minus 12. If this stock was a great performer, which you might expect because it used to be small and it's not anymore, you'd say, well, this stock went up a lot from minus 2 to minus 12. Momentum predicts it's probably going to continue to do well for the next few months, we don't sell it. For individual investors, there's no reason they can't do the same thing. If they are trying to manage their own portfolios in this fashion, so they are trying to pick winners, okay, use momentum in that same fashion that says, okay, if you're going to trade anyway, then pay attention to what's happened in the prior year.

If you were going to buy something and it's underperformed recently, you probably want to wait. If you were going to sell something and it's over performed recently, you probably want to wait. Otherwise do what you would have done anyway. Now, I'm not advocating anybody should be out there actually doing this sort of trading. But if you're going to, that's how you might want to take advantage of momentum.

There's a paper, I don't know if you've read it by Cliff Asness called Market Timing: Sin a Little where he basically says that. Market timing doesn't really work, but if you're going to trade anyway, it's worth looking at momentum.

That makes sense, he's a former student. One of my good friends.

That's great.

So Ken, as you know, many Canadian investors including many of our clients have an overweight to Canadian stocks relative to the market cap. So a question we get quite often is, is home country bias a bad thing?

Home country bias is per se not a bad thing. If you didn't have a bias ... Let's figure out what we mean by home country bias to start with. I'm guessing here, you can correct me. But my guess is Canada is 3 or 4% of the world equity portfolio. A home country bias from that perspective would say Canadians have more than 3 or 4% of their portfolio invested in Canadian stock. If that's how we're going to define home country bias and we say, okay, 7% in Canadian stock is a home country bias. That sounds great to me, no problem whatsoever. And we'll talk about why in a minute. But if I'm a Canadian and just because I'm Canadian I have 83% of my portfolio in Canadian stock, that might be something I want to reconsider.

First, Canada is a small part of the world. Second, Canada is pretty concentrated in terms of the industries. I mean, it's basically finance and energy as far as I understand. So you've got a small part of the world, and even then a huge part of your portfolio would then be focused on two specific industries. So there's plenty of reasons to overweight Canada. For example, you're going to be consuming in Canadian dollars. It makes sense from a hedging perspective that you might want to invest in Canadian dollars. A lot of people care about keeping up with the Joneses. In a period when everybody else in their town is doing well, they don't want to be the only one who's really getting trashed in the global markets. So there's another reason to overinvest in Canada.

If everybody else is investing in Canada, buy more than your fair share in Canada too. But if everybody's trying to hold 87% of their portfolio in Canada, first, they're going to run out of Canadian stocks. But second, there's a big world out there, and the benefits of diversification would justify a lot of buying outside of Canada. There may be some tax advantages to buying inside Canada, and that should certainly be considered. But too much of Canada is probably too much of a good thing.

The tax reasons are big ones that drive us in that direction where Canadian dividends are taxed more favorably. And then in tax advantaged accounts, we don't have any foreign withholding tax on Canadian stocks.

Yeah, those are powerful reasons to push you toward more and more stocks in Canada.

Share buybacks seem to be a really divisive issue where if you look on the Twitter discussions that cover this, there's two sides where some people think buybacks are the worst thing that's ever happened, and some people think that they're the same thing as a dividend. Do you think that the government should look at penalizing firms that buy back their stock as opposed to reinvesting in the business?

I'm going to be coarse here and say, yeah, these buybacks are divisive, they divide people who do understand finance from people who don't. The easy way to think about a buyback and why we see a positive price response when there are buybacks. If I'm a manager of a company, we produce lots of earnings, we've got lots of cash in the vault, we're trying to decide what to do with it. And I look out there and I say, man, this coronavirus is really going to cripple the economy, I don't see any positive net present value projects that I want to invest in. I can keep this money in the vault, which isn't really a good investment either. I mean, that is an investment leaving money in your vault, or I can go out and give it back to my shareholders.

An easy way to give it back to my shareholders is to go out and buy stock. So when I see a company buying stock, what I say is, "Oh, this is a manager who's representing their shareholders well and doing the best thing they can with their shareholder's resources. And the manager has decided the best thing she can do with it is go out and repurchase shares. And that's why the market price goes up because people are saying, "Oh, this is a manager that's respecting the shareholders." And saying, "I don't have anything better to do with it, I'm going to buy up these shares."

I looked at the data recently on a share buyback index and a dividend index, I think it was the S and P 500 aristocrats and the S and P 500 buyback index. And using a five-factor regression, they look very similar in terms of being low priced stocks with good profitability that invest conservatively. I thought that was interesting.

Yeah. To really go back and answer your question, should the government penalize companies that are doing that? If they did that, that would be like saying we insist these companies go and take negative present value projects. Governments ought to be in the business of encouraging companies to make good investments not squandering their shareholders or their citizens' resources.

So how do you think about environmental and sustainable investing, which certainly is exploding in popularity lately?

I think it's great. I don't mean that as a finance professor, I mean that as a citizen of the world. Finance professors, we're not supposed to have an opinion in terms of, is that a good thing or a bad thing? We have an opinion as people. But as a finance professor, usually we worry about the pecuniary effects, so the expected return and the volatility. When we think about environmentally conscious investing or sustainability investing, what's going on there is there's a dimension of people's utility that we miss when we talk about the expected return and the volatility. So people care about the environment they live in, people care about the world that we leave for our children. That's not immediately picked up in the expected return, that's not immediately picked up in the volatility of the return. But it is an important issue for lots of us.

The challenge then is to say, okay, what are the consequences of a lot of us saying we're going to invest more of our portfolio in companies that are environmentally sensitive, that are focused on sustainable strategies? As a finance professor, what I got to tell you is the consequences of that will be to drive up the price. If most of us are out there saying, "Okay, we want to overweight our portfolio towards sustainable companies," that'll drive up the price of those sustainable companies and drive down the expected return. That's not to say we don't want to do it, it is just to say it's not a free lunch. When you go out there and try to persuade management to behave in a different fashion by voting with your dollars, what you're going to do is affect the risk return trade off for those companies. So when you hear people say you can do well by doing good, don't believe them. That's quite different from saying you shouldn't do it. You should be willing to accept a lower expected return because you are doing something better for the world.

I think you and Professor Fama laid out the framework for that in your 2006 paper Disagreement, Tastes, and Asset Prices. And there's been quite a bit of empirical work by other people showing that that is actually happening as the popularity of these things grows.

Oh, that's interesting. I haven't seen the empirical work, I certainly have seen the paper. And I appreciate you mentioning it. It's one of my favorites partly because it's really easy to understand, it's just one picture that makes the point. The point is as people overweight these strategies, they're going to affect prices, and that will affect expected the returns and not in the way that the advocates argue. But that doesn't mean we shouldn't do it.

I think one of the trickiest things for people is that when the prices go up, meaning expected returns are lower, but people see the prices go up. And so you might have short term returns as the popularity of these things grow that look pretty good. And for someone who doesn't understand the things that we're talking about and asset pricing in general, that can be really confusing.

Exactly. Yes. As prices get bid up, you get a good performance out of that price being bid up. But the reason that we have lower expected returns is precisely because of the price got bid up. That's it exactly.

Fascinating. If we step back from asset pricing, which I think we've mostly been talking about so far and think about the governance of the underlying businesses like stocks of businesses, thinking about the governance. Do you think that the management of the businesses should be working for the shareholders or for all corporate stakeholders?

That's a hard question. For me, management should be working for the shareholders. And the reason I argue that, first, the shareholders are the people who's structured, set up the company. Everybody else is involved, but it's the shareholders who own the decision rights. And we'd have to take those decision rights from them if we said, "No, we want management to represent all stakeholders." Second management has to reflect what stakeholders want. Because for example, suppose management says we're going to make really horrible working environment. Well, in order to enable you to work there, you're going to have to pay them an enormous amount. What you'd like is the efficient trade-off between a nice working environment and compensation. Management should invest in working environment to the point where the marginal dollar produces exactly $1 reduction in the present value of compensation.

So management has to take into account what clients want, what consumers want. They have to take into account what the government wants, you better pay your taxes here. You can't ignore the demands of everybody else you interact with. So it's not as though I'm being totally cavalier in saying the only people management should care about are the stockholders. Management has to care about every partner that's out there in this relationship. But the owners, the shareholders, those are the people that management should represent. The other real argument for why management should focus on what the shareholders want. If you allow management to say, "No, no, we're going to represent all stakeholders." That is such an amorphous target. Management is going to be able to do anything they want. If they say, "Oh, we just want a cool company because we think that's what our stakeholders want," who's to say they're wrong? Or if they say, "We think our stakeholders would like us to have beer and music every Friday afternoon," who's to say they're wrong?

I mean, they maybe what maximizes the value of the firm, but that's what the shareholders would want. And if the shareholders want that, then great, maximize the value of the firm. And if that involves beer and music on Friday afternoons, so be it, but only if that's what's maximizing the value of the firm. Now, to be clear, I'm not saying we should go out and pollute or we should do other things that are other externalities bad for the world. I'm saying take account of all those externalities. And once you do that, what society wants us to do is to make the most value for society with the resources we use. If we can take resources that are worth $90 and turn them into something society values at $100, that's the best thing we can do for society, make the most value out of the resources we use.

So I have a totally separate question for you, and it's based on hearing you say at a number of presentations that you in fact have a financial advisor. And I'm curious what you find valuable about that relationship.

My relationship with my financial advisor is enormously valuable both to my wife and myself. I often say it's the most valuable check my wife writes, I don't write any of the checks. So it's the most valuable check my wife writes for lots and lots of reasons. I take care of the portfolio in terms of deciding what we want to do, but actually doing it, my financial advisor does that. My financial advisor is enormously helpful on dealing with our taxes, dealing with our estate planning, dealing with even what are we trying to accomplish with whatever wealth we do have? Helping us think through that, helping us think the charities we want to be involved with.

It's just somebody who can act as a sounding board for lots of the questions and lots of the issues and clarifying lots of the trade-offs that we encounter in lots of different dimensions of our lives. Interacting with lawyers. I mean, they're sort of a quarterback in a sense for a lot of the things that we have to do in our lives. And just having somebody take that off our plate is enormously helpful to us for a couple of reasons. One, it saves us time. But two, it saves us an enormous amount of anxiety. There's a lot of questions we wouldn't even know to ask without the help from our financial advisor. So that gives you some comfort being able to sleep at night knowing somebody else is worried about my problems. And there's a lot of them I don't have to worry about because they've taken care of it.

You talked earlier about the difference between expected outcomes and realized outcomes. And I think that that can make evaluating investment decisions really hard for some people. How do you evaluate your investment decisions?

Your question had the answer in it, which is when I think about the quality of the decisions I've made, I have spent most of my life studying empirical data. And what I know is volatility, the uncertainty, the unexpected part dominates most outcomes. Not all of them, but most outcomes in my life are dominated by the unexpected part. So when I want to judge, let's focus on investing because that's what I know well. When I want to judge the quality of an investment decision I've made, I don't pay much attention to the outcome. I pay attention to, did I make a good decision based on the information I had at the time? The outcome that's dominated by things I can't forecast. So it would be crazy for me to say, "Oh, great, look at this, I made a great decision," or, "oh, darn I made a stupid decision here." No.

Presumably I made a great decision based on the information I had when I made the decision. But the realization, what actually happens is going to be dominated in most situations by the part of the information I never had. The coronavirus, I keep coming back to that because it's dominating the news these days, but it doesn't dominate the way I evaluate my investment portfolio. I certainly regret the fact that I'm a lot poorer today than I was three weeks ago, that's too bad. But I don't say, "Oh, wow, how crazy could I have been to invest in that portfolio?" I look back and I say, "No, that was a perfectly sensible portfolio I had invested in three weeks ago. It's too bad that we got all these bad data over the course of the last three weeks."

It's not my fault, I didn't know anything. I don't have to excuse myself to anybody else, but I do have to look at myself and say, "Is there something I want to change here?" No, for my money, there's nothing I want to change here. And I try to extend that throughout my life. I try to evaluate all of my decisions in exactly that way. Did I make the best decision I could based on the information I had at the time I made the decision?

Yeah. Makes a lot of sense. Professor Ken French, this has been phenomenal. And I think I mentioned this at the onset too, we talk about your work and the work that you've done with Professor Fama as well on this podcast a ton. We use it a ton in making decisions like you just described. And so talking to you has been very special for us, I guess is the best way that I can describe it.

Well, that's very kind of you to say. Thank you, I've enjoyed the conversation.

It's been a privilege on behalf of our listeners. Thanks very much, Ken.