Angelica Montagano

January 21, 2021

EMH, Expected Returns, Factor Investing, Investor Behavior, Portfolio Theory

Episode 133: Adriana Robertson: "Passive" Investing, and What Matters to Investors

Angelica Montagano

January 21, 2021

EMH, Expected Returns, Factor Investing, Investor Behavior, Portfolio Theory

Adriana Robertson is the Honourable Justice Frank Iacobucci Chair in Capital Markets Regulation and an Associate Professor of Law and Finance (with tenure) at the University of Toronto Faculty of Law and Rotman School of Management. She is also the Head of Research & Policy at the Capital Markets Institute. Her research interests lie at the intersection of law and finance.

In the autumn quarter of 2019, Adriana was the Daniel R. Fischel and Sylvia M. Neil Distinguished Visiting Assistant Professor of Law at the University of Chicago Law School.

The terms passive investing and index investing are often intertwined, but they are not exactly the same thing. Today’s guest is Adriana Robertson, the Honourable Justice Frank Iacobucci Chair in Capital Markets Regulation and an associate professor of Law and Finance at the University of Toronto Faculty of Law and Rotman School of Management. Adriana is interested in index investing and, in this episode, we hear her views on whether or not index investing is passive. Hear facts from her paper on the S&P 500 Index fund specifically, and all of the reasons that it's not passive, as well as some of the issues that are potentially arising from the creation of so many indexes or so-called passive investments. A more recent paper by Adriana, published in The Journal of Finance, surveyed a representative sample of U.S. individual investors about how well leading academic theories describe their financial beliefs and decisions, and Adriana shares the differences in something like value growth from an academic perspective versus a real-world perspective. Find out how investors can go about evaluating the performance of their portfolios and what they should be looking for when deciding which index fund to invest in, as well as why index funds aren’t a meaningful category anyway, factors from Adriana’s surveys that might influence investor’s equity allocation, and the trend towards indexing and whether it will overtake active portfolios. Tune in today for all this and more!

Key Points From This Episode:

Whether or not it’s sensible to call the S&P 500 Index fund a passive investment. [0:03:20]
How discretion affects the S&P 500 Index constituents and performance. [0:04:14]
Adriana reflects on Tesla joining the S&P 500 Index and the speculation there. [0:04:49]
Adriana’s view of benchmarking and comparing other investments to the S&P 500. [0:05:34]
Why calling it rules-based investing rather than passive depends on the index. [0:07:35]
How investors can go about evaluating the performance of their portfolios. [0:04:14]
Why Adriana believes there are so many indexes and how they differ. [0:09:29]
Value growth from an academic perspective versus a real-world perspective. [0:11:28]
Why methodology differences between indices aren’t necessarily well-documented. [0:13:14]
The marketing strategies involved in fund managers creating affiliated versus bespoke indices. [0:14:50]
Common differences in index fund tracking and one-to-one mapping. [0:15:45]
What investors should be looking for when evaluating which index fund to invest in. [0:16:53]
Tilting towards factors versus using the market cap as the de facto benchmark. [0:18:19]
Why Adriana’s advice is to compare an investment to the other options available. [0:20:11]
Ex-ante versus ex-post and whether funds choosing a benchmark ex-post to inflate performance is a concern. [0:21:31]
Concerns over asset growth in index funds and why it’s not a meaningful category. [0:23:47]
Factors from the survey results of Adriana’s recent paper that might influence investor’s equity allocation. [0:26:16]
The results that were surprising to her, like the need for cash for routine expenses. [0:28:21]
Reasons there is still so much money invested in active funds – for example, a belief in higher returns and advisor recommendations. [0:29:57]
Notably, how equity allocation is reliant upon professional financial advice. [0:32:12]
Whether or not a year like 2020 will affect the asset allocation of investors. [0:35:17]
The trend towards indexing and whether it will overtake active portfolios. [0:37:02]
The implications of risk on the theoretical explanations for asset pricing anomalies. [0:39:00]
The role of professional financial advisors in high net worth investor’s decisions. [0:37:02]
How Adriana came to be so interested in and passionate about indexing. [0:44:49]
Adriana’s defines success by figuring out what she wants to doing it do it well. [0:47:24]

Read the Transcript:

It seems to us that the funds tracking in the S&P 500 Index have become synonymous with the broader concept of passive investing. Do you think it's sensible to call an S&P 500 Index fund a passive investment?

I don't. Not because there's anything wrong with the S&P 500 per se, just that I don't think the term passive investment has any real meaning, so I don't think it really makes sense to call anything passive investment. Passive implies somehow that it's divorced from decision-making, and that's not true. So indexes don't just fall out of the sky, somebody makes them, making them involves making all sorts of decisions, so if you decide to invest in such a way that you're tracking an index, any index, then somebody's still making investment decisions

In the S&P, you got a paper on this, which is why we're asking you about it? When you looked at the S&P 500, how much does discretion affect the index constituents and its performance?

It's hard to tell exactly, there's a whole bunch of different ways you could think about trying to measure discretion. I would say conservatively, at least 5%. Is that big or small? I guess I don't really know, but it's certainly not zero, and I think it's something that you probably should be thinking about when you're investing your life savings.

Great example we're living right now is Tesla where it was passed to be joining the index in September, but now it's joining in December. Any thoughts on that whole process?

Yeah. That was great because the way the index works is you've got a set of objective rules, and then that determines whether a company is eligible, and then the committee just has discretion to pick and choose from among the eligible companies. And so the moment Tesla passed that eligibility threshold in terms of profitability, the speculation went wild about when it would get added. And it dragged on for several months until finally, the decision was made that it would get at it. And not withstanding all of that speculation, I think the price still went up like nine, 10% in after hours trading that day. So it was still a surprise to people, even though there was a lot of attention being paid to it.

When you think about benchmarking, as opposed to talking about S&P 500 Index funds, the S&P 500 is used prolifically as a benchmark for actively managed funds, but also for other, like anything, any investment strategy you can think of gets compared to the S&P 500, do you think that's problematic?

I do. Again, not because I think there's anything wrong with the S&P 500 as an index, only because just as a matter of logic, any comparison between two things, A and B is as much about the B as it is about the A. And so if you want to compare any strategy to the S&P 500, that means that you're fundamentally comparing it to this one particular large cap portfolio that happens to be picked based on what the committee is doing. And that may or may not make sense depending on what else you would have done if you hadn't picked the strategy that you did pick. So if the outside option, the opportunity costs, we would call it an economics, that's what you're trying to capture with a benchmark.

Essentially, is the opportunity cost of your investment. And so if it's the case that, yeah, the other thing you would have done is invest in this one particular large cap portfolio, then by all means, it should be your benchmark. But if what you were going to do is otherwise invest in like a small cap growth portfolio, then that's what your benchmark should be.

So that's the S&P 500, and you did allude to index funds more generally as well, but if we broaden that scope to all index funds or even something like the CRSP 110 index, do you think it's in any case appropriate to call an index passive?

Well, I don't, because again, even if you're thinking about something as simple as, I'm going to take the 1000 largest companies in CRSP, as the last trading day of the prior year, pick the most mechanical thing you want, somebody still had to pick where to cut the line. There's still decision-making going on. Again, at the end of the day, it's just a matter of who's making the decision and how they go about making those decisions.

That's a really interesting way to think about it. If we said passive means that the index strictly follows a set of rules, so call rules based investing instead of indexing, I guess, where instead of passive, sorry, in that case, the index is actually follow consistent methodologies over time?

Well, so there, I guess the answer would be, it depends. It depends on the index. And so the S&P 500 changes its rules quite regularly. Again, there can be very good reasons for changing your rules, maybe it turns out that your old rules were bad, and so you want to improve on what you're doing, or they don't make sense anymore or whatever it is. But again, they do typically change with some regularity. And then of course you get into the question of, well, how do you go about deciding when to change them? Who gets a say? And so it can get quite complicated quite quickly.

If all indexes are managed portfolios, how should investors think about selecting which ones to evaluate your performance against?

I would say, unfortunately, what it means is that your life gets a little bit more complicated because when you're trying to evaluate how your portfolio did, you can't just grab some default benchmark, you have to actually think about what else you would have done, what the opportunity cost of that investment was. The real comparison ought to be something like, I was deciding between these five strategies or these five portfolio managers or whatever, and this is the one I picked and how did the other ones do? But that's obviously a lot more work than just looking up what the ETF that tracks the index that you were thinking of did.

One of the things that you document in your paper passive in name only is that there are a lot of indexes being used, both as benchmarks and as indexes to be tracked by index funds. Why do you think there are so many indexes?

I think increasingly what we're seeing, and this won't really comes as a surprise to anyone that follows this market closely, we have this paradigm that there's some index out there in the world, and index funds sort of go find that index, but increasingly what's going on is, somebody says, "I'd like to make an index fund with the following characteristics. Cameron, could you please make an index for me that has all those characteristics?" And so the number of indices in part reflects a demand in the market, I think, for index funds. And so it's reversing the direction that we have in mind in the paradigmatic sense.

So in other words, I think there's a lot of marketing behind it, and again, it's not that they just fall out of the sky this way.

So if this is really a demand-driven story, can you talk about how all these different indices differ from each other? For example, is every value index similar or different, small cap indices similar?

It's a little hard to say. If there's different ways you can think about comparing, say value indices to each other, one would be what they say they do, so, "These are the ways that we define value for the purposes of our index." Then of course, another way you could do it would be to run like a factor regression and see what the loading is on, say the value factor. Now, it turns out that no matter which way you do it, the answer to your question is no, they tend to be quite different. And value growth is actually a great example of that because, obviously, in the academic literature, we have a very clear and very consistent idea in mind when we talk about value growth.

Whereas it turns out, in a lot of the real world funds that I've looked at, or indices that I've looked at, they're defining particularly growth in ways that are very different from what I would have in mind.

Can you talk more about that?

Yeah. Often, they're referring to something looked more like momentum when they're talking about growth. So it might be the company has been going up in price, that sounds more like momentum than like growth. And that might also explain why in the past, back when the value factor was doing well, you might not want to take a negative value tilt, but if you take a positive momentum tilt, that could be a good thing maybe for your return. That's maybe a difficult thing to try these days, I don't know. Another thing that I noticed a lot of is, you see funds that market themselves using factors that aren't really recognized in the academic space quite so much.

And again, it's hard for me to classify those because it's not a recognized pricing factor that I could point to in the literature, but for whatever reason, it seems to be marketable.

That's fascinating. That's something that we've talked about quite a bit on this podcast, is the proliferation of factor funds that aren't really tracking any academic factors.

Maybe we're the crazy ones, maybe we just don't realize... And by the way, science is the same thing. Even if you just think about the most prominent size-based indices, so think of your Russell 1,000, 2000, and then the S&P 500, 400 and 600. Russell 1,000 is a large cap index, but it's got 1,000, which means it's going way further down the list than the S&P 500 large cap is. That's fine. There's nothing wrong with either of them, but even on something as simple as size, you're measuring things, you're stopping at different places. Neither one is necessarily wrong, they're not necessarily the same.

Is it easy to find these methodology differences out? Does every index have perfect documentation behind it?

No. The ones I just mentioned, the big ones, like the Russell's and the S&Ps, those ones are quite well documented. Not necessarily always perfect, although I think Russell is very, very good on average. But some of the other indices, especially the more specialized or bespoke ones, you might find like one double-sided piece of paper printed in like Calibri font describing what they're doing and that's about it. It's essentially impossible. Just like it would be impossible, based on a fund manager's description of their strategy, to back out exactly what they're doing. It's not really any different.

Do you think that with, and we have some more specific questions about affiliated indexes, which is the bespoke indexes that you mentioned earlier, but do you think with those types of products, are we just tending more toward traditional active management?

To me, it's very hard to see the difference between a portfolio manager saying, "This is basically, more or less how I'm going to pick the stocks that are going to go into your portfolio," which is what I would expect in active management. And an index saying, "Well, this is basically more or less how we construct our index." To me, the only real difference is, is the person doing the picking and choosing sitting at the fund level or sitting at the index level. But that's really just a matter of who the official employer is. It's not really functionally making a big difference.

It's really interesting though. Can you talk a little bit about why you think the fund managers may be creating these affiliated indexes or at least an entity that's very close to the fund manager creating a bespoke index? Why are we seeing so much of that?

One, and I can't prove this empirically, but my sense from talking to people who do this and just spending a lot of time thinking about it is, a lot of this is marketing. So if I want to create an ETF, what I'm going to do is just create the index so that my ETF can track it, and then now I can sell it as an ETF. And to the extent that there are investors out there that are specifically looking to buy ETFs, that opens up a whole segment of the market that I wouldn't have otherwise,

It's really crazy to think about, because indexing has become this buzzword in the financial media, and people may just be looking for that, but ending up with something closer to active management. When you look at index funds, are there common differences between an index fund tracking, for example the Russell 3000, and an index fund tracking one of the affiliated indexes?

Yeah. One of the biggest things is... And by the way, affiliated indices would be, I would say at least the far end of the spectrum where it's like, literally my right hand makes the index in my left hand tracks the index, and I'm going to call that passive. But there's a lot of space in between where you've got an index that's not necessarily created by an affiliate of the fund, but it's still a one-to-one mapping. And it's still a case that like, I went to Cameron and said, "Hey, Cameron, can you make this index?" You don't work for me or one of my affiliates, but it's still a special purpose index, it's made just for me.

And so in both cases, again, it's being created, it represents, essentially, the strategy of the fund. And so to think about that as anything other than the strategy of the fund is I think missing the real story.

Clearly there's been a massive increase in both the awareness of index funds and the usage of index funds, but given how similar many of these indices are, what do you think investors should be really digging into when they evaluate which one they should be investing in?

Yeah. Unfortunately, as I said on the outset, basically, I think index fund is a meaningless descriptor as a broad category of things. And so if you buy that, as I said, all it tells you is that the defacto portfolio manager is sitting at the index creator rather than at the fund. And so what that means then from an investor's perspective is, you need to evaluate this just as you would any other investment opportunities. Okay, well, this is helpful. At least I now know where the portfolio manager sits, but I'm still going to have to go investigate the strategy that they're going to employ. I still want to go and investigate the fee structure. I still want to go and investigate all the other things that I would normally investigate for any other opportunities.

I can't tell you how many times I've heard from people that they invest in an index funds and their portfolio is an S&P 500 Index fund.

Well, at least that's simple, it's only one thing to evaluate. I know so many people who, they don't even go that far, they just say, "Well, I'm in passive, I'm in index funds." And then I ask them, "What index or indices do your funds track?" And they just say, "Well, I don't know, it's the index."

It's an ETF.

It's an ETF. Exactly. And it's fine. Everybody knows that as long as you just buy ETFs, it's fine, they're going to be low fees, broadly diversified, nothing to worry about. That might be true, but you're going to have to go a little further than just saying it's an ETF or an index fund to get there.

But so much of it is, mutual fund's bad, ETF's good. It's often as simple as that.

Right. Which is of, course, maybe not always true. Maybe sometimes it's true.

Do you think, and full disclosure, this is a bit of a leading question because we believe people should tilt toward factors like the Fama French factors in portfolios. If the market index is effectively arbitrary, like if we're saying that there is no indexing and there is no passive, it's all arbitrary, do you think people should be thinking about tilting towards factors as opposed to just using the market cap as the defacto benchmark?

I think that is a more complicated question. I don't have a strong view about how people should invest their portfolios per se, because I think everybody's risk appetite is different and everybody has different objectives. I think I would be remiss as an academic economist, I'd have to go return my PhD if I said that you should invest in something that's not based on some kind of understanding of factors, whether that be just market beta or any other price factor, I mean, taking on a lot of idiosyncratic risk is probably not optimal, but I get a little bit anxious going any further than that just because people do have different objectives.

I'm thinking about what we were talking about regarding benchmarking and just the idea that if you're invested in a market beta and a market-cap-weighted index fund, should that even be your benchmark or should you be benchmarking against a portfolio that's tilted toward value or something like that? It's not obvious what the answer is.

Well, to me, the answer is just, what was the other thing you could have done and were most likely to have done, or the five other things you were most likely to have done? So if you picked your market-cap-weighted large cap, domestic equity portfolio, as opposed to a value-tilted option, then it makes total sense to compare it to that.

But then you also have a timeframe issue too, right? For example, the value factor has underperformed for the past three years significantly. So even though long term, that value factor may have a higher expected return, over the past three years, it hasn't. Then you get into the whole area of, is that then making an active decision in your comparison benchmark?

Absolutely. You have to be even more careful because when I say compare it to the other thing you would have done, that really means an ex-ante choice not an ex-post because anybody can pick something that makes you look good or bad, depending on your objective, ex-post. I mean, that clearly can't be the right comparison. That's like the old joke about the guy with the bow and arrow and the circles. "I'm not good at hitting things, I'm just good at painting."

From one of your papers on the concept of passive investing, I can't remember which one it was, but you talked about the funds and what you're saying about ex-post was just making me think about it, but funds picking a benchmark ex-post to make the fund performance look better. Do you think that's a big issue in the active management side?

It's hard to know, and it's hard to get data. You actually have to go and read all the prospectuses, which is rather time consuming. And I should say only research is US, not withstanding the fact that I live in Canada, just because. If you change your benchmark, you are required to disclose that. But again, query how carefully people are watching this. I think as a general matter, even just more broadly, the idea again, once you accept, or if you accept, that the right comparison is whatever else you would have done, well then, the outside option I had in mind is probably different from the outside option you had in mind.

And so the idea that there would be a common benchmark to a fund actually makes absolutely no sense. And so given that, the idea that fund gets to pick its benchmark, putting aside the problem there that they're picking something that's probably going to make them look good on average, it just a crazy idea that there's one common benchmark that we can all use, oh and by the way, more likely than not, it's the S&P 500.

I think one of the other data points from your paper that I found really interesting was that people are more, and I think this was you citing other research, but people are more likely to pick a fund that's done well relative to whatever benchmark has been selected for it to be compared to.

Even if you control the... I think the finding in the paper was really, you can match funds to what would be a better benchmark, a better comparator, because again, just so happens that funds tend to pick benchmarks that make them look good. But even controlling for how they did relative to what their benchmark ought to be, flows seem to track performance relative to self-chosen benchmark. So people do seem to pay attention to this, and kind of scary.

Yeah, that is terrifying. We have one more question on index funds more generally, and then we're going to move to your more recent research on a couple of fascinating surveys that you did. Your academic background is at this fascinating intersection of law and finance, which I think is pretty unique. I haven't seen a dual PhD like that from many people. So I want to ask a question about that. With the growth in assets in index funds, do you think that there were any issues from a corporate behavior or a stock market function perspective?

I'll say a little more sanguine about this than some other folks are, mostly because in my view again, index fund is not a meaningful category. And so to say that there's lots and lots of money in index funds tells me essentially nothing about who's controlling anything because those indices are doing all sorts of different things. So to the extent that you're worried, and I think this conversation, because it happens a lot in academia and in the popular press, to some extent as well, misses the fact that there's two different things going on here. There is the growth of the so-called Titans of Wall Street, or just The Big Three asset managers.

But if you're worried about The Big Three asset managers, BlackRock, Vanguard, and State Street, they have a ton of AUM that's not in index funds. So that's really not a story about indices, that's just a story about really large asset managers. So maybe you're worried about that. That's one story. And then there's a story about, well, more than half of AUM in domestic equities is now in so-called passive or index funds. And so we worry about that. But of course, then the question is, "Well, what are those indices actually doing? That's a very different problem to have in your mind.

I have not yet been persuaded that either of those two distinct things are really a problem, but it's certainly the case that both are huge changes in the capital markets and there is something to pay attention to. But no, I'm not terrified that it's going to destroy liquidity in the markets, or it's going to mean that we don't have price efficiency anymore, or corporate governance has gone out the window, none of those things, I think. I haven't seen any evidence to make me worry.

Interesting. And you're right, it does come up a lot in the media. All right. So you've recently had a paper in The Journal of Finance, which is very cool. And it was taking academic literature and comparing survey results from a nationally representative sample of US individuals to see how well academic theory is, and it's such a cool idea, how well leading academic theories describe how real people make financial decisions. So from the survey results, what factors did you find as most important to determining investors equity allocation? And how did that finding line up with what a rational economist might predict?

Yeah. AS you know, we've got all of these theories in the literature. And so what my co-author James Troy and I decided to do was, we would just like ask people what's important to them. And so some of the ones that Rose to the top were, and are, important theories in the academic literature, like rare disaster. So people worry about a crash and that's something that has both theoretical academic foundation and did really well in the survey. Some of the other ones that did really well are things like fixed cost of market participation. It turns out that about half of the people in our sample who have no equities say it's because, basically it's not worth it.

"I don't have enough money to invest, to make it worthwhile, to go and set up the brokerage account and figure out what to buy and all that. It's just not worth it for me." Other things are a number of years until retirement, was really important to people, risk of illness or injury. That risk of illness or injury, it's hard to square with a lot of the academic literature. But on the other hand, if you've talked to a human recently, it's probably not that surprising to you. And I think that's the biggest thing that came out of this was, if you try to explain this to like your mother-in-law, she's going to look at you, like, "Why are you surprised by this?"

But if you try to map it on to some of the academic literature, it doesn't always fit very well. And so that I think is the biggest thing that came out of it to me. That and the fact that, again, in the literature, in theory literature, we have this idea in our mind of the representative investor. And if we could just find which model accurately captures what the representative investor is doing, it's like one thing out there. And that's what it is. Again, if you've talked to a human, it's not going to surprise you so much when I tell you that turns out lots of things matter to different people.

Did any of the results jump out as surprising? Like you really didn't expect to see that?

So one of the ones, and again, the moment I take off my academic hat, you're going to laugh at me for being surprised by this. But one of the factors that we didn't even have in the original survey, because what we did was we did a pilot and at the end of the pilot, we said, "Is there anything else that's important that we haven't included?" It's revealed that I didn't expect to find this because we didn't even have it until people mentioned it in the pilot, is needing to have cash on hand for routine expenses. Because now you have an economist here, I'm like, "Well, everybody has a credit card and so it only takes like a couple of days to settle your trades. You can just use your credit card at the end of the month, you sell off whatever you need to pay things."

It turns out that's not how people think, people don't do that. I go, you're looking at me like I'm crazy for being surprised at this, but there's nothing in the literature that tells us that.

People love their bucket of safe cash, there's no doubt about that.

But you know what, it's particularly fascinating just in thinking about the past few podcast episodes that we've had. We had a couple of authors who recently released a book where they interviewed or actually asked a bunch of notable financial people to write how they invest their own money. And one of the things that they observed from the book was that people on average hold much higher cash balances than you would expect. So that you're finding lining up with that is just really, really interesting. I guess, not surprising, but fascinating.

Well, maybe it's surprising that it's surprising, maybe we just need to update like good Bayesians and stop being surprised by these things.

You also had some results that explain why there's still so much money invested in active funds. Can you talk about that?

Yeah. Obviously an interest. Well, there were two things that seem to be particularly important to this representative sample, belief that it's going to get higher returns. And so the way the question was asked, it was, active versus index funds or passive. Again, trying to use the language people are familiar with. And so it does seem to be largely belief in higher returns and advisor recommendations. So it turns out that people seem to be getting this suggestion and they're following it. And then we asked some follow up, we also asked about people's beliefs, and how much they agree with different factual statements, in particular, the very well-known Birken Green assumptions that drive that model.

The work in Green model basically says, "Well, you've got skill, and then you've got decreasing returns to size. So if really good managers get lots and lots of money, well, everybody's going to look the same in the end." And we found that in our sample, people do seem to believe that past success is evidence of skill, but they don't so much seem to believe in these decreasing returns to size, which is maybe a reason to think that active management is a good thing to do.

Unreal. You wouldn't expect, I don't think the representative sample to be able to cite the Birken Green paper. And it's not exactly intuitive, so it's not surprising, but it also is surprising.

My favorite thing, not surprising, but kind of surprising.

That is the best kind of thing. You had another somewhat similar paper. I read both of them, the one that we just talked about was in the journal of finance. The second one, has it been published?

It is currently, we have a revise and resubmit, so we've been asked to revise it for the Journal of Financial Economics. So fingers crossed that we can satisfy the editors and referees there.

So that's very exciting this one. And I don't know if it's just because we spend a lot of our time talking to high-net-worth investors. This one, there were a lot more things that jumped out at me is it's interesting to think about. In this second paper where you surveyed on a didn't explain what it is. You surveyed only people with over a million dollars in investible assets, which is different from the previous one, which was a representative sample of US investors, many of whom would not have had a million dollars in investible assets. Were there any major differences in the responses to the equity allocation question between the two samples?

Yeah. First of all, across the board, they were less likely to describe anything as being very or extremely important, and that could be due to different things. But if we just look ordinally relative to other factors, the biggest difference, I think, quite noticeably is the reliance on advice from professional financial advisors. So that was really disproportionately important to the high-net-worth individuals relative to the representative sample. They also tend to lean more on their own past experience. Those did very well in the high-net-worth sample and not particularly well in the representative sample.

So would those two reasons be the similar reason to the other group in terms of why they chose actively managed mutual funds or were there other differences?

It's interesting because when we asked the question about the mutual funds, both groups said that advisor recommendation was important for the active management. And we didn't phrase the question just to be, I guess, totally transparent. We phrased the question about the active management slightly differently to the high-net-worth samples. So for the representative sample, it was actively managed mutual funds, whereas in the high-net-worth sample, it was active strategies, just because it might not be a mutual fund, these folks might have access to different kinds of investment opportunities that probably wouldn't be available to random sample or representative sample.

But in any event, instead of conceptually quite similar, I think it's fair to compare them. And so in both, when we looked at that active strategy, roughly half do point to advise recommendations and a belief in higher returns, both still have this hedging demand, a substantial minority think that it's important, very or extremely important. And hedging demand story is basically, "Look, I think on average active management will underperform, but it will tend to do better in times when I really need the money. And so even though the average is a little lower, I still like it because when I want something and when the market tanks, the money will still be there. And so it's valuable to me."

But the biggest difference was that in both, again, going back to those Birken Green assumptions, a little under half believe the skill side, but the high-net-worth group is much more likely to believe in diminishing returns. So they do tend to believe that. Now, I don't know if that's, because they're more likely to have read the paper or if they have just had conversations with advisors who have explained this to them, or they just think about the financial markets a little bit differently.

It's so interesting to think about comparing the two samples. In the millionaire sample some of the factors that were really important to them in terms of how much they invest in stocks were related to personal experience living through market returns and rare disaster risk. And this year, 2020, obviously we've had some interesting cases of all of those things. Do you think that a year like this will affect the asset allocations of investors?

It's a really interesting question, especially given that if you'd asked me this question in, I guess, March when the market fell off a cliff, I would say, "Oh, it's bad." But now we're back up again. So it's a really weird year for that. There is literature. The reason we ask about the personal experience is because there is research showing that this does matter, so there's a paper by [inaudible] looking at people who lived through the Great Depression. And it turns out that that does have long-term effects on people's investing decision-making.

And so it would be really interesting to think about what this means for people going forward. And I've thought a lot about it in a totally speculative way, because on the one hand, the market dropped when the world fell apart, but then the market did really well. And now we're in this weird state of the world where anybody who had any equities has all sorts of money saved, more than they can spend. And then there's a huge segment of the population that's really, really struggling. So we've had this K-shaped results, and I'll be really interested to see what happens.

So if that protection from downside risk is one of the appealing reasons why the high-net-worth people would want to have an active fund, do you think that their drop around the pandemic is good for active portfolios going forward versus indexing? Might it slow down the trend towards indexing?

Well, it's hard to say because my understanding is it doesn't, I don't know, I haven't looked, but my cursory understanding is that active ones haven't outperformed and didn't outperform index funds in that drop. So to the extent that people had this belief and they were motivated by this belief that they wanted to buy these active funds because in these bad states of the world, they would be protected, and it turns out they were no more protected than the index funds, maybe not.

But does belief trump data, I guess that's the ultimate question?

Yup. And again, it turns out that for a lot of people, this crisis wasn't actually a crisis in the sense that their portfolios were doing better than ever.

And they're spending less and saving more.

Yeah. It's really odd. And they have nothing to spend money on. It's weird.

We had Lubos Pastor from the University of Chicago on the podcast not too long ago, and he did a paper on actively managed funds in the COVID-19 crisis and found yeah, not so good.

Yeah. It depends on the fund, it depends on the strategy. It doesn't look like this story about hedging, at least in this one particular crisis, it didn't go anywhere. But of course, the problem is we don't see a lot of crises. So this is like a sample size of one, and I was taught not to make too many inferences of anecdata like that.

It's a good lesson for everybody to hear. On the cross-section of stock returns, and I mentioned earlier that we think people should invest in factor tilted portfolios. And we talked quite a bit about that on this podcast, maybe more than we should, but our listeners like it. So you had some really interesting questions in the survey on that and the results were fascinating. So I want to ask you about that a little bit. One of the ones that jumped out was that for value stocks, for the high-net-worth sample, they believe that they're less risky and have lower expected returns than grow stocks, which is obviously the opposite of what the theory would suggest.

What do you think the implications are, and keeping in mind that this is a sample of high-net-worth investors who presumably control at least the sample that they're representative of, a significant amount of assets. Are there implications for the theoretical rational explanations for asset pricing anomalies, if all of these wealthy investors believe the opposite to be true?

Yeah. I've spent a lot of time trying to figure out what I think this means, and I don't know that I can give you a totally satisfying answer. Obviously, there is this dispute as to whether some of these factors are rational compensation for risk versus something a little bit more behavioral. At least my reading of the literature isn't a clear answer to that question. And so I guess one story is this is more consistent with the ladder, although of course, it's not dispositive because it could well be that these guys are not the marginal investor on that dimension. So they're not necessarily the ones setting price.

Although, you have to think they are, as you said, controlling a substantial fraction of wealth. And if you ask the high-net-worth individuals and they don't say anything, and then you ask the representative sample and they don't say anything, eventually, if you ask enough people, you run out of places to hide. I don't know where the marginal investor is, if I do this again, eventually, there's like, I'm down to the guy on the corner. There's another possibility though, of course, which is that what they have in mind when they think of value and growth is not necessarily what you and I have in mind when we talk about value and growth.

And that goes back a bit to what we were saying earlier about value and growth, the index fund and mutual fund level, even don't necessarily map so well onto the form of French-Value factor like HML. And so to the extent that they are answering a question with respect to what they think of when I say value or growth, then it could be that with respect to HML, they have slightly different beliefs, and they're answering with respect to the former, not the latter. Unfortunately, we can't disentangle those because we're asking about the conscious chain of reasoning as opposed to the underlying true beliefs.

Yeah. That's a really interesting point. If you ask somebody who's not studied finance, what risk is, they probably wouldn't say, the discount rate.

Well, and if you ask them what growth is, I think a lot of them would say it has something... Like what's a growth company. It's not totally crazy to say, well, it's a company that's been growing really faster than the average company. Well, that doesn't sound like what I think of when I think of growth, that actually sounds like momentum, maybe. So I don't want to be too hard on people. Finance can be quite counterintuitive.

Yeah, definitely. That result is fascinating though. Hopefully it doesn't disprove rational asset pricing, but it's very interesting.

What did you learn about the role of professional financial advisors in the decisions that high-net-worth investors are making?

Well, they certainly seem to listen to them or at least, again, they tell us that they listen to them. Why that is and why the high-net worth investors in particular or individuals, I should say, again, there's a couple of different stories you could tell. One is that there are fixed costs to hiring a professional financial advisor, and so it's only worth it if you've got a substantial amount of money. And so these guys listen to them because it's worth it for them to do so. Another story is it just has to do with access. So maybe these guys are just more sophisticated and it would be in everybody's interest, it wouldn't be a worthwhile even for the not so high net worth individuals to go out and work with a professional. They just don't.

There is a sense of what we refer to as finance phobia, just not liking to think about one's finances. And it turns out that in the representative sample, and you ask about why people don't invest, so this is a non-participation question, not liking to think about your finances is actually pretty prevalent. And so to the extent that there's some of that going on, even among people who do own some equities, they still don't want to think about it too much. This is me speculating a little bit beyond what I can show in the paper. It's possible that that's putting some people off as well.

It turns out not everybody is like the three of us and they don't just spend their spare time thinking about finance, they like go hide under the cushions when finance comes up

In this sample for the high-net-worth investors, were you able to tell if the advisors, which we know the high-net-worth investors rely on for advice, were you able to tell at all if they were doing a good job in terms of giving rational information to the investors?

I wish we could, we don't see the portfolios, so we don't actually know what these people are invested in. So we can't tell, A, if from any objective standard, the folks that say that advice from professionals is important, if their portfolios look somehow different, we just don't know. The most that I would infer that I would think you could reasonably infer is, well, if you're listening, if you think that this advice is important, then you're probably not too unhappy with what they're doing, otherwise, you probably wouldn't listen to them. And that's the best I can do on that question, unfortunately.

I would so love to have had the portfolios as well as their answers to these questions, but unfortunately, there are limitations.

Before our last question, I'm really curious, Adriana, how did you get so interested and passionate, quite frankly, in the world of indexing?

I started and mentioned, I do law and finance, and as you actually asked, there's been this explosion of literature about the rise of indexing and what it means for corporate governance, and what it means for corporate law and for securities markets, and all of this stuff that I spend my time thinking about and studying and researching. And so at one point a couple of years ago, I just said, "Well, gosh, these indices are so important, what did they come from? I better go find the paper that somebody must've written that's out there that will explain all of this to me, and then I'll be able to read it and then I'll know what's going on."

And I kept looking for this paper and I couldn't find it. And so eventually, I realized I was going to have to write it myself. And so I went down a bit of a rabbit hole where I read all of the prospectuses of all of the index funds in the United States and all of the methodologies of all of the indices that those funds were tracking, because to me, there's no substitute for actually getting into the weeds on some of these things. And that's something that, I think, is related to my law and finance. Finance we care a lot about doing things very systematically, but maybe not so much in actually reading underlying documents, that's not so much the specialty. Whereas getting into the nitty-gritty of documents is something that people in law do. And so I just did both and then just kept going from there.

But index funds are just so pervasive now that I think a lot of people just take them for granted, right?

It turns out not people that have asked me about it, only because they're like, "Oh my God, she won't shut up. Just don't say anything, you're going to trigger her."

What's your next, and again, because I just find your combination of the law and the finance so interesting. What's your next targeted area of research?

Well, stay tuned. I've got a few more projects intersecting with indices and other stuff, problem with empirical projects, of course, as you know there's a high failure rate. Sometimes you get interested in something and you look into it and you're like, "Oh, this is really cool." And then it turns out maybe there's nothing there, and then you go back to square one because after all, primarily what I care about is getting to the truth. And if there's nothing interesting there, then you just have to abandon the project and move on. So we'll see where it goes.

Our last question for you, we always finish with this one. How do you define success in your life?

I guess, I would say figuring out whatever it is that you want to be doing could be basically anything, but whatever that is, figure it out and then do it and do it in a way that you're proud of.