Benjamin Felix

October 17, 2018

Episode 16: Market Volatility

Benjamin Felix

October 17, 2018

Key Points From This Episode:

How bad was last week’s market volatility? [0:00:55]
Should you make changes to your portfolio in this market? [0:03:29]
Are people better at predicting when markets are volatile? [0:03:36]
How the market prices securities [0:04:00]
The economy vs. the stock market [0:04:20]
When do bear markets typically occur? [0:12:50]
Will passive investing exacerbate the next correction? [0:13:42]
Do index funds affect price discovery? [0:15:00]
The power of capitalism [0:19:10]
Index reconstitution [0:22:12]
Risk over the long-term [0:27:00]
Quant investing does not always pass robustness tests [0:27:00]
50% of business is marketing [0:29:55]
Devil’s in the HML details [0:31:58]
Dimensional has thought of everything [0:32:56]

Read the Transcript:

Ben Felix: This is the Rational Reminder Podcast, a weekly reality check on sensible investing and financial decision making for Canadians. We are hosted by me, Benjamin Felix, and Cameron Passmore.

Welcome to episode 16 of the Rational Reminder Podcast. We are back in Ottawa, Cameron and I, we're back in Ottawa after spending most of last week in Chicago for the Dimensional Fund Advisors Advanced Conference 2018. We did record an episode from Chicago with PWL's president, Brenda Bartlett. The audio wasn't great for that episodes so if you did listen to it, sorry about the sound quality. But we decided to publish it anyway, because I guess we had some good energy from being at the conference and we thought it was a good discussion.

Cameron Passmore: And we learned something about podcasting.

Ben Felix: We learned something about podcasting outside of our little studio that we have here. The other thing that happened last week while we were away was that the market was pretty volatile. It took a bit of a... What day of the week was it that it took most of that dip?

Cameron Passmore: Thursday was the bad day, I think.

Ben Felix: Yeah, so Thursday.

Cameron Passmore: Wednesday and Thursday was down 1,300 points or so on the Dow. It's funny, I look back over the years I've been going to that conference and it seems that that has happened, this is anecdotal of course, but that has happened often in the past where we're sitting at this conference watching and waiting for people like Professor Fama to give his feedback on what's really going on in the markets.

Ben Felix: Remember you talked about a couple of episodes ago, how October is not really that bad historically?

Cameron Passmore: No, I know. That's the data. That's why I say it's anecdotally.

Ben Felix: And here we are. So last week, the Russell 3000, the US market index was down 4.22% for the week. So I looked at all of the weekly returns going back to January 2010 for the Russell 3000, just to see how bad that actually was in the recent history, and it was the 13th worst week going back to January 2010. So out of 458 weeks, it was the 13th worst, which is, I don't know, bad I guess.

Cameron Passmore: Kind of bad, but I was looking at a chart this morning and I think the S&P 500 is back to where we were sometime mid July.

Ben Felix: I believe that.

Cameron Passmore: More or less.

Ben Felix: I believe that.

Cameron Passmore: And I think we're up still for the year 5% on the S&P, so a little bit of context. And I know Michael Batnick did that YouTube video last week with Reformed Broker. They were talking about how some of these big stocks, some of the FANG stocks have had huge drops. But it brings it back to where they were only a few months ago and they're still up 50% or 70% for the year.

Ben Felix: Yeah, unless you just bought.

Cameron Passmore: Well, yeah. Of course if you just bought, you're not happy being down 25%, 30% or 35%.

Ben Felix: Yeah. MSCI international plus emerging markets. It had its 22 worst week of the last 458, so again, not that spectacular. And the Canadian index had its 23rd worst week out of 458 weeks. So yet again, nothing to see here really.

Cameron Passmore: So how many concerned emails and phone calls did you get last week?

Ben Felix: Concerned, not a single one. I got one email from a client saying basically, "Yep, volatility. I'm ready for it." Just a reaffirmation of their own non concern, I guess.

Cameron Passmore: I've had a few people comment that their portfolios, because let's face it, a 60/40 portfolio so far this year has not had a great year.

Ben Felix: It's down 2% or something, right?

Cameron Passmore: Down a little bit, it was up a percent or two a few weeks ago, so it's in that range of flattish. And a couple of people were wondering, "What's going on? Should we change our strategy?" I would imagine their views have changed perhaps a bit with last week's drop.

Ben Felix: I got that question once actually. Yeah. And this is not from last week, but just for this year, I have had the question, "Do we need to make any changes?"

Cameron Passmore: But people know the portfolios are all being rebalanced automatically. This is the beauty of this philosophy, is that it's automatically based on the price of things picking up different parts of the market, different asset classes that may be cheaper. So it's not like we're just closing our eyes and hoping things will be okay. Stuff is happening all the time inside the portfolios.

Ben Felix: And it's maybe tough for investor to see too, because we're in this funny market where interest rates have been rising because the economy is very good, but stock markets haven't been that good. So you get rising rates, which is causing bond returns to be negative or low, while stocks are also not great, despite good economic data. So it is a funny market so far this year, but obviously can't predict what's going to happen next, so you just maintain the asset allocation that's right for you all the time.

Cameron Passmore: And if you look at the potential outcomes, the expected returns, this is not abnormal historically speaking.

Ben Felix: No. I've had a couple of interesting emails where people have said things like, "We were trying to decide between paying off some debt or adding some cash we have to the portfolio, and because markets have been bad, we're going to pay off the debt."

Cameron Passmore: That's backwards.

Ben Felix: It's Backwards. I explained that. And when I had those interactions when markets have gone down or markets are volatile, that's when your expected return is higher. So that's actually a better time to invest. But in both cases I said, "Paying off debt makes more sense." Anyway, as we've been discussing for the last little while, paying off debt.

Cameron Passmore: So I think we both highlighted a tweet from Paul Krugman, who's a Nobel prize winning economist.

Ben Felix: Well, I think around the time markets started to get volatile, like they were last week. A lot of people start... I mean, people are doing this all the time, but especially in periods of volatility, people start coming out and saying, "This is what's happening. And this is what you should do." And Krugman had an awesome tweet. So he's a Nobel prize winning economist, so maybe his opinion is worth something. But he said, "For inquiring minds, why did the market suddenly plunge? I have no idea. Will it keep going down or bounce back? I have no idea. Is this going to translate into problems for the real economy? I have no idea. But what you need to know, is nobody else has any idea either." Which I do think is extremely important, because wherever you... I feel like it's especially bad in Canada.

In the US you have guys like Josh Brown, who's actually on television, he's on there talking about things that are rational. In Canada, at least when I look, if you look at Globe, Toronto Star, Financial Post, it's all prediction based active stuff. You're not going to go to any of those Canadian... But well, Global Mail maybe a little bit with guys like Rob Kerrick, MoneySense is pretty good, obviously with Dan, but a lot of the big financial publications in Canada it's all prediction based stuff.

Cameron Passmore: And that fuels the fear where you think you have to do something, because when the market does fall like that, it is scary. So that fear hits your brain and you want to do something to take that fear away. It's human nature.

Ben Felix: Yeah. And even if someone did know exactly what was going on in the economy, if someone is able to say, "It's this thing that is causing volatility to happen." That person still doesn't know how the market's going to be tomorrow. And nobody does know that, nobody has that perfect economic insight. But if somebody did, it still doesn't mean they can predict what's going to happen, how the market's going to react to that information. Fama talked about, I guess, talked about this in a way when we saw him speak last week. But he reminded the room that prices move due to changes in expected earnings. So how the market perceives the expectation for future earnings-

Cameron Passmore: Which is the fundamental stuff.

Ben Felix: Right. Fundamentals. And investors appetite to pay for them. So if your discount rate goes up, because you see the market as riskier, that discounts the price of stocks lower. So it's those two things that really are what affect stock prices. So if we see a plunge, it could mean, I guess one of two things from Fama's perspective, the market believes future earnings are going to be low, which maybe seems unlikely based on the economic data that's been coming out this year, it's been very strong. Or the market is saying, "Well, these future cash flows are now riskier for whatever reason." So maybe that's what's happening. Maybe the market is pricing in-

Cameron Passmore: Or people just start getting scared. [crosstalk 00:00:08:19].

Ben Felix: Which is the risk, right? That's their-

Cameron Passmore: Their appetite for risk may change.

Ben Felix: That's the discount rate increasing. Whether they believe they're selling blindly or not, if they're selling it's because their discount rate has gone up.

Cameron Passmore: But I think a lot of people are getting smarter. Perhaps you're right in the US given the appetite for index funds in the US, but if go in the index route, you self-selected yourself. You're in this efficient market belief structure. A lot of them are actively traded, but I think more and more people are getting it.

Ben Felix: Maybe, but there's other stuff too. Like we think about how much money is institutional versus retail. And you think about all the money that's still in active mutual funds in Canada, that's still the vast majority of Canadian fund assets. And you think about the mutual fund managers, put yourselves in one of their shoes, they've got massive career risks. I was listening to Howard Marks on a podcast recently, he's got a new book out, I guess, doing the podcast.

Cameron Passmore: That's a lot of different podcasts now.

Ben Felix: Interesting guy to listen to. He is continuing to be a very successful investor in distressed debt. So he's had a fantastic career in terms of his returns, who knows if that's luck or skill, obviously a different conversation. Don't let him hear me say that. I wouldn't want to debate with him whether he's been lucky or skilled.

Cameron Passmore: He talks about trends, right? He's a big trend follower.

Ben Felix: He's a big trend follower. But the thing I wanted to mention is that he talks about Warren Buffet, and he says in his book, one of the things he talks about, is why Buffet has been so successful. I think it was in his book. But he says that one of the reasons Buffet's been so successful is because he doesn't work for anyone. So he can take bets. He can do stuff that other people might not think is a good idea. But you think about active mutual fund managers, where there's a ton of money invested, and they have to do stuff. They have to be doing stuff, and they have to be doing stuff that their investors will see as potentially a good decision.

Cameron Passmore: Because you have to be different.

Ben Felix: Have to be different from the market, but don't want to be too different from the other active managers and be wrong.

Cameron Passmore: But it's such a fiercely competitive market, you have to be different.

Ben Felix: You have to try to be different, then we get into the discussion of closet indexers, which aren't different, but they're still charging active fees. That's a whole other topic. I mentioned strong economic data out of the US, I was looking for an edit report from FactSet on Q3 earnings. And they called it blended earnings, so I guess it's a combination of estimates from companies that haven't released yet, and the actual earnings of companies that have released. But they said the earnings of S&P 500 companies have increased 17% so far this year. So a huge increase in actual earnings, so that's actual economic data companies are doing well. And they also talked about how profit margins are very high and have been increasing, which is potentially due to the big companies like Apple and Amazon, which we know to be... Amazon's not super profitable, right? They've got tight margins.

Cameron Passmore: Yeah. I think pretty tight margins. But anecdotally, I mean, Chicago was booming last week. I was there on the weekend, the weather was good, but the restaurants, and these are pretty nice restaurants, are jammed. Every place we went was jammed.

Ben Felix: I noticed that too.

Cameron Passmore: And the prices in restaurants are unbelievable.

Ben Felix: Everyone's wearing a suit too.

Cameron Passmore: Everyone looks good, they're eating fancy food. It was quite something to see. Maybe we're in a little bubble there perhaps, but boy, they're sure spending the money.

Ben Felix: You told me a story on the opposite side of anecdotes, about in '08, when I guess we had one client who pulled his money, and it was after a trip to the US. Do you remember that story?

Cameron Passmore: I'm racking my brain. No, I don't.

Ben Felix: You told me a story that it was a client who was visiting, I don't remember what city in the US, but they were walking down the street and it was just vacant, vacant, vacant. All of the buildings were vacant and they called you and said they wanted to go to cash.

Cameron Passmore: There's a number of people like that, a number of stories like that, so not surprising.

Ben Felix: Yep. So when things are really good, obviously then people start to get concerned of, "Are we at a top? Earnings are so strong, returns haven't been that strong. What does that mean for the future?" And obviously we have no idea really, but historically we can look at when the S&P 500 has reached peak earnings, because obviously we know in hindsight when that was.

Cameron Passmore: But even think back to when the election was on in the US. Go find me someone if you had told them that you knew Trump was going to win, that they would want to buy stocks.

Ben Felix: There are people that wanted to pull out.

Cameron Passmore: That's my point. I mean, that was a long shot prediction at best. Even after you knew that, people were not in a rush to buy. I mean, who would have thought this could turn out like this economically?

Ben Felix: Yep. And a lot of that growth I think is due to the tax cuts, not all of it, but I think some of it like that is helping the US economy. Obviously there are other implications of that, but whatever. We're not talking about that right now. So historically about 75% of bear markets in the US have occurred during economic recessions, which obviously we're not in right now with earnings where they are. And returns have remained positive until about six months before the recession. So I mean, I guess it's just another way of saying that you can't time the market. That's that Peter Lynch quote, I'm going to mess it up, but something along the lines of, "More money has been lost trying to prepare for corrections than been lost in corrections themselves."

Cameron Passmore: And speaking on the prediction in front. So we had a listener sent in an article this week and wanted us to chat about it. So it was an article that was in Forbes Magazine written by John Mauldin. The title was, With This Extent of Passive Investing, Even a Minor Correction Will Be Disastrous. So John Mauldin is, some people would call him a permabear. And the basic premise of the article is that because so many people are buying the indexes, that when they start to fall, people just blindly sell. And since they didn't do any research at all going in, they didn't to do no research on the way out and just want to get out at any price.

We both read the article. It's loaded with statements that are very prediction, opinion charged, as opposed to fact-based.

Ben Felix: What were your favorites?

Cameron Passmore: So some of the ones I liked, so things like passive investing is taking market distortions to new extremes. Or here's another one, we've created this environment in which badly managed companies can still see their stock prices rise along with those of well-managed companies. Another one, in this environment even a minor correction may be disastrous for stocks.

Ben Felix: Yep. Lots of opinion and hyperbole. I agree.

Cameron Passmore: But it's just loaded with opinion that certainly encourages people to take action.

Ben Felix: Well, you think about what he's basically saying with those comments, he's basically saying that because of index funds, market prices are wrong, because they're forced to buy a large amount of the largest stocks. Which means that the prices are pushed up artificially, even if they shouldn't be, even if that's not justified. I mean, it's the classic story of index funds effecting price discovery, which has been debunked on multiple levels.

Cameron Passmore: I think we talked about that a few weeks ago. It's a very small part of overall trading. It's still the active managers setting price. You can make the argument it's the index funds providing liquidity of shares to active managers who want them.

Ben Felix: It's one of my favorite charts that I've seen recently as Vanguard had a chart out, showing that index funds make up about 1.3% of annual trading volume. So yes, index funds are growing in terms of assets under management, but in terms of actual trading that is going on, and keeping in mind that trading is what sets prices, that is the mechanism that allows prices to be set on the market in a liquid market. And 1.3% of that trading is done by index funds.

Cameron Passmore: Crazy.

Ben Felix: So even if index funds are blindly buying and they have no idea what they're doing, which I guess is true, they're not the ones trading. So it doesn't matter.

Cameron Passmore: Most passive investors, if you go by the definition of passive, are largely accumulating, so they buy and hold.

Ben Felix: Sure. The other thing we have to remember is that anyone investing in an index fund is not necessarily a passive investor.

Cameron Passmore: For sure.

Ben Felix: Like some of them I'm sure, I don't have the data on it, but I'm sure there are tons and tons of people who are actively trading ETFs. Which again, even if indexing was a larger percentage of trading, which it's not, but let's say it was, let's say it was 80% of trading or something like that, you still have people using ETFs actively. Which is still participating in price.

Cameron Passmore: And even when you buy an index ETF, I mean, this is the point of the article. You buy an index ETF, they have to go and create this ETF by picking up the shares in the market, so there's a seller on the other side. So there's price discovery there as well, someone's willing to let them go at that price.

Ben Felix: Yeah. There's somebody on the other side of every trade. Yeah. Always important things to remember.

Cameron Passmore: I got a kick. I did a quick Google search this morning to see what other predictions has he made. So there's one going back to February of-

Ben Felix: This is from the same author?

Cameron Passmore: Same author.

Ben Felix: Okay.

Cameron Passmore: So the same John Mauldin made this prediction back February 2009, which in hindsight may have been the best buying opportunity of certainly my lifetime. But here's the prediction. “Let me reiterate my continued warning. This is not a market you want to buy and hold from today's level. This is just far too precarious an economic and earnings environment.” Which may be legitimate opinion at that point, but you look back, we've had the best decade since then. Unbelievable.

Ben Felix: Yeah. You can have very well-informed, intelligent opinions on what's going on in the world. It's what we were talking about earlier in this episode, no matter how smart you are and how well you understand what's happening, it means very little for what's going to happen in the financial markets and your ability to predict financial markets. I mean, I've seen studies on, I wish I had the data in front of me, but I've seen studies on the ability of economists to predict even the economy, and it's horrible. Worse than flipping a coin. Listening to an economist is worse than flipping a coin in terms of what's going to happen in the future.

Cameron Passmore: That's because you don't know how other market participants are going to react to the information. Let me give the example of the pencil example we had last week? Was it Samuelson who gave that presentation? Or was it Miller?

Ben Felix: No. I don't remember who it was.

Cameron Passmore: Anyway we can clarify for next week, but it's a presentation made by one of the academics-

Ben Felix: Was it Friedman? Or was it Samuelson? I think it was Samuelson.

Cameron Passmore: It's a video that goes back-

Ben Felix: It's a great video.

Cameron Passmore:... 30, 40, 50 years perhaps. And basically said to make a pencil takes so many different people from around the world to mine the lead, to grow the wood, harvest the wood, make the paint, stamp the letters, get the rubber for the eraser, and they come together. So you have all these market participants that come together to make a simple pencil. You take that to every other product around the world, it takes us so much energy and efficiency to pull that off.

Ben Felix: But he talks about how the shared idea of capitalism is what allows that to happen. I mean, he takes it to an extreme and says that capitalism is... I can't remember the words they used, but it's like the mechanism of peace and harmony around the world. Kind of a funny thing to hear, but I mean, it's true.

Cameron Passmore: Enabled a pencil.

Ben Felix: I'm reading this book called Sapiens, it's like a brief history of humankind, of homo sapiens. And it talks a lot about that, about these shared ideas that humans have, like it's been in the past, things like religion and belief in different deities and things like that, that's allowed homo sapiens to organize in large numbers, which we're the first species that can do that. They've been species that can organize in small numbers, and even the Neanderthals were able to organize in small numbers, but homo sapiens is the first species that's able to organize an extremely large numbers based on a shared belief. When the author talks about it as being these imagined things, religion being one. That's not my opinion, it's the author's opinion, religion being one of these imagined things. But he also talks about how capitalism and belief in capitalism is, I mean, it's the fabric of our societies. Our whole culture is built around capitalism. And in the pencil video he's absolutely right. It is true that the world is able to cooperate and work together peacefully based on a shared belief in capitalism.

Cameron Passmore: Especially when you look at the products that make that pencil come from different countries, different environments, different-

Ben Felix: Different cultures.

Cameron Passmore:... regulations, different cultures.

Ben Felix: Yeah. Everyone organizes around capitalism, really is amazing stuff.

Cameron Passmore: So what else did you take out of Chicago?

Ben Felix: So we talked a little bit about Marlina Lee in our last episode. She’s the co-head of research at Dimensional. She's very impressive. So she did her MBA. I don't know if she finished her PhD yet.

Cameron Passmore: She was Fama's TA, right? At one point?

Ben Felix: Yeah. Yeah. But I think she said that she did the same thing as David Booth, where she was studying under Fama and told him, I think she said... I don't know if she finished her PhD because I think she told me that she decided not to finish it and told Fama that, so he hooked her up with Dimensional. And I mean, she must've been his top student for him to do that. But she's very impressive and very relatable. Like when we had dinner, I guess I didn't really know what to expect, but she was just a regular person. I guess that's everybody is. But she was just able to carry on a regular conversation about kids and family and stuff like that, but then as soon as you flip the switch to asking you a question about capital markets or portfolio management, it's like-

Cameron Passmore: She's the real deal.

Ben Felix: Yeah. It's like the Incredible Hulk.

Cameron Passmore: And they had 80 researchers in that group? Largely PhDs I believe.

Ben Felix: It wasn't largely, there were... I can't remember what the number was, 20 PhDs or something like that.

Cameron Passmore: From all kinds of different backgrounds too, right?

Ben Felix: All different disciplines, yeah.

Cameron Passmore: Rocket science, engineering, mathematics, economics, finance.

Ben Felix: It sounds like a fascinating place to be. I mean, even just being around all the Dimensional people, they're all... Even the guy that gave us the talk on the history of the University of Chicago, he's a Stanford graduate. They're all super impressive people. Anyway, a bit of a digression there. So Marlina Lee spoke to the group for two full hours on Friday. And lots of good takeaways there. To be honest, it was a lot of stuff that we've maybe heard before, just because Marlina published a lot of papers. And when you read the papers, you pick up the talking points that she has. But interesting to hear speaking none the less. One of the things that she talked about, which we've known for a long time to be one of the big benefits of Dimensional, is that index funds, when you're tracking a third party index, the index reconstitutes depending on the index, it may reconstitute quarterly or sometimes it's annually. But as soon as an index reconstitutes, the index funds have to match the index, because their job is to reduce tracking error.

So what happens is the index provider announces reconstitution, shows the reconstitution list or the reconstituted index-

Cameron Passmore: And the weightings.

Ben Felix: And the weightings. And then the next day all the funds have to trade. So you get prices being pushed up as everyone's buying the same securities, and then on the other side, prices being pushed down as everyone's kicking their securities out of the portfolio.

Cameron Passmore: But their mandate is to match-

Ben Felix: They got to match the index.

Cameron Passmore:... which is zero tracking error, it's called. They have to track the underlying index set by Russell or S&P or who be it.

Ben Felix: And I don't remember that Dimensional, I've seen the data point in the past where they've estimated the cost of reconstitution from an index funds that have to track an index. I don't remember what the data point was, but it was a meaningful amount. Yeah. So having that reiterated was interesting. And then same thing for active funds obviously. Even more extreme though, if the analyst says, "We need to buy this company." And the portfolio manager says, "Okay, we need to put a million dollars into this stock right now." It's the same thing but more extreme, where you're going to move the price. But if the stock is trading at $10 and the analyst is saying, it's worth $15, you don't care if you push the price up a couple of bucks, because you're still getting, in your eyes, a great deal.

Cameron Passmore: I was quite taken by the amount of data that is actually going through. I think we had the presentation this summer from Apola talking about how it's the largest set of data in the world, I believe that's what he said. Every night they said they upload 1500 data points for over 15,000 securities around the world. So that's 22 million data points a night come into their system for analysis. And the research group does what they do on this data, but also reviewing other published peer reviewed papers to come up with the strategies that the frontline portfolio managers will use.

Ben Felix: And corporate finance announcements, they're not just taking the raw data, they're taking the data and then they've got an overlay where if something's happened like an announcement of a merger or an acquisition that would affect the straight hard data metrics, then they're taking that into account before they make any portfolio decisions. Everything that they're doing is to minimize trading while maximizing exposure to the factors of higher expected returns.

Cameron Passmore: Right. So some companies post different types of expenses differently.

Ben Felix: Or they talked about-

Cameron Passmore: Or that the balance sheet items differently. So they have to go and reenter them under the proper format, given the papers that they will have followed.

Ben Felix: Yeah. I think they had-

Cameron Passmore: To make the data better.

Ben Felix: It's if a company discloses a non-recurring expense on their income statement, if they disclose the same nonrecurring expense multiple times-

Cameron Passmore: That was it.

Ben Felix:... then Dimensional will say, "Well, hey, this is not a non-recurring expense." And then they'll take that into account when they're determining, I guess that'll be for profitability.

Cameron Passmore: It's all about making better data.

Ben Felix: Yeah. Yeah. No, that was really interesting stuff. We also talked about the interaction between different factors. So for example, if you decided that you were going to target only high profitability stocks, then you end up with a large cap portfolio, because the large cap stocks tend to be the most profitable. Obviously we know that small cap stocks have higher expected returns than large cap stocks, so if you only focus on one factor at a time, you end up with these wacky portfolios that actually lower your expected returns. So they talked a lot about them and Marlina talked a lot about how they manage the different factors together to target the higher expected returns without ending up with some wacky result. So I guess there is, to some extent, some subjective overlay, just to determine how much small do we want, versus how much profitability are we willing to give up.

Cameron Passmore: Yeah. Subjective and sensible. And that goes back to what Fama was saying about different risks that science won't necessarily pick up on the Thursday session we talked about last week. So it's the cross-section of science and robustness in the portfolios.

Ben Felix: It's worth revisiting. I know we talked about it in the last episode, but maybe not everybody heard it. When Fama was asked about risk over long periods of time, and he laughed and said, "Yeah, you've got a lower probability of negative outcome, but the magnitude of those negative outcomes gets larger over time." So yes, you've got a lower probability of having a negative outcome, but if you end up with a negative outcome, it's bigger over longer periods of time, which is what you would expect with compounding. But anyway, one of the last things that I wanted to chat about today was Marlina talked about other firms that are doing somewhat similar research to Dimensional. And there are two main competitors who we don't hear too much from in Canada, just because they don't have, and I don't think AQR has a presence at all.

Cameron Passmore: Nope.

Ben Felix: And RAFI, so that's the research affiliates who has the fundamental indexing. They do have some Canadian products, but they're not big. I've never once heard about them other than me doing my own research, but no client has ever asked about R. So anyway, Marlina had talked about the other firms that are doing different types of research and coming to different conclusions. And you think about RAFI, their fundamental indexing strategy is based on the principle that markets are not efficient. So they use what are called economic factors. So stuff like sales or number of employees, where they're basically trying to find undervalued companies. But Marlina showed regressions for both RAFI and also for some other products. Actually I don't think she named the indexes. But anyway, she showed... They're just called a fundamental indexing. But they talked about all these different strategies that end up being just a repackaging of the factors that we already know about.

And I wrote a post about this a few weeks ago, with RAFI for example, you end up with a value, maybe a profitability tilt. But the problem is, and Marlina showed this, if you look at different time periods, so you'd chunk out four years, four years or whatever it is, you don't get consistent exposure to the factors. Which is what you'd expect, because you're not targeting them, you're targeting something else. So what I called it in my blog post was naive factor exposure. But then the question Marlina poses is, "If you're going to target factors by accident, why don't you just target them on purpose?" It doesn't make a lot of sense. AQR comes out with a ton of really good research. And it's one of the firms where I read their stuff, and every now and then it makes me question, "Huh? I wonder if DFA's thought of that." Or Dimensional Intellect being called DFA. "I wonder if Dimensional's thought of that."

Ben Felix: And as I learned from talking to Marlina, yes, they have thought of that. Whatever it is. And Fama had some interesting comments about AQR as well, where someone asked a question about AQR and he laughed and said, "You know they're all my students, right?" Which was funny. But Marlina talked about this too, where everyone's got access to the same data, Dimensional, AQR, RAFI, whoever it is, the data's there. They're third-party data providers, everybody can pay to have access to them. And Fama's comment about these competitors like AQR and RAFI, he said 50% of business is marketing.

Cameron Passmore: So they have to be different. You have to insulate yourself from someone like Dimensional.

Ben Felix: No one's going to come into Dimensional's territory and just say, "Well, hey, we're going to implement small cap value strategies." Because Dimensional's so good at that. And they've been doing it for such a long time. So you have to do something different if you want to compete in the factor space. So then you get companies like RAFI who are taking a totally different approach saying, "Well, we don't believe markets are efficient. Here's a different way to approach it." And then you get companies like AQR who are still taking the efficient market's view, but they're... I don't know what you'd call it. Marlina was very careful not to say that they're doing data mining, but they're taking the data to a different level, and maybe drawing some insights that Dimensional wouldn't agree with, and then putting that into products.

I read an article, I haven't actually read the article, I read a headline about how AQR has really struggled this year. So I don't know whatever that means. But anyway, the way Marlina, the analogy that she gave is that Dimensional is like a diet pill where if it works, you're going get pretty good outcome, but if it doesn't work, you're going to be okay. And then she said more extreme strategies, like if you're doing a momentum strategy, which a lot of companies are promoting. Momentum's been extremely volatile. There's no sensible explanation for it so we don't know if it's going to continue. It's expensive to implement, so she compared that to a cancer drug, where if you take that and it doesn't work, you're actually going to be in trouble, unlike the diet pill where you're still going to be okay.

Ben Felix: So that was all interesting to hear their perspectives on other companies that are trying to do similar strategies. And I do want to mention one more thing about AQR. So one of the most interesting papers they've published that really made me think... I don't remember the name of the paper, actually it was Devils in the HML Details or something like that. But AQR basically said that when Fama and French defined HML, which is high minus low, that's the academic definition of the value factor, Fama and French used lagged price and lagged book value. So they took the price and the book value from six months ago, and they used that data to form the value portfolio today. And then they did the research on that value portfolio. And in the AQR paper, they say that it doesn't make any sense to lag price. It makes sense to lag book, because we don't always have up-to-date books value, but it doesn't make sense to lag price.

Cameron Passmore: [crosstalk] doesn't change as much either.

Ben Felix: Sure. But it doesn't make sense to lag price because we have price. We have price every single day. And I was like, "Geez, that makes a lot of sense." And AQR in the paper, they show that if you actually define value this way, you get way better results. So I'm like, "Man, I wonder if Dimensional's thought about that." So I asked Marlina about it and her answer, I mean, it blew me away really. But she said, "Yeah. Of course we know about that, but when you don't lag price, you end up with momentum effect." So if you use current price to form a value portfolio today, you'll end up with momentum, because stocks that, I guess recently became value stocks are being added to the portfolio.

Cameron Passmore: Price will change recently.

Ben Felix: Right. So I though, "Okay. That makes a lot of sense." So in portfolios, what Dimensional does is they use the Fama French lagged price in book, but they take momentum into account.

Cameron Passmore: On the trading side, because the momentum is a short-term factor, I guess you could say dimension.

Ben Felix: [crosstalk].

Cameron Passmore: With value as a longer term.

Ben Felix: And not only had they thought of it, but they're implementing it in portfolios. And they have been for who knows how long. And she knew the answer cold when you asked her.

Yeah. I mean, I started describing the paper because Fama hadn't... Someone asked a question about it to Fama and he didn't really get it. So I started describing the paper because I didn't think Marlina had read it either, because Fama hadn't, and she's like, "Oh, you're talking about this paper?" Yes. Anyway, the reason AQR got the better result was because they had the momentum effect built into their model naively.

Cameron Passmore: Anyways, great conference. You were impressed.

Ben Felix: I was impressed.

Cameron Passmore: You were impressed.

Ben Felix: Yep. And market volatility, nothing to see here for now.

Cameron Passmore: For now. All right. We'll be back next week.

Ben Felix: Yeah. That's it.