Episode 176: Is the Value Premium Smaller Than We Thought? Featuring Mathias Hasler

Today we have a guest join us on one of our 'us episodes', and we are very lucky to welcome Mathias Hasler to take part in the last section of today's podcast. Mathias is a Visiting Assistant Professor of Finance at Boston College, and his primary research focuses are empirical asset pricing, market efficiency, value investing, and corrections for data mining. In our chat with him today, we zoom in on a specific paper of his and its proposition about 'the six decisions' and their alternatives. Before we dive in with Mathias, we spend a little time with our usual round-up; looking at a new book by Hubert Joly, and fielding a very interesting listener question about value and investing in relation to green investments. Also, make sure to stay tuned for some thought-provoking Talking Sense cards with Mathias at the tail end of today's podcast. 

Key Points From This Episode:

  • This week's book review for The Heart of Business and a look at some of its main ideas. [0:05:12.4]

  • A quick recap of some fundamental information regarding inflation hedging. [0:09:45.1]

  • A listener question about value and ESG investing, and the relationship between factors and sectors. [0:13:40.4]

  • Unpacking the six decisions that Mathias outlines in his recent paper. [0:34:42.8]

  • The process that Mathias went through testing his alternatives to the six decisions. [0:40:18.3]

  • Differences between conditional and unconditional value premiums estimates. [0:43:39.5]

  • The implications of Mathias' findings for investors pursuing value. [0:47:08.2]

  • A round of Talking Sense cards with Mathias relating to saving and spending, job outcomes, and more. [0:49:20.1]

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, portfolio managers at PWL Capital.

Cameron Passmore: Welcome to episode 176 and this week we are once again having a guest join us for what we call an us episode. And this week our guest was Mathias Hasler, who is a visiting assistant professor of finance at Boston college. Do you want to fill in some of the background, Ben?

Ben Felix: Yeah, sure. So Mathias has his primary research interests are in empirical asset pricing, market efficiency value investing, and corrections for data mining. So, I mean, people can guess pretty quickly why we thought he would make for an interesting conversation, which he did.

He's got his PhD in finance from Boston College. The paper that we had him on to talk about, he sent it to me when he had it out as a working paper, just because he listens to our podcast and thought that I would find it interesting, which I did. And later on, the community picked up the paper and started talking about it, so we thought we would have him on for a conversation. And I think it was a really good discussion that's at the end of this episode.

Cameron Passmore: Yeah, he said we might see him in the community at some point as well. And once he gets a bit more free time after this semester, which would be pretty cool.

Ben Felix: Yeah, it would.

Cameron Passmore: In terms of other upcoming guests, next week we have Dr. Anna Lembke who wrote the book Dopamine Nation, which was a terrific book. In three weeks, will be professor Marco DiMaggio. And then the week after that, Andrew Coyne will be joining us to talk about the Canada pension plan, CPPIB, which will be very interesting.

That was a pretty hot topic in some of the papers in Canada earlier this year. I'm also working on the year end show, which is collecting the various, what we found interesting parts of the guests we've had this year. And you're working on a comprehensive overview show, right, on inflation, I believe?

Ben Felix: Yeah, I don't know. Trying to work on something like that. Trying to work on something on Crypto and DeFi and Bitcoin too. When you started reading a lot about Crypto and DeFi, I don't know if you would realize this from the outside, looking at... not that I'm on the inside, but without digging into it, there's within the Crypto and DeFi world, there's a cohort of people called Bitcoin Maximalists, and they are people who believe that all other coins are trash and Bitcoin is the only thing.

Cameron Passmore: Oh wow.

Ben Felix: And that Bitcoin is just this revolutionary thing and nothing else can knock it off of its pedestal and it's the only thing that you need to own. It's just interesting. They're all assets. They've all got somewhat similar characteristics. Lots of stuff tries to improve on Bitcoin. But anyway, there's a group of people that think NFTs are dumb, Altcoins are dumb, you should only own Bitcoin. It's going to the moon and it's going to make you rich. And if you don't own it, you're in trouble. Anyway, digression.

Cameron Passmore: Interesting. A friend of mine was in town this week, who's from the states. So he, for fun, bought some Bitcoin on his Robinhood app. We were at dinner so I said, "Can I see your app, because we don't have Robinhood here, right?" So he showed me his app and I must say, it is really cool. It's really engaging. It shows you in real time the price changes and it's flashing and blinking and upcoming IPOs there, and you just swipe it, I guess, if you want to get in the IPO list. He actually got access to Allbirds on IPO through the Robinhood app. And it's all super simple, super engaging. It looks like a game. It's beautifully designed, easy to read, and I can see why people can get highly engaged, as we talked about in past episodes. It was quite something to see.

As always, you can connect with both of us on Twitter or LinkedIn, I'm on Peloton as CP313. We also have a group going there, #rationalreminder. I'm on Goodreads and love to hear from people in the industry if they want to reach out and connect some time. Anything else to add?

Ben Felix: Yeah, I do want to add something. We said in an episode a while ago that we're looking for advisors, people with experience giving financial advice who have all of their appropriate licenses and designations and all that kind of stuff. And we have had a handful of people reach out, which is awesome. We're always looking for good people to continue to grow our team. And I thought, I would say it again in an episode, just because one of the people that got in touch, it was weeks after the episode aired, so it kind of makes you realize, not everybody's sitting down listening to every episode. So if we're looking for advisors, we should maybe it in more than just one episode and then forget about it.

I did also want to mention that the Rational Reminder community, we are having to upgrade our subscription plan with discourse. I think this is good news, the reason being we've exceeded our monthly page view limit of 500,000, which is a lot of page views. I used to have a blog and if I got 10,000 page views in a year, I was excited. So 500,000 page views per month is what we're exceeding now, not just hitting. So we're going to have to upgrade to the next plan, which gives us a million page view limit. See how long it takes for us to exceed that one.

Cameron Passmore: Yep. Unbelievable growth there. Incredible what's going on.

Ben Felix: Yep.

Cameron Passmore: So with that, let's jump into the main part of the episode.

Ben Felix: Welcome to episode 176 of the Rational Reminder Podcast.

Cameron Passmore: Indeed. And this week's book review... I actually heard this author, he was on with Barry Ritholtz on Masters in Business a month or so ago, and I really enjoyed at the interview. So, the book is called The Heart of Business: Leadership Principles for the Next Era of Capitalism by Hubert Joly. And you've heard my book reviews over the past few months. I'm kind of into business leadership, strategy management, as you know. So, Hubert Joly recently wrote this book and he is the former CEO of Best Buy. And he's the person who led their spectacular turnaround. 2012, Best Buy was a dying brand, and they convinced him to come and join the company, become the CEO. So this book is basically the manifesto of how he did it, and how he thinks about business and leadership. He's also on the board of Johnson and Johnson as well as Ralph Lauren.

And the basic premise of the book is that the old world of top down superhero leaders, who craft a strategy and then instruct the employees to do it, and then design incentives and compensation plans to motivate employees, he believes that rarely works anymore. And his point is that the next era of capitalism is not simply about profit. It's about values. It's about people. It's about community. It's about impact. And if you get all of that right, profit will come afterwards. So, point is, focus on the inputs and the outputs will come there, as opposed to the inverse, which he views as the old way. Really interesting how he came to become the CEO of Best Buy, which was a tired brand. People. They're called blue shirts, the people that work at Best Buy. The service people, they weren't engaged. They weren't helpful. When he visited a bunch of stores before joining, he found people completely disengaged. Nobody really wanted to help and help the customer.

And he came in and the first thing he did was help the people around him set a purpose for the company, to give direction to the company that he thought the blue shirts would believe in and buy into. And their main purpose of the company was to help people figure out how technology can improve their lives. This company was on the verge of bankruptcy, but they developed an eight week plan quickly to get the whole company rallying around this simple message. And this simple message ended up saving the company, and as he put it, it completely unleashed this powerful human energy that changed the environment that completely turned this company around.

And some of the numbers since then are absolutely staggering how successful this company was. Simple things like reinstating employee discounts, helping the team become customer obsessed. And he talks a lot about this in the book, how the lifeblood of a company is human talent. The experience, the dedication, that experience when someone walks into the store that there's someone knowledgeable and helpful that wants to help you make a great decision. That's where the magic happens. It causes customers A to buy stuff and B to come back to the stores.

So it's all about empowering people to pursue the noble purpose of the company. And this is something we talked about with Simon Sinek's book a couple months ago. We talked about that specifically. So some of the beliefs that come out of the book, financial incentives do not motivate, this comes from Daniel pink, which we've also talked about. If you do do a bonus system, base it on the people and make it about sharing, not about motivating certain incentives. Don't pay commissions to try to get someone to buy an extended warranty plan, for example. Profit is the outcome. It's not the purpose of the company. Explore what drives people around you, super important. He also believes that extraordinarily successful companies don't necessarily have smarter or better people, but what they have done is they figured out how to get the best out of people. Bottom line, really interesting book, super nice guy. Barry did a great interview. So, I highly recommend people checking it out.

Ben Felix: Very interesting. Sounds like a really good book and an interesting story.

Cameron Passmore: Interesting story. And to see it manifest in a company that was on the verge of death, how quickly you can get this many people, we're talking thousands of people, rallying around that purpose and to turn the company around and get it on the right footing in eight weeks. That's pretty cool.

Ben Felix: The ability to do that is what makes humans good at surviving, being able to rally around ideas. Other animals can't do that.

Cameron Passmore: Yep. Good point. So, a listener question you wanted to talk about?

Ben Felix: Yep. So a listener question comes from Rudd from Pennsylvania. And just so everyone knows when he wrote this question, he was wearing his Rational Reminder socks.

Cameron Passmore: And let's put it plug in for the socks. Any order in the store gets a free pair of socks.

Ben Felix: At the end of the question, he said, "PS, I'm wearing my Rational Reminder socks. So, the question is, and actually before I get to Rudd's question, inflation is on everybody's mind. It's something that we will cover in an upcoming episode, not a comprehensive overview necessarily, but I, I have some notes on inflation that we'll be able to talk about pretty soon, though I'm not quite ready to talk about them yet. But there have been some good papers in the last sort of six months on inflation. I think right now, everyone's worried about inflation, but wondering what they should be doing in their portfolios-

Cameron Passmore: Yes.

Ben Felix: ... based on that. And I'm not going to go into any of the research or anything like that right now, because that's, we have a different topic to talk about, but I just want to say that if there is a theoretical perfect inflation hedge, that's going to hedge against unexpected inflation.... Well, if it's going to hedge against unexpected inflation, then we've had some of that already. So it's prices gone up. So if you're worried about hedging against future inflation, maybe it would make sense, I guess, if there is a theoretical perfect inflation hedge, which there isn't, but if there was, maybe you would still want to buy it now because you're worried about unexpected future inflation.

But the reality is the only thing we really have any information about is expected inflation. We don't know what we're going to get in terms of unexpected inflation. Current inflation is a really good predictor of future inflation. So if there was this theoretical perfect inflation hedge, buying it now would be a better that we're going to get more unexpected inflation, which is something that I don't think, I mean, we can't predict that it's like trying to reposition your portfolio after the market is crashed.

If you had the foresight to buy the tips, for example, if you had the foresight to buy tips a year ago, maybe. Then, hey you probably did collect a bit of an insurance benefit for having that hedge in there, because inflation did end up being higher than what the market was pricing at that time. But to go and pick up an inflation hedge now, hoping that you're going to benefit from it, well, the unexpected inflation's already happened.

Cameron Passmore: Yep.

Ben Felix: And I don't think more unexpected inflation is any more likely now than it was before we started seeing higher inflation, And any inflation hedge assets are going to be more expensive now, because we have seen some unexpected inflation. We do have high inflation expectations. So now is not the time to be repositioning into the theoretical hedge, whatever that may be. Anyway, in a future episode, we will talk about the couple of papers that I mentioned that go through historically a whole bunch of different asset classes.

And I found papers that go through it from different country perspectives as well, which is also very interesting. Have commodities been a good inflation hedge? Well, it depends where you look and over what time period and which commodity basket. Anyway, we'll come back to that. I just wanted to touch on it a little bit, because I know it's on a lot of people's minds. Oh, and one thing I also wanted to say on this topic is that Bitcoin does not appear to be unflation hedge. Theoretically, it shouldn't be correlated to stocks at all. But one of the papers that I mentioned is actually from Cam Harvey, who was obviously a recent guest. They looked at a bunch of different assets in their paper, but Bitcoin was one of them and what they find, which I guess is kind of obvious when you think about it, there's not much Bitcoin data to think about. But what they find for Bitcoin is that it has a positive beta against US stocks and US stocks tend to do poorly in periods of very high inflation.

And their conclusion, based on that, is that if inflation it's unexpectedly high to the point where US stocks start to have negative returns, the positive beta between Bitcoin and US stocks would make it not such a good inflation hedge. So, it has not been theoretically, it should be uncorrelated to US stocks, but it's actually had quite a positive beta with Us stocks. And that aside, it's too volatile to be a hedge. Okay. That's my rant over. Onto-

Cameron Passmore: That wasn't a rant. Good Intel.

Ben Felix: Onto the listener question. Here's the question. It seems to me that a value tilt implies a tilt to sectors like energy and industrials that are environmentally unfriendly. To make things worse, the more popular ESG gets, the more value E-polluting sectors will get. Is it possible to be an ESG investor and a value investor and stay relatively diversified?

More generally, what is the relationship between factors and sectors, and how much does it change over time? What happens to Factor Premia when you control four sectors?

Cameron Passmore: Great question.

Ben Felix: Good question. There were three papers, I think, that I looked through and there were papers that I had been browsing anyway, but when we got this question, I read them more thoroughly to put together what I hope is a pretty good discussion. So, Pastor, Stambaugh, and Taylor... Pastor being Lubos Pastor, who's a guest on our podcast, they had a paper out in 2021, dissecting green returns, and it's sort of a follow up to their 2019 paper, Sustainable Investing in Equilibrium, which we talked to Lubos about in his episode. And that paper's actually been published in the Journal of Financial Economics, which is one of the top two journals up there with Journal of Finance. That paper theoretically predicts that green assets have lower expected returns than brown, due to investors tastes for green assets, but green assets can have higher realized returns when agents tastes shift unexpectedly in the green direction. Green taste can shift in two ways, investors preferences for green assets can increase, which increases green asset prices, or consumer demands for green products can strengthen due to things like environmental regulations, which drives up the profits for green firms.

Another way to think about all that is that green stocks are a hedge against climate shocks. And this is that's something that we've talked about in a few episodes. So, in Dissecting Green Returns, that's their newer paper, they look at US stock market data using environmental ratings from MSCI and they assign greenness measures to individual stocks. And their sample period is November 2012 through December 2020. And as I understand it, that's when the data got really good for the environmental stuff. Now over that period, and maybe just another note, this second paper, the Dissecting Green Returns, my understanding from reading it is its pretty much an empirical follow up to their first paper. They did the theoretical paper and this is really an empirical study of that theoretical work. So over their sample period, from 2012 to 2020, the valuated, like the cap weighted portfolio of the top third of green stocks, beat the bottom third by 174% cumulative over the period.

Pretty significant out-performance. And their suggestion is that this out-performance doesn't mean that we should expect green stocks to outperforming the future because the out-performance is related to an unexpected increase in environmental concerns. And they actually measured to back that up. They measured environmental concerns using a media index, which shows a steady increase in climate concerns over the past decade. But I think we can all appreciate that climate concerns have increased over the past decade. Shocks to climate concerns are positively related to the green minus brown factor. So they create this long short factor of green minus brown. So green stocks outperform when there's bad news about climate change. So again, you see that hedge for climate shocks.

Cameron Passmore: And that's because the preference is shifting? Is that the main driver there?

Ben Felix: Preference is shifting. I think there's probably a risk story like we did that episode on climate risk recently, and there's probably a bit of a risk story in there too.

Cameron Passmore: Risk on the brown side, perhaps?

Ben Felix: Risk on the brown side, yeah. But when they've removed climate shocks from the sample, so they have climate shocks from the media index, when do people get really worried about climate? That's a, we'll call it a climate shock, as I understand it from the paper. So, when they take those out of the sample, green stocks do not outperform brown stocks and they may have actually underperformed if you control for climate shocks. So, climate shocks are unexpected by definition. After the climate shocks driving up green asset prices, we would expect lower returns going forward. That's back to their theoretical paper, not higher. And this is one of the cautions they're making in this paper is green assets have done really well, and a lot of people, especially the people who are promoting green assets, are saying, look how high the expected returns on these assets are.

And in this paper, these guys are saying, well, no, actually it's the opposite. The returns have been good, which means that the expected returns are really low. Now, it's hard to prove what a stock's expected return is, because it's really noisy. So what they do in the paper is look at green bonds as an analogy because obviously it's, it's easy to observe expected returns for bonds because the cash flows are more certain. So, price changes give us a lot more insight or yield changes give us a lot more insight into changes and expected returns. So, in Germany they issue green and non-green bonds. They've been issued since 2020. The green bonds trade at lower yields suggesting lower expected returns. And the spread in yield between green and non-green bonds shows investors willingness to increasingly accept lower returns to hold green assets. So if the spread is increasing, the preference for green assets is also increasing. The willingness to hold green assets at lower expected returns is also increasing.

The 10 year spread has tripled since the first issuance in 2020, and so they suggest that probably tells us something about investors preference for holding green assets. The green bonds have outperformed non-green due to the spread widening, but it's pretty intuitive in the case of bond yields to say, okay, the returns have been good, but now the yields are a lot lower. So we should expect lower returns from holding these bonds going forward. So they're kind of saying the same things happening with stocks, it's just not always quite as easy to observe. They also did panel regressions on individual stocks and found that a significant relationship between a stock's greenness and its average returns and that the positive relation disappears completely when climate shocks. So again, controlling for climate shocks. So the positive relation between greenness and average returns disappears when climate shocks are, are removed, which again, indicates that climate shocks explain all of the superior performance of green stocks over the period.

So it's all very consistent with their theory. Now this listener question is about being an ESG investor and a value investor at the same time. So we'll start digging into that in the Pastor, Stambaugh, Taylor paper, their green factor... This is really interesting. Their green factor explains 80% of Fama-French HML under performance in the sample. 80%. So, they made a two factor model with the market and a green factor, green minus brown. And the green factor in that model explains 80% of values under performance from 2012 to 2020, which of course has been a very rough patch. HML's monthly cap, M Alpha goes from a significant negative 71 basis points per month to a statistically insignificant negative 15 basis points per month in the two factor model with the green factor. The green factor and HML are negatively correlated, as value stocks are more often brown than green.

So now you can see where we're going with the listener question. The green minus brown portfolio is tilted toward large cap growth stocks and toward recent winners. So there's a momentum tilt in there as well with green. Now, back to the theory in Equilibrium, expected returns of stocks that are better hedges against climate shocks have a negative hedging premium. So, that's important for investors because it tells us that historically in this sample, the green hedge has paid off, which has made value look really rough because value tends to be brown, but going forward now, the expected returns for green are now much lower than they were a decade ago.

Cameron Passmore: This is so interesting.

Ben Felix: I know, I thought so too.

Cameron Passmore: So, you're saying 80%, I mean, in real simple terms, 80% of the values under performance over this period is caused by preference for greenness changing or are the green, it's caused by greenness.

Ben Felix: Yeah, but the performance of green, of the green factor, is all about climate shocks.

Cameron Passmore: Right.

Ben Felix: So, you take out climate shocks and based on their paper, I mean, I don't know if this is true or not, but it seems close. Based on their paper, I think if you control for climate shocks, the under-performance of value is much less severe than it's actually been.

Cameron Passmore: Wow.

Ben Felix: Yeah. Now, this also means though that the expected returns relative to growth, the expected returns for value, we should have lots of confidence in them. Value is not broken, there were just a lot of climate shocks. And now the prices for green assets, which are often the short side of the value portfolio, have really low expected returns. Interesting, right?

Cameron Passmore: Very.

Ben Felix: The other big finding in their paper is that the performance of the green minus brown factor is driven by industry level greenness, not within industry greenness. That'll make more sense as we go here, if people are scratching their heads about what that means. So, just stay tuned for a sec.

So, if we take a brown industry and sort stocks by their greenness within the industry, the greenest of the brown stocks do not appear to be subject to green pricing. Now, that's got really important implications for portfolio formation, which I'm going to talk about in a sec. So, just to summarize the Pastor, Stambaugh, Taylor paper, 80% of the negative value premium in the sample, 2012 to 2020, is explained by the green minus brown factor. Green stocks have dramatically outperformed brown, but all of that goes away if we eliminate climate shocks. The historically high returns of green stocks likely tell us that their expected returns are low, not high, as some people would like to believe, which also tells us something about the value premium, because green stocks tend to be large cap growth.

And then the last important piece is the industry stuff I just mentioned. So, industry greenness not within industry greenness explains green returns. So, what do we do with all that? We want to be a value investor, but it seems like it's pretty hard to do while also being green. Now, I had a good place to look, because who do we know that does sustainable value portfolios? Dimensional, and they've got a very well documented process for how they approach this and think about it. So, I thought that would be a pretty easy place to look at least for a good methodology. And it was. I hadn't thoroughly read their paper on their approach to sustainable investing. I read it to prepare for this, and I found it to be pretty agreeable. So, as Rudd suspected, there is a negative relationship between value and greenness.

So how do you build a green value portfolio? Dimensional takes the view that corporate responsibility is shared between the supply and demand sides of markets. That's an interesting statement. So they give an example. If the demand for fossil fuels remains high, you can't control the demand. If the demand remains high, a sustainable investing strategy should own the companies that supply energy in more environmentally sound ways rather than ignoring energy companies altogether. Feels like a controversial statement. I don't know.

Cameron Passmore: It's basically saying that you can't affect the demand side, right? You're not going to be able to change people's behavior. Is that the point?

Ben Felix: I believe that is the point, yep. People are still going to use fossil fuels, so let's own the companies within that sector, within that industry, that are doing the greenest job.

Cameron Passmore: Right. Who's making an impact in that industry.

Ben Felix: Correct.

Cameron Passmore: Interesting.

Ben Felix: Correct. And they do like, I'll talk about the over underweights at the industry level in a second, but their biggest underweight is energy. So, it's not like they're still owning a huge exposure or an overweight or something like that to energy. They are still underweight at the industry level, but their approach is to find the greenest of the brown companies in brown industries. But then they do have an elimination screen. So if companies are really bad or if they meet certain criteria, then they will be eliminated, which is why I think we see the biggest underweight being in energy. Now, you can apply that process that I just described across all industries. And now this is very important from a portfolio management perspective, because as we just talked about, it is industry greenness, not within industry greenness that has green pricing that's affected by that green factor.

So that you end up only owning green industries, you have low expected returns. If you own green stocks within brown industries, you're no longer affected to the same extent by the low expected returns of green industries.

Cameron Passmore: Interesting.

Ben Felix: In the paper, there's a footnote that mentions that Dimensional's approach to sustainable investing is actually patented, which I just thought was, I don't know, I haven't seen too many investment processes that are patented. It's just an interesting note that I made for myself. Okay. So the process in very broad terms, they start with a universe of global stocks. They sort stocks on size, relative price and profitability, characteristics, business, as usual. Then they over and underweight to achieve the desired exposures to higher expected returning stocks. Then, they evaluate the eligible stocks on sustainability variables and apply over or underweights to reach the desired sustainability score for the portfolio.

And then they do exclusions or produce the weight further of companies with particularly negative environmental or social impacts. And they have a whole set of criteria and the specific areas that they look for. I didn't write all those down in my notes, but it's pretty comprehensive, and I think does speak to what most people would consider to be responsible. That's also, of course, very subjective. So, I looked at the Dimensional World Equity portfolio, which is a market cap weighted geographically, but tilted towards small value and profitability and all right, good stuff. And I compared that to the global sustainability core equity fund, which is designed to be pretty similar, except with a sustainability tilt. You end up with lower tilts towards small value. So, you're at 5% tilt, or 5% exposure, in the sustainability fund versus 7% for the global equity fund. But then I looked at VT.

Yeah, I looked at the Vanguard world stock VT. It's got 2% in small value. So, in both cases with Dimensional, you're still overweight. So, you can still be green and tilt towards small value, apparently. They had 15% for large value in the sustainability fund versus 19% for world equity. And the big difference is at the large growth level. So large growth in sustainability was 22% versus 15% for World Equity. And VT is at 28%.

Cameron Passmore: Interesting.

Ben Felix: Yeah, but you could see, there are still tilts there. They're not as extreme. And presumably they're not as extreme because Dimensional's maintaining diversification while doing the re-waiting for sustainability scores and the exclusions. And because we know green companies are going to tend to be larger and growth here, it makes sense that you would lose some of the tilt towards smaller and more valued companies. So, I mentioned the industry level. At the industry level, the biggest overweight is 3.87% overweight for sustainability relative to world equity in technology.

And then biggest underweights are real estate, basic materials. And like I mentioned, energy and proportionally, the biggest difference in industry allocations is in energy. It's a smaller sector overall. So, it's about one third, the weight in the portfolio. So in percentage terms, it's about minus two point for, but relative to the starting amount in World Equity, it's about a third of the starting amount. In another white paper, Dimensional shows that this approach to sustainability gives them about an 80% reduction in exposure to greenhouse gas emissions. Right. Pretty interesting. Unbelievable. Because a tilt don't seem that right. And a 99.9% reduction in exposure to potential emissions from reserves.

Cameron Passmore: Wow.

Ben Felix: So it's pretty good. And they've got a bunch of other metrics that they...

Cameron Passmore: So, it's the brown, the dark brown companies are really dark brown. Wow.

Ben Felix: Yeah, I guess that is what it tells us. And there's a bunch of other stuff in their paper that they looked at in terms of how well the strategy works, but I only put those into my notes, but the point, I think, is that you can do this, but it's all about doing it within industry, which I think makes sense. So we know there's this clear relationship between greenness and value green stocks have lower expected returns theoretically and increasingly so, as we have climate or environmental shocks, which drive up the prices of green firms, and this is the theoretical model again from Pastor, Stan bond Taylor and they've now empirically tested their theory, which I just thought that was really cool to kind of watch that progression of, they wrote this good theoretical paper. It's now been published in the JFE and, and now they done the empirical work to back it up. Just to reiterate, they found that green stocks outperform brown stocks by 174% cumulative from November 2012 through December 2020.

And all of that performance difference is explained by climate shocks, which they measured by a media index and they measured it by green fund flows as well. If climate shocks and fund flows are set to zero, the performance of green stocks becomes flat for climate shocks and actually becomes negative for green fund flows. They establish all of this with the time series of the green factor and with panel regressions on individual stocks, industry level greenness, not within industry greenness explains the performance of green stocks and the importance of climate shocks in explaining the performance. Because we know if we take them out, the performance goes away. The two factor model, including market beta and the green factor explains 80% of HML under performance from November 2012 to December 2020. The empirical work obviously backs up the theory, so it seems like a pretty good way to think about the world.

Green stocks seem to have lower expected returns, because they hedge climate risk and they've had unexpectedly good returns recently because of there were climate shocks, but going forward, we've got lower, not higher, expected returns for green stocks. Not think I've said that a whole bunch of times, but I also think it's really important. I can't tell you how many times I've heard people say green investing gives you higher expected returns. It doesn't. You got higher returns from it recently, but that actually means you've got lower expected returns going forward. Since there's a negative correlation between HML and the green factor, and HML portfolio won't be green, but taking a within industry approach to greenness can make a lot of sense. Dimensional always, sustainability aside, they only allow a little bit of drift in industry weights relative to market caps. And as an approach, that's confirmed by a whole bunch of different studies that we can put in the notes, showing that price to book value is not priced across industries and its premium comes from within industry stock selection.

So, if you're a value investor, you don't want to just pick the cheapest industries, at least based on the papers that I'm talking about with... There are a whole bunch of them. You want to use it for within industry selection. There's a recent paper too, in the Journal of Portfolio Management, I think, or one of its associated journals, Should Equity Factors be Betting on Industries. And they confirm that HML price book HML and a broad variety of value factors are only effective in selecting stocks within an industry. And there's no premium for industry allocation based on value. And that's important, right?

Because we're building this value portfolio using within industry value tilts, and then unlike the value factor, which is priced within industries, greenness is priced at the industry level, but not within industries. So, that's good news because we don't want the lower expected return of green stocks. So tilting to value and greenness in a portfolio, at the industry level, doesn't give you as much greenness, but it does give you the value tilt that you want. So I guess that's the answer to the question, is you should have to tilt toward value and sustainability within industries, not across industries. So, I think that's pretty much it for the answer to Rudd's question.

Cameron Passmore: Fascinating. Absolutely fascinating stuff. So, we're good now to go over and go to our interview with Mathias Hasler.

Ben Felix: Yes. More on the HML premium. Lots of talk about HML today. People who are active in the Rational Reminder community know that I posted a paper from Adriana Robertson, where she looked at factors across vintages. So, if you pulled the factor data in 2005, is it the same or different as if you pulled it in 2021? And she found that it's actually somewhat materially different, which casts a little bit of doubt on.... Not... A little bit of doubt. Don't get me wrong here. Research is still good, but it makes you question a little bit the quality of the data that you're looking at. And our conversation with Mathias is the same kind of thing, where he looked at the original HML factor and asked what if he had made it slightly different than Fama and French did in that paper? Would it have been the same? And he actually finds that the way that they did it happens be the best in a back test way to do it. So, the premium is higher than if they had just made some slightly different decisions. Anyway, we'll explain this as we talk with Mathias.

Cameron Passmore: Mathias Hasler, so happy to welcome you to the Rational Reminder Podcast.

Mathias Hasler:Thank you much.

Cameron Passmore: Yeah, so, you're joining us from your office in Boston. So again, happy to have you here. So, you want to kick it off, Ben?

Ben Felix: Yeah. So Mathias, you listen to our podcast or at least to some episodes, and you came up with this working paper and you sent me a draft, which I thought was just the coolest thing ever to have someone who's out there doing research who happens to listen to our podcast, to have them send me a paper. So, I appreciate that. And it was awesome and it was a very good paper. I read it with interest. And then in the Rational Reminder community, people started discussing it. Maybe, I don't know, a month or two months after you said it to me, there was a big discussion. And I thought, why don't I reach out and, and see if you'd be interested in coming on the podcast. And, and so here we are. And we want to ask you some questions about your paper.

Mathias Hasler: Yes, that's great.

Ben Felix: Okay. So, in the paper you explain that the original HML, the original value premium portfolio, includes six seemingly innocuous decisions that could have easily been replaced with alternatives that are just as reasonable. Can you describe what those six decisions were?

Mathias Hasler: Yeah, sure. So, as you mentioned, the construction of the original HMR portfolio includes six seemingly innocuous decisions. And I was thinking about these decisions, and I was thinking about alternatives that are just as reasonable as these decisions themselves, right? So, the first decision is about the timing of book equity. So, the original HML portfolio uses book equity of the firms last fiscal year, that's available at the end of December to sort stocks into value and growth portfolios at the end of June. And so as an alternative, I simply use book equity of a firm six months after this, after fiscal year end of this company, right? So, both of these specifications impose a minimum gap of six months for accounting information to become publicly available here. And so, as you can see, this is a minor decision in the construction of this original HML portfolio.

And the alternative decision that I'm proposing is really just as reasonable as the original decision itself, right? So, the second decision is about the timing of market equity. So the original HML portfolio uses market equity at the end of December in the book to market equity variable, right? And it uses this variable to construct portfolios or to salt stocks into value and growth portfolios at the end of June. And so as an alternative, I simply use market equity from the most recent month in the denominator of book to market equity, to sort stocks into these value and growth portfolios. And again, as you can see, this is really a minor decision in the construction of the HML portfolio, and alternative is I think just as reasonable as the original decision itself.

So, the third decision is about negative book equity observations, the regional HML portfolio. Excludes stocks with negative book equity. And I simply include stocks with negative book equity, because negative book equity can occur naturally and legally under US GAAP . So, there's nothing wrong with these observations, right?

And then the fourth decision is about financial firms. So, the original HML portfolio includes financial firms, and I simply exclude financial firms.

The fifth decision is about the break points that I use to sort stocks into these value and growth portfolios. So, the Regional HML portfolio uses the 30th and the 70th percentile of book to market equity of all stocks that are traded on the New York Stock Exchange as break points, sort stocks into these value and growth portfolios, right? And so as an alternative, I simply use slightly more extreme percentiles, the quickest and the easiest to sort stocks into these value and growth portfolios. But I also use likely less extreme break points set with 40th and the 60th percentile high, right. And again, I say these two alternative decisions, on average, are just as reasonable as the regional decision, right?

And then the last decision, the sixth decision about the timing of market equity to account for the size effect. So, the original HMRL portfolio uses market equity at the end of June to account for the size effect. And so as an alternative, I simply use market equity at the end of this December to account for the size effect because the first paper on the size effect is Bonds 1981, right? And so this paper uses market equity at the end of December to measure the size effect, right? And so, as you can see, these are really small decisions in the construction of the original Regional portfolio, and these are alternatives are just as reasonable. And so, to really bring home the point, these alternatives are just as reasonable as the regional research decisions themselves.

I went to the literature and I looked at what kind of decisions were made in the literature, right? And so, specifically, I took the Fama French 1993 paper. I look at all papers that are cited in Fama French 1993. And I look which papers are empirical papers on the value effect, and then I look at the decisions that are made in these papers when they're constructing their kind of value proxy now. And so what I find is that there's a striking heterogeneity in the decisions across the papers, right? I mean, there's some papers that include negative book and some that exclude negative book, right? There are some papers that include financials and some that exclude financials, right? And so, I think that these heterogeneity is consistent with the view that these alternatives are just as reasonable as the original decisions themselves. Yeah.

Ben Felix: So interesting. How did you test the impact of changing those decisions on the original value premium estimate?

Mathias Hasler: So I just explained these six decisions, and I explained the alternatives that are just reasonable. And so next, what I did is I formed all possible combinations of these decisions and at the alternatives and they're 96 possible combinations. So I then construct 96 HML portfolios and all of these 96 HML portfolios are reasonable proxys for the underlying value risk factor, right? Or putting different words. The original HML portfolio is just as reasonable as the other HML portfolios as a proxy for the underlying value risk factor, right? All right, so then what I do is I used data from the original study sample period. So this is from July 1963 to December 1991, right? So this is the sample period that's used in pharma, French 1993. And I calculated the average return of the original HML portfolio using that in sample data, right? So this basically gives me, gives me an estimate for the value premium or for the original value premium, right?

And then what I did is I calculated the average return of all of these other 96 HML portfolios, right? So. I basically have 96 reasonable estimates for the HML portfolio. And I took an average across all of these 96 value premium estimates. And so this average value premium estimate is kind a useful estimate for the value premium because it reflects an average decision and, therefore, mitigates picking up some sort of a decision specific effect, right? And so, what I find is that the average value premium estimate is dramatically smaller than the original value premium estimate, right? So more specifically the average estimate is nine basis points per month on average, smaller than the original value premium estimate. So we are talking about the fourth of the original value premium estimate, right? And also this difference is statistically significant. So the key statistic is 1.79 there.

And so again, this first main empirical finding suggests that the original value premium estimate is upward bias because of a chance result in these seemingly innocuous research decisions. But now, if you're really talking about a chance result, you're right, then you would expect not to see this chance result then more out of sample. Right. And so what I do is I do exactly the same empirical analysis, but now I use data, which is out of sample. So I use the sample before the paper. It's also known as the pre-composite sample. And I use the sample afterwards, right, the post publication sample, right? And so what I find in this sample is that the difference between the reach value premium estimate and the average value premium estimate is statistically insignificant, right? And this is really consistent with the view that we are talking about, kind of a chance result, that the original value premium is picking up simply by using, these specific decisions that were made in this paper.

Ben Felix: So interesting. You look at both the conditional and unconditional value premiums in the paper. Can you describe the difference briefly and then explain your finding what you were just talking about was the unconditional value premium. If you could also explain the finding for the conditional value premium.

Mathias Hasler: Yes. So the unconditional estimate of the value premium, this is just an estimate of the value premium by itself, right.? Unconditionally on anything else, right? So it's just the average return of an HML portfolio by itself. So, this is the unconditional estimate of the value premium. And so what I find, empirically, is that the average value premium estimate average over these 96 value premium estimates that are just as reasonable, right, this average value premium estimate is 27 basis points a month.

And it has a t-statistic of 1.79, right? So an investor that expects to be compensated with the value premium, because the investor is exposed to the value risk factor, right? This investor would expect a better, would expect a premium of 27 basis points, yeah. So, this is the unconditional. And so most of my paper is about this unconditional estimate.

And so why? Well, because I want to be consistent with the Fama French 1993 paper, because in the end, I'm interested in what the original estimate of the value premium is really estimating. Right? And so this is why most of the stuff that I'm doing in my paper is about the unconditional estimate to be consistent with the Fama French 1993 paper.

And so there's another reason I just want to keep everything as simple as possible. The simple paper is better to understand. It's better to talk about, I think, and it's also better to think about, right. Okay. So the last chapter in my research paper is about this conditional estimate of the value premium. And so what does it mean a conditional estimate of the value premium? Well, it means that we want to study the value premium conditionally on assuming another surprising model. Yeah, so I've been studying the value premium conditional on assuming the Fama French five factor model with momentum to have kind of a full blown asset pricing model. And so what I find there is that the average estimate of the value premium and the original estimate of the value premium conditional on this full blown Fama-French 5 factor model with momentum, right? So the difference, or there's not really a difference, or there's not really a systematic difference between these two estimates. And so we can't really draw any new conclusion from that about the value premium, yeah.

Ben Felix: Hm. So did all this research change your perception of the value premium?

Mathias Hasler: Yes, it did. So my empirical findings, they suggest that the value premium is dramatically smaller than we previously thought, right? So this average estimate of the value premium is about a fourth smaller than the original estimate of the value premium, right? So my findings change my perception on the magnitude of the value premium, but the findings also changed my perception on the confidence I have about the value premium, right? So the statistical significance of this average value premium estimate is somewhat lower. Right. I'm less confident about it. Yeah.

Ben Felix: Do you think that there are any implications for investors who are pursuing value? Does this mean value doesn't exist?

Mathias Hasler: So, well, there are two questions, right? So, to the first question, are there any implications for investors? Yes, I think so. Right. So my empirical findings such as that the value premium is dramatically smaller than we previously fought. Right? So an investor that expected to be compensated with the value premium because of the investor's exposure to this value risk factor. Right? So this investor should expect a value premium that's about the fourth smaller, and then he previously fought. Right. But so my, the findings suggest that the value premium is smaller than we previously thought, but they're not strong enough to kind of reject to say that, you the value premium is zero, right? So, the implication is that the value premium is smaller, but, you I can't say whether it's gone or whether it's still there, but so then the other implication, this is more kind of a big picture implication is that, I'm a little bit

So if the original value premium estimate is upper bias, because of a chance result is this seeming innocuous research decisions, then potentially other might also be upper biased because of chance results in these research decisions, right? So this is why I'm a little bit more skeptical about our ability to predict returns in the cross section. And in general, hard to predict the future, right? So...

Ben Felix: That's what the really interesting commentary. There was a paper that just came out from Adriana Robertson. I don't know if you've seen it. She looked at vintages and factor data and found that even that introduces some uncertainty about what we're measuring.

Mathias Hasler: Yeah, big difference.

Ben Felix: Big differences there, but then also you're finding, we take those two things together and it's like, how much do we really know about the data that we think we see?

Mathias Hasler:

Yes.

Ben Felix: Very interesting. All right. Cameron, should we do Talking Sense?

Cameron Passmore: So Talking Cents? So you're willing to stay on, Mathias? We always pull some cards from Talking Sense. These are cards from the University of Chicago Financial Education Initiatives. We do a couple cards every week. So I, I pulled a couple here. We'll let you go first. The question is, when your goal is to save, how do you avoid the temptation of spending money?

Mathias Hasler:

Yes, I think first of all, this is a very interesting question because I think we can probably save the most by just spending less. Right. So, I think this is the easiest way to maybe save more, yeah.

Cameron Passmore: Do you have any tricks to avoid the temptation?

Cameron Passmore: Yeah. Tricks to avoid the temptation... I think that knowing that compounding is an incredible driver of growth in the future or for your retirement is a pretty strong factor or driver for me to avoid unnecessary spending, right? The more you can save today and the earlier you can save, right, the more you start to earn interests on your interest, right? And the more your wealth for retirement will grow. Yeah.

Ben Felix: Makes me think back to when we had Katy Milkman about behavior stuff, and she talked about the... I'm pretty sure it was Katy Milkman talked about the lock boxes, and there was a bank in another country where they, they introduced this bank product where you could not take the money out until it reached a balance or for a certain period of time. And those people accumulated way more in their savings than the people who did not sign up for the lock box program. And it's just interesting, because even if people know about... I agree with everything that you said, Mathias, but even if people know that, managing behaviors really hard, it's like humans are so bad at behaving well that we need mechanical things in place to get the behavior that we want. So I don't know. I don't have anything that I do personally. I try to be disciplined, but I don't have any tricks.

Cameron Passmore: But you and I are alike. We aren't big spenders by nature. So the only trick that I have, I'm not sure it's a trick, but so many of these interviews we've had, especially this year about happiness. When you start to think about what pleasure will come from that purchase, I get more pleasure out of a $16 book on Kindle or something than I do out of some item. Just stuff doesn't do it for me. And perhaps that's a thing with age. I don't know. Next question. Ben, we'll let you go first. What is something you can get from a job that isn't money?

Ben Felix: Oh, engagement, relationships, connection to something outside yourself. It's an easy one. Come on.

Cameron Passmore: It's what they came out. Mathias?

Mathias Hasler : Yeah. I mean, I do research, right? And so I hope to learn something more about kind of the truth right. What's what's going on. And so it's kind of the big takeaway that I get from my job, but I'm also surround that's by like really great people. And I mean, that makes a big difference. Yeah. Yeah.

Cameron Passmore: And making a difference in people's lives is one that I would add to each of your list. So here's another good one. Mathia, we'll let you go first. Ask will let you go first. Would you rather have a free place to live the rest of your life or never have to pay for food again?

Mathias Hasler: Oh, I think I would prefer not to pay for food because I really love food, especially very good food. And so I think that would save me a lot of money. Yeah.

Cameron Passmore: Ben?

Ben Felix: I would take the food too, because I think I find that if I'm not paying for a good meal, it tastes a little bit better. And I, I'm not worried about even if I'm being disciplined and I'm very, very intentionally committed to spending some amount of money on good food. I like to eat good food as well. If I go out to a restaurant or something like that, even if it's in the budget and it's not going to hurt us financially and I know that I can spend the money, I'll still feel guilty about spending the money afterwards. And I'll still think about was that meal really worth it afterwards, and that'll bug me. If it was free I wouldn't think about that. I think economically . Economically housing is probably the better choice, but if, if I can enjoy really good food and never think about the fact that I'm spending money on it again, I'll take that every day of the week.

Cameron Passmore: Yeah, I was expecting you to give more of a spreadsheet kind of answer. I'll let you do some sort of present value of expected inflation of which one's got the greater value to you. That's what I was expecting. What's your answer? Oh man. Not, you mentioned food like that, I must admit sometimes when you go for a really nice dinner of the bill often hits you more than the pleasure of the so I don't have a great answer. I don't know. I guess that's the point of these cards is to make you think. I don't know. I'm ambivalent between the two. I don't have a great answer. All right. Well that was fun.

Ben Felix: That was awesome.

Cameron Passmore: All right. Well, Mathias, thanks so much for joining us. It's been a real pleasure to have you on. And everybody, thanks for listening.

Mathias Hasler:

Yeah, thank you so much for having me. I also really enjoyed it.

Cameron Passmore: Awesome. Thanks. Mathias.