As Chief Investment Officer of Avantis Investors®, Eduardo is responsible for directing the research, design and implementation of our investment strategies, providing oversight of the investment team and the firm's marketing initiatives, and interacting with clients.
Prior to Avantis Investors' establishment in 2019, Eduardo was Co-Chief Executive Officer, Co-Chief Investment Officer and Director at Dimensional Fund Advisors LP ("DFA") until 2017.
While at DFA, Eduardo provided oversight across the investment, client service, marketing, and operational functions of DFA and oversaw their day to day operations, directed the engineering and execution of investment portfolios and was involved in the design, development and delivery of research that informed the firm's investment approach as well as its application through portfolio management and trading.
Dr. Repetto earned a Ph.D. degree in Aeronautics from the California Institute of Technology, an MSc degree in Engineering from Brown University, and a Diploma de Honor in Civil Engineering from the Universidad de Buenos Aires. Eduardo is a Trustee of the California Institute of Technology. He is the recipient of the William F. Ballhaus Prize from the California Institute of Technology for outstanding Doctoral Dissertation in Aeronautics and the Ernest E. Sechler Memorial Award for his teaching and research efforts.
In this episode, we are joined by the CIO of Avantis Investors, Eduardo Repetto, to have an in-depth conversation about his philosophy and approach to many of the central concepts that are important to our listeners. Eduardo weighs in on asset pricing factor investing, premiums, and also shares some of his perspectives on what makes Avantis different from its competitors. Eduardo's wealth of experience and technical know-how make this very practical exploration, complete with some inventive and demonstrative analogies. Despite the high-level concepts discussed, our guest's ability to communicate these in an accessible manner also helped maintain a level of approachability throughout. Toward the end of the episode, we get to hear a little about Eduardo's Ph.D. in aeronautics and some of the surprising overlaps he sees between his two fields of interest.
Key Points From This Episode:
Eduardo's approach to communicating what Avantis can offer their clients. (0:02:57)
Advantages of the ETF structure for managing portfolios. (0:05:07)
Advice for investors for quantitatively assessing the expected return advantage of a factor-tilted portfolio. (0:10:26)
Practical approaches for individual investors when assessing a factor tilt in portfolios. (0:13:54)
Eduardo unpacks the idea of trust in relation to the premium. (0:20:45)
When does a completely small-cap value portfolio make sense? (0:27:23)
Avantis' method for targeting value and profitability. (0:31:03)
The weighting of different metrics that Avantis uses when building portfolios. (0:34:43)
Eduardo unpacks cash profitability versus operating profitability. (0:36:53)
The approach at Avantis to sector weights. (0:39:56)
Understanding adjusted book value when pricing a company. (0:43:53)
Eduardo describes the premium for the Goodwill adjustment. (0:50:02)
How Avantis views pursuing credit premium in fixed income investments. (0:51:32)
Determining the size of factors tilts on particular products. (0:57:05)
Reasons that there are no emerging market small cap value strategies. (0:59:48)
Comparing the research behind inflation-focused equity strategy to a more general value profitability premium. (1:06:03)
Avantis' strategy for staying on the cutting edge of the latest research. (1:10:34)
Conversations between Avantis and American Century Investments about different investment philosophies. (1:18:22)
Eduardo shares his opinion about Avantis' competitive advantage. (1:19:56)
Where Avantis and Eduardo are aiming their energy in the near future, and the succession plan for the company. (1:23:11)
Some surprising similarities between aeronautics and asset management. (1:27:21)
Eduardo talks about his personal definition of success. (1:31:31)
Read The Transcript:
Ben Felix: This is the Rational Reminder Podcast, a weekly reality check on sensible investing and financial-decision making from two Canadians. We’re hosted by me, Benjamin Felix, and Cameron Passmore, portfolio managers at PWL Capital.
Cameron Passmore: Welcome to Episode 228. This week, finally, we welcome the Chief Investment Officer of Avantis Investors, Eduardo Repetto.
Ben Felix: Yep. This is a great conversation. We covered a lot of ground on fundamentals of asset pricing, and factor investing, and premiums and who should tilt toward premiums? Should anyone be a pure small cap value investor, and then what does that investor look like? Lots of interesting comments from Eduardo there. Then of course, we also talked about the approach that Avantis takes and how that may be different from some of their competitors. Lots of interesting points on that as well. Lots of good analogies.
Cameron Passmore: Oh my gosh.
Ben Felix: We have a gas station sushi analogy. There are a couple of other funny analogies in there. There are two food analogies. I don't remember what the other one was. Do you remember what the other one was?
Cameron Passmore: I do not, but they're both pretty funny. It was kind of cool, because we've known Eduardo a long time. So it's a pretty friendly, casual conversation, which was great. Tremendous experience in the field. I mean, he's brilliant, obviously brilliant, but a very good communicator as well.
Ben Felix: Yep. For anyone who doesn't know, Eduardo is responsible for directing the research, design, and implementation of Avantis investment strategies, providing oversight of the investment team, and the firm's marketing initiatives, and interact with the clients. He's doing a lot, and that comes through in this conversation, because he's clearly got deep technical expertise, but also a very impressive ability to communicate that expertise in a way that I think is pretty easy to understand.
Cameron Passmore: I mean, we’ve both known him a long time, but we know him from his previous role when he was co-CEO and co-Chief Investment Officer, and Director at Dimensional Fund Advisors in 2017. I've known Eduardo as of you for probably 10, 12 years, at least, I would think going back.
Ben Felix: Yeah, his pedigree in this world of factor investing is about as good as it gets. As impressive as it gets. He got his PhD in aeronautics from the California Institute of Technology. We talked a little bit about the similarities between that field of study and his PhD dissertation, which he won an award for. Similarity between that and financial economics. To my surprise, they're a lot more similar than you might think. People think of physics as being a hard science, and economics is not so much. I think, Eduardo challenged that.
Cameron Passmore: He pushed back on, yep. That's great. Anyways, here's our conversation with Avantis Investors, Eduardo Repetto.
***
Eduardo Repetto, welcome to the Rational Reminder Podcast.
Thank you, Ben. Thanks, Cameron. It's a pleasure to be here.
We’re super excited to be talking to you. Eduardo, most investors are familiar with a market cap-weighted passive strategy, like just buying index funds. How do you articulate the difference that Avantis products represent?
Look, that's a fair question, because we’re having here, in our market-cap weighted portfolio, like S&P 500, Russell 1000, and Russel 3000. They may see a product for a long time. But think from a valuation framework, if you want to enhance expected returns, you need to consider more than price. Market cap-weighted portfolio basically only considers price. If you want to enhance expected returns, you have to consider price, compare with some fundamental data that is going to give you some information about what securities are being priced in the market at a higher discount rate. So if you want to do that, you need to use just more than price, and market cap-weighted portfolios are not using anything but price. That's basically the main distinction. If you want higher expected returns, you need fundamental data. Once you consider that fundamental data to work with price, then you have an idea of what security have higher and lower expected returns. Then, you can decide how to use that information to create portfolios that are expected to deliver higher returns to clients.
Those portfolios will be different than market cap-weighted portfolios, because they are deviating the market cap-weighted, deviating from market cap-weighted to overweight securities that have higher expected returns, underweight securities that have lower expected returns. You can do that to different degrees. You can do that having a portfolio that has similar risk characteristics to a market portfolio and S&P 500 by overweight in security, expecting to deliver more, and underweight in security that deliver less. Or you can do that by just focus on those securities that have very, very high expected returns, and have portfolios that are more focused on delivery, better performance.
Market cap-weighted produce a great portfolio, it’s basically self-rebalancing. You don't have to rebalance, but also has some drawbacks that you can – you are not really in constant expected returns, you're just delivering what the price it has meet with but price.
Can you talk about the advantages of using the ETF structure in managing these portfolios?
Yeah. Look, this is a great question. A lot of people are speaking about it, but I think the same SMAs, and all of us know mutual funds. Now, we also have ETFs. So you can deliver the same strategy in different properties, in different vehicles. Imagine that you're delivering the strategy in a mutual fund. Well, how does it work? Well, you have a mutual fund, when you are buying a mutual fund using cash into the mutual fund, the portfolio managers buy securities, and so everyone pays for that transaction that comes into a mutual fund. Whether it's a redemption, the portfolio manager has to sell securities, but also has to carry cash. Because if you make a redemption and need to wire the money, as a portfolio manager needs to wire the money, basically right here right now.
But if I sell security, it will settle for a couple of days, so I need to carry cash to be able to satisfy the redemption, or I have to keep the line of credit in order to satisfy the redemption, and then some securities to cover that loan or replenish my cash buffer. On top of that one, some securities have realized capital gains, and then they remind shareholders, not the redeeming shareholder, the long-term shareholders get 1099 at the end of the year, with a capital gains bill. That's a mutual fund.
If you think about an SMA, SMA basically save like a mutual fund. The difference, that SMA, a separate account is that you are not affected by the actions of other shareholders. If you are in a mutual fund, and you’re a long-term shareholder, people coming in and out, impose costs of you, and impose taxes on you. In an SMA, you are the owner. So if you come in and out, it’s your own decision. Only your actions are affecting your portfolio. What's the problem with an SMA? Well, the problem in SMAs, whenever you have to rebalance, you have to sell a security to buy another, you are realizing capital gains, and this is taxation.
Now, in the ETF, most of the rebalancing happens in kind. When you have an ETF, people don't send cash, people buy an ETF in the market. A market maker, it's the one that sells the ETF to you has to create ETF shares. How does it do? In order to create ETF shares, they send securities to the ETF. So the manager receives security. We don't receive cash. The long-term shareholders don't get the costs of buying those security. They will receive the securities in kind. When there is a redemption, so you sell your ETF in the market, it’s the same. The market maker wants to get rid of that ETF share. In order to get rid, we deliver to them not cash, we deliver to them securities in kind, and they sell the securities and get their cash.
All the trading that happened inside the mutual fund, and all the trading that happened inside the SMA, when you had an ETF, happens outside. Since it happened outside, long-term shareholder doesn't get affected for all those costs. Also, since you're not selling security, you're not realizing capital gains. The ETF structure is a very, very efficient structure from the point of view of costs and taxes.
That's interesting. Are there downsides to the ETF structure relative to SMAs and mutual funds?
So directly to mutual fund, probably there is not. But if you think about 401(k) in the United States, 401(k)s cannot deal with ETFs. Why? Because a lot of the 401(k) operation happen overnight. ETF trade during the day. All the system for 401(k), all the plumbing for 401(k) is basically set up for mutual funds, or CIPs, that is collecting investment, another thing similar to mutual funds. Relative to SMAs, if you want to harvest a lot of losses, and use them somewhere else in your wealth management, an SMA can do that for you, because there is no corporate structure like it. The ETF cannot distribute losses and SMA can distribute losses, because it's part of your overall wealth.
Now, the drawback with SMAs, well, I love the harvest in losses. Yeah, we all love that, right? You can harvest loss here to us there. Who doesn't love that? The problem with SMA is that over time, you're buying equities because you think that equities will go up in price. If you write to the equities, and you have this cost basis, and over time, we expect them to go up. The basis remains low, and the market value goes up. So any rebalancing becomes very toxic, costly over time. That's all with an ETF. It's for some special cases, and SMA certainly makes sense.
Imagine that you sold your business today for 50 million bucks, let's say. It's January, so you have big capital gains that you have to pay by December.
So if you put off 50 million bucks in an SMA, you can have some losses to offset the gains. But it has to be this year that you harvest some loss, because if it goes to next year, it’s too late. In the United States, you cannot use losses from next year's against the gains. I think Canada is different. For some special situations, SMA probably make sense. In most cases, ETF is quite good.
That was a great, great overview of the different structures.
We have some write up in our website. If anyone wants it, just send us an email.
Awesome. We talked earlier about differences in expected returns between different types of stocks. How do you think investors should quantitatively assess the expected return advantage of a factor tilted portfolio?
This is a great question, and it's a very, very valid question. I will answer it in two ways. The first one is, do we think that there is an advantage? Then, we say, if we think that there is some advantage. Can we quantify that advantage? The first part of the question, though we think that there is an advantage, and we really think that there is an advantage if you do it right. Why? Because not every security in the market is priced with the same discount rate. Now, there is nothing, to tell you. Every security in the market will be priced exactly the same discount rate. The moment that you have differences in discount rates across securities, that means that you're going to have a difference in expected returns across securities.
Exactly.
That’s good. Now we know, okay, there is some logic why using fundamentals together with prices will allow you to identify securities that are expected to return higher performance to you in the future. That is the reason why some securities will perform better, and now there is some tilt in their portfolio, we want to call it. Tilting will do better than not tilted. There is a reason. We believe there is a reason, and logic, and data shows the reasons.
Now, the second part of the question is, how much is the value add? If I tilt this much, what do I expect my outperformance to be? That's a way more difficult question. Because the fact that we know that there is a reason why there should be an expected performance advantage, doesn't tell you how much that expected performance advantage is. There is nothing that tells us that. So then, you have to record historical data, and historical data, no matter how you do it, is one path in history. And the premiums in the past can be higher or smaller than what will be in the future, and there is not much about that. Historical data is basically the only thing that is going to tell you how big is a premium that you are expected to get from the tilting.
Now, you can do it in different ways. You can do, use historical data in a simulation, and you have a strategy. You simulate, and it's giving you an idea what will be the premium relative to the market or the benchmark that you're looking at. Or you can do it with factor exposure, so you do regression analysis. You say this regression analysis is telling me that I have these loadings, expected premium for these factors is so much, and then I'm going to have – if I multiply the load by the expected premium, it’s going to give me the expected outperform that I should get by tilting. You have to be careful when you do factors, because the factor definition matters. The loadings are not amazing things that are constant and the state variable. The loadings basically depends on how you define the factor. You can define a factor a little bit different than other factor with the different reconstitution than another factor, and then you're going to have a different load. Factors are a very good way to do it. Simulations are a very good way to do it. Probably you want a little bit of both. Factors is probably faster. Anyone can do it. You have websites that do regressions for you on any product in United States. That's faster and easier, but you should know the caveats.
I have a practical question for you, Eduardo. How do you think individual investors should assess whether a factor tilt actually makes sense for them in their portfolio?
Oh, that's a good question. You're now interested in factors in general. The first thing that you have to say is, do we believe in this factor? Let's put it that way. I don’t like to speak about factors. I believe more in our premiums, and we can probably speak about that later. But if you think about factors, there are more than 400 factors that have been documented out there. Do we believe that all of them add performance? No, some of them it's just noise. Some of the are real, they are related to some underline link to valuations or discount rates. Some of them are hedging. They provide hedge, but they really don't provide any higher expected returns.
For example, if you think about the small cap, everyone is speaking about the small cap. So you say, “I'm going to tilt towards the small caps.” The underlying concept there is saying, “Hey, small caps are expected to deliver higher returns than large caps.” And immediately, you say, that by itself is a little bit difficult to think in isolation, because you say, “Hey, I have a small cap company, and I don't look at anything, but just the market capitalization being small.” Do you think that that's all what you need to see higher returns?” The answer is no, because I can’t give you a small cap company with very high price relative to fundamentals. You’re saying, “Huh, certainly, that is going to have higher expected returns.”
Again, you have to have something that tells you relation to valuation, so relation to discount rate. Because the discount rate, the higher discount rate at the end of the is a premium. So if you want to assess and this factor tilts make sense for you, first thing, be sure that whatever you’re thinking, whatever premium you are going after makes sense. That is something that will persist. Once you know that it will persist, and you think, “This is a real premium.” Now, I know that that premium is real. Now, we can decide. Is this premium right for you? I think, for most people, they are very reasonable. A lot of reasons why to deviate from the market portfolio. Under some assumption, the market portfolio is the most efficient portfolio, but those are very extreme assumptions. In reality, that more realistic assumptions will tell you that it's probably not the most efficient portfolio. There are many good reasons to hear from the market portfolio and use some of this premium to some degree.
Now, if you are an investor that is completely obsessed with tracking error, because you don't trust your managers, you don't trust anything. So you have to index. You have to index S&P 500 index or the Russell 3000 index or some index. But if you're an investor that is more relaxed, that is willing to consider tracking error, willing to know that there are deviations from the market, then you can use these factors that make sense, explaining that make sense, and really, enhance performance of your portfolio with a better implementation and a better investment logic. Yeah. I think people should do it as long as they're not obsessed with tracking error.
If tilting toward premiums makes sense for a lot of investors, or most investors, who's on the other side of that trade?
Now, you are going to one magnificent question. The question, we can put a different . Let's think about the market portfolio, and you advisors and you having in front of a humongous amount of clients. You know that not everyone comes to you with the best portfolio. I'm sure that you have people that have the most weird portfolios that come to you. Man, probably one day, we should do just a whole session about that. And you have people that deviate from the market portfolio by weird portfolios, like single stock portfolios. Why they buy a single stock portfolio? Because they love the idea of having a single stock portfolio, because they don't know the drawbacks of having a single stock portfolio. Or some people that deviate for good reasons, from a good portfolio. Deviate for good reason, maybe because they owe a lot in taxes, and they don't want to pay these taxes because they can’t or for some other reason. Or they have restricted stock.
We know a lot of people that deviate from a broadly diversified portfolio that makes sense, for good reasons, for tastes and preferences. So, there is a lot of deviations from a good portfolio. There are people that have bad portfolios. If we know that people have bad portfolios, what is the market? The market is the sum of the people that have bad portfolios, plus the people that have the complement, or that bad portfolio. Okay. Why people will buy a complement portfolio? Well, they will buy a complement portfolio because the price incentive, because it's more optimal portfolio than the bad portfolio. The market is the average of both. The more optimal portfolio and the bad portfolio that some people have.
Why do we have portfolio that have premiums? We have portfolios that have premiums because there are differences in expected returns, there are difference in pricing, and some of them is because people just price security, allow some security, some portfolios that are suboptimal. If people have portfolio that is suboptimal, it means that there is some other portfolio that is optimal, that will have a better risk return tradeoff. The market is just the average of both. When we're tilting, when we're trying to find security with higher expected returns, what we're trying to do is getting toward that optimal portfolio. That is a portfolio that is broadly diversified, similar risk characteristics market portfolio by higher returns. Here at the bank, it’s what we do. Is we deliver those components that allow you to move towards that optimal portfolio. Make sense?
It does, but I have a follow-up question. From the description there, it sounded like the lower expected return portfolio that's suboptimal because people are making errors as opposed to hedging other risks outside of their portfolio like –
It can be hedging. When I said irrational things, so I told you – I said to you, very bad decisions. Some people have very bad decision. “Hey, I like my five-stock portfolio.” You heard that in TV, yeah? But some people have rational reasons why they do it. Taxes is one of them, restricted stocks is some of them, hedging needs is some of them. Your work in the airline industry, and maybe you want to have airlines in your portfolio.
Okay. Yeah.
There are a lot of things. When I say base preference rational decision, it’s a lot of things to one bucket, really. It's suboptimal, in some cases, because of bad decision. In some cases, it’s optimal for them. But they are deviating, the moment they are deviating, there are some securities they are not buying. The moment that their security is not buying, someone else needs to buy. But why will I deviate and buy these other securities if there is no price incentive? So probably there is a price incentive.
You mentioned something, Eduardo that I thought was interesting. You linked the desire to avoid tracking error to trust. You mentioned trust in the manager. Is it also fair to say it's trust in the premium? Because anytime you're different than the market, you're making that decision actively. Can you talk more about that trust?
Yeah. Look, a lot of knowledge and say, “Look, there is a cost for you to monitor your managers. The cost of you to monitor the manager is basically zero if your manager is tracking an index, because the only thing you have to look is the performer match the performance of the index. That is really no cost of monitoring your manager, it’s very, very simple. If your manager is deviating from the performance of any index, now you need to know more. You need to understand why they are deviating from the performance of the index. That's understanding the premiums, the logic, the strategy, and whatnot. Then you have to say, the implementation is following the expectations that you have because of the deviations through the premiums or whatnot and the strategy, embedded in the strategy.
So if you're tracking an index, it’s very simple to monitor. The moment that you deviate, you have to understand the strategy, and you have to understand that this strategy is being managed in the way that you expect it. It's a little bit more difficult. Some investors don't want to do that. They want you tracking error. They don't have to monitor anything and that's fine. There is an opportunity costs for that, because indexing certainly suboptimal. But you know, everyone is free to decide what they want.
I want to keep going on that idea of trust. Then you mentioned or alluded to a couple of times that there are hundreds of brands out there, 400 premiums in one paper that you mentioned. How do you know that Avantis is targeting the right premiums?
That's super important. For anyone, should be super important. It's certainly super important for us. Why? Think about this. Because you observed something in the past, you cannot think that that's a premium that will proceed in the future. Remember payphones? Every big city in United States and in the world have payphones, so we can make an empirical observation based on past data that payphones are a feature in every big city. It’s empirical. We saw it since, I don't know when payphones were in existence. That's part of the past, it’s not going to continue in the future. You rarely see payphones in anywhere now. In the airports maybe, but not really. To the point that I want to buy one to put in my house as a piece of art. I love that. The 9X payphones were beautiful in New York, I don’t know, four years ago. But now, no.
You cannot rely only on empirical data, and that's fundamental. You have to think about why this will persist. For us, that goes back to valuations. It has to be something linked to valuation, because all you have to really look is, is there a discount rate embedded in that price, et cetera. That’s the only thing that you can do, is look in valuation. Look historical research on asset pricing models, factor investing if you want, the asset pricing models, is trying to find variables that tells us something about discount rates. That's a good research, by the way. The other one, start looking for patterns.
For us, everything started with valuation. Do I have a reason if I look at a company why this premium should exist? If you think about that, is how you buy a company, when you go and buy a company, what you think about. When you think about – when you're deciding how much to pay for a company, you have to decide, well, how much equity is in the company, assets minus liability? That should be something that matters when you're pricing a company. What else matters? Expected cash flows. Knowing the company's making money is different when the company's losing money. So expected cash flows matter. Then you're going to apply some discount rate to those cash flows, because those cash flows are in the future are expected. You’re not going to pay a dollar today for a dollar in the future, but it’s expected, and it’s certain.
The price of a company will have to do with the equity, plus something about the expected cash flows if provided by some discount rate. That's giving you a valuation framework where you can relate to price, the equity of the company, and the expected cash flows of the company with the discount rate. Why is that important? Because the market is telling us the price. The price is embedding a discount rate. By using fundamentals of price, you can differentiate what companies have higher and lower discount rate. This is telling you a valuation framework, why there is a difference in expected returns among companies, and why some companies are more affected than others. Once you have that valuation framework, you can say, “Okay. These variables, if combining one way or another give me characteristics or ratios that are related to the discount rate embedded in that price. I can use these variables together not in isolation. We can use these variables in equity, cash flows, product, can be used together in order to differentiate what companies are at price, with a higher embedded discount rate in the price, with a lower embedded discount rate in the price.
Once you have that, you can create portfolios expected to outperform. This is basically the way we think about creating portfolios instead of just chasing empirical data from the past, that may or may not happen in the future. Now, the theoretical model in isolation is not enough, because I can't create a theoretical model that I move my arms and I should fly. I don't want to try, because it's not going to happen. So you need a theoretical model that guides you on what to look, but also, you need empirical data that corroborates with your findings theoretically, also work in practice. You want to have that data across markets, across market cycles, because you want to ensure that it works. I think about my PhD thesis, it was more or less about that. I mean, the thesis, about creating a model that fits some physical phenomena, and then trying to solve that model to see the finding from that model match the physical phenomena. Here, it’s the same. You have a valuation framework that tells you what variables matter, and then you want to see that empirical data based on that model, corroborates historical data, and that the premiums that you predict really were seen in the past, and that gives you a lot of assurances that should continue in the future.
Interesting. I'm curious, what type of investor if anyone does 100% small cap value portfolio makes sense for?
You will answer that one or one of you answer that to a journalist in Canada, because a journalist in Canada told me, “If you go to an island for 50 years. I’ll take one portfolio. I know which one you say. I think the one that’s a small valuable. Strategy. I don’t know who of you. But look, let's go to back to Markowitz. I think that there is an interview that has a beautiful phrase. I will paraphrase. I don’t want to say his right words of saying, look, when he was thinking about the mean balance optimization, he was saying, “It cannot be that people pick – when people pick portfolio, it cannot be the people pick the highest expected return security. Because if you're trying to pick the highest expected return security, you're maximizing return, just returns, but risk is not part of the equation. So you have to consider returns and risk together. That's what the guide of Markowitz, is to create a means by this optimization, or the risk return tradeoff, if you want to think about that.
In general, I would think that most investors will be happy to have a small value. But as part of their portfolio, but wait, it's probably because they want to enhance expected returns. But having it in isolation will be someone very special. Someone that only buys more value will be someone very special like you guys. If you go to an island for, I don't know for how long I think you mentioned. So who will be that someone very special, it will probably be someone that has excess capital, so money that they don't need really, a lot of excess capital, they have very long investment horizon with very long-term asset growth objectives. For someone like that, probably it will make sense. But most of us humans that are not in that situation, we probably have a portfolio that's a little bit more diversified than just a small one.
Good answer. Such an interesting one, because small value might be more volatile. But when you look at again, empirical data, like what outcome is more reliable, small value actually starts to look pretty good. So it's a tricky one to think about.
Remember, diversification matters. We learned that from Markowitz and Markowitz learn it by observing how people behave, and then put it in a mathematical model, that is the risk return tradeoff. But certainly, there are maybe some investors that that’s right portfolio, but most people will have something that is more diversified than just small one.
But it goes back to your comment about trust, you really have to trust in this premium to hang on that long?
Yeah. You feel better if you think that that's related to valuation, it’s not a pattern. That's why when you look at company holistically, instead of just picking a factor. Like for example, if you pick a low price to book security. A low-price security can basically have low price, because they really have no earnings, for example. And you say have low price because of no earnings is not because they have a high discount rate. The price is low, because no earnings. I call them like gas station sushi. The price is low, man, we want cheap sushi. Let's go to a gas station. I don't know if that's the right thing. I prefer to go to a sushi place, like the one you have across the street you actually visit. You say, they’re an old Japanese guy, they have 10 seats, they have great price to be fair, and the quality is missing. Well, I prefer competence that the discount rate is high, the price is low, not because the company doesn’t have earnings, not because the company is full of liabilities. I prefer a company that price is low because the price is embedded a big discount rate, and because that discount rate is my expected return. Low price for a sake of low price doesn't tell you much.
Okay. I want to keep get going to that. We're kind of talking about, you can maybe trust the premium more when you combine relative price and something like profitability, which as we know, many of our listeners know are two of the metrics that you guys are looking at when you build portfolios. Can you talk about how Avantis targets value and profitability together?
First, I'm going to take exception with value. You say first, relative price, and then you call relative price value. Let's define what’s value. Value is not money in low price. It may be low price to book, for example. Low price, but that's not value. What is value for me? For me, value is high discount rates. When you go to buy something at the store, and it's on discount, big sell today. Oh, that's a value buy. If the price is totally discounted, that’s value. That’s value for me. It’s not just low price. How you come to have low price. You come to have low price, because for no profits or big liability. So you can have low price because big discount rate. We care about big discount rates.
The only way that you have to find what company have high discount rates embedded in the price is to consider the equity position, assets minus liabilities, and the expected profits of the company. You cannot do that with one without the other. Both of them have to be together. Because if you just only look at low price to book, that's what we spoke a minute ago. You can’t finish when the company has low price too, because it has net operating loss. That's not a big discount rate, that's just low price. That's just gas station sushi. You get what you pay for. What you care is, about these two things together, because these two things together go into a valuation of a company. When you buy a company, valuation of a company will consider the equity position, expected cash flows the company is generating. These two things together go into the price together with the discount rate. So you want to use price and these two things together, the equity and cash flows in order to assess what companies are cleverly discounting.
Once you find what companies are currently discounted, then you know that you have a value portfolio, good value portfolio, portfolio that has high expected returns, not just low price. I think about low price to book or adjustable low price to book profitability. As you mentioned that you want to have a good pizza. Is a good pizza enough? No, you need good crust. Is good crust enough? No, you need good cheese, you need these two things together for good pizza. So if you want to find a company that at this price is attractive, you need to look not only at the book bind, you don’t need to look only at the profitability. You need to look at these two things together. There is no way out, and that's why we do that.
Is it done – looking at those two metrics together, is it done the same way in large caps as it is in small caps?
Yes. If you see pattern while we are looking. Let's suppose that you are looking for a pattern. You are looking at the pattern, you will think that the pattern is small cap, or the pattern in emerging markets, or the pattern in large cap is different, and you work hard to adjust patterns. But remember, we're not looking at patterns. We're trying to link everything to valuations. Valuations is the same if you’re buying a private company, you're buying a small cap, you're buying a large cap, is you're buying anything that is an opportunity to make money. We go back to the Babylonians and we were buying a business that sell donkeys or to go to Mars in the future. We're having a business that sells water. It's about valuations. So yes, it’s not the same. This is about valuation, not patterns.
Okay. We talked about the two metrics they used together and why that's important. Can we get into the nitty-gritty details of how you actually weighed those metrics when you're building portfolios?
Yeah. Basically, we use a joint metric approach. We can see it and adjust it, book to price, and we use a cash profitability metric. We use them basically equally. Why not wait one more than they are. I cannot tell you that one should have a little bit more weight than the other. If you look at historical data, what you see from historical data, that the patterns are quite symmetric in the two metrics when you're using together. It's difficult to speak without numbers, and I want to show numbers here, but they're quite symmetric. It's not that you consider them jointly equally, you may have to consider one a little bit heavier than the other. But there is not enough information to make one a little bit here and there and by how much. So you have to consider both, we consider them equally. I cannot tell you that it should be 55-45 or before, even 50-50. I can’t tell you that it’s quite close to 50-50, so that's what we use.
Interesting. Okay. Are there any downsides or disadvantages to using that joint metric?
I don't think so. You're using a more complete model than using any one in isolation. Again, when you're buying a company, you will consider all these variables. When you're thinking about the portfolio, you also should consider them together. Because that's basically what leads to valuation of the company, that links to how things work in real life out there. I don't see any downside. I do think that in the future, things can be even more complete. Some models get complete over time, more, and more complete. They're never perfect, by the way. Models get more and more, they've gotten better and better, and more and more complete over time. So there's certainly opportunities to make it better. But the state of the art is here, and whenever the state-of-the-art change, we have shown that we're willing to embrace change, if it makes sense, and we , but we’ll do it.
I want to dig into some more nitty-gritty details for a second here. We've seen some research suggesting that cash profitability, which adjusts for accruals is suboptimal compared to using operating profitability, which does not adjust for accruals, and directly addressing high investment firms, which some research suggest accruals are just a proxy for.
You're saying cash profitability versus operating profitability plus investments together. Yeah?
Yep. That's much cleaner. How do you describe why you use the cash based?
I think, I know the research. I know the researcher; they are great people. I think they’re friend of mine. You can look at the tables that they have, and you will come to the conclusion yourself, that there is no question, even they're recognizing, when you look at the tables. Cash profitability is a better metric than operating profitability. You can link that to Robert Novy-Marx. Robert did amazing breakthrough in my mind, one of the greatest breakthroughs that we have seen in many years. The breakthrough is saying, look, just try to get variables that are linked to the business without manager intervention. Variables that are managers actions, so the CEO, the CFO action doesn’t affect that variable too much, because if it affects too much, then the variable is not comparable, and cash profitability, that's why it's superior. There is no doubt about that, that operating profitability.
Now, the question is, what about investments? Because investment is exactly the same as accruals. While operating profitability, plus investments will be the same as cash profitability. Yeah. Why don't we address the question? Is investment the same as accruals? That's a very simple answer. It’s the same as water and oil, nothing goes one with the other. Investments, and you don't even need historical data for that. You can look at today's data. You get the market, I'm going to get the market and create a matrix. The matrix is going to be company sorted by level of accruals on one axis, and the other axis, companies sorted by the level of investments. If they weren't exactly the same, I will tell you. If one has nothing to do with the other, I will have a full grid full of numbers. No ]. What do you have when you look at that matrix? A full grid.
Accruals have absolutely nothing to do with investments. Okay. So now, we know that accruals have nothing to do with investments. Now, the question is, okay, I can do operating profitability, plus investments, or cash profitability, plus investments, because you can – since investments is not the same as accrual, you can apply to both of them. That's what we do. We use investments. We do use investments, and we also use cash profitability. Why? Cash profitability is superior, and investment is something that should be considered and we use that.
How does Avantis deal with sector weights in all of this?
That's a good question. That's a topic for today’s discussion. There are two underlying things. First, I’ll say what we do, and then I tell you the other side of the coin. We tried to have well diversified portfolios that have high expected returns. In the market wide strategies, sectors are not much of a big deal. The sector aviation side are not so big. In the value strategies, there is big sector aviation. These strategies may become very concentrated in particular sectors at some point in time. What we do in the value strategies, we have sector caps. We don't want to hire a portfolio that is completely dominated by one sector. Because remember, what we were speaking earlier, there is a tradeoff between risk and return. You don’t want to finish with one security with higher expected returns. Part of diversification, we found diversification across sectors.
We have sector caps, even though that may give up a little bit of expected returns. We have sector caps in order to ensure diversification in the value strategies. Now, the beauty of using the join metric, so profitability, and adjusted book to price is that the concentrations that you get are not as big as if you use only, for example, book to price. If you only book to price, you finish with portfolios that are very, very heavy in financials. If you use profitability jointly adjusted with the price. You also have some biases, but they are less, because some companies are priced more based on the cash flow, become more important than the book value. So they don't become as concentrated if you want to think, but still, we have sector caps. That's telling you what we do.
Now, there is another thing that is good in speaking, it's about, why don't you use this valuation framework that you are using, that we are using at the sector level. Then we put the portfolio of different sectors, tilting within sector, instead of tilting all across. We don't do tilting within sector. because it has a little bit lower expected returns than tilting all across. The volatility of the portfolios is very similar, but you're giving up returns. Why you're giving up returns? Imagine that the whole sector moves toward low discount rates. If the whole sector moves towards low discount rate, because the price goes up, and up, and up. Then the whole sector suddenly is going to have low expected returns. If you’re tilting within sector, you're going to have the most attractive company within that sector, but not as attractive as companies in other sectors. So you're giving up a little bit of expected returns. What do you get? What's the benefit of doing, tilting within sector?
If you want to have a strategy that is like in indexing properly tilting within sector, make sense? If you are not trying to do that, you're trying to add expected returns to create components, so someone, an advisor can create a good asset allocation? What we do probably makes sense.
Okay. I want to make sure I understand, so I'm going to try and reiterate what you said. You're tilting toward value across sectors, not within sectors and applying a sector cap.
Yes, exactly.
What is the sector cap?
The value strategy, we have an absolute sector cap of 30%. We don't want sectors to go to us 30% in the strategy. Let's suppose that someone hires us to manage a portfolio in some particular market, where that market has 40% in financials. We had to adjust to cover that into the market. But in our current strategy, our sector cap is 30%.
Interesting. Okay. You also mentioned one of the downsides potentially being tracking error. What about industry specific risk?
That's why we have the sector caps. We want to have sector caps, because we want to be diversified across all the sectors.
Got it. You mentioned a few times or alluded to a few times adjusted book value. Can you talk about the adjustments that you make to book?
Yeah. Yes, of course. So when you're pricing a company, what you want is some measure of the equity of the company, and no one knows the equity of the company. So you have to come up with a proxy. The way to use a proxy, you can use book value. Now, if you look at book value, book value has several components. One of them is Goodwill for example. Goodwill is certainly not equities, so we get rid of goodwill from our measure book, we book X Goodwill. That's why we say adjusted book value. Why this makes sense? First, where that will come from. If I buy your company, my book value after the merger will have a line item called Goodwill. Why is that? So when I'm buying your company, what am I paying for? I'm paying for your equity, you have beautiful building, assets, liability. I’m paying your building, but I’m also paying for your cash flows.
My book value will go up for whatever I pay for your company. So it's going to go up for whatever I pay for your cash flows, and also will go up or whatever I pay for your equity. Assets minus liabilities. How that's going to be reflected in my book after the merger. One, it's going to reflect whatever I pay for your equity, your building, whatnot, is going to be line items, is going to be our property plant and equipments. I’m going to say, “I bought this building from Ben. This is the fair value of that building.” Boom. My book value goes up in that line item for whatever I do. Whatever I paid for your cash flows, where does it go in my book, but there is no line item in my book for cash flows in the future. But where do I put it, there is no place to put it. Whatever I pay for your cash flows goes in Goodwill. If I pay a premium for your company, that's also going to be Goodwill. Everything I pay for your cash flows goes into Goodwill. Goodwill is really not a reflection of the equities, a reflection of whatever I thought that your future cash flows will be worth, and that comes into my book. So it makes no sense.
Even more, I suppose that both of us decide to merge, and most of us have the same book to price, but your company is much bigger than mine. If we merge, and absolutely no synergy, synergies are irrelevant here. Because you finish with Goodwill without – even if there is absolutely no synergy. I told you; you're paying for cash flow. It shows up in the book, no synergies. Let's suppose your company and my company are going to merge. If we decide to merge, then the book of the final company will be different if I merged into you or if you merge into me. Even if we continue being independent businesses, just because it's going to be Cameron & Ben, is the surviving name, or Eduardo & Company is the surviving name, the merged company, even though we will continue operating in isolation without doing any synergy or anything. The book value will be changing, and it will be changing depending on its surviving name is Ben & Cameron or Eduardo & Company.
If I do adjusted book to price, the adjusted book, the way I do it, book value will not change. So Goodwill is something that's really an accounting plan, is a reflection of cash flows on the company that's been acquire. If there is a premium, it's also going to be reflecting, because the premium is when the discounted rate of those cash flows that you're buying is low. That's why the price of the company goes up. You have to adjust if you want to make a good variable. If you look at historical data, you see that that there is a premium, a performance when you do this adjustment. Now, this adjustment was not too relevant if you go 20, 25 years ago, because there was a change in accounting standards. Now, if you look at the typical US company, the Goodwill represent around 45% of the book value of the average US company. And internationals have increased dramatically because of change in accounting standards.
If you go to the original research, for example, 20 years, 30 years, 40 years ago, thinking about book to price and whatnot, that book to price that you have in the past is more reflective of today's adjusted book than today's book because of the change of meaning of book, because of changing accounting standard. So it makes absolute sense to change. It's even more, think about, Ben, and now I put you on the spot. Let’s suppose your company is a company that has very, very high price to fundamentals. So your discount rate in Ben Enterprise is very, very low. So your companies are super high price. What will you do as a CEO of the company, if you want to add value to your shareholders? What you will do is get your shares and started buying other companies. And you're willing to pay premiums for all those other companies. Why? Because your shares are hard currency. Anything that you pay, you buy, any other company that you buy, even if you pay a premium, we have a positive MPV, because you're embedded discount rate and your price is very, very low. So you will go and buy companies with your shares. You are adding value to the shareholders by doing that.
What are you doing in that process? You are increasing, and increasing, and increasing your book. The more that you pay, the more that you increase your book. If you adjust Goodwill, that’s gone. If you don’t adjust, you're going to have a company that has very low discount rate, because they're increasing, increasing, increasing the Goodwill portion of the book. We're still looking at a company that has low price to book, and so you have to make the adjustments.
It's very compelling the way that you explain it. Earlier, you talked about the importance of testing theories like that empirically, what does the premium for the Goodwill adjustment look like in the data?
Thirty something basis points a year. We have it right up there on the website. Anyone that wants to see, please call us. Sunil did amazing work, and that's Sunil Wahal. Professor Sunil Wahal did amazing work on this. We’ve been engaged with people that are in accounting standards, sometimes a whole discussion about Goodwill, because it has some benefits to have. It has some more benefits. If you remember, you go back in time, it was treated completely different. But today, whenever you buy a company, and you create Goodwill, that becomes sticky. It doesn't go away, unless there is an impairment. You say, I'm buying all these future cash flows of this company, and the value of these future cash flows. That's not exactly how it worked, but that's how we’re paraphrasing. The value of the future cash flows is going to be 100 million. So you have 100 million and it goes away.
Now, that 100 million stays there, unless someone say, “Why hat 100 million is not 100 million now? We didn't get it right. It should be 50.” So you're writing it down or you're just completely writing it off to see them. Imagine you are the CEO or CFO of a company. Do you want to do that? No, because it affects your balance sheet and affects your earnings. You don't want to do that. The auditors have to push you very hard, and you're going to push against that. That's why it's a huge number in the book of companies. That's why you have to take into account. You have no choice.
Very interesting. Can we shift to fixed income for a bit?
Okay.
The existence of a credit premium, I think it's fair to say it's sometimes contested. Can you tell us what the Avantis view is on pursuing a credit premium in your fixed income?
Look, I don't contest it at all to be fair. Do I think that the Triple B Company, we have the same discount rate in the bonds as a treasury? No, I don't think. I think the Triple B Company will have a higher risk on that. So that means the higher expected returns and that’s what you see. You see a credit premium. We have no issue, right? I think a credit is part of the market. If I'm willing to – I have to have a reason why to deviate to the market, why we’ll not say, “I'm now going to white, only white treasury.” No, that’s part of the market, happy to buy credit. We invest in credit, and there is no issue with that for us. As long as you do it, you’re doing in a diversified way, with low cost and whatnot, I think there is no issue. We do believe in the credit thing.
Similar to what we asked about with equities earlier, what are the advantages of the event as fixed income strategies relative to just buying cap-weighted bonds?
Cap-weighted is a very interesting thing, because in equity, cap-weighted is market cap-weighted. You're waiting by the equity of the company you want to. In bonds, you are waiting by the death of the company. I issue more there, but have more weight. But when you're saying cap-weighted is interesting. We say, they’re voided bonds, and this is not cap-weighted bonds. That’s what really it is. But if you look at the typical index, what does an index does? The index is, whenever there is a new issue, a company issues a new bond, that bond gets added to the index, and it's held in the index.
For example, if you look at the – I mean, just like they are. It’s held to basically very close to maturity. So you are adding bonds automatically to your index and holding them, disregarding what. So, where is the risk return tradeoff in making that trade? That is not a risk return tradeoff of making the trade. You are automatically in bonds, no matter if they're attractive from the expected returns or not. And you're holding them no matter what. That really doesn't make any sense.
In particular, if you have a dead-weighted portfolio, like a dead-weighted index, because that's what they are. That's the approach that we do. What we're trying to do is whenever we add bonds, and this is systematically done, it’s not just one pick. Whenever we add bonds to the portfolio, we’re adding them because they can enhance our expected returns, or it can enhance our diversification. We are not forced to hold them to maturity. At some point, we may sell that bond and buy another bond that happens to add more to expected returns to diversification that they want that we hold. It’s the same. We’re speaking about the small value. The small value company. It’s small value because it's attractive from their point of view, price, and fundamentals. If the price goes up, suddenly, it used to be attractive. Now, it's not so attractive. You sell that and you buy another one. The same process you kind of think when you're speaking about our fixed income. We buy bonds that happened to be attractive from the point of view of expected returns, and hold them. At some point, they may be less attractive, and so we have to sell them and buy a new one.
If you think about a bond has an average yield to maturity, that average yield to maturity gives you an idea of the average return that the bond has from the moment that you buy today until maturity. Now, that doesn't mean that every year that bond will have that expected return. That's the average expected return over all these years are different holding periods, you're going to have different expected returns. What we do with these yield curves, it just says, what's expected return of the bonds today, of the bonds in the market, and the bonds in our portfolio over for a holding period, let's say for a year? If what we hold is not attractive as what is in the market, we're willing to affect the trade, if it makes sense from the cost point of view. Expected return after costs. If we do that, we are really making decisions based on risk return tradeoff, not just automatically adding bonds, and holding them or what that adds to an investor. That's the difference.
I have a practical question for you, Eduardo. Client might ask, “Okay, my bond portfolio, let's say it's down this year 10%, I can now buy a term deposit for five years at 4% to 5%. Why would I not want to do that?
Well, you should have done it before. Now, it's something percent. In reality, when you buy fixed income, you should consider all the alternatives, you should consider time deposits, you should consider certainly the fixed income, and you should consider even fixed index annuities. At the end of the day, if you can get annuity if we are the commission, it’s also kind of a synthetic bond, if you want to think. You should consider all of that. And in some cases, one makes more sense than the other. If you buy time deposits, and you want to get the premium, you're going to get long-term deposits. That brings illiquidity, the same as a fixed index annuity. That may be okay for some part of the portfolio that wants to bring also liquidity, so you can sell them at any point when you need it. So you have the expected returns, and you also have the liquidity. So it depends on what part of the portfolio. You may use one more than the other, or use all of them.
I want to come back to the sizing of premium tilter or factor tilts. We talked earlier about how should someone decide the factors that make sense, who does 100% small cap value makes sense for? When you design something like the all-equity market strategy, which has tilts, how do you determine what those tilts should be on a product like that?
That's a great question, because at the end of the day, I'm trying to refer based on preference and needs of people. We just – I don't know all the people, so I had to make assumptions. We have been working with advisors for a long, long time. Advisors are the ones really assessing the need, the tolerances, and everything that investors have. I don't speak with the investor and trying to say “When you're creating a strategy, like an illiquid strategy that we have, we are trying to satisfy some need.” We pay attention to these portfolios that advisors are putting together. So we try to get a portfolio that has reasonable tilts that can be done in a commingle way, and it can be done very efficiently. The tilts that we have there, it’s a reflection of what we see in the advisors’ performance.
No one has the same portfolio. I cannot imagine. Maybe someone does, by the way, but I cannot imagine that everyone has exactly the same portfolio. Now, what does it mean, commingling? Commingling, so when you buy an ETF, you can say, “Well, that ETF is not exactly what I really want. I wouldn't want something that's a little bit different.” Well, the solution is you want something a little bit different is you buy an SMA, and it's going to be a little bit different, but the costs are going to be higher, the efficiencies are going to be lower. Whenever we decide to commingle into , we are just giving up a little bit of our personal decision for the benefits of comingling. The same as when you make a customized suit, you can have a customized suit that has five buttons instead of four buttons. Yeah, it's going to cost you more, it's not going to be as efficient. Maybe that's important, so important for you or if not the same. I'm okay with three buttons, I go there.
Basically, what we try to do is create a comingle solution that makes a lot of sense, that is commonly seen in advisor portfolio, and can help advisors have a one stop shop or minimize the number of components because this kind of strategies are very efficient from the point of view or rebalancing. Advisors can use it for a small account, advisor can use them in mixing with fixed income, or some other portfolio, and minimize the number of components and increase efficiency.
Why have we not seen an emerging market small cap value strategy?
That's a good question. I think that we have one, but that's in the eye of the beholder. If you think we have a market-wide strategy, the emerging market equity, then we have an emerging market value strategy. That strategy is mega-cap companies. If you think about mega caps, mega cap’s value has lower premium than mid-caps and small cap value. What we say is, instead of just focus – the emerging markets is smaller market, it's less liquid market than. I’ll say, instead of just focusing only on the small cap, let’s focus on small and mid-caps. Let's try to – let's exclude mega cap basically. Let's try to create a strategy that has strong premiums that you see in mid and small caps, but also have the liquidity and the diversification benefits. We settle not for a small, we settle for a portfolio that excludes mega caps. So basically, it's kind of mid and small caps.
Interesting. Maybe it is a small cap value strategy or close.
It's not a small cap per se, because it is a little high. But if you look at the premiums by market capitalization, premiums mega caps are managed more than the premiums in the mid-caps. Mid-caps and small caps, small caps are higher. I'm not telling you now, but when you go to emerging markets, the costs are higher and the liquidity is lower. So you're making a tradeoff. Yeah.
Yeah. Okay. Makes sense. Something that I was surprised to see, just because it doesn't fit with the typical type of products that you guys make was the inflation focused equity strategy. What goes into developing something like that?
I love it. I love it. Because yeah, I knew that this was going to throw a little bit of questions to us. I love those questions. Remember, I think – I don't know it was you Ben or Cameron at the very beginning that said, “Well, there are hedging needs that people do.” We’re not speak about why people deviate from the market, people deviate based on preference or rational decisions. And the rational decisions may be taxes, or hedging needs, and whatnot. This goes into the hedging needs. We are not telling you that the security has a higher premium by any means, but these securities provide them on top of the typical premiums that we deal with, not the valuation framework. We can also deliver something that is like a hedging move, some portfolio for certain investor makes sense.
I'm going to divide your question in a couple of things. First, from the market point of view, and then from the investor point of view. From the market point of view, there are some securities that do better in some inflationary environment than others. There are some security that correlation, we think with long-term inflation, and others have negative. The market is the average of both sets of securities. If you think about the market having some significant positive correlation with the long-term inflation, what kind of securities are those? Well, that securities really have pricing power in whatever they produce, and they are not affected by pricing power in whatever they need to provide their services, to create their outputs.
For example, think about oil, if you are an oil company, if oil goes up, inflation also goes up, commodity feature, strategic buying, all features go up, and all the stocks probably go up. You feel linkage there between long-term inflation and the cost in this particular case, energy, or oil. There is a set of securities that are more correlated with inflation than others. From that point of view, I can create a portfolio that restrict the universe of securities, higher respective correlation with inflation. Then, once I got that unit of security that have higher correlation with inflation, and I can use all the toolkit that we spoke before our valuations, profitability, adjusted book to price, and whatnot. From the point of view, can I create a strategy? Yes, I can. I can do it in a diversified way. It's more – I'm not limited to using a commodity features, because commodity feature doesn't have higher expected return. The premium is basically zero. I can do it in equities when you have the equity premium and I can do it in a structure that is very tax efficient. So everything is very appealing from the product point of view. I can create a portfolio that is expected to be correlated with inflation, have higher expected returns and it's very tax efficient. That's great.
From an investor point of view, you say, okay, you can create that, so why should I care? Who the heck is going to buy that portfolio? That goes back to what we spoke before? Look, there are certain investors that are more sensitive to inflation than others. Some people have their compensation, completely adjusted by inflation, so they're not really sensitive. Some others just the opposite. So some investors are more sensitive to inflation than others, and having a tilt towards strategy like this, and really portfolio. By no means I’m telling you that it will enhance expected return, like buying a value strategy. Think about this like a way to tilt a core strategy for not expected return, but for hedging needs. You should have similar expected returns than you have when you have a core strategy. But you’re having a hedging benefit that you don't have if you have a regular strategy. There is some investor that would have a benefit for that. It’s certainly better than buying other instruments that you have out there that can provide you inflation hedging. Like if you buy tips, perfect inflation hedge, much better than us. But the opportunity cost of buying tips is huge. The factor analysis super long.
So, well, I can by commodity strategy. By commodity strategy, which basically have low returns. And on top having low returns is very, very tax inefficient. So it’s really not great, and so this gives you the highest expected returns, and the tax efficiencies, and the low fees and everything so it’s good.
So we talked about like the value profitability premium, the research there is pretty good and it goes back decades. How would you compare the rigour of the research behind something like the inflation focused equity strategy to the more general value profitability premium?
Well, value profitability applies on top of the subset of security. We are by no means – I'm not saying no. Basically, this is restricting the value and profitability on a subset of securities that you can apply value and profitability on small cap securities, or you can say apply value and profitability in large cap security. Here, we're saying, we need to apply value and profitability on top of a set of securities that are expected to have higher correlation with long term inflation. By no means we’re saying that you shouldn't give up the value and profitability. No, no, no, no, no. You should use that, but on a subset of securities that are expected to have higher correlation to inflation. This very strong, all this.
This question might be a little too inside baseball, maybe you can’t answer. But I'm curious if you have product examples or tweaks to methodology that were considered but you ended up not implementing?
Yeah. More have you wasted time and money? The answer, yes.
It’s a better way of asking it.
Have you wasted time and money? Yeah, we have wasted tons of time and money, but they don't consider that a waste. Whatever you learn, it's not a waste. I'll give you an example. This is in the spirit of everything that we have. We spoke about cash profitability. There is another variable that people have considered to consider profitability That is free cash flows. I'm sure you guys have heard about these free cash flows. What is the relation between free cash flow and cash profitability? They're very, very similar. If you get cash to profitability, and you subtract CapEx, capital expenses, you finish in free cash flows. The difference between free cash flows and cash profitability is only one line item in the statement of cash flow. It’s called CapEx, the capital expenses.
We look at free cash flows, and we were excited about free cash flow. Very excited to the point that we start thinking about implementation, and the components of implementation while we’re excited, all of that. To be fair, we didn't do it because it doesn't work. Why it doesn’t work? I’m going to give you a very simple example, and then I will link it to Robert Novy-Marx. Again, I think on Robert’s paper, it was a great insight. Let's suppose that you have two companies, and both companies, one company has great cash flows, so great cash profits, and the other one, barely breaking even. Zero cash profits. You're running the company that's making a lot of money, so you decide to invest, so you do capital expense. Your free cash flow is going to be your cash profits minute your CapEx.
Let’s suppose that you’re spending CapEx similar to cash flow. You finish with basically zero free cash flows. Cash profitability minus capex, even though you're making a lot of money, you want to invest in the business, you finish with zero free cash flows. On the other side, I'm running the company and makes no money, I'm not going to invest anything in CapEx. So you finish with basically zero free cash flows, because your business is booming. I finished with zero cash flows because my business making no money. So you see, we added a variable that at best noise, and really confused the underlying businesses, how they're doing. We did all the analysis, we did all the regression, every simulation, and we find this is not working. Then we started scratching our head, why is it not working and it's not working for the reason that we're telling you. It’s not working because CapEx is a manager discretionary item in most cases. A manager has a discretion on how much to invest or invest or not.
If you go back to the paper of Robert. Robert’s paper is saying, go back to the variables that have as little monetary intervention as possible, so you can have variables that are comparable. CapEx is not that. CapEx has a lot of monetary intervention, so it’s making things and that didn’t work. Despite all our excitement about free cash flows and everything, it just didn't work and we didn’t implement.
Yeah, that's very interesting to hear, how that all happened.
We go beyond saying, “Oh, the numbers don't work.” We try to understand why the numbers don't work, from the conceptual point of view, and link it to breakthrough like Robert’s breakthroughs. That's important, because you want to understand that creates knowledge that you can apply in other places.
On this topic of research, some competitor firms of Avantis – competitor firms that you may be very familiar with have massive research teams, hundreds of PhD researchers. How does Avantis remain competitive on research?
I love it. You really have to ask the question, what is all these research people doing? Because they may be doing marketing, they may be doing research, they may be doing client research. They can do different things at the end of the day, you don’t know. If we look at all the breakthroughs in investments, we're speaking about Robert, for example, a minute ago. I think that’s only one that I know, came from a researcher working at the company, and this is more than 50 years ago.
Most of the times with people that are fully dedicated in these environments that are competitive, open foreign of communication, and tradition. It is probably one of the best places for that, if not the best place. You can have the biggest brains ever, you have them in isolation, not really want to work anyway. You need to challenge the environment. Look, I'm very involved with Caltech and I love when I go there, and because you see the thriving, fighting for IBS in a good way, trying to advance the science, and all that happened in academia.
Anything that we're looking, we’re speaking profitability with all the different metrics of profitability, all that came from academia at the end of the day. So you can have a humongous research staff, and the question is, are you really, really are embodied to your clients in the creation strategy or you are an increase in expense? That's a fair question at the end of the day. Some people have big, big research team because they're trying to find signals. I know people that are working in shops, that they are trying to find signals every quarter or every year, whether they see, is the signal working or not. I don't believe in that. Probably you guys don't believe in that. But you know, you need researchers to do things like that. We think about this differently.
Look, let's use every one's idea. I don't care if it's mine. I don't care who is coming. If you have a good idea, you should consider. We should be open minded. We should have a with our team. The Avantis team, and whatever is not Avantis, it’s not good. No, Avantis is, whoever is out there that has a good idea, we’re interested, because that's how you add value. With your clients, it has to make sense, it has to be something that we think that will persist in the future. We're open minded. We’re open minded. I don't care where it come from. Some of the concepts of accruals come from people that were on the other side of rationale, on the behavioral side. What’s the problem with that? I don’t have any problem with that. I want to hear everyone. If we hear everyone, hopefully we can bring the best for our clients.
To follow up and Ben's question, are there any disadvantages to being inside American Century as opposed to being an independent company?
Look, I love being inside American Century. I an employee of American Century with a different business card that says Avantis. Why we have a different business card, because we happen to manage money differently, and that's why we started working in here. American Century wanted to have something different and here we are. From that point of view, what do we do? We manage money. So anything related to investment of Avantis, we do it and we have some marketing capabilities. So we create the content and we have some client service capabilities. But we work with client services team inside American Century, data management, technology. All the different groups in American Century, we have some relationships with them, and they have been terrific partners.
Jonathan Thomas is great. I have nothing to – it's a pleasure working with the him and all the management committee, they are great. Victor Zhang, the CIO of American Century. I know him for something like 22 years or something like that, and that's why we are here. American Century has been terrific. People really care. They have been terrific partners for us. What I love about American Century is how they are a structured. It's a private company. All of us have great ideas why a private company is better than a public company. You don't have to think about quarterly earnings, and whatnot. But you know, every private company has a problem. At some point, the company will be sold, and if the company will be sold, ownership changes, everything change. You’re going to say, management will not change. Everything will change when something happens.
American Century solved that, because James Stowers Jr., the founder of American Century donated all of his shares to create this Stowers Institute of medical research. The controlling shareholder of American Century is an Institute for Medical Research. They do cancer and genetic disease research. It's private, but the structure of perpetuity. And on top of that, the profits go to support a very good cost. So it's great. I’m really proud to work here.
The structure is very cool of American Century. Within the people who worked at American Century for Avantis in the Avantis Group. What are most of those employees doing? What kind of jobs do people have, because the operation was presumably with an American Century? What does Avantis do?
Avantis, we don't have technology people working with them. We don't have a capital market team. We don't have an HR team. We don't have an accounting team. We don't have a – think about all these amazing functions that you need to function. We don't have them because it exits already, and they are really good. They have been running since 1958. So, why you're going to recreate the wheel if the wheel is working, and it's well oiled, and works amazingly well. We're not doing anything over that. And they’re providing great service to us and our clients, so it's great. What do we do? We do investments, because we manage money different than the guys in American Century. Whenever you invest, you need to create all the collateral, the marketing supporting that investment. We do that. We do all the collateral, and the content for the collateral. We create it ourselves. We don't have graphic designers, for example, we don't have people printing and creating website. Those are people in American Century that use our content, and they find ways to deploy it. That’s the same way that the deployed material for the rest of American Century.
We have some client service in the RIA channel and in the wealth management channel for companies channel, consult and relation channel. We work with American Century. We have a really, really good relationship, and they're great people. It is a pleasure working with them. I just came from – I was early yesterday in Dana Point, was a big conference and whatnot. I was together with a couple of guys, Gary, and Rob from American Century, and speaking with a lot of advisors. It's a pleasure working with them. I learned a lot from them, and hopefully they learn something from us, and hopefully, all together, we can provide better service to the clients.
That's a very clean setup. I do like it.
I'm telling you. These guys are really embracing innovation. Not only because of working with, they have done other things like Income America. That is a very innovative product that they – what they view, they associated with the insurance companies in trying to solve the retirement problem. Amazing things. They're really, really trying to make the best for their clients and trying to find ways. Not only inside what they have been doing forever, but associating with others or bringing others like us in order to try to bring benefits to the end clients.
Do you guys ever chat about investment philosophy? Because it's, like you mentioned, very different.
It’s different, but I was just speaking once with one of the portfolio managers for American Century, Jeff John. Great guy, by the way. He does an active small value strategy. If you hear him speak, is quite amazing how similar. Implementations are different, but the concepts, no. I think, I don't want to paraphrase, but I think he says, “I want the company to have a high quality and attractive pricing.” If you link that to profitability, or we do adjusted book to market, the concepts are similar. Certain implementation will be different, and I cannot comment, because I really don't know enough. But it's interesting that your work all your life with your vision, just tunnel visioning what you're doing. But sometimes it's good to open your eyes and listen to other frequency. You see commonality in many things, and not commonality in other things.
What I'm telling you, we're trying to systematize active management. We're trying to do that by having all the benefits that you have, put index fund that is transparency, low turnover, low fees, high tax efficiency. But with the benefits, try not to have a implementation, like just trying to have an implementation that adds value to the consumer valuations. That is – so we're trying to bring something that is different, and different people try to do that in different ways. Our ways is to try and to systematize active management.
There are other firms who do that type of implementation, systematic active management, out there, some direct competitors, and then some other firms that do similar systematic sort of factory tilted products. What do you consider to be the main competitive advantage of Avantis over competitors?
Well, everyone does something that – I would say, we think we are the best. If I don't think we're the best, we’ll change to be the best. Our job is to try to deliver the best, so I have to disclose that at front. But at the end of the day, things are not exactly the same, even though at 10,000 feet, everyone's the same. You lower at 5,000, you can distinguish some people. You lower it, and you can distinguish more. At the end of – when you look close enough, there is quite a lot of differences. If you look at, for example, active share, is a measure or how different portfolios are. It's a simple measure of how different the portfolios are.
If you look at the active share, for example, our small value relative to other small values, and you say, “Well, they're very similar. They’re the same.” Even portfolios that you think they're very similar, and you guys coming from the same place and everything. Active share is like 60%. It’s a big number. Why? Because things are different when you get to the granularity, and so, we are different. They are different, because different belief or historical reasons, so different implementation. Different managers will have different reasons why they are different, and we have reasons why we’re different. We're different because we think we're doing the right thing.
If somebody wanted to compete with you, what's the most difficult part of what you do to replicate?
On the simplistic way, first, everyone is welcome to compete with us. We know that, there is no issue with that. Everyone is competing with us, even without replicating everything that we do, everyone is competing with us. We embrace that competition. That's what keeps us certain that we have to better, and better, and better every day. If you don't do better, and better, then it's a problem. Because, let's suppose we’re doing the best, and that's what they told you. People will catch up, so you have to move the ball and do better and better. And you have to embrace every new technology. We have shown that we embrace new technologies.
Now, we came to market with what is calling United States, fully transparent active ETF and others follow. We can with extremely low fees, and people are still trying to catch up. We embrace fixed indexed annuities, for example, with no commissions for advisors. Why? Because we were speaking at the beginning alternatives to fixed income. We believe in fixed income, and also, we know alternatives, and we embrace that. We are always trying to think in the portfolio, we told you about wasting time with CapEx. We can go forever from that. We are always embracing how to do the next good thing for the clients. That's what keeps you a little bit ahead of everyone else. Can someone come in and try to compete? I'm sure. I'm sure everyone's trying to come in and compete. Even if we say no, they shouldn't, they will do it either way.
That’s right. That’s the way it works.
Recognize that and try to run faster.
If you can say what is the next big thing that you guys are working on?
We're always trying to work on solving client’s portfolios, and trying to provide more tools. and tools from the point of investment solution. We're not a tool provider, by the way. We are not a technology company. You don't want to hear anything from about tools or practice management. Now, we focus on what's in the current low fees, and great investment solutions, and the content supporting that. We are always thinking about what to do. You saw the inflation focus, equity strategy. That's what something new. We have that in line to launch last year, to be fair. We didn't have the time, because we're launching four other structures. We launched a micro-cap strategy. that we call it a small cap, but it’s really micro-cap strategy. It's on the pricing point of 25 basis points. It's really super attractive.
Then we launched the responsibility strategies. This was in line, but we couldn't do it, so we just launched it. But the inflation equities, we were excited because it's not – some people will use this for tactical place. Let me be clear. Some people will use it for tactical place, but we think it has a place in strategic role in some investor portfolios. When people think about us, the location, for some investor, this really deserves a consideration, and that's most exciting to us. We can really make someone's portfolio a little bit better off. We get excited on all of these things. I cannot believe it was an X, until we find and do it, but we're always thinking.
Long-term, what's the succession plan for Avantis?
Well, that’s a good question. From the point of view of ownership, American Century solved that, because the structure of the American Century has, I think it’s amazing. If you ever go to Kansas City, please let me know, because I really, really want you to visit our because the rest that they do there, it’s unbelievable. And being able to be associated with American Century and Stowers is amazing. The ownership structure, that's not an issue.
From the people's point of view, that's a good question. I get that question, what happens if you die? I always say, I hope my wife and my kids cry, but not too much, because I want them to keep on going. All of us believe that we are unique, and we are unique. But there is a lot of people that are unique and can add value to the chain that can replace and do better than us. So we have an amazing investment team. We have associations with great professors, like Sunil. Sunil is amazing. I don’t know if you ever spoke with Suni Wahal. He has great paper about the cost of mutual funds, and you may want to look at that or market microstructure. There are lots of things. We have a lot of people associated with us, that will jump in and help, and we're always looking for people. We're always speaking with people.
Even inside American Century, there are great people that interact with us. I wouldn't worry about that too much. They ownership is the most important, because if you change owners, God knows what's going to happen. The people certainly is at risk, and the whole strategy of the company is at risk. This has been solved, and I’m really proud. When I decided to work here, and I told my wife about all these associations with the Stowers Institute and everything. Some issues with cancer in my wife’s family and whatnot. She was very supportive, very happy with that. So I'm proud of that.
I already said this earlier, but the whole setup of American Century really is, it really is impressive. They've done a great job.
Yeah. We are having an event next week. Hopefully, there are bunch of going there. Again, maybe we do it again, and maybe you guys come, but it's really impressive.
We're Canadian, many of our listeners are European. What would it take for events to launch UCITS or Canadian products?
Everyone knows my phone number. If not, find it. Ask Cameron and Ben, and call me, or send an email. You will find me. Too difficult for us to cross the pond, neither the Atlantic pond or the Pacific pond. It's not going to take launch. Just give us a call. You can think I’m smiling, so that's telling you something. So just give us a call.
Very interesting. All right. Second to the last question here, Eduardo. You referenced this earlier, your dissertation on the fatigue behaviour of ductile FCC metals. You've got a PhD in aeronautics, and you won an award for that dissertation. Can you talk more about the commonalities between aeronautics and asset management?
Well, aeronautic is a very long field. A plane is flying because of a lot of things. I don't think that they know all this, because I know something. When you're doing a PhD, you're working in some narrow field, and you're trying to advance the frontier of that narrow field. What a PhD program teach you is trying to look at the problem, abstract it, try to create some model, and try to solve that model to see that model that you created really reflects reality. That's basically what we have been speaking all the time up to now, valuations. They think about the valuation framework, you see that empirical data feeds historical data so you feel comfortable that the models that you're using work, and that fits reality as well as possible. So that's basically what I did. I want to be more technical in what I did, and there was a physics problem, but there were a couple of physics. The FCC is one of them, but there were a couple of things.
And you look at the physical product, and you try to see what drives that physical product, what variables, in what concept, in what sense they interact to try to create a model. In my case, try to solve that model, then in my case, through computers. Then try to see if what you find to that, it really fits what you observed in reality, and then use it to feel comfortable. Your model is describing that, and then kind of advance and create better materials, or better processes, and whatnot. Similarly, you have some optimization things, and in a very nonlinear optimization, in some of the work that I did. You think about nonlinear optimization, you are dealing with nonlinear optimization all the day in your life when you’re experiencing losses, realize a capital gain to invest in the new strategy, how high the expected return.
You have all these multi-dimensional set of variables that provide more or less optimal depending how you put them together. It's very similar to what you think about investment. But it's very similar to how you think about running a company or very similar how you think about running marketing or everything. Because you always try to observe what's going on, try to create some idea in your mind of what's going on. That's the model, and then try to see if your model is fit, and try to improve things based on that model. It's all very similar in some sense or another.
Having been in the world of physics and the world of financial economics, how do you feel about hypothesis testing in physics, like what you were doing in your dissertation, versus in financial economics? Where maybe there's more, I don't know, parameter uncertainty and things like that.
Yes. In physics, you have a lot of parameter uncertainty.
Interesting.
Look, we have the new telescope, the James Webb telescope. That telescope is finding things that we have a hypothesis based on what we were watching through Hubble. This new observation center, whatever we were thinking based on Hubble is probably not extremely right. We don't know yet, because James Webb has to be calibrated to higher degree and whatnot, but these are there, and it's already just causing a lot of innovation, a lot of thinking. There is always parameter uncertainty, there is always uncertainty. Look, reality is super complex, is way more complex than the models that we put. So we had to try to enhance the model and make it robust, make it more complete. If it's the same, so I think all these problems are complicated.
Very interesting, and sets up our final question super well. Eduardo, how do you define success in your life?
That's a difficult one. I do the simple thing. For me, I have an amazing wife. I have the terrific sons, three sons. I have great parents, and extended family, and that's part of the success. That's the foundation of your life. Without that, it doesn't matter. You make money or you’re in a newspaper, like a superhero, but there’s a big hole in your life. I'm so proud of all of them, and how supportive they have been, and I hope to be able to provide support to them. It's amazing. Then, I just have a great job, with great teammates. And if you come here, we go for sushi across the street, like I mentioned that place. You always see teammates are second to none. Being associated with American Century and the Stowers Institute. The Stowers Institute, it’s really something that makes me proud. I donate money on my own to them because look, trying to find cure for cancer, genetic diseases. That's something that affects all of us, and it is something that really makes me proud. It makes me happy.
Being associated with Cal Tech makes me happy, because advancements in science. Even if it's not it's astronomy or whatever other field, it's just amazing. It's so cool to know more and make life better for everyone. I feel that. Then, if you love is I've been very lucky to be able to meet so many people like you guys. I know you guys for a long time, across countries that have so many great memories of friendships. I remember being once in Toronto, and there was an advisor who was Canadian, but has Scottish ancestry. I was doing the highlander talks. And I can tell you, my meetings in the Middle East, all across the United States, all across Canada, in Asian, Australian, meeting all these people has been terrific. Like I say, do I like to travel? I like to travel. I like to visit different people. I like to see different experience and interact with people. The job allowed me to do that with people like friends, clients, consultants, across the world, monarch across the world. That has been a blessing. I'm very happy about that. I’ve been lucky, I have to say. I mean, very lucky.
Awesome. Well, Eduardo, great to see you again. Thanks so much for joining us.
It's a pleasure. It's really a pleasure. Thank you, guys.
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