December 13, 2018

Episode 24: Evidence: What To Follow And What Not To Follow

December 13, 2018

Welcome back to The Rational Reminder Podcast. Today, Benjamin is getting the factor fill off his chest. We are diving into a range of topics and we are talking about other factors or how far you can push the evidence. This is the first time in a while that we’ve really dug into factors. We cover other interesting topics like increasing CPP benefits, we talk about our regulatory bodies and the debate going on there, as well as the big news around Vanguard. It’s a fun debate and a good conversation. So, keep listening to hear more!

Key Points From This Episode:

How CPP is expanding in 2019. [0:01:48.0]
Advocis putting the business interest of financial advisers before clients. [0:05:00.0]
The rumor circulating about Vanguard. [0:10:22.0]
A none story - How asset owners are falling out of love with index funds. [0:13:00]
Why the rich aren’t happy, why more money does not make people happier. [0:15:44.0]
Factors of a way to beat the market and why factors work. [0:17:38.0]
Factor regression on portfolios. [0:22:46.0]
Long versus short stock picking. [0:27:43.0]

Read the Transcript:

Ben Felix: This is the Rational Reminder podcast, a weekly reality check on sensible investing and financial decision making for Canadians. We are hosted by me, Benjamin Felix, and Cameron Passmore. Today we went a little long, sorry about that.

Cameron Passmore: You got your factor fill off your chest.

Ben Felix: And we talked about a bunch of stuff, and then we talked about other factors, or how far can you push the evidence. Something like that.

Cameron Passmore: [crosstalk 00:00:30] that are coming up, so we had to get into it. Apologies to those that kind of had enough of us talking about factors. Maybe we'll take a factor hiatus for a few weeks, but-

Ben Felix: We have taken a factor hiatus; this is the first time in a while that we've really dug into factors.

Cameron Passmore: But we did cover other interesting things, like increasing CPP benefits. We talked about-

Ben Felix: Advocus not representing us.

Cameron Passmore:... our regulatory bodies and the debate going on there. The big news around Vanguard I think is pretty cool, coming potentially, potentially. We don't know, this is a rumor, coming to Canada with advisor services. So it was a fun debate. I think it was a good conversation here. So people learn [crosstalk 00:01:02]-

Ben Felix: An extra 10 minutes. You can listen to the rest on the way home, I don't know.

Cameron Passmore: An extra 10 minutes hearing Ben talk about factors.

Ben Felix: All right. Enjoy the episode.

Welcome to episode 24 of the Rational Reminder Podcast. We have a whole bunch of stuff to talk about today. We've had a bunch of interviews, so Cameron and I haven't had a chance to cover a bunch of topics that we've wanted to cover. We're going to start off with several topics, and then we do have one kind of big topic that we want to chew on, which is... I don't know how you'd describe it.

Cameron Passmore: If you're dying to get to it.

Ben Felix: Well I am, yeah. But it's like other factors, or like evidence that Dimensional doesn't follow is kind of how I would summarize that section.

Cameron Passmore: Yeah. And what evidence to follow and what evidence not to follow. These are good questions, and how you make those choices.

Ben Felix (0:01:48.0): So we're going to get there. But before we do get there, we wanted to talk about CPP. So CPP is expanding starting in 2019, which is going to affect everybody in Canada that earns a salary income. As of right now, so the old CPP as of 2018, I guess, and prior years, it's been designed to cover, in retirement, 25% of your income up to a yearly maximum amount. So that's called the yearly maximum pensionable earnings. And it's what, around 57,000 this year?

Cameron Passmore: Around that, yes. So I think the maximum CPP benefit-

Ben Felix: It's around 1300 a month.

Cameron Passmore: Correct. That's the average, I think. Average maximum is paid out, but I think you can earn up to 13,000 per year, right?

Ben Felix: Yeah. It's 1300 a month-ish is the maximum benefit-

Cameron Passmore: [crosstalk 00:02:32] the average benefits around 13,000 a year, that's it.

Ben Felix: Sure, makes sense. And most Canadians get like 60% of the maximum.

Cameron Passmore: And you contribute 4.95% of your salary, and your employer matches that.

Ben Felix: Yep.

Cameron Passmore: So call it roughly 10% of your salary now is what's being saved to get you that 13,000 per year.

Ben Felix: Yep. But most people don't get the max, because you have to work for 40 years earning the yearly maximum pension learnings in order to get the maximum benefit. And usually people either don't earn enough, they don't earn the 55 or 57,000 or whatever. In today's dollars, every year, or if they're earning way more than that, for example, they might not work for the full 40 years.

Cameron Passmore: So do you think this is a good idea, a good move?

Ben Felix: Well, so we haven't even talked about what's happening. They're making it bigger, but the way that they're doing it is they're doing two things. So they're increasing the amount that you have to contribute. So it's going up from 4.95% to 5.95% by 2023. So they're taking a few years starting in 2019 to roll that out. So the increased contribution, and they're also making a second tier.

So when your income gets above the yearly maximum pensionable earnings, and then up to a new limit, you'll also have to contribute an additional 4% of your income. So it's 5.95% on the yearly maximum pensionable earnings, and then another 4% on this next traunch of income. And then obviously the overall benefit is going to increase. So the goal is to have 33% of your yearly maximum pensionable earning, but they're also increasing your yearly maximum pensionable earnings. So the overall CPP benefit will be substantially larger for people, but it won't really affect people until retirement as of, I think it said 2065 in the article that I read.

Cameron Passmore: Yeah, they're targeting people at about 20,000 per year in today's dollars of benefits, so roughly 50% higher benefit.

Ben Felix: Yeah.

Cameron Passmore: So that's meaningful money.

Ben Felix: It's a good thing. There is another study that we don't have slated to talk about it today, but there was another study... Or not a study, a survey, I guess, talking about how the savings rate of Canadians is the lowest now as it's been in, I don't know, some number of years.

Cameron Passmore: This is good for savings. It's a well-diversified program. You have pooling of people going on-

Ben Felix: That's a big one.

Cameron Passmore:... which gives you more safety. That to me is a real benefit. I mean, it gives you some fixed income for life, and you do not have to worry about managing it. You live a long time, you're protected.

Ben Felix: The biggest benefit of this... Because say with like CPPIB, the CPP investment board, I'm sure they do an okay job, they've been slammed a little bit over the last few years for having high overall costs and stuff like that. But I'm sure they do fine, but that's not the selling point: the selling point is the mortality pooling.

Cameron Passmore: Absolutely.

Ben Felix: The downside is if you die early, then you lose out on the contributions that you made to CPP. But the plus side is if you live longer then you have this income for life. Now, most people don't do that. Like most people won't buy an annuity. An annuity is a very similar thing; if you die early, your effective rate of return is very low, or maybe even negative. But you live for a long time, it's great. But no one wants to buy that because you lock your money up and all this other stuff. But if you're forced to buy it, I think it's pretty good. Ultimately it's pretty good.

Cameron Passmore: Yeah. I think it's a good move.

Ben Felix: Yeah. Good move overall. Another thing that we want to talk about before we get into the main topic is Advocus, which is the industry lobby group. I don't think they represent us though; we're not members.

Cameron Passmore: No, we're not.

Ben Felix: I wouldn't consider Advocus to represent me. I don't know how you feel about that.

Cameron Passmore: No, it's okay.

Ben Felix: Yeah, it's okay. So Dennis Tew, who's the head of national sales at Franklin Templeton Investments Canada, which I think they've actually had... I was looking at asset flows yesterday for our later conversation in this episode, but I think Franklin Templeton has been bleeding assets if, I remember correctly.

Cameron Passmore: That would not be surprising.

Ben Felix: They had some big negative outflows.

Cameron Passmore: I mean, we used to use their funds extensively back in the mid '90s. Haven't used any of them since then

Ben Felix: Classic high-fee active manager. Anyway, so this guy, the head of national sales, he was speaking at an Advocus symposium. And he said, quote, "They, the CSA, have thrown in this last round of reforms with very little thought put into the business consequences of what they are suggesting." Now it's true. Financial advice as a business, as everything else is. I mean, even dentists and things like that, they're still businesses, but I don't know how you feel Cameron. I always take a little bit of issue when lobby groups like Advocus put the business interests of financial advisers before clients.

Cameron Passmore: Well, they're basically saying that there's no business here that people will not get served. So if you're doing things that impact that business, there's less service to go around. I think that's their basic argument.

Ben Felix: Yeah. So I've got another quote from him: "There's an overall focus on cost being the most important suitability requirement, but lowest cost doesn't always mean better outcomes. We think that any focus in this area that reduces the number of investment service providers in the industry or the investments offered to clients is reducing competition, and that is always bad news for consumers. Anytime you have less choice and restricted access, that's bad for clients." I disagree completely.

Cameron Passmore: It's a shock to any listener.

Ben Felix: I mean, fundamentally, he's right. Like if we're talking about business in general, yes, it is true that when you take away competition, that is not good for the end client. But when we're talking about the competition being between a bunch of firms who are selling high-fee mutual funds to earn big commissions, I mean, in no way, no matter how much competition you have, is that going to be the best thing for the client.

Cameron Passmore: Right. And why does it always have to be wrapped up in these active mutual funds? That I don't understand. I'd love to know how much of the... I mean, I guess we know by looking at the overall data of the mutual fund landscape, but how much of it is invested in low-fee index funds of those Advocus members?

Ben Felix: I bet you it's zero. That's an exaggeration.

Cameron Passmore: Well, the number is pretty small regardless. So like, why can't you just... You can cut the MER in half, expense ratio in half, just in going from active to index mutual funds. I mean, there's a start right there. It doesn't change your advisor comp whatsoever. Why does that have to be wrapped up into we're picking better funds? I never understood that.

Ben Felix: Yeah. I mean, we prerecorded an episode with [Robin Powell 00:08:31] that'll air in January today, but we talked about this, and he made a really interesting observation about the UK where they've actually banned embedded commissions altogether. And what has happened is that the financial advisors who were selling these commission-based fund products, they've continued to recommend actively managed funds from the same companies, because they had close relationships with those fund companies. So it's like, you've been recommending whatever, Franklin Templeton for years, if you're taking off commissions, you're still going to do the same thing, because that's what you know.

Cameron Passmore: Yeah, I was shocked when he told us that.

Ben Felix: Yeah, it was very interesting. But you got to think about it, right? Like, our heads are so deep into indexing and dimensional.

Cameron Passmore: But I remember back when we converted from... Because we used to have a mutual fund dealership here. We went from a mutual fund dealership to using Templeton and all these other brand name funds in the mid '90s. And as soon as we went fee-based, it was just automatic. Once you start looking at what is available in the marketplace, we all became indexers here. And then once you get in the index rule, it's all about how to improve those portfolios from there, which led us on to discovering factors and Dimension and everything else. I don't understand how you stay with the same providers, I don't get it.

Ben Felix: I don't understand either. Anyway, the whole idea that taking away embedded commissions is going to be bad for the end client, that's almost disgusting to me to say that, to make a statement like that. You think about stuff that's out there now, like Wealthsimple, which maybe they don't offer the best face-to-face in person one-on-one advice, but then you've got people out there like Robb Engan, the Boomer & Echo blogger that we had on a while ago. And there's tons of other ones. Now there are tons of fee-only, 400 bucks an hour or whatever they charge, financial planners. So you pair that up with robo-advisors or with the new Vanguard dom funds-

Cameron Passmore: One decision ETFs, one decision funds.

Ben Felix: There's no place for high-fee mutual funds, none. And the idea that that taking those away is going to be bad for clients, I think it's not something-

Cameron Passmore (0:10:22.0): Look at Vanguard's announcement. Was it announcement or rumor this week?

Ben Felix: It is a rumor; it is not an announcement. I actually reached out to Vanguard and their media person responded saying that they could not discuss future business strategies. And they would not give me an expected date, because I asked if they would come on the podcast to talk about it. And he wouldn't even say-

Cameron Passmore: This is potentially a big deal.

Ben Felix: I don't think it is. It's not a big deal to us. It's a big-

Cameron Passmore: Not to us, I'm saying to the marketplace.

Ben Felix: It's a big deal to Wealthsimple. It's a big deal to RBC's new InvestEase service.

Cameron Passmore: So what is it?

Ben Felix: Well, Vanguard has their personal advisor service in the U.S. where they manage 120 billion.

Cameron Passmore: In less than two years?

Ben Felix: Yeah, it's crazy. They just mopped up assets. I mean, Schwab is doing the same thing in the U.S. They launched a robo-advisor, and they just have such a big reach. They have so many clients that trust them.

Cameron Passmore: So they charge 30 basis point fees, fees scale after 5 million bucks.

Ben Felix: 50,000 minimum. But the big thing-

Cameron Passmore: Account size, which that's accessible for many, many investors.

Ben Felix: Absolutely. But you look at it like, so Wealthsimple in Canada, they're charging 40 basis points. And to have advice, like to have an advisor like you get with the Vanguard personal advisor service in the U.S. you have to have a 100K. So you're paying 40 basis points on 100K to get the same thing that Vanguard's offering to their U.S. clients for 30 basis points. So if I'm Wealthsimple, I'm shaking in my boots, same as any of the other robo-advisors.

Cameron Passmore: And you can be sure that Vanguard's figured out the call center and how to organize the people internally. And we had heard from my friend in New York City talking about how much the financial planning talent at Vanguard is mopping up in the U.S., that's a huge talent drain, which is great for their clients.

Ben Felix: So their pitch in the U.S., I went on the Vanguard personal advisor service website, and they said they get to know you, your goals, and your unique financial situation. And then they partner with you to create a custom-tailored financial plan. And then they put your plan into action and manage your portfolio, allowing you to be as involved as you want to be. And they work with you to keep track of your plan's progress. They rebalance your portfolio as necessary and partner with you to revise your plan when important life changes occur.

That's pretty sweet. Like that's more than you're getting with $50,000 from most of the robo-advisors in Canada. So yeah, if I'm a robo-advisor and I hear this announcement, I'm nervous. For us, firms like us, I don't think it affects anything any more than-

Cameron Passmore: [crosstalk 00:12:34] more awareness around this, which is good. Competition is good.

Ben Felix: That's what I mean, like, that's not competit-

Cameron Passmore: [crosstalk 00:12:37] It improves our game-

Ben Felix: Is it competition? Maybe for small clients, I don't know. Because the people that come to us want to talk to a human.

Cameron Passmore: I'm just saying in general, in the marketplace in general, more awareness is good.

Ben Felix: Yeah, it's good. Anyway, I don't think this affects us any more than Wealthsimple affects us, but I think Vanguard's announcement big time affects other robo-advisors that already exist in Canada with their relatively high fees compared to what's in the U.S. You sent me a survey on some active managers and the title was something along the lines of, I don't know, institution-

Cameron Passmore (0:13:00.0): This is so ridiculous.

Ben Felix: Institutions are losing faith in index funds, or something like that.

Cameron Passmore: Yeah. So it was a story that came across Twitter that I saw that might be fun to chat about. And I think you put it, title on this is basically a non-story. So it's just amazing to me how institutions clearly are not aware of what the evidence shows. And there's so much, I guess, agency risk, agency bias, that when you're paid to pick stocks, what are you going to do? You're going to pick stocks.

Ben Felix: It was a non story. The headline was... I don't remember what the headline was, but it was total clickbait. Let me see what the headline was. It was asset owners are falling out of love with index funds. So, okay, that seems pretty interesting [crosstalk 00:13:40].

Cameron Passmore: So what does that mean? Like you're falling in love with capitalism? You don't believe markets work anymore? You don't believe there's fair information, discovery, and prices? It's like, how is that possible?

Ben Felix: Here, I'll tell you what it means. It means you're clueless. Here's the survey results: 61%. So these are institutions, like institutional investors were asked to complete the survey through Natixis Investment Managers. 61% of the respondents to the survey said... Listen to this. They said, "Active management outperforms passive in the long run." So okay, we can stop reading the article now, because clearly it's full of information that is simply untrue.

Cameron Passmore: And four out of five of the institutional investors believe active managers will have an advantage in 2019.

Ben Felix: Yeah, I know. It's ridiculous.

Cameron Passmore: Based on what?

Ben Felix: I know. Anyway, it was a non-story. I thought it would still be fun to talk about, but it was completely ridiculous. Hey, listen to this quote. I copied this quote: "It is likely that they want a skilled investment professional at the helm during these more turbulent times in order to identify opportunities created by higher levels of dispersion and generate better returns overall." That is what the Natixis survey report concluded. Anyways, completely ridiculous, but whatever... fun to talk about, I guess. But you're right, it is crazy that institutional money managers, that a majority of them would say that active outperforms passive in the long run when there is such strong data refuting a statement like that.

Cameron Passmore: But you can see, I mean, times like these where the markets are bouncing around quite a bit, we've had a couple of cases lately where people have chosen to move their money elsewhere to do something. They feel the need to do something. They feel the need. They've seen other people have success choosing stocks, and they feel, given what's happened in the marketplace, the markets are different, or whatever excuse you want to make. They've made choices to invest in stock somewhere else, individual stock picking. So that need obviously just goes all the way through to the institutional world as well; it's no different. People are people.

Ben Felix: It's a bias for action. I always remember what Shane Parrish said when I interviewed him for the podcast. He said, "The two most harmful biases...", I hope I remember this correctly, "... are overconfidence and a bias for action." It's a deadly combination when you add them together. Anyway, that's it. You sent over a story that about why aren't rich people happy, like why does more money not make people happier.

Cameron Passmore: Yeah. It's an interesting little article talking about when people compare themselves to others, which is often what people do, it's hard to know... The example they gave, like how do I know I'm a better parent than my neighbors? So if you're going to compare yourself, it's much easier to choose something that you can actually see that you're better than your neighbor, depending how you define better. So I guess a lot of people do this by looking at their balance sheet. And if I'm wealthier than my neighbor, I'll be happier is what they think. But the reality is even the super rich don't get happier as they get wealthier. And this is something that Daniel Kahneman talked about. Beyond $60,000 of income, we're not necessarily happier beyond that.

Ben Felix: Biggest takeaway from the article was that it talked about how when you get extremely wealthy, and you have everything that someone that's not wealthy could possibly have, then you just start comparing yourself to everybody else. So it's like as you're trying to accumulate wealth and have more and more, you think you're going to measure happiness by the stuff that you have. And as soon as you have everything that you could possibly have, you start measuring how much you have relative to your other rich friends.

Cameron Passmore: But I think a lot of people do that, whether they're super wealthy or not.

Ben Felix: Yeah.

Cameron Passmore: Because it's easy.

Ben Felix: Yeah. And the human adaptability, like you can never have enough unless you make the decision to feel like you have enough.

Cameron Passmore: Right.

Ben Felix: You'll never objectively have enough unless you make that decision yourself.

Cameron Passmore: Humans adapt amazingly.

Ben Felix: Yeah. It's all about perception. All right. Ready?

Cameron Passmore: Big question.

Ben Felix: Okay. We had a listener question, which ties in really well with the main topic that we are so excited to talk about. So the listener question, and I paraphrase it quite a bit; it was kind of long, but I chopped it down. I think I still got the essence of the question though. So they asked, "I understand that indexing makes sense and that the majority of investors cannot beat the market, but I always hear you talking about factors as a way to beat the market. Shouldn't the higher expected returns of the factors be included in prices, eliminating any benefit?" That is true. We do talk... It might sound contradictory, because we talked about how people can't beat the market and we laugh at active managers and how ridiculous they are, but on the other hand, we talk about factors. So it's important to explain why factors work.

When we talk about factors, we're talking about investing in, for example, small cap stocks. So in, in the market as a whole, small cap stocks exist. When you own the market as a whole, you do have exposure to small caps, but only in market cap weights. And when you just have market cap weight of small caps, you don't actually have what we would call small cap factor exposure; you just have market factor exposure.

Cameron Passmore: With maybe, you take in the U.S. market, small caps might be-

Ben Felix: 5%, [crosstalk] small value-

Cameron Passmore: 5-15% maybe in total, right?

Ben Felix: Sure, yeah. Small value might be 5%.

Cameron Passmore: So it's heavily skewed towards large cap stocks, the market return.

Ben Felix: So we started talking about factors, what we mean is adding in more of a specific type of stock relative to the market. So if we're saying the small cap stocks in the U.S. are 15%, it might mean adding up to 30% of your portfolio is in small caps. And now that 15% additional exposure to small caps, we'd call that factor exposure. So now you have small cap exposure in excess of market cap weights. Now, the reason the factors matter is because those types of stocks, so small caps in the example that we're working with, have higher long-term returns than large caps, but they also have higher expected future returns. Now the big question becomes why? Because this listener question here, they're saying, okay, I get that. But if everyone knows that, isn't that priced in? And it seems like, yeah, it should be because we always talk about market efficiency and things like that.

Cameron Passmore: And I think most people, when they look at the overall market, they know there's going to be dispersion of returns. They know that some stocks will have higher expected returns than others. What's debated is the reason for those difference in returns. And as these differences that academia has been looking at for 50 plus years now, what is causing this dispersion of returns?

Ben Felix: And so there are different explanations, two schools of thought. I only care about one of them; I think the other one is... I mean, I just don't care. That's not fair to say. I don't like it, I don't know. So there are two explanations.

Cameron Passmore: One is rational, that's why.

Ben Felix: You're right, that is why probably I don't like it.

Cameron Passmore: The rational reminder.

Ben Felix: That's why we're here. So the two explanations are risk-based, meaning small stocks, or value stocks or whatever it may be, have higher expected returns because they are riskier. Now, there are some pretty good stories to back that up just based on the economics of a small company or a value company. So if the assets are riskier to own, the cost of capital is higher. And the investor that owns the asset has a higher expected return because they're taking more risk. It's not a free lunch; they're taking more risk.

Cameron Passmore: The investor's return is a company's cost of capital.

Ben Felix: That's right.

Cameron Passmore: If you and I set up-

Ben Felix: Expected return.

Cameron Passmore: Expected return. If you and I set up a small business this afternoon and went to raise money, the costs we would have to pay the investor is higher than if Walmart goes out and raises money. Most people get that; it's a risk story.

Ben Felix: Yeah. The other story is behavioral. I don't even want to talk about it. I mean, people undervalue, I guess, small stocks would be the story, or they undervalue value stocks, I guess? Is that the behavioral story for value?

Cameron Passmore: Yeah. They overreact at times and just don't want to own them.

Ben Felix: Right, that's what it is. I know the behavioral story for momentum. Well, it's the same thing, I guess. People overreact and under react to new information. Anyway, I'm not crazy about the behavioral story and the behavioral story for risk premiums has created a whole bunch of other ways of thinking about the evidence, which is what we're going to get into in a second. So anyways, to sum it all up regarding factors, it's a way to take more risk, but more priced risk. So we know that over the longterm and all over the world and over every time period that we can slice up, small stocks have outperformed large stocks, value has outperformed growth. And we hypothesize, I guess, that that is because those assets are riskier.

Cameron Passmore: Right. And when you put them together in a portfolio, you increase your overall returns and lower the overall expected volatility.

Ben Felix: That's where it gets really interesting, because value on their own are riskier than growth, are riskier than market. Small on their own are riskier than market. When you start adding factors together, small is not perfectly correlated with value. Value is not perfectly correlated with market. Small is not perfectly correlated with market. So you add in, say, three or four factors together in a portfolio that have imperfect correlation. All of a sudden, even though you're adding these additional risk factors, they're diversifying risk factors. So you're increasing your expected returns without adding potentially a lot more volatility.

Cameron Passmore: But you are increasing your tracking error, meaning you will look different than the marketplace.

Ben Felix: Which is a risk.

Cameron Passmore: Which is a risk, how you will behave when you look different than the market, and we've gone through periods like that, where we look great compared to the market, at other times you don't look so great.

Ben Felix: And the end investor has to understand, and it ties right into the question from the listener, why would you pursue factors? It's because they have higher expected returns. Higher expected returns do not mean you're going to have higher returns all of the time, but over the longterm, the evidence suggests that you should have a higher return over the long run.

Cameron Passmore: And even if you go a decade without them, that's not unexpected; it's quite possible you have a decade where small does not outperform.

Ben Felix: Statistically, that is very possible. Okay. So I hope that answers the listener question. We're saying that factors are additional risks that you can add into a portfolio. So yes, it seems like we're talking about being able to beat the market and it sort of is true, but it's just adding in targeted risks to a portfolio.

Cameron Passmore: And also too, you can go in and do factor loading on other portfolios. If you've found an active fund that has beaten the market, often if you go and do factor loading, which I know you've done in portfolios-

Ben Felix: Factor regression.

Cameron Passmore: Factor regression on portfolios, someone outperformed the market where you can go back and see, well it's because they had an overweight in small, or an overweight in value.

Ben Felix: It gets really important with benchmarking. So it's like what Cameron's talking about. If we take a U.S. equity fund manager, and they've they've generated alpha, so they've generated higher risk-adjusted returns then, say, the S&P 500, benchmarked against the S&P 500. If we go and run a regression and it turns out that that fund had a whole bunch of small cap exposure, their risk-adjusted alpha, if we add in small cap, may be zero, or may be negative. So while it looks like alpha when you compare them to the S&P 500, as soon as you compare them to a small cap index or some blend of the S&P 500 and a small cap index, all of a sudden, they didn't generate alpha; they just held more small cap.

Anyway. So that whole factor discussion is one of the reasons that it's become so much more challenging to generate alpha, because alpha can now be explained in a lot of cases by beta, or by risk factors.

Okay. But we're running out of time. So I do want to get into this topic that we wanted to talk about. So something that's happened this year is that AQR, which is a firm called Applied Quantitative Research, AQR, founded by a guy named Cliff Asness who studied under Eugene Fama. Now, Cliff is brilliant and has produced a massive amount of helpful and fantastic research. AQR has been having a lot of trouble this year. Now that's no fault of Cliff, it's no fault of EQR. It's not a knock against their company at all. What they do is fine, but it's happening. So they've had serious performance issues. Now, this gives us a good opportunity to talk about a question that we get every now and then. So AQR is a firm that, like the name says, they apply research. And they use fantastic evidence, they use the same kind of evidence that dimensional uses. They use some of Fama and French's work.

Cameron Passmore: And they're a $200 billion plus firm.

Ben Felix: 226, huge.

Cameron Passmore: A serious firm. And in this space, they're a large player in this space.

Ben Felix: Huge. In the [inaudible 00:24:53] investing or evidence-based... Well, I don't know if you group them with evidence-based investing, but the fact is they are using evidence to build portfolios. And that sounds like what we do here at PWL, or what Dimensional does. So we occasionally get questions about why is Dimensional not following this research that AQR is talking about, or why are you guys not using AQR products, and instead just using Dimensional? Like, why are you choosing to follow that research?

We'll talk about what AQR builds. So their core products, I think, are what are called liquid alternative beta. What that means is... alternative investments are like hedge funds or private equity. Those are not liquid. Liquid alt beta is an attempt to create an alternative, so an uncorrelated with equities or fixed income, an uncorrelated asset class that is liquid. So unlike a hedge fund with a lockup or private equity fund with a lockup, you can buy or sell the fund anytime; it's perfectly liquid. And they do that by going long and short. So they'll own stocks and they'll short sell other stocks. What that does is it takes away their correlation with the market.

Cameron Passmore: But it's not negatively correlated.

Ben Felix: It's uncorrelated, uncorrelated. So they take away market beta. So you're no longer exposed to market beta. You're exposed to the long/short portfolios that they build. Now-

Cameron Passmore: My point of being not-

Ben Felix: Uncorrelated.

Cameron Passmore:... But not opposite correlation, because markets are down this year; they're not up this year.

Ben Felix: Right. So it's not a negative correlation.

Cameron Passmore: So it's not a negative corre... My point.

Ben Felix: Yeah. And Cliff makes that very clear. So Cliff wrote a big, long letter to investors because they're doing so poorly this year, but there were a couple of great quotes from that that I pulled out. So Cliff explains why you would want to hold liquid alt beta. So he says, "You do not want to liquid alt because you're bearish..." [Inaudible 00:26:38] kind of like what you're saying, Cameron. "You do not want to liquid alt because you're bearish on stocks or traditional assets. That kind of timing is difficult to do well. Plus, if you're convinced traditional assets are going to plummet, you want to be short, not alternative. In other words, liquid alts are a diversifier, not a hedge. You should invest because you believe that it has a positive expected return and provides diversification versus everything else you're doing. If you can add an asset with a positive expected return that's not correlated to the rest of your portfolio, it makes your portfolio better."

That is true.

Cameron Passmore: Kind of like what we were saying about factors earlier.

Ben Felix: Very similar. You can achieve, for the same risk, a higher expected return. This is through diversification, or the same expected return with lower risk, or you can improve both. That's all true. That's all true. That is all true of liquid alts. They may improve the characteristics overall of the portfolio if we're talking about things like correlation and standard deviation. So it is evidence-based.

Now this is where it's different. While they're following evidence, so they're long and short based on factors, that sounds like a good thing. But AQR is building long/short portfolios by selecting individual stocks based on the factors. So okay, now we've added in a whole-

Cameron Passmore: Yes, that I don't get.

Ben Felix: ... a whole other element. So Dimensional's total market, with a tilt towards small cap and value, they're not picking stocks, they're not using factors to select individual securities. So already AQR is doing something very different. And sure, it's evidence-based. I don't disagree with that, and I would never tell Cliff Asness that what he's doing is not evidence-based. So here's another quote from Cliff: "As a blunt example, in general, we believe in choosing..." I mean, listen to this, it's crazy to me. "... As a blunt example, in general, we believe in choosing individual stocks with good value, good momentum, both price and fundamental, low risk, high quality, example profitability and margins, and positive views from those we think are informed investors."

Cameron Passmore: Sounds like a no-brainer.

Ben Felix: Jeez, it sounds like an actively managed fund.

Cameron Passmore: Of course it does, but it sounds great.

Ben Felix: And then he says, "We like to underweight or sell their opposites." I mean, that's very different from being in a long-only total market portfolio with a slight tilt toward size and value already, right? Like we've added a whole other element of security selection and long/short. If you're long and short, that means if what you think is going to do well does poorly, and what you think is going to do poorly does well, which is probably what's happening this year, you get hit on both sides. So you'll be down twice what you would have been down if you were just long or just-

Cameron Passmore: [crosstalk 00:28:56] So how did he defend this stock picking?

Ben Felix: Well, you tie it back to evidence, right? Well, we're picking stocks based on these known factors, which, I mean, I get it, but I guess it's way more aggressive than DFA or Dimensional. It's like taking what Dimensional is doing and jacking it up in a huge way, and taking it to the absolute extreme.

Cameron Passmore: But they're long/short fund is down like over 15% so far this year.

Ben Felix: Yeah. Well, so they say. I was reading one of the perspectives of the funds and it says, "Long/short equity fund returns come from three independent sources of return: equity market exposure..." Which is beta, which we have exposure to as well. And our portfolios are in Dimensional's portfolios, "... the return from tactically varying exposure to beta..." So now that, all of a sudden, we've added this whole other element where it's like, okay, we're not just going to get passive exposure to beta, which is what dimensional aims to do. We're actually going to tactically vary exposure to beta based on our outlook for the market. Huge difference. And then the last one, and this is the one that blows my mind is long/short stock selection, which is pure alpha. So now all of a sudden, we're not just getting exposure to factors. We're not just getting exposure to market beta. We're getting varying exposure to market beta over time, and we're betting on alpha.

Cameron Passmore: It would be neat to unpack the returns to see based on those three sources, where the returns came from.

Ben Felix: I don't know how you... well it's long/short-

Cameron Passmore: You could never do it, but it'd be fascinating to see if it... I mean, my gut is that the long/short stock selection may have been the culprit, but we don't know. It'd be really fascinating to see that.

Ben Felix: Well it's got to be. Either way, the strategy blowing up. So another quote from Cliff. I don't know if this was from Cliff or from the perspectives actually, but, "Applying these and other proprietary indicators, we take long or short positions in industries, sectors, and companies that we believe are conditionally attractive or unattractive. The result is a portfolio that seeks positive absolute returns with close to zero equity market beta."

Okay, so that's liquid alts. It's like a different asset class created by messing around with long/short portfolios and stocks and bonds based on factors. And yes, you do eliminate exposure to market beta, which some people like, because it does give you an alternative asset class that's potentially diversifying. Okay. Now why do we not use these strategies? First of all, they're expensive. You look at AQR funds, all of the fees over 2%.

Cameron Passmore: Higher turnover.

Ben Felix: Much higher turnover.

Cameron Passmore: So turnover is buying and selling the shares inside the portfolio each year.

Ben Felix: And inherently it's going to be higher turnover, because stock characteristics change. And when you're long/short, you'd have to change your holdings, I guess, relatively frequently, especially compared to a long-only portfolio like Dimensional. So I just looked at their year-end distribution. So they're long/short equity fund, which is the one that's really gotten hammered this year in terms of performance. It's also going to have an estimated year-end distribution of 3.6%. That's a big distribution. Not only are you getting hammered on performance, you're also getting this big distribution from high turnover. Now, some people would say, well, a fund like this, you would hold in your RSP or TFSA. Fair enough, I guess, but then you're also risking the RSP or TFSA room for this alternative strategy.

Anyway, yeah. So it's just a totally different perspective on implementing factors. It's like, okay, instead of using this long-only strategy to get enduring exposure to the factors that we know have higher expected returns, we're going to kind of mess around with individual stocks, using the factors is, I guess, a basis to do so. Yeah, so like you said Cameron, their long/short equity fund is down 15.71%. Their managed future fund is down 14.4%. Global equity, long-only, like a dimensional global equity, is down 7%. So these alternative strategies are down twice as much as the equity market when the equity market is down, which you can't say that you would expect or not expect that, because the alternatives are supposed to be uncorrelated, not negatively correlated. So it can happen sometimes that both are down at the same time.

One of the things Cliff wrote about in his letter to investors was when should you change your mind. We've had that question from clients too. Like we're pursuing small value profitability. At what point do you change your mind? How much evidence do you need? And Cliff's answer was great. Cliff, everything he says is accurate and intelligent and rational. Just their strategies are way more extreme than anything that I would want to touch. And we talked about behavioral earlier. A lot of their strategies are based on exploiting behavioral biases. Anyway. So Cliff said, "One should change their mind based on evidence..." Which we agree with, obviously. "... big enough numbers to change the long-term historical evidence, or a theory going forward that is supported by observation." And Cliff is saying none of those things are true, nothing's changed. Therefore, our strategy should still work going forward, despite this period of really bad performance.

Cameron Passmore: And to bring it back to our role, I guess in our world would be like someone coming to us and saying, "Why don't you guys put all the portfolio into small cap value?" That would be the highest expected returns that of all the different asset classes based on the evidence.

Ben Felix: Well, long small value and short large growth.

Cameron Passmore: Yes. If you could short, but yes.

Ben Felix: But we would never do that because that would be crazy volatility. And one of the things [inaudible 00:33:33] always says that I love is if it doesn't work out, if the factors don't work out, you're still going to get a pretty good result, because you're still total market. You're still betting on capitalism. That's the main basis for your bet, is capitalism.

Cameron Passmore: Remember, these models aren't reality; they're a model of reality to try to understand reality. And you never know what kind of risks are out there. And Gene Fama, every time we see him, always highlights that. This is a model, this is not reality.

Ben Felix: That's right. The map is not the territory. Anyway, so AQR has had net outflows this year of 3.5 billion, which is a lot. I mean, maybe not that much for them, but it's still a lot for any company. That's at the end of October. About half of those outflows were from institutions and about half are from advised retail accounts. So, AQR, similar to Dimensional, they only distribute through advisors for the most part. And I don't know if it's worth pointing out. It seems like it's just a job at AQR, but I was interested, so I looked at the number. Dimensional in the U.S., while AQR has bled 3.5 billion, Dimensional has had inflows of 20 billion in the U.S. And in Canada they've had inflows of 5 billion so far this year. And Dimensional, they've had positive inflows every month, I believe, since inception. That data point may be a couple of years old, but I doubt it's changed. Anyway, but the main topic there was why do we not use liquid alt beta or other evidence-based, sort of more aggressive tools. I guess it's a choice.

Cameron Passmore: Yeah, and we're reasonably balanced. We don't want to be dead wrong for sure. If you go all small value, you could be dead wrong. Well-

Ben Felix: If you go all liquid alt, even if you have some liquid alt, I don't know. The story behind liquid alt, it just does not resonate with me enough. The risk-based story of small value resonates with me enough that tilting toward it, without going full tilt, seems sensible.

Cameron Passmore: And people understand it. And they know that when you put a rules-based platform in place that gives a certain fixed percentage allocation to all of these, with regular rebalancing, people get it. People can live with it. We go out of our way to explain the expect-to-return volatility, so people can stay in their seat, even though they might not look like the broad market.

Ben Felix: You start adding in liquid alt with long/short, high fees, high turnover... it just changes the whole ballgame, even though... I don't know. It's an evidence-based strategy, and I don't disagree with that, but it's kind of pushing the evidence to the limit, like how far can we push this? Meb Faber has this. Cambria Funds, they do something similar. They take... Like, he's got one global value... I can't remember what is called. It's a global value index fund, but they take the 25% cheapest countries and then select stocks in those countries. And I mean, sure, I there's probably basis for that. And Meb Faber has probably written a paper on it. Does that mean that I would do it for our clients or for myself? No. Because again, it's high turnover, relatively high fee compared to a dimensional fund. And you're timing the factors, which maybe there's evidence you can do that, but there's also evidence that you can't. Long-only. Long-only factor tilt. Anything else?

Cameron Passmore: I think that's good for this week. We've factored people up.

Ben Felix: All right.