Samuel M. Hartzmark studies asset pricing and behavioral finance. His research has appeared in the Quarterly Journal of Economics, Journal of Finance, Review of Financial Studies, the Journal of Financial Economics, the Quarterly Journal of Finance, and the Review of Asset Pricing Studies. He has received a number of awards including the DFA prize for best asset pricing paper published in the Journal of Finance; the Exeter prize (the first finance paper to win); the AQR Insight Award; best paper Utah Winter FInance Conference;
The Jack Treynor prize; the Research Affiliates Best Paper Award; the Moskowitz Prize; the BNP Paribas Best Paper Award, the Charles Brandes Prize; Best Paper in the Review of Asset Pricing Studies; 2nd prize Fama-DFA award for best paper in asset pricing research in the Journal of Financial Economics; the Hillcrest Behavioral Finance Award in 2015 and 2018; the UBS Global Asset Management Award; the Michael J. Barclay young scholar award; the SIX Best Paper Award Swiss Society for Financial Market Research; and he was a finalist for the 2014 AQR Insight award. His work has been covered by a variety of media outlets including CNBC, Forbes, The Wall Street Journal, and Bloomberg among others.
Today’s episode is an exhilarating journey into the captivating realms of finance and human behaviour with Professor Samuel Hartzmark, who takes centre stage to explore the complex intersection of asset pricing and behavioural finance. Professor Hartzmark’s career and academic journey are nothing short of inspiring. With a double major in mathematics and economics, a prestigious MBA from the University of Chicago Booth School of Business, and a Ph.D. from the University of Southern California's Marshall School of Business, he has paved a remarkable path through the world of academia. Our conversation takes a deep dive into his groundbreaking research, where he dissects complex financial topics with astonishing clarity. We delve into some of his most-cited papers, including those on dividends and sustainable investing, which consistently reveal counterintuitive conclusions that challenge conventional wisdom. We unpack price-only index returns, dividend juicing, price-only data, the value of sustainability rankings, and the power of capital to make the world a better place. And don't miss our exploration of multi-factor asset pricing, where Samuel’s unique perspective sheds new light on these models in the context of human behaviour. This episode promises an enlightening and engaging conversation that investors and finance enthusiasts alike won't want to miss!
Key Points From This Episode:
(0:03:48) Morningstar's sustainability rating system and its impact on the flow of mutual funds.
(0:07:35) Choosing sustainability ratings over other metrics and how they motivate investors.
(0:16:24) What drives the behaviour of mutual fund investors toward green firms.
(0:18:17) Unpacking the concept of sustainable investing and how impact elasticity is relevant.
(0:23:15) Insights into the impact elasticity differences between brown and green firms.
(0:26:40) The divestment of brown firms and ESG integration.
(0:28:58) Unlocking the power of investor capital to shift toward a green economy.
(0:32:57) Price returns versus dividend returns from a behavioural finance perspective.
(0:39:05) Whether dividends are a safe hedge in a volatile market.
(0:44:26) Reasons behind the demand for dividends and how it impacts expected returns.
(0:47:55) Ways mutual funds exploit the preferences of dividend investors.
(0:50:52) Dividend juicing and the overall cost to investors.
(0:53:21) Advice and recommendations for dividend-loving investors.
(0:54:53) Diving into data preferences: unveiling the prevalence of price-only index usage.
(0:58:09) How price-only data reliance affects media coverage of the market and fund flows.
(1:02:17) Investor expectations regarding price-only index funds and how to avoid the pitfalls.
(1:05:23) Varied asset returns and understanding people's asset allocation motivations.
(1:10:54) What survey results tell us about asset pricing.
(1:13:12) Examining implications of portfolio tilting towards priced risk.
(1:18:56) Professor Hartzmark’s version of success and happiness.
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 are hosted by me, Benjamin Felix and Cameron Passmore, portfolio managers at PWL Capital.
Cameron Passmore: Welcome to Episode 274. This week, we have a great guest. Really nice guy, too, Ben. Professor Samuel Hartzmark joined us. Sam's a professor in the Finance Department at Boston College's Carroll School of Management and he studies asset pricing and behavioural finance and absolutely fascinating, engaging, and really nice guy. With that, Ben, you've got to queue this up. These are great topics to talk about.
Ben Felix: Yes. He's got tons of incredible papers, and I was familiar with a handful of them before we invited him on. Then afterwards, obviously, I read all the papers, at least the ones that we ask questions about. It was a paper on dividends that I was most familiar with, and then a more recent paper on sustainable investing that Sam came out with. I read that one and it was just so good. He does such a good job at really pulling apart topics in a way that is not intentional, I guess, but he brings you these counterintuitive conclusions with his research. I guess, he chooses topics that end up having really counterintuitive conclusions.
On sustainable investing, just a fascinating paper on the actual impact of changing the cost of capital of green and brown firms, like if we're trying to make the world a better place, is depriving brown firms of capital an efficient way to cause a green transition? Anyway, very counterintuitive finding. I won't spoil it. But after I read that paper, I was like, “Oh, we got to see if Sam will come on the podcast.” Then once I dug into his research, there's even more interesting stuff on sustainable investing on dividends. We spent a lot of time talking about those two topics, but then also, about the impact of price-only index returns and how that affects investor behaviour and how the media reports on markets.
Cameron Passmore: That's a subject I don't think we've talked about that bias before. It was really interesting.
Ben Felix: You know, it's a thing. I've had this conversation with people many times where they show me the returns of an index and they're like, “Why am I getting a different number than you?” It's like, well, you're looking at the price-only return. It's something that comes up for sure, but Sam's done incredible research on it.
Then we finished with a discussion on multi-factor asset pricing, which was very interesting. It was last year that we spent a lot of time talking about the ICAPM model, and then of course, we've talked to Robert Merton, and we've talked to John Cochrane, we've talked to John Campbell about this risk story for multi-factor asset pricing. Sam has, again, I'm not going to spoil it, he's got a really, really interesting take on how to interpret those models and how realistic they are, given how people actually behave, or people actually think.
Cameron Passmore:Sam holds a Ph.D. from the Marshall School of Business at the University of Southern California. Also, has an MBA from the University of Chicago Booth School of Business, and a BA in Mathematics Economics, with a double major in religion from Emory University. Anything, Ben, to add?
Ben Felix: No. I think it's a really, really cool episode. I hope people enjoy it. With that as the introduction, I think we can go ahead to our conversation with Professor Sam Hartzmark.
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Ben Felix: Professor Sam Hartzmark, welcome to the Rational Reminder Podcast.
Sam Hartzmark: Well, thank you so much for having me. Pleasure to be here.
Ben Felix: We're super excited to be talking to you. Sam, to kick it off, how does Morningstar's sustainability rating system work?
Sam Hartzmark: Morningstar's sustainability rating system, and how it's different from other rating systems is every mutual fund in the universe. Whether they were green mutual funds, normal mutual funds, and no one had really done that before. What they did is they looked at the holdings of mutual funds, which are disclosed to Morningstar. They look at each of the individual firms, and then they use an ESG score for those firms. Morningstar uses Sustainalytics.
Then what they do is they take the score, which is just a number from, I think, zero to a 100. They average them based on their portfolio weights, and that kicks out a globe rating. They rate everything within a category by percentiles, and they just do the classic Morningstar one to five that they do with the stars. The bottom 10% are one globe, instead of one star. The top 10% are five-globes, instead of five stars. But it's the same, take the top 10%, bottom 10%, those are the really good, those are the really bad with the same cuts in the middle.
Cameron Passmore: How did the introduction of sustainability ratings in 2016 affect mutual fund flows?
Sam Hartzmark: This is the subject of a paper I worked on with Abby Sussman. We were really interested to look at this because we knew that there'd been this huge inflow of green funds. I think at the time, green mutual funds had grown to about 3% or so, 2%, 3%, from roughly zero a few years before. There'd been this big growth. But there was this open question about, okay, there's this fringe set of investors, overall, what do people think about it? That's where this rating system was really cool because it rated everybody. It's a market-wide shock.
We found, basically, that there was a big impact on fund flows. Those five-globe funds that were the most sustainable, that highest rating, according to Morningstar, they experienced really big inflows. The One Globe funds experienced really big outflows. I think we estimate in terms of dollar amount, something like, 25 billion dollars flowed into the five-globe funds. Slightly less flowed out of the one globe funds. That's really interesting because that has both people buying it, but also selling out of it. It says, on aggregate, the net flows were really towards these funds that were rated high in terms of sustainability. The introduction just had a significant effect on mutual funds on aggregate, very much in favour of the high sustainability funds.
Ben Felix: Super interesting. We recently talked to Zahi Ben-David. This sounds a lot like his paper on star ratings.
Sam Hartzmark: Yeah. Yeah. Zahi's paper, which is spectacular, looks at what happens when Morningstar shifts its ratings, basically, and finds that they were basically taking these big factor loadings when they weren't adjusting, and then they switched, and all of a sudden, these factor loadings went away. I'd say, our paper has a similar spirit of, I mean, Morningstar is this big influential rater. People really pay attention to them. They really respond to the ratings, and maybe they don't think too much in terms of the details, which is, I mean, it's what they're selling, right? People like, this is one, this is five, and they respond to that. Yeah. I'd say, Zahi's paper is similar in that they're looking at the star ratings on past performance, and we're looking at the globe ratings.
Ben Felix: Yeah. How important were the globe ratings relative to more detailed information that Morningstar is also presenting, like the percentile rank of sustainability?
Sam Hartzmark: Yeah. When I'm not doing green finance, I very much think a lot about behavioural finance, display of information, and things like that. One of the things that was super interesting with these ratings is Morningstar basically gave you all the information you could want in terms of details about what was going on in this rating. They gave, here's one, here's five, these are the globes. But they also gave you the percentile rank within each category, which is exactly what the globes were based on. Were you one, two, three, four, five, up to 10, you were one, were you at the top 10, you were five. Then, they also gave you the raw score that wasn't necessarily adjusted of just what was the average evaluated ESG score in the portfolio.
There's a little bit of nuance, but to a first approximation, what we find is all of that detail that Morningstar really considerably provided didn't matter at all. People didn't pay attention to it. People didn't really look at it. People really focused on these one and five-globe funds. We can do some cool things in the paper to really show this, where we have funds that were, say, just over the line on one side, or just under the line. They're about the same on sustainability, everything you can look at. The ones that just tipped into those extreme buckets got big flows.
The only thing, I think, people really disliked the absolute worst fund. If you were like, I think, I'm forgetting if it was one was bad, or a 100 was bad, but the absolute most extreme, people really didn't like that percentile. There was a little bit – it wasn't that it was totally ignored, but economically, it was just this course easy to respond to display, not any of the nuance. One other thing I don't think I mentioned in terms of the rating system that's related to this, in where – this is a really interesting system to study. There was no fundamental news that came out of this rating.
You might think that Morningstar would go and do research and new information was created. Then, maybe investors are responding to that. That's not what happened here. They took existing ESG scores, took existing holding data, created these scores, and that's what was going on.
Cameron Passmore: Incredible. Can you give us a sense of what motivated investors to allocate toward funds with higher globe ratings?
Sam Hartzmark: Yeah. This was, I think, an interesting question for us. We went to the data and it was a fun paper in that I didn't have a strong prior. We knew that ESG funds had been growing. At the time, there was a bit of uncertainty about market-wide dynamics. We got the data and we found these huge flows. Then the question comes, okay, so why are those flows there? Well, we can rule out some things. One story, especially at the time was ESG is an institutional game. This is a game that universities are being pressured to do certain things. That is the type of things that are driving this movement. Institutions are clearly important in this space.
Because we're looking at standard US open and mutual funds, it'd be strange if that was the clear driver. We can also split in the institutional and non-institutional share classes in our data. We find very similar patterns in that. The interpretation of that is not being driven by institutions. What we then were left with is, well, is it something related to outperformance that people thought that these were, say, there was alpha associated with ESG, or something like that? Or is this more about people, who, for moral reasons want to hold green funds, people who want to achieve impact, things like that? We could look for performance in the data. We did not find any evidence of over-performance.
With our paper, you've got to take that with a grain of salt. We're looking at about a year. Returns are noisy. We find slightly negative point estimates that five-globe funds underperformed the one globe. I would say, that your prior really matters to there because this is not the paper to definitively say green outperforms or underperforms. There's a big debate about that. But we didn't find any evidence of over-performance.
Then the question becomes, well, is it about returns, and expectations, where these are just better investments? Or is it about environmental concerns, things like that? The problem when looking at the data is that those should have the same prediction. People flow into this. You don't find outperformance.
What we did is we ran experiments on Booth MBA students and then people on an internet survey platform. What we found that was consistent about both those and what we did is we showed them mutual funds, basically screenshots from Morningstar. Then we randomized the sustainability globe rating. In all of them, I believe, were five-star funds. We tried to choose, claim to similar funds that had different globe ratings and then randomized the globes across it. Then we asked people to allocate money to the funds that they saw. Then we also asked them about performance expectations.
What we found is some evidence in favour of both. Those Booth MBA students and the folks on the internet all thought that higher globes were associated with higher returns and lower risk. They just thought that these were better investments on some level. Now, what we also did is we looked at how those allocations shifted based on those perceptions of risk and return. What we found was that people did allocate more money to the five-globe funds than could be explained based on those expectations.
If you dug down even further, it was the folks who said, so afterwards we asked, did you care about environmental concerns when you made this? The folks who said they did, those were the people who drove that excess allocation. The folks who said they didn't care about environmental concerns, they allocated more to the five-globes. It was explained based on performance. I think that's about as far as we can go there is it seems to be some of both in a mixture. I think this is, I think, what's going on in the market is some people think this is related to performance. Some people think it's a moral issue and we're capturing both of those things, which in the data, push things in the same direction and drive those flows.
Ben Felix: Would the performance be related to a hedging demand, or is that something different?
Cameron Passmore: We did not ask for a hedging demand. That is something that we could have done and has become more popular. There's definitely papers now that are trying to say, that perhaps, people like holding, say, low carbon portfolio is because in a world that's transitioning to a green economy, that's a valuable hedge. Now, if you thought that and if you thought it was rationally priced, it should go in the opposite direction, at least in terms of return expectations, where once lots of people are holding stocks as a hedge, that basically means today, they're willing to pay more for that hedge and they should have lower return expectations going forward. We didn't ask about that, but the return expectation numbers go in the opposite direction.
Ben Felix: Yeah, right. The people expecting high returns would really be saying that they don't think carbon risk is priced properly, if they have a hedging demand.
Sam Hartzmark: Yeah, yeah. I mean, I think a mispricing story in many ways is the easiest place to get the outperformance of green stocks. For example, I think one of the papers that did show evidence of something outperformance potentially related to socially responsible investing is this paper by Alex Edmonds, showing that employee satisfaction ratings predict excess returns. What he would argue is that that is a public signal that's informative, that the market wasn't taking into account that was leading to this alpha. That's probably the easiest way to motivate higher performance by green stocks.
The countervailing fact, though, is like, is the world has really turned to focus on ESG investing, the idea that people aren't paying attention to these signals, or systematically underpricing these signals, I think that becomes less likely.
Ben Felix: Super interesting. We had Professor Edman’s on at episode 192, and he told us all about that.
Sam Hartzmark: Oh, yeah. It's a great paper.
Ben Felix: Yeah, yeah. It is super interesting stuff. What are your findings, in this paper that we're talking about? Tell us about what mutual fund investors care about.
Sam Hartzmark: There's a few different bits. One is, at least in this time period, mutual fund investors really did seem to care about a perception of sustainability. They really responded to that. There was a large shift of funds consistent with that. That just seemed to be a positive attribute for these funds and for these investors. I think it also speaks to the fact that these aren't necessarily the most deeply complex, or thought-out decisions necessarily. You can see this on a bunch of dimensions, where this was public beforehand. In a standard model, no new fundamental information is out there, so no flows should have occurred. People aren't really paying attention to the nuance.
If what you really care about is a specific goal, it's unclear as to whether this is the rating you should be looking at. But what is driving things? This very salient rating that was at the top of every Morningstar page that lots of funds used in marketing. It was salient. It was attention-grabbing. It seems broadly something that investors responded to, but probably not in the most thoughtful, deeply, nuanced way.
Zahi's paper, I think, is similar. Like, Morningstar's ratings are hugely influential in terms of the star ratings. It's a formula based on past performance. There's no new information that comes into that, but people like simple heuristics. They like complex data digested for them, and then they can respond to it in a fairly simple way.
Cameron Passmore: Interesting. What's the general idea behind how sustainable investing is supposed to make the world more green?
Sam Hartzmark: The rough idea is that you want to shift the cost of capital of firms so that they can make investments to make things more great. At a broad level, you want to take firms that could end up doing better in terms of how you want to define things. Let's say, emissions, something like that. Maybe they could manufacture something in a lower emissions if they invested in something expensive. You want to allocate money and shift their cost of capital, so that investment makes economic sense for them.
Because if they were already doing it, there'd be no reason to shift money around, so you want to incentivize these firms to improve. The cost of capital is the way that economists conceptualized that idea, like what is the discount rate you use in order to make investments in future products better or worse. In terms of sustainable investing, the rough idea is you send money to those firms that you want to become more green. By sending money to those firms, you allow them to finance the projects you want them to finance. Hopefully, in doing so, you end up making the world more green in the process.
Ben Felix: Yup. Makes sense. Maybe I'll just say actually, just for listeners, you're talking about sending the money in the secondary markets, or you're affecting their cost of capital, but not literally sending the money. I think that's a common misconception with ESG investing.
Sam Hartzmark: Yes. Sorry. There are versions of sustainable investing, like the green bond market, or something like that, where it's directly investing. This is more, yes, you're on the secondary market influencing cost of capital. The major way we think of that is, yeah, you're shifting around share prices. Of course, share prices are increased a lot. Firms can issue more stock and there's some nuance. Yeah, we're talking in, I think, we're going to the paper I've got with Kelly Shue, which is mainly thinking about equity investing, though similar with bonds as well, too.
Ben Felix: Can you talk about impact elasticity in this research?
Sam Hartzmark: Yeah. We'll quickly take a step back and I'll get to impact elasticity. What Kelly and I were interested in this paper is there's a lot of different things that go on in terms of sustainable investing and things along those lines. Truthfully, there's some big themes, like dominant ways that things are implemented. One of those is how do you implement a sustainable fund if you're just a standard, sustainable fund? Well, you buy green firms and you sell brown firms and that's the standard strategy. There are other things that are out there, but that's really what most people tend to do. Most people tend to focus on emissions because greenhouse gas is just this huge overarching issue.
Then, most people want to move the economy to a green economy. They both want to make emissions lower, but not destroy the economy while doing so, achieving green growth, or a green transition. That was the starting point for this paper. We were like, okay. Let's say, that that happens. Let's say, sustainable investors who want to transition to a green economy, who care about lowering emissions to fight greenhouse gas, buy a lot of green stocks, low emission stocks, sell a lot of brown stocks. What would happen?
Well, the first order question is, well, okay, how will these firms respond to these shocks to cost of capital? The green firms that are being bought, they are going to be able to make green investments. How much will their emissions change? We look at emissions intensity, which is emissions scaled by revenue. Then the brown firms who are going to have capital shifted away from them and are going to be pushed towards financial distress and not as good, how are they going to respond to that?
The impact elasticity that we're thinking about is just the answer to what happens to firms when you get shocked in terms of your cost of capital, in terms of your emission’s intensity? Then, of course, the next step is, well, how is that different for green and brown firms? Because that's what you need to know to answer the initial question, right? If these investors actually shifted the cost of capital, what would happen? Well, you're going to shock the green firms in one way, you're going to shock the brown firms in another way, and that should dictate your answer to that question.
Cameron Passmore: How are the impact elasticities between brown and green firms different empirically?
Sam Hartzmark: They are quite different, and we find an impact elasticity of roughly zero for green firms. What that means is if you're a green firm and your cost of capital is increased or decreased, you keep on doing about the same. If you're a brown firm, we find a big negative impact elasticity. What that means is, let's say, lots of sustainable investors shift capital away from brown firms, decrease their share price, they end up emitting a lot more. Then when brown firms are doing quite well, that's actually when they manage to cut emissions, at least in terms of emissions intensity. They tend to produce things in a more environmentally friendly manner.
Ben Felix: Crazy. Well, what's the intuition behind that?
Sam Hartzmark: I think the intuition is just thinking about these different firms and who they tend to be. I think the green firms are the easiest to think about. If you think about who are these green firms, these firms with super low emissions, well, there are firms like, insurance firms, healthcare firms, to some degree, tech firms, and they have very, very low emissions. In our paper, we use an example of Travelers Insurance. Per million dollars of revenue, they emit, I think, about one ton of greenhouse gases, which is about 40 times less than the average US household.
What's going on is they're an insurance firm and they can do things on the margin to get more green. Even if they really were to go incredibly brown and I don't know, buy everyone used cars with no catalytic converters, or something like that, there's just not that much that they can do to get worse and it's not that much they can do to get better. Now, the brown firms are the opposite of that, of these are firms, these are agriculture firms, building material firms, and energy firms who are working in businesses and business types that are emissions-heavy. If you're going to make cement, the process just releases a lot of gas.
What those types of firms, the constraints they're working under is they can either make investments that probably are very costly upfront, but likely, will pay off over the long term in results in lower emissions, or they can say, cut corners today, keep doing what they're doing and likely emit a lot more. A firm like that, if you say, have sustainable investors who say, push it towards financial distress, well, they're not going to then make costly investments in abatement technology. They're going to do what they can to survive the short run. Those green investors, have forced them to be more short-termist. Of course, the goal is to get them to focus on the long term in the future, so there's a bit of a contradiction at its heart there.
Ben Felix: Interesting. It really doesn't incentivize brown firms to turn green. It incentivizes them to survive.
Sam Hartzmark: Yeah. No, exactly. Intuitively, I think that makes sense. When can you invest in the new technology for better production? Well, when things are going well.
Cameron Passmore: This is all so interesting. Based on your findings, Sam, how effective is divestment of brown firms been to promoting a green transition?
Sam Hartzmark:There are two bits to that question. One is, how big is the shift of cost of capital actually been so far? That is an incredibly interesting question that is complicated and difficult to answer that other people have tried to do, and we agnostically threw up our hands and say, “I don't know.” But you can choose your favourite paper there. Now, what's interesting with that being said, and so there's this debate saying, it's either shifted things a bit where green firms have been able to make green investments more, brown firms not, or hasn't shifted it much at all.
Again, the interesting questions is about why, because the dollars flowing that way have been quite big. But what our paper suggests is maybe the best-case scenario is where all of this money has been flowing into these green investments, but hasn't actually shifted the cost of capital yet. Because if you take our results with impact elasticity seriously, it suggests that it could have a counterproductive effect relative to this green transition goal.
Ben Felix: You were mostly looking at divestment. How do you think your findings would change if you looked at ESG integration instead?
Sam Hartzmark: I think that ESG integration would have a very similar intuition to what we're finding. Truthfully, it's something that in the next draft, we're going to write up a bit more, because, I think, the intuition of exclusion is very straightforward. We've written it using that language, but the integration idea of just overweighting, or underweighting, using ESG as an input more holistically in your portfolio, I think everything roughly holds in terms of what you'd expect in terms of the economic impact, influencing the impact elasticity, economically, why you think it might shift around firm's behaviour.
I think that almost anywhere in the paper we talk about, like, avoiding brown firms, if you just say, overlaying an ESG strategy and taking it into account in your portfolio weights would lead to a similar intuition.
Cameron Passmore: I have to ask the question that I'm sure many listeners have right now. If somebody wants to have a positive impact on global sustainability, where should they be advocating their capital based on your research?
Sam Hartzmark: That's a very interesting question. I don't have specific funds, but I think there's some broad things that our paper points to that investors can focus on. I'd say, this is a general theme, both with green finance and also, some of the later papers we're going to talk about is trying to be clear about what it is that you're really trying to achieve. If you are an investor who is say, buying sustainable products for moral reasons, I think the answer might be different than say, buying sustainable products because you want to have an impact on the environment.
If it's moral reasons, maybe it makes sense to focus on exclusionary rules that are aligned with your morals. In terms of impact, you probably want to be focusing to some degree on funds that are actually engaging with brown firms, because at the end of the day, that's really where the improvement has to come from. There are some exceptions where maybe funds that currently look green in terms of emissions, someone who's really focusing on impact would invest in. But in general, the improvements need to come from those brown industries. Agriculture is a big emitter.
If you want a green transition goal, you both want to keep feeding people and you want agriculture to emit less. You would need to really engage with the agriculture industry and find firms that maybe were relatively more green within agriculture, try to grow those firms, try to incentivize them to become more green, maybe avoid the firms that aren't doing that. But you can't just say ignore, all of agriculture and expect the insurance firms to make up for the lost food. That would be bad. Also, there are certain things that sustainable investors seem to be trying to do, but aren't doing very well. Something that could make a lot of sense is to invest in firms that are actually improving. You’re trying to incentivize to them to improve, they do improve, they do better.
One of the things our paper shows is that it looks like, green funds try to do this and also, ESG ratings, but they don't do it in the right units. They actually look at percentage changes in terms of firms that have improved, as opposed to shifts in levels. Now, this is a big mistake because the brown firms emit well over 200 times a higher emissions intensity than the green firms. If you treat 1% the same across each of them, well, the brown from the decreases 1%, that's much bigger in terms of helping global warming than a 100% impact on the green firms. It turns out that people are basically focusing on this wrong unit.
Cameron Passmore: Wow, that's so interesting.
Sam Hartzmark: Yeah. Those, I'd say, or the big things is try to engage, definitely think much more within product, within industry. If you're going to reward for improvement, use the right units.
Ben Felix: Wow. Yeah. Super interesting. I'm sure ESG investors will find the paper very difficult. You get challenged as a lot of what's out there, right?
Sam Hartzmark: Yeah. No, and I think, too, it's really important – these are really important issues. I think that people rightly have big concerns and really would like to be doing things to improve the environment to combat these global warming, these just massive issues. Because of that, I think it's also really important to think hard about, well, how do we actually do that and empirically look at what's going on and hopefully, improve the strategies and hopefully improve the impact it has in the process.
Ben Felix: All right, I want to move on to another topic that people also get very emotionally invested in, which is dividends. Can you talk about how investors treat price returns and dividend returns differently?
Sam Hartzmark: Absolutely. Dividend investors are very emotional investors. I actually had another finance professor who I was presenting one of these papers and he went home to Christmas. His father-in-law was a big dividend investor. He was convinced that our arguments would convince him. I mean, he reported back afterwards that they agreed to disagree, that it was too passionate, the love for dividends. Emotions run high.
But, how do people actually treat prices and returns differently? The first thing to note is that before we bring in important real-world things, they shouldn't be treated differently at all. This is a classic finding from the 60s, whose rough intuition is correct. You've got some sort of a dividend payout. Let's say, stocks at $10 is going to pay a dividend tomorrow. Well, tomorrow, that stock will be worth $9. You've got a dollar in payment. You're not richer, or poorer. You still have $10. If it wasn't paying a dividend, you could have sold a dollar of the stocks, so it should be irrelevant. Then you bring in real-world things, like taxes and trading costs. For most US investors, most of the time, dividends will have a little bit of a tax penalty. If anything, you should probably not necessarily love them.
How do people actually treat them? Well, they view them as different and not together. That leads to a big mistake because think about what I just told you, right? The thing was $10, now it's $9, you've got a dollar in cash, you're better or worse off. If you view say dividends as separate, well, you've got a dollar. This is awesome. This is free money. This is income. This is something you can live on. Firms play this up. They pay dividends in nominal amounts. They try to keep them at levels where they can always pay that amount, maybe slowly increase it. It seems like a safe, stable, nominal income stream. There's the price changes. That's what we think of as in terms of stocks. It can go up, that's awesome. It can go down, that's sad and risky.
You've got this one thing you're holding. It's a stock. You view it almost as two distinct assets. This risky price change component and the dividend component is kind of a safe, stable income stream.
Cameron Passmore:Between us, Sam, what causes people to believe dividends are so special?
Sam Hartzmark: I think that some of it is that if you aren't paying particular attention, it's not very easy to directly identify this theoretical idea. First off, empirically, it's totally the case that when the dividend gets paid, the price drops by roughly the amount of the dividend. There's a big literature in the 70s looking like, it's almost the whole amount related to taxable stuff, things like that. It's like, intuitively the price drops by the amount of the dividends. This is just true. But that's true when I've got a data set of 10, 000 dividend payments and I run a regression and you get this coefficient close to one, with the T stat of 30.
I'm some investor who's just looking at the five stocks in my portfolio. Well, stocks are really volatile. In practice, what happens? Well, you get a couple of basis point dividend payment. On a day, the market moves 2%, you have no idea how should you think of it as a rational person. Well, you should think of in the counterfactual world, market’s down 2%, but it would be down 2% minus those basis point dividends if I hadn't received the dividends, but you don't really see it. There's not really an effort to make you see it.
If you think about your brokerage statement, what happens with every brokerage I've ever seen is you get a dividend payment and it just shows up in cash. It's not very salient which stock it came from. It's not salient that the price of that stock should be higher. If you aren't thinking about it, it looks like free money. This volatile prices moved around. You don't notice where it came from. That's why we call this the free dividends fallacy. You view dividends as this free bit of money that's distinct from the price level, as opposed to the price dropping by the amount of the dividend, which in practice is exactly what happens.
Ben Felix: Yeah, that's crazy. It sounds like a lot of it's related to salience, where the dividends are salient, but price changes are obscure.
Sam Hartzmark: Yeah. No, totally. I think a lot of finance and behavioural finance are things that are obvious when you have the big data set and are obvious when you think about the theory. But, when you're sitting there with your app and your brokerage statement, aren't obvious at all. It's just not very salient. It's hard to find like, what should people be doing? Well, they should be looking at how much more money you have. We've got a measure of that. That is the total return, where you consider that dividend payment because it's all just a pot of money. We want more money at the end. We know how to measure that. Then go and open any finance textbook and page one will be like, “This is a return. This is how we think about stuff.” Then go and look at your brokerage statement and be confused that there's no return on there. That just makes the real world a lot more difficult.
Ben Felix: Super interesting. We rarely have conversations with clients about their income and their capital return, because we report on total returns.
Sam Hartzmark: I'd say, that is improving. It is now easier to find that information. In one of our papers, I think it was Interactive Brokers, now reports total return, in addition to the other things. It was in their marketing that they did this. We do this. It's a competitive advantage that other people don't. Even sophisticated stuff. Maybe things are different. This was a few years ago, but Bloomberg terminals used to ship with the default being price changes. You could flip things into a total return thing. It's like, it's not that it was hidden or anything, but the standard is just often price changes and dividends separately, and that's how they're shown and people respond to price changes and dividends separately.
Cameron Passmore: Are dividends a safe hedge against uncertain fluctuations in price?
Sam Hartzmark: No. Absolutely not. Again, people think about it that way, right? Because if you view a dividend as separate, then all of a sudden, you can view this as a stable asset that's uncorrelated with the price level of the stock. But because the dividend payment comes out of the price level, it's not a hedge at all. It would be like saying, okay, I've got $10 in my right pocket. I'm going to put a dollar bill in my left pocket. Now I've hedged something. It's like, no, you've still got the $10. It appears that way, but it really isn't.
Then, of course, at the extreme level, when prices actually go down a lot, that is when dividends do get cut. It's really not a meaningful hedge in any way. At the end of the day, all of this is coming back to the same concept again of like, well, we know how to look at things. We look at things as returns, because that's the economically meaningful way to do it. If you don't put these things together, all of a sudden, you can start thinking about somewhat nonsensical things. Like, this thing that's coming at the expense of price thing, a hedge against the price, which doesn't make sense.
Ben Felix: I get that. You just said that it's not a hedge because it comes out of the price, which makes sense to me. I've tried to explain this to people, like we talked earlier with very emotional dividend investors, and it's really hard to get across. Do you have a way to explain this to someone in a way that's easy to understand?
Sam Hartzmark: The hedge one is hard. I think, the base intuition of prices and dividends – the analogy I give with like, you've got saved money in one pocket, you've shifted to the other, I think that is helpful. Yeah, I don't know about the hedges in particular. That one, I've had less focus on in general. Why are dividends so hard? First off, people love them, so it's emotional. It's not very salient, so they get it wrong. Then it also gets conflated with other things that could be reasonable related to the characteristics of dividend-paying firms. There is a fundamental difference between, say, holding a stock, because it's a firm that pays dividends and you like that for some reason. You could view it as a signal of ongoing profitability or is a value signal, or any number of things. I'm not saying that's good or bad, but that is a coherent thing you could say.
I believe the dividend-paying firms are a good, safe investment. You could argue they have alpha, and I want to hold them that way. We can debate, do they have alpha? But that's coherent. As opposed to, “This firm announced they're going to pay dividends next Tuesday. I really want to buy the stock today, so I can get the dividend.” What I found is that I can start to de-bias that, like they're going to pay Tuesday, you shouldn't want it. But people then fall back on, “No, but dividend-paying firms are good investments or good firms.” Then you've got to explain, “Okay, maybe they are, maybe they aren't. If they are and you're say, a taxable investor, you probably don't want the dividend payment.”
Maybe you want to hold the dividend-paying stock. Maybe that's your portfolio and maybe you are an active trader. Maybe you still will receive it. But you shouldn't view the dividend as this extra benefit you get. It's like, something that for most investors is probably a tax hit that you want to avoid, but it all gets muddled is what I've found.
Ben Felix: : A 100%. You're so right, because people exactly fall back on the argument that “No, look, dividend stocks have outperformed the market.” Then when you try and say, “But no, they don't have a five-factor alpha.” Then that's just dead. That conversation can't go anywhere from there.
Sam Hartzmark: Oh, yeah. But then you'll get like, they're good firms, they're safe, they outperform the market, and therefore, the different payout’s a hedge. You're like, “No, no, no. But now, we've just broken that dichotomy of dividend payment versus dividend characteristic.” Yeah, I feel like I've lost years of my life trying to explain this. But it's really tricky.
I think a lot of these behavioural finance-type mistakes, one of the common themes is that these are things that if you write down the finance model, they're obvious, right? Miller and Modigliani is right. We need to add in real-world frictions. Sorry, that's the dividend irrelevance paper. I don't know if I said that earlier. But then, if you go to a class of MBA students and start talking through this, you start getting pushback to those ideas and you really see, no, the core intuition is just wrong and even common usage.
Our paper, the Americans Frequent Flyer Program is the Dividends Miles Program, or they may have rebranded, but it was. why is that? Well, because dividends are awesome. This is the free money you get from flying. They didn't mean this is the tax-advantaged irrelevant program. They meant this is the free stuff program. That's how people think about dividends and frequent flyer miles and in the market.
Cameron Passmore: Wow. When does the demand for dividends highest?
Sam Hartzmark: There's a few different reasons why people demand dividends. I think it comes back to that first question. If you have the wrong belief that dividends and price levels are separate, you suffer from this free dividends fallacy. Price changes are this risky bet. Dividends are this safe, stable, nominal income stream. If you view the world that way, you're basically going to like receiving dividend payouts more when that safe, stable income stream looks better. When does it look better? When the market's doing poorly, it's going to look better. In our paper, maybe the only time people didn't really like dividends was the tech bubble. That's the only time we found in the last, I don't know, 40, 50 years or so, where it looked like there weren't systematically dividend investors, which was not active in the market then, didn't really pay attention.
But everybody I've talked to seems to be like, “No, it makes sense.” No one cared about dividends in the tech bubble and our data bears that out. The flip side is when the market's doing poorly, clearly you want the safe, stable income stream. Also, when interest rates are really low. You're viewing this, again, wrongly is this independent payout, almost like a bond coupon. When interest rates went towards zero, demand for dividends just went through the roof. The last thing is you want this safe, stable, nominal income stream. The safer you view it, like, as long as you think it will keep being paid, or maybe if you think it will even grow, you'll like that even more.
Ben Felix: How does a preference for dividend yield affect the expected return of dividend-paying stocks?
Sam Hartzmark: One of the things that's interesting, when you think about the reasons that dividends appear better or worse, they're going to be systematic. In general, any behavioural bias, or most behavioural biases, I should say, that result in say, price impact are going to be systematic. The interest rate’s low for everybody. Everybody who suffers from this free dividend fallacy and wants to get this dividend income stream is going to want to hold dividend-paying stocks. What does that mean? Well, the price of those stocks is going to be bid up at the same time.
What we found when we look at the data is low interest rate periods, things like book-to-market ratios, price-to-earnings ratios, things like that, dividend-paying stocks relative to non-dividend-paying stocks look much more expensive. Then we find that basically, by doing so, you're shifting the valuations and you're shifting expected returns. Right after these periods, where everyone's piling into dividend-paying stocks, returns to dividend-paying firms are significantly lower.
We find about, say, 2% to 4% per year in the period, moving from periods of high-dividend demand to low-dividend demand is that calculation. There seems to be a pretty sizeable shift in terms of demand that does shift around valuations and does tend to lean to underperformance after very high-dividend demand periods.
Cameron Passmore: Wow.
Ben Felix: Those are big numbers.
Cameron Passmore: Very big.
Ben Felix: Crazy stuff. When we talked about salience earlier, can you talk about how mutual funds exploit the preferences of dividend investors?
Sam Hartzmark: Yeah. If you think of the Morningstar ratings, Morningstar is not necessarily getting a benefit out of the salient fact, but you could think of there is something big that investors respond to that lacks some nuance. You can give that to investors. Maybe if you are trying to maximize your profits, do other things behind it that investors aren't paying attention to.
If you're, say, someone who really likes dividend yields when buying, say, a mutual fund, well, that's a weird thing. For a firm, there's all sorts of economic things that could be going on. We talked about why, say, a dividend payout shouldn't be liked, but maybe there's characteristics of firms, things like that. Now, mutual funds are just passed through vehicles. They are just pots of money that hold assets, and so they receive dividends and they pay those dividends out to investors from their investments.
Now, mutual funds tend to report the dividend yield on their fund from those dividend payments. Now, what makes mutual funds interesting is they aren't limited by any means to that amount of payment, because in order to call something a dividend, they've got to have received it and pay it out, but they're a pot of money. They could always just send more money if what investors wanted is more of a payout. In that same Miller and Modigliani intuition holds of that payout leaves the fund, the fund drops by the amount of the money. There's no reason why, I don't know, a fund with a 2% dividend yield couldn't give 4% money out. As an investor, it's not clear why you should prefer a 4% dividend yield to a 2% dividend yield, or something like that.
With that said, investors love dividends and they tend to get shown dividend yield and investors could be making decisions to buy mutual funds based on that. Now, where this gets interesting in terms of providing a salient characteristic is if you're a fund, you can increase that number. You can either just say, hold dividend-paying assets, which is I think what a lot of people tend to have in mind in terms of what that dividend yield is capturing, but you don't have to do that. You could start trading with an eye to win those dividends that are being paid out and start systematically trading to increase that dividend yield. In doing so, you will increase the number that gets shown on that Morningstar page, the prospectus, things like that. Now, you haven't made more money, you haven't done anything like that, but if investors are going to respond to that, that is something that you could actually be doing.
Cameron Passmore: How much does dividend juicing cost investors?
Sam Hartzmark: It costs a pretty sizeable amount for a few reasons. The most direct thing is just tax costs. For most investors who are taxable, the specifics matter a little bit in terms of your level of capital gains, because qualified dividends, you pay a tax on the full dividend amount, but at a lower rate than capital gains. If you're at a massive capital gain, this intuition doesn't hold. For most investors, you would rather sell a dollar worth of stock than get it through a dividend, because you're going to pay tax on the full amount of the dividend, versus only the capital gain on the stock you sold. Now, if you haven't held it very long and it's non-qualified, then that goes out the window. You're always better off selling some stock. Just in terms of taxes, we have a back-of-the-envelope calculation from firms who are doing this juicing. We estimate a lower bound of about 60 basis points per year in terms of tax penalty. That doesn't even begin to take into account things like, the funds that are juicing, are trading a lot more, which is going to cost you money. They also charge higher fees, which are going to cost you money. We don't find any return outperformance. I think the paper finds a slight underperformance as well, too, which intuitively makes sense. These are funds that are providing an economically nonsensical characteristic to a set of investors.
If what you're really good at is saying, providing alpha, or something like that, that's not going to be your clientele. You're catering to a slightly more unsophisticated crowd. What you're good at is selling these characteristics and your funds end up being more costly on ways that are more profitable to the funds. Also, a lot of these folks are probably giving 1% to the IRS, not even to the fund manager, so there's some big costs associated.
Ben Felix: It's so crazy. We heard about salience being sold through structured products from a past guest and through thematic ETFs. These salient attributes are expensive.
Sam Hartzmark: Oh, yeah. I think the structured product is another great example of like, there are so many headline things that people like, right? Like, a capital guarantee. It sounds great. The same with a dividend yield, like higher is better. But for the structured products, no one ever goes, “What am I paying for that capital guarantee?” Except, the hedge fund on the other side who's pricing it and doing quite well.
Ben Felix: On dividends, do you have any final words of wisdom for our listeners?
Sam Hartzmark: First off, really think through the logic and don't dismiss the fact that a dividend payout does not make you richer. I'd say, that is the first order thing. It's really hard and it's really tricky. Many people will be on the internet trying to sell you something otherwise, but that base intuition holds and is true and is what's going on. The second aspect is like, we really do understand what number you should be looking at, which is some number of total returns. Could be more – after-tax total returns. There's further modifications. But as much as possible, try to make sure you are focusing on the right number.
Then lastly, make sure you aren't conflating dividend-paying firms as a return predictor, versus dividend payouts. Dividend payouts themselves are irrelevant to tax disadvantaged and that fact is irrelevant, or is orthogonal, not related to, should I think of dividend-paying firms as a good value proxy, or profitability proxy, or something like that. That's just a totally separate question that shouldn't be conflated.
Ben Felix: That was a great segment on dividends.
Sam Hartzmark: Dividends are fun to talk about. They are emotionally charged.
Ben Felix: Yeah. You talked earlier about price-only indexes and how the Bloomberg terminal ships with the price-only default. Can you talk about how common the use of price-only index data is?
Sam Hartzmark: Yeah. First off, just to make sure everyone's onboard, a price index just looks at price changes, and a total return index puts a dividend back into them, which is super important. Because as we've talked about in the prior segment, the price drops by the amount of dividends. We care about the total pot of money. You need to add the dividend back in. It's important and it's actually big. Give or take, a third of market performances coming from dividends, about two-thirds from different prices. You got to put them together.
Now, in terms of prevalence, almost every major market index that you see is a price index, in terms of the default version that gets shown. If you open the Wall Street Journal, the Financial Times, you want to know how the US market is doing, the S&P 500 you see, the Dow Jones you see, those are price indices. They ignore dividends. That's true with most international markets. The big exceptions are the DAX is actually a total return index that gets shown by defaults in the Brazilian BOVESPA. Both are pretty modern indices.
Now, the other thing that's a bit weird is the right version of all these indices now exist. If you Google S&P 500 total return, that will come up. If you Google S&P 500, what comes up is the price index. You've got to actively search it out and find it. We've talked a lot about salience. What is salient for almost every major index that you see? It's a price-only return index, not a total return index.
Cameron Passmore: Why are price indexes so commonly used as a reference?
Sam Hartzmark: That's a very good question. I mean, particularly in a world where we've got the other version, right? We've got the version that's calculated correctly. This is from a paper with Dave Solomon, who's also at Boston College with us. We dug into a little bit trying to understand what's going on. I think it's largely a historical accident. Think the Dow Jones. The Dow Jones started as a railroad stock index in the 1880s. This was calculated with paper and pencil. Things like, keeping track of dividends and returns and things like that isn't pretty particularly straightforward and easy to do.
The S&P 500 dates back, I think, to the – I figured it was late teens, early 20s, was the initial index that became the S&P 500. Similar idea. You've got some poor guy looking at tickers, calculating it by hand. A price index is an approximation. Why are we still doing it? I think to a first approximation, because that's how we've done it. That's how we've continued to do it. Why does Germany, the DAX, do it the right way? Well, so they used to have the Frankfurt index through, I think, the late 80s. Then they created a new index that became the DAX. When they created the new index in a world with Excel and other type tools, they could calculate it the right way. Most of these indices are old. We keep doing it the way we're doing it. I think it's just largely historical accident.
Ben Felix: How does reference to price-only data affect the media's coverage of the market?
Sam Hartzmark: What's interesting about a price index is that it is predictably and systematically wrong based on how high dividends are that day. That Miller and Modigliani idea of the price dropping by the amount of the dividend that works for firms, it holds for the market. Let's say that the market is paying a dividend yield today of 1%. That means that if you were looking at the total return index, that number you were looking at would be 1% higher than a day with no dividend. Because you should be looking at it, you're looking at the wrong number.
What we show in our papers, we look at New York Times media coverage of the market and we say, well, what is the media coverage reflecting? Is it reflecting the actual market performance, the total return? Or is it the fact that reporters are looking at the number that's blaring right out in front of them? Because, again, none of this is secret. The real number is there, but what we find is that financial coverage is significantly more negative, the higher the dividend yield is, controlling for the actual level of performance, which intuitively makes sense. You're looking at the wrong number, you're responding to the wrong number. That's what coverage is actually responding to.
Cameron Passmore: How does price return data affect fund flows?
Sam Hartzmark: What we look at there is how our mutual fund investors allocating money to funds? A lot of mutual fund performances are benchmarked relative to things. Before going to the wrong things that zips out there, I should say, there are now a lot of examples of the right things of say, total returns to a mutual fund, and total returns is an index that are out there. For example, Morningstar has switched over and is doing that, and a lot of other groups are following suit. But something that's still pretty common to observe is looking at the price of a mutual fund, the change in NAV relative to the, say, S&P 500 price index.
Now, this is now a bizarre mistake for a few different reasons. One is, we shouldn't be using these price indices. We should be looking at total returns. The other is that a mutual fund price doesn't include dividends, but also doesn't include a lot of other stuff. If you distribute capital gains, things like that. You've got, say, the wrong number for mutual funds looking at the prices and not including the distributions, the wrong number for the market, but the wrong in different ways, but they're commonly displayed next to each other.
What we find is using this nonsensical benchmark that's commonly displayed. If you're a mutual fund who beats the S&P 500 price index based on your just shift in price, you end up with significantly higher inflows. Doesn't really make economic sense. It's the wrong benchmark, but it's commonly shown and people respond to it.
Ben Felix: That's crazy. That's like, investors responding to not just performance, which is wrong in its own way, because performance chasing doesn't make sense, but they're responding to the wrong performance metric.
Sam Hartzmark: Yeah. People, they like beating the benchmark, even if it's the wrong benchmark with the wrong performance metric. But the commonly displayed performance metric. Again, a common theme is people will look at what's in front of them without necessarily thinking too deeply about whether it makes sense or not.
Ben Felix: Wow. I mean, I guess it sounds a lot like the sustainability ratings that we talked about earlier.
Sam Hartzmark: Yeah. Yeah. No, exactly. It's like, you've got something that's easy and out there. I haven't looked recently, but in the paper, we have Yahoo Finance. What happens if you Google a fund? Well, it shows you the price path. Then what happens if you click a benchmark and it graphs the price index? It's really obvious for mutual funds because capital gains distributions can be big. You see these big deviations and that's – it's the wrong benchmark, but it's what investors see and they respond to it.
Ben Felix: How does the prevalence of price-only index affect the return expectations that investors hold?
Sam Hartzmark: There's this big puzzle in finance related to the equity premium, like historically markets have returned, give us very high amount. Why is it the case that more people don't own stock? How has it been so high? Things like that. One aspect of this, which is consistent with this, not a whole solution by any means, is that people don't really realize how high the return to the market has been. We said at the beginning that performance on the market has been about a third of dividends historically. I think US historical averages, give or take 8% annual returns.
If you look at say, the S&P 500, it'll be about 5%, because that's the price-only aspect that misses that chunk. If you're an investor and what you pay attention to, it's just how is the S&P 500 been every year, well, you're going to look at a number that's systematically too low. It leads to some interesting things. It's partially joking, but around the time of Brexit, there was some news coverage along the lines that the Brits were just sick of the Germans having better performance than them every year on the market.
Of course, the DAX was a total return index and the UK indices were price indices. So, the German market, basically has to say, a few percent head-start every year and tended to beat them, because they were just different numbers. People perceived the German market to have higher performance, just because the wrong benchmark was being used.
Cameron Passmore: Incredible. Let's end this segment like the other two with some advice from you. What can people do to avoid being biased by price index data?
Sam Hartzmark: The good news with this one, relative to the things we've talked about before, is the take-away here is pretty easy, which is it looks like people are looking at the price index, not really thinking about it and responding to it. That's leading to suboptimal behaviour because they're looking at the wrong number. How do you solve this? Well, you look at the right number. To the extent that you can, you should switch your defaults to total return indices. If you want to look at market performance, you should seek out these total return indices.
Once you've got the right number in front of you, you can go ahead and just keep on ignoring the details, because now you're actually looking at the appropriate number and you can respond to that appropriate number.
It would be good, I would say, to the extent that the default is changed. I think that would just be a societal benefit. The Wall Street Journal should be looking at total return numbers, reporters should be talking about it, brokerage statements should be showing it. This is just something that the default should be shifted to the total return metric. That would solve a lot of these problems.
Ben Felix: All right, I want to move on to our last topic, which is one of our favourites, multi-factor asset pricing.
Sam Hartzmark: Oh, hey. I mean, everyone loves multi-factor assets.
Cameron Passmore: Another crowd favourite.
Ben Felix: How can you not? Can you talk about the theoretical explanation for why some assets have higher expected returns than others?
Sam Hartzmark: Yeah. The rough answer is that some assets have higher returns than others and standard asset pricing theory, because of an insurance market. It's like, what do you care about in standard asset pricing, is you want to consume and you want to consume in the future. You always want to make sure that you have enough consumption, you get all this good stuff, you have as much wealth money as you can.
How do you go about doing that? Well, you think about the correlations with assets and what's going to happen in the future. Is your house price going to go down? Are you going to be fired? Is the market going to – all of these sorts of things. Then you value assets more that have less of a correlation, or an inverse correlation with those bad states of the world because you like assets that will pay off when things are bad. Why is it that, say, stocks have a higher return than bonds? Well, because when bad things in the future happen, the bonds you think are going to be better insurance than the stocks. Because of that correlation, the price today of stocks will be lower, all else equal. That will lead to higher expected returns, which relates to this belief about future states of the world.
Cameron Passmore: How do we know whether investors actually allocate their assets in a manner similar to the theory?
Sam Hartzmark: I'd say, there's two different answers to this question. The first is, look, if you assume that we talked through all of that intuition, but we didn't really mean it, it was just some equations that we wrote down. This is what's known as an as if model. People behave as if this is what was going on. It doesn't really capture the motive. Then the answer is, we'll just take it to the data, see if it fits the data. The short answer, I would say to, does it fit the data in terms of those theories is no. There's now a very big literature that's really dug into trying to build versions of these models to fit the data better, but it's very, very difficult to do.
The second, and I think much more interesting version of this question is, we're taking this model seriously. This model is really trying to capture the economic problem that investors are trying to solve. They really care about this motive. They really think about payoffs in that way. If that's the case, I think the answer is, well, just we need to go and talk to people. I mean, to say, well, do you really care about this stuff? Is this how you're thinking about the world? Is this how you're investing money? That should tell you, is the model making sense or not?
Ben Felix: How reliable do you think that type of survey data are for understanding people's asset allocation motivations?
Sam Hartzmark: I think it depends. There are certain questions that the answer is not very well. There's subtle nuance. There's difficult things. There's people that do subconsciously and clearly, we can't ask people about those things. They're very big limits to survey data. Now, with that being said, you think about what we talked about in terms of asset allocations, fear of future bad states of the world, insurance motives, things like that. These aren't subtleties. These aren't nuances. These are the first-order obvious things, and that should be pretty easy to do.
This is related to a paper I've got with Alex Chinco and Abby Sussman. For example, in that paper, we ask some other first-order obvious things. If you ask investors, do you like things with higher returns? They say, “Yes, please.” With T stats of 15. It is not subtle. People want higher returns. This is obvious. This is the first order. It doesn't matter how you ask it. This falls out of the data. Do you say, do you like more risk? They say, “No. Not at all.” They don't like volatility. Again, I mean, T stat’s very high. Doesn't matter how you ask.
If you ask things related to correlations, you don't find it. Now, this is a bit related to this big debate with Milton Friedman, where he has this idea of as-if models. We're building these as-if models. He's got this famous example of a pool player who goes for a shot and he's a professional billiards player. Friedman said, “Look, he can't tell you the details. He just rubs his rabbit foot for luck and hits the ball. We can model him as if he knows physics and all these crazy equations.”
I think a lot of economists would bring that up as an example for why surveys aren't necessarily very good. Actually, I think that example explains exactly why in this setting, you should be able to talk to people. Because think of a professional billiards player, and go and talk to that guy and be like, “Are you playing billiards or basketball? Which ball are you currently trying to hit and why? What are the rules of billiards?” The first-order obvious things are first order and obvious and not very difficult to get at. Even if he can't explain which muscle is twitching, or the nuance that is going on, if what's going on is these first-order obvious characteristics, it should be pretty straightforward to find that people care about this stuff.
Cameron Passmore: What do your survey results tell us about asset pricing?
Sam Hartzmark: Almost every asset pricing that's been written down post the late 70s, at its core has this insurance motive. It's the idea that people deeply care about correlations of asset paths is in consumption. Then actually, I don't even know if I've mentioned it, but the big takeaway in the paper is, look, people care deeply about memes, people care deeply about volatilities. We show massive swings to this insurance motives, and nobody cares, whatsoever. We show a bunch of experiments showing that. We show versions of open-ended prompts where we can say, write down a paragraph about what you care about. Nobody mentions it. It does not seem to be an aspect of this decision in any meaningful sense.
That says that our asset pricing models are basically missing something fundamental. They're putting in something artificial that shouldn't be there is the first bit. Then at the same time, they're clearly missing something, because just taking these things on their own, you can't explain, like me involved, alone, can't explain asset returns. That's why things shifted to this correlation idea.
This is something that maybe people should be thinking about, but asset prices are set by what people are actually thinking about. It suggests that trying to explain asset prices with this kind of correlation hedging motive as a core concern isn't likely to be a successful endeavour. What the field has done is to take this core idea and layer further complexities on top of it. The initial one is you care about correlations with consumption. Well, that didn't work. Then you put an interaction of that with another state variable and another thing in a more complicated way.
Each of these is just, you care about this core concern in a more complicated, more nuanced way. Given that the first-order thing isn't there, the second and third-order complication seems not particularly likely to explain anything.
Ben Felix: What do you think of the implications for people pursuing higher expected returns with their portfolios through tilting toward these priced risks?
Cameron Passmore: I think it definitely shifts the potential interpretation of these risk factors. Let's take value, for example. Let's ignore the debate about as value bell. Let's say, we expect value to outperform, should I invest in value? Well, the consumption-based version of that that you would say from the standard models is, well, look, how do your risks and correlations compare to the market? Because value is there, but it's there because it represents a systematic, unhedgeable risk. Maybe if you aren't as exposed to this as somebody else, it could be a good thing for you to hold some value.
Now, about half the people you talk to, you should have the conversation, look, value outperforms. But given your correlation with risk, you actually have a little bit more of a loading on this value-risk paper. You should be buying growth. I think in practice in industry, those conversations don't tend to happen that way. You guys probably know much more about that than I do, but it's like, most value investors aren't talking about correlations with systematic risk. They're talking about outperformance, and they're saying, “Look, this is alpha. It's an alpha kind of a great thing.” I do think that it makes it much less likely that what's going on in these risk factors is a systematic correlation with an underlying systematic risk. In the paper, we do a version where we ask about that explicitly, and we find that people don't think about it in that way. Yeah, I think that's the main implication there.
Ben Felix: You're right that those conversations aren't happening, at least from what we see. But you made me feel a lot better because I felt very guilty about not having those conversations ever since we talked to John Cochrane.
Sam Hartzmark: Did John guilt trip you?
Ben Felix: It wasn't a guilt trip, but I mean, John Campbell, too, they gave us very strong explanations of the hedging motive and exactly what you just said, that maybe some people should be tilting toward growth. Then we've been thinking about, how do we have those conversations? Who should actually be tilting toward growth? Yeah, anyway, so now I don’t feel as guilty.
Sam Hartzmark: The value literature, I'd say really grew up in the late 80s and the 90s. This is long before I was a professor. But talking to people who are around that, I think the discussion was, look, we found this predictor of returns, especially in that period. Markets were viewed as quite efficient. Clearly, there was a systematic risk that this was responding to, and people didn't understand what it was at the time, but they were quite confident that they would have a good answer moving forward.
Now, 30 years later, a number of things have been mooted. Most of them, I think, have been discarded. It's very unclear what systematic risk value could be providing compensation for. I think that's another, like all of these stories about efficiently priced risk and return mispricing. The base intuition of our survey is that where there's return predictability in terms of compensation for risk, these shouldn't be mysteries. These should be obvious, straightforward things. In many ways, the academic who writes the paper showing the return mispricing is the last person in the world to find out about this.
What would value be in a rational risk factor type intuition? Well, I mean, look, for the last century, people have viewed these assets as having correlations of a certain type based on whatever that systematic risk is. Prices today reflect that future motive in a knowing way, right? If you are going to say, “Hedge oil prices because you're Southwest Airlines.” Someone goes and says, “Why are you buying these futures contracts?” You're going to say, “Because I'm hedging oil prices. It's obvious it's straightforward. I'm paying to do that today.” That's what should be going on with something like a risk factor with the value premium. But that doesn't seem to be what's actually going on. People have not been able to tell us why it is – this is there.
People have been surprised about these empirical facts, and whatever their systematic surprise about return predictability that seems much more consistent with a mispricing story than a risk factor type story.
Ben Felix: We talked to Adriana Robertson about this too, and she'd done a survey with, I think, fairly similar, at least on this part, results. Crazy stuff. We've had those guests, or we have talked about the hedging motive. We talked about the ICAPM in an episode. A lot of our podcast audience, a lot of the response was like, “Well, I don't think people actually think that way. If you ask somebody why they invest in a growth stock, it's not because they're hedging. It's because they think it's going to have higher returns.”
Sam Hartzmark: Oh, yeah. We can also just read what happened in the past. Go and read Graham and Dodd, the father of value investing. They aren't saying, look, this is an appropriately priced risk factor. They're saying, look, through careful research, you can find under-priced stocks and in modern language, they're going to have alpha because they're mispriced. That seems to be what most people think they're doing in value investing.
Ben Felix: Super, super interesting stuff. That was awesome.
Sam Hartzmark: That was a fun paper. We hit a lot of interesting things and a lot of deep thoughts about asset pricing models, which was fun to think about, fun to do, fun to present, a lot of different opinions. It was good.
Cameron Passmore: Cool. Our final question, which is a fan favourite, much like dividends, how do you define success in your life?
Sam Hartzmark: You shot me this question and it's a very difficult one. It's one that I wish that I thought more about in the moment. I've got a six-month-old at home, so my time for deep reflection has not been as copious as I would like. I'd say, the first thing that I've come to, I'd say is life has gone on, is that is less about concrete goals. I think my 18-year-old self would have really focused on things. You want to achieve X, or you want, I don't know, a certain amount of money, or certain like that. But I don't know, life throws curve balls, life's changing, life's uncertain.
As much as possible, I think I'm now focusing on more concepts and broader goals that even if life changes, even if things are different, are still things that are achievable and are important and hold throughout those different things. With that said, it's like, I was trying to think of a non-cheesy way of talking about broad goals. I don't know. I think I can. It's like, I've got these young kids, so I really want to be a broadly defined good father and a husband. Broadly defined, I would like, too, that others consider me a good person and that I treat people fairly, things like that.
I'm very much an educator, so I hope that I can actually help people in some small amount to educate them to make better decisions. I think finance is important, not just for hedge funds and alphas and things like that, but hopefully, I can help people in some small way, I don't know, make better retirement decisions, or do better in their portfolios and have some fun doing it. Hopefully, do some things I find intellectually satisfying and enjoy the ride as it goes. I was struggling for something more concrete, but I think that was about the best I could come up with these days.
Ben Felix: It's a great answer to the question.
Sam Hartzmark: Thanks. It's a really good question. Now, I want to go back to your other podcasts and see what other people – there was the other thing is I didn't want to cheat. I felt like, I totally could have gone and looked at the last thing of 20 of your podcasts and correlated the most awesome answer, but I didn't do that.
Ben Felix: Oh, your answer was great. All right, Sam, that's it. This has been awesome. We really, really appreciate you coming on the podcast.
Sam Hartzmark: No, no, this has been an absolute blast. Thank you guys, again, for spending the time to go through all the papers and cook these great questions. It's totally my pleasure to chat and do this. Anytime. This is great.
Cameron Passmore: Awesome. Thanks, Sam.
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Episode 192: Professor Alex Edmans — https://rationalreminder.ca/podcast/192
‘Counterproductive Sustainable Investing: The Impact Elasticity of Brown and Green Firms’ — https://dx.doi.org/10.2139/ssrn.4359282
‘Do Investors Value Sustainability? A Natural Experiment Examining Ranking and Fund Flows’ — https://dx.doi.org/10.2139/ssrn.3016092
Travelers Insurance — https://www.travelers.com/
‘Reconsidering Returns’ — https://dx.doi.org/10.2139/ssrn.3039507
‘A New Test Of Risk Factor Relevance’ — https://dx.doi.org/10.2139/ssrn.3487624