Dr. Sunil Wahal is the Jack D. Furst Professor of Finance and Director of the Center for Responsible Investing at the W.P. Carey School of Business, Arizona State University (https://cri.wpcarey.asu.edu/). Before joining the ASU faculty in 2005, Dr. Wahal was on the faculty at Emory University and Purdue University.  Dr Wahal’s research focuses on short and long-horizon investment strategies (momentum, profitability, and others), trading issues (trading algorithm design, trading costs, and high frequency trading), and delegated portfolio management and asset allocation for large institutional investors.  His work covers public equities, fixed income, and private equity.  He has published extensively in the Journal of Finance, the Journal of Financial Economics, the Review of Financial Studies and numerous other journals.  He is a consultant to Avantis Investors.  Prior to that he was a consultant to Dimensional Fund Advisors (2005-2019), and AJO Partners.  He sits on a number of investment committees for several RIAs.  He is a regular speaker at academic and practitioner conferences and has given numerous presentations to sovereign wealth funds, endowments, foundations, family offices, DB plans, DC plans, and registered investment advisors. 

What are the critical factors driving investment success? How can investors balance profitability and risk? In this episode, we sit down with Dr. Sunil Wahal, the Jack D. Furst Professor of Finance and Director of the Center for Responsible Investing at the W.P Carey School of Business at Arizona State University, to delve into the intricacies of financial science. With over 25 years of academic and practical experience, Dr. Wahal shares his unique perspective on factor investing, profitability premiums, and how to approach value investing in today’s complex financial environment. He talks about the joint distribution of value and profitability, explains how profitability premiums work, and discusses the challenges faced when integrating academic research into practical investing strategies. Dr. Wahal also touches on common misconceptions in financial theory, the long-term benefits of maintaining a diversified investor base, and why understanding the nuances of financial risk is key to avoiding costly mistakes. Gain insights into building a successful investment portfolio grounded in the principles of financial science and how to avoid common pitfalls in factor investing. Join us to hear actionable strategies for balancing risk, understanding factors, and applying academic research to real-world scenarios with Dr. Sunil Wahal!

Key Points From This Episode:

(0:04:15) Dr. Wahal’s work on profitability, data sourcing challenges, and its significance.

(0:08:01) The impact of controlling the value of the profitability premium.

(0:10:08) Correlations between value and profitability and the benefits of “tilted” portfolios.

(0:14:48) Steps for unleveraged long-term investors to build profitable portfolios.

(0:17:27) How the joint distribution of value and profitability differs from a profitability screen.

(0:20:43) Approaches of large financial firms to implementing value and profitability in portfolios.

(0:24:41) Time horizons for tiled portfolios and their expected returns after cost. 

(0:30:53) Insight into how institutions decide on which investment managers to hire and fire.

(0:38:00) Exploring how the hiring and firing of managers affects institutional performance. 

(0:40:16) Ways the relationships with institutions influence hiring decisions and performance.

(0:44:35) Uncover how institutions select which private market firms to invest in.

(0:48:58) Key takeaway lessons from Dr. Wahal’s research for institutional investors.

(0:50:52) Why frequently hiring and terminating managers may not be the best approach.

(0:52:32) Advice for retail investors and the importance of cost in managing portfolios.

(0:59:22) Reasons that institutions avoid indexing and the competitiveness of mutual funds.

(1:02:29) How diversification among mutual fund investors affects performance.

(1:09:19) Performance overview of actively managed global equity mutual funds.

(1:12:35) The role of practitioner interaction and his concept of success.

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 326, and today’s guest, I think you said at the end Ben is probably one of the episodes that in hindsight we’ll look back on as a great highlight of all the guests we’ve had but today, we welcomed Sunil Wahal, Professor Sunil Wahal, who I’ve actually seen present a few times over the years. He’s a phenomenal presenter and communicator and researcher. So, kudos to you for tracking him down and bringing him on, Ben.

Ben Felix: You know, it was actually Eduardo Repetto from Avantis that made the introduction. He said, “You guys had Sunil on?” I said, “No.” And he goes, “You got to have him on.” He was right. It was a good introduction. We covered financial science, which is a big part of Sunil’s work and that part of the conversation was incredible. It started out profitability and we kind of meandered later in the episode, somewhat accidentally to momentum and low volatility, but I was very happy we got there because I think that part of the discussion was really interesting.

We also talked about institutional asset management, how institutions make investment decisions and what we can learn from that.

Cameron Passmore: So interesting.

Ben Felix: Right.

Cameron Passmore: This is so good, and applies to normal humans, right? To normal investors.

Ben Felix: Yeah, exactly. So, I found that to be really, really insightful, and then we talked a little bit about just kind of the market for mutual funds, how competitive it is, how much it matters for a mutual fund to have a diversified investor base, and that I found to be mind-blowing, where it’s like, you hear about banks and banks need to have a diversified depositor base to avoid a bank run, like we saw with Silicon Valley Bank, they had a really concentrated deposit raise and that ended up being a bit of a disaster for them.

But Sunil’s got research showing that the same kind of thing matters for mutual funds where if they have homogenous investors that actually detracts from fund performance because of the way it affects the way that the fund has to trade. So, I mean, that’s just incredible research and I think its answer to the success question was also really good.

Cameron Passmore: So, Sunil is the Jack D. Furst Professor of Finance and Director of the Center for Responsible Investing at the WP Carey School of Business at Arizona State University. He joined us today, I think from his office in Scottsdale.

Ben Felix: Yup. The way that he describes his research, I try to do about this over email as we were kind of getting big questions lined up, it’s largely at the intersection of financial science and application, and he talks about that at the end of the episode, about the importance and his view of economists spending time with practitioners, but likewise, there are various practitioners spending time with economist because there’s a lot that each can learn from each other.

So, he kind of separates his research into thinking really carefully about financial science and stats like factor premiums and stuff like that. Implementation and so, that’s where we start talking about portfolio construction which we spend quite a bit of time on and delivery systems. So, that’s mutual funds, manager selection, private equity, those were all the things that we talked about throughout the episode.

It’s pretty broad, like, we covered a lot of ground but he’s such a good engaging speaker, I think it was – like you said at the beginning, Cameron, as I was listening and then, for sure, at the end, it was like, this stands out as, to me, one of the most fascinating episodes that we’ve done. Sunil is a consultant to Avantis Investors. He was previously a consultant to Dimensional Fund Advisors and based on influence from Fisher Black, he really puts an emphasis on spending a lot of time with practitioners.

Cameron Passmore: Yeah, I’m sure he does. Okay Ben, you good to roll?

Ben Felix: Yeah, I think that’s good for the introduction, let’s go to the episode.

***

Ben Felix: Sunil Wahal, welcome to the Rational Reminder Podcast.

Sunil Wahal: Thank you for having me. It’s a pleasure to be here.

Ben Felix: Well, we’re super excited to be talking to you and –

Cameron Passmore: Indeed.

Ben Felix: This is a great set of questions that I think the audience is really going to appreciate the answers to. To kick things off, I want to start with your work on profitability. How robust is the profitability premium in the pre-1963 data?

Sunil Wahal: It’s really pretty robust. I mean, let’s see, post 63, if you do something simple like, not even that’s how the quintile sorts on profitability and look at their premiums, the differences between high and low profitability portfolio as it’s around 50 basis points or so, pre 63, it’s north of 40 basis points. So, it’s pretty much there.

Ben Felix: Now, that data didn’t exist to be tested. How did you get your hands on the pre-1963 data to look at it?

Sunil Wahal: Oh my gosh, well, that’s a story in and of itself, this is pre-AI days. Nowadays, if you ask me how would I do this today, the answer would be totally different, but this is pre-AI days and also, pre – I mean, OCR, this Optical Character Recognition technology did exist, but it wasn’t very good. So, the process was kind of clunky but Darwinian, if you will. I have two excellent research assistants.

So, definitely, a shoutout to them and they organized the whole effort, we downloaded financial segments of thousands over thousands of financial statements for these firms, both dead and live firms, we got PDFs of them and they were scanned PDFs so they weren’t machine-readable. I don’t know if you’re – listeners probably know the firm called UpWork that exists now. It’s used for distributing work to people around the world.

And so, the predecessor to UpWork was the firm that we used to distribute, sort of manual reading of these documents and we needed people who understood financial accounting, so they wouldn’t make mistakes and they literally had to read the documents and pull out the items that we cared about and all we did was – well, it was kind of interesting. We have these people, we would give them financial documents.

So, 10k’s annual reports, and say, pull out these items and we already knew what the answers were because we had done it ourselves and we were basically testing them unbeknownst to them and said, “How accurate are you?” So, we started off with a larger pool and people who didn’t get the answers right, we would sort of eliminate from that pool and whittle it down to a smaller set and these people really knew what they were doing.

They were all over the world. I think there was one in Hungary, one in Pakistan and all over the place and basically, they went and hand-collected the data and then we did randomized checks to make sure everything was right. It was kind of fun. Sort of, pre-AI, AI if you will.

Ben Felix: Very cool. It was real intelligence.

Sunil Wahal: Yeah, sort of.

Ben Felix: Not artificial.

Sunil Wahal: Yeah.

Ben Felix: That’s a huge effort, can you talk about why it was important to do that out of sample testing of the profitability premium?

Sunil Wahal: I mean, the incentives for false discovery in financial markets are really high, and they’re high in both for academics because academics love to do this sort of stuff, and they’re high for practitioners as well, right? People who love to discover or think that they can discover sort of things. They keep looking at the same datasets over and over and over again and so, I think, it’s incredibly important to go to something that people had not looked at before.

And if a truism is really a truism, it should exist where you haven’t seen it before, and that was really the impetus. I just – I was tired of people looking at the same thing over and over again and drawing sometimes, not sensible conclusions and sometimes, sensible conclusions. But really, you need to see it, understandable, so to speak.

Ben Felix: How impactful is controlling for value to the profitability premium?

Sunil Wahal: I think it’s incredibly important. I mean, when we start to think about models of financial models of the world, if you start with something like Modigliani and Miller or Bob Shiller’s work or Campbell Shiller, all of these models say the same thing, right? They say that prices today are a function of expected flows in the future and the term expected returns are determined by those flows and what you paid for those flows today.

So, that’s true in the financial models but it’s even true before then. If you go back and read Graham and Dodd or actually, even the predecessor to Graham and Dodd is the book, like a little booklet called, How to Interpret Financial Statements, something like that by Ben Graham and Spencer Meredith, I think it was published in the 30s. They made the same point that is the same, you have to do that.

Fama and French who are incredibly careful and very precise in their 2015 paper, that people I think often just sort of skim read but if you read it carefully, they mention the word “Joint.” So, the joint distribution of these things, no less than 13 times. I mean, that’s really incredible. When you ask me about this podcast, I actually went into your website, and I said, “Okay, let me see who they’ve talked to before.”

And of course, the name that popped up was Gene Fama and I would think, “Okay, I got to read everything.” I tried to listen and read everything that he’s ever recorded or written because it’s just so incredibly insightful. In your podcast, he is so specific. He basically said, “Look, you have to hold these things constant” in your own podcast. So, I think you have to, I think if you don’t, that’s an investment mistake.

Ben Felix: Can you talk about the correlation between value and profitability in both the pre and post-1963 data?

Sunil Wahal: I mean, it’s negative, as you would kind of expect. Evaluation equation is regardless of which evaluation equation you think of, body and profitability and negatively correlated. They are negatively correlated post-63, they’re negatively correlated pre-63. You can see the negative correlations outside the US as well, and from a valuation perspective, it makes sense that they would be negatively correlated because imagine a firm with very high future profitability.

So, very high expected profitability, people are going to want to buy that, and when they buy that, they bid up prices which means, expected returns fall, and the flip side for value. So, you’re going to expect that negative correlation, it’s there, it’s pretty pervasive, and so it’s worthwhile for people to think through those things.

Ben Felix: How large are the premiums been for portfolios formed on value and profitability? If you compare it to the cap-weighted portfolio.

Sunil Wahal: That depends tremendously on how you do these kinds of things, there is one way in which I think about it. So, one way to think about it is to say, okay, let’s just take a cap-weighted portfolio and think about firms that are, I’ll call them neutral with respect to value or profitability and remember, this is expected profitability. So, think about firms that are relatively neutral, you hold those, that cap-weighted weights, right?

So, their portfolio weights are based on their market cap and then, if you start to think about, “Okay, well, I’d like to hold more firms or firms with larger portfolio weights and have high book-to-market or book-to-price ratios, and then have higher future expected profitability.” Markets have to clear, so if I’m going to hold more of those firms, I got to hold less of firms that are expensive that have low book-to-market ratios or that have low profitability.

So, it’s just a question of tilts. How big are the tilts? So, when I do these kinds of exercises and I do the – my students as well and our student investment management funds, you build tilts in. If you build a tilt like 60/40 kind of tilt, where you hold the neutral and market cap weights and you tilt towards value and profitability on one side and underweight the other side, a 60/40 tilt gives you, I think about a 10-basis point per month improvement in expected returns.

Which, for most investors, compound that over a long period, that’s not chump change. In the trading arena, we pay attention to tenths of basis points, sometimes even hundreds of basis points. You compound that thing over a long period of time and it adds up. It lets you buy your vacation home if you want.

Ben Felix: Was the 60/40 there, 60% in neutral and 40% tilted?

Sunil Wahal: No, the neutral is held at market cap weight and it basically overweights the high-value and profitability firms and underweights them. So, it’s just a little tilt, if you think about the risk aversion of the average investor, you can ramp up those tilts, and if you do, you’re going to juice up expected returns, you can tap them down. It just sort of depends on what the risk aversion is of the investor. That’s an easy way to see it.

Ben Felix: Was that 10 basis points a month, did that factor cost in? I’ve got a more detailed question on cost later but was that before or after cost?

Sunil Wahal: That’s all before cost but basically, you’re holding everything, right? So, this is the difference between, sort of academic portfolios, the way we build them versus live portfolios. When we do this in academia, I mean, we rebalance once a year. So, the rebalancing is pretty infrequent, unless you’re building a momentum portfolio or something like that and that you are rebalancing every month, the costs are not horrendous.

So, you manage them and you're pretty much holding everything. So, it’s all a function of turnover and per unit cost and capacities. So, if you ask me 10 basis points a month, if you widdle away cost, how big is that going to be? Well, that’s going to depend on the capacity of the portfolio but pick a number, half a basis point, one basis point, two basis points. It’s not enough to care about.

Ben Felix: Yeah, yeah, definitely. We agree with you. This is how we invest our client’s money and our own money too so yeah. To take these ideas and implement them, what is the best way for unleveraged long-only investors to take what you’ve talked about and put it into a portfolio?

Sunil Wahal: I mean, the truth is that people have been doing this for a long time. This is not new, it’s not unique. If you go back and look at Charlie Munger's portfolio or somebody like that, what do they do? They tell you, “Well, we like to buy good businesses and we like to not pay too much for them.” That’s a translation of value and profitability, is it not? So, it’s not a new thing, it’s been going around for a long time because it’s very fundamental.

It doesn’t change what environment you’re in or what location you’re in. So, how should you do it? The Charlie Mungers of the world built and actually others, you can imagine hedge funds that do this, they built concentrated portfolios. They make like very systematic concentrated bets on five, 10, 15, whatever it is, stocks that in their judgment, they have made decisions about expected profitability and about value, and they’ve made those bets.

Sometimes, those bets pay off spectacularly, right? Think Julian Robertson. Sometimes they don’t and that’s kind of the equilibrium you would expect. Sometimes they blow up, so one of my colleagues and very good friend, Hank Bessembinder, he is a spectacular work on long rise and returns. I mean, the quote that I always give my students from him is, “You take the wealth creation and the US stock market from 1926 onwards and that premium comes from 4% of the market. You can pick it, that’s great. I can’t. I’m too dumb to do it.

So, my perspective is always do it in a diversified way. So, if you’ll ask me what the best way to do this, do it in a diversified way, make calculated, calibrated decisions about value and profitability. You can integrate them and hold the market portfolio, but tilt, the way I described earlier or for those with a risk appetite that’s bigger, that’s fine. There are targeted portfolios that go in and buy value and profitability stocks, long only, unlevered within small caps, within large caps, within emerging markets.

All it is, is differences in risk aversion of clients and investors. I think they both work, it just depends on the risk capacity of the investor.

Cameron Passmore: Right, how is using the joint distribution of value and profitability different from using a profitability screen on a value portfolio?

Sunil Wahal: It’s quite different. So, labels, semantics, labels, I think are particularly important. When people think about value and I don’t mean to lay the blame at Morning Star but you can certainly do that if you want. When people think about value, they think about how I booked the price stocks, book the market stocks, and I think it kind of distracts from the real purpose of investing, which is about expected returns.

You think about a value stock, how does a value stock become a value stock? Well, it becomes a value stock typically because the prices have fallen. Prices fall, expected returns rise. So, if you think of value in that sense, then value stocks are comprised of value stocks that have high expected returns and that have very low expected returns as well because prices fall for a reason, they don’t just fall randomly.

If you take that and you screen for profitability, so let’s suppose you toss out the low profitability stocks from a value universe, that’s going to handle one portion of it but it’s not going to handle the high profitability stocks with say, middling book-to-market ratios. So, that’s going to start to affect capacity, it’s going to affect security selection, it’s going to affect portfolio weights, and truth be told, portfolio construction is all about portfolio weights, right?

That’s literally all it is. So, it can affect the efficient use of capital, it’s not going to be as robust. So, they’re really quite different. It’s a very different thing to take a value universe and apply a profitability screen to it than to think about them jointly. Again, I go back to Fama and French. They say it over and over again and actually, I do in my paper as well that look, these things are jointly determined, you got to pay attention to both of them.

Think about a client who says – actually, one of my students came up with this idea when they were managing their student investment funds, my students do this in a quantitative way, like, they built portfolios from scratch. They said, “Well, why don’t we create a value portfolio and a profitability portfolio?” And I had to get them to understand that this genius idea is not really a genius idea because when you buy a value portfolio, sure, you’re going to buy stocks that have gone down in price and some of them have gone down in price for a reason.

So, they’re going to have low profitability stocks in them that are not going to have high returns and by the same token, when you buy the profitability stocks, some of them are going to be really expensive, think NVIDIAs of the world, and they’re going to have low expected returns. So, why commit two cardinal sins? It’s bad enough you do one, why do two of them?

Ben Felix: Yeah, that’s a really clear way to think about it. You’ve worked with both Dimensional and Avantis, who are the two companies that are kind of doing what you talked about earlier, they’re building these diversified portfolios that tilt toward these factors. How do you describe the differences in their approaches to implementing value and profitability in portfolios?

Sunil Wahal: Let me say that I spent what, 14 years with Dimensional, a terrific organization, I have a tremendous amount of respect for some of the people there. So, I think on that front, I think that’s really kind of important. I think the joint approach is really quite different from sort of the add-on approach. So, conceptually, it’s very different. It respects the science, the valuation model sort of Campbell Shiller, Modigliani Miller, Fama-French.

It respects the science in a way that the science demands and that’s very different from the Dimensional approach, and actually, it’s not even just Dimensional, there are other organizations out there that build. I mean, you know them, Blackrock, AQR, Aries Trade, et cetera, et cetera, that build these unit-dimensional kinds of things when we know that the science tells us, these things are not unidimensional.

So, I think, that’s really the key difference between them. There are others, part of the thing in Avantis is to always look ahead, to look ahead to see where markets are, where the improvement comes from. So, I mean, you’ve talked to Eduardo Repetto so you know the Goodwill story that’s associated with it. From my perspective, when I think about Goodwill, back when Fama and French were writing some of their papers in the '90s, Goodwill was really nothing, it didn’t really exist.

Now, you look at the aggregate value of Goodwill as a percentage of aggregate book value. It’s north of 40%. It’s a big number and your podcast is titled, “Rational Reminder.” I love that because I think, honestly, people really should be very rational and being rational means, being Bayesian. It means, you have some prior beliefs and you update them and you're not slave to a T statistic of frequentist. Sorry, I’m getting nerdy here but a frequentist T statistic, right?

So, being rational Bayesian means you update your priors, and your priors are, “Hey, goodwill probably shouldn’t count in book value.” So, regardless of the T statistics, you should think about stripping it out and so you know, with Avantis, we do that, and I think the same is true for measuring expected profitability. Many people, half a dozen people, including some of my work, and probably, even more prominently, the Reymond and his coauthors.

Fama and French and their choosing factors paper point out that cash profitability that cleans out accruals from operating profitability is a better predictor of returns than either offering profitability or accruals profitability. There’s a whole slew of new papers coming out these days that are looking at street earnings versus, I/B/E/S forecast of earnings and how much street earnings are better and it’s essentially you’re getting the cash profitability as well.

You wanted to say something about the underlying repetitive nature of the business to say something like expected profits, it works better. I mean, some of these differences are key, not only in understanding what investors get out of Avantis versus DFA but also, out of – and I share as kind of portfolio and others, I think the key really is things are not unidimensional or that I can tell students sometimes, “You know, the heightened way to correlate it, right?” Taller people are heavier and vice versa so, it is what it is. You're not going to escape it.

Cameron Passmore: How important is an investor’s time horizon to their ability to capture the benefits of a tilted portfolio?

Sunil Wahal: I think it’s incredibly important. If we go back, so Fama and Shiller agree about one thing, and that agreement is the prices are more volatile than fundamentals. But at the end of the day, prices have to connect to fundamentals, this is the excess volatility puzzle. At the end of the day, prices have to connect to fundamentals and if they have to connect to fundamentals, there’s no rule like a gravitational rule, right?

This is not Newtonian physics that says prices have to connect to fundamentals right away this month, this year, anything like that. We just know that they have to connect and in academic work when we do forecasting regressions, time series forecasting regressions that think about these sort of convergences and things like that, what, five years, seven years, 10 years out is what we use in terms of these regressions.

So, I think that an investor who goes into these sorts of things and says, “When am I going to get conversions? When is my value in profitability portfolio going to pay off?” It might pay off next month, it might not but you got to be patient with these things. Conversions does take place but there’s no guarantee that it takes place in the next month or the next year. These things require patience and time. So, I think the horizon is incredibly important, you know? Just stick with it.

Ben Felix: Makes a lot of sense. We did an episode recently that caused quite a stir in our podcast audience with Andrew Chen, a very nerdy episode but incredible, he’s got a paper out, I don't know if you’ve seen it, that shows that basically, expected factor premiums net of costs are close to zero. So, for us being factor-tilted investors and Avantis as well and many of our listeners investing the same way, everyone’s like, “Oh no, do we need do to change everything?”

What do you think? Do you think the excess expected returns of the value and profitability and tilted portfolios are still positive after costs?

Sunil Wahal: I think the devil is in the details. I love Andrew and I love that he is a skeptic. I think we need more people who are skeptical of these things and I think it’s incredibly important for people to understand where paper portfolios change from and become real portfolios. So, I think, how long have I been in this area? Probably about 28 years or so now that I think about it. For 28 years, I have spent studying trading cost and implementation and portfolio algorithms and how you actually make this stuff work.

So, the devil really is in the details. Can it all be whittled away? Well, if you trade aggressively enough, trading involves tradeoffs. It’s a tradeoff between price, quantity and time. Sometimes, location as well. But let’s just stick to the price point in time. If you take a portfolio like, say, Momentum, that’s a factor premium or is there anyone that’s labelled as that and you have to trade that thing aggressively, even if you don’t trade it aggressively, guess what?

None of cost, you’re not getting anything, and anybody who tells you that buy-side asset managers traded for free. Not true. They do not understand how markets clear and work. The only people who make money in trading are the Virtues and Citadels and Jane Streets of the world. Everybody else pays positive cost. I don’t care who you are, I don’t care what your trading prowess is.

So, it’s all a question of managing turnover and cost. I think low turnover portfolios have a way of doing it, can you earn a premium over the market? Yeah, you can, and by the way, the market portfolio is a weird thing. Most people think, “Oh, market portfolio, oh, that’s a passive portfolio.” No, it’s not. If you hold the market portfolio, I did this the other day, it’s KC Stream who ran some numbers for me and said, “Okay, fine.”

Let’s suppose, in 1975, when the first index fund was created, you held the market portfolio and then you were truly passive, you did nothing, so you are inert. At the end of 2023, how much of the market portfolio would you still have? Well, it’s not a hundred percent, that number is way south, way south, like, 30% but you have to trade, even the market portfolio trades. Passive funds are not passive, they’re just what’s active.

Vanguard that I love, I have a ton of respect for Vanguard. Their total market index, that’s not a passive portfolio, it’s just one less active portfolio. It’s terrible. It’s terrible, and then you got into the silly side discussions about, “Well, is passive taking over the world, is it going to cause problems? Price discovery” yada-yada-yada. I mean, that’s sort of almost not the issue. There is no passive portfolio.

Ben Felix: I like that label of less active portfolio as opposed to passive.

Sunil Wahal: That’s literally all it is.

Ben Felix: So, that sounds like good news. So, in your view, we don’t have to give up our factor investing?

Sunil Wahal: No, I think the implementation matters tremendously. Like, how you do it, you got to minimize cost, they’re not zero, they can’t be zero in the equilibrium but you have to minimize cost. So, you pay attention to turnover, you do what you can in kind as much as you can do in kind, it makes a ton of difference, you trade sensibly, but you’re still demanding liquidity. The idea that you can sit on the bid side of the market when you’re buying and not demand liquidity, that’s nonsense.

That’s not true, you’re still demanding liquidity, we know how markets really work. You can still move prices and you do move prices when you sit on the bid side of the market.

Ben Felix: I want to move on to some questions about how institutions make investment decisions, and this is of personal interest to me because there’s some investment committee work that I do. So, I’m really looking forward to this. How do institutions decide which investment managers to hire?

Sunil Wahal: Well, they have “a process” and the process involves an investment committee and the process involves consultants, often, doesn’t it always? There’s always a consultant in this. So, committees and consultants are delegated. I have sat on investment committees, you’ve sat on investment committees. Anytime you sit on any committee, the outcome of the committee is very much a function of the quality of that committee.

And if I were to sit on a committee for deciding medical issues, I’d be a disaster. Like, you don’t want me on that committee. So, what kind of people do we want on an investment committee? Well, we want people with expertise in financial markets. We want people with practical knowledge as well because at the end of the day, these things have to work and you don’t have to worry about conflicts of interest. That’s also important.

Many investment committees do not look like that at all and the agency problems and those sorts of investment committees are pretty strong. They’re often quite severe. So, what you see is decision-making that from your podcast perspective is not rational and that’s sort of sad. We bear the cost of it.

Cameron Passmore: And how do managers tend to perform after they have been hired?

Sunil Wahal: Well, they do exactly what you’d expect. They perform average. So, what does the process look like? Well, you hire someone who has done really well in the past and then there’s some mean reversion and performance, and they deliver average performance. It’s not necessarily bad but it depends on what your expectation was. If your expectation was this is going to be RenTech, good luck with that.

You're not going to get RenTech. What you’re going to get is the average outcome. So, that’s kind of what they look like.

Cameron Passmore: Which is exactly what you should expect but I think, people look at past three-year, five-year performance and say, “Yup, that manager looks good.” But, as you say, there’s no reason to expect them to do better in the future. They should deliver average performance which is exactly what they do.

Sunil Wahal: Yeah, that’s actually another pet peeve of mine that a lot of professional investment setups have this very artificial focal point over a three or a five-year performance. I don't know what the difference is between three years versus two years and 11 months. I don't know how it makes a lick of difference. We don’t see that in private equity by the way but certainly in public equities and fixed income and things like that, you can see in the flow data.

If you look carefully, the moment firms or managers cross that 3 or five-year benchmark, you see an uptick, and that’s because people have generated a focal point in their mind that says, “I got to wait for five years.” Why? Because I don't know why, but that’s why, and everybody else is doing it, so it must be right. Unnecessary.

Ben Felix: Yeah. So, fund manager often gets selected based on recent past performance and then deliver average performance. How do institutions decide when to fire managers?

Sunil Wahal: This is a little more nuanced. So, you do see institutions firing managers with poor performance, you kind of expect that, and you want some degree of that to happen, right? So, discipline in financial markets for investors is quite important. So, I don’t want that and the equilibrium can’t be that that number goes to zero. So, some poor performance termination is important but there are other reasons.

People make shifts in asset allocation and they might make them for market timing reasons, or they might make them for very legitimate strategic asset allocation reasons, right? You have to add an asset class or you got to shrink something else. That’s pretty reasonable as well. There’s also risk issues. I mean, you can see this, if you look at the press in the last few weeks or months, you saw LAMCO, right?

The issues that arose at LAMCO and what do you see? A flood of outflows. So, that’s not unexpected that there’s risk associated either with personnel or compliance issues, all these kinds of things. So, that answer is a bit more nuanced, I think. There’s more going on.

Cameron Passmore: You mentioned poor performance, how much tolerance do institutions have for poor performance?

Sunil Wahal: There’s this narrative that’s been going around for decades now that they are quick to the trigger so to speak, very-very quick to the trigger and my coauthor, Amit Goyal, who he and I have worked together on a number of things for a long time now, we teamed up with practitioner in Europe, Ramon Toll, and we surveyed, this was in collaboration with the institutional investors, I should give them credit as well.

We surveyed through very, very large institutions around the world to ask them about that sort of tolerance. It was bigger than I expected. Like, it wasn’t three years and you're out of here kind of thing. It was a lot longer. So, there maybe reflects the sophistication of the very largest institutions but they were tolerant. So, it’s clear that they have some understanding that returns are noisy and that you have to do more than that.

So, this goes back to your investment committee part then that you're asking and the investment committee has to do its due diligence, which means not just looking at performance, but diving deeper into the organization and doing the due diligence and asking, “Do you know what you’re doing? If there is underperformance, what’s the cost and can I tell whether it’s random or something systematic in your process that I have to be worried about?” So, they tend to be more nuanced. I like that outcome.

Ben Felix: You briefly mentioned sophistication, what effect does that have or how does that interact with underperformance tolerance?

Sunil Wahal: It does quite a bit. I mean, the tricky part is being able to separate signals from noise, right? That’s what’s sophistication really gives you. People who, like go into a very quick, just the little attribution system and say, “Oh, you underperform because you had money in this sector or this security or this market, and it under-performed.” Attribution is backward-looking, and that’s not a bad thing.

It doesn’t tell you anything about the future but it does help you diagnose where the issues arose and so, I think the sophistication part is being able to separate signals from noise, right? Being able to say, “Here is why this happened.” And if you can tell that, you make better decisions going forward. I think that’s the key.

Ben Felix: Okay, so let’s talk performance. How do manager hiring and firing decisions affect institutional performance on average?

Sunil Wahal: If they’re poorly done, they’re going to be a drag because what’s going to happen is that there are really significant transaction costs associated with, and/or turnover of managers in the institutional realm. So, you see this, so you go from a legacy portfolio into a target portfolio, you’ve got to transition over in the securities and there are firms out there that will do this for you.

Some of it in kind and they’ll trade the rest but anybody who’s ever sat on a trading desk will tell you that every once in a while, you might get a phone call that says, “Hey, so and so large organization is transitioning from large value to large growth, which means we got some stocks that need to be sold and stocks that need to be bought.” I don’t need that — that information should not enter financial markets ahead of them.

But that’s going to cost them something. So, transitions, portfolio transitions are costly, and if you ignore the marketing hype that you can do this for zero, nothing is done for zero, it costs them something. Ultimately, that’s a drag on the portfolio for that institution. If it’s an endowment or a foundation, you’re going to be able to pay your students or your beneficiaries less. If it’s a retirement plan, that’s going to cost you something. Frictions are a part of life.

Ben Felix: That’s so interesting. So, the winning managers don’t keep winning and firing the losing managers, I think in your paper kind of shows that that doesn’t really matter. So, if they just helped the managers that they had to begin with, they would have been, before transition costs, just as well off. That’s definitely not what happens in real life though.

Sunil Wahal: Yeah, it’s not what happens in real life. Real life is full of frictions, all kinds of frictions and all you want to do is minimize those frictions, and you’re never going to make them go away. So, I think it’s maybe a hopeful but a hopeless exercise at the same time to make frictions go away. Just minimize as best you can.

Cameron Passmore: How have your relationships between managers, investment managers and hiring institutions, how do those relationships affect hiring decisions?

Sunil Wahal: I have a cousin who’s in the – is a doctor, he’s in the dating market and they started to do something and guess what he does? He gets on his dating app and that’s how he’s looking to find a partner, right? But he will also take recommendations from us and say, “Hey, maybe you should reach out to this person.” So, relationships matter, they’re a part of the equilibrium that we live in and in which trades happen and finding a partner is a trade, is it not?

That’s exactly what it is, so it’s part of that equilibrium and relationships do matter, so they can be very helpful because knowing people allows you some information advantage. So, presumably, if my wife or I recommend someone to him, then there’s some degree of vetting that’s already happened but it can also go the other way. You can imagine situations where so and so makes a recommendation and it’s a side payment or that it doesn’t really help you.

So, does it work this way in asset management? Of course, it does, the relationships are key and they should be. It’s not like they should be non-existent. If you just look at conferences that take place that independent organizations like institutional investor Orion, those are essentially networking conferences, right? There’s some content but they’re essentially networking conferences.

So, relationships matter and they matter for whether an asset manager gets hired or not and that’s fine. I think expectations are a different issue and investment committees still need to do their due diligence but yeah, they matter.

Ben Felix: So, you have this paper that looks at this and establishes that this relationship does exist, that if there are relationships between the two entities, they’re more likely to get hired. How do relationship-based hires affect performance? Like, does the trust help them find better managers?

Sunil Wahal: Not really. I mean, financial markets are all about trust, right? I give you my money to manage or you give me your money to manage, that’s all trust. Everything in financial markets is about trust. I pull out a dollar bill, a lumi or a dollar, this is still trust, right? It’s trust in the government, it’s trust in institutions. So, that’s all it really is, so if you hire based on relationships, you don’t do better, you don’t do worse.

You get what you get, you get about average and that’s not necessarily a bad outcome. It depends on what your expectations were. If your expectation was, “I’m connected to you and we make really good investment decisions and I expect to earn really high performance.” That’s great, it all depends on what your expectation is and what the counterfactual is because the alternative could be, “Oh, I handed my money to Bernie Madoff.”

Ben Felix: Yeah, that’s an interesting point. I think in the – either in the out draft or the conclusion of that paper there’s an interesting comment about how those relationships seemed to be a little bit one-sided because when these two people know each other, two entities know each other, the investment manager gains surely from fees, and the customer, the institution kind of just gets nothing.

Sunil Wahal: Yeah, not all relationships are, you know, it’s not like a marriage, which one would hope that marriages are two-sided, matching equilibria. That’s not always the case, sometimes these things can be one-sided. You know the data in that paper were fascinating to begin with. I mean, they came from this organization called, I think they’d been rebranded, but they used to be called Relationship Science.

It’s a very good organization, a lot of intellectual capital behind it, and it’s amazing what they track. I mean, if you want to know Ben, how do I connect to Bill Gates, they’ll find a way for you to connect to Bill Gates. It might be through two or three intermediaries but they’ll find a way to do it. If it’s there, it’s there. It’s clever, I like it.

Cameron Passmore: Amazing, let’s move on to private markets and bid in this realm. How do institutions choose which private market firms to invest in?

Sunil Wahal: Private markets are a tough asset class. I really, really do feel for institutions and actually retail investors as well who want to get into private asset classes. I used to sit on an investment committee that have to get into private asset classes because you know their clients really, really wanted it, high net worth accredited clients that really want to get into private markets, it’s tough.

I think the key aspect what makes it really tough is what we call access. So, I would like access into Andreessen Horowitz or Sequoia but guess what? They’re not going to give me the time of day, I’m a little piddly guy, and that means if I’m excluded from those because I think that there is persistence in performance and if there’s any persistence in performance in private markets, it’s in venture.

So, I’d like that but I can’t get in there, so what am I going to do? I’m going to go to other places. So, this is a bit of a lemon’s problem, so I’m excluding the right tail, which means that I’m going to be working with a truncated distribution of managers and that’s tough. So, if you want exposure, it’s not so easy to do. So, it’s all about selection from that truncated distribution, unless of course, if you’re the Yale endowment you can pretty much go wherever you want then you have no access problem. It’s really about managing that, it’s tough, not easy.

Ben Felix: One of the things that I took away from that paper is that institutions are pretty willing to invest with first-time general partners or people with maybe not a lot of experience managing money. What’s the relationship there between first-time or young GPs and the future performance of their funds?

Sunil Wahal: Yeah, so this has to do with how competitive markets are. So, your investment committee needs to allocate let’s say 10% to private markets. You don’t get access to Andreessen Horowitz, so you’re going to find whatever you can get access to or maybe you have a consultant at Cambridge or whoever comes along and says, “No, we can get you access to some of them, what we think are good ones but it’s still not going to be Andreessen Horowitz.”

“So, and we also think you should take a look at these new folks on the market.” So, this is a new organization, they used to be XYZ firm and now, they’ve created their own organization. You have demand for investment services, you want exposure to private markets. This is your best shot at getting that exposure. So, what we see in the data are exactly that, you see large institutions allocate large amounts of capital in aggregate.

Individually small but in aggregate large to what we call first-time GPs or young GPs that don’t have a performance history because you can’t see their performance, right? The fund lasts for 10 years, you don’t really get to see multiples or IRRs or anything like that until 10 years later. So, three years into the process, you have no idea what things look like. So, it’s a little bit shooting in the dark and in my view, it’s basically demand and supply.

Allocations to private markets are up, you need to get it invested, where are you going to go? Subject to the access problem, you’re going to go to some new folks, and out of the woodwork are going to come some new folks. GPs are going to get creative to meet that demand.

Ben Felix: Yeah, that’s wild. So, there’s so much demand for private assets that a GP can kind of just spin up a story and launch a fund without a track record and still attract capital.

Sunil Wahal: I mean, for some GPs that will be – I mean, this is why again it comes back to the devil is in the details, right? Selection is incredibly important and some of those, I open up a shop, call myself a GP, am I going to attract capital? Maybe, maybe not but if I spent 10 years or 20 years at a private fund, I have a better shot at attracting capital, and some fraction of those will do well, and some fraction won’t.

Cameron Passmore: So, what are the main lessons that institutional investors should take from your research?

Sunil Wahal: You mean overall in terms of selection and stuff? Yeah, I mean, honestly if you ask me what the single most important thing is that an investment committee at an institution does is its selection and monitoring. That is really the key to what they do because it’s not like they manage the individual portfolios, everything is farmed out to professional organizations that do that, it’s selection and monitoring.

And selection and monitoring is very much a function of the quality of the investment committee and the people that you have. If they know what they’re doing, if they are well-versed in the science, and in the practice, I emphasize I think most are incredibly important, the science and the practice, then they have a better shot. I mean, if you take something like the Yale endowment and compare it to there’s a story in today’s Bloomberg about the Harvard endowment.

And it’s relative underperformance over the last two decades or so and how important, looks at how expensive it’s been for Harvard University if you contrast the two, the Harvard management companies rife with or was rife with agency problems and if you look at Yale set up or Stanford set up, it’s not the case. So, people matter and getting the right people in the right places really matters.

Ben Felix: Now, your research shows this and you mentioned you’ve been on investment committees, you’ve probably seen it first hand, investment committees feel this need to hire and terminate managers. I don’t know if it’s to look like they’re doing the right thing, there’s stakeholders, or I don’t know what it is. Maybe you have an idea on that too but how would you communicate to an investment committee or maybe how have you communicated to committees you’ve been on that are doing that, that turnover of managers may not be the right thing to do?

Sunil Wahal: Yeah, there’s some behavioural lesson, isn’t it? Not doing something is doing something, it really is. That’s essentially what it is, so you pay attention. I mean, I’ve gone in front of investment committees and would ask me similar questions and I keep telling them the same thing, not doing something is doing something. You do your job, your job is hire, monitor, monitor, monitor, monitor, and then really if necessary, fire and then hire again.

But you don’t have to do this. It’s not like a haircut, you might need a haircut every month but you don’t need to do this process every month. It’s understanding that the signal-to-noise ratio in financial markets is very low, that’s really what it boils down to. It takes a long time for us to learn from prices but that means you have to find other ways to learn. So, you have to understand your investment managers, understand what they’re doing, how they’re doing it.

Whether you believe their investment thesis or not, what it relies on, where the pain points are, do they reside in turnover, do they reside in personnel. Like you have the Wamco example from last month if a person leaves is that, where Bill Gross if you think about that, a person leaves, everything collapses. You don’t want that kind of risk. So, the committee's job, think about risk, that’s their one job.

Ben Felix: And what lessons from this research do think apply to retail investors?

Sunil Wahal: It’s kind of interesting when I think about institutional investors, so I think about the head of an IC, right? The head of an investment committee is a retail investor. They’re individual, so they have the same biases and preferences that individual investors have as well. So, I think every lesson applies to individuals as well. The institutional and retail arena are not that different, the exception might be taxes. From a retail investor’s perspective, you can pay a lot more attention to taxes or as I tell my students, “Hey, you get to buy that car with after-cost and after-tax dollars, so pay attention.”

Is it a QDI or not? Are you going to get a tax bill when you didn’t even trade? Pay attention to those kinds of things, all of that matters but other than that, it’s the same set of agency problems, the same set of behavioural ideas that exist at the institutional level as existed at the retail level. I think it’s exactly the same thing.

Ben Felix: I want to ask one more on institutions just based on what you’re talking about there, you mentioned cost and taxes in the case of retail investors. We also talked with the Harvard story where they’ve paid some pretty substantial fees. How important are costs for an institution managing a portfolio?

Sunil Wahal: Oh, they’re incredibly important. I mean, it’s a friction. All of these sorts of things are frictions so if you think about an asset manager that delivers a portfolio, an asset manager that delivers a portfolio basically gives you a set of portfolio weights and those portfolio weights change over time. You as the latent owner, that’s what you have. Okay, so what are the frictions and costs associated with delivering you that set of portfolio weight?

Can I do it myself? The answer is no because I need research, I need data, I need to be able to trade this stuff, etcetera, etcetera. So, all of those costs essentially is summed up in two or three different places. One, it gets summed up in an expense ratio and that’s explicit. You get to see that. The second place that gets summed up is in the after-cost returns because costs associated with trading as an investor you don’t get to see those because you just get returns that are net of those costs.

So, those are invisible and then the last part is the tax part. So, all of those get summed up, it’s incredibly important to pay attention to those. Things that look really good on a pretax pre-cost basis, Momentum is a classic example, there are many organizations that run Momentum portfolios, I don’t know a single one. I would not touch it with a birch pole having worked in this area, built portfolios, and knowing what I know about trading over the last 28 years or so, that’s a recipe for writing checks to Jane Street, which many checks written to but I don’t need to write them more checks than they get.

Cameron Passmore: I got to dig into that a little bit more. I know you got a paper on Momentum and we didn’t have it on our list of stuff to discuss but since you mentioned it, it’s a question I get all the time about Ben, you talk about factor investing but what about Momentum? Should I be investing in Momentum? So, you said you wouldn’t touch it, can you just expand a little bit on why?

Sunil Wahal: So, let’s talk about the other things. Think value, think profitability, think all of those, those are anchored strategies. They’re anchored to a fundamental. Momentum is inherently an unanchored strategy, the only thing it cares about is the prior price and the prior price itself is unanchored. So, any strategy like that if unanchored to fundamentals, which means it can have very volatile outcomes.

And because it’s not anchored, it goes up and down, it goes, right? You can see the volatility in the outcomes and the shift goes all over the place as the tide rises and as it falls, and that means it can have crashes and we know that there are – if you Google Momentum crashes, you’ll find, I don’t know, probably at least a dozen papers by well-known authors that say, “We study Momentum crashes.” Well, they crash because they’re unanchored.

So, Momentum as a strategy because it’s unanchored generates very volatile outcomes and for an investor, okay, just take piddly old me, I have some objectives. My objectives are I got to pay my kid’s college tuition and I don’t want to be in a situation where I can’t write you a college tuition bill because my Momentum portfolio really crashed. I just don’t want that, I can’t plan for it. So, uncertain outcomes or as Ken French like to describe, the unexpected, right?

The unexpected is evil, I agree with him a hundred percent, I don’t want that, and that’s what Momentum gives you, and on top of that, it’s incredibly expensive to trade. No matter how well you adjust your trading bands and portfolio breaks and yada-yada-yada, there are a dozen ways in which you could try to minimize turnover but if you minimize turnover, you’re giving up expected returns. That’s kind of the way it works.

Ben Felix: The first part of your answer is – it almost sounded like a risk-based explanation for why the Momentum Premium exists.

Sunil Wahal: If you think of risk in that context.

Ben Felix: Right.

Sunil Wahal: Yeah, I mean anything that’s unanchored makes me nervous. You can think about other strategies, right? So, think about like low-vol or betting against beta, those kinds of strategies and they’re kind of unanchored but they are based on prescriptive models. So, they say cap end betas, low beta stocks earn higher returns than they should. Well, it’s true in the data but you tell me when is the last time you believed in the cap end to begin with.

So, am I going to use that as an investment strategy? From my perspective, the answer is no because it’s telling me to reject a prescriptive model but I already agreed to reject the prescriptive model.

Ben Felix: Yeah, interesting. Basically, like the five-factor model explains the low volatility kind of argument, right? Yeah, man, I wasn’t expecting to go into Momentum or low-vol but here we are. I don’t think anyone is going to complain about it. On institutions, I had one other question in my head, why don’t more institutions just index?

Sunil Wahal: You got to be seen to be doing something, that’s the hard part. That’s the agency friction, it’s really hard to make it away. Do we see some institutions do that? The answer is yes. So, when you say index, you mean in my sense like less active, right? Not a passive portfolio, just less active, hold the market cap rates, and living low, and update. There are institutions that do that but there’s not a ton of them, and the reason is because you got to be seen to be doing something.

Ben Felix: Yeah, it really is incredible and that seems to be the right answer but you know, there’s been this like indexing revolution for retail investors but meanwhile, you look around at institutional portfolios and not a whole lot of them are, at least, not pure, pure index. Maybe they’re using more indexing or more less active strategies but I don’t know, a lot of pretty serious active stuff going on out there.

Sunil Wahal: You look at the Nakumo data for example, I mean, you look at those portfolio allocations and there are a lot of them, actually what people are doing but you’re all over the place and it is what it is. An agency piece costs you something.

Ben Felix: Yeah, super interesting, and also it’s a shame. Like you mentioned earlier, what’s the objective of these institutions, if it’s an endowment or a retirement plan, or whatever, they’re affecting real people and a lot of those dollars are going toward investment managers and alternative investment funds and all that kind of stuff. We talked earlier about competition in private markets, how competitive is the market for mutual funds?

Sunil Wahal: I mean, asset managers in general I think whether it’s mutual funds or ETFs or whatever the wrapper or the delivery vehicle is the asset management market in general I think is quite competitive. I have a paper with a coauthor that looks at this and mutual funds but you can see this in other markets as well and think about the way that this business works is you create a product, you deliver that product to investors.

The cost of entry and exit for an investor into a product is relatively low with the exception of taxes and if you think about the marvel cost of the producer, and there’s some fixed costs for me to set up a fund complex and create a fund but then the marshal cost, especially in days now like there the technology is really good, the personal cost are not that high. So, what does that mean? You get new entrance.

New entrance generate more competition and the more competition there is, I mean, I don’t know anybody who doesn’t like competition, you get better products and better prices, quality improvement, price improvement, what’s not to like? I love it. I wish there are even more electric vehicle producers because what happens? Prices fall, quality goes up, that’s great.

Ben Felix: Yeah, it makes a lot of sense. You got a pretty new paper, it’s mind-blowing, this is a cool paper. How does diversification in mutual fund investors affect the performance of the funds that they invest in?

Sunil Wahal: That’s actually really intuitive, really, really intuitive. So, as long as you are setting up a business, okay? You’re setting up a business, ignore mutual funds, you’re just setting up a business and you have what we call a corner client. Your corner client represents 50% of your business from your perspective, that’s a pretty important client. From your perspective, that’s a big client.

Okay, now suppose you have a customer who’s a small client of yours, so five percent but from their perspective, their investment in your business is 80%. So, they’re a small client to you, you are a big provider to them. Okay, so now let’s go back to your business. Your business, you are worried that that client that you have that represents 50% of your revenue stream says, “I don’t like you anymore, I’m going elsewhere.”

You’re going to be scared of that, right? You don’t want that, so what do you want? Well, you want a diversified client base. That makes sense, right? I don’t have any business that says, “Oh, I only want one client and it’s the government.” Okay, I’m just kidding about the government part but you know what I mean. You don’t want a concentrated client base, you want a diversified client base, so that’s pretty easy.

So, if you have a diversified client base, if you have one client leave, no big deal. Not as big a deal, the other ones give you more business. That’s a good thing, that’s the benefit of diversification from your perspective and now, what about that client that you had, that small fraction of you, so five percent of you but 80% of their investment is going in there into your business?

They are sitting there worried, “Hey, I’m giving 80% of my capital to Cameron and Ben but they’ve got this other client who’s 50% of their business. If they run away, uh-oh, that’s going to be bad for me.” This is the mutual fund business in a nutshell. It simply says, if you’re diversified across clients, different client types with different liquidity needs, then you’re less likely to have what we call bank runs, where one person runs for the exit and everybody else is all crap.

They might run for the exit and we got to go too, and that can be very harmful to investors. So, there was an investment committee I used to sit on, I sat on this committee for I don’t know, many years, at least half a dozen years and one of the things I really liked about the CIO of this IC was that every quarterly meeting what she insisted on was that we start with a look at all the asset managers that we use for this organization.

And all the individual products, the funds or ETFs or whatever, and what their flows had looked like over the last quarter or the last year or the last three years, the last five years, whatever the numbers were, and she insisted on it. I thought that was an incredibly intelligent organizational thing to do and it made a lot of sense because you sort of sit there and you go, “Okay, if I am seeing a fund that’s been bleeding assets, I know it’s going to cost me in terms of performance and it might cost me in terms of tax bills, at least in the mutual fund set up.”

Part of fiduciary due diligence, you want to be able to track those things and so, the flip side of that from the fiduciary perspective is the fund would like to have a diversified client base and the investor would like to have the fund to have a diversified client base as well, and so you don’t want to put all of your money in one basket. It’s pretty simple but it shows up in financial markets.

Ben Felix: It is simple but I had not spent a lot of time thinking about – I mean, it’s like the bank run concept sort of for mutual fund. I think you mentioned that as an example. It’s fascinating. Is there a relationship though between performance and concentration of investor base in a mutual fund space?

Sunil Wahal: For sure. So, the nice thing about mutual funds is that we can do tax things with so much precision. So, we measure flows on a daily basis like every day so we know what each fund’s flow looks like on that day and we know sort of their measures of how diversified their client base is. So, when they have outflows, so you imagine two funds, one with a very diversified client base and one with a not diversified client base, they both have outflows.

So, they’re both going to incur costs, right? Because securities have to be sold and that cost is going to be borne by shareholders who remain in the fund. So, if I stay in the fund, I’m going to pay one way or the other and so that’s why in my example earlier, my illustration, it means I see we keep track of those because we don’t want to pay these costs but all is equal. If you give me two funds, one that has a more diversified client base and one that has a less diversified client base, I want the one with more diversified client base because I pay less. I still pay but I pay less.

Cameron Passmore: So, how do you find that fund with a more diversified investor base?

Sunil Wahal: We use a bunch of different proxies for it, so one proxy is you can look at – this is getting nerdy and technical but the covariants of flows across shared classes, right? Funds will have half a dozen shared classes, retirement class-A, retirement class-B, retail, adviser, blah-blah-blah. So, you can look at covariants of flows across those, that’s sort of the simplest way to do it that tells you.

Think about 2008, if you’re in 2008 and all your clients headed for the exit or COVID, all your clients head for the exit, that’s not what you want. You want some patient clients to stay there to offset and you also want some clients to say, “You know what? All of you are heading for the exit, I think expected returns are high, I’m going to allocate more capital.” That’s what you want.

Ben Felix: That paper, like I mentioned when we started talking about, I found it to be just mind-blowing because I said not a concept I’d thought about in the context of mutual funds but like you said earlier, it makes so much intuitive sense once you explain it but not easy to have been the first one to really think about it, so that’s why it’s a cool paper. How well have actively managed global equity mutual funds performed for retail investors?

Sunil Wahal: A lot depends on what your benchmark is. So, there are two ways to think about a benchmark. One way to think about a benchmark is sort of the way that the investment community thinks about a benchmark, which might be like Aqui or whatever, think of benchmark that way. I think a better way to think about a benchmark from the downstream investor’s perspective is what financial objectives were you trying to meet and were you able to meet those financial objectives.

So, what do active global equity funds do? They invest around the world. Will they give you the global equity premium depending on how they are managed, how concentrated they are, how they handle costs, etcetera, etcetera? Some of them will, some of them won’t. In general, the more active they are, the more costly it is for them to implement their approaches in general, not for every single one, and those costs add up.

So, I think of a continuum of less active to most active as opposed to totally passive, which doesn’t really even exist and as you move along that scale, you hope that expected returns rise and the cost don’t rise commensurate with expected returns. Unfortunately, they do, so it’s a tough gig. It’s not going to be easy but that’s again, where the implementation comes in.

Ben Felix: And what does this suggest about the efficiency of markets outside the US?

Sunil Wahal: So, this is something we hear from investors often, right? That the argument, I can’t tell you how many times I’ve heard this where somebody says, “Well, we believe that west markets are really, really efficient but emerging markets are not, or markets outside the US are not, and so we’re going to use active management there and not active management or passive entering here.”

And my response is, “Well, you’re really using active management everywhere. It’s just a matter of degree and now you tell me you have a prior that let’s say emerging markets are less efficient than US markets but you show me the evidence that that’s the case.” And when you ask for evidence, you don’t get it, and that’s the issue. So, it’s really hard to tell whether emerging markets for example are less efficient than US markets.

I can’t tell and I think that if I asked many of my esteemed colleagues in academia, they would probably tell you at least those who think about these sorts of things, they would tell you the same thing. It’s really hard to tell, where in a Bayesian sense, it’s a very defused prior like there’s something, I cannot take this.

Ben Felix: That’s a very nerdy answer, I love it. Okay, we got two more questions before you, you know, you’ve worked with firms like Dimensional, you mentioned for many years and now with Avantis, how important do you think it is for financial economists to spend time with practitioners?

Sunil Wahal: So, back when I was young and I didn’t have this much grey hair, I remember reading a little piece of writing by Fisher Black, who I think is some sort of practitioner or maybe a financial analyst general, or a general portfolio management, something like that in which he basically made the case that every self-respecting economist, financial economist should spend some time in industry and the case was the following.

It says if you’re an academic, you’re interested in prices. Where do prices come from? Prices come from agents trading, they come from trading, they don’t magically appear. There is no such thing as a wall-raging auctioneer, so they come from real trading and so if you want to understand prices, you should spend some time and figure out where prices really come from with industry.

And then he flipped the argument around the other way and said, “Okay, if you are a practitioner, you’re watching markets clear every single day, you’re watching trading, behaviour, etcetera, etcetera but sometimes, you are so into the details that you missed those structural aspects of what should be rather than what is and because you missed that structural aspect, it’s worth your while to occasionally walk over to your local university or wherever. And attend a seminar or two and learn to think how financial economists think about this because they think about it in a structural way.”

So, from my perspective, I think it’s incredibly important and I am fortunate, I thank many people for the fact that I’ve been able to do this over the last three decades or so, my first engagement came with, I don’t know if you guys know but Ted Aronson.

Ted Aronson is the original firm, Aronson, Johnson & Ortiz, Ted Aronson I think is still the head of the CFA maybe, one of the original value investors. I think it’s incredibly important for academics to spend time in industry and vice versa, you’d learn a lot, and this plethora of research that we have that says, “Oh, here is another signal and here is some other expected returns that you can order, an alpha that you can generate.”

A lot of that would go away when you realize, “It doesn’t work that way.” It’s not how prices performed.

Cameron Passmore: Our final question for you Sunil, how do you define success in your life?

Sunil Wahal: Well, that’s an interesting question. I’ll tell you what a good day is, so a good day is when I can exercise my brain and do some research. A good day is when I can get into the Canyons in Arizona and get into some wilderness, hopefully with a friend or two, get some hikes in. A good day is if I come home and have a fun dinner with my wife and talk to my kids who are neither of them were here, they’re both in colleges in various places.

So, that’s a good day. So, what’s a good life is an accumulation of good days. That’s the way I think about it. So, you asked success and I described happiness and success and happiness are not necessarily the same thing. You can be very successful and unhappy. I kind of prefer to connect them, like have both of them at the same time. It’s kind of like value and profitability if you will.

So, what’s success? Success is an accumulation of good days, leave the world a better place than when you found it, and be happy while doing it. I think for me it’s pretty simple.

Ben Felix: Very cool. Well, having you join us has made today a good day. So, Sunil, great to see you again and thanks for joining us.

Sunil Wahal: Thank you so much, it was fun.

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Books From Today’s Episode:

The Interpretation of Financial Statements — https://www.amazon.com/dp/0887309135

Papers From Today’s Episode:

‘Long-Term Shareholder Returns: Evidence from 64,000 Global Stocks’ — https://doi.org/10.1080/0015198X.2023.2188870

‘Long-Run Stock Market Returns: Probabilities of Big Gains and Post-Event Returns’ — https://dx.doi.org/10.2139/ssrn.3873010

‘Prudential Uncertainty Causes Time-Varying Risk Premiums’ — https://dx.doi.org/10.2139/ssrn.2176896

‘A Five-Factor Asset Pricing Model’ — https://dx.doi.org/10.2139/ssrn.2287202

‘Do Institutional Investors Exacerbate Managerial Myopia?’ — https://doi.org/10.1016/S0929-1199(00)00005-5

Links From Today’s Episode:

Meet with PWL Capital: https://calendly.com/d/3vm-t2j-h3p

Rational Reminder on iTunes — https://itunes.apple.com/ca/podcast/the-rational-reminder-podcast/id1426530582.

Rational Reminder Website — https://rationalreminder.ca/ 

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Rational Reminder Email — info@rationalreminder.ca

Benjamin Felix — https://pwlcapital.com/our-team/ 

Benjamin on X — https://x.com/benjaminwfelix

Benjamin on LinkedIn — https://www.linkedin.com/in/benjaminwfelix/

Cameron Passmore — https://pwlcapital.com/our-team/

Cameron on X — https://x.com/CameronPassmore

Cameron on LinkedIn — https://www.linkedin.com/in/cameronpassmore/

Sunil Wahal on LinkedIn — https://www.linkedin.com/in/sunil-wahal/