On today’s episode of The Rational Reminder, we once again cover a host of topics. We begin with Cameron sharing his thoughts on a book he recently finished, The Ride of a Lifetime, and some of the lessons he took away from it. We then tackle three listener questions, where we cover Mawer and index funds hypothetically driving prices. Then, in the portfolio portion of the show, we turn our attention to value premiums. Fama and French recently released a paper on the topic, and Ben is naturally very excited to share his assessment on it. We unpack how value has performed in the US, unexpected big value findings, and other takeaways from the paper. After that, we explore the total cost of ownership in our planning section. These are expenses that you incur when you begin investing. We shed light on some of them and the effect they have on your investments. Finally, we end the show with Tim Nash’s take on our assessment of sustainable investing in episode 82. His insights offer an interesting perspective on the topic. While we can’t say we’re fully on board with his active position, it’s certainly a fascinating viewpoint. Don't miss out on today’s jam-packed show!
Key Points From This Episode:
Takeaways from the audience’s reception to episode 83 on cryptocurrency. [0:00:52.0]
Insights and lessons from The Ride of a Lifetime, which Cameron recently finished. [0:04:13.0]
More about Mawer: Data about and insights on how the company has fared. [0:08:48.0]
What would happen if index funds could hypothetically drive prices? [0:22:34.0]
What’s interesting about the timing of Fama and French’s new paper, The Value Premium. [0:25:46.0]
The thesis of Fama and French’s paper and what they found over measured periods. [0:26:49.0]
Why Fama and French used how value did relative to the market. [0:29:17.0]
How value performed between 1992-2019 and a surprising finding about big value. [0:31:04.0]
Ben’s takeaways from the Fama and French study. [0:33:18.0]
Conclusions from Fama and French’s 2019 paper, Volatility Lessons. [0:36:37.0]
How other countries performed on market-wide value versus the market. [0:38:30.0]
Clarifying the confusion around the management expense ratio and some empirical data. [0:40:00.0]
The conflict of interest inherent in commission-based products. [0:42:39.0]
What the trading expense ratio is and how it works. [0:43:47.0]
Things similar to fees: Cash drags, large cap against distribution, and withholding tax. [0:47:50.0]
‘Bad advice of the week’: Globe and Mail article. [0:48:48.0]
An overview of Tim Nash’s services and his take on Ben’s ESG presentation. [0:54:00.0]
Tim’s critique of the assumption of lower returns when it comes to equity. [0:57:07.0]
Why externalities are so important with ESG even though they are glossed over. [0:58:12.0]
There is so much that we don’t know about ESG because it’s all so new. [1:01:45.0]
Why Tim believes we should invest in the green companies even with the current market structure. [1:06:08.0]
Ben and Cameron’s take on Tim’s insights. [1:09:32.0]
Read the Transcript:
Ben Felix: This is the Rational Reminder Podcast, a weekly reality check on sensible investing and financial decision-making for Canadians. We are hosted by me, Benjamin Felix and Cameron Passmore.
Cameron Passmore: Off the top, this is a long episode. I think it’s a good episode; a lot of good material, but it is long, so we apologize. At the end, we had to follow-up with Tim Nash on ESG. If that's not of interest to you, you're going to save some time at the back-end with that, but I thought it was a worthwhile discussion that you had with him.
Ben Felix: I thought it was worthwhile too. I think we did talk about some important and interesting topics in the episode, obviously, because-
Cameron Passmore: But the quote of the week, this is my favorite quote of the week, which if people are on the Rational Reminder website, the chat room that we've got going on there. I love the quote you gave back to some of the feedback on the crypto discussion. Your quote was, "Bitcoin makes people angrier than gold and dividend stocks combined."
Ben Felix: So today, I learned. Well, I didn't realize, and maybe I'm just naive. I did not realize that digital currencies get people as fired up as gold and dividend stocks.
Cameron Passmore: Some people, it does.
Ben Felix: But we usually get 15 to 20 comments on an episode, and usually 90% or more of them are positive. In this case, 100% of them were critical. Different levels of niceness, but all critical.
Cameron Passmore: Yeah, which I thought Michael did a great job explaining what it is. We've had so many questions as to what is this crypto thing. I thought he made some compelling arguments as to the kinds of social change it can have. I thought we did bring up the discussion on expected returns well.
Ben Felix: But let's be clear, I wouldn't touch it.
Cameron Passmore: No. We didn't say to touch it.
Ben Felix: I know, but let's... We're making it sound rosy still. The reality is-
Cameron Passmore: But what is wrong with learning? That's the part I don't get.
Ben Felix: I agree.
Cameron Passmore: People learn from this. I don't... I would... Should we have been more truthful to our rational labeling? I guess you can make that argument, but we're also pretty nice guys and Michael's a nice guy.
Ben Felix: Right. We didn't want to be jerks to Michael.
Cameron Passmore: We don't want to be jerks. I thought he did a great job explaining what it is.
Ben Felix: But I think that the reason people get fired up about this is that it's a space that is new, and there have been a ton of scammy things that have happened in this space, a ton.
Cameron Passmore: I know some firsthand with some very large dollars that are totally scammy.
Ben Felix: Like that have been, people have lost money?
Cameron Passmore: People had some of their coins stolen. They can see them in their registry, but they can't access them. I get it.
Ben Felix: But there's also all the scammy ICOs. There was a period of time where this stuff was pretty out of hand. Even beyond that, take Bitcoin, which is now relatively established, it's still not something that I think people should be investing in. I know some people that are doing it, and they've taken the time to educate themselves thoroughly on the topic, and they think it's a good bet. I would not suggest anybody invest in digital currencies. I do not invest in them.
Cameron Passmore: But to take what we did and compare it to anti-vaxxers and flat earthers and climate change deniers, that may be a... It's a little far.
Ben Felix: It was extreme. I think the comments went from a little bit upset, and then when I responded to them, everybody calmed down a little bit.
Cameron Passmore: Anyway, like I said, if we do this, we have to expect this can happen.
Ben Felix: I was honestly surprised. Like you said, I thought it was good information. I don't think we took a side either way. Some people said our questions were too soft ball, and could we have asked harder questions? I mean, maybe. Would we have gotten good answers? Probably not because they don't exist. Would that have made us seem like jerks to Michael? Probably. Anyway, I was surprised that it upset people as much as it did.
Cameron Passmore: Anyways, so lots of good content today, but it is a long episode.
Ben Felix: Fire it up.
Cameron Passmore: Let it go.
Ben Felix: Let's go.
Welcome to episode 84 of The Rational Reminder Podcast.
Cameron Passmore: Last time, I mentioned an interview with Tim Ferriss podcast with Bob Iger, who's the current CEO of Disney. I thought it was a fantastic interview, so I went and read the book that he wrote called The Ride of a Lifetime: Lessons Learned from 15 Years as CEO of Walt Disney Company. You have not read the book yet, right?
Ben Felix: Well, you've told me about it. But no, I have not read it.
Cameron Passmore: I thought it was just a phenomenal book. I'm not sure if I like him because he gets up at 4:50 like I do, but it's such an interesting story how he worked at ABC. Disney acquired ABC. He worked at ABC for 30 years, and grew through the ranks, worked for the famous Roone Arledge in the sports division, and grew up through, and then became, after Michael Eisner, the head of the Disney Corporation.
Ben Felix: Did you say you're not sure if you like him?
Cameron Passmore: No, I'm not sure the reason why I like him is because we both get up at 4:50 in the morning. We have very similar morning habits.
Ben Felix: Got it.
Cameron Passmore: He gets up. He reads and exercises long before he gets to work. I'm just guessing that might be why I have a certain affinity for what he does.
Ben Felix: I understand. It sounded like you said you're not sure if you like him.
Cameron Passmore: No, I do like him. I think he's very personal, and I thought he was great on the Tim Ferris interview. I thought the book was phenomenal, but what to me is really cool is how you got this company arguably one of the most storied competence in the planet who under his direction ended up merging and taking over Pixar, Marvel, Lucas films, and 21st Century Fox, which are four massive takeovers, but he goes through the story of how he pulled all this off and how he had the vision to pull this off.
Even the Super Bowl yesterday, watching that, and there was an ad for the Black Widow, which is the latest Marvel movie coming out. There's absolutely no mention of Disney anywhere on, as I mentioned, the people we're watching the game with. I read about this, and I said, "Oh, I didn't know that Disney owned Marvel," but these four massive brands are now part of the Disney world. You follow that through to the new Disney plus channel and how his vision to pull all these people together, and he talks about how... For example, taking over Pixar and negotiating with Steve Jobs.
They went to a whiteboard, and they put down... How Steve Jobs does things is on a big whiteboard, so he puts on one side the pros and the other side the cons. I guess, there are two main pros and a huge long list of cons, so Bob Iger's saying, "Well, I guess this is just dead." To Steve Job's credit, he says, "No, the pros are pretty compelling." He said, "Let's focus on that," and they did. That's what enabled that deal to happen.
Ben Felix: What did you learn from the book practically?
Cameron Passmore: Practically speaking, I mean, one of the things he talks about is stories that just keep digging in, keep... He was pushed so hard by Roone Arledge early on to just be excellent every single day. I mean, one of the examples he gave was Roone Arledge had a vision of televising Wide World of Sports, which I'm guessing you're too young to remember that show on ABC. But growing up, I can always remember watching Wide World of Sports. They would have these crazy sports from all over the world just stacked back to back on...
I think it was Saturday or Sunday afternoons. I don't remember, but one of them was to televise the world ping pong tournament from North Korea. Roone Arledge has said, "I want to do this. Go figure this out, Bob." Like, "Well, how do you negotiate with North Korea?" It goes into the story, and it's a story of resilience how he ended up... You couldn't work with, because it was against the law to work with North Korea, but he worked with the Ping Pong Federation that was based somewhere in Europe, and then got them to negotiate.
He ended up pulling off a deal to televise the ping pong tournament from North Korea, but he said had he not been pushed as hard by Roone Arledge, he never would have done that. That just showed this resilience and that drive, carried it all through his years. That's one example for you. Anyway, it was a great... I love the book. It's such a great story about brands we all know. I mean, I know you haven't been to Disney yet with your kids, but I've been a number of times. I know the Disney story, but to broaden it out to these massive brands of content is unreal.
Ben Felix: Should we invest in Disney shares?
Cameron Passmore: Well, I'm assuming market's pricing all this information.
Ben Felix: It's already priced in.
Cameron Passmore: Then one last bit of content I'll throw out for you, a totally separate thing is on the Tim Ferriss podcast last week, they interviewed Sam Zell, who is a founder of a company called Equity International. Wow. What a story about vision and real estate going back 50 or 60 years. Incredible. I won't go into details on it, but it's worth listening to it.
Ben Felix: Cool.
Cameron Passmore: On to listener questions.
Ben Felix: Yes, so we're stacked up with listener questions. We had a bunch, but there were three that I thought were worth discussing. We're going to have three listener questions before we jump into our portfolio and planning topics. The first one is what about Mawer?
Cameron Passmore: Mawer?
Ben Felix: Mawer is, I think, how they say it.
Cameron Passmore: Is it how they say it?
Ben Felix: Yeah.
Cameron Passmore: Oh wow.
Ben Felix: M-A-W-E-R. But they're a Canadian active manager.
Cameron Passmore: They go back a long time.
Ben Felix: I think 1988.
Cameron Passmore: I remember when I started, that was a brand back then. I don't know if we could get access to them, but they were certainly a big compelling brand back then.
Ben Felix: They don't have F class funds, I don't think. They only have A class funds. But in terms of access, I'm not actually sure. I think to go direct through Mawer, you have to have a million, so they actually have a pretty high minimum to go direct. Through an advisor, maybe you can get to them. I haven't looked into that, but what I did look into was their performance and of course their time varying factor exposure. Their performance has been really good, which I think is well, survivorship bias, that's why they're still around, but it's also why they come up in questions from people because it's like, "Okay, if markets are efficient and we should index, why is Mawer doing so well?"
It's a totally valid question. I looked at their... They have three... Well, they have a bunch of funds. They have a balanced fund, which I think is quite popular. It is neat because it is a low cost, actively managed global diversified portfolio. If you wanted to go active, this is probably one of the best ways to go.
Cameron Passmore: And probably very disciplined. The whole story will probably cause good behavior on the investor's part.
Ben Felix: Yeah, so they have a balanced fund. I didn't look at that one just because it's easier to look at the components, and the components go back as far as the inception of the firm. I looked at their international equity fund, their U.S. equity fund and their Canadian equity fund. I looked at their performance, their factor exposure. Anyway, so we'll talk about all those things. The Mawer International Equity Fund has returned 7.97% versus 6.03 for the MSCI EAFE + EM from January 1988 through December 2019. That's a long track record of beating the index, and it had a lower volatility over that time period.
Cameron Passmore: Pretty compelling.
Ben Felix: It's a very compelling. U.S. Equity Fund has actually not beaten the market, which fair enough because nobody's beating the S&P 500 for the last few decades. Well, nobody. Not many. Ted Seides can attest to that. That one goes back to 1993. They trailed actually by quite a bit by about 1.4% annualized. Then we also looked at their Canadian fund, which goes back to July 1991, and it's returned 9.31% versus 8.38 for the S&P TSX, again, with lower volatility.
Cameron Passmore: Pretty good storyline.
Ben Felix: Really good storyline, right, and pretty low fees, and it's got the high minimum, so it feels cool. I think if you go direct through Mawer, they give you investment counsel. They'll give you advice.
Cameron Passmore: Then they'll promote star managers, I don't believe, right? It's a team approach. It's a company philosophy. I like that a lot.
Ben Felix: I like the story. It's a good story. For the further regressions to see like, "Can this performance be explained by exposure to the known risk factors?" For international equity, I only had data going back to 1990 for the regression factors. That's where the Ken French datasets start and actually have... The Ken French datasets have international developed and emerging markets factor data now, which is neat, because I think the EM is newer.
I noticed it as being new when I went to pull the data, which is good because we needed it because this fund has a EM exposure.
Cameron Passmore: Okay, so you have 30 years of data.
Ben Felix: Yep. I compared the fund to the index. I mentioned the return's going back to 1988, but for this period where we actually have the factor data starting in 1990, and the returns are a little bit different, obviously. The international fund has returned 8.67% annualized from 1990 through 2019 versus 5.57% for the EAFE + EM index, so again, substantial outperformance.
Cameron Passmore: It's like 300 basis point.
Ben Felix: It's serious.
Cameron Passmore: It's 310 basis points compounded per year.
Ben Felix: Right. So before jumping into the regressions, I just said, "What if we just..." Because... Well, I guess not before, but from the regressions, I know that the funds have a bit of a value tilt and a bit of a... well, a meaningful value tilt and a meaningful profitability tilt. I just compared them before doing the regressions to a dimensional market wide value index, so the dimensional market wide EAFE + EM value index over the same time period returned 8.42% annualized before any fees or withholding taxes, so closer now.
8.67% for Mawer after fees and withholding taxes, but after fees, that's close to the index without fees or withholding tax. Even with a more risk appropriate benchmark, it's still done really well. Then I jumped into the five factor regression using international developed plus emerging market regression factors. Now, this one was a bit tricky because I pulled from Morningstar direct to the emerging markets exposure of the Mawer International Equity Fund. The data doesn't go all the way back to inception.
I only had like, "How much was an emerging market," so I can't remember when it started, but it was not all the way back to inception, and it wasn't constant. It was a time during emerging markets exposure.
Cameron Passmore: Well, that was my next question. How constant was the exposure to emerging markets but also the value and profitability?
Ben Felix: It wasn't. I just took the average, and I used that to proportionally combine the developed and emerging market regression factors, which I think is... It's tricky, right, because over or under allocating to emerging markets is an active decision that they're making. If that's generating alpha, it should be included. So if I went back and retroactively proportionally used EM international, I'm with perfect hindsight taking away the alpha that they've added.
Cameron Passmore: Exactly.
Ben Felix: If I'm doing the regression based on the average, and they're adding value by being over or under the average, that'll show up as alpha. I thought that was a reasonable way to do it. Do you agree?
Cameron Passmore: Yeah, but even without that, the dimensional benchmark beat the broad index benchmark by roughly just under 300 basis points, right?
Ben Felix: Right.
Cameron Passmore: Just those factors are explaining a lot of the difference in returns.
Ben Felix: Right. With that factor model that I just described, which leaves room for Mawer to have some alpha through their emerging markets and developed split, what we see is a large cap tilt. This is from the regression, regression coefficients, a large cap tilt, a strong value tilt and a strong profitability tilt. Now, this one's fascinating because pre Five-Factor research, there weren't a whole lot of value strategies that also looked at profitability, including dimensional, which is interesting because when you look at active managers like Ben Graham, Warren Buffett, Mawer, that's their whole thing is to find these quality companies, but the academic research didn't catch up in terms of being published until 2015 when the Five-Factor model came out.
Ben Felix: I mean, I guess the empirical data was out a little bit earlier than that, but it wasn't all wrapped up into a cohesive model.
Cameron Passmore: Here, you're saying the theoretical data's catching up to the practical reality of Mawer and others.
Ben Felix: Yeah, and it's the same thing that we see through the Buffett's alpha paper that came out from AQR a few years ago, or from some of the guys at AQR, where we can now explain Buffett's success using commonly known factors. It's the same thing that we're seeing here, but to Mawer's credit, the academic research, nobody knew that in 1988 when they started their International Equity Fund. Anyway, so they have this strong value, strong profitability tilt. The value and profitability tilts are statistically significant at the 95% confidence level.
The interesting part, the alpha, which is what we're looking for here is 30 basis points per year after their fees, which roughly interestingly lines up with the difference between the Mawer fund and the dimensional fund over the same time period after fees.
Cameron Passmore: Interesting.
Ben Felix: That alpha though is not statistically significant at the 95% confidence level.
Cameron Passmore: So you're just saying it's luck?
Ben Felix: Well, it's not statistically different from zero.
Cameron Passmore: So you don't know if it's skill or luck.
Ben Felix: Sure, that's another way to... There's not enough data here for us to say with a 95% level of confidence that Mawer has generated alpha through their skill as opposed to just being lucky. Again, it's like that whole survivorship bias question. Now, what do they have going for them in this discussion? The Canadian Fund has also been in the market. U.S. hasn't, so either luck or skill. That's tricky. In the regression, the factors explain 90% of the monthly variation in the funds returns.
The factor model, even my approximate factor model with a time-varying emerging markets exposure that they have in the fund still pretty descriptive of the funds returns. I thought that was interesting. For the Canadian Fund, unfortunately, I don't have the regression factors. There's no good source of the same... AQR publishes some, but they take a different approach, so it wouldn't be really comparing apples to apples, so I didn't do it. But when you look at a value index for Canada over the same time period, it's again much closer.
Cameron Passmore: There's no real surprise here, but it is a quality organization running money in a way that basically the data and the theories caught up to them to explain what is going on here, but it is a testament to manage money like this for three decades plus.
Ben Felix: That's extreme discipline just like Buffett, same type of story. Now, I had the data point in here. I didn't see it in my notes, but here it is. For the dimensional Canadian market wide value index, that's the same one that we compared for the international equity. That index is worth mentioning. It's retroactive obviously, so dimensional constructed it with perfect hindsight based on the information that we have now.
In 1988, dimensional would not have constructed this index the way that they have, but the way that it's constructed today based on everything that we know is with a value tilt, but also with the profitability, also with a bit of a size tilt. It's all the same factors that are being implemented in this index. Over the time period that the Mawer fund existed for Canadian equity, the dimensional market-wide value index has returned 10.77% versus-
Cameron Passmore: Earlier, you said 9.31 for the Mawer, and 8.3 for the index.
Ben Felix: Yep. Again, I don't have the regression data to run that type of analysis, but if we just compare it to the value profitability index, that's done much better than the Mawer Canadian Equity Fund. Now, why is this relevant? Like you said just now, Cameron, it's a testament to Mawer's discipline and following a process that they believed in before there was any theoretical or empirical reason to do so.
Cameron Passmore: Exactly.
Ben Felix: Which is cool, but why is it relevant now? Because now, the academic research has caught up. The theory has caught up. The empirical evidence has caught up. If you're an investor today, looking at Mawer's track record, it's like for international equity, you could have come pretty close with a good mix of factor exposure that we all now are totally aware of. For Canadian market, you could have done better in perfect hindsight, but now, we have this information. For you as equity, they underperformed anyway, and value did better over that time period.
It's tricky, right? Because you're looking at Mawer's past performance. Yes, they've beaten the market. The market cap weighted index, value tilted index with a bit of a profitability filter, not so much. It's not as obvious. Forward-looking, it's like, "Are you better off with a relatively concentrated portfolio, because these are?" Mawer's much more concentrated, which of course, that's one of their benefits. That's what they're doing well. They've got high-active share, but can we reliably say that they're going to continue to deliver the type of returns that they have?
Well, have they even generated alpha? Not statistically. Then what should we expect going forward? It's a huge question mark. Anyway, this is an important discussion because there are other funds like Mawer. I mean, this is a mini... not as sophisticated version of the Buffett's alpha paper, where you look at, "Okay, this active fund has done really well. Can we explain that performance with what we now know to be true about how markets work?"
Cameron Passmore: Usually, the answer is yes.
Ben Felix: Right.
Cameron Passmore: There's always an answer as to why it happens.
Ben Felix: Right. Except for renaissance technologies. That one, we don't have the answer for. By the way, side note, when you read that book, we talked about it on the podcast, and I asked you, "Are they using leverage?" You said no. They for sure were.
Cameron Passmore: Oh no, they used... Absolutely, there's leverage.
Ben Felix: Crazy leverage.
Cameron Passmore: Oh yeah. But I said no. No, that's not correct. There is leverage.
Ben Felix: You said no before.
Cameron Passmore: No. No.
Ben Felix: They're levering up like crazy.
Cameron Passmore: Yeah. They're levering up on lots of small bets. They just hope to be right more than half the time.
Ben Felix: They are now. Their whole thing is... I'm going to do a video on renaissance technology so we can have a proper discussion about it on the podcast in the future, but that's fascinating stuff. Anyway, we won't get bogged down in that now.
Cameron Passmore: Let's roll on the next question. If factors become popular to the point of driving prices, would total cap weighted and factor strategies converge?
Ben Felix: It comes back to that question we've talked about in the past in the context of the index fund bubble. The index funds create a bubble in the market. The index funds drive prices.
Cameron Passmore: That's basically the question.
Ben Felix: I don't remember what episode we talked about that in.
Cameron Passmore: It wasn't that long ago, but the fact that yes, index funds are a large part of the total value of the market, but it's a much smaller part of the total trading of the market.
Ben Felix: And trading sets prices.
Cameron Passmore: It's a very, very small part of trading.
Ben Felix: 5% I believe is the figure I had from Vanguard. It might have gone up a bit since then.
Cameron Passmore: Because index funds are basically price takers or liquidity providers.
Ben Felix: Correct. Let's forget all that real information that we just talked about, and imagine a world where index funds do affect prices. Maybe there's no active trading. The only trading is happening from index funds, which are blindly putting money into securities.
Cameron Passmore: Which is the argument you hear all the time.
Ben Felix: Right. That's not reality, but we're going to talk about it as if it were. Just hypothetically, what would that result in? If we think about a situation where index funds are setting prices, and people are buying value stocks through index funds without doing any fundamental research, and shorting growth stocks, yes, the market would converge just by definition, I guess. It would converge to the point where valuations rose for value stocks and drop for rose stocks to the point where everything would be in perfect equilibrium.
Cameron Passmore: Every stock would have the same expected return.
Ben Felix: Right. Now, I can't... I mean, sure. Could it happen? I guess, again, hypothetically.
Cameron Passmore: But if you believe in different expected returns on different stocks, there has to be value.
Ben Felix: You think about too what we just described there is the market completely breaking. But in reality, if there are still active traders setting prices based on fundamental research, we have to remember that a factor portfolio is always relative. It's always a cheap relative to the market or cheap relative to growth. If you buy value stocks, and they go up in price, that's fine. You just rebalance into more value stocks. If there were something going on that caused value stocks to systematically increase in price, the value portfolio would be rebalancing out of value stocks or into value stocks.
That mechanism is always going on. It's only that case that we described where the market completely breaks. There's no active trading. Prices are no longer being set. Yes, in that case, the factor portfolios would converge to be the market.
Cameron Passmore: Just highly unlikely. We're a long way away from that now, and different companies have different costs and capital. Therefore, that explains other value stocks.
Ben Felix: You know what, that's a really good point because even if nobody was trading, there are no more active traders. Companies that are raising capital are still going to have due diligence performed on them. If a company wants to do a project, and they're going to go and raise capital through an investment bank, there's going to be an underwriting process.
Cameron Passmore: Yeah, because trading stocks, no money goes to the company
Ben Felix: Right. But even if it's only index fund setting prices at the secondary market level, companies raising capital are still going to have... There's still going to be a price evaluation at that time, the cost of capital evaluation.
Cameron Passmore: So along this theme of value, let's go into the portfolio topic this week. I know you wanted to talk about the value premium. I think you're going to talk about a new paper that Fama and French have recently released.
Ben Felix: Have you read it?
Cameron Passmore: I have not read it yet.
Ben Felix: I guess you read books, and I read academic papers.
Cameron Passmore: You read fact or academic papers.
Ben Felix: Fama and French just came out with a new paper, which is always exciting. Well, it is exciting. I had YouTube comments and Twitter messages about this paper over the weekend, so it's not just me. There are other people out there.
Cameron Passmore: Your groupies came out on this.
Ben Felix: Other people that are interested in Fama and French's work as they should be. I mean, come on. I'm making it sound like it's not interesting.
Cameron Passmore: No. No. It is very important.
Ben Felix: So Fama and French, timing of the paper... I don't know. I haven't asked them. Maybe we'll never get the chance to, but the timing of the paper is interesting because number one, it comes at a time when value's underperformed substantially, but number two, it comes at a time where they have exactly 28 years of data post-publication of their 1992 paper in which they use 28 years of data.
Cameron Passmore: Oh, no kidding.
Ben Felix: Yeah.
Cameron Passmore: Well, that's interesting, because so much talk around that paper was the work that was done after that and out of samples. Now, you have the exact same amount of time out of the sample.
Ben Felix: Exactly.
Cameron Passmore: Fascinating.
Ben Felix: Cool, right?
Cameron Passmore: That's pretty cool.
Ben Felix: They look at the full period, so from 1963, which is where their datasets started for the 1992 paper, all the way through to 2019.
Cameron Passmore: Now, this is getting exciting.
Ben Felix: See? There you go. You just need to read the papers, although it wasn't that exciting when you read it. I had to read it three times, and eventually, it's like, "Oh, this is exciting."
Cameron Passmore: What's the punchline?
Ben Felix: Well, there's a lot, so we'll pick through it. I don't have a one-liner for you. The basis of the paper, what they wanted to look at, was, "Can we confidently conclude that the expected value premium in the U.S. declines or disappears after the 1992 paper?" Because that's what a lot of people said.
Cameron Passmore: So, the out of sample question.
Ben Felix: Correct. Now, the out-of-sample question has been addressed in the past. I'm going to talk about that data as well, but one of those-
Cameron Passmore: The out of sample was taken in other countries. It wasn't taken in the same country, right?
Ben Felix: It was taken in further back time periods too, because the original paper in 1992 was 1963 through 1991. In the year 2000... It sounds funny to say the year 2000. In the year 2000, they came out and did a paper where they looked at out of sample historically, because when they did their first paper, I guess the data weren't available.
Cameron Passmore: I think that's a project that Jim Davis worked on, I believe.
Ben Felix: That's the CRSP going all the way back to 1926. In 2000, they took that out of sample set from 1926 to 1963, and they did the out of sample tests there. I'll just talk about the data around that too. I'm sorry, I'm jumping around here, but just back to the why Fama and French wrote the paper, one of the comments that they make at the beginning is that if it is true that the value premium is risk-based, we wouldn't expect a decline post-publication.
But if it's something else, then we would expect to decline, so this question of how does it perform post-publication out of sample is very important.
Cameron Passmore: But there still is a chance that it does outperform at any time period, which we talked about, I forget which episode, but there's always a chance that value factor does not show up.
Ben Felix: Yeah, and I mentioned that data point in this discussion too. So for the full period, going back from the full full period, not the period in this paper, but as far as we have data from 1926 through December 2019, the Fama and French's U.S. value research index had beaten the CRSP 110 index, the total market, by an annualized 2.77%.
Cameron Passmore: That's a lot.
Ben Felix: Right. So then July 1963 to June 1991, this is where Fama and French pulled the data from for their 1992 paper. The premium over the market was 4.96% annualized.
Cameron Passmore: Over 300 basis points more than the full dataset.
Ben Felix: Now, one thing that's interesting actually is that in a lot of the factor research, they talk about long short portfolios, so value minus growth. In this paper and in their paper last year about volatility lessons, the one that came out in 2019, instead of using long short portfolios, they're actually using how did value do relative to the market? They just say, "This is more practically useful." So long only, how did value do relative to long-only the market?
Cameron Passmore: Oh, interesting.
Ben Felix: Those numbers that I just said, the 2.77% for the full period and 4.96 for the 1963, 1991 period, that's value minus market return.
Cameron Passmore: Not value minus growth.
Ben Felix: Correct. In most of these samples, growth was pretty close to market, maybe a little bit under, so it would be pretty close anyway, but anyway. Then in 2000, like I mentioned before, Fama and French looked at what was then out of sample pre-publication from 1926 to 1963. Over that time period, the Fama and French U.S. value research index had beaten the CRSP 110 market by an annualized 2.4%.
Cameron Passmore: To summarize just so the listeners get this, for the period before the sampling period of the paper, that premium was 2.4%. For the period that the original paper was written on is 4.96%, and the period since the paper was 2.77%.
Ben Felix: No, the 2.77-
Cameron Passmore: What's the total? Sorry, you're right.
Ben Felix: ... is 1926 all the way to 2019.
Cameron Passmore: 2.4 before, 4.96 during. We haven't got to this sense yet.
Ben Felix: Correct. But it is interesting to know that this is not the first time they've tested this out of sample. Now, you mentioned this before, Cameron. This is all so far talking about U.S. market data. They also tested this in 2017, I think, was when they did that paper. They'd looked at the value premium in other countries, and they found it was robust.
Cameron Passmore: When are we going to find out what has been since the paper?
Ben Felix: It's coming. It's coming. I think it's the next point actually. For the more recent period, from July 1992 to June 2019, which is what they're looking at in this most recent paper, value did still beat the market, but the premium was an annualized 1.05%. It was not statistically different from zero.
Cameron Passmore: Meaning?
Ben Felix: Meaning, well, it's not statistically different from zero. We can't say with a high degree of confidence that the premium was-
Cameron Passmore: Caused by value?
Ben Felix: Was just random chance.
Cameron Passmore: Interesting. 2.4 to 4.96 to 1.05.
Ben Felix: Right. Now, the biggest decline in premium was for market value and big value, so small value had a decline in premium, but it wasn't as substantial. Small value still did quite well over this time period, but not as well as in past periods. But in both cases, for those big declines, market value and big value, the decline was not statistically different from zero. There was a decline in premium, but the decline was not statistically significant.
Cameron Passmore: Meaning, it's still reasonable to expect a value premium.
Ben Felix: Meaning, we can't say if that decline-
Cameron Passmore: That the opposite is true. You can't definitively say there's no more value premium.
Ben Felix: Correct. This is what they're looking at in this paper. One of the interesting things that they showed to just defer that discussion is that big value... This actually surprised me, but it makes sense. Big value made up an average of 11.6% of the overall market cap and the correlation between market and big value was 0.84. It was pretty high correlation, 0.84.
Cameron Passmore: Meaning, big value will perform much like the market?
Ben Felix: Pretty similar, but Fama and French's point is that the correlation is not one big growth. The correlation was 0.97. Big value, it's .84, so Fama and French are saying that leaves a lot of room for independent variation, just unexplained differences. Then they tied us back to the concepts they looked at in last year's paper about volatility, and they say that the volatility in the monthly premiums is high enough that we can't make any reliable inferences about expected premiums based on the average premiums over this one time period.
Cameron Passmore: This one 28-year time period.
Ben Felix: Correct.
Cameron Passmore: What do you take away from this?
Ben Felix: Well, basically what Fama and French say is that it's tough to draw any conclusions about whether the value premium has disappeared. Well, tough. It's not statistically possible to draw any conclusions about whether the value premium has changed or disappeared post-publication of their original paper. The reason that we can't draw those inferences at least with any degree of confidence is that there's so much noise in the data. There's so much volatility in the premiums that over a given period of time, it's really hard to draw any conclusions.
It's really hard to update our view of the world. Based on how strong our prior is, does this new information give us enough to say that the value premium has changed? Statistically, the answer's no.
Cameron Passmore: How similar do you think this is to the period in the late '90s, early 2000s where growth has such a great run? How much of that decade from 2000 to 2010 where value did outperform, if that happens again, could change the assumptions you can make around this statistical data?
Ben Felix: AQR did a paper last year talking about exactly that. Cliff even says in the paper, Cliff Asness says in the paper that this time period, this last decade is not anything like 1999, 2000. The reason is according to Cliff, and I hope I'm not misquoting him, but the fundamentals are much stronger for a value company. He says even in the last two years for the... Just take the whole decade. For the first eight years of the decade, he says that the outperformance of the growth stocks was warranted. They were actually doing that much better. They were actually surprising everyone.
Cameron Passmore: 0 to 98, you're talking about.
Ben Felix: No. This most recent decade.
Cameron Passmore: Oh, this decade.
Ben Felix: The first eight years, all these growth companies were earning their high evaluations, and continuing to surprise the market. But for the last two years, Cliff says that's not been true. Value stocks have actually been producing really good economic results, but their prices have not been reflecting it. Cliff obviously doesn't take the efficient market's approach as... I don't know if serious is the right word. He takes it seriously, but he allows for a lot more room in thinking about things from a behavioral perspective than say Fama would.
Cameron Passmore: Was all this risk... Because he's saying that the companies are performing better. This is not a higher... It's not a risk story as much.
Ben Felix: Right. He's saying for the last two years, the market is mispricing value and growth. He actually says... That's why I read this paper last night. Cliff did a paper years ago called Market Timing: Sin A Little, where it basically says you probably can't time the market, and you probably shouldn't try. And if you're going to do it, just do it a little bit and only when you're really sure about it. He came up with this paper last year saying, "Now is the time to time value."
If you're going to increase your weight and value stocks, now is the time to do it. The reason being the spread between valuations and value and growth stocks is wider now than I think it's ever been, or maybe not that it's ever been, that it's been for a very, very long time. The cheapness of value is much cheaper than it has been historically.
Cameron Passmore: Interesting.
Ben Felix: But again, Cliff's... He's very clear that market timing is not a good idea, but if you were going to tilt towards value a little bit more than usual, now is probably the good time to do it. I think it's just back to the Fama and French paper, their 2019 paper volatility lessons. Instead of looking at the historical data like they did in the more recent paper, they bootstrapped, well, I guess still using historical data, but they created 100,000 sample periods using random sampling from historical data just to see the effect of volatility on expected outcomes.
They found that in that research using the 100,000 samples over a given 10-year period, so... Well, I guess we're talking about 28 years here, but over a given 10-year period, there's a 9% chance of getting a negative premium for market value over market. Over 30 years, the chance of a negative premium was around 1% if I'm remembering correctly.
Cameron Passmore: Wow.
Ben Felix: I didn't write that one down, but we have not had a negative premium. Remember, it was not statistically different from zero.
Cameron Passmore: It's still there.
Ben Felix: But it was positive and not statistically different from zero, but not negative. It wasn't a statistically significant negative premium. Anyway, when I started reading their paper, I felt... This was just totally judgment and not having the information, but the feeling that I got was this seems like a lot of statistical magic to try and defend a position. Then you actually read the statistical methods that they use to look at this situation, and it makes a ton of sense. We don't have enough information to conclude anything.
Cameron Passmore: That value is dead.
Ben Felix: Correct. Then the other piece that I think is really important, and I thought this was interesting. No, I thought it was really interesting. I looked at that same sample period, July 1991 through June 2019, because remember, that whole discussion was about U.S. stocks. I thought to myself, "What about other countries?" Fortunately, I have easy access to that data, so I looked at the Fama and French research indexes for market wide value versus market for all of the countries that I had access to.
For Japan, over that same time period where U.S. market had a not statistically different from zero value premium-
Cameron Passmore: That's 28 years.
Ben Felix: Japan value minus market was 6.14%, which is huge annualized. UK was 0.29%, smaller. Emerging markets was 3.02%. Asia Pacific was 5.4%. Australia was 2.95%, and Canada, which I thought was interesting was actually negative, -0.53%.
Cameron Passmore: That's the diversification story, I'm assuming.
Ben Felix: It's a diversification story, but it's also like we're getting all worked up about whether the value premium still exists or not post-publication. In the U.S., we can ask that question because the data support... Well, they don't. We can't say statistically value premium is dead as we just talked about, but maybe before Fama and French's paper, it looked like you could have made that argument. Then you look around the world, and it's not so easy to make the same argument. I still don't think the value premium is dead.
Cameron Passmore: I think that's a good note to end on. On to our planning topic.
Ben Felix: Let's go.
Cameron Passmore: We're going to go through this one quickly. I know we're running long on time, but we wanted to talk about the total cost of ownership. These are expenses that happen when you start to invest. We'll start off with some of the hard costs, then go into some of the soft costs, which we'd love to quantify more, but at least we'll cover them in terms of the topics. Number one, the management expense ratio. This, I know there's lots of confusion. There's a lot of people who think the management fee is a management expense ratio. It's actually not.
The management expense ratio is a management fee plus the HST, so the sales tax plus the operating cost of the fund. This wide variations on these fees, depending the type of class of fund. You're in A class or F class, so you took a look at some of the data in the Morningstar database for U.S. funds looking for the 15 years ending December of 2017. I thought this was interesting. The cheapest quartile of funds had an average expense ratio of 0.83, so that's pretty cheap. Things are cheaper in the U.S. than in Canada, safe to say.
25% of funds beat their benchmark. Again, we've talked about this data, SPIVA type data, in the past. The most expensive quartile of funds in the U.S. had a fee of 1.93%, and only 6% of them beat their benchmark. These are the invisible fees. So many people, I've heard, say, "I don't really care what the fee is. As long as they do what they say they're going to do, I'm happy. I'm willing to pay whatever," but fees matter a lot. You start paying...
In Canada, it's not uncommon to see people that are paying well over 2% of management fees. You imagine a bond fund. You're paying 2.5% in many cases, or you even mentioned SEG funds earlier that are often about 3%. That is a lot of fees. This is invisible, just a little shaving off the top that goes on all the time that eats into your returns.
Ben Felix: Well, it's less invisible now, because we have the data and because people are talking about it. I think when you started in the financial services business, then it wasn't visible. People probably didn't even have the same availability of data to benchmark at that time.
Cameron Passmore: Yeah. I think fees weren't even... In my world back then, and this is a long time ago, fees weren't even talked about, didn't really matter. No one really cared.
Ben Felix: I think the point there is that the amount of an expense ratio, which is the easiest fee to see, because it's posted wherever you look at materials for any fund in Canada. That's one of the most important criteria to evaluate the total cost of owning. One of, it's not the most, but it's one of the most important cost to evaluate. It's super easy to find, which is nice.
Cameron Passmore: You also want to understand what part of that fee goes to the advice part of the equation. That's why we like to have the advice separated from the embedded fees of whatever products you might be in. If you're in a type of fund that has say a 1% trailer fee pay the advisor, you should know what that is, so you can find out what level of service you deserve for that fee that you're paying.
Ben Felix: I mean, not to mention the massive conflict of interest inherent in commission-based products.
Cameron Passmore: Right.
Ben Felix: I remember being in the mutual fund business, realizing index funds were the way to go. Then also realizing that there were no index funds that paid trailing commissions. I was not able where I was to charge fees directly to clients, so I literally structurally could not make an income well in recommending the things that I thought were sensible for clients.
Cameron Passmore: I lived that conflict for two or three years, way back then. This was before the real ETF revolution where you can buy an ETF now for five basis, 0.3 basis points, which is a fraction of just the HST that many clients at the time were paying on their mutual funds.
Ben Felix: You know where else this is relevant actually is with the whole class action lawsuit stuff that's going on with the discount brokerage.
Cameron Passmore: For sure.
Ben Felix: Because there were decades where people were buying A class funds that had the embedded commission built in through a discount broker that by definition could not give advice.
Cameron Passmore: Right.
Ben Felix: So when you're looking at the total cost of ownership, it's exactly what you said, Cameron. If you're paying for advice, make sure you're getting it or stop paying for it.
Cameron Passmore: Another one that is easy to see now is the trading expense ratio, the TER. This is the cost of commissions incurred by the fund in executing the portfolio. So if you look it up in the management report of fund performance, the line is in there. The TER is in there.
Ben Felix: It's not as easy as the MER, but if you open up the MRFP, which you can find on the fund webpage, click open the PDF and just control F for TER trading expense ratio, you'll be able to find the number. It's in there. It's not as clear as MER, but it is in there. In some cases, it can be as high as the MER.
Cameron Passmore: I've not seen any of that high, but it would be interesting to see that. The ones that we use are pretty tiny usually.
Ben Felix: Well, they're super low turnover by design, right? You get a high turnover, active ETF with a low MER. The TER could be right up there.
Cameron Passmore: But imagine if you're an active ETF, so all you're picking up there are an active mutual fund. The TER is only picking up the brokerage costs. It's not picking up any market impact costs. If you're deciding you're going to sell a huge amount of some share that you own, you could have an impact on the price. If speed is what matters, so you want to get rid of that stock as fast as you can, and you push the stock down. If you value speed over execution of price, you could have a huge impact. That's a soft cost that's very hard to quantify.
Ben Felix: It's an implicit cost. Stuff easily quantifiable, management expense ratio, trading expense ratio, or explicit, those are published. They're easy to quantify, but the implicit costs like the trading spread that you just mentioned, those can be huge too, but you can't... They're hard to measure. Dimensional has... They've shown us some research that even they said that, "We're not super confident in this because it's really hard to quantify," but they had attempted to quantify through some third party research firm, the market impact of their patient trading strategy, which they use in all of their products and a regular index tracking strategy.
One of the challenges with a regular index fund like the Russell 2000 is the-
Cameron Passmore: The classic example.
Ben Felix: Right, the classic example. It's a purely quantitative index, so the smallest 2000 companies in the U.S. market, I think. I don't know if that's the exact definition.
Cameron Passmore: Or that's the 2,000 smallest of the 3,000 largest.
Ben Felix: There you go. That's easy to identify.
Cameron Passmore: Say on the Russell 1,000, the 1,000 largest. Come that day, I think is in June, people know who's in and who's out.
Ben Felix: Everybody knows. Everybody knows, therefore, that index funds are going to have to buy and sell certain securities.
Cameron Passmore: On that day, because they have to have as little tracking error as they possibly can.
Ben Felix: So you can front-run. There's an extreme example of this going on right now, and I saw a tweet from Eric Balchunas. He had a little tweet thread about SDY, which is the SPDR S&P dividend ETF. It currently owns 22% of Tanger Factory Outlets. 20% of the whole company, that's one ETF.
Cameron Passmore: Oh, yeah. I saw that tweet.
Ben Felix: Right. It's fascinating. The market cap... Now, the reason they own it is interesting too. They own it because of its yield, so the SDY weight securities in the index based on yield. Anyway, so they own 22% of this company, but its market cap has fallen below the 1.5 billion dollar eligibility requirement for the index, so they are going to have to sell their 22% position in the company when index reconstitutes, because they track the index. That's their job. But talk about an opportunity to front-run a trade and talk about how much that hurts the index investors.
It's even the same. I've seen research on the price impact of S&P 500 reconstitution. That's super liquid, super high-volume trading securities, but the prices of companies that get included spike and dropped, drop. But the trick for the challenge for index investors is that on that day when the price spikes, that's when you're buying. That's an implicit cost that has a long-term impact that's hard to measure.
Cameron Passmore: People shouldn't take that as short advice from you, obviously.
Ben Felix: What do you mean?
Cameron Passmore: No, if you think that based on what Eric was saying about the Tanger, that he's going to sell it.
Ben Felix: Oh, don't go short it.
Cameron Passmore: Don't don't go short it now. Other charges, so sales charges, I don't think anyone pays anymore front-end loads. I think that's pretty much dead. I think the backend loads that we've talked about a number of times are going away, but to be aware of that. Other things that people say are similar to fees is one is cash drags. If you have a fund that has say 10% or 20% in cash, you're not going to have the same expected return as a fully invested portfolio.
Ben Felix: Which you might see in an active fund, or you probably will see in an active fund.
Cameron Passmore: They might say, "Well, we're being cautious, and we need to be opportunistic."
Ben Felix: We know the data around that though.
Cameron Passmore: Data is not greater on that because there's always a positive expected return from owning stocks in an efficient market. Another one too with high turnover is you could have a large capital gains distribution. Meaning, you could have a tax bill from them trading, which means less money to invest, so there's an implicit cost to capital gains being triggered.
Ben Felix: Foreign withholding tax, it can be huge.
Cameron Passmore: Not a good one.
Ben Felix: Especially when we're talking about super low fee ETFs, your foreign withholding tax costs can easily be more than the MER and TER combined for an index ETF. That's where you start getting into that concept of which types of ETFs should you hold, and which types of accounts just to minimize foreign withholding tax costs.
Cameron Passmore: Okay, and that's good for fees? We'll keep rolling. Bad advice of the week, we'll do this quickly. This is an article that I saw on The Globe and Mail. It was on actually the payment advisor site section, but it's an article called Advisors Must. Did you know that? Must become more familiar with liquid alternative funds as interest grows. This is an article that was published on January 21st in Globe and Mail. Basically, the article makes the argument that since rules changed just over a year ago to allow these liquid all funds to be sold. Advisors better up their game in the liquid alt game.
Data from the Investment Funds Institute of Canada shows there's over eight billion dollars in these kinds of funds, so funds and ETFs in the past year, but, and I quote, "Demand is expected to grow significantly as the market is forecasted to rise to a size of a $100 billion in AUM, so assets under management, within the next five years." That's pretty serious quote. It comes from the director and head of Alternative Investment Management Association, so AIMA, I guess, it's pronounced. Of course, the industry is telling you that there's going to be massive popularity. Therefore, you better up your game to be able to distribute these, because this is what people want.
The argument they're making is that they're popular due to the fact that they can short. They can use derivatives, leverage and other strategies that were typically only available to the high net worth crowd. That is always the pitch, right? That’s something democratization or something that the high net-worth crowd has. The main measure that advisors need to learn about this space, the providers and the solutions and that quote, "Liquid alt are increasingly important pieces for client portfolios. There needs to be a certain standard of care for any advisor investing in alts, but there is far more risk in being in long-only portfolios-
Ben Felix: Wow.
Cameron Passmore: ... especially given how late we are in a bull market." This again-
Ben Felix: Oh, it smokes.
Cameron Passmore: ... is another version of the 60/40 portfolio is dead argument, which we hear everywhere.
Ben Felix: That's a bold statement, though.
Cameron Passmore: I know, but look where it's coming from.
Ben Felix: There's more risk than being in a long-only portfolio than there is in using liquid alts.
Cameron Passmore: We discussed this back in episode 24, and some of the reasons why you might have different thinking around liquid alts, high fees, high turnover. I mean, I remember you talking about are there any theoretical underpinnings to these strategies? It's worth going back and checking out that episode. My takeaway is here's an article that makes it seem like a no brainer that us as advisors have to do with this. It comes from a part of the industry that's promoting these as solutions. Again, there's a lot of money in this particular part of the market.
These are not cheap products. They provide a tool to use if you believe the markets are dead argument. Bonds are overpriced. Securities are overpriced. Therefore, you have to do something for your client.
Ben Felix: They're pure alpha plays. It's trying to find sources of return that are not related to market risk premium or other risk premiums.
Cameron Passmore: But where is the reliable data to support that.
Ben Felix: Well, that's the voids-
Cameron Passmore: It's a storyline that many in our industry will certainly latch onto, and we've heard it a number of times from participants, but it's also a story, frankly, I think a lot of consumers want to hear too.
Ben Felix: Forget about us reading it. The article almost comes across as offensive to us, I think, but imagine being a DOI investor who's managing their own portfolio, and they read this. It's like, "Oh, the professionals are supposed to be looking at this stuff. I bet I should be looking at it, too."
Cameron Passmore: I better look at it, too.
Ben Felix: Then maybe you don't have the ability to evaluate it critically, and then it's like, "Well, maybe you should allocate to it." I've had questions from clients about liquid alts, surprisingly, but it is the thing. They're not wrong.
Cameron Passmore: For sure.
Ben Felix: I guess that's true actually. They're not wrong in the article. It is important for us to be educated on because people are asking questions about it.
Cameron Passmore: Right.
Ben Felix: We shouldn't be selling it.
Cameron Passmore: Exactly.
Ben Felix: But we should still be educated on it.
Cameron Passmore: You want to go up onto the special segment now?
Ben Felix: Yeah. We're just going to attack this discussion on at the end here. Tim Nash, the sustainable economist who was a guest on I don't remember which episode, but he tweeted at me after we discussed social responsible investing a couple of episodes back, and said that he had some follow-up comments that he'd love to chat about. I said, "Well, hey. Why don't you come back on for a quick discussion?" We had a call last week.
Cameron Passmore: Let's go and play it for everyone to listen to it, and we'll come back in the other slide and talk about our thoughts.
Ben Felix: Oh, good idea.
Cameron Passmore: All right.
Ben Felix: Let's do it.
Tim, you listened to our last Rational Reminder podcast episode, well, two episodes now when people are listening to this, where we talked at some depth about sustainable investing, which is obviously your thing. You reached out on Twitter and said you had some commentary, so I was like, "Hey, let's bring you on the next episode," and so here we are.
Tim Nash: No, it made me so happy to know that you had gone in and done your research on it. I just have so much respect for you and your brain for you to give the thought and the time and the attention to it. I do want to say thank you so much for your description of my services. At the end, you said, "What Tim does is help people figure out these trade-offs, and if they were maybe on the unfinancial part of the spectrum, dragged them over." Thank you so much. I feel heard. That's probably... I'm going to like clip that and create a little advertisement around it.
Ben Felix: I mean, I remember one of the times you and I were speaking, and I was asking you questions about sustainable investing. We ran into this thing where it was like, "Okay, well, this fund for this case that I was looking at, that meets the requirements they want," but I was like, "Man, but it has 60 securities." You were like, "Yes. This is where I live. It's managing that trade-off." I was like, "Okay, now I get it." Anyway, so–
Tim Nash: Some of the trade-offs are absolutely inevitable, so the points of agreement that I have for you is absolutely by screening out companies, you're going to be less diversified without a doubt. I can't really argue the higher fees. That's been a trade-off for a while, although I will say they are coming down. I'm writing a piece for the Toronto Star right now about BMO's new ESG ETFs, where they have the first asset allocation, and the MERs are very low on those. It is coming down too, but obviously, it is slower, right?
In terms of the innovations and those lower fees with ETS, it's going to take a while before we do have ESG options that are as diverse and as cheap as the traditional ones. I really don't have any argument with you about divergence on ESG data. This is just such a headache for me. I can't even tell you how much time I've spent shaking my fist at these different research firms, and really, I think part of it is keeping in mind that I think it is still very, very early days when it comes to ESG. I know there are a lot of these big numbers that get thrown around 50% of assets, but most of the way those things are counted is with very weak and voluntary tick boxes.
So although a lot of these institutional investors with billions and billions of dollars are doing ESG, and I'm using air quotes with my fingers here for the listeners, that it's usually a very weak definition. I would say we're in the second or third inning here, and that certainly one of the biggest things we need is a consolidation or a stricter taxonomy definitions of ESG, and then specifically around financial materiality, which is what I'm going to get into, that some ESG issues are more financially material than others.
So if your goal is to maximize profits, which I know for you and I think most of your listeners, that's the goal here. These wide smattering of ESG, it's going to be sticky. It's going to be money, but that doesn't mean that it's irrelevant. One thing that investors need to be worried about is when it comes to debt. You're absolutely right with the cost of capital assumptions that you've made there that when it comes to things like green bonds or these sustainable debt, I'm hoping for a lower return for investors, because that means that these projects are cheaper.
It means that there's more incentive to be able to build them the discount rates lower, right? So absolutely when it comes to debt, I would agree with you. My critique of your assessment really comes down to that assumption of lower returns when it comes to equities. Really what this comes down to is that a lot of these assessments that were done are assuming this shorter term zero sum game that I know with index investing, because it's the average is you assume, "Well, someone's earning slightly higher. Someone else has to be earning slightly lower," zero sum game.
But for me, it's really about understanding that especially index investors, long-term passive investors, the biggest factor when it comes to your long-term expected returns is going to be the growth in the overall economy, so these macro trends, population growth, productivity rates, market cycles. Those are... I think one study you had looked at was 13 basis points per month differential, and that's just nothing when it does come to these broader movements. I think one thing you did skip over a little bit is this explanation of externalities.
This has been an issue for me since I did my undergrad economics, where oftentimes when it comes to social environmental issues, economists hand wave saying these things are external to the profit maximizing equation. They're outside of it, but these things are hugely important. There was a report that came out from the UN that counted $6.6 trillion in negative environmental externalities. Most of that is from CO2 emissions but also on a lot of water issues, where these are negative impacts on the planet.
Negative externalities are also going to be things like the low wages and these poverty rates and the inequality that we're seeing, which is a huge systemic issue with our market right now. By capturing negative externalities, and investing in companies that have more of these negative externalities, it's like, "This is very much traditional capitalism and almost colonialism." Like, "Let's exploit people. Let's exploit the planet as much as we possibly can in order to capture those returns."
That's just being turned on its head right now. The way it's being turned on its head right now is because we are now starting to internalize those externalities, and it is still early days, but really, I would point to climate change is this is the issue right now, where we are in the midst of internalizing those externalities where all the major central banks, including the Bank of Canada, are really looking at this issue. For me, the biggest thing was the Bank of International Settlements, which is the umbrella for all these central banks.
They released a report this month, within the last few weeks, called The Green Swan. This is talking about a black swan event but specifically around climate change, where if I'm right in my thesis about the carbon bubble and carbon risk, which we've talked about before on the show, that we could have this radical change in asset prices. The way that would materialize is that we're internalizing the price of CO2. That's going to raise the cost of capital for a lot of these carbon intensive companies. That's going to change their discount rates.
All of a sudden, these net present value calculations that the entire market values depend on are now going to almost overnight potentially get lowered. Really, to me, if we're talking about sustainable investors and this assumption that you're going to do as well, if not maybe a little bit better, it really is predicated on this assumption that society will move to internalize these externalities. If that happens, then I think I'm going to be right, and 10 years from now, we'll look back on this podcast, and it's like, "Oh, Tim was there ahead of the time."
Whereas, it might not happen. We might continue to have these populist governments who don't want to do it and keep dragging their feet. I do acknowledge that, which is really why anyone who has any of these specific assertions about what ESG is and whether it underperforms or outperforms, they're all full of it. I won't swear in the show, but it's really like I could, that it's really that nobody knows. All I would argue is that we can't predict the future right now by looking in the rear view mirror, that a lot of these back testing and the backward looking empirical evidence doesn't apply to ESG analysis.
Just because it's so new, we really don't have data pre 2008, 2009 that is consistent, and that these things are emerging so, so quickly that, for sure, past performance is not indicative of future results.
Ben Felix: I think you're absolutely right. I think that prices will fall for the so-called bad companies, but that's not out of line with the research that we talked about when we discussed this in the last episode. That's exactly what they predict. What you would expect to see is as investors internalize the externalities, which is that specific language was used in a couple of those papers, as that happens, that's what causes the differences in cost of capital. You would expect the sustainable companies to have rising prices, the unsustainable companies to have falling prices to reflect the new cost of capital that takes into account the investor tastes.
But assuming you're a rational investor, what are you doing? When your oil companies drop in value, you're rebalancing. You're buying more of those assets that have fallen in price, which now have a higher expected return. That's the crux of the whole argument is that yes, you will see a fall in prices. That has to happen when the expected return increases. But for a long-term investor, it's not actually detrimental.
Tim Nash: Unless cashflow is impacted, right? That assumption that you make that the same profits are now going to be shared by fewer investors assumes that the free cash flow and the profitability of those companies remains unchanged.
Ben Felix: But it's the discount rate, right? The profitability, it's how much you're paying for those profits. That's what affects your expected outcome.
Tim Nash: Except that really that it's... It is that discount rate in terms of the net present value, but... Again, for a specific example, here, we can look at CO2 emissions. If we've got a carbon tax, what that's doing is increasing the price per barrel of costs, and lowering that profit margin over time, which is reducing the free cashflow of those industries. As well, there is this notion of the elasticity of demand that if price is through a Tobin tax, which a carbon tax is like a Tobin tax, this is how we would correct this market failure, that that higher price for the services is going to reduce demand over the longterm, and that what that's going to do is, again, reduce the profitability, reduce those free cash flows of those companies.
It's a fine balance here, right? I think that we're right that it is a little bit pendulum swinging back and forth. I think the biggest thing that I think we agree on here is that we don't have perfect information when it comes to this, and that there are going to be these market corrections and over corrections each way. That's why for me, really balancing those trade-offs is important, but really what I'm trying to communicate here is that I feel that by integrating ESG and by internalizing these externalities, we're going to have more information.
We're going to have a more efficient marketplace that we are going to see corrections to be able to account for that as the market becomes more efficient. For me as an investor, I'm being a little active here. I acknowledge that, that I'm trying to skate to where that puck is headed, and that the variables are going to be how far ahead do we want to skate? How long is it going to take for the markets, for the puck to arrive? It's been really interesting just the momentum over the last few months around ESG.
Really, what I want to... In your thesis, what you're saying is that as preferences shift, we are going to see that price discrepancy. What I'm trying to tell you is that it's second or third inning here that those preferences could continue to shift over the next 10, 20, 30 years.
Ben Felix: Interesting. It's like you said, instead of... It's an active bet, so instead of saying, "We're going to invest in the bad companies because the cost of capital is higher. Therefore, they have higher expected..." assuming profit maximization is the goal. Instead, you're saying, "Let's basically speculate on the green companies having better long-term results despite the market structure that we understand."
Tim Nash: In two ways, one, I would say we're finding new value, so just the way that we saw Warren Buffett recognized the intangible value in a company's brand. You know what I'm saying? This is a new form of value measurement. This might end up being a new factor in terms of these models. I don't know. It'll be interesting to see how that evolves.
Ben Felix: Interesting.
Tim Nash: But that also, I do think that when it comes to the... If we don't solve these systemic issues, like income inequality and climate change, I think that there is risk there for the broader systematic economy. To me, it's one of these things where if I'm right and this happens, then great. Hallelujah, I win. I'm going to outperform my bet. My thesis was correct. If I'm not right, and this doesn't happen, then we could be in serious trouble. Because if these market failures are allowed to continue, this could have a negative impact on the entire global economy as these risks emerge if the market doesn't correct for them.
Then from there, the flip side is that if you don't believe in my thesis, or if you're maybe betting against it, like some people are now going to anti ESG or overweight oil and sands, because they think that rebounds happen. Now, you're in a situation where if they're right, then they are going to earn more profits, but we're going to be left with a planet that's in trouble with the society that continues to see these really big tensions potentially like poor people with pitchforks coming off of the billionaires, which is the illusions that that's where we may be headed.
Really, what I'm doing is I am placing a bet on capitalism figuring out these market failures, because if they don't, my fear is that we are going to have some very serious systemic risks.
Ben Felix: I guess it comes back. This conversation that we're having right now comes back to the other fundamental question of, "Is the best way to change the economy and the behavior of corporations is the best way to do that through the stocks that you own?"
Tim Nash: I think that it has to be all of the above.
Ben Felix: Right.
Tim Nash: These are systemic risks, so there is no one way or the best way. In terms of the scale and the scope of climate change, we need absolutely everybody on board with this, and every strategy and tactic. I would argue that the stock market is such a source of power in our society, in our economy, that if the stock market isn't on board with this change, then I have a hard time seeing it actually having that change. I would just be cautious about this the best tactic or the best way, or these different things.
In my mind, if understanding the climate crisis and the scope of these challenges that we really need all hands on deck here, and that this does need to be across those pivot points, so those little power levers, that we need absolutely every lever to be activated if we are going to turn the ship around.
Ben Felix: That's good perspective, definitely fits with the view of a sustainable economist.
Tim Nash: I'm living up to my name.
Ben Felix: All right. Awesome. Thanks a lot for coming on, Tim.
Tim Nash: Thanks so much for having me.
Cameron Passmore: All right, so...
Ben Felix: The crux of Tim's argument is that the market is not pricing in the extent to which this climate risk is going to affect the economy. Is that an accurate way of describing Tim's comments?
Cameron Passmore: Yeah. My main takeaway was skate where the puck is going to be. He did say he's making a bit of an active-
Ben Felix: 100%.
Cameron Passmore: ...call for the... I'm not saying for the wrong reasons, but for what he believes in. He believes that cost of capital for these companies will decrease, which is exactly what you talked about, but the fact that it will decrease means that their prices will go up. Therefore, I'm going to go there now in anticipation of those prices going up and the cost of capital going down.
Ben Felix: Yeah, but I think it's even... He's thinking one step further, where it's like, "Yes. Yes, the expected returns." What would you expect to happen? Discount rates increase for bad companies and decrease for good companies. Therefore, we get a short-term drop in prices for bad companies, and a short-term rise in price for good companies.
Cameron Passmore: Right.
Ben Felix: Going forward, if you're rebalancing your portfolio, as you should be, into the bad companies that have now dropped in price, you're rebalancing the stock with higher expected returns.
Cameron Passmore: If they don't go to zero.
Ben Felix: That's what Tim is saying. Tim is saying he thinks that the market will not price in how bad it is going to be for those companies, and therefore, it does not make sense to hold them. It is a purely active bet as Tim acknowledged. It does not align with our thinking at all, but it is interesting to hear how Tim is thinking about it.
Cameron Passmore: I never heard the term Green Swan before. Maybe you mentioned it. I don't recall, but the Green Swan could lead to radical change in asset prices. That's exactly the argument that the MSEI chairman and CEO said. I think it was last week or two weeks ago, saying that investors who ignore ESG criteria will underperform dramatically.
Ben Felix: None of that is theoretically or empirically accurate because you look at tobacco companies. I read an article recently where when tobacco companies fell out of favor, when they became bad companies, yes, their cost of capital increased, and they went on to have great returns.
Cameron Passmore: Because they didn't die.
Ben Felix: Because they didn't die. Now, we talked about this in the clip, but Tim says that's because they were able to find... Was that in the clip, or was it before the... I can't remember. But Tim said that's because they were able to find new markets. Tobacco companies fell out of favor in developed countries. Cost of capital went up, and they went, "Okay." They went and exploited all the emerging markets that had less education around the effects of tobacco use. I thought that was a pretty good counter argument to why tobacco did well.
Cameron Passmore: If you believe companies may be going to zero, like oil or natural gas companies, you're also assuming they're not going to reposition the user capital in some other market.
Ben Felix: I asked Tim about that, and he was skeptical. Again, I can't remember if that was in the clip or not. Hopefully it was. I mean, you can say the same thing for small companies or value companies. These are companies that are out of favor with the market. By definition, if you are diversified, you should still be able to capture the risk premium, theoretically. Tim is saying the market's not pricing it properly, and you're toast. It's interesting that Tim is saying that's not only from the perspective of this is good for the environment and whatever, which is an important part of what he's saying, but he's also saying there's alpha here.
Cameron Passmore: Anyways, interesting to get his feedback. Glad to have him back on.
Ben Felix: This episode's over an hour. Someone once told us that they wouldn't want us to go over an hour, so sorry to that person.
Cameron Passmore: All right, thanks for listening.
Book From Today’s Episode:
The Ride of a Lifetime — https://amzn.to/2zT62yn
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Benjamin on Twitter — https://twitter.com/benjaminwfelix
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'The Value Premium' — https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3525096
'Volatility Lessons' — https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3081101
'Market Timing: Sin a Little' — https://www.aqr.com/Insights/Research/White-Papers/Market-Timing-Sin-a-Little
'It’s Time for Venial Value-Timing Sin' — https://www.aqr.com/Insights/Perspectives/Its-Time-for-a-Venial-Value-Timing-Sin
'The Green Swan' Report — https://www.bis.org/publ/othp31.pdf