Episode 98: Rapid Fire Listener Questions, Wealthsimple’s Victory Lap, and the Historic State of Value Investing

Benjamin Felix:

This is The Rational Reminder Podcast, a weekly reality check on sensible investing and financial decision-making for Canadians. You’re hosted by me, Benjamin Felix and Cameron Passmore.

Cameron Passmore:

As Ben tries to sit still and not have his chair squeak, and I’m sitting here at home holding my dog to just be quiet for a couple more minutes.

Benjamin Felix:

That dog’s been good. We’ve been recording for a while.

Cameron Passmore:

The dog has been great actually. We record the intro after we record the episode. I think most people know that now. Anyway, you wanted to kick it off by talking about the new facility we have on The Rational Reminder website.

Benjamin Felix:

Yeah, we’re trying out a new comment engine called Commento. It allows for up votes and down votes, and threaded discussions. It feels a lot like Reddit which is awesome. Some people have said we should start our own sub-Reddit to talk about this stuff. I kind of like the idea of something that we can take with us to whatever website we have.

Cameron Passmore:

Yeah, feels like a community, which I think is good.

Benjamin Felix:

Yeah. Anyway, if you have comments and questions, I get a lot of emails from podcast listeners, which is awesome. If you can instead, post those comments and questions on The Rational Reminder site, that to me just feels better because I don’t think receiving lots of individual emails scales very well. I think if people post their comments on the website, then other people can see it, and then maybe they don’t send the question in because they see the answer, or they see that somebody else has already asked it. Anyway, we’re trying this thing out.

Cameron Passmore:

All the other questions, that might improve the answer as well.

Benjamin Felix:

True.

Cameron Passmore:

It’s just good.

Benjamin Felix:

It turns into a discussion in a community, like you said. At therationalreminder.ca website, we have like a blog post for every podcast episode. At the end, there’s a section for comments.

Cameron Passmore:

Yes, please direct your comments and questions there. Speaking of questions, today we have a new, just for today anyways, we tried a rapid fire series of questions back and forth just to kind of mop up some of the questions that have come in lately, which has been great. Some very good questions.

Benjamin Felix:

I don’t know how rapid fire it was in the end, but we did our best.

Cameron Passmore:

Some were. The first five were pretty rapid, but it was good. Also, we’re on YouTube, so if you want to see Ben’s new Schwinn AirDyne Pro bike, it’s in the background of his …

Benjamin Felix:

Barely, you can barely see it.

Cameron Passmore:

You can barely see it.

Benjamin Felix:

You can barely see it.

Cameron Passmore:

But it’s there. It is there. You’re actually using it every day?

Benjamin Felix:

I’ve used it every day except for two since I got it, so that’s seven of nine days, I think.

Cameron Passmore:

Nice. I’ve only missed one day since we’ve been home and this is week nine. I’ve only missed one day on the Peloton.

Benjamin Felix:

Wow.

Cameron Passmore:

I have some colleagues who I know are listening. We now try to ride most Saturdays. I can’t keep up to them. Man, I don’t know how they do the calorie burn they do, but anyways, I’m getting better every week.

Benjamin Felix:

How do you guys measure what you ride?

Cameron Passmore:

The data is all there, so it measures your output.

Benjamin Felix:

How many kilometers do you go?

Cameron Passmore:

What is it now? I forget. In half an hour I burn almost 500 calories. That’s the main measurement. I think it’s like 18, 19 kilometers in half an hour. Does that make sense? Have you yet watched The Last Dance?

Benjamin Felix:

Nope.

Cameron Passmore:

Ugh, it is so good. We watched the first four. They dropped two more on whatever it was, this week, and two more came out this week. Two came out last week. Two come out this week. Wow, what a series. You’ve got to watch it. It is so good. So fascinating. The drive that Jordan had and the impact he had to get the team to drive for victory through the 90s. Incredible. Absolutely incredible.

Benjamin Felix:

Yeah. Recently I saw something that compelled me to watch it. It was that there’s a … This is from someone who I know knows basketball. They said that there’s a whole storyline in there that they hadn’t previously known about, so I just kind of figured I know that I know the Jordan story, but maybe I don’t, so I might check it out.

Cameron Passmore:

It’s also ownership, and management, and coaching, but it’s his. Man, once he’s down, and his drive to victory. Take that with his unbelievable skill at basketball, it’s so much fun to watch. He is just insanely talented. He was around other like Dennis Rodman, and Scottie Pippen. These guys are crazy talented. Anyway, I love it. I absolutely love it. Can’t wait for the next two to get dropped.

Benjamin Felix:

Anything else?

Cameron Passmore:

Nope. Let’s head on over to the episode. Here we go.

Benjamin Felix:

Welcome to Episode 98 of The Rational Reminder Podcast.

Cameron Passmore:

For recent content, you wanted to kick it off by talking about the Joe Rogan Show?

Benjamin Felix:

Yeah, I don’t always listen to it, but Elon Musk was on there again, and I find him to be interesting. I mean I think everybody does.

Cameron Passmore:

Yeah.

Benjamin Felix:

The overall conversation was, I mean, interesting, but not super relevant to … It’s not going to change your life. It’s interesting to hear that somebody like him is thinking about these things, but something that he said at the beginning I thought was interesting. He’s talked recently about getting rid of all his, or a lot of, his material possessions, and Joe Rogan asked him about that. He said, I don’t remember the exact words, but I remember the idea.

Benjamin Felix:

He said that possessions become an attack vector when you’re very wealthy, so as the billing era, it’s easy for people to come at him and whatever, say bad things about all the things that he has. He does own a whole bunch of houses, so he wanted to eliminate that attack vector, but he also said that …

Cameron Passmore:

That’s interesting. He’s very conscious about being attacked.

Benjamin Felix:

Yeah.

Cameron Passmore:

Has some sort of negative impact on him obviously.

Benjamin Felix:

Yeah, and he says there’s a negative stigma associated with being a billionaire today. He said to him it’s perplexing because he’s, I can’t remember the exact wording that he used, but he’s created this company, or these companies, that are doing lots of great things, and creating jobs, and making the world a better place. He gets now more capital to allocate because of that, and so he’s saying I don’t know why this becomes a bad thing. This is the part that I found most interesting. He says that there’s a conflation of spending and capital allocation.

Benjamin Felix:

The stigma that we have for billionaires comes from this conflation of spending because billionaires can choose to spend a lot, and the ability to allocate capital because the Capitalist machines deemed you to be one of the best capital allocators.

Cameron Passmore:

Right, but what they invest their capital on, in terms of their business and creating new projects, is probably much, much larger than what he spends on his own personal stuff, but the personal stuff is easier to attack on, I guess.

Benjamin Felix:

I think that’s what he’s getting at. Now, he’s just saying I’m not going to have any personal stuff so that people can only view me as an allocator of capital.

Cameron Passmore:

Interesting. Just eliminate the argument completely.

Benjamin Felix:

Yeah, eliminate the attack vector, in his words.

Cameron Passmore:

Fascinating. Yeah. Anything else to add to that?

Benjamin Felix:

Nope. I only listened to the first half of the episode, so if there was other stuff discussed in the second half, I missed it.

Cameron Passmore:

Maybe next podcast, I’ll go check it out and listen to it. I had a couple of books, just quickly. One is Shane Parrish. I give friend Shane Parrish’s new book, The Great Mental Models. I know you and I got a copy of the first book. I ordered the second volume, which again, it’s about the great mental models, and this one is about physics, chemistry, and biology, which was not at all what I was expecting. I knew it would be about mental models, but it’s interesting how he takes these rules from these sciences, and applies it to real world situations.

Cameron Passmore:

I mean we all know that Shane Parrish, and Farnam Street, and The Knowledge Project is all about helping people improve, and learn, and develop their mental disciplines to lead a better life. This book kicks off, if you can believe it, with the theory of relativity, and how it’s founded on empathy, and a quote, “Not empathy in the ordinary sense, but in a rigorous scientific sense, through crucial ideas to imagine how things would appear to someone who is moving in a different way than you are.”

Benjamin Felix:

Wow.

Cameron Passmore:

He gives a scientific example of if you’re on a boat, and you’re dropping a ball, you know gravity pulls that ball to the bottom, so to you, it looks like the ball’s falling straight down, but if there was a porthole and someone was on shore seeing it, they might see the ball kind of go with the boat, so it’s not directly vertical. He then links it to taking a different perspective in looking at life. He does a really nice job about it.

Cameron Passmore:

Much like his first book, the physical presence of the book is impressive. It’s beautifully constructed, beautiful paper, beautiful fonts, so you get this whole … The book is almost representative of what’s in the book. It says, “Complicated, beautifully built thing to give you a framework to make better decisions,” was what the book is about. Great, great book. It took a long time for it to come in. I think it’s sold out on Amazon now.

Benjamin Felix:

Wow.

Cameron Passmore:

Highly recommend that you get your copy.

Benjamin Felix:

Shane puts out great stuff. He’s such a thoughtful guy.

Cameron Passmore:

Yeah, so the next chapter is on thermal dynamics, and I know this is entering your field of engineering, so it’ll be neat to see how he links that to better mental models.

Benjamin Felix:

Yeah.

Cameron Passmore:

The other book, quickly, is a book called Smarter, Faster, Better by Charles Duhigg. Terrific book. It’s actually one of the nine top books recommended by our good friend A Mirzaee of The Fellow App. He put out a tweet a couple weeks ago recommending this as one of his top nine books that will, his quote here, “They’ll help you lead with confidence.” I ordered it up. The book was inspired by another author, Atul Gawande, who wrote the very famous and excellent book called The Checklist Manifesto.

Cameron Passmore:

Charles Duhigg took two years to dig into the science of productivity, and he just poured over scientific research for two years into eight different categories. The categories are motivation, teams, focus, goal-setting, managing others, decision-making, innovation, and absorbing data. What is so good about this book is that each chapter basically stands alone. They’re just fabulously written and really interesting.

Cameron Passmore:

One quick example because I’m sure you’re going to ask me that is on goal-setting, he talks about how stretch goals can spark innovation, but only when people have a system for breaking that big goal into concrete plans. We’ve all heard about having a big, hairy, audacious goal, and that is motivating to some people. While it may be motivating, if you can’t turn that goal into action, his point is kind of what good is it? It’s all about being able to break that goal down into concrete steps.

Cameron Passmore:

Another thing he talked about too is, and this related to me, is to be aware if you have a high drive towards cognitive closure, and I have this pretty seriously where I love to get things done, so he says to watch for when your drive for closure doesn’t freeze you from considering other information that may be important in making that decision. I have to be conscious about that for me. It was interesting that he talks about that at quite a length about this cognitive closure need.

Cameron Passmore:

Other couple of good stories about what can be learned from some pretty serious plane crashes in history, and how there are behavioral things that happened during those crashes. Again, fantastic book.

Benjamin Felix:

Cool. I’ve actually read it.

Cameron Passmore:

There’s my content tips for this week since we missed it last week, last time.

Benjamin Felix:

Oh yeah, we did. We changed the structure last time.

Cameron Passmore:

Yeah. Onto the rapid fire questions.

Benjamin Felix:

Yeah, as we mentioned in the introduction, we’re introducing, maybe this is the only time we do it. I don’t know. Most people say they love it. Although, I guess, we’re also limited by the number of listener questions. We had, for whatever reason, a ton of new listener questions that came in between the last episode and this one.

Benjamin Felix:

Sometimes I look at listener questions and they’re not interesting to answer, or they’re easy to answer in a quick email response to the person asking the question, but for whatever reason, this week we had a whole bunch that were good questions, interesting to discuss, so rather than try to spread them out, we just decided let’s insert this maybe one-time section of rapid fire question and answer.

Cameron Passmore:

All right. Let’s make it rapid. We kick off the first one, which is an audio question.

Speaker 3:

Hi Ben. I’m a US investor from Portland, Oregon, in my late 20s, hoping to capture the value and size premiums. In your paper, Factor Investing With ETFs, you outline a sample portfolio. It includes a 22% equity tilt towards US large value, and US small value ETFs. Would you consider this to be a more conservative or aggressive value tilt, and what would be your upper limit of tilt for a long-term investor?

Benjamin Felix:

Yeah, so the first thing to note is that the model portfolios in that paper are being revamped. Like anyone that pays attention will notice, we’ve taken the model portfolios down off of our website. That was because the historical data was past six months stale, and I don’t think we’re allowed to have it posted when it’s that old, but anyway, we’re taking a bit of time to revamp them. We’ve got our eye on a couple of newer ETFs, but I’m kind of just waiting until they have a bit more performance history.

Benjamin Felix:

Anyway, in that Factor Investing With ETFs paper, I would call the tilts conservative. The design there was meant to match what Dimensional does in their portfolios, which again is a preference based tilt that is aggressive enough to give you higher expected returns, but not aggressive enough to result in really extreme tracking error, which is always the risk with factor investing, and this year has been a really good example of that.

Benjamin Felix:

The most aggressive tilt that you can get without leverage is something like what Alpha Architect is doing. I looked at their QVAL ETF is 41 stocks, so that’s 41 of the cheapest, but still high-quality stocks that you can get. What is aggressive? I mean that is. With the ETFs that we have in that model portfolio, it was IUSV and IJS, if I remember correctly. That’s what was in our model portfolios anyway.

Benjamin Felix:

In terms of a factor tilt, I think those are pretty conservative. IUSV is market wide value. IGS is small cap value, but they’re both fairly diversified. IGS is 488 small value stocks. Remember QVAL, I said, has 41 stocks.

Cameron Passmore:

Big difference.

Benjamin Felix:

Yeah. I mean you can go factor tilt is kind of step one, and then concentration gets you more exposure to that factor tilt. I think with concentration you start introducing the possibility for having a big alpha positive or negative, like an unexplained component of the return just by missing stocks. Basically, the distribution of stock returns is that concentration probably gives you a negative alpha on average, although I think Wes from Alpha Architect would counter that because they’re finding under-valued stocks that’s not a risk story, you’d expect a positive alpha. Anyway, that’s a different debate for a different day.

Benjamin Felix:

Ultimately, I think the level of the tilt is highly subjective. Like I mentioned before, Dimensional basically built a preference based tilt based on what the advisors that they were working with thought that their clients could handle. We’re living that now where we have a slight tilt towards small end value, and even that slight tilt, when values trailing, or small values trailing market by negative 20% so far this year, even a slight overweight starts to make a pretty significant difference.

Benjamin Felix:

Then, just one more note on the idea of factor tilting, being aggressive versus not aggressive, I don’t think it’s as much about the absolute level of risk. I don’t know if it’s fair to say that adding small value and value together with market increases your absolute level of risk, and I say that because they’re independent risks. I don’t think adding small value to market is not the same thing as decreasing your bond exposure.

Cameron Passmore:

Absolutely agree.

Benjamin Felix:

Decreasing bond exposure, that’s decreasing equity risk. Adding small value is adding independent equity risk factor.

Cameron Passmore:

Yep.

Benjamin Felix:

Yeah, so I think it’s going to come down to preference, and the risk is just tracking error. Higher tracking error comes with more factor exposure.

Cameron Passmore:

Of course, number two is for you, and you get one minute less to answer this one because we said three minutes for each one. You’ve got two minutes for this one.

Benjamin Felix:

Okay.

Cameron Passmore:

Is there any noticeable benefit in trying to capture some size premium in Canada by using a combination of ETFs such as a mixture of XIU or XIC with XMD or XCS?

Benjamin Felix:

Okay, so XIU is S&P/TSX 60. It’s short small cap. It’s the 60 largest stocks in the country. By nature of excluding small cap, it’s short small cap. Going XIU plus a small cap ETF, you’re just going to get market. You should have just bought XIC. If you’re starting with XIC, and you’re talking about adding XMD or XCS, they’re both small cap universe funds, which include the small growth low profitability, which we’ve talked about in the past, really hurts the risk adjusted returns of small cap.

Benjamin Felix:

Now, Cliff Asness, I made that suggestion to him that if you’re going for small cap, you have to basically have to go small cap value because small cap universe drags your performance. Cliff disagreed. I think Cliff would disagree with anything anybody said. It’s just what it is, but anyway, he came back with a very, very good point. That was in Episode 93 that we had Cliff. He said that small cap universe has the higher beta than the market portfolio, so it doesn’t give you the independent risk that small value does, for example, but it does give you a higher beta.

Benjamin Felix:

If you want to have a riskier portfolio, you’re already 100% equity, and you don’t want to use leverage, using something like XCS or XMD could give you the higher beta. That’s the goal. More market risk, more market beta than just a market portfolio, and you don’t want leverage, then you could use one of those ETFs, but you’ve got to remember that comment I made earlier about factor risks not necessarily being additive. In this case, it is because it’s not an independent risk factor. You’re getting more market beta. Done.

Cameron Passmore:

There you go. Right to the second. Well done.

Benjamin Felix:

Okay, next one’s for you. How do you adjust RESP asset allocation as kids get closer to school age, and what do you do with leftover money in the RSB?

Cameron Passmore:

Can you tell that certain questions are designer more for you more than me? I think they’re onto us. I learned early in my career that many people consider RESP savings sacred, so I learned to be very in-tune with people’s risk profile in the RESPs because it isn’t always about the timeframe. A lot of people view the RESP just as a vehicle. They’ve got the 20% grant, and prefer to be very conservative.

Cameron Passmore:

My kids are 19 and 21, so they are at their tail end of their RESP. Benefits, we maximize all through the years, and we started the early years with all equity. I think once they got to be about 8 or 10 years old, we migrated over to the 60/40 portfolio. Then, I think when they were 15, we flipped to 40/60, so 40 equity, 60% bond, and we left it there. There’s about a third of the account left, the back end, for them to use up.

Cameron Passmore:

I think it really comes down to whether or not you need the money to fund education costs. If you don’t need it, and you wanted to defer it, that is an argument to have more equity tilt, realizing that you could get some sort of left-hand talent performance that could hurt you. It also becomes a question of tax planning because, of course, the growth and grant comes out taxable, so if your children aren’t working, you may want to take some money out early on just to trigger that taxable income and their low tax bracket hands.

Cameron Passmore:

If you don’t need the money, and they’re over 18 years old, they may have enough TFSA room to use up those funds in their own name, but again, you have to make sure that your kids are mature enough to properly handle an account in their own name, and they don’t go and blow it on other things that you might deem to be appropriate. A lot of people we’ve seen leave it right to the end. Let it defer the growth as long as they possibly can, other than the tax site of course. You would add to that?

Benjamin Felix:

No. Yeah, I think the biggest takeaway for this one is that the time horizon for the RESP is way more flexible than most people think it is. Like your comment about it being sacred, I agree, but I think that’s also a flaw in thinking about it. It’s sacred because it’s very easy to use mental accounting and allocate this specifically to education costs, but it’s just another bucket of assets.

Cameron Passmore:

Absolutely it is.

Benjamin Felix:

The only special characteristics are the way that it’s taxed, which is related to a child being enrolled in post secondary education, but there’s no requirement to take it out to pay for school.

Cameron Passmore:

Sometimes you’ll be talking to parents of not maximizing, you talk to them, and their kids will be 12, 13, 14 and they’re planning on using their line of credit. Instead of using the line of credit, use your line of credit now to get the grant, and then invest it from there.

Benjamin Felix:

Yeah, everyone should use the RSP. I guess unless you’re certain that the child wasn’t going to go to school. Even then, you could probably make an argument for using it. If you think about it, if the child doesn’t go to school, post secondary education, qualifying post secondary education, which is a pretty broad category, it’s not just university, if they don’t go, worst case is you pay back the grants. You pay tax at your tax rate plus a penalty on the growth, and you get your contributions back without any penalty or anything like that. Worst case, it’s not that bad.

Benjamin Felix:

On the asset allocation piece, if you were 100% equity, and markets were down, and you didn’t need this asset to pay for school, if you could afford it from cash flow, you could just leave it invested until they were done. I think it’s six months after they finish their program that you can do the tax efficient withdrawal, so depending on their tax situation too, because obviously all the income is taxable now …

Cameron Passmore:

You just hate to see their lower tax brackets go by each year when you could take it out and do their TFSA if you didn’t need the money.

Benjamin Felix:

You can take it out and stick it in, I mean assuming you can get it out tax efficiently, you can put it in whatever. You can leave it invested is the point.

Cameron Passmore:

Yeah, I agree.

Benjamin Felix:

You can take it out of the RESP and reinvest it in whatever other account. Maybe a taxable account, but from an asset allocation, from an investing perspective, you’re not constrained by the time the child’s in school or especially when they enroll in school.

Cameron Passmore:

Yeah.

Benjamin Felix:

Another one for you. What ETFs would be best to use while implementing the Smith Maneuver? Should it be treated just like any other non-registered account? A vast majority if people online are saying that investing in dividend paying individual stocks is the best way to go for the Smith Maneuver. What would be your take on this?

Cameron Passmore:

Sure. Throw me the dividend question. Keep your blood pressure down. First of all, my bias is against leverage. That’s a personal thing. I prefer to build a plan that doesn’t require leverage. I really like the term that Wade Pfau used a few episodes ago talking about safety first planning, but that’s just my personal bias. For people to say to use dividend stocks because it allows you to take your tax efficient dividends earned in that account, the idea is to use that to pay down the non-deductible part, and that cash flow just comes in.

Cameron Passmore:

We talked about dividends probably dozens of times in this podcast, and I get the appeal of having dividends come in, so it just flows across the non-deductible side. The problem is you end up with a much more concentrated portfolio of Canadian stocks. That’s the biggest thing you’re giving up. If you’re going to behave better because you own dividend stocks, and again we’ve said this many, many times before, fine, own dividend paying stocks, but there’s no reason to expect them to perform any better. I personally just stick with whatever portfolio you deem to be appropriate for you, and stick with that.

Benjamin Felix:

Yeah, I agree. There are little snags, like if you’re doing the Smith Maneuver, and you use the ETFs, and there’s return of capital, that can affect the deductibility of the loan technically, which is another reason I think people say to use dividend stocks, but yeah, I think what you said is the best way to think about it.

Cameron Passmore:

Okay. Here’s one for you. Has the role of bonds, or bond ETFs, changed in light of COVID-19 and the resulting downstream effect on bonds, government or corporate?

Benjamin Felix:

I think what this question is probably getting at is all of the fiscal stimulus that’s been going on. Governments are borrowing lots of money, going into big deficits to stimulate the economy or to provide liquidity to people and businesses. The concern when that’s happening is what happens if governments can’t borrow anymore? Governments are borrowing more and more money, increasing the supply of safe government bonds. What happens if people stop buying them?

Benjamin Felix:

Interest rates go up. Bond prices go down. Are they really a safe asset in that environment? I think that right now, looking at the world as it is now, bond yields are still extremely low. Bond prices have come up this year, and people keep saying that can’t happen anymore. The end of the bond bull market, and I agree.

Cameron Passmore:

I said it for years.

Benjamin Felix:

It’s got to stop at some point. We’re going to talk more about bond, long-term bond returns, in another segment of the episode today, but based on that, based on prices being high, yields being low, the demand for safe debt is very high right now. Is that going to dry up? I mean that’s the question that I can’t answer. We can maybe look at Japan as an example of how this has played out in other countries, but Japan’s kind of gone through what it looks like maybe developed countries Canada and the US are going through now.

Benjamin Felix:

They’ve done massive stimulus packages for years now, monetary and fiscal. We’re talking about fiscal here. Japan’s debt to GDP now, right now, is about 200%. The US is a little over 100%. Canada’s at about 50%.

Cameron Passmore:

Really? Interesting.

Benjamin Felix:

Now, I think one of the criticisms about statistic for Canada is that a lot of our services are provincially run, so a lot of our debt is actually provincial debt.

Cameron Passmore:

Oh, that’s just federal.

Benjamin Felix:

Yeah, so that might not be totally accurate.

Cameron Passmore:

But anyway.

Benjamin Felix:

Focus on the US then. Either way, Japan’s at a much higher debt to GDP ratio. Now, Japan’s debt has gone up steadily since the 1990s when they had their big economic shake up, and they’ve still kind of been struggling to recover from. That keeps going up and up. Maybe we look at what their bond returns have been like over that time period. This is not an academic research paper. I just thought it was an interesting data point.

Benjamin Felix:

Japanese government bond returns hedge to US dollars, and we have to do the hedge, otherwise you get the currency volatility in there, so this is US dollar performance, like evaluated in US dollar terms. Since 1990, Japanese government bonds have returned 5.83% annualized, while the US government bonds have returned 5.77%, and global government bonds hedged to USD have returned 6.02%, so all pretty similar.

Cameron Passmore:

Very tight.

Benjamin Felix:

Very tight. Risk adjusted, it’s actually interesting over this time period, world government bond hedged to USD has had meaningful, I mean it’s all relatively small differences because we’re talking about fixed income, but pretty serious difference in risk adjusted returns over this time period. Anyway, that’s not the point here. Point is, Japan bond market’s been fine despite their continuously increasing debt. That’s not to say it’s not going to collapse one day. Maybe. I can’t predict the future either, but if that’s any proxy for what could happen, the US has a long way to go before their debt levels start to look like that.

Benjamin Felix:

As long as there’s global demand for bonds from these types of countries, Japan, US, Canada, sure, maybe but scary with all the oil stuff happening for our economy, but hey. I think as long as that demand stays high, I don’t think bonds are … Their role in the portfolio has not changed. Their yields are low, but you didn’t own bonds to be a high-yielding asset in the first place.

Benjamin Felix:

Now, to be fair, as low as bond yields are, and like you said Cameron, people have been saying for years that bond returns are going to be terrible. They’re going to be terrible. They’re going to be terrible. They’ve been fantastic.

Cameron Passmore:

Especially long bonds.

Benjamin Felix:

Especially long bonds, but even just ZAC, aggregate bonds in Canada is up 5% year-to-date.

Cameron Passmore:

Yeah. Next question. I’ll take some time back from you. What do you think about Wealthsimple’s claim that their well-designed portfolios protected their clients in this downturn? We talked about Weathsimple’s portfolio’s update in an earlier episode, and you basically said you didn’t agree with some of their main philosophical and structural decisions, but they posted an article, I believe it was late last month, which was kind of sounded like a victory lot on those changes they made. Given your prior commentary, our prior commentary, and this letter, what do you think?

Benjamin Felix:

I got a bunch of questions about it, probably because we put that commentary out there for everyone to see, and then Wealthsimple comes back and has this, I don’t know what you would call it, empirical evidence, that their decisions were good ones.

Cameron Passmore:

Here we go.

Benjamin Felix:

That’s more of an anecdote, not really empirical evidence. Anyway, in their article, they’re basically saying we made all these changes that we told you about, and we did them for these reasons, and they worked in this downturn. We protected your downside. They’re attributing that to mostly to low vol stocks, which we talked about way back whenever we had that discussion about this, and long-term government bonds.

Benjamin Felix:

The framework for doing that, I can’t remember if we talked about this last time we discussed this or not, but the framework for doing that is based on, I guess, risk parody would be the framework. It’s like if you own a 60/40 portfolio of stocks and aggregate bonds, or short-term bonds, the risk in that portfolio, even though it’s 60% by asset allocation, the risk is dominated by stocks, if you measure risk as volatility.

Benjamin Felix:

The volatility contribution to that portfolio is … Probably 90 or more percent of it comes from the stock allocation, even if it’s a 60/40 portfolio. The idea behind adding long bonds is that they’re going to be much more volatile, but negatively correlated, or uncorrelated, or whatever, with stocks. Probably a slight negative correlation in the historical data anyway.

Benjamin Felix:

That’s the idea is if we add these long bonds in there, the risk contribution of our fixed income portion of the portfolio is going to be higher, and that should be a good thing over the long-term, in terms of risk-adjusted returns I guess. Now, in the risk parody world, you don’t care about expected returns. You only care about risk adjusted returns and you leverage up to the expected return level you want. Anyway, they’re not going total risk parody, but it’s sort of approaching that framework.

Benjamin Felix:

Now, this year, low vol stocks have done better in the market. If you look at ACWV, which is what they talked about using in the paper that we critiqued. I don’t know if that’s what they’re actually using in portfolios, must be. Compare that to ACWI, that’s All Country World Index low vol versus All Country World Index from iShares, they’ve got about a 3% premium over the market low volatility stocks, which is meaningful.

Cameron Passmore:

Year-to-date?

Benjamin Felix:

Yeah. I mean that’s a tiny portion of their relatively good performance compared to the market. Most of it’s coming from the long bonds. Across all of their model portfolios, again this is from their white paper, where they show I think conservative, moderate, and aggressive. All of them were 15 to 20% long-term Canadian government bonds using the ETF as EFL from Bima.

Benjamin Felix:

Now, that ETF, when I looked, I haven’t looked today, but as of last week, it was up 12% year-do-date. Keep thinking while everything else is down double digits. It’s up 12% in Canadian dollar terms. I mean that is what it is, right? We just talked about the demand for safe government debt, which is causing prices, bond prices, to go up, and yields to go down. While the longer you are on the maturities spectrum, the more of an effect you’re going to feel from that. We see that with this 12% year-to-date return.

Cameron Passmore:

Completely unexpected.

Benjamin Felix:

Maybe. Yeah. I mean to the extent that it’s gone up, yeah. I think when markets are down, generally bond prices can take a hit. They did at the beginning of this. Yeah. People really want safe assets, I guess, is the only way to think about that, despite all of the government spending, but anyway. Yeah, so I agree. Not necessarily expected. Not totally unexpected, but to that extent, yeah, maybe not expected.

Cameron Passmore:

12% year-to-date was not expected.

Benjamin Felix:

Yeah. Yeah. That might be some resulting that’s going on there. If you compare that portfolio that has the low volatility stocks and the long bonds, to an equity fixed income portfolio using like small value stocks and the equities and relatively shorter mid-term bonds and the fixed income, well simple looks really smart. Their portfolio managers look really smart, or investment strategy team, whoever did all that thinking. It is that risk parody concept of sort of paying off.

Benjamin Felix:

It seems like a good idea to take a victory lap, but the question that started popping into my head, as I was reading their victory lap and get all these questions from people, and Cameron you and I talked about this in a different context actually because we were talking about value stocks versus the market, but is volatility or drawdown a good measure of risk? Our critique of long-term bonds, when we critiqued this portfolio a while ago, was that they have poor risk-adjusted returns on their own. Their expected return profile is not great.

Cameron Passmore:

Taking on more risk than expected return.

Benjamin Felix:

Correct.

Cameron Passmore:

Because they’re so long and more volatile in price.

Benjamin Felix:

You get an equity like volatility without an equity like expected return. If you get negative correlation with stocks, that can be not such a bad thing. That’s that kind of risk parody idea. Wealthsimple finished their victory lap commentary by saying how investments perform in downturns may be more important than how they perform in rallies. That raises the question that I just mentioned, Cameron, which is drawdown risk. What is risk? We’ve talked about this framing risk in the past. Anyway, so I built a model to try and measure risk in a different way.

Benjamin Felix:

It’s a consumption based model. Basically just a 4% rule withdrawal model. I looked at the historic risk adjusted returns. I compared portfolio characteristics first, and then I did the other thing. Historical risk adjusted returns of a 70/30, this is US equities and US fixed income. 70/30 US equity with five year treasury notes versus 70/30 with long-term government bonds. I looked at data going from 1926, July 1926 to March 2020.

Benjamin Felix:

The long-term bond portfolio with the 30% long-term bond allocation outperformed by an annualized 20 basis points for the full period. The risk-adjusted performance was almost identical. That was interesting on its own. Now, these data include the last 40 years, which have been this bond bull market that everyone keeps saying has to end eventually. I thought well let’s look at the data ending when the started, which was July 1981, when interest rates peaked.

Benjamin Felix:

Over that period, the long-term bond portfolio underperformed by 24 basis points annualized, and it was more volatile.

Cameron Passmore:

This is from 1926 to 1981?

Benjamin Felix:

Correct. Full period, including the last 40 years, or 40 or so years.

Cameron Passmore:

That’s 94 years, including the last 40?

Benjamin Felix:

Right.

Cameron Passmore:

Got it.

Benjamin Felix:

Full period, underperformed in absolute terms. Risk adjusted returns were about the same, but if we carve out the last 40 years with that crazy bond bull market, which we can’t structurally have again because interest rates are as low as they are, then over that period, it underperformed in absolute and risk-adjusted terms. That’s when I started asking the question about the consumption model. We know that adding long bonds might help in major downturns, and actually in the historical data it doesn’t really that much on average, which is also interesting.

Benjamin Felix:

That maybe speaks to some of the simulations here, but if we take the consumption approach, like what are the chances of not being able to meet your financial objectives, your consumption objectives?

Cameron Passmore:

You’re defining that as risk, as opposed to drawdown or volatility?

Benjamin Felix:

Correct.

Cameron Passmore:

The risk of not being able to spend as much as you want?

Benjamin Felix:

Correct. I ran 764 historical 30 year simulations using 4% withdrawals just because I know that works in the aggregate data. I can just market it with 5 year treasuries. I know 4% works, just based on the 4% rule research. Staring with a $1 million portfolio with 5 year treasuries as fixed income, there’s one instance of failure, and we know this again from the 4% rule research. That’s December 1968, so the 30 years starting December 1968 is the one period in the historical data where the 4% rule fails in the US data.

Cameron Passmore:

This is real numbers, real market returns?

Benjamin Felix:

Correct, using historical data. I thought about doing a bootstrap too, and I built the bootstrap model, which was kind of fun to build in Visual Basic, but then I kind of realized that it blows up the whole concept behind what Wealthsimple is trying to do. As soon as you go bootstrap, you eliminate correlations, positive and negative.

Cameron Passmore:

Oh right.

Benjamin Felix:

It didn’t work. It didn’t work to illustrate what I wanted to illustrate. Using rolling historical periods, you do get that.

Cameron Passmore:

I think people have kind of figured out this is not going to be a rapid fire answer.

Benjamin Felix:

Ah shoot. You’re right. Anyways, it’s good. It’s interesting.

Cameron Passmore:

Hopefully, listeners agree.

Benjamin Felix:

Yeah, you’re right though. It’s not rapid fire. I got too interested. That works out to 0.13% historical failure rate.

Cameron Passmore:

Right.

Benjamin Felix:

Now, if you had long-term bonds as fixed income, the historical failure rate increases to 4.6%.

Cameron Passmore:

Wow.

Benjamin Felix:

Yeah, and it’s basically, I tried to go back and … I had this same reaction. Why would it make that much of a difference?

Cameron Passmore:

That many more times?

Benjamin Felix:

Especially because the risk adjusted returns aren’t that much different on average over the very long-term.

Cameron Passmore:

Is it volatility?

Benjamin Felix:

I went back and looked at the data. It’s basically in the run-up to peak interest rates in the 1980s, so it’s basically that long bond bear market, there are a whole bunch of failures.

Cameron Passmore:

That being at the back end or the front end? That would be at the front end because it burnt capital up front.

Benjamin Felix:

I didn’t look at that. I didn’t look in that much detail.

Cameron Passmore:

That’s really interesting.

Benjamin Felix:

I just looked at which starting months did this fail over 30 years, and it was all in the sort of mid to late 1960s, which is when the interest rates were going up, up, up, up, up, and inflation was high, so you have all these things working against you, and that’s the same period where using five-year treasuries, that portfolio failed then too. It’s just there were way more instances of failure using long bonds because you got smoked on the interest rates sensitivity.

Cameron Passmore:

Wow.

Benjamin Felix:

Yeah, so if we’re defining risk as consumption, at least in the historical data, adding the long bonds, not so good. The average ending assets, which I guess we’d expect based on the risk-adjusted returns being produced over the long-term, average-ending assets were pretty similar. Average maximum drawdown was also similar, which I found interesting. That negative correlation of the long bonds and the stocks didn’t seem to work that well.

Cameron Passmore:

Drawdown being the bottom end of the portfolio?

Benjamin Felix:

Yeah. The peak to trough, the biggest peak to trough drop, it was a little big higher for the portfolio with treasuries as opposed to long bonds, but I’m talking like points of a percent. Then, I thought I’ll just push this analysis one step further because I’ve already got the model. I said what if we just said we actually don’t mind drawdown and volatility. Let’s use stocks that we know to have higher risk-adjusted returns, but also to be much more volatile, so I’ve replaced stocks in my 30% treasuries portfolio. I’ve replaced total market stocks with US small value stocks.

Cameron Passmore:

100% on the equities side?

Benjamin Felix:

Yep.

Cameron Passmore:

Wow.

Benjamin Felix:

70% US small value, 30% five-year treasuries. Now, I know that there’s sample bias here, and if I used some other country, it might not be the same. We know US small value has a very strong historical characteristics, but they’re also volatile.

Cameron Passmore:

If you want extreme barbell, Larry Swedroe calls this the barbell portfolio.

Benjamin Felix:

Yeah, right. It comes back to Wealthsimple’s point, which was how investments perform in downturns may be more important than how they perform in rallies. This really tests that point. With small value stocks, the failure rate goes to 0%. Remember with US market and treasuries, there’s one instance of failure? Much higher failure rate with the long bonds. Small value and treasuries never failed in the historical data. The maximum draw down goes from 68% to 77%, so bigger maximum draw down, which is crazy. 77% draw down with a 70% equity portfolio.

Cameron Passmore:

It’s still never failed?

Benjamin Felix:

It’s still never failed. The average maximum draw down, that’s looking at every 30-year period, what was the maximum draw down over that 30-year period? Then, taking the average of that, went from 35% to 37%. That was also interesting. That average maximum draw down wasn’t that much worse over all the 30-year periods. Now, this is the crazy part. The average ending assets increased by a multiple of five. It went from like $6 million on average ending assets after 30 years to $33 million.

Cameron Passmore:

Wow.

Benjamin Felix:

Yeah.

Cameron Passmore:

What is risk? Really fascinating question.

Benjamin Felix:

Yeah. My final note that I made to myself was that people might feel better about long bonds in their portfolio, especially in a year like this where it’s like all right, this really helped, really helped cushion the blow. You can make the same argument for gold. Gold’s up a ton recently too, but the historical risk return characteristics are not great. It really comes down to that difference in framework. Do you want to think about this from a expected return perspective, or do you want to think about portfolio construction from a risk parody perspective? Gold fits into the risk parody framework too. Long way of saying I still don’t agree with Wealthsimple’s portfolios, and I think that the victory lap is unjustified.

Cameron Passmore:

Great answer. That could have been our investment topic this week, but still have an investment topic for you.

Benjamin Felix:

I hope people are happy about that.

Cameron Passmore:

We have a lot of investment topics. We had a backlog of ideas to talk about.

Benjamin Felix:

Yeah.

Cameron Passmore:

Just so much to cover. Portfolio topic this week The historic state of value investing. Where do you want to go with this?

Benjamin Felix:

Do you want to kick it off?

Cameron Passmore:

Oddly enough, it’s not a question that comes up a lot in our role with the clients. I mean we have such diversified portfolios, but it sure is a big topic in, I know my Twitter feed, and a lot of the academics and [inaudible 00:42:42] people that we both follow closely, this is a raging debate that’s been going on. There’s been some very, very interesting and good commentary that I think you’ve done a great job of boiling this down into these notes you’ve made up.

Cameron Passmore:

We’ve got now what, 10, 12 years where value has unexpectedly, but did not deliver what you would expect, which is a bit of an excess return, excess premium. Now, we’re biased in looking at articles for sure that suggest that the value premium isn’t dead, so I think it’s fair to acknowledge our biases, but still it’s a good question. Is the value premium dead? Why should we continue to expect it?

Benjamin Felix:

Yeah.

Cameron Passmore:

You dug into the data.

Benjamin Felix:

It was kind of hard to parse through and decide which ones did I want to speak to, or did we want to speak to because it’s kind of like everybody, everybody that’s a value manager right now is putting up research why we should expect value to do better, or just analyzing the situation with value, and a lot of credible people and smart people. I ended up just pulling two from AQR, which maybe it increases the risk of bias, I don’t know, but I think that they’re pretty good in terms of their academic and intellectual integrity. I find those guys to be good. I ended up pulling a piece …

Cameron Passmore:

We did that one paper, and then Cliff Asness jumped on the weekend just to kind of summarize that paper. I thought it was just a very compelling, all data driven.

Benjamin Felix:

Yeah. There’s one long blog post from Cliff that we can link to all these in our post, and then there was the paper from AQR from some of Cliff’s colleagues. I kind of made notes to summarize both of them. I think we’ll just go through it. The data are fascinating. It’s like the title the section you said, Cameron, The historic state of value investing. It truly is that. Anyway, should we jump into it?

Cameron Passmore:

Yeah, it interesting from a big picture how many people are finding reasons now why value is dead. You go back through history, and I think it’s fair to say this happened during similar periods in the past. Applied value is dead. It’s like why does that happen after values underperform? Why doesn’t it happen after value perform really well? It’s just interesting how you question it after. Even though these periods, and we’ve talked about this many times before, are not unexpected. It’s not what you expected, but you have to know to expect the unexpected.

Benjamin Felix:

Yeah. We talked I think it was in that COVID-19 episode we did a while ago, not that long ago I guess. We talked a lot about historical periods where value and small value have taken a real beating because that was happening again when this all started, and it’s still happening now. Anyway, okay first thing I talked about the article that Cliff wrote, and I read through it a couple time, and just made notes, so I hope it’s okay with everyone that I’m basically just reading the notes that I took after reading somebody else’s paper.

Benjamin Felix:

This isn’t exactly the original content, but we’ll try to put as much of our commentary in there as we can.

Cameron Passmore:

He called his summary The brute force commentary of their paper. Just get to the point.

Benjamin Felix:

Yeah.

Cameron Passmore:

Some other people on Twitter jumped on it, even boiled it down to like 125 characters to summarize what he summarized.

Benjamin Felix:

Yeah. I’m not going to do Cliff’s writing justice, so I mean I suggest you read his article, but here’s my attempt at summarizing it.

Benjamin Felix:

Following the Fama-French price to book as a measure of value, which Cliff calls academic style, expensive stocks are sometimes less than 4% as expensive as cheap stocks. The median multiple, I guess, is 5.4 times, and today they’re nearly 12 times more expensive. That is unbelievable.

Cameron Passmore:

What they’re looking at is the 1/3 most expensive stock compared to the 1/3 cheapest stocks. The middle third for this part has been eliminated. If you look at the table, the spikes, there’s a spike now, there’s a spike in 2008, and this is now above the spike for ’99-2000.

Benjamin Felix:

Cliff talks about a bunch of different ways to measure it, and the way that he thinks is most reasonable to measure it, then yes, this is right now, value’s never been this cheap.

Cameron Passmore:

The 100th percentile.

Benjamin Felix:

Yeah. That’s just the regular book to market as Fama- and French define it, without constraining industries. You end up overweight industries, the cheapest industries. Going back the 50+ years of data that he’s talking about, we’re right now at the 100th percentile, so back to 1967. For just the straight spread in valuation between cheap stocks and expensive stocks.

Cameron Passmore:

Yep.

Benjamin Felix:

Cliff comments that some people make the winner take all argument and claim that value measures don’t apply anymore, but he also makes a little quip that I thought was funny. He says, “This applies, the trend is just starting, and we should expect the spread to widen to infinity.” It’s just kind of funny. Then, he looked at other valuation metrics. I can’t remember exactly which ones. Price to cash flow, price to sales, all that kind of stuff.

Cameron Passmore:

Price to sales was 83rd percentile.

Benjamin Felix:

That’s the lowest, but he also says once you constrain for industry, that goes away, but the main point is if we extend to other valuation metrics, other than price to book, things look pretty much the same. Call it still in the 100th percentile, or very close. Then, he said, “What if we throw technology, media, and telecoms for the full data history?”

Cameron Passmore:

Love this one.

Benjamin Felix:

Still, close to the 100th percentile, or at the 100th percentile.

Cameron Passmore:

Right, so this time is different.

Benjamin Felix:

Correct. If we throw … This again does the same thing. If we throw it the largest 5% of stocks for the entire data set, still historically cheap. Close to or at …

Cameron Passmore:

That’s the winner take all argument. You take out the winners all the way through the data set, well it’s now 2008, 1999, different names, throw them out. You’re still at the 100th percentile.

Benjamin Felix:

Yep. If we go industry neutral, instead of letting the portfolio be overweight, the most expensive or the least expensive industries, depending on the portfolio we’re talking about, you do the ranking within the industries. Same thing. Still 100th percentile cheapness.

Cameron Passmore:

Yep.

Benjamin Felix:

Then, Cliff says, “Maybe the cheap companies are just bad businesses. Maybe they’re truly just bad companies and that’s why they’re not doing well.” That, to me, was one of the most interesting parts. He looked at gross profitability, ala Robert Novy-Marx, who he references, and we’ve talked about in the past. Gross profitability, he looks at return on assets, and he looks at leverage to see maybe these businesses just really suck right now, and that’s what’s driving this.

Benjamin Felix:

He finds that cheap stocks are currently in line with their historical profitability compared to expensive stocks, so expensive stocks do tend to be more profitable than cheap stocks.

Cameron Passmore:

Yeah.

Benjamin Felix:

People who are value investors just recognize you really are buying beaten up businesses, and that’s just a fact of value investing, but compared the historical difference in profitability, it’s the same. I think he said the 52nd percentile, so it’s pretty much in line with what has been historically on average.

Benjamin Felix:

Return on assets right now are higher than compared to history. Leverage right now for value stocks is lower compared to gross stocks than compared to history. All of those metrics that you might call quality metrics, like what is the quality of these businesses, show that relative to history, the history, remember, where value has outperformed over most time periods …

Benjamin Felix:

I was reading another thing. I think it’s like 96% or some mid to high 90% of 10-year historical periods where value outperformed growth. Through all of that history, as of right now, values metrics, in terms of business quality, look the same as average, or better, than all that history where they’ve beaten gross stocks.

Benjamin Felix:

They’re not just bad businesses. This one was really interesting, and this is where you get that spike, Cameron, that you were talking about where it’s higher than it was in the tech bubble in air quotes or in video air quotes. When you measure the value spread based on intra-industry HML sorts, that’s constraining for industries, not letting an industry run away and take over the portfolio, while equal weighting the 1,000 largest stocks, and Cliff says that this way of sorting is the most realistic proxy for something like what AQR or a Dimensional would actually do on implementation of portfolio.

Benjamin Felix:

Doing that sort is where the value spread has never been as high in history. You look at the chart, it’s a good clip above where it’s been in the past when it’s been extremely high.

Cameron Passmore:

[inaudible 00:51:06] and I had discussions about this with a few clients this week, after having read Cliff’s piece, and it really does give you belief in your portfolio. Not that I lost belief, but when clients hear these kinds of messages, to know there’s a counterbalance to what’s going on in the world right now with this winner take all kind of mentality.

Benjamin Felix:

I was listening to a podcast recently, and I can’t remember which one, so sorry to whoever it was, but they talked about the difference between a winner take all market for companies versus a winner take all market for the end investors. We’ve implied this in the past where it can be winner take all for the companies, but you’re still buying discounted cash flows. You’re expected returns are still based on the discount rate, so unless the market’s grossly efficient and consistently mispricing these [inaudible 00:51:55] gross stocks, in an efficient market, you can have a winner take all market at the corporate level, and it won’t be a winner take all market at the investor portfolio level.

Cameron Passmore:

Mm-hmm (affirmative). Anyway, I just heard someone say that, and I thought it was an interesting way to frame it.

Benjamin Felix:

Okay, so Cliff concludes that the cheapness of value today is not coming from a broken metric, price book, not from the winner take all companies, it’s not concentrated in tech megacaps or the most expensive stocks. This is a direct quote from Cliff. “We think the medium term odds are now rather dramatically on the side of value with no this time is different explanation we can find, and we’ve tested a lot of them, holding a drop of water, and no other pureed in the 50+ year history matching today.” Now, keep in mind, Cliff has said this a few times now and been burned pretty hard.

Cameron Passmore:

[inaudible 00:52:41] in a little we talked about that.

Benjamin Felix:

Yeah, but he’s saying based on the ways things … What did he say, “We think the medium term odds are now rather dramatically on the side of value.” That was a scary thing to say, but he’s saying it.

Cameron Passmore:

That’s what happened coming out of ’99-2000, and our professional colleagues in the US that had value small cap portfolios because at that point, it really wasn’t available in Canada. That really caused them to really thrive.

Benjamin Felix:

Crazy, but they lived this.

Cameron Passmore:

Absolutely lived this. This is exactly what went on in ’99-2000.

Benjamin Felix:

You’re looking at the data in March 2000, and you can probably have the exact same conversation we’re having now. The data looked, at that time, now it’s more expensive, but at that time, the value spread was as wide as it had ever been.

Cameron Passmore:

Exactly.

Benjamin Felix:

Okay, so that was commentary from Cliff Asness who we had on the podcast. His conversation, just as a side note, was intimidating for anyone that’s interested. Just listening to him talk was mentally exhausting. I had to relisten to the interview. Anyway.

Cameron Passmore:

He was awesome. Great interview if you haven’t listened to it.

Benjamin Felix:

Yeah.

Cameron Passmore:

Brilliant, brilliant man.

Benjamin Felix:

Yeah. That was Cliff. Now this paper is from Cliff’s colleagues from AQR. AQR is the firm Cliff started. The title of Cliff’s post was Is (Systematic) Value Investing Dead? That’s the same as the title of this paper. I tried to distill the main points of the paper. He started off just reminding us what value investors are trying to get. They break it down into three things.

Benjamin Felix:

You’re getting areas in expectations with respect to fundamentals. That’s the idea of people underpricing systematically value stocks, and overpricing gross stocks, so value investors are trying to take advantage of that, and/or a risk premium for exposure to stocks that share exposure to a non-diversifiable source of risk that is reflected in their current cheapness, and/or a premium for investors who are willing to overpay for growth or avoid value, which is a non risk-based preference.

Benjamin Felix:

They also then remind us that value has been strong for decades across stock markets, time periods, and other asset classes, and the guys at AQR have done a ton of research, Cliff I think in particular, on I think the paper was called Value Everywhere or Value and Momentum Everywhere, but then they say it again, reminding us that the recent evidence has been poor, especially in the US.

Benjamin Felix:

We know this from the Fama-French paper that we talked about not too long ago. I guess we talked about a lot separate from that too. Okay, so then they say, and this speaks to the comment you made earlier, Cameron. This underperformance has resulted in ex-post critiques to try and rationalize the underperformance. That’s exactly what you were talking about. They list five critiques. “Book-to-price has not worked for large stocks for a long time, if ever. At least if the value strategy is not applied within industries or sectors.”

Benjamin Felix:

It’s basically saying value for large stocks using price-to-book as a measure has never worked, which a lot of people have said. There’s some pretty compelling data to show that to be true, but doesn’t tell the whole story. I’m getting ahead of myself. “The explosion in share repurchase activity of firms has changed the nature of book equity, rendering book price measures less useful. The growing importance of intangibles and the failure of the accounting system to record such value in the financial statements renders value measures anchored to current financial statements useless.”

Benjamin Felix:

This one I found fascinating. “Central bank interventions and the low interest rate environment over the last decade have distorted asset prices via lowering discount rates than negates the efficacy of value strategies.” The last one, “Systematic value strategies are just too naïve to work, as everyone knows about them.” Rather than recounting the whole paper, because they built a framework to answer these questions and had a whole bunch of other great content, so again, I read the paper, but I just took their answers to the questions and tried to do a bullet point somewhere of each one.

Cameron Passmore:

Bullet away.

Benjamin Felix:

Okay, so book-to-price and large cap stocks. They confirm this to be true in the data, but then they also remind us that building a portfolio using a single metric like book-to-price doesn’t make sense. When you add other valuation metrics, that makes it look a lot better in large caps makes value look a lot better in large caps, and then they also tell us while it’s not directly related to value, using other systematic sources of return, like quality in the AQR world, or profitability in the Dimensional world, make value work a lot better, including in large caps.

Benjamin Felix:

Now, on the adding other metrics for valuation, Dimensional would say, and I’m putting words in their mouth, but I think I know the words well enough to say this. Dimensional would say that controlling for the other factors in the Fama-French Five Factor Model, makes other valuation metrics less useful. If you’re just looking at value, then adding other metrics like price earnings, price sales, price cash flow, whatever, to price book makes it look better. Dimensional would say that may be true, but when you control for …

Cameron Passmore:

Everything else.

Benjamin Felix:

Yeah, relative price, size, profitability, and investment, adding in another evaluation metric to that model doesn’t actually add any value.

Cameron Passmore:

Right. Exactly.

Benjamin Felix:

That probably just comes down to what model are you using, and how are you seeing the world? At the end of the day, I think it’s all pretty similar. They basically confirmed yes, sure, you can make the argument that using purely price book as a measure for value makes value look pretty bad in large caps in the historical data, but then they also remind us that there’s a lot more to think about.

Benjamin Felix:

On repurchases, so saying that the increase in repurchase makes price book less useful, they sorted US stocks by size, relative price, and repurchase activity, basically with the idea that if repurchases affect the efficacy of value measures, particularly price book, we would expect value to be less effective in the high of repurchase group, and especially in more recent years, where repurchase activity has been extremely high.

Benjamin Felix:

With that model, they find mixed evidence of value working less well for high repurchase, the high repurchase sub sample. For book price there is some evidence of lower returns for the high group relative to the zero or low group in the small cap universe, but not in the large cap universe. I think they said they found mixed, mixed but not conclusive evidence.

Benjamin Felix:

Then, across other value measures, so not price book, and their combined valuation metric, there was no evidence either way for a relationship to buybacks. I should have referenced it out. Dimensional did a paper on this a while ago showing as an accounting proof why share repurchases don’t affect book values evaluation measure.

Cameron Passmore:

And if you want a good time, go check out Cliff’s tweets talking about share buybacks. It’s quite something.

Benjamin Felix:

We had a guest, I can’t reveal who it is. They made a comment. It’s a future guest. They made a comment about buybacks and I said that buybacks are divisive. Their response before they answered the question with a very smart answer, they said, “Yeah, buybacks are divisive. They divide the people that understand finance and those that don’t.”

Cameron Passmore:

That’s right.

Benjamin Felix:

Anyway, for both small and large caps, they found no systematic evidence that price book performs worse for firms that repurchase the most, so basically they found there’s no relationship. This is a direct quote. They said, “Even though share repurchase intensity has increased over our sample period, it is not the case that book price has performed worse more recently for share repurchase intensive firms.” Basically, no relationship.

Benjamin Felix:

The growing importance of intangibles, I think this is a big one with the tech companies.

Cameron Passmore:

Yeah. It comes up a lot.

Benjamin Felix:

They say that, “If the issue is a systematic accounting error that affects an asset, for example research and development costs, then comparing similar firms within an industry should help to mitigate it.” That’s just an easy if you’re worried about this in portfolio construction, then you should just sort within industries, which is one of the comments Cliff made in his piece about how actual portfolio managers do it. Dimensional does it too by putting a cap on each industry.

Benjamin Felix:

Now, they also said that there are data vendors that are selling data that’s in quotation marks corrected for the accounting flaws. Now, these corrections, they note, require a bunch of decisions on their own. Just like the accounting metrics in the first place have a bunch of decisions, subjective decisions, which you could call flaws, so do the corrections that are made in the data. Then, they said if these data vendors think that they can build better data to build better valuation metrics, I mean let’s test it. Easy solution.

Benjamin Felix:

Now, a direct quote again. “A key inference to be drawn here is that that their recent underperformance of value strategies extends to value measures that attempts to correct for deficiencies in the financial reporting system. It appears unlikely that the growing importance of intangibles or changes in business models is explaining the underperformance of value strategies.” I think that’s, again, addressing the sort of the winner take all tech, big data argument of values underperformance.

Benjamin Felix:

This was one of my favorites, and I’ve been spending a bunch of time researching the relationship between central banks, monetary policy, and financial markets, so this one, just based on what I’ve been reading recently, was interesting. “Central bank interventions and the low interest rate environment over the last decade have distorted asset prices via lowering discount rates that negates the efficacy of value strategies.” I’ve heard this one a bunch too. Like value is not going to work anymore because of the monetary environment that we’re in.

Benjamin Felix:

They break this down by saying, “The equity evaluation frameworks are based on discounted future cash flows. Gross stock valuations consist of a larger speculative component of future cash flows. Based on this …” This is them explaining why people would say this. How people can justify saying that the monetary environment and the interest rate environment is affecting the value growth, relative performance. “Based on this, leaning on the intuition of the duration concept from a fixed income, value stocks are affectively short duration assets, and as such, their prices will move inversely with interest rates.”

Benjamin Felix:

On the first two points, they said, “Okay, I can see that.” On the last point, their comment was, “But now the arguments are either unreasonable or tenuous at best.” Then, they go on to ask, “What interest rate are we talking about?” “The equity valuation discount rate consists of a risk-free rate and a risky rate. Which risk-free rate are we referring to?” They said, “The absolute level.” Then, the other piece is that is it the absolute level of rates, or is it the change in rates that we’re saying is affecting the relative performance of value growth stocks?

Cameron Passmore:

Yeah. Wow.

Benjamin Felix:

Interest rates affect performance of value stocks. Okay, which interest rates?

Cameron Passmore:

Yeah.

Benjamin Felix:

Is it the shape of the yield curve? Then they ask the question, “Does the cost of duration, does that even carry over to stocks? Does that make sense to say?” They argued no, because equity expected cash flows are not fixed like bond interest is, so the whole math behind duration breaks down, and it breaks down because when the external environment changes, expected cash flows also change, which is not true for bonds, but with stocks, I mean it is. When the external environment changes, expect that cash flows change too.

Benjamin Felix:

They basically say, well again, direct quote. “What looks like an appealing, casual explanation for the troubles of value over the last decade, ie low rates benefiting assets with longer dated claims,” and that’s that idea of growth stocks having these big, huge expected future cash flows far in the future, “is only minimally supported by the data, and then only contemporaneously and not predictively.” They had some regression levels to support that last statement there.

Benjamin Felix:

Okay, and the last one, “Systematic value strategies are just too naïve to work because everybody knows about them.” They agree that it’s always reasonable to consistently ask whether or not a characteristic will be associated with higher future returns. We know it’s happened in the past, is it still reasonable to expect, and this is what the Fama-French paper earlier this year was trying to get at. Can we still expect a positive value premium based on what’s happened the last decade or so?

Benjamin Felix:

Then, their comment is that we have to remember why we held the prior belief, which basically just gets back to the [inaudible 01:03:57] updating concept where if you’ve got really strong priors, it takes really strong new information to change your prior. In the case of value, the prior belief consists of, and the theoretical side, consists of hard to diversify risk, and expectation errors, and both of those should be persistent through time, particularly the risk. The expectation errors piece, you can make arguments based on human biases that aren’t going to go away. That should be persistent.

Benjamin Felix:

I think we’ve talked about that in the past on here, but the risk piece, I think is pretty good. Then, here’s the centerpiece in my opinion. If it did become the case that value was being crowded out, like if value went away because there are too many people putting money into the strategy, basically it is being arbitraged away, we would expect a compression in value spreads. We’re seeing the opposite. The value spread is getting wider.

Cameron Passmore:

Wider. Exactly.

Benjamin Felix:

Yeah, I think it was in Cliff’s piece, he said that people are just really willing, for whatever reason, to overpay for growth right now.

Cameron Passmore:

That was his quote right? “Investors are simply paying way more than usual for the stocks they love versus the ones they hate.”

Benjamin Felix:

Yeah.

Cameron Passmore:

That was his ending quote. If you believe the different stocks, like different expect of returns, or different returns in the future, by definition, there has to be value stocks. Some stocks have to have higher expected returns. Well, why is that?

Benjamin Felix:

If the premium’s gone, if it’s gone, it doesn’t mean value stocks are going to underperform forever. I mean that was Cliff’s joke about the spread going to infinity. That’s not what you would expect. If the premium is gone, you would expect a random outcome going forward, which doesn’t mean constant underperformance. It just means you wouldn’t expect a positive long-term return, but you could still get periods of positive returns. It’s not like, “Oh, the value premium is gone.” That doesn’t mean value is going to underperform forever. That just means you don’t expect a positive premium on average.

Cameron Passmore:

Yeah.

Benjamin Felix:

Which is not the same thing as constant underperformance.

Cameron Passmore:

Right. Onto our planning topic, something we started, I think, four weeks ago, talking about the risk profile. We skipped it last time, but I’ve had a couple of people actually email me for a change, asking when we’re going to follow up with the back half of our risk profile discussion. We talked last time about the two broad approaches to measuring someone’s risk tolerance. One is the cycle metric profiling, which basically is a series of questions that describe your longer term risk-taking mindset. That’s very traditional in our industry to use the cycle metric type questionnaire.

Cameron Passmore:

The other one, which we talked about at length last time is the choice of gambles or prospect theory. We talked last time, and we found, I found it pretty compelling this paper written by four academics that one of the big players in this space, Riskalyze Commission, and that paper made a pretty strong case for the benefit of getting people to focus on their near-term downside risk because that’s all that really matters, that GMO point, Get Me Out point. Where is that point for you?

Cameron Passmore:

It was very compelling. Since then, we’ve had a chance to dig into the arguments that look at the cycle metrics side of things, and what I find appealing about that is that cycle metric responses are much more stable over time than the other gamble near-term downside tolerance type questions. Cycle metric responses are more stable. Things like how easily do you adapt when things go wrong financially? That typically doesn’t change over time.

Cameron Passmore:

When you think of the word risk in a financial context, which of the following words come to mind first? Danger, uncertainty, opportunity, or thrill? I know when you first looked at that questionnaire, the word thrill, I think you found that a bit of a turn off in that sense, right?

Benjamin Felix:

I did. When I think about rational risk-taking, the last thing that comes to mind is thrill. Opportunity makes a lot of sense to me.

Cameron Passmore:

Right.

Benjamin Felix:

Like if I’m taking a risk with a positive expected outcome, I’m not doing it for the thrill.

Cameron Passmore:

No, because thrill’s not rational. Another one would be when faced with a major financial decision, are you more concerned about the possible losses, or the possible gains? What’s neat is you can then take these responses, aggregate them, and then come up with a score, and compare that score to the people with a similar scores. You see where you might be different from people in that population.

Cameron Passmore:

Frankly, one of the best arguments against the prospect theory, or the gambling questions, is that it is gamified, and it’s not really like real life. I think it’s like 30%, I seem to recall, of the population either can’t do the math, or don’t want to do a math type question. That’s a big swat of the population. Cycle metric questions are much easier, much, much easier to answer. There’s also been some commentary about how people know how the gamble questions work, so the fact that it’s a game in gamble questions, they might feel they have to prove something in that.

Cameron Passmore:

I talked to other people, and they said, “Ideally, you would do both of these in a risk questionnaire type scenario to determine what is your best risk profile.” The reality is in our world, this is only one part of determining someone’s risk profile. You also have to take a look at what is their capacity to take on the risk? How stable is their job? What’s their time horizon? Like a lot of people say, “Well, just have your age in bonds.” That’s clearly flawed. That doesn’t take into account any of this cycle metric, or the gamble side. It’s just time horizon alone.

Cameron Passmore:

The other thing we always link it to as well is the long-term financial plan. How much risk do you need to take on? This discussion we’ve had a lot lately where if you don’t need to take on the risk, are you the type of person that would choose not to take on the risk, or are you a rational human being no matter what? I don’t need the risk, but it makes sense to take on the risk for rational reasons. That’s really a preference, I think.

Benjamin Felix:

It’s a preference, and it’s got to do with the margin of utility. I think it’s like objectively more wealth is always better than less, but at the margin, there’s a point where more wealth starts to mean a whole lot less.

Cameron Passmore:

To some people, if they can reduce the risk, they’ll do it all day long. That’s just the way they’re wired. There’s nothing wrong with that, but it’s to be aware of this.

Benjamin Felix:

Yeah, it’s interesting.

Cameron Passmore:

Last up, bad advice of the week. Man, with the collapse of the price of oil. I remembered going back to 2008. I don’t know if you remember this story or not, but the Jeff Rubin prediction of the price of oil back in 2008. Jeff Rubin, who was, at the time, the chief economist at CIBC World Markets, clearly brilliant economist. This is not a commentary on him, but more about the making predictions and making decisions in your portfolio based on big time predictions. In April 2008, he predicted a barrel of oil would cost $225 by 2012. Oil was $118 a barrel at that point, so it was a very controversial call. Got lots of press, and he wrote about it in his book called The World is About to Get A Whole Lot Smaller.

Cameron Passmore:

The basic premise was that oil is the single most important factor of global economic progress, and that based on that, the demand for oil is going to go up, prices are going to soar. Who would have thought that it would be almost worthless recently on [inaudible 01:11:20], and certainly a fraction of what it was back then?

Benjamin Felix:

Yeah.

Cameron Passmore:

There was an article back in Canadian Business in 2012 that said of Rubin, “He joins the ranks of such famous Canadian pop experts as demographer David Foot,” there’s another one I want to do in another future podcast, “technology guru Don Tapscott, and resource-scarcity worrier Thomas Homer-Dixon, and a lost list of other self-declared wisemen who made a living telling the nervous masses what the future holds.” It was wrong back in 2012. Look at it now.

Benjamin Felix:

Yeah.

Cameron Passmore:

Incredible. Absolutely incredible.

Benjamin Felix:

Now, you could argue this point because they all thought they had basis to make a prediction, but I Fama speak recently. In a future episode we might talk a little bit about that talk that he gave, but one of the things he said, I think he was asked what he thinks the outcome of the whole coronavirus situation is going to be, and his response was just so Fama. He said, “If I don’t have the basis to make a prediction, I won’t make it.”

Cameron Passmore:

Classic Fama.

Benjamin Felix:

Yeah.

Cameron Passmore:

Anything else today?

Benjamin Felix:

Nope. I think we covered a whole lot of stuff. The Wealthsimple piece pushed us a little long. Wow, I talked about the length. You talked about it first.

Cameron Passmore:

That’s all right. Anyways, thanks for listening.