Embracing 'Maverick Risk'

markets this week, Sara, you better be prepared. Oh I'm prepared this week? Are you wait for it now? Sarah? You know in our business financial news the words pioneer and revolutionary or thrown thrown around a lot. I'm guilty of using them a lot, but I can't think of a better words for our guests. One of our guests here today he did a lot of important work coming

up with what's known as the I be a fundamental indexing. Basically, you can invest in a passive manner at a very low cost in an index that gives you a lot of diversity. But instead of making market capitalization sort of the center of the indexing universe. Uh, you wait your stocks based on more fundamental things like revenue, cash flow,

dividends and buy backs and book value. And this really launched a lot of popular investment strategies that have sort of taken this and and some more dubious ways to do this under the banner of smart beta factoring, investing, that sort of thing. But joining us today is Rob Barnett, the guy who sort of started it all, the founder of Research Affiliates. Rob, can we call you the godfather of smart beta? Is that is that appropriate? Lots of people have fine with me? That makes it safe? Good good.

That's that's a it's a nice catchy title. As journalist, we need something like that. Also joining us the godfather of the newsroom downstairs, Chris. I think that, uh, groundbreaking would have been pushing groundbreaking breaking. So and Chris is the executive editor here of the markets team at Bloomberg. Um, Rob, I think he's read every single one of your research reports, so we can quiz him on it if you want it. He'd be the only one I sure haven't. But let's

talk about this notion of what you started calling fundamental investing. Uh, and now it's sort of falls under the banner of smart data. I get the oppression you don't like exactly necessarily everything that's now falling under the umbrella smart data is that? Is that fair? That's fair? When UM the term smart beta was invented, it was invented by Towers Watson out of London, a major institutional consulting firm, and they coined the expression actually on the basis of fundamental index.

They recognize that fundamental index doesn't win because of the fundamentals. It wins because you are waiting the portfolio in a fashion that's indifferent to price. So as the price goes up and down, if it's big swings, you're going to contratrate against it. Whatever's sword, you're gonna trim, whatever is tumbled, you're gonna buy. And so it profits from the mean reversion,

as prices tended to mean revert. And so they looked around and said, what other strategies do this equal weight minimum variance UM ed hex risk efficient strategy toebam's maximum diversification strategy and so forth, And so they said, let's call it smart beta, and let's encourage all of our clients to split their money between bulk beta capuated indexing and smart beta mean reversion strategies. Well, the industry loved the term smart beta, embraced it, and attached it to

everything under the sun. So there's a lot of stupid beta under the rubric smart beta. And one of the quickest to embrace the term was the factor investing crowd factor investing starts with cap weight and then puts a tilt on. It's not smart beta under the original definition. So smart beta now means anything and everything. It also means nothing, and that's where we are now. It's it's a catchy term for anything goes. Just to clar the whole mean reversion theory is this idea that when you

get a cap weighted index, things get big. They become basically enslaved to their wargest components, and that to some degree to start the return partly partly, but it's actually

more fundamental than that. Um If a stock is overvalued, by which I mean it's destined to underperform in the years ahead, then it has a weight in a cap weighted portfolio that's higher than it fair value weight indexers will say, yeah, that's a truism, and it's obviously true, but so what you don't know what the fair value weight is. But if you link to market cap, then every single stock that's above its fair value is overweighting your portfolio. Every single stock that's below it's fair value

is underweight. The majority of your money is in over priced stocks. By definition, break the link with price, and now if it's overpriced, it might be overweight, it might be underweight. The airs cancel and the canceling of the error.

As we did a paperback in two thousand fifteen with Harry Markowitz in which we showed that the uh if you cancel the errors by breaking the link with price, firstly you explain the entire value effect, and secondly, cap weighting has about a two perannum reduction in return against anything that breaks that link. Along these lines, you guys put out a re set research paper as well called buy high, Sell Low, which is the opposite of what classic investor's thing to do, where you want to buy

low and sell high. Does it come back to that there is a fundamental issue with index funds and what actually is this problem? Is it very widespread? How do you change this? The notion of buying high and selling low is extremely widespread, and it's it's embedded in human nature. Whatever has given us great profit and joy, we want more of that. Oh, let's buy it, because it's gone up and it's made us money. Whatever is inflicted pain and losses, we want to get rid of that, and

so if it's tumbled, get me out of here. It's totally human nature, and it's the essential basis for the value effect. It's the essential basis for fundamental index alpha, or for equal weight alpha, or a whole host of these strategies. It happens with regard to stocks. It happens with regard to mutual funds and managers. Nothing is better for a mutual funds au M than a recent success

performance may be brilliant, money will pour in. People don't ask the question, did this strategy win because it was getting more popular and more expensive? And if it wins because it's getting more popular and more expensive, it's a sell not to buy. So the paper buy high and sell low. With index funds focused on how index funds do this, it turns out that stocks added to index funds UH index funds don't have zero turnover, they just

have low turnover. But stocks added to index funds on average are priced at three to four times the valuation multiples of stocks that are dropped. By stocks that are dropped, I mean discretionary deletions. If it's UH corporate action, If it's a bankruptcy merger, UM, that doesn't count. But if it's a discretionary deletion, it's inevitably going to be a company that's out of favor, unloved for a long time. So that the attitude is, let's get rid of this

and put put twitter in UM. And so what's added is on average three to four times the valuation multiples of what's dropped. Now, that's fine if what's added is has such such wonderful future growth that it's worth triple, but in point of fact, it's not. What we find is that the stocks that are added on average underperform UH the market by about two In the next year, the stocks that are dropped on average outperformed the market by about twenty percentage points. Because there's value there, and

that I imagine, yeah, yeah. And the other thing that's interesting is UM starting s and P would pre announce, So I got to remember who their clients are. Their clients are the index funds. That's who pays the bills. And so the index funds were saying, hey, stop blindsiding us with these changes in the index, give us some notice, tell us when you're going to make the change, and tell us what the change will be. And being responsive

to their clients, they started doing that. UM. It gives the index funds and opportunity to put the trade in place before the index has changed. Prior to that, they they had to play catch up, which meant that they were moving the share prices, which meant that they were underperforming the index. Now they didn't have to underperform the index as long as they got their trades done by

the time that the stock was being added. And so what we found was that between the day before the announcement and the day after the change in the index took effect, the additions beat the deletions by a thousand basis points. That's pretty amazing, Rob. Some of the um uh interviews I've I've seen with you recently, you talk about putting uh fully half of your own personal assets

in emerging market value. Um. Now, you're a guy in your mid sixties, uh um, picturing sort of the average Joe of that age walking into their local you know, Raymond James office and say to their advisor, I I want to put half my money in the end back up the truck, and I feel like their advisor would be like, I gotta speak to my manager here. But so is that a strategy just for uh someone like you? Where would you advise that to a to a normal retiree.

Most people are sensitive to downside risk and even more sensitive to maverick risk. If the markets up and they're not they're flat, they feel terrible. If the market's flat and they're down, they start to look in the mirror and hate themselves. So maverick risk performing differently from how you think you ought to perform, UH, is the risk that people most want to avoid. Well investing in emerging markets value stocks versus investing in the SMP. The tracking

error between the two is going to be huge. The difference in returns between the two is going to be huge. So it only makes sense to make a big bet like that. If you're somebody who really doesn't care about maverick risk, and I don't for myself, for you seem to embrace maverick risk to something to some to say some extent, yeah, for our clients, UM, I would simply advocate UM put nearly as much into emerging markets as you would view as your maximum comfortable exposure, and put

most of that into value, not growth. And that's about as far as I push it. For a lot of people. That would mean a five or ten percent allocation. That's fine, that's enough to move the needle and make a difference in your performance. But our expectation is that emerging markets value stocks based on our models, should beat the SMP by about a thousand basis points per year for the

next ten years. That adds up big. And I noticed on your website you have sort of a calculator that tries to predict returns, and the the e M equity returns are projected at very high seven percent real versus half a percent real for U S stocks, right right.

But it also uh projects volatility and it looks like uh, some some very healthy volatility, healthy volatility so to speak, in e M. And it made me look, you know, actually, the the SMP is more volatile than the e M index right now, So UM, is that just a functional mean reversion to for for emerging market stocks. Part of that is a matter that emerging markets have been a

little bit more UM benign of late. In terms of volatility, I would expect emerging market stocks to be more volatile than the S and P, but again not drastically so. And uh so people fear emerging markets because of the unfamiliarity, not because they are inherently hugely risky. And certainly when the UM, I like to use the Schiller pe ratio, which was price relative to ten your smooth earnings US stocks, it's north of thirty times emerging market stocks, it's south

of fifteen times. It's more than half off emerging markets deep value it's around eight times. So if you can buy half the world's GDP concentrating on the value end of the spectrum and pay less than eight times the sustainable ten year smooth earnings, that's pretty cool, Chris. I want to bring you in here and get the state of plan markets because we continue to get more headlines on trade, whether it relates to China in Mexico and in that arena, the majority of the investors are saying,

don't go into emerging markets, it's so volatile. Of course, they have a shorter term outlook than ten years, But over this past week, it seems like markets don't really care much, do they? Well, they have stopped being overly concerned because somebody rushed to their aid once again, or to a degree, I mean, depending someone being oh Jerome Pow and if depending on how you slice his his did it did look like he was conscious that he was being called on to issue some some peaceful commentary

and they got that. And I don't know, uh, to me, not in any way surprising that the SNP of volatility is higher than everything right now. It's been a crazy market to cover if there's no sign that it's going to get any easier. There's lots of economics, I mean, I think this is what we're pivoting to. We were obsessed with the Fed, we remain obsessed with the trade war.

But a lot of people are starting to become really concerned that there's emerging evidence that the U. S economy is not what it what not would it looked like a few months ago? And that's probably going to call the tune from here. And are the head winds to the economy fixable by a few rate cuts? Considering how close we all arts is zero? I would just say to that the answer, if the economy is in trouble has historically been No. I mean, eventually rate cuts will

will kick in turn things around. But the economy is too big of a ship I think really in anything but the long term to to to be rescuable by you know, FED gestures, particularly now. I mean they don't have enormous amounts of bandwidth to deal with it. Rob, You were not in your head in agreement there, which is rare with NJ. We don't see that, right, we don't see that in this office. Uh much? Is is this rate cut that everyone's pricing in enough to keep

the party going? Or is there are too many headlines? The short answer is not really. The longer answer is um Monetary policy acts with a lag of about eighteen to thirty six months, so they should have been doing this a year ago. Um. Now, what's interesting is the the markets tell the FED whether it's too loose or too tight. You have a set rate, the short rate, you have a market rate the long rate, and don't view an inverted yield curve as a signal that a

recession may be coming. Few an inverted yield curve as something that creates the recession. Thank you. I've always thought that, Yeah, is that because of the fear that it creates in the investor space, or just because of the actual ways that now banks are lending out we're lending rate stand more the latter, because when you're dealing with long rates at let's say two and a half percent and tenure at um Ballpark of two and the T bill yield

is higher, materially higher. Basically, the long rate is saying, WHOA, we're seeing signs of a slowdown. We think two percent is about it for the cost of capital in a slowing economy, and the FETE is saying, we don't see it yet. By the time they see it, it's way too late. So Cam Harvey did his nine six um PhD dissertation on this very topic. He was the one who originally found the yield curve and versions had a

then perfect track record. To gauge the track record of any indicator, you're looking for false positives and false negatives. False positives would be signal that there's a recession coming and it doesn't happen. False negatives would be no signal and it does happen. There were no false positive those or false negatives from nine well, there's been no false

positives or negatives since then, that's pretty unusual. So when you see an inversion, it doesn't guarantee the recessions coming, but sit up and pay attention, because basically the market is saying this FED is too tight, it's stifling UH investment, and historically it's a perfect indicator. It's never failed. You know, I can't resist the chance to get a little plug in here if you want to hear more about Cam Harvey.

A few episodes ago our four Horsemen of the Apocalypse, we we interviewed Cam Harvey, Rob's colleague at at Research Affiliates UM Rob. We also heard from Mario Draggy this week, and the market didn't react very well to him. I mean they the ECB obviously has less sort of biggle room to stimulate UH still at zero percent interest rates. I mean he's developed Europe a lost cause in the stock market, uh for the over I mean you have European banks index trading at basically the level of traded

at in the in the nineteen eighties. You know, when when Chris was well, you've got you've got to recognize the downside risk is constrained. I mean Deutsche Bank that I can't lose more than two bucks to share because it's a two bucks share um, so you have a firm zero lower bound is firm when it comes to share crisis, I would argue, and central bankers just don't see this that if you reduce rates from six percent to four percent, you're stimulating. If you reduce rates from

two percent to zero percent, probably not. If you're reduced from zero to minus one, you're not stimulating. Your singing signaling panic, and people instead of going out and spending are going to hoard. They're going to um set money aside for a rainy day because the central bank is signaling watch out, big rainy days are coming. So no, I don't think it signals that the opportunity in European

equities are for clothes for the foreseeable future. The market knows about the impact of negative rates even as central bankers don't, and it's already priced it in European stocks. Uh. The European stock index is priced at half the Schiller pe ratio of the US emerging markets. A little cheaper than that, but half off already says we don't like the way things are going here, and we're pricing that in. So I would much rather invest in Europe than in

the US. That's saying a lot. You don't hear that many times, especially when short Europe is still one of the most crowded trades out there, supposedly according to some Bank of America dat Maverick. Maverick, Chris, I don't like crowded. Now, we know that, we know that. I do want to bring it back to Jerome Powell for a second, because he said at the beginning of the week that he would do whatever is appropriate to sustain the expansion, which

is nice and ambiguous. Right what is what it is appropriate? We don't know. But you've said on Bloomberg Television before that this can potentially cause an issue because it encourages investors to buy on the dip, and we did not gloss over the fact that ten minutes ago you just said that over the next ten years, US stocks will

probably return half a percentage point above inflation. Are these two at odds or is it the possibility that investors are buying on dips and continuing to drive the market higher that could potentially make the fall out even worse. I think they've been buying on dips for a long time, and that has a lot to do with evaluation multiples we see here in the US. My concern about US

stocks is all valuation related, it's not growth related. I think US is better positioned for economic growth in Europe or Japan, and I think demograph fix are a big part of that. We still have a rising population and a rising population working age population, um Japan has a shrinking population, in Europe has a shrinking working age population, so they have demographic headwinds that are much more serious

than the ones that we face. But even our demographics, the baby boomer population is huge, and roll the clock forward ten years and the vast majority of boomers will be retired. When the vast majority is retired, they will be having to sell assets in order to buy goods and services in retirement, whether it's through a direct sales or indirect through a pension paying out to them. In either case, those are valuation in different sales. You're selling

because you need to regardless of the price. So baby boomers switch from ten years ago being valuation in different buyers to valuation in different sellers. That's a big switch, and that could easily lead to valuation multiples being rather drastically lower ten years from now, Rob, one quick thing before we get to the craziest thing in markets this week. I think everyone's favorite part of the podcast, and at least mine two and fifteen I actually interviewed it you.

I don't even know if you remember. I'm a very forgettable guy, but one quote really, uh stuck with me, and I just want to read it back to you. Uh. You said, right now, we have earnings coming off of a record high as a percentage of GDP, and yet you have Wall Street saying, don't worry, it's going to sort of new hides. Pardon me, but when when do the peasants with pitchworks come out and start rioting? Society at large has to enjoy some of the large guests,

or else the pitchforks come out, you know. And that's really stuck with me because you look at some of the political developments that populism have since then. The populism, um, you know, the blue collar support for President Trump on one hand, that on the left you have a very big lurch to the left into downright socialism. Um, is that a sign of the pitchforks? And and ultimately, what is the target of pitchforks? I wonder if one of them might be buy backs, which is an element of

the fundamental index um. Where do you see who's going to get punctured by it by a pitchworks? Buy Backs I don't think are a big deal. It reflects companies concerns that they don't have new initiatives that are worth investing in, and therefore the best thing they can do for their share prices to buy back stock. That's a lot healthier than secondary equity offerings, which dilute the shareholder, and through most of market history, secondary equity offerings have

been much bigger than buy backs. But back to the basic question. Populism is a manifestation of the pitchforks. The pitchforks come out with people being angry and not knowing who to be angry at. So the Brexit tears are angry at Brussels, and they're angry at the mainstream politicians that got them married to Brussels. The Trumpians are angry about a lot of things, uh, mostly blaming immigrants and things like that. Um, Well, immigration, healthy, well structured immigration

is a wonderful thing. It's great for growth. You want to welcome people who are willing to work hard, who are willing to obey our laws and pay their taxes, and subject to that, we should be eager to hand out green cards. But are immigration policies are shambles. Uh, it's not at all correctly selective, and so people are angry. Um, across Europe you have populism in a very big way. So is this the pitchforks? It is. It's not yet uh, to a point of anger of truly getting out pitchforks,

but it does. It's a manifestation of the level of anger out there in the broad populace. Right, all right, Well, let's end on a happier note with the craziest thing I ever saw in markets this week, Chris Nag. You've seen a lot of crazy stuff in you. Let's let's

start with you. Mine isn't hugely crazy. It's just the rally and utilities over the last four days, which has been going on all year, that the best performing group in the SNP, which is in of itself kind of crazy, and then the last four days been pretty parabolic to a point where their forward valuation is now like a thirty year high. And I just think it's it's crazy in and of itself. They've all risen basically all week,

and it's just such a lens for this market. People want to bid it up, they want to own stuff, and what they're gonna end up owning is the ultimate safety trade. And as a result of that, defense even something is sort of classically defense boringly to offensive is utilities is now nosebleed valuation. And that's not the hot new growth sector utilit evident it is. There is an inflow into an x l U, which is the e t F at tracks utilities, the largest ever in history.

I mean, people just want to get in. Yeah, it's it's such a psychotic kind of psychological event, just basically euphoria for utilities the most psychotic thing. Sarah, what do you get? So we all know Costco obviously, and we think of Costco, you think of tread or Hunt buying,

you get a lot in bulk for a cheaper amount. Well, there was a wedding ring that was sold at Costco, and the CFO at Costco said, in part their sales got a nice little boost from this gift because if anyone want to take a guess at how much this ring sold for, and if you know you can't guess how. And I read the story and I can't remember that four thousand dollars a wedding ring at Costco. Well, everything's bigger at Costco, So is it like a I don't

think it's ninety five. I think it was something like ten point one. And it's still have a huge diamond. But who knew they sold rings that cost over four dollars at Costco? Did you quiz your boyfriend about whether he's been shopping at Costcos? I? I did not, d It's hard. There's no Costcos in the city, no costs have been had, and there's no point Rob. I don't know if they warned you about our gimmick. Here the craziest thing you saw in markets this week? Have you

have you seen anything crazy? Oh? I sure have. Um, there was and you're familiar with original issue new issue junk bonds UM, pioneered by Milken, and what we've seen is that junk bond yields famously. A year or so ago in Europe were christ that yields lower than US tenure treasuries, and I thought that was crazy. In Japan this past week, there was an original issue new issue junk bond to your junk bond priced at basis points. It's a single b credit, it's expected to be able

to pay. It's a coupon. It's not clear it'll be able to pay. The principle um, so you're buying something for a hundred yen that you expect will give you back a hundred two yen if it doesn't go bust? What you do? That's pretty grave it I prefer junk bond, I excuse me, I prefer emerging markets deep value stocks. That's pretty good. I think Rob might win, but I'll just give you mine anyway. Uh, and Rob, you'll like

this one. Given your discussion about stocks getting dropped out of an index, did anyone notice the stock that get dropped out of the SMP five on Monday night? Let's tell that toyaker? And why is this the craziest thing I've ever seen? And maybe not so crazy given Rob's research? But can anyone guess what the best perform ring stock? The next day in the Let's Hell, of course, and one of the catalyst cited was Mattel announced a licensing deal to make toys based on the Hello Kitty love

their Hello Kitty. Who you know who? Cares about the SMP when you got Hello Kitty, I guess from that, so maybe Tesla will need to add a Hello Kitty version of the Tesla peread themselves a little bit thitterer than people, Like I said. Stocks that are deleted from the SMP on average beat the market by two thousand basis points over the next year, So they just did half of it in one day. They're on their way.

We'll have to leave it there, though, Robert or not, Chris n G thanks so much for coming on the show today. Thanks. What Goes Up will be back next week. Until then, you can find us on the Bloomberg Terminal website and app, or wherever you get your podcasts. We'd love it if you took the time to rate and review the show so more listeners can find us, and you can find us on Twitter. Follow me at at

Sarah pont Seck, Mike is at reg Anonymous. Our guests Rob are Nots Research Affiliates is at r A Underscore Insights, and Chris Nag is at Chris nag One. What Goes Up is produced by TOFA Foreheads and the head of Bloomberg Podcast is Francesca Levie. Thanks for listening See you next time.