Tag: episode-1146


May 8, 2015

CONSUELO MACK: This week on WEALTHTRACK, with both stock and bond markets trading near historic highs alternative investments’ master, Cliff Asness shows how he juggles market risks with the search for better returns by keeping lots of investment balls in the air. AQR Capital Management’s Cliff Asness is next on Consuelo Mack WEALTHTRACK.

Hello and welcome to this edition of WEALTHTRACK, I’m Consuelo Mack. We all know that the stock market is pricey after a six year bull run. It’s not just that the NASDAQ recently hit a new high – finally – after 15 years of trading below its old tech bubble peak.

The market is expensive historically, based on much longer term measures, including one of our favorites. The CAPE ratio, or Cyclically Adjusted Price-Earnings ratio, created by frequent WEALTHTRACK guest, Nobel Prize winning economist Robert Shiller.

The CAPE, which is figured by taking the current price of the S&P 500 and dividing it by the average of S&P earnings over the last ten years, adjusted for inflation, is currently at around 27. That is well above its twentieth century average of 15 times earnings.

Individual investors aren’t the only ones worried about stock market levels. Professional investors are too.

According to a recent survey from State Street Global Advisors, of over 400 institutional investors worldwide, 63% of them increased their stock exposure over the last six months. But 53% wish they could decrease it instead, and would if they had a more attractive alternative. Talk about conflicted!

And 57% expect a market correction of between 10 and 20% in the next 12 months.

Well normally investors could turn to bonds for income and protection, but with bond yields at or near record lows, they are no longer a viable option.

According to this week’s guest, both stocks and bonds are more expensive now than they have been in 90% of market history. He is Clifford Asness, Founder, Managing Principal and Chief Investment Officer at AQR Capital Management. AQR stands for Applied Quantitative Research, which they use in a number of strategies.

Founded in 1998 AQR now a global investment management firm oversees more than 130 billion dollars in hedge funds, mutual funds and a diversified collection of investment strategies from traditional long-only ones to multiple alternative approaches.

I began the conversation by asking Asness how unusual it was for both stocks and bonds to be this expensive at the same time.

CLIFF ASNESS: That is the really unusual part. Again, roughly the 90th percentile more expensive than history for stocks, roughly 90th percentile for 100-some-odd years. So only 10 percent of the time have bonds or stocks been more expensive individually.

CONSUELO MACK: So that kind of scares me. Here we have …

CLIFF ASNESS: I apologize for that.

CONSUELO MACK: … the two major asset classes that individuals own in their portfolio, stocks and bonds, and they’re really expensive together. What do I do with that information? What do I do with my portfolio? Should I be paring back in both my stocks and my bonds? What’s the response to that?

CLIFF ASNESS: It’s the big question. Information is great. What do you do with it? I will admit I think this is my honest opinion with a little bit of cowardice thrown in, but I do not go out to people and say, “Market time. Pare back.” I don’t do that for a number of reasons. For one, 90th percentile. There’s something called 100th percentile, and then not all 100th percentiles are created equal. You could be the highest ever by double or you could be barely touching the highest ever. Timing these things can be very difficult, and when people try to time them, they often have strong conviction at the beginning. It doesn’t work out for two or three years because things get more extreme. They cave. The roundtrip is ugly. In general timing is dangerous. If we ever got to tech bubble-like extremes for either the whole portfolio or either one, I have hubris to think maybe at those extremes, and I’ll still be wrong by a year.

CONSUELO MACK: Right. You’ll be early.

CLIFF ASNESS: But if we got to 50 percent worse than we’ve ever seen before, way past the prior 100th percentile, I think I would come here and tell you, “You know, now is the time to do something odd,” but even at the 90th percentile I do not encourage people to time the market, to pare back, to hope for a dip. We might never get it. It might come tomorrow, but we might never get it. We might just make lower returns for a really long period. The most important thing you can do, is just factor it into your planning. Information is power. When you sit there and say… and this applies to a pension fund. It applies to an individual with a spreadsheet or a piece of paper. What do I need to save for retirement? If you are counting on the historical returns of stocks and bonds which is about five percent over inflation … or the really low ones now are two and a half percent over inflation.

CONSUELO MACK: And that’s what I wanted to ask you. Therefore, if stocks and bonds are expensive historically, therefore, our expected returns are no longer going to be … you were just talking about real returns of let’s say of five percent. That’s ex inflation. You put inflation on top of that, and it could be traditionally seven to eight percent. Right?

CLIFF ASNESS: Yeah, if you have two or three inflation. Sure.

CONSUELO MACK: Therefore, what are the expected returns? Now you just said two and a half percent real.

CLIFF ASNESS: Two and a half percent real.

CONSUELO MACK: That’s ex-inflation.

CLIFF ASNESS: So if you do the same exercise, and again if inflation is different, the answer will come out different. This is assuming we get somewhat near normal.

CONSUELO MACK: But still that’s half the five percent that we’ve been used to.

CLIFF ASNESS: But if this number were actually negative to inflation and not two and a half percent real, negative one percent real, meaning economists were coming out with forecasts of inflation that were larger than the yield in the stock and bond portfolio, I would tell you that’s a bubble. If I believe those numbers, I would say that’s a bubble. That makes no economic sense. At two and a half percent I could only tell you it’s expensive versus history. This could be what the market has decided is it’s going to be now. It could change back tomorrow. We don’t like to forecast that. We think a lot of people go broke trying to forecast that, but anyone saying, “How much do I need?” it’s bad news. I won’t pretend it’s good news. Anyone saying, “How much do I need to save to retire? How much do I have to put in stock and bonds into a portfolio?” If that’s your investment and it’s going to make less, you need to know that.

CONSUELO MACK: Right. You need to save more. You need to spend less.

CLIFF ASNESS: You need to save more, spend less, work longer, all the bad things.

CONSUELO MACK: Asset allocation. Number one, you are a huge proponent of diversification.

CLIFF ASNESS: Diversification figures very big into what we do at our firm at any stage when it comes to how to try to add value and combine different signals in the alpha or the style tilt world, things you and I have talked about before and probably will again, but when it comes to asset allocation, just your weight in stocks, bonds, commodities, international versus the U.S., we are always pushing on the diversification front. We are big proponents of global as opposed to single country. That’s for both stocks and bonds. At the very least we think it does no harm. At the most we think it protects your portfolio … and we’ve written a paper on this… for some truly terrible long-term periods that happened in individual countries more often than the globe. It doesn’t interestingly protect you from crashes. When you have short sharp panics, the world tends to panic at the same time. At least that’s been the historical result, but it does protect you from finding out your country is the sick man for the next decade. So step one…

CONSUELO MACK: So it’s very important to diversify globally.

CLIFF ASNESS: And it falls out of favor from whatever country’s perspective. This is a global world. We’re sitting here in the U.S. but wherever you are…

CONSUELO MACK: Right now U.S. is very popular and it’s done really well. It’s led in the markets.

CLIFF ASNESS: And I think some of the better strategists are out there saying, “You know, don’t give up on international.” You want it all the time for diversification and totally separate I do think in some of the cheaper parts of the world particularly on the equity side. On the bond side I think the rest of the world maybe is even worse than the U.S. So being global. The second is asset class diversification. This is more controversial I’ll admit. It’s a little more off the beaten path, but we believe in it strongly. A traditional portfolio is mostly dominated by equities. If you put 60 percent of your money in equities and 40 percent in bonds, and I don’t know anyone with actually a 60/40 portfolio, but we all use that. If you do that, equities, sure they make more, but the move around a ton more for the good and the bad. The bonds I like to say they’re diluting, not diversifying. They’re dampening the returns, but they’re not enough of an equal partner to equities to actually matter. So 40 percent in a safer asset does dampen the returns, but it doesn’t diversify them. It’s not that different from having 40 percent in cash frankly at that level.

CONSUELO MACK: You’re actually saying at a time when everyone is saying bonds are really more expensive and that one should be avoiding bonds … that’s what a lot of people are saying … you’re actually saying no. In fact, that bonds are not necessarily your enemy and that stock, the stock-centric portfolios which most of us have are actually not the way to go. Right?

CLIFF ASNESS: Sure, if we have a truly terrible economy, they’re pretty much the only thing that’s going to work. They perhaps have more of an insurance role than a diversifier now. It’s a slight subtle difference where it’s hard to argue they’re going to make a ton of money, but being the only thing that can make any money in a disastrous economy is not terrible. Do I wish they were more attractive? Sure, but I’m much more concerned about the combination of the two.

CONSUELO MACK: Then there’s commodities. So that’s a third major asset class that you believe that we should all have exposure to. Correct?

CLIFF ASNESS: I do, not as large as the other two. Both the economic story and the theoretical story for the exposure is not as strong but we think strong enough that you want it, and its empirical properties of being one of the only asset classes … if you think of the two big things that could happen to the economy, growth and inflation shocks. This world where we get a bad inflation shock, and growth can do either really, but a bad inflation shock is very bad for bonds, not particularly good for equities in the short term. Maybe in the long term they can make up for it. An equity investor’s not saying, “Yeah, I’m really looking forward to that inflation shock.” Commodities have been the only thing with the ‘70s being the canonical example of when they were really the only asset class to make money. So we don’t think they become an equal partner with stocks and bonds but a non-zero permanent allocation to them makes sense to us in our strategic allocation.

CONSUELO MACK: To get back to the question at hand, is two and a half percent real returns going forward in a stock and bond portfolio, in a diversified portfolio? How do we do better than that? And of course, Wall Street’s come up with, as has AQR, all sorts of strategies. There’s something called Smart Beta. These have become very popular products. So define what we should understand. What is Smart Beta, and then how do we use it? How does it work? And then, how do we use it?

CLIFF ASNESS: Smart Beta in its most well-known forms … and there are a lot of things that people are calling Smart Beta now these days, but in its well-known form says the capitalization-weighted portfolios overweight the stocks with the high multiples. Whether it’s risk or inefficiency, they’re going to underperform something that tilts away from that, that tilts more towards the cheap and more away from the expensive. I don’t think it’s brand new, but I love the strategy because I’m a believer in value investing. It’s one of the big pillars of things we believe in.

CONSUELO MACK: Right, so your three pillars are …

CLIFF ASNESS: Oh, we’re up to four pillars. Did we only have three last time?

CONSUELO MACK: Oh, I thought, yes, only three last time.

CLIFF ASNESS: I don’t remember. It’s certainly four now. I always know the current number of pillars.

CONSUELO MACK: Cheap is better than expensive.

CLIFF ASNESS: Cheap beats expensive. Momentum still works, so we are somewhat traders.

CONSUELO MACK: So positive momentum is better than negative momentum.

CLIFF ASNESS: And high quality beats low quality both in terms of basic …

CONSUELO MACK: Right, and what is the fourth?

CLIFF ASNESS: … things like profitability and in terms of safety. Lower beta, lower volatility, lower leverage companies could be fundamental or return-based. You might remember three because maybe we were talking about stocks, because the fourth doesn’t apply to stocks. It’s called carry. Carry is what you get in a position if prices don’t change. I shouldn’t say it doesn’t apply to stocks. I should just say it’s too redundant with value. Think of carry as dividend yield. If the price doesn’t change, you get the dividends. None of these four things, value, momentum, carry or quality always work. None of them are panaceas. You want to do it in a diversified way as many ways as you can. Anytime a quant talks to you, they’re talking about averages and they’re talking about diversification. They’re not talking about one bet somewhere but, all else equal every single place, be it stocks, currencies, bond markets, we want things that are cheap, starting to get better, pay us to sit on our whatevers and wait … that’s carry … and finally are also high quality, being safe and profitable.

CONSUELO MACK: So at all times in all markets those are the four qualities that you’re looking for.

CLIFF ASNESS: They’re ubiquitous and that makes us even stronger believers that they’re real because if they only worked in half the markets and different ones worked in different places, you should look at me and start going, “Maybe you’re just a wily statistician who’s made it up,” and I still might be, but the chances are smaller given these things seem to have similar statistical power. They don’t always work, but the work more often than not everywhere we look. The prefect world we’re getting all four everywhere. The world is rarely perfect.

CONSUELO MACK: Back to Smart Beta.


CONSUELO MACK: As an individual, what Smart Beta products do you think work? What kind of performance edge do they give you or enhancement? What can we expect?

CLIFF ASNESS: Well, keep in mind, in case it wasn’t blindingly obvious to your audience, I sell these. I believe in these. I think I’m telling the truth, but everyone should know. Sit on your wallets while you’re listening to me. So I just feel bad I’m about to say, yes, everyone should own these, and everyone can’t own these because remember they’re deviations from the market, but everyone should want to at this point. I do think that there are two basic ways you can do it. You can do it through the long-only Smart Beta implementation in which case looking through all the products, and again I won’t do a commercial. There are a lot of good ones out there far from just ours, where finding people who are doing good, solid, well-tested tilts towards value, low risk, even if you can the other parts like momentum or quality in there at a fair fee. One thing about Smart Beta, and again I’m accepting the term, but it’s an admission that it’s a fairly simple process.

CONSUELO MACK: Yes. What’s a fair fee?

CLIFF ASNESS: A fair fee. You will not pin me down to a number. I’ve gotten too wily over this.

CONSUELO MACK: No, but look.

CLIFF ASNESS: It is clearly in between traditional active management fees. Call it 100 basis points on up and index fund fees, you know, 10 basis points on down.

CONSUELO MACK: Clearly lower than the traditional actively managed mutual fund which I think the average is still like one and a half percent or something.

CLIFF ASNESS: Well, the average is insane. If you’re paying one and a half percent for long-only stock picking …

CONSUELO MACK: You’re crazy.

CLIFF ASNESS: Yeah, let me just say that to your audience right now.

CONSUELO MACK: I should have you say that. I shouldn’t say that.

CLIFF ASNESS: Yeah, I will say that. I think that is a crazy number. Even though I believe there are ways to beat the market that are systematic and have been around for a long time, fees count. If I ever get an economic law named after me, which I do not believe I will ever get, here is what I would like it to be. There is no investment product so good that a high enough fee cannot make it bad. A hundred fifty basis points in a broad portfolio for stock picking; somebody will beat it. Somebody will beat the 150 basis point fee. On average it’s a sucker’s bet. So I don’t think half of that, but for long-only equities, and this is where it gets hard and I’ll geek out on you because different Smart Beta products will essentially deliver a different bet against the index, a different sized bet, and the bigger that bet is, the bigger the deviation from cap-weighted, the more it’s fair for them to charge.

CONSUELO MACK: Right, and that’s your definition of active management is that a truly active manager is far from his or her benchmark.

CLIFF ASNESS: The world calls active management people who visit companies and pick stocks. As long as people know what you mean, it’s just communication, but I in AQR think of it much more in terms of how different are you than the rest of the world. That’s “active” to us.

CONSUELO MACK: Let me ask you an unrelated question, but it has to do with fees, and you have some interesting thoughts about hedge funds. Hedge funds are another area, another asset class that is being marketed to individual investors now. So your view of hedge funds kind of in general is … CLIFF ASNESS: I’m all over the map on this I admit. I believe it’s consistent at the end of the day. It’s a set of pros and cons, and I also admit this. When hedge funds are attacked, I tend to take the other side and explain why the attack goes too far, and when hedge funds are extolled and overhyped, I have tended to take the other side. Let me give you a quick example of both. They are attacked in a sense of … a lot of articles say the last five years they haven’t kept up with stocks or even with 60/40. That’s true. It’s been a giant bull market for the last five years. The idea of hedge funds is they’re supposed to hedge. Ironically I don’t think they hedge quite enough. I would like to see them hedge all the way back to zero to be truly hedged fund. Notice a little difference in pronunciation. A fully hedged fund, but their average market exposure, what the geeks would call beta, what a human would just say percent net long, has been about 35 to 40 percent.

CONSUELO MACK: So they’re hedged, but they’re not a hedge. They’re still very equity, stock-centric. Right?

CLIFF ASNESS: That 35 to 40 percent means if you tell me the stock market fell 20 percent, 40 percent, I expect to fall eight percent right there. Boom. If you were fully hedged you don’t expect to go up. It’s literally still not a hedge. An actual hedge on stocks is something you expect to go up if it falls, but it is internally hedged. You see how nuts this can get with the parsing of the words?


CLIFF ASNESS: I apologize for that, but it’s just true. So what a lot of people do is take something 35, 40 percent net long, compare it to either 100 percent equities which is just crazy or even the 60/40 has more stocks than hedge funds do. Of course they’re going to lose in a giant bull market. If you look at the indices, and the hedge fund indices have allkinds, you don’t want to go there. Not everyone reports. They have survivorship bias, but if you do look at the same indices people use to criticize hedge funds. If you actually hedge them, the part left over has been valuable over time including the last five or six years. The part after hedging them is return that’s unrelated to the markets. It’s been positive and it’s been diversifying. Now that’s the defense. I wrote a piece and I called it a tepid defense. It’s not a full throttled defense. It’s defending them against a narrow accusation. I do think hedge funds should be a better deal for investors. I think to tie this together hedge funds are pursuing some of these simple strategies we’ve been discussing. Now we also pursue more complex versions where we try to make them a little better. Maybe hedge funds are doing that too, but a big part of what they do, things like carry and momentum for instance, very big in the hedge fund world. So partly they’re making their money doing simple strategies and charging the fees you would pay for great complexity that you can only buy from one place. If you’re selling something that’s more generic, you should charge a more generic price, and also as just an empirical observation, that 40 percent equity exposure? Something could be 40 percent and explain all of hedge fund return, or something could be 40 percent and only explain a little of the return. It depends how much other stuff they’re doing. People often confuse … I’m going to freak you out and do math here … beta versus correlation. A lot of people think it’s the same thing. If you take 40 percent of your money and put it in all stocks, 60 percent and put it in cash, you have a 0.4 beta. You will only move 0.4 of the market, but you have 100 percent correlation.

CONSUELO MACK: To the market.

CLIFF ASNESS: The market explains all of the movement.


CLIFF ASNESS: Hedge fund’s beta has not really gone up over time. They’re still taking about it, but their correlation has steadily gone up which means they’re doing less of the part you actually want to pay them for.

CONSUELO MACK: Yes, and a better deal would be, number one, that they change their strategies so that it’s more …

CLIFF ASNESS: More hedge, lower fees.

CONSUELO MACK: Okay, and the lower fees, now it’s a two percent …

CLIFF ASNESS: Tastes great, less filling.

CONSUELO MACK: … management fee, and it’s 20 percent of all the profits.


CONSUELO MACK: And you’re saying they should skew more towards Jack Bogle. Right?

CLIFF ASNESS: They should Bogle-ize themselves a bit. Now a lot of what they do …

CONSUELO MACK: So overall they should Bogle-ize themselves.

CLIFF ASNESS: I don’t want to be a complete cynic, and I’m not. There may be managers who can justify those very high fees through true alpha. I tend not to be a big proponent of that. It’s not what I do. I’m not an expert on it, but I don’t fully dismiss it. I think markets are pretty darn efficient but not perfectly efficient which opens the door to that. So it certainly doesn’t say no one out there can do it, but if you invest in a ton of these, the odds you’re getting a ton of managers who can all do it goes down. You have to tell yourself as the investor, if I’m going to pay those fees, it’s not just can someone do it. It’s can I also pick that person before the fact? So I do think on net the industry has to get more client-friendly. So far I’m wrong because they’re still doing fine without getting more client-friendly.

CONSUELO MACK: One investment for a long-term diversified portfolio. What should we all own some of in a long-term diversified portfolio? The last time you were on in 2013 you made a contrary call, and it was you have to own some bonds because that’s a diversification vehicle, and you need to be there. What would it be now?

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