A Conversation with Cliff Asness
Tyler and investment strategist Cliff Asness discuss momentum and value investing strategies, disagreeing with Eugene Fama, Marvel vs. DC, the inscrutability of risk, high frequency trading, the economics of Ayn Rand, bubble logic, and why never to share a gym with Cirque du Soleil.
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TYLER COWEN: Cliff is one of the most influential figures in global finance. He has a PhD from the University of Chicago, he studied there with Gene Fama. And he is a founder and principal of AQR Capital Management in Connecticut.
On momentum and value investing
Cliff, when I think of your work, the very first word which comes to my mind is momentum. Could you first give us just the super short version of what a momentum trading strategy is?
CLIFF ASNESS: Sure. A momentum investing strategy is the rather insane proposition that you can buy a portfolio of what’s been going up for the last 6 to 12 months, sell a portfolio of what’s been going down for the last 6 to 12 months, and you beat the market. Unfortunately for sanity, that seems to be true.
COWEN: Seems to be true. Now, you call it insane, but if you were to give us a simple example — on average, statistically speaking, not in a free lunch way, but what kinds of supernormal returns might you possibly earn through a momentum trading strategy?
ASNESS: As one example, if you were running against large‑cap US equity, something like the Russell 1000, and you bought the one‑third of stocks with the superior 6 to 12 months returns, you’d probably make 100, 125 basis points extra long‑term, on average. You do that in small stocks. It’s more like 250 to 300.
COWEN: Why is it larger for small stocks?
ASNESS: Almost anything we find in investing, almost any regularity, “this tends to beat this,” seems to be smaller — seems to be larger, excuse me — for small stocks. That is not quite as good a deal as it sounds, because the risk is also larger. Small‑caps have bigger fluctuations.
People have a lot of theories. Analysts’ coverage, Wall Street doesn’t cover them as much, perhaps whatever degree of inefficiency in the market is larger for small‑caps. But it’s a nearly ubiquitous finding. Anything you find works in large‑caps tends to work somewhat better in small.
COWEN: If you have, in terms of excess return, 100, 125 basis points compounded over 20, 30 years, obviously that’s going to be a lot of money, correct?
COWEN: What’s the catch? What’s the qualification? Why doesn’t everyone here run out? They don’t even wait until the talk is over —
COWEN: And as an investment strategy, follow what you have done with momentum. What’s the trick?
ASNESS: There are a number of them. One hypothesis is I’m really not very convincing at all. Another is more people do it these days and I’ll admit I think the strategy is going to survive that, but it’s a concern. It is not something every investor can do. I get this question from clients sometimes and I go, “Are you going to do it?” and they go, “no.” I go, “That’s why.”
With that said, I think it is a fairly unintuitive idea. To some, it’s very intuitive. Just buy what’s going up. To someone who studies markets, particularly for Gene Fama like I did, the idea that you can beat markets — and we do more than just momentum. (Tyler, he’s promised me he’ll get to that.) But it’s a very unintuitive idea if you think markets are anywhere near highly efficient. I think that dissuades some. It nowhere nearly works all the time.
One thing I should really be careful about. I throw out the word “works.” I say “This strategy works.” I mean “in the cowardly statistician fashion.” It works two out of three years for a hundred years. We get small p-values, large t-statistics, if anyone likes those kind of numbers out there. We’re reasonably sure the average return is positive. It has horrible streaks within that of not working.
If your car worked like this, you’d fire your mechanic, if it worked like I use that word. I think it is harder than you might guess, even if something works long term, to have it go away because a lot of investors can’t live through the bad periods. They decide why it’s never going to work again at the wrong time.
If your car worked like this, you’d fire your mechanic, if it worked like I use that word. I think it is harder than you might guess, even if something works long term, to have it go away because a lot of investors can’t live through the bad periods. They decide why it’s never going to work again at the wrong time.
COWEN: I think of you as doing a kind of metaphysics of human nature. On one side, there’s behavioral economics. They put people in the lab, one-off situations, untrained people. But here it’s repeated data, it’s over long periods of time, it’s out of sample. There’s real money on the line, and this still seems to work.
When you back out, what’s the actual vision of human nature? What’s the underlying human imperfection that allows it to be the case, that trading on momentum across say a 3 to 12 month time window, sorry, investing on momentum, will work? What’s with us as people? What’s the core human imperfection?
ASNESS: This is going to be embarrassing because we don’t have a problem of no explanation. We have a problem with too many explanations. Of course, we can observe the data. The explanations you have to fight over and argue over. I will give you the two most prominent explanations for the efficacy of momentum.
The first is called underreaction. Simple idea that comes from behavioral psychology, the phenomenon there called anchoring and adjustment. News comes out. Price moves but not all the way. People update their priors but not fully efficiently. Therefore, just observing the price move is not going to move the same amount again but there’s some statistical tendency to continue.
Take a wild guess what our second best, in my opinion, explanation for momentum’s efficacy is? It’s called overreaction. When your two best explanations are over- and underreaction, you have somewhat of an issue, I admit. Overreaction is much more of a positive feedback. It works over time because people in fact do chase prices. So if you do it somewhat systematically and before them you make some money.
One of the hard things you find out in many fields but I found out in empirical finance is those might be the right explanations but they’re not mutually exclusive.
Remember the movie Highlander? You and I talk about sci‑fi.
COWEN: Of course, yes.
ASNESS: They always say there could only be one. I use this tagline a lot and only one of a thousand people gets it and then one of two thousand laughs. That’s not true in these things. There could be multiple explanations.
Both of these things can be true. There could be underreaction and ultimately, people can go too far. Very often in finance, let me give you two other possible explanations also.
Every empirical regularity, meaning something that works or is terrible with some predictability, it does so for one of three reasons. The worst one is complete accident. You’ve data mined. I sat there in my dissertation in 1990. I found this empirical relationship with a big t‑stat but I really checked 63 things so the t‑stat is a bit of a lie, and it never works again.
Momentum in my opinion — this is editorial — has survived 200 out-of-sample tests, through time, different asset classes. I don’t believe that one but to be intellectually honest, you never reduce that probability to zero. You just make it lower. As it works again, you go “chance you’re just lucky, smaller.”
Second reason is a behavioral story. Someone out there is making a mistake. I gave you two. Underreaction and overreaction are both the behavioral story. They’re both somebody out there making an error, doesn’t mean markets are terrible by any means. I’m a big believer in markets but at the margin, they’re making an error and you take advantage of it.
The third is risk. In a rational world, you get paid. Momentum would work in a rational world if the short-term 6 to 12 month winner were in some deep, important sense riskier than the losers.
COWEN: But they don’t seem to be.
ASNESS: They don’t seem to be.
ASNESS: They do show, there are terrible periods, there are so-called momentum crashes but there are very good periods, of course, and those crashes don’t appear to be a particularly painful time. In the world of economics, it’s not just the bad periods, it’s when you have them. I don’t think people have come up with a very good risk story, but I’m not done.
COWEN: Let me give you my intuition in favor of why it might be overreaction and you tell me what you think.
You receive a signal about the world. It’s to some extent a private signal and you over-interpret that signal and you think it’s a signal about the whole world so you overreact. That leads to some price movement, which is propagated through time. But, at least some people think, past that 12-month time window, momentum ceases, and there’s even a bit of price reversal.
Eventually, you learn that you’ve been overreacting by thinking your private information is more general, more systematic than it is and then things snap back a bit. Does that psychological hypothesis explain this mix of price reversal in the longer term and momentum in the shorter term? Do you think that makes sense or not?
ASNESS: Yeah, I’m going to go with that for now. No, I’m kidding. Yes, it does. I think you’re articulating a version of the overreaction idea.
One thing that Tyler just referred to is if anything pride of place came before momentum and is a super important strategy to us. He’s asking me about momentum because that was a very early part of my work in adding it to the lexicon. But value investing at a longer time horizon, buying what’s cheap in pretty much any way — price divided by something reasonable, price divided by earnings, books, sales. Just buying five-year losers, five-year stocks that have suffered, and selling or underweighting the opposite is also a very good strategy, very much the opposite in spirit to momentum.
Now, in the value world they have the same fight. Does cheap beat expensive because it’s riskier? I don’t think they’ve done a very good job of identifying the risk but I find it inherently more plausible that something priced to a long-term lower level might have a risk element to it than a much more short-term phenomenon like momentum.
COWEN: Then there also be overreaction.
ASNESS: Of course. The second big one is behavioral.
ASNESS: If people make errors of any kind, literally almost of any kind, value is going to work because if two stocks have the same fundamentals, if there’s an error in the price, it’s going to look more expensive so you’re going to dislike that one and you’re going to like the one that looks cheaper.
One thing nice — and I don’t think it’s dispositive and I think both momentum explanations can coexist — and by the way, there are others. I’ve given you my two favorites, there are others.
One thing nice about the overreaction reason for why momentum has worked over time is it is consistent with the behavioral version of value too. If you’re going to get overpriced or underpriced, one would imagine at some point, you overshot something.
ASNESS: So it forms a nice integrated system.
On less than perfect market efficiency
COWEN: Let me give you another reason why maybe overreaction is a possible explanation. In finance I find it’s one of the biggest puzzles: why do people trade at all? People who are fools, people who are well-informed but not better-informed than the market, people all over, they trade like crazy. It seems only a small percentage of that is liquidating funds to send your kid to college.
That suggests people are systematically overconfident. If the fundamental human bias is overconfidence and that leads to overreaction, do we then have some kind of plausible — these metaphysical human microfoundations — for why securities markets stay imperfectly priced?
ASNESS: I’m very pleased to get a promotion to metaphysical. That’s much deeper than I ever thought of it.
COWEN: Is it a promotion or a demotion?
ASNESS: I started — I was never a pure efficient marketer. I was never a person who thought markets price things perfectly — nor is anyone, by the way. The paragons, one of my investing heroes, academic heroes, Gene Fama, likes to shock the class at Chicago. Only the University of Chicago in Gene’s class could this be a shock line.
ASNESS: But kind of day three, he looks at the class and goes, “markets are almost certainly not perfectly efficient.” And this is University of Chicago with the godfather of efficient markets so you get a [sigh of surprise]. Anywhere else — you guys did not do that. You might notice that. He makes making a point that that’s a very extreme hypothesis that all the information’s there.
People individually make errors. Errors are not riskless for even informed people to arbitrage away. I think looking at the world, I share your intuition. I think it’s backed up by the data that the most common error is two kinds. They’re not exactly the same thing but overconfidence and over extrapolation.
COWEN: Are the two of us overconfident? Let’s say someone on Twitter says you’re totally wrong.
ASNESS: I can’t answer for you.
COWEN: Do you underreact or overreact?
ASNESS: I overreact and, therefore, I’m overconfident.
COWEN: If you tell your kids they can’t watch their favorite TV show —
ASNESS: You’re destroying my entire self-image right here.
COWEN: Do they underreact or overreact?
ASNESS: My kids are probably more grown up than I am.
ASNESS: Yeah, but they overreact.
COWEN: They overreact?
ASNESS: I can’t find a lot of examples of people who underreact. I’m picking up on your point here slowly.
COWEN: This is my intuition. You look at these other areas. People at work, they’re given positive or negative feedback. They may overreact more readily than underreact.
ASNESS: Let me take this another way. I think we are mixing overconfidence with overreaction a little bit. New news, people might be overconfident in how much they understand it, but they don’t seem to incorporate it enough.
There is evidence on this outside of just returns to momentum. People look at the actual news that came out, try to gauge what the reaction should be, things like that.
I do think there are things when it comes to processing new information, I do think there is an underreaction in that sense, an anchoring and adjustment. People do all kinds of psychological experiments. You show people a whole lot of numbers and you show them numbers out here. They should move X, they move half-X.
ASNESS: They’re overconfident that they are right. I think that does lead eventually to the overreaction.
I really do think — this is one thing that makes it very hard, when I go to academic seminars where people are fighting about this. There aren’t many things in my life where I’m a peacemaker. If I see a fire, I’m far more inclined to throw gasoline on it than water.
COWEN: OK, good.
ASNESS: But at academic seminars, this idea that there could be multiple explanations, I push at times because there’ll always be, two people they want to win. Somebody has an overreaction, somebody has an underreaction story. Somebody says it’s risk, somebody says it’s behavioral.
It could be both and just to make our lives really hard, the mix of what’s more important doesn’t have to be the same at all points in time. Let me give you an example.
I didn’t start out a perfect efficient marketer. I wrote my dissertation for Gene on momentum. I was already showing a heretical drift at that point. He was quite good about it, by the way. The technology bubble, living through that, where momentum worked but the other thing we believe in many strategies actually, but the other biggest, the second biggest one, the tie for the biggest one is value investing again.
Some of you, distressingly fewer and fewer, look like you actually remembered it live.
ASNESS: Too many of you read about this in the history books, something that one of my partners told me that I look like Lincoln before and after the Civil War from the technology bubble to which I was like, we did well because we stuck with our value strategy but we were nearly destroyed by it. When he said that to me, I’m like, “Yeah, that’s about even. Lincoln kept the Union together and ended slavery. I stuck with a value strategy.” That’s perspective for you.
COWEN: You need a lot of discipline to make momentum investing work, right, because for 10 years, it might get you nowhere or even underperform.
ASNESS: This gets back to your earlier question, “Why doesn’t everyone do it? Why doesn’t all this stuff go away?” Any of these things, value, momentum, there are other things — quality investing, low-risk investing. Fisher Black of the Black-Sholes option pricing model’s discovery in 1970 and then everyone forgot for 35 years. It’s another effective systematic form of investing.
If everyone did them yesterday, they would go away. They work in my opinion — again using my version of “work” — in kind of a sweet spot. Good enough to be really important if you can follow discipline, not so good enough that the world looks at it and goes, “this is easy.” They’re excruciating at times and I hate those times. I won’t pretend I’m neutral as to those times.
COWEN: They help keep your market franchised.
ASNESS: I recognize intellectually you need those times while I will whine and cry horribly during those times. I’m not pretending I’m above that.
COWEN: But momentum investing still works today —
ASNESS: I believe it.
COWEN: Now, if the momentum anomaly and the value anomaly — those to me seem like the two biggest anomalies in pricing theory.
ASNESS: I think so.
COWEN: Does Eugene Fama admit you are correct?
COWEN: You have an academic record on this. You have a track record, right, statistically and the success of your firm. Will he try —
ASNESS: He’s just trying to get me in trouble.
I will tell you. I’m in public here, I’m with someone I admire greatly, this is going to be on the Internet. I’m still more scared of Gene.
ASNESS: With that said, one of the scariest moments — let me take you back — was telling him I wanted to write a dissertation on price momentum. I swear to God I mumbled the second part, “and I find it works really well.”
Because it failing is a perfect Chicago, Gene Fama, efficient markets dissertation. “Look at what these crazy people on Wall Street do. They make all these indicators, and they’re throwing away their money.”
To his credit, he immediately said, “If it’s in the data, write the paper.” Now, we don’t agree fully on it. We don’t agree on two things. For all I know, he changed his mind yesterday, but as of yesterday, I don’t think we agree on this.
Value investing, remember, I think works for a mix of both behavioral and perhaps some risk reasons. I think they’re hard to identify, but I’m more than willing to say that might be a big part of it. I think Gene would say it’s mostly or all risk. I don’t think he’s very positive on the behavioral explanation.
Momentum — Gene’s a risk guy, he’s an efficient markets guy. I think Gene is still cynical about it. I know his latest paper — he and Ken French write if not the best among the best papers in finance. I read every one to this day. It doesn’t mean I agree with every word.
They started out with a so‑called three-factor model about 20 years ago. What drives return on an individual stock? The market’s return and your sensitivity to that. Value’s return and how much of a value stock you are. Size’s return, a small firm effect it’s called — how small you are.
They’ve added to that over time. They’ve added an investment effect of firms that, for instance, reduce their share count tend to do better. There are theories as to why. And a profitability factor. All else equal, more profitable firms seem to outperform less profitable firms. Again, that’s a very strong effect that holds up.
I take the other side from them. I love these guys. We agree on 9 out of 10 things. I don’t see how momentum is not their sixth factor. It adds a tremendous amount of return versus their model.
I take the other side from [Fama and French]. I love these guys. We agree on 9 out of 10 things. I don’t see how momentum is not their sixth factor. It adds a tremendous amount of return versus their model.
The numbers I gave you that you can add versus, say, the Russell 1000, 125 basis points, understates the power greatly because momentum is also in geek speak negatively correlated with value. In English, a good year for momentum is often a bad year for value, and vise versa.
That’s easy to create, if you just do the opposite with your left hand as your right hand. It’s not easy to create two strategies that both go up on average. That’s difficult. That shows up statistically in a model. It becomes even stronger.
So, I don’t understand why. I think they should have it as a sixth factor. If you can get Gene to leave Chicago, which is far more difficult than anything else we’re talking about, he can tell you why it’s not a six factor. But it should be.
On the inscrutability of risk
COWEN: Let me ask you a question about risk, because this key concept comes up again and again in finance. A strategy may appear to have a high return, but risk-adjusted, what are you really getting?
Now, when I read the very latest papers on risk, let me tell you what I see. I see talk of the third moment of probability distributions, the fifth moment, words like coskewness, terms like the U‑shaped pricing kernel, and talk of the volatility of volatility. I’m just waiting on the paper on the volatility of the volatility of volatility.
When I read all this as an outsider, I conclude we don’t know anything about risk. These are Ptolemaic epicycles. Within a pretty broad range of asset classes, is it possible risk doesn’t really explain anything about asset prices? True or false? What do you say?
ASNESS: The epicycle has held up for a long time. They even got the little tiny movements right. That’s not bad.
OK. Of everything you said, a fair amount of those risk models I think are utter nonsense. I don’t think the fifth moment — I’m going to insult someone I care about now by accident, I don’t even remember who wrote this.
I don’t think the fifth moment is a good measure. I don’t even think skewness — skewness is bad stuff. Even if selling worth makes money on average, occasionally really bad stuff happens, more often than really good stuff.
Coskewness, which sounds like one of the geekier things Tyler said, very hard to identify, very hard to prove, very hard to isolate in the data. But coskewness at least makes sense to me as a real risk factor. What that means is not only do very bad things happen more often than you would imagine, but they happen while other very bad things — largely the market crashing, for instance.
If something has occasional giant losses, but those are at very good times, and makes money on average, very reliably, that might stink occasionally, but it’s something you can live with. If something is extremely bad at the same time everything else in your life is extremely bad —
COWEN: Shotgun and can opener time, right?
ASNESS: Yeah, exactly. Well, I use this example in a very different way. If someone says, “What if we get something five times as bad? How do you invest if we get something five times as bad as the global financial crisis?”
And I say, “ammunition and canned goods.” And I don’t think there’s a better answer for that.
But I do think something like coskewness — it’s a geeky idea — I think it’s very hard to establish and prove. The data is not really even there.
Momentum itself, getting back to that one, it has negative skewness. The geeks call that a bad left tail. Nassim Taleb would call it a black swan event. It has standard deviations you’re not supposed to see. Big events.
They have tended to be more, maybe this is luck, but they have tended to only occur in strong markets, not in weak markets. We don’t like that, but we don’t worry about that as much.
To be honest, when it comes to value, Ken and Gene have never embraced this story. I don’t embrace it either, but I give it some credence. Value, buying cheap and selling expensive, has a little better of a risk story on this front, because it has suffered empirically in the Great Depression, in the global financial crisis.
Probably not enough. It probably is not enough to explain it. But that is the exact kind of measure of risk that should work. Does it hurt you? This is a terrible English sentence, and I apologize in advance. “Does it hurt you when it hurts to be hurt?” is an English language version of risk.
Any good quantitative measure, no matter how geeky you make it, should get back to that. If it’s a good measure of risk, it doesn’t just hurt occasionally. It hurts you when it hurts to be hurt.
If it’s a good measure of risk, it doesn’t just hurt occasionally. It hurts you when it hurts to be hurt.
COWEN: Are there still new and significant market inefficiencies to be found, or has that lode been mined? Are you the end of this tradition, or just the beginning?
ASNESS: I’m going to take a guess that there aren’t that many more.
COWEN: But some?
ASNESS: I won’t rule it out, because once you’re horribly wrong about this, hopefully you learn from that. I would have told you 10 years ago that I would not have guessed that low risk anomaly — this is the idea that stocks — by the way, I use stocks as a shorthand.
One kind of wonderful thing, and if we’ve done anything, if there’s something I can brag about, a lot of these things we’ve participated in the research — we’ve written the leapfrogging papers — we have been early in saying, “Let’s go look outside of stocks. Let’s look at bonds. Let’s go look at currencies. Let’s go look at commodities.”
The things that I’m talking to you about in somewhat different forms “work” for all these things. But let me talk about stocks, because it’s the easiest. It’s the most common language.
Stocks that are low risk, backwards to theory, right? Risk should get paid. Stocks that have low betas, low volatilities, low fundamental risks like low leverage, outperform in a fairly strong way.
Fischer Black found that. If anyone wants to be masochistic and ask me why I tell you about leverage aversion and the fact that no one does what you’re supposed to do in theory — low risk outperforms.
Other one is profitability. This is a real anomaly. Stocks out there that make more money and make more money consistently — nothing about price, it’s not a value factor — more money by their book value, scaled by their sales, outperform.
On debt and diversification
COWEN: You mentioned Fischer Black on leverage, just to pursue that a little bit. Fischer thought, and maybe you seem to be agreeing with him, it’s another human imperfection that at least some of us are too afraid of leverage.
Because we could borrow some money, buy some typically low beta stocks, and actually improve the quality of our portfolio. That’s something else which doesn’t quite happen as much as it should. That seems to be almost the opposite of overconfidence.
Is it just debt aversion? We were brought up, don’t get into debt.
ASNESS: I think it is some debt aversion. It also might be less irrational and more constraint. There may be people who just can’t. Mutual funds can literally leverage a little. Most have in their charters, “we won’t leverage.” So, if you’re constrained, you have to do something.
Let me step back. I’m going to draw in my hand an efficient frontier. I promise you it is a perfect artistic rendering. Many of you, I know, have seen it before. If you haven’t, on the X‑axis you have risk. On the Y‑axis you have expected return.
Everyone in the world wants to move up, to the left. You want less risk and you want more expected return.
On the third week of finance class, they teach you — we should all agree, but of course we don’t — but we should all agree on the best portfolio of risky assets. We should all own the same one, because it’s the highest return for risk.
Those of us who are aggressive should apply some leverage to it. Those of us who are not aggressive, who are conservative, should de‑lever, add cash, make it less risky. Why do you do that instead of simply moving your money from low return to high?
Because you have to get undiversified. If you move your money from low expected return to high expected return risky assets, you lose diversification. Ultimately, if you want as much expected return as the best asset out there, you have to be only in that asset. Applying leverage to the entire portfolio, you maintain the benefit of diversification.
What Fischer showed is, imagine leverage is very costly or just no one would do it. He points out that low-risk assets are orphans now. Low-risk assets function in a portfolio in an important way, to make your return for risk better.
But they often don’t make your top line better. They don’t literally make you more money. They make you more money for the risk taken. That’s very boring, if you don’t apply leverage.
You don’t make more money. Most people are interested in some version that makes them more money. And Fischer showed that if that’s true, which I believe it is and I think he was right, those assets that are orphaned will be a little too cheap, because no one wants them. People who want to be aggressive will a little too much be willing to be undiversified.
Again, leverage is not riskless. In the perfect theoretical world, not everyone should leverage to the moon if you’re very aggressive. But neither is concentration, neither is moving your money into fewer and fewer assets.
We don’t tell people leverage is riskless. We do tell people we think people think it’s over-risky versus concentration.
So I don’t even know if it’s risk aversion versus another. It’s risk aversion. It’s more I think people misappropriate the risk of one thing against another. Maybe it’s neither a borrower nor a lender be, your idea that people are just taught that leverage is bad. But I think people prefer concentration risk to leverage risk to their detriment.
On the next bubble, or lack thereof
COWEN: Let me ask you a very practical question about today’s markets. Like myself and like Scott Sumner, you’re pretty skeptical of the concept of a bubble and just going around and calling everything bubbles. But, your most famous piece is called “Bubble Logic.”
There can be bubbles. They may be hard to identify. So, if you were pressed, today in the world, the US, the global economy, if you had to pick what is most likely to be a bubble, are you willing to give us your opinion?
ASNESS: Yes, and it’s incredibly boring. There’s nothing I feel is very, very likely to be a bubble.
COWEN: But there’s always a winner and a loser in any horse race.
ASNESS: If I had to pick one —
COWEN: Have to pick one.
ASNESS: If I had to pick one, and it’s still going to be a different kind of cop out, it’s a diversified portfolio of stocks and bonds. Let me take you through it.
ASNESS: Versus history, on the measures I like. One of the most famous ones — we look at a bunch of different measures — is Bob Shiller’s cyclically adjusted PE. It’s price divided by long term rolling average of earnings for the S&P 500.
You like low prices. You don’t like high prices. That number is more expensive in roughly 90 percent of 100 some odd plus years of history. That is a terrible forecaster for the next month or the next year. Do not do anything. That is not just a legal, it’s a human disclaimer.
But over the next 10 years, nothing is perfect even over 10 years. But it’s statistically powerful. When things are expensive, you’ve made less money. When things are cheap, you’ve made more money.
Bonds are the same idea. A measure for bonds that is very analogous to a PE for stocks is the yield on a government bond minus an economist’s forecast on inflation. People call that a real yield. It’s what you should care about. The nominal yield doesn’t really matter. It’s what you consume in.
That is worse lower. This is a yield, not a price, so lower is bad. But that is worse than roughly 90 percent of history.
The portfolio of half stocks and half bonds, if you take those two measures, scale them and combine them, is the worst ever. How is it the worst ever, when the two are 90th percentile? Well, I think you all have probably figured it out. They’re not usually 90th percentile bad at the same time.
It’s a bit of a puzzle why they are, but they are. Having said that, Tyler, I’m still going to be a coward. We get to about the worst ever. We’ve hit this level before for portfolio.
I used to think 100th percentile was pretty impressive in my career. Now, you never go past the 100th percentile. You’re a math guy. You know how it works.
COWEN: I’m a math guy.
ASNESS: But I will tell you, not all 100th percentiles are equal. If you are the 100th percentile today, but you’re 150 percent of the prior 100th percentile excluding the last couple years, that means you’ve shot off to the moon.
In the technology bubble, the Shiller CAPE is probably 50 percent higher than it had ever been if you excluded the period right around that. Japanese stocks, in ’89, ’90, got to levels like that. You might call it an inverse bubble. I think US stocks in the early ’80s maybe got to a similar extent, well past anything we’ve ever seen on the downside, in the very early ’80s.
I was willing to call those bubbles, and did real time. I wrote that piece you’re talking about.
ASNESS: Because we spent a lot of time — still a subject of measure — but my measure for using the word bubble, remember I’m a Gene Fama student. He hates the word bubble, too. Bubble is an inefficient market phenomenon.
I will use it, but I hope I have a higher standard than many. Many in our field, have I think, dumbed the word bubble down to mean something we think is kind of expensive. That’s not a bubble.
A bubble to me is something still subjective, because your answer may not be the same as mine, but is something I’ve tried my best to come up with future assumptions of growth, be it for a stock, inflation if it’s a bond, and current price, and I can’t come up with assumptions that would lead any rational investor, subjective again, to want to own this.
When we did that for stocks, anywhere late ’99 to 2000, we assumed very aggressive future returns. We took Wall Street’s long-term forecasts, which were nuts, they had never been achieved before, current prices, and we came up with, if that happens, we make less than bonds. We were willing to use the word bubble now.
Right now, this 100th percentile, US stocks and bonds. So you invest half your money in stocks, half your money in bonds. Historically, you’ve made about five percent over inflation. We think it’s priced now, at this level, to make about 2.5 percent over inflation.
COWEN: Rather than five?
ASNESS: Rather than five. Is that a bubble? I can’t prove to you that that’s a bubble. That’s an expensive market versus history.
So, most likely, when you take a whole bunch of expensive things and they get very expensive, and you put them together, you are right. You always can pick a most. But if you ask me the follow up question, “do you think it’s a bubble?” I will say no. I think it’s an expensive market.
A bubble is something where you say this cannot last, and I would not say that.
COWEN: Let me tell you my biggest worry. Maybe you can set me at ease on it. I’m not ready to call it a bubble, but bubble related.
I look at the carry trade. Companies, especially in emerging economies, borrowing in US dollars, typically at quite low rates, and forgetting a bit about future currency risk or future revenue and growth risk on their side. And there being this extreme flow of liquid financial capital into those companies, not really quite backed by forthcoming realities which will match the expectations behind that borrowing.
I’m not sure exactly what’s the single asset price here I want to call a bubble, but that’s my biggest worry, where I think maybe the market isn’t pricing that whole combination correctly. Now, are you less worried than I am?
ASNESS: I am less worried than you are. It’s hard for me to know how metaphysically worried you actually are.
COWEN: Not that worried.
ASNESS: But emerging markets, on that same measure, just looking at the local stock markets, not the carry trade per se, but you’d think if that flow was gigantic you’re talking about, it would show up. On the same kind of Shiller CAPE numbers are considerably cheaper than US or even Western Europe.
So you might very well be right. But again, even though I’m the bubble guy now, I’m the momentum guy, I think as people who try to beat the markets everyday for a living, I’m a startlingly strong believer in efficient markets relative to the norm.
I think what you’re saying has truth to it, but maybe largely in prices already.
COWEN: A lot of people from the hedge fund world, they speak to me. They say, “Tyler, interest rates, or rather bond prices are a bubble,” because of course right now the low rate is at zero. It’s not going to go down much below that. It could go slightly negative. There’s a fear right now we’re living the world’s biggest bond bubble.
Now, personally, I don’t think this at all. But what’s your opinion?
ASNESS: I’m going to be real careful, again. I do not think the word bubble is justified. That’s not careful. That’s overly bold, actually. Having said that, I’ve got to be clear. When I say I don’t think it’s a bubble, I’m not saying I think this thing is great.
When I talked about bonds, I said they were more expensive than 90 percent of recorded history. Actually, the low 90s, now. That is not a commercial for forward-looking bond returns. That is saying I reserve the word bubble for something that cannot work out.
I sit down and I go, how would it work out for a bond investor? It’s very hard to work out for a cash investor. You’ve got me there. But cash is largely — it’s a government set rate. It’s not a market rate.
COWEN: It has other services, right?
ASNESS: Yes. But bonds, how would it work out for a bond investor from here? We look at these ridiculous 2 percent‑ish kind of nominal yields.
For me, to come up with a scenario, not a prediction, not something I think is a good bet, but a reasonable scenario that could happen in the next 20 years, for instance, for a workout, I need one word. Japan. It wasn’t that hard.
ASNESS: If your standard, like mine, is a bubble is something where you can’t really come up with a plausible scenario where this investment might work out, it’s proof by contradiction. We just ended it.
I think it’s an expensive asset. I think equities are actually shockingly similarly expensive. I think people focus on bonds for a bunch of reasons. They focus on bonds because the yields seem much more measurable.
I think equity valuations, things like Shiller’s CAPE and many other measures, are actually about as good for forecasting equity returns as bond yields are long term forecasting bonds. I think the last 20, 30 years, equities look better versus bonds than they have in a while, but that’s because the tech bubble dominates a lot of the last 20, 30 years.
Over the last 100 years, we actually find we’re picking on bonds. We’re nervous because multiple asset classes look not bubble‑ish, but pretty darn expensive at the same time. That’s what worries me.
That also leads into, if a lot of the world, be they institutions that need formal forecasts of what they’re going to make in their portfolio — or my dad. My dad is planning his retirement, 20, 30 years ago. Always had the same sheet of paper. He never showed it to me, but it was, how much do I need to retire?
I’m pretty sure it was off by a factor of 10. I don’t know which direction it was off on. My dad was a trial lawyer. It skips a generation. He’s not a math guy. But I’m sure he had, how much I need to live on, what I think I can make on my money. The number that fell out was how much he needed to retire.
People still do that. Institutions do it very formally. They make forecasts of what they’re going to make in their portfolio. I’m sure there’s a lot of my dads out there. They probably use a spreadsheet now.
If they’re using anything like history and if we’re right that high prices on both stocks and bonds lead to lower than normal returns, it doesn’t have to be a bubble. We don’t need to see a crash. We don’t need to see a fix. But, they’re using too high of an assumption.
It’s a problem going forward, and it makes the whole retirement problem a bigger problem.
On things under- and overrated
COWEN: We’re going to come back to finance, but there’s a segment of these conversations always where we do overrated and underrated. So I toss out something, and you give me a short answer. Is it overrated or underrated?
ASNESS: We already have a problem. I’m not good at short answers. But, OK.
ASNESS: Correctly rated.
COWEN: Correctly rated. In science fiction, the author Robert Heinlein.
ASNESS: Early stuff, underrated. Later stuff, overrated.
COWEN: What’s your favorite?
ASNESS: That is a really — Methuselah’s Children.
COWEN: Ah, good pick.
ASNESS: I could have gone with the obvious. I’m a bit of a libertarian. I could have gone with, The Moon Is A Harsh Mistress. It’s his most famously libertarian book.
COWEN: But it doesn’t age so well.
ASNESS: No, no. I like Methuselah’s Children.
COWEN: Ben Bernanke.
ASNESS: Fairly rated.
COWEN: Fairly rated.
ASNESS: Actually, overrated by half the world dramatically, and underrated by half the world dramatically. And it might be partisan.
COWEN: Reality TV.
ASNESS: I know I’m modifying it every time. I’m destroying the spirit of your question.
COWEN: That’s fine, that’s fine. No, no.
ASNESS: I used to think horribly overrated. I never watched any reality TV. I have 11- and 12‑year olds, and we watch Shark Tank, a reality TV business show. We watch the old Survivors. Just basically teaching game theory to 11‑year olds in a sneak way. This guy’s doing this, so this guy does this.
I will say fairly rated, and much better rated than I gave it credit for in the past.
COWEN: Now, you’ve told me you’re a hockey fan. Wayne Gretzky. Overrated or underrated?
ASNESS: Oh, he’s massively, highly rated, and still underrated.
COWEN: What do people miss?
ASNESS: I think hockey fans don’t miss this, but the general public misses that he was a guy who was undersized, less fast — slower. We have a word for less fast.
ASNESS: Than other people. This is cliché-sounding, but the people always used to say he was a humble guy. People would say this about him, he skated where the puck was going to be, while everyone else was skating where the puck was. Having watched him, I just think it was true.
I don’t know how he got that ability. It’s a mutant ability, but he had it.
COWEN: A bit like a momentum investor.
COWEN: Now, I think I’m interested in this issue, as I think you are. Extreme performances or performers, and it’s measured most readily in sports. So Gretzky is a kind of extreme outlier. In basketball, you could say Kareem Abdul‑Jabbar who would be in the series as an outlier. Maybe Michael Jordan.
In sports or some other area of your choosing, which is the extreme outlier which strikes you as the most amazing? And you just say, “oh my God, I can’t believe there’s a Wayne Gretzky,” or a fill‑in‑the‑blank-there for me, other than Gretzky.
ASNESS: I have no sense if this is actually accurate. But actually, no one could measure this. It can’t be accurate. You’re not going to believe what I’m going to say. Cirque du Soleil.
COWEN: Please explain.
ASNESS: When I sit there and watch Cirque du Soleil, which both my wife and I like, I literally walk out and go, “nobody can do this.” And I don’t think they are cheating.
COWEN: They’re not cheating, right?
ASNESS: But watch it again. It’s like a Looney Tunes show, where Daffy Duck dives from up there into a little thing of water down here, and he doesn’t die. I don’t know how they do it.
Everything else, the crash of ’87 was a 20 standard deviation event. Nothing. Wayne Gretzky, pretty good. The Cirque du Soleil people —
COWEN: Off the charts.
ASNESS: This story was from Vegas, and it’s not staying in Vegas. But, I was in Vegas, and I was exercising. I know you find that hard to believe, but I was.
The Cirque du Soleil people were in the gym, and you don’t want to ever do that. It is one of the most demeaning, humbling experiences.
ASNESS: They exercise exactly as — they did this thing where they just keep leaping over each other, and they go around in a circle, and they did it for like half an hour. And I’m sitting there on the StairMaster on a three.
COWEN: Spider‑Man versus Batman? Who wins that fight?
ASNESS: Batman wins every time, because unlike most superheroes, he cheats violently.
COWEN: Spider‑Man versus Batman? Who wins that fight?
ASNESS: Batman wins every time, because unlike most superheroes, he cheats violently.
COWEN: Superman races with Flash. They both travel at the speed of light. Yet Einstein tells us there are no simultaneous events. Who wins?
ASNESS: I’m going to ignore the physics, much as the comic books do. This is actually a pet peeve of mine. I’m more of a Marvel Comics than a DC Comics. I know everyone wanted to know that, in the audience.
DC is much better now, but when I was a kid, they exaggerated all the powers much more. Marvel had realistic superpowers. You could run at 500 miles per hour, not the speed of light. DC would go with the speed of light.
You have no idea. Actually, you might, but this is one of the things comic geeks will fight about. And they’ve had this, about five times in the comics. They’ve had races between them. Of course, they try to cheat and make them tie. I know you tried to come up with that.
I subscribe to a theory that is on the Internet. It has a name, but I’ve forgotten the name, but it’s a documented theory. But it says the Flash should win, because the specialized power should win.
COWEN: I agree. Related to portfolio theory, in fact. Right, in equilibrium —
ASNESS: Portfolio theory, comparative advantage.
ASNESS: Though it has a little bit of a “the world must work out fairly” notion to it.
COWEN: The world does work out fairly, right?
COWEN: Long-term. Very long-term. Mutual funds, overrated or underrated.
ASNESS: Oh, we run mutual funds. This is a hard one.
COWEN: Other people’s.
ASNESS: I can’t be fired, so I will go overrated. Active management I think is overrated. I believe certain things can win. I’ve talked about a few of them, but on average I think people try too hard to beat the market and pay too much for it.
I love if people listen to me. I believe in what I’m saying. But if you go spend your life listening to man named Jack Bogle, you won’t do terribly.
On small-time investing
COWEN: Super practical question. You’re sitting in this room or listening on YouTube. Let’s say your income is two or three times the national median. So you can save some money, but you cannot operate investment at a significant scale. What’s the mistake those people are most likely to make, and what should they do to stop making it?
ASNESS: Most likely it’s a hard one. You already said it.
COWEN: In expected value terms.
ASNESS: Overtrading, and I don’t mean everyone. In fact, I’d say a minority are daily stock pickers watching the market.
But there is the phenomenon that I still want to look into more, because someone has to be making this money. This is going to sound stupid. No one’s figured out who’s making the money. But Jack Bogle quotes these numbers a lot.
There are all these paradoxes where the average mutual fund investor seems to get out and in at the wrong times. Remember I talked about value and momentum?
COWEN: Of course.
ASNESS: I like to call them — it’s a geeky phrase, maybe I’m the only one who likes it. They are momentum investors at a value time horizon. Remember, I told you value works long term. You have to hold 3, 5, 10 years. Momentum is a 6 to 12 month horizon.
If you’re going to be momentum, you’ve got to really do it. You’ve got to be disciplined. You’ve got to come in every day, and you’ve got to count on these under- and overreaction things.
If you wait five years and buy what’s worked for five years, you can call that a negative value investor or a momentum investor working with the wrong numbers. I do think that is one of the things people do too much out there. It’s probably the biggest —
Somebody is making that money. Maybe we’re making some of that money. Maybe it’s the flipside. It’s very hard to track.
ASNESS: I don’t think anyone’s done a great job of nailing where that money lands. But I think if people came up with good strategies and somehow disciplined themselves to do far, far less.
The worst case is if someone — I don’t think many professional traders can make money trading in and out constantly. I think pretty much nobody in an expected sense — of course, some will get lucky — should do that casually. So, if you’re doing that, you’re making a giant error.
But if you’re even looking at it and going, “I used like this, but the three to five, it’s been tough. Get me out.” If you’re getting out because you feel sick to your stomach about it, you’re making a mistake.
On the fairness of high frequency trading
COWEN: What should we do? Here, I’m leaving the “we” deliberately ambiguous, to make securities trading more just, more fair. You can pick the “we” you want.
ASNESS: Well, just and fair, this is loaded terms, of course.
COWEN: Of course, deliberately loaded.
ASNESS: A finance guy comes in here and starts being wishy‑washy about the terms just and fair, I’m worried already.
COWEN: You get to fill in the blanks.
ASNESS: I don’t know if I’d call this just or fair, the fact that people make this error. They’re hurting themselves. I don’t really attribute a value judgment. I wish they didn’t. It would probably cost us some money. I think the world would be better off, but I don’t know if that’s just or fair.
I think the world has gotten more just and fair. I’m going to say something potentially controversial. Something that is often attacked, the high frequency trading, has made the world more just and fair, particularly for small investors.
High frequency trading has made the world more just and fair, particularly for small investors.
High frequency traders have — I watched the Republican debates last night, so I know to change the topic to something I’m comfortable with. They do a lot of different things, but the core trading strategy is just to do the other side of whatever you want to do.
So, if you want to trade, sell X, they’ll buy it from you. They charge a little thing called the bid‑ask spread. They will buy it from you for a little less than they’ll sell it to you for. It’s very competitive. They fight with each other to do your trade, so they can’t just charge any bid‑ask spread they want.
They get attacked because they charge a bid‑ask spread, and when you ask them to do a lot, they start moving the prices, because they’re getting scared you might know something they don’t know.
But we’ve always had to trade with someone else. We’ve always needed market makers out there. It used to be much more expensive. Worse bid‑ask spreads, worse execution, particularly for the small person.
There is some controversy with high frequency. I mean small investors, not literally small people. You know that, right?
For very large investors, you’re trading very large amounts of money. I believe high frequency has made our trading costs cheaper, but there’s at least an argument for the other side. Some will say, market impact. The price moving on you when you try to execute and buy or sell a lot of a stock is bigger now. I don’t think so, but that’s a fair argument.
There’s no argument for the little guy. What you worry about in trading is something called front running. Someone figuring out what you’re doing and doing it before you. There’s the illegal version, where someone actually gets a peek at what you’re doing, which they’re not supposed to get.
Then there’s the completely legal version. People notices trades occurring and prices moving, and think, “Oh, I better get in front. Maybe this is a wave.” There’s nothing illegal about that, but it still costs you money.
No one bothers, no one front runs a small dollar investor. And it’s not because people are nice, and kind, and care about — there’s no money. You want to rob banks, not people. So, there’s no money in it. The small investor, I think, unambiguously has a fairer, cheaper world.
Now, I’ll dig myself a hole. I don’t think they should trade very much. That was our earlier question.
COWEN: Of course, overconfidence.
ASNESS: Just because it’s cheaper doesn’t necessarily make them better off if cheaper induces more trading. That’s an entire different — but they’re getting cut a fairer deal by Wall Street. Whether they use that to harm or help themselves, open question. But I think they’re getting cut a fairer deal than used to.
COWEN: High frequency trading, it’s getting us back to Superman versus Flash, right? You liked that question.
ASNESS: I have made this observation many times. It is literally the only part of my field where the speed of light is relevant.
COWEN: That’s right.
On how well hedge funds hedge
COWEN: Hedge funds. Your company is much more than a hedge fund. You’ve written a lot on hedge funds. You know them very well.
For most people, is it worth it? The data on hedge fund returns, I’ve put a lot of time in trying to what is actually the net return. Forget about the risk-adjusted return, but just the net return. How much comes from linear and nonlinear strategies?
It makes my head spin. It confuses me in the kind of way where as a naive outsider, I get a little scared. What should I think of hedge funds and how good they are? Overall, again not a question about what you’re doing.
COWEN: But in the end —
ASNESS: I will try to separate those two. It’s hard sometimes.
I think if you have to go buy one of every hedge fund that will take your money, which is a subset of hedge funds. Some of them are closed. You’d probably be better off figuring out what their average exposure to the stock market is and go buying an index fund.
I live in Greenwich, Connecticut. In some parts of the world, if you said, “my daddy runs a hedge fund,” I’d say, “what’s a hedge fund?” In Greenwich, Connecticut, the kids say, “what kind of hedge fund is your daddy running? Is he event arbitrage? Trend following? What does dad do?”
In some parts of the world, if you said, “my daddy runs a hedge fund,” I’d say, “what’s a hedge fund?” In Greenwich, Connecticut, the kids say, “what kind of hedge fund is your daddy running? Is he event arbitrage? Trend following? What does dad do?”
I am going to be persona non grata, but I think hedge funds — and there is a lot of complexity to this answer. They are a universe of smart people, they are doing some good strategies, some I mentioned to you, already. They seem to have grasped the momentum strategy, not so much value oddly enough. But they seem to definitely incorporate the momentum strategy.
There are so-called arbitrage strategies — they don’t use the word like academics. Academics or almost academics like me, use it to mean riskless profits. They mean, a trade that has reliably worked over time where they go long and short, fairly similar things, they are clearly not riskless. But, something like a merger, A is buying B, if the deal closes, it’s going to go to here. A is going to fall, B is going to rise.
The day it is announced, it only goes to here, because there is some chance this deal does not happen, antitrust, the market, shareholder activism, somebody else. What the merger arbitrageur — and my finest achievement today is saying that word in front of you, that’s a hard word to say — buys B, and sells A, and if it happens, they make a little money, and if it fails, they lose a lot of money.
I am dying to do this, I have not done it yet, I have talked about it for two years, I am about ready to try it. I want to ask one of my two older kids, they are a set of twins, they are 12 years old, “Does this sound like a good idea to you?” I’d have to hold their attention throughout this whole thing.
There’s about a 98 percent chance they say, “No. That sounds like a terrible idea to me, you can lose a lot, you can make a little. Who wants to do that?” I’d be the proudest pop on Earth if either one of them kind of paused and said, “how often do both of those two things happen, Dad?” Because, that’s the proper question.
It turns out, if you do this rather with zero skill, you do every merger that ever comes along. Maybe you can do better, maybe not, but you just do this every time, you’ve made a lot of money over time. You get killed occasionally, you are basically selling insurance, when the deals don’t happen, you lose a lot of money.
Hedge funds have figured that out, there are lot of other things they figured out like this, that’s the good part. The bad part is they do not, as a group (and keep in mind, this is self-serving, but we run things people would call hedge funds, not all of our business by any means, we think we are not doing this, we don’t think we are the only ones giving clients the fair deal, I am talking about the industry as a whole) doesn’t hedge enough.
I know that sounds stupid given the name, but if anyone likes geek numbers like correlation, for the last seven years, an index of hedge funds has been about 0.8 correlated with the S&P 500. That means if you tell me what happened in the S&P 500, I got a pretty good idea what’s happening in the hedge funds.
The word “hedging “almost by definition refers to removing that risk. Trying to create returns that go up on average but at different times than stocks. You can get that again from Mr. Bogle for about 11 basis points, near a tenth of a percent.
They don’t hedge enough and they charge a lot. I will never — you have a shot, Tyler, I don’t have a shot — I will never get an economic law named after me. I gave that up when I went to try to make money. If I got one, I’d want it to be: There’s no investment process so good that there’s not a fee high enough that can’t make it bad.*
“I will never get an economic law named after me. I gave that up when I went to try to make money. If I got one, I’d want it to be: There’s no investment process so good that there’s not a fee high enough that can’t make it bad.”
ASNESS: I do think hedge funds don’t hedge away a lot of the risk in return. You can get much cheaper elsewhere and then simply — on average, broad strokes, I’m insulting some people unfairly including myself — but they charge too much.
COWEN: Here’s a historical question, but it can be about recent history. Who is the individual who has done the most to promote liberty who is undervalued in this regard?
ASNESS: Has to be someone fairly terrible in my mind because it has to be a counterexample. I’m going to go with Joe Stalin.
COWEN: Please explain.
ASNESS: It’s a pretty good example of what happens when you don’t have it. Some of us might think it’s a more relevant example than others. I’m not revealing anything that you might not know.
But I think counterexamples are probably more powerful than anything else. That counterexample of what happens when you take liberty away will be with us for a really long time. I don’t think we’re near there yet. I might be a raving lunatic but I’m not that much a raving lunatic.
I wouldn’t have wished it. It wasn’t worth the cost but he’s helped the cause of liberty. Thank you, Joe.
On Ayn Rand
COWEN: The contrarian answer. What’s the side of Ayn Rand’s philosophy that you feel is weakest?
ASNESS: Economics. I’m going to get yelled at by every libertarian friend I have on earth. I’ve never been a very big gold standard person. I respect it. I respect it, I have friends who are fanatic believers in it. I don’t think it will be the disaster to a lot of people — but I don’t think it cures all ills.
I have a lot of friends who I agree with who’ll say “we have too much regulation,” I’ll go “check.” They go, “We have a byzantine crazy tax code that often — not just that they’re high — they create a lot of odd incentives for trade-offs that shouldn’t exist.” I’ll go “check.”
“We should have hard money.” “No check,” and they think that would fix everything. I don’t fully get it. Ayn Rand, the name of her philosophy was Objectivism and she just told you it was objectively right that gold is the standard of value. She’s unkind to silver frankly.
ASNESS: You have succeeded in getting me making fun of Ayn Rand, that’s very impressive. But when she ventures into economics like that and makes very bold, strong statements, I don’t agree with them all.
COWEN: What’s her most underappreciated side or aspect or angle?
ASNESS: Again, I’m going to try to flip it around. I don’t think she was as anti–helping people as she sometimes comes off. If you read her talk about it she certainly — I disagree with her on this, by the way — she didn’t consider charity a primary virtue. But she didn’t have a problem with it whatsoever. She considered the individual sovereign and “if that’s important to you, do it.”
I think it’s a larger virtue. Benevolence, charity is one of the things in her world — and my favorite thing, which you didn’t ask about her, is “you own your own life.” It’s one line. I’m in love with that.
But the idea of a virtue being the desire to help other people — not someone forcing you to, which she was dead set against, but wanting to help other people — I disagree with her on. But I think people come off and think that she’s snarlingly against it. I don’t think she was for it enough, but I think she was rather passive and said it.
If you care about it, she talked about examples — giving up your own life to save someone else. If you value that person more than yourself, it’s rational. Do it. So I don’t think she was quite as nasty about that. Nastier than I think she should have been, but not quite as nasty.
And she could have used an editor. I admit that.
ASNESS: Come on. Come on. That speech — oh my Lord.
On training up a child
COWEN: For this conversation, I read all of these papers of yours, which is the tradition. I’ve read your Wikipedia page. I know you not well, but some modest amount. What is there in your life that’s influenced you that I would have no idea about from what I’ve read by you and about you? What’s the hidden influence on Cliff Asness that I don’t see, maybe others don’t see?
ASNESS: That’s a hard one. I was probably wrong about this, and my parents are going to get mad at me. But we were by no means I’m not telling a poverty story. I love Marco Rubio, but if I hear one more time about the frigging bartender — his dad is a bartender. It’s a wonderful story, but it’s in every answer. But we grew up decidedly middle class, and my dad — he was a trial attorney. He had a job where some years he made a fair amount of money and some years he made no money.
My parents shared that way too much with me. I’ve told them that. I had a sense of impending doom as a child that I think was oddly a positive for achievement. It made me very focused on not being nervous about those kind of things, but doesn’t make you a happy, relaxed person and is impossible to turn off after it’s no longer useful.
My parents shared that way too much with me. I’ve told them that. I had a sense of impending doom as a child that I think was oddly a positive for achievement. It made me very focused on not being nervous about those kind of things, but doesn’t make you a happy, relaxed person and is impossible to turn off after it’s no longer useful.
COWEN: There’s a literature by Ulrike Malmendier, you may know these papers, which try to argue that the risk premium in a given generation depends on exactly what economic conditions they grew up with. Do you think this is generally true, or just about you?
ASNESS: I’ve written probably a much more empirical paper on precisely this idea. I promise I’ll get there. I’m going to get to the point.
There’s this idea. There’s something called the Fed model for valuing stocks that says when interest rates and inflation are low you should pay a higher PE for stocks.
In theory it’s a very weak model because it deals with what are called nominal interest rates, not real interest rates. Unlike bonds, when inflation’s low you expect earnings to grow slower.
Forget all the math. There’s this puzzle that the world seems to follow the Fed model. They price stocks according to it. It’s a very strong empirical regularity. When interest rates are low those PEs are higher and vice versa — though they do vary.
One thing we found — I wrote this as a Financial Analysts Journal article circa — I wrote one in 2001 and a follow‑up in 2004 — that how much more they demand in return, or how much cheaper they need stocks to be — when they’re cheaper they return more — how much excess return they need on stocks versus bonds is a function very strongly of the last 20 years’ relative volatility of stocks and bonds.
In English, I called 20 years a generation. I didn’t monkey around with that too much. I checked. It works for 10 years, it works for 30 years. It’s not cherry‑picked. But if the last 20 years had experienced a wild ride on stocks versus bonds they demanded a very high return, going forward. I got there, if you didn’t notice.
I’ve written on this. I believe it. You can’t make a lot of money, by the way, trading on a 20-year phenomenon. Clients don’t really enjoy the whole, well, I’ve been wrong for 19 years, but give me one more year.
I never give the short answer, but the short answer is I found the same thing myself. I think it’s directly reflected in the numbers. I think people are somewhat a prisoner of their experience.
COWEN: Last question from me before we get to questions from the group. If policymakers could understand one thing better about financial markets that they don’t understand now, what would you want that thing to be, and why?
ASNESS: I’d want them to understand that any form of near certainty without certainty–any time you convince the world that something is a certainty but it’s not, it’s the most dangerous time humanly possible.
I’ve looked back at the financial crisis and the key moments in it. A lot of arguments. I’m not even going to get into the partisan arguments. The right says government did it. The left says Wall Street did it.
Great shocks. You know what did it, if I had to pick one thing, that one primary cause of the financial crisis? The assumption that real estate prices can’t go down. The government made this assumption, the people who say these terrible quantitative models were way off.
At the end of the day, somewhere in this giant model, in a thousand lines of computer code, there was, “What’s the worst case 10‑year return for real estate?” If that worse case was not losing money, it’s garbage in, garbage out. You can have the best model in the world. That’s a problem.
When Lehman failed, we went into a huge spiral, because people were pretty much convinced that the government wouldn’t let anyone fail.
When money markets, when the famous Reserve Fund broke the buck — this is money markets that are supposed to return you a dollar for a dollar. It’s always been a fiction, by the way. You’ve been lied to for years.
Money markets own portfolios of short-term bonds that move in value. They allow them to round to (I could be off by a decimal place) to only two decimal places. That’s not a lot. Two decimal places for short-term securities means most of the time, almost all the time it rounds to a dollar. Therefore, there’s an illusion, but they’re risky.
That is to me a very dangerous asset, because it tells people there’s no risk when there’s actually is risk. I’m not saying you have to go out a billion dollars. No one wants an NAV. What’s your NAV? Pi. No one wants that.
But it’s so short, it artificially looks stable. When you tell the world there’s risk in something, and then bad things happen, it’s not fun. It’s still bad things. But, they tend to deal with it much better.
Many people have observed, the Internet tech bubble that I keep talking about, when that came down, the economic consequences, the threats to our system were far more benign. I think that’s because no matter how crazy they might have gone, nobody thought they’re utterly riskless. They didn’t act as a group as if there was no possible problem.
Equity losses are expected. Bond losses are not expected. So I will say this. If you truly can take all the risk out, great. If you tell everyone it’s risky and it’s risky, great. I think the thing people don’t appreciate is how dangerous things are that you think protect you, but only mostly protect you.
I think the thing people don’t appreciate is how dangerous things are that you think protect you, but only mostly protect you.
COWEN: We’re having a forum here Monday with Greg Ip.
ASNESS: That’s a great example.
COWEN: It’s on the illusion of safety. We’re going to have a full session just on this.
ASNESS: Some people argue — I don’t know what the data is — that football players would be safer if they didn’t wear helmets, because they would know this was dangerous. They point to sports that are very violent, like rugby and whatnot.
That might be true. You can take this logic too far, right? Maybe we all drive more aggressively because we’re wearing a seat belt, and we know we can hit the breaks and we won’t go through the windshield. I’m not going to sit here and say that’s a bad idea.
The effect still exists, by the way. You probably drive a little too aggressively, and you probably have an extra accident or two because of the seat belt. My logic doesn’t mean it’s always bad to take preventative action.
But, if you thought as we sometimes do in finance, like money market funds, that you could do anything in a car because you’re wearing a seat belt, that’s kind of the money market analogy I’m making. I think those are the most dangerous things.
COWEN: Thank you very much, Cliff, for those remarks.
AUDIENCE MEMBER: I hate to name drop, but I was out last week with Mr. Rubenstein of Carlyle. He was asked a question about retail distribution of alternative assets. He said, “It doesn’t matter to us at Carlyle Group, because we can raise money quite readily. But, it will probably go that way.”
Now AQR, you’ve lead with mutual funds. Do you think in the next few years, due to changes in regulation, that the alternatives industry will do more distribution to non-accredited investors? How will the industry handle that opportunity?
ASNESS: The short answer is, I think yes. Remember, I think these strategies can be used very usefully, but I don’t think the hedge fund industry has broadly delivered them on fair terms to investors.
When you look at the mutual fund industry — and they’re often called liquid alts, the hedge fund–like strategies that have started to appear in the mutual fund world — and, we do some of these.
I think they’ve largely been replicating some of the same problems. I think they’re not fully, as a group, and we’re in there, and I clearly like ours, but as a group I think they’re not fully hedged and are probably still too expensive.
I do think that same intellectual battle will go on. But I think there are still reasonable strategies at the core doing reasonable things, and not everyone is in the same position as Mr. Rubenstein. A lot of people actually do want more assets. So, I do think that will get bigger.
AUDIENCE MEMBER: I wanted to ask you to reconcile momentum or any of these strategies related to the passive versus active debate. If you consider that all active strategies summed up effectively are passive — so any active strategy, including something like say momentum or value investing requires not just that someone not do it, but that they actually be on the opposite end of the trade.
So, who’s on the opposite end of the trade? I mean, it is individual investors that are trying to stock pick, or are they other stupider professional managers?
ASNESS: We explicitly use that word.
AUDIENCE MEMBER: How confident can you be that there will continue to be the steady supply of stupider investors on the other side of the trade so that you continue to make money?
ASNESS: That’s a great set of questions.
Backing up, you’re not going to believe me, you’re going to think I’m just copying you. But myself and a colleague, Antti Ilmanen — he’s Finnish, he didn’t just have odd parents — have been planning, we haven’t written it yet, to write a paper with the literal title, “Who is On the Other Side?” Just a little shorter version of what you said, because we do think that is a very disciplining question.
I’ve written — I wrote something in the Financial Analysts Journal on 10 different things in finance that I thought were kind of interesting, short observations. One of them was your point precisely, where I said people think if they follow systematic strategies like we do, even low turnover — value happens to be what’s called a low-turnover strategy — momentum changes its mind. You have to trade momentum more than value.
So, systematic and low turnover, they’ll call passive. Mainly a fight about semantics, but I don’t like that term because, to me, like I think for you, passive should be something we can all do. If we all try to do value, we can’t all do it.
Value, even if it’s systematic, simple to explain, works on average, still requires exactly what this man just said. If you’re overweight cheap stocks, somebody has to be overweight expensive stocks.
I will say a lot of it gets back to the exact conversation I started out with Tyler. There are two possible reasons someone can choose to be on the other side of you. You have to start out right there, thinking about both of them.
One is what you’re talking about works, my use of the word “works,” for risk reasons again. Same thing. Cheap stocks are inherently riskier. There is some scenario where they get killed in a depression, and that’s risk.
You are willing to bear that risk. Someone else is not. They willingly and consciously, maybe implicitly — we do a lot of things in economics that just kind of happens even though we don’t say it — but they in some sense willingly take a lower return because they don’t want that risk.
Right there, might be true, might not be, but it’s a perfectly logically valid story for who is on the other side.
The other is hope springs eternal for value. There are a number of people who simply see whatever has been going on.
Who’s been beating earnings for the last few years? Whose products have been popular? That company probably should be worth more. They go too far. They over‑extrapolate. The behavioral story, the other version besides risk.
Both those stories, you’re exactly right, do require someone on the other side but no means — I’m you asked — do I think these things could be used for everyone to outperform?
This is not Lake Wobegon. We can’t all beat the index. It’s actually a precise mathematical identity.
Having said that, I think there are risk premiums and there are behavioral biases that lead some to willingly or accidentally underperform. You have to have the story for each one.
Your other question, about why would it persist, Tyler asked a version of it, too. I think they can persist because they’re pretty good but not extremely good.
We look at this, the value effect. It’s been a good five years or so for the set of these three or four anomalies I’ve talked about — value, low risk, momentum, profitability.
It’s been a bad five years for value. The pricing of cheap versus expensive is not egregiously weird, but it’s about historically normal when they’ve on average probably looked a little too cheap if you’re a behaviorist.
What happened? Of all these three or four I’ve talked about, that’s the one that’s been around the longest. It’s very hard to arbitrage this away. Somebody is on the other side. Value goes through some horrible periods and hope springs eternal.
I do think it’s a great question because you must always ask that question. I put it even starker sometimes. It’s not a good title for a paper but, “whose money are you taking?” You know the old joke if you’re at a poker table for five minutes and you haven’t figured out who the sucker is, it’s you.
ASNESS: Same answer. If you cannot say, “whose money is being taken?” Maybe, again, it’s perfectly rational. They don’t feel taken. They feel like their risk is being reduced. It’s fair.
Why am I making this extra money? If you don’t ask your question, you’re not doing your job.
AUDIENCE MEMBER: Assuming it’s behavioral and not risk, do you have a sense that the other side is individual stock pickers or other professionals that are stupid?
ASNESS: I think it’s some of both. There is some evidence, for instance, I mentioned —
Remember, I stuck this in, that hedge funds seemed to have figured out and incorporate. This is just empirically — if you look at their returns, look at what strategies they’re correlated to and not, they seem to show that they’ve figured out some of the momentum strategy.
They seem to buy more expensive, not cheap stocks. Maybe they buy the right ones, maybe they figure it out, but they are fighting the value effect. I think at least some of it is coming even from the very “smart” investors.
Other restrictions, like, remember, we talked low-risk investing for the Fisher Black reason, being effective because people are restricted from leverage. Professional mutual fund managers have that restriction left and right.
Whether they do it consciously or they’re just led to it, they get pushed into higher beta stocks. They get pushed into taking more risk and probably overpay for them.
I like that example better than we’re talking mom and pop’s money, but that’s probably in there, too, to some extent. But, keep in mind, I’m being nice. I’m advising mom and pop not to trade. They should go to Jack.
AUDIENCE MEMBER: I have a question specifically about the biotech and healthcare sector. It’s traditionally outperformed the broader market over the past decade or so.
What are your thoughts both as a momentum trader and from a fundamental standpoint? Does that train continue or is it time to get out?
COWEN: Just to calibrate here, we have two more questions and 10 minutes. So, everyone, please time your answers and questions to make it all fit perfectly to the split second.
ASNESS: I’ll do this one quickly then. [whispers] I have no idea.
These techniques, not only do they work on average over the long term, but you need a broad cross‑section all the time. They’re really, really bad at things like, “What do you think of this sector?” I don’t know the answer, first of all.
This will be the third. I told you active management is too expensive, hedge funds are not a good idea. Now I’m going to tell you I don’t know if we’re overweight or underweight biotech. Everyone write that down.
I actually like telling people this. When I go on something, I don’t do it too often, like TV, we coach them. Don’t ask me about individual stocks. We’re long and short thousands of things based on these quantitative measures, and we’re doing that intentionally.
You could be cheap, good momentum, profitable, low beta, and the CEO could have a scandal tomorrow. These are statistical averages. You want to spread your bet. You want to make a lot of them.
A quantitative systematic manager like me shouldn’t know a lot. I could go memorize all 5,000 positions. Biotech, I have no idea, but I think it’s instructive why I have no idea.
If I have an idea, worse, if I have a very strong opinion, I’m just doing my stuff wrong. There are people who may or may not be good at that, but you do not come to a systematic quant manager — if your systematic manager says, “here’s what you do: put it all on biotech” — run.
AUDIENCE MEMBER: I’m wondering who is your favorite superhero? And has you studying economics changed how you felt about certain superheroes?
ASNESS: Oh my God. This may be sappy patriotic, but I’ve always liked Captain America. The whole he fought in World War II, suspended animation for 20 years, which, by the way, happens to anyone who falls into cold water.
ASNESS: That’s just a throwaway. I could sing you the song if you’d like. “When Captain America throws his — “ anyone old enough to remember that? “All those that chose to oppose his shield must yield.” That’s a great rhyme.
Even the most insane billionaire cannot afford a hundredth of what frigging Tony Stark or Bruce Wayne have. It’s infuriating.
I’ve done well. I’m not the most insane out there. But if I wanted to go build a Batcave at my house, it would take approximately 600 times my wealth, and everyone would know about it.
I’ve done well…[b]ut if I wanted to go build a Batcave at my house, it would take approximately 600 times my wealth, and everyone would know about it.
ASNESS: It’s a shockingly good question, which actually has been an annoyance of mine. I have a skyscraper that’s also a missile silo.
COWEN: Your least favorite superhero if I may interject?
ASNESS: Before the movie, I would have said Ant‑Man. But the movie was kind of funny.
There was a character named Hank Pym, one of the original Avengers. Avengers were, of course, as you all know, Thor, Hulk, Iron Man, Giant-Man, which is Hank Pym, and the Wasp. He is a loser.
Giant-Man was just a big guy. He wasn’t even stronger than a regular guy! He was just big! Everyone beat up Giant-Man.
Then he used the same powers to shrink — and control ants, of course, because those go together. Then, he became an alcoholic, and then he hit his wife in the comic books. That’s easy to hate. But I hated him even before the spousal abuse.
COWEN: Last question here.
AUDIENCE MEMBER: Question on advising people to get into the passive, low-cost, Vanguard kind of funds.
We’ve seen people heeding this advice and flowing in. Do you think that in and of itself — more people going to passive strategies — could open up more potential for active managers and more anomalies?
ASNESS: That’s a great question. I’m going to fuse that question with one over here, not the superhero one. My favorite question I might add, but it cannot be fused with this question.
Instinctively, you want to say it’s going to be easier to beat the market if fewer people are trying.
If you’re a PhD student in finance, this is what you do at 3 AM in your bull session is, “what happens if everyone indexed?” No one who has gone through a PhD program in finance or probably economics has not done that. We really don’t know. People will actually argue over this.
Then you try to get a little more realistic. What if almost everyone indexed? Feels very obvious that it would be easier to win.
On the other hand, this constraint that was brought up already, that the average can’t beat the average, whose money are you taking? If everyone else is passive, how do you induce them to take a bet away from passive?
My sense — I think you could literally mathematically disprove this, so it’s a sense of what would happen if we got close, not all the way — is it would easier and you could fool people if you were the one with some information. Information would be easier to get. The informationless trader, you could push away more by just bidding more for their stock. In the short term, you could capture some of their profits.
Still hard to make the math work. Because if you really push them away, they have to tilt away, and they’re trying to be passive. If everyone else is trying to be fully market cap weighted, whom do you trade with? No one is willing to underweight.
You’ve actually brought up a paradox that people are still fighting about.
I think in a more realistic scenario — I do know this — more people chasing my strategy is not good for me.
But, in general, it’s really hard to figure out. But a question everyone talks about, so I’m glad you ask, so I could fail at it also.
COWEN: Cliff, in one of your papers, you cite an old Slovenian proverb, which I quite like. It goes, “Speak the truth, but leave immediately after.”
COWEN: I do think you’ll be here for just a few more minutes if we have not been able to get to your question — but not for hours. Anyway, Cliff, we thank you heartily.
ASNESS: This is a lot of fun. Thank you all.
COWEN: Just for all of you, our next event, “Conversations with Tyler,” will be January 26th. We are honored to have as our guest Kareem Abdul‑Jabbar. We will cover a wide variety of topics. So please put that on your calendar.
ASNESS: You will have an answer to a trivia question. What do Cliff Asness and Kareem Abdul‑Jabbar have in common? Because this will be the only thing.
COWEN: Supernormal returns, right?
The Mercatus Center gratefully acknowledges the assistance of T.J. Whittle in curating most of the hyperlinks found in this transcript.