Full Transcript: Victor Haghani on Dynamic Asset Allocation

We discuss buybacks, market valuations expected returns and a lot more

Justin: Victor, thank you for joining us and welcome to Excess Returns. Great to be here. Thank you. You are the founder and CIO of Elm Wealth. You’re a researcher, you’re a author. You wrote the book, the Missing Billionaires, A Guide to A Better Financial Decisions. You guys also run an ETF. And so we’re excited to jump into a number of different, I think, topics and threads with you today.

part of it’s gonna be talking about investment process, things like dynamic indexing, how you think about expected returns, risk management, and how sort of all this is incorporated in portfolio allocations in that you run for your clients. I’m just gonna say right up front there is tons of valuable content research papers, tools, little widgets you can play with on Elm Wealth Wealth’s site.

We encourage everyone to go there to learn more about sort of the way that you guys think over there, the frameworks that you’ve created and the way that you. Manage money and grow your client’s wealth. so people can learn more@elmwealth.com. And also learn more about your etf@elmfunds.com. so with that little intro, thanks again.

And, yeah, Jack, let me kick it over to you for this to, to set up sort of some, some of the background here.

Jack: Yeah. And just to, to echo what you said about Elm Wealth, like I, I had a hard time coming up with the outline. There was so much good stuff on there. So, we’ll definitely have to have you back sometime to, to cover all, all of these various topics.

Yeah, it’d

Victor: be my pleasure definitely.

Jack: But one thing really, stuck with me when I was doing all the research for this, and that’s what you see is there’s many people in the investing world that think they can beat the market or think they have the greatest investment strategy that run complex strategies.

And you were one of those, you were at long-term Capital management. And what what you almost never see in those people is if, if something blows up or if they don’t outperform the market and they get redeemed. They just think what? The market was wrong or I made a mistake, but I, in hindsight, I know the mistake I made.

And, and they go and they continue to deploy those types of strategies over and over and over again. And you went a completely different direction after long-term capital management. Whereas now you run what I think is mostly a passive strategy. So you really have embraced those principles of simplicity and passive investing.

And I’m just wondering if you could talk about that journey of how you got from there to here.

Victor: Sure. Well, I I think one of the, really interesting parts of my story, which I think is a really common, story, is that I went to Wall Street in 1984, started working at Solomon Brothers, and then eventually was one of the co-founding partners at LTCM.

And from. The time I left university where I had studied finance. But from the time I left university until after the blowup of L-T-C-M-I, was taught and learned very little about personal investing that, that I got to Solomon. And, the training that I got at Solomon Brothers was how to be a valuable, investment banker on the sales, in the sales and trading area.

In the trading area. And I was also in research. And at L-T-C-M-I was also focused on learning and, and doing the best that I could with relative value, hedge fund strategies that we were doing at the time. So when LTCM was over, I realized that I didn’t, I hadn’t really thought about how to invest my family’s savings such as they were after that.

And, um. And then it, it didn’t happen right away, but the, there was this evolution where the first thing that I did this is now going back to like 2000, 2001, is I looked around me and what I saw was everybody was trying to follow the David Swensen Yale Endowment model.

trying to generate alpha, trying to be this long horizon investor that could patiently earn excess alpha type returns. And it took me about five or six years to kind of, to, to realize that this didn’t work for an individual investor, even, an individual investor like myself that was pretty knowledgeable about different investment strategies that had a lot of.

micro market, knowledge and understanding and experience. It just whether it works for Yale is, is, is, is another question, but I can tell you for sure it doesn’t work for, a person like me. And that’s what got me thinking about going back to basics, going back to what I had learned in university and, and, getting to a really simple diversified, portfolio of public market equities and fixed income and just managing that and, and, accepting that as the amount of ex excess return and risk that would be reasonable to take for the rest of my life.

And thereafter. And I think also part of my thinking, or at least was that my thinking was furthered along by a couple of other things too. One of them was. Taxes as a US taxable investor that trying to beat the market is, is very, very, tax challenged. investing in alternatives tends to be very tax inefficient.

and, and being pretty frenetic in your trading is also, fairly tax inefficient and difficult, especially as an individual. And then the other thing was kind of thinking about my kids and grandkids and so on. I have three children. And I was thinking, well what example do I wanna show to them about what they should do if they have savings that they’re investing?

You know, should they devote a large fraction of their lives to trying to generate alpha? You know, is that a reasonable thing for them to do? And if they saw me doing that it would kind of set an example to them like, oh, they should do that. And that was the furthest thing that I would want for them.

You know, or any, or any future family members or anybody around me also just lots and lots. I have nieces and nephews and all kinds of young people that I want to set this example to of, of sensible long-term investing. But really I think one of the most interesting parts of this whole story is like, how, how you can go through 20 years at kind of leading edge institutions surrounded by brilliant, finance professors and, and, and all these people and not really ever be taught about personal investing.

And I think that’s a real, failure of our system that, that we don’t teach people more. And I’d love to talk about that whole topic a lot more. So anyway, that was kind of the journey from, Solomon Brothers and LTCM Hedge Fund proprietary fixed Income trader to, index Investor.

Justin: Well, isn’t there the famous Warren Buffet quote,.

something along the lines like, it’s not the guy with 160 IQ that beats the guy with the 110 iq. It’s the guy that’s able to control his temperament is the one that can be maybe more successful in investing. I dunno if that plays into how you guys think about the markets, but

Victor: Yeah, no, definitely.

I think that’s I think you have to be realistic about, your capabilities. that, that, there are professional investors, there’s alpha out there. We know that there’s Alpha that’s out there. And if you want to get out there and compete with Rentech Medallion fund or all these other, or, or Citadel you’ve gotta take it seriously and compete with them.

You, you gotta have a chance of competing with them and, and realize what they’re bringing to the table. And you’ve gotta bring something similar to the table and you can’t do that as an individual.

Justin: One of the things that you’ve talked about. When constructing a portfolio or building an investment strategy isn’t really the decision on what to buy, although that’s important.

But at Elm Wealth, you guys are mostly focused on trying to get exposure to various parts of the market, very cheaply through index funds. and there’s other holdings in there too, but that’s kind of the, the, the main core of it as I understand it. But just talk about the idea.

It’s not necessarily like it’s, it’s the how much of what you’re buying that’s important. And how do you think about that in terms of position, position sizing in the portfolio and in, in terms of risk management? Sure.

Victor: So yeah, the, we we like to say that, as has been said by many others, investing involves two decisions.

What are you gonna own and how much of it? And like 99.9% of what we. read and, see if we’re in the financial media. If we turn on CNBC, it’s all about the, what question. What should we buy? and that’s really important. You know, you’ve got, you gotta answer both these questions.

I’m not denigrating the what question. We’ll come back to that in a second. But this other question of how much is really, really important too, because if you get that wrong in, either direction, it’s so harmful. so if that, if you decide I’m not going to invest in anything risky at all, even though I recognize that it has a positive, excess expected return, that’s really bad.

And, and that really leaves you way behind where you should be versus a, versus a more sensible allocation to risky assets. But in the other direction, it’s even crazier, right? Like, if you take too much risk, then even if you have good investments, you’ll go broke. Uh. You know, so even if you find stuff that has a 20% return.

let’s say you find stuff that has a 20% return and it has only a 10% risk per anum, or something like that it’s amazing. It’s wonderful. Well, there’s some degree of scaling, there’s some amount that you could own of that, where you will go bust just because you there’s gonna be some period of time when the drawdown multiplied by your leverage wipes you out.

And so that how much decision is as critical or more critical. In fact that if you get the wrong decision on, on the what question, you kind of survive it. If you’re, if you size things reasonably, and you, and you live to invest another day, but if you get the how much question wrong in the two big size then you get wiped out and, and you have to start over.

And that’s, that’s really painful. So the other thing is that the, how much question is easier? You know, that that the what question? Well, the what question? I’m sorry. The what question is can also be easy. Like if you decide that you’re gonna go with something pretty. pretty passive on the what side.

If you’re gonna invest in index funds, you make that decision fine. But if you’re searching for things that are gonna beat the market, now you’re in the most competitive game in the world, and that’s a really hard game to win. Whereas it’s, and it’s zero sum. The how much decision is not zero sum. I can make the optimal how much decision for me.

You can make the optimal how much decision for you and we’re all happy. My, my success is not, your failure. We can all be successful in sizing at the same time, but we can’t all be successful in, in on the what question. Unless we invest in something like index funds then fine, we can all be successful together.

But we’re not, nobody’s beating the market in that case. So if you wanna beat the market, you have to find somebody that you can, that, that, that, is up for losing.

Justin: And, and just like more tactically, I guess, how do you think about that sizing? Is it like you’re looking at how it fits into the overall portfolio and how it affects risk adjusted returns.

Like just kind of walk through how you try to optimize that sizing question.

Victor: Sure. Well, risk, risk should be viewed as having a cost like risk is, risk is like a fee. You know, that, that you’re kind of charging yourself a fee, is a, is a good way to think about it. and, and, and, and you can see what that cost of risk is by asking yourself the question of.

What would you accept as a risk-free return in lieu of a higher risky expected return? So let’s just say that I think about a portfolio of stocks and bonds, and I say, okay, I’m gonna be 70% in stocks, 30% in bonds. I think stocks have an extra 4% expected return above bonds. So I have an expected return of 2.8% above the bonds for my portfolio.

Well, I can, I, I should ask myself, Vic, what would you accept? you are not allowed to invest in stocks. What risk-free return, like over the risk-free rate, would you accept to forego that expected return of 2.8%, and be just as happy, but getting a risk-free return? And I, I should be able to answer that just by noodling on it.

I don’t need I don’t need any kind of formulas or math or anything. I just can think about it and say, well. Okay. You know, I think I guess I would, I would accept 1.6% risk-free in lieu of the 2.8%. So the 1.6% is my risk-free return above the risk-free rate. The, difference between 2.8 and 1.6, that’s 1.2%.

That’s the cost of risk. And what I wanna do is I wanna think about different amounts of equities that I could own, and what amount of equities gives me the highest risk adjusted return. You know, what amount of equities will I answer that question with the highest number? You know, for my portfolio, and I just need to kind of think about that and search over that and think about that a little bit.

And that’s, that’s really all there is to it. Now we can bring in some we can bring in a little bit of machinery if we want to and kind of calibrate our risk aversion using a utility function and all that. But you don’t need to do any of that.

You know, you don’t need to do any of that. You can just really interrogate yourself to come to, the optimal sizing decision. And also we need to realize it was really important when it comes to optimal sizing, is that. Your risk ad if, if on the x axis it’s like how much risky asset or how much equities do I own?

And on the y axis is my, risk adjusted return, that the shape of this curve is very flat at the top. It’s kind of parabolic. It’s not like a mountain top like that. It’s not like the grand Teton Summit. It’s really rounded out. And so what that means is that you don’t need to hit it on the head. Like anything kind of in the vicinity is as good as anything else.

So like, if I would say, okay, given a 4%, excess return for equities and given, um. and, and given kind of a normal amount of riskiness for equities, let’s say, I would say my optimal, the optimal allocation I want to, equities, for me, it’s my personal preferences is 85%. Let’s say. I somehow, I know that’s optimal.

Well, there’s almost no difference between being at 75 or or 92. You know, it’s like almost gonna be the same expected risk adjusted return, and that’s really good. It takes the pressure off. But as you start to get far away, then the slope really gets big. So, like, if I would say, well, I just my optimal is 85, but I’m just gonna be at 20.

Oh, but that’s really bad. You know, I’m really losing out a lot. Or if my optimal is at 80 and I wanna be at 160 and levered, that’s really bad. You know, it’s like I’ve given up everything then, and maybe more so that, that’s how I like to think about it. Really simple just, this idea of the cost of risk, risk adjusted return, expected return, and just putting just thinking about those things.

Justin: One of the things that is on a lot of investors’ minds right now is the market valuation. And there’s a lot of different ways you can look at the market’s valuation, but one of the more popular ways is looking at something called the Cape Ratio or the Shiller pe And as Jack mentioned before and what we appreciate at Elm Wealth is there’s a lot of like original thought and research going on at the firm.

And so you guys are putting out research and white papers, and as I mentioned, you’ve written a book, but you published a piece on the Cape Ratio, but it’s this P cape, which I, I think is incorporating, dividend payouts into the Cape and sort of you found that it helped improve some of the issues with the Cape.

So can you just talk to that? ‘cause that’s, this is gonna be our, a lot of our audience is very familiar with the Cape. We just discussed it with Jim Paulson on our last episode, which she had some interesting thoughts, but. Just explain this concept of the P Cape and sort of what you guys found.

Victor: Sure. So thank you so much for saying that we have a lot of original research.

I mean, our feeling is that most of our stuff is, is actually not original and our whole and we’re really happy to share it. We like a lot of, some of what we do is original, but most of what we do is just trying to take a sensible sensible well. You know, sensible kind of, basic ideas in finance and make them really intelligible to people.

So like everything around sizing is stuff that we’ve pulled out of old academic things that just never got enough attention. But thank you anyway for, I mean, I appreciate, I mean, that, and so it’s, every once in a while we do something a little bit original, but not too often. It’s original to me,

Justin: but

Victor: maybe,

Justin:.

No, but I, I, I certainly appreciate it Anyways. Go ahead. Well, I mean, and that’s

Victor: why we if it were really original, we wouldn’t like, I mean in some ways, like we share everything because we think that it’s, it’s, it’s out there and everything that belongs out there in the public domain to help people anyway, so, so first of all.

the idea of Cape we like to think about Cape not so much as a valuation metric, but really as a long-term expected return metric. And in that sense, what we actually need to think about is one divided by Cape as the earnings yield. and so we like to that, we like to think about the idea that the earnings yield of equities is a good by itself, long term, expected return estimate for the market.

And it’s like you’re buying a building you buy a building, it’s fully rented out, let’s say. And, and, and you look at the, rental yield of the building and you say, well, the rental yield is 5%. And then you just kind of think it’s 5%. I’m gonna have to spend a little bit of money each year keeping it in, in good condition.

but I’m gonna grow the, I think I can grow the rent with inflation or maybe inflation plus a half a percent. And you just take that and now you’ve got the long term real return of that commercial real estate building. Well, with the stock market, kind of the same thing. Like if we just say, well, the earnings yield of the stock market is 4%, and if we think that companies would be able to grow those earnings with inflation, if they paid out all the earnings as dividends, then on a long-term basis that 4% is like a good long-term estimate of the, stock market’s real return.

And, um. So there’s questions then, okay, well what earnings do we use? Do we use last year’s earnings? Do we use next year’s forecast of earnings? And going all the way back to, to Benjamin Graham actually originally in the, whatever in the forties or thirties he said when I’m thinking about earnings, I like to average like the last 10 years.

He just threw that out. You know, I want to average the last 10 years because there’s some cyclicality in earnings and what if last year’s earnings were negative? I’m not, I don’t believe the stock market or a company’s earnings will be negative forever. It’ll be outta business then. So this idea of like, yeah, let’s average the last 10 years of earnings, just totally arbitrary.

You know, why not 12 years or or seven years a little more biblical. anyway, so we so we kind of have this thing of 10 years. Then Bob Schiller and John Campbell came back to that. And so we’ve got this 10 year, uh. You know, inflation adjusted average earnings that we use as an estimate of future earnings as a starting point.

Well one thing, and Schiller Bob Schiller has thought about this too, and other, other people have been thinking about is like, well when we go back and use earnings from five or seven years ago in this average to estimate the starting point for future earnings if the company hasn’t been paying out any dividends we would expect that earnings are gonna be higher because of all this retained earnings.

So when we look back at earnings five years ago, we wanna bring them to today. If they haven’t been paying out a lot as dividends, we wanna bring them to today average bring them higher so that when we’re averaging, we’re starting off at a slightly higher. starting point for earnings.

So that’s the retained earnings adjustment. You know, Schiller has incorporated into his freely available spreadsheet with all the last 150 years of stock market stuff. He does it in a slightly different way. It’s the same thing though, pretty much. and, and so what that does is especially in, in today’s world where the dividend payout rate has gone down, for us stocks is quite low, is like, I dunno, 35, 40% ignoring buybacks.

what that does is it gives us a little bit higher earnings. It gives us a little bit higher estimate for the long term expected return of stocks. And this seems like a reasonable thing to do when you look at it historically. It’s a little bit better, just a little bit better as a predictor.

Not hugely earnings yield is an okay predictor of the long-term return of the stock market. I mean, go back to 1900, guess what the earnings yield on US stocks in 1900 was about. Um. eight, eight and a half. Eight, eight and a half percent. Well, US stocks have delivered, a 10% return over the last 125 years.

And, almost all of it was predicted by, that starting earnings yield and then like a doubling or tripling of the multiple gives us like an extra 1% or something. So over long, over 50 year periods of time, earnings yield has been a pretty good predictor of the long-term return of the market.

But it’s just a predictor. You know, the market’s always gonna be higher or lower than that. I mean, like when we think of the next 10 years, and I mean, everybody’s seen the charts of like earnings yield or pe on the X axis and then kind of the average next 10 years, real return, and how that’s this nice upward sloping bar chart.

It’s hiding a lot of volatility in each bar. But when earnings yield is low, the long term return of equities. We think it’s gonna be relatively low and, and historically that’s been the case. It makes a logical sense too. But it doesn’t always happen like that. I mean, you know, the earnings yield was low 10 years ago already.

I forget what it was. If we go back 10 years and the last 10 years have been bumper US, equity returns. but if we go and look at non-US markets, it’s been a lot better predictor over these last 10, 20 years. So we know that we’re gonna get higher or lower returns. That doesn’t mean we should throw out the estimate, but we need to think about it,?

But I as we think about it, continues to make sense. I mean, I think that companies really do have a hard time growing earnings faster than this notion of if you paid out all your earnings as dividends, you could only grow at inflation. That’s kind of a weird, I think that surprises people sometimes.

You know, it’s like. Why if I paid out everything in, in dividends, shouldn’t they be able to keep up with, real GDP growth? And no, they need to reinvest to be able to keep up. They need to retain earnings to be able to, to keep up, to keep growth going faster with real, real GDP.

Jack: How do you think investors should think about expected returns in practice?

‘cause that’s the question we always get is, all right, we’ve got these estimates of seven to 10 year returns or whatever they are. But like, how do I think about that in terms of how I’m constructing an investment strategy? And I, I think you get those even more these days because. Most estimates of expected return to what you just said have been low for a long time now.

they’ve been projecting lower returns than what we’ve actually gotten. And so people think about like, is this useful to me in practice? So I’m wondering like, how do you think about investors? How do you think investors can use expected returns?

Victor: Well, the first thing I would say is there’s no alternative.

You know, it’s like, okay my expected return was a low estimate for the future. Well, okay, maybe you want to do something different with your maybe you want to think about why it was wrong. Is there something you should change? But we can’t escape thinking about expected returns. I mean, the whole 60 40 portfolio is a total abrogation of duty.

You know, that like that, that, that, it’s like saying, I don’t know anything about expected returns. I’m gonna be 60 40, for no good reason. I mean, it’s, kind of a really weird, like, we always need to be thinking whatever we do, if we don’t have an expected return. Then I think that we can’t do any investing at all.

I mean, we also need a risk number. We need an expected return and risk. And so, we need that. And so the, if, if somebody has a better idea for thinking about the expected return of the stock market they, they should use that. They should come forward and use that. Now, what’s one thing that’s really interesting is if you, if you just spend some, you could spend a half an hour, 45 minutes or just go to an LLM and say, please give me the long-term expected equity return estimates from 25 of the most prominent investment firms in the world.

And like, you can get that or you could do it yourself. But like perplexity will go out and just look at the capital market assumptions of BlackRock and Vanguard and Goldman and Morgan Stanley and pimco and all these guys. And it’s amazing that actually like if you go for 25 of them.

That, like 23 of them are all in the same place. They’re all congregated around earnings yield. they’re, right now they’re all very low and there’s, and they’re all in consensus and they’re all kind of thinking about a little bit differently. There’s like one or two outliers, we won’t mention them necessarily.

There’s one or two outliers. And the outliers don’t believe their numbers anyway because the, the like one of the firms that’s an outlier is like constantly invested in equities even though they think they have a negative expected return. I mean, they, they would be out of business if they believed their negative expected return numbers and put them into practice, but.

You know, 23 of these firms are kind of in consensus. They’re also around earnings yield. And so I think that there really is a basis on which to say that there is an expected return out there. Now, if you poll investors, if you poll when you poll retail investors, they have a, they have an expected return for stocks That’s much higher at the moment.

You know, and, and, and so there’s a lot of, extrapolation by, non non-professional investors tend to extrapolate the past. So non-professional investors and also some of the institutions like some of the pension funds. And part of it is that, that there’s incentives I, I think out there for why some pension funds and.

And others have, have overly optimistic and not, not realistic, expected returns, but, but you need, but we need to we can’t invest without expected returns and risk there’s no way to do it.

Jack: I’m just curious on, on the topic of valuations we’ve been talking about a lot recently, and Justin mentioned our, our conversation, which Jim Paulson, but if you look at that cape all the way back, you’ve kind of got two regimes.

You’ve, you’ve got a regime up to, I dunno, it was like 1990 or so where you had a much lower average. Then you’ve got a regime recently where you’ve got a much higher average. And then it also seems like the average is actually going up over time and continues to as well. So do, do you have any thoughts on that?

Like, on should we expect the market to revert back to historical valuations? Is that even useful to consider? has something changed with the market where valuations are just gonna be higher permanently? Do you have any thoughts on any of those issues? Well, I think,

Victor: so, so first of all right, the, this, uh.

10% stock mar US stock market return from 1900. Right. That this is, this is the basis of what academics have been calling the equity risk premium puzzle for a long time. So I don’t think that we’re going to go back to, the first half of the 20th century kinds of valuations where there was just much less understanding of equities.

You know, there was the, the whole, what do you call it, prudent man, pr, pr prudential, investor rules where so many, so, so much, fiduciary managed money was not, viewed as being prudent to be invested in stocks. So I think we can, like in terms of just thinking about what’s, what’s normal.

I think we can throw out a, a lot of that whole history and thinking about things. the other thing is that we need to always be comparing the expected return of stocks to, safe assets. And so safe asset returns really vary a lot. I mean, there have been times like in the middle of the 20th century where real rates were really negative.

and then of course a few years ago we had negative real rates. You know, now we have somewhat more positive real rates, at least in long-term tips. And so some of this, some of what’s happening is also a function of what’s happening, what has happened and will happen with interest rates.

But, at some point at some point, when the expected return of stocks. Is too low relative to safe assets. We’re gonna see a ton of equity issuance. You know, we’re gonna see a lot of companies, existing companies and new companies and private companies come along and say, Hey, if I can issue, if my cost of capital is equal to the US Treasury, right?

Like, we’re not that far away from that right now. You know, US equities is offering an extra one to 2% more than US treasury bonds. Well if, if the if, if, expected returns drop another 1%, if PEs go up another 50% we’re gonna be at a point where a lot of companies are gonna say this equity capital is basically the same as me issuing investment grade debt.

You know, I’m going to issue a lot of this and, and other people will come along and issue issue equity and, and a lot we’ll see a big move from private to the public sphere as well, when and if that happens. So I think there are bounds on it. Uh. You know, I think that an equity, an equity risk premium of six or 7% just feels kind of high to me given, given the risk of equities.

So I don’t think we’re gonna see those really high levels. Maybe we’ll see them briefly from time to time, as we did in the GFC. But yeah, I think going forward, the expected return of equities is gonna be, lower than it has been on average over the last a hundred years. but probably for the US market, I think it’s gonna be higher than it is today.

I think there’s not enough compensation in US equities today to warrant the, the risk. And at the end of the day equity markets are real, true systematic risk. You know, when equities go down big, you, you might lose your job at the same time and everything is terrible and it’s, it’s a real.

Societal risk that, und diversifiable that should carry a relatively healthy risk premium. And I think that we’re now at a point where it’s starting to really feel pretty poultry.

Jack: I wanna get into how you think about constructing portfolios, but first I just wanted to ask you about buybacks.

‘cause you had another great research piece on your site about buybacks and, just a quote from the piece. You said their rise since the 1990s, maybe one of the most underappreciated drivers of US equity market performance and warrants greater attention from academics, investors, and policy makers. So I’m wondering if you could just talk about what, what you found with that piece of buybacks.

Victor: Sure. So I think that in some ways our buyback piece was more a piece, about, about the elasticity of the stock mar of stock market prices and about how. investors are approaching asset allocation. Then it was I mean it was also about buybacks too. And, but it was really this like, jumping off point to say, let’s think about buybacks.

You know, how much impact could buybacks possibly be having on equity returns? and we said, well I don’t know. I mean, how, how do different investors do their asset allocation? Well, what if everybody just was gonna be 60 40 or had some strategic asset allocation of X and one minus X in, in US equities?

Well, the only way that buybacks could happen would be the market would have to go up a lot so people could still stay at their desired asset allocation. So, so buybacks if, if, if companies were buying back 3% of all outstanding equities each year, which is around where we’ve been the market would’ve to go up five or 6%.

Just so everybody could remain so that the buybacks could happen and then everybody could still be at 60 40 or at 50 50 or wherever they wanted to be in terms of a stock bond mix. Assuming they didn’t want to be at a hundred percent in stocks, then there’s no impact from that. and then we said, well, okay, that’s interesting.

What about some other investors, like some investors come up with their return expectations from extrapolating from the past that, that we’ve been talking about. And there’s a lot of evidence that that goes on. So when returns have been higher in the past, in the recent past, they want more equities, their expected return is higher, and they want more equities, oh boy, that’s a problem.

You know, now that exacerbates things versus the world in which we just had the guys that are the fixed asset allocators. And then we said, well, okay, let’s bring in some other guys that maybe are looking at expected returns. And they’re willing to go when expected returns go down, they’re willing to drop their asset allocation to, or their allocation to equities.

Oh, well that helps. And anyway, we just played around with all of that and we said we don’t know who’s who or how big these different players are or what their parameters are, but it’s pretty easy to see that companies buying back 3% of their stock could be pushing equities up 3 to 5% a year while that’s happening.

And that’s really big that’s like, that’s a really, that’s really sizable in the, in the scheme of things. And then we talked about other things with regard to buybacks. You know, like the fact that they’re kind of a bit of a tax, they’re, tax advantaged. And so the US Treasury is losing out on tax revenue because this is happening.

And we brought up that question and brought up what’s going on with indexing. You know, I think people, misunders, this is a place where people misunderstand indexing because indexing is actually. Helping to smooth things out between buyback and non buyback stocks because index funds are like, here you go.

When, when the company comes in to do the buybacks index funds said, here you go, here’s my stock. And, and then they go and buy back. They, they have to go buy the non buyback stocks and kind of push them up. So there’s pressure on the buyback stocks to go up, but the index funds are helping to, to mitigate that a little bit.

So anyway, we talked about all these things. It was a really fun article, but really in some ways what we were saying is that we, we think like there’s all this carping, and I guess we’ll talk about this at some point. There’s all this whinging and carping out there about index funds.

You know, index funds are worse than Marxism and indexing is ruining the world and indexing is terrible and all this. But I would say that all of the things that we, that people, not me, all of the things that the index fund haters are complaining about are really explained by. Static asset, al allocator, static asset allocators and return chasers.

Like, I think that’s where the problem is, is that people are not approaching asset allocation sensibly, and they’ve conflated and they’ve, they’ve gotten confused between stock picking and, and, and a dynamic asset allocation. They think stock picking is bad. And so also dynamic asset allocation is bad.

Well, no, they’re, they’re totally different things. And I think that what we’re seeing is really being driven. What we’re seeing with this market that just doesn’t wanna go down is the fact that so many asset allocators, are not, driven by forward-looking expected returns.

And I think that’s really causing all the problems that the, that people complaining about indexing are, are seeing and are mis misattributing to to market cap. Uh. Index funds in terms of stock picking.

Jack: Yeah, that’s really interesting. And if, if we get time at the end, we’ll get into some of Mike Green’s work on this, because I, I’d like to talk about it, but I, I wanna get to building portfolios and, and how you think about that because we, we had Rick Ferry on recently, and we sort of started at a very basic level when we were talking about building a portfolio.

I mean, we’ve got, we’ve all got a bunch of assets we can choose from. There’s way more now than there once were with all these new funds and everything, they’re coming out. But at a basic level, we’ve got stocks and bonds, and we have to take those and think about how do we construct a portfolio. So I’m wondering, and I know you primarily use stocks and bonds, how do you think about that decision in terms of what you wanna own and how you wanna put it together into a portfolio?

Victor: Sure. So yeah, so I think the first thing is right, there’s just this like multitude of things that we can invest in. And so you have to have some kind of a screen, you have to have some kind of a screen so that you. Narrow down what you’re investing in. And so for us, and I think everybody needs to build their own kind of screen, but for us, we say, well, when it comes to risky assets, we wanna invest in things that, that where there’s a good reason that they should have a risk premium.

We want the risk premium. If it does that if we think that something should have a risk premium, we wanna be able to verify it. So it’s like trust and verify. We want to be able to calculate it. So oil is a huge, huge asset class, right? It’s enormous. It’s bigger than all the value of stocks in the world, the oil that’s known in the ground, that that is owned by people and countries and companies.

But there’s no way to really come up with its expected return. You know, we don’t know it’s so difficult like we believe it should have a risk premium, but we can’t calculate it. So that would be an example of something that falls out because we can’t calculate it then we want it to be.

Something that’s low fee. We don’t want to pay a lot of fees for it. if it’s in a tax, if we’re gonna hold it in a taxable account, we want it to be tax efficient. And in general, we just don’t want anything that’s zero sum. So we don’t want any kind of strategy or investment that’s like a zero something where somebody’s on the other side from a, for us to make money, somebody else has to lose money.

You know, we don’t want that but really it’s these first these first three things of it. It’s big and it should have a risk premium. We can see what the risk premium is and we can access it at very low fees. So that leads us to some, some low cost broad market index funds on the risky side of things, and it leads us to diversified similar kinds of holdings on the safe asset side, just that are low fee and, and liquid and so on.

so, so we get down to. Then it’s like, okay, well how granular do we want to go? You know, well, we wanna maintain those low fees. So we break the world up into like 10 buckets. US equities, European equities, em developed Asia we break the fixed income into a few groups of t-bills, tips, nominal bonds, more or less.

And we have whatever, 8, 9, 10 buckets altogether. And then we just, for the risky assets, we’re just looking at their expected return and risk level. And we’re, we have a baseline and relative to that baseline, we overweight or underweight. If the expected return is higher or lower than where we peg that for the baseline.

And when the risk is higher or lower, we have less or more of that bucket as well. And that’s how we build the portfolio. You could do it on the back of a napkin. There’s no mean variance optimization. There’s nothing complicated. I mean mean variance is good, but, you can’t do that on the back of a napkin.

So that’s, we do it in a way where everybody. You know, where all of our clients can see and understand what we’re doing and know what to expect. You know, I think there’s probably better ways to do it, but there’s not any way that we found that’s both better and as simple or nearly as simple. So that’s how we, that’s how we build it up.

You know, each client or product has a baseline. and that baseline is, is defined by what’s the expected return and risk in that that we’ve set that baseline out. So then we can go out in the world and see what are the expected returns and risks, and then over underweight relative to that baseline.

So baseline is not just a set of weights, it’s a set of weights and a set of, risk and return for each bucket, which is, which can be arbitrary. It doesn’t have anything to do with history. It could just be, it just is needed for the definition of what the baseline is, that you have to define the baseline with a certain expected return and risk, so that then when you go into the world, you can say, oh, well this is what the expected return is today.

And for my baseline, I had this. So I want more or less,

Jack: one of the things I like to do with the podcast is to challenge some of the things I do with my own clients and my own portfolios. And you wrote a piece recently that does that because you challenged the permanent portfolio and we don’t run that exactly, but we run a, a version of that and, the theory of the permanent portfolio sounds great.

You know, you’ve got your four quadrants, you’ve got one asset that’s doing well. People talk about stocks and bonds. Having this one achilles heel in terms of inflation and you’re covering that. So I just wanna talk you to talk a little about what you found in that piece and, and why you maybe think the permanent portfolio might be suboptimal relative to some of these other options.

Victor: Well, well first of all, the permanent portfolio is exact, has the exactly the same, problem as the 60 40 portfolio is that it has nothing to do with expected returns and risk. I mean, it’s like. Somebody just went like this a while ago, a long time ago, and said 25, 25, 25 so it has nothing to do with expect, so it has nothing to do with expected return risk and, and, and Covance among those different assets.

So I think that if somebody says, look, I wanna own global equities, I want bills, I want long-term bonds, and I want gold, I, that’s, that’s my, that’s what I want my portfolio to consist of. If somebody said that as a starting point, fine, that’s great. I mean, I just said okay, we’re gonna have stocks and bonds, or we’re gonna have, these bonds and we’re gonna have these stocks, right?

I just went through all of that. So you have to come up with what, what are your ingredients? And those ingredients need to be reasonable, and those ingredients are reasonable. You know, for me gold doesn’t make it for me because I can’t really come up with its expected return easily. But I could come up with an expected return.

You know, I could see somebody coming somebody could say, well, I think gold is gonna grow. At, at, at, per capita GDP growth rate above inflation or something like that, is that they could have a model for it. And that’s fine with me. I That’s good. So now you have expected returns for the four pieces.

you have risks for the four pieces, and you’re gonna need some Covance for the four pieces or co correlations, and then you get a portfolio out of that. And, the one thing that portfolio is not going to be is, is never gonna be 25, 25, 25, 25. I mean, it’s just I mean, it might pass through that at some point but like, the probability that it ever comes up at 25, 25, 25, 25 is pretty low.

and if, and if there’s a moment in time when it is supposed to be that great but, two months from then it’s not gonna be that anymore,? And so it just from that point of view, I think it suffers from exactly the same problem as just saying, I’m gonna be 60 40 forever.

so and, and of course yeah, I think that’s really the main kind of the main thing that I would say is like, we just need to build portfolios based on expected return and, and risk or co variance.

Jack: I just have one more before I hand it back to Justin. I would ask you about one, maybe taking things to a little more of a complicated level.

You’re seeing a lot more of these more advanced strategies being available to individual investors through ETFs these days. And one I will say that we use for clients, and I I wanna get your view on it, is managed futures. because if you just look at it from a math perspective, and again, it may fail your expected return framework, but if, if you look at it from a math perspective, managed futures are good in that they’re uncorrelated with all the other asset classes.

They tend to perform well during big drawdowns. Like they tend to create a smoother return when coupled with these other assets. And I’m just wondering, how would you think through an asset like that and whether it should be added to a portfolio?

Victor: I, I have a soft spot for managed futures. You know, I think, that, uh.

it can, it can be a relatively low cost. It’s a very easy strategy to implement. It can be done at very low cost. and I think that there are reasons why that has performed pretty, pretty well over very, very long periods of time. from from our point of view, we’re trying to keep things simple.

We’re trying to keep to this sort of rubric of we want things where we can think about expected returns, perspectively. And our, I think that our, take on it would be like for our clients is that this is what we’re doing for you guys, clients we’re gonna put you into, low cost, diversified public market stuff, but you’re gonna have other investments away from us.

And if you wanted to have managed, if you wanted to ask us what we think of managed futures, we would say that’s a, seems like a reasonable thing as long as you’re doing it with somebody that’s extremely low fee. And isn’t too carried away in terms of getting into really weird illiquid markets.

so, so yeah, I mean, I’m kind of, po somewhat positively disposed towards it. You know, it doesn’t really fit with our with our five star right, our five star thing. It doesn’t fit in there because we can’t, we can’t really say what the expected return is except for looking at history number one and number two it’s, it can be low fee, but it’s never gonna be low enough fee for us.

Like our portfolios have an average expense ratio of like five basis points and and we’re kind of pissed off that there’s not a low cost Canada ETF, if Vanguard is listening, please, Vanguard give us a low cost Canada ETF, so we don’t have to see 18 basis points from, from

Justin: every

Victor: Canada

Justin: one.

Everything up in Canada is expensive. Even the stuff down here that’s Canadian is expensive.

Victor: Well, well, no, but the Canadian. Vanguard has no, a Canada et TF is like three or four basis points, but it’s only for Canadians. It’s not focused. Oh, really? Oh, interesting. Okay. Yeah. Oh yeah, yeah.

Justin: That’s, talk about, I wanted to, and maybe I think you’ve touched on it, but this I idea of, and I think it’s the strategy that you’re using in the etf, so this dynamic asset allocation strategy and how this is being managed over time and how you guys actually construct walk us through the investment process of how you construct the ETF and what its

Victor: long-term objectives are.

Sure. So we, we launched an ETF on the New York Stock Exchange in February, but it was the, it is a, it’s the conversion of a fund that we had, a private fund that we had going back to 2011. So it’s, it’s been around and, and it follows our dynamic index investing approach. And so it starts off with a baseline, 75% equities, 25% fixed income, the buckets we talked about a few moments ago in terms of the different regional equity markets.

And so that’s our baseline. And then we look at the expected return, or the expected risk premium in each asset bucket on the risk asset side. And we, allocate more or less to each bucket, depending on how much above or below 4% those risk premium are, the residual goes into fixed income. and I’m sorry, also as part of the allocation is whether we’re in a high or low risk environment instead of measuring risk, more directly through something like vix.

for US stocks and VIX equivalents for non-US stocks, we use one year moving average momentum. That’s a pretty good proxy for risk. You know, it’s not always pointed the same direction, but it’s pretty good. And so when, for an asset bucket, if it’s in a risk, a high risk state, we reduce its exposure by a third of the bucket size, or we increase the exposure by a third of the bucket size when we’re in a low risk state and that’s it, we add up all those risk buckets.

If they’re less than a hundred percent, the residual is fixed income. If it’s more than a hundred percent, we would scale them all down. So it equals a hundred percent no leverage in the ETF. And then in the fixed income bucket, we kind of split it between bills, tips and nominal bonds with a pretty heavy weighting towards a pretty low weighting towards, nominal bonds.

And we use a little bit of a, of a asset allocation there, but it doesn’t really move the needle very much. But we use, the risk level or momentum to overweight or underweight within. the fixed income bucket relative to bills. So that’s the whole thing. And we’ve, we’ve been running it like that. We rebalance it, on a weekly basis, sometimes more frequently if the markets are moving, but the rebalancing that we do is like a, a slow moving rebalancing where we’re like rebalancing a quarter of the way back to target each week so that the turnover would, the turnover looks like we’re rebalancing monthly, but we’re actually touching the portfolio all during the month to smooth things out.

But, but without getting all that extra trading activity that we would get if we were doing it more, frequently, and we have about $500 million in there. Um. The, the average expense ratio of all the underlying ETFs is about five or six basis points. And then, the fee that we charge and then the fee that also goes to the series Trust, provider that we have is like another, 18 basis points between the two.

So the underlying ETFs, our fee, US banks fee, it all comes up to 24 basis points, which is low for, for this kind of thing. And it’s like, as far as we know, it’s the only, rules-based, rules-based, relatively low cost, dynamic asset allocation product out there. And something that’s just amazing, right?

Is like that asset allocation ETFs, are just tiny. I mean the total outstanding amount of asset allocation ETFs. Is around, $10 billion. And it’s mostly three iShares ones. I mean, we’re getting to be, we’re probably the fifth, I don’t know, fifth biggest one now at 500 million which is tiny.

But the asset allocation mutual funds, right, is like three or $4 trillion. So there’s three or $4 trillion of demand for asset allocation mutual funds, but only $10 billion of asset allocation ETFs. And I think that anybody that’s a taxable investor, right, has to want the, the etf. It’s more tax efficient.

You know, it’s the same thing. You should have the ETF, you shouldn’t own one of these, vanguard, balanced funds or target date funds. I mean, target date funds also are not I mean, I, I think a balanced, I would rather have a balanced fund than a target date fund anyway, for most people, for many people.

but anyway, it’s kind of interesting, right? It’s because of the whole 401k thing. Is like all based on mutual funds and, and everybody’s going into a balanced, some kind of an asset allocation. I mean, so much money is going into asset allocation, mutual funds through the 401k, and and then in the taxable world or sorry, in the rest.

And then for everybody else, there’s like almost no investment in asset allocation ETFs. I think that’ll change probably, but who knows when.

Justin: Yeah. Yeah. Well, and a lot of those investors that are, that are in taxable accounts in those types of strategies probably have like locked in and embedded gains.

They don’t wanna obviously sell and then have to realize. So, I mean, but yeah. Yeah. Tides are, tides are, are clearly changing with the the wave of, of assets going towards etf. So I think it’s just a matter of time. Yeah. But 500 million is nothing to sneeze out either, so That’s great. So congrats.

Thank you. Yeah, thanks. yeah, as we get towards sort of the end, I have a couple more questions just I wanted to ask you. Do you think about, or. See the risk of, I mean, because you obviously have a big percentage of equities and, and US stocks make up probably a significant percentage of that.

So what do you feel about sort of the level of market concentration with the the big tech stocks making up, as much as the market as they do? Is that, is that something that worries you at night or are you like, this is the way that market cap weighted indexes are and I’m not gonna lose too much sleep about it?

Victor: Yeah, more the latter. Also looking at global, the global stock market those concentrations all look 40% smaller in terms of the, the whole thing. But there are big companies with big revenues and the whole the whole US stock market worries me much more than the concentration issue.

but that, yeah, I mean, I’m just really worried about I’m, I’m, yeah, I’m really worried about this level of low expected returns. I’m worried about the degree that investors are extrapolating past returns into the future. I’m worried when I look at the Nancy Pelosi portfolio and see that, and it’s like, oh my God.

You know, like, this is how a, supposedly intelligent person is doing their asset allocation. You know, it just is all it all makes me makes me nervous and, and I think that, yeah, I, I, I, I think that it’s very difficult for corporate earnings to totally break away from GDP growth, the way that people have to be believing that to be the case if they thought about it.

But again it’s like all of the investment professionals are kind of saying the same thing. You know, we’re all saying, okay US equities are gonna give us one to 2% over safer assets. And everybody’s kind of acknowledging that like BlackRock’s not out there saying, we’re about to get some massive earnings growth.

massive earnings growth to a new level forever. And so we’re gonna get 5% over safe assets. No, they’re saying the next 10 years is just gonna be one or 2% above treasuries and, and, that’s what everybody’s saying and it’s, it’s pretty scary in terms of how, how sustainable it is just some things change.

we’re getting one and a half trillion dollars of stock buybacks at, at the current time in the us but I don’t know. I mean, if, if, if open AI and, and and a few other private companies decide to come public all of a sudden that could be a trillion dollars of issuance.

Or again, if, if at some point, if companies are like, I mean, isn’t it amazing? Like, isn’t it amazing that Oracle and Meta are buying their stock back? And issuing hundreds of billions of dollars of debt. Like how can that make any sense at this le at these market levels? They need the money for the for their CapEx stuff, but they just continue to buy back stock and then issue debt.

You know, 30 billion for meta, 80 billion for Oracle. Google’s doing what? 30 billion and at tight spreads. I mean, the whole thing just is really weird.

Justin: it’s a very interesting point. You know, like a lot of people have talked about how companies are staying private longer and they have these crazy valuations, but eventually those investors are gonna wanna realize the investors behind those companies are gonna realize the value in those massive companies like OpenAI and, and others in the future will come into the public markets.

And it’s, it’s just it’s an interesting question. It’s that gonna create like this vacuum almost that the market. You know, the money is gonna go towards them. It’s gonna have to come from somewhere. So how does that, how does that whole thing sort of play out? It’s not, a lot of people talk about

Victor: Yeah, it’s the buybacks in reverse.

So if buybacks are pushing stocks up three to 5% a year we go in the other direction and it’s, it’s it’s, it’s, it’s it’s very procyclical the whole thing. also, right. Companies basically stop buybacks. I mean, really curtail buybacks at times of high uncertainty, volatility and, and economic, slowdown, right?

So in the, in the financial crisis in COVID buybacks came to a standstill. And, we got out of those periods through interventions and other things. but it’s, it’s scary, right? I mean, the buyback machine is not something that’s gonna be there forever. And at some point also, we’re just gonna see.

You know, we’re just, we just have to see equity issuance. Even if companies don’t want to issue stock other people are gonna come along and say, if I can, if I can raise equity capital if the demand for equity capital is like, basically such that I could start a company and invest in treasuries and that would be okay.

You know, it’s gonna be right. I mean, there’s just trillions of dollars for, for that kind of thing, or so yeah, it’s, it’s a weird, right, it’s like I’m, I’ll, I’ll create a company and buy, buy treasury bonds and, and wait until I find something good to do with the money. And it’s like, if the market would be okay with that, which it effectively would be saying once once we get to a pe when we get to a PE of a hundred, which is just a doubling of the market from here, roughly.

Or a PE of 80. You know, we’re back into late 1980s Japan, and believe me, there’s a lot of things that people will raise equity capital to do when, when the market is so, is when the market is so, excited about stocks.

Justin: So we have two standard closing questions that we’d like to ask all of our guests.

The first is, what’s the one thing you believe about investing that most of your peers would disagree with you with? Victor: I think that, I think that in the investing, in the investing world in general, that, that people are not willing to change their asset allocations very dramatically in response to changing expected return or expected risk, premia and risk.

there’s this, feeling that, changing or asset allocation is market timing and market timing is bad. You know, I think market timing is. What we mean by market timing is something different than this, that it’s rational to change your asset allocation, but that for whatever reasons people have, I think a lot of people think it’s rational.

They just don’t want to, they’re just afraid to do it or they’re cautious about doing it, and they know how it, if they had done it, how it would’ve been, and they’re cautious about that. But I think that’s probably one thing that, that, I think so many, different investors, are not really agreeing with me on, which is that we, we should be dynamic in our asset allocation and pretty, and pretty dynamic not just a couple of percent here or there.

but but fairly fairly big changes in asset allocation can be warranted by different conditions.

Justin: And then lastly, based on your experience in the markets, what’s the one lesson you teach your average investor?

Victor: Um. You know, Matt Levine, who’s just such a great writer, for, you know, for Bloomberg Money stuff, he said that, that financial literacy should be boiled down to one question that people should understand.

And that question he wrote is, if somebody comes to you and offers you an investment that has a 20% return with virtually no risk, what should you do? A, jump on it because it’s gonna be gone in a minute. You know, if somebody else is gonna do it, b research it and, and if, and if it is, as presented, do it.

Or c assume the guy is either lying or doesn’t understand the situation and save yourself the time and walk away. And I think that people really have a hard time. Choosing C but I think that CI think that this question kind of embodies like all of the bad things that you can do in investing.

Like if you don’t see like if, if you don’t see that as an individual investor, that it is an excellent working assumption to run the other way. When you hear that or when you think that I think I, I, I, I think that’s like the one lesson that I think it would be so valuable for people to have, and I can’t take credit for it.

It’s a Matt Levine thing, but yeah, I just, I just feel like that encompasses like everything. It encompasses that risk matters, it encompasses market efficiency. it encompasses like all of the, I import not all, but it encompasses so many of the important things that we should know as investors.

Justin: You know, if you just would’ve told me that story, I would’ve been given, given you credit for another original idea, which you would’ve said, that’s not original idea. But, but I love that response, but I love that response and I think it’s spot on. So Vic, thank you very much for joining us. Really appreciate it and enjoyed it.

And, hopefully you come back again soon. Thank you. Yeah,

Victor: me too. Thanks guys. I really enjoyed that too. Thanks for giving me a chance to, to riff on all these things really. That was great.