WEBVTT - Robert Arnott on Global Asset Management (Podcast) 0:00:00.080 --> 0:00:06.080 M. This is Mesters in Business with very Renaults on 0:00:06.240 --> 0:00:10.040 Bluebird Radio. This week on the podcast, I have an 0:00:10.039 --> 0:00:13.400 extra special guest. His name is Rob or Not and 0:00:13.480 --> 0:00:17.200 he is the chairman and founder of Research Affiliates, a 0:00:17.320 --> 0:00:21.880 firm who essentially patented the concept of fundamental index thing 0:00:21.920 --> 0:00:25.599 pretty much they invented it. And uh, I know Rob 0:00:25.640 --> 0:00:27.240 for a good couple of years. He was on the 0:00:27.280 --> 0:00:32.760 show in and his office just cranks out so many 0:00:32.880 --> 0:00:38.320 fascinating research pieces, hence the name Research Affiliates. That you know, 0:00:38.400 --> 0:00:40.720 after you read the third or fourth thing from somebody 0:00:40.760 --> 0:00:43.000 in a couple of months, it's like, damn, I gotta 0:00:43.000 --> 0:00:45.520 get robbed back on. This is some really interesting things. 0:00:46.080 --> 0:00:50.120 We went deep into the woods on electric vehicles in 0:00:50.159 --> 0:00:54.080 Tesla and we talked about what makes a big market 0:00:54.120 --> 0:00:57.440 delusion when an entire sector, not just a company, a 0:00:57.440 --> 0:01:02.000 whole sector runs amuck. We talked about everything really, from 0:01:02.000 --> 0:01:06.080 E s G to bitcoin to value. I thought it 0:01:06.120 --> 0:01:09.880 was really intriguing if you're at all interested in fundamental 0:01:09.920 --> 0:01:14.399 indexing or smart beta, if you're interested in where alpha 0:01:14.480 --> 0:01:19.120 comes from and what the sources of various value and 0:01:19.280 --> 0:01:22.440 other types of factor premiums are, then you're going to 0:01:22.520 --> 0:01:26.560 find this to be absolutely fascinating. So, with no further ado, 0:01:26.959 --> 0:01:33.319 my conversation with Research Affiliates Rob are Not. This is 0:01:33.480 --> 0:01:38.959 mesters in Business with very renaults on Bluebird Radio. My 0:01:39.120 --> 0:01:42.320 special guest this week is Rob are Not. He is 0:01:42.480 --> 0:01:46.560 the founder and chairman of Research Affiliates, a firm that 0:01:46.600 --> 0:01:52.320 has created and patented a methodology for creating indexes based 0:01:52.400 --> 0:01:57.040 on fundamental metrics instead of the traditional market cap waiting. 0:01:57.800 --> 0:02:01.560 Various asset managers are unning over a hundred and sixty 0:02:01.640 --> 0:02:07.200 billion dollars using strategies developed by Research Affiliates. Rob is 0:02:07.240 --> 0:02:11.600 the author of over a hundred academic papers, seven of 0:02:11.639 --> 0:02:15.680 which one Graham and Dodge Scrolls and Awards. He is 0:02:15.680 --> 0:02:18.760 the co author of the book The Fundamental Index A 0:02:18.760 --> 0:02:23.000 Better Way to Invest. Rob are Not, welcome to Bloomberg. 0:02:23.600 --> 0:02:26.400 Thank you so much. It's a privilege. Well, it's pleasure 0:02:26.400 --> 0:02:28.360 to have you back. There's so much to go over 0:02:28.400 --> 0:02:30.480 since the last time we had you on the show 0:02:31.000 --> 0:02:34.840 about three years ago. Let's just start out with Research 0:02:34.880 --> 0:02:39.640 Affiliates or or Raphaels as I know it. Um, you 0:02:39.639 --> 0:02:43.720 guys don't manage assets directly, but advise on over a 0:02:43.760 --> 0:02:47.040 hundred and sixty billion dollars in assets, explained to the 0:02:47.120 --> 0:02:53.559 listeners how that process works well. We want to focus 0:02:53.720 --> 0:02:57.480 on our area of competitive advantage, and that is in 0:02:57.720 --> 0:03:05.760 doing research and develop investment strategies, in carrying out um 0:03:05.880 --> 0:03:12.360 UH and exploring potentially disruptive ideas for the investment management community. 0:03:13.240 --> 0:03:18.000 UM to run an asset management firm also typically means 0:03:18.360 --> 0:03:25.680 UM call center, means portfolio accounting, it means UM trading desk, 0:03:26.880 --> 0:03:30.560 trade reconciliation departments, and the list goes on and on 0:03:30.600 --> 0:03:33.080 and on. So the last time I ran an asset 0:03:33.120 --> 0:03:37.080 management firm first quadrant back in two thousand four, we 0:03:37.120 --> 0:03:40.640 had about twenty people and a roughly twelve were in research. 0:03:41.160 --> 0:03:45.240 Here we've got about eighty people and roughly half of 0:03:45.320 --> 0:03:49.200 them are in research. So we're able to concentrate our 0:03:49.240 --> 0:03:53.240 attention on our area of competitive advantage while at the 0:03:53.280 --> 0:04:01.160 same time using affiliates external distribution partners to handle distribution 0:04:01.200 --> 0:04:06.880 and quiet relationships. And so basically they view us as 0:04:07.440 --> 0:04:10.800 an extension of their R and D capabilities. UH. Certainly, 0:04:10.840 --> 0:04:13.560 they're not going to replace their R and D efforts, 0:04:13.600 --> 0:04:17.200 but if our ideas are complementary, then we're an extension 0:04:17.240 --> 0:04:20.840 of that and we view them as our distribution channel. 0:04:21.320 --> 0:04:26.560 Let's talk about one of the strongest research ideas and 0:04:26.640 --> 0:04:30.440 strategies that you and your farm are behind. And and 0:04:30.480 --> 0:04:34.200 that's the basic concept that hey, we're doing this index 0:04:34.279 --> 0:04:37.440 waiting thing all wrong. Instead of doing it based on 0:04:38.279 --> 0:04:41.520 market cap or the size of the company, it's instead 0:04:42.120 --> 0:04:46.240 it should be based on fundamental metrics like revenues or profits. 0:04:46.560 --> 0:04:50.359 Explain why that's a better approach. Thank you for asking that. 0:04:50.480 --> 0:04:52.880 A lot of the attention in the world of so 0:04:52.960 --> 0:04:59.120 called smart beta is on formula based techniques for investing, 0:04:59.680 --> 0:05:04.200 and the umbrella terms smart beta began as a focus 0:05:04.279 --> 0:05:08.400 on strategies that no longer weight companies in direct proportion 0:05:08.480 --> 0:05:10.920 to their price, which is what cap Waiting does, and 0:05:11.000 --> 0:05:15.800 it's cap Waiting's heel Achilles heel um uh. If you 0:05:15.880 --> 0:05:19.720 wait companies in proportion to the their price, than any 0:05:19.760 --> 0:05:23.440 company that's above its eventual fair value and destined to 0:05:23.560 --> 0:05:28.479 underperform will have a current weight that's too high, and 0:05:28.600 --> 0:05:32.000 any company that's cheap and destined to outperform will have 0:05:32.080 --> 0:05:34.839 a current weight in the portfolio that's too low. So 0:05:34.880 --> 0:05:37.479 you're gonna be overweight the overvalued and underweight the undervalue 0:05:37.800 --> 0:05:40.760 even though you don't know which ones are which, which 0:05:40.839 --> 0:05:45.400 is an interesting nuance UM. But the term smart beta 0:05:45.480 --> 0:05:50.839 has since been broadened to embrace factor investing, and basically 0:05:50.920 --> 0:05:55.719 anything that uses a formula, even momentum investing, is called 0:05:55.720 --> 0:05:59.200 smart beta, although it's the antithesis of the original definition. 0:06:00.160 --> 0:06:03.200 UH Fundamental Index was an idea that we came up 0:06:03.279 --> 0:06:06.960 within two thousand three in the aftermath of the bursting 0:06:07.000 --> 0:06:10.159 of the tech bubble. A dear friend of mine who 0:06:10.240 --> 0:06:13.479 was on the board of the New York State Pension 0:06:13.560 --> 0:06:18.119 and was founding president of Common Fund, which manages commit 0:06:18.920 --> 0:06:26.080 Um university endowments. He was horrified at the amount of 0:06:26.120 --> 0:06:31.040 money that was lost by major pension funds by investing 0:06:31.040 --> 0:06:35.159 in cap weighted indexes. As the tech bubble burst. Four 0:06:35.240 --> 0:06:42.719 percent of the portfolio UM invested UH in the largest 0:06:42.800 --> 0:06:48.400 market cap company at the time UM Cisco, and Cisco 0:06:48.520 --> 0:06:52.720 subsequently went down. Something like so there went if you 0:06:52.800 --> 0:06:55.440 had four percent in it, there went three point six 0:06:55.480 --> 0:06:59.720 percent of your money and one single stock, okay, UH. 0:07:00.040 --> 0:07:03.239 He challenged us to think about better ways to invest, 0:07:03.560 --> 0:07:07.880 and we came up with the idea, an idea I 0:07:07.880 --> 0:07:11.440 had been playing around with for a few years. Why 0:07:11.480 --> 0:07:14.120 on earth do you want to invest in proportion to 0:07:14.400 --> 0:07:18.880 market capitalization, which means that the more expensive the company is, 0:07:18.880 --> 0:07:22.520 the more heaviest weight in the portfolio. Why not wait 0:07:22.680 --> 0:07:27.840 companies in accordance with sales, or with profits, or with 0:07:27.960 --> 0:07:30.680 book value, or or even with a number of employees. 0:07:31.440 --> 0:07:35.920 So UM, we went back and tested the idea first, 0:07:35.920 --> 0:07:39.320 starting with sales and book value and going back thirty 0:07:39.320 --> 0:07:43.480 plus years. We found that if you chose the thousand 0:07:43.600 --> 0:07:47.720 largest businesses in the US based on their sales and 0:07:47.840 --> 0:07:52.040 wasted them by their sales, that you wound up two 0:07:52.040 --> 0:07:53.760 and a half percent a year better off than with 0:07:53.840 --> 0:07:58.400 cap weighted indexing. And we tested it with book value, 0:07:58.400 --> 0:08:02.760 We tested it with offits, with cash flow, with EBA, duh, 0:08:02.880 --> 0:08:08.520 with number of employees. UM, and everything we tested had 0:08:08.560 --> 0:08:10.160 one and a half to two and a half percent 0:08:10.240 --> 0:08:13.040 access return. So that was our first a ha moment 0:08:13.320 --> 0:08:18.440 that oh, it doesn't matter what measure you're using. What 0:08:18.520 --> 0:08:22.840 matters is whether the measure incorporates price, because if the 0:08:22.920 --> 0:08:28.480 price is too high, then any any waiting scheme will 0:08:28.480 --> 0:08:30.680 do better. You could use darts, or you could base 0:08:30.720 --> 0:08:32.760 it on the number of executives who like to have 0:08:32.840 --> 0:08:37.160 a mustache or whatever. Um and you're still breaking the 0:08:37.200 --> 0:08:39.400 link with price, and you're still going to add one 0:08:39.440 --> 0:08:41.880 and a half to two and a half percent a year. Cool. 0:08:42.920 --> 0:08:45.680 And so we developed the idea of Fundamental Index, which 0:08:45.720 --> 0:08:49.440 has become a very important part of our business. It's 0:08:50.520 --> 0:08:54.199 over a hundred forty billion in assets now and it's 0:08:54.280 --> 0:09:00.440 under licensed to other distribution partners Pimco, Schwab, investc Amura, 0:09:00.640 --> 0:09:04.000 and the list goes on and on. We have at 0:09:04.080 --> 0:09:07.280 least eight part distribution partners with at least ten billion 0:09:07.320 --> 0:09:14.560 each managed using our ideas. So what is cool about 0:09:14.640 --> 0:09:19.520 Fundamental Index is that you're earning a profit based on 0:09:19.720 --> 0:09:25.160 two things. First, the obvious one a value tilt. If 0:09:26.720 --> 0:09:30.640 growth stock is priced at lofty multiples to fundamentals, then 0:09:30.720 --> 0:09:34.360 you're rewaiting those stocks down to their economic footprint, the 0:09:34.440 --> 0:09:37.720 size of the business. And if a stock is trading 0:09:37.720 --> 0:09:40.040 at deep discounts, you're rewaiting it up. So you have 0:09:40.120 --> 0:09:43.640 a stark value tilt all the time, and value investing 0:09:43.760 --> 0:09:47.480 usually wins. But it turns out that's not the dominant 0:09:47.840 --> 0:09:50.880 source of incremental return. It turns out that the dominant 0:09:50.880 --> 0:09:54.920 source of access return is a rebalancing discipline. If a 0:09:55.040 --> 0:10:01.359 stock soars and the fundamentals don't, then RAFI. The fundamental 0:10:01.400 --> 0:10:05.440 index will say, thank you for those lovely games. Let's 0:10:05.559 --> 0:10:10.320 rewait this investment down to its economic footprint. And if 0:10:10.320 --> 0:10:15.120 it's company tumbles and its fundamentals don't, rathey will say, oh, 0:10:15.160 --> 0:10:18.200 thanks for the lovely discount. Let's rewait you back up 0:10:18.320 --> 0:10:21.800 to your economic footprint. So, since the market is constantly 0:10:21.920 --> 0:10:25.240 changing its mind as to how much a company is worth, 0:10:25.920 --> 0:10:32.600 you're constantly rebalancing contratrating against the market's most extravagant bets, 0:10:33.120 --> 0:10:37.280 and your biggest bets will be on the companies where 0:10:37.280 --> 0:10:40.040 the market is making the biggest bet. In the opposite direction, 0:10:40.440 --> 0:10:44.920 the companies that have soared the most. Game Stop swared 0:10:45.200 --> 0:10:50.120 tremendously this quarter on top of an already stupendous rise 0:10:50.120 --> 0:10:53.400 in two thousand twenty. So you'd look at that and say, 0:10:53.440 --> 0:10:56.720 if you owned it, which we did, we owned it 0:10:56.800 --> 0:11:00.400 as a value investment with a cost bay syst of 0:11:00.400 --> 0:11:04.680 around a little under four bucks share. If you owned it, 0:11:04.720 --> 0:11:08.360 you'd say, thanks for this great gain. The underlying fundamentals 0:11:08.440 --> 0:11:12.880 haven't changed. Let's take some profits and rebalance that rebalancing 0:11:12.920 --> 0:11:16.880 alpha is the dominant engine for incremental return, and that 0:11:17.080 --> 0:11:21.800 is not true of most of the strategies that currently 0:11:22.440 --> 0:11:26.920 carry the smart beta label. That's interesting that the pushback 0:11:27.080 --> 0:11:32.760 I've heard from the traditional market cap weighted index ers 0:11:32.920 --> 0:11:37.040 are on the on the one hand, you're selling stocks 0:11:37.040 --> 0:11:41.360 that have rallied and very well may continue to rally. 0:11:41.480 --> 0:11:45.559 If if you're rebalancing away from Amazon or Apple anytime 0:11:45.600 --> 0:11:48.120 over the past I don't know, twelve years, you know 0:11:48.280 --> 0:11:51.040 you saw the stock go higher. And on the other hands, 0:11:51.600 --> 0:11:55.480 on the cheap ends, you have a tendency to buy 0:11:55.760 --> 0:11:59.680 into the value traps, things that look cheap because they're 0:11:59.720 --> 0:12:03.000 in a spensive and still have revenues but aren't. What's 0:12:03.040 --> 0:12:08.480 the counter to that critique? That critique is absolutely correct. 0:12:09.480 --> 0:12:15.760 M Here's the deal, though, for every Amazon, there is UM, 0:12:15.800 --> 0:12:22.559 a company that is perceived as a disruptor that subsequently 0:12:22.600 --> 0:12:28.600 gets disrupted UM. Apple has been hugely successful in contratrating 0:12:28.679 --> 0:12:32.120 out of Apple has not been a good thing. But 0:12:32.480 --> 0:12:38.720 who came before Apple? UM? BlackBerry Palm. Palm was dominating 0:12:38.720 --> 0:12:43.920 the world of handheld communication devices back in the year 0:12:43.960 --> 0:12:46.920 two thousand when it was spun off from three com 0:12:46.920 --> 0:12:50.120 it's spun off at evaluation briefly greater than General Motors 0:12:51.920 --> 0:12:54.440 at the time of the spinoff. It was spun off 0:12:54.440 --> 0:12:58.200 from three com at a total market value larger than 0:12:58.280 --> 0:13:02.559 three comes market value before of the spinoff. Isn't that interesting? 0:13:03.400 --> 0:13:09.880 And um, of course it went to zero and BlackBerry 0:13:10.120 --> 0:13:14.839 disrupted Palms business. And then no sooner was BlackBerry dominance 0:13:14.840 --> 0:13:19.360 and world straddling on handheld communication devices than Apple came 0:13:19.360 --> 0:13:21.640 along with the iPhone and said hey, hey, this is 0:13:21.679 --> 0:13:25.040 a whole lot better, and so did the marketplace. So 0:13:25.240 --> 0:13:29.200 disruptors do get disrupted. And yes, we missed the boat 0:13:30.080 --> 0:13:35.480 on highly successful companies that go from strength to strength 0:13:35.520 --> 0:13:41.320 to strength until they don't. And on the down side, 0:13:41.679 --> 0:13:45.720 you do have value traps, you'll rebalance into them in 0:13:45.840 --> 0:13:47.920 theory all the way to zero, which is one reason 0:13:48.000 --> 0:13:53.520 you absolutely do not want to rebalance a fundamental index 0:13:53.600 --> 0:13:57.520 strategy daily, because then you'll just buy into the value 0:13:57.520 --> 0:14:01.600 traps all the way to zero. So there's two broad 0:14:01.720 --> 0:14:05.640 flavors of fundamental index. One rebalances annually, the other does 0:14:05.840 --> 0:14:09.560 what's called quarterly staggered rebalancing, which means every quarter you 0:14:09.640 --> 0:14:11.840 move one fourth of the way to your target weight. 0:14:12.480 --> 0:14:14.640 That way, you're going to be hurt by value traps 0:14:14.679 --> 0:14:20.320 only modestly, only occasionally. And for every value trap there 0:14:20.360 --> 0:14:25.960 are several companies that look cheap and in fact are 0:14:26.680 --> 0:14:30.560 so case in point two thousand nine trough of the 0:14:30.560 --> 0:14:35.360 financial crisis that the March two thousand nine rebalancing that 0:14:35.440 --> 0:14:40.520 took place in Fundamental Index um UH. We rebalanced to 0:14:40.560 --> 0:14:43.880 the economic footprint of businesses b of A and City. 0:14:43.920 --> 0:14:48.320 We're both um priced at a fraction of a percent 0:14:48.400 --> 0:14:51.720 of the market, and yet both of them were about 0:14:51.760 --> 0:14:56.680 two of the US economy measured in terms of of revenues, profits, 0:14:56.720 --> 0:15:01.120 book value, dividends and so forth. General Motors was about 0:15:01.120 --> 0:15:03.520 one percent of the economy and a tenth percent of 0:15:03.560 --> 0:15:07.160 the market. So we rebalanced into all three. We rebalanced 0:15:07.160 --> 0:15:09.240 back up to a one percent WAIT and GM and 0:15:09.280 --> 0:15:13.440 two percent each for the A in City and GM 0:15:13.480 --> 0:15:17.160 went to zero. In the next quarter went bust value trap. 0:15:17.360 --> 0:15:20.440 There went one percent of our portfolio. The two percent 0:15:20.560 --> 0:15:24.480 each in the of A in City tripled, so you 0:15:24.520 --> 0:15:27.840 wound up going from two to six in two stocks 0:15:27.920 --> 0:15:30.720 and from one to zero in a third stock. So 0:15:30.920 --> 0:15:34.640 the beauty of Fundamental Index is not that it has 0:15:34.680 --> 0:15:38.200 any special insights into what the fair value of a 0:15:38.320 --> 0:15:42.280 company is, but that it contra trades against the market's 0:15:42.320 --> 0:15:46.520 most extravagant bets, which often in the long run turn 0:15:46.560 --> 0:15:50.480 out to be wrong. People love to buy growth stocks 0:15:50.480 --> 0:15:53.240 because they've got a great, great story, But the right 0:15:53.320 --> 0:15:58.200 question to ask is not is this company a great company? 0:15:58.240 --> 0:16:01.800 If it's a growth stock, of course it's a great company. 0:16:02.120 --> 0:16:05.440 The question is how much good news is there in 0:16:05.480 --> 0:16:08.640 the future for this business that isn't already in the 0:16:08.720 --> 0:16:15.120 consensus opinion and already in the current price. Is there 0:16:15.160 --> 0:16:19.640 more likely to be downside surprise growth that is less 0:16:19.640 --> 0:16:27.640 extravagant than expected um, or upside surprise where lofty expectations 0:16:27.640 --> 0:16:31.400 are actually exceeded. Amazon is a beautiful example of a 0:16:31.440 --> 0:16:35.000 case where lofty expectations have been exceeded again and again 0:16:35.040 --> 0:16:39.160 and again, and at some point they won't be But 0:16:40.040 --> 0:16:43.800 who knows when it's a brilliantly run company with a 0:16:43.840 --> 0:16:48.160 brilliant product that is disrupting vast squaws of industry um. 0:16:48.600 --> 0:16:51.760 Kudos to Bezos and his team, But the price of 0:16:51.760 --> 0:16:55.280 the stock reflects an expectation that the growth of the 0:16:55.400 --> 0:16:57.960 last decade will persist in the next decade and that's 0:16:57.960 --> 0:17:02.240 a little dangerous. So you guys actually received a patent 0:17:02.400 --> 0:17:08.280 for this methodology of selecting securities and creating indexes. Um. 0:17:08.359 --> 0:17:11.000 Why a patent? What does that do for the firm? 0:17:11.080 --> 0:17:16.080 It's really kind of fascinating to see a financial methodology 0:17:16.119 --> 0:17:21.360 actually awarded a patent. Well, method patents are not new. 0:17:21.440 --> 0:17:26.280 They've been around for decades. UM. Uh early days of patents, 0:17:26.320 --> 0:17:28.000 it had to be something you could hold in your 0:17:28.040 --> 0:17:34.119 hand to be patented. UM. But over time, with the 0:17:34.200 --> 0:17:40.040 advent of computers and so forth. UM, the notion of 0:17:40.359 --> 0:17:48.960 method patents applied to UH, software methods, computer software methods, UH, 0:17:49.000 --> 0:17:53.600 even business methods if they were truly unique, truly different, 0:17:54.040 --> 0:17:59.320 and truly disruptive to an industry. Um, why shouldn't it 0:17:59.359 --> 0:18:04.240 be patent to Now? The issue that I think bears 0:18:04.280 --> 0:18:07.640 mentioned is we could be in the business of product 0:18:07.680 --> 0:18:13.200 innovation or in the business of patent litigation. UH which 0:18:13.240 --> 0:18:16.760 expertise do we have? The former not the latter. So 0:18:17.040 --> 0:18:19.520 I view the patents really as a stake in the 0:18:19.600 --> 0:18:24.080 ground to say to the financial services community, Hey, this 0:18:24.200 --> 0:18:29.399 is our idea, please respect it. Please UM license from 0:18:29.520 --> 0:18:32.720 us at modest fees if you want to use this idea, 0:18:34.200 --> 0:18:37.200 work around the patent if you want to explore something 0:18:37.320 --> 0:18:42.160 similar but different. Competition is a great thing, UM, And 0:18:42.200 --> 0:18:45.680 what we've found is the financial services community as a 0:18:45.720 --> 0:18:52.280 whole lot more um, honest, and has more integrity than 0:18:52.400 --> 0:18:57.080 its reputation. A few bad eggs in the financial services 0:18:57.119 --> 0:19:00.960 community tarnish the reputation of the whole community. So what 0:19:01.000 --> 0:19:03.199 we found is that there have been a handful of 0:19:03.240 --> 0:19:08.680 cases where somebody just took the idea and ran with it, 0:19:09.320 --> 0:19:13.000 and the vast majority of folks in the financial services community, 0:19:13.040 --> 0:19:15.199 if they liked the idea, they'll come to us and 0:19:15.240 --> 0:19:19.120 say we'd like to license it. And if they don't 0:19:19.119 --> 0:19:20.920 like the idea, they don't have to use it. So 0:19:21.560 --> 0:19:25.240 the patent is not so much a basis for going 0:19:25.320 --> 0:19:29.200 after people. It is a basis for saying, hey, please 0:19:29.240 --> 0:19:35.000 respect our space. Speaking for credit for respecting intellectual property. 0:19:35.320 --> 0:19:39.480 For a long time, I've heard you credited with creating 0:19:39.520 --> 0:19:44.400 the phrase smart data, UM, but you've described that as 0:19:44.800 --> 0:19:49.280 more something you've popularized and created. Give us a quick 0:19:49.760 --> 0:19:54.200 explanation of that. Sure, there's a consulting firm that works 0:19:54.240 --> 0:19:56.560 with some of the largest pension funds in the world 0:19:56.680 --> 0:20:02.280 called Towers Watson their London an office. UM coined the 0:20:02.280 --> 0:20:07.440 expression smart beta, and the idea was not that cap 0:20:07.480 --> 0:20:12.199 weighted index funds were stupid beta. The idea was that, um, 0:20:12.960 --> 0:20:17.680 the cap weighted index funds were a neutral form of beta. 0:20:17.720 --> 0:20:23.280 They called it bulk beta um UM. And the stupid 0:20:23.320 --> 0:20:27.239 beta is those who chase fads and load up just 0:20:27.400 --> 0:20:30.560 on whatever's gone up the most. And the phrase smart 0:20:30.640 --> 0:20:34.399 beta was attached initially just as strategies that broke the 0:20:34.440 --> 0:20:39.200 link with price, that would trim a stock if it's 0:20:39.240 --> 0:20:44.680 price went up and all else remained unchanged UM and 0:20:44.760 --> 0:20:47.959 so that included equal weighting equal waiting. Is about as 0:20:48.000 --> 0:20:50.480 simple as strategy as you can imagine. How could it 0:20:50.520 --> 0:20:54.560 be smart? Well, it's smart because it has embedded rebalancing, 0:20:54.640 --> 0:20:57.880 although it does have a profound small cap tilt that 0:20:58.040 --> 0:21:02.240 makes it less liquid and more expensive to trade. Fundamental 0:21:02.280 --> 0:21:07.560 index was the inspiration for the term smart beta, but 0:21:08.160 --> 0:21:11.280 I never invented the term. I liked it. I thought 0:21:11.600 --> 0:21:15.280 that's a clever way to label it. And then pretty 0:21:15.280 --> 0:21:17.480 soon everybody under the sun was saying, oh, we do 0:21:17.600 --> 0:21:23.840 smart beta. You had index calculators saying, hey, our growth 0:21:23.880 --> 0:21:27.560 and value indexes are both smart beta. No, they're both 0:21:27.560 --> 0:21:31.560 tied to the price of the stock. They're still cap weighted. Um. 0:21:31.640 --> 0:21:37.359 You had factor investors saying our value factor is smart beta. Well, 0:21:37.400 --> 0:21:41.560 that's true because it does contratrade. Our momentum factor is 0:21:41.600 --> 0:21:44.720 smart beta. No, that chases whatever has gone up the most. 0:21:45.680 --> 0:21:48.320 Our quality factor is smart data. No, that's going to 0:21:48.440 --> 0:21:51.960 load up on whatever is expensive. Also, so you had 0:21:52.320 --> 0:21:58.040 lots of organizations embrace the phrase because the phrase itself sells. 0:21:58.119 --> 0:22:02.960 It helps selling product. So I like the expression smart data, 0:22:03.560 --> 0:22:07.160 but I like its original definition. And if smart beta 0:22:07.200 --> 0:22:10.960 is applied to everything under the sun, smart ideas and 0:22:11.040 --> 0:22:13.679 stupid ideas, then the term ceases to mean anything. And 0:22:13.680 --> 0:22:16.120 I think that's where we are now. Rob you wrote 0:22:16.119 --> 0:22:19.879 a really fascinating peace with your team titled Big Market 0:22:19.920 --> 0:22:25.320 Delusions Electric Vehicles. I want to start with your definition 0:22:25.800 --> 0:22:29.760 of quote big market delusion. That's when all the firms 0:22:29.840 --> 0:22:35.040 in an evolving industry rise together even though their competitors, 0:22:35.040 --> 0:22:39.000 and ultimately some will win and some will lose. Why 0:22:39.040 --> 0:22:41.720 does it not make sense for investors to just own 0:22:41.840 --> 0:22:45.240 all of the basket of everybody in that space and 0:22:45.720 --> 0:22:48.440 eventually the market will self correct. The winners and the 0:22:48.480 --> 0:22:54.240 all outweigh the losers. Well, that is the basic definition 0:22:54.280 --> 0:22:58.919 of diversification. And it makes sense unless all of the 0:22:58.960 --> 0:23:01.560 firms in the industry are priced as if they will 0:23:01.640 --> 0:23:09.040 be outlier winners, because they won't. Um If if a 0:23:09.240 --> 0:23:13.160 company is priced as if it will achieve stupendous success, 0:23:13.200 --> 0:23:17.440 and it achieves its stupendous success, wonderful you did find 0:23:17.720 --> 0:23:21.200 you didn't get hurt by that. If five companies are 0:23:21.200 --> 0:23:23.840 all priced as if they're going to be stupendous successes 0:23:23.880 --> 0:23:26.720 and you know that only one or two of them will, 0:23:27.960 --> 0:23:31.760 then you've just bought a basket that collectively is destined 0:23:31.800 --> 0:23:36.240 to perform badly. The guy who coined the term big 0:23:36.280 --> 0:23:40.560 market delusion is Brad Cornell, past professor at U C 0:23:40.680 --> 0:23:44.520 l A and at cal Tech, and uh, it's an 0:23:44.520 --> 0:23:47.320 idea that's been around, but it's a great term to 0:23:47.560 --> 0:23:50.879 capture the concept. Back at the peak of the tech bubble, 0:23:50.920 --> 0:23:54.200 there were several of us, me Cliff Fastness, and probably 0:23:54.280 --> 0:23:56.840 dozens of others who pointed out that not all the 0:23:56.880 --> 0:24:00.280 tech companies will win, and they're all priced as if 0:24:00.280 --> 0:24:04.440 they will all win, so as a segment, they were 0:24:04.480 --> 0:24:08.159 collectively extravagantly overpriced. You can even have it on the 0:24:08.200 --> 0:24:12.199 other side and anti bubble like at the trough of 0:24:12.240 --> 0:24:17.480 the financial crisis, financial services companies were all priced based 0:24:17.520 --> 0:24:22.320 on the perceived risk of bankruptcy, and so they were 0:24:22.359 --> 0:24:26.359 priced as a call option on future survival. And yet 0:24:27.320 --> 0:24:31.800 with each company that failed that went out of business, 0:24:32.240 --> 0:24:34.920 the landscape was now cleared for the others to earn 0:24:35.040 --> 0:24:39.719 outsize profits in the subsequent economic rebounds. So big market 0:24:39.760 --> 0:24:43.320 delusion can play out in both directions. We singled out 0:24:43.359 --> 0:24:49.280 electric vehicles because at their peak during this last quarter, 0:24:50.200 --> 0:24:54.840 Tesla was priced at thirty four times its annual run 0:24:54.920 --> 0:25:00.480 rate sales UM. Now there's eight companies around the world 0:25:00.760 --> 0:25:06.520 that specialized in electric vehicles. Tesla was the second cheapest 0:25:06.720 --> 0:25:11.280 of the eight in terms of measured market value to 0:25:11.480 --> 0:25:16.760 prior year revenues. Thirty four times sales was second cheapest 0:25:16.840 --> 0:25:20.840 on the list. The others were ranged from uh The 0:25:20.880 --> 0:25:25.800 others ranged from about twenty times sales to literally ten 0:25:25.880 --> 0:25:31.320 thousand times sales. So when you have those kinds of valuations, 0:25:32.200 --> 0:25:38.280 the winners might might be worth their valuations, but the 0:25:38.359 --> 0:25:42.200 losers most assuredly won't. And that's the nature of big 0:25:42.240 --> 0:25:46.080 market delusion. I have no idea if Tesla will be 0:25:46.160 --> 0:25:51.359 worth its current price. I very much doubt it. But 0:25:51.480 --> 0:25:55.680 I have absolute confidence that the collective e V market 0:25:56.200 --> 0:25:59.400 is not worth its current price. Well, I know they've 0:25:59.400 --> 0:26:05.639 had offense pastic run ending um the in the research piece, 0:26:05.680 --> 0:26:09.160 you use January thirty one of this year to show 0:26:09.200 --> 0:26:13.360 how far all of these companies have have come. Um, 0:26:13.680 --> 0:26:17.120 are they remotely like? I'm thinking of the old days 0:26:17.160 --> 0:26:21.040 of biotech, where it was impossible to come up with 0:26:21.600 --> 0:26:26.359 evaluation because it was so binary. You would end up with, Hey, 0:26:26.480 --> 0:26:30.520 either this company develops a molecule that does what it's 0:26:30.560 --> 0:26:34.240 supposed to and then becomes a stupendent success, or it 0:26:34.320 --> 0:26:38.000 doesn't and it's a zero. Or should we be looking 0:26:38.040 --> 0:26:40.680 at these e V companies the same way. Either they're 0:26:40.680 --> 0:26:43.600 gonna put out a successful car and that's what jump 0:26:43.640 --> 0:26:47.199 starts them, or they're just expensive R and D shops 0:26:47.240 --> 0:26:51.720 for now and perhaps might be worth nothing. Well, the 0:26:52.119 --> 0:26:55.080 correct way to do the kind of analysis you're talking 0:26:55.119 --> 0:27:01.240 about is, if this company produces a disruptive product that 0:27:01.440 --> 0:27:04.320 massively changes the industry, what's it going to be worth 0:27:05.080 --> 0:27:08.120 and what are the odds that this will happen with 0:27:08.200 --> 0:27:11.520 this company as the dominant winner. The missing piece in 0:27:11.560 --> 0:27:15.880 a market. Big market delusion is that latter piece. If 0:27:16.000 --> 0:27:19.720 all of them are priced as if they have the 0:27:19.760 --> 0:27:24.680 potential to be massive successes, then you have a problem. 0:27:24.760 --> 0:27:29.879 And that's that's the issue we're dealing with Tesla. Is 0:27:30.400 --> 0:27:33.880 it is its current valuation too high or is it 0:27:33.960 --> 0:27:36.200 in bubble territory. One of the things that I think 0:27:36.280 --> 0:27:40.359 is interesting is everyone band these around the word bubble 0:27:41.240 --> 0:27:45.240 as if it has some clear meaning, and it doesn't. 0:27:46.160 --> 0:27:49.840 Usually it's used in retrospect after a bubble has burst. 0:27:50.720 --> 0:27:53.960 So we came up with a definition back in two 0:27:54.000 --> 0:27:56.639 thousand eighteen we that we think can be used in 0:27:56.680 --> 0:28:02.240 real time. And that definition is very simple. Um, if 0:28:02.280 --> 0:28:06.159 you're using a discounted cash flow model, you would have 0:28:06.240 --> 0:28:10.800 to make implausible assumptions about future growth to justify the 0:28:10.840 --> 0:28:16.359 current price. And second part of the definition just as important, Um, 0:28:16.480 --> 0:28:21.080 the marginal buyer has no interest in valuation models. Let's 0:28:21.080 --> 0:28:25.399 take Tesla as an example. We UH did a piece 0:28:25.440 --> 0:28:28.880 on Tesla last December as it was on its way 0:28:28.920 --> 0:28:33.240