 Welcome, everyone, to Bogle Heads On Investing, podcast number 43. Our guest this month is Eduardo Rapetto, Chief Investment Officer of Adventist Investors, and former Chief Investment Officer and Chief Executive Officer of Dimensional Fund Advisors. Hi, everyone. My name is Rick Ferry, and I'm the host of Bogle Heads On Investing. This episode, as with all episodes, is brought to you by the John C. Bogle Center for Financial Literacy, a 501C3 non-profit organization that you can find at BogleCenter.net. Your tax-deductible contributions are greatly appreciated. The Bogle Heads Investment philosophy is to keep it simple, and that usually means starting a portfolio with a total stock market index fund, a total international index fund, and a high-quality fixed-income allocation of some type. For most investors, this is all they need to achieve their financial objectives. Sometimes I'm asked, what's next? What's beyond a total stock market and a total international? My answer is, if you wish to take a little extra risk in your portfolio for the potential of a higher return, then look at small cap value investing, but not just any small cap value fund or small cap value index fund. You want a fund that's low-cost and highly concentrated in small cap value factors. The company that pioneered small cap value investing using concentrated factor strategies was Dimensional Fund Advisors, more commonly referred to as DFA. Eduardo Rapetto, our guest today, was the Chief Investment Officer and the Chief Executive Officer of DFA until 2017. Then in 2019, Eduardo joined Advantus Investors, a new company by American Century Investors, where he became the CIO and continued to refine factor strategies for their ETFs, mutual funds, and directed accounts. Whether you believe in this or not, or whether you want to include it or not, this is a very interesting discussion as we go behind the scenes with one of the brightest minds in the industry. With no further ado, let me introduce Eduardo Rapetto. Welcome, Eduardo. I really appreciate you coming on the Bogle Heads-on Investing Podcast today. It's a pleasure. It's always a pleasure to speak with you. Thank you. We kind of go back a ways. I can remember being in your office at DFA, pleading with you to start ETFs at DFA. That was a few years ago. That's probably 10 years ago or something like that, I don't remember. It was a while back. Yeah. Anyway, now both the DFA and your new company have ETFs. So before we go down that road, let's talk a little bit about your very interesting background. Go back as far as you would like to tell us how you got to go from where you started to where you are today. So yeah, I have a weird background. The first thing is I was born in Argentina. Argentina, if you know, was a developed market, then was an emerging market, then was a frontier market. And I don't think that this is a frontier market anymore. It's not even that. But I was always a geek. So like in numbers and whatnot, I started engineering. Then I got a master's at Brown in engineering, mechanical engineering. And then I got a PhD from Caltech here in California in aeronautical engineering. Yeah. Let me interrupt you because you didn't just get a PhD. You won the ballhouse prize for the best PhD thesis of the year. I mean, you were a prodigy. But, you know, sometimes you have to be lacking life. Let's put it that way. OK, all right. Be modest, too. Yeah, I was lucky. Look, I have an amazing advisor and I was an amazing school. And so, look, this was a long time back in 98, I finished in my PhD. So and I was doing things that were extremely interesting. Yeah. But my heart was not to continue in academia. I used to have a boss back. He was a mathematician, a PhD in mathematics. And he went to research in just in mathematics into Wall Street. And he always told me, eh, you will like this. You will like investing. You will like the whole environment and and the cutting edge science, because a lot of the things that we study in science are very applicable in investment. And so I always have that bug in my mind. And so I had the opportunity to switch instead of continuing in academia and become a professor and whatnot. And I switch. And so I'm moving to finance. And I got a job in a DFA in the research group. How did you link up with DFA? That's that's the most weird thing. You know, a lot of things are random in life. So I was at Caltech and the DFA was looking for someone to work in research with Ken French and Jim Fama. And I apply and, you know, you apply and you cross your fingers and I was lucky enough that they hired me. And yeah, the FFA was small. I think that I was employee 107. And I think at the time, the FFA had around 25 billion. It was a great opportunity to work with some magnificent people in a small company where you were able to get involved in basically all the different aspects, not only research, but the legal aspects of what you were doing, the portfolio management, the trading aspect, the marketing aspect. So it was a magnificent opportunity. I was lucky. And interesting, though, that DFA would look at you, given your background. I mean, clearly the forward thinking of the David Booth and Gene Fama, Ken French, who are both on the board of directors, they're decided with you, with no financial background, really, that you were the guy who they're going to bring in. And they kind of overstepped all the PhDs in economics. Well, I don't know who else was applying to be fair. I think you're giving me more credit than I deserve. Look, I was living in California. My wife's from California, and the job was in California. So it was a perfect match for me. And I was very, very lucky on that. And I was extremely lucky to work with the talented people like you mentioned. You know, it was like doing a second PhD when you started working with Ken and Gene, because you had to read and read and do research. But that's what you are trained when you do a PhD from a top university, no matter what's the field, the training is training how to learn, how to get to the cutting edge of the science and then try to push it a little bit more. That's a PhD program. And so working with these professors was basically the same, getting to the cutting edge of the science and then try to push in it a little bit forward. And that's what I was doing. And by 2007, you became the co-chief investment officer with David Booth at DFA. And I think I'm not mistaken. That's probably when I first met you back then, about 15 years ago. And then in 2009, you became the co-CEO. And at this time, wasn't DFA moving to Austin? Yes, DFA opened an office in Austin in 2007. Yeah. And so I told my wife, let's move to Austin. She agreed. So we went there, we have three kids. So I became, I was CIO and then became co-CEO with David. What's a great honor, no? Sure, absolutely. And you got on the board of directors and you became a director of the mutual funds. But then in 2017, I've heard you use the word retire. I use the word resign. I mean, you decided to leave. Yeah. Yeah. So my wife is from LA, no? Her parents are here, LA. So in 2015, before my oldest one started high school, the family wanted to move back to LA because the grandparents are not getting younger. Let's put it that way. And if we were staying in Austin, we would have to stay there at least for another 10 years because we have three sons. And we didn't want to move kids when they are in high school. So the family decided to move in 2015 to Los Angeles. And so I was going back and forth to Texas on top of going everywhere. I was put in 250,000 miles a year between going to Texas, if going, going everywhere around the world. So you see, it was probably not the right balance. And I was never home, never seen the family. And so it was not the right balance. So I basically resigned without any job in mind. You can call it retire. And it was not a permanent retirement, I guess. But well, you started doing research, one of your papers on value and profitability and international and emerging markets that you co-wrote during this period of time. But if I'm the same time as it was being peer reviewed and published, you then decided to take a job with Aventus, which was a new company. Now did the company form because you were coming on board? What did it form? And then you came on board. So let me speak a little bit about how that happened. I was not working, but like you, when you work a long term in the industry, you get to know a lot of people and people have magnificent ideas. And some people at American Central Investment in Kansas City that I know them for a long, long time, they wanted to start something new, something that is more systematic, low cost, because there is a big need for something like that in the market. And they reach out if I wanted to help them and they were willing to do it based in LA, where I live. So that's great. And one of the things that I have as a condition is that the investment strategies, let's call funds, what they were going to be, they have to be low fees. That's what they wanted. They wanted to start something systematic, organized from day one so that you have all the checks and controls on cost so you can be low fee and still have a very good business. So I agreed to work together with American Century and start Avantis. So Avantis was going to be a standalone company where the people in Avantis own a piece of that and American Century owns another piece of that. But we decided not to do that. Why? Because that was going to impose more cost. And that was going to make us have higher expense ratios. So what we did is we created Avantis as a unit inside American Century. So I'm an employee of American Century, but they have a business card that is called Avantis because we manage money different than the traditional American Century manager. And I report to the CEO of American Century. So we're a unit that is a little bit outside of American Century, but we are part of American Century. But all our operations, legal, compliance, HR, think about all the support functions that you need to have a professional asset management company are done by American Century personnel. Yeah. Where is the trading done? Is it done through American Century or are you doing it on your own? Depends on what, you know, when you do ETFs, you know, a lot of the trading is happens in kind, in and out. So if that's the part, we do it on our own. Whenever we need to trade stocks, we work with American Century trading desk that is segregated that were trades in a different way of trading that we think we don't have to demand liquidity to trade and we can be very efficient. And you have different products. I mean, most of your money, I believe, is in ETFs, but you also have traditional mutual funds and you have private individual accounts. But can you break that down? You've got about 10 billion under management right now, which is a great number just getting started over a couple of years. How much of that is ETFs? How much of it is mutual funds and how much of private accounts? The vast majority of the money, but the vast majority of the money is ETF. And why that? Because for most investors, an ETF is a better bet. And you know that. Well, I know that, but why do you know that? That's an inside joke, by the way, between Eduardo and me. So it goes back a long, long way because I spent years trying to convince dimensional fund advisors they should have ETFs. Both of us know that ETF is by far a better vehicle, not only because of tax advantages, but also because you're same on cost of different time, for example, in certain cases, you don't have to pay some taxation when you buy securities like stamp duties when you buy securities in other countries. So ETF is a much better vehicle. But for some investors, let's think about 401k plans. Yeah, the ETF really doesn't work because the operations of the 401k plan is different. So it works for the brokerage window, but not for the default options. Correct. Our goal is to try to help everyone with the right vehicle. We have no biases. But I have looked at the performance of an ETF and a mutual fund. Same strategy, the same might be small cap value, large cap value, whatever it is where you have an ETF and you have a mutual fund. And there are slight differences in return between them. But the fee is the same. So maybe you can explain why that is. Yeah, yeah, that's a great question. If you were running an index fund and you have pre-described holdings so you have securities and weights in both of them, the performance probably will be the same with small differences. But if you're running a strategy that is trying to use today's information, the performance will be slightly different between both. Why? Because a lot of the trading that happened in the mutual fund happened depending on when the cash flows come. You know, if you give me money today, I'm going to invest in the securities that are great to have in the portfolio today. But if I don't have money today, I have money tomorrow. I may have to wait for tomorrow to do so. You have the regular trading and rebalancing, but you have an effect of cash flows that forces more one direction than another. It's more in a mutual fund, you always have to carry cash. Why? Because you have a redemption in a mutual fund. I have to have cash to send it to you tomorrow. Yeah. And I cannot sell securities tomorrow to raise money to wire on the same day because certain men of those securities is two days later. So you have to carry cash in the mutual fund. And not much, but you have to have the same cash. If that cash that you carry is not enough, you have to hit the line of credit in order to be able to wire the money. So even though the strategies are the same, there is more difference in how you have managed them in order to deal with the different set of clients' transactions. Yeah. And if you think about that, the ETF is way more efficient because the ETF, when you purchase an ETF, high-receive securities is in kind. So I'm always interested. And when you redeem, you receive securities in kind. So the long-term shareholders don't have to bear the cost of the redemption. So there is always going to be a difference in performance between the ETF and the fund, but those differences should be small. Now, when can those differences become very big or bigger, let's call it, when the market moves a lot? If you have a day that the market moves 10 percent, and you have a purchase in that it represents a 1 percent of the fund, or 2 percent of the fund in cash flow, well, that money is not invested until tomorrow morning. So the market moves 10 percent. Right there, you can see that you have 20 basis points in difference in performance because you are carrying cash overnight. And it's not your cash. I mean, generally, if the investors are in it for the long-term, it's not their cash that's causing this. It's some other investor's cash that's causing that. Yes, it's not the long-term investors. In ETF, the long-term investor is kind of protected from the actions of people coming in and out. In a mutual fund, no, you are commingling and cash is coming in, cash is going out. So you are exposed to the actions of other shareholders. And that causes difference in performance. Now, Vanguard has a unique structure, and I know they have a patent on this, but their ETF and their open-ended mutual fund are just share classes of the same pot of money. And that patent, someday, I thought it was last year, but maybe this year, is actually going to come off patent. And in which case, is it beneficial or would it be beneficial for other fund companies to adopt that patent where there's one pool of money, and then there's an ETF share class and there's a mutual fund share class? What's the advantage and disadvantage of doing it the Vanguard way? That's a great question. We thought about that to say, do we want to have a big pot of money, a big fund, where one share class is an ETF and the other share class is a mutual fund? And we decided not to do it. Let's go through the logic. Let's suppose that you have a mutual fund share class, a mutual fund, yeah, and with a mutual fund share class. And I decide to attach to that mutual fund an ETF share class. Yeah? If you are the mutual fund shareholder, you are going to be very, very happy about that because you have people coming in kind in and out, dealing with your capital gains, and not imposing any costs on you because they're coming in kind. It's not that they give you cash and the portfolio manager had to trade and the cost is spread out about across all the shareholders. No, if you have a mutual fund and you attach an ETF share class, the mutual fund shareholders will be ecstatic, will be very happy about that, yeah? Right, I agree. Let's go to the other case. I have an ETF share class and I put a mutual fund share class on the side. Will the ETF shareholders be happy? No, they will not be happy. Why? Because people coming in the mutual fund are coming in cash and who pays for those transactions? Everyone. Even the ETF shareholder. So the ETF shareholders paid their way in, paid their way out, but they also have to pay a fraction of all the people coming in and out on the mutual fund. So it's not really fair to them. And so on top of that, if you have the shareholders and mutual fund redeeming a lot of money, the ETF shareholders may take the tax bill that they are not expecting because there are cash transactions in the mutual fund share class. So what we decided is to have different pools of money, one for ETF and one for mutual fund. If you want a mutual fund, you know what you're facing. You're having a coming vehicle and you're exposed to the actions of other shareholders, externalities, due to other shareholders, but you trade at NAB and it's for some people that's easier. And a 401k, as you said, you have to do it that way. In a 401k, you have to do it. If you go to the ETF, you're going to pay your way in and that way out when you buy in the market based on the spreads and whatnot, but you're going to be protected from the actions of other shareholders because of their time purchase and redemption mechanism. So by separating them, we give people a pure benefit of one or the other and they can decide what's better for them. They're not going to be blindly surprised by the action of the other pool of money that is coming in and out in a different way that they are. Okay, let's go into a different topic and then has to do with how you invest money. You invest money using factors. You're a quantitative factor investor, but before we get too deep into all these different factors, what is a factor? So the factor basically is a way to understand the performance of securities. For example, let's suppose that small-cap securities have a better expected performance in large-cap securities. So a factor is the difference in performance between the small-cap securities and large-cap securities. Okay, let me stop for a second. Why would small-cap have a expected higher return than large-cap? Well, that's a good question because let's speak of another factor and then we go back to a small-cap. A small-cap is probably the one that you cannot justify. A company because just being small should not have a premium because you can have a small-cap company with extremely high price and that's not going to have a premium. So let's speak about the value factor. That's easier. What is the value factor? If you can buy a security that has low price relative to a fundamental, let's say the book value of a company, well, that company tends to have a premium relative to a company that has a high price relative to the fundamental. It's like you're buying something on an discount at a lower price. Okay, but why would a company with a low price to earnings, low price to book, low price to cash flow, low price to something or just low price, why would we expect that to have a higher rate of return? That's a great question. So we have to start with the premise. It says we believe that the market is pricing all the securities and we cannot find a better price than what the market has. There's an assumption of different kinds. But we also believe that there is no need for the market to put the same return for every security. Different securities will have different returns. Different returns will have different discount rates. Yeah? The discount rate is a factor of the perceived riskiness of a security, correct? It can be risked or it can be something else. It can be behavioral, you know. Some people just, for whatever reason, dislike a lot a certain set of companies. And if there is enough people that dislike a lot those set of companies, those companies will trade at a little bit lower price. And so that's a higher discount rate. Let me push back just to hear on this. Because I want to make sure I understand it because there's this thing between risk and behavior that always goes back and forth with these factors. But to me, if it's true that there are a lot of people who just don't like these companies, they don't like them for a reason. And isn't it true that they don't like them because they see more risk there and lower returns and that's why they don't like them? So isn't it a fundamental factor? It may or may not be. But the fact that a certain client moves away from certain set of securities certainly will push the price of those securities lower. And that suddenly, you have a higher discount rate because if the price is lower relative to the fundamental, you have a higher discount rate. But let's go a little bit deeper in why there is a premium. Because you're asking is why certain security have a premium, a higher return than others? And so let's think about that. Let's suppose that I give you two options to work. So you work with us for one week and if you work us for one week, I give you $100. That's option one. Option two is if you work with us for one week, I give you $0 or $200. 50-50 depending on the weather of the last day. So 50-50 probability gives you $0 or $200. The expected payment for you is the same. It's $100. So in one, you get $100 for sure. In the other one, you get an expected $100. But you can get $0 or $200. Will you take that deal? In general, you will not take the second deal. You will take the $100 for sure because the other one, you can finish with $0 or $200. So now I'm going to try to spice it for you. I'm going to give you $0 or $250. So now the expected payment to you is not $100 and $100. It's $100 and $125. 50% 0, 50% to 50. So I'm incentivizing you with the premium to take the more risky outcome. At some point, if I keep on increasing the incentive, at some point, you are going to say, I take the risky outcome. So whenever you have a risky investment, it's not that the expected outcome is the same as a less risky investment. The more risky investment will have a return that is a little beyond just the same expectation. It will have a premium because that premium is what incentivizes you to take a little bit of that risk. Because if you do a perfect risk adjustment and you have the same, same expected outcomes, you will never take the risky investment. So there has to be a premium, a little bit more return. So when you're speaking about security, how low price relative to fundamentals, and we're saying that's a value investment strategy, why there is a premium? Because not every security has the same expected returns. There is no need, there is no logic for that. So when you're looking for security that is low relative to fundamentals, what you're trying to do is identify those securities that are having higher discount rate, higher spectrum returns. And then put a diversified portfolio together of just those securities. Yes, but you can see that when I, what you were mentioning, hey, you're saying low price relative to fundamentals, but what we're trying to do is try ways, systematic ways, mechanical ways if you want to think about that, to identify what securities have high discount rates because the discount rate is your expected return. So what security has these high expected returns? Now, every model is incomplete. The models don't describe reality. But what financial science has been doing over time is trying to make better and better models, trying to understand what variables matter most. And that's why you have so many factors because people start looking at different variables and they say, well, this variable explains something about returns and this other variable explains about the other return. And I think that you have like 400 factors now. Yeah, I think it's a paper called the factor zoo. The vector zoo, yes. So the issue that we're facing now is there's so many factors, how we put all these together. And there are many different peoples put these together in different ways. Some people do optimization. So let's put all these factors optimized and we see what happens at the end. But you know, as well as me, whenever you put the big soup of estimated numbers in an optimization, you get very weird outcomes. So the factor zoo. So we've got, I talked about large versus small. And that factor was strong decades ago. But it seems to me since the proliferation of small cap index investing, in other words, became much, much easier to invest in a big massive mega portfolio of small cap stocks. It wasn't so easy 50 years ago. It's easy now to do that. And that led to the term, well, led to factor decay. In other words, it went away. It was easy to identify these small cap companies. It was easy now to package them together into these index funds, mutual funds, extended market small cap funds, whatever. And because of that, I believe, and I might be wrong about this, but I believe that caused this factor to decay to the point where there really isn't a big premium anymore, as you mentioned earlier. What you are observing, it's absolutely right. Now, the question is not if it has decay. The question is, was it there on day one? And why is that? Let's suppose that we go to the soup one day and we see that animals with stripes are zebras. That doesn't mean that every animal with a stripe will be a zebra because a tiger will have stripes. So the fact that people observe that the small caps up to 81, I think it was, have a premium, that can have been a random outcome. And the fact that we don't see much of that after that period, it may be because that's reality. And why I was pushing back in the small cap premium? Because when I was speaking about value, I was telling you, you have a low price related to fundamentals. You are looking for companies that have high discount rates. Any high discount rate will push the price down. So there is a logic there. And just to clarify, a discount rate means you need to get a higher rate of return. It's a cost of capital. Exactly. The company has to get a higher rate of return for you to invest in that company because you perceive true or not, you perceive that there's more risk there. So you need to get a higher rate of return. Yeah. If a company is going to produce a dollar in the future, you are not going to pay that dollar in the future with the dollar today. You are going to pay 70 cents today to get the dollar in the future, 50 cents today to get the dollar in the future. So the lower the number that I'm paying today for the dollar in the future is the higher discount rate. Higher discount rate. So when you have a strategy that is trying to buy low price securities related to fundamentals, what you are really trying to capture is that high discount rate, that higher expected return due to the low price today. But if I tell you you are buying small caps, there is nothing that tells you that the small cap security can have a premium. If not, you can divide a large company in a bunch of pieces and suddenly you have a premium. And more logically, let's suppose that you have a small cap company. Yeah. If I have that small cap company and that company has a very, very high price, relative to fundamentals, that company should not have a premium because the price is too, too high relative to fundamentals. So the small cap premium is highly debatable. Let's put it that way. Well, let's go ahead today and move on to some other factors because we talked about small cap potentially not being there anymore or maybe wasn't there to begin with. We talked about the value factor, price to book, price to some fundamental. You also, at your company, are looking at profitability as a factor. So tell us about profitability. Yes, that's a great question. So imagine that you are going to buy a company. How much you're going to pay for that company? You know, I'm buying Rick's company. What, how much I have to pay? Well, I have to pay for the equity that you have in your company. Yeah. But I also have to pay for your cash flows. But since your cash flows are in the future and they're uncertain, I'm going to discount those future and I'm going to pay less today for those future cash flows than the value of those future cash flows. So the price that I'm paying for your company is your equity plus a discounted value of your future cash flows. Yeah. So remember what I'm interested is in that discount rate. Yeah. And what variables I know, I know the price because Bloomberg telling me the price every minute. I can't have a proxy for the equity in the company and I have a proxy for the cash flows of the company. And these three variables, because of the valuation framework that I mentioned with you, are related to the discount rate to the expected returns. A company that has higher expected returns will have a lower price for the same equity value and for the same cash flow expectations than a company that has a lower expected returns. So the higher expected returns, the lower the price, keeping the other two variable content, keeping the equity and the cash flows. So I need to take into account not only the equity that I can use book value as a proxy for equity, I also need to take into account the cash flows of the company. I have to take both, the both set of financials, the balance sheet and the income statement, both set of financials to identify what companies have high discount rate, high expected returns. When you're selecting the securities then for your funds, is it a fixed formula where you're using some percentage of book value, some percentage of profitability together in your model or is it a variable thing where it moves? No, it's fixed, it's fixed. So look, there is enough uncertainty in life that if you have it fixed, it's already there is uncertainty to add a variable component. There is no way for us to have so much precision. So we want to use the main drivers of selecting securities that are how much money the company is making, what's the equity position of the company, what's the price related to these two variables. And once we have that, we have enough information to put together a well diversified portfolio that in our opinion has high expected returns. Trying to be more clever than that and just changing the weight of the securities with market conditions or the factors or the components with market conditions or everything else is just adding noise with not really known outcome. So I'm going to say one thing but then I'm going to move right on to something else. So what I was getting at was you don't do what's called factor rotation where you're trying to go from one factor to another to another to another. Companies are very hot on doing factor rotation and they're saying that well if we move at this time from this factor to that factor to over to this factor that somehow some way they're going to get an excess return from rotating their portfolio around and highlighting different factors at different times and you don't find any value in that at all. No, that's not predicting where the market is going to be. It's the same. If you can predict the performance of a given factor, it's the same thing. You can predict the performance of the market. Imagine who we could do that. That would be great but the markets that's not how it works. The performance of market is unpredictable because there are news that we don't even know that they're coming and they will come. I don't know what will be but it will come something new tomorrow. So you have your list then you come up with your portfolio of what you would like to buy but there's another factor that we haven't talked about yet. It's called momentum and this is looking at the price and seeing if it's moving down or moving up and we don't want to try to catch a falling knife is a phrase that we hear often with a quantitative analysis. So could you talk about how you use momentum in your portfolio management? Yeah, so momentum is fascinating. It's a little bit like small caps. When I was telling you small caps there is no logic for the system in small caps. There is a logic while the premiums are large in small caps the value premium in small caps is larger than the value premium in large caps. There is a logic for that but the existence of a small cap premium there is no logic. For momentum it's the same. Momentum is something that we observe but we don't understand why it happens and there are two competing visions of why that happens. So what is momentum? A security that has extremely bad performance will continue to have for some short period of time good performance. And a security that has extremely good performance will continue to have for some short period of time good performance. So how do we use momentum? If we have a value strategy whereby in security we have low price. Yeah? How does security become low price? One probability is because the price is going down the security has very bad performance. Well, we can go and buy the security immediately or you can say wait, don't buy it now wait a little bit until the price stabilizes and so that's what we do. We decide not to buy immediately not to jump into this security that have extremely bad performance and we decide to wait a little bit until the price stabilizes. And so we try to prevent buying securities in downward momentum. Yeah? The opposite for upward momentum if you have a security that is a small value for example and it's in upward momentum we are willing to slightly overweight that security and if the security starts going up in price and instead of being a small cap now becomes a mid cap security instead of selling it immediately we may be willing to hold it a little bit longer. Why? Because the momentum premium is very very strong but it's very short-lived. So if I can get a little bit of push because of upward momentum just by holding the security a little bit longer. So we incorporate momentum downward and upward momentum in our strategies but we are very very careful how we do it because if you are not you finish with a very very high turnover. Let me ask a question about factor premiums. Now you have a multi-factor model where you're using profitability and value combined to come up with what you would expect to be a premium over beta expect to be a premium over the market return. Do you have a way of determining what that premium should be going forward or what are we looking for and a long-only portfolio not a long and short but just a long-only portfolio? Yeah no long only I don't think any one of us needs a short portfolio so we're all happy to have a long only. This is a great question so the question is can we know at any point in time how much the market is discounting future cash flows? And the answer is no and why not? That's where behavioral finance gets together with rational markets. In different periods of time for the same level of risk people may be willing to take a lower price or a higher price. We change the market change in periods of high anxiety people are priced humongous discount rates the prices are very very depressed. In other periods the price is higher and so the market is having lower expect returns and you cannot really know at any point in time how big or how small is that premium. What you know is that it's a premium but there is a research that is very interesting that shows look look at the long-term average of these premiums that's probably as good as it gets. Now some people say that if you look at the market historical market performance relative to treasury bills for example probably was higher than what we should expect in the future. I would agree. Some people say that because now the market now more people embrace investing in the market there is more of us that are buying securities that were the wearer in the past and so if you have a higher clientele basically more people willing to take a little bit of that risk we're increasing the price and we're reducing expect return. That is a logic. I think another piece of logic is are treasury bills correctly priced if you're going to use that as the risk-free rate. Based on where treasury bills are currently priced I think that the premium could be high but if treasury drills were correctly priced based on where the inflation rate is I think that the premium might be a lot lower. So I don't know if treasury bills are the right risk-free rate to use even though that's what's being used in the models. Yeah you are right about what is the risk-free rate is interesting and but you know we're not just speaking about short-term periods we're speaking about long-term periods and so if we think about that expect returns of the market maybe a little bit smaller than what we have seen in the past there is more willingness of people to embrace the market and embrace market risk and there is more people to do that then you would expect premiums to be a little bit smaller is that the same for value investing and when I say value I think the generalized ways of value like what we do I think that there is no information about more people embracing this than before then maybe it's more than historical premiums then maybe not. Now the traditional way of defining value like if you are looking low-priced to book without looking at it and at the cash flows of the company that probably is not the right way to do it and so science has evolved from there so better I think it's better if people evolve from that Let me ask a question about US versus international because you did this paper on using value and profitability in international markets is it different outside the US is it different in emerging markets than in the US market and how do you have to change your formula? Okay so if you remember I told you a story about the evaluation of the company and so what is the value of the company the price of the company is the equity plus the cash flows is counted by some discount rate but I never told you that that valuation is only valid in the United States I think that that valuation was valid with the Babylonians who are selling and buying donkeys and for it's going to be the same in the future when we are selling and buying water or oxygen if we ever live in Mars so this is an evaluation framework the beauty of evaluation framework that is valid in all the different environments is different from a pattern a pattern may be valid here and not somewhere else so the way that we do things is based on evaluation framework to understand what factors or what matters in the spectrum returns of a company and basically it works all around the world it works in the US it works in international it works in emerging markets so the research is very robust from that point of view because you have a research that you can apply with the evaluation framework everywhere now when you're speaking about the variables itself you have to adapt to realities for example in the United States companies report financial squirtily but in some countries reports only twice a year and so you have to adapt to the data and try to make the best that you have with the data of the different countries in order to have the model use the right set of information let me ask a question about small cap value funds I personally have a small cap value tilt in my portfolio I don't yet have an international small cap value tilt and one of the questions I have is why are there no global small cap value index funds or ETFs you know I've been asked that many times it's more we we may be thinking about doing one outside the United States not for U.S. investor for outside in the United States and why we don't have one in the United States we have as you know we have a U.S. small value strategy an international small value strategy and an emerging markets meet an small value strategy and we do meet an small together in the emerging just because you have more liquidity and the number of securities but we don't have one that puts the three of them together why is that because different investors want to have different allocation to the U.S. versus the emerging versus international and if we put all together then constrain the investors to the side which one to buy how to weigh them now yeah I understand but think about this when you buy an ETF yeah what is your fixed cost do you pay ticker charges no you don't pay ticker charges so buying three ETFs is the same as buying one because you don't have ticker charges so given that you don't have ticker charges just buy three securities instead of buying one and that gives you the freedom to decide how you want to weigh them okay I will push back here because you have a global real estate portfolio a real estate but you you but you just finished saying you should have a U.S. small value in an international small value but yet you have a global real estate fund so explain why yeah that's a great question so you say you can have a U.S. a real estate an international real estate and I will tell yes you are right we can have a U.S. an international now an international real estate market is much much smaller than the U.S. real estate market yeah 30 percent versus 70 you go international versus U.S. yes yes so an ETF for international real estate that will have a very very small allocation in someone's portfolio we said no let's put it all together in real estate and let's give that to someone because I maybe I'm wrong but we said no one worries too much about how much U.S. or not U.S. or someone wants a full U.S. real estate or they are happy to have a global real estate so we say let's provide global the global real estate market has been developing if you know U.K. REITs I think they are 15 years old JREITs so it's developing at some point we may split it or have two versions or whatnot but for now we decide that global probably is the right decision I can give you the pros and cons of a global small cap value fund the pros are man it's a lot more convenient than buying three funds just buy one small value covers the world I'm happy what's the disadvantage well the disadvantage is taxes and the foreign tax credit if you're going to put it in your taxable account because since less than 50% of the portfolio is going to be an international you don't get the foreign tax credit so in a taxable portfolio you still have to divide it up between a U.S. small value and an international small value so you get the tax credits on the international small value but if this was going to go into an IRA account or a Roth account of some form which I could see a global small cap value into a Roth account that it would make sense at least from my standpoint as an advisor where I get this factor exposure using one fund there is a there is a need for it I believe out there so just plugging that you're not the first one telling us that to be fair but I also go through that and look if you have three ETFs you don't have ticket charges in custodians but you have three funds and I don't want three funds I want something simple anyway let's go to the next thing you know what we've evolved we have the factor zoo now okay we also have things like artificial intelligence and we have machine learning and behavioral finance can be thrown into that as well are you looking at these things to incorporate them into your world and how you do things you know the whole thing of machine learning neural networks and all these is fascinating because what it's trying to do it's trying to emulate how the brain works in learning or a collection of entities works in learning in order to to learn without having a pre predefined model yeah so but isn't that what the market does yeah the market the market is a big machine learning machine that does machine learning and the market is is a network of this you know a loose network of people interacting in order to increase some benefit for everyone collectively everyone but individually each one of the individuals each one is just trying to incorporate the information that they come in order to come with prices so the whole market is a big machine learning network now if I were an acting manager picking stocks and I think that I can do better than the market and find what securities and underpriced and securities underpriced probably will invest a lot of money there and say oh I'm going to be better than everyone else and find all the undervalue securities and all the other value securities that's not us so I'm not going to dispute the market price and create my model and then I will say my model is better than the market because the market is as good as it gets you know whatever our model is is going to be so part of them to the market in my opinion so the market gives us a price of the securities what we do is try to use that price in order to identify what securities have been priced at higher discount rates so they have higher expected returns and what security have been priced at lower expected returns there may be things that are interesting in machine learning to apply even to what we do and for example we were speaking about finding factors or finding drivers of the expected return you could have imagined that all these factor research could have been done with machine learning so we can have a machine learning trying to find what variables that are related to valuations have different levels of impact in the expected returns of the security and that could have been done but that's what the professors you know and researchers around the world have been done in a loose way so yeah you can use it but the lot has been done even we don't call it machine learning let me ask a question that was posed to me it has to do with ESG so ESG has popular in Europe for sure maybe becoming a little more popular here in the United States than in the past but it's very hard to find a small cap value ESG fund for the people who want factors and want ESG any interest there we are getting into the responsible investment business so we're going to launch a couple of strategies three strategies that have high exposure to a small volume in in the near future let's put it that way let's go into the last topic and that has to do with fixed income you do have a few fixed income funds and you do run a strategy based on the yield curve trying to enhance the return based on yield curve in other words you say the yield curve is telling you something could explain your fixed income investment strategy and why it there may be an expectation for a higher return than just doing a a regular straight index fund there is a couple of things that are very very interesting when you think about fixed income let's speak first about indexing you know that how the index work the index that an index manager follows in fixed income incorporates every bond as there have been issues so if you issue a bond that bond is incorporated in the index automatically now if you recap to issue a bond are you going to issue in a way that increases your cost or reduces your cost of servicing that debt you're going to try to minimize your cost so you're going to issue in the conditions say duration or whatever it is that minimize your cost yeah yes but if you are minimizing your cost you're also minimizing my specter returns if I'm the investor in that bond so the automatically inclusion of bonds it's really a detriment for an index in fixed income now you mentioned we use something else we need to have like inequities we need to have an idea what bonds will have higher specter returns than others given the same credit quality and everything the same and we do that by using the yield curve so what do we mean by that let's suppose that you have a bond and you hold it to maturity and let's suppose that the bonds of default yeah what is your expected return on that bond your expected return of that bond is your yield to maturity assuming you can reinvest the income at the yield to maturity rate let's assume that it's zero coupon life is easy life is easy zero coupon zero coupon so your zero coupon bond that has a yield to maturity of two percent your average return if you hold that bond to maturity is two percent a year correct but your return from year to year it's not going to be two percent that's great because if you have a three-year bond under the typical yield curve the yield curve is has lower yields to maturity for shortened durations and higher yields to maturity for longer duration so if I have a three-year bond that gives me yield to maturity two percent one year from now that bond will be shorter to maturity so on expectation we have a lower yield to maturity than today so you can see the yield to maturity was the average return to maturity but that means that doesn't mean that every year is the same in general the longer portion of that holding period will have higher returns than the shorter portion of that holding period so you can use information in the shape of the yield curve to decide when that bond has higher than average returns related to the yield to maturity and when it's going to have lower the specter returns yield to maturity and we use that information to create portfolios in geekish fixed income what you're talking about is a horizon return yes if you're going to use it for two years you're going to keep it for two years and then you're going to sell it you're going to do what we call riding the yield curve yes this two percent bond that you purchased because the last year the yield to maturity on that bond might only be a half a percent and you bought that two percent as a three-year after the first two years if you sold it you're going to get a return on that that's much higher than the two percent yield so the horizon yield might be two and a half or two point seven or whatever it is exactly that's exactly what we're saying see I remember from my CFA days all of that stuff that's exactly what we're doing instead of trying to get an average income to maturity we're happy to get an income from some people's time and a capital appreciation due to the change in the shape of the yield curve and the convexity as another geekish word has a lot to do with this too I mean there are some bonds that this happens rapidly and there are some bonds where it takes more time absolutely and that's why the way we do it is we have an estimated yield curve for different issuers for every issue we have an estimated yield curve depending on the sector the credit quality and whatnot based on market information we don't make predictions remember and then we use that estimated yield curve for every issuer to compute the specter return of the bond for a horizon like you mentioned and then we use that information to create a portfolio very interesting well I wonder what's been fantastic having you on Bogleheads on Investing I thank you very much for your time today and wish you a lot of luck and I know you just passed 10 billion and hopefully you get to 100 billion quickly thank you very much this concludes Bogleheads on Investing episode number 43 join us each month as we have a new guest and talk about a new topic in the meantime visit Bogleheads.org and the Boglehead wiki check out the Bogleheads new YouTube channel Bogleheads Twitter Bogleheads Facebook and find out about your local Bogleheads chapter and tell others about it thanks for listening