 Welcome everyone to Bogleheads On Investing podcast number 27. Today our special guest is Cliff Asnes, founder, managing principal and chief investment officer of AQR Capital Management. Cliff has a PhD from the University of Chicago. Jack Bockel called him a brilliant academic. My name is Rick Ferri and this is Bogleheads On Investing podcast number 27. This podcast, as with all podcasts, are brought to you by the John C. Bogle Center for Financial Literacy, a 501C3 non-profit organization at BogleCenter.net. Today we have a special guest, Cliff Asnes. Cliff is the founder, managing principal and chief investment officer of AQR Capital Management. At the end of 2019 the firm was managing over 186 billion dollars of asset. It's in part on strategies that Cliff developed at the University of Chicago as a PhD student under Nobel Laureate Jean Fama. Cliff has received many awards, including the Bernstein Fibose Jacobs-Levy Award from the Journal of Portfolio Management, the Graham and Dodd Award from the Financial Analyst Journal, the James Burton Award from the CFA Institute, and probably his biggest award, Jack Bogle, referred to Cliff Asnes as a brilliant academic. I will warn you that some of this podcast is going to be a little geeky. So put on your math hat and here we go. With no further ado, let me introduce Cliff Asnes. Welcome, Dr. Asnes. Thank you, Rick, but please call me Cliff. Dr. makes me think you want me to help with an appendectomy. Well, thank you, Cliff. It's a real pleasure to have you on Bogleheads On Investing. You have a lot of followers on the Bogleheads. All of your research and your background is really quite fascinating. And that's where I want to start out with. If we could start as far back as you are comfortable going, how did you get to where you are today? Oh, I was a very unmotivated high school student. My parents thought I was an underachiever. I did very well on standardized tests and very poorly relative to those tests in classes. Partially, back then you can get away with actually not doing your homework and I took advantage of that. When applying to college, my dad found this program at the University of Pennsylvania that was a dual degree program between the Wharton School and the Engineering School. I had not really given any of this much thought at all. And it was my father who suggested, hey, why don't you study two things that both could help with a career? Because you don't know what the heck you want to do and you have no direction. So I really didn't start out going to school and doing that because I had a great love of finance or really wanted to be a computer scientist. It was more of a default. I ended up loving both of those things. Little luck is always a good thing. You got to take advantage of good luck when you get it. You got to minimize bad luck when you get it. But if things work out well and you don't acknowledge the role of luck, you're just not telling the truth. So I went to this program at one point. I started doing research assistant work for a few different professors, one of which is quite well known now, Andrew Lowe of MIT was at Wharton at the time. He was a very young man. I ended up enjoying even the research assistant work. I think I said something to him kind of like, I might want to do what you do. He was like, that's cool. Why don't you think about where you want to go, see where you get in. I applied to a bunch of PhD programs, got into Chicago, Stanford and Wharton, did not get into MIT, for which I'm still bitter about. But eventually, I'm on year 32 of being bitter about that. I think at some point I got to let it go, but I'm not quite there yet. They said something along the lines of, we don't take people directly from undergrad, but I think that was kind of like when someone breaks up with you and says it's not you, it's me. It probably wasn't because of your grades, because according to the bio that I read, you were summa cum laude in both engineering and economics. Yeah, there was a day where I was pretty smart. That day has faded and I couldn't do any of those things again. But sometime in the distant past, the brain used to work. Let's not dwell on the one school I did not get in, though I will one day extract my revenge upon the entire institution. I ended up, Wharton's a great place, but it didn't stack up against Chicago or Stanford when it came to PhD programs. I'm not talking, of course, about MBA programs or whatnot, but PhD programs always have their own kind of unique rankings. I basically went around to 10 professors at Wharton, told them that I'm looking to get a PhD in this. I got in these three schools and almost to a man, they said, shut the door. Largely because they were going to tell me not to go to Wharton. And again, no knock on Wharton. I love my alma mater. But that was how PhD programs ranked those days. And nine out of 10 told me to go to Chicago and many of them had gone to Chicago themselves. One famous professor named Robert Litsenberger, who was the next Stanford professor. He suggested Stanford, but at that point in history, Chicago is where you want to be. As an aside, Chicago offered to fly me out and Stanford didn't. And I asked and they said, no, it's just not in the budget. And I had no money at the time. So I took Chicago up on their offer, visited on one of the most gorgeous spring days Chicago has ever produced. So for years, I am fond of saying that I am the world's only person to choose Chicago over Stanford on the weather, which turned out to be a bit of a bait and switch, but the school worked out well. And not only did it work out well, but you got to study under some future Nobel laureates and one of them was Gene Pharma. And you know what's amazing is back then, we pretty much knew he was a future Nobel laureate. Frankly, I thought they gave him the prize 15 years after they should have, but you knew it at the time. He was an amazing man. Again, it was a lucky break for me to be at Chicago in the late 1980s when Faman French were doing a lot of the early work on what we now call systematic value investing or factor investing. We didn't even use those terms back then. We were just a bunch of geeks running regressions and sorting stocks on different variables, looking at returns. The terminology came later. But I was lucky enough for Gene to ask me to be his teaching assistant at the end of the year, and I did that for two years. So it basically meant I kind of took his class three times. So I sat in on it pretty much every day for three years. Got to teach review sessions and got to know Gene. In PhD programs, getting good advisors, it's just a big part of it. Getting advisors who are interested in you, who think well of you. I think that work helped me get him and Ken French to co-chair my dissertation committee, which was quite wonderful. More luck. Professor Farmer was a big efficient market guy, and your thesis really had nothing to do with the efficient market or maybe almost to disprove efficient markets in some way. Oh, first of all, we never prove or disprove things. Oh, I'm sorry. We're statisticians, so we're cowardly. I joked about the cowardly statisticians that we are. We don't disprove. We just say there's only a one out of a hundred chance we're wrong. Oh, that sounds like a Waldman analyst there. Yeah, but it is, you know, it's funny. It sounds kind of wimpy and cowardly, but it's also just intellectually true. Data can never prove something. It can just, you know, increase the probability of your hypothesis or against your hypothesis. You know, if you see a 99 out of 100 event, it may be in fact that it's true or maybe you got a 99 out of 100 random event. But yeah, a big part of my dissertation, not all of it, but a big part, was one of the very early pieces of work. You know, I was doing a price momentum strategy. You know, Pride of Place is first. It has to go to Professors Jagadish and Titman, who wrote the first big published paper on the price momentum strategy. I was doing it fairly concurrent with them, and I am proud that my definition partly Cusfam and French adopted it for their for Ken French's kind of data website and used it in their papers. It's kind of the most common one people use today. The UMD up minus down for basically one year price momentum. I do remember, and very, very distinctly, being nervous about precisely what you just said, that here I am, I'm lucky to have this relationship with the premier advocate for the efficient market hypothesis in the world, and I have all these preliminary results saying that a fairly straightforward momentum strategy was effective. And I distinctly remember telling him Gene, and I say Gene now, Professor Fama, certainly it took me 15 years after the program, till I would call him Gene, even though he kept telling me to. Professor Fama, I want to write a dissertation on price momentum, and then I mumbled the second part out of fear, and it works really well. And he's like, what? I'm like, and it works really well. And he thought for a bit, and he said something that has always stayed with me. It was actually in a weird geeky way, almost kind of moving. He said, if it's in the data, write the paper, which to me said, look, this might not be something I love. I might not love this result. I might consider it the exception that proves the rule. But data is kind of holy to him, and that kind of stuck with me, and it also allowed me to get on the path to graduation, which was nice. Though even then I was not crazy enough to say, gee, I found something better than your value factor. First of all, that would have been bad economics. They work better if you believe both of them. They work better together. Systematic value can make money over the long-term, systematic momentum can, and they're fairly negatively correlated, which is a wonderful thing to have if both strategies make money. It would have been bad graduation strategy to tell Fama, you know, we're going to do this instead of value, saying it's a compliment to your wonderful value strategy, with some sucking up I was absolutely willing to do. Well, let me ask just a couple of questions on what you just said. Please. Did Fama ever call what he did, value investing? You know, it's funny you asked that, because I keep meaning to go back and check the original papers. I don't believe so. It's certainly possible when the world started calling it that, that they eventually referred to it that way. I don't even know that. But I don't remember them calling it a value factor or whatnot. I think that was index providers and maybe other papers that did it. I think they were just looking at multiples and whatnot to sort stocks. I could be dead wrong about this, but from memory, I don't remember being in Chicago and talking about value investing. But certainly that label caught on, and I actually don't even think it's the best label. It creates tremendous confusion, because your kind of gram and dot old fashioned concentrated portfolio active management value managers, people call themselves value managers, get mad because they look at the quantitative factor and they say that's not value. Value is the price against fundamentals in consideration of things like, which are better companies, safer companies, faster growing companies, more profitable companies. The answer is quants don't think price divided by anything, book, sales, cash flow, earnings is the only thing you should judge on. We agree with those managers and we just call them different factors, things like the profitability factor, earnings, momentum, low risk investing. Those are all in the direction of the things the gram and dot people want us to consider, but they just put the whole thing together and call a cheap company, one that's cheap considering these other factors. We break it up and call them other factors, and a thousand fights have been caused by that when they're really, through very different methods, concentration versus diversification, judgment versus systematic, but through very different methods, I think they're often looking for the same kind of things in the stocks. I always thought that beta can be agreed upon. If you take all the stocks on the market, weight them by either shares outstanding in the public float or total shares outstanding something, but we all can come to an agreement on what beta, the beta of the market should be, and that size, meaning large cap stocks, mid cap stocks, small cap stocks, even micro cap stocks, in general, all of the index providers can sort of agree what that is. I mean, they were all pretty close, but when it comes to value, I always say value is in the eyes of the beholder. Everybody has a different equation. Sure. First, I think that's fair, but let's talk about the value factor, what I would prefer to call the price factor, not the holistic considering other aspects, just price divided by some fundamental. You could choose price to cash flow. I could choose price to book. Someone else could choose a weighted average of how it looks on many different reasonable valuation factors. You could do what we do. We wrote a paper on this in 1994 and try to use this value factor to bet within industries, meaning we don't think it's very effective across industries. It's pretty hard to compare valuations. The standard work in almost all of academia and a fair amount of the indices allows very large industry bets. In fact, it always strikes me that the way we invest in value, we try very hard not to take an industry bet, and the way many speak about value is only in terms of industry bets, you know, tech versus textiles. All of these things make your value possibly different than my value, but if we both use a handful of reasonable measures and have a portfolio construction technique, I also didn't mention how you weight them can be different. FOM in French is a tap weighted. You could do a signal weighted, where the degree of the valuation signal tells you your position. You could do equal weight, and of course, those will have somewhat different results and have somewhat different degrees of implementability. Is that a word? I think it's a word. Implementability. Yeah, we'll call it a word. We'll call it, yeah. It's our podcast. Write a paper on that when you get off this podcast. With that said, I do think if you create your favorite value strategy and it's reasonable, a deflating price by four or five of the major things out there, I might do it within industries, you might allow an industry bet. We're going to be, I'm making this up, don't hold me to it, we're going to be .8 correlated. What's amazing is over a couple of years how different sometimes .8 correlated things can be. That often surprises people. So these choices, they may not be provable which one's better, but over the short, even the medium term can matter. But .8 correlated says to me, you are right. There is no God-given way to measure value, but I think it matters a little less than people worry about because price is the main thing driving the ship. Price compared to anything reasonable leads to at least fairly decently correlated strategies. I'd also say cap weighted market, even that has a little degree of ambiguity. How deep do you go in the capital structure? You know, Wilshire 5000 versus S&P 500. Size is actually even a little more complicated. I would agree still with your statement that size in the market are more common. If you and I both come up with a definition, we're probably going to be more correlated across those. But I still think value, there's a concept that any decent value factor follows. A deflating price by reasonable things and going long, the cheap, and short the expensive on that measure. And again, yours in mind, we might fight to the death over who's is better. We're kind of a co-religionist who differs slightly in our dogma at that point. And as we've seen in history, those are some of the most vicious fights. But I don't think it's really... And I would include myself. I think, of course, after years of doing this, that our way is the best humanly possible. And I don't mean that arrogantly. I mean that in a sense of we would do it differently if we didn't think it was the best way to do it. And I'm sure our competitors would. But again, I think it's a great question. I think you're right directionally, but I think it is less... You didn't even say it was a problem, but I don't think it's a problem. I think most reasonable ways to come up with value will be more similar than you think. Some people believe that a multifactor approach to value might solve the problem, at least for retail investors. In other words, instead of trying to pick which price to something is value, you just have a formula that takes a little bit of everything. I like that approach. We've written on that approach. Everything is going a little too far. Price divided by... You can imagine crazy things. I think I even used this phrase a few minutes ago. Price divided by anything reasonable. Make up your favorite four or five. Price divided by book. Price divided by trailing earnings. Price divided by forecasted earnings. Price divided by free cash flow. Price divided by sales. All reasonable. And I can tell you advantages and disadvantages to each one. I would prefer a stock that is the most attractive on a weighted average of those five more than I would prefer a stock on any one. I'm not smart enough. And I don't know if anyone else is to pick out which of those five is actually... I'm saying five. There can be many more than that, of course. But I don't think we're really smart enough to figure out collectively. I don't think value is that... As you pointed out earlier, that well-defined concept. I would rather take the average. So let's get to the... Another debate. Is the value premium released historically a result of risk? Or is it a result of behavior? Oh, you're going to get me in trouble. Oh, I am. I'm sorry. I like to put it this way. First, they both can have some influence. They both can contribute to a positive value premium. I know you've seen some of my work before. I'm always a peacemaker. Sometimes I like to throw gasoline on a fire. In this particular case, I often throw water on the fire because I've been in academic seminars where I point out... You guys are arguing about this, but the real world is complicated. It could have a risk premium component and a behavioral component. And just to really mess with everyone, those can vary through time. Right now, I think we're in a fairly crazy period. And I'll go out on a limb and say, I think it's better for me to do my things than normal. So maybe behavioralism matters more right now. And maybe there are some times it matters less and it's more of a risk premium. I will tell you, and this is why I said you're going to get me in trouble, even though I wrote my dissertation on momentum as Fama's student, I was probably two-thirds, one-third towards the risk story. Doing this live for now 26 years, going back to 94, I've certainly drifted more towards the behavioral story. I think living through about six cataclysmic events and at least three for value and being frustrated at those times. To be honest, a world I thought was going a little crazy has certainly pushed me. But again, I'm not dismissive of the risk. I'm probably two-thirds, one-third, the other way. Now, I'm not someone who feels intellectually confident and saying we know the answer here. But at this point in my career, if I had to bet on one and couldn't split my vote, I would lean behavioral. Though I warn you, I say that on the coast. If I'm ever in the Midwest and feel like Fama's within a thousand miles, I change my story. It's kind of odd, though, that you would say that. And here's why. It's because you've spent so much work done on behavioral finance and biases and everything that you would think that we would have resolved some of our internal human issues and that we would notice that. But what you're really saying is people are acting worse than they used to be, even though the research by various top Nobel Laureate behavioral economists are putting this information on people are reading the books. No, I think that's a fair observation and I have a few thoughts on it. I think it comes down to this. Value has been on a terrible streak. It's kind of a 10-year drawdown. I think the first seven years of that drawdown were very different than the last three. I think the last three have been far less rational than the first seven. Remember, my distinction that behavioral can matter, but it's not always behavioral. But even a few years ago, not 10 years ago, even two, three years ago, maybe the most common question I got was along the lines of what you're saying. Not just value, but other factors, too, but we'll talk about value here. If this is true, why doesn't it get arbitraged away? It could get arbitraged away by too much capital or people could learn and stop making these biases. The learning part, which is more where you're coming from, again, I don't see a whole lot of evidence that human biases are going away or even ameliorating around the world. You know, we live in a little bit of a bubble where we're very well-versed in all these behavioral issues and we read all the literature. I think you're not to pick on them. It's become an easy punchline, but you go to your average Robin Hood trader, and I don't think we've gotten through. On the arbitrage, why aren't these arbitraged away? Remember, strategy can go away for two reasons. It can go away for either demand or supply. Demand for strategy is too much capital chasing it, which even if there is a certain amount of bias in the world, you can't extract an infinite amount of money from that. You can only take the other side and close the gap on valuation. So if the first trillion dollars closes most of the gap, the second trillion dollars doesn't make any money to close. No one makes any money. Or it can go away because supply, and this is a little bit cynical, but this is behavioral. This is the supply of investor error. People have to continue to make errors and a limited amount of capital has to pursue them. Again, two and a half, three years ago, the question was, why do these things persist? After two and a half, three painful years to these strategies, the question I get now is more, how can anyone stick with these, even if they're great long term? How can anyone stick with these? And I love to point out that these are in a real way the opposite question. One is saying, this is so obvious, everyone should do it and should go away. The other is saying no one can do it. And I think there's an element of truth to both. Real life strategies that can be done in large capacity, I mean a strategy like value that can be done at fairly large scale, is not a super high sharp ratio. I think it's real. So a real positive sharp ratio, you can add to a diversified portfolio, that is a wonderful thing. But it goes through, as we've seen, even before the last 10 years, we've seen horrible periods for value. And the very fact that it can be very hard to stick with, drives a fair amount of people out, makes it hard to see the whole round trip. So you do have this kind of yin-yang. On the one hand, it should go away. On the other hand, it's really hard to stick with. And perversely, I think low sharp ratio, high capacity strategies that are a long term investor's good friend. If you really can stick with them, they can improve a portfolio. And I think they don't go away precisely because they're at that kind of risk adjusted return. That's on the cusp. You can recognize it's good. Some people can stick with them. But a lot of people think they can, but can't. And so if something is real, but 90% of the people throw in the towel when it's had a bad three years, it's going to stay an opportunity and it's going to occasionally really hurt. I think that the overwhelming interest in value investing that occurred in the early 2000s after tech tumbled, and value just had an incredible run, small cap value in particular, created this wave of fundamental weighted ETFs and a whole range of other factor based ETFs just came out of the woodwork, and people were inundated with this. Because of all this interest and because of all this new knowledge that people were getting, it seems to me made this value factor not work, but also not work for a longer period of time than normally would have occurred perhaps. It is certainly possible. We certainly live in a cyclical business where people do in fact overreact to the prior big event. And it's possible. We all collectively did that at one point. I will say ever since 1999, when we started our firm right before, the T to the tech bubble really took off, we invented and have been tracking since then, something that has come to be called the value spread. This was, all right, Faman French and many others in academia sort stocks on some valuation ratio and they look at the spread between the cheap and the expensive in returns. But what was really missing, we couldn't find it anywhere. It's certainly possible someone privately had done it, but we didn't see it in the literature, was anyone who looked at and thought the information was interesting in the magnitude. How cheap is cheap? Imagine all the value is priced to cash flow. And again, like we talked about before, I would much rather use many. But just to make it simple, you're going long, low price to cash flow and short, high price to cash flow. The expensive ones will always be more expensive on your own metric. But how much more expensive and how much cheaper what the spread is between them will vary through time. And we did this in the teeth of a very terrible value market and not surprisingly discovered that after it being terrible, that spread had blown out to record levels. That didn't have to happen. You can lose in a value strategy or any strategy and have it not get cheaper. Simplest example, imagine you bought a stock because it had a low PE and the price fell 50%. A naive, simple approach to say, oh God, it got cheaper. But if the earnings fell 75%, your favorite metric, a PE, doubled. It didn't get cheaper. It got more expensive. So you can actually lose in a strategy if you lose because the fundamentals move against you. It doesn't necessarily get cheaper. So it was worth checking. And we did find it had gotten massively cheaper, which means most of what was going on in the tech bubble actually, I think more than all because I don't think these were high quality companies even, was from price action. We've been monitoring this spread in many different ways in many different places ever since. Halfway, of course, it's symmetric. Halfway to worry about periods like now where that spread is back out to approximately record levels. If you're beaten up in value, is that money gone? Meaning you lost on fundamentals, which you don't give up. You might continue with your strategy, but you never certainly, you don't expect to make that back. You lose on price, where you may have an expectation that it's more attractive than normal now, that the premium is larger than normal. But we didn't track this only for times like today. Maybe even more so, we tracked it to see what if that spread ever compressed well beyond history. The only one I have memorized is price to book. And I think if you look at the standard form of French construction, the price to book of the expensive, 30%, against the cheap, call it 30%. It averages maybe five or six times, so the expensive are five or six times more expensive than the cheap. The low it is maybe the high threes, maybe four was the low, and you've hit that a few times. And the high was about 12 in the tech bubble. 12 to 14, depending upon the precise measurement. And we are back to similar levels to that. But one reason we've monitored this forever is what if that spread smashes down to one and a half to a compressed level where the differences in valuation are just not very large, and in fact, record small compared to history and then stayed there for a few years. Your hypothesis that maybe the world has figured this out, maybe they're not making that error or maybe too much arbitrage capital has come in would be hard to argue with. If a value strategy exists, because there's a spread in valuations, if that spread in valuations is much smaller than it used to be, maybe the world has figured it out. And we've always felt monitoring that in case it was time not to do it was the case. And we've seen lower and we've seen higher and we certainly see extremely high today, but we've never seen it smashed down to levels that say, value is never going to work again, if the world has figured it out. And certainly still happen in the future. Let's pivot back to momentum. In a very short and eloquent, simple way, if you can explain the formula for momentum, that's number one. And the number two, you said that the momentum factor and the value factor are uncorrelated or at least low. No, negatively correlated. Okay, so if they're negatively correlated and you had them both together in the same portfolio, how does that reconcile or do you not have it in the same portfolio? The simplest measure of momentum I know is still the one I used in my dissertation. It is simply one year total return, leaving off some of the very recent returns. I didn't even use daily data, so I left off the last month in my dissertation. You don't really need to leave a whole month off. You need to leave off a few days. That could be because we see some true reversal at the very short term, liquidity provision. You know, if someone tries to trade a lot, they push a price and it's temporary price pressure. Or there are just some microstructure issues. If the last trade is at the bid, the price looks low and the momentum looks worse. But if the next trade is half at the bid and half at the offer, half the time, on average you get a bounce. So it creates a little bit of an artificial contrarian strategy. So I often shorten it to one year price momentum and leave off all the geeky stuff about having to be sure that you don't accidentally get that contrarian part that may or may not be real at the very short term. But call it simply one year price momentum. I actually called this the fool strategy when I presented it to Fama. And I think I was just currying favor there. I knew he wasn't going to like the momentum strategy, so I might as well be self-deprecating about it. But on the face of it, you can't get simpler, right? Buy a diversified portfolio. Again, you can do this. You can wait it in different ways. But buy a diversified portfolio of stocks with strong one-year returns. And sell a diversified portfolio of stocks with weak one-year returns on a relative basis. Doesn't matter which direction the market has gone. Now, of course, I won't get into this, but just like value, you can do this in more complex, perhaps better, perhaps over-engineered. We can always debate that ways. You can take out the industry bet from this. You can look not at total return, but total return net of, say, a beta, or multiple betas to different factors. What's the excess return? There are a lot of different things you could do, and people do pursue these. There are a lot of papers on tweaking the momentum factor, just like there is with value. Same problem and or opportunity, depending on your perspective, that there's no one way. But I think the base way in academia is still this one-year price momentum. Now, negatively correlated strategies. The way I think about this is imagine your value strategy. Long, cheap, short, expensive has a 5% average return and a 5% long-term volatility. And imagine, so does your momentum strategy. If they are uncorrelated, you take their volatility and you divide by the square root of 2. So you do get, if you put half your money in each, you get a diversification benefit. If they are negatively correlated, the volatility comes in even lower. An implausible negative correlation, if you thought they were negative one correlated, they both can't have a positive mean. That's a perpetual motion machine. To say I have two strategies that are perfect hedges, perfectly opposite, but both have a positive average, that would be no volatility ever and making money every day. It's like going long the S&P 500 and short the S&P 500. Yes. That is absolute negative correlation, but it don't make any money. Exactly. But in real life, value and momentum in times, it's higher, times it's lower, but call it a negative 0.5 correlation. And that is actually pretty reasonable. If you say it in English, what you're trying to buy, if you give, and I don't say you have to give half your weight to each, and there are other things besides value and momentum, but if you gave half your weight to value and half your weight to momentum, the actual stocks you're trying to buy, forget the clown stuff, just think about describing the stocks, are cheap stocks that are not disastrous on momentum or even mildly cheap stocks that have good momentum that are getting better. I used to laugh and be kind of obnoxious when more traditional managers would all describe their process as we're looking for value plus a catalyst. And I used to roll my eyes and say, you all say the same thing. And then a friend who was an active stock picker said, don't you do value and momentum? I said, yeah. And he said, don't you think you can describe that as value plus a catalyst? And I said, damn, I think I see where you're going with it. So, you know, just the mechanical math is if you have two strategies that are not unrealistically negatively correlated but are decent. They're not perfect hedges. They just tend to move in the opposite direction and both make money. I think that is both possible at a minus 0.5 correlation and you create a better risk return. Anytime you create a better risk return, you can take that benefit through getting basically the same average return at lower risk or you could be more aggressive and try to translate that into higher returns for similar risk. But I think the idea that there are two strategies that can both make money and partially hedge each other, not fully because that can't work, but partially hedge each other, I just think is what's going on with value and momentum. And I think it's quite intuitive. All a sequel, if the price goes up, the momentum gets better and the value gets worse. So let me ask a question. The Federal Funds does this. They first screen for their value stocks. I mean, the stocks they want to buy based on their value screens. And then they buy the ones that have good momentum. I mean, in some other words, value first and then momentum. How does that work? Sure. You know, I mean, I have great respect, of course, for the guys that are dimensional. Fama and French still do a ton with them and there's nobody in the industry. There's more. We do differ on this. Like I said, people have basically the same religion with small differences. You get your 30 years war, you get your Shia Sunni kind of thing, where essentially we agree on almost everything, but we disagree about this small point. Let's fight about that. So that definitely does happen. I am fond of saying momentum is very hard to reconcile with efficient markets. Ken and Jean would agree. By DFA using it as a screen, in my view, it's very close to just using less of it than we do. You're giving it a say over when you trade, but that's it. You're not giving it any kind of equal status. So I think it's just a point on the spectrum. I think their philosophy started out more value-based. I think they recognize that momentum has been a real phenomenon and they don't want to trade against it. We want it to actively contribute, not to dominate value, but to actively contribute. And people who agree on a lot, who even like each other's processes and think each are good, can differ with where on the spectrum you would be. If you and I both designed a process with similar data and similar empirical results, we wouldn't necessarily come out with the same weights. A screen is not technically the same thing, but I think it's pretty close to thinking of it as them believing in momentum, but less than we do. And I will say if they ever say something negative about momentum, I do make the a little bit pregnant joke. You've already showed you believe in it. You just believe in it less than we do. So I think we're more similar than we are different on this. But yes, clearly we would give momentum closer, not necessarily precisely equal. We don't have to wait these 50-50, but we would give momentum more weight than they would. Well, we sort of got off track a little bit because we were actually... No, no, no, this is fine. This is perfect. But we haven't even gotten out of college yet. I mean, you obviously got your PhD, so they accepted your dissertation. More comfortable with the gear stuff than with the autobiography. But then you went to Goldman Sachs. I went to Chicago. I started a dissertation on momentum when I got an offer from friends who were at Goldman Sachs asset management starting up taking over. It was really close to a startup, but taking over a fixed income area. Initially I went for a summer, which was great. They then said, why don't you come for a year and see if you like this as compared to being a professor? And I still thought I wanted to be a professor at that point, but I did recognize that free options are good things. They teach us that in finance. So I said, let me try this. I ended up being there about a year and a half and was working on my dissertation at night. That was an odd experience to be a portfolio manager, a trader, and a modeler in fixed income during the day and go home and work on Quant Equity at night. I was getting closer to, very close to being done. Fom and friends were great about doing my dissertation from afar. I went back to Chicago. I proposed it. I went back and defended it. They wanted me to go on the academic job market. I got, again, very lucky. PIMCO, the West Coast Asset Manager, wanted to start a Quant Research Group. Quant was getting more popular. It was still a relatively new thing, believe it or not. Back then, PIMCO ended up offering me that job. As an aside, the guy who took me out to lunch asked if sushi was okay. And I had never had sushi and hardly ever had fish at that point in my life. And being a cowardly 24-year-old, or whatever I was, something 24, 25, I said, yeah, sure, sushi would be great. And one point when he wasn't looking, I did spit my food into a napkin. Gotta come clean about that. But I went to Goldman and said, I'm thinking of doing this. This seems perfect. I'm trying to decide between academia and being a practitioner. And this seems to be the best of both worlds. And to be brutally honest, and I feel bad, it was kind of PIMCO's idea, and we ran with it. But Goldman swore to God they were looking to start the same group and they were thinking of talking to me. Again, I made the odd life decision not to live, first not to live in Palo Alto and then not to live in Newport Beach. I have managed to avoid good weather, rather consistently in my career. But Goldman said, start this group. And I said, yeah, my family's from here. I like Goldman. They were treating me well. I'm an East Coast guy. Okay, let's start this. And I hired three people that gave me a budget for a four-person group. Two were fellow PhD students at the University of Chicago. One is still my partner today at AQR. We ended up both building direct quantitative processes to run client money. Over the course of kind of the next three years, we ended up running probably just about $7 billion, about $6 billion in traditional kind of beat the benchmark, no leverage, no shorting, just regular stock picking, though in a quantitative manner, and about $1 billion in long, short, more hedge fund kind of work. To be honest, the hedge fund work being less constrained, we think is a more pure version of what we do, but it's not that different. When our factors beat the benchmark, we tend to get positive return in a similar-based hedge fund. The hedge fund is kind of the alpha part. Life went well. This group, though, had much broader responsibilities than running money. We were also in charge of pretty much anything quantitative. We were like door-to-door quants, especially before we were running money. We were desperate for someone to give us a task. So we were doing asset liability analysis, running efficient frontiers for their marketers. And while there's absolutely nothing wrong with that, it was good stuff. It was really awkward to be running a group that was running billions of dollars and growing and doing well, and being in charge of the graphics for the marketing people, for other people's products. Sometime, I think it was 1996, I had one of my other partners still to today, a guy named David Kabilar, started working on me, particularly on the hedge fund side, saying, you know, we really could do this on our own. You guys are at Goldman Sachs, but you buy all outside data. You don't trade off Goldman Sachs as strategists. It's all self-contained. And there have been various hedge funds, booms and busts, but that was a boom time. And he thought we could do it. And I spent the better part of 1996 doing my Hamlet imitation. You know, should I do this, should I not? Indecisive. Mid-96, I went to Goldman and actually said, I'm thinking about doing this. I was very straightforward. I'm thinking of going off of my own. They said, what would it take to keep you and the whole team, not just me? I said, well, certainly money is part of it and I won't pretend it wasn't. We didn't even propose a deal where we'd make anything like if we ran our own successful hedge fund. But we proposed something in the middle, some kind of sharing arrangement. What was really odd was they certainly didn't jump at our first offer, and that's a decent part of the way on the more crass issue of just the money. But they were very insistent that we kept doing the support work. I ended up saying yes. Goldman Sachs does many things well, but retaining employees they want to retain is something they are excellent at. Suddenly you are sitting with John Corzine, then president of Goldman Sachs multiple times, being told how much they want to keep you, but it turns your 20-something year old head. And I ended up along with the rest of the group deciding to stay. And Rick, you have to have one of these giant decisions that as soon as you finally make the decision after agonizing, you get a wave of relief. Partly just because it's over, but partly it often seems obvious. What was not obvious when you were agonizing seems obvious after the fact. You're like, well, yeah, I don't know what I was agonizing about. I never got my wave of relief. About a month later, I was still going, we should be doing this on our own. And David again, he was the Mephistopheles, the tempter in this story. About a month into it, he and I were talking and I said, is that still an option? And he... You don't say that to David. I gave away the whole ball game at that point. So we agonized for a few more months, but at the end of the year, we did decide to go and do it on our own. But the first time you try to leave when you're someone they want to keep, you get the full charm offensive. The second time, you do not get the charm offensive. You get quite the opposite. Largely because when you come back the second time, they know you're going. But the partner I reported to was not happy with me. It was still... One of the scariest things in my life was telling him I was resigning. I remember that. I was a total child. I played like psych-up music on my Sony cassette Walkman in my office before I went down to his. I was not calm. But it worked out. Well, it sure did. You ended up creating an incredible powerhouse, AQR. By the end of last year, you had $186 billion in assets at a minute. That's a phenomenal number. So clearly you made the right decision. And, of course, to be congratulated. So all that. Your father would be proud of you. I hope so. So I have just a couple more questions from the Bogleheads. I've asked you some already, but I just have a few more. This has to do with things that you've wrote about over the years. One of the things you wrote about was the $6040 portfolio. Is it a good solution going forward? And just realize that a lot of investors kind of invest along the $6040. What's wrong with $6040? We hear a lot about this recently. What do you think? First of all, since we and others have been saying that $6040 just chugs along. Some wild volatility at times. Mid-March this year, it didn't seem like it was chugging along, but on net it continued to do well. My issues with $6040, there are two. A long-term one and a conditional one on where we are today. The long-term one is there's nothing wrong with it. I think it's great to have that as a core of your portfolio. It's magic to the particular weights of $6040. Of course, like everything else, we pick kind of a benchmark and then it gets holy over time. I don't think $65.35 or $55.45 is going to be any great sin, but the general idea of being diversified across stocks and bonds as a core is great. We do think you can do better. Both in a traditional sense, all the classic things we talk about being global, at least to some extent. You can still have a home bias, but $6040 is often a thought of as the domestic U.S. portfolio. There are other ways to make it better, but if you believe that there is a value premium, there is a momentum premium, then you can just view that as another investment. That's not very correlated to $6040. We do think long-term you can at least somewhat improve the risk-adjusted return to take enough risk of $6040. Today, it's a little more serious. These are very long-term phenomenon. We always, thank God, we caution don't use this to time the market, don't use this to make a one-year forecast, but stocks, pick your favorite measure. I remember when the Shiller Cape was a brand new baby in 1996, but it's become kind of a lingua franca and talking about how expensive the stock market, just like any valuation measure, it's not the only one by any means, there are a whole set of them. The Shiller Cape, I think last time I looked, just a few days ago, it was about 32, it hit the low 40s at the end in 99, 2000. So, if you graph it back, you know, 100 years, the only way it looks reasonable is if you squint and compare it to the tech bubble. If you compare it to the whole series, if you compare in the, again, don't hold me to the precise number, then the 92nd percentile expensive versus history. And statistically, it's actually hard to say strong things about long-term returns because you don't get to observe enough, let's call it, 10-year or longer periods, but what we do get to observe seems to fit with intuition. When you buy stocks more expensive, the average return is lower so therefore we'd expect positive returns out of stocks. We're not people who are forecasting giant mean reversion in a crash, but we do forecast a lower risk premium for long-term investors from here. And this is even easier because it fits intuition even more so. The same for bonds. When bonds are selling for near a zero or real yield against economists' forecasts of long-term inflation, not many of us need great convincing but they're probably from here in the next, call it, 10 years going to make less on their bonds than history in a real sense against inflation. If stocks are less than normal and bonds are less than normal, then you could do some very complicated math. This is stochastic calculus. You take 60% of your estimate for stock returns and you add it to 40% of your estimate for bond returns for 60-40%. 4% is really what you're looking at maybe. Nominal. We think it's about 1.5% real. No, you're dead on. I prefer real because it just adjusts for the environment but that comes out to about 1.5% real right now. History is more like 5%. Meaning if you could buy a diversified portfolio at a low transaction cost at a low fee. That's a big F because there's a long part of history where you really couldn't do that. But if you could, you got 5% real just for showing up. We think you get 1.5%, 2% real just for showing up today and that's not negative. You can make it negative if you want to forecast big mean reversion but that's market timing. That's saying we know these prices are going to drop. I don't know that. The prices drop, it'll be even worse. But I'm negative enough. At 1.5%, 2%. If you do have alternatives that can make a portfolio better on average, I think they're more important when the core portfolio is offering you less. Let me ask a question about international stocks because I look at the international market and I look at the industry group weightings of XUS or international stocks and I see very different industry groups and I see very U.S. is certainly more tech and more healthcare and now more communications. So it's a different makeup. It's like 50 years ago we did everything in this country. Now we import all our desks and computers and just about everything I'm looking at right here in front of me. But my point is that if you look at the valuations of international stocks just use the Vanguard total index fund. And I didn't know I was looking at the Vanguard total international index fund. All I was looking at was the price to earnings ratio, book ratio, return on equity growth rate. I thought I'd be looking at a mid cap value index. And then lo and behold, you pull the cover off and it's the international market. Can't people who are doing say a 60-40 portfolio and to your point that a lot of people are thinking about just U.S. stocks can't they diversify or maybe get some of the value premium that you're talking about as simply as adding instead of having all U.S. having 40% U.S. and 20% international with that work? Absolutely. I would say you really don't have to choose one or the other. The international versus the U.S. even when international is cheap is not highly correlated at all to when value works as we do it within industries for picking individual stocks. You know, the basic math of portfolios says you should do everything you believe in that's diversifying. You should just have a high standard for what you believe in. So you don't end up doing a ridiculous amount. But I don't think these are necessarily competitive solutions. I think they're complementary solutions. You can do half of what you would have done over each and have less risk of disaster if you're wrong on either one. But absolutely. I do think even if you adjust for the industry a long, long time ago we wrote a paper in the mid-90s showing that cheap countries with good momentum can now perform expensive countries with bad momentum if you just pretend the index is a single stock and add up the numbers for the underlying components. But years later are talking about that of course you can get some very different industry components particularly in some of the smaller countries where you don't have a very large cross-section. You go to Belgium and you get a ton of financials. You go to Australia and you get a lot of resource stocks. So this gets really geeky and this is your fault, Rick that I'm doing this. You brought it up. But years ago we modified what we do in comparing countries. We still compare them straight out against each other but we also do something where we look at a country's industry composition. We look at the global including the US total cap weighted global industry get its valuation forecast based only on its industry composition what we think the valuation ratio of that country would be if everything was selling at an average for the industry and then call it cheaper expensive only if it if it's lower or higher than that forecast did price. So it's another it's kind of like a similar thing. Remember earlier I said we take our value bet without taking a whole lot of industry exposure at least I think I said that earlier. I say that most of the time. You said that. But we found that makes the country betting a little higher of a risk adjusted return but we still do both. We give weight to both and both will say even adjusting for industries we think the US is expensive against the world. Like everything else value alone particularly for big decisions like US vs global it could be wrong for a long long time. It's just a question of is it a smart bet and we do think it's a smart bet to have to have some outside the US partly because we always think that because we like diversification but also conditionally as you're saying because it has more of a value tilt than it normally does right now. You agreed with me on the last point and made me look very smart. I think I'm going to end the podcast here. You're afraid one more question and I'll disagree and it'll all collapse. That's smart. Remember Seinfeld? That's George Costanza has learned that if he ever says something smart in a meeting he excuses himself from the meeting immediately and says thank you and just claims victory. And that's what I'm going to do. Cliff thank you very much for being our guest and we really appreciate your insights and it's been a real pleasure having you on the show. Thank you Rick. I enjoyed it very much. This concludes Bogleheads on Investing podcast number 27. I'm your host Rick Ferry. Join us each month to hear a new special guest. In the meantime visit Bogleheads.org and the Bogleheads Wiki. Participate in the forum and help others find the forum. Thanks for listening.