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Larry Swedroe: 'The Pool of Victims' Is Expanding

The author and financial expert discusses factor investing, fixed income and retirement planning, as well as trends in ESG investing.

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Our guest this week is noted author and researcher Larry Swedroe. Larry is chief research officer at financial advisory firm Buckingham Wealth Partners, which he joined in 1996. In his role, Larry is responsible for reviewing academic research on financial and investing matters and determining how that research should inform Buckingham's investment strategy. Larry is also a member of the firm's Investment Policy Committee. Larry has written numerous books on investing and finance, the most recent being the second edition of The Incredible Shrinking Alpha, which he coauthored with Andrew Berkin. His work has also been published in various academic journals, including the Journal of Investing. Larry began his career as a risk manager at Citicorp and later at Prudential Home Mortgage. He received his bachelor's in finance from Baruch College in New York and his MBA in finance and investment from New York University.

Background

Bio

Larry Swedroe’s books

Investment Strategies/Factor Investing

Swedroe: A Five-Factor Evaluation,” by Larry Swedroe, Yahoo.com, Sept. 25, 2017.

Swedroe: Factor Persistence & Diversification,” by Larry Swedroe, ETF.com, May 8, 2017.

Swedroe: Simple Factor Investing,” by Larry Swedroe, ETF.com, Sept. 10, 2018.

Swedroe: 3 Factor Investing Myths,” by Larry Swedroe, ETF.com, Feb. 13, 2019.

Swedroe: Virtues of a Long/Short Strategy,” by Larry Swedroe, ETF.com, Aug. 14, 2015

Factors in Commodity Returns,” by Larry Swedroe, seekingalpha.com, Sept. 9, 2020.

Swedroe: Understanding Risk & Return,” by Larry Swedroe, ETF.com, Nov. 7, 2018.

Larry Swedroe: Risk Warrior in Action,” by Janet Levaux, thinkadvisor.com, March 26, 2019.

An Investment Strategy That Reduces the Risk of Black Swans,” by Robert Powell, thestreet.com, March 27, 2019.

Value and Momentum Everywhere,” by Clifford S. Asness, Tobias J. Moskowitz, and Lasse Heje Pedersen, The Journal of Finance, Vol. LXVIII, No. 3, June 2013.

Profitability, Investment and Average Return,” by Eugene F. Fama and Kenneth R. French, Journal of Financial Economics, July 28, 2006.

The Other Side of Value: The Gross Profitability Premium,” by Robert Novy-Marx, National Bureau of Economic Research, April 2010.

The Simple Explanation for Value’s Underperformance,” by Larry Swedroe, evidenceinvestor.com, Jan. 3, 2020.

Even Great Investments Experience Massive Drawdowns,” by Larry Swedroe, alphaarchitect.com, Aug. 20, 2020.

Swedroe: Small Value Lags for 15 Years,” by Larry Swedroe, ETF.com, Feb. 20, 2019.

Passive Investing Without Indexes,” by Larry Swedroe, ETF.com, April 13, 2016.

A Comparison of Passively Managed, Small-Value Funds,” by Larry Swedroe, advisorperspective.com, March 10, 2020.

Fixed Income

Swedroe: Factors in Fixed Income,” by Larry Swedroe, ETF.com, May 4, 2018.

Swedroe: Consider Factors in Fixed Income,” by Larry Swedroe, ETF.com, June 27, 2016.

Swedroe: Why Chasing Yield Fails,” by Larry Swedroe, ETF.com, Dec. 26, 2018.

Swedroe: High-Yield Rewards Underwhelming,” by Larry Swedroe, ETF.com, Dec. 30, 2015.

Retirement Planning

Sequence Risk Is a Big Threat to Retirees,” by Larry Swedroe, evidenceinvestor.com, Oct. 18, 2019.

8 Retirement Planning Mistakes to Avoid,” by Larry Swedroe and Kevin Grogan, nextavenue.org, Jan. 8, 2019.

Safe Withdrawal Rate: Is 3 Percent the new 4 Percent?” by Larry Swedroe, cbsnews.com, Oct. 4, 2013.

Do you Choose a Declining or Rising Equity Strategy in Retirement?” by Larry Swedroe, buckinghamadvisor.com, July 22, 2016.

ESG Investing

Swedroe: ESG Strategy Performance,” by Larry Swedroe, ETF.com, April 10, 2019.

The Risk and Return Implications of ESG,” by Larry Swedroe, buckinghamadvisor.com, May 29, 2018.

How ESG Makes Companies Better,” by Larry Swedroe, advisorperspectives.com, June 16, 2020.

Determining the Nature of ESG Returns,” by Larry Swedroe, thebamalliance.com, Sept. 6, 2018.

Transcript

Jeff Ptak: Hi, and welcome to The Long View. I'm Jeff Ptak, global director of manager research for Morningstar Research Services.

Christine Benz: And I'm Christine Benz, director of personal finance for Morningstar.

Ptak: Our guest this week is noted author and researcher Larry Swedroe. Larry is chief research officer at financial advisory firm Buckingham Wealth Partners, which he joined in 1996. In his role, Larry is responsible for reviewing academic research on financial and investing matters and determining how that research should inform Buckingham's investment strategy. Larry is also a member of the firm's Investment Policy Committee. Larry has written numerous books on investing and finance, the most recent being the second edition of The Incredible Shrinking Alpha, which he coauthored with Andrew Berkin. His work has also been published in various academic journals, including the Journal of Investing. Larry began his career as a risk manager at Citicorp and later at Prudential Home Mortgage. He received his bachelor's in finance from Baruch College in New York and his MBA in finance and investment from New York University.

Larry, welcome to The Long View.

Larry Swedroe: It's my pleasure to be with you.

Ptak: You're an avid reader of academic research on investing and finance. Can you talk about how you separate the wheat from the chaff when you're poring through the literature? And in doing so how do you prevent your own confirmation bias from creeping into that process?

Swedroe: Yeah, that's a really great question. That's hard for anybody to do. We're all as human beings subjects to confirmation bias, number one. And on the other hand, cognitive dissonance when we read something that disagrees with our preconceived notions. So, what I do is, related to the book I wrote with Andy Berkin, who is the chief research officer at Bridgeway Capital Management, our book, Your Complete Guide to Factor-Based Investing, we established five criteria that any factor in the literature would have to meet before we would consider it for investing. And that was that there had to be a premium, of course, that premium was persistent across very long periods of time and economic regimes. And what we're looking for with these five criteria is to minimize, if not eliminate, the risk of a data-mining outcome that just happened to be lucky for that country over that period of time.

So, persistence across long periods of time and economic regimes, pervasiveness around the globe, regions, countries, industries, even asset classes where appropriate. So, we know buying what's cheap, which is a value strategy, and selling what is expensive, works across stocks, bonds, commodities, and currencies. We want it to be robust, meaning it meets various definitions. So, price the book, if that was the only thing that worked in value, we might be skeptical, but almost doesn't matter. You could put in price the zip code is you might joke, and you'd find that there's a correlation. So, price/cash flow, sales, dividends, EBITDA to enterprise value.

We want to make sure that they're intuitive risk-based explanations, or intuitive ones for the premium to persist. We prefer risk-based because you can't arbitrage risk away, although cash flow's popularity can shrink premiums, of course, but should never logically cause them to disappear. But we'll accept behavioral-based ones because human beings tend not to change and there are limits to arbitrage including the cost of shorting, trading, especially in small-cap, micro-cap stocks, those kinds of things. So, those are the criteria. Along with it has survive the transactions costs.

And the last thing I would say whether it's related to factor investing or anything else, after I read the literature, I've developed a great network of friends who are highly respected in the industry. And I will review the papers with them to make sure I'm interpreting the information correctly. And luckily being part of Buckingham Wealth Partners, $50 billion of assets-under-management administration, we get access to some of the leading academics. So, I can pick up the phone and get the top researchers at Dimensional, who I'm on the phone with regularly, to review literature; people like Cliff Asness and Tobi Moskowitz and Antti Ilmanen at AQR. I mentioned Andy Berkin, Marat Molyboga and Wes Gray and Jack Bogle and a whole bunch of others. So, I'm trying to make sure I'm not missing something, or I'm not engaging, as you said, in confirmation bias by going through all of those activities.

Benz: We have more questions about factor investing. But before we get into that, what's a belief that you held that you've reconsidered over the past 10 years or so? And is there one that you rejected or were pessimistic about previously that you've come to embrace?

Swedroe: That's another good question. There was one strategy which I thought was a very good one and I still think it could be a good one except I was always aware that valuations can destroy, or popularity can destroy, even a good investment turning it into a bad one. You buy stocks at 50 or 100 P/Es, you're likely to end up in trouble even though we know over the long term, there should be an equity risk premium.

So, the one asset class, which I included in my book, Your Complete Guide to Alternative Investments that I did invest in, recommended, held personally was an exposure to commodities. That was based upon not an expectation of high returns. I thought the way the fund was designed with TIP yields at the time in the 2% or 3% range would outperform riskless Treasury bills by something in the 1%-plus area. But you had an asset with no correlation to stocks and bonds generally on average and could give you inflation protection. It would also provide you with a hedge against negative supply shocks, although it wouldn't help you against negative demand shocks either to the economy or otherwise in the industry, like fracking led to a huge increase in the supply of energy.

So, what happened here was this. Over the long term, the evidence had showed that in a well-diversified commodity portfolio, on average, there was either no backwardation or contango, or slight on average backwardation. Now, the research also showed that a good strategy in commodities, because it worked everywhere else, was also the carry trade or a value trade. So, going long commodities that were in backwardation, short, and ones that contango also work. So, my premise operating was based on the long evidence was that we should average about zero. I wasn't assuming that the small backwardation that historically was there will continue. But I thought if we got contango because commodities became popular, that that wouldn't last because you would have this headwind and the cash flows would go out. And if you had big backwardation, that wouldn't last because then you have the tailwind and money would flow in and, on average, you'd end up at about zero and then it would fit the paradigm I developed.

What happened was the popularization of commodities, which has been called the financialization of commodities, led to so much cash flows, and that has stayed for a long time, that we ended up with a very large contango, and therefore, a big headwind. And after a while, literally months, not years, I decided that there were now other options that were better, or this had just gotten too expensive. And I got out and anyone who asked me, I told them that I thought it had gotten too expensive there as well.

I just want to add one other thing with commodities. As bad as the return has been, if you follow the advice I gave, which was this: If you're going to add commodities, you should lengthen the maturity of your fixed-income portfolio, because there you typically should have strong negative correlation. So, you get inflation, commodities go up, long bonds do poorly. You get deflation, or contractions in the economy and flight to quality, longer-term Treasuries likely will outperform. So, we have this period, of course, where commodities did poorly and longer bonds did well. So, if you shifted from, say, a medium-term intermediate Treasury fund to a longer-term one, at the same time you added 3% or 5% commodities, there was almost no net impact on the portfolio, because you did both of those things.

So, I'd just add that. If we went back to a world where commodities were trading on average at zero contango, today I still think there are now better alternatives that don't have inflation risk, things like alternative lending, middle-market lending, reinsurance, and others that have much bigger premiums now for risk when commodities should have no real expected return, except what would be in TIPS, which was the collateral use. And now TIP yields are flat or negative. So, I think there are better alternatives. So, that's the one major change in my thinking has occurred because of popularity killed that golden goose.

Benz: How about the flip side of that? Is there a belief where you had once rejected it, but now have said, maybe they have a point by advocating this or that?

Swedroe: The one case I would be somewhere in the middle there is the evidence--and we wrote about this in our book, Your Complete Guide to Factor-Based Investing--the evidence was very clear on low beta as a strategy that it looked good. But it didn't make it into the five factors on the equity side. We included investments considered. And that's because low beta actually only works, meaning it delivers better risk-adjusted returns than actually a premium, when you're in the value regime. And then, you get low beta, lower volatility, and the risk premium historically. When it goes into a growth regime, you get low beta still, but now you get negative premiums. So, I think you're better off just lowering the equity portion of your portfolio and then stick with the other factors that have premiums as well. So, what has happened is popularity killed that goose, I think, and quality as well. Both of them are very expensive now, strongly in growth regimes, and clearly to me, both of these are behavioral anomalies, not risk-based ones. So, I recommend people be more cautious on these. Because I think there's at least more risk that their premiums have now gone with the wind. I wouldn't ignore them necessarily. I wouldn't necessarily want to be on the other side of that trade. I don't want to own high-beta stocks, for example, because they tend to underperform, especially if they're not quality, but lottery stocks.

Ptak: It's a good segue to my next question, which is, you reflecting on the relationship between risk and return and how our understanding of that relationship has evolved over the last few decades. We began with market risk and that has since branched into other factors, some of which you mentioned: style, size, momentum, quality, and more. But has research and experience--has that forced us to revisit our assumptions that greater risk should translate to greater reward over time and vice versa? You just mentioned low beta. I mean, that seems to be an example of something that would violate that iron law that more risk should equal more return or vice versa.

Swedroe: Well, we know this about investors--that they're not economically rational as economists assume when they build models that try to attempt to explain the world. The fact that they're imperfect doesn't make them useless. They're the best picture we have of the world. They help us understand how they work. But they're not like cameras that give us a perfect picture. They are more like engines that advance our understanding of the world. And we know that because investors are not economically rational, they're psychologically rational. Their behaviors, like a preference for these lottery stocks, can lead to mispricings because of limits to arbitrage. The costs of shorting stocks and the risk of unlimited losses is great. The charters of many financial institutions don't even allow them to do so that the sophisticated investors who might be willing to bear the risk can't really fully arbitrage the prices away.

I think your listeners and maybe you might even be shocked. But small-cap growth stocks that are unprofitable, which actually have been about the best-performing stocks this year. And they're the stocks investors love to love. And interestingly enough, it's not the poor people who buy most of the lottery tickets, foolishly, of course, because they don't typically have $400 to meet an emergency. And, on average, they spend $400 a year on lottery tickets. But they're buying a dream, if you will. But interestingly, with lottery-like stocks, like small-growth stocks, with high investment and low profitability, it's the wealthy people who are trying to become the Warren Buffetts or Bill Gates of the world--$5 million is not enough, I have to have $10 million or $20 million that speculate on these things. And the research shows these stocks are so bad, they underperform totally riskless one-month Treasury bills, historically. And yet why does that persist when the research shows it? It's because of these limits to arbitrage.

Benz: Profitability and investment are two factors that Dimensional incorporated into its approach relatively recently. Your firm utilizes DFA strategies. Can you talk about how you conducted diligence on those changes to ensure that those factors passed the persistent, pervasive and robust tests that you suggested be applied to any factors?

Swedroe: We just follow the literature and that prescription. I'm really proud. Andy Berkin and I, I think were the first ones to put those five criteria into place. And now you hear that cited a lot. And so, when we looked at momentum, we wanted to make sure it was persistent. And you see momentum works in every asset class. There's a good paper Value and Momentum Everywhere by Toby Moskowitz and others from AQR. And it not only works everywhere around the world virtually, but it also works across asset classes. And it's robust, for example, so that it works pretty much regardless of your formation and holding period. So, you could look at three months, six months, nine months, 12 months, it doesn't matter, you still get a momentum premium in the same way you get a value premium, whether you look at cash flows or earnings, or EBITDA to enterprise value, it makes no difference.

So, Fama and French finally threw in the towel back in 2003, I believe, on momentum. And I think it was French who convinced Fama as saying, Look, you're the father, if you will, of efficient markets, but we're banging our heads against the wall, and it's hurting our performance. And, of course, this is just my version of what happened. I don't know exactly. But I think it convinced them to at least screen out the negative momentum stocks and Dimensional showed us the research that they thought it would add value. And we reviewed it and so it met all of our tests. Profitability works the same. They built on work that actually a 2006 paper by Fama and French and then Robert Novy-Marx built on that in his paper on gross profitability and others have written now on profitability, which has since been expanded into a quality factor, a broader version. And whether you use quality or profitability--I like to say they're kissing cousins--you're not going to get too much difference; you'll get a premium either way.

So, the research holds up for both of those factors. And now, while we use DFA to a great deal, we also invest with several other fund families, including Vanguard and AQR and Bridgeway, and Stone Ridge, and we're looking at others now, all of whom use the same academic research, all go after the same factors, although their fund-construction rules are somewhat different. But we're also very careful here--I want to make this point--that you're not data mining and coming up with the exact best fit, overfitting the data, because we all know you can look back and see which metric worked the best. So, I'm a big believer actually in using multiple metrics rather than one for any factor, like profitability or quality or value. So, I prefer using those multiple metrics because the science, and not just in investing, shows that multiple measures tend to give you a better answer than any one single one. I'll mention briefly, you could look at any decade with value in one decade, price/cash flow works best, the next is book value, the next one, it's something else. And it turns out, if you take a blend of about three to four, you will get a better outcome in the long term because they somewhat diversify, and you smooth out the returns.

Benz: Small and value have gotten clobbered by large and growth for quite a while now. As of early November, the DFA U.S. small-cap value fund did lag the Russell 1000 Growth Index after fees since Feb. 18, 2001, which is nearly two decades. You've written that alpha becomes beta, but beta can also decay after it's discovered. And you mentioned that earlier in the conversation. Is there a reason to believe that that's the case with small and value?

Swedroe: Well, first of all, all premiums can decay, even if they are risk-based because of popularity or regime changes. So, for example, I think everyone would agree the equity risk premium has collapsed in the U.S. over the very long term. If you go back to the beginning of the 1900s, equities used to trade at single-digit P/E ratios, they were viewed as so risky. Over time, we got the Federal Reserve that dampened the economic volatility, learning from its experiences like the Great Depression. We got much better regulations, we got the SEC coming along in the 30s. And regulations have gotten better, trading costs have come down, which, of course, shrank the equity risk premium, because you could capture more of it. There's lots of reasons why. And you can get bubbles like we had in 1999, early 2000, and that will shrink it. So, that's important to understand that premiums can shrink.

I want to make this point on your observation about small and value. You can look back as you did and say it's now underperformed for 20 years almost. But 100% of that underperformance has been really since I think, October of ‘16. So, it's really been four years of underperformance, not 20. I'm not disagreeing with your point. You look at 20 years, you'll find that. But this is only unusual in the severity. So, I wrote a piece looking back at history. And there were four other periods where value’s drawdown was in excess of 30%. Now, drawdown doesn't mean negative return; it could be growth up 50% and value up 20. That's your drawdown underperformance. It's a long-short portfolio.

This one, instead of being about one third is then about 50%. And that 50% drawdown, maybe even worse, has led to the cumulative over 20 years. But we've been there and done that before. So, your listeners I think might be surprised to learn that if you were looking at March 2000, at that time period, value would underperform growth over one, three, five, 10, 15, 20 years. And one year later, the reverse was true. These things can turn on the dime now. Then the premium had only been down 30%. Now, it's 50 or more. So, it may take more than a year.

But what we want to do as you think about this question, is ask: Has there been a regime change? In other words, there's only two explanations for why small value say underperformed large growth. One is pure speculation: People favor, now, large growth companies for whatever reason, and the valuation spreads go way up. Or it could be there's been a regime change in profitability. So, by that I mean this: Historically, value stocks have had ROAs about 4% to 5% lower than the return on assets of growth stocks, and the ROEs have been about 11% or 12% lower than the ROEs of growth stocks. Those numbers in small value are virtually unchanged and large growth's profit differential has widened a little bit, favoring large growth.

But more than 100% of the underperformance has been the speculative change in valuations. So, that tells me it seems highly likely that there's nothing wrong with the value premium. We're just going through periods like we've had before. We had the Roaring ‘20s when the tech stocks were called Westinghouse, and RCA and maybe airlines. Then you had the Nifty 50. We can name many of those stocks and value underperform. We had super high valuations, 50 stocks with 50 or more P/Es, the Xerox's of their day. And then, of course, you had the late 90s. And in every period following that, growth got slaughtered. So, I'll give you three periods of at least 13 years where the S&P 500 underperformed totally riskless T-bills, not value, but T-bills--'29 to '43, '66 to '82, and 2000 to '12. Now, in the '66 through '82 period of 17 years, small value beat the S&P 500 by over 1,100%.

So, this reminds me, I think, history rhymes, it doesn't necessarily repeat. The lessons we should take is investors make the big mistake of thinking three years is a long time to judge performance of a strategy, five years is very long, and 10 years infinity. Any good financial economist will tell you when it comes to risky assets, 10 years is likely noise. And the evidence of that is those three periods of at least 13 years where the S&P underperformed T-bills. If you want another one, how about 30 years Japanese stocks have had a negative return. And even better, how's this, Christine, I think this may shock even you. Forty years beginning in '69 through '08, the long-term Treasury 20-year outperformed large-cap growth stocks. Now, a long-term Treasury is the riskless instrument for a pension plan with nominal liabilities. So, you go 40 years and you underperform. I would hope people would not have given up on large growth outperforming in the long term. It shows you that discipline and patience is required to be successful. And what we're experiencing now with small and value is likely nothing more than noise. Now, if the economy continues to do poorly, we go in recessions, etc., well, that's when the risk of value companies show up. So, it won't surprise me if value continues to underperform. But if we get economic growth, then I would expect value will turn around and begin to outperform. And you might see a big regime change, or it snaps back like a rubber band that was stretched to its limit.

Ptak: That's helpful. I do have a follow-up, which is a practical question. I know in the book that you co-wrote, The Incredible Shrinking Alpha, you talk about citing research how people have a hard time admitting mistakes and how that can mess with their decision-making, including their investment decisions. Do you think that with the benefit of hindsight some Fama-French acolytes made a mistake in the way they made style and size an article of faith, something that perhaps blinded them and their clients in the possibility of long-term slumps like we've seen small and value experience over the past 15 years or so?

Swedroe: I have no doubt that advisors, or at least some, don't spend enough time on educating their clients about this point that all risk assets go through very long periods of underperformance, which is why our investment strategy at Buckingham has always been based upon three core principles. First, everything we recommend is based on the evidence, not our opinions, not mine, or Jared Kizer's or Kevin Grogan, or anyone else on our committee. And if you believe the academic evidence, then the first conclusion you should draw is, while it's certainly possible to outperform using active strategies, the odds are greatly against you. Twenty years ago, 22 now when I wrote my first book, about 20% of active managers were beating their risk-adjusted benchmark on a pretax basis. So, maybe 10% were doing it on after-tax. That number today, all the studies show, has collapsed to about 2%. So, again, we think it's possible to outperform, but the odds are against you. So, you should adopt systematic strategies.

If you believe the markets are highly efficient, though not perfectly so, then the only logical conclusion you should draw out of that is that all risk assets should have very similar risk premiums. That doesn't mean they have similar returns, because you have to have similar risk-adjusted returns. So, emerging markets should trade at lower valuations, have higher expected returns than U.S. stocks since they're riskier, and small-value stocks should have higher expected returns than large-growth stocks. That's an example.

Now, if you believe that all risk-adjusted returns are similar, the only logical conclusion you should draw is you should diversify across as many unique sources of risk as you can that meet your criteria that you're comfortable with. And that means not having the typical 60-40 portfolio that looks like a total market fund. Because if you do and you hold, like many people say an intermediate Treasury, you don't have 60% of your risk in market beta, it's about 85%. Well, if you believe in the size and value premiums, then you should diversify into them, allow you to hold less market beta risk, because the equities you own have higher expected returns. And this is the whole strategy that many people refer to as risk parity or Ray Dalio's All Weather Portfolio, adding other assets, like reinsurance, alternative lending, private lending, etc., where you can implement them at reasonable costs and not concentrate risk.

I'll add just one last point. When I started in this business, it was '95. And the evidence was clear, small and value outperformed. And very quickly, within three years, we saw the biggest underperformance ever for value '98-'99, early 2000. And we did lose some clients and we learned we had to do a better job of showing people that three years is nowhere near enough, five isn't, and even 10. At 10 years, we should expect that there's a negative equity risk premium about 10% of the time. So, why shouldn't we expect that in value or size or profitability or quality. That's not a reason to avoid risk, it's a reason to diversify it because you don't want to have all your eggs in one basket, and that one turns out to be the wrong one.

So, we coined the phrase, the risk of diversification, to get these benefits and minimize your risk of failing because your portfolio blows up, because all of your assets, or most of them, your portfolio is dominated by one risk. So, you blow up and then you maybe panic and sell and that may mean never recovering. We want to hyper-diversify. And that means there will always be some part of your portfolio that's doing poorly or you're likely not diversified enough. So, patience and discipline is required. And we are always writing about whatever is doing well now, we're writing about the other side, time to take chips off the table, rebalance, stick with the plan. But I will admit, it doesn't matter. There's a small percentage of clients that abandon the strategy because, again, they think three years or five years is long enough. So, we're experiencing more client losses than we've historically had, which has been under 2% a year, maybe it's gone up a couple of percent, because I think we do a great job. But some people just don't have that discipline.

Benz: Is there a reason to believe that the rise of transaction-free platforms like Robinhood and the recent explosion of speculative trading will create fresh, profitable opportunities for professional investors like active fund managers? In the book you wrote about how the pool of victims has shrunk amid the rise of indexing, but as speculators have reentered the picture, doesn't that enlarge the pool again?

Swedroe: I would tend to agree with that. The research shows on average the stocks retail investors buy, on average, go on to underperform the market and the ones they sell go on to outperform. Obviously, it's a zero-sum game, so somebody is on the other side. And the research like Russ Wermers' big paper on mutual funds found that institutional investors are on the other side of those trades. And on average, the stocks they buy go on to outperform by about 70 basis points. The problem is, on average, their cost in total far exceed that. So, they end up losing anyway.

But the pool of victims, I think, is certainly being increased today. And I think COVID is helping to lead or emphasize that occurrence, because people now are stuck at home and have more time. And I think the failure is the average investor never stops to think. Who is on the other side of the trade? If I'm buying Tesla, 90% of the trading is done by the big institutions, and they outperform. Who's the sucker that I'm exploiting? It's not likely Goldman Sachs or Morgan Stanley or Renaissance Technologies. I think any rational person would say, likely, the person on the other side of that trade knows more than me, and therefore, I shouldn't be playing that game. Unless you have an edge, you shouldn't play. It's possible some people have an edge, but I think it's more likely the average Robinhood investor is simply overconfident of their skills.

Ptak: I think I could talk to you all day about active investing and some of what you view as impediments there. But I did want to shift over and talk a bit about fixed income. You have long been a proponent, if I'm not mistaken, of a fairly austere approach to fixed-income investing. You favor high-quality short-duration bonds, avoiding areas like high yield, if I'm not mistaken. There's certainly a diversification argument for that approach, one I know you've made. But do you think that when you have central bankers pulling out all the stops to get investors to take risk on that you have to reassess that approach in some ways?

Swedroe: Well, that's a good question. First, let me address the general one. You're right. We believe in a barbell approach. Take your risks where it's done in the most tax-efficient and diversifiable way, which is in equities, or equity-like risks. And the safe portion you want to own only the safest because correlations tend to be regime dependent. So, for example, often you'll hear the argument high yield diversifies. The problem is diversification always works in the wrong way for high yield. So, let's say, the average correlation is 0.2, it becomes 1 in bad times when you need it to go negative. So, that doesn't help where the high-quality bonds, the average correlation is around zero, and it becomes highly negative when we need it the most.

And so, really, the other point is the research shows that there is almost no credit premium in the corporate bonds--once you adjust for the expenses of the fund, they're gone. And so, if you're buying a high-yield bond, you really should think about that you're buying equities and Treasuries. And you're better off owning the equities and just go buy T-bills, or whatever bonds you're buying, or FDIC-insured CDs where you don't pay any expense to any fund, you don't need any diversification and you could pick up an extra 50, 60, 70 basis points often. So, why do you want to own high yield? To me, it makes no sense. And the argument, “I'll buy high yield when the spreads are wide,” doesn't hold either, because that's just when equities have low valuations. So, just buy equities, and you get a more tax-efficient return and you can diversify it more effectively and globally.

Now, so it doesn't mean I won't buy some higher-yielding assets, but it's not for necessarily the credit premium I will buy them. It is for the illiquidity premium that you don't get in high yield because it's public debt. So, private real estate lending or Stone Ridge has a fund, their Alternative Lending Fund, LENDX, which invests in the fintech loans for consumers and small businesses. It's got today an expected return in the 6% to 7% range, which is about the same as most people think U.S. stocks will have but it's got about a five volatility versus 20 for stocks, and in no way where stocks might drop 60% this fund we estimate would have lost high single digits. We saw that with the coronavirus, the fund lost 3% or 4% in the big down draw where equities dropped 34% and the fund is now up for the year. But you should take that allocation almost certainly from your equities, not the safe bonds. That's the problem. Your safe bonds have to be viewed not for a return, but for the ballast it provides to make sure your portfolio's overall risk is not more than you could take.

Last comment. The problem--and this is where I really think the Fed has made a major mistake. I debated with one of the governors and he happened to agree that my point had validity. And in fact, it was something the Bank of England had done some research on. I told him my experience in talking with clients is, our clients, many of whom are retirees, live off of their interest income and when you drive rates to low levels and keep them there for a long time, they can't generate the interest income and what they do is they cut their spending and you exacerbate the recession. And the Bank of England did a study that found that that effect was definitely there. And all you end up doing is you get a bubble in equities because the Fed is pushing people to take more risks and that can create secondary problems down the road as we saw with the housing crisis in '08. Personally, I think the Fed has got this one wrong and rates should be more normalized here. Keep them down for a short time until we start to recover. But they're world-class economists and who am I? But the point being, you shouldn't be forced to take more risk. You shouldn't use dividend-paying stocks, REITs, high-yield bonds, MLPs for this safe portion of your portfolio because you get an '08, a 2000 to '02, you get a COVID crisis, they all crash. Today, you're better off with things like MYGAs, these annuities that act like CDs with fixed maturities. I just bought one the other day--five years at 3%, a lot better than you get anywhere, and there's no risk, or virtually no risk, because I stayed within the state's insurance guarantee limit.

Benz: You sit on Buckingham's Investment Policy Committee. What's the most significant debate your committee is having at the moment, and how have you implemented the committee's consensus view in the way that you manage strategies for clients?

Swedroe: That's a good question. Our biggest issue now is how do we deal with the demand that we're getting from, especially our higher-end clients, but others for investing in private equity, especially with high U.S. valuations and zero bond yields. We have traditionally taken the stance that that's not our area of expertise because their fund manager selection really matters because you can't build diversified portfolios, if you will, buying all the securities in an asset class. Reputation matters and we don't have the depth of staff, we think, to do that properly and evaluate every investment and project. We're coming to the conclusion that our clients want it, so we need to give that to them and we are doing due diligence on firms like Blackstone and Goldman and others to choose a partner or two that we would work with and say, “If you want these types of investments, we've done our due diligence, we recommend that you use XYZ firm and allocate 10% or 20% or whatever you feel appropriate and work for them.” So, that's the biggest challenge.

And right now is probably the best time--although I'm not a believer in trying to time assets--private equity returns have generally not outperformed on a risk-adjusted basis public equities of similar risk. You have to account for the illiquidity in them and that's worth, say 2% to 3%. But the best returns to private equity are always dependent upon the regime and their best returns are following blowups in the economy when there's great distress and they can bring their capital and buy cheap assets at distressed prices. So, if you're going to do it, now is not a bad time to be doing it. But that's just somewhat coincidental here. So, that's the one thing that we are likely to be changing is, we will be, I think at some point next year, approving one or two firms to work with to give access to things like direct real estate lending. And some of the firms have made it much easier. You now can be on Schwab's platform, for example, and some of them have REITs, direct-lending REITs that you can get 1099s instead of the complex paperwork and all that goes with it, the extra cost of getting K-1s in a partnership. So, that's helping and making it more accessible for us as well, Christine.

Ptak: Let's talk about withdrawal in retirement income. I believe you stated previously you think 3% is a good baseline withdrawal rate as it acknowledges future stock and bond returns are likely to be lower, people are living longer, and you can have outlier expenses like long-term care that are hard to predict and manage. What should someone do if they are entering retirement and 3% isn't going to cut it in maintaining their standard of living?

Swedroe: Well, you have two choices and there's no free lunch here. You can spend more and hope you don't run out of money. The odds may still be good if you're at 4%, maybe 80%, let's say, just to pick a number. And that's pretty good odds, but I don't like the odds of one of five of having to eat cat food, if you will. So, I would suggest those people should rethink their retirement plan, think about what options they could exercise like downsizing a home, moving to a lower cost of living area, plan on working longer, take a part-time job. All those kinds of things are better options than trying to solve the problem by taking more risks. Because if that risk shows up, you're in really bad problem because of sequence risk, which I think everyone is pretty familiar with. It's a risk you just don't want to take. It's what I call or refer to as a Pascal wager, where I don't care what you think the odds are, you have to consider the risk of being wrong, and are you willing to live with that possibility? Even if it's very low, it's just not worth the consequences.

So, I think this is a case where you want to be exceptionally conservative. Only draw more than 3% if you have options that you can exercise if the tail risks show up. So, I might be willing to take 5% if I'm spending $300,000 a year. But I know I could still be happy if I have to cut it to $150,000 a year and then I'll still be able to be OK, that's fine. But if you're a widow, renting an apartment and your income and cash flow and spending needs are like break-even, you can't run even a few percent risk, because you have no options to cut your expenses if the tail risk comes up. So, this is one you have to wear your risk manager hat. The same type of situation where you're a 35-year-old marathon runner, great genes, no one in your family has died before 95, you're married with two young kids. The odds of your dying in the next 10 years are probably under 1%, but you buy the life insurance anyway, and holding your withdrawal rate to 3% is the same type of decision, I think.

Benz: We wanted to ask you about ESG--environmental, social, governance--investing. Do you think ESG investors should expect to incur a penalty for tilting toward securities that are believed to possess more-attractive ESG attributes?

Swedroe: That's really a great and complex question here. I'm actually working on a book now with a friend of mine, Sam Adams, Your Complete Guide to Sustainable Investing. And I've read probably 50 or more papers on this subject, everything that I can get my hands on. And here is what I think is the right way to think about it. Anytime people screen out assets, that means there's fewer people buying them, like tobacco stocks, that means all else equal the cost of capital to that firm will be higher, their stock prices will be lower. And because that behavior doesn't change the earnings of the company, you drive their expected returns up and the stocks you favor, say, solar energy stocks, you drive their prices up, but you don't change their earnings, so the expected returns should go down. So, I think logically in the long term, when we reach an equilibrium, which I'll get to in a moment, you should expect to pay a penalty.

Now, that may be perfectly appropriate. You're willing to pay a penalty to express your social values, beliefs, etc. Even if there is a penalty, that still may be a perfectly rational decision. However, in the short term, Christine, cash flows into ESG investments, which have been massive in recent years, and likely, I think, continue in the same way the trend toward passive investing in general and ETFs because of their greater tax efficiency, as that trend has occurred. If a lot of cash comes into these more favored sustainable companies, that's going to drive their valuations up. So, the short-term effect is, capital gains and long-term effect when you eventually reach the equilibrium, is lower expected returns. But if this trend lasts, say, another decade or two, it's certainly possible that during this transition to the new equilibrium,

that socially responsible investing or ESG investing could actually outperform.

So, it's kind of a tough one. If I had to bet, I sort of take the middle stance. But I think there's a reasonable chance it could outperform because of that momentum in these stocks, these cash flows driving valuations up. But in the end, it logically has to be that there should be a penalty.

Ptak: Well, Larry, this has been a very illuminating conversation. Thanks so much for sharing your time and insights with us. We really appreciate it.

Swedroe: It's my pleasure. Happy to come back anytime.

Benz: Thanks so much, Larry.

Ptak: Thanks for joining us on The Long View. If you liked what you heard, please subscribe to and rate The Long View from Morningstar on iTunes, Google Play, Spotify, or wherever you get your podcasts.

Benz: You can follow us on Twitter @Christine_Benz.

Ptak: And at @Syouth1, which is, S-Y-O-U-T-H and the number 1.

Finally, we'd love to get your feedback. If you have a comment or a guest idea, please email us at TheLongView@Morningstar.com. Until next time, thanks for joining us.

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