Faber: Why Market-Cap Weighting Falls Short

A version of this article was published in the June 2014 issue of Morningstar ETFInvestor. Download a complimentary copy here.

Mebane Faber should be no stranger to readers. He entered the exchange-traded fund business by partnering with AdvisorShares to launch AdvisorShares Cambria Global Tactical (AdvisorShares recently announced that it's proposing to GTAA's board of directors replacing Cambria with Morgan Creek Asset Management). Last year, Faber's firm Cambria Investments struck out on its own to launch Cambria Shareholder Yield (SYLD) and Cambria Foreign Shareholder Yield (FYLD). Both funds invest in stocks with the highest total payout yields, defined as the sum of aggregate dividends, net share repurchases, and net debt reduction over total market capitalization. His firm followed up this year with Cambria Global Value (GVAL), which focuses on value stocks in the most beaten-down, unloved countries. I think of it as a value strategy on steroids.

I interviewed Faber over email to get a greater understanding of how his funds work and his personal portfolio bets. Below is a lightly edited transcript.

Samuel Lee: You launched Cambria Foreign Shareholder Yield as an index fund, but Cambria Shareholder Yield as an actively managed fund. I assume this is to speed up your time to market. Can you explain the big differences in the implementations between the funds?

Mebane Faber: The filing process at the SEC makes it more difficult for foreign active funds than passive funds to get approved, but the SEC seems to be making great progress in these areas. It has no impact on how we implement the strategies.

Lee: Could you explain in detail how Cambria Global Value picks countries and the stocks within those countries?

Faber: Market-cap weighting results in returns an investor will receive from investing in the global portfolio based only on price, but does that really make any sense? It turns out historically market-cap weighting has been a very suboptimal way to invest as it overweights expensive markets and bubbles. A market-cap investor would have had 50% in Japan in the late 1980s in the biggest bubble we have ever seen (Japan is only 8% of world market cap now) and the majority of his assets in one of the most expensive markets in the world currently--the United States. While we don't think the U.S. is in a bubble, we do expect returns to be muted, perhaps 4% nominal per annum for the next 10 years. Most index investors are surprised to hear that at a minimum, even if they followed the Boglehead/indexing model, they should have half of their portfolio invested abroad, but none do, which is called home-country bias. It happens everywhere, and in the U.S. most allocate about 70% of their stock allocation to the U.S.

We talk about this in our new Global Value book a bit, and we believe it is more reasonable to weight markets and companies by value rather than price. It is just as important to avoid what is expensive as to invest in what is cheapest.

GVAL starts with a universe of all global developed and emerging countries, which is around 45 currently. We then invest in the top 25% of the countries, currently 11 based on long-term valuation metrics such as the Shiller 10-year cyclically adjusted price/earnings ratio. That basket has a CAPE in the high single digits, less than half of the value of the U.S. currently (26). We go a step further and select the top 30 stocks in each country by market cap (with minimum of $200 million), then select the top-10 stocks across a valuation composite--sort of a "Dogs of the Dow" approach in each country--with familiar metrics such as price/sales, price/book, and dividends. This deep-value strategy only rebalances yearly, which is important as higher-frequency trading does not allow the strategy time to recover.

Lee: All three stock ETFs you've launched so far seem to equal-weight their holdings and can delve into very small, illiquid securities. How do you reduce market impact costs? At what point do your funds become too big?

Faber: We think investors should be size-agnostic. At some points in the business cycle, small caps can be a much better opportunity than large caps, and vice versa. Now is not one of those times in the U.S. for small caps, and most of the value we are finding is in mid-cap and large-cap stocks. This is not true abroad, where many markets are still extremely depressed from their highs. We think a $200 million market-cap filter keeps investors in large-enough stocks, and low turnover helps. Buying markets and stocks that no one else wants helps as well.

As far as too big, that is not a problem we will have for a very long time--at least $10 billion in any fund. However, this is an important point, as asset flows can distort factors and asset classes. We love dividend stocks and low-volatility stocks historically, but flows have pushed both to expensive levels as investors have been in a search for yield and safety. We would avoid both.

Lee: Let's say GVAL grows to $10 billion. Because it equal-weights 100 stocks, it would mean that the fund could own half the market cap of a $200 million stock. Would you tweak the index to avoid or mitigate such situations, or would you be willing to incur tracking error to the index to gradually ease in or out of such concentrated positions?

Faber: That feature you describe is one nice benefit of being a quant: You can spread your bets out over many names. The first adjustment would be to move back to the market-cap indexes within each country. The value tilt here adds about 100 basis points historically, so it isn't the biggest driver of returns. The second adjustment would be to expand past the top 10 in each country and invest in more names (top 30 in each would take you to more than 300 names, almost all large caps). Both will have the impact of greater depth and liquidity.

Lee: In a recent blog post, you disclosed the rough breakdown of your personal portfolio. Would you mind disclosing exact proportions for your liquid assets, and why you've made those bets?

Faber: I think it is hugely important to have a money manager with skin in the game. In addition, many commentators and portfolio managers are willing to provide you with plenty of advice, but just try getting them to disclose how they invest their own money--impossible! If you don't believe me, or want to see how much your portfolio manager is invested in his own funds, the filings are public, so you can view them at any time. Next time you are chatting with your advisor or broker, or hear someone giving lots of advice at a conference, ask them one simple question: "Specifically, what do you do with your money?"

My net worth is dominated by my ownership in Cambria Investment Management. Next in line would be farmland and real estate owned with my two brothers. I also hold equity stakes in a few other private companies (including The Idea Farm and AlphaClone). On the liquid side, I have 100% invested in our funds. All of my cash flows simply funnel into these four investments on a periodic basis. My horizon is very long-term and I have a high risk tolerance.

The breakdown is currently:

60% Global Tactical Hedge Fund (private)

20% Global Value ETF (GVAL)

10% Shareholder Yield ETF (SYLD)

10% Foreign Shareholder Yield ETF (FYLD)

The percent allocation in the three ETFs is actually higher than stated above, as the Global Tactical private fund is composed of ETFs. I will be adding to this list as we launch new funds in the coming months. Specifically, my assets in the hedge fund will transfer to the Global Momentum ETF when it launches.

As you can see, my holdings are dominated by foreign stocks, portfolios that can and do have the ability to tactically move to cash (and have a high exposure to real assets), and stocks that are shareholder-friendly and returning lots of cash to investors. I am least exposed to traditional bonds, but for me they are not that attractive at these levels for my time horizon and goals. If stocks experienced a large drawdown of 30% to 90%, I would shift more and more of the allocation to the equity portion. As I've mentioned in our new book, I don't think U.S. stocks are that attractive currently, but I am very positive on foreign stocks.

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