Cliff Asness: Value Stocks Still Look Like a Bargain
The AQR co-founder on how to deal with low expected returns, the case for alternatives, private equity and the “illiquidity discount,” and more.
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Our guest this week is Cliff Asness. Cliff is a founder, managing principal, and chief investment officer at AQR Capital Management. Cliff writes often about investing and financial matters on AQR's website and has been a prolific researcher throughout his career, with his contributions appearing in many of the leading scholarly journals, including the Journal of Portfolio Management, Financial Analyst Journal, the Journal of Finance, and the Journal of Financial Economics. This work has earned him accolades, including the James R. Vertin Award, which the CFA Institute bestows on those who produced a body of research notable for its relevance in enduring value to investment professionals. Before cofounding AQR, Cliff was a managing director and director of quantitative research for the asset-management division of Goldman Sachs. He earned dual bachelor's degrees, one in economics from the Wharton School and another in engineering from the Moore School of Electrical Engineering at the University of Pennsylvania, as well as an MBA and Ph.D. in finance from the University of Chicago. We recorded this episode live and in person at the annual Morningstar Investment Conference, which was recently held in Chicago.
Investing Amid Low Expected Returns: Making the Most When Markets Offer the Least, by Antti Ilmanen
"Demystifying Illiquid Assets: Expected Returns for Private Equity," by Antti Ilmanen, Swati Chandra, and Nicholas McQuinn, aqr.com, Jan. 31, 2019.
"The Illiquidity Discount?" by Cliff Asness, aqr.com, Dec. 19, 2019.
"Why Not 100% Equities," by Clifford Asness, aqr.com, Dec. 1, 1996.
"Leverage Aversion and Risk Parity," by Clifford S. Asness, Andrea Frazzini, Lasse H. Pedersen, aqr.com, January/February 2012.
"An Update to Cliff Asness's Study on the Benefits of a Levered 60/40," by Jeremy Schwartz, wisdomtree.com, May 20, 2021.
"Are Value Stocks Cheap for a Fundamental Reason?" by Cliff Asness, aqr.com, Aug. 30, 2021.
"The Long Run Is Lying to You," by Cliff Asness, aqr.com, March 4, 2021.
"Quant Legend Cliff Asness Is Back to Defending Value Again," by Justina Lee, Bloomberg.com, July 15, 2021.
"Still Crazy After All This YTD," by Cliff Asness, aqr.com, May 9, 2022.
"Everything and More," by Cliff Asness, aqr.com, April 4, 2022.
"Bonds Are Frickin' Expensive," by Cliff Asness, aqr.com, Aug. 13, 2019.
"Should Taxable Investors Shun Dividends?" by Ronen Israel, Joseph Liberman, Nathan Sosner, Lixin Wang, The Journal of Wealth Management, Winter 2019.
"Cliff Asness Says ESG Is Here to Stay Amid Growing Interest," by Isabelle Lee and Silla Brush, Bloomberg.com, May 17, 2022.
"Shorting Counts," by Cliff Asness, aqr.com, Feb. 23, 2022.
"Shorting Your Way to a Greener Tomorrow," by Cliff Asness, aqr.com, Sept. 7, 2021.
"Virtue Is Its Own Reward: Or, One Man's Ceiling Is Another Man's Floor," by Cliff Asness, aqr.com, May 8, 2017.
"Now There's Nothing Certain But Death," by Cliff Asness, aqr.com, Jan. 15, 2021.
Christine Benz: Hi, and welcome to The Long View. I'm Christine Benz, director of personal finance and retirement planning for Morningstar.
Jeff Ptak: And I'm Jeff Ptak, chief ratings officer for Morningstar Research Services.
Jeff Ptak: Our guest this week is Cliff Asness. Cliff is a founder, managing principal, and chief investment officer at AQR Capital Management. Cliff writes often about investing and financial matters on AQR's website and has been a prolific researcher throughout his career. With his contributions appearing in many of the leading scholarly journals, including the Journal of Portfolio Management, Financial Analyst Journal, The Journal of Finance, and the Journal of Financial Economics, this work has earned him accolades, including the James R. Vertin Award, which the CFA Institute bestows on those who produced a body of research notable for its relevance in enduring value to investment professionals. Before cofounding AQR, Cliff was a managing director and director of quantitative research for the asset-management division of Goldman Sachs. He earned dual bachelor's degrees. One in economics from the Wharton School and another in engineering from the Moore School of Electrical Engineering at the University of Pennsylvania as well as an MBA and Ph.D. in finance from the University of Chicago. We recorded this episode live and in person at the annual Morningstar Investment Conference, which was recently held in Chicago.
Ptak: Cliff, welcome to The Long View.
Asness: Thank you.
Ptak: Thanks so much for joining us, we're really excited to have an opportunity to speak with you. For my first question, I wanted to build on some work that your colleague, Antti Ilmanen, had done.
Asness: You nailed that by the way.
Ptak: You said of that work, it focuses on future expected returns. You said the central challenge for investors today is what to do about the low expected return environment. What is the best way for investors to surmount that challenge? And maybe we can focus on three cohorts: young investors, middle-aged investors, and then retirees.
Asness: My statement was accidentally, mildly deceptive. It is the number one salient fact of markets that prices on equities, while you may have noticed are lower than they were a few months ago, are still quite high, versus history when you compare to fundamentals. Very similarly, bond yields, you may have noticed they're substantially higher than a few months ago, but they're also still quite low, versus history. And just to back up, while not a perfect predictor by any means, even on long horizons, these things are a terrible predictor at short horizons. I don't think you should do much market-timing to begin with. But if you are going to do it, doing it purely based on valuation.
Antti and I wrote a separate paper that said, you may just have to wait, it does work over the very long term, but you may just have about a 60-year flat period. I have found clients can withstand a two- or three-year period of not making money or even losing money. I don't think I'd be very successful after year 59 of saying, “We've never lost for more than 60 years, so you should stick with us.” So we are in this world, the best guess—and I emphasize best guess—if a decade from now we're at the peak of a new bubble, or at the bottom of a depression, things will be either much better or much worse. This is just what the best guess with the current information. But the best guess with the current information is a decent lower return on a globally diversified portfolio of stocks and bonds.
Now the trick in my question, the place where I said I was a little deceptive, is that maybe the most salient fact, what to do about it? We like to think of kind of multiple possibilities, none of which are a fix. They're all an attempted risky fix. One of them is to do absolutely nothing about it. That's why I said it's a little tricky and deceptive because one of my options is to ignore it. I always joke, this is the Jack Bogle option. Things are expensive now, they'll be cheap one day, I'm bad at timing this, sometimes they're worth it when they're expensive, even if, on average, they're not. I'm not going to cause harm to my portfolio. So yeah, I wish things were cheaper, but I'm going to ignore it.
Another is just to take more risk. That's an odd one. Because what you're saying is the market is currently offering us less. Give me more of that. And when you say it in English, it sounds silly. Probably sounds silly in any language actually. But it doesn't have to be; there are plenty of investors who have a hurdle rate they have to make. And if they see this is offering me less, I need to make a hurdle rate therefore I have to do more, is not crazy. Obviously, this is self-serving because we have quite a few things that attempt to do this. But our favorite solution is to add things to the portfolio that are not simply betting on the market risk premium for either stocks or bonds. And I start to sound too commercial here because we have ours, long, short, or even market-neutral stock selection, trend-following, but there are many others out there, not AQR, that have some hope and some belief that you can find something that is not the exact same thing over and over again.
And you got to be careful because there are many things packaged as alternatives that are still kind of the same risk. On a lot of fronts, I love private equity. It's an asset class the world needs. Having said that, it's still equity. I don't count something as an alternative if it looks diversifying, because I just don't have to write the prices down when everything falls. My preferred solution, even if it's not one of our particular ways to do it, is to make the portfolio better, make it less reliant on just this.
The sad fact I'm sure you're all well aware of is these kinds of suggestions, grow in popularity dramatically after 2008, and after the last year or so. I promise you, we've been talking about this for 25 years, we think it makes a better portfolio. I think it is probably more important right now, just because if the basics are offering you less, an attempt to improve the portfolio is probably at least to some degree more important than normal. But I also admit that I'm a broken record. I'd probably be making the same recommendation under a vast variety of circumstances. I just couldn't tell you it would have the same urgency.
When it comes to the young, versus the middle-aged, the retired. We need one more category, because I think I'm right between those last two. First, I got to start with pure geek, academic theory. A lot of you probably took this class, where if you're very risk-loving, and you're very risk-averse, you're not supposed to own a dramatically different portfolio. One of you is supposed to lever the best portfolio and the other is supposed to delever the best portfolio. I'm drawing an efficient frontier on my hand, is it very clear? This and you have the tendency line. And we actually believe that works.
If you go through time, I wrote a paper on what's come to be called Levered 60/40 in the early '90s, saying, if people are saying be all equities, well, that's great; what you're really saying is be aggressive. If you levered a 60/40 portfolio to similar risks to all equities, you actually did about 1% better a year just because of the power of diversification. So, I don't think, within limits—sometimes leverage is not so feasible—within limits, I don't think the young, the old, and the middle should own dramatically different portfolios; they may be at a very different point on the risk portfolio. But I can tell you one way they differ is what they should be rooting for.
By the way, what you root for doesn't really matter. Because you guys may have noticed we don't control what happens in the markets. But I think it is interesting. If we're in this world that Antti lays out that I believe he's right about. There are multiple ways out of it. One, the most pleasant way is the economy real growth is just amazingly better than it has been historically. This may not be great for bonds but justifies the very high prices on equities and you actually do well. Unlikely we think, but you got to admit it's possible. If it's not the good solution, there are two varieties of the bad solution to very low expected returns.
One is they stay low forever. This is the new normal. You make less on average—that's the bad news. But there's no crash, that prices don't have to return to some prior mean, the mean reversion doesn't… Just because it's usually happened, doesn't have to happen. The world can change. Obviously, I've left the scariest case for last—prices revert rather quickly, to more normal. You get killed. You can't put it any other way in the short term. But in the long term, you are making more money on your portfolio. And there's the key where the young and the old might root for different things.
If you're a young investor, no one, I don't think anyone can actually do this. It's very hard to root to lose a bunch of money on your portfolio. But if you're a young investor, it's almost a certainty that a crash and a long-term buying and investing at much higher expected returns and lower prices is better for your ending wealth. If you've retired already, I'm sorry, you probably don't have enough time to make up a crash. I kind of snuck in an answer. I first dodged it by saying it's really not that different. But there is a substantial difference in what you want to see happen.
Christine Benz: Wanted to ask about value investing. You've written multiple times about the spread…
Asness: I have never heard of value investment.
Benz: You've written multiple times about the spread between value and growth stocks had got exceptionally wide. In other words, value stocks were trading at very low multiples compared with growth stocks. Update us on where that spread, or differential in terms of valuation, stands currently.
Asness: I just wrote a piece on our website. We created this thing, and I'm sure privately, people will look at things different. But I do think publicly, we were the first to do this, in 1999. I'm looking at the crowd. I won't point out the few of you, who I think, physically experienced 1999 and the tech bubble along with me here. There are a couple; you know who you are. But no period is exactly the same. But they do, in the old joke, rhyme. I think '99-2000 is probably the closest to what we saw in 2018 through '20. And then in the subsequent two or three years, which we're just starting now and back then. So, I think they are very related periods.
Value is getting killed. Given, I talk once every 20 years, I become value guy. I'm often momentum guy, because that's what I actually added in my research to the value world, and we've done fine for long periods of value underperformance when value loses for what I call rational reasons. If value loses because the companies underperform on the fundamentals, that's bad for a pure value investor. But we're not pure value, as most investors aren't. A lot of the other things we believe in—quality firms, fundamental momentum—can kick in and help you. When value loses, in what I will call a bubble… I used that word more than when I was a Ph.D. student at the University of Chicago. I was Gene Fama's Ph.D. student. So the word “bubble” still gets me nervous to say. I get more nervous in Chicago than if I say it on the coast. If I say it on the coast, I feel like the chance that Gene is just standing over there is probably smaller.
But in my career, I have moved, not all the way—I don't think markets are wildly inefficient. I think they're a wonderful way to allocate capital, certainly better than anything else the world has come up with. But I have definitely moved from near Gene to, don't ever tell Gene this, but probably closer to Dick Thaler and a behavioralist. They're never going to ask me another question, because they get to ask like three questions. Back up to '99, we wanted to come up with a measure with how insane is this? And this is important. That's why I'm talking about fundamentals. You can lose or win on value. On average, it gets cheaper and more expensive when you lose or win. But not always. If it lost because the companies performed horribly, or the growth companies performed incredibly well on a relative basis.
You don't have to get more attractive. Imagine you bought a stock because it had a low P/E. Don't buy a single stock on a single value measure, please, this is just a simple example. If the price fell 50%, a knee-jerk contrarian might go, “You got to pour into that.” If the earnings fell 75% on your preferred measure just got doubly as expensive. So, you do need to check even if you lose a ton or make a ton on value. Odds are it got cheaper or more expensive, but not definite. We built this thing to check. And sure enough, we compared the prices, compared with fundamentals of expensive to cheap stocks in various ways. And you guys have read these things—nine different ways to make sure you're not cheating and picking out the one way that makes your point. Good papers do that.
When you see a paper that only does something in one way, get very suspicious. We went back about 40 years from the late ‘90s never seen anything like this even in the Nifty Fifty’s kind of eras. And that's again, just like for the stock market—value is a bad timing tool. You don't say it's going to go up tomorrow because look, it's here. Well, yesterday it was here, which was the craziest we ever saw. And it blanked you again, next day. Excuse me, for my bleeped-out expletive. But that is how you feel on those days.
On a three-, five-year horizon, it's a pretty decent predictor, not perfect again. But if you're seeing gigantic spreads, we think it's a darn good bet. We built that, and we've kept updating it forever. By the way, we've not just updated it for crazy bad value periods. We've kept updating it in case value ever goes away. What might that look like? If the spread between cheap and expensive will always be there because you decide your measure of cheap if it's price/sales for you. Unless every company in the world is selling for the same price/sales. You can form a portfolio of expensive and cheap but if they averaged this much, sometimes it got crazy here and sometimes it got narrow to here. If they're here and stay there, you might say the game is over. Value perhaps was a behavioral phenomenon, and the world has figured it out and the pricing is no longer mispriced.
We've kept doing this for both reasons, for symmetric reasons. We got the bad draw for our value measurement from '18 through '20 this measure exploded as value did horribly. It didn't explode from 2010 through '17, which, many of you know, value is famously bad over that whole period since the global financial crisis. It turns out those first seven years are what I called a rational loss for value, meaning it was a bad period for value, but it didn't get very cheap. No one remembers this, because I've been such a value cheerleader for about four years. But in 2017, I was writing, it's not time to overweight value. It's lost a ton, but it actually hasn't gotten cheaper; it deserved to lose.
Last thing I was right about till about a year and a half ago. I had about three years of being wrong. And if I was really smart, I would have told people to short value at that point. I was not that smart. Very long-winded way, I had to back up, explain the whole measure to you. It hit in late 2020, maybe early 2021, kept going up a little even after the peak of returns. It hit a peak, this spread measure. What's the gap between expensive and cheap? It hit a peak well above the tech bubble peak. And here's an example of something I got dead wrong. If you said to me after the tech bubble, are you ever going to see something this crazy in your career again? I would say, “Everything comes back; somebody will see this again. But not in my career. This is the craziest thing in 50 to 100 years; the world's not going to do this again.” And I was right, they did worse.
As of now, the blog I wrote, which I think I started mentioning and then went off on a seven-minute tangent, was called “Still Crazy After All This Year-To-Date.” Paul Simon, he's before some of your time too. He's a singer. And the point is the fundamentals are actually coming in somewhat better for value. Also, we look at six-to-12-month trailing growth and all the things you'd like--sales, earnings, free cash flow, and value always trails growth, we don't see times where it's markets may not be perfect, but they're not totally crazy where the companies who pay much more for are actually worse. They are insufficiently better usually to justify the prices, which is why value wins on average.
But we are at a 25-year low in how much value is giving up on growth in fundamentals while that spread has come way down from the peak—to finally answer your question—to just below tech-bubble levels. There's no guarantee. We can have everything lining up—the momentum is behind value; it's still super cheap; the fundamentals are good. We can have a two-month snap back where half the bubble retraces. That's how markets work. If you go back and look at coming down from '99-2000 It was not a simple linear path, where every day the world woke up and said AQR is a little more right again. It doesn't work that way. You go through some pain even in good periods. But we still feel very excited about the chance to be in the value trade more than we normally are. And one day we won't be the value guys, again, we'll be the multifactor guys with value just a cog in the wheel. But given it's still supercheap versus history, momentum is behind it. And it's actually giving up less on the fundamental side than normal. We're excited about it.
Ptak: Cliff, you mentioned this possibility of what you call rational underperformance or there being an argument, perhaps in certain circumstances, there should be a spread between value and growth. Your team had done some work that examined whether values' relative cheapness that spread—you had mentioned earlier—could be explained by poor fundamentals when compared with expensive firms. How did they go about answering that question? And maybe update us on how that picture has changed over the past year?
Asness: Multiple ways. One I just referred to, they actually did look at these trailing six- and 12-month growth in all the good things you want in a company measure and back then they found it was about average. Meaning value gives up some, but no more than usual and the prices were very unusual. They also looked at still trailing but not changes—things like general ROE; gross profitability as a ratio; how efficiently you're generating. And there again, there was nothing abnormal; if anything, it looked a little better, for value. I got to be careful—better for value here means less worse than normal. It's not the way regular humans use the word "better." If you update that today, and you're going to feel like I'm gilding the lily here, but it's a little stronger. That graph is a little more dramatic in values' favor, which to continue my terrible sentence, means it is giving up some trailing and we think prospective measures of quality and growth. But it is less, considerably less bad than it normally is. While again, we have those prices here. Again, you can have, we all have learned this at some point: You can have everything you love in the world lining up for a trade, as it is now for value, and still have a two-month period where you feel like you've just reentered hell.
I pray no one times to the day with my comments here. My compliance area praise, no one times to the day with my comments here. But on a reasonable time horizon of a year to three years, we're very excited, and that's a big part of it. If right now value spreads are out to here, but you are giving up way more on the fundamentals than normal, you still might like value, you still might make a judgment that that's not going to go on forever. And the markets are overpaying for it. But you have to do a gut check at that point. There's a much clearer trade off: I'm getting super cheap prices, but I'm buying into a fundamental Armageddon.
Right now, it seems like you're getting a little of everything. I have not looked yet today. I try not to look before I publicly speak, because then I start checking wall on the podium or table. But I have probably doomed value today with this comment by just saying everything's lining up for it.
Benz: I want to follow up on Jeff's earlier question about life stage and retirement in particular. This specific environment of stock markets selloff, rising bond yields, high inflation. You touched on the implications for retirees, but I want to delve into that a little bit more. You mentioned the role of alternatives, potentially. What other strategies should pre-retirees and new retirees be thinking about in what seems in a lot of ways like a catastrophic environment?
Asness: I think for the average retiree—and this might be an unpopular answer—they want to do less, not more. The key, which is easy to say after the fact, is to have thought about these kinds of things. What we're going through now, is not unprecedented, by any means, particularly for markets. It's certainly an ugly period. But there have been far worse periods. So not to be obnoxious about it, but if you're knocked off your plan, by this period, your plan was not a good plan. So, most of this stuff is about work upfront, reasonable scenarios of what we might have to live through. And knowing I'll stick with it through that scenario. That's way harder than it sounds. I'm sure you've experienced this many times. You could show people, what if you're down this much? And they're looking at the long-term graph, and any long-term graph of a gain, the wiggles in between you look at you go, "That one didn't bother me at all." Because you see where it ends up, that wiggle was down 27%. And
by definition, a fair amount of people got out at the bottom.
Coming up with worst cases you can tolerate, it's a little bit of method acting. There's no quantitative way to do it with certainty. Sometimes people look at the worst case that has ever happened. That is certainly worth looking and I'll always look at that. You know that's not a perfect estimator of a worst case. Because this is another terrible English sentence, but I'm going to say it anyway: the worst case was not the worst case until it happened. Therefore, if you were using that model, you did not anticipate the worst case. So worst cases are a little bit of art. You can't go way too far the other way, because then you're paralyzed to do nothing. If I invest in stocks, what if they lose 100% in a day? I have to be willing to bear that. You're probably not going to invest enough in stocks if that's your work. So, there's art not science, but setting up a portfolio that is reasonable and including, and this sounds like lecturing, but including some of these alternatives. Again, they certainly don't have to be AQR’s; there are other ones that are long and short, trying to make money from maybe a risk premium or behavioral aspect that's not just the market going up. Trend-following, which, on average, makes money, but seems to do particularly well in tough times.
Trend-following came under a lot of fire for four or five years. And surprisingly, now is back in vogue. I don't know if I'm ever in vogue. That's way too hip a word for me. But what we should all strive for, is to like or dislike. Someone can disagree with me, but like or dislike things like uncorrelated alternatives, trend following, as much after a five-year bull market as we do after a one-year bear. Now, if you haven't, and you've had a portfolio that has none of these things, and you took too much risk, I'm not looking saying, “You screwed up, it's over.”
There is always more time. One lesson is, a lot of us look at things and just go, “I missed it.” And so often, that's not the case—things keep going for longer than you think. Again, I'm talking my book here, but the value trade, you can feel like you missed it, because it's up a ton. But it's still priced at 1999-2000 level. I think it would have been better, of course, to have this all in place beforehand. But if you've not thought through what you can stick with, you do have to make a change that's painful because you're not getting that back. But if there are diversifying alternatives, we can't predict those very well ourselves just because they've worked for a while or not worked for a while. We think they should just be in the portfolio.
There's still time to do that, but the time to do that is all the time. Not now, I'm not really good on what should investors do right now, except in the sense that I go, “I'll answer that, but it's also what I'd say they should always do. With that, sell everything.”
Ptak: Maybe to build on Christine's question…
Asness: One sec. They know that was a joke?
Ptak: I think they know that was a joke, yes. To build on Christine's question, how do you think investors should think prospectively about the role that fixed income can play in the portfolio? Obviously, yields are rising. And so that makes bonds more inviting, in a way, but they're still challenged, given that rates are quite low by historical standards, and bonds have been selling off.
Asness: I'm going to make a weird connection here. Fixed income and asset allocation is very similar to low risk, high quality, low beta stocks. They don't help that much in a portfolio that for instance, won't lever at all. Like that solution, I told you is the academic solution, certainly not to a portfolio of an investor who wants to be aggressive. If you want to be conservative, yes, they can help a lot. But if you're unwilling to say lever, if you're in the individual equity world, you're supposed to own the market portfolio and lever, but you can't. So, what an aggressive investor will do is sell low-beta stocks and buy high-beta stocks.
That's fine. Well, it's not fine. It hurts them a bit. And it causes high-beta stocks to be, on average, overpriced, and low beta stocks to be, on average, underpriced because they're orphans, low beta, if you're unwilling to lever, they make the Sharpe ratio portfolio better. But the old criticism, which I both don't like and admit is true, that you can eat Sharpe ratio, you actually can if you lever it or do something smart with it, but you certainly can't eat the Sharpe ratio of a lower expected return, higher risk-adjusted portfolio. In asset allocation, bonds play very much the same role. Bonds are not useful for an investor who won't apply any gearing to their portfolio and needs to earn a very aggressive return. They have to be in equities.
An investor who is conservative is more than willing to listen to the academics and add cash to a diversified portfolio. There's nothing scary about that. So that leverage aversion makes bonds a little bit of an orphan. Only certain investors, not the whole market—the whole market is supposed to own, in theory, the diversified portfolio of everything. And if there's a segment of the market that won't, and a segment of the market that will, whatever the bias of the ones that won't, makes the thing they don't like underappreciated, undervalued, and so we do think on average over the long term. This will sound crazy, given where we are today is not a tactical view, bonds make a little bit more than they should. They should be a lower Sharpe ratio asset to stocks, and they're actually about equal, which gets into the risk parity world, a whole other thing.
So, the role for bonds going forward, even this will sound really stupid ex-post because it sounds like we got it wrong. I'll argue it's not quite a fair. I'm actually now arguing with myself within the answer. But we have written that even when bond yields were 1%, you may have noticed, they can now go negative. They still played a diversification role; they certainly didn’t play it very high expected return role. But 3%-ish yields, there is upside and downside. We do think they're about as historically expensive as stocks are. That's not good news, because that makes the portfolio of the two of them even more historically expensive, because they're not usually so expensive at the same time.
But the advantage to diversification over a lower base… If we're right, if Antti's book turns out right, we're all going to make less over the next decade. If the depressing thing turns out to be accurate. But the advantage of diversification should still be there. This mathematical relation that owning a little bit more of both, and even if they are not their negatively correlated selves that they've been for a while. As long as they're not very highly positively correlated, you build a better portfolio. So we do think bonds still have a role, maybe an underappreciated one. But I will tell you in our portfolios, which are a subset of what we do, we don't take a lot of market directional opinions. But for instance, in trend-following, even in some others, we have a tactically negative view on bonds. Very different and do they play a long-term role in the portfolio? So with all that extolling that the role is still there, I do want to admit that today I'm betting on yields going up. Are they going up today? Does anyone know? Again, I try not to look. OK. Something good came out of this talk.
Benz: I wanted to ask about ESG investing, which is the theme, I think running through a lot of these sessions at this conference. You've written about the mechanism by which ESG investing can effect positive change. It relates to preferences, cost of capital, hurdle rates, and the projects that firms opt not to pursue. Can you explain that thesis?
Asness: This was not my most popular piece. And I thought it was actually pro ESG. Because I thought I was explaining how ESG might really change the world. And I say might because no one's really done a good job of calibrating the size of these effects. But I do think a lot of ESG investing, and here I'm talking about the form that doesn't own or owns less of, or even in our case, shorts, "bad guys," There's another form of ESG, I'm not going to touch on, that's about engagement, where you are an owner of a bad guy, and you try to make him into a less bad guy.
You may notice one form of ESG here underweights or shorts the stock, and the other form has to go long the stock because you don't get a lot of influence over say, a board, if you don't own the stock. These are not as mutually exclusive as they sound. Some people can pursue one, some can pursue the other, but let's deal with the most popular form of ESG that says we're going to define somehow, and I'm leaving that undone here, the bad guys. And we're going to tilt the portfolio away from those bad guys, either with a complete divestment, as far as we go is shorting. We feel very strongly shorting can play a role there. But even underweighting, it can be a factor in what you do. I want to own less of the bad guys, but up to a point, I don't want to take more than this risk.
Question for a lot of those people, and I think a lot of people, frankly, just haven't thought about it is, “This feels good. Feels like I'm doing the right thing. But how am I actually changing the world?” Got to remember. And again, I'm not telling them what their goals should be. I'm not a commercial for this. I'm not criticizing it, I'm taking it as a given that my client's goal is to change the world. How do their actions do that? Well, if you—and it's much better if it's a lot of yous—one person owning a little bit less of something isn't going to change, but if a decent amount of the market owns less of, won't own, or even shorts the bad guys, markets have to what's called clear; somebody else owns those stocks. And they own more than they wanted to before this. If my two friends here are really nice people who won't own any of the evil stocks, and I don't give a damn, I just want the money.
I own as many evil stocks as I think is optimal. Now they want me to own more because they're selling theirs. I say—because I'm the evil guy, remember that—I say yes, sure, but there's a price. I'm not going to own it at the same price or expected return going forward. Because the opposite of a price is an expected return. You have to induce me to be undiversified to take a bigger risk in being concentrated in what you don't own. There's a really painful part of this that makes if I'm right—and I really, really am, just to be clear—I don't know how big the effect is. That is still being fought over.
But if we are right about this, the expected return on the bad guys is now higher, because that's what the bad investors demanded to be in. And that is a painful thing. If you're an ESG person, it's not fun to know that the people who are taking the other side make more. But what does it mean to have a higher expected return? Well, I know a lot of you took these classes in an MBA program somewhere. The opposite of an expected return is a cost to capital. When you sit there with your spreadsheet, with your negative cash flows up front, turning positive at some point and then getting very big positive because you love this project, and you discount it back at some discount rate. And if it's a positive NPV, your teacher says you should do that project.
Well, quite simply, if the discount rate or expected return is considerably higher, you do fewer projects, you don't do fewer projects because you suddenly become a good guy. You do fewer projects because fewer can cross your hurdle of what you need to make to add value to your company. So that's how you affect the world. The bad guys face a higher cost to capital and make less and do less. There are people in the ESG world who hate this story. Because I think, and I'll be very frank with you, I think too many people in the ESG world have sold it as: you will do wonderful things and feel wonderful, and you'll make much more money. Who doesn't want that? It may be true in the short term, if you view ESG as a trade. By the way, there's nothing wrong with saying, I think there's going to be a big movement to ESG. So, at this point in time, I do think ESG is going to overcome this discount rate effect and make more money. Because that's flows-based argument.
The cynical side of me, which is actually both sides of me, says that very well might be true. But the bad people would do the same thing as the good people there. Because if they agree on the facts, they place the same bets, that means you're doing the trade to make money. The title of this piece was a little condescending, I admit, it was “Virtue Is Its Own Reward.” It's like you shouldn't be expected to be paid tons of extra for doing the right thing. In fact, I think it is actually a very small give-up. I really doubt it's a very large one. But you may even have to give up a small amount of expected return to change the world. That's the argument. And now everyone hates me.
Ptak: I wanted to shift to another topic that your team has written about, which is taxes. They've done some interesting work on how to tax-optimize investing. On the stock side, I think their position is that it makes sense to separate alpha from beta. Can you explain why separating alpha from beta in that fashion is tax-efficient?
Asness: There are a lot of neat tax results. That's one of my favorites. We're not talking about things like, move your money to the Cayman Islands and try to have them not repossess your yacht along with the oligarchs. No, we're talking about things, old-school things: don't sell a winner at 11.5 months, sell it at 12.5 months, because no one knows what will happen over the next month. There are a lot of things—that's the canonical example—there are a lot of small, smart things you can do. This one, though, you have to be able to have a non-traditional portfolio, but it comes out pretty big. And my colleagues have written a paper on this, if you're interested in following up.
Take traditional active management, long stock portfolio, where you're roughly fully invested most of the time, but in a portfolio that trades and you're trying to add value. And let's even assume you're good at it. Let's not be cynics and say there's added value here. What do you pay taxes on? Well, you pay a fair amount of taxes on the general market appreciation. If you're a pure index fund investor, you don't have as good a pretax return as this person with the alpha, but you also have a near zero, very low tax bill—not quite zero, often there are dividends and whatnot—but you have a very low tax bill.
If the active portfolio, as it rebalances. If a market on average goes up, which believe it or not, it does still on average go up, even if it doesn't go up very, very much lately. Then on average, you're still selling winners and paying taxes. So, in effect, you're paying taxes on the near tax-free part of it on the index exposure. If you separate these two, and into a long-short portfolio, where you're long the things you want to overweight and short the things you want to underweight and an index fund. You pay very little taxes here, and you only pay taxes on the alpha here, not on the appreciation of the market. And, again, you'd have to have your assumptions. If your alpha is massively negative, you should just be in an index fund. This won't save you.
No matter what your alpha is, it is a much better solution than the traditional one. Not everyone can do it, you have to be willing to invest in these, you have to avoid certain pitfalls. One of your portfolios is now a market-neutral, long-short portfolio. So, you have to make sure you didn't invest in a crazy one. Because your index funds rarely go to zero. These fellas occasionally, you discover they actually borrowed 17 times more than you thought they did. These are rare exceptions, but you do have to put a little more due diligence into this. And you have to make sure you're not paying an egregious fee for this.
I've said a long time ago and I've even gotten a few people to repeat it but it's not catching on like I wanted. If I get an economic law named after me, which appears unlikely at this point. And if I do get one it'll probably be derisive in some way. But if I get a good one named after me, it will be there's no investment product so good that there isn't a fee that can make it bad. So even if I'm right, if you find this market-neutral product and the tax benefit is really there and really big. If you pay two and 20 for something that’s not worth two and 20… You do have to dot the I’s and make sure… And there's going to be more due diligence on that. But the effect is, again, I'll refer you to the paper. But the effect is pretty large for a taxable investor over the long term. And again, there are a lot of other things of that nature. Not tricky stuff. Just you're allowed to do this, why won't you structure your portfolio this way?
Benz: One quick one, I wanted to hit on.
Asness: You haven't learned I don't do quick ones.
Benz: I'm hoping you can hit this one really quick. Your team did some research…
Asness: Those are my two guys leaving. I know, but come on. It's going to be a groundswell now, and it's my guys who started it.
Benz: Your team did some research about dividend payers and where to hold them and conventional wisdom on that is keep them out of your taxable account because they deliver these dividends that you're paying taxes on. They issued the counterpoint that they think that they're actually OK to hold within a taxable account. Can you summarize that research?
Asness: Not particularly well, except that it's one of the more counterintuitive results you will find. It has a lot to do with when you can trade things and how you can trade and when you ultimately have to pay the taxes. But I will confirm, you're right, this is not as big a deal as something like take the alpha and put it separate. And that is actually a very big deal. But all else equal, let's just say where you put the dividend payers are less important than people think, particularly if there's a total return difference. If the dividend payers are correlated with value, shunning them certainly can be more costly than the tax benefit.
Ptak: Wanted to shift and talk about private equity, which you mentioned earlier in the conversation. I think you and your team have put forth the idea that investors and private securities don't actually stand to earn an excess return compared with public securities, if I'm not mistaken, but instead they must accept an illiquidity discount, that discount representing the returns that they forego in exchange for the lower volatility private securities tend to exhibit. Can you explain why investors would prize lower volatility so much that they'd overpay for it?
Asness: First, you're probably right in what I actually think. But in the piece, I was a little more careful. It was a conjecture. I don't actually know where it comes out. And I'll explain, but I'm pretty sure I know the direction. So, imagine, and this is going to be too clean of a story. It's always a combination. But imagine 25 years ago, a private equity investor was about the returns in the alpha. Well, to get those returns in alpha, they generally own—this is a broad generalization; it won't apply to everyone—but it's not uncommon to have a decently levered portfolio of small- and mid-cap stocks. They are illiquid firms, by definition, they're privates. You have to have a buyer by appointment with lots of lawyers and whatnot. The fund itself is illiquid to its investors. Pretty basic theory, or even common sense, would say, well, illiquidity is bad. I should get a premium in return for being willing to accept this illiquidity.
And then everything's copacetic. I get paid a little for it, though, if I really need the money, I'm in more pain, because it is an illiquid asset. So, I'm taking a risk to get it. I do think over like the next 25 years. And again, it's not necessarily clean, even 25 years ago, people might have been thinking about this. But there are two other properties to private equity. You can't sell it. There's a secondary market sometimes, but you'd get your face ripped off; you mainly can't sell it. And even more important, very rarely, and at a big lag and not as extreme as it should be, do they market to market. It is really easy to live with. I resent this highly. It's a mathematical fact that I resent. And when you resent mathematical facts, you're tilting at obvious windmills, but call them levered mid-cap. They move around like crazy.
I have a story I'm going to make you listen to. It's short. This is 1997. Some of you weren't born. I'm aware of that. We had something called the Asian debt crisis. It was one of the more minor crises in 30 years of a lot of crises, but the S&P 500 was down 7% in a day, and that was after a fairly long, calm period, so it felt even worse. I was at Goldman Sachs at the time doing early precursor to what we do today. The head of Goldman Sachs, Jon Corzine, went on to be senator, governor, and then had a tougher time in a different role, but great guy—came by, looked at our screen, and it said, we were like up 5% in this market-neutral thing we'd only been doing for a few years. And that would be great, because we were making money in a bull market. It's not that any one thing proves anything, but it’s kind of an acid test—markets way down.
Unfortunately, he was looking at the screen, which we knew was wrong. The screen was wrong, because one of our big trades at the time was short the U.S. and long Europe. It was late in the day. Do you know how to look really smart? Be short a market that's crashing and long a market that's closed. Your P&L system looks wonderful. We had actually done guesswork—what if it opens up moving with its beta tomorrow, similar to the U.S. and we said we'd be about flat, which we thought was a home run after making money. But you can't take a man from up 6% to flat and have him still be happy. I guess it was probably the best thing he had going that day. And he was like, “Yeah, flats OK, whatever.”
Then the head of our private equity comes by, and I'm manning the screens now. So, he says, “How you doing?” And I say, “We're flat.” And he says, “Oh, that's great. Me too.” And I go, because I was shy and understated, even back then. I said, “No, you're not.” He said, “What do you mean?” I go, “If you had to sell your whole portfolio yesterday, I don't mean a fire sale. But if you did it, if yesterday was the sell date, versus today, wouldn't you get way less today? Again, aren't you leveraged stocks, and don't they just move the multiples with the market?” And to his credit, he said, “Oh, way less. But we don't have to sell today. And no one's writing the number down.” And that was my first experience with going a) This is kind of crazy. They're not less volatile than us. They just don't tell you about it. But b) To be nice to them. If the investors are doing it with open eyes, just because it makes them better investors, it can long term add to their welfare. If there was a way to invest in AQR where we only told you the results every 10 years. And you couldn't get out anyway in between? I think we’d do better for you. I think every manager thinks they would do better for people if they had that deal. But I think the reasons are obvious. Doesn't exist. It turns out every like five years, someone at our firm says, can we build something like that?
And it turns out that if you actually can look up the prices to the second on Bloomberg, it is quite illegal not to tell people about that. But if you can't look them up, it is kind of an out. And if you talk to people in the institutional world, investing in privates, or the private equity managers themselves, if they're not doing a public presentation, and if you have at least two drinks with them, I don't golf, but they all golf like crazy. So maybe after 18 holes, they'll tell you this is true, that people really value this ability to hold it, which really amounts to I can't see you, I can't hear you. It is, again, volatile, you just can't see it.
I'm finally getting to the answer. If people are valuing this property, remember, this is a property we used to think was a negative, you can't have the money back when you want. It's illiquid. And we can't even tell you what it's really worth. If that was a presumed negative, you needed to be paid extra to bear it. And again, I don't know how far this goes. So, I'm not willing to say it's now much worse, but directionally if now a big part of why you want a lot of privates is they're easier to live with, well, if that's a good property, you pay for good properties; you get paid to bear bad properties. So if you go again, it's anecdotal. It's not great data on private equity.
Private equity managers will tell you, there used to be three people looking at every deal. There are now 15. And the IRRs, which look at the world a little different, are considerably lower, even compared with public markets than they used to be. So, I am never 100% confident but I'm very confident we're right in direction. That privates are being more prized today, at least on a relative basis compared with the past, for their hiding of the risk. They're hiding with open eyes. No one's really being fooled here but their ability to hide the risk. And if that's true, people used to be paid a premium. And they're now giving up something to be in it versus the similar aggressive equity portfolio.
By the way, it could still be the right call for these people, if it allows them to take considerably more risk, even if they have negative alpha to the public markets, if they can take more risk on average, and stick with it, and not sell it at a terrible time, they could still be right. But it will still irk anyone, and I'm assuming many in this room who have to mark their portfolio to market every day. I'll tell you AQR had a terrible '18 through '20 and a wonderful last year and a half. And if we were private equity, none of it ever happened. We just well marks were a little bit lower at the end of 2020. But it all came back, and, nothing to see here.” So, with everything I say about privates. I do think I'm right. But you should discount a little bit by my professional jealousy of the deal they get.
Ptak: Well, Cliff, this has been a treat. Thanks so much for joining us…
Asness: I really enjoyed this.
Ptak: ...for this live recording of The Long View.
Asness: Thank you.
Ptak: Thank you so much.
Benz: Thank you so much.
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