Eduardo Repetto, Ph.D. joins us for Episode 43 in our Bogleheads on Investing Podcast series.
Eduardo is the Chief Investment Officer (CIO) of Avantis Investors, where he is responsible for directing the research, design and implementation of investment strategies, and has oversight of the investment team managing over $10 billion in factor-based ETFs. Prior to Avantis Investors’ establishment in 2019, Eduardo was Co-Chief Executive Officer, Co-Chief Investment Officer, and Director at Dimensional Fund Advisors (DFA).
Dr. Repetto earned a Ph.D. degree in Aeronautics from the California Institute of Technology, an MSc degree in Engineering from Brown University, and a Diploma de Honor in Civil Engineering from the Universidad de Buenos Aires. He is a Trustee of the California Institute of Technology and the recipient of the William F. Ballhaus Prize from the California Institute of Technology for outstanding Doctoral Dissertation in Aeronautics and the Ernest E. Sechler Memorial Award for his teaching and research efforts.
In this episode we discuss his career, the migration many Ph.D’s make from engineering to investing, his time at DFA, and now at Avantis. At the center of the discussion we examine factor investing, and primarily small-cap value investing. What does the past data say, what’s going on today, what’s the competition, and does it make sense to consider this niche part of the equity market for a slice of your portfolio.
You can discuss this podcast in the Bogleheads forum here.
Rick Ferri: Welcome everyone to Bogleheads on Investing Podcast Episode 43. Our guest this month is Eduardo Repetto, Chief Executive Officer (CEO) of Adventis Investors and former Chief Investment Officer (CIO) and Chief Executive Officer of Dimensional Fund Advisors (DFA)
Hi everyone. My name is Rick Ferri and I’m the host of Bogleheads on Investing. This episode, as with all episodes is brought to you by the John C. Bogle Center for Financial Literacy, a 501c3 non-profit organization that you can find at boglecenter. net. Your tax-deductible contributions are greatly appreciated.
The Bogleheads investment philosophy is to keep it simple and that usually means starting a portfolio with a total stock market index fund, a total international index fund and a high quality fixed income fund of some type. For most investors this is all they need to achieve their financial objectives. Sometimes I’m asked, “What’s next? What’s beyond a total stock market and a total international?”
And my answer is if you wish to take a little extra risk in your portfolio for the potential of a higher return then look at small cap value investing. But not just any small cap value fund, or any small cap value index fund. You want a fund that’s low cost and highly concentrated in small cap value companies. The company that pioneered small cap value investing using concentrated factor strategies was Dimensional Fund Advisors, more commonly referred to as DFA.
Eduardo Repetto, our guest today, was Chief Investment Officer and the Chief Executive Officer of DFA until 2017. Then in 2019 Eduardo joined Aventis Investors, a new company by American Century Investors, where he became the CIO, and continued to refine factor strategies for their ETFs [Exchange-traded funds], mutual funds, and directed accounts.
Whether you believe in this or not, or whether you want to include it or not, this is a very interesting discussion, as we go behind the scenes with one of the brightest minds in the industry. With no further ado, let me introduce Eduardo Repetto. Welcome Eduardo. I really appreciate you coming on Bogleheads on Investing Podcast today.
Eduardo Repetto: Oh it’s a pleasure. It’s always a pleasure to speak with you.
Rick Ferri: Thank you. We kind of go back a ways. I can remember being in your office at DFA pleading with you to start ETFs at DFA.. That was a few years ago.
Eduardo Repetto: That’s probably ten years ago or something like that. I remember well.
Rick Ferri: It was a while back.
Eduardo Repetto: Yeah, yeah I remember.
Rick Ferri: Anyway, now both DFA and your new company have ETFs. So before we go down that road let’s talk a little bit about your very interesting background. Go back as far as you would like to tell us how you got to go from where you started to where you are today.
Eduardo Repetto: So yeah. I have a weird background. The first thing is I was born in Argentina. Argentina, you know, was a developed market. It was an emerging market, it was a frontier market. And I don’t think that this is a frontier market anymore. It’s not even that.
So, but I was always a geek. So like in numbers and whatnot. I studied engineering. Then I got a master’s at Brown in engineering, mechanical engineering. And then I got a PhD from Caltech, here in California, in aeronautical engineering. Yeah.
Rick Ferri: Let me interrupt you because you didn’t just get a PhD. You won the Ballhaus Prize for the best PhD thesis of the year1. I mean you were a prodigy.
Eduardo Repetto: But you know sometimes you have to be lucky in life. Let’s put it that way.
Rick Ferri: Okay all right. Can be modest too.
Eduardo Repetto: Yeah I was lucky. Look, I had an amazing advisor and I was in an amazing school. And so look, this was a long time, back in ‘98 I finished my PhD. So I was doing things that were extremely interesting, yeah. But my heart was not to continue in academia.
I used to have a boss a while back. He was a mathematician, a PhD in mathematics. And he went to research in mathematics into Wall Street and he always told me,”Hey you will like this.You will like investing and you will like the whole environment and the cutting-edge science. Because a lot of the things that we study in science are very applicable in investment.”
And so I always have that back in my mind. And so I have the opportunity to switch instead of continue being in academia and become a professor and whatnot. And I switch, and so I move into finance, and I got a job in DFA in the research group.
Rick Ferri: How did you link up with DFA?
Eduardo Repetto: That’s the most weird thing. A lot of things are random in life. So I was at Caltech and DFA was looking for someone to work in research with Ken French and Gene Fama and I apply. And, you know, you apply and you cross your fingers and I was lucky enough that they hired me. And yeah, DFA was small. I think that was employee 107, and I think that at the time DFA had around 25 billion.
It was a great opportunity to work with some magnificent people in a small company where you were able to get involved in basically all the different aspects, not only research, but the legal aspects of what you were doing, in portfolio management, the trading aspect, the marketing aspect. So it was a magnificent opportunity. I was lucky.
Rick Ferri: And interesting though that DFA would look at you given your background. I mean clearly, the forward thinking of the David Booth and Gene Fama, Ken French who were both on the board of directors there, decided with you with no financial background really, that you were the guy who they’re going to bring in and they kind of overstepped all the PhDs in economics.
Eduardo Repetto: Well I don’t know who else was applying to be fair. Yeah I think you’re giving me more credit than I deserved. Look, I was living in California. My wife is from California and the job was in California. So it was a perfect match for me and I was very, very lucky about that and I was extremely lucky to work with the talented people like you mentioned. It was like doing a second PhD when you start working with Ken and Gene because you have to read and read and read and do research and–but that’s what you are trained when you do a PhD from a top university– no matter what the field – the training is training how to learn, how to get to the cutting edge of the science and then try to push it a little bit more. That’s a PhD program, and so working with these professors was basically the same. Get into the cutting edge of the science and then try to help pushing it a little bit forward. And that’s what I was doing.
Rick Ferri: And by 2007 you became the Co-chief Investment Officer with David Booth at DFA. And I think I’m not mistaken, that’s probably when I first met you back then about 15 years ago. And then in 2009 you became the Co-CEO and at this time wasn’t DFA moving to Austin?
Eduardo Repetto: Yes, DFA opened an office in Austin, I think 2007. Yeah, and so I told my wife let’s move to Austin. She agreed so we went there. We have three kids. So I became– I was CIO and then became Co-CEO with David, it was a great honor, no?
Rick Ferri: Sure, absolutely. And you got on the board of directors and, you know, you became a director of the mutual funds. But then in 2017, I heard you use the word “retire”. I heard you use the word “resign”. I mean you decided to leave.
Eduardo Repetto: Yeah, yeah, yeah. So my wife is from L.A., no. Her parents are here in L.A., and so in 2015 before my oldest one started high school. The family wanted to move back to L.A. because the grandparents are not getting younger, let’s put it that way. And if we were staying in Austin we would have to stay there at least for another ten years because we have three sons and we didn’t want to move kids when they are in high school.
So the family decided to move in 2015 to Los Angeles and so I was going back and forth to Texas on top of going everywhere. I was putting 250 thousand miles a year between going to Texas, going everywhere around the world. So you see it was probably not the right balance, and I was never home. Never seeing the family. And so it was not the right balance.
So I basically resigned without any job in mind. You can call it “retire”. It was not a permanent retirement I guess.
Rick Ferri: Well you started doing research. One of your papers on value and profitability and international and emerging markets that you co-wrote during this period of time2. But around the same time as it was being peer-reviewed and published you then decided to take a job with Avantis which was a new company. Now did the company form because you were coming on board? And did it form and then you came on board?
Eduardo Repetto: So let me speak a little bit about how that happened. I was not working, but like when you work a long term in the industry you get to know a lot of people and people have magnificent ideas, and some people at American Century Investment, you know, in Kansas City that I know them for a long, long time. They wanted to start something new, something that is more systematic, low cost, because there is a big need for something like that in the market. And they reached out, if I wanted to help them and they were willing to do it based in L.A., where I live.
So that’s great and one of the things that I have as a condition is that the investment strategies, let’s call funds ETF, what they were going to be, they have to be low fees. That’s what they wanted. They wanted to start something systematic, organized from day one, so that you have all the checks and controls on costs, so you can be low fee and still have a very good business.
So I agreed to work together with American Century and start Avantis. So Avantis was going to be a standalone company where the people in Avantis own a piece of that and American Century owns another piece of that, yeah. But we decided not to do that.
Why? Because that was going to impose more costs and that was going to make us have higher expense ratios. So what we did is we created Avantis as a unit inside American Century. So I’m an employee of American Century but I have a business card that is called Avantis because we manage money different than the traditional American Century manager. I report to the CEO of American Century. So we’re a unit that is a little bit outside of American Century but we are part of American Century.But all our operations, legal, compliance–think about all the support functions that you need to have a professional asset management company–are done by American Century personnel.
But all our operations, legal, compliance–think about all the support functions that you need to have a professional asset management company–are done by American Century personnel.
Rick Ferri: Where is the trading done? Is it done through American Century or are you doing it on your own?
Eduardo Repetto: Depends on what – you know when you do ETF– you know a lot of the trading, this happens in kind, in and out– so if that’s the part, we do it on our own. Whenever we need to trade stocks we work with American Century trading desks that segregated our trades in a different way of trading that we think we don’t have to demand liquidity to trade and we can be very efficient.
Rick Ferri: And you have different products. I mean most of your money, I believe, is in ETFs but you also have traditional mutual funds and you have private individual accounts. But can you break that down? You’ve got about 10 billion under management right now, which is great number just getting started over a couple of years. How much of that is ETFs? How much of it is mutual funds? And how much are private accounts?
Eduardo Repetto: The vast majority of the money is ETF and why that? Because for most investors an ETF is a better vehicle and you know that.
Rick Ferri: Well I know that, but why do you know that? That’s an inside joke, by the way, between Eduardo and me. So it goes back a long, long way because I spent years trying to convince Dimensional Fund Advisors they should have ETFs.
Eduardo Repetto: Both of us know that ETF is by far a better vehicle not only because of tax advantages but also because you save on costs of different time. For example, in certain cases you don’t have to pay some taxation when you buy securities, like stamp duties when you buy securities in other countries. So ETF, it’s a much better vehicle.
But for some investors–let’s think about 401k plans – the ETF really doesn’t work because the operations of a 401k plan is different. So it works for the broker’s window but not for the default options.
Rick Ferri: Correct.
Eduardo Repetto: Our goal is to try to help everyone with the right vehicle. We have no biases.
Rick Ferri: But I have looked at the performance of an ETF and a mutual fund, same strategy. The same – might be small cap value, large cap value, whatever it is – where you have an ETF and you have a mutual fund and there are slight differences in return between them, yeah. But the fee is the same, so maybe you can explain why that is?
Eduardo Repetto: Yeah, yeah. That’s a great question. If you were running an index fund and you have pre-described holdings so you have securities and weights in both of them the performance probably will be the same with small differences. But if you’re running a strategy that is trying to use today’s information, the performance will be slightly different between both.
Why? Because a lot of the trading that happens in the mutual fund happens depending on where, when the cash flows come. You know. If you give me money today I’m going to invest in the securities that are great to have in the portfolio today. But if I don’t have money today, I have money tomorrow, I may have to wait for tomorrow to do so. You have the regular trading and rebalancing but you have an effect of cash flows that forces more one direction than another. It’s more.
In a mutual fund, you always have to carry cash. Why? Because you have a redemption in a mutual fund, I have to have cash to send it to you tomorrow, yeah? And I cannot sell securities tomorrow to raise money to wire on the same day because settlement of those securities is two days later. So you have to carry cash in the mutual fund. And not much, but you have to have recent cash. If that cash that you carry is not enough, you have to hit the line of credit in order to be able to wire the money.
So even though the strategies are the same there are small differences in how you have to manage them in order to deal with the different settlement of clients’ transactions, yeah? And if you think about that, the ETF is way more efficient because the ETF, when you purchase an ETF I receive securities in time. So I’m always investing, and when you redeem you receive securities in kind, so the long-term shareholders don’t have to bear the cost of the redemption.
So there is always going to be a difference in performance between the ETF and the fund but those differences should be small. Now when can those difference become very big or bigger, let’s call it when the market moves a lot? If you have day the market moves ten percent and you have a purchase here, it represents one percent of the fund or two percent of the funding cash flow, well that money is not invested until tomorrow morning, so the market move ten percent, right there you can see that you have 20 basis points in difference in performance because you are carrying cash overnight.
Rick Ferri: And it’s not your cash. I mean generally if the investors are renting for the long term, it’s not their cash that’s causing this, it’s some other investors’ cash that’s causing this.
Eduardo Repetto: Yes. No it’s not the long-term investors. In an ETF the long-term investor is kind of protected from the actions of people coming in and out. In a mutual fund, no. You are commingling, and cash is coming in, cash is going out, so you are exposed to the actions of other shareholders and that causes difference in performance.
Rick Ferri: Now Vanguard has a unique structure and I know they have a patent on this, but their ETF and their open-end mutual fund are just share classes of the same pot of money. And that patent – someday, I thought it was last year, but maybe this year– is actually going to come off patent. In which case is it beneficial, or would it be beneficial, for other fund companies to adopt that patent where there’s one pool of money and then there’s an ETF share class and there’s a mutual fund share class. What’s the advantage and disadvantage of doing it the Vanguard way?
Eduardo Repetto: That’s a great question. We thought about that. To say do we want to have a big pot of money, big fund, where one share class is an ETF and other share class is a mutual fund. And we decided not to do it. Let’s go through the logic. Let’s suppose that you have a mutual fund share class, a mutual fund, and with the mutual fund share class, and I decide to attach to the mutual fund an ETF share class, yeah? If you are the mutual fund shareholder you are going to be very, very happy about that because you have people coming in-kind in and out dealing with your capital gains and not imposing any costs on you because they are coming in-kind. It’s not that they’re giving you cash and the portfolio manager had to trade and the cost is spread out about across all the shareholders. No, if you have a mutual fund and you attach an ETF share class, the mutual fund shareholders will be ecstatic. We’ll be very happy about that, yeah?
Rick Ferri: I agree.
Eduardo Repetto: Let’s go to the other case, I have an ETF share class and I put a mutual fund share class on the side. Will the ETF shareholders be happy? No they will not be happy. Why? Because people coming in the mutual fund are coming in cash and who pays for those transactions? Everyone, even the ETF shareholders. So the ETF shareholders pay their way in, they pay their way out, but they also have to pay a fraction of all the people coming in and out of the mutual fund, so it’s not really fair to them.
And so on top of that, if you have the shareholders and mutual fund redeeming a lot of money, the ETF shareholder may take the tax bill that they are not expecting because there are cash transactions in the mutual fund share class. So what we decided is to have different pools of money. One for ETF and one for mutual fund. If you want a mutual fund, you know what you’re facing. You’re having a commingled vehicle and you’re exposed to the actions of other shareholders, externalities due to other shareholders.
But you trade at NAV [Net Asset Value] and you know for some people that’s easier.
Rick Ferri: In a 401k, as you said, you have to do it that way.
Eduardo Repetto: In a 401k you have to. If you go to the ETF you’re going to pay your way in and way out when you buy in the market based on the spreads and whatnot, but you are going to be protected from the actions of other shareholders because of the entire purchase and redemption mechanism. So by separating them we give people a pure benefit of one or the other. They can decide what’s better for them. They are not going to be blindly surprised by the action of the other pool of money that is coming in and out in a different way than they are.
Rick Ferri: Okay. Let’s go into a different topic. And that has to do with how you invest money. You invest money using factors, and you’re a quantitative factor investor. But before we get too deep into all these different factors, what is a factor?
Eduardo Repetto: So the factor basically is a way to understand the performance of securities. For example, let’s suppose that small cap securities have a better expected performance than large cap securities, so a factor is the difference in performance between the small cap securities and large cap securities.
Rick Ferri: Okay. Well let me stop for a second. Why would small cap have expected higher return than large cap?
Eduardo Repetto: Well that’s a great question. Because I’m going… let’s just pick another factor and then we go back to small. Because a small cap is probably the one that you cannot justify. A company because just being small should not have a premium because you can have a small cap company with extremely high price and that’s not going to have a premium. So let’s speak about the value factor?
That’s easy. Anybody, what is the value factor? If you can buy a security that has a low price relative to a fundamental, let’s say the book value of a company, well that company tends to have a premium related to a company that has a high price related to the fundamental, yeah? It’s like you’re buying something on discount at the lower price, yeah?
Rick Ferri: Okay, but why would a company with a low price to earnings, low price to book, low price to cash flow, low price to something, or just low price, why would we expect that to have a higher rate of return?
Eduardo Repetto: That’s a great question. So we start with a premise. It says we believe that the market is pricing all the securities and we cannot find a better price than what the market has. There’s an assumption of different kinds, but we also believe that there is no need for the market to put the same return for every security. Different securities will have different returns. Different returns will have different discount rates.
Rick Ferri: The discount rate is a factor of the perceived riskiness of a security, correct?
Eduardo Repetto: It can be risk, or it can be something else. It can be behavioral, you know? Some people just for whatever reason dislike a lot of a certain set of companies and if there are enough people, that is, like a lot of those set of companies, those companies will trade at a little bit lower price. And so that’s a higher discount rate.
Rick Ferri: Let me push back just a hair on this because I want to make sure I understand it. Because there’s this thing between risk and behavior that always goes back and forth with these factors. But to me, if it’s true that there are a lot of people who just don’t like these companies they don’t like them for a reason, and isn’t it true that they don’t like them because they see more risk there and lower returns and that’s why they don’t like them. So isn’t it a fundamental factor?
Eduardo Repetto: It may or may not be. But the fact that a certain clientele moves away from a certain set of securities certainly will push the price of those securities lower and that suddenly you have a higher discount rate because if the price is lower relative to the same fundamentals you have a higher discount rate.
But let’s go a little bit deeper in why there is a premium because you’re asking is why certain securities have a premium, a higher return than others. And so let’s think about that. Let’s suppose that I give you two options to work. So you work with us for one week and if you work for one week, I give you a hundred dollars. That’s option one. Option two is if you work with us for one week I give you zero dollars, or two hundred dollars 50/ 50 depending on the weather of the last day. So 50/50 probability gives you 0 or 200 expected, expected payment for you is the same, it’s a hundred dollars. So in one you get a hundred dollars for sure. In the other one you get an expected hundred dollars, but you can get zero or two hundred. Will you take that deal? In general, you will not take the second deal ,you will take the hundred dollars for sure. Because the other one you can finish with zero, two hundred.
So now I’m going to try to spice it for you. I’m going to give you 0 or 250. So now expected payment to you is not a hundred and hundred, it’s a hundred and a hundred and twenty-five. 50% zero, 50% of 250. So I’m incentivizing you with a premium to take the more risky outcome, yeah? At some point if I keep on increasing the incentive at some point you are going to say I take the risky outcome.
So whenever you have a risky investment it’s not that the expected outcome is the same as a less risky investment. The more risky investment will have a return that is a little beyond just the same expectation. It will have a premium because that premium is what incentivizes you to take a little bit of that risk because if you do a perfect risk adjustment and you have the same expected outcomes you will never take the risky investment. So there has to be a premium, a little bit more return. So when you are speaking about security, how low price related to fundamentals, and we’re saying that’s a value investment strategy, why there is a premium? Because not every security has the same expected returns. There is no need. There is no logic for that.
So when you are looking for securities that are very low relative to fundamentals, what you are trying to do is identify those securities that are having higher discount rate, higher expected returns.
Rick Ferri: And then put a diversified portfolio together of just those securities.
Eduardo Repetto: Yes but you can see that when I what you were mentioning, hey, you are saying low price related to fundamentals but what we’re trying to do is try systematic ways, mechanical ways if you want to think about that, to identify what securities have high discount rates. Because the discount rate is your expected return. So what security has this high expected returns?
Now every model is incomplete. The models don’t describe reality, but what financial science has been doing over time is trying to make better and better models, trying to understand what variables matter most, and that’s why you have so many factors. Because people start looking at different variables, and they think well this variable explains something in our returns and this other variable explains about the return and I think you have like 400 factors now.
I think it is a paper called The Factor Zoo3.
Rick Ferri: The Factor Zoo, yes.
Eduardo Repetto: So the issue that we’re facing now is there’s so many factors how we put all this together. And there are many, many different people put this together in different ways. Some people do optimization. So let’s put all these factors, optimize and we see what happens at the end. But you know as well as me whenever you put a big soup of estimated numbers in an optimization you get very weird outcomes.
Rick Ferri: So the factor zoo, we’ve got– I talked about large versus small–and that factor was strong decades ago but it seems to me since the proliferation of small cap index investing, in other words, it became much, much easier to invest in a big massive mega portfolio of small cap stocks. It wasn’t so easy fifty years ago. It’s easy now to do that and that led to the term, it led to factor decay. In other words, it went away. It was easy to identify these small cap companies. It was easy now to package them together into these index funds, mutual funds, extended market, small cap funds whatever. And because of that I believe, I might be wrong about this, but I believe that caused this factor to decay to the point where there really isn’t a big premium anymore, as you mentioned earlier.
Eduardo Repetto: What you’re observing it’s absolutely right now the question is not if it has decay the question is was it there on day one.
Rick Ferri: Okay.
Eduardo Repetto: And why is that? Let’s suppose that we go to the zoo one day and we see that animals with stripes are zebras. That doesn’t mean that every animal with the stripe will be a zebra because a tiger will have stripes. Yeah, so the fact that people observe that the small caps up to ‘81, I think it was, have a premium–that can have been a random outcome–and the fact that we don’t see much of that after that period, it may be because that’s reality, and why I was pushing back in the small cap premium because when I was speaking about value I was telling you you have a low price related to fundamentals. You are looking for companies that have high discount rates and if they have any high discount rate will push the price down so there is a logic there.
Rick Ferri: Yeah, and just to clarify, a discount rate means you need to get a higher rate of return, it’s a cost of capital.
Eduardo Repetto: Exactly.
Rick Ferri: The company has to get a higher rate of return for you to invest in that company because you perceive, true or not, you perceive that there’s more risk there so you need to get a higher rate of return.
Eduardo Repetto: Yeah if a company is going to produce a dollar in the future you are not going to pay that dollar in the future with the dollar today. You are going to pay 70 cents today to get a dollar in the future; 50 cents today to get the dollar in the future. So the lower the number that I paid today for the dollar in the future is the higher discount rate. So when you have a strategy that is trying to buy low price securities related to fundamentals, what you are really trying to capture is that high discount rate that that high expected return due to the low price today.
But if I tell you you are buying small caps there is nothing that tells you that the small cap security can have a premium. If not, you can divide a large company in a bunch of pieces and suddenly you have a premium and more logically let’s suppose I have a small cap company, yeah. If I have that small cap company and that company has a very, very high price relative to fundamentals. That company should not have a premium because the price is too high related to fundamentals. So the small cap premium is highly debatable, let’s put it that way.
Rick Ferri: Well let’s go ahead and move on to some other factors. Because we talked about small cap potentially not being there anymore or maybe wasn’t there to begin with. We talked about the value factor, price to book, price to some fundamental. You also, at your company, are looking at profitability as a factor. So tell us about profitability.
Eduardo Repetto: Yes, that’s a great question. So imagine that you are going to buy a company. How much you’re going to pay for that company. You know I’m buying Rick’s company. What, how much do I have to pay? Well I have to pay for the equity that you have in your company, but I also have to pay for your cash flows. But since your cash flows are in the future and they’re uncertain, and going to discount those future and I’m going to pay less today for those future cash flows, and the value of those future cash flows. So the price I’m paying for your company is your equity plus a discounted value of your future cash flows. So remember what I’m interested in is that discount rate.
And what variables I know? I know the price because Bloomberg is telling me the price every minute. I can have a proxy for the equity in the company, and I have a proxy for the cash flows of the company, and these three variables, because of the valuation framework that I mentioned with you, are related to the discount rate, to the expected returns. A company that has higher expected returns will have a lower price for the same equity value and for the same cash flow expectations than a company that has a lower expected return. So the higher the expected returns, the lower the price, keeping the other two variable constant, keeping the equity and the cash flows. So I need to take into account not only the equity that I can use book value as a proxy for equity, I also need to take into account the cash flows of the company. I have to take both set of financials, the balance sheet and the income statement, both set of financials to identify what companies have high discount rate, high expected returns4.
Rick Ferri: When you’re selecting the securities then for your funds, is it a fixed formula where you’re using some percentage of book value, some percentage of profitability together in your model? Or is it a variable thing, where it moves?
Eduardo Repetto: No, it’s fixed. It’s fixed, so look, there is enough uncertainty in life that if you have it fixed it’s already there is uncertainty. To add a variable component there is no way for us to have so much precision. So we want to use the main drivers of selecting securities. That is how much money the company is making, what’s the equity position of the company, what’s the price related to these two variables, and once we have that we have enough information to put together a well-diversified portfolio that in our opinion has high expected returns. Trying to be more clever than that, than just changing the weight of the security with market conditions or the factors or the components with market conditions and everything else is just adding noise with no really known outcome.
Rick Ferri: So I’m going to say one thing, but then I’m going to move right on to something else so what I was getting at was you don’t do what’s called factor rotation, where you’re trying to go from one factor to another to another to another.
Eduardo Repetto: No.
Rick Ferri: Companies are very hot on doing factor rotation and they’re saying that well if we move at this time from this factor to that factor to over to this factor that somehow, some way they’re going to get an excess return from rotating their portfolio around, highlighting different factors at different times. And you don’t find any value in that at all.
Eduardo Repetto: No, that’s predicting where the market is going to be is the same – you know if you can predict the performance of a given factor, it’s the same as saying you can predict the performance of the market. Imagine if we could do that. That would be great. But the markets, that’s not how it works. The performance of the market is unpredictable because there are new stuff that we don’t even know that they’re coming and they will come. I don’t know what will be, but it will come, something. That’s something new tomorrow.
Rick Ferri: So you have your list then. You come up with your portfolio of what you would like to buy. But there’s another factor that we haven’t talked about yet: it’s called momentum. And this is looking at the price and seeing if it’s moving down or moving up. And we don’t want to “try to catch a falling knife” is a phrase that we hear often with quantitative analysis, so could you talk about how you use momentum in your portfolio management?
Eduardo Repetto: Yeah. So momentum is fascinating. It is a little bit like a small caps when I was telling you small caps, there is no logic for investing in small caps.There is a logic, while the premiums are small, largely small caps, small. The value premium in small cap is larger than the value premium in large capital. It’s a logic for that but the existence of a small cap premium there is no logic for.
Momentum is the same. Momentum is something that we observe but we don’t understand why it happens, and there are two competing visions of why that happens. So what is momentum? A security that has extremely bad performance will continue to have for some short period of time bad performance, and the security that has extremely good performance will continue to have for some short period of time good performance.
So how do we use momentum? If we have a value strategy whereby a security has a low price, how the security becomes low price? One probability is because the price is going down. The security has very bad performance. Well we can go and buy the security immediately or you can say, “Wait don’t buy it now. Wait a little bit until the price stabilizes.” And so that’s what we do. We decide not to buy immediately. Not to jump into this security that has extremely bad performance and we decide to wait a little bit until the price stabilizes and so we try to prevent buying securities in downward momentum.
The opposite for upward momentum. If you have a security that is a small value, for example, and it’s an upward momentum we are willing to slightly overweight that security. And if the security starts going up in price, and instead of being a small cap now becomes a mid-cap security, instead of sell it immediately, we may be willing to hold it a little bit longer. Why? Because the momentum premium is very, very strong but is very short-lived. So if I can get a little bit of push because of upward momentum just by holding the security a little bit longer. So we incorporate momentum downward and upper momentum in our strategies but we are very, very careful how we do it because if you are not, you finish with a very, very high turnover.
Rick Ferri: Let me ask a question about factor premiums. So you have a multi-factor model where you’re using profitability and value combined to come up with what you would expect to be a premium over beta. Expect to be a premium over the market return. Do you have a way of determining what that premium should be going forward? What are we looking for, and a long only portfolio, not a long and short, but just a long only portfolio?
Eduardo Repetto: No, Long only. I don’t think any one of us needs a short portfolio. So we’re happy to have a long only, you know. This is a great question. So the question is can we know at any point in time how much the market is discounting future cash flows. And the answer is no. And why not? That’s where behavioral finance gets together with rational markets. In different periods of time, for the same level of risk, people may be willing to take a lower price or a higher price.
You know we change; you know the market changes; you know in periods of high anxiety people have priced humongous discount rates; the prices are very, very depressed. In other periods, the price is higher and so the market is having lower expected returns, and you cannot really know at any point in time how big or how small is that premium. What you know is that it’s a premium, but there is research that is very interesting that shows, look at the long term average of these premiums. That’s probably as good as it gets.
Now some people say that if you look at the market, historical market performance relative to treasury bills, for example, probably was higher than what we should expect in the future.
Rick Ferri: I would agree.
Eduardo Repetto: Some people say that because now the market, more people embrace investing in the market, there is more more of us that are buying securities than what they were in the past, and so if you have a higher clientele, let’s have more people willing to take a little bit of that risk, we’re increasing the price and we’re reducing expected returns. There is a logic.
Rick Ferri: I think another piece of logic is, are treasury bills correctly priced? If you’re going to use that as the risk-free rate. Based on where treasury bills are currently priced, I think that the premium could be high. But if treasury bills were correctly priced based on where the inflation rate is, I think that the premium might be a lot lower. So I don’t know if treasury bills are the right risk-free rate to use even though that’s what’s being used in the models.
Eduardo Repetto: Yeah. You are right about what is your risk rate – it’s interesting but you know we’re not speaking about short-term periods, we’re speaking about long-term periods.
Sure. And so if we think about that, expected returns of the market may be a little bit smaller than we have seen in the past. There is more willingness of people to embrace the market and embrace market rates, and there are more people to do that, then you would expect premiums to be a little bit smaller.
Is that the same for value investing? And when I say value, and I think the generalized ways of value, like what we do, I think there is no information about more people embracing this than before. They may be smaller than historical premiums, they may be not. Now the traditional way of defining value, like if you are looking low price to book without looking at the cash flows of the company, that probably is not the right way to do it. And so science has evolved from there. So better, I think it’s better if people evolve from that.
Rick Ferri: Let me ask a question about U.S. versus international, because you did this paper on using value and profitability in international markets. Is it different outside the U.S.? Is it different in emerging markets than in the U.S. market? And how do you have to change your formula?
Eduardo Repetto: Okay. So, if you remember, I told you a story about the valuation of the company. So what is the value of the company? The price of the company is the equity plus the cash flows, discounted by some discount rate. But I never told you that that valuation is only valid in the United States.
I think that evaluation was valid with the Babylonians– were selling and buying donkeys– and probably it’s going to be the same in the future when we’re selling and buying water, of oxygen, if we ever live on Mars. So this is an evaluation framework. The beauty of evaluation framework that is valid in all the different environments. It’s different from a pattern. A pattern may be valid here, not somewhere else. So the way that we do things is based on evaluation framework to understand what factors or what matters in the expected returns of a company, and basically it works all around the world. It works in the U.S. It works in international; works in emerging markets. So the research is very robust from that point of view because you have a research that you can apply with the evaluation framework everywhere.
Now when you are speaking about the variables itself you have to adapt to realities. For example, in the United States companies report financials quarterly but in some countries report only twice a year. And so you have to adapt with the data and try to make the best that you have with the data of the different countries, in order to have the model use the right set of information.
Rick Ferri: Let me ask a question about small cap value funds. I personally have a small cap value tilt in my portfolio. I don’t yet have an international small cap value tilt and one of the questions I have is why are there no global small cap value index funds or ETFs?
Eduardo Repetto: You know, I’ve been asked that many times. It’s more we may be thinking about doing one outside the United States – not for U.S. investors, for outside the United States – and why we don’t have one in the United States? We have, as you know, a U.S. small value strategy, an international small value strategy, and an emerging markets mid and small value strategy. And we do mid and small together in emerging just because you have more liquidity in the number of securities. But we don’t have one that puts the three of them together.
Rick Ferri: Correct.
Eduardo Repetto: Why is that? Because different investors want to have different allocation to the U.S. versus the emerging versus international and if we put all together, then constrain the investors to decide which one to buy. Now how to weigh them?
Rick Ferri: [laughing]
Eduardo Repetto: Now yeah, I understand. But think about this: when you buy an ETF, what is your fixed cost? Do you pay ticker charges? No, you don’t pay ticker charges, so buying three ETFs, it’s the same as buying one, because you don’t have ticket charges. So given that you don’t have ticker charges, just buy three securities instead of buying one and that gives you the freedom to decide how you want to weight them.
Rick Ferri: Okay. I will push back here because you have a global real estate portfolio, a real estate portfolio, but you just finished saying you should have a U.S. small value and an international small value, but yet you have a global real estate fund. So explain why.
Eduardo Repetto: Yeah, that’s a great question. So you say you can have a U.S. real estate and international real estate, and I will tell you, yes, you are right. We can have a U.S. and international. Now an international real estate market is much, much smaller than the U.S. real estate market.
Rick Ferri: Thirty percent versus seventies– in international versus U.S.
Eduardo Repetto: So an ETF for international real estate that will have a very, very small allocation in someone’s portfolio, we said, “No, let’s put it all together in real estate and let’s give that to someone.” Because maybe I’m wrong, but we said no one worries too much about how much U.S. or non-U.S. So someone wants a full U.S. in real estate or they are happy to have a global real estate. So we say let’s provide global. The global real estate market has been developing. You know the UK reached, I think that they are 15 years old. J- REITs, so it’s developing. At some point we may split it or have two versions or whatnot. But for now we decided global probably is the right decision.
Rick Ferri: I can give you the pros and cons of a global small cap value fund. The pros are, man it’s a lot more convenient than buying three funds, just buy one small value, covers the world, I’m happy. What’s the disadvantage? Well the disadvantage is taxes and the foreign tax credit if you’re going to put it in your taxable account. Because since less than 50 per cent of the portfolio is going to be international, you don’t get the foreign tax credit. So in a taxable portfolio you still have to divide it up between a U.S. small value in an international small value so you get the tax credits on the international small value.
But if this was going to go into an IRA account or a Roth account of some form, in which I could see a global small cap value into a Roth account, that it would make sense, at least from my standpoint as an advisor, where I get this factor exposure using one fund. There is a need for it, I believe, out there. So I’m just plugging that.
Eduardo Repetto: You’re not the first one telling us that. But I also go through there saying look if you have three ETFs you don’t have ticket charges in custodians.
Rick Ferri: But you have three funds. I don’t want the three funds, I want something simple. Anyway, let’s go to the next thing. You know we’ve evolved. We have the factor zoo now, okay? We also have things like artificial intelligence and we have machine learning, and behavioral finance can be thrown into that as well. Are you looking at these things, to incorporate them into your world, and how you do things?
Eduardo Repetto: You know, the whole thing of machine learning and neural networks and all this is fascinating because what is trying to do is trying to emulate how the brain works in learning – or a collection of entities works in that way – in order to to learn without having a predefined model. Yeah so, but isn’t that what the market does? The market is a big machine, learning machine that does machine learning, the market is a network of this. You know, a loose network of people interacting in order to increase some benefit for everyone – collectively, everyone – but individually, each one of the individuals, each one is just trying to incorporate the information that they come – in order to come with prices. So the whole market is a big machine learning network.
Now if I were an active manager picking stocks and I think that I can do better than the market and find what securities aren’t underpriced and securities underpriced probably will invest a lot of money there and say, ”Oh, I’m going to be better than everyone else and find all the undervalued securities and all the other value securities.” That’s not us, so I’m not going to dispute the market price and create my model and then I will say my model is better than the market. Because the market is as good as it gets.
You know whatever, our model is going to be some part of the market in my opinion, so the market gives us the price of the securities. What we do is try to use that price in order to identify what securities have been priced at higher discount rates so they have higher expected returns, and what security has been priced at a lower expected returns.
There may be things that are interesting in machine learning to apply even to what we do and, for example, we were speaking about finding factors, or finding drivers of expected returns, you could have imagined that all these factor research could have been done with machine learning. So we can have a machine learning trying to find what variables that are related to valuations, have different levels of impact in the spectral returns of the security. And that could have been done, but that’s what the professors, you know, and researchers all around the world have done in a loose way. So, yeah, you can use it but a lot has been done even we don’t call it machine learning.
Rick Ferri: Let me ask a question that was posed to me. It has to do with ESG [Environmental, Social, and Governance]. So ESG is popular in Europe for sure and maybe becoming a little more popular here in the United States than in the past. But it’s very hard to find a small cap value ESG fund for the people who want factors and want ESG. Any interest there?
Eduardo Repetto: We are getting into the responsible investment business so we’re going to launch a couple of strategies, three strategies that have high exposure to small value in the near future, let’s put it that way.
Rick Ferri: Let’s get into the last topic and that has to do with fixed income. You do have a few fixed income funds and you do run a strategy based on the yield curve, trying to enhance the return based on the yield curve. In other words you say the yield curve is telling you something. Could you explain your fixed income investment strategy, and why there may be an expectation for a higher return than just doing a regular straight index fund?
Eduardo Repetto: There are a couple of things that are very, very interesting when you think about fixed income. Let’s speak first about indexing. You know how the index works and the index that an index manager follows in fixed income incorporates every bond that has been issued, so you reissue a bond, that bond is incorporated in the index automatically. Now if you recap to issue a bond are you going to issue in a way that increases your cost or reduces your cost of servicing that debt? You’re going to try to minimize your cost. So you’re going to issue in the conditions, say duration or whatever else, that minimize your cost. Yes, but if you are minimizing your costs you are also minimizing my expected returns if I’m the investor in that one. So the automatic inclusion of bonds, it’s really a detriment for an index in fixed income.
Now you mentioned we use something else we need to have, like in equities we need to have an idea what bonds will have higher respect returns than others given the same credit quality and everything the same, And we do that by using the yield curve. So what do we mean by that? Let’s suppose that you have a bond and you hold it to maturity and let’s suppose that the bonds don’t default, what is your expected return on that bond? Your expected return of that bond is your yield to maturity.
Rick Ferri: Assuming you can reinvest the income at the yield to maturity rate.
Eduardo Repetto: Let’s assume that the zero coupon – life is easy.
Rick Ferri: Life is easy, zero coupon.
Eduardo Repetto: So your zero coupon bond that has a yield to maturity of two percent, your average return, if you hold that bond to maturity is two percent a year.
Rick Ferri: Correct.
Eduardo Repetto: But your return from year to year is not going to be two percent.
Rick Ferri: That’s correct.
Eduardo Repetto: Because if you have a three-year bond under the typical yield curve the yield curve has lower yields to maturity for shortened durations and higher yields to maturity for longer duration. So if I have a three-year bond that gives me yield to maturity to two percent, one year from now that bond will be shorter to maturity. So on expectation we have a lower yield to maturity than today. So you can see the yield to maturity was the average return to maturity but that means, that doesn’t mean that every year is the same. In general the longer portion of that holding period will have higher returns than the shorter portion of that holding period.
So you can use information in the shape of the yield curve to decide when that bond has higher than average returns related to the yield to maturity and when it is going to have lower expected returns relative to maturity and we use that information to create portfolios.
Rick Ferri: In geekish fixed income, what you’re talking about is a horizon return.
If you’re going to use it for two years you’re going to keep it for two years and then you’re going to sell it. You’re going to do what we call riding the yield curve. This two percent bond that you purchase because the last year the yield to maturity on that bond might only be a half a percent and you bought it at two percent as a three-year, after the first two years if you sold it you’re going to get a return on that that’s much higher than the two percent yield. So the horizon yield might be two and a half or 2.7 or whatever it is.
Eduardo Repetto: Exactly, that’s exactly what we’re saying.
Rick Ferri: See I remember from my CFA days all of that stuff.
Eduardo Repetto: That’s exactly what we’re doing, instead of trying to get an average income to maturity we are happy to get an income from some period of time and a capital appreciation due to the change in the shape of the yield curve.
Rick Ferri: And the convexity, that’s another geekish word, has a lot to do with this, too. I mean there are some bonds that this happens rapidly and there are some bonds where it takes more time.
Eduardo Repetto: Absolutely, and that’s why the way we do it is we have an estimated yield curve for different issues, for every issue we have an estimated yield curve depending on the sector, the credit quality, and whatnot based on market information. We don’t make predictions, remember, and then we use that estimated yield curve for every issue to compute the expected return of the bond for a horizon, like you mentioned, and then we use that information to create a portfolio.
Rick Ferri: Very interesting. Well Eduardo, it’s been fantastic having you on Bogleheads on Investing, and thank you very much for your time today. And I wish you a lot of luck, and I know you just passed 10 billion and hopefully you get to 100 billion quickly.
Eduardo Repetto: Thank you very much.
Rick Ferri: This concludes Bogleheads on Investing, episode number 42. Join us each month as we have a new guest and talk about a new topic. In the meantime visit Bogleheads.org and the Boglehead Wiki, check out the Boglehead’s new Youtube channel, Bogleheads twitter, Bogleheads Facebook, and find out about your local Bogleheads chapter, and tell others about it. Thanks for listening.
- See Eduardo Repetto Elected as Caltech Trustee , Dec. 2 ,2015 [↩]
- Wahal, Sunil and Repetto, Eduardo, The Joint Distribution of Value and Profitability: International Evidence (November 30, 2020). Available at SSRN: https://ssrn.com/abstract=3739571 or http://dx.doi.org/10.2139/ssrn.3739571. [↩]
- The Factor Zoo: Harvey, Campbell R. and Liu, Yan, A Census of the Factor Zoo (February 25, 2019). Available at SSRN: https://ssrn.com/abstract=3341728 or http://dx.doi.org/10.2139/ssrn.3341728. [↩]
- Wahal, Sunil and Repetto, Eduardo, On the Conjoint Nature of Value and Profitability (June 25, 2020). Available at SSRN:: https://ssrn.com/abstract=3635714 [↩]