Asset Management has become a more challenging place to make a living in the past decade. On the strategy side, alpha has become much more difficult to generate, as skill within the industry and computing power have risen and factor-based strategies have become more widely available. On the business side, falling fees and increasing market share for the largest players have made it very difficult for smaller firms to compete.
But despite that, some smaller firms have succeeded and have overcome these headwinds to grow their businesses. One such firm is Cambria Investments, which was founded by my guest this week, Meb Faber.
Meb and his team have built Cambria into a $700 million+ asset management firm during a period where many small managers have been struggling. In this interview, we talk about how they did that and also get his views on some popular investment strategies that have been struggling recently, and the future of the asset management business.
Just a note before we begin. This interview was transcribed from an audio conversation, so please forgive any grammatical errors.
Jack: Thank you for taking the time to talk to us. And congratulations on the success of Cambria.
I wanted to ask you about some of the lessons you have learned along the way. The asset management business is obviously a very challenging one right now. Fees are falling across the board and the large players are dominating in terms of asset growth. But you guys have been able to buck that trend, and the way you have done it has been a very unconventional one. Can you talk a little about what you attribute the success of Cambria to and the approaches you have found successful in growing the business?
Meb: I think we’ve long said that the biggest compliment you can give anyone in our world, and this actually applies to any entrepreneur or business, is simply surviving. Financial markets consistently have bear markets, times of booms and busts, and anyone that survived the last 12 years, that’s a compliment. So, if we have achieved any success, it’s been an overnight success 12 years in the making.
We try to take a little different tact than most when we launch funds, and we currently have 11. We really approach it with four criteria, the first being it has to be something that doesn’t exist. If it does exist, we only would launch a fund if we believe we could deliver a solution that is much better or much cheaper.
Second, the fund concept and approach has to be backed up with a fair amount of academic or practitioner research, hopefully both, and hopefully going back a long time.
Third, it has to be something that I want to invest my own money into. Most professional investment managers actually don’t invest anything into their own public investment funds, and we think it’s important to have skin in the game.
Lastly, it has to be something that people want. We realize the importance of narrative and storytelling when it comes to investments, and want to have investors that are interested in our products and understand the approach. We’ve done a lot of this through education, and that’s been our approach. I don’t think it’s anything particularly new. It’s been around for many decades with people doing radio and print.
Our approach started with academic papers, blogs, speeches, and books and evolved into social venues like the podcast, Twitter and YouTube. We try to be authentic and deliver a research driven message that resonates with investors rather than something that’s sold to them. The old school way of Wall Street doing business will be a challenge for many of the incumbents to continue in the age of transparency and the internet.
Jack: You have called the asset management business in general a “terminal short” and I can’t really disagree with that assessment. The industry has traditionally been a place where the smartest people go with dreams of making large sums of money, but it seems like falling fees and technology are rapidly changing that. These recent trends have been very good for investors, but tougher for those who make a living managing money. What are your thoughts on the future of the asset management business? What do you think it will look like in ten years?
Meb: The trends that have been playing out over the last three, four or five decades have culminated in it never being a better time to be an investor. I look back at the eighties when there were massive commissions, front-end loads, sales loads; even transacting in securities was tough. The world was littered with conflicts of interests, and you could argue that’s still true today, but the beauty of the internet is that it’s a great disinfectant and it shines a light on a lot of these practices, whether they’re dying a very quick death like commissions did in most brokerages in the course of one week, or a slow death like a lot of these other slimy practices we talk about in the high fee world.
The example we like to give is likening it to the quote about science advances one death at a time, and this transition from investors allocating to high fee “do nothing” funds that are tax inefficient to lower fee choices that probably are much better suited. While I would like this transition to happen overnight, it will likely occur over the course of a generation as people die, as they pass along money, as they get divorced, as funds get sold.
Most people won’t go back to the old way of doing business that was really not in their best interest. The biggest challenge with this, of course, is the education gap. A lot of investors have to be self-interested and avoid these conflicts. But the good news is the internet is providing a lot of that education. So, today you can find yourself in a scenario where you could invest in a global portfolio for essentially a 0% fee. I’m kind of rounding, the fee is actually 0.03% or something. But if you include short interest lending on that portfolio, the fee is actually negative. You’re getting paid to own the portfolio!
Many of the incumbents have funds that still charge 1.25%, and how do they compete in a world where the default now is zero commissions or zero fees? It’s a challenging business. You have to be extremely concentrated, weird and different if you want to be an active manager that’s going to compete with what I like to call, “investing for dummies” benchmark hurdle of no cost. Is that possible? Absolutely.
You mentioned young people who want to get involved in investing. It’s still possible, and sky’s the limit, but most of the advice that I give is it’s pretty hard to be that weird and different, and it goes along with the advice of Charlie Munger who says to go where the fish are.
If you’re a fisherman, is your time best spent researching large cap stocks in the United States where there are 50 other analysts on Wall Street publishing research on, or is it maybe the market in Nigeria or Pakistan or somewhere else that’s probably a lot less efficient where you have some sort of value add?
Jack: Moving from the business in general to investment strategy, I wanted to ask you about the balance between process and outcome. You and I have both been big advocates of evidence-based investing, but some of the investment approaches that have the most significant evidence behind them have struggled in the past decade. Things like value investing and trend following have proven themselves over very long periods of time, but their recent struggles have led some to question whether this time is different. Whether it be because of technology or Fed policy or some other reason, some argue that things have changed and we can’t rely on the past anymore to help guide our view of the future. How do you think about evaluating an investment strategy when it struggles and strike the balance between relying on long-term data, but also questioning whether something might have changed to make that long-term data less predictive?
Meb: The first best answer is you have to become a student of history. It sounds like we have a lot of history in investing, but in reality it’s only probably 200 years in the modern era. Then if you were to say even the era of floating currencies, it’s only 50 years. So, even with that, we can extrapolate a fair amount of information that sets the stage to be a guide or a foundation from which to build our ideas.
My favorite investing book Triumph of the Optimists, looks back at over 120 years of investment history to show that in general, stocks, bonds, bills, have all done nice jobs of preserving your wealth, but at times have really struggled. And any one individual market can go to zero.
Broadly speaking, entire asset classes like global stocks, global bonds, global bills, have done well and diversified your portfolio. The rule of thumb I like to use is that stocks have historically done about five percent per year real after inflation, bonds around two, bills one. That doesn’t mean, however, that any of those can’t go years, even decades having negative returns.
The longest period for U.S Stocks underperforming bonds was 68 years in the 19th century, even in the 20th century they have gone numerous decades underperforming. The biggest challenge with any one of these asset classes also is that on a real basis after inflation, they can experience very large losses. All of these assets have lost at least 50% at some point. Stocks, the biggest risk tends to be price-based declines like the great depression or more recently our two bear markets in the 2000s, but the biggest risk for bills and bonds is the long eroding effects of inflation.
The long periods of underperformance also applies to active management. If you start to diverge from the global market portfolio or market cap weighted indexes into active management into areas which we think have a high expectation that they will outperform over time, like you mentioned, my two favorite pillars, both of these go back a hundred years, value and the two cousins of momentum and trend. As we go back to the time of Ben Graham and Charles Dow, if not long before that, these approaches can go in and out of favor for very long periods.
The most recent decade we just finished, U.S Large cap stocks outperformed just about everything, but the decade prior was the exact opposite. Many other asset classes outperformed U.S Stocks, many other strategies did particularly well. In general, you want to put as many arrows in your quiver, diversify across not just asset classes but also strategies, and in general stocks and bonds and real assets tend to zig and zag, but also value and trend and momentum within and across assets.
You touched on one last point though that I think is critical, and that is when is this time actually different where you need to take into account structural change?
An example we often give is the case with dividends where for a long time dividends have been a strategy that many investors flocked to, but due to legislative changes in the early ’80s that made it easier for companies to buy back their own stock, companies started buying back more stock, and then starting in the 1990s stock buybacks have outpaced dividends in every year, in some years meaningfully so.
This is example of a structural change that if you’re an equity analyst not looking at all the way that stock companies can distribute their cash flows, you would be missing out on over half of the total amount that companies distribute their cash to investors, so you’d be missing the big picture.
You have to make sure that it’s actually a structural change and not something that has just underperformed for a while leading you to base your decision on recent history instead of a full opportunity set. The big challenge here for many investors is underperformance tolerance. We did a Twitter poll asking people how long they could tolerate an actively manager underperforming before they liquidated the position. Most said under three years, and something like 95% said under a decade. But many managers, including Warren Buffet, could go even 10, 20 years underperforming and still be a viable allocation.
Jack: One of the topics I have been working to educate myself on recently is the concept of direct indexing. As someone who is involved in the ETF business like you are, I have a personal bias that leads me to believe that it isn’t possible to create a vehicle that can improve upon the ability of an ETF to differ taxes indefinitely. But direct indexing proponents argue that they can do one better than that by harvesting losses every year to generate positive tax alpha. Direct indexing also offers a greater degree of customization, allows a portfolio to be built for each client based on their specific preferences, and can include things like personal ESG restrictions and single stock exclusions. What are your thoughts on direct indexing as a strategy and its potential in the marketplace? Do you think it will become a major threat to ETFs?
Meb: There’s an old John Bogle quote where someone asks him about his allocation, or maybe this is just about indexing in general, and he said something along the lines of, “Are there investment investing approaches that are better? Sure, but there’s infinite ones that are worse.”
We spend so much time in our world talking about the ideal or optimal investing approach, but in reality there’s plenty that are just fine. And the most important investment approach is one that you’re going to stick to so that you have a chance of compounding wealth over long periods without behavioral disruptions and fractures to your investing plan. There’s plenty of low-cost investing funds, individual securities that work just fine.
If you were to ask me if one was better than the other or optimal, I happily would give you my opinion. The reality is we are still in a world where the vast majority of assets are still stuck in very high fee tax-inefficient funds. The Venn diagram people often ask me about, they say, “Meb, why should I use your funds instead of Vanguard?” And I say, ” You should use whatever is most comfortable and agrees with your stated goals and objectives, and if that line of thinking leads you to our funds, great. If it leads to Vanguard’s funds, that’s fine too.”
Speaking to direct indexing specifically, I think it’s a fine choice. It sort of reminds me of Cliff Asness talking about fees in general, and he said there’s an example where fees went from one and a half to 75 basis points, amazing. Oh my gosh, that’s a huge difference. Then they went from 75 to 20 basis points. Oh my God, awesome. Not as good as going from over one, but still pretty good. Then they went from 20 to 10. Cool, but at this point, we’re starting to be rounding errors. Then some of the newspapers are like, “Oh my God, something went from 10 to eight. It’s down 20%,” and kind of smiling at this point, if you’re comparing something that cost 10 basis points to eight, you know the difference is so minute that the big decision, the big muscle movement in the first place was going from one and a half all the way down to 10, not 10 versus eight.
I think direct indexing is interesting if it is designed thoughtfully and offered at a lost cost. It defeats the purpose if you’re just using it to charge 1 or 2 or 3%!
I think there are specific use cases, the biggest possibly being customization. If an investor wants to exclude certain securities or overweight others. There’s of course problems with the strategy relative to ETFs. ETFs have a built in tax efficiency, whether or not direct indexing can do things like short lending, which in funds like ETFs can be a very material source of revenue and in some cases being as much as tens of basis points to even over 100 basis points of return, and whether or not the custodian enables that and passes it along to the end investor, that’s very specific to the platform. But overall, positive development.
Jack: With the market at all-time highs, many investors have been looking for ways to hedge their portfolios in anticipation of the fact that the party can’t go on forever. With many doubting that bonds can provide the hedge they have in the past at current levels, some have looked outside of the traditional methods of hedging to manage their market risk. Your tail risk fund offers one of the more unique approaches I have seen to hedging downside risk. Can you talk a little about tail risk strategies, where they work best, and the advantages they can offer over more traditional forms of hedging market risk?
Meb: There’s nothing about all-time highs that’s necessarily bearish. In fact, we just put out a paper about investing at all-time highs that demonstrates that it’s very similar to a trend following approach in that all-time highs are actually probably bullish, not bearish. The challenge of course comes with certain asset classes currently when you include valuation are probably more fragile to downturns because of their high valuations. We put U.S Stocks in that bucket, not so much foreign stocks, which are cheaper, and certain other stock markets, which are very cheap. That having been said, when we’re talking about approaches, diversification and risks, the first thing we always say to people, if you want to hedge risks, the first and best way is to not take the risk in the first place.
If you have a 100% stock portfolio, the first thing you can do is reduce the amount of stocks you own. The second way is to diversify, so you can own other stocks and other countries and sectors. If you own just U.S Stocks like most U.S Investors do with a big home country bias, you could diversify into foreign developed as well as emerging markets. You could also use tilts like value instead of just market cap weightings. You can move into other asset classes, like bonds, real assets, commodities and real estate, into a true diversified portfolio. Value and momentum and trend can also help diversify a portfolio. In my mind, only then probably do you want to be interested in tail risk, because all of the things we mentioned up to this point have a positive return expectancy, meaning they’re all strategies that in and of themselves siloed should have a positive return over time.
Tail risk, despite the fact that our research has shown that you can generate portfolios and strategies that have a positive carry, a lot of that had to do with the fact that bonds historically were yielding four, six, eight percent, ten percent even. In the world today, they’re only yielding about one percent. The way we think about tail risk is illustrated in a white paper we wrote where we wanted to implement it as simply as possible. We have a fund that does this, where 90% of the portfolio sits in 10-year U.S government bonds. And with the rest, we buy a ladder of puts on the US stock market ranging from, say, three to 16 months. The goal is that this combination gives you an exposure that when things hit the fan in any given day or month, that you have a portfolio of one asset that historically does well when stocks don’t. It’s not guaranteed. None of these assets that historically diversify an equity portfolio, whether it’s gold or bonds, real estate, commodities, foreign stocks, do it all the time. Bonds certainly diversify more often than foreign stocks, and gold sometimes diversifies, sometimes doesn’t.
Puts in general should almost universally hedge when stocks have a bad day or month. By definition that’s what they’re set out to do. This strategy falls into a bucket of an insurance category. In the same way you can think about insurance on your house or insurance on your car, you want it to be a cost because that means the rest of the portfolio is going up and you don’t mind paying that cost. However, you’re pretty happy to have it when the market does go down. I think part of the benefit is psychological or behavioral, meaning if you think back to the fourth quarter of 2018, or God forbid we ever have another month like October 1987, when the U.S Stock market fell 20%, you have the ability to have something that’s likely green on your brokerage statement or on your phone app when everything else is red. And if that holding helps you comply with your stated investing goals and expectations and process, then that’s a positive, regardless of it’s a net cost over time.
Update: This interview was recorded before the market events of the last week of February 2020, where a tail risk strategy performed as expected.
Many people think about tail risk strategies not as a permanent hold. Some investors believe that U.S Stocks are expensive, and a hedge at this point is somewhat prudent after a 10 year plus bull market. We had the first year in history where stocks went up every calendar month of the year in 2017. We had the first decade in history without a recession, so a lot of these events are aligning to make investors a little nervous about this bull ending. One final comment would be that a lot of people, and we talk about this in the white paper, that work in the financial industry have, because of their human capital, a multiplier effect on their leveraged exposure to the stock market.
They themselves own stocks, their clients own stocks, so their revenue is directly tied to the stock market. Their clients often behave poorly and pull out of stocks when the market’s down a lot, say 30, 50% plus. And on top of that, if they don’t own their own business, they could get fired from their employer because of downsizing, because the employer’s earnings went down in a bear market, which often usually coincides with a recession. So, many investors, particularly financial advisors, are double, triple, quadruple levered the stock market. You can make an argument that much like airlines hedge the price of fuel, food companies hedge the price of wheat, that an investor should not own U.S stocks, but if they did, hedge them out to smooth their return stream but also to hedge their life exposures.
Not a lot of people follow that advice. I do. Tail risk strategies are one of my largest holdings, but it’s something that I think is at least a good thought exercise for people who may want to hedge their portfolio to sleep at night.
Jack: Thank you again for taking the time to talk to us today. If investors want to find out more about you and Cambria, where are the best places for them to go?
Meb: We’re easy to find. My day job is cambriafunds.com or cambriainvestments.com. We’ve written over 2,000 blog posts at mebfaber.com. You can find us on the podcast as well, which is the Meb Faber show, as well as on Twitter at @mebfaber.
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