Our Podcast Interview with “Money Tree”
On the heels of our publishing Adaptive Asset Allocation, over the past couple months, we were invited to join a number of excellent financial podcasts. We love these types of opportunities, and they differ from traditional media interviews in that we actually have the time for a meaningful discussion with the hosts and their audiences.
Normally when we appear on a podcast, we like to publish a lightly edited transcript. By adding in additional links to useful information, filling in knowledge gaps and clarifying important points, the post becomes a useful resource. However, here on Skew we’ve also committed to keeping things nice and short, and in this case it isn’t exactly possible.
See, the team at Money Tree spoke with Adam Butler for nearly half an hour. And while we’re exceptionally grateful for that, we also know that Skew’s readership isn’t terribly interested in 5,000 word longform missives (that’s what Gestaltu.com is for!). So, instead of a transcript, this time we’ve pulled out some of the more interesting portions from the interview for your reading pleasure.
Joe Saul-Sehy: When you found out your book was #1 Hot New Release in Investments on Amazon, how great was that?
Adam Butler: Yeah. We didn’t know what to expect for the book. It can get pretty technical at times. It does touch on some higher level or higher order thinking like how to think about your cognitive biases and how they influence decision making, how to think about expert judgment, why people deserve to be compensated with excess returns in markets and what drives those over time. We get into stock market valuations and how current valuations impact forward returns.
Then we get into some hard core – heavily mathematical at times – portfolio optimization topics. So we cover a lot of ground. We really don’t know what to expect. We do know that our research blog Gestaltu.com gets a good amount of traffic from a wide variety of demographics from all over the world. A lot of the topics that we touch on in the book were distilled from some of the hottest topics that we covered in the blog.
On Strategic, Tactical and Adaptive Asset Allocation
Joe Saul-Sehy: So, let’s dive in because the name of the book is Adaptive Asset Allocation. If I’ve got tactical allocation on one side and I have this long term strategic allocation on the other side, where does “adaptive” asset allocation fit in?
Adam Butler: Adaptive asset allocation – like the tactical asset allocation you mentioned – is just an active asset allocation strategy. So the presumption, if you’re going to move towards an active asset allocation strategy is that you have some sort of edge over the average market participant in selecting which asset is going to underperform or outperform, presumably on some sort of risk-adjusted basis over a shorter term horizon. Therefore you’re going to rotate between these different asset classes over time, hopefully in a diversified way in order to generate higher risk adjusted returns you might get from a static portfolio.
On “Market Timing” versus Factor Harvesting
Joe Saul-Sehy: Everybody listening to this podcast then is thinking the same question I am Adam, which is “OK, if you’re adapting toward where the market is headed, what levers are you pulling to decide what those places are?” Because it begins to sound like market timing.
Adam Butler: We’d call it a form of market rotation. Certainly there are times that we would emphasize different global equity markets, times when you would emphasize safe fixed income, and times you would emphasize gold or commodities or real estate investment trust around the world.
But the premise is that there are long term anomalies in markets your listeners may be familiar with, such as the value premium. The idea that you can buy cheap things and by systematically continuing to buy cheap things over and over again, over time those cheap things are going to deliver returns that are higher than you get from just owning the market cap index.
There are other anomalies like the size premium. You buy small cap stocks. You expect to get a slightly higher return and then there are other factors like momentum, which has been proven to be just as statistically significant, pervasive and persistent as value and size. There are five or six factors that have been proven to be extremely economically significant.
One that we focus on for asset allocation is momentum and now, there are some really great seminal works on this. They demonstrate that momentum works just as well, if not better, when trying to select across global asset classes does in trying to select within asset classes. So we just systematically harvest this momentum premium across the asset classes in pursuit of long term excess performance.
On Asset Allocation versus Security Selection
Joe Saul-Sehy: When you’re looking at this stuff, you’re using exchange traded funds. Why exchange traded funds instead of individual positions?
Adam Butler: Because they’re already diversified exposures to the asset classes. If you look across a wide variety of studies, it’s really hard to find any literature, any analysis that’s not actually published by the mutual fund industry that demonstrates that anybody has got a meaningful ability to deliver excess returns through stock picking.
Our thesis on this is that – you know, whatever. Call it 90 or 99 or 99.9 percent of all cognitive and computational effort in markets. It’s focused on securities selection and probably 80 percent of it is focused on stock selection. Maybe 20 percent is focused on credit selection or some other individual securities, but most of it is stock selection.
Well, if the vast majority of people are trying to arbitrage opportunities in individual securities, then a relatively small number of people are trying to arbitrage opportunities across global markets. This means that the opportunities across global markets are going to be much larger than the individual stocks.
[Editor’s Note: For those interested, we have a very thorough discussion of asset allocation versus security selection in our whitepaper “Tactical Alpha: A Quantitative Case for Active Asset Allocation.” The paper makes a compelling case that both asset allocation is superior to security selection and that active approaches are superior to strategic approaches.]
On Attribution Bias, Systematic Investing and Frying Pans to the Face
Joe Saul-Sehy: I think what you’re saying is once you give away the fact that you’re not that smart, that’s where the power is, right? Because then you will depend on systems and processes instead of on your magic wand. Once you give that away, you become much more powerful.
Adam Butler: It’s incredibly liberating and I mean I can speak from experience because prior to the 2008, 2009 financial crisis, I was in the position where I believed that I was an expert and that my judgment alone could lead to smart, profitable, active trades. I listen to other experts and I had a well-formed narrative constructed from a mosaic of incredible knowledge and insight and it didn’t pay off for me in 2008, 2009. As I scanned the horizon of all the smart gurus out there that I followed, it didn’t work out for any of them either.
So that was the frying pan on the face that led to a complete overhaul of how I thought about markets and that eventually led to the perspective that we brought to bear in this book.
On Sequence of Returns
Joe Saul-Sehy: You talk about savings and withdrawing from portfolios. How is that going to change your asset allocation?
Adam Butler: When you’re younger, you’ve got a lot of time ahead of you to accrue savings and to generate growth from your investments. So when you start your savings process, you have very little at risk. So you want to maximize your allocation to risky assets when you have a long time horizon and you have a very small portion of your total lifetime expected wealth that’s actualy at risk in the markets.
Then as you get a little older and as you accrue more savings, and as you approach retirement, that becomes a very critical period. When you have a lot in savings and very little time to make up for savings that you lose from bad market returns, then the sequence of returns has a profound impact on your probability of success.
You’ve got to increase your diversification as you approach retirement to minimize the likelihood of a major impairment when your amount of capital is large and your time to make up for it is small.
On Economic Regimes and Structural Diversification
Joe Saul-Sehy: Yeah. You talk a lot in the book about correlation and about how having non-correlating assets and negatively correlating assets really can be a powerful tool. Talk about that for a moment.
Adam Butler: Absolutely. I mean optimally what you want to have for your portfolio is an allocation to as many sources of risk premium. In other words, sources of excess return above cash as possible. But you want to have them coming from as diverse sources as possible, so that you’re not relying on – for example – strong growth and low inflation to get you to your retirement goals because I mean we know that stocks only really thrive during periods of strong economic growth and relatively low inflation. Once you get a major acceleration in inflation or deflation, stocks do very badly if you have a period of low growth. We know during recessions that stocks do very badly.
We know that there are really four states of the world. We’ve got states of accelerating inflation and high growth, decelerating inflation and high growth, accelerating inflation and low growth and decelerating inflation and low growth. Those are the four states of the world.
There are different asset classes that thrive in each of those states.
[Editor’s Note: On several occasions, we’ve called this “structural diversification.” It’s vitally important to include in one’s investment universe asset classes that thrive in each of the four different economic regimes.]
Joe Saul-Sehy: Right. The book is called Adaptive Asset Allocation. Wiley is the publisher. I think probably the biggest business book publisher to my mind. The book is available everywhere Adam?
Adam Butler: Yeah, yeah, absolutely, widely distributed and we’re constantly soliciting feedback and – you know, it’s amazing. I was told by so many authors when we went to press that the second you complete the draft of your book is the second that you start to hate it because you’re continuing to learn and you’re revising your rethinking. But a lot of the broad topics that we cover in there are evergreen and universal.
As long as there are principle agent problems, as long as people exhibit a home bias, as long as people return chase and focus on short term benchmark tracking and the wide variety of other very human foibles, that drive markets from day to day, then these principles will apply.