This post is the first of a series where we will be providing some of our own thoughts and commentary the conversations we had in the first season of our new podcast.
This post covers our conversation with Meb Faber, which you can listen to here.
2:09 - Meb hijacks the show to ask a very important question.
Nathan Faber (“NF”)… no relation… that I know of: If you follow @choffstein on Twitter, you know that this intro music is right up his alley.
Justin Sibears (“JS”): I voted for Taylor Swift, but when you aren’t the CIO you don’t get to make those kinds of crucial decisions.
4:14 - What was the catalyst for writing A Quantitative Approach to Tactical Asset Allocation?
NF: I like how the catalyst for Meb’s writing this paper was to get out of taking a test. What an impact it turned out to have and great timing on writing it before 2008. This was one of the first papers I read when I got into the asset management industry, and it had a big effect on my thinking about active management in terms of developing rules and sticking with them.
JS: I find it fascinating, but not too surprising, that Rob Arnott was one of the folks that actually responded to Meb with constructive feedback. In my mind and despite their entertaining disagreements, both Rob and Cliff Asness have been so hugely influential in quantitative finance by acting as a bridge between academia and practice.
Corey Hoffstein ("CH"): As I mentioned in the podcast, I asked a lot of people if they knew what made Meb write this piece. Getting to hear the actual story was a lot of fun for me. I think Meb would say that publishing this paper changed his life, and he only did it because he wanted to avoid taking a test.
9:59 - Meb discusses what helped make the paper so popular.
NF: The paper did not rely on complex math or statistics to make investing decisions. The simplicity of the system is very appealing. Yet, the simplicity also makes the system a natural target for tweaking in search of improvements, especially during periods of underperformance.
JS: We talk about timing luck a lot at Newfound. Timing luck is very important when it comes to strategy popularity and asset retention. A positive early experience can fortify investors with the wherewithal to ride out later underperformance, whereas early losses can rattle confidence and lead to an early exit.
CH: I would speculate that the fortunate timing in the publishing of this had a tremendous amount to do with its rise in popularity. Had Meb published it in 1996 instead of 2006, I doubt many investors would have cared. But publishing a paper that immediately proved itself out-of-sample, coupled with a rapidly increasing preference among investors for risk-managed solutions, put rockets behind its popularity.
12:52 - Meb reflects on a decade of out-of-sample performance.
NF: The out-of-sample experience for trend following post-2007 is so interesting because of how it first worked so well right after the publishing of the paper and then lagged many popular equity benchmarks in the years following. The problem with this is not the trend following; the problem is with investor expectations for long/flat trend following strategies.
JS: Trend-following is a risk management tool. Benchmarking a long/flat, momentum-based equity strategy to long-only equities is no less problematic than benchmarking a 100/0 stock/bond mix to a 60/40 stock/bond mix. Ultimately, these strategies are about avoiding large drawdowns at a cost that is competitive relative to other risk management tools available in the hopes of (1) managing sequence risk and (2) managing investor behavior by lessening the risk of panicked decision-making during times of market crisis.
CH: We always say that "risk cannot be destroyed, only transformed." With long/flat trend following, the risk of a sustained and prolonged drawdown is often transformed into the risk of whipsaw. The 2008 and post-2008 experience with long/flat trend following has been a near perfect representation of this trade-off.
15:33 - Corey asks Meb what he thinks the common misinterpretations of the paper are.
NF: Personally, I have experienced this disagreement with models. The important ways to avoid this are to develop a system that you can stick with (e.g. rules are intuitive and the testing has highlighted some weaknesses) and fully automate it so that you do not have the opportunity to override the model.
JS: Quantitative + Qualitative = Qualitative.
CH: Enhancements can be a slippery slope. There is a very fine line between applying new learning and evidence and simply overfitting to history. The former may improve your model while the latter will almost certainly hurt it. This asymmetric payoff should make us lean away from needless tinkering.
This does not mean we should not continue researching methods of improvement, but we should be hesitant in needlessly complicating our model.
21:54 - Meb dives into how his thinking on investing has evolved since 2006.
NF: Hitting a 100-bagger biotech stock can be an investing goal, but chasing that goal can cause a lot of pain. Meb’s starting point of a global market portfolio can provide a good amount of diversification and prevent the ruin that can come about when trying to pick stocks. You can still make tactical tilts around the base allocations, but a good strategic core should serve as a basis for most investment portfolios.
JS: The optimal plan is the one you can stick with.
CH: "It's a journey." My thesis has always been that the method an investor adopts is heavily influenced by their experience. With over a decade of blog posts, we have the privilege of being able to go back and re-live this journey with Meb. I would speculate that Meb's curiosity and studies into many different angles of investing has given him a variety of perspectives and frameworks to approach the problem from. His ultimate takeaway is simply trying to build sometime robust and balanced that he can stick with no matter the environment. In practice, this is easier said than done, but the important conclusion is that after scouring the investment landscape, Meb's holy grail is avoiding mistakes.
26:48 - Historically, it's really hard to find a buy-and-hold portfolio that has not lost 25% on a real basis at some point.
NF: I may not have said that bonds lost 0-10%, but I certainly would not have said they lost 50%+.
JS: Being over-allocated to bonds can be just as “risky” as being over-allocated to stocks. It’s just a matter of whether you are failing slow or failing fast.
I think Meb’s thinking around portfolio construction and minimizing regret through strategy diversification (e.g. buy-and-hold + trend-following) are very underutilized.
32:27 - Corey asks Meb to distill his thoughts and answer, "What does Meb Faber actually believe in?" It all sums up to: "just survive."
NF: This applies to many areas of life. You are not a Monte Carlo simulation (as long as you do not live in a commune… and even then, that is only financially and not for things like health, education, etc.)
JS: How much is survival of the fittest vs. the survival of the luckiest?
CH: I would speculate that Meb's philosophy of "just survive" is largely guided by his experience and explorations of so many different investing approaches and styles. I like to say that in the world of investing, "hubris sells but humility survives." For Meb to say that his simple goal is, first and foremost, just to survive is an acknowledgement of just how hard investing is. Of course, it echoes Warren Buffett's first rule of investing as well: "Never lose money."
37:57 - Meb discusses how the "just survive" mentality leads to the Trinity Portfolio.
NF: The Trinity portfolio is similar to the All-Weather portfolio that tries to survive in any market environment. I like Meb’s inclusion of trend-following as a sleeve, which the All-Weather does not have. Creating a mental framework where we treat systematic strategies like asset classes is a good way to create a more diversified portfolio.
JS: One of the topics that has always fascinated me is how much commonsense investing wisdom for U.S.-based investors is colored by the fact that our markets have delivered such strong long-term outperformance relative to other countries. There is no holy grail in investing. There are certainly examples of countries/geographies where buy-and-hold investing could have ended in disaster, despite how well it has done in the U.S.
CH: Meb's Trinity Portfolio embraces diversification across economic exposures, asset classes, and active styles. But as we've said in the past, diversification will always disappoint. While the portfolio itself may be designed to sustain just about any environment, investors in the portfolio have to be sustainable as well.
Ultimately, diversification is a means of managing risk and risk management often has a cost (think premium to an insurance policy). The catastrophic risks that the portfolio might protect against may never be realized in our lifetimes, meaning that we paid a premium for nothing. Yet our other choice is to be completely naked to these risks. In many ways, this is akin to having some form of property insurance. If we go our entire lives without a catastrophic fire or flood, are we upset about the premiums we paid? With the perfect benefit of hindsight, we know we didn't need them, but they provided a tremendous amount of security along the way.
For some investors, this security is invaluable. For others, however, missing out on market returns can be psychologically devastating.
42:20 - Meb discusses how financial advisors and asset managers have implicit exposure to financial markets.
NF: I am sure many do not think about being 4x levered to stock market. Thinking about the relationships between your assets, your job, your investments, etc. can uncover hidden risks that lead to different investing decisions.
CH: I think this point goes under appreciated by a large number of people who work in investment management. Even before investing their own assets, financial advisors have a tremendous amount of implicit skin in the game. If we consider our holistic net-worth as a combination of human and investment capital, investment professionals may actually consider investing very conservatively based upon the implicit (and often levered) market exposure they already have.
44:02 - Meb opens up about his experience with farmland and angel investing.
NF: Non-public assets can be difficult to access with higher barriers to entry and a large amount of due diligence required to understand the risks.
JS: I love the mindset that Meb has here. He talks about his angel investments as tuition. It shows a willingness to continue to learn and evolve in one’s thinking.
46:52 - Meb discusses the criteria he uses to think about launching a new strategy or ETF at Cambria.
NF: Going back to the implicit leverage that financial professionals have, investing in your own products increases this multiple. But having a company owner do this is a good signal that they have a strong belief in their product and are not afraid to have more skin in the game.
JS: Performance chasing, while never a good thing (unless you are doing so as part of a disciplined, trend-following program), is especially problematic for risk-managed strategies. Waiting for good performance to buy is akin to waiting for your house to burn down to buy home insurance. It just doesn’t work.
CH: I really appreciated Meb's 4th criteria. A good investment strategy is not always a good investment product from the point of view of an asset manager.
53:44 - Meb explores the balance of simple versus complex in strategy design and management.
NF: There is a fine balance between simple and complex. A strategy should be simple to understand, which was Meb’s point, but the complexity should only be as much as it needs to be (e.g. not overfit). This point reminds me of the Zen of Python – Simple is better than complex. Complex is better than complicated.
58:00 - If you were an investment strategy, what strategy would you be and why?