Take 15 Series Interview Recorded 08 Nov 2016
Meb Faber on the Challenges of Active Management (Take 15)
Mebane Faber, co-founder and chief investment officer at Cambria Investment Management, takes a quantitative approach to investing. In this brief interview, he shares his views on common behavioral pitfalls, active management, shareholder yield, and the exaggerated impact of asset allocation on returns.
The Take 15 Series is a series of short interviews with leading practitioners on timely topics focused on the investment profession.
[MUSIC PLAYING] DAVID LARRABEE: Welcome to another Take 15 interview from CFA Institute. I'm Dave Larrabee. And today I'm joined by Meb Faber.
Meb is co-founder, chief investment officer, and fund manager at Cambria Investment Management. He's also a prolific writer, having authored numerous articles, white papers, and five books, including his most recent, Invest With the House-- Hacking the Top Hedge Funds. Meb, welcome and thanks for joining us.
MEBANE FABER: Great to be here.
DAVID LARRABEE: Well, you take a quantitative approach to investing, which helps you avoid many of the common behavioral pitfalls. In your experience, what are some of the most destructive biases that investors face?
MEBANE FABER: I don't know if it helps me avoid all the pitfalls, because we still have all the same drawdowns and exposures. But at least it makes it systematic.
And the way that we got to this is I have all the biases. So I'm overconfident, I'll take more risk if you can give it to me. But at least starting to understand what a lot of these biases are helps you craft and understand your reactions to approaches.
And we talked a little bit today in the talk about expected returns. And so examples like being overconfident, expected returns that are just unlikely in the future.
If you start to be able to frame it in a way that you understand that what we really evolved-- the Savannah millions of years ago was not the right world for-- did not prepare us for a world of trading IBM, and asset allocation, and shorting stocks, and investing. History did not teach us to run towards the lion, which in many cases in investing is things you want to be doing-- like investing in value, investing in things that have gone down, and selling the things that are dear. So start to learn a little bit about your own biases, but also a little history, can help give people a lot more comfort and have future outcomes a little more certain.
DAVID LARRABEE: Now home country bias is a common affliction. And in the US, investors have, what, 70%, 80% of their portfolios invested in US stocks when US stocks make up roughly half of the global market cap of stocks. So what's behind this home country bias and how does it impact investors' portfolios and returns?
MEBANE FABER: It's pretty simple and it's also understandable. For the same reason I'm a Denver Broncos fan, I cheer for the Virginia Cavaliers-- it's what I understand, it's what's familiar, it's close to home, and it's comfortable.
And I talk to so many investors around the world. But in the US, they say, well, I just don't understand foreign markets as much. But then you talk to foreign-- it's the same thing everywhere and everyone has it. It would be a little different if it was just Americans. Italians just as bad, Aussies just as bad, everyone-- the Japanese. Everyone. invests the most in their own markets.
The problem is, it's really a terrible idea. Because it gives you a lot of concentration risk that you don't need and isn't compensated for. And so ask any Greek, Brazilian, Russian investor over the last five years if it was a great idea to have 80% in your own market. It's not.
So there's other problems that that also causes. But in general, you want to be diversified and you want to at least have the starting point of being the global portfolio, which in the case in the US is half in the US, half abroad.
DAVID LARRABEE: OK. Now you've noted the secular decline of dividend payout ratios over the years. You've also suggested that investors should instead focus on shareholder yield. So if you would, take a moment and explain the concept of shareholder yield and what you've found in terms of any performance advantages using that metric.
MEBANE FABER: Looking at dividends is one of the most irrational approaches we've seen over history. Now people love it. And dividend stocks historically have worked great.
And the reason they've worked is because it's been a slight value tilt. But if you look at a company and say, look, there's only five ways they can use their cash-- and it's pay a dividend, they could buy back stock, that could pay down debt, they could reinvest in the business, or they could go acquire another business. That's it. You can't do anything else.
And so what's happened in the US is that CFAs will know, finance 101, dividends and buybacks are the exact same thing. Given valuations-- stock trading at normal valuation, ignoring stuff like taxes-- they're the exact same thing.
So what happened is starting in the early '80s, the SEC passed a rule to let companies buy back stock, gave them safe harbor for not being in trouble for buying back stock. And because buybacks are a more efficient means of distributing cash-- because you're not paying taxes on the dividends-- more and more companies started buying back stock. And so what you've seen since the early '80s now, in any given year, stock buybacks often outpace dividends.
And so if you're a dividend investor, you're ignoring half of how companies distribute their cash. Buyback investors make the same mistake. If you're focusing just on buybacks, you're ignoring dividends. So you need to look at this holistic measure.
And we also say you have to look at net buybacks. Because a lot of companies issue a lot of stock. So dividends plus net buybacks.
And the good news there is that has a very high correlation with free cash flow. And so if you have that approach-- and also we recommend using a valuation filter as well. But buying back companies that have high yield and are cheap has historically been a wonderful portfolio.
And on top of that, dividend stocks have historically underperformed in a rising rate environment. Whether that's happening now, it's been going on for two weeks, who knows. But shareholder yield stocks have historically done well in a rising rate environment. So we think it's a much better place to be.
DAVID LARRABEE: OK. Active managers have been under fire of late. But there are still a few active managers out there who've demonstrated they can outperform the market over time. You've studied a lot of these folks. What are some of the common characteristics or traits that they share?
MEBANE FABER: So there is a lot in that question. One is we think of active and passive much differently than most. And so passive to me historically has meant only market cap indexing. But passive now today just means anything that's rules-based, as nonsensical as that being. Active has historically meant-- the way people think about it is the Peter Lynch or Warren Buffett. So the way that we think about true active is the guys that are out there concentrate-- and you want to be concentrated, you want to look very different. Because otherwise there's no reason to pay high fees for a closet indexer.
So bigger question-- can you identify managers-- are there managers that outperform and can you identify those ahead of time? And we think you can. And we think it's actually not that hard.
There's been a lot of these managers. And the ones to look at-- and we talk about this in our book-- are these managers that historically are stock pickers, they have long-term time horizons. So Buffett is a great example. And so they're not trading a lot and they're value-oriented. And historically, that's a great pool to choose from.
And the good news is you can look up holdings for any of those guys totally free once a quarter-- they have to disclose their portfolios. And you can mimic-- or we call it clone them. And in many cases, it's a wonderful way to either screen or get exposure to these hedge fund managers. The best part is you don't have to pay them a fee.
DAVID LARRABEE: Now you've examined the performance of a wide range of asset allocation models over the years. And you've found little difference in terms of returns. So one of your conclusions was that the impact of asset allocation has been overrated. So what does that say about the importance of re-balancing our portfolios? And what should investors be focused on instead?
MEBANE FABER: People spend way too much time on the asset allocation decision. In reality, we say it almost doesn't matter. As long as you have some global stocks, some global bonds, some global assets. That's a great core. And for that core, you should pay as little as possible.
And re-balance-- if it's taxable account, re-balance based on cash flows and optimize it. If it's tax-exempt, you can re-balance once a year and be done with it. Pay as little as possible. Because ETFs and funds out there that will charge less than 30 basis points. You can be done-- go play golf, go do whatever else you like to do and be done with the asset allocation. We think it's a commodity.
However, if you then say, OK, I want to spend my time either tilting that portfolios-- so coming up with better indexes maybe that move away from market cap-- I want to come up with liquid alt additions, such as managed futures, maybe long short equity, private equity, timber, whatever it may be that may diversify that core, fine. Go spend your time doing that. We think that's a great way to do it.
I've often said that managed futures is my desert island strategy. I think it's one of the best diversifies. But for that basic core, I don't think you have to pay that much. And I think people spend way too much time worrying about it when in reality, yes, the results show that it doesn't matter exactly how much you put in each little box.
DAVID LARRABEE: Meb, thanks very much for sharing your insights with us today.
MEBANE FABER: Thank you.
DAVID LARRABEE: And thank you for watching.
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About the Speaker(s)
Mebane Faber is a cofounder and the chief investment officer of Cambria Investment Management. He is the manager of Cambria’s ETFs and separate accounts. Mr. Faber is the host of The Meb Faber Show podcast and has authored numerous white papers and leather-bound books. He is a frequent speaker and writer on investment strategies and has been featured in Barron’s, the New York Times, and the New Yorker. Mr. Faber graduated from the University of Virginia with a double major in engineering science and biology.