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Cliff Asness Great WealthTrack Interview [TRANSCRIPT]

Cliff Asness’ interview with Consuelo Mack aired this weekend on WealthTrack. The interview covers asset allocation, Shiller PE, Ben Graham, leverage, shorting, derivatives and more. The interview was really informative so we decided to transcribe it. The interview can be printed and/or made into a PDF by using the tool at the bottom of the page. NOTE: This is not a perfect transcription, but you can also see the full video below, enjoy!

Also see Cliff Asness: Low-risk investing Without industry Risk

Cliff Asness video and transcript

This week on WealthTrack  a financial thought leader and money manager who says you are not totally diversified until the 3 dirty words of finance are in your portfolio, AQR capital management’s Cliff Asness explains what they are next on Consuelo Mack WealthTrack Consuelo Mack

Hello and welcome to this addition of WealthTrack I am Consuelo Mack get a comfortable seat take out your note pads and be prepared for a graduate level seminar on investing mostly in laymen’s terms but just in case I am providing some definitions, our guest this week is a financial thought leader with an academic and research vent, he his Clifford Asness the managing and founding principal of AQR capital management, AQR stand for Applied quantitative research Asness and several of his team mates are what are known as Quants and I will define that in a moment, Asness co foundered AQR in 1998 the global investment management firm which runs Hedge funds mutual funds and a diversified collection of investments strategies as over 83 billion $ in assets under management 11 billion of which is in mutual funds, Asness has a PHD in finance from the university of Chicago as received several awards for numerous financial research papers some of which we will have on our website, so what does a quant do? Here is how the financial times puts it.

Cliff Asness Great WealthTrack Interview [TRANSCRIPT]

A quantitative analyst typically combines information and techniques from economic theory accounting statistics computer programming and information technology in order to identify the proper value for a financial instrument such as a stock bond derivative or other security, well that is as deep as I want to go but luckily Asness speaks plain English and was able to communicate on my level, and I started with the basics, why he believes stocks are expensive and will not provide the 8% annual returns most investors expect, he basis his lower forecasts on a valuation method devised by one of our favorite guests Yale professor Robert chillers cape ratio which stands for cyclically adjusted priced to earnings ratio, it is figured over a 10 year periods instead of the typical PE multiple which is based on current price and earnings.

Cliff Asness

It’s obvious that stocks have value and you want to use a longer term period to evaluate them Bobs method we have been using it for more than 10 years so we didn’t pick it because its 10 years and its very useful to use the same method for a long time, because it doesn’t let you cheat, and if you want to be a perma bear one great way to do it is to keep moving your method around to whatever measure set tells you what you like at that time but we have been using the same method for a long time, its be all end all its not perfect but the average for this number is going to be 15s,16s,17s something like that

Consuelo Mack

This pricing is multiple over 10 years

Cliff Asness

It’s right now around 23, 24

Consuelo Mack

So it’s relatively expensive

Cliff Asness

Well relatively expensive and historically if you look at every 10 year period and divide them into starting periods by this cape number and then look at the average return in the next 10 years, the average return has been zero over inflation, when starting from this level

Consuelo Mack

You just said we are talking about long term now even though, so you and I are looking at the current market by Bob Shillers price range ratio measure its expensive its 22 or 23 the average is 15 so that’s now but so looking at now let’s say 5 to 10 years you still think that stock returns are going top be lower than they have been in the past?

Cliff Asness

I think they are going to either be a little bit lower or a bunch lower, if PE stay high they will be a little bit lower because you won’t suffer that lost for me conversion but your buying at a higher price and a lower yield, and if they stay where they are instead of what historically has been a 5, 6,7 percent re over turn over inflation I think more like a 4% return over inflation, inflation you could argue what it is but if that’s a 2 right now and if it stays steady we are talking about a 6 instead of an 8, if inflation goes up I can get to an 8 but that’s not the fun way to get to an 8, that doesn’t make anyone any happier

Consuelo Mack

So why do I care so why is this so important to understand that the returns the real returns that’s actual inflation that you’re going to get from stocks are lower than what you have been expecting?

Cliff Asness

You care about this for planning purposes, if you have a fearing individual with a spreadsheet at home which I believe every individual who knows how to use a spreadsheet as tucked away somewhere of how much I have to save for retirement, one number you put into that spreadsheet is what am I going to earn on my nest egg, if you are an institution a pension fund and endowment and you have either obligations or you want to know what you can fund at a school that you’re going to get the endowment for, you make an assumption on what you’re going to make on your investments, if you are assuming 8 and the true answer is 6 your being too optimistic

Consuelo Mack

So that’s one of the things of how you can adjust that you can work longer or you can save more, but hey you’re a money manager and your running hedge funds and your running mutual funds, you have another approach that you think that we can get higher returns right? , so talk about number one how you think we should be adjusting our portfolio strategy and away from an over alliance on stocks which is dangerous to other strategies?

Cliff Asness

Well you are right we do start out thinking investors over rely on stocks, if you take your famous 60/40 investor I am not trying to say that actually owns it but we all use it the canonical example, bonds are also expensive these days that’s the last thing you need someone to come here and explain it they are lower yielding, they will tax you double  whammy but the typical portfolio if that’s 60/40 it’s really a stock portfolio, stocks drive the up stocks drive the downs they drive the long term risk they drive the long term return, bonds are diluting the return on stocks, so we think in a lot of ways people should be looking for other things other than just equities, let me step back and tell you how we at AQR view the world of investing, how do you turn $ today to more than a $ tomorrow?, we think of it has 3 ways one is markets go up over time even with my rather depressing talk early on its still 6% per year

Consuelo Mack

They do

Cliff Asness

And you still want that in your portfolio, we are not saying oh none of that, another is Alfa you can be a complete efficient market cynic about it you can believe you find it left and right, but it should be relatively unique, meaning it’s a skill set one or a handful of mangers possess but I can’t explain it to you, if I possess it I can’t explain it to you in 30 seconds, I can’t tell you here’s a simple strategy to pursue its very bespoken its very customized

Consuelo Mack

Also we can’t as individual investors we can’t rely on it, history as shown that basically there are hot managers and they cool off

Cliff Asness

You are exactly right, we do think there is a middle ground between those two, of strategies that are known and when I say a strategy I mean if a hedge fund manager’s doing it its long this and short this, if a traditional manager and you know we do both, its overly weighed this and under weighed this, but let me give you a bunch of examples, academic research as taught us a lot, cheap things be it expensive things over time, it was originally found for individual stocks we and others have extended it to markets around the world to bond markets to currencies to commodities, momentum

Consuelo Mack

And actually Ben Graham could have told you that as well 20s are dead but yes

Cliff Asness

Sometimes I come clean before someone says that and says that I don’t claim I have discovered this and I point out Ben Graham would roll over in his grave if I tried to pretend I or the academic’s in the 80s when a lot of this was studied, but

Consuelo Mack

But study is actually panned out it’s actually been proven to be a good strategy to buy cheap

Cliff Asness

It has and what I am talking about is a little bit different than the Ben Graham approach, in that the Ben Graham approach which a lot of people have practiced successfully I am certainly not putting down that approach its much more of a systematic thing, if you go around the world and buy the 500 cheapest stocks on an average of 10 of your favorite measures and you come up with similar ones to me priced to earnings sales cash flow, whatever your favorites are and sure let’s pretend we are hedge fund managers now the 500 worst there has been a fairly reliable and when a statistician like me says reliable I mean 2 out of 3 years, if your mechanics are reliable like this you fire your mechanic, but 2 out of 3 years is actually a very great investment, where cheap as beaten expensive, that’s a little bit different and that’s what was really studied in the 80s Farm and French was among the first to study this I added some to this literature its grown over time and that as held up so value is one momentum is another and it feels like the opposite of value

Consuelo Mack

Yes it certainly does because momentum I think as being short term

Cliff Asness

I would say its shorter term, the momentum that has been successful in both the academic literature and I think in real life or at least the 20 years I’ve been looking at it is more like 6 to 12 months momentum it’s not super high frequency that use a buzz word today it’s that things have been going up over what I call the short to medium term tend to keep going

Consuelo Mack

Now 6 to 12 months that’s kind of your window from a man to man and I am actually as we are talking when you look at the strategies that you employ value is one and momentum is another AQR as well so this is

Cliff Asness

And those two often disagree if you want to get full geek credentials you refer to them as negatively correlate but they often disagree because something that has been going up a lot in the last year is expensive but what if the 12th most expensive thing as finally started to give it up a bit maybe it was the most expensive thing a year ago maybe that guys both expensive and has bad momentum, that’s a candidate for underweight or a short when these things agree, other things that and AQR as contributed a lot to this but this is not unique to us this is giant literature on this two other very big things is we believe in are defensive high quality low beta meaning low when the stock market moves it doesn’t move very much, other forms of quality things like profitable companies, systematically the same way I will never talk about your favorite individual stock but systematically stocks that protect you have actually out performed there risk level

Consuelo Mack

And so don’t those overlap with value?

Cliff Asness

You know the answer is yes, it is ok that things over lap and you know people like me doing when we write papers on these things we literally try to answer the question is the overlap driving all of this or is there anything new to this, and it turns out there is some overlap but you really want both, think of it this way every measure is imperfect,

Consuelo Mack

So what is the defensive then I mean what makes an investment defensive?

Cliff Asness

A defensive stock the simplest definition you can broaden it would be a low volatility of stock that doesn’t bounce around much or a low beta stock that’s often referred to, when the market moves up it moves up 80 % as much and goes down 80%

Consuelo Mack

So I know you don’t touch stocks but is there a classic example of a defensive of stock?

Cliff Asness

Well I will give you a classic example and then I will shoot it down is that ok , most people think about industries when they think about this, they think about utilities as the classic example of defensive and real sipricals of technologies that are a classic example, you know I am also talking about papers we write its oddly my first love is still writing in these things, but myself and two colleagues have just written a paper saying that if you remove the industry bet entirely meaning we take about 50 industries and buy the defensive half of that industry it works better, the industry bet is actually part of it but you don’t need to make the industry bet, so can I come up with one stock example I will fail with that like I fail every time you ask me about it, but in general buying things that are cheap buying things that have started to get better and buying things that can protect you which is related to cheap your right but not the same, the best assets in the world as all of those and there are other things we look for at AQR it’s not the be all end all but I’m giving you the digits

Consuelo Mack

So these are right so these are the big themes, so one of the things when you and I had talked earlier you talked about that it’s very important to diversify your portfolio and these are strategies that enable you to diversify because momentum is not correlated with value and whatever

Cliff Asness

When you do them in a long short way neither is correlated with the market

Consuelo Mack

So most of us we hear long short and we think ok this is fun for Cliff Asness to talk about your capitol but I am just a regular guy or gal and there’s no way that I can do long short so what are the accessible diversifiers to the average person

Cliff Asness

I think you want to go out there and look for funds that are constructing themselves in some way they are taking out some of the market risk and betting on something else, I’ve just given you the things I believe in I don’t think ive figured out the all world, there are probably plenty of other examples, but finding a small tiny tilt that’s mainly still equity market risk is probably not going to get the job done in a world where equity is going to return lower maybe it will be slightly better, but pretty much anything you believe in so it can apply to any manager that is done in a fun form and increasingly you can do this you can create a hedged fund , we notice I said hedged fund not hedge fund, because I am talking about regular old fashioned neutral funds are perfectly viable for this , we joke at AQR and its not just a joke that there are 3 dirty words in finance, George Carling used to have (inaudible15.07) on TV as a side point you now can say 6 of them and I will leave that to the viewer’s imagination

Consuelo Mack

Three is a better number for Television

Cliff Asness

Three dirty words of finance are leverage derivatives and shorting, and of course they are scary and first let me tell you they really are scary, we think

Consuelo Mack

Leverage having debt is a disaster if you had too much of it during a financial crisis

Cliff Asness

Absolutely shorting can get you in trouble certainly if you concentrate on an individual name derivatives certainly if you don’t understand about what you are doing, this would be a very general statement but the worse use for these things so its giving them there worse name if you ask me, is twofold it levering and often done with derivatives and what not a bad bet to try to make it into more money, and let me give you an example, if I sat here and told you stocks are going to return less than normal which I did someone can come along and say well I can fix that for you, and I am going to make the math easier on myself when I am on TV I can’t do math any better than someone who’s not a Quant, let’s say they are half as good as normal someone comes along and says I will just lever it two to one first of all they are not wrong they did return your expected return as gone up as doubled, the only problem is of course they have also doubled their risk, and that can be a total disaster and the other dangerous use of these things is obfuscation particularly in derivatives I am not a big regulation guy that won’t surprise you but I will give people advise that there’s no particularly great or pressing need for super complicate derivatives but the basic one

Consuelo Mack

Such as…

Cliff Asness

Financial futures, short selling individual stock is not a good derivative but it’s my 3rd dirty word, when these three things are used not to lever up a bad bet to try to make as much money as the past, not to out escape the complicated bet but to create a new return and risk and I say both there is still a risk that wasn’t there before, long cheap stocks with good momentum and good quality characteristic’s that are defensive, short there opposite brethren that’s not an arbitrage you don’t make money all the time, but it’s a different risk in the stock market that we believe pays you to do far more often than it doesn’t , so when these techniques are used in moderation to diversify more to make something that would not matter now matter a little bit then we think they can be a force for good

Consuelo Mack

The typical diversifiers are for instance Gold I mean cash is considered to be a diversifier of limited partnerships, there are reaps that are considered none to correlated are there other simpler tools that we should have or investments that we should have in our portfolios if we can’t go the kind of more sophisticated route

Cliff Asness

Sure, you’ve managed to name 4 of the many things I consider myself not an expert on but leaps are a certain possibility they are a real assets in general should get more play in our portfolio and the stock market doesn’t have enough of them, I would buy diversified portfolio of leaps and that could be my expertise I don’t have special expertise, I do think cash even at zero if you are, it becomes a timing situation I do not think people should all run there cash the risk premiums are still positive, but here is where I prefer some people I set up a straw man that you can ask me about, a lot of people ask me about should I buy Puts now should I go buy an insurance against a market decline, I think that is almost always a bad idea unless your timing is superb, Puts are almost optional

Consuelo Mack

They are short term you can lose money on them and they can be expensive

Cliff Asness

Hugely expensive you’ve nailed it

Consuelo Mack

What about just Gold as an insurance policy against disaster

Cliff Asness

I would own a small amount in any portfolio, and not a large amount but Gold is true it’s not a bad world it’s a disastrous world, insurance so I would own a small amount of that I would own a small amount of Reads but to be brutally honest without access to those 3 dirty words, there’s not an all lot you can do to escape from stock market dominating your portfolio, its most of what’s out there

Consuelo Mack

Greatest risks in the market or risk in the market right now Cliff

Cliff Asness

The greatest risk in the market which is certainly I am not forecasting is I think an expensive market is more subject to bolt from the blue bad news than a cheap market

Consuelo Mack

One investment for a long term risk of my portfolio what would you have us all own some of?

Cliff Asness

I am going to be very counter intuitive and this is not a forecast I am actually picking a expensive investment one more expensive than stock I am going to pick the bond market, and I don’t want anyone to listen to your show and go he loves bonds, having said that people understate the power of diversification, take the 1970s the 1970s was a disastrous period for bonds the decade a portfolio took equal risks in stocks bonds and commodities, something like we might prefer, did better than all stocks and it had way more bonds,

Consuelo Mack

In the 70s

Cliff Asness

One thing commodities where strong which helped which in an inflationary period which is when you’re going to see a bond disaster not a certainty but it’s not a bad bet I think, second the power of diversification is that strong, than having 3 different horse even if one doesn’t work, if you commit yourself to diversification negatively the glass is empty half empty, another way to view it is your always is always the worst thing but the glass is half full and your always in the best thing turned out to be commodities that decade, if you look over the long term we think balance risk even when rates mildly rise we look at period’s from the 40s to the 80s you know your interest rate it mildly rose and then they shot up in the early 80s and they have been coming down ever since until very recently, even over that rising period having a relatively equal amount of risk involved not even $ worked better than traditional approaches, so this is not a short term forecast I am certainly not sitting here telling your viewers here’s a undervalued asset

Consuelo Mack

But don’t abandon bonds and always have a portion in your portfolio

Cliff Asness

Exactly and I love it because its counter intuitive and it gives me a chance to beat to death what is almost always our most important theme diversification beats timing

Consuelo Mack

 

Cliff to get back to real basics so we just mentioned 3 different asset classes to diversification, commodities, stocks, bonds so should those be the 3 foundations of our investment stool

Cliff Asness

The short answer is yes but I always give the slightly longer answer they are the 3 biggies, but a few other things that I give honorable mention to are inflation protective bonds which in some actions some big movements they look a lot like regular old government bonds, but you can easily imagine and we have seen times where they behave quite differently they are inflation protected so if we ever hit a period of real inflation they would have to have that

Consuelo Mack

Which we will at some point but right now they are growing popular so this is probably a good time to buy them

Cliff Asness

It pretty might well be again I avoid all attempts of you to trick me into timing something, I am joking

Consuelo Mack

Except value you do pay a lot of attention to value so

Cliff Asness

We do but we always do we don’t say now so those are the 3 big legs of the school but inflation protected bonds and then another thing I give an honorable mention to which I want to sneak in is making sure your very global, and that’s another thing that might be unpopular now particularly for the US investors because the US as done better than global portfolios particularly this year, we have no idea speaking for myself I have no idea and I think the Royal We of the world as very little idea in this short term or the next year which part of the world is going to do better, global diversification protects you over the long term, we have written on this we wrote a paper that said global diversification works with parenthesis eventually, meaning it doesn’t do a great job in the short term if everything crashes if the world crashes it’s going to affect everything, but global diversification to us is much more about the chance that it turns out that your country whatever that countries is , is the Japan of the 1990s you are the worlds basket case, maybe that will be the post a job for a long time because it happened recently and I don’t mean to pick on japan but when we go do the study every country to some degree maybe not as bad as japan was then but to some degree has been the japan for a while, for long periods so diversifying globally takes away the chance that you have all your eggs in the wrong basket

Consuelo Mack

Cliff Asness

it is always a treat to have you on WealthTrack so thank you so much for being with us from AQR capital management