Transcript: GMO’s Matt Kadnar



The transcript from this week’s MIB: Matt Kadnar of GMO is below.

You can stream/download the full conversation, including the podcast extras on iTunesBloombergOvercast, and Soundcloud. Our earlier podcasts can all be found on iTunesSoundcloudOvercast and Bloomberg.



ANNOUNCER (voice-over): This is Masters in Business with Barry Ritholtz on Bloomberg Radio.

BARRY RITHOLTZ, HOST: So, I was fortunate enough to get invited up to a GMO in Boston where I sat with Matt Kadnar. He’s a member of the Asset Allocation Committee and really one of the people who is the right-hand man to Jeremy Grantham.

He has such an unusual background and so interesting. I don’t know what’s more fascinating, the fact that everybody knows GMO and very few people have heard of Matt Kadnar or his really unique background. He comes out of a law firm background and in fact, he was in-house counsel for LPL, which is a giant brokerage firm and ended up at one of the preeminent shops — value shops in the world.

Fascinating guy, mathy enough that I think you can rely on his analysis, but sort of right brain squishy enough that he can weave an interesting narrative discussion about how GMO sets about setting up their entire outlook and their asset allocation and portfolio management.

It really is quite a fascinating conversation. He’s really tremendously insightful and this is just one of those conversations that I don’t think you can hear anywhere else. So with no further ado, my sit-down straight from GMO’s offices in Boston, GMO’s Matt Kadnar.


RITHOLTZ: I am sitting in a conference room at GMO’s office here in Boston overlooking Boston Harbor and it is a spectacular view and I’m sitting with Matt Kadnar who is a member of GMO’s asset allocation team where he focuses on research and portfolio management.

He’s been with GMO for almost 15 years, you joined in 2004. Before that, he was an investment specialist and consultant relations manager at Putnam Investments and even more fascinating, he served as in-house counsel for LPL Financial Services. We’ll spend some time talking about that. That’s a really interesting transition from legal to law to finance.

You went to school here in Boston College and you hail from the Midwest. You have a J.D. from Saint Louis University and you are a CFA charterholder.

Normally at this point, I say, Matt Kadnar, welcome to Bloomberg. But instead, I’m going to say thank you for having me here at GMO.


RITHOLTZ: So, let’s start with that initial fascinating background, you’re an in-house counsel for LPL Financial Services, you have a J.D. You spent years as an associate at Melick & Porter. So, you’ve done pretty much the full legal gig. What made you decide, hey, let’s let shift to finance?

KADNAR: It was pretty simple, Barry. I was just miserable.


KADNAR: You know, I did litigation for my legal career and so while I always enjoyed advocating for my clients, the adversarial process was pretty miserable.


KADNAR: And here in Boston, you know, a lot of the litigation was pretty brass knuckled. And so, I just, you know, I would take the train into work every day and I would look, you know, watch the T coming back out and just could not wait to be on that T coming back home.

RITHOLTZ: The other ride home.

KADNAR: And so, my father-in-law, he wasn’t my father-in-law at that time but he has a lot of wisdom. And so, he said — he knew I was miserable and he said, “Son, if you enjoy what you’re doing, you’ll never work a day in your life.”

And so, he actually gave me the book, “What Color is Your Parachute?” and that did a nice job of matching up what I enjoy doing, what I thought I was good at and that was finance and sales and communicating with the people.

And so, I was lucky enough to kind of get an opportunity at Putnam where a couple of guys, Alex Nelson and Kevin Sullivan took a chance. And so, I joined them in the fall of 2000 and I discovered that you could actually enjoy working.

RITHOLTZ: That’s fascinating. If memory serves, I believe the data point is something like 50 percent of all law school grads seven years later are no longer practicing attorneys.

KADNAR: I’m surprised it’s that low.

RITHOLTZ: Really? And by the way, I’m part of that 50 percent. I moved on from law 25 years ago and couldn’t be more thrilled to have, like you, made the transition to finance.

KADNAR: Yes. I think the hardest part was getting my mom to understand that there was a better way to make a living.

RITHOLTZ: I had the same issue with my wife. She’s like, “What do you mean? I married a lawyer. You’re going to become a trader? What are you talking about? This stable income is going away and you’re going to replace it with something speculative and risky? That doesn’t sound like a smart move.”

So, you’re at LPL. How do you do the transition? You go from LPL to Putnam. What was your first gig, what we’re you doing then?

KADNAR: So, I was in the DC Investment Only group. So, basically working with institutional clients that had Putnam Investments on their DC platform. I did that for a couple of years and then transitioned over into the consultant relations channel where I was covering the West Coast DB consultants.

And the travels started to wear a little bit. My wife was pregnant with twins and I got an opportunity to come work at GMO in ’04 and GMO, you know, had made its way through the bubble acquitted itself very well and —

RITHOLTZ: Very well.

KADNAR: Very well.

RITHOLTZ: You’re under stating it. Not only did GMO pretty much call the bubble in real time but they were one of the few who turned around and said, “Hey, this is about as bad as it gets. Things look cheap. Feel free to start adding equity to your portfolios.”

KADNAR: Yes. And they did a performance out of bubble actually. You know, Jeremy will talk about, you know, generally, we don’t do well in bull markets. But the performance, you know, into the bubble through it and out of it was really spectacular where there was a lot of cheap low-quality assets international small-cap emerging that just did spectacularly well.

RITHOLTZ: Cheap low-quality as opposed to cheap high-quality.

KADNAR: Correct.

RITHOLTZ: High quality doesn’t get quite as cheap as the low quality does, is that the thinking?

KADNAR: Well, you know, there’s a price for everything.


KADNAR: And high quality got pretty expensive kind of in the 2000 and as the, you know, value tends to be lower in quality. And so, you know, the value in U.S. and outside the U.S. particularly international small value, particularly EM just got really left behind. And so, as the market got its legs and rallied, that stuff was so cheap and just was, you know, just took off.

RITHOLTZ: Let me come back to what you just said because it’s kind of a fascinating observation, value tends to be low quality. How are you defining quality? In my mind, I know there are technical definitions and other definitions, is it — and some of them involves the amount of debt, the variable crazy things that sometimes happens that may not show up on a balance sheet but constant turnover in the executive suite. How do you define value onto those circumstances?

KADNAR: So, here, value is is basically the cheap half of the market whereas quality is quantitatively low debt, high ROE and stable ROE. And so, value because it tends to be in the more cyclical sectors it has more financials, tends to be on average lower quality than growth.

RITHOLTZ: By those definitions?

KADNAR: Correct.

RITHOLTZ: That makes a lot of sense. So, you transitioned from law to finance, you start at GMO in ’04, what’s your day-to-day like? What do you focus on?

KADNAR: Well, back then actually I was — I joined as a client relationship manager. And so — because GMO is always growing, they need more folks to deal with clients —


KADNAR: — and so I spent a lot of time in those early days trying to better understand asset allocation because I felt it was my edge as a relationship manager that I could go in and talk to a client about our seven-year forecast, about how we think about the total portfolio.

And I guess I spent so much time up talking to the asset allocation folks. After several months, they said, “Hey, you know, you seem like you have a lot of interesting stuff. Why don’t you join the asset allocation team? We need somebody out there as a portfolio strategist talking to clients. You seem like a nice guy. Why don’t you take the gig?”

RITHOLTZ: Is that a fluid sort of — is that typical of GMO where people move within departments or was that a little bit of an unusual shift?

KADNAR: I think that was atypical for somebody to go from the relationship side to the investment side. That’s actually happened a couple of times since then. GMO tends to be a pretty flat place. So, that does produce a fair amount of fluidity between roles.

But I think that was just an opportunity to kind of do something that I discovered that I really loved that I thought was interesting, I thought it would give me an edge. But I’d probably took it to the next level trying to really understand it.

RITHOLTZ: So, you go from effectively client facing to portfolio managing, how did you educate yourself on what works for portfolios, what doesn’t? Because there’s a fairly broad and rich literature about everything related to asset allocation and portfolio management although some of it contradicts itself. How did you teach yourself what was the right way to do this?

KADNAR: You know, I found that the way GMO approaches the world is different than a lot of other firms, a lot of other academic literatures. So, I basically asked my boss Ben Inker a million questions and I spent a lot of time with Jeremy and other members of the team listening, asking questions, you know, trying to understand how we approach the world, you know, why we did what we did, all in an effort to be able to educate clients —


KADNAR: — what we did. But I would say most of that education was internal as well as, you know, there’s, you know, a handful of other kind of friends at the firm out there that, you know, we — Andrew Smithers in the UK with a lot of very good pieces that seem to rhyme with what we are doing.

So, it was an education with a limited outside but mostly trying to take the wealth of information that my colleagues had and digest it in a way that I could use.

RITHOLTZ: And when you are originally client facing, GMO was a hundred percent or almost a hundred percent institutional, is that correct?

KADNAR: It was — not quite a hundred percent. We had a small relationship with Evergreen at the time on the retail side.

RITHOLTZ: And today?

KADNAR: We have a relationship with Wells Fargo that grew into Wachovia which grew into —


KADNAR: — Wells Fargo. So, the Wells Fargo Absolute Return Fund is still a big piece of our business.

RITHOLTZ: But you’re traditionally known as an institutional shop.

KADNAR: Correct.

RITHOLTZ: The vast majority, is that —


RITHOLTZ: And if memory serves, you guys are up to about $70 billion?

KADNAR: That’s correct.

RITHOLTZ: Something along those numbers. So, you mentioned the seven-year forecast, let’s talk about that a little bit because Jeremy Grantham has been doing this seven-year forecast for as long as I’ve been in the industry.

KADNAR: 1994.

RITHOLTZ: And which is about when I started and he has, over that long period of time, been fairly consistent. Nobody is 100 percent right but he’s been a whole lot more right than wrong over that period of time. Why seven years? What’s the significance of seven years and how did that come about?

KADNAR: So, the forecasts originally when they started in 1994 were — they were a 10-year forecast. And so, what we had heard from clients was, hey, we get that you’re long term but 10 years just too long.

And so, actually, in 1998, Ben Inker, the current — my boss that had asset allocation, he had done this study where he had found 28 bubbles going back to the South Sea Bubble in the 18th century.

RITHOLTZ: I remember that. Yes.

KADNAR: And so, at some point, he just did the math to see how long it took for those bubbles to rise and fall. And so, it turns out that the average of those was actually six and a half years and so, we converted to a seven-year forecast.

RITHOLTZ: I automatically assumed it was biblical and the seven fat years —

KADNAR: It’s got a nice rhyme to it.

RITHOLTZ: For sure. So, that’s interesting. So, that raises a fascinating question, back in February ’09, right before the market bottoms, Jeremy comes out with a seven-year or I should say GMO comes out with a seven-year forecast and that forecast for U.S. large stocks was close to 9 percent a year going forward, which if you remember back to February ’09 was kind of hard to imagine.

A lot of people were hiding under their desks. The thought of, hey, you’re going to get 8.9 percent a year for the next seven years. No one really believed it. It turned out as bullish as that was at the bottom it was fairly cautious over the next seven years. We soar over 12 percent returns.

So, the questions that come up from there is are you as bullish today as you were back then, what’s the outlook going forward and why do you think the market did as — exceeded your bullish expectations from pretty much the nadir of the financial crisis?

KADNAR: Yes. Well, that last one is a — that’s a tough one so I’m going to start with the easier questions first —

KADNAR: — and then come back. But, you know, I think our view today is certainly cautious that you’ve been in this environment where you had extraordinary equity returns. We’ve gotten kind of 20 years with returns in a, you know, nine or 10-year period.

And so, we think that that — and we believe in mean reversion there’s going to be a give back to that. So, I think we are cautious in our outlook and that there’s just not much return left in markets because everything with duration, stocks and bonds have done incredibly well.

I would contrast this with 2007 where valuations were also poor but you had a wonderful three standard deviation housing bubble —


KADNAR: — staring you in the face. You had this market narrative of the great moderation that central bankers had figured out the rhymes and the rhythms of the capitalist cycle and that recessions were a thing of the past. You had just unbelievable stupidity in the credit markets. People levering things 15 times to make 200 basis points over LIBOR.

And so, we were very defensive. You know, I think Jeremy’s term was that there was a bubble in risk assets and we were very defensive and we were very scared. In many ways, the valuation certainly of U.S. equity is actually worse today but we are not as defensive as we were in 2007.

We don’t have an obvious bubble kind of staring us in the face. You have some signs of stupidity in the credit markets but it’s not as nearly as pervasive as it was back in ’07.

RITHOLTZ: Give us an example. I mean, everybody seems to go to the subprime auto market but that seems to be not the foundation for the rest of the economy the way the subprime housing model was.

KADNAR: Exactly. Yes. I mean, you know, the return with a vengeance of cov-light lending, you know, I would have bet a lot of money and lost that, you know, cov-light lending would have been, you know, forever.

RITHOLTZ: Daunting.

KADNAR: Exactly.

RITHOLTZ: Yes. You and me, both, I’m shocked that that — is that a substantial amount of capital at risk in that?

KADNAR: I mean, it’s a reasonable amount of capital and I think, you know, one of the things that is a source of worry is the rise of mutual funds and ETFs and high yield and the levered loan market where that market used to be dominated by insurance companies. Now, it’s dominated by mutual funds and ETFs which have, you know, obviously the daily liquidity.

You know, Stein and some others have had, you know, quote, “that they’re liquid claims on illiquid investments.” And so, I think that’s a potential source of worry.

RITHOLTZ: Liquid claims on illiquid investments. That’s never a good thing, is it?

KADNAR: It’s OK until it’s not and then it tends to end pretty badly.

RITHOLTZ: Well, the last time we soar a bit of a run on some of the high-yield products was two or three years ago when one of the funds effectively blew up. It that the concern going forward? They’ll be some — either some fund unable to meet its obligations and that sets off the next cascade. What do you guys think is the bigger concern looking out?

KADNAR: I think it’s difficult to figure out like what that concern is. I think that the general concern is there’s been a huge reach for yield and people are of the belief that these mutual funds and ETFs that you can get daily liquidity on these things. And you can, it’s just that the prices underneath them aren’t going to reflect that.

And so, as everybody starts going for the door, it might result in some results that hadn’t quite anticipated.

RITHOLTZ: You can either get price or liquidity but not necessarily both at the same time.

KADNAR: Exactly. Exactly.

RITHOLTZ: So, that’s kind of interesting. One of the things that GMO has talked about is benchmark free investing. Clearly, any of the high-yield or lower quality illiquid stuff is not going to have a real benchmark. But if we’re talking equities, what is the significance of the phrase benchmark free investing?

KADNAR: Well, benchmark free investing kind of really came out in the run-up in the bubble and, you know, our flagship strategy that has been around since 1988 with Princeton and Phillips Exeter was our balanced strategy. And so, you know, 65 equity, 35 bonds.

And so, we had two groups of clients, one of whom was firing us and another group was saying, “Hey, you know, Jeremy and Ben, you know, why do you have so much U.S. equities? It’s the most expensive that it’s ever been.”

RITHOLTZ: And is this in 1988 or is this —

KADNAR: 1998, 1999. And so — and the reason was we have tracking — we have a benchmark that we’re supposed to beat and we have tracking error constraints that run into it. And so, they took that feedback, went back to the lab, and they came up with what they call the where-to-hide portfolio and they actually —

RITHOLTZ: I remember that phrase very distinctly in the late ’90s.

KADNAR: And it was a very interesting portfolio and they actually unveiled it at our fall conference in 1999 and GMO grew up investing a lot of — investing for a lot of endowments and foundations. So, the concept of five real was, you know, we’ve kind of been part of who we are for a long time.

And so, they said, the best way to make five real —

RITHOLTZ: Five real.

KADNAR: Five percent over inflation is to own a portfolio that is basically 75 percent bonds, a little bit REITs, and a little bit of emerging equities. And I wasn’t at GMO at that time but I can imagine kind of the crickets in the audience —

RITHOLTZ: For sure.

KADNAR: — after they unveiled this in the middle of the dotcom bubble.

RITHOLTZ: So, this is 1999. The previous year, the S&P was up 30 percent, NASDAQ was up 40 something percent that year, I’m doing it off the top of my head.


RITHOLTZ: And you’re telling people, no, no, no U.S. equity, mostly bonds, here we are the time 20 years into a bond bull market and people were already saying it was old and it was long in the tooth and a little bit of EM and a little bit of REITs.

KADNAR: It was a portfolio that was so far out of central casting for any institution that it went over basically like a Led Zeppelin. Nobody could take that portfolio back to their investment committee and say, this is the best way to compound wealth going forward.

And so, it wasn’t until 2001 when the market started to fall apart during the middle of the bear market that we got somebody to say, hey, just maybe this thing isn’t as half-baked as it originally seemed.


KADNAR: And, you know, benchmarks are necessary for measurement for institutions, for individuals. But what is very difficult for us about benchmark-oriented investing is that it forces you to own more of the things that you don’t like and less of the things that you really do like.


KADNAR: And if your goal is to compound wealth, that’s a pretty big inhibitor —


KADNAR: — to that because the ability to get out of the way of the oncoming freight train, the ability to load up on an asset when it’s really cheap, that’s really how you compound wealth through time.

And so, that benchmark free investing which was originally the where-to-hide portfolio, you know, really has been part of our DNA since 1999. It wasn’t until ’01 that somebody gave — you know, have the gumption to give us some money to invest that way.

RITHOLTZ: And how has that portfolio done since and how much assets has it attracted?

KADNAR: It’s done very well versus stocks and bonds or any combination over that very long period that it’s compounded, I don’t know off the top my head but much higher than stocks over that time period with half the volatilities. It’s got a sharp ratio of over one.

RITHOLTZ: Sure. From 2000 to call it 2012, U.S. equities are effectively flat with a ton of volatility in between and bonds just kept getting better and better and better over that time.

So, now looking at real plus five from here with what a number of high profile bond people be it Bill Gross or Jeff Gundlach have pretty much declared the bond bull market over, what’s your outlook on bonds from here? Does GMO see the bond market and that bond bull run that dates back to Fed Chair Paul Volcker? Is that still have any life left to it or it’s Gross and Gundlach correct the best years of the bond bull market or behind us?

KADNAR: Over the intermediate to long term, I think it’s hard to see how bonds could deliver anything associated with the longer-term returns that we’ve seen in this bull market. Obviously, the yield is what the yield is.


KADNAR: You’ve had duration, you know, the benefits of duration and falling yields over that time period. So, you know, our best guesses going forward that bonds are going to be very disappointing certainly relative to the last 30 or so years.

We do like tips. We think that tips offer an interesting inflation hedge relative to nominal bonds. So, you know, as we think about benchmark free, we have very little in the way of nominal duration. Most of our duration at this point is in real duration through tips.

In a benchmark-oriented portfolio, it’s about half and half. But —

RITHOLTZ: Half tips, half?

KADNAR: Nominals.

RITHOLTZ: OK. So, tips for where we are today are going to be a measure of inflation that gets adjusted I think it’s twice a year based on CPI data something along those lines. So, does this imply you’re expecting higher inflation going forward?

KADNAR: I think that’s the worry. The thing that will cripple anyone’s portfolio is a rise in the discount rate. So, that would impact anything with duration. Both stocks and bonds actually impact stocks the most because they have the higher duration.

But I think that’s the concern and if you weigh the risks one versus the other, I think over the longer term, the concern is that inflation is a higher risk than that deflation at this point.

RITHOLTZ: So, what does that tell us about forward expectations for U.S. equities?

KADNAR: I’m not quite sure what that specifically tells you about the — how the interest rates impact the expected return for U.S. equities. I think as we look at U.S. equities, they’re just expensive on every metric that we can come up with even the kindest and gentlest metrics.

So, you know, I think what has happened to us as well as all investors is basically the Fed has bullied us into owning more risk assets than we would normally given how poor cash yields and bond yields have been.

RITHOLTZ: So, I’ve heard that phrase before, the Fed has bullied us into riskier assets, but that was through quantitative easing where they’re buying up a lot of paper and through essentially zero interest rate. Now that QE is pretty much over and they’re — whatever is on their balance sheet is apparently being allowed to run off naturally, there — it’s not that they’re selling anything but things had maturity and they don’t seem to go out and replace it.

So, the conditions that led to the bullying into risk assets are now going away. The expectation is three more increases this year. But even if it’s one or two, we had a few increases last year. It seems that everybody in the Fed is lined up with ongoing normalization of interest rates.

Does that mean risk assets become that much less attractive for a considerable period of time?

KADNAR: Well, it’s hard to envision quantitative tightening being bullish for assets.


KADNAR: I’m not quite sure what it really means because the market can take on different narratives in the interim. If the economy — economic growth is stronger, you know, the market can kind of twisted — you know, we can twist the justification almost any way that we want.

What I think is interesting is if we do get, you know, the continued hike in rates over the next several years, I think the fascinating question is, what point were those rates tip the economy over into recession?

RITHOLTZ: That’s an interesting question.

KADNAR: You know, if it’s, you know, two in a quarter on Fed funds, that’s a pretty good indication that secular stagnation, you know, things are very different this time. If it’s at three and a half on Fed funds or three or three and a half on Fed funds, that’s a pretty good indication that secular stagnation — that things aren’t different this time that secular stagnation might not be the argument that’s winning the day.

RITHOLTZ: There’s a lot of variables in there and the way I’m hearing you contextualize this is the Fed rate whatever it happens to be when the economy is then tipped into recession is going to be informative as to the broader macro cycle as to whether or not, hey, was that new normal behind us or we still want a stag a slow growth — I don’t want to say stagflation a low wage, low growth period of time or is it possible that what takes us into — tips us into recession has nothing whatsoever to do with the Fed.

KADNAR: I think it would be a pretty good indication of, you know, it’s not — it won’t be this positive but it will be a pretty good signal or pretty good signpost as were — what regime we’re in. You know, when we think about our forecast, our traditional forecasts assume normal mean reversion to cash rates, a term premium on top of that and then equity risk premium on top of that.

You know, Ben Inker has written several quarterly letters about this alternative universe that we coined hell which is basically zero real for cash rates and then —


KADNAR: — you get your bond premium on that and your equity risk premium on top of that. But if you’re getting zero real for cash instead of one and a quarter real, which is our normal traditional assumption —


KADNAR: — your expected return for bonds and stocks falls —

RITHOLTZ: Similarly lower.

KADNAR: — should fall similarly lower and it has — in the short run, it actually has the impact of — you’re assuming less mean reversion. So, your forecast actually improved equities two to three points, bonds of about a point.

We call it hell because over the long term, if you’re not getting five and a half or six real at equities, if you’re getting four or four and a half real at equities and you’re getting two real at bonds not three, it really blows up everybody’s asset allocation. Your ability to generate five real in that environment is really hampered.

And so, the hard part with predicting what environment you’re in, hell versus purgatory, is, you know, we don’t have — you know, we have people working on a model that will predict what Powell is going to do or Powell’s successors going to do. We really don’t have somebody working on that because that’s a useless piece of —


KADNAR: — activity. You can’t forecast that. And so — but we do have to weigh those probabilities and we’re thinking about expected returns for our portfolios. And, you know, we are kind of card-carrying members of mean reversion, we’re kind of the founding members of the mean reversion society and for us to recognize that there’s a chance that things are different this time is very different — is certainly very different for us.

RITHOLTZ: That is uncharted territory.

KADNAR: Certainly as far as asset allocation is concerned.

RITHOLTZ: So, you keep talking about five real. I’m used to the institutional side focused on five because if you’re an endowment or a foundation, you have to disperse five percent to maintain your tax-exempt status. What is the significance of five real? Why has that number become such a focus?

KADNAR: I mean, that’s just historically the spending rate for most institutions.

RITHOLTZ: Five percent real.

KADNAR: Yes. So, you know —

RITHOLTZ: So, that’s coming from the actual behavior of clients as opposed to some abstract theoretical —

KADNAR: Correct. So, you know, if you are an educational institution, your endowment oftentimes is contributing, you know, five percent of that endowment into the budget for the school. You think about it in real terms because you want to maintain the purchasing power of that environment over time.

RITHOLTZ: And we’re sitting here in Boston. We’re stone’s throw from two fairly famous institutions, both of which have enormous endowments. When you guys are reading about changing of the guard at the Harvard endowment or some personnel change in MIT, what is the thought process like?

Do — and I know I’m kind of pulling the saw up out of left field but you mentioned educational institutions because I’ve been following that saga now for it seems like going back to Larry Summers 15 years ago, is it long or is it 20 years ago, and I’m always astonished, wait, aren’t they supposed to be really smart at Harvard? Why is this — why did they kick out people who were doing so well? That original endowment team was just crushing it and it seems like there’s a different flavor each year and nobody really seems to last.

Obviously, I don’t expect you to tell us what’s going on in the inside but do things like that cross your viewpoint, do you look at that and say, what’s going on here?

KADNAR: You know, I think we read about it just because they’re important parts of our industry. But, you know, our focus is not on kind of what the internal politics or what Harvard is doing. Our focus is more on, hey, how do we generate returns for our clients. So, it’s interesting to read but it’s not really germane at the end of the day.

RITHOLTZ: So, let me ask not about something that you read but something that you wrote. Last summer, you co-authored a paper with James Montier and I love both the title and some of the quotes from it. The title was, “The S&P 500: Just Say No” and within that, you have this delightful quote, “Please do not mistake us for members of that species known as Parma bears. We don’t always hate U.S. equities as a matter of principle. We are just governed by the precepts of valuation.”

So, let’s leap off — use that as a leaping off point and discuss valuation, how do you guys measure valuation of equities and it’s obvious but I have to ask the question, why do you believe valuation is so important?

KADNAR: Yet. So, you know, we think that valuation is going to determine the vast bulk of your outcomes that no asset – no assets period aim to make you money unless it’s priced to do so.

So, our investment process if you wanted to sum it up into 11 words is figure out what you think something’s worth and where you can be wrong. And so, valuation process is the thing that we have the highest degree of confidence in and, you know, trying to predict the rhymes and rhythms of, you know, the S&P, it’s a $23 trillion market, it’s complex, it’s reflexive, it’s got stochastic as a quants call, you know, random elements toss in that, trying to predict that in the short run is simply impossible to do consistently.

But we know and we can test this back to the Chester A. Arthur administration that valuation really is going to do — your starting valuation, the price you pay for an asset is really going to really determine the vast bulk of your outcomes. There’s not a guarantee but there’s —

RITHOLTZ: It’s a good statistical bet.

KADNAR: Exactly. Exactly.

RITHOLTZ: Every now and then Jeremy says something that within the framework of a valuation of a value investor brings in a little bit of behavioral finance. I’m always curious how clients respond to that.

So, the most recent seven-year forecast was pretty, I don’t want to say bearish but it was pretty subdued. Is that a fair assessment?

KADNAR: I think you’re being kind.

RITHOLTZ: But at the same time, he very publicly said, I don’t think we’re up to the melt-up stage yet, meaning the bull market still has ways to go and that last stage, things can really get out of hand. How do you reconcile our seven-year forecast is negative but there’s some crazy stuff coming before that?

KADNAR: Yes. I think, you know, certainly as we talk to clients, the clients are pretty — we’re pretty clear with them, you know, with the process they bought was based on our long-term valuation forecast. That’s the process that is going to be the primary input in terms of putting together their portfolio.

I think Jeremy wove a very interesting mosaic with respect to, hey, the pieces might be in place for this thing to really blow off and melt up. He put — I think he put a probability of, you know, 50 percent probability on it. So, he wasn’t saying it was a sure thing by any stretch.

And I think it was an interesting — it is an interesting speculation but our job is to not speculate obviously with the client’s money.


KADNAR: It’s just to follow the process that we’ve been doing for almost 30 years with an asset allocation. We do, from time to time, have shorter-term views on the markets but they are few and far between it’s a high bar to implement those views.


KADNAR: You know, we got more defensive in ’08 because we were more scared about what was going on. That was a shorter-term view. But Jeremy’s kind of one in two chance of things melting up. You know, we get less questions about it now after, you know, the market fell 11 percent.


KADNAR: Then we did at the end of January when the market taking off. But I think —

RITHOLTZ: Right. And just following the tax reform, everything seems to just explode upwards. Did anyone say, hey, is this the melt-up? Where are we with this?

KADNAR: It felt — certainly felt like in January, things were trending in that direction. I think there is room for that narrative to come back into the market but I think February really was a shakeup for some investors.

RITHOLTZ: What? No. Let me — that’s a really valid and interesting point. We’ve had, during this run, much more significant pullbacks than what we saw in February and this is a little squishy and qualitative of me, not quantitative, but it felt that that 11 percent drawdown had a far greater resonance amongst many more people than the previous, there were a couple of 19 and 20 percent pullbacks.

February really seem to scare the bejesus out of a lot of people. What — so, the question is why — what made this pullback so significant?

KADNAR: I think it was — if you — when you just had such an extended period where nothing happened at the markets and so, you know, when that gets jostled in a pretty violent way —


KADNAR: — and I think that just re-awoken the fact to investors like, hey, this thing is not a one-way train that bad things can happen to your —

RITHOLTZ: Wait, stocks can go down, too? Is that what you’re saying?

KADNAR: Yes. And also, you know, you didn’t get as much help from bonds in this particular —


KADNAR: — run either. So, you know, investors’ portfolios were a bit more exposed. Now, the markets can come back, not all the way. Bond yields have stayed high. But I think it was a nice reminder that, hey, you know, bad things can happen out there.

RITHOLTZ: So, when you look at valuation, how do you construct a measure of valuation? Surely, it’s more than just price-to-earnings ratio.

KADNAR: Yes. So, our seven-year forecast, the framework is pretty simple, you have valuation and you have growth and income. On the valuation side, you have PEs and you have margins or I think it’s probably more technically, we have proxies for return on capital.

So, we know that what really mean reverts for equities is returns on capital. And so, we’ll look at that, we’ll cut that several different ways in building our forecast and we’ll combine that with the PE to get a sense of the valuation.

We’ll also combine that with growth. You get that as an equity investor. You get income as an equity investor and that provides a fairly simple framework for thinking about what you think something is worth. And then you ask the risk management question of where you might be wrong.

RITHOLTZ: So, are you looking at valuation across all assets or is it strictly equity? How you evaluate bonds? How do you evaluate other non-equity assets or non-bond assets?

KADNAR: So, we value a whole host and I think there’s 40 or 50 different equity markets. We’ll do a similar exercise with respect to bonds. The issue however with bonds is that the evidence for mean reversion is not —


KADNAR: — to be kind of nearly as strong as it is within equities. You get the central bankers you can kind of mock around with the front end of the curve or the long end of the curve depending upon that particular market.

So, the case for mean reversion within bonds is less strong. And so, that leads us to, you know, having a mean reverting model, having a model that doesn’t mean revert, having a — kind of adopting a Leibowitz-type framework with constant duration in real term. So, you — it’s a little bit more of a mosaic with respect to bonds.

Currencies, we also — you know, we value as well. It’s primarily purchasing power parity. We make some adjustments for it.

RITHOLTZ: So, it just becomes relative to other major —

KADNAR: Exactly.

RITHOLTZ: — finance centers?

KADNAR: Yes. Yes.

RITHOLTZ: So, it’s U.S., Japan, Europe or are you looking at a broader range of currencies?

KADNAR: It, you know, it’s all the developed currencies and 25 or 30 different emerging currencies. Maybe to — probably 20-25 different emerging currencies.

RITHOLTZ: And EM currencies can give help, contribute to a read of is the dollar fairly valued? Is it weak? Is it strong?

KADNAR: Yes. I think, you know, the interesting thing about emerging currencies is that they, you know, they can be valued in and of themselves. You have the meaner version of the currency which you get as part an — as being an equity owner. You get the real — you don’t get the real rate aspect of things.

But for us, as we think about emerging historically, the times where emerging has really gotten to a lot of trouble has been when the currencies have been overvalued.

So, kind of heading in to the Asian crisis —


KADNAR: — ’13 or ’14, we thought that the EM currencies were very expensive. So, that almost becomes, in addition to an expected return to, it almost becomes a risk management tool as well.

And so, EM currencies have ripped. They’ve had, you know, but they’re at the point where they’re basically fairly valued. They’re, you know, it’s — you know, it’s not — you know, there’s certainly not expensive enough to really cause you to lease — lose sleep at night and they certainly have room to run.

When you’re dealing with purchasing power parity with the EM, you always have to take with a grain of salt because the data’s not so great. But, you know, when you’re really looking at currencies, you’re looking at extremes and that’s when that really matters.

RITHOLTZ: Do commodities come under the same process or they really are so dollar dependent that you don’t look at it the same way?

KADNAR: Well, they’re different for different reasons. Commodities, we do look at oil, iron, ore — copper, iron, ore, oil, and natural gas.

RITHOLTZ: Copper, iron, ore, so there’s your industry side. Natural gas and what was the last one?


RITHOLTZ: And oil. So, that’s your heating and your transportation.


RITHOLTZ: Pretty much.

KADNAR: The problem — the confidence in those forecasts is less understanding the supply and demand dynamics in those markets is very difficult. We had — we did have strong views on copper and iron ore in 2011 and 2012. We had a fairly exhaustive view of the supply side and we just felt like demand couldn’t be strong enough to match the prices in the supply coming on.

So, but the confidence in those forecasts generally tends to be lower and I didn’t hear you mention precious metals or goals and which has its own set of issues.

KADNAR: Yes. Well, you know, I asked Jim Grant once how he valued gold and he basically said it was the value manager’s indulgence. So, he said even he could not put a price on it.

You know, for years, Jeremy said I’ll own gold when it yields the same thing as a T-bill. And so, there — ’08, it actually yielded —

RITHOLTZ: Came close.

KADNAR: They actually yielded more than T-bill for a period of time. And so, we did own some gold in our mean reversion hedge fund for a period.

And then, we actually made a good bit of money on it and we tried to value it and we just couldn’t and we got scared and we just took our profits and ran.

RITHOLTZ: Totally understandable. That’s a lot of value investors view on gold.

So, as some of the founding members of the mean reversion club, let’s talk about those corporate profits that you referenced. Why haven’t we seen corporate profits mean revert? They seem not just at record levels but significantly elevated over pass cycles, can we credit or blame the Fed for this or something else going on?

KADNAR: Yes. That’s a — I mean, that’s a really hard question. It’s a question that we puzzled over for, you know, literally years and years. Actually, before the financial crisis when profit margins were high. We spent a lot of time thinking about why those profit margins are.

Jeremy has put together, again, in a pretty interesting mosaic as to why profit margins are high that you have a decreasing competition within industry that leads to higher profits. You have greater — after Citizens United, you have greater corporate influence in Washington, making it harder for new companies to come in.

And so, there’s — I think there’s qualitative reasons that we can come up with as to why profit margins are higher. We tried to quantify those and we’ve been less successful in being able to do put data to that.

I think it’s something that we struggle to answer. We do — as we think about our valuation models, we do build in higher profitability assumptions for the U.S., but I also think it comes back to an observation, you know, that we made years ago. Actually, Jeremy, years ago, that the real median wage in the United States hasn’t moved in 45 years.

And so, the —

RITHOLTZ: Meaning real after inflation wages have been flat for half a century.

KADNAR: Half a century.

RITHOLTZ: Since the early ’60s?

KADNAR: And so — and I think — so, all of the, you know, the benefits have accrued to capital rather than labor and that’s allowed profit margins to be to be higher. And I think that does present some pretty difficult issues for the economy in the long run.

So, I completely agree with that assessment but I want to push back a little bit because I’ve heard some interesting counter arguments elsewhere and they go something like this.

On formation side for a company, it’s never been cheap or easier to get a laptop and an Internet connection, and suddenly, you’re in business. As a — even during the dotcoms, you needed $10 million or $20 million to build the backend infrastructure that literally a laptop provides today and a handful of off-the-shelf web products.

And that a lot of the new companies, be they Google or Facebook or some of the other firms that are more digital than physical, you don’t need giant factories, you don’t need tremendous amounts of capital, you don’t need huge pools of labor, you could be incredibly efficient and incredibly effective.

And so, of course, Google should have a higher P/E ratio than Ford. The same with Facebook. Shouldn’t Facebook be worth more than U.S. steel? Shouldn’t we value — shouldn’t the return on investment be much higher for that? Maybe Amazon is little different because they have so much physical facilities and Apple is its own sort of unique creature.

Are we seeing more and more of the — if not Google, but digital or low cost, low capital, low personnel companies, and therefore, they should be more profitable and are entitled to a higher P/E? Or is that just an excuse for an overvalued market?

KADNAR: Well, I think what you’re saving is true. The issue that we have with that is it is true for the technology sector. It is not true for the system as a whole.


KADNAR: And so, as we value profits for the system as a whole, that is what is elevated. Tech is a part of it, but it’s also true outside of tech as well.

RITHOLTZ: So, aren’t — so I’m using my firm as an example and I assume GMO has the same experience. The things you can do with, again, a laptop and some software doesn’t require as much manpower as necessary. If we were to go back in time and I was going to say, hey, you’re going to manage $70 billion, communicate with clients all over the world, and run a dozen different strategies across various hedge funds, mutual funds, SMAs down the list, you’d say, well, that’s a 3,000-person entity.

And today, it’s a tiny fraction of it. So, even out of — outside of the Googles and the technology companies, aren’t we all that much more effective and efficient? Thanks to technology or, again, is that just excuse making?

KADNAR: You know, just as you are giving that hypothetical, I just started thinking about how many more people that we have in compliance and how complex our business has become and the demands of clients are greater and how you deal with the data. You know, those issues are, you know, so much data has been created in the last two years. Like, how do you deal with that data? So, you need people for that.


KADNAR: So, I think — I think our world, in general, is becoming more complex and that is requiring additional resources in order to — in order to combat that.

You know, I think we have to work harder on the investment side. I think you need more people. I think you need more smarter people in order to do that as well. You can run multiple portfolios and you can do it more easily, but that doesn’t mean you do it as well.

So, one of the things you mentioned was when you’re putting together a forecast, the risk management side is how and where might this be off and how can we anticipate and adjust for that. So, when you look at this changing dynamic in earnings and corporate profits, how would you think you might be off how might it be different this time? Usually, the most expensive forwards you can say, but there’s no doubt the world is changing and technology and business is changing. What might that mean to future profit models?

KADNAR: You know, the world has always changed. And so, you know, if you think about 100 years ago, how the economy has evolved over that — over that time period. It’s really been unbelievable.

And I think, we would say that the normal required return to stocks has fallen through time because there’s less volatility in economy, there are less volatility inflation. You have things like the SEC. You can debate whether the Feds actually helpful or hurtful.

But there’s more institutional controls in the economy and so that we do think that the required return to stocks has come down because they are inherently less risky than they were.

RITHOLTZ: Less friction as well —


RITHOLTZ: — to even execute something or just go buy something is cheaper, faster, easier.

KADNAR: Exactly. So, it justifies a higher multiple. Now, the real questions are what — how much higher. And so, if you think a 25 multiple is a normal return for stocks, well, then your long-term expectations are pretty small. Your earnings yield is four. There’s some slippage in there between the earnings yield and what you receive.

I don’t know how many investors really think stocks are there to determine you, you know, are there — they generate there generate real. So, you know, for us what was always — there’s the risk parity folks out there. We’ve always had a greater confidence in the equity risk premium and we would we rather have more of our portfolios associated with the equity risk premium because equities are inconvenient assets. They go down at the time —


KADNAR: — that you’ve just — you don’t want him to as recession as people lose jobs as that hits. And so, there should be a required rate of return there.

And so, you can debate, you know, whether that is six or five or four but when you look at the market today and, you know, whether you value it based on historical assumptions or if you can evaluate it in new normal assumptions, you know, the U.S. market just is so expensive no the matter which way we slice it, that it’s just hard to justify these multiples.

RITHOLTZ: So, what part of the world from an equity perspective is not expensive? We look at Japan, we look at Europe, we look at EM, what do you think are the attractive of regions where the valuation is not a stretch as it is here?

KADNAR: Yes, EM is really the only game in town. And specifically, EM value. So, the — you know, the value side of EM is the exact opposite of the Tencent and the Baidu and the Alibaba. It is, you know, it is Taiwanese semiconductors, it’s Russian energy stocks, it’s Brazilian utilities, Turkish financials, it’s a fairly Korean chaebols, it’s a fairly motley group of stocks.

But those value stocks are priced to deliver a significantly higher return versus the rest of the market. And we think about this and we call this the margin of superiority that how — how cheap is the cheapest asset class versus the next cheapest asset class? And normally, you have two or three things that are within spitting distance of each other.

But today, EM value is so — by so far, the most dominant in terms of its forecast that we’ve actually, you know, altered our portfolio construction to take a bigger bet on it because there are so few other opportunities out there.

RITHOLTZ: Really? That — that’s quite fascinating. So, I don’t disagree that the US is pricey, but when we look around the rest — when I look around the rest of the world, Japan doesn’t look that horrific especially if you can hedge the currency. And Europe is isn’t the craziest that’s been. It’s had a nice move off the lows. How do you see what’s in between the U.S. and EM?

Yes, if a value — so, kind of taking what you dissent is broadening at the EAFE value default value is the next — is really the next cheapest asset class outside of EM. It is certainly relative to the U.S. EAFE is, I think, it’s in the top decile of attractiveness of —


KADNAR: — EAFE versus the U.S.

RITHOLTZ: So, this is Europa, Australia, Far East on a value basis?

KADNAR: Right. Sorry, on just — just S&P versus MSCI, EAFE. And then, you get some premium for owning value on top of it. So, we still have 11percent of the portfolio in EAFE value.

Now, it’s not cheap in absolute terms. You know, we think it’s worthy of having some space in the equity portfolio. It’s hard to get, you know, stand on the table pound — you know, pound your fist bullish on it, but we think that certainly relative to the U.S. You could get very bullish on it. Absolute terms, it’s a little harder to get — to get excited about it. But we think it’s still worth a portion of your portfolio and benchmark free.

RITHOLTZ: So, priority, it’s EM at the top, EAFE in the middle, and —

KADNAR: S&P far below.

RITHOLTZ: Far below. So, when we come back to this extended valuation, what we blame more credit? That price? Are we overemphasizing the role of the Fed? Is it other factors?

KADNAR: Well, it’s always fun to bash Fed, at least in these — in these halls.


KADNAR: You know, I give them full credit for the transparency. You know, Bernanke went on “The Washington Post” and wrote an op-ed saying, hey, were trying to gin up the prices of these things. So —

RITHOLTZ: By the way, anybody who didn’t read that and go up and by equities, really should not be managing money. It’s like, when the Fed chief says we want equity prices higher, you have to pay attention to that. I did — what was that like the morning after that came out in these halls? Were people aghast and astonished that a Fed chief actually said, hey, strap yourself, were taking higher?

KADNAR: It was extraordinary. And, you know, I think we have an inherent skepticism for central bankers and their ability to influence the economy and markets. But I think, you know we did not grasp that as quickly as some others did.

You know, took us a while for us to really internalize that and think about it within our framework and that really was the genesis for kind of creating these hell forecasts which take into account the fact that financial repression can go on long enough that can really start impact, you know, impact the cash flows and then the fair value for equities.

But it’s, you know, it — the Fed seems to continue to play a dangerous game. Who knows what Powell will do? Maybe he’s more hawkish, maybe he’s got more of a business background versus the academics that have preceded him.

But it seems like, you know, the meaner version of profit margins, stocks trading at higher multiples than normal, kind of start of the Greenspan, continued with Bernanke —


KADNAR: — Yellen, you know.

RITHOLTZ: So, if interest rates keep going higher, if they normalize, if the Feds successfully gets us to — I don’t know — pick your poison, three and three quarters, four and a half, whatever they consider normal, what should that do to valuations?

KADNAR: You know, stock should be vulnerable under that scenario? We’ve certainly read and heard so much from the sell side over the past, you know, five, seven, nine years. Lower rates require higher multiples. So, it will be interesting to see how they walk back. They’re always pretty good at giving a pretty elegant explanation as to why it’s different.


KADNAR: But it certainly seems like that would be a pretty key underpinning as to why you should justify paying, you know, multiples similar to these. I think the, you know, as we were talking about before, the real concern is what happens with inflation and that is the one thing that could really croak, you know, all portfolios, and I think that’s just — that’s just longer-term worry.

RITHOLTZ: So, I’m going to focus on the concept of financial repression for a moment. Over this period of financial repression, one valuation has been median priced to sales and this has been not just elevated, but record highs for five or six years. What do you make of that as a value investor?

KADNAR: Yes. Price to sales is an interesting one because there’s not a — we can’t think of a theoretical reasons why price to sales should mean revert.


KADNAR: Yes. It has, historically.


KADNAR: It’s actually nicely mean reverting historically. But —

RITHOLTZ: But you don’t — you don’t assume that’s a requirement?

KADNAR: No. It’s — it’s your return on capital that should — that should mean revert through time. So, we’re not quite sure what to make of it. We used to run our models exclusively on price to sales because it was nicely comparable across regions in and across time.

RITHOLTZ: Right. Right. You don’t have all the different GAAP, accounting rules, and a lot of things change on some of the other metrics.

KADNAR: And if we were to continue just following price to sales methodology, I think our forecaster minus eight or minus nine real for the S&P 500. So, we’ve diversified that into other — what we think are reasonable proxies and that has — you know, those are expensive but just not nearly as expensive as price to sales.

RITHOLTZ: So, what do you end up as the forecast if you’re using other valuation metrics?

KADNAR: As we, kind of hot off the press, the forecast for U.S. large, assuming normal meaner version, is minus 4.9 real a year for seven years —

RITHOLTZ: A year. Wow.

KADNAR: So, I mean, that — that’s definitely not built in to anybody’s asset allocation models if we, you know, we talked about that hell scenario earlier, that forecast is minus 2 real. So, it’s better but it’s still a far cry from five or six.

RITHOLTZ: So, if you end up with a big uptick in inflation, you could end up with flat markets over seven years and essentially zero return. That — that’s a — not a forecast but a significant probability.

KADNAR: I think if you had significant uptick in inflation, it would really do a number on P/E. So, Jeremy and Ben have something they called as comfort model which is an explanatory model for current P/Es and it looks at the volatility of inflation, the volatility of GDP, and the level of profit margins.

And so, if you do get higher inflation, I think that has an impact on profit margins or at least Buffett thought in the ’70s inflation, it had a big impact on profit margins. That model would be perturbed and you would get a much lower — a much lower multiple.

And we saw in the ’70s certainly, that inflation really was scary for equity and bond investors. But, I think, inflation definitely, your multiple comes down.

RITHOLTZ: So, let’s talk a little bit about investing, in general. This is a topic that everybody is interested in.

One of the things that you — this office, the GMO, has to be on guard against is the — what some people have called the danger of success. Obviously, the firm has been tremendously successful over a multi-decade period, how does this affect the psychology here? How does it affect your outlook? Does it make you more cautious because you’re protecting gains or is — can the firms still be a risk taker and an innovator despite all the success?

KADNAR: Well, I feel like the market does a wonderful job of humbling you —

RITHOLTZ: For sure.

KADNAR: — very, very quickly. And you know, Jeremy has an expression that you always cry over spilt milk. And so, I think, part of our process is to ask questions as to, you know, what we did, why we did what we did, what we didn’t do and why we did that and whether that’s right. So, I think that process of self-introspection is very important. I think having James Montier around who is a known expert in behavioral aspects is very helpful.

And, you know, the game is hard. And so, you know, figuring out whether you’re in a bubble or not, you know, we have technical quantitative definitions. But it’s much more nuanced than that.

So, there was a lot of success calling both the dotcom bubble and the housing bubble. Do you run a risk of, hey, we’ve really built a reputation as spotting these bubbles? Do you start to see bubbles everywhere? Is that a genuine concern?

I think — I think that’s a — you know, there’s a concern for any investor as to their process and what they’re doing and whether things are different this time. And certainly, if you believe on mean reversion, things being different this time is really the critical — the critical question.

So, we spend an inordinate amount of time in what we would refer to as risk management as, you know, where this forecast can be wrong and how are things different this time. And it’s, you know, there — it’s nuanced. Unfortunately, there’s not — you know, can’t quantify, you know, all of these things. It tends to be more art than science, although we do want to reduce things to numbers.

But I also think having, you know, people who’ve been around the block, like Jeremy and Ben, is very helpful because, you know, they’ve seen multiple cycles.

RITHOLTZ: So, a lot of people like to make the claim they’re contrarians. GMO has very much been a contrarian over the years. And that, sometimes, means being a little early. I don’t want t use the use the word wrong but it sometimes mean, hey, this market is stretched.

How does it effect interacting with clients, how does it affect forecast. Do you start to recognize? Were always early. We’re going to be a little early now and we just have to write it out until time proves this right or not.

KADNAR: We certainly don’t frequently refer to ourselves as contrarian. What we refer to ourselves are value investors. And it feels like people are tripping over themselves to call themselves contrarian these days, so you know, kind of a natural responses. You need to be a trend follower in order to be — in order to be contrarian, it feels like.

You know, I think, you know, we try and design a process that we recognize that we tend to be early. We build some things in to the process to try and help ameliorate that, but it is what we do. It is kind of the curse of the value investor. There’s nothing worse than thinking something’s cheap and not owning it and having it go up.

If so, you know, we try and be as transparent as we can with clients as to what we’re doing and why we’re doing it so that they can kind of get to the finish line, so that they can get to the finish line with us.

RITHOLTZ: When seven-year real returns are expected to be negative for U.S. large cap stocks and negative for U.S. equities across the board, how do you discuss that with clients? Are they comfortable with the expectation? Don’t look to the U.S. equity side of things for any real returns going forward?

KADNAR: I think our mantra with clients has been own as little U.S. equities as your committee or your career will allow. That, you know, they’ve beaten the rest of the world by a hundred points. They’ve beaten, you know, EM by 150 points and you can look historically and see these cycles were U.S. performs and then EAFE outperforms and we’ve just been through the period where we’ve had the greatest outperformance of the US stocks relative to the rest of the world.

RITHOLTZ: In history.

KADNAR: That what we’ve seen since the ’70s, where you can have legitimate — legitimate data. And so, we got a lot of questions from clients in ’16, the beginning of ’16, saying, hey, this diversification sounds like, you know, sounds good in principle, but I general defer more money to last, like, what are we doing here. We’re really not seeing the benefits of that.

Now, there’s less questions about that over the preceding two years as EAFE and EM have done — have done much better. But, you know, as we think about, you know, benchmark free for instance, you know, we owned the quality stocks in the U.S. outright and then actually, recently, this year we converted that to a long short so we go long quality and we short the market against it. The only longs that we are, you know, EAFE value and EM value at this point on the cycle.

RITHOLTZ: So, let’s talk a little about hedge funds since you mention long/short. After doing pretty well in the ’90s and the early 2000s, hedge fund performance has been fairly mediocre, at least back to the financial crisis.

And certainly, since the recovery, what do you make of that? Is that cyclical? Are we ever going to see mean reversion and hedge fund performance or has the game changed? It was one thing when it was 200 hedge funds, and now, here’s 12,000, you’ll never see those sort of numbers again across the whole industry.

KADNAR: Yes. I think the game has changed. You know, I remember looking at some data from MorningStar that, you know, there is about a thousand hedge funds in 2000 or something like that and it rose to 7,000 or 8,000. I don’t know how many there are today.

RITHOLTZ: It’s over 11,000.

KADNAR: Is it over 11,000?

RITHOLTZ: And about 25percent of them disappear each year —

KADNAR: Right.

RITHOLTZ: — reform without the high watermark.

KADNAR: Right.

RITHOLTZ: So, it — they kind of reboot. Apparently, clients come along with them.

KADNAR: Yes, that’s a dirty, dirty little secret of the hedge fund industry.

RITHOLTZ: I won’t tell anybody.

KADNAR: Well, you know, I think the game has changed for hedge funds, although, you know, just like most things, like the pendulum swings too far the other way where people are kind of throwing the baby out with the bathwater.


KADNAR: And one of the things that we like about profile of some hedge fund returns is that you are taking risk but you’re with a shorter duration. So, merger arb is kind of the poster child for this.


KADNAR: So, you’re trying to capture an equity risk premium. You’re doing it. You know, our merger arb portfolio, there’s 20 to 30 deals. The average, you know, average duration of the deal is 90 days.

If you do get that duration increase that we talked about earlier, you know, merger arb may get hit but it’s going to hit a lot less than been something else.

So, we think that diversifying hedge funds, particularly, at this point of a cycle are reasonable activities to be thinking about for your portfolio.

There’s another question as to how much you should pay for them. I think the 2 and 20 model is under significant pressure. And certainly, the fund-to-fund industry seems to have gone, you know, the way the dinosaur —

RITHOLTZ: Fund to fee is something —

KADNAR: Yes. Yes.

RITHOLTZ: Yes, that — that becomes harder to justify. And I want to say that 1.5 and 15 seem to be the new 2 and 20, but that’s just anecdotal. Along the — same lines as hedge funds, perhaps, being a little cyclical, what do you make of the value underperformance in the past few years and does it remind you of any other periods?

KADNAR: Yes. Values underperformance has been brutal particularly for us. You tend to tilt more towards value-type strategies. Its magnitude is not as bad as it was in the dotcom bubble but the duration has been — has been longer.

So, we think that there is — the opportunities for certainly for value outside the U.S. that we think is much cheaper than growth, we do think value is cheaper than growth in the U.S., however, we still think quality is more attractive, more attractive in the U.S..

It’s been a long cycle, you know, whether the rise of interest rates and inflation, you know, value stocks, they have kind of intrinsically a shorter duration whether they do better in that type of environment. We’re not — you know, I think that’s tough to tell. I think that story makes sense. But we’d rather focus on the valuation which looks attractive particularly in EM.

RITHOLTZ: And then finally, the question that you guys are perfect to ask, everybody has been looking at the rise of indexing be it BlackRock or Vanguard or what have you and a number of people have ascribed indexing as a distorting factor and it’s making price discovery more challenging and perhaps even contributing to this extended valuation issue. What are your views on indexing and do you put any incontinence in any of these indexing or making things pricier?

KADNAR: I think as the comes more and more into the — you know, does more and more indexing, the ability to find cheap stocks out there increases. So, I think, for active management, the more the world indexes, the better it becomes. There’s nothing better than a cheap stock but stays cheap because you get the gift that keeps on giving. You keep —


KADNAR: — you keep on getting that earnings yield. You keep generating the dividend yield. You know, Bernstein has some great research on the — you know, the asset management industry but they — I read a report they had. At least according to the S&P, there’s over a million indexes now which just seems like that’s —

RITHOLTZ: Yes. That sounds like a lot.

KADNAR: That’s not possible. You know, I know Bloomberg ran a story last summer saying that there are more indexes than there are stocks. In the U.S. —

RITHOLTZ: Well, a couple of years ago, there were more mutual funds than stocks, now they’re more indexes than stocks. I recall — I recall seeing that — that same thing.

So, what does it mean? Does it — does it — is it contributing to the valuation conundrum?

KADNAR: I mean — certainly, that more people are investing in indexes, that generates momentum, and I think, that generates price inefficiencies.

So, you know, for us, we’re largely quantitative in our equity investing. I think it presents them opportunity. Now, we do need to work harder than we did 10 10 years ago. You know, quant tools, smart beta, you know, those things have, you know, been largely commoditized.


KADNAR: So, I think, you know, our efforts in quantitative — we’ve done a lot of work over the past several years with our models trying to uncover intrinsic value, you know, we’re less about AI and more about trying to discover the intrinsic value. So, I think we have to work harder in that realm that we did historically. But I think that there’s certainly more scope for alpha than there was a couple years ago.

RITHOLTZ: Thank you, Matt, this has been absently fascinating. We have been speaking with Matt Kadnar. He is a member of GMO’s asset allocation team and a value investor, par excellence.

If you enjoy this conversation, be sure and stick around for the podcast extras where we keep the tape rolling and continue discussing all things asset allocation, valuation, hedge fund, etc.

Be sure and check out my daily column. You can find that on You could follow me on Twitter @ritholtz. We love your comments, feedback, and suggestions. Write to us at

I’m Barry Ritholtz. You’re listening to Masters in Business on Bloomberg Radio.

Welcome to the podcast. Thank you, Matt, so much for doing this. Tell us the most important thing that we don’t know about you?

KADNAR: I mean, frankly, I don’t know that there’s — I don’t know if I have anything. I don’t know.

RITHOLTZ: Well, what don’t — OK, so let me rephrase that. Tell us the most important thing that friends and family who know you might not be aware of?

KADNAR: I’m probably more competitive than people realize, you know. There’s a veneer of trying to be calm and cool. But inside, you know, I run pretty hot.

RITHOLTZ: You want to win.

KADNAR: It’s what it’s all about.

RITHOLTZ: I can’t say I disagree. Tell us about your early mentors. Who helped guide your career?

KADNAR: Yes. I — you know, like you, I kind of put the legal stuff to the — aside because it was a such a painful episode of my life. But you know, when I think about Putnam, you know, I had such valuable business mentors.

So, you know, Kevin Sullivan and Alex Nelson. Originally Rob, Joe, you know, consultant relations, they were, you know, such — they were so formative. John Brown, who ran the institutional group. It was such a good group of people that there was a ton of things that we learn from — that I learned from them.

And then, you know, more recently, you know, it’s really been Jeremy and Ben. You know, I found that the way we approached asset allocation, the world was so different than what I learned in the CFA or kind of normal institutional investing that — that that has just such a profound influence on the way I think about returns.

And you know, if I would’ve known about the seven-year forecast in 1999 or mean reversion, I mean, I think it could have — it would have been very interesting.

RITHOLTZ: To say the least. Who else influenced your approach to investing?

KADNAR: I mean there are other — kind of the traditional value — value folks out there. I think Ed Chancellor is also an influencer. Ed was a former colleague, although, he still is engaged with the firm. He’s a financial historian and he has a deep understanding of bubbles.

And I think, his historical approach is so helpful because there’s so much rhetoric as to why it’s different this time or elegant explanations as to why it’s different. And his, you know, understanding of history cuts across a lot of that in ways that you, you know, I just find so much more credible than, you know, a sell side, generic sell side report.

RITHOLTZ: Makes a lot of sense. Everybody’s favorite question. What are some of your favorite books be they finance, nonfinance, fiction, nonfiction — what do you enjoy reading and what books would you recommend other people should read?

KADNAR: Yes. On the finance side, you know, Antti Ilmanen wrote a fantastic book called “Expected Returns” which is kind of a basic finance textbook and he goes through all of the asset classes and the risk premiums and he does a wonderful job of laying those out and I think that’s a very good book.

I did read, you know, years ago, at David Rosenberg’s recommendation, a diary of the great depression. It’s about this lawyer, Benjamin Roth, in Youngstown, Ohio, and it was his diary, you know, contemporaneous diary of what the depression was like and it was fascinating. And that he had to do to survive, you know, terms of the businessman, you know, bartering.

I was amazed how he was worried about inflation over that time period. And it also struck me how much he looked at stocks, these blue-chip stocks, and how cheap he said they were, but he said he had no money to invest in them and how much money he could’ve made if he did put some capital work.

And I’m struck by today, where — you know, the concern for illiquidity is so removed, you know, a private equity —


KADNAR: Direct lending, you know, everybody’s trying to lock up their money for 10 years. You know, nine years ago, we saw how important liquidity was. And today, that seems to be a very much a backseat consideration. And I think about Benjamin Roth and that book.

RITHOLTZ: That’s quite fascinating. What excites you right now? It’s a complicated environment. What do you find very interesting or exciting today?

KADNAR: I think building a portfolio today is — is really hard that, you know, in ’08, at least on our numbers, it was pretty clear what to do. You should take as little risk as your career should allow.

I think today, it’s much more difficult. It’s much more complicated. And the other aspect of it is the — our business is evolving so rapidly where, you know, 20 or 30 years ago, you know, Jeremy and Dick Mayo and (inaudible), they can focus on — they could focus on defined benefit pensions and that’s all they needed to worry about.


KADNAR: I mean, obviously, today, you know, you can’t do that. You know, defined contribution, we know that there are issues there. The RIA space, high-net worth, family office, how taxes impact that.


KADNAR: I think that trying to solve the problems for clients is much more layered and intricate than it was, you know, even 10 years ago.

RITHOLTZ: Quite interesting. What are you looking forward to as upcoming changes in the asset management business? What do you think is going to either shift or surprise us going forward?

So, being part of in a team that’s done asset allocation for coming on 30 years, one of the things that I’m impressed by the number of people who believe that they can do asset allocation today and I wonder how many of those people were around in ’07 and ’08, how many people were around in 1999 and 2000 towards you get to the — when you get towards the end of the cycle, everybody seems to be able to do this asset allocation thing quite easily.


KADNAR: And so, you know, I am looking for to the turn of the cycle and that kind of — that shaking of the industry where people, you know, know people with skill will be differentiated from people who really don’t have skill.

RITHOLTZ: I’m trying to remember the book. It might’ve been Adam Smith’s “Money Game” where he’s talking to a manager who’s in his ’40s and he hires these young twenty-somethings to run the portfolios because he said I couldn’t touch any of this stuff, it’s all terrible junk but they’re making money of it — from it which is great for the firm and as soon as the cycle turns, we’ll get rid of all these guys.

I don’t remember if it was “Money Game” or it might have been market wizards. But it stood out as, yes, I can’t touch any of that but they don’t — they’ve lived through the cycle, so they don’t know. It will be very interesting to see what happens when things go through the next substantial downturn.

KADNAR: And because they’re always very different. And so, you know, the cause for this one’s going to be different. How we come through is going to be different. What’s going to be cheap is going to be different.

And I think it’s just, you know, as you talk to clients, you talk to folks out there, you know, I think there’s more a sense of like, we do the asset allocation, you know, we’ll listen to what you guys have say but we’ve got this. Thank you.

RITHOLTZ: Right. It’s always amazing whenever I see anybody writing something along the lines of everybody who’s working on a trading desk today, who started since filling the blank, has not seen a rising rate environment, has not seen inflation, has not seen — so if any of these things come back, everybody — half of or more of the the desk out there are going to be experiencing things for the first time. That will be very interesting.

KADNAR: Yes. And there’s always new lessons to be learned. And I’m sure some of the people will navigate it, you know, fine but. It does feel like it is late cycle in terms of the number of people who claim that they can do it well.

RITHOLTZ: Tell us about a time you failed and what you learned from the experience?

KADNAR: Yes. You know, when I — when I was a lawyer, I was — I was desperately trying to get out. You know, first in private practice and then, you know, at LPL. And I can’t tell you how many times I got to, like, the final round or the final person and I just didn’t get the job.

And it was so frustrating and disheartening because I knew I wasn’t doing what I enjoyed or what I wanted to do with my life. And so, you know, it was just that perseverance of, like, listen, you know, there’s a — there’s got to be a better way to do this. And so, kind of keeping to push and to kind of deal with that failure but keep — you know, adapting and evolving to get to a point where, you know, I was excited about coming to work every day.

And I think that process was a long and difficult one and much more difficult than I would have hoped. But I think it also gave me a greater appreciation for how incredible it is to be excited on a Monday morning to come in to work.

RITHOLTZ: That’s quite a happy answer. That that’s a fulfilling answer. Tell us what you do for fun outside of the office? What gets you excited?

KADNAR: Yes. I mean, obviously, the family. You know, we have three kids. You know, 13-year-old boy/girl twins and then a 9-year-old daughter, wonderful wife, wonderful family, and that’s a lot of fun. So, we’re going skiing in Vermont this weekend. Got, you know, lots of snow here in Boston, up in the mountains. So, skiing in the winter and then golf — golf in the summer.

RITHOLTZ: What sort of advice would you give to a millennial or a recent college graduate who is interested in a career in either finance or asset allocation?

KADNAR: It’s reading. You know, it’s reading and Buffetts compounding knowledge through time. And you just need to be a voracious reader.

I would also say that, you know, certainly, you know, when I was in college, my understanding of, you know, being a portfolio manager is quite glamorous. I mean, it is a humbling, soul crushing. It is a — in many times, when you’re not doing well, it is a miserable existence.

And so, you really need to love it in order to kind of persevere and stay in the game. And if you don’t really love it, I would encourage you to find something that you really did because I think it’s impossible to be successful, certainly in this industry, unless you really love it and you can give it 110.

RITHOLTZ: And it could be that painful over — over certain periods of the cycle.

KADNAR: You just — you just — it’s hard to get out of bed. That — those of the times where it’s actually hard to get out of bed.

RITHOLTZ: Thank you, Matt. This has been absolutely fascinating.


We have been speaking with Matt Kandnar of GMO. If you enjoy this conversation, be sure and look up an inch or down an inch on Apple iTunes where you can see any of the 200 such conversations we’ve had.

We love your comments, feedback, and suggestions. Write to us at

I would be remiss if I did not thank the staff who helps put together this weekly show. Michael Batnick is my Head of Research. Taylor Riggs is our booker/producer. Medina Parwana is our audio engineer/producer par excellence.

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