The transcript from this week’s MIB: Roger Ibbotson of Yale, Ibbotson Associates, and Zebra Capital, is below.
You can stream/download the full conversation, including the podcast extras on iTunes, Bloomberg, Overcast, and Stitcher. Our earlier podcasts can all be found at iTunes, Stitcher, Overcast, and Bloomberg.
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ANNOUNCER: This is Masters in Business with Barry Ritholtz on Bloomberg Radio.
BARRY RITHOLTZ, HOST, MASTERS IN BUSINESS: This week on the podcast, wow, what a delightful conversation I had with Roger Ibbotson. If you don’t know who he is, well, you need to become a little more familiar with financial histories, he is one of the founding fathers about modern thoughts on asset allocation, portfolio, management valuation factor, go down the list of a million things, he really was instrumental in the development and expansion of CRSP which is the joint stock database originally out of the University of Chicago.
Davidson Associates, he’s on the board of advisors at Dimensional Funds, his curriculum vitae as his pages and pages long, he was extremely generous with his time and shared all sorts of fascinating things with us.
If you are at all a stock market wonk, if you are at all interested in why some stocks go up and others don’t, then you are to find this conversation to be absolutely fascinating. So with no further ado, my conversation with Yale University’s Roger Ibbotson.
This week I have an extra special guest his name is Roger Ibbotson, he is a professor at the Yale School of Management where he is Professor of Practice Emeritus of Finance, he is also the Founder and Chairman of Ibbotson Associates which was sold not too long ago to Morningstar, he is on the Board of Directors of Dimensional Fund Advisors, he is the chairman and CIO of Zebra Capital Management, an equity investment and hedge fund manager, he has also taught all for many years and served as executive director for the Center for Research in Security Prices better known as CRSP.
He’s the author of numerous books including “Investment Markets, Gaining The Performance Advantage”, and “Global Investing The Professionals Guide To The World Of Capital Markets” Roger Ibbotson, welcome to Bloomberg.
ROGER IBBOTSON, PROFESSOR IN THE PRACTICE EMERITUS OF FINANCE, YALE SCHOOL OF MANAGEMENT: Great to be here.
RITHOLTZ: I’ve been looking forward to having this conversation with you for a long, long time, I’ve certainly been familiar with Ibbotson and Associates, since you founded them back in 1977, but let’s go back to your days when you got your PhD from Chicago, what was the state of the world in finance like when you first entered the markets?
IBBOTSON: Well, you know, it was really, things were happening at the University of Chicago and ultimately many of the people that got Nobel Prizes for what went on, so but if you just take us back a few years before that, finance really hadn’t developed as an academic subject or as a security analyst or how to pick a stock or something like that.
And then we started really developing a whole theory of how finance works, and I got to say I had great people to work with there, my chairman of my committee when I wrote my dissertation was Eugene Fama, he won a Nobel Prize, I had on my committee, Merton Miller, he won a Nobel Prize, at Myron Scholes won a Nobel Prize, Fischer Black, you have to be alive to win a Nobel Prize, unfortunately, he died before that but he certainly would have, so it was really a tremendous group of people to work with.
That’s a 1926 Yankees murderers row of Nobel Laureates there.
IBBOTSON: Yes. So yes, it was a wonderful time going on, so actually all the – so many different discoveries were taking place.
RITHOLTZ: You mentioned that the study of finance really hadn’t developed academically as much as it has since, tell us about the Center for Research in Security Prices for CRSP, how did that come about and what was your involvement?
IBBOTSON: So the Center for Research in Security Prices, we call it CRSP — C, R, S, P, while CRSP was really set up by James Lorie and Larry Fisher and they were collecting data on the stock market returns, and the data started 1926 and now you see a lot of things start in 1926, so they were collecting this data and that’s what started the center and I got to say that once they published this data, they never kept it quite up-to-date, but once they published it, was people were so interested because they had no idea what actually would had happened in the stock market, they didn’t actually have any sense for what how stock market returns were like.
In fact, I kind of remember the 30s and how terrible it was and so forth and they knew things were better lately, but they still did realize the high returns that actually had happened in the stock market.
RITHOLTZ: That’s quite fascinating, so when you say this was not much of an academic study are you really referring to the fact that previous to the creation of crisp, there wasn’t a whole lot of data that could be analyzed at least not consistent data in anything approaching a well structured way?
IBBOTSON: Yes, CRSP really put the data on the map and then when I got my PhD or the PhD there but actually stayed on as a professor, and when I stayed on, I became the Executive Director of CRSP. So I was and I guess helping to put the data together and it was really not only the University of Chicago that was using the data but all the other universities were really using that data.
So this suddenly finance became an empirical subject that people could study.
RITHOLTZ: That’s the word I was hunting for, it had no empiricism previous, this was — what years did you begin with the CRSP?
IBBOTSON: Well, I got there as a student in 1968 and became a faculty member in 1974 and I guess I became Executive Director I don’t remember, a few years after that of the center, but I was always involved with CRSP from the start because I was always interested in data and in fact, I get a job while I was getting my PhD in the investment office of the University.
RITHOLTZ: The endowment in other words.
IBBOTSON: The endowment right, I was a consultant to the office and one of the things they asked me as a consultant was “What do we do with his bond portfolio?” And I said “Well, I can manage that” and so they actually had a PhD student that was actually managing the University of Chicago bond portfolio.
RITHOLTZ: And how large was that at the time?
IBBOTSON: Well, these numbers were not large in today’s time, a couple of hundred million you know.
RITHOLTZ: But still, a PhD student is like “Okay, congratulations, you’re running a few hundred million dollars.” That’s not nothing especially in the late 60s.
IBBOTSON: Yes, and it was a great thing to do and it gets back to what you’re talking about when people – once I was running the bond portfolio, people would ask me “When are Fisher and Lorrie going to update the study?” Because the first data came out from 1926 to 1960 and then it was the 1926 to 1965, and then 1968 but this was ’72, ’73 and people were asking “When do I see the updated data?” and I would ask Larry Fisher when it’s going to get updated and Larry would give me a date but the date would go by and it wouldn’t get done and so this is what I really took the ball by our hands, I worked with Rex Sinquefield who was a …
RITHOLTZ: Oh sure.
(Crosstalk)
IBBOTSON: A student of mine at the time and we decided to put this — put data that literally all the — we used the Center for Research prices but we put up some quicker data together to get a sense of what – something up-to-date actually and where we brought it up to date actually through 1976 at the time.
RITHOLTZ: So that brings us to 1977 which not coincidentally is when you launched Ibbotson Associates, tells about what motivated you to go out and hang your own shingle?
IBBOTSON: Well, it was “Stocks, Bonds, Bills and Inflation”, I was an assistant professor and we’re just — we had just published “Stocks, Bonds, Bills and Inflation” first as a couple of journal articles and one which is on the bathroom (ph) actually predicted n the future long-term ,but then also as a monograph from the CFA Institute and everybody was so interested that I was getting inundated with letters coming in CEOs asking me for information and response of this question that question and I was at a — I barely had a secretary, had a part of a secretary and I didn’t know what to do with all these letters from these CIOs, CEOs and CIOs and so forth.
So I started hiring a couple of people to help me out with this and that’s what caused me to actually start the consulting – I had plenty of business at the start because so many people are actually requesting things from me.
RITHOLTZ: You sold Ibbotson Associates and Advisers to Morningstar back in 2006, pretty good timing before the tide went out in ’08, ’09, what was that process like? They’re a pretty big shop, Morningstar, how did that transaction go?
IBBOTSON: Well in 2006, by that time, I was already at Yale School of Management as a professor in practice there, but in 2006, we had 150 people at Ibbotson Associates Offices in Chicago and New York and Tokyo actually, but still we were very small compared to Morningstar.
RITHOLTZ: Yes, they’re giant also in Chicago, right? Aren’t they…
(Crosstalk)
IBBOTSON: They weren’t very far, they were just – we were like two firms that were somewhat similar that were only a couple blocks away from each other.
RITHOLTZ: That’s a pretty natural fit that the large Morningstar will acquire the smaller Ibbotson in the same hometown.
IBBOTSON: Well, actually, I got to say that we were around first because I remember when Joe Mansueto in the 1980s came to a few of our holiday parties and things like that and but I got to say, you have to give Joe Mansueto credit, Morningstar really took off and grew, we were going fast too, but nothing like they were like.
RITHOLTZ: Well, you focused on data about markets generally, they focus specifically on mutual funds and that became a giant growth area for them especially with the ERISA laws and 401(k) coming up in the early ’70s.
IBBOTSON: Well, everybody was – ERISA was more, yes 401(k) really start developing and that really in the 1980s, first thing was a defined venture — defined-benefit pension plans, the DB plans and we worked with them to some extent but Morningstar actually picked the retail end of it with a 401(k) market and the mutual funds, yes.
RITHOLTZ: Yes.
IBBOTSON: And so, but we are two very fast growing firms that were alongside each other for a couple decades in Chicago before they actually bought us out.
RITHOLTZ: Quite intriguing, let’s talk a little bit about CRSP and we mentioned earlier you worked on the 1926 to present database of stock market returns, but not too long ago, a new historical database was added for the New York Stock Exchange going back to 1815 straight up to the original 1926 date. What did you learn from that database about equity returns and about volatility?
IBBOTSON: Well, you know first of all, we had to hand collect all the data back to…
RITHOLTZ: What do you mean hand collect?
IBBOTSON: Well, it was…
RITHOLTZ: Was it newspaper?
IBBOTSON: It was in the Yale Beinecke Library where you had a look at the microfiche and old newspapers…
RITHOLTZ: Really?
IBBOTSON: …of the “New York Shipping and Commercial Chronicle” and it was mostly about which ships are coming in to the harbor but they also listed the New York Stock Market prices.
RITHOLTZ: So how do you era check that to make sure that nobody makes a transcription error? That sounds like, you know, a century of data, it’s really easy to make a mistake with that.
IBBOTSON: Well, it is and I’m not saying there is no possible mistakes in there because it had to be hand-collected, but there aren’t that many companies in the early days.
RITHOLTZ: Right.
IBBOTSON: So we are not talking about the 3,000 stocks that we may be talking about today, we’re talking about, you know, that’s less than a hundred stocks over most of this period.
RITHOLTZ: Wow, quite fascinating, so what you learn about equity returns and volatility?
IBBOTSON: Well you know that data in the 1890s, 1800s was kind of unusual because stocks tend to be issued around 100…
RITHOLTZ: Right.
IBBOTSON: It almost looked like you’re looking at bond data.
RITHOLTZ: Because everything is trading at par or a little above or a little below?
IBBOTSON: Well, yes, they may trade in the range of 50 to 200 or something…
RITHOLTZ: Right.
IBBOTSON: But they kind of looked like bonds and we had to keep on investigating further and further to find out where these are stocks that they, you know, and they were of course, stocks, but they look like bonds.
They weren’t that volatile, they weren’t – of course the trading wasn’t anything like the trading today.
RITHOLTZ: Not a lot of volume and trade by appointment only or did they actually …
IBBOTSON: Well, it was on the – there was the – (inaudible) would agree with me, you know, they are traded on the curb and then eventually inside, but so they were continuously traded, but not and even the volume wasn’t even recorded at that time, but we didn’t get the last prices.
RITHOLTZ: That’s quite fascinating. And so, you know, CRSP is very often associated with factor-based investing and equity risk premium, what can you tell us about that? What do we know today about the equity risk premium that we didn’t know in the pre-CRSP days?
IBBOTSON: Back in the – the theory was developing in the 1960s especially with the — and the 1950s and ’60s, where we had the Harry Markowitz came out with his “Portfolio Theory” in 1952, it was at the University of Chicago actually, and I got to say, it was kind of interesting because at first, I didn’t even, Milton Friedman was reluctant to give Harry Markowitz a PhD for this because he wasn’t sure this was economics.
RITHOLTZ: Okay, so you just lowered my S&H in Milton Freeman a notch. How do you not — well, my hindsight bias is Harry Markowitz, of course, you give him PhD, but I guess that’s just hindsight bias, isn’t it?
IBBOTSON: Yeah, well, of course, now — of course, you know, Harry has a Nobel Prize, too. And so — and then we had the capital asset pricing models coming along in 1965 with Bill Sharpe and John Lintner. By the way, Harry Markowitz and Bill Sharpe, they’re still around the day, we can talk to them and so forth.
RITHOLTZ: Sure. Sharpe is out in Northern California. And where is Markowitz these days.
IBBOTSON: He’s in Southern California.
RITHOLTZ: Southern California. So, at the University of Chicago when you get an office as a faculty member, do they give you like a key to the office and a Nobel Prize? How does that work? Everybody faculty has — that’s a lot of jewelry in that — in that faculty department.
IBBOTSON: Well, actually, Bill Sharpe wasn’t ever at the University of Chicago, so that every Nobel Prize went to the University of Chicago people.
RITHOLTZ: But you’ve named seven or eight of them, not counting Bill.
IBBOTSON: Yes.
RITHOLTZ: You’ve gone through a whole bunch of them. What was it like working with that crew? That is some amazing list of advisors.
IBBOTSON: Well, we did know — we did recognize that things are going on that this was — this was a special place. We — we could see that. I mean, it wasn’t like we were surprised afterwards or something.
RITHOLTZ: Right.
IBBOTSON: I guess we’re surprised about the Nobel Prize’s aspect. We weren’t surprised that we were the center of thought leadership at — at that time.
And — and one of the things we were theoretically understanding is risk premiums. So not — not only the stock buyer where there’s an equity risk premium, but also in the bond market where there is an interest rate or a rise in risk premium that long bonds have higher yields than short bonds.
RITHOLTZ: Most of the time.
IBBOTSON: And then there’s a default premium …
RITHOLTZ: Right.
IBBOTSON: … the fact that if you buy lower-grade bonds that tend to have higher — certain higher yields, but even higher returns and higher grade bonds, so you had all these different — different risk premiums. And that’s what caused me to put this stocks, bonds, bills and inflation together, this data, because it was really the purpose of seeing what are — what were the historical pay-offs and stocks versus bonds, stocks versus treasury bills, bonds versus treasury bills, treasury bills versus inflation, the bonds that could default versus treasury bonds. All these things were risk premiums, and the purpose originally was to measure these risk premiums and see how they had done historically because we had the theory.
RITHOLTZ: Let’s see if it works.
IBBOTSON: Yes, and it did. Of course, they had great pay-offs and that’s part of the reason why it became so well-known so fast because everybody could now see the numbers of the kinds of things that we kind of knew were there, but we hadn’t seen the numbers.
RITHOLTZ: You could quantify risk and apply it to future expected returns.
IBBOTSON: Well, that’s the other thing. These were historical, but we — what other paper we had this is with Ibbotson and Sinquefield.
The other paper we had back in 1975 — 1976 was a projection of what would happen and how you could go out the next 25 years using the last 50 years to extrapolate out into the next 25 years. And we’re not literally just extrapolating just the pure numbers, but we’re extrapolating the risk premiums. And those risk premiums were extrapolated out to come up with these forecasts, which actually turned out to be almost out of the money forecasted what would happen in — by the year 2000.
RITHOLTZ: So of those four — stocks, bonds bills and inflation — which do you find is the easiest to forecast and which is the hardest?
IBBOTSON: Well, the easy — well, the hardest to forecast is always the stock market because there’s so much volatility, there’s so much noise. It’s a scary place to be. That’s why it has that equity risk premium.
RITHOLTZ: Exactly, and — and which is the easiest to forecast?
IBBOTSON: Actually, it would be the — I would say in — in a derivative format would be the real — kind of the real interest rate, the difference between inflation and treasury bills. But, of course, treasury bills — treasury bills are mostly moving. Yields are and bond yields, in general, are mostly higher or lower because of the expected inflation. So when you’re in high inflationary periods, you have high bond yields. And when you’re in lower inflationary periods, you have low bond yields like we have very low bond yields today, but we have very low inflation.
So a very large part of a bond yield is the expected inflation. And so if you — we — we know it at every point in time, but the inflation is and that’s usually a pretty good indication of what the expected inflation is going to be. As you go further out, you can — you can’t forecast it quite as well. But at least in the near-term, you have a pretty good idea of what expected inflation will be and, therefore, you have a pretty good idea what these yields and bonds are going to be.
RITHOLTZ: So you’re the perfect person to ask a question about that we’ve been debating internally in the office isn’t back and forth as to should stocks have a higher valuation these days for a variety of reasons. But I’m going to ask it differently. It costs nothing to trade today, it’s practically free. You could buy mutual funds or ETFs for practically nothing.
When you look at the historical returns and let’s call equity 8 percent to 10 percent with dividends reinvested, you’re paying a lot more for portfolio, you’re paying more for transactions. This was go back before discount brokerage, it was not cheap to buy or sell something. How does that figure into historical returns or on in a large enough portfolio even those higher prices on all that relevant?
IBBOTSON: Well, it may mean that the valuations should be higher because — because the trading costs are not as high. Anything that’s — and I’ve said we studied liquidity, risk is one — one big consideration, but liquidity is probably the second most important consideration.
RITHOLTZ: Liquidity?
IBBOTSON: Yes, the more liquid something is, the more valuable it is. The less liquid, the less valuable it is.
And by that — the counter of this question is that something that’s less liquid might have a lower valuation, but a higher expected return.
RITHOLTZ: Oh, very — very, very interesting. So you are currently a professor at Yale. You spent time at the University of Chicago. Let’s talk a little bit about academia and the real world. And you’ve moved pretty comfortably back and forth. Between the two, what is the difference between how ideas get applied in the business world? I probably shouldn’t call it the real world, but the business world versus the scholarly application of ideas at a place like Chicago or Yale.
IBBOTSON: Well, you know, there used to be a big gap in time. I — I remember like studying, as an example, duration on bonds where the duration was developed around 1940. And — and I — and I was managing a bond portfolio for the University of Chicago at the time. And — and I was using duration and I could figure out — with duration you could figure out easily in your head how much — if in yield change, how much the price of a bond would change. And — but nobody knew that in the 1970’s.
RITHOLTZ: Really?
IBBOTSON: Yes. And — and I gave a talk on that I remember and — and it drew a large crowd. But it wasn’t new — new material, it was merely stating something that was known, I guess, academically but not known in the business world or the real world. And so …
RITHOLTZ: Giant arbitrage opportunity, isn’t it?
IBBOTSON: We’re talking about 30, 40 years of delay before something kind of caught-on and even though it’s a very simple concept. So I think that that time though has dramatically shrunk now.
There is a connection. All my life, I guess, I’ve been trying to break that connection down. In fact, the title I have, you’ve read these long titles that I have at the — at Yale University as a professor in — in the practice of finance. That is up — that is a title that actually is — is a professor rank, but not — not tenured but it allows me to have business activities on the site. And so …
RITHOLTZ: Understood.
IBBOTSON: … ordinarily, you’re constrained. As a professor, you can’t do a lot of business …
RITHOLTZ: Right.
IBBOTSON: … activities on the site. But with this title I can, and I — and I guess I, in the end, not tenured so I don’t go to the committee meetings as many — as many of the committee meetings setting. You don’t have to go to a lot of them.
RITHOLTZ: So — so you — you’re identifying that effectively that bonds are mispriced relative to changes in interest rates. Was there an investment opportunity to arbitrage those prices relative to where they’re supposed to be?
IBBOTSON: This was a question in the 1970s. So not — not today I don’t think you find these kind of possibilities, but you did find distortions in the — in the 1970s. And so that was one of the things I did, now of course, the bond market has dramatically changed.
RITHOLTZ: Much more efficient than it was back then.
IBBOTSON: And all the markets have become much more efficient since they were back then because when something is discovered, it — it — the financial literature is not something that just academics-free, it’s something that — that the business world reads, and so now things are almost immediately implemented. There’s — I — I don’t know what the leg would be between — it wouldn’t even be five years between what’s discovered and what actually goes into practice.
RITHOLTZ: Ed Thorp wrote about the — the arbitrage opportunity between equities and warrants, and nobody was tracking them. There was a giant gap, and that also took a good couple of years before everybody else going on. And for a while it was easy money, and then that arbitrage went away.
IBBOTSON: It particularly went away with the Black-Scholes options model, which could price everything very accurately.
RITHOLTZ: From warrants to options to any derivative relative to the underline.
IBBOTSON: Yes. And — and, you know, I was in — in — at the University of Chicago with Fischer Black and Myron Scholes there right after they developed it. And — and before they published it, I — I said to them why don’t we …
RITHOLTZ: We should trade on them.
IBBOTSON: Yes, I suggested that. And actually I had a — I had actually bought a seat on the CBOE. I had a seat on the CBOE — CBOE, and I — I didn’t go down there myself. The trader — I sent a trader down there. But — but I wanted it — it was trading on it. So I was trading on that for a while …
RITHOLTZ: Using their model.
IBBOTSON: … using their model after it was published. It didn’t matter that it was published because at first the Black-Scholes model with all its log normal distributions and continuous time was complicated enough that you can hand it out on a piece of paper to people that wouldn’t …
RITHOLTZ: Nobody would get it.
IBBOTSON: Right. But what did happen not long after I started trading these was they …
RITHOLTZ: You figured it out?
IBBOTSON: Well, more than that, Black and Scholes — Fischer Black put it up in the members’ lounge of the — and a computer system in the CBOE. So, my game was over.
(LAUGHTER)
RITHOLTZ: Well, let’s talk a little bit about your game and in the real world as opposed to or in the asset management world as opposed to the theoretical academic world. Maybe that’s a better way to describe it. You’re Chairman and Chief Investment Officer of Zebra Capital Management. What do you do with Zebra? What sort of strategies do you invest in and — and how do you take the academic theories that you work on and apply it to actual management of assets and capital?
IBBOTSON: We have a — a new monograph. I have a new monograph with the CFA Institute. It’s — it’s called “Popularity: A Bridge Between Classical and Behavioral Finance.” And this — this monograph is co-authored with Tom Idzorek, and Paul Kaplan and James Xiong. They’re all three authors from Morningstar and myself. But it’s not popularity. And really popularity is the main concept, the principle that we manage the money at Zebra Capital. Popularity comes down to something kind of easily understand and, of course, you can get a copy of the monograph, it’s not expensive. You buy it on Amazon for $22, I think, and you can get it — download it for free, I think, at the ICFA Institute. So …
RITHOLTZ: Cfainstitute.org, here it is.
IBBOTSON: Perhaps you have to be a member — you have to be a CFA member in some form to — to get the access to it. But it’s free for the members — membership anyway.
RITHOLTZ: So — so when you talk about popularity, what does that mean in actual terms of — of investment? How do you apply popularity to deploying capital?
IBBOTSON: So a — anything that is popular tends to have a higher price. Anything that is unpopular tends to have a lower price. So think of two — two assets that have the same cash flows, but one of them is popular./
RITHOLTZ: That will be more expensive than one that’s unpopular.
IBBOTSON: That’s right.
RITHOLTZ: So are you long the unpopular, short the popular or how do you — how do you do that trade?
IBBOTSON: You’re ready — you’re ready to go here.
(LAUGHTER)
RITHOLTZ: Okay.
IBBOTSON: Yes.
RITHOLTZ: That makes sense, so it’s a hedge position and your — even if they both go up, the theory is that cheaper one will go up more than the expensive one or vice versa. If they both go down, the cheaper one will go down less than the expensive one. And you do this across how many different asset classes? Is it just equities, not — no bonds, no bills?
IBBOTSON: At Zebra Capital, we just do them with equities, but the concept applies to anything. And — and it’s really getting to be able to think differently about capital markets because, for example, in the capital asset pricing model, it’s systematic risk or beta risk that’s unpopular and, therefore, any — any stock that has high systematic risk, high beta risk is supposed to have a — a higher expected return …
RITHOLTZ: Right.
IBBOTSON: … according to the capital asset pricing model.
RITHOLTZ: But I sense you disagree with that.
IBBOTSON: I don’t necessarily disagree with that, but that’s only one aspect of popularity.
RITHOLTZ: Okay.
IBBOTSON: Risk is unpopular, but there are a lot of other things that are popular or unpopular, and one of them we’ve already talked about. I talked about …
RITHOLTZ: Liquidity.
IBBOTSON: … in an earlier episode here. We — I talked about the liquidity, yes. So, liquidity is popular.
RITHOLTZ: Do you pay a premium for more liquid stocks than illiquid stocks?
IBBOTSON: Yes.
RITHOLTZ: Or if said differently, do you get a discount for illiquid stocks?
IBBOTSON: Yes. And, of course, it is also obviously true in other markets. And you can see it more directly in the bond market, for example, or at the most extreme case, think of the treasury yield. There’s an on the run treasury yield or you buy the most liquid — liquid security with a certain maturity. And then there’s an off the run, and there’s a — there’s a spread out between those at 10 or 20 basis points between the on-the-run and the off-the-run yields, so it’s just a matter of one being more liquid than the other, and we’re not talking about much difference here. The on-the-run things may be trading every minute or every two seconds even whereas the off-the-run might be trading every few minutes, you know. But even small amounts of liquidity might — might make differences and how you get the difference of expected return.
RITHOLTZ: So is that one element of the thinking that goes into the portfolio or do you similarly create paired trades with illiquid versus an illiquid stock. You’re buying something at a discount and shorting something at a premium. And I don’t want to ask you give away all your secrets, but I’m trying to get a handle on how you use these different aspects of popularity.
IBBOTSON: Well, they’re not paired because we’re just a whole bundle of stocks at a long side that are …
RITHOLTZ: Oh, okay.
IBBOTSON: … that are less popular and a whole bundle of another stock — stocks that are more popular, but there are many different dimensions to being popular. We’ve already mentioned, too, and that’s the capital asset price, the amount we’re really focused on that first one, risk.
RITHOLTZ: Right.
IBBOTSON: And — and the whole financial literature has so much focus on risk.
RITHOLTZ: Too much focus?
IBBOTSON: Well, perhaps because there’s other aspects of things that are popular and unpopular.
RITHOLTZ: So we mentioned valuation, we mentioned CAPM, we mentioned liquidity, what other elements do you consider when — when looking at your popular versus unpopular — let’s not call it pairs, but pools of longs and shorts.
IBBOTSON: So the monograph that we’re talking about says Popularity: A Bridge Between Classical and Behavioral Finance.
RITHOLTZ: Ah, so some of the behavioral factors come up also. How do they apply?
IBBOTSON: So let me give you one more of the classical …
RITHOLTZ: Sure.
IBBOTSON: … factor. I guess I had to name three — the three big classical considerations, one of them is risk and it might be systematic but it can have all different dimensions or different types of risk.
RITHOLTZ: Right.
IBBOTSON: Another one is a liquidity. Another one is taxation. Some securities are taxed differently than others.
RITHOLTZ: So different tasks treatments between different types of pass-through holdings, what is the third one?
IBBOTSON: Tax treatment. At the most extreme, you can see it with a — which you want to see it directly would be compare municipal bond to say a corporate bond and the same …
RITHOLTZ: Right.
IBBOTSON: … default and maturity characteristics.
The municipal bond is going to have a lower yield …
RITHOLTZ: Right.
IBBOTSON: … but it’s going to have — that’s because it’s popular, it has better tax treatment.
RITHOLTZ: MLP is treated differently than regular equities, according to the tax man, and that changes how you perceive them in the overall portfolio. Similar to muni bonds, which are also treated differently, a lower yield effectively net of taxes turns out to be comparable to a non-municipal bond.
IBBOTSON: So things that are popular like MLPs are going to be priced more effectively.
RITHOLTZ: Quite, quite fascinating.
IBBOTSON: So that’s just on the — on the classical side, but then you have the behavioral side. And on the behavioral side, you have things — like one of the things we tested in this monograph were brands, brand value, the companies and there’s different ranking systems of how valuable the different brands are. But the companies that have the highest brand value, you might imagine, those are the companies you would like in your portfolio, right?
RITHOLTZ: No, the opposite. I know where you’re going.
IBBOTSON: Yeah.
RITHOLTZ: I’m cheating because I know where you’re going, but, for example, in 2018 in the beginning of the year, Apple was one of the — it was either one or two in the brand ranking down 30 percent since then. And I don’t know how far down the list of unpopular brands you go, but I would imagine there is a line that — in the sand where you say, on a list of 500 below this number, these unpopular brands start to become attractive.
So first question on that is where is that line, how unpopular something have to get before it becomes attractive?
IBBOTSON: It’s always a relative. I mean, you want — you want to short the most popular names, the most popular brands. And really the unpopular brands, you don’t have to go after the brands that are in some sort of scandal or anything. But we — mainly most of these brands you’ve never heard of. You know, they’re not — they’re not well-known brands./
RITHOLTZ: So not G.E. that’s running the hard times, but some entity that just seems to have fallen out of favor.
IBBOTSON: Yes or just — or just overlooked, things that are overlooked. Stocks that are overlooked that are unpopular, stocks that are in the news all the time are the popular stocks.
RITHOLTZ: Sure.
IBBOTSON: Now — and — and the value of factors related to this because stocks, you know, valued over the long-term outperforms growth. But the value companies, when you look at those things, those are not great companies whereas the growth companies are the companies that are really much more exciting, much better companies. But there’s a difference between buying a great company and buying a great stock.
The great stocks are not the great companies, great stocks of — in fact, it’s easier to fix a company that is something wrong with it than to improve a company as everything is going great.
RITHOLTZ: But just isn’t popular?
IBBOTSON: Whether they’re great, they’re popular, that’s their problem.
RITHOLTZ: So give us one more behavioral measure to consider with popularity.
IBBOTSON: Another one we measured was reputation value. Well, I’ll give you another one that’s a little more different is tail risk.
RITHOLTZ: Okay.
IBBOTSON: Any — any stock that has actually gone through a tail event, a negative event has come in its history — recent history last five, 10 years …
RITHOLTZ: So let’s talk about B.P. in the Gulf of Mexico or Boeing and the 737 Max, those are kind of tail events. What does that tell you about how you would expect the stock to do going forward? Are they — is the stock like Boeing post 737 issue become attractive because of that tail event?
IBBOTSON: It can not necessarily the next month or so, but people are going to remember that tale for a long time. They’re going to remember that bad event, and — and it’s going to be — the reputation is somewhat permanently damaged, but I have actually studied this with one of my co-authors that I named James Xiong here where we looked at tail risk. And it turns out that future tail risk is not so related to past tail events.
RITHOLTZ: That’s interesting.
IBBOTSON: So something really went wrong, say with Boeing, they will have actually fixed it …
RITHOLTZ: Right.
IBBOTSON: … and get back on track with a lower reputation, but they’re not necessarily prone to have another tail event.
RITHOLTZ: Quite fascinating. We were talking earlier about the difference between academia and real-world application of ideas into actual investments and trades. How often you come across an idea that looks great on paper, but just doesn’t work, just can’t be implemented in a real portfolio?
IBBOTSON: The problem with real portfolios is, as they have a lot of trade — they may have trading costs. A lot of the very best ideas have high trading costs, and most of us are not in a position to actually implement these and get rid of those trading costs.
There’s another — another problem though and that is that the kinds of things that have worked in the past when you look at a — you do some back testing and you discovered things from the past, those sorts of things, once they’re discovered and known tend to be heavily invested and get popular actually.
RITHOLTZ: Right.
IBBOTSON: And once they get popular, they get priced out — out of the — out of contention, and — and they don’t have the same sort of pay-off. So it’s no longer is easy to translate all these ideas that come out of academics and actually make a lot of money from them.
RITHOLTZ: Quite interesting. One of those big topics these days is index funds and the move away from active towards passive. Where do you find yourself in terms of some people seem to think the flow into index funds is distorting the market or at least hurting price discovery? What are we 15, 20 percent indexed in the U.S.? What’s the impact of that?
IBBOTSON: The — I — I don’t actually think it’s hurting markets. Actually, the index has come in so many different forms. You can buy a whole index on say the Russell 3000 or the S&P 500, but you can also buy indexes in different forms and ETFs and every mutual funds on — by a specific industry or by value stocks, or by small cap stocks or by a particular type of stock. So it’s — and if it’s really taking — you’re actually taken aback when you actually buy that type of stock.
If you — if you though, for example, that — that oil or energy was going to do poorly in the future, in the old days, you’d have to — how do I translate under which stocks to avoid and so forth or …
RITHOLTZ: It’s much easy to express the trade today.
IBBOTSON: Yes, and that makes the markets more efficient because if we can target our opinions into a trade directly rather than trying to mix it in with some stocks that — that are really noisy and not so related to that trade, it’s — it makes it very hard to accomplish.
RITHOLTZ: So one of the things I keep hearing from you is it was much easier back then, it’s more efficient today. Is this part of the reason why so many active managers seem to be unable to keep up with their benchmark? Have the markets become that efficient?
IBBOTSON: By definition though, the market is a zero-sum game before costs in the sense that if — if you’re going to beat the market I have to do worse than the market or we have to sum up to the market collectively, and that’s before cost. And after cost we’re going, on average, do a little bit worse with the market. So this isn’t that really efficient capital markets. This is just a mathematical identity. It’s called a zero-sum game …
RITHOLTZ: Right.
IBBOTSON: … and, in this case, a zero relative sum game because it’s relative to the market. So we never could all collectively, on average, beat the market. We always had to — have most of us actually do a little bit worse to the market on average.
RITHOLTZ: So it’s not like Lake Wobegon where all the children are above average? It doesn’t work that way?
IBBOTSON: Well, that’s a — that’s a good analogy because that’s what keeps the market going. We all think we’re above average. And if we — this is behavior, of course.
RITHOLTZ: Sure.
IBBOTSON: But if we all think we’re above average, then — then, of course, we can — we’re all willing to play the game even though some of us are clearly not above average and …
RITHOLTZ: By definition, all of us can’t be above average. My — my favorite question anytime I’m at a conference and presenting somewhere, I always ask the room full of people, how many of you are above average drivers? Just about every hand in the room goes up. And my response is always, “I’ve been on the road with you folks. Some of you are wrong,” because clearly we can all be above average.
So let’s talk a little bit about what — what was discussed in Forward Thinker, which was something you wrote for wealth manager back in December ’08. You talked about the financial system being restructured following the financial crisis. Have we sufficiently restructured the system to avoid the next crisis or did we simply restructured enough to avoid a repeat of the last crisis?
IBBOTSON: It would be mostly a repeat of the last crisis. Restructuring primarily involves having less leverage and — and — and actually we’re also worried about counterparty risk. And, of course, some of that counterparty risk has been — been fixed. We’re getting more leverage back into the system probably now.
RITHOLTZ: Slowly but surely it’s creeping back in.
IBBOTSON: Yes, so I don’t — I don’t see these were as any permanent fixes and a question anytime you regulate markets. You also add a lot of encumbrances that way to the way the markets work, so both good and bad here that it’s — where I don’t see a financial crisis coming soon.
Most recessions, by the way, most drops in the market are not really a financial crisis. But the one in 2008 was like the — like the tech bubble crash in — in 2000s or 2002.
RITHOLTZ: Not a financial crisis.
IBBOTSON: But what I’ll do as a financer is a just technology, right.
RITHOLTZ: Right. Speaking of behavior, access sentiment had gotten so enthusiastic people decided valuation doesn’t matter, you can pay any price for these things. Nifty 50 like it’ll work out except when eventually doesn’t, so clearly not a — a financial crisis.
’87, how you describe that? Not a financial crisis, really a plumbing and structural issue?
IBBOTSON: Well, it wasn’t a financial crisis, it’s just that it only lasted about a week.
RITHOLTZ: So not much — that’s not much of a crisis, then I think back to ’73, ’74 so just a deep recession not a financial crisis. The 50s predate me, but when you read the history books, those late 50s, early 60s recessions, they don’t seem like right. You have to go all the way back to what, 1929, for a previous financial crisis?
IBBOTSON: Yeah, 1929 to the 1930s were financial crisis. So we had the big one then, we had the smaller one in ‘87 and — or — or the limited one in ‘87 and we had a — a potentially severe financial crisis in ’08. And we got through it, which was very fortunate, but it was a potlential …
RITHOLTZ: So.
IBBOTSON: … financial real breakdown of financial markets.
RITHOLTZ: So that leads to the next question, people have been — some people, especially people on the bond side of the universe, have been very critical about how the Fed intervenes in the markets and they’ve continued to be critical about low rates being as low as they’ve been causing risk assets to rise. What are your thoughts on the job the Fed did during the financial crisis? And how do you think the Fed has done since then?
IBBOTSON: I think during the financial crisis the Fed really had to do some special things that they hadn’t done, have developed their balance sheet which they had really never done before. It used to be the Fed was just raising — lowering the — the interest rate. And that was not — that didn’t do anything after you got down to zero interest rates, so they then had to build up their balance sheets. So I think the Fed did a great job, in my opinion, in — in helping to avoid that …
RITHOLTZ: Another great depression?
IBBOTSON: A real catastrophe definitely.
RITHOLTZ: You think you could have been — I think people have forgotten. It’s been a decade and they’ve already forgotten. Were we on the precipice of another depression similar to the ‘29 in the 1930s?
IBBOTSON: We were on the precipice of a financial breakdown. I don’t know that it would cause a depression, but it would cause a lot of chaos. And certainly, I’m not clear what it would cost, you know, but we were definitely on the precipice of a financial breakdown, which could have been very severe.
I — as far as what the Fed’s done since then, well, I think they could have — we’re now 10 years later and we haven’t – we’re now interest rates less than the window — the Fed window that really only charging less than three percent …
RITHOLTZ: Right.
IBBOTSON: … at this point.
One of the — one of the levers the Fed has to protect against recessions is to lower the rate. We can’t lower the rate if we never rose it. And so I think they could have done much more, but they were very reluctant to raise rates over this long recovery, which has been now a very long 10-year recovery.
RITHOLTZ: So we still don’t have normalized interest rates and the Fed is — are they behind the curve or have they just not gotten us to a place that resembles neutral yet.
IBBOTSON: The rates are so low and the — and although they are finally reducing the balance sheet of the Fed, it’s still a big balance sheet. So they don’t have the same fire power going into any new activity that happens that we had back in ’08.
RITHOLTZ: Quite interesting. So let’s talk a little bit about annuities, which are somewhat controversial to some people. I don’t know if that’s really the right descriptor of it. You wrote not too long ago, “Investors should consider indexed annuities as bond substitutes.” Explain what those are and how would that operate in a — in a portfolio.
IBBOTSON: Oh, let me first explain why we might need a bond substitute. If you — bonds today, at least treasury yields, are below three percent. The 10-year I looked at — I looked recently the 10-year was definitely below three percent. And — and a return on a bond is the yield, plus or minus, a capital gain or a loss.
If yields rise, you have a capital loss on bonds and I mentioned duration at an earlier time. The — essentially if yields rise one percent and the duration is 10 on a bond, you — you lose 10 — 10 percent on that bond. So there is a potential for actually bonds that have that negative returns in the future.
And if you look at the history of all these yields, we — from the 40’s on, we had very low yields that rose in ’80, ’81, they were double-digits. And — but since then they’ve been straight down.
RITHOLTZ: Thirty-three years of falling interest rates.
IBBOTSON: And that meant really good returns because not only do we get those high yields that you started with, but then you got these capital gains. That’s probably not going to happen going forward here. We’re going to have a low yield and a potential capital lost. So I wanted to see what else you could — you could — we could have that would be an alternative for that.
RITHOLTZ: Sure. So short of going back to 1982 and building a bond portfolio, how — how — so how would an indexed annuity work? What is — what’s in — what’s in — because an annuity is just a wrapper, right, and for the most part tax deferred. How do indexed annuities work?
IBBOTSON: Indexed annuities are — they’re insurance products. And I — and I have to say that Zebra Capital has indexes — a co-branded index with the New York Stock Exchange, and that index is actually used by an insurance company to — in — in creating a accumulation annuity that I’ll mention here. So — so I — I have some incentive here to actually …
RITHOLTZ: So you’re talking your book but you’re the expert in this space so we — we know that you take your academic theory and apply practicum and here’s a perfect example of it. So what does that annuity holds? And are we kind of doing a little bit of a magic taking something and creating a — a yield that doesn’t have the same parameters of a bond? What is that metamorphosis there?
IBBOTSON: So the — what — what’s happening is we take the index — actually the insurance company takes this index, and it — it insures the downside essentially. So it does this actually by buying — buying options and so forth. So what it — what it means is that a — an actual person then can buy a annuity — an index annuity that they get a participation and our nexus in (ph) and equity index that has some bonds in it, and it’s risk-controlled to have a five percent volatility. But they can buy that index with that — with that five percent volatility. The insurance company ensures it so that you get equity participation, but you don’t lose any money.
RITHOLTZ: So this isn’t we’re not taking lead and turning them to gold, this is essentially a hedged equity product that behaves like a bond. Is that a fair way to describe it?
IBBOTSON: It has roughly the same returns as a bond on average, but it doesn’t have any losses that the losses are insured. And essentially, your — you have equity participation on the upside, not full equity participation. It’s not a subsidy for stocks, it’s a subsidy for bonds that doesn’t ever lose money.
RITHOLTZ: So it’s a dividend yield plus whatever capital appreciation you get minus the cost of — of hedging against the downside.
IBBOTSON: You got the capital appreciation and — and a participation of the equity market. And, of course, no losses on the downside, that’s what — by having less than 100 percent participation in the equity market and by getting the capital appreciation, you are able — the insurance company is able to use that to have insured the downside so that there are no losses. So you end up with a distribution of returns that is maybe roughly comparable in terms of returns to a bond market, but has upside but not downside.
RITHOLTZ: Quite fascinating. You’re a Chicago guy, you work with Gene Fama. There are a number of factors that just keep getting discovered. Last count it was excess of 400, maybe even more than that. What do you think about all these different factors in the textbooks? And — and how does that work in the real world?
IBBOTSON: Well, these say 400 factors, they’re — a lot of them are coordinating with each other so it’s not really 400. But — but there’s still many of them, you know. And the way to evaluate it has to do with our monographic and popularity because in order for a — a factor to really pay-off and forward over the long-term in anyway, it has to be unpopular, in some sense.
RITHOLTZ: Unpopular.
IBBOTSON: Yeah.
RITHOLTZ: So the popular ones are valuation, quality, momentum. Those are probably the four most popular ones I can think of. You want to go further down the list and find ones that are either overlooked or — or unpopular.
IBBOTSON: Well, for example, liquidity …
RITHOLTZ: Sure.
IBBOTSON: … is something that’s inherently popular and lastly, liquidity is inherently less popular, so if you have a factor based on liquidity, that’s likely to pay off. If you have a factor based on risk, they’re often likely to pay off because risk is always going to be unpopular and less risk is going to be more popular.
If you have factors based on — on — it could be quality, it could be any of these sort of things, it could be value — value-based. Essentially, if value companies are distressed companies that we don’t like, the value premium might be unpopular, I guess, and if so that’s — that’s the rationale why you might have a value premium because if people — they’re the type of companies that we don’t like, then — then they’re going to be relatively less demand for them, they’re going to be unpopular, but that means — that less demand means they’re going to have higher expected returns.
RITHOLTZ: So — so here we are in 2019, value has gotten its butt kicked over the past decade by growth. I am going to take that — I’m going to interpret what you’re saying as implying value — value as a factor is less popular, but value should expect better returns going forward or value should have a higher expected return going forward versus the more popular growth.
IBBOTSON: Yes, I think it does especially now that we have this bad period because once — once — after value does so well, everybody gets excited and says — say, well, I — I should be buying value stocks instead of growth stocks. So the question — you always have to ask yourself this question, that’s what does monograph is all about.
RITHOLTZ: I can’t help but point out that a number of famous and infamous hedge fund managers over the past decade all of whom kind of came to the public’s attention eight, 10, 12 years ago, the more popular they got and the more capital they got, the worst their performance seems to be. Is this the same sort of issue where suddenly popularity just exceeds their ability to manage the capital or is there something about, hey, that’s way late in the cycle by the time it gets popular, it’s just too late.
IBBOTSON: Well, it’s probably both of that that certainly when they get a lot of money that their particular idea they put a lot of money behind that they’re putting too much money behind it, and then — and then they’re moving the price themselves, and then that makes it overvalued and then too popular in our words. So too popular could be overvalued, too popular could be just classical types of things like risk or liquidity, but popularity is the thing that ties everything together. That’s why I guess I’m so excited about our new — our new monograph here because it — it’s not always — it ties all these premiums together that people are talking about, say the 400 premiums and which ones might work. And it also ties in the complete because it — we were evolving into behavioral finance and classical finance as being different fields to some extent. This ties them back together again. So I’m — I’m really excited about the — the whole approach here.
RITHOLTZ: And I’ll — I’ll include a link to that white paper on the write-up about this so people can find it. We have been speaking with Roger Ibbotson, Professor of Finance at the Yale School of Management and Chairman of Ibbotson Associates as well as Chairman and CIO of Zebra Capital Management.
If you enjoy this conversation, well, be sure and check out the podcast extras where we keep the tape rolling and continue discussing all things factor and popularity-related. You can find that at iTune, Overcast, Stitcher, bloomberg.com, wherever finer podcasts are found.
We love your comments, feedback and suggestions. Write to us at mibpodcast@bloomberg.net. Check out my daily column on bloomberg.com/opinion. Follow me on Twitter @ritholtz. I am Barry Ritholtz. You’re listening to Masters in Business on Bloomberg Radio.
(BREAK)
Welcome to the podcast. Roger, thank you so much. I don’t know what to call you, Professor Ibbotson, Roger. What’s your preferred …
IBBOTSON: Well, with a person like you, Barry, I’ll call you Barry, you should call me Roger.
(LAUGHTER)
RITHOLTZ: OK. I feel like I’m — I’m definitely punching above my weight in this conversation. But this has been just really fantastic stuff. I know I’ve been following your career and your research and writings for my whole career in finance, and I’m very much looking forward to this conversation. So let’s jump to our favorite questions. I ask these of all our guests and some of — some of these are especially resident for — for different listeners.
Let’s start with — I used to ask this question just as a sound check for the audio engineer and the answers were so fascinating that I have started asking all the guests this question. So what was the first car you ever owned, year, make and model?
IBBOTSON: Well, it was a 1961 Plymouth Valiant light blue. And I was a junior — I guess, just a starting senior in college at Purdue. And I really love that car. I got to say kind of a sporty-looking car and so it was a really …
RITHOLTZ: Two-door or four-door?
IBBOTSON: It was a — it was a four-door car, but it was still very — so very sporty-looking car. And — and it was great fun, although unfortunately I didn’t get to keep it that long.
RITHOLTZ: I can remember the Valiant — I’m trying to remember if that was like the Dodge Dart similar shape, sort of a big long hood and a big long …
IBBOTSON: No, it’s actually a little bit smaller than that.
RITHOLTZ: A what?
IBBOTSON: A very sporty-looking car. It wasn’t like that in …
RITHOLTZ: Back in the day when Plymouth made some pretty substantial sports cars.
IBBOTSON: Yeah, they don’t make the sports cars. But, unfortunately, that car — my first job after I got my MBA so I had that car for three years, my senior and then two years as an MBA student. But I — I worked on a cattle ranch actually in my first job …
RITHOLTZ: Cattle ranch.
IBBOTSON: … in Nevada.
RITHOLTZ: So I was going to ask my next question is what is the most important thing we don’t know that Roger Ibbotson, but before I get to that, how do you go from the University of Chicago on an MBA in finance to a cattle ranch?
IBBOTSON: Well, I thought that — I have an offer so I took that I thought — it seemed like a good opportunity to do something really great. And — but — but I was out of my own then I — I was fired at the end of the summer.
RITHOLTZ: So you weren’t trading cattle futures, you were actually on a horse with — in a ranch.
IBBOTSON: Well, it’s more like trucks and planes and …
RITHOLTZ: Okay.
IBBOTSON: … but your — let me tell you, a car does not last on a cattle rancher long because it — they’re all dirt road …
RITHOLTZ: Right.
IBBOTSON: … and the car was just covered with — thick with dust and …
RITHOLTZ: Sure.
IBBOTSON: … every — and every bump and so forth the transmission went out, you know, all the things. So that was the — my car had that kind of ending life there. And — and I didn’t work out either the cattle ranch and so I actually ended that job and put it on my resume as a summer job.
(LAUGHTER)
RITHOLTZ: That — that’s pretty — that’s pretty hilarious. So I — I — given that I’m reluctant to ask the next question, but what’s the most important thing people don’t know about Roger Ibbotson?
IBBOTSON: I would actually say though I’ll take it all the way to the present.
RITHOLTZ: Sure.
IBBOTSON: Then I’m not — I, you know, I have, of course, been working in finance all these years, but I’m actually very interested in long-term data and time over time and so forth. I’m getting very interested and I might be writing at least I’m researching whether to write on the subject of — of long history going forward and — forward and back essentially, perhaps even starting with the Big Bang and — and …
RITHOLTZ: Oh, really?
IBBOTSON: … and then really for more predictive purposes though and — and long-term kind of predictions and what’s going to happen to — to humanity and so forth. So that’s — that’s one of the things. You have to interview me a couple of years later in order to …
RITHOLTZ: When this book comes out, you’re absolutely welcome back. We love to talk about that. So tell us about — and I — I’m afraid to even ask this question, but I have to because I know who’s coming up in the answer. Who were your early mentors?
IBBOTSON: Well, I — I — it is the — it is the University of Chicago people with the — the …
RITHOLTZ: Fama, Merton, Markowitz, who else is on that run?
IBBOTSON: Well, it’s Myron Scholes, and Fischer Black, and yeah — and Merton Miller and Gene Fama. They’re — they’re all my early mentors, yes.
RITHOLTZ: That — that’s an incredible line-up. What about investors? What investors influence the way you think about taking theory and applying it in the real world?
IBBOTSON: You know, I — they work literally in investors because I have to say that getting grounded in efficient capital market theory gives you a whole approach to investing. And — and instead of starting out with imagining that every stock you imagine is — is unrelated to the price in some way, if you started out with the fact that you’re — that you know nothing about a company or — or a security, it’s — the prices — the kind of the best guess of what its value is. And so that’s such a dramatic approach.
Even if you’re looking for any inefficients (ph) with the market, it’s such an — it changes your whole way of approaching everything and thinking about everything because you — instead of — well, for example, as a portfolio manager, you could do nothing and you might do fine. You know, it’s — you don’t have to literally trade every day to make things work. It’s a matter of — of you only want to trade when you really do have the edge that you’re actually going to add value.
So one of the things I always think of — and I’ve managed companies and I’ve managed stocks. And I think stocks, in some way, manage themselves. People …
RITHOLTZ: Well — well, if you start out from the belief that the prices of fair estimation of the value, that should really take care of itself.
IBBOTSON: That’s right, that’s — that’s sort of the key. I mean, once you sort of know that, your stocks are managing themselves but then you try to improve by that.
RITHOLTZ: Right.
IBBOTSON: But your people don’t manage themselves.
RITHOLTZ: That’s right.
IBBOTSON: So it’s much harder to manage people than it is to manage stocks once you understand this principle. If you don’t understand that principle though, managing stock markets, you got hundreds of thousands of stocks, you got hundreds — hundreds or thousands or whatever, you got all the stocks and you kind of think out is this one overvalued or undervalued or you may have to attack it that way, you can quickly get overwhelmed in the situation. So it’s just a principle that so much simplifies the process …
RITHOLTZ: Starting with the assumption that, hey, most stocks are going to be more or less priced relative to their value.
IBBOTSON: Yeah.
RITHOLTZ: So they’re good starting points. All right. Let’s get to everybody’s favorite question. I get emails about this all the time. Tell us some of your favorite books.
IBBOTSON: Well …
RITHOLTZ: And by the way, I will include your books when we — when this goes live, I will include a list of all your published books. So tell us some of the favorite books that you’ve read of other authors.
IBBOTSON: Yeah, I want to say, of course, I’m not going to promote my own books. I always love my own books.
(LAUGHTER)
RITHOLTZ: Who does it? What author does it?
(LAUGHTER)
IBBOTSON: But because I’ve been looking at the long-term things, I’ve been …
RITHOLTZ: I know where you’re going to go. Go ahead, let’s see it.
IBBOTSON: I — I — for example, there is this Yuval Harari who have been writing “Sapiens” and then the prediction of …
RITHOLTZ: Homo Deus, right.
IBBOTSON: … of the — the future of that and really that like I’ve been reading like Steven Pinker’s — I think it’s called “Better Angels” …
RITHOLTZ: “Better Angels of our Nature,” yeah.
IBBOTSON: Yes, about how — how — how we’re changing over time and so forth, and how we’re less violent and so forth. I — David Christian is an author — he’s Australian — well, he’s not really Australian, he’s been over the world, but he’s — I think he’s teaching in Australia at this point. But he — he’s — he’s written a book and there are a lot of — of course — electronic courses on — on big history, which is looking at history from the start all the way out into the future.
RITHOLTZ: What’s the — is that the name of the book, “Big History”?
IBBOTSON: Well, he has a book that — his most thorough (ph) book is Maps in Time (sic).
RITHOLTZ: Okay, quite interesting.
IBBOTSON: It comes from about 10 — 10, 15 years ago.
RITHOLTZ: You have any other books you want to mention because I’m going to circle back to something you said earlier?
IBBOTSON: Well, I could name many books …
RITHOLTZ: Keep going.
IBBOTSON: … on this subject.
RITHOLTZ: Give us — give us what you want.
IBBOTSON: Well, one that I’m just — just finished was Johan Norberg out of Sweden wrote a book on progress and how — how we’re getting better off in lots of different dimensions and so forth. So these are all subjects that are of interest to me. I don’t think it’s all good new though, of course, because at Yale, for example, the recent Nobel Prize winner Bill Nordhaus really worked on pollution and so forth and how.,..
RITHOLTZ: Right.
IBBOTSON: … global warning and so forth, so lots of other things are going on. I’m not saying it’s all good news. I’m interested in the overall effect though and trying to understand this. So I — I am interested in long-term history, and I’m always interested in long-term forecasting.
RITHOLTZ: I’m fascinated by the two Harari books cause “Sapiens” is so interesting, and while some of it’s got a little bit of a negative cast, generally speaking, it’s the history of progress even though along the way he kind of annotates it with all these, yeah, well, farms and cities or where diseases began and — but it’s not a completely bleak picture.
The “Homo Deus” book is a little negative looking forward, then “Sapiens” sort of had this wide-eyed wonder to it, which did not come across in “Homo Deus.” I’m curious as to your — your take on the two books.
IBBOTSON: Well, I – that’s what you’re saying and — and I might say humans have been remarkable species. And I’m always just amazed with the fact that — that we — we actually can understand the start of the universe and we can understand …
RITHOLTZ: Well, we — maybe we do, we’re not sure we do yet.
IBBOTSON: Well, we know a lot about it and some amazing a lot about it. And we also know — I mean, that’s how they got the Higg boson, for example …
RITHOLTZ: Sure.
IBBOTSON: … oh, that kind of thing, they could predict these sort of things. And we also know something about the scale of the universe …
RITHOLTZ: Which is astonishing.
IBBOTSON: And — and this has all happened in the last 300 or 400 years, you know, since — since Copernicus, and Kepler, and Galileo so forth, these things — we went from nowhere thinking the earth was the center of everything to …
RITHOLTZ: Right.
IBBOTSON: … actually understanding everything. That’s at the macro level. But at the micro level, we also understand how, of course, atoms and electrons and …
RITHOLTZ: Quarks and gluons.
IBBOTSON: … and quark, and DNA and so forth. So our — our species has just — has amazing accomplishments and — and — and — but I don’t know where — so you have to weather that given all this huge acceleration and knowledge, and actually collection of knowledge just seems building on its own, where does that go?
RITHOLTZ: Right, especially — especially the past 50 years, we’re in a golden age of physics. I mean, the past 50 years and then the past decade, quite — quite astonishing the sort of progress we’ve made. All that said, the Big Bang theory is still a very preliminary theory. We don’t understand the whole inflationary expansion that took place. We still don’t understand if we’re measuring the universe right, how much dark matter is out there, what are we missing, what are we not seeing. Why our galaxy is accelerating away from each other no matter what direction you look? I’m fascinated by that. Like you are, I share just a genuine astonishment about that.
I’m also — there was a book that came out about a decade ago that you might appreciate if you’re — if you’re working your way forward from the Big Bang called the “Rare Earth Thesis,” which basically says, well, life is probably common in the galaxy because — in the universe because every galaxy has all the build — fundamental building blocks: hydrogen, carbon, oxygen, nitrogen, et cetera, but intelligent life is really, really rare. It’s a whole series of incredibly unused — unusual events that lead to a planet like this that’s stable enough for — for billions of years for long enough for intelligent technologically advanced life to develop.
And I’m — I’m just intrigued by that sort of circling back to the original pre-enlightenment. Oh, no, no, it’s just humans. The rest of the universe doesn’t — doesn’t matter. The whole universe was just created by God for us. And maybe there’s actually some — for completely different reasons — theoretical basis for that thesis from a physics approach, but — but I digress far often.
It’s not the best written book, but it’s a fascinating concept. If you — if you’re enjoying all the modern astrophysics work, and I’m sure you’ve — you’ve come across Brian Greene and his string theory work and other stuff, I’ve endlessly fascinated by that. I’m just intrigued by that stuff.
IBBOTSON: So one of the great things about being a professor is — is you get to study whatever you want, and — and you — you share this fascination with me with this. And now I relate and kind of work on this now you see so …
RITHOLTZ: Do you ever pick up the phone at Yale and say, “Oh, so and so is in the Astrophysics Department. Let me get him on the phone.” and you have access to all these folks who can — who can steer you in certain directions?
IBBOTSON: I’m starting to do that, yeah. I haven’t been doing that, you know, because more I have been pretty focus over the — I just had — I have a broad breadth of activities here, but — but they hadn’t gotten into this sort of thing. Now I’m getting into all the other arms of the university, and I find that really exciting to — to see — really I’m applying kind of the things I’ve always done because I always was interested in history and data.
RITHOLTZ: Right.
IBBOTSON: And I’ve always …
RITHOLTZ: And you’re taking it to the next level.
IBBOTSON: … and always interested in making projections and — and so forth. And now I’m just trying to broaden this out, so — so this is — it is a great — I guess at this point, I would say it’s a hobby, but — but they’re trying to make it into — I don’t think I’ll make money from this (inaudible)..
(LAUGHTER)
RITHOLTZ: Well, it’s tough to do that. So — so it makes me want to ask you the question, universal entropy. Are we eventually just going to dissipate or the big crunch and all starts over again?
IBBOTSON: You really do want the big question, don’t you?
(LAUGHTER)
RITHOLTZ: You know, I — I come prepared.
IBBOTSON: Well, the — of course, entropy eventually dissipates everything. But — but one of the things that the universe is built on is complexity. And even though you have this overall entropy going on, which is spreading everything out and dissipating, you have — gravity has been one of the big things, pulling things — pulling parts of things together.
RITHOLTZ: Right.
IBBOTSON: So at the same time, everything’s dissipating. Obviously, we are the — we are getting more and more complex and that’s certainly humans are an example of that.
RITHOLTZ: Sure.
IBBOTSON: So the world is getting more complex, not less complex despite this — despite the second law of thermodynamics.
RITHOLTZ: So I’m fascinated by the concept and I wish I can remember where I read it that — and this will be the last astrophysics part of our conversation. The idea that nothingness is inherently unstable and the Big Bang comes around that you can’t have nothingness forever, nothingness eventually just explodes into something else because if it’s an error and instability. And that’s a little mind-blowing to me. Us humans can barely conceptualize it, but it’s a fascinating concept where — how did the universe come out of nothingness, and the answer is, well, maybe nothingness just is someone’s stable that it has no choice but to create a universe. I’m — I’m fascinated by that.
IBBOTSON: So in my case I’m going to limit this a little bit more.
(LAUGHTER)
But …
RITHOLTZ: You’re going to keep it limited to just the universe.
IBBOTSON: Well, I mean, I may look at the next 100 years or the next 1,000 years.
RITHOLTZ: Okay.
IBBOTSON: Something like that, so the — instead of — or maybe mainly our planet, you know, and so the whole universe and so forth so — but they’re all related, I mean, it’s certainly having some understanding of the big picture helps you — helps you understand still the very big picture.
RITHOLTZ: Quite interesting. So let me move forward away from the universe and ask you this. Tell us about a time you failed and what you learned from the experience.
IBBOTSON: You know, I’ve failed quite a bit in my early days. And my — my father was in the heating and air-conditioning business, and had I been more mechanically-inclined …
RITHOLTZ: You have gone into that field?
IBBOTSON: Yes, that’s certainly true.
RITHOLTZ: Well, thank goodness you weren’t because we — we need you here in finance doing what you’re doing.
(LAUGHTER)
IBBOTSON: And — and then even — even when I — so my — when I went to college, my father said take engineering because the corporate presidents are mostly engineers, that was true after World War II but it’s not true today.
RITHOLTZ: Right.
IBBOTSON: The — and so I took engineering, but I really couldn’t handle all the hands-on stuff of even engineering. And — and so I tied into math and physics as my major. But then I — but even — so I need to be something more abstract, but when I got to math, it got too abstract for me …
RITHOLTZ: Right.
IBBOTSON: … and I couldn’t even handle that. And so I had to find a niche, and finance — finance is actually the perfect hitch. It’s kind of abstract, but it’s not as abstract as — as abstract. I — I actually tried to make something like abstract things practical that’s been our key. I guess, that — that piece in between the fully abstract and the practical and blend them together.
RITHOLTZ: That’s your sweet spot right in the middle, between the — between the two of them. So what do you do for fun when you’re not contemplating the universe? What — what does Roger Ibbotson do to keep himself entertained?
IBBOTSON: Well, I mean, I — I — I have a family and so — I have two sons here in Brooklyn, and I pay to get together with them because I exercise and all that. And I go hiking and all that. But — but, to me, the most fun and it even connects my family and everything is the world of ideas. I mean, that’s what’s so great about being a professor. Essentially you’re told do what you want. You have to come out with something once in a while, but do whatever you want.
RITHOLTZ: Right, every once in a while, educate the kids if you can, but …
IBBOTSON: Also, I actually do love teaching too, so the teaching is really exciting to me and stimulating, so it’s a — it’s a — it’s a great combination. So — so I thought that I’m a workaholic because I’m really not a workaholic, but it’s about the most fun you could have. And even when I talk to my sons, for example, and it’s our — we’re talking about economics all the time and it’s an exciting area that just thinking out next about but about the universe or whatever, you know, talking about all these ideas. So the world of ideas is really fun.
RITHOLTZ: Quite — quite charming. So you mentioned teaching, if a millennial or recent college grad came to you and asked for career advice about the world of finance, what sort of advice would you give them?
IBBOTSON: Well, it starts with follow your passion and follow your interest request (ph). Don’t just try to maximize money here. The — and if they’re — they’re going to be likely successful if they are following their passion, so — so that — that’s definitely what I — I would tell them to do.
Fortunately, finance is a pretty well-paid profession so most people end up doing reasonably well, and to me that’s — I’m glad that happens because I guess it all worked out great for me so.
(LAUGHTER)
RITHOLTZ: And our — and our final question, what is it that you know about the world of investing today that you wish you knew 40 years ago when you were coming out of your MBA program and just getting started?
IBBOTSON: And that question I’m not going to really answer the way you asked it because, in fact, I did know. And the — the whole idea of coming out of understanding what equilibrium is and how prices are formed and how …
RITHOLTZ: Mean reversion
IBBOTSON: … and how — starting with market efficiency and so forth, that really changed my life in how I approach everything and made everything easier.
RITHOLTZ: So — so you were fortunate to figure out at the beginning of your career what a lot of people don’t figure out until towards the end of their career?
IBBOTSON: So it’s not like I don’t — I don’t know what to tell you about what I didn’t know because I actually did know these important concepts.
(LAUGHTER)
And they actually had wonderful — wonderful impact on me.
RITHOLTZ: Well, that’s quite fascinating. Roger Ibbotson, thank you so much for being so generous with your time. We have been speaking with Roger Ibbotson. He is a Professor in the Practice Emeritus of Finance at the Yale School of Management as well as Founder and Chairman of Ibbotson Associates and Chairman and Chief Investment Officer of Zebra Capital Management.
We love your comments, feedback and suggestions. Be sure and write to us at mibpodcast@bloomberg.net. Check out some of the other 248 such previous conversations that we’ve had if you look up an inch or down an inch ono Apple iTunes, Stitcher, Overcast, bloomberg.com, wherever finer podcasts are sold. You could see the rest of all of our previous conversations.
I would be remiss if I did not thank the craft staff that helps put this project together each week. Madena Parwana is my producer/audio engineer. Taylor Riggs is our booker. Atika Valbrun is our project manager. Michael Batnick is our Head of Research.
I have to thank Charlie Palett (ph) this week for giving us his desk and his recording studio because of my SNAFU with daylight savings time in — in the U.K.
I’m Barry Ritholtz. You’ve been listening to Masters in Business on Bloomberg Radio.
