The transcript from this week’s, MiB: Harindra de Silva, Wells Fargo Asset Management, is below.
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RITHOLTZ: My special guest this week is Harin de Silva is a fascinating quant, a pioneer in low vol and factor-based investing, he runs the Analytic Investors Group at Wells Fargo Asset Management. His team runs over $20 billion in an assortment of quantitative strategies and really just a fascinating guy who has spent a lot of time studying factors, studying quantitative investing thinking about what does and doesn’t work and when and why.
I find a lot of quants tend to be a little more singularly focused and he’s a pretty broad-based holistic sort of guy. He’s quite a fascinating background and really interesting set of hobbies and so with no further ado, my conversation with Wells Fargo’s Harin de Silva.
VOICEOVER: This is Masters in Business with Barry Ritholtz on Bloomberg Radio.
RITHOLTZ: My special guest this week is Harin de Silva. He is a leader and portfolio manager at the analytic investors group of Wells Fargo Asset Management. His team runs a variety of quantitative strategies with assets of over $20 billion. Harin is known as a pioneer in both low volatility and factor-based investing. He has won numerous awards including multiple CFA Institute Graham and Dodd awards as well as multiple Bernstein Fabozzi awards from institutional investor, Harindra de Silva, welcome to Bloomberg.
HARINDRA DE SILVA, LEADER AND PORTFOLIO MANAGER, WELLS FARGO ASSET MANAGEMENT ANALYTIC INVESTORS GROUP: Thanks for having me on, Barry. It’s a pleasure r to chat with you.
RITHOLTZ: Yes, I’m looking forward to talking to you because you have such an interesting background and your career has taken so many interesting paths. Tell us about your life a bit. How did you get into the financial services business, how do you go from Sri Lanka to UC Irvine?
DE SILVA: (LAUGHTER) Well, apart from watching that episode of “The Graduate” as a kid where the advice to the guy was “Go West, young man” that was kind of the original inspiration. But I really you know growing up in Sri Lanka, it is traditional for people to go to school or university in the UK, and so I studied as an engineer undergrad and had the misfortune to graduate in 1982 which was the height of the recession.
And you know, at the time I had two choices I could go on to graduate school or I could go back to Sri Lanka and you know, Sri Lanka was in the middle of aCivil War at the time, so the choice was not difficult.
And I made the decision to go to graduate school of the University of Manchester to study finance. And I was interested in finance because I saw a lot of similarities between finance and engineering which was the, you know, the ability to kind of design product, design strategies and idea that you could build something, actually put it to the test really appealed to me. So that’s why I initially went to the University of Manchester to study finance and the study finance for several years and then started working for a consulting firm called Analysis Group.
And I was – by another stroke of good fortune got assigned to a project for Merrill Lynch in the mid-80s, where we were picking manages to going to the Merrill Lynch Consults Program, and there’s a room (inaudible) of that program…
RITHOLTZ: Sure.
DE SILVA: But it was more – that programs and so I was 25 years old and I got to visit something like 300 money managers in person, so you go to a money manager, you listen to their story and you try to capture in a quantitative way what they were doing, and that’s when I first got really kind of interesting in factor investing because I realized that you know you go and talk to for example a bunch of growth managers. And talking to them, you realized that all the ones that were doing well at that particular time were focused on a particular factor.
So not only were they growth focused, they were for example, focused on earning deceleration and those were the guys who were doing well at that time. And then you go talk to value managers for example and you realize well the only ones that are doing really well are the ones who were focused on for example, dividend yields.
And that’s when I realized wow, you know, the sector actually explained a lot and I can I asked the question was obviously were wasn’t related to the project I was working on, is it the manager or is it the factor?
RITHOLTZ: I’m hearing a parallel between what you described in your background with mechanical engineering and the ability to test that in the real world with factor investing and being able to quantify what’s driving returns. Am I reading too much into that or is there some parallel there?
DE SILVA: Well, I think there is a parallel.
I think it’s the same idea of kind of what makes this work, and you know it maybe even a biased view, because as an engineer you think there is always – there is a way, there’s a formula or there’s a way to quantify something.
So obviously throughout the history of that fund, (inaudible) we thinking was the manager….
RITHOLTZ: Right.
DE SILVA: Or the that process as opposed to something they were doing that was focusing on the factor. So I think the engineering aspect really kind of affected the way I looked at the problem.
RITHOLTZ: Very interesting. And some of the factors that you cover include not just the traditional factors, but you spend a lot of time focusing on low volatility. Tell us a little bit why that factor is significant, what are the common elements in the factors that that you find intriguing?
DE SILVA: Well, that factor to me was probably the one that was — I call it the most neglected factor because I was working on my Ph.D. thesis in the early 90’s when Fama and French came out with this paper that basically said if you want to describe what they — what academics kind of call the cross-section of returns, in other words, which stocks go up and which stocks go, that value book-to-market and small cap were very good at explaining it. And the beta did a really poor job, and that high beta stocks had the same return as low beta stocks.
To me, everybody, when they read the paper in ’92 focused on — oh, yeah, the value premium and the small cap premium, and what I found really curious was, well, you can build a portfolio of low beta stocks that’s going to have a way better return risk profile than a portfolio of high beta stocks or beta one portfolio. And I was really fascinated by why, A, no one focused on it and most people didn’t think it was really that interesting.
So, what I call, you know, what’s now referred to in our team as a low vol anomaly is this idea that if you build a portfolio of low beta stocks, you get a much better Sharp ratio and a much better return risk ratio than the market portfolio.
RITHOLTZ: Translate that for the lay listener what are low — what are low beta stocks and how the — what is the significance of the Sharpe ratio.
DE SILVA: Typically, a low beta stock is — what we mean by a low beta stock is a stock that doesn’t move a lot with the market. So, you know …
RITHOLTZ: It’ll move less than the — it’ll go up down less than the market, it’ll go down less than the market.
DE SILVA: Go down less than the market, exactly. And what — if you put them in a portfolio, the — obviously, if you buy a portfolio of low beta stocks, and beta is at point A, they’ll actually move less than the market, so portfolio will go up less than the market and go down less than the market.
But what it also means is that the — because you’re 100 percent invested in equities, you get the equity risk premium, so the long run return of equities with a lot less volatility.
RITHOLTZ: So, on a risk-adjusted basis …
DE SILVA: So, the (inaudible) …
RITHOLTZ: … it’s better than traditional portfolios?
DE SILVA: Right, right. And what Fama — all the work the Fama and French that showed was that low beta stocks have actually the same return over the very long run as high beta stocks or beta one stocks.
And what’s really fascinating is if you look at low beta stocks, we know that when you first tell people, they tell you, oh, yeah, low beta stocks, oh, yeah, that’s just — that’s Amazon. Sorry, that’s — that’s electric utility.
RITHOLTZ: Right.
DE SILVA: And you go, no, no, don’t know, that’s not electric utilities. A low beta stock is a stock that doesn’t move with the market. So early on in its cycle, Amazon was indeed a low beta stock because what was driving it was this idiosyncratic return related to doing business in a very unusual way.
As the company evolve, it became increasingly a beta one stock and now it’s a beta 1.2, 1.3 stock because it’s a very, very large cap company. It’s a very large component of the economy, and it’s no longer a very idiosyncratic return.
So, if you look at our portfolios, very — you’ll find that companies like — that are now high beta, for example, even [Kesler] was actually in a low beta portfolio four years ago.
RITHOLTZ: Wow.
DE SILVA: It’s no longer in a low beta portfolio because it’s mega cap and it moves so much with the market.
RITHOLTZ: (Inaudible).
DE SILVA: But when people think of the low beta portfolios, you know, the other thing you see often in low beta portfolios that you got to be very careful with is biotech companies, right, because the biotech company will often have two or three patents, and it’s going through a process for regulatory approval of the drug, so it’s not really moving the moving the — moving the market at all. So, a stuff like that, very often you see those in low beta portfolios, so it — it really is kind — it’s kind of fascinating to — to — to watch this.
And if you look at sectors, for example, it’s been more of my life studying this anomaly and anything else. But if you look in the 60’s, energy was low beta, nobody really cared about it. It was almost utility, went through that — a lot of crisis in the 70’s it became very high beta because it was — with OPEC it sort of started moving the market.
Through the 70’s and 80’s, oil companies are very high beta. We know when the market was dominated by the Seven Sisters, then it became a low beta. And as we went through this last crisis with energy consumption falling, they became high beta once again. So, it really is sounding a little bit geek like, but it’s fascinating to watch the evolution of companies and industries because it’s not as simple as oh, yeah, low beta stocks but dividend paying utilities.
(COMMERCIAL BREAK)
RITHOLTZ: So, let’s talk a little bit about factor investing. And in general, we’ve seen many factors significantly underperform over the past decade. Why is that? What are your thoughts here?
DE SILVA: Well, when you say factors underperform, you know, you’re saying the return to the factor was not the expected sign. Is that the — is that the thought area? So, for example, you know, value …
RITHOLTZ: Well, you know, the — the granddaddy of underperformance the past decade has been value versus growth, but …
DE SILVA: Right.
RITHOLTZ: … there has been some other factor surprises to the downside, I guess. When — when we had the big blow-up in — in volatility a couple of years ago, that seem to affect some factor performance. And small cap has dramatically lagged for — for quite a while. It’s starting to catch up over the past year, but the past decade was not kind to small caps.
When you look at the world of factors, and I know there are many, many more factors than just, you know, this three or six that most people are familiar with, how do you look at what’s doing well, what’s doing poorly, and — and how do you contextualize that?
DE SILVA: Yes, so I would really look at it from two dimensions. One is does the factor matter, right? So, does the factor describe what’s going on in the market, and what I mean by describe, if you look at the factor, can it tell you whether a group of stocks are either outperforming or underperforming. So, to me, define doesn’t really matter and the first dimension is is this factor meaningful.
So just to pick a — you know, a random factor, you could pick a factor as where the name of the company is in the alphabet, right? That’s a factor. You’ll find that that (inaudible) is actually completely useless in explaining whether a group of stocks went up or down, right, because it was random.
On the other hand, small cap, as you mentioned, is actually really useful in terms of if people are running away from risk, usually small cap companies do really poorly, still running towards risk as they’ve done a little bit in the last three to six months, small cap companies really generally do well. The correlation is one. But generally, regardless of the environment, there is a difference in performance in large cap companies versus small cap companies. And the same versus value, the same in set of quality-related factors.
Now, the expectation that people form on these factors is they look at the long run return, you know, whether it’s (inaudible) Fama-French study or elsewhere, and then they say, wow, you know, this factor, on average, has been positive so I expected to be positive going forward. And that I think is one other misunderstanding with factor investing because, you know, when you — when you place a quantitative bet, the first thing that goes through my head is what’s the hit rate, right? Because when I — when I tell you something is going to outperform, the first thing you need to be doing as an investor is to say, OK, how often is that going to happen.
My conjecture is that even the best practice will outperform six or seven out of — out of 10 times. So, you can think of that in one, so you can think of that …
RITHOLTZ: Meaning it’s going to miss three or four out of 10 times.
DE SILVA: Yeah, so they underperform three to four out of 10 times.
So, you think about coin, if you have a 60 percent chance of winning, you can get a bunch of losses in a row even with a 60 percent chance of winning.
RITHOLTZ: Right.
DE SILVA: So — so the degree of underperformance and the length of period of underperformance can be really, really long. And that I think has not been adequately communicated to people who are investing in their strategies because the other things is faster (inaudible) momentum, and this is only recently coming to the fore where people are talking about it. And this is something I — I …
RITHOLTZ: So, you’re not — let me interrupt you a second, Harin. You’re not talking about momentum itself as a factor, you’re talking about the momentum of other factors impacting that factor.
DE SILVA: Exactly. And I think that is probably one of the most least appreciated things in investing, and it’s something to be really, really aware of.
And I noticed this when I first got into investing because I look at these investment firms and, you know, they were growing like gangmasters because their performance was great. You know, the head of the firm was viewed as a genius. And I’d look at it really closely as a, you know, X engineer and go it’s not (inaudible) genius, but (inaudible) on this once.
And this factor …
RITHOLTZ: Right.
DE SILVA: … with its earnings acceleration of underleveraged companies, one of the fact is that’s being in favor for the last five years. And as long as it’s in favor, they’re going to do really, really well. And then suddenly the factor starts underperforming and the manager says, well, you know, my style is out of favor, but it’s going to come back.
So cynically, you know, if you’re an investor, you know, this right because if — if you’re doing well, you’re a genius, but if you’re doing poorly, your style is out of favor. That’s the euphemism that the management would like …
RITHOLTZ: It’s an asymmetrical bet.
DE SILVA: Yeah, it’s a — it’s an asymmetrical bet.
RITHOLTZ: Right. So, beyond momentum, factors have persistence that …
DE SILVA: Right.
RITHOLTZ: … tends to continue to exist, are some factors more persistent than others? Are we going to really get into wonky geek territory here? But how consistent does persistence apply to different factors? Is it similar or — or — or some factors, do they tend to enjoy that momentum for longer periods than other factors?
DE SILVA: It’s remarkably consistent. I mean, I — in all the work I’ve done, the work, the time and effort I put into modeling each factor individually has not been fruitful.
What I see very consistently is that factors tend to — the factors that I worked in the last year tend to continue to work. The ones that have worked in the last two to three years, they tend to work well, but a little less, so the — the persistence is very strong over one year, less strong over two to three years. And then after three years, you actually start to see some mean reversion.
When you look at manager cycles, you’ll really, really stop seeing that. What I mean by manager cycles is the tendency for certain types of managers to outperform.
And so, I think when you — when you’re thinking about factor investing, it’s really important to actually weigh the factors that have been working well not only recently, but also think about the mean reversion factor, right? So, if you think about, you know, value factors right now, right now is kind of a nice time for value, right, because the last six months have been very strong to the fact that it has momentum, not great momentum because it’s only been strong for three to four months, maybe six months. But the mean reversion aspect of it is actually quite strong.
What’s really fascinating about it is when I first started running money using this factor momentum approach. I was doing it for a U.S. client using U.S. stocks. And it was a client who was based out of Japan, and they came to me and said, “Hey, will this work in Japan?” And, you know, being the typical quant, I said, “Yeah, well let me check,” right? So, I collected all this data on Japan, and I found that the same effect exists to Japanese stocks, that you see the same effect, the momentum. And then, you know, subsequently, we’ve tested it in — in the emerging markets and in Europe. And you see the same [density].
So I think what you’re seeing is really — and you can — depending on which camp you fall into, either it’s the economic cycle or it’s just human behavior, right? So, think about the way our decision-making process tends to work is we tend to like things that we tend to focus something that work recently. So, their recency bias, I think, is there in the way we buy stocks and the way we think of fads coming in and out of favor.
And that’s what’s driving — that’s what something you need to take into account when you’re factor investing because I think the idea that, yeah, value works, small cap works, quality works so you take these, you know, fiber optic factor tools and you’re going to beat the market regardless of what happens, well, that’s going to work if you have a very long horizon. But if those factors out of favor for the last three years, you’re in for a little bit of pain for the next two or three years.
RITHOLTZ: So, Harin, let’s talk a little bit about the idea of managers expressing their philosophy in their portfolio. I — I can’t help, but think that you’re a part low vol, part value sort of quant. Is that a fair description?
DE SILVA: Yeah, I would say it’s part low vol active quant …
RITHOLTZ: Active quant, OK.
DE SILVA: … because I really think — I mean, low vol is an anomaly, but as a manager, you can express a lot more views than just having a low vol view in a portfolio.
RITHOLTZ: I want to talk to you about some of the funds you guys specifically manage, but before I do I have to ask you a question, what is the fundamental law of active management?
DE SILVA: Well, that is actually a formula. And the idea behind the formula is that you can relate your investing success to really three things. So, if you think about investing in U.S. large cap stocks, the first thing that’s going to matter for you in terms of your relative success of investing is how big your universe is, so what we call breadth.
The second is your ability to forecast, which is, as a quant, measured by the correlation between your predictions and what actually happens. And quants call that your information coefficient, how much information you have.
And then the third thing is how effectively you transfer your information into your portfolio. So are you overweight the stocks you like and are you underweight the stocks you don’t like, and that’s what quants refer to as the transfer coefficient.
So, the — the three decisions that — or the three inputs of determining your success is — one is how big the universe, you know, what the breadth of your investment decisions. The second is how well are you forecasting. And the third is how effectively are you transferring all your information into the portfolio to transfer coefficient.
And that’s a formula that is very useful when you think about how much outperformance you can get from a portfolio. And it’s a formula that my colleagues, Steve Thorley and Roger Clarke and I developed in the 90’s, and then published a paper in the 2000-time frame.
RITHOLTZ: That’s where that question came from. So now let’s talk about some of the specific funds that — that you manage over at Wells Fargo, starting with the Global Dividend Opportunity Fund. From the name, I’m going to guess that it is both global and dividend focused. What do we make of the trend of falling dividends, at least here in the U.S. over the past call it a few decades?
DE SILVA: Yeah, I mean, that’s being kind of corporate trend, right, because of the tendency to have buybacks as a methodology for returning money to — to shareholders. So, I mean, it’s a challenge from a — from a dividend focus strategy.
In that particular portfolio, the other thing we do is use covered call, so analytic got its start as a firm in doing covered call strategies. So, we actually use a locally forecasting model to identify all valued call options and then use that to generate additional income for the portfolio.
RITHOLTZ: Interesting.
DE SILVA: So, it’s a little bit unusual, but is a typical …
RITHOLTZ: Yeah.
DE SILVA: … quant approach, and that you’re not just using one way to generate income, you’re using dividends as well as covered calls as a way to generate income for the portfolio.
RITHOLTZ: So — so historically …
DE SILVA: I think …
RITHOLTZ: … covered call writing was always a challenge because you’re balancing the risk of — of a stock that’s working out getting called away versus the — versus the — the income you get from selling the calls.
I’m going to assume, given your background in low vol, that you — you manage to offset that because you’re going to have a — a lower beta group of names there. They’re less likely to get called away when the stock starts to run up or I should say less likely to run up and, therefore, have the stock called away.
DE SILVA: Yeah, so that — I mean, that portfolio is — is team-managed, so it actually uses some of the other skills within Wells Fargo as well. So, we’re not the only manager, so we just manage the option portfolio.
And the reason — the way we avoid the stock getting called away is by using index calls …
RITHOLTZ: Ah.
DE SILVA: … because if you use index calls, all you’re susceptible to is the market run-up, not the individual stocks themselves going up, right?
RITHOLTZ: Right. You still run the risk of having a buy-in to replace the — the — the underlying, right?
DE SILVA: Well, the underlying wouldn’t get called way because you’re selling the calls on their S&P 500 index, for example.
RITHOLTZ: Right.
DE SILVA: So, you would have to be — you’d be on the hook for the payment. But the key with call writing that most people don’t think about is you have to have a way to value the call.
RITHOLTZ: Right.
DE SILVA: So, if volatilities overpriced, you know, as it was at the start of this year, for example, that’s a great time to be selling calls.
RITHOLTZ: Sure. Then you’re getting paid for the risk.
DE SILVA: Your — exactly, you’re getting paid for the risk. But having a call writing strategy where you’re always selling the same call, that is usually not going to be successful. It’s something that is actually constantly looking at, you know, one-month, two-month, three-month horizon and different strikes, and trying to figure out where is the most amount of mispricing coming in the marketplace.
RITHOLTZ: Makes a lot of sense.
DE SILVA: So right now, for example, as we are in — sitting here in — you know, in the end of May, longer-dated call is actually more mispriced than shorter-dated calls. So, you really need to be thinking about increasing the tenor of your call if you’re in the call writing strategy.
RITHOLTZ: Very, very interesting. What about the Low Volatility U.S. Equity Fund, what’s the philosophy behind that?
DE SILVA: So that’s a fairly vanilla fund from — if you think about everything that we do because it’s long U.S. stock. The idea is we have a volatility of about 70 percent of the equity market and — and a similar return.
The fund details is new, but we run that strategy now since the early 2000’s, so it’s — you know, I’m going to show my age because it — I’ve been involved with that type of — for 16 years, and be building a portfolio that has — that has a low beta. So, the average beta for all the stocks in the portfolio is around 0.6., 0.7, But at the same time with tilting towards the characteristics that are in favor. So, if you look at the portfolio right now, you’ll see that it has a very big loading on price-to-sales as a characteristic. That’s a factor that has really, really been rewarded in the marketplace.
Investors that are really focusing on that right now trading earnings is not useful because any trailings — earnings number contains the pandemic, so using forward-looking numbers like forward P.E. price to sales are really, really important.
RITHOLTZ: That’s interesting.
DE SILVA: Asset turnover is a factor that is really important right now as well, so you’ll see a lot of stocks with high asset turnover in that portfolio. So, we tend to look at a very broad range of taxes not just sort of, you know, value growth, quality small cap, but really kind of try to capture the cross-section of factors that fundamental investors look at.
RITHOLTZ: Let’s talk a little bit about where we are in this market cycle today. Do you look at us as sort of late cycle or was last year a reset, and this is a relatively young market or do you not care about any of those things?
DE SILVA: I do care from the perspective of looking at things in a historical context because that’s also kind of a useful guide as we’re trying to figure out which factors to overweight and underweight and, you know, does it makes sense.
And I would say, given the way factors are behaving right now is much more of a really early cycle. There’s a huge focus on — in the U.S. and globally on estimate revisions. So, stocks with high being revised upwards are doing incredibly well, so people are really focused on that as a factor. Small cap is doing well. Low prices sale stocks are doing well. Those are all things that are associated early in the — early in the cycle.
If you look at interest rate sensitivity as a factor, you know, that is something really people are really focused on because there is concern that there’s going to be a rise in rates, and you should think about equities having duration. Most people don’t, but equities do have duration and different equities have different type — different levels of duration, so that’s a major advantage in your portfolio.
RITHOLTZ: So, when you say duration, let me …
DE SILVA: All those …
RITHOLTZ: Harin, let me interrupt you a sec. When you say duration, most people think in terms of fixed income and bonds is having a duration. Hey, this is a 10-year bond, a 20-year bond, a 90-day bond, what have you. What is duration mean when it comes to equity?
I’m assuming there’s some sensitivity to changes in interest rate policy. What — what do you mean by duration?
DE SILVA: So, to me, the duration of a stock is how sensitive a stock is in the 10-year yield. So, if it’s (inaudible), then you’ll see that it was insensitive. You’ll see that it’s not affected by changes in rates.
And, you know, when you look at individual companies, it’s really fascinating you stop — when you look at them carefully from that perspective, you’ll see that some companies, for example, have a lot of floating rate debt. So as rates rise, their interest payments are going to rise. So those companies tend to be more interest rate-sensitive than others.
RITHOLTZ: That’s really, that’s really interesting. So much has happened since you started in the industry to today. What do you think are the biggest differences in asset management relative to 25 years ago or so?
DE SILVA: Well, there’s been a lot of good developments. I think, you know, on the positive side, fees have come down. The trading costs have come down, so your ability to create a portfolio more, you know, to have higher turnover to capture factorization, that’s become a lot easier.
The cost of data have come down, but at the same time, the amount of data available for purchase has gone up. So, if you look at us as a group, as a team, you know, our data cost is millions, but it seems to always go up not come down.
RITHOLTZ: What — what are your thoughts on some of these alternative data sources? I know people are buying the satellite data where you can see movement of tankers and — and ships that are — I’ve — I’ve even seen some people say we could tell how loaded the ship is by how low it sits in the water relative to its water line. Do — do you have any thoughts on these alternative data sources?
DE SILVA: Yeah, I think those — that type of data is really useful in terms of updating your earnings estimate forecast because that’s ultimately what it comes down to. The challenge with that data is that it’s really, really time sensitive. So, when I think of data quality, I’m always trying to think about what horizon do I need to invest with to actually use that.
Now that’s really useful for me in the short run trading model, but that’s not the sweet spot for — from a side because we can’t turn those portfolios over enough to capture that. So, I — I prefer data, for example, that looks at, you know, just to pick up example of something I’m looking on now is what’s the carbon footprint of a company and how can it be measured, right, because we know what the cost of emitting carbon is going to go up in the future. That’s going to be a big factor in the profitability of companies and their behavior, and they need to invest in terms of new plant and equipment. So what data can we use to capture that?
That’s kind of a more of an intermediate long horizon factor, and the more data I can collect on that dimension the better off I am. But it doesn’t rely on me getting to some information quicker than somebody else and the information kind of dying at the next earnings announcement.
RITHOLTZ: That’s really …
DE SILVA: Does that make sense, Barry?
RITHOLTZ: You know, that makes a lot of sense. In fact, since you mentioned low carb and I’m going to jump ahead to another question, what are your thoughts on ESG, on environmental, social and corporate governance as potential factors?
I’ve — I’ve heard people describe them as risk screens. What do you think of ESG?
DE SILVA: I think they’re really important as risk screens. I think if you — what we found is that if you use ESG-related factors, they’re actually incredibly important in describing the future return volatility of a stock.
The thing that’s most important is governance, and you’ll find that companies with poor governance, the returns are very, very fat-tailed. And as a portfolio manager, you need to account for that because most risk models miss that, right.
A poorly-governed company has a significant chance of a really negative return, but it doesn’t happen very often, it will happen once every 15 years, once every 30 years. So, in a typical risk model, it actually doesn’t show up. But it does show up if we look at, you know, long time series of data. And we — I find those ESG factors are really, really important in risk forecasting.
They’re not useful in return forecasting because I think you can make the case that people like these stocks or dislike the stocks for other reasons, you know, just like you have people like sin — some people like sin stocks, right? That’s why there’s a sin stock ETF. So, I think the return aspect for me is less important than the volatility aspect.
RITHOLTZ: Huh, that’s really interesting. It’s — it’s sort of the Charlie Munger approach, which is don’t be more smart, be less stupid. In other words — and I love how he phrases it, but you’re — you’re looking to screen out potential disasters with ESG rather than screen in additional alpha.
DE SILVA: Right, that’s — to me, that’s exactly the way we think about it because these companies have something in their behavior where there’s going to be a chance that they have a bad outcome in the next 20 years …
RITHOLTZ: Right.
DE SILVA: … right? But if you have a portfolio of wholly-governed companies and suppose you have 100 stocks in them, there’s a significant chance that one of them is going to have a bad outcome next year. So that, to me …
RITHOLTZ: (Inaudible) …
DE SILVA: … is a really key dimension in — in using ESG in — in a portfolio because most people think — don’t think about it that way. But I found that with ESG factors and increasingly with the environmental factors like carbon or water pollution or, you know, even something as like plastics — a company’s plastic emissions, is there a way to measure that, and quantify, and incorporate in the portfolio because that’s increasingly going to be something that investors care about and something that the company will have to care about in the way people assess their future profitability?
RITHOLTZ: Huh, that’s really — that’s really kind of — kind of intriguing. So — so here we are, the economy is just starting to re-open, people are more concerned with inflation, and they are with unemployment it seems. What factors do you see really taking advantage of — of the post COVID reopening? Anything stand out, in particular? And what do you think is the wrong factor for this phase of the recovery?
DE SILVA: Well, I would stay away from anything that users’ recent accounting data. So just to — just to give you something tangible, you know, people focus some things like ROE and ROA, right, return on equity, return on assets.
RITHOLTZ: Right.
DE SILVA: Those numbers are really have been affected by the company’s performance in COVID, so that’s — those are factors I would focus on.
RITHOLTZ: Right.
DE SILVA: I mentioned trailing earnings yield as a factor you should not look at. So the — anything that uses trailing accounting data, you got to stay away from. But if you want to look at the valuation, which I think there’s a lot of valuation factors that are — you should be looking at, looking at the ratio of price to sales is a really excellent factor right now given where we are in the cycle.
Staying away from companies with a lot of debt, specially debt that is floating rate as supposed to fixed rate is something that’s — that you should be looking at. Doing going towards companies that have high operating margins in terms of their business model, that’s a little bit difficult to do because of the accounting data problem for the last year. That’s something that you should be incorporating into your portfolio.
And the other thing that I would really emphasize in the current cycle because of the change we are seeing in the way companies do business is staying away from companies where there’s a lot of disagreement about their future earnings. So, one thing people don’t pay enough attention to is looking at analyst dispersion.
So, if you look at an earnings forecast, everybody looks at the mean. What you should also look at is look at the difference between the high and the low or the spread between (inaudible) because whenever there’s a big spread, that means there’s a lot of disagreement as to the future profitability of the company. And that factor is something that’s going to be really important in this stage of the cycle.
RITHOLTZ: Really interesting. I — I have one curveball question to — to throw at you. What sort of motorcycle do you like to ride?
DE SILVA: Oh, my goodness, how much time do you have?
RITHOLTZ: Well, I — I did read that you have bikes pretty much all over the world. How much of an exaggeration is that?
DE SILVA: No, that — that is true. I mean, motorcycles [readily] speaking are cheap. And one of my hobbies is exploring the world on a motorcycle, so I like to keep bikes at different parts of the world. I can — you know, I can show up, I leave my clothes on the bike and we can hop on and ride.
But my — my daily rider because I ride to work is an electric Harley-Davidson, which is actually a wonderful bike. It’s called Harley Davidson LiveWire. It’s quiet, it’s fast. And when I leave early morning for work I don’t disturb my neighbors. And we have solar panels at home, so it doesn’t cost me anything to run.
My favorite bike to ride on the weekends is have an obscure Italian bike called the Bimota V Due, which is a two-stroke, very light sport bike. And then my favorite bike for touring is, you know, the BMWs because you can get them serviced anywhere in the world, and it’s almost like a train. They almost never break down.
RITHOLTZ: Right. They’re big, they’re solid, they’re comfortable, and they could go on and on and on.
Do you find — I asked this question as a kid who used to ride dirt bikes and — and some of the smaller 150’s. Do you find like traffic is so heavy these days and people are just not paying attention? It’s a little more challenging to — to be on a motorcycle.
DE SILVA: There is considerably more distracted driving in — in Southern California. Actually, in California, it’s legal to filter or split lanes. So, when you’re driving down the middle of lanes, what you’ll often see is, you know, the person next to you in driving a car has their phone in their lap, and I don’t know why there’s this tendency. If you’re — if you’re texting, you always put the phone in your lap and then you look down away from where you’re driving and you text.
RITHOLTZ: Right.
DE SILVA: And I see that probably, you know, 20 percent of the time in the — in the morning. So that is …
RITHOLTZ: Wow.
DE SILVA: … it is a hazard that one has to deal with. And it does make it — so that we — usually when I get to work in the morning, I’m — I’m really awake because my adrenaline is — is flowing.
RITHOLTZ: To say — to say the very least. And you have a — a trip planned later for parts of Asia. Where — where are you heading to this year?
DE SILVA: Well, this is actually a continuation of a trip that was — got canceled last year because of COVID. So last year I left the motorcycle I was driving in Riga in Latvia. And I’m riding this year — the plan is to ride from Riga to St. Petersburg to Moscow, and then …
RITHOLTZ: Right.
DE SILVA: … next year to ride from Moscow all the way to the east coast of Russia to Vladivostok, which is right next to Tokyo.
RITHOLTZ: Right. I’ve never been to Moscow, but Saint Petersburg is an amazing city and you can spend weeks there. It’s just an unbelievable amount of — of things to see and do.
DE SILVA: Yeah, I’m really looking forward to that. I’ve heard lots of wonderful things about that city.
RITHOLTZ: All right. So, I know I only have you for a couple more minutes. Let’s jump to our favorite questions that we ask all of our guests s starting with what are you streaming these days. Give us some of your favorite Netflix, Amazon Prime, podcast entertainment.
DE SILVA: So, I’m — I’m going to be a disappointment on that dimension because I don’t think I watch Netflix in over a year.
RITHOLTZ: Wow.
DE SILVA: So, I’m — I’m not — I didn’t grow up with television in Sri Lanka or screens, so I’m — I almost never watch them.
RITHOLTZ: Wow, all right. And listen, I would be more productive if I wasn’t …
DE SILVA: Big — big — big reader.
RITHOLTZ: … if I wasn’t watching Netflix.
DE SILVA: I’m a big — I’m a big reader. I mean, I — I read more — more than anybody else I know, so I’m probably — got the world’s biggest Amazon books bill.
RITHOLTZ: So — so let me — let me jump to that question then, tell us about some of your favorite books. What have some of your all-time favorites and what are you reading now?
DE SILVA: Well, what I’m reading now, there’s two books that I’m really enjoying. One is called “The Well-Gardened Mind.” It’s a book on how gardening and nature affects the way we think. And this book, I think, during investor day is really fascinating because it — it talks about how your exposure to nature affects your decision-making.
So, if we take two people, for example, or two groups of students and they’re about to take the exam, one of them works through an urban environment, other group works in arboretum so they’re exposed to nature. The one that works in arboretum will have 20 percent high test scores. And that’s because of something that’s called attention restoration because we are all so focused in such a short time period now that after a while we’ll get attention fatigue. So, you have to figure out a way to restore that. And if you are involved in trading or building portfolios, this is something that’s really, really critical.
So, this book is — is a really fascinating book from — from that standpoint because I think, especially in the COVID environment, we all are working longer hours and you have to figure out a way to restore your attention during the day. And that’s kind of one of the big things I got out of this book.
The other book I’m reading is I’m a — I’m a total Formula One fanatic. I’m reading this book by one of my favorite designers Adrian Newey. And he wrote a book last year called “How to Build a Car.”
And Adrian Newey, I think, is one of the — he’s the designer for Red Bull if you didn’t know, but he’s one of the best car designers ever to go through Formula One. And the book goes through his design philosophy and how his philosophy evolved over time and all the different cars that he design, but also the fact he describes his career. And, you know, you — if — most people don’t realize it, but Adrian was, you know, one of the key partners at Williams, which is now one of the worst Formula One teams.
And he was in disagreement with the owners of the company that left him (inaudible) leaving. So, if not for that disagreement, Williams would probably be the — continued to be the number one team in — in Formula One. So, it kind of highlights to me one of the importance of realizing that teams are really important to business. And if you let key team members go, that’s going to have a big impact on your business. So, there is a really strong tie to how to build an effective team in a very high-performance environment in this book.
RITHOLTZ: Give us another.
DE SILVA: The last one, the more — other book I read more recently, which is a little more academic is “Noise.”
RITHOLTZ: Sure.
DE SILVA: Yeah. And I’m — I think you’ve talked about that. I think I’ve seen that in your podcast.
The other one that I really liked that I read recently was actually by one of the people who was one of the founders of analytic or involved in its founding, which is a book called “A Man for All Markets.”
RITHOLTZ: Sure.
DE SILVA: And I think it’s a book that anybody going into quantitative finance should read by Ed Thorp who’s definitely one of the smartest guys I’ve ever met. And so, that I really, really enjoyed reading. So, I — you know, pretty, pretty wide array, but I’m really fascinated by this interaction between how — what — what we are faced with affects our decision-making.
And another book I read recently that I really liked was called “The Nature of Fear” about survival lessons from the wild as how we — what happens to us when we are fearful. Because if you think about investors, you know, one of the issues that’s happened is with 401(k) is — and people having to manage their own portfolios is I don’t think people realize how their environment affects their decision-making. And that’s why it’s really important to feel kind of an average investor investing — you know, having exposure in 401(k).
Not to make decisions very often, you know, generally they say look at it once a year, but also realize what type of mood you’re in when you’re making the decision. And I think that’s really underappreciated to make sure that you’re not in a fearful state or what can cause you to be in a fearful state when you look at that. So, you know, do — do simple things like download your statement, look at it, you know, wait a month then make the decision, but don’t be in a hurry and allow yourself time to think about the decision you’re going to make, get input on the decision.
But, you know, if I can think about the theme is this broader theme of thinking about how the — your state of mind affects your decision and how can you manage your state of mind.
RITHOLTZ: Really interesting. Tell us about any mentors you might have had. Who — who helped guide your career?
DE SILVA: I was pretty lucky, I think, when I went to the University of Rochester, so there was a gentleman by the name of Paul McAvoy who was the Dean of the Business School. And I was making a living, at the time, you know, in addition to going to school programming, and he hired me as a programmer for some research projects. And Paul was a very well-known economist. He was on the President’s Council of Economic Advisors.
So, working with him I really learned this kind of — think about how to solve problems, but also think about applying economics in a much broader context than [my group] policy or interest rate policy and thinking about, you know, the whole Keynesian world of animal spirits and how they affect markets. So that was — he was probably, I think, one of the most instrumental people to me.
And then also Sheen Kassouf who was the founder of Analytic. He was the head of the Econ Department at the University of California at Irvine. He’s very fortunate to work with them.
And then also I would say the gentleman who was my Ph.D. advisor and also kind of a well-known figure in — in finance, Professor Robert Haugen who wrote a book called “The Inefficient [Market Hypothesis]” and “The Incredible January Effect.” So very, very colorful character, but somebody who was always willing to question markets and do unusual things to build portfolios in terms of using, at the time, large scale optimizes and building large-scale factor models in a world where everybody — you know, back in the 80’s we were convinced that markets were perfectly efficient, and now we know that’s not the case.
RITHOLTZ: To say the very least. What sort of advice would you give to a recent college grad who was interested in a career in either factor investing or quantitative finance?
DE SILVA: I think the hardest thing in starting in the business right now is figuring out whether you’re actually interested in investing or you’re interested in what you think is investing because investing is really about doing research to figure out what’s going on in the market and then figuring out a way to exploit that for the benefit of your clients, right? It’s not about frequent trading or moving faster than somebody else.
And what I find when I talk to younger people is they’re really focused on trying to get an edge by getting this short run informational advantage. And that’s not — that’s not sustainable, and you also can use that to invest institutional money because people tend to have longer horizons. So, my piece of advice to them is understand what type of investing you’re interested in and whether you like doing that type of research, because the hardest thing about doing research is, 80 percent of the time, it’s a dead end.
So, if you don’t enjoy the journey, it can be really frustrating, right? I mean, think about — think about it this way, it felt like being a chef, but 80 percent of the dishes you make taste absolutely horrible.
RITHOLTZ: Four — four out of five gets sent back to the kitchen, huh, really, really interesting.
DE SILVA: Exactly.
RITHOLTZ: And …
DE SILVA: Yeah. So, if it’s …
RITHOLTZ: … our final question, what do you know about the world of research and portfolio management today that you wish you knew back in the 90’s when you were really first getting started?
DE SILVA: Without a doubt, Barry, for me, it would be the impact of human emotions and sentiment on markets. I think I — the time I did not appreciate how much that mattered, and now I see that it — it matters a great degree. And I think something I work very hard at is trying away — to build a way to quantify that. But I didn’t have an appreciation for how much emotion and people’s attitude and sentiment matters in the way assets are priced. And I think that is not taught enough in schools.
RITHOLTZ: Huh, really quite, quite interesting. Thank you, Harin, for being so generous with your time. We have been speaking with Harindra de Silva. He is the leader of Wells Fargo’s Quantitative Strategy Group, known as Analytic Investors. They manage over $20 billion in assets.
If you enjoy this conversation, well, be sure to check out all of our previous interviews. There are nearly 400 of them and you can find them at iTunes or Spotify or any of your favorite podcast sites.
We love your comments, feedback and suggestions. Write to us at mibpodcast@bloomberg.net. You can sign up for my daily at ritholtz.com. Checkout my weekly column on bloomberg.com/opinion. Follow me on Twitter @ritholtz.
I would be remiss if I did not thank the crack staff that helps put these conversations together each week. Atika Valbrun is our Project Manager. [Tim Harrow] is my Audio Engineer. Michael Boyle is my Producer. Michael Batnick is my Head of Research.
I’m Barry Ritholtz. You’re listening to Masters in Business on Bloomberg Radio.
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