Robert Leonard (00:02:42):
We’re going to jump around a bit throughout this episode and talk about a lot of different topics related to investing and personal finance. We’re going to talk about everything from day trading to retiring early to market crashes, Dave Ramsey, IPOs and everything in between. But let’s start with day trading. It’s something that a lot of millennials are interested in. What is it and why does it draw so much attention, especially from young and new investors?

Ben Felix (00:03:08):
I don’t know if there’s an academic definition of day trading. In one paper, I read they referred to it as a buying and selling the same financial asset on the same day. But I think we can probably generalize and just call it short-term trading. I know when I posted a video on this topic and use that definition, buying and selling the same financial assets on the same day, a lot of people in the comments were asking, ” Well, what about if I’m holding it for a week as if that makes it materially different?” I think short-term trading is short-term trading, so when we talked about the data on day trading, more generally, I think it applies to any short-term trading. So if you’re buying a stock, holding it for a few days or even a week and then selling it and buying something else, I would generalize that as a day trading.

Robert Leonard (00:03:51):
Why does it draw so much attention?

Ben Felix (00:03:53):
I could speculate, but instead of doing that, I’ll give some of the reasons. One of the papers in the academic literature, it’s a paper called Learning Fast and Slow by some of the big names in behavioral finance published in the review of asset pricing studies. So they looked at three possible reasons why people are drawn to this. One of them, which is pretty interesting to think about is that day traders might not have the type of risk averse preferences that a standard rational economic model would predict. So they actually prefer investments with lottery like payoffs. So it’s called a skewed outcome. Small chance at a really good outcome with a large chance of a somewhat bad outcome. So day traders, they must have that preference in order to day trade, because that’s the outcome that you get. With day trading, you get a skewed outcome, a lottery like outcome.

Ben Felix (00:04:41):
Now, interestingly, in this paper, the authors actually suggest that if that’s the outcome day trader you’re looking for instead of buying and selling assets, they could just buy individual stocks and hold them because you get a highly skewed outcome by holding on individual stock. And you save on all the transaction costs which are going to come up as we continue to talk through this. Another big one and I think when you look at places like Wall Street bets, which is always fun to read. I think this is probably the one that is quite relevant, where day traders are overconfident and they have to be. And I think a lot of that comes from, and this is from this paper, their suggestion, but it comes from positive stories of day traders circulating in non-representative proportions. I mean, it’s a fancy way of saying, “You only hear about the good outcomes,” which isn’t always true on Wall street bets. You see a lot of the bad outcomes too, but I think people are drawn to the good outcomes.

Ben Felix (00:05:33):
I think I remember reading about someone going from $460 to a million dollars using Tesla call options. And that’s thrilling. I love to do that too, but we’ll talk more about the data around day trading in a sec. And I think the last one, which is also relevant to things like Wall Street bets and other trading communities is day traders, may trade for non-financial reasons. So you get, there’s an element of entertainment, there’s an element of gambling, there’s an element of impressing other people. Which again, with all the loss and gain posts we see on Wall Street bets, I think it seems pretty realistic as a motivation.

Ben Felix (00:06:10):
And in that case, it’s interesting because even if people are losing money and again, this makes me think of Wall Street bets. Even if you are losing money trading, it’s the cost of admission to doing an activity that you enjoy. So to summarize those points, I think day traders have non-standard risk preferences. They prefer those skewed outcomes. They’re probably overconfident, and that probably happens because of the way that information circulates. And there’s a good chance they’re trading for non-financial reasons altogether.

Robert Leonard (00:06:39):
We so often only see the positive trades or when people are doing well. I have a friend who dips his toe in day trading, and he only sends me the trades that he does really well on. And I’m like, “Yes, that’s an amazing trade. Bravo.” I clapped my hands for him and I say but, “You haven’t sent me one in probably 10 days. What happened in those other 10 days? I know you’ve been trading. So what happened? Why didn’t you send me any of those?” So clearly he’s only sharing the ones that are positive and you see this all over the web or social media everywhere. That’s all you hear about is the good ones. You don’t necessarily hear about all the bad ones.

Ben Felix (00:07:10):
And I think where it’s even worse and it’s definitely exacerbates the problem and draws people into trying to day trade, is that all of these people selling online courses. If I ever go and look at one of my old YouTube videos before I can watch it, I always have to watch the ad, and the ad is almost always someone selling a course on day trading, talking about how much money they’re making and all this kind of stuff. And a lot of cases, those are just going to be outright lies, but people don’t necessarily know that. And so you get drawn into this concept. So I think even if it’s cases where people aren’t showing their actual good outcomes, there’s a lot of cases where people are just saying, “Look at the outcome. You can get if you buy my course.”

Robert Leonard (00:07:47):
And it’s like, if you just take a step back and think rationally, right? Logically you say, “Okay, well, if I did this while on a trade, or if that person did that while on a trade,” and they can do that consistently. They could start with a $1000, and then with, I forget the exact statistic, but within a couple of years, they’ll have $84 trillion. It’s just something ridiculous. It’s like, “Clearly this is not something sustainable.” You got to temper back those expectations.

Ben Felix (00:08:11):
Yeah. I know you want to talk about Renaissance Technologies later too. And they’re this perfect example of that, where they’ve actually closed their fund to new investors for many years. And it’s a secret. Nobody really knows what they’re doing. They’re the ultimate short-term trading success story, but they won’t take your money. They don’t even keep their own profits in the fund. They distribute them to the investors every year, and nobody knows what they’re doing. So the idea that somebody who’s as good as Renaissance Technologies or even close to that level is going to tell you what they’re doing, is a bit ridiculous.

Robert Leonard (00:08:41):
If somebody was making so much money from day trading, they wouldn’t need to sell the course, right? Ultimately, I think if you were to look at somebody’s financial statement, I bet they make more money from selling the courses than they’re actually day trading. And I think that for me is a misalignment of incentives and not necessarily the right person I want to be learning from.

Ben Felix (00:08:58):
Absolutely. Sometimes I’ll click on the Twitter Ads or the YouTube ads to see what the people are pitching in. And in a lot of cases, they actually address that. They’ll say, “If I’m so successful, why am I sharing this with you?” And then they always have some ridiculous reason. But you think about it, that they would be the logical thought process for a lot of people to say what you just said. But these people selling the courses, they’re addressing that in the pitch, “Well, here’s why I’m telling you this, even though I don’t need any more money.” It’s hard for people to see that without all the data and know that it’s ridiculous.

Robert Leonard (00:09:25):
And I’m speaking this a little bit from experience because that’s how I actually first got started in investing was, I saw a guy, a guru, who was supposedly teaching a course that was going to teach you how to get rich quick. They trading penny stocks. And I was 14, 15 at the time. I didn’t know anything about investing. Of course, that sucked me in. Thank God I quickly realized I was like, “All right, this isn’t really possible.” And I didn’t spend any money. I didn’t lose any money. Thankfully. And I found Warren Buffet and the rest is history from there. But I’m speaking about this because it happened to me and I still see it all over the place nowadays. So we’re talking a bit about some of the downfalls, but what do you see as the downfalls of day trading? Why doesn’t it necessarily work?

Ben Felix (00:10:03):
I think if we take a big step back from day trading and think about investing more generally, there’s some pretty strong evidence that the market is at least efficient enough that investors should probably approach it as if it is efficient when they’re making investment decisions. Now, an efficient market is a theoretical state. It’s a model where the market fully reflects all available information in prices. So at any point in time, if you look at the price of a stock, that price reflects all available information about that company. Now, that’s a really, really important concept in finance. And I’m not saying the market is perfectly efficient. It’s a model, it’s not designed to be reality. If markets were perfectly efficient, it wouldn’t be a model. So if the market is efficient, if prices do reflect information at a point in time, then future price changes are going to happen based on new information.

Ben Felix (00:10:52):
And new information is basically by definition impossible to predict consistently. Nobody can predict the future, and if you can’t predict the future, then price changes are going to be random. Now, that’s important because if information is not in prices, if you have information about a stock that is not currently reflected in prices, then you shouldn’t be able to make a profit without taking on a whole lot of risk. That’s an arbitrage. Those arbitrage opportunities don’t tend to exist very often in real markets. One of the ways that we know that is through the study of professional money managers. So a mutual fund manager, for example, their job is to take investors’ money and pick the right stocks at the right time and time the market, in an effort to perform better than the market as a whole, to beat a benchmark index. Now, the data on their ability to do that is really poor.

Ben Felix (00:11:43):
It’s pretty conclusive that at least on average, active managers don’t beat the market. And there’s other evidence of market efficiency too like events studies that when something happens, the information tends to get reflected really quickly in prices. But if we just think about that more general statement, that the market is efficient and that active managers tend to not beat the market. The same thinking applies to day traders. So in an efficient market, a day trader shouldn’t be able to consistently generate excess profits. Now, that’s been studied as well specific to day traders. So there’s a couple of papers, they’re a bit older, and I’m going to address the fact that they’re older in a second. But there’s a 2000 paper in the journal of finance titled, Trading is Hazardous to Your Wealth. And this is a paper where they looked at 66,000 US households with accounts at a discount broker between 1991 and 1996.

Ben Felix (00:12:34):
And it was really interesting concept in the paper. They were actually testing two competing theories of individual trading activity. So one theory is that investors will trade when the marginal benefit of trading exceeds the marginal cost. In other words, they’ll trade when they’re going to make a profit. And then the other theory is, investors are overconfident and trade to their own detriment. Which is effectively saying that the market’s efficient, but individual investors are still going to trade thinking that they can profit even if the data show that they can’t. So in the paper, they find that investors tend to underperform the market on average just like active fund managers. They found that the average household earns a return close to the market before costs or trails the market by about 1.1% per year after costs. So in other words, they trade to their own detriment.

Ben Felix (00:13:20):
They’re not only trading when the marginal benefit of doing so exceeds the marginal cost. And if you think about that logically, all of the day traders, 66,000 households on average, they’re going to hold something like the market. And unless they’re making really smart trades, they’re going to underperform by costs, basic mathematics. And then the another interesting point of the paper is that, they found that individual investors in this sample, they were actually holding more small cap and value stocks than the market. So when you adjust for that in assessing their performance, they actually trailed that risk adjusted benchmark by 3.7% annually as opposed to the 1.1% after costs relative to the market. And then they also found that the 20% of households in that sample that traded the most often earned returns that trailed the market by 5.5% and trailed the risk appropriate benchmark by 10.3%.

Ben Felix (00:14:12):
So we see the sample of day traders really struggling, and that was a US sample. Funny of day trading is also interesting just because of the data availability is not always there, researchers have to find a data set that a discount brokerage is willing to give them in order to study it. So there’s that one from the US, I don’t know if there are any other ones that study US day traders. And then there are a few from Taiwan. So I had touched on one of those quickly, and it seems like the Taiwan stock exchange was just willing to give this group of researchers the data to study. So this looks at day traders from 1995 to 1999 in Taiwan, which is the world’s 12th largest stock market, or it was at that time. And in this case, they found that the people who engage in day trading, and I think this is where that definition of buying and selling the same asset on the same day came from this paper.

Ben Felix (00:14:59):
So they found that the individuals engaged in day trading reduced the aggregate portfolio for all individual investors by 3.8% per year. Obviously that’s a little bit painful. And the other interesting thing about this study is that, because they had the data for all market participants in Taiwan, so they had the individual day traders, but they also had institutions. And one of the things that they were able to see is that, while the individuals have market timing losses when they’re trying to make their day trades trading on market timing losses, institutions, so the big institutional investors like whatever it may be, mutual funds and insurance companies and all that kind of stuff, they tend to profit from those same trades. And there’s a great quote where they said that the institutional profits associated with passive trades are realized quickly, as institutions provide liquidity to aggressive but apparently uninformed investors.

Ben Felix (00:15:54):
And that’s one of the things that if you’re day trading, you have to think about is, “Who is it that you’re trading against?” It’s probably not another day trader. It’s probably not another Robinhood user, it’s probably an institution. Now, I mentioned costs as reducing the aggregate portfolio return of day traders, which is again, just mathematics. When I posted a video on this, a lot of the comments focused on these studies being old and the world looking very different today. I think this is important to address. So what is different today? Information is more available, absolutely. I mean, those studies were from the late ’90s. Information is more available and trading looks free and it’s not, but I want to touch on that in a second. So on the first point, that information is more available. I think today is actually worse for day traders because of that. Information is not more available to day traders and less available to institutions, it’s more available to everybody.

Ben Felix (00:16:50):
And there’s evidence from a 2014 paper titled, Scale and Skill in Active Management, that active managers have actually gotten meaningfully more skilled over time. That’s not translating to out performance in actively managed funds because the active management industry is also getting bigger. So now we have these increasingly skilled managers, but they’re competing for alpha for excess risk adjusted profits with each other. So everyone’s getting more skilled, which means that there’s no opportunity to profit because you’re not trading against someone who’s less skilled. You’re trading against competition that’s increasingly skilled. And they found that this scale increase is mainly driven by fund managers who are better educated. And actually this is their finding, this is their suggestion, the access scale, or the additional skills coming from fund managers who are better educated and better acquainted with new technology.

Ben Felix (00:17:40):
So that backs up what I was saying a second ago, that if you’re a day trader and you have a good interface and quick access to information, so do the fund managers. And realistically, they probably have better access to information than you do. So I think the argument that access to information makes it day trading easier is actually the opposite. I think it makes day trading harder because everybody has access to more information. And then the trading costs on this one is fascinating, and this is actually a fine that the SEC just issued. I think yesterday is when I first saw it. So they just fined Robinhood $65 million for misleading their customers on the concept of no trading fees from 2015 to 2018. They found that in most cases, Robinhood customers would have been better off actually paying trading commissions at a different brokerage because of the way that Robinhood was executing the trades.

Ben Felix (00:18:35):
So that’s interesting. Because if you’re robbing at a customer and it feels like you’re placing free trades, at least from 2015 to 2018, and maybe they’ve changed something, I’m not sure. But the way that they were executing the orders resulted in costs that were in many cases equivalent to, and in a lot of cases, they found for larger orders of over 2000 shares, their customers were effectively paying $23 per order. So more than you would have been paying, if you just been paying a commission. So this idea that trading costs have gone down, I don’t know how true that is. I think they’d been repackaged with the idea that you can look at the previous studies and say, “Well, those are no longer relevant because trading costs are zero. I don’t think it’s a valid argument.”

Robert Leonard (00:19:16):
What exactly what was Robinhood doing to somewhat mask those costs?

Ben Felix (00:19:20):
So I’m not a Robinhood expert, but they wrote the orders through high-frequency trading firms, they sell the order flow to other firms. And the way that the trades end up getting executed in the case of Robinhood, is not as good as it would have been with another broker. So it’s something called price improvement and what the SEC fine was based on is that the price improvement on the trades through Robinhood is not as good as it would have been through a different platform, through another discount broker that was maybe charging a commission to execute the trades. So it’s basically the way that the orders are being fulfilled. So you’re not paying a commission, but you’re not getting execution that is based on, that’s fine from the SEC, that is as good as it would have been dealing with a different discount broker.

Robert Leonard (00:20:02):
Do you think we’re seeing similar types of things happen with other brokerages now that they’ve gone to zero trading commissions?

Ben Felix (00:20:09):
It’s tough to say, but I think that there’s a cost to doing business, I guess generally. And when something is free or it looks free or sold as free in a lot of cases, it isn’t free. And it’s what I mentioned a second ago that in a lot of cases, when we think costs have gone away or being told something is free. Their costs have in many cases just been repackaged or as… I can’t remember who I heard say this but, “If you’re not paying for the service, then you are the product.” Which is what we hear about social media and stuff like that.

Ben Felix (00:20:37):
But the same thing can be said about Robinhood, where you’re not paying for the service, you’re getting this free order execution. But they’re selling your order execution, and that’s how they’re making their profits. Therefore, you are the product. So I don’t know if other brokerages are going to or are doing better execution, and I don’t know if a fine like this for Robinhood would change a fair or not. But I think anything that’s free, and I think we’re learning this as a society. Anything that is sold to us as free in many cases, just as costs that are packaged different way.

Robert Leonard (00:21:06):
When I heard this news story break, what I found fascinating about it is, Robinhood essentially changed the brokerage industry. And they were essentially at the forefront of zero trade commissions, or at least marketed it that way as we just discussed. And I would argue that they pushed major brokerages to be forced to go to zero trade commissions. And what’s interesting is, Robinhood was touting zero trade commissions, made all the other brokerages change their business model to go to zero trade commissions. And they weren’t really offering zero trade commissions and they were actually weren’t doing anything beneficial for investors. So I just find that really interesting is that they totally changed the model for everybody, yet they weren’t even doing it themselves.

Ben Felix (00:21:45):
It is interesting, and brokerages will find different ways to make money. They always do, and that’s not a negative comment at all. It’s just a comment about innovation. I mean, we can think back to even way before my time working in the financial services industry, there was a time where our financial services professional, their value was giving people access to mutual funds. There was a time where that was a value add, and then that changes substantially. And over time, financial services has progressed to a point where you can do your own trading extremely easily and for a pretty low cost. I mean, even if we think about a brokerage that is charging a low commission, that’s still a lot more cost-effective than it may be once was. And I think that there’s… Some people are talking about what the next evolution might be.

Ben Felix (00:22:27):
You might hear a lot of people talking about direct indexing, where are you going to be able to build your own custom index portfolio and the brokerage guru will execute it for you. But that’s going to come at a fee. I mean, with the growth of ETFs, the securities lending revenues become meaningful. So there are all different ways that financial institutions can make money and do make money, and they’re always evolving. And at the end of the day, if they’re adding value to customers like the direct indexing idea, then people will pay for it. And the brokerages will be able to continue to make money. But that also stems from trading costs going to basically zero. And I guess this is just, again, the comment about innovation, direct indexing becomes possible…

Ben Felix (00:23:03):
Just again, the comment about innovation, direct indexing becomes possible when that happens. So in a lot of ways, you’re right, Robinhood did push forward innovation in financial services, even if it was on a false pretense.

Robert Leonard (00:23:12):
Another common strategy or tactic that a lot of new investors and they’re often millennials like to try and implement is investing work day trading sometimes with leverage. And that’s mostly done with options, that’s the most popular way I see is with the options. What does it mean to invest with leverage? How can it be beneficial and how can it be dangerous?

Ben Felix (00:23:34):
So when you’re investing with leverage, it basically means you’re getting more exposure to an underlying asset than the amount of money that you’re investing in it. So if you put $10 toward the asset, you might be getting $20 to $30 worth of exposure to that asset. Meaning if it’s price goes up or down, you’re going to get an amplified or magnified exposure to those movements. Options are definitely a way to do that, you can also use futures, you can invest in leverage ETFs. You can straight up borrow money and invest somebody else’s money, some of the bank’s money alongside your own. Those are all different ways to accomplish that same concept of amplifying your exposure to the asset. People like options because they have nonlinear payoffs, which makes them feel better to use. I think when you’re trading, if we’re trading options, all this stuff that we talked about with day trading is pretty well the same.

Ben Felix (00:24:22):
You shouldn’t expect to be able to trade options in a way that’s going to give you excess returns. And I think if we start talking about options, introducing leverage to the whole concept of day trading, which again, just amplifies the outcome good or bad. In most cases with short-term trading, it’s going to be bad. But I think leverage is more interesting, at least from an academic perspective, when we start talking about it in a longer term perspective. So instead of trading options or borrowing to day trade, trading on margin, what does it look like? And is it sensible to think about leverage as a long-term investor? Which is something that you can do. You can, again, borrow money to invest in index funds in a long-term account. You can use options to do the same thing. And there are lots of different ways to think about that.

Ben Felix (00:25:07):
There is a paper and a book actually by a couple of guys named Ian Harrison [inaudible 00:25:11] LeBoeuf who are professors at Yale. And they championed this idea that for young people using leverage is actually sensible. And I mean, if you read their stuff, it’s more than sensible. They’re saying, “Everyone should be doing this without question.” I don’t necessarily agree with that, but it is interesting that there is a part of the academic community saying that young people should be borrowing to invest. And the concept is basically that the goal of an investor is to get to their lifetime equity exposure, their lifetime exposure to stocks as soon as possible. And when you’re young, you’re so far off of your lifetime exposure to stocks that it’s going to take you decades to get there.

Ben Felix (00:25:50):
So the idea with leverage is that if you borrow money when you’re young, you can get closer to that target lifetime allocation to stocks sooner. Which that you have more time to keep that stock allocation invested, which leads this argument for something called time diversification. Where for example, if you accumulate throughout your life and when you’re 55, you’ve just got to your $2 million lifetime allocation in stocks. And it happens to be at that time that markets are at a peak and they end up crashing. That’s going to have a materially negative impact on your retirement. Whereas if you got to that 2 million, when you were 30 by borrowing really aggressively to invest, then you’re going to have many more market cycles with your $2 million or closer to it, invest it.

Ben Felix (00:26:36):
So that risk of getting to your peak savings right before a crash decreases. So that concept of time diversification, I think sounds compelling. I think there’s some problems with it too, though. So leverage increases your risk, as I’ve mentioned, the idea that leverage is going to increase your odds of success is true. If we believe that stocks have positive expected returns, which I believe they do. But I think this completely discounts the idea that stock returns are still very uncertain. Even if we can say that stocks have positive expected returns, there are absolutely still instances where over 20 years or longer, it’s possible to have a bad outcome investing in stocks. And if you use leverage, that’s just going to be amplified.

Ben Felix (00:27:17):
So I think conceptually the idea of using leverage, and I know when I talked about this on my podcast a couple of times when I did a YouTube video about it. I had a lot of people reaching out, being really interested in this idea and because it sounds really smart and on paper, it looks really good. And like I said, Harrison and LeBoeuf basically show it as everyone should absolutely be doing this. It’s actually interesting to note too that their concept was based on this idea of lifecycle investing, which was created by a couple of guys, a couple of economists. And that’s the idea that you should get to your lifetime allocation of stocks as soon as possible. Where everybody should have their constant asset allocation throughout their life. And Harrison and LeBoeuf say that with leverage, you can get there faster basically.

Ben Felix (00:27:59):
But the economist had actually created the concept of lifecycle investing. They came back pretty hard and said, “Don’t use our concept to justify leverage, because if we don’t think it makes sense.” Which is an interesting note. There’s actually some pretty interesting written debates with those guys online, pretty heated debates about this whole concept. So leverage increases your exposure to an underlying asset. Academically, it can be beneficial. It looks really good on paper. Practically, I think there’s the risk of uncertain future stock returns. There’s also a massive behavioral risk where, I mean, this can be pretty scary. And if someone doesn’t have the stomach to tolerate a really aggressive portfolio and stick with it, because we don’t stick with leverage then there’s a high chance it gives you a bad outcome.

Ben Felix (00:28:40):
I mean, even in Harrison and LeBoeuf research, they talk about wipe outs where using leverage, there are instances where you end up losing everything. But as long as you get back up and re-invest and releverage, it’s still going to give you a better expected outcome. But if you think about that practically, if someone loses everything by borrowing to invest, what are the chances that they’re actually going to get back up, dust themselves off and leave their back up to maintain their same positive expected outcome? I think they’re pretty low. And I think psychologically, this is a really challenging strategy to stick through.

Robert Leonard (00:29:08):
And when we talk about using this type of leverage, how does somebody service that debt? Is there a monthly payment, like a car note, or how does that work tactically? How is somebody servicing this leverage that they have?

Ben Felix (00:29:21):
It depends how you set it up. So one of the ways that’s interesting is for example, if you have a home that happens to be paid off, and I know that’s maybe a stretch for a lot of people. But just as a hypothetical example, you can borrow against a home using a traditional mortgage to invest in stocks. And if you do it that way, then the way that you’re covering the financing is by making mortgage payments. Likewise, you could do with the line of credit against a home where you’re making interest only payments to reduce the cash flow cost of servicing the debt. If you’re using a margin, it could be a service through the assets that are in the account or through new monthly contributions from paychecks.

Ben Felix (00:29:57):
And then if you’re using derivatives, that cash servicing costs changed a little bit and you end up paying a cost through the way that the derivative contacts are structured. So it depends how you approach it. I mean, there are other ways too, you can use leverage ETFs where you can actually purchase an ETF that gives you two extra 3X exposure to the daily returns. And that’s important. I won’t get into the details because it gets a bit complicated. But a leverage ETF can give you levered exposure of the daily returns of an underlying index. And in that case, you don’t have to worry about any of the debt servicing, its being done by the ETF provider.

Robert Leonard (00:30:26):
Millennials seem to also love IPOs as well, what does IPO stand for and how should millennial investors approach them?

Ben Felix (00:30:35):
Yeah, IPOs do cause a lot of buzz. People do get really excited about them, which I think is really problematic. And I’ll talk a little bit about some of the data. So an IPO is an initial public offering. This is when a company that was previously private, so you couldn’t purchase it shares on the stock market, it’s when they initially sell their shares to the public. So when a company has been successful and they want to finance continued for the growth, or maybe the original shareholders want to have a liquidity event to realize the value of their asset, they’ll often list on a public stock, they’ll sell their shares to the public. So this firm that used to be private, you couldn’t purchase it shares, they’ll go to an investment bank and they’ll figure out what price they should sell to the market.

Ben Felix (00:31:16):
And then they’ll go different ways to execute on the actual offering, but they’ll go and sell their shares to the public. Now, that initial offering has historically been under priced, meaning that if you could get in on the initial IPO offer price, the returns have been phenomenal. There’s a data series online from a guy named Jay Ritter. He’s got data from 1980 to 2018, excluding 1999 to 2000, and he shows that tech IPO’s had three-year buy and hold returns of 28.3% above the market measured from the IPO offer price. So if you can get in on an IPO at the offer price, the returns are phenomenal. But the problem is that you can’t get in on the initial allocation, especially for a good IPO, like a big company like Airbnb going public getting in on that IPO allocation. Unless you’re an institution or a large client and large doesn’t necessarily mean you have a lot of assets in index funds with a big brokerage, it means you’re generating a lot of revenue for the brokerage.

Ben Felix (00:32:19):
So there is a paper that looked at power IPO allocations made, and it was basically the people that get the allocations are generating massive amounts of revenue for the firm through fees that they’re paying or other business relationships or whatever it may be. But if you’re not one of those top customers or other institutions, you’re not going to get in on good allocations. Good being the ones that are under priced and expected to pop. There is an adverse selection effect where if you can as a retail investor, if you’re able to get in on an IPO allocation, it’s probably not a good one. It’s probably not one of the ones that’s expected to have a big pop, which is why you would have been able to get it. So if you go on and buy an IPO or if it feels like you’re buying an IPO, chances are you’re buying it on the secondary market once it started to trade.

Ben Felix (00:33:03):
So after that initial allocation has been done, people have purchased their shares, once those have been sold to the market on the first day of trading, that’s when people tend to buy IPO shares. And when you measure it from that date, from the first trade on the public market, or usually it’s measured in the research from the end of the first trading day, the data is so much different. It’s crazy. So if we measure IPO returns from the first trade on the public market, or the day of the close of the first trading day, that same data series that I just mentioned. So that sample of tech IPO’s from 1980 to 2018, instead of beating the market by 28.3% for three year hold periods by measuring it from the close of the first trading day and actually, they trail the market by 2.7% on average. Which is obviously a staggering difference.

Ben Felix (00:33:51):
So that IPO pop that people hear about, that’s not attainable. You can’t get access to that. And it’s not from the first trading price that you hear about the pop, it’s from the offer price that the initial allocation went out at. There’ve been a bunch of studies that have looked at this from the close of the first trading day like I mentioned. There’s a paper called the Long-term Performance of IPOs. They looked at 7,487 IPOs from 1975 through 2014 from the first trading day, and they found that IPO firms tend to underperform the first two years even when you account for different things like company size and relative price. So they tend to underperform for the first two years, and then after the first two years, that becomes statistically insignificant. And then another paper from Dimensional Fund Advisors, they built a portfolio of IPO’s.

Ben Felix (00:34:37):
So 6,362 IPOs from 1991 to 2018. And they made a market cap weighted portfolio of IPOs that were issued over the proceeding 12 month period, and then rebalance the portfolio monthly. And then similar to the other data series that I just mentioned a minute ago, they found that the IPO portfolio trailed the market by about 2% while being way more volatile. So I think the tricky thing with IPO is, as we hear about the first day pops and people imagine, “If I buy the next one on the first day, I’m going to get the pop.” But you’re never going to get the pop. Nobody gets the pop, unless you’re an institution or for some other reasons and paying large fees to an investment bank. And then once you measure from the first trading day when people can actually access IPOs, the results have been really bad. I mean, you end up taking a ton of extra risk and on average trailing the market.

Robert Leonard (00:35:25):
I actually just talked about this on my Instagram story about Airbnb’s IPO. And I’m not going to get the numbers exactly right. But it IPO to say around a$100 or so. And then the first trade, I think it was around $180. So as soon as you log onto Yahoo Finance, and you look at the Airbnb ticker, it says it’s up 80%. People are like, “Oh my God,” a bunch of people just made a ton of money and that’s true, but not retail investors just like you explained. And so I went through that in my Instagram stories and I said, “Even if you bought at 180, it closed at, I don’t know, 186, 190, something like that.

Robert Leonard (00:35:58):
I mean, you made $6 to $10 a share, which is great, but on $180, it’s not as much as from 180. So like you said, it’s just the access to IPOs that’s very different than a lot of people expect. They have that bias or that incorrect thought that they can access it if they buy on the first day. And that’s just not the case. And you mentioned Renaissance Technologies earlier, and I do want to talk about them. So for those who don’t know, Renaissance Technologies is a hedge fund that follows a quantitative investing strategy. It’s not quite day trading I don’t think. First, who is Jim Simons and what is a quantitative trading strategy?

Ben Felix (00:36:34):
All right. So Jim Simons, he’s famous as a trader for what he’s done with Renaissance Technologies and the Medallion fund. The fascinating thing about Jim Simons and all of this comes from a book by Greg Zuckerman called, The Man who Solved the Market that does a great job documenting his whole lifestyle, which is fascinating. And the book is worth reading. I’m sure it’ll be a movie eventually. So Jim Simons before Renaissance Technologies, and even in addition to being famous for that, he is a famous mathematician and codebreaker. That’s pretty crazy on its own and he’d be a notable human being just for that. And now he’s got the Renaissance Technology success story under his belt too. So he was awarded the American Mathematical Society’s Oswald Veblen Prize in Geometry at the age of 37 for his work in mathematics, including his work on something called the Chern–Simons theory, which has many thousands of citations in the academic literature now.

Ben Felix (00:37:33):
He also spent time chairing the math department at SUNY Stony Brook. He built it into one of the best math departments in the world. So he’s this impressive guy. And one of the things that comes up in Greg Zuckerman’s book is that, he had this unusual intersection between being a brilliant mathematician, but also through his time at SUNY Stony Brook, he gained the ability to manage other very intelligent people as he built up the math department. So those two things came together where… And the crazy thing about Renaissance Technologies is that the other people that Simons was able to hire and still employees, were in many cases by Simons’ own description, much smarter than him. Which is also crazy to think about, that there’s someone that intelligent and then there are people that he looks up to as being more intelligent. But Simons had this intersection of the ability to converse on a technical level with these brilliant people, but also the ability to manage them to be as effective as possible.

Ben Felix (00:38:29):
Now, when you read the story about Simons, there’s also all these crazy instances of luck. Where there were times early on, and maybe times later on that we don’t get to hear about that Simon stepped in and made human calls, but ended up working out. It’s crazy to think about if Simons had gotten those wrong along the way, we may not be talking about Renaissance Technologies. There’s a bit of luck in there. So that’s Jim Simons is a brilliant guy who brought together a bunch of other brilliant people and they built this fund that through some combination of brilliance. Being ahead of the times, in terms of information processing abilities and some stroke of luck which I think is required anytime that you’re that successful in financial markets. He’s built this fund that has just done in terms of rate of return, better than anybody.

Robert Leonard (00:39:15):
What is a quantitative trading strategy?

Ben Felix (00:39:17):
So they basically just built an algorithm or algorithms that eat tons of data. And even that, when you read it again, the story about Renaissance Technologies, just data was at a time and may still be, nobody really knows exactly what they’re doing, but just access to data was one of their main advantages. They were manually tabulating and collecting data that didn’t exist in a digital format into a digital format, so they can actually shove it into their algorithm. But nobody else had that at the time. So you can see just based on that, how they might’ve had an edge back then. So they build these algorithms. A lot of them had background and speech recognition, and there’s a whole conversation in that book about how financial markets behave like hidden Markov chains. And if someone’s an expert in mathematics, I may be butchering that explanation. But speech recognition is similar.

Ben Felix (00:40:07):
So a lot of the people that brought their expertise to the Medallion fund, came from, I think it was IBM, where they were experts in developing speech recognition platforms. So it’s fascinating because speech recognition is predictive and obviously to exploit inefficiencies in financial markets, you have to be predictive. So you mash all these guys together and they built this algorithm or algorithms that digest data and provide trading signals. And that sounds like every other online course that people try to sell, but this is the case, like we mentioned earlier, where they’ve actually been able to do it successfully. And they’ve been able to do it successfully for a really long time, which is part of the crazy thing of this whole story.

Robert Leonard (00:40:48):
Yeah. It said that they’ve had a return of about 66% before fees since 1988, and that is just an unreal track record. How and why is this quantitative strategy so successful?

Ben Felix (00:41:04):
I can’t tell you the how, if I could have, maybe we wouldn’t be talking and I’d be doing the same thing they’re doing. All we know is what I’ve told you basically. I mean, there’s a lot more detail that goes into it, but we don’t know a lot. Greg Zuckerman was able to get time with Simons and find a bunch of other people that had been with Renaissance Technologies and talked to them in general terms, what they’ve been doing. But they’re extremely strict with releasing any information about how they’re actually doing, what they’re doing. So it’s a lot of, I guess, trade secret type stuff that I don’t know, and that nobody really knows. So how it’s been successful? I don’t know. I mean, you could think of all reasons. It’s got something to do with the fact presumably that there’s so many brilliant people involved.

Ben Felix (00:41:46):
I don’t know exactly how they’re doing it though. Now why it’s been successful is more interesting and a little bit easier to answer. It’s been closed to outside investors for a very long time. They booted out their external investors pretty early on when they started to be successful. So it’s only employees of the fund that invest in the fund. And every year they push out all of their profits and they keep the fund capped at a certain level, and they reset that level every single year. And I think that’s one of the main reasons they’ve been able to be persistently successful over such a long period of time. They have some edge obviously, and when you have an edge like that, there’s a limit to it. So for example, if they found some inefficiencies that do exist in the market, those efficiencies are going to be limited.

Ben Felix (00:42:31):
There are only so many of them to go around. You got to think there are lots of traders that are looking for opportunities like this, and therefore most of them are going to be exploited away pretty quickly. Medallion has been able to find ones that, while that they’re the ones that are better exploding, and they’ve been able to do that consistently. If you have too much capital in a strategy like that, it won’t work because there are not unlimited opportunities to explore it. So I think that their foresight to cap the fund, push out the profits, not let it grow exponentially over time, is one of the main reasons that they’d been so successful. From the investor standpoint though, it’s also interesting because you can’t invest in it. We can look at this number, it’s like the IPO pop. We can look at it and say, “Oh man, imagine if he gets 66% a year,” but you can’t. The people that work for Medallion and the people that invest in the fund can, but there haven’t been outside investors for many, many years.

Ben Felix (00:43:20):
So no nobody got the 66% unless you are a very, very close to the fund. So I think that’s one of the interesting things to think about when we talk about Medallion is that, we know they have been super successful and nobody knows quite how. And not many people got to actually partake in their gains, which like I mentioned is one of the reasons they’ve been so successful. But when you extrapolate that to other active managers, like an actively fund that’s being marketed or somebody selling their investment strategy. And like I mentioned earlier, it just doesn’t make sense. There’s clear example of a firm that really did figure out an edge to the extent that no matter how secretive they’ve tried to be over the years, we know about them because they’ve been that successful, but they’ve also been secretive about it. They don’t want us to have this conversation.

Robert Leonard (00:44:08):
And they have to give that money back if they want to give those returns, because it goes back to what I said earlier about people who are flaunting these amazing day trading returns with these individual trades. If he compounded 66% every year since 1988, even if you started with a very small amount of money, he’d owned the whole world. So you have to give those returns back and essentially reset to whatever that dollar amount is. I want to say it’s a billion dollars, but I could totally be wrong.

Ben Felix (00:44:32):
I think it’s 10. Yeah.

Robert Leonard (00:44:34):
Maybe 10 billion. Yeah. But if you don’t do that, I mean 10 billion, 66%, it doesn’t take very long to own the world. So just mathematically, it’s impossible to continue to compound at that return for so long without resetting.

Ben Felix (00:44:45):
Absolutely. And I mean, I know we’re going to talk about Dave Ramsey, but when you start talking about active fund managers, it’s the same thing. If an actively managed fund is successful, their success sows the seeds of their own destruction because they attract more capital and all of a sudden they can’t execute on the strategy. But they want to take the assets because they’re charging fees on it, and they’re capitalists too. And all of a sudden the strategy gets diluted and is no longer going to be successful. And that’s arguably one of the reasons that we see the lack of persistence in fund manager performance.

Robert Leonard (00:45:11):
So how does Renaissance Technologies make money if they’re close to outside investors? They must just only make profit off of the returns. They’re not looking for any management fees or anything like that because nobody is there money managing, right?

Ben Felix (00:45:23):
I think when you look at the returns data, I think they do still charge fees, but I guess they’re just charging fees to themselves. So I think actually Simons said that… I’m maybe misremembering, but I read the book a while ago. But I think he even told an outside investor at one point when they asked about why the fees are so high, Simons was like, “Well, we pay for them too.” So I’m pretty sure the fund owners or the employees, they also pay the fees, but to themselves, I guess.

Robert Leonard (00:45:46):
Interesting. Yeah. There’s probably a smaller amount of owners of the fund itself. So not everybody invested in the fund is actually paying themselves. So that’s probably how that works out. How does this all play into efficient markets and the Efficient Market Hypothesis? And for those who don’t know, give us a brief explanation of what the Efficient Market Hypothesis…

Robert Leonard (00:46:03):
A brief explanation of what the Efficient Market Hypothesis is.

Ben Felix (00:46:05):
So we kind of touched on it earlier. The Efficient Market Hypothesis is a theory that says that in a perfectly efficient market prices always reflect all available information. And again, that’s a theory, it’s a model. It’s not reality. Markets are not perfectly efficient. It’s always funny when you bring it up to say that, index funds make sense because the market’s efficient and people say, well, no, they’re not. And it’s true, but they’re efficient enough that we should probably think about them as being efficient, practically speaking, but then you’d take Renaissance Technologies. And this is why I made a video about this, about their fund is because whenever I would say, or reference the market’s being efficient, people would say, well, what about Renaissance Technologies? And it’s a good question because if the market was perfectly efficient, they would never have been able to have the success that they’ve had, but it comes back to what is Market Efficiency while it’s a model.

Ben Felix (00:46:50):
It’s not reality. They’re not perfectly efficient. There are inefficiencies in the market. They’re really hard for most people to find, exploited, especially consistently. Renaissance by some means that we don’t exactly know was able to pull it off. So, that’s all we can say about it. We know markets aren’t perfectly efficient. This is maybe evidence of that, but the fact that they have to cap the fund and distribute all the profits every year, that also tells us that markets are not infinitely inefficient. There’s a limit to the inefficiencies that exist. And Medallia has just been kind of exploding those and maybe pushing the limit of finding them. But there aren’t so many inefficiencies. They can just keep on taking new money and making more money.

Robert Leonard (00:47:28):
So I want to talk about this concept that I hadn’t really thought of until I think it was last night, I was doing an interview with a gentleman named Gary Mishuris and he is one of the best value investing thinkers that I’ve personally had the opportunity to chat with and learn from. I was asking him about why he thinks Warren Buffet is so coined as the greatest investor of all time.

Robert Leonard (00:47:52):
Now, I got into investing because of Warren Buffet. I loved Buffett. I’m not trying to take anything away from him, but when you look at something like Renaissance Technologies, that’s done 66% since 1988, how is something like that? And Jim Simons and his colleagues that have come up with this quantitative strategy, how are they not defined as the best investors of all time? Is it more of a marketing thing? Is it because Buffett’s, he has giving back capital in his private partnership days, but in general, Berkshire Hathaway has just kind of continued to grow. It does, it may be like a combination of marketing as Warren Buffett’s like personal brand is just so well-known and Renaissance Technologies is more secretive. Maybe it’s because Renaissance technology gives their money back. What do you think it is?

Ben Felix (00:48:36):
It’s a good question. And I’ll, tell you what I think, I think the answer is longevity buffett’s been doing this for longer. He’s generated more wealth. Like if you compare the net worth of the two, despite the ridiculously high returns that Simons has had, who has a larger personal balance sheet off, Buffet’s still going to win in that discussion. And it’s because of his longevity, he was very successful for a very long time. And he stuck with doing exactly what he was doing. And the effect of compounding have worked in his favor if Simons had started, because Simons started pretty late. If Simons had started the same time as Buffet and started earning the same kind of returns that Simons has earned for the time that he was investing, he would be far wealthier. And he may be known as, the greatest investor of all time. Although I think that he probably still does earn that title, but yeah, Buffett’s better known because he’s been around longer, he’s generated more wealth and he’s just had more time to compound. So it comes back to longevity.

Robert Leonard (00:49:30):
Well, if it’s been doing it since about the fifties, sixties, something along those lines, so it definitely is. He’s got a 30, 40 year headstart on Simons, but I also wonder if there’s a component of Buffet picks his companies himself. He does the research, he does the due diligence. He’s making those investments. I mean, of course you could argue he has a team and he has Munger and he has all these people helping him nowadays. But in general, he’s thinking he’s making these picks, whereas with Simons, it’s a quantitative strategy. So he made the algorithm and he’s not making the picks, right. The algorithm is. So does that really make Simons and investor or trader or is he more just a mathematician that happened to manipulate markets?

Ben Felix (00:50:06):
That’s a good question. And it probably depends who you ask too. I think Simons is held right up there with Buffett. I think Buffett’s probably better knowing maybe it’s for the reasons that you described, which could make sense. I think watching the rest of Buffet’s career is going to be very interesting culturally in the investing world, but also in directly from an academic perspective, he’s trailed the market and a value index for 20 years for the market and 18 years for a value index. We’ve started talking about active manager persistence and all this stuff. We’ve mentioned a few times in this conversation, seeing where Buffett ends his career is going to be just very interesting. And I know he’s been very open and humble about that. Like people have asked him if he thinks he’s going to beat the market over the next however many years.

Ben Felix (00:50:51):
And he’s never said, absolutely. I think he said about the S and P 500, that it would be a toss up, but it’s not like he’s claiming that he’s going to be able to continue beating the market. But I think regardless, it’s going to be really interesting to see how that plays out because he’s held out as this again, just like with Jim Simons, whenever I mentioned markets being efficient, people will say, well, what about Warren Buffet? And you look at the data right now and you can kind of say, well, yeah, what about him? But then he could have some big wins to finish his career. That would completely change the data. Again,

Robert Leonard (00:51:20):
It is really interesting to see how over the last two decades or so he really hasn’t done much in terms of out-performance, but it also comes back to a law of large numbers, right? He doesn’t really, I mean, Berkshire doesn’t give money back necessarily. It’s just, it’s the conglomerate that he’s investing in his fully owned subsidiaries that Berkshire owns generate so much cash that his investible cash just continues to grow and grow and grow. So it’s just, doesn’t have as many ideas that you can deploy all that capital, a big story in the U.S. In 2020, as it relates to the market is the fed’s money printing and QE. What is QE? And what does it mean when the fed prints money?

Ben Felix (00:51:57):
This is a bit Of a big topic. And I’ll tell you that I earlier this year, because this was such a big story of what was happening. I spent a lot of time trying to get into this, get my head into it. And it’s, it’s a big topic. It was exhausting. I remember when I finally made a video on this, I was like, I don’t know. I just felt like I ran a marathon or something. So I think to answer the question, we have to think about what money is in the first place, money is necessary for any functioning economy. It facilitates the exchange of goods. It’s a unit of account. It provides a standardized way to measure income wealth as a price, as profits for companies. And it’s a store of value, which is obviously important for how individuals and businesses store their wealth, especially in the short term money today for the most part is Fiat money, which is money that has no intrinsic value, but it’s used in an economy based on government announcement.

Ben Felix (00:52:45):
The government says, we’re going to use USD. There’s no gold backing, but we’re going to use it. And the stability of that money of Fiat money comes from the economies productive capacity and the state’s endorsement and protection of its use. And the fact that they do taxation in that medium. So that’s what money is. Now, One of the things that I don’t think people realize is, and this is one of the really important pieces of answering your specific question about the fed printing money. The government doesn’t actually create most of the money in the economy. Governments are typically responsible for printing physical currency like bills and then coins, sometimes three different entities. But that physical currency is a really small portion of the overall money that exists in the market. Most of the money in the economy comes from private banks, making loans to individuals and businesses.

Ben Felix (00:53:33):
Every time the private bank makes a loan, it creates a loan, which is an asset to the bank and a liability to the bank’s customer and a deposit, which is a liability to the bank and an asset to the customer. So when that happens, it’s like net neutral on both sides of the balance sheet. When they do that, they’re creating money out of thin air and banks, private banks do this every day. This is normal. This has nothing to do with QE. And this is just normal. How banking works in a capitalist economy, the private banks are competing with each other to create money. So they’re competing with each other to make loans. They want to get more customers borrowing from them because that’s how they make their profits or one of the ways that they make their profits. Now that profitability is their primary constraint in lending, because if they go and make a bunch of loans to people that they know won’t be able to pay them back, then they’ll hurt their own profitability.

Ben Felix (00:54:16):
So that’s the main constraint on lending on money creation is having a sufficient amount of qualified borrowers who are interested in actually taking loans. Now that constraint is very different from what many people believe to be true. And this is one of the things that I didn’t know until I started doing the research, but fractional reserve banking, the idea is that banks take in deposits and then keep some of them in reserve and lend the rest out and the money multiplier effect and all that stuff. That’s completely false. And this isn’t just me saying this. This is something that while we can, why do we don’t have to prove anything that bank of Canada or banks in Canada don’t have reserve requirements banks in the United States? As of, I think March of this year don’t have reserve requirements. So right there, we can see that there is no money multiplier effect and the banks don’t take in deposits and then loan them out.

Ben Felix (00:55:08):
And that was at least a big deal for me. When I started digging into this as the bank don’t have reserve requirements and banks just make money out of thin air, as long as they have qualified borrowers. So another way to say that is that borrowing is the money creating process that allows for saving and not the other way around. And I think a lot of people have it backwards because to be fair, that’s what we’re taught. And that’s what a lot of economics texts books do say, but it’s not how it actually works. Now, the banks need to keep an eye on their flows of money. Their flood of cash and if they make a loan and the customer takes the deposit that’s created and moves it to a different bank. That’s an outflow and banks need to clear their net flows. At the end of every day.

Ben Felix (00:55:47):
This is where the central bank starts to play a role so that they become the central clearing house for all the banks that are clearing these transactions. If a bank has a negative flow, they have to meet that shortfall. In many cases by borrowing bank reserves in the overnight lending market. And if a bank had a positive flow, they might lend their excess reserves to another bank. Now it’s kind of tricky because banks don’t have reserve requirements, but bank reserves are like a special type of money that banks use to settle transactions between each other. It’s not real money. And this becomes important. We start talking about quantitative easing. It’s not money that you or I could go and spend at the grocery store bank reserves or specific type of money that banks use to settle transactions with each other in the overnight lending market.

Ben Felix (00:56:29):
Now the interest rate on those overnight loans becomes very important to the economy because it then dictates how much banks are willing to lend to their customers or what rate banks are willing to lend to their customers at. The central bank tries to influence that overnight lending rate by influencing the amount of bank reserves that exist in the private banking system. They do this thing called open market operations, where they’ll transact with the banks to purchase short-term government securities, and exchange for bankers herbs to manage the level of bank reserves that exist, which then affects the overnight lending rate, which could affect lending by effecting the interest rate that banks were willing to lend to their customers at. Now, all of that is just normal. Like this is happening every day, all the time. And if the central bank is in a position where they want to try to stimulate the economy, they’ll try and reduce that overnight lending rate.

Ben Felix (00:57:15):
And if they, in our situation where they want to slow things down, because they’re worried about maybe inflation, then they’ll allow that rate to increase or they’ll make it increase that overnight lending rate quantitative easing is kind of like a special case of those open market rates, operations, where in cases where the overnight lending rate is already low, so they can’t reduce it anymore. That’s when they start thinking about something like quantitative easing think so normal open market operations are no one is conventional monetary policy. Quantitative easing is known as unconventional monetary policy. And it’s basically the same kind of thing. Conceptually, where the central bank is transacting with the private banks. But in the case of quantitative easing, they’re typically buying larger amounts of assets and they’re typically buying longer term debt securities. And we could be other than government debt as well. So an open market operations, typically the transacting with bank reserves to purchase short-term government securities, quantitative easing they’re using bank reserves to purchase longer-term government debt, and sometimes corporate debt and other types of assets.

Ben Felix (00:58:15):
And in this recent crisis, they expanded that to include a whole bunch of other things. Now, when they start doing quantitative easing the amount of excess bank reserves that banks hold, like I mentioned, those flows of the net money flows, all of the banks end up having massive amounts of reserves when the central bank starts doing quantitative easing. So the central bank needs a way to make sure that they don’t want to just get rid of those reserves. And the way that they do that is by paying interest on reserves. So this is a big deal when they started doing that. And what it effectively did was turn quantitative easing into an asset swap. Where all the central bank is doing is swapping bank reserves, which are now short term government debt effectively because they’re paying interest on them for a longer-term government debt. When that happens, the central bank is not changing the net amount of assets that exist in the private banking system.

Ben Felix (00:59:07):
It’s neutral from that the perspective of the private sector balance sheet, what they are doing is changing the composition of the assets. So instead of the bank holding longer-term government securities, they’re now holding these short-term bank reserves. And the intention of that is to push down longer-term interest rates. I mentioned with open market operations, central banks try to manipulate overnight lending rates. Short-term interest rates, but longer- term rates are typically influenced by market forces wants a database is a case where the central bank is trying to influence longer-term lending rates. And the reason they want to do that is to incentivize borrowers. Again, it comes back to where does money come from? The central bank is trying to get interest rates down so that qualified borrowers are more likely to take loans, which again, starts that money creating process that starts with borrowing. Now, all of that gets termed money printing the Fed’s printing money, which makes people think of the fed printing like bills and shoving them into people’s pockets, which could be inflationary.

Ben Felix (01:00:03):
But because QE is just an asset swap where they’re swapping short term reserves or bank reserves for long-term government debt. It shouldn’t be inflationary. It’s not dumping cash into people’s pockets. It’s increasing the amount of bank reserves in the private banking system, but because they pay interest, it’s not really affecting anything. And because reserves are not actually related to lending like a bank has a lot of bank reserves. It doesn’t mean they can make more loans because there’s no reserve requirement. Anyway, it doesn’t make a difference, but by affecting interest rates, it might make the private sector more likely to borrow, which could stimulate the economy, whether it does or not. I think that’s still up for debate. Japan has been doing it since 2001. The U.S. has been using as a tool since 2008. And as far as I know, the evidence is conflicting on how successful QE is as a monetary policy tool.

Robert Leonard (01:00:51):
Where does Bitcoin land all this?

Ben Felix (01:00:53):
I don’t know. I mean, where does gold play and all this they’re separate from the banking system that exists, or where could it play into this? That’s a big philosophical and economic question that I don’t know if I know the answer to.

Robert Leonard (01:01:05):
It is separate from what we just talked about. But, and the reason I asked that is because everything you just talked about is why people are piling into Bitcoin. That’s why people love that coin is because of everything you just talked about. So do you see it as a solution to some of the issues that what you just explained to causes?

Ben Felix (01:01:20):
I don’t know if it causes issues like the biggest issues that quantitative easing causes are probably wealth inequality effects because when the central bank is doing this, who’s benefiting from it, not people at the lower end of the wealth spectrum. Generally, it’s going to be people from the higher end of the wealth spectrum.

Ben Felix (01:01:37):
I mean, if QE decrease discount rates and it can increase asset prices, and that can be from a suppression of interest rates, or it can be from making the economy actually safer by stimulating the economy, but either way who benefits from that, not more people. So I think that’s one of the negative effects from QE, but from the perspective of inflation, for example, and the integrity of a currency, I don’t think QE has an effect. It’s not increasing the supply of money directly. It’s potentially making people more likely to borrow, but I don’t think it affects the integrity of the U.S Dollar. For example, I think there’s a perception that it does. I think that might be one of the reasons we’ve seen the increase in gold and Bitcoin, but I don’t think the QE is actually causing any problems, at least the way it’s being done currently, or potential problems with the banking system.

Robert Leonard (01:02:21):
You are a very rational thinker. What do you think about Bitcoin, personally?

Ben Felix (01:02:26):
I mean, I wish I bought it like the first time I heard about it and held it obviously, but I live in Ottawa where Shopify is headquartered and I wish I bought their stock when they IPO. I think the IPO at $17 and the first trade was at $28. If I bought it in held my net worth to be a lot higher. So there are lots of things like that. Do I think Bitcoin is going to be the future of anything? I don’t know. I think, I don’t think I would buy it. I don’t think I would buy gold either. I mean, I wouldn’t, I don’t because they don’t have positive, expected returns. I think it’s speculative. I think that financial services is going to adapt to the existence of digital currencies. And I think that’s one of the other big trends that we’re going to see, like earlier we talked about direct indexing.

Ben Felix (01:03:09):
I think one of the other things that we’re going to see in the next couple of years is going to be custody of digital currencies from like retail brokerages. And that’s going to become less of a niche thing and more of a common place thing. Does that mean it’s a good thing to hold and invest in? I mean, I don’t think so. There are a lot of alternative assets that you can make an argument for holding. And I don’t really know why you’d pick Bitcoin over, I don’t know, farmland or Timberland or art. Like there are just so many different assets that you could say, well, let’s put our money in that. Bitcoin has a bunch of attention around it. So people focus on it as a potential investment, but why that the opportunity set of alternative investments is enormous. And if I had to pick one, I don’t know if it would be the Bitcoin.

Robert Leonard (01:03:49):
Bitcoin just has such a cult following that those other alternative assets don’t right. Like you don’t hear a cult of art followers or art investors going around screaming like you do Bitcoin owners and the same for farmland or any other alternative asset that there is,

Ben Felix (01:04:03):
Unless you’re in the world of art collecting. I’m sure that it feels like they are screaming. I think Bitcoin is more mainstream. And I think in the Millennial online culture, we hear a lot about Bitcoin and the media likes to talk about the Bitcoin, but if you take any asset, that’s increased in price a lot recently it’s going to be in the media a lot. It’s going to be talked about a lot. Bitcoin’s back in the news more recently because it’s price has gone up again, but just the rise that it had from where it started to where it is now, of course that’s going to attract attention, but I don’t know if that means it’s something that should be included in your portfolio.

Robert Leonard (01:04:36):
Yeah, there definitely is a correlation between rising prices and people’s interest in certain given assets. So for me, I just so happened to meet with two very well-known Bitcoin experts. Back in March, I happened to allocate a percentage of my portfolio to it. I bought my literally my cost basis is $4,200 today. It just crossed like $23,000 last night or something. So it was a good trade, but like at $4,000, I didn’t really care about it for six months. I really didn’t care about it. It really didn’t do anything. It was more or less flat. I just hadn’t really focused on it. And now that it’s over $20,000, I’m interested in it and I’m focusing on it. And I like to think I’m pretty rational. I can put my emotions aside, but even me, I get wrapped up in that. And so I’m not surprised to see. I mean, we had this happen with Tilray, Beyond meat. You know, all of these other companies that you just see go up in price so much people want love talking about it.

Ben Felix (01:05:27):
One of the papers that I looked at when I did my video on day trading, I didn’t bring it up in our conversation, but I guess I’m going to bring it up now is the question of how do individual investors choose what they’re going to invest in.

Ben Felix (01:05:37):
And that paper looked at the relationship between attention and they measured attention by, I think it was stocks that had recently had extreme price swings up or down, stocks that had been mentioned in the media. And I think there was one other criteria, but they found that individual investors with discount, brokerage accounts were much more likely to buy those attention, grabbing stocks than they were to buy any other stocks. And you think about it, there are thousands of stocks that exist in the market and even more asset classes, if we start considering other stuff and we choose to invest in the ones that like we’re talking about that you heard about recently, but I’m sure we could go and look around and find a liquid asset class. That’s increased a lot more than Bitcoin has in the last few months. I don’t know what it would be, but I’m sure there’s something out there. And we could just as easily be talking about that, but we’re not because it’s not in the media.

Robert Leonard (01:06:23):
We’ll look at Zoom right at his trough in March ish to now you’re up five times ish. So like 500%. I mean, that’s roughly what Bitcoin’s up and that had similar popularity around it. We see it with Tesla. We see what things like that all the time.

Ben Felix (01:06:39):
And it’s interesting to think about what the impact of expected returns is when you have big run-ups like that. If you’re buying assets, when they become expensive, when they get exciting and your story, it was before that happened, which is good. But if you’re buying things, when they’ve gone up in price and that’s when they get exciting, I mean, I guess in the case of Tesla, if you bought it, when the price had increased a year ago, you still done just fine. But in a lot of cases, you’re going to end up with lower expected returns. Once an asset’s already increased in value,

Robert Leonard (01:07:04):
So I want to actually dive into that concept for a second, because if you’re familiar with the Motley fool, and if you’re listening to this and you’re familiar with the Motley fool, one of their big investing philosophies is adding to your winners. And typically a winner is something that’s gone up in price and has done well. So theoretically, if you’re adding to a winner you’re buying at higher prices than you bought previously. And just mathematically, if a price is higher, your most likely expected return is lower. So how do you combat that dynamic of adding to your winners, continuing to buy things that have done well versus not wanting to buy something that has a potentially lower expected return

Ben Felix (01:07:44):
Momentum doesn’t fit in the framework of rational asset pricing models, which is what I’m talking about. When I say expected returns, momentum is the well-documented as one of the things that does tend to be related to positive returns. So there are different ways to measure momentum, but to generalize buying an asset that has increased in price recently does tend to lead to better returns in the data. The challenge from a practical perspective is that a momentum strategy tends to lead to higher turnover, which leads to higher costs. And it also tends to have what are called whipsaws where you can get these really big drawdowns in momentum. Now that’s not to say it doesn’t work, but I think from the perspective of building a diversified portfolio, that has a positive expected returns, there’s a better way to use momentum as opposed to trying to chase momentum, which again is a high turnover, relatively expensive strategy.

Ben Felix (01:08:35):
As a value investor. For example, you can use momentum to help make decisions about longer-term holds. For example, not selling a stock that has positive momentum or waiting to buy a stock that has negative momentum. Now I don’t invest that way where I’m holding individual securities, but you, when you’re using a value fund, you would also hope that they’re doing the same thing. If it’s a systematic value strategy, you don’t really want to be buying the stocks when it became a value stock when it has a negative price momentum, because there’s a good chance that.

Ben Felix (01:09:03):
… stocks when it became a value stock, when it has a negative price momentum, because there’s a good chance that it’s going to continue to go down. So, anyway, all that to say, there’s a difference between expected returns, which is buying stocks at low prices, or at least the relationship between the discount rate. It’s the discount rate of it. You’re buying the future cash flows. That’s an expected return. Momentum is more related to an unexpected return, which definitely can happen. It exists in the data. Some funds try to capture it.

Ben Felix (01:09:28):
At the individual stock level, I mean, I guess the data still apply, but I think when you’re holding individual stocks, there’s so much idiosyncratic risk that I don’t know if we can apply the same rules that exist in the data. But all that to say momentum is a real thing, so the Motley Fool’s saying that you should add to your winners isn’t totally crazy unless it’s in a relatively concentrated portfolio. If we’re talking about one stock, I don’t know. I mean, I think the data kind of goes out the window.

Robert Leonard (01:09:50):
What I do like about the momentum strategy, and I’m a value investor at heart, but lately I’ve been adding a bit of a momentum component to my portfolio, combining value and momentum, mostly just to avoid value traps and selling too soon. So, we might analyze a company and say, “It’s worth $10.” It’s trading at $5, so we have a 50% margin of safety. Great. We should buy. You can do that, and then as long as you hold for the next five, 10 years, hopefully it’ll work out.

Robert Leonard (01:10:17):
Or you could look at that and say, “Okay, the value’s $10. Stock price is $5. So, there is that discount, but over the last year it’s been trending down. I probably don’t want to buy right now because this looks like a falling knife, and I don’t want to ride it down. Why don’t I wait a little, let the momentum keep coming down, wait for that momentum to reverse a little, if it does.” Once you see that momentum reverse, then you can buy in as long as it’s still below your intrinsic value, and that way you can avoid the falling knife.

Ben Felix (01:10:43):
I totally agree. So, I invest my own money in dimensional funds, which are funds that… Actually they just launched ETF. They didn’t used to be available to the public. Now they are through their ETF structure. There’s another company that’s came into existence at the end of last year called Avantis. It’s actually a bunch of left Dimensional fund advisors. And they’re systematic diversified value, small cap and value products, but they do exactly what you just described. They use momentum as part of their trading strategy, but they don’t directly target momentum as a standalone strategy.

Ben Felix (01:11:13):
I think that approach makes a lot of sense because you get to take advantage of the information that we know exists with momentum, but you don’t end up with a really high turnover portfolio, which a momentum strategy typically will be, which comes with other things like tax implications and trading costs. I mean, I totally agree, and for value traps, I think the other thing that’s interesting, I think about, and again, Dimensional and Avantis are both doing this, is looking at gross profitability in addition to a valuation metric, because if you’re buying a cheap stock that’s cheap because it’s a piece of junk, that may not have a good expected outcome. But if you’re buying something that has robust profitability and is trading at a low price, that’s probably a better business to invest in.

Robert Leonard (01:11:50):
And it works at the top, too. The way I use it this way is, if a stock is rising and say it’s now trading at $20, but it’s still the intrinsic value is $10, you might say, “Okay, this is a little overpriced. Maybe I should reduce my position.” Whereas, then you could layer in that momentum component and say, “Well, the momentum is still really strong, so I probably don’t need to sell yet. Let it ride.” Then maybe once that reverses a little bit at the top, you could trim your position or sell out once the momentum reverses and not necessarily go only on the intrinsic value and the stock price.

Ben Felix (01:12:22):
Yeah. I think do it systematically you can pick a momentum rule, a timeframe that you’re observing momentum through, and use that as opposed to waiting for the trend to reverse.

Robert Leonard (01:12:33):
How do we delineate the stock market that we’ve talked a lot about and the economy? Why is it important to understand the difference between the two?

Ben Felix (01:12:42):
I’ll talk more about how we delineate them, but the reason that it’s important to understand the difference is that in many cases, investors will react to economic news in their portfolio. I think that can be extremely detrimental, and I’ll explain why. That gets us to how we delineate them. If we look at the crisis that we’ve just lived in and are continuing to live through, especially when we had a lot of volatility, there were a lot of days where we had the combination of historically bad economic data announcements, like jobless claims and all that kind of stuff, and also on the same trading day, historically high stock market returns.

Ben Felix (01:13:22):
A lot of people say that’s confusing that the market’s detached from reality. I don’t think that’s true, and I’ll explain why. So, we’ve talked about market efficiency a few times, and I think understanding the relationship between the stock market returns and economic data starts with that concept of market efficiency. If we think about what a company is or what a stock, is just like we were just talking about it, it’s the right to participate in a company’s future profits. That’s true across the board with all of the stocks that trade.

Ben Felix (01:13:51):
In an efficient market, as we’ve mentioned a few times, prices contain information about expected profits and the riskiness of those profits, the discount rate. Now, economic news can affect all of that, but economic news from the past is only known in the future. There’s a lag in economic news being announced. So, when we see economic news come out and stock markets react in a way that is different than we might have expected, for example, bad economic news being paired with good stock market returns, all that’s telling us is that the information that was embedded in stock prices before that news came out was worse than the actual news.

Ben Felix (01:14:27):
I mentioned jobless claims a second ago. We can imagine a situation where the market has priced in some number, some amount of jobless claims, and when that actual economic data is released, it’s not as bad as the market had priced in. Prices should increase. That’s just a market efficiency argument. As new information develops prices change, and if the information, even if it’s bad, is better than expected, we would expect a positive change and likewise in the opposite direction.

Ben Felix (01:14:54):
If we think about an example from the financial crisis, the U.S. stock market started to decline in October, 2007. Now, that was two months before the National Bureau of Economic Research defines, and they define these in hindsight, defines the economic recession as having started. So, they define it as December, 2007 until June, 2009. Now, like I just mentioned, those dates were not announced until way later. So, it was in December, 2008 that NBER came back and said, “This is when it started.”

Ben Felix (01:15:22):
Now, those recession dates, they’re determined way in the future, in many cases a year after the recession and recovery start. They’re also not determined quantitative. This is one of the things that I think came out to me as really interesting when I did this research is that there’s no hard and fast definition of what a recession is. It’s actually a committee, the Business Cycle Dating Committee through the National Bureau of Economic Research. They’re sitting down at a boardroom presumably, and they’re deciding when the recession started.

Ben Felix (01:15:52):
I’ve heard people throw around different metrics like GDP declines for some period of time or a number of quarters or something, but it’s not. It’s a committee decision. So if we come back to the example of the Great Recession, U.S. unemployment had been above 9% since May, 2009. It peaked at 10% in October, 2009. Real GDP in the U.S. its lowest point for the recession in the second quarter of 2009. Now, the committee, they had not decided yet when the recession dates were. It wasn’t until 2010 that they made those calls.

Ben Felix (01:16:24):
But if you think about living through that time in 2009, the economic data are coming out as worse and worse. It was not obvious at the time things were going to get better. We didn’t have have the NBER definition of when this recession started and ended yet. All we see is worse and worse economic data coming to light. It seems like that would be a bad time to invest in stocks, a really bad time. You think about leading through that. The data are just worse and worse. I can see how it would be scary to invest, but if you look at stock returns throughout that period, the market bottomed out in February, 2009, and then started a historic, in hindsight, rebound.

Ben Felix (01:16:58):
Also, keeping in mind that when this rebound is happening in the stock market, the economic data were continuing to deteriorate.it was only getting worse in the economic data, but the stock market is having this big resurgence. It actually increased 56% from March through the end of December, 2009, and then had the recovery that we’re all somewhat familiar with, although the U.S. market did have a flat decade following that. But it ties back to what I was just saying about the market being efficient and prices reflecting information.

Ben Felix (01:17:27):
In the example that I just talked about, the economic data we’re continuing to come out as worse and worse, but the efficient market’s explanation is that the data were not coming out as bad as the market expected. The recovery was able to begin, and then, of course, data starts to improve. Things start to improve for companies, and prices start to come up. Another example from the academic literature, as opposed to an anecdote is Eugene Fama and Ken French had a paper in 2018 titled Inverted Yield Curves and Expected Stock Returns.

Ben Felix (01:17:58):
Now, they know from actually some of Eugene Fama’s research that there is a strong relationship between inverted yield curves and economic activity. So, people probably have heard that inverted yield curves tend to predict recessions, but the whole point of their paper was to ask if there’s a relationship between inverted yield curves and stock market returns. So, we know that they forecast recessions. They forecast stock returns, and they found in their paper, there is no evidence that the yield curve inversions can help investors avoid poor stock returns.

Ben Felix (01:18:27):
They go on to explain the simplest interpretation of the negative act of premiums. They built a market timing strategy based on the yield curve. We observe is that yield curves do not forecast the equity premium. So, that’s important to yield curves forecast economic activity. They do not forecast the equity premium, which is another way to think about the delineation between the stock market and the economy. That was all short term. Longer term there’s also really interesting research that shows that companies with decreasing GDPs or lower GDP growth tend to have higher stock market returns over the longterm than countries with higher GDP growth. There’s been a couple of studies that looked at that for developed and emerging markets countries, and it’s the same thing. There’s a negative correlation between GDP growth and stock market returns, and I think again, the efficient market argument for why that’s happening… Actually, this is not an efficient market argument. This is an overpaying for growth argument. If people expect GDP growth to be high, there’ll be willing to pay more for stocks in those countries, and that will decrease the returns because your returns, they’re not the profits that you got there, what you paid for them, as I’m sure people are familiar with.

Ben Felix (01:19:29):
It’s all about the discount rate. If your discount rate is lower because you expect higher growth, or if you’re just paying for more profits than you actually ended up getting, then your returns will be lower. That’s exactly what the long-term data show. But I think in the context of the current crisis, it’s interesting because people say GDP growth is going to be lower, and things are going to be so bad in the economy. That’s true, but if we look at data that I was just talking about, that doesn’t necessarily mean we’re going to have low stock market returns.

Robert Leonard (01:19:56):
I’m not sure how many podcasts go from day trading to Renaissance Technologies to Dave Ramsey. But that’s what we’re going to do here. Over the last six months or so I’ve actually been studying Dave Ramsey quite a bit. I’ve been reading his books and listening to some of his other content. I have a lot of people that ask me about it, so I’m trying to familiarize myself a little bit more. What is Dave Ramsey’s investing strategy, and what is your opinion on his approach for millennials?

Ben Felix (01:20:23):
I like Dave, when you listen to him, some things about him, anyway. He seems like a guy that I’d like to talk to about money and investing. His advice on investing is some of the worst advice that anybody could get anywhere from anyone. It’s literally at odds with everything. On every point that Dave makes, it is at odds with the academic literature. Suffice it to say, I don’t think that he’s given good investing advice.

Ben Felix (01:20:50):
His philosophy is that you should use actively managed mutual funds. Now, I’m not up to date on Dave, so if you’ve been doing research on him, maybe this has changed. But as far as I know, when I did my research, his idea is that you should use actively managed mutual funds, and he says that the high fees that we know actively managed funds have relative to index funds don’t really matter because you’re going to invest in funds that have strong returns. This is true. Fees don’t matter if you’re going to get a fund with really strong returns, but doing that, finding funds that are going to give you strong returns in the future is next to impossible.

Ben Felix (01:21:24):
I think that’s come up as a thread a few times throughout our conversation, but I’ll frame it a little bit more. So, there’s a paper in 1991 titled The Arithmetic of Active Management. This is pretty basic stuff, but it’s still interesting. We’re thinking about. So, he said, “If active and passive…” So, stock-picking, active management. And index type investing, passive management… “Styles are defined in sensible ways, it must be the case that before costs the return on the average actively managed dollar will equal the return on the average passively managed dollar.”

Ben Felix (01:21:51):
You think about it. Everybody owns the market, therefore on average, everybody has the same return before costs. After costs, the return on the average actively managed dollar must be less than the return on the average passively managed dollar. That’s just mathematics. There’s nothing fancy in there. It has to be true. If the average costs are higher for active funds, they must have lower returns than lower cost index funds. Actually, that’s 1991. There’s been research that’s come out since then as recent as 2019, showing that the other big factor that plays into that is that stock returns at the individual stock level have an extremely positive skew, which means that a very small number of stocks that exist on the market drive most of the returns. If you’re picking a subset of stocks, that skewness means that you’re much more likely to underperform the market that outperform, all else equal, if you’re picking stocks randomly. Now, if you’re picking stocks based on value and stuff like that, it changes it a little bit. But we can say basically that due to the higher costs, and I think lack of diversification based on [inaudible 01:22:46] comment I just made, most active funds should under perform, which is obviously at odds with what Dave is saying.

Ben Felix (01:22:52):
Then Morningstar, which is an investment research company that many people may be familiar with, they’ve done two different papers in the last 10 years where they looked at of all the funds that they have in their database, what are the criteria that determine success? If we can generalize, what are those criteria? Fees, in both studies, ended up being one of the most. So, the guy that did the report, he said, “If there’s anything in the whole world of mutual funds that you can take to the bank, it’s that expense ratios help you make a better decision. In every single time period in data point tested, low cost funds beat high cost funds.”

Ben Felix (01:23:25):
So, again, that’s at odds with what Dave is telling us. He’s saying, “Don’t worry about fees as long as you pick a fund with good past returns,” which is something we’re going to talk more about in a sec. Then in their followup report, they said, again, the expense ratio is the most proven predictor of future fund returns. This is a quote from the Morningstar paper. “I find that it is a dependable predictor when we run the data.” That’s also what academics fund companies and, of course, Jack Bogle, Vanguard founder now deceased, find when they run the data.

Ben Felix (01:23:51):
So, I mean, I think it’s safe to say that it’s very clear that fees are important, and I think it’s a bit irresponsible for Dave Ramsey be saying that they’re not. Now, Dave’s counter argument to what I just said is that all of that is maybe true if you’re picking an average fund, but Dave doesn’t think you should pick average funds. He says you should go and find funds with good track records and invest in those. Then they’ll give you better returns in the future.

Ben Felix (01:24:15):
So, there are a couple of sources we can look to to answer that question. One is the SPIVA Persistent Scorecard, which is a report put out by Standard & Poor’s, where they look at the five-year track records of funds and they sort them. So, they take the top quartile based on five-year track records, and they look at how they do for the next five years. That study from ending March, 2019, found that of the top quartile funds, only 0.7% of them remain the top quartile for the following five years. That’s four of the 569 funds that started the top quartile.

Ben Felix (01:24:48):
Now, that’s only looking at five-year periods. Maybe Dave Ramsey would tell me that’s not long enough because I think he says you should look for a longer successful track record. But if we look to the academic literature, Eugene Fama and Ken French had a paper in 2010 where they looked at the question of whether funds that have done well in the past continue to do well in the future, which is another way of testing if fund managers are skilled or if they’re lucky. If they’re lucky, then we wouldn’t expect their positive performance to be persistent.

Ben Felix (01:25:15):
They found in that study, this is a quote. “They found few funds have enough skill to cover their costs.” Then there’s another 1997 study by a guy named Mark Carhart, which looked at a similar thing. He found that the results do not support the existence of scaled or informed mutual fund portfolio managers. In both of those cases, they weren’t just looking at the returns of funds relative to a market benchmark. They were looking at it in terms of a risk-adjusted benchmark, and they were adjusting for risks in two different asset pricing models.

Ben Felix (01:25:46):
Fama and French were using their own model. Mark Carhart was using his model that includes momentum, actually. But the idea is basically, this is from an academic perspective, a bit of a butchering, but I think it makes sense intuitively. They’re basically testing if we compare the mutual fund to an index portfolio of similar types of stocks, did it still have excess performance that was persistent. Both of those studies were looking at that.

Ben Felix (01:26:11):
For example, we can think about a fund benchmark against the S&P 500. If that fund invests in small cap value stocks and outperforms, that could look like outperformance. But if we adjust for the fact that it was invested in small cap value stocks and compare it to a small cap value benchmark, that outperformance will go away. So, it’s a way of improving the benchmarking process to see if they’re really generating excess returns or just taking on excess risk to generate higher returns. Small cap value stocks being higher risk than the S&P 500, you would expect them to have higher returns, but if we benchmark that small cap value manager against a small cap value index, they may no longer have excess performance.

Ben Felix (01:26:48):
Now, I’ve seen some people speculate about Dave because he does show his mutual fund portfolio that has pretty good historical performance. I think some people have tried to reverse engineer what he actually holds, and some people believe it’s from a mutual fund company in the States that has relatively low fees and a pretty heavy value tilt, which, if he’s invested in that, that could explain why his funds have done well. Now, to be fair, he also doesn’t give us his statements to verify how well his funds have really done, but this is one of the things Dave says. “Look how well my portfolio has done. You can do this too, if you pick the same kind of funds.” But I don’t think he goes through the multifactor benchmarking that I just talked about.

Ben Felix (01:27:25):
So, I think fees are super important, which Dave says they’re not. He says they’re not because you can pick funds with good past performance that are going to have good future performance, and I think I just explained that that’s not necessarily true. Then the last piece that I think is really important is that he’ll hold up a piece of paper and say, “I have the list of mutual funds. I’ve got them right here, and I can see that 40 or 50% of them have beaten the market over long periods of time. So you pick the ones on the good side and that’s it. But forgetting about that, if it’s 50/50, that’s still a pretty good chance. Why would you not try and pick a good fund?”

Ben Felix (01:27:59):
Now, the problem with this, and it’s a big problem, is that when you take the list of funds that exist at this time, that list has a massive survivorship bias. You’re looking at the funds that exist today, but if we look over time, for example, in the U.S. for a 15-year period, 43% of U.S. mutual funds survive over… I don’t remember exactly what 15-year period this is, probably ending 2019. So, if you’re looking at a non-survivorship bias adjusted list of mutual funds, you’re looking at the list of funds that basically by definition have done well, because if a fund doesn’t do well, what happens?

Ben Felix (01:28:35):
Well, it loses assets and eventually it closes, and you don’t get to see it, the performance history anymore. When you adjust for survivorship bias, and there are reports that do this. So, Standard & Poor’s does a scorecard twice a year for that same 15-year period, they found that 89% of actively managed mutual funds have failed to beat their benchmark. That’s with a survivorship bias correction.

Ben Felix (01:28:56):
So Dave saying half of funds beat their benchmark, that’s probably true at a point in time based on the funds that you can go and pull up in Morningstar. But if we correct for survivorship bias and add in all of the funds that closed because I didn’t do very well, all of a sudden the number of funds that actually beat their benchmark drops a lot. So, anyway, taken altogether, I find Dave’s investing advice to be… I don’t know what I’d name it. I don’t know if disingenuous is the right word, because I think he really believes what he’s saying. But it’s wrong. I’ll call it that.

Robert Leonard (01:29:25):
I say it’s surprising. I mean, I agree with everything you said 100%, but just the only way that I can describe it is surprising. As I’m reading through his book and knowing his personal finance philosophies, it amazes me that he, one, wants active managed funds. Maybe it’s a [inaudible 01:29:42] bias or something where typically people who follow his personal finance strategies tend to like VTSAX and just index funds.

Robert Leonard (01:29:50):
Maybe I’m just making him seem like those people, but for me, it just seems like he would like just a simple, low-cost index fund for the longterm. That just seems like a Dave-type investment. So, to hear him talk, doesn’t it? But then you hear them talk about, “Oh, fees don’t matter,” and I’m like, “That just doesn’t go well with his personal finance strategies.” So, it’s a big disconnect for me. I guess, the way I would describe it is surprising and a disconnect.

Ben Felix (01:30:13):
That’s nicer than just calling it wrong. But, yeah, I agree.

Robert Leonard (01:30:16):
Well, I would agree that it’s also wrong, but you covered that for us both. Thank you so much for joining me again. Just like our last conversation, I really enjoyed this one, and we’ll definitely be doing this again in the future. For everyone listening today that wants to learn more about you and all that you got going on, where’s the best place for them to find you.

Ben Felix (01:30:33):
I’ve got my YouTube channel and podcast. We have a pretty cool community that we’re building around our podcasts, and by community, I just mean a discourse site, which is like a forum-type idea, I guess. I guess I’m in there a lot. In terms of responsiveness and answering comments and stuff like that, it’s hard to keep up on YouTube, but in the Rational Reminder community, I tend to be a little bit more present because it’s a bit more centralized. That’s it.

Robert Leonard (01:30:58):
I will be sure to put a link to those resources in the show notes. So, anybody interested in connecting with Ben, you can do that below. Ben, thanks so much.

Ben Felix (01:31:06):
All right, Robert. Thank you.

Robert Leonard (01:31:07):
All right, guys. That’s all I had for this week’s episode of Millennial Investing. I’ll see you again next week.

Outro (01:31:13):
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