Cliff Asness on Comics and Why Never to Share a Gym with Cirque du Soleil (Live at Mason)

Conversations with Tyler is produced by the Mercatus Center at George Mason University, bridging the gap between academic ideas and real-world problems. Learn more at mercatus.org. And for more conversations, including videos, transcripts, and upcoming dates, visit conversationswithtyler.com. Cliff is one of the most influential figures in global finance. He has a PhD from the University of Chicago. He studied there with Gene Fama, and he is a founder and principal of AQR Capital Management in Connecticut. So Cliff, when I think of your work, the very first word which comes to my mind is momentum. Could you first give us just the super short version of what is a momentum trading strategy?

Sure. A momentum investing strategy is the rather insane proposition that you can buy a portfolio of what's been going up for the last 6 to 12 months, sell a portfolio of what's been going down for the last 6 to 12 months, and you beat the market. Unfortunately for sanity, that seems to be true.

Seems to be true. Now, you call it insane, but if you were to give us a simple example, on average, statistically speaking, not in a free lunch way, but what kinds of supernormal returns might you possibly earn through a momentum trading strategy?

Sure. As one example, if you were running against large-cap US equities, something like the Russell 1000, and you bought the 1/3 of stocks with the superior 6 to 12 month returns, you'd probably make 100, 125 basis points extra long-term on average. If you do that in small stocks, it's more like 250 to 300.

And why is it larger for small stocks?

Almost anything we find in investing, almost any regularity, this tends to beat this, seems to be smaller— seems to be larger, excuse me, for small stocks. That it's not quite as good a deal as it sounds because the risk is also larger. Small caps have bigger fluctuations. People have a lot of theories— analyst coverage, Wall Street doesn't cover them as much perhaps, if there's whatever degree of inefficiency is in the market is larger for small caps, but it's a nearly ubiquitous finding. Anything Anything you find works in large caps tends to work somewhat better in small.

So if you have a— in terms of excess return— 100, 125 basis points compounded over 20, 30 years, obviously that's going to be a lot of money, correct?

Correct.

So what's the catch? What's the qualification? Why doesn't everyone here run out? They don't even wait till the talk is over and as an investment strategy follow what you have done with momentum. What's the trick?

There are a number of them. One hypothesis is I'm really not very convincing at all. Another is more people do it these days, and I'll admit, I think the strategy's gonna survive that, but it's a concern. It is not something every investor can do. I get this question from clients sometimes, and I go, "Are you gonna do it?" And they go, "No." And I go, "That's why." With that said, I think it is a fairly unintuitive idea. To some, it's very intuitive, just by what's going up. To someone who studies markets, particularly for Gene Fama like I did, the idea that you can beat markets— and we do more than just momentum, and Tyler, I promise— he's promised me he'll get to that. But it's a very unintuitive idea if you think markets are anywhere near highly efficient. And I think that dissuades some. And it nowhere nearly works all the time. One thing I should really be careful about, I throw out the word works. I say this strategy works. I mean in the cowardly statistician fashion. It works 2 out of 3 years for 100 years. We get small p-values, large t-statistics, if anyone likes those kind of numbers out there. So we think we're reasonably sure the average return is positive. It has horrible streaks within that. Of not working. If your car worked like this, you'd fire your mechanic. If it worked like the word— if it worked like I use that word. So I think it is harder than you might guess, even if something works long-term, to have it go away, because a lot of investors can't live through the bad periods. They decide why it's never going to work again at the wrong time.

So I think of you as doing a kind of metaphysics of human nature. So on one side, there's behavioral economics. They put people in the lab, one-off situations, untrained people. But here it's repeated data, it's over long periods of time, it's out-of-sample, there's real money on the line, and this still seems to work. So when you back out, well, what's the actual vision of human nature? What's the underlying human imperfection that allows it to be the case that trading on momentum across, say, a 3 to 12 month time window sorry, investing on momentum will work. What's wrong with us as people? What's the core human imperfection?

Well, this is going to be embarrassing because we don't have a problem of no explanation. We have a problem of too many explanations. Of course, we can observe the data. The explanations you have to fight over and argue over. I will give you the two most prominent explanations for the efficacy of momentum. The first is called underreaction. Simple idea. It comes from behavioral psychology, the phenomenon there called anchoring and adjustment. News comes out, price moves, but not all the way. People update their priors, but not fully efficiently. Therefore, just observing the price move, it's not going to move the same amount again, but there's some statistical tendency to continue. Take a wild guess what our second best, in my opinion, explanation for momentum's efficacy is. It's called overreaction. When your two best explanations are over- and underreaction, you have somewhat of an issue, I admit. But overreaction is much more of a positive feedback. It works over time, 'cause people in fact do chase prices. So if you do it somewhat systematically and before them, you make some money. One of the hard things you find out in, probably in many fields, but I found out in empirical finance, is those might be the right explanations, but they're not mutually exclusive. Remember the movie Highlander? You and I talk about sci-fi. Of course, yes. It ends up, they always say there can only be one. I use this tagline a lot and only 1 out of 1,000 people gets it. And then 1 out of 2,000 people laughs. That's not true in these things. There can be multiple explanations. Both of these things can be true. There can be underreaction and ultimately people can go too far. Very often in finance, There are two other, let me give you two other possible explanations also. Every empirical regularity, meaning something that works or is terrible with some predictability, it does so for one of three reasons. The worst one is complete accident. You've data-mined, you know, I sat there in my dissertation in 1990, I found this empirical relationship with a big T-stat, but I really checked 63 things, so the t-stat is a bit of a lie, and it never works again. Momentum, in my opinion, this is editorial, has survived 200 out-of-sample tests through time, different asset classes, so I don't believe that one, but to be intellectually honest, you never reduce that probability to zero, you just make it lower. As it works again, you go, chance you're just lucky's smaller. Second reason is a behavioral story. Someone out there is making a mistake. I gave you two. Underreaction and overreaction are both a behavioral story. They're both somebody out there making an error. Doesn't mean markets are terrible by any means. I'm a big believer in markets. But at the margin, they're making an error, and you take advantage of it. The third is risk. In a rational world, you get paid— momentum would work in a rational world if the short-term 6- to 12-month winners were in some deep —important sense—riskier than the losers. But they don't seem to be. They don't seem to be. Correct. They do show— there are terrible periods. There are so-called momentum crashes. But there are very good periods, of course. And those crashes don't appear to be particularly painful times. In the world of economics, it's not just that you have bad periods. It's when you have them. So I don't think people have come up with a very good risk story. But I'm not done.

But let me give you my intuition in favor of why it might be overreaction. And you tell me what you think. Tyler Cowen. So you receive a signal about the world. It's to some extent a private signal, and you over-interpret that signal, and you think it's a signal about the whole world, so you overreact. That leads to some price movement, which is propagated through time, but at least some people think past that 12-month time window, momentum ceases, and there's even a bit of price reversal. So eventually you learn that you've been overreacting by by thinking your private information is more general, more systematic than it is, and then things snap back a bit. And does that psychological hypothesis explain this mix of price reversal in the longer term and momentum in the shorter term? Do you think that makes sense or not?

Yeah, I'm going to go with that from now on. No, I'm kidding. Yes, it does. I think you're articulating a version of the overreaction idea. And one thing Tyler just referred to is, if anything, pride of place came before momentum and is a super important strategy to us. He's asking me about momentum because that was a very early part of my work in adding it to the lexicon. But value investing at a longer time horizon, buying what's cheap on pretty much any— price divided by something reasonable, price divided by earnings, book sales, just buying 5-year losers, 5-year stocks that have suffered, and selling or underweighting the opposite is also a very good strategy. Very much the opposite in spirit to momentum. Now, in the value world, they have the same fight. Does cheap beat expensive because it's riskier? I don't think they've done a very good job of identifying the risk, but I find it inherently more plausible that something priced to a long-term lower level might have a risk element to it than a much more short-term phenomenon like momentum.

And then there— But it could also be overreacting.

Of course. The second big one is behavioral. If people make errors of any kind, literally almost of any kind, value's going to work. Because if two stocks have the same fundamentals, if there's an error in the price, it's going to look more expensive. So you're going to dislike that one. And you're going to like the one that looks cheaper. One thing nice— and I don't think it's dispositive. And I think both momentum explanations can coexist. And by the way, there are other. I've given you my two favorites. There are other. One thing nice about the overreaction reason for why momentum has worked over time is it is consistent with the behavioral version of value too. If you're going to get overpriced or underpriced, one would imagine at some point you overshot something. Right. So it forms a nice integrated system.

Let me give you another reason why maybe overreaction is a possible explanation. In finance, I find it's one of the biggest puzzles. Why do people trade at all? People who are fools, people who are well-informed but not better informed than the market, people all over. They trade like crazy. It seems only a small percentage of that is liquidating funds to send your kid to college. That suggests people are systematically overconfident. If the fundamental human bias is overconfidence and that leads to overreaction, do we then have some kind of plausible— these metaphysical human microfoundations for why securities markets stay imperfectly priced?

I'm very pleased to get a promotion in metaphysical. That's much deeper than I've ever thought of.

A promotion or a demotion?

Ah, but I started out, I was never a pure efficient marketer. I was never a person who thought markets price things perfectly, nor is anyone, by the way. The paragon's, one of my investing heroes, academic heroes, Gene Fama, likes to shock the class at Chicago. Only at the University of Chicago in Gene's class could this be a shock line. But kind of day 3, he looks at the class and goes, markets are almost certainly not perfectly efficient. And this is University of Chicago with the godfather of efficient markets, so you get a, Anywhere else, you guys did not do that. You might notice that. And he's making a point that that's a very extreme hypothesis, that all the information's there. People individually make errors. Errors are not riskless for even informed people to arbitrage away. I think looking at the world, I share your intuition. I think it's backed up by the data that the most common error is some two kinds. And they're not exactly the same thing, but overconfidence and overextrapolation.

Are the two of us overconfident? Let's say someone on Twitter—

I can't answer for you. Underreact or overreact? I overreact, and therefore I'm overconfident.

If you tell your kids they can't watch their favorite TV show, they're going to—

You're destroying my entire self-image right here. Or overreact. My kids are probably more grown up than I am. Yeah? Yeah, but they overreact. They overreact. I can't find a lot of examples of people who underreact. I think this is— I'm picking up on your point here slowly.

This is my intuition. You look at these other areas, people at work, they're given positive or negative feedback, they may overreact more readily than underreact.

Let me take this another way. I think when it comes I think we are mixing overconfidence with overreaction a little bit. New news, people might be overconfident in how much they understand it. Yeah. But they don't seem to incorporate it enough. And there is evidence on this outside of just returns to momentum. People look at the actual news that came out, try to gauge what the reaction should be, things like that. I do think there are things we— when it comes to processing new information, I do think there is an underreaction in that sense, that anchoring and adjustment. People do all kinds of psychological experiments. You show people a whole lot of numbers and you show 'em numbers out here. They should move X, they move half X. They are overconfident that they are right. And I think that does lead eventually to the overreaction. I really do think, this is one thing that makes it very hard. When I go to academic seminars where people are fighting about this, there aren't many things in my life where I'm a peacemaker. If I see a fire, I'm, far more inclined to throw gasoline on it than water. But at academic seminars, this idea that there can be multiple explanations, I push at times. 'Cause there'll always be, you know, two people— they wanna win. Somebody has an overreaction, somebody has an underreaction story. Somebody says it's risk, somebody says it's behavioral. It could be both, and just to make our lives really hard, the mix of what's more important doesn't have to be the same at all points in time. And let me give you an example. I didn't start out a perfect efficient marketer. I wrote my dissertation for Gene on momentum. I was already showing a heretical drift at that point. He was quite good about it, by the way. The technology bubble, living through that, where momentum worked, but the other thing— we believe in many strategies, actually, but the other biggest, the second biggest one, the tied for the biggest one, is value investing again, and some of you Distressingly fewer and fewer look like you actually remembered it live. Too many of you read about this in the history books, something that one of my partners told me, I look like Lincoln before and after the Civil War from the technology bubble. To which I was like, we did well because we stuck with our value strategy, but we were nearly destroyed by it. And when he said that to me, I'm like, yeah, that's about even. Lincoln kept the Union together and ended slavery. I stuck with a value strategy. That's perspective for you.

So you need a lot of discipline to make momentum investing work, right? Because for 10 years, it might get you nowhere or even underperform.

This gets back to your earlier question. Why doesn't everyone do it? Why doesn't all this stuff go away? It is— any of these things, value, momentum, there are other things, quality investing, low-risk investing. So Fisher Black, the Black-Scholes option pricing model discovered in 1970 and that everyone forgot for 35 years. It's another effective systematic form of investing. If everyone did them, yes, they would go away. They work, in my opinion— again, using my word version of work— in kind of a sweet spot. Good enough to be really important if you can follow them with discipline, not so good enough that the world looks at it and goes, this is easy. They're excruciating at times. And I hate those times. I do not— I won't pretend I'm— neutral as to those times. But they help keep your market franchise. I recognize intellectually you need those times, while I will whine and cry horribly during those times. I'm not pretending I'm above that.

But momentum investing still works. I believe it. Today, stochastically. Yes. Now, if the momentum anomaly and the value anomaly— those to me seem like the two biggest anomalies in pricing theory. Does Eugene Fama admit you are correct?

No.

You have an academic record on this. You have a track record, right? Statistically and the success of your firm. OK. Will you try—

He's just trying to get me in trouble. I will tell you, I'm in public here. I'm with someone I admire greatly. This is going to be on the internet. I'm still more scared of Gene. So with that said, one of the scariest moments— let me take you back— was telling him I wanted to write a dissertation on price momentum. And I swear to God, I mumbled the second part, and I find it works really well. Because it failing is a perfect Chicago, Gene Fama, Efficient Markets dissertation. Look what these crazy people on Wall Street do. They make all these indicators and they're throwing away their money. To his credit, he immediately said, if it's in the data, write the paper. Now, we don't agree fully on it. We don't agree on two things. And for all I know, he changed his mind yesterday. But as of yesterday, I don't think we agree on this. Value investing, remember, I think works for a mix of both behavioral and perhaps some risk reasons. I think they're hard to identify, but I'm more than willing to say that might be a big part of it. I think Gene would say it's mostly or all risk. I don't think he's very positive on the behavioral explanation. Momentum, Gene's a risk guy. He's an efficient markets guy. I think Gene is still cynical about it. I know his latest, paper, he and Ken French write them, if not the best, among the best papers in finance. I read every one to this day. Doesn't mean I agree with every word. They started out with a so-called three-factor model about 20 years ago. What drives return on an individual stock? The market's return and your sensitivity to that. Value's return and how much of a value stock you are. Moment— not moment— size's return, how small firm effect it's called, and how small you are. They've added to that over time. They've added an investment effect of firms that, for instance, reduce their share count tend to do better, and there are theories as to why. And a profitability factor. All else equal, more profitable firms seem to outperform less profitable firms. And again, that's a very strong effect that holds up. I wrote a piece on our blog saying something— our factor model goes to 6. And for those of you who are curious, it was a reference to Spinal Tap, where our amps go to 11. I take the other side from them. I love these guys. We agree on 9 out of 10 things. I don't see how momentum is not their sixth factor. It adds a tremendous amount of return versus their model. The numbers I gave you versus— that you can add versus, say, the Russell 1000, 125 companies. Kind of basis points, understates the power greatly because momentum's also, in geek speak, negatively correlated with value. In English, a good year for momentum is often a bad year for value, and vice versa. That's easy to create if you just do the opposite with your left hand as your right hand. It's not easy to create two strategies that both go up on average. That's difficult. And that shows up statistically in a model. It becomes even stronger. I don't understand why. I think they should have it as a sixth factor. You'd have to— if you can get Gene to leave Chicago, which is far more difficult than anything else we're talking about, he can tell you why it's not a sixth factor. But it should be.

Let me ask you a question about risk, because this key concept comes up again and again in finance. Strategy may appear to have a high return, but risk adjusted, what are you really getting? Now when I read the very latest papers on risk, let me tell you what I see. I see talk of the third moment of probability distributions, the fifth moment, words like coskewness, terms like the U-shaped pricing kernel, and talk of the volatility of volatility. And I'm just waiting for a paper on the volatility of the volatility of volatility. When I read all this as an outsider, I conclude we don't know anything about risk. These are Ptolemaic epicycles. And within a pretty broad range of asset classes, is it possible risk doesn't really explain anything about asset prices?

True or false? The epicycles held up for a long time. They even got the little tiny movements right. That's not bad. Okay, of everything you said, a fair amount of those risk models I think are utter nonsense. I don't think the fifth moment— I'm gonna insult someone I care about now by accident. I don't even remember who wrote this. I don't think the fifth moment is a good measure. I don't even think skewness is— skewness is bad stuff. Even if something makes money on average, Occasionally really bad stuff happens more often than really good stuff. Co-skewness, which sounds like one of the geekier things Tyler Cowen said, very hard to identify, very hard to prove, very hard to isolate in the data, but co-skewness at least makes sense to me as a real risk factor. What that means is not only do very bad things happen more often than you would imagine, but they happen while other very bad things, largely the market crashing, for instance, If something has occasional giant losses, but those are at very good times, and makes money on average very reliably, that might stink occasionally, but it's something you can live with. If something is extremely bad at the same time everything else in your life is extremely bad—

Shotgun and can opener time, right? Yeah, exactly.

I use this example in a very different way. If someone says, what if we get something 5 times as bad? How do you invest if we get something 5 times as bad as the global financial crisis? And I say ammunition and canned goods. And I don't think there's a better answer for that. But I do think something like co-skewness, it's a geeky idea, I think it's very hard to establish and prove. And the data's not really even there. Momentum itself, and getting back to that one, has had what's called, it has negative skewness, the geeks call that a bad left tail, Nassim Taleb would call it a black swan event. It has standard deviations you're not supposed to see, big events. They have tended to be more, maybe this is luck, but they have tended to only occur in strong markets, not in weak markets. We don't like that, but we don't worry about that as much. To be honest, when it comes to value, Ken and Gene have never embraced this story. I don't embrace it either, but I give it some credence. Value, buying cheap and selling expensive, has a little better of a risk story on this front, because it has suffered empirically in the Great Depression, in the global financial crisis. Probably not enough. It probably is not enough to explain it. But that is the exact kind of measure of risk that should work. Does it hurt you— this is a terrible English sentence, and I apologize in advance— does it hurt you when it hurts to be hurt? Is the English language version of risk. And any good quant, no matter how geeky you make it, should get back to that. If it's a good measure of risk, it doesn't just hurt occasionally. It hurts you when it hurts to be hurt.

Are there still new and significant market inefficiencies to be found? Or has that lode been mined? I am. Are you the end of this tradition or just the beginning?

I think— I'm going to take a guess that there aren't that many. More? But some? I won't rule it out because, you know, once you're horribly wrong about this, hopefully you learn from that. I would have told you 10 years ago, I would not have guessed that low-risk anomaly— and this is the idea that stocks— and by the way, I use stocks as a shorthand. One kind of wonderful thing, and if we've done anything, if there's something I can brag about, a lot of these things we've participated in the research. We've written the leapfrogging papers. We have been early in saying, let's go look outside of stocks. Let's go look at bonds. Let's go look at currencies. Let's go look at commodities. The things I'm talking to you about in somewhat different forms work, work for all these things. But let me talk about stocks because it's the easiest. It's the most common language. Stocks that are low risk, backwards to theory, right? Risk should get paid. Right. Stocks that have low betas, low volatilities, low fundamental risk, like low leverage, outperform in a fairly strong way. Fisher Black found that. If anyone wants to be masochistic and ask me why I tell you about leverage aversion and the fact that no one does what you're supposed to do in theory, but low risk outperforms. Another one is profitability. This is a real anomaly. Stocks out there that make more money and make more money consistently. Nothing about price. It's not a value factor. More money divided by their book value, scaled by their sales. Outperform.

You mentioned Fisher Black on leverage, just to pursue that a little bit. So Fisher thought, and maybe you seem to be agreeing with him, it's another human imperfection that at least some of us are too afraid of leverage because we could borrow some money, buy some typically low beta stocks, and actually improve the quality of our portfolio. And that's something else which doesn't quite happen as much as it should, and that seems to be almost the opposite of overconfidence? Well— Is it just debt aversion? We were brought up, don't get into debt.

I think it is some debt aversion. It also might be less irrational and more constrained. There may be people who just can't. Mutual funds can literally leverage a little. Most have in their charters, we won't leverage. So if you're constrained, you have to do something. Let me step back. I'm going to draw on my hand an efficient frontier. I promise you it is a perfect artistic rendering. Many of you I know have seen it before. If you haven't, on the x-axis you have risk, on the y-axis you have expected return. Everyone in the world wants to move up to the left. You want less risk and you want more expected return. Kind of third week of finance class they teach you we should all agree, of course we don't, but we should all agree on the best portfolio of risky assets. We should all own the same one because it's the highest return for risk. Those of us who are aggressive should apply some leverage to it. Those of us who are not aggressive or conservative should deleverage, add cash, make it less risky. Why do you do that instead of simply moving your money from low return to high? Because you have to get undiversified. If you move your money from low expected return to high expected return risky assets, you lose diversification. Ultimately, if you want as much expected return as the best asset out there, You have to be only in that asset. Applying leverage to the entire portfolio, you maintain the benefit of diversification. What Fisher showed is imagine leverage was very costly, or just no one would do it. He points out that low-risk assets are orphans now. Low-risk assets function in a portfolio in an important way to make your return for risk better, but they often don't make your top line better. They don't literally make you more money, They make you more money for the risk taken. That's very boring if you don't apply leverage. You don't make more money. Most people are interested in some version that makes them more money. And Fisher showed that if that's true, which I believe it is, and I think he was right, those assets that are orphaned will be a little too cheap because no one wants them. And people who want to be aggressive will a little too much be willing to be undiversified. And again, leverage is not riskless. The perfect theoretical world, Not everyone should lever to the moon if you're very aggressive. But neither is concentration. Neither is moving your money into fewer and fewer assets. We don't tell people leverage is riskless. We do tell people we think people think it's over-risky versus concentration. So I don't even know if it's risk aversion versus another. It's risk aversion. It's more, I think people do misappropriate the risk of one thing against another. Maybe it's neither a borrower nor a lender be, your idea that people are just taught Leverage is bad, right? But I think people prefer concentration risk to leverage risk, to their detriment.

Let me ask you a very practical question about today's markets. Like myself and like Scott Sumner, you're pretty skeptical of the concept of a bubble and just going around and calling everything bubbles. But your most famous piece is called "Bubble Logic." There can be bubbles. They may be hard to identify. So if you were pressed today in the world, the US, the global economy, if you had to pick what is most likely to be a bubble Are you willing to give us your opinion? Yes, and it's incredibly boring.

There's nothing I feel is very, very likely to be a bubble. There are—

But there's always a winner in any— or loser in any bubble. All right, if I had to pick one— Had to pick one.

If I had to pick one, and it's still going to be a different kind of cop-out, it's a diversified portfolio of stocks and bonds. And let me take you through it. OK. Versus history, on the measures I like, one of the most famous ones— we look at a bunch of different measures— is Bob Shiller's Cyclically adjusted PE. It's price divided by a long-term rolling average of earnings for the S&P 500. You like low prices. You don't like high prices. That number is more expensive in roughly 90% of 100-some-odd years, plus years of history. That is a terrible forecaster for the next month or next year. Do not do anything. That is not just a legal, it's a human disclaimer. But over the next 10 years, nothing's perfect even over 10 years, but it's statistically powerful. When things are expensive, you've made less money. When things are cheap, you've made more money. Bonds are the same idea. Another measure for bonds is very analogous to a P/E for stocks, is the yield on a government bond minus economists' forecast of inflation. People call that a real yield. It's what you should care about. The nominal yield doesn't really matter. It's what you consume in. That is worse, lower. This is a yield, not a price, so lower is bad. But that is worse than roughly 90% of history. The portfolio of half stocks and half bonds, if you take those two measures, scale them, and combine them, is the worst ever. How is it the worst ever when the two are 90th percentile? Well, I think you all have probably figured it out. They're not usually 90th percentile bad at the same time. That's— it's a bit of a puzzle why they are, but they are. Having said that, Tyler, I'm still going to be a coward. We get to about the worst ever. We've hit this level before for the portfolio. I used to think 100th percentile is pretty impressive in my career. Now you never go past the 100th percentile. You're, you're a math guy, you know how it works. Math guy. But I will tell you, not all 100th percentiles are equal. If you are the 100th percentile today, but you're higher than— but you're 150% of the prior 100th percentile, excluding the last couple of years, that means you've shot off to the moon. In the technology bubble, the Shiller CAPE was probably 50% higher than it had ever been if you excluded the period right around that. Japanese stocks in '89, '90 got to levels. Like that. You might call it an inverse bubble. I think US stocks in the early '80s maybe got to a similar extended, well past anything we've ever seen on the downside in the very early '80s. I was willing to call those bubbles and did real time. I wrote that piece you're talking about. Because we spent a lot of time— still a subjective measure, but my measure for using the word bubble— remember, I'm a Gene Fama student. He hates the word bubble too. Bubble is an inefficient market. Phenomenon. I will use it, but I hope I have a higher standard than many. Many in our field have, I think, dumbed the word bubble down to mean something we think is kind of expensive. That's not a bubble. A bubble to me is something— still subjective, because your answer might not be the same as mine— but it's something that I have tried my best to come up with future assumptions of growth, be it for a stock, inflation if it's a bond, and current price And I can't come up with assumptions that would lead any rational investor, subjective again, to wanna own this. When we did that for stocks, anywhere late '99, 2000, we assumed very aggressive future returns. We took Wall Street's long-term forecasts, which were nuts, they had never been achieved before, current prices, and we came up with, if that happens, we make less than bonds. We were willing to use the word bubble now. Right now, this 100th percentile, US stocks and bonds, So you invest half your money in stocks, half your money in bonds. Historically, you've made about 5% over inflation. We think it's priced now at this level to make about 2.5% over inflation. Rather than 5%. Rather than 5%. Is that a bubble? I can't prove to you that that's a bubble. That's an expensive market versus history. So most likely, when you take a whole bunch of expensive things and they get very expensive when you put them together, you are right. You always can pick a most. But if you ask me the follow-up question, do you think it's a bubble? I will say no, I think it's an expensive market. But a bubble is something where you say this cannot last. And I would not say that.

Let me tell you my biggest worry. Maybe you can set me at ease on it. I'm not ready to call it a bubble, but bubble related. I look at the carry trade. Companies especially in emerging economies borrowing in US dollars, typically at quite low rates, and forgetting a bit about future currency risk or future revenue and growth risk on their side.— and there being this extreme flow of liquid financial capital into those companies, not really quite backed by forthcoming realities which will match to the expectations behind that borrowing. I'm not sure exactly what's the single asset price here I want to call a bubble, but that's my biggest worry, where I think maybe the market isn't pricing that whole combination correctly. Now, are you less worried than I am? I am.

Less worried than you are. It's hard for me to know how metaphysically worried you are. Not that worried. But emerging markets, on that same measure, just looking at the local stock markets, not the carry trade per se, but you think if that flow was gigantic you're talking about, it would show up on the same kind of Shiller CAPE numbers, are considerably cheaper than US or even Western Europe. So you might very well be right. But again, even though I'm the bubble guy now, I'm the momentum guy, I think as people who try to beat the markets every day for a living, I'm a startlingly strong believer in efficient markets relative to the norm. I think what you're saying has truth to it, but maybe largely in prices already.

A lot of people from the hedge fund world, they speak to me, they say, Tyler, interest rates are out of bond prices or a bubble, because right now the low rate, of course, is at zero. It's not going to go down much below that. It could go slightly negative. And there's a fear that right now we're living in the world's biggest bond bubble. Now, personally, I don't think this at all. But what's your opinion? I have to be—

I'm going to be real careful again. I do not think the word bubble is justified. So that's not careful. That's overly bold, actually. Having said that, I got to be clear. When I say I don't think it's a bubble, it doesn't mean I'm saying this thing is great. I'm saying— when I talked about bonds, I said they were more expensive than about 90% of recorded Actually, the low '90s. Now, that is not a commercial for forward-looking bond returns. That is saying I reserve the word bubble for something that cannot work out. And I sit down and I go, well, how would it work out for a bond investor? It's very hard to work out for a cash investor. You got me there. But cash is largely— it's a government set rate. It's not a market rate.

And it has other services, right?

Yes. But bonds, how would it work out for a bond investor from here? We look at these ridiculous, you know, 2%-ish kind of kind of nominal yields. And for me to come up with a scenario, not a prediction, not saying I think it's a good bet, but a reasonable scenario that could happen in the next 20 years, for instance, for workout, I need one word: Japan. Wasn't that hard? Sure. I, I, I, I, if, if your standard is like mine, is a bubble is something where you can't really come up with a plausible scenario where this investment might work out, it's proof by contradiction. We just ended it. I think it's an expensive asset. I think equities are actually shockingly similarly expensive. I think people focus on bonds for a bunch of reasons. They focus on bonds because the yields seem much more measurable. I think equity valuations, things like Shiller's CAPE and many other measures are actually about as good for forecasting equity returns as bond yields are long-term for forecasting bonds. I think the last 20, 30 years equities look better versus bonds than they have in a while. But that's because the tech bubble dominates a lot of the last 20, 30 years. Over the last 100 years, we actually find— we're picking on bonds— we're nervous because multiple asset classes look not bubblish, but pretty darn expensive at the same time. That's what worries me. And that also leads into if a lot of the world, be they institutions that need formal forecasts of what they're going to make in their portfolio, Or my dad, my dad is planning his retirement 30, 20, 30 years ago, always had the same sheet of paper and he never showed it to me, but it was how much I need to retire. And I'm pretty sure it was off by a factor of 10, I don't know which direction it was off on. My dad was a trial lawyer, it skips a generation, I was not math, he's not a math guy, but I'm sure he had how much I need to live on, what I think I can make on my money, and the number that fell out was how much he needed to retire. People still do that. Institutions do it very formally. They make forecasts of what they're going to make in their portfolio. And I'm sure there are a lot of my dads out there, they probably use a spreadsheet now. If they're using anything like history, and if we're right that high prices on both stocks and bonds lead to lower than normal returns— doesn't have to be a bubble, we don't need to see a crash, we don't need to see it fix— but they're using too high of an assumption. It's a problem going forward, and it makes the whole retirement problem a bigger problem.

We're going to come back to finance, but there's a segment of these conversations always where we do overrated and underrated. So I toss out something and you give me a short answer. Is it overrated or underrated?

We already have a problem. I'm not good at short answers, but okay.

Bitcoin. Correctly rated. Correctly rated. In science fiction, the author Robert Heinlein.

Early stuff underrated, later stuff overrated. And what's your favorite? That is a really— Malthus' Children. Ah, good pick. I could have gone with the obvious. I'm a bit of a libertarian. I could have gone with The Moon is the Harsh Mistress as his most famously libertarian book.

It doesn't age so well.

No, I like Malthus' Children. Ben Bernanke. Fairly rated. Fairly rated. Actually overrated by half the world dramatically and underrated by half the world dramatically. That might be partisan. Reality TV. I know I'm modifying it every time. I'm destroying the spirit of your question.

That's fine.

No, no. I used to think horribly overrated. I never watched any reality TV. I have 11 and 12-year-olds and we watch Shark Tank, a reality TV business show. We watch the old Survivors, which is basically teaching game theory to 11-year-olds in a sneaky way. This guy's doing this so this guy doesn't. It's, um, so I, I now, I, I, I will say fairly rated and much better rated than I, than I gave it credit for in the past.

Now, you've told me you're a hockey fan. Wayne Gretzky, overrated or underrated?

Oh, he's massively highly rated and still underrated. And what do people miss? People miss— I think hockey fans don't miss this, but the general public misses that he was a guy who was undersized, less fast, slower— we have a word for less fast— than other people. And this is cliché sounding, but people always used to say he was a humble guy. People would say this about him. He skated where the puck was going to be, where everyone else was skating where the puck was. And having watched him, I just think it was true. I don't know how he got that ability. It's a mutant ability, but he had it.

A bit like a momentum investor. Yes. Now I'm interested in this issue, as I think you are, extreme performances or performers, and it's measured most readily in sports. So Gretzky is a kind of extreme outlier. In basketball, you could say Kareem Abdul-Jabbar, who will be in the series, is an outlier, maybe Michael Jordan. In sports or some other area of your choosing, which is the extreme outlier which strikes you as the most amazing, and you just say, oh my God, I can't believe there's Wayne Gretzky, or fill in the blank there for me, other than Gretzky?

I have no sense if this is actually accurate, but I'm gonna go— actually, no one could measure this, it can't be accurate. You're not gonna believe what I'm gonna say. Cirque du Soleil. Please explain. When I sit there and watch Cirque du Soleil, which both my wife and I like, I literally walk out and go, nobody can do this. And I don't think they're cheating.

They're not cheating, right?

And what is— Go watch it again. It's like a Looney Tunes show where Daffy Duck dives from up there into a little thing of water down here, and he doesn't die. I don't know how they do it. Everything else, the crash of '87 was a 20 standard deviation event, nothing. Wayne Gretzky, pretty good. The Cirque du Soleil people. Off the charts. This story was from Vegas and it's not staying in Vegas. But I was in Vegas and I was exercising. And I know you find that hard to believe, but I was. And the Cirque du Soleil people were in the gym. And you don't want to ever do that. It is one of the most demeaning, humbling experiences. They exercise exactly as you— they did this thing where they just keep leaping over each other. And they go around in a circle. And they did it for like half an hour. And I'm sitting there on the StairMaster on a 3.

Spider-Man versus Batman, who wins and why?

Batman wins every time because unlike most superheroes, he cheats violently.

Superman races with Flash. They both travel at the speed of light, yet Einstein tells us there are no simultaneous events. Who wins?

I'm going to ignore the physics, much as the comic books do. This is actually a pet peeve of mine. I'm more of a Marvel Comics than a DC Comics. I know everyone wanted to know that in the audience. DC is much better now. But when I was a kid, they exaggerated all the powers much more. Marvel had realistic superpowers. You could run at 500 miles an hour, not the speed of light. DC would go at the speed of light. You have no idea. You might, actually you might, but— This is one of the things comic geeks will fight about. And they've had this about 5 times in the comics. They've had races between them, and of course they try to cheat and make them a tie. I know why you tried to come up with that. I subscribe to a theory that is on the internet. It has a name, I've forgotten the name, but it's a documented theory. But it says the Flash should win 'cause the specialized power should win. I agree. And it, but what I like— I like it.

It's the portfolio theory, in fact, right? In equilibrium.

Portfolio theory, comparative advantage. Absolutely. Though it has a little bit of a, the world must work out fairly notion to it. The world does work out fairly, right?

Long term. Long term. Very long term. Mutual funds, overrated or underrated? Oh, we run mutual funds.

This is a hard one. All right, I'm going to be— Other people. I can't be fired, so I will go overrated. Active management, I think, is overrated. I believe certain things can win. I've talked about a few of them, but on average, I think people try Too hard to beat the market and pay too much for it. I love if people listen to me. I believe in what I'm saying. But if you go spend your life listening to a man named Jack Bogle, you won't do terribly.

Super practical question. You're sitting in this room or listening on YouTube. And let's say your income is 2 or 3 times the national median. So you can save some money. But you cannot operate investment at a significant scale. What's the mistake those people are most likely to make And what should they do to stop making it?

They're— this most likely is a hard one.

You already said it. In expected value terms.

Overtrading. And I don't mean— not everyone, very— in fact, I'd say a minority are daily stock pickers watching the market. But there is this phenomenon that I still want to look into more because it's a method. Somebody has to be making this money. No one's ever— this is going to sound stupid— no one's figured out who's making the money. But Jack Bogle quotes these numbers a lot. There are all these paradoxes where the average mutual fund investor seems to get out and in at the wrong times. They're— remember I talked about value and momentum? Of course. I like to call them— it's a geeky phrase, maybe I'm the only one who likes it— they are momentum investors at a value time horizon. Remember I told you value works long term? You have to hold 3, 5, 10, 5 years. Momentum is a 6- to 12-month horizon. If you're going to beat momentum, you've got to really do it. You've got to be disciplined. You've got to come in every day. And you've got to count on these under- and overreaction things. If you wait 5 years and buy what's worked for 5 years, you are not— you can call that a negative value investor or a momentum investor working with the wrong numbers. And I do think that is one of the things people do too much out there. It's probably the biggest. Somebody's making that money. Maybe we're making some of that money. Maybe that's the flip side of our— it's very hard to track. So I don't think anyone's done a great job of nailing where that money lands. But I think if people came up with good strategies and somehow disciplined themselves to do far, far less— and the worst case is if someone— I don't think many professional traders can make money trading in and out constantly. I think pretty much Nobody, in an expected sense— of course, some will get lucky— should do that casually. So if you're doing that, you're making a giant error. But if you are, if you're even looking at it and going, I used to like this, but the 3 to 5, it's been tough, get me out. If you're getting out because you feel sick to your stomach about it, you're making a mistake.

What should we do— and here I'm leaving the we deliberately ambiguous— to make securities trading more just, more fair? And you can pick the way you want.

Well, just and fair, this is loaded terms, of course. Deliberately loaded. You know, a finance guy comes in here and starts being wishy-washy about the terms just and fair. You get this deliberately. I'm worried already. I don't know if I'd call this just or fair, the fact that people make this error. They're hurting themselves. I don't really attribute a value judgment. I wish they didn't. It would probably cost us some money. I think the world would be better off, but I don't know if that's just or fair. I think the world has gotten more just and fair, and I'm gonna say something potentially controversial, something that is often attacked, high-frequency trading, has made the world more just and fair, particularly for small investors. High-frequency traders have, I watched the Republican debates last night, so I know to change the topic to something I'm comfortable. With. They do a lot of different things, but the core trading strategy is just to do the other side of whatever you want to do. So if you want to trade, sell X, they'll buy it from you, and they charge a little thing called the bid-ask spread. They will buy it from you for a little less than they'll sell it to you for, and it's very competitive. They fight with each other to do your trade, so they can't just charge any bid-ask spread they want. That is always, but they get attacked 'cause they charge a bid-ask spread, and when you ask them to do a lot, they start moving the prices. Because they're getting scared that you might know something they don't know. But we've always had to trade with someone else. We've always needed market makers out there. Used to be much more expensive, worse bid-ask spreads, worse execution, particularly for the small person. There's some controversy with high-frequency, I mean small investors, not literally small people, you know that, right? For very large investors, you're trading large amounts of money. I believe high-frequency has made our trading costs cheaper, but there's at least an argument for the other side. Some will say market impact, what's the price moving on you when you try to execute and buy or sell a lot of a stock is bigger now. I don't think so, but that's a fair argument. There's no argument for the little guy. What you worry about in trading is something called front-running. Someone figuring out what you're doing and doing it before you. There's the illegal version where someone actually gets a peek at what you're doing, which they're not supposed to get. And then there's the completely legal version. People notice trades occurring and prices moving and think, "Oh, I better get in front, maybe this is a wave." There's nothing illegal about that, but it still costs you money. No one bothers, no one front runs a small dollar investor. And it's not because people are nice and kind and care about, there's no money. You wanna rob banks, not people. No, so there's no money in it. So the small investor, I think, unambiguously has a fairer, cheaper world. Now, I'll dig myself a hole. I don't think they should trade very much. That was our earlier question. Of course, overcom— So just because it's cheaper doesn't necessarily make them better off if cheaper induces more trading. That's an entire different— but they're getting cut a fairer deal by Wall Street. Whether they use that to harm or help themselves, open question. But I think they're getting cut a fairer deal than they used to.

And high-frequency trading, it's getting us back to Superman versus Flash, right? You like that question.

No, well, I have made this observation many times. It's literally the only part of my field where the speed of light is relevant. That's right.

Hedge funds. Your company is much more than a hedge fund. You've written a lot on hedge funds. You know them very well. For most people, is it worth it, the data on hedge fund returns? I've put a lot of time in trying to find out what is actually the net return, forget about the risk-adjusted return, but just the net return, how much comes from linear, nonlinear strategies, it makes my head spin. It confuses me in the kind of way where as a naive outsider I get a little scared. What should I think of hedge funds and how good they are? Overall, again, not a question about what you're doing. Sure.

But in the end— I will try to separate those two. It's hard sometimes. I think if you have to go buy one of every hedge fund that will take your money, which is a subset, of hedge funds, some of them are closed, you'd probably be better off figuring out what their average exposure to the stock market is and go buying an index fund. That's gonna get me into, I live in Greenwich, Connecticut, where in some parts of the world, if you said, my daddy runs a hedge fund, they say, what's a hedge fund? In Greenwich, Connecticut, the kids say, what kind of hedge fund does your daddy run? So is he event arbitrage or trend following? What does dad do? So I'm going to be persona non grata. But I think hedge funds— and this is a lot of complexity to this answer— they're a universe of very smart people. They are doing some good strategies. Some I've mentioned to you already. They seem to have grasped the momentum strategy. Not so much value, oddly enough. But they seem to definitely incorporate the momentum strategy. There are so-called arbitrage strategies. They don't use the word like academics. Academics, or almost academics like me, use it to mean riskless profit. They mean a trade that has reliably worked over time where they go long and short fairly similar things. They are clearly not riskless. But something like a merger, A is buying B. If the deal closes, it's gonna go to here. A's gonna fall and B's gonna rise. The day it's announced, it only goes to here 'cause there's some chance this deal doesn't happen. Antitrust, the market, shareholder activism, somebody else. So what the merger arbitrageur, and my finest achievement today is saying that word in front of you, that's a hard word to say, buys B and sells A, and if it happens, they make a little money, and if it fails, they lose a lot of money. Now I'm dying to do this, I have not done it yet, I've talked about it for about 2 years, I'm about ready to try it, I wanna ask one of my 2 older kids, they're a set of twins, they're 12 years old, Does this sound like a good idea to you? I'd have to hold their attention throughout this whole thing. And I think there's about a 98% chance they say, no, that sounds like a terrible idea to me. You can lose a lot, you can make a little, who wants to do that? I'd be the proudest pop on earth if either of them kind of paused and said, how often do both of those two things happen, Dad? 'Cause that's the proper question, right? It turns out if you do this rather, with zero skill, you just do every merger that ever comes along. Maybe you can do better, maybe not, but you just do this every time. You've made a lot of money over time. You get killed occasionally, you're basically selling insurance. When the deals don't happen, you lose a lot. Hedge funds have figured that out. There are a lot of other things they've figured out like this. That's the good part. The bad part is they do not, as a group, and keep in mind, this is self-serving, but we run things people would call hedge funds. Not all of our business by any means. We think we're not doing this, and we don't think we're the only ones giving clients a fair deal. I'm talking about the industry as a whole doesn't hedge enough. I know that sounds stupid given the name, but if anyone likes geek numbers like correlation, for the last 7 years, an index of hedge funds has been about 0.8 correlated with the S&P 500. That means if you tell me what happened to the S&P 500, I got a pretty good idea what's happening to hedge funds. The word hedging almost by definition refers to removing that risk, trying to create returns that go up on average, but at different times than stocks, 'cause you can get that again from Mr. Bogle for about 11 basis points, near a 10th of a percent. They don't hedge enough and they charge a lot. I will never, you have a shot, Tyler, I don't have a shot. I will never get an economic law named after me. I gave that up when I went to try to make money. But if I got one, I want it to be, there is no investment process so good that there's not a fee high enough that can make it bad. And I do think hedge funds don't hedge away a lot of the risk and return you can get much cheaper elsewhere. And then simply, on average, broad strokes, I'm insulting some people unfairly, including myself, but they charge too much.

Here's a historical question, but it can be about recent history. Who is the individual who has done the most to promote liberty who is undervalued in this regard? Ooh.

Has to be someone fairly terrible in my mind, 'cause it has to be a counterexample. I'm gonna go with Joe Stalin. Please explain. It's a pretty good example of what happens when you don't have it. Some of us might think it's a more relevant example than others. I'm not revealing anything that you might not know. Sure. But I think counterexamples are probably more powerful than anything else. That counterexample of what happens when you take liberty away, I think will be with us for a really long time. And I don't think we're near there yet. I might be a raving lunatic, but I'm not that much of a raving lunatic. But I think I wouldn't have wished it. You know, it wasn't worth the cost, but he's helped the cause of liberty.

Thank you, Joe. The contrarian answer. What's the side of Ayn Rand's philosophy that you feel is weakest?

Economics. I don't mean— I'm gonna get so— I'm gonna get yelled at by every libertarian friend I have on earth. I've never been a very big gold standard. Person. I respect it. I respect it. I have friends who are fanatic believers in it. I don't think it would be the disaster that a lot of people— but I don't think it cures all ills. I have a lot of friends who I agree with who'll say we have too much regulation. I'll go, check. I go, we have a Byzantine crazy tax code that often— it's not just that they're high, they create a lot of odd incentives for trade-offs that shouldn't exist. I'll go, check. We should have hard money, no check, and they think that would fix everything. I don't fully get it. And Ayn Rand, she basically— the name of her philosophy was Objectivism, and she just told you it was objectively right, that gold is the standard of value. I think she's kind of unkind to silver, frankly. You have succeeded in getting me making fun of Ayn Rand. That's very impressive. But when I read— when she ventures into economics like that, makes very bold, strong statements.

I don't agree with them all. And what's her most underappreciated side or aspect or angle?

You know, let me turn, try to make, again, I'm gonna try to flip it around. I'm gonna, I don't think she was as anti-helping people as she sometimes comes off. If you read her talk about it, she certainly, I disagree with her on this, by the way, She didn't consider charity a primary virtue, but she didn't have a problem with it whatsoever. She says you're— she considered the individual sovereign, and if that's important to you, do it. I think it's a larger virtue. Benevolence, charity is one of the things in her world, and I— my favorite thing, which you didn't ask about her, is just you own your own life. It's one line. I'm in love with that. But the idea of a virtue being the desire to help other people, not someone forcing you to, which she was dead set against, but wanting to help other people, I disagree with her on. But I think people come off, think that she's snarlingly against it. I don't think she was for it enough, but I think she was rather passive and said it. You know, if you care about it, she talked about examples, giving up your own life to save someone else. If you value that person more than yourself, It's rational. Do it. So I don't think she was quite as nasty about that. Nastier than I think she should have been, but not quite as nasty. I know you just a bit. And she could have used an editor. I admit that.

Absolutely.

Come on. Come on. That speech, oh my lord.

For this conversation, I read all of these papers of yours, right, which is the tradition. I've read your Wikipedia page. I know you not well, but some modest amount. What is there in your life that's influenced you that I would have no idea about from what I've read by you and about you? What's the hidden influence on Cliff Asness that I don't see, maybe others don't see?

That's a hard one. I was probably wrong about this, and my parents are gonna get mad at me, He was mad at me. But we weren't, we were by no means, I'm not telling a poverty story. I love Marco Rubio, but if I hear one more time about the frigging bartender. His dad's a bartender. It's a wonderful story, but it's in every answer. But we grew up decidedly middle class. And my dad, well, he was a trial attorney. And he had a job where some years he made a fair amount of money and some years he made no money. And my parents shared that. Way too much with me. I've told him that I had a sense of impending doom as a child that I think was oddly a positive for achievement. It made me very focused on not being nervous about those kind of things. But it doesn't make you a happy, relaxed person and is impossible to turn off after it's no longer useful.

There's a literature by Ulrike Almendier— you may know these papers— which try to argue that the risk premium in a given generation depends on exactly what economic conditions they grew up with. Do you think this is generally true or just about you?

I've written probably a much more empirical paper on precisely this idea. I promise I'll get there. I'm going to get to the point. There's this idea, something called the Fed model for valuing stocks, that says when interest rates and inflation are low, you should pay a higher P/E. For stocks. In theory, it's a very weak model because it deals with what are called nominal interest rates, not real interest rates. And unlike bonds, when inflation's low, you expect earnings to grow slower. Forget all the math. There's this puzzle that the world seems to follow the Fed model. They price stocks according to it. It's a very strong empirical regularity. When interest rates are low, those P/E's are higher and vice versa. Though they do vary. One thing we found, I wrote this as a Financial Analyst Journal article circa, I wrote one in 2001 and a follow-up in 2004, that how much more they demand in return or how much cheaper they need stocks to be, when they're cheaper, they return more, how much excess return they need on stocks versus bonds is a function very strongly of the last 20 years relative volatility of stocks and bonds. In English, if I called 20 years a generation, I didn't monkey around with that too much, I checked, it works for 10 years, it works for 30 years, it's not cherry-picked, but if the last 20 years had experienced a wild ride on stocks versus bonds, they demanded a very high return going forward. See, I got there, if you didn't notice. I've written on this, I believe it. You can't make a lot of money, by the way, trading on 20-year. Phenomenon. You know, clients don't really enjoy the whole, "Well, I've been wrong for 19 years, but give me one more year." But I do— I never give the short answer, but the short answer is I found the same thing myself. I think it's directly reflected in the numbers. And I think people are somewhat a prisoner of their experience.

Last question from me before we get to questions from the group. If policymakers could understand one thing better about financial markets, that they don't understand now, what would you want that thing to be and why?

I'd want them to understand that any form of near certainty without certainty, anytime you convince the world that something is a certainty, but it's not, is the most dangerous time humanly possible. I'd look back at the financial crisis and the key moments in it. A lot of arguments. I'm not even going to get into the partisan arguments. The right says government did it. The left says Wall Street did it. Great shocks. You know what did it? If I had to pick one thing, one primary cause of the financial crisis, the assumption that real estate prices can't go down. The government made this assumption. The so-called— people will say these terrible quantitative models were way off. At the end of the day, somewhere in this giant model, in 1,000 lines of computer code, there was, what's the worst case 10-year return for real estate? If that worst case was not losing money, that's garbage in, garbage out. You can have the best model in the world, that's a problem. When Lehman failed, we went into a huge spiral because people were pretty much convinced that the government wouldn't let anyone fail. When money markets, when the famous Reserve Fund broke the buck, money markets is supposed to return you a dollar for a dollar. It's always been a fiction, by the way. You've been lied to. For years. Money markets own portfolios of short-term bonds that move in value. They allow them to round to only, I think, two— I could be off by a decimal place— to only two decimal places. That's not a lot. Two decimal places for short-term securities means most of the time, almost all the time, it rounds to a dollar. Therefore, there's an illusion. But they're risky. That is, to me, a very dangerous asset, because it tells people there's no risk when they're actually is risk. I'm not saying you have to go out a billion— no one wants an NAV— what's your NAV? Pi. No one wants that. But it's so short, it artificially looks stable. And when you tell the world there's risk in something and then bad things happen, it's not fun. It's still bad things. But they tend to deal with it much better. Many people have observed the internet tech bubble that I keep talking about, when that came down, the economic consequences, the threats to our system were far more benign. And I think that's because no matter how crazy they might have gone, nobody thought they were utterly riskless. They didn't act as a group as if there was no possible problem. Equity losses are expected, bond losses are not expected. So I will say this, if you truly can take all the risk out, great. If you tell everyone it's risky and it's risky, great. I think the people think, people don't appreciate is how dangerous things are you think protect you, but only mostly protect you.

We're having a forum here Monday with Greg Gipp. Great example. On the very theme of the illusion of safety. We're gonna have a whole session just on this.

Some people argue, I don't know what the data is, that football players would be safer if they didn't wear helmets. Because they would know this was dangerous. They point to sports that are very, very violent like rugby and whatnot. That might be true. You can take this logic too far, right? Maybe we all drive more aggressively 'cause we're wearing a seatbelt and we know we can hit the brakes and we won't go through the windshield. I'm not gonna sit here and say that's a bad idea. The effect exists still, by the way. You probably drive a little too much, too aggressively, and you probably have an extra accident or two because of the seatbelt. My logic doesn't mean it's always bad to take preventive action. But if you thought, as we sometimes do in finance, like money market funds, that you could do anything in a car 'cause you're wearing a seatbelt. That's kind of the money market analogy I'm making, and I think those are the most dangerous things.

Thank you very much, Cliff, for those remarks. We do have time for questions. There are two mics on each side of the room. Please get behind a mic, and I will alternate calling Left and right mics. Please do not make statements. These are questions for the focus to be on our guest. Anyway, over here, your question, sir. Please introduce yourself. Thank you.

John Graham from the National Center for Policy Analysis. And I hate to name-drop, but I was at a— last week with Mr. Rubenstein of Carlyle, and he was asked a question about retail distribution of alternative assets, and he said, "Well, it doesn't matter to us at Carlyle Group because we can raise money quite readily, but it'll probably go that way." Now, AQR, you've led with mutual funds Do you think in the next few years, due to changes in regulation, that the alternatives industry will do more distribution to non-accredited investors? And how will the industry handle that opportunity?

The short answer is I think, I think yes. Remember, I think these strategies can be used very usefully, but I don't think the hedge fund industry has broadly delivered them on fair terms. To investors. When you look at the mutual fund industry, and they're often called liquid alts, the hedge fund-like strategies that have started to appear in the mutual fund world, and we do some of these, I think they've largely been replicating some of the same problems. I think they're not fully, as a group, and we're in there, and I clearly like ours, but as a group, I think they're not fully hedged and are probably still too expensive. So I do think that same intellectual battle will go on. But I think they are still reasonable strategies at the core doing reasonable things. And not everyone is in the same position as Mr. Rubenstein. A lot of people actually do want more assets. So I do think that will get bigger.

Next question.

Hello, Ed Bartholomew representing myself. I wanted to just sort of ask you to reconcile momentum or any of these strategies with sort of the, the related to sort of the passive versus active debate. If you consider that all active strategies summed up effectively are passive, so any active strategy including say something like momentum or value investing requires not just that someone not do it, but that they actually be on the opposite end of the trade. So who, who's on the opposite ends of the trade? I mean, is it individual investors they're trying to stock pick or are they other stupid professional managers? And how can you— Will you explicitly use that word? And when do you— how confident can you be that there will continue to be the steady supply of stupider investors on the other side of the trade so that you can continue to make money?

That's a great set of questions. Backing out, you're not going to believe me, you're going to think I'm just copying you, but myself and a colleague, Antti Ilmanen, He's Finnish. He didn't just have odd parents. Have been planning, we haven't written it yet, to write a paper with the literal title, "Who Was on the Other Side?" So it's a little shorter version of what you said, 'cause we do think that is a very disciplining question. I've written, I wrote something in the Financial Analyst Journal on 10 different things in finance that I thought were kind of interesting, short observations. And one of them was your point precisely, where I said people think if they follow systematic strategies like we do, even low-turnover systematic— value happens to be what's called a low-turnover strategy. Momentum changes its mind. You have to trade momentum more than value. So systematic and low-turnover, they'll call passive. It's mainly a fight about semantics, but I don't like that term. Because to me, like I think for you, passive should be something we can all do. And for a— if we all try to do value, we can't all do it. Value, even if it's systematic, simple to explain, works on average, still requires exactly what this man just said. Somebody— if you're overweight cheap stocks, somebody has to be overweight expensive stocks. I will say a lot of it gets back to the exact conversation we started out with Tyler. I started out with Tyler Cowen. There are two possible reasons someone can choose to be on the other side. Of you, so you have to start out right there thinking about both of them. One is they— is what you're talking about works, my use of the word works, for risk reasons again. Same thing. Cheap stocks are inherently riskier. There's some scenario where they get killed in a depression, and that's risk. You are willing to bear that risk. Someone else is not. They willingly and consciously, maybe implicitly, we do a lot of things in economics, it just kind of happens, right, even though we don't say it. But they, they in some sense willingly take a lower return because they don't want that risk. Right there, might be true, might not be, but it's a very perfectly logically valid story for who's on the other side. The other is hope springs eternal for value. There are a number of people who simply see whatever's been going on, who's been beating earnings for the last few years, whose products have been popular, That company probably should be worth more. They go too far, they overextrapolate, the behavioral story, the other version besides risk. Both those stories, you're exactly right, do require someone on the other side. By no means, and I'm glad you asked, do I think these things can be used for everyone to outperform. This is not like Wobegon, we can't all beat the index. It's actually a precise mathematical identity. Having said that, I think there are risk premiums and there are behavioral biases that lead some to willingly or accidentally underperform. And you have to have the story for each one. And your other question about why would it persist is also— Tyler asked a version of it too. I think they can persist because they're pretty good, but not extremely good. We look at this, the value effect. It's been a good 5 years or so for the set of these 3 or 4 anomalies I've talked about— value, low risk, momentum. Profitability. It's been a bad 5 years for value, and the pricing of cheap versus expensive stocks is not egregiously weird, but it's about historically normal. When they've, on average, probably looked a little too cheap if you're a behavior theorist. What happened? Of all these 3 or 4 I've talked about, that's the longest— one that's been around the longest. It's very hard to arbitrage this away. Somebody is on the other side. Value goes through some horrible periods and Hope springs eternal. So I do think you're— it's a great question because you must always ask that question. I put it even starker sometimes. It's not a good title for paper, but whose money are you taking? You know the old joke, if you're at a poker table for 5 minutes and you haven't figured out who the sucker is, it's you? Same answer. If you cannot say whose money am I— whose money is taking me, maybe again, it's perfectly rational and they don't feel taken, they feel like their risk is being reduced. It's fair. But why am I making this extra money? If you don't ask your question, you're not doing your job.

And assuming it's behavioral and not risk, right, do you have a sense that the other side is individual stock pickers or other professionals that are stupid?

Some of both. I think it's some of both. There is some evidence, for instance, I mentioned— remember, I snuck this in— that hedge funds seem to have figured out and incorporate— this is just empirically. If you look at their returns, look at what strategies they're correlated to and not. They seem to show that they figured out some of the momentum strategy. They seem to buy more expensive, not cheap stocks. Maybe they buy the right ones. Maybe they figure it out. But they are fighting the value effect. So I think at least some of it is coming even from the very, quote, smart investors. Other restrictions, like remember we talked about low-risk investing for the Fisher-Black reason being effective because people are restricted from leverage. Professional mutual fund managers have that restriction left and right. Whether they do it consciously or they're just led to it, they get pushed into higher beta stocks. They get pushed into taking more risk and probably overpay for them. So I like that example better than we're taking mom and pop's money, but that's probably in there too, to some extent. But keep in mind, I'm being nice. I'm advising mom and pop not to trade. They should go to Jack.

Next question. Oh, sorry, this side.

Yes.

I have a question specifically about the biotech and healthcare sector. It's traditionally outperformed the broader market over the past decade or so.

What are your thoughts, both as a momentum trader and from a fundamental standpoint? Does that trend continue, or is it time to get out?

Just to calibrate here, we have 2 more questions in 10 minutes. So everyone please time your answers and questions to make it all fit perfectly to the split second. Cliff?

Yeah, I'll do this one quickly then. I have no idea. These techniques, not only do they work on average over the long term, but you need a broad cross-section all the time. They're really, really bad at things like, what do you think of this sector? I could literally— I don't know the answer, first of all. I'm going to tell— this will be the third thing. I told you active management. It's too expensive. Hedge funds are not a good idea. And now I'm going to tell you, I don't know if we're overweight or underweight biotech. Everyone write that down. I actually like telling people this. When I go on something— I don't do it too often, but like TV— we coach them. Don't ask me about individual stocks. We're long and short thousands of things based on these quantitative measures. And we're doing that intentionally because you can be cheap, good momentum, profitable, low beta, and the CEO can have a scandal tomorrow. These are statistical averages, you want to spread your bets, so you want to make a lot of them. So a quantitative systematic manager like me shouldn't know a lot. I mean, I could go memorize all 5,000 positions, but biotech, I have no idea, but I think it's instructive why I have no idea. If I have an idea, worse, if I have a very strong opinion, I'm just doing my stuff wrong. There are people who may or may not be good at that, But you do not come to a systematic quant manager and if your systematic manager says, "And here's what you do, put it all on biotech, run." Next question. My name is Evan Dunks. I'm wondering who's your favorite superhero and has you studying economics changed how you felt about certain superheroes? Oh my God. I've always, this might be sappy patriotic, but I've always liked Captain America. The whole, he fought in World War II, suspended animation for 20 years, which by the way happens to anyone who falls into cold water. That's just a throwaway, I could sing you the song if you'd like when Captain America throws his, anyone old enough to remember that? All those who chose to oppose his shield must yield. It's a great rhyme. Yeah, even the most insane billionaire cannot afford a hundredth of what friggin' Tony Stark or Bruce Wayne have. It's infuriating. I've done well, I'm not the most insane out there, but if I wanted to go build a Batcave at my house, it would take approximately 600 times my wealth and everyone would know about it. So, it's a shockingly good question, which actually has been an annoyance of mine. Yeah, I have a skyscraper that's also a missile silo.

Your least favorite superhero, if I may interject?

Hmm, you know what it used to be before? Before the movie, I would have said Ant-Man. But the movie was kind of funny. I liked the— but there was a character named Hank Pym, one of the original Avengers. Avengers were, of course, as you all know, Thor, Hulk, Iron Man, Giant Man, which is Hank Pym, and the Wasp. He's a loser. Giant Man was just a big guy. He wasn't even stronger than a regular guy. He was just big. Everyone beat up Giant Man. Then he used the same powers to shrink. And control ants, of course, because those go together. And then he became an alcoholic, and then he hit his wife in the comic books. And that's easy to hate. But I hated him even before the spousal abuse.

Last question here.

Chris Kiper. I'm a master's student with the Mercatus Center. Question on advising people to get into the passive, low-cost Vanguard kind of funds. We've seen people— heeding this advice and flowing in. Do you think that in and of itself, more people going to passive strategies could open up more potential for active managers and more anomalies? That is a great question. I'm going to fuse that question with, with the one over here, not the superhero one, my favorite question, I might add, but it cannot be fused with this question. Instinctively, you want to say it's going to be easier to beat the market if fewer people are trying? The amount— if you're a PhD student in finance, this is what you do at 3:00 AM in your bull session is what happens if everyone indexed? No one who's gone through a PhD program in finance or probably economics has not done that. We really don't know. It's a very— people will actually argue over this and then you try to get a little more realistic. What if almost everyone indexed. Feels very obvious that it'll be easier to win. On the other hand, this constraint that was brought up already, that the average can't beat the average. Whose money are you taking? If everyone else is passive, how do you induce them to take a bet away from passive? My sense, and I think you can literally mathematically disprove this, so it's a sense of what would happen if we got close, not all the way, is it would be easier and you could fool people if you were the one with some information. Information would be easier to get. And the informationless trader, you could push away more. By just bidding more for their stock in short term, you could capture some of their profits. Still hard to make the math work. Because if you really push them away, they have to tilt away, and they're trying to be passive. If everyone else is trying to be fully market cap weighted, whom do you trade with? No one is willing to underweight. So you've actually brought up a paradox that people are still fighting about. I think in a more realistic scenario, I do know this, more people chasing my strategy is not good for me. But in general, it's really hard to figure out. But a question everyone talks about, so I'm glad you asked so I could fail at it also.

Cliff, in one of your papers, you cite an old Slovenian proverb which I quite like, and it goes, "Speak the truth, but leave immediately after." I do think you'll be here for just a few more minutes if We have not been able to get to your question, but not for hours. But anyway, Cliff, we thank you heartily.

This is a lot of fun. Thank you all. It's fun. You read that.

And just for all of you, our next event, Conversations with Tyler Cowen, will be January 26th. We are honored to have as our guest Kareem Abdul-Jabbar. And we will cover a wide variety of topics. So please put that on your calendar. And you will have an answer to a trivia question.

What do Cliff Asness and Kareem Abdul-Jabbar have in common? Because this will be the only thing.

Super normal returns, right? Super normal.

Thank you again. That was great. Thank you.