Eduardo Repetto: ETFs Are Winning the Battle
The CIO of Avantis Investors discusses the firm's strategies and academic research, as well as his thoughts on the future of ESG and ETFs.
Our guest this week is Eduardo Repetto. Eduardo is chief investment officer of Avantis Investors, where he is responsible for overseeing the research, design, and implementation of the firm's investment strategies. Prior to forming Avantis in 2019, Eduardo was co-CEO, co-CIO, and a director at Dimensional Fund Advisors. Eduardo earned a Ph.D. in aeronautics from the California Institute of Technology, and an MSc degree in engineering from Brown University.
“American Century Launches Systematic Active Manager Avantis Investors,” by Christine Williamson, Pensions & Investments, June 26, 2019.
Markets and Factors
"'Is a Hot Dog a Sandwich?' Ex-DFA Chief Weighs Factor Funds and Starting Anew,” by Alex Steger, citywireusa.com, July 30, 2019.
“The Joint Distribution of Value and Profitability: International Evidence,” by Sunil Wahal and Eduardo Repetto, papers.ssrn.com, Nov. 30, 2020.
“Could ‘Flying to Safety’ Be Dangerous?” by Eduardo Repetto and Phil McInnis, avantisinvestors.com, April 2020.
“Patrick O’Shaughnessy: ‘Custom Indexing Unlocks a Lot of Benefits,’” The Long View, Morningstar.com, May 12, 2021.
“A Discussion About Value and Small-Cap Factors With Avantis Investors’ CIO Dr. Eduardo Repetto,” Jonathan Chevreau, findependencehub.com, March 30, 2021.”
“Two Active ETFs We Like,” by Ben Johnson and Susan Dziubinski, Morningstar.com, Feb. 21, 2021.
Jeff Ptak: Hi, and welcome to The Long View. I'm Jeff Ptak, chief ratings officer at Morningstar Research Services.
Christine Benz: And I'm Christine Benz, director of personal finance for Morningstar.
Ptak: Our guest this week is Eduardo Repetto. Eduardo is chief investment officer of Avantis Investors, where he is responsible for overseeing the research, design, and implementation of the firm's investment strategies. Prior to forming Avantis in 2019, Eduardo was co-CEO, co-CIO, and a director at Dimensional Fund Advisors. Eduardo earned a Ph.D. in aeronautics from the California Institute of Technology, and an MSc degree in engineering from Brown University.
Eduardo, welcome to The Long View.
Eduardo Repetto: Thank you very much. Thank you for having me here. It's a pleasure.
Ptak: Well, it's our pleasure as well. Some of our listeners will be familiar with your background, but not all of them will be. Let's start by discussing your career in investing and finance. What has led you to this point?
Repetto: Well, I have a weird background. So, I was born in Argentina, and then I studied engineering, and then a master in a different engineering and then a PhD in a different engineering. But then I wanted to do something that have more effect on people, something you can see and not have to wait 20 years, like the research that I was doing during my PhD. And so, what I decided is, finance is something that all of us touch. Finance touches our lives, our family's life. And so, I said, I want to work in finance. And I was lucky enough to be able to move from researching material science and mathematics, things that I was doing, into finance.
So, I started working at DFA. I started in research and then over time, I became CIO, and then co-CEO. And I've been involved with many, many different financial projects. And now, after returning from Dimensional, we started a new venture. It's called Avantis, Avantis Investors. And I cannot be more thankful about all the people that are interacting with finance, because I learn from all of them. And finance really matters and matter for all the investors, for all the people saving for retirement, for their kids' weddings, for their kids' education. It's just a beautiful field to work in because you can help people.
Benz: When you entered investment management, you were not formally trained for it, as you said. For instance, you didn't come out of business school or have a CFA charter in hand. Did you find that beneficial insofar as you didn't bring ingrained habits or hardened thinking along with you and could look at things with a fresh set of eyes?
Repetto: I think that would be unfair. Some people come with great backgrounds, and they build up their backgrounds and do quite a lot of good things in the industry. Mine was different. I was more trained in typical science, let's say, hard sciences--think about mathematics, computer science, engineering, and then I have a PhD from Caltech in aeronautical and engineering. So, yes, I didn't have much of the background that people coming from an MBA school. But I was looking already at finance, because there was something very intriguing.
A friend of mine, a former boss of mine, has a PhD in mathematics from Caltech and he moved to finance and he was telling me all the time, you will like finance, because it's similar mathematical concepts applied in a different way. And you can apply the logics and all the things that you do when you're doing research, you can apply to finance, to marketing, to running a company. And he was right. So, when I started, I didn't know as much as probably someone with an MBA, but they have a very good training and learning. Because when you hire a PhD from Caltech, you learn things quite fast and quite in-depth. That's why it's the top school.
And so, I was able to learn a lot of things over time on my own, but also interacting with great individuals like professors Fama and French, Merton, Myron Scholes, great minds in finance. And by interacting with them and working with them, I was able to learn concepts that probably you cannot learn in regular courses much in-depth. And so, I was lucky. You need to put effort, but you also need to be lucky. And I put the effort, but I also recognize that I was lucky in having all these things.
Ptak: Shifting to Avantis, which you mentioned before, you joined up with Avantis--you probably had time to reflect after you left Dimensional. Did you consider doing something other than leading an investment organization?
Repetto: So, as you mentioned, I was at DFA for more than 17 years, but I needed to leave. And why is because my office was in Texas, the clients and employees were all around the world. My family lives in Los Angeles. And so, I had a conflict there and I needed to solve this. So, I basically resigned without any plan. I resigned, and I spent time off, taking my kids to school, something that I have not done in the case of my youngest son. And so, it's time off to think what you want to do. And my wife was thinking ideas--why don't you do this, why you don't do that. And you always have people offering you to work, running a company or doing other things. Nothing was clicking, to be fair.
Some people from American Century reached out and said, are you interested in helping us build an asset management with these concepts? And the concepts were very, very interesting because they wanted to build an offering based on financial science at low expense ratios. And so, it was really, really appealing because it can make a difference to the end investor. And that clicked with me. And so, I said, well, this is interesting. We can create something from scratch, bring a whole culture of service to the end client, apply the cutting-edge research and new technologies. And so, this was really more appealing than anything else that I was hearing at the time. And that's why we started Avantis inside American Century.
Benz: This is the first time that you've had an opportunity to forge a company's culture and identity from scratch. What were your key priorities in doing so? And how has that informed decisions that you've made in setting up Avantis?
Repetto: I think that you're right speaking about culture, because culture is really, really important in the company. You want a company that has a fighting spirit and tries to win, but at the same time, winning is not something that you do if you don't think about your clients. And our culture is a culture of service to our clients, and that's how we set it up. And we set that culture of service into our clients by how we hire, how we create alignment of interest inside the company, how we create investment strategies and the low expense ratios that we have. And Avantis is a very, very flat organization. It's part of American Century, it's a little bit independent, but it's part of American Century. But inside Avantis the people with the Avantis business card, recognize that it's a flat organization. Everyone has a saying, everyone works, and we have a motto that is, hey, we need to make those clients better off. And we do that by creating good investment strategies, by being humble when we interact with them and trying to learn from them and also give our knowledge to them. And that's why the alignment of interest is important.
Everyone across the company has this spirit. And I think that makes a difference. Sometimes people tend to be a little bit arrogant when they know more analysis and whatnot. But in reality, none of us know all the answers for all the possible problems certain investors may have. And so, we want to listen to them, and then interact with those clients and try to find what about this, what about that, we have seen this before. And in that way, not only we provide a service to them, we also learn how to provide the same service to many other people. And that's the culture we want to have.
Ptak: In addition to your service ethic, which you just described really well, I think you've also said that you value open interaction, debate, discussion of ideas. Can you talk about what the most active debate on the team is right now? Just to give an example, maybe it's an investment topic, maybe it's pertinent to the way you're running the business. What's a debate that your team is having that you particularly relish seeing them have?
Repetto: Every day, there is something new. And you can imagine, when you have a team like ours, many things happen at the same time, spoken by different groups of people. And so, it can be from communications issues, to the possible tax changes that are coming down the road and the effect on products. That's a big one. We don't know where taxes will go and how it will affect the whole industry of wealth management, and how we can set up our offering, our material, our teachings, so people can be prepared for that in case there is a big, big change.
But we also think about new strategies. If you think about our portfolios, we're going to be managing for a new ETF in the second part of the year. So, we are just refining all the details of how they are going to be run, what the details of the strategies, how people can use them in an asset allocation, because not only think about the product, but how they are going to be using an asset allocation for the benefit of investors.
So, there are many things going on, not one particular one. And sometimes it's not our expertise. Sometimes we reach out to people to bring expertise. For example, on the possible tax changes, we interact with people that are experts on the topics to tell us, how is the effect of this in wealth management? So, the debate is not only internal to us, sometimes it's people coming from outside and helping us with the topics.
Benz: When you were there, Dimensional was focused heavily on selling to financial advisors. Avantis is different. You'll sell your products to any market. What have been the biggest lessons for you as you've made that transition to selling to different investor types? And are there choices you've made in building the business that you wouldn't have made if you were focused solely on selling to financial advisors?
Repetto: This is a great question because I will make a difference between us selling and people buying. So, as you know, we have funds: ETFs and SMAs. So, the funds and SMAs we deal only with financial advisors, and SMAs is separate manage accounts. But in ETF, ETF is a public security. So, when you launch an ETF, anyone can buy. And when I say anyone, I literally mean anyone, because it can be a retail investor from the United States or an advisor for their clients, or it can be from outside the United States. We look at the custody reports and we know that we have clients that come from Europe, from Asia, from Korea, from Australia, so clients from many different places, and we're not selling to them. They find out our name because Morningstar or press or because they happen to know us from the past, but they're buying that. So, we're not selling to many different kinds of investors, but they are buying.
Our selling focus is on wealth managers, like advisors, consultants, or institutions. So, that's where we really focus on selling. And why we do that, because we are trying to create investment solutions that fits asset allocation. So, we really want to deal with people that are thinking an asset allocation and give them enough information about what we do, so they can use our investment solutions, no matter if it's a fund or ETF or a separate account, they can use it in conjunction with any other investment account in order to achieve the end investor's goal.
So, we really are selling to wealth managers, advisors, and institutions, though our clients, because the ETF, it is a public security, tends to be way broader than that. Whereas sometimes we hear from an investor, sometimes we are very polite, and we answer, and we provide all the information that has been asked. But we don't have a big marketing campaign with buying a page in the The Wall Street Journal or in Financial Times or any other place. So, we're not reaching out to the end investors. It’s a little bit different marketing approach and a little bit sophisticated product. So, given that, we're better off with speaking directly to professional investors that they will understand all what we say extremely well.
Ptak: We're going to shift gears and talk about markets and factor investing in a bit. But before we did that, we wanted to get your perspective on a few other topics that are pertinent to business strategy in the investment management business, and one of those is advice. One of the things that we've seen is in the public investments, business funds and ETFs. It's going through a sea change with passive taking share from active and costs looming large and how funds are chosen. The advice business, though, hasn't seen the same degree of change. For instance, it's still pretty common for advisors to charge clients 1% of assets. Do you expect that to change? And what are the implications for a firm like yours as the advice business comes to experience the kind of price pressure that is now familiar within the fund and ETF business?
Repetto: Jeff, you're absolutely right. The asset-management business, the fees have been going down, and they've been going down because the fees are going down but also because people can move their assets from high-fee products to low-fee products. And so, that is seen everywhere. When you speak about advisory business, wealth management, one thing that you see is that the business has evolved a little bit from just being asset allocation to being a more comprehensive service that people receive. People integrate the investments with the taxes, with the wealth planning, wealth transfer across generations. So, the business, the services that the advisors are providing are broader than just the typical asset allocation.
For example, I have advice, and you say, “Eduardo, why do you want advice, you should know how to do an asset allocation.” And I always say, “I know how to do an asset allocation. But in reality, I don't know enough about how to set up trusts, how to integrate that with my taxes.” So, the advice business is more than just an asset allocation, and advisors are providing a broader set of tools than just an asset allocation today.
Now, fees, you're right, if you go back in time, maybe 1% was a typical number. But today, you have different advisors providing different services at different level of fees. You have from advisors providing a flat fee--so, it's just a dollar number--to advisors providing an hourly number, and advisors providing a 1% or lower percentage depending on how much money people have working with that advisor. So, the beauty of that is that you have a whole set of advisors with a lot of different services, and the end investor can select, the end investor can pick one that provides certain services and given fees, or someone that provides different service at lower fees, or they can be just doing the investments on their own.
I'm a big believer in the market. And what I mean by that is, you have full disclosures of all these services and all these fees, people select what's best for them based on what they need. And the advice that we have out there today, it's really good. It's not that everyone is the same. And probably, you are seeing the same, but that's what I'm seeing.
Benz: Some are arguing that technology will usher out packaged products like ETFs and funds in favor of personalized solutions, direct indexing, custom indexing. What's your take on this? And is this a possibility you're preparing for as a firm? Is it something that you've talked about?
Repetto: It's very, very interesting, because direct investments or model delivery portfolios or separate accounts, really provide a tool for investors that have very particular needs. Like imagine that you have certain set of constraints that no one else has. So, I don't want to invest in these kinds of companies, because some personal or family issue. Let's put it to that extreme. And if that's the case, you buy an ETF or you buy a mutual fund, you probably will not find a mutual fund because of these considerations that you have in mind. A mutual fund is created or an ETF is created for many people at the same time, and your particular considerations are not going to be included in that strategy in general, unless if you share those with everyone else, then it's not personal.
And so, a separate account, or direct indexing, probably allows you to have these very particular considerations in your investments. Now, it's true that costs have gone down dramatically, so people can have even fractional shares today. So, very low amount of money, have a fully diversified portfolio with a lot of names, because you don't even have to buy a share, you can buy a fraction of a share nowadays. So, that's also something that's telling you, wow, holding individual securities is probably going to become big in the future.
On the other side, when you have an SMA, or you have a direct indexing, you don't have the tax advantages of an ETF. So, you know that ETFs have big tax advantages, and ETF is good to rebalance inside the ETF structure and shield shareholders from big capital gains distributions. You cannot do that when you hold individual securities. Because whenever you want to rebalance the portfolio, you are selling that security, and then you're realizing the capital gains. So, ETFs provide benefits that really you cannot find when you have an SMA or individual securities in your portfolio. So, for certain investors, an SMA, a separate account or holding individual securities is the right solution, because they really cannot find a commingled strategy in an ETF way that can deliver what they want. So, it will be absolutely personalized to them and no one else shares those constraints.
Now, on the other side, if you can share the constraints, you're probably better off with an ETF, because you achieve probably lower fees, you have better taxation, it’s more efficient and better diversified. So, again, this depends on who is the investor and what do they want. How do we prepare ourselves? Well, we have ETF offering, this magnificent vehicle, you have the numbers and if I look up some Morningstar cash flows, and you can see that ETFs are really winning the battle when compared to mutual funds where mutual funds is 1940 technology, ETF is very recent technology, and the flows are showing what's people's preference. So, ETF are growing, mutual funds are shrinking. And direct indexing is somewhere in between. It’s growing. It has a lot of benefits, and it can help you customize your portfolio in a way that you probably cannot do with an ETF, but it doesn't have the tax advantages that an ETF has. So, we have all the offerings with our mutual fund, we have SMAs, we have ETFs, and we provide people with the advantages or disadvantages of each one of them so they can decide based on their personal circumstances which one of the structures will be better for them. And again, it's like what I was telling you before is, I believe in markets. You provide people information, and they can make the best decision well informed.
Ptak: That's a good segue to our next topic, which is macro. I wanted to ask you about something that you stated on the Avantis website, which is: “We believe market prices represent an unbiased view of a company's prospects and risks and that paying lower prices for our share of future cash flows has the potential to produce outperformance versus a benchmark.” My question is, until relatively recently, we were seeing a frenzy in things like meme stocks, crypto, NFTs, SPACs, and other speculative assets. How do you reconcile that frenzied behavior with the statement that you make that market prices represent an unbiased view of a company's or an asset's prospects?
Repetto: This is the classical question: Are markets efficient or not? And what does it mean? So, how can it be that some assets are priced this way, and because we cannot rationalize. And it's the link where behavioral finance meets rational markets at the end of the day. And it's beautiful, because you price a company, applying a discount rate to the future cash flows of the company. And you say, well, something that is more risky should have a higher tax rate. But then, it's based on preference also and that discount rate. If no one likes something, that discount rate will be higher and the price will be lower, and everyone likes something, now the price will be higher, and the discount rate will be lower. And so, the discount rate itself has a behavioral component. That's why you think about finance as a humanistic science. There is a behavioral aspect that affects prices. And that's important.
Now, how do I link all these? You say, well, the behavioral aspect may be persistent and be there forever or may change. So, you cannot say that because something has a price, and you say, well, this price I cannot rationalize. You cannot say that the price may not move in a way that you thought it was going to move. It can be there forever. And it can have information that is beyond what we know. This is important, because when we're thinking about the price of a company, we're thinking about how is that company being priced, how the market comes to the price. And if market comes to this price by considering risks of the company, opportunities, not only of the company, it's all the competitors around the company, because they affect the company tastes. Now people taste, you see ESG is becoming bigger and bigger. So, there is a taste component of people trying to be investors in a company. Preferences of different kinds. And so, all this goes together in the price, but we cannot really predict if the price is going to go up or down tomorrow.
Now, what we can do, thanks to financial science, is say, at this price, this company has long-term expected returns that are high or low, but I'd emphasize long term. I cannot tell you when, but I can tell if the price is too high of a company relative to fundamentals and tell you if that company probably has very low expected returns over the long term. And so, that's how we reconcile with that. We recognize the behavioral aspects that push prices up and down. But we cannot provide a timing on when these things will correct if you want to think all that to a different level. But what we can tell you at this price level, the long-term expected returns of this company are high or low. And that's information that we use. We use that price, together with a lot of fundamentals to say this company is attractive from a long-term expected return point of view. And that's how we reconcile and that's how we use information. And you mentioned SPACs, for example, well, at the given price, buying those SPACs is certainly not a good long-term investment. We cannot tell you when the correction will happen, in this case we can after the fact, but, if we're going to deploy money thinking long term, that's probably not the right place to put it.
Benz: Retirees are having to wrestle with high valuations and very low yields today. What advice do you have for those who are trying to maintain their standards of living through retirement while fending with these issues?
Repetto: This is a very tough problem. A lot of people have been thinking about retirees. And there is a concept that is very, very important that probably we haven't emphasized enough in the past. What is the risk-free asset when you are saving for retirement? Many people think that an asset that has low risk is short-term bonds, short-term Treasuries. But when you're saving for retirement, it's way more risky to invest in short-term Treasuries than to invest in long-term Treasuries. Because long-term Treasuries are less risky if you think about the variability of the cash flow that you're going to get in the future. And so, part of the issue that we're facing today is that people probably didn't have the best asset allocation going back in time. They were focusing on daily volatility by buying short-term debt instead of buying long-term debt, to enhance their portfolio when they were at the point of retirement.
But now, you say we're too late, now what do we do? Well, we can do a couple of things. First is recognize the current situation. And second is don't think so much about income. So, everyone thinks, what's the income that the portfolio will produce, because that's what they consume. And I should literally be back on thinking about income. And I think more about the overall portfolio and the total returns of the overall portfolio. You really don't care if the return that you get come from income or from capital appreciation. What you care is how much you have to consume. If it comes from capital appreciation, doesn't make a difference to me. It's probably even better, because I paid less in taxes. I paid capital gains taxes instead of income taxes.
So, one thing that I hope people think today is drop the idea of thinking about income and let's think about the overall asset allocation and the total return of the portfolio as a source for our funding of retirement. And if we do that, I think we are going to be a little better off than if we think just about the income, because as you say, income is extremely low today. Think about the last year or the last two years. If you think about income, income is very low. But if you think about the market, the market produced good returns, and you can live from those returns, even though they are capital appreciation, not income. So, it's good to think about overall portfolio, not just the income component.
Ptak: Wanted to shift and talk about factor investing. The investing principles you follow would probably look familiar to many factor investors. I'm thinking about tilts toward things like small value, quality, emerging markets. Where do you think you break from the factor-investing orthodoxy?
Repetto: This is a very current topic. And it's obvious that you are speaking about this, and this is the current debate. I'll tell you how I think about factor investing, and in reality, how I think about asset-pricing models, because at the end of the day factor investment is a part of asset-pricing models. So, if you go back in time, investing was an art. You go Graham and Dodd, and investment is an art. But over time, you start thinking about Markowitz, Sharpe, and all the research that came after, they were trying to put a financial framework, a scientific framework around that art of investing. And people started looking at certain securities moving in a given way and say, these securities do better than these others. And that created the idea of, by looking at these characteristics versus these others, securities perform better. And then, we start creating factors, like high book to market versus low book to market, like high market cap versus low market cap, like high earnings price versus low earnings price. And all these factors are helping us understand how the market is pricing securities. We are discovering that securities that have certain characteristics have higher expected returns than securities that have different characteristics. But we are doing that one characteristic at a time. And this was the factor framework. And then, you have multi-factor framework trying to mix all these factors. But when you mix all these factors, you're pushing one factor, even without noticing, you're pushing against another. So, if you buy high-quality, you push against value. You buy value, you get low quality. So, this factor framework is like thinking about the pizza, not as a pizza, but thinking about all the components of the pizza. And if you are a great chef, you think about the components. But in reality, you think about the whole pizza. That's why the best chef makes a difference beyond the ingredients.
And the way we think about this is in a post-factor framework, just past performance, go up to here, now we need to think beyond factors. And what do I mean by this? We learn a lot from factors. We learned that certain characteristics matter. How can we think about valuations given everything that we learned about factors? And that's what we do. So, we think about the price of a company and it's a function of what? Well, it has to be a function of how much equity the company has inside. It also has to be a function of the cash flows that the company is generating. And certainly, it's a function of the discount rate, the expected return, because those future cash flows are discounted at some discount rate. So, if you think about this valuation framework, it's telling you how to use all these factors together: equity to price, famous book to market, if you want to think. Profits to price, you think earnings price; profits to equity, return on equity. So, it's telling you all the levers and how they interact together at the company level. So, then you can say, let's just stop thinking about factors. Let's start thinking about the whole company and what characteristics make this company interesting from the expected return point of view. And that's what we do, is one more step toward systematizing active management, to leave from the art that was in the past to a fully scientific process that is becoming today and going in the future. And that's where we are, that's what we bring to the table.
Benz: Value has had a rough time, but it has surged lately. No one should expect a factor like value to work all the time. But this has been an especially prolonged and painful slump for value. Can you talk about why it happened and how should that experience shape the expectations that investors form about value's long-term payoff?
Repetto: Yes, it has been a long time. But, people that study markets and you guys certainly study markets that have a lot of beta, certainly remember that equities underperformed bonds for 18 years in a row. That's a long stretch. So, when you're thinking about markets, you have a rational component and a behavioral component, that is (indecipherable), and what do I mean is (indecipherable)--sometimes prices go one direction and you say, “It's going beyond fundamentals, how can it be?” Yeah, these things happen. And it's still the only thing that we can do is make decisions based on best expectations and sometimes it takes a while for these things to recover.
Now, when you have been around for a while, you always remember, for example, 1999-2000, and you remember companies trading at a very, very high price, much, much higher than the fundamentals. And you say, how can it be? Well, at some point, fundamentals is gravity. There is a gravity pull from fundamentals that bring prices to a more rational reality. So, if you go back to 2000, you have all these very high-price companies having very high price relative to book, to earnings, to cash flows, so all the different fundamentals that matter. And what happened after that? Well, those companies that have very high price, have very low, even negative, expected returns going forward. And the other asset classes that were priced reasonably did much, much better. And this is what I mean discursion. Something just goes beyond fundamental, but at some point, fundamentals pull them back and things become more rational.
You were mentioning up to very recently still now we have a very similar situation what we saw in 2000, with prices of certain companies going way beyond fundamentals; companies with no earnings trading at very, very high price. So, what we can say--let’s assume that we're speaking what we were speaking when we chatted before--now, if the price is very high for something, its expected return is low. We don't know when it's going to change. We cannot tell you if it's tomorrow, or next month, six months from now. But we can tell you long term, those companies have low expected returns. So, it is part of investing. You have to be exposed to this, sometimes unpleasant realities that last a while. But if you do things based on fundamentals, and you do things in a scientific way with diversification focusing on technology and everything, over the long term, I think that you are going to be OK.
We did a little bit of a research project, and we looked at the performance of a small value versus the performance of the market over 20-year windows. And if you go back to 1927, every 20-year window small value beat the market. Now, inside those 20-year windows, there are many periods, sub-periods, where it didn't go as well for small value, but it did recover. So, now lifetime investment really means thinking about long term and doing things in a way that is basically based on expectations. And that's what we do.
Ptak: We had Patrick O'Shaughnessy, who heads up O'Shaughnessy Asset Management, on our podcast recently. And he said his firm, which is also quantitative, doesn't expect small-cap stocks to outperform large cap just because they are the stocks of smaller companies. Do you agree with that? And if not, what role should market capitalization play in one's investment process?
Repetto: If a company is small, just pick any small-cap company, you cannot tell me that that company has higher or lower expected returns. This is something that we were expecting a minute ago. If you have a company that is small cap and the price is very, very high relative to fundamentals, that company will not have a high expected return. That company will have low expected returns. So, by being in small caps, you're certainly not assured high expected returns. Valuations matter. Valuations matter in large caps. Valuation matters in small caps. And there are many, many small-cap companies that are trading at a very, very high price. And so, you cannot expect high expected returns from them. So, I don't think that you can say I'm going to have higher performance because I buy small-cap companies. I don't think that there is a fundamental issue there that any fundamental theory or anything that would say small-cap companies should outperform because they are just small caps.
Now, what is the role of market capitalization? And that's a very important question, because market capitalization plays a role. What is the role? If you look at the premiums, think about the expected performance of one set of companies versus the others, for example, performance of value companies minus growth companies. If you look at the premiums in large caps, so large value minus a large growth company, the premium in large cap, the difference in expected returns among companies in large cap is smaller than the premiums in small cap. In small cap, it has everything magnified. So, the best performers are way more better performers than in large cap and the worst performers are really very worst performers than the large cap.
So, small caps magnify the premiums. So, how can we use that information to add value to the portfolio? Well, a way to add information--I want to create a portfolio that has higher performance. How can I do that? I can search for companies in large cap that are expected to outperform and I will get some outperformance, or I can do the same in small caps where the outperformance is expected to be much, much higher. And so, if you are keen on performance, the small caps give you broader opportunities. So, the way we think about small caps is if you want to look for high expected returns, large caps provide opportunities, but small caps provide much more of an opportunity set than what you can find in large caps.
Benz: You widely diversify the portfolios you manage and don't trade a lot. In explaining that in the past, we've heard you say costs are certain but expected returns are not. Can you expand on that reasoning?
Repetto: Wow, you take notes of everything in the past. So, yes, expected returns are very, very interesting. They are expected. That means that you think that it will happen, but it's absolutely not sure that that they will happen. So, if I'm going to incur $1 in cost today to earn $1 tomorrow in expectations, you'll say to me, “You're crazy because you're spending $1 today and that dollar that you're going to earn tomorrow—first, is tomorrow and secondly, it's an expectation, so may or may not happen.” So, costs matter in the sense that it's certain. You are spending today with expectation of having some benefit tomorrow. So, that benefit that you are expecting tomorrow has to be meaningfully higher than the cost, because there is a risk about that benefit tomorrow. Certain is not certain at all.
So, if you have a portfolio that has very high turnover, you're incurring a lot of costs. How many great opportunities you are having tomorrow that basically gives you any kind of warranty that it's good to spend all that money today with that hope of making money tomorrow. It's better to be very, very conscious across costs today and just focus on the great opportunities of tomorrow so there is a meaningful benefit, not a marginal benefit. Because for a marginal benefit, probably your trade-off after the fact will not be possible. You'll be spending way more money than their realized benefits. And so, we are really focused on turnover. We really focus on costs, because we recognize uncertainty of the future. And whenever we trade, we do it in a way that we really believe that the benefits of tomorrow are much, much higher than the cost that we incur today.
Ptak: Wanted to shift gears. You've engaged several big-name academics--Hal Hershfield, Suzanne Shu, Meir Statman--as consultants to your firm. They focus more on behavioral finance and advice, whereas your firm's focus is clearly on investing. What do you think is a good model for determining when to outsource, in this case, you're doing it to academic researchers, versus building up the expertise in-house and offering it to clients?
Repetto: We work with Hal, Suzanne, Meir Statman as you mentioned, but also with Sunil Wahal and Andrew Karolyi. And so, the last two on the rational market, so let's say, asset pricing, the previous three more on the behavioral aspects. And both things matter. Remember, we were speaking a minute ago about the SPACs and prices and say, behavioral and rational markets meet at some point because there is a humanistic determination of the discount rate. Everything matters, everything. And there are two different points of view, but at some point, they converge together.
So, we tried to work with anyone that we think that is an expert and will add value to our clients and us. And so, we engage with many, many people. And the goal is to learn and to help our clients learn from them and for them to get feedback from real-life investors that are facing problems now, or they are trying to solve problems in the future. And so, everyone wins in this kind of environment where you can have these open discussions, and everyone contributes with a problem, with the solution, with an alternative or just with ideas.
And so, how we decide what to outsource or not? In reality, we discuss many things with many people. And it's not that we need to be the ones bringing the idea first. Sometimes we are not the first to bring the idea. Maybe a client tells us, “What about this?” And then, we start working on that. Or we ask an academic, “Have you heard about this before? Has anyone been thinking about the problem like this before?” So, we try to socialize ideas across clients, our own team, our academic friends, and try to see what results from there? What's the best outcome? Because sometimes the best outcomes, it seems that it's a combination of ideas of everyone else, and that's what we want. We want everyone just to bring something to the table. And the different backgrounds of the different academics is great, because if it were exactly the same, one will replace all of them. But if everyone has different views, it's a more rich environment, more diverse environment and everyone has a different point of view to bring to the table. And we appreciate that a lot.
Benz: As someone who has spent a lot of time reviewing academic research, what are the things that make a paper compelling and practical? And what's the method that you've used to separate the wheat from the chaff?
Repetto: That's a tough question. So, I personally like papers that are not only empirical data, have some theoretical or some good reason why that empirical data is showing advantage in the tables published by the paper. And why do I say that? It is easy to get confused when you're looking at empirical data on something that may have happened in the past but may not happen in the future, so a pattern in the past. Like if you know, if you are trying to find a payphone, you will say, well, airports have payphones, because in historical data, every airport has a payphone. Well, I don't know if airports have payphones anymore. So, historical pattern in the past doesn't need to continue in the future. And a theoretical framework gives you the assurance that the past will extend to the future. So, I really like papers that have some theoretical or very logical reason why something that you've seen in the past will continue in the future, because we invest the money for the future. The past is just a guidance to how we do things better going forward.
And so, if you give me a paper that just has numbers and the logic is not sound of why those numbers are there, I personally will not like that paper too much. I will like a paper that gives me a reason why I see something in the past and why that will continue in the future. And there are great papers about that. And sometimes the logic in the paper is not there, but you can find a logic by the process of discussing with people or just thinking about it on your own. And so, I really care about papers that make a difference going forward and not just the paper that shows me something that happened, even though they don't say, it may have happened randomly in the past.
I also like papers that are implementable. So, if you have something that is implementable, I like it a lot, way more than something that is not implementable. Say, I see a dollar flying in the sky. Can I grab it? Not really, because it's flying the sky and I can't reach it. So, why does it matter to me? It's interesting but doesn't matter to me. So, I really like things that are implementable because that may make a difference for our clients and us. And so, that's the second layer of things that I will look at in a paper.
Ptak: Well, Eduardo, this has been a very enlightening discussion. Thanks so much for joining us and sharing your insights. We really appreciate it.
Repetto: Oh, it's a pleasure, please. Thank you very much for having me and I really appreciate everything that you guys do.
Benz: Thanks so much.
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