116 In Pursuit of the Perfect Portfolio ft. Professor Steve Foerster, Ivey Business School at Western University

Niels
Hey everyone, and welcome to another edition of Top Traders Unplugged, where today I’m joined by Steve Foerster who’s a finance professor at Ivey Business School at Western University, and the co-author (along with one of my previous guests, namely Professor Andrew Lo) of a great new booked called “In Pursuit of the Perfect Portfolio,” which by the way is a great title.

So, first off Steve, thanks so much for joining me today. I have looked forward to our conversation. How are you doing and how are things where you are in the world?

Steve
I am doing great and really appreciate being here and chatting with you.

Niels
Absolutely.
Now, I mentioned that you wrote this highly recommended book together with Andrew Lo. So, perhaps we start out with you sharing a bit of the back-story as to how you got to become a professor of finance, how you met Andrew Lo and what was the inspiration for writing this book together? (Of course that is three questions in one. So, I’ll remind you if somewhere you forget along the way.)

Steve
Certainly.
So, I’ve actually come full circle. I did my undergrad in business at the Ivey Business School and enjoyed that experience. I had an opportunity to teach at Ivey for a couple of years, just on a contract basis, and I really enjoyed that. So, I decided to see if I could make a profession; I had to choose a discipline; I enjoyed finance, so, that’s what I chose, and decided to get a PhD and tried to see what would be the best school that would take me. It turned out that I was fortunate enough to be accepted to the Wharton School at the University of Pennsylvania.

That’s where I met a younger than me, bright, new professor who had just graduated with a PhD from Harvard at the ripe old age of, I think it was, 24. He was teaching his first PhD course that I had the pleasure of being in. Of course, that was Andrew Lo. So, that’s how we met. That’s the back-story of that.

We stayed in touch and, gosh, it was almost ten years ago that I reached out to him with this idea of writing a book. I didn’t have much in mind except for this title, which is In Pursuit of the Perfect Portfolio.

Niels
Yeah, which is a great one, yeah.

Steve
I invited him to see whether he might be willing to be on board and he immediately said yes. So, everything fell into place after that. We just kept adding luminaries that we thought would be engaging both in the academic world and beyond.
What really helped was starting with Harry Markowitz. Everything, I think, leads back to Harry Markowitz. So, once he was on board others got on board as well and that’s the story.

Niels
So, did you manage to do interviews with most of these people?

Steve
Yes, so, I often felt like a kid in a candy store actually meeting these heroes that, of course we had read about, and having the opportunity to talk with them. We actually decided to make video recordings. So, these are all available on our book website, there are links to it. So, that was a real treat to meet and interview all of them.

Niels
Just so I don’t forget, do you know the URL, or where people can go to watch these? Otherwise I’ll put it in the show notes if you don’t.

Steve
Yes, it’s the book title. It’s not a short one but it’s the book title: InPursuitofthePerfectPortfolio.com. So, that’s where it is at.

Niels
OK, well I’m definitely going to go and check that out.

Now, the book is a tribute, in some ways, to the academics who created a framework and repeatable process for investors and, as you call it, a democratization of investment management.

Before we get into who these characters are, perhaps you can talk about some of the concepts of this framework and explain why it is so crucial to how we invest today.

Steve
Sure, I think the most important concept is the one of diversification. When we talk about Harry Markowitz we can get into that in more detail. That’s where the framework for the whole portfolio management industry really goes back to. We’ve got these two components: expected return and risk, and I think the luminaries have really helped us to understand the different elements that go into thinking about risk. So, that’s an important concept that is part of this book as well.

Another concept and theme that I think recurs throughout the book is the importance of cost. I know you are very well aware, and in your fund are very aware of keeping costs low for investors. That comes out time and time again.

I would say that the last theme and concept has to do with what we call now behavioral economics: trying to avoid mistakes. We all make them. We’re all prone to various biases. So, the first step is, I think, an awareness of these biases and then trying to overcome them. So, these are some of the key concepts and some of the key themes.

Niels
Yeah, absolutely.
Now, early on in the book you show this wonderful organizational chart of the characters in your book and how they are all linked to each other in some way. I have to say that it’s quite amazing to see how closely they were, or are still linked. Is this how academics tend to work and how it all evolves?

Steve
Well, you’re absolutely right, there are very few degrees of freedom among the luminaries, in particular the academics, but even across the academics and the practitioners there are many connections. I’m not sure how typical this might be but it is fascinating just in terms of looking at who was a supervisor of someone else’s PhD committee.
I

t’s funny, a spinoff of that is that you can create some ancestry charts of who your PhD supervisor is and who was their PhD supervisor. So, for example, my grandfather (in terms of supervisors) is Gene Fama, one of the luminaries that we’re going to talk about. So, there are a lot of interconnections that way.

Niels
Yeah, it’s fascinating.
Now, you start out by giving an historical account of the history of investments. Unfortunately, we don’t have time to go into all of that. If you were to highlight one or two pivotal things that happened, that helped shape the world of investments as we know it today, what would you say that has been?

Steve
Well, I think what’s fascinating (when you look into the history) are so called investment products (that we think of as fairly recent like derivative products), have actually been around for centuries. Futures contracts go back to 2400 BC in various forms. Call options go back to 600 BC at least. In the 18th century BCE not only were there personal loans but there was a liquid secondary market for these promissory notes.
So, it’s fascinating looking at what we think of as new inventions [and which] are very old. Government bonds, the precursor to government bonds… A lot of these things (what’s interesting as well) happened not by intent but out of necessity. The first precursor to government bonds dates back to Venice in 1172 where there was a need to raise some funds to fight a war, which didn’t turn out very well for the Venetians but did have this lasting legacy.

There are all kinds of interesting historical facts. Here’s one more that I’ll just share. When we think of mutual funds (this goes back to the 1700s), the second mutual fund that was created is really a value investing fund. That was its mandate: to look for stocks that could be purchased below their intrinsic value. So, there are interesting milestones when we look at history.

Niels
Yeah, absolutely, it’s fascinating.
Now, I want to shift gears and focus more on some of these characters in your book which starts with a much celebrated economist and Nobel Prize winner, Harry Markowitz. But before we do so, I wanted to ask you about an earlier twentieth century French mathematician who died in obscurity but whose work, on the Random Walk of Stocks, was pretty much ground breaking. His name was Louis Bachelier, and he was born (I think) in 1870. Tell us a little bit about that because I think that this is something that I think, probably, a lot of people are not aware of.

Steve
Yes, absolutely. He was a French post-graduate student, and it was in 1900 (actually) that he successfully defended his dissertation called The Theory of Speculation. Really, what he was proposing (and this predated Einstein by a few years) was a model of a Brownian motion that was explaining the randomness of security crises. So, this was groundbreaking and, unfortunately for Louis, in his time, he didn’t get the recognition that he deserved.

His committee passed him but not with flying colors. So, he had a difficult time landing any prestigious academic job. It wasn’t until a half century later where a well known University of Chicago mathematician, Jimmy Savage, rediscovered his work, translated it to English, brought it to the attention of future Nobel Prize winner Paul Samuelson and that really gave it the attention that it deserves. He was incredibly ahead of his time and fortunately (though not in his lifetime) got the credit that he deserved.

Niels
Absolutely.
Now, let’s get back to, as you also pointed out, one of the really main characters. By the way, I should say that the book has a lot more people in it than we’re going to have time for today. I want to just start out with Harry Markowitz, as you said, born in Chicago in 1927. Many people know him from the article Portfolio Selection, which he published in 1952. So, tell us about his story (so to speak).

Steve
Yeah, so, Harry Markowitz is a fascinating individual. A few months ago, I think he just turned 94. We met with him and interviewed him a few years ago. He was still active; writing (I think) the third of four planned volumes of a book; still teaching. What’s fascinating is that he really had a background in operations research and he stumbled into the whole investment world.

The story that we tell, and it has been told before, is that (as many struggling PhD students can relate to) he had gone through his course work and he was struggling to find a topic for his dissertation. So, he went to see his supervisor, and his supervisor was busy, so Harry was waiting in the anti-room and another gentleman was waiting there as well. They struck up a conversation.

It turns out this gentleman was a stockbroker. So, while they were talking, that gave Harry some ideas. When he went in to see his supervisor Harry said that this guy out in the hallway, he’s a stockbroker, he thinks I should do a dissertation on stocks. What do you think? And Harry Markowitz calls it, “the best advice he ever received from a stockbroker.” So, that was how he stumbled into it.

The other fascinating event was (the real “aha” moment) Markowitz was then given a reading list since he wasn’t familiar with the investment literature, which of course was much less developed than it is today. There were some classic books that Markowitz was asked to read. One of the books that Harry was reading talked about how one should make investment decisions. It really focused on looking at the expected return of a security.

What bothered Markowitz is that, if that was the case then one would end up with a portfolio of putting all of your money in the one security that had the highest expected return and that didn’t seem to make sense. So this is where Markowitz certainly was aware (and others were aware at the time) of the premise of not putting all of your eggs in one basket. So, he started to think about what must be missing.

He pulled out a book on probability theory and his “aha” moment was coming across what is now familiar to anyone who has taken an investments course and a portfolio management course, which is a formula for the variants of a portfolio. Think of a very simple two stock portfolio which has a couple of variance terms but it also has this covariance term which incorporates the correlation. So, the “aha” moment was that, yes, expected returns are important; yes, risk measured by volatility of returns (standard deviation variants) that’s important; but, also the missing link was that correlations are critical as well. In fact, as we know, the more securities that you put into a portfolio it’s those correlations, or that covariance component, that really dominates.

So, that’s where he was able to take these concepts and create what we now call an Efficient Frontier. Basically, if we think of risk return space, the Efficient Frontier shows us the permination of individual securities (in other words shows us the portfolios) that have the important property of the highest expected return for a given level of risk, or the lowest level of risk for a given level of expected return. So, that’s really the focus of, as you mentioned, his 1952 Portfolio Selection article in the Journal of Finance that really was the start of a whole industry.

Niels
Yeah, to me, again, when I read the book, I think it’s difficult not to stress the importance of how differently he was thinking, at the time. You are right in that I think a lot of people back then were thinking about, “Yeah, we’ll put everything into one basket and we’ll watch the basket really carefully. Here he comes along and says, “No, no, no, actually that’s not what you need to do.”

So, we don’t think of that as revolutionary today, but it would have been massively different from how the general academics were thinking back then. I think that’s quite interesting.

Steve
The paper itself was just so different than other papers even that were published in the distinguished Journal of Finance. At the time most would have been… In fact the vast majority if not almost all [of the articles published at the time] would have been qualitative in nature.

So, with his, what’s unique, relative to today: his was solo authors; had very few references; and it had lots of equations. So, that’s what really made it different. He was able to take these concepts and come up with this framework that we still rely on today.

Niels
Yeah, now, he published the article in ‘52 but that’s not when he got his PhD, right?

Steve
Correct, he got it three years later in 1955. So, this would have been a portion of it, and by the way, that’s something unique as well – to be published even before you have your dissertation.

Niels
Was there some controversy about him getting his PhD? I just seem to remember, from the book, that he felt pretty sure that he could go in and defend it. Then when they came out they weren’t that excited.

Steve
So, on his committee was the future Nobel Prize winner Milton Friedman. So, Harry was very confident going in. He knew the material and could anticipate what questions would come up. So, he felt very confident until, in the first five minutes, Milton Friedman says, “Well, Harry, I took a look at your math and everything is fine but you are here for a PhD in economics and this isn’t economics. This is mathematics.”

So, I think there was a debate among the committee members. Whether this was a show stopper or not, it certainly gave Markowitz some anxious moments. It really speaks to how much of a trailblazer Markowitz was in this whole area in really creating this new branch of economics: finance, and investments (more specifically). This speaks to the importance of his work.

Niels
Yeah, and I guess in some ways (clearly certainly on my side – coming from the quantitative side of investing) this probably is the birth of quantitative investing as we know it, or were there others that, at that early stage, had already ventured into this?

Steve
I think this is the first. Interestingly, there were some others outside of finance (and this came to light, I think, later), who were grappling with similar types of concepts but in a different context. For example, there was a paper in 1952, by a fellow named Roy, that was in an insurance context. It was very mathematical as well and, in retrospect, had some of the same properties of Markowitz’s Efficient Frontier.
So, in other disciplines there were some quantitative models being created. This would have to be one of the first in finance, with the exception of Louis Bachelier, that we talked about earlier. Of course, it didn’t get the prominence that it deserved.

Niels
Right, absolutely.
Now, what I thought could be fun also is, before we leave Markowitz and before we leave the others that we decided to talk about today, for you to summarize for each of them. So, in this case Markowitz, what (in his opinion) is or was the perfect portfolio so-to-speak?
Steve

So, clearly for Markowitz it’s a diversified portfolio. – diversifying across not only stocks but across bonds as well. What’s fascinating about what we found is that, unlike Bill Sharpe (who we’ll talk about in a little while), Markowitz didn’t seem to put any particular prominence on what we refer to now as “the market portfolio.”

So, I think going back to Markowitz’s Efficient Frontier, it’s important to be diversified, and it’s important to have a portfolio of securities. I think the key takeaway is whether or not we are perfectly on this Efficient Frontier is less important than getting close to this Efficient Frontier. So, thinking of a diversified mix. There’s nothing wrong with having a market portfolio so long as you’re diversified. So, really that was his key takeaway in terms of how he sees the perfect portfolio.

The other thing that he would also want to emphasize is that we should always be taking into account any new information. So, he would refer to himself as a “die-hard Bayesian.” If there is new information then update your beliefs. So, that’s an important part of this as well.

Niels
Yeah, absolutely.
You mentioned Bill Sharpe, or William Sharpe, and let’s continue the story because Markowitz meets Bill Sharpe when they both work at Rand, which is a think tank in California. Of course Bill Sharpe is another very important person in the history of finance. So, tell us about Bill Sharpe.
Steve

Bill Sharpe, again, is a very interesting individual. He, on many occasions, is a great example of resilience and overcoming setbacks. These setbacks go all the way back to grade four. Bill Sharpe actually failed grade four. The reason he failed grade four was because of one math test. These were in the days when you had to know your times tables.

So, Bill Sharpe had studied his times tables, up to ten times ten, but unfortunately it turned out that the test was going all the way up to twelve times twelve. Because of that, if you can believe it, Bill Sharpe failed grade four and had to repeat grade four.

Niels
That’s a great story.

Steve
Fast forward to Bill Sharpe then embarking on his PhD thesis. He found what he thought was a fascinating topic on which to do a dissertation and had done all kinds of work and figured that he was about half way there and the topic was transfer pricing. So, he was asked to talk to one of the local experts on this area of research. When he shared his progress the expert came back and said, “I’m sorry but this really is not promising for a thesis and it’s best that you just leave it and start somewhere else.”

So, Sharpe was devastated and the good news for us and for his profession, of course, is that Sharpe’s supervisor said, “Well, remember this fellow, Harry Markowitz, who gave a seminar talk at UCLA? He’s a Rand now and you should go talk to him.” So, that’s how the two of them met. It was really Sharpe then picking up on the work of Harry Markowitz that led to both of them being co-recipients of the Nobel Prize in Economics in 1990.
So, that’s a bit of the back-story there.

Niels
Yeah, absolutely, and I think also, from reading your book, there was this funny thing that there’s actually another coincidental thing. Originally Sharpe was meant to become a medical… originally he was studying medicine, initially, but he didn’t like blood. So, that kind of changed the subject.

Steve
That’s absolutely right. In fact, one of the other luminaries that I’m going to talk about today, Bob Shiller, was debating between medicine and economics and chose economics. So, I think we’re fortunate where these individuals ended up.

Niels
Yeah.
So, he joins Rand in 1956, as far as I recall, and of course as you said, it’s the beginning of a long working relationship between him and Markowitz. Tell me a little bit more about some of the things that they started working on. Some of the things that I seem to remember that are important today, even though many people may not think about it in this way, is that Sharpe kind of coined the phrase or the concept of Beta when he was trying to simplify Markowitz’s model and referred it to the market portfolio.

But he, for example (as far as I know), never talked about index funds as far as I can tell. But, of course, this was very instrumental in the whole passive investment revolution that happened as well. So, a lot of things started growing, or the seeds were laid for things that came later. So, you can go anywhere with this, but there’s so much to dig into with these people.

Steve
Absolutely, let’s see if I can unpack a number of these great directions that you have been given me.
So, Markowitz had completed his dissertation, and we know this 1952 paper that you mentioned called The Portfolio of Selection. In the next six or seven years what Markowitz did was work on the same area, going into more depth in terms of the various concepts. That led to a book by the same title, Portfolio Selection, that came out of Rand Corporation as a monograph in 1959. So, it was around this time, when Sharpe met Markowitz, that he was developing these various concepts.

In one of the chapters (I believe it was actually a footnote), Markowitz talked about a way of extending his model, his Efficient Frontier. So, if your listeners can imagine this Efficient Frontier, which is in this expected return and risk space and has this concave shape to it, the insight that Sharpe picked up on was what happens to this model if we add one more security, and that security is a riskless security?
So, now we’re choosing between a riskless security, and choosing among all the portfolios of risky securities on this Efficient Frontier that Markowitz created. So, it turns out (if you can picture this visually), imagine then just simply drawing a straight line to the tangency of the Efficient Frontier. It turns out to be that the optimal portfolio of risky assets is on that tangent because it’s closest to this northwest quarter of lowest risk for the highest amount of expected return.

So, the magic in that is in this world, in this model, everybody should choose that one particular portfolio (call it “M”, call it the market portfolio), and that’s your risky asset. Then you take a proportion of your assets and put them in that and then you put the other proportion in risk free investments. So, you can go up and down that curve, depending on your preference for risk.

It was really Sharpe that was digging down, and focusing, and then trying to model and come up with an equilibrium model that would then tell us, “OK, if everyone is choosing this market portfolio, how do we price each individual stock?” That’s where this magical concept of Beta comes into play.

All that matters (and this goes back to correlations and covariances), all that matters is how each stock varies relative to the market. So, that simplifies things because we don’t have to worry about how Tesla does, how does its stock return correlate with Alphabet and how do each of those correlate with Microsoft? We can simply look at each individual stock and how it varies relative to the market. That’s what Beta is all about and that’s the backbone of the Capital Asset Pricing Model.

An interesting sidebar to this is, before coming up with this formal model, Bill Sharpe published a paper that really was the precursor to this whole motion index funds and it was simply coming up with an ad hoc model looking at what we now call Beta and how each stock varies relative to the market. The motivation for that paper was based on computing costs at the time. It was much less costly and much faster to run a program that tries to incorporate correlations to the market rather than much more numerous covariances across all these securities.
So, that was really the driver behind the innovation of what we now call Beta.

Niels
Yeah, fascinating. Thank you for sharing that.
Is Sharpe the first one of these luminaries, as you call them, that started using computers in his work as a main driver of these things? Is that fair to say?

Steve
I believe that’s fair to say. In fact, on our website (for the really inquisitive readers) we actually have posted Bill Sharpe’s dissertation. It’s fascinating to even just flip through it to see how much quantitative modelling he was doing. Now-a-days, when we think about AI, really what’s built into that is what I would call a primitive AI because he had looked at professional investors and how they were making their decisions. He tried to model that. So, it’s fascinating and it’s worth just skimming to see how he was going about building out these quantitative models and creating (what we now call) Capital Asset Pricing.

Niels
Yeah, yeah, and I can’t help wondering how different would finance be, today, if they hadn’t started using computers back then? They wouldn’t have come up with the same things that we look at today. So, did theory come first, or did computers change things; yeah, a chicken or egg sort of thing.

Steve
Absolutely, and Sharpe was back in the days of punch cards, which many of your listeners might not be familiar with. You had to type out using a particular type of machine, you’d have to type out your code which would go into a batch of cards. Then a large mainframe computer would be reading these programs and executing these programs.

Sharpe mused that, if he wasn’t successful in his dissertation, he would at least be able to fall back on being a punch card reader. That was his fallback position.

Niels
Yeah, as a fun side note to that, when you mentioned punch cards, my day job is that I work for one of the oldest systematic managers in the world. We’ve been around for forty-seven years just this past month and, actually, our founder and his son, the way they started out was to go to the local library every night to run the system, so to speak (the trend following system) using punch cards. So, we have those in our offices in the U.S.

Absolutely.

I want to interact in asking you for a personal view, as well, other than just describing these people. We’ll come back to the Sharpe Ratio because we can’t leave that out when we talk about Bill Sharpe.

I mentioned, just briefly, that these were some of the beginnings to the active and passive type of investment and, of course, in this case the passive investment revolution. As a professor of finance, I’m just curious, what do you make of this debate? You, obviously also touch on Vanguard, and so on, and so forth, which we won’t have time for today, but there has been (and some of the guests have been on the podcast) like Mike Green who talked about the challenges we have.

From where you sit, what is your view on this debate? Is it all good? Is it some good but maybe we’re getting to a point where there are some real risks because of the amounts being managed in passive forms?

Steve
Certainly, if we can narrow the perspective in terms of models like the Capital Asset Pricing Model, the implication is that passive is the way to go. When you look at Bill Sharpe’s Perfect Portfolio, he is a passive investor in terms of stocks and bonds.

I think if we were to go back, Niels, fifteen, twenty years ago, a consensus among academics would be that passive is absolutely the way to go. As you are well aware, since then we’ve had this emergence, and a better appreciation of all the behavioral biases that we alluded to earlier which then (I think) leaves the door open for firms, like yours, that can try to take advantage of perceived inefficiencies. So, I think that’s where there is an appreciation that there is room for active investing.

For non-professionals, my personal view is, the best starting point is to start passively; start with an index fund. Even Warren Buffet talks about index funds as a way to go for many investors.

Niels
Yeah, absolutely.
Now, of course, most people know Sharpe from the Sharpe Ratio. So, this is kind of the origins of thinking about risk in terms of volatility. So, I’m curious for you to put a few words to that, and then I have a follow-up question about volatility and the changing role of volatility, but do you want to put a few words into the breakthrough of the Sharpe Ratio?

Steve
Sure. So, the well known Sharpe Ratio has, as its numerator, the return on a particular investment or a particular asset above the risk free rate, relative to its volatility or risk, as measured by the standard deviation of the returns. So, again, going back, if we can visualize this Efficient Frontier and this tangency line between a risk free rate and the Efficient Frontier, basically the Sharpe Ratio is describing this slope that we have here. Our objective, as investors, is to try to maximize that (we’ll call it) excess return (return above the risk free rate) relative to the amount of risk that we’re taking on. So, it gives a nice metric return per unit of risk.

Niels
Yeah, of course. There’s certainly a lot of debate, in my world, about how good a measure the Sharpe Ratio is because it has been taken a little bit out of context meaning that I think he intended it to be a portfolio wide measure, but now-a-days we look at it on every single little investment strategy we can find (so the individual components), and that might create some problems.

That’s actually not where I want to go with my next question because (and, again, I am curious about your personal opinion here) volatility is something that (when you look at the history it kind of gets invented to look at riskiness) is a measure of riskiness in a portfolio. But, as we know today, the world of finance has become very, very quantitative and very much driven by “algorithms”, and so on, and so forth. Volatility is really an integral part of a lot of these formulas that we all use, especially when it comes to position sizing, and so on, and so forth. What do you think of this transition from measure to ingredient in the models? Does this present some unintended risks in your opinion?

Steve
Yeah, that’s a fascinating question if we go back to Markowitz (we need some sort of starting point to make these models tractable), so by assuming that we can capture volatility by something like the standard deviation then we can make some traction with these models. Now, Markowitz did not say this (and I think he would emphasize this), that he did not make the assumption that stock returns are normally distributed. So this is, I think, where we get into some misinterpretation. However there are some assumption, in terms of the utility functions that would be consistent with a risk measure using standard deviation.

I think what we have seen is that, if we think of standard deviation as a risk measure, it is a great first approximation but it certainly doesn’t capture the tail risk. That’s where we saw that during the financial crisis, for example. We saw it during the beginning of the pandemic where we had these incredible extreme returns that are not consistent with a normal distribution.

This has, I think, caused us to really rethink ways of measuring and thinking about risk. Again, we won’t have time to talk about Myron Scholes. He’s a big proponent of thinking about the tails: both the lower tail and the upper tail as well.

Niels
Yeah, absolutely, I appreciate that.
Now, you mentioned before what you would say that Bill Sharpe would choose as his perfect portfolio. So, I wanted to ask a slightly different question and that is, what do you think (if you had to choose), what do you think is going to be the main legacy that he is going to be known for (because there are quite a few things to choose from)?

Steve
Yeah, I think [it would be] the Capital Asset Pricing Model for Sharpe. It has been criticized, and we have a chance to talk about Gene Fama next. It’s partly where some of the criticism has come from. I think really laying the foundation for passive investing is his lasting contribution that Jack Bogle, at Vanguard, and others picked up on and really created this index revolution. I think that’s where it can go back to Bill Sharpe’s contributions.

Niels
Sure.
OK, so let’s shift gears again, because in the 1960s ‘70s, and ‘80s we have this guy called Mac McGowen, I think he was called, who was essentially given a carte blanche by Wells Fargo to hire anybody who really wanted to do some interesting stuff, and pay them whatever they needed and, at various times, you had Eugene Fama, Bill Sharpe, Harry Markowitz, Myron Scholes, and Ficsher Black working there. So, as you rightly pointed out, we’re going to spend some time talking about Eugene Fama because that is another really interesting and important character. So, why don’t you start from the beginning.

Steve
So, Fama is an interesting individual who really had aspirations to be a high school gym teacher. That’s what he wanted to be. He was very athletic (if you met [Gene Fama], he’s not a tall individual, maybe 5’ 8”), but he actually excelled at high jumping when he was young. Football was another sport that he played. He had a summer job working at an investment firm where the job was to try to predict what stocks were going to be doing well.

So, he did some primitive modelling and, of course as you know and your colleagues know, you’ve probably never seen a backtest that you don’t like. There are great backtests. But what he found, after finding these great relationships, is nothing worked going forward. So, when he was doing his dissertation, at the University of Chicago, that’s where he started to focus his attention. His major contributions have been empirical. This was also around the time when the well known database that we call CRSP (Center for Research and Security Prices), was really born. This was a follow-up of data that was provided by the industry.

So, Fama had access to this data and was one of the first to really drill down and look at individual stock returns and risk and get a sense of whether there was any predictability in terms of these returns. He focused in on what were (in the mid 1960s) the Dow Jones 30 Stocks.
Looking at various patterns and looking at time series and correlations across time (autocorrelations), he concluded that (by and large) stocks followed a random walk which should sound familiar going back to 1900 and Louis Bachelier. So, this is where Fama, then, went on to coin the notion of the Efficient Markets Hypothesis which, basically, says that prices will immediately reflect all relevant information.
So, this has now been synonymous with the Chicago School. This whole thinking was prevalent, particularly through the ‘60s and the ‘70s, that markets are efficient. Test after test seemed to confirm this notion of market efficiency.
So, let me just pause there and I can continue on in the story perhaps.

Niels
Yeah, you mentioned Chicago and of course Chicago features, with many of these luminaries. Actually, I think there’s a little bit of a fun back-story that you might want to share because it wasn’t certain that Fama was going to get into Chicago because of the fact that they hadn’t received his application.

Steve
Yes, absolutely. So, Fama had attended Tufts University. He was applying to various schools and got accepted to various schools, but where he really wanted to go was Chicago. So, he just called up the University of Chicago and, as it happened, the Dean of Admissions answered the phone, and they got to chatting, and one thing led to another, and the Dean of Admissions said, “Well, we actually have a scholarship for Tufts graduates.” Which, again, it would be unheard of today, without actually seeing Fama’s application Fama was accepted into the University of Chicago PhD program and that’s how he got in. If not for that phone call, Fama would have been somewhere else and not where he is now.

Niels
I think some of these coincidences are just extraordinary when you think of what could have happened if they didn’t occur. I don’t want to talk too much about the person, but I do think he’s an interesting one, and people should maybe read up on him. It’s certainly a name that figures, in my industry, to some extent. It’s also at Chicago that he meets Benoit Mendelbrot who was this Polish, French, American mathematician and who told Fama, as far as I remember, of this apparent randomness in financial markets. He was a fan of Louis Bachelier, as I remember as well from your book.

Steve
Absolutely, and this is where, I think, Fama’s dissertation, and actually some of his earlier papers, talked about tail risk. There were a lot of technical articles about how stocks weren’t perfectly normally distributed. So, there were these different models that better captured the tail risk and the so called kurtosis or the peakness of stock returns. So, a lot of Fama’s earlier studies were influenced by his conversations.

Niels
Yeah, absolutely. Maybe also, you mentioned (of course) CRSP, because that organization also seemed to have been quite influential in bringing a lot of these people together at their semi-annual events. One individual (I don’t know if he specifically met him at one of these events), one of the individuals who, I think we can’t not mention when we talk about Fama, is Ken French.

Again, just briefly, because a lot of the models that we know today (the Fama-French models), were the result of their collaborations. So, a lot of people have used them since. Was there anything, any fun facts that you remember from that side of Eugene Fama’s career – that “French Connection” so to speak?

Steve
Yeah, that’s a great way of putting it.
Certainly Fama has had many co-authors, and Fama has made many contributions through his solo research. You’re absolutely right, it has been this long lasting and continuing co-authorship with French. And Ken French had done some things on his own as well, but it was really this synergy between the two of them. I think they both have a similar work ethic. So, they continue to churn out research, starting with (we can certainly talk about it if you like) the beginnings of the Fama-French model, which really ended up being a critique of Bill Sharpe’s Capital Asset Pricing.

Niels
Sure, we need also to leave something for the people who are going to read the book, of course, but what I did pick up, and you already alluded to (which I think is worth mentioning at least), what is somewhat unique about Fama is also the fact that some of his best work, as I think you write that three of his best pieces of work, actually comes in three different decades – meaning that he has continued.
A lot of people, as far as I understand, a lot of the academics kind of peak early (if I can put it that way). He has actually continued to deliver some pretty groundbreaking stuff (so to speak). Of course, he also had quite a few famous students, as far as I am aware: David Booth of DFA, and (of course maybe better known in my industry) Cliff Asness of AQR, and they seem to have done pretty well from following some of his work.

Steve
Absolutely, and you’re right that it is amazing. Even a lot of the Nobel prize winners, what they’re most known for is some of their early work. Fama has consistently… If you look at some of the most cited papers, Fama is near the top of the list and in so many different areas.

He had done a lot of early work on corporate finance rather than investing and was well known for his contributions there. He had done a lot of work related to economics models, and looking at interest rates and inflation in his early years. Many of your listeners will know him from Fama-French but he has had many more contributions.

Niels
Sure, absolutely.
Maybe to round off Eugene Fama, if you were going to describe, from your knowledge now, what he would describe as his perfect portfolio, how would you think about that?

Steve
Sure, so it really goes back to the Fama-French Model, the Three Factor Model that has been expanded to five factors and who knows how many more to come. The path breaking papers in 1992, 1993 by Fama and French really ended up being captured by this notion (I think it was a New York Times article) that captured the phrase that Beta is dead.

What Fama and French found was that, while the Market Portfolio (in and of itself) seemed to be correlated with stock returns (in other words, implicitly stock returns are driven by some kind of market factor), by adding these two other factors: one capturing the difference in returns between values and growth stocks, and the other capturing the difference between small stocks and large stocks, those two other factors dominated the power of the Market Portfolio, thus leading to the notion that the Capital Asset Pricing Model is dead.

What’s surprising, in terms of Fama’s Perfect Portfolio, is that, despite that, Fama’s Perfect Portfolio starts with a Market Portfolio. So, Fama would say to start by being diversified through an index fund or through a market portfolio but also be consistent with the Fama-French model. Fama says that once you’re there, as the starting point, you may want to tilt. You may want to tilt to value stocks (which Fama and French have shown, over a very long horizon, perhaps not in the last decade, but over a very long horizon), tend to outperform growth stocks.

So, tilt towards value stocks – those that have low price/earnings ratios; and also tilt toward small cap stocks which, again, have done well, but not necessarily over the last decade. So, that would be Fama’s Perfect Portfolio. Thinking in terms of different dimensions in terms of ways we can capture this.

Niels
Sure, fantastic, great.

Now, of course, there are a lot more people that have shaped the world of finance, as we know it today, and to get to know them I would strongly suggest all of our listeners should go, of course, and buy your book.

I want to ask a couple of different things as my last few questions before we wrap up for today. One question is that, given all the research that you and Andrew Lo have done to write this book, how do you view the question of what is the perfect portfolio?

Steve
We’re careful to say that the perfect portfolio, it’s a moving target. This is why the book title is The Pursuit of the Perfect Portfolio rather than The Perfect Portfolio per se. So, it varies over time and it varies across individuals. The analogy we use is that if someone asks, “What do I need to do to be healthy?” It depends on a lot of factors. It depends on your particular health situation and there are so many different ways that you can take the health angle through exercise, through diet, through nutrients and so on.

I think what is the Perfect Portfolio? There are some common elements. Clearly diversification is probably the most important element that all of our Perfect Portfolios should include.

I think a second thing is really having an appreciation of what our own risk appetite is. That’s not something that is static. That will change over time given different life circumstances. It’s really being aware of what that risk appetite is.

I think another element (coming back to this whole notion of whatever you’re going to do you should do it in a very cost efficient manner), you should be mindful of what the costs are going to be. The final thing I would say, in terms of the Perfect Portfolio, is avoid what might be some obvious mistakes. We often are over confident in our abilities. Sometimes that can lead to excessive trading. So, try to be mindful of all of those things and that will help you along the road to this Perfect Portfolio.

Niels
Yeah, I like how you just threw in all the behavioral stuff at the very end because that could be a whole other conversation, which maybe we’ll have one day.

Let me ask you my final question, Steve. It’s kind of a selfish question because I come from the world of systematic trend following, using a fully diversified and global portfolio of liquid futures markets that include stocks and bonds and currencies and lots of commodities where we are completely agnostic to going long or short. What we can see, in terms of the evidence of track record (such as the firm I work for and other firms that have been around for more than 40, 50 years) is it continues to work.

Of course your co-author, Andrew Lo, has also embraced the strategy by founding one of the very large players in our industry today, but here’s my question. We often talk about this, on the podcast, as being the perfect portfolio and I’m curious how this type of approach stacks up against all the work and information that you have done considering how we approach the market.

Steve
So, I think [we have to come] back to the premise that there isn’t one Perfect Portfolio. What I will say is that, let me pick up on one element of what you just described and that’s the vastness in terms of the types of assets that you include. Perhaps we’ll end on this.

Coming back to Bill Sharpe’s Capital Asset Pricing Model, he developed this theoretical model that talks about investing in “the market.” What seems to have gotten lost throughout the ages is that as we operationalize and as we measure Beta the proxy for the market is a domestic equity portfolio, like the S&P 500, or in England the FTSE. So, what I like about what you just described is that truly the market portfolio is all investable assets, and even those that aren’t investable which proven to have some challenges.

So, I think what you are doing is really, in spirit, what we mean by the Market Portfolio. So, from the sounds of things, from a diversification perspective it’s going to be hard to be more diversified than that, so kudos for that strategy.

Niels
Yeah, I think more kudos to the people who, back in the ‘60s and certainly in the early ‘70s, worked that out without the knowledge we have today but they were able to work this out. I think that this is absolutely extraordinary. I’m so glad for the kind of seal of approval from you, Steve. That’s going to help us a lot and give us a lot positive feedback in our industry for sure.
On that note we’re going to wrap up this very fascinating conversation. Steve, thank you so much for being on the podcast and for sharing your thoughts and insights with me. It has been incredibly interesting to learn about how relatively few people, so to speak, had such a profound impact on the Pursuit of the Perfect Portfolio.

To all of you listening today, I hope that you were able to take something from today’s conversation onto your own investment journey and if you did, please share these episodes with your friends and colleagues and send us a comment to let us know what topics you want us to bring up in the upcoming conversations with industry leaders in the world of finance and investing. From me, Niels Kaastrup-Larsen, thanks for listening and I look forward to being back with you on the next episode of Top Traders Unplugged. In the meantime, go check out the show notes for this episode and all the other resources that you can find on our website.
Until next time, take care of yourself and take care of each other.

Ending
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