The Surprising Success of the U.S. Economy ft. Elroy Dimson & Kiran Ganesh

[00:00:07] Elroy

We would not have expected America to continue to be world beating compared to other markets. We were wrong on that. America has had a marvelous quarter century this time around.

The last few months have become a bit more of a puzzle, but the first 25 years of the new millennium have been very favorable for the United States. And so, one of the things which you might come back to later on is what we think will happen for the future.

[00:00:41] Intro

Imagine spending an hour with the world’s greatest traders. Imagine learning from their experiences, their successes and their failures. Imagine no more. Welcome to Top Traders Unplugged, the place where you can learn from the best hedge fund managers in the world so you can take your manager diligence or investment career to the next level.

Before we begin today’s conversation, remember to keep two things in mind. All the discussion we’ll have about investment performance is about the past, and past performance does not guarantee or even infer anything about future performance. Also understand that there’s a significant risk of financial loss with all investment strategies and you need to request and understand the specific risks from the investment manager about their products before you make investment decisions. Here’s your host, veteran hedge fund manager Niels Kaastrup-Larsen.

[00:01:36] Niels

Welcome and welcome back to another conversation in our series of episodes that focuses on markets and investing from a global macro perspective. This is a series that I not only find incredibly interesting as well as intellectually challenging, but also very important given where we are in the global economy and the geopolitical cycle.

We want to dig deep into the minds of some of the most prominent experts to help us better understand what this new global macro-driven world may look like. We want to explore their perspectives on a host of game changing issues and hopefully dig out nuances in their work through meaningful conversations.

Please enjoy today’s episode hosted by Alan Dunne.

[00:02:20] Alan

Thanks for that introduction, Niels. Today I’m delighted to be joined by Elroy Dimson and Kiran Ganesh.

Elroy is professor of Finance and Director of Research at Cambridge Judge Business School. He is a founder and Chairman of the Centre for Endowment Asset Management at Cambridge. He was formerly Chairman of the Strategy Council for Norway’s Sovereign Wealth Fund and his research focuses on Long Horizon Investing with his notable books including the Triumph of the Optimists and he is one of the authors of the Global Investment Returns Yearbook which we’re talking about today.

And also, I have Kiran Ganesh who is a Managing Director and Head of Investment Communications at UBS Global Wealth Management. In his role he leads a team responsible for writing UBS’s House View from a macro perspective. And he regularly meets with clients to advise on financial markets and appears regularly in the financial media. So, that’s a lot to get through. Two very accomplished guests. Great to have you both with me today.

I might just kick off by getting a quick sense on your backgrounds. Quite different obviously, but we do like to get a sense on our guests, how they got involved in their respective fields. So maybe. Elroy, I mean, obviously you’ve spent a long time researching financial markets and financial market history and asset market returns. What got you interested in that in the first place?

[00:03:43] Elroy

Well, if you take my journey back to earlier stages of my career, I was at London Business School. I did a degree at LBs, just like Kiran did at an earlier stage for himself (so, perhaps we’re not quite so divergent). I’ve spent a long time looking at indexes, designing indexes and looking at the performance of markets around the world.

I think, although I’d done earlier work, probably the point I’d start is the design of the FTSE 100 index which I undertook with Paul Marsh when we were at London Business School. And what followed on from that was a continuing interest in creating indexes and understanding what a good index would be and what a weaker index would be.

At the end of the 1990s, the organization with which we were producing a number of index numbers pointed out that Millennium was coming up, and that it was soon going to be New Year 2000, and we ought to have something which celebrates that. And instead of looking again at US and UK data, we gathered together data for a number of countries around the world. We called it the Millennium Book for the New Millennium.

And it was the Millennium Book also because we had 100 years of data for each of 10 different national markets. So, we had 1,000 years of data. We launched that. It segued, in the end, into other work and the continuing yearbook which we produce in conjunction with UBS.

[00:05:28] Alan

Very good, and Kiran, obviously you kind of started with a similar academic background but have spent most of your career in UBS. I mean, what got you interested in the markets in the first place?

[00:05:42] Kiran

Well, I think, when I was a kid, I quite enjoyed playing fantasy football and picking my players and seeing who would perform well on the weekends. And I thought that this would be a sort of more grown-up version of that, perhaps, constructing portfolios of stocks and seeing what would win.

I think when I was a bit younger, I think I had a clearer belief that I could really pick the winners and watch them rise. So, I entered into investment banking with bright eyes on a rather inauspicious day. My first day at UBS was the day that Lehman Brothers collapsed, or the morning after Lehman Brothers collapsed, I should say. So, back in 2008 initially I was in an equity research role looking at stocks in the media and telecom space and then later moved on to a broader role which has really led to my position today which is in UBS Global Wealth Management.

And its quite an interesting seat because I’m able to really gather together and discuss macro views with all of our specialists, whether economists, or asset class specialists, or people covering single securities. And then it’s my responsibility and my team’s responsibility to try and bring those together into the overall house view, which, particularly at these volatile times that we’re in today, is quite an interesting role to be in.

There’s certainly lots of questions that we get from clients, and then we’re charged with trying to find a good and constructive answer to those questions and help them guide their portfolios through some uncertain times.

[00:07:16] Alan

Very good. Well, as you say, we’re living in very uncertain times and the day-to-day volatility we’re seeing at the moment is immense. But, I guess for today’s conversation we’re going to take a step back, and take a look at the big picture, and see what we can infer from the big picture.

So, Elroy and his co-authors are the author of the Global Investment Returns Yearbook. As Elroy mentioned, it started off as the Millennium Book and then became quite a well known publication or hardcover book called the Triumph of the Optimists. And then it’s been published every year since then.

I mean, you gave a sense on how it originally came about, Elroy. I guess, when you did it first, did you imagine that you would update annually and it would become such a kind of a reference book for people?

[00:08:04] Elroy

No, the evolution was kind of a surprise. We thought there were some really big questions like, has America been so unusual that the common basis for estimating long-term returns may not work? It may relate to one country’s history and that may not be true of other countries. So, we thought that looking at long term stock market returns and looking at the equity risk premium for a range of countries would be informative.

We called the book Triumph of the Optimists because it became clear that the optimists, the people who bought risky assets back in 1900 had triumphed. But we didn’t realize that there are lots and lots of other questions that we could use to confront data, and we could get answers to other sorts of important questions, and there’s been a lot of them.

So, we started out with a book which we thought dealt with a big question and answered it. We ended up with a data set, and a data set which has grown over the years, that we could use to answer all sorts of other contemporary questions.

[00:09:23] Alan

That’s right. And obviously each year I think you’ve taken some interesting themes and topics and delved into those, and we might get to some of those as well.

Kiran, I’m just, just curious. Obviously, UBS have now partnered with DEEM in this respect. It was Credit Suisse previously. I mean, from your perspective, when you engage with clients around this, what kind of feedback challenges do you get?

I mean, sometimes you’ll get the view, well, you know, what happened 100 years ago, how relevant is that for today’s market? But equally, I guess, it’s interesting to anchor to kind of returns that we’ve observed over the long term. I’m just curious, what kind of feedback do you get?

[00:10:03] Kiran

Yes, I think firstly to say that this is one of the most popular reports that we issue each year, and really proud to partner with Elroy and his colleagues on this. Clients really have a very strong appetite for trying to anchor their decisions in the long-term.

I think exactly as Elroy said, the fact that we are able to not only show US data, which is quite commonly available, but also make the case by showing certain things that work across a whole variety of different countries, I think that really helps us make the case around some important investing principles. So, I think that’s really important for clients.

Literally, just this morning, I was talking about the yearbook with a large group of clients from Latin America and they were asking many questions around things like real interest rates, or correlations between equities and bonds, or prospective returns for equities, or the equity risk premium. These are all very, very topical questions and sometimes we have to be honest that we don’t always have a very clear answer about what things are going to be like in the near term.

But being able to at least ground those conversations in longer term data, longer term norms, understanding different regimes we can enter, really helps frame the conversation and frame the reference so that then our clients are able to make decisions using certain parameters for their investment portfolio. So, I think, really, it’s a valuable study. People use it for a wide variety of purposes. But just having that breadth of country level data and the time span really makes it a very powerful set of data.

[00:11:45] Alan

Sure. And, I mean, when you look at the numbers, do you find that investors are surprised? (We’ll get into some of the details in a bit.) I mean, say, in terms of the size of equity returns outside the US, maybe certainly not as strong as what we’ve seen in the S&P 500 over the last few years, is that more sobering for people or how did it take those kind of perspectives?

[00:12:08] Kiran

Yeah. So, I think one thing is on the power of compounding, which we know that Buffett is called one of the wonders of the world. But I think that really comes over such a long time span because you can see differences either in asset returns of maybe a few percentage points, or between countries of maybe 1 or 2 percentage points. When you look over that very long timespan, it makes a massive difference to wealth. So, particularly for our clients who are thinking on a multi-generational time frame, that’s, I think, an interesting illustration for them.

And then, look, it depends where clients are coming from as to whether they’re sort of surprised positively or negatively about some of the prospective returns in other countries. But we found that the study really does show the importance and the power of diversifying globally, and the importance and the power of making sure you have a strong allocation to equities because of the scale of the outperformance you get over time.

[00:13:06] Alan

Absolutely. And I guess, Elroy, the outcome, the results are very much consistent with the other well-known book on this called Stocks For the Long Run. I mean, this is the message here as well, that you show the outperformance of equities over bonds, and over bills or cash, over a long period of time, notwithstanding some pretty dramatic drawdowns along the way. I mean, that, presumably, didn’t come as a surprise to you. Or did the magnitude come as a surprise to you when you started doing this research?

[00:13:40] Elroy

Well, the book entitled Stocks For the Long Run, written by Jeremy Siegel, professor at the Wharton School, in the US, was when we began a very influential volume. So, in the end of the 1990s, I was going to the US from time to time and every cab driver in New York would tell you about their plans, what they’re planning for the future. There’d be a big wedding for the daughter, a Bar Mitzvah for the son.

It was all going to be very ambitious, but everything was under control because it wasn’t for another 10 or 15 years. And they’ve got their money invested, and they’ve got it invested in common stocks. And that was going to produce the high return that would enable them to manage their aspirations.

And then the tech bubble burst. We went through an experience which is not dissimilar to the things that people are worrying about now. And it wasn’t quite so clear that a recipe for your financial future is simply investing in common stocks. So, there are these differing points of view. You might be cautious, or you might be focused on equity risk.

And our thoughts on that have evolved over time. But it did become clear, as we looked at lots of countries, that the US had done remarkably well and that in other countries you had to hold for far longer than your daughter’s wedding if you were to become wealthy through investing in common stocks.

So, for me, probably for you, having a balanced portfolio makes more sense than plunging very heavily into one asset class and BAPS selected components of that asset class.

[00:15:39] Alan

That’s interesting, I mean, because even today the standard view is equity heavy. And obviously we’ve had a period, a 15 year period, that’s been particularly favorable.

So, you touch on US exceptionalism. When you look at that outcome (and I don’t have the numbers to hand), the nominal return in the US equity market is about 10%, I believe. And outside of the US it might be 2% or 3% less than that or something like that. And as Kiran says, when you compare that over time, that is quite a dramatic difference.

When you look at that, is that a reason to believe that would be the case in the next 100, 125 years, or is that just one 125 year sample in the fullness of time?

[00:16:26] Elroy

When we published our work in New Year 2000, in this pre Triumph of the Optimists volume, which we called the Millennium Book, we had the history for the whole of the 20th century. And two features were very prominent in all of that.

One was the remarkable performance of common stocks, and the other one was the remarkable performance of the United States. And so, looking forward, we would not have expected, in the 21st century, to see common stocks doing quite so well as they had in the past. And that we were correct on.

And we would not have expected America to continue to be world beating compared to other markets. We were wrong on that. America has had a marvelous quarter century this time around. The last few months have become a bit more of a puzzle. But the first 25 years of the new millennium have been very favorable for the United States. And so, one of the things which we might come back to later on is what we think will happen for the future.

[00:17:41] Alan

Yeah, absolutely.

Kiran, I mean, that is a topical point at the moment. We’ve had this strong outperformance from the US, and capital has been flowing in, and obviously (we’re recording this in the early April) we’ve started see cracks in the American exceptionalism story.

How, how are you finding investors are balancing that kind of 25 year or 125 years of US exceptionalism versus, you know, a few months of underperformance?

[00:18:14] Kiran

Yes, well, I think in recent years the US has had almost everything going for it because it’s been an economy with somewhat higher growth than we’ve seen in other regions. It’s also been perceived as a safe store of money. And it’s also had a lot of the biggest and fastest growing companies and the companies with share prices appreciating most dramatically. And if you’re in the startup space, it has also had the most interesting venture capital opportunity. So, it’s had pretty much everything going from it from growth, to safety, to economic performance.

And obviously now we’re getting some cracks in that, whether it’s uncertainty about some of the business models on the AI side, obviously some of the political disruption that we’re seeing. So, we’re seeing some cracks in there.

I think when we’re talking to clients about what might happen over the longer term, I think it’s important also to remember… And this isn’t from the Global Investment Returns Yearbook, but this is a study that was cited in there from Hendrik Bessembinder, from Arizona State, which shows that the performance of equity markets is of course heavily driven by the individual companies that compose them, and not just the individual companies in aggregate. It’s a very few individual companies that really drive the majority of the growth over the longer term.

So, I think we also have to be somewhat humble about our ability to predict, over the next hundred years, what are going to be those dominant companies of the future and in which country will they reside. And the US has done fabulously, in the last two decades, because the technology giants that now dominate the equity markets were founded and grew in America. In the next decades, maybe it will still be in America, maybe it will be somewhere else.

I don’t think we can have a clear view or we say to our clients, is that you just need to be diversifying broadly across all of these markets to make sure you’re not missing out on the next Nvidia or Amazon or Apple or some of these great companies of the future that will be really dominant in driving portfolio returns.

[00:20:21] Alan

Absolutely. And it does seem that investors tend to extrapolate from the recent past and assume that the world will continue to be dominated by the Mag 7. But Elroy, as you show in the book, you show one notwithstanding the high level of concentration in the US, it’s not that concentrated relative to some non US indices. And also, you show that we’ve seen it more concentrated in the past. And you also show how dramatically things change over time. If you go back to 1900s, the index was very much concentrated in railway stocks, isn’t that right?

So, I mean, it sounds like, in reading the book, you don’t seem to be overly concerned about the concentration in the US market.

[00:21:05] Elroy

Well, let’s think a little bit about the way that we visualize concentration. Typically, it’s the proportion of a particular national market that’s allocated to particular stocks or particular sectors. And the United States is not internationally unusual from that point of view. However, it is very important because two thirds of the world’s equity market, at least at the time that we published our book, and certainly well over half on the worst days we’ve had recently. So, the majority of the world’s equity market is the US.

So what we have is a moderately concentrated United States. We have a moderately concentrated World index. And that means that we are exposed to what’s important at present, which is certain types of tech stocks. That’s perhaps not very different from 1999 when there were somewhat different tech stocks that were important, or the 1970s when energy stocks were very important, or going all the way back to railways, as you’ve done, or even canal stocks, if we go back essentially before that, but if we think about the industries that have provided growth, though not necessarily stock market performance.

China, of course, is now creeping up very fast. And who knows whether the next century will be the century for Asia or whether the United States, with its unusual economic attributes, will resume powering ahead of the rest of the world.

[00:22:49] Alan

Yeah, I mean, I guess that’s the way investors look at it. I mean, you can (I guess, without running the risk of putting a narrative exposed) you look at the US – it is business friendly, low regulations. So, I guess people might not be shocked to see that the US has been the best market. Would you agree with that or are we just applying that…

[00:23:12] Elroy

No, no, I don’t agree with that interpretation at all.

[00:23:15] Alan

Okay, okay.

[00:23:16] Elroy

The general view has been business friendly, and the rule of law, and so forth. If that’s the case, that would make the US low risk. And if it’s low risk, it should have been low return. So, if I was taking a different interpretation from you, I think I could justify that.

And so why has the US done? Well, it surprise is because we misjudged the degree of innovation in the country. We failed to appreciate the ways in which it might benefit, amongst other things. And thinking about the current turmoil, from benefiting from low cost alternatives externally and building new businesses and new insights internally within the United States, we underestimated the growth dramatically.

[00:24:10] Alan

Yeah, I mean, Kiran touched on the point about the small number of stocks which has driven the index returns and has emphasized, obviously, the importance of diversification.

So, presumably when you think about that, I mean, I don’t know if it’s explicitly a message, but it seems to be a challenge for individual investors to try and identify those. And again, it’s further support for indexing, I guess, isn’t that fair to say?

[00:24:39] Elroy

Well, usually when there’s new investment evidence, one side of the active/passive debate cites it and the other side tries to take a contrary view. But what we’ve gone through lately is one in which there’s the same body of evidence, that is these very large companies which have performed extremely well. And you find the passive managers are citing the evidence saying, well, if you want to get your share of the good performers, you’ve got to be well diversified otherwise you’ll leave them out of your portfolio. And the active managers are saying it all comes from a few stocks. Get the stocks right and you’ll do very well.

And so, this story of the impact of concentration and of concentrated performance within large companies, both active and passive managers, find support for their favored way of managing portfolios.

[00:25:39] Alan

Yeah, interesting. And I mean from the perspective of risk, you said, okay, if you’re safer, maybe it’s less risky. I mean, how should we think about the risk? Obviously, some people use volatility, standard deviation. I guess a lot of people in the wealth management community will point to the statistics around it that if you linked in the holding period for equities, you’ve reduced the likelihood of having a negative outcome. And I think the longest you had to wait was 16 years or 18 years if you immediately went into a drawdown.

I mean, if you’re looking across different equity markets, how do you think in terms of ranking them according to risk?

[00:26:27] Elroy

Well, if we ask ourselves for how long could you be underwater, that is producing returns which after adjusting for inflation are negative? Yes, the US, 16, 17 years was long enough over a very long period in history. But there are other countries where you would have got left behind for a very long time and where, in some cases, if you were investing just in that country, you’d have been waiting 50, 60, 70 years just to break even. And that’s without incurring any costs from reinvesting dividends or asset management fees. So, the US had this very favorable story.

I think the bottom line from that is that we don’t know which countries are going to be the ones that perform well and which ones will not. And so, diversifying across countries, across asset classes, and over time makes sense.

[00:27:23] Alan

Yeah. And in terms of drawdown, obviously, in the last 125 years, we’ve seen the Great Depression where stocks fell by 75%, 80% in real terms. We’ve had at least two episodes of 50% declines. We’ve had the decline in ‘73, ‘74. So, there’s, what, four or five episodes of kind of 50% plus declines. So, should we expect one of those, on average, every 20 years or so, or what would your guidance be around that?

[00:27:51] Elroy

Collapses of a big nature are more likely when people feel they’re in good times, when they feel optimistic. Because when you feel optimistic, you’re willing to spend more on getting exposure to the stock market. And that means quite small changes in growth expectations can have a bigger impact.

That’s why the shift from ‘98,’ 99 through to 2000, 2001 was dramatic because people thought the risk had gone down and growth expectations had gone up. So, despite the turmoil that we’ve been going through in March, April of this year, I think we’re still in quite good times. The world is in much better shape than it was many decades ago. And so, we should expect big collapses with a greater frequency than one saw early on.

Big collapses, say, in the periods prior to world wars, were preceded by people feeling pretty glum anyway, so there wasn’t the scope for a sudden decline of huge impact in the stock market. So, I stand by the diversification mantra as being very important.

[00:29:15] Alan

I mean, speaking of diversification, bonds are the typical diversifier historically for equities. But there’s a lot of interesting information around bonds. It struck me, you know, some of the drawdowns, in real terms, for bonds have been very stark. We can also talk a little bit about the bond equity correlation. But it seems unusual, I mean, if you look around the world, pension authorities have been kind of encouraging corporate and pensions to invest more in bonds over the last couple of decades. But when you look at your outcomes, you know, you can get quite negative real returns in bonds for quite long periods. Does that surprise you?

[00:29:56] Elroy

Yeah. So, if we look at the drawdowns that is the decline we always look in inflation adjusted terms. So, the decline in real terms from a high, and how long it takes to return to that previous high, the periods of being underwater – of being cumulatively in negative territory, have been much greater for the bond market.

So, if you chose the wrong time to invest in government bonds, you could be struggling for a very long time, and in some cases for an indefinitely long time, if you had been in Germany or Austria at the wrong time. So, what you see is that there have been very dramatic drawdowns. And the recovery time for equity markets, after a big setback, has been shorter than the recovery time from bonds. But that, in part, was to do with high inflation rates that we had over the last several decades.

Inflation rates alleviated, interest rates moved from substantial double-digit levels down to about zero. They’ve gone up a bit now. They’re more like what we might have expected a few years back.

So the scope to make money from interest rates declining and bond prices improving, that was something which represented several decades prior to 2022. That can’t be repeated.

The extreme variability of bonds for a long-term investor, I don’t think is as extreme as it would have been if we had been thinking in 1970 or 1980 as to what we would do with our fixed income investing. Kiran, you may have a differing view on that. I don’t know.

[00:31:46] Kiran

Yeah, so, I mean, I think when we’re thinking about how to manage through drawdowns, at least from a private wealth context, it depends as much around the psychology of the investor as it does on the market itself. So, what I mean by that is if we see that, historically, equities have had periods where they’ve been underwater for 5 years, 10 years, up to 15 years, we can use that to think about, well, if investors can keep an allocation to safer assets like fixed income (and I’ll come on to why we would consider those to be safe), then psychologically they can sometimes get their way through some of these drawdown periods because they have that fixed income allocation to draw on during the periods when equities are underwater. And it will give them enough time for them to recover, at least if we see drawdown lengths of historical averages.

And on the fixed income side, I think there’s maybe, from a private wealth context, two ways to think about bonds. The one is where you have a fixed duration (which is what was looked at in the study) of perhaps 10 years, perhaps 20 years, and then it can act as something of a diversifier to the equity portion of the portfolio. But of course, you can also look at fixed income or bonds from a maturity standpoint and think about, okay, well, next year I want to spend £10,000, so I’m going to invest £10,000 in a gilt. And then it’s almost risk free. You’re inoculating yourself against interest rate risk. You’re going to get that money back in a year’s time.

You can do the same in two years, three years, four years, and you have this bond ladder. So, from a wealth perspective, you can often build diversified portfolios in different ways. You end up, in aggregate, with a stock and bond mix.

But from a psychological perspective, having that bond ladder as part of the bond component can give investors more confidence to allocate their sort of longer-term portfolio more towards equities because they know that their spending is quite well secured from that bond ladder in the near term.

[00:34:01] Alan

It makes sense. You have a chart in the report about the bond/equity correlation going back all the way over the 125 year period. And it shows very clearly that bond served as a fantastic diversifier in that 30, 40 year period from, I guess maybe, the 1990s up until recently with that negative correlation between bonds and equities. But it does very much stand out as an outlier in the context of the overall 125 years.

Obviously, we’ve seen bonds and equities become more positively correlated. I guess it’s impossible to say what the next 20 or any period of time.. But I guess it does highlight, as you were alluding to Elroy, that period we’ve been through, kind of from 1980 to 2020, was unusual, and fixed income conditions were unusually favorable, I guess, with falling inflation and how bonds fitted with equities.

[00:35:03] Elroy

Well, bonds had an important role in a mixed portfolio and that’s why people talk about 70/30 or 60/40, institutional or high net worth portfolios. And then the first couple of decades of this millennium was different.

Paul Marsh and Mike Staunton and I believe that we are back to where we were in 1999, when we were looking back, and that the role of bonds as a diversifier with lower expected returns but attractive risk diversification properties are there. Quite how much you should invest does depend on the taste of the individual.

Kiran is identifying one part of this. Another one which financial advisors focus on is how much you ought to invest if you are young, middling, older. But the people who are older sometimes have the good fortune of having more money than they’re going to be able to spend on themselves. And so, their time horizon should be long. It should be the time horizon that is appropriate for their children or grandchildren, or for the charities they wish to support, whichever way they’re going to spend the money.

So, some people, as they get wealthier and older, should be thinking more about what would make sense for them for the long term. And then there’s others who should be thinking about what they need for 5 and 10 years time – the way Kiran was describing it, in terms of personal needs for expenditures.

[00:36:50] Alan

Yeah, well, we’ve obviously seen that bond equity correlation change, and a lot of that came from 2021, 2022, when we had this spike in inflation. And you also review inflation over long periods of time as well. I mean, notwithstanding, I suppose, current central bank targets of around 2%. I mean, the historical experience of inflation around the world has generally been higher on average than that, isn’t that right?

[00:37:19] Elroy

Well, inflation has been incredibly important, and so important that when we compare different countries, we always do it either in inflation adjusted terms or in common currency terms. But then when we switch into a common currency, we are adjusting for the inflation differentials between countries. So yes, inflation is incredibly important and that’s why we present all of our data in real terms.

[00:37:48] Alan

And I think for the US over the full period, inflation averaged about 3% or so, maybe 2.9% or something like that. So, I mean, that would seem a reasonable expectation going forward, or what would you say?

[00:38:00] Elroy

Yes, I think that’s what people are currently thinking about. But over the weeks we’ve been going through recently, I think all bets are off for projections. And so one of the other issues which gets to be important is what should you be doing if you’re no good with projections, if you’re just concerned about the downside or wanting to maximize the upside? That’s the area that UBS would be focusing on, not especially Paul Marsh and Mike Staunton and Nick.

[00:38:32] Alan

Yeah, and in terms of inflation, you’ve looked at how different asset classes perform in inflationary periods and which are the best asset classes to diversify into. And broadly, it’s, I guess, not surprising that commodities do well. Gold is seen as a good inflation protector. I’m not sure if you call it as an inflation hedge. And likewise, equities over time have outpaced inflation, so have been a good store of value too. But my reading is you wouldn’t call them an inflation hedge.

[00:39:04] Elroy

Well, to us, a hedge is an asset which gives you a return that moves in the opposite direction to inflation, so that if inflation is high, it performs well, so at times we’ve looked at different novel sorts of assets. So, wine can be an inflation hedge, so can investment quality postage stamps. If inflation gets to be bad, I probably prefer to have the wine bottled versus postage stamps.

[00:39:39] Kiran

The thing is, the point on the hedge is an interesting one because I was speaking to some clients this morning around this and I was showing the chart that’s from the Yearbook showing the positive correlation between commodities and bonds and inflation, but the negative correlation that inflation linked bonds and equities have demonstrated with inflation. We got into quite an interesting debate about well over what period am I trying to hedge the inflation?

Because if you’re trying to hedge it on a sort of few months basis or a one year basis, then the gold and the commodities have proven to be better. If you’re trying to hedge inflation on a 5 year or 10 year basis, then you want to be invested in assets that are going to outpace it or at least match it, in which case then the inflation linked bonds or the equities certainly are the better asset class. So, it sort of depends a little bit in terms of your portfolio, your situation, or your withdrawals, or what exactly you’re trying to manage, whether you should be allocating a bit towards the gold and commodities to hedge in the short term or you should be more towards that sort of equity and inflation linked space to outpace it in the longer term.

[00:40:49] Alan

Makes sense. I know another one of the studies you’ve done, at one point, that you update now is around regimes. And one of the types of regimes you identify is the interest rate environment where the rates are falling or rising. And the differences in returns are quite stark, certainly in equities, but I think probably across all the asset classes. I’m not sure if you can recall the numbers, but I mean, certainly most of the returns for equity I think come from falling rate environments. Is that right?

[00:41:20] Elroy

Absolutely. It is striking that in different monetary conditions you don’t find the same pattern for equities and for bonds and that when the Fed, in the US. or its counterparts in other countries have been kind to investors, there’s been a favorable outcome for equities and that the equity risk premium does not accrue steadily throughout history. It comes about when interest rates have dropped.

[00:41:58] Alan

And I mean, taking that lens at the moment, Kiran, I mean we’re in a little bit of an uncertain period.

We’ve obviously gone through a period of rapidly rising interest rates and then rates have come off a little bit, but kind of hard to infer, you know, structurally, are we in a kind of a generally rising or falling rate? So, from a UBS perspective, how do you incorporate that into current process?

[00:42:23] Kiran

Yeah, so, I think if we look at where real interest rates are today and you look at the very long-term study from the Global Investment Returns Yearbook, we’re not massively out of line with the long-term averages, about somewhere between 0% and 1% as a real rate. That’s quite well lined up with what the Fed is telling us as their long-term expectation for the real rate.

So, I think that is sort of making it unclear as to which direction do we go longer term? Of course, on the shorter term and tactical horizon, I think, in recent years investors have grown used to the idea that Elroy expressed that when the Fed is cutting interest rates, or when the Fed is intervening in markets, or when the Fed is trying to support financial stability, markets go up and they struggle to go up without that.

And I think if you translate that onto today’s situation, obviously there’s a lot of uncertainty in markets and we would say that one of the prerequisites for a sustainable recovery, not the only thing that can happen, but one of the prerequisites would be the Fed coming in with either faster than expected interest rate cuts or some kind of package to guarantee financial stability through this period. And we see the volatility in the treasury markets today.

So, I think that long-term idea, that Elroy expressed, that markets do well when the Fed is cutting interest rates or when central banks are cutting interest rates, I think really does hold over tactical horizons as well.

[00:43:50] Alan

Absolutely. You cover the major asset classes and you touched on some alternative asset classes there with wine, et cetera. I mean, the growth of crypto has been one of the features of the last decade or so. It’s still a new. I don’t know if you would call it an asset class or if you would group it in with currencies, but how do you think about the likes of Bitcoin? And you know, looking back over 125 years, have we seen similar episodes of new asset classes emerging and then going away, or is this something very different?

[00:44:24] Elroy

I think when you go back in history and you want to look for crypto assets, you have to be a little bit broad minded about how you interpret history. There was a time, which is well documented by a couple of economic historians who looked at the prices of artworks during the run up to the early stages of the Second World War.

And it turned out that one of the deciding factors that makes a difference is the size of the artwork. The bigger it is, the less it’s worth, because people wanted to be able to roll paintings up, stick them down their trouser leg and try to escape whichever country they were in. So, it was a sort of crypto asset because it could be moved unobtrusively. So, there can be utilities from having particular sorts of assets. So crypto is fulfilling some of the role that gold had, but also has extreme anonymity. It’s a difficult question.

I go periodically to a meeting of people who are involved in endowments, some of them university endowments, and some are charitable endowments. And we were discussing asset mix at our last meeting just a few weeks ago. The person who was chairing this meeting went round endowment managers, some responsible for very large endowments and some for medium sized endowments, asking about their attitudes to crypto. Every single person said they wouldn’t touch crypto with a barge pole. So, when I got back to my office, I looked up some of these people. One of them is Cambridge University, my employer. There, on the website, it’s made clear that they accept donations in crypto and have no problem with that.

And then I looked at who are the big philanthropists, and there’s an estimate of the magnitude of philanthropy from crypto people, which over the last few years has totaled $5 billion US. Do I believe that? I don’t know. I have no way of verifying that. But there are a number of crypto enthusiasts.

So, I went back to my group and said we really should talk about this again at our next meeting, which is in May, and see what our attitude is a little bit more deeply, because many people are invested in common stocks or investing, in fact, in companies which are involved with crypto and many of them will handle crypto donations. So maybe we were all being too narrow-minded on all of this.

It’s a problem. But I don’t think that by just saying it’s a gentle idea that we can sort the world out. Maybe that’s too many middle-aged people who are being negative about ideas which belong in our children’s generation.

[00:47:44] Kiran

We’ve been thinking from a portfolio perspective as well, that sort of in a classic risk return Sharpe ratio maximization framework, it’s very hard to make an allocation to crypto make any sense because the volatility is just so high. It just dominates the rest of the portfolio. But we know that for a lot of private individuals, that isn’t the framework that they’re using to think about their portfolio.

Some of them have more of, perhaps a return maximization framework. And then thinking about an asset that has the potential to do almost anything, that can sort of make sense mentally in that sort of framework. And equally, I think that certain high net worth individuals will have quite a different attitude to the way we classically think about risk.

So, in an investment framework, we often think about risk in terms of volatility or potential drawdowns. They may think more in terms of potential event risk in the world. And Elroy mentioned wars and artworks. And those clients who think more about risk in those terms might value assets like gold, like our work, like wine, like crypto in that context, as a hedge against those types of risks.

Maybe it’s handy that you’ve got a crypto portfolio or some gold in those types of events, because you’re probably not going to be looking at your standard deviations anymore when those kind of things happen.

[00:49:13] Alan

Sure. But has it been viewed largely in those terms as a defensive holding store of value or, for some people, it’s behaved more like a growth risk asset of late?

[00:49:26] Kiran

It’s both. So, as I said, some clients will be looking at this from a return maximizer perspective. They want something that has the potential to double or triple. That’s the kind of things that they look for. And others are holding it in the spirit that they hold gold or artwork and that. So, it’s a variety of use cases.

As I said, it doesn’t make a lot of sense in a classic context, but when you think about it from just different ways that private individuals can look at these assets, then it’s not totally irrational.

[00:50:01] Alan

And Elroy, the other area of the investing world where you devote a couple of chapters and where we’ve seen very big growth is the area of factor-based best investing and what you might call smart beta. Some interesting results in the study from that side.

[00:50:18] Elroy

Yes, factor investing has become very popular. Factor investing deals with exposing a portfolio to the performance of particular sorts of factors, such as the relative returns from value stocks compared to growth stocks, or positive momentum stocks – companies which are going up in price rather than declining, or small cap stocks versus large cap stocks. There are a number of these strategies, Altogether economists have identified many hundreds of them. But almost all of them will evaporate if you look afterwards and see whether a good idea actually persists and will work in the future.

But there are probably half a dozen of these factors which are thought to be important and are thought to provide a reward to investors, possibly for risks that they are taking, but a risk premium nonetheless. And so, evidence-based investors look towards loading up their portfolios with exposure to particular styles of running the portfolio.

[00:51:28] Alan

Yeah, interesting. And you do point out, in the study, about how investors tend to surge into a particular factor after it’s done well and the return premiums are maybe not fleeting, but they’re certainly not consistent over time. Isn’t that fair to say?

[00:51:44] Elroy

I think that is fair to say. Some people would then say, well, why not have a diversified portfolio of these exposures? And I think my answer to that would be yes, if you’re putting together a number of ETFs or specialized funds, certainly diversify them. But actually, it’s not obvious that multi-style, multi -actor packaged products, single product from a single supplier, will do the trick because then you’re relying on that supplier’s capacity to put together a factor portfolio which suits you.

But this is a growing area, and investors should take account of factor exposure for at least two reasons. One is there may be a risk premium that’s involved. And the other one is that many investors unconsciously expose a portfolio to particular styles.

So, for example, if you believe in always having a tidy portfolio that does not contain stocks that have dropped in price, that might be true for some asset managers. Then what you’re doing is selling out to stocks which have been falling in price and you’ve got to put it back in others that have been going up in value. Those are all factored strategies. And you need to understand factor investing even if you are pursuing a strategy which is not directly driven by factor risk premiums.

[00:53:21] Alan

Yeah. And as you say, momentum, or kind of chasing the winners and selling the losers, based on your data, seems to have done very well over time and particularly well in recent years. But even going back over longer periods, I think it was the strongest factor, if I’m not mistaken.

[00:53:37] Elroy

Momentum has done well. That’s absolutely correct. It is not a cheap factor to implement because if you buy into a stock which has gone up in price, well, after a while it will have gone up and you’re going to have to sell it to have the money to go for another stock which has gone up in price. But it involves turnover. Turnover is costly, so I think the evidence is fairly compelling. But over long periods, momentum has done well even after costs. But it’s not a cheap one to follow.

It’s different from say, buying small cap rather than large cap stocks, where sadly, if you bought a bunch of small cap stocks this year, they’ll probably mostly be small caps next year because they won’t run that well. But then you at least hang onto them for the following year and the year after that. So that’s a lower turnover strategy.

[00:54:38] Alan

Yep. And I mean, some of these factors or some of these approaches have struggled of late. Like value being the obvious one, has had a kind of a prolonged period of tough performance. And now people suggest, oh, maybe it’s the end of value investing as we know it.

But I mean, you do plot the returns of the various factors over time through different decades, and they come and go. So, would you see that kind of underperformance of late as just normal statistical fluctuation? Or do you think there might be something in that view that value investing has become structurally more challenged?

[00:55:12] Elroy

Well, value investing involved buying stocks which look cheap on fundamental grounds and being light on growth stocks. And if we look at the last half decade or decade, those growth stock contrast to the ones that you, with hindsight, would wish you had held. So, there is an investment decision that’s buried in all of that.

Those people who are saying that growth stocks have now reached their peak and maybe even got past that peak, then for them, this is the right time to be investing in value.

[00:55:49] Alan

Okay, so maybe tying everything we’ve talked about together with an eye on the future and thinking about projected returns. As you say, when you wrote the book first, at the turn of the millennium, you were, I guess, more pessimistic than the market based on the fact that returns had been very strong and just preceding that. I mean, where are we now? Or what would you say are the expectations in the major asset classes? What kind of order of magnitude should we expect going forward?

[00:56:21] Elroy

I think we should continue to expect some reward for investing in equities compared to bonds and a small reward for investing in longer bonds compared to cash or short-term exposures. My take on it would be that the equity premium, the reward you would get compared to bonds would be something of the order of 2.5% to 3% per year. But people share our data, we’re very public about that. And others will have somewhat different views.

But if I look around at the endowments that I was mentioning earlier, some of them will have spending rules of CPI plus 4%. That’s a little bit on the high side, but there are some that are still willing to spend 5%. I think if you spend 5%, you will be quite challenged to maintain the real value of your portfolio. And so, my college at Cambridge is closer to the 2.5%, 5% level in terms of spending after adjusting for consumer price inflation.

[00:57:37] Alan

Yeah, so I mean, you mentioned the work you’re doing with the endowments, and, I mean, I’m curious to get your perspective on their approach and maybe your own thoughts. I mean in terms of constructing a long-term portfolio, obviously it’s equity centric, I guess. But you do emphasize the need for diversification. So what would be if you were the broad parameters or the broad outline of an asset allocation, do you think that would be appropriate for a relatively long-term portfolio?

[00:58:05] Elroy

Your audience includes some who, like those involved in the endowment world, are concerned to maintain value for a long time into the future. And it also includes individual investors or high net worth investors. My guidance for people who are at the sort of moderately comfortable end of the spectrum is that you should invest in the highest return assets, which is education.

For the starting point would be that money spent on educating your family or if you’ve had the good fortune to become wealthy, educating other children, that is money that’s well spent. When it comes to investing for the long-term, if you don’t have immediate spending needs, yes, I’m somebody who leans towards equities. The taste that I will have may differ from UPS’s. I’m relatively tilted towards a passive investment.

I can find that other things apart from investing to spend my time on. So, I prefer to leave others to get on with organizing my portfolio for me and just buy a bit of everything.

But you know, going back to my example of the esoteric things that we’ve looked at over time – artworks, wine, and so forth, if you get some pleasure, you’ll receive less financial income, but you may have more psychic income from some of those assets as well.

[00:59:45] Alan

Yeah, and we haven’t touched on property much at all. I mean my impression is for a lot of high-net-worth investors the they do like owning bricks and mortar, particularly here in Ireland it’s definitely the case. Where does property fit into that framework?

[01:00:00] Elroy

Residential property is in the same category as wine and artworks. That is you receive something which is a benefit that you value personally. There’s an increasing volume of academic research on private assets which give you private enjoyment. So, buying your own home gives you a dividend which exceeds what you would be paying if you were renting a similar place that was produced to somebody else’s taste.

As an asset class, we can be thinking about commercial real estate, but we are cautious in what we write about long-term investment returns from real estate because the number of good quality studies that go back a long way in real estate are limited. There’s very little data going back more than about 40 years.

We know that if we were looking at bonds we wouldn’t settle for just the last 40 years because that’s the time that interest rates came down and bond prices went up. Well, we shouldn’t be looking at just the last 40 years for commercial property, which is sort of if it’s high quality, it’s a bit like a bond with a bit of added equity kicker. We would like to have 125 years as well for that, but there are only a few studies that go back that far.

[01:01:28] Alan

Okay, great stuff. Well, it’s a fascinating study. For people who want to read the report or get access. How can they do that?

[01:01:37] Elroy

• They can either email me, but I’m not going to sort of start leaving details that nobody, while driving their car, can get here. I’m happy for people to write to me. My addresses are on the web all over the place – Elroy Dimson. Or if they come through to you, I’m happy to respond to questions that listeners send my way. And it may be that the better qualified co-author is Mike Staunton or Paul Marsh. So, the amount you can reply from that.

[01:02:11] Alan

Very good. Well, we will include a link to the study in the show notes so people know where to have a look for it. But Elroy and Kiran, thanks very much for coming on today. It’s been a fascinating conversation and very valuable information, I think, for all of us in terms of conceptualizing what we should expect from asset market returns going forward and understanding the past. So, for all of us here, thanks very much and stay tuned. We’ll be back with further episodes.

[01:02:42] Ending

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