In your blog, you touch upon a wide variety of issues. How do you choose your topics?
“I’m famously averse to models and theories, and always look for empirical studies. Also, I am fascinated by financial markets from both a perspective of how they make the economic world go round, and as a reflection of millions and millions of human beings, with their behavioral traits, trading with each other. So, to me it’s kind of a study of the human brain rather than anything else.”
“And what usually piques my interest is something unexpected. For example, I was just reading a study about outcome bias and how football coaches tend to stick with teams that eked out a narrow win in the last match and the match before, but will mess around with their team if they concede a narrow loss.”
“Similarly, I know so many fund managers who will stick with their investment process as long as it provides outperformance but will start to tinker around with it if it starts to underperform. Even though we all are rationally fully aware that no investment process works all the time, we all get nervous when we underperform for a while.”
How do you view the current state of research in finance and economics? Do we produce too much? Is it too biased? How would you address the main challenges?
“Over the past two decades, the research output has grown exponentially. The flow has grown so much that we’re a bit overwhelmed now. This is due to various factors. Google wasn’t around when I was at university in the 1990s. We had to go to the library. Also, the ability to create both interesting and nonsensical research has increased a lot, mostly due to the rise in computing power.”
“So, we push out more and more papers within shorter and shorter timeframes. Now that I am on the sell side for the first time in my career, I see the amount of research brokers send to their fund management clients, and it’s just maddening. That’s exactly the problem. If we have too much research, it becomes harder and harder to find the really interesting studies, or the really important results.”
“And so, your skillset as a user of research must shift away from understanding research to finding the important and good stuff among the many, many things other people are doing. That’s really where we are now. We become less productive simply because there is so much stuff inundating us day in and day out.”
One of the fields that has generated the most interest among researchers is quantitative investing. What are your views regarding quantitative investing, and in particular factor investing?
“Quant analysis is the foundation of my investment process. The first reason is that I was originally trained as a physicist and my way of thinking is that of a natural scientist. I will always start with the data. I will always start with some quantitative analysis. The second reason that quant allows you to keep your behavioral biases in check. Where I get hesitant is when quant starts to add a lot of complexity.”
“Over the last 20 years, many factors have been added to the literature; more and more intricate econometric ways of forecasting markets have been developed. And, in the process, we’ve lost robustness. Markets change all the time. So, if you have a very highly specified quant model that is very fragile to changes in market drivers, things can go horribly wrong very quickly.”
“I prefer going for very simple things that work. Take the value factor for example. Many value indices from commercial index providers use a combination of valuation metrics to identify value stocks. But when you compare that with the original price-to-book factor of Fama and French, are they any better? No, they’re just more complex.”
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How do you view recent developments, such as the use of alternative data and artificial intelligence (AI)?
“I have mixed feelings. Most AI applications I’ve seen are not a lot better than a simple regression analysis, except that you have a massive ‘black box’ around it and you don’t know how the algorithm comes up with the result. With a regression analysis, at least you can look at your factor exposures.”
“Where I get interested in AI is natural language processing (NLP). The reason is that probably less than 5% of all information included in company reports is numerical in nature. The rest is management discussion and analysis, and things like that. And if you can analyze that information in a systematic and hopefully bias-free way, then you can access huge amounts of information other investors don’t have.”
One of your favorite topics seems to be the integration of sustainability aspects in the investment process. In your daily comments, you often try to debunk misperceptions. What are the most common ones?
“My absolute favorite is to reel against exclusions. I often hear skeptics say ESG investing is just optimization with additional constraints. So, it can never be as good as kind of traditional investing where you have fewer constraints. But, in my experience, that is a viewpoint people in Europe increasingly abandoning.”
“Instead, people are going more and more for integrated approaches, where it’s perfectly fine to include in your portfolio fossil fuel companies, for example, if certain criteria are met – either because they have a credible pathway to reducing their greenhouse gas emissions or because they are in a situation where the risk premium overcompensates any kind of risk from environmental hazards.”
“As an alternative, I’m a big fan of engagement with companies and excluding almost nothing. You must be a very, very strange company for me to say: I wouldn’t include you in my portfolio under absolutely any circumstances. And if you engage with companies, you will find that you can have the same risk-return trade-off with sustainable investments as with traditional investments.”
“At the other end of the spectrum, I also usually try to calm ESG fans down and say: sustainable investing is not a way to generate alpha. You’re trying to assess risks you can’t see in financial statements and that might not be priced in by markets, but that can materialize and hurt your portfolio. That’s what I like about ESG investing: it’s a risk management tool, not an alpha generation tool.”
