Meb Faber on the Big Bear Market in Diversification and Tactical Allocation

26:49It feels like you can't get that much lower. But maybe you can. There's a lot about ETFs that I think that people don't know. first of all a lot of public funds will do short lending and return that revenue to the consumers so on top of the fee you have let's say like we charge half a percent well the short lending revenue in some funds it may be 10 basis points it may be 20 in some cases it could be very material 50 over 100 basis points so there are plenty of etfs out there that actually already have a negative expense ratio so let that sink in you're getting paid to own this fund that's pretty cool, right?

27:26Second is the ETF expense ratio is also tax deductible, right? It's coming out of the income. So if you're comparing that to a traditional separate account, which is not deductible, that's an additional essentially benefit of the ETF over these traditional structures. But here's the challenge. If you've been participating, you're one of the lucky ones, you bought a bunch of stocks, you own a bunch of NVIDIA since 2009, you're sitting on a 10-bagger gain. And if you talk to, you know, older generation, if you look at Buffett, you know, all these decisions that he has to make on Apple, where he has to eventually pay the taxes, right?

28:02You talk to the older generation and say, well, I just can't sell my Microsoft or GE or IBM because the tax man would kill me. We had Hank Bessenbinder on the show recently who did the famous paper to stocks outperform T-bills. We had Hank run for the past hundred years. I said, Hank, what's the best performing stock of all time and listeners you have to guess this too you may get it of the top five the top three i don't think i could guess two or three ever heard of them but vulcan materials was i think two kansas city was third and number one was kansas city railroad yeah okay and this is just you are optimizing on length of compound yeah so 100 years but altria you put it's like you put a thousand dollars in altria 100 years ago you now have two billion anyway the The point being is that if you invest, you eventually have a bunch of capital gains.

28:51Great. Good problem to have, right? If you're a taxable investor. And if you have been investing in US stocks since 2009, you have 10x capital gains on average, right? So that's a problem for investors, right? Because you got to make a decision. Am I just going to bite the bullet, sell this, pay the taxes and move on? Because these power laws dominate everything we do in investing. It's in VC, it's true in public markets, where the best performers, it's like 5 % of stocks generate all the return. So if you end up with one of these, your whole portfolio is now this appreciated stock or portfolio.

29:24What I'm getting at is, what do you do? Well, there's actually been something that's been around for 100 years called the Exchange Fund. It was popularized really in the 1970s by Eden Vance, by now Morgan Stanley, Goldman does it. And it's like a 1031 exchange. If you have a portfolio. The 1031, is that how real estate investors never have to pay taxes? That's like when you buy a house, if you sell it and then buy another one. Like commercial, you buy a hotel, you buy some farm. Commercial real estate people love this. This is like the essence of the whole game. It's an indefinite tax referral and it builds generational wealth.

29:59And it's why you see so many people that, you know, they talk, well, my grandmother bought this property at$10 ,000 and now it's$10 million. You know, on and on. So it's great. It's a huge wealth compounder over time. But so with stocks, you eventually have to pay the piper. So there's this thing that's been around forever called exchange funds. And the way they work is if you have highly appreciated positions, you get a bunch of other people, you contribute them to a portfolio, and there's some rules. You got to be accredited or qualified. You got to hold it for seven years. And at the end of seven years, you get back a diversified portfolio.

30:32So you eliminate your concentration risk. But the problem, of course, is it's run by the traditional asset managers who love to charge exceptionally high fees. They're going to ding you probably a percent or two just to get in. And then they're going to ding you a percent or two every year for seven years for the privilege of having this exchange fund. So there's others trying to do this. There's a company called Cash that's doing this, trying to disrupt this. But if you think of the ETF structure, which is a massive innovation where you have an actively managed portfolio, indexed portfolio, you're only paying taxes when you sell that fund.

31:07So the turnover doesn't matter. I think that's well understood by most investors today, hopefully. But if you look back at SPY, if you bought it in 97, you've paid no capital gains at all, despite the fact it trades consistently. That's not a feature of mutual funds or hedge funds. And that's why ETFs are eating asset management. They're vastly more tax efficient, which on average is probably about a 70 basis point after tax benefit relative to mutual funds. Monster number, probably more important than the expense ratio. However, what if you've got a bunch of stocks that have gone up a ton? So you could go this exchange fund route, you're stuck, you could sell it.

31:41But what you've started to see over the past five years, you've seen the writing on the wall and the traditional mutual fund industry is doing one of two things. They're going ostrich style, head in sand. I'm just going to ride this till I retire and we'll just deal with the outflows and someone else's problem. Or there's shops like DFA that say, you know what, we're going to convert. we're going to, well, they do 50 billion of mutual funds to ETFs. And then you see some innovation going on where a group we're partnering with, Wes Gray and his team at Alpha Architect, ETF Architect, they were able to go to an asset manager and say, okay, well, let's convert your clients.

32:20So they had 5 ,000 clients from separate accounts to an ETF, and it's not a taxable transaction. And so I started to think about this. It's called a 351 exchange, again, been around for 100 years. And you start the brain working in an odd lots way and taking this to its logical conclusion. I say, this is a really cool idea. And to my knowledge, we're going to be the first to do this. And so I said, why can't we open this to everyone? Why can't we make this so that it's disrupting the entire industry and make it democratize it where you don't have to be a qualified investor. You can just be any investor that's sitting on capital gains.

32:56And so the way that works is you can contribute a portfolio, stocks, ETFs, whatever. And there's some rules like one position can't be over 25%. The top five can't be over 50. You contribute a basket of stocks, you get an ETF in return, and you get essentially a tax deferral diversified portfolio that now has a diversified strategy. It could be whatever strategy. The first one we're doing is actually a riff on an old paper we wrote, which demonstrated that if you're a high tax investor in a place like California or New York, the last thing you want is dividends or high dividends. So we demonstrated that if you had a value strategy that targeted stocks that paid low to no dividends, you're actually after tax, you do much better than the S &P or high dividend strategy.

33:41So this takeaway of this idea is that you can contribute a basket of stocks, end up with a great ETF, and you could launch a series of these every year, every three months, every six months and let people opt in. What do you think? Great. It sounds good. I wish I had some gigantic capital gains that I needed to solve for, but alas, that's not my problem. But let's just talk a little bit more mechanics. So let's say 10 years ago, I bought a bunch of Apple and NVIDIA and Microsoft and whatever else, JP Morgan, a bunch of names that have done well. Okay, so I have these. And now I'm thinking, oh, the market's kind of expensive these days.

34:22I'm nervous, et cetera. I'm thinking about, want to sell them, but I don't want to like write a huge check come next April. Okay, so that's my problem. Talk to me the specific mechanics. Now your fund suddenly, your new ETF suddenly exists. Walk me through the specific mechanics of what I have to do to swap those. Yeah, I don't understand how you like deliver. Yeah, so I swap that into this thing so that now I'm in a diversified portfolio that's a little bit de-risked thanks to diversification. I don't have my concentration problem, but I didn't have to pay the taxes. So talk to me about exactly how this is.

34:58This is why we're partnering with our friends, ETF architect. Like you have things like 1031, have very established templated rules, how to do it. And this is the first time we go in through it. So I'm sure it's not going to be 100 % without headaches and hiccups. But the first thing you inquire, right? So we set up camberinvestments.com forward slash tax, put in your name, your info. I got this portfolio. Joe's got a portfolio at Schwab. Yeah. I literally do have a portfolio at Schwab. So, you know, here's, I'm interested, send me more information. I'm sure we'll do a webinar, we'll educate everyone.

35:28And we'll say, here's the menu. Here's the process of what's going to happen on, I'm just making up this date, December 1st, your portfolio will contribute to the ETF. But how does that work? Magic, hopefully. You know, the plumbing and the pipes of it, we'll have to get Wes on the show and get him to get really deep on it. But they just did it with the 5 ,000 account. But like Schwab or whatever, like they have mechanisms for. Yeah. I mean, I'm sure like, I don't know whether it's going to be, you know, ACADing it, whether it's going to be just trans electronic transfer. Okay. But you can do that with shares.

36:02Yeah. Okay. Okay. So we wrangle up a bunch of people with all sorts of different securities and they all contribute them. And then the next morning they have an ETF in their Schwab account. It's beautiful. And then They have a diversified portfolio. And we have a few different ones lined up. We have an endowment style. You guys have probably seen me pick my fights with CalPERS over the years. We have a global shareholder yield style. So the menu will be different for people that may want different ideas. But the first one, at least, we're doing US stock exposure. So once you're in the diversified portfolio, the ETF, presumably if you sold that, you would still have to pay capital gains.

36:40But the benefit is that you're getting out of that big concentrated position. and going into something more diversified. That's the hope. Okay. That sounds interesting. It sounds very interesting. Can I ask you a question? You mentioned Wes's company, Wes Gray, is that? You mentioned Wes's company is called Alpha Architect. Since you've been in the ETF game for a long time, can you talk a little bit about how, you know, if Tracy and I have an idea for an ETF, some strategy that we think could be interesting, How much easier is it today in 2024 to build? What is the process of like, okay, we want to build an ETF around this versus say 2014 or 2004?

37:25It's night and day. So what's that like? You know, we originally were going to sub-advise on a couple of funds. The Forbes family was going to move into ETFs. It's a fun fact. They didn't because it was 2009. So we eventually sub-advised on a fund with advisor shares because back then, it costs half a million, a million bucks a year just to get the trust permission to launch ETF. So a huge pain. We eventually bit the bullet starting launching funds in 2013. Fast forward a decade and the ETF rule, which was passed a few years ago that really streamlined everything, changed it all. And so the two main companies, so ETF Architect and then Tidal, which are both groups that do this white label ETF business, you could go to them now and say, Joe's got his idea for this ETF.

38:11It's only going to invest in companies in North Carolina with the letter M, like whatever it may be, you know, who knows? Three months from now, you could have a fund out. Wow. It's going to cost you, I don't know, 50 grand in startup fees. But the big problem and, you know, everyone sees the gold at the end of the rainbow, but you really need to be able to get to 20, 30, 40 million. So a lot of people sit at zero. Is that just to make the economics of actually like managing and trading the ETF actually work? Well, if it sits at zero, you're on the hook for probably a quarter million expenses per year.

38:41So$250 ,000, but that's if it sits at zero. And so then you're subsidizing, you know, writing 20K checks per month adds up over time.

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40:25Paid for by Public Investing. All investing involves the risk of loss, including loss of principal. Brokerage services for U.S.-listed registered securities, options and bonds, and a self-directed account are offered by Public Investing, Inc., member FINRA and SIPC. Crypto trading provided by Backed Crypto Solutions, LLC. Complete disclosures available at public.com. slash disclosure. Here's something I always wanted to write about or talk about. Reverse inquiries in ETFs. I think this is sometimes like an underappreciated aspect of how ETFs come into being. But I have heard that like a hedge fund or an investor will go out and say, we want the opposite exposure to this particular thing.

41:01We want to take the other side of the bet. Will you create an ETF that allows me to do this? Yeah, you see that more at a lot of the trade specific shops and firms that want those thematic exposures. You know, we tend to focus on ideas I want to put money into. You know, the average mutual fund manager has zero dollars invested in their own fund, which is an astonishing statistic. And half of all public funds close over the course of 10 years. So there's a massive amount of turnover and people that don't have skin in the game. And so a lot of these ideas, I want nothing to do with a lot of these tradable thematics, right?

41:38But if people build them and they want to invest them, God bless them, right? But we err on the side of things that we think make a material impact to investors, future returns and portfolios. And a lot of what's out there, I wouldn't touch with a 10-foot pole, but some of them raise a billion,$10 billion. So what do I know? So it's interesting hearing you describe how much easier ETF creation has gotten because it strikes me that it's like the ETFization of the ETF industry because ETFs, of course, make investing in a country or a theme much easier than if you had to do it by hand and buy a bunch of stocks.

42:19And this is essentially taking that same idea, except applying it to the creation of ETFs where you have all these white label things, the infrastructure is already there. So all you have to do is supply the idea. This gives me just something I've always just sort of been wondering about. What happens when an ETF dies? So Tracy and I launch our fund where we only invest in North Carolina stocks where the ticker has the letter M in them. And then for whatever reason, in two years, we have$500 ,000 under management, which is probably high, but clearly not enough to build a business on. You're like, you know what?

42:55We don't want to do this. We don't want to write the$20 ,000 checks a month to support this. When we decide to wind it down, what happens? They go to the ETF ticker in the sky graveyard. I mean, it's a pretty orderly process. There's a lot of prior art, of course. I think on very, very rare cases. Do the investors get distributed the stock or do they get distributed the cash? I believe it's usually cash. But the correct answer for the vast majority of investors, is just sell it before it closes down. You'd sell it on the secondary market. You're like, hey, we're going to close this in a year. We'll just sell it now and just be done with it.

43:29But I think a lot of people take a negative view of the amount of products out there. You often hear people say there's more ETFs than stocks. And say, well, there's more words than letters. Like that doesn't really have - Yeah, right. More sentences than words. But you have sort of the ability to have this limitless grocery choice. There's a lot of areas that I think haven't developed the way that they will eventually. And one example is the all in one asset allocation ETF. We have three of these. But if you look at the traditional mutual fund asset allocation industry, it is multiples more expensive and tax inefficient compared to the ETFs.

44:06And yet they still have about a trillion in assets. And those type of assets, it's usually death or divorce or bear markets where they all come out, all the money at some point, but they never go back to paying 2%. And so I think you'll see over the next 10 to 20 years, a big shift in assets and structures, but eventually it all leads to the ETF. You know, you mentioned the sort of global market portfolio, and we can never own the global market portfolio truly. So you only are like trying to get close, right? Because the global market portfolio also includes all real estate in the world and just a number of things like you can approach it maybe asymptotically, but you'll never truly own the global market portfolio.

44:49But the old academic research says like to own the global market portfolio, every asset in the world. How close do you get in one of these funds? Are you like 95 % of the way there? I'd say it's closer to like 99. If you look at one of my favorite examples, we always joke on these asset allocation portfolios. We have one called the Talmud portfolio, which is based on, And there's a piece of advice where it was like, let every man invest a third in business, a third in land, and a third keep in reserve, which we interpret as a third in stocks, a third in real assets, and a third in bonds. That portfolio is almost impossible to beat.

45:25And if you look at a lot of like CalPERS, Bridgewater, and we do all these articles and say, should these big institutions just be managed by a robot? And they, for the most part, usually can't beat these basic asset allocation benchmarks. It's really hard for them. some you include a little leverage because they have a lot of private equity and leverage vehicles. But these basic portfolios are a high bar. That's funny. I hadn't considered a Talmudic investment philosophy for the win, but I guess it works. Okay. So this whole conversation has reminded me that I am old enough to remember when active ETFs were first becoming a thing and they were going through like regulatory approval process.

46:04Obviously, they've become much more of a thing since then. And we've seen mutual funds convert into ETFs, as you mentioned. What's the next big thing in the ETFification of the market? There's a few areas we're always interested in. And when we look at the Venn diagram, or you make the columns of things that are totally fine, okay, good, there's plenty, right? I was chatting with someone last night and he's like, look, I use DFA. Why should I use your funds. I'm like, don't. DFA is fine. But the bad news is there's a whole universe of absolutely awful, god-awful, terrible. I have a Twitter thread that's just...

46:44I made the mistake of bookmarking a spammy, sleazy Instagram ad for private real estate. It's always private real estate, right? 50 % per year. They're claiming... Those guys got clobbered in 2022. Some of the videos are like, if you just commit investment and tax fraud, you can make like a 200 % return in six months. So all my ads are now these scams. I just get delivered because I bookmarked it. So I get all these. So just avoiding and doing the really dumb stuff is the key to almost all of this, right? We did an old article about the food pyramid. You remember the food pyramid? The base of that when we were kids was eat a bunch of cereal and bread and pasta.

47:26you know and it's kind of inverted now we're thinking about it but the same thing with investing is like the basics get the basics right pay low fees pay low taxes get your money invested that's the number one piece of advice of all this is get to work let it compound right and then the other things take care of themselves so but because this is a wonky show and we get into this i think the things like the 351 exchange idea we're talking about are going to be extremely material and we're talking about this in a year or two i've seen some other companies and we don't do this but I love the idea of taxable target date ETFs.

47:59We see people behave better in target date style funds. I think there's some ideas and concepts around building personal pensions where people are locked into their investments and get them to behave in a good way where these fiduciaries, you're kind of forced to hold investments and let the compounding do its work. There's a lot of innovation in some of those ideas. But if you go back, I have a joke. I'm Vanguard with a shiny coat of paint, right? Like you already have pretty great out there, but there's, there's some more ideas we're working on too. I love the idea of like a sort of like forced pension because it intuitively, it seems like a, most people make mistakes when they're like left on their own.

48:42So you just sort of want to lock it up. But B, it also seems like there's probably excess returns for like that commitment where if you trade off the liquidity profile, then you get paid more. Anyway, Meb Faber, it's so great to finally have the show. Great to catch up with you in your natural environment at the beach. Surfing on a beach, yeah. Yeah, it's like, okay, yeah, we didn't have Meb on for a long time, but when we did finally have it, we're literally on the beach right now. Listeners, you heard it here. They're committed to surfing with us next year's future. I said only if the temperature is above 80 degrees or someone loans me a wetsuit.

49:18Yeah, just get a win. It's freezing. I'm really cold. We'll take care of it. I've been cold for two days. Yeah, it is cold. All right. Thanks so much, Meb. Take care. It's great, y 'all.

49:34Well,

49:39I'm glad we were finally able to do that, Joe. As you say, in Meb's natural environment, one thing I was thinking was just about that new fund and the sort of tax focus of it. It is interesting because our whole conversation was about how over the past 10 years or so, those big concentrated investments are what have paid off the most. And I guess people are now trying to think through how they actually crystallize those wins. And so it's interesting to see the market trying to come up with a solution to that problem. The solution to the problem of people having to pay taxes and people having to eventually pay taxes.

50:18You know what I think is interesting to me too, and going back to the sort of diversification story and getting punished for diversification where we started. I like the idea that one day, like the sort of, I'm still kind of diversified, you know, that like my prudent approach is going to pay off. But it's also interesting that like the periods where it pays off are like not great, period. Yeah. So it's like, okay, I want my diversification. Very like mediocre and forgettable, I guess. Yeah. Or like the aftermath of a crash. Yes. And so like, I want my diversification to pay off, but I don't want to crash.

50:54This is exactly what I was thinking. The trigger for diversification coming back would be something very bad happening. That's right. In the U.S. Yeah. And as people who live in the U.S. were de facto over levered to stuff in the U.S. We're always going to be levered to the U.S. economy, right? So I think about this a lot, which is like, okay, it makes me uncomfortable as not just someone with money in the market, but it makes me uncomfortable as a person in the world that we have this market that is just so heavily concentrated and so levered to the success of Meta and NVIDIA and Amazon. And I don't really like that.

51:34It rubs me the wrong way. It doesn't sit right with me as something. But on the other hand, if I think about what would change that, it's nothing good. There doesn't seem to be like a positive version. Now, I would say the one exception where maybe this doesn't have to be the case would be kind of like a market in which the investments that are being made in things like the Inflation Reduction Act and the CHIPS Act, where there's like this industrial renaissance in the US and that really started taking off or where you have such above trend growth and productivity that a lot of the so-called like real economy stocks really start to do well, et cetera.

52:15So there is like that sort of golden scenario. Where more winners come into being, right? And so like having more exposure to potential winners pays off. But on the other hand, it feels like the downside scenario where like the current winners just get wiped out. just are no longer the winners and everyone loses. And then. Seems more probable. That seems more probable. And so it's hard. Yeah. It feels like when the regime shifts, which will happen because regimes shift and maybe it'll be a hundred years from now and it will be dead and whatever. But it seems most likely that when the regime shifts, it will not be because things are good.

52:54Yeah. Nothing lasts forever. Shed dramatic tear. Yeah. including our time at Future Proof on the beach. So shall we leave it there? Let's leave it there. This has been another episode of the Odd Lots podcast. I'm Tracy Alloway. You can follow me at Tracy Alloway. And I'm Joe Weisenthal. You can follow me at The Stalwart. Follow our guest, Meb Faber. He's at Meb Faber. Follow our producer, Kerman Rodriguez at Kermanerman. Dashel Bennett at Dashbot. And Kale Brooks at Kale Brooks. Thank you to our producer, Moses Andam. For more Odd Lots content, go to Bloomberg.com slash Odd Lots. We have transcripts, a blog, and a newsletter.

53:29And you can chat about all of these topics 24-7 in our Discord. We have a markets channel and people talk about stocks and debate the market. Discord.gg slash oddlots. And if you enjoy Oddlots, if you like it when we talk about the pain of being a diversified investor, then please leave us a positive review on your favorite podcast platform. And remember, if you are a Bloomberg subscriber, you can listen to all of our episodes absolutely ad free. All you need to do is find the Bloomberg channel on Apple Podcasts and follow the instructions there. Thanks for listening.

54:25Thank you.

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