Expected Returns and Factor Investing (EP.213)

Episode Summary

Executive Summary: Episode 213 combines community updates, transparency about podcast sponsorship practices, and a deep dive into whether factor investing is worth its costs and risks. The hosts also discuss a study on pooling money in relationships, explain why rising rates improved financial plans and pension funding, and share book and reading recommendations, all while reinforcing evidence-based decision making.

Main Topics: Podcast transparency, ethics, and guest selection (Priority: 5/5): The hosts address a Bloomberg story about guests paying to appear on podcasts and clarify that Rational Reminder has never accepted payment from guests or PR firms, nor paid guests. They emphasize that guest selection comes from their own relationships and effort. Crypto series reflection and listener feedback (Priority: 4/5): They revisit the re-release of the Cam Harvey crypto discussion and how subsequent crypto-series episodes changed the way listeners interpret the earlier interview. They highlight one listener who bought crypto after the Cam episode and later learned a broader lesson about not relying on a single opinion. Reading, book recommendations, and workplace learning culture (Priority: 3/5): They recommend Way of the Warrior Kid 3 for children, strongly endorse Morgan Housel’s The Psychology of Money, and describe launching an internal PWL book club. The section frames reading as a tool for personal growth and organizational learning. Pooling finances and relationship satisfaction (Priority: 4/5): They discuss a Journal of Personality and Social Psychology paper finding that couples who pool all finances report greater relationship satisfaction, more commitment, and lower breakup likelihood, especially when resources are scarce. Interest rates, liabilities, and improved financial plans (Priority: 5/5): They explain why rising bond yields improved expected fixed-income returns and dramatically reduced the present value of long-duration consumption liabilities, boosting financial plans and pension funding status despite bond price declines. Is factor investing worth it? (Priority: 5/5): The main segment evaluates factor investing through theory, empirical evidence, expected premiums, costs, and tracking error. Using a conservative methodology, the hosts estimate modest net excess returns for factor-tilted funds but stress that the strategy is not suitable for everyone and can be hard to stick with. Community feedback and listener engagement (Priority: 2/5): They read a large batch of positive reviews, mention community interactions, and note how listeners are using the podcast and associated community to improve investing decisions, reading habits, and professional practice.

Key Arguments: The podcast has never accepted payments for guests or from PR firms, and they believe undisclosed paid appearances create obvious trust problems. Listener reactions to the crypto series show that education and context can materially improve judgment, even when earlier content seemed persuasive. Pooling finances may strengthen relationships because financial interdependence can reinforce commitment, especially under financial stress. Rising interest rates can be beneficial for investors with long-duration liabilities because liabilities can fall more than shorter-duration bond assets. Factor premiums exist in the data, but historical returns likely overstate future expectations, so a conservative shrinkage haircut is appropriate. Factor investing can add expected return, but after fees the gain may be modest; its real value may also be improved outcome reliability and diversification across return drivers. Tracking error and long periods of underperformance create a real behavioral risk; investors can abandon a factor strategy before it pays off. The strategy only makes sense if the investor is not the type of person who effectively becomes the source of the factor premium for others.

Data Points: QAFP exam ranking: Top score - Melissa Larson received the top score on the May 2022 sitting of the QAFP exam. QAFP candidate pool: 185 candidates - The exam cohort was described as about 185 candidates. Bitcoin price at Cam Harvey episode release: USD 57,000 - Bitcoin was around 57,000 when the Cam Harvey crypto discussion originally aired on October 14, 2021. Community size: About 7,500 people - The Rational Reminder community was cited as a place where listeners can ask questions and get help. Expected fixed-income return (Dec 2021): 2.48% nominal - Baseline fixed-income expected return estimate before the rise in yields. Expected fixed-income return (June 2022): 3.91% nominal - Updated fixed-income expected return estimate after bond yields rose. XBB duration: 7.67 years - Used as an example of aggregate bond fund duration. Dimensional fixed-income duration: 4 years - Used to show why client consumption liabilities are more duration-sensitive than the bond portfolio. Consumption liability change: About -25% year to date - Illustrative present value drop in a hypothetical 60-year cash flow stream due to higher yields. Pension funded status shift: Below 100% to well above 100% - Canadian pension plans improved materially as liabilities fell with higher rates. World equity risk premium (Jul 1992-May 2022): 5.5% - Historical premium used as a starting point in factor-return estimation. Size premium: 0.36% - Historical size premium over the sample period, described as small and not statistically significant. Value premium: 3.07% - Historical value premium over the sample period. Profitability premium: 3.91% - Historical profitability premium over the sample period. Investment premium: 2.65% - Historical investment premium over the sample period. Factor return haircut: 30% - A conservative reduction applied to historical factor premiums to account for publication effects and decay. AVUS expense ratio: 0.15% - Used when comparing a factor-tilted U.S. ETF to a market-cap-weighted alternative. ITOT expense ratio: 0.03% - Used as the lower-cost market-cap-weighted comparison fund. AVUS estimated excess return before fees: About 50 bps - Estimated factor-related excess return from regression and shrunk premiums. AVUS net expected excess return after fee difference: 0.38% - Estimated net of fee advantage versus the market-cap-weighted alternative. Dimensional global equity fund estimated net excess return: 0.45% - Estimated premium versus comparable market-cap-weighted Canadian index exposure. 10-year negative equity premium probability: Approximately 16% - From bootstrap analysis in Fama-French volatility lessons work. 10-year small cap value underperformance probability: Approximately 5% - Bootstrap analysis suggests lower downside probability than the market over 10 years. Out-of-sample factor return decay after publication: 32% lower - Academic research found predictive returns were reduced after publication and trading. Potential factor return decay used by hosts: 30% - They align their haircut with evidence of post-publication decay. Expected audience for children's book: Ages 8 to 12 - Way of the Warrior Kid 3 was recommended for kids in this age range.

Pivotal Quotes: "Crypto is the sideshow." — Benjamin Felix: He argues the crypto series is really a vehicle for exploring broader themes like philosophy, sociology, governance, and decision making. "We have never accepted payment to have a guest on the podcast." — Cameron Passmore: Used to clarify their independence after a Bloomberg report on paid podcast guests. "I think so, but it's not right for everybody. Again, by definition, it can't be." — Benjamin Felix: His bottom-line view on whether factor investing is worth it.

Implications: Listeners should treat factor investing as a conservative, evidence-informed tilt rather than a sure thing; the bigger lesson is to avoid overreacting to narratives, prioritize long-term fit and behavior, and use community, research, and transparency to make better decisions.