Financial Theory in Practice: Gaining Insight from Models with Marlena Lee (EP.79)

Episode Summary

Executive Summary: In this episode, hosts Benjamin Felix and Cameron Passmore interview Marlena Lee, co-head of research at Dimensional Fund Advisors, about factor investing, the limitations of models, and how Dimensional applies academic research to portfolio management. Lee explains that factors are drivers of expected returns, but understanding them requires going beyond simple definitions to consider why they work, when they work, and how they interact. She discusses Dimensional's use of a valuation framework, the persistence of premiums like value, and the importance of discipline and diversification. The conversation also covers fixed income, alternatives, and the challenges of market timing.

Main Topics: Limitations of Models in Investing (Priority: 5/5): Lee discusses how models simplify reality but are inherently incomplete, using the analogy of pi to illustrate that the right model depends on the purpose. She emphasizes that the efficient markets hypothesis is useful but not exact, and investors should act as if markets are efficient. Understanding Factors and Drivers of Expected Returns (Priority: 5/5): Lee defines factors as long-short portfolios that explain common variation in returns, but notes that Dimensional focuses on deeper understanding: why a factor works, when it works, where it works, and how it interacts with other portfolio components. She argues that many purported factors are variations on a few themes. Value Premium and Its Persistence (Priority: 4/5): Lee explains that the value premium is expected to be positive due to the valuation framework (lower prices indicate higher expected returns), but it is noisy and can underperform for extended periods. She cites a Fama-French paper showing a >5% chance of underperformance over 10 years even if the premium is known. Dividend Growth Stocks vs. Factor-Based Portfolios (Priority: 4/5): Lee argues that dividend growth stocks behave like high-profitability value stocks, and their outperformance can be explained by factor exposures. She warns that focusing on dividends can lead to loss of diversification and may not be optimal for total return. Fixed Income and Systematic Investing (Priority: 3/5): Lee explains that for bonds, yields are readily observable and can be used to target higher expected returns. She cautions against using noisy proxies when the actual variable is available. Alternatives and Private Equity (Priority: 3/5): Lee provides a framework for evaluating alternatives: do they expand the investment universe? She notes that liquid alts often don't, while private equity does, but fees, idiosyncratic risk, and manager selection challenges make them questionable. She cites a study showing endowments underperformed a simple 60/40 portfolio. Market Timing and Yield Curve Inversions (Priority: 3/5): Lee states that there is no evidence that yield curve inversions or other signals can successfully time markets. She highlights the difficulty of making two correct decisions in a row, even with high odds.

Key Arguments: Models are useful but incomplete; investors should act as if markets are efficient but recognize limitations. Factors are not just variables; understanding requires deep analysis of why, when, where, and how they work. The value premium is expected to be positive due to valuation theory, but it is noisy and can underperform for a decade. Dividend growth stocks are essentially high-profitability value stocks; focusing on dividends can reduce diversification. For fixed income, yields are directly observable and should be used to target expected returns. Alternatives like private equity may expand the universe but come with high fees and idiosyncratic risk; evidence does not support their widespread use. Market timing is extremely difficult; even a 70% success rate per decision yields only 49% for two decisions. Precision in language reflects precision in thinking, a key lesson from Eugene Fama. Success is a mindset of appreciation and continuous improvement, not a destination.

Data Points: Dimensional's AUM: ~$800 billion Canadian - Globally managed by Dimensional Fund Advisors. Value premium (historical): ~3.5% annual - From Fama-French paper 'Volatility Lessons', assuming historical distribution. Chance of value underperforming over 10 years: >5% - Even if the value premium is known to be 3.5% annual, there is still a >5% chance of underperformance over a decade. U.S. equities underperformance vs T-bills: 17 years - Historical period where U.S. equities underperformed T-bills. S&P 500 Dividend Aristocrats Index constituents: Just over 50 - As of July of the year mentioned, indicating low diversification. Endowment portfolio vs Dimensional 60/40 index: 5.8% vs 6.8% annualized return - Over 10 years ending June 2018, average endowment underperformed a simple 60/40 portfolio with higher standard deviation. Cross-sectional standard deviation of private equity returns: Over 40% - From an academic study, highlighting huge dispersion in manager outcomes. Momentum portfolio turnover (academic literature): 200-300% - Typical turnover for a momentum portfolio in academic studies. Momentum portfolio turnover (live funds): 75-100% - Observed turnover in actual Dimensional funds.

Pivotal Quotes: "We think of models as something that's useful to simplify reality, but hopefully they're still capturing some salient features of how something works, right? They're really useful for gaining insights about the world, but inherently they're going to be incomplete." — Marlena Lee: Discussing the limitations of models in investment decision-making. "If you have information about expected returns, wouldn't you want to use all of it?" — Marlena Lee: Arguing for an integrated approach to factor investing rather than focusing on a single factor. "Success for me is having an appreciation for where I've been, kind of appreciation for where I am today, and being optimistic about the future because we should always be striving to be better in the future." — Marlena Lee: Responding to the question of how she defines success in her own life.

Implications: Investors should focus on a disciplined, diversified approach using multiple drivers of expected returns rather than chasing factors or timing markets. Understanding the noise in premiums and the importance of staying invested is crucial. Alternatives and dividend-focused strategies may not add value over well-diversified factor-based portfolios.