Prof. Ken French: Expect the Unexpected (EP.100)

Episode Summary

Executive Summary: Episode 100 features Benjamin Felix and Cameron Passmore interviewing Ken French about asset pricing, active versus passive investing, volatility, value and momentum, ESG, buybacks, home-country bias, and corporate purpose. French argues that most investors should index, that short-term returns are dominated by noise, and that market volatility is best used as a self-check on risk tolerance rather than a timing signal.

Main Topics: Asset pricing basics and factor models (Priority: 5/5): French explains asset pricing as estimating expected returns from exposures to systematic risks such as the market, size, and value factors, emphasizing that expected return is built from these characteristics. Why active management usually fails (Priority: 5/5): He argues mutual fund evidence shows active managers as a group underperform after fees, and even skillful managers face crowded competition and rapid capital inflows that dilute any edge. Volatility, market drops, and investor behavior (Priority: 5/5): Using the March 2020 COVID selloff, French frames volatility as a reassessment of future cash flows and says market declines may reveal an investor’s true risk tolerance rather than create timing opportunities. Long-run probabilities and the equity risk premium (Priority: 5/5): French discusses simulations from his paper with Eugene Fama showing that even over 20 years, negative realized equity premiums are possible due to large unexpected-return noise. Value investing, intangibles, and momentum (Priority: 4/5): He defends book-to-market as a practical proxy for future cash flows, notes out-of-sample value evidence remains noisy but not disproven, and recommends momentum only as a trading filter to reduce costs. ESG, buybacks, and corporate governance (Priority: 4/5): French says sustainable investing can reflect genuine preferences but is not a free lunch because higher demand raises prices and lowers expected returns; he also defends buybacks and argues management should maximize shareholder value while accounting for stakeholder effects. Portfolio construction and home-country bias (Priority: 3/5): He says Canadian investors may rationally overweight Canada for currency, taxes, and familiarity, but too much home bias reduces diversification.

Key Arguments: Expected return should be understood through exposures to systematic factors like market, size, and value, not through recent performance alone. Active management fails for most investors because the group of active managers, after fees, underperforms the market; even identifying skill is difficult and capital quickly crowds in. Market downturns are not usually signals to sell because prices already reflect widely known information; they are better viewed as a test of whether your portfolio risk is right for you. Realized returns can differ dramatically from expected returns because unexpected returns dominate over short and medium horizons, even over 20 years in some cases. Five years is far too short to infer skill, judge a manager, or conclude much about a return premium. Book-to-market remains a useful value proxy because it captures similar information to earnings, cash flow, and other ratios while keeping turnover and transaction costs lower. Momentum is empirically strong but hard to justify as risk-based; if used at all, it should be a trading aid, not a stand-alone high-turnover strategy. ESG investing is ethically meaningful, but higher demand for ESG firms raises their prices and reduces expected returns; investors should not expect a free lunch. Buybacks are a rational way to return excess cash when firms lack positive NPV projects; penalizing buybacks would push firms toward worse uses of capital. Management should primarily serve shareholders because they hold decision rights, though managers must still account for workers, customers, governments, and broader externalities. A financial advisor can add value beyond portfolio selection by helping with taxes, estate planning, charitable goals, and emotional discipline. Investment decisions should be evaluated by the quality of the process at the time, not by outcomes heavily driven by randomness and unforeseen events.

Data Points: Episode number: 100 - The hosts note this is the podcast’s 100th episode. SP 500 decline: 25% - Mentioned as the U.S. market drop over the prior couple of weeks during the March 2020 COVID shock. Simulation horizon: 20 years - French and Fama test the probability of a positive equity premium over a 20-year holding period. Simulation draws: 100,000 - They run 100,000 sampled 20-year return paths to estimate outcome probabilities. Negative equity premium frequency: About 8% - Rough share of simulated 20-year samples producing a negative equity premium. Historical sample period: 1963 to 2016 - The data window used in the volatility lessons simulations. Value premium in-sample period: 1963 to 1991 - Original published sample for the 1992 value premium paper. Value premium out-of-sample period: 1991 to 2019 - Later sample compared against the in-sample evidence in the 2020 paper. Out-of-sample value premium conclusion: Not statistically different from zero - French says the lower out-of-sample value premium cannot be distinguished from zero with precision. Five-year horizon: Too short to learn much - He states five years is insufficient to infer manager skill or risk premia. Ten- to fifteen-year small-value negative-premium likelihood: Around 4% - French recalls the approximate probability of a negative premium over this horizon. Canadian equity share of world market: 3-4% - Used to frame home-country bias for Canadian investors. Potential Canadian portfolio overweight example: 7% - French says a modest overweight to Canada could be reasonable. Excessive Canadian concentration example: 83% - Used as an extreme example of home-country bias. Renaissance Medallion fund fees: Approximately 5% and 40% - Mentioned as an anecdotal example of a highly profitable active strategy closed to outsiders.

Pivotal Quotes: "a bear market is a great opportunity to learn more about yourself" — Ken French: On how investors should interpret volatility and market drawdowns. "the realized return is the expected return plus the unexpected return" — Ken French: On why short-run performance often tells you little about underlying expected returns. "don't believe them" — Ken French: On claims that investors can do well by doing good through ESG investing without sacrificing expected return.

Implications: Listeners should treat volatility as a risk-tolerance test, not a market-timing tool. The episode reinforces indexing, diversification, low turnover, and evaluating decisions by process rather than short-term outcomes.