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

Episode Summary

Executive Summary: This special 100th episode features Professor Ken French, a transformational figure in financial economics. The discussion covers asset pricing models, the futility of active management, the nature of market volatility (recorded during the early COVID-19 crash), home country bias, value investing's persistence, and the role of financial advisors. French emphasizes that unexpected returns dominate expected returns, and that investors should focus on the quality of their decisions (based on information at hand) rather than outcomes.

Main Topics: Asset Pricing Models and Their Purpose (Priority: 5/5): French explains asset pricing models as tools to estimate expected returns based on a portfolio's sensitivity to factors like market, size, and value. These models help investors understand return drivers. Why Active Management Often Fails (Priority: 5/5): French argues that active managers as a group underperform passive indices after fees, and even skilled managers are hard to identify and may not leave returns for investors due to competition and noise. Market Volatility and Investor Behavior (Priority: 4/5): Addressing the early COVID-19 crash, French advises against market timing. He suggests using volatility as a 'gut check' on risk tolerance, and notes that expected returns tend to rise during turbulent times. Value Premium Persistence and Measurement (Priority: 4/5): French discusses the value premium's out-of-sample persistence, arguing that book-to-market remains a useful (though noisy) measure. He is skeptical of 'this time is different' narratives. Home Country Bias and Diversification (Priority: 3/5): Canadian investors' home bias is not inherently bad, but excessive concentration (e.g., 83% in Canada) is problematic due to limited diversification. Tax and currency considerations are valid reasons for some overweighting. Evaluating Investment Decisions (Priority: 4/5): French emphasizes focusing on decision inputs (process) rather than outcomes, since unexpected events dominate realized returns. He applies this philosophy personally.

Key Arguments: Active management as a group underperforms passive strategies after fees; it is difficult to identify skilled managers and even harder to benefit from their skill due to competition. Market timing is futile—unexpected events dominate returns. Instead, investors should reassess their own risk tolerance during volatile periods, not try to predict the market. The value premium persists out-of-sample (1991-2019), though it is smaller than the 1963-1991 period. It cannot be statistically distinguished from the earlier period or from zero in isolation. Book-to-market is a robust value measure because it is cost-effective and correlates well with other proxies like earnings/price, avoiding excessive turnover. Share buybacks are efficient—they return capital to shareholders when no positive-NPV projects exist. Penalizing them would force companies into negative-NPV investments. Environmental/sustainable investing is a matter of personal taste; it tends to bid up prices and lower expected returns, so 'doing well by doing good' is not guaranteed. Management should work for shareholders, while naturally considering all stakeholders' interests to maintain efficient operations. Financial advisors provide value through holistic planning, reducing anxiety, and handling tax, estate, and charitable decisions. Home country bias is acceptable to a degree (e.g., currency hedging, tax advantages), but extreme concentration is harmful. Decision quality should be evaluated based on the information available at the time, not the outcome, which is dominated by unexpected events.

Data Points: Probability of negative equity premium over 20 years: ~8% - From Fama-French 'Volatility Lessons' paper (1963-2016 data) Renaissance Medallion Fund fees (estimated): 6% of assets under management and 45% of profits - Mentioned as an example of high skill but closed to outside investors Market drop (S&P 500) at time of recording (early March 2020): 25% - Recorded during the early COVID-19 crash Typical Canadian home country bias example: 83% of portfolio in Canadian stocks - Used as an extreme example of overconcentration (Canada ~3-4% of world equity) Time horizon for meaningful inference on investment performance: More than 5 years; 3-5 years is too short - French states that 3-5 years of performance cannot reliably distinguish skill from luck Out-of-sample value premium period: 1991 to 2019 (28 years) - Compared to in-sample period 1963-1991

Pivotal Quotes: "If you know the market's going to keep dropping, get the hell out. But if you know the market's going to keep dropping and you're not special with respect to that information, so does everybody else. And it's already impounded in prices." — Ken French: Responding to the question of moving to cash during market declines "The realized return is the expected return plus the unexpected return. And the trouble with equity is the unexpected return...can totally dominate the expected return." — Ken French: Explaining why long-term expected premiums are not guaranteed in shorter periods "When I want to judge the quality of an investment decision I've made, I don't pay much attention to the outcome. I pay attention to: did I make a good decision based on the information I had at the time?" — Ken French: Personal philosophy on evaluating decisions, especially during volatile markets

Implications: For investors: ignore active management and market timing; focus on low-cost, factor-tilted portfolios, re-evaluate risk tolerance during crises, and consider the process-based evaluation of decisions. For the industry: the rise of passive investing likely improves price efficiency, and ESG investing involves trade-offs (lower expected returns). Canadian investors should limit extreme home bias.