MASTERCLASS: Quantitative Investing - September 2019

Kim Inglis: Quantitative investing is a form of advanced portfolio management that uses systemized ties to processes to create optimal portfolios. Now, any disciplined investment process really ends up boiling down to two things: risk and return.

Kim Inglis: The return side of things is pretty straightforward. Investors are looking for a specific return for their individual risk tolerance. Some might be looking for pure capital appreciation while others might be looking for more of a total return approach, adding in dividends and interest income.

Kim Inglis: Risk, on the other hand, is a little less straightforward, and that's where quantitative investing comes into play. We're going to delve into this topic today. And with us, we've got three industry experts that are going to help us explore all the intricacies of quantitative investing.

Kim Inglis: Joining us today, we have Art Johnson, Founder and CIO of SmartBe Wealth; Rodrigo Gordillo, Managing Partner and Portfolio Manager of ReSolve Asset Management; and Noah Solomon, President and CIO of Outcome Wealth.

Kim Inglis: I'm Kim Inglis, Financial Advisor and Associate Project Manager with Raymond James; and this is Asset TV's quantitative investing masterclass.

Kim Inglis: Good morning, gentlemen.

Rodrigo Gordillo: Morning.

Art Johnson: Good morning, Kim.

Kim Inglis: There are countless definitions of quantitative investing, so let's start at the beginning. Art, how would you describe quantitative investing, and what does it mean to you?

Art Johnson: Yeah, that's a great question. There are so many different versions of it. You've got high frequency trading, all various different avenues of quant. First and foremost, it really is looking at data and information and trying to use data and information to make wise choices and wise decisions.

Art Johnson: For us, especially, quant means that in order to make wise decisions, what we want to use is something like a gold standard to get our information. And we've decided to use academic research for that.

Art Johnson: The other types of quant like high frequency trading and that; they're using their own proprietary algorithms and various things like that. We stay more on what we think is the gold standard of academic evidence, and trying to take those ideas and advance, and then build efficient ways that we can execute systematic and rules-based strategies so that investors can benefit from this stuff.

Art Johnson: I think that is probably the best application for investors. A lot of the other quant strategies really just don't have the capacity to get retail money into them. They're great strategies for small amounts of money, but they don't scale very well, and they can't be used very well.

Art Johnson: I really like the idea of taking the ideas from academia and then putting a practical BANT on them, and then bringing them forward. And so, quant, to me, represents the application of the gold standard of academic research for retail clients, and away from kind of seat-of-your-pants or bias or all of those things; bringing some rigor and rules to the type of scenario.

Kim Inglis: How about you, Rodrigo? Is that your definition?

Rodrigo Gordillo: Well, there's a lot of it, that I think it's a perfectly well-defined way, the way that Art did it. But I think I have two ways of looking at systematic or quantitative investing. The first one is, as Art said, we're trying to identify improper behaviors or inefficiencies in the market. And a lot of it has started with just human intuition. Right? Value investing, Warren Buffet. All these individuals are looking at how humans behave, and then created a checklist in their notebook. Well, we've now, the quantitative community, has moved that checklist from the notebook to the spreadsheet, then to actually creating some sort of programming resources that we can put into it. And the more data we have ... We have more data than ever before. We're able to kind of get more granularity as we extract those errors.

Rodrigo Gordillo: And those errors could be human mistakes, behavioral errors like herding, where you can apply chain of momentum; or errors because of risk, because in value, you have too much risk or too little risk, and the people that don't want to take the risk aren't going to get the excess returns that you might get from value.

Rodrigo Gordillo: So, the first and foremost aspect of quantitative investing is identifying what errors you think exist out there, using the data to put together some rules to see if you can extract that value, that excess return. And you do that up front. Okay?

Rodrigo Gordillo: And the second part of systematic or quantitative investing is in executing on that erros. Right? And so that's 50% of the battle. It also has the execution side of things; how often are you going to rebalance? What markets are you going to trade? The discipline of going back over and over again, even though you have a six-month, one year, two year draw down in a particular quantitative system. The execution of it is just as important as identifying the inefficiencies and creating rules around it. So those are the two quant that I think are important to highlight.

Kim Inglis: How about you, Noah, would you define it that way?

Noah Solomon: I would define it as a synthesis of what Art and Rodrigo said. So, it is looking at ... I'll speak in our case. We are using artificial intelligence and machine learning to pour through huge quantities of historical data to come up with rules. And these rules are your rules that you then use going forward.

Noah Solomon: And you can do this machine learning for two reasons. Number one is to identify sources of return, which is obviously desirable. And the other one, and I'd say at least as important, is to identify and manage sources of risk or loss. So, you're basically looking at this historical data, use the machine to learn, and come up with logic-based rules that you then follow to deliver some kind of higher returns or lower risk, or some combination of both.

Noah Solomon: And what Rodrigo was saying is, in most cases, these rules are exploiting or taking advantage of the fact that there are some systematic common errors made by market participants which then, you can capitalize on.

Noah Solomon: So there is this thing called behavioral economics, which has been around for a few decades now. And from a high level, what behavioral economics studies is the effect of our emotions and our cognitive biases on our financial or investment decisions. And the jury is pretty clear on this one. The verdict has been had is, when it comes to investment decision making, our emotions are not our friend.

Noah Solomon: So the very same things which were very valuable for us to survive as a species and be here today rather than go the way of the dinosaur, like if you're being chased by a tiger, run, are very horrible things when it comes to investment decision making. There've been two Nobel Prize winners, for example, in behavioral economics, already.

Noah Solomon: So I would say you are basically taking the emotion out of it and taking advantage of the fact that a lot of market participants don't take the emotion out of it. And you're doing it in a very logical way.

Kim Inglis: So I want to circle back to you and talk a little bit about Smart beta.

Art Johnson: Mm-hmm (affirmative).

Kim Inglis: So Smart beta has emerged as a subset of factor investing. I'd like to know a little bit more about why you've chosen to focus in a little bit more on Smart beta.

Art Johnson: Well, I think, as everyone's talking here, it is taking the wisdom from information and making it accessible to investors. It really is the democratization of a lot of these ideas that have run institutions and been beneficial to investors.

Art Johnson: Where I think it fits, I would really say quant strategies should take up a place in that permanent part of your portfolio. And what I mean by that is, there should be a place in your portfolio that is not emotionally driven or driven by the whims of the market. What you're trying to do are to take the major moving muscles of where risk and return pay off for investors, and then combine them and build rules that take away the emotion for the investors.

Art Johnson: To Noah's point, it really is about this intersection between data and information and making better decisions. So, what Smart beta represents, to me, is the mechanical execution of that. And I've been doing quant strategy since the early 2000s, and I can certainly tell you even someone that is pounding these thoughts into my head every day, my DNA was built for the savanna. And my monkey brain wants to kick in and do these things.

Art Johnson: So Smart beta done well is a place where advisors and clients can easily take a portion of their portfolio and put it into strategies that have golden rules around execution, golden rules around ways that they're going to take risk and reward, do it in a much more robust, repeatable, reliable fashion.

Art Johnson: So it's a really exciting time, because I used to do this for very wealthy people. And now, it's being driven down into the ETF structure. So that's what's so exciting about the time for people like me. And you can see it in Noah's talk and Rodrigo's talk. It's this democratization of these ideas.

Art Johnson: Now, you do need to have people that you can rely on to help understand, as an advisor. Our job is really to get advisors comfortable in these ideas and comfortable with the fact that they can get out of the business of driving people around the stock market; that we can do that a lot better than they could. That's the challenge that Noah's talking about. There's a hesitancy in Canada to actually allow something else to do a better job than you. It's a hesitancy mainly from the advisory community, because there's lots of data that says people have a massive appreciation for algorithms because the fact, they aren't emotional and they actually do the things that we're not really great at, whether it's behaviorally biased, or I'm just kind of lazy.

Art Johnson: So Smart beta's a really cool part of the growth ... what I believe in the business, and advisors, now, are tasked on being portfolio managers. Before, it was really just a high-cost, heavily concentrated portfolio competing against the other high-cost, heavily concentrated portfolio at the other stop. Now, you're being tasked to do wealth management and you're being tasked to actually be a long-term portfolio manager.

Art Johnson: So I think these tools are fantastic for individual investors and advisors. So that's why I'm excited about it.

Kim Inglis: So behaviors as a factor, can you elaborate on that, and how you build that in?

Art Johnson: Yeah. I mean, it goes back to the models. The first way models were built in finance, is we thought that returns were kind of normally distributed and that stock prices were independent of each other; the random walk. What these gentlemen are talking about, and I believe, as well, is you look at something called momentum in markets, which used to be called relative price. And that, if your stocks are going up in value, tend to go up in value longer than they should if markets were a true random walk; the price should be independent. And they also do this on the downside.

Art Johnson: So what behavioral, we believe is happening, is that the ... The easiest way to think of it is Kahneman won a Nobel Prize on prospect theory. And what he said is, to make you survive as a human on the savanna, your DNA said if you eat something good, it's okay; but if you eat something bad, it's three times as bad. And so, what that does it keep you away from stocks that are going down, and make you overbuy stocks that seem safe. So, it's the simplest way to think about behavioral finance.

Art Johnson: There are all sorts of cognitive biases along with that, but those are the two big moving muscles. That means if you constructed a portfolio of momentum stocks that are going up in price, it's probably the better way to buy growth or any of these other styles that we've been kind of thought about. It's actually a pure way to think about what things are doing.

Art Johnson: And what we know is that if you just look back 12 months, buy them for a quarter, or ... Ideally, it'd be a month, but the frictional costs are too high. But there seems to be this lag in prices, that people still go up.

Art Johnson: Behaviorally, what you can do, is people underreact when stocks go up. They don't buy them until later on, and they overreact. So behavioral finance is very interesting, because what it lends itself are to systematic ways that you can build additional returns rather than market cap. And whether you're doing it machine learning or other ways to do it, it's all kind of the same.

Art Johnson: So I think it's a fascinating way to keep traditional investors doing kind of the blocking and tackling that they need to do, but in a systematic, rules-based way.

Kim Inglis: How about you, Rodrigo? Do you use behaviors as a specific factor, use them in the same fashion?

Rodrigo Gordillo: It's all behavior, right? It all comes down to, as I mentioned in the beginning of this interview, we have to make certain theoretical assumptions as to why the markets and stocks and asset classes have moved the way they are. And the random walk doesn't fit quite nicely. And we ... I mean, we've all been advisors, here. We all know how inefficient an individual investor can be and continues to be.

Rodrigo Gordillo: And so it's all based on my opinion, on behavioral inefficiencies that, by applying a set of rules, we can harvest over time. Right? They're not always going to work that well, but over time, especially if you're going to throw billions and billions of dollars to it, these behavioral flaws are likely to always be there, and therefore a well-crafted, quantitative strategy that is harvesting them is likely to, over time, also produce excess returns.

Rodrigo Gordillo: So absolutely, I think that this is ... As long as that continues to be true, we're going to find ways of doing it. And I think to your point, with regards to data mining and everybody piling onto one thing, even if that does happen, eventually that one thing that people piled onto and is now performing at zero, people will disavow all knowledge of it five, six years from now, and less money will be chasing that. And all of a sudden, that ability to extract returns from that behavioral inefficiency comes up again.

Rodrigo Gordillo: So I think it's more of an ebb and flow of these factors coming into and out of favor, and you gotta watch out for that, and you gotta diversify. And it's like anything. It's how emotions ebb and flow, factors will ebb and flow, and diversification rules.

Kim Inglis: How about you, Noah?

Noah Solomon: I would agree with Rodrigo. You're trying to find an anomaly where you can take advantage of this anomaly to make money or make extra return or lower risk, or some combination of both. And I would agree with Rodrigo that if you ask the why; why does hits anomaly exist, it is all behavior. It is all consistent mistakes that people make.

Noah Solomon: And for that reason, it's sort of a chicken-egg problem, because for that very reason, if you think that people will never become automatons and perfectly rational, then these factors will persist. But they may persist in lower magnitudes, and they may dispersit for extended periods of time.

Noah Solomon: Take value, for example. That thing has been crushed for 10 years. So even though it may exist, someone has to know it exists, so they have the patience. Does an investor, maybe one of your clients, have the patience to say, "Trust me. Trust me. It's going to work," as it's been getting killed for 10 years. So, it's a chicken-egg. Even though they will persist because of behavior, behavior means that maybe relatively few people will ever be able to take advantage of them. And yes, factors will rotate in and out. The question is, for example, a value factor, if you're trying to take advantage of it, and it's getting killed, and maybe some other is ascending and it's been working; some other anomaly phenomenon, when do you make that switch? And when you make the switch ... Again, you're looking in the rear view mirror to hit something in front of you.

Noah Solomon: So I do believe that these anomaly factors will persist over the long-term, I'm just not sure if they're commercializable.

Art Johnson: The one pushback I'd have on any investing is for a Canadian, because a lot of times in the factor talks, we talked about factors going away and not persisting and that. Well, the reality was, from September 2000 to September 2013, a dollar in the S&P was underwater for 12 years. It did not break a dollar until September 2013. No one was saying, "Oh my god, there's something wrong with the market cap index." Investing risky. You're taking risks. The minute you step away from a treasury bill, you're accepting different types of risk. No one was agonizing over the fact that the S&P was over owned.

Art Johnson: And for 12 years, I sat with clients saying, "You're a very dumb person, and I don't really like you. And why do you make me buy this thing?" And I say, "Because at the end of the day, risk and return works. You bought the risk; we should stick around for the reward."

Art Johnson: And so sometimes in factor talk, you gotta take it a little bit nuanced because the same could be said about indexing. And right now, the S&P's all the rage, and that's all you should own. But for 12 years, as a Canadian, it went from a dollar to about 60 cents, and you only got your dollar back in September of 2013.

Kim Inglis: So some industry experts have talked about how quantitative investing has really added to the disciplined nature of the whole process and how it's ultimately led to better entry and exit points. So, in other words, market timing.

Kim Inglis: Noah, I want to hear your thoughts on market timing.

Noah Solomon: So market timing is what people define it as. So, when I think of true market timing, I think of higher frequency adjustments and trying to pick the exact tops and bottoms; getting in and out of the market, out of the market. And the history of doing that is not very good. It doesn't work.

Noah Solomon: I mean, traditionally, it's been done by macroeconomic forecasting. So, I'm forecasting a recession as an economist or a strategist because I'm looking at bond yields or inflation or rising unemployment rates, or whatever ... Forecasting. Usually macroeconomic forecasting. I have never seen that work consistently versus a simple buy and hold a mix of stocks or bonds or what have you. I have never seen it work consistently in my life.

Noah Solomon: And the problem is, for example, if I'm forecasting a bear market, because I think unemployment is going to go up, or I think there's going to be a trade war or whatever, eventually I'll be right. Eventually, there will be a recession and a bear market. Recessions and bear markets are not a question of if; they're a question of when. But the problem is when.

Noah Solomon: So for example, if I make this forecast, eventually I'll be right. Maybe I'm right two years from now, maybe I'll be right five years from now. But if the market goes up 30% in that time, and then eventually I'll be right, and the market goes down 30%, I haven't made you any money; I'm just offsetting opportunity costs. So, I have never seen that traditional market timing, picking tops and bottoms based on macroeconomic forecasting work. You will either be way to early or way too late to add any value versus a simple buy and hold strategy.

Noah Solomon: But then there's a different kind of marketing timing, which I don't call market timing, but it basically is, from a high level, shifting your risk up or down based on what is actually happening in markets rather than what you think is going to happen. And there's a variety of ways of doing that. Very rarely are they based on macro-economic forecasts, but there's a history of people who do this, who have done extremely well. One of them is Warren Buffet.

Noah Solomon: Now, wait a minute. You go, "Wait a minute. Warren Buffet's not a market timer." Well, as it turns out, there's the side of Warren Buffet that people know and understand, which is he buys great companies and he holds them forever. But then there's the side of Warren Buffet, which is maybe underappreciated, which is just as important, which is ... Again, I wouldn't call him a market timer, but if you look at history, here's what Warren Buffet does.

Noah Solomon: So let's say it's the technology bubble of the late '90s and everyone thinks it's easy to make 25% returns per year, because everything's going up at an astronomical pace. And they look at Warren Buffet and he's underperforming, and he says, "Yeah, you know ... " And they say, "You're a senile old man. You don't get it, it's a new paradigm." And he says, with his nice grin, he says, "Yeah, maybe silly old me," you know, in his folksy way. "Maybe I don't get it anymore."

Noah Solomon: Now, he doesn't sell, because he never sells. But he has all these insurance companies and dividend-paying. They are paying cash. Now, what is he doing with this cash? Nothing. He is amassing war chest. And then when they find out he's not senile and it's not different this time, he goes on a shopping spree. He deploys all that cash that he's been amassing, when everyone else is choking. He's a grave dancer. And his favorite expression is, when it's raining, don't grab a thimble, grab a bucket. And he does.

Noah Solomon: He went on a shopping spree after the tech wreck. And he did it again in 2008. He went to Goldman Sachs and he said, "Sure you want $5 billion from me? Be happy to do it, but you're going to pay me a 10% coupon on my money and give me options on the stock. Let me know what you want to do."

Noah Solomon: So there are people like Warren Buffet that ... I wouldn't say market timing and literally high frequency and picking local tops and bottoms; but they are adjusting their portfolio based on what is going on in the markets. And I would say that's a very good idea if you have a good process. But it's a very good idea for doing, if nothing else, because as Art pointed out, it can take years to recover from losses. Investing is really about harnessing the magic of compounding. And the best way to harness the magic is don't have large losses in bear markets, because it ruins the magic.

Noah Solomon: A 30% gain does not make you whole from a 30% loss. If you have a $1 million portfolio and it loses 30%, you now have $700,000. If you then make 30%, you don't have $1 million, you have $910,000. You're still off by $90,000. You need a 43% gain to offset a 30% loss. It ruins the magic.

Noah Solomon: So I wouldn't say market timing, but adjusting your portfolio accordingly based on where you are and what the probabilities are is a very good idea to, if nothing else, harness the magic of compounding and sleep at night.

Rodrigo Gordillo: Well, I actually think that, like you said, the definition of market timing is crucial, here. Right? I think we're all market timing.

Art Johnson: Yeah. [crosstalk 00:24:26] is market timing.

Rodrigo Gordillo: You had a great example with Warren Buffet, but we're all doing it. I think what you're talking about is that the traditional market timing of, it's the top of the S&P 500 or, in Canada, the S&P TSX 60, I want out; wait for the fall, and then get back in. I recently saw an interview with Ed Thorpe, that he was asked, "Do you believe in efficient markets?" And he said, "If you believe efficient markets are real," and he said, "For you, they're real. For me, they're not real."

Rodrigo Gordillo: And so my answer to market timing is for you, market timing doesn't work. Because you're doing the 200-day moving average, and you're getting out with a bit of a lag, then you're getting back in, maybe you're executing. That thing works depending on the market you're looking at, 51% of the time. There's an edge there, but you're going to lose 49% of the time. You lose over and over again, but if you stick to the process, you might make some money.

Rodrigo Gordillo: Now for me, I don't want to use a single asset class. I want to use a wide variety of asset classes. I don't want to use a 200-day moving average. I could be using anywhere from 20 days to 300 days, I could be using different definitions of where an asset class is based on its price, based on its Sharpe ratio.

Rodrigo Gordillo: This is the way I equate it: I run a wide variety of quantitative systems that market time and have a slight edge. I'm like a casino in Vegas. Vegas doesn't have a 90% hit rate. Their edge is like 50.5%, 51% depending on the strategy. And when you walk into a casino, it's similar to our casino. A wide variety of games; roulette, blackjack and so on. Right? All these games are being played by multiple people at different times, and you're getting paid off a little bit at a time. You're allowing the law of large numbers to get you there.

Rodrigo Gordillo: The average investor that thinks about market timing is running a casino right next to us that has a roulette table, and it's playing black or white with a little green in the middle. Right? That market timing doesn't work. A well thought out, quantitative market timing approach, that works overtime.

Rodrigo Gordillo: So I think the answer is yes, market timing works, but you just have to make sure you're executing appropriately.

Kim Inglis: Art, would you agree?

Art Johnson: Yeah. I think that there's a seminal difference in the belief system. I am always ... I've been amazed my whole career, at the time, the money, interest people will put into accumulating money. What Noah and Rodrigo and I am talking about are strategies to preserve and grow money. And people do not spend a lot of time on that.

Art Johnson: So a typical buy and hold portfolio is not a very efficient way to preserve and grow your money; especially now with interest rates being so low, it's a real challenge. But you could literally say that rebalancing is market timing.

Art Johnson: I think where the confusion comes between quant and former, kind of seat-of-your-pants ideas, I really want to dispel that notion. This is looking at not so much the best way to accumulate wealth; it is how do we preserve and grow it? So, something like trend following, whether you do it the way Rodrigo does it or the way we do it, it really is a way to manage the basic pain that Noah was talking about, that really does destroy your preservation and your growth of wealth.

Art Johnson: And I think that is the task where the advisory business is ... That is the task that's being put on you, now. It's being put on me by our clients. They're coming to us and saying, "Okay, well I have done a great job at accumulating my wealth," whether I was a great saver or an entrepreneur, but there doesn't seem to be a great knowledge of how to preserve and grow without these very basic ideas that were out there.

Art Johnson: And what these gentlemen and myself are talking about are these new approaches to this concept of how do I preserve and grow? So, if that's what you're trying to do; you're trying to eliminate the fact that markets go down 60%, 70%, 80%. And there are proven academic ways that you can actually mitigate that part of the pain of a portfolio.

Art Johnson: In doing so, even if you lose on these, you gain from the ... $1 million going down to $600,000, which is where all of your bad emotional decisions come in. If you lose for a while, and that only goes down to $240,000, you've done a wonderful service to the client. The difference, I think, is that they trade quite differently, so the education has to be around these. But if you're in the preserve and grow business, everything that's been said here is really geared to that, so that's the big distinction I'd make.

Art Johnson: So market timing to accumulate wealth and preserving and growing are two different things all together.

Rodrigo Gordillo: It's not even the behavioral side of losing 40%, it's also the safe withdrawal rate.

Art Johnson: Yeah, exactly.

Rodrigo Gordillo: There's a big difference between a person that has $1 million, who's never going to put money in or take money out and is going to come back 30 years from now and hope that the world grows. And the world here is likely to grow in 30, 40, 50 years. If you have no cash flows, you're good.

Rodrigo Gordillo: The moment you have a cash flow, that's when it becomes important to minimize the max losses, the maximum losses and maximum drawdowns. And in our book, we wrote a piece that kind of analyzed the annualized rate of return of the Dow Jones to 1967 to 1997 or something like that. And it was around 8%, exactly what everybody believes the long-term return of markets to be.

Rodrigo Gordillo: But the big difference was that from 1967 to around 1980, you annualized it to zero. And from 1981 to '97, you annualized at 16%. On average, you're 8% rate of return.

Art Johnson: Yeah.

Rodrigo Gordillo: But if you had retired in 1967 with whatever and you're withdrawing the traditional 4% a year, you're out of money in seven years. Right? You don't make it.

Rodrigo Gordillo: The same person, let's say that the return's at 16%, annualized return started in the beginning of the path, and then you had zero afterwards, that $1 million that that person withdrew, ain't getting 16% the first half of this time series. Even though they had zero returns for the latter half, ended up leaving a legacy of around $4 million. Right?

Rodrigo Gordillo: So safe withdrawal rate and the sequence of returns is massive for private wealth, for retail investing. And so, I think it's a disservice if you're not being thoughtful about market timing and minimizing the chances, you're going to have those big drawdowns at 30% that goes from $700,000 to $910,000. When your $1 million goes down to $900,000, you need 11% to break back to even. Right? Not 10%, but 11%. One percentage point, I think we can deal with that.

Rodrigo Gordillo: So I think that's key in this discussion of marketing timing; being thoughtful and protecting it for the people that we service, which is retail.

Kim Inglis: So Art, I want to circle back to you and just the whole concept that we've just been talking about surrounding risk management a little bit, there. You've talked before about partial relationship between personal risk/reward relationship with factors. How can investors mitigate that a bit?

Art Johnson: When I look at my career and the decisions that we've made, even using models, we tried to tilt our models various times, even tiny, and back to what Noah and Rodrigo were saying, it was very humbling to find out that the things we thought would be cool actually took away from our returns.

Art Johnson: What we really found is that there's kind of two primary ways you're going to get paid as an investor. One is to buy cheap stocks of high quality that are out of favor, that'd be traditional value, different metrics you want to work on them. The other one, which is very underrepresented, is called momentum investing; which is stocks that move up in price tend to move up in price.

Art Johnson: And the fantastic thing is if you do price momentum and value, there's ... You go back to what Markowitz was talking about, is that you take these two separate things, but them together, and you get a much better portfolio.

Art Johnson: So if I was going to talk to someone, I'd want those two things in your portfolio. We believe that you want to put those together kind of like Rodrigo does, because it's just very difficult to do these things on your own. They'll be out of favor, in favor, and we just want to chase performance, as people.

Art Johnson: But I think a better thing that was coming out in academic papers, and it really pertains to withdrawal rates, is something called trend following. And trend following is about this idea that the herd actually does some things to markets that a rational person wouldn't do. When markets go back, they go really bad. And they do this at a much greater rate than a normal statistical model would tell you. You know, you say three standard deviations, 99%. This is the 100-year flood theory. Well, that happens every 15, 20 years in our case.

Art Johnson: And so what trend following does, is basically do that kind of going to cash or going fully into stocks for people. And it's been well researched now, and it is a fantastic way to enhance your withdrawal rates, as an advisor. We're in a period where interest rates are low and our clients are living longer, so it's these types of tools that I think are really important.

Art Johnson: So if you're looking at any type of quant strategies, I'd go around what the more robust, reliable ones are; momentum, value and maybe trend, and kind of stick around that and get your toe in there, understand those.

Kim Inglis: So with risk management, I'd like to touch on ETFs a bit and how they are used in quantitative investing. Rodrigo, what are your thoughts on ETFs, and can they be used to mitigate risk?

Rodrigo Gordillo: 100%. And this is a new technology. Right? It allows investors to get exposure to asset classes easily, that they didn't have 10, 15 years ago. It's a fantastic technology. And with great power, also comes great responsibility. Right?

Noah Solomon: That's very Marvel Comics of you.

Rodrigo Gordillo: That's right, that's right.

Art Johnson: Yeah.

Rodrigo Gordillo: It is ... President of Resolve Asset Management, that's all he talks about all day.

Rodrigo Gordillo: But much like Spiderman had to learn how to deal with his powers, it's highly important for investors and advisors to learn the power that these tools have and implement them the right way.

Rodrigo Gordillo: So for example, in 2008, we have this concept that everything correlated to one. Right? Which is what, if you look at equity markets globally, and the vast majority of investor's portfolios did go down. As a Canadian investor, you actually would've done a favor if you invested in US long-term treasuries. Now, I mean that concept is even kind of weird. Isn't it? A Canadian investor, advisor buying US government bonds? It seems difficult, it seems like a big hurdle. But the reality is that there was an exchange-traded fund, an iShares, TLT is the symbol. That, for that year, for Canadian investors, was up 68% if you take into account the currency. It outperformed the vast majority of hedge fund managers out there, and it is the simplest and most widely held asset class on the planet.

Rodrigo Gordillo: So you see the power of that as a benefit to your portfolio, and eventually we were part of trying to bring this Canada in a Canadian-based ETF through Horizons that is actually able to ... Investors are able to use that in an overall portfolio in order to benefit the risk adjusted returns, the safe withdrawal rate, and so on. All right?

Rodrigo Gordillo: So I think that exchange-traded funds are wonderful things. We have more than we've ever had, and we are getting all the parts right now, but we have no assembly instructions. And the key here is to see if there are ETF strategists, like people here. We run an ETF that runs ETFs, because we have a game plan and we're able to use those tools for Canadians within an ETF structure.

Rodrigo Gordillo: And so there's definitely ... If you do it the right way, you can do really, really well it. If you do it the wrong way, you can get hurt.

Kim Inglis: Noah, do you agree?

Noah Solomon: I do agree, 100%. I think ETFs are a wonderful thing. And I'll explain why. But before that, I got to say, I love ETFs and I hate ETFs. I have a love/hate relationship. And what I would say is ETFs, in many ways, are no different than any other financial product or innovation that's come out over the last 50 years, in the sense that you generally ... I'm being optimistic, here. It generally starts off as a good idea, and then eventually, the financial industry perverts it and Frankensteinizes it.

Noah Solomon: So for example, the original ETFs, the broad-based index tracking or sector tracking, cap-weighted ETFs, uber liquid, were a good idea then; and they're a good idea now. At the end of the day, what they are doing, and what they will continue to do is engender a huge transfer of wealth from the investment management industry to the investor. And I have no problem with that. They're a wonderful thing.

Noah Solomon: But today, you now have 6,000 ETFs in the world or something. Seems like 100 new a day. And you can get exposure to anything. You can get triple-leveraged exposure to the basket weaving industry in Kuala Lumpur. I'm sure if they don't have an ETF does that, it's in the works. Those are dumb ideas. And they will end in tears.

Noah Solomon: So the two main criticisms of ETFs that I hear are investors aren't aware of the risks they're taking because they're really not liquid, and when you have a disruption in the market, investors won't be able to get out. And again, you can't tar everyone with the same brush. So, I would say that's true of some very bad ETFs, but not true of the original liquid, vanilla index tracking, or even some of the Smart beta ETFs. So, I don't think that criticism is valid for all ETFs, certainly not for the bigger ones.

Noah Solomon: The other criticism I hear, which is sort of a, "I'm doing this as charity to the world," is the markets are really inefficient because of these index-weighted ETFs that no one's thinking about what a company's really worth or what their earnings are, or their debt level; they're just buying them based on their weight in the index, because the biggest ETFs are the cap-weighted index tracking ETFs. And therefore, security prices aren't efficient. Okay.

Noah Solomon: But if I was an active manager, I would hope that's the case. That's a gift for me. Like, please make the market inefficient. Why are you complaining? And by the way, if the markets were so inefficient because of the rise of indexing or index tracking ETFs, then they should be outperforming; not 90% of them underperforming.

Noah Solomon: So I'm a little confused. So that's kind of how I think about ETFs.

Kim Inglis: So we've covered a lot of ground here today, and I want to wrap up by asking each of you what would be the key element of being a successful quant investor.

Art Johnson: I think you have to believe that they're going to be a permanent spot in your portfolio. We talk about long-term investing and we talk about ... We try to mitigate the impact of factors going in and out, but you have to basically adopt a philosophy that these things matter, and they should be in your portfolio.

Art Johnson: Or else, what will happen is you will crystallize your shame or your emotions or something else when something doesn't happen in these. And then on top of that, is get with providers that can talk about the history of Samuelson or why linear regression models matter or don't model. You may not even like that stuff, but it's very important that you get a sense of that there's a long history here, and there's a reason why you should be doing this.

Art Johnson: And I think those types of things will build you guardrails of success to hang onto things for clients. That's what they've done for me, is that I had academic and knowledgeable guardrails around the choices to make better decisions. And then the other thing is that data and information leads to better decisions. You need high input data and information to make those decisions, and that's the way the business is going.

Art Johnson: So I think that those make great quant investors.

Rodrigo Gordillo: Yeah, I think that it's what we've been touching upon. It's education. It's making sure that you understand the process and kind of forgo the outcome a little bit. All right? We know that human nature is constantly going to be going against us, and what we want to do through education is to force people to look at the research, reemphasize that research, make sure they fully understand it, they find ways to explain it to their clients; because every strategy, including the momentum S&P 500 strategy, go through a decade worth of flat or negative returns, a big drawdown.

Rodrigo Gordillo: So if education is not the most important thing for you and your clients, then you are going to have return-seeking clients making the wrong decisions at the wrong time.

Rodrigo Gordillo: And so we wrote a piece called It's Time for Advisors to Get Comfortable with Being Uncomfortable. That's what we need to do. We need to educate, we need to tell clients it's time to forgo just passive 60/40 investing and start learning about global investing, to start off with. Right? Everything's super expensive right now in North America. There's a lot of cheap asset classes and equities in the world. Start being comfortable with being a global investor, even though we've seen a 10-year bull market in North America.

Rodrigo Gordillo: Then, start getting comfortable with using Smart beta and different factors, and then possibly go out even further into the hedge fund space; but start to get comfortable with being uncomfortable. And the way you get comfortable is through education.

Kim Inglis: And Noah, some final thoughts?

Noah Solomon: I would say to be a successful quant manager or firm, you need discipline, humility and perseverance. Discipline to stick with your process, even because it makes sense based on long-term history or theory or academia, even if it hasn't worked for the last month or quarter or year. So that's the discipline. The humility is understanding that it won't work all the time, and that's okay, because nothing is a silver bullet or a panacea. And as Rodrigo pointed out, what I call perseverance. When I say perseverance, I mean perseverance in terms of education.

Noah Solomon: So the same thing that makes Canadians wonderful in many regards also, like everything else, it's a two-edged sword. So, we are pretty chilled out compared to our neighbors to the south, and maybe less industrious or aggressive in some ways. So, there's a little bit of a do nothing and hope nothing happens. You know? If it ain't broke, don't fix it, kind of a thing. You could call it complacency. You can call it civility, you can call it whatever it is, but we do have that, a little bit.

Noah Solomon: So this is the way we never have done things, ergo it's the way we never should do things. And perhaps we're a little more guilty of that than other nations, just because of our culture, and that's fine. It also makes it a very chilled out, civilized place to live.

Noah Solomon: But you do need to persevere, saying, "You know what? Maybe spend a little less time worrying about what series you're going to watch next on Netflix, because this is important to your future and your children's future. And please, let me tell you about a way to, at the very least, diversify your portfolio," and maybe even the most, maybe get better results, as well.

Kim Inglis: Okay, thanks very much gentlemen, for joining us. You've certainly helped clarify this ever-evolving strategy.

Rodrigo Gordillo: Thank you.

Art Johnson: Thank you.

Rodrigo Gordillo: Appreciate it.

Noah Solomon: Thank you very much. Thanks for having us.

Kim Inglis: I'm Kim Inglis of Raymond James, and this has been Asset TV's quantitative investing masterclass.