Josh Brown On Evidence Based Investing

May 30, 2017

If you have access to any financial media, Josh Brown is hard to miss. Also known as “The Reformed Broker,” he has one of the biggest media presences in the financial services industry. Brown’s blog, “The Reformed Broker,” is a must-read for anyone following financial news. He has more than 650,000 followers on Twitter (@ReformedBroker), he appears regularly on CNBC-TV’s “Halftime Report” and has published books including “Backstage Wall Street.”

Brown is also CEO of Ritholtz Wealth Management, which is the new conference partner with IMN for the 22nd annual Global Indexing & ETFs: An Evidence-Based Approach, in Dana Point, California, June 25-27. Among other topics discussed with Brown was the idea of “evidence-based investing.” Let’s first talk about what your firm’s role is for the conference, and this evidence-based approach to investing.

Josh Brown: We've been on this conference like ivy. I’ve attended it twice now, and in both cases, I thought it was one of the best conferences I’ve ever been to. So IMN certainly doesn't need our help to put on a great event.

However, there's a movement in finance that goes far beyond just which index do I buy, which is evidence-based investing, and it deserves its own conference.

And to IMN's credit, this was their idea to approach us—it wasn't our idea—because they see the same thing we see, which is that people are reorienting the way they allocate assets and build portfolios around data, and obviously historical prices and current trends.

There’s a lot less gut instincts, or arguments of authority or "this guy's really smart." That paradigm is dead or dying.

Now, the younger generation especially wants evidence that the way they're investing has some basis in fact and that it's got a chance to work. So the conference is being arranged around that principle. “Evidence-based investing” is a new term, at least from my perspective. How is it different than the old paradigm?

Brown: The old paradigm was, "trust me; I'll figure this out." In other words, I'm a really smart manager. Here's my track record. Here's where I got my MBA. This is the pedigree of firms I worked at. Look at how much I manage already. I'm obviously successful. So just give me the money and I'll figure it out. We've been doing this for 50 years; trust us, we know what we're doing. Look at my boat. Look at my watch.

Evidence-based investing flips that on its head and says, “Don't take my word for it. This is, to the best of our ability, a statistical model of what usually happens, what the probabilities are, what roughly you can expect if A, B and C happens. And things will happen that have never happened before.”

On one hand, evidence-based investing is attempting to draw answers out of data. On the other hand, it's also attempting to build portfolios that are durable enough so that if something unexpected happens, it's not game-over for the end investor.

But that's part of the challenge of conferences, to define what is evidence-based and what is wishful thinking, or pure speculation. We'll never all be able to agree on a black-and-white line. But that's what makes this interesting.

Investing is never going to be physics. It's never going to be Input A plus Input B equals Input C. It can't be, because the market is not mechanical; it's biological. All of the market participants are biological. Even the machines that we build to trade the market are being built by biological people. So the market is never going to obey a law.

The purpose of the conference is to discuss the methods that people are using to try to find those answers. And those methods are increasingly quantitative and evidence-based. Looking at the agenda, two themes stand out to me. Obviously smart beta is always coming up in these kinds of conferences, but also socially responsible investing or ESG (environmental, social, governance). Can you meld those two? Can you put a factor into a virtuous type of investment?

Brown: I'm so bored of the active versus passive debate. I'm so much more interested in talking about whether virtuous companies' stocks are rewarded or if sin stocks are rewarded.

We've all seen the data that tobacco stocks were the best-performing subsector of the British stock market over 200 years, and eliminating tobacco and alcohol and whatever has been not additive.

But the real question is, will ESG skew returns toward some sectors and away from others going forward? We don't know the answer now. We can look at history and we can use that; we can say it's instructive, but things genuinely change.

Think about the composition of the S&P in the 1970s. These smokestack copper smelter companies had 2-3% profit margins. And we're trying to look at the multiples of today's stocks versus those stocks?

Cap-ex for today's stocks are that you invent a piece of software and then you spend no more money, you just make copies of it for free, forever, and continue to sell them at increasingly higher prices. That didn't exist.

Millennials are the largest generation just by sheer population. They obviously don't represent nearly the same amount of investable assets, but that's not yet. What happens when they do? What areas of the market will benefit as a result of the types of things they want to invest in? I think the jury's out. If I tell you I want to get into socially responsible investing, I don't want any fossil-fuel type of companies in my portfolio, and energy's such a big component in the market, when does that start to hurt you?

Brown: It's not my job to tell you that you can't have that. It's my job to say, “OK, I appreciate that you don't want to own stocks that sell firearms or weapons of war. I appreciate that you don't want a portfolio that’s investing in companies that are big greenhouse-gas emitters, or companies that won't hire women on their boards of directors. I appreciate where you’re at.”

My job in that context is to explain what the potential downside is of constructing a portfolio based on these proclivities or these predispositions that you have. That's my role as your advisor. I can only give you the evidence of what's happened historically. I can't tell you that'll be repeated the future. And I certainly can't say no to you. Your firm is focusing on ESG with portfolios built around these themes.

Brown: We have built three model portfolios that are meant to be, let's call them “greener versions” of our existing main asset allocation strategies.

We’re absolutely giving up some exposure to some things. We're not using the term “SRI” [socially responsible investing], because SRI has a different connotation than ESG. The SRI funds that became popular in the '80s and then got a bad name were glorified S&P funds that cost a lot more and basically ended up in the same place as the index, net of fees.


What's going on with ESG now is that they're being delivered at low cost because they're quantitatively assembled. No. 2, more and more corporations are doing things to make sure they adhere to ESG best practices and being a part of these indices.

We might get to the point where 90% of the S&P is already ESG-ready, just purely based on the way these companies are behaving and the policies they're adopting. And it's not a U.S. phenomenon. ESG is gigantic in Europe, much bigger outside of the U.S. than inside. That's going to change.

When it comes to socially responsible investing, one client's social orientation is not going to be the same as another client's. We can't really build models on the social aspect of this. We could have some baseline, but what we're really focused on at Ritholtz in our ESG portfolios is on the environmental and sustainable portion of it.

We're not doing any of the Christian stuff, any of the Muslim stuff. We're not taking stands on alcohol. We just don't think we can do that in a general enough way to satisfy everyone.

However, on the governance and sustainable sides, we think there are some important baselines to establish. The different funds we're using look at—are women paid the same amount as men who do the same job within these companies? They're looking at the carbon footprint of these companies. And clients want it.

I want to have an answer for that, that I also think will be a successful investment for them. People work their whole lives to save this money, and if they don't want their dollars directed into serial polluters, they don't want to have that just because the return might be 12 basis points higher 20 years from now. You make a great distinction that we here need to focus on a little: socially responsible versus ESG is not the same thing, is it?

Brown: When I run into someone who's been in the business for more than 20 years, let's say, they will use SRI and ESG interchangeably.

I ran into a financial advisor from one of the wire houses in New York City. He manages money for the [Catholic] Archdiocese. He's got all these pension assets for different churches. That’s the thrust of his whole business; that's his niche. And he's got a great business, but he's got to adhere to very specific Catholic principles in the portfolios he's building. That's not what we're doing.

I would say that what he’s doing is much closer to SRI than what we're doing. And he's not calling it faith-based investing, because doesn't that have the connotation that it's the opposite of evidence-based investing? I hate when people say “faith-based,” because it sounds like they’re praying it’s going to work out.

There also may be a behavioral value to doing an ESG strategy that people haven't considered yet, which is: In a standard 15% correction from the highs where you're only 5% away from an official bear market, clients will start to panic.

Which clients are going to be more tenacious about staying with their portfolio in that moment? The ones who just own a collection of funds or the ones who own a collection of funds that are specifically selected to adhere to their personal social bent.

In some way, ESG investing is a behavioral hack, a way to get people to be not only satisfied with what they’re investing in, but to defend it more fiercely in times of market stress.


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