Jay:  Today’s show guest is Chris Meredith. Chris is the director of research, co-chief investment officer, and portfolio manager at O’shaughnessy Asset Management. O’shaughnessy Asset Management is a quantitative money management firm based out of Stamford, Connecticut. Chris is responsible for managing investment-related activities, including investment strategy research, portfolio management, and the firm’s trading efforts.

Today we give our audience a brief primer on quantitative and factor-based investing. This is an area that has been picking up in popularity recently, not only amongst institutional and high-net worth individuals but also amongst retail investors. Please enjoy my conversation with Chris.

Chris, thank you so much for joining us. We’re very, very excited to have you on. Appreciate the time.

Chris:  Thank you. Thank you for having me on. I’m looking forward to discussing everything about O’shaughnessy Asset Management.

Jay:  Absolutely. For the audience listening in, perhaps you could give a quick background introduction of yourself. Who is Chris Meredith, and what do you do for a living?

Chris:  Sure. I am the director of research at O’shaughnessy Asset Management. We manage about $6 billion through quantitative equities.

My background is one where I was actually…it’s a quantitative firm, but I have an English undergrad degree from Colgate University, but I wound up getting a master’s in business, MBA, from Cornell University, where I really started getting into investing, with a masters in financial mathematics from Columbia, as well as a CFA, just to get broad in an academic background. And I actually am now also a visiting lecturer back at Cornell where I teach an applied portfolio management class. It’s a combination of quantitative and fundamental investing.

Jay:  I see. Wow. It’s interesting to me because I’m certainly not as educated as you are, but I know that when it comes to investing, the markets are abundant, and there are many ways to make money in the market. And a lot of people choose a lot of different strategies to pursue. Was it just because of your mathematics and just your personality, is that what led you down this quant path?

Chris:  The quant path for me was an interesting one. I went to the MBA program to learn more about investing. And the program was set up where, obviously, they build up a lot of the fundamentals of learning about finance, accounting, etc. And then it came time to start picking stocks. What I noticed was it felt really subjective to me. It felt, one, where I was looking at an individual name, doing your DCF models. You could do growth rates and discount rate, and you could really move the prices around a lot with it.

I started trying to build more systematized ways to get to investment ideas. And this actually is just, my background is one in technology where I’d always been good with computers. Before I even went to Cornell, I had been looking at ways to download information from Yahoo and build my own datasets on trying to understand what was going on with really bad quantitative investing at that point. But analysts estimates and looking at information.

The way that I think — and this is the way that quantitative investors think about it too — the investing process is essentially you try to use the same fundamental concepts that would be used within a financial statement analysis and doing your full one-stock pitch, but taking that and trying to do it where it’s codified across the entire universe of stocks.

So the part for us — or a part about getting data, which is similar to a fundamental process. If you think about you on the Southside dialing in, you’ve got all your reports. You put on your headset. You start making phone calls to the IR group. Those pieces where you’re going through and you’re building our spreadsheets and models, we try to do it by getting large datasets where we’re seeing all 3,000 companies at once. Here’s my balance sheets and income statements. Here are the ratios between those, and here are the returns. Then you can investigate historically how these strategies have done over time.

I would say that there’s a lot more similarities between quantitative investing and fundamental investing than people know. I think the number one reason is because there’s not enough education around how quantitative strategies work.

Jay:  Right. I tend to agree with you. I myself am a full-time investor at a hedge fund. We’re very fundamental, long-short equity, by very bottom-up, fundamental biased. Even being a full-time investor and having done it my entire career, when I talk about quantitative trading and strategies, it’s kind of this dark area where I’m kind of like “I don’t know much about it, and I’m scared.” But having said that, I know that if you look — and I’ve read a few things. I can’t remember where I read this. And it wasn’t an academic journal. It might have just been buzzy news. But saying that market participation in the last, say, five to ten years, has sifted, and there’s a lot more quants and algos and higher frequency trading participants as opposed to fundamental guys.

The lens that I was reading it from was it’s a lot harder for fundamental guys to make money now in the market. That was my takeaway from whatever I was reading.

You bring up an interesting point with your background, saying how fundamental investing, there is a lot of subjectivity to it. It’s basically based on you building a model. Your assumptions versus the street, how you’re going to differentiate yourself. And then you take advantage of the quarterly events and data points to structure your trades around.

Now, I guess the intrinsic, least common denominator, lowest common denominator there is it’s the human element of it. And this goes from the retail investor all the way up to the hedge fund manager. Like the most successful hedge fund managers in the world, there’s always still a human element.

So if you take a look at it from an institutional investor standpoint, like a pension fund or something, at the end of day, you’re still betting on that jockey when you’re talking about a long-short-type shot. So you’re still at risk if he has a divorce or he’s going through a drug problem or something like that. That’s a risk.

So to me it seems like quantitative trading and strategies kind of eliminate that. And so I want to ask what your view is on investing in general. Why are human beings so bad at investing, which has basically spawned this entire quant strategy subset?

Chris:  The part you’re hitting on is a key part of what’s going on inside of industry. Factor investing, quantitative investing, has become a lot more popular.

Part of this is just the expansion of the number of ideas you talked about. You mentioned a few things in there. One, like the high-frequency trading, which is much more of looking for… There’s a handful of strategies in there. People trading off of news or trying to sit there and evaluate market micro structure and ways to look at if one market has a different price than another market.

There’s another group that is basically like the quant hedge funds that are working on a quarter-to-quarter basis of trying to get ahead of earnings. They’re trying to get informational edge. Like getting information before other people by looking at purchasing credit card data before the quarter end to understand where people are spending their money, looking at… There’s going to be more and more explosion around this, around satellite data, around location data, etc.

But there’s also this portion about more longer-term investment factors, which is where we reside. Your listeners have heard about where there’s ideas of low-volatility strategies, values strategies, momentum strategies, and those types of investment ideas.

So the part about the popularity of those in particular, those have gathered a lot of interest from people. And I think part of this is there’s a couple of benefits to it.

One is, as you said, the fundamental process is one that’s typically a lot harder to describe. If you talk about a potential client or a client of yours and you walk in and you talk about your investment process, you’ll talk about how you look at companies. You’ll talk about your theory for things like quality versus value, but there’s no systematized, overall arch of saying, “Here’s the one thing that we’re looking for in a company.”

Whereas you get more clarity on that with what happens inside of a quantitative strategy. You get a little bit more of “I understand that this portfolio will be built around this theme, and all the stocks in it will exhibit those characteristics.” And you can understand how it’s being constructed around it.

Now there’s that clarity for it of how it’s being constructed gives more usefulness to the investor who’s trying to build an allocation. Some will view it as a completion of their portfolio or they’ll say, “You know what? This is something I’m missing. I have a good fundamental growth manager, but I don’t have momentum or value or low-vol,” and I can use that low-vol as, say, a defensive equity part of my portfolio.

Some people are looking at it as a replacement part where they’re saying, “I’m going to take my value strategies and replace another fundamental manager.” Because the plain part is that fundamental active management has struggled for the last several years.

If you look at things like the SPIVA report from S&P of index versus active, you can see that the number of times in the universe where over a trailing five-year period where the index has beaten the manager is about 82% over the last five years. It’s not a really good indication of how the industry is doing.

People are looking at this and saying, “My traditional fundamental management has not been doing well.” They’re going through and they’re basically saying, “I think factors can help me on this. A quantitative approach can help me on this.”

And I do think one thing that comes with it — and this is a key aspect for anybody that I would talk to about investing — is also the discipline that comes with it.

The number one thing we have learned as an investment shop is that discipline wins in markets. The idea is that you have investment styles, and you separate out the part of your investment process versus your investment results, because there are good times with good processes, like value investing, which has struggled essentially over the last ten years. And there are reasons that we think that that has happened, but it doesn’t mean that value investing is broken; it just means that there have been headwinds on how value investing has worked within the market.

Jay:  Interesting. Let’s take an even further step back for some of the audience that might not even be well-versed in what factor investing or what factors actually are. Maybe you could give us just a handful of examples. What are the different factors that you look at that you use to base your models on?

Chris:  You can boil it down to six main themes that we look at inside of our portfolio, and they each have different ways about looking at stocks. Valuation is one I talked about. The idea is that you want to pay as little as possible for a company. Think of the company as generating economic benefits through earnings, cash flow, and you look and say, “If I can get the same dollar of cash flow for five dollars instead of ten dollars, why wouldn’t I buy it at five dollars?”

There’s momentum, which is looking at trends in the marketplace and stocks that have done well over the last three, six, nine months continue to do well over the next 12 months. This can also come through on the individual, like you said, bottom-up stock picking. It can come through general trends in the marketplace of saying, like, energy is an area that’s been beat up in the market, potentially some risk or downside attached to that area, versus potential upside from areas like biotech, internet stocks, etc. That can come through within momentum.

We also look at yield, the total return of capital through share repurchases as well as dividends. And we’ve done a lot of research on share repurchases. I would highly recommend going to OSAM.com and looking at our commentaries if you have more interest in that theme. We’ve explored it a lot.

There’s also quality themes we use to remove stocks. This is something that, from our point, we think is a little bit unique. We say there are stocks you just should not own. There are stocks based on things like financial strength of the balance sheet, looking at the leverage of the balance sheet as well as the direction it’s headed in and basically penalizing and removing companies that are financing themselves through external sources versus their own cash flow of operations.

We look at earning growth where you’ve seen a decline in earnings over the last quarter and the last year, and they’re unlikely to turn it around.

And we look at the quality of earnings which is accounting, essentially. You’re getting in under the hood to see if there’s companies that might be boosting their earnings by moving things within their balance sheet, tipping into inventory, receivables, to possibly be a boost in revenue, and looking for imbalances to identify companies that are manipulating earnings.

Now these themes, the way that we build them, sound very fundamental. They sound a lot like what you would have for anybody out there who is doing a full fundamental analysis of a company.

What we do is that we take these, and we look over long historical cycles. Within Asia, we’re able to look back to the late 1980s, in these themes within various markets, how have they done and played out over time. We’re also able to take those ideas and themes and look at in not just within Asia but also within the US and Canada, within emerging markets. What we’ve seen is that these are robust ideas that are based on…some would say risk. Some would say mis-pricings in the marketplace. But what we have seen is that they are factors that are able to separate out stocks that have access returns from those that will underperform in the marketplace.

Jay:  One of the quant-type terms that you hear about and you read about a lot but a lot of people don’t know about is this term called smart beta. Maybe you could give us, again, a 101 on what is smart beta. And know that at O’shaughnessy, you guys actually have another strategy that sort of differentiates yourself from the traditional smart beta. Right?

Chris:  Correct. Again, the way that smart beta works is the whole idea is that how you get rewarded in the marketplace for positioning your portfolio in a certain way. And the story was originally the old beta was market risk. The idea is the stock market goes up; does your beta have stock that goes up more, it’s got a beta of like 1.1. If it goes up less, then it has a beta of .9. Those are numbers, obviously, that are approximations. But the idea is beta of 1 means the market goes up, you go up. The market goes down, you go down. And the idea was that was your exposure. That was what was explaining the returns of your stocks.

Research was done and found that market beta is actually not the best way to explain returns out there. And that’s where there was whole academic researchers saying there are other exposures. Beta is a term that comes from the regression of, within that, what’s is your exposure to a certain factor. And that’s where smart beta came through. Dumb beta was old market beta. Smart beta is value. It is size. It is momentum — these other ones that are out there. And that’s where the term smart beta comes from — the idea that there could be systematic, factor-investing styles that will give you more exposure and better ways to position your portfolio.

From out of view, what we’ve seen from the industry is the smart beta solutions that are out there fundamentally have a certain investment solution, which is they are giving broad exposure to the marketplace and then applying some small tilts the it. The idea would be either through a factor, a weighting of, like, revenue or earnings, which is highly correlated with market cap weighting. It’s just a modest difference where earnings weighted versus market-cap weighting has a correlation of like .82. So it’s highly correlated when the overall weights come out.

Smart beta, there’s other people that do approaches where they say, I’m just going to buy the market, and I’m going to trim the tails and say that I’m just going to, if I have my conviction on what I know for value signals, I will sell 10% of my portfolio, as in sell from a market weight and go down to zero weight, and I’ll double down on the top 10%. But 80% of my overall portfolio will wind up being market essentially, will be the overall passive market, which is similar to what you get from a [inaudible], like five basis points out there. But I’m going to add a little bit of edge based on those tails.

Our approach is one we call factor alpha. And factor alpha is the idea that we’re looking to generate excess returns, which means we offer a portfolio that is more concentrated, more focused on those names, and have the absolute best characteristics out there, because our belief is that if you have information that says that this group of stocks is going to have the potential to outperform by 4%, and this group has the potential to underperform by 4%, and the rest of the stocks out there you don’t have a lot of conviction on, the smart beta approach is sell the 10%, buy up 10%, and take the 80% at the market weight.

And our opinion is if I have a group of stocks that I think is going to outperform 4%, why wouldn’t I put all my money in that? And that, for us, is that theory of where we have a very differentiated approach on… We think we have a differentiated approach on several steps. One is identifying the characteristics, but the most tangible, obvious way is that we build small, concentrated portfolios for a select group of clients through our boutique business.

Jay:  That’s very interesting. You guys cater to both institutional and private high-net worth type individuals. Is that right?

Chris:  Yes, we do.

Jay:  This is interesting to me as well, when you think about quantitative trading, you think, “Oh, that’s only for the big players, the big institutions. How can a regular guy like me” — high-net worth guy maybe — “How could I have exposure to that? The cost associated must be…” These are all preconceived notions that you have when it comes to this sort of thing. So for, say, an individual guy, maybe a high-net worth client, they come to O’shaughnessy Asset Management, and they say, “Look, I want to allocate some of my pension or retirement money into some of these strategies, say a factor alpha.” Or maybe not a factor alpha. They come to you. What’s the process? Do you guys walk them through just a tailored approach? Or is it “Here is what we offer. Here are our offerings. We can put you into these allocations and you’re off to the races”?

Chris:  We have a series of ways that we can deliver our ideas to clients. We do offer separately managed accounts for institutions and high-net worth, typically through financial advisors or registered investment advisors. And it’s one where our strategies are ones that we believe, we have high conviction in. So we’ll have one like our large-cap value strategy, which is named market leaders value. It’s a strategy that essentially goes through looking at the large stocks universe, which is market cap about 7.5 billion and higher, and going through leaves you with about 500 companies to look from.

We eliminate the worst of the companies based on those themes that we talked about, saying these are stocks that are essentially over levered. They look like they might be boosting their earnings. They’ve seen a drop in their earnings over the last 12 months. Or they’re overpriced and haven’t been penalized in the marketplace. Those get just ripped out of the portfolios. We don’t want to focus on those.

We focus on that shareholder yield metric, that total return of capital within the large stocks universe where these are healthy companies that are saying, “We have reinvested in our business. We have excess capital, and our best thing that we can do is repurchase our stock because it is so attractively valued right now.” And that’s where it will come through in a portfolio that we rebalanced on a frequent, monthly basis, looking for the opportunity. So more responsive than, say, a passive index, which might rebalance twice a year or once a year and look to get into these characteristics and take advantage of moving into the market as the characteristics shift.

So we have separately managed accounts. We also have mutual funds for clients out there. That Market Leaders Value strategies available through (ticker) OFVIX. This is one where there’s a smaller minimum attached to that.

We don’t have an ETF that’s out there. We were talking about that internally and debating about it. There are some benefits to the structure. But overall, we believe in our strategies, and we think we have plenty of avenues for people to come and invest with us.

Jay:  One of the investor, in general, biases, obviously, is home country bias. And I think that a lot of… That’s something that… I’m American, and it’s not just something specific to the States. People here in Hong Kong, they just like to trade their Hong Kong shares and China. They don’t like to look outside of their comfort zone.

But having said that, obviously the US equity markets in particular are extremely overvalued by a number of metrics — almost every metric that you look out there. So there’s this need to relieve some of this pressure. A lot of people are saying that we’re looking very top-ish now. People are wondering what to do, potentially looking to rotate some of their money out, take some chips off the table, and look at some other markets, such as Asia.

I know that you guys have a couple of international products. Do you guys look at Asia specifically or do you just kind of encompass it in some of your international strategies?

Chris:  We have international strategies where we look in total. It’s essentially looking at EAFE markets. We have one global that’s looking comprehensively at the whole world.

The EAFE markets, obviously it’s Asia, Japan, Australia, as well as developed Europe. We have one international ADR strategy. So for US investors, or even other investors who have difficulty getting to local markets — so international investing — there are challenges that could possibly lead to that home bias. So for a US investor to go and get access to buy local shares in Asia, there has to be some custodial relationships. All these other issues that come through. So ADRs do offer a way for individuals to get access between the US market across a number of geographies. And that’s a strategy for us, again, that uses those themes that we’ve talked about. It just applies it solely to the ADR market.

We do have, for institutional clients, essentially, an international strategy that is focused on developed. And that is one that essentially goes to the ordinary markets and works within each of those.

So we have multiple ways for clients both of the retail and on institutional side to access us through international.

Jay:  Do you find that there are challenges when you are determining the factors for international markets? Just from the top of my head, I can tell you from first-hand experience that many of the Asian companies do not trade on fundamentals. So it’s been extremely challenging for us with what I do. But that obviously filters down into the factor level when you’re incorporating that into your strategies.

Does it take a dedicated team to build that sort of model out?

Chris:  Our team is general structure. We have everybody working on…nobody dedicated to international versus domestic. But for us, we’ve definitely dug in and understood some of the intricacies of international investing.

You’re looking at different accounting standards for different ways to represent — Japanese gap, local standards, IRFS, and one of the challenges is for us, because we are building a systematized process, is taking a look and saying, how do I build a process that’s going to look across all these different standards and all these different geographies and make sure that I’m getting the same concept, that I’m not creating a bias towards one market or another based on something as simple as how R&D expenses are essentially calculated within the income statement or balance sheet.

There’s also the challenges of FX. FX will move around. There’s a lot of questions on looking the impact of FX, particularly if you think about something like momentum investing where the price basically goes up if you’re looking at it in USD, and it’s one where you’ll capture in the effects of what’s happening with, say, the Hong Kong dollar. But if you’re looking at it only within the local market, you can see how the currency can have a huge effect on exporters versus importers.

So there’s ways that you have to go through and adjust for these items. But this is the part about quantitative investing, which is that we look at the data. We test all of these ideas out. And there are different markets that have different challenges, but the themes we have talked about, the really interesting part about it, is that if you’re looking at that, you can identify concepts that have worked across all markets based on these mis-pricings from people or, as some would say, a risk that is inside the market that you can capture and generate excess returns.

Jay:  Right. Let’s take value investing for an example. The whole premise of it is finding intrinsic value of a company and then figuring out, maybe adding in a margin of safety, then figuring out where your entry point is and then taking advantage of market dislocation. But that’s all based off of your own conviction level that you have to build based on your analysis and you’re shifting through data. And you have to bear that yourself. So when the market corrects or draws down and there’s a huge dislocation, at the end of the day, you’re still battling against yourself because you’re second guessing. Are my numbers correct? What’s going on here?

So I feel like that battle is probably still there, but I would feel a lot better if I had 30 years of back-tested data behind it or whatever. You know what I mean?

Chris:  I’m not as young as I used to be, but it’s comforting to have 85 years of data where you can look back at ideas across different geographies and different parts. But you have it exactly right.

You asked at the beginning of quantitative investing and the struggle of investors, essentially. My response was around the discipline of it. I said how O’shaughnessy, one of the key aspect is obviously factor alpha, building those concentrated portfolios that give you a better chance to outperform. But it’s also about never ever leaving your strategy. The idea is that if you’re going to be value investor, you keep to your strategy. This is the research originally done by Jim O’shaughnessy, in his Invest like the Best book where he said he thought originally the best managers are going to be people that see trends and they move back and forth between different styles. What he found was that the best managers out there are the ones that build a discipline, and they keep to it.

Now that discipline though has to also be borne by the investors. They have to have it where they can continue to hire the manager, even if there’s a short-term period of underperformance one even a moderate period of underperformance.

What’s interesting about ETFs and factors is going ETF market, what people are doing is they’re tending to use them a bit more tactically. They’re trying to jump in and out of trades. And that lower barrier, that lower cost of switching, is perhaps reducing any sort of structural barrier on cost that people would have of going back and forth between these.

And what you can see is things like low-vol investing last year, which had taken in enormous amounts of assets, because low-volatility, as an asset class, just to talk a little bit about it as a strategy — low-volatility historically has not generated excess returns, more than a modest amount, maybe 50 basis points, a hundred basis points, buying the absolute best names out there through our approach. So it’s not something like yield or value, which we have generated 400 basis points of excess return off of.

What it does do is offer you lower volatility. It’s a defensive equity category. So if you’re thinking about bonds versus equities but you think that you want to have something kind of in the middle where it’s more of a defensive equity, low-vol is a good situation for you.

But after two years of outperformance where low-vol happened to have a good run, where it outperformed 500 basis points a year, the flows into low-vol were enormous, and that’s because people look at a short two-year period, and they said, this looks really attractive to me, because I can get outperformance, and I can get lower-volatilities with it. So the assets flew into the ETFs very, very strongly.

Third quarter, low-volatility underperformed. The assets then after the underperformance flowed out. Value picked up in the fourth quarter. Assets flowed into it.

And what’s happening is people are chasing performance through ETFs. And my part of this is for factor investors anywhere — for any investors anywhere, which is build a discipline allocation to your investment managers and your investment styles as well as your factors, and give them time to play out over longer market cycles of five years plus. And that, for me, is about having the discipline on the investor’s side, that we have because we’ve done the research on the factors, and we believe in them. But then we need to have that to basically keep with your manager through thick and thin.

Jay:  Yeah. That’s absolutely right. I feel like the institutional investors that invest in Asia are even more finicky. They’ll come and in out and fire you and hire you within 18 months. Oh, Asia’s hot again. And so all of a sudden, you’ll see all of the fund flows coming back in. And these are the guys that fired you 18 months ago because everyone was spooked or because the renminbi devalued or something like that.

But I absolutely agree with what you said about discipline. I think on every level, even at the highest levels, you see guys that are very, very successful fund managers, like a David Einhorn, for example. Brilliant manager. Huge, long track record. And then he started doing some stuff outside of his regular process. I’m sure he’s going to be fine in the long run, but as you said, if you don’t have to discipline, even 20 years, 30 years track record in, you veer off the path, and that’s what’s going to happen.

Chris:  What’s interesting is that same SNP index versus active report that I said where 82% of managers underperform, they used to have in there a style consistency across managers, and over a ten year basis, basically, the style consistency is about half. So they have said how much managers have switched around within their own process. Value versus growth etc. And you hear this all the time.

I was loving it where Bloomberg radio, you hear basically some manager talking about their process. They’re a devalue investor, and they demand dividend yield out of it. This was like five years ago. And they started talking about “Well, I guess you don’t own Apple.”

They were like “No, no, I love Apple. They’re going to eventually pay a dividend, so I’m going to put it in there.” Or Amazon getting into the portfolio. They’re saying “Just believe in the company.” Right? And there’s times where people will bend their process.

Income managers, when they’re searching for yield, sometimes they’ll take 10 to 15% of their portfolio and put it in high-dividend paying stocks. These things happen within this industry, so you’ve got to understand what’s inside of the portfolios that you’re looking at.

Jay:  Absolutely. Chris, thank you so much for the time and for sharing your insights. It was actually very educational for myself, and I’m sure for a vast majority of the audience. Are there any exciting things that you guys are working on right now — either personally or at O’shaughnessy — that you would like to share with the audience?

Chris:  We’re always continuing to look for ways to educate clients. We’re doing more thought leadership. I would say the commentaries that we’ve been putting out, we’ve been getting good reception on those. And this idea, as it used to be ten years ago, we would have to go around explaining what factor investing was. We still have to do some of that. Now it’s the whole marketplace basically saying that they’ve embraced this idea. There’s multiple ideas out there.

The part for us is trying to educate clients on the benefits of our approach, the factor alpha approach of having concentrated portfolios, looking at characteristics versus the broader way of basically implementing where it’s a more risk controlled focus versus ours that is a return focus portfolio.

And that, for us, is really what we’ve been spending a lot of time on, is trying to educate clients and prospects of it. Check our website and our commentary that’s out there.

Jay:  Yeah. You have some good literature out there. Last question is where can people find you, follow you, connect with you, and learn more about you yourself personally or O’shaughnessy?

Chris:  O’shaughnessy, OSAM.com. I have a personal blog out there. CuttingThroughNoise.com, just get a couple of insights. There’s some overlap between those two, but it’s got some more market ideas that I’m looking at besides just what’s going on with OSAM.

Jay:  Fantastic. Thanks again, Chris. We appreciate your time.

Chris:  Thanks, Jay.

Jay:  Alright.