Ep. 2005: The Habanero Portfolio

SPEAKER_02 0:42

It was just time. Don't you think it was time for a good mariachi band? Okay, not necessarily a good one. An AI-generated mariachi band? The trumpets are a little tinny, I thought. Just you know, a little critical. Why did I use a mariachi band for today's theme song? Well, it's because the article that we're uh that's that instigated this conversation came from Spencer Jacob at the Wall Street Journal, and it its title was Like Eating a Habanero.

Factor Investing: Reward, Risk, and Tracking Error

SPEAKER_02 1:13

Isn't it an abonero? But I don't know. Uh in other words, too much of a good thing can be good or can be bad for you. And we're talking about the whole concept of factor investing, where you go for uh you you you overweight small companies, you overweight value companies, you overweight profitable companies. And how is it good for you? Why is it good for you? And is too much of it bad for you, Tom?

SPEAKER_03 1:42

Yeah, I think you first got to answer a question is when you say overweight, what does that mean?

SPEAKER_02 1:48

It means own more of those factors, those types of stocks than the overall index holds.

SPEAKER_03 1:56

So if you just bought the index, you would be very much small.

SPEAKER_02 2:01

You wouldn't have a lot of small, you wouldn't have a lot of value.

SPEAKER_03 2:03

Yeah, and you wouldn't have a lot of highly profitable small and value companies.

SPEAKER_02 2:08

You wouldn't be able to have more as a percentage of your, you know, of the portfolio that normally exists. Yeah.

SPEAKER_03 2:15

And the reason that you would want to do it that way, more small, more value, more profitable companies, is the academic work is going to say those are provided provided a greater return, correct?

SPEAKER_02 2:29

Yeah, they've provided actually a sub since uh according to the to Wes Krill, who works for dimensional funds, he's a uh big shot over at dimensional funds. He said if you combined small value and profitability, you just own those segments of the market from 1963 till now, your average annual return would have been 17% per year.

SPEAKER_03 2:54

Yeah, it's quite a bit more than the market that would have still been pretty good at 10.9%. Yeah, but it's it's 70% more. Why don't we all do that? It's uh $10,000 in 1963, which is a long time ago, by the way. That's the year I believe John Kennedy was assassinated. $10,000 into this strategy would be a whopping $208 million today, $208 million today. Now, if I could just go back to the U.S.

SPEAKER_02 3:27

Something else to blame my parents for, not giving me $10,000 to put in the market.

SPEAKER_03 3:33

This is a fascinating topic because as you know, we are believers in index funds. But kind of.

SPEAKER_02 3:40

Yeah.

SPEAKER_03 3:41

Yeah. This is this this is the argument, right? Should I use factor-based or what a uh transparently active, that's what David Booth called it.

SPEAKER_02 3:52

Use that name, David. Which which transparently active.

SPEAKER_03 3:54

Okay, I'm gonna say this. This is politically incorrect, but he said it. I didn't say it.

SPEAKER_02 3:58

I know.

SPEAKER_03 3:59

He said somebody asked him about dimensional. He said, dimensional is like a religion, except it's supported by facts. Uh David said that. I didn't say that.

SPEAKER_02 4:09

So that's so send your cards and letters to David Booth, care of Dimensional Funds. Great line, Austin, Texas.

SPEAKER_03 4:16

Yeah, because they both they're so fervent in what they believe. They say they they think they can back it up with numbers, but the the reality is, and we'll talk about this in a minute, not only do you face a thing called tracking error, but you also face periods if you just invest in this, you know, small small value, high profitability, yes. Those things there will be periods of time where you will lose buckets of money and you will say, There's no way I'm sticking with that strategy. No absolute way, right?

SPEAKER_02 4:46

Or as as Les Krill uh invoked Jack Nicholson, he said, You can't handle the tracking error.

SPEAKER_03 4:54

Which goes back to a very famous Nicholson movie. They quote a couple of a couple of numbers here that I don't think to earn that, as he points out, extra 6.3% a year. The portfolio, he says, trailed by as much as 39% over a 12-month period and a gut-wrenching 72.5% over 36 months. Wow.

SPEAKER_02 5:18

Okay, so so that means you put that 10,000 in in 63 when you were a small child, and you watched it grow to say a million or two, and let's say it's a million, and you got to watch it drop to three less than $300,000.

SPEAKER_03 5:35

Yeah, and while everyone else was making money, because that is, I believe what he's comparing it to is that portfolio versus a general like SP type, or you know, I guess probably he doesn't specifically say, but it wouldn't even be total market. Um the point of the matter is, and he points this out, that if you could just make that, you said young, uh, make that investment in 1963 and then not pay any attention to it, which very few people can do. They gotta look at it, they gotta touch it, they gotta say, this is never coming back, uh, or I need the money. Um, you would have made a lot more money, but it's uncomfortable. That's his word. Uh it and again, this and the habanero, I think, is a good example of how and why. But there's the reality. We have told you repeatedly, and you can go buy small in value right now. A V U V, very fine fund. Convention law is a very fine.

SPEAKER_02 6:32

Yeah, you're you're but you're that's your focused fund. That's the one where you're really getting deep in the weeds.

SPEAKER_03 6:39

Yep. We wouldn't say just own that. No, too nearly.

SPEAKER_02 6:44

No, because that's where that 72% might have come into play uh just by owning

Why Diversification Beats Concentrating in Factors

SPEAKER_02 6:50

an AVUV. That's why we are huge advocates of the keep it simple, stupid strategy, which is own the whole market, but tilt a little to the good stuff or the stuff that's been good a little. But why has it been better? Why have small stocks and value stocks, particularly, those two particularly, uh so dramatically outperformed over incredibly long periods of time? It's a the amp the answer is incredibly simple. They are more risky.

SPEAKER_03 7:27

That's it. Yeah. You have to say it at a little bit. You don't want to believe it.

SPEAKER_02 7:31

And it makes the the ride a lot more comfortable if it's just a little.

SPEAKER_03 7:37

Yeah, and this is just discussing the returns. What is this he mentions tracking air? The fact is, when other everybody else is making money and the market's making money, and you're not, that's really hard to stick with it. I've seen this in one of the facts.

SPEAKER_02 7:55

Actually, we've seen the most the most powerful example of it over the past couple of decades. Yeah. Where we had a period where I, you know, you argued with us. Why would I want to own those value in those small cap stocks or in those international stocks when the U.S. large cap market is doing so well? Why don't I just buy the SP 500? Well, yeah, that worked out for you really, really well. But what happens when those larger company growth stocks slide and the value in small cap, which they've done in the past, rise when the big ones are falling? You're gonna miss that offsetting change in price that can smooth while improving your potential returns, can also at the same time smooth the interim ride. That's so important.

SPEAKER_03 8:51

It indeed it is. So, again, better idea, I think, in the long haul to be more diversified than just this strategy. But here's another thing to

Should DIY Investors Tilt Toward Profitability?

SPEAKER_03 8:59

consider. You mentioned it's okay to tilt to small and to value. You did not mention profitability. I truly believe for most do-it-yourselfers, and you're out there in that audience, some of you, I know this because I talked to you. I'm not sure that profitability is a good factor for you to own as a do-it-yourselfer.

SPEAKER_02 9:19

Because it's hard to own.

SPEAKER_03 9:21

It's hard, and it's really counterintuitive. We've had a great run recently, but there were periods of time, a long time, where it made far less than the market. Really hard to stick with.

SPEAKER_02 9:33

Yeah, and profitability is one of those things. Value is really, really, really easy to assign based on some very simple price-to-book kind of numbers. Uh small is easy because you're just looking at market capitalization. Profitability can change from you know month to month, day to day. Uh, a company can be wildly profitable, and then it's really that's a hard number to track. That's one I would always leave to the experts, and that's why I would let dimensional or Avantis add that profitability component to the portfolio and not try to do it on your own.

SPEAKER_03 10:11

That sounds like a pitch, but it's not. Okay, but here's the other thing about that. It's somewhat easy to understand the aspect of smaller companies have made more because they're riskier, value companies have made more because the market doesn't put the same value on them that the accountants do. That then you can kind of understand those things. But when you really deep dive more into the profitability part and the comparison to capital that it holds, because it's not just more profitable, it's profitable compared to the assets it has. It's so it's more complicated than that.

SPEAKER_02 10:42

I think although it does sound like a duh factor. Oh, a company that's more profitable makes more money.

SPEAKER_03 10:48

But managing it, I think, is harder than small into value, no question. And by the way, here's another thing to consider. All of this may be you may look at this after we're long gone from the air and long gone from the earth, and find out that simplicity was fine. It was better, right? Just owning the globe was okay. It really was.

SPEAKER_02 11:08

Just because these factors have shown a tendency to outperform over the last hundred years doesn't mean they're going to do it over the next hundred, which is another reason for greater diversification. Don't focus on any one or two or even three areas of the market. Just own the whole darn thing. And then if you want to push the envelope a little bit, if you want to potentially reduce the volatility a bit, then you add these academically not proven, but uh vetted. Vetted. Yeah, it's a good word. Vetted factors to the portfolio.

SPEAKER_03 11:47

Yeah. It's it's it's worth doing. But I personally, again, small value, okay, profitability. I'd probably leave that to the pros.

SPEAKER_02 11:57

Well, and that's why one of the because it isn't that easy. Uh that's one of the reasons why dimensional funds has grown as large as they have over the the decades they've been around. And that's why Avantis started from Dimensional. It's an offshoot, basically. It's somebody who said, this is a great idea, but we think we can do it slightly better, which is the way capitalism works. Hey, good for

Listener Mail: A 457(b) Fund Holding 45% Cash

SPEAKER_02 12:19

it. Uh we want to help you in ways that are particular to you, though, in addition to these broader topics. And that's why in every episode we try to answer a couple of questions two, three, five, six, seven. Uh on these regular shows, we we answer questions that you send in to us by typing them at talkingrealmoney.com on the ask a question form. Then Tom, being the old-fashioned guy he is, likes to uh likes to carve them out in stone and read them off a tablet. Bringing it down. At least you're using the more modern version of a tablet known as paper.

SPEAKER_03 12:57

That's good. Uh Sushiel writes us from Sycamore, Illinois, and I apologize if I got your name wrong. So if your name is you know hard to under hard to read, give me a pronouncer. I'll do better. Uh, hello, Tom and Don. My contribution toward my 457B retirement plan in Illinois, and that sounds like it's for a public type organization, right? 457B.

SPEAKER_02 13:22

A 457 plan is a public plan. Yes.

SPEAKER_03 13:25

Yeah. In Illinois, through Voya, which we don't favor, but okay, that's where it is, and that's where you are, is 50% U.S. I'm assuming that means U.S. stocks, and 50% non-U.S. asset allocation. For the U for pardon me, for the non-U.S. portion, I currently have 40% going to the SURS, that's S U R S, which stands for Oh, uh State uh State University Retirement System. Okay. Uh non-U.S. equity index fund. And 10% towards the SURS non-U.S. value equity fund. I noticed on the fact sheet that the SURS non-U.S. value equity fund is composed of 45% cash.

SPEAKER_02 14:15

I was shocked when I heard that. I have never in my life looked at this fund. Uh it is used by the state universities as part of their portfolios. And uh it's man, it's it's absolutely 45% in cash. Yeah, it really is. As of June 30th, 2026, according to their quarterly reports, yeah. They have 45.4% in cash.

SPEAKER_03 14:52

Is the University of Chicago still in Illinois?

SPEAKER_02 14:56

Last I checked, I don't think he's succeeded.

SPEAKER_03 14:58

Is Gene Fama still involved with the University of Chicago?

SPEAKER_02 15:01

I think only as an emeritus in a in an emeritus capacity.

SPEAKER_03 15:04

So they don't have to listen to him anymore?

SPEAKER_02 15:06

Right, exactly.

SPEAKER_03 15:08

Because he would not like this. I'm just putting it out there.

SPEAKER_02 15:12

And what's really interesting is that SERS does not offer, from what I can tell. Well, no, actually, they do. Never mind. SERS does have a non- They have a non-U.S. equity index fund. That's what you need to be in.

SPEAKER_03 15:30

But no, this one's value, non-U.S. value equity. I know.

SPEAKER_02 15:33

You don't want to be in the value fund. You want to get out of that. It's actively managed.

SPEAKER_03 15:37

Yeah, he's not a good idea.

SPEAKER_02 15:38

The index is not going to give you a value tilt, but it is going to be invested. Well, yeah. Although I have to say, the performance of the SURS equity uh non-U.S. equity value fund has been pretty good. Um I'm not sure why. I don't know why it's done well. Uh but it's also the index fund is also substantially cheaper. It's about a quarter of a percentage point cheaper than the the actively managed product. Uh I I really this the I've never looked at these before. So I did a cursory look and they're wacky.

SPEAKER_03 16:20

I I mean they're they're really I don't understand why a university system has to have its own proprietary fund. Why can't they just use a gazillion other things?

SPEAKER_02 16:32

Oh you know why. They want to keep the money.

SPEAKER_03 16:35

I get it.

SPEAKER_02 16:35

No, because they think their people are smarter than those other people. Okay. They think it at Columbia Thread Needle, which, by the way, thread needle? Really? Come on. Sounds like you're making a quilt. Um it's which is, by the way, guess who owns Columbia Thread Needle? Did you know this? I did not know this. Ameraprize.

SPEAKER_03 16:57

Oh, good lord. Yeah. Okay. Well, talk about a patchwork organization. Okay, so um, sorry, I'd be here all week. Here's the thing, Sushil. I'm with Don. Uh, let's keep it simple and let's keep it low cost and let's keep it invested. Because maybe the return's been great for whatever reason, I don't understand, but I wouldn't invest in anything where half the money's in cash. There's just no way. That makes no sense to me whatsoever.

SPEAKER_02 17:22

And according to their own information, they are 45 or were 45% in cash. That's just to me, that's just crazy talk. It's weird. It's weird. Yeah, and I can't even pull up the portfolio. I'm trying to find the actual portfolio.

SPEAKER_03 17:38

It's proprietary, it's probably in the basement of some university system.

SPEAKER_02 17:42

You know, I honestly cannot find the portfolio.

SPEAKER_03 17:45

Hmm.

SPEAKER_02 17:46

Crazy.

SPEAKER_03 17:47

Uh let's go to another. Alexandria, Virginia. Uh Karen. I thought we were going to Egypt. I know. I was trying to hold on to that little suspense there for you. I've been a devoted listener for about two years.

SPEAKER_02 17:59

Not devoted enough since we've been here a lot longer than that.

SPEAKER_03 18:02

Did you get a medal or something for that? I don't know. Two years. No, thank you. Be nice. Okay. I appreciate your banter, Tom's jokes, and now Don's music. So I should be nicer to Karen because she's not that type of Karen. On September 28th, there was a question on. I wonder how real Karen's feel about Karen.

SPEAKER_02 18:20

I don't think they feel good about it. They can't feel good about it.

SPEAKER_03 18:24

I apologize on behalf of the rest of us,

Converting a Bond Mutual Fund to an ETF

SPEAKER_03 18:26

Karen. I'm sorry. On September 28th, there was a question on converting Vanguard mutual funds to exchange traded funds. And Don said in a taxable account, it makes sense to convert the funds to ETFs and provided reasons. I received a notification from Fidelity they're allowing conversion of a bond fund I own, FSHBX, to FSTB, the Fidelity Short-Term Mutual Fidelity Short Term Bond Fund, Mutual Fund to the newly created Exchange Traded Fund version. During conversion windows, my FSHBX mutual funds are in my IRA. So my question is should I go ahead and have these funds converted ETFs or not bother since they're in a retirement account? I'm 71, so in two years I'll need to start taking RMDs, important consideration. That really shouldn't matter. Thank you both much. And I do appreciate you making this all more understandable.

SPEAKER_02 19:20

Okay.

SPEAKER_03 19:20

Um yeah.

SPEAKER_02 19:21

There are a few things. The advantages are less large. The biggest one I I share with you about equity portfolios is the fact that capital uh non-realized capital gains, well, they don't realize capital gains. So you generally they don't realize them, so you get that tax deferral on capital gains. There are far fewer capital gains in a bond fund. So that argument is gone. However, ETFs do tend to have a lower expense ratio. Check that. If your expense ratio is lower, that's good. Also, ETFs are easier to move between accounts. If you ever decided someday I want to go from Fidelity to Schwab or Fidelity to Vanguard or whoever, ETFs can move along. Funds can't always. Funds sometimes, and plus buying or selling funds with another firm can can uh cause you to get hit with a surrender charge, which you won't with ETFs.

SPEAKER_03 20:18

Yeah, I don't see a whole lot of change here. No, not a big deal. Um and then as you said, in a taxable account, whole different situation, although fixed income not being a big deal now.

SPEAKER_02 20:29

Not as big a deal.

SPEAKER_03 20:30

So Karen, frankly, it's up to you.

SPEAKER_02 20:33

Oh, and the other advantage to the fund that I forgot about was the fact that there it's your purchases or your sales when you're selling it off occur at net asset value. There's no bid ask spread.

SPEAKER_03 20:45

That's can be pretty important, especially if you're starting the withdrawal phase.

SPEAKER_02 20:48

Yeah.

SPEAKER_03 20:49

Can be. Yeah. Again, maybe. So none of those are

Is Securities Lending Worth the Risk?

SPEAKER_03 20:53

big ones. All right. This comes from Anonymous in Flower Mound, Texas. You know Flower Mound? Yeah, it's in the Dallas-Fort Worth area. Oh, okay. Uh recently I received a mailing from Schwab regarding subject program. The way I understand it is they pay you a fee for loaning them stock you own. The stock is backed backstop by cash collateral, and I keep earning the dividends. I will have access to my shares at any time at existing market price. Is this a safe way to earn extra income? I have a thousand shares of a company in Naira that would qualify for this program.

SPEAKER_02 21:28

Well, that's called hypothecating your shares.

SPEAKER_03 21:31

And only can be used if you can spell it.

SPEAKER_02 21:35

Hypothecate uh H Y O T H that's pretty good. Uh I C A T uh Yeah, something like that.

SPEAKER_03 21:45

I used to be a good speller too.

SPEAKER_02 21:47

So anyway. Um It's called hypothecating stock. It is giving your broker the right to lend your stock to short sellers. Uh you're pledging your shares as collateral for a Margin loan or securities back line of credit. And the downside is um technically there you lose some control. They say you don't, but you know, there really hasn't been. Because you own you you still own the shares. I see. Okay. You're just using them as collateral. You're not you're not actually getting the shares. You're just using the company.

SPEAKER_03 22:28

I don't know how big that would be with a thousand shares of a company. There are huge fund managers that do this and make a pretty decent living off it. I think Dimensional loans out a bunch of their stuff and they make a pretty a decent amount when they loan it to short sellers.

SPEAKER_02 22:42

But um Oh, yeah, they do a lot of that, actually. They do a lot of it. They you know it's a nice way to make a little money.

SPEAKER_03 22:48

Yeah, I don't know that a thousand shares is going to be dramatic in terms of the amount of money you could make. But I guess if it's no trouble.

SPEAKER_02 23:01

How much? Uh huh. I'm looking at high.

SPEAKER_03 23:09

Because I've got some shares of Washington Mutual.

SPEAKER_02 23:12

Oh, yeah, those are a lot.

SPEAKER_03 23:14

I could lend that out, no problem. Yes, I think. And I have a share of endless.

SPEAKER_02 23:18

You're not hypothecating your own loan. You're allowing someone else to use it for hypothecation. Exactly. Oh, you aren't borrowing. Let's see. So um let's see. Oh, here it is. Schwab divides the lending revenue 50-50, which may not be bad. I mean, what are they were they're getting like 6%, I think?

SPEAKER_03 23:40

Nah, that was the question. How what's the rate? So 3%? Yeah, sure, why not, right?

SPEAKER_02 23:45

3% could be a couple of bucks.

SPEAKER_03 23:48

I don't know how that's taxed either, by the way, but it's taxed as regular income. Okay. So it's gonna be lumping on. So if you made some great calculations about it.

SPEAKER_02 23:59

Yeah, you don't make anything unless they lend the shares out. So let's say your thousand shares, thousand shares, worth $100 a share.

SPEAKER_03 24:07

Okay.

SPEAKER_02 24:07

You're gonna get about $3,000 a year.

unknown 24:11

Yeah.

SPEAKER_02 24:11

If they're continuously lent out during that year.

SPEAKER_03 24:14

$3,000, $3,000. Yeah.

SPEAKER_02 24:16

It's like a dividend.

SPEAKER_03 24:17

Sure.

SPEAKER_02 24:18

And you still get the dividend.

SPEAKER_03 24:20

So I guess it's it's a issue with it.

SPEAKER_02 24:24

Yeah, because Schwab. You know, if doing it with Schwab, I again, it's the stress testing that worries me. What happens when the whole thing falls apart and everybody's scrambling to cover all of these short sales and Schwab uh is is having trouble. They they they have what they they claim they're gonna have collateral of 102% of the value. Um but you know it only works as long as it works. And if it doesn't work, then you find out after the fact. I can't know under what scenario it might collapse. Just like AIG didn't know that they were going to need to be bailed out by the government, or uh Bear Stearns didn't know they were gonna fail. They thought they were pretty secure, until they weren't. Uh Washington Mutual.

SPEAKER_03 25:14

Thought they were a friend of the family. Come on, man.

SPEAKER_02 25:18

And and again, Schwab is big. Schwab is trustworthy, but could something happen? Yeah. Could? Will it? I don't think so, but could? You always have to say, yeah, it could. Even the government, we talk about that wild, far-fetched scenario in which the U.S. government fails. Is it likely? No. Could it happen? Yeah. Particularly if we start building bridges like they do in England for $300 billion.

SPEAKER_03 25:48

More than the Titanic, more than the Space Needle, more than the More than Disneyland. Eiffel Tower, Disneyland. Yeah, okay. Now you're really getting it.

SPEAKER_02 25:56

No, seriously, they built a 60-foot-long railroad bridge over a road in Oxford, England. Yeah. They built a 60, six zero feet, folks. Thirty sixty feet. 20 yards. That's as big as this bridge is, and it's big enough to put trains on top of. That's it. And it costs almost a third of a not a billion. A third of a trillion dollars for one bridge.

SPEAKER_03 26:27

It was expected that it was going to take, I think they said four to six weeks and ended up taking 41 months.

SPEAKER_02 26:34

Yeah.

SPEAKER_03 26:36

It doesn't show them well. Let's put it that way.

SPEAKER_02 26:38

That's a $300 billion bridge. Walt built Disneyland for less money adjusted for inflation in 1955.

SPEAKER_03 26:48

These are all adjusted for inflation, yeah. Titanic. I mean, they can't. By the way, I don't know, holding out to Titanic is a great example because let's just say it didn't turn out well. Let's just put it that way. You can blame the ships, you can blame the captain, but you thought you got a good ship for that. As you just said previously, everything looks good until it doesn't. Until it doesn't. Wait a minute. This is going down? Yeah. This ship is made of steel, and that's the water, and you're going under. So yeah, not good.

SPEAKER_02 27:13

Your space needle costs less there in Seattle.

SPEAKER_03 27:18

And by the way, I'm proud to say it's never sunk and it's still standing.

SPEAKER_02 27:21

So Yeah. You haven't had the big one yet, though.

SPEAKER_03 27:24

Oh god. You know, that's a good question. But we had what seven and two one or something.

SPEAKER_02 27:31

The big one is like an eight.

SPEAKER_03 27:33

Yeah, that's well, I'm glad I live, you know, 20 miles from it. So if it's a big one.

SPEAKER_02 27:37

Oh, yeah, right next to the bathtub. You get an eight, that bathtub's sloshing right up into the house.

SPEAKER_03 27:45

I'll be washed

Listener Questions, Show Sign-Off, and Disclosures

SPEAKER_03 27:46

quickly. Yeah.

SPEAKER_02 27:47

Yeah. All right. I don't know why we got off on that tangent, but we did. That's the way it works here on Talking Real Money. We go tangential all the time. And uh we try to answer your questions. We try to help you out where we can. We try to make your financial life a whole lot easier if we are able. And you can help us do that by one, asking your questions. By two, asking us for help. Just go to talkingrealmoney.com and click on meet an advisor. Three, on the podcast service you're currently listening to us on listening there. There's a button that says follow. You see it? Click that. There you go. That was all it took. Wasn't that? Did you follow? Yeah. You followed? Did you follow?

SPEAKER_03 28:30

Yeah. Uh huh. Got it.

SPEAKER_02 28:32

And um now we have to bid you a fond farewell, or as they say, in Mexico, adios muchachos. We are talking real money.

SPEAKER_00 28:49

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