Investment Research Retreat



The Research Affiliates annual Investment Research Retreat (formerly Advisory Panel conference) brings together researchers to delve into economic and investment issues relevant to investors. The forum is intended to stimulate broad insights and lively debate. We highlight here summaries of the most recent Retreats.


"Research has found a statistically significant relationship between ethnically and gender diverse leadership teams and better financial performance." 

—Alex Edmans, London Business School

Does ESG Investing Make Sense?

Confirmation bias—accepting “evidence” if it corroborates what we would like to be true—is often a concern in ESG investing. Most of us would love to live in a world in which ESG investing pays off, in which investing in ethical companies leads to positive long-term returns. Alex Edmans examines the evidence currently available on ESG investing outcomes. He concludes that certain ESG strategies do outperform when they invest in companies with strong shareholder rights, proper CEO incentives, high employee and customer satisfaction, positive eco-efficiency, and reliable performance on material issues important in the respective industry. The key is that investors must focus on the right dimensions of ESG when analyzing a strategy and be discerning about the data they use in their analysis. Ultimately, the challenges in ESG implementation can increase the value of good ESG strategies.

"Investors collectively place a positive value on sustainability." 

—Samuel Hartzmark, University of Chicago


Do Investors Value Sustainability? Natural Experiment Examining Ranking and Fund Flow

In March 2016, Morningstar began publishing a sustainability rating, from one globe to five, as a measure of how well each of the 20,000 US-domiciled rated funds is meeting ESG challenges. Samuel Hartmark demonstrates that investors place a positive value on sustainability. For the 11 months post rating, funds having low sustainability scores experienced net outflows of more than $12 billion, and funds having high sustainability scores experienced net inflows of more than $24 billion. The experimental evidence suggests that sustainability is viewed by investors as positively predicting future performance, but does not confirm that this is the case—that is, the evidence does not show that high sustainability funds outperform low sustainability funds. These findings are consistent with prior research and indicate that positive affect influences expectations of sustainable fund performance and that nonpecuniary motives can impact investment decisions


"Size doesn’t matter. Small stocks have higher beta…because size is correlated with price." 

—Kelly Shue, Yale University

Can the Market Multiply and Divide? Nonproportional Thinking in Financial Markets

In financial markets, rational investors should react to news about firm value in terms of proportional price changes—that is, in percentage terms, or returns. More often than not, investors think about stock and market price changes in dollar terms, or as nonproportional price changes.  Holding firm size constant, the nominal price of a financial security has no real meaning and can be changed easily through splits or reverse splits. Kelly Shue’s research shows that nonproportional thinking in financial markets leads to return overreactions for low-priced stocks and return underreactions for high-priced stocks. The reaction is not driven by size; the size-volatility relation flattens by 80% after controlling for price. These findings offer a new explanation of over- and underreaction to news, complementing other behavioral explanations. Furthermore, the observation that small stocks have higher volatility and higher beta can be explained by price. 

"The positive [US stock] market we’re all familiar with is driven by relatively few stocks." 

—Hendrik Bessembinder, Arizona State Universityy



Do Stocks Outperform Treasury Bills? Evidence and Implications

Analyzing US stock returns from 1926 through 2016, Hendrik Bessembinder found strong positive skewness in the return distribution: a few large right-tail observations pull up the mean return to the point that it is not representative of typical stocks.  His findings challenge conventional wisdom that typical stocks enjoyed a positive long-term return over this period.  According to Bessembinder, “in the long run, a stock selected at random from the CRSP database loses money.”  In fact, four of seven stocks in the CRSP database underperformed US Treasury bills over their history.  He also examined "wealth creation" for investors, which he measured as ending wealth from holding a stock (while receiving dividends and net share repurchases), in excess of that earned by holding Treasury bills. Just 4% of stocks accounted for all of the $34 trillion in net wealth creation in the US stock market since 1926.  Extending his research to global stocks from November 1990 through December 2018, Bessembinder found that the top performing 1% of non-US stocks accounted for all the wealth creation in non-US markets over the last 28 years.


"We found [investment consultants’] recommendations have a significant impact on fund flows." 

—Tim Jenkinson, Oxford University

Virtual Reality? Investment Consultants’ Claims about Their Own Performance

Curiously, investment consultants have largely escaped the scrutiny of academic researchers even though they are widely recognized to be key gatekeepers to asset owners. New research by Tim Jenkinson, using data for three leading UK investment consultants with a combined market share of nearly 50%, seeks to determine if investment consultants have manager selection capabilities and if the claims made in their marketing materials are substantiated. No evidence was found that consultants have skill at manager selection. Jenkinson suggests several explanations for the difference in claims versus assessment, such as comparisons to benchmarks rather than to peer funds and the use of simulated and backfilled returns. The products recommended by investment consultants have similar risk and return characteristics as those they do not pick, but the recommended products deviate less from the benchmarks. A question central to his research remains largely unresolved: Do investment consultants, by raising false hopes of active management, impose significant costs on pensioners and other beneficiaries, as well their ultimate guarantor, the tax payer? 

"We cannot really deeply understand major economic events if we don’t figure out how people were thinking back then."

—Robert Shiller, Yale University


Narrative Economics and the History of Economic Crises

Applying the principle of consilience—that evidence from diverse fields of study can help us converge on strong conclusions—Robert Shiller shared his analysis of the importance of narratives, used in other disciplines as important explanatory tools, in driving past economic crises. The preference for or tendency toward narrative thinking has been documented in both the social and the medical sciences. With technology now allowing for the digitization of narrative data, a host of new research opportunities has opened for economists. Shiller explains that narratives are like viruses—spread by contagion—and notes the similarity of the epidemic curve modeled by epidemiologists with the growth and spread patterns of economic crises and their narratives. Future research could turn narrative economics into more of a science by using focus interviews and focus groups, digitizing unconventional texts such as sermons and diaries, and developing co-epidemic models of narratives and the economy.


"Factor investing is a good idea. It’s just wildly oversold and overhyped." 

—Rob Arnott, Research Affiliates

Alice’s Adventures in Factorland: Three Mistakes That Plague Factor Investing

As factor investing has failed to live up to its many promises, Rob Arnott explains that much of investors’ disappointment can be traced to three underappreciated pitfalls that were conveniently ignored by the proponents of blind adoption. First, many investors have exaggerated expectations about factor performance arising from often data-mined backtests and/or real-world implementation that can reduce expected returns. Second, some investors use naive risk management tools that do not account for factor returns experiencing outsized downside shocks, which happen far more often than many expect. Third, investors too frequently believe their factor portfolio is diversified. In certain economic conditions when factor returns become much more correlated, diversification can vanish. Arnott concluded: “Investors must answer the call to be more realistic, to curb return expectations, and to expect occasionally large drawdowns and only modest diversification benefits. Factor investing requires patience just like any active strategy."

"I’m very bullish on emerging markets in that technology has the ability to unleash a vast amount of human capital."

—Cam Harvey, Duke University


At the Nexus of Financial and Technological Innovation

Throughout history, most industries have experienced substantial disruption resulting from technological advancement. Today, the financial industry is being consumed by a very forecastable technology wave. In the wave’s wake will be winners and losers—and consequently, risks. Each of the four fintech spaces faces disruption as a result of rapid innovation: peer-to-peer (P2P) financing; robo-advising and systematic asset management; blockchain and smart contracting; and machine learning. P2P financing presents a substantial disruptive threat to the traditional banking function, including established securities exchanges. Contrary to the view of many, however, Cam Harvey believes technology is creating opportunities in asset management. For example, firms with advanced quantitative capabilities will likely squeeze out traditional discretionary advisors. As a result, medium-skilled workers in developed countries, who lack the appropriate training, will experience under- and unemployment, raising the specter of political risk. Winners will be those who until now have been underserved in education and in financial services—largely, the emerging markets. Alongside the positives of fintech advances, we need to manage the probable political risks. 



andrew lo ap

"We need new narratives in finance. And if we have the right narrative, we can accomplish anything." 

—Andrew Lo, MIT

Adaptive Investing in an Evolving World

Lo’s adaptive markets hypothesis brings a welcome challenge to the traditional, largely efficient markets–based, investment paradigm and its assumptions, which he argues have been good approximations during the period in which the standard models were developed.  Over the past two decades, however, these approximations—the existence of simple static linear relations between risk and return, the rationality of investors, and the stability and efficiency of financial markets—have started breaking down. In Lo’s adaptive markets framework, investors act in their own self-interest, but they make mistakes, and they ultimately learn and adapt as financial institutions and capital markets evolve. Market competition drives this process of adaptation and innovation. Success in this new paradigm requires investors to be vigilant, creative, and cognizant of ever-changing risks as they emerge. In Lo’s words: “In the long run we’re all dead, but let’s make sure the short run doesn’t kill us first.”

"The core economic ideas in FinTech are cost reduction and customization."

—Sanjiv Das, Santa Clara University

sanjiv das ap

Machine Learning/Artificial Intelligence in FinTech

As an accepted definition of FinTech is still being formed, Das defines FinTech as any technology that eliminates or reduces the cost of “the middleman” in finance and drives efficiencies. The explosion of FinTech over the last decade has been fueled by three big game changers in computing: innovation in analytical methods that “unlock” new information; increasingly agile and sophisticated hardware (often consumed as a service in the Cloud); and abundant amounts of new and often big data. Artificial general intelligence, or AGI, has moved beyond the earliest forms of AI, which was pre-programmed with fixed rules and thus could never be more intelligent than its creators. Today’s AGI is data driven and can adapt itself to reflect the data patterns it discerns, with the possibility that advanced skills can emerge organically. Given today’s high costs of financial intermediation, FinTech allows for disintermediation in raising, allocating, and transferring of capital, with applications in virtually every area of the financial and investment industry.

deborah lucas as

"Home equity [is] a giant, but very underutilized asset class, and…at least on paper, reverse mortgages are probably the answer to how people will be able to dip into that very important source of funds. As currently designed though, reverse mortgages are a disaster of a product." 

—Deborah Lucas, MIT

Accessing Home Equity in Retirement

At yearend 2017, US homeowners had accumulated equity in their homes totaling more than US$13 trillion, nearly rivaling balances in other forms of private retirement savings. Nevertheless, home equity is rarely considered a retirement asset class and consequently is severely underutilized in retirement planning and during retirement itself. In the abstract, a reverse mortgage is a potential way to create liquidity for what would be an otherwise very illiquid retirement asset. Yet reverse mortgages are particularly unpopular, as evidenced by their limited adoption. Lucas calls the unpopularity of this financial product, which happens to be a socially valuable strategy allowing seniors to access needed cash and to age in place, the “reverse mortgage puzzle.” In Lucas’s analysis, major program and regulatory changes designed to reduce costs and improve incentives are needed to resolve the puzzle. If these changes are not made, a key innovation in retirement planning will be left underutilized for the foreseeable future.

"Retail investors…[as well as those] that are very sophisticated, [such as] institutional investors and consultants, put far too much weight on noisy past returns. If you…recognize that bias, then you have a better chance of correcting for it."

—Campbell Harvey, Duke University

cam harvey ap

Rare Effects and Investment Management

Investors—a subclass of the broader set of “human beings”—tend to poorly comprehend statistics, which leads them to make a number of errors in investment decisions. A pervasive mistake is their believing a strategy should be a winner in the future, based on past history, when ultimately it turns out to be a losing strategy; this is a Type I error or a false positive. Should we blame investors for this type of behavior if we believe this form of optimism is part of the evolutionary success of our species? Harvey explains that the combination of 1) frequent Type I errors to which we are evolutionarily predisposed; 2) poor research testing methods that fail to separate luck from skill and drift into “p-hacking” or data mining; 3) not controlling for implausible rare effects; and 4) failure to reduce noise provides important lessons for asset management. To lessen the false positives, investors are encouraged to look beyond Sharpe ratios and to assess other information such as the research culture of the asset manager, and to approach new research with caution, if not cynicism. The low-hanging fruit in long-term risk premia have now been picked, suggesting that most newly promoted empirical research findings may be false, that most managers are just lucky, that most smart beta products are not smart, and that there is no predictability in performance based on noisy past performance.

john cochrane ap

"If interest rates go up to 5%, debt service goes, within two years, up to a trillion dollars a year. It doubles the already unsustainable deficits. And then if that happens, markets charge even higher interest rates. So by having short-term debt and a large amount outstanding, we are in danger of a classic debt crisis." 

—John Cochrane, Hoover Institution

Eight Heresies of Monetary Policy

Cochrane challenges conventional thinking on monetary policy. He argues that conventional narratives are far overstated. During the years of near-zero rates, the Fed was not holding rates down, if anything it was pushing rates up from what market forces would have wanted. The massive QE operations had no visible effect on interest rates or the economy. Large quantities of interest-paying reserves don’t cause inflation and are to be welcomed as useful liquidity. The Fed is not stoking “bubbles” in financial markets. Markets are always high in expansions and this one is no different. Conventional theory, as used by the Fed, predicts that long years of near-zero rates should have resulted in a deflation spiral. That inflation is stable clearly invalidates those theories: inflation is stable when interest rates don’t move. Consequently, if the Fed were to raise interest rates and keep them there, inflation would likely rise. Cochrane closed by warning that the main inflation danger comes from fiscal policy.

"When considering how to invest, we should ask ourselves: Are we comfortable with heroic assumptions of 3% real share-price growth? Or do we want to invest in markets where sensible returns can be expected, based on sensible assumptions about future growth and mean reversion?"

—Rob Arnott, Chair and Founder, Research Affiliates

rob arnott ap

CAPE Fear: Why CAPE Naysayers Are Wrong

Has the Shiller PE lost its usefulness as a predictor of long-term returns? Arnott looks at the evidence from US and international equity markets and shows that the arguments made to justify current elevated CAPE ratios are based on factors that are subject to mean reversion. Mean reversion skeptics rationalize the co-existence of sustained high CAPE levels and high future returns in various ways: increases in the structural EPS growth rate along with recent changes in earnings measurement; large numbers of working-age savers who are valuation-indifferent stock purchasers today for retirement spending tomorrow; a low discount rate as a function of current low interest rates; and a prolonged low macro-volatility environment. Arnott explains the market forces with the potential to cause CAPE to tumble and highlights why CAPE naysayers are wrong about the measure. For those investors willing to accept that a high CAPE is here to stay, they must also accept that low expected returns are also here to stay.