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Focusing on Growth (Not Market Cap) · Masters in Business

• 0:01
  Speaker 1: The load up man, and you put the load and
• 0:08
  Speaker 1: run the loan right on.
• 0:17
  Speaker 2: Traditional market cap weighted indexes like the S and P
• 0:22
  Speaker 2: five hundred have really done a great job in dominating
• 0:26
  Speaker 2: investor inflows. But today there's concerns of cap weighting that
• 0:31
  Speaker 2: is leading into increased market concentration into just a handful
• 0:36
  Speaker 2: of stocks, especially the MAC seven, higher valuations, and increase
• 0:41
  Speaker 2: risks for investors. How should an index investor think about this? Well,
• 0:46
  Speaker 2: to help us unpack all of it and what it
• 0:48
  Speaker 2: means for your portfolio, let's bring in Rob or Not,
• 0:51
  Speaker 2: founder of Research Affiliates. The firm recently put out the
• 0:55
  Speaker 2: Research Affiliates Growth Index that's different from both cap weighted ETFs,
• 1:02
  Speaker 2: but also different from equal weight ETFs. So I'm fascinated
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  Speaker 2: by this index which you guys put out. You're tracking
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  Speaker 2: it live today. It's not yet investible, but I assume
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  Speaker 2: there'll be an ETF out sooner rather than later. Define graphic,
• 1:19
  Speaker 2: Define the research affiliate's growth index, What are the weights
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  Speaker 2: based on? How do you think about alternatives to cap
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  Speaker 2: weighted growth.
• 1:29
  Speaker 1: Let's back up just a little bit and challenge one
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  Speaker 1: of the basic principles of modern investing and modern finance,
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  Speaker 1: the principle that there's this binary duality of growth and value.
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  Speaker 1: If it's not value, it's growth. If it's not growth,
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  Speaker 1: it's value. Pardon me, Those are not one dimension. Those
• 1:54
  Speaker 1: are two dimensions. You can have cheap and expensive, you
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  Speaker 1: can have fast and slow growing, two different, completely different dimensions.
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  Speaker 1: Our industry has had a fixation on this simple duality
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  Speaker 1: where if it's cheap, its value, and if it's expensive
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  Speaker 1: its growth. No, if it's expensive, it's expensive, it's much simpler.
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  Speaker 1: If it's growth, it's growth. So, to my astonishment, looking back,
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  Speaker 1: cap weighted indexing goes back to the fifties, as investible
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  Speaker 1: portfolios to the seventies, and growth indexes to the late seventies,
• 2:40
  Speaker 1: and growth investible growth strategies to the nineteen eighties. Nobody
• 2:47
  Speaker 1: has posed the question, why don't we look at this
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  Speaker 1: fundamentally instead of based on valuations. Nobody has asked the question,
• 2:56
  Speaker 1: why don't we create an index that chooses growth stocks
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  Speaker 1: based on how fast they're growing, and weight's growth stocks
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  Speaker 1: based on how big their dollar contribution to the growth
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  Speaker 1: of the macroeconomy is. If you do that, if you
• 3:13
  Speaker 1: choose companies that are growing rapidly, and you weight them
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  Speaker 1: on the dollar magnitude of that growth. You wind up
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  Speaker 1: with an index that, over the last thirty years would
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  Speaker 1: have outperformed Russell growth by four and a half percent
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  Speaker 1: peranum going back almost thirty years.
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  Speaker 2: Russell growth not Russell value.
• 3:32
  Speaker 1: So correct.
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  Speaker 2: So if that's the case, what are we selecting on
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  Speaker 2: It's not just cap weight. I'm assuming it's and I've
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  Speaker 2: read some of the research. You're looking at increasing sales,
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  Speaker 2: increasing profits, increasing R and D explain what goes in growth?
• 3:52
  Speaker 1: Well, there's an article coming out in the next issue
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  Speaker 1: of the Financial Analyst Journal that takes a deep dive.
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  Speaker 1: So anyone who's got access to the f AJ take
• 4:01
  Speaker 1: a look for the moment. You can also find it
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  Speaker 1: on SSRN. Just look up are Not Fundamental Growth and
• 4:08
  Speaker 1: it'll take you right there. Anyway, if you wanted a
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  Speaker 1: growth index that didn't anchor on expensive stocks but anchored
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  Speaker 1: on fast growing companies, how would you instinctively choose to
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  Speaker 1: measure that? Growth? Sales, profits? Those are the obvious choices,
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  Speaker 1: slightly less obvious. Most growth companies have R and D
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  Speaker 1: and it's a big enough part of their business that
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  Speaker 1: they break it out as a separate item in their
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  Speaker 1: P and L. So what about growth in P and L?
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  Speaker 1: Excuse me, growth in R and D because if they're
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  Speaker 1: shrinking their R and D budget, that's a bad sign.
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  Speaker 1: And so if you have three different growth rates, growth
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  Speaker 1: in sales, growth in profits, and growth in R and
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  Speaker 1: D spending, if that's available two of the three, if
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  Speaker 1: it's no, you average those growth rates, and you've got
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  Speaker 1: a very good gauge of how fast the company's growing.
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  Speaker 1: If it's growing rapidly enough to be in the top
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  Speaker 1: twenty five percent, let's use it. Here's a fun factoid.
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  Speaker 1: Two of the Magnificent seven don't make the cut for
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  Speaker 1: the Raffi Growth Index.
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  Speaker 2: H really, which two?
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  Speaker 1: Take a guess?
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  Speaker 2: So who's cutting way back on their R and D
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  Speaker 2: and not seeing increases in revenue? Apple and Amazon. I'm
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  Speaker 2: just spitballing.
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  Speaker 1: You got one out of two.
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  Speaker 2: So Apple is the first.
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  Speaker 1: Amazon, Amazon and Microsoft both were growing incredibly fast into
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  Speaker 1: the twenty tens and have been growing nicely in the
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  Speaker 1: twenty twenties, but not fast enough to make the cut,
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  Speaker 1: so they're left out of the Raffie Growth Index. The
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  Speaker 1: index is on Bloomberg has been since last March, and
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  Speaker 1: it's already thirteen percentage points in less than a year
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  Speaker 1: ahead of Russell growth. So the idea works and it's exciting.
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  Speaker 1: I wish I was on your show to announce that
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  Speaker 1: it's an investible ETF for mutual fund. Not yet.
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  Speaker 2: When it comes out, when it becomes investible, we'll have
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  Speaker 2: you back. I want to ask you a question about
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  Speaker 2: dollar magnitude as opposed to percentage magnitude of growth. This
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  Speaker 2: is something that every metric I see is almost always
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  Speaker 2: a percentage. You're looking at absolute dollars of growth. Explain
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  Speaker 2: the thinking behind this. How does it manifest in performance?
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  Speaker 1: How does it work? We select based on percentage growth.
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  Speaker 1: You could have a huge company that has sales grow
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  Speaker 1: by one hundred billion in a year and it's only
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  Speaker 1: ten percent growth five percent growth, and if that's the case,
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  Speaker 1: it's not a particularly growth company. So percentage growth is
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  Speaker 1: used to choose the companies. Now, the two biggest stocks
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  Speaker 1: in Raffie growth are in Nvidia and Apple. One has
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  Speaker 1: had stupendous growth from a low base. One has had
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  Speaker 1: good growth from a high base. Both have had percentage
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  Speaker 1: growth fast enough to make the cut. They are both
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  Speaker 1: a little over ten percent of our index. Now, think
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  Speaker 1: what that means. If it's a ten percent weight, that
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  Speaker 1: means that Nvidia has singularly, all by itself been ten
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  Speaker 1: percent of these sales or profit growth in the aggregate
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  Speaker 1: US economy. Wow, huge Apple has been ten percent of
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  Speaker 1: the aggregate growth in sales or profits of the US economy.
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  Speaker 1: So by weighting company in proportion to the dollar magnitude,
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  Speaker 1: you're not going to introduce a bias towards frothy, tiny
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  Speaker 1: companies that have had just a big percentage search. You
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  Speaker 1: could have a tiny company that's grown tenfold, and if
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  Speaker 1: you wait it by that tenfold growth, it's going to
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  Speaker 1: get a huge weight and it's a tiny company and
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  Speaker 1: it might be a flash in the pan.
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  Speaker 2: So, in other words, the percentage gains matter, but so
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  Speaker 2: too do the real dollar gains. Exactly right, I understand that.
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  Speaker 2: So curious about the volatility of this versus traditional capwaiting indexes.
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  Speaker 2: How does this compare? Are you getting better performance but
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  Speaker 2: you have to live with a little more volatility.
• 8:40
  Speaker 1: The short answer is you have to live with a
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  Speaker 1: little bit more volatility, and you have to live with
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  Speaker 1: occasional periods when it will underperformed on average over the
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  Speaker 1: last twenty eight years, it adds four and a half
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  Speaker 1: percent a year, plus or minus seven percent. So in
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  Speaker 1: just a normal disappointing year, it's going to underperform by
• 9:03
  Speaker 1: about two In a normal excellent year, it's going to
• 9:06
  Speaker 1: outperform by about twelve. So since we launched in last March,
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  Speaker 1: the thirteen percent out performance means this is a very typical,
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  Speaker 1: very normal good year, and so you have to be
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  Speaker 1: willing to take a little bit of volatility. But if
• 9:24
  Speaker 1: you go back, you find that it wins about seven
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  Speaker 1: out of ten years. Wow, that's pretty cool.
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  Speaker 2: Yeah, to say the very least. So, since we're talking
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  Speaker 2: about a lot of not just large cap companies, but
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  Speaker 2: companies with a substantial economic footprint, my assumption is there
• 9:42
  Speaker 2: are a whole lot of capacity or liquiditly constraints. I'm
• 9:45
  Speaker 2: assuming this can ramp up just like an S ANDP
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  Speaker 2: index or what have you.
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  Speaker 1: Short answer your question is current AUM is zero, so
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  Speaker 1: there's loads of capacity. Longer answer is a educated guess
• 10:01
  Speaker 1: would be it could. It has about four times the
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  Speaker 1: turnover of the S and P maybe five, So just
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  Speaker 1: on that alone, its capacity would be a fourth or
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  Speaker 1: a fifth out of the S and P. It's also
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  Speaker 1: tilted towards a particular category, not the whole broad market,
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  Speaker 1: so that would suggest another haircut. I think its capacity
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  Speaker 1: would be ten to twenty percent of the S and P.
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  Speaker 1: Given that there's about fifteen trillion index to the S
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  Speaker 1: and P that would be that would give us something
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  Speaker 1: on the order of one and a half to three
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  Speaker 1: trillion as a capacity.
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  Speaker 2: So plenty of capacity. Last question, I've been watching various
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  Speaker 2: narratives come into favor and then fade. We went through
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  Speaker 2: a whole blockchain crypto set of narratives. AI seems to
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  Speaker 2: be in the midst of its various narratives.
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  Speaker 1: When you think.
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  Speaker 2: About the Research Affiliates Growth Index Fundamental Growth Index, does
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  Speaker 2: the dominant narrative matter or is it us redefining its
• 11:01
  Speaker 2: constituents based on what is best working today, what is
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  Speaker 2: seeing the highest increases in revenue, profits and research and developments.
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  Speaker 1: Mended well between RAFI, the fundamental index, which has stark
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  Speaker 1: value tilt, and RAFFI growth, which has a stark growth tilt.
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  Speaker 1: I like to think that we're launching a revolution in indexing.
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  Speaker 1: I mean, the runway for this is huge. One other
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  Speaker 1: observation we're quantitative investors. We love testing things. Quantitative investors
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  Speaker 1: are addicted to data mining. Go back historically and ask
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  Speaker 1: what can I construct that's worked. We don't do that.
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  Speaker 1: Scientific method means you start with a hypothesis and you
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  Speaker 1: only use the data to test the hypothesis. Our hypothesis
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  Speaker 1: was if you select companies on how fast they're growing
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  Speaker 1: and wait them on how large the magnitude of their
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  Speaker 1: contribution to the economic growth. This is an idea that
• 11:59
  Speaker 1: might work pretty darn well. And lo and behold it does.
• 12:03
  Speaker 1: The back tests of RAFFI when we launched it twenty
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  Speaker 1: years ago showed about two percent value add relative to
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  Speaker 1: cap weighted value. It's added two to two and a
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  Speaker 1: half percent live for twenty years. So you don't fall
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  Speaker 1: into the trap of creating a strategy that looks great
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  Speaker 1: in back test and falls apart instantly.
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  Speaker 2: I'm so glad you said that, because when do you
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  Speaker 2: ever see a bad back test?
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  Speaker 1: Right?
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  Speaker 2: All back tests are great?
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  Speaker 1: That I see lots of bad vatus. Oh no, I
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  Speaker 1: mean that gain never promoted.
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  Speaker 2: The back tests that get shared are the ones that there's.
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  Speaker 1: A little worse.
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  Speaker 2: There are totally and and you know inherent in every
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  Speaker 2: back test is the concept that the future is going
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  Speaker 2: to look like the past, and very often we see
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  Speaker 2: the future does not look like the past. So the
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  Speaker 2: back tests all fail. Many back tests that look great
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  Speaker 2: fail to perform in real life. The world changes.
• 13:04
  Speaker 1: And if you're doing a back test to create a better.
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  Speaker 2: Back test, right, that's right, that's.
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  Speaker 1: That's the epitome of data mining, and it's endemic in
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  Speaker 1: our business, absolutely so.
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  Speaker 2: Rob when the when this comes out as an investible product,
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  Speaker 2: be it an ETF or an SMA or a mutual fund,
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  Speaker 2: come back tell us about it.
• 13:29
  Speaker 1: I'm sure it will because I'm trying to keep it
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  Speaker 1: secret because it's so good.
• 13:34
  Speaker 2: Well, you and Jim Simon's like, kick out all the
• 13:36
  Speaker 2: outside investors and just keep your own money into it
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  Speaker 2: works well. So to wrap up, if you're concerned about
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  Speaker 2: cap weight, if you're concerned about market concentration or valuation,
• 13:50
  Speaker 2: take a look at the research affiliate's growth index. It's
• 13:54
  Speaker 2: not market cap weighted, it's not yet investible. But I
• 13:59
  Speaker 2: know research affiliates, and I'm pretty confident there will be
• 14:03
  Speaker 2: an ETF for you to put money into at some
• 14:07
  Speaker 2: point in the future. I'm Barry results you've been listening
• 14:10
  Speaker 2: to Bloomberg's At the Money, you put the load right alone,
• 14:20
  Speaker 2: right on