The Long View

Patrick O'Shaughnessy: 'Custom Indexing Unlocks a Lot of Benefits'

Episode Summary

The investor, author, and popular podcast host talks ESG, factor investing, some of his favorite podcast guests, and more.

Episode Notes

Our guest this week is Patrick O’Shaughnessy. Patrick is the CEO of O’Shaughnessy Asset Management. He also is a portfolio manager at the firm. Prior to assuming his current role, Patrick served on O’Shaugnessy’s research and portfolio management teams. Patrick is the author of Millennial Money: How Young Investors Can Build a Fortune and was a contributing author to the fourth edition of What Works on Wall Street. Patrick is also the host of the popular Invest Like the Best podcast. He received his bachelor’s in philosophy from the University of Notre Dame and is a CFA charter holder.



O’Shaughnessy Asset Management


Millennial Money: How Young Investors Can Build a Fortune

What Works on Wall Street, Fourth Edition: The Classic Guide to the Best-Performing Investment Strategies of All Time

Invest Like the Best Podcasts


ESG the Right Way: Customization and Not Scale,” by Travis Fairchild,, October 2019.

Custom Indexing Leader Canvas Expands ESG/SRI Offering,”, March 9, 2021.

Investing in Environmental Protection,” by the OSAM Research Team,, April 2021.

Helping Financial Advisors Solve ESG Investing Challenges,” by Travis Fairchild,, March 2021.

Factors and Custom Indexing

Combining the Best of Passive and Active Investing,” by Patrick O’Shaughnessy,, March 6, 2013.

Alpha or Assets? Factor Alpha Vs. Smart Beta,” by Patrick O’Shaughnessy,, April 2016.

Combining the Best Stock Selection Factors by Patrick O’Shaughnessy at QuantCon 2016,”, April 14, 2016.

Factors From Scratch: A Look Back, and Forward, at How, When, and Why Factors Work,” by Chris Meredith, Jesse Livermore, and Patrick O’Shaughnessy,, May 2018.

"'Humans Love a Narrative. We Have Safeguarded Against That': Jim and Patrick O’Shaughnessy,” by Vicky Ge Huang,, Dec. 6, 2018.

Introducing Canvas,” by Patrick O’Shaughnessy,, September 2019.

Custom Indexing: The Next Evolution of Index Investing,” by Patrick O’Shaughnessy,, December 2020.

O’Shaughnessy’s Quarterly Letter Q4 2019,” by Patrick O’Shaughnessy,, January 2020.

Podcast and Reading

Chetan Puttagunta--Go Slow to Go Fast: Software Building and Investing,” Invest Like the Best With Patrick O’Shaughnessy,, Jan. 28, 2020.

Nick Kokonas—Know What You Are Selling,” Invest Like the Best With Patrick O’Shaughnessy,, Nov. 19, 2020.

The Psychology of Money: Timeless Lessons on Wealth, Greed, and Happiness, by Morgan Housel

The Razor’s Edge by Somerset Maugham

Episode Transcription

Jeff Ptak: Hi, and welcome to The Long View. I'm Jeff Ptak, chief ratings officer for Morningstar Research Services.

Christine Benz: And I'm Christine Benz, director of personal finance for Morningstar.

Ptak: Our guest this week is Patrick O'Shaughnessy. Patrick is the CEO of O'Shaughnessy Asset Management. He also is a portfolio manager at the firm. Prior to assuming his current role, Patrick served in O'Shaughnessy's research and portfolio management teams. Patrick is the author of Millennial Money: How Young Investors Can Build a Fortune and was a contributing author to the fourth edition of What Works on Wall Street. Patrick is also the host of the popular "Invest Like the Best" podcast. He received his bachelor's in philosophy from the University of Notre Dame and is a CFA charterholder.

Patrick, welcome to The Long View.

Patrick O’Shaughnessy: Thank you so much to you both for having me.

Ptak: So, let's start with ESG, a topic your team has written a lot about. Your firm thinks the best approach to ESG is customization, contouring the portfolio around a client's personal preferences. How do you help clients weigh the trade-offs associated with those preferences?

O’Shaughnessy: Well, we try to just be very upfront about what choices in an investment strategy mean for each investor. And in the case of ESG, I think the cleanest way to describe that is what we would call tracking error--how much are you putting into your strategy that's going to make your returns different than, say, the S&P 500. And we don't know, to be clear, whether that tracking error is going to be good or bad. It just means they are going to be different than the underlying benchmark. And we think of that as a nice measurement of what I'll call cost. So, if you care deeply about not owning a certain type of company or owning a lot more of a different type of company that has a feature that you want to support, again, we don't know if there will be alpha in that decision or not. It's very hard to say, like anything. But we can give a good clean estimate of we think in a normal market, this will cause you to perform X percent plus or minus the benchmark. And we find that framing to be, I think, one it’s the responsible way to think about it, but it also arms the investor to really understand the trade-offs associated with their choices. And what we've seen is that that tracking error as the measure is a great way for advisors and for clients to guide their ESG decision-making.

Benz: How well equipped are advisors and individual investors to express their ESG preferences? For example, do you think they know what terms like “water stress” or “carbon intensity” really mean, let alone the investing implications of managing for such preferences?

O’Shaughnessy: Well, I think this is a classic case of the average not being the right statistic here, there are definitely distinct cohorts of types of investors. Lots probably would not know what “water stress” means. And almost entirely that group that doesn't know is also not adjusting for it. What we've seen is that there is a strong, a very strong and vocal sort of minority that cares deeply about these ESG issues in their portfolios. And for many of them it is the single most important thing in their portfolios. We think it's 15% or 20% of investors today, which is roughly the percentage of Canvas users that adjust for ESG when given the option to do so. But that means 80% don't. That number is rising, to be clear. But I think it's really two distinct groups with lots of subgroups: Those that don't know what water stress means or what a lot of these things mean and haven't really thought about it; and those that know deeply what these things mean. In many cases, advisors build their whole practice around a certain type of ESG profile portfolio that we help fulfill. And then, of course, the advisor knows deeply, and they are attracting clients who have similar interests, values, and desire to impute those values into their portfolio.

Ptak: So, after you've implemented, how do you measure and monitor the portfolio to ensure it meets the clients' needs? Excess return and alpha are the types of metrics we've used to this point. But are those the right measures when you are highly customizing to satisfy nonfinancial preferences? And I suppose the question, it's most apt for that cohort that you described as much more dialed in and informed about ESG? When you're dealing with them, how do you measure and monitor?

O’Shaughnessy: Well, I think there are two new things that get introduced into the equation, which we found to be really important. We've built both. One is what I'll call the ESG-specific performance reporting. And all that is a very simple idea. All that really means is, if you chose to overweight companies with more diverse boards or the best scores on carbon emissions, what did that actually do in terms of performance relative to just a simple benchmark like the S&P or the Russell 3000 or something? Did you outperform or did you underperform because of that choice in a given period of time? So, again, simple returns-based but attributed back to the actual choice that you made on ESG specifically is the first new piece of reporting. So, we'll call that the returns-based piece.

The second piece is the actual data on the ESG, I'll call it, performance or characteristics, of the portfolio. So, luckily, with lots of new data, we can measure these things. We can measure board diversity quantitatively; we can measure emissions quantitatively, and all these other many factors. And therefore, you can say, “OK, here is your portfolio that's been adjusted for these things. How much better is it than the broad market on the factors that you care about, not in terms of returns, just based on the characteristics of the companies themselves in the portfolio?” So, when you show both those things, the characteristics and the attributed returns to the ESG choices made with tracking error that I mentioned before, those three things together, I think give investors a really good picture of what they are getting and whether or not it's worth it.

Benz: Like anything, ESG-preferred stocks and bonds can get really expensive. So, given that, why shouldn't one conclude that ESG preferences can come at a potentially steep cost?

O’Shaughnessy: Well, again, I think steep costs, it depends on the frame of reference here. I think if you think about valuation as another form of cost for just equities more generally speaking, what we've seen in the last decade is that the most expensive stocks have by far done the best. And it's very hard to say whether or not value or costs are the right metrics for evaluating a choice, because very often expensive stocks do well as a category, maybe not over the long run, but certainly over long periods like we've seen in the last decade. And companies that have the best ESG practices, maybe they carry a higher market multiple or something like this. But maybe those ESG choices are going to contribute to outsize continued ongoing earnings growth for those companies relative to companies that don't have that same orientation around ESG.

That's not our judgment. We honestly don't know. There is not enough data to suggest who is right in this debate, whether better ESG companies will be better performers. But it may be worth paying up for it. And our view is that we want to facilitate that decision by the advisor and their clients, the investors, versus try to impose paternalistically our view of ESG or the world onto them.

Ptak: That's understandable. By the same token, there's different schools of thought, one of which is that maybe it makes sense to just keep it simple in the financial portfolio aiming to maximize financial returns consistent with an investment plan, and then handle the E, S, and G preferences separately. That's what I suppose you could argue that Buffett does more or less. So, in the conversations that you've had with your clients and partners, for those that have been reckoning with that, what does that conversation, what has that sounded like? And what do you say to those that feel like maybe ESG really ought to be separate?

O’Shaughnessy: Look, I think that's a good option. And one that, like I said earlier, 75% of the time, that's what we see people doing--not adjusting for ESG in the portfolio. And I'm sure--we haven't asked specifically--but I'm sure a lot, some large portion of those investors care about some of these issues, and maybe they are doing something about it away from their investing. And we think that's a fine option.

I think what this whole experience with custom indexing has taught me is that there is no central one right way or one right view that should be imposed top down. Investors all care about different things and want to do things differently. So, I think it's much more about empowering them with the ability to make their own choices and then giving them the right feedback mechanisms, like we've talked about already, to make sure they understand the costs and, or the trade-offs, if you will, of the choices that they're making.

So, yeah, I think Buffett's approach is a fine approach. I think heavily adjusting in your portfolio is a fine approach. What we've learned is that one size just does not fit all, not just in investing; this kind of personalization trend is much broader than that in the world of technology. And we see that there's demand for that. I mean, setting aside ESG, almost 80% of the accounts on the platform have completely unique settings. So, people are aggressively, and the vast majority of the time customizing something--maybe not ESG, but maybe it's taxes, maybe it's factors, maybe it's something else, asset allocation--to them specifically. And I think that's the important point here.

Benz: You recently wrote that by 2025 most financial advisors will use web-based software to create and manage custom indexes for their clients. That's a big claim given that we continue to see advisors pump money into traditional index funds and ETFs. Can you explain why you think we'll see such a rapid sea change to custom indexing?

O’Shaughnessy: My view here is that you have to carefully study the landscape in which you're playing. And there are always trends beyond what you're doing that will impact what you're doing, and you just have to be eyes open to them. In our world, it's technology and cost deflation. The cost of, on the operational side, trading costs are now zero, fractionalize shares are coming to market. The ability to slice and dice and trade equities at extreme small levels of precision is effectively already free and getting more toward free. And that will continue over the next five years. And that's all driven by other firms' technology and software and infrastructure that's been built out over the last decade.

So, the bigger steady here is, we can do custom indexing. For a long time, we couldn't. It was just cost prohibitive. Custom indexing unlocks a lot of benefits that are impossible in a bundled package product like a mutual fund or an ETF--the two big ones being better tax management, the ability to create losses in the portfolio, or just manage around the tax preferences of the person, which sometimes are, “I've got a big gain this year, and so, I need a lot of losses, I'm willing to live with a lot of tracking error.” It's not something you could do in an ETF wrapper, even though ETFs are great from a tax standpoint. So, it unlocks sort of lots of tax potential.

And then, it unlocks the customization that we've already started talking about with ESG. There's lots of other dimensions to that as well. None of those are possible in packaged product wrappers. And so, I just think that those benefits are going to be appealing to a broader and broader audience over the next five years. I mean, we are already seeing it at the high end, almost like Tesla style, they started with the Roadster, then the S, then the Model 3. I think this custom-indexing trend will move the same direction. And in five years, you're going to see robos and things like this that let you put $10,000 into an account and make very granular choices about what you do and don't own, and that technology makes that inevitable. So, that's why we make a big claim like that, that we just kind of step back and view the playing field here, and we've seen firsthand, with real evidence, the benefits of custom indexing, and what it unlocks, which is why we think so many advisors will, at least for a portion of their clients, adopt these technologies.

Ptak: That makes sense. I did have a follow-up. If I'm an advisor, and we've seen this really strong move toward what could be argued are really simple, all-market tracking products. In essence, they've been simplifying the investment portfolios in some ways of the clients that they manage. And so, I wonder in the conversations that you've had with advisors and partners to this point, have they asked why they should prioritize customizing the investment portfolio when they could keep that part simple and instead customize the financial plan to that client's goals and other circumstances?

O’Shaughnessy: I guess my response, and again, it comes back to technology enabling this is, why in the world wouldn't you do both? Why wouldn't you do better on the financial plan but also then leverage technology as the advisor and tailor something much more specific to a cohort that you are going after as an advisory practice or an individual? What we've seen over and over again from our early partners is, in many cases, we are seeing the average account size that we are getting from one RIA in particular, meaning the same firm, their average accounts are getting bigger. They're using Canvas and winning larger relationships, because they are able to do more in terms of investment strategy fulfillment, getting the person exactly what they want than they could with some of these simple broad market exposures.

And maybe it's an important time to bring up this kind of fascinating thing that what we're seeing is, the demand for quant research is really high. It's just not an alpha research. It seems that people care far less about alpha these days, and they care far more about other things like ESG, like tax, like income generated from the portfolio, like a defensive posture to the equities that they own. These are all things that don't have "alpha" historically but are things that people want. And so, I think the answer is have your cake and eat it too here that you can pour as an advisor practice even more attention into the financial-planning portion of what you do for clients and then use a technology platform like Canvas--and there will be others and we won't be the only one--to fulfill against that plan and outsource a lot of the work that used to live inside the RIA--building performance reports, doing the trading internally, a lot of operational tasks--outsource those things to free up more time to focus on the plan and the needs of the client rather than less.

Benz: Are the best candidates for custom indexing those RIAs that tend to lead with investments as their value-add? Or would you say that's an oversimplification?

O’Shaughnessy: I guess the honest answer is I don't know. It's certainly true that the early partners that we've had in our first cohort of RIAs and now in the second that we're onboarding now, are all very investment savvy. They speak the language of factors and taxes and loss harvesting and all these things. And I would say that's a helpful feature in an RIA to make this very useful. But that's a point-in-time answer. I think that will be less true as time goes on. In the same way that today everyone understands Vanguard Total Market Fund, which is a great product. I think, in the same way, five years from now, everyone will understand a custom index as a concept. It won't cause much brain damage even if it's not an investing-first practice.

Ptak: Do you or the partners you work with find there are trade-offs of investing clients in numerous individual securities versus a handful of funds or ETFs that own those securities? For instance, does it make it more important for the advisor to set expectations upfront and manage client behavior on an ongoing basis?

O’Shaughnessy: Look, there are always trade-offs. When you own a lot of positions and you're doing loss harvesting, like, statements get longer. So, little things like, we have clients suppress paper confirms and stuff like that, but mostly, that's our experience with that—that's usually done already. So, slightly longer reports is one thing to consider. I think reporting and understanding what you own is always important. And if you just own the total stock market, that's pretty simple. One of our key goals is to have best-in-class custom reporting, not just custom investing, but custom reporting, that boils down things so that the advisor can click a button, have a report, understand it very quickly, hand it to the client, have them understand it very quickly and not have a lot of friction in that end-to-end process. And that will be something that we keep getting better and better at. And I would argue that it will be easier to understand a custom index than the S&P 500, because you'll have had a hand--we call this the IKEA effect--like when you help build something, you care more about it, there's more of an endowment effect and you'll understand it better. And so, as our reporting gets better and better, hopefully, we'll get to the point that people know even more about what's going on without much effort because of the quality of the reporting. So, yes, there are trade-offs. There is more complexity here just because you own more positions than owning two funds or something. But ultimately, those trade-offs I think are worth it.

Ptak: That's helpful. I might quick follow up with, how did users have your custom indexing solution, how did they react a year ago or so as markets were selling off?

O’Shaughnessy: Well, they wanted to know what was going on. I think like everyone in a crisis--I've been through a lot of these now as an investor and also as an investor managing, knowing my own money, but other clients' money. And the pattern is very constant, which is, usually in the worst periods of the crisis--so I'm thinking about whatever that date was March 19 of 2020--people are not acting necessarily. They're not necessarily panic selling. They want to know what's going on. They want information. They want reports. They want details. They want options. And so, that's, I think, what happened in March of 2020 as well. Now, luckily, for us, because loss harvesting is a big part of the value proposition of custom indexing, the answer was: here's what's happened in the portfolio, here's the returns, here's what we are doing, which is, we're following our system's plan, it's systematic, we've harvested a lot of losses, which if you look back on 2020, it was kind of a fascinating year, because portfolios were up, but they generated net taxable losses, often significant ones, because of that action that we took very quickly in March on behalf of clients last year. So, it's kind of interesting in the first year of the service to have a data point to show why tax-loss harvesting can be so powerful.

So, that's what we saw back then was, just please help us understand what's going on, how can we frame this to our customers, what actions are you taking--you always have to have a plan, right? So, what does the plan mean? What's the activity? And I'm very proud of the team. We went through that period, it was tough for everybody, but the net result to our end investors was very positive.

Benz: You've talked about some of the benefits of custom indexing relating to taxes, tax-loss harvesting and other strategies. But as you noted, ETFs are remarkably tax-efficient. So, how do you suggest that an individual investor or advisor should approach assessing whether the potential tax efficiency savings from direct indexing are worth it?

O’Shaughnessy: Well, while the algorithm and the optimization that we built that manages the tax-loss harvesting is quite complicated. What's actually happening is quite simple and easy to digest, which is, you are generating a certain amount of losses throughout the year, and you've got a certain return. And it's sort of like a risk-return scenario, or an information ratio, or something like how much tracking error am I incurring to get the benefit, the tangible benefit, of some percentage equivalent loss on the portfolio level. And at the end of the day, this should only be interesting if all you cared about was aftertax returns, which, like ESG, would be something separate than that. But let's just say all you cared about was aftertax returns. That's the metric you should be considering. And then, the comparison should be, “I put $100,000 into SPY today, and I put $100,000 into a direct index today. I'm going to come back in 10 years, and I'm going to look at the comparable return aftertax before liquidation and after liquidation. Because, obviously, when you liquidate the SPY, you're going to have a pretty large on average embedded gain, that's a real cost.” So, we do both a pre- and post-liquidation comparison. And what you find in our research, it was about 80 basis points. Some say it's higher. We were pretty conservative about the assumptions that go into that. But you're about 80 basis points ahead of something simple, like an ETF, which as you pointed out, is still very tax-efficient if you're just a pure direct indexer.

Now, that's just the most apples-to-apples comparison that we can make. There are lots of other interesting tax benefits that we find that are not traditional tax-loss selling, such as--this is probably the most common one: so and so client is about to monetize $20 million of, let's say, its Coinbase stock, because that's going public this week. Coinbase stock, it's basically zero basis. They don't want to be on Coinbase. They've got a couple of million other dollars on the side. They want to manage a tax transition from this concentrated position to a different end state. And we don't want to minimize taxes in that transition. Well, that's another use case of custom indexing here, that it's not just the loss harvesting in steady state, it's the movement from one portfolio to another. And very often, that's the most powerful thing to see on clients' eyes, because they are used to be shown a destination, but we're able to also show them a roadmap to get to that destination from where they are today. And that tax implication can be very large.

So, the direct answer to your question is maybe that sort of 80 basis point concept that just apples-to-apples versus an ETF that's roughly the expectation over, say, a 10-year investment horizon, which is the horizon that we used in the research. And that ranges from anywhere from zero to 250 basis points, where the average is about 80.

Ptak: You mentioned one of the applications of custom indexing in your opinion is it sounds like income optimization. We've interviewed a number of experts, financial planners, and the like and talked at length about retirement income. As you know, it's a really, really tough problem to solve in many ways. Do you view a technology-enabled mass-customized approach, like the one you offer, is a key way to win income in the future, that that's the best way to solve the retirement income puzzle and how have you applied it in practice with your Canvas solution?

O’Shaughnessy: You'll have to cut me off if I start going on too much of a sidewinder here, because I'm just really excited about this area. I think there's two big things that we are realizing live. One, we are already managing against, meaning, we are using the platform to solve the problem. The second, we are just beginning to digest as an opportunity set. And so, I'll cover both.

The first thing we've realized is, if you think about the popularity of the big dividend income-oriented equity ETFs, there's lots of them out there, there's tons of assets in them, those methodologies are all available. You can go to the websites and see what the rule sets are that determine these indexes, and they're usually straightforward. The beauty of custom indexing is that it unbundles that ETF concept, those methodologies, and hands the levers that are being used, let's say, it's consistent dividend growth year-over-year or some sort of balance sheet metric that's used as a quality proxy, or whatever those levers that really drive the ETF strategies might be, the ETF strategies have chosen points on those spectrums. They've made a choice, this matters more than this, everything's a trade-off. And what custom indexing allows you to do is, say, “Well, yeah, here are the levers that matter.” Let's say, it's dividend yield and dividend consistency, that those are imagine like a two-by-two grid or something. Those are the things that matter. Now, you get to pick where on the spectrums you want to be and there's trade-offs, and we'll tell you what they are. Higher focus on yield means higher yield, it also means higher volatility. So, what matters more? Higher average income or lower volatility? You can choose now. We are not going to choose for you. We are going to give you the tools to fulfill. And that's exactly what we've seen people do. So, this is the one that we are already managing, where we work with the RIAs to design their own solutions for their customers based on their needs, versus just saying, “Here's the average of the two spectrums, we think this is a good choice.”

And people fall in different parts of the spectrum--some care more about stability, some care more about you. And those are two simple dimensions. There's more than just those two. So, all of a sudden, these index methodology strategies, whether that be quality or yield, or whatever it might be, you're turning the controls over with your guidance, to be clear. We are not just giving it like an unfettered access to the platform. We want to make sure that we are doing things the right way in partnership with the RIAs. But again, you are opening up more possibilities that map on to the circumstances and preferences of the end investor. That's the person who matters here. Those are the needs that we are trying to meet. So, that's very exciting.

The second is one that's a little bit more--my team may yell at me for bringing up since we are just starting to talk about it--but just with the building blocks we built, all of a sudden, you could have customizable target-date funds, too. You could say, here's the income needs of the investor in retirement, here's a risk profile, here's other inputs that matter--design something that just does this automatically, just make this self-driving, but also give me all the benefits that we’ve already talked about here today, of custom indexing versus a 2035 target-date fund or something like this. So, you can see why we get so excited about custom indexing, because it starts to attack all of these huge categories--whether that's target-date funds, or thematic ETFs, or income-based solutions--and do it in a way that doesn't have to be one size fits all, it can be one size fits one. So, that's where we see this all going on the income side.

Benz: We want to switch over to discuss the evolution of your business. When you present your firm O'Shaughnessy Asset Management to clients and prospective clients, how do you describe it and how does that description compare to when you started at the firm?

O’Shaughnessy: It's a great question. I'm a big believer that in different industries, there are always one, maybe two competitive frontiers that really matter. Said a different way, there are a couple of things that will sort the winners from the losers based on their performance in these one or two categories. And that's changed a lot in asset management. We all know the story of the move toward passive, the pressure on active management, the fee pressure, the asset pressure, etc. Luckily, markets have gone up, so that industry has still done OK or even well with a big market tailwind. But in terms of market share, it's lost a lot to passive. And so, you could argue that based on that market share story, it's sort of an industry in secular decline. And the competitive frontier was performance. People wanted performance, and maybe a lot of hedge funds still do this, and some great mutual funds still do this, and there will always be some demand for that. But the competitive frontier was, can you perform better than your benchmark and better than your peers?

Well, we've seen shift demonstrably in my career, so I started my career in 2007, right before the global financial crisis, is really a move away from performance, and, what I'll call alpha, toward these other dimensions. Give me give me the financial plan mindset, like, give me what I need out of the portfolio, not just the highest-possible return; make sure that I can sleep at night, make sure that I can have something that fulfills my needs. And passive often is just the answer to that question of what fulfills those needs. I think now, looking forward, the competitive frontiers have changed a lot. And now, they are two things: quantitative research and software development. I think that asset management is going to go through this period of rapid change on to a more technology kind of platform route than it has existed today where most asset managers are definitely not technology firms, they are stock-picking firms or they are something else. And the world is demanding that everything be accessible through software and everything be personalized, et cetera. So, I think in terms of who will win going forward, sure, there will always be a corner of strong-performing hedge funds and mutual funds that will do extremely well as asset-management firms. But that the big pie here--the pie that BlackRock and Vanguard and State Street and others have won and will continue to fight for--is much more along this idea of custom quant research and concurrent software development so that the consumers of that research in the form of portfolios, both advisors and institutions and customers and investors, get their investing like they get everything else digitally.

So, when I talk about the firm, I say those are the two areas that we have historically excelled at. Always quant research--we're a quantitative investment firm. So, that's always been our core competency. Software was something that we had to be good at but didn't necessarily lead with. Like, you wouldn't have heard me talk about our software development capabilities five years ago. Today, I talk about both in concert because they both play off each other and make us more valuable to our end users, our clients, and that's where I think this business is going. So, that's where we're focused as a firm.

Ptak: As you reflect on that process of retooling the firm to build a software platform, what did you find were the toughest trade-offs to make?

O’Shaughnessy: Oh, all of them. When I took over the firm as CEO, three, four years ago, we were, call it, a 35-, 40-person firm. And inertia is even strong in a firm that small. I can't imagine inertia inside of large companies, which is really what makes me marvel at these large technology companies like a Microsoft or an Amazon that, despite their size, still seem to be able to fight inertia. It's just really kind of incredible. But I think any kind of change in a business is just really, really hard. And even if everyone is excited about it and it's growing and it's working, which is luckily the situation we find ourselves in, it's still really hard. Three years in, growth is hard, it's painful, it's expensive, it's challenging, it's stressful. So, retooling a business and a business model, you can see why incumbents or disruptors can win, because it's just really, really hard to change direction of something that in our case had been around for a really long time.

And look, a lot of the reason we are in this position is because of that history. We built all this technology for our own purposes, and we just got lucky that we thought carefully about it, but we thought to repurpose some of that and offer now a second leg of products that enhance the first leg, which the first leg is still the core of our business and growing nicely. And so, that's the answer. It's all hard. Pivoting a business or offering a new product is painful. I don't want anyone to think it's anything but. But ultimately, it's very rewarding because it makes you really, really search for where there is demand, where there is traction versus just trying to sell something you are not sure if people want.

Benz: We've tended to think of asset managers as having a few parts. There's the portfolio managers and research, sales and marketing, operations. Talk about why you think that framework is outmoded, and how that's informed the approach that you've taken to recruiting talent and deepening the firm's expertise in the areas that you've identified as strategic priorities?

O’Shaughnessy: Well, it's an interesting question. Outmoded, I don't know if I'd use that word. I think that model can still work for some. I just think that the entire world is going this direction, where there's less barriers between, I'll call it, divisions of the firm. When we are exploring something like this income thing you just asked about--I wish we could show people the internal discussions. What you would see is, our client team, many of whom have their CFA designation, these are well-trained, smart investors, really, that happen to be on the client side of the business, them coming back to our quant research team and our technology team and saying, “Here's the problem--the pain point that we see in the market from talking to customers and seeing what they are unable to do but want to do, how can we use our platform to attack that problem?” And a lot of times, we can't. But when we can, what ensues is this really cool--and we've gotten better at every time we've done it--this really cool collaboration between our client team, our quant team, our software team, and even our operations team, that then leads to something that is a complete package. And that collaboration is really fun. So, whether or not the more siloed kind of division approach to asset-management businesses is outmoded or not, I can tell you for sure that this collaborative approach is a lot more fun.

Ptak: Let's shift and talk about factors. We've talked a lot about mass customization and technology-driven investing. So, maybe a logical question to ask is what are the implications of those trends, mass customization and technology-driven investing, and some of the relationships that have historically been found to hold in markets?

O’Shaughnessy: Well, it's a fascinating question, of course. And I guess, if I knew the answer I maybe would be doing something else with the information and talking about it. I surely don't know what will happen with traditional factor relationships, things like value versus growth, small versus large, U.S. versus international, momentum versus laggards and so on, high quality versus low quality. The empirical evidence for these factors, everyone knows probably that's listening, is aware of that story. And look, like anything, I believe very deeply in some of these factor relationships as long-term things. I also believe very deeply that they are impossible to time and that there can be long excruciating painful periods of underperformance for a traditional factor relationship like what we've seen value underperforming growth over the last, really since the global financial crisis, sometimes incredibly acutely so, like in 2020, one of the worst years for that relationship we've ever seen.

I don't know what all this will mean for those factor relationships. I can't remember who said this, but the idea that flows affecting factors makes a lot of sense to me. If you zoom in enough on any business situation, like you find a supply/demand problem. And I think if there's more demand for factors, it probably isn't a good thing for their prospective future returns. If there's less demand, it's probably better. And all things equal, if people are--and this has been our observation--if people care less about alpha factors than they used to, maybe that portends good things for those alpha factors than if they wanted more of them. Again, I'm speculating a little bit here, because the true answer is, I don't know. It's too complex. There are too many variables at play that will determine whether value beats growth or large beats small or U.S. beats international. And I think anyone that has a falsely precise prediction on those things is fooling themselves and fooling others, because there's just too much complexity.

Benz: You recently said that you think value could outperform in the coming years if legacy companies outside of the tech sector adopt the very same technologies that have disrupted their businesses in recent years. Can you expand on that thinking?

O’Shaughnessy: I really went out on a limb there with the “could.” Again--and it sounds like an uncommitted answer, but I think intellectually honest position--I think, yes, if value outperforms, it will be for one of two reasons. We know where equity returns come from. It's three sources-- and really, it's two sources: It's change in multiple, is the market consensus of the value of the business and something like a P/E ratio better or worse than when you bought it? And fundamental growth, are the earnings going up or down? And you can really boil down all return into those two categories. So, if value does well versus growth, it will be in one of those two categories. So, let's maybe touch on each.

From a fundamental growth perspective, growth always beats value. It's not controversial to say that. It's clear in the data. Fast-growing companies outperform slow-growing companies when it comes to earnings growth or something like this. But the question is by how much. So, since 2010, this dominant period for the FAANG stocks and the famous big technology stocks, that gap has been really wide. But it's also been really wide in terms of the multiple change. So, growth companies were more pricey to start. Now, they are way more pricey than value. So, they've gotten it both ways. The businesses have grown faster, and the market's expectation of future growth has grown more than for value. And where that leaves us today is that the spread just on price/earnings ratio, how much you have to pay for a growth stock versus how much you have to pay for a value stock is the widest it's ever been, by a lot--way wider than in March of 2000, which, as researchers we thought we would never ever see again. And during 2020, we saw that spread explode through the March 2020 period. And you need to look no further than a company like Snowflake, where here you have this incredible business by any measure, it's an incredible business, but trading at 100 times plus sales or revenues. In the public markets at $100 billion valuation. That's just an incredible thing. If value does well, it will probably be because the markets say, wait a minute, it's not worth 100 times sales, maybe it's worth 20 times sales. That would still be a crazy valuation, but it's an 80% contribution decline in the stock price. So, value could do well that way that the market realizes, wait a minute, these growth stocks are great, but they are not worth this much relative to the rest of the market.

And the second way is more what you were saying that I must have written somewhere, which I certainly do believe is true, that the fundamental growth, the earnings growth of the value businesses may do very well relative to growth or relative to how they have versus growth over the last 10 years, because they are using all these same technologies that have led earnings growth for Microsoft and Amazon and Netflix and all these other great places in their own businesses. And we are already seeing this in many places like old-world businesses being transformed into new-world ones like a company like Adobe. Even though it's always been a software maker, it was an old-world software maker and it adjusted to the cloud and has done incredibly well. And I think you can see that across a lot of sectors. So, those are the two ways that value would do better. I wish I could be more of a Nostradamus and predict something specific, but I just think that would be foolhardy.

Ptak: The factors you focus on are financial strength, earnings quality, earnings growth, value momentum, and shareholder value. You use the first three, if I'm not mistaken, to weed out, call them “bad firms,” that might go to zero and then apply the last three to the remaining stocks to identify those that will outperform. What lessons has the past decade or so imparted about the role and relative importance of those factors?

O’Shaughnessy: Well, actually, interestingly, those factors all map back on to that idea of where returns come from. So, I left out the third category, which is yield, income that either through dividends or buybacks that companies send back to investors. That is the third category of return. So, all six of those factors map on to either yield, multiple growth, or fundamental growth. And what we've learned, and we've always believed this, is like anything in investing, you want to be diversified. You don't want to put all your eggs in the multiple expansion basket, which is the value factor. You don't want to put all your eggs in the momentum factor, which is the fundamental growth concept. You don't want to put all your eggs in the shareholder yield basket, which is the income source of return that's being targeted. So, diversification works. Even though value has been crushed in the last 10 years, momentum has done incredibly well. You still probably didn't do as well if you had a large value exposure as, say, a broad index or a momentum-only strategy. But that's definitely been one key lesson is that you have to diversify, not just across asset classes and within a portfolio in terms of the number of stocks you own, you have to diversify across factors too. And I think the last decade taught us that in spades.

The second thing it taught, which it’s taught many investors in generations before, is that if you don't really buy into the structural advantage of these factors long term, you will get scared out of them, because there will be some long period when they do poorly and your metal is tested, and it's tempting to abandon the strategy. And lots of people did that. And for some people, that's the right decision. For others that understand the sourcing of these returns and stuck with it, I think that long term, they will be rewarded. But those are the two big lessons I take away is you want diversified factor exposure and you need to be able to understand that these things take time, and you have to have the metal and the conviction to stick with them. And if you don't, don't bother with factor investing, because it won't be right for you.

Benz: Where have you seen the steepest erosion in advantages that systematic investors like your firm might have enjoyed in the past? And how have you adapted to that change in the way that you run money?

O’Shaughnessy: So, I think, for sure, the one where there is clear erosion is the market capitalization factor. We've never used it, meaning we have never biased our portfolios toward small stocks deliberately as a standalone factor. All the other factors have that bias baked into them. So, you'll tend to have a slightly smaller market-cap portfolio, even if you don't actively seek a smaller portfolio. But that factor, I think, either never existed or is gone, meaning we don't expect small cap to outperform large cap just because they're small. And there's a couple of reasons for that.

One, the research originally placed a lot of that return in the tiniest companies that no real large investor could own in the first place. So, it's sort of an academic, not real-world exercise and therefore should be ignored. But second, by virtue of popularity of that factor--just think about it again, supply and demand--if you add up every micro-cap and small-cap stock, all of the market cap of the Russell 2000 adds up to like a couple of the big mega-cap companies. So, this is a small total universe of market cap, and too much demand will erode an advantage that was or wasn't there beforehand. So, that's probably the most obvious one that I think people should think about is that you are not going to get paid just for owning small cap and that's it. And we certainly have made sure our portfolios aren't based on that core idea.

And then, more broadly speaking, I think everything has a half-life. So, we've been very vocal about the fact that we don't believe in nor do we use the price/book factor for measuring value because, while it was a great measure when companies were mostly about PP&E and their factories and the hard asset value that they had as a measure of their fundamentals, that's just not true anymore. And how do you measure a brand value of a Google or of software or of all these other things? It's very hard to put into book value. So, you have to evolve. And that's one simple example of just don't use that factor anymore. Find things that are more representative of how the world actually works today. And we are doing that constantly. That's every quarter, every month, every year, that's something that I think all good quantitative investors are trying to improve upon is how they measure their core principles, but then sticking to the core principles--the ideas of value, momentum, yield, quality, and so on--because those themselves are likely timeless concepts.

Ptak: Let's shift and talk about podcasting. Looking back, can you talk about what you expected to get out of the "Invest Like the Best" podcast that you host, when you started it, and what the actual experience has been?

O’Shaughnessy: It's a very simple answer. I didn't expect anything. I expected to learn, and that's why I did it. I was trying to expand my personal horizons beyond just pure quant. I was interested in everything. I still am interested in everything, from growth investing to software to cryptocurrencies to boring value investing to you name it and I find it interesting. And I had spent my career to that point really focused on knowing everything about one thing. And I was ready to move on from that. And so, I did. And I tried a lot of ways to do that. And I believe very deeply in this mantra I have, which goes: learn, build, share, repeat. And that share portion is really key. It's I think the one that the fewest people do. A lot of people learn, fewer build, fewer share what they've built. And I wanted to do all of them and do it over and over again.

So, my producer, Matthew, if he is listening, will laugh. I remember telling him, “I'm going to try seven of these. And if it's any fun, or any good, we'll keep going.” And I've missed very few weeks over five years. In fact, we've doubled and tripled the amount of output this year with a more focused strategy now. But in the early days, I expected nothing but to learn. And I surely did that in spades.

Benz: What have been your favorite conversations and why?

O’Shaughnessy: So many of them. I certainly couldn't pick one or two. There are so many that have changed the way I think about something big or something small. I've come to believe, literally, anyone you talk to has something interesting to teach you, doesn't matter who they are, what their background, doesn't matter. Everyone's got something interesting to teach. And so, everyone, honestly, teaches me something.

Some are enormous. There's a gentleman named Chetan Puttagunta, who is a partner at Benchmark Capital, who I was just thinking about today, because he basically gave us the playbook for how to build custom indexing in Canvas. Not because he knew anything about custom indexing, but he knew how to build enterprise software and had been a part of a lot of the most interesting enterprise software companies as a board member. And without him, I don't know that we would have the success or even the vision that became Canvas. There are so many others like that that influenced the way we think.

There's a guy that comes to mind named Nick Kokonas, who runs a restaurant group in Chicago, the world's best restaurant arguably, and came from a Wall Street background. And honestly, I think you could give that conversation in lieu of a business school and you'd be better off, because it's just a masterclass in how to think about a business and how to build businesses that matter and that are successful. And there's just so many of these things. But the beauty of them all is that they impacted me in many ways, sometimes small, sometimes big, but by sharing them, by forcing yourself to share what you learn and not hoard it, not hoard the lessons, it's like this open sourcing of knowledge that just benefits everybody. And I know of a lot of value in commerce that's happened as a result of my podcast that I've had no participation in. And I love that. I love that there is a lot more value created in this open model than captured. And I think long term it's a fantastic place to be. So, hard to pick one, but those two maybe come to mind.

Ptak: You're a voracious reader. What are the best financial and nonfinancial books you've read lately?

O’Shaughnessy: There are almost no good financial books. I don't think. I almost never read an investing book. Even the very best ones are I don't think that great. I think that in investing, as with most kinds of risk taking, you can kind of only learn by doing it. And you should still read a lot. I'm not saying you shouldn't. It's great to learn from the mistakes of others. But there's nothing like your own mistakes in my experience, and investing is a great way to make a lot of mistakes quickly.

So, I couldn't tell you the last great investing book that was meant to be an investing book that I read. I think Morgan Housel's Psychology of Money is a fantastic finance book and sort of psychology book. I don't know that it's an investing book. So, shout out to Morgan on that one. Other than that, look, I read everything you can imagine. I read a lot of philosophy. That was my original background. I still read a lot of that. I read a lot of narrative nonfiction. I enjoy that a lot. But I also read far fewer books than I used to, because I think a book as a piece of technology is actually quite antiquated these days. And so, I really don't read nonfiction anymore, unless it's narrative and interesting.

I read a lot of fiction. And so, most of my answers would be there. I just re-read The Razor's Edge by Somerset Maugham--I think that’s how you pronounce his last name. It was just amazing. It's such an incredible read. But as a technology, nonfiction books kind of stink. They're not specific enough and yet somehow still overlong. They are based on the needs of the publishers, not the desires of the authors. And you can find much denser, richer information in podcasts and essays and articles and things like that, and on Twitter. So, I spend more of my learning time there, not in books anymore, sadly, because I used to read so many books. But I sort of think nonfiction books have had their day in the sun and are on the way out.

Benz: You work with your dad, Jim O'Shaughnessy, someone who has been a pioneer in his own right. What was the most valuable lesson he imparted to you as you were taking the leadership reins from him?

O’Shaughnessy: Good question. The most valuable lesson was not something he told me. It's just something he did, which was that he left me alone. He said it was my responsibility and that he wanted to know what was going on and to run major strategic decisions by him, which was always and remains incredibly fun to do. But on literally day one, he gave me an incredible amount of autonomy. And I have tried my best to do that with others that I work with--set a course and then really, really give people autonomy to do the right thing and to make decisions for themselves. I think that lesson alone has been incredibly powerful. It's something that, having been on the receiving end of it, I get why it's such a smart thing to do, even though it's hard, it's very hard to do. It's hard to relinquish control when you're opinionated and excited and engaged. But it's always, almost always, the best thing to do so long as you have really talented people. And so, I would say, he never said: go do this with everybody else. But just by him doing it, that's what I've tried to do. So, that's probably the most powerful thing.

Ptak: Well, Patrick, this has been a really enjoyable discussion. Thanks, so much for sharing your insights and perspectives with us. We really appreciate it.

O’Shaughnessy: Really interesting, wide ranging set of questions. So, I really appreciate you having me on. Thank you very much. Really fun.

Benz: Thank you so much, Patrick.

Ptak: Thanks for joining us on The Long View. If you liked what you heard, please subscribe to and rate The Long View from Morningstar on iTunes, Google Play, Spotify, or wherever you get your podcasts.

You can follow us on Twitter @Syouth1, which is, S-Y-O-U-T-H and the number 1.

Benz: And @Christine_Benz.

Ptak: George Castady is our engineer for the podcast and Kari Greczek produces the show notes each week.

Finally, we'd love to get your feedback. If you have a comment or a guest idea, please email us at Until next time, thanks for joining us.

(Disclaimer: This recording is for informational purposes only and should not be considered investment advice. Opinions expressed are as of the date of recording. Such opinions are subject to change. The views and opinions of guests on this program are not necessarily those of Morningstar, Inc. and its affiliates. Morningstar and its affiliates are not affiliated with this guest or his or her business affiliates unless otherwise stated. Morningstar does not guarantee the accuracy, or the completeness of the data presented herein. Jeff Ptak is an employee of Morningstar Research Services LLC. Morningstar Research Services is a subsidiary of Morningstar, Inc. and is registered with and governed by the U.S. Securities and Exchange Commission. Morningstar Research Services shall not be responsible for any trading decisions, damages or other losses resulting from or related to the information, data analysis, or opinions, or their use. Past performance is not a guarantee of future results. All investments are subject to investment risk, including possible loss of principal. Individuals should seriously consider if an investment is suitable for them by referencing their own financial position, investment objectives and risk profile before making any investment decision.)