Illiquidity smoothing and diversification myths

In this episode, we're joined by Mamdouh Medhat, VP and Senior Researcher at Dimensional Fund Advisors, for an exceptionally deep, exceptionally nerdy exploration of factor investing—focusing on profitability, value, defensive equity, and the persistent misunderstandings that surround them. Mamdouh walks us through his retrospective paper (co-authored with Robert Novy-Marx) on the profitability premium, why profitability subsumes a wide range of quality metrics, and why it dramatically clarifies how we should think about defensive/low-volatility strategies. He also explains the role of profitability in value's US underperformance since 2007, why price-to-book remains a remarkably effective valuation metric, and how Dimensional incorporates these insights into portfolio construction. In the second half of the conversation, we shift to private markets. Mamdouh unpacks Dimensional's research on buyouts, venture capital, private credit, and private real estate—revealing what percentage of the global investable universe these funds actually represent, how to benchmark them properly, how much dispersion exists across managers, how fair-value accounting changed the game post-2007, and why many perceived diversification benefits are actually just return smoothing.

Key Points From This Episode:

(0:04) Intro to Mamdouh Medhat and why his research fits the Rational Reminder "nerdy happy place."

(1:32) The story behind Mamdouh's retrospective paper with Robert Novy-Marx and the impact of the original profitability research on academia and practice.

(5:36) Three things the paper examines: quality investing, defensive/low-risk strategies, and value—unified through profitability.

(6:55) Why none of the 15 major academic and practitioner quality metrics add explanatory power beyond profitability.

(8:18) How spanning tests show profitability explains quality, but quality does not explain profitability.

(12:24) Quality measures largely load on profitability—they're noisier versions of the same thing.

(13:14) The link between quality metrics and fundamental momentum, especially for QMJ and quarterly ROE.

(15:18) Practical implications: profitability is a parsimonious, more efficient way to capture the "quality" dimension.

(16:30) Defensive equity through the profitability lens—why high profitability predicts low volatility.

(18:58) Why long-only low-volatility strategies produce zero five-factor alpha—and why a simple high-profitability/low-investment portfolio plus T-bills beats them.

(22:14) Alternative value metrics (EBITDA/EV, intangible-adjusted book-to-market, etc.) don't outperform price-to-book when profitability is accounted for.

(24:57) Many "improved" value metrics simply rotate in profitability exposure, not better value information.

(26:17) Roughly half of US value's post-2007 underperformance is explained by its negative correlation with profitability.

(28:42) Industry tilts (e.g., energy/financials vs. tech/healthcare) drive much of value's volatility—not its long-term return.

(30:33) The theoretical case for combining clean valuation (price-to-book) with clean expected cash flow (profitability).

(33:36) Academic implications: models must jointly explain value and profitability—and their negative correlation.

(35:09) Practitioner implications: parsimony—use clear valuation and cash-flow measures, limit excessive complexity.

(36:53) How Dimensional measures profitability: operating profitability (revenue – COGS – SG&A – interest) scaled by book equity.

(41:09) Why tilting toward or away from countries based on aggregate characteristics rarely adds value—premiums come from stocks, not countries.

(42:57) Industry-level tilts show similar patterns—industry momentum exists but is impractical due to massive turnover.

(46:15) How Dimensional handles country and industry weights: sort within countries, then apply sector caps.

(48:27) Private markets: private funds make up roughly 10% of the global investable universe—not 25–100% as sometimes claimed.

(50:53) Benchmark choice for private funds is crucial—S&P 500 is not appropriate for buyouts or VCs.

(52:00) Using KSPME (public-market equivalent), buyouts and VCs match small-cap value/growth benchmarks; private credit matches high yield; private real estate underperforms listed real estate.

(55:50) Factor exposures post-2007 explain 70–80% of private-fund return variation due to fair-value accounting.

(1:00:48) Wide dispersion in private-fund performance—top 5% double or triple capital; bottom 5% lose half.

(1:03:49) Little evidence of manager persistence—manager selection must rely on due diligence, not past vintages.

(1:08:24) No strong time trend in private-fund outperformance, but correlations with public markets have increased.

(1:09:13) Many diversification benefits historically attributed to private assets were actually illiquidity-driven smoothing.

(1:12:25) Rising demand and democratization likely reduce expected returns in private markets—exclusivity is fading.

Links From Today's Episode: Meet with PWL Capital: https://calendly.com/d/3vm-t2j-h3p

Rational Reminder on iTunes — https://itunes.apple.com/ca/podcast/the-rational-reminder-podcast/id1426530582.

Rational Reminder on Instagram — https://www.instagram.com/rationalreminder/

Rational Reminder on YouTube — https://www.youtube.com/channel/ Benjamin Felix — https://pwlcapital.com/our-team/

Benjamin on X — https://x.com/benjaminwfelix

Benjamin on LinkedIn — https://www.linkedin.com/in/benjaminwfelix/

Cameron Passmore — https://pwlcapital.com/our-team/

Cameron on X — https://x.com/CameronPassmore

Cameron on LinkedIn — https://www.linkedin.com/in/cameronpassmore/

Editing and post-production work for this episode was provided by The Podcast Consultant (https://thepodcastconsultant.com)