How does the choice of using index funds or core funds with an emphasis on value, size, and profitability impact your retirement savings?
Mathieu Pellerin, Senior Researcher and Vice President at Dimensional Fund Advisors, shares his recently published research on the impact of factor investing on retirement outcomes.
Listen now and learn:
- How a core portfolio differs from an index portfolio
- The impact of investment strategy on accumulation, decumulation, and bequest outcomes
- When short-term ends and long-term begins
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Show Notes
Mathieu Pellerin is a Senior Researcher and Vice President at Dimensional Fund Advisors. He conducts research on goals-based investing with a focus on retirement and works closely with clients to translate research insights into solutions that address their needs. He also has experience working on ESG topics.
Mathieu is a regular speaker at industry events, and his research has been featured in the New York Times, MarketWatch, the Harvard Law School Forum on Corporate Governance, and other finance industry outlets. Before joining Dimensional, Mathieu earned a Ph.D. in economics from Brown University, where he specialized in econometrics and survey statistics.
In this conversation, we discuss Mathieu’s recently published research on the impact of factor investing on retirement outcomes.
These days, most employer-sponsored retirement plans such as 401(k), 403(b), or 457 plans offer index funds and/or target date funds comprised of broad market index funds. Total market index funds are popular among investors seeking a straightforward and cost-effective way to participate in the overall performance of the stock market.
Mathieu’s research compares these broad market portfolios to a “core” portfolio with moderate overweights to size, value, and profitability factors.
Here are notes from my conversation…
Defining The Factor Tilts (4:45)
- Value factor refers to the propensity of stocks with a lower relative price to outperform stocks with a higher relative price. Basically, cheap beats expensive.
- Profitability refers to the tendency of firms with high operating profits relative to their book assets to outperform unprofitable firms. Mathieu notes that this is especially true when investors pair it with value because profitable firms tend to have a bit of a growth tilt.
- Size refers to the tendency of firms with a smaller market capitalization (small cap) to have higher expected long-term returns than large-cap firms.
Mathieu notes that there are other factors Dimensional considers that he could have included in the research, but these three are the most material drivers of differences in performance.
Factor Investing Impact on Retirement Savings, Decumulation, and Bequests (8:09)
It’s common to look at investment strategies by comparing their average annual returns. As Mathieu notes, the core portfolio used in his research has historically outperformed a broad market index by roughly one percent a year.
But he wanted to make that number more tangible for savers.
Impact on Retirement Savings
Mathieu’s research starts by comparing two investors who contribute the same amount to a retirement account from age 25 to 65, invested in a mix of stocks and bonds that gets progressively less aggressive as the investor approaches retirement—much like a target date fund glide path.
His results show that an investor in the core portfolio will typically retire with 20% more assets than an investor using the broad market index portfolio. In other words, if the market portfolio investor retires with $1 million, the core portfolio investor retires with $1.2 million.
Their research team performed this analysis with savers making rising contributions over the course of their careers. This makes sense because usually, a 25-year-old investor has less income to save and more in their 50s and 60s. In this analysis, the result is closer to a 15% outcome.
The reason he likes this type of analysis is that it makes it easier to digest how small differences in returns make a big difference in retirement outcomes.
Impact on Retirement Spending
Next, Mathieu describes the impact of a market portfolio versus a core portfolio on sustained retirement spending. After all, saving for retirement is only half of the equation. You must consider how investment returns impact the decumulation phase of your life.
Mathieu assumes investors entering retirement have a 50/50 mix of stocks and bonds and spend 4% of their initial assets adjusted for inflation every year. In this base-case-type scenario, the failure rate was very low for both the market and core portfolios. However, when evaluating a scenario in which stock returns are lower than they’ve been historically in the long run, the core portfolio is about 13% compared to the market portfolio failure rate of about 20%.
Whenever we start talking about investment choices and tradeoffs, it’s important to think about how you can minimize regret. That’s why I found this next part of Mathieu’s paper so interesting.
I’ve also talked about this in my episode on minimizing regret.
Below is a table from Mathieu’s paper, classifying outcomes from 100,000 simulated 30-year retirements into four buckets. As Mathieu points out in our discussion, the instances where market and core both succeed or both fail aren’t terribly interesting—it’s the periods in which one strategy succeeds and the other fails that introduce the opportunity for regret.
To me, this is an interesting visual for savers that might regret a decision to use a factor approach to investing akin to the core portfolio described in this research. The probability that you fail in retirement is very small in absolute terms, but it’s also very tiny compared to the more likely scenario of the lower expected returns provided by a market portfolio.
Impact on Bequests
The last finding of the paper has to do with bequests. Using a historical return distribution, the median bequest as a percentage of initial retirement assets is 29.2% higher for the core portfolio than the market portfolio. That’s a meaningful difference in dollars if you’re passionate about leaving money to family or charity.
Implementation of a Core Portfolio (16:40)
As I mentioned earlier, there is a lot to like about a broad market index portfolio. It’s low-cost, highly diversified, rules-based, transparent, and tax-efficient. A core weighting scheme has those same characteristics. The key differentiator is the rules governing the portfolio’s construction.
A broad market index portfolio weights companies in the portfolio by the size of their market capitalization. This removes any need for prediction or human judgment, which we know is a risk factor.
I’ve discussed this in my post on Why Expert Predictions Are Bullsh*t and my episode on The Failure of Active Management.
The core weighting scheme is also rules-based, starting with market capitalization weighting and adjusting those weightings based on certain characteristics. For instance, a large-cap stock with value characteristics might be overweighted. A small-cap stock might be overweighted.
On top of the weighting scheme, there are some targeted exclusions. For instance, within the small-cap segment, firms with the highest asset growth historically have abysmal returns. This is a very small segment of the market, so their exclusion maybe drops 200 names out of 3000.
The goal is to use those kinds of adjustment factors so that you still hold a very broadly diversified portfolio with weights that aren’t too far out of whack with the market. How hard you tilt towards factors relative to market prices creates tradeoffs between the degree of tracking error and higher expected returns.
The other thing Mathieu notes is that trying to use factors that aren’t perfectly correlated (like value and profitability) can help smooth out some of the tracking errors. Ideally, you end up with something very close to the market portfolio but with enough of a tilt that you can expect to outperform over the long run.
How to Think About Tracking Error (21:08)
Something I point out at this point in the conversation is that we are comparing two very good investment options. While the core portfolio improves outcomes over a broad market index portfolio, the broad market index portfolio is much better than many options found in retirement plans.
While the core portfolio Mathieu describes leads to better outcomes in his research, I think it’s really important for investors to realize that the journey to such outcomes isn’t a pain-free experience.
A common phrase used throughout our conversation was “tracking error,” which is simply the difference in performance between the investment strategy and the benchmark index. The moment you decide to deviate from the market portfolio, you’re going to introduce a tracking error.
Everyone loves positive tracking error, more commonly referred to simply as “outperformance,” but negative tracking error is something you must accept in exchange for higher expected returns. I’ve come to learn in my career that it doesn’t matter if you’ve built the perfect portfolio or chosen the best-designed investment product if the end investor can’t stick with it through periods of negative tracking error (i.e., underperformance).
So, I asked Mathieu how one should prepare for inevitable periods of underperformance of a core/factor portfolio versus a broad market index portfolio.
Mathieu suggests that how you think about the inevitable periods of underperformance in advance is essential. His first question is perhaps the most important for advisors recommending this approach than clients adopting it, which is: How much do you really trust this approach?
It is probably unreasonable to expect clients or end investors to dedicate the time to review all of the evidence and theoretic rationale, but advisors obviously should be doing so with any investment they make, factor or otherwise.
The second question Mathieu suggests asking yourself is: How much pain am I willing to take?
This is really just a matter of assessing your risk tolerance. Financial planning can often uncover a person’s ability to tolerate risk, but the willingness to tolerate risk is much more subjective. How would you feel trailing an index by 3% in a year? How about underperforming by 6%? How about trailing an index by 1% per year for a decade?
These are important questions to ask in advance that set expectations, much like setting expectations for the overall market’s tendency to experience losses. When periods of relative or absolute losses present themselves, the best thing to do is stay the course.
Having an advisor makes this far easier than if you are making your investments on your own. Individual investors don’t have somebody to act as that ballast and keep their hand on the wheel when things don’t look like maybe they’re working.
When Does Short-Term Become Long-Term? (28:32)
One of my favorite things to talk about with researchers is the definition of “the long-term.” Financial theory tends to play out fairly consistently in the long term, but quarters and even years often feel like an eternity.
So when does Mathieu believe the short-term becomes the long-term? He says the answer is always going to be context specific.
Within the context of this conversation in choosing between a core portfolio and a market portfolio, he doesn’t think the time horizon will make a lot of difference, in part because equities are a long-term horizon holding.
I’ll admit that I feel this way about my own investments, but I don’t know that this is really true for how clients feel about time horizons. While I’ve always thought about investment decisions with a multi-decade horizon, I know from client meetings that their definition of long-term doesn’t always align with what I would consider long-term from a historical, statistical, or financial perspective.
We don’t live in a spreadsheet where the long-term doesn’t always feel so long. To me, this seems like a conversation investors ought to have before choosing an investing strategy.
Resources:
- How Targeting the Size, Value, and Profitability Premiums Can Improve Retirement Outcomes by Mathieu Pellerin (full article)
- How Targeting the Size, Value, and Profitability Premiums Can Improve Retirement Outcomes (summary article)
- How to Minimize Regret (Read)
- EP. 7: How to Minimize Regret (Listen)
- Assessing Your Risk Tolerance
- EP. 2: How I Invest My Money
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