There is no such thing as a perfect portfolio. There is only the portfolio that you can stick with for as long as possible. In this episode, Vanguard’s Liz Anne Muirhead and Natalie Marvi-Romeo explain three evidence-based strategies for your portfolio: Index Investing, Factor Investing, and ESG Investing.
Listen now and learn:
- The case for each of these different investment strategies
- What potential shortfalls each strategy presents
- How to choose the strategy that’s right for you.
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Show Notes
There is no such thing as a perfect portfolio. There is only the portfolio that you can stick with for as long as possible.
In this episode, I speak with Vanguard’s Liz Anne Muirhead and Natalie Marvi-Romeo about three evidence-based investment strategies: Index Investing, Factor Investing, and ESG Investing.
Liz Anne and Natalie are senior portfolio specialists with Vanguard Financial Advisor Services, where they provide Vanguard’s insights and outlook to advisors and their clients.
Listen now and learn:
- The case for each of these different investment strategies
- What potential shortfalls each strategy presents
- How to choose the strategy that’s right for you.
Here are some notes I took from the conversation…
There is no perfect portfolio, no one-size-fits-all, so it’s important to find a strategy that you can stick with for as long as possible. So we walk through three equity strategies at a high level, starting with Factor Investing.
The reason I asked Vanguard to speak to these three strategies is that they offer them all, so they don’t have any bias or preference towards one over the other.
3:37 – The case for Factor Investing
Factor investing is a systematic method of allocating to securities with characteristics (or factors) that have historically earned higher expected returns.
Liz draws on her decade of experience doing manager research to explain that factor investing was born out of an evolution in our understanding of the alpha an active manager creates. Attribution models used to assess manager skill have come a long way.
Back in the 1980s, managers were all compared to the S&P 500. Then, there was the realization that value and size were significant influencers of long-term returns. As attribution models got more sophisticated, it became clear that most of the value-added by active managers was really strategic factor biases rather than true manager skill.
Investors then started to question the need to pay an active manager when those factor exposures could be systematically replicated at lower costs. Enter factor investing. The technology and data available has allowed managers and firms to offer systematically structured factor products with consistent exposures to their targeted exposures at a low cost.
Empirically, there is well-proven support for factor risk premium in areas like value, momentum, quality, liquidity, and volatility. But capturing them requires patience.
Ten years ago, there was some talk that these factors get crowded out because everyone knows about them. But even if people know about them, it doesn’t mean that they’re patient enough to wait through long periods of underperformance. Value investing, for example, has required investors to wait over a decade to start coming back against growth recently.
6:05 – Potential concerns for Factor Investing
While there’s a lot of empirical evidence supporting factor investing, it can be very difficult behaviorally. When you look at 10-year or 20-year periods, the win rates for factor investing look great. But 20 years feels like an eternity in the moment. And people may not feel like they have 20 years.
This is probably the most important concern or consideration. Style factors can underperform for long periods of time, so patience to stick with your investment strategy is paramount. Your success or failure in achieving the long-term empirically proven benefit of factor exposures is going to be whether you can stay the course through some periods of underperformance.
Another consideration is that there’s no one single way to build and implement factor portfolios. That means you must understand how any given provider is building their portfolios and whether that leads to any unintended consequences.
A final thing to keep in mind is that factor investing may not be as tax efficient as other alternatives.
8:33 – Who is a good fit for Factor Investing?
Investors that are committed to using factors as a strategic tool, not a tactical one, are going to be good candidates for factors.
Factor rotation – choosing which factor will perform well and when – is really hard to get right. Most managers that try such a strategy will underperform.
Someone who can tolerate a tax inefficient portfolio or has adequate space in their tax-sheltered accounts for factor investments.
Another use case might be an investor who has built a portfolio of high conviction active products and, in doing so, may have an unintended factor tilt to their portfolio that is no empirically supported. A small allocation to a factor strategy can help neutralize that unintended exposure while staying invested in their highest conviction products.
10:24 –ESG risks impact a company’s value
There has been a sentiment shift from investors over the past few years. ESG investing used to be associated with giving up some returns. Now the belief is that integrating ESG risks to the investment process can potentially improve returns.
Vanguard’s research on U.S. equity ESG mutual funds and ETFs over a 15-year period concludes that ESG funds have neither systematically higher or lower raw returns or risks than the broader market. It really must be evaluated on a fund-by-fund basis.
Vanguard also has a believe that unchecked ESG risks can potentially negatively impact a company’s long-term value, so they engage with companies as they’re voting proxies.
For example, think about a mining company with a mine that collapses. There’s the loss of human life, of course, but there’s also environmental risks. Maybe it’s spewing chemicals on the ground and getting into the water. The fines and cost of clean up is going to translate into value destruction.
Or think about what material risks to a service company liked data. Data is pretty important to most service companies, but if we think about a bank as an example, a data breach could result in fines, expenses, and customers – again, all translating into value destruction.
13:57 – Ways to Be an ESG Investor
Read More: 6 Methods to Consider When Choosing an ESG Investing Strategy
Socially responsible investing is the oldest method. It uses negative (exclusionary) screening to avoid companies that have a product or service that don’t fit with an investor’s values.
- Pro: Transparent and easy to understand
- Con: Lack of exposure to large segments of the market. Also, miss out on companies within those screened-out segments of the market that are managing their ESG risks well.
Positive screening uses ESG ratings from one of a variety of rating agencies to target companies with the best ratings versus their peers or other investment opportunities.
- Pro: Transparent and easy to understand.
- Con: Lack of standardization in ratings. Companies self-report.
Active ESG (what I’ve historically referred to as an integration approach) is where managers take ESG risks and opportunities into consideration as part of their fundamental analysis. The difference between classifying something as active ESG versus simply an ESG integration approach would be that active ESG is likely going to be engaging with the company management and boards to try to influence them on key ESG issues.
- Pro: Captures companies trending in the right direction.
- Con: Harder to align with your values.
Impact investing allows a person to have a positive impact on the environment or society while also getting a financial return. Historically it’s been mostly in the private markets, but there have been more public market opportunities recently (particularly in fixed income).
- Pro: Easier to target investments that match your values
- Con: Because it’s often done through private equity, there is less liquidity. Also less diversified, higher cost, and higher tracking error.
Thematic investing selects securities in a really granular theme such as energy, health, innovation, diversity, leadership, etc.
- Pro: Closely align investments to your values
- Con: Less diversified, higher costs, and higher tracking error.
ESG Investing is a good fit for anyone that wants to align their investments with their personal values.
If that’s you, then you need to decide (1) what are your goals, (2) what are your options, (3) what approach will you choose, (4) how do you document it, and (5) how do you assess it.
20:37 – Stewardship and the impact of proxy voting across all investment strategies
Vanguard was one of the first large asset managers to vocalize their role in stewardship.
For ESG funds, you want to know if proxy votes are being made at the fund level rather than the firm level. If you start with the belief that unchecked material ESG risks can potentially negatively impact long-term returns, you really must balance both the ESG goals of the fund as well as the fiduciary duty to shareholders to earn a return.
An index fund is likely to be both a larger holder of stock as well as an extremely long-term one (in many cases some stocks are held almost in perpetuity). Even though indexing is considered to be passive, engagement with boards and proxy voting doesn’t have to be.
Vanguard in particularly focuses on board composition and effectiveness, board oversight of strategy and risk, and executive compensation. Basically, they want to hold company boards accountable to ensure the company is managed in a way that is aligned with investors so that the passive investors in index funds are actually getting the most out of their long-term investment in those companies.
26:31 – The case for indexing
There are four main things.
- Investing is a zero-sum game. For every stock that outperforms, there is a stock that underperforms. For every manager who is outperforming, there’s one taking the other side of every single one of those trades. The market average is derived from that aggregate performance, and it’s really hard to always be on the positive side of that distribution chart.
- Cost. Every piece of research h shows that costs are a significant influence on long-term returns. Generally the lower the cost, the better the long-term investment results. That indexing can be done at the lowest cost possible is a real tailwind for investors in that strategy.
- Taxes. Just like costs, taxes can really eat away at investor returns. Most traditional index funds, which are market-capitalization weighted, are managed in a fairly tax-efficient manner.
- Even though there is an opportunity to invest in outperforming managers, it’s very difficult to actually choose that manager in advance. Research shows that looking at historical performance is not a great way to choose the outperforming manager going forward. So when you think about how the average active investor underperforms long-term after taxes and fees, that’s a big incentive to index.
28:57 – Potential downsides of Index Investing?
The most important thing is to know your investment. There are still some firms offering high-cost index products. There are products that are positioned as indexing that aren’t such as alternatively weighted products, which an element of active management.
Another thing that is a potential downside in a traditional index approach is that you can’t underweight or exclude a company that you’re concerned about from an ESG perspective, debt load perspective, or something else that could negatively impact value. Similarly, if you wanted to benefit from a small cap or value premium, an index approach in its purest sense doesn’t really allow for it.
30:26 – Who is a good fit for index investing?
Anyone can be a good fit for index investing. It’s almost like the default approach.
There are lots of reasons to go into ESG or factors, but there are also so many positives about getting the market return from a fiduciary and investment perspective. Just set it and forget.
Somebody who is seeking consistent and transparent exposure to an asset class. Someone who would benefit from reduced transaction costs, management fees, and tax costs. And most importantly, if someone doesn’t have the stomach for an active manager or a factor strategy, indexing is a good idea.
Research shows the behavioral tendency is for investors to not stick with a manager or strategy over the long term – they tend to buy high and sell low. So investors end up with returns that are worse than the fund’s returns.
Book recommendations:
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Long-term investing made simple. Most people enter the markets without understanding how to grow their wealth over the long term or clearly hit their financial goals. The Long Term Investor shows you how to proactively minimize taxes, hedge against rising inflation, and ride the waves of volatility with confidence.
Hosted by the advisor, Chief Investment Officer of Plancorp, and author of “Making Money Simple,” Peter Lazaroff shares practical advice on how to make smart investment decisions your future self with thank you for. A go-to source for top media outlets like CNBC, the Wall Street Journal, and CNN Money, Peter unpacks the clear, strategic, and calculated approach he uses to decisively manage over 5.5 billion in investments for clients at Plancorp.
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