In this podcast Jason interviews Todd Schlanger, CFA. Mr. Schlanger is a senior investment strategist in Vanguard’s Investment Strategy Group (ISG) where his responsibilities include research on portfolio construction and asset allocation, model portfolio development, and tailored portfolio solutions.
Resources mentioned in this episode:
Vanguard
Centers For Research In Security Prices
Transcript:
Welcome back America to Sound Retirement Radio, where we bring you concepts, ideas, and strategies designed to help you achieve clarity, confidence, and freedom as you prepare for and transition through retirement. And now here is your host, Jason Parker.
Jason Parker:
America, welcome back to another round of Sound Retirement Radio. So glad to have you tuning in today. It’s my good fortune to have Amelia joining me. She’s been over here giggling the whole time with this joke that she’s bringing, but we like to get the morning started, right? Two ways. The first is by renewing our mind, and so I’ve got a verse here for you. This is one that I have written on the whiteboard in my office Every day I look at this one, this is one of my favorites, Joshua 1:9. Have I not commanded you? Be strong and courageous. Do not be afraid. Do not be discouraged for the Lord, your God, will be with you wherever you go. And then Amelia, you got a joke for us.
Amelia:
I do. And I just have to give a little shout-out to my friend Nikki for this one, so in case she ever hears me.
Jason Parker:
Nikki?
Amelia:
Yeah. Her name is Nikki. All right, so what do you get when you cross an onion with a bean?
Jason Parker:
I don’t know.
Amelia:
Tear gas.
Jason Parker:
[inaudible 00:01:14]. Oh, you’re so funny.
Amelia:
When she said it to me, I couldn’t stop laughing a little bit. I told her I’d try it.
Jason Parker:
I bet [inaudible 00:01:22], I bet my kids would really like that one.
Amelia:
I thought she would. I thought it might’ve been one that she’s already told us so.
Jason Parker:
I can’t wait to get into this interview with our listeners, Amelia. Today I’m bringing on a guest from Vanguard. This should be a good interview. Thanks for being here today.
Amelia:
Thanks for having me.
Jason Parker:
So this interview came to be because at my firm, at Parker Financial, we walk life with people who are getting ready to retire and we manage investments for our clients. We custody at Fidelity Investments, but we use a lot of Vanguard funds for our client’s investment portfolios. We also utilize the research from CRSP, C-R-S-P. CRSP stands for Centers for Research in Security Prices, which is an affiliate of the University of Chicago Booth School of Business. Vanguard has a great reputation for helping keep our client’s fees low, and CRSP has a great reputation when it comes to research regarding asset allocation. We utilize CRSP research to align our strategies with some of the top academic research. Chicago Booth is the second-oldest business school in the world and has nine Nobel Prize winners on its faculty. CRSP helps to bridge the gap between theory and practice. The CRSP research incorporates the most modern and forward-thinking approaches, and Vanguard as a mutual company has low-cost ETFs to help serve our clients.
So let me tell you a little bit about my guest, Todd Schlanger, CFA, is a senior investment strategist in Vanguard’s Investment Strategy Group where his responsibilities include research on portfolio construction and asset allocation, model portfolio development, and tailored portfolio solutions. Mr. Schlanger joined Vanguard in 2005 and has been a member of the Investment Strategy Group for over 10 years with most of that time on international assignments to Vanguard’s London, UK, and Toronto, Canada offices where he was the senior representative for the group in the region. Prior to joining ISG, the Investment Strategy Group, he was a member of the institutional advisory team. He earned a BS and business administration from the University of Scranton and is a CFA charter holder. Without any further ado, let me bring on my guest, Todd Schlanger with Vanguard. Todd, welcome to Sound Retirement Radio.
Todd Schlanger:
Happy to be here.
Jason Parker:
Yeah, thank you for being a guest. I’ve been looking forward to this interview for a long time. I know Vanguard is huge in the investing space, but we should probably start from square one and maybe you could just fill us in, let our listeners know who is Vanguard?
Todd Schlanger:
Sure. So Vanguard is one of the world’s largest asset management companies. We’re headquartered in Valley Forge, Pennsylvania right outside Philadelphia. Founded in 1976. We manage about $7 trillion in assets around the world. I think we’re probably best known as a provider of index funds and ETFs, but we’re actually also one of the world’s largest active managers, if you can believe it. We’re in the top three. They’re around 2 trillion in active assets. I would say our core belief is that lower-cost products will outperform higher cost products, and we can get into that in the conversation. But Vanguard is actually organized as a mutual meaning if you invest in a Vanguard fund or ETF, you’re actually a part owner of the company. And the way that we compensate our owners is by passing on the economies of scale of our business back to them in the form of lower fees. We think index funds, active funds, they can all make sense, but our ownership structure really allows us to provide it all for a low cost.
Jason Parker:
Yeah, we love that. I quote Jack Bogle quite a bit saying that the costs matter hypothesis. What specifically is your role then with Vanguard?
Todd Schlanger:
So I work in what’s called the Investment Strategy Group, and you can think of that as about 70 analysts around the world, probably let’s say two thirds of them in the US but then we also have offices in Europe and Asia. And our role is primarily to answer the question, what does Vanguard think about X, Y, Z investment topic? So my particular role, I work on what’s called the asset allocation team. So essentially, our role is to figure out what different types of investment strategies work for investors achieving different objectives. We also have teams that look at our market and economic outlook, for example, groups that focus on retirement planning, but we’re all essentially the retirement research group at Vanguard.
Jason Parker:
Awesome. I want to dig into all those topics, asset allocation, retirement planning, economics, economic outlook. Before we get into some of the finer details here, why Vanguard? Why did you choose to have a career with Vanguard?
Todd Schlanger:
Yeah, it’s interesting. It was no particular thing. It was like everything came together at once. I knew I wanted to be in investing, the investment management business when I was in university. I remember talking to my father and asking him what different firms he would recommend. He mentioned Vanguard. He didn’t have a lot of specifics, but he mentioned for me that there was something unique about the company and the products tended to perform really well. I talked to some professors at my university, they could give me a little bit more details about Vanguard being known as an index provider, the fact that it was a mutual, and then I reached out to some alumni as well.
I would say the core for me, why I joined Vanguard was really the ownership structure made sense in the sense that you felt like you were doing good for investors by lowering fees. At the same time, it was also a firm that was growing because if your investors do well, they invest more with you and it was a growing business. I really saw that, the opportunity to grow with the company, Vanguard tends to have a longer-term career pathing and some other firms. So I found all that attractive and about 15 years later, I’m still here.
Jason Parker:
Awesome. I’m excited to have you on as a guest today. It’s interesting that you said your dad was one of the first, as you were listing off the research that you were doing and who you were going to work with, your dad played a part in that. And why I find that interesting is my dad introduced me to my mentor in this field, and when I had Christine Benz on the program from Morningstar, she also mentioned that her dad played a big role in her going to work with Morningstar. Just noticing this with dads having a role in the direction that their kids go, but it’s kind of interesting.
So let’s start talking about financial planning as it relates to retirement. You may not know this, but most of the people that listen to Sound Retirement Radio are probably within a couple of years of retirement or recently retired. And one of the things that we’re always talking about is asset allocation. So would you take a minute, maybe share your thoughts on why asset allocation is important?
Todd Schlanger:
Yeah, so at the highest level, if you define asset allocation as just the percent of your portfolios in equity is the percent of your in bonds. Research has shown, there was really a seminal study back in the eighties that showed about somewhere between 85 and 90% of the overall return pattern of your portfolio can be explained by just that, how much of the portfolio is invested in equity. So it’s a powerful driver in terms of what it does for investors, but it’s also a tool that’s really in their control. If you think about the financial markets and even the past year, the volatility we’ve had, asset allocation is really a tool investors can use to manage how much [inaudible 00:09:36] to the equity market.
The second thing I would say, and I think we’re going to get a little bit into Vanguard model portfolios, is if you think about kind of the baseline asset allocation as just the total US market, for example, the total bond market, the total international markets, due to the low-cost nature of those types of strategies, because you can usually buy them at a low cost and also they tend to have low turnover, those are actually the two most powerful drivers in predictability, in terms of predictability of your future returns, just the broad asset allocation tends to be really competitive relative to those higher cost, higher turnover strategies. As I said, we’re also a believer in active, but we would always start investors with just a total portfolio passive mix, and then from there figure out if there’s something more they’re trying to achieve. And then you could always tailor a portfolio from there.
Jason Parker:
Okay. And we’ll talk a little bit more about passive and active here in a minute, but. What are your thoughts? Because right now we’ve got things like Robinhood that is encouraging a lot of day trading. We’ve got a lot of these newsletters that are growing in popularity that encourage people to buy individual stocks. So as you think about the advantages and disadvantages of asset allocation versus individual stock picking, would you speak to that for me?
Todd Schlanger:
Yeah, so in the individual stock picking, when you bring up what’s happened with some of the speculation in the last few months with the game stock and et cetera, we really wouldn’t consider that investing. We would consider that more speculation, which is very difficult to get right. Investing in individual stocks, let’s say in a long-run manner, it can work for investors. But the thing there is you have to think that individual stock risk tends to be uncompensated. So what I mean by that is the amount of volatility you get for investing in a single stock tends to just be exponentially higher than, let’s say the total market as an example. Tends to be uncompensated. Investors could build their own portfolio of individual stocks, but that tends to be costly both in terms of monitoring and transaction costs. So that’s why we really prefer a more scaled, broadly diversified portfolio like you would get by investing in, for example, the total market indices.
Jason Parker:
Yeah. Especially if you’re making this transition into retirement. Now is not the time in your financial life to be speculating, taking big bets with your investments as you’re getting ready to make a transition into retirement. I always tell people we want them to have a great retirement and a boring investment strategy.
Todd Schlanger:
Yeah, exactly.
Jason Parker:
The investing portion of your life should not be what’s generating all of the excitement. So several years ago, Vanguard created somewhat of a partnership with CRSP as a benchmark. Would you take a minute and tell us who CRSP is and why Vanguard decided to include them as one of their benchmarks?
Todd Schlanger:
Sure. So CRSP is the Center for Research and Securities Prices. It’s really an arm of the University of Chicago. And it’s really the leading provider of stock and equity data to the academic community in terms of a lot of industry research uses CRSP data. And we started using their indexes actually at the same time that we started using FTSE indexes for outside the US. So CRSP we use for a lot of our US equity indices and FTSE outside the US. So really the reason behind that is over time, let’s say over the last 20 years, because we actually started this partnership about 10 years ago. So for the 10 years prior to that, we had really seen index providers adopt what we call a set of industry best practices. And the differences in indexing methodologies and returns just tended to be getting smaller.
At the same time, I mentioned Vanguard’s operating model is to drive down the cost of investing through economies of scale, the way that index providers typically work is a percent of assets. And as ETFs have become cheaper and cheaper, you can buy a broadly diversified index for less than five basis points. Those index licensing fees were becoming just a larger and larger percentage of the total fee that our investors were charged. We were able to partner with CRSP to really build a set of indices that we consider to be conforming to best practices and as good as as any others that are negotiated through a flat fee. So that really allows us to scale our business as we grow the firm. And it’s the same… We have the same flat fee agreement with the FTSE indexes that we switched to at the same time.
Vanguard doesn’t prefer one index provider to another. We actually have six different index providers we work with, but in the particular case for the US equity indexes, we were able to really get good exposure at a competitive cost, and that’s why we choose them as our default benchmark for our US equity indexes.
Jason Parker:
Okay. So tell me about market cap-weighted. This is a topic that I had heard and I’ve read that Jack Bogle talked about in years past, and there’s some controversy about market cap weighting versus maybe equal weighting. Share with our listeners why Vanguard prefers a market cap-weighted index.
Todd Schlanger:
Sure. So if you’re indexing a market, really the goal we think is to match the risk and return characteristics of the market. So let’s take the US equity market for example. If you’re following a market cap-weighted strategy, you’re really investing proportionate to the size of the individual stock. So for example, Apple is the largest stock in the US equity market. So essentially that would be your largest weight. At the same time you have 10 equity sectors and you would invest in each of the sectors in the weight it is proportionate to its size in the market. So when you do that, you have a couple of advantages. One is you do get really the overall performance of the equity market. And secondly, because they’re all proportionate to their size, it tends to lead to pretty low turnover as well. And so you end up with a pretty attractive risk return profile and also something that can be implemented at a low cost.
Jason Parker:
So in this world where we find, say, more people heading towards passive index investing, and if the largest funds are market cap-weighted, does it create inefficiencies within indexing? In other words, could people go in and just cherry-pick and say, “If I know all of the money that’s going to be flowing into these biggest funds,” the 10 companies that make up the greater weighting of the fund, could people just cherry-pick the indexes that way?
Todd Schlanger:
Sure. So you bring up a good point, and this is something that we’ve spent a lot of time on and the fact that really when I talked about these industry best practices that we really believe in for choosing our index providers, a lot of that is being transparent and having a system of rules that can be followed. So in terms of the potential for front-running, et cetera, what our portfolio managers do is they can actually figure out essentially where the index is going. We don’t have to trade on, for example, the last day of the month that the index is reconstituted, but we can actually trade either side of that. And by doing that, they can really protect our investors. So it is something that our investment management group has spent some time on, and there’s information out there I believe on our website that broadly explains what we do. But we do have established practices in place to protect investors from that.
Jason Parker:
Okay, so the other question I had there was we had Dr. James Cloonan, who was the founder of AAII, I don’t know if you’re familiar with them, the American Association of Individual Investors, had him as a guest on the program years ago, and at the time he had a new book out, I think it was Level3 Investing. And one of the things that he and I had talked about was the fact that he was a big believer, value and size, so overweighting towards value stocks and smaller cap stocks. So he made an argument that by equal weighting to something like the S&P 500 index, that it gave you more exposure to smaller cap companies as well as more value opportunities rather than a market cap-weighted. What are your thoughts equal weighting versus market cap weighting?
Todd Schlanger:
Yeah, so the equal weighted is the simplest form of what you would call like a smart beta index, different alternative weighting schemes. These were popular I would say about five years ago. And really what you get with an equal weighted, if you think about it, is the market itself tends to have a little bit more growth than value because, by definition, the growth companies have higher prices. And also if you’re investing in a market cap-weighted index, you’re investing in the larger securities. Now, there’s a whole body of work in the academic literature on factors that tend to explain a large portion. So I mentioned the most important one earlier, which is just the market beta. Also value, size, liquidity, volatility, quality. These are all, if you think of them, traits of different securities that have a body of research around them. And there’s reason to believe either through different behavioral explanations or risk-based explanations that these securities might outperform or outperform relative to their level of risk.
And so the equal weight strategy essentially tends to load because of how it is situated versus the broader market towards smaller value type securities. I say it was popular around five years ago and maybe the five years preceding that because coming out of the global financial crisis, smaller value type securities had performed exceptionally well. In the past five years, really been the story of large growth stocks. So we don’t hear much anymore about the equal weighted, but what I would say also is that for investors that are interested in targeting more value and small, the equal weighted tends to be pretty inefficient because by definition, if you’re equal weighting, it means you’re constantly rebalancing. So I mentioned before how those transaction costs just tend to eat up your return. So the equal weighted tends to be a less efficient way of doing that. For investors that are interested, it’s generally easier to buy a more targeted factor type strategy that can be a little bit more low cost and also a little bit more specific about the underlying factors that investors are trying to get exposure to, if that is indeed their objective.
Jason Parker:
Okay. I talked to somebody the other day and one of the questions he asked was, is there a risk in only using Vanguard funds and not being broadly diversified across other [inaudible 00:21:49] companies? What are your thoughts on that?
Todd Schlanger:
Yeah, so an asset manager like Vanguard, we’re really like an agent in the sense that we’re essentially buying securities and managing them for investors. We’re not like a bank that’s taking risk and positions with our own assets. A lot of the comment you hear about large firms, etc, posing risk, that’s typically directed at banks. For asset managers, again, more like Vanguard. Ultimately if you’re investing in our securities, all of the securities are 100% invested and it’s a different type of situation that we think ultimately poses a low risk to investors.
Jason Parker:
Okay. So Vanguard, you guys are designing some model portfolios now. Talk to me a little bit about these model portfolios that Vanguard has available.
Todd Schlanger:
So we have a number of different model portfolios that we offer. The baseline models, I mentioned before the CRSP and the FTSE indices for US equities and international equities. And then we use Bloomberg Barclays for fixed income. These are really the broad market cap-weighted index portfolios. They’re pretty much completely market proportional except for the home bias that we have in equities and fixed income. So it’s a common practice in portfolio construction to overweight the market that an investor is domiciled in. So US equities make up about 57% of global equities. We invest 60%, so it’s a slight overweight. On the fixed income side, US bonds are about 45% of the global market and we invest 70%.
Really based on our research, the reason we’ve done that is we’re able to capture most of the diversification benefits that you would get by going more global and really providing an investment that’s diversified, but a little bit overweight US. Essentially, the idea that I talked about before is the broad diversification, low cost, low turnover. We would consider these like the baseline asset allocation, if you will, that investors should consider. And then again, if they have more tailored goals or specific objectives, you could always add some active funds or make some changes from there. But we think it’s a great starting place.
We offer 11 different asset allocations, so anything from 100% equities to 100% bonds with 10% equities, spacing between the portfolios. So that really allows an investor, depending on their time horizon, depending on their risk tolerance, to really tailor one of these portfolios to their needs. And again, we would consider them like a baseline or default for asset allocation.
Jason Parker:
You mentioned active management several times now, and I think most people think of Vanguard as more of a passive, where’s the least expensive place to buy an index fund? So speak for a minute about active management and Vanguard’s thoughts on active strategies.
Todd Schlanger:
Sure. You might be surprised to hear that Vanguard was actually founded with all active funds. So Mr. Bogle, who founded Vanguard, he was also the president of Wellington Management Company, which is still today one of our large partners in active management. And when he founded Vanguard, it was really the ownership structure and the idea of placing the client at the center of everything as the owner of the firm, that it was the founding principle of Vanguard, not indexing. Indexing came later. Active can certainly work. Actually, the track record of our active strategies is actually one of the best in the industry. I would say what’s unique about Vanguard, we tend to be very long-term with our managers. It’s pretty lengthy and diligent process to get hired as an active manager at Vanguard. They tend to be a little bit more long-term oriented than your typical active fund. And there’s a whole process around that led by our Portfolio Review Department.
But in terms of using active in a portfolio, if you think of it, there’s three levels of risk that an investor can be subjected to. The first is the beta risk, so the broad market risk. The second is factor risk. So I mentioned some of those factors before, like value in small that explain returns, and really the active adds on top individual stock selection ability. So again, we think investors can be successful with the pure beta by adding in some factors or stock picking. Each one comes with its own different risks and consideration, the primary one being the risk of underperformance.
We’ve done some work in our group to show that if you look over a 15-year period and you carve out just the funds that outperform the market, keeping into consideration that only about a third of funds end up outperforming after fees in the long run, you look at just the outperforming funds, they tend to out underperform about half the time. So let’s say in 15 years, odds are you’re probably underperforming for half of that period. And so for us, it’s also the behavioral side in terms of making sure that if an investor is selecting active, they’re comfortable with the strategy and they’re willing to go through those periods of underperformance so that ultimately they can achieve the goal of active, which is outperformance in the long run.
Jason Parker:
There was a time when management was really focused on the star asset manager, and it seems these days that Vanguard has taken more of a team approach to a lot of these active funds. Would you say that’s the case?
Todd Schlanger:
It is. I mentioned the Portfolio Review group earlier. So they do a lot of work in terms of, a lot of our active funds are multi-managed. So let’s say you have one… Let’s say within a growth fund, you have one manager who’s a bit more volatile and maybe provides a bit more longer term return potential, but it’s a little bit more volatile. They might pair them with a more conservative, lower volatility growth manager. And the idea is, by pairing them, you have the best of the both worlds. Also, I mentioned before that even successful managers, they all go through periods of underperformance. So the idea is if you have more than one manager, some of that volatility is dampened by that.
Jason Parker:
Okay. Back to these model portfolios that you guys have started to create and build. You have these different indexes. You’ve got CRSP, Centers for Research in Security Prices, S&P 500, Russell, FTSE you mentioned. So as you think about the application of the data that’s coming from the Centers on Research for Security Prices versus that coming from S&P 500 or Russell, what would you say the biggest differentiator is with the CRSP methodology compared to some of these other index providers?
Todd Schlanger:
Sure. So they’re broadly similar, and that’s again getting back to one of the reasons that we decided to go with CRSP. I would say CRSP is a very diversified index. We were also able to work with them on some of the best practices that we’ve learned over the years, really getting to the idea of reducing costs for investors, which is a theme I’ve been saying. But for example, if you’re not investing in the full US market, let’s say you’re investing in a subset like a mid-cap Index for example. So we have CRSP mid-cap. It can be the case that a mid-cap security might go through a period where it outperforms and all of a sudden now it’s in large cap. With CRSP, you have what’s called packaging, which is just trying to reduce some of that volatility.
So essentially, if a mid-cap stock indeed grows into a large cap, eventually it is going to move to the large cap, but it just slows down that practice, I’m sorry, slows down that process with the goal that we don’t… The last thing you would want is to sell that stock from the mid-cap index, go into the large cap, and then next thing you have to sell it from the large cap and go back to small. So it just eases that transition. So at the margin, like I said, there’s a few things that we like with CRSP. But ultimately, it’s the idea that they’re broadly similar, but we’re able to negotiate favorable flat fee agreements with CRSP.
Jason Parker:
But potentially also reducing transactions within the strategy so we can keep those fees down as a result of not-
Todd Schlanger:
Exactly.
Jason Parker:
Yeah. Okay. So Jack Bogle, he’s famous for… At least maybe in my mind, famous for the costs matter hypothesis, and he once said in investing that you get what you don’t pay for. So one of the questions that comes up is how does someone balance low-cost investing with the value of working with a financial advisor, say they’re paying 1% per year in fees?
Todd Schlanger:
Sure. You’re absolutely right. One of the sayings in investing is you get what you don’t pay for, and you usually shop for something more quality, you pay more, you expect to get more, and people have an experience that is not easily transported to investing where the costs come out of the return. And so typically the lower-cost funds tend to perform higher. I would say at the same time, we’re a big supporter of financial advisors. We’ve done work, it’s called our Vanguard Advisor’s Alpha framework. It was actually my old boss who came up with it around 10, 15 years ago. And there what we did is really identified the areas that we think advisors can really help investors relative to what they might achieve on their own.
The first part is we mentioned asset allocation and just how important that is. So really advisors can help investors with the expertise of really pairing an asset allocation for them. We also talked about costs, how important they are. So there’s alpha and value that advisors can bring by reducing costs in the portfolio. Tax location. So for example, bonds tend to be less tax-efficient than equities. So if you only have so much space in an IRA or a 401(k), an advisor can help there.
But aside from that, really the biggest areas are around rebalancing and behavioral coaching. And I mentioned before some of the challenges with investing in general, you don’t have to look very far looking at 2000 and the volatility we saw around Coronavirus. I know I certainly saw very large swings in my portfolio. At the same time, my portfolio is worth a lot more now than it was before the pandemic. We think a lot of the value that advisors can bring is really helping work to get that asset allocation, preparing clients for the inevitable volatility that they’re likely to experience, and then really being there as that coach and circuit breaker when the markets are volatile so that they can reach their objectives.
Jason Parker:
Now, when you say that, when you talk about the behavioral component that advisors bring to the table, is that because at Vanguard you can see self-directed accounts and you can see advisor-traded accounts and you can identify that advisor-traded accounts tend to be more stable? Or where is that information? Where’s that data coming from?
Todd Schlanger:
Sure. So we have a number of different sources for that. I should have mentioned we quantify the complete value of what an advisor can bring, approximately 3% through Advisor’s Alpha. Half of that is the behavioral coaching, which is 150 basis points. So that’s really a mixture of the academic research. There’s a number of different studies that have been done, data we can pull from Morningstar for example in terms of the average industry experience if you look on a money-weighted basis and how much the money and mutual funds tends to trail the underlying funds. And then of course, yeah, we do have our own record-keeping business where we can look and see what the experience is there. It’s not a precise number. We call it 150 basis points, but generally those different studies I mentioned tend to range between 100 and 200 basis points. So we just average it out to be about 150.
Jason Parker:
When you talk about the 3% then through that Advisor’s Alpha, is that an annual number and is that net of fees?
Todd Schlanger:
That would be an annual number, which yeah, the fees are part of that in terms of the reduced fees. So it would take fees into consideration. It would be like an annual average, but we’re quick to say it can be episodic. For example, if in the middle of the coronavirus pandemic somebody had sold a significant portion of their equities, they might be behind now by tens of percents. And so there’s a lot of value to be yielded in those particularly volatile periods like coronavirus, like the global financial crisis. So it might not be that year in, year out, particularly when it comes to the behavioral coaching, but it is a long-term average. A lot of it will be earned in those high volatility periods.
Jason Parker:
Okay, interesting. Oftentimes when people are heading into retirement, they want less volatility in their investments, and historically the way that that has been achieved is through increasing their exposure to fixed income, increasing their exposure to bonds. Do you think that bonds will have the same diversification effect going forward as they have in the past?
Todd Schlanger:
Yeah, so we’re a big believer in bonds for diversification. I’ve seen some pieces saying, okay, the correlation of equities and bonds has been increasing over time, but it’s really the magnitude of the volatility of the two asset classes. So if you think about, let’s say equities, they can go down by as much as 50% in a year. That’s what we saw in the global financial crisis. Last year, they were down 20, 30%. Bonds, even in the worst years for bonds, they rarely go down by more than 5%. The relative volatility of the two asset classes. Also, the correlations of equities and bonds tend to work well together, particularly in stress periods.
So the way we really think of bonds and the role of bonds is if you believe there’s an equity risk premium, which we do, then if you don’t care at all about volatility, you would invest 100% in equities. But of course, as you say, if you’re getting closer to retirement, you’re drawing down on the portfolio, you do want to have those bonds in the portfolio to reduce that volatility. And particularly in stress periods, high quality bonds particularly, high quality governments and corporates are really the only asset class that has consistently shown that positive counterbalancing in stress periods.
I would say over the last 10 years and maybe even the last 15 years since, really 10 years since the global financial crisis, we’ve seen a lot more credit sensitive bonds in portfolios given low yields and investors trying to earn a little bit more yield and credit premium there. But we have some charts we’ve used over the years to show some of those different things, whether you’re talking about high yield bonds, emerging market bonds, even investors adding, let’s say, commodities as diversifiers. In those stress periods, they all tend to go down much more than those high quality bonds. So for that reason, we do still believe in the diversification benefits of those high quality fixed-income portfolios.
Jason Parker:
In the world that we live in today where we have the price to earnings on a cyclically adjusted basis at these all time highs. And then we have the yield on 10-year treasuries at all-time lows. As people are trying to make this transition into retirement, one of the things they often do is they need to have some type of idea from a performance standpoint, what rate of return would they need to assume on their money to know whether or not it’s going to last into retirement? Should people be assuming lower future returns as a result of where we’re at in the economic cycle if they’re just now getting ready to retire? Or can some of those historical returns still hold up? What would Vanguard say, they should be aiming lower going forward or still rely on the historical averages?
Todd Schlanger:
Sure. I would say generally yes, but it’s a little bit nuanced. I’ll explain, is that generally over the last 10 years, equity evaluations, particularly in the US, have increased to the point where you might say the US market is slightly overvalued. We don’t see US equities broadly as let’s say in a bubble or anything like that, but it’s to the top end and a little bit above of what you could justify based on the fundamentals. So if you look at the US equity market, we think that you’re likely to see over the next 10 years, let’s say that 3 to 5% return relative to the 9, 10%, which has been the historical experience. If you look outside the US, the valuations are also a little bit higher than average, but not quite so much. So we think an investor investing in global equities outside the US might see a 6 to 8% return, so much closer to that long term historical average.
And then even if you look within asset classes, for example, we’ve seen very strong performance in growth securities over the last 10 years. Value is pretty much at one of the lowest valuations in history relative to growth. So we think even within the US equity market, you might see 5, 6% returns from growth. So if you’re broadly diversified, we think investors can still achieve their objectives. Certainly relative to the alternatives, we think there’s still compelling reasons to invest. Returns are going to be lower, which is going to mean costs are going to be more important. You might need to save a little bit more, maybe need to work a few extra years to save more for retirement. But ultimately, again, we do think there’s still compelling reason to invest.
Jason Parker:
I want to ask you about inflation and then I want to ask you about the economy overall. The Fed keeps telling us that inflation is tame. I don’t know about you, but it’s hard to understand where they’re getting that data from because when we look out just locally trying to find somebody that can do work or buying lumber for building projects or food at the grocery store, it sure seems like we’re experiencing a lot of inflation. Maybe it’s not constant around the country, but what are your thoughts? Are we going through a period of hyperinflation right now? The Fed has said they want inflation. Are we experiencing that or do you think that them saying that we’re having a hard time achieving a 2% inflation is accurate? Another area that we’re seeing inflation is with housing, housing prices are just skyrocketing. So what are your thoughts on inflation?
Todd Schlanger:
Yeah, so in terms of inflation, if you go back pre-pandemic, the Fed was really here in the US struggling to hit their goal, which is 2% inflation, and we were really trending more like 1% inflation. And so ultimately, with the amount of fiscal and monetary stimulus that’s been put in to deal with the pandemic, we do see 2% inflation as much more likely, and that would kind of be our base case. So in a way, we do see more inflation today than let’s say before the pandemic. At the same time, we don’t see broadly any kind of runaway inflation. We think there’ll be what our chief economist calls inflation scares as the economy starts to come back on. We do think we’ll see maybe even 7% or more growth this year in the US. So [inaudible 00:43:25] be scarce, but ultimately there’s structural forces around globalization and technology that we think will ultimately keep inflation low. And when I say low, I mean around that 2% figure.
When you mentioned the housing market, that’s an area where really you have supply and demand at play where given the pandemic, people haven’t been moving, which means inventory for houses is low. Also, building supply lines have been interrupted too, so the amount of new houses on the market is also low. So there’s just not many houses for sale. I’m speaking for somebody who’s looking for a house right now actually, so I know this well. I’m hopeful that, as Vanguard believes, that eventually those supply-demand dynamics will come back into balance. But that’s primarily what you’re seeing right now, as well as the very low interest rates that have come about through the response to the pandemic. All of those things you can of rationalize the higher prices a bit in real estate.
Jason Parker:
I had Garrett Watson on the program recently. He is with the Tax Foundation. One of the things that we were talking about was President Biden’s tax proposals or tax policy. One of the things that we’re looking at potentially is higher corporate taxes. So of course they dropped from 35% down to 21%, and now they may be going up to 28%. What kind of impact would higher corporate taxes have on 401(k)s, their IRAs, their investments at Vanguard? What do you think we would expect to see happen if taxes go up for corporations?
Todd Schlanger:
So I have to admit, I haven’t really studied that in the sense that I think what’s happening there is they want to invest more in infrastructure, they have to fund it. Generally, infrastructure spending is positive for the economy. Government spending tends to have a multiplicative effect on spending, or I’m sorry, on growth. And so I really haven’t looked what’s the trade-off. Obviously taxes are a cost and at the margin, you might think that that would lead to lower growth. So I have to confess, I’m sure that our team, particularly our economics team, will be… As the proposals become more concrete, I’m sure [inaudible 00:46:01] study that and we can come back to you on that. But I have to confess, I haven’t fully studied those tax proposals.
Jason Parker:
Yeah, sure. No problem, thank you. And then what about Vanguard’s economic outlook? So as we’re in the middle of the first quarter of 2021 here, we are looking out, we just were coming through the pandemic. Is Vanguard bullish or bearish on the economy going forward?
Todd Schlanger:
I would say… If you think about the year 2000 overall, it was [inaudible 00:46:35], but the economy, the US economy shrunk by about 3%. This year, coming from that lower base, we think with the combination of monetary stimulus, fiscal stimulus that we’ve had, we think we could hit, like I said, 7%. Our chief economist was calling it for a time being, we could be at China-like growth in the US. Again, coming from a lower base. So on the economic side, I would say we’re rather bullish. It’s worth mentioning for your investors, often economic returns don’t translate perfectly into investment returns. So we’re still a bit more guarded or a bit more muted in our investment outlook. But on the economic side, from the low base, we’re pretty bullish.
Jason Parker:
Yeah. Wow, that’s great. That’s an excellent point that the economy and the stock market don’t always walk hand in hand. They can decouple, and so we can have a booming economy and maybe a lackluster stock returns. This has been really, really fascinating, Todd. I sure have enjoyed our time together. Is there any final points, anything that you would want to just summarize or finish up with as we finish our conversation today?
Todd Schlanger:
I hope we went through for your audience how we think about these models, the different index providers we partner with, how we think active and passive can work. Some of the importance of particularly when working with advisors, the behavioral coaching aspects, and then ultimately working with Vanguard as a client-owned company. We try and put investors at the center of everything we do, and if there’s anything we can do for you or your audience, feel free to reach out.
Jason Parker:
Awesome. Thank you so much. Thanks for being a guest on Sound Retirement Radio.
Todd Schlanger:
All right, thank you for having me.
Jason Parker:
Thanks, Todd.
Information and opinions expressed here are believed to be accurate and complete for general information only and should not be construed as specific tax, legal, or financial advice for any individual, and does not constitute a solicitation for any securities or insurance products. Please consult with your financial professional before taking action on anything discussed in this program. Parker Financial, its representatives or its affiliates have no liability for investment decisions or other actions taken or made by you based on the information provided in this program. All insurance-related discussions are subject to the claims-paying ability of the company. Investing involves risk. Jason Parker is the president of Parker Financial, an independent fee-based wealth management firm, located at 9057 Washington Ave, NW, Silverdale, Washington. For additional information, call 1-(800)-514-5046 or visit us online at soundretirementplanning.com.
