It is my good fortune to have Wes Crill, PhD as a guest on the podcast today. Wes is a senior investment director and Vice President with Dimensional Fund Advisors. Prior to joining Dimensional, he was a PhD student studying materials science engineering at North Carolina State. His research focused on modeling engineering processes at a scale of 1 billionth the size of a human hair.
In today’s podcast we discuss the difference between investing and gambling. The benefits of global diversification. Some of the nuances associated with only investing in the S&P 500 index. We discuss the life cycle theory of finance, should you buys gold, the reconstitution effect of index funds, the importance of having a financial plan, mutual funds vs ETF’s, Why not all small cap investing is the same among fund providers. We discuss the science of investing and the pursuit of higher expected returns.
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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. Now here is your host, Jason Parker.
Jason Parker:
America. Welcome back to another round of Sound Retirement Radio, so glad to have you tune in into this episode. This is number 422, Pursuing Higher Expected Returns with my guest Wes Crill, PhD. Before we get started though, I always like to start out by renewing our mind and I’ve got a verse here for us from Ephesians 2, Verse 10, “For we are God’s handiwork, created in Christ Jesus to do good works, which God prepared in advance for us to do.” And then something fun for the grandkids. What did the stamp say to the envelope on Valentine’s Day? I’m stuck on you.
The number one focus of my career has been to help as many people as possible achieve clarity, confidence, and freedom in their financial lives as they prepare for and transition into and through retirement. Many of you know that we have spent years creating a very detailed retirement cashflow planning app called retirementbudgetcalculator.com. I am on a mission to democratize retirement and give every American the ability to have an amazing retirement plan. I’m proud to say that we’ve had thousands of people sign up for the calculator. In addition to the software, I’m the founder and president of Parker Financial, which is an SEC registered investment advisory firm. We are fiduciaries who create and manage investment strategies that align closely with our software, process, and philosophy.
If you have used the calculator, you know that it’s very detailed. We put a lot of thought into engineering a powerful retirement planning tool. So you can only imagine the process and thought and focus that has gone into creating our investment philosophy. We are constantly learning and refining our process to ensure that those who benefit from our software and entrust us with investment management have the highest probability of achieving their desired outcomes with confidence. Our commitment to excellence drives us to continually optimize our approach. In my latest book, I recommend researching Vanguard and Dimensional as exemplary exchange traded fund companies. Earlier this year I participated in some additional training on the Dimensional Funds approach to ETF Construction and management. Their approach seamlessly integrates the science of investing into the construction of diversified ETFs, aimed at achieving higher expected returns. While attending the conference, I let those folks know that I’d like to bring some of their expertise to those of you who listen to Sound Retirement Radio.
It’s my good fortune to have Wes Crill, PhD, as a guest on the podcast today. Wes is a senior investment director and vice president with Dimensional Fund Advisors. Prior to joining Dimensional, he was a PhD student studying material science engineering at North Carolina State. His research focused on modeling engineering processes at a scale of 1000000000th the size of a human hair. In today’s podcast, we discuss the difference between investing and gambling, the benefits of global diversification, some of the nuances associated with only investing in the S&P 500 index. We discussed lifecycle theory of finance, should you buy gold, the reconstitution effect of index funds, the importance of having a financial plan, mutual funds versus ETFs. Why not all small cap investing is the same among fund providers, and we discuss the science of investing and the pursuit of higher expected returns.
As always, articles, links, and resources mentioned in today’s podcast can be found @soundretirementplanning.com. Just click on episode number 422. Without any further ado, here is my interview with Wes Crill. All right, it’s my good fortune to have Wes Krill on the program. Wes, welcome to Sound Retirement Radio.
Wes Crill:
Yeah, thank you so much for having me.
Jason Parker:
Well, this is such an honor, such a treat. I’ve heard great things about you. I’m looking forward to this conversation. The first one I want to ask you about specifically has to do, there’s a lot of people today that they think of investing as a game or they refer to it as gambling. I thought we could start with just the basics. What is investing and is it a game and is it gambling?
Wes Crill:
Yeah, I think sometimes that connotation with gambling stems from the discomfort most people have with uncertainty. Anything short of a guarantee some people might see as a gamble. If you think about investing, the reason why you would earn a certain rate of return, is related to the amount of risk that it entails. For example if we look at the stock market, the historical rate of return has been about 10% per year, but there’s no guarantee of a profit over any time horizon. In fact, if we look at rolling 10-year periods, about 85% of the time stocks have outperformed US treasuries. But that implies, for the math majors out there, 15% of the time it has underperformed treasuries, so there is risk associated with it. Now, if we put this in the context of what many people might think of as successful odds when it comes to gambling, if you told me that there was a poker table in Vegas that had an 85% chance of winning, I can tell you which casino is going to have the longest lines out the door.
I think those odds viewed in the grand scheme of things are pretty good in terms of outperforming. I always urge investors to remember the gamble that you take if you don’t invest. As we’ve all witnessed lately, consumer prices can increase, what we pay for food, housing, cars, that stuff tends to go up over time. If you’re parking your money under your mattress, well you’re not receiving the benefit of investing and what you can afford today might not be what you can afford in the future. You might not keep up with inflation. There’s a risk associated with meeting your certain cashflow needs in the future, whether you’re investing or not. I think that’s an important thing to keep in mind for investors.
Now when people think about gambling, I think that starts to take on a more negative connotation With investing, if you pass on broad diversification, if you’re starting to chase meme stocks or if you pick speculative investments, in those scenarios, that likelihood of success might be dramatically lower. So I think that’s when it becomes more in line with what people think of as a casino style gamble. But for a broadly diversified portfolio, I think overall you’re increasing the likelihood of success in most cases.
Jason Parker:
I heard the founder of Dimensional say that the reason for diversification is because we’re trying to avoid extreme outcomes, especially on the downside. Talk to us about diversification. Some people we’ve met with only have the S&P 500 as their equity diversification component. Why would you want to have thousands of companies to be diversified instead of just 500?
Wes Crill:
I think that’s a good way to describe it. Generally is, you’re trying to avoid both tails of the distribution, definitely trying to avoid the left tail of the distribution and very negative outcomes. What that also means is you’re likely giving up being in the far right tail. But just in the simplest scenario, let’s say the only thing I’m invested in is stocks of companies that make swimwear. I’m likely to have very good performance if there is an unexpectedly long period of sunshine, but it also means if we have an unexpectedly long winter, then my portfolio is not going to fare as well. The natural counterpoint to that would be stocks of companies that only make parkas. Okay, well unexpectedly long winter, probably doing well and the opposite will be true with a long summer.
The point of diversification is, you balance out the extremes there where you reduce the range of outcomes in terms of your investment results. You mentioned the S&P 500. Many people actually think of the S&P 500 as a proxy for the market, but it’s still only a percentage of the overall market. It contains more or less 500 stocks. There’s over 15,000 stocks in the global equity portfolio spanning more than 40 different countries and numerous currencies. You can think of this as being a snapshot of all the global diversification opportunity set available to investors, where you get exposure to lots of different types of businesses and you’re less likely to be impacted by the fortunes of specific industries or companies.
Again, that’s a benefit that investors can take advantage of any very cost-effective way. More recently we’ve been looking at the very large companies when the S&P 500, the magnificent seven so to speak, some of the seven largest companies in the US, they’re really huge weight in the 500. If investors are sensitive to that, if they want their investment returns to be driven by more than just the fortunes of those companies, then broadly diversifying away in a global opportunity set is one way to mitigate the outsize impact of a few companies.
Jason Parker:
It wasn’t all that long ago that the Angela Brooks 500, I remember that time period from 2000 to 2009, the lost decade, where you lost money basically only investing in the Angela Brooks 500. Today the Angela Brooks 500 has, I think it’s 30% weighted towards the top 10 stocks and two of those companies, Microsoft and Apple are each at about 7%, so 14%. Is that considered a diversified portfolio if you have 30% of your money in 10 positions?
Wes Crill:
Yeah. Again, this is why we always like to point to a globally diversified portfolio, is that weight that they would occupy in the S&P 500 becomes substantially less when you’re outside of the US. I think the magnificent seven themselves were over 25% weight than the S&P 500 or in the US market. Then you look outside the US in a globally diversified market, their weight was about half of that. But you bring up a really good point. Another reason to have global diversification is, when you look at the performance of countries, it varies year to year. The top performing country doesn’t tend to be the best performer in every year. The lost decade was an interesting period of time because the S&P 500, to your point, had a negative compound return for that 10 year stretch.
Now when we look at the period since then, the S&P 500 has been one of the best performing asset classes. I know that in conversations I’ve had with clients, they’ve become weary of the story about the lost decade. They sometimes refer it as a boogeyman, that how likely is this to actually happen again? Well, if we look around the world, look at every country’s equity market, just look at the worst 10 year stretch for 44 different countries in their stocks, all but six of these other countries have had at least one 10 year stretch where the return on their country’s equity market was negative. What that tells me is it’s not that unlikely for a country to have a weak decade, a 10-year stretch, where their stocks are delivering below zero. If it could happen once in the US, it could potentially happen again and all the more reason to have global diversification.
Jason Parker:
With all of the concern these days, these geopolitical risks that we run into, are there any times when you would not want to have a globally diversified portfolio or when you would want to tilt away from certain countries?
Wes Crill:
When I think about geopolitical risks and ones that could potentially happen in the future, unless you know what those risks are going to be, unless you know what countries are going to impact, then you don’t necessarily know which countries are going to be faring worse based on that. I think that’s even more of a reason to have global diversification, is if one particular country is impacted heavily by one of these geopolitical incidents, then your portfolio’s performance is going to be less subject to that. Now, I think the specter for geopolitical risk, which is, how sensitive do I think certain countries or certain regions are to these risks? I go back to what we think is the function of the market, which is to incorporate these into market prices. The weight of different countries is going to be, in part reflecting what these perceived risks are going to be.
I believe there’s a risk and return element potentially there. I think that for developed markets, whether it’s US or non-US markets, that risk is probably not hugely different across different countries. But when we get into emerging markets, some of these less developed economies, maybe less liquid stock markets, I think some of those risks can be more prevalent. But then those countries are also a smaller weight in the global portfolio, maybe in part to reflect those higher risks, but they potentially might offer higher returns as well. The data are far too noisy to tell us definitively whether emerging market countries offer higher rates of return, but that is a reasonable assumption on the part of market participants if they believe risk and return are related.
Jason Parker:
You guys have a new film out telling the story about dimensional funds called Tune Out The Noise. What is the noise that needs to be tuned out and what kind of news headlines might people want to respond to and actually take action on? Is there any?
Wes Crill:
Yeah, that’s always the challenge with news is, if it’s relevant for stock prices, if it’s going to move markets. What you really needed to take advantage of that was a note beforehand, but that’s why they call it news if it were known beforehand, it’s not news, it’s olds. One classic example is Q1 of 2020. Now we look back and we see that there was enormous amount of stock market volatility. Markets around the world were down very substantially in that quarter, but we know why with the benefit of hindsight, that was because a pandemic sprung up. There was going to be ramifications from an economic standpoint, many businesses closing down, a lot of restriction in terms of activity.
If you had known in advance, you would’ve been able to sidestep your exposure to markets, but that would’ve required knowing that there was going to be a pandemic before anyone else did, before there were any signs of it. Then the real question is, well, what happens once those circumstances are known, once it’s really no longer literal news. Well, if you look at the return on the global stock markets starting at the end of March of 2020. At this point nothing’s really been solved with the pandemic, most countries have lockdowns in terms of restrictions on activity, and yet for the next six months, global stocks return more than 25%. So when we think about-
Jason Parker:
Not an expected outcome.
Wes Crill:
Exactly. It’s really the expectations versus what actually comes to pass. Another example that goes in the positive direction in terms of news that year, I remember like it was yesterday, it was the first time I was on TV. It was I believe November 8th, 2020. It was the Monday after the election results were finally declared. I looked and US small cap value stocks were up 9% early on in the day and I thought, “Wow, that seems like a very extreme reaction to the election, but who knows?” But then I started looking through the additional news of the day and we saw that, I believe it was Pfizer announced the results from their efficacy test for the COVID-19 vaccine. The numbers were overwhelmingly high and it looked like all of a sudden there was a light at the end of the tunnel for the economy. So the companies that would be most standing to benefit from a reopening of the economy, the smaller value type companies shot up in value.
Again, if you had known the results of that pharmaceutical study the previous week, surely you would’ve made adjustments in your asset allocation. But I think that’s a good example of the adjustments you would want to make. You would have to know the information in advance and what the data tell us is that by the time it’s known to the market, there’s no benefit to making these asset allocation adjustments and if anything, you’re likely to miss out on the returns that occur in the future.
Jason Parker:
How does somebody’s time horizon… Here at Sound Retirement Radio, most of the people that are listening to this podcast are getting ready to retire or recently retired. Talk to us about time horizon and investments and risk. How should people think about, if they need to use money in the short term, how much risk should they take with that portfolio versus money that they don’t need for a long period of time?
Wes Crill:
I think just looking at the range of outcomes for something like stocks versus bonds is useful to get a sense of what the uncertainty is around the value of our portfolio that is posed by these asset classes. Like I mentioned earlier, even though stocks have had a very high average return in the long run over a given time horizon, there’s a non-zero chance that they could actually underperform. Now, the likelihood of stocks outperforming bills increases as that time horizon gets greater. The way to think about it is, the range of outcomes of your portfolio’s value. If you’re in a hundred percent stocks, the range of outcomes is going to be vast at future time horizons. But what happens is, as that range of outcomes increases, the average, so whatever is the center of the distribution, that average is moving to the right as well. The probability of a positive return gets higher and higher over longer time horizons.
But again, if investors want to decrease the uncertainty around really what they can afford to spend in the future, let’s say they’re preparing for retirement. What that implies is as you get closer to what we sometimes call the drawdown phase or when you’re actually consuming in retirement, then there is a natural tendency to reduce your exposure to something like stocks or risky assets that are widening the range of outcomes. There is a name for this, it’s called a lifecycle theory of finance. Where the idea is that your overall balance sheet of assets, when you’re still in your accumulation phase, when you’re still working and still saving, you have really two primary assets here. You have your financial assets, which that’s the stuff you save, might be in stocks and bonds, but you also have your human capital, which is your ability to continue to work, continue to make money, and continue to save and contribute to your portfolio.
Now when you’re far from retirement, the lion’s share of your assets are going to be your human capital. It’s not generally going to be your financial assets. We also know that your human capital is considered lower risk than financial assets like stocks, because it tends to be uncorrelated with the stock market or less correlated. Then over a long time horizon, you can continue to make more money and save. If the majority of your balance sheet is in these relatively low risk human capital assets, then that means your financial assets can take on more exposure to risky assets. That’s why we have a larger proportion of our savings in stocks, generally speaking, when we are younger and far from retirement. But that also implies as you deplete your human capital, no one wants to work forever, eventually going to reach retirement, then you have more of your overall balance sheet is in these financial assets, which means the financial assets need to take on less exposure to risk.
That’s why we had that transition from stock heavy to maybe lighter in stocks as we approach retirement. There’s no magic number around it what that split is when you get to retirement, many investors might look at a balanced portfolio. It’s somewhere between 60%, 40% stocks. Again, it’s going to depend on what your financial goals are. Do you have other considerations in addition to spending? Are you looking to leave a bequest or something of that nature? That’s going to factor into what the exact split is, but certainly we know from the data that reducing your exposure to stocks narrows the range of outcomes, but it’s also going to reduce the probability of increasing the value of those assets over time.
Jason Parker:
One of the headlines that we’ve been seeing a lot lately has been around inflation. Inflation shot way up. Inflation was coming back down just yesterday. The news was bad about inflation came in a little bit hotter than expected and the stock market did not like that. Talk to us about inflation. How can investors, if they’re worried about inflation, what have you found to be the best way to mitigate that risk?
Wes Crill:
I think we’re starting with the two different components of inflation. So you have expected inflation, that’s what market participants in aggregate believe is going to be the change in consumer prices in the future. And you have unexpected inflation, which are shocks that happen from things that could not have been foreseen. Certainly all of the supply chain madness associated with the COVID-19 pandemic had unforeseen impacts on consumer prices. But then over the long haul, there’s just a natural expectation, whether it’s in the short term or the long term, of what changes in consumer prices are going to be. Now here’s the good news is, to the extent that you’re reading about headlines associated with inflation, that implies it’s expected inflation. Expected inflation is reflected in current market prices, which means to the extent that certain investments are sensitive to rising consumer prices, there expected returns are going to have to be set to a level that offsets whatever that inflation impact is going to be.
Now, the test for this is to look at average real return. If you look at the average returns for different asset classes historically, net of inflation. If I subtract that inflation, what have their average returns been? Almost every asset class in fixed income and equities has had a positive average real return in high inflation years. Everything except one month, US treasury bills. Whether I’m looking at other types of fixed income asset classes, whether it’s longer duration government bonds, corporate bonds, stocks of various sorts, whether it’s large cap growth stocks, small cap value stocks, we have seen high positive average returns across all of these, and that’s a testament to these inflation expectations being reflected. If you believe that… Well, let’s say you don’t have a reason to believe in a higher rate of inflation than the rest of the market, or if you’re not of higher sensitivity to inflation than the average person, then a traditional portfolio consisting of stocks and bonds is likely to outpace inflation over the long haul, which means it might not have a big impact on you.
Now, if I have a reason to believe I’m more sensitive to inflation than the average person, there are financial tools to actually mitigating the impact of that. There are certain asset classes that we sometimes refer to them as inflation protected or inflation hedged, which pay you actual inflation. Because of that, they’re able to effectively hedge the impact of rising consumer prices. Now that comes at a cost. Those are typically lower expected return assets, but they will hedge unexpected changes in consumer prices. There are tools to deal with it, but I think the implication here is by and large. If your concern around inflation is related to headlines you’re reading, you might be okay at the end of the day with traditional financial assets.
Jason Parker:
Tell me what your thoughts are about gold. This is something that we hear a lot about from people these days. You see people concerned with inflation, they think that gold is a store of value, that it’s a way to invest to try to beat inflation in the long run. Should people own physical gold as part of a diversified investment strategy?
Wes Crill:
Gold in particular, and commodities just more generally speaking, have often been touted as inflation hedges. They check one of the two boxes that we would look for in something that is truly hedging inflation. They are correlated with consumer price changes. So if consumer prices go up, then we tend to see commodities will rise in value as well. That’s one thing you would be looking for hedge. Now the other box, which I think is equally important to check, I don’t think commodities fair as well. If I think back to what my goal is if I’m sensitive to inflation, what I’m really saying is, “I want to reduce the uncertainty around what my current assets can afford in the future. I want to minimize the uncertainty around what I can spend in real terms at some point in the future.” Commodities typically don’t fare as well there because their return variance is very high.
In fact, typically about 10 times the variance around consumer prices themselves. What that means is, while my returns are correlated, my range of outcomes is getting broader by investing in these assets. Another type of asset class like inflation protected bonds, are both correlated with changes in consumer prices because they’re literally paying you for these changes in inflation or for inflation itself. But they’re also low volatility and so they reduce the range of outcomes going forward. For that reason an investor’s primary goal is to tame the impact of inflation. I think there’s better ways to do it than through commodities such as gold.
Jason Parker:
Dimensional funds specifically built a reputation around small cap investing, when you were first launched and the research that came out about having exposure to small cap investing. Talk to us about the process that Dimensional uses specifically for identifying what type of companies are included in a small cap strategy. What type of companies would be excluded from a small cap strategy, and how that might differ from just an overall small cap index fund from a different carrier.
Wes Crill:
I think the implementation of small cap strategies is indicative of what I think is the hallmark of Dimensional, which is capitalizing on the big ideas in finance and finding a way to implement them in the real world. What that implies is, we’re continuously doing research on financial markets to uncover what we think are relevant drivers of expected returns, what are characteristics that tell us about which stocks or bonds should have higher returns? Then we use those to inform our portfolio design, where we will build portfolios around securities to pursue higher expected returns.
That’s been a continuous process that’s definitely had some high water marks along the way where, it was small caps that we learned about in the early eighties, and then along the way we found a systematic way to identify low relative price stocks, so companies with low price ratios we now call value stocks. That was a development that we were able to capitalize on in the early nineties. And more recently in the late 2000s, I’m trying to take a walk down memory lane here, we started to learn more about a profitability effect. In 2012 there was a very seminal paper on high profitability stocks versus low profitability stocks,. We did a lot of research to understand the interaction between the profitability effect and the value effect, and how we could leverage both within portfolios. Then things we’ve done along the way, companies with high asset growth, companies whose stocks were of high demand and the securities lending market and things of that nature. We’re always incrementally improving our understanding of expected returns and we will improve our portfolios or alter our implementation as we learn more and more about financial markets.
Jason Parker:
That brings me to the process that you have implemented, this daily process of rebalancing. Many index funds, many market cap weighted index funds are just reconstituted annually. You guys have a daily process. Can you talk to our investors, our listeners, and help them understand why a daily process might be more efficient or more effective rather than just reconstituting once per year?
Wes Crill:
I sometimes use oral hygiene as an analog for this, where there’s two different ways you could go about preparing for a dental visit. One of them is to brush your teeth a couple of minutes every day. You’re doing all of this incrementally throughout the year. The other way to do it is to brush your teeth for 12 hours a day before the exam. One of them is going to give you more reliable results than the other, and that’s the way we think about turning over our portfolios. Our level of turnover, the amount of buying and selling of securities we do is actually similar to indices that would be in the same asset class. I should say, index funds in the same asset class. The difference is that we space it out throughout the year a little bit every day rather than doing it once or a few times during the calendar year, and that has a couple of really big benefits.
The first is the cost per unit of that turnover. If I have to do all of my trades at a certain point on the calendar, that means I don’t have flexibility about what I’m buying and selling. If there are stocks that I want to add to my portfolio that maybe have very little prevailing liquidity out there in markets, that means that I’m going to be potentially inducing a lot more trading than would be otherwise occurring in those securities, and that could potentially cost me. We see that in terms of a reconstitution effect with index funds where when the indices change the composition, then the market knows there’s going to be changes within the index fund composition and you see prices move accordingly. That’s one big benefit.
The other one is when we think about when we’re trying to pursue higher expected returns. One of the critical inputs there is market prices. Now, when market prices change, expected returns are changing. Market prices change every day because we have news that can potentially come out every single day. Having to wait until three months from now or six months from now to make changes in our portfolio when there’s real information we could be capitalizing on now that’s relevant for expected returns, that’s an artificial constraint in many ways. We are prioritizing the expected return, so we want to be able to make that change.
Now, there’s a perfectly good reason why index funds are doing all this. This is not something that’s unknown to the designers of indices. But if you think about what the objectives are for indices, index providers more generally speaking, Standard & Poor’s, MSCI and others. What their goal is at the end of the day is to have as many people tracking their indices as possible. They’re not necessarily trying to pursue higher expected returns, they would probably know how to do that. But if you’re prioritizing having more people tracking your indices, you got to make them easier to track. Which means having fewer turnover events, which means having more transparency about what’s going in and out of the indices. Those are impediments to expected returns, but they are contributors to having more people tracking your indices. It’s different objectives and clearly what we’re prioritizing is better returns for investors.
Jason Parker:
As more and more people use index funds, it seems like there would be inefficiencies created just based on these reconstitution dates. If index fund providers are required to trade to have that index matches closely to the index as possible, and they have to trade within a small window of time, does it create opportunities for small investors to try to front run those trades and take advantage of them?
Wes Crill:
This is essentially the reconstitution effect. When we think about what is actually happening, what the implications are for security prices? If you have securities that are being added to an index, let’s just as an example, let’s say it’s the Russell 2000 small cap index, the securities that are being added, well, they’re known in advance what the identity is of those securities. What can happen between the announcement of when the changes are going to be taking place and when the changes actually take place, you can have bidding up as people seek to add those securities into inventory, and then they sell them to the index fund managers upon the actual reconstitution date. That means that the index fund managers are buying any higher price than what they would’ve been able to get just a few weeks earlier. The reverse is true when you have securities that are being deleted or leaving the index where you could have downward pressure on the prices of those companies as more and more people are looking to sell.
To your point, that’s going to be a function of how many assets are actually tracking that index. Now in the case of the Russell indices, you have many, many, many billions of dollars tracking those indices, and this can be a pretty meaningful impact. Probably the most recent one was actually the NASDAQ 100 rebalance that happened this past summer. There was a decision made by the index provider that there was too much weight in the magnificent seven stocks. Don’t ask me to name all of them, can’t usually do that off the top of my head. They’re tickers spell, TANMAMA, in case anyone wants to use a good memory device there. But those companies were accounting for, I want to say it was more than 55% of the index, so the decision was made to trim that collective weight back by about 12 percentage points.
If you look at the price impact on the changes in weights, if an investor who is ostensibly trying to replicate the holdings of the NASDAQ 100, if they could have made the changes on the announcement date instead of five days later when the changes became official, that investor would’ve saved about 0.4% in terms of their return. That’s a pretty big number, especially when you contextualize that in terms of expense ratios for different funds. Just throwing out random numbers, say it’s 10 to 20, 30 basis points. You’re talking about on par with an expense ratio level for investment products. These numbers matter and they are going to be a reflection of how popular these various indices are.
Jason Parker:
Talk to us about rebalancing. What are your thoughts? How frequent is rebalancing a good idea as a risk mitigation tool, and how often should people consider it
Wes Crill:
In this context when we think about rebalancing, we’re talking about probably an investor’s allocation between different portfolios. How do you make the determination of, let’s say your stock portfolio has been increasing in value, maybe it’s drifted away from whatever your target split was between stocks and bonds. Even within stocks, let’s say I have a value portfolio and a growth portfolio and let’s say I have some idea of what percentage I want each one to account for. Well, as you have relative performance differences, obviously those are going to drift away from your target weights. The trade-off you’re always balancing is going to be what the risk is of being different from what my prescribed mix was of the assets. In the case of stocks and bonds, let’s say it was 60/40, now I’m at 65/35. What is the implication there versus what is the cost associated with selling some of my stock portfolios and buying some of my bond portfolios? That risk is going to be different for different people.
Some investors like to simplify it and do it just on a reoccurring basis, let’s say quarterly might look at this. Some investors might want to see the drift be even less, so they might do it on a monthly basis. Some investors who don’t think as much about their portfolios might do it on an annual basis, which means they have more drift away from their targeted split between assets potentially, but they’re also spending less in terms of transaction costs, ticket charges, let’s say if it’s mutual funds, trading costs if it happens to be ETFs. There’s always going to be that balance there. I don’t think there’s a right or wrong answer there. We’ve done some writing about this in the past about what you’re tracking here might be versus the market, and I think the big trade-off is really going to be how much are you comfortable with in terms of transactions, and also how willing are you to just overlook this on a continuous basis. There’s certainly going to be some investor sentiment that factors in that the more often I look, the more sensitive I am to those deviations.
Jason Parker:
Jack Bogel said he had the Cost Matters Hypothesis. Tell us about costs. What is a reasonable cost people should expect to pay for investing?
Wes Crill:
Costs are, if you think about it, that’s one of the few elements that you have some control over. Expected returns and you’re going to get what the market gives you. But there are many selections that we can make that are going to impact our costs. If we think about funds themselves. Funds have numerous different types of costs, the most obvious one would be the expense ratio you’re paying. When we look at funds within an asset class, they’re going to have a huge range. Some of that depends on whether it’s an index fund, which for the reasons we were speaking about earlier, because they outsource their investment process to the indices, they have potentially lower expected returns, but also lower costs, but then the active space is usually a huge range. But that’s not necessarily going to be an investor’s total cost of ownership.
I think that’s where you get to some of the other potential embedded costs that can be created within a fund strategy. The reconstitution effect is a big one. If you’re reducing your expense ratio by a few basis points, but then you have potentially tens of basis points worth of a reconstitution effect, well, that’s an additional cost that an investor might not necessarily see on the surface with expense ratio. Those are the types of things that are going to be informative about an investors expected return, but there’s also other elements like taxes. Some funds might have similar levels of turnover, similar expense ratios, but then they might generate more in the way of costs. Where maybe if the capital gains distributions that are occurring from a mutual fund for one manager who’s very careful about ensuring that those are long-term capital gains, well, that’s going to be a lower tax implication versus a manager that might have some short-term capital gains that are embedded there.
You can also have different types of income that’s thrown off in the portfolio. Some dividends, depending on certain requirements that are satisfied might become qualified dividends, which means they have a lower tax cost than unqualified dividends. For example, REITs tend to have mostly unqualified dividends stemming from them, so investors who are at different tax brackets or different types of accounts might be more sensitive to those than others. For me, one of the biggest costs is the cost of drifting from your asset allocation. If you are trying to manage your own investments and if you’re reacting to markets. If you are drifting, if you are getting out of stocks at the wrong time, or if you’re deviating from let’s say a value tilt when you’re reacting based on your beliefs going forward and you miss out on some of the returns that the market is delivering. I think over the long haul, that can be one of the most deleterious effects to an investor’s return. But certainly having a broad consideration of cost is important.
Jason Parker:
Yeah, that’s good. Ultimately, at the end of the day, we want the people that listen to this show to achieve clarity, confidence, and freedom. Clarity to know what’s most important in their life, confidence to know the numbers are going to work, and freedom so that they can be free from fear and free from greed. If you were talking to your mom or your grandparents and you were trying to encourage them to put together an investment strategy for the long haul, what advice would you give them? How would you help them to create a portfolio that’s sustainable for a long period of time?
Wes Crill:
Ooh, that’s always a really tricky question. I actually do have these conversations with my parents sometime, and frankly, I don’t think they always listen to me. But what I try to do is to your point, think about what are your objectives. I think once you determine what you want to do with this money that you’re saving, that can help inform form the types of exposures you’re willing to take or the types of risks that you’re willing to embed in the portfolio, and then make it as broadly diversified as possible.
It’s often said that diversification is really the only free lunch you get in finance, and it’s something that can really help you mitigate all the idiosyncratic risks, so that the risks you do take are compensated risks. I think that’s a really important element. Then potentially put a block on news media, financial TV stations on your cable box. Because to the extent that you can tune out the noise, again, getting back to the name of the Dimensional movie, the better off you are. Because if you think about the types of viewpoints that are being espoused by media sources, their objective at the end of the day is not to make you money. Their objective is to sell ads to garner views because they want to make things very exciting. Excitement should be the antithesis of investing. It should be like watching grass grow, and to the extent that you could make your investment approach as boring as possible, you’re likely on the right track to more reliable investment outcomes.
Jason Parker:
How important would you say it is to have a plan if you’re getting ready to retire, a financial plan and not just an investment strategy?
Wes Crill:
I think if you don’t have a plan, then it’s like not having a North star, where you don’t know really what direction you want to be moving, and it makes it harder to stick with investment results. I always think about, all investments are going to have periods where they don’t fare well, where a source of expected returns is not panning out. And having conviction and, “Here’s why I’m invested in this. Here’s why it is a good fit for what my goals are in the future,” it just makes you more likely to stick with it and avoid getting out at the wrong time.
I keep thinking back to Q1 of 2020 and we saw all the money that was going into money market funds, I think 700 billion in flows in March of 2020 alone, and many of those investors missed out on the gains that came roaring back. A similar story happened another year later with value stocks. To the extent that we know why we’re invested in certain assets and we know why we have that plan in place in the first place, it makes it more likely we’re going to stick with it.
Jason Parker:
Absolutely. If you don’t stick to your plan, there is no plan. You’re just bouncing from one idea to the next and it could destroy a good retirement strategy. Wes, this has been a lot of fun. I always value having people of your expertise on the program. One of the questions we hear often, and I know you guys are newer to the ETF space, but there’s a debate between mutual funds versus exchange traded funds. Can you maybe share with our listeners your thoughts about the pros and the cons of those two different types of structures, and is there a reason to use one over the other?
Wes Crill:
I think the primary distinction between the two is how investors would access liquidity for them. For example, if you want to sell shares of a mutual fund, then you’re interacting directly with the fund provider. If you are trying to sell shares of an ETF, you’re doing it on a secondary market. The trading that happens between buyers and sellers of ETF shares generally don’t induce any trading within the ETF fund, the portfolio of underlying securities. There’s not necessarily going to be sales of securities in that portfolio or purchases of securities for the portfolio, but that can’t happen with a mutual fund. That distinction really comes down to what potential tax exposure you might have. For example, a mutual fund might have capital gains that get distributed out to investors if there are cells of securities for the portfolio that are needed to meet redemptions for investors who are looking for liquidity.
Whereas in the ETF, again, if I just have two ETF investors who are one selling shares of the ETF to the other, if it’s not impacting anything to do with the underlying ETF portfolio, then that won’t necessarily trigger capital gains. In practice what this means is, ETF investors can generally determine when they trigger their capital gains. You don’t get out of them entirely, always going to have to pay your taxes eventually, but you don’t trigger capital gains for yourself until you actually sell your shares of the ETF. There’s certainly value in being able to determine when that liability is actually exercised, but I think that the overall investment implications, a more important set of investment implications, I should say, is what the underlying portfolio is.
For the most part, ETFs and index funds were used synonymously for many, many years with the rise of active ETFs, of which Dimensional is a part, actually the largest by AUM active ETF manager out there. I think that there’s the opportunity to really go beyond indexing and to have an ETF type of strategy that can deliver even more reliable performance for investors. But I think that’s one of the key distinctions. Now, just like every investment implication out there, there’s trade-off’s, there’s pros and cons. When it comes to ETFs, because you’re going to be trading in a secondary market, well, you have less certainty over what the price is actually going to be when you’re trying to sell shares of the ETF, you effectively become a trader. Whereas with a mutual fund, you’re going to get whatever the net asset value is at the end of the day. There’s potentially less uncertainty there. I think it’s different strokes for different folks and there’s no one superior structure versus the other, but depending on what investor’s circumstances are, one of them might be more appealing.
Jason Parker:
You mentioned two phrases there, active versus passive. Talk to us, how does Dimensional fit into that discussion between active and passive?
Wes Crill:
I think the precise way to differentiate it is really index versus non index. An index strategy implies you’re tracking an index. I think if you’re not doing that, you are active. I think of active as essentially being non index. There’s different ways to go about active investing, and I think that’s where there’s a little bit of nuance where Dimensional compared to other traditional methods of active investing, there is definitely a distinction. If you’re deviating from the market, it depends on what the inputs are to that deviation. Dimensional deviates from the market is not indexed because we’re pursuing higher expected returns. We believe that not all stocks and bonds have the same expected return, and we will emphasize certain securities with higher expected returns.
Deviations from the market that are motivated by trying to find mis-pricing trying to time markets. That was the traditional definition of active, I think has been shown in the data to be a less reliable way to pursue higher expected returns. But I think that’s the key distinction, which is index versus non index. There’s clearly drawbacks when it comes to an index style of investing. A lot of it stems from what I was mentioning earlier, which is the motivation, the objective for indices is not to pursue the highest expected return, it’s to facilitate tracking, and so there’re drawbacks that come along with that. We believe with a lack of a mandate to dogmatically track an index, you can improve upon those drawbacks and add value at which we believe our track record suggests that we’ve been able to do. But that’s the main distinction there, whether you’re tracking an index or not.
Jason Parker:
Well, I’ve enjoyed our time together. Any final thoughts for our listeners this morning?
Wes Crill:
I think the main lesson that hopefully has come through in all of this is, words that our co-CEO Dave Butler is very fond of saying, which is, “Control what you can control.” There’s so many elements of financial markets, the economy, the world at large that are out of our control, but to the extent that you can exercise control over the things that are in your power, the costs we were talking about mitigating against some of the biases that would influence unnecessary turnover in your portfolio, buying and selling at the wrong time. These are very helpful things to keep in mind to increase the reliability of an investor’s experience.
Jason Parker:
Awesome. Wes Crill, thanks so much for being a guest on Sound Retirement Radio.
Wes Crill:
Yeah, thanks for having me today.
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 Avenue, Northwest, Silverdale, Washington. For additional information, call 1 800 514 5046 or visit us online @soundretirementplanning.com.
