Guest User

October 28, 2021

Expected Returns, Factor Investing, Index Funds, Portfolio Management

Episode 173: Antonio Picca: From Index Investing to Factor Investing at Vanguard

Guest User

October 28, 2021

Expected Returns, Factor Investing, Index Funds, Portfolio Management

Mr. Picca is a senior portfolio manager and head of factor-based strategies in Vanguard Quantitative Equity Group (QEG), responsible for conducting and overseeing research and portfolio management for all of QEG’s active factor strategies. Prior to joining Vanguard in 2017, Mr. Picca was a senior member of the strategy research team at Dimensional Fund Advisors, where he worked on the design and the implementation of factor-based investment solutions.

Mr. Picca earned his M.B.A. and joint Ph.D. in finance and economics from the University of Chicago Booth School of Business and the University of Chicago department of economics, where he did his doctoral work under the supervision of Gene Fama. He has an M.S. in finance and economics from the London School of Economics and a B.S. in international economics and management from Bocconi University in Italy.

In our conversation this week, we take a deep dive into factor investing. We are joined by the formidable Antonio Picca, Head of Factor Strategies at Vanguard, to help us navigate this complicated topic. Antonio is one of the largest asset managers in the world, with over seven trillion dollars under management. Among his credentials is a Master's in Finance and Economics from the London School of Economics, as well as a Doctorate in Finance and Economics from Chicago, where he was also a teaching assistant with Gene Fama. During our discussion, we cover a broad series of questions on factor investing, while also venturing into deeply technical territory. We examine how one might make the transition to factor investing after gaining confidence in passive investing and unpack important questions around factor investing and risk. Another fascinating topic we cover is how factor investing resembles active investing, including some crucial distinctions. Next, we take a look at some of the negative connotations of active investing and investigate why those issues may not apply to factor investing. Antonio goes on to explain why factor investing is a natural extension of a broad equity market investing and illustrates how it aligns with Vanguard’s philosophy, which is a belief in low-cost, long-term focus, and broad diversification. You won’t want to miss this excellent opportunity to gain a deeper understanding of factor investing from one of the leading experts in the field. Tune in today to hear it all!

Key Points From This Episode:

Introducing today’s guest Antonio Picca, Head of Factor Strategies at Vanguard. [00:00:17]
How Antonio would explain factor investing to an existing Vanguard client who's already sold on the idea of low-cost, cap-weighted index investing. [00:03:16]
Why clients need to be educated on factor investing, and why factor investing is a form of active investing. [00:04:31]
The benefits of targeting other factors in addition to the market risk factor. [00:05:20]
Some of the drawbacks to a strategy that targets other factors in addition to the market risk factor. [00:06:41]
How Vanguard helps clients determine whether factor investing is the correct course of action for them. [00:08:19]
The role that cap-weighted investing plays in the structure of factor products when capital forms the core of your investing, and factor portfolios are secondary. [00:09:35]
How investors should think about sizing their factor position, relative to their market cap-weighted position. [00:11:12]
How they decide which factors to target in Vanguard's product lineup. [00:12:37]
Vanguard’s approach to capacity when considering factors. [00:15:03]
How Vanguard decided to target momentum as a standalone factor. [00:16:24]
More on the liquidity factor and how Vanguard is targeting it. [00:17:40]
A breakdown of what the value factor is. [00:20:12]
Why factor investors should want to be active, rather than follow a factor index, despite the negative connotations that come with active investing. [00:22:25]
Why negative connotations of active aren’t applicable to active factor investing. [00:24:27]
The frequency with which factor funds need to be rebalanced to effectively capture the factor premiums. [00:25:52]
Instances where it is possible to quantify the benefit of more frequent rebalancing, or more flexible rebalancing. [00:27:01]
Some of the days in early 2020 where there were market movements of multiple percentage points and how Vanguard made decisions accordingly. [00:28:05]
Antonio's thoughts on the prospect of quantifying premiums for factors. [00:30:46]
The paper that Vanguard is currently working on to determine whether it is possible to time factor premiums, or whether investors maintain consistent exposure to them. [00:32:32]
How factor investing is different from traditional active management. [00:33:51]
Some of the instances where a factor portfolio can replace an active manager. [00:35:40]
Antonio’s experience leading the factor group at Vanguard during a period when large-cap growth stocks have dominated so powerfully. [00:36:43]
How Antonio addresses client concerns that factor premiums have changed or decreased. [00:39:30]
Antonio’s thoughts on winner-take-all companies and their proliferation. [00:41:47]
What Antonio advises investors should be looking for when they're choosing a factor fund. [00:45:49]
Some insights into how Antonio’s clients are using factor products. [00:47:15]
How Antonio approaches combining multiple factors. [00:48:33]
Antonio shares his thoughts on do-it-yourself investors implementing factor portfolios and why he thinks advisors are essential. [00:50:21]
How Antonio defines success in life and investing. [00:54:38]

Read the Transcript:

So Antonio, you run factor investing at Vanguard. We're very excited to be talking to you, because we talk a lot about factor investing, and Vanguard's obviously a huge player in asset management. So the first question I want to ask you is, how would you explain factor investing to an existing Vanguard client who's already sold on the idea of low cost, cap weighted index investing?

Yeah, no, listen. The way I've been explaining that is that factor is the underlying drivers that influence and explain the way an investment behaves. And both of these words are important. Influence is about control. You can use factors to achieve a certain investment goal that could be out performing the market or equity market exposure but with lower volatility. Explain is about understanding and transparency. People have used factors to understand what drives the performance of their portfolios. Now people tend to forget that the equity market was the original factor. Going back to the research, the academic research in the 60s, the equity market was identified as the first factor in the capital asset pricing model or the CAPM. So factor investing is a natural extension of a broad equity market investing. And it's fully in line with our philosophy as a firm at Vanguard. We believe in low cost, long term focus and broad diversification and factor investing is aligned to all of those principles.

Do you find it tough to convince people that factors are simply an extension?

There is a lot of education that needs to go in there. So a lot of what we have been doing over the past few years, including in the Canadian market, has been talking to clients, educating them on what factors are and what factors are not. They're not a miracle. They're not a solution that will outperform in every environment. But for those investors who have patience and long term focus and understand that there is cyclicality in active investing because factors are a form of active investing. Anytime you deviate from market capitalization, you are taking an active position. They are a good investment solution. They are low cost, they're transparent, and they can help you achieve your long term investment goal.

Can you talk a little bit more about the benefits of targeting other factors in addition to the market risk factor?

Yeah, absolutely. I mean, listen, it all depends on what your investment goal I was mentioning before. If you want outperform the market and you have a long term focus and you have the willingness to store periods of under-performance that can protected in time, as we've seen with value, value investing is the poster child for factory investing, then factor investing is for you. The other goal that you might try to achieve is if you want exposure to the equity market, but you want to reduce your volatility, then a solution like minimum volatility can help you achieve the goal. Now factors are a diversification to the market premium tool. Now, after 10 years of a very long bull market in equities, it's easy to forget that the equity market return can be lower than the one that we've been used to over the past 10 years. So factors help you outperform in an environment where market returns might be lower.

Also we have seen investors using factors or factor like value, going back to value, as a way to reduce the risk of stretch valuations in the market because the markets are trading close to all time high valuations, especially the US market, and, well, value stocks appear to be more fairly priced these days.

So a client says, okay, Antonio, I get it. But what are the drawbacks of this strategy?

Yeah, absolutely. Listen. And we value you clearly seeing it. You are taking active risk. So that is a good chance that you can underperform even active periods in time. So you have to be ready to stomach that underperformance and willing to stay the course. Again, it goes back to the fact that this is an active form of active investing and any active investing can lead to underperformance over periods of time, and it's cyclical. I mean, value almost by definition is cyclical. Because you are exactly compensated for your potential underperformance in periods like slow down or contraction when investors are the most adverse to losses. But it's exactly that understanding that you can underperform in periods of time when you don't like it, that compensate you for the risk that you're taking. So again, there's a lot of education and understanding that you need before you can be a successful factor investor.

Again, coming back to the idea of the Vanguard investor that owns the cap weighted funds. I don't know if you've read the John Cochran's paper on portfolios for long term investors where he emphasizes the average investor theorem. It's like average investor owns the market portfolio. So you got to figure out how you're different from them. Traditionally, I think people think of Vanguard as giving access to that, to the average investor's portfolio. So again, if that customer's sitting there, that Vanguard customer's sitting there with their cap weighted Vanguard portfolio, how do they decide if they're different from average in a way that they should be pursuing factor investing?

I mean, and really the way we think about factor investing and I should have gone back to principles is a core satellite. We strongly, strongly believe in capitalization based investing and the core of your allocation is in almost every case, the broad market, and then yield to factors, more or less, if you want to deviate from market capitalization. For example, again, if you want to outperform, and then if you have the long term focus that allows you to do that, and also you have to, again, understand what's your appetite for risk. And if you understand a combination of these three and you, for example, want to outperform because you have certain funding requirements that you are trying to achieve, or you want to lower the volatility potentially with the possibility of reducing draw down risk without staying exposed to the equity market, these are considerations that you can make to decide whether you are a factor investor or not. But again, for us, it's not really about substituting completely your core equity allocation with factors. It's much more about complementing your equity allocation with factors.

Yeah. That makes a lot of sense. So core is the market cap. The satellite is the factor portfolios. Given that, what role, if any, do cap weights play in the structure of the factor product?

Yeah. Well, I mean, that's a perfect segue for us because really when we were thinking about construction, we decided to disregard marketing capitalization from our portfolio construction exactly because of that reason. It's not that we don't think market capitalization is important. It's super important. We're Vanguard after all, but it is the fact that you are really trying to get away from market capitalization when you think about factor investing. You are trying to have a very capital efficient compliment to the market that gives you a very targeted factor exposure. And to do that, you necessarily need to deviate from market capitalization. So this is really, and that's a way we do it. We weigh stocks according to the intensity or the factor exposure. And we target stocks across the broad capitalization spectrum. And we do that to really deliver a strong exposure. We maintain that exposure consistent over time through our active implementation. And that's designed exactly to be a very capital official complement to the broad market, which is going to deliver you the factor exposure that you need without having to allocate a large amount of your portfolio to factors.

How do you think someone should think about sizing their factor position relative to their market cap weighted position? And, and I know you mentioned the core satellite approach, but would it ever make sense for someone to go 100% in factors?

I would say that unless you have a super strong conviction that one factor is going to outperform over any given horizon. For example, one investor might say, "Given where valuations are, I think that value might be the investment opportunity of a lifetime." And so when I put all the eggs in one basket, that's possible, but it requires very, very, very strong conviction. I don't think that I personally myself wouldn't do that. So even though I'm a super strong believer in factors, I don't believe that I have the ability to time factors to that extent. So I would say that for most investors, generally factors will represent less than 50% of their equity allocation. And even when you think about the 50% of equity allocation, you are, most of the time, not thinking about one specific factor, but you're thinking about a balance allocation to different factors because, again, it goes back to the principle of diversification. Factors pay off at different times. So by combining together multiple factors, you're able to get a more balanced investment experience.

So you mentioned different factors and we've talked about the factors many times on this podcast, there's something like 400 documented factors out there right now. How do you decide which factors to target in Vanguard's product lineup?

I mean, we use, fairly, I would say, standard criteria for high quality managers. And that's the fact that you need to identify what's the sound economic intuition behind the factor. And then you need to look at the empirical evidence. Is the factor supported by empirical evidence across different periods, different regions, different asset classes? With that philosophy in mind, we really boil it down to a small set of factors, definitely not the three to 400 that you look at in the literature and bear in mind, I mean, even in the literature, many of the factors that have been identifying the literature and we should call them factors quotation mark, because they're not really different factors. They're just different characteristics that measure an exposure to a factor in a slightly different way.

Right.

And I think that there is a value to that. I think that even when you, going back to the principle of diversification, we think that it makes sense for you to use multiple lenses to look at the factor exposure. For example, for value, we think it makes absolute sense to look at things like price to book, price to cash, price to earnings, because value investing is almost like trying to value a firm. So you want to look at different multiples together, different idea about how cheap a firm is. On top of that, you also stay away from things like data mining. You don't want to put all of your eggs in the basket of the valuable related to the best returns in sample to for example, and you also stay away from noise in the data. Because even though we have very, very high quality data when it comes to these factors, there can still be errors and missing data, and the ability to use multiple valuations or different characteristics for other factors like momentum or even volatility allows you a more complete picture and better coverage of the universe.

How do you think about capacity? With momentum is maybe a good example. I'm not as familiar with liquidity. Minimum volatility is another one where I think capacity comes up as a potential consideration. And you combine that with Vanguard's size, obviously, where if a relatively small portion of Vanguard's assets move into these products, it's pretty big dollars. How do you think about capacity for the factors?

Capacity was a big consideration when we consider launching these factors exactly for the reasons that you just discussed. And we really landed on an approach that is broadly diversified because of our broad diversification, we put less than 1% in the global funds, really in any single names. We have hundreds on names, 1,000 in many funds. So it really goes back to the principle of diversification. I would say our factor funds are high conviction funds in the sense that they really go after a targeted exposure to the factor, which is, again, comes from deviating from market capitalization. But at the same time, they are really, really broadly diversified. So you can do high conviction and broad diversification at the same time. And that allows you to reduce concerns related to capacity, reduce concerns related to also the cyclicality sometimes. I mean, if you invested, let's say, only the top 50%, most attractive value or momentum names, it becomes a much more cyclical payoff. So those are considerations we made when designing the funds and when we launched them.

How did you decide to go with momentum as a standalone factor, as opposed like I know Avantis and Dimensional Fund Advisors, they use it as sort of a trading filter. How did you decide to target it directly?

We based on our experience. So I should tell you that I used to work at DFA, very familiar what they do. I used to work with the folks at Avantis. They're great people, but I'm part now of a quantitative equity group that has been in this business for 30 plus years and momentum is one of the strategies that we've been targeting for a long time and given our execution ability at Vanguard, like where we've been used to trading thousands of stocks for years and years, we have an execution that allows us to capture momentum in real world, broad, diversified portfolios. And so based on that, we launch our momentum strategy. And again, the other point is we have a flexible implementation in all of our factor strategies and the flexible implementation allows you to optimally balance the trade off between maintaining a strong and consistent exposure to the factor, but also minimize the impact of trading costs.

Very interesting. I want to dig a little bit more into the liquidity factor. I think most of our listeners are pretty familiar with the other factor of Vanguard is targeting, but liquidity is one that we have not talked about much in the podcast, and it doesn't seem to be as prolific in other funds out there. So can we talk about the liquidity factor?

Yeah, for sure. Absolutely. We think the liquidity factor is actually the driver behind the performance of what people have for a long time considered the size factor. We have an exposure to size across all of our factor funds because we believe the factors deliver stronger premium within smaller capitalization securities. So that's very deliberate. At the same time, we don't necessarily believe that small caps deliver a premium on their own, but they do give you an exposure to value and liquidity. So because we already offer a value fund, the idea was if we want to really hone in on a driver of expected returns, why don't we go after liquidity? And there we are really targeting the relatively less liquid stocks, not in liquid stocks, because we want the strategies to be able to grow at capacity, but we target relatively less liquid stocks. And the idea there is that you are really providing liquidity to the market. So you are getting compensated for being a liquidity provided to the market.

The other big advantage of the strategy is that, and I think it's really shining today, is you are staying away, it's almost like popularity and I've seen people using the concept of popularity for liquidity, you're really staying away from, if I told you like you can target the Russell two or those small caps, but you can stay away from the mean stocks because those are not good for long term investors. They might be good for speculators, but not for long term investors. Do you want the strategy? And my answer would be, yeah. Yeah. I believe that I can get higher returns from investing in smaller capitalization security, but I can stay away from those type of stocks that tend to get very expensive and overheated, and liquidity is getting you that as well. So I think at the moment we see that really resonating with investors who want to get access to that small part of the market, but they want to stay away from some of these speculative dynamics we have seen there.

And generally in small caps, we see this everywhere, high volatility, high growth and profitable small caps now represent a large fraction of the Russell two, for example, the Russell 2000, which is a small capitalization index. So, a factor like liquidity gives you access to the part of the space without having to take the baggage.

I have a very basic question for you, Antonio. How do you explain in the simplest terms what the value factor is?

I need to think hard about this because I think we are given every possible explanation for value and I don't know what resonates the most. I come from an academic mindset. So I go back to the explanation that when you buy value stocks, you are buying more cyclical stocks, which means that you're buying stocks that tend to do better during an economic recovery and expansion and worse during a slow down and a contraction, which when during a contraction and a slow down is when investors are the most adverse to losses. So it's this idea of covariance with your overall wealth and then makes value stocks risky. And so if you're willing to take the risk you get compensated. Now, this is not an easy explanation. You asked me for the easy explanation The easiest explanation, you're just buying stocks that are cheaper with respect to their fundamentals. And those stocks tend to out perform over the long term.

It's almost like, and we used to use this analogy I think when I was at DFA, talking about you want to buy, like suppose you can buy a pair of shoes. How much happier are you if you can buy the pair of shoes on sale, as opposed to pay full price, considering that you get the same utility from working with those shoes? So that's a easy explanation, but the reality is a little bit more complex than that. And I think if people understand what is the risk embedded in value, then they can more easily live with the underperformance like the one we have observed over the past few years.

Antonio, you mentioned the word active a couple times, and I know Vanguard's funds are labeled, the factor funds are labeled as active. We see this in our day to day where talking to somebody expect that concept of the Vanguard investor whose sold on indexing. They hear the word active and they kind of cringe like, "No, I don't want that. That's why I'm using index funds." Can you explain why factor investors should actually want to be active rather than follow a factor index?

For sure. I mean, listen, a couple of things there. First, this idea of active that has a bad connotation might be potentially changing because now you see many more active ETFs coming into the market. And when we launch these as active ETFs, we totally face the same conversations. People were like, "Why do you label like as active? That's a bad connotation." We made the choice very deliberately because when it comes to delivering a strong and consistent exposure to the factor, you want to have the flexibility of rebalancing, not on a schedule. You don't want to be tied to a schedule like every six months because within six months, your exposure to the factor can change completely. So over six months, your exposure to a factor like value or momentum will decay meaningfully. So if you are able to rebalance a little bit over time and what people get most of the time they get confused with is that they believe that because it is active, it needs to have more turnover.

That's not the case. It's just about spreading turnover more evenly over time and being able to more effectively balance the trade off between factor exposure and trading costs at any point in time. So we believe that there really adds and the flexibility really can add a substantial amount of premium for investors thanks to the fact that allows you to keep the factor exposure more consistent over time. And also with the fact that active ETFs are becoming more mainstream, I expect the people to become a more comfortable with the idea of active again. So I'm really excited about the development that we have seen recently in the markets.

But active is such a loaded word, isn't it, in investing today? I mean so many people think of active as being predicting or speculating, be it interest rates, be it direction of the market, be it direction of stocks, direction of sectors. That's not what you're talking about here.

Yeah, absolutely. So if you think about it, the way I will talk about it is active implementation.

Right.

So these funds are completely rules based. We are not trying to take any position or timing of the factors. We get if you want a fresh benchmark every day and we try to maintain the exposure to that benchmark as consistent as possible over time. And sometimes that means that you have to rebalance in a factor like momentum recently, every couple of weeks. Again, it doesn't mean that you need to use more turnover. It just about being able to use the same turnover, but more flexibly. Sometimes you rebalance every month or every couple of months, the other advantage is flows. As you get flows, both inflows and outflows, you are able to use those flows to invest in the most attractive stocks, for example, if it's an inflow, which is a great advantage. Because in a traditional index fund, let me use this example. Suppose you have an index factor fund, you are financing to the rebalancing. So you are one month away from your rebalancing and you get a considerable amount of money.

You cannot use the money to buy the more attractive names from a factor perspective today, you have to buy a snapshot of the portfolio as it looked like five months ago. So that's not very efficient. Again, it's all about the idea of using capital in an efficient way. And that's really what the active implementation allows us to do.

On the topic of rebalancing, how frequently do you think a factor fund needs to be rebalanced to effectively capture the factor premiums?

In most cases we will rebalance every month, but there are periods in which we more rebalance more frequently. For example, this year, we have seen it. Momentum has gone through many directions because we went from stay at home trade to a reopening trade. And now we're going a little bit back into the stay home team. But normally I would say a monthly, in our analysis, a monthly rebalance gives you the most effective user capital. We actually have a paper on the advantage of an active implementation where we even looked at daily rebalancing. You even see an improvement from daily to monthly to semiannual, but it's not so much about the ability to re balance daily. It's much more about the flexibility to use deploy turnover on days when you need it. So it's much more about the flexibility than the frequency.

Oh, that's interesting. You mentioned a paper. Can you quantify the benefit of more frequent rebalancing or more flexible rebalancing?

It depends on the factor. The factor that has higher turnover like momentum will have the most benefit. So for that one, our baseline was a 4% excess return. And then we were able on a semiannual basis, than we were able the factor to double the premium on a daily. So I'd say the advantage of an active implementation in the will be really two to 3% on top of your baseline. A factor like value also, you can add another two, 2.5%. Quality is lower moving factor. So you're adding a 1% and a multifactor is a combination of this. So will be in the two to two and a half range. So that's what that paper is with Kevin Kago is in our investment strategy group and that's published on the journal portfolio management.

Fascinating. So you mentioned flexibility and ability to rebalance on days when you need to. Can you talk about, perhaps in general, some of the days in early 2020 when we had market movements of multiple percent?

Yeah. Those are one of the days when you need it the most, because those are days when leadership changes. So when there are big market at these locations, what we've seen is also that leadership in the market tends to change. And those are generally during periods of either market or economic transition. So it's the beginning of a new economic cycle or the beginning of a new bull market or bear market. And those are really the days and generally they tend to be clustered together. It's not one day. It's more like a week where you progressively see this pattern, but those are really the days when you want to have the flexibility. And if you are talking exposure like we are on a daily basis, the way you will see this is that suppose that you're targeting hypothetically like a 100% exposure. And that really is a simple measure. It's like a valuated factor score of your portfolio compared to the valuated factor score of your internal benchmark, if you want, or index, and suppose you are starting from 100%, you could see dropping to 80%.

So you might lose like 20% over the course of a few days and that's when we believe that it makes the most sense to not to be reactive, but to gradually take action to bring your exposure in line, because those are actually the days when, or the periods, where you can get the most advantage in having a more flexible rebalancing. If you are tied instead to, and the other thing is that we look at the tracking error, but we don't necessarily take action on tracking error because tracking error is a function of volatility in the market. If volatility goes up in the market, your tracking error will go up, even though your portfolio hasn't changed at all compared to your benchmark. So not to be overly technical, but we think that a measure of exposure is a better indicator of when to deploy turnover as opposed to tracking error. And then when you deploy that turnover, you can minimize tracking error as a way to stay closer to your signal, your benchmark.

I wouldn't worry about being too technical. The listeners of this podcast tend to be on the more technical side. So I think that's generally, yeah, not a concern.

Technical away.

I've actually seen indices, not to name names, that have formalized the very same framework. And so there was, it was good to see that we have validation for that.

Just on the topic of quantifying, we were talking about quantifying the benefit of more flexible rebalancing. Does Vanguard take a position on quantifying prospective premiums for the factors?

That's a loaded question. I don't know that I have a good answer to that. I'll tell you my long term expectation for factor premium, somewhere in, again, everything else considered, in the two to 3% over very long term in excess of the market over long periods of time. And those numbers might seem different than the numbers I gave you earlier. But I also think that you always have to reduce what you get from a back test, but I will tell you this, without putting necessarily a number on factors, I'd say that given where the valuations are of the factors today, across all of them, compared to the broad market, I definitely believe that in the next three to five years, we are going to see higher than historical returns, how that valuation, relative valuation gets back in line. And again, it's a matter of when you look at relative valuations, you always to think about three scenarios.

So there is a scenario in which valuations revert back to the mean so the valuation gap shrinks, and that's really going to add returns on top of your baseline expectation. There is a scenario in which valuations stay where they are, and then the point, your factor can still deliver a premium because the premium is not necessarily tied to the valuation movement. They can be much more in line with it, it's historical, or there is a scenario in which the valuation gap between the factors and the market keeps widen. And it's hard to see this scenario because we are already at some of the widest valuations we ever seen in history, but hey, the market can stay rational longer than you can stay solvent. So you never know.

That leads me to another important question. Do you think that it's possible that time factor premiums or should investors maintain consistent exposure to them?

We are actually working on a paper on that. And the point of the paper is there is evidence and in the broader quantitative equity group here at Vanguard, we do look at the indicator of factor. I don't know if I would call it factor timing, but much more indicator about potential factor access returns over their historical averages or relative to one another. And those are based on things like the momentum of the factor. And there are papers out there on factor momentum, but also the valuation of a factor and its relative volatility, but that is a very sophisticated model. So my point being, unless you have a very sophisticated model and lots of data, lots of knowledge, the strategical location to factor is equal weighted. That's what we are looking at in that paper as really a sensible benchmark. Does remarkably well. Is very hard to bid it. So again, unless you have a very, very sophisticated model, lots of knowledge, lots of data that should be your default location.

One of the things that a lot of people don't know about Vanguard is that it's also one of the world's largest traditional active managers. Can you talk a little bit about how factor investing is different from traditional active management?

Yeah. And it really goes back to the framework that I started with in the beginning, this idea that the market was originally first factor and before the market active managers could claim 100% of the equity returns and it was easy to be an active manager or an equity manager back then. And then the exposure to the market came in and everything on top of the alpha that you could generate on top of the equity market exposure was your scale. And then with these other systematic diverse expected returns, value momentum, quality, liquidity, minimum volatility, to mention a few, those are now part of more of the systematic framework. So you have the market, you have these other factors, and then you still have, if you think about regression, you still have alpha from the regression and that alpha could be skill and skill can come from a stock selection, traditional right conviction, fundamental managers, or it can come from timing.

So managers were able to time the market. So, yeah, I mean, factor model is not against if you want traditional active manager. And we started out the conversation saying, oh, your factors are active. So they're bad. No, no, we're not against active. We're not against active any way, shape or form. But again, we think about active as a complement to your broad market exposure, just like factors. And there can even be a framework where you have the market factors and on top of that an active manager.

As the factor models have gotten better and explain more of returns, has it become the case, maybe not in all cases, but in some cases where a actor portfolio can replace an active manager?

Yeah, absolutely. Especially an active managers charging. And that's the reason why factors have become popular by the way. Really the reason behind the popularity of factors over the past few years has been the fact that active managers have had lackluster performance. Now there are change over the last few years, I'd say traditional active has done fairly well. And also the fact that some managers used to charge a lot for just a static exposure to factors, and that's not cool anymore. You cannot afford to do that. It just has been prized away from the markets. So if you want a static exposure to factor, you buy relatively inexpensive or targeted factor fund. So that's really the genesis behind the popularity of factor investing.

So Antonio, what has it been like leading the factor group at a company like Vanguard, which is so well known for alter cheap broad market cap exposure during a period where like the mega large cap growth stocks have dominated so much? What's it been like?

That is a fantastic question. I love it. I mean, when I joined Vanguard, I knew that this was our own to do factor investing because going back to the original question, it was about factor investing is about low cost, broad diversification and a long term focus, which is so perfectly aligned with Vanguard mission. It's Vanguard mission. It's not perfectly aligned with Vanguard mission. It is Vanguard mission. So Vanguard is one of the few places in the world that can be successful at factor investing. So even being here during a tough time, and it was tough. I mean, it was tough for a variety of reasons. It was tough because of the underperformance. It was tough because of COVID. But we know that we have the support of the organization. We know that the organization is not looking at this. We never want to offer products that are necessarily easy to sell to investors.

And that was our decision when designing these factor funds. We don't want to offer products that delivered the outcome that we believe in. So when we were having those tough conversations, we were having those tough conversations, even internally with our senior leadership around, "Okay. Explain to me why we are seeing this underperformance." They're always coming from a positive place of, "Yeah, we understand it. We understand that this represents a challenge, even from a distribution perspective, but we believe that that's the right long term goal." And so having that north star, if you want, you know that you're doing the right thing, really helps to navigate these periods of underperformance. And I think given the performance over the last year, I think we have seen the worst of it. And now we see greater interest in the products across the globe. So we are starting to see that paying off.

And I think we are just in the beginning of the cycle. Because you have asked me the question about mega cap, mega cap growth. You know mega cap growth has under performed over the last year. It keeps grinding. And in the last year we've seen potentially even more evidence of some corners of the markets that are a bit exuberant. Think about the continuous marching and some of the unprofitable I growth potential stocks, your meme stocks, your cryptocurrencies, not to take any negative positions on those, but they are definitely assets that not sure if they align with a long term investment philosophy.

How do you address or how did you address the concerns with clients that the factor premiums have changed, decreased or gone away completely. We heard that with value so much over the last few years that the premium's gone. How do you address that?

It goes back to the point we were discussing before about valuations, and I'm not the only one making this point, but we've been looking at it all along. RAFI has been making the same point. AQR has been making the same points, which is, yeah, it's true. The underperformance of value has been getting worse, rightly rebounded over the last year. But at the same time, the valuation discount respect to the market was getting wider. So you expect that at some point to mean revert. It would be a completely different consideration if value stocks were getting crushed and were also staying relatively comparable in terms of valuations, relative to the market. And then the point that you pretty much have lost the money, but no, that's not the case actually. Just telling you that there is even stronger opportunity today in value than there was a few years ago.

And you need the long term focus because it will mean revert, but valuations are terrible indicators of when to time, because they can be dislocated for a long period of time, but they're a good indicator about the opportunity. So you can look at them from that perspective. We believe it's going to happen. We don't know when.~ Of course it has happened this year. And also the important thing is that has happened exactly for the reasons that we expected, which is value stocks are cyclical. And you can say whatever you want, but value stocks are cyclical. They tend to do well during early stage recovery and during expansion. What we have seen in the last year has been a recovery. Now that recovery hasn't been smooth because of continuous conversations around and concerns around COVID. And COVID coming back representing a big headwind to that recovery. But I think we've just seen the beginning of it and there's much more to come.

And the other point that I want to make is value stocks have done incredibly well from a fundamental perspective to the point that despite the recent strong prize appreciation, their fundamentals don't look much different from where they did last year compared to the market, because they really outperformed the market from a fundamental perspective. But their performance has not been, again, has not quite closed the gap yet.

So I have a similar question to Ben's and one that we get fairly often and it's yeah, but it's different this time because of the number of winner take all type companies. How do you respond or think about that?

We have faced the narrative all along. So we are with you, like regarding the question so many times and to borrow a quote from some of my peers in the industry, history doesn't repeat it itself, but it rhymes. So it's not that we have not seen this before and that's probably the reason why we are confident in our beliefs. The fact is that, and that's the reason why I was drawn to factors to start with. I can always look at it. So factors like value momentum are supported by 200 zero of empirical evidence. Because I'm a skeptic and I don't particularly trust myself, I could never be a fundamental manager, but the fact that I'm able to look at data, understand the intuition behind that allows me to live, even with the strong period demand performance. So it all changed my expectation about factors like value or momentum or any of the factors really going forward.

And a similar type of dynamic has been seen before in history. If you look at, of course, the late 90s, everybody will use that analogy, but also the early 70s, the famous, not sure if many of your listeners are familiar with that, but that's when a group of darlings of extremely large companies who were doing extremely well and everybody was in love with those companies. Those companies were one decision companies, buy and never sell. And you had a lot of interesting companies in there, like just to name one, Xerox. Yeah. What happened to Xerox? Not exactly. Then just the name of company is still in the S&P 500. Many of those companies are gone. They go through massive waves of consolidation and M and A activity, but what do these periods have in common with the current one? So they happened at the end of very long bull runs. So the early 90s and the early 70s coincided with the end of the second and the third longest bull runs in modern US market history which generally like also align with global.

And today's the longest. Also at the time we had extremely accommodating monetary policy that really fueled the growth expectations, because you could put any expectations you wanted on growth. After such a long expansion, people tend to over extrapolate growth. You can only grow from here. And if interest rates are low, I can justify any distant possibility of flows, whether far in the future they are. And then they changed because it naturally changes because every cycle is different and then the cycles eventually reset. So we, yeah, are absolutely confident that we are going to see that again. It's been an incredible long cycle and we've seen these incredible attraction for very large companies at the end of this period. But again, that's going to change. 10 years from now, it's very highly likely going to look very different. And all those mega cap companies they're facing headwinds too.

It's not that their business, some people say their business more bullet proof, but it's all about growth. I mean, when you are very, very, very large, it hard to grow at the same pace as a smaller company. And so that's assuming that these companies can keep growing at this rate, it leads a bit a dystopian outcome if you want. I don't know if I want to leave it that word.

That's an interesting point. I think you're probably right though. So we're talking about factor investing. Vanguard's got a flavor of an approach to building factor products. We mentioned earlier Avantis and Dimensional, and there are lots of other ones too. There are tons of factor products out there today. What do you think investors should be looking for when they're choosing a factor fund?

I would say if you are choosing a factor fund, go for a factor that deliver strong and intense exposure, because you don't want to pay for market capitalization. You can get market capitalization for very cheap. Many of our competitors, I have to say, and not to name names, but just the nature of the way the market has evolved have offered factor funds almost like an offspring of the style box world, where they're still relying on market capitalization. And that's been, frankly, just easier to sell because the style box is used much more ubiquitously than some of the responders that I use for factors, but you're just getting capitalization. You're paying more for capitalization than you could be getting from a very low cost data solution. So my advice to investors is focus on a solution that delivers a strong capital efficient exposure, and also do focus on things like broad diversification. And in my opinion, an active implementation is very important because you want to maintain that factor exposure consistent over time and the active implementation enables you to do that.

I'm really curious if you have some insights from the data in terms of how your investors use your factor products. Is the use of them increasing? How do they behave in different parts of the market? Any insights from that would be great.

It depends. So in a sense it's cyclical so we're definitely see more interest in value now because of where the valuations are, and also the fact that there has been strong, recent performance, and I think that's been the reason. It's not, listen, I don't want to say investors are timing it, because it's also about validation. A lot of the concerns that you guys have been raising are legitimate. Is value broken and doesn't make sense? So it's good that people can see that there is a comeback in performance and that validates their expectations that, "Hey, no, value is not broken. It's still a sensible concept. So I can use it." Besides that, I mean, we generally see investors combining multiple factors together. I yet have to talk to a single investor who has total conviction in just one factor and not in the others.

And yeah, so these are the ways we have seen them using factor products, a combination of them in a core satellite approach sometimes to, in many cases, substitute traditional active managers, sometimes to substitute beta, like for those investors who want to branch out of beta and add something to their portfolios for some of their, like if it's advisors, for of their investors, not all of them. So really that's the way we have seen factors being used.

You mentioned combining multiple factors. Do you think it makes more sense to do that by combining individual factor products that target different factors together or using a product that combines multiple factor characteristics integrated into a single portfolio?

I'm in the count that both solutions makes sense and they fit different goals. If you believe, for example, if you're a very strong conviction in one factor, as opposed to another, then you can customize that. So we call this a top down or bottom up. I think that's the conversation. I think at some point people use the word mixing versus integrating. Might have been AQR who was doing that, but top down, very simply, you're combining together multiple factor funds. In a bottom up, you are offering a fund that offers a balanced exposure to different factors. The top down approach is much more customizable. It's transparent and transparency should not be underestimated because it really easy to do an attribution when you have three funds in your portfolio, as opposed to when you're targeting three factors, because targeting three factors can lead to an outcome that is very different from targeting three funds.

And then at that point, the attribution is more difficult. But in general, I mean, I believe that if you use the bottom up approach, which is the balance allocation of two, three different factors, you have the potential for higher specter returns over long periods of time because you're taking to account to cross correlation across factors to a certain extent.

Interesting. So Vanguard's always been a huge proponent of financial advice with the famous advisors, alpha research, of course, with the wildly successful personal advisor services. I'm curious what your thoughts are on do it yourself investors implementing factor portfolios.

I'm of the belief that the role of advice in factor investing is very, very important going back to the considerations that we discussed in the beginning. I know those might have been vague because those concepts are hard to pin down. Things like, do you have a long term focus? Are you willing to stomach periods underperformance? I can be here pontificating about that, but I'm not sure that any investor is going to be able to stay the course truly when things get ugly. And the role of an advisor is I think in factors besides offering the factor specific knowledge and being able to educate investor is also most importantly, in my opinion, the ability to make sure that they're comfortable with the concepts and they are able to stay the course during those periods of drawdowns, that can be protective in time. So I think it's very important to have an advisor in this space. Now there are going to be certain investors who are very, very sophisticated and can do it on their own. But I expect there is a strong benefit in using an advisor in this space.

We would tend to agree. Lots of the people listening may not, because I think a lot of our podcast community consists of self-perceived above average investors, which is always a funny concept.

Hey, listen. I mean, I'm not here to judge anybody. So I mean, I'm going to take you your word at fair value. If you believe you're a sophisticated investor, I'm going to believe you, but just be mindful of the fact that it's not easy. It's not easy even for me and I have years and years of training.

Right. Back to our podcast community, the Vanguard factor products and your research and interviews have been discussed pretty extensively within our podcast community. One of the big concerns it comes up is that the factor funds in Europe were closed down. And one of the products in Canada, the liquidity factor fund, was also closed down. So that's been the biggest hesitation that people have. It's like these products look great. The philosophy's great, but I'm worried they're going to close. How do you think people should think about that?

It's about preferences in different markets and in the Canadian market, in the US market and the Australian market, I think investors are much further along their journey. We definitely want to offer products that resonate with investors because you need to have a certain scale in order to be able to operate them in a cost effective way. We are always trying to operate in a cost effective way. And I'd say that things have changed. You also mentioned the fact a few moments ago that yeah, we launched in the worst possible environment. We timed it in the worst possible way, but we're over it. And now we start seeing flows more consistently across the different regions. So I'd say value's definitely been a spotlight in the Canadian market and we've seen flows more consistently in other global markets as well. So I'd say that the worst is over truly, I mean, and I say that not only from a product perspective, but also as a staunch believer in factor investing. The worst is over.

I've got a question that I don't know if you can answer or not, but I, I want to ask it the Vanguard all in one funds, the global asset allocation portfolios in Canada have been hugely successful and we think that they're just an absolutely phenomenal development in the marketplace. Do you think it's in the future to have portfolios like that with factor loading built in?

We are definitely evaluating that option. To me, it's not if it's more a matter of time, but like there's a million priorities when it comes to products and we're always very, very, very careful. Vanguard doesn't launch a lot of products, so it takes us a long time to get to market. So it's also about patience, but yeah, we believe in the framework and my expectation is that sooner or later we'll have a product like that.

Oh, the day those are launched there'll be a big celebration within our podcast community, I think.

I would love if your podcast community will look more, more aggressive with our factor, well, our factors. Definitely the more demand is for the factors, the more it justifies a balanced product, like the one you described.

Our final question for you, Antonio, how do you define success in your life?

As a father, as a? No. I mean, the objective as a factor manager. I'm going to address the question as a factor manager. The objective for us is to outperform the market and the vast majority of our competitors, when the factors are delivering their goal, their objective, which is outperformance. So when a factor is delivering, we will expect to outperform the market and the vast majority of our competitors. So that's really how we evaluate success in our world. It's not by trying to constantly outperform the market or by trying to smooth out the return profile necessarily. It's truly about having the right conviction and being there when the factor shows up. That's really the philosophy behind our approach to factor investing.

That's awesome. Antonio, this has been great. Thanks so much for joining us.

Oh, thank you so much. I loved it.