Markets & Economy
Portfolio construction: What's on investors' minds?
May 16, 2014
Catherine Gordon: So Joe, in the Investment Strategy Group we spent a lot of time talking to clients and to clients about portfolio construction issues specifically. You know, over the past year or so, what would you say are emerging as sort of the key trends in terms of client concerns, client strategies that we've seen in the investment strategy?
Joe Davis: Yeah, great question Catherine. And there's so much to tackle. One is just around the concern, the outlook for the equity market. So we've seen a very significant performance in the United States. It's generally been consistent with our outlook even several years ago, returns have significantly outperformed bonds. But then the key question is, are we overvalued or so forth? So that gets into how one should be positioned say relative to a static portfolio for those that are trying to outperform or add value over a policy portfolio.
You know, we still remain optimistic on the equity market but we find ourselves stressing, the importance of rebalancing overseas, where if anything the valuations at the margin are a little bit more compelling than the U.S. This notion of just because emerging market cash flows and European cash flows may be less positive than the U.S., that actually in our minds smart investors, right, and this is because our research, I'm actually putting that money to work to rebalance back to their targets.
So that would be one. In the fixed income side the, either shedding duration1 risk and getting much shorter portfolios, should I have bonds at all, the rise of alternatives in terms of those conversations which you handle a lot of Catherine, so that's some of those questions that we're seeing.
Catherine Gordon: Yeah, and you mentioned, you know trying to outperform a policy portfolio, so that brings up the age old question of active versus passive. I mean, we've certainly seen a greater interest in passive strategies over the past several years.
Joe Davis: Yes.
Catherine Gordon: But your thoughts on that debate?
Joe Davis: Well again I'd love to hear your thoughts as well Catherine. I would say that there's a secular adoption without that. We've talked about this at the rise of index portfolios. And clearly index portfolios means market cap proportional portfolios. But then that said, I think that we may see a cyclical interest in some active equity and long only mandates. But I think you know what is even defined of as "active management" is changing. I mean something that I think you're seeing a lot of.
Catherine Gordon: Yeah, actually you know you talk about a market cap weighted index, and you know a lot of interest in alternatively weighted indexes or factor strategies. You know, I want to make it very clear that we think moving off of market cap weighted strategy is an active choice, and everything that comes with an active choice in order to make that successful, finding the right manager, at the right cost, as successful, you know an enduring strategy.
So it feels as though more and more is in the active space right now than five or ten years ago where you'd move off a market cap weighted index straight into a traditional fundamentally driven security selection, sort of traditional equity manager.
Joe Davis: Yeah, yeah, and I think it's just clearer for, you know at Vanguard we believe in low cost, because we know lost cost investing, both active and passive. I mean I don't see the tremendous amount of benefits of an index fund if it was priced at 300 basis points. So, I think you know the amount of the different products available to investors has increased and in some regards have exploded perhaps too far. But at the same time is what is one trying to achieve in your portfolio, and where do you want to have confidence in either through a risk factor exposure, or through an active manager to help incrementally add value over a benchmark. We're seeing those conversations more and more.
Catherine Gordon: This wouldn't be a portfolio construction trend conversation if we didn't talk about ETFs. And you know as an active manager trying to outperform a particular benchmark how should, you know, an adviser or an institution think about structuring ETF model portfolios?
Joe Davis: Yeah I mean I think it's, you know, let's just for sake of argument, let's just say a policy portfolio is 60 percent stocks and 40 percent bonds with some global orientation to that. Which in and of itself is very tough portfolio to beat, it's, as your team's research has shown on the endowment side, the institutional side and investors at large. So you know, I think we can see where cash flow has gone, it has been going more to U.S. centric investments and it has been going to fixed income investments that tend to be, have higher credit risks such as corporate bonds, even high yield bonds and have less interest rate risk.
You know interesting given the recent events, you know the so called risk Premia outlook so that, or return outlook, capital markets outlook is actually improved for those areas that have had the more negative cash flow. So at the margin things such as overseas investing and in the fixed income world there's a very steep U.S. Treasury yield curves. So I think if I was, if hypothetically if I was an active manager I'd be thinking about (a) my horizon over which the longer the horizon the more risk I'm willing to take, the more equity centric I would be relative to that policy portfolio.
But that said, be very cautious of saying if I'm concerned at all about near term volatility I should have more high grade2 fixed income investments to weather and moderate that volatility and I think that's something that may be lost in this low interest rate environment.
Catherine Gordon: And I didn't think that really captures, at least from our experience, or the three or four big trends that we're having conversations with clients about. Great thanks.
Joe Davis: Thank you Catherine.
1Duration: A measure of the sensitivity of bond—and bond mutual fund—prices to interest rate movements.
2High grade: A bond whose credit quality is considered to be among the highest by independent bond-rating agencies.
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Vanguard's chief economist talks about key trends
What themes are on the minds of clients right now? In this video, Catherine Gordon, a principal in Vanguard Investment Strategy Group, and Joe Davis, Vanguard's chief economist, discuss key emerging trends in client conversations, including the outlook on equity markets and fixed income tactics.
Also of interest:
- Is the global recovery on track?
- What's ahead for interest rates?
- Time for optimism in Europe?
- Where are emerging markets headed?
- Is China headed for a slowdown?
- How to manage "country risk"
- All investing is subject to risk, including the possible loss of the money you invest. Past performance is not a guarantee of future returns.