Tackling high-fee headwinds

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Glenn Freeman: In this edition of "How We Invest Your Money?" I'm talking with Mike Roach from Vanguard, which is traditionally known in the Australian market as being an index manager. But they have got a growing focus on active management, too. Mike, thanks for joining us. Mike Roach: Sure. Thanks for having me. Freeman: Now, Mike, factor-based investing is a key part of what you do within your Quantitative Equity Group. Can you just explain for us how that differs from strategic beta and what some of the risks investors need to be aware of in this type of investing? Roach: Well, we view our active factor-based funds really as very similar to what most in the marketplace refer to as strategic beta or fundamental investing. What these products are offering specific exposures for clients to either target a factor to enhance return, like value, or reduce risk, like a minimum volatility product. We just implement them in an active framework. These are products that are taking bets against the broad market. So, they are very different than a traditional market cap-weighted product. And we feel that investors should be aware of those concerns, evaluate these products as active products. But there's also key benefits to implementing them in an active fashion rather than following an index, which is really important when you step away from that market cap-weighted framework. We can keep a constant evaluation of our exposures, trade as needed and not be tied to a specific index reconstitution. These products are active. They are going to have different return patterns associated than what many investors are used to when they are investing in a traditional market cap-weighted product. Typically, higher tracking error relative to that. But there's still a place for these types of active products in conjunction with indexing. We feel when active management is done right, when it focuses on cost and the long-term, these types of products can offer different objectives for an investor to help achieve their goals in a diversified portfolio. For us, as we approach the factor investing landscape, we focus on some key requirements. One, what is the risk or behavioral reason why an investor should expect a return premium above the broad market. We look at the academic research available. Is there empirical evidence, but also can you invest these on a very scalable fashion. So, once we look through those particular lenses, we landed on a couple of specific factors, one being value, which is a very well-known investment approach going back to Graham and Dodd's seminal book on Security Analysis in the late 1920s, what we are able to do is just offer exposure to value-oriented stocks in a very controlled systematic and transparent format all within a low-cost framework. Additionally, we also view that there are potentially risks and volatilities in the market that investors aren't really fully diversified away from. So, we looked at a minimum volatility fund, which really is explicitly designed to help reduce the volatility of broad equity markets which play a really great pace in a diversified portfolio. Freeman: Now, Mike, you are Head of the Quantitative Equity Group. Can you just explain for us what quantitative means in this context? Roach: Sure. Well, as you point out, most Australian investors are probably more familiar with Vanguard as an index manager. But I think it's important to point out that Vanguard really has a deep-worded history in active management which goes back to the launch of our Vanguard Wellington Fund in 1929. But QEG specifically has been running active asset for Vanguard for over 25 years. And maybe I'll talk a little bit about what that word quantitative means to us. At the heart of our investment philosophy, we are fundamentally-based investors. We look at the same types of metrics that a traditional analyst may review. But when it comes to the quantitative nature, we take those metrics and really view them in a very systematic rules-based process to meet specific objectives of either return enhancement or risk reduction. Freeman: Now, Mike, finally, you've previously said that to be a successful active investor there are three key steps that investors should follow. Can you just expand on some of those for us? Roach: Yeah. Well, we do believe that as a whole the market is a zero-sum game. So, half of the investors will potentially outperform the broad market, others will underperform. But once you factor in costs, then that overall ratio shifts down and it becomes much harder to outperform. So, investors need to keep a keen eye on costs, which is really the biggest headwinds to outperformance. Additionally, when it comes to reviewing talent, they really need to come to terms with the paradox that you don't have to pay higher-end fees for top talent. Managers that have shown discipline and provide systematic processes are out there and are available to provide products or exposures at a very low price. So, it's something that investors need to be aware of. And lastly is patience. When it comes to any active investment, investors need to be aware that there will be times when certain strategies will underperform. But if they stick to the long-term nature of these products as there are their enduring philosophies continue, we think that they will add value for investors.