Jim Nelson: Factors are the underlying characteristics that drive investment performance, but factors aren’t a recent development. What is new is using the factor lens to evaluate portfolios.

I’m Jim Nelson, and welcome to Vanguard’s Investment Commentary podcast series. In this month’s episode, which we’re taping on February 13, 2018, we’re going to be talking with Frank Chism, a senior product manager and one of the driving forces behind the launch of factor funds at Vanguard.

Frank, thanks for joining us today.

Frank Chism: Hey, Jim, my pleasure. Thanks for having me.

Jim Nelson: Let’s start high-level. What are factors?

Frank Chism: Jim, factors are characteristics of a stock or a portfolio that’s going to give you some indication of how that portfolio or individual stock is going to perform in the future. A very simple definition of factors is a fact or circumstance that’s going to influence an outcome.

Jim Nelson: So why should investors care about them?

Frank Chism: Well, we care about them, investors do, because it’s important to know, Do you have factor exposure in your portfolio? What’s driving your portfolio return?” So, it’s important to know, if you have stocks in your portfolio that have very different characteristics than the broad market, those are going to drive the return variation of your portfolio, the risk of your portfolio. So, it’s important that we know what factor exposure do we have and is that the factor exposure that ultimately I want in my portfolio?

Jim Nelson: It’s like looking under the hood of the car and maybe you have a little bit more insight about what is driving things.

Frank Chism: Yes, exactly. Do you have antilock brake systems? How many cylinders do you have, etc.? It’s going to tell you something about, how is your investment going to do compared to not having those things or having sort of what the baseline model would be in your car example.

Jim Nelson: So that baseline model, I wonder if that’s like, if you have a broad index-based portfolio, that’s kind of baseline model before you get into any factors.

Frank Chism: It’s a great way to think about it, Jim. The broad market itself really doesn’t have factor exposure, right, because it has value and growth and it has quality and junky stocks, it has large stocks, small stocks. It really has everything, so the broad market index is your kind of baseline and then from there, you decide, how do I want to adjust that or what other things do I want to have? Do I want to have value exposure, or do I want to have more growth stocks or smaller stocks, etc.? But that’s a very good way to think about that.

Jim Nelson: Say you’re interested in factors and you want to do something with them, how do you take advantage of these factor exposures?

Frank Chism: The first thing, Jim, you have to do is figure out do you have them already. I think the interesting conversation I have a lot with investors and advisors is, you know, a lot of people are already employing these things. Factors are not new, necessarily. I think what’s new is the capacity as an investor to go and really single out factors and have a targeted approach to getting exposure to factors. That’s new. The products themselves are new, but people have been using factors for a very long time. Anything in your portfolio that has value in its name or small-cap in its name or mid-cap, you’re getting factor exposure, so a lot of people have already been doing it.

And then the question you have to ask yourself is, what, from a factor point of view, do I want to have exposure to? Or what do I think may add value over long periods of time versus the baseline model? If you think stocks that are generally cheaper than the market do better— that’s traditional value investing—then you want to have more of those in your portfolio than what the broad market has in an effort to potentially outperform over long periods of time.

Jim Nelson: With the advent of factors, or a more intense look at them, has that made active managers’ jobs a little bit harder because they were maybe riding on the coattails of factors instead of just the stock selection?

Frank Chism: I think it has. I think if you think about the genesis of active management, originally—I say originally, I mean back 30 years ago—if you outperformed the index, you just got credit for it. You outperformed; you’re a great manager, off you go. You’re worth every penny that we pay you.

And then with Fama-French and value and momentum and size—those factors—then we started to say, “Okay, well, some of that outperformance was just because you have cheaper stocks.”

Jim Nelson: Like a tilt one way or the other.

Frank Chism: Correct, you have a tilt toward cheaper stocks. So, if I take away your tilt to cheaper stocks, which is very easy to implement in a portfolio, then what do we have left? And that’s really your true alpha.

Jim Nelson: And I’m thinking now: Vanguard just came out with their factor funds. What differentiates their approach from what’s out there in the market?

Frank Chism: The easiest way to think about it, Jim, is when you look at factor products, we’re all trying to get exposure to a factor. And what does that really mean? We talk a lot about factor exposure. What you’re saying is if a particular factor does well in the market, I want my portfolio to behave in a similar fashion. So, if momentum does well, I want to have constructed a portfolio that’s going to behave in line with that.

Now, how do you go about doing that? You have to identify some underlying characteristics of the stocks that are going to point you toward momentum.

And then, for us, our biggest differentiator is that we’re going to look across the full market-cap spectrum. So most factor products are tilted toward the large-, mid-cap part of the market. And for us, we look for the factor wherever the factor sits. So we will go into the small-cap part of the market, the mid-cap part of the market, and the large-cap part of the market. So we’ll really be across the entire market spectrum.

Jim Nelson: So the effect of that is what?

Frank Chism: Well, the effect of that is, a lot of the factor premiums that are out there to be harnessed come from the small part of the market, for the first thing. I mean, people have often argued that small-cap stocks do better over long periods of time just because they’re small. We would say it’s not just because they’re small. It’s because they have these factor exposures built into them. They have liquidity; they have value; they have some momentum, etc.

So, part of it is we’re really looking at, over time, wherever any given factor is sitting in the market from a cap spectrum point of view. And from a sector point of view, we can go anywhere in the market to go after that factor, where most other products have a constraint that they’re really just large-cap-type products.

Jim Nelson: So we’re kind of like free-range factors.

Frank Chism: Free-range factors, that’s a good way to think about it. So we’re really going after factor exposure. So we’re going to identify stocks we like. We’re going to put them in the portfolio at their factor strength or their factor score. So what decides how big a holding you are is not your market-cap weighting in the index, it’s how good is your factor score.

And when we look at some of the other products, most of them—not all but most of them—are tied to market-cap weighting. So you may have enough value exposure to get in the value factor product, but if you’re Apple, you could be the biggest thing in there and you may have the weakest factor score of any stock in the portfolio.

And with us, we’re going to say the stock with the best value score is going to be the biggest thing that we’re holding across the market. And so we could have a tiny small-cap stock have the best factor score and be the biggest thing in our portfolio. And that’s very different from the way most of our competitors are putting their products together.

Jim Nelson: I know Vanguard’s got some single factor funds and a multifactor fund. Can you talk about the single factor funds and why we chose those particular ones?

Frank Chism: Yes, absolutely. The idea of single factors is investors have a particular opinion about one of those factors. And generally speaking, we think the way to use a single factor is as a tilt in your portfolio over long periods of time, which is generally what people do now.

With the single factors, we have value, quality, momentum, and liquidity. Value, quality, and momentum I think are very well established in the marketplace. Liquidity, we’re the only folks who offer a liquidity product. And what we’re trying to get there is not illiquid stocks. A lot of people think, “Oh, this is going after stocks that don’t trade.” We’re going after less-liquid stocks. So we want stocks that are liquid—they still have to have a certain amount of liquidity to even be considered to be in a portfolio—but we want stocks that are less liquid.

And the idea there is, you know, there’s a liquidity premium. If you have to unload the Treasury this afternoon, it’s no problem. If you have to unload your car this afternoon, there’s a liquidity premium attached to that. Maybe you get a good price, maybe you don’t. How good of a negotiator, Jim, are you? I don’t know.

Jim Nelson: My wife’s a better negotiator.

Frank Chism: Let your wife get rid of it. Maybe it’s more liquid. But that’s part of that conversation. The idea with the single factors is can you get at premiums that we think exist in the marketplace over long periods of time? So we offer those single factor products for folks who just want to target an individual factor.

Jim Nelson: Can you talk a little bit about Vanguard’s active implementation and what that means in the real world?

Frank Chism: Yes. So, the biggest thing is the reason we’re doing these actively is because again, when you look at the space, most ETFs in the space are done on an index basis. So we’re doing it actively because the thing about factors and factor exposure is when you create an ideal factor portfolio, it has an exposure that you can measure to that factor.

But if you and I got together and put a momentum portfolio together today with our best momentum stocks, if we came back two months later to do it again, we would have a different portfolio. Maybe 80% of those stocks would be the same, but then we would want a different set for the other, say, 20%. And we call that factor decay; so we had good exposure and that exposure decayed over those two months.

Jim Nelson: So, like for a dentist, decay is bad.

Frank Chism: Right, decay is bad. So being active allows us to evaluate the portfolio every day, so we can kind of look for the ideal portfolio on a day-to-day basis. And then when our current portfolio, if the decay has been significant, we can rebalance back to recapture a higher exposure to the factor. And over time, active doesn’t necessarily give us higher factor exposure, it gives us more consistent factor exposure. So instead of dropping between rebalancing dates, which is what you get with most index approaches, we’re going to be more consistent over time.

Jim Nelson: Yes, that makes a lot of sense. So turning to the multifactor fund, if I were going to make a multifactor fund, I would just take some value, some momentum, some growth, and put them altogether; I got a multifactor fund. But that’s not the way Vanguard operates, right?

Frank Chism: No, it’s not the way you want to do it. And the reason is if you do it the way you’re talking about, Jim, you’re going to have great value stocks that may be low-quality and have no momentum. And then you might have really good momentum stocks that are junky and overvalued. So the idea with multifactor is not to combine the best in each of those classes of stocks, but rather it’s to say, “I want to look for stocks that are good on all of those characteristics, so I want a really well-rounded stock. I want a stock that’s trading at a good valuation, that has good quality scores, a good balance sheet, that are good businesses, and then they’ve had some recent momentum.” And that’s very different than going out and buying individual products and combining it yourself. So we call that a bottom-up construction. We’re going to start at the bottom. We’re going to look at all the stocks across three of the characteristics—value, quality, momentum—and then we’re going to get stocks that are good on all of those, so that you get a well-rounded stock at the end of the day.

Jim Nelson: It’s kind of like if you wanted to really excel at a triathlon, you want to be good at a few of the different things that’s involved there.

Frank Chism: Yes, absolutely. I mean I think I could do the run, but I would drown. Like I would clearly drown. Like I can’t swim ever. Even if it’s 30 feet, I’m not swimming that, so you don’t want me to do the triathlon. You want someone who’s pretty good on all of them, not necessarily a great swimmer, great biker, etc.

Jim Nelson: That makes sense. Talk a little bit about the characteristics. I guess it gets into what a factor is and how do you define a factor, and how many characteristics do you need to define a factor?

Frank Chism: Yes, so you’re trying to get exposure to the factor and move like the factor is moving with your portfolio. So how you do that is you decide—and everybody does it differently—you have to decide what underlying characteristics of stocks gives me exposure to that factor. So value is kind of an easy one. With value we say, “Let’s look at price to book.” That’s an age-old valuation measure. Forward price to earnings, that’s another one that people are very familiar with, and then price to cash flow.

So we look at three. The reason we look at three—and most folks in the business are looking at three, some people look at one, but, generally speaking, you want more than one and here’s why—you may have a company that looks very good on price to book, but they generate no cash flow, or they are good on forward P/E, which is price to earnings, so they have good expected earnings but their balance sheet’s a bit of a mess, or compared to where they’re priced versus what they actually own, that’s a little bit out of whack. So, for us, you have to have a robust factor. You have to look across at least three. And for all of our products, and even the multifactor, we’re looking at three characteristics.

Jim Nelson: We talked a little bit about factors and how you’re kind of tilting away from the broad market, but we probably need to talk about some of the risk in a little bit more detail. What’s going on there?

Frank Chism: Yes, so the risk is the same with active management. You’re doing something different than the broad market. So, whenever you’re doing something different than the broad market, you have an opportunity to outperform. But by the same token, you have a good opportunity to underperform as well.

And I think with single factors, you’re buying a portfolio that’s very, very different from the broad market and that portfolio could behave very, very differently. So how much divergence do you have, or variation in return, versus the broad market? You’ll have a lot. With single factor products there, you should have a pretty significant tracking error. They’re going to behave very differently.

Whereas the multifactor, when you’re combining the three factors together, you’re going to smooth that out to some degree, but you’re still going to behave very differently from the market. And that’s something people need to be aware of and understand and it takes patience. And in the single factor products and the multifactor product, like all active management, you may underperform for some period of time, and you have to be able to stomach that.

Jim Nelson: Can you talk a little about Vanguard’s approach, which is kind of concentrating on consistent factor exposure, and maybe other market-cap-weighted approaches to factor exposure and the relative risk of one versus the other?

Frank Chism: Yes, I think the biggest difference is with our concentrated approach, you’re getting two things. You’re getting exposure to all parts of the market-cap spectrum, and then you are getting stocks weighted by factor score, not by their market cap. So you’re going to get a portfolio that looks very different from the broad market index, say, the Russell 3000. So you’re getting a very different portfolio.

Jim Nelson: You kind of laid out a good foundation for understanding factors. So, for people who want to take that leap and get into it, that’s one thing, but we’re not saying that factors are for everyone, are we?

Frank Chism: We’re not. It’s a sophisticated way to invest. It’s a quantitative process. It’s based on a lot of academic research. It’s not quite as intuitive, necessarily, as the market-cap-weighted index or an active manager who says, “Hey, I’m just going to buy good stocks at reasonable valuation.”

So there’s a lot to learn. And then, finally, it depends on what you’re trying to achieve. It’s all about the end client objective. Market-cap-weighted index is not the answer to everything, but it’s a good starting point. And then you have to go away from that depending on what you want. Not everybody will want this kind of a significant factor tilt in their portfolio.

So not for everybody, but for some folks it should be a really good way for them to express their particular opinion about the market and their long-term beliefs, but it’s going to be very different than the tools we previously had to do that.

Jim Nelson: So if advisors or investors want to learn more about factor investing, where can they go?

Frank Chism: So Vanguard’s website—we have a factor education center. It has a lot of great information around the definitions of factors, how we are putting our products together, but it also will point them in the direction of our research, other research. And then there’s a tremendous amount of research out in the world, but Vanguard’s website is a good place to start.

Jim Nelson: Well, Frank, that’s a great way to end things right now. I think you clearly laid out what factor investing is about and also what Vanguard’s factor funds are about.

So thanks for joining us today.

Frank Chism: Jim, thank you for having me. I really enjoyed visiting with you.

Jim Nelson: And thank you for joining us for this Vanguard Investment Commentary podcast. To learn more about Vanguard’s thoughts on factor investing, check out our website and be sure to check back with us each month for more insights into the markets and investing. Remember, you can always follow us on Twitter and LinkedIn. Thanks for listening.

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