At the 2017 Morningstar ETF Conference, we sat down with Fran Kinniry, a principal in Vanguard Investment Strategy Group. Fran shared his thoughts on the active versus passive debate as well as discusses best practices for financial advisors. He also shared his perspective on emerging markets, investment due diligence and explained how investors can navigate the geopolitical risks in today’s global markets.
ETFdb.com: Please tell us about yourself.
Fran Kinniry (F.K.): I’m Fran Kinniry, a principal in Vanguard Investment Strategy Group. The Investment Strategy Group is a global group that focuses on portfolio construction, economic outlook, and investment strategy. We also design the portfolio construction for all of our single fund solutions, such as our retirement funds and ETF model.
ETFdb.com: Where do you land on the whole active versus passive debate right now?
F.K.: A lot of people know Vanguard as indexing, and I think that’s a misnomer. Actually, we have a lot of assets in active management. What Vanguard really believes in is high talent and low cost. Now whether or not you are an index manager, you need talent. You can’t just put yourself out there as being an index manager. There’s tracking error of course. But Vanguard does believe in active management.
What we don’t believe in is that high-cost active management is going to work. The reason for that is a real body of work known as the paradox of skill. I’m not sure if the audience is familiar with that. But quickly, the paradox of skill is that, as skill rises, the differential of skill shrinks.
So think about that with regard to school sports. The standout athlete in high school is probably far superior to his peers. But as he goes to college, and as he makes it to the professional level, his absolute level of skill grows, but his differential between his counterparty shrinks. So with that being said, active management doesn’t fail because of lack of talent, it fails because there’s so much talent, and people charging too much for it.
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ETFdb.com: A recent study suggested that almost one trillion dollars of AUM have shifted from active to passive strategies in recent years. What are some of the reasons that have led to this migration?
F.K.: It’s a multifactor thing. Certainly, we do see people using cost as the primary criteria in their decision selection. That is new. It used to be people just used performance, where they used third-party evaluators.
I think people now know that costs are the driver of future performance, so they’re using it as the ingredient. That is one. Two is what I would call product development. This doesn’t get talked about enough. What I mean by the “product” are ETFs themselves as well as target-date retirement funds.
ETFdb.com: How do you see active management evolving over the next five years?
F.K.: The interesting thing is that trillion dollars you mentioned of active outflow, if you actually look at the low cost quartile of active. That would be the bottom 25 percent if you sorted on costs. Over the same decade that we’ve lost a trillion dollars, they’ve had positive flow. I think that you’re going to see a situation where active certainly may not grow to have the same history that it had in the 80s and 90s, but you’re going to continue to see low cost active generate positive flow. You’re probably going to continue to see active that has expense ratios around 100 basis points really struggle.
Read Smart-Beta ETFs Can Help You Navigate the Market Cycle to find out about the individual factors within smart-beta ETFs.
ETFdb.com: How are financial advisors changing how they adopt the financial options that are available to them, namely ETFs, mutual funds and/or target-date funds?
F.K.: We think this is going to be really good for end investors. That’s what Vanguard really cares about is what is good for end investors.
We created something about 15 years ago called the Vanguard Advisor’s Alpha. That is the advisor serving in a different capacity than separately managed accounts, or laddered portfolios. It’s really about what is the right asset allocation. How can I invest tax efficiently? Behavioral coaching is a big aspect of how can I keep my client invested in 2008? How do I not have them become overly aggressive here? How can I motivate them to rebalance here? So those we see are going to be the value attributes of advisors in the future, much less on what we would say are the investment competencies of outperforming. That will give them plenty of time, so they can use ETFs or packaged solutions. Vanguard’s actively managed funds, especially actively managed ETFs that we released in Canada last year – we combined active and passive, almost outsource the real-time consuming investment components, and have allowed the financial advisor to get back to the financial planning and wealth planning components. We see a very bright future for the advisor community.
Being aware of risks and costs is important regardless of your ETF investing strategy. Read The Hidden Risks and Costs of ETFs to find out more.
ETFdb.com: What would you tell advisors regarding best practices when it comes to financial and wealth planning?
F.K.: I would tell advisors, first of all, technology is impacting all businesses and to embrace it, don’t fight it. The tendency is I’m late career, I’m not going to adapt, I’m not going to change. My advice in any industry is to embrace technology, embrace innovation, scale your business, and then really operate in the areas where you feel you can add value. The areas you can probably add value are around behavioral coaching, family planning, savings, second-generational transfer of wealth, estate planning, and spending from a portfolio tax efficiently.
ETFdb.com: What would you tell investors on how best to navigate geopolitical risks?
F.K.: First off geopolitical risks have always been out there. We’ve gone through two World Wars, and we’ve fought in many other different wars. The time to think about geopolitical risk is not in the moment. So, your portfolio should be allocated assuming all potential scenarios.
The irony is with what would be perceived to be headline geopolitical risk. Let’s just put it as what we call headline shock risk that’s been out there since the election, with North Korea and others, etc., which has caused low decile VIX. For the audience, VIX is a volatility index. It prices in the volatility of the market. Or if you look at other metrics, like percentage of days that are up one percent, or two percent, or three percent. The bottom line is we’ve been in the lowest decile of volatility in the last 12 months. So, don’t let the headline alter your investment plan.
ETFdb.com: What is the biggest misconception that investors have when investing in emerging markets?
F.K.: A big misconception is that most people think of it as a diversifier. What we do know is that when equities are in contagion, historically EM has a beta that’s higher than one, which means that it leads on the downside as well. So, it’s not necessarily going to be there as a diversifier. That doesn’t mean that it isn’t part of a portfolio. We believe investors should own an emerging market in its market-cap weight relative to their home bias. So, first you start with your home bias, then you would own EM relative to its non-home weight.
ETFdb.com: What advice would you give investors as they are doing their investment due diligence?
F.K.: First off, I think simplicity has really been a benefit to investors. We have studied this. If you had to choose between a single fund that combines emerging, pacific and European exposure or bought three individual funds providing you exposure to each of the three regions, you would find that investors’ performance is better in the one fund, because the behavior of the three underlying is geared toward ‘if this one is doing better, I’ll add more,’ or they don’t rebalance them. So, by owning things in a more holistic way, investors become more successful, or advisors who help advisors are more successful.
ETFdb.com: What makes an ETF or a fund succeed or fail in the marketplace?
F.K.: I would you say you definitely want to have broad diversification. You would want to make sure that the asset class is enduring, not a fringe asset class. That it’s best in class. Best in class could be the brand of the manager, and a low-cost situation. Transparency is important as well.
ETFdb.com: What are some of the biggest trends in the asset management space? How do you see them playing out over the next three years?
F.K.: The trends that are coming around that we see most are that investors are not comfortable with the low return environment. If the outlook on stocks is seven or eight percent, and the outlook on bonds is two, and for a 60/40 portfolio you get to five, most investors are not comfortable with that. So our concern is that investors are stretching and trying to make five become seven.
We look at bond flows. Bond flows have been all into the lower tier of bonds. So, people are not buying Treasuries; they’re overweighting corporate high-yielding emerging bank loan notes. It’s amazing. It’s very similar to some of the things we were seeing in other environments, and that doesn’t usually end well. So our concern, and we keep trying to educate and tell investors the market is going to give you what it’s going to give you by trying to stretch for more. When we do have a bear market, you’re really going to be left out to dry.
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The Bottom Line
Vanguard suggests that financial advisors embrace technology and innovation. By scaling your business as a financial advisor, you can operate in areas in which you feel you can add value. Some of these areas include behavioral coaching, family planning, savings and wealth transfer planning.
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