Skip to Content
Investing Specialists

Tom Idzorek: Exploring the Role of Human and Financial Capital in Retirement Planning

The prominent researcher shares his thoughts on retirement managed accounts, what makes ESG tick, the 'popularity' concept, and more.

Listen Now: Listen and subscribe to Morningstar's The Long View from your mobile device: Apple Podcasts | Spotify | Google Play | Stitcher

Tom Idzorek Show Notes

Our guest this week is Tom Idzorek. Tom is chief investment officer, retirement, for Morningstar Investment Management, which is Morningstar's affiliated asset-management arm. Previously, Tom was president of Morningstar Investment Management and before that was a leading researcher at Ibbotson Associates. Tom has collaborated on a number of influential academic studies on topics including asset allocation, the liquidity of stocks, and the role of popularity and security prices. Tom serves on the editorial board of the CFA Institute's Financial Analysts Journal. He received his bachelor's degree from Arizona State University and his MBA from Thunderbird School of Global Management. He is also a CFA charterholder.

Background

Bio

Asset Allocation and Managed Accounts

Roger Ibbotson

Peng Chen

Barton Waring

Larry Siegel

Active Portfolio Management: A Quantitative Approach for Producing Superior Returns and Controlling Risk, by Richard Grinold and Ronald Kahn

Stop Guessing: Using Participant Data to Select the Optimal QDIA,” by Thomas Idzorek, David Blanchett, and Daniel Bruns, Morningstar.com, Jan. 30, 2018.

ByAllAccounts

Modern Portfolio Theory

Academic Research

Liquidity Style of Mutual Funds,” by Thomas Idzorek, James Xiong, and Roger Ibbotson, papers.ssrn.com, Feb. 10, 2012.

The Popularity Asset Pricing Model,” by Thomas Idzorek, Paul Kaplan, and Roger Ibbotson, papers.ssrn.com, Oct. 25, 2021.

Forming ESG-Oriented Portfolios: A Popularity Approach,” by Thomas Idzorek and Paul Kaplan, papers.ssrn.com, May 20, 2022.

Popularity: A Bridge Between Classical and Behavioral Finance,” by Roger Ibbotson, Thomas Idzorek, Paul Kaplan, and James Xiong, papers.ssrn.com, Dec. 10, 2018.

Transcript

Jeff Ptak: Hi, and welcome to The Long View. I'm Jeff Ptak, chief ratings officer for Morningstar Research Services.

Christine Benz: And I'm Christine Benz, director of personal finance and retirement planning for Morningstar.

Ptak: Our guest this week is Tom Idzorek. Tom is chief investment officer, retirement, for Morningstar Investment Management, which is Morningstar's affiliated asset-management arm. Previously, Tom was president of Morningstar Investment Management and before that was a leading researcher at Ibbotson Associates. Tom has collaborated on a number of influential academic studies on topics including asset allocation, the liquidity of stocks, and the role of popularity and security prices. Tom serves on the editorial board of the CFA Institute's Financial Analysts Journal. He received his bachelor's degree from Arizona State University and his MBA from Thunderbird School of Global Management. He is also a CFA charterholder.

Tom, welcome to The Long View.

Tom Idzorek: Thanks for having me.

Ptak: You're quite welcome. Thank you so much for being with us. As we mentioned in the intro, you're the chief investment officer, retirement, for Morningstar Investment Management. Can you talk about what your role entails day to day?

Idzorek: I oversee two teams. One is, what I'd say is, a quantitative research-focused team that is really thinking about the different methodologies that we use across our Workplace business within Morningstar. And then, the second team is the team of investment professionals, portfolio managers, analysts that are carrying out the methodologies. And then, our team interacts heavily with various, what I'll call an engine-creation team and/or technology team that is often taking the methodologies that we create and refine and cooking that into scalable technology-based solutions that drive a number of our automated advice-oriented offerings.

Benz: Who have been some of your professional influences? I'm sure Roger Ibbotson and our former colleague, Peng Chen, would be on that list, and perhaps you can discuss your relationship with them and your roots in what was Ibbotson Associates, and then perhaps also discuss some other people who have been influential in terms of your professional development?

Idzorek: Again, I started my, what I'll call, my financial career at a place called Zephyr Associates and was hired away from there to Ibbotson Associates. And the person that hired me was one of the people that you just mentioned, Peng Chen. And so, I went to work for Ibbotson Associates, and I'd say, had some interaction with Roger Ibbotson, the founder of Ibbotson Associates, who was at Yale at that point in time. But my primary influence at that point in time was Peng. And he was a wonderful mentor and really believed in what I brought to the table.

In 2006, as you all would know, Morningstar ended up purchasing Ibbotson Associates from Roger. And eventually, I ended up serving as the President of Ibbotson Associates. And it was after the purchase of Ibbotson Associates by Morningstar that I'd say my level or degree of interaction with Roger Ibbotson increased significantly. And we, as we'll probably get into later in the podcast, I've collaborated both with Peng and Roger significantly since then, and they've been wonderful influences.

Thinking about other people, anybody that's been at Morningstar as long as all of us have, and for me going back to 2006, of course, Joe Mansueto and Don Phillips are just fabulous people to interact with, so smart. Thinking out beyond the Morningstar circle, there was a firm, Barclays Global Investors, or BGI, that ends up getting acquired by BlackRock. But at BGI, there was a guy, Richard Grinold and Ron Kahn, and they wrote a book called Active Portfolio Management. And I'd say that's just really been a big influence. I don't know Richard or Ron at all. But people that worked very closely with Richard Grinold and Ron Kahn are two ex-Ibbotson Associates people, Barton Waring and Larry Siegel, and I'd say both Barton and Larry have been very involved in a portfolio construction framework that we use heavily at our business today and have used it for 20 years, which is an alpha-tracking error optimization framework. But often when our opportunity set of investments that we're trying to combine into portfolio include, what I'll call pooled-investment vehicles, whether these are mutual funds or separate accounts or ETFs. And then, circling back to Morningstar just a smidge, I have had the good fortune of working with a number of really talented coworkers and coauthored a number of pieces with, say, James Xiong, for example, and Paul Kaplan.

Ptak: I wanted to talk about output from your role. One important piece of that is managed accounts. We should mention again that a lot of your work is focused on the defined-contribution space, and that's why it makes managed accounts a logical place to go next. I think it's fair to say you're a strong proponent for retirement managed accounts. Maybe you can talk about what a managed account is and why you think they have merit for retirement plan participants?

Idzorek: So, a retirement managed account, and we should distinguish that from a separately managed account, is really a flavor of a robo digital-advice solution that people access typically through their employer's retirement plan that is provided through a recordkeeping service. And I would argue that these retirement-oriented robo-advisors are probably more sophisticated than the current crop of robo-advisors that people are probably more familiar with in the retail setting, where I think of the current grouping of robo-advisors is being mostly, you take a risk-tolerance questionnaire, it slots you into a portfolio. And going back to the retirement managed accounts, again, I think of it as being much more akin to the type of investment services that a financial advisor would offer, or even leaning a little bit toward what I might call financial planning light, where it is really trying to understand, based on the information that is available on the recordkeeping system, the individual investor's unique situation, determine what their retirement need is going to look like, and that can be influenced by information provided by the participant. And then, based on that estimated retirement need, make sure that they are on track for a successful retirement by evaluating the progress that they're making toward that goal—are they saving enough, when is an appropriate age for them to retire. This type of solution contemplates not only the assets that are in their primary retirement account, or DC account, but has the ability to contemplate outside assets. And again, I think of it as being a wonderful advisor solution, or advisor-oriented solution, for an individual who might not have access to a real-world financial advisor.

Benz: You mentioned some of these other inputs that you would like to see in order for the managed account offering to be as robust as it could be, so what sorts of outside assets does the participant have and so on? How big a challenge is it to get clients to supply the data that they need in order for the managed account to work as it should? And I'm just wondering how you and the team have thought about just trying to simplify that for participants, so they can give you what you need to make a good recommendation.

Idzorek: Again, obviously, if you have more information about an individual and their unique circumstances, the more personalized and more tailored, and the better, I would argue, that your advice can be. Now, maybe before we get to what the individual can input via the system, I will say pleasantly the amount of information that is available on most retirement recordkeeping platforms has increased over the years. And so, we used to just know a handful of data points about an individual. Again, the types of data points that are available on the recordkeeping system have increased over the years. So, in terms of what we need, that's great that we have that extra information.

And then, account aggregation or aggregators, that's kind of a new thing that's out there. And our system is attempting to use our own integration system, which is a firm we purchased, which is ByAllAccounts. There are other aggregators out there that different recordkeepers have access to. And so, there's a desire to automate what can be automated. Now, of course, there's probably a limit to that. And so, that's where you get into a user interface, user-experience challenge as to how do you make it easy for that individual to supply you with information about themselves? And again, like I said, the more information that we have, the better that our advice would be. And I think the same thing is true, if an individual went out to see a real-world human advisor, and they only provided a limited set of information about themselves, the advisor would do the best that they can on behalf of that individual, but it would be limited to what the advisor knew, and I'm afraid our system has the same real-world limitation that that advisor would have. And again, we are attempting to get that in an automated fashion and then augment that with what the individual would be willing to share with us.

Ptak: Supposing you had a participant who was really forthcoming and able to provide you with the data that you need in order to enable the personalization and really tailor something to suit their objectives and circumstances, how do you think they should go about trying to quantify the benefits of the personalized analysis service that they're getting, just so that they can better weigh the trade-off of a managed account versus something that's a little bit more off the shelf, like a target-date fund?

Idzorek: I think that quantifying, at least just, let's say, the personalized aspect of it is definitely a real challenge. And I don't know that I have a good answer for that. I will say, we did write a paper a few years back called, “Stop Guessing.” And the motivation for this paper was, if I think about just within the Workplace area of Morningstar and the different product offerings is, we have the retirement managed account offering, which is the ultimate level of personalization beyond going to, say, a real-world human financial advisor, financial planner. We also offer a plethora of, what I'll call, off-the-shelf target-date funds, as well as at the plan level something that's referred to as a custom target-date fund. And my guess is that if I went and spoke to the product manager of each of those services, they would all want to say, well, of course, my solution is the most appropriate for, say, an individual or a given plan. And as a pseudo quant, I would say I dislike that type of answer and would love to be able to quantify in some sort of measurable terms, is one of those solutions more appropriate for a given investor?

And so, if we go back to Modern Portfolio Theory as put forth by Harry Markowitz, there's the idea that there's a utility maximizing portfolio for a given investor. And if that investor is invested in, say, the wrong point on what you might think of as an efficient frontier, they're not maximizing the utility for them, because there's a mismatch between the appropriateness of that portfolio and the portfolio that they're actually getting. And so, in the spirit of that Markowitz utility maximization framework in the “Stop Guessing” paper that I'm talking about here, what we do is we attempt to say, what is the utility provided by managed accounts under the assumption that it is finding the exact right portfolio for a given person and personalizing that in an appropriate way. And then, if they were to be slotted into whether it's an off-the-shelf target-date fund, or a custom target-date fund, or somebody else's target-date fund, for that matter, some other third party, chances are they aren't going to be at the exact right asset allocation that they should be as determined, say, by a retirement managed account. And by not being in the right solution, they're going to give up some level of utility.

Now, typically, not always, but in most cases, that additional level of personalization offered through a retirement managed account comes at additional cost. And so, what our framework is attempting to do is, say, there is a utility loss from not being in the appropriate solution, but we also want to focus in on what is the real-world cost for retirement managed accounts. And so, what this paper puts forth is this utility framework for trying to quantify, given a plurality of different potential investment solutions, which one is actually the best. And we're doing that in the spirit of the Markowitz framework.

Benz: I don't think you're a fan of active management in general, but you'd probably agree that it does have its place in some situations. Where are the spots where you think it makes sense to perhaps use some sort of an actively managed product in lieu of an indexed product?

Idzorek: That’s a good question. They've all been good questions. I almost want to be a little bit offended, like am I not a fan of active management. Of course, in order for the markets to be reasonably efficient, we have to have some level of active management. And I would love to be able to find great active managers that consistently outperformed after fees. And it's not that I'm not a fan of active management. It's just that, boy, it is really, really hard to outperform on an after-fee risk-adjusted basis through time. First of all, I think there's very few good active managers that are going to truly outperform. And then, I think our ability as advisors, as investors to find them ahead of time, I think that's very hard. And I think my takeaway from that is that most people should throw up their hands up and then just really focus on lower fees.

Earlier, I mentioned that my favorite book within the investment world is Active Portfolio Management, again, by Richard Grinold and Ron Kahn, which is the art of attempting to outperform. So, again, my favorite book. Again, that's the framework for doing it. It's just darn difficult. In the vast majority of asset classes, I think most people should probably just be buying passive products at the lowest possible cost. I'm not 100% sure it is an asset class, but maybe commodity futures would be one where I would tend to want to be a little bit more active. And so, you have these commodity futures indexes and I'll call them, popular products for getting that exposure existing in an ETF or an ETN. And to me, these ETFs and ETNs, essentially need to track the underlying index. And I think this creates an opportunity where active investors, or hedge funds, or other CTAs, commodity trading advisors are able to front-run what these ETFs and ETNs are doing. So, commodities might be the one, if we can call it, asset class where I would prefer active management.

Benz: So, delving into asset allocation further, a key research interest of yours has been the role of human capital in influencing how we invest our financial capital. Has the pandemic revealed anything about human capital and the way we think that concept ought to be integrated into financial planning and asset allocation? And also, perhaps you can define how you think about human capital in this context.

Idzorek: I wish that individuals would receive an updated balance sheet that represented what I think of as their total wealth and the nature of what I sometimes referred to as the retirement income liability, recognizing that it may not be a legal liability, but again, most of us have a consumption series even before retirement, and then after retirement that we want a standard of living that we want to maintain. Thinking about the left-hand side of the balance sheet, which is, let's say, the asset side of the balance sheet, it's very clear, I think, often what are, what I would say, as our financial capital. But for many investors, their largest single asset is what we refer to as their human capital. And you can think of human capital as being all of the earnings that they're going to make throughout their lifetime. And again, in our kind of model, we typically focus mostly on the portion of human capital that would be used to eventually pay for retirement. And so, our somewhat nerdy definition of human capital is it's the mortality weighted net present value of all future earnings that would be used for retirement.

And then if you think about, say, Social Security, or maybe for the lucky few that have access to a defined-benefit pension, I think of those as a form of deferred labor income or another flavor of human capital. And then, for most people, we think of human capital, it's often a little bit more bondlike, than stocklike, and we arrive at that conclusion by thinking about the nature of the cash flows of that saving series. And again, for most people, it is relatively stable, it's relatively safer. And to the degree that people have more human capital, a safe asset that is going to help, whether it's providing Social Security, a DB, or simply money that is getting saved or converted from human capital into financial capital. Again, this is a wonderful, somewhat safe asset.

And to tie this back to the part of your question dealing with has the pandemic changed our view of human capital, I don't know that it's changed our view on it. I think something maybe that it's highlighted is that we often assume that people are going to continue to work throughout their lifetime. And it's something that we've seen during the pandemic here is a number of people have, at least temporarily, if not permanently, decided to leave the workforce. And so, our working assumption that most people will be working to some retirement age of, say, 65, or whatever it happens to be for them, I'd say maybe need to revisit that a bit.

Benz: I wanted to ask about that, because it does seem like younger people, and this is a huge generalization, but it seems like there's some embrace of lumpier income streams, that people are not hooking up with an employer and staying there for many years. They're perhaps a little bit more entrepreneurial. They seem more willing to put up with variability in their cash flows. Do you think that will influence how you make investment recommendations for people in that situation?

Idzorek: I think it probably should. And again, we are always trying to learn and improve our models. I will say, it's probably a good sign that young people have, I'll call it the flexibility, to choose to have that lumpier workstream. Again, this isn't everybody, of course. But that sounds great that one can have the flexibility to choose maybe to take a year off from work where I think that for those of us that are a little bit older, the mindset was, you always had to be working and striving for that savings. But in terms of the way we're trying to, I would say, design the ultimate financial advisor, ultimate financial planner in a box with our team of Ph.D.s and we want our advice to be as prudent, as suitable as possible and reflect the way investors actually behave. And I think this is highlighting a new flavor of behavior.

Ptak: As you know, interest rates have been rising amid higher inflation, and for the first time in quite a while, investors are having to deal with losses in both the stock and bond sleeves of their portfolios. Do you think investors ought to be thinking about adjusting their portfolios so as to better withstand rising rates in inflation should that arise in the future?

Idzorek: Jeff, probably. Again, to me, the ideal time to have adjusted your asset allocation in your portfolio probably would have been before the increases in interest rates and inflation. And I'd say that that is something that we try to cook into our lifetime asset-allocation policies in the way we evolve our intra-stock and intra-bond detailed asset allocations within our retirement managed account platform, as well as the target-date solutions that we provide. A technique that, I would say, institutional investors, especially, maybe pension plans and endowments that think about funding some sort of liability, a technique that is often used there is liability relative investing, or a flavor of liability relative investing is liability relative optimization. And you can think of that as being an extension of the Markowitz mean-variance optimization, except when you're running your optimizer, you have constrained the optimizer to hold either an asset or a combination of assets that represent what I would think of as the systematic characteristics of that liability.

And so, if I think about an individual investor, what does their income stream or desired expense stream look like in retirement, to me, most people in retirement have this thing, it's almost as if they've issued a TIPS bond of some sort, where they have to pay out an ongoing real expense. And you might think of that as one way of thinking about their liability. And then, as one ages, the duration of that bond shortens. And we use this liability relative optimization framework, and we attempt to model the changing nature of the cash flow structure of somebody's retirement expenses, capturing the interest-rate risk and inflation risk associated with that liability. And an outcome of applying that type of optimization is, for somebody that is nearing retirement or in retirement, you are somewhat attempting to match with your bond portfolio the embedded inflation risk and interest-rate risk that would be embedded in that, and you can somewhat offset that with your detailed fixed-income portfolio. I'm not saying you can fully offset that. But again, ideally, the right time to have thought about the risks that are inherent in the world that people face, you would want to create your asset allocation in such a way that you would have contemplated raising interest rates and rising inflation prior to actually occurring.

Benz: I would just like to ask, so what would the portfolio look like if the goal is to defend against those future threats of rising rates and inflation from a practical standpoint? What are the things that retirees could think about having in their toolkit and acknowledging that they'd want to be preemptive rather than reactive in adding those positions?

Idzorek: If you think about life expectancy, for example, and maybe you're 60, 65, life expectancy is, it's relatively long, 30-plus years. And so, the duration of those cash flows is pretty long. One may actually want to have a reasonable amount of duration in their portfolio at age 65, but as you move to 70, 75, 85, and the duration of those cash flows becomes lower, you would decrease the amount of duration exposure that you have within your portfolio. From an asset allocation, this would be a movement from a portfolio that may have been more intermediate-term bonds and/or some sort of long-term bond exposure from an asset-class perspective into something that is probably more a mix of money market, stable value, short-term bond, and probably a mix of intermediate bond and phasing out long-term bonds as somebody ages.

And then, thinking about the split between nominal bonds versus TIPS or inflation-linked bonds—earlier, you'd asked, Christine, about human capital and the nature of human capital. One of the things that we like to think about is how do the two big elements of the left-hand side of that balance sheet—your financial capital and human capital—evolve through time. Younger investors, the left-hand side of their balance sheet is dominated by human capital. And I would say, again, earlier I described human capital as being a safe asset. But it also provides an inflation hedge. Most salaries tend to go up, albeit with a lag, during periods of high inflation. And so, younger people who are primarily also invested in equities, have a lot of built-in inflation hedging into their overall total wealth portfolio. But then, in retirement, when on a relative basis, human capital is probably much smaller and the primary mechanism for which people are going to pay for retirement is by drawing down their financial capital, again, I would argue that their asset allocation should evolve in such a way that they are well-positioned to fight the risks that… Well, I want to say, inflation is always a risk that people face. Inflation has been very low for a long time. And now, it is definitely ticking up. Whether it will continue to do so or not, remains to be seen, but high inflation erodes the purchasing power of somebody's portfolio. And so, in terms of their bond allocation, as somebody is nearing retirement and moving through retirement, I would argue that a larger and larger portion of their fixed-income side of their portfolio should be implemented with inflation-linked bonds as opposed to nominal bonds.

Ptak: I think that we could probably ask you questions about asset allocation for hours. But I think in the interest of time, maybe we'll pick your brain a little bit on retirement planning and specifically, the 4% rule. Curious, as somebody who has spent a lot of time thinking about researching, not just accumulation of assets, but also orderly withdrawal of assets in retirement, what's your take on the 4% spending rule? Do you think it remains a good rule of thumb for retirement spending? Or do you think it needs to be rethought in some ways?

Idzorek: I almost should turn this question around and ask you guys. I know that both of you along with John Rekenthaler recently did a deep-dive study on the 4% rule. So, as a back-of-the-envelope, heuristic in terms of thinking about what you might need, that seems reasonable. But I think our whole need for this type of heuristic in an age when we have calculators and systems that can do a much better job of determining is somebody on track and what can they spend and how do you factor in a variety of other things such as Social Security, a DB, whether or not they have access to annuities, what's their tax structure look like. One can just use, again, a machine—and of course, our retirement managed account engine and machines do all of this—to do a much better job of determining is somebody on track to meet their goals. And if they're not on track, how do you course correct? Or let's say that they were being overly conservative and wanted to spend money more money, one could figure that out as well. So, I think it's an unnecessary heuristic at this point.

Benz: You referenced annuities, Tom, and I'd like to dig into that a little bit. What role do you think they should play in retirement planning and for whom and also, what types of annuities would tend to be most beneficial in your view?

Idzorek: It is such a complicated question. And I think for some people, annuities absolutely can and should play a role in their retirement plan. I believe many advisors and planners come down on one side of the fence. They either love annuities or they hate annuities. And I guess, I would just say, I have a nuanced view. And people in retirement, depending upon how well they're funded, they may or may not face a significant amount of longevity risk. So, I've talked about interest-rate risk and inflation risk. And now we're going to talk about longevity risk. This is another risk that people face. And to the degree that they face that risk, we would want to provide some level of protection against it. And if you're fortunate enough to have Social Security and a defined-benefit pension meeting the vast majority of your income need in retirement, chances are, you don't need an annuity. Conversely, there's a number of us that will probably save just enough so that we will run out of money right around life expectancy. And if that describes you, well, the risk that you face is you're going to live five years too long, or 10 years too long, and you've run out of money, and annuities can absolutely provide you with that form of longevity production.

And so, a challenge when speaking about annuities is that there's so many different flavors. A type that seems to be, I'll say, unpopular, but one that I think is excellent is the immediate annuity where somebody that is in retirement, whether they're 65 or 70, would exchange a lump sum in exchange for income for life. And now, for probably a number of reasons that behavioral finance would have to explain, people are often worried about that large exchange of control of a lump sum of money in exchange for income for life. And so, another popular flavor of annuity that isn't quite as efficient at producing the income would be a deferred variable annuity with a guaranteed living benefit rider attached to it. That provides people with the flexibility to sell off the remaining account value should they choose to, so they have that liquidity flexibility, if you will, but of course, doing so erodes any longevity protection that they would have had. And so, I would argue that if you're contemplating a purchase of a deferred variable annuity with a guaranteed minimum withdrawal benefit or living benefit rider, you should absolutely be viewing that as a purchase for life and really adhere to the income that it provides and not erode what is referred to as your benefit base.

Ptak: Wanted to ask you, if I may, about another benefit that I suppose we could liken to an annuity, which is Social Security. Do you think enough is being done on Social Security optimization? The decision on when to claim by itself can be pretty complicated. So, what's your take on that? Do you think that's a missed opportunity for many who are planning for retirement, that they haven't really thought through how to optimize Social Security?

Idzorek: The people that mess that up are the ones that aren't working with something like our retirement managed account service, or they're not working with an advisor or planner. The biggest mistake that most people would make is that they just go ahead and take that Social Security payment as soon as possible, when many of them would benefit by simply delaying.

Benz: We wanted to discuss some of your academic research, which has received a lot of acclaim. For instance, you coauthored a paper with our colleague James Xiong and Roger Ibbotson, called the Liquidity Style of Mutual Funds. That one won the prestigious Graham & Dodd Scroll Award from the CFA Institute. Can you talk about the paper's key findings and implications?

Idzorek: We wrote this paper after Roger and some of his other coauthors had written a paper looking at individual stocks and the impact that liquidity seemed to have on the returns of those stocks. And so, what Roger and his colleagues did is, I think they went back to either 1970 or 1972. And they took all the U.S. equities in each year. They formed them into either quartiles or quintiles, I can't recall, based on their estimated level of liquidity, and then each year rebalanced. And they found that monotonically that quartile or quintile representing the lower liquidity stocks, and these are still very liquid stocks, they're just less liquid than, let's say, the most liquid stocks, systematically outperformed. And then, in our paper that you mentioned with Roger Ibbotson and James Xiong, we were wondering, could you see the same kind of effect in mutual funds? And so, using the Morningstar Category system within the different categories, we looked at whether we could see the same thing. And so, we basically sorted within a category the mutual funds by their estimated liquidity level of their holdings and then formed—again, I believe it was quartiles, possibly quintiles—across all categories that we looked at, the mutual funds that were holding the less liquid stocks systematically outperformed those within the same category, the mutual funds that were by and large holding higher liquidity stocks.

Ptak: And so, that paper was published, I think, about a decade ago. Can you update us on the research? One of the things that's been striking about the last 10 years or so, as we think about it, is until relatively recently small caps hadn't fared as well versus large caps. And I tend to think of large caps as maybe more liquid, small caps as less liquid. And so, how has it held up over the intervening years since you published the paper?

Idzorek: We haven't really updated those exact numbers. And Jeff, that would be an interesting thing that we probably should do. Something that's been interesting over the last 10 years is large cap has done exceptionally well. And I would say, in general, large cap is often more liquid than small cap. To me, this is where my journey, along with Roger Ibbotson and Paul Kaplan, and to some degree, Jim Xiong, is why is it that liquidity would seem to explain returns. And of course, I would say that this relates to our developing theory of the theory of popularity, and then eventually, an asset-pricing model, the popularity asset-pricing model.

I think it makes sense that all else equal, all of us would prefer more liquidity, than less liquidity. And because we all share that same preference, and some of us really have a stronger maybe liquidity need than others. And again, I would say that, in general, some investors are willing to pay up, you might think of that as a premium purchase price, in order to hold an asset that is more liquid. And this could describe active managers, people that have purchases upcoming. Again, people, in general, like liquidity. And we have turned that to other, I'll call it, characteristics that investments may have, and in general, any characteristic that the vast majority of investors tend to, let's say, like, that tends to move asset prices somewhat, and investments with desirable characteristics tend to be able to trade at a bit of a premium relative to investments that have, I'll call it, unpopular characteristics.

Benz: Well, Tom, you've referenced the work that you've done on popularity, asset popularity. Can you talk about how you defined popularity? And also, can you tie that back to the work that you've done on liquidity?

Idzorek: I would just think liquidity in and of itself as a characteristic. And any characteristic that is popular, chances are, it's going to be more expensive, all else equal, than a characteristic that is unpopular. And I think that you could apply that to a wide range of characteristics that are embedded or coupled with investments. People that are taxable investors, all else equal, they would prefer investments that are more tax-efficient. Thinking about glamor stocks, I think that there's a number of people out there that really like the big names, the glamorous names and want to avoid the boring names. And arguably, the degree to which a given characteristic is more popular or less popular, that ebbs and flows with time. And part of that reflects the business models that people think are more attractive than others per se.

Ptak: I wanted to build on that and ask you about ESG. How does ESG, and maybe nonfinancial objectives in general, how does that tie into the concept of popularity, in your opinion?

Idzorek: I think it's a wonderful topic that is very much aligned, let's say, with popularity. When I think about ESG, I think that people tend to think of it as either being a financial or pecuniary perspective, and is global warming, is green, is that better for business? And so, that would be thinking about it, let's say, from a pecuniary perspective. And then, there's this nonfinancial or non-pecuniary perspective, in which regardless of impact it may or may not have on risk and return, do I like a given characteristic.

I think of E, S, and G as being characteristics of an investment. And then, of course, within the E, the S, and the G, you could drill down and subdivide that into a wide variety of other characteristics. And again, from a popularity perspective to the degree that people like green investments, firms with good governance, and so on, and the degree to which people are liking that, the number of investors that are liking those characteristics, that can create upward price pressure on things. I think ESG fits very nicely into the popularity framework. If I switch over from popularity to maybe the more formal popularity asset-pricing model that we've developed, you would be able to think about investments can have different expected returns and risks. And within the popularity asset-pricing model, each investor should be estimating and including all kinds of relative risk factors in terms of how do they think about risk and return. And if I believe that a variety of E, S, and G characteristics or factors will influence risk and return, I should incorporate that into, what I'll call, my capital market expectations when optimizing a portfolio. But similarly, or conversely, maybe, at the same time, the popularity asset-pricing model allows for people to have these preferences or tastes. And based on their tastes, they can also derive utility. So, you always want to build a portfolio that's maximizing utility for you, and that should reflect both how you think the pecuniary aspect of ESG as well as the non-pecuniary aspect of ESG.

Benz: Well, I wanted to follow up on that. If someone is owning ESG in an effort to minimize those ESG risk factors, should they expect to have to give up something in return for that? Should they anticipate that they will have lower returns?

Idzorek: I'm going to say probably. Risk is risk. So, if we go back to Harry Markowitz and mean-variance optimization, Modern Portfolio Theory, Dr. Markowitz didn't tell us how to come up with our inputs for mean-variance optimization. But presumably, a good analyst should be considering any and all relative factors that influence risk and return. And to the degree that those are ESG factors, again, that are relevant to impacting risk and return, those should be included in one's analysis. And a key takeaway, I'd say, from Modern Portfolio Theory is that lower expected risk should result in lower expected returns. And to me, that makes sense.

If I put a popularity lens on to this, if the overall popularity of ESG investing is on the rise, so there is a shift in the equilibrium in terms of the overall demand for ESG-centric assets, as that shift in popularity occurs, that could result in a period of time when lower ESG risk-oriented investments might temporarily outperform, but at some point, you'll reach that new equilibrium state, and now you'll simply be paying up for something with desirable ESG characteristics, including lower ESG risk, and I think a reasonable expectation in the long run would be lower expected return.

Ptak: Wanted to shift gears and ask you about advice. You have lots of experience thinking about delivering financial advice in automated, scalable ways. You've alluded to that in different points in the conversation. But you've also worked with a lot of advisors over time. So, my question is, with respect to human being advisors, where do you think they could be most helpful in, say, the accumulation years and working with clients? And then, also, when it comes to retirement income, what do you think is the most beneficial thing that they could be doing for their clients to help them navigate through those years?

Idzorek: I don't know that I have a good answer for that, Jeff. I think that the most important thing is that the individual is, in fact, working with an advisor, whether it's a human advisor or a robo-advisor. And the key thing is that the advisor is, whether it's human or robo, is going to assess, is that person on track to meet their goals, and if not, what do you do? And again, maybe getting into something that a human advisor can do really well, that a robo-advisor can't do is—market volatility is inevitable. We know that these 20% declines, let's say, in the stock market, they seem to occur on average, based on our Morningstar data, about once every seven years. So quite frequently. And the worst thing that investors could do is panic and leave the market, and something human advisors are great at is helping coach their clientele through those times of market volatility.

Ptak: Well, Tom, this has been a very enlightening conversation. Thanks so much for sharing your insights with us. We really have enjoyed it.

Idzorek: Well, thanks, Jeff. I appreciate the opportunity to be here.

Benz: Thanks for doing it, Tom.

Idzorek: Thanks, Christine.

Ptak: Thanks for joining us on The Long View. If you could, please take a minute to subscribe to and rate the podcast on Apple, Spotify, or wherever you get your podcasts.

You can follow us on Twitter @Syouth1, which is, S-Y-O-U-T-H and the number 1.

Benz: And @Christine_Benz.

Ptak: George Castady is our engineer for the podcast and Kari Greczek produces the show notes each week.

Finally, we'd love to get your feedback. If you have a comment or a guest idea, please email us at TheLongView@Morningstar.com. Until next time, thanks for joining us.

(Disclaimer: This recording is for informational purposes only and should not be considered investment advice. Opinions expressed are as of the date of recording. Such opinions are subject to change. The views and opinions of guests on this program are not necessarily those of Morningstar, Inc. and its affiliates. Morningstar and its affiliates are not affiliated with this guest or his or her business affiliates unless otherwise stated. Morningstar does not guarantee the accuracy, or the completeness of the data presented herein. Jeff Ptak is an employee of Morningstar Research Services LLC. Morningstar Research Services is a subsidiary of Morningstar, Inc. and is registered with and governed by the U.S. Securities and Exchange Commission. Morningstar Research Services shall not be responsible for any trading decisions, damages or other losses resulting from or related to the information, data analysis, or opinions, or their use. Past performance is not a guarantee of future results. All investments are subject to investment risk, including possible loss of principal. Individuals should seriously consider if an investment is suitable for them by referencing their own financial position, investment objectives and risk profile before making any investment decision.)