Diversifying Outside of the Box

Jason Kephart: Hi, I'm Jason Kephart, an alternative analyst at Morningstar, and I'm joined today with John Ameriks, head of the quantitative equity group at Vanguard. Vanguard Market Neutral (VMNIX), which that team runs, was named Morningstar's Alternative Fund Manager of the Year for 2016.

Thanks for joining us, John.

John Ameriks: Thank you very much. It's great to be here, and it's a real pleasure to have won the award this year.

Kephart: I think the first thing that people think of with Vanguard is probably anything but alternative.

Ameriks: I think you are right--it is a little bit unusual. I don't think, these days, we're quite as well known for the long history that the organization has managing active funds. And certainly, the idea of alternatives is a little something different, I think, in most minds.

Kephart: So, what does Vanguard see as the benefit of having an alternative investment like the Market Neutral Fund?

Ameriks: Well, as you know, we start with active management, and I'll repeat the fact that the founding principle behind The Vanguard Group, again, is focused on low cost. Our view is that, by lowering costs, we can help investors achieve their investment goals better--whether those are tracking the market or whether they are beating the market, in terms of attempting to meet an active goal.

The Market Neutral Fund takes our active process and strips away the benchmark. It really does give someone the cleanest exposure that they can get to the process that we use to choose stocks that we think are going to be better bets against those that are going to be worse bets.

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Kephart: Market-neutral funds, I've found, are some of the most misunderstood funds in the alternative world. People don't really know how to benchmark them or how to use them or even what they are really trying to accomplish. So, maybe in that vein, could you give us a little bit of background on what the goal of the fund is and what you guys do to achieve it?

Ameriks: Sure. I'll do what I can--try to keep me within time! I think there are a couple of things here. Market-neutral funds, alternative funds--there's a lot of history. They go back a long time. The original hedge funds, I think, were designed like this. And again, the idea is if you think a manager has some skill at picking good stocks and also being able to recognize the bad stocks as well, you'd like for them to be able to really overweight the things they like and underweight the things that they don't.

Market Neutral just gives full flexibility to do that. We have a long portfolio and a short portfolio that are about the same size in terms of their nominal exposure. But the things in the long portfolio are things we tend to like and think are going to be better bets within an industry than things that are in the short portfolio. So, that's sort of the structure of how we do it.

What do people use it for? Why is that useful? Well, one of the big things is very low correlation with the market. That's the name: Market Neutral. We use a lot of quantitative techniques in our selection process to try to make sure that we have a minimal exposure to the benchmark so that when the market's up or when the market's down there is no systematic relationship with the payoff in our portfolio.

So, if you think that our process adds value and if you believe that we are skilled active managers and if you think that we can do that in a way that's not correlated to the market, you can get a lot of utility out of this approach as a diversifier--in particular, as a diversifier that has (in the way that we've structured it) slightly lower total risk than a broad equity market fund. It maybe has a little bit more risk than a fixed-income fund, but it's kind of in the middle and has very unique correlation properties. So, that helps with diversification.

Kephart: What do you think sets Vanguard's process apart from peers when it comes to building a market-neutral strategy?

Ameriks: I get asked that question a lot. And I know our process, so I can describe that. But the outside world is constantly changing. A couple of hallmarks of what we do, though, is we've really stuck very strictly to a quantitatively oriented process. That said, we think of ourselves as fundamental managers. We're trying to look at the characteristics of individual firms within industry, and we have a model and a lens that we've been working on and improving over more than 20 years now that looks at characteristics of individual firms, compares them with one another, and then applies those comparisons systematically across a very large universe of securities.

So, that quantitative orientation--that model--those signals are refreshed every day. Our portfolio-management team, as skilled as those guys are, they are taking their cues from what comes out of the model. So, in our setup, the portfolio manager really executes. It's their job to take the signal and get it into the portfolio, taking away as little as possible. They want to really focus on transaction costs; they want to focus on risk constraints, giving us the exposures that we want and getting the most alpha in a portfolio. I think we have a lot of discipline around doing that. We stick with the quantitative process through thick and thin. We use an awful lot of rigorous mathematics to evaluate our fundamental models before we add them to the portfolio. And then we use an awful lot of risk control. That's what really sets us apart.

Kephart: And there are five key signals you're really looking for in stocks, right?

Ameriks: That's right. You know our methodology pretty well. So, these are our five key signals in the domestic bottle: quality--we're looking at firms with good-quality earnings; we're looking at firms that have good sentiment. I'll come back to that in a minute, because a lot of people don't think of sentiment as a fundamental indicator, but we use it in a fundamental process. We think about good management decisions. How's the firm using capital? How's the structure of the firm changing over time? We think about consistent earnings growth. Does the firm have a track record of being able to grow and deliver in terms of profitability over time? Lastly, we look for good valuations.

So, all five of those things fit together. I would tell you the one exception that doesn't really fit into that fundamental mantra is the sentiment piece. That's based on how you see the market reacting to the firm. Do we see, in the market, a price trend that leads us to believe that the other four signals are giving us the right directional answer around the firm? So, we kind of view it as a reflecting mirror on the rest of the model as well.

Kephart: So, market-neutral funds are basically "cash-plus" vehicles in a sense, where you are expecting some kind of return over cash. So, what are the expectations investors should have around the performance of these funds?

Ameriks: Well, this is a very tricky subject--and one that I want to make sure that I sound a lot like Vanguard when we talk about it. We want investors to have modest expectations for what we do. Again, as I've mentioned, this fund embodies the cleanest signal of our stock-selection process. We think we can add alpha. To have really large expectations about alpha, I think, is to some extent really naïve. We know that markets are not perfectly efficient, but they're pretty efficient. We still think we can add value, but it's at the margins. So, to be a little bit more technical--I hope this doesn't bother anyone--we see a tracking error or a targeted volatility in this fund of around 5% to 6% over the course of a year. We think that our information ratio, our ability to add value, is around 0.25.

So, you take 5% or 6%, you take 0.25, our alpha expectations are somewhere in the order of between, I would say, one and two percentage points annually. That would be a great result for us. That's the alpha. Because our expense ratios are so low, we think that that adds value in a portfolio. And despite the wonderful results that we've turned in this year--and actually for the last couple of years--people do need to understand that there's volatility there. We're market neutral. It doesn't mean we have a negative beta. It doesn't mean that when the market goes down our fund should somehow be expected to go up.

What it should be expected to do is be unpredictable. It shouldn't be related to the market, but there are going to be occasions when the market's down and the fund is down. The idea is diversification, a little bit better than cash, and a more robust profile structure for investors.

Kephart: So, what are some of the best practices you could share with investors when it comes to using a fund like this in their own portfolio?

Ameriks: Well, again, I think it's about building a diversified portfolio. We use this fund as a part of our Managed Payout Fund (VPGDX), which is another fund that Vanguard offers that builds together exposures to various asset classes. This fund has been between 10% and 15% of that fund historically. It's a nice piece, again, that gives you a risk exposure that's probably somewhere between fixed income and equity, and offers a real diversification value. And in an environment like this where the credit markets aren't delivering as much in terms of systematic return and the equity markets up until at least the end of the year had been relatively richly valued--that's come back a bit--that type of noncorrelated exposure to value added could be an important part of the portfolio.

Kephart: Great. Thank you so much for joining us today, John.

Ameriks: Very happy to be here, Jason. Thank you.