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Susan Dziubinski: Hi, I'm Susan Dziubinski from Morningstar.com. Morningstar director of personal finance, Christine Benz, recently introduced a series of model portfolios featuring mutual funds and ETFs with an ESG focus--ESG standing for environmental, social, and governance. She's here with me to discuss how investors can put together their own ESG portfolios if they're so inclined.
Christine, thanks for joining us today.
Christine Benz: Susan, it's great to be here.
Dziubinski: Now, first, let's step back. How many portfolios have you created, and what are they?
Benz: There are 12 portfolios altogether. Six of them are geared toward people who are already retired. So, there are three mutual fund retiree portfolios, aggressive, moderate, and conservative. There are three ETF portfolios for retirees as well--also aggressive, moderate and, conservative. Then we also have counterparts for people who are still accumulating assets for retirement. So, again, we have portfolios that are composed of exchange-traded funds, as well as portfolios that are composed of traditional mutual funds.
Dziubinski: Great. Now, the first step in putting together a portfolio, whether it's ESG or not, is setting an asset allocation. So, how did you go about doing that?
Benz: I relied on our Morningstar Lifetime Allocation indexes to kind of lay the groundwork for the asset allocations of the portfolios. I would urge investors who are putting together their own portfolios to either get some professional guidance here from a financial advisor or maybe--if they're not working with an advisor--maybe lean on some professionally managed allocation. So, look at a target date that's geared toward someone with your same expected retirement date just to see what they are mapping out in terms of asset allocations. In retirement, I like the idea of people customizing their own asset allocation, really depending on how much they expect to be spending from their portfolio.
So, as you know, Susan, I'm a big believer in this Bucket approach to retirement portfolio planning, where you use your expected portfolio withdrawals to guide how much to hold in each asset class. So, with near-term expenditures, you'd want to keep that money really safe in cash, and then you step out on the risk spectrum from there. I've written about this topic on Morningstar.com before, but I think it is very individual-specific. This is a spot to get some help from a financial advisor. But definitely think about your own portfolio spending plan as well as your own risk tolerance. If you are someone who is extremely risk averse, I think you'd probably want to hold more in cash and bonds than if you're someone who feels comfortable riding out periodic bouts of market volatility.
Dziubinski: Once you have that asset-allocation step taken care of, the next is choosing your holdings. And you've said that one thing you need to figure out if you want to be investing in ESG fashion is to figure out: How ESG do you want to be? What do you mean by that?
Benz: This was really a learning process for me, Susan, from the standpoint of understanding how some of these ESG products are put together. And one thing to know is that some funds are willing to put up with a lot of idiosyncratic risk, whether sector bets or heavy individual stock positions in the interest of having a very ESG-friendly portfolio. So, they don't want to own, say, any companies that are producing fossil fuels, that's just an example, which might give them very divergent sector positioning relative to the broad market. Other funds, especially you see this in the index fund space, want to more or less reduce their tracking error relative to a market benchmark. So, they kind of want to keep performance in line with that market benchmark. But they at the same time want to have some ESG characteristics as well. So, just I would say get clear on how you are threading that needle. It's really a matter for each of ourselves to decide.
In the case of the model portfolios, I set up the ETF portfolios to have limited tracking error, meaning that they're going to deliver kind of indexlike performance, whereas the mutual fund portfolios are composed largely of actively managed funds. Those are more ESG-y portfolios, and I would expect them to have higher tracking error relative to the benchmark. I worked with our colleague, Jon Hale, who is Morningstar's head of sustainability research, to help figure out how to populate these portfolios. In the mutual fund portfolios, we were able to use some of the funds that Jon respects most from the standpoint of their ESG criteria. So, one firm that we used is Parnassus, which has long been a big name in this space. That's an example of a firm that Jon thinks highly of in terms of their investment acumen as well as their ESG characteristics.
Dziubinski: What are some of the things that ESG investors should be looking for in an equity fund?
Benz: I think a key fork in the road that you'll face whether looking at equity or fixed-income holdings is that you need to decide whether you want to be in a passively managed product or in an actively managed product. So, that's the same fork in the road that really any investor faces. Think about what you want there. Of course, with the passively managed product, you do have the lower costs at, typically, a company index funds and ETFs. But you might have a little less of that intentionality that can accompany some of the actively managed ESG products. So, think through that issue. And again, it's pretty individual-specific to decide. You definitely want to focus on costs. So, even though ESG fund costs have come down quite a bit, there are still some higher-cost products out there. So, be paying attention to that as well.
Dziubinski: And on the bond side of things, there are fewer funds to choose among it seems like, even though that space does seem to be growing.
Benz: It does. We've seen a lot of new launches in the bond area. Pimco has some funds. Some of the big players are engaging with ESG products. So, there are more choices. But you're right, you are, I would say, less flexible in terms of your choices. You won't be able to cover every nook and cranny of the bond market with ESG bond-fund choices. There are definitely some good-quality core products out there. There are index funds as well as active products. Another thing to think about is, there might be some exposures you'd want in the portfolio such as inflation-protected bonds, which are something that I typically include in my in-retirement portfolios.
One thing to think about is that in many bond ESG products, U.S. government bonds actually make it through the funnel. So, if you're putting together a holistic portfolio and you want your bond portfolio to be encompassing, by that logic, I think you could realistically own a stand-alone Treasury Inflation-Protected Securities fund, for example, if you wanted to, because those are government bonds. But I would watch that space because I would expect to see more and more products coming online.
Here, though, costs are even more crucial, because as I was winnowing through this universe, I did see some funds with terribly high costs. And when we're looking at bond yields today of like, 2%, do you really want to be ceding, say, 1% of your 2% return that you might earn to costs? I don't think so. So, you need to be careful that you're not sacrificing too much in an effort to build an ESG-friendly portfolio.
Dziubinski: And then from a portfolio-construction standpoint, are there things that you'd be leaving out--parts of the market or types of investments--if you were pursuing sort of this all-ESG approach?
Benz: Not necessarily. There might be a few categories, sort of, the niche categories. A commodities tracker, for example, or precious metals; you probably, at this point, cannot delve into ESG-specific products in that space. I think that's OK. It didn't really limit me in terms of putting together the portfolios. You'll also find fewer smaller bore equity funds. So, you won't necessarily find--well, you might be able to find an ESG small-growth fund, but you won't have many choices. So, for people who really like to micromanage the equity exposures in their portfolios, that probably is not going to be an easy task currently either. But again, I don't think that's the worst thing in the world.
Dziubinski: Right. Right. Christine, thank you so much for your time today.
Benz: Thank you, Susan.
Dziubinski: I'm Susan Dziubinski from Morningstar. Thanks for tuning in.
Damien Conover: Today we're talking about AbbVie. AbbVie is a stock that we think is both undervalued and well positioned with its dividend. Right now, the dividend yield is close to 5%, and in a landscape where it's difficult to get yield, we think AbbVie's yield is both secure and has potential for some modest growth over the next few years.
When we think about AbbVie, it's a stock that is trading from a price/earnings basis on a very low metric. It's close to 10 times earnings. And we think it's very secure with its earnings growth over the next three years. But the main reason why it's trading so low is it does have a massive patent loss coming up. In 2024 we think the Humira patent loss will put a lot of pressure on earnings, but from a dividend perspective, we still think AbbVie will be able to support its dividend in the 2024 time period.
Now at that time, we will see a dividend payout ratio go up to a little bit over 60%, which will weigh on the company's ability to pay the dividend. But nevertheless, we still think it's secure. And we think it's secure for three key reasons.
First off, we think there'll be continued growth of a lot of products outside of Humira. So currently marketed products that are really well positioned for further growth, in particular Imbruvica and Venclexta, both for blood cancers, look very well positioned for further growth.
Second reason we think the dividend is secure and growth potential looks likely is the pipeline. AbbVie's pipeline looks very well positioned. It has new drugs coming into immunology that are well-positioned, better than a lot of other drugs out there. In particular, we're looking at SKYRIZI to be a very important new drug in psoriasis.
And the third point why we like AbbVie, and we think that dividend is secure, is the recent acquisition of Allergan will diversify its product portfolio. So, unless there is something very substantially negative that hits Allergan, we think AbbVie's very well positioned. In particular we think Botox from Allergan is well positioned, both in the aesthetics market and in the therapeutic market. So that should drive further diversification that really enables AbbVie for solid growth over the next several years.
Christine Benz: Hi, I'm Christine Benz for Morningstar.com. Headline inflation has been pretty mild, but that doesn't mean investors should ignore inflation protection when putting together their portfolios. Joining me to share some thoughts on this topic is Alex Bryan. He's Morningstar's director of passive strategies research for North America.
Alex, thank you so much for being here.
Alex Bryan: Thank you for having me.
Benz: Let's talk about how investors should approach this, starting with life stage. To what extent should whether I'm in drawdown mode--where I'm retired, and I'm pulling from my portfolio--influence how much I care about inflation versus whether I'm still working and earning a paycheck.
Bryan: I think if you're currently in the workforce and drawing most of your income from your salary, there's a good chance that you're going to experience cost of living adjustments, where your salary will grow with inflation over time.
If you're retired and drawing more of your income from the bond portion of your portfolio, in that case it's more important to start thinking about maybe considering an allocation to inflation-protected bonds. I think it really just depends on whether or not you are currently in the workforce or in retirement. As you draw more of your income from your portfolio, inflation protection becomes more important.
Benz: How about my personal inflation area experience? It seems like that should influence it, too. Like, what I'm spending money on and the extent to which those categories are inflating or maybe not experiencing so much inflation. Let's talk about that.
Bryan: Absolutely. So, inflation-protected bonds typically index to the Consumer Price Index, which is a broad measure of consumer inflation and consumer prices. That's based on survey data across thousands of households, and it basically takes the typical experience of a large sample of households to try to gauge what inflation is.
Now, if your expenditures are different than the typical U.S. household--let's say, for example, you spend a lot on medical bills and healthcare--in that case, your inflation experience may be very different from the typical American household.
I think, if that's the case, then inflation-protected bonds may not be as good of a hedge for inflation as you might expect. So, it's really important to kind of gauge your expenses and see if they're similar to the broader U.S. households.
Benz: You've referenced Treasury Inflation-Protected Securities, or inflation-protected bonds. Let's just talk in very general terms about how these bonds work and how they look to incorporate inflation expectations into the return that investors earn.
Bryan: Principle value of TIPS is tied to changes in the Consumer Price Index. So, when inflation picks up, that will increase the principle value of these bonds. In turn, the coupon rate that these bonds pay is tied to the principle value, so as the principle value increases in response to inflation, that will increase the coupon payments that these bonds make.
For example, if a TIPS bond is issued at $1,000, and we have 2% inflation? The principle value will be adjusted upward to $1,020, and then the coupon payment is going to be based on that higher principle value, so you get growth in income with growth of inflation over time.
Benz: How about I Bonds? I know that that's another investment type that some individual investors like to have in their tool kits. They function in a similar way, right?
Bryan: Yes and no. So, I Bonds are very similar to EE savings bonds. These are basically bonds that you can invest a few thousand dollars in them. They provide a fixed rate of interest. On top of that, they provide an inflation earnings rate, so it's tied to the changes in the CPI. So, the ultimate value that you receive from the bond when you go to cash it is going to be tied to changes in the Consumer Price Index.
But, unlike TIPS, these don't pay out regular coupons. So, you don't actually earn income while you hold those bonds. You have to wait until you cash the bonds to actually get the value from those inflation adjustments. So, it can be a good long-term savings vehicle if you are concerned about inflation, but it's not going to give you regular coupon payments the way that a TIPS bond might.
Benz: I guess another thing to know is that you're quite limited in terms of how much of those I Bonds you can purchase--that if you're a very large investor, it might be difficult to build a significant bulwark against inflation because the purchase limits are lower.
Bryan: That's right. So, for I Bonds you're allowed to purchase up to $10,000 per year. So that can be quite limiting if you're looking to protect a large portion of your portfolio.
Benz: You've brought a couple of ETFs that you like that invest in Treasury Inflation-Protected Securities. One that you like is Vanguard's short-term TIPS fund--an ETF. Let's talk about why you like it and why you think the short-term product can make sense in some instances.
Bryan: Yeah, so this fund basically invests in TIPS bonds with up to five years until maturity, and I think that makes it a really good hedge against inflation because changes in the Consumer Price Index reflect effectively short-term inflation. And short-term interest rates tend to be more closely tied to short-term inflation than longer-term interest rates. So, I think short-term TIPS can actually provide a closer hedge against changes in the CPI than longer-term TIPS.
I think this does a really good job of providing really cleaning exposure to short-term inflation. So, I think that's a really important point. The other point here is that with this fund, you're not taking a lot of interest-rate risk. You're certainly not taking, you know, any credit risk because these bonds are backed by the full faith and credit of the U.S. government. These are very low-risk bonds, very conservative bonds. So, if you're looking to preserve your purchasing power and you want something that's really closely tied to changes in the Consumer Price Index, I think it's really hard to beat short-term TIPS. And it's really hard to beat this Vanguard fund because it's one of the lowest-cost options for getting exposure to this part of the yield curve.
Benz: Another fund that you like--this is more of sort of broad-spectrum TIPS fund. This is Schwab US TIPS ETF. Let's talk about that one, and where you think that could fit and what sort of time horizon you'd want to have in mind if you owned a product like this one.
Bryan: So this one invests in TIPS kind of across the maturity spectrum--so, anything with at least one year to maturity. So it goes all the way out, owning some long-term TIPS. That inclusion of some of those longer duration bonds tends to give it a higher yield than the short-term fund that we just talked about. But that also introduces some additional risk, right? Because now this fund tends to be more sensitive to interest-rate changes.
Also longer-term interest rates don't move as closely in line with short-term inflation as shorter-term rates. So, the value and the change in the value of this fund may not be as closely tied to what's happening with short-term inflation as what's happening with the short TIPS fund.
But I think if you're a long-term investor and you don't need to necessarily access that principle for a while, I think this could be a really good option for earning additional yield compared to the short-term TIPS product. And you still get that purchasing power adjustment--the same way that the short-term TIPS work--you still get an increase in the coupon payments that you receive based off of the changes in the Consumer Price Index.
The only real difference here is that the principle value of your investment is going to fluctuate a bit more with longer-term TIPS, but you will be compensated in the form of higher yield over time. So, I think this is a good option if you're a bit more comfortable with risk and you're looking to earn a little bit more yield.
Benz: Alex, always great to get your perspective. Thank you so much for being here.
Bryan: Thank you for having me.
Benz: Thanks for watching. I'm Christine Benz for Morningstar.com.
Linda Abu Mushrefova: We think Diamond Hill is a standout boutique that has consistently applied its intrinsic value philosophy across its strategies. Its equity offerings span the market-cap spectrum from small to large cap, and more recently, it has also expanded into global and international stock investing. However, its domestic-equity-focused funds still dominate its lineup.
The team has consistently applied the same proven approach to relative value investing across the board. It buys companies when their market prices are lower than the estimate of their intrinsic business value and sells them when they reach that value. The firm’s centralized research group of roughly two dozen sector specialists model companies’ cash flows using a five-year time horizon. The analysts then dive into balance sheets and income statements to estimate cash flows, normalized earnings, and an appropriate growth rate. Stocks trading at a discount to the team’s estimates of intrinsic value are eligible for inclusion, and portfolio managers at Diamond Hill are long-term investors. Bottom-up research determines positioning.
Its measured approach has rewarded investors through strong stock-picking over the long haul. Diamond Hill’s disciplined process, rooted in deep, fundamental analysis, earns several of the firm’s strategies medalist ratings. Diamond Hill Large Cap, Diamond Hill Mid Cap, and Diamond Hill Small-Mid Cap, which is closed to new investors, earn a Morningstar Analyst Rating of Gold, while Diamond Hill Small Cap, which reopened to new investors in early 2019, earns a Silver, and Diamond Hill Long-Short earns a Bronze rating. Their proven philosophy has been consistently applied, and we expect it to continue to reward investors over a full market cycle.
Ben Johnson: Hi, I'm Ben Johnson, director of Global ETF Research with Morningstar.
In recent years an ever-broader swath of investors has been introduced to a new concept, the concept of investment factors, things like value, momentum, and low volatility. And too many of the uninitiated, this is effectively a new language, one which is very difficult for many to decipher. Morningstar has been working to develop the toolkit to help investors understand this new language and to put it to use when it comes to investing in funds and selecting amongst the very best of breed. Here to discuss a new tool, specifically the Morningstar Factor Profile, with me is Morningstar's Director of Quantitative Research, Tim Strauts.
Tim, thanks for being here.
Timothy Strauts: Yeah, thank you.
Johnson: So, Tim, let's start with the very most basic question, which is, what is the Morningstar Factor Profile?
Strauts: The Morningstar Factor Profile is a new visualization which allows an investor to look at an equity portfolio through the lens of seven investment factors that we think are standard throughout the industry today. And we think these factors are important drivers of risk and return.
We think that there's really two main use cases out of the gate, probably many more than that, but just initial two are to evaluate strategic-beta funds. Many products have come out in the last several years, for example, that maybe target momentum. And up to this point, you just had to follow the marketing literature to believe what they say is the amount of momentum exposure a fund is taking. But with Factor Profile, you'll actually be able to see the amount of momentum and actually make comparisons between funds.
The second area is that it can be a good way to analyze active manager investment process. When a portfolio manager discusses how they pick stocks, they often don't use the language of factors. But when you look at the data, you find that many managers are actually employing factor strategies even if they don't realize it themselves. So, you can use Factor Profile to even evaluate active managers.
Johnson: So, some of these metrics are already sort of evident--they're surfaced in things that are very familiar to investors today, notably the Morningstar Style Box, which allows investors to understand kind of on the value growth spectrum. The size spectrum is measured from large to small caps--where their managers stack up, where they tend to go fishing. How does the Factor Profile relate to the Morningstar Style Box?
Strauts: I really think Factor Profile builds on the Style Box. So we still have the two initial factors in the Style Box, the size and style factors, but we have added five additional factors. And those factors are yield, momentum, quality, volatility, and liquidity. And when choosing them, we kind of looked across the academic research that's out there, and obviously, there's hundreds, if not thousands of papers that talk about new investment factors. But the problem with most of that research is, is the back test always looks great. But then, once it's live and people are actually accessing it, the returns usually suffer. And so, we look for factors that had come out decades prior, that had held up to the scrutiny and still provide value to investors today.
Johnson: So, that's helpful context both on the relation to the Morningstar Style Box as well as kind of our rationale behind picking the factors that we've picked to include in the Factor Profile. What about factor definitions, which in academic research as far as practitioners are concerned, there are many different definitions of value, let's say. What are our definitions? Why did we arrive at the definitions that we arrived at?
Strauts: This is a hard problem, right? Because everyone has their own definition. So, we tried to look at the academic literature, what the industry was doing, and make Morningstar's best determination of what the industry standard definition was. In some cases, like momentum, it's pretty easy. Twelve-month minus the most recent one-month momentum is standard in the academic literature and generally accepted in the industry. Other factors like quality are a little more contentious. There's lots of different ways to measure quality. We tried to find a definition that was simple, easy to understand, but still measured what we wanted. And for quality, it's a measure of profitability and financial leverage.
Johnson: So, generally speaking, we're aiming to be noncontroversial to define these factors in a way that's readily intelligible to the end investor and hopefully, durable over time. Is that a fair characterization?
Strauts: Definitely. I mean, we definitely don't want to launch a factor in the Factor Profile that we're concerned would be at risk of not providing value in, say, five years from now.
Johnson: OK. That's helpful. So, you mentioned some of the use cases, specifically as it pertains to strategic-beta funds, which tend to have factors embedded in their DNA. What are some of the other ways that an investor might use this tool, use this visualization when it comes to doing due-diligence on funds they're either vetting or funds that they already own?
Strauts: Yeah, I think the easiest way is to look at an example. So, we do have an example here. And you'll see in the visual that we have the seven factors going across, with the style factor on the far left and the size factor on the far right, the two original Style Box factors, and then the five new factors in the middle. The blue dot shows you, based on the current portfolio, what the exposure to that factor is. And then, the black dot and line show you where the category average is. So, you can compare the blue dot to the black dot to see, Is this fund taking more or less exposure than the relevant peers?
So, for example, in the middle here, we have the quality factor. This fund takes very high-quality exposure, which is much higher than its average peer in the small-growth category, which is, kind of more middle of the range.
And then, finally, we have the five-year historic range. And the historic range, I think, is actually one of the most important aspects because it really tells you if the fund is attempting to target a certain factor. So, if you see a very tight range, it's likely that the manager is targeting that factor. Whereas if you see a very wide range, it might more just be random noise.
So, for example, the quality factor has a very tight range. You can barely even see the shading beneath the blue dot. The manager’s targeting very high-quality stocks consistently. But then move over to the left and look at momentum. Momentum tends to head--it's above-average momentum today, but it's gone from very high to very low across the whole spectrum. So, this manager is really not focusing on momentum when they're choosing stocks. It just happens to be that they have high- or low-momentum stocks based on the day or week or the month.
So, looking at this fund, you can see the seven factors for this small-growth fund. And it's clearly small-growth based on the style and size, but it's really--its defining characteristic is a very high-quality exposure, which is something new you would not have known before we had the Factor Profile.
Johnson: So, it's almost a way at the margin to validate an investment manager's stated process, be they a flesh-and-blood human being actively managing a portfolio, or a strategic-beta index underpinning a factor-oriented fund?
Strauts: Yeah, and I would mention is that this hypothetical fund, which we're not going to mention, is actually covered by a Morningstar analyst and our Morningstar analyst actually picked out this quality exposure in their report. But as you know, not every fund is covered by an analyst and so Factor Profile can fill in the gaps whenever an analyst isn't there.
Johnson: That's great. And Tim, the final question I have for you is, where will investors be able to find the Morningstar Factor Profile?
Strauts: We have a very broad launch across all of our software platforms, specifically Direct, Office, Advisor Workstation, and our Morningstar.com website. If you want to find the Factor Profile, you need to go to a quote page. So, type in the ticker of your favorite fund, equity fund, and go to the portfolio section of the quote page and you should see the Factor Profile next to the Style Box.
Johnson: Well, Tim, thanks for joining me to discuss this exciting development, the Morningstar Factor Profile.
Strauts: Thanks for having me.
Johnson: For Morningstar, I’m Ben Johnson.
The author or authors do not own shares in any securities mentioned in this article. Find out about Morningstar’s editorial policies.