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Have Investors Stopped Chasing Performance?

Christine Benz

Christine Benz: Hi, I'm Christine Benz for Morningstar.com. The equity market has continued to perform well in 2018, but investors aren't embracing risk with open arms. Joining me to discuss the latest reading of Vanguard's risk speedometer is Fran Kinniry. He is a senior leader with Vanguard's Investment Strategy Group where he is the global head of portfolio construction.

Fran, thank you so much for being here.

Fran Kinniry: Thank you, Christine.

Benz: Fran, let's talk about the risk speedometer. What are you trying to measure with this gauge?

Kinniry: We created the Vanguard Risk Speedometer about two years ago, and what we were really trying to do is get a historical lens into cash flow and how it relates to different parts of the market. First, we wanted to gather all of the data historically and then, we could look month by month how today's cash flow and the market performance, leader or laggards, looks relative to history. Does it look the same, does it look different? That was really an information for us to then comment on that to what things investors maybe doing similar to the past or different than the past.

Benz: In this latest reading one trend that you picked up on, and it's one that you've been following for a while, is that investors' appetite for very risky assets seems to be below the five-year trend. Do you have any conjecture about what might be going on there?

Kinniry: We are actually seeing a lot of different behavior in this last episode than we've seen in our entire history of financial markets. It tended to be that investors--you always hear the analogy "buy trailing returns" or "chase performance,"--so when you would see an asset class or a subasset class doing really well, that's where the cash flow went. In the last three to five years--and we've been commenting on this--we're seeing a very difference behavior. I would call it an institutional behavior, one that is a rebalanced type behavior, selling the winning asset class, buying the underperforming asset class. That's quite healthy, we think, for investors' outcomes over the long run.

Benz: Specifically, in terms of some of the categories that you see investors adding to, I noticed cash was toward the top of the list, short-term fixed income, I believe, just the safe stuff, right?

Kinniry: You think about it, we're in one of the longest and largest bull markets ever, and anytime that has happened in the past, you saw investors go all in to the equity market. We are applauding investors and advisors who help them with keeping balance in the portfolio.

Benz: Another thing that jumped out at me was that looking over longer time frames, so over the past three and five years, the clear favorite in terms of allocations, in terms of categories was the foreign large-cap blend category. Here again, foreign stocks have had periods where they have performed well, but recently they have not been so great, but investors continue to put their money there. What's going on from that standpoint do you think?

Kinniry: Very similar to the stock-bond mix that we are seeing. We are seeing the U.S. dominate non-U.S., whether it'd be developed or emerging, one, three, five, 10 in the past when that happened. And inversely, if international have dominated, you see cash flow follow performance. We are actually seeing contrarian cash flow to trailing performance. So, a great sign to see if you believe in asset allocation, developing a plan and rebalancing into it, and quite different than we've seen at any period of our past.

Benz: Another thing I want to talk about is within domestic equity, and this is something we've been observing at Morningstar as well, the large-cap growth category, which has performed really, really well has been a category that investors have been dumping hand over fist really. They have been swapping out of it. I'd like to get your take on what's going on there, another seeming contrarian tendency?

Kinniry: Very much along the same lines if we put one, two, and three together, our hypothesis is just that. You have the rise of, what I would say, target retirement funds; Vanguard created quite a while ago called Vanguard's advisors' alpha, which is really redefining the value proposition of advice. It used to be that a lot of people were fund selectors or fund-pickers, where they would go and maybe get to a policy portfolio haphazardly. What we think is happening is, people are being diligent to the policy, the asset allocation and rebalancing into it, because all of the trends we're seeing, you're talking about large growth, dominating one, three, five, and 10, yet having negative cash flows. So, it's just really interesting to watch and see.

Benz: Do you think a related trend is the uptake of broad market index funds and ETFs, which tend to be core, as opposed to investors assembling portfolios of maybe finer-bore building blocks?

Kinniry: Yeah, it is interesting because I actually look at our speedometer's index, ETFs and active. We are not actually seeing real healthy flows even into ETF large growth. This idea is, a lot of people believe that what is going on with index active and ETF is substitution, meaning let's substitute a high-cost active growth fund within a large-cap growth ETF. We are not seeing that. We are seeing total transformation of the portfolio allocation process. So, selling large-cap growth active and maybe putting it into fixed income or developed international. Any switching going on from active mutual funds is not a switch, large growth to large growth, it's a switch and a transformation of the asset allocation.

Benz: The broader phenomenon is that investors seem to be doing a better job in terms of not performance chasing. Would you say that that is probably over for good? Or what could give rise to having investors gravitate to strong performance again?

Kinniry: We've have had this hypothesis now for the last three years, and I'm still going to leave it as a hypothesis because I think that would give me the ability to move it from a hypothesis to a conviction would be if we get a market sell-off. If stocks go down 20% or 30% and we see strong flows to stocks, that would really make the hypothesis a little stronger. Right now, everything seems to be working as we would hope, but we'll see if it happens in a bear market.

Benz:  Last question, when you look at the risk speedometers and how investors have subsequently done with some of these choices, and I'm sure you monitor that, what do you see? How have investors done in the past?

Kinniry: You all at Morningstar have done a great job on the behavioral gap, which is looking at the internal rate of return, which is actually the investor returns, and that's actually what investors get to keep versus just the fund prospectus return which is agnostic to when the cash flow comes in. There's always been this gap, the behavioral gap. We see that gap really go away when investors use single fund solutions. People don't time a target retirement fund, we see very tight gaps. 

We are hoping that this will close the gaps of unbundled investors, meaning people that are buying the components and rebalancing. If this trend continues, we would expect that closure to happen. We haven't seen it yet, because we haven't seen the trend break. But if stocks were to actually underperform bonds or international would underperform U.S., we would see that gap narrow relative to that we've seen it in the past. It's too early to tell, but if we look at single-fund solution gap, to unbundled gap, the hope is there that this does investors do better.

Benz: Fran, always great to get your insights. Thank you so much for being here.

Kinniry: Thank you, Christine. I appreciate it.

Benz: Thanks for watching. I'm Christine Benz for Morningstar.com.

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