[00:03:10] Wes Crill: The world of research, I think there was just a natural philosophical fit right away. It was an attempt to, not necessarily outsmart the market, but then to work with markets. And that just really resonated with me from the start. I started off in the research team at Dimensional, so doing a lot of empirical research studies around, furthering our understanding of these, what I’ll call anomalies or factors that were arising in the academic literature.

[00:03:32] Wes Crill: And then just figuring out, what parts of that were relevant to our clients. And over the years, I became really interested in the aspect of my work that was revolving around the communication to clients. And my team that I sit in, the Investment Solutions Group really sits at the intersection between our investments and our clients.

[00:03:49] Wes Crill: And it really helps me kind of further the impact that I can have on clients through, whether it’s writing about things that are of top go interest to our clients, and then also articulating dimensional’s investment philosophy and how we sit within the broader investment landscape. So I think that more or less covers the last 12 years.

[00:04:05] Rebecca Hotsko: Yeah, and it’s so interesting. Touching on Dimensional a little bit. For our listeners who just aren’t familiar with Dimensional strategy, can you talk a little bit about what makes Dimensional’s investment strategy and philosophy just different from other active management companies? 

[00:04:21] Wes Crill: Yeah, in some ways I’ve even heard the term that Dimensional is a grandfather of factor investing dimensional, and I are about the same age, and so I sort of take offense to that one.

[00:04:29] Wes Crill: I don’t think of myself as a grandfather just yet, but you know, we were founded back in 1981. We now, we’re a global firm. We have about 1500 ish employees across 14 different countries in different offices, managing about 500 billion globally as of the end of September. But the key aspect is we have one investment philosophy, and that philosophy really is a deep-seated belief in the power of markets.

[00:04:52] Wes Crill: There was evidence, even dating back to the sixties, showing that traditional active managers trying to add value through our guessing markets through timing markets were not consistently successful. And so what we set out to do was to find ways to outperform markets without out guessing them.

[00:05:08] Wes Crill: And that was simply just leveraging all of the research that was being done around differences in expected returns within stocks and bonds. And we quickly saw that there was a way to leverage all of that research. But the key ingredient here was the role of implementation. And that’s something that we were just fanatical about from the start.

[00:05:26] Wes Crill: How can we implement this in the most efficient way possible? And that’s, I think what we’ve been able to build over four decades now is just this expertise in implementing this way of investing. And, it becomes almost an easier way to communicate what we’re setting out to do, right? So if I tell you that I am going to outguess markets, that I have a secret widget that helps me pick stocks so the rest of the market doesn’t have, that becomes hard to explain when investment results are disappointing.

[00:05:52] Wes Crill: But when we are setting a balance to capture differences in expect returns within markets, that becomes much easier to explain when [00:06:00] investment results are disappointing. And so I find it to be a very refreshing way in some cases to invest this way. And know, fortunately, dimensional has had a lot of success doing this.

[00:06:10] Rebecca Hotsko: Yeah, I have  to say, when I learned about this strategy a few years back, it just made so much sense to me and was a relief honestly, that I didn’t have to pick stocks to beat the market. And so I want to dive into how to invest using a factor approach with you now because there are a ton of ETFs available for investors that all target different factor exposures, some being small caps, small cap value, high profitability, et.

[00:06:35] Rebecca Hotsko: And I think some investors just don’t know where to start with adding factors to their portfolio. What advice would you give our listeners on how we can think about which factors to prioritize?

[00:06:46] Wes Crill: It is challenging figuring out how to get started. And that’s because there’s a reason why we call this the factor zoo, for example.

[00:06:53] Wes Crill: So there was an academic paper from a few years ago where they were looking across all of the academic literature on different factors and found 316 different ones that have been published. And so that just kind of suggests how daunting this task is. So then the question is, and this is part of the research that we do around this stuff, is how do you figure.

[00:07:12] Wes Crill: Which ones are useful? Which ones are completely spurious? Probably have no economic intuition behind them. Which ones are just repackaging of something else that’s already been discovered? You know, That’s kind of something for Dimensional other practitioners to go through. I think it’s helpful just to start with what an investor’s goals are and what their tolerances or other considerations are.

[00:07:31] Wes Crill: So it’s like, okay, are you trying to achieve higher returns than the market? By definition, that means you’re going to have to deviate from the market if you just hold everything in the entire market at its natural market cap. You’re going to get the market return. So if you want to do better, that means overweighting and underweighting certain groups of stocks.

[00:07:48] Wes Crill: And from there it’s figuring out how much you’re willing to differ from the market on a year to year basis. That’s going to dictate how much you deviate from the overall market when you’re over and underweighting certain stocks. So  are you comfortable underperforming the market by 8% in one year if it means having higher expected returns than the market?

[00:08:05] Wes Crill: I think these are the kind of considerations investors need to have. And then finally, when you’re thinking about how you would want to deviate, and this comes back to your question about what factors would I want to choose? You want to have a really good sound underpinning for the factors or for these characteristics you’re using to inform how you deviate from the market.

[00:08:24] Wes Crill: There’s kind of a point of limiting benefit, whereas you add more and more factors to a portfolio, you start to decrease the impact they have on your expected returns. There’s kind of a point of diminishing returns, I guess. I should say it happens pretty quickly once you get past two or three factors. And the other stuff you’re adding in is really just going to be adding in complexity when you’re thinking about your asset allocation.

[00:08:44] Wes Crill: And so you want to be pretty judicious with these. We always want to start with what is the theoretical basis for why I should see this actor in the first place? If you go shopping for anything, let’s leave securities on the table for a second. If you go shopping for shoes, cars, watches, [00:09:00] houses, You’re thinking about two primary considerations that factor into your expected return, right?

[00:09:05] Wes Crill: There’s what do I expect to receive? So let’s use a car, for example. What’s the make model, the trim level, the mileage on this thing. What’s the brand’s reputation for reliability. That’s telling you something about what you expect to receive in the future. And then how do I make those characteristics meaningful for my purchase decision?

[00:09:22] Wes Crill: Well, it’s how much do I have to pay? So that’s how we think about figuring out what factors are useful for deviating from the market is, okay. You know what informs me about how much I’m paying? Well, we have a couple of price based variables. There’s market capitalization or what some people call the size factor.

[00:09:36] Wes Crill: You have value. So that’s price skilled by fundamentals such as book equity. Those are giving you information about how much you’re paying. And then we also think about profitability as giving you some information about what you expect to receive in the future in terms of cash flows, whether it’s dividends or share repurchases.

[00:09:52] Wes Crill: And that comes about because profitability is a pretty sticky characteristic. So all it’s being equal, the more profitable the firm is today, more profitable they’ll be in the [00:10:00] future. So that’s a pretty parsimonious group of factors there. And we see that those have been really useful for deviating from the market because they are pretty low turnover.

[00:10:10] Wes Crill: The other thing I’ll mention about these is that they’re applicable across the market Using size, value, and profitability factors doesn’t just mean holding stocks that rank really high on each one of those variables. You can actually do it in a seamless way across the market where you can have every stock in the US, for example, in your portfolio, but you can overweight stocks that have smaller market capitalization, lower price to book ratio, or deeper value as we call them, or higher profitability.

[00:10:37] Rebecca Hotsko: And so I guess when listeners are looking at different ETFs that offer single factor exposure versus a multi-factor exposure approach, how can we think about which one is better or maybe which one is right for us? Is it just that a multi-factor one perhaps has more risk than if it’s say, a small cap value versus a small cap etf?

[00:10:59] Rebecca Hotsko: How should we [00:11:00] decipher maybe which one’s best for our portfolio? So 

[00:11:03] Wes Crill: this is where there’s almost a, a bit of a, a surprising aspect of what are often called single factor investment solutions. There’s really no such thing as sorting on only one variable. There’s really no such thing as a single factor, because when you sort stocks on a characteristic, let’s use market capitalization as an example.

[00:11:20] Wes Crill: If all I’m doing is sorting on market capitalization, I actually do get some inadvertent tilts towards other factors. Like, for example, I’m probably going to end up with lower profitability than the market. If I only hold small. There is an interesting empirical result we see where if we go through and just look at the Morningstar category for strategic beta, that’s kind of the name they have for investment strategies, that use factors, so to speak, to deviate from the market.

[00:11:44] Wes Crill: It only includes index funds, so it doesn’t include everything out there that we would probably think of as a factor strategy. But it’s a good proxy for what the universe looks like for all of these different strategies that’s held towards one or more factors. And the reason why I bring up this collection of [00:12:00] strategies is if you put them all together in one bucket and calculate a weighted average return across all of these think up these days is up to one and a half billion dollars worth of strategies.

[00:12:10] Wes Crill: Their return looks just like the market in aggregate. They don’t have meaningful deviations from the. And that suggests there’s a potential outcome where if you have a collection of single factor strategies that are strong together, their tilts might end up offsetting each other and you can end up not getting what you’re paying for.

[00:12:27] Wes Crill: For that reason, we think it’s important to, in any strategy, have an integration of the information along with all of these different factors. Even if you’re not referring it as a multi-factor strategy, you’re balancing the trade offs. Where if I sort towards small cap stocks, well do I want to screen for lower profitability stocks.

[00:12:46] Wes Crill: Now the advantage with an integrated approach where it’s a multifactor type of strategy is for the same level of expected outperformance. Let’s say my goal is to outperform the market by, I dunno, I was throwing out a number 1% per [00:13:00] year. The more factors I have in the portfolio, if I’m using size, value, and profitability together.

[00:13:05] Wes Crill: Rather than just one of ’em at a time. The lower my overall deviation is from the market. The way we would measure that is tracking error and you actually reduce that tracking error for your given level of outperformance. I would actually think of a multifactor approach as in some ways lower risk than a single factor approach.

[00:13:21] Wes Crill: If my primary measurement of risk is how different from the market, I. 

[00:13:26] Rebecca Hotsko: Okay. That is super interesting, and I’m glad you brought that up because I just read it in a paper the other day, how factors are either negatively or positively correlated with each other. And so value and momentum, I believe were negatively correlated.

[00:13:41] Rebecca Hotsko: So when these are combined, they increase diversification. But on the other hand, if two factors are positively correlated, is it only in that case then that it would increase the risk and expected return with the factors?

[00:13:53] Wes Crill: So the way I think about it, it is a really important consideration, by the way, for building a multi-factor portfolio, is you have to know how [00:14:00] they interact.

[00:14:01] Wes Crill: The way we would typically measure an interaction between these is the cross-sectional correlation. I’ll explain what I mean by that in a second. But the cross-sectional correlation between the characteristics. So I already mentioned one where market capitalization and profitability are negatively correlated or positively correlated and the cross-section.

[00:14:17] Wes Crill: So if I go towards small caps, I tend to give up some profitability, all outs being equal. You mentioned another good one, which is, how does the stock become a value stock in the first place? I’ll give a spoiler For the audience, they tend to not IPO that. They tend to become value stocks because they’ve had relatively poor performance compared to the market.

[00:14:34] Wes Crill: But the momentum phenomenon, like you mentioned, we see that stocks that have had relatively poor returns over the past six to 12 months tend to continue to underperform the market in the short term. So you want to be careful when you’re buying stocks for a value portfolio that you’re not catching a falling knife.

[00:14:51] Wes Crill: And so we want to have provisions in place for our portfolio management process so that we are taken into account as this stock end downward momentum. That can [00:15:00] influence when we buy a stock for a a value portfolio. And that’s another way of potentially increasing expected returns just by virtue of the fact that you’re taking in additional information about the expected returns of a stock.

[00:15:13] Wes Crill: And that’s why, there’s a whole host of things that we have to do within our strategies that really kind of come down to using different types of inform. The momentum and value one is a particular interest because they both have very robust information about expected returns. And when I say robust, I mean that the empirical evidence, if you go back and look at premiums associated with value and profitability, very strong historical evidence supporting the existence of those premiums.

[00:15:37] Wes Crill: So we want to use both those pieces of information, but we’re not going to use ’em in the same way. And the reason why is getting back to something I mentioned earlier, that value, and this is also true of market capitalization and profitability. They can inform the asset allocation of a portfolio in a way that it has very low expected turnover.

[00:15:55] Wes Crill: For example, stock might stay in a value portfolio on average for about four to five [00:16:00] years, which implies that turnovers the amount of buying and selling you have to do for that portfolio might be only 20 to 25% per year. Momentum. On the other hand, if you look at academic definition of momentum, it’s almost an entirely different set of stocks in a upward momentum portfolio from month to month.

[00:16:16] Wes Crill: And the academic definition of the momentum factor has turnover well in excess of a hundred percent. Turnover is never free. So to the extent that you can capture a premium associated with something like that, without incurring the turnover, that’s always going to be beneficial for a portfolio. And so it’s finding ways to use stuff like momentum.

[00:16:35] Wes Crill: And again, this is kind of what comes down to the expertise you built up over decades. This is really challenging to manage these things. If you’re trying to launch investment strategies from scratch. 

[00:16:44] Rebecca Hotsko: I’m so glad you brought up that point on not catching a falling knife, because I think that gets into the heart of why it’s so important to look at the implementation of the factory ETF you’re looking to invest in to see if it has the correct filters and provisions in place to give you the best chance at getting the premiums you’re after.

[00:17:02] Rebecca Hotsko: That’s why I wanted to have you on today to dive deeper into these strategies because I just had a guest on Larry Swedro a while back, and he mentioned this point too, where there are far more important things to look for in factor ETFs beyond just which is the lowest cost. Because if you just look to the lowest cost provider, those factor ETFs typically miss the boat on the expected premium.

[00:17:27] Wes Crill: Cost is a tricky one because I think what matters to investors at the end of the day is total cost of ownership that is not well approximated by an expense ratio. I’ll give you an example. So if we look at the way that these premiums, let’s say I want to outperform the market by holding small cap value stocks.

[00:17:44] Wes Crill: Those premiums are not delivered really pro rata every single day. They tend to come in spurts. We saw that this year where you had really strong performance for the value premium over a very short period of time. So what that implies is you need to be continuously [00:18:00] focused on those stocks with higher expected.

[00:18:02] Wes Crill: To really capture them most effectively. So what do we see from, let’s just use a hypothetical example of an index fund that is, let’s say, rebalancing only periodically. Most indices go through a either annual, semi-annual, or just periodic rebalancing. We call it a restitution where the index is redefined.

[00:18:21] Wes Crill: So what is in the index yesterday might change today. Based on if a new stock becomes eligible, then that’ll be added to the index. If a stock no longer fits the definition that the index is going after, then they will delete it. What happens from there will index funds will follow suit. All the index fund managers will go out and buy the stocks that are going into the index.

[00:18:40] Wes Crill: Again, they kind of have to, because if they’re trying to preserve what tracking area, you need to mimic what the index is holding. Same deal with the deletions from the index. They have to sell those and in a very short order, again, to minimize tracking error versus the index. So then what happens in between these rebalance events?

[00:18:56] Wes Crill: Well, this might come as a surprise, but prices don’t wait to [00:19:00] change for the next reconstitution. Events. Prices are continuously changing throughout the year in response to new information, changes in expectation, and so it becomes a bit of a drift phenomenon if you’re approaching your turnover this way.

[00:19:12] Wes Crill: One way often to describe it is, most people in the audience out there will elect to brush their teeth a couple minutes every day, right? That might be how they prepare for a dental exam. The alternative if you want to handle your oral hygiene, the way an index fund is going to approach its turnover is just to brush your teeth once per year, a couple hours right before you go to the dentist.

[00:19:31] Wes Crill: Clearly one of those is going to have better outcomes for your oral hygiene than the other. And that’s kind of the way we think about doing our turnover to capture these premiums. We believe that there is value in continuously repositioning your portfolio incrementally just a little bit every day so you can do the same amount of total turnover was spread out through the entire year.

[00:19:50] Wes Crill: And that can really help investors. That’s one of the ways that we try and add value versus an index type of approach. So, an index fund tends to have very low expense ratios, but then if you look at what they might [00:20:00] be giving up in terms of the premiums that are available for a more flexible approach, you can see that’s potentially an additional cost for investors.

[00:20:08] Wes Crill: And so 

[00:20:09] Rebecca Hotsko: I did have a listener reach out and ask how they can build a globally diversified portfolio with as few as ETFs as possible with the highest expected returns. I guess their question was how many of these factor ETFs do they have to hold and which ones. 

[00:20:28] Wes Crill: You can potentially do with one portfolio.

[00:20:30] Wes Crill: For example, I mean there’s, there are multi-factor ETFs that would span all the different regions, whether it’s US developed x uuss and emerging market stocks. It gives you an opportunity set of, more than 12,000 different stocks across 40 some countries, and lots of different currencies very well, very broadly diversified across the investment opportunity set.

[00:20:48] Wes Crill: Now, when you bring in the expected return goal, I mean there’s always going to be a trade off between diversification and expected returns. If you want to outperform the market by a very large amount [00:21:00] on expectations, then that means you’re going to have to deviate from the market more. You won’t have as broad of coverage or you want, you’ll have more deviation, I guess, from the overall market.

[00:21:09] Wes Crill: So it really just comes down to what your goals are. But there’s certainly are investment solutions out there that will offer this type of factor exposure across all of these different regions. And there are efficiencies, by the way, to doing it. Fewer funds, when we think about what we call our core portfolios, so it’s, strategies that will cover an investible market tilt towards these drivers of higher expected returns.

[00:21:30] Wes Crill: You can think of those as an amalgamation of component portfolios. If I think about a market as being made up of large growth, large value, small growth, small value. You could have four different portfolios each accounting for one of those quadrants and combine ’em together to replicate an overall regionwide portfolio.

[00:21:48] Wes Crill: Or you can do it all in one portfolio. And there are some efficiencies when it comes to you don’t have to sell something out of large value and then buy in large growth. If you have one portfolio just kind of seamlessly moves from one part of the portfolio to [00:22:00] another. There’s certainly are opportunities to do that.

[00:22:02] Wes Crill: And it kind of comes down to what your goals are at the end of the. 

[00:22:06] Rebecca Hotsko: Okay. If someone’s goal is just wanting the highest expected return possible, let’s assume nothing else matters to them. What factor combination would most likely 

[00:22:16] Wes Crill: achieve this? Yeah, I mean, just using size, value, and profitability to identify stocks based on their expected returns.

[00:22:23] Wes Crill: Certainly there’s going to be a subset of the market, so it would be small cap companies with very low valuation ratios and relatively high profitability. That’s going to be your highest expected return subset of the market. And if you had no other considerations whatsoever, certainly you could focus a portfolio.

[00:22:40] Wes Crill: Just on a small segment of the market like that, the challenge really comes down to, again, there, there’s no free lunch out there, right? It’s sort of like there’s not a whole lot of foods out there that satisfy my competing goals of their delicious, and they’re really good for me. So there are going to be trade-offs when it comes to risk and return.

[00:22:56] Wes Crill: And in this case, your risk is if you’re defining it as the potential to [00:23:00] underperform the market. It’s not a sure bed, even over a very long period of time that these expected return premiums that we talk about in the historical data are going to pan out because your real performance is going to be a function of both the expected return and the unexpected return that you could not have predicted in advance.

[00:23:18] Wes Crill: And that’s going to be stuff that’s affected by whatever’s going on in the world at large. There was a really cool academic paper from a few years ago from professors Eugene Fama and Ken. They tried to estimate the probability of something like a group of stocks, say small value, for example. What is the probability that they could underperform the market over a 10 year period?

[00:23:37] Wes Crill: Now, we know historically they’ve outperformed the market pretty substantially, might say three or 4% per year. But they estimated a probability of even over a 10 year period, these stocks underperforming. The probability is like 6%. That’s only like a couple of standard deviations. We’re not exactly talking about a black swan event, and if that were to happen, then you would see the downside of being focused on only on having, I guess I should say, that much of a [00:24:00] tilt away from the market.

[00:24:01] Wes Crill: So for many investors that won’t be satisfactory to have that probability of outperforming over that long arm period of time. And so they might, they might decide to hue a little bit closer to the market. So that’s why, I guess to summarize like, yes, there are very high expected return segments of the market.

[00:24:16] Wes Crill: And it kind of depends on how much investors are willing to tolerate in terms of their deviations. 

[00:24:21] Rebecca Hotsko: And so I guess if investors already hold a very broad-based E tf, like a total market et TF V T I or VO O for the s and p 500, and they want to start implementing a factor approach, is it wise for them to also keep those total stock market exposures or should they just move towards a more factor-based 

[00:24:42] Wes Crill: approach?

[00:24:43] Wes Crill: I guess it kind of depends on their goals. I think the beauty of our way of investing is that it works both kind of at the macro scale, so in a core type of strategy across regions, but it also works in component type strategy. Sort of depends on where they want to make changes in terms of their asset allocation.

[00:24:59] Wes Crill: [00:25:00] It’s nice that both the research implies that this way of investing should work and really any segment of the market. And it also across our track record, I mean, we’ve seen that we’ve been able to generate outperformance versus markets and benchmark. Not just at the market wide level, but also segment by segment and in both US and non markets.

[00:25:17] Wes Crill: And so I guess it’s really not a bad way to go about incorporating that into your portfolio. 

[00:25:22] Rebecca Hotsko: So now I want to dive into Dimensional products because Dimensional has been a leading provider factor strategies, and these ETFs are now available to retail investors. And there’s also other providers that offer factor ETFs through passively tracking and index.

[00:25:38] Rebecca Hotsko: But the results are clear when doing back tests. Of Dimensionals ETFs and other active ETF providers that they quite significantly outperform the comparable passive factor etf. So I’m wondering, can you talk a bit about what’s driving this outperformance when both funds are targeting the same factor exposure, yet [00:26:00] they yield quite different results in terms of performance?

[00:26:04] Wes Crill: So this is where the importance of implementation comes in. And I can use a really simple example. So if we look at the Russell Indices, not index funds, this is before you even get to the cost associated with managing a strategy that’s tracking these indices. But if I look at the Russell indices here in the US you have the Russell one thousands, the largest 1000 stocks in the US market.

[00:26:22] Wes Crill: The Russell 2000 is the next smallest 2000 stocks. Very common measurements for large caps and small caps in the us. If I go back to the inception for the data for these indices, 1979 in January, the Russell 1000 has had a higher average return since 1979 than the small cap Russell 2000 submit about a percentage point higher actually.

[00:26:44] Wes Crill: That kind of tells you a really important lesson about implementation. Capturing these premiums We’ve seen there has been a size premium since 1979, but you can potentially miss out on some of it depending on the quality of your implementation. In the case of the Russell 2000 versus Russell 1000, you have a [00:27:00] couple of different elements here.

[00:27:00] Wes Crill: You have some stocks that drag down the performance of small caps that are included in the Russell 2000 Index. They’re small caps with high prices and very low profitability. You have that reconstitution effect I talked about earlier where when you have lots of buying and selling concentrated into a very short period of time, you can push prices and if you push prices, you might end up buying at a very high price, selling at a very low price.

[00:27:21] Wes Crill: You can have on paper a similar type of asset allocation, but have very different results going forward. This is where I think in some cases, the active versus passive categorization of strategies is not quite, it’s alluded to course grained. The way I would think about it is if you split the investments design into the philosophy behind why a portfolio is doing what it’s doing versus the actual implementation, how it’s doing what it’s doing.

[00:27:47] Wes Crill: I would apply the active versus passive delineation separately between those two. So the investment philosophy will passive, which, if you go back to the early days, the first index funds that were launched, that’s [00:28:00] embracing market prices. It’s a tacit admission that Trias markets has generally not been successful.

[00:28:05] Wes Crill: But the implementation, and this is where you get to a big distinction between what Dimensional does and then what a typical index fund is going to do. We believe in active implementation, and what that means is having a daily investment process that has flexibility rather than trading whenever the index tells us to, we’re going to trade based on what we believe the portfolio should be holding on a day-to-day basis.

[00:28:27] Wes Crill: And we have flexibility because we’re not adhering to an index and we can buy stuff that has high expected returns a day. We can sell stuff that has lower expected returns and we can re reevaluate that every single day. So just that element of flexibility is hugely impactful for setting us up for what we want to in our portfolios, and it allows us to capture in our belief more of the premium than if we lack that flexibility.

[00:28:51] Rebecca Hotsko: And I went on portfolio visualizer today, and I looked at the factor premiums, the loadings of dimensional versus [00:29:00] some of the other passive ones like vanguards or iShares. And the factor loadings are higher for dimensional funds. And so, That was another thing that I noticed about the active strategy versus a passive one.

[00:29:13] Rebecca Hotsko: It’s you seem to get more of a premium or you got more of the small cap that you were looking for, the value tilt that you were looking for in those funds. So I found that 

[00:29:21] Wes Crill: interesting. I mean, you can think of those factor loadings as telling you like the time series average, roughly speaking of your exposure to one of these dimensions of expect to return, like small cloud value or profitability.

[00:29:33] Wes Crill: And certainly the more of that you have, the higher the expect to return. You know what sometimes doesn’t show up in a factor. Loading is kind of the. The costs associated with attaining that loading. So like, we were saying earlier, screen Z might want to have in a small cap space around lower profitability or downward momentum.

[00:29:50] Wes Crill: Managing the trade off between your tilts towards value and profitability. Those are things that don’t necessarily show up in the asset allocation if you’re looking at just size, value, and [00:30:00] profitability, but are enormously critical to actually capturing those premiums net of the cost of implement.

[00:30:06] Rebecca Hotsko: I want to jump into some of the research that you’ve done too. Cause I really like a lot of the insights that you write on Dimensional. One of them, I recently read an article you wrote, does fill in the blank, belong in my portfolio. And I think that this article can resonate with a lot of investors because for those investors who are managing their portfolio themselves, we’re often think.

[00:30:29] Rebecca Hotsko: Does this belong in my portfolio? And so we have guests come on and talk about what investments they think are great or going to be in the next bull run. And it leaves us wondering, at the end of the day, should I invest in this? Is this right for me? And so I really liked your analysis on this topic and I was just hoping that you could go over how we can think about evaluating whether something actually belongs in our portfolio or not.

[00:30:54] Wes Crill: Yeah, this is another challenging one for investors really to get started, which is you have all of these different options. I mean, we’ve been [00:31:00] talking a lot about factor ETFs or things that are, in the mutual fund or ETF wrapper. Even going beyond that, there’s just so many other options Investors have greeting ’em these days, and so there’s no one size fits all type of approach.

[00:31:11] Wes Crill: I think just having a really very solid framework for how to evaluate the merit of an investment is a good place to start, and it can help you answer questions that are specific to your circumstances and what else you have in your portfolio. And it kind of comes down to a cost benefit analysis. It’s pretty simple.

[00:31:26] Wes Crill: It’s like, okay, what’s the benefit from adding in this investment? In my view, it really should be one of two things that it needs to satisfy. It’s either increasing your expected return or it’s helping you manage risk. So we can unpack that one a little bit. So what’s the evidence that this asset can increase your expected return?

[00:31:42] Wes Crill: That it has higher returns than stuff that’s elsewhere in your portfolio. Certainly you want to see some really strong evidence that that’s been the case historically. Is there good data on it? Is it something that has been a consistent value add to a portfolio? Can you make a case for it? It’s really easy to make a case for an equity [00:32:00] premium, so stocks having a higher return than bonds.

[00:32:03] Wes Crill: We think it’s pretty sensible to make a case for size, value and profitability premiums because they’re telling you something again about how much you’re paying or what you expect to. If I don’t have that kind of theoretical basis for why this should be delivering high returns, then the empirical evidence better be really, really, really good.

[00:32:18] Wes Crill: So that’s one aspect. Managing risk Again, is it helping me tailor the volatility of my portfolio? Is it expanding my opportunity set? So is it providing diversification in addition to what’s elsewhere in my portfolio? If it’s providing a type of asset that is not present in the rest of my asset allocation, maybe it is expanding my opportunity set and helping to manage risk.

[00:32:40] Wes Crill: And then you get down to the costs, and this is where it could be things as simple as, The opportunity costs. If I’m tying up capital in this investment over here, then that means I have less to deploy elsewhere in my portfolio where, maybe I don’t get to participate in other investments.

[00:32:56] Wes Crill: Sometimes costs are as literal as what’s the expense of investing here? So you get into something like private markets, as they’re going to have much higher cost than public markets. So that’s something for investors to be cognizant. What this framework allows you to do is to think about individual examples, and you start to ask questions about, okay, given this framework, does this still make sense for me?

[00:33:18] Wes Crill: A really simple example is cryptocurrencies, or if we just look at Bitcoin, so would an investor want to have that in their portfolio? So let’s go through these criteria and relatively quickly, but one at a time. So what’s the expected return case for cryptocurrency? Frankly, there’s not a real solid one holding one.

[00:33:34] Wes Crill: Bitcoin today doesn’t entitle me to more Bitcoin in the future, right? So it doesn’t have the same logic behind why I expect to gain return from holding stocks or in return from holding bonds. The volatility of cryptocurrency, I think is dissuasive of it being a risk management tool. So then it’s not totally clear what role it would play in a portfolio.

[00:33:56] Wes Crill: And then you also look at, okay, is this expanding my opportunity set? Well, the total [00:34:00] value of Bitcoin, this is going to be probably completely outdated cause those valuations tend to fluctuate on a week to week basis. But the last time I checked it was less than 0.5% of the value of the global stock and bond markets.

[00:34:11] Wes Crill: So that would imply that if you had a million dollar portfolio, you would have less than $50,000 in Bitcoin and market cap weights and. When you start to assess something based on these criteria, then in some cases that can be a more helpful way to think about what goes into your portfolio than just, oh, well this sounds interesting.

[00:34:26] Wes Crill: It’s a more robust type of assessment. 

[00:34:30] Rebecca Hotsko: That was super helpful and I think that that’s applicable for, yeah, any investment we come across, we hear about these hot stocks or hot ETF funds that maybe seem really appealing to buy or inflation hedges, but it comes down to those things you talked about, and I think that’s just such a great framework that we can use for all of our choices going forward.

[00:34:51] Rebecca Hotsko: And I also want to talk to you about inflation hedges because it kind of ties into what we just talked about and if we should add them, we can kind of work through that framework. But Dimensional actually did a really great paper on this. This is something that I’ve been thinking about for a long time, and a lot of our listeners, it’s on their minds about how can we hedge against inflation.

[00:35:13] Rebecca Hotsko: And so I really love Dimensional’s paper on this titled US Inflation and Global Asset. I was just hoping that you could talk a bit about this and if there are any assets that are hedges against expected inflation and unexpected inflation, and kind of the key takeaways for our listeners. 

[00:35:32] Wes Crill: You said it. Well, just mentioning the distinction between expected and unexpected inflation.

[00:35:37] Wes Crill: These names are very transparent in terms of what they imply. So expected inflation is what the market believes is going to be. The rise in consumer prices in the future. And unexpected inflation is obviously the other side of the coin. It’s really what could happen to consumer prices. It is not currently expected by the.

[00:35:53] Wes Crill: Now if we believe markets are forward-looking and they include information about expectations and current market prices, which [00:36:00] that’s, the main ethos of dimensional, that implies that expected inflation should be compensated in the form of current asset prices, meaning the expected returns are going to compensate you for expected changes in consumer price.

[00:36:14] Wes Crill: Now the outcome of that nicely aligns with what we see in the data, which is that most asset classes have outperformed, have delivered positive real returns. So positive average returns, net of inflation, even in high inflation years. We see that across all segments of fixed income, apart from one month US treasury bills, that was the only asset that did now pace inflation.

[00:36:35] Wes Crill: But corporate bonds, government bonds longer data. All of these different segments of equity markets, whether it’s factor portfolios, like small value or different sectors, all of them have delivered positive, average real returns, which is consistent with the idea that if what you’re trying to do is outpace expected inflation, traditional asset classes can do it.

[00:36:53] Wes Crill: This kind of goes back to the previous framework about does X Y, Z belong in your portfolio? If you feel like you’re probably about of [00:37:00] average sensitivity to the effects of inflation, and if you believe markets are reflecting expected inflation and prices, you might not have to do anything with your asset allocation, which is nice.

[00:37:09] Wes Crill: Now, there are going to be people who either have a different belief of inflation going forward than the market as a whole, or maybe they’re more sensitive to the impact of increases in consumer prices than the average investor. Those investors might want to hedge unexpected inflation. Now there’s a bit of a caveat here.

[00:37:25] Wes Crill: If you think about a risk management tool, generally you’re not going to be able to manage risk without giving up something. In this case, it’s going to be expected returns. So to hedge risks, I would say the needs to really do two things well, number one needs to be positively correlated with inflation.

[00:37:39] Wes Crill: So as consumer prices go up, the value of this asset should go up. There’s actually a number of asset classes that will satisfy that one. The second part of hedging unexpected inflation means that it has, it should have relatively low volatility. And the reason why is if I’m concerned about inflation, at the end of the day, what I’m really concerned about is whether what I’ve saved up today is going to [00:38:00] continue to afford in the future what I can afford today.

[00:38:02] Wes Crill: Am I going to preserve my purchasing power? And there needs to be a narrowing of volatility around that, right? So if I have something that is correlated with inflation, but it has huge return volatility, then that’s still introducing a lot of uncertainty into what I can spend in the future. We do have assets out there that can satisfy those two criteria, inflation protected bond portfolios, whether it’s tips that are offered by the US Treasury.

[00:38:27] Wes Crill: Or bond portfolios that have inflation protection overlays where they purchase inflation swaps and manage unexpected inflation that way, those have been successful in curbing the impact of unexpected inflation. Other asset classes that are positively correlated with inflation, but really in my view, haven’t been as good of inflation hedges, whether it’s energy stocks, whether it’s commodities.

[00:38:48] Wes Crill: They only check one of those two boxes. They do check the box of being positively correlated, but they have much more volatility than inflation itself. So again, it kind of comes back to what your goals are. To manage a risk, you’re generally going to have to give up [00:39:00] something in return, and that’s kind of, that’s up to each investor to decide where they want to be in that spectrum.

[00:39:05] Rebecca Hotsko: That was super helpful. Thank you for going over that with us. I think it’s really interesting to hear you bring that evidence back to it because we’ve heard a lot about energy being a great diversifier and that is true. And while the was shown to be true in the paper as well, it adds so much volatility, as you mentioned.

[00:39:23] Rebecca Hotsko: And so if you’re someone who doesn’t want to experience a bunch of volatility, , that investment probably wouldn’t be right for you. And so they can go back and think about that framework that you talked about as well to figure out if it really fits in their portfolio and if they think it’s worth it with that additional volatility it would add.

[00:39:40] Wes Crill: Yeah. I mean, and the energy stocks, again, are going to outpace inflation just like we believe all other stocks should. And so then the question is, would you want to overweight energy stocks? Well, if your goal is to manage your inflation exposure, and if you want to hedge unexpected inflation, we find that that’s a less sensible way to do it than just having inflation protected bond portfolio.

[00:39:58] Rebecca Hotsko: And just on that unexpected [00:40:00] inflation, the last time I looked, markets were still expecting inflation or pricing in inflation to be around 3%, which was interesting to me because it’s still nowhere near that. And so, To me that would suggest that hedging against unexpected inflation could be important for some people if that actually, if inflation persists higher than expected by the markets, but we’ll never know that until after the fact.

[00:40:28] Wes Crill: That’s one of the challenges with looking at, we have these proxies for the market’s expectation of inflation that you might have been alluding to, which is, we’ll look at the difference between yields on inflation protected versus nominal bonds. They’re not an exact proxy for expected inflation.

[00:40:41] Wes Crill: There’s some other, things kind of going on with that measure, whether it’s, there’s actually a, a premium you get for bearing the risk of inflation that’s in nominal bonds, which accounts for some of that difference in. It’s also technically just the, it would be, we call it break even for a reason where if inflation ends up being exactly what that break even number is, so you know if it is 3%, [00:41:00] if actual inflation ends up being 3% over that horizon, then you are indifferent effectively, whether you had nominals or inflation protected bonds.

[00:41:08] Wes Crill: That’s kind of one consideration. Certainly we’ve seen some cooling of the C P I prints. I think we probably all noticed the market going wild last week when C P I was just slightly lower than expected. But you know, even if you have an expectation of inflation in the future, and even if it’s a market gauge, The deviation between realized inflation and expected inflation can be enormous.

[00:41:27] Wes Crill: If we go back to April where the trailing 12 month change in consumer prices was, over 8%, if we go back to the beginning of that 12 month period, expected inflation was about two and a half percent. Clearly there was a big divergence there, and I think that’s, at the end of the day if, if you were especially sensitive to that, then it might make sense to try and hedge out that unexpected inflation.

[00:41:48] Wes Crill: But again, I think if your primary gauge of what is going to impact your ability to spend is just reflecting what expected inflation is, it might be covered with traditional asset allocations. [00:42:00] So I 

[00:42:00] Rebecca Hotsko: also want to talk to you about another article you wrote titled Fangs Gone Value. This one was really interesting.

[00:42:08] Rebecca Hotsko: You write about how some of the FANG stocks have been reclassified as value companies now, and typically when we hear value company, that might lead us to think that they now have a higher expected return going forward. Can you walk us through your take on this and what this. 

[00:42:26] Wes Crill: Yeah, I thought this was just an interesting anecdote because for so long, there was some opposition around the value premium or value investing that was really rooted in this belief that we were in a new normal, that technology firms were the way to go, and that, these growth stocks were really poised for long-term success.

[00:42:41] Wes Crill: And I always thought of that as conflating the characteristics of a good company with the characteristics of a good investment set. And what I mean by that is investors are desiring higher expected returns general. A company that is really strong, that has been very successful historically, one of the largest firms in the [00:43:00] us.

[00:43:00] Wes Crill: All else being equal should have a lower discount rate exploited to the expected future cash flows. If everyone believes this firm is going to be great for a long time, there’s maybe less uncertainty around what their cash flows are going to be and the future. I think that’s an interesting backstop because again, you know these five companies, these FANG stocks being the poster children for why value investing was dead.

[00:43:19] Wes Crill: It’s mildly ironic that two of them became value this year. We wrote that before the losses got even bigger. I think at this point they’ve lost over two and a half trillion in terms of market capitalization between those five stocks. If that were to be its own stock market, that would be the fifth largest stock market in the entire world, which is kind of interesting.

[00:43:36] Wes Crill: But I think it just comes back to the principles of, what tells you about differences in expected returns. If you knew which companies were going to be the rock stars in the future and you can get in on them early, then yes, that would be a very high rate of return strategy. But unless you can predict those in advance, the companies that are already at the top of the market might not be the highest expect to return stocks for investors.

[00:43:59] Rebecca Hotsko: Another takeaway that I would just love to share with our listeners is in that article you talked about what happens, what typically happens to stocks and companies that grow to become the largest in the market, and kind of what happens to their expected returns. Can you share that with our audience?

[00:44:17] Wes Crill: You can think about this in terms of a career progression for an employee where, you know, as you rise up the ranks of a firm, the expectations keep increasing. So you’re going to be gaining potentially higher and higher compensation, but then the stuff that you did when you were an analyst might not be, it might not really cut it if you’re an executive at that point, right?

[00:44:35] Wes Crill: And so, as the expectations start to rise, that’s the way I think about companies is they rise up the ranks of the largest. And the us you know, the stuff that propelled them to the top of the market was probably rewarded with really strong realized returns. But then going forward, once the expectation is excellence, their expected returns might actually go down.

[00:44:54] Wes Crill: Because what happens is valuations go up, right? The threshold for what is acceptable for the [00:45:00] productivity of that firm goes up, and that’s what you see in the data. So if we track companies, If you look back historically, every time a company joins the top 10 for the US market, and when I say top 10, that’s just largest 10 based on market capitalization.

[00:45:13] Wes Crill: In the years leading up to them joining the top 10, they have really strong returns versus the market outperforming the broad market by over 10% per year. But then once they join the top 10, their returns look very similar to the market. And in fact, five years after they’ve joined the top 10, they actually tend to slightly underperform the broad market.

[00:45:32] Wes Crill: And so I just think that comes back to expectations and how those get embedded into valuations. All it’s being equal to higher. The valuation for a company, the lower the expected return because they’re pricing in great success and they’re willing to pay a very high price for those future cash flow. 

[00:45:47] Rebecca Hotsko: I found that super interesting when reading that.

[00:45:49] Rebecca Hotsko: Cause I think a lot of investors might think the opposite, where a larger company would now all of a sudden it’s made it to the top so they’re going to stay there or they’re going [00:46:00] to continue to meet those expectations. But it’s just really cool looking at what the data has to say. And another one that I want to talk to you about, cause I found this really interesting when reading it, is how you talk about value is an asset class and not an investment strategy.

[00:46:15] Rebecca Hotsko: And so talking about this on our show, a lot of our listeners are familiar with Warren Buffet style value investing approach, and that’s a strategy. I was wondering if you could kind of talk about this distinction and explain what you mean by values in asset class and not a strategy. 

[00:46:33] Wes Crill: I think of it as the sentiment behind value investment.

[00:46:36] Wes Crill: When people talk about that as a way to go about buying stocks, what they’re really talking about is just generally speaking, looking for low price stocks. There are dozens of different ways you could potentially measure the price of a stock to determine whether it’s high or low. I think the main takeaway for me is when I look at value investing, it comes in lots of different forms and not all of ’em have been similarly successful.

[00:46:57] Wes Crill: And we talked about some of the ways in which, you know, a [00:47:00] strategy that is adhering rigidly to an index might leave some of the premium on the table. You can have so-called style drift where you might start out with really good value exposure at the moment of rebalancing. But during the course of the year in between rebalance events, and you can start to drift and have a good portion of your portfolio no longer in value.

[00:47:18] Wes Crill: But that can happen for active reasons as well. So there was a paper a few years. Where they look at the holdings of value mutual funds this is across all US domicile mutual funds, and what they saw was a large portion of value mutual funds actually plotted out like growth stocks. They were high price to book stocks.

[00:47:38] Wes Crill: So we see that anecdotally when we look at, for example, the US large cap value category in Morningstar and just pull out all the value strategies there. It’s probably over 200 of them over the past 10 years, and they’re valuation ratios. So if I look at the aggregate price to book, it plots out everywhere from right around one, all the way up to over seven.

[00:47:57] Wes Crill: There’s a lot of dispersion in terms of the characteristics, and [00:48:00] that can come from anything that causes you to drift from a focus on value stocks. The reason why that’s relevant is because the less exposure, actually, let me flip this into a glass half full. The more exposure you have to the value premium, the more consistent you are in that exposure.

[00:48:15] Wes Crill: The better your performance is going to be when the value premium is positive. Again, all that’s being equal. That’s why you would want that consistent focus. And when we think about the design of our portfolios, we’re trying to, number one, be broadly diversified. We don’t know what stocks are going to deliver the value premium in any given year.

[00:48:31] Wes Crill: It’s not all of ’em. In fact, that was another really seminal paper from Fama in French, where they showed that it was a small subset of the asset class that delivered the premium. We want to make sure we’re holding those, hence the broad diversification, but also the consistent focus. As prices change, we want to be making incremental changes to our portfolio on a daily basis.

[00:48:48] Wes Crill: So we capture those stocks when they deliver the value premium. And I think when you look at just all of the different ways that you could potentially miss out on the premium, that’s where I, I come back to that notion of value is, it can sound great in theory, but the actual results on paper can vary drastically.

[00:49:05] Rebecca Hotsko: That was so great. Thank you so much, Wes. Before I let you go today, where can our listeners go to learn more about Dimensional, their products and everything that you do there? 

[00:49:18] Wes Crill: You can always go to our site, which in the US is us.dimensional.com I believe. Certainly if you Google Dimensional Fund advisors, it will pop up and there you can find everything from our investment philosophy, a lot of the commentary we have on market events, it’s public facing, and then of course a whole suite of information on all the different investment strategies that we offer. 

[00:49:37] Rebecca Hotsko: I will make sure to link that all in the show notes today. I want to thank you again so much for taking the time to come on today. Wes. 

[00:49:45] Rebecca Hotsko: All right. I hope you enjoyed today’s episode. Make sure to follow the show on your favorite podcast app so that you never miss a new episode. And if you’ve been enjoying the podcast, I would really appreciate it if you left a rating or review. This really helps support us and is the best way to help new people discover the show.

[00:50:05] Rebecca Hotsko: And if you haven’t already, make sure to sign up for our free newsletter, We Study Markets which goes out daily and will help you understand what’s going on in the markets in just a few minutes. So with that all said, I will see you again next time. 

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