Benjamin M. Lavine, CFA, CAIA, RICP
Chief Investment Officer, 3D
3D Capital Management, LLC (3D) attended the 2022 Dimensional Funds Advanced Research Conference. 3D received permission from Dimensional Funds to publish highlights along with our own feedback on some of the findings. This blog piece should not be construed as an endorsement of Dimensional Funds nor of any of the topics covered below. Contact us if you would like to receive a copy of the presentations, and we will coordinate with Dimensional.
Focus on the Experience, Not the Outcome
One of the consistent themes we hear from Dimensional’s leadership team is for financial planners to coach their clients in focusing more on the investor ‘experience’ rather than the investment ‘outcome.’ Setting high expectations for achieving superior investor experience and meeting those expectations consistently over time is how client trust is durably built.
One may cynically accuse this posture as attempting to avoid accountability or not be subject to objective performance metrics. But, it is difficult to distinguish between elements of an investment program where an advisor can exert more control (fund or security selection, asset allocation shifts, trading) versus those outside of anyone’s control, let alone an advisor, such as performance cycles where a particular investment style / strategy falls out of favor, such as Value vs Growth or Small vs Large Cap Investing, or when the bond portion of a 60/40 program fails to buffer the volatility from the equity portion, as has been the case so far this year.
Unlike the financial profession, other professions deal in environments of higher certainty – where outcomes are directly aligned with expectations. Think of an experienced auto mechanic properly diagnosing and fixing an engine problem, a master chef preparing a fine dining experience, a professional race car driver achieving a top lap time, a dentist filling a cavity or performing a root canal.
The challenge for the financial planning profession is that expertise is not necessarily correlated to investment outcome as financial markets have this annoying habit of humbling even the smartest, most experienced professional investor. Hence, advisors should be upfront with clients on communicating investment risks while emphasizing the importance of adhering to a systematic process of investment management and planning. The discipline in sticking with a financial plan can maximize the probability of achieving client expectations, even if the achievement of those outcomes is still uncertain.
We are reminded of what is becoming somewhat of an old saw in the professional sports world – Trust the Process (“TTP”), attributed to former Philadelphia 76ers General Manager Sam Hinkie. Bleacher Report wrote an essay documenting the timeline of Hinkie’s attempt to apply TTP to achieve a winning season through a systematic, but unorthodox, process of deconstructing the team (some would accuse tanking the season) in order to rebuild from the ground up. Even as Philly fans initially suffered through losing seasons, Hinkie kept emphasizing TTP as it would pay dividends down the road. Unfortunately, Hinkie’s tenure did not outlast front office impatience before TTP finally delivered on what was expected – a spot in the playoffs after a long drought of losing seasons. Hinkie’s TTP ultimately endured as a rallying cry not just for Philly sports fans but for anyone initiative that seeks to sacrifice short-term gains for long-term outcomes.
Investment management remains a key, but still just one component of financial planning, yet both call for a well thought-out, disciplined process because of inherent uncertainties, whether related to elevated market volatility or life-altering circumstances that require a course correction in spending plans. A successful advisor is not one who can necessarily deliver on unrealistic client expectations (i.e. high returns with little to no risk) but is one who employs a process built on solid, time-tested rationales and principles to maximize the probability of achieving client goals – a process that can be viewed as more trustworthy.
And for the financial planner tasked with building out an investment program, the planner must determine if they truly trust in the underlying processes used in selecting and trading underlying investments (stocks, bonds, alternative assets), whether systematic processes built on academic principles or traditional active management employed by experienced professional investors. Even in the face of underperformance and failing to deliver on short-term expectations, does the planner still trust the process?
No process is failsafe (nor do regulators allow any sort of marketing that would convey ‘failsafe’) as investment styles and strategies can come in and out of favor. Time-tested risk premiums such as ‘value’ and ‘small cap’ investing may not be earned over shorter periods of time despite the long-term track records of those premiums’ durability. Historically ‘safer’ assets such as fixed income may not buffer the volatility of riskier assets such as equities, like what we’re experiencing so far in 2022.
But client communication remains paramount to delivering a superior experience even if the outcome falls short of expectations as long as the process designed to deliver an expected outcome is built on a solid foundation that would invite the client to trust the process. Clients should be reminded of the importance of incorporating time horizons into the financial plan as ‘time’ can help smooth out short-term volatility.
3D has built a platform to deliver a superior ‘advisory’ experience for our independent practicing partners, such as personal account handling, performance reporting, custodial interactions, and trade execution / model rebalancing. From an investment standpoint, 3D has emphasized the importance of following certain principles we believe increase probabilities of achieving client outcomes:
- Align investment risks with time horizons of expected cash flow needs (a.k.a. liability-driven investing). Rather than view a client’s portfolio as one lump sum with an aggregate risk profile (conservative to aggressive), a client’s portfolio should be deconstructed into segments or sleeves (buckets) depending on projected cash flow needs. Those investment risks embedded into those segments should be appropriate to the time horizons aligned with those risks. Short time horizons imply a more conservative risk posture and vice versa.
- Make market volatility work for you rather than against you. We emphasize dollar cost averaging for allocating to the market to help smooth out volatility, better increasing the chance of having that volatility compound investment returns. Likewise, we caution against taking distributions in market-exposed strategies, especially during a market downturn leading to Sequence of Returns Risk, where volatility locks in losses realized by distributions, effectively compounding those losses. As has been the common experience this year, even short-term fixed income strategies have produced larger than usual negative returns due to this year’s sharp rise in interest rates.
- Employ cost-effective systematic (rules-based) strategies to capture equity and fixed income risk premiums, while selectively employing traditional active management in areas where the risk premiums are narrower than usual or more difficult to achieve. 3D philosophically adheres to strategic asset allocation disciplines in our managed model approach where we do not attempt to ‘time’ the markets but periodically make changes to underlying equity and fixed income exposures based on our assessment of risk and reward.
Challenges in Communicating Negative Bond Market Returns
We covered some of the challenges in communicating negative bond market returns in our July 2022 podcast with Dimensional Fund’s Wes Crill. Short of having one’s fixed income program allocated to a principal-protected vehicle (bank deposit, CD, money market, insurance MYG fixed annuity), this year’s negative bond market returns have provided a less than satisfying investment experience for the typical risk-based program allocated between stocks and bonds.
Having lived through the sell-off and subsequent recovery of the COVID pandemic of 2020, the investing public has been conditioned to sharp equity market swings but still expect the fixed income portfolio to serve as a ballast against market volatility – the low cross-asset correlation that has benefited the 60/40 portfolio over the last few decades (1994 representing the last significant calendar year of negative bond performance). 2022 is proving to be the exception as interest rates have risen ~3-4% from the August 2020 lows as global central banks contend with headline inflation that has proven to be less than transitory. Indeed, YTD 2022 is proving to be the worst bond market experience over the last 70 years per Jim Reid from Deutsche Bank (Figure 1).
Figure 1 – Worst Bond Market Performance in 70 Years
How does one provide a practical response to nearly unprecedented negative bond market performance that most of the investment public has not experienced? Dave Plecha, Global Head of Fixed Income at Dimensional, provided a practical way of framing bond market losses within the context of investment risks and time horizons to help ride out those risks.
Figure 2 redisplays a hypothetical case of an investor with a 20-year time horizon allocating to a bond portfolio yielding 1% with a 5-year duration (not too dissimilar to the conditions prevailing throughout 2020-2021). Then he presupposes that the investor’s timing could not have been any worse as interest rates immediately rose to 4% – again similar to what fixed income investors have experienced in 2022. This case study assumes a 4% rise in interest rates across the maturity spectrum (a.k.a. a flat yield curve) and remains at 4% throughout the entire 20-year holding period and that interest is reinvested as well as no defaults. This is for illustrative purposes only.
Scenario 1 presents the cumulative growth in the portfolio had interest rates remained at 1% (no capital loss due to rising interest rates). Scenario 2 presents the cumulative growth assuming an initial marked down value of the portfolio due to the rise in interest rates followed by reinvestment of income at higher rates. Although the hit to year 1 market value is an eye-watering 14% loss, given enough time the losses on paper are eventually made up due to the reinvestment at higher rates. All year 1 investment losses are made up by the fourth year and the portfolio catches up to Scenario 1 by the fifth year.
What this case study reveals is that even fixed income allocations imply long enough time horizons necessary to ride out interest rate volatility, even if 2022 may end up representing a 1000-year flood moment for rate volatility. Fixed income may revert back to its defensive role as buffering equity market volatility, but outside of risk-free ‘cash’, fixed income investing still poses uncertainty as captured by Term Premium and Credit Risk Premium spreads. As with equity investing, a long enough time horizon increases the probability of capturing those premiums.
Figure 2 – Fixed Income Case Study: How Long Enough Time Horizons Can Overcome Short-Term Volatility (Red and Green Circle Highlights 3D)
Source: Dimensional Advanced Research Conference 2022, “Bond Talk: Current Topics in Fixed Income”
Without going into much detail (we’d be happy to do a deeper dive upon request), here are other takeaways from the conference:
- In response to a question posed during a fireside chat, Professor Ken French was ambivalent in providing a risk-based rationale for why investors should be compensated for taking on Profitability risk as opposed to Value or Size risk, the latter two along with general Market Risk make up the classic 3-Factor Fama/French model. The Profitability premium has been historically documented (see Novy-Marx research) and has proven to be robust enough to be included in an expanded 5-factor model alongside Investment Total Assets. From Professor French’s point of view, Profitability is expressed through ‘price’ as captured in the Dividend Discount Model when solving for the discount rate that equates future cash flows to present value. No risk-based rationale is needed although some have speculated that investors demand compensation due to the uncertainty of the company maintaining high profitability (abnormal growth) which is susceptible to competitive threats and shifting product cycles/consumption tastes. What is interesting is a subtle shift in the firm’s narrative on how to think about a market risk factor model from a more intuitive compensation-for-risk framework to a more abstract price-based framework (i.e. it’s captured in the price so what do we care what’s ultimately driving the premium).
- In response to another question, Professor French did not specifically address why Dimensional treats equity risk premiums differently from fixed income premiums in portfolio applications. For instance, the firm has demonstrated that equity risk premiums are time varying where ‘timing’ the premiums based on trailing performance or valuation disparities provides no significant advantage over a buy-and-hold approach. However, when it comes to fixed income, the firm will adjust its exposure to Term Premium (or relative duration positioning depending on the shape of the yield curve) and Credit Risk Premium (spread to risk-free sovereign debt) across global fixed income portfolios and within domestic portfolios. Duration will be extended and credit exposures increased when the premiums are priced more attractively and vice versa. This implies that, unlike the equity risk premiums, the fixed income premiums are not as time varying such that relative portfolio exposures to the premiums can be influenced by their relative attractiveness.
- Dimensional gave updates on the Separately Managed Accounts (SMA) and Exchange-Traded Fund (ETF) initiatives. On the ETF front, Dimensional has opted to publish two separate baskets for share creation and redemptions, a degree of market making flexibility afforded by the ETF Rule. Dimensional cares more about moving portfolios to desired characteristics rather than holding specific securities or minimizing error versus a tracking index. Very few ETF providers, especially index fund providers, will issue separate baskets, but doing so assists authorized counterparties in their market making activities which helps bring down execution costs observed through narrower bid/ask spreads. Managers of transparent active ETFs will generally not want to publish separate baskets for fear of revealing their preferences and risk getting front-run.
- Dimensional presented research arguing that the integrated, price-weighted approach used in their Core portfolios represents the optimal approach when compared to other schemes from a risk-adjusted return standpoint. However, much of this analysis is influenced by the explicit incorporation of ‘Size’ or small cap vs large cap exposure into the multi-factor model. We suspect that if you remove ‘Size’ as a distinct factor, the relative performance differences would be more diminished especially when comparing to other price-based schemes such as a Cap-and-Rank Weighted Approach.
- In addition to the useful case study cited above, Plecha also provided research on whether Fed policy ‘matters’ in relation to future bond market performance. By regressing prior Fed rate hike and rate cut cycles on subsequent bond market behavior, Dimensional found insignificant relationships to future changes in bond yields and bond market performance. They also found that Fed Funds Futures are no better at predicting future Fed rate actions, consistent with the lack of forecasting ability of the voting member dot plot projections following each Fed meeting.
- David Victor, Climate Science Professor at UC San Diego, gave a balanced presentation on the challenges posed by man-made climate change as well as providing updates on innovations taking place in sourcing and transmitting non-fossil fuel sourced energy. Victor maintains that green advocates must concede on physical realities posed by the green energy transition from conventional fuels such as the necessity of natural gas inputs to maintain base load electricity demand. Solar panels also make much more economic sense when deployed at commercial scale (utilities) rather than retail (i.e. rooftops). There are also other innovations taking place such as government policies to encourage local population clustering when recharging batteries at certain times of the day.
- With respect to advisory practices, Dimensional finds that high performing advisors are ones who pursue target marketing strategies (identify specific groups to target including influencers), focus on recruiting and retaining talent (human capital as opposed to technology), and expand their service offerings.
The above is the opinion of the author and should not be relied upon as investment advice or a forecast of the future. It is not a recommendation, offer or solicitation to buy or sell any securities or implement any investment strategy. It is for informational purposes only. The above statistics, data, anecdotes, and opinions of others are assumed to be true and accurate however 3D Capital Management, LLC (3D) does not warrant the accuracy of any of these. There is also no assurance that any of the above are all inclusive or complete. This article does not constitute an offer to sell or a solicitation of an offer to purchase interests in any investment vehicles or securities. This article is not a prospectus, an advertisement, or an offering of any interests in either the Strategy or other portfolios. This article and the information contained herein is intended for informational purposes only. It does not constitute investment advice or a recommendation with respect to investment. Investing in any strategy should only occur after consulting with a financial advisor.
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