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How does Avantis use financial science to build investment strategies?
When we talk about financial science, what we're really taking about is academic research. You have academic research and asset pricing. Asset pricing is a field within financial science that has advanced tremendously over the last 50 to 60 years. If you look back 60 to 70 years, there wasn't a lot of data or the ability to process a large amount of data to help understand what drives stock or bond returns.
Since then, we believe what drives stock and bond returns has improved with the development of asset pricing—on both the theoretical and empirical side. When we look at that research, we evaluate its validity and incorporate what we deem reliable into the design and implementation of our strategies.
Evaluation theory, for example, is the idea of how investors set stock prices and why you would expect companies trading at lower valuations to have higher profitability than those trading at higher valuations with lower profitability. If you look at long-term historical data sets, that's what you see. To us at Avantis, it's about using that research as the foundation for our strategies and finding the most efficient way to combine the information that's built into market prices with other financial data.
What is your view on market prices?
The market price is just where the security is trading today, or on any given day and what we consider to be the fair market price. It's the best indicator of value for that security. It's incorporating all the information disseminated through investors buying, selling and agreeing to transact and trade that security. A lot of updated information gets embedded into those prices. What we want to do is extract that data efficiently and use it in the process to help distinguish differences in expected returns among stocks.
We think there's a misconception anytime people speak about the efficient market hypothesis—meaning you can't outperform the market or that all stocks have the same expected return. We know there are many reasons why you wouldn't expect every stock in the universe to have the same expected return—whether it’s the differences in perceived opportunities and risks or the differences in taste and preferences. Investors assign different discount rates for different securities.
We rely on that market price to be a good indicator of the value of the security. We discussed valuation theory earlier and the idea of market prices. Valuation theory gives us clues as to what to look for when we're trying to identify stocks with higher expected returns. The price at which a company stock is trading is a function of three things. This is a simplified valuation framework, but you can think about it as current assets or its current equity. So, it's assets minus liabilities. It's expected future profits and the discount rate. If we have two companies trading at the same price, the company with higher equity relative to price or the company with higher profits relative to equity has a higher discount rate or higher expected returns.
Would you describe your approach as active or passive?
That’s an important question because investors have a lot to navigate, especially with the proliferation of different strategic data strategies in the market. We’ve seen a lot of rebranding or repackaging of investment strategies. The idea of where you fall on the active/passive spectrum is important with indexing, obviously, at the passive end and a hedge fund, for example, at the most active end with its ability to go long, short and invest in any type of security.
Indexing was an incredibly important development in asset management—Jack Bogle, Mac McQuown and David Booth, among others, really changed the game for investors. We like a lot of qualities about indexing.
When you think about what people like most about indexing, it’s usually the fact that it's low cost, typically broadly diversified, low turnover and transparent. We love all those things, and we designed our strategies to have those qualities, but we're doing a couple of things differently.
For one, we know prices change every day. We mentioned the idea of market prices adjusting daily while incorporating new information from investors. We look to see how price changes affect expected returns every day. If we don’t, we might be leaving something on the table. If you're making decisions based on an index that reconstitutes once or twice a year, you're potentially making investment decisions based on stale information during the time between the reconstitution dates. We make investment decisions based on up-to-date information. That's one thing we do a little bit differently.
The other thing we do, also related to looking at prices every day and understanding how the portfolio is positioned, is how we decide to rebalance. We've mentioned turnover as a good characteristic and as a trait of indexing. Most indexes control turnover by controlling how often they trade. The Russell indexes, for example, reconstitute once a year on the third Friday in June. And all of it happens at once. That's how they control turnover. We think low turnover's a good thing because all else equal, the less you trade, the lower your costs. But we seek to control turnover in a different way. What we do is trade a little bit every day, as opposed to all in one day once or twice a year. Trading a little bit each day gives us the ability to work with the natural liquidity in the marketplace. We believe that leads to lower trade costs and helps us improve outcomes for clients.
How is your process designed for consistency?
There’s a few things we do to ensure we're executing consistently. The first is that we view the world objectively. We take an academically supported untested framework to assess differences in expected returns and then we apply it in a methodical and transparent way looking to add value where possible. We talked about this earlier—we look at the prices of companies and company fundamentals each day through a consistent lens to compare which securities have higher or lower expected returns. We don’t fall in love with one stock based on its name or recent news about it in the marketplace. We're objective in looking for companies with higher book-to-market ratios or those with higher profit-to-book ratios. Securities with better momentum characteristics are the ones we're going to emphasize in our strategy as opposed to stocks someone personally believes are going to perform well over the next three or six months. We think that leads to a lot of consistency in executing the strategy.
The second thing we do concerns stock-specific risk. If you have 20 names in a portfolio and the largest weight is 12% or 15%, that puts a significant amount of risk for the portfolio on one stock. From our perspective, you may not need to take that much concentrated risk in a single name to generate returns. There’s plenty of uncertainty that comes with investing in equities, so what we try to do is minimize unnecessary risks like too much concentration in a single stock or sector. The emphasis on diversification, even the law of large numbers, is another way that we believe allows us to provide more consistent outcomes.
Why should advisors consider your strategy?
Any advisor who’s looking to build portfolios for their clients should think about the long term. Obviously, investors have different demographics and different goals, which also means different investment horizons and different risk profiles. Think about somebody who starts saving in their 20s and may plan to retire at age 65 or 70, that's a long time. We're talking about 45 to 50 years and that's not even counting retirement.
If you take the S&P 500 as an example, it's gone up a lot over the long term, but it's not going up every year or every three years or every five years. There's a chance that you're going to have negative returns over those different investment horizons, so we're looking to build portfolios that can support long-term investors, and we encourage people to stick with their allocations for the long haul. Sticking with it, in my mind, is the only way to get the potential benefits that may come along with investing in equity— those higher expected returns.
We build our strategies and broader business on helping support clients and advisers invest for the long term. It's a big reason why we emphasize transparency in our strategies. We want to avoid surprises wherever possible. We think it's important to articulate how we invest and why we invest to clearly set and manage expectations. We also produce a lot of materials related to how market performance connects to portfolio performance.
Our goal is to make it easy for investors to judge if we're delivering on the intended strategy. Going back to indexing, when I talk about transparency, it's easy to see if an index manager did what it said it would. Do the returns basically match the return of the index its tracking?
While we can't promise a certain level of return, we can show you that we delivered in the way we intended. At the end of the day, we're looking to combine the benefits of indexing, transparency and diversification with performance. Potentially doing a little bit better over the long haul is something we're looking to provide whether it's ETFs, mutual funds or separately managed accounts. We offer a choice of vehicles so that an advisor can pick the one that best meets or best suits their client’s needs.
This material has been prepared for educational purposes only. It is not intended to provide, and should not be relied upon for, investment, accounting, legal or tax advice.
The information in this document does not represent a recommendation to buy, sell or hold security. The trading techniques offered in this report do not guarantee best execution or pricing.
Investment return and principal value of security investments will fluctuate. The value at the time of redemption may be more or less than the original cost past performance is no guaranteed of future results.
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