Capitalizing on Market Inefficiencies with ETFs

Capitalizing on Market Inefficiencies with ETFs

USAA Investments and MSCI present how multi-factor equity and actively managed fixed income ETFs can be deployed to potentially enhance a portfolio’s risk adjusted return.

The Benefits of Combining Value and Momentum Factors

The Benefits of Combining Value and Momentum Factors

Why USAA believes factors should be persistent, pervasive, robust and intuitive.

This segment explores the four criteria USAA employs when selecting factors for their Smart Beta portfolios and how Value and Momentum check all the boxes.

The Advantages of Risk Weighting Portfolios

The Advantages of Risk Weighting Portfolios

A discussion of Cap Weighting vs. Equal Weighting vs. Risk Weighting a Portfolio.

This segment explores how risk weighting seeks to reduce risk in a portfolio and at the same time can also boost its absolute return.

Why USAA Believes in Active Fixed Income Management

Why USAA Believes in Active Fixed Income Management

Our pursuit of a bottom up, bond-by-bond, yield oriented strategy.

Hear why USAA likes beat-up and dislocated markets; Taxable Munis; and A and BBB credits.

Characteristics of Value and Momentum Factors

Characteristics of Value and Momentum Factors

How Value and Momentum work together; when they may underperform and may outperform.

This segment explores why Value was the strategy to buy in early 2009 and why Momentum thrived from 1997-99.

Characteristics of Value and Momentum Factors

A New Approach to Evaluating Factor ETFs

Smart Beta ETFs driven by a rules-based approach can be evaluated using an alternative framework.

In this segment, learn why the “Four P’s” should give way to the “Five C’s” when considering an investment in factor ETFs.

About the Speakers

John Spear

John Spear, CFA

Chief Investment Officer USAA Mutual Funds.

John Spear, CFA, Chief Investment Officer of USAA Mutual Funds, joined USAA in 1998 and has more than 30 years of investment experience. He currently leads the investment team responsible for managing USAA’s mutual funds and affiliate portfolios, which totals more than $150 billion* and co-manages USAA’s Life Insurance company fixed-income portfolio. He previously served as the head of fixed-income, overseeing the USAA Investments fixed- income platform.

Prior to joining USAA, John was a fixed-income portfolio manager with American United Life (now One America) and a fixed-income analyst with Franklin Life. John received his bachelor’s degree from Western Illinois University and his master’s degree in business administration from Butler University. He holds the Certified Financial Analyst designation and is a Fellow, Life Management Institute (FLMI).

Lance Humphrey

Lance Humphrey

Portfolio Manager of Global Multi-Assets, USAA Mutual Funds

Lance joined USAA in 2007. Prior to his portfolio management responsibilities, Lance was a research analyst as a member of the Global Multi-Assets Team focused on asset allocation research, quantitative investment strategies, risk management, and manager research.

Lance earned a B.A. in Business from Texas State University in San Marcos, TX, and is a CFA charter holder and a member of the CFA Institute and CFA Society of San Antonio.

Mark Carver

Mark Carver

Executive Director, Americas Index Products — MSCI.

Mark is an Executive Director and Head of Factor Index Products, Americas. In this role Mark is responsible for commercial strategy, client support & education and partners with Applied Research and New Product Development to develop strategies to enhance the industry leading MSCI factor index products.

Prior to joining MSCI, Mark was a member of the Global Alternative Premia group at AQR Capital Management. Mark joined AQR from BlackRock where he spent ten years, most recently as a regional executive and Head of Smart Beta for iShares. In this role Mark was responsible for developing the commercial strategy including client support, product development and marketing for a $45B suite of smart beta ETFs. Before BlackRock, Mark served as Vice President and Senior Product Specialist at Columbia Management Group covering equity growth strategies. Mark began his career at Fidelity Investments in Boston.

Mark earned an MBA from University of New Hampshire and an ALM with a concentration in Finance from Harvard. Mark lives in Westport, CT with his wife and two daughters.


Gillian: [0:00:08] Welcome to Asset TV, I'm Gillian Kemmerer. Recognized by leading research companies as one of America’s most trusted providers, USAA has been serving the military and their families for over 90 years. USAA Investments has also quietly grown its reputation and an enviable track record since 1971, with over 166 billion in assets under management across fixed income, equities and multi asset strategies. These consist of mutual funds and six ETFs that were launched last October, two actively managed fixed income and four multifactor smart beta funds. Unlike many of USAA’s other products, membership or military service is not required to invest. Today several USAA experts are here to tell us more about their strategies, gentlemen, thanks for joining us. So I’d like to get started with some just quick introductions. And, John, I’ll kick it off with you, tell us a little bit about yourself.

John: [0:01:00] So I’m John Spear and I’m the Chief Investment Officer for USAA’s asset management company in San Antonio, Texas. I’ve been with USAA for over 20 years now, spent most of my career in fixed income, most recently managing the $25 billion affiliate portfolio, USAA’s life insurance portfolio.

Gillian: [0:01:17] Excellent, thank you, Lance.

Lance: [0:01:19] Lance, I’m a Portfolio Manager for USAA’s asset allocation products, so that includes our target retirement funds, our cornerstone strategy funds. We also manage some assets within our property and casualty portfolio. Within those portfolios we have about $12 billion in total. And then we also have about $6 billion in ETF assets that are embedded within those portfolios.

Gillian: [0:01:39] Excellent. And, Mark, last but not least.

Mark: [0:01:40] Yeah, thank you, Gillian. So I’m Mark Carver, I’m the Head of Factor Index Products at MSCI. In that role I’m responsible for working with our research and our coverage teams to develop new factor indexes, new factor data products, work with research on the development of new thought leadership content that we put out to the marketplace. MSCI is probably familiar to you and many of your viewers. We are a leading independent research organization with a deep history in risk management, analytics and obviously indexing.

Gillian: [0:02:08] Excellent, thank you so much. So USAA has only recently decided to enter the ETF market and congrats on your success. Obviously you’re new but you’re already up to assets of about 700 million. So I’d like to talk to you a little bit about why you chose to enter ETFs. So, John, I’ll kick it off with you.

John: [0:02:24] Well, this is a very natural extension of what we’ve been doing for a long time now. USAA has been in the asset management business for almost 50 years, mostly in the 40 Act retail space, mutual fund space as well as USAA’s own balance sheet. So we know our members are buying ETFs, and we want to be the ones providing them.

Gillian: [0:02:42] Excellent, Lance.

Lance: [0:02:43] Yeah, from the equity side, on the smart beta side, again we’ve been investors in factor based products, ETF products for more than five years within our asset allocation portfolios. And through that experience and expertise we really thought that there were some areas of the market where we could bring a new product to market that we could use within our own portfolios and that our members and advisors could incorporate into their portfolios. And so we thought that we had a unique take on the way to build multifactor portfolios.

Gillian: [0:03:08] Great. So you’ve mentioned factors, obviously we’ve seen a lot of growth in smart beta ETFs and factor based investing. So, Mark, I’m going to transition over to you. Can you just give us a high level view of factors and how we’ve arrived to where the industry is today?

Mark: [0:03:20] Sure, of course, this is a common question. And it’s a good starting point; the truth of the matter is factors are not new. These ideas have been traded by investors for over 100 years. So we have to just recognize that fact. It’s also important just to define what a factor is. It’s really nothing more than the characteristics that helps them understand the risk return behavior of an asset or specifically stocks. Many of these ideas are highly intuitive, the idea that I want to invest in cheap versus expensive, healthy versus faltering, rising versus falling stocks, value, quality, momentum, some very intuitive ideas. Many investors are exposed to these strategies. The factor conversation today really was born out of two things; one is the academic work that started with the capital asset pricing model, the single factor, the market factor, then later the arbitrage pricing theory. Academics then looked at anomalies. How did they find characteristics that influenced asset pricing? I’m happy to say that my organization, MSCI was highly influential in this space as well, with the first generation of the Barra risk model, which allowed people to see what exposure they had to these style factors. So that was more than 40 years ago. What’s different today however is the way I can access and get exposure to these factors, they’re much more readily available in things like factor indexes, many more product providers including obviously my colleagues here from USAA.

Gillian: [0:04:43] Excellent. So in light of this context that was given to us, Lance, tell us about why they’re useful in a portfolio setting. What makes them so relevant to you now?

Lance: [0:04:50] Well, as Mark mentioned, there’s nothing new about factors. There’s been, for instance, value based mutual funds or growth or dividend mutual funds that have been in existence for quite some time now. And I think where we’ve really seen the evolution in the industry is the ability to deliver these factors in a low cost format, whether it be through an ETF or through a traditional mutual fund. And so as an asset allocator, it’s a bit of [inaudible] because it allows us to really dial in what we’re trying to target or the outcome we’re trying to achieve within a portfolio. So for example, today we could access for instance, stocks with lower volatility than the overall market, if we wanted to make adjustments to the risk profile within our portfolio. So again, what I think is more relevant today is just the access that we as asset allocators have to be able to target these things that traditionally had been offered at a much higher cost and now we can get them much more efficiently within our portfolios.

Gillian: [0:05:38] Excellent. So, Mark, you outlined several factors, but do you think it makes more sense to combine multiple factors or to focus on individual ones?

Mark: [0:05:46] Yeah. So the cheeky answer is, yes, the truth of the matter is the way to think about this is what is your ultimate objective within the portfolio setting? If what I’m trying to do is express an investment view or diversify a portfolio that may have a bias, commonly that’s to value, then a single factor might be the cleanest and most efficient way to do that. So I can express my view, might be based on my opinion about the economic cycle, or you know, I diversify away from my bias on the factor sense. However, if I’m starting from, you know, ground zero and I’m looking for something that’s a foundation or a building block to my portfolio, the diversification and attractive risk return characteristics of a multifactor portfolio may make more sense.

Gillian: [0:06:29] Now, Lance, coming back to you. How can factors battle market inefficiencies? And to capitalize on inefficiencies should investors look at a factor based index or perhaps an active manager?

Lance: [0:06:38] Well, USAA we tend to use both. So taking a step back, we do believe that markets are oftentimes inefficient. And so as active managers, whether that’s the factor based index or a traditional active manager, we’re ultimately trying to exploit some of those inefficiencies in markets. And so what’s nice about some of these factor portfolios is what we find is that investors tend to make a very common set of mistakes. And a couple of examples of that would be that they tend to over-extrapolate the past on both sides. So value for instance, what oftentimes happens is if a company’s going through a struggling time period and making changes, oftentimes investors will extrapolate that poor growth well into the future. And oftentimes be overly pessimistic on that particular security. At the same time as new information comes in, many times investors become anchored to their existing set of beliefs, which can cause sometimes a stock not to move fast enough. And that’s really where value and momentum come in, in the sense that it’s applying a systematic strategy to try to take advantage of some of these inefficiencies. And again, it doesn’t mean that every stock is going to be inefficient or there’s going to be times where a stock might be correctly priced. But within a factor based index what that allows you to do is really take a broad opportunity set and buy a large number of securities that might follow those same characteristics. And again what we believe is over time, by focusing on these factors that have a proven long term track record in a portfolio, we can put those together in a portfolio setting to take advantage of some of those inefficiencies in the market.

Gillian: [0:08:03] And, Lance, you’ve given us the equities perspective. But, John, I haven’t forgotten about you, so how do you think about applying factors in fixed income?

John: [0:08:09] We’re big believers in active in fixed income at USAA. So we don’t talk about factor investing. But really those characteristics do exist. We like certain rating categories, we’re looking for certain incremental yield pick up, they’re duration bucketing, issue sizes. There are many things that we gravitate towards to where we see value. But we never really refer to it as factor investing.

Gillian: [0:08:36] So we have a nice picture of the factor landscape. But now I want to move into how exactly USAA is positioning within that. So, Lance, I’m going to kick it off with you. Your ETFs focus on value and momentum, why did you choose these two in particular and how are you defining them?

Lance: [0:08:49] Sure. So when we’re looking at factors we really look at them through a lens of four primary criteria. And that would be that we want to see their factor is persistent, pervasive, robust and then, most importantly, intuitive. So when we look at value and momentum particularly across all the factors we find that those two really check those boxes all very strongly. In the sense of from a persistent standpoint we see that value and momentum, they’ve been factors that have worked well beyond 100 years, that we have well documented research for. From a robustness standpoint we find that regardless of the definition, how we define value, it might be price to book, it might be price to earnings, they all tend to work. And then importantly they tend to work in different asset classes. So we find that value is a successful investment strategy, not only in equities but in fixed income, commodities and across asset classes. So that gives us great comfort that it’s not something that’s simply a data mined factor which can be easy to do in today’s day and age with computing power and all the, you know, computing we have.
And so we find that value and momentum particularly check all those boxes. Again, we also find they’re intuitive. It makes a lot of sense from the standpoint we just mentioned before in the inefficiencies, that it’s hard to own value stocks oftentimes. It might be stocks that have a flawed business model or they’re very hard to tell a potential investor that we’re buying these types of securities. And because it’s hard we think that that’s why investors that have a long term patient view are able to reap the benefits of those. So we find that those two factors in particular are very good across those metrics. And then perhaps most importantly would be that when combining those two metrics we find they pair very well together because oftentimes when value is doing poorly, momentum conversely might be doing a little bit better and vice versa. So we find it in a portfolio construction context, they have some offsetting features that are very beneficial.

Mark: [0:10:36] Yeah. I just want to build on that answer because I think the second part of your question was, you know, how do you define value in momentum? And the fact is they are utilizing our MSCI indexes. And I think Lance highlighted a few things that are really important to draw out in this conversation. The first he uses the term ‘robustness’. And what that means is that for something to be a factor should stand up to more than one signal. So when we build these indexes we think about that. So we define value, thematically it’s cheap versus expensive. But then the way you capture that is we look at three signals, book to price, forward earnings to price and price value to cash flow. The reason for that is we want to have an asset based view, an earnings based view and a whole firm view. The utility of that is that you’re picking up insight that you would not pick up if you only use a single signal. The way clients might experience that is if I built a decile portfolio, right, took value securities, created 10 decile portfolios, what I find is by using the three signals, I can improve the drawdown characteristics, in other words have lower drawdown across all 10 deciles, which is an effective way to build an investable portfolio and deliver this factor.
For momentum, we’re using two horizons, we use 6 and 12 month return, but we use a risk adjusted momentum characteristic. So we take and we adjust stocks, the momentum’s score based on the volatility of the stock. The simple way to think about that is if a stock’s very volatile, it’ll have a lower score and if it’s less volatile it can potentially have a higher score, given its return. Using two horizons brings up additional information. If I only use a sort of a classic 12 minus 1 view of momentum, I may have a stock that had a lot of its attractive returns in the early months of that 12 minus 1 view. Using both a 12 month and then the 6 month view gives me that intermediate term. That gives me more confidence. By risk adjusting what I can do is dampen some of the volatility and that’s a good thing because we know that factors independently can be highly volatile.

Gillian: [0:12:44] Okay. So we have a strong working definition, we’ve talked about a little bit the universal applicability of value and momentum. So, John, can you dive into how these factors work in fixed income?

John: [0:12:53] Some of the factors would be transferrable but some really are not. Value, absolutely, we like to pick cheap bonds that may be cheap for a rating category, liquidity, duration, many ways we can identify what we believe to be cheap bonds. The momentum, not so much, if we’re looking at bonds and we see bonds that are tightening versus treasuries, for instance if AT&T bonds tightened from 100 over to 80 over we don’t see that as a signal that they’re going to 70 over, 60 over. And really we like to do it the other way. As we see bonds cheapen up, spreads widen, you get selling, maybe it’s for reasons that don’t make sense. We like those bonds. So we’re kind of doing it the opposite way. So we don’t see momentum as a valid strategy in fixed income.

Gillian: [0:13:40] I’d like to come back to the equity side. And I’m going to direct this question to both you, Mark and Lance. Some value momentum portfolios tend to wind up with a tilt towards specific sectors, so energy and retailers look cheap for example. How do you account for this in the USAA ETFs?

Lance: [0:13:55] So I’ll kick that off. So it’s a great question because when we’re looking at the stocks within these particular indices, we’re scoring the stocks within their own sector. So for instance with energy and retailers what we’re going to do is look for the retailers that have the best value momentum characteristics or the energy stocks with the best value momentum characteristics and so on. So we’ll be doing that across all the sectors to ensure that we’re getting a broad representative set within each particular sector.

Gillian: [0:14:21] Excellent, Mark.

Mark: [0:14:22] Yeah. And the logic of that is to what Lance was just hinting at is you get this broad set. You get diversification by doing that. But we have to recognize and I think it would be intuitive to most listeners in that sectors and industries trade at different valuation levels. It’s not uncommon to see technology trading at a premium to materials or industrials. And so if you don’t look at the particular factors within their sectors, you could then have that persistent bias which changes your risk return profile. And so it’s logical to rank the stocks within their peer groups. And ultimately we think we deliver a very good outcome through doing that.

Gillian: [0:15:02] Now, Lance, there are two different ways to allocate to factors, there’s top down and bottom up approaches. You use the bottom up approach, why do you choose to go that route?

Lance: [0:15:09] Sure. Well, I’ll take a step back first for any listeners who don’t know the difference between top down and bottom up. What we’re referring to there is whenever you’re building a multifactor portfolio, whether it be two or more factors, you have a decision on how do you want to combine those factors together in the portfolio, so two common industry definitions would be top down being that you’re building a portfolio on each factor. So in the case of value and momentum it would be buy a portfolio of value stocks and then buying a separate portfolio of momentum stocks, for example, and then bringing those two portfolios together at some weight, it could be 50/50 or any weight the investor chooses. A bottom up approach however is looking for stocks that share those characteristics. So it’s looking for securities that have positive value and improving price momentum or improving trends. So we’re looking for companies that are cheap and showing signs of improvement. So we look historically, you know, both approaches tend to work very well. And they both have different pros and cons. What we find particularly with the bottom up approach is that it allows us to really maintain the exposure that we’re seeking. Because oftentimes if you put two portfolios together, again using value and momentum as an example, you may end up cancelling out some of the factor exposures.
So you might have some stocks that are very cheap but they’re going straight down. And some would call that a value trap or catching a falling knife. Conversely there might be stocks that have very high momentum, but are also extraordinarily expensive. So when you put those together in a portfolio, you could end up washing out some of those factor exposures. So it’s very important to us that in this product we deliver investors value and momentum exposure. And so by choosing a bottom up approach it helps us retain that exposure throughout the overall portfolio. On the downside to that is that approach does need to deliver a high tracking error within a portfolio. So the top down approach tends to be a less risky approach for many investors. But again when we look at the historical results we believe that the bottom up approach is a slightly better way to put these two factors together.

Gillian: [0:17:02] Now, Mark, obviously MSCI has a wealth of research. Do you see any material difference in the risk reward profiles of these two approaches?

Mark: [0:17:08] For sure you do now. The truth of the matter is that clients will make a decision based on sort of what they’re trying to achieve. The top down approach has the advantage of higher capacity, lower tracking error, so some investors that’s attractive to them. And some might argue it’s easier to do factor attribution in a top down approach. However, if your goal is to get high exposure to the factors and you have conviction that these factors will give you a reward over time. The bottom up approach will give you two to three times the level of factor exposure because it doesn’t cancel out, to Lance’s point, like you see in the top down approach. So you can get much more of the intended exposure in a more true sense. The downside to that is you don’t have quite the same level of capacity. You might have more volatility. But over
time your returns are likely to be higher because you’re generating more return from those factors.

Gillian: [0:18:07] Now, I’d like to shift over to risk weighting. We understand how you select securities now, Lance, and obviously, Mark, please feel free to comment. You’re combining value momentum, it’s a bottom up approach, but how do you size the individual positions when putting together your portfolio?

Lance: [0:18:21] Sure. So when we were going about constructing these particular ETF index products, it was really important to us to make sure that we had a very balanced approach in the way that we choose securities. And so when we think about how we weight each name, first of all, I think that’s one of the most important aspects to many factor based strategies, it’s often overlooked and can have a profound impact on the risk and return profile of a particular set of securities. But I think it helps to put this into perspective on an example, where, you know, let’s say you’ve chosen stocks for whatever the reason might be, it might just be 10 stocks that you like for whatever the reason. You now have to determine how you want to weight them in a portfolio. And what is a very common methodology in the broad based indices would be market cap weighting, which essentially is weighting the stock in accordance to its overall size or its market capitalization. That makes a lot of sense in a broad based index fund where you’re looking to track an actual index or buy the market; market cap weighting it makes a lot of sense. Obviously one of the implications of that would be that you end up having very high concentrations in the biggest names in the universe.
So if we look today for instance in the S&P 500, a company like Apple might be nearly 4% of the index. And a stock like Costco might be .4%. So implicitly you’re saying that you have 10 times the weight on Apple that you would Costco. So when we look at an active strategy we don’t necessarily believe that market cap weighting is the right approach. One additional way of doing it that’s very common is simply equal weighting. And that tends to make a lot of sense again, if we want to balance the risk of the portfolio. What ends up happening when you equal weight is you inadvertently put a little higher risk in the more volatile names. So as an example, if we were to build a portfolio of let’s say Netflix and Procter & Gamble, and we equal weighted those two securities, well, Netflix is about three times as volatile as Procter & Gamble. So even though those two securities would be equally represented in the portfolio, the riskier stock, Netflix in this example would drive much more of the risk. So what we look to do again within our process is we’re seeking stocks based on their value and momentum characteristics 25% of the overall universe. We want all those stocks to approximately contribute the same amount of risk in the portfolio. So the way that we’re able to achieve that is through this risk weighting. And where we take stocks that are slightly higher volatility and give them a slightly lower weight within the portfolio, in stocks that are less volatile we give a slightly higher weight. And what this does is it creates a much more balanced risk approach throughout the portfolio.

Gillian: [0:20:39] Now, I saw you nodding your head when Lance was talking about how important it is to size these positions correctly.

Mark: [0:20:44] Yeah, for sure it is. I mean let’s be honest; it’s a lot more interesting and fun to talk about picking stocks. It probably is more important to investors’ outcome how you put those stocks together. People think just get a bunch of good stocks, put them together, however you weight them, I’ll do well. But that’s not true. So ineffective construction can have a real impact. And I think that the utility of risk weighting is that not only do you underweight systematically those highly volatile stocks and then overweight some of the more risky stocks, assuming they are less risky stocks. You also introduce other things that could be beneficial to the portfolio. In this case a lower cap bias or what we would call the size factor. Now, that’s been a good thing for investors over time. You get rewarded for holding smaller cap stocks. But interestingly, through the risk weighting approach you’re getting that benefit of having that size bias. But you don’t have the same level of volatility as you might in a pure equal weighted strategy. Or say you just said I want to invest in mid caps, so you can isolate the good stocks of value momentum in this example, and then construct them effectively then bring some additional benefits.

Gillian: [0:21:54] Now, to the two of you again, can you demonstrate that this approach has both enhanced returns and reduced risk?

Lance: [0:22:00] Well, interesting, what we find is again philosophically we want to ensure that we balance risk across the portfolio. But in addition to that, when we look historically, if we take something like the MSCI World Index and rather than cap weighting that index, there is a version that’s a risk weighted MSCI World where we have over 40 years of history. And what we’ve found over that time period is that the risk weighting approach not only reduced risk within the portfolio, but it actually had a higher absolute return as well, compared to both equal weight and capitalization weighting. So again, when we look historically the results have been very strong, while also giving us those desirable benefits that Mark mentioned.

Gillian: [0:22:34] And, Mark, did you have anything to add there?

Mark: [0:22:36] Well said.

Gillian: [0:22:36] Perfect. So I’m going to come to you, John. When you think about the weighting scheme of a bond index like the Agg for example, they’re structured rather differently, isn’t that correct?

John: [0:22:46] Yes, they are. So the Agg does change over time. And I don’t know that people really appreciate that. Right now it’s very exposed to long low yielding treasury securities and very exposed to residential mortgage backed securities, which may be a poor fit for a lot of investors. The other thing that I don’t think people fully appreciate is the most indebted corporations become the very heavy weights in the index. And we as bond investors actually like companies with less debt, not more debt. So we don’t feel like the way it’s constructed is a good fit for many investors.

Gillian: [0:23:21] So, Lance, putting it all together can you provide a summary on how each of these concepts together really fit into the USAA ETF portfolios?

Lance: [0:23:29] Sure. So again what we set out to ultimately do was to build a multifactor portfolio that targeted what we believed to be the most core factors that pair well together, in this case being value and momentum. And we want to then select securities based on their value and momentum characteristics simultaneously. So we get a bottom up approach that’s seeking stocks, that are attractively valued and showing signs of improving price trends. We also then wanted to take those securities that we select and put them together in a balanced way where we reduce the overall concentration within the portfolio and have a broad representation of those stocks that have attractive value momentum characteristics. Lastly, we’re very thoughtful about the implementation, so we have several controls in place to help the ETFs increase their liquidity and reduce the turnover within the overall portfolios. Ultimately we believe this provides investors with the potential to have more consistent long term outcomes.

Gillian: [0:24:21] Mark, anything to add here?

Mark: [0:24:22] Yeah. I think what Lance is really getting at is that we’ve got to go back to those two components of putting together a good and effective factor index. You have selection and construction. And what we’re doing here is we’re selecting factors that we know have long term history. And we believe will work going forward, value and momentum they pair well together. So that’s smart selection. But you can’t just have smart selection; you have to put these portfolios together well. And in this case, we’ll go back to that risk weighting idea where we’re systematically underweighting the most volatile stocks and overweighting the least volatile stocks from those that score well to value momentum. By doing so you’re not only getting the value momentum that you want, you’re also introducing lower volatility to the portfolio. And you’re bringing in that other element of the size factor which we know has been a strong factor going forward. So in this case you have smart and effective selection, smart and effective construction.

Gillian: [0:25:22] Great. So I’m going to move away from the two of you briefly, Lance and Mark, and we’re going to go over to John to talk a little bit about taxable fixed income. So, John, USAA has been managing fixed income money for nearly 50 years. Tell us a little bit about your approach and how it applies to the fixed income ETFs?

John: [0:25:38] So we are not a macro shop. We’re not attempting to make interest rate calls. As I mentioned, we do very little in treasury and agency mortgage backed securities. We’re a credit shop, we like picking bonds. So it’s bottom up bond by bond, very yield oriented strategy. We like that incremental yield that wins over time. And we invest heavily in our research staff. So when you look at our retail 40 Act funds you see heavy credit, A, triple-B, and again very little in treasury agency. And that will be quite similar to our ETFs.

Gillian: [0:26:10] Now, do you believe or why do you believe that USAA’s taxable fixed income ETFs could be use as core holdings within an investor’s allocation?

John: [0:26:18] So the difference being in the past we’ve done more in credit. And again you’ll see that in our 40 Act funds. We’ve decided to populate the ETFs with some more of the treasury and agency, to give them that liquidity you need in the ETF space, but still get the performance that you would get from our credit team.

Gillian: [0:26:36] Now, I feel like we’re always talking about the active/passive debate. But let’s go specifically within active. History shows that active fixed income managers have outperformed their active equity counterparts. Why do you think this is the case?

John: [0:26:48] It’s a bit of a different market. So remember that the S&P 500, very liquid, you can, you know, get in and out without any problem, everyone gets pretty much the same price. In fixed income it’s still highly negotiated. People over the telephone, you’re getting bonds where you may be offered the wrong price and you spend a long time negotiating. A lot of fixed income is more like buying and selling your own home. You may put it on the market, may take a while, you negotiate. So it is a different market and it takes human judgment in many cases.

Gillian: [0:27:23] Can you give us … please go ahead.

Mark: [0:27:25] It’s interesting because people often ask why there isn’t more sort of factor research in the fixed income space. And John just hinted toward part of that reason which is there isn’t as much transparency in pricing. So I don’t have the ability to necessarily put these ideas, put fixed income through the factor lens like I can do with equities where I have decades and hundreds of years of pricing information, right. So as we get that as an industry you’ll see a lot more academic research, industry research around factors in the fixed income context.

Gillian: [0:28:01] And, John, can you give us an example, securities that align here?

John: [0:28:03] Yeah. So we like markets when they’re sort of beat up and dislocated. So there are times when municipal credits may become cheap. We like the taxable muni market; it’s very inefficient in small market. But when we find rewarding, we’ve had many times where we could invest in a structured product, asset backed securities, commercial mortgage backed securities, when they go out of favor. And individual credits, we like bonds that there is a story and something to really dig into when maybe they’re oversold. There was a time a few years ago when BP was in the headlines; their bonds were very beat up. And we found very good entry points for that name.

Gillian: [0:28:43] Now, Lance, you’re obviously an asset allocator sitting on this panel with us. So how do you think about making a decision between active and passive in fixed income?

Lance: [0:28:51] What John mentioned here, we believe that active management, by finding a skilled team with a proven process is a more effective way to capture the fixed income market. However, as an asset allocator there’s times where we may tactically want to come into a certain segment of the fixed income market, whether it’s to control for duration or to reduce or increase credit quality. So within our portfolios what we generally do is our long term strategic holdings are generally going to be held through actively managed mutual funds or actively managed sleeves within our portfolios. However, we do tend to use passive portfolios quite a bit when making those tactical decisions. So for instance in early 2016 we wanted to make a tactical overweight to high yield bonds. And so rather than having to go to an active manager and deploy this money, knowing that we might need it back very quickly, we tend to use passive ETFs to make those quick tactical exposures. But again our core holdings within fixed income are generally going to be actively managed.

Gillian: [0:29:43] Now, John, you run 100 billion in fixed income. And you’ve done it well over the long term. So can you tell me a little bit about how these ETFs are different from what you’re already doing today?

John: [0:29:51] So the ETFs will have a bigger portion in treasury and agency mortgage backs, which we don’t typically do. It’s a market where clearly the liquidity is better and we feel like we need that in the ETF space. And it gives our investors the ability to use them as part of the core holding. So they are a little different. We have the same portfolio manager, same research staff, same traders. So you would expect the same type of performance, just a little different with the higher quality.

Gillian: [0:30:21] John, so many will believe that we’re late in the credit cycle and that we’re starting to see bond valuations extended. So what do you see for fixed income investors moving forward?

John: [0:30:29] So it’s been risk on for quite some time now, credit spreads are at pre crisis levels. So spreads are tight and it’s an environment where you’re not really getting paid to take risk and go down in credit quality. So we see it as a good time to just patiently wait, give up a little yield, wait for an environment where spreads are wider and redeploy some of that money. But right now we’re just being cautious.

Gillian: [0:30:52] So, John, you run a 100 billion in fixed income and you’ve done it well over the long term. So tell me a little bit about how these ETFs differ from what you’re already doing day-to-day?

John: [0:30:59] So in the ETFs we’ll be using more treasury and agency mortgage backed securities, the higher quality more liquid segment of the bond market. We still will be using the same traders, portfolio managers, research analysts for the majority of the investments we’re making in the ETFs. But they will be a little higher quality and a little more liquid than our 40 Act funds.

Gillian: [0:31:20] Great, thank you so much for taking the time to give us a little bit of an overview of how you manage fixed income and then about the market as well. So I’m going to transition over and, Mark, I’m going to have you take the lead here, but, Lance, please feel free to jump in. There are a lot of different ways to use smart beta within an investor’s allocation. One way is to complement the traditional cap weighted passive strategies. So talk to us a little bit about its impact on tracking error.

Mark: [0:31:43] Yeah, for sure. I think the real question on the minds of many people is if I make an allocation to a factor strategy or smart beta, do I fund it from my active portfolio or my passive portfolio? And the answer depends really on three things. What’s the level of your conviction of your existing active portfolio? Do you believe that those managers can deliver the investment goal that you have? The second thing you want to think about is do you have a specific targeted tracking error active risk budget? In other words do you want your portfolio outcome to be very tight to your policy benchmark, MSCI equity for instance? Or are you okay if it’s a little bit wider off of that? And the third thing is how important is the exposure you have to the factors? Do you want to be very deliberate about it? Or do you want it to sort of fall out? And depending on your views on those three questions, then you may come to a different conclusion of pulling it from active or passive. What we often see is that for people who are willing to accept wider tracking error for instance, they will fund a factor strategy or smart beta from their passive portfolio with the belief that it’s still implemented very systematically with full transparency. So I’ll fund it from passive and I’ll accept the tracking error and hopefully I’ll get a good outcome. Conversely, for people who are much more concerned about tracking error and want the delivered exposure to factors, they’re going to fund it from their active portfolio and say, “I’m comfortable managing my overall market exposure through traditional betas and then I’ll use factors instead of active, so that I can complement that sort of passive exposure”, if you will.

Lance: [0:33:21] And the way that we’re doing it within our own asset allocation portfolios is we’re using it as a complement to both types of strategies. So we think of factor based investing or smart beta as another tool in our toolkit as we construct portfolios. So today if we look at for example, our target retirement funds there is going to be some of our assets that are passively invested. We have some that are active managed across the equity and fixed income space. And then we also utilize smart beta in the middle of those two, kind of as a hybrid between the active and passive approaches. So what we look to do is find where is the most efficient way we can fill a particular gap, so again in the case of value, historically the way to do that was to find a value manager, where what they might be delivering is simply the value factor. So now within our portfolios what we can do is significantly reduce the cost of gaining that exposure by using it in an ETF or an index based strategy, focused on value. So again, we tend to use it both passive, active and smart beta when building our portfolios.

Gillian: [0:34:18] So, Lance has already alluded to it, but obviously smart beta can act as a complement to active managers. So how does that work in practice?

Mark: [0:34:26] Well, it works in practice first by having a way to actually see how much exposure an active manager is delivering me to a targeted factor. We have introduced what we call FaCS, MISC FaCS or Factor Classification Standard which is a data file that allows me to compare managers’ factor exposure apples to apples. So you want to start there and say, “How much exposure do I have to these factors today? And then where is it coming from? Is it coming from, you know, one active manager versus another?” You compare that to how much you could get in the Factor Index, the Select Value Momentum Indexes for instance. And then you’d adjust your portfolio to ensure your outcome or your portfolio’s allocated to your beliefs. It gives me the factor exposures I want, it has the active budget or TE that I’m comfortable with and ultimately it’s allocated appropriately.

Lance: [0:35:17] I think another interesting use case to complement active managers would be as Mark mentioned; we can take a look within a given portfolio and see where the factor exposures lie when the portfolio is constructed. And what we oftentimes do is use factor based strategies as a risk management tool. So we may have one of our active equity managers who focuses on value. And we have a lot of trust in what they’re doing in their portfolios. But there may be times where let’s say that portfolio is loaded up on volatility, and if we look across our portfolio that might be an exposure that we want to mitigate. So what could we do? We could complement that active manager with a factor based strategy that focuses on low volatility securities which would help the overall portfolio become more balanced. So we often use particularly single factor strategies to help us mitigate risks or manage risks across our portfolio, to make sure that the resulting portfolio has the factor exposures that we’re ultimately trying to target.

Gillian: [0:36:11] Now, John, obviously we’ve been talking about complementing active managers. But you are an active manager sitting here on this panel. So how do you think about complementing versus replacing passive fixed income strategies in an investor’s portfolio?

John: [0:36:22] So out of the 160 billion we manage at USAA, over a 100 billion is in fixed income. All of that is active fixed. So that will tell you that we’re a big believe in active fixed. We’ve talked about reasons why the index is not a good fit for many investors. And the research would support if you like active managers you would like them in fixed income above anywhere else. So again we’re big believers in active fixed.

Gillian: [0:36:49] So we have talked about complementing passive and active. But now I want to think about core satellite investing, so Mark and Lance I’m going to direct this to the two of you. Should investors think of smart beta as a core investment or as a satellite?

Lance: [0:37:00] Well, I think it depends. And we use it for both. So our general philosophy is that multifactor smart beta products can be used as a core part of a portfolio. So in the case of the value momentum indices we’ve been discussing today, we think that that can serve as a core portion of an investor’s portfolio, because again it’s targeting two factors that have positive correlation benefits and that we believe to be two of the most robust factors in the factor landscape. So by combining multiple factors together that oftentimes can serve as a core for portfolios. And we use it as a core within our portfolios. But then we’ll also use single factor strategies more as a satellite approach. So for instance, a factor like quality might be a factor that we believe in over time but we don’t necessarily want it in our portfolio all the time. So there are certain times in our economic cycle that we might want to increase the quality profile within our portfolios, or we might want to increase the volatility reduction within our portfolios. So we tend to use the single factors more as a satellite approach. But we tend to want to have the multifactor as a core part of the portfolio.

Gillian: [0:38:07] Mark.

Mark: [0:38:07] Yeah. And that is the most common approaches to using single factors where you think about overlaying your current investment view. And it could be based on valuations. It could be based on where you think we are in the economic cycle or economic regime. And you’re going to use factors to try to manage that current cycle. So the way we’ve thought about this from a research context is that there are some factors that are very pro cyclical, meaning they tend to move with the economy and some that are more defensive. So value is a sort of a classic early cycle pro cyclical factor, where quality, to Lance’s point tends to work sort of late cycle, particularly where you see dispersion start to widen. And so some people will think about factors in that context, and express that view in a very satellite approach.

Gillian: [0:38:58] Mark, let’s talk specifically about the value momentum strategy. In what conditions does it outperform and when would it underperform?

Mark: [0:39:04] Yeah. So we think, sort of falling on my previous answer, we think value’s very pro cyclical, right, so it’ll work early stage. I like to think of value as the strategy that you buy at the darkest point of the cycle, you know, the February/March of 2009, when you’re least likely to buy the cheapest stocks, value can be a very attractive trade at that point. But the important thing to think about with value and momentum are really any factor pairs, how do they work together. And what we find is that because they’re negatively correlated when one idea is underperforming and the other idea is outperforming. And to sort of bring this answer together let’s think about the tech bubble. Many of your viewers will have been in the industry at that point. There were a lot of people who thought value securities were dead for the three years sort of at the end of the tech bubble, 97-99, value was a stinker. It underperformed in the US market by 600, 700, 800 basis points, while momentum was outperforming by a 1,000 basis points. We fast forward to the financial crisis, in the heart of the financial crisis, middle of 2008, momentum really started to underperform, you saw the, you know, three years from mid 2008, mid 2011 momentum was a stinker. But value did very well. And so when you combine these things you can think of it as a timing aspect or you can think about it as combining them to take advantage of that offsetting nature of the returns, the correlation benefits, if you will.

Lance: [0:40:40] And I think with these ETFs in particular again, we talked earlier about the importance of the weighting scheme within the portfolio and the impacts that ends up having on the portfolio. So again because within our process we’re creating a much more balanced approach across the name, so if you look at relative to a Market Cap Index we talked about earlier how some of the top names in the index account for a very large proportion of the weight. So if you think again today in the S&P 500, stocks like the FANG stocks are very popular, they’ve been doing very well. And they account for a large proportion of a Market Capitalization Index. So these ETFs by definition are going to be underweight the largest names within a portfolio, simply because we balance the risk across the different names. So we’re not going to have a 4% name in any weight within these particular indices. So going back to 1999 and that timeframe, these indices would have fared relatively poorly over that time period because the performance was so concentrated in the very top of the market capitalization structure. However, after that time period from, call it 2001 to 2008/2009, markets were far more balanced, that risk weighting approach fared far better coming off of that time period. So we think that one of the large drivers of performance of these particular ETFs relative to the market cap benchmark is going to be the concentration of those top names and how they’re doing within a particular index.

Gillian: [0:41:59] John, I want to direct a similar question to you, when we think about fixed income when might your style outperform versus underperform?

John: [0:42:05] Yield drives performance in fixed income over time. So we are yield investors, we like earning that credit spread. So in an environment where credit spreads are widening, we will underperform. But it tends to be temporary, and that provides an attractive entry point, a buying opportunity that will drive performance going forward.

Gillian: [0:42:23] And, Lance, coming back to you, within your 20 billion asset allocation funds, where do you find the most compelling opportunities within your own ETF strategies?

Lance: [0:42:31] Well, today we really like value as a factor in general. So whether it’s our own ETFs or other ETFs that we’re using, we’re really focusing on adding more exposure value within our portfolios. So when we look across our own opportunity set in the USAA ETFs we really like emerging markets and international. So to put a couple of numbers around that on the emerging market side, these ETFs in the indices will typically trade at a discount relative to the Market Cap Index, it’s about 15% typical discount. How we look today that discount is north of 30%. So we’re seeing a significant valuation gap in the Select Value Momentum Indices relative to the market cap, when we’ve seen these types of disparities in the past, that’s tended to lead to strong subsequent performance. So we’re very excited about the opportunities we’re seeing in emerging markets, in international, focusing on these value based strategies.

Gillian: [0:43:22] And, John, can you give us the fixed income perspective here?

John: [0:43:24] Yeah. So credit spreads are on the tight end of a range. We recognize that, it’s a good time to be up in quality and not stretched for yield. And we can give up a little bit of yield for a while and be patient and really wait for better days. So right now it’s up in quality.

Gillian: [0:43:39] Mark, with the multitude of products available and the increase in investor interest, there is some fear that factors are getting crowded and we might see a reduction in their premiums, how do you approach this?

Mark: [0:43:47] Well, it’s surprising it took us this long into the conversation to get to this question. It comes up in virtually every meeting I have around factors. The truth of the matter is there is a lot of attention to factors. But the flows is probably not as dramatic as what people are asserting. But even so, let’s imagine that all the flows are going into factor products like people are suggesting, it’s irresponsible and maybe not that effective just to think about where flows are going to, without thinking about where they came from. So imagine I move from one value strategy, it could be a fundamental manager picking value stocks one at a time and I substitute that for a factor index. I’m still trading value; I’m just getting it in a different way. So the importance is that there’s no impact potentially on the asset price of a value security. So the better way to think about crowding is not about flows, which are so common in the media today. But rather, think about the impact on asset prices. You can look at things like value spreads, how expensive are the top quintile versus the bottom quintile to a factor. You can think of short interest spreads, how heavily shorted is the bottom quintile versus the top quintile? How has the correlation, the pair wise correlation across these quintiles changed? As correlation goes up, maybe the factors are getting more crowded. But by looking at these types of dimensions we have a much more effective way to think about crowding than just looking at things like flows.

Lance: [0:45:20 ] I think it’s also important to add that smart beta is a very broad term of factor investing. So many people might say, “Is smart beta itself too popular or too crowded?” Well, again, as we talked about, there’s many different factors, many of which are opposites. So it would be very unlikely that all factors simultaneously could become crowded. There may be at times certain factors that may be more crowded than others. And again, you would tend to see that in something like valuation spreads or the valuations changing amongst these factors. But I also think that it’s important, if we look at value for example, generally if something was overly crowded or overextended, that would mean that it would have performed very well recently. But if we look again at value, it’s actually underperformed the market based benchmarks for the last five to seven years. So it’s hard to argue that a factor like value could be crowded or over popular, despite underperforming over the last several years.

Gillian: [0:46:10] Well, you mentioned that the crowd may be moving around at certain times. So is there any value to timing factors?

Lance: [0:46:15] So we don’t believe necessarily in timing, if anything I would say we are light touch tactical around factors. So we do think that there are certain market environments that may favor one factor or the other. So again if you believe that you’re in the late part of a cycle you may want to increase things like low volatility or quality as they tend to do a little bit better in a market downturn. Conversely, if you think that you’re more at the bottom of a cycle where there’s a lot more upside in the market, a strategy such as value might tend to perform a little better. That being said we tend to not move around factors too often. We believe with value and momentum in particular, those are factors we always want to have in our portfolio because of those correlation benefits. And they do tend to work at different times. But we may introduce certain factors from time to time based on an economic view. The other thing that we do take into account is the valuation of factors. So if we see that certain factors are very cheap relative to history, we believe that that is an indication that there might be room for future outperformance. So, if we look even just to last year or the year before we found that certain strategies such as low volatility or dividends or quality became very expensive, some of which still are today. And that would lead us to want to underwrite those a little bit more in our portfolio than we typically would. So again, we might around the margin change from a factor exposure but we’re not going to be full scale going in and out of value to momentum and to quality or so forth, we believe it’s important to have a static exposure to those core factors.

Gillian: [0:47:42] Anything to add on the topic of timing?

Mark: [0:47:44] Yeah. I think what he’s really hinting toward is do smart tilting, right. And what we see is that oftentimes investors have a lot of exposure in their factor portfolio to US factors, but less so to international. And we know that the industry generally has a home bias and we’re over-allocated to the US market and under-allocated to international markets. But picking up where, you know, Lance left off around valuations, it does seem that some of these factors are seemingly trading at lower valuations outside of the US than inside of the US. So you might have sort of a dual benefit there by getting a factor that could be rewarded outside the US and getting it when it’s maybe a little more attractive.

Gillian: [0:48:26] I can’t believe we’re already coming to the end of it. But I want to give each of you an opportunity to just summarize for us what anyone who’s watching this program should take away and what they should be focused on. So, Mark, I’m going to begin with you.

Mark: [0:48:36] Sure. I’ll summarize sort of where I started which is this idea that while factors are more popular today, or more in the mainstream. The truth is these ideas are not new. They’ve been well documented, well researched, but everybody is afraid of, you know, buying an idea that worked yesterday but may not work tomorrow. And the truth of the matter is for the factors we’re talking about here, particularly value and momentum, they stand up to both academic research, but then also the live evidence where you can see that these ideas have worked in the US markets, in developed markets outside of the US, in emerging markets. So they have that sort of persistence and pervasiveness that Lance talked about earlier, they have that robustness. That should give people more confidence that these things can work going forward, not just in the back.

Gillian: [0:49:25] So we have a robust track record to pull from here. Lance.

Lance: [0:49:28] Well, I think as an asset allocator I think it’s just exciting to see the developments that we’ve had in the investment choices over the last 10 years. Again the ability to access these institutional level strategies at the cost that we can get them today makes portfolio construction so much easier and much more effective and targeted. And so I think that for many investors, again incorporating some of these long term proven robust factors in their portfolio, can certainly improve the factor profile of any portfolio, whether it’s a passive portfolio or an active portfolio, we think that investors focusing on value and momentum and taking advantage of those correlation benefits in a risk balanced way, we believe can really add to any type of portfolio construction process.

Gillian: [0:50:10] Excellent. And John, last but not least.

John: [0:50:12] We’re a strong believer in active fixed income. We’re very proud of our long term track records. And credit spread and yield win over time. And you can see it in our performance.

Gillian: [0:50:22] Well, this was a great note to end on, John. So thank you all so much for taking the time to chat with us. We appreciate you telling us a bit more about the USAA’s strategies and what’s really driving the success of factor strategies. And thank you for tuning in. From our studios in New York I'm Gillian Kemmerer, and this was the USAA Exclusive Masterclass.


John Spear

John Spear

Chief Investment Officer — USAA Mutual Funds

John Spear, CFA, Chief Investment Officer of USAA Mutual Funds, joined USAA in 1998 and has more than 30 years of investment experience. He currently leads the investment team responsible for managing USAA's mutual funds and affiliate portfolios, which totals more than $150 billion* and co-manages USAA’s Life Insurance company fixed-income portfolio. He previously served as the head of fixed-income, overseeing the USAA Investments fixed-income platform.

Prior to joining USAA, John was a fixed-income portfolio manager with American United Life (now One America) and a fixed-income analyst with Franklin Life. John received his bachelor’s degree from Western Illinois University and his master’s degree in business administration from Butler University. He holds the Certified Financial Analyst designation and is a Fellow, Life Management Institute (FLMI).

Lance Humphrey

Lance Humphrey

Portfolio Manager of Global Multi-Assets — USAA Mutual Funds

Lance joined USAA in 2007. Prior to his portfolio management responsibilities, Lance was a research analyst as a member of the Global Multi-Assets Team focused on asset allocation research, quantitative investment strategies, risk management, and manager research.

Lance earned a B.A. in Business from Texas State University in San Marcos, TX, and is a CFA charter holder and a member of the CFA Institute and CFA Society of San Antonio.

Mark Carver

Mark Carver

Executive Director, Americas Index Products — MSCI

Mark is an Executive Director and Head of Factor Index Products, Americas. In this role Mark is responsible for commercial strategy, client support & education and partners with Applied Research and New Product Development to develop strategies to enhance the industry leading MSCI factor index products.

Prior to joining MSCI, Mark was a member of the Global Alternative Premia group at AQR Capital Management. Mark joined AQR from BlackRock where he spent ten years, most recently as a regional executive and Head of Smart Beta for iShares. In this role Mark was responsible for developing the commercial strategy including client support, product development and marketing for a $45B suite of smart beta ETFs. Before BlackRock, Mark served as Vice President and Senior Product Specialist at Columbia Management Group covering equity growth strategies. Mark began his career at Fidelity Investments in Boston.

Mark earned an MBA from University of New Hampshire and an ALM with a concentration in Finance from Harvard. Mark lives in Westport, CT with his wife and two daughters.