Market perspectives from Vanguard's chief investment officer
29 May 2018 | Markets and Economy
In 2017, Greg Davis succeeded Tim Buckley as Vanguard's chief investment officer. Mr Davis has spent the past 18 years at Vanguard as a fixed income trader, CIO of Vanguard Australia, fixed income portfolio manager, and more recently as head of Vanguard Fixed Income Group.
In this interview, Mr Davis reflects on the markets, indexing, factor funds, and how his past experiences have prepared him for his new role.
What's your take on the current sharemarket environment?
Greg Davis: We had a very significant run in the equity market in the last several years. When you look at P/E [price-to-earnings] ratios or a variety of other metrics, equity valuations look stretched.
Vanguard Investment Strategy Group [ISG] has done some really good work that looked at the Shiller CAPE [cyclically adjusted P/E ratio] index, one of the most widely followed measures of stock market valuation. The Shiller CAPE shows equity valuations are well above historical averages. However, after adjusting for interest rates and inflation, ISG found we've reached the high end of the fair-value range.
Equity P/E ratios: Shiller's CAPE vs. Vanguard's proprietary fair-value model:
Note: Shares are represented by the S&P 500 Index. "Fair-value CAPE" is based on a statistical model that corrects CAPE measures for the level of inflation expectations and for lower interest rates. The statistical model specification is a three-variable vector error correction, including equity-earnings yields, ten-year trailing inflation, and 10-year US Treasury note yields estimated over the period January 1940–December 2017. For details, see Vanguard's economic and investment outlook (Davis, Aliaga-Díaz, Westaway, Wang, Patterson, and Ahluwalia, 2016). Sources: Vanguard calculations, based on Robert Shiller's website at aida.wss.yale.edu/~shiller/data.htm, US Bureau of Labour Statistics, and US Federal Reserve Board.
What does that mean for investors?
Greg Davis: We need to have more realistic expectations of what the next five to ten years are going to look like from a return standpoint relative to what we've seen over the last five to ten years. The Vanguard Capital Markets Model, which ISG runs, points to 3%–5% returns in the global equity market because valuations are a bit stretched.
There's still value in diversification globally because valuations around the globe aren't quite as elevated as what we've seen in the United States. There's also value in diversifying across asset classes. Diversification is even more important now because it can provide downside protection without giving up much on the upside based on our model.
Would you say valuations are also stretched in the bond market?
Greg Davis: In the bond market, there are a couple of different considerations. Unemployment rates continue to decline in many leading economies. That could be a signal that inflation is going to pick up and cause bonds to be at risk. But despite all the stimulus we've seen in the market and the tightening of the labour markets, inflation just hasn't been an issue yet. There are a number of explanations, including technology, demographics, and income inequality.
Because of this environment, we may be in a sweet spot where we have solid growth and low inflation. That's not necessarily a bad environment for bonds.
Factor-based funds have received a lot of attention recently. Can you tell us about the strategies behind these funds and how they differ from 'smart beta' funds?
Greg Davis: There's been a tremendous amount of academic research on factors, and what you see is that many active managers have factor biases in their portfolios. For investors who want exposure to a specific strategy, such as a value strategy or a momentum strategy, factor funds are an inexpensive way to get that exposure without having to pay the high costs of active management.
For Vanguard, I wouldn't call our funds smart beta funds. Our factor portfolios are actively managed and are not tracking an index like smart beta funds. Within certain constraints, we're trying to maximise that factor exposure within those portfolios. Our portfolios are not market-capitalisation-weighted, and we evaluate securities based on their exposure to a specific factor. Ultimately, the goal of these funds is to outperform in the long run relative to a broad-based index.
How do you respond to claims that indexing is getting too big?
Greg Davis: Our numbers show that about 10% of the global equity market and 15% of the US equity market were in index-oriented strategies as at 30 September 2017. The vast majority of trading activity is still dictated by active managers. Only about 5% of the trading volume on US exchanges comes from index managers.1
There's a tremendous amount of room for indexing to grow when you look at the broader market. There has been a lot of conversation about whether indexing is distorting the market. The reality is index funds are price takers; active managers are the price setters. We're a very long way from indexing's size becoming a problem.
Ultimately, as long as you have participants in the marketplace who have different views on the value of securities and they can agree to trade, there's price setting. As long as there's that price-setting mechanism in the marketplace and indexing isn't 100% of the trading volume, there shouldn't be any problems.
How are you finding your new role, and how have your previous responsibilities prepared you for this position?
Greg Davis: I'm very fortunate to have a highly experienced and dedicated team of investment professionals. Whether you're looking at the head of our Equity Investment Group, Risk Management Group, Fixed Income Group, Quantitative Equity Group, or Investment Strategy Group, it's a very dedicated, talented team of senior professionals to work with every day. And the broader team is a very dedicated, talented group of investment professionals. It's a true privilege to work with this high-performing team.
My experience starting off as a fixed income trader, as well as my role as a portfolio manager in our Fixed Income Group, has given me a thorough understanding of fixed income markets and risk management.
I also had the opportunity to serve as chief investment officer in Australia, which allowed me to oversee our Australian equity and investment strategy groups. So, the combination of trading, portfolio management, and my experience in Australia have really helped to prepare me for this role.
What steps are you taking to develop the next generation of investment leaders at Vanguard?
Greg Davis: It's a combination of things. We want to make sure we invest in our talented teams of investment professionals and give them the right opportunities. We focus on rotating individuals as a developmental tool so that they have exposure to different positions within the organisation.
This is a great way to help people develop their skills and careers. I've benefitted from this approach, and many of my peers have benefitted from having held different positions. We continue to invest in developing leadership capabilities and technical expertise so that our next generation of leaders and specialists can take broader responsibilities over time and help produce stronger investment results for our clients.
1 These figures represent indexed assets in registered funds. Assets can also be invested in index-based strategies that are not in registered-fund format, such as separately managed accounts. Source: Setting the record straight: Truths about indexing, Vanguard, January 2018.
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