Andrew Miller: ‘No Index Is Truly Passive’

Our guest this week is Andrew Miller. Andrew is a partner at Creative Planning where he advises clients on financial planning and investment issues. Prior to joining Creative Planning in 2020, Andrew was a partner at Miller Financial Management, where he focused on portfolio construction, financial and tax planning, as well as investment management. He's active on social media--you can find him on Twitter @millerak42--and has authored research on various financial-planning and investing topics that you can find online. Andrew is a CFA charterholder and also is a certified financial planner. He received his bachelor's degree in finance from Indiana University.

Background

Bio

General

“Alpha, Beta, and Now ... Gamma,” by David Blanchett and Paul Kaplan, Morningstar.com, Aug. 28, 2013.

Asset Allocation and Portfolio Construction

“Alternative Investments--A Field Manual,” by Andrew Miller, alphaarchitect.com, Oct. 3, 2019.

“Who’s Afraid of a Big Bad Bear? Many Investors Shouldn’t Be That Concerned,” by Andrew Miller, alphaarchitect.com, March 2, 2018.

Investing

What Is Home Country Bias?

“Investors Have Fewer Reasons Than Ever for Home Bias,” by Ben Johnson, Morningstar.com, June 7, 2019.

“The Illiquidity Discount?” by Cliff Asness, aqr.com, Dec. 19, 2019.

“Rebalance Your Portfolio? You Are a Market Timer and Here’s What to Consider,” by Andrew Miller, alphaarchitect.com, March 23, 2017.

“Large-Cap Price-to-Book Investing: What Is Dead May Never Die,” by Andrew Miller, alphaarchitect.com, June 25, 2019.

“Upside-Down Markets: Profits, Inflation and Equity Valuation in Fiscal Policy Regimes,” by Jesse Livermore, osam.com, September 2020.

What Is FRED?

Retirement

“Using Trend-Following Managed Futures to Increase Expected Withdrawal Rates,” by Andrew Miller,

Papers.ssrn.com, Oct. 7, 2017.

“Using Flexible Spending to Achieve Financial Goals,” by Andrew Miller, alphaarchitect.com, March 5, 2019.

“Should Retirees Still Follow the 4% Rule?” The Long View podcast, Morningstar.com, Dec. 23, 2021.

“The State of Retirement Income: Safe Withdrawal Rates,” by Christine Benz, Jeffrey Ptak, and John Rekenthaler, Morningstar.com, Nov. 11, 2021.

Jeff Ptak: Hi, and welcome to The Long View. I'm Jeff Ptak chief ratings officer for Morningstar Research Services.

Our guest this week is Andrew Miller. Andrew is a partner at Creative Planning where he advises clients on financial planning and investment issues. Prior to joining Creative Planning in 2020, Andrew was a partner at Miller Financial Management, where he focused on portfolio construction, financial and tax planning, as well as investment management. He's active on social media--you can find him on Twitter @millerak42--and has authored research on various financial planning and investing topics that you can find online. Andrew is a CFA charterholder, and also is a certified financial planner. He received his bachelor's degree in finance from Indiana University.

Andrew, welcome to The Long View.

Andrew Miller: Well, thank you, Jeff. And thank you Christine for hosting me.

Ptak: It's our pleasure. Thanks so much for being here. We wanted to start with some general questions, one of which is--more and more advisors seem to be giving up on investment selection. They're instead using broad market indexes to populate client portfolios and aiming to add value through financial planning. Do you think they're wrong in doing that?

Miller: Wrong? No. I think when it comes to looking at how advisors can add value to clients' investment and security selection is probably the least impactful. And that planning itself, there could be lots of different ways to add value--understanding client circumstances, and actually working on financial-planning process. Not sure who to attribute the credit to but have often heard and believed that no amount of alpha can save a bad financial plan. So, the time and effort on security selection is probably better spent working with a client to better cash flow planning or working on insurance or estate planning documents or education planning, Medicare planning--any number of potential topics.

Christine Benz: I wanted to ask about that. In a Morningstar research paper, David Blanchett and Paul Kaplan wrote about gamma, where they identified the key areas where advisors can add value beyond investment selection. If you had to prioritize the key areas where you feel like you and your practice add the most value, could you talk us through that?

Miller: So, the concept of alpha, I think most people attribute to excess return, when alpha is really just unexplained return. And one of the kind of concepts in my mind between alpha--and I know in this case, its gamma--is the concept of zero sum, where in order for a client to win, somebody else has to lose. And I think one situation that is a little bit like that, but where the person who's going to lose, might be OK losing, is the U.S. Government. And I think, therefore tax planning is probably the most important or most impactful as far as when you have the right client and the right set of circumstances, you could add the most value.

Kind of related to that asset location and asset allocation are also incredibly important, and just natural outcomes of a financial-planning process. One that they hinted on that I think also can add a lot of value and that is in the withdrawal process of once someone starts to use their nest egg to actually support themselves in retirement. The levers that you can pull to help prolong the assets or add some flexibility into how much they might be able to withdraw from their portfolio is incredibly impactful. I thought they approached it in a somewhat novel way, by looking at the amount of return that would be required from the portfolio, in a normal 4% withdrawal rate and treating that as gamma, so to speak, in the research paper. Investment selection, again, probably comes in dead last here. I don't think it’s going to make a big impact in someone's financial plan or the outcome. And probably advisors are well-served spending the least amount of time in that topic area.

Ptak: You talked about investment selection being one of the areas that's perhaps a bit overrated. What else do you find in practice, advisors, planners might overrate a bit, or for that matter, that their clients might overemphasize where just the ROI isn't really there?

Miller: That's a great question. I feel somewhat inequipped to answer that. So maybe thinking just generally in the planning process, it's important to understand generally where a client is and where they want to go. And different clients are going to have different topic areas that you cannot spend as much time on. As an example, a married couple with with no children and two working incomes probably don't need to spend too much time in prioritizing life insurance, as an example, and how to structure that to minimize cost, how to go about ensuring that. So, I'd say, maybe client-dependent, that as you get to know someone's circumstances, it'd be on a more client-by-client basis. I'm not sure if that adequately answers your question, though.

Ptak: It does. Thank you.

Miller: OK.

Benz: You've said something like all the alpha and tax optimization in the world isn't important unless it can be translated back into something the client actually wants. So how does that principle inform the way you set goals with the clients who you work with?

Miller: It all starts with the big picture. If anybody's read, 7 Habits of Highly Effective People, starting with the end in mind, is critical to the planning process. Sitting down with the clients and helping them translate important and meaningful life events into planning geek of when, how long, how much is helpful. And that then allows us to work backward to tie in their goal into very practical decision-making purposes. And it acts as a guidepost all along the way where you can begin to help answer the questions of does this move you toward where you said you wanted to go or away from, and if a different decision or a topic that you can talk about with a client seems to be in conflict with the stated goal, that's a key sign to stop and spend a lot more time talking about that, because that means that either their goals have changed in their financial plan and where they want to go. Or perhaps it's a sign that the client and the planner aren't on the same page, as far as trying to achieve the same goal.

So, a lot of times, there's a lot of information in conflict, when you start to get answers that don't seem to answer the client’s plan. And then once you understand where the client wants to go--for example, how a portfolio is implemented, whether it's with very inexpensive index funds, or a whole bunch of whiz-bang portfolio implementation. Once you can translate the implementation then into how the goal is going to be achieved, it makes it easier to stick through the inevitable ups and downs. And the client is well informed as to why you're doing certain things, and you, the planner, are informed on why you're doing certain things. And I'd say maybe I'm weak-minded, but it seems like sometimes planners can go through the same questioning process on implementation sometimes, as clients might go through about, are we really doing the right thing? Is this really implemented in the best way? It's pretty easy to second guess. So, when you can tie that second-guessing back to a core tenant, and why you're doing something, makes it a little easier to stick with it.

Ptak: Since you mentioned portfolio construction, I thought I would go there next. I think that you've written--when building a portfolio, you shouldn't forecast, but instead should build what you call a portfolio of compensated risk premiums and look to collect free options along the way that might hedge risks. What does that mean in practical terms?

Miller: That's a great question. Jeff. I think some of that is taking a look at someone's circumstances in the planning process. And I'll use a hypothetical example here, but one that is maybe more timely and pertinent. When you're working with an individual, and the individual portfolio is intended to cover withdrawals or expenses for the rest of their life, is you take a look at that in a very geeky sense that liability is a real liability in the sense of it adjusts upward and downward for the rate of inflation. Well, that means that potentially when you look at the types of bonds that that client might own in a portfolio, inflation-protected bonds might be a far better fit in that portfolio than nominal bonds.

And so, if the market is efficient, the inflation-protected bonds and the nominal bonds should have about the same expected long-term return at any point in time. But the TIPS provide some inflation hedging for the portfolio and is picking up a free option on unexpected inflation shocks to the portfolio. You can take a look at doing something similar various aspects of portfolio for inflation hedging as an example. Arguably, owning perhaps a little more energy or value in a portfolio could potentially help hedge some inflation risks. Owning international stocks denominated in foreign currencies could do the same thing. All of these help further diversify a portfolio and potentially hedge some risks embedded in a client's plan that if the portfolio's implemented in a slightly different way, may not be as successful in eliminating some of those risks.

Benz: I wanted to follow up on that comment about various inflation-protective investments. We've been hearing so much about inflation, obviously, recently. And I wonder if some investors might be inclined to jump in and out of inflation protection based on how concerned they are about it? Is that a bad way to approach it? Should people have permanent inflation-protective qualities in their portfolio and not try to time their entrances and exits?

Miller: Great question. Christine, I think some of that might be dependent on what they're using. So as an example, if someone were to want to use commodities, or gold, or something like that, to potentially hedge inflation risks, there's been a lot of research to show that commodities in and of themselves don't really provide a risk premium. And I'm not sure a permanent allocation to commodities make strategic sense versus something like TIPS or real estate, or foreign stocks denominated in foreign currencies, or even the same with bonds. There's a risk premium there and it probably makes sense to have a strategic long-term allocation that doesn't make sense to time. And I think, as you build a portfolio, the more degrees of freedom and the more choices that you have in how the portfolio is implemented, frankly, the more chances there are to mess it up, and timing is one of those and can be a big one. And so, taking the timing risk out of the portfolio, or even a piece of it, can greatly reduce the harm that can be done to the portfolio. And kind of longer-term strategic risk premiums make a lot more sense of just know why you put it in there. Know that it's going to go through times when it works well, and it doesn't, and try to continue to hold on to it no matter how the performance is.

Ptak: Just to build on Christine's prior question--are you getting a lot of questions from clients right now about how resilient their plan is to inflation? And how are you reassuring them that it is? And are there any changes that you're making in light of recent events, including the uptick in inflation?

Miller: Great question. I like to take a look at different scenarios every time we update a plan. And those different scenarios can be anywhere from what happens in a bear market when stocks decline 50%, and what happens to your plan, assuming that that happens, to taking a look at higher inflation and the impact that that can have on your plan. So, some of the conversations are had ahead of time and preemptively to help people understand what happens to their plan, what kind of risks are embedded in their financial plan. And really prepare for these types of events ahead of time, not necessarily that we could predict that they're going to happen. But any financial plan is wrong as soon as you hit “print”--that doesn't mean that it isn't useful.

And the way you can make it useful is you simply begin to adjust assumptions that you make and different states of the world and see what happens to the plan. And if there's a scenario or an outcome that is unbearable to the clients or in the plan, that's a really great sign of, this risk needs to be addressed--either self-ensure it, or pay to have this risk insured, or create a portfolio that helps hedge the risk. Specifically, with recent conversations, we've had some conversations about, we expect these types of assets to perform well in periods of inflation. TIPS is a great example; value stocks is another example—an asset that tends to do well during times of inflation. And patting ourselves on the back a little bit about not abandoning value after a decade where it's been very tough to be a value investor and saying, this is why you don't try to time things. It can take decades sometimes for some of the portfolio construction to really pay off.

Benz: Speaking of risk, you have said that investing based on risk capacity is superior to investing based on risk tolerance. Can you talk about the distinction between those two things? Because I think some people have questions about that. And also, why do you think it's so? Why do you think that risk capacity is the more important thing to be attuned to?

Miller: Great question, Christine. Let me take a second and define each, where I would define risk capacity as the ability for someone's financial plan to absorb downside risks in markets. And the way that I would look at that is, when you do a financial plan, you can create a scenario where it could be anywhere from a run-of-the-mill bear market, to potentially measuring--and I apologize for how geeky this may sound--something like a value at risk, or how likely or unlikely it is that someone's surplus in their financial plan is likely to be wiped out by their existing investment portfolio. All of those are a form of risk capacity-- it's an actual definition, you can measure it--of how likely or how well their plan would do to absorb market risk.

Risk tolerance is simply a client's ability to stick with their stated asset allocation or what asset allocation works for how much wiggle they can tolerate month to month or year to year in their investment portfolio. The reason I think risk capacity is likely superior is, one, it's directly measurable; and, second, is we can kind of control it. Risk tolerance can be a little more volatile, it's harder to measure. A lot of studies have shown that risk tolerance is dependent on recent market performance. So, risk tolerance tends to go up when investment performance has been good and down when it's poor. And it's important to respect risk tolerance. But we can actually help control and define risk capacity and ensure that the risk-capacity measure isn't ever really violated in a client's portfolio.

Ptak: I'd imagine in practice, those things, how you are feeling about the environment, which is maybe more akin to how we would define risk tolerance can be in conflict with put pen to paper and come up with a measure of risk capacity. I think back to periods that we've had only recently, where stocks were maybe running really hot and meme stocks were in a frenzy. And so, it could be that some of your clients are feeling like they want to take a little bit more risk; they're feeling more tolerant about it. Can you talk about in practice, how you have those conversations to reconcile those two things and keep the client, ensure that they adhere to the plan?

Miller: I'd say the first thing that often comes up is, changes on the margin aren't likely to move the needle very much. So, if a client wants to take slightly less risk or slightly more risk, there's likely not much harm done in doing so. Second, it takes an opportunity to take a look at the portfolio implementation itself and oftentimes, in a well-diversified portfolio a client likely owns some of the meme stocks somewhere. That also means on the flip side, sometimes when certain companies hit the news headlines in not a great way it also means they likely own some of it as well. But that often comes back to, and I think that's a great example of the comments earlier, about understanding the whys of the financial plan, because that answer is often, “Well, if you'd like to own more meme stocks, how does that help you achieve your plan?”

And oftentimes, what you find is a client perhaps feels like they might be being left out, or that their neighbor might be getting slightly richer, slightly faster than they are. But it's not actually about achieving the plan, their stated plan. We can have some good conversations around revisiting some first principles of why it is that they’re doing what they're doing and why they want to do what they want to do. But if they want to own a little bit of a particular stock, it won't violate a risk tolerance and risk capacity, and likely won't move the needle. And sometimes they can find out later on down the road, maybe this wasn't a real great decision and happy that we stuck with, for the most part, what the plan called for all along.

Benz: One lively debate in our financial community is the utility of target-date funds. You came up with a cool flowchart that actually helps someone decide whether a target-date fund is appropriate for them. Can you walk us through that visualization?

Miller: Well, Christine, this actually started from a little bit of a Twitter conversation that we had, and I'm sure you were shocked as I am that 240 characters doesn't exactly allow for the nuance of some of these discussions. Target-date funds I think are a great way to have a starting allocation or an anchor point to what someone should own. And, for the most part, provides a pretty good portfolio for someone who perhaps wants to spend 30 seconds a year in taking a look at what they should be doing. As you begin to delve deeper into target-date funds, there are a number of assumptions that are made. And, depending on the methodology of the target-date fund provider, what they're really trying to do is take a look at human capital and financial capital, where human capital is all of the future savings that someone is going to make, and the financial capital being the actual balance of their retirement savings.

And the first thing to take a look at is, are you saving more than whatever the methodology calls for? And different firms use different methodologies. It's been a while since I've read it, but I think a large firm somewhere in Valley Forge assumed about a 6% gross savings rate in computing their human capital. And they try to then adjust the stock and bond allocation, where they treat human capital as a bond or something similar to a bond. And that's why the asset allocation starts out very heavy in stocks and gets less aggressive over time, under the assumption that human capital becomes a smaller part of the overall portfolio and the financial capital a larger part. And, therefore, getting less aggressive in stocks, or less aggressive overall, helps offset that.

So the first thing to look at is a long-winded way to get to, are you saving more than is implied in the methodology? The second is going to be, are there other things that are happening in your financial life that act a lot like a bond? So if someone's carrying a lot of debt that's higher-interest credit card debt, they might be better off to take some financial capital, decrease their bond allocation, and pay off the higher interest credit card debt. Effectively, it looks the same as owning a bond, except it's just a much higher-returning bond. People could have different actual target dates. And then one of the big differences comes down to tax optimization.

And I think there's been a great recent example of that from another fund family, where the target-date fund had a really large capital gain payout. People who owned a target-date fund in a taxable account, were probably unpleasantly surprised to find out some of the downsides to not tax optimizing their investments. And so, there are just a number of small things to consider that, if any of those apply to you and your circumstances, it might be worth taking a look at doing a little more research each year and how you implement your portfolio. If none of those apply, that's probably a good sign that perhaps a target-date fund is just fine for you.

Ptak: I wanted to stick with portfolio construction if we can, specifically in the topic of home country bias. I think you've written about the problem of home-country bias whereby an investor comes to disproportionately weight their home country. My question for you is whether an argument can be made that a home country bias is justified to hedge against risks that are maybe unique to an investor's home country? For instance, rising housing and goods prices, those might reflect a strong local economy, which would translate to a higher local market return. But if an investor were to overweight foreign markets, there's potentially a mismatch there, where maybe they're not earning that higher return and yet they're faced with these rising costs. What do you think of that?

Miller: Potentially it has some merit. I think one would need to drill down further. I think a great example might be if you're a Swiss investor, for example, owning a lot of Swiss stocks might cause a lot of sector imbalance in your portfolio and might be something to take a look at about whether that's really an intended implementation of your portfolio, or an unintended implementation of your portfolio. Depending on how specific you get, hedging out the currency risks, or embracing the currency risk could be another way to potentially address some of the potential home country bias, and whether you'd really like to take it or not.

I think, in some ways, the market itself is incredibly intelligent in how it integrates and prices risk. And I think a very good starting point for every investor should be start with a global portfolio and begin to ask yourself, why would you want to deviate from that? And to the extent you have good answers, deviate from the market portfolio, not just a portfolio of local stocks. And personal thought--that you're much more likely to end up with a much better efficient portfolio that probably does a better job of helping you get where you want to go than simply biasing yourself to names of companies that you're familiar with, because you use on a daily basis. Peter Lynch probably would disagree there. But I still think you'd end up with a better overall portfolio.

Benz: Can you talk about how you approach that, from a practical standpoint, with client portfolios, setting their exposure to U.S. versus non-U.S.? How do you do it?

Miller: Christine, that is something that's probably been, I've changed my views on a little bit. I think all diversification runs in a spectrum, where the most helpful step of diversification is the first step. And you can get a long way to optimal with very little effort. And I would say, I used to be one that would try to optimize to the nth degree and try to get very close to global market-cap weights with maybe a little bit of a home-country bias. But there's a whole range of acceptable. So, if somebody doesn't have any international exposure, allocating 10% to international is going to go a long way; 20% will get you closer, and then there's just diminishing marginal utility from there. I'd also say, it would be important to take into consideration how likely the potential investor might be to stick with the portfolio when things don't go well. And if a 20% allocation to non-home country allows them to stick with the portfolio through ups and downs, that's the right answer, especially if 21% would cause them to throw up their hands and say, “This doesn't work; I'm changing.”

Benz: Do you tend to vary that exposure to non-U.S. by age at all? Is it more appropriate for younger investors to be closer to that total global market cap and then older investors might want to back off of that a little bit or are you age agnostic?

Miller: It's largely age agnostic and sometimes it's client dependent. Someone might have a lot of embedded gain in international position--although it may not necessarily feel like it now--that you continue to hold on to something, maybe even though you wouldn't in a vacuum decide to hold on to it simply because of the tax consequences. So, it's important to take a look at exactly what's happening and the clients and what it means for them in their portfolio. And not necessarily say, “Well, we want to have 42.5% of portfolios in international stocks, and we're going to make it so.”

Ptak: I think we want to talk about stocks and bonds of which you've written thoughtfully, previously. But before we go there, I did want to ask a quick portfolio-construction-related question about real estate. I think you've written that you're fond of it, because it sounds like it's for behavioral reasons, to a certain extent that even your most risk-averse clients are willing to own it despite its low liquidity because the price doesn't rattle around that much. Do you think a similar case could be made for private equity, which is a topic that's come up now and again on this podcast, and private equity is I think, as we know, they're making a bid to go down market more to retail and high-net worth? So, what do you think of that as a potential candidate for an allocation to clients that you work with? Is there a behavioral case that could be made for it?

Miller: Certainly there's a behavioral case. And I think Cliff Asness has written extensively about--historically people view it as illiquidity premium of earning a higher return because the money's locked up. And I think he's even somewhat recently written a piece that they call “The Illiquidity Discount”--that arguably one of the reasons it's been so successful, and you may get lower returns going forward, is because of the behavioral aspect. That they're being paid to hide the volatility that really exists, but because they're private, you can smooth out. Another example of perhaps where opinions would have changed between now and a little while ago--to the extent a client needs an equity risk premium in their portfolio, anything that will help them earn that equity risk premium, not only on paper, but also in practice through behavioral changes, is fantastic. And I'm not quite sure what it might mean for downstream investors--I like that terminology--whether they're kind of prepared for it or not. But to the extent that it can be a tool that people can use to help them achieve their goals and plans. I'm all for that.

Benz: Switching over to discussing investments a little bit more, you've said, you're fascinated by what you call the “active decisions of indexes.” Can you explain what you mean there and why you think that's worth paying attention to what goes into an indexes construction?

Miller: Christine, I can probably talk about this till I'm blue in the face. I really do. I'm sure I'm lots of fun at cocktail parties. I really do find this fascinating. A great example, recently, Tesla was added to the S&P 500, somewhere about almost exactly 12 months ago, and I think a couple of other companies were kicked out. And no index is truly passive. In S&P 500, there's a committee that gets together and decides what companies are included, which ones aren't. And, in this instance, much like historical patterns have been, the timing of the addition of Tesla wasn't really great. And Tesla's gone on to underperform the two companies that were kicked out over the last 12 months by a pretty meaningful amount. That's just one example of some of the ways that indexes make these kinds of decisions about what gets included and what doesn't.

I think another great example, historically, has been the S&P 600 has had some de facto, I'll call it, quality filters. They require companies to have positive earnings over the trailing 12 months, whereas the Russell Indexes don't have that same requirement. And that seemingly minor distinction can sometimes create some fairly meaningful dispersions in returns over time. So as one begins to think about choosing an index on how to implement a portfolio, sometimes it's not as simple as just choosing an index fund--that actually becomes important which index fund. And that is greater compounded by the fact that as investment costs come down, they have the ability now to pick different indexes based off of basis-point difference in costs. The little decisions about inclusion criteria, or trading implementation on how companies are added or deleted, and how well they're communicated or not to other investors, really can make a very big difference in performance between indexes over time. So, it's important to be aware of those choices on just minutia. Because it really does add up over time.

Ptak: I think one example of that, that you've written about before, is how one defines value. I think earlier in the conversation you expressed your affinity for value investing. One popular measure of value has been price/book or book/market, whichever you prefer. Does it still work as a measure of value? It seems like it is important because there are some index families that use price/book, or something like it, to define growth versus value. And if price/book doesn't work, what should value investors use as a rule of thumb for value instead?

Miller: Jeff, great question. I'll start with: They all work. And what they're trying to do is approximate what one might argue as a very accurate discounted cash flow analysis on every company. And value investing off of metrics is just a shorthand way to go about doing that. Now, the question is, are some better than others? And I think the answer to that question is also, yes. So maybe on the one extreme of kind of the least helpful, even something like sorting companies on past five-year performance is very correlated with a value composite, if you will, of all the other ways to measure value. Price/book I think has some potential theoretical flaws.

I think I'll probably get this term wrong--pseudonym Jesse Livermore had a very insightful and very long-winded research article about how, because price/book is a measure of "stock and not flow," it's impacted by inflation, and the price that a company may have paid for something a long time ago. During periods of high inflation, and over time because of inflation, it's a less-accurate representation of the value of those assets. That's also the case for things like goodwill, where the name of a company could be worth something and that amortized over time.

So, it may just be less accurate of a representation of value. Whereas something like sales/enterprise value perhaps might be better because it captures the whole capitalization of a company and is something that is less likely to be manipulated on the income statement. It's all varying degrees of accurateness in trying to approximate a nice full discounted cash flow analysis of a company. Interestingly enough, if you go back to the original works of Fama and French, the way that they constructed the market-neutral value index, if you will, to determine if value investing "worked," was they took half the portfolio and they invested in large-company stocks that were value based, and half with small-company stocks that were valued based.

And when you use book/market, which is what they used to sort, book/market works in smaller companies, but it actually never worked in the larger companies. And there could be numerous reasons why. But when you do the same sort, but on price/earnings, price/earnings as a value metric, "works" in both large companies and small companies. So how you measure the value factor can have an impact in performance over time. You can also run into certain things like how little decisions impact results--they're using month-end data. And so there can sometimes be a turn-of-the-month effect, where you get a little slightly better performance after the turn of a month than before.

So even the value premium itself could be perhaps inflated due to some of the decisions on when that portfolio was rebalanced and reconstituted. So sometimes a lot of detail needs to be paid attention to before you can proclaim something works or something doesn't. That said, they all tend to follow each other, because they're all being a proxy for the same thing. And that is the cheapness of a company to some fundamental metric.

Benz: Wanted to switch over to ask about interest rates. Rates are rising, and that seems to be creating turmoil everywhere we look. Does that mean that price multiples will definitely compress during this period? Or do you think that's too simplistic?

Miller: Well, I fear that my actual answer will be very unsatisfying. And that is, I'm not sure. So let me perhaps, maybe throw some ideas out on some things to consider on why I'm not sure. Interest rates you can break down into two components: one being the real rate, or the rate over and above inflation; and the second is just inflation. And if interest rates are rising, but the real rate is staying the same, I could see an argument for: no, price multiples really shouldn't change, because investors at large, aren't really demanding a larger premium for having capital invested. One converse of that also can be true. There's also a case to be made that as you value a company in a discounted cash flow, somewhere along the line, you're going to be running into this nasty thing called weighted average cost of capital being your discount rate. And interest rates are embedded into that computation. So as interest rates go up, arguably, your weighted average cost of capital is going to be going up. And when that happens, prices go down. So, I could see some theories on both sides making a lot of sense. And typically, when I see that, my conclusion is I'm simply not smart enough to make a call one way or the other.

Ptak: I wanted to stick with bonds for a minute. I think that you have written that investors don't necessarily get paid for credit risk, which I think probably will strike to some as counterintuitive. Can you talk about why you have that view? And why it would be the case that investors wouldn't get paid for credit risk?

Miller: Well, Jeff, I think to quickly answer that question, they've gotten paid a little for taking credit risk, but it's, I think, far less than people think. There's a really neat database by the St. Louis Fed, called FRED, where you can look up a whole bunch of data series. A great way to spend a Saturday morning with coffee if you're data geek. And one of the data series in there is an option-adjusted spread computation for the bond market at large. And you can use that as a rough approximation for how much should an investor get paid for taking credit risk? And when you regress that against the actual return of investable indexes, or however you want to look at it, it's not a dollar-for-dollar kind of trade off there, and investors get paid a fraction of the option-adjusted spread. And what's happening is certain indexes have requirements on credit ratings of the bonds that get to make up those indexes.

And what one tends to find is that as different bonds are downgraded, they begin to leave the indexes. And the owners of those are left with the losses from the downgrades over time, and there simply isn't much return that's picked up. Very theoretical way--I think a researcher at AQR wrote about, there's some very good fundamental reasons why equity risk and credit risk should be very related. And that if you take a look at sector composition of credit indexes and equity indexes, they're very, very different. And the lack of credit risk premium could also just be due to some luck on the way that the sectors were constructed in the credit indexes versus the equity indexes. So that's kind of a long-winded way of saying empirically, people haven't been rewarded for taking much credit risk. But it doesn't necessarily mean that they won't going forward. Because it could be due to something as simple as sector composition.

Benz: It sounds like you're not a believer in stretching for yield into longer maturities either. I'm wondering if you can explain your thinking there. Also, I guess the takeaway is, what should investors who want fixed-income exposure be doing and maybe maybe you can talk about how you position client portfolios in terms of their fixed-income exposure?

Miller: Generally, I'm not a huge fan of owning longer-duration bonds. But it certainly can make sense for some investors. As you think about pension funds who have a liability they need to match to an asset, longer-duration bonds make a lot of sense there. For most individual investors--this may be little simplistic--but the way that portfolios are constructed, generally would be: You can use 10 years or so of withdrawals--I'm just making this number up; it'd be very client-dependent--and have that matched against the bonds in their portfolio. And any cash need out of the portfolio beyond say 10 years is pseudo-matched by their stock exposure. And the reason I say that is you can take a look at the likelihood that stocks have retained their nominal value over time. And hitting about a 10-year mark, it's very, very, very likely that stocks will have retained at least their nominal value. And so bonds may not make a whole lot of sense from that point going forward.

When you think about it that way, it addresses your second question, Christine, on how we implement bond portfolios for clients is really done in a sense a little bit like a pension fund, where the first several years’ worth of withdrawals are duration-matched to a bond portfolio. And anything longer than a need of say, somewhere between 10 and 15 years, it's not necessarily duration-matched, but we use equity, or stock exposure and real estate exposure and other exposures, to statistically replicate a bond in the sense that it's very, very likely that the value of those investments will be greater than the starting value over that period of time.

Ptak: How about annuities? Where do they fit in? I think a lot of the academic research points to the value of annuities in retirement drawdown. Do you use them? And if so, what kinds?

Miller: That can be a very wide range of potential uses. So, annuities run the gamut from very, very simple to incredibly complex. I think there could be a couple of great roles for some simple annuities and client portfolios, where we talk about creating a plan and understanding the risks in a client's plan. If longevity is a risk, and it's perhaps bizarre and morbid to think about it that way, but to the extent that longevity is a risk in a client's portfolio, single-premium annuities can be a wonderful tool to help hedge some or all of that risk. Risk is never really destroyed or created; it's simply transferred. So, using something like a single-premium annuity introduces things like liquidity risk and default risk with the insurer. And so those have to be weighed in the decision to use those, as well as if a client has a bequest that they want to make, using an annuity presents its own kind of risk.

It's trying to create an implementation of a portfolio that helps eliminate risks that clients want to eliminate. And allow a client to get paid risks in places where they're OK taking risks and should be paid for embracing them. Potentially some other benefits--some insurance companies are coming out with really, really low-cost variable annuities, where what you're really buying is tax deferral. In certain circumstances with clients and certain tax rates and time horizons, that tax deferral can be worth way more than the cost of the annuity itself. So, that’s another example where that could potentially come into play. But oftentimes, what you see is that things like guaranteed minimum withdrawal benefits and annuities with caps and different participation rates and things like that--clients often pay more than the value of the embedded option in those annuity contracts. And oftentimes, those don't make a lot of sense.

Benz: Sticking with retirement, in-retirement withdrawal rates are a hot topic, or at least to us. What sort of system do you use when setting your clients' withdrawal rates and determining how much they can take out of their portfolios sustainably over their retirement time horizons?

Miller: That, I think, Christine is a great plug for everyone to actually have a customized financial plan for them. Using a rule of thumb withdrawal rate is great when the only asset that a client has to fund their withdrawal needs in retirement is their portfolio. But the reality is, most clients, and everybody else, has at least one other asset, and that is Social Security. And when you begin to, for example, marry their portfolio withdrawal with their Social Security-claiming decision, you can have withdrawal rates that are very, very large, for example, until age 70, and then much, much smaller than even a 4% after age 70, when Social Security begins to be claimed. You have clients with pensions and investment real estate and farmland, and all of these different sources of income and cash should be taken into account when understanding the sustainability of a withdrawal rate.

So, all of that said, the financial plan should really address: how likely are you to achieve your goal? What kind of surplus is there? How does your risk capacity play in and shock your financial plan for risks that are likely to happen? Big bear markets, higher inflation--what happens to your plan and your surplus? And as long as the intended withdrawals don't cause the plan to fail, you're at a withdrawal rate that works for you and your specific financial plan. So, 4%'s a decent rule of thumb. I think you've recently written some great research that shows that it's likely lower. And there are some things that maybe argue that it's not nearly as dire as some of those would appear. But people should really have a customized withdrawal plan for their portfolio and their other income sources.

Ptak: Wanted to close by asking about charitable giving. You're a fan of donor-advised funds. One knock on them is costs--even Vanguard's charitable, or I should say donor-advised fund, charges a 60-point admin fee on top of the investment costs. Given that, how do you urge clients to use donor-advised funds so as to limit the expense drag on their eventual charitable gifts?

Miller: Quickly. Fund it and disperse it. And if that's a problem, the big benefit of doing donor-advised funds is the ability to gift appreciated securities in kind. One can work with a lot of charitable organizations, and you can actually gift directly without having to use a donor-advised fund. But there are costs associated with it. So certainly, measure the benefit you're deriving from the use of a donor-advised fund and make sure that you're getting a lot more benefit than you're paying in cost. It tends to be the case with most clients. But a lot of times in life, there are trade-offs to some of the benefits that the one receives, and as long as you're OK and knowledgeable of it, then by all means move forward.

Ptak: Well, Andrew, this has been a very interesting discussion. Thanks so much for sharing your time and insights with us. We really appreciated it.

Miller: Well, Jeff, you're very welcome and Christine, it’s fantastic.

Benz: Thank you so much.

Ptak: Thanks for joining us on The Long View. If you could, please take a minute to subscribe to and rate the podcast on Apple, Spotify, or wherever you get your podcasts.

You can follow us on Twitter @Syouth1, which is, S-Y-O-U-T-H and the number 1.

Benz: And @Christine_Benz.

Ptak: George Castady is our engineer for the podcast and Kari Greczek produces the show notes each week.

Finally, we'd love to get your feedback. If you have a comment or a guest idea, please email us at TheLongView@Morningstar.com. Until next time, thanks for joining us.

(Disclaimer: This recording is for informational purposes only and should not be considered investment advice. Opinions expressed are as of the date of recording. Such opinions are subject to change. The views and opinions of guests on this program are not necessarily those of Morningstar, Inc. and its affiliates. Morningstar and its affiliates are not affiliated with this guest or his or her business affiliates unless otherwise stated. Morningstar does not guarantee the accuracy, or the completeness of the data presented herein. Jeff Ptak is an employee of Morningstar Research Services LLC. Morningstar Research Services is a subsidiary of Morningstar, Inc. and is registered with and governed by the U.S. Securities and Exchange Commission. Morningstar Research Services shall not be responsible for any trading decisions, damages or other losses resulting from or related to the information, data analysis, or opinions, or their use. Past performance is not a guarantee of future results. All investments are subject to investment risk, including possible loss of principal. Individuals should seriously consider if an investment is suitable for them by referencing their own financial position, investment objectives and risk profile before making any investment decision.)