Vanguard’s view on portfolio construction and ETF model · Building a diversified equity...

Vanguard’s view on portfolio

construction and ETF model

portfolios

2

Guarded, but not bearish outlook

34%

62%

40%

63%

58%

Economic

outlook

• Low growth,

not stagnation

• 3 structural

forces:

Demographics

Globalisation

Technology

• Uneven but

resilient

• Policy

uncertainty

• Decent

growth, but

dented by

political

uncertainty

• Brexit likely to

be costly for

UK

• Hard landing

unlikely

• Policymakers

in “fighting

retreat”

• Structural

headwinds

• QQE with

yield curve

control

Source: Vanguard.

3

-5%

0%

5%

10%

15%

20%

25%

Global Equity(Unhedged)

Global Bonds(Hedged, USD)

Inflation 20%/80% 60%/40% 80%/20%

Historical Average: 1958-2016

Historical Average: 2000-2016

Return expectations need to be realistic

Projected ten-year nominal return outlook

Source: Vanguard Capital Markets Model (see disclaimer).

4

What does Vanguard believe? Focus on elements within your control

Source: Vanguard.

Vanguard’s principles for investing success

Cost

Minimise cost.

Balance

Develop a suitable

asset allocation

using broadly

diversified funds.

Goals

Create clear,

appropriate

investment goals.

Discipline

Maintain

perspective

and long-term

discipline.

Vanguard’s principles for investment success

5

The strategic asset allocation drives the experience

86%

14%

Asset allocation

Security selection and markettiming

Source: Vanguard based on Hong Kong balanced funds, as at February 2014.

Investment return variability is largely determined by the mixture of assets in a portfolio

6

Source: Barclays Live, FactSet, and Morningstar as at 31 December 2016. Notes: Benchmarks: Global Bonds: Bloomberg Barclays Global Aggregate Index Hedged to HKD. US Equity: FTSE US.

Japan Equity: FTSE Japan. Europe Equity: FTSE World Europe. Hong Kong Equity: FTSE Hong Kong. World Equity: FTSE MPF All-World.

The next “winning” asset class is impossible to predict

Rank 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016

1Japan

Equities

HK

Equities

HK

Equities

Global

Bonds

HK

Equities

HK

Equities

Global

Bonds

HK

Equities

US

Equities

US

Equities

Japan

Equities

US

Equities

2HK

Equities

Europe

Equities

Europe

Equities

Japan

Equities

Europe

Equities

Japan

Equities

US

Equities

Europe

Equities

Japan

Equities

Global

Bonds

Global

Bonds

MPF All

World

Equities

3

MPF All

World

Equities

MPF All

World

Equities

MPF All

World

Equities

US

Equities

MPF All

World

Equities

US

Equities

MPF All

World

Equities

MPF All

World

Equities

Europe

Equities

MPF All

World

Equities

US

Equities

HK

Equities

4Europe

Equities

US

Equities

US

Equities

MPF All

World

Equities

US

Equities

MPF All

World

Equities

Europe

Equities

US

Equities

MPF All

World

Equities

HK

Equities

MPF All

World

Equities

Global

Bonds

5US

Equities

Japan

Equities

Global

Bonds

Europe

Equities

Japan

Equities

Europe

Equities

Japan

Equities

Japan

Equities

HK

Equities

Japan

Equities

Europe

Equities

Japan

Equities

6Global

Bonds

Global

Bonds

Japan

Equities

HK

Equities

Global

Bonds

Global

Bonds

HK

Equities

Global

Bonds

Global

Bonds

Europe

Equities

HK

Equities

Europe

Equities

7

Diversification leads to lower risk across cycles

-10%

-8%

-6%

-4%

-2%

0%

2%

Sources: Vanguard, using data from FactSet, Barclays Live and Bloomberg. Notes: US equities represented by Dow Jones U.S. Total Stock Market Index through April 2005, MSCI US Broad Market Index through June 2013 and CRSP US Total Market Index thereafter; emerging markets equities by MSCI Emerging Markets Index; REITs by FTSE NAREIT Equity REIT Index; dividend stocks by Dow Jones U.S. Select Dividend Index; commodities by S&P GSCI Commodity Index; high-yield bonds by Bloomberg Barclays U.S. Corporate High Yield Bond Index; emerging markets bonds by Bloomberg Barclays EM USD Aggregate Index; investment-grade corporate bonds by Bloomberg Barclays U.S. Corporate Index; US Treasury bonds by Bloomberg Barclays U.S. Treasury Bond Index; hedge funds by HFRI fund-weighted total return Index; and non-US bonds by Bloomberg Barclays Global Aggregate ex-USD Bond Index. The Dow Jones U.S. Select Dividend Index starts in January 1992; Bloomberg Barclays EM USD Aggregate Index starts in January 1993; hedge fund data start in 1994 and Bloomberg Barclays Global Aggregate ex USD Bond Index starts in January 1990. All data provided through 31 December 2016.

Median return of various asset classes during the worst decile of monthly equity returns, 1988–2016

8

Diversification

Understanding today, investing for tomorrow

Relative to history, we can expect…

• Low growth

• Low rates

Managing this world requires disciplined investing…

ETF

s

Indexing Low costs

ETFs

Source: Vanguard.

• Low inflation

• Low(er) returns

9

Active management has been challenging

Percentage of active funds outperforming the average return of low-cost ETFs over

the five years ending 31 December 2016

Source: Vanguard, using data from Morningstar through 31 December 2016.

36% 36%

49%

16%

44% 43%

0%

20%

40%

60%

80%

100%

Asia ex Japanequity

Japanese equity Emerging marketequity

US equity Global equity Global fixedincome

Perc

enta

ge o

utp

erf

orm

ing

Based on survivors and dead funds

10

In a low-return environment, costs matter even more

The long-term impact of investment costs on portfolio balances

Note: The portfolio balances shown are hypothetical and do not reflect any particular investment. The final account balances do not reflect any taxes or penalties that might be due upon distribution.

The data assumes a starting balance of $0 with $40K investing annually and a yearly return of 6%, which is reinvested. Source: Vanguard, using data from Morningstar.

25-year-old investor

Saves HKD 40K

per year for their retirement

Fees

Managed fund: 1.27% pa

ETF: 0.42% pa

HK$0

HK$1,000,000

HK$2,000,000

HK$3,000,000

HK$4,000,000

HK$5,000,000

HK$6,000,000

HK$7,000,000

HK$8,000,000

40 yrs old 50 yrs old 60 yrs old 70 yrs old

Managed Fund ETF

+ HKD 67K

+ HKD 259K

+ HKD 729K

+ HKD 1.8M

11

Four Vanguard US ETFs provide global coverage

27%

23%23%

28%

Model portfolio: US-domiciled ETFs

Total US Stock:VTI

Total InternationalStock:VXUS

Total US Bond:BND

Total InternationalBond:BNDX

Sources: Vanguard, using data from FactSet. Notes: Corresponding indices used for each ETF are as follows: VTI: Dow Jones US Total Stock Market through 22 April 2005; MSCI US Broad Market

Index through 2 June 2013; and CRSP US Total Market Index thereafter. VXUS: Total International Composite Index through 31 August 2006; MSCI EAFE + Emerging Markets Index through 15

December 2010; MSCI ACWI ex USA IMI Index through 2 June 2013; and FTSE Global All Cap ex US Index thereafter. BND: Bloomberg Barclays U.S. Aggregate Bond Index through 31 December

2009; Bloomberg Barclays U.S. Aggregate Float Adjusted Index thereafter. BNDX: Bloomberg Barclays Global Aggregate ex USD (USD hedged) through January 2003; Bloomberg Barclays Global

Aggregate ex-USD Float Adjusted RIC Capped Index Back Tested (USD hedged) through January 2013; and Bloomberg Barclays Global Aggregate ex-USD Float Adjusted RIC Capped Index (USD

hedged) thereafter.

Portfolio characteristics

Asset class 50% equity/50% fixed income

TER 10 bps asset-weighted

Number of global stocks 9,000+

Number of global bonds 20,000+

Index performance

15-year annualised return 6.1%

15-year annualised volatility 7.8%

12

Building a diversified portfolio with Vanguard UCITS ETFs

50%

4%

14%

3%

13%

16%

Diversified portfolio: UCITS ETFs

FTSE All-World UCITS:VWRL

EUR Corporate Bond UCITS:VECP

EUR Eurozone GovernmentBond UCITS:VETY

U.K. Gilt UCITS:VGOV

USD Corporate Bond UCITS:VUCP

USD Treasury Bond UCITS:VUTY

Sources: Vanguard, using data from FactSet. Notes: Corresponding indices for each ETF are as follows: VWRL: FTSE All-World. VECP: Bloomberg Barclays Euro Aggregate Credit – Corporate.

VETY: Bloomberg Barclays Euro Aggregate Government – Treasury. VGOV: Bloomberg Barclays Gilts Float Adjusted. VUCP: Bloomberg Barclays Global Aggregate Corporate – USD. VUTY:

Bloomberg Barclays Global Aggregate - US Treasury Float Adjusted.


Asset class 50% equity/50% fixed income


Number of global stocks Nearly 3,000, 88% of total

market-cap

Number of global bonds 1,000+, 55% of total

market-cap

Index performance



13

Building a diversified equity portfolio with Vanguard Hong Kong ETFs

57%

10%

23%

9%

Equity portfolio: Hong Kong-domiciled ETFs

S&P 500:3140

FTSE Asia exJapan Index:2805

FTSE DevelopedEurope Index:3101

FTSE Japan IndexETF:3126

Sources: Vanguard, using data from FactSet.Notes: Corresponding indices for each ETF are as follows: 3140: S&P 500. 2805: FTSE All-World Asia Pacific ex Japan Australia New Zealand. 3101:

FTSE All-World Developed Europe. 3126: FTSE Japan.


Asset class 100% equity


Number of global stocks 2,000+, 78% of total market-cap

Index performance



14

A caution… product proliferation does not mean diversification

Liquidity

Large-cap

Mid-cap

Small-cap

Growth

Value

FTSE 100

Momentum

Russell

1000

Russell

2000 Fundamental

indicesEnhanced

indices

FTSE

RAFI

Developed

1000

Smart Beta

Alternative-

weighted indices

β/α

Minimum

volatility

index

Factors

Source: Vanguard.

15

Higher expected return comes with higher risk

Long-term risk-adjusted returns, more similar than different

Notes: Dotted line indicates trend of risk and return for selected US benchmarks. Benchmarks are as follows: US 30-day T-bill represented by IA SBBI US 30 Day T-Bill TR Index; US intermediate-

term government bond represented by IA SBBI US IT Govt TR Index; US long-term corporate bond represented by IA SBBI US LT Corp TR Index; “Large-growth” represented by Fama-French Large

Growth TR Index; ”Large-value” represented by Fama-French Large Value TR Index; “Small-growth” represented by Fama-French Small Growth TR Index; “Small-value” represented by Fama-French

Small Value TR Index. Index names as reported by Morningstar; all are total-return indices. Source: Illustration by The Vanguard Group, Inc., using data from Vanguard and Morningstar, Inc.

16

LiquidityStructure

Selecting which ETFs to use

• Global manager

• Support and resources

• Service model

• Physically backed

• Leveraged and inversed

• Synthetics

• ETF liquidity

• Benchmark liquidity

• Liquidity providers

Source: Vanguard.

Provider

2 31

17

Fund vs. ETF: The holding period matters

Source: Vanguard.

Expense ratio

Mutual fund

> ETF

Mutual fund

< ETF

Mutual fund

> ETF

Scenario 1:

ETF costs less

Scenario 2:

Breakeven-period

analysis required

(shorter favors ETF)

Mutual fund

< ETF

Scenario 4:

Breakeven-period

analysis required (shorter

favors mutual fund)

Scenario 3:

Mutual fund costs lessTra

nsaction c

osts

18

Notes: This illustration does not represent the returns of any particular investment. Assuming a portfolio of 50% global stocks and 50% global bonds. All returns are in nominal US dollars. For

benchmark data, see “Best Practices for Portfolio Rebalancing,” November 2015 by Ziberling, et al. There were no new contributions or withdrawals. Dividend payments were reinvested in equities;

interest payments were reinvested in bonds. There were no taxes. All statistics were annualised. Source: Vanguard calculations, using data from FactSet.

Rebalancing is critical to maintaining the portfolio

The most important aspect of rebalancing is to have a rule

Monitoring frequency Monthly Quarterly Annually

Threshold 0% 1% 5% 10% 1% 5% 10% 1% 5% 10% NA

Average equity

allocation 50.1% 50.1% 51.2% 52.2% 50.2% 50.9% 51.0% 50.6% 51.2% 52.4% 80.6%

Costs of rebalancing

Annual turnover 2.6% 2.3% 1.6% 1.3% 2.1% 1.5% 1.2% 1.7% 1.6% 1.5% 0.0%

Number of

rebalancing events1,068 423 64 24 227 50 22 79 36 19 0

Absolute framework

Average annualised

return 8.0% 8.0% 8.1% 8.3% 8.2% 8.3% 8.3% 8.1% 8.2% 8.3% 8.9%

Annualised volatility 10.1% 10.1% 10.1% 10.2% 10.1% 10.2% 10.1% 9.9% 9.8% 10.0% 13.2%

Never

19

Focus on the

controllable.

Think globally.Asset allocation

drives returns.

ETFs are a great way to meet client needs

Source: Vanguard.

2 31

2020

Appendix

21

Rolling 3-year correlation betweenUCITS 50/50 index and global benchmark

98.0%

98.5%

99.0%

99.5%

100.0%

2004 2007 2010 2013 2016

Correlation across

the whole period

Sources: Vanguard, using data from FactSet. Notes: Corresponding indices for each ETF in the UCITS portfolio are as follows: VWRL: FTSE All-World. VECP: Bloomberg Barclays Euro Aggregate

Credit – Corporate. VETY: Bloomberg Barclays Euro Aggregate Government – Treasury. VGOV: Bloomberg Barclays Gilts Float Adjusted. VUCP: Bloomberg Barclays Global Aggregate Corporate –

USD. VUTY: Bloomberg Barclays Global Aggregate - US Treasury Float Adjusted. The 50/50 benchmark used for comparison assumes an equal split between equity, as represented by MSCI AC

World Investable Market Index through September 2003; and FTSE Global All Cap Index thereafter, and bonds, as represented by Bloomberg Barclays Global Aggregate Index.

22

Rolling 3-year correlation between Hong Kong index portfolio and equity benchmark

99.0%

99.5%

100.0%

2004 2007 2010 2013 2016

Correlation across

the whole period

Sources: Vanguard, using data from FactSet.Notes: Corresponding indices for each ETF in the HK equity portfolio are as follows: 3140: S&P 500. 2805: FTSE All-World Asia Pacific ex Japan Australia

New Zealand. 3101: FTSE All-World Developed Europe. 3126: FTSE Japan. The equity benchmark used for comparison is represented by MSCI AC World Investable Market Index through September

2003; and FTSE Global All Cap Index thereafter.

23

Fund flows often follow performance

Net cash flow into equity funds vs. relative global equity/bond market performance

Source: Vanguard, using data from the Hong Kong Investment Association and Datastream through 31 January 2017.

-60%

-40%

-20%

0%

20%

40%

60%

-12,000

-8,000

-4,000

0

4,000

8,000

12,000

2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016

Rolli

ng a

nnual re

lative g

lobal equity

vs.

glo

bal bond r

etu

rn (

%)

Rolli

ng a

nnual net

equity

flow

(U

SD

m

illio

n)

Net equity flow (USD million, LHS) Relative equity / bond market return (%, RHS)

24

Building a diversified portfolio with Vanguard UCITS ETFs

Asset allocation by product

Ticker

Expense

ratio 0/100 10/90 20/80 30/70 40/60 50/50 60/40 70/30 80/20 90/10 100/0

Equity

FTSE All-World UCITS VWRL 0.25% 0.0% 10.0% 20.0% 30.0% 40.0% 50.0% 60.0% 70.0% 80.0% 90.0% 100.0%

Fixed income

USD Treasury Bond UCITS VUTY 0.12% 31.7% 28.5% 25.4% 22.2% 19.0% 15.9% 12.7% 9.5% 6.3% 3.2% 0.0%

EUR Eurozone Government Bond UCITS VETY 0.12% 28.9% 26.0% 23.1% 20.2% 17.3% 14.4% 11.6% 8.7% 5.8% 2.9% 0.0%

USD Corporate Bond UCITS VUCP 0.12% 26.1% 23.5% 20.9% 18.3% 15.6% 13.0% 10.4% 7.8% 5.2% 2.6% 0.0%

EUR Corporate Bond UCITS VECP 0.12% 8.2% 7.3% 6.5% 5.7% 4.9% 4.1% 3.3% 2.4% 1.6% 0.8% 0.0%

U.K. Gilt UCITS VGOV 0.12% 5.1% 4.6% 4.1% 3.6% 3.1% 2.6% 2.1% 1.5% 1.0% 0.5% 0.0%

Asset-weighted expense ratio 0.12% 0.13% 0.15% 0.16% 0.17% 0.19% 0.20% 0.21% 0.22% 0.24% 0.25%

Index performance

15-year annualised return 5.7% 5.9% 6.2% 6.4% 6.6% 6.7% 6.8% 6.8% 6.8% 6.8% 6.6%

15-year annualised volatility 6.9% 6.9% 7.2% 7.8% 8.6% 9.5% 10.6% 11.7% 13.0% 14.3% 15.7%

Asset allocation (%)Equity / Fixed income

Sources: Vanguard, using data from FactSet, as at 31 December 2016. Notes: Corresponding indices for each ETF are as follows: VWRL: FTSE All-World. VECP: Bloomberg Barclays Euro Aggregate


USD. VUTY: Bloomberg Barclays Global Aggregate - US Treasury Float Adjusted.

25

Index performance of a Vanguard UCITS ETF portfolio

Returns and volatility of underlying indices

0/100 10/90 20/80 30/70 40/60 50/50 60/40 70/30 80/20 90/10 100/0









Sources: Vanguard, using data from FactSet, as at 31 December 2016. Notes: Corresponding indices for each ETF are as follows: VWRL: FTSE All-World. VECP: Bloomberg Barclays Euro Aggregate


USD. VUTY: Bloomberg Barclays Global Aggregate - US Treasury Float Adjusted.

Asset allocation (%)Equity / Fixed income

26

Important information

The contents of this document and any attachments/links contained in this document are for general information only and are not advice. The information does not take into account your specificinvestment objectives, financial situation and individual needs and is not designed as a substitute for professional advice. You should seek independent professional advice regarding the suitability ofan investment product, taking into account your specific investment objectives, financial situation and individual needs before making an investment.

The contents of this document and any attachments/links contained in this document have been prepared in good faith. The Vanguard Group, Inc., and all of its subsidiaries and affiliates (collectively,the “Vanguard Entities”) accept no liability for any errors or omissions. Please note that the information may also have become outdated since its publication.

The Vanguard Entities make no representation that such information is accurate, reliable or complete. In particular, any information sourced from third parties is not necessarily endorsed by theVanguard Entities, and the Vanguard Entities have not checked the accuracy or completeness of such third party information.

This document contains links to materials which may have been prepared in the United States and which may have been commissioned by the Vanguard Entities. They are for your information andreference only and they may not represent our views. The materials may include incidental references to products issued by the Vanguard Entities. The information contained in this document doesnot constitute an offer or solicitation and may not be treated as an offer or solicitation in any jurisdiction where such an offer or solicitation is against the law, or to anyone to whom it is unlawful tomake such an offer or solicitation, or if the person making the offer or solicitation is not qualified to do so. The Vanguard Entities may be unable to facilitate investment for you in any products whichmay be offered by the Vanguard Group, Inc.

No part of this document or any attachments/links contained in this document may be reproduced in any form, or referred to in any other publication, without express written consent from theVanguard Entities. Any attachments and any information in the links contained in this document may not be detached from this document and/or be separately made available for distribution.

This document is being made available in Hong Kong by Vanguard Investments Hong Kong Limited (CE No. : AYT820) (“Vanguard Hong Kong”). Vanguard Hong Kong is licensed with the Securitiesand Futures Commission to carry on Type 1 – Dealing in Securities, Type 4 – Advising on Securities, Type 6 – Advising on Corporate Finance and Type 9 – Asset Management regulated activities, asdefined under the Securities and Futures Ordinance of Hong Kong (Cap. 571). The contents of this document have not been reviewed by the Securities and Futures Commission in Hong Kong.

About Vanguard Capital Markets Model (VCMM): The Vanguard Capital Markets Model is a proprietary financial simulation tool developed and maintained by Vanguard's primary investment research and advice teams. The model forecasts distributions of future returns for a wide array of broad asset classes. Those asset classes include Australian and international equity markets, several maturities of the Australian Treasury and corporate fixed income markets, international fixed income markets, money markets, commodities, and certain alternative investment strategies. The theoretical and empirical foundation for the VCMM is that the returns of various asset classes reflect the compensation investors require for bearing different types of systematic risk (beta). At the core of the model are estimates of the dynamic statistical relationship between risk factors and asset returns, obtained from statistical analysis based on available monthly financial and economic data from as early as 1960. Using a system of estimated equations, the model then applies a Monte Carlo simulation method to project the estimated interrelationships among risk factors and asset classes as well as uncertainty and randomness over time. The model generates a large set of simulated outcomes for each asset class over several time horizons. Forecasts are obtained by computing measures of central tendency in these simulations. Results produced by the tool will vary with each use and over time.

© 2017 Vanguard Investments Hong Kong Limited. All rights reserved.

Reference no.: VIHK-2017-04-20-1980

Vanguard’s view on portfolio construction and ETF model · Building a diversified equity...

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