Episode Transcript
David: Small caps play a very, very distinct role in diversifying a US equity portfolio. So, many portfolios today are naturally tilted towards large cap stocks, as mentioned earlier. And this is driven by the market cap weighting exposure and strong exceptionally strong mega cap performances. Small caps broaden that diversification. Adding a Russell 2000 exposure introduces companies with different business models in return drivers. So it's not just more holdings but a different source of return. To help balance concentration small caps can complement large cap exposures and reduce reliance on a relatively small number of dominant stocks, creating a more even distribution across the market.
Cyril: Welcome, I'm Cyril Bosch, product manager at FTSE Russell focusing on equity and multi-asset index. I'm joined today by David Hsu, head of ETF product specialism at Vanguard. Today we're discussing how Russell US index-based ETFs can help market participants build diversified US equity exposure and position portfolios across size, style, and market cycles. Welcome, David. When investors look at US equity ETFs, they often focus first on cost, liquidity, or historical performance. But how important is the benchmark construction that underlies the ETF itself?
David: When you're buying an ETF, when investors buy an ETF, you're not just buying the wrapper, you are buying actually the index underneath it. And the index is what really, really determines what you actually own. So it defines what you own in terms of country allocation, weights, segments. And so while cost and liquidity are very important when you're thinking about buying it. The benchmark construction is fundamental because it shapes your exposure and your diversification and ultimately your risk and return profile. And that's where the Russell US indices are very important and very helpful. They're built on very transparent and rules-based methodology. And it clearly defines how companies are included, how companies are weighted, and in some cases, how they're excluded. So importantly, they provide consistent segmentation across the market from total market to large cap to small cap to even growth and value as well. So investors can see exactly which part of the market they own instead of just the rather broad US equity. So the key takeaway is that it's quite simple. Cost and liquidity does matter, but the index determines what the investor actually owns.
Cyril: The Russell US index framework allows investors to access broad US equity exposure or target specific segments of the market. So how does Vanguard think about using Russell based ETFs as long term core holdings versus more targeted allocation tools?
David: So the Russell benchmarks can serve as both core and targeted building blocks. So let's start with core. So we typically encourage investors to begin with a broad low-cost US equity exposure. This then provides the diversification the simplicity and is a very strong foundation for long term investing. Then we add the position if needed. The strength is that of the Russell framework is its modular design. You can move from total market exposure into large caps, mid cap, small cap or style segments like growth and value. Then we. That enables us targeted allocations. Investors can then fine tune the proportions of the portfolio, for example, adding small cap to broader diversification or adjusting growth and value exposures to align with the long-term gains or long-term goals, I should say. But importantly, this is about being deliberate and not tactical. These are not short-term investments. We always encourage investors to have a very thoughtful process behind this and look for the long-term gains. So think of it as a continuum, at one end it is a single broad ETF that can stand alone as a complete portfolio. And at the other end you have a more granular exposure which helps shape the outcomes with precision. And what makes the Russell useful is its consistency. You can move from broad to specific exposures within one rules-based framework. Which really helps investors understand how each piece can fit together.
Cyril: When looking at the market, does Vanguard put more emphasis on broad US equity exposure, or do you split exposure across large cap, small cap and styles like growth and value?
David: Well, it's not a matter of core or targeted. It's not like one or the other. It's actually both. So let's start with core again. If you notice, we always have to start with the core because that's the foundation. We emphasise this broad low-cost US equity exposure as the foundation. Very simple diversified and built for the long term. Then we layer in the precision. The Russell framework is modular, so investors can break the market into consistent segments like large, mid cap, small cap growth, and value. Then we use target exposures to complement and not to replace. So for example, adding small caps to a broader diversification or tilting growth in value is to align with some of the long-term goals. But we want to stay deliberate and not tactical. And that's quite important as well, because these are structural portfolio choices and not for the short-term market timing. So the key point to take away is really that you build a strong core first. Then you use targeted exposures to fine tune it keeping your portfolio simple, transparent, and aligned with long term investment outcomes.
Cyril: One of the strengths of the Russell framework is that it lets investors move from a broad exposure to much more precise segments. So how does that modularity help investors build portfolios more deliberately and more focussed?
David: So the Russell's modular design means the indices work as connected building blocks, beginning with the full market at the very top level, you have broad US equity exposure, very simple, diversified, and easy to use as a core allocation. And mind you, just to note that some investors are perfectly fine with that. They don't want to pivot away from anywhere other than broad. And that's perfectly fine. That's the way they're designed. Then we break it down consistently. So that same market can be split into the different sizes, large, mid and small cap and further into style, the growth and value all within one rules-based framework which promotes consistency. And every segment uses the same definitions and processes. And that's where the importance of consistency comes in. So you're not mixing different views, different methodologies, or you're just working with one single coherent framework. And that enables flexible portfolio construction. So you start core, then you add the position. And given that it's a single framework, it allows you to have some flexibility and investors can start to tilt some of it deliberately if they wish to, they can add more to the small cap or adjust in growth and value. And overall it becomes transparent. So each building block has a clear role. So investors can understand what they own and how the portfolio behaves over time.
Cyril: Which segments do you see your advisors wanting to fine tune in their portfolios today? Do you think they want to focus more on large cap versus small caps growth versus value or more total market cap?
David: It's a very good question because we get that all the time. Advisors are actually using segments to complement and not to replace one another. Or rather replace the core. This is quite important because once again, we start with the core. So most portfolios already have a significant large cap exposure. So the focus is often on how to diversify around it. And that's been the talk for the last couple of years. Now small caps and style are very key levers for this advisor adding more small caps just to really broaden the diversification and also using growth and value to balance long term preferences. Everything is relative to the core. So the goal isn't really to replace a broad market exposure, it's how do I refine it from an investor's point of view? So the Russell actually enables this position. Its modular framework lets advisors adjust size and style consistently without changing the overall portfolio construction. So the key point is that the trend isn't picking segments or it's using them discretionary. Rather keep the core simple and add target exposures only where they feel it's necessary and where they're comfortable with that exposure.
Cyril: US equity returns have often been heavily influenced by large companies and especially tech. How can investors use Russell-based exposures, particularly small cap or style specific ETFs, to diversify beyond market cap weighted portfolios that might be very dominated by the largest companies or the tech sector.
David: Yeah. Also a very common question that we get all the time. Let's begin with the context of this, right? So the US equity markets have become more concentrated as quite obvious for many of our clients that mentioned that as well with a large share of those returns really driven by the mega cap stocks in most of the indices that are market cap weighted. So then when we begin with the broad core, most investors will start with total market exposure to capture the full opportunity set in a simple, diversified way. And as I mentioned earlier, many investors are very comfortable with that total broad exposure. But then we can also add a diversification lever, right? By adding small cap exposure, we can broaden that diversification in a little bit away from that large core allocation. As you know, small caps are driven by different factors and do reduce reliance on a handful of mega caps. Mid caps also play a very important role and in fact mid caps sometimes get overlooked. They sit between the large and the small caps, and sometimes they do get underrepresented, but it helps balance the overall size profile of the portfolio. Style adds another dimension. Growth and value exposures can help manage portfolio characteristics. So for example, balancing a growth heavy large cap tilts focus on the structural, not the tactical changes. As I mentioned earlier, these are very long-term diversification decisions and not short-term market timing. So the key point really is to start with a broad core then use size and style exposure, diversify beyond that concentration and then building a more balanced portfolio overall across the full US market.
Cyril: You mentioned concentration. Are you concerned about concentration in the largest US stocks at the moment? And how do you think market participants are reacting to try and address some of these concerns?
David: Yeah, I think concentration is a natural part of any market cap investing. But it can also be managed. Market cap indices naturally concentrate in the largest companies. That reflects how markets evolve. And that's really one of the benefits of buying a index product is so that you can participate fully in the performance of the market, but it can lead to reliance on a very few stocks. So it's important to assess where your risk and returns are really coming from. Russell's modular framework helps address this, so investors can really complement core exposures by adding small caps or mid cap segments to broaden that diversification. Now notice that I point adding and not replacing, which is a very important fact to take note of. The style can also help as well. So for example, you can add value exposure to complement and offset a growth, very heavy growth heavy, large cap tilts. So it's not about avoiding large caps altogether. Which is a very common misconception. It's about complementing them. And, so portfolios are more balanced across the full market.
Cyril: Russell style indices use a transparent methodology to classify stocks by growth and value. For investors who want to position portfolios across changing market environments, how can growth and value Russell ETFs help them express views, rebalance their exposures, or invest more systematically?
David: Yeah, very good question. So the Russell growth and value exposures really provide clarity and control in any portfolio construction. Russell uses a very clear rules-based methodology. So growth and value classifications are transparent and consistent. That actually helps investors understand exactly what they own. There's a couple of benefits here. So the first benefit is really expressing a view. Growth and value behave differently across market environments. Investors can tilt to value. For more valuation sensitive defensive exposure or tilt towards growth for innovation led, higher growth companies. The key is that these exposures are clearly defined within one framework. The second benefit is really about rebalancing. So over time, market moves can shift a portfolio style mix. So for example strong growth performance can increase exposure unintentionally. Russell style benchmarks allow investors to rebalance back to their intended allocation in a very defined and in a very disciplined way. And why this works well? Well, growth and value come from the same underlying universe. So investors can adjust the exposures really without changing frameworks or creating inconsistencies. And this is actually quite aligned with the Vanguard's approach. We start with broad diversified core, then use style exposure selectively to maintain balance, not to time the markets and target a very long-term investment growth.
Cyril: While we are talking about timing the markets. This is a question that I think everyone out there would really like to have the answer to. Which style do you think is better positioned over the next year. Growth value or a blend of both?
David: Yeah, we always encourage our investors to avoid picking the winners and, avoid timing the markets, but focus on the long-term and focus on balance. Be cautious on the short-term calls. I mean, you see a lot of media out there promoting and even independence promoting. And you get a lot of this, I guess the FOMO effect and that creates a lot of chasing some of these stocks. And it's really difficult to predict whether growth or value will outperform. Leadership can shift very quickly. We have geopolitical risks, that also can shift very quickly as well as we've experienced in the last couple of years. Focus on the long-term. That is the key. Growth and value play different roles and tend to perform at different points in the cycles. Using the Russell for clarity and consistency, the framework defines both styles clearly. So investors can really assess and combine them in a very structured way. And of course, taking a blended approach. Many investors hold both styles or use broad exposure, adjusting only when it supports a long-term goal. So I think the key point is rather than picking a winner, focus on balance, use growth and value together to build portfolios that can perform across different market environments.
Cyril: Small cap exposure is often discussed as a way to access different parts of the US equity opportunity set. How does Vanguard think about the role of Russell 2000 ETFs in a diversified portfolio, especially for investors who may already have significant large cap or tech exposure?
David: Yeah. Also a very common question that we get asked. Small caps play a very, very distinct role in diversifying a US equity portfolio. So many portfolios today are naturally tilted towards large cap stocks as mentioned earlier. And this is driven by the market cap weighting exposure. And strong, exceptionally strong mega cap performances. Small caps broaden that diversification. Adding a Russell 2000 exposure introduces companies with different business models and return drivers. So it's not just more holdings but a different source of return. They help balance concentration. Small caps can complement large cap exposures and reduce reliance on a relatively small number of dominant stocks, creating a more even distribution across the market. They also add cycle diversification. So small caps tend to perform differently across market cycles. So combining them with the large or the mega caps can really help build a more resilient long-term portfolio. And all this is all delivered within a very consistent framework. The Russell framework allows investors to combine large, mid, small caps in a very coherent rule-based, consistent manner. And once again, that's aligned with Vanguard's approach. Start with broad, diversify core, and then using small caps where we feel there is a purpose for the long-term portfolio.
Cyril: How do you see your clients positioning small cap exposure in their clients’ portfolios, and how do you think that's changed over the last few years, given what's happened in large caps in big tech? And what do you see happening going forward?
David: Yeah. Small caps are now used more deliberately as a diversification tool. I think many investors are still very reluctant to unwind their large caps. And some have, but only to trace it back at higher levels. And so small cap is really used as a diversifier, which complements the portfolio for the long term, very, very nicely. I think also with the portfolios increasingly tilting towards mega caps, investors are turning to small caps to introduce a different return drivers, as mentioned earlier. It also gives you more reason to have a more deliberate portfolio construction. So rather than being a passive allocation, small caps becomes a targeted tilt using alongside a core to improve balance across the size spectrum. And over time, you can also reduce that exposure as well, depending on what the long-term goals of the investors are. So it's really about a balance and not a market call. Clients are not necessarily increasing exposure, but making sure the portfolios are not overly reliant on one particular segment.
Cyril: Beyond the benchmark, what practical factors should investors evaluate when selecting Russell US ETFs?
David: When you're choosing an ETF it's more about than just the benchmark. And this goes back to what we were mentioning in the beginning. Cost matters, but look beyond the headline fee. I think the expense ratio does matter, which most investors look at because it's quite obvious, but they should also focus on the total cost of ownership. And this is a very, very important point that we always tell our clients. So what does that mean? Well, you got to look at the tracking differences. The trading costs. How efficiently is the ETF delivering the index over time. And looking at that overall performance over a period like a one year, three year, five year, then you can have a better sense of what the real cost is to the investor. Then, of course, you want to consider liquidity and trading. ETFs trade on exchange. So execution matters a lot. That includes bid-ask spreads, the underlying market liquidity and really how well the ETF is supported by market makers. And you can see this quite obviously on some of the on screen trading that happens. Now, mind you, in Europe a lot of the on screen trading does hop in off screen. So that's something that's very important as well to take note of. Then implementation also matters, two ETFs tracking the same index can perform differently depending on how that portfolio is managed. So how rebalance are handled, how costs are controlled. This is where the experience managers have an advantage. And then of course you've got to think about tax relevancy. Depending on the investor's situation, the tax treatment in terms of dividends, withholding tax, capital gains tax, can be different as well depending on which domiciled ETF you end up choosing. But most importantly, just focusing on the portfolio tilt. So investors should really ask themselves, what role does this ETF play? Is it a core holding or a targeted exposure? Does it fit clearly within the portfolio and support a very long discipline long-term approach. So these are some of the key things that they should be asking.
Cyril: What does Vanguard do behind the scenes that investors may not see, But that makes a big difference to how the portfolio is implemented and how it performs relative to your peers?
David: What happens behind the scenes can really materially impact outcomes. There's three areas that matters most in our opinion. First is the index implementation. Second is the trading execution. And third is the ongoing risk management. Implementation isn't mechanical. I think many, I should say, I think the broad misconception is that managing an index portfolio is very simple. You follow the rules and away you go. And it's almost robotic, but it isn't. In fact, it's very active in some of the decision making. So rebalances and index changes are very carefully managed and analysed. Really balancing the tracking accuracy because you really want to track the index tightly, but at a minimal cost. And minimal transaction costs. Execution drives some of the real costs. Scale trading experience and access to liquidity really help minimise some of the bid-ask spreads and market impact. Risk management really ensures the consistency. Continuous monitoring and oversight really help keep performance closely aligned with the benchmarks. So giving that example of like the two ETFs, they can track the exact same index, but you will notice that sometimes they will deliver very different outcomes. So how that ETF is managed behind the scenes is absolutely crucial in making the real difference over time.
Cyril: Thanks, David. One final question from me. So looking ahead, where do you see the greatest opportunity for investors to use Russell US ETFs more effectively as long-term core holdings, do you think it's more tactical allocation tools or as diversification complements to what they've already got in their portfolios?
David: The opportunity is really in combining the roles, core and targeted more effectively. The biggest opportunity remains using broad US equity ETFs as long-term core holdings, providing simple, low cost and diversified exposure. The evolution is really around what sits around that core. Investors are becoming more deliberate in how they use target exposures across size and style to refine portfolios. So Russell's modular framework enables this. It allows investors to add small or mid-caps to diversify that broader large concentration beyond the large concentration of that portfolio and also to adjust for growth in value to maintain that balance over the long term. So focusing on the structural diversification and not a tactical timing. So rather than making short-term calls rather than chasing the latest hot stock, the value comes really from building a more balanced portfolio across time and across different segments.
Cyril: David, thank you very much for joining us today. It's been a real pleasure to have you and to discuss how Vanguard is using Russell US indices to deliver value for their clients. So thank you very much.
David: Thank you. Thank you for having me.
