Wes Crill, Senior Investment Director & VP at Dimensional Fund Advisors answers questions about factor investing: pursuing the small and value risk premiums for the chance to earn a higher investment return.
Show Notes
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Wes Crill, Senior Investment Director & VP at Dimensional Fund Advisors answers questions about factor investing: pursuing the small and value risk premiums for the chance to earn a higher investment return.
Show Notes
The John C. Bogle Center for Financial Literacy is a 501(c)3 nonprofit organization. At Boglecenter.net/donate, your tax-deductible donations are greatly appreciated.
[00:00:00] Jon Luskin: Folks, welcome to the 45th episode of the Bogleheads® Live podcast, our ongoing live Twitter series, where the do-it-yourself investor community asks questions to financial experts live on Twitter. My name is Jon Luskin, and I'm your host.
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Before we get started on today’s show, a disclaimer. This is for informational and entertainment purposes only.
Let's get started on today's show with Wes Crill, Vice President at Dimensional Fund Advisors. Today's topic: factor investing. Getting the small value premium when investing.
For our Bogleheads® out there, you may know that we're big fans of using low-cost diversified funds to invest, and sometimes that can mean using low-cost index funds. That lets us invest in the global economy at ultra-low cost, getting the investment returns of the global economy.
Tell us, Wes, how is factor investing different from index fund investing?
[00:01:39] Wes Crill: The idea behind factor investing started many, many decades ago with the intent to try and do better than markets; to deliver a higher rate of return than the broad market. Traditional methods of attempting to do so by outguessing markets, trying to time stocks, things of that nature were historically unsuccessful.
But what arose out of the academic literature was there were sources of higher expected returns. So, securities that could be identified using their characteristics and market prices that in the historical data had higher average returns than the overall market. That's really the idea behind factor investing.
Now that can be done either in a passive or index wrapper or it can be done in an active approach. It's really just the idea of selecting or overweighting securities based on their characteristics to target higher expected returns.
Now, like everything in life, implementation is key when it comes down to actually capturing these sources of higher expected returns that looked great in the historical data.
There's a whole process that really informs your ability to be able to capture those in the real world, net of fees and expenses. And that takes place in portfolio design, management, and trading.
Many methods of pursuing factor investing are in fact indexed. But there are some challenges when it comes to index-based strategies. What an index fund manager buys and sells is dictated by what the index providers such as Russell or MSCI or FTSE are determining. And that's typically done on an irregular basis.
So, we believe that to capture these premiums - that in many cases stem from differences in market prices - it's important to have a process that can be continuously updated to take advantage of as prices change. Which as we all know, those changes happen every day.
[00:03:26] Jon Luskin: This question is from username “9-5 Suited” from the Bogleheads® Forums, who asks:
"When long-term investors are making financial planning assumptions, how, if at all, should they adjust their expected returns if they are ‘factorheads?’ Those who invest in the small cap premium, value premium, momentum, et cetera. And should they plan for more volatility in their outcomes?"
So perhaps that a little bit differently, Wes, what sort of investment return should we expect by pursuing this strategy?
[00:03:59] Wes Crill: So, you're really trying to answer two questions. One, what can I say generally about the increase in expected return or the increase in standard deviation that would be associated with increasing my exposure to high expected return stocks? So, whether that's small cap stocks, value stocks, or high profitability stocks.
And the other related question is, is there a time varying nature to this expectation? So, do I have a different expectation than I might have had in the past?
So, I'll start with the first one. Generally speaking, what we see from these premiums - and when I say premium, that's just a return difference associated with differences in characteristics like market capitalization and so on and so forth - and the average premiums associated with these have been very substantial. They range from 2% to 4% per year for size, value, and profitability premiums.
Now, there is some measurement noise around those. And so, we're really looking at historical averages. Not to say that the future is going to be exactly like that, but it does suggest that they are meaningful to pursue.
And they've been very similar across different segments of the market, like different sectors and different regions. So, it's not just in the US. These factors have generally worked everywhere for which we have data.
When we're talking about a portfolio that is using all of these collectively, what we sometimes say is integrated approach. Let's say I just want to hold one strategy for regions such as the US. It'd be one portfolio that's holding a broadly diversified swath of the market and using those three factors: size, value, and profitability to determine which securities are overweight, and which securities are underweight relative to their natural market cap weights.
[00:05:39] Jon Luskin: Jon Luskin, your Bogleheads® Live host, jumping in for a podcast edit.
Here Wes Crill mentions three factors, size, value, and profitability to determine which securities are overweight and which securities are underweight relative to their natural market cap weights.
If you were using a size factor approach to investing, you would invest in those smaller companies in the hopes of earning a higher return. If you were pursuing the value factor, you would invest in those companies that might be underpriced to pursue a higher return. And investing in those companies that have greater profitability may also increase your investment return.
We would invest more in those companies compared to what an index fund would invest in them. That index fund being market cap weighted, meaning we're investing in everything not based on their exposure to those factors, size et cetera, but simply how much those companies are worth compared to other companies. That's a market cap weighting, what you can find in index funds.
And now back to the show.
[00:06:46] Wes Crill: And then the question is what is collectively the payoff from those factors? And we see it's dependent on how much exposure you take to them. It can be maybe a 1% per year pickup for expected returns. Or it could be even higher the more you tilt towards the premiums.
So, the good news there is there is a very meaningful increase in expected returns, in terms of projecting going forward. And then there's also relatively good news when we talk about another important input into financial planning, which is volatility. So, what we see is if you tilt towards small cap stocks, you tend to pick up volatility historically, if you tilt towards value, it tends to be pretty neutral - neither increase nor decrease in standard deviation - and then when you tilt towards high profitability stocks, it tends to be the case historically that you decrease your volatility.
So, the net effect of pursuing multiple premiums in an integrated approach when done with expertise, when done with skill has minimal pickup in volatility. But like I mentioned, it does increase your expected return.
The related question is, do we see indicators that allow us to ascertain whether the expected premiums are increasing or decreasing? Are there times when we can spot when the value premium is going to be higher or lower? And that's where the historical data has not been particularly informative.
We don't see a strong correlation between the realized magnitudes of these premiums and any signals. And that's true whether we look at macroeconomic indicators, GDP growth, interest rate levels, inflation. Also, when we look at things like valuation spreads - differences in price to book ratios between different segments of the market.
People have been trying to time these premiums and that would rely on being able to say when they were going to be positive or negative in the future. People have been trying to do that for decades and historically have not been consistently successful. What we see, the most reliable way to capture those premiums is to stay consistently invested in them.
[00:08:40] Jon Luskin: And that's certainly part of investing 101. As Jack Bogle would say, “stay the course." And that's going to apply whether you're investing in plain vanilla index funds or going for that factor investing approach as well. I’ll link to the Bogleheads® investing philosophy in the show notes, so folks can read up on some investing 101.
So, we've got higher returns. Perhaps, the catch is that sometimes they can take a while for these factor premiums to show up. Certainly, longtime value investors have been lamenting often on Twitter about how value has underperformed growth for some time.
Maybe you can speak a little bit to that.
[00:09:19] Wes Crill: Yeah, I think that's one of the primary considerations when you're thinking about is factor investing for me? One of the important things to know is can you tolerate deviations from the market that could be negative?
Value is a good example. It's one that's been in the news. The historical calendar year value premium in the US is a little bit over 4% per year, so that's the return difference between US value stocks and US growth stocks on an annual basis.
But when we look at rolling 10-year periods - so each month I look back over the previous 10 years - what was the return for value stocks? What was the return for growth stocks? Value has underperformed growth in about 20% of those rolling 10-year periods.
For investors who are probably thinking 10 years, that's a substantial amount of time, there is a non-zero chance that you could have a negative outcome from any of these premiums.
And that's true, by the way, for the equity premium. There's really no premium that's immune to this variability. I mean, we had a 17-year period in the US starting in 1965 when stocks underperformed 1 month Treasury bills. So, there's no free lunch here. And I think that's important for investors to understand.
Now, that being said, the extent to which that impacts your portfolio in a negative way is going to depend on how much you're tilted.
And these are sort of like spice levels for peppers. The underlying ingredient that makes peppers hot is still capsaicin, no matter what the pepper is. But you can take on a little bit, maybe in poblano peppers. If your tolerance for spice is not super high, you still add that flavor. Or if you love spice, you can go all the way up to habaneros. There's a whole spectrum in between.
And the deeper your tilts are towards these premiums, the more emphasis you have on higher expected returns, the higher the long-run potential reward. But, the higher the possibility for underperformance over any length of time.
[00:11:06] Jon Luskin: And then with respect to using financial planning software: for the Bogleheads® on Investing podcast, we had Stephen Chen of New Retirement discussing how do-it-yourself investors can use retirement planning tech themselves for their own retirement plan. I'll link to that in the show notes for folks to check out.
For more on the pros and cons of investing in factors, Rick Ferri debated Paul Merriman at the 2023 Bogleheads® Conference. If that video hasn't already been published by the time this podcast episode goes live, it will be soon at boglecenter.net.
And if you enjoyed that video or this podcast or anything else by the John C. Bogle Center for Financial Literacy, go to boglecenter.net/donate to support the mission of improving financial literacy.
This question is from Jim Parker from the John C. Bogle Center for Financial Literacy on LinkedIn, who writes:
"Historically, retirees have used a 60/40 portfolio, that's 60% stocks and 40% bonds, as their benchmark. Now that money market funds earn over 5% virtually risk free and bond yield are so high, what percentage of equities do you suggest for someone entering or in retirement?"
[00:12:28] Wes Crill: It kind of comes back to, what are the goals? Why would you be using fixed income in the first place? What kind of expected return goal do you have?
One way to think about this is - let's talk about the expected returns, for example. The portion you have in stocks, if you expect that to be driving the income growth of your portfolio, one thing to note is that whether interest rates have been high or low, returns for stocks have been very strong. Since 1955, where we have yields on three year treasuries, if we divide up that period into high interest rate years and low interest rate years - and to put some perspective around what it means to be a high interest rate year, the average yield on the three month treasury over that period was over 6% - so we’re talking about very high yield environments, and the average real return on stocks was still 7% on average over those years.
So, the interest rate level would not be a big determinant for my allocation of stocks necessarily, because I still expect them to provide a high rate of return. And then the fixed income, again, the reason why you would have a slug there in terms of bonds is to mitigate the volatility associated with stock returns.
And it's not clear that the extent to which an addition of bonds reduces your volatility is sensitive to interest rates. It's going to do a good job of reducing the volatility in your ride regardless of what interest rate levels are.
The reason why people default to a 60/40 is because it's a reasonable balance between the expected returns of stocks and the volatility associated with them. It's not to say it's the perfect number for everyone. But historically it's been really tough to beat a reasonable balance like that between equities and fixed income.
[00:14:10] Jon Luskin: This question is from the Bogleheads® Forums, who asks about what percent of small cap value or large cap value do you need to hold to make a difference in expected returns in your investment portfolio?
[00:14:22] Wes Crill: Yeah, that's another one that comes back to the pepper analogy for me. How much spice do you have to have to make it a flavorful dish? It depends on how much you really like spice. And in the context of tilts and equity markets, it depends on how tolerant you are of deviations from the market.
For example, you could have a somewhat lightly tilted portfolio that emphasizes small cap stocks at about 2x their natural weight. So small caps, if they're 10% of the market, then maybe overweight those by a factor of two and you have 20% allocation to small caps. But you can take it even further and you could allocate 30% to that segment of the market.
And what you see historically is that more and more weight you have in these higher expected return stocks, the higher the return has been, but also the higher the tracking error versus the overall market.
[00:15:10] Jon Luskin: Tracking error is when your particular portfolio has an investment return different than a particular index. For example, if you're investing, using a small cap value approach, you'll have quite the tracking error compared to the S&P 500. Of course, if you're investing in a total broad market index fund, like Vanguard's Total Stock Market Index – VTI or VTSAX - your tracking error will be quite small.
[00:15:45] Wes Crill: But I think the good news there is that you don't have to take these huge overweights. You don't have to have a 30-stock portfolio consisting exclusively of small cap stocks to pursue higher expected returns. And you can have a broadly diversified asset allocation that is holding the whole market. But then just tilting up more weight within these higher expected return stocks.
[00:16:07] Jon Luskin: Rick Ferri, the host of the Bogleheads® on Investing podcast has a 'total economy' model portfolio and in that he has 20% as his benchmark of a small cap value fund relative to your broad market fund. So certainly, that can be one reasonable way to tilt towards those factor premiums if that is something that you want to pursue. I'll link to Rick Ferri's Core-4 in the show notes for our podcast listeners.
Let's talk about implementing, putting in place, a small cap value strategy. “jocdoc” from the Bogleheads® Forums and also username “HomerJ”, they had related questions asking how does one pick the correct small cap value fund?
[00:16:53] Wes Crill: It comes back to this idea that so much of the performance and the realized outcomes is going to be a function of the skill and expertise. What is the set of signs or the indicators that this manager has expertise within that space?
A track record is a good place to start. And not like a three-year track record where returns can be mostly noise. The cross-sectional dispersion is high, especially in that subset of the market. So, you're looking for a demonstrated history of delivering on these premiums. And it's especially beneficial if that track record spans multiple types of value strategies or small cap strategies, across different regions and things of that nature. Has a manager delivered on what they said they were going to deliver?
And then what is their investment process? Is it one that has a lot of constraints embedded in it, where it's trying to layer on expectations above and beyond the market’s expectations?
In the case of some passive strategies, does it have constraints just based around the mechanics of index reconstitutions? And flexibility is really key when it comes to consistent exposure because stocks don't wait to become small cap value stocks for a once-a-year reconstitution of an index. You get a price movement throughout the year.
It's a bit like when you're preparing for a dental visit, you don't brush your teeth once the day before the exam for eight hours, you generally going to brush your teeth a little bit every day. And we find that a flexible approach that can turn over the portfolio a small amount each and every day is a really critical aspect to capturing these sources of higher expected returns, like small value.
[00:18:28] Jon Luskin: Here, Wes mentions index reconstitutions. Let's break that down.
An index fund is a mutual fund or exchange traded fund that follows an index. An index is a list of investments. So, your stock index fund invests in those companies listed in the index.
If you're using a broad market investing approach, investing in something like VTSAX just mentioned, then index reconstitution might not matter all that much.
But if you're taking a factor investing approach by using a small cap value index fund, then index constitution might have an impact on your investment returns. That's because, using Russell indices as an example, Russell only reconstitutes its indices once a year.
So, if a particular company moves in or out of the small cap value space, but the index fund isn't reconstituted until much later, that could mean missing out on the investment return offered by that company were your index fund to invest in it sooner.
Funds pursuing a small value or similar factor approach are able to move in and out of investments more quickly than a small value index fund with its less frequent reconstitution. That might mean that pursuing a factor strategy not using index funds might increase your investment returns.
Small cap value offerings by Dimensional in the ETF format - the ones that are going to be available for do-it-yourselfers - and other factor funds that are out there are somewhat newer. But folks have been pursuing the small cap value premium for some time.
For me personally, as an example, I bought VBR, Vanguard's small cap value ETF years ago, before Dimensional came out with their own small cap value focused offerings.
What should investors be considering in making the switch or not from a broader small cap value index like VBR to something that is really focused on pursuing small cap value premiums?
[00:20:48] Wes Crill: If your goal is to pursue higher expected returns with an allocation to small cap value, then a strategy that stays very consistently focused on that group of stocks is going to capture more of that rate of return.
Some hypothetical numbers: if small cap value has an expected premium over the market of 3% per year, and let's say that the turnover associated with just small cap value is 25% per year. If that turnover happens pro rata throughout the year, then that means that a strategy, if it's an index strategy that is only reconstituted maybe once per year might be holding up to 12.5% of its assets outside of small value. That's not an uncommon observation to see within the small cap value space.
So, if the small cap value excess return is delivered by small cap value stocks, then you're already putting in a return drag in it that could be as many as 35 or 40 basis points per year.
There's an important element there to having a consistent focus on that group of stocks, and what that means is when the premium shows up, you're there to capture more of it.
And it can show up in huge bunches. I was thinking from the beginning of Q4 2020 through Q1 of 2021, we saw the biggest premium in the US market since World War II for small cap value stocks versus large cap growth stocks. It was just an enormous run for small value. And right before that, we saw many funds that were in the small value asset class that didn't have substantial exposure to small cap value stocks.
So, it's something to consider when you're thinking about producing more reliable outcomes for your portfolio.
[00:22:24] Jon Luskin: Wes, this question is from username “er999” from the Forums who asks: "Currently, there's quite a diversion between international and US PE ratios in the US versus international markets. Can international investing itself be thought of effectively as a value tilt?"
And why don't you tell us a little bit about what a PE ratio is for those who aren't investing nerds.
[00:22:50] Wes Crill: PE ratio is generally a price to earnings. The price for - whether it's a security, a sector, a country – is scaled by the aggregate earnings. It's one measure of relative price.
And why do we need valuation ratios like that? Because valuation ratios tell us about characteristics that have been associated with differences in average returns.
Value stocks are the ones that have the lowest valuations or lowest price to book or price to earnings ratios. So, it's helpful to identify a value premium, which I think was some of the spirit behind that question.
Now, the real question is, are there limitations to how we can make comparisons based on these valuation ratios? We see within a market it works very well to tease out expected value premiums. It doesn't work as well when I compare, say, the valuation ratio of a sector to the valuation ratio of another sector.
So, if I look at the PE ratio of financials and the PE ratio of energy, it doesn't tell me much about the expected premium between the stocks going forward that I wouldn't have already gotten just by comparing the individual security PE ratios.
Same thing for countries. If I compare the PE ratio of the US and the PE ratio of developed ex-US or of emerging markets, it doesn't tell me that one of those regions is “a value region” and will have higher expected returns than the other regions.
It tends to be pretty noisy. One of the ways I've contextualized this in the past is compared it to a sundial in your yard versus an oven timer. So technically speaking, you can use a sundial to gauge the passage of time. If you're cooking something in the oven, you need something way more precise than that. And that's why these valuation ratios at the market level have not been strong indicators of relative returns, again, for those markets.
But clearly PE ratios, and any other valuation ratio is going to be important for identifying value stocks within subsets of those markets.
All that being said, there is a human element at play where if investors are suspicious of high valuations in the US - and it tends to be US large cap growth is where you find the high valuations - for those investors, having less of a bias towards US stocks might help them sleep more easily at night. It might help them have an allocation to other countries where valuations are not quite as high.
[00:24:59] Jon Luskin: Let's follow up with a related question from Bogleheads® LinkedIn.
Jack Bogle didn't see a need to invest internationally, felt that there were enough companies with international exposure in the S&P 500. So, do you suggest that investors invest overseas? And if so, what percent of equities do you recommend?
[00:25:21] Wes Crill: If you ask most investors at the end of the 2000s, whether they wanted to have international exposure in their portfolios, the answer would have been a resounding, "yes!" Because that was “The Lost Decade” where US stocks were flat to even slightly negative, whereas non-US stocks - especially non-US small cap value stocks - delivered strong returns.
One of the things we've looked at in the data is how rare an occurrence is like that where you have a 10-year period where a country's equity market is not positive. We looked across 45 different countries' equity markets and looked at the worst decade.
All but six of those 45 countries had at least one 10-year period that was negative. A lost decade - like what we had in the US - is maybe not that uncommon for a country's equity market. For investors who want to spare themselves of that being in the range of outcomes, global diversification could be a good way to go about doing it.
[00:26:13] Jon Luskin: Username “aj76er” from the Bogleheads® Forums writes:
"Is the historical small cap premium now being harvested by private equity? With companies staying private for longer and having larger initial public offerings, can the public markets still harvest the small cap and value risk premiums that we've had in the past?"
[00:26:37] Wes Crill: Yeah, we can start with just some data around private market investing and what we've seen with small caps. Some of the spirit behind this question I think was originally generated by a reduction in the cross-sectional count of small caps.
So, if you go back and look at how many small cap stocks we had in the mid-nineties compared to now, yeah, there's been a decrease. It was really just a run up in the number of small cap stocks in the 1990s. And then, by the time the 2000s rolled around, you had that coming back down.
Globally, we haven't seen the same effect. So, it seems hard to say what was the aberration there.
When we look at the stats around IPOs, there's some interesting trends. So, the average age of IPOs has crept up a little bit. It used to be around 7 to 8 years. In the past couple of decades, that's gone up to about 9 to 10 years. But the size characteristics have not dramatically changed.
You know, most IPOs are still very small stocks. So, it doesn't suggest that that premium is being harvested outside of public markets. There's still many, many small cap stocks out there. And then even when we look at, for example, private equity assets, the dollar value invested in private equity appears to have gone up substantially over the past couple of decades, but so has the public market size.
If you scale the assets in private equity by the assets in public equity markets, that ratio seems to have stayed relatively similar over the past 30 years. It's not totally clear that the premium has been diminished because of that kind of activity.
And then there's also the question of, well, it still makes sense for investors to have small caps in their portfolio. They're part of the global market. And they help us target these premiums. We've been talking about small cap value. Value premiums have been bigger in small caps than in large caps. So, if your goal as an investor is to capture the value premium, then an allocation of small caps is a good recipe for doing so even above and beyond the expected size premium, which we still very much believe in.
[00:28:28] Jon Luskin: This question comes from username “Nahtanoj” from the Bogleheads® Forums, who writes:
"Dimensional recently started offering ETFs for many of the same asset classes and strategies that it uses for its mutual funds. A mutual fund manager can close a fund to new investors if it attracts more cash than the manager thinks he or she can deploy effectively. But that's not possible with an ETF. How does Dimensional think about the risk to its investment process from the potential hot money flows into ETFs, especially into ETFs in some of these smaller and presumably less liquid asset classes and strategies?"
Maybe said a little bit differently, sometimes there can be more investing dollars than there are investing opportunities. So, for some of these smaller companies where there's not a lot to go around, maybe a lot of money flowing into those smaller companies can impact investment returns.
Wes, maybe you can tell us a little bit about why that would be a consideration. Give us some backdrop about what it means for presumably less liquid asset classes for those who aren't investing nerds.
[00:29:38] Wes Crill: This comes down to the potential for capacity constraints. And what's interesting is you see this with index ETFs all the time. When you have a lot of flows come in or if you have a big change in terms of the composition of the index - and if that index is being tracked by a lot of assets - then the trading that occurs from index fund managers moving to comply with the change in the composition of that index can impact prices.
We just had one this past summer with the Nasdaq 100, where the magnificent seven stocks were trimmed in terms of their weight in the index by about 12% in aggregate market weight. And there's many, many billions of dollars that are tracking that index. And so, what we saw was substantial price impact where the names that were being trimmed in their weight had downward pressure on their prices and the names that were being increased in their weight had upward pressure. And so, you can have an impact on prices.
That's clearly something we see in index fund ETFs. So, you can think about the amount of turnover that we conduct being spread out across 250 trading days. And a way to contextualize this is the size of a room versus the size of the door. The size of the room would be the size of the overall market in which you're investing, but then when you're accessing liquidity in that segment of a market, that's the size of the door. That's effectively how much trading you have to do as a proportion of the total amount of trading that's done out there.
[00:31:03] Jon Luskin: Wes, any final thoughts before I let you go?
[00:31:08] Wes Crill: I think that a lot of these questions really hint at how the idea of factor investing sounds really simple on the surface, but when you start getting into the details, you see just how important the implementation is.
And we see this consistently when we look at within a Morningstar investment category. The range of outcomes over any given time period for strategies that might look very similar in terms of their on-paper characteristics can be vastly different in the real world. So hopefully we've touched a little bit of that content today.
And again, thank you for having me on today.
[00:31:36] Jon Luskin: Absolutely, Wes. Thank you for joining us.
Well, folks, that's going to be all the time we have for today's episode of Bogleheads® Live. Thank you to Wes for joining us today. And thank you to everyone who joined us for today's Bogleheads® Live.
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Between now and our next episode of the Bogleheads® Live show, check out a wealth of information for do-it-yourself investors at the John C. Bogle Center for Financial Literacy at boglecenter.net and bogleheads.org, the Bogleheads® Wiki, Bogleheads® Twitter, the Bogleheads® YouTube channel, the Bogleheads® on Investing podcast, Bogleheads® Facebook, Bogleheads® Reddit, the John C. Bogle Center for Financial Literacy on LinkedIn, and local and virtual chapters.
And finally, an announcement. This is the shortest of the Bogleheads® Live seasons, having resumed from taking time off to take over the Bogleheads® on Investing show, I'm now going to be taking time off from this show as I expect baby number two shortly. Wish me luck, everybody! Once I've got parenthood of two young children figured out, I will resume the Bogleheads® Live series.
In the meantime, make sure to check out Rick Ferri's Bogleheads® on Investing podcast now that he's back from his Alaska summer sabbatical.
Thank you again, everyone. I look forward to seeing you all again on the next episode. Have a great one.