Animal Spirits Podcast - Talk Your Book: What's In an Index?

Episode Date: October 16, 2020

On this edition of Talk Your Book we spoke with Laurence Black, founder of The Index Standard about how to pick the right products, ETFs and indices for your portfolio.   Find complete shownotes on our blogs... Ben Carlson’s A Wealth of Common Sense Michael Batnick’s The Irrelevant Investor Like us on Facebook And feel free to shoot us an email at [e-mail] with any feedback, questions, recommendations, or ideas for future topics of conversation. Learn more about your ad choices. Visit megaphone.fm/adchoices

Today's Animal Spirits is brought to you by the Index Standard. Welcome to Animal Spirits, a show about markets, life, and investing. Join Michael Battenick and Ben Carlson as they talk about what they're reading, writing, and watching. Michael Battenick and Ben Carlson work for Ritt Holt's Wealth Management. All opinions expressed by Michael and Ben or any podcast guests are solely their own opinions and do not reflect the opinion of Ritt Holt's Wealth Management. This podcast is for informational purposes only and should not be relied upon for investment. decisions. Clients of Ritthold's wealth management may maintain positions in the securities

discussed in this podcast. Ben, we just spoke with Lawrence Black founder, and he's created a product for advisors that allows you to take a look under the hood and really compare different indexes with one another. I think the timing of the launch of his firm, it just was founded this year, is pretty optimal because people are going to have to or want to get more creative in their portfolios in the years ahead. They're probably going to need help because even a simple value or quality or momentum or dividend strategy, there's a million different ways you can do it now. And a lot of advisors probably don't understand them well enough to get under the hood a little bit and know what's going on in there. Yeah, so we've moved well past IVV, VOO, SPY, all of the

S&P 500 index ETFs, which are those are all apples and apples. But there are a lot of more creative ones. We had a conversation last week with Simplify. We've spoken with innovator ETFs in the past the defined outcome ETFs. There is a lot more choice, a lot more options that investors have these days. And I think they're going to need help, having somebody really break it down and plain English what they're getting exposure to. In this talk with Lawrence, we get into the fact that he think this stuff is going to explode in the future. And I tend to agree with him that there are going to be so many new options for people and investors to choose from. And it's going to be very hard to set some filters on that stuff to know what makes sense to use and what is not worth the time.

So here's our conversation with Lawrence Black of the Index Standard. We are sitting here with Lawrence Black, founder of the Index Standard. Lawrence, thank you so much for coming on. Hey, it's great to be here with you guys. So before we get started, just a quick 30 second background. Who are you? Why do you create this company? So I spent about 15 years working in investment banking, designing and developing indices. And it's been great to sort of see the industry progress where we now have a lot more

technology to do better back testing. We have alternative data. We've seen the rise of factors. So that's been my background. And during that time, I was also fortunate enough to work with some well-known investors and academics. So in my career, I worked with a guy called Joel Greenblatt, who's a well-known value investor. Barry Ridthold's had a podcast with him last week. Yeah, that's awesome. And I worked with Jim Rogers, the commodities guy, and Robert Schiller, the academic as well.

And about 18 months ago, I felt that there is just a proliferation of indices and that there was a real need for index information. I would do a lot of speeches at events, and I'd get a lot of questions. How does the index work? Or tell me about this volatility control mechanism. So I thought there was a real gap and need for

someone to rate and forecast indices. So hence, I founded the index standard. So by the way, you just answered our first question just in your introduction. I guess it's indices, not indexes. Yeah, well, it's a little like tomato tomatoes. Maybe the British say indices. Ben, what do you say? I kind of go back and forth. I don't have a preference. All right. So we hear this all the time. There are now more ETFs than there are stocks. Talk a little bit about how the heck we got here where the asset management industry is headed. I think it's a really interesting time. So I How do we get here? There's a couple factors. I think, number one, low fees. The fact that the fees have come down on ETFs have really made them very attractive to almost everyone, but especially

advisors. Advisors can now use them in building blocks as portfolio allocation. So that's really been helpful. The second thing is, we've now seen that benchmarks and indices have outperformed active managers. If you look at the Spiever survey from S&P, you can see roughly about 70% of active managers have underperformed. So people have now realized this. And then the other thing, I think it's kind of interesting point. I feel like it's the democratization of information. So you think about like 10, 15 years ago, a hedge fund would be running a factor portfolio, going along the best factors, short the worst, kind of making sure they were evenly balanced between the factors. And now a lot of people know about that. Advises have heard of factors.

So really, you can almost do that at home. So the fact that we've now sort of democratized finance, we can all do this ourselves. So that's contributed to the growth of ETAF. So with regard to where the industry is going, I think it's a really interesting time. You're seeing a tremendous amount of innovation. So within the passive space, all the index providers are going to continue with their innovation. You're going to see continued use of alternative technology. You're going to see continued use of new innovative ideas, like define indices using

and put some calls to give you buffers. So I think we'll see that growth. But then how do the active managers react? That's really interesting. And my kind of view is, if you can't beat them, join them. So what I see is a lot of the active managers are actually now creating indices. So for example, you've got fidelity, you created indices and selling them in their own ETFs.

Same with Franklin Templeton. They've got Liberty shares created indices, selling them in Liberty shares. But another interesting point is in the U.S. annuity market where a lot of annuity products are now linked to indices, you're seeing some of the bigger asset managers are actually creating indices and selling products here. So Pimco, Putnam, AQR, Fidelity, have all actually created indices that are being sold in an annuity. So obviously, this is great because investors have more choice than ever. The other side of it is the paradox of choice. So what are some of the things that you're seeing that people are running

up against in terms of trying to better understand this and sift through all these new products and services? So right now, there are more than 3 million indices. And as you say, there's a huge choice. And what I see is now that the fees have come down in the industry, so it really becomes about choosing the right index, because the index is going to be the engine of your returns, right? For example, it just used to be that I could choose a dividend index with maybe a low fee, and I'd be fine, but actually with all the dividend in ETFs now having low fees, which one do you choose? And that's where you need help. And that's kind of why I founded the index standard to help guide people as to what is a good index. Let me give you some quick examples that if you think about

the dividends base, everyone loves dividends. And in the last one year, there's a 10% performance difference between the best dividend ETF and the worst. And if I think about value ETFs, There's about a 70% difference between the best value ETF and the worst value ETF in the last five years. So back to my point, it's really about understanding what the right index is and making sure you pick the right one. So how do you pitch yourself to potential customers? I mean, I would say that right off the bat, it sounds like you're similar to Morningstar,

but what? How would you fill in the blank? So what we are really is we're an independent and objective information portal for everything about indices. My objective is really to demystify indices for the. advisors and self-directed investors. And I really want to empower them with knowledge, and I want them to do better in their investing. So that's our mission. And how do we differ from Morningstar? So I respect Morningstar. They've been around for a long time. I think we do a

couple things different. So firstly, Morningstar are quite focused on the fees and the liquidity of an ETA. I'm more focused on evaluating the underlying index. As I said, I think that's going to be the key to getting the right returns going forward. And the second thing is, actually provide forward-looking forecasts. One of the problems I found in my career is that investors always look at the back test, and the past is not going to repeat itself. So you need to try and look forward. So we're providing forward-looking forecasts. So that's some of the differentiators between us and Morningstar. So how do these forecasts work? Are you forecasting expected returns, expected risk parameters around these different indices? How does that work?

So what we're doing is we're forecasting expected returns. And we're going to go to like a three-step methodology. Really what we want to do is try and help investors think about the future and project some forward-looking returns. So the way we do that is, number one, we get the wisdom of the crowds. So we take about 30 asset managers, we take their capital market assumptions, and we kind of average those out. So I call that the wisdom of the crowd. So we kind of get what are the market expectations. And then for each index, we analyze which factors it leans on. We look at about 15 factors. And then step three is we take the forecasts and we have for 15 factors. We look at the factors that the index leans on. We run 10,000 simulations and then we get an

average return. And then that's what we display is our expected returns. And then do you have some sort of range? So let's just say, for example, midcap growth, you're looking at six and a half percent plus or minus two percent and there's a 95 percent confidence. Is that sort of how it works? It's exactly what we do. We actually show the average forecast and then we show the 75th and the 25th decile to kind of give people a range. Because look, listen, we know forecasting is difficult. So we want to provide a range. And the way that we see people using the forecast is, it's sort of on a relative basis. It's very hard to say this index is going to return exactly certain percentage. But what you

can do is look on a relative basis. For example, right now, we forecast the US might have a sort of six, seven percent returns in the next 10 years. But emerging markets might be 9 or 10%. So that helps you figure out that emerging markets might be the place where I want to tilt some of my portfolio to. So there's two ways to look at this. You could look for factors that are positive about a certain index or ETF or maybe negative. Are there any knockout factors you look at when you're looking at something that is maybe an index that someone should avoid? Yeah, absolutely. And that's why we design these index ratings. So our index ratings are really designed to help identify a high-quality, robust, well-designed index. And the way we do this is we look

at about 30 metrics and we try and go under the hood. And then what we do is we group our metrics into six categories. We look at transparency, robustness. We have two risk categories. We also look at returns and efficiencies. And let me give you some examples to kind of like tease out some of the stuff that we're trying to do. For example, we look at value at risk. because looking at volatility doesn't tell you the whole picture. And I give you an example. XIV was a very popular product a couple years ago. It was basically selling the VIX and it had a very low volatility from 2015 to 2018.

And then when VIX spiked, it was short. It actually dropped about 90%. So that's an example of just looking at volatility. It doesn't give you the story. You need to look at VAR. Another example that we have is we like to look at the mechanism. is it well designed? I was talking about dividends earlier. I'll give you another example. If you look at dividend methodologies, if you just look at historical dividends, that can actually

sometimes be a sign of distress. So you actually want to look at dividend sustainability as well as the yield or cumulative dividends. And we find those kind of methodologies do better. Another final example, I'm big on diversification across country or top 10 stocks and also sort of getting the index right. Right now, there's a cyber defense index that sort of builds itself as giving you access to the software cyber defense companies. But if you look at the largest two constituents, they're actually Cisco and BAE Systems. BAE Systems is an English company that manufactures tanks and submarines. It's not really giving you what you want. So investors are faced with all these choices. And that's why we have the ratings and we rate each index. And then we just

Give it a simple score, and we put a platinum, gold, silver, copper, watch, or neutral rating on it. Simple and easy for the end investor to understand. So there's a lot going on here. Who's using this product? I would imagine that the target audience is financial advisors and intermediaries. Exactly. You got it right. That's where we see the most traction.

We're definitely trying to help the advisors, anyone at RIA or even the wirehouses. And we see them using our ratings for due diligence, also to prove that they're acting and the client's sort of fiduciary best interest by saying, here's your portfolio. We can show you we've got some gold, silver indices. So that's a very big use case. And then also we're finding some good interest actually in the insurance space. We find some of the insurance companies are buying ETFs. And actually, there are a lot of insurance marketing agencies that are selling annuities and they're

all linked to indices. Now, some of these indices are very common. They're starting to use mean variance optimization with volatility control, and that can get a little complex. So we're trying to shed some light and bring some transparency and help rate and evaluate indices there. And then lastly, it's also important to me. One thing you may notice, actually, on our site, you know, we have 400 ETFs. We don't charge anyone to see the ratings. I want the self-directed investor to be able to do better and empower them and give them more knowledge.

So I would imagine that one of the use cases for a financial advisor would be they could give you their portfolio of 8 to 10 ETFs and then they could use your system to look at it and say, are there any better alternatives out there for what I'm doing? Is there a better mouse trap? That's exactly the way we envisage people using our system. You can go to the website and you can sort of type in the name of the ETF and it pulls up whether it's a gold or platinum or so on. And the other thing that you could also do is you can give us a list of your ETFs and we can give you an overall portfolio rating as well. So there's many ways that you can use the scores for due diligence, for validation,

or even we see some people just taking the fact sheets and using them to explain how an index works to the end client. So let's talk about how the industry is currently structured for a minute. So let's use just iShare as an example. Are they building their own indices or is it outsourced? And then a secondary question would be, are you analyzing the index that they're using or the actual ETF wrapper? I would say the industry is evolving, and what we see now is kind of like an interesting split.

What you see is most of the big index players such as Ishares, Vanguard and Spider, they tend to use the indices from the big names such as MSCI, S&P, and NASDAQ, and so on. And then what you're finding sort of at the smaller level where you get the smaller ETF players, they're being more innovative and they're using indices that they've either self-created, or they're using from indices from innovative, smaller, more nimble players such as Solactive or Compass Financial Technologies or Mercube who are doing defined outcome indices. So it's kind of interesting stage of the industry. So in one of your recent press releases, when you rolled out the firm, you said,

we think structured products could replace fixed income products. Obviously, this is a big worry for a lot of investors these days. And Michael and I have talked to a number of fund firms in the past few months or years that are using different strategies. They're using options or leverage and some stuff that people had never had access to before, frankly, in such a tax-efficient, low-cost manner. Where do you think this stuff is going and based on what there is now and where we could be going and what do you see from this angle of the industry? I think this is going to be a huge growth area. Same. We had on a simplify, they have a new ETF using calls inputs. We spoke to Innovator with the

buffer DTFs. And as soon as we saw this, Ben, we were like, wow, this company is going to do extraordinarily well. Yeah, I think Paul Kim and Barry Bond are doing a great job, right? And at a very macro level, I'll give you an example. If I look at our forecasts, we expect negative point three returns for the US ag over the next 10 years. So that's point number one. Point number two is the whole fixed income market dwarfs the equity market. So you've got this huge amount of money that needs a home. And I think the old's the 64. That's almost dead. You can't almost invest in that because of...

Those are fighting words around here. So, listen, I think structured products, one where bank issues are debt and it's linked to an equity index that gives you some kind of coupon, that's going to grow. And then secondly, as we talk about these defined ETFs, I think that's going to be a new area of growth. We're probably going to see more and more of them. And it's becoming actually, there's already a lot of them. It's become a little bit confusing for investors because they kind of launch one that expires

each month. And their investors are like, oh, I don't know which one's got the best barrier. And I think someone is needed to kind of help people figure out which is the best barrier. But this is going to be, I think, a big growth area. Then finally, I think technology, alternative data, that's going to continue. We're going to see more thematic indices. So I'm bullish on the index industry. All right.

So two-part question. I would imagine that an ETF that's tracking the S&P 500, for the most, part, it's tracking the SEP 500, whether it's Vanguard or I shares or State Street. Fees are all very similar. There's not much for you to do there. However, then you have products like the buffered ETFs and the one from Simplify and all of these new ones that have a lot of moving parts. So for the dividend, the value, the traditional factor stuff, I would imagine that you have a sort of whatever, some sort of algorithm that just sorts it. How much manual work do you have to do for these new ones? Like, how does that whole process work behind the scenes?

So the way we do, everything we do is automated and we have our algorithm. But the key thing is we really always want to make sure we compare like to like. So for example, we'll always compare all dividend indices together or all growth indices together or all quality indices because you can't really compare a value and a growth index, right? There's such a huge discrepancy. So for us, what we do is we actually put all these indices together. We make sure that we get the right benchmark and then we categorize them together, and then we can really see which ones stick out. And we also have a process where we do this for the indices used in the fixed annuity side. Again, we put all like-to-like indices together.

We don't mix a multi-acid index or an index that has equity in bonds because they're very, very different. So how do you compare what I'm talking about? Would that be an alternative bucket, or how do you group those? Yeah. So we would group all the defined indices together because they're very distinct and separate. You know, it's not their sort of beta profile, their drawdown profiles are very different from S&P 500.

So I don't want to compare them. So what I will do is put them all together and compare them. And then that's the way we'll be able to see which is the best. What about tactical indices? A lot of these are rules-based pacer, for example, has done incredibly well raising assets. How do you compare products that are using technical rule-based systems? What we do, again, we categorize those together. But there's sort of something that I like to look at and sort of drawing upon my experience.

When I think about a well-designed index that will do well in our ratings, it's got a, what do I mean by well-design. I mean, the methodology doesn't have too many bells and whistles, doesn't have too many parameters, and it's not over-engineered. So that's something that I look for. And for example, when I worked with Joel Greenblatt one time, always remember, he said to me, I looked at some factors and I was looking at two-factor model and a 70-factor model. And the two-factor model did just as well. So if you can do something simply, that's better because it runs the less risk of over-engineering. So, for example, that pacer index, I like it. It's actually quite simple.

It has a 200-day moving average. It kind of gets you out of trouble. My one sort of concern in probably why it's slipped a little bit in the rankings, it kind of helps you avoid the trouble. But then when markets rebound, it's a little bit slow in picking it up. So you might want something with a, you know, be aware of that, that it's for the ultra-cautious investor. So another piece that you wrote recently,

we wrote this piece called The Devils and the Dividend Methodology, and there are so many dividend strategies out there these days. And I'm sure a lot of investors are kicking the tires on these things because they want to find yields somewhere for their portfolio. So I'm interested in what you went through and how you figured out some of these different levers to the book, because actually this is something Michael and I have been looking at for a while now, too, and what were some of your finding the best dividend strategies you found?

Sure. It just took a long, long time. So what we did was we actually ran all the dividend indices through our rating model. And then we sort of looked and found a certain segment we're doing quite well. And then I was quite intrigued because, as you say, everyone is always looking at dividend indices. And then I went and tried to find some commonalities between which ones were doing well and which ones were not. Sorry, Lawrence, sorry to interrupt, but just to clarify, when you say doing quite well, do you mean on the rating system or performance or both? both actually yeah both so you know looking for an index that rated well and perform well and in general

they were the same sort of thing and i was also actually looking for another point that was actually important to me it had low drawdowns because what i found was there was actually a certain segment of these dividend indices that had very big drawdowns and essentially what i found was when i looked at all the methodologies to sum it up i found that the dividend methodologies that look at historical dividends and just historical dividends alone did poorly. Because what you think can happen is they're looking at the historical dividend payment. Let's just say it's 10, for example, and the share price was 100, so it's giving you a 10% yield. But if the share price drops to 50, suddenly it's 10, because you're looking at the historic dividend, 10 divide by 50, it looks like it's 20%. Wow, that looks attractive, right?

But actually, sometimes that can be a sign of distress. So that's what we figured out, that the historical dividend, you need some kind of sustainability filter or cumulative filter to find strong companies that are able to continue paying their dividends. Is it possible for you to have a high rating on an index that has performed really lousy? In general, no. I do sort of believe in mean reversions, so we do give some points if you have not performed well for a long time in the expectation that you may come back. I'll give you an example, sort of value hasn't performed that well.

as a sort of group, but I think eventually value will come back. So that grouping, they will get a bit more points because value has underperformed. And then on the converse, momentum growth has done very well. So we take away a couple points. And actually, it's a really interesting point, Michael, because for me, I see this in myself and my own investing. Everyone's kind of tempted to buy something when it's done well. And they want to buy high and sell higher.

So I want to try and help people sort of say, well, think about the timing. we actually have a metric on our under and aath our ratings when we say the current attractiveness. So you can sort of see if we think it's attractive or not. And then also we have the forecast to try and help people look forward because the worst thing is you could sort of, let's say, you don't want to be putting all your money in the NASDAQ right now. It's a little bit overvalued. It's had a great run. So you want to think about diversification. Now, you don't have to give specific companies or tickers or anything like that, but what are you what you think of as some of the worst types of indexes or products that people

should generally avoid? So from my point of view, I think there's a couple things that really stick out to me, man. One is very narrow indices, indices that have got, let's say, less than 30 constituents. So that's just risky, especially if they're waiting them by market cap. That can be very bad for investors. So right now there's some MLP indices that have got very few constituents and big weights to some large stocks.

So if any of one of those large stocks has an accident, that's going to end up very badly for the investor. I think about the Dow's industrial average. I've just got 13 names, price weighted. That's not a great index rather by the S&P 500 or the Russell 3. It's just much more diverse. And let me give you an example. There's a Taiwanese index that's got more than about 25% to Taiwan semiconductor manufacturing. And if you had chosen that, you would have done very well. I'll contrast this with some Hong Kong indices where I've got about 25% to a company called AIA, which is an insurance company. And they've suffered through the COVID crisis. So if you had just said, oh, well, I'm going to pick an Asian economy. It doesn't really

make a difference. Taiwan, Hong Kong. Actually, it does. You need to understand the index. You need to understand what's in it and how it's been designed. And that's what our ratings are there to help you do. And then the final point is, I just don't like indices with a lot of bells and whistles and mechanisms. That's always a recipe for disaster in my experience. All right. So we'd be remiss if we didn't bring up ESG. It's gotten more and more popular over the years, but now there's actually some money really being allocated to the space. So this seems like an area more than almost anything else where investors really need to get a sense of what they're investing in this. There's a lot of subjectivity involved in these sort of products. What are your general thoughts on ESJ? Well, I could go on for a long time on this. So overall, at the high level, I like it. I think it's good for investors that we understand that you've got to be more socially responsible. You've got to think about the environment. But listen, I do actually have some quite deep concerns. Number one, there is no consistency across all the ratings providers. So that makes it very difficult for the average person to understand what is good, what is bad.

I give you an example. Some ESG indices include Facebook and some don't. So that's just difficult for the man on the street. But my second point is it's more like around valuations, Michael. So you mentioned there's a lot of money now behind it. So ESG indices have actually done quite well through COVID, and I'm going to touch on that. But also, the pool of ESG-friendly stocks is quite small. So you're seeing stretched valuations.

So that's a big concern of mine, stretched valuations. And then the second thing is ESG indices have some quite radical tilts. Everyone's been talking how strong the ESG performance has been, how wonderful they are through the COVID, but actually, they naturally tilt towards technology companies and healthcare because they have less issues. They don't have a big mine that may have pollution and so on. So they naturally have excluded energy and they have naturally excluded materials and some big industrial companies. Now, those are the three sectors that did very badly over COVID. And eventually it's going to come back. And you'll probably find over the next couple years that ESG indices

from a valuation point of view may not perform well. And also these other sectors that they've natural biases against may actually come back and do well. So I like the concept, but if you're thinking about buying an ESG index, really be careful. Think about the valuation. Think about what's going to happen with those sectors. So last thing, Lawrence, how exactly does your product work? Is this a subscription product? When people try and learn more about the services, what exactly would they find?

So right now, we have 400 ETF ratings that anyone can see for free and just ask you to sign up. And then for our forecasts, we display five for four. free. If you want to see those, you'll need to sign up. And then also to see the rest of the ETFs that we rate and also the risk-controlled indices that are used in the US annuity space, you have to subscribe. So I think we offer something for everyone. The self-directed investor can go and see some ETS for free. But for the rest of the world, there's a lot of great content there that you have to subscribe to. All right. This is great. Thank you very much, Lawrence. We really

appreciate it. Thank you, guys. I really enjoyed being here with you today. We want to thank Lawrence for coming on. We're going to have a bunch of links to his stuff. He writes a good blog at the Index Standard that breaks some of this stuff down. So go to the Indexstander.com, Animal Spiritspot at gmail.com. If you have any questions, we'll talk to you next week.