ETF Edge - A new strategy to unlock winners from two underperforming sectors 6/12/24

Episode Date: June 12, 2024

Small cap, value and international stocks have been lagging for a better part of the past decade. But, sometimes all it may take is a different perspective to find diamonds in the rough. Could this strategy be it?   Hosted by Simplecast, an AdsWizz company. See pcm.adswizz.com for information about our collection and use of personal data for advertising.

The ETF Edge podcast is sponsored by InvescoQQQQ, supporting the innovators changing the world. Investco Distributors, Inc. Welcome to ETF Edge, the podcast. If you're looking to learn the latest insights on all things, exchange, traded funds, you are in the right place every week. We're bringing you interviews, market analysis, and breaking down what it all means for investors. I'm your host, Bob Pisani. Smallcaps in value have been underperforming for a decade. But one new strategy is looking to swim against that current. And here is my conversation with Phil McKinnis chief investment strategist at

Adventist's investors as well as financial futurist Dave Naughting. Phil, investors seem to only want large-cap growth stocks these days. They've been outperforming for a long time, but you've got a very large suite of ETFs in the value space, small-cap and international. Given tech has outperformed most of the last decade, what is the argument for diversification? And can you make an argument small-cap and value will mount a comeback? Yeah, great question. And I think there's really two components to have. One, if you look at so far this year, as you said, if you go back to 2023, it's been a pretty concentrated market, right? 2023, we had eight stocks contribute more than half of the overall U.S. stock market return. That's actually a little bit more anomalous than I think or understand. If we go back to 2000, that sort of average median has been more like 27, 28 percent of the market return. Now, given the,

where the top 10 stocks are in terms of how much they make up of the marketplace, that number makes a lot more sense. So I would say 2023 was a little bit more of an anomaly. But to your point, growth stocks and mega cap tech have been doing really well. When we think about looking for companies, and this is across the cap range, whether it's within large caps, within mid caps, within small caps, it's coming back to a couple of basic principles, the idea that valuations matter, but just as important, those cash flows matter.

And so as we're sifting through and identifying those companies that are trading in more attractive prices, we're doing so while looking at the profits. And so that goes beyond if you think about the typical more kind of passive instruments that are out there that are making a definition of value versus growth on like a single variable or a whole compendium variable. We're really trying to target it and focus on those elements that we think really make a lot more sense. And so far that's worked quite well for us. So I like this additional factor, this profitability factor you're throwing. So value and small cap have underperformed for over a a decade, but you seem to have come up with some ways to address that. You're combining value in small

cap metrics as factors with profitability to create a sort of new form of active management. You seem to be having some success. Is that the idea here, add a profitability overlay? Well, for us, it's actually kind of going all the way back if you think more like in a Graham and Dodd kind of framework, because I think what kind of happened is at some point along the way, this concept of value investing just became synonymous with cheap, right? And there's not really a lot of value in things that are cheap. Our offices here in Little Tokyo in LA, there's a lot of great sushi restaurants just down the street here. I could invite you out to take you out to one of them.

But if I said I found a great deal on sushi and then I take you to 7-Eleven, you're not going to be too excited to eat that, right? So it's the idea that, all right, price plays a component here if we're thinking about value, but the quality matters, right? The quality absolutely matters. And small caps in particular, right, this has been definitely in the news over the last few years. You look at the number of small caps that trade at negative earnings, right? Those are not necessarily companies you're going to want to have in the portfolio.

So we definitely, as we're building portfolios, we want to emphasize broad diversification. The ETF wrapper is incredibly powerful, as you guys know better than anyone around kind of the tax efficiency of that wrapper. But as we're doing that, as we're building out that broadly diversified portfolio, we're considering the cash flows right alongside that price multiple relative to the equity. And that has worked well for us. This strategy, this small value strategy, has kept up with the S&B 500. I don't think there are too many strategies that can say that. And I want to put up, if we can, some of the holdings that you have here, including Abercrombie and Jackson, financial, KB, home.

This is the small cap value. But I want to bring Dave in here and just ask you, what is the reason? Is there a reason that small cap and value keeps lagging? We know what the economic theories tell us. We know what the academic theories tell us. Small caps should outperform over long periods, value should outperform growth, and yet it hasn't really been happening.

Independent of this additional profitability overlay, what's the problem? Why is it not working? I think that we have to acknowledge that we live in a different market than when a lot of those original academic papers that suggested long small cap value, long value should be always a winner.

The problem with value investing is that you may figure out a stock is worth $10, and you only get to make sense of that when somebody shows up to pay you 20 for it. Eventually, you have to be right about your pricing call and somebody has to take you out or at least market at a higher price. That I think has been the fundamental problem.

We've heard a lot of pretty well-known value investors, folks that are really looking for those bargains, whether it's a David Einhorn or a Cliff Asnes, really talk about how difficult it is to find those buyers in a world where most of the flow, let's be honest, goes into big index products that are generally blaming the poor index investors who are buying small cap? I'm not saying, are a problem.

This is what I'm not, Horn complaining about. I'm not blaming them. I'm thinking that the gap that you need for your value bet to pay off may be wider than it has been historically. What Avanus has done with their sort of profitability overlay and having some ability to trade around that, I think may have unlocked some of that. By focusing on profitability, I suspect what they're doing is

putting companies in front of its, investors with a different screen, right? Not that many people are just screening for low P.E. stocks anymore and buying off the bottom. It's not the debt, you know, the dogs or the Russell 2000. Doesn't work anymore. Yeah. Does that make some sense to you, Phil? I mean, about just generically, forget about the overlay of profitability, why small cap and value have been underperforming. It's been really since the financial crisis. I know, you know, they say our friend who did the original research over in Chicago some time ago, some of the research people that said, well, it takes a long time, Bob, maybe more than a decade, but it's been 12, 13 years now.

What's your thoughts? It's been a while, and I think you can't really ignore some of the multiple expansion that's gone on, right, if we think about that component. You've got, and again, this, you have to do this at the company level. You can paint with some broader brushes if you look at indexes, but you look at the Russell 1000 growth index just as an example, right? That's a massive P-E multiple, massive price-to-book multiple, massive price-to-sales-to-sales to sales multiple that it's trading at.

And if we think about those spreads, the spreads of that index, say, versus a small-cap index, a small-cap value index, or even if we start looking outside the U.S. to international markets, those spreads are as wide or wider than they've been in quite some time, right? I think if you think about those spreads, I think back to 2000, I think back to the end of 2021, or the two times so far this century where we've sort of seen those. The subsequent event was you saw some of the rest of the market really start to kind of keep back up. Yeah. So multiple expansion.

I think that's a valid point. Absolutely. And people putting a lot of money into passive funds. So Einhorn has a point. He made this a few months ago. And I sort of, it sounded like he was complaining. It was a little whining. It was a little whining.

It sounded like, oh, I'm a famous fund manager. I made a lot of money on this strategy. I'm brilliant, therefore, and it's not working, therefore something's wrong and can't be me. It's got to be the market. It's got to be these people buying these passive index funds. Well, it may have sounded a little whiny, but I think it may also be true, right?

Both of those things can be true at the same time. There's no question that passive is having an impact. If the average dollars coming in and investing along with the market cap table, very few of those dollars are going to magically end up in a small cap value portion of that fund. So I think unless you're hunting for small cap value, you're not necessarily going to be driving those prices up. But then again, we have opportunities like with AVUV where a little bit of performance can

bring a little bit of spotlight to that from advisors and individual investors, and you can create a bit of a self-fulfilling prophecy. Phil, I want to put up your holdings in your U.S. equity ETF. A-V-U-S. is the symbol here, and I look at the largest holdings. It looks a lot like the S&P 500. It's big cap tech. Apple, Microsoft, Nvidia, Amazon, Alphabet, meta. Do you use the same kind of metrics here, profitability? What are you using to pick this? Because it does look a little bit like the S&B on top. Yeah, great question. So we have really two kind of flavors of strategies as we think about the ETFs that we offer on the equity side. So those ones that are labeled value are going to be pushing a little bit harder on this philosophy

that we have, this application of trying to identify those companies that have both of those metrics, you know, profitability and that adjusted book to price we use together being super attractive. We also build just what are labeled more equity strategies. And those are those core building blocks. Those end up being used as kind of a total market exposure, right, a replacement for something that's tracking the Russell 3000 index or, you know, another total market index. And what we're trying to do there is it's much more of a weighting function than it is a selection. So you're exactly right, Bob. You're going to see those largest names that are in the universe in the portfolio. The weights are going to be different than what you see in terms of like the top 10, we're going to be less concentrated.

You know, you've got three names making up more than 20% in the S&P 500. You're not going to see that in the strategy. So we are kind of making a lot of smaller bets on these evaluation, better profitability, paying off through time. Does that change the sector weights at all? I mean, are you not participating in the 40% of the market now that is tech and telecom combined? Is that part of the reason for that re-weighting?

So with sectors, we're doing this. We're doing the comparison across most of the sectors, right? So starting more at the company level and the sectors being a byproduct. We do have caps with the sectors to make sure that those bets aren't too big, that we aren't too concentrated in an individual sector. I kind of want to go back to a point that you made, though, Dave, that I think is really important, really relevant. If we think about a lot of the adoption of index-based ETFs that have been going on, right?

There's a study that Vanguard put out that I thought was incredible in the sense that it looked at who's buying the overall market and then who's buying a lot of different subsets of the market and a lot more of the growth in indexing and index based ETFs because people want the tax efficiency of that wrapper, right? And maybe they want more flexibility in trading. A lot of that has come from these non total market type indexes. It's more of an expression of a part of the market. And that's where the conversation that we're having with a lot of investors and where I think this story is really resists. is, well, as soon as I move away from the market, say I build a value index, well, I'm now talking about that index provider's definition of what value is. And so I've got to look under the hood to say, well, how are they assessing a value stock relative to a growth stock? And you see massive differences across the index providers there. So this idea of a, you know, a once a year rebalancing with a specific index provider's definition of value, it leads to massive dispersion and outcomes, right? You saw this in 2023. If you look at it. at NS&P 500 value index ETFs or Russell 1,000 value index ETFs.

Spread and returns are something around 11%. Massive difference. So it's really helping us unlock this conversation of, let's get back to what do we think is actually going to drive performance over long term. And then as we're building that out, make sure we still have those good kind of broad diversification, right, low turnover, those other investments,

principles that we think are pretty subtle. This has been a problem with any fund. Oh yeah. Once you get past the S&P 500, we have this problem with dividend ETFs. There's 50 of them. They're totally, China ETFs. You can get all sorts of different results. Index construction definitely matters, and certainly active versus index,

definitely matters. It matters more the narrower the part of the market you're headed towards. Okay. I want to just move on here. You're also talking about the value of international investing and other underrepresented sector. You've got a large emerging markets, ETF that's out. there, the symbol A-V-E-M, and you also have an ex-China one I thought was very interesting,

A-V-E-M. I'm sorry, I think that's it. So, you know, the argument here is we've got 40% of U.S. corporate revenues are outside the United States, and the S&P's been outperforming in the last decade. So what does international investing get you? Make the case for international at this point. Yeah, absolutely. So I go back to kind of that global market. opportunity set, right, getting exposure to different economies, everything else. Certainly, you know, you can make the argument, as you said, where some businesses in the U.S. are generating revenues outside the U.S. from other countries. We still don't see that really show up in terms of if you look at long-term performance and the diversification that non-U.S. investing

can bring you, right? We still think that having exposure to the companies that are domiciled there makes some sense. The emerging market strategy we have, we did launch, as you said, an X-China strategy that's AVXC. And there, its investors looking for a little bit more control over how they're accessing China and then the way to China in the portfolio. So we felt like we can offer both of those strategies. We can still, what we're doing in terms of screening these companies, looking at the more attractive opportunities. When we do that in a multi-country or multi-region portfolio, we're doing it at the country level. And then giving you country weights that are similar to the beta as you get from an index-based strategy.

So in that sense, we aren't really making big country bets in these broader strategies. excluding a single country and still offering kind of that broad diversification, that absolutely works for us. But Bob, I'm going to sound like a broken record here. I'm going to go back to valuations when you think about non-U.S. developed emerging markets, particularly if you think about small caps within there, again, just really, really widespread. And so from that standpoint, it's, you know, I think at some point, these things have to come back to fundamentals. Yeah. It's amazing. We have, look, we have an ex-China ETF. 10 years ago, we didn't have any of this. And now, just in the last few years, a lot of Internet, national funds. They have ex-China.

I mean, that's just the way the political wins are going right now. We've now got tariffs on the major car makers in Europe and in the United States. To his point, though, that international diversification pays off the most when those valuation differences are the widest, right? This looks more like what we saw in 2010. What are we dealing with like 12, 13 times forward earnings on emerging markets, Phil? What are we talking about? Yeah, it's about as wide as we've seen for some time, just as Dave's pointed out.

I looked at the average over kind of the last 20 years and where the S&P trades versus EFA versus EM, it's kind of about double as wide as it has been. So that to me, you know, again, and there's a lot of other news that can come up. There's a lot of other things that can impact this. So we don't think you can reliably time these things over short horizons, but for that longer horizon investor, it does look like an attractive opportunity. All right. Any thoughts on the Fed at this point?

We got a great CPI today. Everything's up. Even small caps are up 3% today, Phil. You'd be happy. Oh, that was music to my ears that's DPI print because you've seen a whole bunch of green out strategy that they're flattening them up. I think, so I think they've done a pretty good job. I think they've done a pretty good job.

We saw, even with the news this morning, right, you saw what the market's pricing in in terms of rate cuts that went from two rate cuts this year. I think the probability jumped from 50 up to around 70%. So people are thinking about that they think they're landing the plane quite well. the actual what's going to happen, right, we're going to see. I don't tend to forecast too much on that, but I think they've done a great job so far. Now it's time to round out the conversation with some analysis and perspective to help you better understand ETFs. This is the Market's 102 portion of the podcast.

Financial Futurist Dave Nautic continues with us now. Dave, we talked a lot about international value, growth, small caps. I wonder, give us a synopsis. We're halfway through the year. How are the fund flows looking right now? Is this a good year or poor year? It's an average year. I think compared to what we've had in the last couple years,

which were some pretty blowout years, we're probably going to close the year at about $700,000, $800 billion in net flows. That would be a big year a couple years ago. Now it's sort of average for the last four or five. So we're sitting on $9 trillion in assets. We're sitting on $9 trillion in assets. Recently we've had a decent pickup, particularly in equity flows. We've been about $75 billion flow in the last 30 days.

That's a big month. And if you look at where folks are putting their money, it honestly looks like a pretty reasonable portfolio. It's been about 60, 40 equity in bonds. It's been about something like 80, 20, domestic to international, probably not enough international, probably not enough commodities and alternatives exposure, but otherwise pretty straightforward stuff, with the exception obviously of the Bitcoin launches this year, which are responsible for 20, 30, 40 billion dollars of flows by themselves.

So most of the six, 700 billion is still in plain vanilla. Yeah. S&P 500. Yeah, the top of the leaderboard is generally the top three ETF funds, you know, VOO, SPUI, and IEV. Those are S&P 500 funds. They're all S&P ETFs. Trade's a little bit between which ones pulling the assets on a given month, but they're almost always at the top of the leaderboard. We've seen a lot of uptick, too, in like big, broad market funds like Vanguard's VT and VTI, International and the U.S. versions.

And they're doing phenomenally well in terms of asset gathering. So that's pretty smart. I think investors are generally making smart allocations. You mentioned Bitcoin. It's been a success. I think it's fair to say. What are we north of $30 billion in assets? Depends of whether it would include gray scale or not.

If we include the gray scale, draw it down, we're like somewhere between 10 and $15 billion in net flows. We've actually had some negative flows in the last couple days. But I would say in the noise range. Like at this point, with $30 billion in assets, you're going to expect an average day to be plus or minus $100 million because that's the size of the pool. So it's been successful. Now, unexpectedly, the SEC gave the go-ahead for spot ether ETFs. We've heard nothing about the timing for this stuff. Yes, we've gotten step one, right? So we've got an approval from trading in markets to the exchanges for them to be allowed to trade

these things. We have not actually had any of the prospectuses from the Division of Investment management approved to actually launch the products. However, just like we saw with Bitcoin and frankly like we've seen with things like non-transparent active, first they deal with the trading issues, then they tell everybody to polish up their prospectus, their S-1s, then we get the launch states. But we don't have any time table when they'll approve the S-1. We don't have the launch states. But at this point, as much as a skeptic as I am, I would suspect it's in the next couple of

weeks. I don't think we're talking about months and months. Oh, that's interesting. Okay. What else? we have an IPO pricing this week. AI is a hot topic. Which is almost a surprise to have an IPO price.

Tempice AI is a medical diagnostics company. They use AI to do medical diagnostics. They're supposed to be trading on the NASDAQ this Friday. But it's still been pretty tough for the IPO market. The IPO ETF is not really outperforming this year. It's a basket of ETFs that are out there of IPOs, recent ones, the symbol is IPO. I don't know.

Any thoughts here? Yeah, I mean, we had, look, we had an anomalous year. A couple years ago, we had the biggest IPO year, I think, in history, whatever, a thousand IPOs. Most of them, I think, seven or 800 of them sort of SPAC projects. Those have all gone away. We're not doing those SPAC projects anymore. They've changed the rules. Companies now have to report directly to the SEC. You can't sort of backdoor your way in. They really clamp down on the sort of progressive financial situation where you say anything you want. So what we're left with is a fairly anemic, I pipeline and those companies that are coming public are coming public huge. That's the real

trend here. It's not that no money is getting raised, it's that people are only going public when they're effectively guaranteed of at least Russell 1,000 inclusion. Or they can't keep raising money in the private markets or their valuations are flatish. Right. So but there's still plenty of pressure to cut prior fundraising rounds for these tech companies generally when they go public, they usually take a haircut. I think that's fair. Look, people just don't raise money in the public markets anymore. They raise money in the private markets and then the private equity holders cash out in

the public markets. That's what makes it lousy. I mean, our poor viewers don't get to 25 years ago. It might have been more volatile because they were young companies going public, but at least they got to participate here, they don't. Well, at least they were young companies, right? The problem is now what we see going public are giant companies that are well established, which may or may not be fairly valued.

the opportunity to participate in something young and exciting and new really isn't there for the average equity investor anymore. Yeah, it's very frustrating. All right, Dave, I'm going to have to leave it there. And that does it for ETF Edge, the podcast. Thanks for listening. Remember, join us again next week or go to ETFedge.c.cnbc.com. We'll see all of our shows. Inves QQQQQQ believes new innovations create new opportunities. Become an agent of innovation. InvescoQQQQ, Invesco Distributors, Inc.