ETF Edge - Grantham's GMO Gets into ETF Game 11/13/23

Episode Date: November 13, 2023

CNBC’s Bob Pisani sat down with Tom Hancock, Head of the Focused Equity Team at GMO and Portfolio Manager for GMO’s Quality Strategies - along with Nate Geraci, President of The ETF Store. They discussed the future of value investing and the rapid rise of ETFs, as legendary investor Jeremy Grantham’s firm gears up to launch its first ETF ever – and the name of the game is quality. They also waded into the growth vs. value debate and delved deeper into key investing trends in the year ahead. Plus, our panel of experts explored the recent explosion of active ETFs and continued demand for Treasury ETFs – on both the short and long end. In the “Markets 102” portion, Bob continued the conversation with Nate Geraci from The ETF Store. 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. Today on the show, we're discussing the future of value investing and the rapid rise of ETFs as legendary investor, Jeremy Grantham's firm gears up to launch its first

ETF ever, and the name of the game is quality. We'll talk to the man who runs the fund and find out why now, why get into ETFs now, get GMO's take on the growth versus value debate and delve deeper into key investing trends in the year ahead. We'll also get more on the recent explosion of active ETFs and continuing demand for Treasury ETFs on both the short and long end. Here's my conversation with Tom Hancock. He's the head of the focused equity team at GMO and portfolio manager for GMO's quality strategies.

And Nate Geraci is the president of the ETF store. Tom, Jeremy Grantham, what happened? 45 years ago must have founded GMO. Why get into the ETF business now and why quality? GMO is famous for value investing for why quality? Yeah, well, truly coming from our clients. A lot of them are really excited about investing in ETFs. so the tax advantages, but even amongst our institutional clients, just the ease of trading them

is pretty material. And then the other thing is that active strategies, we imagine active portfolio, there's a lot more interest in active ETFs than there was even a few years ago. Yeah, that makes sense to me. Now, you already run a quality mutual fund, GMO quality mutual fund, the symbol is GQETX, those of you were writing this down. How is this different? Is it, the fund is, I understand slightly, the mutual fund is slightly different than the ETF, you're going to be running. And while you're doing this, define quality for us. So we all understand we're talking about the same thing. Yeah, so similar style investment philosophy team. The difference with the ETF is it's only invested in U.S. stocks, whereas the mutual fund has

about 20% in non-U.S. multinationals. Now, what does quality mean for us? Quality is about companies that can sustainably deploy capital at high rates of return. They can do things competitors can't moats around their business. They have strong balance sheets. These are battleship companies that are going to remain relevant and important going forward. Now, we're putting up the GQ ETX. This is the mutual fund that you're managing. I assume that your biggest holdings in the ETF will be similar here. You see Microsoft, United Health, Johnson, and Johnson.

These are names familiar to all of us. This shows up on quality screens all the time. You also get Apple and Alphabet and Amazon. It's really a big cap fund with a slight tilt towards, technology, I guess, at this point, right? Yeah, that's right. There are really three sectors where we've traditionally found attractive opportunities. It's technology.

It's also health care. And then a lot of the consumer staples, the branded consumer companies that have been around for so long. Yeah, the Johnson & Johnsons of the world. That always shows up on a quality ETF screen. Nate, this is a pretty saturated ETF market. There's

an awful lot of quality ETFs out there, more than a dozen, at least. Can somebody like a GMO really stand out in this kind of market? I do think so. You know, I love the fact that more traditional active managers are getting involved in ETFs because that offers choice for investors. And really, it's a natural evolution of the ETF wrapper, which over the years, that

wrapper has proven to be lower cost and more tax efficient. And if you think of an active manager attempting to generate after tax alpha, the ETF wrapper helps lower that hurdle. It offers a better chance at outperformance. But bigger picture, I think it's interesting because the ETF industry was built on the back of passive management, but the industry has evolved. And quite simply, asset managers are meeting investors where investors want to be met. And that's in the ETF wrapper. I was actually looking at flow data the other day. Over the past 10 years, there's been about $4.3 trillion that has gone into ETFs. Well, 2.3 trillion. trillion has come out of mutual funds. Much of that on the equity mutual fund side, that's a

$6.5 trillion swing. I think that's obviously tough for any asset manager to ignore. So I think active managers coming into the space, offering their best strategies in an ETF wrapper, I think, is their best chance at success longer term. Yeah, that makes a complete sense to me. I mean, that's been, we've seen notable inflows this year. In a year, Nate, when there's been sort of underwhelming inflows in stocks and bonds we've seen notable inflows into actively managed. I want to ask you about value because Jeremy Grantham has always been associated with value. Values underperformed growth for years, I think, except for 2022. S&P growth has outperformed S&P value over 20 years, 10 years, five years, and even year to date,

it's underperform, values underperformed. In theory, I'm a Jack Bogle guy. He believed in reversion to me. This makes some sense to me. I think so. And yet it's not really happening in a big way. Can you describe why this is happening? What accounts for this long term outperformance of growth over value? And is that going to continue? Yeah. And we are value investors at GMO. But to us, value doesn't mean just a low price index. There's a lot of low quality cyclical businesses that can't really differentiate and are kind of going to know going nowhere over time. We like to talk about intrinsic value, which is companies that can grow and grow at a high return on capital, and that can be reasonably priced. And that kind of company has been doing very well.

And I think that kind of trend can continue, as long as there's innovation and growth opportunities going forward. You know, and yet, Nate, year to date, as I said, growth is outperforming value. Not only that, but the flows are going the same way. Growth ETFs, I think you gave me this, $16 billion in inflows. inflows, value ETFs, $6 billion in outflows. So we had that one good year in 2022, but we're back to the trend of growth over value, and the investor seems to smell that again. It's amazing. I mean, there's been a massive performance spread this year between growth and

value. I show over a 30% differential in performance. If you compare, say, the I share is Russell 1000 growth ETF to the Russell 1,000 value ETF. If you think about this, That's a really tough pill to swallow for value investors. After, to your point, it appeared value was turning the corner in 2022 following years of underperformance. You look last year, value outperformed growth by 21, 22%. So I think coming into 2023, a lot of investors expected that to continue. It's been the exact opposite. Yeah.

And yet everything has a price, right, Tom? I mean, if value is not cheap enough, it eventually will get cheap and somebody should buy it. In theory, if you believe in reversion to the mean, I know value guys, we debate about China all the time. There are value guys who don't care about the political debates in China. They'll buy if it's 14 times forward earnings or less on a certain index in China and don't care about anything else. Why isn't value get cheap enough for all of a sudden to outperform? I mean, even crummy stocks, you know, that don't have much earnings growth. do have a price. Everything's got a price where somebody will buy it.

Yeah, but I think if you look at those crummy stocks in the market today, they're not particularly cheap by historical standards. Really, the action is in growth. Values gone down nowhere. And we've seen a lot of interesting things going, obviously AI and stuff going on this year. There is a lot of innovation. And from a point of view of a value investor, while some of the most well-known stocks may be kind of frothy valuations, there's a pretty big supply chain, pretty big ecosystem there. So there's a lot of growth at a reasonable price, high quality opportunities to invest. So is it that value has, it's not value as dramatically underperformance, growth is dramatically

outperforming. I think that's the way to think about it. I mean, when you get top 10 stocks up and 30% on average, that's pretty remarkable overall. Yeah, this is an unusual environment where there are so many opportunities for large-cap equities. You don't normally see that. Nate, does this whole game of growth versus value make a lot of difference anymore? This is one of the longest old-school debates I've ever had, you know, growth versus value.

of a factor debate. Maybe it's just obsolete these days. Maybe we should just stop debating this whole game. And some stocks are, you know, growth prospects and others aren't just forget about it. I've been doing this for 30 years. And after why, I just want to say, well, it's time for everybody to move on. Well, you're right. It's always a compelling argument to just own the S&P 500 and not attempt to split into factors. But, you know, to what Tom was saying, if you look, a lot of gross performance this year has been driven by the so-called magnificent seven. Because if you look at many of the growth indices, they're pretty top-heavy. And so the largest growth companies have been enough to really drive that performance differential versus value.

And I would say even if you look a layer deeper than that, obviously the artificial intelligence, mania we saw earlier this year, that's been a big driver of mega-cap tech stocks. And then I think you have investors just anticipate. or assuming the Fed will cut rates at some point, which theoretically would help growth. But to what you're saying, do you want to attempt to play all of that or just own the S&P 500? The other thing is value tends to be pretty heavy financials in energy. You look at the performance of both of those sectors this year. It's been very underwhelming. Yeah, dramatically.

And here we have another example of an actively managed ETF. So I know you mentioned before, the industry's on pace made for a record number of new launches, but they seem to be primarily active ETFs. So what does that tell us now about the state of active? I mean, what it tells me is it seems like we've sort of exhausted the possibility for growth or new funds in the index space. Active has sort of become popular because of the exhaustion of the possibilities of indexes. and the success of that space is pulling money away from mutual fund.

So if you're an active mutual fund manager, you have to consider some kind of ETF at this point, it seems to me. Yeah, I 100% agree with that. I mean, the fact of the matter is all of the passive strategies are spoken for, right? Somebody isn't coming to market with a new S&P 500 ETF or Russell 2000 ETF. You're not going to compete there. And even if you look at the smart beta or factory ETF space, there's just not a ton of room for new products.

But with active management, you can differentiate assuming the active manager is actually doing something meaningfully different than the underlying benchmark. But that ability to differentiate, I think, is the key driver here because it's a way to stand out in a highly competitive industry. And what you were saying, you look at launches this year. So we've had about 450 new ETFs come to market. it, that actually puts the industry on pace to eclipse 2021's record of around 475 ETFs. And when you look at the composition of those launches, I show about 75% are actively managed. And it's all stripes of strategies from some of the largest names in active management. Obviously, GMO, you look at Capital Group, Fidelity, Calamos, Franklin Templeton, T. Roe Price, Dimensional, J.P. Morgan.

We could go on and on. it's truly the biggest brands and asset management continuing to leverage the ETF wrapper. Yeah, it's quite remarkable. I like to always say, and joke, Nate and I know this joke, that a mediocre active manager and a mutual fund wrapper is going to be a mediocre active manager and an ETF wrapper. You just have the lower costs overall. How has your actively managed mutual fund, the quality fund, fared against, say, the S&P 500? We've done quite well. We've added value against the S&P since inception, which is 2004. And I think what our clients value as much as that

is that we've been universally protected capital in a relative sense in the down market. So, of course, the financial crisis, but also last year, we managed a quality strategy that outperforms a down market in part because of its valuation focus historically, but also can participate in growth in a year like this. How are you doing this year, your performance?

We're outperforming in our mutual fund by about five percentage points for us. is the S&P you today. That's fine. Now, let me just ask you about asset bubbles because Grantham famously has called a number of asset bubbles in the past. The Japanese

asset price bubble in 1980, the dot-com bubble with 2000 and the housing bubble in the mid-2000s. Does GMO see any asset bubbles that are out there right now? At the broad asset class level, no, they're always little dislocations,

but our asset allocation group, as we call it does actually see a lot more opportunities there than GMO, which I know we do have reputations being bearish, but we're seeing opportunities out there. Jeremy has, yes, that is generally the perception of him, although he's been very successful. His perception is generally he's bearish. Now, he's famous for value investing and for making bets when asset prices deviate from their historic norms.

That's sort of been the mantra here. So where are we? I mean, can you tell us generically, do you think asset prices, is the stock market cheap or expensive right now overall. Yeah. Well, Jeremy would tell you the stock market's expensive. And I would say maybe that's true about the stock market, but there are a lot of opportunities out there. And that's why I think active management is particularly important right now. It's maybe a dangerous time to buy the whole index. Very, a dangerous time to buy the index? The whole index. And why is it dangerous now?

Well, I think valuations are stretched. Of course, there's a lot of uncertainty. We care a lot more about long-term things like geopolitical than just the economic cycle. But But valuations are stretched now, and the S&P is up 15%. I mean, if Jack Bogle was sitting here, he'd say, okay, so the valuations are stretched, but we're still up 15%. Yeah, well, we're a log-only equity shop. So, again, there's a lot of great opportunity there. And we've talked about AI, GLP1 drugs. There's a lot of reasons to be excited about investing in corporate America.

So let's talk about 2024. I mean, this has been a very choppy year for investors. Generally, mega-cap tech stocks have dominated. We all know that. interest rate sense of sectors, reits, utilities, generally have had a tough time of it recently. And even defensive sectors like health care and consumer staples have had a tough time of it recently. A large part of the investing public seems very happy to park all their money in money market funds these days, $6 trillion in money market funds.

Do you have any sense? Does GMO give any outlook for 2024, say stocks versus bonds, your overall macro view? Well, GMO takes a long view, so we're not going to have a view on 2020. 24 particularly. I would say rates were going up. They are up. So I think that damage has been done for a lot of asset classes. Are they going to go higher? Well, I wouldn't make that call myself, but I'm not an expert on that. Yeah. So you don't have a call for 2024, though, overall? No, I have a call that there are great stocks to invest in. We want to invest in them, and they're priced in a way that you don't have to wait too long to enjoy the return.

I'm sorry, Nate, do you have any other thoughts other than the big story this year is flows somewhat lower than in the past overall stocks and bonds, big inflows into any kind of short-term treasury funds, and inflows into active management? That's the sort of 30,000 foot point of view. Any other sub areas that you think are very interesting that have been going on or that might be big trends in 2024? for? Well, a couple points. First of all, I do want to go back to valuations. And I would agree with Tom that valuations appear stretched right now, but valuations can be very poor short-term timing indicators or much better, longer-term tools. And so actually doing something around where valuations are right now, and as we head into 2024, I think you have to be careful as an investor. When I look at ETF flow specifically, flows have been muted this year, but we still have.

had about 400 billion come into ETF. So it's still been a solid year, despite everything going on. I think if I were to look at a specific area, it would be Treasury ETFs, because the bottom line is the fact that you can get a 5% plus risk-free yield is a game changer when you consider everything going on right now, from questions over whether the Fed will be able to orchestrate a soft landing to geopolitical concerns. We have an upcoming election next year, which could contribute. to volatility. And so I think some investors are content to simply hide out in treasuries and scoop up that 5% plus yield without worrying. And then I think if you look on the longer end, so that would be on the short end side of the equation. On the longer end, we're seeing flows into ETFs like

TLT, the I share share share share treasury ETF. I think you have some investors that are attempting to call the top in long-term rates. They want to hedge against a potential economic slowdown. And TLT could be a nice portfolio diversifier. So I think we're going to continue to see flows into fixed income ETFs, particularly Treasury ETFs, because I think some investors don't want to take on that credit risk, looking onto the corporate credit and the high yield side. So that's a trend I expect to continue as we move into 2024. Yeah. The TLT is the most interesting thing I've seen in a while in terms of movement because that was such a mess earlier. And to see that turn around a little bit, That's a big story.

I want to talk about that a little bit in the ETF Edge podcast. 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. We'll be continuing the conversation with Nate Tracy from the ETF store. Nate, thanks for staying with us. You were mentioning at the end of the show the big inflows into TLT, which is the 20-plus-year Treasury ETFs. I find this one of the most interesting phenomenons of the year here. because what's happening is here is the yield curve is uninverting a little bit.

And by that I mean long-term yields have been rising recently more than short-term yields. Now all the yields have been down just recently, but that's been a big trend. And it looks to me like some people are now trying to reverse that and call a little bit of a market top here. I don't know. The investing public generally has a terrible track record. calling tops of any kind, stock tops or yield tops at all. But summarize what you make of that. Well, first of all, a high level to your point, we've seen about $110 billion go into Treasury ETFs overall this year. That's compared to about $400 billion across the entire industry.

When you look at the composition of the flows into Treasury ETFs, it is all across the curve, but it's primarily on the front end and then on the long end to what you were speaking to. What is amazing is you look at TLT, $21 billion has gone into that product this year, and it's down 9%. Down 9%. And if you take the flows and go all the way back to the beginning of last year, the flows are even greater and the performance is even worse. And what that tells me is you do have a large contingent of investors who are attempting to call a top in rates. But it's been a very tough trade. I'll tell you from my perspective, when I think about constructing a portfolio, I want that bond piece to really serve as a ballast.

I don't want that type of volatility on the bond side of the equation. Now, certainly, if we get an economic slowdown, rates come back in, you can get capital appreciation in a product like TLT, but boy, that's a lot of volatility, again, in the bond side of the portfolio. Well, but we are seeing a once-in-a-generation move in bond yields. So this kind of volatility is not normal, but that's the point. This is like a once-in-a-generation thing that we're seeing here. When you say, by the way, it's down 9%. You're referring to just price or price plus the dividend? It's total return.

Total return. That includes the dividend or the interest. Yeah. Yeah. And you're talking about near four to four and a half percent, I presume, throughout the year for the TLT. That's pretty remarkable. Let me just talk about the Tom Ford we had just on with GMO and who is running this quality fund.

They're about to launch on Wednesday. And I can't help but get involved in this debate about quality and growth versus value. So a lot of these factors just aren't working at all. So the classic ones, and this goes back to research, you know, there's 50 years old, over law and period. of time, small cap tends to outperform large cap. Over long periods of time, value tends to outperform growth. And yet neither has worked for a awfully long period of time. And in fact, this year you'd think, you know, combine it to get a small cap value fund. It would really do well eventually. And I actually own a small cap value fund. And it's not doing it. It's doing terribly this year again.

And has been for years, except maybe for 2020, maybe a small outperformance. So, it's very frustrating to those of us who believe what, you know, decades-long research holds, and yet it doesn't seem to be working. And I'm wondering if some of these ideas about factors aren't as valuable as they used to be. That seems to be heresy to some people, but I'm just asking. Yeah, so, I mean, factor timing is notoriously difficult, just period in and of itself. But I think, to be fair, if we go back following the financial crisis up until a about the COVID crash in March of 2020.

We were in a very unique environment. And then even following that COVID crash, we saw rates come down to zero. All of that was very supportive for growth and some of the largest tech companies out there. And so it makes sense to me that some of these factors underperformed. Whether or not the environment is now shifting, you know, that's tough to say, Bob.

I mean, I think you can make the case that if the Fed fails to orchestrate a soft landing and the economy rolls over, owning high-quality stocks or even potentially value stocks, given where valuations are at, that can make a lot of sense. But it's just so tough to time factors. That's the challenge. Here's the problem I have. You can say, oh, well, the financial crisis of 2008, that was extraordinary.

That's like a 100-year flood. Oh, who would have predicted COVID? That's like a 100-year flood. The problem, these 100-year floods are coming a lot more often than people thought. And so when people say, okay, you know, value has been underperforming since the financial crisis, but it'll go, you'll get reversion to the mean. You know, 15 years is a long time to wait for something to revert to the mean. That's testing the patience of any investor.

You know, I could see one year, two years, even five years. past 10 years, you know, that's a long time to wait. That's my point. And it concerns me a little bit. And I don't care what the excuse is, whether it's the great financial crisis, whether it's the, you know, Russia invasion of Ukraine, or whether it's COVID. These kinds of factor investing have been very popular for a long, long time and haven't generally worked. So I don't, I'll move on and just say that it's, it's to I want to ask you about, I want to ask you about Bitcoin, the Bitcoin ETFs. Everyone seems to think they're coming fairly soon. You want to handicap this for us, since you sit there and watch ETFs all day?

Well, as we sit here today, we're actually in a unique time period because we're in a window where the SEC could issue 19B4 approval orders literally this week. So those are rule changes that would allow spot Bitcoin ETFs to list and trade on their respective exchanges, such as denies he. Basically, there are several issuers who filed later than others, and those issuers are set to enter a public comment period next week, where the SEC is not going to approve those issuers or the exchange is 19B4 filings while they're in that comment period. And so theoretically, the SEC could approve the 19B4s this week, which would really just signal their intention to batch up approvals for multiple ETFs at the same time.

So you're saying, I think it's, go ahead. I want to point out, I think it's very important to note there are two pieces to approval here, right? So there are the exchange rule changes, and that's the 19B4 approvals, and then the issuers actual registration statement. So that's the S-1s who are in a gray scales case. It's an S-3. Those registration statements are much more important to actual launch timing.

and those are likely to be approved at a later date. And so really what would happen is the approval of these 19B4s, if that were to happen this week, that would just signal that the SEC intends to batch up launches. And obviously it would indicate the SEC is ready and willing to move forward with spot Bitcoin ETFs overall. So would they use the fact that the last batch of ETFs that filed, or companies that filed for a Bitcoin ETF,

has to be given a thumbs up or thumbs down this week as a platform for them to approve all the other ones? You seem to be saying that. Yeah, it really comes down to the fact if you look at the roughly 12 filings that are out there, they're all on different clocks. And I think nine of them are outside of their public comment period, but there's three that are also outside this week that will come back into that public comment period next week. And when they do, just historically speaking, the SEC isn't going to, you know, issue an approval order on a filing that has entered a public comment period.

And so if you look at the timing on that, that would then push that out to around early January. And so it's all optics. All I'm saying is that the SEC did want to batch approve these filings, they have a window this week to do so. If they don't take advantage of this window, it would get pushed out until early January. Yeah, that's a good point. The final point I want to bring up with you is the direction of technology ETFs, and particularly any kind of thematic tech ETFs that are out there, because this is another group that people are always trying to find some little edge to have. And we saw this in 2016 and 17th, cybersecurity.

ETS, 3D printing ETFs, they all sort of have come and gone. And what seems to happen is they have this moment of window where everybody launches a new thematic tech ETF, the prices go up, and then people sort of lose interest in the prices come down. So the public kind of buys at the top on these things. Are we going to see this with AI? There's a lot of small AI companies out there. People just think it's Microsoft and Nvidia, and it's not.

There's just dozens of tiny little companies out there that are eager to try to go public. And they may have a shot at the IPO window with everybody else doing terribly. So I foresee new AI ETFs coming in 2024, and I'm wondering if that's the same problem we're going to have eventually that we had with, for example, cybersecurity or 3D printing or even clean energy, for example. Yeah, I think so. I think we tend to see these thematic ETFs launch at the most inopportune time. And investors pile in. They end up getting underperformance. I think if we want to look back, Bob, the poster child here is Ark Invest and their lineup of

ETFs. You know, you look since the peak in February of 2021 in an ETF like ARKKK, that's down something like last I checked 75 to 80%. And so a lot of investors were burned pretty badly there. I do think investors are a little more skittish to come back into some of those types of disruptive tech ETFs. That's not to say that there won't be an audience there. I just think investors are much more discerning now. All right. Nate, thank you very much for joining us. Appreciate it. Nate Geraci is the president of the ETF store. Thank you everyone for listening to the

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