ETF Edge - Markets Post-Powell & Tracking Thematic Trends 8/29/22

Episode Date: August 29, 2022

CNBC’s Bob Pisani spoke with Dave Nadig, Financial Futurist at Vetta-Fi and Wes Crill, Head of Investment Strategists at Dimensional Fund Advisors. As the sell-off spills over from last week, they discussed how to navigate the choppy market terrain post-Powell – plus, the case for global diversification and China, why the run in value stocks is not over, and what's so right – and wrong – about the single stock ETF craze. In the Markets ‘102’ portion of the podcast, Bob continues the conversation with Wes Crill from Dimensional Fund Advisors. Hosted by Simplecast, an AdsWizz company. See https://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. Invesco Distributors, Inc. Welcome to ETF Edge, the podcast. If you're looking to learn the latest insights on all things, exchange-traded funds, you're 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 Pazani today on the show. As the sell-off spills over from last week, we'll discuss how to navigate the choppy market terrain post-Garon Powell. Plus the case for global diversification in China, why the run in value stocks is not over and what's right and wrong about this single stock ETF craze.

Here's my conversation with Dave Naughtick, Financial Futurist, and Vettify and West Krill, head of investment strategists at Dimensional Fund Advisors. What advice are you giving investors worried about the impact of inflation on corporate earnings right now? Well, there's a couple of ways to look at this. First of all, we have market-based gauges about what inflation. expectations are. I know we've come out of a period where there's been a very large change in consumer prices. But if I look at break-even inflation, so the difference between yields of inflation-protected treasuries and nominal treasuries of the same maturity, it's dropped down to about 2.4% as of the end of last week. So that would seem to imply that forward-looking inflation expectations may not be

as high as what some people would have you believe. Yeah, that's a good point. So you always emphasize the long-term investing. And I love it when you bring these statistics. The S&P's down. about 15% this year. In emphasizing long-term investing, you've often pointed out that there's been 15 drops of at least 20% since the market in 1926. At the worst this year, we were about 22% off of the highs. But drops worse than that are fairly rare occurrences. Not many of these 26 events went past even the 20% mark. Yeah, exactly. And like you mentioned, we have 15 of these bare markets historically where there's been a drop of at least 20% in the U.S. market. And more than half of those, the drop stopped pretty soon after we cross that 20% barrier.

We never made it to the next threshold, which would be minus 30%. Those were much rarer. And a really key aspect here is the recoveries were often very swift. So within one year, about 60% of these bare markets were recovered back to pre-market downturn levels. So they can happen fast. That is an amazing statistic. I want to have you repeat this.

Within a year, when you had a drop of 20% or more, within a year, half the time, you've recovered all the losses. More than about 60% of those 15% of the time, recover within a year. So this obviously goes to the point about staying invested. It does. And here's another interesting aspect. Okay, so we've mentioned the recovery happened. Even during the recovery, it wasn't like a linear piece of progress from the bottom and back up to the top. 39% of days in between the markets trough, I'm sure I'm mispronouncing that as my father.

always tells me, and the recovery point, 39% of those days saw negative returns in the market. Yeah, it's trough, by the way, but I think. But I'm not sure. Maybe Dave can tell us. Dave, you know, you're good at etymology and pronunciation. What stuck out to you in terms of fund flows in the last few weeks? Let's be a short-term viewer because people want to know what's going on. Well, yeah, so over the last five weeks, we've seen 50 billion more flow into this market. That's been broadly leaning on U.S. equities and U.S. fixed income, which frankly, Bob, it's been the story we've seen all year. We haven't really been able to see much on the international

side, a little bit of emerging markets. Interestingly, emerging markets debt has been probably the best performing in terms of flows part of the international ecosystem. So to the point of long-term investing, I worry that U.S. investors here have gotten a little over their skis in terms of home bias. It sort of worked for you because we've had such a strong dollar. But I think as we think about positioning portfolios for the rest of this year, we've got to be talking about international diversification. Yeah. Dave was making a point.

We have to be talking about international diversification at this point. So does this across the board decline in global assets that we've seen this year, does this strengthen the case for global diversification? And we've had this debate about China, that China should sort of be

considered a separate case. There's people arguing out there that it's not sufficient to just invest a country by market capitalization. Because China's 20% of the world doesn't necessarily move. we should do that, that other metrics like values on democracy and capitalism should be taken into account. What's the right way to look at this global diversification story?

So we'll start with the value that global diversification brings, and I think especially when we look over the past number of years when we've seen that the S&P 500 has been one of the best performing asset classes, we're very quick to forget a period when the S&P 500 was on the weaker side of the spectrum, what we call the lost decades sometimes from 2000 to 2009. where US stocks were essentially flat for the decade. A globally diversified equity portfolio provided a meaningful return during that same period. And so I think right there is the case

for global diversification. Now, how much you allocate to each country then becomes maybe a function of your circumstances. Market capitalization waits, a great place to start. China certainly a large portion of the emerging markets portfolio in the world, but emerging markets is only about 11 or 12% of the global equity portfolio.

Now, there might be reasons to deviate if you have a belief in scaling back your exposure to one country. And, you know, our investors, we have investment solutions available to them so they can customize their exposure to China in particular. There's lots of reasons why you might deviate from market cap weights, but it's a great place to start for a global diversified portfolio. Dave, we've talked about this before. What's the right way to view this whole asset allocation issue?

Is it more subtle than just market capitalization? I think when you think about country allocations, you have to. I mean, we all know Perth Toll and the Freedom Index, FRDM as the fund, which explicitly excludes China and other countries that have human rights and other freedom issues. I think that's a reasonable approach. And we're seeing right now some of the activity, the negotiation going on between U.S. and Chinese regulators around audits.

These are not wide open markets. It's not just a question of whether or not you support their policies. It has to do with the rule of law and whether or not you're actually doing the same thing by investing in a Chinese equity that you are in a U.S. equity, it's reasonable to have different metrics there and to reweight your portfolio to take into account some of that extra risk you get for being under China's thumb. Yeah, it's a good point. I want to move on because I want to hit you on several different issues here. I want to move on to the value issue. Dimension is known to have a value tilt. You've said the run in value stocks is not over yet. Why not? And what's the idea

behind this. Well, one place we can start is what is the value effect? The value effect means that there are stocks with different discount rates apply to their expected future cash flows. Perfectly reasonable assumption. I think it's very evergreen. Value investing is about identifying the stocks that relative to their expected future cash flows have low prices. That's as evergreen of a concept as you can get in terms of pursuing higher expect to returns. The only way I would believe that goes away is that there's no longer differences of discount rates across stocks. So that's point number one. Now, we can look at this in the data, right? You know, the belief that maybe the value premium is petering

out arises from this notion that a strong value premium may mean revert and turn weak in the future. If I go back historically, okay, we have value premium data in the U.S. going back to 1926, if I rank all of the calendar year observations, you've got more than 95 of them at this point, the year is following a particularly bad value premium year. So bottom quartile, what happens in the next year, value premium on average of about 4.2%. If I look in the years following the top quartile observations, it's about 4.5%. So right there, you see that the subsequent average for the value premium has been similar, no matter what happened in the preceding year.

We've looked everywhere for signals that'll tell you when it's going to turn. What accounts for the relative underperformance of value in the last, say, decade or so? Is it the Fed pumping liquidity in that's thrown more money into growth stocks? How do you account for that? It would be great if we could really lay it at the feet of one particular indicator that would be useful on a forward-looking basis. And we look at so many different macroeconomic indicators and try and find a correlation between these and the value premium. Changes and interest rates, sometimes there's a belief that the expected future cash flows of growth stocks compared to value stocks have different sensitivity to interest rates. It doesn't seem to hold up in the data in terms of the relation between changes and interest rates.

Inflation, GDP growth, none of these have been strong predictors of the value premium. I think what you see is just a set of circumstances that with the benefit of hindsight, favored growth company, the pandemic, the not favor value companies, the favorite growth companies, right? So you can look at these things and see, okay, what about that is useful going forward, and it's not going to tell you about future value premiums long expectations. Dave, is it still, values taken ahead. We know that. The stalwart's like dimensional is still here, and they may well be right in the next few years. This seems like a good year for value overall. has also been mixed up.

The results have been mixed and honestly, investors don't seem to be caring that much. We did see some interest in mid-cap value over the last few weeks here, but in general, this has still been very much either a broad asset class market, a thematic market, or a growth market. Value really hasn't been able to catch a bid the way some of those other things have. And when we talk to advisors at VETify, what we actually hear is less of a focus on value, more of a focus on dividends. seen a lot of interest in dividend payers, dividend growers. A lot of time, there's huge

overlap there with value and quality as well. But that seems to be the way advisors are trying to play this by focusing on the income and focusing on things that are going to react to an inflationary environment, not just looking at PE and PV levels. And how about that? West, there's been a lot of interest in dividend stocks for a down market. But you said that this may not be the most efficient way, the most efficient solution to a tough market buying dividend stocks. Explain why. Yeah, I mean, dividend payers are sometimes seen as a ballast that will provide some sort of, you know, benefit to investors when there's a market downturn, hence the popularity.

People should be aware that these companies that are paying dividends always have the flexibility to cut their dividends. And that's what we actually see is that there were visions in dividend payout policy that coincide a lot of times with economic downturns. And so it might not always be there just because it's getting paid today. You know, today's point, what we see with dividend payers is they tend to look like somewhat value stocks, but also. high profitability stocks. You can target that type of asset allocation in your portfolio. You can have a

high profitability set of value stocks. But we see fixed income is a better way to tailor your overall return volatility because compared to fixed income, even high dividend paying stocks still pretty volatile. I want to move on. I'm hearing several topics right now, but ESG, environmental, social governance funds. I know you've got some sustainability ETFs coming up down the road here, but how do you view ESG in the overall context of investing? Is there a place for it, or is it this one of these thematic ideas that in the long run get washed out, as Jack Bogle would say, don't really matter that much?

I'm talking about just from a purely investing point. Absolutely. That's what I'm here to do is represent the investment side of it. ESG investments can help investors align their portfolios with their values, whether it's sustainability type considerations, whether it's social considerations. When done effectively with careful implementation, you can reflect these in a broadly diversified portfolio. I think where the interest might be and where maybe some of the misconceptions lie is to what extent they drive differences in expected returns.

Now, if you think for a second about, okay, I have a sustainable company. Let's say it's more sustainable than its peers. Well, that's likely going to be reflected in its discount rate. All of its being equal, it might have a lower discount rate for its expected future cash flows. It might have higher expected future cash flows if it's believed to be sustainable. more around for the long term than appear. Guess what? If you're using price and you're using a proxy for expected future cash flows like profitability in your investment strategy, then you're likely capturing a lot of the impact that would have on expected returns. I want to move on here

because I know I've talked to Dave many times about ESG, but I want to talk about the single stock craze because Dave and I did a whole roundabout on this a few weeks ago. This single stock ETF craze, is this just more noise for the markets? What does it mean that we're introducing more ways to essentially trade volatility? Only in this case, we're talking about individual stocks. I mean, the way I look at it is this is not 2005. Many of us do not have defined benefit plans anymore to support our retirement. Most of us are on the hook for building out our investment portfolio to support us in retirement,

which means we need more reliable, robust, diversified investment solutions to help us achieve those goals. We don't need more ways to reduce diversification. to add any of theocratic risk to the portfolio. And when you layer on the potential role of, you know, of levering up with the single-stock ETS, this is not like levering up the market portfolio, which has a volatility of about 20% per year for standard deviation. The average single-stock standard aviation is closer to 40%.

And so you're talking about levering up a more volatile asset, and that seems counterproductive to me for many investors when it comes to preparing for their feature. And yet, Dave, there seems to be a class of investors that like these. that the Tesla single-stock ETS have gotten some very interesting volume around them. Some of the other ones, maybe not so much. Well, I mean, volume's the right word here, right? It's not that they've garnered a lot of assets.

They've garnered tons of volume. The Tesla one, as you pointed out, that complex is trading essentially its entire AUM every single day. That actually makes me happy. That means these products are being used predominantly as they're designed, which is those day-trading vehicles. I agree with Wes here. I'm not sure these are solving anything. anybody's retirement plan problems. They're very sharp tools, however, if you are a day trader

or a hedge fund who really needs to make liquidity matter. Can they, can they, and I know I've asked you this before, Dave, but is there a scenario where these compose some kind of systemic risk to the overall market or even a risk to the individual stocks? They do rebalance every day. We've talked about the mechanism by which they rebalance. Is there any overall risk to the market from this? Yeah. If you got a real disconnect where the the complex of these ETPs had more volume or a substantial amount of volume compared to the underlying. Probably not going to happen with Tesla anytime soon.

But you could imagine if we had mid and small cap versions of this where the trading vehicles get all of the play and the underlying stock stops trading as much, especially at the end of the day. That's when you could actually end up with a situation where the rebalance on the complex is actually driving the end of day prices. We saw that with volatility ETFs a few years ago. So it's theoretically possible with these, but we need to see enormous amounts more money flow into them and the volumes really juice up. So I don't think the sky is following just yet, but it's definitely got cracks if you want to look carefully.

We've talked about value. We've talked about ESG. We've talked about dividend. What about the broader issues, thematic ETFs and other subsets of investing? As a broad investor, is there evidence that they outperform long term or do they not? matter at all. You know, Jack Bogle, was the guy who had the biggest influence on me in my life, was sitting here, he'd say, you know, Bob, it's all washes out in the long run. You think you want to buy a crypto ETF, you know, or you think you want to buy a cybersecurity ETF, and you think you're going to be outperform, and the long run, it's all going to wash out. That's, I think, what Bogle would say about all this. Yeah, this is interesting

context, as you think about what the genesis was for index fund investing, which many people consider synonymous with ETFs, is it was almost a tacit admission. that markets worked or that trying to our guest markets was a fruitless endeavor. So it's interesting to me to see with some of these thematic investment ETFs, they seem to be a way to facilitate a traditional active mindset for investing, whether it's timing markets, whether it's predicting what stocks or what sectors are going to be going up. And so in that way, it does kind of seem antithetical to the Réonde de Trey, another word I'm probably butching for why ETS exists in the first place.

I love the one you speak Latin. Actually, I think it's French. Correct me, Dave. It is French, I believe. The important thing here is... He raised on debt, right. Okay. See, now he's corrected both of us, which really annoys me. And I'm hitting a lot of subjects here, but I want to move on here. Crypto and Bitcoin and blockchain.

Where does that fit into overall investing, in your opinion? Well, one way you can think about whether something should be in your portfolio, and to one extent it should be, is try to answer a couple of questions. Number one, what is this thing doing for my portfolio? Is it helping me increase expect a return? Is it helping me manage a risk? I'll start with the risk part. I don't think anything they can fluctuate by tens of percentage points in one day

really qualifies as a risk mitigation tool. Expect a return. Okay, well, I get the expect to return proposition for stocks and bonds. One of them is giving me a claim on expected future cash flows. Another one is giving me a stated level of venture payments. You don't get any of that potentially with crypto, right? You know, having one crypto today doesn't mean you're going to get more crypto tomorrow. So I think both the expected return and risk management portions of that are very difficult to answer.

And then lastly, okay, let's say I wanted in my portfolio, what's the value of crypto now? Well, it's probably less than a half a percent of the overall global stock and bond markets. And so if I have a million dollar portfolio, I'm probably talking about putting $40,000 into it, you know, in terms of crypto. So I think that's helpful for perspective if you were to try and assess how much you should have, whether you should have it at all. Yeah, Dave, any thoughts on on blockchain flows or crypto flows? Yeah, well, we've definitely seen the flows come down as you would expect. But I would push back a little bit here. I think something like crypto gives you the opportunity to participate in something exciting

that's happening as we're watching it, right? It's a little bit like investing in unprofitable tech companies in 1999. That doesn't mean that they should be a, you know, a major percentage of everybody's portfolio. but I do think a few percent acts as a significant diversifier. Even with this drawdown we've seen, the math would suggest a small allocation over the last five years has actually been a great diversifier. I think there's a big difference between going all in and crypto and finding a couple percent to put in as a bit of a diversifier and a potential flyer.

I don't think there's anything wrong with that. Yeah, it's a good point. Now it's time to round out the conversation with some analysis and perspective to help you better understand ETFs. This is the Markets 102 portion of the podcast. Today we'll be continuing the conversation with Wes Krill from Dimensional. And Wes, I want to get your thoughts on retirement because in the last six months, I've gotten a lot of messages from people. They're 60, 70 years old. They're thinking about retirement. And they want to know what should they be doing. And I basically say to them, you know, I'm 66. I'm planning to live to 85 to 90. You need to

have a very long-prim perspective and not worry about this single year that's sitting in front of it as a down year. What are you telling people? You know, you also have these great stats about how long people are going to potentially live. What kind of advice are you giving people? Yeah, I mean, we can use the actual aerial tables to give you a rough approximation of life expectancy at any age. And at age 65, the 50th percentile would be another 20 years and going on out to 85 years. And a lot of the research dimensional does around saving for retirement and then drawing down on that savings in retirement, we'll use an additional buffer on top of that.

So we'll look at 25 years starting at age 65, which captures about two-thirds of the population, again, based on the actuarial tables. Now, obviously, on an idiosyncratic basis, I mean, I had two grandmothers live to over 100 years old, so I might have to factor in a different expectancy for my life, for life expectancy compared to just the average person. And I think that's where it's so important

to have good information on how long your savings are going to last. You know, it's important to have your investment portfolio in some cases aligned with what the goals are, which is spending cash flows throughout retirement. And then you can get an approximation based on interest rate expectations, based on inflation expectations, kind of see, okay, is this going to be sustainable to spend what I want to spend? Yeah, a lot of people just staying on this retirement issue, underestimate how long they're going to live. I know I used to live, use 85 for a long time. And then I talked to my friends like you who know more about the actuarials.

And they've convinced me, Bob, this is wrong. You should use 90. And realistically, given the advances in medical technology, you ought to be using 95, in fact. And the useful thing here is not, of course, outliving your retirement money. That's a key point about all this. So I look at this very, very carefully. And I look at example, my own father, who lived in 90, held together. had many, many maladies towards the last 15 years of his life,

and yet was held together with advances in medical technology. So it's really quite remarkable when you think about it. Well, that's one challenge. And the other one is how much do I actually need for retirement? If you ask most people what their replacement rate is going to be, they'll give you that kind of wall-lined stare, how much do I actually need to replace from my income? And that's an important thing for investors to determine that as well.

I want to ask you of the young people out there. Robin Hood, a year and a half ago, 20 million accounts. Now, never mind, most people had $5,000 and it was the average. Today they have maybe 15 million accounts, maybe 3,000, but there's 15 million young people that are out there. How do we keep those people from leaving and saying, oh, well, I lost money, it's all rigged, it's all nonsense. How do we keep them as long-term investors?

Because we need those young people. We can't have, we need new investors, quite simply. Well-functioning markets need people trading, so hopefully they continue to trade. You know, it's great that we foster an interest in financial markets. that's a really key component, hopefully a good outcome from the environment these days. But I think you also want to foster the discipline of broad diversification. And I think that's a more challenging lesson to learn, frankly.

I mean, certainly if you have a bad experience in a meme stock, for example, then maybe you're more likely to turn to a broadly diversified portfolio. But maybe not. I think that's going to be something that we'll have to wait and find out to see if that lesson permeates. Thanks very much for joining us. West Crill is Dimensional Fund's head of investment strategists, and everybody thank you for joining us on the ETF Edge podcast. Inves QQQQ believes new innovations create new opportunities.

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