ETF Edge - Most tech funds blow off higher rates… and another fund just loves “higher for longer” 5/6/24

Episode Date: May 6, 2024

Investment dollars flowing into tech funds are seemingly ignoring higher interest rates… with one major exception in a former sector darling. Plus, one fund is hoping for “higher for”… as long as possible.         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 exchanged traded funds, you're in the right place. Every week we're bringing new interviews, market analysis, and breaking down what it all means for investors. I'm your host, Bha-Bazani. Money keeps pouring into tech funds despite higher interest rates, and one fund is looking to capitalize on higher for longer. Here's my conversation with Nate Jeracy, head to the ETF store, John Davy from Astoria Advisors,

and Jim Davilos, portfolio manager at Horizon Kinetics, who runs an inflation ETF. But Nate, let me turn to you. What's the reasoning here with these strong tech inflows? I see every broad tech fund from the Spider technology, the XLK, QQ, VANQ, Vanguard technology, has seen inflows this year, even though higher rates usually hurt technology. Yeah, and you could even broaden that out to the S&P 500 ETFs, which are all in the top 10 of ETF inflows. Those obviously are very concentrated in mega-cap growth and tech. But I think what this gets back to is investors are viewing mega-cap tech as a quality play.

These companies have tangible earning. They have cash on the balance sheet. And if you go back to when we were in a zero-interest rate environment, there was no hurdle rate. And it was much easier to take speculative bets. But now we have short-term treasuries yielding north of 5%. I think that causes investors to rethink making bets on companies with earnings that are far out into the future. Investors want earnings and cash flow they can see now. And in general, that's what you're going to find in tech ETFs.

It's almost as if it's a quality approach. Yeah, that makes a lot of sense to me. Now, I noticed one exception here when I was looking at flows, and that's Kathy Wood's ARC funds. They're continuing to see outflows like they did in 2023. And what's the difference here? Why are investors pouring money into broad tech funds and not into Kathy Woods? And by the way, it's not just ARC. I see the robotics fund.

I see Space Exploration Fund, ARC space exploration, outflows, FinTech, Outflows, Next Gen Internet Arc Fund, Outflows, right across the board. Well, again, I think investors want earnings here and now. They want to see cash flow. And if you look at the types of companies that are in, for example, ARCS products, these are very speculative bets. And you're betting on something way out into the future. Investors aren't comfortable with that right now. We could have higher for longer rates.

Obviously, rates are elevated right now. I think it remains to be seen what happens with rates moving forward. We have had some inflation data that has been hotter than expected. And so investors are shying away from those speculative bets like you see in something like ARKKKK. John, weigh in on this. This seems to make some sense. I'm trying to figure why is Kathy Wood seeing outflows and big cap tech are still seeing inflows. And his point is the emphasis is not just on technology, but on quality in technology. And for those you don't know, quality is generally, what, high return on equity, stable earnings growth, low debt to equity. There's a whole series of criteria for quality. But does that make sense? What do you say? I think so. I mean, I think you usually get like one bite at the apples. So if you buy like some unprofitable technology, If it goes down 70%, you know, you have a problem explaining it to your end client. Whereas tickers like Qual, the MSI quality ETF, you know, you're going to get, like you said,

companies with stable cash flow, low debt to equity, kind of stable earnings growth. So those are tried and true kind of measures. So I think investors in a new interest rate environment, like Nate said, when Fed funds is like five, five in a quarter, I think it changes the game for the last classes. So you actually, you run a quality ETF, right? ROE is the symbol there, put that up, maybe we can just talk about that a little bit. This is 100 large and mid-cap stocks, all equal-weighted. How do you decide what's quality?

Okay, so we are looking for companies that, you know, paid dividends, stable cash flow, low debt to equity, good R-O-E, good R-O-A. Our issue, though, and we sector optimized. So if tech is 30% of the S&P, REE is going to have 30% technology exposure. Our issue with these broad market cap weighted indices is that you are put in a lot of eggs in just a small select technology stock. So we just say, look, we want to get each stock 1% weight and pick 100 of the highest quality stocks. And that's what our fund does, Ticker ROE. And we're looking here about your biggest holding, Super Micro, NVIDIA. These are all well-known names.

CINCORA. Tell us about that. Yeah. So we, you know, because we are optimizing against ESP tech sector weight, we're going to have like 30 technology stocks and each stock is going to have 1%. If a stock goes up a lot until the next year balance, you may see some size trip. That's why super microcomput is 2.3%.

But it was very important for us because of what you're talking about with flows. People don't want to be underweight tech, right? Tech is projected to deliver 40% of this year's earnings growth in S&P and next year 35%. So tech is the market, the market is tech. So that is why I think like if you look at the S&P equally weighted and next or the Russell 1000 equal related and next, those will only give you like 15% technology exposure, whereas we're going to give you the S&P's tech sector wait 30%. Yeah, because that's quality waits towards earnings growth too, right?

That's a very important tilt that you've got here. Nate, this word quality we're throwing around, I follow the academic research on this. It's often mentioned as one of the few factors that outperform the market. You get size, generally small cap outperforms big cap, over time, value, generally value outperforms growth over long periods of time, profitability and momentum as well and quality is one of these factors that people seem to pay a lot of attention to these days.

Yeah, and again, I think it just goes back to the environment we're in where there is some uncertainty moving forward, it's to whether or not the Fed is going to get this right. And it is possible we have an economic slowdown. In that scenario, investors want earnings, they want cash flow, they want things again that they can see and feel and touch right now. I really think it's that simple. What's interesting to what John was saying

is if you look at flows into some other ETFs, we have seen a pick up the flows into something like the Invesco S&P 500 equal weight ETF, ticker RSP, or the I shares quality ETF, ticker QUAL. And so you're seeing investors hone in on these sorts of factors. Yeah, it's a good point. I want to pivot here and get an update on something we covered last year and bringing Jim Davilos. He is the portfolio manager at Horizon Kinetics. He runs the inflation beneficiaries, ETF, INFL. And of course, this was a big topic of last year, Jim, you started the fund way back in the heady inflationary days of 2021. The Fed's been fighting inflation. And are you still, where are we now in this generically? Are you still in the camp that higher prices are going to be here for longer? that should be a factor in stock selection? Yeah, absolutely. I mean, you know, we launched the fund when inflation was still printing well below 1%.

The world was worried about a deflationary bust coming out of the COVID pandemic lockdowns. And I think one of the nuances that's not properly understood is that the portfolio is not designed, nor do we think that 7, 8, 9, 10% inflation is sustainable. The negative feedback loop into the real world economy is just too severe, whether it's in, impairing workers' ability to consume or companies with their profits.

So now we're actually going into the mature phase of inflation, but how I think we're actually ideally positioned, which is we're going to be stuck in a new world of three, four, five percent inflation. And I think that the Federal Reserve basically just admitted last week that we're going to prioritize the economy and employment and accept these higher inflation levels. And I don't think most portfolios are properly designed for that. Yeah, so your INFL, ETF, inflation, ETF, it's composed of companies that are expected to benefit from inflation, but you have a very particular take on this. So it's mining companies, exploration and production companies, transportation, real estate, stock exchanges.

But when I talked to you last year about this, you talked about the asset light model. Explain what that means. What's in this INFL that makes a particular interesting or unusual? So you actually just explained the companies in my fund very well. When you went through every one of those criteria of quality, so asset light means you have very high profit margins, you have high operating leverage, meaning that your profit margins go up with revenue growth, and that also you can benefit from a very long and during cycle.

And so asset light facilitates that, but you might not think you can actually get access to companies with these attributes in things like energy, financials. financial services, metals, and mining. But we have a proprietary process where we have identified these companies. We think they're valued at very severe discounts. And we also think that they can compound for multiple cycles or certainly multiple years as this cycle plays out. And asset light simply means the companies don't own as much, right? I mean, that's the point. So the carrying costs are not as high? What's the theory behind asset light? Yeah. So it's actually capital light. So you have a huge asset base, but you're not

capital intensive. So a royalty and energy, you literally have 90% gross profit margins, whereas an energy explorer would be lucky to be printing 20. Yeah, you own physical things. You own wells and you have all sorts of things. But these companies have the asset lights, or excuse me, the capital light business models that have the high margins, the high returns on capital, and the low reinvestment risk, which is what makes it a full cycle explosion. Good, thank you. Put this up there. So you own land companies here, like Texas, specific land and you own energy companies and metal wheat and precious metals here you also own

the stock exchange there's intercontinental exchange here so explain this what's prior prairie sky royalty and what do you what do you get here this that's sure energy but it's it's not an exploiter production company no so prairie sky owns approximately 20 million royalty acres in western canada so what this means is energy producer a comes in and spends a couple hundred million dollars to drill on their land. Prairie Sky just sits there and gets a check on a formulaic royalty based on the volume of oil and gas and the price of oil gas. So they own the land. They control the land. They're just leasing the land to a company and they get paid a royalty. Is that how it works? Explain that. Essentially, the minerals. So in many jurisdictions, you can separate the minerals, which is physical

ownership from a fee simple acre ownership, which would be like the land under your house. But because of that revenue model, they can earn these extraordinarily high returns versus a very capital-intensive capital-destroying industry. The E&P is essentially taking all the risk with capital investment. Precisely. And why exchanges, like inter-the-continental exchange? They own the NYC, by the way, folks. So if you think about the exchange at its core, it's a toll booth.

They put no balance sheet capital at risk, and they're matching buyers and sellers in financial instruments whether it's interest rates its currencies its commodity futures its index futures but to the extent you have more volume flowing through this exchange which happens when there's volatility when there's inflation when there's high nominal growth but again they have almost no marginal cost because now the exchange is effectively a technology platform so very high profit margins that grow commensurately with inflation so the whole idea here is these are companies that potentially would benefit from inflation.

A company like Prairie Sky Royalty, they would benefit more if asset prices went up. Oil, natural gas went up, which happens in inflation environment, and they would be a beneficiary of that, even though they don't own their asset light, as you said. Yes, it's basically find the best business model, the quality at the right price, to benefit sustainably from what we think is a radically different macro environment from the past 25 years. You know, Nate, I'm going to bring you back in here. Inflation fighting ETFs or that would benefit from inflation sounds like a great idea, but INFL has underperformed the S&P. I mean, I know if we can put up a comparison chart here by about over 20% in the last year,

and has also had some outflows as well. What is happening here? What's going on? Why is it underperforming? In theory, this is a perfectly reasonable expectation, right? Well, I think the one thing that we have to take at face value is the Fed saying their data dependent. And if inflation continues to run hotter than they would like, I think we have to take them at their word. That rates will remain elevated. They'll be higher for longer. And so that makes me a bit nervous piling into inflation-oriented ETFs because the Fed's going to do whatever they can to snuff inflation out. And I'm wondering if that has been the investor mentality over the past year or so. Now, that said, I think it's important to remember,

the Fed didn't exactly get this right back in 2021 as inflation started accelerating, right? They were late to react. And so you can make the case they might not get this right this time. As a matter of fact, maybe that should be the base case. But I think that's the investment. Jim, just looking at this here, I mean, in November, the S&P started notably outperforming. And that's when tech started outperforming. That's when the Magnificent Seven kind of, you know, moved up on the upside.

So what's happened here is they bought tech. This is why we led with that with the story in the very top of the show. Exactly. And that bifurcation point coincided with the December Fed meeting when everybody thought that Powell had pivoted and was pricing in seven rate cuts this year. Right. But the thing is the market hasn't readjusted yet. We're in a new reality. People keep buying tech not realizing we're higher for longer and there's a duration aspect to those names.

So I expect this to continue reversing and reversing sharply as we get through the remainder of this year. What about you, John? I look at other inflation. I look at gold. I look at Bitcoin, at least until recently. Copper has been up here. The trend there for most of the year has been higher for these commodity type plays. Your thoughts on inflation? Where's it going? I mean, I think inflation is such a highly nuanced area. You know, Jim, James runs an active strategy. We run an active strategy. If you pull a PPI versus the S&P 500, you know, since 2020, you know, 2020 when we launch it, I mean, we've actually. outperform the S&P by like 15%. So we pick very different sectors and stocks. We're looking at like really, you know, stocks that are geared towards higher interest rates, higher inflation, vis-a-vis the energy stocks, industrial stocks, but we do have things like gold with, which helps our downside volatility. I think the point is like if you put 3 to 5% that will offset any sort of like technology long duration of risk that investors have, so we're not saying

and put a lot of it into like things like NFL or PPI, but just a comfortable, in case inflation winds up being, you know, sticking high for long ago, which if you go back to the 70s, CPI was between 5 to 15% for 10 years, right? So we're only in year like four of this inflation cycle. I forgot to mention you do have an inflation. PPI is your inflation. How does that different from Jim's? Jim is, you know, picking actively based on, you know, his views. And we're just much more quantitative, systematic, but then we have like commodities in there, we have fixed income in there. So it's more of like a multi-asset approach, I would say. So 70% to 80% in stocks, and then 5 to 10% tips and 5% to 10% in commodities.

And I think what we... That's done fairly well. Yeah, year-to-day PPI is up 13%. S&P is up 7. So like in the quant world, we would say, you know, when the market goes up, we make more than a market, or we've outperformed. When the market goes down, we lose less. So that sort of asymmetry is a nice positive attribute to have

in a multi-assad portfolio. Again, we tell people like, you know, put 3% to 5%. The P ratio for our fund to start a team, when we launched it, it was like 6 or 7. So these are just stocks that, again, for the last 10 years, people were enamored with buying technology stocks and unprofitable tech. Nobody wanted to own energy stocks, material stocks,

the stocks that INF all owns or we own. But I just think that now, as we live in the next, you know, few years in a different industry environment, different inflation world. Yeah, these are some of the sectors and things you want to. And you mentioned something, Jim, just last word I'll give to you. You expect inflation to persist and you expect some outperformance on your INF over technology stocks. Just sum up why you feel that way, because I know you made that comment. Sure, yeah, and I'm glad you're touching on this. So So basically the Fed acknowledging they're letting, they're going to have to let inflation run higher

than this 2% target, which is completely made up, which is a point for another time. That means that rates are structurally going to have to be higher as well. And this is a completely different macro environment from the preceding 20 years. And so a lot of fund flows have gone into tech saying quality, cash balances, profit margins, certainly a lot of zeitgeist around artificial intelligence. But I think once the fundamentals, the weighing machine takes over from the voting machine, you're going to see the type of capital-like companies that are in my fund start to really remove themselves from the broader market.

In a sense, you're describing quality to a large extent. These phrase come up in different forms. Our definition of quality applied to a very unique subset of companies, yes. 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. John Davy from Astoria Advisors continues with us now. John, thanks for sticking around. What do you make of some of this weaker economic data of late?

Non-farm payrolls were kind of weak. The ISM numbers, the manufacturing numbers, were contraction territory in 49 last week. The market seemed to like this, but what's the implication for investors longer term? So it's good to see bad news is back to being good news. So now rate cuts are back on the horizon. And I think what that means for portfolios is that we have, when I was on your show, ETF Fed in February, I presented like a very constructive outlook. I thought you should be overweight equities.

I thought you should still own quality, but branch out to equal weight. And I still very much think now that's still the case. I mean, at the end of the day, like, you know, I think earnings are coming in better than expected, you know, so far in this earning season. The Fed has a rate cut or two in their back pocket that they can provide a floor. So I like that sort of risk award for equities where, you know, if the data gets in, it continues to come in weaker, the Fed cuts rates, provides a floor, and the stocks to rally. Last thing I'll say, Bob, is like, you know, S&P last year was up 24%.

This year it's up 7%. I mean, nobody expected this type of total return for equities, you know, at the start of last year. So it just proved... It's rather remarkable. And we're only... We had a 5% correction. and we're now 2% from the historic high. We're 100 points on the S&P from a new high,

and it's sort of going to creep up on everybody. The pain trade, it seems to me, is up now. People will be really surprised if we hit a new high. Yeah, and I think, you know, the keys, like the average stock did nothing for two years because it was just about the Mag 7, which drove up the returns of Q's of S&P 500. The average stock, if you think about when Fed funds went from zero to five,

inflation went from, you know, basically two to nine, you know, interest rates are an input cost into like cash flow, you know, formulas. So, like, people just didn't know how to value stocks when, like, you had all this volatility in inflation rates. But now that interest rates have settled, like, yes, they may get cut once or twice by the Fed, but people know how to value inflation input. So I'm very constructive. I think the average stock would do much better than, like, Spock. So people, it seems still a position for Goldilocks. they're still positioned for the idea that rates might be a little higher, but not much higher, and the Fed's not going to hike rates.

There's a good chance there'll be some kind of cut one or two towards the end of the year. And so I watch the earnings. They've been remarkably stable. Full year earnings estimates are spent to be up 7 or 8 percent. First quarter numbers held up fine. Second quarter numbers are also moving up in the month of April, which is a little unusual. So unless the economy kind of goes. goes south, unless the job market goes much further south. It seems to me the earnings are

going to hold up. I hear some companies complaining about pushback on prices, and who could blame them? You know, the price of snacks, you know, has gone way up. Some people are going to push back. We heard this about Starbucks last week. They said the occasional customer has gone away. Well, maybe the occasional customer can't afford a $5 latte. Yeah, yeah. The lower end can't afford it. So that I see. I see pushback from some people about higher food prices or fast food prices. But overall, I don't see the earnings slipping. Yeah, and I've been following earnings too and Starbucks Mist and some of the low-end consumers.

But it doesn't signal some like fall off a cliff economy, maybe a little bit of the slowdown. But again, now that you know the Fed has signaled to us per the press for last week that they're willing to cut. and they will cut rather than hike. I just think you've got that, you know, the tail win for equities. But I would think, I would say that like, you know, if you look at the S&P 493 versus the MAG 7, earnings estimates are projected to be higher by the end of this year for the S&P 493.

So, you know, a lot of portfolios, you know, they're stuck with just owning cues and those are very concentrated. And you saw this year, like, there's a dichotomy, right? Apple was down 13% prior to earnings. You know, Tesla was down 40% and 1.3.3% point this year. So you're starting to see like dichotomy in the mag seven. So all that I think bodes well for just broader diversification across stocks. You know obviously we believe you should be the other thing that amazes me is just how much people want to stay in short and

intermediate duration bonds. They love this four and a half percent money market fund. They love the four and a half percent 10 year. They don't seem very interested in moving out. And yet you look at the prices. I mean, it's astonishing how much like your average bond fund has been down in the last couple of years. If this, some of these are down 30 or 40 percent. If this would happen in the stock market, that people would be standing on the ledge of windows. And yet we're having this debacle in the bond market. And I'm glad rates are higher, but, you know, my bond funds are getting killed here.

Yeah. And nobody's complaining. Is it because people just like, oh, now all of a sudden, I have a higher yield that makes me happy. There's a little mental, you know, people were just, I forgot that you could get, you know, four or five percent risk free.

And we're just normalizing to our more normal insured environment, which we had for the last 20, 30 years outside of the last 10. But I agree with you about duration, Bob. I mean, we shorten our duration of our fixed income ETFs, just because, you know, it was tricky for us to know whether the next move higher rate, the next moving rates were up 50 to 100 or down 50 to, 100. So I think you've learned that now duration equals risk, right? So just be careful if you

own things like TLT. TLT this year is down 8%. That got killed. Last year at one point it was down like 28%. If that would happen if the SMP would be down 28%. I mean it was down at 1.22% in 20% and people were thinking it was the end of the world. I'm just saying mentally people see a bond. This is the worst bond market in 40 years. How long has it ever been since you've seen that? TLT dropped something like that. I agree, Bob. I mean, And, you know, but then again, like, people were always claiming, okay, at the end of the 30-year bond bull market. So maybe we did see. Or 40 years.

Yeah, 82. It's good to rent and own yields, front-in yield. John, always a pleasure chatting with you. Thank you. Thank you. That does a ETF Edge, the podcast. Thanks for listening. Join us again next week.

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