ETF Edge - Small caps: new approaches to large challenges 10/14/24

Episode Date: October 14, 2024

As a group, small caps are supposed to outperform over the long run. But it’s a been a very long time since that’s happened. New active funds are looking to weed out the winners.         �� 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 InvescoQQQ. Let's rethink possibility. 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 am your host, Bob Pisani. As a group, small caps are supposed to outperform big caps over the long run. That hasn't happened in a very long time.

Could a new approach weed out the winners? Here's my conversation with Rob Harvey, Vice President of Dimensional Funds, and Ben Slavin is the global head of ETFs for BNY Mellon. Rob, including 2024, the S&P has outperformed the Russell 2000, 12 of the last 15 years. I know at Dimensional, you believe you can get some outperformance by using a profitability overlay.

Explain what you guys do and why you think a profitability overlay is important. Yeah, that's right. So we're starting from a still a very, very well diversified group of small cap securities, but you can refine that investment universe a little bit. There's no reason to hold companies that really are scraping the bottom of the barrel

in terms of profitability, dragging down and returns historically as well. You remove those from your small cap universe, you can do a lot for boosting returns. And so when you look at some of our products that we have a dimensional, comparing those to commercial indices that don't have those refinements,

it's a night and day difference when you look at the small cap. When you say night and day, you're talking, you can get what, one, two percentage over time outperformance? You're not talking about massive outperformance compared to like the Russell 2000, are you? Or what kind of outperformance are we talking about? Well, when we look at DFS, which has been around since 1999,

we see that it's not only outperformed the Russell 2000 by a substantial margin. On a net fees basis, it's also outperformed the S&P 500 and the Russell 3000 by almost 1%. So now you're really starting to see that small cap premium pop up, but you don't get that if you don't have those refinements to your investment universe. So it's really something that attracts investors to a dimensional way of thinking about investors.

Ben, we all know about the academic research. It's a long supported the notion that over long periods of time, small caps outperform, large caps, value outperforms, growth. But that's not happened on any consistent basis in over 15 years. Can you just give us a riff on this? Why is this happening? And is adding a profitability overlay, as Rob suggests, actually helpful? You're exactly right. The academic research has been out there for quite a long time.

What's changed is the number of products that are in the market that allow investors not only to provide some kind of a factor tilt, but also even more active stock picking product as well. And also the issuers have done quite a good job over the last several years really educating investors on how these factors can be used inside their asset allocation models, inside their portfolios, and many of these products, as you just mentioned, have track records which investors can use to really amyed. analyze how this would look on a risk-adjusted basis. But clearly, investor sentiment has shifted towards small caps. And you can see that in the numbers in terms of where investors are putting their dollars from a flow standpoint, and these type of strategies are benefiting.

Yeah. You know, a lot of people, I want to get to the why of this a little bit. Many people blame the composition of the Russell 2000, which is very heavily weighted, as you both know, towards small-capped bank stocks and biotechs, most of which are unprofitable. So, you know, if you look at that, I know we can put up my full screen here about the composition of the Russell 2000, but you look at it here, 25% are financials, 15% are health care. Look, health technology here, that's biotech, by the way. You can see what the impact is tech is only 10%. That's a tiny portion compared to the S&P 500 technology sector here.

So I'm trying to get a why is this happening. Why are we getting this persistent underperformance? And I think it's because of the unprofitability of some of the core sectors here like financials and health technology. I mean, that's a big part of it, too. When you look at these sectors as well, they happen to be in the growth side of the market, which means investors are ready to pay a lot to obtain these companies that don't have a lot of profits. So it's kind of a double whammy going against these companies. When you exclude those again, then you really start to see you can still have diversification across sectors,

but you're not holding on to these securities that really drag down in returns. So let's talk about, I have a little full screen here, potential factors in small cap underperformance. So we talked about tech dominance. As you mentioned, the growth aspect. Investors are buying growthier parts of the market, number one. Lower profit margins come up, too. You know, the small caps have lower profit margins,

I think probably because big cap is dominated by growth, which have higher profit margins. Some people will point out higher interest rates have been a factor that small caps are more sensitive to higher interest rates. that obviously interest rates have come down the last two years. And some people bought up to inflation, that small companies lack the pricing power of larger firms. I'm trying to figure out, give the viewers an answer about this underperformance

because I think many of them are just baffled about it. I think the simplest answer is the tech dominance. Investors seem to prefer growthier parts of the market. What about this idea that passive investing is a problem? Let's call blame ETFs, okay? passive investors are buying the S&P 500 reflexively without thinking about it and that has a growth overlay to it and therefore it's making it much more difficult for value investors to make we've had big hedge fund managers come on and say this it's not the same as value used to be 20 years ago

if I thought a stock was worth it was $10 and I thought it was worth $12 and I waited two years I'd be rewarded and now I'm not being rewarded the same and it's got to be those passive investors yeah Ah, the passive active debate and the growth versus value debate all wrapped up into one. I think, look, from a, you know, a small cap perspective, again, ETFs give investors that choice. And so you see even on the small cap passive benchmarks, you can go value, you can go growth. Now, of course, growth, even in the small cap space, is outperforming this year. And certainly, we've seen that sentiment play out. You know, we'll see what happens through the rest of the year.

That gap has significantly narrowed. Still, it does allow investors that choice. And again, even with the factor-based, whether it be profitability or others, it gives investors a quick way to gain that exposure, given how they want to approach the market. And there's just lots of options out there for investors and to do so with liquidity and cheaply as well. Yeah. And I want to note that there's other small-cap ETFs out there that screen for profitability.

I know the Spider, S&P, small-cap, 600, ETF, the symbol is SPSM. They do exactly that. Now, they have a very specific rules base here in the Spider one. It screens for positive gap earnings, generally accepted accounting principal earnings, for the past 12 months. So you have to have positive earnings the past 12 months and in the most recent quarter on top of liquidity. How does that compare to your approach? You have a rules-based approach to doing this too, right?

We do, too. I mean, we think about profitability in a little bit of a different way. A big difference between us and a commercial index though is how often is your index looking at the profitability of the companies that are constituents? For us, that answer is every day, which means that as financials are coming out to light, right, you have reported earnings every single day for all kinds of different companies. You want your investment universe to reflect that information. You want your investment universe to be refined for that.

In a commercial index, you're looking at maybe once, four times a year, usually at most, where there's going to be changes made, really what we've seen is when you have these premiums show up, they can be quick and they can be powerful. Like what we saw, for example, in July of this year, phenomenally strong period for small caps, right? You see the same thing for profitability and value as well. It can happen quickly and in large magnitude.

So by having that daily process to really focus on, making sure that you're getting those premiums, that can be the difference between a great investment experience and just an okay one. I'm trying to get at, and I know I'm belaboring this about why the underperformance is so strong, but it's got to be related to the fact that 40% of the companies in the S&P 500 are unprofitable. I'm sorry, 40% of the companies in the Russell 2000 are unprofitable. That's not the case with the S&P 500 at all.

That's not even close to that number. So can we talk about why this unprofitability has been occurring for it? It wasn't that way 20 years ago. It wasn't that bad. I don't know, I'm trying to look it up now. I don't know the exact number was 20 years ago, but 40% of the Russell 2000 was not unprofitable 20 years ago. So there's a whole, there's a sludge here of companies that are consistently unprofitable that I think are weighing down, is weighing down the Russell that doesn't happen with the S&P 500 for some reason.

Yeah, that's true, but I do also think you have to think about, well, what are you holding when you invest in microcaps and small caps? You know, these are companies that are very early on in the stages of their life cycle. There's lots of room to grow and to becoming more profitable companies. as well. So we don't necessarily anticipate that companies have to be massively profitable right off the gates. That's one of the reasons that people are attracted to things like private equity or small cap investing, right? So you do have a part of the universe that has lower profitability. You can screen out for that. And that by itself is enough to boost returns. Yeah. So we have about 40% that are unprofitable, right?

weeding out on profitable companies is a form of active management, right? Absolutely. I would think so, even if it's done in a rules-based fashion like you have. Yes. Would this approach, using profitability as a factor, also work in large caps? Yes. Because you do this with the S.P. 500. From our perspective, thinking about the impact that a solid income statement has

on large-cap companies is very similar to what you see in small-cap companies, right? It matters to have profitability. And so over longer periods of time, across sectors and geographies and securities, it tends to be the case that having that profitability emphasis in your portfolio is helpful. In 2021, 15% of the S&P 500 companies were unprofitable. So it's a big difference, 15 versus 40% being unprofitable.

So this factor debate has been around for a long time. The original factor was just beta out. you had to take risk, higher beta stocks, tend to outperform because they had more risk. Then Fama French came along, and we had the two factor model, which was small caps tend to outperform big caps, value tends to outperform growth.

And we've added other factors as time goes on. Profitability factor, this all gets wrapped up in this quality issue. There's a momentum factor as well. How much should investors be paying attention to these different factors? We're essentially talking about paying attention to one of them, profitability.

here do it does this actually matter in terms of outperformance a long time? Absolutely it does and by the way the factors that we're talking about are not mutually exclusive in fact when you combine those factors together you know value with profitability for example even in periods of time where you see value not performing great like we've seen in the US over the last couple years if profitability is doing well you're diversified inside of your strategy even to the factor exposure that you have so making sure that you have a manager and have selected that manager based off of how they're integrating these premiums is also very important.

Yeah, I guess the question is what should the average investor do? I mean, viewers are smart enough. They message me or stop in the street and say, I know we should have a diversified portfolio. I can't just own the S&P 500. That's not diversified up. I need to have some small cap exposure. I need to have international exposure. I need to have some bond exposure. But Bob, look at this thing. look at the Russell for 15 years. Well, we do see some of that changing as well. So certain investors are doing exactly what Rob just mentioned, where they're looking at products or combination of factors

to try to generate some kind of an outcome, whether that be alpha or at least on a risk-adjusted basis, depending on their goals. And then again, back to this story around ActiveBob, we do see investors starting to choose actively managed product for exactly these reasons because they are unsure. And we've seen flows go, to both. I think it's more pronounced in the small cap space in these less efficient markets

where these factor combinations can offer you know a stronger tilt or provide you know some kind of an active manage overlay which again investors are betting that it's going to receive some type of alpha compared to large cap but those are those are picking up you know flow as well. You seem to be saying though diversification still matters. I mean we've been debating about why so many small cap stocks are unprofitable. I guess it doesn't mean it doesn't mean investors reduced their allocation to small caps, right? I mean, the diversity story is still very real, right? Absolutely.

Look, if you asked most investors, what would you have wanted to hold more of over the course of the last year? They're going to tell you Nvidia, right? That's the stock that everybody thinks about. Invidia isn't even in the top 40, top performing names in the Russell 3000 through the first three quarters of this year.

Where did the rest of those names come from? Small caps, microcaps, microcaps, right? That's the power of diversification, is that you get to pick up these securities that are doubling, tripling, in value even over a couple of months, you probably haven't heard of those before. That's a good thing. That's why you want to have well-diversified portfolio. And you're the master of flows, B&Y Mellon, you watch all of that stuff incessantly.

Are investors coming to believe this? Are there actually flows into any small cap? There are. You had flows this year, right? We did. Dependionals had flows? Absolutely. Yeah, I mean, clearly the numbers are also showing that as well. Yes, the flow data is showing that. I think what's also really interesting is that it's not just simply flows, but we see these products being added to asset allocation models, specifically in the wealth channel, most notably in the RIA market, who are starting to add more small caps and do so via active management. In fact, around two-thirds of the flow that we've seen this year, based on

our data, shows that it's active that's being added to those models. So it's really a change from what we've seen even in the past year or so from where we are today. Well, they seem to be, investors seem to be believing this profitability overlay. So DFAS, which is yours, has had inflows this year. Yep. That means investors are putting money in above and beyond any price changes, folks. That's what it means. Their shares are being created.

IJR, which is the I shares small cap BTF, that has a profitability overlay. We already mentioned the Spider, S-MP, SM, S-P-S-P-S-M, that's had inflows as well. So somebody's believing this, although, as you mentioned earlier, the whole market's getting inflows to a certain extent. Yeah, I mean, everything seems to be benefiting from an ETF standpoint this year, just given the overall flow picture. I mean, again, we're at a record year this year. So, again, everything is benefiting, at least from a structural standpoint, we see that money, again, continue to come out of mutual funds into the ETF. wrapper and obviously markets have a big you know a big part in this as well given what's happening with the broader market and specifically small caps obviously

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 Ben Slavin the global head of ETF for B&Y Mellon continues with us now and we talked a lot about small caps versus big caps but I want to get your thoughts on these record inflows that we're seeing we have a shot at a trillion dollar year of inflows. ETS in the United States already surpassed $10 trillion. But as far as I can see, there's records in everything this year. Tell us what kind of records and why is it happening? Everything is big. I mean, we're seeing records across the board. And this last quarter was the

best quarter ever for ETFs here in the U.S. It was also the same globally, by the way. And year to date, we're at around 700 billion in inflow for the industry. And we are certainly within distance and likely on trajectory to break the all-time record and exceed a trillion dollars in it in for the industry. Part of that's the current trajectory and also the history shows that Q4 tends to be the best quarter historically for ETF inflows. So we had a record third quarter. We've had a record year-to-date inflows. We have record globally. We have a record in U.S. ETF assets undermined, a 10 trillion. Why is this happening? You know, it's a structural shift that's been in place for really the last

last several years and that structural shift is accelerating. There's a variety of reasons that are happening in the industry, everything ranging from fees to movement to asset allocation models, which are just tailor-made for ETFs. And, you know, investors are really changing their book away from mutual funds towards that ETF wrapper. And certainly markets have helped. And as money has come out of mutual funds, the new money has certainly cycled back into ETFs. And you saw that really exaggerated with the market sell off really a couple years ago and now with this bull market the ETF are just benefiting clearly that's what the puzzles me because we have this we do have this record bull market here and we

there's always this this old phrase flows follow prices that is when you have new highs it tends to attract more money duh right so that makes some sense but there's something else going on here we've had record number of new products coming on. Yes, the majority of the money is still going into plain vanilla ETFs like the S&P 500, but there's this record number of new products occurring as well. The industry seems to be going nuts here. But why is that? Yeah, it's a variety of things. I mean, certainly you're exactly right, but the industry obviously has caught on to this structural shift, and there's just an

incredible amount of product coming to market by new issuers and the existing ETF issuers trying to vacuum up all of this investor interest. But the breadth of product that's actually taking in money is staggering. So over 2,000 products year to date have taken in net new cash. 2,000 ETF. There's only 3,000 ETFs in the United States, right?

Exactly. It's just, it's really incredible. So 2, third, all the ETFs have taken in money, regardless of prices in general. That's what I mean. It's sort of unusual. And here's something else to think about too. Yes, you're exactly right.

The passive is getting its fair share as well and those are coming through asset allocation models, etc. But one of the things that we see is advisors certainly getting comfortable with some of these newer products, also actively managed strategies, which have been a big hit this year, around a 30% or so of the flow, has been going into actively managed ETSs. And many of these products are starting to hit their three-year track records or if started to really scale and making investors comfortable being able to allocate, in larger size. Is there any sector or industry that's high? I mean, Bitcoin ETF started this year.

They've done, they've raked in some nice amounts of money. One thing I don't see huge amounts of money. And again, thematic tech ETFs. I mean, six, seven years ago, cybersecurity ETFs or software ETFs or AI focused ETFs seem to be really big. That doesn't seem so big. ESG does not seem so big and still not getting inflows into that. What else is hot right now in general? Yeah, the thematic products are still alive and kicking, but you're exactly right. We haven't seen quite the enthusiasm from investors as we had really even a couple years ago in some of these type of products. I think part of that, like you mentioned with tech, could be a little bit about this as being a momentum-driven market

and certainly, you know, the broad-based benchmarks, you know, have been having these incredible run from a performance standpoint. point, but we also are seeing some signs in active, just straight up active management, whether it be quant active or stock picking active, but also these option-based products have been really the hot space this year from a product development and from flows. And these are providing an option overlay over the equity market to provide income, some kind of a market hedge, and these different variants have proven to be popular with investors. I worry about these derivative-based products. They're difficult to explain to the average viewer.

Some of them like these buffered products are very complex. Others get even more complex out there. I mean, who buys these kinds of products? I mean, reasonably sophisticated investors, right? I mean, investors who want some protection on the downside. But I'm just curious, it seems like a limited amount of money is going to go into those kinds of products. Yeah, I think that is the case.

But honestly, I think it's certainly. surprised my expectations on the upside and the category continues to grow. There has been an incredible amount of product there creating a lot of noise in the market, but you're exactly right. They are challenging to explain. The industry is trying to make educational materials and more available, but also these should be products that really are discussed with your financial advisor and we see that's where a lot of the money is coming. Yeah, that's for sure. RIAs have got to be pretty sophisticated to recommend these products. Ben, thank you very much. Appreciate it as always.

That does it for ETF Edge, the podcast. Thanks for listening. Join us again next week, or you can go to our website, etfedge.cc.com. How does InvescoQQQQ rethink possibility? By rethinking access to innovation and the NASDAQ 100. Let's rethink possibility, Investributors, Inc.