ETF Edge - Talking Technicals: Sector Rotation ETF Strategies 12/14/22

Episode Date: December 14, 2022

CNBC’s Bob Pisani spoke with Katie Stockton, Founder of Fairlead Strategies, and Ben Lavine, CIO of 3-D-L Capital Asset Management. With the fundamental picture next year looking cloudier by the minute, many investors are turning to technical analysis to determine where to put their money to work next. Today on the show they laid out some key asset sector rotation and asset allocation strategies to help ETF investors wade through the murky economic environment. In the Markets ‘102’ portion of the podcast, Bob continues the conversation with Katie Stockton from Fairlead Strategies. 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. 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'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, Bob Pazani, with the fundamental picture next year looking cloudier by the minute. Many investors are turning to technical analysis to determine where to put this. money. Today on the show, we'll discuss a couple of key asset sector rotation and asset allocation

strategies to help the ETS investors wade through the murky economic environment. Here's my conversation with Katie Stockton, founder of Fair League Strategies, along with Ben Levine, CIO of 3DL capital asset management. Katie, your ETF started in March and it uses a sector rotation strategy. You toggle between equities, sectors, S&P sectors, treasuries, gold. How does this work? Where is it invested? So we have a model that we've developed based on our long-term methodology. So we're really trying to identify sectors that have the best long-term upside momentum. And when the market doesn't allow for a lot of that,

then we move into these risk-off categories, including the short-term treasuries, long-term treasuries, and gold. So right now it's very highly risk-off because only the energy sector via the energy sector, spider, ETF, or XLE is exhibiting those positive characteristics that we identify. in our model. Yeah. So this is, as you see here, it's rebalanced monthly. So this is really tactical. You could move around a lot here. But look at what's here. It's treasuries. You're 30% in long term treasuries, 30% in short term, 22% in gold. The only equity exposure have is energy. So what conditions would need to exist for you to flip this over and suddenly

have a larger equity exposure? What would have to happen? Yeah, so it would really have to be a top-down event, right, where the S&P 500 becomes more oversold than it is already on a long-term basis and actually starts to react to that by seeing the long-term momentum indicator shift and or oversold by signals. There's a combination of factors that we're looking for to trigger essentially the end to the bare market cycle, and that's when we would expect tack as the ETF to ramp up very quickly to a full sector exposure. A full sector exposure would look like eight sector ETFs, none of the risk-off categories. But for now, we're pretty comfortable being more risk-off. We do think that the market has another down draft in store. Not surprisingly,

it's not obvious looking at that chart, but you have much lower volatility in the S&P 500, which of course makes sense. You own treasuries in here. So if the S&P goes up rather dramatically, you don't tend to rise, obviously. And if it goes down a lot, you don't tend to fall nearly as much. Not when, yeah, not when the holdings are as such. But in an environment where it does have that sector exposure, our primary goal is to outperform, essentially, you know, not only participate, but actually beat the broader market by being in the sectors that have that best long-term momentum and relative strength. And Ben, you actually use, you're a practitioner, you actually use ETFs. Yes. You have a turnkey platform for financial advisors. You provide mid, back office

support, but also you do strategic asset allocation using ETFs. Explain how 3DL works. So we are a managed model provider, but also a turnkey service provider for the independent financial advisor who is looking to have more home office type support, but maintain an independent practice. That way, they can focus more on their value add, which is financial planning, which is building their book of business and so forth, and leaving all the pain points to us as a platform provider. So not only do we provide as an investment strategist, managed models, including cost-effective ETFs, but we also provide the mid-and-back office support, such as portfolio accounting, investment reporting, model rebalancing, dealing with the custodians, again, all those pain

points that advisors deal with in their everyday practice. So I talk to people all the time, they were ex-Morgan Stanley, you know, wealth management guys, and they want to go into their own business. So is that a typical client? I mean, RIAs that are setting up their own shop, for example, You know, it's typically used, this is typically used by, it seems like people who may not have a deep investment backdrop. So maybe they don't want to set up their own back office. They don't want to necessarily personally pick and choose their own investments. They want to use modeled portfolios. Sure.

Am I right? Who's the client here? What's great about the financial advisor industry is it's a spectrum of backgrounds. So you have people, for instance, brought up on the insurance side who can tear apart an insurance, contract and annuity contract, but it doesn't have as much knowledge in the investment side. And then you have for on the other side of the spectrum, the former Morgan Stanley rep who wants to go out on their own and do independent financial planning. Well, they may have an investment background, but they have also limited bandwidth. They can't do everything. So the advisor needs to

make that decision, do I buy or do I build? Do I build my in-house capabilities, which isn't just investment, but it's also compliance because they're SEC. There's a SEC oversight and then there's all the reporting and making sure that you have systematic processes in place to run a smooth operation. The Morgan Stanley planner used to be able to rely on the home office where much of that support in return for a rev share. Well now that they're on their own they're finding that they may retain more of their revenue but they still need that support and so that's where a turnkey platform can come in and provide the level of support

depending on what the advisor needs. Yeah, and they're not accountants. If I'm an RIA working at Morgan Stanley, I'm used to have it Morgan Stanley take care of the whole back office stuff. I'm not doing the taxes. I'm not making sure people get paid and things like that. I want to focus on building a client base. So let's assume, I understand the turnkey concept.

How about picking stuff? I mean, the reason this show exists is because ETFs are being widely used by the investor. Particularly the RRA community, because it's cheaper, lower cost. Explain how you use ETFs. If I'm an old Morgan Stanley guy, I want to open my own shop. I hire you for back office stuff. What about model portfolios?

Can I log into Vanguard or BlackRock's model portfolio? Do you have your own model ETF portfolios? Do I build them for each individual client? How does that invest in side work? As a platform, we provide both. So we provide both access to third-party managed models like a BlackRock or in Vanguard through our technology partners.

We also provide our own proprietary models. And the reason why some advisors might prefer going to the in-house proprietary route is, one, we're third-party, so we're not a fund provider putting models out there invested in our own funds. It's independent third-party model provider. But we also do so in a way where we believe we pick the best areas in the markets from a cost-effective standpoint and from a risk-premium standpoint that we use. believe best compensate investors for the risk that they're taking their portfolios, whether

in equity or fixed income. So we are strategic asset allocators in the sense that we do not tactically move around the markets, inequities, and fixed income. But from time to time, we will make changes where we believe that risk reward is skewed in favor or perhaps against the investor from a long-term standpoint. Do you find most of your clients or RAs, for example, Are they themselves tactical managers? Will they simply buy your model and buy and hold? Or will they actually recommend situations where, like Katie's involved, where you're tactical allocator, you're moving things around?

Think of us as providing that basic building block, that basic foundation for an investment program where at the core you have the asset allocation for long-term risk exposures. Then as you move up from the foundation, you can consider things like tactical strategies or alternative illiquid type of strategies or perhaps you as the R.A. have a specific expertise that you believe you have expertise

in being able to allocate to above and beyond kind of those other building block foundations. So just to give an example, I talked to an R.A. who came from the agricultural industry. Knows the agricultural inside now, does agricultural-based investment? He didn't have the time, though, to focus on the other aspects of the investment program. He'd rather leave that to the other building blocks, the other foundation providers, so that he can

focus more of his time on what he believes he's truly an expert at, which is ag-based investing. Yeah. So you can focus your models on different things, for example, factor investing. If I want to buy value or size or profitability, you can basically tailor to whatever the RIA wants. So our investment philosophy is predicated on FOMA French, the classic three-factor or five-factor risk-based model, so that we are providing risk premiums not just to the markets, equities and fixed income, but premiums within the market, such as value, size, profitability, things that, risk premiums that have been sourced through financial academic literature and are seen as sustainable and rational as well.

You should be compensated, for instance, for being invested in value stocks because they are riskier in the sense that their growth outlook is less certain, or perhaps they're more financially leveraged, and that leverage feeds through in terms of their overall earnings behavior. So we believe that rationally being exposed to those risk premiums over long run compensates you, even though there might be volatility in the short term. So what is the RRA community saying to you now? Do they have particular concerns or interest this year? Is there something unusual going on? So we go into 20203. This community is getting bigger and bigger. There's more private managers out there, advisors, more of them using ETFs.

You talk to them. What are they telling you now? So 2022 is when we all discovered bond math for the first time in the sense that duration acts like beta, just like beta acts like with inequities. And in the sense that the price, the return that you see in your portfolio, two bonds depends on changes in interest rates as well as interest rate volatility. So this year, this past year to the point where the 10-year Treasury got up to 4.5% we saw a nearly 3% move in interest rates.

Well, your typical bond portfolio has roughly 6 or 7 years of duration in it. So now you're looking at 15 to 20% loss in portfolio. Advisors nor their clients have seen that kind of magnitude of loss. for the last 70 years. I mean, this is kind of an unprecedented period that we're having in the fixed income space. So the equity market volatility is one thing. I think most investors and most advisors are educated to expect to see that kind of volatility in equity. They're not educated to expect that kind of volatility and fixed income like we're seeing this year. Those are the kinds of conversations and discussions that we're having. And the inquiries that we're

getting from advisors are like, look, how can I lock in fixed income without experiencing the kind of volatility that we've experienced this last year. And it might mean having to look outside of the investment landscape and looking at other type of products that can insulate you from that kind of volatility, whether it's insurance-based products or bank products. It's all a matter of trade-offs. Liquidity, mark-to-market, pricing, locking in yields. These are things that advisors are now having to contend with for the first time that they've

not had to contend with in quite a while. Yeah. And we've seen, for example, buffering. products become really big this year. So these products provide equity exposure, and then you get some exposure to the downside. We've seen equity kickers where they're selling options, call options, collecting the premium, and hoping the market moves in the right direction for them. So unusual strategies have done well this year.

And your strategy, you know, tactical models, trend following models, Katie, have done really well. There has to be an hour for years. Yeah, I mean, there really has to be, especially in this environment, I think it draws people to my discipline, which is technical analysis, because we are somewhat unemotional and unbiased. You know, we're not looking at the company's fundamentals and getting married to that sort of growth trend, but rather respecting the market when it loses that momentum. And it tends to leave no stone unturned. So you have to have a way to stay invested through this type of environment as well. And to his point, the challenge has really been just the dual bear market. in treasuries because that caught a lot of people off guard.

Yeah. I just want to get clear with the viewers how you charge for access to the platform. So we have your technology, you have mid-back office charge. Suppose, I mean, for example, I'm the RIA. You're charging me pick a number, 60 basis points or something. Not that high. All right, whatever it is. And am I charging a fee on top of that?

How does it work if I'm running? If I want to run an RIA, a business like this, how does a fee structure? So assuming you come on as a representative of 3D, where 3D serves in essence the RIA on record as far as the custodian's concerned, we basically do an all-in-one encompassing fee that incorporates you, your fee, the financial advisor fee, as well as the platform fee. And the fee that we charge on our platform, this is all disclosed in our ADV, is there is a platform delivery fee, so access to the platform itself. of that as the technology fee. And then there's what's called the model delivery fee. And

that model delivery fee is either a fee we charge if you are invested in our models, or it's a fee that's charged by a third-party model provider that you may access through our technology. But the two are distinct. The technology platform fee is distinct from the model delivery fee. And then you as the advisor charge your own fee on top of that. And then depending on your arrangement, the selling arrangement that you have with 3D, we will handle your billing to the client on your behalf, and we do monthly billing. So if I say you're going to charge me whatever, 50 bases, or whatever we're going to charge, and I need to get 40 basis points minimum, and ultimately the client, we charge 90 basis points.

It's going to be something like on those levels. So that's what the client sees, and then how it's deconstructed or how it's charged. You know, we charge our fee, your fee is charged, and then we will forward onto you the fees that are passed on from that total feed that's charged to the client. You know, I know you're not in this business, Katie, but this kind of turnkey solutions seem to be gaining a lot of adherence. We've done this several times this year. More people go into this financial advisory business.

I don't know where this type of service fits in in the overall investment landscape, but it's growing for sure. Yeah, there's definitely a demand for it. In developing our own ETF, we were kind of addressing a similar need on the advisory front. So we found that the traction has really been very strong from the RIA, environment. And I think it's because a lot of them were trying to do this tactical or strategic allocation themselves. And they were doing so with limited success because they weren't approaching it systematically. So here you have solutions, right, that are kind of doing it for you.

So you can go focus on the rest of your business. Yeah. One of the remarkable things to me, I have been covering ETFs for 20 years. And it's the ocean of money that just keeps coming in. Here we have one of the worst years since 2008. And we still have $500 billion in inflows into ETFs this year. Even with bonds down, much of this is money that keeps coming out of mutual funds going into ETF structures. But most of it is still just oceans of money going into plain vanilla, you know, S&P 500 ETFs, Russell, 1,000 ETFs, Triple Qs, NASDAQs, NASDAQ 100, ETFs, just slow every year. And it seems to be price insensitive. It just keeps coming in.

Up year, up. Down year, up. Inflows still coming in. And just imagine when the 401Ks allow it even more. Yes, and that is the final business that hasn't been cracked yet. And, of course, that business is, as you know, way too lucrative. When will that happen? When will ETFs finally crack?

Recordkeepers are the gatekeepers. So record keepers for now, at least, still prefer to have mutual funds, is the primary investment vehicle to the plans that they record kept. Well, they prefer because there are higher fees associated. Is there another reason? Part of its execution. I mean, think about how ETFs can be executed, for instance, intraday. So the technology, to be able to get the kind of seamless type of allocation and distributions

that are normally handled through a mutual fund vehicle, now you have to incorporate intraday considerations as well, and you have to worry about pricing and execution on top of that. So record keepers, if they are going to give access or allow access to include ETFs as part of the plan lineup, they're going to basically charge a higher fee to the end participant or the plan sponsor to give access to it. So really for ETF adoption to pick up more broadly in the 401k or the ERISA plan space that is record kept, you need to see record keepers be able to offer that at scale on par with what they currently do with mutual funds, and we're not quite there yet.

There's no way to just say, like mutual funds, everyone's going to get the last price at the end of the day. You can't do that. You're saying you'd have to open it up to intraday trading, essentially? So basically, maybe not open it up to intraday trading, but you have to keep track of that execution and making sure that in the end you're achieving best execution on behalf of the plan participant. Not only that, but the cash flows are, although they are periodic in the sense that their payroll, driven. Let's say that an immediate distribution is being made and it's sort of unexpected. And so you go in and you execute that, you have to basically be able to keep track of how you executed it

unlike a mutual fund where all you have to do is just referred to the end of day close. Yeah, yeah, it's a tough one. 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. continuing the conversation with Katie Stockton from Fair Lead Strategies. Katie, thanks for sticking around. We've talked about your new ETF this year, the Fair Lead Tactical Sector ETF, the symbol is TAC, which is a sector rotation strategy. You know, you're one of those people that's been successful.

You had a successful business doing technical analysis and advisory for clients, and you started your own ETF. It's your first one. It's been successful this year. I wonder if you could share with the audience the experience of starting up an ETF. What is it like? It was a pleasant, awful, difficult? A major learning curve.

And as you mentioned, I had a research business to really support it. So I had a great sort of client base that I could go to and vet interest. So that gave me the confidence to do it. And at the same time, for a couple of years, in fact, I worked on a model. And a technical model is not easy to develop, especially a sophisticated one with moving parts, sort of a multi-factor model, if you will. So working with a quantitative consultant, I developed a sort of a rules-based system

around my methodology, and that was, I have to say, really exciting and interesting. I learned a lot in a way about myself and my process in doing that, but it was a big leap, right, to get from that place to actually bringing a product to market. So thankfully, we had a wonderful partner, they're Carrie Street partners, they're the funds advisor,

and we act as the portfolio manager and the sub-advisor, and they've been able to take off of my plate some of the back end stuff, you know, the stuff that compliance-related, accounting, et cetera, and that's been a huge help so I could really focus on strategy. Technical analysis is sort of the foundation of trend-following strategies, as you know, and I'm wondering how there seems to be a lot of interest in trend-following strategies this year, and it seems the reason to me is because so many people are sort of clueless about the

fundamentals. Where is the economy going? The big macro questions, it's really unusually difficult to figure this out right now. And my experience, having done this for a long time, is when people are clueless on the fundamentals, they turn to the technicals more because, well, maybe the technicals. We don't know what we're doing with fundamentals. Is that your experience? Am I kidding myself? Is there an unusually high level of interest in it? I think there is, but I think in addition to that, which I do think is a real thing, we have a whole younger of folks that have access to so much information that they can get a chart, a very sophisticated chart with a lot of technical indicators nearly for free. And so already being intrigued by the

markets usually at a younger age, now they have this tool that's very accessible. So to me, that's part of the interest. In fact, on my train ride into the city, a young man next to me, he was looking over my shoulder at my charts and said, what is that? I really want to get into markets. You know, tell me about that. So I think there's a lot of. just a genuine interest there at early ages and now they have access to the charts and the indicators, which is fantastic. But I'd say this year, the fact that it's happened really sort of obviously this year is the bare market cycle in equities. I think it's where technical analysis can really shine as a risk management tool, not just an opportunistic way of understanding markets.

Yeah, I hate to go into fundamentals to talking to a technical analyst, but I have to ask you, What's very obvious to me right now is that the strategists, the people who look from the top down at stocks from the economic perspective, macroeconomic expectives, they're lowering their earnings expectations for 2023, rather aggressively. Most of them now expect negative earnings for 2023. So this sets up a tough environment for price-wise. I mean, if you have a negative earnings outlook, it's hard to argue for a price increase. you think the multiple is going to expand. And we're already fairly rich on the multiple historically. We're almost 18 times forward earnings. The average is 17. To have an argument towards 18, 19, 20, you have to think the economy is going to be in pretty good shape. You're

definitely on a soft landing side to make that kind of argument. That's right. Yeah. So it's a tough, I see this as a tough setup. And that's why some of these strategies they have an ugly first half and better the second half of the year because they're looking forward to 2024. But eventually, it gets a little exhausting, figure this out. That's right. So we kind of feel like we're chasing it, right? The market should be a leading sort of indicator of a turnaround. So we can trust that the market, the stock market, measured by the S&P 500, should bottom before really the economic data does.

You know, it should be an anticipation of that turnaround that we see it manifests itself in a shift in momentum. I try not to get clouded by the fundamentals and the macro inputs, but rather look at just purely the charts and the indicators that have added value for us in our methodology. And they do point lower still. If you just look at past bare market cycles, we're still at not an average duration yet. So there's that issue. But they don't end in a V bottom fashion. They end with a bottoming process, which is an initial low established and then sort of a retest process. And it takes time for that to unfold. And as that unfolds, you get positive divergences. So we think we also

have a ways to go to really get out of this, but we think that that first sort of major low that will really only recognize in hindsight perhaps is likely in the first half of this coming year. And that's simply based on the fact that we've had a long-term oversold condition in place for some time. So we're going to get into that mindset where we're looking out for indications that the market has established that first low. Katie, thanks very much for joining us. It's going to be fascinating to see what happens in 2023. I'm sure we'll have you. you back to talk more about TAC and your outlook for the markets here. Katie Stockton is the founder of managing partner of Fairlead Strategies.

So the important portfolio manager for the fairly tactical sector ETIP symbol there, TACK or TAC. Everybody, thank you for listening to EETF Edge podcast. InvescoQQQQ believes new innovations create new opportunities. Become an agent of innovation. Invesco QQQ, Invesco Distributors, Inc.