ETF Edge - The Russell rebalancing and what it says about the growth investing 6/24/24

Episode Date: June 24, 2024

The Russell 1000 and Russell 2000 are set to rebalance at the end of the week. FTSE Russell is one of largest indexing firms in the world and owns the small-cap benchmark Russell 2000 and large-cap Russell 1000. CEO Fiona Bassett explains the rebalancing process, what it says about popular investment strategies and more. Vettafi head of research Todd Rosenbluth also joins. 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'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 Pisani. My guest today on the ETF Edge podcast, Fiona Bassett, is CEO of Putsi Russell, one of the largest indexing firms in the world, owner of the small-cap

benchmark Russell 2000 and large cap Russell 1000. Also joining us as Todd Rosenbluth, head of research at VETA 5. Fiona, the reconstitution, as we like to call it, for the footsie, is going to be happening this Friday. It'll be one of the highest volume days of the year. I've seen estimates we could have 135 billion in equities trading on the closed. There's stocks moving from the Russell 2000, the small cap, to the Russell 1000, the big cap, also vice versa.

Briefly, for viewers who aren't familiar with this, explain how this process works. Yeah, so thanks, Bob. Great to be here. So, yeah, hugely important event in the Russell calendar. So as one of the leading US equity benchmarks, we annually reconstitute or rebalance the index. What we do on a rank date on the 30th of April is we basically score the companies by market cap. We look at the eligibility of companies for inclusion in the index. We look at their respective characteristics from a growth and values. perspective and then on the 24th of May we start preliminary announcements of the additions and deletions the index and that process runs for a four-week

period concluding this Friday on the close yeah so the what we see here is there's several tech names that had a very strong year and they're moving up from the Russell 2000 to the 1,000 I see super micro computer is going from the 2000 to the 1,000 that's what up 600% in the last year micro strategy I see is going into the Russell 1000, that's up 270 percent. It's easy to see. So a bunch of, it seems like technology are the ones that are moving up. Yeah, it's certainly the story for Russell 1000, which is being replenished by technology

and the overall direction which I think speaks to the re-engineering of the US economy around technology. So interestingly, the Russell 2000 is much more of a healthcare story. So a very different story depending on whether you're looking at large or small caps. Yeah. Todd, let me bring you in here. You know this argument about passive investing. As passive investing has gathered more assets. Old school stock pickers have complained that passive investing is taking up too much of the investment dollars. And some have implied that just mechanically putting money into big cap indexes like the Russell 1000 or the S&P 500 is reducing the effectiveness of other strategies like value investing. How do you respond to those criticism?

Well, I think we're seeing, we're seeing stocks moving day-to-day regardless of whether or not something is making it into the index. So the Russell 1000 and the Russell-2000 and those respective ETFs are important to focus on. But we at VETI-Fi are focusing on the growth and the value slices of those respective benchmarks. And so, for example, Home Depot is now going to be part of the value. The I-Share is Russell-1000 value ETF. Accenture is moving from the growth to the value. These companies are moving from one to the other because the index calculations show these are now value-oriented companies. There's still opportunities for active managers to outperform a benchmark by choosing which stocks are going to be more growth-oriented or more value-oriented or over-wading or underweighting that exposure.

So that hasn't changed, and we continue to find active managers having some success competing with the benchmarks. And yet, is there a reason, how do you feel about this whole argument? We've had value managers come on and say, I don't know why, but for some reason, value's not working. I've been a famous value manager for many years. I used to do very well. And suddenly I'm not doing very well. Some of them sound like they're complaining that, well, I don't know why because I made a lot

of money before. Why aren't I making a lot of money now? there must be something wrong with the market. It can't be my methodology. It's got to be this something. And they usually point to all these passive investors. They're buying big cap indexes like the Russell 1000 passively on the S&P 500 passively. And it's changing the metrics, the calculus.

There's not enough value investors to buy these stocks cheap and then move them up later on. Is there any validity to these arguments? They're very persistent, these people. They're persistent. The research doesn't tend to validate it. I will say the rise of indexed. investing is really driven by the solution that it brings to clients for transparency, low-cost diversification. Clearly, I think from a structural perspective from the economy, the story has been one of growth

driven by technology, particularly in the large-cap space. Interestingly, out of the top 10 and the Russell 1000, just one of those is a value stock with Berkshire Hathaway. But clearly there is a question of, is there the limit to the tech-led expansion story? And over the long-term, mean reversion, I think will be an interesting potential for the rise of value managers. Yeah. How do you feel about it, Todd? I mean, we've seen a persistent underperformance for the last, oh, almost 15 years, small cap versus large cap.

And you can see that with the Russell 1000 and the 2000 indexes. I don't know, look, just year to date, the Russell 1,000's up 14%. The 2000's flat, essentially. And again, growth is outperforming. value here. We keep waiting for mean reversion. I mean, our understanding has always been this mean reversion, long-term small-cap outperforms, big-cap value outperforms growth, but that hasn't happened for a long time. You're right. I mean, we still think that we're going to see a mega-cap growth-oriented market based on what we're hearing from advisors. They're leaning

towards quality, they're leaning towards growth heading into the second half and not into value. small cap is underperformed. I do think the environment is going to shift when the Fed begins cutting interest rates. We've been waiting for that to happen the first half of the year. No interest rate cuts, as you know, and the audience knows. If and when we have that coming up in the third quarter, that should likely signal an opportunity for small cap strategies to do better. The Russell 2000-based strategies, the S&P 600-based strategies,

and some of those smart beta strategies that are tied to it. So we could see a stronger second half for small caps, but I still think growth is going to outperform value based on the sentiment we're hearing from advisors. Yeah. So Todd, what accounts for this persistent outperformance on big cap growth here? I mean, we're talking with Fiona about this. Some want to blame passive investing. You study this very carefully. Is that an issue or is there some other problem going on here? Well, I think Nvidia has been driving the stock market in 2024. I don't think that. That's a passive approach. There are active stock pickers, both individual investors, professional managers,

that are betting on Nvidia's continued growth tied to artificial intelligence. So that has not been tied to TTS. We've seen money going into broad market-based, market cap-weighted strategies tied to the S&P 500 and other strategies thus far this year. Invidia is driving the market higher. It's not that money is flowing in to one stock in particular.

because we've seen a performance disparity between the MAG7 stocks. They all were going up in 2023. They have not all continued in 2024, even though money has gone in to the Vanguard of 500 ETF. So active stock picking is still driving the market, just not everybody's having success. Yeah, you know what amazes me, Fiona, how the small cap market is small

and sort of getting smaller relative to the big cap market. So I'm looking at the Russell 1000. This is your data, $50 trillion market cap right now. The Russell 2000, 2,000 stocks, not 1,000, has $2.9 trillion in market cap. I mean, it's 116th, the Russell 2000, the size of the Russell 1,000, with twice as many stocks in it. The 10 largest companies in the Russell 1,000 are 30% of the Russell 1,000, so about 15 trillion of the market cap. So the big essentially keep getting bigger, you know, and it's rather remote. And it's not just tech.

Even, you know, some of these indexes, you know, Exxon dominates energy indexes, for example. Amazon dominates consumer discretionary indexes. And alphabet dominates, I guess you call it, communication services indexes. So the big keep getting bigger. So the value guys do have a certain point here, that money just keeps going into these areas here.

Well, I mean, the indices just reflect the nature of the market. the nature of the market, right? And the reality is that in many of the sectors, there's a concentration in that between the winners and the losers. So it's interesting, you mentioned Russell 2000, actually, the threshold for the break point from small to large caps has actually increased to 4.6 billion, which is a rise of nearly 10%. So there is an underlying dynamic there.

But clearly, I think one of the benefits to the Russell franchise generally is our ability to provide different sleeves of exposure. For those of people who want to get concentrated exposure to value or to growth, we have the industries available to do that. Yeah. And it's the same way with not just size, with Big Cap getting bigger and bigger, but it's the same with growth.

All the money is going into growth. So look at these numbers. $98 billion in assets under management in the Russell growth. This is the ETF here for this. And $56 billion in the Russell 1,000. value. And again, I know you're an index provider, you're sort of agnostic on all this, but it's quite remarkable to see the money, the size of it that keeps going in. Todd, same thing here. So again, larger cap companies keep, larger companies keep getting bigger and growth companies

continue to keep getting more money into them. Would it take a dot com thing? Or would it take, We're certainly not in the dot-com atmosphere. Would it take a financial crisis to change that at all? I'm just curious about we've been waiting for 15 years for something to happen here, mean reversion. It's just not happening. Well, we have seen periods when value outperform growth. So it's been, it feels like the long time that growth is outperformed value,

but there have been periods when the pendulum is swung back in favor of value. And so you showed about $55, $56 billion. in that I shares Russell 1,000 value debt. That's still a lot of money that is being impacted by these rebalance that's taking place next week of new companies coming in, companies moving to the growth, companies moving into the small cap space. So I do think it's worth paying attention to value, but money has stayed in growth, and it's up 20%.

I think the I shares Russell 1,000 growth ETF is up 20% this year. So the assets under management continues to climb higher. we do think there's a place for both growth and value within a broader portfolio, just people are skewed more towards growth heading into the second half of the year. Russell has a lot of different indexes besides the 1000 and the 2000. You have ESG ETFs, environmental social governance ETFs. We've seen a whole big debate about this in the last couple of years. It's got somewhat politicized, frankly, which I find rather depressing. But how is that affecting flows at all? And any thoughts about, I know Footsie Russell has a series of ESG

ETFs? Yeah, so I think it's interesting because there's so much opportunity for growth in the index space generally. And you've seen that actually if you look at the development of fixed income ETFs, more recently, obviously the rise of sustainable ETFs and a much more nascent stage in its development around tokenization. So our role as an index provider is obviously to make sure that we're providing the toolkit for our clients to navigate what is a complex world of change. risk parameters. So yes, we do have a range of sustainable ETS. I think the dialogue around that, as you rightly point out, has been somewhat politicized in some quarters. I would say nonetheless, though, that we are seeing particularly a focus from our clients around climate transition

and how indices can actually help manage that. Yeah. I hope this argument, this debate would evolve a little bit. I've had a lot of intellectual issues with ESG. It's sort of an odd bolting together, environmental, social and governance, just bolting them into one process. I've had problems with the fact that some of this is qualitatively. It's very, a lot of this is qualitative. It's difficult to get quantitative with it, which is what you need to do. But those are intellectual differences. And to watch it become politicized, it's a rather unfortunate.

Hopefully, I would hope that you will get some new movement in this space where people will sort of move on. I don't think people are necessarily opposed to diversity in the boardroom, for example. boardroom, for example. That seems like a non-controversial issue. It would seem to me, and certainly people don't want more pollution out there, and yet these things get politicized. It's remarkable to me, you know. It is, but I think the debate is also evolving. And, you know, frankly we're seeing a lot of, a lot of the discussion actually now move from a broader ESG lens, actually around climate and the transition and the decarbonization and the path to do that. And so I think it's also a process of whenever you get a new area, particularly where the data is evolving, regulations are evolving.

It just to me speaks to the need for actually a lot of education. And clearly that's a role that we really take that as a serious responsibility of ours, not just in the context of sustainable, but more broadly. Because I still think even though we celebrate 40 years of the Russell franchise this year, I still think we're early in the overall development of the industry. Yeah. I want to ask you about how Futsi classifies countries. So, for example, Vanguard is the emerging markets ETFs, the VWO, and they use your Futsi emerging market index. South Korea is not in that. And Ayeshares, the emerging market, the EEM, does have South Korea. And so this has sort of been a debate for a long time about, you know, the politics of indexing what goes where, particularly in emerging markets. South Korea is part of the developed markets, the VEA, for example. So can you explain how that works? How do you determine what's emerging market versus what's developed markets?

Yeah, so I think one of the distinguishing characteristics of FITSE actually is our governance structure and our overall approach from a policy perspective. So we actually, as well as having an in-depth policy team and research team, we actually have outside advisory committees that are constituted from representations across the index ecosystem that then feed into our thinking and classification. So we have a kind of robust methodology around it. As you say, there are differences between us and other index providers. I think personally that's what makes indexing interesting.

Yeah, it is a little bit of an art, Todd, right? I mean, it's an interesting question. Is South Korea developed or an emerging market at this point? And there's other ones that come out there too as well. And what's important is because South Korea is so big, it affects the performance of the ETF. And so you have to be cognizant of the fact that a decision like that is made. And when you're buying an ETF, this goes to what you and I talked about many times, looking under the hood of what these ETS are.

Owning South Korea in an emerging market fund or not owning it will produce different outcomes. And so you have to be aware of that. This is where it gets tricky with this ETF selection process. You're right. So it's up to the investor to make sure they do their homework and look inside the portfolio to understand what they're getting and what they're not getting. But equally as important, you would be missing out on South Korea if you bought the iShare's developed market, international equity ETF, and the vanguard emerging markets, one, because they're two different index providers with two different classifications. So it goes back to understanding what's inside the fund, making sure people do that. I agree with Fiona. It's what makes it interesting, but it also makes it a challenge for folks who are trying to click the easy button and just buy the cheapest ETF without doing that extra homework. Yeah, it's part of the question. You want to do it. Most people don't get the high level intellectual skills that you need to do this. I mean, most people want to buy the

S&P 500 and they do it. So there's a sort of a level of complexity here that's added when you have these, when you have to make a decision like that, I think I'm not sure myself whether I would classify South Korea as an emerging market or as a developed country. I think it has characteristics of both, so it's a tough call. Yeah, and it's why we spend so much time actually in education and working with our clients on some of those issues. Yeah, different ones. All right, fascinating discussion. Thank you both very much. Todd, thanks for sticking around. We had a very interesting discussion with Fiona Bassett, the CEO of Futsi Russell, about the upcoming Futsi Russell Reconstitution this week and about the whole idea of why small cap has been underperforming big cap, value has been

underperforming growth. One of the things we didn't get to talk about, I wonder what you have to say about it is we talk about these metrics and these factors, values should outperform big cap, excuse me, value should outperform growth long term, small caps should outperform growth. But in recent years, there's been other kinds of research that indicates that if you overlay a profitability factor on top of that, you get even better performance. So I know, for example, dimensional funds has a small cap value with a profitability bent. Avantis also has a small cap value with a profitability bent. And they seem to be doing a little bit better than indexes that are just small cap value. cap value tied to indexes.

Any thoughts on that? Is this really good evidence now that there is a real, at least a third factor that matters for our performance? The quality factor that you're talking about has demonstrated our performance is one of those five factors that people tend to. And when you blend them together as Avantus and as dimensional do with their active approach,

or even when we're seeing it from an index stamp firms like Victory shares has a free cash flow, small cap oriented ETF, S flow. You're seeing the benefits of combining that. Quality has outperformed in this kind of environment, stronger balance sheets, companies with consistent earnings records. Those have held up better during the market volatility we've seen in small caps. So I do think quality plays an important role and can be bundled in as a multi-factor approach the way they talked about. Yeah. Yes. And so there's another factor that sometimes brought up as well,

which is momentum here. So now you have small and you have value and you have profitability and you have momentum. These factors seem to be growing and growing every time. We used to have only one, which was beta. And then we got small cap and value as a factor. And then we suddenly had profitability. And now people even talking about momentum as another factor. I guess this makes some sense to me, but my concern is if everybody finds this out, of course, you're not going to get any outperformance long term. But I guess we should just be happy to find any kind of relevance at all, right? If you can find a way to outperform the market and do it in a low-cost index-based way, that's a win for everybody. And this year, the first half of 2024, we've seen momentum do better

than all of those factors individually. Because the trend that work, in 2023, those mega cap growth stocks have continued to lead the market higher in 2024, Nvidia being the poster child of that success. So the S&P 500 momentum ETF is the strongest of those factors that are tied to the S&P 500, but you would have done well with just a quality approach as well. SPHQ is the Investco ETF that's tied to quality that people I know have had some success in in 2024 and it's seen some inflows too right uh you watch uh flows of etfs pretty carefully it seems to me like we're having a pretty good year we seem to be on track for 500 billion 600 billion in inflows somewhere around there but most of the money still going into plain

vanilla uh indexed equities it seems to me is there anything that sort of stands out to you that's a little unusual this year well well we have seen some success and you're right money has gone into low-cost S&P 500 index-based products. The Vanguard 500 ETF VOO could actually set the record for most inflows for an individual ETF. But we've seen actively managed ETFs have a lot of success. We talked about Avantus and dimensional funds a second ago, but we've seen success with BlackRock's factor ETF, DYNF.

We've seen Capital Group have success. We've seen Tiro Price have some success. I could name many firms that are doing very well with actively managed equity ETFs. So for a long time, it was just an index-based approach. Actively managed equity ETFs have moved in. They're gaining market share. Now, they're gaining some of that share because people continue to move out of active mutual funds. But they're getting more comfortable with the ETF structure.

And we think that's a win for the overall ETF industry as these larger firms enter and compete using the scale as an advantage. And yet, is it, I've had this discussion with people before, is it really active management? So a lot of these strategies are owning the S&P 500, selling options overlays over it, JEPI does that. They consider that active, but in the sense that you and I think of active, which is old school stock picking, you know, I wouldn't consider that to be a particularly active management strategy. But it gets thrown into that bucket.

So yes, if you want to say, you know, yes, there's more active because the way, there's some new products out there that aren't exactly pegged to an index because you're selling options against the S&P 500. But how active is that as a strategy? You know what I'm saying? Todd? You don't understand that. I do. So the data that's lumped in together. So the JP Morgan Equity Premium Income ETF, JEP is part of that actively managed. of the dimensional small cap value ETF is part of that actively managed

ETF, even though they're not making that many stock calls. They're indexed light versions of it. But the capital group dividend value ETF, CGDV, is a stock picking ETF that's seen in flows this year. The TRO price, capital appreciation, equity ETF, TCAF, TCAF is another one that's had success. So there are some success stories in the stock picking world. Right. I guess my point is, I am not seeing a dramatic expansion of old school. There are a few, but old school stock picking ETFs there are suddenly existing. I don't see a dramatic expansion of those right now. We're about $9 trillion in assets in ETFs, right? Right. Yes. That's slowly going up, but we're still a long way from challenging mutual funds.

Mutual funds still have, what, $19 trillion in assets under management? There's still a lot of money to be gathered in terms of gaining share to be in the same league as mutual funds. So active mutual funds is still dominant. It's amazing how sticky the mutual fund is. I saw a study somewhere. I've got to pull it up for next week, a shockingly large number of mutual funds. financial funds still charge north of 1% for what is essentially indexing strategies. And people don't do anything.

It's like legacy money, your, you know, grandma's fund there and nobody ever bothered to touch it. And I just, I wonder how we can get to a lot of those people that are paying one or one and a half percent for index strategies when you can buy it for three basis points and get to those people. It's sort of a frustration of mine. Well, money is just inertia that happens. So people have been investing for retirement and hold on to the strategies that got them there or that are close to getting them there. So it's probably going to be more of a generational wealth shift before some of that money moves into lower cost, likely index-based strategies. But I think that's something for us to look forward to.

All right. It's the middle of the summer here and everybody's getting on vacation here. Volumes are dropping a little bit. We're going to have a nice rebalancing at the end of the week for the for the for the for the footsy one, the Russell, 1000 and 2000. We had nice volume on Friday for the S&P rebounds, and particularly in a bunch of tech names. Invidia had some big volume. Apple had some big volumes. So this stuff really does matter, folks. These ETFs and the weightings in the ETFs do cause people to buy and sell stocks. So we're going to keep an eye on that for Friday's close. And that does it. Thank you, Todd. That does it for the ETF, the podcast. My guest, of course, Todd Rosenblit of Research at VETI.

Thanks for listening. Join us again next week. Or head to our website. ETFH.cNBC.com. How does InvescoQQQ rethink possibility? By rethinking access to innovation and the NASDAQ 100, let's rethink possibility. Investorbiters, Inc.