ETF Edge - Will H1 “hot trends” cool or keep simmering? 7/10/23

Episode Date: July 10, 2023

There’s been slowing in the biggest trends of the first half of the year… but they still may prove key through the rest of ‘23. 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, exchange traded funds, you are in the right place. Every week, we're bringing you interviews, market analysis, and breaking down what it means for investors. I'm your host, Bob Pazani. Today on the show, two of the hottest trends in ETFs, cool it off a bit. Buying protection against the downturn in the market was.

the hottest trend of 2022 and into 2023, but the strategy has underperformed this year, as has international investing, another hot strategy at the start of the year. What's going on? Here's my conversation with Kim Arthur, the CEO of Maine Management and Mike Aiken's ETF Actions founding partner. Kim, the big ETF winner last year was the JP Morgan Equity Premium ETF, that's Jeppi, 27 billion in assets right now, and you've got one of the competitors, the main buy-right ETF, B-U-Y-W, they do similar things. They own stocks and sell calls against them, but both are underperforming this year. So when you're selling calls, you're betting the market's going to remain range-bound or lower.

So, you know, what's going on here? Why are we underperforming and why are people continuing to pour money into these strategies? Yeah, Bob, you nailed it. It's when you're selling calls, you're capping your upside. So obviously, that works. The tradeoff is to get an extra stream of income to protect you in a down tape like 2022 or in a flat tape. It works very well.

But when you have an up 16% first half of the year, these types of strategies are going to underperform. I'm a big proponent, though, Bob. You want to set the expectation for each product or strategy that, that a client gets and then deliver on that. So if you set the messaging right, that two out of three that they'll do well, then you can kind of like, you know,

get through the difficult periods. But if you've told people that, hey, these things do well in all market environments, that's not the case. And the other thing that's happening now is as the VIX has collapsed, you now have much smaller premiums that you are bringing in.

So some of the things these strategies that tried to have double-digit type of distributions, those are unsustainable. You need to have something that is a level that you can do repeatedly in all environments. You know, Mike, what is your take on buying protection, this kind of strategy? You noted to me that in a bull market, it's questionable if the juice you're getting from selling the calls is worth to squeeze. Explain that. It makes a lot of sense to me, actually. Yeah. So I mean, I think at the end of the day, you have a situation with these strategies where they're designed to provide a little less volatility and more income. So a specific set of investor that's looking for a particular outcome, these tools work really well. Oftentimes, however, especially after you come out of a bear market, albeit the short one that we just had, they start getting sold more as alpha tools or tools that can generate alpha. And that's just not the case. And almost all full market cycle. these types of strategies are going to have a much lower up capture ratio.

And oftentimes a similar downside capture ratio. So over long time frames, for example, a standard call writing strategy on the S&P 500 would have an up capture of, say, 60%, a down capture of 70%. That's great if you're looking for a specific, you understand those expectations, but in a full market, you're going to fall. And as we know, the markets over time go up. So you are not going to keep up with the market with these types of strategies. And the important thing is you're getting a premium here, of course, Kim.

It's just not compensating you for the fact that the market's going up at the same time. So you're underperforming, essentially. That's what's going on. I just want to make sure our viewers understand what happens with these things. Yeah, exactly. And, you know, another thing, Bob, I like to say that these have a place in people's portfolios, but it's kind of glue between the wall, which is fixed income, investment grade. You're supposed to have downside protection.

Last year it didn't happen. And they're supposed to live between that and the wallpaper, which is risk on equities. And if you look over an extended period of time, they do deliver in that bucket. In that bucket, it should be 6% type of returns, not equity returns, but better than fixed income. Yeah. All right. I want to turn now to the other strategy that's sort of been underperforming as well this year, and that's international. And it all started out so promising, guys, that Europe and emerging markets outperform the United States very early on.

A lot of people called for that to happen. It did. But it all basically faded. Look at the charts so far. I'm just looking at EFA, Europe, Australia, Far East, only up 8% this year. This is basically the global benchmark for ex-United States, the rest of the world, ex-United States. Emerging markets, which is almost 30% Hong Kong and China, also underperforming. And there's the S&P 500, up 15%.

So the U.S. is far outperforming. Guys, as you know, this has been happening for a decade. But this was supposed to be the year. What happened? This was the year for international investing. All the cards were aligned in the right direction, at least, and it hasn't happened. Either one of you. Go ahead.

So maybe I'll jump in there, Mike, and then you can come on there. So, Bob, I think a couple things. I think, one, the highest predicting factor for future performance of international stocks versus U.S. stocks is what the U.S. dollar does. And that period that you mentioned from basically 2002 all the way up until, you know, up until 2011 to 2022, the dollar was in a straight bull market. So you were going to lose in international equities no matter what you did. The dollar topped. The dollar topped last September. So you really have to have an opinion on where the dollar is going. We personally think the

dollar is heading down for various reasons. But I think the second thing that people need to make sure don't confuse international equities with U.S. S&P. The S&P is over 60% growth. International equities are less than 40% growth. The comparable index here in the U.S. is large cap value. Large cap value is also just under 40%. If you look at that versus large cap value, it is outperforming year to date and on a trailing 12-month basis. So I think you need to make sure that the viewers know what they're looking for. You've mentioned plenty of times, Bob. You know, the S&P for the first half of the year was eight stocks, eight stocks that drove it completely, and they were all gross stocks. Yeah. So, Mike, does this make sense? I mean, the dollar story certainly makes sense.

not sure about comparing the rest of the world to the U.S. value. I mean, it's true. One of the reasons I think you can cite why Europe has underperformed is, for example, the German stock market has far fewer growth stocks in it than the U.S. stock market. That's certainly true. I guess you could call them value-oriented. Does that account for a big reason why we're seeing the underperformance? Well, absolutely. I mean, you think about it from a multiples perspective. Look at the S&P 500, 10 years ago, you know, on a forward multiple basis on earnings versus today, the multiples expanded 20%. You look at EFA, you look at emerging markets, they're basically the exact same.

And what's also interesting is they're actually the exact same if you look at the equal weight S&P 500 index. So it's not just international. It comes back to those Fang Plus stocks, right? You have the situation where the market continues to get led by mega cap names, primarily mega cap technology or tech-like names. And in that, the big difference in returns over this past decade has been multiple expansion. You've seen no multiple expansion anywhere outside of the mega-cap indexes. And I think that is the primary reason behind this. And then, of course, it just feeds on itself. If you look at just flows of the marketplace, you see more and more flows continuing to go into U.S. stocks, U.S. ETS, which leads to U.S. stocks, where very little money is going into the international marketplace, and then it kind of just creates this cell.

I'm not sure what the catalyst is there, other than to say that it has to start with those big names, Microsoft, Apple, Amazon, Tesla now, Google, those names that are creating this multiple expansion for the broader S&P 500 because they make up such a large percentage of it, that's where the catalyst will have to be to see value come back, to see international comeback, see emerging comeback. The problem is, you know, all three of us sort of grew up in the last 20, 30 years with research that indicated that long-term value tended to outperform growth and long-term, small-cap tended to outperform big caps. This is well-known research. It goes back into the 1990s and even before. And yet, it's been over a decade now where this has not really happened. So it's a little – something kind of has. to give. There's been a paradigm shift of some kind. I mean, 10, 12 years since 2010, essentially, is a long time. You know, you can't say, well, you have to wait for 25 years for something to work.

Twelve years is a long time. And yet still, growth outperforms value, large cap, outperforms small cap. Yeah. Bob, you do get, oh, sorry, you do get, like going back to the mid-70s, This is only, if it were to persist here, would be the sixth time that international would outperform the U.S. So they are long periods of in between. They're brief periods that usually are less than four years in duration when international does outperform. And again, that's what I go back with the U.S. dollar. That's the biggest predictor there. And right now, the U.S. dollar is 10% off its top.

You look at we are way ahead of the rest of the world in terms of fighting inflation. Our inflation numbers are lower than the rest of the world. Our interest rates are higher than the rest of the world. So what does that mean? That's a perfect setup where we're going to be cutting rates before the rest of the world. And that differential leads to a stronger dollar. And I would just reiterate, I don't mean to beat a dead horse, but you can't underappreciate the fact that it's just like here in the U.S.

If I'm a value investor, then I know it's because I've got 40% growth in my strategies. But if I'm a growth investor, I better have strategies that have 60 plus percent of I'm going to keep up with the other growth indices. Yeah. Mike, did you want to say something? Yeah, I mean, well, I just say, I graduated college in 99, and I've been in the markets pretty much since I graduated. And I would still note that I have benefited from being in small cap stocks, right? I mean, I think we lose sight of the fact, just going back to 2000, the small cap index, the S&P small cap index, has trounced the S&P 500 in that time frame. So in my investing life cycle, it's just getting harder and harder to remember that alpha that was delivered in that first part of that life cycle.

And to Kim's point, and you're talking about the S&P, you're talking about the S&P small cup, the 600, right? Not the Russell 2000, because those are different indexes, right? To a certain extent. They are very different indexes, yes. I like to look at the S&P, but as long as you keep it Russell to Russell or S&P to S&P, you get similar results over those full market cycles. But yeah, I think the point being to Kemp's, to reiterate Kim's point is that they can last in long cycles. And when it turns, it can turn very, very quickly. So it's painful right now.

That diversification is real and it's hard to stay the course. But ultimately, I think the long term data, long, long term data, proves out the benefit of being value, being international, being small. We're all going heading towards retirement on the long-term data. That's, I think, the problem. Kim, the other big story this year is how many active managers are jumping on the ETF bandwagon. BlackRock has, I think, 18 now, active mutual fund managers jumping to ETF conversions. Fidelity is also jumping in.

Now, some of these are replacing actively managed mutual funds. Some are in addition to mutual funds. Kim, you're one of the two believers of ETFs. You manage, what, 2.7 billion in assets. It's all in the ETFs. Where is all of this going? I mean, to me, this just looks like just another nail in the coffin of the mutual fund industry,

because the money, people seem saying, oh, hi, see, active's working, but it's coming out of active mutual funds into active ETFs. It's not coming out of passive ETFs into active, at least to any great extent that I see. So I keep going to the point about this long, slow death of the mutual funds.

industry. Yeah, and I think, you know, Mike's got some great data on this that he can opine on. But I would point out last year, 2022, again, was another nail in the coffin of mutual funds where growth mutual funds gave you a negative return. And, oh, they went ahead and distributed a gain to you because of all the outflows that happened and the way the wrapper works, you got nailed on both sides. That hadn't happened since 2008, so it was a painful reminder. And you're exactly right, Bob, that what is happening is active ETFs are replacing more

expensive mutual funds. So you get a cheaper wrapper and you get the tax aware coming out of it. So we've got four of those active ETS. And again, I said, you know, Mike's got some great data on the growth in that area, but they're better constructed and more tax aware. Mike, you want to weigh in on this? I mean, would you agree with me? Everybody, I always get these active managers that say, yeah, ha, you see, the ETF industry is finally catching on to active management. But it's at the expense of the active mutual fund industry, not passive ETFs. They're going from active mutual funds into active ETFs, not out of passive. They seem to think some victories being had here. It's just money sort of moving around from mutual funds to ETFs. Definitely a big part of the whole game is the conversion and the transfer of mutual fund ATF assets.

That's why no matter what market we're in, ATFs over the last two decades, have seen steady, powerful growth is because you're continuing to see more and more. As required minimum distributions come out of mutual funds, they flow into ATFs in taxable accounts, and that's for obvious reasons. Kim pointed out the tax efficiency, you just can't beat it. But I think there's another word that we're forgetting here, and that's transparency. Right. So I'm actually a little more bullish on active ETFs.

Now, I'll be active with some asterisk, right? So DFA is active, but DFA is active where I would think of it more like I think of a factor strategy with an index or a smart beta strategy, even though I don't like that term. Right. But the transparency of the portfolio is also huge because more and more assets is being controlled by firms like Maine. You know, Maine was a leader in taking this idea of tactical allocation using each. because they're so tax efficient, because they're so transparent, you can build very powerful models for your clients using your macro research, your companies, you know, assumptions to build these portfolios, and that transparency factor is huge. ETFs, you know, I guarantee you that Kim and his team can log in every day and they can look

right through the ETF holdings into the individual companies and they know what their portfolios live like. Right. And that's a huge thing that we're seeing, I think, in addition is, you know, everybody talked about the non-transparent wrapper. that's not happening. Active transparent is happening. I want to hit one other hot topic right now, Mike or Kim, you can weigh in too. Avoiding losses. It's sort of been a growth industry in the last year in addition to buying protection here and selling stocks and going out and buying calls. Another hot

ETAF product are the buffered products. So they're slightly different. Those of you don't know about it, they avoid losses up to a stated amount. And once you go through the floor, then it's sort of you follow the benchmark. Black Rock's iShares launched a couple new buffer products recently. Mike, can you explain how these work? And it's sort of the same idea, buying some kind of protection at this point. Absolutely. I mean, buffer strategies, these types of strategies have been around for a long time outside of the ETF world where you're providing a certain amount of protection to the first set of down downside. That's why all these buffer ETFs have a name in it, right? Like the power nine or the power 20

because that nine refers to, we're going to protect you for the first 9% of losses. So you're not going to experience that loss on the S&P. But once you go through it, you're going to keep going through it. And obviously, the growth, the timing of the launch of these in the ETF market couldn't have been better. Timing is everything in the ETF world. It came into kind of that first volatile marketplace that we've had in 10 years. We had a bare market. And these strategies delivered as long as you know how to use them.

What I mean by that, Innovator ETF says a really good job. explaining it on their website, providing the right data. But you have to understand that once you go through that buffer, that cap, that loss protection, you're now going to start tracking whatever your reference index is one for one. And so you need to be active with this. And the good news is the data proves out that the investors are. If you look at the flows, we've gone from zero to 20 billion. The money is going to the front month of the resets these products. Yeah. And Kim, the one thing, again, I notice is money keeps pouring into these. kinds of strategies. Even though we're in an up market, people seem to have this sense that the

rally is very fragile. There's a lot of naysayers still out there, I think. And that's why these products still attract money. Well, yeah, to that point, Bob, think about the strategists for Wall Street as a whole for the second half of the year. Their target price is negative 5% from the last, you know, from the end of the June quarter. So you are right. I would also point out that as Mike said, you have to, I go back to the promise that you're supposed to make clients is that we're going to deliver this expectation for the strategy or product. And then you need to deliver on that. You need to deliver just on your expectation. It's very, very difficult for these buffers to actually deliver for the average investor because there's so much timing involved. And I just look

quickly at First Trust's D-Dec. So David, David, Edward, Charlie, that's their oldest ones. They've been out for almost four years. They don't tell you to buy and hold. But if you were to buy and hold it, you were up four, the S&P was up 11% over that period. Not so good. How about for periods like 2021 when the tape was running and you were supposed to be capped at up 15%. You were up 8 and the S&P was up 29. Okay, how about 2021? You're supposed to be, or 22, you're supposed to be down, you know, like only five because you're protected on the down five to 30. Well, you were down seven. That's because there's a wrapper expense. There's some slippage. So again, it's really, really tough to deliver on the expectation and those prospectuses are thick. Yeah. And even these things that

Jack Bogle and me kind of gets all up about this, that you're still doing market timing of some kind. and Jack always wagged his tail. You know, you can't do that successfully in the long run, guys. One of the precepts on which Jack lived for many, many years. 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. We'll be continuing the conversation with Mike Aiken's ETF Action's founding partner.

Mike, thank you for sticking around. And we were chatting here about the continuing underperformance of international versus the United States. started out promising this year. Now underperforming has been for 10 years. I'm puzzled about the small cap underperformance still. And I guess the question is, when is small cap going to start adding some alpha? Some people have been sitting around waiting for 10 years. It's not happening. Some people have been using different indexes like the S&P small cap 600 versus the Russell 2000. Some people have been trying to slice and dice this in different kinds of ways. And yet, we still see the dominance of a big cap.

Yeah, I mean, I wish I had the answer. I wish I could say out of magic ball, tell me when the catalyst is going to happen. I do believe firmly that it will happen. I do think there's some dynamics in this market that eventually will change, and primarily that's fang. I think one of the biggest factors in this entire time period has been the fang plus stocks.

And the fact that you've had these mega-cap tech companies that have just led the market over and over again. They've done it in just an incredible consistency to their growth. I do think there's evidence that started to slow down, whether it be imposed by the government, which is a very possible thing that could happen here, where we start seeing more regulation on these massive companies in the way they are acquiring smaller companies.

Probably the biggest concern I have for it not coming back is potentially the trend we've seen, in the company staying private longer, right? So part of the boost to small caps is a little bit, has been over the years, has been you get these companies that go public and they start out in the small cap indices, and they work their way into the mid-cap, worked their way up into the large cap.

You haven't seen that transition of companies in quite some time where they're coming out sooner. You see that private markets have gotten so large. The capital is so available that companies are taking a lot longer time where they go public and by time they go public, they're mega cap companies or they're definitely large cap companies, right? So they kind of bypass that whole small cap stage. That's probably the biggest, the long term, like if this trend doesn't revert, if we don't see small comes back, small caps come back, that's one of the areas that worries me, though, I still believe that long term,

it's a risk reward game. And as long as you're investing broadly in the market, if you take on a little more risk, longer term, you're going to get a little larger reward. And that gets small caps. you know, to a T. It also fits emerging markets to a T. I agree with everything. I agree with everything you're saying. And yet year after year, you know, we know about the history of the research on this. Over long period, small cap has tended to outperform big caps. Value has tended to outperform growth, but that has not generally been the case since the financial crisis. And you would think then, logically,

small cap value would do really well over the long term, but that's not been true in the last, since the financial crisis. And so I get this all the time, and it frustrates a lot of people. Maybe it's the low interest rate environment that has something to do with it, too, and maybe that'll change. But we have not seen any outperformance from small cap value this year. No, we certainly have it. And I think you're seeing signs in the data that people are giving them, right?

More and more over the last, you know, five years, as you look at flows, if I go back 10 years following our ETF flow, it was pretty split up, right? In the sense that if you had broad models that suggested 65% US, you know, 20% developed, 15% emerging, the flows followed that. Over the last several years, flows into the ETF market have been dominant by US strategies. So now you also kind of have this self-fulfilling prophecy where if people are starting to give up, it's going to take even a bigger catalyst because you're starting to see a situation where the money is driving or the tails wagging the dog of you.

Yeah. I want to ask about something completely different here. Over late Friday night, NASDAQ announced that we're going to do a special rebalancing of the NASDAQ 100, which is the largest 100 non-financial stocks at NASDAQ, effective, I believe it's July 24th. What I thought was curious about this is there's typically a rebalancing done of the, of the NASDAQ 100, four times a year. The last one was the end of May, and now they're announcing a special rebalancing. Can you sort of explain that because the triple Q is one of the top five ETFs that are out there in terms of assets under management? So this is not

a small thing here. And it looks like they're going to take some of the biggest names and lower the weighting in them. That's what it appears to be. We don't know that, but that's what it looks like. Why is that happening? So, I mean, this is speculation of my part. I think it's educated assumptions. But if you look at the rulebook, the rulebooks has this idea about not having one company larger than 24% or not having any other companies that are greater than 4.5% in aggregate be greater than 48%. And it's really that comes from this IRS diversification rule that's required for

registered investment companies. And if I were to guess on 630, you have to be in a, you have to be. in compliance with those rules at the end of each quarter. And my guess is that things, the big names ran so quickly in 630 and you probably had another name like Tesla come into that greater than 4.5% bucket that they needed to cure. Now, if you break the rule, it's not a big deal as long as you fix it before 30 days. And the fact that they're rebalancing on the 24th, that's within 30 days. It's my speculation, but my guess is this is purely staying in compliance with various

SEC and IRS rules as it pertains to registered investment companies. Now, you're getting a lot of speculation out there that, oh, it's right before earning season and they're trying to get some of the bigger names weighted down. I do not think that's what we're seeing. I think it's really a technical issue as it pertains to the bench. So the key is that, and I always use this as an educational moment to highlight people, and I think you're probably right. So the rule here is that if you're waiting over 4.5%, any company,

whatever those companies are, if there's 5, 6, 7, and whatever their percentage, if they're over 4.5%, the total of companies that are weightings over 4.5% can't exceed 48% of the index. Is that right? That is their rule. The actual compliance rule, the IRS rule, is 5% and 50, but they obviously built the rule book to give themselves a little bit of buffer. A little bit of edge, right.

99% of the time that edge gives them everything they need, But it just goes more to the conversation we've been having all morning where these big names are running so fast relative to the rest of the index. But it makes some sense because I know in June, for example, those the big, I mean Apple, Microsoft, Nvidia, particularly, Tesla probably too. They're all there. They ran pretty fast in June. And that's probably what kicked that in at this point. So my point is some people wrote to be saying, what's going on? Are they making some weird decisions here? It's a fairly mechanical decision. There's some degree of discretion here, but it's a fairly mechanical decision

as the way you described it to me, at the 4.5% over that. You can't combine, can't go exceeding 48%. They had to do. Yes, I think it's 100% technical. Yeah, okay. Mike, thank you very much for joining us. Appreciate it.

As always, everybody, Mike Akins, of course, is the founding partner, of course, with TTF action. Thank you for listening to the ECF Edge Podcast. InvescoQQQ believes new innovations create new opportunities. Become an agent of innovation. InvescoQQQQ, Invesco Distributors, Inc.