Welcome to Inside Active, a podcast about active managers that goes beyond sound bites and headlines and looks deeper into their processes, challenges and philosophies and security selection. I'm David Cohne, I lead mutual fund and active research at Bloomberg Intelligence. I'm joined today by Christopher Kaine, US quantitive strategists at Bloomberg Intelligence. Who'll be my co host, Chris. Thank you for joining me today.
Thank you so much for having me, David, So, in.
What are your recent factor Friday notes, you wrote about adding in profitabil profitability to avoid value traps. This really ties into our discussion with our guests today. Can you explain how combining the value and profitability factors has led to a winning strategy recently?
Yes?
Absolutely, As you may, I'm a big fan of having some kind of profitability or sometimes called quality component too value strategies. I mean to me, the main benefit of that is to avoid the value traps.
Right.
So, value traps are these companies that are cheap, but maybe they're cheap for a very good reason. There is little, you know, hope of a turnaround, so you don't want to buy those companies. So having some kind of profitability factor with your with your value factor, you know has been beneficial, and I would also add, at least in large caps, you know, that does improve the overall factor exposures of a portfolio when you can bind profitability and value.
So for example, obviously it increases the profitability when you add that factor directly, but it also increases things like momentum because high momentum is currently pretty profitable, so that increases the momentum exposure of a portfolio and even things like low volatility. When you add some profitability to your value factor, you also skew to a bit lower of all utility, which has historically been you know, the way you want to go.
Okay, I think it's time to bring our guests in. I'd like to welcome Eduardo or Peto, the chief investment officer of Avontis Investors and a portfolio manager for their funds. Vontis has actually some great stats twenty eight ETFs. Every one of them has seen inflows this year. Their three year flows are thirty four billion, which has them number five overall in ETFs. Eduardo, thank you so much for joining us.
Thank you for coming me a pleasure.
Edwardo before we touch upon the two factors Chris was talking about. I want to ask, you have a master's in engineering in a PhD in aeronautics. How did you decide to get into investing.
Well, that's a long story, but it is a long time back. Yes, I have a civil engineering undergrad, a mechanical engineering masters and a PhD in aaronical engineering. But they say, what the heck are you doing in finance today? Well? I thought there was more interesting I use to have. I used to work with the mathematician Louis Rayne. He's a pH d in mathematic from hell Tech and he moved from science to finance and he always told me
you will have fun, just try to do it. And so when I finished my PhD, now you have to make a decision. What do you do? You you are going to become a professor what I want to do? And I said, well, let's let's give it a try. And you know that the financial war is full of people with science degree or engineering degree or computer science degree, and so I was lucky enough to get the job. And then it's history. I love it. You have to learn a lot of things, but you know, you always
have to learn. No matter what you do, you have to learn. Imagine you the technology that we're using today is not the technology you were using five years ago, So you have to learn. So learning is part of life, and so this has been an amazing journey for me.
Okay, great, now, you know, I do want to touch upon the Evantage Small Cap Value ETF. We actually just Eric and I Eric Beltoons, looked at it this morning and we realized that it's outperforming the S and P five hundred since the inceptions almost five years ago. Can you kind of give us an overview of the investment philosophy of advantage so we can understand how you've been able to beat the MAG seven with small cap value stocks.
Well not the MAC seven s and P five hundred. Let's put it away. So over a long time, I'm pretty sure we're going to to do okay, But so the way we think about the investment, the way we came to market. We started four years and ten months ago and today we have a round fifty billion under management, a little bit more the fifty billion under March, so we have been growing very nicely. You mentioned we have a twenty eightytas were actually new ones. We're even going
to Europe with some strategies and useage. So things have been going well, and so we came to market with the proposition we try to systematize acting management. And what do I mean by that? You know they haven't picking stock one by one with a lot of analysts. A big team is expensive. So the idea is can we systematize the process so it's still continue adding value, but being able to have a more diversify portfolio at a
lower cost. So you see our ETF have very attractive expense ratios, have great have deliver great out performance and the expand ration is very attractive, and they are also well leversified. You're speaking about our small value strategy. I think at our performance related to Russell two thousand values around eight percent a year and it has seven hundred names.
So you can deliver our performance without sacrifice and diversification and it's twenty five days his point, and you can do it a very attractive fee, and you can do it in ETF. What great delivers great tax efficiency and that's very very important for a small value strategies because the while low price securities and they get really when the price goes up. So it's a very good package what we have been able to put together for investor,
and that's what's delivered the growth. So our goal is to find securities that the market is pricing with the big discount rate embedded in the price. What do I mean by that? I don't care so much about low price securities. Christopher was saying very nicely, you buy low price security. The price may be low because deserve to be low. No, if we go to buy Sush in the gas station, the price is going to be low. It's going to be a great experience. I don't think so.
Maybe it is in some gas station, but in general answer is no. So low price is not the goal. High high discount rate is the goal. Prices having pushes down by a high disc count rate because that high this cant rate as and indication of higher respect returns. So in general, the security that we love are security, have good balanced sheet, could cash flows. But the price is low enough that implies a high disc cant rate, a high opportunity to growth in that price. And that's
what we do across everything. We do it in a small value, we do it in a large value, we do it in a marching markets were doing luge gap everywhere around the world. Interesting.
I mean, the uh, the performance of yours funds are just absolutely incredible. And uh, I also would not eat gas station sushi. But that's a great analogy.
You know.
I was wondering, you know, like you you you describe some of your process there, and without giving away the secret sauce, you know, is it one.
Hundred percent systematic?
I mean, you know, obviously when you have a systematic process, there's a human input to develop the model.
We know that.
But after that, is it one hundred percent where you are are screening for value and other things like margins, profitability, et cetera. Or is there some kind of discretionary decision making where you have a bunch of value stocks and you dig in and say, you know which ones are worth your investment?
Okay, so this is a great question. So I mentioned at the beginning that our world was systematized acting management, like word is systematizing type writing. Remember typewriters in the past a little bit writers now now we use war. So that doesn't mean that war writes everything for you. But really, the process of writing a paper or a memo has been you know, transformed dramatically since WARS is
with us because it's way more efficient. Here is the same o wur going is to systematize act the management. But you cannot put every possibly scenario in a piece of code, you know, because at the end of the day, systematizing everything is a computer runs everything. We humans look at that and smile, and that's not possible because that means that a piece of cold will have to have absolutely every possible scenario you can ever imagine, and no piece of code does something like that. So there is
human intervention. Our portfolios are managed on a daily basis. It's not that we just buy today, hold securities no matter what for six months and then we're rebalance our security. Our performance are managed on the daily basis. Why because prices changed on a daily basis. Remember game is Top Top was a small company went to twenty three billion bucks in January. Well prosss reconstituting June, so it went up and down with without being sold. And so we
need humans. But you need a special set of humans. It's a human that understand finance, understand valuations of companies, understand systems because we have systems that running, so they need to understand the system and the limitation, understand data and so our portfolio manages are people that are able to combine these sets of skills to interact with the computers, interact with the data to be very very efficient. But whenever they have to step in, step in.
Okay, you know you had mentioned you know, your other funds. So the strategy is pretty similar across the different market caps. So you know, in addition to the small cap value you have a US largeat equity which is a little newer. Is that the strategy is pretty much the same, just with the different market cap.
That that's a great question. So the ETF is newer. We haven't running the strategy for a longer time with the with the keeps track record because we used to we have that in separate accounts. At some point a client in a separate account to all us, can you transform a separate account in ANTF so I holdly one name is holding four hundred names and said yeah, sure we can. And that's how the strategy came to life. Uh,
we have we have different set of a strategy. We have a strategy that focus in them in the security trading at the highest country possibles. Yeah, and that's what we call value strategy. For US. Value is a high discount rate. So when you say a small value, what it is is of all these small cup companies, we buy the security that are training at the highest count rate, the twenty five percent of the companies the highest count rate. In large cup values similar story or international small value,
that's value strategy for US. Then we have blended strategies. And in a blended strategy like the large copy strategy that you mentioned, the bench market is are Russell one selves and so we have most of the securities in the Russell one in our large copy strategy, but the waiting is very different. You can add value by security selection or you can add value by security waiting. Waiting securities are higher respect relturns you overweighth an underweight security
lower respect returns is a weay to add value. So our blend strategies, the main source of value added is security is waiting overweighting securities who higher respect returns underweighted security who lower respect returns our value strategies. The man's the main source of value. Security selection. They also do security weighting, but security selection is the main source of value. Added, so the feel also is the same across all our strategies.
We are looking to emphasize securities that despite the good balance sheet, despite the good cash flows, the price is attractive enough. Those are the security who are trying to emphasize or select, and security that have bad balance sheet or weak balance sheet and not good cash flows or negative cash flows and high price. Those ones the ones that are trying to shy away. And that's the same across everything that we do. One is selection, selection, one
is waiting. But the philosophy is the same. So interesting.
You know, one thing I wanted to ask you, and you know, I like to ask people that do small cap factors, and I know you do more than that, but specifically your small cap fund is just just on fire?
Do you I see this.
Argument, and I don't really have an opinion here. I mean, I see this argument that factor investing should do better in small caps, and I think the theory basically goes that you know, these these smaller caps have less attention, maybe they're you know, marget less efficient, and thus you know common factors, you know, open secrets if you will, and finance should work better in small caps. Empirically, that seems to be true. Do you do you subscribe to that theory?
Absolutely? I think because of different storages. So so think about that. In large cups, let's let's follow Russle definition. A large cup you have a thousand companies. In small cups you have twenty five hundred companies or three thousand companies, so you have more companies. If you look at evaluations of company the dispersion of valuation, how different evaluation is
among large cup companies. You know the most attractive large company vers so the least attractive larger company, That difference in valuation is smaller than the different need dispersion of valuation that you have in a small cup. In a small cup, you have some companies that are way more attractive and you also have some that are real less attractive. So a small cup, because of this is personal evaluation, provides bigger opportunity to find companies that are price very,
very attractively. And that's why the premiums that you can achieve in small cups are larger. I give you some statistic and sorry if I get a little bit kicky. You know I high PhD for cultextry. Okay, So if you look at the For example, we have a metric that is like an adjusted book tow price that we use for some part of the evaluation. If I look at the standard aviation, I get all the companies in large cups and I compute the standard aviation of this
book to price metric. The standard aviation in large cup is point thirty five. If I look at the symmetric among the small cup companies is one point three. It's four times bigger that these personal invaluations that you're achieving. You see observing small cups relative to large cups. That means that some companies are really really much more a active and others are really Please don't touch me, because you're going to suffer.
I want to ask to macroeconomic issues affect your decision making.
It has to be something extremely big, like a market is top functioning? You know? If not, it doesn't. So we are being hired to deliver very good equity portfolio that deliver higher respector turns value added to clients. And so our job is someone the equity securities that we have to select, be sure that we pick the ones that, in our opinion, are going to deliver more for the client, and do that at the low cost, weill lot turn
over with high tax efficiency, good diversification. We don't like very concentrated portfolio, as you can see from our retfs, and so if we are able to achieve that, we think we're delivering what the client was Sometimes you have to tap in because something happened in some market and let's stop investing in this market, or things like that. In general, more common macro decisions doesn't effect like what happened with the FED meeting, and that doesn't affect us too much. Okay.
So actually a follow up for that is what about sectors? You know, are you more focused on kind of the bottom up or you actually kind of evaluating sectors as well.
That's a great question. So our decision making is all bottom up, if you want to think about that. So we look at the most attractive securities and then we have a collection the most attractive securities and those are the ones that create our portfolio. You know, we want the minimum level of diversification, but it's bought on up.
Now we look at sector. We don't want to have portfolios that are extremely concentrated in any word sector because we want to deliver portfolios that are diversified, and unless if you speak about our real estate portfolio, our global reachs, that's only one sector. The rest are broadly the ify across all different sectors. Some sectors we don't include in some of our portfolios. For example, if you look at our value portfolio, what is a value portfolio for us?
The portfolio where we want to have very very high spector returns. So if you think about utilities, they're not going to deliver high spector returns in general. Why everyone all of us think about that's a defensive lot better. So we don't include utilities in our value portfolios because we can't really achieve much higher spect returns with other sets of companies. So things like that we take into account. There's some modifications how we do valuations in some sectors
related to others because some metrics are not present. But if we treat all the companies basically the same after these considerations, what you will see in our portfolios that sometimes they get overweighted in some particular sector and other times other sectors. And why is that? Because if we are finding more attractive securities in one particular sector than others, that sector would have more representation in our portfolio than others,
and that sector will become overweighted. So when you look at our stategery, you will see some slow moving sector rotation. But it's not that we are just oh, let's buy energy today or let's buy financials today. It's because of the underlying securities that we're finding that are becoming more attracted at that point in time. Give enterprise and fundamentals, and those are the one we find more energy securities today than financial Well, energy will be a little bit more overweighted.
I want to quickly just go back to a security waiting real fast. You know, you mentioned kind of two sources of alpha, you know, waiting the securities by expected returns and security selection. So let's put aside waitings by
by factory returns? Is there or expected returns? Is there any other you know, things that you look at from a risk reducing uh, you know, perspectives such as you know, do you do any kind of like me invariance optimization or eco risk parity or anything like that as far as other inputs to your security weighting.
Yes, not not the ones that you mentioned. So we we we we don't do mean vialdance optimization. We don't think it is too stable, and so, but we do something similar in order to mean virdance optimization basically trying to maximize returns subject to risk consideration, we do something similar or not me imviotance optimization, per se, we do something that is way more stable than mean bodless optimization.
And we have other considerations. So, look, if you're buying a value portfolio, for example, what is the buying security have a low price? While it's if security has high price and the price crashes, you know dramatically, at some point it will be low price. You're going to wit immediately or you're going to consider other things. You mentioned momentum at the very beginning of the conversation when you
were speaking with David. Yeah, we have to take into account momentum, We have to take into account other things that that gives you a little bit better approach of when to enter the position, when to get out of
the position. So, yes, you have valuations, but if you have an expectation that that price will continue to go down for some short period of time, and you can't wait and do it a little bit later, and so we take into account other let's call it factors or considerations when we're managing portfolios.
I know you had mentioned you're looking at prices daily. How do you keep turnover low when you're you know, keeping track of the portfolio on a daily basis.
That's a great question. The first the first question that I get asked when I say, oh, we manage the portfolio on a daily basis, everyone said, oh, your turnomo must be here. Our turnomo is not big at all, because basically it's a trade off. You're always thinking about what how much do I gain my making this trade? The benefit of making the trade persue what the costs associated with the trade. Yeah, the moment that you consider that trade off, it will cause some benefits. Turnover goes
down dramatically. So in high turnover in general is high cost, and so you don't want to have high costs for no purpose. So I'm willing to enter into a cost if I get the benefit that is much better than the cost that I'm facing. And that's a consideration happens on a daily basis in our porfolio. Now, some people have managed turnover by doing buy and holy strategies. So think about any one of the inst we were speaking
about Russell Russia constitutes once a year. Yeah, so the turnover is low because they buy small caps today, they close their eyes for twelve months, they open their eyes and say, oh, some of the securities a small cup, let's change it. So that's not the best way for us to deal with turn over. The best way to deliver and over is dealing on a daily basis. And it's a security moved from a small too large, Maybe
it's time to sell it. But it's a security moved from a small to a little bit higher than a small. Maybe you should wait because the truth is that it's more or less small at this point. So that kind of trade off on a spector returns. How much is a spector return that I'm picking up? So the cost associated with that trade is what we are considering a daily basis to maintain turnover reasonably low.
I have another question on specifically the value factor. I know you do more than just a value factor, but specifically with value and I'm not asking for the secret sauce here, but you know, I get a lot of questions like, you know, what value factors should I use? You know, the classic farmer of French is like book to market, but there could be potentially some problems with that. The economy has changed a lot over the you know, fifty years. Do you find value in like a composite
of value factors as opposed to just one? How do you think through that? Yeah, without giving away the secret sauce, I would love to know.
We think about value differently, and we're going to do it together. So you are a very solvy investor. You're working in Bloombergers amazing company. And if I tell you, will you ever buy a company by just looking at the balance sheet and not thinking about the cash flows? The answer is no. So when you buy companies based on price to book, that's what you are doing. You are in learning cash flows and band price to look because book is balance sheet information. So we agree that
that's not enough information. The same if I tell you, will you ever buy a company based on price to earnings, say, well, I would be scared that someone sells me a company has good earnings, but the balance sheet is full of liabilities, and that's reasonable to be scared of that. So that's telling you that you need to consider balance sheet and cash flows or earnings at the same time that you're considering price. You cannot ignore any one of the fundamentals.
You have to consider all of the fundamentals, and you can think about the compositey of erations. Like you say, the way for us to deal with that is just dealing with higher discount rates. So and I totally at the very beginning that translates into what balance sheet good balance sheet, good cash flows and low price, because if you have a company that has balance sheet, good cash flows and the price is low, the indication is that price has been pushed down, so it's a high discount rate.
That's value for us.
So you just mentioned a little while ago that you know, you might consider selling a security if it gets too big. You know, if we're talking about the small cap value, is there anything else that would trigger a sell signal, you know, if it goes beyond that discount rate or other factors that might have you want to, you know, sell security in the portfolio.
Yeah, there may be many different different things. So why white things change? The fundamentals may be changing. So you can have an amazingly positive surprise in some of the fundamentals or negative surprise in the fundamentals now, or it can be a merger, or it can be there are many reasons beyond price that may be the reason why a company just leaves the portfolio. And so price is
the main source of turnover. So that's always why we mentioned price because you think about how much fundamentals change, but so how much price changes. Price changes on a second, no, every minute, everything is changing a lot. So price is the main source of turnover for our strategy, but there are other sources of turnover.
Okay, I just said a couple more, you know, before we go. So you know, Eric and our team, we've looked at expense ratios compared to inflows, you know, for active ETFs and found that the most successful active funds so far only charged for active and not beta, you know, whereas the old way of you know, in the old mutual funds twenty years ago, we charge a high fee for both beta and active. In your average expense ratio is around twenty four basis points or something around that range.
What are your thoughts about the future of active products and only charging for the active component.
Look, we can, as I mentioned at the very beginning, we came to market trying to have a very very attractive proposition for investors. So if you have a good restaurant. Let's just peak up a soushal. Now let's peak about restaurants. You have a good restaurant where you have a good menu, good service and low price, the restaurant will be before Yeah. And so we want to have good products, good service,
and very recentable expense rations. And I want expense rations go from fifteen basis points like you mentioned a large cape strategy or large Baldy strategies or our US market. Why fifteen basis points? The small values is twenty five? You going to international, we have higher costs, so we have to charge a little bit more, but that our expense ratios are are very attractive and we think we're going to get We got a lot of clients and
we think we're going to get even more clients. So from the point of view of running a business, I think we're running some business that can provide something that is good value after expense ratios to the in client. So if you provide something that is good to the in client, your business will grow. And that's our philosophy. We want to be providing something that is good for you, mister investor, misinvestor, and if we do that, you will knock at the door and buy what we have and
everyone is happy. We are happy because we provide a good service that hopefully you like and you enjoy our long pinions of time. And if investors are happy, we succeed.
Well, you're definitely setting the blueprint for active management, you know, at least in the etf rapper. But you know, I do want to ask you one question before we let you go. What do you would you say that you know today about invest thing you wish you knew twenty twenty five years ago.
Oh, that's a difficult one. I will say, every day we learn something so and in the next twenty years we will learn new things. So it is a difficult one. But one thing that is important I think with Christopher was mentioned at the beginning, is all of us learn a lot through factors, you know, so we come try re quiant worlds of factors. And I think that factors and valuations are merging into something that now is indistinguishable,
you know, And that's where we are. We are at the point where thinking about factors, thinking of valuation is basically thinking. If you think about right, a lot of the things you are really thinking about valuations holistically. The company level, because that's what drives the existence of factors. That's what it drives the existence of premiums. And it's much much better to think about a company holistically than
thinking about individual factors that they are. There is a paper out there called the Factors Zoo and probably Christopher knows very well, or four hundred factors documenting there what doesn't mean? Well, can we put all that into evaluation of a company and from there understand what's going on? Because that's going to help us have better portfolios. And so I will have a love to know this and think about these twenty years ago. Oh, but you know,
that's life. We'll learn every day we learn something new and we evolved when we come better hopefully and in the next twenty years, we will speak again and say what you learned from from last time that start meeting twenty years ago? And I say, oh, we learned all these things, and you know, I hope I could have known that twenty years ago. But that's life. You know, we'll learn markets has changed twenty years ago. It CTF were just nothing. Remember twenty years ago, Yeah, we're tiny.
And today you know you see the flows into TF. So that flows into funds. It's obvious. You know, what's a better technology?
Yeah, well, this is definitely a great discussion. Chris Eduardo, thank you guys so much for joining me today.
A pleasure. Thank you Eduardo.
Until our next episode, this is David Cohne with Inside Active