ETF Expert Corner

Portfolio Manager Mike LaBella Discusses Solution-Driven Legg Mason ETFs

August 23rd, 2016 by ETF Store Staff

Mike LaBella, Portfolio Manager at QS Investors, offers his views on the shortcomings of market cap weighting and spotlights the Legg Mason lineup of Diversified Core ETFs.



Transcript

You can listen to our interview with Mike LaBella by using the above media player or enjoy a full transcription of the interview below.

Nate Geraci: I'm now pleased to welcome to the program, Mike LaBella, portfolio manager at QS Investors. QS Investors is the sub advisor on the Legg Mason lineup of ETFs. Legg Mason, of course, has a long and story history in the mutual fund space. They currently manage some 700 billion dollars, but they launched their first ETFs at the end of last year. They now offer two suites of ETFs. The first of which is their diversification based investing approach, which is what we'll focus on today. Then they also offer a low volatility, high dividend, approach, which we'll be highlighting in September. Mike is now joining us via phone from New York. Mike, a pleasure to have you on the program today.

Mike LaBella: Pleasure to be here, Nate.

Nate Geraci: We talked in the first segment about some of the recent fund flow trends with investors moving away from traditional active management, and moving towards index-based approaches, including so called smart beta. The Legg Mason ETFs we'll look at today fall into that smart beta category. To begin with today, how do you generally define smart beta, and why are investors putting money to work here?

Mike LaBella: It's a great question. Unfortunately the name smart beta gives a lot of people heartburn in terms of the disagreements in terms of what it actually means. The common definition is, these are rules based strategies that are typically screening the index for certain characteristics, and are weighting it in a non-market cap weighted function. Unfortunately, that's where the similarities with these smart beta strategies stop. They're more different than alike in that regard. That's why it's really important to look beyond the name, and look toward the outcome that these smart beta strategies deliver. That's going to be really what's important, and what investors should be focusing on.

Nate Geraci: Why do you think investors have been gravitating towards smart beta approaches?

Mike LaBella: I think a lot of these approaches, while they seem new to be wrapped in the ETF wrapper, aren't actually new investment strategies. They're just taking some of the benefits of traditional active management like screening stocks for things like profitability, or quality, or value metrics, but combining it with some of the great features that investors have come to love from passive investing, particularly from ETFs. Full transparency, a rules based process, where they don't have to worry about style drift, or a manager going off the rails and doing something he shouldn't be. It's just combining those two advantages. I think a lot of other investors are starting to realize some of the shortcomings with more traditional market cap weighted ETFs.

Nate Geraci: Let's talk about some of those shortcomings, because I know you have some very specific views regarding shortcomings of traditional market cap weighted indexes. I thought, perhaps, we could take this in two pieces. First, I want to talk about sector exposure. What's the potential issue with sector exposure in a market cap weighted approach?

Mike LaBella: As most of your viewers probably realize is that when we construct a market cap weighted index, you're weighting stocks based on the best stocks to market capitalization, or size. In a sense, the bigger a stock becomes, or the higher a price moves, the more exposure you'll have. The first part is, that's a strategy where you're going to be buying high and selling low. It's not exactly a great investment principle. The other thing that we were talking about is really about when these exposures are getting so high, it can really tilt your portfolio, and become a very concentrated exposure. When we talked about sector before, people look at broad based industries like the S&P 500, or the Russel 3000, they think that they're really diversified because they're investing in so many different stocks, but when you actually cut it a different way, and you look at sector allocation, for example, you'll find that it's actually pretty concentrated. Currently, the S&P 500 or Russel 3, has about 50% exposure in just three sectors: financial, information technology, and healthcare. In periods of market bubbles, that can get pronouncedly worse. If you remember back in the technology bubble, back in the nineties, technology alone was almost 35% of the index.

Nate Geraci: I know another shortcoming you see in market cap weighting is country exposure. Why is that an issue?

Mike LaBella: When you actually look at some of the key drivers of returns in equity markets, what you find is an enormous amount of that return profile comes from what country that stock is based out of, and what line of business they're in, and then their sector exposure. Just like you have in domestic ETFs, when you look abroad at international ETFs, thinking you're getting a very diversified international exposure, what you often end up with is a highly concentrated ETF in just a couple of countries. If you take MSCI EAFE, for example, which is a very popular index to benchmark for international developed exposure, you'll find that two countries represent almost 45% of your exposure. That's the UK and Japan. For an investor thinking he's buying this really diversified international exposure, he ends up really getting a whole lot of exposure to just two countries. The question is, what's the problem with that? Think about Abe Enomics in terms of what's the potential outcome? Then think of Brexit. These types of macro events can occur, and really leave investors vulnerable to just one or two outcomes in their index.

Nate Geraci: Let's discuss the Legg Mason diversified core ETFs. Legg Mason currently offers one US stock ETF, and two international stock ETFs. Let's start with the Legg Mason Diversified Core ETF, ticker symbol UDBI. How is this ETF constructed, and what's the goal here?

Mike LaBella: This ETF is really meant for a better core US exposure. Like we said, we talked about some of the risks of being overly concentrated. The entire objective of these three ETFs is to really develop a more diversified exposure, and in the US case, that's a really more diversified exposure across industries. When we take a look, what we do is we actually group the universe into industries, and what we do is we look at the industries in terms of correlations, as well, to see where are the pockets of risk in the market? Then we group those risks together, and diversify across them, so we can develop a more balanced, and broad based exposure, to the market. That means we can capture more of the market upside, but when the market goes down, you can likely be more diversified. That's when you're going to have better downside protection.

Nate Geraci: Can you maybe give us an example of two industries that behave similarly that might surprise some investors?

Mike LaBella: Industries are constantly changing, and that's why it's important to refresh the outlook when it comes to correlations. For example, when you look at the biotechnology sector, and you actually look at what biotech sector has the highest relationships to, they have more in common with the tech sector than they do with traditional healthcare services. That's a big problem because, what many investors view in terms of healthcare, they think of it as a defensive sector, but if you look at health care's performance over the last couple of years, it's been acting much more pro cyclical. That's because of the biotechnology sector becoming a bigger and bigger component of that. That's why investors have to take a little bit more of a thoughtful approach, and take a look at these relationships. Another clear example that's been in the news is REITS, or real estate investment trusts. A lot of news has been coming out where they were coming out of financials into its own sector, but when you look at the correlations, you actually find that REITS have more in common with utilities, being high dividend, low volatility, than they do with traditional financial.

Nate Geraci: If I were to summarize this ETF, just at a basic level, the idea here is to get US stock exposure, but to limit overexposure to individual industries, or sectors, or perhaps industries or sectors that are highly correlated. Is that correct?

Mike LaBella: That's exactly right.

Nate Geraci: Again, we're visiting with Mike LaBella, portfolio manager at QS Investors. They're the sub advisor on Legg Mason's ETFs. Mike, on the international side, Legg Mason offers the Developed X-US Diversified Core ETF, ticker symbol DDBI, and the Emerging Market Diversified Core ETF, ticker symbol EDBI. These take into account country market clusters in addition to sector clusters. Tell us a little bit more about both of those two ETFs.

Mike LaBella: International ETFs has been really at the forefront this year. As we start to end a five to six year bull market in the US, and investors are really starting to take a good look at international and emerging markets again ... We've seen that in the numbers, especially with the emerging markets being up about 16/17% this year. The problem is, just like we talked about in the US market, traditional cap weighted industries can be highly concentrated in just a couple countries. If we take emerging markets as an example, you have China up at around 25% of the index. Then when you take in two countries that are highly correlated to China, Korea and Taiwan, you're at over 50% of the emerging market index. Again, that just puts one potential bet, which is China, at almost 50% exposure. The DBI approach in international investing takes the same approach we did in the US, where we divvy out those country and sector exposures, we look for correlations like the China example, and then diversify across that. We don't just rely on one bet working out.

Nate Geraci: On all three of these ETFs, how does this sector or country approach compare to some of the other smart beta ETFs on the market? In other words, why do you believe this is a potentially better approach?

Mike LaBella: It all comes down to what the underlying investor's objective is. That's an important concept. When looking at these other smart beta strategies, you really have to look at everything independently, and determine what is the outcome you're trying to see? The goal is, if you look at these exposures, you're going to find that we're much more balanced across industry, sector, and a geographic exposure, than many of the competitors in the marketplace. What a lot of other smart beta strategies are trying to do is, they might single in on a single factor like low volatility, or value. What happens with those strategies are, is that they become highly concentrated in just a couple sectors, or countries because they're looking for just one particular characteristic. That can have a certain outcome, like give you value exposure, or lower your volatility in your portfolio. For broad based core exposure, we think diversification is the right way to go.

Nate Geraci: Any thoughts on some of the new multi factor approaches that are coming out? How do these ETFs compare to those?

Mike LaBella: Similar to these ETFs, what the multi factor approach is, you're going to be looking at several characteristics at once rather than filtering in on one. The idea is by looking at several, and diversifying across them, it will smooth out your ride. A similar philosophy to what the DBI strategy is doing, but the one thing to take into consideration is many of those strategies don't take into account the industry, or country, weighting schemes. They'll pick different stocks based on the factors, but they'll still chain you to the cap weight when it comes to the country and sector allocation. Again, as we mentioned before, if there's a particular event in any one given sector or country, your portfolio can still be exposed. That's the thing about sector exposure. There's a high degree of dispersion. The average weight, the difference between the best and worst sector over the last fifteen years has been 40%. You think about this year, the utilities and telecoms are up about 20%, financials is down by close to 1%. That's a really big difference, so depending on how your tilt is, that's going to really impact your returns.

Nate Geraci: Again, we're visiting with Mike LaBella, portfolio manager at QS Investors. They're the sub advisor on Legg Mason's ETFs. Mike, what might be the down side to this diversified based investing approach? Outside of just the normal market risks.

Mike LaBella: The down side to any one of these smart beta strategies is really making sure you understand when the strategy is supposed to work, and when the strategy might be under more of a strain, or might struggle more. Really making sure you have the right expectations. One of the safe havens of just having a traditional cap weighted index is people just go, "I just got the market return." When you go to a smart beta strategy, you're going to have something that's not the market return. You have to understand, and make sure that you don't pull out at the wrong time. For example, for these diversification strategies, if you're in a market environment where the largest sector, or the largest country, is really doing much better than everything else, it's a really strong up market, diversification is probably not really going to help out as much in that market, so you might lack. Conversely, if the markets are going down, and that biggest thing is likely doing poorly, you have a lot of other opportunities to do well by being more diversified. That's when diversification is going to work best. It's important to keep a long term view with any of these smart beta strategies. We recommend that clients look at them over a three to five year window to make sure you look at it through an investment cycle.

Nate Geraci: To that point, to be clear here, in terms of where these ETFs fit in an investor's portfolio, given that core is in their name, I assume you view these as core holdings in a portfolio?

Mike LaBella: We view these as core holdings, or core compliments, to traditional cap weighted indices. Again, for investors who want more diversified exposure, particularly for the international side, when investors may not know as much about their particular, or have much of a view on a particular sector or particular country, diversification is definitely the way to go in terms of being prepared rather than try to predict a lot of these macro events. These DBI strategies are really meant as that core compliment there.

Nate Geraci: Mike, before we let you go, as I look at these strategies being offered through Legg Mason ETFs, these are institutional caliber strategies that most investors would have had difficulty accessing in the past. I'm just curious, what role do you think ETFs have played in opening up these types of strategies to everyday investors?

Mike LaBella: I really think that we're at the start of a really signature moment in markets right now. You really start to move a lot of ... that's really part of the value here, is that these strategies, which we've been running on the institutional side for well over fifteen or twenty years, are now being opened up to the retail investor. Not only that, they're being opened up at a very attractive pricing point. In terms of the opportunities for the retail investor, we think this is going to continue, and really provide a greater amount of choice for the underlying investor, that's going to help them better manage their risk, and really align their investments with their tolerances.

Nate Geraci: Mike, we'll have to leave it there. We appreciate you joining us today, and we certainly look forward to chatting again in September. Thank you.

Mike LaBella: Thanks a lot for having me.

Nate Geraci: That was Mike LaBella, portfolio manager at QS Investors. Again, they're the sub advisor of Legg Mason's ETFs. As I mentioned, Mike will join us again on September 20th to spotlight their low volatility, high dividend, ETFs.