ETF Expert Corner

iSectors’ Chuck Self Discusses Current Financial Markets, ETF Strategies

September 11th, 2018 by ETF Store Staff

Chuck Self, Chief Investment Officer at iSectors, offers his perspective on the current financial markets and managing ETF-based asset allocation strategies.



Transcript

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

Nate Geraci: We are now very pleased to be joined by Chuck Self, Chief Investment Officer at iSectors. iSectors is an ETF strategist. They manage a suite of 16 ETF based asset allocation strategies. These strategies have some $260 million invested in them, and Chuck himself has over 30 years of experience in investment management. Chuck is joining us via phone today from Appleton, Wisconsin. Chuck, great having you back on the program.

Chuck Self: Thank you Nate for having me.

Nate Geraci: Chuck, it's been an interesting year in the financial markets in 2018. For the most part it's been U.S. stocks and not much else in terms of performance. Obviously there have been a lot of headlines, trade wars. There's been a lot of politically related headlines. We've seen a flattening of the yield curve. Then I think if you look internationally no question emerging markets are experiencing some turmoil. You also have the pending Brexit over in Europe. To begin here, I just want to open it up to you. I'm curious what's on your radar right now? What gives you the most concern?

Chuck Self: It's interesting because, and this program's becoming a little bit of a Debbie Downer with your previous guest's comments, and I'm going to add to it, but in any case it's interesting because trade has been of course the headline du jour for the past week. It's been more than a day, it's been for many days. Our view is that the trade stuff is pretty much baked into the market. If we wouldn't have the trade concerns, the great earnings that we're getting based on, shall I say the sugar high that we've gotten from the tax cuts, the market would be probably much higher here in the short term. Actually, our major concern is what the Fed is doing because I learned early on in my investment career not to fight the Fed. There's the talk about the yield curve, and we could talk about that, but people have forgotten also that the balance sheet has been going down. We've actually dual tightening going on and because the earnings have been good the market has been supportive, but when the effects of the tax cuts start to fade away, which will be probably next year, we could see some concerns as far as what the market's going to do.

Nate Geraci: Well how do you think the fed is doing in terms of managing the process of removing stimulus and raising rates? Do you think they're on the right track? We actually talked in our previous segment about if you looked back at how they navigated the financial crisis I think all in all you have to give them a pretty good grade. What about removing stimulus?

Chuck Self: Yeah. I 100% agree that they did a great job. I am not in the camp where people say oh well they unnecessarily propped up the economy or whatever. Without it the economy would have tanked even more, so I agree that the fed should get an A grade for keeping the economy afloat. This is the tricky part because the fed wants to normalize, they should want to normalize because when the next recession comes they're going to want to be able to decrease interest rates, but we don't see, in our base case, we don't see that inflation is going to be going too high and being too much of a problem, and we're going to get to the point where, if we're not already there, where the real fed fund rate is so high that it starts impacting the economy. Then on top of it, the fed is selling back their bonds that they own, which put pressure on fixed income instruments keeping rates higher than they would be otherwise. Of course, this gets us to the third horse of the apocalypse and that is our debt. I just saw something David Kelly at JP Morgan said that the amount of debt that we owe as a country indirectly through our government, whether it's government bonds, mortgage bonds, whatever, is greater than the debt that we directly own. It's never been that way. The debt problem that we're going to have when the economy slows, when interest rates are higher, is my major concern. How many discussions have you seen in the financial press about debt? It's been more about all these other issues. I think we should be worried about the debt level.

Jason Lank: Chuck, this is Jason Lank. Let's remind everyone that the sun is going to come up tomorrow regardless. I want to continue discussion on monetary policy. I just find it fascinating, not just what the fed is doing, but the worldwide divergence of monetary policy between the major central banks, the fed, the ECB, and the Japanese Central Bank. Those other organizations are going in a different direction, or at least not where we're going. There are so many dots you can connect when our interest rates are potentially rising and others are not. What are some of the ramifications of that?

Chuck Self: It's clear that the other countries have to continue to be at a relatively accommodating mode. Again, they don't have the sugar high that we've gotten from our tax cut, and they never recovered to the extent that we did. Now part of it was their fault because certainly in the case of Europe they thought early on in the decade that there was going to be another inflation scare and they tightened while we were still in accommodative mode. Now the tables are switched for that. But the good news for investors at least is that the expectations of growth in Europe and Asia are probably not as high as they should be, which makes international securities, I'm talking about developed market securities, an attractive area to look at, especially those markets that are not going to be hurt by a rising dollar if the dollar continues to go up.

Nate Geraci: Chuck let's talk more about that because I think as we have seen the U.S. dollar strengthening because of these differing policies among central banks. Clearly that's impacted emerging markets. And it seems like for several years now there's been a lot of talk about how emerging markets are undervalued, or at least more attractively valued than the U.S. and other developed market stocks, but here we are. I know emerging market stocks had a good year in 2017, but we're down now 20% plus from the highs. These markets just seem so tied to the dollar. Then I think you layer on tariffs, the trade wars, obviously these countries are predominately exporters. Is there any light at the end of the tunnel for emerging markets?

Chuck Self: There is light at the end of the tunnel and the sun will rise in those countries too tomorrow. One of the things, I've been in business for a long time, as you indicated, and I was a bond guy through the 1998 Southeast Asian currency crisis, in 1997 I'm sorry. Then in 1998 Russian crisis that had the long term capital ramifications. Oddly enough, the U.S. economy still kept on going for a couple more years, so that's one point that people should realize, but also eventually all of these economies recovered. What is really different this time than 20 years ago is that they were able to issue debt in local currency. Last time it was very much, pretty much all dollar denominated currency. The old timers will remember things called Brady Bonds that were U.S. dollar denominated. Because the debt is in local currency, they don't have as much of an impact with the rising dollar. But the one thing I took away from that that we use in our portfolio management is that emerging markets cannot be passively managed. It's a losing strategy. Of course the reason, especially on the bond side, is obvious. A passively managed emerging market bond portfolio the biggest debtors are going to have the biggest percentage of your portfolio. Then they're the ones that are more susceptible to the kind of crisis that happened in Turkey and Argentina regularly. Although we are an ETF strategist, we mainly use low cost passively managed funds, when it comes to emerging markets you have to have, if you're going to play, you've got to have an active manager involved. That's the one thing I'd love to leave with your audience. Now unfortunately in our analysis we've not found an active ETF that we can recommend to place our client's portfolio in, so we tend to go with mutual funds in other markets.

Jason Lank: Chuck, on that question about ETFs. As a strategist describe for me your process for locating ETFs? Is there a screen? Are you agnostic to the provider? Do you have relationships with them? What is the relationship between you and the tools you're using?

Chuck Self: We are completely agnostic. We're completely independent of any provider. We have over 100 ETFs that we're using in our 16 different strategies. Multiple ETFs will be used in multiple strategies. We don't really care where it comes from. One of the things that an ETF strategist can do, especially one that's not one of the major behemoths in this field, that other people can't do is that we can jump on funds while they're small, or while they're not very actively trading. We will at times you'll be one of the early investors in a fund. We have a wide range of relationship with at least 15 to 20 different providers where they know us and we know them, and then there's other in which they come up on our risk based screens and then we start talking to them. It's just really a lot of blocking and tackling to try to find the ones that fit best in our client's portfolios. But then it's also beyond just finding securities. It's also putting together portfolios. We use a pretty sophisticated holding space risk management system that Blackrock has that allows us to do that and make sure that we're not overdoing our risk. It's really interesting. Just to give this anecdote, a typical portfolio that a financial advisor will advise is a 60/40 portfolio, 60% equity, 40% fixed income. But then when you run it through a risk analysis it turns out that 85% of the portfolio's risk comes from the equity market. Your fixed income part is not hardly doing much as far as risk is concerned. One of the things that's very important whether it's an individual investor or using an institutional investor is making sure that the portfolios are truly diversified and have balanced sources of risk.

Nate Geraci: Our guest is Chuck Self, Chief Investment Officer at iSectors. They're an ETF strategist. Chuck we have a few minutes left here. I want to go back to the economy and specifically the U.S. I want to talk more about the yield curve. You mentioned your deep background in fixed income. As I'm sure you're well aware, the past seven or eight times the yield curve has inverted that's proceeded a recession. Are you concerned with that at all? I hate to use the term this time could be different, so is that the case? Are you concerned that the yield curve does in fact invert?

Chuck Self: Unfortunately I've been in the business four or five of those times, so I've seen it happen. The academic studies, it makes it clear that this is the case, especially if you look at the inversion of the very long securities through your treasury and the shorter security, fed funds for instance. That spread is around 70, so it's not yet at inversion level, but I am not a believer in that this time is different because the mechanisms that happen when the curve inverts is still going to happen in that the banks find it very difficult, the large banks, the New York City banks and the large international banks, all fund themselves in the fed fund market. That's how they get the money to lend. When that money costs more than what they can get from buying securities or lending out securities, that slows down the growth of the economy. I can't tell you, I'm not good enough to be able to say that the next slowdown is going to be a deep recession or shallow recession, or whether it's going to be stagflation, I can't tell you that, but I'm very confident that the combination of, again, the high debt levels, the inverted yield curve, the feds lowering their balance sheet, plus the removal of the positives that have come from the tax cut will slow down economic growth significantly in 2019 and 2020 and probably will lead to a recession in that time frame.

Nate Geraci: Chuck, we have about two minutes left here on this topic of rates and I guess more specifically fixed income. We've actually spent a lot of time on this show discussing how challenging the environment is for bond investors right now. I know you recently launched a new fixed income strategy. Can you maybe first just talk about some of the challenges you see in fixed income? Then just briefly tell us a little bit about the new strategy.

Chuck Self: You're exactly correct in that in order to get yields that at all compete with potential equity returns, even much muted ones than the ones that we've had, and you’ve had to take on big amounts of risk. There are income strategies out there that have done well, but the reason why they've done well is because they've taken a big amount of equity risk. The average mutual fund, income strategy mutual fund, will have about 40% of their portfolio in dividend stocks and 35% of their portfolio in high yield securities, high yield bond securities. Well high yield bonds are much more correlated with the equity market than they are to the broad fixed income market, so in essence you have 75% of your portfolio in equities, or at least equity like securities. That's the challenge that investors have had to face. As we have gotten tremendous interest in creating a strategy and now implementing a strategy in that field, one of the things we wanted to do was make sure that we had a truly diversified portfolio where the securities have low correlations to each other and the equity and fixed income markets. We have to have equity securities in there too. It's about half equities, half fixed income, but the equity securities are high income infrastructure, MLP, high dividend stocks. Then the fixed income securities we also had to make sure that they were not just all going to go up and down together. That's what we've done in our strategy. We call it the iSectors endowment strategy. Information about it can be found on our website, isectors.com, or call 800-ISECTORS. We'd be happy to talk to investors and financial advisors about the strategy.

Nate Geraci: Chuck with that we'll have to leave it there. Really enjoyed the conversation today. Great having you back on the program. Thank you.

Chuck Self: Thank you Nate, and good luck to your listeners, and the sun will rise tomorrow.

Nate Geraci: Thank you. That was Chuck Self, Chief Investment Officer at iSectors. As Chuck mentioned, you can learn more about their ETF strategies by visiting isectors.com.