Q&A With Chief ETF Strategist Paul Baiocchi of SS&C ALPS

Nick Peters-Golden, staff writer, VettaFi: Hi Paul, thanks so much for joining me for this conversation. 2023 has been a complicated one for investors so far and I’m sure it will be going forward, too. What’s the big takeaway you and the team at SS&C ALPS Advisors are looking at right now that others might be missing?

Paul Baiocchi, Chief ETF Strategist, SS&C ALPS Advisors: I think the high level theme that we’re focused on is this idea that we’re undergoing a massive regime change in the market whereby we’re coming out of a period that was defined by really low interest rates and really low inflation. Those two dynamics dominated a lot of the market backdrop and distorted in some ways the perspective that investors have on what drives total return in the equity sleeve of an investor’s portfolio, specifically, price returns.

What you’ve seen over the course of the past decade or so is that unlike the bigger picture of market history, the bulk of your total return came from price appreciation. That’s at odds with what the market has provided, historically. The bulk of your total return over the long period of market history, 100 years or so, has come from reinvested dividend income.

So, because that period was so unique and anomalous in terms of the level of interest rates and the level of inflation, I think investors have just grown accustomed to their equity portfolio being driven by price appreciation as opposed to total return generated largely by dividends being reinvested and compounded over time.

Peters-Golden: Interesting! What’s changed, then, between that regime and the new market environment that we’re in?

Baiocchi: With this regime change, we believe that rates are going to be higher than they’ve been over the course of the past 10 years and inflation is also likely to be higher than it’s been over the past 10 years means that once again, dividends have become an important component of an equity portfolio’s total return profile.

To that end, we think investors should start to reposition toward dividend-paying equities in the equity sleeve of their asset allocation. In so doing they should also understand the risks of being in a dividend heavy strategy, specifically, sector overweights. These strategies typically have a lot of exposure to utilities, to consumer staples to healthcare. You also typically have a lot of exposure to leverage by nature, a lot of dividend paying companies tend to have a lot of leverage on their balance sheet.

Peters-Golden: How are you and your team breaking that down?

Baiocchi: What we focused on from equity factor perspective and from a product perspective is the quality factor. Focusing on quality companies in the equity market, regardless of what segment of the market you’re talking about, whether that’s large caps, whether that’s smid caps, whether that’s European stocks.

Ultimately, investors would do well to consider pockets of the portfolio that are even riskier than their large cap exposure. Because if you look at the S&P 500, and what’s driven the performance year to date, that’s really been a small number of stocks that have been responsible for a lot of the total return so far in 2023.

That’s fine. Those are big multinational companies with strong cash flow, strong balance sheets, and actually not a ton of leverage, when you think about who those companies are, Apple and Amazon and Microsoft, etc.

Now, once you sort of click down, if you will, from the top 500 companies in the United States, for example, below that, all of a sudden, you get by nature, into an inherently riskier pocket of the market, mid caps, small caps. And if you look at small caps, the Russell 2000, the S&P 600, a lot of those companies don’t make money. If you look at the Russell 2000, as much as 35%, or 40% of those companies are not profitable.

That’s been fine in an environment where you can roll over your financing at really low cost because interest rates are effectively zero. But in an environment like we’ve described, where interest rates are likely to be higher going forward, that can be a very risky proposition to have a naive market cap allocation in the small cap space.

Peters-Golden: So how then should investors respond, what products at SS&C ALPS Advisors might be positioned to benefit?

Baiocchi: The ALPS O’Shares US Small-Cap Quality Dividend ETF (OUSM A) is a product we’re focused on because it takes that universe below the top 500 and filters for less leverage or lower net debt to EBITDA, it filters for higher ROA or higher quality or profitability, it focuses on companies with less volatility, and better dividend growth. So in theory, what you’re doing is you’re taking that pocket in the market that is inherently more risky than the top 500 companies in the market.

Then you’re culling it down from this massive universe of small companies that have a wide range of operational results, a wide range of economic exposures, and a wide range of financial statement attributes and you’re isolating 100 or 125 names that have strong balance sheets that have high quality that generate strong profitability, and are growing their dividends. In so doing, you’re in theory, avoiding some of the worst offenders in that segment of the marketplace.

Paul Baiocchi is a Registered Representative of ALPS Distributors, Inc. and ALPS Portfolio Solutions Distributor, Inc.  

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