Turning Market-Cap Weighting on Its Head: A Chat With Kevin Quigg, Chief Strategist at Exponential ETFs

ETFdb.com (ETFdb): Please tell us a little about yourself and about the career trajectory that led you to becoming Chief Strategist at Exponential ETFs.

Kevin Quigg (K.Q.): I have spent the entirety of my career (23 years) in the wealth management space with the last 18 years dedicated to exchange-traded funds working at both SSgA SPDRs and Blackrock iShares. I’ve been fortunate to have seen the ETF industry from many different perspectives having spent time on the distribution/sales side working with both financial advisors and institutions, the research/strategy side helping develop ETF research and educational material for investors, and the capital markets side working with market makers, trading desks and exchanges.

My path to Exponential was the result of three distinct beliefs:

1. ETFs have forever changed the world of investing and will likely be the engine of growth in the financial services space for many years to come.

2. With great power comes great responsibility and, as an industry, we can do better for investors by creating thoughtful, elegant solutions that could move the industry forward and potentially create better long-term outcomes for investors.

3. Innovation in every industry is led by those looking to scale the mountain, not those who are already on top.

Exponential ETFs is the next wave of ETF leadership being built with the perfect combination of industry experience and “start-up” innovation. Having come from two very successful ETF organizations, I have come to realize “building it is the fun part” and the energy, passion and opportunity that exists at Exponential (and outside “the big three”) was too much to resist. ETF investors deserve innovative solutions that come from innovative organizations. Exponential is that innovation coming to life.

For a full list of Exponential ETFs, click here. Take a look at all issuer pages here and stay up to date with new ETF launches here.

ETFdb: What would you say are some of the benefits and risks associated with ETFs?

K.Q.: ETFs have slowly become the “vehicle of the masses” and allow investors a simple, transparent mean for building portfolios. Exchange-traded funds provide diversification and tax efficiency in a low-cost structure. Additionally, ETFs provide investors with intra-day liquidity, which allows an increased ability to navigate volatile markets.

The primary challenge for investors with exchange-traded funds lies in the exchange-traded nature of the vehicle. Like stocks (and unlike Mutual Funds), ETFs trade on the secondary market and the price at which one acquires (or sells) shares is determined by the prevailing market price of the ETF at the time one acquires it (not the 4 p.m. net asset value, which is the norm for mutual funds). While the price of an ETF should always be in line with the funds underlying value, it is important that investors be mindful of their exchange-traded nature when they buy or sell shares. They should place buy and sell orders accordingly.

Being aware of risks and costs is important regardless of your ETF investing strategy. Read The Hidden Risks and Costs of ETF to find out more.

ETFdb: What inspired the creation of the Reverse Cap Weighted U.S. Large Cap ETF (RVRS )? What are the advantages and disadvantages of using a reverse cap-weighted strategy?

K.Q.: RVRS was created as a simple, elegant solution that allows investors to get exposure to the broader U.S. economy. RVRS starts with the constituent companies of the S&P 500 that are universally recognized as the leaders of U.S. industry. Where RVRS differs from the traditional capitalization-weighted S&P 500 is how these companies are weighted. As opposed to the traditional “cap-weighting” methodology, which gives the largest weighting to the largest companies of the S&P 500, RVRS instead weights by the reciprocal of a company’s size (i.e. smallest companies get largest weighting, largest companies get smallest weighting). This methodology counters both the “buy high, sell low” and “momentum” biases inherent in capitalization weighting while exploiting the Fama-French “small minus big” size premium factor within the U.S. large-cap universe.

Additionally, RVRS provides greater diversification within the U.S. large-cap space by reducing both single stock risk (As of 02/28/18, in the S&P 500 cap-weighted methodology, AAPL has the same weighting as the bottom 114 companies of the S&P 500 Index COMBINED), as well as the technology sector and mega-cap concentration (as of 02/28/2018, technology represented over 25% of the cap-weighted S&P 500 and the weighted-average market cap of cap-weighted S&P 500 is approximately $189 billion versus $17 billion for RVRS).

Compare and contrast commodity ETFs such as the Reverse Cap Weighted U.S. Large Cap ETF (RVRS ) and the SPDR S&P 500 ETF (SPY A) using our Head-to-Head Comparison tool. Analyze the ETFs on a variety of criteria such as performance, technicals, fund flows, AUM, expenses, trading volume and more.

ETFdb: What type of an investor should use this ETF? When would an investor expect the RVRS ETF to outperform? Would you recommend the RVRS ETF as a core or satellite holding in an investor’s portfolio?

K.Q.: RVRS is designed to be a core U.S. equity holding within any investor’s portfolio as well as a strategic “cap management tool” when used in conjunction with a traditional cap-weighted S&P 500 product for investors looking to target a specific cap range within their U.S. large-cap exposure. As a U.S. large-cap product comprised of the same companies as the S&P 500, one would expect it to behave directionally in tandem with the S&P 500. However, because of the tilt away from mega-cap stocks in favor of “large-cap” companies, one would also expect RVRS to outperform during periods where the market favors smaller stocks over larger capitalization companies, a phenomenon that has held true historically for stocks over long time periods.

ETFdb: Employing a reverse cap-weighted strategy is a type of smart-beta strategy. In your opinion, what is smart beta? What would you suggest to investors and advisors when evaluating and choosing a smart-beta ETF?

K.Q.: “Smart” or “strategic” or “advanced” beta is any attempt to gain exposure to a market segment utilizing a systematic “factor” other than market capitalization. The key for investors when analyzing a smart-beta ETF comes down to three things: 1) do you understand the factor that is being targeted? 2) do you understand/believe in the investment merit of that factor and why you are targeting it? and 3) do you understand how that factor is impacted in different market conditions (i.e. when it will do well/poorly relative to other factors)?

Read Smart Beta ETFs Can Help You Navigate the Market Cycle to find out about the individual factors within smart beta ETFs.

ETFdb: Do you think every investor should have some exposure to smart beta in their portfolio? What are the advantages of investing in these types of active beta ETFs, as opposed to investing in passive ETFs?

K.Q.: Every investor has unique goals, timeframes and situations, so it is unwise to say “every investor” should invest a certain way (smart beta, traditional passive or other). With that said, smart-beta strategies (like RVRS) can provide long-term investors with thoughtful, targeted exposure to market factors that have historically shown to provide a variety of benefits including the potential for enhanced long-term returns. Additionally, smart-beta products can allow strategic investors to express their market view by moving between different targeted “factors” during different market “regimes.” The potential “downside” to smart-beta products comes in times when the “factor” being exploited by the product is out of favor which can potentially lead to underperformance for that period of time. Additionally, more strategic and tactical users of smart-beta products also introduce “timing risk” into their portfolios as they need to accurately determine when to move between smart-beta factors in order to realize maximum benefits of this rotational strategy.

ETFdb: ETF issuers have reduced fees for several broad-exposure focused ETFs in recent months. Where do you see this fierce price competition among ETF issuers heading?

K.Q.: Cost should always be a consideration when choosing an ETF. In this context, the “race to zero” is beneficial to investors looking to access vanilla broad market exposure. As the industry continues to grow, the combination of increased assets in these products (which creates economies of scale for issuers) along with increased competition, should lead to a continuation of this trend to lower costs.

There are a couple of additional factors that should be considered in the context of this conversation, however. First, TER (total expense ratio) is only one cost component of ETF ownership. In addition to the expense ratio, investors also need to be mindful of the “execution costs” (trading commissions, bid/ask spread, etc.) of buying and selling ETFs as they also contribute to total cost of ownership.

Lastly, it is important to not “let the tail wag the dog” when analyzing expense ratios. There are many factors that investors should consider when selecting an ETF (fund style, liquidity, performance, tracking error, etc.) and, while important, expense ratio is only one of these factors. For the average investor, expense ratio is often overemphasized, which leads to the elimination of solutions that could potentially be more beneficial. For example, a product with a TER of 0.10% versus one with a TER of 0.29% will cost an investor an additional $190/year for a $100,000 account ($15.83/month). One can easily envision a scenario where the “more expensive” product overcomes this relatively small difference in expense-through-fund performance. Investors should take the entire picture into account when selecting an investment solution, not just the expense ratio.

ETFdb: How do you see the ETF industry evolving over the next five years? What are three trends, besides fee compression, in the ETF industry that have a high probability of panning out during the same time period?

K.Q.: In the next 5 years, the ETF industry will continue the transition of replacing mutual funds as the primary solution for investors building portfolios. This should lead to three trends that are directly tied to “filling the gaps” that currently exist within the ETF space:

1. Active/Smart-beta ETFs will gather assets at a greater rate than traditional cap-weighted products from a year-over-year growth (percentage, not dollars). Many of the assets still in mutual funds reside there because of the false perception that ETFs cannot be “alpha-seeking” vehicles. This will change.

2. Fixed income ETFs will exhibit the fastest growth rate in the entire ETF industry. The global fixed income market is roughly twice the size of the global equities market, yet fixed income ETF assets are a fraction of equity ETF assets. This is due to the “late start” fixed income ETFs had versus their equity peers (first equity ETF listed in 1993 while the first fixed income ETF listed in 2003). Fixed income ETFs also solve many of the inherent challenges of individual fixed income investing (competitive pricing, liquidity, ability to manage duration/credit quality, etc.). These benefits will be more pronounced over the next 5 years leading to a “boom” of fixed income ETF assets.

3. ETFs will begin their assault on the “hill” that mutual fund companies are willing to die on: the 401k. Approximately 50% of mutual fund assets are housed within retirement plans. Due to several operational factors, ETFs and mutual funds cannot reside comfortably within the same plan, thus investors predominantly utilize mutual funds within these plans. With the transition from mutual funds to ETFs well under way within the taxable portion of investors accounts, we will begin to see the popularity of “ETF-only” 401(k) plans increase as well as Unified Management Accounts (UMA) style 401(k) plans that allow investors to choose between mutual funds and ETFs freely.

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RVRS is designed to be a core U.S. equity holding within any investor’s portfolio as well as a strategic “cap management tool” when used in conjunction with a traditional cap-weighted S&P 500 product for investors looking to target a specific cap range within their U.S. large-cap exposure. Because of the tilt away from mega-cap stocks in favor of “large-cap” companies, investors can expect RVRS to outperform during periods where the market favors smaller stocks over larger capitalization companies.