At the Morningstar ETF Conference, we gained insights from James Norman, President of QS Investors, a subsidiary of Legg Mason. During our conversation, James discussed Legg Mason’s ETF strategy, emerging markets, multi-factor ETFs and his new Legg Mason International Low Volatility High Dividend ETF (LVHI ). James also shared his thoughts on the rapidly evolving ETF landscape.
ETFdb.com (ETFdb): Please introduce yourself.
James Norman (J.N.): My name is James Norman and I am the President of QS Investors. QS Investors is an investment research and portfolio management boutique. Essentially, we have two parts to our business. One is the equity business, where we manage approximately $10 billion for institutional clients as well as mutual funds, insurance companies, governments and so on. The second part of our business is where we manage $14 billion in multi-asset class strategies to create target risk funds and target date funds. We became part of Legg Mason several years ago. We are primarily an investment research and portfolio management boutique, and we don’t have a large sales staff. We wanted to partner with Legg Mason, because they have the distribution on the retail side including wholesalers and web support.
ETFdb: Can you discuss the approaches you utilize in developing your ETF strategies?
J.N.: At QS Investors, we are investors first, at our core. We come up with insights into what drives markets; once we have the idea, we test it to see if we understand it. Our focus is on three things: diversifying, finding systematic drivers and adaptive allocation. In terms of diversification, we believe that no one way of looking at the market 0 whether it be momentum based, quality or dividend growth – works all the time. We want to test our ideas and systematically capture particular behaviors where investors misprice securities. If we can understand why something works and when it works, we can combine them. In this way, we can adapt to changes in the marketplace or create strategies that have a certain outcome i.e. consistent repeatable outperformance that investors are looking for.
We have two main strategies that we’ve put into ETFs; we’ve been running them for institutional clients for years. The first strategy is diversification-based investing; it is a core investment strategy that seeks to consistently outperform market-cap-weighted indices over time by taking advantage of market inefficiencies and the behavioral biases that people have. The second strategy is outcome oriented, which is geared towards investors who need steady income and who hate to lose money when markets go down. These include our low volatility, high dividend or defensive equity types of approaches through, (DDBI ), (EDBI ), (LVHI ) and (LVHD ).
ETFdb: Can you elaborate on how QS Investors incorporates behavioral finance in your investing approaches?
J.N.: In terms of diversification-based investing, we see investors being concerned when people tend to become overly optimistic about something. Usually, there is a catalyst, such as a technology or regulatory change, which makes people think that a particular country or sector is going to outperform. What happens is that money starts flowing into that country or sector, and it becomes a bigger weight in the index. When this is happening, individuals are usually focused on one or two things in the market and are usually overpaying. Invariably, they are then also overlooking a variety of other opportunities. This is exactly what happened to Japan in the 80s, technology stocks in the 90s, and commodity stocks and financials in the mid-2000s. We can certainly see this in China in the emerging markets most recently, where people felt a lot of pain since China is such a big part of the emerging markets index. When people are nervous about China, it tends to drive all the emerging market indices down, since these indices carry such a large weight in that country.
There are great opportunities outside of China, whether it’s Eastern Europe, Latin America or other parts of Asia. We developed a solution to this problem 15 years ago by utilizing asset allocation across a country and its sectors, rather than asset classes such as bonds and stocks. Once we identify highly correlated sectors within the country that will outperform, we then diversify across the baskets by equal weighting the capital going to each.
ETFdb: Which emerging countries will likely outperform, in your opinion, over the next three to five years?
J.N.: We believe that it is extremely hard to predict which countries are going to outperform. If it was easy to do that, we would be a lot richer. It’s extremely difficult to do that. However, we can prepare by being diversified across the best opportunities globally.
If we look at any emerging market index, China is likely close to 30% percent as a weighting. Over 10% of Chinese exposure is in Chinese banks, state-owned and not run to maximize shareholder value. China continues to have structural issues fundamentally, and having
30% of your exposure to one country seems imprudent.
We think opportunities in Latin America are attractive. As an example, Peru is one of the best performing markets in recent years, but it has a minuscule weighting within an emerging market index. Other countries where people might miss out on some of the opportunities include the Philippines, Indonesia, Malaysia and Egypt. Many of these countries are undergoing difficult time periods, but their markets are priced for that. For all we know, they might experience stability over the next five years and those returns might be very attractive. In reality, we don’t know; we don’t know where the next political event risk is going to happen and which countries it’s going to affect. Diversification is the best way to capture those opportunities and address the risk.
ETFdb: What is the rationale behind combining several factors for multi-factor ETFs? What are some best practices for investors conducting ETF due diligence with respect to multi-factor ETFs?
J.N.: Extensive research has shown that single factor ETFs have historically outperformed. Small cap, low volatility, quality and momentum are factors that have outperformed. Each individual factor, however, will underperform or overperform in a cyclical manner. Investors want these multi-factor ETFs to combine more than one driver of return that is attractive to them over the long term. By combining factors that have low correlation to one another, investors can mitigate prolonged time periods of underperformance. The best way to conduct diligence on an index is to examine its track record to see if it outperforms and underperforms under the conditions that you expect it to. You must also analyze if the index has met both its risk and return objectives.
ETFdb: How important is analyzing index methodologies for multi-factor ETFs?
J.N.: There are several criteria that need to be assessed when analyzing index methodologies. First, you must look at the factors that are included. Second, you must analyze if the investment process leads to a liquid portfolio of underlying securities. Third, you must understand the turnover strategy of the fund. Fourth, you must analyze the frequency with which the portfolio is re-adjusted. Finally, you must understand how quickly that strategy can react to changes in the marketplace.
ETFdb: One of your newest ETF launches, the Legg Mason International Low Volatility High Dividend ETF (LVHI ), could become a great hit with investors. Investors get a combination of income, low volatility, international exposure and currency hedging. What inspired the creation of this ETF? Can you elaborate on the selection process that you use to uncover these companies? What type of investors should hold this ETF?
J.N.: It has been very difficult for investors to find income in recent years. It is a challenging environment for fixed income investors, because of the difficulty finding yield – whether it’s in the U.S. or in the international markets.
We wanted to focus on high-quality dividend-paying companies that have sustainable earnings and stable cash flows. We combined this with a volatility factor that combines a 12-month historical price volatility (backward and forward looking) with earnings volatility (forward looking). We look back three years at earnings and look forward two years for earnings estimates. That combination leads to a multi-dimensional diversified view of volatility, which we find is supportive of sustainable dividends. It gives investors higher income, but also mitigates any drawdown risk they might have from investing in equities.
Investors want to invest in international markets, because of attractive valuations, higher dividend payouts and growth rates, and portfolio diversification benefits. Companies outside the U.S. pay bigger dividends; it’s just corporate policy. Currency hedging is equally important, since it helps mitigate currency risk and lowers the overall risk of investing outside the U.S. A combination of these strategies and reasons, we feel, will allow investors to reap the benefits of this ETF.
ETFdb: Back in 2010, there were roughly 900 ETFs; in 2016, there are 1800+ ETFs competing for more than $2 trillion dollars in the United States alone. How do you see the ETF industry evolving over the next few years, and what type of trends do you feel investors and advisors should be aware of?
J.N.: There are two observations I would make. Firstly, ETF growth has been extremely fast and we expect it to continue. We think it is an excellent vehicle, because of its liquidity, tax efficiency and lower fees. In terms of where the growth is going to be, I think that both single-factor and multi-factor ETF approaches are going to continue to replace traditional active management approaches. The smart beta space is going to continue to grow. Secondly, I think that more investors will start thinking about, “What is the outcome I am looking for?” For instance, rather than having a value ETF or multi-factor ETF, advisors may want a low volatility high dividend outcome for older clients/investors, who may be nervous when there are large drawdowns or who may be afraid that they may live longer than expected. I think that will be a large growth in multi-factor ETFs using a subsets of certain factors being combined with a certain outcome in mind.
The Bottom Line
The best way that investors can position their portfolios is by being diversified across the best opportunities globally, because it is difficult to predict which countries will outperform in the future. Focusing on multiple factors will allow investors to minimize underperformance over prolonged periods of time. QS Investors believes that future ETF growth will likely utilize multi-factors and be outcome focused.
