The Upside: ETF mini-series pt. 3: Advanced insights from a Fidelity ETF strategist

[00:00:34] Nicole Correale: Hello, and welcome to The Upside. I'm Nicole Correale. Today we're jumping into part three of our ETF mini-series. If you missed parts one and two go check those out for a quick crash course on ETF basics, multi-asset strategies, and the Fidelity product lineup. Today we are tackling one of the coolest and one of most misunderstood concepts in investing, factors. Once you get how they work you can start making more intentional, smarter choices in your portfolio. We're talking why factors rotate, how to use them without the stress, and how Fidelity's quant team gives you a serious edge. Joining me to break it all down is Fidelity ETF strategist, Vince Kraljevic. Let's get into it. Thank you for joining me, Vince.

[00:01:15] Vince Kraljevic: Thanks for having me.

[00:01:17] Nicole Correale: So what is a factor?

[00:01:20] Vince Kraljevic: I think that's a great way to start. What is a factor and what is factor investing is a question that comes up a lot in conversations. I can get very technical and bore everybody by saying there are anomalies that happen, that if you use a systematic approach you can generate alpha, it gets very technical.  I think just breaking it down to some basics so that everyone can understand not using some industry jargon. A factor is a set of characteristics that a stock has that may potentially lead to outperformance in the future. What does that mean? I guess the best way of explaining it is giving an example. Let's say both me and you are judges for a talent show. It's the Fidelity factor, or the X factor. It's a talent show, you have 1,000 people that show up and they all want to be famous. Unfortunately, not everybody can be famous. We can start picking, let's say we can choose anywhere between 50 to 100 people that we think might become famous, let's say I was a singer in a past life and you were an athlete.

[00:02:31] Nicole Correale: Let's go with that.

[00:02:34] Vince Kraljevic: I would be picking the people that I think would be famous for singing. What's their vocal range, do they have a perfect pitch, how many octaves, what's the range, et cetera, et cetera. You would be looking at how fast can they run, how far can they throw a ball, so on and so forth. We could theoretically be looking at different things within the group of people, 1,000 people that want to be famous. Some might go on to be all-stars on NBA all-star team, so on and so forth, some might make a career out of it, some might flunk out. Based off of what we know and how to pick the best of the best we might generate that outperformance.

[00:03:13] Relating that to investing, if you have 1,000 stocks the median, 500 will underperform, 500 will outperform, so if we can use metrics or characteristics that have been studied that can generate outperformance that's theoretically what factors are. Factor investing, we'll just change being a singer and an athlete to value-based or a momentum-based investing. Different ways of looking at stocks can generate outperformance.

[00:03:39] Nicole Correale: That is such a wonderful way to tell everybody what a factor is. When it comes to investing then what are...  I think there's six? What are the ... five or six?

[00:03:53] Vince Kraljevic: Theoretically, there's a lot. There's arguments or definitions. If you look back at history, I think the first factor, any reference to a factor was Securities Analysis written in 1934. It became the Bible for value-based investing. Thereafter Fama and French, they did a three factor model, they went on to win a Nobel Prize. I studied for the CFA and we looked at quality, profitability, momentum, so on and so forth. If you think about all of the factors, I think Bloomberg has 30 of them, but if you start narrowing it down ... people say growth but growth and momentum can be used interchangeably. Profitability and quality, leverage and quality, beta and low volatility. If you start narrowing it down, you are right, when you start narrowing it down to the option there's about five or six.

[00:04:42] If we start trying to walk through them, a lot of people have heard these not knowing that they're factors. Some people call it investment style. You look at value. Value, Warren Buffett's favourite, buying things below their intrinsic value. Warren Buffet always likes getting a deal. If you have two things, they're identical, one's trading at $10, one's trading at $8 and they're doing the same thing you buy the thing for $8. It's buying things below their intrinsic value.

[00:05:07] The next one would be momentum. Some people, again, confuse it for growth, so on and so forth. That's just buying things that are doing extremely well. The price is going up and it's just momentum. It's just inertia. If you push a ball down a hill it just keeps picking up, picking up, picking up speed until acted on by another force. That's momentum-based investing.

[00:05:26] The next one would be quality. High quality companies typically outperform. If you're a badly run company, you'll go out of business. High quality companies, healthy balance sheets, high return on invested capital typically outperform in the long run.

[00:05:41] Low volatility, contrary to popular belief, you're just hitting singles, not trying to hit home runs, you're just trying not to lose you get a better jump off point so low volatility is a factor that generally outperforms in the long run.

[00:05:54] Dividend, typically people call them blue chips, large companies, they're generating so much cash, they're well established, they're generating so much cash they don't know what to do with it so they pay it back to you either on a quarterly or annual basis. Dividend companies typically outperform in the long run.

[00:06:11] The last one that's generally accepted would be size, typically smaller companies, small-cap. For a number of reasons they're a bit more riskier, there's not a lot of people analyzing them, typically generate outperformance in the long run. Those would be the six factors that are generally accepted in academia and in the real world.

[00:06:30] Nicole Correale: What are some of the misconceptions about factors or factor investing?

[00:06:34] Vince Kraljevic: The biggest one with regards to factors is that they work all the time. Factors don't work all of the time. They work at different times in the business cycle. We always say factors work over the long run but not all the time. People will see Warren Buffett on the front page of Time Magazine, the best investor of all time, and then two years later, is Warren Buffet wrong and is his style ...  they do come in and out of style but in the long run, even in that example that I gave about being famous, you can't win the Super Bowl every year, you can't win a Grammy every year. You do come in and out of favour but in the long run you'll be known as the GOAT or something.

[00:07:20] Nicole Correale: We often hear you and others on the team, like Bobby Barnes, discuss factors that are in and out of favour, in and out of cycle. Last year with the rise of AI momentum was really killing it. Now we're hearing it's low volatility. What makes factors go in and out of cycle?

[00:07:38] Vince Kraljevic: That's a great question. Again, I can make this extremely technical or I can really simplify it down. From a technical perspective, macro and microeconomic decisions affect how factors behave, interest rates, geopolitical risks, GDP growth, each one of those things. When you actually distil it down the market is just made of decisions that individuals. What drives the market, what drives factors, I would say is human psychology. I think it was Benjamin Graham, he actually wrote Securities Analysis, he said that in the short run the markets are a voting machine, people just vote, but in the long run it's a weighing machine. In the long run factors work but in the short run people are making these individual votes and decisions, so on and so forth.

[00:08:26] We have this great slide of a business cycle and it kind of explains where factors work and why. In the early cycle value typically works. In the early cycle you're coming out of a recession, people just indiscriminately sold so they're throwing out babies with the bath water. For a value-based investor they're contrarian. They are going to go in and buy these things, they're effectively dumpster diving, trying to find these undervalued companies that people have just thrown away. Typically in the earlier cycle value works.

[00:08:56] Then you get to the mid-cycle and psychologically speaking the stock market's going up, everything seems great. The common analogy is don't fight the trend. The market's going up, just go in, you get that euphoria, markets just keep creating all-time highs. That's the mid-cycle. It's typically the longest part of the business cycle.

[00:09:15] Then you get into the late cycle where markets aren't making all-time highs, inflation might be a problem so they're increasing interest rates. Then you hear people say hybrid your portfolio. Don't get out of the risky stuff, go into the higher quality. Quality starts working in the late cycle because they typically have higher moats, they have higher margins so if interest rates are going up they can protect their profit or operating margins. Quality works in the late cycle.

[00:09:41] Last but not least, you're entering into a recession and market might be correcting, either having a correction or bear market 10 or 20% so it's coming off and then low volatility pays off because you're protecting the downside. They're not as sensitive to what the market does because they're typically not sexy companies. They're just hitting singles, not any home runs, usually have nothing to do with artificial intelligence and things along those lines. Dividend typically works well at that time as well. You hear the analogy you're getting paid to wait.

[00:10:12] Each one works at a different time and there's kind of like psychological factors that go into it. Again, there are the technical factors, interest rates going up, GDP going down, things along those lines, but I say it's human decisions that mainly drive when the factors work.

[00:10:27] Nicole Correale: For an everyday investor, a new investor, where do factor ETFs fit in within a diversified portfolio?

[00:10:36] Vince Kraljevic: It's a great question. I would say for a beginner ... in my job I usually approach factors three different ways. It's either a strategic core holding, it's tactical change that you want to do, or it's a portfolio correction that you need to make. Let's go through those. As a strategic or holding, as I said, if you buy all of them and hold them for a very long time in the long run, the market's a weighing machine, academically factors do generate outperformance, or the intent is to generate out performance over the long run, so just strategic core holding is probably the best. Then, again, where do you think you are in the business cycle, if you're a bit more intermediate or advanced, if you think we're entering into a late cycle or a mid-cycle you might want to tilt towards one of those factors in your portfolio.

[00:11:24] I usually have those conversations with corner office brokers, they give me their opinion and you start talking about it. Last but not least is you're dealing with that broker and they have a portfolio and find out that they have a hidden bias. They've been over tilted towards growth because they've been in the US tech sector, we find a pairing value that pairs well with that. For a beginner I would just say get a diversified portfolio of all the factors because each one works at a different time in the business cycle, and just hold it for the long term.

[00:11:55] Nicole Correale: This is where the Fidelity All-in-One ETFs come into play. Let's unpack that.

[00:12:04] Vince Kraljevic: When we first launched our ETFs we launched each individual factor individually and you could choose your own adventure on how you want to construct and put them all together. The feedback that we were getting was could you just put them altogether for us? That took us three years and then we finally said, okay, let's just do this. We created our first All-in-One. Balanced and growth are celebrating their five-year anniversary and they've done extremely well. They've become the flagship of our ETF platform. They blossomed into the full suite. Now there's six of them so based off of what your risk tolerance is you can pick the one that best suits the goal you're trying to accomplish. Kind of like a single turnkey solution, if you will.

[00:12:45] The best part is we've married all the four factors, value, momentum, quality, and low volatility. Each one works at a different time in the business cycle so you don't have to time the factors yourself. You just know that if you buy and hold over the long run one factor will work at a different time in the business cycle. I call it business cycle neutral. You're not making a call. You just know that they will work in the long run, or the intent is to work in the long run. I've studied a lot, I took economics classes, got a CFA, did a lot of work in the industry, your core allocation, that decision on if I'm a 60/40, 80/20, 100% equity, that decision, based off of the research that you read, dictates 80 to 90% of your total long term return. Those little decisions on security selection sometimes don't even add alpha to a portfolio so that's why I think the All-In-Ones is an excellent solution for just someone starting off.

[00:13:44] Nicole Correale: What makes Fidelity so great, one of the reasons that makes Fidelity so great, is that we have such a robust research team and we have a great quant team down in Boston. Can you explain a bit of the history of the quant team, how you work with them to make everything come together so nicely.

[00:14:03] Vince Kraljevic: We have an amazing quant team based out of Boston. You have to go back to how this all started. I believe we hired our first quant in 1965. We have half a century of looking at quantitative analytics, these characteristics of stocks that generate outperformance. Obviously, I make the joke, you must have done a good job because now we have over 200, I think approaching 300 quants. Somebody told me if you spin off that quant team it would be one of the largest in the world. So embedded within us is one of the largest quant teams in the world. A lot of the active managers can just ask them questions so they're a resource for even the active managers.

[00:14:42] We consolidated them down into a team called QRI, quantitative research and investments and now it's went from being embedded or helping the active managers with questions to developing our ETF suite. That's headed off by Bobby Barnes and his team. So I'll upon him in a second. Then we're actually going the next level where we're using high frequency data, actual decisions, information that's coming in real time, and those characteristics on how we can generate outperformance. It's really evolved from being passive ... not passive but research oriented, being very proactive. We're almost on the vanguard, on the forefront of trying to utilize all the tools that we have to kind of help investors achieve their investment goals.

[00:15:27] Going back to Bobby, Bobby's responsible for our factor suite of ETFs. He helped us design it. A lot of funny stories about Bobby but the one thing I will say is that he's literally a rocket scientist. He worked on the Mars Rover program. You're having a conversation with him, I have a CFA and he's a rock scientist so there's just this different hierarchy of knowledge. He's an extremely pleasant person to talk with. We have a standing meeting with him, he explains what happened last month, last quarter, providing attribution like what happened. He provides us what he thinks will happen. He has a deja vu model so he goes back in time, what are we most like?

[00:16:07] It's a very collaborative team that we have. I could literally pick up the phone right now and ask him a question. If I'm confused or something happened within one of our factor ETS that I can't understand he's more than happy to jump on a call. I would say that it's an open door, open communication, it's one of the best working relationships I probably have.

[00:16:26] Nicole Correale: Yeah, Bobby is a gem. Like you said, the whole history of the team and the knowledge that they bring is just something that I think gives Fidelity that edge that others don't have. If viewers can take away one thing from today about factor investing or the quant team what should they keep?

[00:16:56] Vince Kraljevic: Great question. I'm going to give you two. First is there's a lot of terms and analogies and lingo used in the industry but factors are just characteristics that a stock has that can generate outperformance in the long run. That's all we're trying to do. People try making it a lot more complicated than it needs to be and I guess people get confused and they shy away from it. That's all it is, what does this stock have which may generate out performance in the long run. We have over half a century of looking for those characteristics.

[00:17:27] The other thing is they don't work all the time, they work over a long period of time. The best strategy is kind of to have a diversified portfolio of all of them, that way each one is helping you achieve your investment goals.

[00:17:39] Nicole Correale: Wonderful. Thank you, Vince.

[00:17:41] Vince Kraljevic: Always a pleasure.

[00:17:42] Nicole Correale: And thank you for joining me on The Upside. For more investor content be sure to subscribe to our YouTube page to never miss an episode and sign up for our newsletter. Remember, working with a financial advisor is the best investment you can make on your financial journey. For The Upside I'm Nicole Correale.