FidelityConnects: Outperformers – Factors in favour

[00:05:29] Lauren Gardy: Hello, and welcome to Fidelity Connects. I'm Lauren Gardy. Today's guest is here to unpack the market forces driving investor decisions so far through 2025 with a focus on how quantitative insights can help us navigate what's ahead. From tariffs and rate cuts to factor leadership and the influence of AI we'll explore how these themes are shaping both North American and international equity markets. We'll also examine where investors are finding opportunities whether in momentum, value or high quality. I am very pleased to be joined in studio by Bobby Barnes, Fidelity Head of Quantitative Index Solutions, who will help us put these trends into context for our listeners. Welcome, Bobby. It's great to have you in our Toronto studio today.

[00:06:15] Bobby Barnes: Yes, I'm thrilled to be here, it's the first time.

[00:06:18] Lauren Gardy: Excellent. Last time you were on Fidelity Connects back in June tariffs were a really big topic of our conversation, and this has continued over the past quarter. Curious if you can start us off today by unpacking for our listeners how tariffs are impacting current market conditions and factors.

[00:06:33] Bobby Barnes: It's been quite a roller coaster ride with respect to tariffs this year, still very important where we are now. What's very interesting is I've observed three very distinct phases of factor in market performance over the course of the year. At the beginning of the year you kind of had a continuation of the trend, of the prior trend which was kind of led by the Mag Seven, from a factor perspective quality and momentum were outperforming. That was kind of phase one. It lasted up until about the middle of February. Then from February to early April you have what I call the tariff tantrum. That's when there was a lot of uncertainty and there was a bit of sticker shock when the tariffs were first announced on Liberation Day. It was very, very interesting from a market perspective. Not only was the market down a lot but from a factor, you had a massive factor rotation where what had been working, quality and momentum, those were the worst performing factors and then basically everything that had not worked, whether we're talking about value or small size or international, all of that did extremely well. Off of the April 8th low, that's kind of your phase three, and it's continued on through Q3 of this year where you have a little bit of a resumption of trend with the one caveat. This is a bit more recent, momentum's still kind of the dominating factor but you're also seeing high beta outperforming. That's expressing itself, especially most recently, in things like small-caps.

[00:08:07] Lauren Gardy: That's right. Right around the corner we have earnings season, I'm curious if you're expecting generally positive news or do you think investors might be in for any surprises?

[00:08:16] Bobby Barnes: What's interesting there, I guess to answer your question very succinctly, I am expecting positive news. What I am seeing that makes me think that is when I look at throughout the quarter, earnings revisions, a very interesting thing has happened, and it's actually rare. What's happened is for the U.S. market earnings have been revised higher. What's rare about that is that it almost never happens. As investment professionals we all tend to be overly optimistic. When you look at our forecast at the beginning of the year they're usually too high so the natural progression of revisions is typically down. Because we were in a rare environment where you're seeing positive revisions company reports are going to start rolling out. I think you're going to see some surprises as a result of that. Basically, I think what's going to happen is the tariffs hasn't been as bad as what people thought. The positive revision, I think, is an unwind of that. I think that we'll see that play out as companies continue to report. The most important question to answer is how long is that going to persist? Is it just an unwind of an overly downside pessimistic view of tariffs or is it going to be actually persistent into 2026 where ... and this kind of brings into the conversation fiscal policy, the Big Beautiful Bill, is that going to be stimulative in a way that drives more forward upside surprises.

[00:09:47] Lauren Gardy: That's very fascinating. Can you talk to us from your quantitative lens where you believe we are in the current market cycle?

[00:09:56] Bobby Barnes: Where we are in the cycle, I've been saying this all along, I think we're in late cycle. There are a couple of ways that I get there. Some of your viewers might've heard me talk about a date, what we call our deja vu model, which essentially looks at macro variables, where they are today, things like oil, ISM, unemployment, so on and so forth. Just looking at those levels it kind of creates a fingerprint that we can then compare to other points in time to see what are the points that are most similar. When you do that and then kind of just say pick the top 10 almost uniformly all of them are late cycle. Even if you take that aside, if you just look at the characteristics of the current market environment, we're kind of at full employment. Unemployment bottomed at 2.4% in, I think, 2022, 2023-ish. That's a very low level of unemployment. If you think about the cycles, okay, that is too low to be early cycle because early cycle you've got your unemployment very high and falling. It's also not mid-cycle because that's characterized by unemployment that's also continuing to fall as additional people find jobs. If you kind of take that simplistic view at answering where we are in a cycle you arrive at a similar place as what I said from our deja vu model, which is, okay, unemployment has bottomed, we're still experiencing positive growth but at a slowing rate so, therefore, late cycle.

[00:11:30] Lauren Gardy: I like the branding you put there. Let's talk about interest rates. We've seen interest rate cuts and sounds like we're expecting more but can you tell us from a factor perspective, are certain factors more sensitive to interest rate movements than others?

[00:11:43] Bobby Barnes: In the work that I've done there the obvious one is dividends. High dividend paying stocks, in a lot of ways they trade similar to a bond. If you think about just bond math, when interest rates go up bonds are worth less and then vice versa, when interest rates fall the coupons you get from a bond are more valuable and hence the bond itself is more valuable. High dividend paying stocks perform very similarly. If you run the correlation you'll see that they move directionally the same way that a bond will as interest rates rise or fall. The other factor is not as much sensitivity. When you look at things like value, quality, momentum, they're not as sensitive, and in small size also not very sensitive. You do see some of that characteristic exhibit itself with low volatility, not as much as you see it with dividend but low vol does have kind of a bond-like characteristic to it. To the extent that interest rates fall or continue to it can be a tailwind to high dividend and low volatility.

[00:12:52] Lauren Gardy: That's helpful for our investors listening. Thank you, Bobby. Let's bring FX into the conversation while we're on interest rates. How should investors be thinking about FX movements when it comes to factor investing and investing geographically as well?

[00:13:05] Bobby Barnes: FX is interesting. My unsatisfactory answer to you is that it's really hard and I don't think you should do it, at least in terms of trying to forecast where currencies are headed. A lot of very smart people try to do it and do it unsuccessfully. I do think it's very important when you look back over the course of this year to understand how FX has played into the market dynamics and kind of think about, okay, from where we are today do I think that those dynamics will be persistent? The important thing about FX, it's very well known that developed international stocks have substantially outperformed North American stocks year-to-date. To put round numbers on it, developed international I think is about 25% cumulatively at the end of Q3, the S&P 500 is, call it, 15 so it's a 1,000 basis points outperformance. That's been driving a lot of investor interest as a result of that.

[00:14:07] If you unpack, okay, well how much of that was due to actual fundamentals being better in the international space as opposed to just the currency a lot it was actually the currency. If you recompute international's performance year-to-date and strip out currency effect you actually end up with returns that look very similar to the S&P. On top of that, the other consideration that you always have to make when comparing the S& P to other regions is the mix shift. The U.S. market is a very tech-heavy market. It's about 30% of the U.S. portfolio, that's what you're implicitly getting. When you pivot to developed international you end up betting much more heavily on financials. Your calculus then is, okay, do I think international financials are going to outperform U.S. tech. When you control for that, for the currency and the mix shift, the composition of the sectors being different, then you actually get, you find out that the developed international stocks have actually underperformed the U.S. stocks. I think those are the key things that people should think about when looking ahead, okay, if I'm running a global portfolio from here, from this point forward, do I want to overweight developed international versus U.S.

[00:15:24] Lauren Gardy: That's a very interesting perspective. Thank you for sharing. Focusing on the U.S., I mean, we have seen such a polarization in policy so far this year what should we be thinking there and how much of that uncertainty is priced in?

[00:15:37] Bobby Barnes: Zero is priced in. The way I arrive at that conclusion is if you look at valuation multiples stocks are at a very large premium. On a trailing basis I think the S&P last time I looked was maybe as high as 28X on a trailing P/E basis. Even on a forward basis it's not much better, maybe 25, which from a historical lens is very high. That basically says that we aren't discounting risks if we're willing to pay that much of a premium ...  or that much of a multiple on future expected earnings. Same thing in bonds, when you look at credit spreads they're very tight. When they're very tight the investor's implicitly saying I'm not really that worried about any of this uncertainty and hence I'm willing to pay a large amount of money for these bond coupons. I'm not saying that any of those assessments are right but it just is what it is.

[00:16:37] That having been said, it's very instructive to listen to what company management is saying. There's very much still a lot of uncertainty out there. If you listen to the company management a lot of them are saying, listen, our customers don't know what to do. Our orders are down because we don't know what the tariff tax is going to be on the order, or in terms of capital investment  I don't have the comfort or the clarity to make a hundred million dollar investment in a new plant because I don't know what it's going to cost me in order to get the materials back and forth. I think that looking where we are today and looking going forward that's still an outstanding risk. It's probably worthwhile to have that discounted either in the valuation multiple or the credit spreads.

[00:17:28] Lauren Gardy: For sure. On a positive note in the U.S., of course, we've seen AI drive so much of the market growth in that space, can you talk to us about how AI is impacting factors?

[00:17:40] Bobby Barnes: I've been doing a lot of work on AI. I've got a lot to say there. From a factor perspective it's been driving the outperformance. If you take the performance of the various factors, value, quality, momentum, low vol, small size, high dividend, and just sort them by performance what you will find, and I said this earlier that momentum is kind of at the top, it's the leading performer year-to-date, what you'll find is that if you sort them by performance you'll get a certain stack ranking. If you conversely sort them by their exposure to AI, how much of this factor portfolio have invested in AI, you get a very similar ranking to the performance ranking. What that means is that AI is driving the performance of factors. I think that's important to know because you have to decide, okay, if someone says, hey, Bobby, I want to invest in small-caps. What you don't necessarily know but the implicit bet that you're making is that small-caps actually has the least exposure to AI so that's actually a bet against AI. If that's the bet you want to make that's fine but I would probably guess that a lot of investors don't realize that with these various factors they could be making a bet for or against AI unknowingly.

[00:19:06] Lauren Gardy: Very interesting. Within your team at Fidelity has AI influenced your process at all or enhanced how you work or do things?

[00:19:13] Bobby Barnes: It absolutely has. The first thing I'll say is that it's very important to us, however, that we keep a human in the loop. AI isn't making any investment decisions. We're using it as a tool to inform our decisions but nowhere at Fidelity is there investor assets that are purely being invested based off of AI. That having been said, my little disclaimer, what it looks like internally is from a fundamental perspective we're enabling our fundamental analysts to do their job faster. If you think about earnings call transcripts and summarizing what's said from company management on those earnings calls, pulling out the relevant data, tables, etc., we're using AI in that respect. Within the quant team that I manage we're using AI. Quant is a discipline that requires coding, for example, so my direct reports have access to AI tools that will ... you literally can prompt AI and it'll write a snippet of code for you, or a long piece of code for you that will take you maybe an hour to write yourself, you're getting that done in seconds. Here again, similar to my fundamental counterparts that's really an expression of productivity enhancement. That's what AI looks like today within the investment landscape at Fidelity.

[00:20:35] Lauren Gardy: Very fascinating, thank you. Outside of Fidelity have you seen proof of AI productivity advancements, especially thinking against the backdrop of a changing labour force.

[00:20:44] Bobby Barnes: I've heard a lot of anecdotal evidence. I shared what my team is doing. I have a background where a lot of my friends went on to get PhDs and so they're now professors at various universities. When I talk with them about their workflow it's very similar where they're using AI to summarize or effectively read through hundreds of research reports and come up with a summary. You're definitely seeing that productivity enhancement but you also used the word workforce and any impacts there, that I'm not necessarily seeing. I'm not hearing people say, hey, because I use this AI I'm not hiring the one incremental person that I would have hired otherwise. That's something that I think a lot of people are worried about. I do get this question, particularly from students who are aspiring investment professionals, but I'm not yet seeing that concretely in decision makers decision making.

[00:21:46] Lauren Gardy: So our jobs are safe for now.

[00:21:47] Bobby Barnes: For now.

[00:21:49] Lauren Gardy: I'll pause there for a minute and encourage our listeners, if you do have any questions please bring them forward and I will bring them to Bobby as well. In the meantime let's pivot to factor performance so far this year, Bobby. We've seen value, high quality, momentum, all interchangeably lead the charge so far this year, could you walk us through what we've seen with this performance year-to-date and which factors you're favouring currently.

[00:22:10] Bobby Barnes: As I mentioned at the top we've kind of round-tripped. We had the three different phases, the continuation of the prior trend led by quality and momentum, momentum number one and quality was second. The tariff tantrum was kind of an episodic reversal of that trend that has subsequently subsided so now we're back to the continuation of that trend led principally by momentum, so that is the best performing factor year-to-date. Quality, ever since the bottom of the tariff tantrum quality has not participated as much but a lot of that has just been because of the outperformers of the high beta that I mentioned earlier which, again, the question as an investment professional you're always asking is is the trend that I'm seeing right now going to be persistent. I would submit that I don't see that being persistent with high beta continuing to outperform. I think it's going to end up being episodic and then we'll get to a different place where quality will resume its outperformance much similar to what it did earlier in the year. From a factor perspective those would be my top two, momentum and then quality.

[00:23:28] Lauren Gardy: Very helpful. Actually, it's great that you mentioned those two. I wanted to ask you if there's anything that Fidelity does to differentiate ourselves from the industry in terms of how we develop those factors. Maybe you can walk us through quality and talk to that.

[00:23:44] Bobby Barnes: One of the tenets at Fidelity, if you're ever listening to someone like me or anyone else, an investment professional Fidelity we say that stocks follow earnings. It permeates how we think about the markets and how we design any portfolio whether it's a quant factor portfolio, which is my area of expertise, or a fundamental portfolio. With that mantra in mind, you mentioned quality, we are very differentiated in how we define our factors. It's kind of two-fold. One is how we do our stock selection. For quality, we define quality using the best ideas from both our fundamental analysts and our quantitative analysts. With that mantra that stocks follow earnings our quality definition is using things like free cash flow, margin and free cash flow stability as being key features for that definition.

[00:24:37] Similarly, on momentum same thing. We believe that stocks follow earnings and so to the extent that you want to have a high momentum portfolio that's going to continue to exhibit those qualities we look at things like earnings surprise as part of our definition for defining a momentum stock. Those are key differentiators across our entire factor suite that help us do a better job at stock selection than our competitors. The other big one, which is a little bit more subtle, is in our portfolio construction. As an active manager we're always thinking very deeply about what bets are we making, both implicit and explicit. That was kind of some of my commentary today about, okay, well, here's some other bets you might not realize you're making in a portfolio. We take a very thoughtful portfolio construction approach such that we're trying to drive consistency of return over time when we've constructed the portfolio in a way that mitigates any unintended bets that the shareholder might not be looking to have.

[00:25:36] Lauren Gardy: That sounds like a great advantage that Fidelity is providing to our investors so thank you for that. We've had a question come in from the audience asking about gold and your thoughts on it as a sector or area of the market.

[00:25:47] Bobby Barnes: Gold is very interesting. I probably have a very provocative, although not unique, thought on gold. A lot of people, asset allocators talk about it as a diversifier. I don't disagree. You can run those correlations yourself and see that. Where I struggle with gold is I don't know what it's worth. It's sitting at, call it, $4,000 announced today. If you said, Bobby, sitting at 4,000 today, it cuts in half to 2,000, what do you do? Well, I don't have an earnings outlook for gold. Same thing on the other side. What if it doubles? It's sitting at four today and it goes to eight, what do you do? Similarly, I can't tell you to sell it because I also don't know whether or not, you know, it doesn't have an earnings outlook. For that reason people of a similar mindsets, Warren Buffett is one who thinks the way I do about it, he calls it an unproductive asset. Sure, it's got these diversifying attributes but I struggle with knowing how to react to it and when, which is a problem I don't have if you're me this question about stocks. I can look at their earnings outlook and the valuation multiple and can triangulate to what I think an investor should do with it.

[00:27:10] Lauren Gardy: That makes a lot of sense when you say it that way. I wanted to go back to small-caps for a minute. You phrased it earlier as possibly being a bet against AI. We don't have a small-cap factor ETF but curious your thoughts on this space.

[00:27:23] Bobby Barnes: Small-caps, like all factors, have their own time in the sun. There's a time that is very fertile and a tailwind for that asset class. There is a bit of a debate on its attractiveness right now and I'm going to explain both sides. There's one argument that's being made that based off of the current fiscal policy, tax policy, rate policy, that these things are going to be a tailwind for economic activity and therefore a tailwind for small-caps as a beneficiary from the increased economic activity and the lower cost because a lot of the debt held by small companies, it's variable debt. If you take the short end rates from the Fed and lower that, all things being equal that lowers the interest cost and burden of a small-cap company. That's the argument, that's the framing.

[00:28:18] As you can probably see I'm not necessarily in agreement with that because I think that there are parts of that framing that are bit in the vacuum. Yes, that's true that interest rates are going down, in a vacuum if you don't change anything else then that should be a tailwind to small-caps. The problem is we don't live in a vacuum so you need to ask, well, why are interest rates going down? If they're going down because there's concern about economic activity slowing, which I think there's at least a reasonable argument to be made for that, that kind of offsets some of that tailwind and then you kind of arrive at a place where you're not as constructive on small-caps.

[00:28:57] That's kind of where I am in my framing and my thinking based off of where we are in the economic cycle, late growth which is characterized by a growing economy but growing at a slower rate. With the rate policy, the forward outlook being more cuts but some of that due to concerns about labour market weakness. A weak labour market is not illustrative of an environment where you've got increasing economic activity. Those things don't go together. With respect to small-cap when I weigh those things plus the implicit bet you're making against AI, as I mentioned before, in terms of my rank order of factors I'm least constructive on small-cap. Again, there's a bull, bear, you know, that's what makes the market, that's where I fall in thinking about where investors should allocate.

[00:29:54] Lauren Gardy: It's a good perspective to be thinking of it from a wide variety of different influences not just the one of interest rates, as you said, which maybe we do most commonly. You touched on international earlier in our conversation, I wanted to spend a little bit more time here since we've seen tremendous flows in the industry into international ETFs this year. Interestingly enough, in Canada it's the first time that quantitative is outselling passive in the international and global space so far. Curious to hear a little bit of a deeper dive on factors within the international space.

[00:30:24] Bobby Barnes: It's a very interesting dynamic. I explained why I think, at least from an allocator's perspective, I'm not as bullish on underweighting say, North America to allocate to international but a lot of people do run global portfolios so you're going to have some allocation. The interesting thing that I'm saying with respect to international amongst the allocation that you plan on having there is from a factor perspective value is doing extremely well internationally. Part of the reason why it's doing well is, especially our Canadian value factor ETF, on its way to exposing the shareholders to cheap stocks it's overweighting financials.

[00:31:06] Again, back to the mantra of stocks follow earnings, and that's why I focus so much of my mental calories on earnings and where they're headed, where the revisions are happening, in the international market European financials are having the best earnings revisions year-to-date that we've seen in a long time, and far better than the other sectors. To the extent that you've got a factor portfolio that's overweighting European financials, which our value factor does, that's been a tremendous tailwind year-to-date and actually gets to my second thing that I always harp on about persistence, is it going to be persistent from here moving forward, I think that there's a good likelihood that it will, partly driven by the fact that the European ... with all the global turmoil we're having what's come out of that is that they're going to ... a lot of these European countries are going to need to finance their own defence and that's going to very great for the capital providers who do that which fall in the financial sector. Within your developed international allocation my favourite would be a value factor portfolio. From there followed by momentum because here again, based off where we are in the cycle, I think that momentum is doing a better job of capturing those stocks that have the secular growth in that region.

[00:32:24] Lauren Gardy: It sounds if you were to provide constructive advice for someone who might be looking to diversify away from U.S. large-cap you would favour an international value or momentum over small-cap.

[00:32:34] Bobby Barnes: Yes. I think the best diversification versus top-heavy U.S. market European value would be my number one favourite approach as opposed to small-cap because, again, if I explain the trade-off that you're making between seeing the two of those small-cap also has more economic sensitivity. You don't get as much of that if you go European value and so hence that's why I would tie break in that way.

[00:33:03] Lauren Gardy: Very helpful advice. Thank you. As we start to wrap up our conversation today, Bobby, what can you tell us and leave our listeners with on the path forward for interest rates?

[00:33:13] Bobby Barnes: The last time I looked at the futures curves I think it's pricing in about five interest rates from today on into the end of 2026. That having been said, futures curves are notoriously wrong so I wouldn't prescribe, hey, place this bet based off of the futures interest rate curve. The things that I am thinking a lot about and paying very close attention to is the impact of tariffs. Its twofold. The ones we already have are still very uncertain. I think there's going to be a Supreme Court ruling within the next couple of months that may or may not make the ones we have currently illegal. That can cause things to move and shake a different way. Even if the ones that we have stay in place it takes a while for  tariffs or taxes, what they are, for it to percolate through the supply chain system. I don't think we've seen the full effect of all that yet.

[00:34:11] If that does what I think it does, conceptually it removes capital from the system, as a result of that the entire system economy moves slower. For that reason that could provide the impetus for you to get the five cuts that are currently priced in from the Fed futures curve. Those are the things I'm paying a close amount of attention to. For that reason that's why I continue to prescribe an overweight to quality because those are companies that are going to be the most able to endure those increases in costs and in compression in margins should those tariffs stay in place.

[00:34:54] Lauren Gardy: Thank you very much for those final thoughts, Bobby. It's been a pleasure speaking with you and really appreciate all the valuable and unique insight you've shared with our listeners today. Enjoy the rest of your time in Toronto while you're here.

[00:35:03] Bobby Barnes: Awesome, thank you.

[00:35:04] Lauren Gardy: And thank you for joining me today on Fidelity Connects. Coming up on the webcast, tomorrow we will be airing a replay of our conversation with Peter Drake, former Vice President of Retirement and Economic Research, on the transition into retirement and lessons learned along the way.

[00:35:21] We will be off the air next Monday for the Thanksgiving holiday but please join us on Tuesday when Pamela Ritchie sits down with Fidelity Director of Alternatives, Rory Poole, and alternatives strategist, Brendan Sims, for an informative discussion on the state of alternative investments in today's markets and Fidelity's latest product release, the Fidelity Multi-Alternative Equity Fund.

[00:35:43] Next Wednesday, portfolio manager Shilpa Mehra will sit down and discuss and introduce a new small and mid-cap equity strategy that may complement your clients' large-cap portfolios. Thank you for watching. I'm Lauren Gardy.