Speaker 1: Welcome to Inside Active, a podcast about active managers that
Speaker 1: goes beyond sound bites and headlines and looks deeper into
Speaker 1: the processes, challenges, and philosophies and security selection. I'm David Cohne,
Speaker 1: I lead mutual fund and active Research at Bloomberg Intelligence.
Speaker 1: Today I'm joined by Christopher Kaine, us quantitative strategist at
Speaker 1: Bloomberg Intelligence. Chris, thanks for joining me today.
Speaker 2: Thank you for David.
Speaker 1: So you wrote a note last week on the BI
Speaker 1: factor scorecard. Can you tell our listeners what the scorecard
Speaker 1: is and where the quality factor currently rings?
Speaker 2: Sure? So the design of the scorecard is to inform
Speaker 2: let's call it tactical decision making around factors or timing factors,
Speaker 2: if you will. Now that's a bit of a controversial subject,
Speaker 2: no doubt about it. But some, you know, many clients
Speaker 2: do want, you know, to be a little tactical around
Speaker 2: the factors. So the factor scorecard really takes two broad
Speaker 2: you know, variables into account. It's the the the trends
Speaker 2: of the long short factors themselves, which has been shown
Speaker 2: to at least somewhat predict future factor returns, as well
Speaker 2: as the relative valuations of the long and the short
Speaker 2: legs and how that compares the history. So of our
Speaker 2: five main factors, which is low ball, quality, momentum, value,
Speaker 2: and small size, we have a quality as the second
Speaker 2: best or the second highest on the on the scorecard,
Speaker 2: low volatility is number one. Now, both low volatility, as
Speaker 2: far as long short factors, and quality have done very
Speaker 2: well this year. You know, even though the market is
Speaker 2: you know, coming to all time highs or making all
Speaker 2: time highs, there is a bit of a defensive tone
Speaker 2: of the market, meaning like low vall stocks are beating
Speaker 2: high vall, high qualities beating low quality. So both of
Speaker 2: those trends are positive. That's why they're number one and
Speaker 2: number two. Now. Lowvall is number one because its valuations
Speaker 2: historically are not extreme, whereas quality is a little expensive
Speaker 2: historically when you look at the high quality verse low
Speaker 2: or high quality versity index, so that does drop it
Speaker 2: down just a notch. So quality number two. Momentum is
Speaker 2: the middle of the pack, and in value in small
Speaker 2: size around out the scorecard great well.
Speaker 1: Speaking of quality, I'd like to welcome Tom Hancock, head
Speaker 1: of Focused Equity and a portfolio manager at GMO. Tom
Speaker 1: manages the GMO US Quality ETF ticker qlt Y, and
Speaker 1: a number of other funds at the firm. Tom, thank
Speaker 1: you for taking the time to speak with us today.
Speaker 3: Hey David, thanks for having me.
Speaker 1: So I'd like to begin by asking you about your
Speaker 1: investment background. Can you tell us how you got your
Speaker 1: start in investing.
Speaker 3: Yeah, so I've been at GMO, granted maya an autoloo
Speaker 3: for approaching thirty years now. I joined in nineteen ninety five,
Speaker 3: and maybe not coincidentally, this is the only investment industry
Speaker 3: job I've had. My background before GMO was actually in
Speaker 3: computer science. I worked as a software engineer for a period,
Speaker 3: then I went to grad school did academic research actually
Speaker 3: in the artificial intelligence area, which is the time a
Speaker 3: little bit of a sleepy backwater. And for many years
Speaker 3: I said, I mean there were great right to rear
Speaker 3: choice to come into investments. Now I'm not so sure,
Speaker 3: but nonetheless I've enjoyed it for thirty years, so I
Speaker 3: think it was still the right choice. And so with
Speaker 3: that kind of quantitative background when I joined GMO, one
Speaker 3: of the things GMO is known for is quantitative investing,
Speaker 3: fundamental quantitative investing, things like quality factors, and that's kind
Speaker 3: of how I got my start, initially in portfolio optimization construction,
Speaker 3: then into the investment models, then into portfolio management. Originally
Speaker 3: just on the quantitative side, but I've transitioned over the
Speaker 3: last couple decades into more of a traditional fundamental role.
Speaker 3: But I have that dual quantum fundamental background, that is
Speaker 3: the background in which a lot of our stredges are managed,
Speaker 3: including the quality ETF. It's sort of a quant fundamental hybrid.
Speaker 3: You could say, that's.
Speaker 1: An interesting approach. Actually, so can you give us an
Speaker 1: overview of the GMO approach to investig in I guess
Speaker 1: talk more specifically about the investment process of QLTY.
Speaker 3: Yeah, speaking specifically to our quality strategy and the QLTY investment.
Speaker 3: Our approach is bottom up, and we start with systematic
Speaker 3: screening on a quality factor. Of course, everybody's quality factor
Speaker 3: is a little bit different, but ours includes elements of profitability,
Speaker 3: historical profitability, stability and that profitability, strong balance sheets, and
Speaker 3: I should say, maybe to beat our own drum a
Speaker 3: little bit, the having quality factors an integrade management investment
Speaker 3: process goes all the way back to the nineteen eighty
Speaker 3: stort GMO. So well, I'm not sure I could hold out.
Speaker 3: Our factor is being extremely differentiated. Now we're a very
Speaker 3: early mover in that space. That quality factor, though, is
Speaker 3: just a bit of a starting point for us in
Speaker 3: two ways. One is integrating the fundamental work. So companies
Speaker 3: that have a great history, as measured by this approach
Speaker 3: are probably high quality, but not all of them are
Speaker 3: in a forward looking sense, at least in our views.
Speaker 3: So we want to screen out a few companies that
Speaker 3: we don't think meet that the bill looking forward. We
Speaker 3: also want to be a little bit open minded for
Speaker 3: companies that maybe are newer and don't have the history,
Speaker 3: have all the attributes to being a quality business, but
Speaker 3: don't fit the backward looking quant screen. That's one thing,
Speaker 3: and then the second thing is that we integrate valuation
Speaker 3: into our approach as well. So we don't want to
Speaker 3: buy quality companies at any price. We want to buy
Speaker 3: quality companies at a reasonable price. If you go back
Speaker 3: through GMO's history, we actually originally were very much a
Speaker 3: deep value manager when the firm was founded. The integration
Speaker 3: of quality came kind of later in the game, as
Speaker 3: the founders, Jeremy Granthams, appreciated the benefits of quality companies,
Speaker 3: but we actually started from value. Now we do it
Speaker 3: in the other order. We start with quality for our
Speaker 3: strategy and then add value to it. But that is
Speaker 3: I think an important differentiator from a lot of quality managers,
Speaker 3: whether they be active or passive. Is that valuation tilt
Speaker 3: as well.
Speaker 2: That's really interesting, Tom, I mean, you know, you're kind
Speaker 2: of still in my thunder. I had some of these
Speaker 2: questions already, but you know, one of my questions to you,
Speaker 2: which you already answered, was is your process completely systematic
Speaker 2: or is there some discretionary elements? Obviously there is some
Speaker 2: discretionary elements.
Speaker 3: You know.
Speaker 2: I do speak to a lot of our customers that
Speaker 2: do want to do something like that, right, I mean
Speaker 2: they want to They're not pure quants, but they want
Speaker 2: to use quant screens to maybe whittle down a universe
Speaker 2: and then use their fundamental analysis and kind of discretionary
Speaker 2: decision making. So can you expand on that a little bit?
Speaker 2: Like you don't have to give specifics, but I mean,
Speaker 2: is it more like you're screening for quality stocks and
Speaker 2: you're just kind of like kicking out the bad apples
Speaker 2: or is it more like you're you're just picking the
Speaker 2: best ones? How does the fundamental research. And again you
Speaker 2: have to go in specifics, but how does the fundamental
Speaker 2: research happen with those stocks? Do you do you have
Speaker 2: different analysts look into the companies. A little more insight
Speaker 2: there would be really helpful.
Speaker 3: Yeah. I mean, I think there's a lot to that,
Speaker 3: and it's been forever answering that question. But I think
Speaker 3: it is mainly about bad apples or maybe not great apples.
Speaker 3: Let's say they're not all rotten companies. I mean some
Speaker 3: might be a company like well, not today. A couple
Speaker 3: of years ago, Intel would have, for example, screened is
Speaker 3: a very high quality, and that would be an example,
Speaker 3: a real life example where while we didn't maybe foresee
Speaker 3: all their problems, we would have said and did say, hey,
Speaker 3: you know this model they had where you integrate building
Speaker 3: the chip with designing the chip was kind of yesterday's model.
Speaker 3: And now the actual manufacturing is so expensive and complicated.
Speaker 3: It's consolidated at TSMC and the fabulous companies at the lead.
Speaker 3: So the future isn't going to be like the past.
Speaker 3: Would be sort of an example. One of the things
Speaker 3: we've also found just with our quantitative scoring is sometimes
Speaker 3: they can get fooled by a cycle. So a more
Speaker 3: simple example kind of is just you go back to
Speaker 3: the financial crisis, Like home builders look really great for
Speaker 3: a number of years. Has just been such a long
Speaker 3: bull cycle for them that they were scoring very well,
Speaker 3: but we felt they at their heart weren't quality businesses.
Speaker 3: So that's very important part of what we do. Our
Speaker 3: portfolio is reasonably concentrated. It has about forty stocks in it,
Speaker 3: so it's not like every stock we don't own we
Speaker 3: think is definitely a bad company. There's also a portfolio
Speaker 3: management element of sort of curating it into a basket.
Speaker 3: That is, we have high conviction we can follow each
Speaker 3: of these companies, we have the human capacity for that,
Speaker 3: and yet at the same time give us diversification between
Speaker 3: different kinds of quality stocks. And I heard earlier talking
Speaker 3: about sort of low vall, which is different from quality
Speaker 3: but sort of related. One kind of quality stock is
Speaker 3: or of those more defensive companies. But equally, we think
Speaker 3: the growth companies that of course have been the winner
Speaker 3: or the last decade. There's Microsofts and so forth. Those
Speaker 3: high quality growth companies are also high quality. And we
Speaker 3: think even within sort of what you might think of
Speaker 3: as a narrowly targeted group like quality, you can actually
Speaker 3: got a fairly diversified basket of Going back to your
Speaker 3: original question about what do we do, sort of fundamentally
Speaker 3: beyond the screening, our valuation is also an important fundamental aspect,
Speaker 3: and we're not necessarily trying to find these totally discounted
Speaker 3: fifty cent on the dollar kind of companies that tends
Speaker 3: not to exist in a high quality universe. We want
Speaker 3: to at least find reasonably priced companies and avoid companies
Speaker 3: where maybe the business is great, but the stock price
Speaker 3: has just gotten way ahead of it.
Speaker 2: Thank you. Quality is one of those factors. I would
Speaker 2: say it's the factor with the most let's call it
Speaker 2: dispersion in definitions, you know, I mean I think you know,
Speaker 2: we know what momentum is, we know about value is.
Speaker 2: You could have your own spin on a value or
Speaker 2: momentum factor, but it's not gonna be that different. I mean,
Speaker 2: you touched on, you know, profitability in my experience, and
Speaker 2: you're the experts, so please feel free to push back.
Speaker 2: But profitability seems to be like the constant in almost
Speaker 2: every quality factor I've seen. And then you usually see
Speaker 2: things like low leverage, like you said, financial stability, things
Speaker 2: like volatility of earnings or sales. I've always seen things
Speaker 2: like a CRULS, so you don't have to give away
Speaker 2: the secret sauce, but like, how do you like do
Speaker 2: you equally wait those different types of descriptors, how do
Speaker 2: you think about combining those things with your quality factor?
Speaker 3: And maybe to start a little bit with the history
Speaker 3: and I'll give you kind of a long ash answer
Speaker 3: that question because it's important. One is and when GMO
Speaker 3: started as a value investor and we're buying things like
Speaker 3: low price to book, low pe stocks in nineteen eighty,
Speaker 3: what we're realized we were missing was these companies got
Speaker 3: a high return on their investment capital when they reinvested,
Speaker 3: they had growth opportunities they could invest in, they got
Speaker 3: high return on that. Therefore they should should create a
Speaker 3: premium valuation, and we weren't buying them. So we started
Speaker 3: from a place of how should we adjust the valuation
Speaker 3: target of companies to take into account these better businesses.
Speaker 3: And the key idea for us was companies that will
Speaker 3: deliver a high return on capital on incremental investments. And
Speaker 3: that's great, of course in theory, but that's the future.
Speaker 3: You can't see the future, can do I see the past,
Speaker 3: so we're looking at things that were predictive about of that.
Speaker 3: And the focus on profitability is largely because profitability past
Speaker 3: profitability is actually pretty predictive future profitable, but it's a
Speaker 3: relatively stable characteristic, unlike if you look at growth factors,
Speaker 3: they tend not to persist very long. So you know,
Speaker 3: you buy growth portfolio, you don't have one in three
Speaker 3: years is kind of the risk. So I'll tell you
Speaker 3: that the secret sauce in nineteen eighty five, kind of
Speaker 3: the very original version of a quality factor was simply
Speaker 3: eight year history of high return on equity, eight year
Speaker 3: stability in that return on equity, and low debt to
Speaker 3: equity ratio. So it was profitability, stability, and balance sheet
Speaker 3: and we ranked the universe on those companies and we
Speaker 3: average the ranks. I think the worst one got halfway. Actually,
Speaker 3: that was it for version one point zero. The version
Speaker 3: we use now has a similar flavor in that there's
Speaker 3: a profitability component, a stability of profitability component, and a
Speaker 3: balanced street sheet strength component, and they have many more
Speaker 3: components beneath them, and the combinations a little bit more complicated,
Speaker 3: but in the spirit of that original idea, one thing
Speaker 3: that's different about us, and I think goes back to
Speaker 3: the fact that we actually think valuation is a big
Speaker 3: part of the return driver too. Is when we think
Speaker 3: about an improvement to our or change to our quality factor,
Speaker 3: does this make it better or worse than what we're
Speaker 3: using last year? The question we're tend to be asking
Speaker 3: is does this predict future profitability better? So, if we
Speaker 3: do back testing, it's not does this generate high return
Speaker 3: in the market just as a quality factor. It's more
Speaker 3: do the companies identified on this metric have better profitability
Speaker 3: ten years from now than the ones that don't. So
Speaker 3: we're focused on the fundamentals, and that does, I think
Speaker 3: lead us to some differences in factors we highlight. So
Speaker 3: things like acrules, which are sort of maybe a short
Speaker 3: term alpha factor, they aren't really what we think of
Speaker 3: as a quality factor, so they're not part of our metric.
Speaker 3: They tend not to have meaning over as long horizon.
Speaker 3: Things like stability or like stock price volatility. It's very
Speaker 3: predictive of defensiveness, and so if you're looking for just
Speaker 3: a defensive factor, it's great, but we're not looking just
Speaker 3: for defensiveness. We tend to get defensiveness because if you
Speaker 3: buy businesses where the profitability is reliable, when times are tough,
Speaker 3: the profitability will be relatively reliable. It's more of an
Speaker 3: outcome than explicit objective in our process. And then one
Speaker 3: thing that you mention, and you're right, quality means lots
Speaker 3: of things to lots of people. And I've never heard
Speaker 3: of manager who says their process isn't high quality. But
Speaker 3: one thing we don't use is dividend type metrics, so
Speaker 3: stability and dividend, dividend growth, things like that. Not that
Speaker 3: we have anything against dividends. We like receiving them, but
Speaker 3: what we like even better is companies that reinvest in
Speaker 3: a high rate of return. So they think there are
Speaker 3: a lot of great, high quality companies that don't pay
Speaker 3: a dividend because they're growing the business. Of course, we
Speaker 3: want companies that when their growth opportunities dry up, they
Speaker 3: return capital. But it's not the only way you could
Speaker 3: be a high quality company.
Speaker 2: Yeah, that's some really great insight. I mean, you know,
Speaker 2: that was one of my other questions you kind of
Speaker 2: hit on. It was, you know, I've seen some quants,
Speaker 2: you know, kind of lump in low risk, low vall
Speaker 2: low beta, even things like low idiosyncratic volatility to their
Speaker 2: quality factor, because the thought is like they're similar ideas.
Speaker 2: But I always view the low risk factor as a
Speaker 2: as a separate factor from quality. I would it sounds
Speaker 2: like you agree with that.
Speaker 3: Yeah, yeah, we do.
Speaker 1: Yeah, you mentioned growth, so I kind of want to
Speaker 1: touch upon that a little bit. I'm guessing it's part
Speaker 1: of the fundamental approach, you know, after you've screened you know,
Speaker 1: so I'm just interested in the evaluation of growth. How
Speaker 1: do you assess growth opportunities in these companies as part
Speaker 1: of the process.
Speaker 3: Yeah, and what it is, You're right, it's part of
Speaker 3: the fundamental approach. And now it's not because we it's
Speaker 3: kind of because it's harder. I guess for us, the
Speaker 3: earlier point is we haven't cracked the nut on how
Speaker 3: to find good quantitative metrics for predicting growth over longer periods.
Speaker 3: And I guess the one is that the obvious one
Speaker 3: is high valuation. That's a very good predictor, but that's
Speaker 3: you know, history would suggest you don't want to include
Speaker 3: high valuation in your quantitative model. Is a positive selection criteria,
Speaker 3: So that's not so helpful for us. So when we
Speaker 3: think about growth. What we're really mindful of is who
Speaker 3: has growth that is really going to be sustainable. So
Speaker 3: the kind of growth we like is when there's a
Speaker 3: secular trend that we feel a company can latch onto,
Speaker 3: So for example, demographic trends and what that might imply
Speaker 3: about healthcare, we are willing to the broader the trend
Speaker 3: is the better. So we feel very comfortable with say,
Speaker 3: semiconductor tech content growing broadly, and if your growth as
Speaker 3: a company is sort of levered to that broad thing,
Speaker 3: that's great. If it's a specific technology, that's where we
Speaker 3: are going to be, let's say more conservatives. So honestly,
Speaker 3: something like artificial intelligence, we're probably going to be on
Speaker 3: the more conservative side. As that gets into a more
Speaker 3: specific thing our just experiences, it's harder for us to
Speaker 3: get that right. And then beyond the secular growth that
Speaker 3: they might be associated with an industry, the other thing
Speaker 3: we're asking ourselves around an individual company is they're probably
Speaker 3: going to benefit from if they're in that industry. They'll
Speaker 3: benefit initially because that rising tide raise all boats. The
Speaker 3: question is do they have a competitive advantage that will
Speaker 3: allow them to maintain and grow their share to get
Speaker 3: more than their fair share of the pie. Hopefully, so
Speaker 3: the kind of company where, because of its growth, will
Speaker 3: pay a higher multiple four will be one that's sort
Speaker 3: of in the participating in the early stages of a
Speaker 3: secularly growing industry and as a super strong competitive position
Speaker 3: that we think won't be dislodged. So a intuitive surgical
Speaker 3: for example, in surgical robotics, there's not just broad healthcare trends.
Speaker 3: There's robotic assisted surgery, which you think has a lot
Speaker 3: of legs and their strong competitive position within that. The way,
Speaker 3: we kind of think of that as not so much
Speaker 3: about higher growth within the next one or two years.
Speaker 3: We're more focused on durability above average growth because finding
Speaker 3: those companies that can really outgrow the market for five
Speaker 3: ten years that's actually pretty hard and those are pretty
Speaker 3: rare companies, so it's not like anyone can do that.
Speaker 1: That makes sense. I also want to ask you about
Speaker 1: the portfolio. You know, so if you look at the
Speaker 1: portfolio on the website as of I don't know, I'm
Speaker 1: guessing that's as of August. I noticed a lot of
Speaker 1: large caps. Are you finding more quality in large caps
Speaker 1: as opposed to more of the you know, other mid
Speaker 1: or smaller cap companies.
Speaker 3: Yeah, we are, and that's not a new trend. The
Speaker 3: large cap universe, particularly in the US market, is a
Speaker 3: much higher quality one. Not by definition, i should say,
Speaker 3: but also if you're a great company and a big
Speaker 3: business you are, do you tend to get large. There's
Speaker 3: also a value hit, not so much today, but over
Speaker 3: the past decade or so, there's a been a valuation
Speaker 3: reason in our minds too, where we found smaller cap
Speaker 3: quality companies that tend to be at a premium. That is,
Speaker 3: that has changed a little bit in the last couple
Speaker 3: of years. We actually did launch. It's not not in
Speaker 3: the ETF format. The ETF is large cap, but the
Speaker 3: we do have a small cap quality strategy that's a
Speaker 3: couple of years old. That's looking for kind of those
Speaker 3: niche businesses that maybe they don't grow with much because
Speaker 3: they're smaller cap. They do a specific thing, but they
Speaker 3: do it really well. It's an important thing. So there
Speaker 3: is quality there, but it's not it's not as prevalent.
Speaker 3: Let's say, in the small cap universe.
Speaker 2: Tom, what about waiting your stocks? I mean, just looking
Speaker 2: at the portfolio, it does seem to be market cap
Speaker 2: weighted or at least partially market cap weighted, and please
Speaker 2: correct me if I'm wrong. How do you think about that?
Speaker 2: Is that kind of a function of liquidity and slippage concerns,
Speaker 2: or how do you think about the waiting of the
Speaker 2: stocks in the portfolio?
Speaker 3: Yeah, and you're right there. We're market cap weight in
Speaker 3: the sense that we are close to S and P
Speaker 3: five hundred type market cap, which is unusual for an
Speaker 3: active manager. But we're not actually explicitly market cap waiting
Speaker 3: our positions or managing directly to the benchmark for that matter.
Speaker 3: The general framework for how we think about position sizing
Speaker 3: is the quality of the business that's kind of a
Speaker 3: maximum weight will hold in a stock, and then valuation
Speaker 3: is a little bit of a you know, how far
Speaker 3: through the dial should you be? So even the best
Speaker 3: company in the world, we wouldn't hold it an expensive valuation,
Speaker 3: et cetera, or probably won't hold unless your high quality.
Speaker 3: So the biggest positions in the portfolio will be companies
Speaker 3: that are we're convinced about black quality, and we're also
Speaker 3: find the valuation very compelling, at least when we initially
Speaker 3: bought the company. We do let winners run a bit
Speaker 3: so that doesn't necessarily mean the the cheapest stock in
Speaker 3: the world today, but they were very attractive when we
Speaker 3: originally bought them. And then yes, liquidity matters, and there
Speaker 3: are there will be a few smaller companies. Girrell hold
Speaker 3: small or midcaps companies grow hold smaller positions, but if
Speaker 3: you look at the top ten holdings in that kind
Speaker 3: of name, these are obviously megacap type stocks. For liquid
Speaker 3: is in the constraint for us.
Speaker 2: Yeah, because I talked to a lot of customers that
Speaker 2: that ask me about this, like, are you, you know,
Speaker 2: should you wait your stocks buy let's just call it
Speaker 2: your expect did alpha of the of the of the company,
Speaker 2: which does sound like in a way is what you're
Speaker 2: doing or is it like a explicit you know, I
Speaker 2: talked to other people that are it is you know,
Speaker 2: the waiting decision is an explicit risk management thing, like,
Speaker 2: you know, give me the highest expect to return for
Speaker 2: you know, no ball over ten percent or something like that.
Speaker 2: So I'm always interested in those the thought process behind
Speaker 2: the stock weightings.
Speaker 3: Yeah, and we're maybe not as scientific of as any
Speaker 3: of those things. I think one reason why we're not
Speaker 3: I mentioned doing portfolio optimization earlier in my career is
Speaker 3: I feel there's a risk that the technology around waiting
Speaker 3: them becomes more and more sophisticated the actual precision of
Speaker 3: the inputs, so you're kind of limited in or maybe
Speaker 3: free if you're not that at precise in your valuations,
Speaker 3: you probably shouldn't have your portfolio weights be very sensitive
Speaker 3: to small changes in them. One thing we have changed
Speaker 3: sort of philosophically in how we size positions is maybe
Speaker 3: a decade ago would have been more like expected return rating.
Speaker 3: You'd have a price target and that would feed into
Speaker 3: what a position size should be, and we do a
Speaker 3: fair amount of trading around that, and stock went up
Speaker 3: a bit, we'd trim and vice versa. Now we think
Speaker 3: of it a little more as kind of a corridor
Speaker 3: of just don't take any action kind of so as
Speaker 3: that was our earlier point about when we buy it
Speaker 3: it has to be fairly cheap, but once it's sort
Speaker 3: of in the portfolio, as long as we feel good
Speaker 3: about the quality of the business and the company executing,
Speaker 3: we will let it ride a little bit up and down,
Speaker 3: and we have when characteristic you would see if you
Speaker 3: looked at our longer term portfolio is turnover went down.
Speaker 3: It used to be at one point about fifty percent
Speaker 3: a year, so now it's super high but reasonably high,
Speaker 3: and now it's more like twenty percent a year.
Speaker 1: I actually have a follow up question for that. You know,
Speaker 1: you mentioned you know some stocks, you know their waitings
Speaker 1: may increase. How do you handle risk when you might
Speaker 1: have substantial exposure to an industry or sector, even to
Speaker 1: a single security.
Speaker 3: Yeah, so everything I've talked about so far really has
Speaker 3: been focused about individual securities. Of course, you do care
Speaker 3: about the overall portfolio, and we certainly will trim back
Speaker 3: positions if we think we are betting too much on
Speaker 3: a thing in aggregate, or if there's another way I
Speaker 3: think about as if one thing goes wrong or we're
Speaker 3: wrong about one thing, how many of our valuations would
Speaker 3: that or quality assessments would that invalidate? And well, we
Speaker 3: don't manage a portfolio against the benchmark. We do manage
Speaker 3: it in absolute terms from a diversification point of view.
Speaker 3: So there's any number of things we might worry about,
Speaker 3: obviously sector type things or you know, a thing that's
Speaker 3: big on our mind over the last few years is
Speaker 3: companies in entertwirement with China, and how much of a
Speaker 3: risk factor that is, or any sort of macro variable
Speaker 3: that might cut across a lot of the portfolio. We
Speaker 3: don't really want to make calls on that. So if
Speaker 3: we feel like we're just where we're finre stocks is
Speaker 3: leading us in one direction, we will either trim back
Speaker 3: on we will trim back on positions. The other thing
Speaker 3: that will do is kind of affect our research agenda.
Speaker 3: We're always you know, we have a limited human capacity
Speaker 3: to downside of fundamental work is you need people to
Speaker 3: do it, and that takes time and energy, and so
Speaker 3: we want to direct it in the right place, in
Speaker 3: the right places companies that are going to diversify the portfolio,
Speaker 3: not finding the twelfth company in the same industry that yeah,
Speaker 3: it may also be high quality and cheap, but doesn't
Speaker 3: really bring anything you don't already have.
Speaker 2: I'm interested.
Speaker 3: Do you do you do?
Speaker 2: You do the same thing with like other factors, meaning
Speaker 2: like let's say your portfolio for your ETF is very
Speaker 2: you know, all the stocks are very high momentum, and
Speaker 2: you run it through a risk model and it shows
Speaker 2: very high exposure to to long for momentum. I'm just
Speaker 2: I'm just making that as an example, would you do
Speaker 2: any hedging there or would you just you know, whatever
Speaker 2: quality is it is?
Speaker 3: So that's that is We definitely do a lot we
Speaker 3: look at that kind of stuff. Momentum is an example
Speaker 3: of the thing. We're all looking at our correlation with
Speaker 3: momentum as well as sort of macro type variables. Momentum
Speaker 3: sort of a it's a confusing, ephemeral kind of thing.
Speaker 3: So if we saw a high correlation momentum, we'd probably
Speaker 3: first be asking, Okay, what's going on behind that? And
Speaker 3: it's probably going to be an answer something like the
Speaker 3: markets being led by artificial intelligence stocks, those have all
Speaker 3: the momentum. We have a bunch of those, so we
Speaker 3: would probably the momentum would sort of be an indicator
Speaker 3: that we should pay attention and then we peel a
Speaker 3: few layers from the onion and then we'd say, yeah,
Speaker 3: like we do have a lot of exposure to these stocks.
Speaker 3: That doesn't mean we take down the risk. We might
Speaker 3: look at them and say, yeah, we're that's a position
Speaker 3: we're comfortable with. Let's we've re underwritten that. We'll hold
Speaker 3: with it. But it's it creates conversations and sometimes we
Speaker 3: will adjust the portfolio.
Speaker 2: And my last question is around rebalancing. I mean, you know,
Speaker 2: the classic Quan portfolio is like rebalance every month, end
Speaker 2: of the month. Is that what you do or is
Speaker 2: it more like a dynamic rebalance skin or how does
Speaker 2: that work?
Speaker 3: Yeah, so our extra trading doesn't follow a schedule. The
Speaker 3: systematic inputs our quality factor. Yeah, it's a traditional quant
Speaker 3: kind of thing. It's recomputed monthly. That gives us a
Speaker 3: new screen to look at. However, it's also true that
Speaker 3: the inputs to it are financial financial statement data that
Speaker 3: almost entirely that doesn't even change even at a monthly frequency.
Speaker 3: And then we're looking at profitability averaged over a long period. Deliberately,
Speaker 3: we want to look across cycles, and so even if
Speaker 3: one month changes, the whole screen can't change very much.
Speaker 3: And so it's kind of like watching a paint dry
Speaker 3: when you look at it every month. I would say,
Speaker 3: by the way, that that makes it sound like qulant
Speaker 3: screens are always going to be way behind the curve
Speaker 3: and you know, too slow to react. One of the
Speaker 3: advantages of a quant screen is because in the real world,
Speaker 3: quality changes slowly is a fundamental analysis you may never
Speaker 3: noticed it happening. It happened so slowly, and one of
Speaker 3: the things over the last couple of decades it really
Speaker 3: helped us by having the quant screening was identifying the
Speaker 3: rise in tech companies, like fifteen years ago, it was
Speaker 3: controversial to call it tech company quality. Technology is always changing,
Speaker 3: there's always new leadership, too much volatility. But our quant
Speaker 3: screening was saying, hey, look at these companies, like they
Speaker 3: have high return on investments, the strong balance sheets, they
Speaker 3: have all the signatures. Maybe something's going on there. And
Speaker 3: we did fundamental work on top of that. But I
Speaker 3: think having that quant screening really sort of dragged us
Speaker 3: to led the horse to water. If you maybe didn't
Speaker 3: make us drink, but certainly made us pay attention. That
Speaker 3: was a bit of a digression from your earlier question
Speaker 3: rebalancing the So the systematic part goes monthly, the actual
Speaker 3: fundamental trading decisions are a little more at hoc. Let's say,
Speaker 3: no calendar to that. And as I said, it's actually
Speaker 3: relatively low level of turnover.
Speaker 1: So you also manage the GMO quality mutual fund aside
Speaker 1: from the wrapper. Is there any differences between the two strategies.
Speaker 3: Yeah, there's one meaningful difference, which is that the mutual
Speaker 3: fund has a global opportunity set and the quality ETF
Speaker 3: is specifically a US quality ETF. In the mutual fund,
Speaker 3: by weight, it's about eighty twenty between US and rest
Speaker 3: of the world. The rest of the world stocks they're
Speaker 3: large cap multinational, So if you're talking about NESTLEI or TSMCS,
Speaker 3: know this is not hardcore international investing by any means,
Speaker 3: but it does have that global opportunity set. And factly,
Speaker 3: some people like that, They like that breadth of opportunity,
Speaker 3: and some people are a little more stylebox oriented and
Speaker 3: kind of wish we stuck a little bit closer to
Speaker 3: our knitting to the extent people put us in a
Speaker 3: large cap US core bucket. So when we started the ETF,
Speaker 3: there are technical advantages to having just US listed US
Speaker 3: time zone companies, but there's also a client demand for
Speaker 3: a pure vehicle and the exposure to the US market.
Speaker 3: So that is the difference.
Speaker 1: Okay, no, it makes sense now you have one.
Speaker 3: For each exactly I think for everyone.
Speaker 1: So my final question before I let you go, what
Speaker 1: you note today that you wish you knew twenty years
Speaker 1: ago in regards to investing.
Speaker 3: Yeah, well, if I think about my twenty years ago self,
Speaker 3: it was a lot less sophisticated on the fundamental side.
Speaker 3: It was a more skilled quantitatively, but I'd say generally
Speaker 3: it was a little too much of a cynic and
Speaker 3: too much of a contrarian and value based investor. And
Speaker 3: that would be that would apply, you know, a factor
Speaker 3: point of view, just too much in love with like
Speaker 3: low multiple stocks, and maybe from a sort of sentiment
Speaker 3: point of view, too much just too much of a contrarian,
Speaker 3: like if everybody thinks something that most of the time
Speaker 3: they're not wrong about it, right. So I think that's
Speaker 3: something that based on my natural personality is softened a
Speaker 3: little bit with age, and I think that's help helped
Speaker 3: my investing results.
Speaker 1: Great, well, this is a great discussion. Tom, thank you
Speaker 1: again for taking the time today.
Speaker 3: Yay, well, thank you, thank you, and I've enjoyed it
Speaker 3: very much.
Speaker 1: And Chris thanks again for being my co host this week.
Speaker 2: Thank you David, and thank you Tom very much.
Speaker 1: Until our next episode. This is David Cone with Inside
Speaker 1: Active