Wed, 17 Apr 2013
JAForlines Global's John Forlines III discusses his firm's strategy, the correlations and emerging trends in global credit markets, and the impact of behavioral finance in ETF managed portfolios.
Andrew Gogerty: ETF managed portfolios grew 60% last year as advisors and institutions continue to be drawn to this outsourced asset-allocation model. Hi, I am Andrew Gogerty, ETF managed portfolios strategist here at Morningstar. Managed portfolios in our space that primarily use ETFs as the underlying investment vehicle grew 60% in 2012. Morningstar is now tracking $63 billion in these strategies.
Joining me today for a discussion both on this growth and global investment opportunities is, John Forlines III, chairman and chief investment officer of JAForlines Global, John, thank you for joining me today.
John Forlines III: Thanks for having me, Andrew.
Gogerty: Let's start with the growth of this space first. Obviously advisor education and comfort level is really driving the flows to these strategies, but we're also seeing renewed interest or new interest from small institutions, pensions, and endowments. What comfort level or what is changing in their mind-set that is allowing them to outsource part of their asset allocation to third-party managers, such as, yourself?
Forlines III: I think the short answer to that question is a lot of the institutions that traditionally serve them with products, such as the PIMCOs and the BlackRocks and the Morningstars of the world, have a focus on ETFs now, either they manufacturer them or they sponsor them or do research on them. And that gives comfort to the institutions to say this is a space we need to look at.
Gogerty: How about, let's go right to your strategy, your global tactical allocation strategy. It is very wide-ranging. It can go across the globe and across asset classes. What are some of the key inputs that drive the asset-allocation decisions in your strategy?
Forlines III: We're a little bit different from the traditional quantitative ETF shop, which is how the business started. We are more fundamental in the sense that we emphasize credit systems and credit allocations, as well as liquidity in the system to the assets what we look at. So, for example it's a funny saying, but we say, if you want to know what's going on the equity market, look at the credit markets, if you want to know what's going on the alternatives, look at the credit markets. And for sure with fixed income, you need to look at the credit markets. So, that's sort of how we start, with a fundamental monthly look at our data sets both contracted and proprietary and we take a view on the liquidity and credit health wherever we want to invest and whatever asset class we're going to be in.
Gogerty: Along with credit and looking at credit around the globe, correlations are something that you've talked about in the past and commented on, that they've been changing over the last year. What types of correlation changes are you seeing either within asset classes or between asset classes around the globe?
Forlines III: I think what started the correlations to break down, that is, for everything to be correlated, risk-on, risk-off, really was the crash of 2008 and then the subsequent recovery, which has been sort of manipulated by central banks and governments. Now you're starting to see some underlying strength in some places like the U.S. You are seeing concerted actions that are starting to work in places like Japan, and as a result, some of the subasset classes.
So for example, agency and Treasury bonds versus spread products--they are starting to diverge. Performances are starting to diverge. And you're also starting to see that for the first time in regions, where you've got a Japan, that's vastly outperforming almost any other equity class this year. That hadn't occurred in the last three or four years, either it was risk-on, the S&P went up and MSCI went up or nothing.
Gogerty: How about within emerging markets. You had mentioned regions and obviously Japan could be considered a region given its breadth, but you know may be looking at emerging markets for example, are you seeing any changes in there because emerging-markets equities especially, and now bonds, continue to be interesting to investors and they're warming up to it. Any correlation changes there?
Forlines III: Yes, definitely. First, some of the sponsors have come out with more vehicles. It used to be you could just get dollar-based exposure to emerging-markets debt, for example. Now, you get local currency exposure. And I think part of the change on the debt side is a realization that not all emerging-markets regions are going to behave or perform at the same time, and that's certainly the case.
So, you need to really first of all, have a dollar view when you are looking at that asset class, but then you need to know what's really in it, and so, this kind of goes to the equity side. There is a breakdown now occurring. There is the traditional BRIC products, which serve Brazil, India, Russia, and China, and the effects of those BRIC economies. And then there is sort of a new wave of emerging markets. The countries that are starting to emerge, that go closer to developed on their own in different ways.
They are not resource-prevalent, as say the BRICs are. A perfect example of that is Indonesia, which is now 70% consumption-driven. You have got places in Latin America like Chile like that. So, differentiation is starting to become important in emerging markets, and that wasn't really the case five years ago.
Gogerty: Going forward into this year, we are few months in, but to maybe summarize or bring to a nice concise point, what are some of the things that you're looking at this year either from the technical or even on the credit side that could really drive some of the key asset-allocation decisions for your portfolio?
Forlines III: On the credit side we continue to see health generally and spread product almost everywhere, but Europe. So we also see continued weakness, trend weakness in government bonds, and we think that's probably going to continue. And you are going to have the outliers, for example where countries are trying to repair or still repairing balance sheets or they are in the early stages, particularly on the government side. But the spread product side is still is probably the most interesting part of the whole complex.
Gogerty: The last thing and maybe moving away from the technicals, which I find a little bit interesting is, you've lectured on the topic of behavioral finance in the past and, that's something that's long been a discussion point in traditional asset management or even long-only Morningstar Style Box type investing. What impact does behavioral finance have, if any, or how relevant is it to tactical managers using ETFs that are built on models that are very technical or quantitative based. What impact does behavioral finance have or what is there to learn in this space under that concept?
Forlines III: What's there to learn is, if you look back even taking the S&P proxy and look back into the 1880s, and then look at the two main historic drivers of that proxy and it's been the fair value of corporate earnings, cash flows, and GDP growth. Both GDP growth and the fair value corporate earnings, about 70% of the time over that long, long period deviate at about 1% standard deviation. So, if you had the moxie and the client base to last that long, over those long periods, then you've done fine.
The problem though, if you enter an overlay the S&P proxy performance, which includes when it started as an index here in the United States, you'll see erratic performance relative to the drivers. So what that tells me is that the quantitative programs are right for a while and then they can be really wrong for a while. And as a result you have clients dropping out of the market at all the wrong times. It's the classic buy high and sell low.
So, tactical really helps. If you are using a fundamental approach as opposed to a quantitative approach, you are sort of getting a scent of the herd before the herd moves, because the herd is humans making this type of the move, and I think that's the chief value of tactical.
Gogerty: Do you think that helps on the backside too, if you think about markets such as housing that overbuild when the momentum stopped? Can you using that type of the analysis, maybe cut down on volatility on the back end where a strategy stays too late in some asset classes or not really?
Forlines III: Yes, absolutely. I can still remember the angry e-mails I got in 2006, starting to offload financial exposure and in '07 offloading the REIT exposure. Certainly, pundits were out saying the housing market has never declined ever in a single year. We had no inclination of a systemic meltdown, but we felt that there was a problem with a rising interest-rate environment in financials. It's really just a simple concept that mortgage players and financial and banks and financial services would have a hard time making money in that kind of environment. Now, little did we know that there was so much toxic product manufactured during that period that it would all cause a house of cards to come down there, that's a different story.
Gogerty: Great. Thank you for your time today and also for your perspective. This has been Andrew Gogerty with Morningstar and John Forlines III from JAForlines Global. For more information on ETF managed portfolios, please visit the ETF managed portfolio center on morningstaradvisor.com. Thank you.