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Where to Invest in a Muted Recovery

Scott Burns

Scott Burns: Hi, there. I am Scott Burns, Morningstar's director of ETF research, coming to you live from Morningstar's premiere ETF Invest Conference.

Joining me today is Dan Farley, SSgA's Global Head of Investments for their Multi Asset Class Solutions team. Dan and his team oversee over $190 billion of institutional money globally.

Dan, thanks for joining us.

Dan Farley: My pleasure.

Burns: So, Dan, you're actually kicking off the conference today, giving an overview of the state of the market. One of the things that we always tell investors is, don't go looking for an ETF first, go looking for an investment idea. And that's why we've actually asked you to come and talk about that.

So, maybe you can give us just a quick sneak preview into your talk today, and let's just jump right into areas around the asset class world, around the globe, that SSgA and your team are finding in favor right now?

Farley: Sure. So I think generally speaking from a backdrop perspective, it's our opinion that we are in what will be a very prolonged but sustainable recovery. We're not in the double-dip camp. We're not in the V camp, but rather something that is going to take several years to work itself out. And so with that, we think that we're going to be in a more muted market return environment.

And so what we've tried to do is, say, let's focus our portfolio on areas where we're going to be compensated for risk, where we're going to be able to help generate more stability of returns. And so what we have done is, currently we're positioned relatively neutral to the stock-bond question, right. So not really taking on a whole lot of equity risk in the portfolio right now, but what we've tried to do is focus in on areas that we think will help investors get paid as we wait out this solution.

Burns: So 90-day Treasuries are not...

Farley: 90-day Treasuries are not the place to be.

Burns: You mean getting 2 basis points is not getting paid?

Farley: No. But say, in U.S. large cap, for example, tilting towards dividends. If we see equity returns over the next 12 to 18 months to be sort of in the mid- to upper single digits, and I can get half of that out of my dividend yield, [that's] a much more stable return.

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Burns: Right. Now, when you are looking at those equity returns, and especially looking at dividends in light of everything that happened where we had a lot of false positives on dividend yields, especially in the financial sector, are you doing any screens for credit quality or doing any sector capping or anything like that?

Farley: When we look at it, I think, at a broad level, we are taking that into consideration into the overall process. But I think there's a lot of other good things that are happening. When you look at the level of cash on balance sheets, you look at the fact that companies have in general, ex-financials, been looking to move towards raising their dividends. I think even in the bank space, while we haven't seen much move in that area, I think that's largely regulatory, and from an oversight perspective, that the government is not quite ready for people to start raising dividends. They want to see that capital piece shorn up. So, I think the fact that the banks haven't brought their dividends back is perhaps not as much a sign of weakness, it's just sort of the environment that we are in.

Burns: Right. And we're hearing from everybody, investors and asset managers alike: yield, yield, yield. Do you think this rush for yield will collapse that opportunity? What are you waiting for to say, okay, the party is over, maybe.

Farley: At some point, that's always the case, right, and I think it's true in dividend stocks. High-yield and investment-grade credit are two other areas that we've been focused on. Clearly, that's not a spread compression play, necessarily, anymore, because much of that has happened. But if I can still clip a 9% coupon of my high-yield portfolio, that's a pretty good base as I wait for things to shake out here.

Ultimately, if more money flows in that space, spreads will continue to compress, and at that point, it's just clearly risk-return trade-off, and it gets back to the idea of, "what do we think the expected return is going to be for the volatility and the risk," and then at some point, that isn't a good trade-off anymore, and you want to start to reduce that.

Burns: So areas that your group is finding out of favor, I think we kind of joked a little bit about the short-term Treasuries and things like that.

What is it right now? I mean we look at the money flows, and although I hear from a lot of people that you don't want to be in Treasuries, and [if] you are looking for yield, you should get out on the risk a little bit more. The fund flows tell a totally different story, and everybody is still running into short-duration fixed income, and fixed income continues to just wallop equity in terms of flows, and that's true whether it's ETFs or mutual funds or separate accounts, across the board.

So what is it about fixed income right now?

Farley: It's safety. I mean, everyone continues to be concerned about the downside risks that we just experienced, and it's clearly obvious why that is. And it's logical, and it makes sense. One of my big concerns, however, is that we, as investors, both institutional and Main Street, focus so much on this risk reduction trade. And if that pendulum swings too far, then we've lost sight of our return goals, and whether that be to make your pension payments or that's to save for retirement or put your kids through school or whatever it is, there's a certain level of return that's either required or you have to offset that with increased savings.

Burns: I think it could get even worse. The pendulum swings beyond that missing the return to turning a risk-free asset into a risky asset.

Farley: Sure.

Burns: And I think when we look at some of the longer-dated Treasuries, especially, that risk is real, and even the shorter dated paper, I mean, the law of small numbers here is something to worry about, right. I mean a move from 2 basis points to 50 basis points would be a tremendous loss of wealth even on 90-day paper.

Farley: In concept, the long-dated Treasury is the risk-free asset because in theory we're always going to get paid back. It doesn't mean that the ride isn't very, very bumpy along the way.

Burns: Right. Are there any other areas for concern outside of Treasuries that your group is seeing?

Farley: Well, I think that that is probably amongst the more overheated marketplace. You start to look at some of the other asset classes that have seen extended runs. I think there's none that jump out at us that says "we're in 'bubble range,'" although that term is often overused. But I think right now, it is less a question of something that is a screaming sell, but rather that there's very little catalyst to move some of the other asset classes forward, which is why I have said we've taken some of the risk down in the portfolio, and tried to redeploy into areas that we think are going to be more stable from a return perspective. They still have some risks to them; there's no question. But if can try to offset some of that risk with a stability of income, in this case, it seems to make sense to us.

Burns: And I think that makes complete sense. I mean if you're going to have to wait, you should at least get paid to wait, and rather than sit there and stuff money in your mattress for all practical purposes.

Farley: That's right.

Burns: So, Dan, thanks for joining me and thank you for your insights.

Farley: My pleasure.