Editors’ Note: This is the transcript of the podcast we posted last week. Please note that due to time and audio constraints, transcription may not be perfect. We encourage you to listen to the podcast, embedded below, if you need any clarification. We hope you enjoy.
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Jonathan Liss: Welcome to Let’s Talk ETFs. I’m your host Jonathan Liss, and I’ve been closely tracking the ETF space for more than 13 years through a variety of roles here at seekingalpha.com. Each week, a different guests and I will take an in-depth look at a particular aspect of the rapidly evolving exchange traded fund space with a focus on how investors can best utilize ETFs to reach their investing goals.
Before we begin, a brief disclaimer, this podcast is for entertainment and educational purposes only. Nothing said here should be taken as investment advice. All opinions expressed on this show are those of the individuals expressing them alone. A full set of disclosures will be included at the end of this show. You can subscribe to Let’s Talk ETFs on Apple podcasts, Google podcasts, Spotify, or whichever podcast platform you prefer.
For reference purposes, this podcast is being recorded on the morning of Tuesday, September 8, 2020. I’m joined today by Sean O’Hara, President of PacerETFs. Sean began his carrier at PLANCO/Hartford in 1985, where he spent 22 years as a wholesaler, Division Manager, and Managing Director of the National Wholesaler Team. In 2007, Sean joined his PLANCO co-Founder, Joe Thompson again at Pacer Financial to serve as a national wholesaling company for various products, including Exchange Traded Funds, Exchange Traded Notes, annuities and SMEs.
In 2015, Pacer ETFs was launched. With Sean’s leadership, the company has become one of the fastest growing ETF companies. Sean often appears on Fox Business Network, CNBC, and various other news outlets to give insight into the market. Anyway, enough of an intro. Welcome to the show, Sean, it’s a thrill to have you here.
Sean O’Hara: Great. Thanks for having me, Jonathan.
JL: So, I think that timing of this conversation is pretty much perfect. And I want to say at the outset that I definitely will need to have you back on the show at some point, because Pacer has some really unique ETFs, you now have 26 in total, with nearly $6 billion in AUM, and we’re not going to be able to discuss all of them, obviously, in a single conversation, but the timing of this conversation in particular, I think is pretty much perfect, because the search for a COVID-19 vaccine has been, I’d say the top story in the news over the last few weeks and picking up steam the later into the year we get.
Just last week, I believe it was President Trump and then the CDC announced and told states that they may need to be ready to start distributing a vaccine by the beginning of November, which coincidentally is a week before the election. So, maybe take that with a grain of salt, but the point is, we are definitely getting closer here. And so, I was just curious in terms of the Pacer BioThreat Strategy ETF, ticker symbol VIRS, which you launched on June 24. And it seems to me at least that the timing of this was pretty unbelievable in terms of the launch of the fund. So, I’m just curious, a lot of funds obviously can take a year or longer to get to market. And is this something that you were planning before the virus struck, or is this something that you actually were able to rush to market and just somehow get out the door very quickly.
SO: It’s sort of a combination of the two, if you want to know the truth. The idea is an idea that we first heard about in 2016. So, we had had a lengthy set of discussions with LifeSci, which is a biotech firm in New York City about a number of different biotech ideas. And they didn’t eventually turn into a partnership. One of the things they did share with us is that they did build this index. And I believe they actually filed this index with another ETF company, but it never actually made it to market.
And so when the virus hit, it sort of was one of those things very simple. Holy cow, we remember we had that idea, so we started to talk to them again about the index. And so we were able to pretty quickly put together an agreement between them and us to get the product out on the street. So, it happened quickly, but not quickly, if you will. It sort of has been bouncing around here for a good four or five years. We just, you know, the timeliness of launching it today just seemed right to us.
JL: Yeah, makes total sense. And did you have to make adjustments to the underlying index over the last few months or were you able to essentially go with the initial idea that BioSci had?
SO: No, we used our initial idea. And our initial idea was really, we think well thought out. I mean, it’s, you know, so you mentioned vaccine, right? And that’s like the Holy Grail here, right? If somebody can come up with a vaccine then that’s going to potentially solve the problem. There are a number of people working on vaccines. And there are a lot of ways to play that, even with just a straight Biotech ETF, you could do that. Their premise was that pandemics are coming around more and more, there’s been like six in the last 15 years. And this is not going to be the last pandemic or biological threat. And the impact of this one probably has a deeper, longer lasting trend that can be invested in, when you start to think about things beyond the obvious.
Healthcare is the obvious. That’s vaccine, protocols, and therapeutics, right. But then when you go beyond that and you go to testing and detection, we were caught flat footed and the world was really in terms of that issue. And that goes beyond names like quest, which is the portfolio or Abbott Labs, who manufacturers a lot of it. It goes to the companies that provide the reagents, which are like the cake mix, if you will, for the tests. So, they went really deep in terms of how they were thinking about these biological threats. Now, there is a competitor product out there.
They got launched right around the same time that’s a little more focused on the healthcare side of things, but we think this is, you know, this is not a story that’s over once COVID-19 goes away, because there’s going to be another threat down the road. It’s sort of like, you know, if you see these when there’s a hurricane in the Caribbean, or in the Gulf of Mexico, and you can see it out there out in the distance, and it’s coming, there are going to be more and more of these. And so we think this is a long term investment play that is going to be focused on the obvious health care solutions, but also one of the longer-term structural changes that society is beginning as a result of this particular one.
JL: Yeah, sure. And I mean, I think, unfortunately, there’s probably a lot of different factors going on in the world today, whether it’s continuing growth of populations and interaction with animals on a daily basis, just the speed with which things can travel around the globe. So, you can have a virus in China one day and in Italy the next week, and then in New York and San Francisco, maybe a week after that. And so, yes, certainly, I don’t think this problem is going away anywhere.
So, I’d like to go through some of the different things you mentioned, but before we get into that, I think there are some other areas that the index actually focuses on, which may be surprising to listeners, and which is one of the reasons that I wanted to have a conversation with you. So, you mentioned specifically the vaccine, you mentioned, treatments for the virus, you mentioned tracking of it or detection. There is some other elements here also. So, would you be able to just go through briefly what the other elements of the index are?
SO: This is going to change the way we do lots and lots of things here. I’ll give you a couple of examples of structural changes that we think are investment or investable themes. Post-9/11, after the terrorist attack in New York, the amount of security around entrance to facilities got ramped up big time. You know, we all eventually got comfortable dealing with that, you know going into a sporting event and not being able to carry a bag or going through a metal detector and having, you know then folks [threw a bag] if you had one, airports, [court security]. So two specific ideas as an example.
If in fact, we’re going to get the economy up and going again, then people are going to have to feel more comfortable going out in public. And the things that will make them feel more comfortable going out in public are going to be things like the buildings and the venues that we’re going to want to drive at restaurants and venues that we’re going to want to travel to, we’ll have to be able to make people feel more comfortable.
So, I can name this in the portfolio that I had owned it – I owned at one point recently and I really liked the name, it’s FLIR Technologies, and they manufacture thermal imaging cameras. And so essentially what you know, like in our office here, where I’m doing this call from, we’ve got 40 or 50 people that work in the building. We can have a person standing up front with a thermometer and taking everybody’s temperature to make sure everybody you know is not above 100 point whatever the CDC guidelines is, right?
SO: If you work in a big city and there’s 60 stories through your building and 7,000 or 10,000 people in the building, you can’t have somebody with a handheld thermometer, well FLIR manufacturing of these cameras that they’re starting to show up in a commercial use perspective, that as you walk past it, it basically is scanning everybody and it can pick out the person instantaneously is above a certain threshold. So, that’s going to be a permanent change. We’re going to become more comfortable doing that going forward. And so, I think you’ll see them at airports, I think you’ll see in big office buildings, I think you’ll see them in stadiums and big venues. And that’s going to be like a long-term shift, if you will.
The other long-term shift that’s taking place is the way we actually get treatment and interact with doctors. So, Teladoc is a stock that’s in the index, I actually hold that stock personally as well. It’s a terrific service. If you remember, when the virus first hit, they told people don’t go to the doctor. And the reason they didn’t want them to go to the doctor was they didn’t want to potentially infect the person sitting in a waiting room with 10 or 15 other people waiting to get seen, while Teladoc solves that problem to a certain extent because you know you can essentially be seen by a doctor for almost all, you know a lot of the things that you deal with, that you don’t have to get your car and go anywhere, there’s no co-pay, they did, I think help the telemedicine names by mandating that the doc’s can get the same coverage by insurance in terms of the repayment, because they were a little apprehensive at first doing this, but now they’re making the same amount of money, whether they see it virtually or in person.
And so, we’re going to, we’re going to be more and more as things go forward comfortable with this model. I don’t have to leave my office to go to the doctor. I call out, I tell him what my problem is, a doc calls me back, I can video and send pictures. And then they can diagnose me and then call in a prescription and I just go pick it up later on my way home from work. So, there’s going to be structural changes to the way we live. This is a great example of what we’re doing today. You know, you’re in Tel Aviv, I think, is what you said?
JL: Yeah, I’m in Jerusalem, but yeah, the Seeking Alpha office is just north of Tel Aviv. It hasn’t been open. But yeah, I’m in my house, you’re in your office halfway around the world.
SO: Yeah. And so we’re having a meeting via zoom, a technology, right. And so we’re going to be – more and more people are going to be working remotely. I don’t think it’s going to be the entire workforce, but it’s going to be a bigger percentage of it. And so those technologies and those companies that can enable that, we think are part of – that are also part of the index as well, where we think that’s a longer term trend that will take place. If you think about restaurants, you know the restaurant industry in order for them to be able to reopen, whenever we get past this whole 25% capacity than 50% capacity or indoor and outdoor dining thing, the general public is going to want to make sure that they feel safe there.
So, food and water safety and purity are going to be long-term investible trends. So like Ecolab, for example, is the biggest company in that business. They are in this index. Think about the college case. They go back to college, and they all go to the cafeteria, there’s going to be structural changes that are beyond the coin flip of who gets the vaccine or doesn’t get the vaccine. And so, we think this is a, you know, a long term investment thesis that is sustainable over time that has a component part of it, which is vaccine or therapeutics or protocol driven, but it’s also bigger than that.
JL: Sure, yeah. So, getting into some of those other parts of it, if you look at the breakdown by sector, I believe that fund right now is just under 50% in the healthcare sector, you know, at least according to [GIGS]. So, the top three holdings are actually Nvidia, Amazon, and Netflix. And these companies, none of them really are in the health care sector per se. So, just curious in terms of the selection methodology, how pure play a company has to be in terms of its exposure to the overall theme. And then what the other side of the fund is beyond all of the things you mentioned, not just direct health care, but also monitoring and biological security. I mean, I think when you’re talking about a company like Netflix, or Amazon, or even Nvidia video, it doesn’t really fall into any of those categories there.
SO: But if you understand there are essentially seven basic categories, and one of them is stay at home, work at home.
SO: Or social distancing as a way to slow the spread of a pandemic. Nvidia powers all of the stay at home, work at home stuff. I mean, in terms of video, they’re like the linchpin that makes a lot of that work. And so, it’s a way to construct the index and have that be one of the themes, which is what LifeSci did, and not have to necessarily pick winners and losers in terms of streaming or whatever. Now Netflix is that, you know, we’re all sort of like binge watching [dromophobic quarters and preppers] today. And so, you know it was obvious to look at, you know staying at home, and you know, we – what are we going to do? We’re going to watch more video.
On the Amazon side, to me, that’s a long-term trend that fits here as well, because the e-commerce revolution accelerated under COVID. And as the supply chains continue to get built out, and as we get more and more efficient at delivering goods and services, including groceries, for example, then if I’m nervous about going out, because I’m worried about the next pandemic that comes down the road and getting it before they have a vaccine or a therapeutic that works, then being able to do all of my shopping online at home, including groceries is, obviously we think, a big long-term trend there.
So, that’s why that particular names and you have names like Home Depot, which is sort of, you know, the hoarding piece of this, if you will. Walmart’s in the portfolio for the same reason. CBS is in there again, because of the, you know the need to buy, you know, it used to be initially the first wave was nobody had toilet paper, and hand sanitizer and masks, and now it’s, you know, Clorox wipes and things of that nature. So, they fit in the portfolio if you understand the effect of a pandemic on our day to day lives. And that was what I think is so fascinating about the way the LifeSci guys built the index is that they thought about, like, bigger than just biotech or health care.
JL: Sure, yeah. So, it’s a really holistic approach here. You’re not, for example, just buying homebuilders to play the housing market. It’s playing every single element of a pandemic economy. And so, of course, you have those frontline companies working on a vaccine, working on treatments, working on detection, but then you also have all of the companies that stand to benefit from the new reality. And so yeah, it is pretty incredible that they were able to map all of that out because you mentioned we’ve had six pandemics over the last 15 years, but in reality the last time the world had something that looked like this, forget about there being no internet, internet, there was no television, you know, tiny fraction of people even had telephones.
There were basically no cars, certainly no antibiotics, they barely understood the germ theory of disease. And so for all of the forward movement, we’ve had this really a lot of similarities in the way that everything has just been totally shut down the world over. I’d love to get into the composition of the fund a little more in the underlying index. How does the weighting methodology work exactly, the mix of companies and the mix of different industries and ways to play this? So, how is that determination being made exactly?
SO: It’s a modified market cap weighting approach to building an index. So, the way that it works is that they’re basically looking at seven big themes. So, research, which would be your vaccine therapeutic protocol, combating agents of biological warfare, you know, so like, it wasn’t too long ago that Anthrax was a big problem. And so, Homeland Security as a part of that – getting the biological threats is a part of the approach, detection and testing is a piece of it, secure borders, stockpiling, food water safety, and then enable technology for people to be more socially distance if you will.
They get together. And they start to try to find what they believe who the industry leaders are in each one of those categories. Some companies fit multiple categories. And so every six months, the index committee will get together and they’ll look at their current list and these big long term themes and try to figure out, you know, do we have the right names, if you will, the leaders in each one of these areas, there is a chance that for example, the portfolio could change a little more dynamically, as they are, you know, since they’re [smacked at] in the middle of you know, biotech and healthcare, if things change rapidly and they think in order for this to really continue to be an effective broad based approach to the pandemic beyond just the obvious health care piece. They could add a name here or there, or if they feel like somebody has got a clear advantage, either on a therapeutic solution or on the vaccine side, they could add a name here or there.
Like I give you an example like how this could happen, right. So, I would love to be able to own a UV name publicly, ultraviolet, right. And I have not been able to find something yet, because I don’t think there’s anything really out there yet that’s purely publicly traded in that space. But you know, you probably have seen the same stories that I have where, at the airlines, if the airlines are going to get back on their feet, people got to feel safe getting that confined to and breathing everybody’s air, right?
And so they have these UV machines that they’re rolling down the center aisle of these airlines and ultraviolet light kills most of these things. And so that’s a safety issue. That’s not necessarily a vaccine story, right. But it is a part of this. And so, if somebody were to somehow pop up in that space, and look to be the leader, whether it’s in, you know cleaning the airlines, or you know, I think it probably won’t be too long before we’re walking through these ultraviolet tunnels to get into buildings, or to get on a plane as well, then something like that could theoretically become a constituent in the index, but they haven’t found that solution yet, if you will.
And so it’s a little bit, it’s a little bit more fluid than your traditional, you know passive index. It is a passive strategy because it’s based on their methodology. But that methodology is sort of forward-looking as well in terms of how they think about what should or shouldn’t be in the index. And this happens, by the way, this is an argument that I think is kind of a silly argument. We just saw that Dow Jones Industrial Average, which is only 30 stocks, make big changes to the way that index is constructed based on Apple’s splitting their stock price. And Exxon got thrown out and Salesforce got put in, well, these indexes, no matter what they are, change from time-to-time based on what’s going on at this particular point in time. And so this is how they look at that.
JL: Sure. Yeah. I mean, we’re talking on Tuesday, September 8, right here, the day after Labor Day, and shares of Tesla are down about 20%, because the S&P 500 balked on including them in the index, again. Everybody thinks of, you know, passive investing, it’s so different than active investing. The reality is, these index committees are making decisions that are as active as any, you know, hedge fund trying to trade the market is making – they’re just making them a little less frequently or a lot less frequently. And with some set of rules attached.
So, yeah, I was going to get into that a bit in terms of the fact that this index here is not akin to let’s take something like the Russell 2,000, or 3,000, which really is by and large, just a collection of the largest companies by market cap at a given point in time. And that’s probably as close to a kind of a passive approach as you get there. This is a more active approach. And so, the reality is that you’re relying on the committee to get these decisions, right to some extent.
SO: And I would not expect a lot of changes. So, I think the more appropriate reference would just be to the look at what the Dow just did, right? It’s just, it’s common, and the S&P does this once a year, they reconstitute as well. I think there’s going to be probably more changes in the S&P 500 this year than they have been in maybe a decade or so.
SO: Because of some of the internal screens that they have at S&P. So, this is a little wonky, if you will, in terms of, you know, inside baseball discussion about index construction, but we do anticipate that people will say, well, how in the world can you call this passive? Well, we can call it passive because it has a very specific methodology. But embedded in that methodology, you have to be a little bit reactive to what’s going on at any given point in time. You just can’t stay completely fixed on whatever you started with. And candidly, most indexes that people are comfortable with don’t do that anyway.
JL: Yeah, sure. I mean, and it’s a good thing. If you look back at, let’s say, something like the Dow Jones Industrial Average, which has been around for well over a 100 years at this point, there are no original companies from the index that are still trading. So, you would have gone down to zero if they weren’t reconstituting on a regular basis. So, yeah.
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So, I think this is a good point to pivot back towards the vaccine, and how the index offers coverage for people that want to have at least some play there. There are about 75 different vaccines in development globally, right now. Obviously, not every one of those vaccines is being developed by a publicly traded company, but many of them are.
And so I’m curious along the lines of playing vaccine, how it’s possible to be relatively certain that you’ll be holding the companies that really do get to the finish line there and see the big payout as a result of the fact that they’ve headed first, and obviously, it’s going to be quite expensive when it first comes out likely only be available in, “first world countries” because they’ll be the ones that can afford to pay, and they’ll likely be the ones that developed it. You’ve got 45 companies total in the index, probably no more than 10 or 15 of them are potential vaccine makers. So, just curious how people in the fund can feel comfortable, confident, that you have this covered properly in terms of actually benefiting when a vaccine is found and starts to be sold.
SO: I mean, so I think the answer to that is that, you know, you have names in here that have been, you know, at the forefront on vaccine development, you know, the one that comes to mind would be J&J, I mean they’re very, very robust in terms of their practice there.
JL: [Indiscernible] and they’re also…
SO: [Indiscernible] is in the portfolio. Glaxo is in the portfolio. So there’s a basket of names that for – that are, you know, probably going to be right in the middle of all of that. And, you know, so that’s part of your, if you will, your buffer against, you know not getting left out in the cold, if you will, with regard to finding that solution. The better, probably investment play is the therapeutic piece of it, as – because vaccine is very, very difficult to come up with. I mean, I know that we have had tremendous work being done all over the world on this, but, you know, we still don’t have a vaccine for AIDS, for example.
SO: But the impact of AIDS today is far different than it was when it first emerged because of the development of therapeutics. And so you got that side of it covered as well. And then as an overall investment, you know, I don’t think you want the – the biotech guys will tell you that when they go through the FDA trials that you know, you’re basically in a card flip world. It’s either yeah or nay, and you can get through one or two, and then you can still fail on the third one. And essentially, all that capital that’s been deployed and invested in hoping to get those returns obviously becomes almost worthless, if you will, that’s the risk that you run.
And so, you have your own basket here, you have a secondary leg to which is the therapeutic piece of it. And then the last thing about this that I think from an investor’s perspective is that it is a broader approach. So, you have the other parts of what the objective of the index and the funds are supposed to be trying to accomplish. That can provide for some, a little bit of a balance against maybe not ever coming up with a vaccine solution, but still having a solid investable idea.
JL: Yeah, sure. Moving over to the therapeutic side of things here, what are a couple companies in the portfolio that investors maybe aren’t that familiar with that – or names there?
SO: Gilead is in the portfolio, and they have their drug remdesivir, which has been, you know, used a little bit here and there, you have, you know, J&J are working on things, like Regeneron would be one of those names that would be in the therapeutic side of things. BioTech would be a small name that again, involved in that. Illumina is another name that would be involved there relatively a smaller biotech name. Emergent BioSolutions would be, ticker EBS would be one.
SO: So, you know, those were the kind of names that, you know, that are not, you know, sort of the big names that everybody talks about. So, there’s three or four names there for you in terms of the therapeutic side of things.
JL: And then in terms of one of the seven screening categories, and this really stood out to me when reviewing what VIRS is all about as a fund. So, you mentioned 9/11 earlier, and then of course, there was the series of Anthrax scares that came immediately after that. And one of the mandates of the index and the fund is fighting biological warfare. Why have you grouped this together with maybe a non-manmade or non-intentional sort of pandemic like we’re going through right now? And what sorts of names would fall into companies that are fighting this on the biological warfare side of things?
SO: Well, like Thermo Fisher, for example, would be one of the names there Ecolab, which is a water testing company would be a name for sure. PerkinElmer would be a big name. You know, warfare is kind of a funny thing today, right? We talk about nuclear, we talk about, you know, kind of conventional man-on-man if you will. Most of the industrialized countries around the world have labs that are studying these biological agents. And, you know, there is some thought that cyber is going to be a big front on the warfare side, as well as potentially biological. And so, it’s just a little bit a little bit outside of perhaps the pandemic. I’m not even sure that people would, you know universally agree that this was not a manmade virus.
JL: I think that’s an open question. I mean, I don’t think many people think that this was unleashed intentionally by the Chinese, which would I think take the warfare part out of it. But yeah, I mean, it’s – I think it’s – I was just listening to a podcast that Siddhartha Mukherjee, The New Yorker, [indiscernible] virologist by training. He said, you know it’s silly to rule out that theoretical possibility, and may have been something that accidentally escaped from a lab in Wuhan. So that is possible.
SO: So, you know, stepping aside, you know, whether, what particular conspiracy theory you wanted to assign yourself to, if you will. The reality is, is that there are labs working on these things all the time, and they’re working on them on a couple of different fronts. One is to try to understand them so that we can become more effective at treating them if they do emerge, but the other side of it is that there’s always work being done and trying to make them, you know, more contagious or more dangerous and things of that nature. So, that’s why you have just a little tiny sliver, and it’s a very, very small way there in terms of Homeland Security. But it has to do with [indiscernible], when she talked about earlier, the blessing and the curse of that society today.
The blessing is that we have the ability to go anywhere, almost instantaneously more often than not, right. That’s the blessing. So we can travel the world, and business is global today and interconnected. And there’s tremendous freedom and benefit in that. But the curse in that is that that things travel. And so, you know and they travel much quicker. They don’t travel, like something being held up in the whole of Christopher Columbus’ boat as he was going from Italy to the new world.
They travel much quicker in terms of transport of goods, and you know, goods, you know, these big shipping containers, and so forth that arrive at all these ports and all those things get screened today. And I think that the amount of screening going forward will probably increase, not decrease as a result of what’s happened with this virus. I think we’re all a little bit more diligent today, perhaps. And so that’s the real reason that the guys at LifeSci included just a little sliver there to be a little bit forward thinking about how this works.
JL: Yeah, makes total sense. This has all been really fascinating so far. I’d love to get into a few of the other funds that you launched on that same date back in June 24, I believe it was, because I think they’re really relevant just to the way that the markets have behaved in 2020. This has really been kind of a crazy whipsaw back and forth year. We saw the fastest most violent sell off since the beginning of the Great Depression. I believe the sell off that started it in 1929 may have been further down quicker, but 37% peak to trough on the Dow Jones Industrial and the S&P 500 in a matter of just 23 trading days in February and March.
We saw crazy snapback rally. We’re now seeing really just a huge amount of volatility again, tech in particular, which has been up so much is getting killed right now. You release these three ETFs that you’ve [indiscernible] the alternator series. The three funds are the Pacer Lunt Large Cap Alternator ETF, ticker symbol ALTL, the Pacer Lunt Large Cap Multi-Factor Alternator ETF, ticker symbol PALC, and the Pacer Lunt MidCap Multi-Factor Alternator ETF, ticker symbol PAMC. What’s the underlying strategy here?
SO: Well factor investing has been around for quite some time. You know factor is really, you know can be just as simple as a characteristic that you can label a group of stocks by that will give you their – you know what their characteristics are. And then you can measure the returns of those things. In the ETF landscape, there are some single factor stories that have been very successful. For example, low vol has been a terrific ETF category. There are multi-factor strategies as well, they sort of blend them together if you will. We believe and we work with a group out in Salt Lake City, Utah Lunt Capital who developed all these indexes in conjunction with S&P.
We believe that factor investing makes sense, but that being single factor only, over time probably can produce higher returns. But the path to that excess return is inconsistent. So, you can go through periods where you have underperformance. And so, when we think about building ETFs at Pacer we try to figure out where do we think we can gather assets and solve problems? And so if you own a single factor ETF, and you’re not willing to wait through those extended periods of time before, you know ultimately achieve your long-term goal than having something that alternates between two simple factors like low vol, and high beta, which are the two pairs if you will, there, we think makes sense.
JL: Wait, sorry. So that’s the first fund large cap one, it goes between …
SO: That’s ALT, low-vol and [indiscernible].
JL: Got you. Okay. Yeah, that’s what – so the alternator part, I think, is what piqued my interest because, again, we’ve discussed factors a fair bit on this podcast, particularly just how difficult it’s been for people that have put their belief in value and small caps over the last decade, that’s certainly been a losing strategy right to your point. Growth has obviously killed it, as evidenced by the fact that the NASDAQ 100 is probably more than doubled up on the S&P 500 over the last five years or so. And so, the alternator part of it, I think, is very interesting. So, how does that work exactly? What kind of signals are you relying on to alternate between low-beta and or low-vol and high-beta? And what vehicles or names are you using to alternate between those themes?
SO: So for that particular ETF, S&P has distinct sleeves of the S&P 500. They have their own defined low-vol. And their own defined high-beta, which are essentially 100 stocks on either side. The 100 stocks that have their lowest relative volatility and the 100 stocks that have the highest beta relative to the S&P 500. And so we’re using two S&P constituents there of sub indexes.
And then Lunt has a proprietary relative strength screen that they run on a monthly basis. And if that relative strength signal that they run says that it’s supposed to change, it will change. Often it does, it will stay the same value either low-vol or high-beta for some period of time. These strategies work terrific in an ETF when you think about it, because an ETF has a slight advantage from a tax perspective than a traditional mutual fund.
And then we can rebalance the portfolio and minimize if not eliminate entirely the capital gains piece of it. So, we see low-vol as a factor gathering a lot of assets. And thought, you know, like, it makes sense probably to have an alternative idea there not to, no-pun intended, that would allow people who wanted to try to capture low-vol long-term, but not necessarily have to stay there forever to have something that would move their portfolio from low-vol to high-beta when high beta was in favor and capture that excess return.
So that was the first of the series that we launched with them.
JL: Sure. And so that’s a monthly decision making process, correct?
SO: Correct? It is?
JL: And are you buying the 100 names, individual – not buying or maybe in kind transacting to get them in and out individually or is there a way that you can just buy them all in a single transaction, like you were saying?
SO: We buy the underlyers. It’s less expensive for us to just simply replicate the index than it is to buy, you know, SPLV, for example, which would be the ETF to [indiscernible] by itself. So…
JL: Right. I guess you don’t have to pass on that fund to funds style costs, by avoiding that, okay, yeah, it makes sense.
SO: And then the other two are multifactor stories. And what Lunt figured out, which we thought was really smart was that when you look at your traditional factors like value, momentum, quality, or volatility, that S&P built two versions of each one of those four factors, a high and a low. And so, if you just simply do factor investing based on those four categories, you want the whole factor, the high and the low, and what Lunt figured out was that within each one of those factors the high and the low performed differently.
In other words, there was a huge difference in the return from high to low at different points in time. And so, they broke it one other step further out, and so they have now taken those four factors, and created factor pairs, the high and the low part of it with S&P. So S&P is calculating eight indexes as a part of the S&P 500. Four factors and a high-low version. Same thing with their portfolio, which is we evaluate on a monthly basis. All eight of them on a relative strength basis, and we selected two of those factors, either side of the factor, that have the highest relative strength score.
So, the portfolio can change on a monthly basis, although oftentimes it will stay where it is. And what’s fascinating about it is that when you look at the returns of those eight factors versus let’s say, the S&P 500 going back, the S&P itself isn’t the best performing of those nine comparatives. In other words, usually one or two or three of those sub factors, the higher low pairs if you will, has a better return on a calendar year basis than the broad market. And so, what we’re trying to do here is to capture that excess return. It’s just a different way of owning the S&P 500.
So, you know, I think it’s healthy for people to have a chunk of their portfolio in the S&P because, you know, you can own it for next to nothing today. And you think about its relative performance versus people who are trying to beat it, you know, eight out of 10 times, you’ll wind up losing to the S&P 500’s very robust index. So, if you’re trying to seek excess return, all we’re doing is we’re saying, we’re going to hold the S&P 500, but we’re only going to own certain parts of it at different pieces of time based on relative strength then based on the factors we can identify that over time are attributes that would call us higher long term returns.
So, an extension of somebody’s ability to just simply say, I just want to own cheap beta, which is great, but if you can own something that’s based on cheap beta that just pulls it apart a little bit and uses relative strength, we think you should be able to produce excess return. And so far, it’s been the case. I mean, the performance. I didn’t look at it Friday after the [bloodbath Friday], but prior to Friday, or Thursday of last week, I think the S&P was up around 5% for the year, and the large cap product was up like 17% or 18%.
JL: Which, the multifactor one?
SO: Yes, yeah, PILC, and PAMC, which is just a mid-cap version of it, which is based on the S&P mid-cap 400. The mid-cap 400 was actually down year-to-date and the multifactor version of it was up like 16% or 17% as well. So, if you’re trying to produce excess return over time, this is a vehicle that you could do that.
JL: Sure. And in terms of taxation, so yeah, there is generally the possibility of doing income transactions and avoiding having to pay out capital gains taxes at the end of the year, obviously, these funds just launched this year, but how if you can kind of give investors a sneak peek of how that’s going so far, it’s not always possible to avoid capital gains. And obviously, having a payout gains is a product of having them to begin with. So it’s, you know, it’s kind of a good problem to have, but just curious if, if you think it really will be possible to remain cap gains free with a strategy that theoretically replaces its entire set of holdings on a monthly basis.
SO: [Indiscernible] a change to the way that ETFs are taxed, in other words, a real structural change either coming from the IRS or the SEC or some other, you know, regulatory body. We have a pretty high degree of confidence that we should be able to use the ETF structure and the rules that go with it. And custom baskets for creation and redemption around rebalances to be able to do exactly that is to reposition the portfolio without creating capital gains. And the way that debt gets done, essentially is that we’ll look at the portfolio, when it’s time to rebalance. There’s always going to be something in the portfolio that is at a loss, right. So, if I own 200 stocks, some percentage of them I’m going to, while I own them, we’re going to have a negative return.
So, I’m going to sell those right away, and then I’m going to start to sell some gains to match them up. The remainder gets moved out of the portfolio in a custom creation redemption, a market maker will create new shares one day. So, increase the fund size, if you will. And what they’re creating, we’re asking them to send us what we want. And then the next day, they’ll request a redemption. So, the fund will go back down to its normal size the next day, and then the net redemption will just send them the stuff in a portfolio that we don’t want to sell and create a taxable game with. So, there’s two leavers there that are part of it. And then the third lever is that even though you have eight factors, each one of those indexes is a 100 stocks in large cap land, for example.
So if you think about the S&P 500, some stocks are in two categories. So, they might be in volatility and momentum, for example, at the same time. Some portion of the portfolio may just remain even though we’re changing the sub index. If you have 800 stocks in 8 indexes, and the S&P 500 is 500 stocks, then it’s obvious that some are in both buckets or two buckets. And that’s just the way indexes work, you know, like, the easiest example would be to say, when you look at the low vol at high beta or value in growth, like the value index from the S&P 500 and the growth index, if you add those two together is more than 700, stocks.
JL: Sure. A lot of those large holdings, your Apple’s, your Microsoft’s end up in both parts of it, yeah.
SO: Yeah. So, I think we’re pretty confident. We can continue to do what ETF companies have been able to do with regard to the capital gains issue.
JL: Should be reassuring for investors. Anyway, Sean, this has been awesome. We’ll definitely have to do it again sometime. We did not get into your trend pilot series at all. Those are obviously the Pacer Funds that have the largest number of assets in them, peaking at least one of my parents 401-K accounts, I saw that at some of those Trendpilot Funds or we’re in there. So their advisor, definitely steered them in there. And certainly in a year like 2020, those are funds that I think a lot of investors would want to be in. So, we’ll have to get you back on here. In terms of where investors should go to research what we’ve been discussing here today further, where online, they can go, you want to just point people in a direction?
SO: Well, so the first thing I would say is that I would beg them profusely to work with a financial advisor. We believe wholeheartedly in the value of advice. And so that would be my first recommendation.
JL: Sure. I mean, we have a lot of advisors, a lot of FAs and RAs that listen to this show. So, yes, but for people that are doing this themselves.
SO: Our website, paceretfs.com, there’s, you know, all the products are listed there. There’s, you know, some white papers, and there’s a couple of videos that, you know, we used to explain how these different strategies work. So that’s where I would send them if they wanted to go look personally is just go to paceretfs.com.
JL: Sure. And do you guys do the social media thing? Is there a place people can follow you there?
SO: We are on Twitter at Pacer ETFs, and we have a LinkedIn, a company LinkedIn account that posts stuff quite a bit as well. And so you can go follow us there as well at LinkedIn at Pacer ETFs.
JL: Awesome. Anyway, Sean, want to wish you luck with all the new launches and with your existing product lineup also, which continues to gain steam and popularity, and I wish you health and sanity through the rest of this crazy time that we’re all living through here.
SO: Sanity being the most important of those to be sure upon right. All sort of loosing our mind. So, I appreciate you taking the time today. It was great to talk to you, Jonathan. And we do definitely appreciate it a great deal when people take an interest in what we’re doing here. So, thank you for that.
JL: Sure. Likewise. For disclosures, Sean O’Hara is long TDOC, NVDA, ILMN, and AMZN. Jonathan Liss is long QQQ and VOO.
Disclosure: I am/we are long TDOC, NVDA, ILMN, AMZN. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: Sean O’Hara is long TDOC, NVDA, ILMN and AMZN.
Jonathan Liss does not have positions in any of the ETFs or stocks mentioned in today’s show.