Lead-Lag Live

Beyond the S&P 500 with Paul Baiocchi

• Michael A. Gayed, CFA

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What happens when the investment playbook that worked for the past decade suddenly stops working? In this eye-opening discussion with Paul Baiocchi, Chief ETF Strategist at SS&C Alps Advisors, we explore the compelling case for looking beyond the S&P 500 and its dominant mega-cap tech stocks.

The conversation centers on one of the most overlooked megatrends reshaping our economy: electrification. As Paul explains, this isn't just about utilities—it's a convergence of AI data centers, EV adoption, and home electrification driving unprecedented electricity demand growth after two decades of flat consumption. This transformation creates investment opportunities across multiple sectors, from midstream energy companies transporting natural gas to industrial firms building the expanded grid infrastructure.

We also examine why international markets are showing signs of life after 16 years of U.S. dominance. With developed markets outside the U.S. trading at a 30% valuation discount, experiencing stronger earnings growth, and benefiting from a weakening dollar, the stage may be set for a multi-year period of outperformance. Similarly, small caps and REITs represent potential mean reversion opportunities, with both segments trading at historically deep discounts despite improving fundamentals.

The key takeaway? Investment cycles eventually turn, and positioning your portfolio for what's next rather than what's worked in the past requires looking beyond the obvious. Whether through thematic approaches capturing structural economic shifts, international allocations benefiting from valuation gaps, or quality-focused small cap strategies, diversification may be coming back into favor.

Ready to explore investment opportunities beyond the concentrated mega-cap tech trade? This conversation provides a roadmap for navigating the next market cycle rather than the last one.

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Speaker 1:

It sounds to me like it's actually hard for sort of the average investor that believes in everything you just said to sort of really properly identify individual stocks. So talk me through sort of the nuances there a little bit more.

Speaker 2:

Yeah. So let's just take AI, for example, as a theme that everyone's hearing about, everyone's reading about. I think a lot of people just assume I'm getting AI exposure from my S&P 500 portfolio because it has the hyperscalers in it, it has the chip makers in it, dominated, of course, by NVIDIA. Now, the reality is, once you start to get away from just the chips and just the compute and just the hyperscalers, you start to realize that there's knock-on effects of AI, whether it's increasing electricity demand, which is increasing natural gas demand, which is also increasing, logically, copper demand as an input to grid expansion and grid modernization. Then you start to understand that there is not necessarily one way to play a given theme in terms of a specific sector or a specific portfolio approach. And so, to get back to your question, I think the nuance of building a thematic portfolio is it's not going to fit cleanly in any one investment bucket.

Speaker 2:

It's not necessarily just going to be utilities, not necessarily just going to be industrials or midstream energy infrastructure. It, in theory, is going to be a combination of those. But how do you define that Well?

Speaker 1:

this would be a really good conversation with Paul, who I've gotten over the last several months. His firm is now one of my clients, so this is a sponsored conversation of Lead Black Live, but we're going to be talking about one of my favorite topics of the market, which is small caps holding the key and maybe if that key is going to be turned here and what that key could actually be. With all that said, my name is Michael Guy, a publisher of the Lead Lagrime. You're joining me at Paul Biaki of Alps. So, paul, I'm sure people have seen you doing some media routes, but introduce yourself formally. Who are you? What's your background? What have you done throughout your career? What are you doing currently?

Speaker 2:

Yeah, I appreciate it. Thanks for the opportunity here. So opportunity here. So Paul Biocchi title is Chief ETF Strategist at SS&C Alps Advisors, which means effectively. I help support our distribution and travel with our sales guys, both the national accounts team that is engaging with home offices, as well as our wholesalers, who are trying to engage advisors and help tell the story around our product suite and they bring me in to be the SME on the various categories where our products compete, know the competitive landscape, put it in the context of the capital markets backdrop and portfolio construction topics and ultimately be a resource for the advisors that we partner with beyond simply the products but as it relates to content, perspectives and increasingly, as advisors get away from the home office model or the wirehouse model and break away and become independent, they lose a lot of the access that they have to research and perspectives. And that's sort of where I bridge the gap between research and sales.

Speaker 2:

And my background is pretty simple. I studied finance, knew I wanted to get into financial services, my uncle was in the industry and he taught me a lot about the industry and so when I came out of undergrad I went and worked for a small broker dealer as a series seven broker realized that I wanted to do more, maybe strategically, went back to get my MBA. And when I was in grad school I got introduced to a sub-advisory relationship through a guy who I used to work with. He sort of hired me to do some consulting for his RIA who was doing sub-advisory work for a fun shop which some people might remember, claymore, building indexes for UITs and we were doing thematics. So Global Coal or Canadian Royalty Trust for those of you who remember those or other global thematic strategies and they came to us one day and said, for those of you who remember those or other global thematic strategies, and they came to us one day and said, hey, can you build an index for an ETF? And we said yes, of course. But also, once we started digging into the ETF wrapper, you sort of become enamored with the opportunities.

Speaker 2:

And this was 2008, 2009.

Speaker 2:

And we built a global shipping index for a global shipping ETF which timing-wise wasn't ideal because the world entered the great financial crisis and it was hard to get a letter of credit just to ship goods across the world, let alone to invest in global shipping companies.

Speaker 2:

But that was my first introduction to the ETF wrapper and earnest, and so shortly after that I was able to get a position at a firm at the time called Index Universe, which has since become ETFcom, building ETF analytics and a classification system, moderating panels at the old Inside ETFs conferences and really just getting to know the landscape and networking, but also just living, breathing the ETF wrapper every day.

Speaker 2:

And that set me up for a role at Fidelity, helping to build their ETF capability and expand their ETF offering and engage both their branch network and advisors that custody there and beyond around Fidelity ETFs. And I've been at Alps now for just over five years doing a lot of the same things in terms of helping to support the growth of the ETF lineup, contributing to the ETF roadmap as it relates to product development, but also on a day-to-day basis, ensuring that the products we have fit the right types of strategies and get their model insertion opportunities and, ultimately, that the story that we tell around our product suite is consistent and clear and transparent, aligned with the ETF wrapper itself. So that's sort of who I am and where I've come from and how I came to be in the seat I'm in.

Speaker 1:

So there's a lot of directions that we can go, but I want to touch on sort of advisor frustrations for a bit. Since you're talking and dealing with so many of these guys, let's do it. I got to assume that the last several years have been mildly irritating to the advisor community because, let's face it, I mean it's been hard to beat the S&P 500 and the NASDAQ when those have been kind of the only game in town they do. Any kind of asset allocation doesn't really translate in terms of outperformance because you're diluting automatically the number one winner. What are you hearing from advisors in terms of their viewpoints going forward? Do they believe that we're maybe in a better environment for diversification, the finding interesting, fun ideas like what you guys offer?

Speaker 2:

Yeah. So to get back to the period we've come out of, because I think that informs the answer to the question, I do think a lot of advisors were frustrated in, say, 2022, because the 60-40 portfolio was down, and it was remarkable because it really hadn't happened. You hadn't had a year in which you had such poor performance from equities paired with such poor performance from fixed income. That was really anomalous. And so the idea that they had been telling their clients that they're diversifying between stocks and bonds for the specific purpose of insulating them somewhat against that type of market backdrop, and then for that market backdrop to play out in the way that it did and have both stocks and bonds down, was really challenging for advisors. And so I do think that the cycle we've been in, where the S&P 500's outperformance of every other category and global markets writ large, as well as the dominance of so few companies in the index and the increased concentration in the index, was a point of frustration for some advisors. I think it was a point of pride for other advisors who would tell you hey, I have this big position in NVIDIA, or I'm not focused on anything else other than large cap growth and that worked, and so maybe those advisors are a little bit more frustrated here in early 2025, because what has worked over the cycle hasn't necessarily worked so far in 2025, although the May bounce back was dramatic, and certainly that performance of the S&P 500 in May was historic, going back 30 years and led by the MAG-7 and the companies that had dominated over the course of this two-plus-year bull market. And so I do think to get back to your question that advisors are getting a little bit maybe more excited, rubbing their hands together at the prospect that diversification is starting to become back in vogue, and not just diversification between cap buckets or relative to the S&P 500, but also diversification among different asset classes, whether that's developed, xus, emerging markets, whether it's commodities, whether it's hard assets, real assets, whatever it might be.

Speaker 2:

I do think that there is a subset of advisors, and maybe a strong preponderance of advisors, who are at a point where they're feeling excited about the prospects of that type of dirty work that they do, rolling up their sleeves to try and build out an asset allocation framework for their clients that's customized to meet their needs and does include things other than, say, just the S&P 500. And I think that's the setup that we have in this market on a go-forward basis is exciting for a firm like us, because we're not the firm that offers the cheapest version of the S&P 500 and a passive wrapper. We do offer either factor-oriented, active or thematic strategies that don't necessarily constitute the bulk of a diversified asset allocation strategy. In the core categories, they either live at the margins in the case of thematics or they're a way to sort of reorient a segment of an asset allocation, whether it's equities or fixed income, away from cap-weighted or value-weighted toward a factor or leaning on an active manager.

Speaker 1:

All right. So let's go to the thematic side, because I do think there's a lot of interesting themes that you can argue the administration is enabling, right. So nuclear comes to mind because of the recent order that Trump gave. But from your vantage point, if we think from a cycle perspective, from a thematic perspective, what are some of the more interesting areas that are getting traction?

Speaker 2:

Yeah. So themes are interesting because they come in favor and they come out of favor and by nature themes are. They tend to be a little bit challenging to implement for some advisors because they're GIX breakers by definition. They don't fit cleanly into one given GIX sector. They tend to span multiples Renewable energy is a great example of that. Where you have technology companies, you have energy companies, you have industrials companies. If you look at disruptive technology portfolios or cybersecurity portfolios, in many cases they just don't fit cleanly in your typical buckets as defined by GICs or IC or whatever sector framework you're implementing. And so in that way, there's been a challenge at times for investors and advisors working on their behalf to implement themes because they don't necessarily know how they fit. They don't necessarily know what percentage you should have in a diversified asset allocation framework.

Speaker 2:

But to your point about the current administration, I think part of it is owed to their policy and what they're focused on. I think part of it is just the nature of some of the economic changes and capital markets changes that we're seeing and in many ways, the theme we're most focused on, which is in some ways, a convergence of multiple themes, so that energy transition theme converges upon the AI theme, which converges upon the electrification theme, all of which we think are the biggest megatrend in investing, which is the electrification theme at a high level. You've got increasing demand from AI data centers for electricity, which is driving this upward mobility and overall electricity demand expectations and forecasts. You're also seeing increased EV adoption domestically and globally. You're seeing the push toward electrifying things like your gas stove into an induction stove, your heater in your house toward a heat pump, all of which is going to require significantly more grid infrastructure and grid investment, as well as additional electricity demand capacity or electricity generation capacity. And so the electrification of the economy, I think, is the biggest megatrend because it's a convergence of a number of different trends that are going to impact our economy over the course of the next five years. When you look at electricity demand growth in the United States expected to increase dramatically, depending on your forecast, over the course of the next five years, coming off of a period where it's basically been flat over the course of the past 20 or so years, and then, in addition to that, you have all of these small thematic entry points that are also influencing the electricity and electrification theme, and so that's the thing I would say we're most focused on, from a thematic perspective, talking to advisors about and the numbers are pretty astonishing when you think about all of these AI data centers that are going to be required to be built to support all of these LLMs and the implementation of AI economy-wide, not just as it relates to technology, but also as it relates to other sectors of the market, whether it's healthcare, whether it's industrials, whether it's energy companies, all of which are going to be impacted by the electrification theme and the implementation of AI. And so when we think about the electrification theme, we think it's one of those thematics that naturally doesn't fit within any one sector. When we think about the electrification theme, we think it's one of those thematics that naturally doesn't fit within any one sector.

Speaker 2:

Now you could argue utilities are the clearest beneficiary of increasing electricity demand because that's what they provide. But the reality is is there's nuance to it, because a lot of these utilities are regulated and they can only increase rates so much, based on what the commission says. And even if you've got increasing electricity demand, they're not able to necessarily have full leverage to the increase in demand and the increasing output. And so, from the perspective of the electrification theme. You mentioned nuclear that's certainly at some point in the future five years, 10 years, 15 years down the road, likely to be implemented as part of our energy matrix. But when you think about the midstream companies that are moving natural gas from where it's produced here in the United States to where it's increasingly consumed, which is not just abroad in the form of LNG, but also increasingly in order to support the electricity needs of these AI data centers, we're seeing midstream companies building pipelines specifically earmarked for a data center project which is then being run by a GE Vernova gas turbine. So when you think about the electrification theme and just that example of it an AI data center getting a natural gas pipeline built specifically to support its electricity needs well, all of a sudden you're talking about midstream companies, you're talking about components, you're talking about industrials as well as utilities companies and, in theory, nuclear eventually.

Speaker 2:

And so the textured approach to investing in themes is one of the most important concepts as it relates to thematic investing, and the right index methodology, the right starting universe, the right definition of what's included, goes a long way to ensuring that, when you're trying to capitalize on a theme, that the portfolio that you invest in is actually going to reflect the performance of that theme.

Speaker 2:

Because the worst thing that can happen is you put a thematic investment in a client's portfolio, they read headlines about something like electrification or increasing electricity demand or name another theme, and then all of a sudden they look in their portfolio and that strategy is down or that strategy is not outperforming the market and they're wondering why you're in that thematic strategy. And so, to the extent that you can have a durable process for selecting companies that also is reflective of all of the beneficiaries of that theme not in one sector but in multiple sectors and then ensure that the way that portfolio is constructed at the very least avoids some of the worst offenders or some of the worst outcomes in that theme, goes a long way toward making a thematic portfolio investable not just for individual retail investors on a brokerage website but also, importantly, for an advisor who's trying to build a durable asset allocation strategy customized to meet individual investor needs.

Speaker 1:

And I believe you have a fund for that which we should touch on. But let's talk about you hit on it. The index constitution, the definitions. It sounds to me like it's actually hard for the average investor that believes in everything you just said to really properly identify individual stocks. So talk me through the nuances there a little bit more.

Speaker 2:

Yeah. So let's just take AI, for example, as a theme that everyone's hearing about, everyone's reading about. I think a lot of people just assume I'm getting AI exposure from my S&P 500 portfolio because it has the hyperscalers in it, it has the chip makers in it, dominated of course, by NVIDIA headlines, and on the earnings calls and on the conference calls from companies like NVIDIA that they're at the forefront of producing the chips that are supporting the most complicated use cases of AI. And there's scarcity in that chip because they're hard to produce, they're expensive to produce, they have a lot of inputs that are hard to source. We have these complicated global supply chains and they're really only produced in a very small geographical location globally. Now the reality is, once you start to get away from just the chips and just the compute and just the hyperscalers, you start to realize that there's knock-on effects of AI, whether it's increasing electricity demand, which is increasing natural gas demand, which is also increasing, logically, copper demand as an input to grid expansion and grid modernization. Then you start to understand that there is not necessarily one way to play a given theme in terms of a specific sector or a specific portfolio approach. And so, to get back to your question, I think the nuance of building a thematic portfolio is it's not going to fit cleanly in any one investment bucket. It's not necessarily just going to be utilities, not necessarily just going to be industrials or midstream energy infrastructure. It, in theory, is going to be a combination of those.

Speaker 2:

But how do you define that? Well, in the case of Elfie, our ETF that focuses on electrification, we partnered with an analyst, someone who has experience in utility finance and in this theme decades actually and has been working on this index and trying to determine which subsectors of the market are likely to be influenced by the electrification theme. And then you start with a universe that is defined by 18 different subsectors. You start with companies that have 5 billion in market cap or larger, so you avoid some of these companies that might be in the startup phase, might be pre-profitability or pre-cash flow, so you try and avoid some of the worst outcomes in terms of companies who are just, in some ways, drafting on some of these key themes from a headline basis or from a relative performance perspective and building a portfolio that is durable. Actually, in the case of Elfie, you're also equally weighting all of the portfolio positions and so you're not going to have the high concentration that you typically have in a cap weighted strategy or a revenue weighted strategy, and so ultimately what you have is a lot more balance in terms of the companies that you have in the portfolio.

Speaker 2:

It spreads across a number of different subsectors pulled from a number of different sectors, so energy materials, industrials, utilities all included in the sort of comprehensive type of exposure that you're getting in this specific theme. And so, getting back to a portfolio construction conversation, the challenge is where does the theme fit? Because I think if I'm an investor, my S&P 500 exposure gives me disproportionate access to the AI theme. But the electrification theme is not just about AI, data center demand, increasing electricity demand. It's also about the other drivers of increasing electricity demand which we laid out before, whether that's the electrification of home appliances, electrification of the automobile industry. And ultimately, the goal should be to ensure that the portfolio that you're investing in that is targeting that theme has a unique and nuanced approach to getting exposure to that theme that isn't so rigid that it doesn't allow for companies to grow into eligibility and doesn't quickly watch companies fall out of the portfolio, if that makes sense 100% makes sense and I encourage those that are listening to learn more about that fund.

Speaker 1:

It's funny. I don't know if people consider international investing a theme, but it seems like it's a theme in some way shape or form, because international investing tends to have certain style tilts, tends to be more value than growth, has to be more sector heavy and financials and other things as opposed to tech. Obviously, I want to hear from you as far as the idea we could be at a cycle shift that favors international markets, finally, after more than a decade of underperformance.

Speaker 2:

Yeah. So your typical cycle of US outperformance of developed ex-US and vice versa is around 8 to 10 years and to your point, we were going on coming into 2025, about 16 years or so of US outperformance of developed XUS. So S&P 500 outperformance of something like IFA, and if you even look at it on a three-year rolling basis, so three-year relative performance of US versus developed XUS it hasn't been green for developed XUS since, let's call it 2010. So that's a pretty big sample size of US outperformance and what that leads to, as you know, michael, is a behavioral shift in advisors' approach to asset allocation, meaning you see this contribution of global market cap and the acui of the US market grow as a result of that relative outperformance and we were coming into the year upwards of 60 plus percent of global market cap in the United States, just as defined by MSCI ACWI, and I think that's a proxy for how most people were positioning because, just anecdotally, talking to advisors, a lot of advisors had zero exposure to developed XUS over the course of the past couple of years, largely because it hasn't worked and it's been a sore thumb in client portfolios and they were just tired of clients asking about why you had this developed XUS through this emerging markets exposure, when they're underperforming the US year in and year out. And a lot of clients, a lot of advisors just sort of threw up their hands on this story. And the reality is is you're right, there is a factor orientation to developed XUS and to non-US markets that's distinct from the profile of the US market, whether it's value relative to growth, whether it's the dividend yield on offer from developed XUS relative to the dividend yield on offer in the US market. That part of the calculus is important.

Speaker 2:

But it's also about positioning. And if you look at where we were coming into the year based on the B of A manager survey, we were basically at all-time highs in terms of US overweights relative to developed ex-US overweights, at least in December of 2024. And that quickly shifted. If you go to March of this year in the same survey, there was a massive reversal in that overall allocation and that quickly shifted. If you go to March of this year in the same survey, there was a massive reversal in that overall allocation and we actually saw one of a historical amount of fleeing from US markets relative to developed ex-US markets. So at the positioning level, people were offsides US markets relative to developed, they were either at zero, they were below their sort of neutral recommendations and they started either inching or running toward developed ex-US allocations. And the question of course is is this a head fake? Is this sustainable? And there's no way to answer that question because I don't have a crystal ball and certainly nobody listening to this does.

Speaker 2:

But when you try to break down what a catalyst might be for developed XUS to continue to outperform the market remember EFA is up about 15%, 16%, maybe 17% on the S&P 500 so far in 2025. Typically, the catalysts have been a wide gap in the relative valuation which is in place coming into the year. If you look at the valuation spread from developed XUS to the US market, there was about a 30% or so discount on a PE basis to the US market in developed XUS as measured by IFA. But also one of the most important determinants of relative performance for developed XUS versus the US market, at least historically, has been the dollar and the dollar had been strong and that's been a headwind for developed XUS. We're starting to see some weakness in the Dixie and the dollar index, which measures a basket of currencies against the US dollar, and ultimately, if we're starting to see a meaningful, maybe even structural, decline in the Dixie that is, and historically has been, a tailwind for US investors investing in those foreign markets. Because when you repatriate those returns and the dollar is going down, the value of those returns goes up and most people have been oriented in that developed market world below neutral or some investors have been implying a hedged portfolio in order to insulate themselves against the strength of the dollar in those strategies.

Speaker 2:

Given that we're seeing the dollar start to break down, at least technically, maybe not fundamentally, and the fundamental perspective which we've talked about, the valuations, we've talked about the dollar, the fundamental case for developed XUS is perhaps just as strong. When you think about the earnings growth expected from developed XUS versus the US in Q3 2025, you're expecting upwards of 10.5%, maybe 11% earnings growth for the MSCI IFA index in aggregate, you're expecting in Q3 2025, maybe sub 1%, maybe even negative earnings growth on a quarter, over a quarter basis for S&P 500 companies in aggregate. And the earnings revision momentum for US stocks is negative, not positive, whereas in some of these markets in the developed ex-US universe you're seeing positive revisions or slightly less negative revisions from an earnings perspective and long-term stocks follow earnings. So that's a big driver of your overall performance attribution. But when you stack those three things together valuation, the dollar and fundamentals with some of the capital markets which is easy monetary policy we saw another cut from the EU just this week.

Speaker 2:

The relative monetary policy posture in developed ex-US is easier than it is currently in the United States.

Speaker 2:

We're seeing fiscal stimulus in some of these key markets, in some cases directed toward defense spending, but fiscal spending nonetheless, which is expansionary from a fiscal policy perspective, which is also, in theory, supportive of a developed XUS rotation.

Speaker 2:

So I tend to be on the side of the opportunity set, for developed XUS is maybe a little bit better than it has been over the course of this cycle, certainly going back 15 or 16 years of this US outperformance. But the reality is, in order for this to be a sustained relative performance rotation, you need some of these things to follow through, so that earnings growth needs to be realized, that monetary policy needs to be fully captured, as does the fiscal stimulus, and that alligator mouth of valuation differences needs to close, and it needs to close based on relative performance, not necessarily because PEs in the United States are going in the wrong direction and PEs in Europe are staying flat. That is one way that they close, but ideally, over time, you'd see PEs or multiple expansion in Europe, as well as some normalization of the PE on offer for the domestic market, which we've seen to some degree here in 2025.

Speaker 1:

I mean this is a very early trend. If it's a trend right. I mean you mentioned the jaws. I mean it's not like a one-year type of dynamic. If it's real, it's going to be multi-year.

Speaker 2:

No, you're absolutely right, and we're five months into this, so this could in fact be a head fake.

Speaker 2:

And you're starting to see in some of those manager surveys and even from some of the home office research, that people are starting to temper their expectations for developed ex-US outperformance, xus outperformance, given that we seem to have moved forward some of that relative performance so far here in 2025 on the back of that strong EFA outperformance of the S&P 500 so far in 2025.

Speaker 2:

And so, naturally, because Alps is focused largely on products that aren't cap-weighted and don't necessarily track the given benchmark in a given category of the market, the way we're talking to advisors is by legging back toward developed XUS, but doing so in a way that is maybe a little bit more value oriented, yield oriented and, importantly, has a little bit more balance to the sector profile.

Speaker 2:

So iDog is a product which equally weights the highest yielding stocks, five highest yielding stocks in the gig sectors in the developed ex-US market, excluding real estate, and by doing that you end up getting away from some of the financials which you mentioned which dominate the EFA index, some of those European banks which have been problematic and still have a lot of uncertainty on a go-forward basis and get some additional exposure to other sectors which are more cyclical value in nature than they are at the index level. And so, in terms of approaching a given market segment, oftentimes the story we're telling is here's the setup for the category, writ large. But here's why you might want to reorient away from the cap-weighted view of, away from the value weighted view of the market in the case of fixed income. Here's the factor that we think you should. Theme of mine for the last two years.

Speaker 1:

Small caps have been I keep joking in the US have been. It's not even a joke. It's halfway through a lost decade when you look at the Russell 2000. And I'm of the mindset that if deregulation is going to be a big picture theme, if yields end up dropping, there's a lot of potential for small cap stocks to really run. But talk us through what's held back that part of the marketplace and what's it going to take for that to wake up.

Speaker 2:

Yeah. So I'm with you. We've been talking about small caps for a couple of years now and we've been sort of banging our head against the wall because the story really hasn't worked to your point and we're going on a historic run of large cap outperformance of small caps that shows no signs of abating, based on the, even the relative performance we've seen here in 2025, that the reality is, and this is probably a term that gets used a little bit too much as it relates to investment strategies. Reversion to the mean is real and sometimes you have to have patience in order for that to play out. And so you can go back historically and say the small cap factor is one of the most important drivers of return. Historically, if you look at small caps, going back to 1925, they've outperformed large caps consistently.

Speaker 2:

But there are naturally cycles within the cycle, and this current cycle, which has been dominated by inflation and interest rates, is naturally very punishing for the small cap universe because, famously, 40% or so of the Russell 2000 is unprofitable. Famously, most of those companies have higher leverage levels and less capital markets access than their large cap counterparts and in an environment where interest rates are going up and staying up, that's a much more punishing environment for companies that are profitable and have more leverage. And when you pile on that with the fact that 35% or so of the leverage in small caps is floating rate, it makes sense that this would be a segment of the fact that 35% or so of the leverage in small caps is floating rate. It makes sense that this would be a segment of the market that is harmed in an environment where interest rates have gone up, inflation has been challenging and the overall operating environment has been uncertain at best. And so if you just sort of take that as a driver of the underperformance of small caps in this cycle and then you start to say, well, why would that change? Well, in theory we're going to get a couple of Fed cuts, either later this year or maybe out in 2026. That should be supportive of the small cap story. And if you look at the Russell 2000, 9% of it is regional banks. 18% of the Russell 2000, or value or so, is regional banks. Those are companies that naturally are a little bit more impacted by the interest rate backdrop and the leverage that comes with operating a regional bank. And so if we do get some Fed rate cuts, that should be supportive of the small cap universe.

Speaker 2:

In theory, a reshoring and or domestic reorientation of our economy based on the tariff policy, based on the current administration's policy, should be supportive of companies that are more domestically oriented. Famously, so much of the large cap universe gets so much of their revenue from abroad. Technology is the one that stands out. But then you have other segments of the large cap universe also have a lot of exposure to foreign revenue sources and so, to the extent that the policy is implemented and does lead to a reshoring and a domestic reorientation of our economy, that in theory is also supportive of the more domestic orientation in the small cap universe. But again, getting back to this idea that you're starting with the case for small caps, which is they trade at historically cheap levels on a PE basis to their large cap counterparts 30% or so discount to the S&P 500, just based on forward PE, they typically do generate strong relative performance over long periods of time to large caps.

Speaker 2:

If that's the starting case for Y to be in small caps, then you also have to come to grips with the fact that most people just default to the index, whether it's the S&P 600 or the Russell 2000 and ETFs that track them. And the case we're making, as you can imagine, is that you can take that universe and call it down to a smaller sampling of that universe that is defined by higher ROA, lower net debt to EBITDA, five-year dividend growth and strong dividend coverage. Ousm is that product. The idea is you don't have to resign yourself to the fact that, just because I'm in small caps, I'm going to have to deal with the fact that a lot of these companies are unprofitable or they're not really well run or they're really low quality, because I know that small caps have generally outperformed over long periods of time.

Speaker 2:

You can take that universe and bring down the overall volatility of it, bring down your drawdown risk and improve your risk-adjusted outperformance by simply filtering that universe down to companies that are able to generate profitability important when 40% of the companies can on their asset base without excess leverage that have dividends that are well-covered and have been growing. Those are factors that an active manager sitting across the table from you might say that they're fishing for in the small cap pond, but have a team of analysts to do. In the case of something like OUSM, or a smart beta or strategic beta or a factor-based strategy, all you're doing is systematizing that process, and so you don't have people looking at satellite photos of parking lots, but you're also trying to drill down to the same characteristics that an active manager might tell you. We want high quality companies with strong balance sheets who are growing their dividends. Well, you can do that, but you can do it in a rules-based way and sort of remove some of the emotional impact of trying to manage a portfolio and not getting married to individual positions.

Speaker 1:

Yeah, I mean, I think the big takeaway there is that you've got to be selective right Much more when you're dealing with smaller companies than the mega cap companies.

Speaker 2:

Yeah, because the reality is, when interest rates started to rise, when the Fed started its hiking cycle, interestingly, the net interest costs of the S&P 500 actually went down. It didn't go up. And why is that? Because most of the companies that dominate that index don't actually have a lot of leverage. In fact, a lot of them have a lot of cash and they were earning more on that cash than they were prior to the beginning of that hiking cycle. And so the opposite is true for small cap companies, because they do have a lot of leverage, much of which is floating rate, and so when interest rates go up, their interest costs go up, and naturally that puts pressure on their operations.

Speaker 2:

And one of the things that's important about small caps is, I think a lot of people go fishing in that pond because they believe by buying a small cap portfolio, they're going to be buying some of the companies that will eventually graduate to mid rates, from small to mid to large, in a high interest rate environment, which is somewhat, I guess, confusing, because you would think that would be a more punishing environment for small caps, but the reality is it kind of separates the wheat from the chaff, and so to that end, I think it's important to know that there are companies that are just destined to be small caps.

Speaker 2:

The addressable market's not necessarily big enough to be supportive of a large cap, market cap or large cap valuation, and those companies are often really well run and run in a way that aligns with the quality factor, and so you don't necessarily just have to think about small caps as the next large cap portfolio.

Speaker 2:

They in some cases might just be companies who are destined to always be in the small cap universe but are really well run, executed at a high level operationally and generate really strong ROA, roe or ROIC. But, importantly, the approach you take to small caps should be different than the approach you take to other segments of the market, because of all of those risks, and even just your quality metrics matter. If you look at just ROE and small caps, it tends to be less successful as a screening metric in that universe than something like ROA. Well, why is that? Because of the leverage. If you're just looking at the equity piece of the balance sheet, you're ignoring a big slice of the balance sheet on a lot of these companies, and so their ability to generate profitability on a comprehensive measure of assets, as opposed to just equity has been an important signal for that segment of the universe historically, whereas ROE, roic, those measures tend to be, at least historically, a little bit more effective in the large cap segment of the market as opposed to small caps.

Speaker 1:

Before we wrap, I know you want to touch on REITs for a bit, which I typically don't tend to talk about. Who?

Speaker 2:

does.

Speaker 1:

Because REITs are not exactly the most exciting area, but they could be. So let's make the case for REITs here.

Speaker 2:

Yeah. So REITs are again not to beat a dead horse with the mean reversion story, but they are, in my mind, another mean reversion candidate, Because I think you go back to COVID and we had these stories about people working from home and the debtmageddon for commercial real estate, and people just associate REITs with commercial real estate and, in the private case, people investing in private real estate portfolios they do tend to have a lot of commercial real estate exposure, but if you look at public REITs as measured by the indexes that the largest ETFs follow, there's a very small slug of public REITs that are actually in the commercial real estate segment, and I think that's partly owed to the evolution that we've seen in our economy, but also the evolution in the REIT category. You also have dominance now of cell towers, of data center REITs, of industrial REITs a very different makeup of public REITs than most people think, and so in some ways it feels as if REITs themselves have been caught up in the negativity and the headline risk associated with commercial real estate, when in reality, public REITs don't have a lot to do with that commercial real estate story, which is still a very challenging dynamic for regional banks, tying back to that small cap story, but also the balance sheets of a number of companies that have exposure to commercial real estate. And so if you look at the valuation again breaking it down by valuation fundamentals and the operating backdrop as well as the capital markets backdrop the public REIT segment is trading at let's call it a 10% or so discount to net asset value.

Speaker 2:

If you look at the spread to the S&P 500 between REITs and AFFO one of the important measures of profitability for REITs it's trading at a discount we really haven't seen since COVID, and so in some ways, reits are being priced as if we're in the midst of COVID, as if the world is shut down and everyone's forced to be at their home and wear masks when they're walking their dog, when in reality the operating environment is a little bit better than that. And that points to the fundamental story, where you've got a lot of resiliency in the segments that public REITs actually measure, which is not office but rather industrials, retail apartments, as well as the data center footprint, which is increasing. And so if you look at NOI growth year over year in those categories over the course of the past couple of years, you're talking about 4%, 3%, expected to be 4% through 2029. That's a pretty strong baseline of net operating growth for a category that is in many ways being priced as if the world is still in COVID. And so when you think about the operating environment and you combine that relative valuation case with that fundamental story and the fact that we are not in COVID and the operating environment is much better for a lot of these public REITs than is being priced in the market, and you combine that with the historical context, which is, if you look at REITs over the course of the past 25 years you don't even have to go back 50 years or to 1925, like we did with small caps. You're talking about outperformance over the S&P 500 of 2.5% or so annualized over the past 25 years and yet we've seen strong relative underperformance of REITs compared to the S&P 500 over the course of the past five years.

Speaker 2:

So that mean reversion story in terms of REITs being a diversifier, having inflation mitigation characteristics, having some of these drafting on some of these bigger trends, whether it's electrification or the AI data center investment and then you combine it with the fact that they perform so poorly relative to other sectors and relative to the broader market, the setup for REITs is potentially attractive on a go-forward basis, coming out of this period where they've had such poor relative performance. And again, speaking to our book, we've got an actively managed REIT strategy which allows you to leverage the insights, our book. We've got an actively managed REIT strategy which allows you to leverage the insights, perspectives, expertise of a team of managers who have been doing that. Roll your sleeves up. Fundamental valuation research on REITs going back 30 years and REIT is the ticker there. It's another way to take advantage of the confluence of valuations, fundamentals and the operating backdrop which, in some ways, is not being priced relative to what the reality is in some cases.

Speaker 1:

Paul, for those who want to learn more about the various funds your firm offers, where would you point them to?

Speaker 2:

Alpsfundscom is where you go for everything Alps. We've got our lineup there, we've got research, we've got insights. Of course, if you ever want to connect with me directly, my email address is the best way to reach me. That's paulbiaki at ssncinccom.

Speaker 1:

Appreciate those that watch this live. Again, this will be a sponsored conversation by SSNC Alps. Special thanks to Paul and I'll see you all in the next episode. Thank you, Paul, Appreciate it.

Speaker 2:

Thanks, Michael.

Speaker 1:

Cheers everybody.

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Michael A. Gayed, CFA

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