Using ETFs In Model Portfolios

Sage Advisory’s Komson Silapachai discusses how his firm uses ETFs.

Komson Silapachai, VP of research and portfolio strategy at Sage Advisory, sits down with etf.com's Senior Analyst Sumit Roy to discuss Sage’s work with ETFs, the portfolios he and his colleagues are building and running, how they vet ETFs, and the big-picture ETF trends and topics on Sage’s radar.

Sumit Roy: Hi. This is etf.com's Exchange Traded Fridays podcast, a weekly podcast covering developments in the ETF industry. My name is Sumit Roy and I'm senior analyst for etf.com. This week I'm talking with Komson Silapachai, who is the VP of research and portfolio strategy at Sage Advisory, where he plays a major role in overseeing all of their ETF-focused efforts. Komson, welcome to the show.

Komson Silapachai: Thanks for having me.

Roy: Great to have you. And it's great timing, because the Federal Reserve is meeting next week and it's a highly anticipated meeting, because they're anticipated to potentially pause their interest rate hikes after over a year straight of raising them. What do you expect is going to happen at that meeting?

Silapachai: Well, it's definitely been an unprecedented kind of Fed cycle, and I think that kind of the shift to whatever we call this, a pause, now they're caught in a skip. So it’s also going to be very tricky.

So we expect them to pause interest rate hikes at this meeting. But as if you’ve been following the headlines at all with the Fed, they've kind of communicated that inflation remains too high and they still want to fight inflation.

And so they're kind of opening the door to a rate hike potentially in July. The markets are kind of pricing in a potential for that as well.

I think that that's something that's on the table and has kind of been manifesting itself in interest rates markets for quite some time.

Our framework for thinking about the Fed is that coming into, I would say, the second quarter of this year, pre-Silicon Valley, they were really taking away any type of forward guidance.

So they wanted to kind of shift to this data-dependent kind of regime. They stopped giving forward guidance; really trying to maximize the optionality for themselves to kind of react to data.

And so with the market saying, well, you're going to have to cut rates later this year, you're definitely going to pause, they're starting to push back on that.

They're saying, we actually may skip kind of inventing this new kind of rate path that benefits them.

So I think that what they’re trying to do is just keep markets on their toes. That's how we're reading it, and it just depends on how the data develops.

Inflation has been coming down quite a bit, and so as long as it continues to come down, I think the Fed, even if they hike one more time, they're largely done.

We're not going to see a cycle like we did last year. And so that's really how we're viewing it. And I think that in terms of kind of the easing part, you know, are they going to cut rates sometime this year?

We don't think they're really going to be as aggressive this time on easing interest rates, because if you look at pre-COVID, anytime we had a slowdown, you'd have a response in terms of quantitative easing or just easing of financial conditions from the Fed, with no consequences. Asset prices would move higher; there wouldn't be a cost.

In terms of inflation, you started to see that in full force in 2021, 2022, lots of policy stimulus resulting in super high persistent inflation.

And it's been a really painful process to get that down. And so are we going back to zero interest rate policy? Are we going to see QE at the first sign of a recession?

We think the Fed probably waits a little bit closer to when it's more obvious, and so therefore you may not see them be as easy on the policy trigger.

So we think it's probably right that the interest rates cuts are being priced out of the end of this year, although we don't think they're going to hike much more.

Roy: It's going to be interesting to see whether it is a pause or a skip or what is it, because we did see the Bank of Canada come out and they actually resumed interest rate hikes after pausing for four months. So maybe the Fed does something similar.

Silapachai: Definitely. And I think that's what the market reacted to, for sure. You saw rates really kind of sold off pretty hard on a BOC decision and so, to us, that's definitely going to be a possibility.

It just really depends on kind of the appetite for the Fed in terms of tolerating this high level of inflation and one or two more hikes.

In the grand scheme of things, it'll definitely be painful in certain parts of the market. But again, I think the really aggressive parts of the hike str largely over.

I think now we're kind of trying to land the plane, so to speak, for the economy to kind of a more of a Goldilock, so to speak. We're of the mind that it's going to be very hard to get that soft landing, but that's what the Fed is trying to do.

Roy: That sounds great. It makes a lot of sense and let's hope we do get that soft landing. Now, shifting gears a little bit, you work for Sage Advisory, so I'd love it if you could tell us a little bit about Sage. What does the firm do and how does it work with ETFs?

Silapachai: Sage was founded in 1996 based here in Austin, Texas as a fixed income manager. Most of our strategies are based in U.S. fixed income across sectors.

The way we got into ETFs and kind of building ETF portfolios was really interesting. In 1998, we had an institutional client that really wanted a kind of a bolt-on exposure to equities.

At the time, we identified that there was this new technology on the scene called ETFs, and it allowed you to get efficient access to a diversified portfolio of equities. And so we started to build an equity strategy at that time for that client.

That's grown into kind of an ETF strategist business that we've kind of cultivated alongside the growth of the ETF industry since that time.

And so we don't issue ETFs ourselves, we just use ETFs from across the universe of providers.

And we build portfolios and strategies really across equities, fixed income, multi-asset strategies as well as more purpose-driven models like income-based strategies as well as things like cash balance plans and the like.

Roy: That's great. And can you tell us about some of the portfolios that your firm has built? What type of strategies are you running and who is using these strategies?

Silapachai: The largest segment of our strategies are your traditional 60/40 strategies, and so your balance models consist of a global equity allocation as well as a fixed income allocation.

On the equity side, we invest on a global basis across developed and emerging markets, across the market cap structure.

And so what we try and do is build a portfolio that tracks whatever risk level the clients have chosen and then we try to tactically allocate among different market segments.

We conduct tactical asset allocation to try and manage risk or outperform the market over the long term.

And so we have regional views on equities, emerging markets versus developed markets, U.S. versus developed, international as well as industry sector styles we could express those in these portfolios.

That's on the equity side kind of how we look at the world in terms of the ETF universe.

We try to partition the world into, again, the region, industry and sector styles, and then we try and pick the best of breed. Oftentimes, we will have portfolio shifts on a monthly basis based on where we see the market three to six months out. On the fixed income side, we manage a kind of core plus strategy.

And so that looks like an investment-grade portfolio plus a noncore segment which consists of things like high yield emerging market debts. We could even go into preferred stocks, so, income-based segments. So we'll allocate to those as there's opportunity.

Obviously, spreads are pretty richer than fair here, but when things are really cheap you can see us kind of allocate a lot more to kind of some of these spread sectors. That's our fixed income allocation.

I think one other notable strategy for us has been multi-asset income, which is an income-based strategy. So we try to maximize income relative to risk of the portfolio.

And we try to optimize around having a properly diversified and balanced portfolio across income generating segments, so things like dividend, equities, income-based equities, noncore fixed income I mentioned before, like things like high yield corporates EM debt, international bonds and then core fixed income, things like just your investment-grade corporate bonds, Treasuries.

And then we have a hybrid component which has things like preferred, MLPs when they're attractive, although we haven't used MLPs in a long time.

The last thing is that we have some ESG-oriented models, similar to what I've just mentioned, except we're trying to screen for ETFs that have a superior ESG profile.

Roy: Now, obviously you use ETFs pretty extensively, but when you consider the universe of ETFs, when you want exposure to a certain type of investment, there's a lot of ETFs to choose from. So how do you choose? I'd love to learn more about how you vet ETFs.

Silapachai: It depends on what we're looking for. But I would say I'll just start from the largest segments.

So when you're looking for your largest liquid indexed segments, at that point it's a cost game.

A lot of these big-name providers have pretty much lowered the cost to close to zero on some of these core U.S. equity ETFs. So that's not super interesting.

I think what's more interesting is when you look under the hood to different styles, regions and industries, we start to now look at the index construction, and it's not necessarily that one is better than the other. We just want to make sure that we're getting the right exposure based on our macro view.

So, for example, with a U.S. value ETF, there are a lot of different ways to construct value ETFs. Is it a market-cap-weighted ETF? How do they define value? Is it just your traditional price-to-book-type measure, or is it like a free cash flow yield?

One thing we look at is sector exposure. So sometimes you want to go long value, but you don't want to take the sector risk of your traditional value sectors like energy and financial. So maybe there's an ETF that's sector neutral or sector constrained. And so that's one way we look at it.

On the fixed income side or on the income side, ultimately that's a lot more uniform, in my opinion. A lot of these ETFs are primarily indexed, so they're just indexed to a benchmark with kind of market cap weight.

Fixed income, especially on the corporate side, is largely less liquid. So it's hard to kind of have extremely custom ETFs. But I think there's a huge amount of active ETFs on the fixed income side at scale.

And so what we'll do is on the fixed income side, we'll definitely be meeting with those management teams, figuring out what makes them tick in terms of their edge, how they generate alpha, what are their exposures like over time.

We want to make sure we're not surprised as we invest with these folks, and then we'll pick folks that we think that can generate alpha outside of the index names that's coming to bear a little bit in equity space.

There's been a proliferation of active ETFs, so I could see that happening as well in the equity space.

Roy: So Komson, earlier in the show, we talked about your outlook for the Fed. It sounds like you think they're close to winding down the rate hikes, if they haven't already. So given that, where do you see the opportunities, whether it be in fixed income or equities? Are you preferring domestic equities, international equities?

Silapachai: So, big picture, right now we've been fairly defensive on our positioning, just given our outlook on the second half of the year. So for example, we have a lower beta exposure in our equity model, but also in our multi-asset strategies as well.

So overweight fixed income versus equity, so lower risk than what we would typically be doing. That's because of a couple of different things.

First, we think that growth is slowing and you're seeing kind of a pretty rapid decrease in inflation.

But also on the liquidity side, we think you're going to see a period of liquidity withdrawal in the markets, that it's not going to be good for asset prices nor the economy.

So I think with this debt ceiling debate, we haven't seen a ton of increase in Treasury issuance, especially T-bills, particularly the U.S. government has been kind of funding the U.S. spending by drawing down their bank account, the Treasury general account.

They have to refill that. They have to restock that by issuing a lot of Treasuries, a lot more than they were forecasting.

And so I think that that liquidity withdrawal kind of takes money out of the private sector, potentially bank reserves. That's taking money directly out of the economy, banking stresses that emanated in March.

While we think that they're contained in terms of contagion risk, a higher cost of lending, lower loan demand, just results in less credit in the system.

So money and credit equals liquidity. That's less liquidity on the margin.

You also have things like overseas, the ECB TLTROs, there'll be 500 billion of euros of maturities this month, the end of this month, which means that the banks that have been funding themselves with TLTROs now have to go find new and more expensive sources of funding.

And so I think that all that means that you're going to see a period of liquidity withdrawal in the second half of the year and then the Fed is talking about hiking a little bit more and so that's more tightening on the margin.

When you look at the liquidity and policy picture, it's actually not going to be very favorable for asset markets. So we're taking risks down across our portfolios.

In terms of kind of market segments, I think we're trying to focus on income, and so overweight fixed income, focus on the areas that we think still provide somewhat of a high income that will be somewhat resilient in this upcoming environment.

We think that high yield bonds still provide some value here, especially as we wait out this environment. So you're seeing yields in high yield, upwards of 8.5-plus.

And high yield, when you look at kind of the composition of that market, has totally shifted in terms of kind of the quality. So over the last 20 years, quality of high yield indexes has improved significantly, much more secured borrowing. For a given level of spread in high yield, it's much higher quality.

Also, the rise of private credit and things like that over the last 10 or 15 years or so means that a lot of the lower quality borrowers went to the private markets, went to the shadow banking system in order to access liquidity.

So the high yield markets is going to be more resilient to a default cycle this time, especially when a lot of the defaults took place during the last oil bust in 2015.

A lot of those companies are obviously doing pretty well right now, given where oil prices have been. And so we're still overweight some high yield here. We still like the income that it provides.

And in terms of regional allocation, we're pretty neutral. I think you can see some pain in Europe. They've definitely outperformed since October.

But again, I think we think that TLTRO maturity could hurt the banking system and the eurozone, which could see some weakness, could result in some weakness in European equities. And so we're underweight Europe a little bit, but not a big regional exposure at this point.

Roy: Fantastic. Well, we're going to have to leave it there. Komson, a ton of great information. Thank you for coming on the show and sharing your insights with us.

Silapachai: Thanks for having us. Really appreciate it.

Roy: Listeners, I hope you enjoyed this episode. You can find this and all other exchange Traded Fridays episodes on ETF.com or on any major podcast platform. See you next week.