Investing In The Modern World: Ep. 2

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Welcome back everyone, to another episode of the Associates on Fire podcast. My name is Drew Phillips and I'll be the host of today's episode. For those who haven't had a chance to check out our Associates on Fire program yet, I'm a CPA and CFO advisor at Practice CFO and one of the instructors in our Associates on Fire program. Be sure to check us out at www.associatesonfire.com. with another quarter in the books, it's time for another episode with practice CFOs investment director, Brandon Hobson. In our quarterly investment podcast, our goal is to bring you our our take on the latest economic trends, discuss monetary policy updates, provide our outlook on the markets and everything else in between as it relates to investment management. Before we get started, I have to make a special announcement. We're extremely proud and thrilled to announce that Brandon has officially become a CFA Charter holder, which is considered to be one of the top designations in the finance world, and rightfully so, as a level of fortitude and commitment that is required is second to none in the licensing world. Over the course of three grueling exams, the average amount of time required for a candidate to pass is between four and five years. The average candidate spends between 300 and 350 hours studying per exam. The pass rate for all three exams combined is a mind blowing 8.3%. In other words, only one in 12 candidates that start the path of becoming a CFA Charter Holder actually make it through all three exams. Brandon now holds both a CPA license and is a CFA charter holder, which puts him in an elite group of less than 10,000 people across the globe. For sake of comparison, there are approximately 250,000 dentists in America and approximately 7, 500 oral surgeons. So needless to say, we love having Brandon on our Practice CFO team and as a guest here on our Associates on Fire podcast. Okay, Brandon, time to get started. In our last quarterly investment management podcast, we talked a lot about inflation, so let's start there. Can you give our listeners an update on inflation and touch on any changes the Federal Reserve has made since the last time we spoke?

Yeah, so that is a great topic because we spoke last time a lot about how things shift quickly and how the dot plot, which is the Federal Reserve's chart that kind of shows where the members of the Federal Reserve are voting to increase rates. And last time we spoke, it didn't look like there were going to be many rate increases this year that's changed significantly because inflation has continued to run hot. It's close to 8%, which is a 40 year high. And so the Fed, and just yesterday, I think three or four Fed members came out and did interviews and they're basically, you know, my interpretation of that is they're, they're trying to tell the markets, hey, we're going to lift rates off faster than expected and we are going to also make other adjustments to basically bring inflation down. We're going to do whatever it takes to bring this down. Right. And people in the markets, meaning market participants, haven't necessarily been pricing that into the market. At least it doesn't look like it. Based on the recovery that we've seen over the last week or so, stocks have recovered quite a bit. And so I think the Fed's coming out not to spook markets, but to say, hey, you're not listening. This is, this is what we're doing. We're serious about this, get ready because it's coming. And so the, they've already hiked rates once last month. In fact, it was a 0.25 bips hike. So 0.25%, 25 bips, I should say. And they're looking at doing a half a point hike, 50 bips next month on top of the 25 that they already did. And they're targeting somewhere between 1.75 to 2%, I think, by year end. And so that's going to result in probably about six more hikes. Depending on how they get there, they may do another half, a half a percent increase. But the point is, is that when we spoke last time, a lot has changed and this isn't just one Fed member. This is consensus now among many Fed members that this needs to change and that interest rates need to go up and that they need to start adjusting to, to account for inflation and bring it down.

And the federal funds rate, just to reiterate to our listeners, it's the interest rate that banks are charged to trade federal funds with each other overnight. In simple terms, a bank with excess cash, which is often referred to as liquidity, will lend to another bank that needs to quickly raise liquidity. The federal funds rate is the central interest rate in the US Financial markets. It influences other interest rates Such as the prime rate, which is the rate banks charge their customers with higher credit ratings. And additionally, the federal funds rate indirectly influences longer term interest rates such as mortgages, loans and savings, all of which are very important to consumer wealth and confidence. The federal funds rate is also known as the overnight rate, the central rate, the base rate and the key interest rate. Brandon, you mentioned that you think the federal funds rate will be somewhere around 2% near the end of 2022. To better relate this topic to something our listeners are more in tune with from an interest rate perspective, can you help Translate how a 2% federal funds rate will influence mortgage rates?

Yeah, yeah. So the fed funds rate is basically that, that overnight rate or the lending rate to banks. And so when you talk about mortgage rates, they actually follow the ten year pretty closely. Now there's a premium put on the 10 year because of mortgages and a Treasury bond. Right. So there's more risk associated with that. But the main point there is if the 10 year treasury moves about 25 bips or 0.25%, you're probably going to see a pretty equal move on the mortgage rates. And that's what we've seen. So they're above 5% right now mortgages and that just came out yesterday. They've, it hasn't been that way since 2011, the last time we had rates above 5% for mortgages. And so that's, that's coming through there in turn. To your point, the fed funds rate is, is not necessarily the, you know, having a direct impact on the mortgage rates. It's having an indirect impact as it moves up. All of these other rates have to move up to adjust as well. Another good example would be credit cards that those rates are starting to move up. I just talked to somebody recently that was telling me they had Mint and they use that as their budgeting tool and they just got like five alerts the other day that all of their credit cards are increasing their, their, their interest rates. Because Mint notifies you. It's like a personal finance tool that, not you, it's hard to figure that out if you don't look at your rate. So I, I do recommend that everyone start to pay a little bit closer attention to that because it's going to start to matter a lot more going forward.

Let's talk about the relationship between these increasing interest rates and demand for goods and services. Demand is ultimately going to impact GDP growth here at home and also abroad. So help our listeners tie in the interest rate environment to the demand on goods. And services.

Yeah, yeah. So that's a great question and a great segue into, I think we spoke last time a lot about the supply chain, and that was the Fed's focus for about a year there, where they were talking about supply chain constraints and that this was all going to work itself out once the supply chains were relieved and everyone came back to work and so forth. Well, here we are. And you can see the Fed starting to move a little bit faster because they're starting to realize that maybe that some of their opinions that they previously had weren't, weren't accurate and they're a little behind the curve, meaning they should have started hiking much sooner. And so, you know, when you're speaking about inflation specifically, there are really two sides of the coin. You got supply and demand. And both of them drive can have an impact on inflation. So I would say the main focus of the Fed over the last, you know, 12 to 18 months, when they talked about supply chain constraints, they really were focusing on the supply side, which is fine to say that the supply chains are constrained. That makes total sense that prices of goods would increase. However, some of the criticism now that Chairman Jerome Powell is getting is that he's ignored the demand side for too long. And so even though supply chains are constrained, you still have to find a way to slow demand in that moment. Otherwise you're going to have significantly increased inflation, which is what we're experiencing now. And I'll give you an example. As you start to raise rates, demand is going to be impacted. So we talked about mortgage rates increasing over 5% for the first time in over a decade. Well, what do you think that has? What impact do you think that that has on housing purchases? Well, we should start to see, you know, less increases in housing prices. I just saw an article today on CNBC that there's been a 40% decrease in mortgage demand. Now, that includes refinances, but a 40% decrease in mortgage demand year over year. And the reason for that is, is because people can't refinance or they're not going to when rates are going up because their rate now is lower than the current rate. And so that, that has a major impact on, you know, banks and institutions that do refinancing. It affects their bottom line. And so, and also credit card rates we talked about earlier, as those rates go up, people will be less likely to use their credit card, which drives down demand. And so the only way you can really get those rates higher is by lifting off interest rates. The Federal Reserve needs to lift off the fed funds rate so that everything adjust accordingly. That in turn will bring down demand, which since the supply chains are still constrained, you know, there still may be an issue there on the supply side, but now you've hiked rates on the demand side to the point to where you've reduced some of that demand, which inevitably is going to reduce some of that inflation pressure. Because even though you had too few goods, too many people chasing too few goods before, you've now removed some of those people from the demand side, you got less people chasing those goods than you did before. It may still be that the supply chains are constrained and that there is not enough of them, but at least now you've reduced the demand a little bit. That will help relieve some of those inflationary pressures.

Absolutely. And Brandon, when, when I, when I think about, you know, asset prices or the cost of goods or services and how they're correlating to a change in interest rates. Well, and we'll continue on your example of mortgages because I think it's easy for people to relate to and put real life situations to when we have, let's say a 1% increase in mortgage rates. And I was in, I'm going to use an example where I can afford $5,000 a month and in mortgage, mortgage expenses before that 1% rate increase, that would have been $1 million home, just hypothetical. And then after the 1% increase, well, now I can only afford $850,000 home because the amount of cash flow that I have as a borrower and as a mortgage purchaser is the same. It's fixed. Unless, of course, it manifests down to wage inflation, which in this scenario it hasn't happened yet because people like we mentioned in our last episode, do everything that they can in their power to hold off and let inflation be fixed by the Federal Reserve before increasing wages. Because wage inflation is real. It's hard to tell somebody, it's hard to come to work the next day and tell that person you're going to make less. It's easy to say, hey, you can make more. But so point is is that now I can afford a home that is, in this example, $150,000 less than I could just a week ago. Now, the home prices in this equation, right, they're still this same home is still a million dollars. Well, the way that, and you tell me if I'm wrong, but the way that these asset prices should respond to an increase rate is that that price of that same home should come down somewhere close to that $850,000 range. So now that my 5,000 do budget that I have can still afford to buy that same home, even after the interest rate increase. But the problem is typically that the asset prices, especially on real estate, on the real estate side, they lag a little bit in terms of when the interest rates increase to when the actual asset price goes down. And so that disparity, if the Fed is hiking rates too quickly, could lead to too much of a decline in demand. And that unintended overcorrection in demand can actually push our economy into a recession. So the Fed has to walk a pretty fine tightrope of increasing rates while monitoring demand changes and asset price responses to ensure it's not doing anything counterproductive to the economy. Brennan, can you expand on these points and talk about what the Federal Reserve might do to mitigate this risk?

Yeah, that's a really good example. To get to the main issue which you, you ended with there, which is that the Federal Reserve overreacts in some way or moves too fast and then tips the economy into a recession, which has historically happened, you know, most of the time, actually a significant amount of the time. I think if you look back, it's like two of the last 18 times the Fed was actually able to orchestrate a soft landing, meaning not push the economy into a recession.

That's a pretty bad record.

That's a very bad record. And that's why you're getting a lot of people coming out now starting to say, well, the Fed didn't react when they should have. Maybe they should have reacted last year and lifted rates. Now maybe they're going to move too fast. Right. In order to make up for, you know, some of the errors, if you will, that they made in the past. And I think, I think Chairman Jerome Powell would even say that they were misguided and that they, if they could go back and change things, they would have done things differently. So by saying errors, I'm not necessarily critical criticizing the Fed. And it's a very difficult job. And a lot of it's based on data that is lagging, like you mentioned with mortgage rates. And so with the mortgage rate lag, typically it could be 60 to 90 days or more before that shows up in housing prices. And the reason for that is because people lock in rates. And so what you'll often see, which is what we're seeing now, is people get into bidding wars because they're scared to lose the rate that they've locked. Usually a lot could be for 30 or 60 days, for example. And if a home buyer has been in the market for 45 days and they have 15 more days for that lock to expire, they're going to start getting antsy because let's say they have a locked 3.75% 30 year fixed rate, which is great right now because it's at 5.1 or whatever it is, you know, somewhere around there. So they know that it's worth spending $50,000 more for the house than to lose that rate and then reapply and get this new high rate. Because to your point, people shop based on what they can afford on a monthly basis. They don't care how the home price or how that home payment breaks down versus, you know, principal and interest. Most of the time they just know, hey, I can afford $5,000 if more of that is made up in interest, which is what happens when rates rise. Well, now you can only if your principal payment is going to be reduced, which means the house price has to come down to accommodate those rates. And, and so what I would expect, and you know, on the high end properties, some of this stuff may not apply as much. So by, by that I mean if, you know, looking at an oceanfront property here in San Diego that's worth three and a half million dollars, guess what? Those houses probably aren't being bought with bank loans anyway. In a lot of cases, people are just swooping in and buying those things, cash money. However.

The overwhelming majority of people that are shopping for mortgages are not in that category. And in fact, many of them are first time home buyers. And so we can sit here and talk about outliers on what is not going to be impacted in that way. But I think it's easier to look at what's the large, what's more likely to happen with a first time homebuyer because they're the ones that are driving the market. Middle America is the one that's going to be driving the market. Right. And to your point, we should start to see home prices decline as a result of rising rates. And that is, you know, very common.

That'S happened in the past. And so, you know, when that happens, who knows, There's a lot of people with equity right now that they've sold a house, say in la and they have million dollars or whatever because they made it on that house and they're willing to now buy another house and maybe overpay because they made out pretty well on that other house. And so you kind of get that effect pushing up home prices higher and higher. And there's so many things at play there that can continue to push housing prices higher in the short term. But overall, and you can look at the projections for real estate, they're changing and in fact a lot of, a lot of economists aren't making them anymore because it's almost impossible to figure out when this is going stop.

And if you'll, if you guys are listening closely, what branding Brandon is really sort of starting is the story of how bubbles form. Right. Because think about the person that's buying this house now before the housing price because of the lag that we talked about a moment ago, is buying this house before the asset prices had a chance to reduce in value. Well, if they need to sell for any reason in the next two years, well, we're, we're just starting this interest rate environment change. Right. So by the end of, we have until the end of the year before we even may have reached the peak in which rates will get to it in this particular segment of time. It may not be until 90 days until end of March, early April of 2023 before home prices stabilize or reflect the true change over this interest rate period. Well, if I buy a house right now.

The market hasn't taken into account any change in asset prices. Well, if I need to sell because I've lost my job in 18 months, well, most likely I'm going to be upside down on that mortgage. And so, and so that's the another to tie back into demand when why the Federal Reserve has such a tough job. Well, demand directly impacts jobs because if I have to go and get debt out in this world as a business owner and that interest rate's higher, well now my cost of capital is higher and I have less money, have less available cash flow to go expand and hire people to come in. And so, you know, unless you're in a position where you've got a really steady job or maybe you are a business owner in sort of this inflation protected industry potentially. But outside of that, this is sort of the, this is the precursor to how bubbles form.

Yep. And I'll even add on to that just a little bit is that, you know, the banks also, what do you think? Over the last, you know, decade or so their position has been very lenient in terms of lending on homes. And, and the reason for that is, is because they have good insight into where the real estate market's going. They've spent a lot of money, a lot of people and resources to try to forecast this stuff. And if they know that Your home price is going to continue increasing over the next five years per se. Well, then they're going to be more likely to give you a million dollar house on that loan or a million dollar loan on that house because the house is being used as collateral for the loan. So if, if they need to, they can just go take your house, sell it, they'll charge you a bunch of bank fees to do it and they'll also get 100% of their money back. Well, that's changing now. Like Drew mentioned, if there's any type of underwater property, the banks want to avoid that. And they learned that lesson in 2008 when that great Recession took place. So they're, they're going to start to tighten their lending standards here. It's going to be more difficult to get a mortgage down. Payments are going to rise. They're going to want a higher down payment because that's their buffer on that collateral to make sure that if it does decrease in price, we can still come back, take it and sell it, and be made whole in that regard. And so yeah, there's, it's not only the demand issue due to interest rates rising, it's going to be this whole entire change in the way that banking and lenders operate and say, hey, we're going to require more, more stricter standards coming into place now, which is then going to also decrease the demand.

And if you take it one all the way down to the consumer level, Brandon, you know, this change in credit card interest rates and, and what does that, what does that do? Well, we've been in a period of time where, as you just mentioned, banks were very free to give money both on the credit card side on conventional loans.

And if we get to a period where your normal consumer needs to go and refinance their credit card debt into 1 maybe 0% interest rate credit card for like a 6 month period before it goes back to normal, pay interest to just sort of help.

Absorb some of the blow that these rate changes are going to have. And when you get to a point where rates get high enough, their ability or their options to go refinance their personal debts are going to be much more limited. And that in turn could significantly increase the pace that demand falls.

Yeah, absolutely.

Because not only are my credit markets tightening from the amount of liquidity they're going to provide, but now I can't even refinance my debt to get into a payment situation where my current income satisfies those loan obligations. Okay, so we've talked about a little bit now how interest rates impact demand. And I think that most of our listeners are astute enough to know that that also has a pretty powerful impact on the markets both here at home and abroad. Let's talk now how this rate environment is going to impact portfolio management, which we could talk about how the economics of this stuff all day long. But, but what does it mean to our listeners in terms of our strategic changes on the portfolio management side to combat or even work with these changes so that we're going with the tide as opposed to going against it?

Yeah, that's a good question. I like the analogy there of going with the tide as opposed to against it. Because the bottom line is that when you talk about changing your investment strategy, the question should always be for the client, has your goals changed, which most of the time they haven't. A client's goals don't change day to day. However, their emotions do and the way they feel about the market does. And so that's our job as investors in the investment management and investment advisor space to try to, you know, educate participants on the market to try to reduce some of that, you know, changing the investment strategy based on short term fluctuations or things that they're hearing about in the news so that they can stick to that long term strategy and continue to work towards those goals. So to your point, we're still invested, you know, we're always going to be invested. However, we can find certain pockets in the market where we want to invest more or less. And one of those areas that we want to invest less in is growth stocks, which typically are synonymous with technology stocks right now. And the reason for that is, is most, you know, especially smaller companies that are not as mature, which is a lot of technology companies out there, their revenue is far out into the future and so they're not going to be experiencing any type of, you know, profits in the near term. And those companies are going to be impacted significantly more in a rising rate environment versus a value stock that's outside of the technology sector that may be say in G and oil or materials, which has done phenomenally well. Healthcare is very undervalued right now. So we can pick and tilt towards certain sectors, but not only that, we can also change the types of stocks that we're looking at in those sectors to be more value oriented people that are making companies that are making money today right now paying a dividend as opposed to more growth oriented companies that are going to be more negatively impacted in a rising rate environment who pay no dividend and have many years before they become profitable.

I would imagine most of our listeners probably watch this. You know, if you're listening to this episode, you probably, you probably watch the equities market, probably watch the markets in general to some degree and in your portfolios that you may manage yourself. You, you may have noticed some of these growth stocks and tech stocks that, that, that, that Brandon's mentioning that are for the, for the most part traded on the NASDAQ Exchange have, are down 60, 50, 70% even from six months ago. And some of you may be thinking what Brandon just said. Well, I've actually noticed a pretty heavy decline, but that doesn't necessarily mean that the asset decline represents the true value of the company. And so Brandon, can you take a step back and just tell give our listeners a flavor for a why the Nasdaq may not be a good representation of what they're seeing in some of these growth and tech stocks that they own, but also why the value valuations, even after the decline of, you know, 40, upwards of 70% on some of these individual securities, may still not be a good representation of the true value of that company.

Yeah. Yeah. So to, to your point on the index, you know, about 6 large mega cap, we'll call them mega cap tech companies account for well over 20% of the NASDAQ. That includes Google, Apple, Netflix, which is just completely slammed this year, but they still make up a fairly large part of the nasdaq. Microsoft is another one, and Tesla. And so all of these companies.

Some of them have held up better than some of those smaller companies we were talking about. For example, Apple has held up relatively well. When you compare it to some of the smaller tech companies that have been down, you know, 50, 60%. I mean, you look at them, PayPal, Square, Teladoc.

DocuSign, these are all companies that were flying high on a momentum trade and have come crashing down pretty significantly. And I don't think the damage is done yet. But to your point, if you look at the overall index, the Nasdaq, I would say, yeah, it's down, it's down on the year, but I would say it's not reflective at all of the what's really going on under the hood. And the reason for that is, is because those mega tech cap or those mega tech companies, mega cap tech companies that make up a large part of that index have done better. And so they're kind of propping up the index, if you will, whereas some of those companies that make up a much, much smaller part of that index that have just been hammered. Those results aren't showing up in the Nasdaq if you're just looking at the high level index. And so, you know, to Drew's point, we expect to see that continue that downtrend continue. And it's difficult to pick and choose where that's going to happen. But broadly speaking, in the tech sector, I feel comfortable saying that there's going to be a continued downtrend there. And one of the reasons that it hasn't been fully priced in yet, which was one of your other questions, is simply because the Federal Reserve doesn't even know exactly how they're going to, you know, make adjustments over the next couple of months. So when prices start to adjust, what they're doing is there because the stock market is a discounting mechanism. So it's always trying to price. And it's not just pricing in today's news and yesterday's news, it's pricing in today's news, yesterday's news and forecasts for the future. And so as those forecasts change and get adjusted, which has happened significantly this year, we just talked about the change in the forecast for interest rate hikes. But I could go through several other areas where there's been significant changes in forecast and mortgages. For example, like we were talking about, there's been a massive change in mortgage demand and also in home price appreciation now for this year. And so that impacts home builders, you know, in a much different way than it would have six months ago. And so we'll continue to watch what the Fed does. Generally speaking, if the Fed comes out and changes a policy that they previously announced, or any other, you know, government entity that could be a have an impact on the market if they've set an expectation, you can assume that, generally speaking, that that expectation is what the market started to price in. Now if they start to change that expectation, which is what happened this year, meaning higher rate or more rate hikes than expected six months ago, well then now you're going to have stocks start to change their expectations, which is going to bring that stock price down. And it's going to be that discounting mechanism, pricing in the future forecast, if you will, that drives the stock prices down even lower.

When people think about diversification. I thought you made a really great point earlier when you say diversification. People think it's what I own and how much of what I own. But true diversification is how you're allocated based on your short, intermediate and long term goals.

Diversification can mean a lot of different things to many people. But in terms of how practice CFO manages our clients portfolios, we use an index based approach. And there are plenty of people out there that would equate that index based approach as more passive, broad market investing and not necessarily as an approach that's looking for areas to take a more active approach. On the investment management side, can you speak to how our investment style can be used to be more active, more selective and more tailored to the market conditions than someone listening this episode may think based on their more general understanding of our investment approach?

Yeah, yeah. So like you said, diversification is, is a loaded term because it can mean so many things. If I, if I had to boil it down to a few things, it would be geographical diversification, which is, you know, very important not only to have your money in US which is a large part of global equities market, but to also have exposure to Europe, China and Australia, all those other different countries. Then you can also think about diversification within a country which would be kind of like a sector diversification. So that, that would be to say, don't put all your money in tech stocks because if something goes wrong or something happens that impacts that specific sector, it's not only going to impact one or two stocks, these things tend to impact the entire sector at once. And so not every stock is going to fall the same amount or gain the same amount. However, there will be an impact and you want to go with the trends, you don't want to fight the trend. And so you want to invest in those sectors that are going to be, or perceived to be a better value, if you will, and a better beneficiary of rising interest rates. So we talked about geographical diversification, sector diversification, and then last but not least, you also have diversification between, you know, types of investments in terms of value versus growth. So to your point, at certain times, you know, diversification, diversification is always a good idea because what happens is people think that, well, the US market's done so good for so long that I don't need to diversify, I'm just going to put all my money in the U.S. well, that may work for a short period of time. And by a short period of time, I'm not talking months, I'm talking, you know, three, five years, seven years, maybe even a decade, which is what happened. If you look at the S&P's performance, which is a US based equity index versus global performance, the US market has outperformed international markets and emerging markets quite significantly over the last decade. And so in Hindsight, it would make sense to say, oh yeah, we should have just put all our money in the US equities market. Well, now, you know, a lot of that is shifting and U S markets are not performing as well. If not, you know, international markets may be performing better than the US Market at some point in time. And so you just don't know what the future holds in terms of, you know, diversified performance. And so you, you want to keep everything spread out all the time so that you have exposure to mitigate risks in any one market or any one non diversified segment. With that said, within that sector or within that international market, you can pick and choose to either buy stocks, buy ETFs that, that are focused on certain factors like momentum. I know everyone's probably heard of a momentum factor that an ETF that's based on momentum would hold a bunch of stocks that have done well over the last, you know, so many months and that's what's generating the momentum tag. So those stocks have had momentum, they're fitting an etf. And every ETF has criteria as to what gets in and what doesn't. Right. So a momentum ETF is going to have very different criteria than a value or dividend paying etf. And so we're, we're focused on those right now, those value and dividend paying ETFs. Like you mentioned, we, I would say we are passive active, meaning we're not one or the other. We're a little bit passive in the international markets in our portfolio design. And that's by design because it's a little bit harder for us to predict international markets. You've got a lot going on there with foreign currency fluctuations. Not only that, we live in the United States. And so, you know, what we know best is of course domestic, our domestic market. And so we're going to be less likely to rotate or take an active approach in an international market. We're going to get that exposure through a passive index. And then in the US Market, I, I can tilt based on, you know, certain sectors that I feel are going to outperform certain value stocks that I think are going to outperform. And hey, at some point growth is going to come back in. And by come back, I mean be on my radar in terms of an, as an investor, I'm never going to write one thing off. I'm just saying at this point in time, growth is still in my eyes and many others significantly overvalued. And until it comes back down to where we feel it's a good investment, then we're going to definitely weight that significantly lower in our portfolios versus say value which will weight heavier at this moment.

That was really, really well said. Thank you. When, if you think about an ETF or an index fund and what is, what is behind the scenes, what does that mean? Maybe you don't even know what an ETF is. Well an ETF is just, just think what Brandon does here. He's a portfolio manager. He helps to build portfolios and then keep them in balance and all the other things that go along with that. Think about Brandon being at a different company that is, let's say the US ETF and that's a made up etf. But for this example, just bear with me. He is the portfolio manager at US ETF and that etf, his job over there is to go pick securities based on the target or the goal of that etf. Whether it's matching, it's trying to do its best job of being a representation of US equities or it can take on many forms but it has a certain target and objective. There's someone like Brandon over there that picks and rotates in and out of securities based on their objectives.

With that in mind now you've got to come over to the private or the client facing side which is what Brandon and myself do every single day. And we in. And so Brandon I want you to, after you know, going over through that, how do you then of all the ETFs and the index based funds out there in the, in the investment universe, how do you find and choose the ones that will be utilized in our clients portfolios?

That's a really good question. And so one of the most important factors that we look at here because we understand that expenses have a significant drag on portfolio performance. So we want to use low expense ratios, very low expense ratio ETFs. What that means is basically the expense ratio is what is charged to the funds to the participants of the, or the holders of that ETF in order to conduct those operations that Drew just mentioned, there's people that, that have to be paid that run that etf. There's algorithms that run, there's computers associated with those algorithms. So even though there's an expense there, we want to minimize it. Now we don't want to minimize it just simply by looking at expense only because that's, you know, nobody wants to be the Walmart of investment management be low budget operation. So what we then look to is the size of the etf because what you get is is economies of scale with these things, you know, so the more money that flows into that etf, the more assets it holds, the lower the expense ratio in general, which will lead you most of the time to a Vanguard ETF or a Schwab. ETFs are very good as well. They're very large, low expense ratios as opposed to, you know, ETFs. And they're out there that are very small 1% expense ratios, very difficult to justify. So that, that's kind of, you know, high level on, on how I screen ETFs. I also look at the underlying holdings which you can easily find online for any ETF. I'll give you an example. One of my favorite ETFs right now is VFH, which is a bank, a Vanguard banking financial sector ETF. And that ETF specifically will hold companies like JP Morgan, Morgan Stanley, Wells Fargo, bank of America. And you can go and look at the weighting of each of those holdings and it'll tell you, you know, these top five holdings make up 25% of the ETF or whatever that number is. And so you want to, you don't want to be too concentrated. You want diversification within the etf. Because it doesn't do us any good to buy an ETF if 80% of its Tesla and the other 20% is 100 other different stocks. Well now Tesla is going to drive that ETF's performance significantly more than what you expected. So you need to know what's in there.

And I agree completely that the diversification is on these, is on many different levels. Right. As you, as the listeners trying to envision sort of how we go through this process and what diversification means. We've got diversification based on where you are in your life cycle, from your age to retirement and many other factors. And this is just another layer of diversification, how we're trying to achieve that. So with the comment that you just made about, and really we're talking about, you know, market capitalization based on, you know, the companies that are, that make up the, the index and how big their market cap is relative to the total market cap of, of the ETF that they're that they're managing now, and you said that you want to choose ETFs that aren't heavily concentrated in maybe one to 10 securities. Are there ever instances when you actually take the other side of that equation? Which, you know what, I actually do like this ETF because of its concentration now, it's not going to be a large percentage of your total portfolio. But I really believe that within, even though I think that there is a downtrend in tech and growth, this one is concentrated in securities that I actually feel are undervalued in the NASDAQ currently right now. And they may, because of their concentration, this ETF may actually perform fairly well relative to the general index. And so are you ever looking from that side of the equation to choose ETFs.

To help with the portfolio management?

Yeah, that's a great question. And so, yeah, it can go both ways, right? It can go from wanting to have an ETF that has many, many holdings for increased diversification. Some of these ETFs hold 5001000 stocks. In fact, many of them do. And then you can have certain ETFs that may hold 10 to 15 stocks. Of course, the, the ETF that holds less stocks is more concentrated, which is going to have more, what they call idiosyncratic risk, which is each company in that ETF poses a greater risk to your portfolio now. And that, you know, that theoretically makes sense and is easy to follow. So if you have less stocks in the etf, each one of those companies are going to now have a bigger impact on your portfolio.

And to answer your question as to whether or not we ever make that strategic decision to dabble in the ETF with, with a lower quantity of holdings, we do. And I would give an example of Vox. Vox is a good ticker symbol here. And that's a Vanguard Communications etf. It's a little bit more concentrated in Facebook than I would want. But at this moment, Facebook is trading at a great valuation. It's, it's down on the year quite significantly. But that's by nature how these ETFs work. If the investment manager feels that that's a good buy, they will increase the holdings in that ETF to, to basically capitalize on that opportunity. And also in communications, if you think about it, Facebook as a communications company is, it's almost like, how do you categorize that company? Because it's also tech. It's all of these different things, right? So you kind of run out of companies to put in these very specific ETFs. If you, if you're looking for us based, you talk about your screening criteria that you mentioned earlier. You may have a market cap criteria that says these companies need to be above a certain threshold. 10 billion, let's say. Then you got a criteria that they have to be in the communication sector. There's not a ton of communication companies because These are companies like AT&T, Verizon, T Mobile. These are companies that essentially have mandate government mandated monopolies in a lot of ways. And those industries tend to be very concentrated. And so depending on the industry that you're investing in, when you're picking the industry etf, you may just have a more concentrated ETF because the industry is very consolidated. Another good one would be airlines. There's not hundreds of companies out there that, that are running an airline. You got the big, you know, less than a dozen probably. So, yeah, that's, that's, you're definitely going to run into those things and you just kind of weigh them and consider the underlying holdings and, and adjust accordingly.

You know, if anything, I think this has hopefully provided some perspective and that, you know, even though we are utilizing ETFs to accomplish a lot of our investment objectives here with our clients, that there's still a great amount of research and attention that the investment managers.

Have to do day in and day out as these ETFs and the fund managers over there are rotating potentially in and out of certain securities to take advantage of what they feel are changes in the market. So there's this sort of dual sided investment research approach that we have to take to balance and make informed decisions. And I think that Brandon's last comments really sort of gave some light to, to our listeners and what that experience looks like on our side.

Okay, so before the show is over, it'd be, it'd be, it'd be wrong of us if we didn't bring up the, the elephant in the room which is the conflict abroad and, and what sort of our outlook is going to be now. It's really hard with any, with any situation like this to predict a best or worst case scenario with any degree of certainty. And our job isn't necessarily to do that, but it is to pay attention and to try to understand that the changes both currently and potentially systemic long term. And so Brandon, what is your bit? What has been your thoughts on what's happening abroad and.

Sure, yeah, so, so of course most of my discussion here is going to be investment focused and so it's not going to be, you know, to speak about the atrocities which I, you know, absolutely condemn and everything that's taken place over there is just heartbreaking and certainly takes us back to, you know, a century or so ago. I feel like we've just moved backwards in many respects as a, as a world, not just as a country, but as a world for somebody to be able to, to lead a country and commit those types of violent acts that he's been committing Putin over there. It's just been awful to see. And you know, I reread the Wall Street Journal every day. And you know, I'm not exaggerating when I say that some days, if not many days, over the last, probably 50 to 60 days, however long this war has been going on, Russia's and Ukraine have made up 70% of that paper in some days. And so how do we put that into context? Right. If, if the Wall Street Journal is just focused on it, how does that impact the investment portfolio? And that's going to be the main focus on where I'm headed with this discussion. And the bottom line is, is that Russia is no longer a large player in the global economy. They're just not very large. And you know, I know Putin would like to think that they're very important and they are in certain sectors, meaning energy, very, very mineral rich metals, things like that. Russia has, they have a lot of oil. Of course, everyone's feeling the pain at the pump as a result of the sanctions the US has put and our allies have put on Russia. And so I'm not saying that there's not an impact in certain pockets of the market. What I'm saying is that Russia is, if you look in terms of GDP, they're the 11th largest country in the world, which is not that large, being number 11. That means there's 10 other countries that have a bigger GDP than Russia. A lot of people are not aware of that. They still think that Russia is this massive powerhouse. Right. And if you think that, then you're going to be more anxious about your portfolio having any exposure to Russia. But when you realize that Russia does not make up a large part of your investment portfolio simply because they're not a huge player in the global economy, then you can relieve some of that anxiety there because you know that, that your exposure is pretty limited.

One other thing that I would say about Russia too, just to put into context, is that Texas, the state of Texas, they have a higher GDP than Russia. So just, just think about that for a moment. Keep it in context that the state of Texas, just that one state is larger than all of Russia's economy.

That's a cool, that's a really, that's a really cool stat.

Yeah. So, you know, just to put that into perspective now, now we take a step back and we say, okay, what is our exposure for our clients specifically to Russia? And you say, okay, we spoke about having more of a passive exposure internationally because we're not in, we're not in the business of picking international stocks because it's a little bit harder for us to predict. And this is not uncommon among investment managers. And so our, our exposure to Russia for any exposure that we do have is passive. Meaning we didn't go in and pick a country specific etf. We invest in a general emerging market etf. And within that emerging market etf, the manager of that, that fund goes and picks what to invest in and maintains a certain country exposure that is commensurate with that country's GDP in the global economy. And so for example, Russia in an emerging, even in an emerging markets ETF is going to make up a very, very small portion of that ETF because it's, it's an index based ETF and Russia has a very small part of the global economy. We spoke about that a moment ago. And so I did some research just today just to take a look at what our emerging market ETF holds in terms of Russia exposure. And the ticker there is VWO. It's emerging market ETF from Vanguard, very low expense. It's got 0.8% exposure to Russia in that emerging market ETF. So that ETF, depending on the portfolio that you're in, you know, with our firm here at practice CFO, that specific ETF may make up 7 to 10% of your portfolio. And of that 7 to 10%, 0.8% had exposure to Russia, which by the way, many ETFs are now just dumping all their Russian assets. More sanctions came out today restricting investments in Russia. And so we expect to continue to see that come down as a result of this whole tragedy. But the key takeaway there is that you don't have significant exposure to Russia even through your emerging market ETF exposure. Now does that mean that this thing isn't going to come over into other countries and other areas that we do have more exposure to? No, because Europe does have a huge reliance on Russian energy and we do have significant exposure to Europe because they are a lot. The, the countries in Europe make up a larger part of global gdp and so that therefore becomes more weighted in our portfolios versus say Russia. And they'll be impacted in many ways. But like Drew mentioned earlier, it's kind of hard to, to determine how that impact and how that's all going to flow through right now. There are many positives that could come out of this for our country. And again, not to say that this event is positive in any way, shape or form, but Speaking in terms of energy production to Europe, the US has an opportunity to replace some of that lost supply that Europe is going to have as a result of cutting off Russia. You know, all of these sanctions now make it impossible for them to do business with Russia while they're going to have to find somebody else to do business with. And so there's going to be things like, that's why it's very difficult to say, sell everything and sit on the sidelines, because there's some kind of geopolitical conflict. You just don't really know how it's going to be impacted or impact these different countries that then flows down to the companies in those countries. And your best bet is to stay invested, collect your dividends, which get paid out, and let things unfold and kind of see where everything falls out. And once it's all said and done from a investment management perspective, I don't think that this is going to have a very large impact on anybody's portfolio. It is going to have a huge impact on globalization. And by that I mean how different countries. Over the many years, probably over the last 30 years, since China was introduced into the World Trade Organization back in the 90s, there has been a move towards more globalization, higher trade, buying more goods from China, letting them buy our goods, businesses setting up shop, US Companies going to China, Russia setting up their physical locations. All of that stuff is going to be revisited now because this challenge with Russia is making many companies in the US Step back and say, hey, do we want to take this risk in other countries? Do we want to set up shop there? Do we want to build and invest in all this money into their country and then risk a chance of something going on where we just lose everything and have to bail? I mean, Russia's not even giving back the planes that they lease from major US Airliners. And so, and there's nothing that says we can go in there and just take, you know, huge Boeing planes. So it's, it's just, you gotta adjust as you go. You realize, okay, maybe this globalization thing that we've pushed for the last 30 years has some risks that we didn't see because the world was in general kind of more peaceful. And as things start to happen like this, you start to see companies start to second guess that. And maybe you start to see companies doing less business in many other countries in the, in the world.

And to add a little perspective too, you know.

When we look at this particular conflict with Ukraine and Russia and how the US and other NATO allies have sort of responded to mitigate future events within this conflict. It's been vastly different than you've seen across all of history. They've used sanctions and they've used. Because we are such a global economy now, the impact that we can have by cutting resources off to these various countries has such a significant impact to their, to the communities in those countries and their livelihoods in a lot of ways. And so we're seeing this conflict almost.

Have a shorter duration potentially because of these levers that we have to pull now because we are a global economy and because every country relies so much more heavily on one another than they did historically. So it's like a lot of things, it can be a catch 22. And to Brandon's point, there are risks by investing and investing in infrastructure and in the economies of these emerging countries. But there's also.

The potential gain of being able to mitigate conflict by having a global economy and investing. It's not necessarily a one size fit all answer there, but I think that both perspectives are good to understand and to look at. So Brandon, because energy is obviously one of the biggest ones, just to your point, because Russia is such a big producer there and help our listeners understand why from the time this conflict has started up until even today, gas pump prices and prices that the consumer feels have increased, but that increase in America is set to hopefully start trending down. And why abroad maybe in Europe and some other countries that are maybe a little bit more reliant on oil imports, that they may still continue to see this upward trend in gas or consumer facing prices as that that are tied or correlated with with oil or in other energy sources.

Yeah, yeah. So, so for in general, you know, we're already facing an inflation problem not only in this country, but Europe's dealing with inflation. Canada, all countries are dealing with inflation in general. And you know, oil is going to add to that problem. So any increases that we're seeing at the pump which have been significant and very swift, in fact it was there was a significant overreaction where oil was trading above 130A barrel for a while and now it's back down to, you know, around 103 or 104, somewhere like that. But day to day that volatility has been huge as people try to again, the market as a discount mechanism is trying to analyze the data that's coming in and adjust accordingly. And you're seeing these fluctuations as that data is starting to come in and people are starting to change expectations.

So with that said, Europe, I believe, get they get about 60% of their energy from Russia, whereas the US is much, much lower. I'm not sure the specific number, but it's much lower than that. And so Europe, you would expect to have more of an inflation impact as a result of the Russian Ukraine conflict compared to the US it's all relative right now. That doesn't mean we're not going to have an impact, have an impact as a result either, because we do get.

A good bit of our energy comes from Russia, specifically oil. And so it doesn't take a whole lot of a shake up there to create a problem in the supply chain. And that's what's happened. And so I would expect to continue to see inflation rise not only in oil, but in other commodities as well. And that is going to have an impact obviously on demand. You may reduce the amount of miles or the trips that somebody's willing to drive because prices of gas are higher. And so they can't take that trip in their RV this summer or whatever the case is. That's definitely going to show through in many ways and it's definitely going to impact Europe more than the United States. Now how can we as a country, you know, how can we respond in a way that helps mitigate some of that? So you're starting to see it. President Biden.

Basically approved a massive release from the emergency oil reserves each day for, I think it was the next 90 days or something like that. So there's so many months that he's allowing the strategic oil reserves to put out so many barrels and that increases the supply which hopefully with falling demand as a result of the prices going up, you'll have kind of a two edged, a double edged sword there. And it's in. The result should be a decrease in prices. So as that supply comes onto the market, you know, prices are going to come down. And as demand comes down as a result of prices being high, hopefully that will drive prices down as well. And other countries are doing it too. By the way, there's been many countries that have announced releases from their strategic oil reserves. So that's having an impact. Number two would be increasing production. So what can the US Government and all of these other countries do to increase domestic production? And look, there's all these concerns about global warming and all of those are long term considerations. But in the short term they need to find a solution to be able to replace this oil that has been sanctioned coming from Russia. And they need to do it quickly. So how do you do that? You can change the way that you regulate industries, you can do a lot of things. Is Congress willing to do it? Is the President willing to do it? Who knows? It probably depends on the policy that, that we recommend that they put in place or whoever's making that recommendation. But there's certainly some levers that can be pulled. What levers get pulled and, and when or how will affect how this impacts our economy and how long that duration is. And another thing will be like, to Drew's point, it was really good earlier about how globalization has given us a lot of leverage in this war with Russia and Ukraine and we've been able to levy massive, massive sanctions that have had a huge immediate impact on that country. And so any change in Russia's strategic goals in Ukraine also impact all of this. Now if everything, you know, if Russia pulls out today, the damage is done, obviously lives have been lost and they're not coming back on to the global system anytime soon. So even if they pull out today, it's not like we're going to go back, you know, to like it was two months ago. There's going to be significant changes that are made for the foreseeable future. However, how long that war extends certainly has an impact on, on the short term pain that we're feeling now and, and how we react accordingly to, to increase production, develop strategic partnerships with say, Europe. I know that we're in discussions with them to provide LNG or natural gas, which they used to get from Russia, significant amount of natural gas from Russia. And so those are areas where the US may be able to export more, which would be great for, you know, our economy and also possibly increase jobs in the field of natural gas and exploration and all of that good stuff. So you, you'll probably see some significant investments in general in the oil energy markets here in this country and other countries as well will start investing a lot heavier in those areas.

You know, I don't remember exact, the exact time frame in which this was happening, but when oil prices, and it was not long ago, it's been pretty recent. In fact, when oil prices got to almost historic lows and America decided to go on a spending spree and buy as many barrels of oil more so than they had ever done in the history of the economy. And here we are. And I'm thinking to myself, well, probably it was just a bet, but it was a heck of a great bet because now our oil reserves are incredibly strong. And I think that this, and the reason I bring this up is because with this oil reserves that we have and that we're releasing it ties so well in as an example to bridge what we were speaking about earlier from lagging asset prices and how those assets and why those asset prices lag. And this is, this is a great example. So if as America releases, as Biden has authorized the release of this, of these oil reserves, and Brendan said it very well, anytime that you have an increase in supply, right, that's going to naturally bring the price of that underlying product down.

And you can equate that to the same thing as an American consumer savings account balance and how that may cushion or mask some of these economic pressures from interest rates and inflation in the short term. Because in the short term, our oil reserves are going to help mitigate these gas prices. They're going to bring them down, at least for American consumers, because we have reserves now over in Europe. The biggest problem is they don't have any reserves or at least not enough to help shield them and mitigate this inflation from what's happening in Russia. So if we take that same sort of principle, that same sort of example, and we apply it to the average American consumer's bank account, which over the pandemic, counterintuitive, I know, but most Americans saving account balances are greater than they were before the pandemic. And a lot of it had to do with stimulus. A lot of the money that was printed by the government to help prop up businesses and keep jobs from PPP loans, EIDL, etc.

These savings account balances similar to these oil reserves are going to mask some of these interest rate pressures and this inflation pressure that we're going to experience. But mask is the right term because it's not a solution. Because when our oil reserves run out, the global market is ultimately going to be the driver of prices again. And when our savings account balances run out, well, real estate prices and other asset prices are left to do nothing but comply to market forces. And so to tie that back in, it's why the Federal Reserve's job is so difficult. Because this tightrope that they're walking can be masked by so many various factors that aren't always apparent real time and in the moment. And it could take years for that to flush out and actually reveal itself in the true harm or good that it ultimately provided.

So, Brandon, we. It's been such. I always love talking to Brandon. I hope that you guys love listening because he's such a fun person to talk to, so knowledgeable about so many things in this world that matter to what we're trying to do as you know, business owners, as employees to get to our ultimate goal, which is to hopefully be able to relax and enjoy our retirement years. Brandon, before we adjourn for our this for this quarterly's podcast, do you have anything else that you want to share with our listeners? Anything that they should be thinking about right now?

The only thing that I would say is just buckle up and be ready for some headlines on not only inflation, of course, we've been seeing those. But on Federal Reserve moves, my expectation is that you're going to start hearing a lot more from the Reserve members. They're going to come out and they've been very proactive. And so I would expect them to continue to do that, to continue to message where they're headed. And so as you have questions that come up about these things, like I said, it's going to be very obvious that over the next year, two years that things are changing from an interest rate perspective. Just please don't hesitate to reach out to us, talk to us about it, voice your concerns. We're here for you as advisors and managers and we want to make sure that, you know, you have the information that you need so that you don't make an emotional decision that could be detrimental to your, you know, future financial well being.

So, Brandon, before we adjourn today, you know, we're, it's, it's hard for us to tell our listeners, hey, go, we like this one stock or these three stocks. But, but what we can do is we can help provide direction for our listeners that maybe manage some of their assets themselves or maybe just context to what we think from just the market in general, what we think is going to happen to the upside? Do you have any sectors or industries that you could point our listeners toward that you feel are going to perform really well just given everything going on in the both the, you know, economy here at home and abroad?

Yeah, yeah, absolutely. So we, we spoke about the power diversification and how important that is, but we also talked about how we rotate here at practice cfo from the investment management side, we rotate into certain sectors, meaning we can heavily weight those or weight them more heavier than other sectors because we feel that they're going to outperform. And if I were to pick a few sectors that I think are poised to outperform here in the near future, I would definitely turn to materials, which are driven, you know, a lot by commodity prices. And I would also turn to, I would think communications are going to be well or do well. The reason for that being they are a lot of them pay high dividends. Verizon, AT T, those, those are all high dividend paying companies which will perform well in a interest rate, rising interest rate environment. Another sector, I would say health care just simply because it's significantly undervalued right now based on historical metrics. Not only that, they have inflation. Their health care is a little bit more protected from inflation than other industries. They can raise prices. You and I cannot necessarily go and negotiate directly with drug companies. You just either you buy the product or you don't. And so there's some inflation protection associate associated with investing in healthcare industry. So I would say that that's also a good place to be right now. And last but not least, I would say oil or energy, which has also run up quite a bit over the last year and a half. It actually started, I think in January of 2021 is when energy started to turn around. But it has a long way to run. And so I feel comfortable with those four industries. But the main sectors or industries that I would increase exposure to.

Awesome advice, Brandon. Thanks so much for joining us on the show today. This concludes another quarterly investment podcast. We will be back in July with our Q2 update. Stay tuned.

You bet. Thanks for having me.