Phil Kosmala, CFA, is managing partner at Taiko, a full-service outsourced chief investment officer for RIAs, advisor networks, broker-dealers and trust companies.
etf.com's Kent Thune talked with Kosmala about portfolio management amid flawed Fed policy and inflation data, as well as using ETFs as tools to measure market sentiment and the interrelationships among asset classes.
etf.com: How do you use ETFs in your investment tactics and portfolio strategies?
Phil Kosmala: As an OCIO, we customize portfolios based upon each client's articulated investment approach. For example, we have some clients that use ETF portfolios exclusively. In those cases, ETFs are the core of the portfolio, and we assist with tactical tilts in order to express an opinion on a specific asset class, industry group, factor exposure, duration or credit quality bias.
On the other hand, our larger clients will use separate accounts, or institutional share class mutual funds, for exposure to major asset classes, and round out portfolios with ETFs to express tilts around the core positions. The proliferation of actively managed ETFs enhances our ability to take advantage of thematic opinions our Investment Committee seeks to express in client portfolios.
A great example of that is the Van Eck IG Floating Rate bond ETF (FLTR). After the Fed's abrupt about-face on monetary policy early in 2022, we were able to quickly shift client portfolios away from intermediate bonds and into investment-grade floating-rate securities which benefited from the Fed's 500 basis point move in interest rates.
This tactical tilt helped defend client portfolios against the precipitous fall in bond prices in 2022, which was the worst year for bonds in 150 years. We were also able to modify duration, increase credit quality, and increase income with other short-term Treasury ETFs throughout the year.
etf.com: Do you believe that inflation will remain “sticky” through 2023 and how are you using ETFs in your related strategies?
Kosmala: Inflation data is skewed by the antiquated methodology our government utilizes to calculate 40% of the core inflation index and 34% of the headline inflation index represented in the shelter component of CPI.
If the Fed continues to emphasize this flawed services inflation methodology, then inflation will appear to be stickier. This simply increases the risk of the Fed inducing a recession rather than a soft landing through additional tightening. Shorter-term trend inflation, as in the three- and six-month moving average data, is moving in the right direction and in line with the Fed's Summary of Economic Projections forecasts.
The Fed is currently running very restrictive monetary policy given: 1) the fed funds rate is 100 basis points above CPI; and 2) the current 5% fed funds rate is double the Fed's estimate of neutral, which is 2.5%. The Fed also appears overly tight given the notable slowing in the ISM services and manufacturing surveys as well as the steeply inverted yield curve.
As a result, we are now lengthening duration in client portfolios in anticipation of a Fed policy error. Unlike the beginning of 2022, when 10-year bond yields were 1.4%, a 3.8% 10-year Treasury will provide a hedge against equity positions.
etf.com: What do you believe are the greatest threats to your client assets now, and how are you balancing those risks with ETFs?
Kosmala: The biggest threat to client portfolios is that of a Fed policy error. The Fed historically has tightened until something breaks, and we believe that crack was exhibited in the functioning of bank lending markets after Silicon Valley Bank's implosion.
Historically, it takes six to nine months to see the impact of Fed hike tightening in economic data. We have not even felt the impact of the late-2022 and early-2023 interest rate hikes and yet the Fed appears committed to at least two more hikes this year.
With inflation falling from 9.1% last June to 4% through the end of May, monetary policy is very tight given the understated fall in inflation. In fact, if we substitute Zillow price data and apartmentlist.com data for the Fed's antiquated owners’ equivalent rent calculations, CPI would be under 2%— below the Fed's inflation target!
It certainly appears as if the Fed is driving the car looking through the rearview mirror, as inflation and employment are lagging economic indicators. Intermediate and longer duration Treasury bond ETFs will offer a nice hedge against a Fed-induced recession.
etf.com: How do you feel about the recent popularity of covered call ETFs and the stratospheric rise of the JPMorgan Equity Premium Income ETF (JEPI)?
Kosmala: We have used covered call strategies with clients for 20 years. Generally speaking, buy-write strategies enhance client yield or benefit risk-adjusted returns in volatile and trendless markets due to the fact that option income increases as implied volatility rises.
We are currently not using covered call strategies in light of the fact that we can generate 6% income in short duration investment-grade credit. Further, if the Fed is going to tighten rates until the economy falls into a recession, our preference would be to reduce equity beta through hedged alternatives or increases to fixed income and cash allocations. Covered call strategies are not immune to recessions and/or bear markets.
etf.com: At etf.com, we’re proud of our Markets Monitor tool. How do you use ETFs to monitor market trends? Do you use certain ETFs as benchmarks to track prices and performance of assets, such as stocks, bonds and commodities?
Kosmala: We use ETF dashboards to monitor an array of interrelationships among asset classes. These relative performance relationships help us to assess the market's appetite for risk at a point in time.
A couple of the great historical guideposts for shorter-term investment decisions are the relative performance of gold relative to silver, consumer discretionary relative to consumer staples, and high yield bond ETFs relative to Treasuries.
We are not market timers, but many of our clients seek assistance in decisions regarding portfolio inflows and outflows, such as when to dollar cost average versus fully investing to investment policy targets. These relative performance relationships have provided very useful information in terms of market sentiment.
Originally published by: https://www.etf.com/sections/features/using-etfs-manage-fed-policy