Chief Investment Officer Jon Maier and Head of Thematic Solutions Scott Helfstein offer their perspectives on the current investing landscape, which today can be described as a period of major adjustments. After years of historically low rates, this higher rate environment creates different dynamic for investors. Consider that short-term treasuries at 5% are now in the conversation. Elsewhere, changes brought forth by innovation raise questions about how best to integrate thematic equity in a portfolio. Jon and Scott also discuss what it means to write research with artificial intelligence (AI), all the rage in 2023. Speaking of next-gen tech, and the capital behind it, they start with the news out of Silicon Valley.

The Silicon Valley Bank (SVB) failure is a fluid story, and it will continue to evolve in the coming days, weeks, and months. What are your thoughts about the situation?

Maier & Helfstein: Well, at least SVB clients have access to their funds. For that, they can thank the Treasury, the Federal Reserve, and the Federal Deposit Insurance Corporation (FDIC). The Fed created a new Bank Term Funding Program (BTFP) to protect deposits offered to banks, saving associations, credit unions, and others. As late as Friday, March 10, Treasury Secretary Janet Yellen said that “the banking system remains resilient.” But the Fed acted very quickly to put a plan in place by Sunday, March 11, so it’s reasonable to surmise that contagion was a major risk. And the contagion is not isolated to the United States, the situation is fluid globally.

SVB’s absence will be felt. The bank grew from roughly $7 billion in assets in 2007 to roughly $200 billion upon collapse.¹ It was the sixteenth largest bank in the United States and an important institution for high-tech startups. The impact on regional banks cannot be taken lightly. We can expect capital raises and increased scrutiny of both regional and large banks. Some big banks may be winners, while startups with less access to capital are likely to be losers.

More broadly, we expect that banks will be forced to raise deposit rates, and from a lending standpoint, standards are likely to tighten. Additionally, marking to market is likely to become a much bigger topic. We also expect the regulatory framework to become more restrictive, though politics will play into this discussion.

What should investors keep in mind from an equities standpoint when considering Fed rate hikes at this point in the cycle?

Maier: Equity markets certainly prefer when interest rates are lower, as higher rates means lower earnings growth. But we’ve seen periods of higher rates and equity markets with mixed results before. In the short run, the formula is simple. When earnings growth expectations are lower, stocks are lower. But higher interest rates offer investors options that previously did not exist: cash or some other equivalent fixed income. Higher-multiple stocks are most at risk. When the market becomes confident in the Fed’s ability to attain its objectives of taming inflation, it will start to anticipate future interest rate cuts. However, investors must remember that the future merely resembles the past, and the current environment is largely unchartered territory.

Helfstein: Something that often gets lost in a Fed tightening cycle is increased discipline in capital allocation, which in my view is the single most important impact of rate hikes. Higher rates could force investors to deploy capital more selectively, favoring higher quality assets. Higher quality could mean better balance sheets and stable cash flows, which should be true of growth or value investments. Lower quality assets could get shunned.

Historically, financial assets do well with higher interest rates. The level of interest rates has less of an impact on equity performance than a change in rates. Should the Fed raise the terminal rate, a modest equities selloff is possible. This scenario could prove relevant to traders looking to play market swings. For investors with time on their side, changing the terminal rate by 25, 50, or 75 basis point likely has little impact on the market over the long term.

With 6-month treasuries paying near 5%, should investors seize on that opportunity?

Helfstein: The opportunity to secure an almost 5% annualized return for a 6-month asset seems appealing after a decade of short-term rates that ranged from 0–2%.² The answer to this question, however, depends on investment objectives and financial plans. For example, in a portfolio with a target rate of return of 7%, a 50% allocation to 5% treasuries would have to be paired with a 50% weight in an asset yielding 9% to reach the target return. At a 70% allocation to 5% treasuries, the remaining 30% would have to find an asset returning 12% to reach the target. Higher weighting in 5% treasuries increases the return needed in the remaining assets to hit the target.

Beyond growth equities, investors don’t have many options to find assets with track records of returns above 9%. Investors loading up on treasuries near 5% might want to consider a barbell strategy with some growth exposure. Practically speaking, with inflation still at 6.4%, a 5% treasury locks in a real loss of 1.4%, which does not sound like a great strategy to me.

Maier: I don’t disagree with Scott’s answer. However, considering all the current uncertainty, which I discuss further in CIO Insights, cash offering an almost 5% yield for 6 months and providing an alternative to long-term bonds and stocks doesn’t seem like a bad place to wait. But I cannot tell you the exact moment to jump back in the market. Timing the market is extremely difficult. Only a few get it right, and those who do are likely lucky. The S&P 500 is unlikely to outperform cash in the near term, but it is very likely to over the long term. The S&P’s annualized return from 1970 to March 9, 2023 is 7.3%.³

The low rates era following the Global Financial Crisis fueled higher stock prices, and higher rates post-pandemic will require a period of adjustment, the effects of which likely include the 60/40 portfolio’s return to relevance. However, I cannot fault any investor for waiting, especially given SVB’s collapse and renewed concerns about the banking system.

What are the benefits of diversification versus concentration in thematic investing?

Maier: Let’s start here. Thematic equity is best suited for investors with a long-term investment horizon who are willing to remain invested as the concept moves from innovative and novel to ubiquitous. This space can be high risk, high reward, so limits on the maximum desired level of exposure are advisable. Limits help financial advisors establish a framework for including thematic equity across different market environments. Appropriately scaled exposure can help financial advisors and clients maintain focus on long-term objectives, particularly while navigating more challenging market conditions. The level of thematic exposure in a broader portfolio should change over time, but the narrative of disruption remains strong—and can be a good way for advisors to generate Conversational Alpha® with clients.

The nature of the existing equity sleeve determines the level of diversification benefits thematic equity can provide. The diversification benefits remain relevant across the risk spectrum, provided thematic equity is included at levels that remain appropriate for the risk profile of a client. At Global X, we believe thematic equity should be all cap and global in nature, increasing the level of thematic equity reduces exposure to U.S. large caps, which can affect portfolio volatility and increase tracking from a portfolio’s benchmark.

When scaling thematic equity into a portfolio, the maximum limit should be lowered if there’s already a high level of mid- and small-cap exposure. At high levels of thematic inclusion, the approach used to scale thematic equity into a broader portfolio can have a meaningful impact on the level of mid- and small-cap exposure in the overall portfolio. Depending on the size exposure in the underlying core portfolio, without the equity adjustment, typically there will be a smaller transition to mid and small caps. The increase in equity exposure will likely maintain diversification within the equity sleeve at higher levels of thematic exposure.

Helfstein: In certain instances, concentrated approaches to thematic investing have worked well, and in others they crashed. Meanwhile, too much diversification waters down thematic exposure, which can produce a market-like return. The diversification-concentration balance boils down to an essential rule of investing, the relationship between risk and return. Also, the level of diversification-concentration should align with investing objectives.

Concentrated portfolios can deliver higher returns, but they come with higher risk. There is more idiosyncratic, or company, risk than thematic or economic risk. Concentrated thematics is more akin to angel investing, venture capital, and long-only hedge funds. Rewards can be generous, but the risk is high. One strength of thematic investing is capturing emerging industries, though forecasting the pathways of newly emerging industries and their technologies is challenging and trying to pick winners adds a layer of complexity. I believe thematics should be concentrated enough to represent the newly emerging industry, but still offer a sufficiently diversified basket to limit the impact of company risk.

Innovation can come from top down through big companies and bottom up from small companies. How should investors look at innovation when investing in this environment?

Helfstein: It’s hard to separate top-down versus bottom-up innovation today, but they both play critical roles in the broad innovation landscape. Small companies often fuel breakthrough innovations, and large companies provide them with necessary funding, market access, and resources, including incubation labs. This pattern has been a hallmark of the pharmaceutical and biotech industries for years. For the bigger companies, their size can make it more difficult to innovate, so they actively look to smaller companies for big breakthroughs. The Microsoft and OpenAI relationship is an example.

The return on capital expenditure from big technology firms has been on a downward swing and rising for other companies. However, I am excited by the idea that companies are reinvesting in their businesses at a faster rate than in the past 30 years, which could be the most important driver of innovation in the years to come.

Maier: If you don’t evolve, you can become irrelevant. There are plenty of examples of companies that are no longer with us. Blockbuster, Kodak and MySpace come to mind. Perhaps because of the efficiency of capital markets and the flow of information, the past few decades show that large companies evolve more effectively than in the past. One reason may be that they incubate internally, creating an entrepreneurial feel within a large, well-funded organization. The likes of Apple, Microsoft, and Amazon have access to vast amounts of data that they can experiment with and the capital to turn it into something.

Small and mid-sized companies often drive innovation. But innovation and the proliferation of that innovation requires capital, which can present challenges for smaller companies, especially when black swan events like SVB occur. Such events can impact the timing of innovation negatively, though we can also point to the two years of the pandemic as a boon for innovation.

The use of ChatGPT has exploded in 2023. Now that AI is here, do humans need to write research reports anymore?

Maier: AI certainly changes the way we can approach our research and information-gathering, but it does not completely eliminate the need for writing research reports. AI can quickly analyze vast amounts of data and provide insights, but it may not always capture the full context and nuances of a particular topic. In many cases, a thorough analysis and understanding of a topic requires human interpretation and critical thinking. Also, while many sources of information are available online, not all information found online is reliable or accurate. And some may only be accessible in physical collections, like those found in libraries. Remember those? They still exist. And they’re needed. I still have a few years left writing, so ChatGPT and the likes have no chance of replacing me!!

Helfstein: I echo Jon’s sentiment and have several concerns with relying on AI. First, AI is still prone to error, a byproduct of combining disparate data sources and trying to reduce inconsistency. Of course, humans err as well, but in research, humans source the material they use to draw their conclusions. AI doesn’t yet. Sourcing is an annoying but critical part of research and required by regulators for a reason. Sourcing helps to identify the origin of errors when they arise.

More broadly, my biggest concern with AI is the synthesis of existing information versus the creation of new knowledge. Great research creates new knowledge, something AI has not proven a consistent ability to do. The ability to deliver unique insights, rather than revisit old arguments, is often a product of creative serendipity. The equivalent of looking for a specific book from library stacks and then grabbing two more from the shelf because they looked interesting can lead to new and unforeseen insights by happenstance. AI might reach that level of sophistication, but we are not there yet.