TDAM Talks Podcast: Celebrating Three Years of TQSM

JONATHAN NEEDHAM: Hello and welcome to TDAM Talks ETFs. My name is Jonathan Needham. And I lead our ETF distribution team efforts here at TD Asset Management.

Today, I have the pleasure of discussing a unique Quant ETF that focuses on the US small mid-cap market. To help me do that, I have a special guest, Julien Palardy, Managing Director and Head of the Quantitative Equity Team.

Julien, how you doing today, sir?

JULIEN PALARDY: Doing good. Thanks, John. How about you?

JONATHAN NEEDHAM: Can't complain, all is well, minus the markets, that is. I'm really, really, really glad to have you here today. And no one better to do a deep dive into our ETF ticker, TQSM, which is our TD US small mid-cap ETF.

Now, before we do that, do you mind giving us a brief history of yourself? And maybe explain to our listeners today what your role as Managing Director and Head of the Quantitative Equity Group looks like.

JULIEN PALARDY: Yeah, sure. So, I'm what we would call a TD lifer, or in fact, I would say a TD Quant lifer because I joined-- right out of school, I joined the Quantitative team 16 years ago. And I've stayed pretty much ever since. I spent maybe a couple of years on the asset allocation team in Toronto a few years ago.

Then I moved back entirely to TD Quantum. And I started the Quant team by doing Alpha research, so the same kind of Alpha strategies that evolved over time, obviously, but same kind of alphas that we use in managing the TQSM ETFs.

So, I started working on this when I joined the team. Then I went on to managing portfolios and doing asset allocation for a few years, then moving back to head the team of-- the portfolio management team on the Quant team, and then to become the head of the Quant team as a whole.

So, on a day-to-day basis, this means, first of all, there's a lot of-- when you're the boss of a team, there's a lot of paperwork and admin stuff that's not the fun part. But the fun part is really thinking about the evolution of our models, how to do a better job at delivering returns, managing risk.

Then there's the day-to-day management of the portfolios. The FPMs on the team take care of that. But I always, always keep an eye open, given my past background as a portfolio manager, to make sure that things are going well there and to make sure that the portfolios are lined up with the models.

And there's the data as well that's super important, in my opinion. We have a data team within part of the broader Quant team that's managing the data and making sure that the data is impeccable when we manage our funds. Because if you have small errors in there, then the models are going to pick up on those errors and try to maximize our load on those errors in the portfolio.

So, we want to avoid that. Obviously, I don't do this on a day-to-day basis. But there's plenty of questions around that, that need to be managed, like getting access to the cloud, or dealing with vendors, data vendors, and things like this, so data vendors that we use in our models.

So that's pretty much what I do on a day-to-day basis, I would say.

JONATHAN NEEDHAM: Awesome. Thanks for that, Julien. So multiple decades at TD. You still look so youthful. So, they're doing something right in Montreal that I'm not doing here in Toronto.

JULIEN PALARDY: It's in the water.

JONATHAN NEEDHAM: So maybe I should get some tips and tricks.

JULIEN PALARDY: It's the water.

JONATHAN NEEDHAM: It's the water, it's the water. That's good. Maybe I need to put in for a relocation.

And data, I mean, as you know, I tease you and your team. I always think of you guys as the propeller heads, right, the data geeks. I love it. You've figured out multiple ways to harness Alpha and to harness better risk adjusted return.

So, thank you for continuing to run money on behalf of our clients and being such a great fiduciary. This year, in particular, which has been a really, really tough market as we know, you guys are just doing a phenomenal job on a relative basis at preserving capital. So, thanks for that.

So, let's talk a little bit now about the market. Because it has been ugly. And I know you're navigating it better than most. Can you explain, in particular, the small mid-cap market, which tends to be a little bit more volatile than the broad market over time, and what opportunities are you seeing that exist in the small mid-cap US space?

JULIEN PALARDY: Yeah, so I like the mid- and small-cap space because a lot of people tend to forget about this. These are US stocks. So, they think they have exposure to the S&P 500. They think it's highly correlated anyway. It's the same market, right?

So actually, there's nothing further from the truth. Even if you think about the S&P 1,500, which is supposed to cover large-cap, mid-cap, small caps, if you buy an index S&P 500 index fund, there's going to be less than 8% of the [INAUDIBLE] that are going to be on mid- and small-caps. Like, 92% is going to be S&P 500. So, it's nearly-- you end up buying largely large-caps. And it's nearly the same thing as buying SBYs.

And in fact, there's more commonality between the S&P 500 and MSCI World, let's say, where there's nearly close to 70% overlap between those two universes. So MSCI World is largely US plus a few internationals-- not a few, but one-third international stocks, compared to when you look at the S&P 500 versus US mid.

And the US mid index looks very different from what you have in the large-cap space. So, you're going to have, for example, a lot more-- it's going to be more cyclical but also more diversified. So, you're going to have-- the top sector is industrials.

So, among all the sectors out there, it's probably a more like a mix and match up multiple things. It's probably the most diversified sector out there. And then you're going to have financials as well, which tend to be a bit more cyclicals. But within the sector, you're going to have a lot more regional banks.

And they tend to be less volatile, interestingly, than the big, capital market exposed banks in the US like-- I'm not going to name names. But there's plenty of them. So, these are, interestingly, names that we tend to hold, like the regional banks, are names that we tend to hold more often, and let's say are low volatility funds because of their interesting risk properties.

And another interesting thing with the small cap universe, and more specifically the S&P 1,000, is that it's a lot more diversified. So just to give you an idea in terms of numbers for the S&P 500, if you think about the top 10 names, if I'm not mistaken, it's pretty close to one-third of the weight at the index. And in terms of risk, it's even more.

So, I know from the best of my memory, the top five names, the top five risk contributors of the S&P 500, they explain close to 30% of the volatility of the index. So that's a lot of concentration in your portfolio when you buy the S&P 500. You would think it's fairly diversified because it's an index. But actually, not so much.

And yeah, there's a big contrast with the S&P 1,000, so small cap, mid-cap. And top 10 names capture about a bit more than 4%, so 4.5% approximately, of the market cap of the index or the weights of the index. And risk-wise, it's roughly in the same range as well.

So, it's a lot more diversified. There's a lot more dispersion in the index. So even though small cap names tend to be more volatile than large-cap names, it's worth mentioning that there's a lot more diversification in this portfolio, which is attractive, I would say, or should be attractive, for an investor. And the only way to get real exposure to this is to buy the index or to buy a small-cap or mid-cap fund. Because everything else is going to give you-- because of the cap weighting-- it's going to give you very little exposure to this universe.

So, two-thirds of the S&P 1,500, you have only 8% exposure in this if you buy an S&P 1,500 index, unfortunately.

JONATHAN NEEDHAM: Thanks for that context, Julien. I think that's really important to help educate our listeners today, that you're buying the market. It has a place in a portfolio. But you're taking on more concentration risk today than you were 10 years ago. And you're taking on more risk and more volatility today than you were even a couple of years ago. And I think that's actually showing true, based on what we're seeing in the markets.

And in particularly, the large-cap space also drives US large-cap space. Or market cap weighted S&P 500 drives a lot of its revenue from the International markets, right, 50%-plus of their revenue outside of the US, which when the US dollar is strengthening as it has, as of late, that's impacting earnings and impacting their bottom line.

And so, we're seeing revisions this year. And I think small- and mid-cap obviously are going to be more focused on the US market and not going to have the same impact as currency.

So, I think it's important for our listeners to realize that sure, certainly, beta, or passive, or broad-based indices have a place in a portfolio. But there's a lot of merit in adding small mid-caps, in particularly in this type of strategy to get better diversification and lower risk.

And diversification, not just from a market capitalization perspective, but from sectors. So, appreciate that. Now, in terms of your Quant monitor, specifically for the small-, mid-cap space, what metrics do you use that are unique? And what metrics do you use to help determine which individual securities and stocks get included in the portfolio?

JULIEN PALARDY: Yeah, so I wouldn't say that we use unique metrics, specifically for the small cap space. When we build our Quant models, we try to be a bit agnostic to the market that we operate in. We want models that are robust enough to operate and to work in various market conditions, but also a large number of markets as well.

So, we want the model to figure out what works and what it should be exposed to, as opposed to imposing this on the model. So right now, in our Alpha models, we have roughly 21 factors, if I'm not mistaken. And they're aggregated into multiple, what we call, factor composites, that represent the kind of teams that we can be exposed to.

So, you're going to have, for example, valuations, which is probably part of every Quant model out there. And we're going to be looking at the EBITDA enterprise value, cash flow to invested capital. We're going to be looking at the forward earnings price and sales price as well, and things like this.

Then there's going to be what we call value with reasonable quality, where we use similar metrics, but we adjust them based on the quality of the company. And we use multiple metrics there as well. So, we look at, if the company is expanding its balance sheet, we look at if the company is taking on more leverage, or issuing shares, or if it has negative earnings.

And every time the company scores negative points and we decrease the way that we put on those specific metrics. So, this is to avoid value traps. And then we have a quality composite on its own, or quality team, I would say.

And within this team, we have a variety of composites or sub-composites, like the way a company handles its cash. Is it redistributing cash to shareholders? Or is it focusing more on expanding its balance sheet and increasing its capex? We look at the strength of the balance sheet of a company, how much leverage the company has, and how much volatility the company has as well.

So obviously, the more leverage and the more volatile the company is, the higher the default risk. So, this is something that we call the sensory default. It's a measure of the credit risk of companies that we invest in.

We look at growth measures as well, profitability measures, and the growth of those profitability measures also. So, think about our return on equity and how much return on equity has grown over the years for each company that we invest in.

And then we have what I would call market-related metrics or market sentiment metrics, including analyst forecasts in there. And then we have short interest also that we look at, which captures the view, the broad view, of the market on stocks. So, the more a stock is shorted, typically the more negative our view is going to be on that stock. So, this allows us to retain kind of the input from hedge funds and other entities that can short in the market.

So, these are the metrics that we look at. But also, it's worth mentioning what's in our pipeline. We're in the process of expanding our database of factors to 525 factors.

So, this is a lot more than what we have now, obviously. And we've been working on this for a few years. But we built models that identify what are the best factors in each universe that we invest in. So, the process of figuring out what are the metrics that matter is going to be something that's going to be fully automated, and then how we position ourselves on those metrics as well. So, the investment model, or the Alpha model, is going to be much more generalized in then the year to come, I would say.

JONATHAN NEEDHAM: Thanks for that, Julien. There's a lot going on behind the scenes. And I think from my perspective, what I'm hearing there, is there's a lot of due diligence. There's a lot of thoughtfulness. There's a lot of thoroughness that goes through to making sure we're picking the right companies based on a number of important metrics that we think are going to help them be successful relative to others.

And I think a lot of that went out with the end investor. In the last couple of years, there was a lot of capital-chasing companies that didn't really fulfill a lot of these metrics that you're talking about. And hence why I think today, when I look at how the broad markets are doing and how I look at certain individual stocks are doing, down 70%, 80% in some contexts, we're not seeing that within your model. Now I know why. There's a lot behind the scenes that goes into screening those companies out.

So, I appreciate that. Now, if you don't mind, let's talk specifically about the ETF. And again, I'll plug the ticker-- TQSM. Can you give us a summary of the ETF? In your words, what is this meant to do for investors? And why did we bring it to market?

JULIEN PALARDY: Yeah, so the ETF is built-- the primary focus is Alpha. So, our Alpha models are really at the core of our decisions when it comes to what stocks we buy, or hold, or sell.

And the construction is more cap-weighted centric, I would say, than an overall fund. But also, we have quite a bit of room to overweight and underweight specific stocks. So, I'm going to use the TD US Quant fund as a comparison. Because that's also Quant, Alpha-driven fund in the S&P 500. So, the TD US Quant fund has a 4% active risk budget to overweight and underweight stocks.

For the TQSM ETF, we increased that to 5%. So, we try to control our risk versus the cap-weighted index. But we still have a lot of room to generate performance. And the reason why we control this risk is to make sure that the performance is as consistent as possible over time.

We also have a maximum cap of the total amount of risk that we can take within the ETF relative to where the index is. So, I mentioned that the index is fairly diversified. So, we're pretty confident that, in the case of the [INAUDIBLE] universe, the risk allocation and the diversification of the benchmark is reasonable.

So, we can use this also as a benchmark not only for returns, but also for risk. So, we're going to try not to go too much above the benchmark in terms of total risk for the fund. So, when it comes to risk management, it's a mix of both not deviating too much by more than 5% active risk, but also not going too much above in terms of total risk, above the benchmark.

And when it comes to portfolio construction and constraints, everything is on an absolute basis. But as I mentioned before, we manage the risk versus the index as well. So, our maximum weights, technically, are at 3% per stock and 30% per sector, which is a lot of room, actually, given the amount of diversification that we have in this market.

We're never going to have a hard time holding the index. It wouldn't necessarily be the case for other markets like the Canadian market or even the US market right now, given the concentration.

It's difficult if you have constraints like these to manage a portfolio relative to the index. But in this mid space, it's not an issue at all. And ultimately, the goal is to maintain exposure as much as possible to the Alpha.

And we do a rebalancing, a fixed rebalancing, on a quarterly basis, even though at some point in the future, we may readjust the approach, depending on how much exposure we have to our Alpha. And if we feel like we need to trade more often, then maybe at some point we will. So it's not a recipe that is hardcoded, I would say. We have always some degree of discretion as to how we manage a fund, in the best interest of the unitholders.

So as long as we can deliver on the Alpha promise and deliver the outperformance, then that's going to be a process that we're going to follow, I would say.

JONATHAN NEEDHAM: Awesome. Thanks, Julien. And what I'm hearing here is, essentially, the goal is to minimize risk while still adding outperformance relative to our competitors, and more importantly, relative to the broad-based benchmarks.

And so, I think for the end investor out there, I'll remind you when we talk Alpha, that really means outperformance. And that's a tough space to outperform. I mean, let's be honest, if you look at the charts over the long-term, small cap tends to be the best performing area of the market. And mid-cap does quite well as well, but obviously, with a little more volatility.

And so, what I've seen for this product and obviously the evolution-- and thanks for sharing that do have an evolution process. So sure, all the PhDs in mathematics have these quants, and these screens, and these restrictions to manage risks. But it evolves over time.

And I think that's important for our end investors and our advisors on the call to hear today, that this has active oversight and obviously is there to add outperformance.

One of the things, Julien, I'll share with you and share with the listeners on the call today, is I've been working with the financial advisor community here in Canada for 20-plus years. And most advisors tend to outsource their small-, mid-cap stock-picking, if you will because it's tough to navigate. It's very volatile. And obviously, you want instant diversification, which outsourcing to a fund, an ETF in particular, can do.

And I think that served most of my advisors well. And in particularly this year, I'll say, it seems as though all the benefits of outsourcing and the benefits in the way in which you run this Quant strategy has seemed to work. And so, this is my opportunity here to toot your horn, if you will, and say congratulations to you and thank your team.

We're coming up-- we've just hit the three-year mark, so three-year track record of TQSM in the market. And when I just recently looked at the one-year percentile ranking a couple of weeks ago, which again, for those on the call, is based on the CIFSC category, US Small-Cap Equity category, TQSM is first percentile. I'll say that again-- first percentile, not quartile, but actually percentile.

I mean, that is absolutely amazing. Can you comment, if you are able to-- how are you able to beat your competitors during a time like this? What's the secret sauce?

JULIEN PALARDY: This year specifically, we've played defense, so both when it comes to our Alpha view, so what we tilt on. But also, even the portfolio construction for the majority of the year, we penalize risk to some extent. So, we've been a lot more defensive than the broad market.

And even though that small cap space was not impacted as much as the S&P 500 by the big concentration that we see in the market and all the expensive tech names coming down, obviously given the cyclicality of the space, the market, the Smith market was still down. So, playing defense was really helpful there.

So, we had more exposure to less volatile names within this environment, within this investment universe. Including within industrials, we would have held less cyclical industrials. And there's plenty of them. Would have had more utilities, as an example, less communication services as well.

So, we tended to underweight the more volatile sectors. And this played out really well this year. So low volatility funds would have had the same kind of ranking, I'm pretty sure, within the broader investment universe. Because global is actually the thing that did the best this year.

And that TQSM fund was slightly-- shared similar properties as [INAUDIBLE] funds, given the environment. And a lot of that is an explicit decision, let's call it, this way, of the Alpha models that picked up on the de-risking trend in the market and positioned accordingly.

So, our positioning has been very defensive. So, think about the [INAUDIBLE] default that I talked about previously, which, as I said, is kind of the default risk of companies. So, we went to towards high quality names. And this really helped us navigate the inner market conditions that we've seen this year.

And to be very transparent, in 2020, it would have been a tougher time for an approach like this. But now it's playing out. It's paying off. We're seeing a clear reversal of the environment that we had in 2020 this year. So, people who have been patient and held on to high quality names, they're being rewarded in the current market conditions. And this is what's happening to the ETF.

JONATHAN NEEDHAM: Thanks for that, Julien. And thanks for being such a great producer here. And thank your team, on behalf of me and behalf of all the investors in TQSM. And the full suite of products-- I know today we're here to focus on the small US, small-, mid-cap space.

But as a reminder for those listeners, that Julien and his team run a suite of quantitative ETFs for us in our lineup-- our [INAUDIBLE] Suite, Canadian, US, and International have done exceptionally well on a relative basis this year. Our dividend strategies, both TQCD and TQTD have done, again, exceptionally well while providing an income stream for our investors.

So, it's been a year of defense. This has been the year of quality. Personally, from what I'm hearing from TD Asset Management, that's our view, that that's going to persist. And you definitely want to make sure you're playing a little bit of defense while still being exposed to the equity market. And so thank you again. Great conversation today, Julien. Thanks for your time. With one more question, maybe I'll call out there, is there any final thoughts or anything final you'd like to share with our listeners before I wrap it up?

JULIEN PALARDY: Yeah, I would like to say, in case it wasn't clear before, I'm going to reiterate it. But small-cap space is really important. And small- and mid-cap space is really important for investors' portfolios.

You're going to be, by default, underexposed to this. So, think about buying into some exposure to keep a diversified portfolio. And you're going to have to do this on your own because there's no index fund or broad index fund that's going to give you this exposure naturally, or a reasonable amount of exposure. And then doing it using a Quant approach makes a whole lot of sense because it's a diversified index. In the case of US Mid, it's 1,000 stocks for the S&P 1,000.

So, think about the amount of work that it requires to go to all of those companies, to have a full understanding of what's going on there, most [INAUDIBLE] managers, they are going to know just really well a bunch of those companies. And those companies may or may not do well relative to the index based on various macro phenomenon.

So, you need a manager that has a broad understanding of the entire investment universe to really make decisions on what should be overweighted or underweighted. And this is something that a Quant manager can do. And we have a fairly good track record at doing this.

And even though a lot of people could decide to go index in this space, and it's not a bad decision necessarily, but I like to highlight the fact that-- I think value in the small-cap space is much easier than adding value in the large-cap space, which tends to be much more efficient.

And we've done a good job at both. But I think over the long run, is going to be much easier to add a long-term value over the index versus an S&P 500 fund that's-- so yeah, I think that would conclude pretty much what I have to say on my end, John.

JONATHAN NEEDHAM: Wonderful. Thanks again, Julien. I agree with you wholeheartedly. I think this is a great solution to outsource to you and your team, get better diversification, get better risk-- reduce risk concentration, better at risk-adjusted returns. And, I mean, the proof is in the pudding, as the old saying likes to say.

You're certainly adding outperformance relative to the benchmark. So, we appreciate that.

Thanks again for your time. Thanks for helping me dive into this ETF.

For all you listening, we thank you for tuning in.

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Thanks, everyone. And have a wonderful day.