Capital Appreciation Equity ETF (TCAF): Exploiting market inefficiencies and the early success of an active ETF

Ira Carnahan: Hi, everyone, and thank you for joining us for today's webcast to discuss the T. Rowe Price Capital Appreciation Equity ETF. I'm Ira Carnahan, portfolio specialist for the Capital Appreciation Suite, and I'll be moderating today's discussion.

With that, let me introduce David Giroux.

David, to level set for our audience. We're just marking a first full year with this portfolio. Assets have grown to over $1.5 billion. Can you walk us through the concept for the ETF and how this portfolio came to be?

David Giroux: Sure. Happy to do that. You know, I think, with TCAF we really wanted to create a product in an ETF wrapper that we thought was highly differentiated.

And so we created a product that had really three, still has three simple goals. We want to outperform the market, year in and year out, two we want to be less risky than the market and be more tax efficient than an S&P 500 index strategy.

And so we think if you if you can provide clients with higher returns, less risk and more tax efficient, I think that's a compelling value proposition.

Ira Carnahan: Great. So building on that, can you explain how you narrow the universe of stocks to get to a workable list of potential investments?

David Giroux: Yeah, I think what's interesting is if you if you just take a step back and you ask yourself, why do stocks underperform? You know, there's really like six kind of characteristics.

We've discovered over time as we've kind of delved into this issue, like what caused the stocks underperform and these six issues kind of come down to know poor capital allocation. You know, poor management teams can be sort of ongoing secular challenge, companies that have an extreme valuation where it's hard to actually generate a good return with extreme valuation or companies don't have a business model that supports, let's call it a high single digit algorithm or a combination of EPS growth and a dividend yield over a full cycle or something that has a high single digit algorithm but are very, very high risk or high beta, right?

So, if you, essentially if you go through the S&P 500 company by company and you say how many companies have one of those six kind of fatal flaws, it's actually a very large number. It's somewhere between 365 to 375 companies in the market have one of those fatal flaws.

And essentially what we are doing. And I think we're going to we create a lot of alpha by simply ignoring those 375 companies in the marketplace. That kind of leaves you with a universe of, let's call it 125-135 stocks. We add a handful of non S&P 500 stocks into the into the portfolio. And then we basically say, how do how do we get it down to 95 to 105 stocks. And we're really optimizing around, let's call it four things we want to try to balance to the magnitude of outperformance with the odds of outperformance.

Those are two things we're focused on. I mention one of the value propositions of the strategy here is making sure that we're less risky than the market. So we want to make sure that our beta, our downside is kind of 3 to 5% less risky than the market. We want to make sure the portfolio has those characteristics.

We also want to make sure we don't have too much industry risk in one area. There might be 10 or 12 utilities that kind of hit that don’t have any of those fatal flaws, but we don't want to own 12 utilities in the strategy. There might be 7 or 8 life science tool companies that actually get past, that don't have the six fatal flaws. But we can’t own 7 or 8 life science tool companies. So we might optimize around what are the six or seven best utilities? What are the four or five best life science tool companies? And if you think about all those in combination, kind of get you to that 95 to 105 kind of stock portfolio that makes up kind of TCAF. But I would say a lot of the alpha, actually a lot of the alpha that we generate is simply by removing all these inferior companies that every investor who buys an S&P 500 index fund is forced to buy along with it.

Ira Carnahan: So looking at markets today, how are you viewing things and how are you positioning the portfolio?

David Giroux: What I would say is equity markets are expensive today. It's a real contrast to what the environment we saw two years ago where everybody was talking about a recession, everybody was really very scared about where rates were going to go and valuations were attractive and cyclicals were out of favor.

And today we find ourselves in an environment where everybody thinks the Fed's going to cut rates, everybody thinks inflation is going to come under a little more control. Everyone is playing a cyclical recovery. And what we find ourselves today is at with the market over 5000, when we do our micro analysis at the company level for the S&P 500 for the next five years, you know, we think despite having maybe a little faster earnings growth of the market next five years, we think the multiple will probably come down over the next five years.

And so the result is that the equity market likely will have a period of time the next five years where returns will be below what you think about as a long term average of the very, very high single digits. We would expect S&P 500 returns next five, five plus years, kind of more, mid-single-digit kind of returns mid to high single digit returns as opposed to high returns given where we are from a valuation and sentiment perspective.

And really what that leads us to do is really focus a little more time on areas that are, you know, attractive on a longer term basis but maybe don't fit with the current macroeconomic consensus of the time. That might be a health care company, that might be a utility, that might be a waste company, or might be a software company or a GARP stock, or “growth at a reasonable price” stock.

Ira Carnahan: And when you think about risks that you're kind of focused on today, what would those be? Are they kind of some shorter term? Longer term? Maybe you could just discuss that a bit.

David Giroux: Well, see there are 2 risks we talked a little bit about this is this idea that, you know, people have very positive expectations about we're going to have a soft landing, which we probably will. Probably will.

But also rates are going to come down. The Fed's going to cut rates and earnings growth can accelerate those. Those things may happen. But at this kind of market level, they have to happen. If they don't happen, there's a lot of downside risk. If any one of those things kind of doesn't play so that your risk reward in the market is skewed negatively as opposed to positively.

On a longer term basis, though. You know, I don't really worry about Fed policy or the economy. What I tell people, Ira, is I worry about low probability, very, very bad outcome events. That's what that I spent a lot of time thinking about and it's the what is the odds any one year that China invades Taiwan? What are the odds that there's something that happens between Ukraine and Russia, where it uses a nuclear weapon.

There's those days where the market's down ten, 15, 20, 25%.

Ira Carnahan: So what should an investor in the Capital Appreciation Equity ETF expect and what would you tell an investor is a benefit of the approach in this fund versus what you would get, say, which is a standard S&P index product?

David Giroux: Well, again, it goes back to I think the biggest challenge with S&P 500 index strategy is that, you know, there's so many bad companies or inferior companies, not necessarily bad but companies, that don't have high odds of outperformance over a five year period. If you buy an S&P 500 index fund, you're kind of burdened with all those companies in the portfolio.

So again, I think we create a tremendous amount of value by just excluding those 365 or 375 companies where essentially we are swimming, we are fishing in a lake with a lot more fishes or fish and a lot bigger fishes, if you will, as opposed to in positive areas where odds are a little lower, I would say.

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