MW This ETF has trounced the S&P 500 with bets on AI in a surprising sector
By Philip van Doorn
Macrae Sykes of Gabelli Funds explains his strategy, which looks beyond the Nvidia-focused AI hardware buildout
A cycle of declining interest rates bodes well for financial-services stocks. But Gabelli Funds portfolio manager Macrae Sykes is taking a much longer view when selecting investments for the Gabelli Financial Services Opportunities ETF - and his approach has been working out very well for investors.
The financial media's coverage of generative artificial intelligence has been centering on Nvidia Corp.'s $(NVDA)$ dominant position supplying graphics processing units (GPU) to data centers. The data centers need the GPUs to support their clients' efforts to develop AI-enabled products and services.
Read: Nvidia's stock hits new high as it reaches this milestone level
Investors are looking beyond the current hardware story to prepare for an expected wave of innovation as companies use AI to improve efficiency and better serve their customers. Both should improve profitability.
This AI-enabled innovation wave is already in full swing in the financial-services space, Sykes said during an interview with MarketWatch.
Three interest-rate catalysts
Before getting to Skyes's comments related to AI, consider how well the table has been set for various financial-services providers.
The Federal Open Market Committee cut the target range for the federal-funds rate by 50 basis points, to a range of 4.75% to 5% last month. Assuming the Federal Reserve makes a series of additional cuts, this will help banks reverse the trend of narrowing net interest margins - the spreads between what banks earn on loans and investments and what they pay for funding (deposits and wholesale borrowings).
Declining interest rates can also help investment banks. The lower cost of funds will spur bond issuance and initial public offerings of stock. Sykes said the IPO market has been "essentially closed for four years," and that a lower cost of capital would enable alternative asset managers "to monetize their investments" through IPOs. This group includes Blackstone Inc. $(BX)$, KKR & Co. $(KKR)$ and Apollo Global Management Inc. $(APO)$, he said.
Sliding rates can feed further gains in the stock market as well, which, combined with rising bond prices, can increase assets under management for financial-services companies that run any type of investment fund. That means more fee income.
So there are three financial-services profit centers primed for improvement as interest rates decline.
This helps explain why the S&P 500's financials sector XX:SP500.40 has returned 27.1% this year through Monday, ahead of the full S&P 500's SPX 24.1% return so far in 2024. (All investment returns in this article include reinvested dividends.)
An outperforming financial-services ETF
Now let's look at total returns for the Gabelli Financial Services Opportunities ETF GABF compared with those of exchange-traded funds tracking the S&P 500 financials sector and the full S&P 500. We don't have a very long record to look at, since GABF was established in May 2022.
ETF Ticker 2024 return through Oct. 21 12-month return through Oct. 21 2023 return Return from May 10, 2022 through Oct. 21, 2024
Gabelli Financial Services Opportunities ETF GABF 39.8% 73.5% 38.8% 95%
Financial Select Sector SPDR Fund XLF 27.1% 49.1% 12.0% 47%
SPDR S&P 500 ETF Trust SPY 24.0% 40.4% 26.2% 52%
Source: FactSet
These results are net of expenses, which are 0.09% of assets under management annually for the Financial Select Sector SPDR ETF and 0.0945% for the SPDR S&P 500 ETF Trust. For GABF, the expense ratio is 0.90%; however, the expenses have been waived for the first $25 million of assets under management, until at least until April 30. The fund had $28.7 million in assets as of market close on Monday, according to Morningstar.
Active management will cost much more than the passive management of funds that track indexes. Generally, it is difficult for an active manager to beat the performance of a broad index over the long term, in part because of the higher fees. Even if GABF had been charging full fees, its performance would have measured up very well over the past 21/2 years, especially compared to the S&P 500's financials sector.
Sykes's views on AI and innovation
The Gabelli Financial Services Opportunities ETF holds 43 stocks of companies providing an array of financial services. Sykes looks for companies with "strong" financial fundamentals that he thinks are well positioned against competitors, and with expected profit-growth rates higher than those of the financial sector as a whole.
Sykes highlighted recent innovation developments for several companies held by GABF:
FTAI Aviation Ltd. $(FTAI)$ is the fund's largest holding and, according to Sykes, has been the largest contributor to its outperformance. The company specializes in leasing and maintaining aircraft engines, which has become a very important business for airlines facing delays in aircraft deliveries from Boeing Inc. $(BA)$ "Airlines have been running their old fleets longer, and air-travel demand has been intense. So engines need to be swapped out," he said.
Sykes added that FTAI can turn around maintenance work on a jet engine more quickly than airlines' own mechanics. He described the company as "vertically integrated," setting it up for rapid growth. Analysts polled by FactSet expect the company's revenue to increase by 40% this year. The projected compound annual growth rate (CAGR) for revenue from 2024 through 2026 is 19.3%. The company is expected by analysts to swing from a net loss of 42 cents a share this year to earnings per share of $4.55 in 2025 and $5.84 in 2026. "They are smart capital allocators," Sykes said.
For Morgan Stanley $(MS)$, Sykes cited how the adoption of AI technology is enabling financial advisers to spend less time on administrative tasks and more time helping clients and bringing in more assets under management. For example, the firm's new technology enables an adviser's video call with a client to be transcribed immediately, with organized notes and feedback. "So the adviser gets off the call and has a list of action points or critical components for the client," Sykes said.
During the firm's earnings conference call on Oct. 16, Morgan Stanley Chief Financial Officer Sharon Yeshaya said the investment bank is "using technology, different parts of AI and different ways to begin to appropriately match individuals with [financial advisers] we think will suit them," according to a transcript provided by FactSet.
"You can see the possibilities of all this information and mining your own book for better solutions, more contacts and bespoke components," Sykes said. "The firms who have already been successful with the technology will be outsized winners." In addition to Morgan Stanley, he holds shares of several other companies competing in the asset-management and investment-banking industries in the fund, including JPMorgan Chase & Co. $(JPM)$, $Bank of America Corp(BAC-N)$. $(BAC.SI)$ and Charles Schwab Corp. $(SCHW)$
Read: Schwab leads list of banks expected to profit most in 2025 from Fed's rate cuts
In a recent research note, Sykes cited technology investment by American Express & Co. $(AXP)$ as a contributing factor to its stellar credit-risk management. "It is worth noting that since 4Q19, the firm is the only one in its competitive class to have charge-offs (bad customer debt) trending below prepandemic levels." That was based on an analysis of credit-card net charge-off rates (loan losses less recoveries) for the fourth quarter of 2023 with those four years earlier for American Express, Bank of America, $Capital One Financial Corp(COF-N)$. $(COF)$, $Citigroup Inc(C-N)$. (C) and JPMorgan Chase.
For financial-information providers (the fund holds shares of S&P Global Inc. $(SPGI)$, Moody's Corp. $(MCO)$ and FactSet Research Systems Inc. $(FDS)$), Sykes wrote that he expected "the AI wave [to] be very accretive" because the new technology can help these firms identify themes through improving abilities to sift large regulatory filings and call transcripts.
Top holdings of GABF
The Gabelli Financial Services Opportunities ETF publishes its full portfolio list here daily.
These are the fund's top holdings, aside from the cash that made up 8.4% of the portfolio on Tuesday:
Company Ticker % of GABF portfolio FTAI Aviation Ltd. FTAI 8.3% Berkshire Hathaway Inc. Class B BRK.B 7.5% Blue Owl Capital Inc. OWL 4.9% SuRo Capital Corp. SSSS 4.7% Wells Fargo & Co. WFC 4.1% FactSet Research Systems Inc. FDS 4.0% Paysafe Ltd. PSFE 3.7% Charles Schwab Corp. SCHW 3.7% JPMorgan Chase & Co. JPM 3.7% W.R. Berkley Corp. WRB 3.7% Source: Gabelli Funds
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October 26, 2024 08:27 ET (12:27 GMT)
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