The big bet on AI

You know, companies have become sort of value stocks at this point. So that's actually becoming interesting. They've had such a headwind this year that the valuations might actually change the classic kitchen from growth to value. Hello and welcome back to Citywire USA's latest podcast, The PB Pod, where we will be interviewing some of asset and wealth management's most significant names. I'm your host, Tania Mitra, Deputy Editor of Citywire Probuyer, and today we have with us BlackRock's head of Model portfolio solutions, Michael Gates. Thank you so much for joining us today. Pleasure to be here. Thanks. And then I want to start with AI. You've been a huge proponent of AI and you've been very consistent with the AI team and you recently concentrated your tech position there as well. Can you walk us to why? Sure. I mean, we identified this as something that was really important in investments a couple years back and we have a great fundamental team at BlackRock that is focused on the technology segment. And after some conversations, they went ahead and built an active ETF, which is BAI, that we allowed to kind of season for a bit and we're excited to begin investing any year ago. And that's been a huge success. It's had tremendous performance, given a great exposure to the theme. And if you compare what happens when you are dedicated to that theme versus kind of broad investing into the SEA technology index, you see a pretty big difference. And I guess to your question is to why it's a profound technology. The the use case for it wasn't necessarily as visible to the average person as it is today. And I think in corporate America, the use case has become very evident with the advent of some of the new tools that are coming out from the frontier labs. And it's a still I think a good theme to lean toward. Number one, there's no leading against it really. It's the performance of AI names is driving what's happening with the broad market indices globally. We've seen that this year. We've seen that in last 12 months. But with respect to the fundamentals, there has been a major shift in the first six months of this year, which is that the frontier labs themselves are reporting operating profitability including for training and inference. So that's that's a huge change because one of the concerns that was out there was that those labs were not viable business models. And I think that that is largely behind us at this point, at least based on what we're seeing right now. Yeah. And I'm curious, what does this mean for just AI versus other equities, particularly in tech as you said things are changing these are either profitability or bottom line. Do you see opportunities elsewhere at all in equities and tech specifically? In tech specifically, you know, software companies have become sort of value stocks at this point. They've they've had such a such a headwind this year that that the the valuations might might actually change the classification from growth to value. So that's interesting. I'd say outside of tech, looking at tech beneficiaries is an interesting theme. It's it's easier said them done. We're using an active manager again for this manager with very high performance relative to peers in in the ETF BLCR. And their method for stock selection focuses on their own internal estimate of earnings for the companies and what they like to see are companies with earnings that they expect over the next 12 and 24 months that are substantially ahead of what the consensus is such that you know, you're you're buying a company at a lower price than that's really worth. And many of those companies are companies that are effectively deploying AI into their operations. So I think that's an exciting theme. It's it's not very easy actually to find companies that are putting AI to use profitably, but I think it's going to be important, especially over the coming months and years. Yeah, I do want to touch on one thing you just said, which is how software is becoming more value oriented. And that's because of you know AI. I'm wondering are there any other similar shifts that you're seeing these are we asset classes and sectors that are being driven because of this as well. I think it's most profound in the software segment. You know, the tech segment itself is pretty dominated by AI now to the upside and to the downside. So one thing we're really focused on is just getting at the the health and direction of different segments of the of the tech market tech tech and comm services now are over 40% of the S&P 500. So it's super relevant for everyone at this point. Yeah, and I'm really glad you bring that up because I was going to ask what this means for diversification. Obviously diversification is one of you know, very basics of investing itself. And AI is touching everything as you said. There's going to be winners and losers and that's across sectors. It's not just tech. So what does this mean for diversification? You know, how are you assessing that now? Well, I guess I'd look at it two ways. One would be just within equities, right? And so within equities, we still want to have some investments outside of tech. Certainly we do. And the models I manage. So building a diversified portfolio of stocks is important. And and and stocks are have been diversifying to each other. If you look at different sectors here, their performances, there's been an incredible dispersion actually in terms of industry and sector performance. But there is an opportunity there to maintain and obtain diversification outside of stocks. Of course, if you're building a client portfolio, typically you're looking at a stock bond mix for your benchmarks. So the the most popular one being 60% equity, 40% bonds. And so the question mark then can fall onto the bonds and how to achieve diversification with bonds with fixed income. And so we have a number of thoughts about that that are specific to the current environment. Would you want to share a couple of those thoughts? Well, sure. One thought is that credit spreads are incredibly tight. And if you look at the performance of credit as an asset class, taking away the rate sensitivity. So the the interest rate duration portion of the returns from credit bonds, you see that credit is highly correlated to the stock market. So in that way, it's not diversifying to that 60% of the portfolio. So one of the moves we've made this year is to go actively underway to credit risk. And the reason for that is that credit compensation or spreads are in the bottom, 10 20% of history at this point. So it's only been you've only been paid less about 10% of the time historically to take on credit risk. And so we think that's one obvious lever to pull is to step away from things that have a lot of risk, but don't have upside. Because a bond, you never make more than the yield to maturity, right? Unless there's some kind of provision to convert into equity, you're going to get the yield to maturity. And so when when we see bills and spreads so tight, that that is a red flag. The other thing I'd point to is on, you know, pressures themselves. The Fed is fighting inflation from above right now. That is to say, the Fed is looking at headline inflation that is above target core inflation as well. And so, you know, that's not an environment that where you see treasury bonds moving the opposite direction from stocks in terms of prices. So there's this notion of risk parity that you can build a better portfolio by having long duration treasuries and being long equities. And you get a lot of risk offset there. That's not been the case in the last three years. So that's that's not a solution. Yeah. And I'm curious whether you see this changing because yeah, in your recent most recent trade, you did add a liquid alls, you know, ETF to act as a diversifier because of all the reasons you just mentioned. But do you think that's going to change? Because when we last spoke, you kind of said that this has been happening for a couple of years now. So like why? And is that going to like us change? You think? That's a great question. I do think it's going to change eventually because I think that the bigger picture here is that we're in a productivity boom. That productivity boom has been visible to us at BlackRock since the second half of 2023. And at some point, the chickens are going to come home to roost on that, which is to say the core inflation is going to reflect the innovation, which is going to be deflationary. And indeed, in the most recent CPI report, if you took out what was kind of a weird housing component contribution to core inflation. The inflation number actually looked pretty good to us. So it is potential that we could be in an environment and the tariff inflation on the good side, that's no longer visible in the data. It's actually worked through the system at this point that the tariff, the tariff strip of some inflation increase. So now what we're left with is kind of a headline inflation that's high and the Fed is responsive to that. So we're still facing that. I think as long as that's the case, you're not going to see this diversification benefit from Treasury bonds that we historically saw. But I think at some point in the future, that can change. Again, the thing that's driving the positive and out correlation between Treasury and bond returns, primarily we think is inflation. And the headline inflation rate has been persistently higher than the Fed's target for some time. So it puts the market on notice that higher short-term rates from the Fed policy is a potential. Once we see that fade away, I think you could return to a more normal environment. I'm curious if that decision to add the All's Fund in your recent trade was that kind of also informed by changing expectations around what the Fed might be doing for the rest of this year? In some way, I suppose, I'm saying at some point things could return to normal, but I don't know when. With respect to when is the Fed not going to be fighting inflation from above? And so in the meantime, you don't get that diversification benefit from Treasuries. Well, you don't get a lot of return conversation from going to credit as an alternative to Treasuries. Okay. So what do you do? Historically, in the models, I think we've done when we faced off against the bond market that has issues, has been to consider alternatives funded from fixed income. So back in 2021, we introduced a commodity exposure and then in 2024, a broad commodity exposure, and then took that out a couple of years later. And then in 2024, we introduced a gold position that we still hold. It's been very successful. We trimmed that in March. And then just now in June, we add this liquid alternatives. Now, why did we choose to do it now? Two reasons. That the product itself is extraordinary. It's the IALT product. It's a highly diversified, very high skill collection of hedge fund strategies. Over a thousand signals, driving it. We know the team very well. We know the process. And we have other products from the team that have outstanding track records. So based on its own track record and based on the track record of what the team delivers, we're very confident this is a high skill, long short equity, and global long short macro alternative exposure that's highly diversified. And that's important because you want to have with all multiple drivers to the strategy and you want to have conviction in the manager. That's very hard to find in 1940 at compliant, 1940 at structure liquid alternatives. It just is. And IALT is very good in that regard. And because it's that good, the basic path of it looks pretty attractive to us from a capital market perspective. We see returns coming off this more than 50 to 100% of what the yield is on the Barclays US universal bond index, for example. So that's the kind of payoff we see coming from this relative to what we're funding from, which is fixed income. And then just on the Alts portion of it, kind of outside of liquid Alts, but we are seeing a public private convergence and that's coming into model portfolios as well. Can you speak on that a little bit and what kind of role this public private convergence you think is going to happen is going to take place in model portfolios? We've been using some what are called interval funds to get exposure to liquid alternatives both in private credit and private equity. And certain models, I think the that structure is very useful for providing access to a broad set of households. Typically we're trying to keep the allocation to 20% or less because there is a provision with these interval funds that the redemption side can be gated in the event that there's more redemptions coming in than there's cash in the funds to support. Long term private equity and private credit are really driven by the manager skill in our view and rather than by the asset class itself. But in these cases with the private credit and private equity interval funds that we're using, we have that conviction with these managers they have excellent long term track records and a process that gives us confidence. Do you think that exposure is kind of like for instance you added that liquid all is fund because of the correlation in the bonds and equity side is the private market allocation kind of akin to that or do you see it as different as just providing access to that realm of products or investment of opportunities. No I think the private is quite different. And with respect to the liquid all just to be clear the lack of correlation, negative correlation between treasuries and equities helps motivate it. But the main motivation is that that last thing I said about the high skill and the kind of our expectation that it's going to give us something well above what the funding vehicle is giving us in terms of total return. So that's the main motive and that's not as sensitive to any correlation. On private equity and private credit, private equity goes into the equity sleeve and private credit would go into the bond sleeve. So we think about them as being very much akin to the traditional equity and fixed income type exposures in terms of their correlation. I just want to go back on the macro perspective for a quick second because I know we talked about inflation, we talked about what the Fed might do. What other, I know the war in Iran is going on. What other kind of macro factors are you really taking into consideration right now and how are you navigating them? Well, the thing that's been very important is been to keep an eye on what's happening with the AI investment cycle because at this point it is contributing over a point to global GDP. So it's something we're paying a lot of attention to. At this point in the United States, there's a significant capital deepening happening, which is positive for long-term productivity in addition to the technological advancement, which itself is also adding to long-term productivity. So that's happening right now at a higher scale than it was last year. And the productivity expansion that is to say a productivity growth rate greater than 3% has been going on since the second half of 2023. So we're in the midst of a productivity boom. It seems like the drivers for that are pushing toward even higher rates of productivity growth in the out years. So then what you're left with as far as important topics is inflation and the consumer. And we're seeing mixed indicators on both, as I mentioned with inflation earlier, and with consumers continued spending is evident. Some portions of the spending population are not growing their spending as much. And there's kind of a K-shape idea out there, and I think there's some truth to that. So that's something we have an eye on, but continues to chuck along. One other thing with regards to AI that I want to touch on is how you're viewing it outside the US. I know that you had made some moves around this as well in your most recent trade. So if you can just stop us through that thinking, because AI is a global phenomenon, but it's happening at different places and it's happening differently. So what's it looking like for outside US? Well there are exposures that are important outside the US. There's a very important company out of the Netherlands that makes semiconductor equipment kind of unique one. There's a couple of very important companies in South Korea, a few in Japan. So AI is not just a US phenomenon. And I think that this AI adoption and infusion of AI into corporate operations to raise margins, is something we're going to see globally. I don't think it's going to know any borders. Moving away from AI for a second, I want to talk about the changes happening in the model portfolio world itself in terms of customization, because that's a huge trend that I want to say has been taking place for a couple of years now. advises are outside. more of that investment, you know, responsibility to focus elsewhere. What are the biggest things in this customization, you know, race almost that you're thinking about and that's taking shape? - Well, there is a sort of race happening. And I think that race is driven by a competitive dynamic that advisors and advisor groups that use models in a model's based practice introduce a lot of efficiency and scale into their operations. And they also, for their clients, when these BlackRock model have enjoyed really strong relative performance. And so the customization part of this makes it so that the advisor can see their own kind of fingerprint on the allocations and can speak to specific exposures in the asset allocation that they have conviction in. And so when a advisor works with BlackRock to build a custom model solution, our team will design a process so that the investment guidance that's coming out from the model portfolio solutions team translates into a custom model. And typically what we look to do is to make sure that the major kind of changes that are happening in asset allocation manifest in that custom model, but with the particular exposures that the advisor prefers. And so that's been very successful. We're continuing to see strong growth in that business here at BlackRock. - Okay. And then one of the other things is, I guess the overlays, I know advisors are thinking about tax management, maybe I don't know, option strategies and all of those things. So how's your team navigating that? Do you have models that cater to those needs? Yeah, just how's your team managing that? - Absolutely. I think that's been very important and it's growing as a portion of the customized models that we are building. Let me just take each part and turn the use of separately managed accounts. We have a great offering here at BlackRock from a period. And one of the many benefits that advisors and clients get from using a separately managed account is what you mentioned, Tanya, which is the ability to manage taxes. And so when a client is holding the underlying, something tracking the underlying index, a couple hundred stocks, because of the dispersed set of returns that come off those stocks, there's an ability to harvest losses from them throughout the years. And that can then offset any gains coming from other parts of the portfolio. So that's a real economic benefit. We call it tax alpha. And on the option side, similarly, you can use options to manage positions that you're holding at a gain and kind of work out of a, say, you had a large position that you've been carrying. You can work out of that over time using an option strategy and kind of deal with the taxes at your own pace rather than doing it all at once while managing risk. - I'm curious what you're hearing from clients on this run. And we just talked about some of those things that are like crucial and what they're looking for. But are there other things that they're asking for than maybe the industry's not there yet, or just that you're working on or thinking about? - I think the clients right now, just my impression as having spoken to a lot of them are happy to work with us just navigating what's happening in the stock and bond markets and in the commodity markets. So in terms of what's new, certainly, a lot of questions about our SMA offerings from a period, a lot of questions about the options overlays from spider rock, a lot of interest in the active ETFs that have become more prevalent in the models. But by and large, I would say that the, the what we call surround sound communication that we deliver to clients that explain what the important themes are in the portfolio and why and how we're investing. Those have been very important this year that's been very well received. And we've been having more conversations than ever with our clients. - Yeah, and to that point, I feel like the relationship is changing a bit as the priorities of the advisors kind of also shift. And so as the Asset Manager, as the model provider, you're kind of absorbing some of those responsibilities. So can you talk a little bit about that relationship change and what's the nature of that? - Well, that's what's so amazing about a model portfolio is that it really does take a big part of the work and moves it to the Asset Manager BlackRock. And so these customizations, we just discussed are certainly in the mix, but those don't need to be reviewed every month. And so for the Asset allocation, our teams here at BlackRock are working on this constantly. So there's a constant set of work happening. So it's just kind of classic gains from trade. It's both parties are made better off. We have a huge number of subject matter experts who are able to drop on for these Asset allocation questions and advisors recognize that, that the scale at which this being done is something that they wouldn't want to attempt to replicate on Asset allocation decision making. And it's very effective, our performance shows it. - Kind of to end with, I wanted to talk about the future a little bit with you. As someone who's been in this industry for so many years and you're running such a big model portfolio suite, you've seen all the changes that are currently happening with AI, with customization, all of these things happening. What do you think the future looks like for model portfolios specifically, but also just more broadly how that advisor and relationship changes as the markets also evolve? - A couple of things. One is the points you mentioned around the use of sophisticated tools like simple managed accounts and options. I see that as a trend that's clearly visible right now with what's happening with a period and spider rock at BlackRock and I think it's gonna continue. And then I think that there's a real potential for, just as model portfolios have driven scale and efficiency into advisor practices for advisors to interact with BlackRock in a new way over time as we incorporate some tools from AI potentially. So I would say over the next several years there's a real potential for that. - Thank you so much, Mike, for your time. It was great having you on and I'm super excited to listen to the end product. (upbeat music)