MASTERCLASS: ETF Product Evolution - May 2018

Passive strategies are on the rise and the strategies available in an ETF wrapper are multiplying. In this edition of MASTERCLASS, three industry experts share their views on where the market is headed.

  • Christopher Davis- Chaiman and Portfolio Manager at Davis Advisors
  • Allison M. Fumai- Partner at Dechert LLP
  • Jodie Gunzberg, CFA- Managing Director & Head of U.S. Equities at S&P Dow Jones Indices
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    • 46 mins 45 secs

Gillian: Welcome to Asset TV, I’m Gillian Kemmerer. Passive strategies are on the rise and the strategies available in an ETF wrapper are multiplying as new entrants hit the market and ETF construction becomes more sophisticated. How should you think about your allocations? Today I am joined by experts across the spectrum to share their views on where the market is headed. Welcome to the ETF Masterclass. Thanks so much for joining us here today everyone. We have a nice variety of representation across the ETF industry here today and across indices as well. So it will be a really interesting discussion I think. Allison, I’m going to kick it off with you. And this is a question I’ll pose to all of you. You all have storied careers in the business. Tell me a little bit about how you’ve seen Exchange Traded Funds or products really develop across the course of your career? Allison M. Fumai: Sure. Well, there’s no doubt that assets have increased in the ETF space over the last 15 plus years. Where those assets have gone has expanded dramatically through that time. Where we started with some of the bigger name indices like the S&P 500 and others, we are now seeing a lot more indices, a lot more specialty developed smart beta indices and back in 2008 we saw the introduction of the active ETF wrapper, which while still a minority of the ETF assets, continues to grow. And year after year we continue to see more players coming into the active ETF space. And as regulatory developments occur we hope to see more of that in the future as well. Gillian: So new players, more sophisticated strategies, more indices, just an explosion, I suppose, of talent and interest? Allison M. Fumai: Correct, and more variety for investors. Gillian: Excellent. Jodie, how have you seen it change? Jodie Gunzberg: When I first started my career it was just at about the time that the SPY launched. That is one of the ETFs on the S&P 500, and they just passed their 25th year anniversary. I had not heard of an ETF back then. The first time I heard of an ETF was probably around the year 2000. And I was in active management at the time speaking to another active manager who ran a strategy of selecting only ETFs. And I asked, “How many ETFs do you have in your universe to pick from?” And he said he had about 100 that he picked from, which I think at the time looking back was about a third of the available ETFs. Today we see over 5,000 ETFs available listed globally. So the industry has grown tremendously. And it has grown from everything, from the most passive indices to more active strategies. Gillian: Now, Jodie, it might make sense as the index provider on the panel to start with a bit of a definition. What is the difference between an index and an ETF? Jodie Gunzberg: I’m glad you asked that, because that’s an important distinction. An index is really just the result of a set of rules from a methodology that may define what the eligibility criteria of constituents are, the weighting schemes, the rebalancing and the reconstitution. The results of that are the printed level of the index, which then serve as the underlying for the ETF or any other available wrappers. It could be mutual funds, it could be derivatives, again an ETF is just one of those choices. But it’s very important that the index is kept separate from the securities pricing that goes into it, and the product creation, in order to maintain the independence. Gillian: Okay. That’s a helpful definition for us as we move forward. Now, Chris, the fact that I’m speaking to a traditional active manager about the progression of the Exchange Traded product industry is interesting in and of itself, tell me a bit more about how you’ve seen it progress? Christopher C. Davis: Well, I think there is a great analog here. When our firm started more than 50 years ago we were institutional managers. So that meant we managed money for endowments and pension plans and high net worth individuals, this sort of thing. And one of our advisors who had referred clients to us came to my father and said, “Well, could you offer your services as a mutual fund?” And his first reaction was, “Well, you should go to a mutual fund shop, we’re institutional managers.” And of course that’s when the scales fell from his eyes and he realized, really what we have is a truly active, research driven, long term investment management discipline. But the way in which we package that service, we can offer it in whatever vehicle best suits the financial advisors. So we started with mutual funds about 50 years ago. And then about 3 years ago a financial advisor came to us and said, “Well, what about an ETF? After all you have low turnover, you’re a large…” In fact our turnover is lower than some of the indexes. And they said, “So couldn’t you offer your services in the form of an ETF, because I have clients for whom an ETF structure has advantages. And maybe around the tax structure, the ease, they’re on an ETF platform.” And so the same thing, our first reaction is, oh no, ETFs, they’re passive, there’s something different. And then realizing, no, it’s a structure through which we could offer our services. And I think we were the first true active managers in the equity space with a long term record, sort of a proven approach to offer it in an ETF structure and we now have four of them. Gillian: Well, Chris, I’m going to stay with you for a second because my next question was going to be, how have you seen this explosion of investor interest in either passive vehicles or strategies, how has it impacted your business? It sounds like you’ve been very responsive to that investor demand for these more liquid products. Christopher C. Davis: Well, I think one of the things we understand is that the draw of passive, to passive has been based on the assumption, which is true that over time the average active manager has underperformed the passive indexes. So this has led to sort of a wave of acceptance, including some regulatory pressure that pushes people towards passive strategies. And they should look more deeply because there’s something about passive that is very positive, which is, it has low fees, it has low turnover, therefore it’s quite tax efficient. And it also has this philosophy of being in some ways long term, in the sense that there’s not things being traded in and out every day. But yet if you look at the characteristics of proven successful active management, you can have those same characteristics. You can have reasonably low fees, a long term time horizon, and the opportunity to generate results that exceed the indexes, and so when people say, “Well, what are those characteristics?” Well, it’s of course we want to have modest fees, and alignment of interests. You know, that large cap, low turnover orientation and looking different than the index, what they now call Active Share. But you put those characteristics together and what you see is there are active managers that have outperformed over a long period of time. And I think in the ETF space there are investors and advisors that were ready now to say, “Well, if we want the opportunity to outperform, do we have a vehicle available?” And so that’s where we saw that growth in passive, then creating this opportunity for people within that to say, “Where is there an opportunity to have an active manager in this ETF structure?” Gillian: Excellent. Now, Allison, coming back to you, when you look at this kind of explosion of investor interest in passive vehicles, I’m curious to know, what opportunities and challenges have been associated with this increase in interest, and probably the number of product launches, you deal with those every day? Allison M. Fumai: Sure. I think that one of the things that this explosion has really done is expand the possibility of investments by clients. And while you’re right, there are some clients and investors that come out and say, “I want something in a passive wrapper, I believe in passive management.” We’re seeing more and more investors, especially those that are in the traditional mutual fund wrapper, also think about it in an ETF wrapper. And we’re seeing that not only in the proliferation of active ETFs, but also the more sophisticated indices. So again we’re not seeing the old S&P 500 ETFs anymore. We’re seeing Smart Beta Indices. We’re seeing Alternative Asset Class Indices, which then could easily be translated into the active ETF wrapper. So I think that the opportunities for investors are huge. And the distribution opportunities for asset managers are just as huge because you have the expertise, just like you were saying, well, why limit yourself to just one wrapper. If there is demand in multiple wrappers, take that expertise and put it in each of these wrappers, to the extent you meet the regulatory hurdles. But some of those regulatory hurdles over the years have loosened a little bit, which has allowed for some of this proliferation. Gillian: And, Jodie, obviously Allison just alluded to this, but we’ve seen the rise of the custom index etc. So as you see kind of these new indices coming to market, this investor interest, how has it impacted the way the S&P manages its business? Jodie Gunzberg: The S&P 500 really started as the core. And from there many strategies have been developed. We manage over a million indices a day, the industry has over three million indices printed, which has again shown that there’s an ability to move, not just from this market cap weighted, beta representation of the market. But that many changes can be made in order to provide the index strategies that are demanded by the market today. Gillian: So I want to take a little bit of a focus toward the regulatory side, because, Allison, you’ve mentioned a few times already about some of the regulatory hurdles etc. How do you think about this ETF rule that’s coming up, it’s going to impact everyone who’s sitting on this panel and watching? And what are you hoping to get out of it? Obviously we’re still unclear on what its final iteration will look like. Allison M. Fumai: Sure. And just a little background for those of you that heard Dalia Blass’ speech and looked at the reg-flex agenda, an ETF rule is on the horizon. To some extent I think we’re going to see more of the same, meaning allowing passive and active ETF managers to get into the space without this one hurdle of exemptive relief, although it does prove to be a smaller hurdle these days. What we’re really hoping to see, which would be beneficial for both passive and active managers, if it does hit both, is flexibility and basket construction. Which what that really means is at the beginning of every day or before the market opens an ETF puts out the basket of securities that will accept on a create and go out on a redeem. Right now the regulatory relief afforded in these exemptive applications for the newer applications, say post 2008, really is pro rata slice of the portfolio, except in limited instances such as rebalancings, sampling in certain instances, which really leads to some inefficiencies, especially on the active side. So what we’re hoping to see is a little more flexibility around those baskets, with certain controls that the SEC gets comfortable with that actually benefits the managers from being able to more efficiently turn over their portfolios. And then from a tax efficiency point of view, really benefit the underlying investors. Gillian: Excellent. So I feel like we have a really strong picture of how all of you have grown up in this industry and where we are today. So I’d like to maybe start to shift and think about more specific opportunities, risks and regulatory issues or opportunities. And actually, Jodie, I think I might kick this off with you. You always kind of set the scene with the definition. Give us a sense of the difference between active and passive at its core? Jodie Gunzberg: That’s a really interesting question because there has been sometimes some difficulty in understanding the difference between passive and active. So first I would start by separating passive and beta. Beta by definition is the market risk, the systematic risk. An index like the S&P 500 that represents the US equities market, can be considered beta. However, an index like the S&P 500 equal weighted, which overweights smaller cap stocks at the expense of larger cap stocks can be considered passive, but it’s not beta, it’s not the way that the market looks. So I might associate passive with more of a process that can be replicated in an indexing format. But it’s not really beta in many cases. Some of the strategies are beta, but some move along the spectrum from beta to alpha. But in an index, in something that’s passive would be that the history of the index cannot be continued if the rules change materially. But in an active strategy, if a manager changes the rules or the process it is possible to keep that track record going. Gillian: Interesting. I feel like we just see that blanket headline, active versus passive all the time. But there’s some really important distinctions that need to be made when you’re defining the two buckets. Allison M. Fumai: And I think where the confusion occurs is from the regulatory point of view, there truly is black and white but not along the same lines as you describe. Basically they define passive for these regulatory reasons, as any fund whose investment objective is to track an index, no matter what that rules based process is. And everything else is active. So there’s definitely confusion in the market between the use of the terminology, passive and active and the way different folks in the industry define it for different purposes. Gillian: And I think this is a good time to bring in Chris, obviously you are an active manager within an ETF wrapper, help us understand some of the opportunities and challenges with running your strategy within an ETF? Christopher C. Davis: Well, we’re particularly well suited for an ETF because we have very low turnover, meaning that we’re not making a lot of changes. I think there are a few misnomers, and you’ve done such a good job at separating out this idea of passive, versus index, versus beta, because some of the things that people don’t realize, they’ll think, well, I’m in an index, an index fund, it must be very diversified, for example. And for example, we run a financial ETF that is based on the long record we had, 25 years ago I started our financial mutual fund. And since the XLF, or the Largest Financial Index Fund, ETF started, we’ve had about twice the return in our mutual fund. And yet the ETF is much, much larger because people say, “Well, we don’t want to be active, we’ll just take the financial index.” What they may not realize is nearly … over 40% of that index is in five stocks. So there’s an assumption, well, I’m in an index, it must be more diversified but it may be more concentrated. Then there’s the second assumption, well, I’m in an index, it must have very low turnover. And when you look at some of these indexes that have, you know, value or growth or mid cap value blend or some … there’s a lot of coming and going every day, every week, every month, however often they adjust the index, but a lot of new buys, a lot of things being taken out of the index. So in a sense our approach was, well, we’re active managers because we study each company individually, we value it, we want it to be our best ideas. It’ll look nothing like the index. In that sense we’re active. But we also had these characteristics of having low turnover, so very long term time horizons and also having the fiduciary sense of responsibility that we want to be well diversified. We want to think about stewardship as part of what we do. So if there’s an index that’s producing a crazy outcome, like super concentration in a few mega names or some of the global ones where they’re way over-weighted to state run enterprises and, you know, big state banks where you think, well, that’s a lot of concentration of risk in these small subsectors. Then we think the active layer of judgment helps sort of moderate that. So it’s another example where I think the terminology gets blurred and the assumptions that people have don’t stand up to the closer scrutiny. Gillian: Now, I’d like to talk a little bit about the market environment that we’re in because I think that, you know, at the moment we are faced with a bit of political uncertainty, even though equity markets, while increasingly volatile, slowly have weathered the storm pretty well. So, Jodie, I’ll start with you, when you look at some of this near term uncertainty, how do you approach it from the index perspective, and how does investor sentiment play into this? Jodie Gunzberg: There is two different ways. So one is by the transparency, the liquidity, the lower fees. That’s a hallmark of the pressures that we’re seeing today. And it’s something that we really strive to deliver in indices. The other thing is more of a focus on a top down analysis rather than so much bottoms up, because the indices can cover broad markets. So in today’s sort of environment where we’re seeing possibly rising inflation, interest rates rising, a falling dollar, GDP growth. It tends to have favored the small caps through history. So we’re seeing more possibilities perhaps for small caps, maybe for growth, even for mid caps than we are in the large cap space that just had the biggest outperformance over the smaller companies since 1997. Gillian: Now, Chris, when you think about the opportunity set as well, what are your thoughts on this market environment and how do you deal with investor sentiment and perhaps some skittishness around volatility? Christopher C. Davis: Well, you know, there’s such a disconnect between what we read and see on TV every day, and just sort of this statistical overwhelming data. So in other words, every two and a half years on average, the market has declined 20%, right. Now, if the market were to decline 20% tomorrow there’s no newspaper on earth that would say, “Well, we were overdue, it’s been about eight years or nine years, this is to be expected.” And so people are going to say, “Route, pandemonium.” The market went down 1% a couple of days last week, and every day I’d open the paper and I’d see these words, ‘route, panic’, you know, ‘collapse’. And so there’s this sense that there is a … well, that there’s a market for sensationalism, and that wreaks havoc on the investor behavior side. And so, you know, I often say that if you think about the weather channel, the weather channel is not in the business of predicting the weather, it’s in the business of selling ads. And to sell ads they need viewers, they need excitement. So they need a storm of the century or a snow apocalypse or a heat dome sort of every few weeks to keep people excited. And the financial markets can be like that. They can create this sort of sensationalism. And the downside of that is it really makes investors more likely to panic. And I think that when you see this volatility just creeping up from these historic lows, a huge run in stocks, normal corrections to be expected, the trouble is that it really makes people anxious. And I think that’s really where the role of the advisor comes in. In a lot of this low fee, minimized fee world, people are forgetting the value of the advisor goes up dramatically when there’s more volatility, when there’s these sorts of headlines. So I would say we’re in an environment where I would expect higher volatility, more unsettling headlines, ups and down days. And so this is a market where the opportunity to add value by simply calming people down is enormous. And I think this is where that move from self-service and robo investing, back to the advisor could be very pronounced if this environment really gains steam. Gillian: And with an increase in volatility there’s often some opportunities for active managers. I’m going to dive into some of those opportunities you like in a moment. Allison, I want to come to you for a second. I want to talk a little bit about some of these non-fully transparent active products. We don’t have a whole lot of regulatory clarity yet, is that true, what are you expecting? Allison M. Fumai: So we have seen applications in the last 10 years for an ETF wrapper that would not require full portfolio transparency. And one of the great things about your story is if you go back 15 plus years, a number of equity managers said, “Well, I can’t run my mutual fund strategy or some variation of it within a fully transparent environment.” Luckily, quite a few asset managers have gotten past that, but there’s still a school of thought among many asset managers that they don’t want to do so. So what we’ve seen in the last year and a half or so is more movement in those applications. And there’s different varieties of those applications. But ultimately it does not require full transparency of the portfolio, more like mutual funds with offering products in an ETF wrapper. And some of the concerns that the SEC addressed in a public pronouncement back in 2014, the ETF industry has really done a great job of whether you call it resolving their concerns, addressing their concerns, finding ways to really show the regulators that this is a viable product that can meet the concerns of the regulators. Now, the big question being is that these applications still have to go up through the commissioners, three of whom are new, new chair, and so more to see on that front. But I think the amendments we’ve seen in the applications and the responses to the SEC issues addressed back in 2014, really is profound. So I am hoping that that’s a good indication of where this is going, and a little bit more of a kind of settling sentiment in the eyes of the regulators and more comfort with ETFs, such that they can move to this next step. Because I do think if we are able to move to this next step, that group of asset managers that have always been uncomfortable with full transparency can kind of come to light more strategies, even amongst those that are comfortable in certain strategies, may be able to come to light and really allow for investors to have more opportunities and more choices out there. Gillian: Now, beyond the non-fully transparent active, is there anything else you’re awaiting regulatory clarity on that you think will really impact the product managers in a positive way? Allison M. Fumai: So I think that both the ETF rule allowing the flexibility that we’ve spoken about already, that again will be a huge benefit to investors, along with just the ability to add more diversification to investors that want to see something in the ETF wrapper, are the most profound. And frankly, the most profound we have seen in the ETF wrapper since the approval of actively managed ETFs. Gillian: So stay tuned, we’re going to have a lot of interesting things to talk about at the end of the year. Jodie, how do you see investors using indices as passive strategies have grown in general in interest? Jodie Gunzberg: Again the demand from investors to grow from just the basic beta into other strategies has been tremendous. And with the volatility in the market we see opportunities coming from ETFs on indices of other asset classes, multi strategy sorts of indices that can underlie ETFs, everything from your separate asset class of equities, fixed income, commodities, going into things like infrastructure, real assets and retirement date strategies. Where you can combine all of these different asset classes in order to reduce risk, and then there’s another side of the equation where people love the volatility and love the risk. And they like their concentrated ETFs, the sector indices, even in commodities, single commodity indices, leverage inverse. They are going for the VIX. I mean again the volatility is not really a bad thing in indexing. It just opens the door for more strategies to come out based on the investor demand. Gillian: And speaking of more strategies coming out, obviously, Chris, we have an actively managed strategy here. It’s interesting to get to ask this question on an ETF masterclass, I don’t normally. So tell me about some of the opportunities in the market you like right now. Christopher C. Davis: Well, I think that a lot of the opportunities in the market are being created by the general move towards indexes. In other words I think that what’s happening is you’ve got, you know, a small group of active managers in Ohio, like the hedge fund space that are very interested in short term results, managing predictable results, they’re terrified of down years, they have a very short term oriented investment horizon. Then you have by and large, indexes which are very long term, structurally somewhat inflexible. And you’ve got this middle ground that I think is where the real opportunities are opening up. So that the opportunities that can play out not over weeks or months, or even a year or two, but can play out over a half a decade or longer. So I would say that the big areas would be, I think, broadly in financial services. You know, the memories of the financial crisis are finally just beginning to recede. But every time there’s a little uncertainty, the financial stocks go down because people remember how bad it was. And I think what they’re failing to see is that in a sense, financial services is as low risk as it’s ever been in more than my career, maybe in the last 50 years because capital ratios are so high, lending standards have been significantly improved. So you have less risk, you have great profitability and you have the likelihood over the next decade that dividends will be rising steadily, share counts will be going down. And I think what will happen gradually is people will start to realize these are conservative, safe and ultimately, dividend growth vehicles, trading at 30 or 40% less than the market. So I think that’s one category. I think the second category is global, that around the world you have such inefficiencies created because either they’re the cap weighted indexes or they’re geographically weighted. So the opportunity to own wonderful companies that might not be the largest in an economy, to be flexible, the opportunity to add value almost all of over the global and international indexes, just wide open for us. And I think we have a long record of doing that, that’s sort of expanding. And I think people are going to look at some of these passive international vehicles and say, “My God, I’m going to add a 100/200 basis points.” Lots of managers with records of doing that, maybe now we’ll see others. But right now we still seem to be fairly alone in the ETF space in offering that. So I think international inefficiency is another whole category, we’d expect opportunities to stay wide. Gillian: So, Jodie, Chris was talking a little bit about financials, which brings up a larger question. When we think about the different variances that investors have access to, you know, on one hand we could look at the broad sector, on the other hand we could look at an active manager, what are some of the opportunities in between? Jodie Gunzberg: There’s a wide range of how we classify the sector. So the sectors are the broadest classification in the … we call, GICS, it’s the Global Industry Classification System that S&P developed with MSCI a number of years ago. And the financials are a sector. But inside of the sector are industry groups and then more granularly there’s industries and sub industries. And there are ETFs available on some of the more granular groups, some of the industry. So if you were to look across what’s available there are not only narrower slices like in financials for example, banks can be a slice, whereas insurance companies might be another slice. So you can arbitrage that in your own way if you have a view on which sub industry may outperform. And then within that too there are also different weighting schemes. So just because it’s financials, doesn’t mean that it’s market cap weighted. There are equally weighted financials or there are revenue weighted financials. So there are many different types of weighting schemes and slices of the indices that do allow for opportunities, that sit somewhere in between your most passive or beta strategies and the more active strategies that may be bottoms up in picking stocks. Christopher C. Davis: And, Jodie’s hit on something very interesting too, which is when a broad sector like financial services is in favor, you can get a lot of outperformance happening in a single subsector. So I mentioned the broad financial index has about 40% in five stocks, four of them are mega cap banks. And there’s a lot of danger when that happens. If you go back, and remember in 2007, because we’ve been running this financial fund for a long time, and I was so irritated that there was one fund that was always at the top of the performance chart. And I won’t say who the sponsor was, but it’s x company’s home finance fund. And it was the number one performing financial services fund for 20 years. And of course it was in Fannie Mae, Fred, well that fund doesn’t exist anymore. It almost literally vaporized, I mean it just collapsed; it was all in a single subsector. And sometimes when a sector’s hot people want more of the subsector that’s driven it, and you can get additional risk within the risk. But you also can get diversification from that, people could say, “Well, now I can use an ETF to reduce my risk to that single subsector and look at others.” But it is amazing, even within that broad category how you get those anomalies. Gillian: So, Chris, you gave us an example that sometimes we see some anomalies created in international investing in the indices. Can you give us a specific example of a stock maybe that really serves to illustrate this point? Christopher C. Davis: Well, I think it’s amazing how people on Wall Street still think in terms of geographies, like, “I’m a domestic analyst or I’m international or I’m developed markets or emerging markets.” And of course, businesses globalized. I think Wall Street is slowly following in terms of how people think about investing geographically. So a good example I would give you is one of the best managed and most successful companies in China is called Tencent. And it’s a video game company, but it also runs internet chat services and all sorts of other things, a very, very valuable company. And when people want exposure to the Chinese internet sector, they might buy an index that’s based on that or an emerging markets index or a China index and so on. But interestingly, there is a company in South Africa called Naspers that owns 30% of Tencent. Now, as I recall, last time I checked, that 30% was worth about $180 billion, just that ownership. The entire market cap of Naspers is 130 billion. And I think you can only explain that big an anomaly if you think about fund flows, that somehow people when they want exposure to China, aren’t looking at a South African holding company. And so I use that as an example where I think active management can find that opportunity that won’t be obvious to people that are thinking geographically or even in terms of sector. They are thinking internet or they’re thinking China or they’re thinking both, but nothing takes them to then look at this South African holding company. Gillian: Jodie, anything to add from the index perspective here? Jodie Gunzberg: There are many different ways that anomalies, as you say or different reflections can be measured and printed inside of an index. One of those ways can be by geographical revenues. It doesn’t have to be market cap weighting. Just because the S&P 500 is market cap weighting, the indices have evolved well beyond that, and equally weighting, revenues weighting, by the geographic region that comes out. We go across the world and then it gets even narrower, you can go into sectors or any number of processes that can be put into a systematic format that can, again, be printed out in an index. It’s not so much about whether there’s an alpha opportunity or not. The indexing does stop at where the systematic process stops. Once it’s not able to be put into the methodology is really where the line of indexing is maybe stopping and the next phase of active management comes in. And there may be a place for both, but I do think that it’s worth taking a look at what’s available in indexing strategies, because there is liquidity, there is transparency. There is the opportunity for lower fees. And there is the choices these days to take, to reflect whatever your investment view is. So when we talk about the future of where is the industry going, I think one of the areas is in the due diligence areas. All of the analysts that are going through, active managers and doing all of their due diligence, one day are going to realize, wait we’re just measuring them against what was the beta. But is that actually the right measurement, because there may be indices that are closer to the strategies of the active managers, and maybe they should be held to a higher bar. And now there’s three million indices, maybe we need to be doing due diligence on indices instead, and seeing how those managers perform against more closely aligned index strategies. Gillian: So we have a sense now of investor interest, the market technicals bit. And I want to talk a little bit about the business side of managing ETFs. And I want to talk also about the future. So, Allison, I might kick it off with you. The marketplace is filled with new product launches and entrants. Obviously you’re working with them every single day. What are some of the challenges and opportunities associated with that, particularly on let’s say the pricing competition distribution side? Allison M. Fumai: Sure. So we have seen and asset managers have seen real price competition in the last couple of years. So I think when folks decide to bring out a product in an ETF wrapper, they have to take that into consideration. And it’s difficult sometimes in shops like yours where you have a mutual fund that’s historically been priced at one level. And as you see ETFs really kind of come down in pricing, especially the passive ETFs, you have to consider where is that price point for active ETFs? So I think that with the evolution of active ETFs, and were folks jumping into that market, that’s definitely a challenge, but it’s also an opportunity. I think secondly, as you probably learned as you jumped into the ETF space, the distribution of ETFs is very different from the distribution of mutual funds. And that’s very key for asset managers trying to get into this business, to really understand, how can they take the distribution channel that they have now, the sales force and the like and really adapt it to be able to sell ETFs either with similar strategies or with non-similar strategies and get out there into the market. So I think that’s just another challenge, but again, an opportunity because there’s a lot of talent out there in the distribution space. A lot of folks now than say 20 years ago, that really know what is the distribution strategy that should be used for ETFs? So, again, a lot of opportunities for asset managers to get into this space, and not cannibalize, as was a fear 10 plus years ago, existing lineups especially in a mutual fund wrapper. Christopher C. Davis: And I think this is … I think Allison is exactly right. When we think about why more, what I would say, traditional proven long term active managers haven’t been offering ETFs, I think you hit on a good example, fee arbitrage, right. So you already have to have a low cost culture. So for us we are able to bring it out at roughly the same fee structure because we were already a low fee structure place. The culture of transparency, some people just haven’t opened up to that transparency yet. So it’s hard for them to consider doing so, and then you’re right, distribution. They say, “Well, I’m going to bring this out, but I don’t even know where to begin.” And there I think we were lucky, our decision was driven by advisors that had been with us for 20 years, 30 years, saying, “Now, I have a group of clients or I’m on a platform where ETFs are available and of interest. And so I would love to have something that you do, that traditional approach available to my clients.” So we didn’t have to go out and invent a new distribution source. And when you start checking those venn diagram circles, the overlap gets smaller and smaller. And that’s why I don’t expect under the current structure there to be a whole wave of true actively managed ETFs, because they’ll have to solve, some of them are worried about transparency. Some of them are worried about fees, some are worried about turnover or small cap, which is more difficult to do, some are worried about distribution, and all of those things make it a very small circle. So at first we thought it was troubling that there weren’t a lot of others doing this. We thought, well, we’ve offered this and we expected others. But as we’ve looked at it more closely we can see why, although there’s a demand for active ETFs and not just by the financial advisors that had historically been interested in active management, but also by those that have committed historically to passive, and now they realize, my God, there are periods of time, five year stretches where even the average active manager outperforms passive. And so they start realizing that that tends to be correlated inversely with market returns. When index returns are lower, the percentage of active managers that outperform is higher. So we’re starting to hear from traditional passive ETF advisors who say, “Well, we better reserve a place in our portfolio for active management.” And so in that sense, it’s been a very, very interesting time. But it hasn’t surprised me that even though there is demand, it’s one where it’s difficult for the traditional managers to fill or meet that demand. Gillian: I was going to say, when you looked out and didn’t see much competition; I was going to say, be careful of what you wish for. Jodie, I want to come to you, we’ve talked so much about the evolution of Exchange Traded products in the present, but what does the future look like, do you think? Jodie Gunzberg: We are continuing to see a growth of indices and ETFs. But the challenge is that the majority of the assets are all concentrated in just a few. And to be able to see the new ETFs survive, I don’t know if perhaps there may be some industry consolidation that may happen. We have seen some ETFs even start to close after the assets don’t really grow as much as expected. So with this range of products and choices, the question becomes, where do the assets go and how do they spread out? Because it does take a certain level of assets per ETF or per company in order to survive. So now with this explosion of ETFs, over 5,000 ETFs, over three million indices, there’s a strategy for everyone it seems. And if that’s the case where do the assets go, is the next question. Gillian: So even with rabid investor interest we may see consolidation, because you do have to reach critical mass inevitably. Allison, what does the future look like from the legal perspective? Allison M. Fumai: I think, frankly more of these innovative products, we’ll continue to see smart beta, hopefully we’ll see some non-fully transparent active ETFs, which really lend itself to more asset classes in these wrappers. We’ll always see, and we’ve always seen liquidation of certain ETFs that don’t come to scale. But I think that just gives way to other ETFs where the demand may be greater, the timing may be greater and new product launches are possible. We still see concentration in big historical ETF managers. But one of the things we’ve seen over the last couple of years is also a number of new asset managers really gaining strength in the ETF space, again, allowing for a little bit more diversification, different products for investors and different strategies. So I think that’ll be interesting to watch as well in the future. Jodie Gunzberg: Well, it will be interesting as perhaps this bull market comes to an end at some point, what types of strategies become popular. Is it something in a multi asset class? Is it fixed income? Is it commodities? It depends where we are in the cycle. Is it something that looks like a hedge fund alternative? For example, we have seen this migration of assets from active to passive where saving on fees has been one of the main reasons for the migration and where hedge funds charge even bigger fees, the savings might be greater, so moving into the alternative space. So I think as investors shape their strategies to position themselves in the markets going forward too. It may create opportunity to spread out across the different asset classes, new products, things that are long and short that may hedge the traditional market cap weighted indices that I would call beta, the traditional market cap, like the S&P 500. Gillian: That’s an important characterization. We have seen an influx of interest also during a goldilocks scenario, so what happens if that correction comes. Chris, when your firm was founded there, you know, was no possibility or perhaps no interest yet in putting your strategy into a passive vehicle. But now here we are, so obviously that was a future could not have predicted at the beginning. What’s the future you look at now? Christopher C. Davis: Well, I think that the future almost always makes sense in retrospect. But at the time is very unpredictable. But I think there is some … there’s a deep truth which is that a certain group of active managers on average have been able to add a lot of value over the indexes, over a long period of time. Now, Morningstar and Capital Group put out a shared study that said if you simply took managers that had low costs, active managers with low cost and were in the top quartile for insider ownership, in other words, they ate their own cooking, they put their money where their mouth is, they invested alongside their clients, that group of managers outperformed 89% of all rolling 10 year periods. So I think that the simple rules of thumb like active underperforms, costs are the problem, they need to be looked at more closely. And then in a sense, economics takes care of the rest. If you have a group of managers that have outperformed over a long period of time, after all their fees, after all their prices, money will find its way to them. And there can be all sorts of obstructions put up in the way, there can be regulatory barriers, there can be salesmanship. But over time that will carry the day. So when I look to the future what I see is, I think within the world of ETFs, of course there’s a lot of things being thrown at the wall that aren’t going to stick. There are gimmicks. There’s a lot more risk in some of those vehicles than people realize. I mean obviously trying to unwind ETFs that are promising minute to minute liquidity, but are in illiquid or less liquid assets that is of course, that could be wildly interesting to watch that unfold, the asset classes, the leverage and so on. But the fundamental vehicle has enormous advantages. It has enormous advantages of ease of transactions, of low cost. So if you can combine that with a manager that over time can generate excess returns and has those sort of identifiable characteristics, I think that segment of the market will grow, and ETF is certainly here to stay, unless the regulatory environment changes completely. Gillian: Well, you tee us up nicely, Chris. We’re coming to the end of our discussion and I really want to give each of you an opportunity to help us understand your firm, its position within this space and what your competitive advantages are. So, Allison, I’m going to start with you. Allison M. Fumai: As we talked about this landscape in the ETF space has really evolved over the last two decades. One of the things that I, together with a number of my other lawyers at Dechert has been able to do has really been at the forefront of the development of these ETFs. Whether it be the launch of the first actively managed ETF or just different asset classes in the various strategies, we’ve really been at the forefront of educating our clients on how to get there. What are the hurdles? What are the advantages? What’s the appropriate way to get there? And as we continue to evolve, meaning the ETF industry continues to evolve, whether through the ETF rule or through non-fully transparent active ETFs, we will continue to counsel our clients in that regard. And one final thing is one of the other benefits that we really bring to our clients is the global nature of our practice. Our ETF practice is not only domestic, it spans a global nature. So whether you’re trying to distribute your US ETFs on a global scale or you’re launching similar strategies [inaudible] ETF wrapper outside of the US, I think that the way that I work with my colleagues on these issues really benefits our clients in that regard. Gillian: And with so many regulatory changes on the docket, obviously being able to navigate, that’s going to be increasingly important. Allison M. Fumai: Without a doubt and having the history behind us to really understand what are the regulators’ concerns, what are they looking for at the exchanges and the like has really helped us to counsel our clients in that regard. Gillian: Jodie, what about S&P Dow Jones Indices? Jodie Gunzberg: I think our size and our history give us a distinct advantage. I think our exchange relationships are very special and unique to us. I think our ability to offer indices in multiple asset classes is unique. And I think that our flexibility in providing what the market needs as we move from passive to active gives us a distinct advantage because we have what is considered the passive indices. Gillian: Excellent, and Chris, take us home. Christopher C. Davis: Well, I think if I think about our competitive advantages, I’d say we have a single investment philosophy, and it is a long term disciplined approach, it’s driven by research. We have a team that’s been together a long time and is going to be together a long time. So it’s a stable sort of platform. We offer five strategies. Now, over the last year or two, we’ve been offering four of them in an ETF wrapper. So think of those five strategies, one has been around for 50 years, one has been around for 25 years, one for 20, one for 13, one for 10, roughly so. But what do they have in common, these five strategies? Well, think of it, they all are truly active; they look nothing like their benchmarks. In all of them we are the largest or among the largest investors, so we invest alongside. All of them have low cost, low fees, right. But this is the most important; all of them have outperformed their peers and their benchmarks since we started them. And so I think it’s not a competitive advantage for raising assets in any one time, it’s not a sales culture, there’s no gimmick. It’s a long term sort of grinded out approach. And it’s a time when active is very out of favor. But of course, as contrarians at heart, we love this sort of environment. And we think the competitive advantage is not just around the results and the history and the staying power, but it’s also around the patience and the idea that we are going to be here for the other side. And in a sense, when people think about active management, real active management, we want to be a firm that they consider both capable, and trustworthy. Gillian: Well, thank you, Chris and Jodie and Allison, thank you as well. I feel like we’ve had such a diverse representation of viewpoints around the industry. And therefore you’ve painted a really robust picture of where ETFs are now and where they’re going. So I very much appreciate it. And thank you for tuning in. From our studios in New York, I'm Gillian Kemmerer and this is the ETF Masterclass.