Gillian: Welcome to Asset TV, I am Gillian Kemmerer. The ETF industry has ballooned in assets in recent years with innovative new listings coming online every day, from smart beta applied to fixed income, to active management within a passive wrapper, ETFs are increasingly diverse in their scope. Today I’m joined by three experts who will share their outlook on the growth of the industry and will detail some of the most interesting new products coming to market. Welcome, to the ETF Masterclass, gentlemen, thanks for joining us today. Let’s take a look back before we look forward and, Chris; I’m going to start with you, how have you seen the ETF market change post crisis to now?
Christopher Davis: Well, I think you used the word, it’s ballooned. There’s been enormous growth in ETFs. And in a sense, that’s the headline. But then there’s the second story which I think of as the dog that didn’t bark, like the old Sherlock Holmes dog. What’s been surprising to me is you’ve had this enormous growth, but it’s been almost entirely passive, that was the first wave. And then this wave of smart beta beginning, but what we haven’t seen until very recently was true proven active management within the ETF space. And that’s taken longer than I would have thought, given the growth. But now I think those trends are all accelerating.
Gillian: So assets ballooning and variety of products certainly coming to market?
Christopher Davis: Absolutely.
Gillian: Okay. Sal, the first ETF came in I believe 1993 it was the SPDR S&P. You are now working on things like fixed income and alternatives, I’m sure you’ve seen some changes?
Salvatore Bruno: That’s exactly right. And just to follow on that Chris is saying about growth, it has not just been growth in terms of number of products, in terms of assets, which we’ve seen on all the charts, but it’s the breadth of the product offering. So it started out as equity, high yield has just hit a 10 year anniversary of the first high yield bond ETF, which is pretty phenomenal, when people said it can never actually be done and it has been done. And now we’ve seen the next wave on that. So we’re talking about, now we’re getting core exposure to high yield, how do you actually cut that up into different risk profiles within high yield for example, or commodities, or real estate, or volatility or currencies. I mean the list is almost endless in terms of the asset classes now that are covered by ETFs. And we think that’s a good thing for investors.
Gillian: So 10 years of high yield, but we’re seeing the products grow and mature into more complicated and interesting strategies within that?
Salvatore Bruno: Right.
Gillian: Okay. Douglas, you come to us from the New York Stock Exchange, you’re sitting beside two gentlemen who list their products there. I am sure you’ve seen some changes as well.
Doug Yones: Yeah, we have. I mean the growth rate for us has been pretty incredible. We’re coming up on almost 2,000 ETFs in the industry now, and coming up on almost 3 trillion in assets under management. And as you said, it’s really only been over a pretty short time period. What I’m hearing, you know, my colleagues say and what we hear in the marketplace is it really comes down to choice. The reality is we continue to offer more and more choice to investors, it’s a choice of asset class, it’s a choice of style, it’s a choice of how deep you might want to go with the strategy. But it really comes down to choosing the way in which you implement your portfolio. You know, we started out with post crisis. And I think that’s really it, right, it’s post crisis, people had a lot of questions in their mind about how do I set up my portfolio asset allocation model? How should I be invested? What do I own? And ETFs start to solve all these different problems. And I think the growth rate is reflective of the fact that, you know, to some extent they have been better for investors than traditional mutual funds.
Gillian: So assets have grown, product diversity has grown. Have you seen regulations grow in tandem?
Doug Yones: We have, and in some cases in a way that’s helpful and more beneficial to not just investors, but issuers themselves. So most of what our focus is as an exchange as you can imagine, we want to drive liquidity. So we want to make it easier for investors to come and find very good prices. And really lower the barriers to entry so that when people do have great investment strategies, they can package them in an ETF and deliver them to clients. And so a lot of what we tend to focus on in the regulatory world is reducing barriers to entry. So a great example, last year we created what’s called generic listing standards. And for those listening, what does that mean? It basically makes it a lot easier for an issuer such as my colleagues with me, to take their strategy, wrap it up and put it into an ETF and launch, instead of a one to two year question mark on that process. They can come from start to finish with us four to eight weeks tops.
Gillian: Let’s put some numbers to what we’re discussing. And I’m actually going to tee up a graphic. It was tweeted by Eric Balchunas who’s one of the top ETF strategists at Bloomberg. This just shows very simply how much assets have grown. And, Sal, starting with you, how have you seen investor trends pick up? Are you seeing a new make up in terms of the face of your investors, are they demanding new things, what’s changed?
Salvatore Bruno: They are. And it’s reflected in the types of conversations that we’re having, a diverse investor base; we’re having a lot more conversations with advisors who are working with younger people, millennials. They’re an increasingly larger portion of the client base and they’re more rapid adopters in ETFs. So we’re definitely starting to see a little bit different demographic. Not to say that, you know, people are a little bit further on in life aren’t using them too, because we are seeing that as well. But a lot of the growth is coming from the younger generation, the millennials.
Gillian: Very interesting point. And, Chris, when you look at this, how have you seen the demand change since when you began your business until now?
Christopher Davis: Well, we trace our roots back almost 50 years. And we started as sort of institutional investors, institutional portfolio managers. And at the time there was this new thing out there called mutual funds. And very few institutional managers managed mutual funds. It was considered sort of beneath them. And my father, it really gave him enormous credit, looked at the mutual fund and said, “Well, it’s really from our point of view, we’re trying to offer proven long term investment management.” It is the case that the mutual fund is a better packaging of that service for certain types of clients. So we were one of the first institutional money managers to also move into mutual funds. And that evolution has continued through our history offering separately managed accounts or our services through variable annuities, or whatever it may be. And I think as we looked out at ETFs we saw this strange same dichotomy, that traditional long term proven equity managers viewed ETFs as something different. And I think they believed they must be passive for example. And we looked at it and we said, “Well, this is peculiar. We understand why low turnover is important. We understand why large cap is important, why low cost transparency.” But those are all characteristics of how we manage money anyway. And so we looked at the ETF and we said, “There are clients for whom that structure is a real advantage.” The tax advantages, the ease of transactions, the low cost, the transparency and so on.
And we thought, well, we can offer our services through this package. And the first clients that were interested were traditional financial advisors, many of whom had been with us for decades. And what they said is, “We have these millennial clients or we’re on a new platform, we’ve left our old wirehouse firm, we’re on a new platform that focuses on ETFs. Could you offer your service as an ETF, because we’ve very comfortable with your approach? We’ve been with you for decades, could you do that?” So that was the start. But then something peculiar happened, which is now we’re hearing from traditional ETF investors who have always been passive, that they’re saying, you know, “We want to reserve a place in our portfolio for true active management, you know, benchmark agnostic, you know, high conviction, not the sort of benchmark hugging thing. And we want to reserve a place because we know that there are times when active managers do relatively better.” And so just the same way they want a portion in gold or something like that, and that was unexpected. We offered this initially because of our existing clients, existing financial advisors, wanting our services as an ETF. And now we’re finding traditional ETF investors wanting to have a place in their portfolio for true active management.
Gillian: Okay. So, Douglas, we’ve heard from two product providers who have seen a changing face of investors as well as changing size and what they’ve demanded. I know you’ve brought some data for us, from an exchange perspective, how have you seen things change?
Doug Yones: Yeah. The story’s been pretty incredible. When we look across age groups, in almost every age bracket one in three investors owns an ETF, which is a pretty significant adoption rate. But for millennials, it’s even less. What we’re finding is millennials are adopting faster than every other age bracket. And so we try and dig into the details as to why, and because all of us would love to drive that for the other age categories. But what I think the story this year, and you put it up in that graphic was we had a record breaking assets under management growth for our industry in the first quarter, $133 billion dollars in net cash flow. There’s a lot of stories in those numbers. But for me, I always tend to come back to the fixed income story. The first quarter this year was not necessarily very kind to fixed income. And yet you still had a record breaking almost $35 billion come into fixed income ETFs this year. So there’s so many various themes that are happening and it really does come down to investors like the structure of an ETF, it provides flexibility for them, it provides some level of transparency for them. They can add it to their portfolio. They know exactly what they’re invested in. And when you look at a lot of the studies what comes back is usually number one is I want to know what I own, which is a great thing I think for all of us, both the developers of investment products as well as the individuals that are investing in them, right. As people are taking a little bit more control of the way their money is spent.
Gillian: The fixed income point is interesting. So you’re finding that performance inflows aren’t necessarily in tandem immediately?
Doug Yones: That’s right. It doesn’t necessarily mean if an asset class isn’t performing that well that people are still not necessarily using the ETF. And one of the reasons we see that happen is the net outflows from high cost other vehicles is what I’ll say. So let’s say a high cost fund or a high cost SMA, money will leave that during time periods of underperformance and enter into a new strategy that provides a more transparent, greater tax efficiency, lower cost which those three things end up in the ETF.
Gillian: Okay. So great points, and let’s stay on fixed income for a second, Sal, we have Janet Yellen raising rates, we are now, I guess officially in a rising rate environment but they’re still quite low. Give us a little bit of an outlook for capital markets this year.
Salvatore Bruno: So, yeah, the consensus is three rate hikes for this year. And we’re already one in, we’re of the view we’re probably pretty much in line with the consensus, although we do think there’s a bit of a risk that we could get a fourth rate hike, which may be a little bit surprising to some of the capital market participants. The equity market has powered on, eight years of a bull market. And the most recent flourish at the end coming with the Trump trade and the rally. So the equity markets are definitely at levels not seen before, from a valuation perspective they’re probably pretty close to richly valued. So we think from a capital markets perspective, we’re seeing where equities are, we’re seeing where fixed income is, and we think that it’s important for investors to think about how they can diversify some of that risk. So we think about alternative exposure, alternative beta, as ways to maybe take out some of the duration risk, some of the equity risk and get non-correlated or diversifying assets into the portfolio.
Gillian: Okay. Chris, you look globally for investment ideas, can you give us a little sense of where valuations are let’s say comparing developed to emerging, US to Europe.
Christopher Davis: Well, I really want to pick up on what Sal says, because in a way it’s related. You know, when you get a long bull market and you get to the later stages of that, people begin to forget about first, the inevitably of corrections, right. If you go back to 1928 to today, there’s been a 20% correction every two and a half years. Now, as you say, we’ve been almost eight years without that. And so it’s inevitable and when it comes people will believe the world is ending. You know, there’ll be sort of screaming headlines and people panicking and there’ll be all sorts of fundamental reasons why people are terrified, instead of saying, “This is just a normal part of the landscape.” So I think the first thing is about setting expectations.
Now, when we look around the world, let’s start in the US and think about exactly Sal’s point on valuations. Are they stretched? Are they at the high end? Well, what I would say is, is this, that this is a time when selectivity is going to be very important. We’re starting in a world where corporate profit margins are very high and growth is low and valuations are high but not unreasonably so. In other words they aren’t particularly high relative to interest rates, relative to commercial real estate, relative to a lot of other asset classes. But they aren’t giveaway prices. So you put those three things together, low growth, high profit margins and high valuations. That is a dangerous time for the averages. And this is where I think active management and selectivity will matter a lot in the years ahead. And this is what we’re hearing from more traditionally passive investors is the idea that, well, if I want to build a portfolio where the stock specific companies I choose still have room for margin expansion or have relatively lower valuations, or relatively higher growth rates, you start putting together the possibility of outperformance. And I think in the US that’s step one, look for selectivity is key, be sensitive to high profit margins where margin compression could really hurt you. And be sensitive to where you can really get underlying durable growth.
I would add as a footnote, I think it’s a time to be very, very wary of companies where everybody looks backwards, for example, at the high dividend yields. You know, this company x, y, z has always paid a dividend, it’ll be safe. And one of the things I noticed, the top 25 holdings of the largest dividend ETFs in the US, over the last five years, you wouldn’t believe this, over the last five years their revenue has actually gone down. So they’ve been shrinking. They’re paying out more than 75% of their earnings to cover the dividend. And they’re at premium valuations to the market, 22/23 times earnings. So you know, we think there are areas that are very richly valued, but there are areas of opportunity. Now, you get to Europe and of course Europe is another example where selectivity maters a lot. There are so many structures there. And I think Jamie Diamond just recently wrote in the JP Morgan annual about some concerns about what could strain the euro, what could break it up. So there again I think you want to be very focused on looking at companies whose growth is tied to world growth, not just to what’s happening in Europe. Because I think the outlook for Europe could be really troubling. You have to be very specific.
But you mentioned my favorite category, emerging markets, and it’s my favorite not because I think you should throw a dart and buy emerging markets, but because it’s a crazy category. What does Brazil have in common with China or Russia or India? They’re totally different, demographics, economies, legal systems, valuations, market caps, I mean all sorts, interest rate outlooks all are very different. And yet people view this as a category. And when they invest, and especially when they buy an emerging market ETF we think that’s crazy. You get a cap weighted index where the biggest companies are mostly formerly state owned enterprises. There are the large ones that are wrapped up in corruption scandals, bureaucracies, low growth. And yet within a lot of these emerging markets there are wonderful growth companies. I mean just imagine a Brazilian beer company that was so successful that they now own Anheuser-Busch and Miller. That was the Brazilian company, Brahma that became InBev and then AmBev and then bought Anheuser-Busch and is now buying Miller. So you think about that, that sort of power that can come out of specific companies, what we’ve seen in Alibaba or Tencent in China, what we’ve seen with tremendous Indian airline, Indigo. Stock specific and I think that’s the opportunity within the ETF space that is opening up. That is recognizing that as you look at opportunities around the world there are both greater risks to the average company and greater opportunities being presented for stock specific investors.
Gillian: And we’re going to drill down into your due diligence process in a moment. Douglas, you have a front row seat to what’s happening in the US economy. You’re watching IPOs ring the bell almost every morning, it seems like, and you’ve just had one of the largest tech ones in years ring the New York Stock Exchange opening bell. That was Snap. What is your outlook for 2017?
Doug Yones: Yeah, it’s been a really exciting time at the Exchange as you mentioned. You know the number of IPOs and the pipeline for IPOs that, you know, we never try and predict the future but it’s certainly bright right now. And it’s been like that for the first quarter of the year. And we’ve had significant IPOs come to the market. So you know we’re excited about the direction we’re heading. I think, you know, Chris and Sal have made some really interesting points about what’s happening, not just in the global economy in the way in which you might want to think about actively managing your portfolio. But it always does come back to that ETF structure and the reality is you can now make these choices using ETFs. They truly have democratized investing. Historically, you know, so many of the strategies that Chris was mentioning about how do we pinpoint and select an individual security in one of these countries, if we really wanted that level of expertise, what would we do? We’d have to go out, engage the institutional advisory capacity. And as an investor, not all of us have the ability to go out and find that, that level of investing expertise. But when issuers such as these gentlemen come and bring these strategies to the market and they wrap them in the ETF, well, now you have access to those tools.
And so now even as an individual investor, as an institution, I’m able to tap directly into the knowledge set that we’re talking about, the ability to go in and actively select companies. And it’s not just in pure active, we’re also seeing in the ETF space what I like to say is quasi active, who will have index strategies that they themselves are pretty active. And they’re not just a traditional cap weight own everything in a marketplace. Now the indexes themselves are becoming so much smarter, we’ve tried to avoid the term smart beta and call it alternative beta because I think we all like that name better. But the reality is the indexes themselves are adding a level of expertise that we haven’t historically seen. And then wrapping them in an ETF, putting them on the exchange, it means all of us have access now to these tools for our investments.
Gillian: Okay. do a very sunny outlook going into the rest of the year as these indices even get smarter, or alternative we should say. Sal, give us a sense, when you’re talking to a client, how do you explain to them the advantages of the ETF structure?
Salvatore Bruno: So there are numerous advantages and Douglas has mentioned a number of them right away. Typically they are lower cost than the average mutual fund. And of course have been coming down in the ETF world, so low cost and getting lower. Tax advantage is a huge issue for a taxable client. So ETFs take advantage of the in kind creation redemption process. And that allows you to meet redemptions or rebalance a portfolio in a much more tax efficient way than a mutual fund can. So you get to keep more of what you earned, the worst thing ever for a mutual fund client is you see them at the end of the year and you lost money on paper and you get a capital gain distribution. That tends not to happen for most ETFs because of the in kind process. Transparency, I think Douglas hit the nail on the head with that one; people want to know what they own. And the regulatory environment for ETFs is such that you need to disclose your holdings on a daily basis so anybody on any day can go in and say, “I know what I own.” And if they’re not comfortable with it they can sell and buy something else. So I think that’s great. And liquidity too, in the sense that as the market has grown, as more market participants have come in, authorized participants, market makers, they’ve made the markets deeper, spreads tighter, and that’s great for investors.
Gillian: And liquidity is particularly interesting given that you’re focused on fixed income today.
Salvatore Bruno: Absolutely.
Gillian: Douglas, he’s touched on quite a few, can you add any more, any other things that you would mention particularly to providers who are coming in the market?
Doug Yones: Yeah. I think the liquidity piece is, you know, exactly what we’re trying to focus on at each and every day. So when we think about the role of the Exchange, our role is to create a marketplace. We want that marketplace to offer really two things, we want price transparency, right, price discovery, people being able to come in and figure out exactly what something’s worth so that a buyer and a seller feel comfortable. And we want to offer liquidity. And the reality is in the ETF ecosystem, liquidity typically comes from market makers. And those are firms, individual firms that are, you know, incentivized to basically be there all day every day, willing to buy and sell the ETF. And the way in which we facilitate is really twofold. One is we’ll work with issuers to make sure the products themselves are very liquid. And so as they mentioned, that creation redemption process, making sure that that is as liquid as possible, and then on the other side, creating incentives to make the market makers want to connect to the pool of liquidity, right. And so we try and drive as much liquidity to a singular marketplace as possible so that whenever a market maker is thinking about do I want to buy or sell the ETF, they want to connect in to the New York Stock Exchange, because they know there’s going to be the most liquidity possible, so that they’re able to facilitate those transactions.
Gillian: Okay. Chris, I come from a hedge fund background reporting, so when I think active, I think two and twenty or three and thirty, or God knows what they have now. You’re offering an actively managed product in a passive wrapper. I would imagine the fees are to some extent a big advantage that you pitch to clients when you’re talking about this.
Christopher Davis: Well, I mean Douglas and Sal highlighted the advantages of an ETF, right, low cost, transparency, that ease of transacting, the liquidity, the tax advantages for many clients under many circumstances. You know, these are an enormous advantage. But I also think there are enormous advantages to proven traditional long term benchmark agnostic active management. And I think when you think of those sorts of advantages, when you think of the end investor, well, what haven’t ETFs offered in the past? Well, alignment of interests, right. There is something, you know, we don’t own a single stock on behalf of our clients where the management isn’t an investor in that stock. And when you look at the data, even for traditional active managers, it’s amazing the number, 88% of all rolling 10 year periods, active managers that had … were in the top quartile for co-investment, in other words they were in the top quartile for eating their own cooking, and in the bottom quartile for costs. They outperformed 88% of all rolling 10 year periods. So the case about active management doesn’t beat the index is absolutely true when you think of high cost, benchmark hugging, inexperience, no alignment of interests and so on. But when you start refining that the characteristics have proven successful long term active management, then you see a very different picture.
So we look out and say, “Well, if we could combine those strengths of a traditional ETF that Douglas and Sal outlined, if we could combine those with judgment, with adaptability, with alignment and create the opportunity, the opportunity for outperformance over a long period of time, well, we increase that opportunity if we have low costs. Well, we have low costs. And we increase it if we have this culture of transparency. Well, I grew up in New York and there was a retailer named Sy Sims and I don’t know how many of you remember, he used to do ads, and he said, “An informed consumer is our best customer.” And we have a culture of transparency. We’ve been sort of surprised that traditional active managers have viewed that as a negative. Why don’t you want your clients to understand what they own, so…
Gillian: I think you just said that too, they want to know what they own.
Christopher Davis: They want to know what they…
Doug Yones: Yeah, it tends to come up in most studies as the number one thing that investors are seeking. And one of the things that the industry used to face up until the middle of last year was when you did want to launch an active fund structure but put it in an ETF wrapper, it was really hard to get through the regulatory process from start to finish. And when you’re building a new product, you don’t want to have a question mark around maybe this takes six months, maybe this takes three years. What we’ve done at the Exchange level is we’ve reduced the barriers of entry and so we are now finally seeing more and more active ETFs come to market. One of the things that I find interesting is a lot of people don’t realize the growth rate that’s happening. So compound annual growth rate is well over 50% a year when we start to look back over the last 10 years of active ETFs. So they’re by far coming into the market at a pretty quick pace and they’re also growing assets at a pretty terrific pace as well. So it’s definitely ripe for blossoming, I think it’s up to the asset managers themselves to choose to come into this space and develop their structure and put it in an ETF wrapper. I think the point that’s been made is perfect, which is it’s not that active doesn’t outperform; it’s that high cost active really struggles to outperform. And so a lot of what we’re seeing come to market today are a lower cost active product. The reason it can be lower cost is because the ETF structure allows an asset manager to reduce their costs significantly. And so it’s sort of the best of both worlds, the asset manager can now focus on what they do best, right. And at the investor level they now are able to have a package solution at a lower cost.
Gillian: So let’s drill down into the actual specifics of some of these really innovative structures that both of you are looking at. And obviously the adoption rates are looking great. So, Sal, I’m going to start with you quickly. I think the fixed income indices world is very, very interesting, it’s liability driven, not asset driven. You’re kind of at the mercy of the size of the debt issuance. Tell us how smart beta takes advantage of opportunities here when looking at fixed income.
Salvatore Bruno: So what it really does is to isolate different risk premia. So when you’re investing in fixed income there are typically two types of risks you’re facing. You’re facing credit risk if you’re in the corporate space, credit risk and duration or interest rate risk. So we’ve seen a lot of product development trying to split that out and trying to get different risk return profiles centered around different, of those two risk premia that you’re looking at. And I think that’s a great benefit to investors because they can decide, I’m comfortable taking credit risk now because I think spreads are likely to narrow from where they are, if that’s the case. Or I’m comfortable taking duration risk, but I don’t want to take duration risk, depending upon what your outlook is for interest rates. So being able to split apart those different risk premia I think is really important, and creating different risk return profiles. So for example, we took the US high yield corporate bond and we devised a metric to try to identify low volatility, high yield bonds, borrowing on a concept that we’ve seen works successfully in the equity world, to take low vol and sort of split that out and say, “Look, we want it just on the lowest vol.” Now, of course you run into different issues, different problems in fixed income because bonds don’t trade every day. So how do you measure the volatility of an individual bond? You can’t take the standard deviation, and I don’t want to use credit ratings because they tend to be a little bit delayed.
We’re actually using market implied data, so we use the credit spread, which is the yield of that particular bond relative to the yield of the comparable treasury in terms of duration. And then the duration of that bond, so if you’re using market implied data, which is readily available on the market you can get a very timely measure of lower volatility bonds and you can array them high to low and segment different portions of it. So we own an ETF that came out in February, HYLV, High Yield Low Volatility that separates the highest risk bonds from lowest risk and only owns the lowest risk bonds. It can give you a significant capture of the yield that you’re getting in high yield with much lower volatility. And in an environment where we saw 2016, credit spreads went from 8½% at the beginning of the year in 2016 on oil price weakness, to just about 3% by the end of the year¹ as the oil price had recovered. There seems to be a little bit of an asymmetric risk return profile going on there with credit spreads that they’re much more likely to go up than they are go even further lower. And we’ve seen that, they’ve gone back up to 3½%. So that’s a good environment for a lower volatility bonds. So again, it’s the ability to separate out the different risk premia and take more targeted exposures depending upon your outlook for the capital market.
Gillian: So borrowing from equity smart beta, you’re looking at factors, low volatility would be one of them, is momentum another?
Salvatore Bruno: Momentum is another one and we came out with a couple of ETFs last year, in May of last year, looking at the investment grade, US investment grade taxable space. And what we looked at was momentum and how could you do a rotation around different parts of the aggregate bond universe to try to pick up on the trend, because those trends tend to persist for a while. And our research has shown that it has worked quite well historically. I mean it has worked well out of sample as well. Go back 2004 to 2006, the last time we saw a meaningful rise in interest rates. We had a rotation into more investment grade corporate and a little bit less on the treasury side as rates were rising. But then once rates had gone up, momentum was starting to build a little bit more on the short end of the curve where you’re picking up better coupons. So was that ability to rotate around different parts of the investment grade universe that enabled you to kind of navigate that rising rate environment a little bit better.
Gillian: Okay. Now, Douglas we talked a bit about the growth of smart or alternative beta products. Are you seeing a kind of continued growth in the fixed income application of this or is this a relatively new product?
Dou Yones: We’re seeing growth really everywhere. And I think it’s worth for all of us to take a step back and when we say smart beta or alternative weighting, maybe start with, well, what we call traditional weighting. So the market cap weighting is really pretty simple, we take shares outstanding or debt outstanding in the fixed income space, we multiply it by its value and there you have it. And the largest value becomes number one holding. And so, you know, the naysayers to that process, when you sort of force rank that way is well, we think that if we off weight or we go with a different valuation, then we can extract value by doing so. And so exactly, you know, what we’re talking about is sometimes we look at it in the world of factors. So we might look at value, we might look at momentum. We might look at quality. We might look at volatility, right, so traditional factors. But we also might look at weighting by GDP or by revenue, right, or an equal weight structure. The great thing is that all of these various choices and all of these factors and factor driven investing can now be captured using an ETF. Now, I don’t think we’re done yet. I think there’s still opportunity for choice. And the reason I say that is when we line up all the choices of mutual funds, and then we line up our choices of ETFs, we only have about a quarter of the choices in ETFs than we do in funds. And so there’s a lot of opportunity for growth.
And so a lot of what we’re seeing, as I mentioned, the growth space around alternative weighting, there’s almost $600 billion invested in alternative weighted ETFs today. But it’s also one of the faster growing growth segments that we’re seeing. And so not just growth of new products coming to market, but actually growth of adoption as investors are starting to wonder about how are valuations? What’s happening in the economy? Where are we going to go from here? And a lot of, you know, traditionalists would say, “Look, expect muted valuations moving forward. So what’s another way I can capture maybe additional growth?” And it’s probably in one of these factors. So we are seeing money start to shift away from traditional market cap weighted structures and into a factor driven or an active structure.
Gillian: Okay. So let’s move on to the active structure. Chris, talk us through some of the attributes that make for a great active manager. And then can you talk us through some of the factors that you’re considering within your ETFs that you’ve brought to market.
Christopher Davis: Well, I think it is amazing, if you sit on an investment committee or you think about, you know, entrusting your family savings to a manager, and you think about the qualities. They’re so obvious as you think about them. Of course low costs matter. But you also want somebody that is in a sense, benchmark agnostic and high conviction, right. You can’t do what everybody else does and expect a different result. There’s a lot of closet indexers out there. You want alignment of interests, right. I think it matters a lot, particularly when people go through times of disruption. You know, there are clients for whom it really matters that there is somebody making decisions, right, that there’s somebody that’s aligned. And that doesn’t matter for others, but for some it does. And so certainly it’s something we look for in our investments. And I think it is a characteristic of successful active managers over a long period of time. You look back at their record; do they have a record of delivering outperformance over a long period of time? So they have to look different and they have to have high conviction. They have to be, you know, so benchmark agnostic, have low costs. I think low turnover matters. I mean turnover is a cost, but it’s also a sign of sort of a trading mentality versus an investment mentality. So that would be another characteristic that I would look for.
And you know, the thing that we like to say is, it is obviously true that the average person couldn’t climb Mount Everest, right. But it doesn’t mean that there aren’t characteristics that you would look for that would give you some indication in advance that somebody is more likely to be able to do it, right. You would look at all sorts of their fitness and their risk, how they think about risk and you’d look at their experience. And you’d look at whether they’ve done it before. I mean there’d be a lot of characteristics. And so I think there’s shorthand that the average active manager underperforms, that is absolutely true. But it doesn’t mean that there aren’t active managers that can outperform. And those characteristics, low costs, willingness to be benchmark agnostic, high conviction, the alignment of interests, those have a huge bearing. And so when we look out, we take those characteristics and then we think about the underlying asset classes, where could an active manager have a great advantage relative to an index? Because of course the traditional smart beta is a move in that direction, right. People are looking for the opportunity to outperform, to have a small advantage over a long period of time. The difference with true active management is that rather than are looking for a fixed factor that could be inflexible, we’re recognizing that the nature of markets is that they change and the importance of being able to adapt over 10 years, 20 years, 30 years, matters greatly, so we look for areas where there’s an opportunity to outperform, so I’ll use as an example, within the financial sector.
Gillian: I was just going to ask you about that.
Christopher Davis: Well, you know, so we have our ETF, DFNL, Davis Select Financial ETF. And the reason is, well, we have a long history investing in this sector. I actually started our financial mutual fund 25 years ago. And yet it’s an area where the traditional index approach has huge distortions. The largest index in the financial space has 45% invested in five stocks and four of them are mega cap banks. I think that is a recipe for either higher risk or for underperformance, right. Either, I would not be comfortable with that allocation for clients. And I think index investors don’t necessarily realize that, the type of risk that they’re taking. So that’s an area where we have a long record as a mutual fund manager of adding outperformance. It was an area where we looked at the ETFs that were available and felt that we had an opportunity to add value there. Global, I mean again, I mention the sort of the strangeness of how global indexes have been cap weighted and emerging markets lumped together. We think global is an area where an active manager can add a lot of performance. So we had a great record managing a global mutual fund. So that gave us some confidence in our ability to create value in this space, so we launched Davis Select Worldwide DWLD, our sort of a least constrained portfolio that we have, any size company where anywhere in the world. And that creates a great opportunity for outperformance.
And then finally, in the USA, you’re not going to create outperformance owning 300 stocks. You’re going to look like the index, and so our approach has always been to be more concentrated, to be benchmark agnostic. And here we have DUSA, which is a 25 stock portfolio based on what we think of as the companies where we have this combination of growth, of valuation, and of margin expansion, where all of those factors could add to performance. And where we think we can add value versus the traditional index approach.
Gillian: Douglas, can you explain to us the DNA of these actively managed ETFs? How does the structure work? How do you promote this kind of decision making within a traditionally passive structure?
Doug Yones: Yeah. You know, the really, the almost no key differences between the active manager that’s running a traditional mutual fund or the active manager that’s running an exchange traded fund. Really the difference is in the distribution model. So, instead of having to go open account directly with each active manager that you’re selecting from, and then you have your scattered group of holdings and you’re trying to figure out how you consolidate them together. Now, they’re packaged in one place and they’re offered through one account. And as an advisor you can imagine the tremendous benefits of being able to pull that portfolio information together. All of us, we’ve talked about risk, we’ve talked about valuation. When it comes back to economic theory, when we’re looking at portfolio allocation and portfolio modeling, what are we trying to do? We’re trying to find non-correlated assets. We’re trying to create exposures in our portfolio that won’t act like each other when we do have the inevitable pullback, when we do have a particular run in a certain area. And so as investors and as advisors we’re trying to seek out all those different choices, right. And we want to be able to put them tougher with somewhat ease to determine, hey, when I add this ETF or I take away this fund, what happens, what’s the change in my portfolio and how are they either correlated or non-correlated against each other?
What I find fascinating at the exchange level is the level of detail and choice and strategy that is now being packaged in an ETF. We have balanced funds that are coming in the ETFs. We have currency vehicles. We have vehicles that will go from a hedge model to an unhedged model. We have ETFs that’ll take you long a portfolio and then move back into cash based on dynamics in the overall marketplace. These are smart, intelligent, live, moving, active vehicles, but effectively packaged into a single portfolio investment. And so as a, you know, a manager of money, you can imagine that you now have all these additional tools in your tool belt that allow you to diversify an investor’s portfolio, that’ll allow you to take advantage of different factors in the marketplace. And you’re able to get them in one location. And I think that it really does come down to simplicity and ease of executing a portfolio.
Gillian: And, Sal, actually some of the things that Douglas just referenced reminded me of the alternative ETFs that you’ve been working on. So can you tell us a bit more about those?
Salvatore Bruno: Yeah. But before we jump into alternatives I actually wanted to come back to something Chris was mentioning about the quality of the manager and particularly in fixed income. Managing a fixed income fund is very different than managing an equity fund. So when we launched our HYLV ETF, we were fortunate to be part of the New York Life family that has MacKay Shields as a sister, a boutique, if you will, the multi boutique structure, long track record of running fixed income. They’re actually the sub advisor and the portfolio manager. So there is, it’s not an active fund, but there is some skill and some value added on the liquidity and the trading and the rebalancing from the portfolio managers, that’s very important on the fixed income. So I wanted to make sure that we mention that.
In terms of the alternatives, so Index IQ has a long history of being in the alternative ETF space, we were one of the first to get into it, we have the largest ETF out there, QAI, that’s a multi strategy alternative beta offering. And it gets back to what Doug was just talking about, how do we get to non-correlated assets or more lowly correlated assets? QAI is one example, M&A merger arbitrage ETF is something that we came out with in 2009, it runs a beta of less than .2 versus the S&P, has a sharp ratio just about a level of 1. And has been very successful, has been gathering a lot of assets. And what it does is it diversifies portions of your portfolio. It’s mechanical, it’s rules based, but it’s in the alternative sleeve. So it’s kind of combining, we think, the best of both worlds. You’re getting alternative exposure in the ETF wrapper, with all of the attendant benefits, much lower cost at 75 basis points, has paid on one capital gain distribution in its history since 2009, that was in 2011. And for a merger arb strategy that’s pretty phenomenal given the level of turnover you see in merger arb just by the nature of the strategy. So it’s those types of offerings and products that we think are important building blocks into the portfolio.
Gillian: Absolutely. Now, Chris, because you’re an active manager I have to ask you for a stock pick, so can you give us maybe one name in your portfolio that exemplifies your process?
Christopher Davis: I always find this dangerous because I always think 97% of the portfolio will be what I’m not mentioning, you know. But, well, what I do is I’d say, well, we have three ETFs each focused on a particular area of opportunity. So maybe I’ll give you a quick stock from each as an example of why we have confidence in that strategy. So let’s start with this unconstrained global fund, DWLD. And here what’s funny is that we own a company in South Africa. And you think, well, what are you doing with a South African company? Well, the largest asset of this South African company is its 30% ownership of one of the finest companies in China, Tencent. So the company is Naspers. And the inefficiency is created because although the Tencent holding represents this huge value, there is this idea that it’s not in this South African index and this sort of anomaly. So we view Naspers as a South African company as the way to buy this wonderful Chinese company at a discount. So that would be an example from DWLD.
Now, DFNL, our financial ETF, here I’d say that I mentioned that the largest financial ETFs have 45% in five stocks, four of them are mega cap banks. Now, I happen to like some of those companies. But to put such a huge weighting into this four institutions, I think is very dangerous. So I’d highlight a stock that’s completely differentiated. So the one I picked is Markel because it’s not a household name, it’s an insurance company in Richmond. I started as an insurance analyst 25 years ago and I met the folks that run Markel 25 years ago. I think their stock was at about $19 a share. It’s about 800 today, they’ve built a wonderful record, very similar to the Berkshire model of a good insurance company and an outstanding investment operation put together with a long term culture, so, a real differentiator from the index to be able to own a wonderful company like that.
And then in the USA, well, here I’d say I wanted to pick something close to home, but it wasn’t a huge index name. So I picked United Technologies, UTX, because everybody knows these wonderful companies, Otis, Carrier, Pratt & Whitney, these beautiful, and a value investor’s dream is when you can buy that sort of quality on sale. And the sale is created by short term concerns. And there was the Carrier issue that became a political football. There was a rollout of a new jet engine at Pratt & Whitney. There was a slowdown in China so new skyscrapers were slowing and that hurt Otis Elevators, so a lot of short term noise. And when a lot of people are being judged on three months, six months, one year results, for a long term investor to be able to buy an above average company at a below average price, well, that’s the heart of DUSA, our US strategy. And so those would be three examples.
Gillian: Excellent. Now, Douglas, kind of shifting to back to a conversation that includes all of us, can you give us a little bit on the do’s and don’ts of ETF trading for anyone who’s watching today?
Doug Yones: Yeah. I think that’s a great topic, because as users of an exchange traded fund we do have to think about the mechanics a little differently than we do with a traditional fund where we’re sending a cash order in and we’re waiting for a singular price at the end of the day. You know, the benefit of the exchange traded fund is we’re buying it and we know exactly what the price is when we’re buying it. But the reality is, let’s go back to that model of the exchange market maker, right, the individuals that are choosing to place liquidity on the exchange and buy and sell. The way they’re doing that is they’re figuring out all the different holdings in each ETF. And then real time they’re valuing that asset value. So instead of doing it once a day like a traditional fund, they’re doing it thousands of times a second. So their computers are really sophisticated, their pricing models are very sophisticated. But we have to think about certain times of the day where those prices aren’t available. So we always say, you know, “If you’re going to be investing, especially right off of the open, right at the close when there’s a lot of volatility and those prices might be changing, if you are going to invest at those times, please, please use limit orders, they’re going to make sure your price is protected and you don’t have to worry about the markets moving faster than you might be willing to buy or sell something.”
The other piece we always think about is well, where is that strategy investing? So if it’s a European ETF, well, the prices are updating in the morning in the United States while the European underlying assets are trading. And that’s great because the market maker knows exactly what the fund is worth. And then they can buy and sell it for exactly what it’s worth. But if we wait until the end of the US investing day, now Europe’s closed. And so what do I do as a market maker? I have to do the best guess I can, we would call it fair value. I’ll do a fair value model, where I’m guessing what the underlying components are worth, but I don’t really know. And so as an investor we just want to be a little extra cautious about when we’re placing those orders, is there a best time of the day? Is there a wrong time of the day? Or can I wait? Can I wait till another time period? You know, it does come back to just being aware. The other example, we always hear the ETF capital markets teams talk about is in the fixed income space. There are days where the fixed income markets are closed, but the US equity markets are open. So we think about, Columbus Day as a great example. The bonds themselves are not trading but the bond ETFs, they’re still trading. And so we always want to be a little cautious, what we’ll typically mention at the exchange level is almost every single ETF issuer has what’s called a capital markets desk or a capital markets executive, someone who’s there to help you execute your trade. And so if you’re a manager of assets and you’re about to place an order, there is someone who can actually help you. And so we always say, “Just grab the phone and contact your ETF issuer. They’re going to put a specialist on the phone and they can actually execute the order alongside of you.”
Gillian: Perfect. So we’ve got the do’s and don’ts of execution. We’re coming toward the end of our discussion. So, Sal, I’m going to start with you, help us understand where your products fit into a larger portfolio.
Salvatore Bruno: So we have a broad range of products, right. We started out with alternatives. We have since come, and then that included sort of hedge fund type strategies, merge arb multi strategy, commodities, REITs, we have a small cap REIT ETF. So we have some real estate offerings there. And we’ve moved over into the fixed income world as well. We have the investment grade that uses momentum. We have the low volatility in high yield. And so what we’re trying to do is build out a toolset, in an environment where as Chris mentioned, you know, equity valuations are high, maybe not extended, but definitely at the upper end of the range. Interest rates are low and probably moving higher, we think that the expected outlook, the expected return for the broad asset classes, it’s probably a little bit muted relative to where it’s been over the last 10 years or so. The 60/40 portfolio has done great because equity markets have run and interest rates continued to fall. We maybe at an inflection point, so how do investors get a little bit more out of their portfolio? We think it’s some of these unique ways of thinking about different risk exposures and trying to add, as Douglas mentioned, trying to add a little bit more return by weighting things differently or getting a little bit different, maybe I’m taking credit risk, maybe I’m taking duration risk in the fixed income world, being a little smarter about how you put things … what you put into your portfolio. And so we have core building blocks across kind of the spectrum of different asset classes. So we think we’re trying to create those tools for smart portfolios.
Gillian: Okay, great. And, Chris, last but not least, same question to you, where do the Davis actively managed ETFs fit into a portfolio?
Christopher Davis: Well, Sal said his firm offers enormous breadth, enormous amount of choices. We’re really specialists, right. We’re really an investment specialist in equities only. We’re trying to offer this time tested approach to long term true active management, high conviction. So what I would say is where we would see … I’ll start with DFNL, our financial ETF. There are three portfolio users that we’re seeing. One, are the people that think like I do, that over time there are great opportunities to buy what we call growth stocks in disguise. These are companies that happen to be in the financial services industry, but can grow for decades. I mean think of what [inaudible] did for example, and the ability to invest in those sorts of companies at low prices. Then there are the cyclical investors, the ones that say, you know, “Financials are just cheap now. People remember the financial crisis, they don’t want to be in there, I’ve got rising earnings, rising dividends, low valuations, a lot of capital being returned to shareholders, discounted PEs, you know, I want to be in that sector, maybe not forever, but I see a cyclical opportunity.” So certainly we have seen people using that. And then I would say the most sophisticated ETF investors, the formulaic, that sort of mindset says, “Well, it’s interesting, financials might only be, you know, 13 or 14% of the index cap weighted. But they’re a much bigger percentage of the earnings. So I want to top up my holding in financials because I’m capturing a bigger percentage of the earnings that way so that my portfolio begins to … will look more like the earnings power of the market, not just the cap weighted.”
Now, you go to DWLD, and what I’d say here is that the ETF investors that either own big global indexes around the world, but want that specialist almost in alternative, in the sense where we look so different than the index, we’ve been very non-correlated. It’s really a specialist portfolio. But it’s also been the traditional financial advisor that says, “I’ve been very US centric, I like the idea of having an unconstrained manager.” More and more people are realizing that the constraints that have been put on active managers have been a mistake. There are ones that make them say, “You’re just a garp manager or your mid cap value blend.” So DWLD is the least constrained portfolio I can imagine in the equity space. So it can invest any company size, anywhere around the world. And it’s an area where we feel over the years we’ve built a real proven competence there. So people use it in that sense as a real … I’ll say it, alpha generator or potential alpha generator. And then the third, DUSA, I think there it’s the idea that, well, I’m an index investor. I have a lot of S&P Index but I recognize that there are reasons that the index could go through a tough period. And when it does, I would like to be with a true active manager where that judgment, that flexibility can be incorporated not just due to market turmoil, but turmoil in the economy, technological disruption, obsolescence, regulatory changes. People like the idea of having a portion of their portfolio invested with somebody that can be adaptable and flexible in those sorts of disruptive times.
Gillian: Perfect. Well, gentlemen, thank you so much for taking the time to share your expertise with us and we’ll look forward to having you back as the ETF industry continues to grow. Thank you for tuning in, from our studios in New York, I’m Gillian Kemmerer and this was the latest edition of Masterclass.
1. Bloomberg as of 12/21/16.
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IQ S&P High Yield Low Volatility Bond ETF (HYLV): As a new fund, there can be no assurance that it will grow to or maintain an economically viable size, in which case it may experience greater tracking error to its Underlying Index than it otherwise would at higher asset levels or it could ultimately liquidate. Investments in foreign securities may be riskier than investments in U.S. securities. Differences, including less stringent investor protections and disclosure standards, less liquid trading markets and political and economic developments in foreign countries, may affect the value of the Fund's investments in foreign securities. The Underlying Index seeks to provide exposure to U.S. dollar-denominated high yield corporate bonds that are measured to have less credit risk based on their Marginal Contribution to Risk. As with any measure of a bond’s credit risk, Marginal Contribution to Risk may fail to accurately reflect the credit risk of an individual bond. In addition, Marginal Contribution to Risk is not predictive of the price performance of fixed income securities. In addition, there is no guarantee that the construction methodology of the Underlying Index will accurately provide exposure to U.S. dollar denominated high yield corporate bonds with lower credit risk. As with all investments, there are certain risks of investing in the Fund. The Fund’s Shares will change in value and you could lose money by investing in the Fund. There is no assurance that the investment objectives can be met. High yield securities generally offer a higher current yield than the yield available from higher grade issues, but typically involve greater risk. Securities rated below investment grade are commonly referred to as “junk bonds.” Funds that invest in bonds are subject to interest rate risk and can lose principal value when interest rates rise. Interest rates in the United States are near historic lows, which may increase the Fund’s exposure to risks associated with rising interest rates. Bonds are also subject to credit risk, which is the possibility that the bond issuer may fail to pay interest and principal in a timely manner.
IQ Hedge Multi-Strategy Tracker ETF (QAI): The Fund's investment performance, because it is a fund of funds, depends on the investment performance of the underlying ETFs in which it invests. There is no guarantee that the Fund itself, or any of the ETFs in the Fund's portfolio, will perform exactly as its underlying index. The Fund’s underlying ETFs invest in: foreign securities, which subject them to risk of loss not typically associated with domestic markets, such as currency fluctuations and political uncertainty; commodities markets, which subject them to greater volatility than investments in traditional securities, such as stocks and bonds; and fixed income securities, which subject them to credit risk – the possibility that the issuer of a security will be unable to make interest payments and/or repay the principal on its debt – and interest rate risk – changes in the value of a fixed-income security resulting from changes in interest rates. Leverage, including borrowing, will cause some of the Fund’s underlying ETFs to be more volatile than if the underlying ETFs had not been leveraged.
IQ Merger Arbitrage ETF (MNA): Certain of the proposed takeover transactions in which the Fund invests may be renegotiated, terminated or involve a longer time frame than originally contemplated, which may negatively impact the Fund’s returns. The Fund’s investment strategy may result in high portfolio turnover, which, in turn, may result in increased transaction costs to the Fund and lower total returns. The Fund is susceptible to foreign securities risk – since the Fund invests in foreign markets, it will be subject to risk of loss not typically associated with domestic markets, including currency transaction risk. Diversification does not eliminate the risk of experiencing investment losses. Stock prices of mid and small capitalization companies generally are more volatile than those of larger companies and also more vulnerable than those of larger capitalization companies to adverse economic developments. The Fund is non-diversified and is susceptible to greater losses if a single portfolio investment declines than would a diversified fund. The ETF should be considered a speculative investment with a high degree of risk, does not represent a complete investment program and is not suitable for all investors.
Active management refers to a portfolio management strategy where the manager makes a specific investment with the goal of outperforming an investment benchmark index. Active management typically charges higher fees then passive management.
Passive management refers to a portfolio in which the manager attempts to beat the market with various investing strategies and buying/selling decisions of a portfolio’s securities.
High yield bond is a high paying bond with lower credit rating than investment grade corporate bonds, Treasury bonds and municipal bonds.
A commodity is a basic good used in commerce that is interchangeable with other commodities of the same type: commodities are most often used as inputs in production of other goods or services.
Real estate investments consists of investments in real estate to profit from rental income or general price appreciation.
Momentum investing is an investment strategy that aims to capitalize on the continuance of existing trends in the market.
A smart beta investment strategy is designed to add value by strategically choosing, weighting and rebalancing the companies built into an index based upon objective factors.
Alternative beta or Smart beta defines a set of investment strategies that emphasizes the use of alternative index construction rules to traditional market capitalization based indices.
Duration risk is the measure of the sensitivity of the price of a fixed-income investment to a change in interest rates.
Equity risk premium (risk Premia) is the excess return that investing in the stock market provides over the risk free rate.
Non correlated assets are those that move in different directions from one and other.
Credit risk refers to the risk that a borrower may not repay a loan and that the lender may lose principal of the loan or interest associated with it.
Credit spreads refer to the difference between yields on differing debt instruments of varying maturities, credit ratings and risk, calculated by deducting the yield of one instrument from another.
Standard deviation is a measure of the dispersion of a set of data from its mean.
Short end of the yield curve refers to bonds 0-5 years from maturity.
Beta is the measure of the volatility, or systematic risk, of a security or a portfolio in comparison to the market as a whole.
Sharpe ratio is the measure for calculation risk adjusted return.
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