MASTERCLASS: Fixed Income & LDI - October 2020
September 30, 2020
Jenna Dagenhart: Welcome to Asset TV's ETF Masterclass. We'll cover the current market environment for exchange-traded funds, how they've evolved over time and what's next for the growing industry. Joining us now to share their outlooks and more are two expert panelists. Dodd Kittsley, director at Davis ETFs and Davis advisors and Rich Koerner, senior vice president, sector and ETF strategist manager at Fidelity Institutional. Everyone, thank you for joining us. To set the scene a little bit here, ETF assets have ballooned to more than $4 trillion and that could just be the tip of the iceberg. Rich, starting with you, what do you think has led to all of this growth in the past decade?
Richard Koerner: Thanks, Jenna. Clearly, what ETFs have brought to the marketplace always have been low cost, tax efficiency, the ability to trade them throughout the day and I think those characteristics really propelled what I'd call wave one of the growth that we saw over the last 10 years. Wave two is certainly been accelerated by just the increased amount of choice in terms of the products that are out there. No longer is it just purely passive, index-based solutions. You have factor-based solutions. You have active solutions. You have thematic solutions.
Richard Koerner: That wave two is really, I think, increased the utilization and we're starting to see another new trend really accelerate here in the past few years in the model-based solution delivery for ETFs. No longer do I have to put together an entire portfolio of all these choices. I can turn to large ETF issuers, I can turn to my asset managers, I can turn to my broker dealer and they're providing all sorts of solutions, packaged up for all different types of risk tolerances as well as income needs.
Jenna Dagenhart: There's an ETF for everyone.
Richard Koerner: Yeah, Definitely.
Dodd Kittsley: Yeah, it's really has been nothing short of amazing and Rich really hit on it. It's just the breadth of products out there and over 2,300 in every kind of shape and size and I'll know we'll get into that, but it's amazing. Then, this breadth of types of investors that are using ETFs from the individual all the way up to central banks and everyone in between. It's an amazing delivery vehicle. It's an amazing product. We've come a long way in the 27 years we've been around.
Jenna Dagenhart: Certainly, and I know Rich mentioned we're maybe in the second wave now. Rich, how many waves could there be?
Richard Koerner: Well, I think as we continue to ... I think we're still in the early days of active equity ETFs. We've just seen the first launches. Starting in April, Fidelity's brought our products to market. In June, a couple new products came out here recently as well and more in registration. Dodd and team have had active equity ETFs out there and you're starting to see that Bloomberg just came out with a new report that they're actually more active equity launches this year in 2020 than index-based ETF launches. I continue to believe that we're in the early days of active investing in the ETF wrapper and still not too far along in the factor-based solution.
Richard Koerner: Certainly when you think about on the fixed income side, we've probably just started to scratch the surface of introducing these concepts that are becoming more broadly recognized on the equity side into the fixed income landscape.
Jenna Dagenhart: Dodd, I see you nodding your head over there, especially when Rich mentioned factors.
Dodd Kittsley: There's never been a more exciting time in the ETF business right now. It really is so dynamic. It's the hotbed for innovation. What Rich's firm at Fidelity has done and what we've done in terms of opening the doors to active type of strategies in an ETF wrapper, which I think still today, a lot of folks think of ETFs synonymous with just indexing and that's really a misnomer, and to be able to open that up and all the advantages that Rich highlighted earlier that the ETF structure provides is really driving tremendous value for investors today.
Dodd Kittsley: There's a lot to be excited about. There's a lot coming down the pipeline, and gosh, I can think back 15 years ago when folks said, "Oh, growth of ETFs is going to diminish because all the great indexes are taken." How shortsighted is that? It's exciting and I know we'll get into it, but I share Rich's enthusiasm and outlook.
Jenna Dagenhart: Certainly, an exciting space to be in. ETFs seem to be doing quite well, still thriving despite 2020 which has been quite a year to say the least with the coronavirus crisis and historic selloff. Dodd, what's been the impact on ETFs in 2020?
Dodd Kittsley: I like the way you described it, Jenna, quite a year, certainly with the selloff and now the march back to where we began the year which is just amazing. It's a story that no one could have written. We're still left in the wake of such uncertainty around coronavirus, its impact on the economy. I wanted to just share on behalf of myself and the firm, just empathy for all the folks that have been affected personally, professionally, with the impact of COVID-19. We're really, really optimistic going forward for a lot of reasons.
Dodd Kittsley: I know we're going to get into some opportunities we're seeing in the market later on, so I'll leave that for them. I think this was really a test for the ETF industry for our capital markets in terms of the extreme volatility that we're seeing. It certainly hasn't been our first test. Being around 27 years, we've had our fair share of difficulty in tough times, 9/11, the financial crisis. You can spill off a ton of these, even though this is unprecedented, and no one could predict that the details that have transpired. Still uncertainty.
Dodd Kittsley: To answer your question directly, the impact we've seen on the ETF market has been continued growth. In the second quarter, we saw $136 billion flow into the ETF industry. That's new money put to work, year-to-date over $200 billion. Despite the difficulty in the markets, ETFs are taking in new money. Investors are voting with their dollars. The other trend, I'd say is, look, we're seeing an uptick in volume around ETFs too and typically ETFs account for one out of every $4 traded on equity exchanges, but during periods of distress and heightened volatility, we see that number typically spike.
Dodd Kittsley: What that says to me is that investors are comfortable with the ETF structure. They're comfortable being able to put money to work in a variety different asset classes and strategies and they're doing so. It's really created this level of liquidity in the market, almost a buffer of liquidity in the market that has been advantageous to our capital markets. Who benefits is the end investor.
Jenna Dagenhart: Comfort during times that can be very fearful for investors like we've seen this year. That's a great point there, Dodd. Anything you'd like to add, Rich, about 2020 and the impact on ETFs?
Richard Koerner: No, I think the point that Dodd hit in terms of the flows, we're spot on, strong first quarter flows in spite of all the volatility that we had. Sometimes, you have to remind folks that in March, we had four 15-minute circuit breakers. We had four moves where the market had a stop because it was down more than 7%. Throughout all that, ETFs continue to attract assets, more than doubled those flows in the second quarter. It really feels like people are using the products, continue to see, as we talked about in the beginning, a lot of interest in the broad-based market exposures because there's some of the oldest products. They have some of the lowest cost and have some of the best liquidity.
Richard Koerner: I think that ability, especially with this market volatility, to time your trades, we've seen so many days where the market either starts up and ends down or starts down and ends up or sometimes does a whole round trip throughout a day, that intraday liquidity has really probably never been more important than it is right now.
Jenna Dagenhart: Yeah, that's a great point. Anything else that you would like to add Rich about the current market environment and economic environment for ETFs? We are seeing extreme volatility and we have this year, as you mentioned, with the circuit breakers, I remember when some of those were triggered.
Richard Koerner: I would say, cautious optimism. We certainly are seeing some signs that this quick deep recession that we went into that we're starting to see some leading economic indicators already come back and starting to see some evidence of a V-shaped recovery, but at the same time, there's still so many unknowns. We are seeing a rise in certain areas of the country in terms of new cases. We're starting to see some states and cities and counties having a roll back some of their reopening’s.
Richard Koerner: Our approach in this environment right now is we think about it as a barbell. Things like healthcare, they've done well this year, staples, utilities, which hasn't done as well, but you know, still historically, the defensive sectors offer a nice balance with an, I'd say, equal attribution to more pro-cyclical sectors or more factors that we've started to see a recovery in terms of flows in things that have been, I would say, beaten up over the last 10 years things like value stocks or dividend paying stocks.
Richard Koerner: I think, again, staying close to those target allocations, thinking about a barbell approach to your investment portfolio, really important today.
Jenna Dagenhart: Digging a little bit deeper into your strategies, Dodd, why did Davis enter the ETF market in 2017? You mentioned earlier some people had been saying, "Oh, it's maybe a little bit too crowded," but you said, "No, we're going to get in here."
Dodd Kittsley: We feel really fortunate to be among the first to offer active equity ETFs. What we really did hear was marry two beautiful things. The first is time-tested proven active management. Our strategies aren't new. They've been around for over 50 years in the case of our large cap strategy. To be able to bring that team, bring that investment discipline that's been refined and enhanced over the years to the ETF market is pretty remarkable and then to also be able to marry that with all the benefits that traditional ETFs offer.
Dodd Kittsley: Again, Rich talked about, but it's worthy of repeating the liquidity, the transparency, the tax efficiency, generally lower operating costs. We did that for two real reasons. The first is our clients asked. We had longstanding clients that approached us and said like, "Look, I'm changing the way I'm managing money. I see the advantages in ETFs, but unfortunately, my only choices are passive." We all know that the best portfolios combined both passive and active together, so there was really a void in terms of choice out there for folks.
Dodd Kittsley: I said, "Why can't you do that?" and to our firm's credit, we took a deep look on a lot of different avenues we could have gone. The long and short of it is we were able to launch an active strategy in the traditional ETF format. We were fortunate because of the way we manage money, being low turnover, large liquid securities, so a lot of the concerns that made other active managers have to wait, really more in play for us in our four strategies that we have out in ETF. The other thing is really just choice. We felt like, "Look, we want to provide access to Davis, to those that are interested and understand the value. We can bring to the marketplace, but we don't want structure to drive if you're going to use us or if you're not."
Dodd Kittsley: The fact of the matter is for a lot of investors; mutual funds may be the most appropriate delivery vehicle. It meets their wants and needs, may be separately managed accounts are and maybe ETFs are. It's a real position of power to be able to offer our strategies in whatever delivery vehicle meets the wants and needs of end investors. Just a quick analogy on that too, our firm formally launched 51 years ago, but we, prior that, were an institutional money manager. Our chairman's father, Shelby Davis, was approached and said like, "Why don't you deliver your strategies in a mutual fund?"
Dodd Kittsley:The knee jerk reaction is, "Well, we don't do that. We're an institutional money manager. Let a mutual fund shop do that," but long story short, that's what started our firm 51 years ago in the launch of our large cap strategy. Fast forward to the '90s, there was demand for separately managed accounts for a lot of good reasons. Then fast forward to 2017, there's demand for ETFs. A long-winded way of really saying that we want to provide our strategies in the way that folks want to consume them is in their best interest. It's very rewarding to be able to do that.
Jenna Dagenhart: I've heard some good Shelby Davis quotes too if you'd like to share any of those with us throughout the panel.
Dodd Kittsley: We'll try to work a couple of those. No one says it better than Chris, but I'll give it my best.
Jenna Dagenhart: Rich, tell me a little bit more about Fidelity's ETF initiative.
Richard Koerner: We came back to the ETF marketplace in the fall of 2013. We launched 10 sector ETFs. This was part of a broader initiative at Fidelity to ... We wanted to come back to the marketplace because we had a long history and heritage of sector investing. We launched some of the first sector in industry mutual funds in the early '80s. By the end of 2000, we had over 40 products and $40 billion in assets under management. We wanted to come back and reengage and reinvigorate that discussion around what are useful tools sectors are in portfolio construction to either make the portfolio more defensive, to add more income, but we recognized where we were in the marketplace.
Richard Koerner: As Dodd alluded to, we need a choice. Investors, advisors, their clients, they wanted that ability to have choice in terms of, "Do I want an active solution, or do I want a passive ETF solution?" We launched those 10 products in the fall of 2013. We added real estate in 2014. Today, we have over $15 billion in our passive lineup. The exciting for us as an organization is, we really invigorated that discussion broadly and more than doubled our active sector mutual fund assets. Since then, what we've tried to do is bring the very best of Fidelity in the ETF wrapper.
Richard Koerner: In the fall of 2014, we launched our first three actively managed fixed income ETFs. Today, that lineup is over a billion dollars in assets under management, and then, we introduced our factor-based lineup in the fall of 2016. This has been a real success story for us as well. I think part of the Fidelity history and heritage is people think of some of our great historical portfolio managers like Peter Lynch, today Will Danoff, and you think a bottom-up fundamental stock picking as Fidelity's strength, but what most folks don't know is we've actually had quants on staff since the mid '60s, and for the last 20 years, our quantitative investment team is fully integrated with our fundamental investment team.
Richard Koerner: The quants sit and work alongside the fundamental PMs that they help support. We have a library of over 3,000 different factor models. To be able to come into this factor marketplace was a natural evolution for us. We took the approach to not go to an index provider and get an off-the-shelf solution. Today, we have over 12 equity factor-based solutions. We have two fixed income factor-based solutions and over $1.5 billion inside that factor lineup.
Richard Koerner: Then, finally, as we talked about at the beginning, we just launched a little bit over a month ago that next evolution in the ETF industry and that's active equity in a nontransparent wrapper. We just launched those three products a little bit over four weeks ago. We've already seen a really good success, across the three products and really good client interest.
Jenna Dagenhart: Wow, and sticking with active here, Dodd, how can active add value in client portfolios?
Dodd Kittsley: Well, active can add a tremendous amount of value. Let me asterisks that a little bit and just say good active can add a tremendous amount of value to the client portfolios really by increasing the amount of wealth that can be compounded relative to just the average of the overall market. Human judgment, discretion, experience really can come into play to take advantage of inefficiencies that are in the marketplace. We're in this environment where sentiment and conventional wisdom is active can't outperform passive and that simply hasn't been the case historically. It tends to follow a very kind of cyclical pattern and we have been in a decade of a momentum-based bull market where the average active manager certainly has not outperformed passive.
Dodd KittsleyI can understand why many investors are gravitating more towards passive than active, but that's not the right question to ask. The right question is really, what are the characteristics of a good active manager? Just a few to share, one is an established track record of experience. That is incredibly important. Somebody who's been able to do it in the past but certainly is in a position and has the experience of having gone through different market cycles to really make very sound decisions. Reasonable fees is another. You see a lot of bad actor there that is charging a ridiculous amount.
Dodd Kittsley: I think ETFs have put pressure overall in active management on the mutual fund industry and for very, very good reason because a lot of folks aren't priced accordingly. Looking different than beta, looking different than the market is so very important and there's an enormous amount of pressure on portfolio managers today to keep their jobs and not underperform over a short period of time. You have that risk when you have a high-conviction portfolio of underperforming short term but doing the right thing for the long-term investor. Being able to not look like low-cost beta because if you do, if you window dress and you threw up sector in stock positions, why not just buy the S&P at three or four basis points. You're not paying for anything now, really having your best idea is in a portfolio that you're delivering to folks.
Dodd Kittsley: Finally, I think being aligned with investors is so very important and it shocks me how rare it is where roughly 50% of all US mutual funds, the portfolio manager doesn't have a single dollar invested alongside clients. That was one of the things when I joined Davis about four years ago that really attracted me to the firm is that we eat our own cooking. The firm and the employees are amongst the largest shareholders in every single one of our strategies. That's incredibly important and results can speak for themselves.
Dodd Kittsley: Our large cap strategy has been around 51 years and a few months, and it has doubled the return on a compounded basis of the S&P 500 over that time period. I know it's a long time period, but when you're talking a $10,000 investment turning into over $2.3 million, it's a big deal. There are folks that can do that. We believe we can over a long period of time and active can be very exciting, but I also want to say, it's going to be for folks with the right temperament as well. We talked about these periods of outperformance and underperformance.
Dodd Kittsley: Active can be really hard for folks that don't have their emotions in check. That's where financial advisors certainly come in but being able to withstand underperformance in a manager that you have strong conviction within is going to build wealth over long periods of time. That's the right client base for us and the right client base for active managers.
Jenna Dagenhart: Making sure you can still sleep at night.
Dodd Kittsley: Absolutely. For those that are driven by emotion and are going to overreact, Lord knows we've had a lot of headlines, particularly this year, which is easy to overreact to and not seeing the big picture. Going an index route and not looking at relative performance over short periods of time might be in the right avenue, but for those serious about compounding wealth over the long term, active can be a very viable solution.
Jenna Dagenhart: Rich, can you expand a little bit on your goals with active equity or nontransparent ETFs?
Richard Koerner: Yeah, we're looking to be a leader in terms of not only launching the products and being an innovator in that space. So far, as I mentioned, we've seen good success in terms of not only the AUM growth, but since this is a new vehicle. We've seen tight bid ask spreads and we've seen good liquidity across the product suite which are always some of the questions that you get anytime you launch any new ETF. The other exciting avenue for Fidelity is we're licensing the technology to other asset managers. We want to continue to do that and bring more people onto the Fidelity platform for active equity ETFs.
Jenna Dagenhart: Dodd, what makes Davis' ETFs unique in the marketplace would you say?
Dodd Kittsley: Well, gosh, we're unique in a couple different dimensions. One, I think just by the very nature of being active and not being in a new active strategy but being a time-tested strategy with portfolio managers and a research team that's been together for more than 20 years is something really special in the ETF space. When you look at assets across the overall industry, we're talking of $4.4 trillion industry, active at large is only 3% and active equities less than 1%. As Fidelity and some of these other firms that are getting into the game, it's going to change that and you're going to find ...
Dodd Kittsley: In my opinion, it's going to be the fastest growing segment of the ETF industry, but we're unique and differentiated just by the virtue of being active and being time tested and not some kind of new just rules-based strategy. I think we're also just very unique in our approach within active, of being a high-conviction manager where we only own 25 to say, 30, 35 stocks in a particular ETF. We want to make sure these are our best ideas. These are companies that are going to compound wealth over time and what we don't own is as important as what we do own.
Dodd Kittsley: The Davis follows this characteristics that I believe in my heart of hearts are so important if you're going to go with any active manager. That's a low cost, looking different than the benchmark and eating your own cooking. I think from all of those characteristics we're quite differentiated.
Jenna Dagenhart: Rich, turning to industry flows, what are you seeing in terms of flows in your lineup?
Richard Koerner: We've seen really strong flows within our sector ETFs and that's not surprising. With the volatility that we've seen in the market, people are looking to take advantage of some of the areas that are really driving growth, so no surprise. Things like technology, healthcare, really seeing strong flows. Some of the more cyclical sectors inside of the sector space are also attracting flows, but I'd say up and down, the lineup in our sector area, they have different viewpoints and that's what you can do with an ETF is express those viewpoints.
Richard Koerner: Some people might have a different outlook on real estate and so we've seen flows in and out across that area as well as some other areas inside the sector space. In the active area, our fixed income flows continue to see really strong demand from clients. I think right now what people are looking for in the actively managed fixed income space is help building a well-constructed portfolio. With yields this low, it's hard to find income, it's hard to determine how much high yield or emerging market debt exposure.
Richard Koerner: Our strongest flows a bit into our core plus product FBND, that's the Fidelity Total Bond ETF, but we've also seen nice flows into the factor lineup. I think the interesting thing that we've seen there is, in 2019, industry flows were off the charts for more defensive factors like low vol and quality, started the year like that as well, but now we started to see those areas slow down and we've seen this rotation into more of the value, early cycle names, value dividend plays, a little bit of a broadening out inside the factor landscape.
Richard Koerner: Then finally, as I mentioned, the active equity ETF is off to a good start, I think, as Dodd mentioned, we're in the early days of active equity ETFs and certainly going to continue to see strong flows in that area.
Jenna Dagenhart: We've seen so much innovation and it sounds like there's still so much more yet to come. Dodd, can you comment on the evolution of the ETF marketplace?
Dodd Kittsley: Sure, yeah. ETFs have gone through a revolution and an evolution at the same time and revolution in the perspective of the broadening investor base, diversity of users, diversity of products, but the evolution is probably the easiest way to describe this, just do a short timeline with some signposts and inflection points if I could. First ETF 1993 on a January day, S&P 500 exposure, SPY, not a lot happened in the ETF industry really until 2000. It was primarily used by institutions, a handful of sectors, couple country funds, but most of the activity was in the three largest ETFs giving market exposure.
Dodd Kittsley: 2000, a gentleman by the name of Lee Kranefuss came along and took a risk at PGI and launched iShares. Essentially what they did is they launched 40 products that were viewed by the marketplace as building blocks, putting together portfolios. All of a sudden, you can build an asset allocation model using exclusively ETFs, again, largely just market cap weighted. 2004 in November, GLD was launched and this to me was the most profound moment in the ETF industry for two reasons. First, it instantly made an asset class relevant to a broader investor base.
Dodd Kittsley: Prior to that time, you couldn't buy a physical gold without significant challenges in storage costs and quality and procurement and what have you, but the more profound thing that really happened then is it signaled to the marketplace that ETFs are not just about indexing. ETFs are truly about providing exposures in a more efficient way. Those exposures can certainly be indexes, bull markets, market segments and strategies. After that time, we began to see this renaissance of innovation in terms of folks thinking about indexes but different angles.
Dodd Kittsley: As Rich mentioned, low volatility or dividend growers or all things that you could really map out mathematically in terms of a stock screen or a filter to a broader market and that's where really factor-based investing, strategic investing in the ETF landscape began to really take off. We define that category as not market cap weighted but weighting stocks based on particular characteristics and selecting stocks based on particular characteristics. You can go the gauntlet there and we're still seeing a lot of innovation.
Dodd Kittsley: Then enter active and active is very different than factor-based investing or strategic beta because it brings in the human element. You have to have the belief that experience, and judgment can add value over market cycles in the long term. That is, I think, a beautiful thing because we finally see ETFs not just be about indexing, not just be about indexing plus but really representing higher opportunity set that now everyone can access, not just the largest institutions. It's really democratized things and allowed individual investors, advisors, all the way up to the biggest investors to be able to employ pretty sophisticated strategies or if they want something very, very simple as well.
Jenna Dagenhart: You don't have to be a mega institution to invest in something that you have conviction about.
Dodd Kittsley: Absolutely. I think the beauty of that also is everyone's on a level playing field. Unlike other products where if you're a big boy coming in, a big investor, you get breakpoints, you get different kind of levels of access. If I'm buying one share of an ETF, I share the same economies and scales that the Federal Reserve just enjoyed and buying fixed income bond ETFs. That's pretty cool to me and that's another reason why I wholeheartedly believe in this industry and the value that we're driving.
Jenna Dagenhart: I will touch on that in just a moment with the Fed, but before we get there, Rich, what are you hearing from clients? What's resonating with them right now?
Richard Koerner: I think in the early days of the COVID-19 situation, with all the market volatility, people transitioning to working from home, there was a need and I think a lot of asset managers, Fidelity included, provided this solution was, "Tell me everything. Please tell me everything that's going on because there's so much happening, and I need to wrap my arms around everything that's going on." In the early days, you could find a Fidelity webinar or Zoom call happening almost every single day of the week. I think as people have now transitioned, we've seen, although we're still seeing volatility in the marketplace, I think people now have a little bit better handle on what's happening in the economy, what signs are we looking for?
Richard Koerner: We still continue to provide the same regular updates that we always have in terms of quarterly market updates, quarterly sector updates, but what we found is clients are really Now looking for specific information. We've really tailored our content for shorter timeframes, but specific topics. We've recently conducted a call just on the COVID-19 situation as it relates to testing and antibodies and vaccines. Certainly, there's obviously a broad interest in that, but if you have enough of that information, you don't have to attend that.
Richard Koerner: Also, we've been we've done things thematic in nature, a lot of interest around 5g and how that is playing out in the marketplace and how you can tailor your investment portfolio to take advantage of this 5g theme that we're seeing. Whether it's market related or pandemic related or thematic related, I think the more specific you can be, you won't attract the broadest audience that we did in the early days, but what you're going to find is advisors who are really engaged, want to better understand that subject, rather than talking about, "All things factors," we'll focus in on maybe some of the early cycle recovery factor plays and just focus in on value and dividends.
Richard Koerner: As I said, it might not attract the same large audience, but people who are there are engaged. They're submitting questions. They're very excited about the topic and it shows in that engagement.
Jenna Dagenhart: Helping people understand a variety of topics from COVID-19 to the Fed's actions. As part of the Coronavirus Pandemic Stimulus Package, the Fed has been buying corporate bond ETFs, as Dodd mentioned, for the first time ever. What are your thoughts on this, Rich?
Richard Koerner: Well, I think the Fed understood the importance of ETFs to the corporate bond ecosystem. Certainly, in March, as you looked at the volume associated with some of the largest corporate bond and high-yield bond ETFs out there, they were trading 75,000, 80,000 times the volume of some of the largest individual issuers in that space. I think it was just a natural evolution that the Fed recognized, "We need to provide liquidity to the corporate bond market," ETFs help provide that liquidity that help provide a price discovery mechanism. It's a natural evolution to using ETFs in that manner.
Jenna Dagenhart: Dodd, I know you're more focused on equity ETFs, but broadly speaking, what does this move by the Fed mean for ETFs?
Dodd Kittsley: It means a lot both ETFs and importantly on the overall market them stepping in and it was a modest amount of money that they put to work in terms of purchases relative to their whole facility allocation. I want to say it's just over $6 billion they put into purchase mostly corporates and some high yield in there. It also signal to the market, "Look, the Fed is serious here. They're going to back the markets up." I think it set a lot of a lot of people at ease. I think it was tremendous for our whole financial institutions here in our capital markets that the Fed stood there, acted and more importantly, I think, send positive sentiment that they are there to backstop this and this is not a financial crisis type of scenario.
Dodd Kittsley: They're not they're not the first central bank to purchase ETFs. The Bank of Japan has been doing this since 2012, more in the equity side in their local market. The last thing I'll say is that I think it legitimizes ETFs too, the fact that they're purchasing ETFs. ETFs have really changed our capital markets and fixed income by providing this extra level of liquidity to a fixed income space which in many segments is a very discontinuously liquid market where you can see a lot of divergence in terms of true values. High-yield bonds don't trade every day. A lot of bonds don't trade every day, so it's really hard to kind of assess the true level.
Dodd Kittsley: I think ETFs really do step in there and provide more price discovery, provide more transparency in a traditionally over-the-counter market that it's opaque. It's negotiated and putting out on an equity exchange. It's competitive and transparent. It really changes the game. It was exciting to say.
Jenna Dagenhart: Certainly a big move for ETFs. Even if it wasn't a large amount, as you mentioned it, it really does signal that the Fed is there. Turning now to opportunities, Rich, do you have any hidden gem or undiscovered ETFs that investors should be aware of, you think?
Richard Koerner: We're really excited about FDHY, which is the Fidelity High Yield Factor ETF. As I mentioned earlier, we think we're still in the early days of factor-based investing on the fixed income side and we're continuing to educate advisors and their clients about some of the same factors that they're familiar with on the equity side, but just translating them to the fixed income side. FDHY uses the value factor as well as the quality factor to screen and select securities. The product, it's somewhat hidden. It's been out for over two years, but it has over $100 million in AUM. That's a critical threshold, we think, to start attracting platform interest.
Richard Koerner: Since it's been out for over two years, it's outperforming its benchmark by almost 300 basis points. It's outperforming the traditional, some of the older, larger passive-based high-yield ETFs by over 450 basis points and it's beaten 98% of its peers across the high-yield universe. We're really excited about FDHY as a solution for folks who want to have that high-yield allocation inside their investment portfolio.
Jenna Dagenhart: Dodd, turning over to you, where are you finding opportunities and risks in today's market?
Dodd Kittsley: Well, we are seeing a lot of opportunity, despite certainly the selloff and now the runoff again. It's a very interesting market. Maybe, I'd start where we're avoiding because we do see a lot of risk out there as well. Certainly, companies that have plummeting revenue, high-fixed costs and a lot of debt. Let's face it, we don't know how long it's going to take for the economy to be able to get back to a more normalized rate. We're seeing that in earnings coming out last week, this week, throughout the quarter which is challenging and depressed numbers and it's really hard to get a handle on the long-term earnings potential which is where we're focused on as a research team in terms of companies that on the other side of this thing can really grow market share and grow earnings.
Dodd Kittsley: Where we're finding opportunities is really in businesses, in stocks that have a couple characteristics. Probably the most important is durability. What is their capital position? What do they have in terms of reserves? Do they have low debt? Can they be a going concern if this uncertainty and economic activity remains repressed for quarters on end? You got to survive. It's a survival game for a lot of companies. Then, another character that we look at is long-term relevance. Consumer preferences are changing.
Dodd Kittsley: There are some nice-to-have companies thinking like luxury goods and some aspects of the travel industry and what have you, and then, there's some must haves. We need banks to survive long term. We need certain types of industry. That's where we're focused on. To answer your question even more directly, we see an enormous opportunity in financial right now. We think that the market is severely mispricing financials where they're pricing it as an almost go out of business, dire type of scenario based on earnings where certainly hit in a big way over the last quarter, in the last few quarters.
Dodd Kittsley: Will that persist for three years from now? I don't think so. We're seeing some great financial companies trading at five times, six times earnings, which as earnings begin to go up again which they will, we know we will-
Jenna Dagenhart: With trading and other services.
Dodd Kittsley: Absolutely. Yeah, absolutely. For every reason that people give of why-not financials, a flat-yield curve, memories of what happened during the financial crisis, this time is very different. There are at least one or two reasons why financials right now and I don't think the market is really getting that as much. You look at capital, financials have two times the capital they had going into the financial crisis in 2008. Their long-term earnings power to your point doesn't just come from net interest margin. It comes from a lot of other types of revenue.
Dodd Kittsley: We saw that with JP Morgan's earnings. We're going to see that with other company's earnings as well but recognizing that the headline numbers aren't going to look really good for the foreseeable future, but the business and the businesses of some of these banks is way undervalued.
Jenna Dagenhart: A lot of them are being defensive too with how much capital they're setting aside in case of an emergency.
Dodd Kittsley: Absolutely, yeah. Setting aside ahead of time. If there was a sector and industry that was overprepared for what we're going for, it's the financial sector, right? We learned the financial sector learned a tremendous amount of result of the financial crisis. To your point, having capital ratios that are 2x what they were going into the financial crisis and marking down expected loan losses in a very conservative type of fashion. That hits today's earnings. Will those losses be realized? Maybe, but over a long periods of time. We're seeing these earnings numbers that are really just distorting the real long-term viability and growth of those businesses.
Jenna Dagenhart: Well, speaking of financials, Bank of America has called for ETF assets to grow to $50 trillion in the next decade. That's obviously a lot of growth considering we're just over $4 trillion right now. Do you think that's doable, Dodd?
Dodd KittsleyOh, my gosh, we're in the business at Davis of not doing predictions but preparing. I think directionally ETFs have a huge bright future. There's no reason why that 25% compounded annual growth rate that the industry has had can't continue for quite a long time. The $50 trillion is a big number.
Jenna Dagenhart: It is.
Dodd Kittsley: Even Austin Powers, I don't think, could get his arms around that one, but yeah, you look at the mutual fund industry today. We're at 21 and in change and that's doubled over the last decade. Foreseeably, yes. It can grow pretty dramatically. I don't think all that growth comes from just everyone going in the past. I know the report you're referring to and I read it and I think a lot of their premises in terms of catalysts for growth and drivers for growth were spot on. Factor investing. We heard about thematic stuff. Fixed Income for sure, that's going to be again a huge, huge driver.
Dodd Kittsley: I didn't see active really being mentioned there. It's more of an angle on continued growth of passive. That, I'm a little bit less bullish on. My view in passive is that it is an incredibly valuable tool for all investors to employ, but going all passive is, I think, just as dangerous as going all active and anything in between. I think what we've seen over the last decade and a half has been a truing up where individual investors and financial advisors didn't use that indexing tool at all. It was getting to almost, I don't want to say equilibrium, you're never going to know where that's going to be. Long-winded way of saying yes, I think it's going to grow. $50 trillion is a big number, but we'd all be happy if that was the case.
Jenna Dagenhart: Rich, what do you think?
Richard Koerner: I'm glad you asked Dodd first.
Jenna Dagenhart: Put him in the hotseat.
Richard Koerner: I agree with Dodd. $50 trillion is a very big number. I think if we get there, there'll be a lot of happy folks in the ETF industry, but I agree with Dodd. Even though we continue to see a lot of strong flows, it's a broad market passive. There's a tremendous amount of concentration right now, just inside, you look at the top five names in the S&P 500 accounting for about 22% of the index. They're driving a tremendous amount of the return this year. I think folks are going to look at that. If you have the news media on, it's a big topic, "How much technology is too much technology? How much FANG is too much FANG?"
Richard Koerner: I think that's going to open up more avenues. We just crossed over S$1 trillion in factor-based investing. I think that will continue to grow. We've talked about it today, early days of factor-based fixed income investing. Then, active ETFs are here to stay and we're going to continue, I think, to see more and more product launches on the equity side, but still this is a great environment for all active management, whether it's on the equity side or on the fixed income side. People need those solutions now more than ever.
Richard Koerner: As we talked about, what the ETF wrapper affords you is usually a lower cost structure with more trading flexibility and usually more tax efficiency than the mutual fund wrapper. Putting all that together and then giving folks the choice as to what vehicle fits their investment needs is the best. I think ETFs are always going to remain at the top of the discussion list.
Jenna Dagenhart: I see you nodding your head over there, Dodd. Are there any ETF trends that you think will continue or accelerate in the years to come? I know we've talked a lot about active.
Dodd Kittsley: Yeah, I think active has got to be first and foremost and we know it takes a while. I think maybe the market is underestimating how big this really could be. In most segments of the ETF markets historically, it's been almost a hockey stick type of growth period where it takes two to three years of market getting familiar with new strategies, new structures, what have you. Then, they really started to take off. I know we're obviously interested in and I'm knee deep as Rich is in active, but that Rich highlighted fixed income, I can't underscore that enough.
Dodd Kittsley: The ETFs are changing our capital markets for the better by creating more buffer of liquidity and more access to a market that's traditionally been not that accessible. Indexing is going to grow as well for sure, but I guess the thing I will say is a lot of folks look at this forecasts and assume that that is predicated on the mutual fund business going out of business or losing such a share that it'd be so dramatic. We don't see that happening as well. We think there is certainly a right user, right situations for mutual funds as there are for SMEs.
Dodd Kittsley: ETFs stacked up against those two. For a lot of investors, it's super compelling but not for all investors. Our view is that ETFs aren't going to wipe out the mutual fund industry, whatsoever. Just wanted to throw that out there because I think a lot of folks assume that it's an either/or and it doesn't necessarily have to be.
Jenna Dagenhart: I like to end by looking forward, Rich. Moving forward, what's your outlook for the future?
Richard Koerner: Well, I'm really excited for the future of ETFs. I think as we've talked about, we're moving along to the next innings in ETF product development. We've seen the explosion of factor-based solutions. We continue to see more thematic solutions that you get to exposure to more granulated themes that folks are looking to play in this environment. We've had this explosion of active, whether it be active fixed income or now here recently active equity. This is an exciting time for us at Fidelity. It really allows us to take our history and heritage of over 74 years of active equity in fixed income investment management and offer those solutions in the ETF wrapper.
Richard Koerner: Whether that solution be an active fixed income, a factor-based solution or now the active equity really is an exciting time. I think as we continue to have these discussions, we'll look less at the newness of, "You don't have active equity," and we'll have more discussions about how the products are performing, how they're stacking up versus some of their passive benchmarks. I think we'll continue to see more adoption throughout the industry.
Jenna Dagenhart: It'll be interesting to see what we'll be talking about on this panel in the years to come.
Richard Koerner: Definitely.
Jenna Dagenhart: Dodd, any final thoughts from you on where we go from here?
Dodd Kittsley: I Just want to underscore how excited we are for the future. It may seem a little tone deaf given how difficult and challenging and uncertain the markets may appear and the headlines that we see, but we see a really bright opportunity. I believe in the human spirit and we overcome these things. We don't know when and we have to prepare for that. It's really hard to predict. Focus on the preparation from an investment perspective is really important. I think selectivity is going to be really, really important as well in the coming decade where that may not have come to bear or be believed over the last 10 years we've been through.
Dodd Kittsley: I'm just so excited like Rich. Hey, the toolbox for investors is getting bigger. It's getting better. It's becoming more efficient. It's becoming lower costs. We're democratizing investing and it's exciting really to be a part of that. Those are my final thought.
Jenna Dagenhart: Exciting times indeed. Well, gentlemen, thank you so much for joining us.
Richard Koerner: Thanks for having us.
Dodd Kittsley: Thank you, Jenna.
Jenna Dagenhart: Thank you for watching this ETF Masterclass.