MASTERCLASS: Small Caps - June 2020
May 20, 2020
Remy Blaire: Welcome to Asset TV. This is your ETF Masterclass. 2019 was a momentous year for the ETF industry. The market continues to expand in the US and around the globe. As the major US equity averages soar to new record highs, US-listed ETF assets topped $4 trillion, while the global ETF market has grown beyond $5 trillion. Joining me to discuss the investment landscape for ETFs: Jeremie Capron, Director of Research and Managing Partner at ROBO Global; Todd Rosenbluth, Director of ETF and Mutual Fund Research at CFRA; Jeremy Senderowicz, Partner at Dechert; and Scott Szever, Director of Exchange Traded Products at the New York Stock Exchange.
Well, first and foremost, as we head into the final round of 2019, we know it's been a momentous year for the ETF industry. Jeremy, starting out with you, can you tell me about your area of expertise and what the key milestone has been for you?
Jeremy Senderowicz: Sure, sure. I'm a partner at the firm of Dechert, and in that capacity, I've represented ETF sponsors for coming up on 15 years or so, and from a regulatory standpoint, we've seen two real milestones this year, each of which I think we are going to focus on in greater depth later on in this program. The first one being the adoption of the ETF Rule, which has been over a decade in the making, and coupled with some other regulatory initiatives by the SEC, really promises to harmonize the regulatory landscape for ETFs and make life easier for sponsors looking to get into the space.
The second key milestone was the approval at two separate times relating to two different models by the SEC of models for non-transparent or semi-transparent active ETFs, which also have been in the works or at least in negotiations with the SEC for many years, and also signals a new type of products, which hopefully will be entering the ETF marketplace in 2020.
Remy Blaire: Well Jeremy, we'll be taking a deeper dive into the ETF rule as well as the new ETF model later in this masterclass.
Jeremy Senderowicz: Mm-hmm (affirmative).
Remy Blaire: Now Todd moving on to you, can you give us a little bit more insight into your area of the ETF universe?
Todd Rosenbluth: Sure, so I head up the ETF and mutual fund research for CFRA. We're an independent research company that covers stocks, ETFs, and mutual funds primarily for the wealth management space. We cover 1500 ETFs based in part on what's inside the portfolio and how much it costs, and so it's been exciting of what's happened in 2019 we've seen.
I think we're going to cover about the record inflows that we're seeing to fixed income ETFs and the differentiation between the credit quality and interest rate sensitivity of some of the more popular products and then separately, even though I don't love that investors are racing towards the bottom and paying as little as possible, we now have our first zero fee and negative fee ETFs that have come to the marketplace so something that we were predicting would happen in 2019.
Remy Blaire: Thank you Todd for that. We know that we have seen US listed asset surpassed the $4 trillion mark this year, so we'll be taking a closer look at some of the flows we've seen this year. Now Scott, can you tell me a little bit more about the expertise you bring to the table and what the key milestone has been for you in 2019?
Scott Szever: Absolutely. I'm a member of our exchange traded products team at the New York Stock Exchange, and what we do is we support our issuers with their products in coming to market. We help them prelaunch and evaluating how they can bring that strategy to market, looking at the regulatory side, looking at the trade ability of that product, and then actually bringing it to market, and then post-launch of now you have this product, evaluating the trade ability of that product, evaluating how do you promote, how do you extend the education of that product for investors. I think Jeremy had spoken a little bit about some of the milestones that we recognize this year, definitely impactful to us.
Also, the approval of extending ETFs to the floor of the New York Stock Exchange, which is going to be in support of some of these models going into 2020.
Remy Blaire: Mm-hmm (affirmative). Scott, I'll be asking you a little bit more of that about the DMM later on in the segment and last but not least, Jeremie, can you tell us a little bit more about the expertise you bring to the table?
Jeremie Capron: Yes, I'm Jeremie Capron. I'm a partner and the director of research at ROBO Global. We are a technology and investment research boutique that is dedicated to helping investors capture the returns and the alpha that's presented by disruptive technologies and particularly robotics, automation, artificial intelligence. We have two ETFs on the New York Stock Exchange. The first one is ROBO, that's focused on robotics and AI, and the more recent one that launched in June that's focused on healthcare, technology, and innovation, that's HTEC.
In 2019, I think we remained focused on our mission dedicated and with passion and if anything, the market told us that this is a really good place to be. I don't see any milestone that really distracted us from our mission.
Remy Blaire: Gentlemen, I think we have a great panel here today. Without further ado, I do want to talk about the changing investment landscape for ETFs and Jeremy, you did mention the SEC approval of semi-transparent or non-transparent actively managed ETFs. From a regulatory perspective, can you give us your take on the approval?
Jeremy Senderowicz: Sure, and the first thing that has to be said is that it was a very, very long time coming and that in fact, the earliest iterations of these products were first put before the SEC well over a decade ago, more than 15 years ago in fact, and been through a lot of twists and turns. We're just very happy on behalf of our clients and everyone else who's been applying for these that the SEC's finally agreed to allow these products to go forward. It's going to be very interesting to see how they're received in the marketplace. From our perspective, there are two main issues that are presented by the approvals.
First is that it's likely that we're going to see enter into the marketplace a few large asset managers that to this point have mostly or wholly stayed out of the ETF space in part because they believe in active management and believe that the requirements to this point of full transparency are inconsistent with their strategies. At least with respect to US equity, this structure finally allows these managers to offer some of their strategies in ETF form, and I think it can only be good for investors to have more choice in terms of strategies that they can invest in within an ETF wrapper.
Yeah. The second key features that these products, at least in the first generation are going to be limited to US equities only. Now it's not surprising in so far is that it traces the history of the SEC's approval of ETFs in the first place and initially, those were also limited to US equities and then gradually built out. I think a lot of people in the industry are hoping that the same pattern will hold this time that if you get your first generation of products and it's a successful proof of concept, then the SEC will be willing to extend its approval of this structure to cover other asset classes.
I should note that just last week, there was a letter from two of the SEC commissioners basically pouring cold water on that idea, at least in the short term, saying that while they voted in favor of approving the latest models of semi-transparent active ETFs, they would be very reluctant to consider extending it to asset classes beyond US equity for now, but we'll have to see how the first generation of products shapes up and if they trade effectively, maybe the commission will be willing to extend that.
Todd Rosenbluth: If I can add, I think the big boys that we're talking about. T. Rowe Price has not had an ETF present beforehand. They're one of the firms that got the initial approval for this fidelity while they have index-based ETFs and they have actively managed fixed income ETFs. They're known for active management in the equity space, Fidelity Magellan, Fidelity Contrafund. We're not saying we're going to see those products exactly in an ETF wrapper, but the proven management that those firms and others bring to the table I think is going to open the doors quite nicely.
We haven't seen much demand for active equity ETFs because we haven't seen much supply of active equity ETFs, but we've seen demand for active fixed income in a fully transparent manner, and we at CFRA I think we're going to see more interest as investors rotate from mutual funds into ETFs in 2020 and beyond.
Jeremy Senderowicz: Right, and I should note that even in the fully transparent space, some of the demand for active product, especially on the equity side, has been limited due to a series of some obscure regulatory positions taken by the SEC at one point or another, but in keeping with the trends of 2019, which is harmonizing and making life easier to go into this space, most of those positions have been relaxed or just abandoned by the SEC over the last couple of years.
I think there has been a real effort to encourage innovation and more products, not just in the semi-transparent space, which has achieved all the headlines, but even in the transparent space, and we'll get to the ETF Rule later on in this masterclass, but that is one of the main themes of the ETF's Rule adoption as well.
Remy Blaire: Mm-hmm (affirmative). Scott, I've seen you nodding your head in response to Todd and Jeremy, so what's your perspective?
Scott Szever: I mean, first of all, it's really exciting and as Jeremy had said, this is a long time that the New York Stock Exchange has been working towards these solutions. The New York Stock Exchange had filed jointly with Natixis for our actively managed solution, so of course we've been supportive of that for our clients, but we also support Precidian, Blue Tractor, T. Rowe, Fidelity and those others that are in registration right now. We spent a lot of years working with the overall partners in those solutions and with the SEC, so November 14th was a very exciting day for us from the proxy standpoint. There’re two different models right now.
There's Precidian who has more of a non-transparent feel to it, and then you have the proxy solutions that are more of a semi-transparent model. Precidian was recognized and approved in May and the proxies were noticed November 14th, so we expect by early to be able to see approval on those. Very exciting for us. What is keeping us busy is, again, we support all those models and working with the issuers to understand how can you bring product to market utilizing these, because each one of them has a different way of supporting that investment strategy.
Persidian very different from the proxy models and then all of the different proxy models have their own little twist or change to bringing that product to market, to allow for market participants to be able to price it accordingly. A lot of education there, a lot of evaluation because some issuers are going to use multiple solutions, maybe four different strategies. They may want to use a Precidian model. Maybe they're going to use a Blue Tractor or Fidelity or NYSE solution. We're there to support all of those as an exchange. Of course, we're there to support the listing and the liquidity of these products. It's a very interesting time and very busy time for us.
Jeremy Senderowicz: Yeah. From our perspective, they can say that while we've been fortunate enough to represent both Fidelity and T. Rowe in connection with obtaining their notice and Scott said, hopefully the final order will be issued in less than a month, we've also workedwith a lot of our clients are very interested and many have licensed already the Precidian model. We're seeing a lot of interest in all the various options that are now on the table.
Remy Blaire: Mm-hmm (affirmative), and I think it's very helpful for the viewing audience to make that distinction when it comes to those different models as well and Jeremie, moving on to you, this model is a significant step forward for the industry, so what do you think are the implications when it comes to new products?
Jeremie Capron: Well, I think investors deserve choice in terms of the strategies and in terms of the providers, and certainly ETFs have been great for that. We've chosen the ETF wrapper to put our strategies out in the market and certainly given the mass exodus towards ETFs in index bonds, I suspect that there's going to be a shift of active funds towards ETFs as well. Certainly, some of these assets could shift to the ETF wrapper, but that is not going to reduce the challenges faced by active managers. The different wrapper doesn't change those challenges in terms of beating a benchmark and I myself have been a sell-side analyst advising active portfolio managers around the world for many years, and it's very hard to beat the index.
I think the market is now saturated with very smart participants and alpha as rarefied, so we need to be creative and thoughtful when it comes to trying to capture alpha, and I think technology certainly is an area that's proven to offer this alpha opportunity. At ROBO, we are dedicated to try and provide a consistent stream of risk adjusted returns that beat their global equities benchmark by focusing on this next technology revolution where we're seeing superior growth and returns on capital.
Todd Rosenbluth: I think that's interesting because while we're talking about active management, most actively managed funds have historically underperformed the S&P 500 or the benchmark that's appropriate for. Part of that reason is that high fee that is often charged. If these funds that come to market are relatively low priced or reasonably priced and they become more tax efficient, they can appeal to investors, but an asset manager that's launching a product that underperforms because it's expensive is going to struggle in the mutual fund world and the ETF world as well.
Jeremie Capron: Yes. If I could add to that, at ROBO we decided to go with the ETF wrapper because of its tax efficiency and low cost. I think for investors out there looking to reduce cost, that's probably an ideal vehicle, and then another point I think is important is that with the ETF format, it's not enough to just propose your strategy under the ETF format. You're going to have to show that history, that track record of delivering returns or risk profile that investors have appetite for.
Remy Blaire: Mm-hmm (affirmative). Well, Jeremie and Todd, both of you brought up tax. Todd, can you give us a little bit of a better understanding when it comes to capital gains and ETFs?
Todd Rosenbluth: Sure. I mean, so we're in the season right now where ETF providers and mutual fund providers are showing how tax efficient or not their products are. Mutual funds in general are less tax efficient than ETFs. Most ETF trading takes place between participants leaving the asset manager out of the equation. I'm selling and you're buying and we're leaving Jeremy the asset manager out of the equation. With a mutual fund, if I want my money back from Jeremy's fund, I have to go to Jeremy. He has to then either sell securities or have cash on hand, and that's a taxable event. We recently wrote about that iShares, State Street, and Vanguard, the three largest of the ETF providers. They have the most products.
They have the most assets as a whole, all have disclosed their limited capital gains implications. State Street is going to have no capital gains being passed on to investors, whereas Vanguard has two bond ETFs and iShares has a handful of ETFs, but mostly they're currency hedged ETFs where the currency hedging aspect is not an in-kind transaction that can limit the tax impact. Whereas mutual funds, it's quite common to have 10% or 20% or even worse of their net asset value being passed along in the form of capital gains regardless of whether or not the fund performed well or didn't. If you held the fund, you're still likely to be paying a capital gain no matter what.
Remy Blaire: When it comes to taxes or ETF models, I think education is so important when it comes to the ETF industry. We have financial professionals, registered advisors watching this masterclass, so what's your advice when it comes to education? I'll throw it out to the panel.
Todd Rosenbluth: You want to do this? You guys at New York Stock Exchange, that's what they do so-
Scott Szever: Absolutely.
Todd Rosenbluth:... I'll let you start there.
Scott Szever: Which is interesting because we're the New York Stock Exchange and our number one goal is to provide liquidity in most efficient markets for our investors, but that is our number one priority, but along with that is then partnering with our issuers to be able to understand what that strategy is and help them relay that message to their existing clients, their potential clients to be able to understand how to utilize these strategies. So much diversity across the product offerings that we see today and that are continuously launching, and how do you implement them into that diversified portfolio? From the New York Stock Exchange standpoint, we do a lot.
We're working with Asset TV to promote a show on a weekly basis to continue to invest their acumen of what's happening in our space. We leverage a lot of our resources at the exchange as well to be able to understand what is that strategy, how should investors be looking at that, and continue and boarding that messaging because that's what's most important for our issuers to really make sure that clients understand the usability and how to utilize that type of strategy, is it strategic, is it tactical, is it core, is it alpha, looking at those different perspectives and allowing investors to really understand how to utilize that in their portfolio.
Todd Rosenbluth: From our perspective at CFRA, the way that we're doing research on ETFs, which I think is a compliment to the work that New York Stock Exchange is doing, we're focused on what's inside the portfolio and how that differentiates between it, so how ROBO is different from some of the other robotics and AI oriented funds, how some of these low volatility or minimum volatility ETFs are different from one another. Technology, I could go through the whole list of suite of products. There's three S&P 500 index based ETFs, and then everybody else is different than the S&P, and it's important to understand why they're different, how they're different and is that right for you and your client's portfolio.
Remy Blaire: Mm-hmm (affirmative), and...
Jeremy Senderowicz: Yeah. From our perspective, let's go back to basics when you think about investor education because while it's not usually cited as something that's a key source of education per se for investors, most educational materials stem from the prospectus. In that respect, nothing is more important for investor education than making sure that your prospectus accurately describes what the ETF strategy is and what its exposures and risks are, and the fact is that anyone should be able to pick up a prospectus and basically answer questions that they have about what is the fund strategy, how does the fund make money, under what conditions and what are the costs of it and what are the risks of things going wrong.
All the educational materials that are more commonly used among retail investors all trace back to that.
Remy Blaire: Well, that's a very important, but the basic point you bring up about the perspective, so I think this is a great time to take a closer look at strategies as well as structure. Jeremie, moving on to you, what do you think makes a theme investible?
Jeremie Capron: Well, in 2013, we embarked on this mission of helping investors generate returns from what we believe is the next technology revolution. Why am I talking about a technology revolution? Robotics and AI, we believe is comparable to what happened with the internet over the past 20 years. That is a set of general purpose technologies that can be applied not in a niche, but to every market, every industry and it's happening now. It cuts across all economic sectors and that's what I would define as an investable theme. That's also something that has length. We talked about rarefied alpha earlier. I think a lot of that and the difficulty for active managers to beat a benchmark has to do with the short term nature of the investment profession these days.
When a manager is focused on the next quarter and trying to beat his benchmark in the next quarter, it's extremely difficult and it has unexpected consequences in the future. I think a theme need to have this capacity to work over a long timeframe, and when we started our journey in 2013, we took the time to put together the research expertise to deliver on that theme, and Todd mentioned that there has been a raft of new robotics named ETFs in the market. If you look under the hood, they're all very different. I think the large providers and issuers have recognized that we've been successful companies and that robotics investing was probably a good thing to do, and they have smart marketing departments that rushed after all that.
I think it's important for investors to really look under the hood and we're very grateful that they are ETF research organizations out there that do that, that really help investors do that effectively. Then also recently, we've seen thematic ETFs that in my opinion are just simply not investible, either because they are too short term oriented or they are really niche, and that means they are very difficult to fit in an investor's overall portfolio. In terms of asset allocation, how do you manage a thematic investment around blockchain when there are no pure play blockchain companies in the public equity markets? I think it's really important that investors do their homework and due diligence.
Remy Blaire: Mm-hmm (affirmative), and Todd, going back to you based on your research for thematic investing, what does it take to see something that's a success?
Todd Rosenbluth: I think you could judge success a couple of different ways. You could judge it based on gathering assets in those products where they gained enough scale, and then it becomes a snowball effect. Often it invites competition, I'm sorry to say, but that's the result of a successful product or a product that is performing better than the broader markets. Now it's performing as it would expect to do because it's the underlying securities. I think there's a handful of themes that have resonated with investors. We've got cybersecurity that has been popular.
There's a product hack that was first to market, and then there's been competition that's resulted there as well, ROBO which we've seen it in the robotics space. We now are seeing a growing number of other products. There's now six cannabis related ETFs in the marketplace as well. We've seen video gaming that is a long-term potential theme in the east sports. I think there's room for these players. There's certainly room for multiple choice within this space, but as Jeremie mentioned earlier, it's important to understand the distinction. Not everybody is going to look at that theme the same way percentage of revenues, the potential that's happening within that space, is it tied to an index anybody knows of beforehand.
You really need to dig into the details, do your homework as he mentioned earlier, and make sure you know what you're getting because there's going to be notable differences in the performance record of these ETFs because of what's inside the portfolio.
Remy Blaire: Mm-hmm (affirmative), and Scott, based on your work at the New York Stock Exchange when it comes to thematic investing, what trends are you seeing this year?
Scott Szever: This year, just like last year as well, really seeing an uptake in thematic investing, and two different spectrums. Very broad based thematic investing and very concentrated offerings are coming out and it's across the board. If it's energy, real estate, communications, technology, even lifestyle focused type ETFs are coming into existence. Really exciting strategies, and I think Todd hit on it as well. There’re different ways to evaluate, are these successful or success maybe looked at in a couple of different ways, but from an investor perspective, is this something that I should be looking at to put into my put into my diversified portfolio.
I think we'll talk a little bit more about the ETF Rule, but even prior to that, the ETF responsibility for ROBO is to really promote what is in this product, what is the exposure you're getting because there are different products out there and you really have to know the underlying, and you can't just look at one performance over another because it really comes down to what is the exposure, and you need to decide as the investment professional, as the DIY investor, what is it that you're trying to achieve in getting this focus and again, is it a long-term holding, is it that satellite alpha that you're looking for short term.
It really comes down to working with those issuers of education and positioning. As far as success, I think that's as an investor would look to say, is this the right holding for my portfolio, and the other part is going to be tradability, is this how easily can I get into this portfolio. I think we'll talk about some of this later, but it's not necessarily just seeing how many shares have traded today, but it's the underlying liquidity of that portfolio, and I think 611 or the ETF Rule is going to help us and help issuers portray that liquidity in a little bit more demonstrative way on their websites.
Remy Blaire: Indeed, we will take a closer look at the ETF Rule later on in the segment, but before I move away from thematic investing, Jeremy, I know that you wanted to speak about ESG and we've seen investing in ESGs as well as integration grow not just in the US but also globally. When we look at the inflows in the latest month, that does prove that as well, but when people are looking at ESG, they don't think that they're sacrificing performance for values. What are some of the challenges that you see ahead?
Jeremy Senderowicz: Well, I think from a US perspective, think that one of the main challenges is going to be dealing with the regulatory and political pressures around ESG themes broadly stated, and to this point, the SEC has not come out with any formal guidance in terms of what it believes constitutes ESG rather leaving it to individual sponsors or index providers to define their ESG criteria as they reasonably see fit, and that is consistent with the SEC's general approach when it comes to investment strategy disclosure.
There is a fair amount of discretion left to advisors and index providers to define their own methodologies as long as they are reasonable and fully and fairly disclosed to investors, but the SEC itself has been under a lot of pressure both from investor groups and potentially from political actors as well requesting that they issue some type of formal guidance in terms of what constitutes ESG and what does not. One of the interesting stories to look ahead for in 2020 is going to be whether or not the SEC does in fact respond to that pressure and issue some type of formal guidance.
Remy Blaire: Well, now that we've covered ESG as well as shed light on technology, robotics and AI, we can't ignore the record that we've seen for fixed income ETFs. Todd, can you tell us a little bit about what we've seen in terms of performance inflows this year, and do you see the trend continuing?
Todd Rosenbluth: Sure. For perspective, the fixed income ETF market is about 20% of the overall ETF pie. Not that large, but it's been growing. This year, we're on pace to have more than 50% of the net inflows be tied to fixed income ETFs. It's also on pace to be the first year in 10 where we'll see more money going into fixed income ETFs than equity ETFs. Not since the great financial crisis, not a lot of good things came out of the great financial crisis, but there was initial demand for bond ETFs. We've seen investors favoring the lower cost structure, the transparency and the tactical use for it. Core bond ETFs, products like AGG and BND and BNDX have been relatively popular.
BNDX is an international product, but we've seen investors favor taking on a bit of interest rate risk with the products like TLT for much of the year as bond yields crept lower. We've seen investors now hunker down a bit more into some of the ultra-short products as interest rates have been rising. You can be both strategic and tactical with these products, and I think we're going to see continued demand. We may not see 50/50 on a yearly basis as from an asset allocation perspective, but we are certainly going to see between 30% and 40% on a regular basis. These products are likely to stay within the portfolio.
Jeremy Senderowicz: Just to tease the ETF Rule one more time before we actually get to it, one thing that might have an impact on demand for fixed income ETFs is the fact that one of the key features of the ETF Rule that we'll talk about in some greater detail later is broadening of the ability of ETFs to use, where to refer to as custom baskets, which as a practical matter will have a disproportionate and positive impact on fixed income in ETFs as opposed to equity ETFs, and make it easier for fixed income products to be offered and scale up. That's one tailwinds that might help fixed income ETFs increase their share of the ETF market.
Todd Rosenbluth: Yeah, the institution of marketplace is likely to have greater adoption of some of these products that have come to market in the last five or so years, and I think that opens the door for more greater usage and then greater liquidity, which helps everybody out as well.
Remy Blaire: I think we're all eager to talk about the ETF rule, so let's get straight into that topic. Now Jeremy, can you give us further insight into the ETF Rule and tell me about this long awaited regulation and why it matters?
Jeremy Senderowicz: Sure, sure. A version of the ETF rule was first proposed back in 2008. At that point, it was much more difficult and expensive to get the necessary exemptive relief to get into the ETF market and many fewer sponsors than today actually have that exemptive relief. If it had been adopted then, it would have had a really sea-changing impact in terms of the ability of sponsors to get into the markets. The SEC had intended to adopt that version of the ETF Rule by the end of 2008. Unfortunately, something called the great financial crisis happened in the interim, so that did not happen and then in the interim, the SEC had a combination of other priorities, and they had some misgivings about the initial version of the rule.
Finally, a version of the rules re-proposed in 2018 and was adopted this past fall and what the ETF rule does, it mostly codifies many of the standard conditions of exemptive relief that sponsors had been required to obtain in order to get into the ETF markets, but it did make some tweaks and almost all of the tweaks were in a direction, which the industry regards as being user friendly and flexible and helping to encourage people to get into the market and the most important example of those tweaks was the ability to use what are called custom baskets, which just to oversimplify a bit, for a long time, most ETF sponsors were required under the terms of their exemptive relief to only use creation and redemption baskets that corresponded to a pro rata slice of their portfolio at any given time, which limited the ability of ETFs to use the tax efficient creation redemption process to rebalance their portfolios.
There’re always some exceptions around it and also it was a controversial topic because the first generation of ETF sponsors did not have that condition in their exemptive relief. You essentially had an un-level playing field that persisted for a long time where the early players had operational advantages over the later entrance into the markets, and the SEC was sensitive to this concern and not only does the ETF rule enact a level playing field, but it enacts a level playing field that is user-friendly for the industry. It's a more permissive structure and does allow ETFs to use custom baskets subject to certain conditions and policies and procedures, which will make it a lot easier for ETFs to use that process to rebalance their portfolios.
As a practical matter, it matters most for the fixed income space because especially when you're dealing with an index products, just the nature of fixed income is such that you're holding a relatively small portion of the index and it's an extreme convenience to have the ability to accept certain substitutes either for securities in the index or to use that process to get security you don't yet have in your portfolio, but want to obtain. The custom basket function is something which is extremely convenient for the industry and has been long sought after. The only other thing I'd add in terms of the ramifications of the ETF Rule is that it's not just the ETF Rule that the SEC has enacted.
It has attracted much less publicity to this point, but simultaneously with the ETF rule, the SEC issued some exemptive relief which harmonized and updated some of the other backgrounds exemptive and regulatory relief that ETFs were required to obtain under the Securities Exchange Act because that relief had been issued in piecemeal fashion over the prior 20 years or so and led to some extremely niche and challenging situations for certain types of products or whenever certain types of product wanted to change their strategies, it ran into some obscure Securities Exchange Act concerns. This was an attempt to respond to that and update that and make it more efficient.
The last thing which Scott might refer to is that just very recently, the exchanges have filed for a rule change to essentially supersede most of the individual rule changes they have been required to obtain over the years for various types of ETFs which without going into too much detail in terms of the rule change process, this process has played an unsung role in holding down the supply of active ETFs in the marketplace. It was a process whereby exchanges often had to apply for individual rule changes for various types of ETFs including for a long time many active ETFs.
While the SEC has moved to loosen those, assuming that they approve these rule changes that are filed by the exchange, it will mostly do away with that particular process, which can be extremely time consuming and inefficient for most at least transparent ETFs.
Remy Blaire: Well, Jeremy, you gave us a comprehensive as well as very thorough look at the ETF rule and Scott, I know you want to weigh in on this, so go ahead.
Scott Szever: Yeah, absolutely. I mean this is a huge impact not only to our issuers, to our trading community, but also to the investors and advisors and RAs and users of ETFs. A couple of different things. First of all, it does help that process to bring product to market and as Jeremy said, the New York Stock Exchange has filed rules to apply to that rule 611, which is the ETF Rule. We're looking forward to working through that process to continue to help that streamline process to come to market, but a couple of considerations, and I think we'll all talk some way about custom baskets, as Jeremy had said just for us to make sure we understand what that means.
For assets to come in and out of the ETF, how does an ETF accumulate assets under management? It's through this create redeem process. Every night the issuer's going to publish a basket and market participants who are trading these products, depending upon market demand, may create new shares of that ETF to deliver to that demand, or if there's a lot of selling, they may redeem those shares back to the issuer for that market demand. That's the elementary one-on-one of how ETFs and create redeem baskets were. Why is that important? As Jeremy said, prior to if you were a passive, if you were an index product, you had to do a perfect slice of that index.
Today with 611, with the ETF rule, you may not have to do that perfect slices. It could be smaller. Maybe you can institute cash into it. The other part is you could do smaller basket sizes. Before, there was minimum basket size that you can do. Now they can reduce that. Why is that important? As an investor in ETFs, why do I care about that segment? Number one, it allows the asset manager, I don't care if it's passive or if it's active, allows them to be able to manage their portfolio in a more efficient way. They can utilize this custom basket in ways to be able to support the trading, rebalancing, the changing to their strategies a little bit more efficient.
Number two, the basket sizes and that custom process to those market participants who are providing that liquidity maybe able to do it with less cost because it's a smaller create basket or a redeem basket that they're managing to, so that in turn may lessen the cost to the market makers, which in turn now investor, here's why it's important to you. In turn, you may see better market quality. You're going to see maybe different liquidity in that product, but most importantly to be approved and to be able to launch products through this ETF rule, the SEC provided guidelines of what has to be featured to the issuer's website, bringing more transparency to that product.
What is the investment strategy, what is the trading profile of each of those products, so that the investor has a better assessment of this overall strategy, its liquidity, and other concerns that will be addressed in this rule.
Remy Blaire: Mm-hmm (affirmative).
Todd Rosenbluth: To add to it, so the liquidity is enhanced by this, but the costs that are tied to the ETF that are going to be disclosed. We at CFRA believed that the trading costs, the price in that asset value are just as important as the expense ratio in future returns, and so investors focus solely on the expense ratio of the product, maybe the performance record, and a little else behind it. This is going to shine a brighter light on those additional costs and make it easier for investors to use some of these smaller in size products, even though there's greater liquidity behind the scenes.
Remy Blaire: I think it's helpful to get all of your different perspectives when it comes to the ETF rule, so Jeremie, what's your take?
Jeremie Capron: We love the ETF rule. We think it was long overdue.
Remy Blaire: Well, I do want to move on to discussion about best practices when it comes to ETF. Todd, what are your thoughts when it comes to best practices for investing in ETFs?
Todd Rosenbluth: Sure. Well, so you shouldn't just judge the ETF based on its label, or as I mentioned earlier, the expense ratio or its performance record, but dig inside, understand what is inside the portfolio, how that matches up with what else is inside your client's portfolio, both from an equity and fixed income perspective, understand the risk reward characteristics of that portfolio, and how it differentiates between peers that are out there. You can use our research at CFRA. There's other third parties that are out there that are judging ETFs. You can use the content that's on the website like ROBO and others to be able to do that, but don't just choose the easy button when you're looking at an ETF. I'll leave the trading aspect to I think my friend to the left of me.
Remy Blaire: Jeremy tell me about the future of ETFs in an investor's portfolio?
Jeremy Senderowicz: Well, from our perspective, I mean we're hoping that there continues to be an increasing slate of choices for an investor to possibly include in its portfolio, and that's really what our mission is. We're glad to work with our clients as they keep innovating, and we'll see if say the non-transparent or semi-transparent active products replace some options that investors might use for alpha generation as opposed to index replication in their portfolios. I mean, only time will tell with respect to that.
Remy Blaire: Continuing this discussion on best practices, Jeremie what are some of the most notable interactions that you've had with clients, and what do you think is most helpful when it comes to ETFs as an investment?
Jeremie Capron: I will echo a lot of what Todd said earlier. At ROBO Global, an investor that considers exposure and does its due diligence on what's in the ETF is our best customer, and we spend a lot of time educating investors around our process, our people, and our investment strategy. The ROBO Global ETFs are very different from the vast majority of ETFs in the market in the sense that they combine a research driven selection of best in class companies around the world that drive their robotics AI revolution on the one hand and on the other hand, the benefits and the discipline of index investing.
That means an equal waiting across the portfolio to give strong representation, not only to mature companies, established very large market cap companies as in traditional equity indices, but also to the more innovative, smaller and mid-sized companies that are out there and that are core to the robotics AI industry. By mixing these two approaches, the ETF is really the perfect vehicle for us to express this investment strategy.
Remy Blaire: Mm-hmm (affirmative), and Jeremie, before I move away from you, you've been in the technology robotics as well as AI and healthcare tech space. What are some of these trends that you're seeing and what do you think investors out there need to know?
Jeremie Capron: I think the most important point is that this is not a niche. This is truly a technology platform that is affecting every market and every industry and yes, certain areas like manufacturing have been going at automating for a long time, but most industries are pretty new at it, and I think healthcare really stands out. In fact, healthcare is one of the big economic sectors that is the least digitized and a digitization of an economic sector strongly correlates with productivity gains. If you were to plot economic sectors across digitization and productivity, you'd find healthcare as a huge almost 20% of US GDP sector that sits there with no productivity gains and no digitization, but it's happening and it's happening now thanks to new technologies.
Think about surgical robots, think about lab automation, think about how we're able to leverage data across drug discovery, across patient data. We have wearables that help us finally understand the way our body reacts, and I think this is a true revolution and for investors that are future oriented, it's something not to miss.
Remy Blaire: Mm-hmm (affirmative). Well, I think those statistics are very interesting and we'll see what comes out of those sectors going forward and Scott, before we wrap up this discussion on best practices, you work closely with the issuer community at the New York Stock Exchange, so can you tell us a little bit about some of the support that's being offered when it comes to future listings as well as new products?
Scott Szever: Yeah, so again, you think of the New York Stock Exchange, and you first just think it's about having a product listed on the exchange and providing for the most efficient market, but our team really has changed, and we're there to be able to support as consultants to our issuers. Going from the early stages of product development, looking at what are they trying to do, looking at the regulatory framework, and how that may fit into play moving forward to what's the trade ability working with the market makers and those market participants out there to understand how to trade this product, how can you get this to be as best on screen as possible to see the tighter spread, to see the greatest depth.
We're working with them on that and helping them bring to market and then next is, as I said earlier in the show, is helping them promote that product and not just the product but that usability. I think Todd and Jeremie adjust very well the importance of understanding the underlying strategy and how it fits into that product or into your portfolio.
We target a lot of that working with the issuers, and then the next piece again is ensuring that we have the tightest markets for those ETFs and listening to the market participants who are providing that liquidity to say how can we make this a more efficient market for these ETS, how can we partner with the issuers to be able to provide as much transparency even in these semi non-transparent models, but giving them enough information and capabilities to feel secure and providing the liquidity that is doing that product.
Remy Blaire: Mm-hmm (affirmative). Well, I think we've covered a lot of ground, so we get to the fun part, which is myths surrounding ETFs. We know that all of us have heard some very interesting myth. Starting out with you Jeremy, what is the myth that you'd like to dispel the most?
Jeremy Senderowicz: Well, I'm glad to go first because I think this is probably the most popular choice among people in the ETF industry, which is the notion that ETFs, either by nature or sometimes the claim is made specifically about fixed income ETFs, represent some type of new systemic risk to the financial system. I basically haven't seen a claim to that effect that stands up to scrutiny, and I don't expect that will change it, and I wish people would stop making them.
Remy Blaire: Todd, what about you?
Todd Rosenbluth: Well, I'll piggyback on that, but with a bit of a twist to it. I think investors think or outside of the ETF world, think that money is all going into the same ETFs, and that ETFs are all owning the same underlying securities, but some of the more popular products are targeted. These are rules-based strategies. The iShares MSCI EAFE and the iShares MSCI Emerging Markets ETFs, two of the largest ETFs around don't have any stocks overlapping with one another, and the same way they don't have any overlapping exposure to the iShares S and P 500 ETF. Three very popular ETFs, three very liquid ETFs, they all have different exposures. If money is going into all three of those products, it's not triple the effect.
It's what's inside the portfolio on an individual basis that's doing it. Fortunately, in dollars, you started with earlier, we're likely headed to 5 trillion in the coming years. That sounds like a lot of money, but it's not all going into the same strategies. These are quite different from one another.
Remy Blaire: Mm-hmm (affirmative). That's a very important point there that you brought up, Todd. Now Scott, I'm sure you've heard it all. What's the one myth you'd like to dispel?
Scott Szever: Probably looking at the size of the ETF and how much assets under management, and then looking at the average daily volume of that product. A lot of us look at those aspects and specifically the average daily volume of the ETF because we think about our experiences trading common stocks. If the liquidity is not there, how are you going to be able to trade into that product if there's no supply to my demand. The ETF is much different as we talked about custom baskets and the capability to create and redeem. That's what's most important is when you look at the strategy, what is the underlying liquidity of that portfolio and of that basket, because a product may have $10 million in assets under management.
It could have $1 billion in assets under management, but if you look at and it's a large cap, domestic equity, probably pretty liquid. Even though you may not see a million shares trading today, you may only see 10,000 shares trading, that doesn't mean that you can't place an order for a very large size in that ETF. It's very easy to do as you work through the process and using limit orders and using a block desk to be able to execute. Probably my biggest myth that I would love to talk to because it is something that I think investors should really take notice to.
Remy Blaire: Mm-hmm (affirmative). These are all very interesting myths that we're hearing and Jeremie, I see that you are nodding your head so what's the one myth you'd like to dispel?
Jeremie Capron: Oh, I think we've covered it. The tail that works the dog, that's number one and then the liquidity, underlying liquidity that of the basket that is represented, and I think that's something that's particularly tough for a lot of very smart, smaller issuers that are out there in the market. As we all know, the market is extremely dominated by a handful of very large companies, but there's also a lot of talent and innovation outside of those firms. I think it's important for us as an industry to help support these players because innovation is what drives us.
Remy Blaire: Now that we've covered myths in the ETF industry, I'd like to take a look at the ETF industry looking forward. Now there are plenty of headwinds as well as tailwinds on the horizon, and we're marking the 10-year anniversary this year of the bull market as well as nearly three decades since the inception of the ETF. Todd, starting out with you, where do you see challenges in the ETF market and how do you think advisors can address some of those challenges out there?
Todd Rosenbluth: I think we're getting much more crowded. We cover 1500 ETFs at CFRA. There are additional ones that have come to market or they're leverage products that we don't cover that get you closer to 2000 and beyond forward. I think it's become more complicated for an advisor to be able to find the products and be able to differentiate what they are. I think it's really important for them to use tools either at their own firm or from third parties to be able to compare and contrast these products, to be able to understand there's some great innovative products that are coming out as Jeremie mentioned. There are also some products that are relatively low cost, that are relatively simple, and it's important to be able to understand that.
Advisors have a lot at their disposal. I think they just have to make sure they're doing the same due diligence they might do for an individual stock and not just do the easy button.
Remy Blaire: Mm-hmm (affirmative). I think you brought up an important point as of the end of October, there are over 2300 ETFs and although we've seen more launches this year the enclosures, the ratio is getting narrower as we head into year end. Now, Jeremy, you have extensive experience when it comes to advising and representing ETF sponsors as well as fun complexes. What do you see as some of the challenges on the horizon?
Jeremy Senderowicz: Sure. From a regulatory perspective, it has never been easier to get into the ETF business, but from a business perspective, the challenge of achieving scale remains very large and while there are plenty of other sponsors including major managers that have entered the field over the last decade or so and achieved at least some success with products, it's still a massively disproportionate number of the overall assets are held by the top three to five companies, and because the flip side of lower cost structure to the investor is lower margins to the sponsor such that it becomes a challenging business perspective to succeed in the ETF industry, unless you have scale and achieving that scale as you said remains very challenging.
The only other thing that I would note is that I think from a regulatory standpoint, there is some degree of political risk faced by the ETF industry, and that is in light of the ETF Rule and related updates to the regulatory structure that we just discussed that the SEC has been implementing both on its own in coordination with the exchanges. From a regulatory perspective, life has never been better for the ETF industry. Depending on what happens with the election next year and with the composition of the SEC that results from it, there's a possibility that even if that is not reversed, that at least progress in innovation would stop.
We saw a hint of that with the letter that we referred to from Commissioners Jackson and Lee about how trying to lay a marker down that they don't intend to approve at least in the foreseeable future further extensions of the semi-transparent ETF. If that position becomes a majority on the commission following the election, then at the very least, you wouldn't expect the commission to be as friendly to further innovation.
Remy Blaire: Scott, what are some of the conversations that you're having at the New York Stock Exchange?
Scott Szever: Right. We're excited moving into 2020 with everything that we spoke about today. If it's the ETF rule with the capabilities for issuers to bring product to market, how the exchange is looking at our exchange rules to be able to support that innovation, looking at the non-transparent and semi-transparent solutions that were either approved in May or that were noticed here in November, we're really excited about where that's going, saying that we don't know where the markets are going to be and that concentration.
A lot of conversations with issuers in 2020 of how again are you positioning your product, what are you looking to bring to market, and depending upon where the market's going during that time, do you have that product suite available to be able to assist clients to understand how will you protect yourself, how will you transition your portfolio depending upon the type of economic calendar that we're working with.
Remy Blaire: Mm-hmm (affirmative), and indeed, we don't have a crystal ball and as Jeremy mentioned, we are heading into an election year next year and last but not least, Jeremie, what are some of the headwinds as well as tailwinds that you're watching as we head into the new year?
Jeremie Capron: Okay. Well, I'll speak as the director of my research team and we are very focused on our portfolio companies. We spend much of our time meeting with the leaders of robotics and AI companies around the world, and what we hear from them is that the sector hasn't been immune to the economic slowdown, particularly in industrial end markets. We've basically been in an industrial recession for over 18 months now and that started in Asia, that spread into Europe, and now the US is also slowing, but the good news is that we are probably at or very near the bottom in terms of industrial activity, particularly in the regions that have been hit the hardest, and that would be China where issues have been compounded by the trade war and the trade war is not only about trade.
As we all know, it's about technology so it's affected to a large extent many of our companies, particularly in markets like Japan. What we've heard of late is that many companies have seen a stabilization in terms of their monthly order rates for factory robotic components for many of the high value components that make automated systems. Our view going into 2020 is that we already passed the bottom and we are gearing up for a new app cycle. As much as 2016 and '17, we're phenomenal for investors in robotics and AI and then '18 and '19 have been a period of consolidation. We think we're ready for a new app cycle.
Remy Blaire: Okay gentlemen, well thank you so much for joining me, and thank you so much for all of your insights.
All: Thank you.
Remy Blaire: Thank you for watching. I was joined Jeremie Capron, Director of Research and Managing Partner at ROBO Global; Todd Rosenbluth, Director of ETF and Mutual Fund Research at CFRA; Jeremy Senderowicz, Partner at Dechert; and Scott Szever, Director of Exchange Traded Products at the New York Stock Exchange. From our studios in New York City, I'm Remy Blaire for Asset TV.