MASTERCLASS: Fixed Income - January 2020
December 19, 2019
Remy Blaire: Welcome to Asset TV. This is your ETF master class. The market for exchange traded funds continues to expand at an accelerated pace, not just in the US, but also around the globe. As the major US equity averages surge to new record highs, US listed ETFs have seen a surge in new inflows. Joining me to discuss the industry is Rich Koerner, ETF Sales Manager at Fidelity Investments, Mark Hackett, Chief of Investment Research at Nationwide, Ed Rosenberg, Senior Vice President and Head of ETFs at American Century Investments and Dodd Kittsley, Director at Davis Advisors. Gentlemen, thank you so much for joining me today.
Ed Rosenberg: Thank you for having us.
Remy Blaire: Well, first and foremost, the ETF industry globally has surpassed the $5 trillion mark, and the US ETF market has surpassed the $4 trillion mark. It goes without saying that the US equity market continues to hit record highs given that expectations. So, first and foremost, before we start looking at ETFs, Rich, can you tell me what you make of performance you've seen overall this year?
Rich Koerner: Well, I think it's been, obviously, as you said, a very strong equity market this year, and it's been a strong market for ETFs with a little bit over $115 billion in net flows. That's off the record pace that we saw last year and in 2017. But I think one of the things that's a little bit surprising when you look at just the ETF industry is, over half the flows have gone into fixed income ETFs. We're seeing a lot of flows into treasury bonds as well as investment grade corporates.
Rich Koerner: And even on the equity side, investors are looking more towards defensive strategies like low volatility, and even at the sector level, more defensive sectors like staples, healthcare and utilities have dominated flows to start the year.
Remy Blaire: And I think those are key observations, and we'll take a closer look as we get into this masterclass. Now, Dodd, I want to ask you about what we've been seeing in ETF investing, especially the landscape that has changed since 1993. So, what stands out the most to you when it comes to the current environment?
Dodd Kittsley: Well, it's been an amazing journey. Who would've thought 26 years yet ETFs are still new to so many people, that so much education needs to happen, and the growth really hasn't slowed down. Assets are up 16% already this year, and we're looking at double digit growth rates pretty consistently throughout the board, over the last 10 years.
Dodd Kittsley: It's been nothing short of amazing though in terms of, I'd say, growth innovation and adoption, very widespread adoption. We entered the year 2000 with literally a 34 products, less than $40 billion in assets. So to get at that $4 trillion number or five and a half globally is pretty amazing. To put it in context, this is 23% of the mutual fund industry. So it's not just a small little spec.
Dodd Kittsley: Today, what we're really seeing is, I think, the third chapter in the ETF book. The first chapter, in my opinion, was an introduction of making indexing relevant to a broader investor base, market cap weighted index is if you will. Chapter two was really isolating characteristics, whether they be factor base, whatever you want to call them, smart beta, maybe some themes or stocks with particular characteristics.
Dodd Kittsley: The third chapter really is active in my opinion. And there has been a real recognition in this industry that ETF's shouldn't be regarded as just about indexing, but what they're really about is providing a more efficient way to access indexes, markets, market segments in the case of active strategies.
Remy Blaire: And I think you've brought up a lot of key points when it comes to the ETF industry. And I know we'll be focusing on a lot of those points later on in the segment. Now, Mark, I do want to ask you about current market conditions. Obviously, investors may be nervous about what's around the corner as we head into the second half of this year, especially given current elevated equity market levels. So, what do you expect as we head into the rest of this year, and what are some of the fundamentals you're paying attention to?
Mark Hackett: Sure. So, obviously, we've had this big kind of mirror image of the fourth quarter being the worst quarter since 2011, followed up by the first half, best first half since 1998. And so clearly, there's a lot of positive expectations built into equity markets at this point. But I think moving forward, it's a bit of a confusing time, frankly, for equity investors. We're sitting here with the equity markets at an all-time high, the same time that the bond market is really forecasting a recession, given the absolute level of race that we're seeing.
Mark Hackett: So, there's a lot of confusion even within investors' minds. Sentiment's starting to improve, but at the same time, we're not seeing equity flows. ETF flows are okay, but that's more than offset by negative outflows from mutual funds. So again, there's a lot of positive expectations currently embedded both with regards to the Fed cutting rates this year and also a China trade deal.
Mark Hackett: So, perhaps we're in a period of asymmetric expectations at this point. There is a possibility that if the Fed fails to be as dovish as is expected or the China trade deal gets pushed out, there's the possibility that we miss the expectations, and that can be disappointing to equity investors. The long-term situation looks okay at this point. We have to keep an eye on what happens to earnings. We're in earning season now, it's really about what is the kind of forecast for the rest of year into 2020.
Mark Hackett: But as long as the earning situation kind of holds, the intermediate to long-term is in a pretty good situation for equity markets. But again, there's a little bit of asymmetric risk at this point, given how much we've moved just this year.
Remy Blaire: And I think you brought up an important point when it comes to flows; we need to keep an eye on those numbers. And as you mentioned, earning season is kicking off here in the US, and indeed investors as well as firms will be keeping a close eye on those forecasts coming out. Now Ed, I know you've been entrenched in the ETF space, so what are the current challenges that stand out the most in the ETF industry?
Ed Rosenberg: The current challenges for any sponsor, any individual is just differentiation. What makes your products different? And it's also access to different places. So if you look at the ETF space, starting with what Don talked about, he's saying we're in the third chapter, which we may be. And if you look at the active equity space, it's only $10 to $15 billion out of a $4 trillion market. Why hasn't that grown yet, or why is it going? And you'll notice it's starting to grow, but it's taking time.
Ed Rosenberg: So, as you get through to the investor, that we've been in years, been educating the master on what indexes are and how they work and why and how an ETF works. Now we're onto the next phase. We have to educate still on the structure, but that the structure doesn't need to be tied to a basic index, it can be alternative weighted index, it can be active, whether it's equity or fixed income or whatever the next phase brings us.
Ed Rosenberg: And it's really the education aspect, to introduce to the investor what this vehicle really means. Not that it's just index, but it really carries forth a wrapper that can be used in any type of structure for the product underneath and bring forth the product that you want that's tax efficient with the benefits of the ETF.
Remy Blaire: And, Ed, before I move away from you, you mentioned education, and of course that's very important from the investor perspective as well as advisor perspective. There are plenty of financial professionals that will be watching this, the ETF masterclass. So in terms of education, what do you think needs to happen?
Ed Rosenberg: Well, I really think it's becoming comfortable with the vehicle. So if you think about that, you've been trading mutual funds your whole life, you don't have to deal with a quote, there's no bid ask you have to talk about, there's no understanding how to trade, there's no volume that matters in your mind or in theirs.
Ed Rosenberg: So, when the invest in the advisor starts switching over or the investors start switching over, they have to remember what these are. All spreads on ETFs aren't equivalent, they're not a penny. They're just going to be as liquid as the underlying. It's basic steps to go through of understanding how to trade. And realistically, that volume does not equal liquidity.
Ed Rosenberg: And, crossing that point that you have a 5,000 share average daily volume ETF that you could probably trade, depending on what it is, if it's large cap US, $50 million, would never move the price. But it just doesn't feel that way. And so it's really educating the advisor on those differences that they're not used to having to deal with, working through the ETFs that the structure brings with it that other products don't.
Remy Blaire: Well this year marked the 10-year anniversary of the bull market. We have come a long way when we look at the broader market. And given the uncertainty we had in the final quarter of 2018, we know that it's a different environment as we head into the second half of 2019. So, Rich, could you tell me about some of the concerns you're hearing based on your interactions with clients and how you're addressing them?
Rich Koerner: So, I would say we're hearing two big concerns. One is a little bit more on the macro side where, advisors are spending more time doing holistic planning for their clients and they're trying to provide them with more long-term, life-based planning solutions. If you think about the industry and the evolution of digital advice, we're finding that advisors are spending much less time today on traditional asset allocation and building investment portfolios, and that's leading to the proliferation of more and more model usage by advisors. And that's because we see it as part of an advisor value stack, where they want to spend more time on the relationship and less time on the financial planning or asset allocation side.
Rich Koerner: As it relates to specific investment portfolios, it does tie into that. We talked about we're getting later in this investment cycle, and so we think it's a good time to make sure your portfolios are balanced, both from an offensive side and a defensive side.
Rich Koerner: But you can also maybe hedge a little bit of that offense with some more defensive characteristics, there was still a place for core bonds and you can see that in the performance to start the year.
Remy Blaire: And indeed as we head into the second half of this year, we know that especially in the ETF space, the search for yield continues. Now, Dodd, where are you finding opportunities in the current environment?
Dodd Kittsley: Yeah. So Davis Advisors, we're a research driven shop, so looking at companies from the bottom up. But a core belief of our firm is some of the greatest long term opportunities reside where sentiment is negative, where there are negative headlines. Conversely, we also believe that some of the greatest risk resides where investors are complacent and feel comfortable. Areas such as that would be some areas of the fixed income market, certainly high dividend paying stocks that have been bid up in terms of valuation, even all in on just passive and momentum based type of strategies.
Dodd Kittsley: But what focusing on the positive, because that's what you asked. There are two areas that are unloved and underappreciated in this market that we find particularly attractive right now. The first is financials. And it's understandable that there's negative sentiment coming off of the financial crisis, which is still raw on a lot of people’s minds. But the fact of the matter is financials have the best balance sheets we've seen in the last 50 years. Their capital ratios are very high, they're retaining earnings, we're seeing record earnings.
Dodd Kittsley: It's the cheapest valuation in the S&P 500 amongst all of the sectors, and we think it's the next future kind of dividend player. We're seeing reasonable dividends right now, but very low your payout ratios of around 30%, 33%. And then a lot of buyback too. So even in an environment where rates don't go up, which a lot of folks think is the necessary catalyst for financials to outperform and perform well, right now, they're cash cows and they're really bringing great earnings. And I think for the long-term investor, that's going to be great place to be.
Dodd Kittsley: The other unloved area is international markets. And I'll put a caveat on that, we don't believe kind of paint international markets with just a broad brush, but we see some of the best run businesses in the world in international markets really recession-like types of valuations. And one area I'll just focus on in a theme because I know we can't go too long on this is the Chinese consumer. If you look at online consumption as a percent of retail sales in the US, it's 10%. You see all the smiling boxes on our doorsteps? It's 20% in China, and we're seeing that grow at a much quicker pace, double digit pace.
Dodd Kittsley: So, that really is the future. And with the growing global middle class, with 5 billion people expected to be the global middle class, 90% outside the United States, dominant companies and online consumer areas, to us, is a really great place to be.
Mark Hackett: Just to follow up on that point, with the international space, another part of that is, since the beginning of this expansion, we've seen a doubling roughly on the S&P 500 and the price to book basis where the MSCI EM is roughly flat, IF is roughly flat. The trends within the EM space are actually in pretty good shape right now. Their currencies are at multiyear highs.
Mark Hackett: We get a lot of attention placed towards a Europe and Japan situation, which aren't so good. But the emerging market space is becoming an increasingly important part of the index, is increasingly an important part of the global economy. And they're actually in pretty good shape right now and really haven't moved at all on evaluation basis since the beginning of this expansion.
Remy Blaire: And I think Dodd and Mark, you brought up a lot of important points. Depending on your age, you might remember the financial crisis very well. So I think when we're talking about advisors advising clients, it's always a helpful to think about the generational gap and how technology has changed the way that investors look at investing and the overwhelming amount of information that everyone has access to nowadays. And that does indeed, affect investment decisions. So, Mark, you tell me about some of the changes in the ETF market that you're monitoring and we'll continue to look at.
Mark Hackett: Sure. So, I think that... Ed talked about this at the beginning, where we see this really interesting transition over the last, let's say 20 years, where it was primarily an institutional beta play. It was a bet mechanism, let's say 20 or 30 years ago. It's now been democratized to the point where it's a buy and hold retail strategy at this point. I think that's a very healthy development for the long-term nature of the ETF business.
Mark Hackett: But also, the secondary part that was also mentioned it's gone more from a product line to much more of a portfolio implementation tool. And we've become much more agnostic in terms of, is it an index fund? Is it an active fund? Is it an ETF? To much more of a, does this solution fit the needs of the client? Going away from a traditional style box approach where you have to talk about is it an ETF, is it a fund, is it a large cap, is it a small cap, the same, what is it that the client's portfolio needs in order to hit the expectations and the outcome that they're looking for, that whole portfolio modeling aspect of the ETF business, I think, is much healthier today than it was certainly in the previous expansions.
Remy Blaire: Well, I think it's helpful to note those observations. And as you mentioned, international emerging markets, we are seeing growing interest in sector investing when it comes to those regions of the world. Now, Ed, I do want to ask you about some of the changes we've been seeing in the ETF landscape here in the US, especially when it comes to the nontransparent ETFs and SEC regulations. So can you tell me a little bit about that?
Ed Rosenberg: Yeah. So, so far, we have the SEC approving Precidian model active shares so far, and as we go forward, there are five others out there in what was called the proxy basket. Precidian is very different. We call them semi-transparent because some of you can see a little more into the holdings than not. But what they're going to bring forth is a new way of active style products, where you can start doing things in the ETF space that you currently couldn't do today.
Ed Rosenberg: For example, you couldn't put forth a product with 30 holdings, and if that grows to $10 billion as a product, you wouldn't be able to trade all the holdings in one day, so you're to open the front running and other things. You won't be open to that in these structures. So I think you're going to start seeing new firms getting into the ETF space. We filed for it. We're out there in the Precidian model.
Ed Rosenberg: And what you're also going to see is new innovative products, things that can really generate alpha, your firms best IP, because no one can front run or see exactly what you're doing, and that's what everyone's afraid of. And, so you'll see new firms, new entrants, new products. And, to make on a point earlier that Dodd said or that I picked up on is I think you're going to see a huge expansion in the active equity space. It is so such a small portion of the ETF space today, that is the next big wave to come.
Ed Rosenberg: And you're going to see a lot of growth, whether it's the semi-transparent or people looking at it and saying, "Oh, I can do active, and I'll just go into the transparent active space now." And it really does add value to what we're doing.
Dodd Kittsley: If I can add on that too, I think either the Precidian approval was such a watershed moment, in my opinion, for this industry because it is going to open up a pretty much any active manager on the planet to be able to issue product, and it's going to give relevance to the active equity space. Now, we got into offering actively managed transparent ETFs two and a half years ago, and we were fortunate to be able to do that because of the way we manage money, which is very long term. It's very large cap in nature.
Dodd Kittsley: But we recognize we're a very small part of the actively managed space. But I guess it's a long winded way of saying, this is going to give credibility to the category that we've been wanting since day one and is still, I think, very foreign to folks. But with more entrants into the space, I think they're really going to recognize the advantages that ETFs can offer and the issues and problems that they can solve and pain points that they can solve that other structures unfortunately have.
Ed Rosenberg: Yeah, and even to add onto that, if you think of the active space today, 75% of all the active money that people put into ETFs is fixed income. Right? And the problem you have is, people think of the vehicle as always indexed, and this next wave will lend credibility to that active side. So firms like Dodd's, or my own, or anyone else up here who launches, it's going to be a big difference because you're going to have to think about, what's the investment thesis I'm trying to accomplish, and then what's the best vehicle for accomplishing that thesis, not just, "Oh, I can only do it in this structure or this structure." Now I have choice and choice is really what the investor needs.
Mark Hackett: We've seen good growth recently in the fixed income space and even the small cap space. Those are two areas that have been historically thought of as active areas. The fact that we now have actives ETFs available to us, that you would expect that the small cap space and the fixed income space, which has been underrepresented to a certain degree in the ETF space will continue to catch up with the large domestic core and the International core type of exposures.
Remy Blaire: And I think before we move on to ETF strategies as well as structure, which we have started discussing, Ed, could you tell me about the significance of nontransparent ETFs? There've been different ways of describing the differences. Are they opaque, are they translucent, are they transparent?
Dodd Kittsley: Translucent.
Remy Blaire: For viewers in the audience who may not be as familiar with ETFs or they're not familiar with this rule or what's happening at the SEC, can you give us a primer?
Ed Rosenberg: Yeah, so let's start with Precidian itself. Precidian is the one that is the most opaque, we'll say. You will have some semi transparency. I'm just going to call it an intraday nav that is published every second for Precidian. So people know the valuation, and that number has compared to insider from two different ways to make sure it's accurate. And it goes out every second, whereas a traditional iNAV today is every 15 seconds.
Ed Rosenberg: Other than that, no one outside of what's called an AP representative will know what the holdings are in that fund until we publish them either monthly or quarterly with a lag. If you look at the proxy basket structures that are waiting for approval, those are a little bit different. You're going to have some look into the holdings, depending on the model, whether it's like NYSE, Fidelity. T.Rowe Price.
Ed Rosenberg: What they all do is something different, but it gives you a glimpse whether it's using other ETFs. One of them proposed swap based, one of them is just altering the holdings and putting in holdings that aren't in the fund. So you'll have a way to see into the portfolio, but it may not be that accurate. It might just be a proxy of what it is, which is what the purpose of it is.
Ed Rosenberg: And what the idea behind them is, is so that it can shield the holdings, to a degree, to protect the alpha of those portfolios. And realistically, the goal is to, for anyone to put forth a product is to offer as much alpha generation as possible. And if you're protecting the front running and anything else that can occur, what you're getting is the best ideas of those advisors, whether it's in the active share structure or any of the others.
Remy Blaire: And it does really matter which side of the fence you are because investors do prefer transparency. But if you're on the other side of the fence, that is a different story.
Ed Rosenberg: Well, it depends. Investors prefer transparency because that's all we've offered today. We don't know if investors will prefer this or not. So there are some investors who are looking forward to this. ETFs naturally, because of certain, the way they're structured, have slightly less expenses than a mutual fund. So an ETF could be the same or a little bit better priced if when it's done copycat to a mutual fund. It's very possible.
Ed Rosenberg: If you look at some of the providers today that marry up, they're either right on top or a little bit below. So by offering that, you may be able to offer a better price with the same strategy. And you offer the trading flexibility, right? You can get in and out when you choose, as opposed to having to wait to the end of the day. And if you have a lovely day or sometime in the fourth quarter is past year, you may just want to get out, not wait till the end of the day, or you may want to buy when the market seems to hit a bottom. You can't do that with a mutual fund. So there are advantages to the ETF, not in every case, but there are ways that may make it more attractive.
Remy Blaire: Well, I think it's very helpful to weigh the advantages as well as disadvantages when it comes to this. Now, Rich, I do want to turn the focus back to you and ask about your observations of the ETF industry. Now, you offer a different perspective. So what do you think is most important to factor in from a macro perspective right now?
Rich Koerner: So, I enjoyed the conversation around semi-transparent active equity ETFs, and I think the only one we forgot was... Tax efficiency, certainly, in the ETF wrapper is another advantage. But I think when we look at some of the trends that we've touched on, whether it's active fixed income ETFs or even factor based or smart beta ETFs, what we tend to see is investors want to see that track record. Even if you're taking the same exact active strategy that you've offered in a mutual fund and put it into an ETF wrapper, we tend to see flows really pick up as you start hitting those milestone anniversaries, whether it's one year or three years, or coming up on five years.
Rich Koerner: And so I think the offering choice will be really good for the industry, but I think we all have to step back and remember that the industry is still dominated by those passive flows, and low cost passive flows have been where investors have been allocating money towards ETFs. I think we all know this. So we all continue need to do a really good job of educating advisors about how to use factor based products, smart beta products or active ETF products in their portfolios because they do come with a little bit higher cost structure.
Remy Blaire: And I think that's important to keep in mind, especially given where the broader market is right now. If we do see a significant downturn, I'm sure we'll see a difference in flows. Now, Mark, I do want to turn to you. The evolution in ETFs have obviously affected how advisors as well as investors approach the marketplace. So, what do you think is the most notable shift from your perspective when it comes to structure as well as strategy, and how do you think this has affected advisors?
Mark Hackett: I think one of the really healthy aspects is the advisor has come to... It's not an us versus them mentality anymore. Even a decade ago, there's certain advisors that we talked to that wouldn't even consider either passive or ETFs and there was others that were much more dedicated to that structure. At this point, it's really much more agnostic in terms of... In certain cases, as Ed mentioned, the ETF is a better structure and therefore should be part of the portfolio. But it's really about the needs of the client more so than the apparatus you use to get there at this point, which I think is a much healthier development for the industry, getting away from the kind of us versus them mentality.
Mark Hackett: The other one that's obvious is the move towards strategic beta. Obviously, the ETF business grew up on a more traditional index based approach, market cap weighted approach, and that was really healthy to ramp up scale. But at this point, there's... At certain points in the cycle when we have this maturation of the business cycle that we're getting to the point of experiencing, there is greater differentiating between winners and losers.
Mark Hackett: You can be more tactical in your exposures. For example, whether it's quality, it tends to outperform... As growth becomes more difficult to achieve later in the cycle, having a factor bet towards quality tends to work. Low volatility can be that solution for that investor that's worried about the downturn coming, but the advisor is still trying to keep them on their path towards remaining invested in equities.
Mark Hackett: So there's a lot of ways that you can now use a more tactical approach within your portfolio to expose yourself and how you see the macro world developing. But before it was a little bit more of a blunt instrument. Again, once we moved to the active space, that becomes an even more potential within this argument.
Remy Blaire: And while we're talking about the subject, you mentioned the word healthy, and there are so many misconceptions when it comes to the ETF industry. So gentlemen, if you'd like to jump in, what are some of the misconceptions regarding ETFs that irk you. If you wanted to educate the broader viewing audience, what would you say?
Ed Rosenberg: So I have two. One of them I mentioned earlier, which is volume does not equal liquidity, right? So if you look... If people set volume thresholds and say, "I can't buy this ETF unless it trades a million shares or more." I don't know. There's very few on the panel that have any, and that represents 8% of the entire ETF marketplace. And they all look the same basically. It's basic indexes leveraged and inverse. So if that's what you're looking for, then that threshold makes sense.
Ed Rosenberg: But the other one that's also bothers me is that just because I put value in the title of my ETF or I put growth, that it's all the same compared to everything else. So, we should look at expense ratio only. We, and I don't think you guys will disagree with this, we create tickers and names of funds so that people will look at them. Maybe they'll buy them. But the problem is if you look at something like the Morningstar category for value, the difference last year in performance from the top to the bottom was something like 18 and a half percent. That is a tremendous difference. And if you are expecting one of those returns versus the other, you would be rather surprised because you bought it based on the name of value.
Ed Rosenberg: It's really, advisors need to look under the hood, investors need to look under the hood, understand the engine that creates that ETF or what it's trying to accomplish, and does it actually fit with as you as the investor or you as the advisor are trying to accomplish? Name and expense ratio are nice, how much volume you trade, but those are all much later considerations. Match the investment to what you want to do, and then come up with that solution and say, "Okay, this is what I can use now. How do I invest in it?"
Rich Koerner: I want to jump in there. I couldn't agree more with Ed. I think if you're looking at smart beta, you've got to do the same amount of due diligence that you'd be doing on an active strategy because there are... As Ed talked about, there's difference in cap structure. You might have low ball strategies that are tilted more towards large mega cap names. You might find some playing in the small mid space. There's huge sector dispersions across smart beta strategies. And so it's important to do your homework.
Rich Koerner: And I think the other arbitrary frustration is and we've talked about this, but it's really the underlying securities that determine the liquidity of the product, and that allows you to trade not only coming into the product, but also if you decide to leave and exit that position. So AUM is another misconception.
Dodd Kittsley: It absolutely is. You guys hit on the real big ones. It's like we see people automatically try to take a shortcut and jump to a conclusion that the cheapest ETF is always the best, the biggest ETF is always the best, the most liquid ETF is always the best. And you guys have all hit on all of those. And those are all huge myths, right? As Ed said, know which you own, ETF's are turns parent or semi-transparent, you're still able to know what's in there. And just because it doesn't trade a lot doesn't mean you can't get access to it, because it is the liquidity of the underlying stocks.
Dodd Kittsley: The other one I'll throw in there is just a good case in point that we need more education. There are a lot of folks that think ETFs make zero capital gains distributions. So just to set people's expectations, it's really... The structure of the ETF really protects existing and remaining shareholders from other shareholder activity and other flows, cash flows going in and out. But if there's a change in the portfolio, an ETF is essentially no different than a mutual funds. 10% of ETF's did make capital gains distributions, and I think it's important that folks realize that and don't go eyes wide open when they're buying an ETF. Certainly, more tax efficient than other structures, but it's not an elixir for all a capital gains.
Remy Blaire: And I think now that we've addressed some of the most common myths out there regarding ETFs, we'll transition into best practices. Now, Dodd, going back to you, can you tell me your thoughts on best practices when it comes to investing in ETFs?
Dodd Kittsley: Yeah. Again, we hit on the real big one of know what you own. I think the second one, and then probably the most common pitfall that particularly new advisors to ETFs can fall into is they forget about the T and ETF's. They forget that this is exchange traded. And operationally, it's very similar to buying an individual equity, whether it be Microsoft or GE or what have you. But there's several caveats, and I think best practices are rules of the road that if you follow, you're going to be in really, really good shape.
Dodd Kittsley: The first is to use limit orders. What does that do? That allows you control over the price in which you're going to get executed. Now, the risk as you might not get executed, but by putting a limit order in and not a market order in, if there's a spike in volatility, you're going to not get executed at a ridiculous price. And that can happen. Doesn't happen often, but it can.
Dodd Kittsley: A couple others is never buy at the open or never buy at the clothes. And a lot of folks are so used to doing that because it's the way mutual funds transactions are at the close. But when you think about it, the value of an ETF is derived by what it holds, right? And at 9:30 in the morning, New York time, not all stocks have opened yet, right? So it takes a little bit of time, and the same thing on the back end.
Dodd Kittsley: And then the last one, again, to just build on what the group has talked about is, don't confuse average daily volume with the capacity to accommodate large trades. Our funds maybe trade $500,000 a day, a million dollars a day, sometimes. We've been able to execute 10-$12 million trades inside the offer very efficiently. So, this is a practice, and the only thing I would say is people should go to help their trading desk as well as any of the issuers because we all have these teams called capital markets desks that are there to make liquidity work for you and be able to execute. If you're thinking of a large trade, it can be done.
Remy Blaire: Well, I think that's an interesting observation, that the T part of ETFs is often forgotten, but it is a key element of what makes up an exchange traded funds.
Dodd Kittsley: It's an extra step.
Remy Blaire: Yes, indeed.
Dodd Kittsley: But I can also work for you. People are scared of that. Because we're traditionally a mutual fund and SMA shop, so a lot of folks know Davis are for the first time buying an ETF, and this is the thing that scares the heck out of them. And it doesn't have to be scary if the right education is there and they know how to work it. And oftentimes, it can get you a more efficient execution than you ever could get by doing an end-of-the-day kind of trade.
Remy Blaire: That's very helpful. Now, Ed, if you could tell me about your expectations for the future of ETFs, now, we don't have a crystal ball obviously, but what do you expect to see going forward?
Ed Rosenberg: Could I just say growth? No. I would say in the next five years, you're going to see more than a doubling in the US ETF market anyway, and globally as well. We're five and a half trillion. I would say we're probably going to get to 10-11 trillion in the next five years. And why is that? Now, we have these products that will be coming out that are going to challenge mutual funds directly.
Ed Rosenberg: So in the past, if you look at volume across the exchanges, as volume has gone down of the individual securities, ETF volume's gone up, makes up about 28% average across the exchanges today. On a really volatile day, it might go up to 40. But realistically, I think what you're going to see is as we bring out more products that look exactly like mutual fund counterparts, you're going to see a direct correlation of dollars leaving mutual funds going into ETFs. And I expect that pace to pick up, especially now that the semi-transparent products are out there and firms like Dodd's continue to launch more transparent, active equities. As that becomes more adopted, you're going to see an exponential growth.
Remy Blaire: And moving on to Rich, what are some of the most notable interactions that you've had with clients that can be helpful when it comes to ETFs?
Rich Koerner: Well, I think clients are... We talked about this process of educating clients and making sure that they understand and knowing what they own. But I think clients are now, especially when you think about in the factor space, they're looking for solutions, and I think that's what's driving more adoption of model portfolios. I think initially when you talk to clients that aren't familiar with factors and you start that education process, they understand value, they get momentum, they know what low vol does, quality makes sense to them. But I think their initial adoption was, "You know what, I'll just buy a product that equally weights all of these things."
Rich Koerner: And you saw a fair amount of success with some multifactor strategies that just equally weighted those. And I think equally weighting works and it is a good approach, but I think you can now tailor-design solutions based on advisor and end client needs. So if a client needs more downside protection, you can build a model portfolio of factors that skews to that downside. If they need more income, you can accomplish that. If they're just looking for capital appreciation, there are probably more efficient ways than just equally waiting.
Rich Koerner: So I think that education process... and that's something that we've done at Fidelity. We did a little bit over a year ago, we wrote a white paper about how factors work over a long period of time, and that strategic nature of them, and we put it out there in a paper portfolio, and now. I think that's what they're looking for as they continue to adopt factors in their portfolio.
Remy Blaire: And Rich, when it comes to factors, we know that depending on which generation you're speaking to, they might think that this is a very recent development, but it has been around for several decades. So I think education is very important.
Rich Koerner: No, without a doubt. We all know it goes back to Fama and French and defining factors in the overall marketplace. But we can't stress the importance of educating when it comes to factors because there's three different names. We've all referenced it in different ways here, whether it's factors or smart beta, strategic factors, however you want to call it. So that education role is especially important in this space.
Remy Blaire: Indeed. And Mark, you are in the investment research space, so you can also shed light on education as well as offer your perspective. So where do you see challenges right now in the ETF market, and how do you think advisors should be addressing these challenges?
Mark Hackett: We're definitely in a period where we're making progress. Clearly, there's much more education out there now than there had been in the past. There's still a bit of perception issue that this is meant for actively trading or meant for risk seeking type of exposures. We really don't see that. It's really much more of a maturation process than that. There are some issues that I think we have to address as an industry. There is concentration risk in very certain areas.
Mark Hackett: Obviously, there's a guilt by association with some of the ETFs that had a very bad time, like XIV. We need to continue to educate people about the differences between ETN, for example, and an ETF. But also, that the progress that we made, we just have to continue, in terms of educating of what these really are. One of the things we focus on a lot at Nationwide is trying to remind people to stick with their plan, avoid reacting to the headlines that can get you off your plan and cause you to react to news flow. For example, political news that's going to be coming up over the next 18 months.
Mark Hackett: An ETF structure and also traditionally an ETF client tends to be more reactive and more risk seeking in terms of the demographics that have been participating in this area. So again, it's going to be up to the advisor. Let's keep that in the back of their mind to avoid the temptation to use this as a really kind of an active, tactical, in and out reactionary type of structure and really use all the other things that we talked about that make these advantageous.
Remy Blaire: And I think that's a very important point, especially as we head into the election year next year. We know we're all connected to our smart devices; we have access to so much information as well as misinformation. So I think those insights are very helpful. And as you mentioned, as we look forward to the rest of this year, looking ahead to 2020, we know that a lot of people will be paying attention to politics, and of course the Central Bank here in the US. We have the Fed reserve meeting coming up, so we know how that will dictate market direction. So Ed, what do you think is on the horizon as we head into the rest of this year?
Ed Rosenberg: If you look at just the rest of this year, it has to be, you're going to see some volatility to start with, right? And so I think what you're going to see is people are waiting for something. Earlier points made in the beginning about how much flow is going into fixed income versus equity, I feel like there's some pent up demand. People want to wait to see what happens with equity. And I think as volatility picks up, you're going to start seeing flows change throughout the year. Last year alone was the second best year in flows and ETFs and most of it happened in the fourth quarter. So it's just something to think about that people seem to be waiting, that's what's going on, but you have political turmoil one, which seems... It feels like there's no end in sight in the US, but I'm sure there will be.
Ed Rosenberg: Secondly, we also have the China deal that's out there. And China is not the only trade deal that exists that seems to have issues, right? There's been talk of European trade deals and others. And how do they impact the earnings going forward? One of the big topics for the companies in their reporting earnings this quarter has been how much of the dollars hurt their earnings this year. And so does that trend continue throughout the year and cause us to slow down naturally? And so I think what you're going to see is just volatility is going to pick up if it already fell. Feels like it has in some parts.
Ed Rosenberg: But I think what you're going to see is people are going to slowly change. They're looking for that. And when they see volatility, especially on the downside, they're going to be able to start changing to the investment vehicles they want to, which will be a shift into those equities that they're waiting for to drop. How many of us have said or read this bull market has to end? What is the real definition of an end? Is it what we felt in the fourth quarter last year where it tied for a while, or does it actually really drop off and hold steady for a while?
Ed Rosenberg: And the funny part is the environment we live in, you mentioned phones. What's the real cycle now? Because it feels like every cycle we go through, it gets shorter because we have more information and people have more information. So as it gets shorter, what's the real drop off? And when it happens, everyone sees it now. It's not like you have to wait for the news at night to see what happened so that we can put it forth and investors can shift quickly. So I think that's the trend you're going to see for the rest of the year and going into next year, especially with the political turmoil.
Rich Koerner: I think it's the square root recovery, market's down and it's up, and then it's kind of sideways for a little while.
Remy Blaire: And indeed [crosstalk 00:42:48]. Yeah, that's a very good way of looking at it. Now, as you mentioned, we all have access to so much information. We all have smart phones, and nowadays it seems as though social media is also incorporated into our daily diet. Ed, did you have any insights into that?
Ed Rosenberg: Well, it's hard with social media. So I'm sure we all use social media, right? And how it impacts us. But the key with anything that happens on social media is most things on social media are quick hits, right? So they're there to get your attention no matter who's posting it. And realistically, those are not the items you should react to. Those are just blips on a radar. What realistically we have to react to is what's actually causing financial issues. Is it the earnings? Is it the dollar, one way or the other? What's actually driving the market? If I'm going to change my plan or an investor's going to change their plan, why are they doing it? If it's over a tweet, that's the wrong reason. Let's be honest. It has to be over real fundamental information that causes you to be something different or a personal situation. I need more income. I need something that's causing me to shift from one side to the other.
Ed Rosenberg: So I think social media is the influence, and it's been out there and it continues to grow. But it feels to me, and I don't know how you guys think, it feels more like noise now. We're so used to these raging tweets coming from all sides that we're almost numb to it, right? There's so many things that when they happen are shocking years ago that now we're like, "Oh, that's happening again?" And I think people are starting to become numb to it. But it's really the fundamental pace of why we're investing in the first place. What are we trying to accomplish? What do we need? Have those needs change based on the tweet? I certainly hope not.
Dodd Kittsley: In this environment, it's really an opportunity for advisors to shine in the value of helping control client emotions as well. Because to both of your points, the headlines out there are very sensationalized. There's going to be more volatility, there's more to react to. And it makes me think back to the Dalbar Study that they do pretty periodically, but their conclusion there is the average mutual fund outperformed the average mutual fund investor over the last 20 years by a 250 basis points, meaning that investors overreact often to volatility, to headlines, to things of that nature.
Dodd Kittsley: And look, one of the things we do know for certain is that market corrections occur, right? You get a 5% sell off every two months on average, you get a 10% sell off every eight months, you get a 20% sell off every two and a half years on average going back 80, 90 years. So, I think that's really where the value advice and controlling emotions and not overreacting but sticking to a long-term plan and high conviction ideas can really, really pay off.
Ed Rosenberg: And one thing to add... I'm sorry. One thing to add is, think of how headlines themselves have changed from 10 years ago. Even the headlines You read on any new site, no matter how reputable, are so much more sensationalized to force you to read the article. And most people don't read the article. They'll look at a headline and say, "Oh, did you see this article," like they read it and they'll react to it. So it's very much about understanding what everyone's trying to do to get you to look at something and what does it really mean?
Mark Hackett: Yeah. One of the realities we've found in our research is that while trading based on emotion has been a bad thing historically, trading on politically based emotion is even worse, because you have 50% of people who view things certain way and 50% of the people do it this way. Pew studies have said that over the last 15 years, the left has moved left and the right moved right, so you're viewing it through the lens of what your echo chamber is. And if you're trading based on that, a lot of the trading that we saw around the 2016 election ended up being over reactive on both sides. The optimists were too optimistic, the pessimists are too pessimistic, most of that driven by the echo chamber that you live in. That's what we are continuing to push over the next 18 months, is just try and keep things in perspective. Don't necessarily sell the healthcare names because of a democratic debate, for example.
Remy Blaire: Sure. And I think you've brought up a lot of important points when it comes to the changing landscape of technology. We know that having access to information is good, but we don't want it to move your investment decisions too quickly without thinking it over. So Rich, I do want to ask you about your outlook going forward, especially in the ETF space. Do you think they'll continue to have a presence in the same capacity that they do now?
Rich Koerner: Oh, I think without a doubt. I would echo Ed's comments from earlier. I continue to see very strong growth. I think Dodd threw the stat, over 23% now of the mutual fund industry in ETF. So this is a growing part of the business. I think this is the part of the business that you want to be in. Clients are adopting it and investors are adopting ETFs in record number and we're providing more and more solutions, whether that be a model portfolio solution, whether that be active solutions, whether that'd be the smart beta solutions that we've talked about here today.
Rich Koerner: So I think we're providing clients more choice and more solutions. And to the point that we talked about earlier as well, as these strategies start hitting those milestones, one year, three year, five year, I think you'll continue to see more adoption. So I continue to see strong growth for the ETF industry across the board. I don't think folks are probably going to give up their low cost passive products, but I think you're going to continue to see more adoption in those active and smart beta areas.
Remy Blaire: And last but not least, gentlemen, as we wrap up today's discussion, one thing seems to be clear, and that is that our attention spans have gotten shorter in this day and age of social media and just having all our information at our fingertips. But for the viewing audience, if you could address some of the concerns as well as educational concerns, what would you say to the people in the viewing audience? What do you want them to know as we close this discussion on ETFs?
Ed Rosenberg: I think really, that one, there's one with we never covered, so I'm going to end with that, which is ETFs are never the cause of anything, so they get headlines at the ETFs are causing trading issues or they're causing this. ETFs are based on the underlings, and so they are a result of what happens with the underlying securities. And I think understanding how ETFs work is the biggest thing the audience seems to take away, understanding what makes them tick, whether it's the investment thesis or the structure is one of the most important things someone can do.
Ed Rosenberg: Think about a car you wouldn't buy a car without at least test driving it or looking at or getting an understanding of it. Why would you put your money into something you're investing in without really understanding what it does or how the structure works? And I think it's really just understanding everything that goes into it and learning. There are so many resources out there now. When I started in the ETF industry 15 years ago, there was nothing for people to educate. Every firm has put stuff out. There's a lot of good material for people to just understand anything they wanted to, from books to white papers, to just basic web modules that are out there. And I think it's really just learning how it works and what should go into it.
Remy Blaire: Okay gentlemen. Well, thank you so much for your insights today into the ETF industry, and thank you so much for your contributing comments. And thank you for watching. I was joined by Rich Koerner, ETF Sales Manager at Fidelity Investments, Mark Hackett, Chief of Investment Research at Nationwide, Ed Rosenberg, Senior Vice President and Head of ETFs at American Century Investments and Dodd Kittsley, Director at Davis Advisors. From our studio in New York City, I'm Remy Blaire for Asset TV.
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