MASTERCLASS: Exchange-Traded Funds
- 50 mins 54 secs
Three experts unpack some of the key trends and product developments in the ever-growing marketplace. They cover how to think about liquidity and different ETFs in the context of portfolio construction, discuss the findings of a new advisor survey, and much more.Channel: MASTERCLASS
- Bobby Barnes, Head of Quantitative Index Solutions - Fidelity Investments
- David Stack, Senior Capital Markets Specialist Systematic Investment Solutions - DWS - Xtrackers
- Marc Zeitoun, CFA, Head of Strategic Beta - Columbia Threadneedle Investments
People: Bobby Barnes, David Stack, Marc Zeitoun
Companies: Columbia Threadneedle Investments, Fidelity Investments
Topics: ETFs, Factors, Liquidity, Interest Rates, Volatility, Active Management, CE Credit, Federal Reserve, DWS - 2,
Companies: Columbia Threadneedle Investments, Fidelity Investments
Topics: ETFs, Factors, Liquidity, Interest Rates, Volatility, Active Management, CE Credit, Federal Reserve, DWS - 2,
Jenna Dagenhart: Hello and welcome to this Asset TV ETF Masterclass. We'll unpack some of the key trends and product developments in the marketplace, cover how to think about different ETFs in the context of portfolio construction, discuss the findings of a new advisor survey, and much more. Joining us now we have Bobby Barnes, Head of Quantitative Index Solutions at Fidelity Investments. Mark Zeitoun, Head of Strategic Beta at Columbia Threadneedle Investments, and David Stack, a Senior Capital Market Specialist, Systematic Investment Solutions at DWS-Xtrackers.
Well everyone, thank you so much for joining us. David, kicking us off, could you explain to our viewers what the ETF capital markets' role is in the ETF ecosystem?
David Stack: Sure, thanks, Jenna. It's an essential role in the ETF ecosystem as we touch all parts of the value chain from product origination to trade execution. We work closely with our liquidity providers that are providing markets both on exchange and as well as OTC. We also work closely with our authorized participants. These are the firms that are creating or redeeming our ETFs based off of supply and demand. We also spend a large amount of time analyzing liquidity metrics across our suite of product, so that entails analyzing such metrics as examining onscreen spreads, market depth, underlying basket liquidity, implied liquidity, just to name a few. We also work very closely with our distribution teams, helping investors understand the liquidity formation of our suite of products, so we are completely ingrained throughout the whole value chain of ETFs.
Jenna Dagenhart: Mark, turning to you, how do you think about different types of ETFs and how they fit into an investor's arsenal?
Marc Zeitoun: Thanks, Jenna. The ETF landscape has changed so much in the last few years. It's kind of hard to say it's one thing, it looks more like a mutual fund or a separately managed account in the sense that it's a pool vehicle, and I think that what matters now more than ever is what do you do at that pool vehicle, and what are the different kinds of flavors that can go into that? And we look at all of these on an alpha beta continuum, right? And on the one hand, pure beta, benchmark tracking, there's no discretionary anything, and then completely on the other side is all alpha, and all these solutions that advisors have in their arsenals, to use your word, they fit on that continuum somewhere, and the client figures out where they want to be. Now the good thing is cost sometimes calibrates at the same level as that incremental alpha, but it's all on a spectrum. It's all on a continuum, and I think the cool thing is that the new ETF structures are permitting more and more imagination and creativity in that space.
Jenna Dagenhart: Bobby, I see you nodding your head. I'm sure you'll want to weigh in on that as well, and then we'd love to hear your take on why investors should use factor-based strategies.
Bobby Barnes: Thanks, Jenna. Yes, I was nodding my head because I was in very much agreement with Mark with what Mark said about ETFs as a structure allowing for more unique ways to carve out exposures, unique exposures, for our shareholders. And so in thinking about factors in particular within that, if you go back to the genesis of indexing in ETFs, back in the earlier days, we only had exposure to what I would consider to be plain, vanilla exposures. Whether you wanted to be large cap, small cap, or value style or growth style. But when you think about factor investing, these are really better investment building blocks for our shareholders. Factors are characteristics of stocks that have been found to outperform over time, and so by having these products available to investors, that'll give them more precise control over the risk and or return profile of their portfolios.
Jenna Dagenhart: Now David, what key trends have you noticed in the ETF marketplace regarding flows and product development?
David Stack: Great question. Key trends in terms of flows that we've seen year to date, obviously investors have been positioning their portfolios defensively. We've seen investors gravitate towards value over growth in sector flows. Obviously, there's been a preference for staples, utilities, healthcare versus cyclical sectors. In fixed income, we've seen an investor preference for safety. We've seen a tremendous amount of in flows into gubbies and other high quality credit aims. Why high yields has been under pressure year to date. Interestingly though, though markets are down here to date from a flow lens through August month end, ETFs have taken in 374 billion of net new assets, which if we stay at this level to the end of the year, would actually mark the fourth best year in ETF in terms of flows. From a product development, as of August month end, there was 269 new products of which 169, or roughly 63% of new fund launches, have been active. We've seen a handful of new issuers enter the market, and we've seen a few high profile mutual fund to ETF conversions, which I find extremely interesting as it solidifies ETF as the predominant fund structure.
Jenna Dagenhart: That's a really interesting point too about the flows and a little surprising, David, given the year we've had in terms of volatility, but not really hurting flows?
David Stack: No. It's been quite interesting just to see the flows. Now obviously things could shape up differently over the next few months going into year end. Obviously there's a bit of volatility out there and a bit of uncertainty, but year to date so far it's actually been very well for the ETF industry.
Jenna Dagenhart: And any recent developments that have helped the ETF marketplace that investors might not be aware of, David?
David Stack: Yeah, actually two things come top to mind. One's probably a bit more well known than the other. The first was the ETF Rule, which was established in 2019. Essentially it removed regulatory hurdles for advisors to enter the ETF marketplace. It streamlined and simplified certain disclosures which helped eliminate cost and delays. It also harmonized rules between fully transparent active and index based ETFs, and obviously we saw that in the product development, which I just spoke about for new products year to date. Why this is important for investors? It increases competition, it drives product development, and may help reduce fees for investors, which are all value add.
The second one, which investors are probably not that aware of with something that's been happening over the last few years is listing exchanges have added supplemental liquidity programs. So what this means, it's added incentives for liquidity providers to focus on developing deep liquidity across the ETF ecosystem. In particular, a focus on new and low volume ETFs. So what that means for investors for those types of products, it's improved spreads, it's deeper displayed liquidity, improved auctions for these ETFs, right? And programs like this help with the liquidity conversation with end advisors. So both of these developments, I believe are value add to the ETF marketplace since they drive competition, product innovation, and they improve market quality.
Jenna Dagenhart: Compared to the benchmark, Mark, how are strategic beta and thematic offerings capturing inefficiencies?
Marc Zeitoun: I think they're capturing inefficiencies, and they're capturing preferences, and they're capturing building blocks that Bobby was talking about. I think sort of when the choice was large or small, that's sort of all that could be expressed in the marketplace. Now there are many more ways to tap into more specialized exposures, and I think the reason that the market has so many of these types of products is because clients want them, and they want them because they see that benchmark investing is non-differentiated and is subject to a certain amount of randomness.
And advisors are trying to control their exposures by overweighting, underweighting certain themes or certain sectors. And we know, you had mentioned before about a survey, we were out in the market earlier this year asking a very similar question as we do year over year around how important are the rules or how important are the constituents when you're picking an ETF? And we're finding that that's becoming increasingly important. Advisors and clients not only want to understand what's inside, but they want to start to control what's inside. Which is interesting because on the one hand we're buying passive exposures, which we think just means a blunt instrument, and on the other hand they're trying to manage it, which we think as of active, and so we try to find these hybrid terms, but at its core, it's advisors and allocators looking for ways to control other client's portfolios.
Jenna Dagenhart: How does Fidelity think about building factor indices, Bobby?
Bobby Barnes: Well, Fidelity obviously is known for being an active manager and having skill in that area. And so in thinking about building factor indices, again, I'll piggyback off of a comment that Mark made about control. One of the mantras within our actively managed side of the business is that investors should always be aware of and explicit with the exposures or the bets that they're making in the fund. And so that also manifests itself into the way that we design our factor products where we aim to offer our shareholder high exposure to the internet factor, so if they want cheap stocks, then we'll all things being equal, we'll offer exposure to the cheapest stocks possible, but we'll do that by controlling what we refer to as unintended risks. And by that we, there's typically three areas that will just tend to see unintended risks within a portfolio.
I refer to them as a three S's, so size, sector, and security. And so just a little brief commentary on what those are and how they impact the portfolio. Going back to my example, if you have a portfolio that's buying cheap stocks, and let's say it equal weights those stocks, you have offered the shareholder exposure to cheap stocks, but the unintended risk when you would do something like that is that they will also be making a bet on smaller cap stocks. And so because of that we create our factor indices such that they have the same weighted average market cap as their broader market so that our shareholders, if they want to express that separate and independent bet, they can do so without having it underlying their portfolio unintentionally.
Similar thing with sector. There, we create the factor indices such that they have the same sector composition as the broader market with the same purpose in mind, that a sector can have exposure to things like value, quality, momentum, implement, et cetera. But if separate and independent from that they want to overweight tech or consumer staples, then they can do that as well.
And then finally the last one, and this is kind of my favorite one given that I grew up on the active side of our business, is security. And what's meant by that, and I'll give an example on an active side of the business. There, when we have a demonstrable edge on the future fundamentals of a stock, say Apple, internally what we want to do is back up the truck or own as much of Apple as possible because we have high conviction in that name. When you think about factor investing, however, we don't necessarily have that much conviction on any of the names. And again, going back to my valuation example, the cheapest stock has odds of outperforming that are similar to that of the say the 50th cheapest stock. So because of that with the factor index, we found that it's best to spread the overweights across the portfolio equally as a way of betting on the factor but not allowing any one or two names to dominate the portfolio.
Jenna Dagenhart: And Mark, I know Columbia Threadneedle has built out their smart beta lineup a bit differently. Could you talk about the thinking behind these products?
Marc Zeitoun: Sure. It's differently, but it's not that different than what Bobby talked about, which forgive me for extending, I think we're trying to put our best thinking or some of our best thinking in all that we do. And I think that that is of the value proposition of any active manager is passing along that insight, and you do so in different degrees. We are very proud of our fixed income franchise. So for us, when we launch a fixed income ETF, we do it with that team. So we are launching extensions of our core competency.
We find that clients don't have binary decisions. Do I want this product? Yes, no. Do I like this price? Yes, no. They want to be given a choice. And so back to the continuum, think of that also for any given strategy. You've got your best thinking, you've got informed by your best thinking, influenced by your thinking, incorporates research that's also on a sliding scale. And what we've successfully done is launched smart beta ETFs within our core competencies to satellite, those core active solutions that we've built our franchise on, and we're thinking about using this institutionally as well as offering these smart beta indices as separate accounts. There is no limitations to what you can do when they are hub and spoked off of a research competency.
Jenna Dagenhart: Bobby, turning back to you now, how should investors use factors in the context of portfolio construction?
Bobby Barnes: It's a very good question. It's a question I get often when talking with clients. And so what I share with them is that there are three main use cases for using factors within your context of portfolio construction. They are strategical or cyclical or tactical and for portfolio construction in the way of plugging a hole. So just to briefly describe what each of those use cases are.
The first, which is strategical, that entails taking a buy and hold approach to using factors. The reason that this works is that factors have been found. Again, there are characteristics of stocks that have been found to outperform over time but not all of the time, and so one way for a shareholder or an investor to benefit from those long term performance benefits is just to take a buy and hold, set it, forget it approach.
Contrast that with taking a more cyclical or tactical approach. The reason why an investor can use factors cyclically is because factors tend to have their own unique performance behaviors depending on where we are within the economic cycle. And so because of that, one way that a shareholder can use factors is to tilt their portfolio into those factors that are likely to do well in these current state of the economic environment or where they think the economic environment is likely to head.
And so then the last use case for factors, and the analogy I like to draw here is that it's kind of taking a multivitamin. And so the landscape between active and passive has gotten very blurred over time. I actually would submit that there are very few passive people or investors out there because even with the many building blocks that are available, people are still placing bets with these passing building blocks, and when you aggregate their portfolio up, it doesn't look like the market. And so one of the ways that factors are very useful in that context is that an investor may have bought either active managers or passive products that they felt good about and ultimately have a collection of these investments in their portfolio. In aggregate, that portfolio might be deficient in something, say like dividends for example. And so one of the ways then that an investor can use factors would be to buy a high dividend factor ETF as a way of plugging that gap within their portfolio.
Jenna Dagenhart: So passive isn't always passive purely, Mark?
Marc Zeitoun: It's not a great term, right? And unfortunately it defines more. As Bobby was saying, you imagine the passive means nothing when actually people who are constructing benchmark exposures through five or six different ETFs are very active, so to speak, or very deliberate. And I think that I prefer sort of random versus deliberate to tell you the truth. And I think that to own a benchmark is to be subject to a deliberate, I mean to a random collection of CUSIPs that are weighted as the market would want it. You have no control into that, but if you were to do what Bobby was saying or use one of the solutions that either David or Columbia has, you're tapping into something that's a bit more deliberate and more intentional, and I think that that's the difference. To me, those are better. It's a better taxonomy, but I don't get to write that book.
Jenna Dagenhart: No. David, what support can DWS provide advisors when evaluating ETFs for portfolio selection?
David Stack: Yeah, sure. So one thing to be cognizant of is there's roughly about 2,900 listed ETFs here in the US, so there's a ton of different types of exposures, whether it's straight beta or factor based or lever to inverse. There's so many different ways that the market has been sliced and diced which is great for ETF investors, but it also begs the question is how do you slice and dice that and filter that out to exactly what you're looking for? So as an issuer of ETFs, we have many resources that are available to investors to help educate them on our suite of products such as how is this product constructed? What are the attributes of this ETF? How does this ETF compare to other ETFs that are in the market? We can do head-to-head comparisons which essentially show how the product differentiates itself between or from its competitor funds. We can also provide detailed liquidity analysis of the ETF secondary market and as well as the primary market. But the overall goal of these support services is to help advisors to find the right solution for their clients.
Jenna Dagenhart: How do they find that right solution, Bobby? You want to weigh in on that?
Bobby Barnes: Well, I think it depends on their investment objective. In my work, clients oftentimes will want one of three things. They'll want either capital appreciation, downside protection, or income. And so depending on which one of those three buckets that the investor is optimizing over, there are a plethora of products that can be constructed or built in such a way to help achieve that outcome.
Jenna Dagenhart: And Mark, you recently surveyed advisors to learn more about their attitudes and beliefs related to ETFs. Was there anything that stood out to you in the results?
Marc Zeitoun: A lot stood out to us. I'm not going to bore you with all the super detail, although Bobby might enjoy it because everything he's saying is pretty much in line with what the survey was. But just on the point of preferences and client objectives, one of the things that we've noticed since 2020 versus 2022, capital appreciation went down in terms of most important. You can expect that, right? And cap preservation increased and income increased. And so I think it's a healthy reminder that clients have investment objectives and preferences when they approach our suites and that our suites need to be ready to accept that. So one was the changing of attitudes around ETF and what they're looking for. The other was, interestingly two years ago only 40% of advisors surveyed were comfortable talking about strategic beta. This year's 72%. So even though you've heard me say in the past that it's probably the worst term out there, strategic beta, the concept of what we're launching is becoming more normalized for investors and allocators, and they're willing to accept that in their portfolio, so that that's a great thing for ETF issuers.
And to back to one of the earlier points that we were making, with that comes in increasing frustration about what's in the portfolio and this desire to control your exposure. And why does this fund own this security? It just declared bankruptcy. They're in the news right now. Why do I have to buy it because it's part of an index? And so you have an index approach that's being second guessed which just speaks to how clients are perceiving the lack of control that they have with their exposures. So I thought those three things for us, so as I said, 65% were concerned about what was inside, frustrated, I should say. That was the actual question. Are you frustrated by the holdings in your index? 65% had said yes. Now we're 78% ,and this will lead to customization capabilities I believe outside the ETF wrapper as many of us have read about around direct indexing.
Jenna Dagenhart: Bobby, do you want to add to that?
Bobby Barnes: Yeah, I think Mark hit the nail on the head. I mean if you look at where the marketplace is likely to head in future, it's going to revolve around customization because increasingly investors, we haven't talked about ESG, but that's yet another say, exposure that, or preference, that investors like to express. And so I think moving forward, you're still going to have many of the same building blocks that we have, whether it's large cap, small cap, strategic betas, value growth, whatever the case may be, but there will be other investor preferences that they'll want to layer on top of that, and direct indexing will be the vehicle that'll allow them to still get the market exposures that they're after but do so in a way that also incorporates their other tilts that they would like to have as well.
Marc Zeitoun: I think clients want to be understood, Jenna. They want to feel like their advisors get them, and when you can offer a customized solution that reflects their values, it's proof that we understand who they are and what they need.
Jenna Dagenhart: Mm-hmm. Hey, I'm giving you something special that was made in line with your preferences. Not, I'm giving you the same thing I've given to everyone else.
Marc Zeitoun: Well, I think that clients understand that that capability exists in other industries and other facets of their lives, and so they will begin to demand it in this very important part as well.
Jenna Dagenhart: Mm-hmm. It's everywhere, that's for sure. Now David, what are the different ways that an investor can trade an ETF?
David Stack: Sure. There's a few different ways that investors can buy and sell ETFs. The first one is on exchange. That's just interacting with the display liquidity. They can do that through via market orders or limit orders. The second way is OTC which is off exchange. Here, the execution desks and all the major firms out there, it can source liquidity for liquidity providers. They usually do it through a request for quote. This is essentially where the execution desk reaches out to a few ETF liquidity providers, and they ask them for a price or a bid and offer. And why this is beneficial is you can trade very large sizes with price immediacy. The ETF liquidity providers, they all know they're in competition with others and will respond with the tightest market for that size.
The third way is via nav market. We tend to see that more on the institutional side, but this is essentially where an execution broker will supply a market such as nav plus cost or nav minus cost. And this is the level where the client can transact at. Just a reminder, transaction costs are externalized to the fund and are born by the buyer and seller. Lastly, is an agency or a working order. This can take the shape of an algorithmic strategy. Execution workers have all different types of algo capabilities. Essentially it takes an order, and it slices and it dices it based off of what your goal is from an execution standpoint. So I would suggest that any of your viewers that are watching here, and if they're not familiar with the capabilities of their executing broker, is definitely something to look into because there's many benefits of these types of execution strategies, especially if there's a bit of volatility in the market since they can slice and dice and work it out throughout the day.
Jenna Dagenhart: Looking at performance, Bobby, how have different factors performed over time and should investors try and time factors?
Bobby Barnes: Yeah, so great question, and the first thing I want to emphasize is that factors work over time and not all the time. In fact, there's no investment approach, active or passive, that works all the time in all environment. And so going back to one of the things I said earlier, there are three use cases for utilizing factors, and I mentioned that one of them is to use them cyclically or tactically, but that does beg the question, well how tactical are you prescribing investors be here? And so I don't think that it makes sense to tilt or time factors on a one month basis, month to month or quarter to quarter, but that being said, if you have a view on the, say, the business cycle for example, and classically there are four phases, early recovery, mid cycle expansion, late cycle, and then slow down and then recession or contraction. These things don't last a month or a quarter. They typically last 12 to 18 months at least. And it is the case that factors do have their unique performance behaviors depending on which one of those that we're in.
And so with that, armed with that knowledge, investors can again either tilt a portfolio into these factors. And so by tilting what I mean is that they've got some core allocation, and there's only really at the margin that they're slightly over or underweighting versus that core portfolio. And so in doing so, assuming they get that call right over time, now there will be performance benefits associated with that.
Jenna Dagenhart: But they're not betting the ranch.
Bobby Barnes: Right, right. You're not betting the ranch.
Jenna Dagenhart: And to follow up on that, could you share a bit more about how factors perform during rising and following economic activity, Bobby?
Bobby Barnes: Yeah. So rising and falling economic activities is another way. I mean that's one of the underpinnings I would say of the definitions of the four business cycles that I mentioned before. And the way to think about that is that some factors are more offensive or pro-cyclical. They do better when the economy is re-accelerating. Whereas other factors are defensive, and so they tend to do better when the economy is experiencing slowing growth or even contraction in growth. And so in looking at say the ISM as an example, that's just one expression of economic activity, it is the case that you could use that as a pulse or a gauge as to the direction of the economy and then react accordingly and go into those either pro-cyclical or defensive factors.
Jenna Dagenhart: You mentioned liquidity earlier, David. How should investors evaluate an ETF's liquidity profile?
David Stack: Always start with underlying liquidity of ETF, meaning how much does the underlying securities that it holds, how much do they trade? We refer to an ETF supply liquidity. It's a data metric. It's essentially, it's how much can be traded of an ETF based off of its creation basket. This helps advisors and clients gauge how much can be traded. It's really helpful for low volume secondary market ETFs. One thing to mention, before a product ever comes to market, issuers are analyzing the implied liquidity. I think this is sometimes lost in the conversation because we build products for scale, so if we bring a product to market, it has an AUM of $5 million on day one, the implied liquidity is going to be much larger than that. If there's limited capacity, well, then that type of product is probably better suited for maybe the private markets where they can add lock ups and liquidation periods, but for ETFs, just remember we bring product to market for large scale investments.
Jenna Dagenhart: Yeah. So if an ETF has $5 million in its holdings, but the holdings are highly liquid, then those are different stories there, David.
David Stack: Absolutely. I mean that's why the implied liquidity is so important for investors to kind of gauge how much the underlying basket trades. Chances are you're going to see the ETF with 5 million, but the implied liquidity is going to be 50 or a hundred billion dollars. So there's tons of liquidity that are in ETFs, so if the ETF has small AUM, just keeping the back of your mind that we're building products for large scale investments. So if you're going to put a million dollars or 2 million dollars to work, you're going to have minimal impact.
Marc Zeitoun: Jenna, that's such an important point. And David, thank you for saying it that way because I'm in the middle of these conversations constantly and basically what you're saying is we don't want to create a headache for ourselves, so why would we launch an illiquid product? And there's a simplicity in that, and it's true, right? I'm sure all of us have lots of zeros in our cost benefit analysis when we launch new products, and we would not do so if it was a problem early on.
Jenna Dagenhart: Do you think that some advisors, though, or investors might see a small AUM and run in the opposite direction when really it's liquid?
David Stack: No, absolutely. It goes down to the education process because ETFs trade on exchange, so the first thing that they're thinking about and then they see a low ADV is if they're thinking about a stock that doesn't really trade, so they're going to have to move that stock around and have potential impacts. Now, the ETF is the basket of securities and that baskets are securities, if you're putting 10 million dollars to work, is going to have very minimal impact on a basket that trades 50 or a hundred billion per day. So again, just always for investors, always think about that as an issuer, our products that we're bringing these things to market for scale, not just a 5 million or a 10 million dollar investment.
Jenna Dagenhart: Looking at how investors think about these products, Mark, what needs are they looking to fill when looking at smart data ETFs?
Marc Zeitoun: Hopefully they're looking for professional management. When you think about why do investors come to asset managers, it's for that. Outside of tracking four mainstream benchmarks, I think that they're looking for a little extra from the asset manager, and I try to boil it down to they want our research, they want what we think. They're interested in our points of view. And I think that with all of the different structures that exist and that are coming to market, investors are going to spend a lot of time trying to understand, does this structure work? Does that structure work? And I think they should also try to figure out if the issuer themselves has standing in launching a certain strategy.
And so you take semi-active for example, a lot of focus on how does that structure work? Is it safe for people? And it is, but let's also not forget that there's an active manager behind that and what's that active manager's experience and what have they done? And they don't stop at the structure conversation, which is in line with our survey. Go inside. Clients need to understand. They need to do their due diligence. And by the way, advisors have been doing this on active funds and SMAs for quite some time, so I think you'll see a harmonization of a due diligence approach across all the different structures.
Jenna Dagenhart: How are you thinking about factors in the context of Fed rate hikes? Bobby, you mentioned business cycles earlier and how that impacts factors.
Bobby Barnes: Sure. Yes. So I think the first thing that one must understand in thinking about what drives not only factors but what drives stocks more generally over time, and the answer is earnings, growth and earnings revisions. And so with that having been said, if you think about the Fed rate heightened cycle, it is a case that it has the intended outcome, which is the Fed wants to slow the economy down, they want to prevent the economy from overheating. And so just to explain some of the anatomy and mechanisms behind the stock market, the Fed raising the interest rates, that's increasing the cost of money. And in my work, what you'll find is that that transmits through the economy over about an 18 month period.
And so what that means is over the course of the rate hikes, you're going to get moving forward slowing growth or slowing economic activity. And so that's going to manifest itself in earnings revisions to the downside for some stocks. And so the bank shock then is to ask the question, well, which factors are likely to do better in a slowing growth environment? And so with that back drop, those defensive factors, which I alluded to before, were some factors are behaved more defensively than others. And so naturally speaking, within that you would have things like quality, low volatility, but then also momentum depending on the duration of that performance behavior that you've experienced because momentum is defined as what has worked over the last 12 months. And so if you've been in a slowing growth environment for 12 months or more, then a momentum portfolio is also going to have a more defensive posture.
Jenna Dagenhart: And David, what should best practices be when considering an ETF with low secondary market volume? Going back to our conversation around liquidity.
David Stack: Sure. Investors need to be thoughtful on how they approach the trade, just as thoughtful as the selection process. I suggest using limits or marketable limits. While limits don't guarantee a fill, they do give price certainty, and you can adjust the limit. If you have to utilize a market order, I would suggest a marketable limit, which is if you're buying would be a limit price above the prevailing ask or if you were selling it would be below the prevailing bid. This essentially is, the books are electronic, and things can move around, but at least this kind of helps protect you on price if volatility starts to pick up. If you ever have any questions around what's out there from a display side at the inside and as well as on the order book, you can obviously always just reach out to us at DWS, and we can help guide you about what we're seeing out there in the market to help you when you're placing your trade.
Jenna Dagenhart: What about during periods of volatility which we've had many of in recent years?
David Stack: Yeah. Same advice. Use limits or marketable limits during periods of volatility. One thing to just note, during periods of heightened volatility, what we do tend to see is the display sizes on the order books decreasing because of that uncertainty. So using limits or marketable limits are highly advised, especially when volatility picks up. And as I previously mentioned, the execution asset, all these firms out there have tremendous capabilities. They have different avenues of source and liquidity, whether it's through an algo strategy or reaching out to a liquidity provider. So I definitely think it's in a best interest for advisors to check to see what the capabilities are of their execution desk because they're there to support them on their trade execution process.
Jenna Dagenhart: And those orders are more likely to be filled during these periods of heightened volatility.
David Stack: Yeah, absolutely. It's funny, advisors out there try to help plan for uncertain times with their end clients, but sometimes there's capital needs or capital demands during periods of heightened volatility. But how you go about your execution can obviously be beneficial for your clients. So always either reach out to us from a capital markets perspective on our ETFs or utilize the execution desks of these firms.
Jenna Dagenhart: And given where we are in the current market cycle, I won't ask you to pin that down to a T, but Bobby, how can factors be used in the portfolio?
Bobby Barnes: Well, to answer that question actually I would harken back to some of Davis's comments about heightened volatility, heightened uncertainty. And so when I think about the job and the role of an advisor, some of that is just to help your clients sleep at night, and so one of the ways that when there's a lot of that uncertainty that advisor can do that would be an allocation to say low ball, because it is more defensive, it's going to offer us smoother ride, and so it actually will, in our work, protect the end investor from themselves because behaviorally investors tend to sell out at the bottom of a market due to the heightened volatility and then they buy it back in at some higher level later on, and so one way to kind of mitigate that effect is to allocate to say something like low ball or other defensive factors so that they're less likely to sell out right as things reach their peak uncertainty.
But then again, that being said, if you go back to the economic cycle and the like, I mean it is the case that our asset allocation team has declared the US market to be in late. And so there are prescriptions from a factor perspective of what to invest in such an environment. And then you also have investor needs that are almost market cycle agnostic, and I think my fellow panelists, either Mark or David, mentioned this where one of my favorite statistics is that as it stands today, every day there's a million new retirees who wake up in the morning and need income. And so here's a need that really is not dependent on the market cycle itself, but that being said, factor products like high dividends are a way of satisfying that investor need.
Jenna Dagenhart: Now during these periods of volatility, we tend to hear more about large premiums and discounts. David, can you discuss what's happening?
David Stack: We do. There's a lot of misconceptions around premium discounts. A lot of people think there's something wrong with the ETF when the opposite is true. Premium discounts is an observable difference between the last price of the ETF and the funds net asset value. With US equities, for the most part, the underlying securities are closing at 4:00 PM which is the same time the ETF is closing, so premiums and discounts should be very minimal. For international ETFs, it's measuring versus the local close and the farm market for nav versus the 4:00 PM near close. So if you were thinking about Europe, which closes at 11:30 AM Eastern versus the 4:00 PM, there's a lot that can happen in between there that will manifest into premium and discount. So if there's a lot of volatility or the market moves directionally up or down, right, that's going to be impactful to premium and discounts. So it's just more tying it telling you what happened in the market from the local close.
The fixed income is slightly, is similar but slightly different. Bond markets are slower to adjust, so the ETF actually will reflect that risk in the market, and during periods of stress, we've seen where fixed income ETFs will have a large premium or discount, but after bonds start to adjust by the pricing committees, or if there's an observable trade, the premium and discount will collapse, and the nav will be more in line to where the ETF is trading. So we do see an uptick in premium discount questions during periods of volatility, all which are explainable, and that's part of the education process around ETFs.
Jenna Dagenhart: Going back to our conversation around control and active management during turbulent times when markets are messy and more complicated, some would argued that there are more opportunities for active management to shine. And given the recent proliferation of active ETFs, Mark, what should investors consider when evaluating these newer ETF sponsors and products?
Marc Zeitoun: I think all product development is subject to the similar level of due diligence. From an investor perspective, what are you getting into? I mean, just to be frank about it, do you understand it? Have you paid attention to how the rules and the exposures were created? Who did that? I think there's a shortcut where we look at price, we look at volume. And ETFs used to be, I don't know what to do in this asset class, so I'll just buy the ETF. And it has evolved so much more that issuers are launching products that are much more deliberate and precise so that advisors in turn can be more deliberate and precise themselves. So I think that both sides are going to need to think twice about what they're launching. So from the investor perspective, that due diligence that we talked about before, from the issuer perspective, there will be tremendous desire to start launching in new things, and you'll see an increase in thematics, you'll see an increase in micro exposures, and you will also see an increase in traditional active solutions that active managers have been performing for a while.
Some will argue the conversions, some will argue that the assets are moving from one chassis to another. My advice to asset managers unsolicited is stick to your knitting. Don't be tempted. Do what you do best and keep doing it well in all these different chassis. So I think that for a lot of active managers who is trying to scratch their heads and saying, "How do I deliver what I do in a passive setting?" And strategic beta is not enough, I think active will offer that. Obviously there is a difference between fully transparent, semi transparent, and the asset class limitations that each provide. I think that we're in a period of transition though, and so the same rules apply. Don't get gimmicky and pay attention to read the warning label.
Jenna Dagenhart: Always important to read those warning labels regardless of what they are. Exactly. Well David, how should an investor evaluate a new ETF in the same asset class against one that already trades and owns many of the same securities?
David Stack: Sure, I mean just very similar to Mark just spoke about, there's many different ways, and you always start with the fund's objective. What is it trying to achieve, right? And how does that compare to the other fund? What are their sector weightings? Ups or downs? Is there overweights? Underweights? How has the index perform versus the competitor index of the other ETF? What is the expense ratio? Is it cheaper, the same, or expensive? What are the screen spreads of the ETF? How does it compare to the other EFT? What's the overlap of securities? He implied liquidity? What would my impact cost be for a 5 million dollar allocation or 25 million dollar allocation across my book?
As I mentioned before, we can help evaluate ETFs for investors by doing head-to-head comparisons. I mean the goal is to really partner with advisors and investors to help them find the right solution for what they're looking for, and we can bring those head to heads just to kind of show them like how this fund is expected to perform during this types of these types of periods, but there's lots of resources across the whole ETF ecosystem to help advisors and clients find that right solution.
Jenna Dagenhart: And just because factors have worked in the past, Bobby, why do you believe that factors will continue to work in the future?
Bobby Barnes: I'm very glad you asked that question because that's one of the areas of push back that I hear most often when talking to clients. They say that, "Hey, I see that in the back test that these things have worked but prove to me that it's going to work moving forward." And the way to think about that, and this is kind of going back again to the anatomy and mechanics of the market, is really earnings that drive the relative performance of stocks, sectors, and factors over time.
But with factors, earnings drive the performance but in different and unique ways. And so just to give one example, buying cheap stocks has been found to outperform over time, but the reason that earnings is the attributing factor to that is that typically what happens when you buy cheap stock is that the marketplace has decided that this stock has worth, say, a 10 times multiple on earnings. But then when the companies surprises on earnings, you basically get paid twice. You get paid once just for the higher E or the earnings, but then you get paid again because the market participants then do what we call re-rate the stock, and so instead of being willing to pay a multiple of 10, it goes to something higher, maybe 11, because the realized growth has been higher than what was anticipated.
Similarly, another example would be on quality. I mean, the whole reason that quality works over time is because in order for a company to have a higher level of profitability versus their competitors, they must have some competitive advantage that allows them to earn those higher profits, and so these are things like having a better brand or operational efficiency or intellectual property, and these are things that are sticky. And so if you have them today, you're likely to have them tomorrow and then to the future as well.
And so to the extent that you do continue to have those things, that'll lead to higher profits or higher earnings. And again, because thoughts follow earnings, that kind of drives the performance of quality over time. And so then in asking the question then, will factors go on to continue to outperform going forward? What you're really asking is, will earnings continue to be a driver of stocks over time? And so there's been a lot of work that we've done that suggests that earnings are the key driver of stocks and so hence we have a conviction then that they'll continue to drive the performance of factor moving forward as well.
Jenna Dagenhart: And moving forward, Mark, where do you see opportunity for ETF sponsors in the coming years?
Marc Zeitoun: I think going forward, ETF sponsors are going to have lots of choices, more choices than before. I think there'll be some structural choices we talked about before. I think that based on the surveys that we've fielded and the answers that we get from an investment objective perspective, we really want to focus on income, cap preservation, reduction of portfolio volatility. That speaks a little bit to what Bobby talks about with factors that are diversifiers. There are other ways of achieving diversification as well beyond just a factor, but I think that concept of bringing a little bit of stability to the portfolio over the next few years, whether actively managed or passively managed or deliberately constructed or randomly avoided whatever the right words are, it's that guidance through the turmoil that ETF providers and clients are going to be well suited focusing on.
Jenna Dagenhart: And we've covered a lot of ground today, liquidity, factors, you name it, advisor surveys, so I want to give everyone a chance to just go around the room and share final thoughts with our viewers. David, why don't you kick us off?
David Stack: Sure. Final thoughts, there's lots of resources that are available to end investors that are utilizing ETFs. Please reach out, not only to us, but any other [inaudible 00:49:32] that's out there that has product out there to help answer questions, to get them comfortable with the structure, the investment, anything around trading and liquidity, tons of resources. Just please reach out.
Jenna Dagenhart: Bobby, over to you.
Bobby Barnes: Yeah, I would further underscore some of the points that we've made thus far. I mean, I think that the current market landscape is very exciting. I mean, investors have unique ways and more precise way of controlling their portfolio, that they've never had before. But that being said, as I've mentioned before, I think that the line between active and passive is blurring, and I think all of it's active, it's just kind of a matter of where in the spectrum it's actually happening. And so because of that, as one of my fellow panelists said, you have to do your homework. And so you don't get to absolve yourself of that work, but after you do that, the in outcome can be very beneficial to our shareholders.
Jenna Dagenhart: Mark, I'll give you the final word.
Marc Zeitoun: Just a reminder that vehicles are just that. They're not the underlying, they're not the strategy. Think about the strategy first, vehicles second. There's so much swapping going back and forth between passive SMAs and active ETFs that the vehicles themselves don't have the same meaning as they did years ago. Think more about how these strategies should work together and then figure out what the appropriate vehicle is that's available.
Jenna Dagenhart: Well, we better leave it there. And everyone, thank you so much for joining us.
Bobby Barnes: Thank you.
Marc Zeitoun: Thank you so much.
David Stack: Thank you.
Jenna Dagenhart: And thank you to everyone watching this ETF Masterclass. Once again, I was joined by Bobby Barnes, Head of Quantitative Index Solutions at Fidelity Investments. Mark Zeitoun, Head of strategic beta at Columbia Threadneedle Investments, and David Stack, Senior Capital Market Specialist, Systematic Investment Solutions at DWS-Xtrackers. And I'm Jenna Dagenhard with Asset TV.