MASTERCLASS: Fixed Income - February 2021
February 10, 2021
Jenna Dagenhart: Hello. You're watching BNY Mellon's Exclusive ETF Masterclass. 2020 was no doubt a very volatile year, but it also gave us a lot of new launches. Today we'll look back on what we've learned so that we can also forward to new opportunities in 2021. I'm joined now by Stephanie Pierce, CEO of ETF, Index and Cash Investment Strategies at BNY Mellon Investment Management, Ben Slavin, Global Head of ETFs, Asset Servicing at BNY Mellon, Ben Johnson, Director of Global ETF Research at Morningstar, and Eric Balchunas, a senior ETF Analyst at Bloomberg Intelligence.
Jenna Dagenhart: Everyone, thank you for joining us. Setting the scene here, Stephanie, why did BNY Mellon choose the enter the ETF product space in 2020?
Stephanie Pierce: Thanks, Jenna. As a leading global asset manager, our goal is always to deepen and broaden our client relationships by meeting their current needs and anticipating their future needs. ETFs represent a $5 trillion asset base just in the U.S. and about $7 trillion globally. At the current growth rates, ETFs are set to outpace mutual fund assets in just three to four years. So, put simply, ETFs are becoming the vehicle of choice for many of our clients. By launching ETFs, we're making the capabilities that we're known for across our investment organization available to a broader range of clients through the ETF structure, with which clients are really voting with their feet.
Stephanie Pierce: From an enterprise perspective, BNY Mellon has long been a leader across what we think of as the ETF ecosystem. That's from fund administration to custody and clearing to capital markets and securities lending and even ETF sub-advisory. So, launching BNY Mellon sponsored ETFs really completes what we think of as the end to end ETF value chain of products and services across the firm and enables us to provide our clients with a one-stop shopping experience for all their ETF needs. So, this is a pretty important strategic initiative for us this year.
Jenna Dagenhart: What a year to be entering this space. Stephanie, we can't talk about 2020 without mentioning coronavirus. Did this have any impact on your plans?
Stephanie Pierce: It's a great question. Our ETFs went effective with the Securities and Exchange Commission, which means we had the green light to launch them on March 9th of 2020 amidst COVID-related market volatility, dislocation in many fixed income markets and so forth, and every day, we gathered to review market conditions and really analyze the key metrics to determine whether the environment was suitable for a new ETF launch. Our ETF board members as well as our portfolio managers and traders and capital markets and market risk teams each provided incredibly valuable perspective that ultimately helped inform the timing of our launch strategy, which included something we hadn't previously contemplated, which was the sequencing of our U.S. equity ETFs first followed by our non-U.S. equity and fixed income ETFs a couple weeks later.
Jenna Dagenhart: I don't think anyone will forget March 2020 and we'll talk more about that later in the program. But looking at the wider ETF market, the sheer number of launches has been pretty impressive. Ben, why are we seeing so many new ETFs coming to market and why now?
Ben Johnson: Well, Jenna, I think it's important to step back and really frame what we see going on within the ETF category within its broader context, which I would argue is almost a wholesale re-platforming of the asset management industry. We've seen asset managers, we've even seen investors, increasingly move away from traditional open-ended mutual funds as their format of choice as their investment vehicle of choice and in the direction of other non-mutual fund formats. So notably in the retirement space, we've seen a movement from 1940 Act mutual funds to collective investment trusts, or CITs, which can be more efficient for large employers within defined contribution plans. Within the intermediary and individual investor space, we've seen a movement away from mutual funds and towards ETFs, which have been a huge beneficiary of outflows from open-ended mutual funds of incremental investments from even the smallest individual investors.
Ben Johnson: Simultaneously, what we've also seen and what is very important to note is that ETFs have benefited from a substitution effect. A substitution effective specifically among institutional investors away from other ways of getting market exposure, be it through futures or swaps, and towards a cash-based exchange traded instrument which is the ETF as their vehicle of choice of obtaining those same exposures, which can be more efficient and more cost-efficient in particular for those institutions.
Jenna Dagenhart: Eric, anything you'd add?
Eric Balchunas: No, I would just reiterate everything Ben said. I think we just simplify it with that's where the money's going. So, it's a tough industry and if you look at the flows, it's very difficult to actually get assets. Then on top of that, it's difficult to get any revenue, especially compared to what active mutual funds made in terms of revenue in the past several decades. It's a brutal market. It's a meritocracy. That said, people rough it and try it because that's where the money's going. This year, I just looked, I think currently ETF flows are about 416 billion, but given Decembers are really big because of tax-loss harvesting, they're probably going to wind up right around the record, maybe 460, 470 billion. Meanwhile, mutual funds are going to see about 550 billion in outflow. Something in that nature. So that's a trillion-dollar swing.
Eric Balchunas: That's a lot of flows, especially given the fact the S&P was up, I don't know, 15% was the last I checked, year to date. That's good. I mean, that's definitely above what you normally get. But the previous record of ETF flows was 2018, I believe, and the S&P, I believe, was up 22%. So, given the rough year and the S&P not up as much, it's almost a more impressive haul this year in flows. So, wherever the money is going, you're going to see people... that's where they're going to fish. So that's where all the new products are going to come out to try to appeal to all the cash going there.
Jenna Dagenhart: In addition to the number of launches, there were also a lot of different types. Ben, now why don't you walk us through some of these new ETFs coming to market?
Ben Slavin: Well, the sheer volume of ETF launches remains high. I think we're at 230 plus on the year and that number will no doubt continue to rise in the next couple weeks before year end. So, to Eric's point, a very competitive industry is already getting more competitive with all the new launches. The launches we're seeing are coming in a variety of different categories this year. First, it would be hard to think about new launches without mentioning active, so we're seeing a very high percentage of active ETFs being launched relative to passive as we've seen in the past. Those are coming in both the fully transparent and non-transparent variety, which has taken up a considerable amount of attention. But those launches still are in their infancy and it will take some time for those products to gain traction.
Ben Slavin: I think also we're seeing, especially into next year, a queue forming for fixed income ETFs. Part of that is driven by market conditions. Part of that is also driven by the regulatory environment, which is making it easier and really leveling the playing field for issuers to launch those types of products. Also, I think the defined outcome or target outcome space is another area where several of our clients are looking for those types of exposures and launching those types of products. I think the interest in those products is being driven by a few different factors. Certainly, some fear in the run up to the election, but looking forward, I think those products are really serving a purpose for investors despite whatever their view on market conditions may be. I think that's going to be a trend that we're going to see from a launch perspective and certainly another area where we're getting traction.
Ben Slavin: I would say one more area really thematic. Just when you think you've seen every ETF sliced and diced in every which way possible, here comes another one. This year, not surprisingly, the work from home theme, e-health or telemedicine. We've seen some other successful thematic type ETFs around sports betting and some of these other themes, which have been really hot this year, especially as more retail investors have moved into the ETF space.
Jenna Dagenhart: Themes we didn't even know it'd exist in, say, 2019.
Ben Slavin: Absolutely. So many of these ETFs seem to just find a way to either cut the market differently or, as in a few of the other products I mentioned, it's really been a platform for innovation. So I've always thought that from a product development standpoint that in asset management, ETFs are the most fun because it really provides a platform to innovate, whether, again, it's cutting an index or a basket of securities one way or being able to innovate and structure, again, whether it'd be a defined or target outcome, certainly ESG, and some of the other active strategies that we're seeing come into the market.
Jenna Dagenhart: I'm sure everyone here agrees that ETFs are a lot of fun, but one of the not so fun parts about ETFs is when they close. Eric, I know you've done some research on closures. Do you want to share that with us?
Eric Balchunas: Sure. I mean, this year, we will see record closures. It was a rough year. There's always going to be closures. About one of every four ETFs launched has closed. So that's about a 25% death rate, if you will. There is some interesting characteristics of closed ETFs. Typically, they're pricey. The expense ratio is typically much higher. They are also young. Usually it's like three years is about the average lifespan of a closed ETF. They're nothing too awful for the investor. You might have a tax issue if there's gains in there and that's if you forget everything and they mail you a check for the NAV. But there is no loss of principal or anything like that, so I think they're more annoying if they happen. But typically, they close because nobody's in them. There was a couple this year that closed that had decent assets though and I think we should spend a little time on that.
Eric Balchunas: You tend to get some closures... Like I saw a closure, it was like the minimal volatility currency hedge Japan ETF. That might not be exact, but you get my idea. There's always a little extra launch when a fad happens and then a couple years later, they have trimmed a lot of that fat. So, currency hedged ETFs are closing and theme ETFs, a lot of these ones we just mentioned are not going to make it. So, you see that that's traditional.
Eric Balchunas: What was different about this year was the exotics. I'm talking about ETNs, leveraged ETFs. When you're trying to do 3X leverage and you're having limit up, limit down every day in March, it's virtually impossible. It's like a little rowboat being tossed around these giant waves. So, a lot of the leveraged ETFs were unable to fulfill their mission and they closed some actually went from 3X to 2X as well. So, I think the last I checked, the total exotics in terms of closures was something like 70. Normally they make up a high percentage of closures, but this year, they made up even higher. That, I think, was the difference maker beyond a normal year of closures and this record year, was those exotics.
Eric Balchunas: I'm sure there's some people happy that some of these have closed. Like a TVIX or UWTI. Some of these products are very dangerous. We have a traffic light advanced warning system for ETFs that alerts you of nasty surprises and these were... Largely we call these the red-light district. These were ones that have multiple things you need to know about before buying them. But ironically these are the ones those day traders loved. So, a lot of the ones that closed had decent assets. More than you'd normally see from a closure.
Eric Balchunas: So those, I think, were the two sides of the closures. But I find closures to be fine. If it takes out some exotics that can be dangerous, fine. If it takes out ones that don't have much assets and can have wide spreads where you can get hit on a market order and lose some money, fine. I think it's just part of the healthy, maturing industry. I did read a stat that 99% of apps close or don't made it. So, ETFs, for 25%, we're not as bad as the tech world yet.
Stephanie Pierce: Eric, it's interesting to compare that trend and those dynamics to what you see in the mutual fund industry where you don't see that kind of velocity in terms of the closures, right? In almost any given year. You know the stats better than me. But I feel like this has something to do with the quintessential everything gets marked to market and what doesn't make sense doesn't make sense and ultimately that washes out, right? That's a little bit of what's going on, right?
Eric Balchunas: Yeah. The other thing is when mutual funds came up, they paid people to put the client in the fund. So, they built up this nice base of assets and the market's been on fire. So even if you had investors leave in droves, you're making more money than ever. So, ETFs do not have that buffer. They have nothing going for them. That's why I call it the terror dome. You're sent out there with nothing into this big, broad jungle and its actually more true capitalism. I think the mutual funds live in a buffered, sweet world where you get this thing called the bull market subsidy where you can actually see customers leave and you have more assets and more revenue. That's fine. Good for them. I think that takes some pressure off of them closing.
Eric Balchunas: If you took the bull market subsidy away, we actually ran the stats, in 2010, active equity mutual funds had 3 trillion. They've seen 2.3 trillion in outflows. So, let's say the market was flat over the last 10 years, they would have 600 billion and you'd probably see two-thirds of them close. But instead, the market went up 200%. They now have 5 trillion. So, they've almost doubled their assets even though they have lost 80% of their base. There is no other industry like that, and I think that's something people might miss when they think, "Well, how come there's not more mutual fund closures and why is there so much ETF closures?" I just think it's because ETFs are much more of a pure meritocracy, not to mention you have cost obsessed advisors as your base. They will sell you out for a basis point. They're very brutal. Unless you are a shiny object or you're dirt cheap, your life is going to be very, very difficult in the ETF world. Mutual funds don't quite have to deal with that.
Ben Johnson: What I would just add to the conversation is that if you look at the ETF graveyard, there is some simple rules of thumb that you can walk away with that can help investors to avoid being the victim and the wounds aren't that deep, as Eric alluded to, of a fund closuring. I think first and foremost, if you look at just assets under management, there are only a tiny handful of all of the hundreds of ETFs that have ever been closed that had more than $100 million in assets under management. So, if you're going to use any one rule of thumb and just play the probabilities, that's as good a rule as any.
Ben Johnson: The other one is just to look at the underlying exposure. So, the gimmickier the underlying exposure, so I'm thinking of the whiskey ETF that's no longer with us, the pair of restaurant ETFs that, between the two of them, had an average lifespan of 13 months, and many others. I'd be remiss if I didn't mention the Nashville ETF as being among those. You can tell as you're approaching from street level that this is a building you probably don't want to walk into with your hard-earned savings.
Ben Johnson: The other element to look at is just the track record of the issuer themselves. So, there are some firms that have been serial spaghetti slingers, they're just throwing ideas at the wall and hoping some will stick, and there are others that have exhibited monk-like discipline when it comes to their product development. You look at the likes of, say, Vanguard and First Trust that have never closed an ETF in their history. So, I think those three simple rules of thumb will do a lot to protect investors from investing in a fund that might ultimately close its doors.
Stephanie Pierce: Ben, that resonates with me as the newest issuer amongst the group here. We're very fortunate that we have Ben Slavin who is with us today and, I would say, a coterie of informal advisors to us in investment management at BNY Mellon that are in all of the other ETF businesses where we have a leadership position, whether that'd be at Pershing or Capital Markets or Asset Servicing or Securities Lending. We touch all of these other parts of the business that you guys are talking about such that those lessons are ones that came to me. "Stephanie, make sure you do this. Make sure you don't do that. Here's what you want for your spreads. Here's how you should seed them. Here's how you should think about market makers. Here's how many APs you need." It was exactly all those things you guys are talking about. Ben, I think those are really important lessons.
Stephanie Pierce: We were also very fortunate coming into this as one of the leading ETF subadvisors, so we happen to be working very closely with other ETF issuers, even managing the money for them and doing the implementation. So, we've seen it all as a firm. It doesn't mean we won't trip up somewhere, but I think we have a pretty good head start with the advice that we've gotten from our own Ben Slavin who is on the video here and our other colleagues around the organization. But I think those are really good points that you made.
Ben Slavin: Yeah, I think there's been some great points made. I would only add that the rule of thumb for the ETF community has been around three years to incubate a new ETF. But we're seeing that number come down a bit, especially as the competitive pressure has intensified, but also as the pressure for the seed capital has intensified as well. So, where certain seed providers were willing to give a longer leash to incubate a new ETF, that's coming under pressure and the time clock is certainly speeding up. Again, as those demands for the seed cap really start to increase, it's just, again, put pressure on the time that the community's willing to incubate those new launches.
Jenna Dagenhart: Ben, now, what about the ETF Rule?
Ben Slavin: Well, the ETF Rule, there's a lot to unpack there. I think that at a minimum, it's really going to spawn quite a bit of additional activity from a product development standpoint, but also has widespread implications for the industry. From a product development standpoint, really the ability to use custom baskets and providing that as a toolkit that the industry can use is really going to spawn a significant amount of innovation, specifically around fixed income ETFs. Before the ETF Rule, certain issuers had it and certain issuers did not.
Ben Slavin: Now the playing field has been leveled and I think the result of that will be additional product development and making use of those custom baskets. We're spending quite a bit of time and resource upgrading our technology and our platform to be able to service the industry and provide the ability for our clients to avail themselves of the custom basket ability across a wide variety of products. But also embedded in there, certainly, is the rule set that will allow new issuers to come to market faster so the barriers to launching product are going down. I think the competitive pressure certainly is going up, but that won't stop new issuers from coming to market. Again, our queue is growing in terms of asset managers looking to either launch a new product, but certainly new managers looking to come into the market.
Ben Slavin: Finally, I think the other issue that's less talked about but there's a significant amount of disclosure requirements that come with the ETF Rule. Our clients are looking for solutions to help them get there to comply with the rule and it's a significant amount of data. The jury is out whether or not the market is going to be able to fully digest all of that data, but my general view is that really the transparency aspect of ETFs and certainly the additional enhanced data requirements is a good thing for investors and likely a good thing for the industry. But it is putting a lot of pressure and some last-minute scrambling by the industry to make sure that they're able to comply with the ETF Rule.
Jenna Dagenhart: Going back to mutual funds, while mutual funds still largely outweigh ETFs in terms of total assets, ETFs are becoming more and more popular. Likewise, we are starting to see mutual fund to ETF conversions. Do you think we'll see more asset managers following in the footsteps of Guinness Atkinson and Dimensional Fund Advisors with conversions?
Ben Johnson: Yeah, I'd be happy to take a first crack at that one, Jenna. I think the answer I would provide is definitely maybe. I think asset managers are going to have to be selective in how they might approach this. So, I think the DFA case, having announced that six of its tax managed mutual funds will be converted into ETFs effective next year, is interesting in that it is probably as streamlined, as an example, as you could find. So, you're talking about six funds that have a single share class each. They're tax managed. They're actively managed, but active managed in a very systematic way.
Ben Johnson: So this makes DFA's process of converting these funds as streamlined, as easy, as straightforward as possible because they're being distributed to a very specific type of investor, a taxable investor, that is tax sensitive, in a very specific channel, in one single share class. Further to that, given the strategy at play, that it's systematic, it's fairly rules-based, somewhat rigidly so, they're not worried about operating in a fully transparent, active ETF and leaking their secret sauce or their IP. Their formula has been out there in the public view now for decades, so they're not really worried about that.
Ben Johnson: So to be able to convert, they really don't have any of the other obstacles that other mutual funds distributed across a variety of channels might face. So, in retirement accounts for example, one of the primary benefits of having an ETF wrapper as opposed to a fund wrapper is that the ETF can help shield you from taxable capital gains distributions. Well, if I'm in a tax deferred setting, I really don't care about that any longer. So, the ETF format doesn't really have any real appeal to me.
Ben Johnson: So I think it's an interesting example. Asset managers will look at doing it selectively. Others, like we've seen this year in the likes of American Century, Fidelity, T. Rowe Price, may simply opt to launch actively managed versions, transparent or not, of existing mutual fund strategies.
Ben Slavin: Yeah, I think you raise some of the logistical challenges doing the conversion. We've seen a lot of interest from our asset manager clients looking to figure out that roadmap. They come to us and say, "Ben, how do you do it?" I think you pointed out a couple of the key challenges. But the roadmap is not clear as things are still settling in terms of exactly what the process is like. But to me, the bigger question is really the marketing and distribution question. It's not simply the case where you could just convert a mutual fund, an ETF, and magic will happen. So, my question back to these issuers is always, "That's great. So how are you going to retool your marketing and distribution program to be able to really raise assets and grow this ETF?"
Ben Slavin: I think the other major question that we're getting from issuers, and we've had several conversations in the last few months, about the conflicts that may arise with cloning funds and ETFs. So instead of a conversion, it's just simply launching an ETF that effectively is the same strategy or very similar to a mutual fund. So, dealing with some of the fee disparities and some of the other conflicts that can arise on the platforms is another key issue. Unfortunately, the answer is not necessarily an easy one depending on the particulars, but certainly the fiduciary duties that the platforms have are really forcing some tough conversations and some tough decisions at the different tables across the industry as to how to approach it.
Ben Johnson: Yeah, Ben, that's an all-important point and one I don't think, frankly, gets enough airtime, is that a lot of these platforms now are faced with the same strategy in two different formats. One of those formats works quite well for their existing economic model, which has been in place for quite some time when it comes to the new payment for distribution. The other one, the question becomes, well, this is great for my clients and our advisor's clients, but how do we get paid on this? So that friction, I think, is real and doesn't get enough attention at the moment.
Stephanie Pierce: Ben, is it fair to say that that's not exactly a new conversation when you think about retail SMAs or even collected funds? It's just a much bigger version and particularly because it's coming in a '40 Act structure that perhaps it's a bigger deal now than it was for those other vehicles? Is that fair?
Ben Johnson: Yeah. I think that's exactly right. What you've seen is a lot of these platforms try to get creative with respect to how they're going to monetize ETFs' existence on their shelves. So now gone are the days of preferential treatment, getting eye level placement through commission-free trading lists. So, you're seeing other things like data fees that are nominally data fees, that effective, again, payment for distribution for all intents and purposes, just under a different guise. Now almost uniformly, what you can see based on the publicly available information is that the rake is much smaller for the distributors, which is a victory for investors, but it's still there and it's something that you're going to pry out of most distributors' cold, dead hands, I would imagine.
Eric Balchunas: Let me jump in here. A couple things. We had T. Rowe and Fidelity on our podcast recently. We asked them, "Are you going to convert your mutual funds to ETFs?" They were really pretty sour on them, or not sour, but you could tell they were just not really seriously looking at that yet. You brought the word clone up. Fidelity in particular brought up the word clone-ish. I think they're banking on just putting out these active nontransparent ETFs, these clone-ish ETFs. They're like, "This is how the young people want the active now." It's sort of like, "They want the Pearl Jam." The question is do the young people want the active? I get they like the ETF wrapper, but do they want stock picking?
Eric Balchunas: I think that is the tough conversation. Yeah, it's a better wrapper, it's one that it's on the platforms, the distribution is wide, the young people like it, but do they want what's in it? I think that's going to be the tough question. I just don't see a lot of organic growth for something that's above 30 bips and that is stock picking, especially large cap. I don't care what wrapper it is. I just find that's going to be a tough sell for a long time.
Ben Slavin: I think you raised a great point about the preference, I think, for younger investors to the ETF structure. I was young when I started in this business and I definitely wanted ETFs. Now I've grown older and I'm not even sure what I want, but it still seems to revolve around ETFs for sure. But I would say though that on the conversions, it won't stop the asset managers from trying. So, I think, Eric, you raised some great points, but I still think the numbers are just, and the tide that's shifting, is just too great. There was a great stat quoted about the disparity between ETF flows and mutual fund flows a few minutes ago. It's just impossible to ignore.
Ben Slavin: But I do think there might be some room for... I mean, I think there will be some room in certain circumstances for active, and you raised ARK ETFs and Cathie Wood. They've had a phenomenal year. They're one of our clients and we've been watching them quite closely supporting their growth. Again, there, it might be more of an isolated case, but there seems to be a market that investors will pay for performance if you're able to deliver that or something particularly unique or differentiated that the markets want. Again, it's just hard to ignore the traction and the performance that those products have seen this year.
Jenna Dagenhart: And selloffs are inevitable. As already mentioned, 2020 has been a bumpy year. Eric, would you say that the March volatility was a stress test of sorts for ETFs as an investment vehicle? If so, did they pass?
Eric Balchunas: Absolutely. I'll keep this brief because I just rambled on about the other topic. But absolutely, I think anytime you have a sell-off of that degree, what I look to is volume. You're not going to see heightened ETF volume if people aren't happy with what they're getting. You saw volume basically in March. ETFs as a whole traded about 5.3 trillion. That's normally what they trade in a quarter. Bond ETFs saw double their records. Professionals are doing this trading. This is not a lot of grandmas, okay? So, I think the volume was proof that people who are in the market a lot were okay with the prices they were getting.
Eric Balchunas: That said, that definitely is different than the optics that sometimes a peer with bond ETFs were to peers the prices below the NAV and there's the fair value. But the NAVs are partially stale, and I think there's a lot of wonky information around that that should be explored for sure. But it appears again that that optical illusion, I guess, to a degree, of the bond ETF is something that the professionals do not care about. Because the volume would not be there. You wouldn't see the flows come back in.
Eric Balchunas: So I really just look for each of these experiences. When you look back to 2008 and some other selloffs, fixed income ETFs, the same thing happened. I will say this year, I found that the press, the media, shifted a little more positively on ETFs. I think they started to use ETFs like we analysts used them. If the discount forms, that's like a thermometer and a turkey. It's telling you the temperature of the underlying market. So, they were using the discount more as thermometer than a ETFs are broken measure, I think there was a lot of times when they'd see the discount form and go, "Man, there really must be no bids on treasuries right now." I think that's an accurate way and a good way to use it.
Eric Balchunas: So I did see some shift into using them like that. But of course, there was some stories that came out that were about the discount and whether you were getting a bad deal, especially relative to mutual funds. Those will persist. But the assets, the volume, and the flows, I think, tell the story that mostly people were fine with the... If it was a test, people were fine with it and thought they passed.
Ben Slavin: Yeah. I would say back in March and into April, we were on the other end of that. From an asset servicing standpoint, we saw a tremendous volume. Two to three times our normal volume heading into a, at the time, a work from home environment that was new to the world, or at least from an asset servicing standpoint for sure. Really, the industry pulled it off flawlessly. The ecosystem really responded, and I think it's the other piece of the resiliency story. The question then becomes, well, how did that actually happen? Really, it's all about the technology that underpins the industry and how the ecosystem interacts with each other. So, we had been making some significant investments from a technology standpoint, as did the rest of the industry. Certainly, that technology was key to being able to handle that volume and handle it again without incident and be able to support that sort of ecosystem and really the volume that we're seeing.
Ben Slavin: But ultimately, I think there's going to be more pressure on the industry from that standpoint as the types of products that we were talking about earlier become more complex. I had mentioned custom baskets for one example earlier. That does require additional technology to support the ecosystem and support it effectively in a frictionless or a lower risk automated type of environment. As the next time the markets are under stress, we ultimately get the same result that we saw earlier in the spring.
Jenna Dagenhart: Ben, how would you say the ETF wrapper held up during the abrupt sell-off?
Ben Johnson: I would say ETFs came through the crisis having passed with flying colors. You think about just the ETF ecosystem as being this complex web of interdependencies that involves, I think, more so than anything else, to the very millisecond, hand-offs of copious amounts of information. Like massive amounts of information on a just in time basis. Like I need it now to make sure that prices are right, to make sure that spreads are tight, to make sure that premiums and discounts are reasonable and reflective of what's going on in the markets. I think in terms of the dislocations we saw during the worst of the crisis, what do you want when you're setting prices? Right? When you're buying anything, you want real time, reliable information and more is better. Where is there more reliable, real time information than in these ETFs' prices? Be it in the bond markets, be it in the equity markets, you name it. There's more volume going through that system than there is sometimes in the underlying. That is, I think, most pronounced in the case of fixed income ETFs.
Ben Johnson: So I think if you look back at it, ETFs did exactly what they were designed to do, which was to facilitate liquidity. Even if under, if not unprecedented, at near unprecedented circumstances, they did exactly that. What you see that's post now is that regulators are going back and dusting off proposals to figure out whether or not it makes sense to introduce swing pricing models for mutual funds to make them fair in the way that ETFs are to the extent that they immunized those people who sat tight throughout all that market volatility and were insulated from all of that volume that was going on, didn't care about premiums or discounts because they weren't transacting.
Ben Johnson: But there are instances where you've got ETFs that are a separate share class of the same mutual fund. So, Vanguard and Vanguard Total Bond for example, whereby at the end of any given day, the investor and the ETF was actually getting a different price than an investor buying and selling it NAV from the mutual fund share class. Some days that was better for one and worse for the other. But I think it lays bare this fundamental issue as it pertains to pricing and fairness when it comes to collective investment schemes.
Jenna Dagenhart: To help prop up markets during these volatile times, we saw the Feds step in with several stimulus measures, including buying ETFs for the first time ever. While it's a pretty bold endorsement for ETFs, Stephanie, how would you describe the significance of this move?
Stephanie Pierce: It's very significant. As I think you mentioned, Jenna, this is the first time ever that we've seen this, that Fed stimulus measures in March, while they applied the playbook from the 2008 crisis in terms of unfreezing the short-term funding markets with the MMLF Facility that backstopped commercial paper by buying money market funds and so forth, the Fed's ETF buying program was new. This is really in contrast to the playbook from 2008. It reflects the evolution in credit markets that I think you heard Ben and Eric talk about since 2008.
Stephanie Pierce: So just to give you a little bit of a sense here, over the past 12 years since the Great Financial Crisis of 2008, dealer inventories of fixed income securities have really shrunk as many banks are adhering to tighter capital liquidity requirements post the crisis. At the same time, the corporate bond ETF market has actually grown substantially. Just to give you a couple of numbers, if you look back pre the 2008 crisis, so Q1 of '08, and these numbers by the way come from the FCC's recent report on this topic, total net assets for just investment grade and high yield corporate bonds ETFs respectively were 3.7 billion for investment grade ETFs and 600 million for high yield ETFs. That's back in 2008. If you look at those numbers today, they are 117 billion for investment grade ETFs and 66 billion for high yield ETFs.
Stephanie Pierce: In the Securities and Exchange Commission's recently published report on this which analyzed the March liquidity events, what it really suggests is that the combination of this decreased turnover in the bond market with dealer inventory shrinking and so forth and the combination of the rapid growth in the ETF market could be an indicator that trading in corporate debt is actually migrating from the cash bond market to ETFs. So, shouldn't really be surprising that the Fed then targeted the ETF market with its stimulus program to improve bond market liquidity. It is a testament, as I think the others have said, to the growing importance that ETFs have actually begun to play in the fixed income capital markets more broadly. So, it is important and significant, I think, in many of the respects that Ben and Eric highlighted.
Jenna Dagenhart: Yeah, Eric, was the Fed's ETF portfolio more or less diversified than you anticipated?
Eric Balchunas: Much more. We were impressed. In the book I wrote on ETFs, I studied how institutions use ETFs. Over and over, you look at their 13Fs and they all hold the top 10 most liquid ones if they use them. They use them for liquidity purposes. They rarely venture outside of, say... Let's say they're using a bond ETF. LQD, HYG. They're not going much further than that. They're very much stuck on volume. But ETFs have implied liquidity. We found ETF strategists, which are kind of like master ETF users who build model portfolios are very good about using implied liquidity. So, we would look at portfolios from like CLS and Windhaven or... Stadion was a good example. They'll use ETFs that you never heard of. Even as an analyst sometimes. Like, "Oh, I forgot that thing existed." But they are very good at using implied liquidity.
Eric Balchunas: You look at the Fed's portfolio, they owned about 13, 14 ETFs, including stuff like USIG, USHY, which is a broader version of HYG that a lot of people aren't even aware of, ANGL, which is the Fallen Angel's, which honestly was probably the most rifle shot of what the Fed was trying to do. But the bulk of what they bought were in the biggies: LQD, VCIT, HYG, JNK. But they went deeper and that's because they were with BlackRock. BlackRock clearly understands how to use implied liquidity, how these things work. If they didn't have BlackRock, I don't think they would have gone that deep. I think it gave some credibility to ETFs for sure.
Eric Balchunas: I will say though, there was this narrative that somehow the Fed saved ETFs. We were looking at active fixed income mutual funds, which started to get really hit with outflows. They were on a three-week delay. ETFs get hit right off the bat. They're like the tip of the iceberg. Mutual funds start to see outflows on a delayed basis, but they were serious. I think it was 90 billion two weeks straight, then the Fed came in. Some of those active mutual funds were going to have to sell bonds and it was not a pretty scene to be a bond seller.
Eric Balchunas: So who knows how that would have played out? But we're actually worried about the mutual funds in terms of having some sort of liquidity crisis because now they're so big, how will the unload bonds in a crisis? ETFs were already in that living hell for three weeks. It helped that they were helped by the Fed, but I think the active fixed income, we're about to get a little exposed in terms of their fake, fake is the wrong word, their partially stale NAVs and the fact that they didn't have to sell much as Ben said earlier. So, I think the Fed did a good service to the mutual fund market and also the ETF market. I think they helped both in one fell swoop and then we haven't looked back since. It's just been on fire since the end of March.
Ben Johnson: It's important to note that part of it is just an efficiency play, right? So, it's the beginning of December now, so most people already probably finished cleaning up their yards post-fall. But I liken it to fall cleanup for the Fed, right? They were trying to clean up the corporate bond market so they could go out in their backyard with a pair of chopsticks and try to pick up each leaf, taking months to do so, and relying on their dexterity or they could go out with a rake, which is the ETF, which just allows you to efficiently pile up all of those leaves and clean up your yard in short order. It does so in a way that allows you to make those transactions in the secondary market over the stock exchange where these ETFs are traded.
Ben Johnson: Because these are indexed ETFs, there is no implicit endorsement on any one manager's skill. They were never going to hire a discretionary bond portfolio manager to do this on their behalf. So, ETFs are agnostic to that extent and they also, by requisite, given that an affiliate of BlackRock was implementing this program, had to be agnostic with respect to which ETFs that they were going to buy. So, they couldn't show favoritism. In fact, they came up just a few percentage points shy of even just being breakeven for BlackRock iShares ETFs themselves when you looked at the final balance sheet.
Ben Johnson: So I think it was really an efficiency play and we've seen ETFs used in this manner in other markets. Eric always brings up the example of the Bank of Japan, which is the single largest ETF owner in that country. We've seen other sovereigns. In Hong Kong, the birth of the ETF market in Hong Kong was part and parcel by that country's government to liquidate stock holdings that it had on its balance sheet following the Asian Financial Crisis. So I think the ETF at its core is just it's a technology improvement over prior ways of packaging and distributing investment strategies, be they index, be they active, be they in between, and is not unlike any other technological advancement, incrementally much more efficient than those that came before it.
Stephanie Pierce: Ben, your comment reminds me of the discussion I had with one of our fixed income portfolio managers that manages our high yield beta ETF. He's based in San Francisco; I'm based in Boston. He was describing the old way that you would get from San Francisco to Boston. You'd pull out a map and you'd take all the side roads and the scenic routes. He said, "If ETFs were more like a GPS system for markets, the most efficient way to get from," in this case, "point A to point B or San Francisco to Boston." I think it's exactly as you described it. It's absolutely an efficiency play. Your leaf analogy was my GPS analogy.
Eric Balchunas: I just want to add real quick that I've been asked, "Okay, now, is the Fed ever going to buy equity ETFs?" Because the Bank of Japan's on a whole another level. I mean, they own 75% of their whole ETF market. I mean, that's like... If we go there, I mean, it's possible. But what's interesting about the Bank of Japan, and I say if the Fed does ever consider equity ETFs, the Bank of Japan had iShares make these special smart beta ETFs that weighted companies by CapEx. So, they could reward companies that spent money on capital and hired people rather than buy-backs. I think if the Fed ever does go equities, I think they should do something similar because I think a lot of people are a little upset over how much of the monetary policy goes towards buy-backs.
Jenna Dagenhart: Another big talking point this year has been whether or not the S&P 500 Index Committee would include Tesla. Of course, they eventually gave Tesla the green light. The full float-adjusted market cap is being added on December 21st. Stephanie, what's this inclusion mean for different ETFs?
Stephanie Pierce: This is probably one of the most significant additions to the S&P 500 or any index in years. So, it's a big deal for ETF managers, index managers like ourselves, and so forth. Just by way of background, Jenna, the Tesla as a company has been a member of most other large cap equity benchmarks since the early 2000s, 2010, 2013, including Morningstar. That's the benchmark we use for our BNY Mellon large cap equity ETF, which is one of our zero fee ETFs. The Morningstar Benchmark, as an example, which is representative, I think, of what you see the other benchmarks, has a little more than 1.2% waiting in Tesla. That's been there since 2013 and the stock has risen about 1,400% since its inclusion.
Stephanie Pierce: The performance at Tesla this year in particular and the absence of Tesla in the S&P 500 has been a driver of the return differential that we've seen this year between the S&P 500 and the Morningstar and other U.S. large cap benchmarks. Our index team that subadvises our large cap ETF has actually done some great work on the methodology differences between the index vendors and why it matters. Tesla is probably the most powerful case in point. What some investors might not know is that the S&P Committee includes qualitative and quantitative factors when adding or removing securities from the benchmark while other vendors generally use a more transparent, quantitative process.
Stephanie Pierce: So in this instance, as you mentioned, the S&P Committee elected actually not to add Tesla back in September as was widely anticipated. In fact, we did hear through the grapevine that there were some index managers out there that traded ahead of the expected inclusion had to reverse the trade, which creates, obviously, a lot of transaction cost drag and dispersion for their clients. But the S&P Committee reversed course in November with the decision to not only add Tesla, but add Tesla at a full weight later this month as you mentioned. So, what is the key takeaway from my perspective for this example? It's, of course, know what you own. That's benchmark methodology really matters when it comes to ETFs and, in particular, ETF performance and look no further from this example to understand that.
Jenna Dagenhart: Turning to year-end tax considerations. Ben, now, do you think that this will be another year like 2018 where ETFs demonstrate their tax benefits versus other funds from a capital gains perspective?
Ben Slavin: Well, we're entering tax loss harvesting season. The short answer is yes. I mean, I think ETFs once again are set to shine. Typically, this is highlighted when we see volatile markets. So, when there's lots of churn in the portfolio, especially when compared to actively managed funds or just in the mutual fund structures where we saw significant flows, some of which we talked about earlier, can really drive the potential for capital gains inside these portfolios. ETFs, from a structural standpoint, are positioned to really avoid, for a large percentage of the products, those types of capital gains. I mean, in the end, just like a mutual fund, ETFs are a '40 Act structure under the hood and they're required to pay out any accrued gains that might build up in the portfolio. But really because of the mechanics, the in-kind creation redemption mechanism allows the ETF structure really to avoid those gains whether they be from actual shareholder creation redemption activity or some of the re-balances that might occur in the index, one of which we were just talking about.
Ben Slavin: But certainly there are some types of ETFs that don't necessarily... are not able, I should say, to eliminate all of the capital gains. Typically, those portfolios are ones where you need to create and cash. Those types of ETFs are the leveraged and short ETFs or certain types of emerging market ETFs or other asset classes or other types of exposures where in-kind is just simply not either, from a regulatory approval, possible or just functionally not able to be able to make themselves use that particular process to eliminate those gains. So, I do think, again, it will be a change for ETFs to shine.
Ben Johnson: I would just add if you look at the estimates that we've received among the largest providers thus far for 2020 cap gains distributions, the other cohort that I would add to the list of less than airtight tax efficiency propositions notably this year is fixed income ETFs. So, there's only a small handful of equity ETFs this year that expect to distribute any taxable capital gains. There is a few dozen bond ETFs thus far that have been called out. The gains are small, I should stress, but they're still there. I think oftentimes what you see is that investors equate ETFs with just being an airtight, there will be no leakage, no cap gains whatsoever proposition that's, again, not always the case.
Ben Johnson: Fixed income ETFs this year, I think, being affected because first and foremost, bond markets have been buoyant. So, we've seen a rally in bonds. We've seen one directional flow, so there have been fewer outflows, which means fewer opportunities for these ETFs to get rid of these low-cost tax lots. So, the ETF tax efficiency proposition, it's kind of a dialysis machine for ETF taxes for embedded gains and it requires that regular circulation, that regular two-way flow to really remain airtight. So, you've seen less two-way flow. It's generally been one-way this year.
Ben Johnson: Many fixed income ETFs too are bookended. If you look at the makeup of their underlying benchmark, Eric mentioned one before, VCIT, an intermediate term bond ETF has a date which things go from intermediate term to short-term. Absent redemptions, the only way to remove those securities from that portfolio is to sell them or to cross them internally, at which point you're going to have to realize those gains. Is not surprising that in a year where bonds have been buoyant, flows have been one directional, and some of these things have crossed over, that a lot of the bond ETFs that are distributing gains are fitting that profile where they've got a maturity bracket that they're focusing on.
Ben Slavin: No, I think it's a great point. One additional add from a tax standpoint is obviously we talk a lot about fees and certainly after fee performance matters. It matters a lot. But also, the after-tax performance is critical. That really is what it all boils down to, that after fee, but also after-tax performance that the investors really care about. That's, again, I think part of what's driving the attractiveness of the ETF wrapper.
Jenna Dagenhart: That last question on year-end tax considerations leads us nicely into my next question, which is what are you watching in the new year? Sticking with you here, Ben. What are your 2021 ETF predictions?
Ben Slavin: Look, I think certainly ETFs have been on an incredible trajectory this year. It's certainly hard to predict where markets are going to go next year, but no doubt that we will see a strong year from a flow perspective for one. Certainly, I think the trend we mentioned earlier in terms of the shift out of mutual funds into ETFs, I think, will continue. It's hard to imagine how it could accelerate, but I think that's certainly possible. I certainly think that we're going to see potentially a significant raft of new products, some of which we already talked about, in the market. I think we'll also see potentially a good batch of new issuers come to market, specifically around the active, nontransparent structure that's really going to drive these new managers to come into the space. I think the assets are a different story and I think it's going to take some time for those to build traction in the market. So, I don't expect a significant amount of traction from an asset gathering standpoint in those products. So again, the number of products probably outstripping the assets raised.
Ben Slavin: But I do think we are going to see some additional movement from, I think, large changes from a portfolio standpoint as the new administration takes office and we start to get more visibility on the economy and the importance of ETF model portfolios, which have become an increasingly driving force of ETF flows aren't going to make a huge difference. So as we see those models start to shift their mix of assets to respond to some of those changes in the market, we could see some pretty large shifts in ETF flows either between asset classes or between products, either, again, models adopting some of the new products as they grow in size or just, again, making those tactical shifts. But the large influence, I think, that those models will have will really change some of the nature of the way we look at flows next year and continuing on in years past.
Jenna Dagenhart: Eric, looking into your crystal ball, what do you see for 2021?
Eric Balchunas: Yeah, I don't really do predictions, but I'll entertain it. I'll say that one of our big themes next year is what we call big active. Sort of loosely based on big pharma. I think big active, we just talked about 29 billion will instantly come in from DFA. So, we're predicting maybe 100 billion. We think there's going to be a couple surprises. Don't know what it's going to be, but you might have Capital Group coming in. You might have Fidelity, got Magellan fund launching. We think big active has some stuff up their sleeve. I was a little negative on the organic opportunity, but I think the other opportunities that come from that 10 trillion of assets, I think we're going to see some of that come over. Even if 100 billion went over, it would be a small fraction of their total. So, we're looking of that.
Eric Balchunas: We're also a little bearish on direct indexing. These are the democratization of SMAs. We just don't think the ETF is going to be disrupted that easily. It's dirt cheap, it's liquid, it's tax efficient. We just think that this is an area that even though BlackRock just bought a direct indexing issuer and so did Morgan Stanley, maybe they get 2, 3% market share. We just don't see that taking off. Then ESG, we see the flows probably continuing, especially if BlackRock is that interested in it. But we do feel like they could have a rough stretch because if value or energy has a nice, long run, if and when, we've been waiting for this movie to happen for a long time, and tech with these high valuations cools off, that would be bad for ESG. I think they could struggle a little performance-wise and that could mute some of the in-flows and the hype that we've seen around them since they tend to be overweight tech and underweight energy.
Eric Balchunas: So those are some predictions. I don't know. We'll see though.
Jenna Dagenhart: Stephanie?
Stephanie Pierce: I'm going to give you a nerdy answer and I figure the rest of the gang can give you the big actives and the product themes. So if you sit where I sit in the middle of the ecosystem at this organization, probably the most powerful trend that we're seeing and I think will accelerate next year is the sheer number of new use cases or ways of using ETFs across all of our clients, across this enterprise, BNY Mellon, across all the businesses. And, I think, as the guys have said, will really catalyze the accelerating use of ETFs for a lot of things and drive liquidian flows even further next year. Let me give you a couple of examples.
Stephanie Pierce: So for example, in our securities lending business, which is one of the largest in the industry, we're seeing fixed income ETFs in particular, but ETFs broadly starting to be used more as collateral by institutional clients. In our cash and liquidity businesses, another hat that I wear, wearing my money market hat, clients are starting to look at our one to five corporate bond ETF, BKSB is the ticker, as an option for more strategic and long-term cash given the yield environment. Obviously, that presents a nice opportunity, as the team has said, in terms of short-term instrument with similar liquidity to money market funds and so forth. In our custody business, we're seeing insurance clients using more ETF exposure in their general account portfolios to manage assets and liabilities.
Stephanie Pierce: Finally, back to the fiduciary side of things, the advisors on our Pershing platform, which is the very large one, as well as our own fiduciary businesses across BNY Mellon Investment Management, which is a $2 trillion asset manager, are starting to use more and more ETFs for tax efficient investment exposure, for tactical overlays to their strategic allocation. I think as you look across all these use cases, it's not only going to improve liquidity, but it will drive flows and assets into the space. So that's my nerdy answer for you, sitting in the heart of the ecosystem that we have here at BNY Mellon.
Jenna Dagenhart: Ben, looking to 2021, what impact will a Biden presidency have on the industry?
Ben Johnson: Oh, I get to make the toughest prediction of all, which is I'm going to punt on that one to be honest. I can tell you what people are thinking. I mean, we've seen massive flows into clean energy ETFs this year, some of which have more than doubled on a year to date basis. I can tell you what people are betting on, but I have no particular thoughts of my own other than to piggyback on what Stephanie just said, which is the ETF is such a dynamic vehicle.
Ben Johnson: The ETFs in my mind that over the long-term are going to continue to see the greatest flows, gain scale, gain liquidity, are the ones that can be used in the widest variety of ways by the widest spectrum of users. I mean, the ETF is inherently more dynamic than a mutual fund because it's a security. You can go long in ETF, you can sell it short, you can lend it out. There are options chains around some of the larger ETFs. I think that dynamism is what has continued to drive the overwhelming majority of flows to the largest, the most liquid, the most broadly useful, and the widely used ETFs. So, I think we'll see a continuation of that trend.
Ben Johnson: I think we'll see a continuation of product development in ESG, an area that Eric alluded to and an area that already, as recently as today, we've seen an announcement from MSCI that they're making some material changes to some of their existing indexes to place a greater emphasis on carbon emissions amongst individual stocks. So that's a very dynamic corner of the market and I think by its very dynamic, very subjective nature, has got a lot of runway ahead of it, if measured only in terms of potential for product development, if not assets and uptake by the end investor.
Ben Johnson: I think thematic is going to be with us for a long time because it's almost a revolving door of sorts. So, we've seen three work from home ETFs launched just this year. We might have three let's all get back to work now ETFs launched in 2021. At least, I hope so.
Jenna Dagenhart: Finally, Ben, now how is technology changing the game for ETFs and what is BNY Mellon doing to drive value for ETF issuers?
Ben Slavin: Well, technology really is what it's all about. I think in terms of investing in the technology to, again, support all of these products, all of the innovation, all the things we've been talking about, I think is really central from a strategic standpoint to really grow our business. It's not just in the U.S., that's also globally. When you look at markets in EMEA and also in Asia, which we didn't talk about today, but certainly the growth trajectory is starting to accelerate there and we see lots of opportunity.
Ben Slavin: I think though more broadly, what ETF issuers are looking for in many ways is data, right? That's becoming an increasingly important part of the way we engage with clients and another area where we're making investments. I have often said that I think the ETF segment of asset management is really the most advanced in their use of data, both in terms of consuming it and also in sending it out to raise assets to construct portfolios in other ways to use that data to be able to really service the broader industry and, again, the ecosystem.
Ben Slavin: It's that data, I think, going forward that's really going to become an increasing part of our business, whether that, again, be from a back office standpoint to be able to remove some of the operating friction in the market, ultimately to make ETFs better, faster, cheaper, or, on the other side, to be able to take some of that data, some of the analytics, and things that we have inherent on our platform ultimately to drive some of the decision making from a portfolio construction standpoint, a distribution and marketing standpoint, to really help our clients grow their business. All of those things, I think, are big areas of focus as, again, we look forward in terms of how we're engaging and interacting and really helping to grow the broader industry.
Jenna Dagenhart: Well, everyone, thank you so much for joining us. Great to have you.
Ben Slavin: Thank you.
Stephanie Pierce: Thanks, Jenna.
Ben Johnson: Thank you.
Eric Balchunas: Thank you.