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ETFs offer a high level of transparency as well as easy diversification for investors. Watch as four ETF experts discuss the rapid growth of ETFs and why investors should consider them for their portfolios.
Eric Pollackov - Managing Director of ETF Capital Markets and Client Portfolio Strategist at Charles Schwab Investment Management
John Roberts, Esq. - Portfolio Manager, Workplace Equality IndexTM at Denver Investments
Matthew Goulet - Vice President, Sector Investment Strategy at Fidelity Investments
Reid Steadman - Managing Director of Product Management at S&P Dow Jones Indices
Duration:
00:57:36
Transcript:
Courtney: We’ve seen massive growth in the ETF industry. We saw two trillion the end of last year, three trillion globally. Matt, what’s driving this growth?
Matthew Goulet: Absolutely. At Fidelity we think a lot of this has been driven by retail customers coming online in the United States. If you look across the globe at flow trends, there’s a lot going on in Europe. There’s something called RDR – Retail Distribution Review, that’s leading a lot of advisors to change their practice to fee based. That’s driving growth in Europe. There’s growth in Asia. But from what we see in the United States there’s a lot of retail customers coming online for the first time since 25 years of this industry being around.
Courtney: Okay. So mostly retail investors driving the growth in the US, we actually have a chart of US ETF growth. You can see May 2015 we’re just over two trillion. John, what do you see there?
John Roberts: ETFs have become a very, very valid tool to use. There are places where they work very well as an investment advisor. And I think there’s a lot of places where they don’t work. And so like any growth industry, think the dot com industry where, you know, we had to try a lot of things in this country to find out that, you know, hey, maybe we don’t need online pet food distribution companies. You know, I think the ETF industry is much like that in that growth ... steep growth curve that there’s a lot of things that are being created that, you know, maybe ETFs aren’t the best asset class for them, but we’re going to try.
Courtney: And Reid, joining us remotely. We’ve seen such a proliferation of assets flowing into ETFs. Why do you think they’re so popular?
Reid Steadman: ETFs are really gaining popularity because of some very simple characteristics that they offer. First of all, most ... the vast majority of ETFs attract indices. And these indices can be easily accessed and investors can understand exactly what is in the portfolio. And so this high level of transparency gives investors the assurance that they in fact do know exactly what they are holding. Another great attribute about ETFs is that they tend to be lower cost than other types of structures. So ETFs that are offering exposure to a particular asset class, say US large cap stocks can be ... have expense ratios that are a third or even lower than the expense ratios of mutual funds that offer the exact same exposure. So these attributes are really appealing to investors and they continue to take money that they had in other funds, offering the same exposure and putting them into ETFs.
Eric Pollackov: At Schwab we’ve seen a 10% increase in assets under management in ETFs alone, compared to last year at this time. And a lot of that growth is not so much from the registered investment advisors, which had been using them for years, almost about 90% of advisors at Schwab have used ETFs already, but from the real retail self-directing, which is around 20/21%, at Schwab that’s up, trending upward for the past few years. So I think that’s an important distinction with this whole trend is we’ve clearly seen institutions get into them, you know, such as insurance companies, you know, RIAs, pension funds etc. But it’s really the individual retail investor that’s kind of discovering these ETFs and kind of, I think, helping push this, you know this growth chart.
John Roberts: And I think as an advisor, you need to be able to, when a client says, “Do you do passive or active, individual stocks, ETFs?” You know, our answer is yes, you can ... it’s just a vehicle to access an asset class, right. An ETF is nothing more than a vehicle to access an index representing.
Eric Pollackov: I think that’s a very important point because literally ETFs have democratized asset classes, right. If you look about 20 years ago, you wanted access to platinum or palladium or platinum specifically, you’d have to do it [inaudible] was to go to a jewellery store, right. But now you can actually buy those types of products in an Exchange Traded Fund wrapper. So even like individual countries such as Nigeria now, you can actually have access to an ETF wrapper, it’s just fascinating.
Matthew Goulet: Should you want it.
John Roberts: Should you want it, correct, that’s a very good point.
Courtney: Should you want it. But I think democratizing is such a great word. And when you mention asset classes, I know equities have the majority, but where are you seeing inflows?
Eric Pollackov: Yeah. Yeah, so I mean on the Schwab platform specifically, we have seen domestic US outflows being replaced by mostly large cap international, including Japan, Europe etc. And then also a lot of the ... about 20/25% is going into fixed income ETFs as well.
Courtney: Reid, among the different asset classes where are you seeing the most demand?
Reid Steadman: When ETFs first started they primarily focused on equity. But over the past decade we’ve seen just this huge proliferation of ETFs across many different asset classes. So we’ve seen an expansion into fixed income, also into commodities, and then into some less traditional asset classes such as volatility. But in terms of where we’ve seen the most massive growth, it’s really been in the fixed income space. We’ve seen more and more investors who may be were in traditional mutual funds tracking fixed income or active funds in fixed income, moving to ETFs that track the same asset classes.
Matthew Goulet: Yeah. At Fidelity we see the same thing. I think we see alternatives to the traditional asset allocation process which was ... used to be large cap, mid cap, small cap growth in value. And now you see alternatively weighted index products, you know, Schwab has a few. At our platform we see tons of growth in the sector space. So people slicing and dicing the US equity markets by sector, technology, healthcare. On top of that we see trends in the active space, so whether it’s active or what Morningstar call strategic beta. Those two categories represent probably less than a quarter of the ETF industry. But they represent significant growth, both this year, last year and going forward.
Courtney: So a lot of growth in sector active. But just stepping back broadly, where do you see the industry having changed over the past decade, Matt?
Matthew Goulet: Yeah. So from my perspective the industry was formed in 1993 and in the 90s it was predominantly institutions. In 2000 or the early 2000s you saw iShares come onboard. And it really focused on educating the advisors. So throughout the 2000s it was predominantly driven by RIAs, independent advisors, and White House advisors. And like I said earlier, you’re seeing a lot of that retail growth coming online now. So any time ... and I kind of joke around that my college roommates who aren’t in financial services or my parents ask me about ETFs, what they are, how they work, you know, retail is coming online because they’re not in the industry. So that’s what kind of we see. And one of the phrases we use all the time is skill, will and time. If you’re a retail investor and you don’t have the skill, will and time to pick an ETF, that’s when you want to pick up the phone and leverage an advisor.
Courtney: Reid, is the user base for ETFs shifting?
Reid Steadman: It has changed quite a bit. When ETFs were initially started people thought that they were going to be more like futures and options, that they would just be something that mostly institutional investors would use and access through the exchange. But more and more we’re seeing that it’s not just institutional investors, although they remain heavy users of ETFs. But we see retail investors also using ETFs more and more just because these retail investors can access these ETFs just as they would a stock, trading over the exchange and very efficiently gaining the exposure that they want.
John Roberts: I think you can see it from the flows here to date that the retail investors are doing what they typically do, you know, they’re buying the asset class where there might be a bubble. So we’ve seen what, about 25 billion dollars come into bond ETFs year to date and about 25 billion come out of stock ETFs. And you know, unfortunately, retail investors have a lousy timing perspective, if you look at, you know, retail fund flows, they tend to buy at the top and sell at the bottom. And so I think you are seeing some of that as the retail investor flocks to ETFs, because it’s easy. You know, they think they’re smarter than the market and the ETF is just the market.
Courtney: But as tradable as and liquid as ETFs are, how important is it though for people to be cognizant of you know, holding ETFs?
Eric Pollackov: Yeah. Well, I mean it’s like anything else that people invest in, whether it be a mutual fund, whether it be a collective trust, a 401K, whatever it is, it’s important to obviously know what you own. So there may be 50 to 60 large cap US ETFs in the United States but their variance of performance is it’s going to be illustrative. And it’s going to be seen and that really is all dependent upon in the passively managed space, what index is it being used? How is that portfolio manager managing that portfolio to the index? And then all those different types of factors that really kind of need to be understood by any investor, institutional, retail etc. So I think that’s an important...
Courtney: That’s a very good point.
Matthew Goulet: Yeah. And I wonder how many end retail clients actually know that they own ETFs today. So you’ve seen the emergence of model portfolios and the advisors or asset managers are out there saying, “I am going to achieve something like downside risk or yield or income. I’m going to do it using ETFs.” So I would guess that many clients already own ETFs today and don’t necessarily know they own it because it’s in a wrap or model based product that uses the underlying vehicles.
Courtney: That’s an interesting. Interesting point.
John Roberts: I think, I mean there are certainly some areas where ETFs make from an advisor perspective and from an index creator standpoint, they make some wonderful sense, I mean, you know, big liquid transparent, easily tradable markets, think large cap. I mean to me an ETF makes a lot of sense there. When you start getting into some of the less liquid, less transparent, less efficient markets, having an index strategy there becomes, in our minds, a little bit more problematic because they don’t lend themselves to that. So you know, I think there’s ... if you look at where the growth of indexing is, you know, there’s a lot of money piling into large cap indexes where it makes all the sense in the world.
Courtney: Reid, is there anything else advisors should be aware of when it comes to investing in ETFs?
Reid Steadman: Just simply that they are great tools. I think some people who became aware of ETFs maybe five, seven, ten years ago, when they first started looking into ETFs they may not have been able to find the exact type of strategy that they have wanted. But now there are ETFs that are available across almost every conceivable asset class. And so investors really have this ... an incredible variety of ETFs to look to as they’re thinking about how to best allocate their money.
Eric Pollackov: I mean I think that pendulum since 2008 has really swung towards indexing. It’s not just Exchange Traded Funds that have been a beneficiary, that its index, it’s mutual funds as well and active managers have been suffering since. But I truly feel that performance, you know, that pendulum will start to swing back the other way to the active management world to actually illustrate their alpha generation performance etc.
Matthew Goulet: You’re certainly seeing that year to date. So at Fidelity we’re firm believers in active management, the sector products we have are passively managed. But the fixed income ETFs we have are just an extension of our existing investment capability. And those ETFs, when I look at them are something like F Core FCORs or Corporate Bond ETF compared to the passive instruments year to date. It’s outperforming by a significant margin. So we think that pendulum is shifting in real time. And last six months, last nine months there are certain asset classes, like John mentioned where you’re going to want an active manager or at least some more thoughtful process to your index based approach.
Courtney: So it’s a nuanced approach?
Eric Pollackov: Well, as I said earlier, I think the industry’s in such a growth phase that you know, we’re trying a lot of things as an ETF industry, a lot of products are getting put in the ETF wrapper and just because the ETF structure works really well for one asset class, right, large liquid markets that are efficient, doesn’t mean it’s necessarily a great vehicle for every asset class. And I think that that’s something that advisors are learning and the retail investors are going to have to get educated, hopefully not in a painful way. But ETFs are not a ... it’s just another vehicle, they work better, the vehicle works better for some asset classes than others.
Courtney: [9:39.5] Alright. Well, I think that leads us to an interesting point about asset allocation. Can ETFs now serve as the ballast of the portfolio?
Eric Pollackov: Yeah. So if you think about our strategy within the production of Exchange Traded Funds, we focus on costs and being, you know, the pillars of the clients’ portfolios. And what we think about when asset allocation is ... it’s based upon many, many factors such as your age and your risk tolerance and your understanding and when you want to retire and are you saving for a house or a child’s education. So there are different models that we can, you know, produce for those clients. But again, I think at the end of the day, we want to make sure that the lowest cost makes the most sense. And that’s why we build our products based upon that kind of mantra.
Courtney: Based upon cost.
Mathew Goulet: I think we’re in the business of both core and satellite. When you think what sector ETFs, I would never advocate that somebody put technology as the core 60% out of their equity allocation. But on the fixed income side our products are multi sector. So we try to play both angles and let advisors choose what product’s best for them.
John Roberts: I think one good thing about the proliferation of ETFs is that it does give investors ... there’s a democratization there, right. It gives investors ways to invest to show, you know, to invest along with their values. You want no nuclear exposure, done. You want, you know, no weapons, done. You know, we created an index that’s tracked by an ETF that’s companies that treat their LGBT employees with equality. Well, that’s a very, very timely and very values based investment strategy. Now, we happen to do it in such a way that it’s liquid, big market, efficient. So kind of broad market representation for people that don’t want to own companies that don’t support equality. And so I think that keeps in the theme of there are ways you can use ETFs very efficiently. And there’s also ways not to. I mean that’s the, you know, inefficient, illiquid markets.
Eric Pollackov: I think the one point though that really kind of needs to be put out there though is that there are over 1700 Exchange Traded products in just the US alone. But there are over 7,000 registered mutual funds as well in the United States. So I still think there’s a lot more room for that graph to go, in terms of just sheer number of products. But again I think to your point, the ETF, and we’ve seen this, we’ve seen the maturation of our industry with ETFs closing, that haven’t been significant asset gatherers. And I think that’s a good thing for investors because it says, it may not work for this asset class, we may not be able to distribute this product very well as a company. Well, let’s take it off the board and make sure that investors don’t get burned potentially by it. So I think it’s a good thing. But again I think we need to put the context there that even assets under management, it’s almost I think 11/12 trillion dollars in mutual funds versus just the two or three that we were talking about here.
Courtney: So there is a huge, huge opportunity?
John Roberts: There’s a huge opportunity still. There is, I mean the growth rate in ETF assets under management has been phenomenal as advisors and investors realize that they’re a great way to gain access to fast moving markets, to broad exposure. I think the institutional base has used them for a long time. We use them from an institutional perspective. I think if you look at most actively managed mutual fund prospectuses, again understand what’s in there, they’ll have the ability to buy and sell ETFs, to deal with liquidity. And so you know, you’re seeing that, them use, you’re seeing ETFs used by lots of market players for lots of different reasons.
Matthew Goulet: Agreed. Agreed. So John’s got a point regarding institutions, I think it’s interesting that the use case though might be changing, whereas in the 90s and 2000s, it was largely people using equity ETFs. What we see now, and I’m sure you can see the same is that insurance general accounts are using fixed income ETFs as bond replacements. That’s not something we had seen previously. You’re seeing pension funds or more institutional clients using some of the ETFs that have very low expense ratios and significant yields as proxies for cash. They’re not using money market funds. They’re using low duration fixed income ETFs in certain cases. So I think you’re still seeing a broadening of the client usage within the institutional space even today.
Courtney: Yeah. I mean in a low yield world, people are searching for yields, do you think that there’s, you know, you mentioned a few places where people can get it through ETFs. Any other places in ETFs where people can get yield, maybe a fixed income proxy?
Eric Pollackov: Yeah. I mean there’s some put right strategies now in an ETF wrapper. Again, you know, just going back to the original premise, the ETF is really just a wrapper around an investment idea or a manager or an index. And then, you know, we need to think about how is that ETF being managed. But yeah, there are yield plays in the ETF industry, there are, you know, there are definitely different types of concepts that can be wrapped around an ETF wrapper is my ultimate point.
John Roberts: As an investment advisor I think we’ve used some of the ETF strategies as somewhat problematic, for example, fixed income ETFs. We’re not big fans of them. We would prefer an active manager who in times of stress can actually sell where they can, you know, sell an asset where they can get a decent bid rather than having to sell a whole basket. And that’s where advisors and investors have to understand how ETFs are created. How the creation redemption process works, that if you have to sell a big basket of muni bonds for example, you know, the municipal bond market is one of the last of the inefficient, you know, traded by phone markets, you look back at 2008 in the financial crisis when muni spreads gapped wide open and you’d pick up the phone to get a bid for a bond and there was no bid. And so if you’re a muni bond ETF with a big redemption and how are you going to sell that basket if a third of the bonds don’t have a bid? If you’re an active manager you can say, “Hey, I’ve got this pre-refunded, you know, six month maturity bond where I can definitely get a decent bid.” And it creates, you know, I’m getting good value for my shareholders rather than selling that bond that has no bid.
Eric Pollackov: But, John, I would opine though that the ETF though, wrapper, again and going back to that concept, has really kind of shed light on some of those more opaque marketplaces which are over the counter, being used by phone, right, because ETFs trade real time, pricing is available on free websites now. That you can see as an investor a bid, whether it’s efficient or not, is not the point. But you can actually see a place where you can actually sell the ETF share whereas in again, as you just stated, the municipal bond market, for example, if you wanted to call somebody at an institutional desk to sell that they may not want to buy it. And they may not want to have a bid for it. But in the ETF there’s always that consistent bid or offer there, again not always going to be the best, if everybody rushes for the exit, it’s not going to be a good outcome or a good experience.
Courtney: Might be a wide spread.
Eric Pollackov: Correct.
Courtney: But it’s transparent.
Eric Pollackov: But it’s there.
John Roberts: Well, it’s kind of transparent and again in those inefficient markets, you know, if you’ve got a muni bond ETF that, you know, some of those bonds don’t trade but once every month, two months, three months, what’s the actual price of that bond. You have no idea. And so while the ETF can print a price, the price of the underlying, it’s kind of like selling a foreign ETF during US market hours, where you don’t know what the underlying prices are. You know, it’s not as efficient as one would think.
Eric Pollackov: Efficient, maybe not, I agree with that point. But again you have the ability to get the done, get the trade done. It’s the most important part, right.
John Roberts: You can get it done. You can always get a trade done at a price.
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Eric Pollackov: At a price, exactly. Well, I think that’s the point, so.
Courtney: Well, actually we have a viewer question. It’s Lori Van Dusen at LVW Advisors.
Lori Van Dusen: So in ETF investing, one of the things that we think about is what are the key considerations to assess how much liquidity you actually have in the structure or the underlying market.
Courtney: Matt, your thoughts.
Matthew Goulet: Yeah. So a phrase we use always and Eric knows this one is ETFs are as liquid as the underlying components. So if you have large cap US equities, the ETF is going to be as liquid as those underlying components. And as you go down the scale towards high yield bonds, municipal bonds, they’ll get less liquid, all things remaining constant, so most advisor websites or retail websites have tools that allow you to evaluate, things like bid at spread, premium discount, their average trading volume. And I think for advisors that are listening in here, it’s important to note that what you see on the screen in terms of secondary market liquidity, there is actually deeper liquidity if you’re willing to call a capital markets desk, call a trading desk at your own firm and work through that order, right. So a simple rule of thumb might be if you see an ETF and you like the investment process behind it but your trade represents more than 20% of that ETF’s volume that might be when you want to think before putting a market order in. You always want to use limited orders and use trade order guidance if you have it on your own trading desk, when it represents x percent of the ETF’s GDP.
Courtney: Right, because with a market order you’ll just get filled with wherever the market takes you.
John Roberts: I think part of that is understanding that creation process, how ETFs were created, understanding the indexes behind it. And so having the experience of creating an index that’s not tracked by an ETF, you know, I think we were very cognizant, as money managers of the liquidity of smaller cap stocks. And so when we created our Workplace Equality Index, we said, you know, “We have a 250 million dollar market cap. We have liquidity requirements in the rule book that says the stock has to trade two million dollars of average daily volume in the last 90 days.” So there is that secondary liquidity pool, so the authorized participants, the market makers can create shares of the ETF at ease, they can go out, borrow, buy the stocks. So understand what’s underneath. Every index has a rule book, take a look at that rule book. What are the liquidity constraints with that index? And I don’t think enough advisors are, you know, doing that kind of thing. What’s in there? You know, how does this get created? Where are we going to see some bottlenecks in liquidity? And so as was just mentioned, there are two sets of liquidity. There’s the tape that you see and then there’s what’s underneath it and how easy is it for the authorized participants, the market makers to go out and create or redeem shares.
Eric Pollackov: And that’s not always a very easily measurable kind of metric, right. But to build on what Matt said, I think one of the important concepts that we’ve been talking about a lot at Schwab is with particularly in the advisor space is, don’t always equate low volume with low liquidity in the Exchange Traded Fund world. If you’re looking at a single security, a stock, average daily volume is generally one of the number one metrics that should be used in evaluating the overall liquidity of that individual stock. With ETFs we knock that factor down to around three or four when evaluating the overall liquidity of an ETF, because again it may not be trading because maybe investors aren’t interested in it. Maybe there’s not a great sales force behind the ETF firm selling the products, whatever it is. Maybe no one’s ever heard of it, right, we’re over 1700 products, it’s not easy to get, you know, shelf space so to speak. So again, I think understanding how liquid the securities that make up that ETF is paramount and as Matt talked about, you know, as you go out the spectrum you should expect the ETF to be wider in bid out spreads and less liquid as you go up that [inaudible].
Courtney: Now, what type of products would this be, micro caps, small caps, what other types of products would fit into that?
Eric Pollackov: One of the ones I always think about is emerging market bonds, you know, they’re difficult to source, they’re difficult to price, they’re difficult to buy and sell over the counter. Therefore the ETF generally becomes a little bit more difficult to price and therefore difficult to buy and sell etc, etc.
Courtney: Reid any thoughts on that?
Reid Steadman: That’s a great question. Liquidity is something that comes up a lot when investors are thinking about whether to invest in ETFs. And it’s important to know that there’s two levels of liquidity. One is the level of liquidity that is obtained through the structure itself, so how the shares trade on the exchange. The other type of liquidity which is actually the more important type of liquidity is the underlying constituents that make up the index and also that are invested in to gain the exposure to the asset class. And retail investor or an institutional investor is looking at an ETF, they need to take into account these two types of liquidity. Typically institutional investor if they’re trading a very large size may want to contact the ETF sponsor directly to understand how they can efficiently gain that exposure. With most retail investors they’re not trading the amount of assets that would allow them to really materially move the price of the security. So with the most popular ETFs liquidity typically isn’t a concern.
Matthew Goulet: The last point there would just be that ETF provider offers resources to advisors regardless of where you custody clear or have a relationship, right. So I’m not just talking about RIAs on Fidelity’s platform or RIAs on Schwab’s platform. If you’re Edward Jones, [inaudible] Price, Merrill Lynch, they have trading desk contacts for you that specialize in ETFs. But typically the ETF provider, the person putting the ETF out into the marketplace, whether it’s Fidelity or Schwab, has a resource, has an ETF capital markets team dedicated to providing some of that guidance to you. So I just educate folks and say, “Pick up the phone and work with your issuer.”
Courtney: And talking about guidance, I mean as we just went through, the universe is vast, ETFs are now on 62 different exchanges in 51 different countries, there’s a lot, you named, what was it, 7,000 different, I mean there’s a lot to choose from, which is a good thing. But how can investors, especially when they’re comparing ETFs that track the exact same index, how can they compare? How can they compare efficiently?
Matthew Goulet: So my perspective would be total cost, that’s a phrase we hear all the time. And to me total cost, it’s not just the management fee, it’s not just the tax efficiency and the liquidity cost. The part of the liquidity costs that we’re seeing advisors pay attention to is commissions, right, if it’s a commission free product on a certain platform versus a non-commission free product that can be significant when you pay that commission across various accounts. On top of that I think one of the total cost elements you’re starting to see people pay more attention to is just the active management overlay. If you take a broad based market cap weighted product and something that’s alternatively weighted or full blown actively managed, that’s part of the cost too. So you’re seeing this definition of total cost expand in the ETF universe as the number of products expand. But I think it comes down to some element of total cost that captures all five or six things that go into what you’re paying as an advisor.
Courtney: So five or six different elements. Is there an easy current rating system?
Matthew Goulet: Good question.
John Roberts: Not at the current time, that we’ve seen, I mean it’s...
Matthew Goulet: Yeah. The big third parties in this space are obviously Morningstar, ETF.com has great resources on their website. There are certain rating systems. And it depends on what you value I guess as an advisor. So if you’re a bigger advisor that manages a book of business of a billion dollars, what matters to you more might be liquidity and tax efficiency as you have higher net worth clients. But if you’re an advisor with a 100 million dollars or less you may not care as much about those things and you’re really caring more about what the underlying investment strategy is. So I’d put it back on the advisor and say, “Which is most important to you?” But I think Bloomberg, ETF.com, Morningstar, and then again bring it back to the issuer websites, they’re all phenomenal in my opinion.
Eric Pollackov: So, John, what would you use when you guys evaluate like ETFs?
John Roberts: Well, we actually look at the underlying index, you know, how is that, how is the underlying index constructed. You know, great examples, and you know, emerging markets, right, where you have different ETF providers use different indices. So you could have an emerging market ETF where one of the, you know, five largest countries is South Korea. And then the other emerging market ETF, South Korea is non-existent. And so you do have to be careful as you’re mixing and matching ETFs from different providers, you know, you could very, very easily be in a situation where depending upon who’s indexes you’re using, you know, South Korea’s, one of the, you know, probably 20 largest economies in the world where you’d have zero exposure to it because you picked ETFs where one index, you know, one index doesn’t have it and the other index doesn’t have it, where does it, you know.
Eric Pollackov: It goes back to the premise of know what you own.
John Roberts: Know what you own, you know, [inaudible] in all financial products, know what you own.
Courtney: Absolutely. What about for robo advisors, are you seeing a proliferation of use of ETFs in robo advisors?
Matthew Goulet: Absolutely, I mean it’s core to their practice. When you meet with these advisors, they are advisors but they spend so much time from my experience and Eric, maybe you hear focusing on tax efficiency and tax loss harvesting and swapping from one ETF in the energy space to another ETF in a different market to recognize that capital gain offset or an offset against the client’s ordinary income, they are so sensitive to tax efficiency in multiple ways, that ETFs are just a natural wrapper for them.
Eric Pollackov: I mean I just think electronic advisements, or the rise of it has really just taken certain parts of the advisor’s job and made it easier and made it more efficient such as tax loss harvesting or rebalancing etc. So that’s where I think the ETF also comes into play in that space because it’s easier to transact in and it’s generally easier to rebalance. So therefore it kind of fits into that electronic offering in a more natural way than say some other types of products in the investment world.
John Roberts: Robo advisors a bit of a kind of four letter word for a traditional investment advisor because, you know, it’s an algorithm. And as we have seen with everything else, with hedging, with, you know, underwriting of subprime mortgages, you know if you’re basing your algorithm on what happened in the past, history doesn’t necessarily repeat, it may rhyme, but things change. And you’re really, really putting a lot of faith in an algorithm to capture everything going on in the world and assume that it’s going to repeat. And I’m not sure that, you know that we haven’t learned that, hey, history doesn’t repeat, things change. And you’ve got to be careful with what your correlations, you know, it’s all based on correlations, robo advising and any ETF models are based on correlations staying somewhat similar. And as we have seen in every liquidity crisis, correlations change dramatically. And you know that which you were able to trade at this level under these circumstances, when you’re not able to.
Eric Pollackov: But again, I think, you know, we were talking about asset allocation versus making some of the investment metrics, right. So it’s not just asset allocation and you walk away, right. There’s rebalancing, there’s tax loss harvesting, you know, opportunities that, you know, a typical advisor can now just make it electronically done for them. So that’s where I think the benefits of the electronic advisor really kind of show their merits.
Courtney: So there’s efficiencies there?
Eric Pollackov: There’s efficiencies that can be, you know, that are less taxing on your time, right, or even an individual investor’s time that doesn’t have the wherewithal to even fully understand what some of these things mean. So this kind of platform allows for that to become more efficient.
Courtney: To scalability.
Matthew Goulet: It’s definitely scalability. You’re going to see not corporate mergers but a blending I guess of the robo offering with the traditional model. And it just depends on the customer service and the level of engagement that individual clients want with their financial advisor. If you’re more of a hands off and you don’t need to be calling them all the time or every quarter, robo might be a better service model for you. And there’s no reason that traditional RIAs or advisors can’t offer that to their clients. So I think that’s what you may see over the next five years is blending of those two offerings, to end retail clients.
Courtney: That’s an interesting trend. I want to pivot a little bit, Eric, tell me about what you’re seeing in the rise of fundamental strategies?
Eric Pollackov: Yeah. So just for full disclosure, we offer fundamental mutual funds, fundamentally weighted ETFs. And they’ve grown precipitously this year particularly. And the way we think about it in terms of just flows, there have been significant flows into non-market cap weighted strategies, and whether that’s mine or somebody else’s, it’s not the point. I think the whole point here is that there is another way of looking at the economic footprint of a company outside of its price of share and the amount of shares outstanding. And whether you use things like dividends and buybacks or cash, you know, on balance sheets or different types of economic factors, that’s what these indexes are designed to do. And they’re really just thinking about, thoughtfully I think, maybe you differ John, but I think they’re just looking at, you know, a company in a slightly different manner than the traditional original ETFs that had come out years ago.
Courtney: So it’s a new spin on the original ETF model?
Eric Pollackov: It’s a different way to slice the apple, a fundamental index is just a different way to slice the apple, looking at different factors, much like a, you know, you traditionally had most indices were cap weighted. Then you had equal weight, now fundamental weight. It’s just a different way to slice the apple, not necessarily better, not necessarily worse, a different way to slice the apple.
Courtney: And we hear so many different terms, factor investing, fundamental, smart beta, you know, if you’re an investor or an advisor interested in getting into this, what would you say to them to be able to differentiate in that space?
Matthew Goulet: Yeah. It’s difficult because it’s an emerging marketplace, right. So that chart you put up earlier, the 2.1/2.2 trillion in ETF assets, about 20% or 400 billion of that is in strategic beta products, alternatively weighted products. John made a point earlier about looking at the index provider. And I think that’s the starting point is what is the underlying index methodology. And that can be difficult to understand because there’s not a single place that puts in all these index rules into a single location. But I do think the emerging trend you’re going to see is the evolution of full blown active managers. So you as an advisor going to have to look at a factor product versus an active strategy and understand how they differ because to John’s point earlier, one is algorithm based and in many situations it’ll do the same thing in different market cycles and different environments, whereas the active manager may act differently based on what’s going on in the business cycle. So it’s difficult as an advisor to do this. But as the category grows I would imagine you’ll see more resources, more education.
Eric Pollackov: Yeah. And to that very good point, Matt, we, you know, for our retail client base we offer basically allocation per asset class between actively managed, passively managed and fundamentally or strategic, you know, strategically ... strategic beta, excuse me. So we give that asset allocation out to our clients so they have an idea of what we think is probably best for that asset class in that portfolio for their risk tolerances. And one other quick point, I’d love to point out is most investors I think don’t overly understand, like the Dow Jones Industrial Average is not a market cap weighted index, it’s a price weighted index, which is again, another oddity in my mind. But yet a lot of people look at that number, it’s on the news often, we think about that number when we think about the stock market, right. But like there’s an example of something that’s been around for many, many years now that is not strictly a market capitalization weighted index. And I think that’s just an important kind of concept.
Courtney: Reid, how do you characterize the opportunity set in smart beta?
Reid Steadman: There are more and more smart beta ETFs with every passing month. We see this is probably the largest growth category for ETFs. But as more and more of these ETFs come out, investors need to be more diligent in making sure that they understand the strategies that they invest in. Smart beta is a category that is sometimes difficult to define. Typically what happens is there’s a parent index, say like the S&P 500 that is the starting point. And then a new version of that index is created. So an example we have from S&P Dow Jones is the S&P 500 low volatility ETF where we take one factor, in this case looking at the volatility of each constituent and then we rank those 500 constituents by the level of volatility that they’ve experienced. And then we screen for the top or for the lowest 100. And so this gives us a portfolio of stocks that have traditionally behaved in a low volatility way in more volatile times. And so investors need to get into the details of these various ETFs to understand exactly, you know the strategy that they’re pursuing and how they’re executing it.
Matthew Goulet: Well, when you compare ETF issuers to mutual fund issuers one of the things that I’ve been impressed at is the capabilities they have around portfolio construction. So most ETF providers, iShare, Spider, Vanguard, Fidelity, Schwab, have some level of portfolio construction guidance available to customers, I know we have. And this team will look at the overall portfolio and talk to you about how the mutual funds and the strategic beta and the active ETFs fit together in an entire portfolio construction context. So I think that’s just another resource you have at your fingertips if you’re using ETFs is to tap into those teams that’ll do the work for you and tell you how the pieces fit together.
Courtney: So this isn’t a binary choice, these could be viewed as very complementary?
Matthew Goulet: The overwhelming majority, there was a Wall Street article this year that talked about do you use active? Do you use passive? Do you use both? And I forget what the number was but I think it was somewhere around 50 or 60% use both. It’s rare to find somebody who is full blown index market cap weighted or full blown active portfolio management these days.
Courtney: Reid, how should advisors think about smart beta given there are so many efficient beta strategies out there right now?
Reid Steadman: Investors when they think about these smart beta solutions they should recognize that there’s going to be periods where they’re going to outperform the market and other times when they’re going to underperform the market. So you’re going to get a different return profile than you would with say the S&P 500 or another broad index that tracks a particular asset class. And so when an investor is thinking about investing in these Exchange Traded Funds, they need to have a particular objective in mind. And they need to have a certain time horizon in mind. And also they may want to think about the type of risk that they’re taking on or the risk that they’re trying to minimize, because risk is something that comes into play quite a bit as investors think about how they want to best utilize smart beta strategies.
John Roberts: That’s what I talked about earlier, you know, you need to understand that ETFs are a tool in your toolbox and as an advisor they react differently. And we’re seeing people use them for different things. I mean you know, I saw some data recently that talked about the share of ETFs as a percentage of the broad tape versus the VIX. And when you see the VIX rise, when volatility rises, ETFs go from about 10 to 15% of all NYSE volume to 25%, I mean with the rise in the VIX. And so people are using ETFs clearly as a way to trade around fear. And so I thought that was interesting that, you know, ETF trading can be a quarter of the market when the VIX spikes. And so clearly you’re seeing not just retail investors but institutional investors, a lot of people are using ETFs and you can look at their share market volume and it really does correlate to the VIX.
Eric Pollackov: No, a 100%, and that’s a good point. And again I think it goes back to that point that we made earlier was if you’re trying to sell an individual bond you have to pick up a phone potentially and call somebody. And that other person has to pick up that phone and if they want, and has to actually give you a price with an Exchange Traded Fund and the trading platforms that are all available at the custodial level and the trading level that you have access to that readily. And it does right or wrong, good or bad, you know, institutional money generally uses Exchange Traded Fund as a fast vehicle to decrease exposure in times of fear or increase exposure in times of better knowledge than anybody else, right. So that’s a fact and it’s something that we see and correlates and it’s part of the ETF landscape.
Courtney: Reid, let’s talk about volatility. Usually people want to either mitigate it or capture the upside. How can ETFs do that?
Reid Steadman: That’s correct, investors more and more are using ETFs either to minimize the impact of volatility on their portfolios or they’re using ETFs to profit in times of volatility. And what investors are doing is they’re seeking out ETFs like those tracking the S&P 500 low volatility index, these indices that were created to help investors minimize this impact of volatility on their portfolios or they’re looking for ETFs that say attract the futures that are tied to the CBOE Volatility Index, better known as VIX. This index is a range bound index that tends to go up and down as investors worry about the performance of the market. And there are indices based upon the futures that track VIX. And if the markets are more fearful and an investor wants to profit in times of volatility they may invest in the short term into one of these Exchange Traded Funds in order to soften the blow of their broader portfolio being negatively impacted by the negative performance in the market.
Courtney: And how much could they be used to smooth out volatility in a portfolio?
Eric Pollackov: Well, that question, you know, again I think it goes back to how ETFs work and why we put them in a portfolio, right. So there are low volatility index based ETFs. There are inversed ETFs that go to the exact opposite on a daily basis of their set index; those could be used to smooth out volatility. There are, you know, options listed on ETFs that can be, you know, used to smooth out some of that volatility. So it’s not really just so how do ETFs ... they don’t smooth out volatility but they can be used to help, you know, smooth out volatility within a client’s portfolio.
John Roberts: [35:00.7] But as an investment advisor, Courtney, you’ve got to look at the basic asset allocation building blocks, right. ETFs aren’t this silver bullet to panacea of volatility, right. You go back to the basics of asset allocation, stocks versus bonds, look at correlations and again, you know, not being a big fan of bond ETFs, you know, we look at what are the fundamentals of bond ownership, income streams and return of principal. Well, the bond ETF doesn’t offer one of those, return of principal.
Courtney: The return of principal, right.
John Roberts: And so you know, there’s nothing better in times of stress than telling a client, “Well, you just had a bond mature, you just got your money back.”
Courtney: Reid, are there any other ways investors can profit from volatility?
Reid Steadman: There are more and more ETFs that are based upon futures contracts that are tired to VIX. And the majority of these ETFs, you can buy them as there’s more fear in the market and VIX is going up so you can profit from that increase in volatility. But there are also ETFs that are [inaudible] ETFs. That you can hold and profit from as volatility goes down. And because of the nature of futures contracts where sometimes there’s a negative roll cost to holding these futures contracts, if you’re holding these ETFs during times of low volatility you can continue to profit. And so many retail and institutional investors have begun to use these indices and ETFs more and more to profit in times of both high volatility and times of calm.
Matthew Goulet: So our perspective on risk is it’s tied to the business cycle, right. So Fidelity, we’ll tell our clients every month where we are in the business cycle, early, mid, late or recession. And those certain environments, certain sectors tend to outperform. So currently we think we’re in mid cycle, that’s where technology tends to do well. But as you shift to late cycle you expect a shift towards consumer staples, healthcare, more defensive products getting ready for a recession.
Courtney: And that’s where the sector based ETFs come in.
Matthew Goulet: Right. And that’s why we think there’s been such a growth of sector investing, right, it’s eating away at some of the style based approaches to investing because the underlying investment tools are more precise. They allow you to control and tilt based on where we are on the business cycle. Now, that’s just one view and I’m sure there’s a number of different views.
John Roberts: You’ve got to be careful though with the sector ETFs, for example, you know, we’ve heard a lot about US consumer and look at a common consumer sector ETF, it was only 40% retail stocks and 40% media and advertising. And so if you’re thinking I’m going to buy this consumer sector or trim this consumer sector ETF because it’s retail. Well, again, understand what the underlying index is, right. And because you may think, oh, I’m selling retail, well, it doesn’t, it’s only 40% retail.
Matthew Goulet: It’s amazing that in the sector space we talk to customers who are looking at our products versus Vanguard’s or versus different sector ETFs. And they all charge somewhere between 12 and 20 basis points of a management fee. But to John’s point, what’s really driving the performance of each product is the market cap weight, how much they have in small caps, the industry level weights, right. In the healthcare sector, what percent you have in biotech.
John Roberts: Right. I was just going to say healthcare, what’s the underlying index.
Matthew Goulet: So it’s just interesting to me that I think you’ll see as the ETF industry evolves, you’ll see people do deeper level analysis on what they hold and not just pick a product based on which management fee is cheaper, because you may save three basis points on management fee and lose 200 [inaudible] based on the wrong execution of your investment [inaudible].
Courtney: So that’s where it really goes back to, the evaluation.
Matthew Goulet: Right.
Courtney: And I want to talk about currency hedged ETFs. We heard so much about them the first quarter this year. We’re still hearing about them, people buying into Europe, hedging out the euro, buying into Japan, hedging out the yen. Does that trade still have runway, and where else are you seeing interest there?
Eric Pollackov: So you know, on our platform we’ve seen about 39% of our international ETF flows have gone into a currency hedge product. And it’s about 22% of the overall flows that have come into any products on our platform. But yet it only represents about 2% of the 255 billion that we see at Schwab. So you know, I think fiscal policy will dictate certain, you know, growth or retraction in any type of financial instrument. And this is a type of product that will basically isolate that currency, which is this asset, right, and just basically take it out of the equation. So you know, that’s how we think about it, we know about them. We don’t offer them physically but we see them and we’re aware of them and we’ll see whether they, you know, will continue to grow over the long term.
Matthew Goulet: I think most of the products are binary too. You’re making a bet one way investment, I should say one way or the other, long dollar, long euro, long yen, whatever it might be. You haven’t seen products out there that are kind of saying, “I don’t want to make a currency bet and I want something that’s kind of currency neutral.” We haven’t seen them grow significantly yet.
Courtney: Do you think we will?
Matthew Goulet: I wonder that, if you’ll start to see that as people now are more aware of the currency implications for their underlying investments in the ETF wrapper and will start to think about well, what is my position on that. I think that’s what it’s really doing is forcing advisors to think about the currency impact of their portfolio when many of them may be didn’t think about that as much in the past.
Courtney: Do you think most of it, that has happened so far was driven by people just wanting to get exposure to Europe or Japan and they just didn’t want to deal with the FX?
Eric Pollackov: I think it’s mainly institutional money to be honest with you, that’s in the products where they are isolating a performance metric in their return stream. And that’s all they’re doing. And maybe Matt, you were probably right, they are making a bet, right, on a dollar versus euro or a dollar versus yen move by buying or selling that product. So I do think that’s ... again, it’s isolation of a piece of the return factor that’s going on and that’s what ... and then from there they’re making a bet.
John Roberts: And I think for the individual investor, that’s a, you know, that’s almost playing with fire, right. It’s kind of what I said that, you know, just because the ETF wrapper works really well for some asset classes doesn’t necessarily make it a panacea for all asset classes.
Courtney: What do you guys think of the current regulatory environment and how it’s, you know, affecting ETFs?
Matthew Goulet: Sure. I mean there’s a number of issues going on right now, specific to ETFs. One of the things we’ve been following is the New York Stock Exchange is lobbying for a faster process for transparent active ETFs. So we talked about it earlier, 2.1/2.2 trillion, only 1% of that is in active products. And the log jam seems to be focused on the fact that the trading markets division of the SEC takes a period of time to examine products rightfully so. So what the stock exchanges are doing is working with the regulators to see if they can streamline that process for existing issuers. So there’s no news to say, but that’s something that we’re keeping an eye on. And certainly then there’s regulatory issues there taking places on the exchanges, I’m sure, Eric.
Eric Pollackov: Yeah. I mean I just think, you know, what the SEC is trying to do and we’ll look at that graph again, right, listen, there’s a lot of US investors dollars in a certain type of product. And they’re trying to make sure that investors are being, you know, protected to the best of their ability by talking about things such as, you know, active, transparent etc. So in my mind I think it’s only a positive thing to have the SEC examining any type of product that is attracting dollars at the rate that the ETFs – Exchange Traded product world is. So I’d welcome, you know, any thoughts and comments from...
Courtney: What about widening tick sizes, how would that directly impact ETFs?
Eric Pollackov: Well, the pilot program that’s going onto effect later this year, essentially there’s three programs within the program so to speak. And based upon different rules for each one of those programs we’ll see some sort of outcome. We’re anticipating potentially slightly wider spreads in certain stocks, that make up the ETF and certain stocks we should hopefully see tighter spreads that make up the ETF, right. So that’s something that we’re clearly aware of and watching. And it is an experiment and hopefully we’ll see something productive come out of that experiment and that will help all investors.
Courtney:So the overarching theme though is that the SEC is trying to put the retail investor ahead of the institutional, ahead of the high frequency, is that the correct sentiment?
Matthew Goulet: Well, or at least on par, right. It is making an equal playing field and we feel that there are proper regulatory rules in place, that they kind of protect the retail investor. But I think it goes back to education, I mean that’s what we spend all of our time thinking about is how do we educate advisors, how do we educate the end client on what an ETF is, what the benefits are and then what the risks are and what they should be looking out for.
John Roberts: I think the SEC is, you know, clearly struggling with some of the things, like transparency. You know, as we said, ETFs, you know, an index fund lists all of its holdings every day. And you think about an active manager in say a small cap space, it can take you weeks to build a position. Well, if you just showed that initial position to the rest of the world on day one of the trading and it’s going to take you 10/15 trading days to build the position that impacts your ability to active, you know, to effectively manage. So maybe active, transparency, you know, most active managers are not going to want to tell the world what they’re buying on the first day they’re buying.
Eric Pollackov: Yeah. And listen, you know, we’ve evolved from a strict market cap weighted S&P 500 ETF to various multiple strategies. And the SEC is evolving with that as well. So I think it’s a good thing that they’re looking at many aspects of the Exchange Traded product world. And we’re here to help, you know, support them in any kind of thoughts that they have with it.
Courtney: And last question that you touched on the exchanges, not too long ago we saw the New York Stock Exchange hold trading for three hours. There are 61 other exchanges globally that house ETFs or that, you know, that they’re listed on. What impact would that have or what did it have to ETFs? And say that happens again, what’s the impact?
Matthew Goulet: Yeah. I think Eric’s more of a capital markets expert so I might let him answer. But from our perspective what we saw is that some of the liquidity just moved to other exchanges. It moved to BATS or it moved to NASDAQ. That’s the great thing about the exchange system we have now is that it can move to different places. The bottom line for us was that the ETFs were generally not affected in terms of bid out spreads widening or volumes going down to nothing. There was still quality, depth of quote, all the things we look for in our products. And market makers that we work with did their job, so it virtually had no affect on our clients, but having said that, Eric’s the expert here.
Eric Pollackov: Yeah. I mean fragmentation actually rose to the occasion I guess, so to speak, as it’s been clearly slammed for many years now. But again the diversification of liquidity pools, at least during that one day really showed up. And there was very little effect, there was small effect because it’s confidence, right. There’s confidence in wow, the MIC’s down, is there something wrong with the broader market?
Courtney: Small effect in the bid out spread when it came back or...
Eric Pollackov: Potential, at the very outset there was for our products that we were watching but overall for the three hours in change that it was closed, it was very little to do about nothing, you know, so.
Courtney: So it reacted very similarly to how stocks reacted?
Eric Pollackov: Yeah. Yeah.
Courtney: Okay. Well, that’s reassuring.
John Roberts: Well, and that’s the difference between investing and trading, right. You know, if you’re an investor and a three minute, three hour, three day time period shouldn’t matter.
Courtney: Shouldn’t matter, very good point.
Eric Pollackov: It’s a good point. It’s a very good point.
Courtney: Reid do you have anything to add?
Reid Steadman: Well as an index provider we are always monitoring the constituents the companies, the shares that go into our index and because it was just one exchange and there’s many different exchanges that operate in the US. We didn’t see a material impact on how our indices operated.
Courtney: Alright, well, these insights have been fantastic, thank you so much gentlemen. But before we go I want to get everybody’s final thoughts and I’ll start with you Eric.
Eric Pollackov: The Exchange Traded Fund, like I said at the very outset has really democratized asset classes for better or worse for any individual investor. And I think, you know, they offer diversification. They offer low costs. And they offer a place to put your dollars that are hard earned, for any type of event. And again, whether you’re saving for education, a house, children etc, it’s a good place for you to make a decision on where to put your dollars for savings.
John Roberts: As I said, you know, ETFs are just another wrapper around financial products, and indexes come in lots of different flavours. I think the proliferation of ETFs does allow investors to tailor maybe their investments more toward their values. You have lots of options. Do your homework, caveat emptor and same thing with advisors; understand what’s behind the index. Understand what’s in there.
Matt Goulet: So my three final thoughts would be one, you’re going to see a change, an evolution in the way advisors ar