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17320
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55352b82150ba032278b46cf
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ETFs Continue to Grow
ETFs have continued to be a growing asset class since their inception 25 years ago. Watch as three top experts discuss how investors can take advantage of ETFs in the current market.
Bill Ferrell - President & CIO at Ferrell Capital Management
Todd Yannuzzi - Managing Director & Senior Portfolio Management Director at Morgan Stanley
Cathie Wood - CEO & CIO at ARK Investment Management
Duration:
00:49:36
Transcript:
Courtney: Cathy, around the end of the last year we had the two trillion mark in AUM for ETFs, PwC recently came out with a study saying, “We’re going to see five trillion by 2020.” To what do you attribute these massive inflows?
Cathy Wood: [00:00:13] Well, I think there are massive share shifts taking place away from products that are much more expensive, less transparent, less tax efficient and less liquid. So that would describe mutual funds, separately managed accounts, even hedge funds are losing to ETFs. Hedge funds are also using ETFs as are institutions to manage cash and manage risk. So I guess what I’m saying is the share shift away from these other wrappers is because of the benefits I described, but also because active management has really not performed over the last five years or so. And the reason is because of two crashes in the last 15 years. Managers have become very benchmark sensitive, benchmark aware, they’re managing very close to their benchmark which defines risk. And because they charge fees on top of that they are underperforming those benchmarks. So it kind of makes sense.
Courtney: [00:01:13] Interesting.
Todd Yannuzzi: [00:01:15] Well, I would like to add that I still see a tremendous amount of money coming out of cash, okay. So that’s going everywhere, much of it’s going into the ETF space as has happened historically. It’s also a fact that there’s innovation in the space so there’s a lot more options, currency hedged portfolios for example. But it’s a combination of transparency, ease, comfort in the markets and search for good ideas and innovation. And you tend to see a lot of that in the ETF space, broad practice.
Cathy Wood: [00:01:44] Yeah. And I’d like to add that most ETFs are passive. Most ETFs are passive. So this is a shift away from active to passive.
Courtney: [00:01:53] What’s the percentage breakdown approximately right now?
Cathy Wood: [00:01:54] In terms of active versus passive?
Courtney: [00:01:55] Active versus passive.
Cathy Wood: [00:01:56] Less than 1% of the funds out there are active. And active in the ETF space doesn’t mean what it means in the traditional space. It usually means asset allocation or fund of ETFs. But in the traditional sense of the word active meaning stock selection, research driven, less than 1%.
Courtney: [00:02:20] Interesting. And, Bill, I know you were a fixed income manager prior getting into the ETF space, and we’ve seen 15% growth into fixed income over the past five years, that’s a huge shift there, why do you think that is?
Bill Ferrell: [00:02:33] Well, it’s very interesting to me because I’m not a big fixed income fan anymore. I really think that fixed income right now is soaking up a lot of assets because of regulations more than because of the attractiveness of the asset class. But I like what Cathy was saying about the fact that innovation hasn’t really taken place in the ETF space yet in terms of active management, because I think that’s the next trend that’s going to fuel a lot of the growth going forward. It’s easy to say that ETFs are efficient, they’re liquid. They’re a terrific way to express an opinion about the market. And they’re now coming in many different sizes and shapes for passive management. But the active management side is in its infancy. And people with this fund approach on the active side can possibly benefit from the growth ahead.
Courtney: [00:03:18] And I think you touched on a word we’re going to get to which is ‘innovation’ and ‘disruption’ which I think we’re going to get to later. But, Todd, do you think investors appreciate the differentiation in the market right now with ETFs?
Todd Yannuzzi: [00:03:28] I’m really not sure that they do, okay. And that’s where an advisor comes into play or just doing your research. There are plenty of good spaces to get that research. But I’ve heard the comment, “Well, I own ETFs.” And it sounds like what I heard 10 years ago, “Well, I own mutual funds.” And are you diversified because which ones do you own? And the name alone doesn’t always tell … doesn’t ever tell the story, you know. I was going to say doesn’t always, it doesn’t ever, okay. And you made a very nifty catchy name, but then if you look into actually the mechanics behind that, what is it really doing, is another story. On the active versus passive, we’ve seen a lot of growth within our managed portfolio, so as a discretionary manager we use ETFs. Ten years ago they were primarily or even exclusively just indexed product effectively. Today we have more than twice as many individual positions per given model and many of those are closed end funds for example that trade on the exchange, so it’s an ETF but there is an active manager behind it.
Cathy Wood: [00:04:33] Right. And to your point about the five trillion or PwC’s five trillion, the way we get there as Bill mentioned is active but there’s a step that has to take place for most traditional asset managers, active asset managers would prefer not to disclose their holdings at the end of every day, so this transparency feature. So there is a movement toward non-transparent ETFs. And the SEC seems to be looking a little more favorably on it. It’s taking a long time. We don’t think it’s going to happen for quite a while. But that would probably be the next big wave as well as active funds like ours who don’t mind being transparent.
Courtney: [00:05:18] So non-transparent you think is the next big thing?
Cathy Wood: [00:05:21] If the SEC allows it. If the SEC does not allow it to go forward I think active is going to happen as more and more people understand the merits behind this kind of a wrapper which is what an ETF is. The transparency is something they’ll have to get over and I think they will.
Courtney: [00:05:40] Interesting. Bill, what trends are you seeing?
Bill Ferrell: [00:05:42] Well, the number one trend that I’m seeing is that people right now are very concerned about risk. And they’re concerned about risk for all the reasons that you brought up when you initiated the conversation about the crises that have taken place in the last couple of decades. People understand that they have wealth accumulation they can’t grow by buying fixed income or putting money into money markets because there’s no yield anymore. And they’re very concerned about their exposure to the equities simply because they’ve seen the market take away big chunks very quickly. So with that in mind what we’re looking at is the fact that we think that the ETF space is going to go from basically getting out of the cap weighted benchmark arena to the smart beta arena where people try to improve on the cap weighting to have their own weighting to what we think will be the next evolution. Will be the risk managed, where people will take the same assets that are in the benchmark but allocate according to risk, not according to where they’ve been in the past.
Courtney: [00:06:41] I think that’s a really interesting point you brought up about risk. And going back to the PwC study, they said 46% of their participants identified smart beta as the greatest area for innovation, would you agree with that Cathy?
Cathy Wood: [00:06:56] Well, I’m not really focused on it myself, I’m sure there is a lot of innovation. People are looking at ETFs and trying to take advantage of the flows into them and be creative. So, yes, but I also think that traditional active will be also quite attractive in terms of attracting flows.
Courtney: [00:07:17] And continuing on this thread with the disruption, when you think about disruption and innovation it’s a buzzword that means different things to different people. But within ETFs, what does disruption mean to you.
Cathy Wood: [00:07:28] Well, the disruption really is away from the mutual fund separately managed account world where the fees really do mount into something that’s much more cost effective, cost efficient and more tax efficient given the custom baskets and the tax-free exchanges that can take place. I also think again the liquidity, being able to trade them all day long is really important. So the disruption is to traditional asset management primarily.
Courtney: [00:08:05] You know, and people have said, Bill, this is a stock picker’s market, when we go back to the active versus passive debate, do you believe that’s true and will that be fuelling growth within active managers?
Bill Ferrell: [00:08:16] Stock picking is nothing more than the extension of what I was talking about when I said benchmarks that are cap weighted to smart beta, to risk manage. Basically a market that’s relatively stable, an investment manager can outperform the market best by picking [unclear] that are going to outperform the ones that are in the benchmarks. Benchmark investing to me is a [unclear], I really think it’s a thing of the past. I don’t think people should pay any attention to what’s cap weighted because cap weighting tells you all about what got big in the past. It doesn’t tell you anything about what’s going to be big in the future. So if you look at the benchmark weighted indices you see that a lot of things that are cap weighted have diametrically opposed risk factors which makes it very difficult for the benchmark to make money. If you look at the smart beta that’s generally someone’s opinion about how to make a forecast for the future that’s better than what they’ve seen in the past. And they think they can outperform the benchmark by being smarter than the benchmark. What I’m talking about is something that’s actively managed so that you can take daily observations of what the market’s telling you and get those observations incorporated into your exposures. So instead of being exposed to something and forecasting and letting it sit for six months or a quarter, you’re basically saying, “I know that these exposures could change. I know the market is going to change almost daily and I want to be ready for it when it does.” So the big flaw in the benchmark and the smart beta is that they don’t change quick enough. Markets change quicker and investors want to be more flexible.
Courtney: [00:09:51] So they’re not nimble enough?
Bill Ferrell: [00:09:52] Not nimble enough.
Todd Yannuzzi: [00:09:54] Well, I think that’s a pretty interesting point. And when you take the phone calls from individuals they tend to be knee jerk and emotional, they’re watching a show, they’re worrying about what’s happening in Europe, the phone rings, you answer it and on the other line, “Get me out of Europe.” “What do you have in Europe, do you even know? Why do you have it? What does in Europe even mean?” Okay, because if they say they want to sell Europe, we’re going to sell basically money managers, active funds or ETFs or passive, you know, whatever they want it, we’ll sell the European exposure. The large multinationals in Europe are globally diversified companies such as Nestlés and Total. So if they’re selling … they’re worried about what’s happening in Greece, they’re selling a company that own Poland Springs. And I give the example of BMW for example, it’s a German company, they sell more in the US than anywhere else in the world. So do you want to sell that because of concerns about Greece? You know, so what we have to do is control emotions. And ETFs generally are more transparent, either a methodology or in holdings. And so that allows us to control the emotion. What I worry about with smart beta is really anyone … first of all, what are those 46% of the people, how do they all define smart beta? You’d probably get a spread of definition, one.
Courtney: [00:11:15] Good point.
Todd Yannuzzi: [00:11:16] Number two, I’ve never seen a new smart beta offering that didn’t have a positive back tested history, okay. So are they regression to the mean investing? Clearly not, they’re going after what has won in the past. Will they win in the future? Maybe, maybe not, but where is the evidence of that or the case for that?
Courtney: [00:11:37] And when you mentioned the, you know, Germany, the DAX was up what, 20%, a lot of these companies, when people, you know, see the headlines and get upset. But I think we’ve seen especially in the first quarter the opportunity to buy into Europe, hedge out the euro, buy into Japan, hedge out the yen. And these are ETFs that allow this.
Todd Yannuzzi: [00:11:55] ETFs that didn’t exist in that structure. So why is ETF marketplace growing disproportionately? Because there’s more innovation and more access for individual investors and empowerment of individual investors or investors with advice, you know.
Cathy Wood: [00:12:11] Yeah. One of the things I like too in terms of thinking about benchmarks and the backward looking nature of benchmarks, companies that are well managed tend to remain well managed through time and change. So I can see some merit to getting exposure to the market in some sense quickly and so forth. But we are in a rapidly transforming world. And we think that disruptive innovation, a term we like to use in our investing is really going to change the way people are going to have to invest, that what worked in the past may not work in the future. Because managements will need a completely different DNA to manage through the changes that we are about to witness or that we are starting to witness.
Courtney: [00:13:05] So there’ll be a necessity to be forward looking whereas in the past it was very backward looking related to benchmarks?
Cathy Wood: [00:13:12] Right. And I think as people defined risk in terms of the benchmarks, in terms of tracking error relative to the benchmarks, in the context of the two crashes, the tech and telecom bubble and bust and then the financial crash essentially in 08/09. The benchmark became all mighty because of those. Anyone who did better or anywhere near the benchmark, in other words had not taken a lot of risk relative to the benchmark won. So they were defining risk in terms of the benchmark in the context of some very unusual periods. We think that’s about to change.
Courtney: [00:13:49] Interesting.
Bill Ferrell: [00:13:50] I’d like to comment on what Cathy just said about relative to benchmark because I think that’s the one of the big picture issues that’s changing in the marketplace. We’ve had a situation where institutional investors who are very benchmark driven and their decisions are made based on having a certain percentage of their assets allocated to each benchmark as a proxy for their portfolio. Well, they are rigid. And if you tell them that you want to risk manage their portfolio by changing those by more than 2 or 3%, they say, “Well, that takes an act of congress, we can’t do that.” That’s changing now. The individual investor are the ones that we really like to work with in the family offices, are much more performance driven. So they really don’t care about the performance relative to the benchmark that you’re talking about. If the benchmark is down 20 and you’re down 18, no one is rejoicing in a performance driven environment, they don’t care. They don’t want to be down 18, they want to be doing better. And everyone knows that benchmarks are very unreliable in terms of their own price behavior.
Cathy Wood: [00:14:51] Yeah. I’m sorry, go ahead.
Todd Yannuzzi: [00:14:53] I was just going to say, and even the term going back, we were talking about with smart beta, but risk management, what does it mean? And it may mean a different thing to a different investor. But to me as an investor, and I run fiduciary money for individuals and primarily individuals, we are trying to compress returns, trying to compress that volatility. And the example I give is would you rather be up 25% a year for two years, and I’ll guarantee you the number but with a lot of volatility or 10% a year or with no volatility. Most people will choose the 25 because I guaranteed it. Well, if you start at a dollar and are up 100% the first year you get $2. If you’re down 50% the next year you’re back at a buck, forget that you probably paid taxes on the way. But you ended up nowhere even though you were plus a 100 minus 50, averaged to plus 25 over two years, versus going from 1 to 1.10 and from 1.10 up 11, to 1.21, so consistency, compressing the volatility. For individuals it’s hard to get as sophisticated as a professional manager can or someone within the structure, whether it’s ETTF or a fund basis. So that’s where we’re going to with these smart betas or more esoteric types of structures. But for us we’ll manage cash as the first buffer, how much cash and what are the allocations. If you can live with your allocations through a market shock and expect a volatility then you’re not going to be forced into a panic move. Those are the people that really got hurt, were the ones who were over-levered or couldn’t risk the pain of a further default and then liquidated, didn’t recover.
Cathy Wood: [00:16:21] I think one of the things we have to do is educate. This is … and we feel it’s very important now that there is so much benchmark sensitivity and benchmark aware behavior in the market to educate people about the changes that are going to take place that are not represented in benchmarks. And I think again back to family offices, individual investors generally, they want to know about this because … these sorts of changes because it’s going to affect their lives, their children’s lives, their grandchildren’s lives. So we’re trying to put into that context the need to know about the disruptions that are underway, mostly technologically enabled.
Courtney: [00:17:07] Can you give an example of one of the disruptions or…
Cathy Wood: [00:17:09] Sure, robotics for example. We’ve hit prime time for robotics. Oxford University put out a study last year which said that 47% of all the jobs in the United States will be lost to automation and artificial intelligence during the next 10-20 years. Now, that sounds terrible. It’s important for people to know though, right. There’s going to be a lot of displacement. We happen to think it’s going to be a very positive thing that will … or dynamic that will drive a lot of productivity and wealth creation by our estimates, 12 trillion dollars in wealth creation by the end of 2035. But there will be dislocations along the way. We know we’ve hit prime time because Amazon last year went from 1,000 robots in its distribution centers to 15,000 in one year. Amazon is leading the charge in all kinds of ways. So it’s important for people to understand, this is interestingly only 11 billion dollars were spent on robotics last year in the United States. We think that is going to 250 billion during the next 20 years. So there’s a huge investment opportunity around robotics. And it’s going to have ramifications throughout every sector in the economy.
Courtney: [00:18:31] Yeah. And Amazon is such a leader, I mean if they’re doing that, that’s sort of the leading indicator for what’s going to happen. And even if there are those dislocations it sounds like it’s a net positive.
Cathy Wood: [00:18:41] Well, and it’s important for us to educate our investors, not only for their portfolio’s sake but for their family’s sake. I really do think we have a role there.
Courtney: [00:18:51] Right, that’s a really good point. And we touched on developed Europe and the US but I want to ask you, Bill, about emerging markets, what are you seeing there?
Bill Ferrell: [00:18:58] Well, emerging markets have gone through five years of pain and suffering, not because all of the emerging markets haven’t done well, but because there have always been countries that have performed well and others that throw all their profits away. Last year it was Russia losing 44% of asset value during the course of the 12 months of 2014. But there always seems to be some country, this year Brazil, who knows what the next one’s going to be, which points to one of the real problems in benchmarks. They’re carved in stone, they don’t change. They’re static. So whatever their allocations are, don’t change, even if the particular environment for a country, its political environment, its economic environment changes dramatically the allocation is still the same. So whether China’s up this year with a 22% allocation of the VWO Index or whether it gets killed in the remaining summer months, it doesn’t really matter to the benchmark, but it matters to the investor. And so we’re picking on emerging markets because it’s a great straw man. It’s had very poor performance for structural reasons, because it’s static, it doesn’t change, it doesn’t live with the times. And we think that, as I said, the [unclear] versus the one that we can use now, but technology allows us to look at those markets, evaluate the risk in them every day. And we can make rebalancing decisions whenever we need to, to make sure that we don’t hold on to Russia when it’s in trouble or Brazil. And we make sure we allocate to China when it’s doing well and has a good risk adjusted return, not just because it’s fair.
Courtney: [00:20:34] And I think that goes to the heart of the active versus passive argument, I mean that you can technically say, “Okay, I would like to be in India, Indonesia, China and get out of Brazil and Russia.” Versus having just this broad emerging markets exposure, same thing if you looked at the energy complex, if you had all of that exposure or the commodity complex right now.
Bill Ferrell: [00:20:53] Very well said.
Cathy Wood: [00:20:53] I just wanted to tell a story about, and illustrate a point that Bill just made. I was at an ETF conference earlier this year and it felt to me like the 80s and 90s in the equity markets when we were in boom times, right. And I spoke to the person who was putting on the ETF conference and I said, “Do you know, this feels like that but there’s one big difference. I don’t notice any terminals so that I can punch out a stock and I don’t notice any CMBC. People here don’t care about what’s happening inside the portfolios. They all are working with indexes.” So they really don’t care about what’s going in the … internally in the markets.” That was what it seemed like to me.
Todd Yannuzzi: [00:21:53] I think that the right answer for our portfolios at least is to have a blend of both, okay. We run a core and satellite structure within. And that’s really been possible due to the … we’ve already had the last 10 years in the ETF space, we started running fiduciary portfolios about a decade ago. There were about 150 ETFs. And think of that small number and how many were really mainstream within that number, okay. So now we have an ETF research book at my company which has in excess of 300 pages, okay. And there are about close to 1500 ETFs to choose from. So what we do is we’ll take a normal index exposure, may have been 4% that’s now down to 2% and the other 2% may be split between smart beta and hedged or in the case of a fixed income portfolio, a closed end fund where we know the manager, we know their strategy. They’re available as an open ended mutual fund as well but there’ll be a closed end fund where we might get a discount to NAV. And we’ll understand that they’re going to mitigate interest rate risk. So there’s risk management within the fund and we’re looking for that. And we don’t necessarily have to overlay on top of it as a fiduciary.
Courtney: [00:23:01] So do you think most retail clients are aware of the role of ETFs, that they can be alpha generators, beta generators, risk mitigators, hedging vehicles, that they have such a broad role?
Todd Yannuzzi: [00:23:13] Well, I think they’re trained to ask a couple of questions. One is, well, what are the fees. They want to know the fees before we even have a plan for what the strategy is going to be, okay. And well, the fee’s going to range from zero to here, I mean we don’t know what we’re going to do for you, right. But they can identify what a fee is and if a fee is higher or lower and make a … what’s the value, they think they’re making a value judgment because the fee is higher or lower. I want to know what’s going on within my fund, alright, and within the structures, okay, so.
Courtney: [00:23:44] Because on a relative basis the fees are much … even at the highest end of the spectrum, they’re still a lot less than other comparable.
Todd Yannuzzi: [00:23:51] Absolutely generally the case, right. And there are exceptions, you know, that one could find. But they are … there are a lot of attractive reasons that are generally true. You can trade within the day first of all, so we can get an exposure. And we as a fiduciary have regression to the mean investors. So if the market’s down 200 we do care what’s happening in the moment because we have a list of accounts we’re funding for. And we’d prefer to fund on a minus 200 day than a plus 200 day. Because that tends to be a better time, you know, and we’re dollar cost average and we’ll use the efficiency of getting into an ETF or the penny or two spread and the ability to buy multiple transactions because the transactions aren’t costly, right, there’s no cost to them on a fiduciary platform. But that allows us to … that’s where we see the growth really coming from.
Cathy Wood: [00:24:38] Yeah. And also what’s happening is … you’ve heard about Robo Advisors?
Courtney: [00:24:42] Yes.
Cathy Wood: [00:24:43] Okay. That’s completely fund based.
Bill Ferrell: [00:24:45] I thought that’s what you were talking about, the robot.
Cathy Wood: [00:24:46] Well, this is completely [unclear].
Bill Ferrell: [00:24:49] You won’t need [unclear].
Cathy Wood: [00:24:51] No. That’s completely fee based. So 25 basis points, they’re partnered, you know, typically with the largest index providers. And you know that seems to be the one variable they’re operating on. I know they’re trying to attract the millennials and Silicon Valley type investors. But you know, if these people were to look into the portfolios they’re buying, my guess is they would not want to work for those companies. Those companies are the big well established, you know, they are not the emerging growthy companies. But that’s what they’re getting. I don’t know if they understand it, if they understand it that’s fine. But it’s completely a fee driven decision.
Courtney: [00:25:38] I think that’s such a good point, the irony of it, the Robo Advisors are appealing to the millennials, the Silicon Valley and like you said, it’s the huge, huge index companies. It’s not the nimble, you know, more innovative, more disruptive companies that are on their platforms. So I think that’s a really good point.
Todd Yannuzzi: [00:25:56] And going back to education, I were, you know, the most important aspect to me for an investor and to consider is what … the educational aspect, you know, has it really been a thoughtful process to get you to the point? And you can throw out a risk questionnaire and that’s all fine and good. But we have a lot of husbands and wives fell out the questionnaire. Usually it’s one of the two, not always the husband, maybe the wife, but it’s infrequently both together answering the questions. I prefer to send out a risk and ask them each to fill out it independently even though they’re joint assets. And then we can talk about what those differences may be. So taking the time and really having those conversations, the millennials, they’re used to the technology. And they’re used to thinking that they can do it themselves. We’re seeing an evolution over time where they may be trying to do it and they realize, hey, they’re time is better spent doing their core interest, number one. And when the markets really get tested, you gave a couple of extreme examples. But their example is just the fear factor, and little shocks that may happen, well, then they want advice and they want to talk to someone. And they want someone else to stand up and say, “Hey, here’s an opinion, it may be right, it may be wrong, here’s the spectrum. But here’s what it’s based upon.” And have a real human dialogue in order to get to the conclusion, that’s what we’re seeing.
Bill Ferrell: [00:27:15] I can give you a good example of that and something that happened with us just a couple of months ago. One of our clients has a family office in Europe. And he was saying how one of the largest families took a very large investment portfolio and cashed the whole thing out, just went completely to cash. And he said, “You people in America seem to understand that we’ve got troubles in the world. There’s a lot of political turmoil. There’s a lot of economic turmoil. And there doesn’t seem to be a lot of rational for why equities are so high, except for the fact that there’s really not much else to invest in. Having said that, you haven’t gone through what Europeans have gone through because at the time we were speaking the euro was at 1.06. And so when the euro went from 1.37 in July of 14 to 1.06 in January of 2015, this family decided, I’m out of here. I want to get in cash, I want to get out of the way because I just can’t afford to take what I’ve got and throw it away this fast. The commendation of my currency and the markets are killing me.” So I think people are starting to understand that risk is an overarching problem. People are not as happy as you think they should be given where the markets are. They’re actually getting more afraid as the market trades higher because they’re saying, “I’ve been at the top of this ladder before and when I fell it broke a lot of bones and it hurt. So I want to make sure that I’m putting my money in a place and having it watched. I want to do something about it today that’s different from what I did last time. And last time didn’t work so what’s the new paradigm that’s going to help me avoid a calamity?”
Todd Yannuzzi: [00:28:54] I was going to say that the markets climb a wall of worry, and I like that, I like hearing a little bit of constraint set, okay.
Cathy Wood: [00:28:58] Yeah, that’s what I was going to say.
Todd Yannuzzi: [00:29:00] So we agree again.
Cathy Wood: [00:29:01] We agree, yeah.
Todd Yannuzzi: [00:29:03] But if there’s euphoria out there and the most common call that I heard at the … towards the end of last year was, if you had a balanced portfolio, globally diversified, asset allocated, moderate risk, 60/40 benchmark type portfolio, there would have been a range, you should have been around 4 to maybe 5% return, because that’s what the … I’m saying that’s what the indexes did. So if you did 10% you were doing something different, what was it? What’s the … clients don’t ask about the attribution of their return, 10%. Well, you could have been levered with bonds for the last 20 years and you would have done great. Is it going to do well for the next 20 years? Let’s build a smart beta, you know, ETF for one. Well, you know, I don’t want to own it going forward. And so when there’s a common view behind elderly and the young, between institutional and individual and everybody is saying, “Where’s the dollar going?” The common view is the dollar is going to continue to be strong in a straight line, right. Straight lines don’t…
Bill Ferrell: [00:30:02] Straight lines don’t exist.
Todd Yannuzzi: [1 00:30:02] At least in my world, you know, and so they sold at 1.06, it’s 1.07 today, right. You know, so … but everyone was thinking it was going to, you know, keep going in a straight line. So we have to check the emotions out the door, be that rational sounding board and really best understand what’s the structure of the portfolio and why is it built the way and how are we evolving it over time. That’s how we manage risk and…
Bill Ferrell: [00:30:25] And Cathy and Todd, I think you would both agree with me that one of the things that a lot of investors don’t pay enough attention to is that correlation itself changes dramatically over time. And the markets and the securities in those markets that are correlated today don’t have much in common with what it’s going to be correlated to tomorrow. So we look at three things. We look at the volatility. We look at the correlations. And we look at the pace of change above. So we’re constantly concerned about what’s volatile and risky, what’s correlated and what’s not correlated, diversified and then how those paces of change will move things in the future. And if you do that and you do it every day then you have a pretty good handle on what’s going on.
Cathy Wood: [00:31:10] Yeah. And our portfolios tend to have a low correlation of relative returns to traditional growth and a negative correlation to traditional value. And just to the wall of worry question, actually once the NYSDEC hit 5,000 there was another spasm of worry, which actually made me feel much more confident that this is a sustainable equity market move and that the fixed income might be where there’s going to be a little bit more of a treacherous environment going forward.
Todd Yannuzzi: [00:31:46] That brings up another point now. You know, how is the US doing? Well, look at the DOW, look at the S&P and look at the technology sector, NYSDEC, right, and very different numbers, you know. And so when you have lack of correlation within equity markets or within any set of asset classes that’s when you start to think asset allocation really can make a difference, an active asset allocation more than just passive allocation is a good way to add value.
Courtney: [00:32:14] And I want to talk about liquidity too, especially with everything that’s happening in the markets. What do you see there, Cathy with … in terms of ETFs?
Cathy Wood: [00:32:21] Well, in terms of ETFs, we are … we’ve just started our fund so we have no liquidity issues at all. But we are hearing in both the equity and in the fixed income market, it is very difficult to establish sizeable positions if you’re a large asset manager these days. So with all of the capital constraints now placed on traditional financial institutions, you know, they’ve pulled away from market making. And you know people are struggling out there to establish positions.
Courtney: [00:32:54] Yeah. Are you seeing that as well, Bill?
Bill Ferrell: [00:32:55] Yeah. I think the consolidation of Wall Street is a real problem. And I mean the truth is there are not that many market makers now. And so if anything goes wrong with one or two or three, you’ve really decreased the liquidity by a great deal. And it’s a problem.
Todd Yannuzzi: [00:33:14] Yeah. I would add that there is a difference between liquidity and volume, okay. There might be a lot of volume but that doesn’t mean there’s liquidity. Liquidity matters when? When there’s a shock, there’s a problem. What happens in a marketplace such as or in municipal bonds when a certain credit comes under pressure, okay, where are the bonds indicated? Which ones are trading? You know, how are they really being priced? But that’s again where using a blended diversified structure of a manager may be in an ETF structure or not, but a manager with better diversification and larger access to the market, you’re going to have an edge by having that professional. You’ll pay a fee, but how does that fee compare to spreads that may really be very, very wide in times of stress which is exactly when the individual may make a decision, panicked or otherwise.
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Courtney: [00:34:07] But I think, especially with you Cathy, if you look at an ETF there could be liquidity at the ETF level but if the underlying stocks are liquid that should pose a lot less of a problem.
Cathy Wood: [00:34:17] Right. So we’re just starting and so our shares traded are very low each day, you know, as is the case typically with a startup. But the right gauge for the liquidity of our funds is not how many shares are traded each day, but the liquidity of the underlying stocks. People don’t ask mutual funds, “How many shares have you traded today?” You know, they are thinking in terms of the liquidity of the underlying stocks with the mutual fund. An ETF is the same thing. It’s a 40 Act fund. There is a liquidity issue though cropping up in the ETF world, I think ETFs of bank loans for example. You know, those are not liquid, if everybody wanted to get out of those at the same time, that would be a problem. So again you do have … some of the instruments that are being created out there or ETFs that are being created do have liquidity issues inherently in a tumultuous market.
Courtney: [00:35:22] And even across all asset classes, Jamie Diamond just pointed out that the volatility we saw in treasuries, there was a warning shot that if this happens again there could be a huge liquidity crisis there. So I think that’s kind of something that everyone is becoming more cognizant of. And would you agree, Todd, that even your investors, are they more aware of liquidity and its importance if we have another correction?
Todd Yannuzzi: [00:35:45] I think they’re hyperaware, and really post 2008/2009. You know, so we are starting to see a lot more interest in alternatives than we’ve seen, you know, and I’m talking about non-ETF alternatives. But where investments may be tied up for five, seven or even with extensions up to 10 year period. And again those sorts of lockups were not popular. I mean you could end the conversation before you started it back a few years ago. But when it comes to ETFs there is the perceived liquidity. But again it does fall back to the markets themselves and what the underlyings are, and great differentiation within this space comes back to education. I think one of the sectors too, one within ETFs, leveraged funds or double or triple leveraged funds, right, as an example. They don’t always do what you think they’re going to do, okay, critical issue is being educated, or commodity priced funds, are another area where people think they’re getting something, they may not be getting what they hoped to.
Courtney: [00:36:51] And I think tax is another interesting question, Cathy. We’ve seen a dialogue going on at the SEC and with ICI about active versus passive. Can you tell us a little bit about that?
Cathy Wood: [00:37:01] Yes. We’ve been watching this very carefully, because there is different treatment between active and passive ETFs. Passive ETFs are allowed to rebalance with custom baskets and do in kind exchanges. So there’s no capital gains tax in that circumstance. Active funds are not allowed to do custom baskets daily for the most part. I know that one has been grandfathered in. But the SEC is not allowing that right now. We know there’s a discussion between the ICI and the SEC about this issue and the inequity of the issue. So we hope that that will move in a positive direction. By the way, that discussion I think was, I guess it was exposed inadvertently by someone. So I know it’s been in the ETF newsletters out there. We think it’s an important discussion and we’re happy it’s taking place. There’s just one other thing about taxes that is very interesting especially after the 08/09 experience of people in mutual funds being forced into capital gains taxes because portfolio managers had to satisfy redemptions, even if an investor did not want to sell, wanted to hold through the crisis. They had to realize those capital gains. That would not happen in an ETF. So that’s a really big positive, no matter whether an ETF is passive or active.
Courtney: [00:38:38] Yeah, that’s a huge point, I think. Are investors aware of that, Todd?
Todd Yannuzzi: [00:38:41] I think so. Well, they become aware of it perhaps a little late, you know, but it certainly adds insult to injury if you have … if you’ve joined the fund, not made those gains, been passed through those gains and not pay a tax, and in some cases a very high tax on it. So with many of our investors who are also building up their portfolios and reallocating cash or earnings to their portfolios, so we can rebalance into our portfolios in a tax sensitive manner, you know, as opposed to just outright selling and buying. We look at the cash flows at the individual level, to be tax sensitive. And many years we’re retaining 95% plus of the gains. In an extreme rebalancing year, close to 10% realization, meaning we’re retaining 90% plus of the embedded gains. So now you’re having gains on your tax drag as it were and that’s going to pay dividends for as long as you can keep it going.
Cathy Wood: [00:39:38] The reason this is, I think, more well known today is because of what happened last year. There was a very high profile departure from a bond fund. And I think the shocker was that fixed income investors were forced into these capital gains because of the redemptions associated with that. So I think last year the education around this accelerated somewhat.
Courtney: [00:40:07] Yeah, definitely.
Bill Ferrell: [00:40:08] And there’s one other thing that’s really important in addition to the tax issue, it’s clear that the tax issue’s very important from the standpoint of an active manager. Because if you’re going to be buying and selling then you could be creating taxable events unless you’re basically protected by the fact that the investor had not sold the ETF. But the other thing is that the cost of transactions. The transaction costs involved with moving things around has dropped dramatically. And it appears that it’s going to continue to do so. And as the cost of transacting business drops it makes active management even more attractive because now the active manager’s not being penalized by the amount that it costs to get in and out of security positions.
Cathy Wood: [00:40:53] And I think because we’ve been through a 35 year bull market in bonds, which you know, judging from the dispersion between what’s happening in our bond market this year and Europe’s, in other words we’re not hitting new lows anymore like Europe is. I think more and more people are thinking I’ve got to perhaps reallocate assets a little bit, even at the margin. There could be a change here. I mean The Fed is telegraphing it’s in the mood to make a change. So I think this issue of capital gains and where to move assets is going to be paramount this year.
Courtney: [00:41:29] Yeah. I think everyone’s really closely watching, especially The Fed, is it going to be a one and done? Is it going to be a string of rate increases? I think, when, I think those are all things that the market is really, really honing in on. And, Bill, I want to ask you, are there any examples of product innovation in ETFs that you’ve noticed or that you’ve seen yourself personally?
Bill Ferrell: [00:41:50] I think innovation is in the eyes of the beholder. And I think that … I think that innovation in itself is trying to change the way that investors behave. And the ETF has made it really possible for people to change the way investors behave. And I don’t know that many people have actually done that. To me, money is still managed in very much the same way it was 10 years ago. And almost no other industry can say that because everything is changing very rapidly. So Cathy’s point about the robots taking over and what Amazon has done to take advantage of it, I mean there are lots of innovations going on in other industries that have not yet permeated the investment industry. So we talked about following benchmarks, we talked about using ETF to express exposures. All of that is happening. But I think that the innovation is still ahead as to how people are going to be innovative in the way they go about taking advantage of technology.
Courtney: [00:42:49] It’s a really good point. And I want to go to our viewer question. We have Ben Wheeler, he’s a founding principal at Schwarz, Dygos & Wheeler. He has a question for you.
Ben Wheeler: [00:43:01] Thank you for having me. My question is, should one be concerned with AUM size when selecting an ETF?
Courtney: [00:43:10] Cathy, do you want to take that?
Cathy Wood: [00:43:10] Well, again this comes down to the liquidity of the underlying stocks in the ETF. If we’re talking just a plain vanilla index fund, like the Spiders or the QQQ’s, I don’t think you have to worry at all. If on the other hand you’re looking at a fund, an ETF of bank loans and … I would be very careful there because I think liquidity concerns could be very problematic when interest rates start moving up. And if they were to move up in an unusually or unexpectedly fast way, so I’d be very careful there. So again it’s the liquidity of the underlying stocks or bonds that I would focus on.
Courtney: [00:44:08] Okay.
Todd Yannuzzi: [00:44:10] I think AUM is a factor, you know, as are fees. But we don’t always go with the lowest fee and we don’t always go with the highest AUM, okay, the so called gorilla in the space, okay. We’re going to look at a blend of aspects and how differentiated is it and how clear is the methodology that it’s constructed and what’s the asset class? Those are all relevant. But we have to think about the AUM only in the context of if we’re going to have a 1% position and we manage 400 million, 4 million dollars is going to have to go into this. But usually the market itself, the bid ask and what’s indicated on the screen is not even a clear representation of the depth of the market. ETFs are going to create or compress shares to fill a need. So as long as you’re going in with a larger order and using it on a disciplined trading basis with a limit or with a trader that’s going to work the order which again, does the individual understand that when they’re doing that? Not necessarily, and then you can see little spikes in movements that have caused people some money because they didn’t have that knowledge.
Bill Ferrell: [00:45:15] Well, [unclear] has been a pretty good indicator most of the time. But I think to your point, assets under management are important. Daily turnover is also very important. Average daily turnover is not important, because it’s not really a question of what the average is, it’s a question of what turnover this kind of security experience is on a very high turnover day and a very low turnover day. And what your chances are that you want to get in or out and have liquidity on one of those days it’s not very liquid. And so we take a percentage of the lowest turnover and we also look at the asset under management and we also look at the [unclear]. But we’d probably stay away from taking any indications of average and more in terms of the extremes so we get an idea of how much liquidity that market can take, to your point about bank loans, whereas some days you really don’t want to be selling those.
Cathy Wood: [00:46:10] Absolutely. And I do think putting limits on prices in terms of their willingness to buy or sell at a given price is really important, as liquidity has become more problematic generally, and especially in the smaller funds. Because I see … I mean I see the discrepancies sometimes when there’s a move in or when we know someone’s trading in a particular stock. You know, and it’s well known out there, the price can go crazy, so.
Todd Yannuzzi: [00:46:46] Remember the flash crash day?
Cathy Wood: [00:46:47] Yes.
Todd Yannuzzi: [00:46:48] Okay. Thursday afternoon and the difference between a stop loss and a stop limit order in even a liquid, big liquid name, right, big liquid technology name, I mean so things don’t matter until they do, but a little bit of education, do you want it to be a stop or limit order and do you really know the difference? And it probably may not matter but here’s how it could, education.
Courtney: [00:47:16] Yeah. And if we had a hacking event, I mean that seems like it’s very likely in the next five to ten years, we could have another event just like the flash crash where you’re right, the limit order or the stop limit, I mean people kind of need to have that level of education for those one off or black swans or what have you. And I’ve had such a great time listening to everything about ETFs, but I just want to get your final takeaways really quickly and start with you Cathy.
Cathy Wood: [00:47:41] ETFs, well, again I do think that the share shift will continue because of all of the advantages. The next phase is active. We are certainly focused on, you know, active active which is focusing on disruptive innovation out there. We think that needs to be brought into the ETF space, that it’s lacking in the ETF space right now. But active generally I think will improve this class or this wrapper, and take us to that five trillion mark.
Courtney: [00:48:18] Right, by 2020, as PwC said, Todd, your final takeaways.
Todd Yannuzzi: [00:48:21] The same thing I tell my children, do your homework, right. And know what you’re buying, okay. Don’t lump them all into one category, there’s a lot of differentiation and more on the way.
Bill Ferrell: [00:48:35] Well first, Courtney, let me thank you for having me on the panel, this has been a lot of fun. And Cathy and Todd and I have shared some ideas. So I think we have a mutual agreement that there’s a lot of innovation yet to come in the ETF space. And a lot of what’s going to drive the ETF to the five trillion dollar mark is going to be coming up with ways to use the actual product itself in ways that are innovative, creative and helpful to investors. And if we have any vision in the future it’s not only that we’ll be a big company, but that we’ll be doing something that’s inherently good for investors, because that’ll protect them from getting into trouble when the rest of the world doesn’t know how to protect itself.
Courtney: [00:49:14] Well said. Well, thank you all so much. And we want to continue this conversation about ETFs, follow us on our social media on LinkedIn or Twitter. From our studios in New York, I’m Courtney Woodworth.
All information contained herein is for informational purposes only. This is not a solicitation to offer investment advice in any state where it would be unlawful. There is no assurance that the programs will produce profitable returns or that any account will have results similar to that of the comingled funds or the composite. Past performance is not a guarantee of future results. You may lose money. Factors impacting client returns in separately managed accounts include individual client risk tolerance, restrictions a client may place on the account, investment objectives, choice of broker/dealer or custodian, as well as other factors. Any particular client’s account performance may differ from the program results due to, among other things, point of entry into the program, commission, and timing or type of order entry . No person has been authorized to give any information or to make any representation other than that which is contained in this document and, if given or made, such information or representation must not be relied upon as having been authorized by Ferrell Capital Management. This material is for the confidential use of only those persons to whom it is transmitted and is not to be reproduced or used for any other purpose.
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Masterclass: exchange traded funds - may 2015
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