Diving into Exchange Traded Funds (ETFs) on Market Mashup Podcast

A discussion of the importance of ETFs and the presidential election

Managing Editor
Oct 27, 2020 at 1:00 PM
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Schaeffer's Market Mashup is back for a deep dive into exchange-traded funds (ETFs). On the latest episode of the Schaeffer's Market Mashup podcast, Patrick enlists Graham Day, Vice President of Product and Research for Innovator ETFs, and Sumit Roy, ETF Analyst for ETF.com. They talk about ETF popularity (2:35), the trend toward the thematic (6:34), desired outcome ETFs (11:35), and their importance to the upcoming election and beyond (19:31)

 

Transcript of Schaeffer's Market Mashup Podcast: October 27, 2020

Patrick: Ladies and gentlemen, welcome back to the Schaeffer's Market Mashup. I'm a man of my word, as I've said numerous times, and I've brought two more esteemed guests with me today. I'm joined by Graham Day, Vice President of Product and Research for Innovator ETFs, and Sumit Roy, ETF analyst for ETF.com. Gentlemen, welcome.

Sumit Roy: Thanks for having us, Patrick. 

Graham Day: Great to be here.

Patrick: Awesome. Good to hear, you guys might be my first guests that aren't from Chicago or currently living in Chicago because usually I've got Cboe guests. Are you the first non-Chicago people here?

Sumit Roy: Yeah, I mean, I'm in San Francisco. We're out on the west coast. Quite a ways away from Chicago. 

Graham Day: Patrick, I'm actually kind of in your backyard. We're in Wheaton, Illinois. So just about a 40-minute train ride outside of the city. So we'll say we're not in Chicago, if that helps you out.

Patrick: I'm in Cincinnati right now, really don't like that we in news in division three soccer. Stings a little bit there, but you know what? I won't hold it against you. So today we're going to talk about ETFs and the trends and trades around them. Exchange traded fund, which is what it stands for. They are growing in popularity at a rapid rate and Cboe Global Markets is the listing exchange for more than 450 exchange-traded products from over 55 unique issuers globally. Since 2014, Cboe listings business has grown to capture approximately 30% of all US listed ETFs. Graham, I know your Innovator ETF's is a Cboe-listed issuer. You guys work on kind of like the next wave of innovation, in specialized and defined outcome ETF's. Sumit I know you're like the go-to for the news analysis and education about ETFs both online and in print. So in other words, I've got the two experts you need for this. So let's dive into it. My first question really is why are ETFs continuing to grow in popularity, especially in 2020. Graham, why don't you take that first?

Graham Day: That's a great question, Patrick. And you know, from our vantage point, we feel ETF's continued to grow at really an exponential rate in 2020 for the same reasons that they've been growing for the better part of the last two decades. And it's really simplicity. People know what they're getting with ETF's, but the benefits of the ETF are well known. And I think continued to be pervasive in the investment community, tax efficiency, lower cost, ease of access. I think that might be one of the bigger reasons accessing a product on the exchange, you can buy and sell just like any stock. Those are the things that people want and need for their investments today. And the ETF really cuts through a lot of the weeds of investing and we feel like it's the best way to, in many asset classes, access the markets today.

Sumit Roy: Yeah, I mean, Graham hit on all of the key selling points, the major ones. I mean the tax efficiency, the lower costs, the transparency, intraday trading, those are all super, super attractive for investors. Another important one I'd point out is just the sheer scope of ETFs. There's so many ETFs out there, 2300 plus a vast number of strategies, anything you want, and that's helped fuel this huge growth in the market as well. You have everything from stock ETFs to volatility ETFs, to hedge fund ETFs and even gold ETFs out there. So there really is something for everyone, including both retail investors and institutional investors. Now, a lot of ETF success has come at the expense of mutual funds. I think it's worth pointing that out. And that's something that continues in 2020. So far this year, we've had about $350 billion of inflows for US listed ETFs.

That's the second largest amount ever in any year. And then at the same time, we've seen outflows from mutual funds OF more than 300 billion. So that's a gap of 650 billion or so in less than a year. And which according to Morningstar is the largest disparity between each year. So mutual fund flows since 1993. But aside from that migration away from mutual funds and into ETFs, which has been going on for quite a while now, there are a couple of more recent catalysts that are driving the inflows. One is the low-interest rate environment. We have rates near zero, as many people are aware. And so investors are stretching for yield and stretching for returns to meet their savings and investment objectives. 

You can't simply stock your money in a bank account or a CD  anymore and hope to make a decent return. So a lot of individual investors are shifting into bonds, into equities and even some alternative strategies that you find in ETFs. And then another factor driving individual investors into ETFs is the pandemic itself. I mean it may sound like a silly thing, but all this time that people have been sitting at home as fuels a lot of interest in the financial markets, including ETFs. We've seen trading in the market become kind of like a form of entertainment for some of the younger generation who use platforms like Robin hood and other large-cost brokerages. And so they're using ETFs to move in and out of the markets.

Patrick: Yeah. A couple of things come to mind through both of your explanations. One is the word streamlined, where it basically takes out all the fluff of a product and offers you really the kind of flexibility that you want. And then it was almost like boredom really that, that brought investors into this. I think these products are so unique that it's not really going to fade once the pandemic is cleared up and we're out of this period, kind of on that note. Are there any other recent market trends in listed tradable products in trading strategies? Graham, I'll let you take that one first.

Graham Day: Yeah, I think there definitely are. And I would probably echo what Sumit was saying about this, the movement that continues from active to passive particularly in the equity markets. I think it's probably maybe 10 years in a row of outflows from mutual funds, equity exposures into ETFs. And I think that that is going to continue into the future. There's really no reason to think that active is going to make a comeback in terms of instability to garner flows, but maybe even more importantly deliver any relevant amount of outperformance relative to an index. But I think another thing that we're seeing in the markets is, a shift from traditional size and style investing, sector investing, to more thematic investing. What I mean by that is, for a long time, people would maybe look at the various gigs, sectors, energy, technology, healthcare industrials and that's really how they would rotate their exposure within the market, or maybe they're moving from large value to large growth.

And I think what we've seen in the ETF structure has really alliterated this idea, is investing in themes and really feeling that themes are the new sectors. So whether that's 5G or Junior IO technology, Junior internet stocks, I think we're seeing a lot of that coming to fruition through the ETF space. And so I think it's just an evolution where a lot of times people think of thematic as a very niche idea and they're never going to make up a large portion of investors portfolios. But I think the thinking has evolved to where more people are saying, look, I'm moving away from a traditional sector-based investment style or size and style, and I'm moving more to a thematic approach than anything else. So I think those are probably do think that I would highlight for trends diversity.

Sumit Roy: Yeah, absolutely. I mean, I have to back up exactly what Graham is saying and this movement from sectors to thematic ETFs really can't be understated, just how significant that is. And I think a reason why it's happening is that investors, people in general, they really like stories and themes are a great, well great way to tell a story in just one word or just a few words and things that are intuitive to understand like certain futuristic technology themes, those tend to do very well, because they're very easy to explain it. You have a lot of next-generation tech ETFs. Graham mentioned some of them that have really caught the imagination of investors and have attracted billions of dollars of inflows. So we have funds that track themes like robotics, artificial intelligence, e-commerce, gaming, people understand those ideas and these ETFs have done really well, not just in terms of popularity, but also in terms of performance, especially with the pandemic acting as a tailwind for a lot of these funds.

So when you see some of these funds up 50, 60, 90, a hundred percent, that adds interest to them as well. And it's not just those high-flying technology themes that are doing really well, but also seeing interest in something like jets, which is the airline. And it's attracted hundreds of millions of dollars this year. And it's simply because investors know that industry, they know their airline industry, they know the companies in it, and they know it struggled this year, but they think it could be a rebound play for the coming months and the coming years. So they've reached for this straight forward thematic fund to make. So when an ETF can tell a simple, straightforward story, investors love that.

Patrick: I love the concept of the thematic because coming from someone without a financial background in a liberal arts education, I think it's so much easier, like you said, for someone new to the game to grasp it. For example, we at Schaeffer's wrote an article about a month ago talking about the correlation between jets and I think it was the financial XLF ETF. So the banking one, and it was so easy just to plot and pinpoint when you break it down from banks to airlines. And I think that is incredibly intriguing to these new droves of investors that are coming in. To back up for a second I mentioned it earlier. Graham, talk to me about defined outcome ETFs.

Graham Day: Yeah. Will be happy to Patrick. And it may be for those aren't aware of what a defined outcome ETF is. Really very simple. It provides beta exposure to a well-known index, like the S&P 500 in exchange for capping upside appreciation over a one-year period. We provide a known built in buffer of 9, 15 or 30%. And we think that that's incredibly valuable for many investors today. I think 2020 is highlighted really the need for people to reevaluate their ability to take risk in the market. When the stock market sold off over 30% here in 2020, many people had to wake up and say, can I take on this type of risk? And what if the market correction has lasted even longer, instead of rebounding significantly? And that's really the power of the defined outcome ETF, is that you can buy it and know exactly how much upside you have relative to say the S&P 500, as well as how much downside buffer I have against losses. The concept of defined outcome investing isn't new, or it's new to the ETF world, but it's been around for decades in other wrappers, other bank, whether it's through banks or insurance companies, but the ETF wrapper is just another way to deliver these types of payoffs.

But we think that the benefits that they provide investors are significant. Through the ETF wrapper, there's liquidity, there's daily transparency, there's tax efficiency, there's no credit risk. And before these ETFs, there really hadn't been a way to be able to own the market with a level of protection in place prior to investing in. We think that that's game changing for a lot of those, we talked about thematic investing. At the end of the day thematic investing is never going to make up the large portion of a client's portfolio. Most people are owning a healthy mix of stocks and bonds. As you look at maybe the clientele or looking at retirees or pre-retirees, their risk tolerance is lowering. And they may be looking at the stock market today and saying, gosh, should I be invested in stocks or they are at all time equity, valuation levels? Or what about bonds? Gosh, they're not yielding anything. 

The defined outcome ETFs are a happy medium for a lot of those investors because they can still invest in the market. They can own the S&P 500, but they can have a known built in buffer against losses. And so it's that peace of mind for a lot of more conservative clients that can keep them invested, as opposed to saying, you know what, maybe I just need to put more money on the sidelines and with rates at zero, you're not earning anything on that as Sumit pointed out. So that is telling you, you have to take risks if you want to make money, but these ETFs are a solution for people that say, like, I understand I need cigarettes, but I want to know what I'm getting before I invest. And that's exactly what the defined outcome ETFs provide.

Patrick: For fear of dating myself and sounding like a millennial, it essentially eliminates the fear of missing out, really because even, you know, the most conservative people can dip their toe in. How are options utilized with the defined outcome ETF, is there a difference when compared with the other options type that's applicable to us at Schaeffer's here of course?

Graham Day: Yeah. So we use flex options to construct these ETFs. And a lot of times people can think, options, that sounds complicated. I'm not sure if I really want to go down that path, but in reality, these are amongst most simple ETFs that we've ever built. And they hold a basket of options that are fixed for a one-year outcome period. We don't do anything for that one year outcome period. We're not buying and selling options. We buy a basket that provides the defined outcome over the one-year period. And then only at the end of the outcome period, we changed the basket and we'll rebalance and do a new one year outcome period, by a fresh basket of options that will give you a new upside cap to the market, as well as the fresh downside buffer. But the biggest difference of our ETFs and really the first time ever in a 40 act fund is this defined outcome. Options have been used in 40 act vehicles for decades, but they've never given an investor an ability to achieve a defined outcome.

Again, meaning I can buy it today and know that at if the S&P goes up 10%, I'm going to match the returns of the S&P up 10%, one for one. If the S&P goes up 20% maybe I'm going to be capped out at 12%. So that's where I'm giving up some of my uncapped exposure for a known buffer. And if the market drops 5%, I'm going to be buffered. I've been dropped 50%. If I have a 50% buffer, I will not participate in any of those losses. If the market drops 30%, I know that I will only participate in the last 15%. And so, again, it's knowing before you invest, that's what makes these defined outcome ETFs so game changing.

Patrick: Yeah, it sounds almost too good to be true at this point. You mentioned a couple of times the risk management involved with ETFs. Sumit, can you elaborate on the benefits and the advantages that they have when it comes to risk management?

Sumit Roy: Yeah, the benefits come back to what I talked about earlier, and that is just the sheer scope of that ETF market gives investors, the ability to buy so many different strategies. You can mold your portfolio to fit your risk tolerance easily. If you want to diversify across asset classes, across sectors, across geographies, you can overweight and underweight industries. On the fixed income side you can raise or lower the duration of your portfolio by buying different ETFs. You can buy uncorrelated assets like gold and fixed futures. And like Graham was saying, you can buy these defined outcome ETFs, which are just fantastic instruments for hedging your downside risk, while maintaining a lot of that upside potential. If you look at what we saw earlier this year, when the S&P 500 dropped 30% plus in a matter of weeks, the defined outcome ETF only last a fraction of that amount. And then when the S&P 500 rebounded, the defined outcome ETFs captured most of that upside, if not all of that upside. So that kind of risk reward profile is very compelling for some investors who are more risk averse

Patrick: And speaking of risk adverse, we are approaching less than two weeks away, the monumental volatility event, that is the US presidential election. What could some possible outcomes be with ETFs in regards to in general, whatever happens with the election?

Graham Day: Yeah, I think it's a great question. And maybe to even borrow from Sumit, he had mentioned earlier, there's really an ETF for everything. And so whether you think the election could impacting things like clean energy if Biden wins, or if you want to play oil, there are ETFs to give you that exposure. And if you're looking to maybe take some risks off the table, leading up to, through the election, again, that's one of the areas where we see our defined outcome ETFs used because a lot of times, you see these strategies that come to market with risk management being touted as their selling points. But the problem is they work until they don't. And you know, I'll pick on something that we marketed at a previous firm, low volatility. Low volatility historically has given you a low beta to the market in periods of sell off. A beta of around 0.5, 0.6.

But if you look at 2020, you actually saw low-volatility stocks, underperforming the market, having a larger max shroud on it. So I think it's important to understand what you're buying, and if you're looking for a risk management tool and you know the 2020 election, know what you're buying, but also if you want to position yourself for emerging trends that might result from either candidate, there are ETFs to provide that exposure. And so I think the growth of ETFs will only accelerate. I don't think either candidate is going to derail that in any way, shape or form.

Patrick: I agree, Sumit.

Sumit Roy: I mean when we talk about the election, obviously everyone's going to have their own opinion just in terms of the outcome, and then also have their own opinion in terms of how that outcome is going to affect the markets. So you kind of stray into this area of speculation, but I think the two scenarios that people are most talking about are this blue wave, where the Democrats capture the Senate house and presidency. Then you have the other outcome, which could be a split government where the Republicans hold onto the Senate and or the presidency. So if we have that blue wave scenario, you're probably gonna see, and most people agree with this. You're going to have to see the Democrats pass a lot of different bills. And those include bills for higher taxes on capital gains, higher taxes on corporate cost, things like that. But at the same time, you're going to see these big spending bills, things like Corona virus relief measures, green energy and infrastructure, and even more healthcare legislation, which could offer insurance to more American citizens. So all else equal big spending like this is usually at least a short-term positive for the markets. 

So you might see a bid for the market from that. And in particular, you could see some interest in clean energy stocks, like Graham mentioned, and also healthcare infrastructure ETFs and things like that. The other scenario I just mentioned, which is the split government scenario that is going to result in grid lock, just like we've had for the last two years. Usually the market does like gridlock, but one thing to keep in mind is that in that scenario, tensions between China and the US could stay high, especially if President Trump is still in power. So you might see some pressure on the China ETFs. If we've got that scenario,

Patrick: It is a perfect situation where, however you think things are going to lean come January inauguration. That's how you can play that whole theme. So speaking of January in 2021, let's close out with Sumit, then Graham. What do you expect to see from the ETF space in 2021 and beyond? And you can kind of include like your closing thoughts and arguments in with this. 

Sumit Roy: So in 2021, I'd definitely expect to see more active ETFs come to market. So this year was a big year in that we got several new active ETF structures approved by the SEC, which allowed managers to put their strategies in the ETF wrapper without disclosing their holdings every day, so essentially this allows active managers to hide their secret sauce from the rest of the market. And this is likely going to push a lot of fund managers who don't want to reveal their holdings into the industry. And that could be big for ETFs. We're going to see even more assets probably flow from mutual funds into ETFs because of this. And as many people are aware, ETFs have been historically dominated by index strategies. Right now over 80% of the ETFs on the market are index based products. So having active join the party could lead to a shake up in terms of the mix of funds available to investors.

That could be a more even split between index products and mutual fund products out there. Now it remains to be seen whether investors are going to embrace these active funds. The academic research is pretty clear that active managers, as a whole tend to underperform broad indices over time, but a small fraction of active managers do consistently outperform. The question is, can an investor identify those managers? That's really, really hard to do, especially without the benefit of hindsight. So we will see more active products on the market. It just remains to be seen whether investors are going to actually put their money in that.

Patrick: I feel like it even like not transition year, but it will take some kind of like a transition phase. 

Sumit Roy: Definitely.

Graham Day: Yeah, I think Sumit is spot on. We're going to see more products being brought to market. The barriers to entry have never been lower in the ETF space, but I would definitely argue that the barriers to success have never been higher. And there's just so much competition. If you think about the wirehouses and home offices that approved these products there are risks in them approving new products and putting them on their platforms and making them available to their advisors. And, and because of that, the ability to gain access to distribution channels is more challenging than ever. But I agree with Sumit. I think you're going to continue to see a lot of these active management shops try to play catch up. They have resisted the ETF vehicle for a long time, but realize they can't really do that anymore, but I'll play more of a skeptical role in what they're providing the end investor.

In most ways I would argue the product proliferation that you'll see from active managers, whether it's transparent, active, or non-transparent active. At the end of the day I don't see the benefit that that will provide an end investor. I think it's a solution for a mutual fund company, but not a solution for the advisor and they're end client. And mostly because as Sumit pointed out, it is very hard to outperform the market and being able to select a manager that has out performed and will continue to outperform is also very, very challenging. And so if we know that's true, then it doesn't really matter if you are showing your holdings, or you're not because in mutual funds there isn't that same level of transparency that you have with ETF, but they still were not able to outperform. So I'm very skeptical on the adviser traction in this, because I don't think it solves a problem. The most successful ETFs have always been solutions for advisors and their clients. And I think these are a solution that are trying to find a problem. That's really a mutual fund company problem, not an advisor problem. 

Patrick: Interesting, so differentiating new points there. There's only one way to find out is I have to have you guys on a year from now and say, tell me what happened. 

Graham Day: I would love to be here.

Patrick: That's great. Well, I'm ready to wrap up. Graham Day, Vice President of Product and Research for Innovator ETFs, and Sumit Roy, ETF analyst for ETF.com. Thanks again, guys, for coming on. It was a great chat. I learned a ton, you know, I've been writing for Schaeffer's for three years and we cover ETFs pretty extensively. And I feel like I can now write a little better. So at least from my standpoint, thank you. And I'm sure my listeners learned something as well. Thanks again, guys. We'll talk soon. Take care.

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