In this episode of Markets in Focus

Exchange-traded funds (ETFs) have grown in popularity and breadth since the early 2000s. How can investors assess potential pitfalls and conduct proper due diligence? Jason Richey, CFA, Co-Portfolio Manager at Cougar Global Investments, joins Matt Orton, CFA, Chief Market Strategist at Carillon Tower Advisers, to trace the history of ETFs and consider the future.

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Transcript

Matt Orton:
Investors are pouring money into exchange-traded funds at a historic pace as equity in corporate bond markets rally to new peaks and asset managers increasingly turn to these vehicles to build portfolios. ETF (Exchange-traded fund) flows so far in 2021 have already outpaced those for all of last year. The strength in ETF flows reflects not only a strong rebound in asset prices from their pandemic lows of 2020, but also how fund managers are using ETFs as an important instrument in portfolios. In some cases replacing or being used in conjunction with individual securities.

Given the breadth of these instruments, there's passive ETFs, active ETFs, thematic ETFs, ones that provide specific factor exposure among others, it makes sense that they have become an important part of any investor's toolkit, but where is the industry heading? How can investors conduct due diligence? How should we assess some of the potential pitfalls of these instruments? These are all important questions to consider as ETFs become ever more common in the investment landscape.

Today, I am joined by Jason Richey, co-portfolio manager at Cougar Global Investments for a deep dive into the ETF industry and the impact of some of these seismic changes on active investing. This is Markets in Focus from Carillon Tower Advisers. I'm your host, Matt Orton. Join me and my colleagues as we discuss the latest trends and developments driving the markets. Visit us at marketsinfocuspodcast.com for additional episodes and insights. Jason, thanks for being here today.

Jason Richey:
Thanks a lot, Matt. Great to speak with you again.

Matt Orton:
Yeah. And likewise. And I'm sure many of our listeners are already very familiar with the mechanics of ETFs and the growth that we've seen over the past few years, but I still think it's worth spending a minute or two taking stock of how ETFs have evolved and their impact on the overall finance industry, particularly active investing. So Jason, perhaps you can provide just a little bit of color here, starting with some recent flows and then going from there.

Jason Richey:
Yeah, sure. The growth of ETFs has really been quite fascinating. If you go back and you look at the numbers, the true industry diehards have been basically accurate in forecasting the trend over a decade ago. Was a crazy forecast back then. But the quotable line about ETF growth was that ETF assets would catch up with mutual fund assets by 2025. Now we might be a year or two off of that projection, but we're not going to be too far off of it. So for me, I started paying attention after the 2008 financial crisis when the entire world was collapsing. And we learned that it wasn't a good idea to lend to somebody who was already juggling five other mortgages. And in the market and for investors, we had all of these different asset classes basically lose 30% or 40% or more all in unison and you had mutual funds lose almost two and a half trillion in assets that year.

Then you had this one little section of the financial universe that had really picked up steam the year before, actually in 2007 and it held up fine. And actually somehow grew in 2008. So you go back and you can look at the numbers if you want. The Investment Company Institute tracks it. There were about 150 new ETFs launched and only about 50 closed in 2008 in the U.S. and the ETF universe was net positive in asset flows. Now, if you look back on it today, I think we can say that 2008 proved the vehicle worked and like most industries, if you can create something cheaper, something more user friendly, it's just a matter of time before you have some success.

Matt Orton:
Yeah, that's a great point. And maybe just to dive a little bit deeper into that, are there any particular asset classes that over the past decade and really over the past couple of years have seen the most interest or inflows? Whether it's active ETFs or just specific passive asset classes.

Jason Richey:
Yeah. Well, you're seeing growth pretty much everywhere for the industry as a whole, starting with the basic passive category, meaning just pure index exposure only. Whether it's benchmark bonds, or domestic, or international stocks, those see consistent flows every month really. In fact, JP Morgan, they publish an annual ETF handbook going back 16 years now. By the way that started out at, I think less than 30 pages, it's now 112, but they've tracked what I call the big three ETF providers, meaning BlackRock, State Street, and Vanguard and the market share for those three has remained around 80% of the ETF market pretty consistently over the years. So those core products have continued to grow alongside the whole category and the subsection of what I call or what is categorized as thematic ETFs, those can be either passive or active as you referenced. And that's been an interesting niche that's really taken off the past couple of years as ETFs continue to get sliced and diced.

And especially as more active managers get into this space. And then finally, another category that's been discussed for a decade, I think it's finally achieved critical mass. The options for ESG investors have really exploded in the past couple of years and there's probably 50 or so ESG related ETFs in the U.S. at this point, maybe another 40 to 50 globally. It's another space with some growing pains. We probably need more quantifiable measureables, probably a bit less marketing and emotion, but I do think that we're going to get that data over time. So ESG will remain another area of growth.

Matt Orton:
Yeah, that's really helpful just for context for the overall industry and within just the traditional passive index tracking ETFs that exist. Is there a heavy bias towards say large caps, which I think get so much attention you see so many investors going passive or has it been fairly broad across large and small?

Jason Richey:
Yeah. It's been broad across large and small. You can sort of diametrically oppose passive line and the active line really, it looks like a mirror image of one another. And another space that's seen a lot of interest is the fixed income space actually. There's been a little bit of a lack of growth in the fixed income space relative to equities. But I think that's just simply the lack of market appreciation given that the stock market has doubled in a couple of years and yields are stuck where they've been. But if you look at flows year to date, for example, within fixed income, within U.S. fixed income at least, it's actually seen better asset flows on a percentage basis than the U.S. equity category. A lot of that is probably rebalancing too. I think that's fair. It's also a newer market as well.

The first fixed income ETF launched in 2002 versus the first equity ETF, which was launched in 1990. And now traditionally given their 10,000 or so individual bonds in the Barclay's aggregate index. This was one of those spaces where active managers could add a lot of value, especially in the less efficient corners, say high yield or emerging market debt, or maybe mortgages perhaps. But it's a really interesting area. And I think there's another reason that you've seen some flows in the income, at least in the U.S.

If you think about it from here, where yields are and spread compression, and depending on your view of rates in the economy, if going forward, you can expect a 2% nominal return, let's say, give or take in the fixed income portion of your portfolio. Again, unless you're taking a ton of risk and you can't get much return from duration or credit, and maybe it makes sense to basically benchmark your fixed income exposure and basically live to fight another day. There are several new fixed income ETFs that are looking to squeeze a little bit more juice, whether through interest rate hedging, or duration hedging, or specific slices of credit within the fixed income market. But for me, I'd say the jury's still out on these newer products, but it's definitely a category worth watching.

Matt Orton:
That's great. And I'm glad you brought up fixed income ETFs Jason, since I do agree that it's probably an area of a lot of long term growth given how much newer they are than equity ETFs and also the growth in model portfolios and strategically balancing allocation between equities and fixed income. And earlier you brought up active and thematic ETFs. What are your thoughts on the long term growth prospects of this area? We've seen a lot of growth recently, but is there demand for more and more of these going forward and what are some of the drawbacks?

Jason Richey:
In terms of market share, if the U.S. ETF market is closing in on say seven trillion in total assets, active ETFs are only a couple hundred billion of that, but still it is a segment growing faster overall, especially in the past few years. Now, thematic investing, that's been around forever. You're just trying to capture a fast-moving theme. Maybe it's macro related, maybe it's technology related, whether digitization or genomics. There's actually nice overlap with the ESG category as well if you think about water or natural resource themes.

Now, one of the concerns is you have to remember that this is generally hot money, so you can see some big inflows, you can see some big outflows if you're trying to trade these things. And many of these ETFs are newer. So you don't have a long standing track record to evaluate where they fit in terms of portfolio construction. Another interesting element is that the average expense ratio on the industry overall stopped falling last year, primarily because of these newer launches of active ETFs, which they tend to carry a little higher associated fees. But overall active and thematic products, they have a great trajectory right now with some credit to the SEC for approving these new non-transparent ETF structures in the past couple of years. These ETFs do add an extra layer of complexity if you're an investor doing your due diligence, but I'd say it's mostly sort of behind the scenes complexity.

Matt Orton:
Let's zoom in on that complexity argument, because I think that sets us up really well for a key part of this discussion that I want to hit on, which is due diligence. And as an active investor who uses ETFs to implement your views, I'd love to get your view for the process of reviewing ETFs. What are some of the key criteria to consider for both traditional passive ETFs, as well as some of these active ETFs or smart beta that we've been discussing?

Jason Richey:
Absolutely. ETF due diligence is very important. It's basically has become its own cottage industry at this point today, which is fabulous because there's a host of free sites for most of the basics. You can always go to any individual ETF provider's website for more information. There's plenty of pay sites as well with all sorts of detail, whether Bloomberg or ETFdb, there's a range of them. For us, our process is a bit more institutional in nature only because we're moving large amounts of money. So we have to worry about the impact of trading and flows. We pay attention to minor changes to an ETF's index construction, but most ETF investors can manage a smaller due diligence checklist. So for example, say you have an exposure you want, perhaps large cap growth and you can go to any of those free evaluation sites, you can figure out your total cost to ownership, which would include trading, it would include commissions.

And hopefully you don't have to worry about bid ask spreads and you can trade it anytime you want during the trading day. The one pitfall, there's all sorts of catchy names. So you can’t go by the ETF name alone. You have to look at how many positions it has. Does it have 30? Does it have 300? How expensive is it? How long has it been around? And do you recognize any of the underlying holdings? Now ETF investors have no shortage of strategies, but in my view, a couple of options include, first, either stay around or near the largest 150 to 200 ETFs to avoid liquidity risk or closure risk, and then construct your portfolio as you see fit. Or another option is to outsource completely to somebody with a lot of expertise, and they can perform the extra due diligence on the lesser-known ETFs. Now I think that the extra due diligence is helpful as we see a whole category of newer ETFs from large, well known active managers that either have launched or are coming soon with sizable asset bases.

Matt Orton:
And also another part of the due diligence process is probably fees. So even some passive ETFs probably have more substantial fees, even relative to an index fund or some active mutual funds that investors might not realize. Active ETFs could also be harder to contextualize from that fee landscape. So how would you recommend looking at fees across the various ETF offerings?

Jason Richey:
Yeah, it's a great point. I hardly touched on the vast differences you can come across in expense ratios in the various categories and you're exactly right. Fees can be a challenging topic. Most people just consider that what I'll call the operating expense ratio. And yes, in general, for the basic passive ETFs where you're simply following an index, there's less total costs, there's less administrative cost in running those ETFs versus mutual funds. And those ETFs can be accessed very cheaply. So if you look at the top 10 ETFs in terms of assets, all are passive and nine of the 10 of them carry expense ratios under 10 basis points. They're all super liquid, but on the other hand, all you get are very basic exposures. And by the way, they didn't start out that cheap. But now that they're tens of billions of dollars, those ETFs operate on razor thin margins and they've achieved massive economies at scale, which has helped them from a cost point of view and helped investors.

Now, the beauty of being able to trade ETFs all day long can also be a curse if that's all you choose to do. And so all those other costs I mentioned would add up premiums, discounts, bid ask spreads, et cetera. And once you get to the more interesting exposures or smaller ETFs that have an achieved scale or many of the thematic ETFs, where you get actual money management and expertise behind it, those can cost just as much or even more than a mutual fund. And the asset class matters as well. If it's a small cap or micro cap, it's actively managed. Those funds can be a bit pricier since they have to be smaller by nature in order to deliver alpha. But just to put some numbers on it, a decade ago, it was probably 100 basis points in terms of average expense ratio, the difference between mutual funds and ETFs. And today it's closer to 50 or 60. Again, it does depend on the asset class.

Matt Orton:
That's great. That's really, really helpful to add some context around fees since I know that it's so important to a lot of investors today. And I'd be remiss if I didn't bring up another area, which is risks and pitfalls on some of the ETFs. The first vehicles that come to my mind on this are levered or inverse ETFs, as well as some commodity ETFs, where you can have a futures curve in contango. Maybe you can discuss some of the challenges here and the best ways to potentially use these vehicles.

Jason Richey:
Yeah, that's the category that always gets picked on. And the biggest risk for 95% of your normal or average investors are avoiding those esoteric exchange-traded products. They are very interesting to read up on and research and understand. And I'm going to use energy as an example. You can't go buy and take delivery of a barrel of oil, but you can buy a futures based exchange-traded product for oil or for natural gas for that matter. But the problem is that the return you get in the exchange traded product is not the return of the commodity itself, just due to the way that the fund works. So take natural gas this year, for example. Natural gas, the commodity itself is up 125, 130% or whatever it is, but the products tracking it are up somewhere around 50%, maybe 60%. So it sounds like a great idea, buying natural gas without actually buying natural gas, but the numbers don't usually work out as well as you hope even if you happen to have perfect foresight into the coming temperature this winter.

I think another big risk of ETFs worth mentioning for most investors, other than not knowing what you own is closure risk. If you look at the universe in Morningstar, they track almost 2,800 ETFs in the U.S. at this point. Now fully half of those 2,800 have less than 100 million in assets. The bottom 400 have less than 10 million in assets. The asset number that most people quote is around 100 million, somewhere from 80 to 100 million is the magic number for assets in terms of being sizable enough and being profitable enough to keep a product alive. And again, for context, they were close to 200 ETF closures last year, though, there are a lot less funds closing this year. Again, here's a situation where the growth of the industry is also a curse. You have hundreds of new product launches and product ideas, but the life cycle of ETFs is shrinking if they don't ramp up pretty quickly in their first three to five years. So those smaller ETFs can come and go.

Matt Orton:
Yeah. That's really, really helpful. And finally, I think it would be good to maybe we conclude our discussion by getting your thoughts on where you expect to see most of the long term growth going forward be it traditional passive ETFs, active ETFs, thematic, or anything else that I may not have mentioned.

Jason Richey:
Sure. The traditional passive space that will continue to grow just because you can't be owning the S&P 500 at three basis points. That's just about as efficient as you can get, but there's a lot of other exciting developments here, especially recently. At the industry level, mutual fund conversions are a big deal, meaning converting mutual funds into ETFs. The big surprise was DFAs announcement. Back in November 2020, they were converting six of their mutual funds into the ETF structure. It wasn't as big a deal as all our vaccine announcements that we got that month, but it was still a big deal for ETF followers. It ended up being for DFA, almost 30 billion in assets when that conversion happened. And I think it happened this past June. It also clearly opened up the floodgates with JP Morgan having their own announcement a couple of months ago, Goldman's in the space and now American Funds will launch products in 2022.

These are all really exciting advances because investors will be able to get these big traditional providers at better prices without being hamstrung by fund minimums and other operational requirements. Getting ETFs into 401ks yeah, in a more widespread fashion, I think that's just a matter of time, technology. It is easier to handle a single transaction at 4:00 PM for mutual funds, from a record keeping point of view, I think technology will fix that over time. And the third item I'd mention are the products themselves. We talked about thematic ETFs earlier. And actually I'll throw in one more.

The last one I'll mention is crypto ETFs. There are not any in the U.S. yet. There is some scuttle that the new CFTC chair is a fan and he'll eventually allow some type of crypto related ETF, which I'm sure will generate a ton of investor interest when it happens. Now, I'm personally probably not the target audience for a Bitcoin product, but I can say the handful that have launched up here in Canada have been hugely successful. I think the largest Bitcoin ETF crossed a billion in assets and it took only three weeks or something like that after launch. And that was six months ago. I think it's still around a billion. So it hasn't really done a lot since, but it's still certainly one of the largest ETFs in the Canadian marketplace.

Matt Orton:
Yeah. There's definitely likely going to be staying power to that for sure going forward. But I greatly appreciate your time, Jason. This has been really, really insightful. Hopefully our listeners have found it to be just as insightful as I have. So thank you for coming back and thank you very much to our listeners for tuning in. Until next time, take care. Thanks for listening to Markets in Focus from Carillon Tower Advisers. Please find additional episodes and market insights at marketsinfocuspodcast.com. You can also subscribe to our podcast on Apple Podcasts, Spotify, or your favorite podcast app. Until next time, I'm Matt Orton.