ETF Edge - Downside Protection Plays

Episode Date: January 26, 2022

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The ETF Edge podcast is sponsored by InvescoQQQ, Supporting the Innovators Changing the World, Investco Distributors, Inc. Welcome to ETF Edge, the podcast. If you're looking to learn the latest insights on all things, exchange, traded funds, you are in the right place. Every week, we're bringing you interviews and market analysis and breaking down what it all means for investors. I'm your host, Bob Pisani. Today on the show, we'll go big on the market turmoil this week. What's driving the biggest flows? Where has the volume been heaviest? is now the time for active management. Plus, we'll talk thematic trends and drill down on new ETF products that help you stay in the market while weathering the storm. We've got two of the best in the business with us today.

Dave Naughtick is the CIO and Director of Research at ETF Trends, along with Brian Lake. He's the global head of ETF Solutions at J.P. Morgan Asset Management. Ryan, you oversee the largest active fixed income ETF. That's the ultra-short income ETF. Tell us why active management,

in your opinion, is again becoming a very big play in 2022. Yeah, thanks, Bob. You know, I think the key is it combines the best of both worlds. You've got the benefits of the ETF wrapper, trades throughout the day, tax efficient, transparent, with the intentionality of active management, a portfolio manager that knows exactly what they own, why they own it, when it goes into the portfolio. And, you know, as a lot of folks on this on this show have talked about in the past or, you know,

that are on on CNBC all the time, talk about why they own things. And I think it's important that investors want to know why they own it. And so to have intentional investing from a portfolio manager, I think that's why active ETFs are having such a big year already in 2022. Speaking of a lot of trading, Dave, I want your take here. I want to go back to the active trading part, but give us your take on the trading this week. I saw volume four or five times normal in some of the big exchange traded funds like the S&P 500. That's trading. But what about flows?

What did you see in terms of flows? Yeah, well, the last five days have been great from an ETF flows perspective. We've had about $13, $14 billion flow into equities. About two-thirds of that has been international. We've seen a lot of folks allocating into domestic emerging or emerging to developed markets internationally. Europe has been getting a bit of a bid. But there's still been $4 or $5 billion in new flows into U.S. equities just in the last five trading sessions. So to me, that means that we've really had a raft of advisors and investors who have been

looking to buy the dip here. We've seen no evidence that the ETF side of the balance sheet, if you will, is what's panicking and pushing the button to sell. If you look at things like the volume weighted average price, even in something like the cues, there really hasn't been any volume at the tails. The volume has been very much right in the center of the trading where we'd expect. It hasn't been a lot of folks just using the ETF to Whipsaw. It's been folks using the ETF to allocate. And Dave, while we're on the subject, we were just chatting with Brian, about active management. Do you think there is going to be significant upside for active management this year because of the market volatility? We've talked about this so many times, and it always

essentially peters out, indexing still wins out. But is this something different? It is a little bit different. The last three or four years have been really different with active management coming in a big way. And it hasn't just been sort of short-term fixed income with all due respect to JPSD, which is a great fun. We've seen active equity show up in a big way. We had about 13% of the flows last year come into active ETS. That was a big uptick from the sort of 11% we were seen before. A great chart we've seen from FACCET. You guys just put it up there quickly. Those flows into active just continuing to come in year after year increasing and increasing. I wouldn't be surprised to see a 15% year for active management this year. I think the volatility in the

market is good at least for the story of active management, whether or not sort of traditional active stock picking equity managers are going to be able to outperform, that I remain skeptical of. But I think there's really a place for active management when folks are looking at the corners of their portfolios. Yeah, I agree. It's good for the story of active management, for sure. Brian, there's also a lot of interest in products that enable you to stay in the stock market and still have downside protection. Now, you have the JP Morgan Equity Premium Income ETF. The symbol is JEPI. That's the fastest growing active equity ETF, you've got $6 billion in assets under management. What is that owned? And how do you get this downside protection that is sort of a side aspect of this? Yeah, I think it's a big part

and it ties down to the point that Dave's making as well, which is when investors are using active ETFs, they're trying to achieve an outcome. If they're buying the ultra short, they're trying to step out of cash, maybe get a little bit of extra yield above and beyond, you know, just what cash is giving you right now. Equity premium income, Jeppe is a great example of that as well. We all know that there's a lot of investors that want a lot of income. Jeppe has a distributor 6 to 9% income stream that comes off that portfolio. So for investors that are looking for the outcome of income, that certainly checks the box there. And then because of the way that the strategy is set up, it should only have about two-thirds the risk of the S&P 500. And

the way we're doing that, Bob, is we own a basket of quality securities, U.S. equities, and then we're writing out of the money calls on that, which allow us to collect that premium into the portfolio. And so investors have found that that really can play a role in their portfolios to both achieve the income and to get some of that downside protection that you're talking about. So it's a buy-right strategy, right? You're buying out-of-the-money calls. You're writing out-of-the-money calls, right? That's right, but it's an active, strategy, which I think is key. The underlying basket, there's fundamental research that goes into every single one of those stocks that we own. And then we have the portfolio manager that's writing the

out-of-the-money calls, to your point, that's doing that with intentionality as well. So it's not just a rigid process. Yeah. And I'm looking at the top holdings here, DTE Energy, Microsoft, AbbVe, Progressive, Alphabet. This is quite a group here. Is there any rhyme or reason to the methodology for picking what's in this? Yeah, well, I mean, we're doing bottom. up research there. So there's a fundamental analysis to that. We've got one of the best equity franchises on the street. And so we're doing the research on those individual names. We're looking to buy good quality names that can be a core of a portfolio. Dave, talk to me about these downside protection products that are out there. Are they getting

any more assets gathered? Yeah. And what are the risks of owning them? They've been actually one of the big stories for the last two years. Last year, it was about 8, 10 percent of the flows went into products with some sort of downside protection claim, at least. Whether they've been things like the covered call writing strategy on the income equities like JEPI, whether they've been other funds that are doing more collared strategies where they're actually buying puts off the bottom, creating so-called defined outcome tranches that you can expect your returns to be in, those have been pulling in quite a bit of assets over the last

two years, really. I expect those products are going to have done well when we look back here in a month or two. The kind of markets we've been have been the markets that are designed for those products, or rather those products are designed for. So I think they're going to have their moment in the sun here. I think that will draw additional assets. And frankly, you mentioned this is a way for people to stay invested. That's what it's done. It's allowed advisors and investors to stay in these equity markets as opposed to just going to cash and yielding a couple basis points. Yeah, they make sense and certainly in a downside situation, Brian. I always wonder about what happens when the market goes back to normal.

You get outflows, again, from these kinds of strategies. You know, we all know the behavioral economics here. People panic and they think, I can't get out, but I need some protection. And so the money flows out if the market normalizes. You know, I think what we're talking about, though, is that investors have more tools than ever to build the portfolios that they need. And if investors start with, what am I trying to achieve here? and then look at the tools that are available to them to achieve those goals, they're going to do well.

And so now they have more tools that can help them protect the downside. And, you know, those tools should do the job. And when the job's done, maybe they'll use another ETF that helps them accomplish something else. And, you know, I think that's what's so exciting about being an investor right now. I just want to move on to talk about this whole conversion process from mutual funds to ETFs again. And Brian, beginning in April, I know J.P. Morgan is going to begin converting just under $10 billion in mutual funds into ETFs. We had Gerardo Riley and the team on from dimensional funds last year when they did that

conversion. They were a leader in doing that. Why are you doing this now? And is there some kind of tipping point? I keep waiting for this to happen where this small group of funds converted to ETFs eventually turns into a flood for the whole industry. Yeah. Well, we think the announcement that we made around converting four mutual funds to ETFs is great

for investors. as we talked about at the top, you know, the benefit of the ETF wrapper, combined with these strategies, we think, makes a very attractive proposition. We are lowering the fees on all of the strategies that we've announced that we're going to do that on. So, you know, that's something that we're excited about and we're going to convert those four mutual funds into ETS. As far as a tipping point, I don't think so. You know, speaking for J.P. Morgan, we've got $800 billion in our mutual fund franchise. We're very successful. successful in that space. We know that investors use mutual funds across their entire book of

business. That plays an important role in the ecosystem as well. So I don't think it's neither or I think it's a both conversation. We do know that the ETF space is growing rapidly. We know that investors are starting to incorporate more and more ETS into their portfolios, but they're also using mutual funds and those get the job done as well. Dave, yeah. Brian was speaking like a guy who not only runs ETS, but has a firm that has a lot of mutual funds, too. Let me throw it to you. When will it be? We keep waiting for this to happen.

You know how my brains butted on this. When will it become a flood? I think we're in the middle of the flood. You just can't tell because the water's rising a little bit slower than you were expecting. You're not seeing the wave come down the wall. I mean, we had Capital Group just announced what yesterday or the day before, that they've licensed Fidelity's non-transparent active system for their conversion and bringing new product to market.

So look, we're going to see every major active and passive asset manager in the ETF space. Some of them will convert mutual funds where it makes sense. Some of them, like, say, Fidelity, it's going to have to launch clone funds like they did with Magellan. Because Magellan is sitting in too many 401K plans, it makes it too complicated. So all of this money will eventually show up in the ETF space, but whether it's converted or not is largely irrelevant. The point is the active managers are here. They're coming even faster than we expected.

And I suspect this is going to be a big year for active flows. Okay, that's a good point. Now, Brian, let's move on. The thematic stuff, sustainable stuff. Still a big trend in 2022. We beat it to death in ESG in 2019 and 2020, but it's still there. You just launched the JP Morgan Climate Change Solution. Temp, like that to EMP.

It's an actively managed ETF around climate change. How is this set up? How do you do active management on climate change? Yeah, so this is designed with data and refined by research is what we like to say there. So we're taking our proprietary artificial intelligence and machine learning process to evaluate millions of different data points across 13,000 different securities to establish a starting basket of companies that could potentially benefit from the different climate change solutions and trends that'll emerge on the back of that. And then we're refining it by research. And so our active analysts are doing fundamental research on every single one of the names and deciding which of those names deserves a spot within the portfolio.

And so we think we're combining the best of both worlds. The macro story there is huge. We estimate there needs to be $140 trillion investment in energy and global infrastructure in order to get to some of the net zero targets that many of the countries and regions are talking about by 2050. so $140 trillion of investment, these companies are the companies that are working on those solutions right now. And so we're really excited about that. It's the first active climate change solution strategy to come out in an ETF. Ticker temp is also a nod towards the temperature as well.

Well, what I look at this list here, the top holdings, deer, Eaton, train, Johnson controls. These are global industrials, essentially. To what extent are they actually truly participating in climate change solutions? I guess I have no problem with the idea that these companies are very involved in affecting the climate. How are they involved in climate change solutions, I guess?

Yeah, I think that's the point. I think one of the things that we've observed is that climate change affects all different industries. It's not just we need to, to move from, you know, natural resources to solar or renewables or something like that. That certainly plays a big part of it, but it's also in construction, it's also in agriculture,

it's also in healthcare and a number of other industries that need to do that. And so that's why we think this is such a nuanced conversation and that you can't just set up a simple rule that screens for, you know, some buzzwords that help us stock it into an index. By having the fundamental research that are evaluated, those names that you just mentioned, understanding what it is that they're really trying to accomplish

when it comes to climate change and making sure that they do deserve a spot in that portfolio and that they can affect change there, that's where we think the active management really comes into play. Yeah, you do understand, I want to get your response there, but you do understand that there are a lot of people, when I bring this up, I get emails from people to say, you know, Bob, those old global industrials, we used to be part of the problem, not part of the solution, and now it's more nuanced. We have to consider, you know, you get the fundamental problem here. There are people who push back pretty heavily every time we do this kind of thing about that idea. Dave, you want to respond to that?

And what are you going to make a point? Yeah, I think you're actually right on the money here, right? ESG, climate change investing, whatever, sustainability, it exists on a spectrum, right? And obviously, all the way at one end of the spectrum, you have companies that are only making a direct impact, and that is their entire reason for existing. All the way on the other, you have companies that have broad, ranges of business that are actually changing how they do business to respond to what's going on in climate change. And reasonable people can disagree about whether it's smart to invest

on one end of those spectrums or not. What Brian's talking about here and what a lot of the net zero type solutions we've seen launched in the last year are talking about is looking at the global economy from the perspective of what does it look like in a net zero world. It doesn't mean that you no longer manufacture chemicals and no longer put rubber on your car. It means that how you do those things and the impact of those things is going to change. So it doesn't surprise me at all to see a bunch of global industrials on the list there. I think that's actually the right approach when you're trying to think about the global climate change problem. You just have to recognize that's very different than buying a solar energy company. There are different kinds of investing for

different purposes. What Brian's talking about is actually where the institutional market is very strongly headed. Forty billion inflows into ESG ETFs last year. It's a trend that's going to keep continuing. Dave, Brian, you anything you want to say about? I think Dave had a very good response there. They were part of the problem, and now they're getting more nuance. You use the word nuance. I'm reflecting what you said.

But you understand. I get the emails from people who still don't quite understand. How is this part of the global solution? Yeah, I think that's right. And I would agree with everything that Dave just said. But I think the other thing when we were designing this, this, this, the CF is we wanted it to be durable. We wanted this to be something that could play a role in portfolios for the long term.

We didn't want this to be a market timing thing where I'm in this week out next week because of certain things that got tweeted out or what we're seeing in some of the trendy spaces around some of these other areas. We wanted it to be durable and have a lasting place in portfolios. And as a fiduciary, that's how we're kind of thinking about that. So I definitely understand some of those names have kind of that nature to them. But that's how we designed this with intentionality in mind. Yeah, Dave, I want to just switch subjects for a minute and something that's very topical here that I'll be dealing with in the next hour. We've got a Fed meeting coming up in another hour.

I know you're not an economist, but how does the Fed decision factor into ETF holding? It seems like everything the last month we've been dealing with essentially has got the Fed's fingerprints on it right now. Any thoughts on what may happen with the ETF community around the Fed? I mean, this feels like one of the most forecast and broadcast bed meetings I think I've ever seen. Obviously, there's going to be a lot of nuance, and that nuance is going to be really important. But in terms of what's going on inside ETFs, no, this doesn't make that much a difference. Most financial, that much difference. Most financial advisors are well positioned already going into this.

They're not going to be surprised almost regardless of what happens out of this one meeting. I think the bigger issue is, is there some set of relief rally that comes out of this, or is there just a bunch of rearranging that goes on based on what? what comes out of this. These kinds of earnings running into a Fed meeting is probably the most uncertain the market ever is. So I think most investors just want to get past this and get to Monday next week. I completely agree. I sat and watched Microsoft's trading after hours after the earnings release yesterday. Insanity. It moved. It was truly breathtaking. It went from after the earnings release down 5%. Then the conference call where they clarified and gave guidance, it went to

up five. The second biggest stock in the United States, a $2 trillion market cap moved 10% in two hours. And when I pointed this out to people, they said, well, you know, there's a lot of bot trading around the headlines. And I said, no, that's pretty breathtaking. And that shows you how crazy and weird and jittery the market is. And also highlights that people ought to be very, very careful trading in the after hours, which is the obvious. It's a great week to take a vacation and come back Monday and look at your portfolio. I think that's actually the best investment device I could get. Yeah.

And don't trade in the after hours. Don't trade it by 5.30 when you're waiting for a conference call. Yeah, really, seriously. Now it's time to round out the conversation with some analysis and perspective to help you better understand ETS. This is the market's 102 portion of the podcast. Today we'll be continuing the conversation with Dave Nautic from ETF Trends. Dave, thanks for sticking with us.

I wanted to ask you about two news items. that came out in the last week that caught my eye. One was a report from the Center for American Progress. That's a progressive think tank. And they say the creators of indexes have to be more transparent and how they create indexes and what goes in them. I mean, the creators of indexes are the people you and I know, the SMPs and the MSCIs of the world.

I'm wondering this might get the year of the SEC. And what's the issue here? What was the center complaining about? Well, so, you know, I think there has been this pushback against passive management that we've talked about many, many times, right? This is a normal thing that we hear every time the index business gets bigger and bigger, people want to poke holes at it. And one of the arguments is that if you're the S&P and you're making the S&P 500, you should have the exact same set of responsibilities and rules and regulations that say the active manager running Fidelity Magellan should have. Now, I understand how people get there, but it also just doesn't really represent how the real world works, right? You personally could create the Bob Pazani index in eight seconds in a spreadsheet.

At what point you then become required to do something about it? When you license it to an issuer who then decides to start running money against it? Well, that's bizarre because the end investor has no contractual relationship with the Pazani Index. So who's going to sue who? So that's why index providers have traditionally had this sort of, not protected, but a slightly set-aside role. They're much more of a media company, if you think about it, than they are an actual manager of money. Because even once I've licensed the S&P 500 or the Pazani Index, I, as the manager of that fund still have to do the work of running a fund. I think people assume that these funds just get run by spreadsheets by robots. It's not true.

There is somebody sitting on the desk making sure that SPY is high. correctly allocated, that money is being put to work, that overnight cash is being invested. Like, there's a real job that's at stake here. That's the person who should be on the hook. Yeah, I guess this goes into what I call the politics of indexing. There are funds like the Russell Indexes, the Russell 1000. They're very mechanical. They're basically market cap index, and those are pretty easy. But others, and people have argued the S&P 500 is not a mechanical index. It's a committee, even though we say it's the 500 biggest company. it basically is, but when you saw with Tesla, you know, it could sometimes weird things can happen,

although Tesla is a bit of an anomaly that's happened. So I'm generally- The Q's, right? The Q's has an incredibly complex index when they do a rebalance. So it's a legit concern, right? It's not everything is simple. Yeah, and it's the 100 non-financial stocks that happen to list on the NASDAQ. You know, with a strange reverse cap weighting allocation system to make sure

that Apple doesn't become too much of it. That's not exactly the Russell 1000 there. But, yes, it's a, it's a, it's a, it's a, that goes to what I say, the politics of index construction, how exactly are these things constructed. Many of them are not really market cap weighted, but we all know that. I mean, everybody sort of knows that that. What I don't like about the implication of this is somehow there's something nefarious going on when it's pretty transparent how they're picking the stuff.

You just have to pay attention. And I wonder like, oh, well, we need to know more about it. I don't know. Are you not paying attention to you? If you don't understand how they're constructed, that you're not reading the prospectus. It's not a mystery for most of these. This is, now, there are some edge cases here. So I don't want to just completely dismiss this.

There are plenty of indexes that are truly black boxes, right? Trust us. We have a smart beta engine. It spits out the holdings. Here are the inputs, but we're not going to tell you all of the nitty-gritty math. I understand why some folks might be nervous about that, to which my answer would be don't own that product. Right, right.

I think that's a very good point. And thank you for clarifying that. There is some smart beta stuff. AI powered stuff, frankly, that mystifies me. When I say, why is this here? Can you explain? And they almost like, well, that's what the algorithm spits out. So that's not a very satisfying answer.

So thank you for clarifying that. And I agree with you on that. Let me just move on about there's another story that's went out recently about model ETF providers. And, you know, these ETF providers provide, you know, recommend baskets of stocks for clients. They're pretty popular. We've talked about them. But the firms designing them, this research has shown, tend to favor their own exchange traded funds. And they tend to have higher fees and lower performance than recommended unaffiliated ETF. That's what this study says. I think there's a lot of value to a model portfolio. But is it, certainly?

First off, surprising that some would recommend their own ETFs. Is there a problem here, I guess, without the disclosure? So the fact that, the fact that, you know, Vanguard would recommend Vanguard funds and BlackRock would recommend BlackRock funds should shock absolutely nobody in the history of finance. I mean, that is pretty normal. If I'm going to put together a free portfolio that shows you how to construct an aggressive portfolio using Wisdom Tree Funds, of course I'm going to include Wisdom Tree Funds in it. I mean, that's the reason I put the portfolio together was to teach you how to use my products.

That's mostly what model portfolios are. They're great education tools. Now, of course, some financial advisors, you know, subscribe to a house model, say it at Wells Fargo or an LPL or something like that, and they put their money in that religiously. And in that case, sure, there is some sort of actual work being done to take ownership of a client's portfolio by the model provider. But everybody can say they have a model. There's a big difference between an advisor algorithmically giving money to a model and just BlackRock publishing one.

And the report that you're talking about completely conflates the two. Real money portfolios versus paper model portfolios versus paper model portfolios that then get tweaked by advisors, which is probably the norm in model portfolios. Very few clients are in the model at the model weights with zero other exposure. That's just not the real world we live in. They're guidelines that help investors make better decisions. I don't quite get what they're after here. Yeah.

Again, this is picking at the edges of ETFs, index construction, and portfolios. I don't think anyone should be surprised. Again, I just tell everyone, pay attention. I don't find Vanguard, recommending Vanguard ETFs to be shocking in the lease or Fidelity recommending Fidelity ETFs. What I want to know is the underlying. stuff okay and you know to a certain extent you can you can do all the disclosure you want it doesn't necessarily prevent people from making incorrect decisions or preventing market downturns

so I'm in favor of disclosure but there's a point at which you know you're not going to disclose away risk you're just not and sometimes people don't pay attention and they need to pay more attention I'm I'm more I think you and I are very aligned on this I call it common sense there's a point at which I could have, instead of 100 pages of disclosures, I can have 500 pages of disclosure, and I'm still not necessarily going to be better informed, nor is it going to create a better informed investor, necessarily. I would say the opposite, right? The 500-page disclosure guarantees that nobody will read it. A good one sheet is actually something that's particularly useful. And you know what? Every one of these model providers and every one of these index providers has a good one sheet. And that's a tough one to

write and write correctly. Got to run, Dave. It is always a place. pleasure to talk with you. Dave Naughtick, everybody is the CIO and Director of Research at ETF Trends. Dave, thank you for joining us. And everybody, thank you for listening in to the ETF Edge podcast. Investco QQ believes new innovations create new opportunities. Become an agent of innovation. Invesco QQQQ, Invesco Distributors, Inc.