ETF Edge - Fixed Income Flows & The Pulse of Active ETFs in 2023 2/13/23

Episode Date: February 13, 2023

CNBC’s Mike Santoli spoke with Todd Rosenbluth, Head of Research at VettaFi, Jerome Schneider, Head of Short & Low Duration Portfolio Strategies at PIMCO and James McNerny, Portfolio Manager at J.P. Morgan Asset Management. They discussed the rally on bonds – digging deeper beneath the surface and honing in on the bright spots for investors' portfolios in 2023. Where are the flows going in the fixed income space and what does that say about investor sentiment? Plus, they weighed in on the age-old active versus passive debate, as more and more actively managed ETFs come to market in 2023. Hosted by Simplecast, an AdsWizz company. See pcm.adswizz.com for information about our collection and use of personal data for advertising.

The ETF Edge podcast is sponsored by InvescoQQQ, Supporting the Innovators Changing the World, Invesco Distributors, Inc. Welcome to ETF Edge, the podcast. If you're looking to learn the latest insights on all things, exchange-traded funds, you're in the right place. Every week, we're bringing you compelling interviews, thoughtful market analysis, and breaking down what it all means for investors. I'm your host, Mike Santoli, filling in for Bob Bassani. Today, on the show, we'll dig deeper beneath the surface of the bond rally,

to hone in on the bright spots for investors' portfolios in 2023. Where are the flows going and what does that tell us about investor sentiment as the market grappled with stubborn inflation and a still relatively hawkish bet? We'll also get an update on the age-old active versus passive debate with more and more actively managed ETFs coming to market in 2023. Here's my conversation with Todd Rosenbluff, head of research at VETI, Jerome Schneider, head of short and low duration portfolio strategies at Pimco and James McNerney,

portfolio manager at JPMorgan Asset Management, who runs the firm's ultra-short income ETF, ticker JPST. Jerome, let's start with you. In terms of just the backdrop here, we await yet another crucial monthly CPI number tomorrow. The market seemed to be gaining comfort with this idea of a soft landing, inflation, getting some downside momentum, and then maybe the Fed's ultimate destination. being within sight. Now we're rethinking it. Maybe the economy looks firmer. How would you characterize the outlook around those issues right now? Yeah, you know, we're going to see a lot of data

dependency still remaining in the market as well as the Federal Reserve. It's really too early to declare and wave a victory flag with regard to the soft landing. There's admittedly some issues that are going to be, you know, continuing to be evolving in terms of the inflation outlook. We still foresee at PEMCO, 3% core CPI as we end 2023, so it's still elevated beyond the FOMC's current comfort zone. But I think what it ultimately leads to investors is a bit of uncertainty leading to thinking about, more importantly, how to insulate portfolios to the uncertainty that we see both in terms of the earnings outlook, but also the volatility we see in the marketplace. Just look at what's happened over the past four weeks of trading. We've had rates rally, rates sell off. all things corresponding to the uncertain outlook between and the divergence of market views between

the market itself and the Federal Reserve. And that in of itself creates a little bit of confusion, but also opportunity. So as we seek the Fed to provide more clarity in terms of where their outlook's going to be in terms of the FOMC and the dots that we'll see later on in March, for investors right now, we have to be really looking at how to think about sectors and allocation in terms of portfolios and insulating those portfolios to the outlooks, which may not necessarily be 100% convinced that the soft landing is here at hand. That's how investors should be playing about it and thinking about it over for the next few quarters. James, I mean, how much of the macro expectations filter into your process? I mean, what do you have to assume when you're going in in terms of

looking at what makes sense to own right now? No, I mean, 100%, we have to take a look at all the macro factors, right, and look at what's driving bond yields, bond credit spreads right now. I mean, to Jerome's point, We think that there isn't a high enough likelihood priced into credit spreads in the front end of the curve right now that there is a harder landing potentially to come. And so we've seen credit spreads rip tighter here to start the year. I think that we're a little cautious on that. So at the moment, we're taking in, obviously, this idea that maybe the macro is a little leaning a little bit more towards softer landing than we had even thought to start the year. But with that being said, valuations are very tight right now and look a little too rich for us. So we're taking a little bit more of a conservative approach here.

So you're suggesting valuation's a little rich, so spreads are a little too tight to compensate you for the possibility that we do get a harder landing? Certainly, yeah. And certainly in some sectors and individual names, essentially. Todd, a broader picture in terms of the asset class right now. I mean, I was joking coming into the year that for a generation of investors, it's this massive novelty value in the fact that there's four and a half percent pretty safe yield out there in the world.

And so you've seen the money follow in that direction in terms of people trying to capture some of that. How is that playing into the, I guess, aggregate portfolio construction here? People aren't necessarily betting on lower rates to come or devish fed. They're just almost using the yield as a buffer for the rest of their portfolios. Right. So there's now income within the fixed income ETFs that are available. We had $26 billion in January alone. That's coming off of nearly $200 billion of net inflows into.

fixed income ETFs in 2022. But what we're seeing is investors are taking on yield. So we've seen higher quality investment-grade corporate bond ETFs. We've seen high yield fixed-income ETFs see inflows this year, as well as some of these safer products. So there's a mixture. Some folks are moving into a product like JPST for the relative safety, but they're also going into a product like YG, which is a high-yield bond ETF from I shares, to get a mixture of exposure, a barbell approach, some risk on, some risk off, and being able to balance their portfolio to get a ballast as opposed to what you had within just equities. People were going to equity ETFs for the dividend orientation. Now you can get income within fixed income ETFs.

Yeah, I mean, I certainly also have seen all the data about how retail investors at least seemed underinvested in fixed income coming into this period. So it's a catch-up move to, I think, grab some of that exposure perhaps. Jerome, I'm interested in drilling down a little bit more of what you're saying about this kind of two-sided risk. I mean, it seems like it could go in either direction. So either inflation remains stickier, the Fed has to be more hawkish, maybe the economy holds up better in that scenario, or all the leading indicators of a recession that we're seeing right now on display take hold and we actually have a harder landing scenario. So how do you, I guess, remain with your weight balanced on both feet to be prepared for both those

scenarios? Yeah, it is a bit of a turntable economy and investment horizon for many investors, meaning they just go round and round and are sort of looking around at the data du jour for what the outlook is. We've already seen that to start the year. I think more holistically, what investors really need to be doing is pivoting and putting portfolios in the position for maintaining some optionality. That means high liquidity and really having the option as we get more visibility, both in terms of where Federal Reserve's resolve is for fighting inflation long term versus the market conditions and more importantly, the evolving evolutionary process that we see with regard to earnings and corporate earnings specifically, that's going to be, you know, remove some clouds as we get

further along into the year. So as we sit here right now, and as you put it at the outset, you're the four and a half to five and a half percent that you're seeing in fixed income is doing two things. One, you're right, it's providing yield and income to those investors in the portfolios in terms of safety and really insulating portfolios. But it's also doing the second thing, which is providing optionality specifically to a group of investors who really haven't focused on fixed income for probably more than a decade. They're doing that through mutual funds. They're doing that obviously through ETS, as we're discussing here.

And in that resolve, we're going to see a really discussion not in terms of just interest rate exposure, but in terms of sector allocations. And that sector allocation discussion is leaning in of itself to provide that insulation to fixed income. So when we find more clarity in terms of the reconciliation of inflationary expectations, really being ultimately subdued by Federal Reserve policies ultimately, when that happens, we're going to ultimately see some healthy opportunities emerge within not only the fixed income landscape, but the broader investment market in general. James, you focus on the shorter end of the curve.

Obviously, your fund is targeted that direction. You also hear a lot of folks who suggest, even if they're generalists, that that is where the value seems to be, or at least the risk reward looks okay, right? higher yields, keep duration low, you don't really know how it's going to go. But clearly, given the fact that the yield curve is so inverted, there's a lot of money piled into the longer end because that's how you get the inversion. Is that purely mechanical money? Is it because people really are at least assigning some high probability to a recession

and therefore a doveish fed down the road? What's your interpretation of that setup? I think it's a little bit of everything we've already discussed, which is investors traditionally have been underweight fixed income now, where we have the zero bound. Now there's yield back in fixed income, and it's now going to serve as a hedge in a portfolio for downside risk. So I think that that's why we see when we break down the flows that we're seeing, we're seeing flows into higher quality, to Todd's point, longer duration products, and then credit products in the front end of the curve. Those have been the lion share of the majority

of the flows that we've seen. Obviously, the smattering of flows into EM, high yield, but the big, big flows are into higher quality, aggregate-type strategies, and then barbelling that with some high quality credit in the front end where you can get these attractive yields, you know, five to five and a half percent. And then within your slice with this fund's target area of fixed income, what are you emphasizing most right now and what are you kind of leaving aside? Yeah, so our big, you know, our number one trade right now is in bank paper and the one-year part of the curve, A-rated banks yielding five and a quarter of five and a half percent.

We like that it's a low ball play. We are lagging into some duration, though. your question before, you know, obviously investors in fixed income generally are lagging into duration. We're doing that in the front end as well. As we see sort of the light at the end of the tunnel here with regard to the Fed hiking cycle, we want to be lagging in somewhat. That being said, we're being cautious on some of the credit spreads that I mentioned before. You know, see some really high quality industrial names come with extremely tight spreads in the new issue market. To me, that starts to say, you know, maybe it's time to step back from some of those names,

concentrate on relative value in an active way in some of these cheaper names, especially in the bank paper that I mentioned before. It's interesting because those same tight spreads that you're seeing and you suggest they don't really have a lot of value in there are being used as ammunition for people saying, look, the economy can't be in such bad shape, right? You have tight triple B spreads or whatever. So I guess obviously nobody knows the future, so we're trying to read what the clues are. Yeah, no, agreed. And I think, again, you know, we're staring down the barrel of some sort of slowdown. We know that, right?

We don't know the extent to which it's going to be whether it's a harder landing or not. But to that extent, there's not a whole lot priced in with regard to downside protection there. So, you know, we'd rather stay in the new issue market where we can get spread concessions of 30 to 50 basis points, call it, and a new issue relative to secondary market paper. And then we're getting a little bit of pickup then to cushion us against the potential for spread winding on the back of a harder landing. Todd, talk a little bit about active management, actively managed ETFs within fixed income, why they seem to be in demand at the moment. I mean, I do know the kind of conceptual advantages, of course, within a vast universe like fixed income where you'd want to be able to do some credit selection.

Well, I think we're hearing it right now. You've got two of the leading fixed income ETF providers offering up some of the largest products, and they're able to balance the portfolio shifting by taking on more duration or taking on more credit or less based on the environment that they're seeing. And investors are confused. It's okay that they're confused. We've got a market that has been volatile in both 2022 and in 2023. It's not clear how fast the Fed is going to slow down and how quickly that that's going to adjust the marketplace. So they want to lean on the active managers to be able to do that. And we just now have more products that are out there.

We haven't had this number of fixed income ETF products available from some of the leading firms that are here. Also Capital Group, Morgan Stanley. These are some of the firms that were quite visible at the exchange ETF companies. conference down in Florida that we're a part of. And now advisors and investors can tap into them to leverage that for not only equity, but also their fixed income portfolios. And articulate why the ETF structure in this instance makes sense, because I think you must get that question of, you know, actively managed fixed income mutual funds. We know how they behave. What's the disadvantage or relative advantages? Well, so in general, active ETFs are

going to be less expensive than even an active mutual fund. There's just more competition. it's easier to be able to have. The liquidity is stronger. So when you're buying and selling an active ETF, you're often trading on an exchange. You're getting the benefits of that liquidity, that transparency of price, unlike with a mutual fund. And you can really tap into the overall experience of ETFs. Even though you're buying bonds, you're getting a stock-like experience through ETFs. Right. Jerome, I know that you've got some takes on this and exactly why maybe this type of approach makes sense in fixed income? Yeah, you know, I think one of the things to keep in mind, aside from all the systematic processes, is you're in an environment right now

where we've moved from a dramatic shock in interest rates, a dramatic shot in risk premium, and it's ultimately translating into understanding the macroeconomic conditions that lay before us. What the active approach ultimately does is allows you to discern between those attributes where you have visibility, where you like risk, and those that don't. And right now, we're finding a preponderance of situations where caution probably abounds ever so more slightly than taking a little more risk into the portfolios. At PEMCO, we're ultimately saying that we want to be more conservative on the corporate credit side for sure. The starting point of spreads being tight is actually one arena that we would agree on. But then broaden out to see where

the landscape where there is also safe opportunities. Look to high quality asset back securities, agency mortgages, asset classes which have not only credit spread which can produce additional income, but do so in a safe manner by offering over collateralization as well as assets underlying the actual securities as opposed to just unsecured corporate credit. And those things create differentiation within portfolios, especially if you should move into a more left-tail scenario where the economy suffers perhaps a slight recession as we move further along into 2023. But ultimately, the active approach allows you to discern these risk factors, allows you

to within the fixed-income market, find those opportunities, and evolve them. as more opportunities become clear, which we undoubtedly think is going to happen as we get later into this year and into 2024. The clarity from the Federal Reserve, more clarity from corporate earnings. Frankly, when we see liquidity conditions start to become better, perhaps, or more clear as quantitative tightening continues, these are factors which are a little bit unknown to the marketplace right now, create uncertainty for advisors and investors alike. And so the yield component of fixed income right now is something that we haven't seen for decades. And in doing so, creates opportunity not just to embrace the yield, but also earn some additional returns by

being that active approach by differentiating between places where you should be more defensive and taking opportunities where you can take a little bit more risk, but do so in a constrained safe manner. This is the exact environment where active management really, really, really holds its own. Yeah, and not to mention, I guess, James, just the practical difficulty of perfectly replicating the asset class and fixed income, just the number of securities. And I mean, if you look at the index where you're benchmarked, I assume it's pretty vast, there's constantly new issuance and things like that. Yeah, and in the front end of the curve, especially where we operate five years and shorter,

it is difficult to replicate benchmarks. So active approach is certainly paramount, not only from, you know, everything that Jerome just mentioned with regard to, you know, taking diversified risk, finding spaces where you see good relative value, but also it is difficult to replicate a benchmark. in the front end. When you think about a lot of bonds get bought and put away to maturity, and so you need that active approach in order to replicate the risk of a benchmark. All right. Makes sense, guys. Great to talk to you. Thanks so much. That's it for today. I'm Mike Santoli. Filling in for Fafasani. Thank you for listening and make

sure you tune in next week. In the meantime, you can tweet us your questions or topic ideas at ETF Edge, CNBC. InvesQQQQQQQ believes new innovations create new. opportunities become an agent of innovation Invesco QQQQ Invesco Distributors Inc.