ETF Edge - Low-volatility ETFs & Chinese Stocks

Episode Date: May 27, 2020

CNBC’s Bob Pisani spoke with Douglas Yones, head of exchange-traded products at the New York Stock Exchange, Salvatore Bruno, chief investment officer at IndexIQ, and Todd Rosenbluth, senior director of ETF and mutual fund research at CFRA Research. They discussed what Chinese stock delistings could mean for emerging-market funds and low-volatility ETF’s rebalancing. In the 'Markets 102' section, Bob discusses the growing dominance of ETFs. Hosted by Simplecast, an AdsWizz company. See pcm.adswizz.com for information about our collection and use of personal data for advertising.

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 and market analysis and breaking down what it all means for investors. I'm your host, Bob Pisani. So let's get right into it. Today on the show, we cover a range of topics from the state of the industry and the impact of delisting certain Chinese companies from U.S. exchanges to what the new normal looks like for so-called low volatility. Turns out a lot of those low volatility stocks aren't so low volatility. Here's my conversation with Todd Rosenbluth from CFRA Research,

Sal Bruno, the CIO of Index IQ, and Doug Yonis. He's the head of exchange traded products at the New York Stock Exchange. Gentlemen, thanks very much for joining us. Doug, I want to start with you. I wonder if you could update us on the state of the ETF business. You do a quarterly report on the ETF business. This only goes through the first quarter of this year through March. But some impressive numbers. We still have 2,300 ETFs in the United States. I'm quoting from Doug's report, folks. Assets under management, $3.7 billion. We're close to $4 billion. Doug, give us a little update on where we're at. I know there's been a little bit fewer ETFs in the last few months. Some funds have closed, but overall, I still see on that continued inflows and continue high interest in ETFs.

Yeah, it's been a very active market, Bob, and I don't just mean volatility. With respect to new products launching, we've had 87 ETFs launch year-to-date. Net cash flow for the year, close to $188 billion in ETF. So even with the significant market swings, it's been a positive year. New asset managers entering the space, which BNY Mellon is a new asset manager. We're expecting Alianz to enter in the next few weeks. So with over $4 trillion right now sitting in the U.S. ETF market, there's still a lot of greenfield opportunity for new managers to come in. And regardless of a volatile market,

the reality is that ETFs have performed exceedingly well. In fact, they've brought in net cash flow every single month. So even in the midst of the sell-off in March, we saw equity ETFs bring in probably about close to $18 billion that month. So ETF investors certainly wholehearty and certainly still active regardless of market conditions. And this is why we continue to see new entrance into the market, like B&Y Mellon and Alianz. People a couple years ago said, oh, everything's been invented. It's like physics 100 years ago. We've invented everything.

What else can you do? And it turns out, even if you have a product that's essentially the same thing, Schwab proved this very definitively, I think, a few years ago. They have an active base of investors in their own camp. Why let somebody like a Vanguard or an I shares capture that when you can essentially do the same thing? so I certainly think, Doug, it's very smart. I wonder if you could update us on this whole ant product, active, non-transparent ETFs.

This was a hot thing in the beginning of the year. And even though a few firms have started doing it, creating ETFs that are actively managed parallels to their mutual funds, I don't think it's caught on in any big way. Can you give us 20 or 30 seconds and where we're at on that because it was a hot topic a few months ago?

Yeah, and I know we're pretty early in 2020, but I will say this could be the year of active. And what I mean by that, over half of the ETF launches year-to-date have been actively managed ETS. Now, the reality is the majority of those products are still showing their holdings every day. As you mentioned, though, we have two products year-to-date that have launched in this semi-transparent structure. They do a quarterly holdings release, and about half of the models are now approved. So active managers that are thinking about coming to the space but don't want to show their holdings every day,

we're really engaged now with a lot of conversation about bringing those products to market. The reality is active is performing. We're seeing net cash flow into those products, even just looking year over year at actively managed ETFs, about a 36% increase in assets under management. So for those investors that are looking for an active structure, they do seem to want to access that in an ETF wrapper. And for the issuer of active management, the ETF wrapper offers a lot of benefits. they tend to be lower cost and they offer global distribution. So there's a lot of reasons on both sides of the fence why an active manager or investors want to be involved with an ETF wrapper.

Okay, Todd and Sal, let me bring you two in on this. Just a quick comment from you. I know, Todd, you're a very active observer of this whole space. We're approaching the half-year market. What's amazing to me is despite all of the volatility, number one, ETF products have held up very well. Yes, we had a very specific issue. around the oil, ETF that had to do with the fact that you're owning futures products.

And this is a very separate part of the whole ETP space. I want to separate that a little out. I'm talking about the equity products out there, even the leverage and inverse ETFs. What struck me is they all held up remarkably well. And I wonder if you could quickly comment on that and what it tells us. Secondly, on the corporate bond space, tremendous stress in that area. We did have some differences in the net asset values there and the prices of the ETFs.

But even here, it seems like the ETFs are on the right side of things. Just give us a brief overview of where we're at here, Todd. Yeah, Bob, so what we've seen is that investors actually flock to ETFs during the market volatility that we covered earlier. Doug talked about at the end of the first quarter. And we've actually seen money flowing back in to fixed income ETF. They've actually been the more popular product where we've seen outflows in the past month to S&P 500 index-based products like Spy, IvyV, and VU.

It's rare to see those three EPS together see outflows when the market's been up. But it's been high yield. It's been investment-grade products that held up exactly as they should have during the market volatility. And now with the Federal Reserve looking to get into this space or actually having EPS to get stability, we've seen investors going into that. Real quickly, if I could, we're seeing active EPS actually in the transport. In the second quarter that Doug talked about, so JPMorgan entered with active equity ETFs about a week ago when we seen smaller firms like TrueMark actively managed ESG products.

So we are starting to see firms, including Sal's firm, that are offering actively managed ETS. Sal, did you want to step in here? Yeah, I was going to just jump through with a quick point. I think it's interesting that ETS have taken in assets when we've seen flow and a lot of trading volume, it's easy to remember because things like time is just going amazingly quickly, but it's only been eight or nine months ago that we go back to October, and we actually saw, you know, all the TD Ameritrade, Schwab, E-Trade and others dropped trading commission

down to zero. And I think that was actually a really interesting development that we lose sight of. So for investors in this point in time in the market and seeing the volatility and trying to react nimbly, you removed all the transaction costs. Of course, it saw the bid after spread in market impact potentially, but in terms of hard cause, those went away. So I think it enabled investors to move even more quickly throughout the more volatile times into and out of ETS, and then they're trying to trade, you know, equities and trying to position themselves well. So that's kind of an interesting observation of point. Did you, do you think that it, the fact that we went to zero commissions on stock trading and many ETFs encouraged more active trading?

I think it not necessarily encouraged it, but enabled it. And I think investors were looking in this volatile period where you saw, you know, stocks fall from the February highs right around President's Day to late March where they bought them that came back. I think people who were looking to be nimble found that they did not have to worry about transaction costs as an impediment. So I wouldn't say it encouraged it, but it definitely enabled it. Doug, what do you think of this? The, you know, the reality is individual investors, hedge funds, all the way through institutions and insurance companies, when the markets were swinging

so volatile, right, day over day, we were seeing them really engage with ETS. And, you know, the fixed income was a very good spot to really highlight because we've had over $55 billion in net cash flow in fixed income ETS year to date. But we saw ETS trade the way the fixed income markets were trading. When there was a sell-off in fixed income, we saw sell-offs in ETS. And those ETS provided a bit a buffer for the underlying securities. And I think that's one of the pieces that the market gurus get into, but individual investors, if you want to tap into, let's say, high yield bonds or muni bonds, it can be very difficult in times of stress to trade the underlying bond.

Yet individual investors on some of those platforms with zero commissions had the ability to go in and trade, whether it be they wanted to own more exposure or reduce their exposure. They could do so through ETS with zero commission at a time when the underlying bonds were struggling to trade. Yeah, I think the whole thing that happened with the bonds, with the LQD trading at, you know, at times, premium times of discount to net S values, exonerated ETFs. We saw this with Chinese ETFs earlier in the year when the China market was closed. And the ETFs here, the United States, traded perfectly well and very accurately reflected ultimately where the pricing was going. So I'm hopeful that this will accelerate electronic trading of bonds or whatever we can do to get quicker, more accurate bond prices because the ETFs, excuse me, the ETFs, the corporate bond ETFs certainly were able to figure that out.

I want to move on here because we can get into this discussion for a long time. Todd, maybe you can comment on this. The U.S. Senate passed the bill this week that would result, could potentially result in the delisting of certain Chinese securities from U.S. exchanges. It seems to me that's going to have a very big impact on a lot of emerging market ETFs, of course. We talk about EEM, which is the main one. That's 30% China. But VWO, IWMG, big global funds that are out there where China's heavily represented.

Todd, any thoughts on this? Here we have politics sort of intruding politics and global issues intruding on the entire global structure of ETFs and indexing. frankly. So what we find is that China is roughly 40% of most diversified emerging market ETFs. You mentioned the IEMG, VWO, EEM. State Street has a product, which is SPEM. The weighting in China is roughly about the same.

But most people tend to think of companies like 10 cents or China Construction Bank or China Telecom, which are domiciled and traded in either China or in Hong Kong. but what is easily lost, I think, on many investors is that Alibaba and JD.com, among others, trade on the New York Stock Exchange or the NASDAQ. So these are those companies that could be impacted. If they're delisted, obviously, they would no longer trade here. They would no longer be in the index. So it's important to make sure investors look inside and know what their exposure to China is

in their emerging market, EPS, as well as where they're getting that exposure. they can, of course, also find some smaller ETS like FRDM that actually has no Chinese exposure due to the freedom waiting that's used for that ETF. Yeah. Doug, any thoughts on this? Obviously, there's also the political overlays around this. You know, my attitude is if you are, we all know about the problems associated with China. We all know about the problems with the auditing of Chinese firms and how difficult it is. We all have a feeling, I think, that there are times when the Chinese firms are not forthcoming

adequately for U.S. investors. We've seen numerous problems associated with this. And yet, it's one thing that you already know all this. It's like you're a qualified investor. You know that there are risks going in for China, but you want a globally diversified portfolio. I don't know. What's the right way to look at this? Doug, any particular thoughts on this?

I think it's important we all take a step back and think about the overall global markets, right? I think we'd all agree America has the greatest capital markets, the most liquid. And so at any kind of regulation, we always want to be sure that we're balancing both investor protections alongside investor choice. And when we think about the Chinese companies from an ETF perspective, as mentioned, right, there are quite a few ETFs that cover the Chinese companies, but it doesn't always necessarily state where that company has to list. So the net impact on ETFs could be a bit muted. And what I mean by that is, let's say a company was currently listed in the United States. If it were to move to another market, it might just stay at the same weighting, same percentage

and within that ETF. And the ETAF is now just buying and selling the Chinese company on another market. And so the net impact to ETS, I think, could potentially be muted. But the net impact to the overall global capital markets, I think that's real. And something that we want to make sure we're weighing and balancing before we make make any major changes. Go ahead. Go ahead.

I think it's interesting to look at this as a capital market issue. I think it's actually more of a political issue because as you mentioned, nothing is really new. We all know about the Chinese accounting issues and their lack of transparency sometimes and the audit issues. But it's coming up now during a time period where we're seeing increased tension, potentially between the U.S. and China. And to me, this is just kind of one of the bricks in the wall there. And so we're looking at, obviously, we had trade weighing on it in 2019.

We have the coronavirus and the political ramifications that are going on. And just today we had the U.S. State Department basically saying that Hong Kong is basically no longer autonomous from China. So I think it really, we have to look at this in a larger picture and what it means, not just for ETS, but I think it's a political bargaining chip, if you will, between the administration and how they approach China. Yeah, good point. I just want to move on and hit a couple of other topics. And Todd, you were mentioning Know What You Own. You're on that theme all of the time. I just want to highlight what happened to the low volatility ETF. You know, these ETFs, they rebalance regularly, many of them quarterly. Low volatility was very popular in the last year and a half.

It rebalanced this recently. Now you think low volatility, you think like, oh, that's got to be utilities, right? Or REITs or something like that, or Procter & Gamble or Consumer St. And well, it was. It turns out they rebalanced and they got rid of most of the utilities. And now they own Amazon and they own eBay. And it sold the utility. The con ed, it sold Con Ed. And McDonald's used to be low volatility. Apparently it's not anymore. And Todd, I found this very amusing because this is a little straight to your point here. So reeds and utilities, it turns out they weren't so low volatility back in March and April. When the rebalancing

came in, they threw out a bunch of them. And low volatility is now more associated with with health care, essentially, and some of the consumer staples names. Todd, I guess this makes sense. I don't know why we think if Amazon is low volatility now, but... Well, Amazon held up better than the broader market, I guess, is the takeaway, and the fact that people are using it more than they ever did beforehand, given that we're staying at home. But you're right. So this used to be...

SPLV used to be considered a real estate and a utility heavily weighted... product, and it rotated away from those. Those stocks did not hold up during the most recent quarter as part of the rebalance, and the stocks that held up much better were primarily in consumer staples and health care. So still defensive sectors. We've just seen a rotation from two defensive sectors to another two defensive sectors. What also caught my eye is this ETF now actually has more exposure to technology stock. It's now 9% of the ETF than real estate and utilities combined.

SPLV has always been underweighted towards the growthier sectors like technology, unlike USMV, which is ISHAER's minimum volatility. ETIF, IShares uses more of a sector-constrained approach. So 20% is normal to find within USMV to the technology sector, and under 10% is common to find within those defensive sectors. So these ETFs rebalance, it's important if you own them to make sure you look inside and use third-party research to be able to help you validate that. Yeah, I guess what, Todd, what's the conclusion here?

In a high volatility environment, low volatility doesn't necessarily outperform. I mean, what is the conclusion we could have here? Presumably people own low volatility because they make an association. If the market gets crazy, these stocks will move less. And it turns out this assumption is wrong. I'm trying to figure out what's the teaching lesson here from this. Well, I think the teaching lesson is that if you're buying a smart-bated ETF, don't just buy it and hold it and forget about it. But make sure you understand.

So it's now owning what are the most recently low-volatility stock. So it's actually doing what you'd want it to do. It's rotating away from what had been previously low-volved, but then spite the bit. But after the fact it's doing it, you almost want actively manage low volatility on a daily basis to figure this out. I mean, my point is people bought this thing or used to buy it because they're not. They thought low volatility would outperform in a high volatility environment, and that did not happen here. So it sort of makes you challenge your assumptions about what you own some of these things for.

They don't work the way you actually think they may necessarily work, maybe because the assumptions were wrong. Like the idea that utilities would always be low volatility, turns out that to be true. You see? So I don't know. Go ahead, Sam. Because we're looking at it through the prism of the equity market. and the way that a lot of these low-voluntary equity markets are looking at historical volatility.

And you're right, they're not necessarily predictive of future volatility. You know, we've worked with S&P to create an index and an ETF that actually applies a similar concept to the high-yield corporate bond market, which in some ways has parallels to the equity market, but it actually uses forward-looking information like option-adjusted spreads and duration. And when we find there it actually does really well during periods of volatility, heightened volatility. Some of it is from security collection, but a big piece of it is actually coming from the sector selection. And we've done research looking back over 20 years. And we found that it's a consistent theme. So going back to the early 2000, media and telecom companies were actually underweight as we had the TMT crisis.

Orders and financials are a great financial crisis. More recently, it's been underweight things like energy and financials and overweight health care and consumer staples. communication services. So it is a little bit more forward-looking. And maybe there are clues that you can take out of the high-yield corporate bond market that maybe you could actually apply to equity. We can invest directly in the high-yield corporate bonds as a way to potentially advance in-volatility. Now it's time to round out the conversation with some in-depth analysis and perspective to help you better understand ETFs and put them in the context of today's markets. This is our Markets 102 portion of the podcast. Today we'll be discussing the growing dominance of

ETFs and key mechanisms behind them. I'll be joined by my producer, Kirsten Chang. Bob, probably the top question we get from investors, ETFs versus mutual funds. What are the most crucial differences between them? Well, actually, there's a lot of similarities. I mean, both of them hold portfolios or stocks or bonds or commodities. And basically, they've got it adhere to the same regulations about what they can own and how much can be concentrated in the size of the holdings and things like that.

But there are a couple of big differences. First off, the most important thing about it is. about ETFs is that you can buy and sell during the trading day. You can't do that with mutual funds. So the information, essentially, the reason I like that is it gets updated with ETFs a lot faster than mutual funds. They price at the end of the day and don't trade during the day. And if you have something like a country like China where the stocks are closed, the ETFs that trade in the United States can keep trading even with the underlying stocks closed. You might say, how does that happen? But that's the magic of the crowds. The crowds try to figure out where it's

going to go and they've proven to be uncannily accurate. So ETS can sort of reflect a new market reality, I think faster the mutual funds can. So that's the first thing. You can buy and sell during the day. But secondly, it's important to know the ETSs are typically cheaper because they tend to track indexes. And those indexes tend to have lower costs. So in the long run, investors save money. ETFs are considered more tax-efficient. Why is that? What are the key tax advantages there?

Well, they are more tax-efficient. And the reason that happens, if you think about it, investors in ETFs and mutual funds, they're taxed each year based on the gains and the losses that are incurred with the portfolios. But remember, mutual funds, often the manager will trade the stocks in the fund. That creates taxable events.

ETFs don't really have that. ETFs engage in less internal trading. So it's the market makers create and redeem the ETF shares, and it doesn't create any real taxable event for the ETF holder. Now, mutual funds generate these trading that results in taxable gains that's passed on the ETF holder eventually. So you do get taxed, for example, on capital gains for both ETFs and mutual funds. So if you go to sell your mutual fund or ETF after owning it,

you'll get taxed on a capital gains. But that happens only when you actually sell. You don't get these distributions for ETFs that you get for mutual funds that happened because the mutual fund manager is trading the stocks for you. That's the important thing. So the bottom line is you get low costs and you get ease of access

and you get an emphasis on index tracking that makes things cheaper. And the overall setup is just more, That's it for today. I'm Bob Bizani. Thank you for listening. And make sure you tune in next week. And in the meantime, you can tweet us your questions or topic ideas at ETF Edge, CNBC.