ETF Edge - Silicon Valley Blank Blowup: Impact on Broader ETF Biz 3/13/23

Episode Date: March 13, 2023

CNBC’s Bob Pisani spoke with Dan Draper, CEO of S&P Dow Jones Indices – along with John Davi, Founder & CEO of Astoria Portfolio Advisors. While markets are still suffering in the wake of Silicon Valley Bank’s big blowup they drilled down into the impact the collapse is having on the broader banking business and regional bank ETFs – as well as what it could mean for the future of Fed rate hikes. They also broke down the results of the latest SPIVA survey and talk active versus passive with the man in charge of S&P Dow Jones Indices.In the “Markets 102” portion, Bob continued the conversation with Dan Draper from S&P Dow Jones Indices. 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 InvescoQQQQ, supporting the innovators changing the world. Investco Distributors, Inc. And welcome to ETF Edge, the podcast, if you're looking to learn the latest insights on all things, exchanged traded funds. You're in the right place. Every week we're bringing you interviews, market analysis and breaking down what it all means for investors. I'm your host, Bob Pisani. Markets are still suffering in the wake of Silicon Valley Bank's big blow-up. Today on the show, we're drilling down into the impact the collapse is having on the broader bank.

business and regional bank ETS, as well as what it could mean for the future. Bedrae Heights. Plus, we'll break down the results of the latest SPIVA survey. We'll talk about active versus passive management with the man in charge of S&T Dow Jones indices. Here's my conversation with Dan Draper. He's the CEO of S&P Dow Jones indices, along with John Davy. He's the founder and CEO of Astoria Portfolio Advisors. Dan, talk to me about a little bit about the ripple effects of the Silicon Valley Bank collapse

on the index business and on ETF markets. Well, you watch this every day. What impact this is having? Yeah, I mean, great to be here. Thank you very much. Look, in terms of the good news is markets are working. We're seeing price discovery. We're seeing even though it is higher volatility,

we're seeing risk, again, being priced efficiently. So going through the markets. So the indices are working well, particularly in equities, but we are having some impact. You're seeing Silicon Valley Bank, we announced, has left or we'll be leaving on the open on Wednesday of the S&P 500 index. also announced this morning signature bank

will also, pending a time after the close will be leaving the index as well. Yeah, and John, what I saw last week was really remarkable, the moves in the ETFs. The Spider Bank ETF, the KBE was, it's down 25% in the last three days. I mean, these are big banks.

It's rather stunning. And this is an equal-weighted index. It's targeted to the S&P bank index, right? I saw volumes on Friday. I don't think it was an all-time record. This has been around about 18 years, but it was close to an historic record, maybe some stuff in 2008, 2009. What if any trading stresses emerged from this wild week? What I saw was a lot of price drops, but the plumbing intact.

But what's your point of view? Yeah, I think what's important is that, you know, despite all the volatility, stocks get hold to the ETF continues to trade, volumes go up. People look at the ETF as a price discovery tool, so they're not. not sure where like the next regional bank stock that's halted is going to open, but people look to the ETF market to say, okay, what does the market expect the sector to do? And, you know, I think the plumbing actually time and time again always, you know, prevails and we find out the ETF is the go-to place to get liquidity and to see what the market expects. And the important thing we kept to keep, and this is an educational moment about the ETF business,

a lot of the underlying stock never trades when you're trading, for example, the KBE. You simply trade the stock itself. And while you might. have the underlying trade if you're having redemptions and creations, for the most part, that's an enormous amount of liquidity that happens trading banks, the KBE, without actually trading the underlying stocks. And that provides some kind of relief to the overall market worried about trading those individual stocks. Absolutely. Yeah. So the ETIP is a go-toe vehicle. There's so much liquidity in the secondary market that there's not even a need to kind of do a creation or redemption. So that's a good thing about ETIP. We also had huge inflows into sort of

short-term cash instruments. I've been putting up the I-Share short treasury bond, the SHV that's out there. Spider, one-to-three-month T-bill, very attractive for investors who are worried about everything from rising interest rates to further market volatility. Those are yields on those are reversing a little bit in the last few days.

But again, volume is titanic. And for everyone who says, oh, you're never going to be able to price these moments of volatility, because the underlying bonds will freeze up. Well, it just hasn't happened yet. It's not, nobody's trying to say it's not been a mess, but the plumbing works. Yeah. Yeah, I think

the naysayers need to pick a different topic, because we've seen time and time again fix on the ETFs. Liquidity goes up, even though the underlying volatility in the bond market. So, yeah. Okay, maybe you should just pivot back. The larger liquidity story, I think, is really strong. ETFs are part of, and a big driver,

but a bigger liquidity story. Think about exchange traded derivatives, futures. you know, options. The SPX options had a record trading day on Friday. People are trying to, you know, price risk. They're trying to find portfolio insurance in many ways. Yeah. I want to move on to another topic. I've got a lot of stuff, you know, we don't get Dan here that often. He's the indexing master. S&P released its annual spivot report last week. This looks at the performance, those of you don't know, of active managers against passive benchmarks. It's sort of the gold standard on how that debate goes.

On the surface, this looked like very good news for active managers. 49% of large-cap managers beat the benchmark, 51% underperform. That sounds terrible. But actually, this was the best performance since 2009 for active management overall. And yet underneath that 2022 had some very unusual tailwinds that might not be repeated, Dan. Tell us a little bit about those tailwinds. wins. The average stock outperform the S&P, but big cap tech underperform. That was a big factor. It was. So if you think about 2021 going into last year, 85% of Big Cac active managers

underperformed the S&P 500. Conditions changed a lot last year that we know. S&P 500 total return, as well as even investment grade fixed income, were both down 18% total return last year. So conditions meant correlations were high, but importantly, dispersion was high. Those are two critical variables for active managers to outperform, to take more concentrated risk in their portfolios. And you saw some of the results. The question is they still 51% underperformed. The question is, can they sustain it? Generally, active management tends to be a zero-sum game.

They need the really poor active managers to be even poorer to get that alpha. Yeah, this is a statistical point that's very important for people to understand. The average stock outperform the S&P 500, big tech underperform. And years before, big tech has been so big and powerful that when it outperforms, the rest of the market often will underperform. So you could have 100 stocks in the S&P up in a year and 400 down, and the S&P will be up because the big cap tech stocks moved. That didn't happen last year. And so statistically it's very important at what your authors pointed out was it's not quite a dartboard effect, but your chances of outperforming are very high when the average stock outperforms the S&P 500. It's not quite throwing darts at a board, but statistically, you know, they can demonstrate that your chances of outperforming are better.

That's right. You know, you use the word dispersion. Yeah. I have to define that when people, smart guys like you say that. I have to define what you're talking about. You know, I think in theory, though, dispersion, you know, should have been higher last year. So people's view on what a stock is worth versus the spot price, you know, should have been a lot wider. And it should have had more opportunity to have performed.

But I think, you know, what we find is that there's this massive, you know, influence. into ETFs, you know, U.S. large-cap index is very difficult to outperform. So you're kind of better off being in active managers in like small caps, mid-caps, international bonds. I think U.S. large-cap is just very, very difficult to have perform and, you know, and the speed report shows it. So the takeaway, and this is very important, about long-term, what's really going on here. And I use the same line for years. Ninety-one percent of large-cap managers underperform after 10 years. Now, you have many different variables, but for large-cap, after 10 years, 91 percent underperformed. That's a pretty dismal fact. And the other important point that you bring out

that I think is really one of the reasons your report is sort of the gold standard is the survivorship bias. Hedge funds like to point out, oh, I outperform 90 percent of all hedge funds, but they only take hedge funds that have been surviving 10 years. And as it turns out, a vast number of funds, mutual funds, close because they're terrible, because they underperform. And it's the number is something like 30% over a 10-year period don't survive 10 years. So you account for that survivorship by it, because if I'm trapped in that stock and it closes after 60 years, I still lost money even if it doesn't show up in some hedge fund index somewhere. That's exactly right. So you're getting the true apples-to-apples comparison through the survivorship, also making sure that, you know,

things like the largest share classes or we're not double-counting on share classes. So, and in addition to the relative performance of passive versus. is active and that outperformance, if you will, for passive. We've saved investors over $400 billion in fees over the past 26 years across the 500, 400, 600 industry, you know, product-related indices. Why don't active managers ever outperform? What's the problem? Can you summarize that?

I think they charge too much. So the more fees you pay, you know, than that detracts in return. There's not enough dispersion in, like, let's say, U.S. large cap. They don't take as much active bets, right? Like when you read sometimes what a portfolio manager owns in their large-cap, you know, active mutual funds, you know, it's like basically the same stocks as the S&P. So you have to do something different than the S&P if you want to outperform. Sounds trivial, but, you know, that's just something that they don't do. This is why Kathy Wood's so famous.

I mean, she's sort of the anti-S&P. She's a fund manager that took bets outside the norm. She became famous. She briefly was enormous performance and struggled. Look, you have some incredibly smart, talented people competing with each other, you know, Kathy's, you know, and dogs every day. Yeah, well that's the key point. There's no competitive advantage. I mean, 50 years ago, you had less information dispersion. A few people might have been able to outperform and do a little bit better than the rest of the crowd. But it's, you know, people ask me,

why are the fund manager so stupid? They're not stupid. Actually, it's the opposite problem. They're really smart. They're all really smart. And when you have a room full of 99% geniuses, it's going to be hard to outperform on that test. And that's why they keep referring to. I find it annoying, but retail is dumb money because they're often not as well-informed as the professional investor. And there's few of that around, few retail traders that are actually around these days. On Friday, Dan, I want to go back to indexing. The S&P is going to see a rebounds in its sectors.

And I'll make this simple. There's two major ones. There's a number of things that are happening here. But Target, dollar general, and dollar tree are going to move from consumer discretionary to consumer staples. So we're going to see consumer staples get bigger and discretionary get a little smaller. And then Visa, MasterCard, PayPal, and a few others are going to move from technology to financials. So technology is going to get a little smaller. And financials are going to get a little bigger.

This is the annual change, what we call the GICS CLICS, classification system. I love saying GICS. Explain it. General index classification system. You're right. So this was something that S&P Dow Jones Endices in partnership with MSCI really started 1999, and it had, I think, a big impact on helping standardize and the growth of passive investing. And really, especially in global equities, giving them this classification system. So this is a formal process. We go through open public consultations to get feedback from all market participants. but the key is making sure these indices are relevant. Are they reflecting changes in consumer demand,

or are they changes in the marketplace structure and getting open consultations to make sure this system remains relevant? Well, I like to say these reflect common sense changes. For example, I got asked for years, why is Walmart a consumer staples, and Target is a consumer discretionary? And I'd say, I don't know.

Ask S-C-MPIP. They are, it seems to me. And now they're sort of recognizing that. I don't think Visa is a technology, I think visas of financial stock. I mean, common sense would say, yes, but, you know, they're finally recognizing that. Well, if you think over time, I'm sorry to interrupt us. I think the retail is a great example that, you know, previously before internet shopping in many ways, you thought about how retailers distribute, and maybe that is a criteria. Today's world, the distribution matters less.

What do they sell? What are the products? And I think taking that type of input to ensure that an industry group is defined the right way is important. Yeah. And you've made other big changes. I mean, when you took REITs out and created a whole 11th sector there, that was a common sense thing. Reets are, you know, real estate's a separate category to be from financials. You know, John, when we used to do this 30 years ago, this was sort of a nice academic discussion, but now there's a lot of money. Yeah. And this is why I keep bringing this up. I always like to say, you know, you supervise the biggest, you know, fund management company in the world, essentially because so much is indexed, so much money is indexed.

Let me, we're not. We're not a fiduciary. I understand that. I understand that. I understand that. But you're, what you guys determine in the S&P and in the Dow Jones Industrial average, there's real money to it now. 30 years ago, we were a bunch of academics talking about this.

But I think the crucial thing is it's that you break a good point because the independence of what we do to have standards, to have benchmarks and these indices, not only for passive, but for active, to do performance attribution, risk attribution. That's why to have this separation with a fiduciary like John, that is crucial because trust is what builds the markets. And having independent benchmarks, transparent benchmarks is crucial. Seven trillion index to the S&P 500. And that's only the guys who pay you. We don't even know, I haven't seen a number of how many, you know, I call them closet indexers, guys who, you know, benchmarked to the S&P 500 but won't pay you for a licensing fee.

I don't even know how big that is, but it's probably as big as the $7 trillion. $7 trillion is what, $18, 19, 20% of the S&P's value. And that's why it's hard to beat the S&P. Well, there you go. There's so much money tracking it and you don't have it. So what's the implication for investors? I often say index providers are the biggest fund managers in the world. I know you get antsy about that, but you understand my point.

What's the implication? I think if you're trading like XLP, XLY, you know, XLK, XLF, you have to understand now that there's different stocks that are going to be put into these ETFs. So you need to be mindful of your risk. So again, you always always. use a portfolio construction tool, look under the hood, see what the aggregated risk is before and after. So these are good changes. You know, and your firm consults, you know, a lot of independent people. We've been asked to participate. So, you know, they make a lot of sense

to me. But unless you're trading like sector products, I think, you know, for the most part, if you just buying VTI, VO, IVV, you know, generally speaking, you're not going to have much to worry about. Yeah, those are S&P 500 indexes that are out there. I get this asked every time from every time there's a change in the S&P 500, somebody, a half a dozen people index me and say, how does this committee work that the S&P 500 has? You are the CEO of indexing. So you're not on the committees to make these determinations.

There's an S&P 500 committee, determine what goes in and out. They meet, you're not on the committee. There's a Dow Jones Industrial Committee. They meet, you're not on that committee. Correct. You all know that. He's not on the committee. With all of that said, explain how, for example, the S&P 500 people, how often does it work, how many people are in it and what?

Well, again, I think this is the crucial thing is if you think of what we're trying to accomplish is to create, again, these independent transparent benchmarks, not managing money. That's crucial because for those who do and their fund boards and other fiduciaries dependent on, they need some level of true independence to prove their performance and in risk attribution. But for us, we keep an independent process. we again have public consultations from all market participants that will go into that committee all the methodologies are published online you can go right now in terms of online once public information becomes available it'll come to me the same time it does to you or anyone else in the marketplace now do you first of how often do the the s&p 500 committee i know there's dozens of these committees how many how often does that mean well it depends like something like

friday they had to make a decision they will meet ad hoc and their formal meetings as well but as appropriate for them to make decisions. And how many people are on the committee? That a dozen or 15? We don't really disclose that type of... And you don't disclose who's on it as well, right? The methodologies, the changes, all of that is public information. And some of it can be market sensitive.

So that's where the independence and the separation of our analytical and commercial activities are very well documented in making sure that we keep market trust and respect. But the size of the committee and the people are on the committee is not publicly... No, we don't make that. It's broader employee information we don't disclose as a company. as a company. Yeah. And so the committee will meet. They'll come out and make a decision, let's just say about a new stock going in the S&P 500. They report to you, right? I'm the CEO responsible for the business. But in terms of their mandate, again,

which is defined, publicly disclosed on their methodologies, what have you on the website, they will be able to act, and then they have a responsibility to publicly disclose any potential changes on that through our process. And is there any public input? I mean, do they go around, is there any way for the public to say, you know, let's, I think XYZ shocks should be in the S&P 500. I mean, people think, and it's convenient to say the S&P is the 500 largest companies in the United States, and it usually is, but there were instances, Tesla, for example, where it wasn't yet in there, and it was one of the biggest ones. So it's a... I think we talked about earlier, like I said, the Gick exchanges. This was all the results of public consultation. So for us,

monitoring going to the public getting John's feedback as well as anyone in the marketplace to provide so are there within the methodology say we'd like input or how is that absolutely there will be a request of public press release asking for our consultations a date and time will be presented for that kind of discussion okay john you like this process is it this seems to be the process that works the most the world

has gone to indexing and it's gone to indexing because exactly what we just talked about the inability of active management to outperform in the high cost of that. This is a logical response, but it, it, they now have become very powerful. Yeah, I mean, I think Tesla was the kind of behemoth, right? Because it wasn't added. I mean, you have to have four quarters of net positive earnings in order to be included into any S&P index. And I think that was a, you know, something that hung up on Tesla a lot. But the more quantitative and systematic the index is, I think the better for everyone, so that there's no surprises.

Okay. I think we'll give it to emphasize, any marketplace, whether it's equity or financial, depends on Buyers and sellers feel that that's where having these standards, this independent away from being a fiduciary, not biased by managing money or having that fiduciary responsibility. It's crucial. Having independent data, benchmarks, and ultimately indices, that's what gives people kind of the independent trust to be able to transact effectively. Now it's time to round out the conversation with some analysis and perspective to help you better understand EPS. This is the market's 102 portion of the podcast. We'll be continuing the conversation with Dan Draper. MSNP Dow Jones indices.

Dan, thanks for staying by with us. You know, one thing that always amazes me is the astonishing growth of indexing in ETFs in general. I've said several times $7 trillion indexed to the S&P 500 directly. That's 18% of the S&P's value. It grows every year. ETF's a $7 trillion business now grows every year. It growed last year.

Bonds down, stocks down. ETF still assets under management goes up. The index haters, the ETF haters, have now switched their arguments from saying, well, the ETAF business won't work because if there's volatility, you won't be able to trade the underlying stocks or the underlying bonds. They don't make that argument so much anymore. They'll have a new argument. The new argument is passive investing, index investing, has gotten so big

that it's going to make the market less liquid or in some way not as efficient. They use a word efficiency. Is there any truth at all to that? As S&P studied this? Is this a concern? We have looked at this, and I think maybe defining efficiency in what you look at. Today, in terms of assets under management,

passive investing is roughly somewhere between 25 and 30 percent of total. So it's still a minority. But importantly, when I think efficiency, a lot of ways you think about price discovery, what impact is it having on prices and the marketplace for people to transact? And if you actually look, even with, say, you know, up to 30% of the assets under management, the actual daily trading volume related to

passive strategies is still less than 10%. So if you really think about it, for active managers who are still making up over 90% of the trading and, if you will, active price discovery of individual stocks and bonds, really for passive to even approach 50%, to be half of that impact, the AU would have to grow over 80%. We estimated S&P about 83% at today's levels to really have that impact. So we are miles and miles away from having that impact on price discovery. So you're making a very important distinction between investing levels with about 30% to passive and the actual daily trading patterns where passive investors are still only, as you said, about 10%. If you think about active managers trying to outperform an index and on a relative

basis outperform their peer group, they're having to take bigger, more concentrated, in many cases, higher risk bets. So that generally means there's higher turnover. more trading of individual securities, which can then influence the price. Whereas passive, for the most part, is a price taker. We reflect the broader market perspective. I want to ask you about market capitalization versus other ways of looking at index. I've grown up with market capitalization. The S&P 500 is sort of the benchmark for everything.

The Dow Jones is a price-weighted index, but I've grown up with market capitalization, and most of the ETF business is indexed with market capitalization. And yet, in the last few years, I've become a little more cognizant of alternative ways to weight the market, particularly equal weight indexes. S&P has an equal weight index. And there are some compelling reasons, particularly last year, where we saw the average stock outperforming the S&P 500 because tech stocks, which have such a big weighting, underperform. Has S&P studied any of this?

Is there any recommendations you can make? We have. Well, it's interesting you mentioned, because if you actually look back with the New York Stock Exchange now, The first attempted indices back in the 1970s were equal weighted. But the problem was back then you had dollar, fixed dollar commissions. You had high trading costs. The costs of constructing and rebalancing these indices were ridiculous. So as we would say in the industry, the tracking error of actually tracking that industry was so high,

you had no alternative but to move to market capitalization weighted. What do we see decades later? There are no commissions. Fractional shares. A lot of the market frictions have really left. So when you look at something you mentioned like the S&P 500, absolutely the original, if you will, market cap weighted version still really dominates incredible price discovery, the most liquid equity security in the world in terms of an

ETF wrapper. But then you can also see that liquidity now to do equal weight. It's changed. You can actually do it very efficiently, the hedging for that within an S&P 500. So you can get those characteristics, maybe a bit more of the value, a bit more of the, the mid-cap, if you will, characteristics, I shouldn't say mid-cap, it's still large-cap, but the smaller capitalization waiting there. So it gives you a different risk-return profile, you know, in terms of the index itself. So it's a very nice complement that we offer alongside the main S&P 500.

Well, there's a good example of technological efficiency. It's just gotten better and easier to calculate these indexes. You know, I can't imagine. I know the origins of S&P go back to 1926 when the combination of standard and PORS was created. And the modern S&P, you know, the modern S&P goes back to 1957, I can't imagine prior to computers, even in 1957, when the modern S&P came in, what it was like calculating the S&P on a daily basis? I mean, you'd have people with slide rules sitting there. I mean, literally, I actually have never read a historical account of this. And I can't speak to 1926, but yes, you're right, a lot of manual processes.

But that's really, I think, what our job is, you know, within the broader global capital markets is to bring this historical, you know, data presence, but the independence. How can we provide the pricing, but also the transparency through these long-term market cycles? How can we kind of bring to help investors globally, our clients, who are the asset managers, the fiduciaries, really, you know, be able to look at markets and economies over long periods of time? So where do we go from here? You're in charge of indexes. You've got to be in charge of growing the business a little bit. What's new and exciting in the index world? Where do you see it heading in the next few years.

Yeah, what's happening now is as many investors we have are now looking, and we can see in today's volatile market, people need diversification. And diversification can take many forms, but one we're seeing is multi-asset. So now being able to look at equities, fixed income, and even commodities. As you know, we have the GSC Index as well. So how can they build better portfolios for their clients and having all of those in an efficient way? and particularly certain client channels for us, like insurance.

Insurance has been historically a very active area. They're increasingly moving passive, but they want to do it with these multiple asset classes. Dan Draper, thanks very much for joining us. Dan Draper is the CEO of S&P Dow Jones indices. He's the manned that people report to for the S&P 500 committee and the Dow Jones Industrial Label. And no, he is not on those committees.

Please stop writing to me. Thank you, everybody, for listening to the EPSA podcast. Invesco QQ believes new innovations create new opportunities. Become an agent of innovation. Invesco QQQ, Invesco Distributors, Inc.