ETF Edge - Single-Bond ETFs: Mad Dash for Yields 10/17/22

Episode Date: October 17, 2022

CNBC’s Bob Pisani spoke with Alex Morris, President and CIO of F-M Investments, and John Davi, founder and CIO of Astoria Portfolio Advisors. They took a closer look at the ripple effects of Europe���s energy crisis and fluctuating demand in China. They discussed the advent of single-bond ETFs. As investors clamor for heftier yields and move from thinking “there is no alternative” to “there are reasonable alternatives,” more and more market participants are clamoring for exposure to targeted Treasuries like the 2-year Treasury note. Turns out, there’s an ETF for that! In the Markets ‘102’ portion of the podcast, Bob continues the conversation with John Davi from Astoria Portfolio Advisors. Hosted by Simplecast, an AdsWizz company. See https://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. 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're in the right place, my friend. Every week we're bringing you interviews, market analysis, and breaking down what it means for investors. I'm your host, Bob Pisani. Today on the show, we're talking about a new phenomenon, single bond ETFs. You heard of single stock ETS, but does it's an investor?

investors clamor for heftier yields and we move from thinking there's no alternative to stocks to there are reasonable alternatives to stocks more and more market participants are clamoring for exposure to targeted treasuries like the two-year treasury though for example turns out there's an etf for that here's my conversation with alex morris the president and cio of fm investments and john davy founder and cio of astoria portfolio advisors Alex uh we've talked about single stock ETFs on this show for a long time that test a long and short ETF, for example. Single bond ETFs are really new. You've got a 10-year, a two-year, a three-month that launched in August. Tell us, for example, about the two-year. Tell us how this whole thing works.

What are you getting when you buy this? Sure. So you're getting access to the U.S. Treasury on the run two-year. It's cash bond. There's no leverage. There's no derivatives. It's quite different than a single-stock ETF. In that sense, it's simpler. It's easier. You get access to what you would buy if you were to go and purchase an ETF, sorry, a two-year treasury on its own. So every month, and you see the notes here, there is a new auction of two-year notes that happens every month. We know that. And you sell the old one, and you buy the new one, right?

So you always have the most recent auction. Correct. Now, this is not free. You charge 15 basis points for this, so you don't necessarily, you're not actually going to get the exact number when the fees are deducted. But taxable events. No taxable events. Right. And that's because of the magic of ETS, right?

Because the market maker actually is the one that does the trading and there's no taxable event. Exactly. Explain that to people. So when you roll the Treasury from, say, last months to this month, if there's a negative event, you know, we would just make a trade. But if there's a positive capital gain, we'll go out and we'll work with the market maker to eliminate that. And since we're going to roll it 12 times a year, we know that's coming, which is good news for us, because we can plan with the market makers to get really good pricing when that happens. so you're not worried about are we a good trader?

You're worried more about are we planning appropriately? And the answer is given the regularity of the auctions, we can do that. And to date, we've done trading at the NAV itself. So the fund hasn't paid for liquidity. The shareholders haven't paid for that liquidity. They've not experienced a taxable event as a result. Yeah, so John, we've got single-stock ETFs. Now we have these single-bond ETFs.

You're an investment advisor. That's why we have you here. Is there room for these kinds of investments? I mean, where would they fit in, for example, as an investment advisor? Is there circumstances under which you would recommend them, or would you just say, yeah, just go to the Treasury Direct and buy them? Try to tell us how you use these. Sure.

So, in full disclosure, we've been buying it direct from the Treasury Direct, so at our custodians. You know, maybe we should look at Alex's funds. But, you know, for me, as a multi-accent investor that's allocating across stocks, bonds, commodities, alternatives, you know, for me, like the game has changed now that, you know, Fed funds at 3, on its way to four, the two years is at, you know, 4.3%. I think stocks have competition. So what we've been telling our advisors, our clients, is like, look, you know, you don't have to be long just stocks at this point.

You should be clipping coupons vis-a-vis, you know, the two-year treasurer. I think that's a sweet spot. We've been going, you know, direct to the government, but, you know, perhaps we should be looking at Alex's product. They seem to make a lot of sense that they do the role for you. So effectively, I'm just outsourcing my role to Alex's firm, which we're not opposed to. There's a cost, like you said, 15 basis points. But conceptually, the idea that you want to own treasuries, I think makes a lot of sense.

Yeah. So you were mentioning stocks, bonds, commodities. Diversification is the key here. Here you're only owning a very specific product within the bond universe. So obviously, generally, being a Jack Bogle disciple, you want diversification too as well. You don't want everybody just throwing their money to a two-year note, for example. Yeah. And we've been laddering bonds across not only treasuries, but, you know,

municipal and corporates. So we've been using some of these Bullshare products, BSCO, BSMO. So those are for, you know, corporates, and they're from munis, and that's the 2024 maturity. So I agree with you, Bob, you know, own not just treasuries, but also other, you know, fixed income securities. Right. So, I know I'm sort of, this is an educational moment to explain to people, why own a single

bond ETFs versus, say, going on Treasury direct, which is the way. website and buying just a two-year bond, for example. What's the difference and what advantages do you have? Sure. So I encourage folks to try it. I mean, the Treasury Direct is access to the government. It's the real deal. But it's somewhat complicated. Bond math is hard. It's the part of finance. Most folks prefer to forget or never have done in the first place. The cash flows are messy, getting a 1099 with all of the action of accretion and coupon payments is sometimes off-putting. It's much easier to buy the ETF. And since we give you direct access, it's essentially the same proxy.

It's also easier to trade. It's easier to rebalance. There's no commission at most places when you charge it. And the market makers have done a great job keeping the spreads tight, often tighter than most folks would get trading the bond itself. And what's the advantage of rolling over every month? So again, I could buy a two-year treasury and hold it for two years at the current coupon, but here you're rolling it over.

So you're getting whatever the new coupon changes. What is the advantage of that versus just holding that old. two-year? Ultimately, it's liquidity. Most risk managers want to be on the run at the most... Because that's the most liquid one. It's the most liquid by a wide margin. When you move even a month or two off, the spreads can triple or five or six X, which doesn't sound like much, but when you're buying tens of thousands of units, that's a very large number very quickly. So the on-the-run tends to be the most liquid. The on-the-run tenure, for example, underpins most of the global financial infrastructure we come to. Prices everything from mortgages to car loans to, to

what the forward valuation on the NASDAX ultimately going to be. So staying on the run is important. And for both folks, that liquidity when you want it is what's there. If we go back to March 8th, 2020, some of the spreads on multi-bond products got very large. And it wasn't because the on-the-run treasuries lost liquidity where the treasury market dried up. It was those market makers also had to move a substantial number of bonds that were not particularly popular. Yeah. So who's your target audience here?

Is it the buy-and-hold crowd? Is it active traders? I mean, one thing that strikes me is very interesting is you could short this, right? You certainly can. So this could be part of some kind of portfolio where you're doing some very complicated maneuvers going long and short equities or long and short bond funds, for example. Exactly. So we think treasuries are probably appropriate for most folks.

But long term, we suspect that the active user set are advisors who have a very specific interest in being a certain place on the country. curve, as well as in some institutions who don't want to do the roles on their own. And then finally, some retail investors who traditionally haven't had access to some of the rates mechanisms that institutional investors have. So if you want to, you could always buy a future on a bond. It's $1,000 a point, 32 points per percentage point. There's a lot of math to do that and a lot of leverage. You know, John, one of the obvious advantages of a single bond ETF is that I get this complain all the time. Multi-bond ETFs, you're locking in all these low yields, potentially for

several years down the road. I get people saying, I can't get this yield on my multi-bond ETS. Well, the reason you can't is they own old bonds that have lousy yields on them. So, I mean, this strikes me as another interesting reason why people might want to just stay with the front, whatever the most, beyond the run, as he calls them. Yeah, I think Alex Firm is always going to roll it for you. So, you know, effectively you get the latest, you know, bonds. So that seems to sense to me. I just think big picture, like, you know, we want to be laddered. We want on targeted maturities because, you know, the curve is very flat. So I like the two-year, it's a sweet spot. I don't know if I would be going out and buying like LQD specifically

or J&K specifically. Like I think LQD is the largest corporate bond ETF. Right. It's a basket of corporate bonds of different maturities. Correct. It's a basket, you know, thousands of bonds, investment-grade corporates. J&K is, you know, the high-yield bond ETF that gives you you again exposure to a broad basket of junk bonds. But, you know, I think, like, my message is to get laddered and specific maturities, given that the curve is pretty flat, two years of sweet spot. And it sounds like what Alex's firm is doing is outsourcing the roll-in. So I think, for your question before, it makes sense for people that don't want to sit on

their computers and roll their, you know, their bond, you know, maturity is constantly. So it's another extension of the ETF ecosystem, just extend, you know, outsourcing the portfolio management to another firm. Now, are we expecting just like single stock ETFs are proliferating? Like rabbits, are we going to see single bond ETFs proliferating? You're going to launch other products, right? We are. I hadn't thought about the rabbit analogy, but, yeah, so we're looking at launching a six-month

and a 12-month, then a 30-year, which will round out the sort of short end of the curve, so folks can have access to that very steep part. As John points out, the middle part of the curve is pretty flat, but we do know folks have some interest in the long-bond. just add duration to portfolios and for all of the other risk management characteristics of having a 30-year treasure. Can you see this happening internationally, launching guilds, for example, or German bonds? Is that feasible? So we couldn't launch a single gilt ETF, although that would be fairly spicy today, simply because it wouldn't be an ETF. It would be an ETN. The government, the IRS actually sets the ETF rule and the issues were concentration, but they have one exception, treasuries.

So all of the ETFs that buy treasuries are invested 100% in one issuer. It's the United States government. But the cash exemption rule allows us to hold just that security. Could you have a single bond, corporate bond ETF? Could you launch a GE corporate bond ETF if they had an auction, for example, or they launched a new bond? You could offer it as a product, but it wouldn't qualify under the tax code as best. We've been advised as an ETF because it would violate the issuer concentration.

You could try, like many of the single stock ETFs, to create a swap or something. Would you say it would violate the issuer concentration? What does that mean? There's a rule that requires you to hold no more than 20%, 25% sorry, in any one issuer. So as a result, you have to hold five things. Four issuers at minimum in cash, or five issuers. The government is a single issuer, but it's exempted itself from that rule. So it's why when you look at the single stock, stock ETFs, they actually hold a swap and a handful of other things. One, to get some leverage, and two, because if they held just one issuer, they wouldn't qualify for the tax benefits of an

ETF. Yeah, it's a very good point. John, I want to, while I have you here, ask you about the broader market. Obviously, we're down, SEP's down 24% this year. Viewers are writing in asking what they should be doing, should they put more money into bonds, but bonds are down this year really big. I'm market historian and so are you about this. I always tell people to use that old British line, keep calm and carry on. It is extremely unusual to have a down 24% year. In fact, it's only happened 15 times since 1926. I tell people that they don't believe me. But maybe you can point out how unusual this is and how usually the following year is a bounce back. It's almost invariably an up year the following year. Yeah, that's a good point. So,

Back-to-back, so back-to-back down 20% years is very rare. You have to go back to the 1930s, where we had two consecutive years of down 20. I feel like when I look at Wall Street research or I turn on CNBC, everyone is extremely bearish. My point is, if I look at our portfolio, going into this year, we were extremely defensively positioned. We owned a lot of alternatives. We had inflation fighting strategies. Most of our exposures was the quality factor. We own a lot of like short duration bonds, cash like bonds.

So on a relative basis, we're actually, our clients have experienced a lot different portfolio returns this year compared to like our benchmark. Need to say, Bob, like, I just think for me to be as bearish now for the next six to 12 months, it's just not the view that we have. Like, we think at a story that, yes, could there be an earnings recession? Absolutely. And I read your note today. I actually agree with what you're rowing your blog.

Are there other risks out there? Can more UK pension funds blow up? Yes, but like my edge and a story's edge isn't like trying to predict the next UK Pension fund from blowing up. So I just think like our operating word is like start to nibble by you know Nibble on stocks high quality stocks look at bonds because bonds now are yielding you some attractive You know coupons with the goal of trying to deploy that cash the next three to six months and that is a very different view like again when I watch TV or I read research like everyone's like run for the hills. But my point is that like that we've already had our DEF comp fine moment. Like the average stock is down like 30%. So I just don't see that playbook going forward. You know, I'm a Jack Bogle disciple. And one of the things Jack used to say is don't just do something stand there. That often the best strategy is to do nothing. And you do make serious mistakes

when you start second guessing your strategy and saying, oh my God, I got to do something. That's when you make mistakes. As most people know, market timing doesn't work. You have to be right going in and going out. And it's extraordinary. how many mistakes that you can make. I want to reiterate that again. It's only been 15 times since 1926. The S&P is down 20% year over year, and two-thirds of the times, the following year, you were made whole again. In other words, you bounced back within a year. Years where you don't bounce back dramatically are not that common. I also want to point out the direction of the S&P has always historically been up. It's up three out of four years. Seventy-two percent of the

time, the S&P 500 is higher year over year since the 1920s. 72%, three out of four years. And normally it goes up big. 56%. I'm sorry to be professorial, but it's important to point this out. John has all these statistics. 56% of the time, the S&P 500 is up 10% or more a year. 56% of the time since the 1920s. Only 12% of the times is down 10% or more. So you see, the market direction is up. And John, as you know, the people say, well, why is that? Let's cause capitalism. Capitalism is, you know, people, some people hate capitalism. Winston Churchill said it was, democracy was the worst form of political system except for all the others.

Capitalism is the worst economic system except for all the others. And the relentless efficiency of capitalism, and particularly the relentless efficiency of American corporations a capital allocation is why the U.S. does so well. So I know, John, you know, you do this lecture on capitalism and why we need to keep investing in the markets, but I try to walk people off the viewers who write me in saying, oh my God, we're going to fall apart. The world's going to go to hell. I said, only if you think capitalism in the U.S. is going to go to hell. And I don't, that is not my base case. It never has been.

Yeah. So people need to be reminded about the fundamentals of investing in where we go from here. Where is your base case for the S&P 500 by the end of the year? I think there's some downside risk to earnings, you know, potentially being worse than expected. But I think like, you know, inflation is what got us, you know, in this, you know, bear market recession. I think the stock market is obviously priced in a recession. For you to be bearish now, thinking there's another 10, 15 percent decline in the S&P means that you believe that we're going into a protracted, elongated recession. I don't see that.

I see inflation. all these forward-looking inflation indicators actually materially declined, whether you look at gasoline, commodities, timber, break-even. So I'm more constructive. I think probably there's maybe 5 to 10 percent downside in S&P. I think the key is whether or not these earnings actually are lower and comes in worse than expected. But again, like, you know, we try not to predict what's going to happen, but just use like, you know, buy high-quality stocks, buy value stocks,

look where there's a margin of safety. 10-11 times PE ratio for value stocks, I think, enough. Yeah. And Alex, one of the things people ask me all the time is, well, gee, shouldn't I do something? I said, how long are you going to live for? If you're a 30 or 40 year old guy, you're going to have another 50 years of investing. This year is not going to matter. Right. So, you know, telling people about historical perspectives is really important. You have 50 more years than investor if you're 40 years old, even, and a lot more if you're younger than that. And that's kind of the way to look at this, I think, and the important thing is you

You think you want to pull out all your money now and you know when to put it back in, you don't. So my favorite charts are, you know, what happens if you invested $1,000 in the S&P and pick a date, 1970. And now you have $300,000. But if you miss the five best up days, you'd only have $200,000. And the best 10, you'd have significantly lower. And you don't know what no those five best days are. That's the problem with the stock market. You don't know.

And so the odds are you have to stay in the game, knowing that the long-term trend is up. And by the way, yes, it's true if you were not in on the five worst days, you'd still do better. But the trend is always up long-term. So that's what the game is. It's a long-term game that's out there, Alex. Well, that's why, you know, we, if you look the way we structured our products as an infinite time horizon. This is an infinite game for folks. Yes, we may have certain spending needs we want or certain objectives, but long-term, if you want to make money, you're going to have to be in the market.

You don't need to do a lot of marketing, do you? I mean, this is a wonderful product for you in the right year. You just launched this in August, right? We did, yeah. I mean, if you would have done this three years ago, I would have said, why, and who cares? I don't think we would have had the support to do it three years ago. We did this because advisors were asking for it. For our clients, we'd call up and say, what happens if looking at valuations going into January?

And our answer was, we'll go to the treasuries. The treasury market generally has positive yield and negative correlation to equities, particularly U.S. equities. So that's your refuge. But it's somewhat complicated and really an anticipation of a large interest in treasuries. We looked at multi-bond treasury funds but didn't get the liquidity we wanted. We're a little worried by some of those funds on March 8th, 2020, and how big those discounts and premiums were and how long it took for those to come back in. And that's what we decided to launch the products.

It just made sense to give access. Well, it's nice to have, you know, we used to say, Tina, there is no alternative, but now there is alternatives that are interesting. And it's painful to have a year in the stock market down. and the bomb market. Most people have never seen that, certainly not since the 2000s. And look, think of all those grandmas out there

that buying those CDs. Finally, you know, there's a little bit of hope for all of those people. Now it's time to round out the conversation with some analysis and perspective to help you better understand ETFs. This is the Market 102 portion of the podcast. Today we'll be continuing the conversation

with John Davy from Astoria Portfolio Advisors. John, thanks for sticking around. I asked you while we were waiting to start the podcast how you were doing this year, and you said it was the best year ever. What does the best year ever mean? And why is this your best year? Yeah. So just for context, we went into this year very defensively positioned. We owned a lot of alternatives.

We had a lot of short duration bonds, a lot of cash-like instruments. Most of our equity exposures are an equality factor. We had inflation hedges in our portfolio. So if you just look at our... And what does the quality factor mean, not to interrupt, but quality implies... companies with strong balance sheets, growing earnings. So what is that long and what is it short on, essentially, quality? I think, like, if you look at stocks like Apple, Apple has, like, a lot of free cash flow.

They're defensive in this market, like the NASDAQ is down 30%. Apple may have been down, like, 15 to 18% year to date. So Apple's been shielded because it's the high-quality stocks. And during times of market turmoil, people will, you know, tend to bid up and own high-quality stocks because eventually over time, they do outperform. It's like what Warren Buffett does. He buys good brands at reasonable prices. So, you know, generally speaking, quality is one of these factors that's persistent,

pervasive, robust. They work over long periods of time, and it's defensive in a market downturn. Okay. So you were very bearish going into 2022. And now we have a year with bonds and stocks are down. We had talked on the show about how rare it is to be down 20%. It's only having 15 times. since the 1920s at this point.

But what most shocking of people is that 6040 portfolio, 6040 stocks, bonds, and it's having, according to the Bank of America, the worst year and 100 years. Is that a contrary an indicator? Is that mean buy stocks and bonds? Buy a 6040 portfolio? I don't know what it means.

This is the worst in 100 years. Is that a buy signal or is it a cell signal? I think in combination with a lot of different indicators and signals, you use that And you say, okay, here's another indicator that says how extreme this market downturn is. But, you know, when I see, okay, the worst than 100 years, like at the end of the day, we know inflation is a problem. It was a big problem in the 70s. You look at empirical evidence, what happened to stocks and bonds in the 70s?

Yes, they did, both did poorly when you had these big CPI prints. But, you know, the Fed has done like a massive draconian ray-hithe cycle. They've increased their ray hikes by, you know, 300 basis points here to date. And I think the economy is slowing, like forward inflation indicators like commodities, gas, timber, break-evens, they're all declining pretty significantly. So I don't think the Fed's going to be able to jack up rates as what they talk about in the marketplace. So for me, like, okay, I was so bearish going into this year. It's translated. We're having a good year in terms of how we're doing versus our benchmark, past performance, on indicative future results.

But for me to be bearish now and say like this. What are we down? 24% in the S&P. in the average stock, including small caps, probably down 30%. Correct. This is what I tell people, play averages. And it's rather, again, very rare. Would you ever see a year down 24%?

And then the next year is a down year. It just almost never happens. It happened maybe once in the early 1930s, 30 and 31 maybe. But usually you bounce back within a year on these. Because of the nature of capitalism, essentially. So the markets have an upward trend. trajectory and have been for a long time. This is what happened in 2009 that got me so depressed, and I have a book coming out, shut up and keep talking, it's coming out tomorrow where I talk

about this, that I saw, we were down 50% by March 2009 from the high about September 2007. That's an extraordinarily rare event. Normally, market declines, serious ones, are 20 to 30%. Occasionally, you'll get them in the mid-30s. The 50s, I mean, that's literally, you know, tiny, you know, less than a handful of times that has ever happened. But if you're down 50%, unless you think the world's literally going to hell, you don't sell down 50%. You either hold or buy. And yet, when we were at March 2009, I remember reporting that people were selling their mutual

funds because they couldn't handle the pain anymore. And that's when I realized my whole generation was in serious trouble, because they were doing this real estate too, selling at the bottom. So it turns out people don't buy low and sell high. They buy high and sell low. This is when I became a real behavior in behavioral economics. That people generally cannot stand to the pain of a loss is greater than the expectation of a gain. And people will hold on to stuff for a long, long time before they recognize a loss.

And the fact that you don't sell down 50% makes perfect rational sense, but that's not what people do. So you have to look this very, very carefully and understand the way human beings really act and move from there. That's why I say, I keep quoting Bogle, where he says, don't just do something, stand there. Just simply have a plan and recognize that you're going to live a lot longer than you think. Most people who are into their, if you can make it into your mid-60s, you've got a good chance to make it into your 90s. And so this year isn't going to matter long term. and you have to keep, you know, pushing that idea forward. So we've got competition with bonds.

Have you changed your portfolio allocation recommendations at all? So our operating word in terms of what we want. So I agree with everything you just said. I think people should not be derisking down, you know, 25% in the S&P. I think you want to start nibbling, and the operating word is start and then nibble. With the goal of looking to complete and to reallocate your portfolio and deploying funds, you know, in the next three to six months. I think your downside is limited. What we thought, you know, this summer, you know, again, you look at these signposts, you know, the worst year

ever for 6040, multiples have been massively decompressed. Are multiple still high in growth stocks? Yes. Our multiple is going to contract? Most likely, yes, especially now with Fed funds at three on its way to four. So there is some competition. So we started nibbling and buying like, you know, corporate bonds, mini bonds, treasury bonds. We're using these laddered from Investco Bullishers, so BSCO, BMCO. These are like 2024, IG corporate bonds, you know, 2024 municipal bonds. And we're buying the treasuries directly from the government, which maybe we should look at Alex's, you know, ETF a little bit, closer.

But, you know, I think, you know, you don't have to have 100% equities. We've had financial advisors that came to us, you know, a couple years ago and they wanted to deploy, you know, money for their clients. And they were like, okay, give me your best 100%. percent stock portfolio. And we were very worried. I knew that was probably the top of the market. And now we're saying, okay, instead of 100 percent equities, let's have 70-30. So the big question now is with earnings. Are they going to come down? What we've seen this year come down is not earnings, it's the multiple. The market, what are you willing to pay

for a future stream of earnings? It was 2021 in January. It's down to 15 or so right now, depending on what your earnings estimate is. So the market multiple has gone down. The earnings These estimates have really not come down much. They're still expected to be up this year. So what's the right multiple? Nobody seems to know to put on when you have a risk-free rate of return, when you can get 4% on a 2-year, almost 4% on a 10-year, what's the right return for stocks? Risk-free, I can get 4%.

So what should I get for stocks? What's the right, you know, returns? So that is basically the number one provocative question in portfolio construction line is like what is the right multiple to pay? I still think 22 times for NASDAQ is way too high. Value stocks at like 10 times multiple, that makes sense. I wouldn't really take on the risk of like EM or Europe or Japan, which is like seven, eight times. So again, I go ahead and say, okay, put, you know, if you're going to construct a portfolio, you know,

own high quality stocks, we like the DGRI, WETF. That's maybe about 13, 14 times earn-ins. Some of these value ETFs we have, SDIY, DVY, dividend-paying stocks. They're like 10-11 times earn-ins. I think that makes a lot of sense. But that is, you know, the biggest question in portfolio construction line. Yeah. All right, John, I'm going to have to leave it there.

And I want to thank you for joining us. It's always good to see you again. John Davy, folks, the founder and CIO of Historia Portfolio Advisors. And everybody, thank you for listening to the ETF Edge podcast. InvescoQQQQ believes new innovations create new opportunities. Become an agent of innovation. InvescoQQQQ, Invesco Distributors, Inc.