ETF Edge - The controversial rise of private credit/equity 3/3/25

Episode Date: March 3, 2025

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The ETF Edge podcast is sponsored by InvescoQQQ. Let's rethink possibility. Invesco Distributors, Inc. Welcome to ETF Edge. The podcast, if you are looking to learn the latest insights on all things, exchange, traded funds, you are in the right place. Every week we're bringing you interviews, market analysis, and breaking down what it all means for investors.

I am your host, Bob Pisani. A push for private credit and private equity ETFs is all the rage right now, but is it too much too soon? Which investors are they really right for? Here is my conversation with Joanna Gallagos. She's the co-founder of Bond Blocks and with Todd Sohn, head of ETFs at Straticus. First, I want to bring you an update on a story we brought you last week. The Spider-S-S-SGA Apollo Public and Private Credit ETF.

I know it's a mouthful, but it launched last Thursday. We talked about it. It allowed retail investors to buy into private credit assets. And late on that day, the SEC sent letter to the company saying there was quote significant remaining outstanding issues close quote and listed worries centered on the funds liquidity its use of the name Apollo in the title and its ability to comply with valuation rules State Street did respond Friday night to the SEC saying they would revise the

name of the fund as soon as practicable presumably removing Apollo's name they clarified that the fund's ill-liquid products will not be exclusively tied to Apollo and that other broker dealers can provide quotes and that the funds NAV or net asset value will be calculated on a daily basis. State Street told CNBC they would have no further comments at this time. Joanna, I want to talk to you about your fund and what's going on with you, but you've had extensive experience filing ETF registrations with the SEC. It's a little unusual for a fund to become effective and then get questions from the SEC after the fact. So is there any sense, and I know this isn't your fund, but any sense of what happened here?

It's unusual. It's not unprecedented. It does happen from time to time. You, as an issuer, if you're an established issuer, you have a 75-day clock from which to work with the SEC, and then, you know, you can take your filing effective. Most issuers work with the SEC to satisfy their concerns, because mostly the important thing here is that investors on a follow-on basis know how to conduct due diligence on your fund, understand what your fund is doing, and it's just totally clear what's going on in the fund, and your prospectus reflects that. So that's what that process is about. And this is notable, not unprecedented, but it definitely raised to my brows last week.

So Todd, I'm going to lean on you a little to educate us about the procedural aspects of this, because most people don't know anything about this. So as Joanna mentioned, typically a fund can become effective. you can start trading after 75 days unless the SEC raises objections. I understand I saw there were several extensions to this already, but for some reason it was allowed to become effective, and the SEC then raised questions afterwards. And Joanna said this was a little unusual.

I think this is cool. Just educate about how this works. The whole episode seems strange. Yeah, if you're an existing issuer, you file a 485A, right? That's for the announcing the ETF. What is the strategy of the ETF? and any of the key risks involved. You go through the 75-day process,

SEC hits all their checkmarks, checkboxes, asks any questions, and then eventually the fund goes effective, and we start trading. For some strange reason, none of the questions were really addressed publicly, and what I find out is why, you know, they mentioned that other counterparties

are going to be involved with the fund instead of just Apollo, that Apollo is going to provide three bids per day, I think in 15-minute intervals, just like that. Why wasn't any of that brought up in the initial filing? I think that would have cleared a lot of hurdles here and a lot of the confusion too. And so I'm not quite sure why that happened. It just seems like maybe the new administration came in and this fell through the cracks.

Well, maybe that's a possibility. We don't really know. The point is that there's a procedure to this that's pretty well-worn. Joanna's been through this many times. You're a veteran doing this. And usually this doesn't come up like this. Like why after the file? I mean, I think this one gets under the microscope because you're talking about

private assets. I think if this was just a standard vanilla equity fund, it would have been figured out. And we should point out, a bullet on the radar. State Street responded. And we didn't hear back from the SEC. I presume then presumably everything is, and it's trading today, presumably everything, they're addressing their concerns. Yeah, it looks like it. It looks like they're going to file their responses publicly. There were some requests that it actually go through the avenues that allow the public and the investing public to read. That means Edgar. Edgar is the official filing on the website where you can see what they're saying and not just personal correspondence on an email, for example. That's right. So there'll probably be more transparency into exactly what's going on and clear up the confusion,

help investors understand what's going on with that product. Okay. I want to move on because you have a competing product that I want to talk about. You have a private credit CLO ETF, CLO collateralized loan obligation. It invests in at least 80% in collateralized loan obligations. Tell us a little bit about this. How does this work and CLOs? And why is this a good way to get at private credit? We think this is the right way to get at private credit right now.

Fundamentally, first and foremost, it invests that 80% of its portfolio holdings are in CLOs and invest in private credit. So in contracts to the product we were just talking about, that product doesn't have the moniker of private credit only in its name. It's an investment grade and a private credit product together. So what you want, if you're really seeking exposure, true direct exposure to private credit, your product should invest a majority, significant majority. Ours is 80% in private credit debt. So the way ours works is we do use a wrapper, the CLO. If you know anything about ETS, there's a lot of people that watch your show do.

They all know that the ETOF is a wrapper to something. ETF wraps 500 stocks in a portfolio and calls it SPY. In this instance, a CLO is a package of loans. given to private companies, and those private companies use those loans to operate their businesses. It's lending money to companies just like any other bond that happens in the United States, corporate America. These loans are packaged by professional managers, and they're put into the ETF. So the ETF holds 42 CLOs. Each CLO has about 100 loans in it. That's the point. So each seal is 100 loans to package.

It's a package. And you have 42, you said? 42 right now. Okay. And you're getting direct exposure to the economics of that loan. You're getting direct exposure to the coupons of those loans and all of those companies. The only difference here is that these companies are private versus public. And so when you package them up in the CLOs and then the ETF buys them, you're really connecting

to markets in a powerful way so that there's a lot of liquidity. for the ETF on the secondary market for investors that buy the ETF to come in and out of the ETF and then the underlying holdings themselves are liquid tradable priceable you know we can price those every day our enemy gets priced every day and it's a robust set of capital markets coming together and you're getting pure exposure to direct credit credit so and this is our chance to educate the viewers a little bit when you buy into private credit like this using a CLO what are you getting I mean I'm asking a broad

portfolio question how do you use this in your portfolio I mean what place does it have okay I have stocks and I have bonds I have real estate I mean why do I need this in my portfolio I'm asking a broad generic the net the net result of that portfolio is a on a weighted average basis and a rated portfolio of of loans and and CLOs the SEC yield on on the fund right now the most recent SCC yield is 7.44%. The portfolio itself is yielding the coupons underneath that portfolio of loans is yielding over 8%. And then the key here is the duration. It's ultra short duration. This is a 0.25 in duration. So that's three months of duration. Duration is sensitivity to interest rate.

Right. So as interest rates. It's not the same as maturity. People confuse this all the time. They do. They do. So because they're quoted in in years or months. So anyway, the point here is that being so low in duration and interest rate sensitivity reduces and dampens the volatility of this portfolio significantly. So it's very, very low volatility, gives you more price stability to enter these markets that have a lot of uncertainty right now. And we're seeing volatility on the long end of the curve. We're seeing volatility in equity assets.

One of the key things here, and this is the part of the hat trick I spoke about, the third thing is all of this together gives you a lot of diversification. You have over 4,000 loans in here, 22 managers wrapped up in this portfolio. And importantly, this asset class, private credit, private assets, is very low correlated to public markets, both equity and fixed income. So it's a true diversifier. So the way you use it. Well, that's important when you're considering how to use it in a portfolio. You put it in your portfolio to truly diversify. That's why it's such a popular access point. So you're saying you have more than 100 different loans in each CLO here? Now tell us what the risks are.

Where will this go south or what, explain what the issues are here in terms of the risk. Yeah, so you think of a CLO like a bond. It has a Q-SIP, it has a coupon. Underneath that, there's exposures in that CLO. Like I said, there's 100 loans in each CLO and there's 42 CLO. So you have exposure to 4,000 loans. There's a lot of diversification there. Some of those loans could default.

In the past, we haven't seen broad defaults in CLOs, and they've been a very stable place in terms of defaults over time. So it's a credit. It's a credit. It's debt. The principal risk is nonpayment, right? Isn't that sort of the obvious? And that can happen.

But you're in a portfolio with a lot of diversification. And that's sort of the beauty of not only the asset class being so low correlated to public markets, but also the portfolio itself is very diverse. What kind of loans are we talking about? I mean, it's easy to just sort of broadly say. What kind of what's the loans? We're loaning to companies that are middle market. That's defined as small to mid-cap companies.

Their EBITDA is less than 100 million. They're companies that are operating privately because it's probably easier from a regulatory standpoint to do so. It's also they're at a stage of their growth where their performance. And they could be anything. It could be anything.

There's a industrial technology. I mean, literally, I'm just trying to get a sense of what's a typical. There's a company. is a mattress company that builds mattresses and you know markets them to the retail public it can be across all industries and I think a really interesting thing is that it's it's you know it's we're talking about 300,000 companies in the United States this is a really important segment of growth the United States

and you just don't have access to it but these are you know small companies yeah so Todd let me bring you in here be the guru here I always say when I see this happening, the world rushing to private and private equity and private credit like this. This seems to be this mad rush to do it. I always ask myself, is this peak, fill in the blank, is this peak whatever? Is this peak private credit? Are we in the late stages of the alternative credit cycle or am I just, you know, being a little too professorial here? Wall Street is great at making supply of something when they're demand. Supply. Over supply.

The oversupply, we've seen it happen time and time again in the ETF industry, the distinction is on the quality of the product. So I can look up the QSips in Joanna and Bond Blocks as product and understand what's in the ETF. I look at this new ETF from State Street, and there's about seven holdings in there that I can't even Google. I Google it, nothing's there. Good luck finding out what you own and what the risks are there. So I have a problem with putting really opaque assets into the ETF. when there is information there, then I say, okay, we're not the peak private credit, but perhaps peak opakness?

Maybe that's the right phrase to think of it here. Like there would be room for things like what Joanna has where it actually makes sense for diversification. But when you start putting assets without any sort of paper trail under shape of they are, that's trouble. Well, how does the creation and redemption process work? If you have to buy more or sell more of these CLOs, how are you obtaining them? There's a robust market for CLOs, a secondary market. Essentially, these are loans that have been repackaged from managers like Ares, Blackstone.

They've made their initial loan. They repackaged them and they sell them again. So there's a robust secondary market to buy these CLOs. Our portfolio is, as defined by the SEC, has a very liquid profile in terms of like basically, you know, our portfolio managers can go out and add more CLOs or sell. more CLOs as needed. In this case, the creation redemption process is in cash. A lot of funds in fixed income operate that way. And there's been a lot of innovation because the whole category in CLOs and ETSs is bigger than just this private credit ETF. And that's getting

to be closer and closer to what the technical side of in-kinding is happening. So the markets are connecting and they're developing together and they're facilitating this overwhelming demand in CLO exposure and ETFs that use them. Todd, I'm wondering, I brought this up last week on halftime report, and some people were saying about whether or not there was a simpler way to go out and do this. You know, we had talked about this last week. We were talking about private equity. And one of the things that you could do is you don't necessarily want to buy the private equity,

you want to buy the private equity companies, not their products. So, you know, you want to look at, you know, KKR, for example, or there's some ETFs that invest in PSP, which is the Investco Global Listed Private. equity. They actually invest in like KKR, which is the company that actually goes out and tries to deal with these companies. They invest, ARI's Capital, they do deals with small and middle market companies directly. You know, there's different ways. My point is there's different ways to attack this. And it's fairly complicated to figure out, if I want exposure to private equity, how do I get it? There are different ways to go ahead and do that. The easiest route is through

listed private equity names, right? Yeah, KKR, for example. PSP, PX, I think, is the other one. Yeah, ARI, S. Capital, ARCCC. The other way, if you're an investor, is, okay, if I want SpaceX, well, buy a company like Rocket Labs or buy an ETF that has the space theme in it, because they'll probably trade like SpaceX, or whatever other, you know, credit, if there's a credit card name like Klarna out there, you can go that route, too, to get the benefit.

I'm not a fan of the ETFs out there that have the private assets in them that don't get valued every day. I think that's a little odd and against what ETFs have been about, which is transparency and liquidity. So I think you just have to look for the parallels to what's out there, right, and go through the ETFs that have the exposure to that category. Yeah. So private equity and private credit, I'm going to just get a little deeper in the weeds here. They're part of what we call alt investments. I'll say alt investments a big category includes not just private equity and private credit, but also things like venture capital and hedge funds, for example.

But, you know, these alt investments for decades have been criticized for charging very high fees, for example. There's been some academic research indicating they don't really outperform at all, despite all this hoopla and this mystery about, oh, we've got to get in. Do alternative investments add value at all? I'm trying to think about it like Jack Bogle would think about it. Bob, what are you buying here? And is it really giving you some kind of outperformance or what is it doing for? Most people don't need it.

If you have a diversified portfolio of five low-cost ETSs, you're pretty good, right? The only case I can make for is... It sounds like Jack Bogle for a crime. I won't argue with Bogle there. The one area that I think is really interesting, and maybe I'm a bit envious, is just sports ownership. Sports teams are the only thing that have not gone down in the last 20 years. How do you get into that? Yeah, that's hard.

But you need... That's for only doubt. But if it's true what you're saying, how... How is it that alternative investments have grown so much? I mean, how have, for example, pension funds and other institutional investors been convinced they need to add alt funds to their portfolio? It's a red velvet rope then. Joanna, come on. We don't believe in the velvet rope.

We believe in connecting markets and solving these problems in valuation and creation and redemption to fix that velvet rope problem. This is the first time a product like this has been offered to the public in terms of like normally you'd only have access to you. You're a high net worth investor or an institution. The other types of vehicles that these are in are interval funds. They sure will allow you to come in as much as you want on the creation side, but they'll lock you up on the redemption side. And I think that the trying harder and innovating is what the ETF industry is about. I feel like this is the same comfort level you should have here is in the early 2000s, when small cap equities started to trade in an ETF or emerging market equity started to

trade in the ETF. We heard the same pushback, high yield, the ETFs. Oh, you can't price that. It's too expensive. And then the ETF connected that market in a way that allowed investors to participate, drove the prices down in the category in terms of distributed funds. And so I take a big issue with a red velvet rope. I think that what you're seeing being put into some products that feel like direct investment,

you know, we were talking about the other product earlier, may not actually be the right structure or the right exposure if you're trying to offer a lot of diversification or a lot of exposure to those direct access. You just need to solve the valuation issue. You need to be more transparent. So we heard the same thing as active ETS. Nobody wanted to put their portfolio out there. No one wanted to know one to see what we were trading.

But you get his point. I mean, Steve Weiss said this on halftime, does the average, you know, investor, retail investor need to go into something like this? It's a fairly dense structure to understand. It's tough for people. What I can appreciate you about the PCM is the low duration aspect, because duration has not worked in three or five years. So that makes it get the yield, much lower volatility, smoother rise. What's the fee, by the way? 68 basis points, PCMM.

So again, that duration is three months. months. It's yielding, you know, high sevens at this moment. The portfolio securities itself. The SEC yield is 7.44. It has three-month duration and it has low volatility. And so that's a cake and eat it to product. People have not had access to it. It makes sense in a portfolio. People should have access to power a power tool like that in their portfolio. Now it's time to round out the conversation with some analysis and perspective to help you better understand ETFs.

This is the Markets 102 portion of the podcast. Todd Sohn's Strategic Securities, Senior ETF and Technical Strategist continues with us now. You've got to shorten your title for crying out loud. I just called you the ETF guys. You got to tell Jason. Yeah. So we want to talk a little bit of great discussion

with Joanna Gallagos about what's going on in the ETF market and particularly about what's going on in private credit. But I want to review what's been going going on in January and February so far on the year. What are we seeing in terms of new ETFs? Very exotic. Exotic. Exotic.

What does that mean? Complex derivative usage. We've gone from the passive era into the complexity era. Why is it getting harder to explain everything? I think it's because the ETF industry for years has been dominated by low-cost vanilla, three or four issuers, right? And there's only so much room there. So now you have much more

creative, quantitative folks entering the industry and offering solutions that probably weren't available to the majority of investors. So for example, return stacking portable alpha where you're basically taking a dollar and using futures to leverage that into $2 worth of exposure to split between two assets. So SMP and gold, gold and Bitcoin, Navidia and I want to say like Tesla is a new one right out there. So now you're stacking single stocks and you're stacking asset classes. And what do you get here? Why do we want to do this?

It's a, why is an interesting question. It's the efficient use of resources, I think is the way to think about it. You're using $1, $100 or $200 or $2 worth of exposure. An asset class. What could go wrong with that? Yeah, it could blow up. It has happened before, 2008, right? If a credit crisis happens.

But it's to get more bang for your buck, basically. Tech's having a tough time of it. Yeah. Mag 7 and even XMAG 7, tech technology stocks. We've seen a few outflows this month in the last two months, right? You're finally starting to see a little bit of less demand for tech, modest outflows in February. That's a change from the last 15 months when it was all in on tech.

I think the crowd got a two head of themselves. AI enthusiasm was a little bit too high for me. And the market's getting more defensive. So you've seen some bites to healthcare and staples and utilities. not the story stock utilities, the regulated defensive plays that are typically known for their yield. And you know, the old rule, you and I always talk about, flow usually follows price. That is, people are momentum followers, so they see price moving, and then they put in money or they take out money. But this wasn't the case with gold.

It puzzled me. Gold was hitting new highs for ages, and I didn't see any inflows with gold. And I know we just talked a little while ago. You said, we're finally starting to see inflows. Why didn't we get any inflows when gold was hitting new highs and now we are? I think gold had too much competition from stocks that were good, 4% yields, and crypto. Crypto had a big run, why not, right after the election. Now crypto stalled out, stocks became more defensive and you're finally seeing some significant money going to gold Athias.

Of course, at a 3,000 year high, whatever it is. The other thing is gold can go up because you have significant central bank buying now. That would be completely independent of they're not buying gold DT's. central banks, they're buying gold bullion. Right. They help push off the price. Yeah. ETF investors kind of ignored it for so long, and now all of a sudden you're seeing significant allocations coming to gold ETS. So exotic products, seeing some outflows from tech, and finally some inflows into gold ETSs.

Anything else stand out? Europe's been flying high. I'm curious to the models there are there any inflows though? Eh, I'd call it restrained. Very restrained. There's a disbelief for Europe is the way I would look at it. I like that. I like that from a market.

Well, given the fact that it's underperformed for 15 years, I would say the skepticism is warranted. But by the time it really starts outperforming dramatically, it has this year, though. Yeah. Europe, ETFs have done really well, hedged or unhedged too. And there's a lack of demand from issuers. They don't launch new European products anymore. Okay. Todd, thanks very much.

Appreciate your thoughts as always. That does it for EETF Edge, the podcast. Thanks for listening. Join us again next week. And remember all the shows on our website, ETFedge.c.com. Vesco QQQR rethink possibility by rethinking access to innovation and the NASDAQ 100. Let's rethink possibility in Vesco Distributors, Inc.