ETF Edge - The ETF Flowdown: Plenty of “Scared” Money Still Parked in Treasuries 11/20/23

Episode Date: November 20, 2023

CNBC’s Kate Rooney spoke with Matt Bartolini, Head of SPDR Americas Research at State Street Global Advisors, and Dan Egan, Vice President of Behavioral Finance and Investing at Betterment. They dove into the world of dividend plays and broke down the latest big dividend ETF launch. They tackled a wide array of topics in the ETF industry: investor sentiment, bond fund flows and artificial intelligence – specifically, AI’s role in the future of money management – as well as what to expect as we gear up for 2024 amid the Federal Reserve’s higher-for-longer rate regime. It’s almost crunch time for many holding short-term Treasuries, but will many be too scared to make the switch to equities again? Hosted by Simplecast, an AdsWizz company. See pcm.adswizz.com for information about our collection and use of personal data for advertising.

The ETF Edge podcast is sponsored by InvescoQQQ, Supporting the Innovators Changing the World, Investco Distributors, Inc. Welcome to ETF Edge, the podcast. If you're looking to learn the latest insights on all things, exchange, traded funds that are in the right place every week. We're going to bring you compelling interviews, thoughtful market analysis, and breaking down what it all means for investors. I'm Kate Rooney and filling in for Bob Pisani today. On the show, we're going to tackle a wide array of topics in the ETF industry. Investor sentiment, bond fund flows, and artificial intelligence, specifically AI's role in the future of money management, as well as what to expect as we gear up for 2024 amid the Federal Reserve's higher or longer rate regime. It's almost crunch time for many holding short-term treasuries, but will many be too scared to make the switch to equity scheme?

Here's my conversation with Matt Gordolini, who's the head of Spider-America's research at State Street Global Advisors and Dan Egan, Vice President of Behavioral Finance and Investing at Betterment. And gentlemen, thank you both for being here. Dan, we're going to start with you. That psychological element. Why is this money sticky? Are we calling that and talk about sort of that scared money psychological side of the investing landscape?

How are you working with your clients right now? And what are you recommending with that backdrop? It's very interesting right now. We're coming out of obviously a period of very low interest rates. Then they went back high again. And it's a uniquely American experience how dramatic that can feel at a consumer sentiment level. Americans are unusual in having the 30-year fixed-rate mortgage, which plays into a lot of our feeling about how wealthy we are being related to the housing that we afford and also the expectation

that our house prices are going to go up and therefore we have more house money. Consumers also have an unusual expectation around inflation, which is that they think about inflation at levels rather than a rate of change. So when consumers are thinking about a combination of, I'm worried that my house price might not keep interested, keep appreciating. Therefore, I don't feel as wealthy. And also, it doesn't seem like prices are going to come down. Therefore, I'm scared about spending money and about putting it into work.

We have this combination of people being locked in and not feeling good. And when people don't feel good, they're defensive. They're less likely to invest. And they're less likely to spend their money out in the world to keep the economy from the So I think one of the things we're looking at now is we're at a bit of the sort of top of the mountain where people need to start thinking about if interest rates start coming down in the next two to three years, what are good moves I need to be thinking about right now to be making and maybe even preparing myself psychologically for things that are going to feel uncomfortable

like investing, going into longer duration bonds. There's some opportunities too around refinancing debt and paying it down. Yeah, that's a great point about the housing market and how it all plays into the investing landscape here. Matt, I want to go over to you. Data is suggesting that fixed income growth is going to endure despite bond returns being down for the third straight year. That's kind of surprising for a lot of people. Why do you think that is? Yeah, so I think for fixed income, the flows just continue to support a strategic use case, you know, within the ETF market set. But also that on a forward-looking basis, the returns are starting to look a little bit stronger

because you do have a rise in yields. Meanwhile, you're still balanced on a duration perspective. So your subsequent forward-looking returns do appear to be stronger. One of the indicators that we look at is your yield per unit of duration profile. And the yield-per-per-unit duration on the ag itself is actually at a level we haven't seen since 2009. So you can say from that big portion of the bond market, you're more fairly balanced than you've ever been in the last 15 years. And so your subsequent forward-looking return, even if you do have a rise in rates, which is not the consensus expectation, but let's just say that you did, you still, over the next 12 months, could be, potentially have a positive return from bonds. That type of duration math hasn't happened as well

since 2009. So those flows in the fixed income really represent, again, sort of a strategic use case, growing importance of ETFs from a portfolio perspective, but also because from a relative return perspective for the amount of risk that you're taking, bonds are starting to look far more balanced than they've ever been in the last 15 years. That's a great point. It's a new paradigm. We've had so many investors get into the market you think of sort of the pandemic and how many people are just new to this market and really trying to strategize around adding some fixed income. Dan, I want to go back to you. Talk about bringing rates back down. That's already starting. Do you think it's too soon for investors to start

planning? You kind of hinted at that, but I just wonder when is the right time to start strategizing, moving money in a way that you're kind of allocating for cash and fixed income holdings when it comes to interest rates, is it too soon to start making that move? It's never too soon. I always say, like, the best decisions that I'm happy about today I made probably three years ago. And sometimes they're just about setting myself up for success. One component that we've seen be very effective is to help consumers to kind of divide their money into different goals or accounts to leverage mental accounting. So a great example of it is, if I want to feel safe, I should set up an emergency fund. That emergency fund, our advice

tends to be, it should be at least three months, if not six to nine months, if you have dependents or if you're in a job or industry that's a little bit more prone to throw thrashes or unemployment sessions. That means that you can put it into cash and feel safe and say, yes, this is going to be some percentage of my wealth, I'm going to be covered. That safety allows you to, therefore, take more risk in your retirement accounts, be more comfortable going out longer duration in other areas. So I think now setting up mental accounts, goals, and various things that allow you to say,

I am positioned well, I am insulated from short-term risks that I'm worried about. That's going to allow me to be more opportunistic with my higher risk budget. Do that now so that when the opportunity is there, you're ready to pull the trigger. Matt, similar question. How are you telling investors to allocate their money, whether it's certain duration risk, cash? I just wonder your game plan and what you're telling clients at this point. So what we're telling clients is to start to move further up the risk curve.

And that could mean going into equities or going into other portions of the credit market. But honestly, I think one of the fairest sort of trades, because you're in cash, you're in sort of the risk-free rate. And the yield environment is still likely to be above 5%. You know, the Fed's only looking to cut rates, probably 25 basis points at the first meeting, maybe another 25 basis points in that July meeting in around summer. So you're probably still going to get somewhere in the neighborhood around 5% for, you know, upper force. But moving further out the risk curve, you can still stay in that shorter duration space. You can go into the one-to-three-year duration, use an active management,

actively managed strategy that can sort of have that total return mindset to get higher yield, to sort of mitigate some duration-induced volatility. I think from a sector, though, perspective, that one to 10-year high-grade corporate bonds, so investment-grade corporate bond segment in the marketplace, right now it's around 6% yield, roughly like four years of duration, so you're taking on some duration risk, but you're being more fairly compensated for it. And you're not taking a lot of spread risk because you're still an investment grade. So I think those are some of the ways, just to sort of start to edge yourself up that curve out of that cash position. And you can start to look at two things in my mind, that one to three year duration space. And then if you want to

lengthen that out, take some duration, but still be more fairly compensated. One to ten, that sort of belly short end of the curve on the investment grade space actually has a pretty optimal balance from that perspective. And bond ETFs seem to be a popular way to do that. I wonder where you're seeing money kind of pan out at this point versus money market funds versus bond ETFs. What's the breakdown in terms of how people are allocating to some of these fixed income instruments? Well, yeah, I mean, just where rates are, a trillion dollars went into money markets over the past year. My expectation with rates coming down is we start to see that come out. And I think my expectation again, before it to go into either equities and people re-risk, but if you're staying

within fixed income to produce that high level of income, it would be in that sort of one to 10-year space, you know, taking on some duration risk. Owning the 30-year bond, you're buying a yield that's not really being compensated for the volatility that you're going to endure. So sticking in that one-to-10 space, sticking with more of a stable mandate, having stable income, I think, is going to be the next era, not to quote Taylor Swift or anything, but to be the next era of fixed income investing, that's stable income. And I think that's where investors are starting to look at. Actively manages a big portion of that. Actively fixed income ETFs in October took in the most money they've ever taken in ever. And fixed income ETFs are continuing to grow as a result of that.

So I think those are the things that we're starting to see. And we're probably going to see more and more as rates start to normalize. Yeah. So let's keep diving into the active versus passive debate here. Matt, you noted 5.5 billion of inflows so far in November. Active ETF's just breaking records for that annual total. I just wonder how much of that is equities versus fixed income. Give us a bit of a breakdown on what you're seeing there. So, I mean, equities have been driving a lot of the active flows. There's a lot of headlines related to it. But honestly, the active equity universe is a market of many markets. Some of these are not your alpha generating strategies. They're just active because it gives more flexibility, you know, the buffered ETFs, if you will.

They're active only because of the role strike and some of the option flexibility from that perspective. So it's not really a lot of alpha-generating active equity that are driving everything. There are some, but it's not all of it. Active fixed income has been a really consistent engine of support within the active construct, not only from flows, but also returns. A lot of the active managers are alpha generators. And roughly this year, intermediate core and intermediate core plus managers have outperform their benchmark by roughly around 70% this year. and at a lower fee than you typically get in the mutual fund space and with lower historical

capital gains. So it's really becoming a strong sort of melting pot of beneficial results to investors. High performance, strong performance, consistent performance, lower fees, and lower or say improved tax efficiency. So both areas are driving the market. I think there's more opportunity in the act of fixed income space from a return perspective. And there's more, I would say, flexibility in the active equity space. Dan, what have you seen from your clients over Betterment?

Is the emphasis still on this overall cost savings of the passive ETF wrapper or clients starting to express a bit more interest in some of the managed strategies? What we've seen of late is still very much a focus on the high-yield cash space. It is very, very difficult. I'm not sure that investors really ever think about even shorter intermediate term bonds as being an engine for growth in capital appreciation as opposed to just paying out interest in income. And right now, Betterment's yielding, I think, five or five and a half percent in their high-yield cash accounts, it's very hard to get people to think about bonds when you can get

that risk-free. And also, don't forget that FDIC insurance plays a very big role in people's sense of safety, especially after the events, I think, of last summer Silicon Valley Bank, signature bank, et cetera. That's a really big sense of safety. They're going to be in-cash savings accounts. So we tend to see more retirement assets. We now have over $13 billion in retirement assets on the platform. Those are just treated very differently than your short-term emergency fund cash interest savings accounts. It's going to be hard to get out of them. It's interesting, too. We talked about the bond market. There's been a lot of volatility, at least on the shorter end. I wonder how that will go back over to you for this. How are you telling clients to kind of ride that out?

I was joking with a colleague that bond market feels like the crypto market at certain points. What are you telling clients in terms of how to kind of manage that and get exposure to fixed income without some of the volatility? Yeah, I mean, fixed income markets from a volatility perspective are quite anomalous. So you have the implied volatility on the 30-year bond, roughly about four percentage points in excess of that equity market. Typically, it is four percentage points below that. So rates volatility is higher than equity volatility, and that usually does not happen.

So it's really unnerving. And that's why I think going into that 30-year space, while people say, oh, I could just earn 5% for the next 30 years, you don't actually earn that. if you're buying, unless you're buying the actual 30-year treasury, which I think many retail investors are probably not doing. They're probably buying some form of index fund that constantly rebalances. So you're not going to get that 5%. But we are going to get us a lot of the volatility associated with it. So that's why we like striking a balance between stability and income. And that's the thing that we keep going back to it with investors about creating portfolios

that can generate income returns while maximizing the amount of risk that you're taking to get those. because yields are high. Your forward-looking returns are better than they have been in a while. But with higher returns comes higher volatility. So you really need to strike that balance. We like active management in the space. We like different portions of the curve. Like I said, that one to 10-year space. Even mortgages, for instance, could be a beneficial allocation because they do tend to have higher yields than treasuries. And they still have that sort of, you know, full-faith backing from the government. They're a defensive asset. If the Fed cuts rates, in mortgage backs, duration is quite extended.

The Fed cuts rates. You can see that come down. So I think there's a lot of opportunities there. I think it's just the whole big thing is when selecting an asset or selecting a strategy is to look at the stability of that income. And even so, right on the cash portion of the market, that income is not going to be as stable as it once was because of reinvestment risk. And I think that's a big thing that investors are starting to grapple with is when

would this reinvestment risk become real? rather than implied. Absolutely. Well, finally, guys, so sitting here on the West Coast, we've been talking a lot about the shake-up in AI over the weekend with Open AI. I would be remiss if I didn't ask about it. Dan, what do you think long-term artificial intelligence?

What is the impact on a money management? Is there any sense of clients at any point saying to betterment, you know, I just want AI to manage my money. Does it, in any way, threaten your business? I just wonder what that looks like long-term in terms. terms of portfolio management, are we going to see AI play a bigger role here? I think everything that we've seen in the sense that is going to play a role. It's not going to be anything revolutionary. At the end of the day, a lot of the source material is still us.

It's still humans thinking about things, expressing things, and communicating them. It does bring up a lot of convenience in terms of, you know, if I want something to explain to me in a way that I'm going to really understand, either I have to pay sometimes an expensive financial advisor to do it, or I can ask a GPT that has been trained specifically to talk. in this case, Betterman's has a very large backlog of educational material. You can imagine us training a GBT to say, this is how we think about things, and we like to you to express it to clients this way. So again, I don't think we're going to see GBT's being used to manage money or make the

financial decisions, but I think they can be used for some back office stuff as well as communicating with clients more easily. Matt, final word on this. What do you think is on the horizon as far as incorporating AI into the ETF space? What's your take on that? Well, I mean, we actually do have some funds from an index provider, S&P Ken, show, that actually leverages AI as part of the stock selection portion of the strategy. So it's to some extent it's already infiltrated the ETF marketplace through sort of

index design, stock selection, but sort of the generative AI, that's, I think, still a long ways away. I think the biggest hindrance would probably just be regulation. The asset management industry is heavily regulated, and regulation sort of tries to sort prevent, you know, tail risks. And I think generative AI could be a positive tail risk or a negative one, depending on your viewpoint on how it could be utilized and some of the gamification of it and some of the risks associated with it as well.

That's it for today. I'm Kay Bruni. Filling me for Bob Pisani. Thank you so much for listening. Make sure you tune in next week. In the meantime, you can tweet us your questions or topic ideas at ETF Edge. NBC. InvescoQQQQQ believes new innovations create new opportunities.

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