ETF Edge - “The rotation” & the next $10T 7/17/24

Episode Date: July 17, 2024

A long-anticipated leadership rotation may be starting to build. Which sectors will inherit the fortune? Plus, with the industry poised to hit $10T soon, where will next $10T come from and where will it go?  Hosted by Simplecast, an AdsWizz company. See pcm.adswizz.com for information about our collection and use of personal data for advertising.

Welcome to ETF Edge, the podcast. If you're looking to learn the latest insights on all things, exchange traded funds, you 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. We're assessing the great rotation trade and where the next $10 trillion will flow into the ETF business.

Here is my discussion with Annapalea, Executive Vice President and Chief Business Office for State Street Global Advisors, Anna is in charge of State Street's ETF index and 401k business. Also joining us, ETF journalists and financial futurist Dave Notting. Anna, you're a big shot now. She is. I've known it for a long time.

She's got a great new job. You run the S&P 500 index business. They report to you, all those ETFs. Is this rotation real? Is there actually money following some of these moves in small caps? Well, first of all, I've always been a big shot. Thank you, Ma. I love that.

Put me in my place pretty fast there, all right. And yes, the money is following the trend. In the last five days, we have seen a huge uptick into our sector, ETFs, tilt with small cap, financials, home builders, so the money is following the trend, for sure. It seems that way. And so we're talking not just about small caps, but other things too. So we've been looking at value stocks.

We all know value's been underpenter. value's been underperforming. You also manage, oversee, the S&P value ETF. That finally hit a new high recently. But is there any signs these traditional value sectors, the industrials, the energy, materials, and maybe some of the financials. Are they seeing any inflows at all? I know I'm going on to a different thing here, value over small caps, but any sign that's happening? They are seeing positive flows. Now the question is out there. Is it the value tilt or Or is it the cyclical investments, an investor appetite for that?

But definitely the numbers are there. We see positive momentum with value-related strategies. You know, Dave, let me bring you here. What about this great rotation? Does it have legs and what are you watching right now? Yeah, so for the moment, I would get a little cautious about calling this a rotation, because that implies that everybody's out there selling their QQQs and selling their SBY. That's not what's happening.

What we're seeing is money that I hate to use this for. phrase, but we have to say it's coming in off the sidelines that is just buying, buying, buying, they are now for the first time in ages, buying value, buying some of these defensive sectors, buying small caps, but they haven't stopped buying the other things as well. If you look at the amazing five days we've had $50 billion in flows in five trading sessions, it has gone into things like equal weight and two things like small cap, but it's also gone into things like SPY, which has had $11 billion in flows in five days as well. So I think this is money coming in from that giant bucket of money markets that we know is sitting out there.

Well, that would be rotation. It is rotation, but it's coming into the market into these other sectors, these non-Mag 7 ways of playing the market. That's not the same as everybody's selling off the Mag 7. Yeah. I have two problems with this rotation trade. And maybe, Dave, you can comment at first. Traditionally, small cap rallies usually come off of economic bottoms and major market lows. And we have the opposite of that here.

That's one problem. And it's not clear if this is just a playoff of lower interest rates and whether or not that's enough to sustain the rally. Finally, you know this. We have a seasonally difficult period come out. The middle of July through October, usually, volatility usually rises and the market usually has a tough time. It might this make any sense?

I'm trying to figure out whether this is real legs here. I think there is some legs in the diversification trade. I think that's really what we're seeing more than a, you know, full-throated small caps are going to dominate rally. I think what we're seeing is a diversification trade. We're seeing flows into everything. And that to me means people are looking to get a little bit broader in their exposure, which is smart in an election year, right?

Election years, one thing we do know, however the rest of the next six months goes, we know it's going to have increased volatility and uncertainty about outcomes. That means diversification is your friend. Yeah. What about, Anna, other flows, what about, say, bond funds right now? I've been looking, SPHY, this is the high-yield bond fund that you oversee. It's spiking recently. Prices have been spiking here. What's going on and is there any flow behind any of these? It is, it is spiking. High-yield is spiking, but we are also seeing positive flows in either fixed income, ETIFs like investment grade senior loans. Senior loans have had a very, very good couple of weeks

or a couple of months. So to us, that is a signal that investors are really getting comfortable with risk and there will be momentum behind that. Bond funds have dominated, almost dominated the senior loan funds. Explain how that are those short, shorter duration loans? What's a length of a a typical maturity for a senior loan. They are on the short and duration side. Our fund is active, so it is really managed to take into account some active sentiment and the best way to... So if the prices are going up on a senior loan fund, it's an indication that people think yields potentially will be lower in the near future.

That's correct. So I think that while we are all focused on the equity market, people are really looking at a soft lending as something that is really inside. And now it's becoming more and more plausible to see interest rate cuts. So this is fueling. But to Dave's point, we keep waiting for this crowd that's parked all this money in money market funds. And my mother, who calls me up delighted that her one-year CD is getting, you know, 4.5%. She's just ecstatic. This is very sticky money.

These people love their 4.5% bank CDs. Yeah, but Bob, they love their 8% high yield better, right? That's the thing. I think we are seeing this sign that folks are getting more comfortable with credit risk. We haven't seen the raft of bankruptcies. Everybody's thought we might get because rates came up and the junk market wouldn't be able to refinance. Hasn't really happened in any kind of doomsday scenario. Now we've got the prospect of falling rates, which we know is good for bond prices.

If we're in a falling rate regime, people are getting more comfortable with credit. And they want more than that four and a quarter or four and a half. They can get the CD right now. But how sticky are those people who are, he keeps implying that suddenly there's going to be raft of people who are going to suddenly throw money into the stock market or even high yield. They seem very sticky to me, those people. Even the people who are owning two-year and 10-year treasury bonds, they seem to believe that they are getting a real yield, that is inflation-adjusted yield, and the evidence is that they

are at this point, and that they're comfortable with that. Is there reasons they should not be comfortable and more money should be going into other kinds of bond funds? I agree with you. I don't think that there will be this huge wave of investors coming out of money market funds and reallocating to the stock market or to ETFs. We actually run a very successful money market fund business and everybody has been waiting and looking at those flows or looking at this business to say, well, at some point money's

going to come out. Well, guess what? It's not because people who invest in cash, they want cash for a reason. So some of it is defensive, some of it is going to come out and reallocate to ATFs, but most of it is sticky. I don't suspect this big wave coming out of cash. Yeah. Well, all I can tell you is we ask people all the time and I'm waiting for this to happen. I don't see any tidal wave happening yet. And when I look, I mean, my wife is money in various money market mutual funds at 5%. They seem very happy sitting there. My wife

doesn't bother me. Honey, what are we going to do? Oh my God. But net flow is net flow, right? And $50 billion in five days came from somewhere, right? And it probably didn't come from people just selling their mutual funds. A lot of that money came from cash. Let's talk about flows in general. We have $411 billion coming into ETFs through the end of June. I think it's the second best first half ever.

I think this is your statistic, Anna. I think what was the record? $460 billion in 2021? That's the first half. There have been some modest flows now in small cap and value, as you've been noting to us. But most of the money, and Dave, you said this is still going into tech and big cap indices like the S&P 500. Are we going to see a record this year? What is the record for inflows?

Nine something. And I think we're going to hit a trillion this year. Okay. It seems almost inevitable. Okay. So this would be a record year, right? I think so too. And if you look at what happened over the last two weeks, $411 billion was at the end of June.

In the last week, so we have seen a great acceleration. We now have almost $500 billion of new money that came into the industry. Okay, so we are definitely on track for a trillion dollar year. We are. Okay. And again, most of this, the majority of this money is still going to plain vanilla index stuff. It's going to tech, and tech, XLK, which you oversee. That's right. It still has big inflows.

That's right. Now, if this thing really broadens out, if we actually get, let me look how underfunded small cap and value, been for years and years. We keep waiting for one year when this thing will finally happen. The academic studies, as you know Dave, Fama French, two-factor, three-factor models, small cap, eventually outperforms big cap, value eventually outperforms growth, but it hasn't worked very well for 15 years, maybe 2021 it worked. Could this actually happen this year? If that happens, wouldn't we see another, an additional flow of money perhaps coming out? of the money markets into the small caps.

Yeah, I mean, certainly if we have a sustained rally in small caps, and by sustained, I mean, like we have two or three months where small caps of all varieties are clearly beaten the pants off of large caps. Then I think you'll see a ton of money chase that performance. That always happens. It obviously shouldn't, but it does when we're adults. We know that's how it will work. If what we're seeing instead is just a re-diversification trade,

I think you would expect this to sort of bobble along a little bit here for the rest of the year. Well, that's my question. If you're just going to take money out of XLK and put it in small caps, that's just a rotation. But if you're taking money out of money market funds and putting it in small caps, now you're putting real money in the market. That's why the flow number matters, right? That's why it's worth looking at what is the entire ETF industry capturing of new flow that's coming into the markets. And the answer is, it is the biggest money grabber right now. The ETF structure is clearly one. Right. So we are now approaching $10 trillion. We haven't hit that.

It's $9.4, $9.4 trillion. Couple good days. I know we're obsessed about this folks, but you know, 10 trillion is a big round number. And the mutual fund billion industry is still with $19,000, something like that. But it's catching, it's slowly, slowly, mutual funds down, ETF assets. Underband's slowly going up. So let's just say we're essentially a $10 trillion business here. I know, Ana, you are doing a panel tonight on the next $10 trillion. That's the title of the panel.

So where is the next wave of ETF growth coming? Is it still going to be just slow trickles into plain vanilla? ETFs, is there some new wave that's going to open up? What are you going to tell people tonight? Sure. So, Bob, to me, the next 10 trillions are going to be investor-driven. Now, if you think about the last two decades, they have been, in a way manufacturing driven.

Sponsors like us came up with the good ideas for new products, those good products, those good ideas, found a place in clients' portfolios. The next 10 trillion dollars are going to be driven by clients, not by us. Their preference are going to drive what we are going to do. It's going to be around attending to the interest of young investors. Do it yourself investors, millennials,

who are buying ETFs for the first time. first time. How do you communicate with them? How do you communicate with advisors so that you are going to be replaceable for them? Partnerships are going to become more important than product proliferation. And that's going to be to the benefit of the end of the client, which is always how the entire market should behave. You didn't bring up active. I've been waiting for the whole active story to come in. The ETF people love talking about active here. Is that going to be, We've seen a significant part of the inflows already, but is that going to last in any way? Well, Bob, let's talk about the technology.

The ETF technology we have established is a much more modern technology compared to the mutual fund of wrapper. Now, technology and content are different. Alpha, there will be a place for good, effective alpha in an ETF wrapper. Old-fashioned stock picking. All the fashion stock picking. but you know what? The ETF market is not forgiving. So good alpha, are you outperforming the benchmarks?

The benchmarks are so strong. That alpha is going to survive. It's going to thrive. But the other strategies are not going to become important just because they are going to be in an ETF wrapper. So the active segment of the market is growing, but you always have to do a double-click to understand exactly what is really active, what is driven by fundamentals,

Is that segment really going? You and I have talked about this before. People consider, you know, JEPI, options overlay active. And I don't really consider, it's sort of index plus. I don't know what you would call these. It's quant, right? It's quant. It's quantitative and active and I think that's fine.

What we have seen, however, is that the real quant stuff, smart beta, remember we used to talk about smart beta all the time? We don't use that word anymore. No real interest in that. None of the smart beta darlings have really gotten much flow, even though some of them have actually performed quite well over the last couple of years, that haven't been able to pull in that flow.

Active is much better in terms of talking to investors, giving them a story to understand why they own what they own. So I think you're going to see the 10 trillion come from all of the places it's been coming from so far. But I agree with you. I don't think it's coming from product innovation anymore. It's going to come from distribution and helping investors learn how to use these things well.

Let me just ask you, Dave, about the election and what's going on. We saw today comments from the Trump camp about Taiwan. Semiconductors are down. today, how do you factor this into thinking in general? Think about it all as short-term volatility. I think it's very easy for us to all get caught up in team red, team blue, and our tribalism. As investors, what we should understand is this election brings uncertainty.

Uncertainty means it's difficult to make narrow calls on the market and it's always better to be diversified. This is not the six months. I think the average investors should be making big changes in their allocations, whether that's into a sector, out of a sector, into bonds, out of bonds. This is a time when you should be focused on, is my long-term portfolio, you know, Armageddon proof as it can possibly be.

And then, honestly, next year, we'll have more clarity and almost regardless of the election outcomes, clarity will be better for markets than uncertainty. Anna, you oversee a number of interesting sub-sectors. Aerospace and Defense, for example, XAR. That's obviously a space that's seen a lot of interest. What kind of flows are we seeing in that?

We are seeing positive flows is one of the best performing the sector ETF when it comes to flows because this geopolitical uncertainty is really fueling people's interest in defense spending. And this type of products are the perfect vehicle to accommodate this type of preferences. Yeah, I'm moving on to a couple quick topics here. Dave, Ether, ETFs, Spot Ether.

We're expecting, we have not gotten a word, but we are expecting approval soon, likely begin trading next Tuesday potentially. The spot Bitcoin ETFs by any measure have been a success. Inflows have been, I think, generally better than expected. Ether is a much smaller product in terms of assets under management and Bitcoin. What are we expecting? My opening bid here is that we'll get about a tenth of the AUM at the end of the day.

So give it a six month run. I think we'll look at this and we'll say the ETH funds have about 10% of what's in the Bitcoin funds. That makes sense to me. Bitcoin's a store of value. It's a very different kind of story. Heath is utility effectively. It's like buying Arbaugh there.

You're buying gas for the crypto economy. And so that's a very narrow play on how crypto gets used to rebuild a new decentralized finance world. If you're a believer in that, the ETFs are going to be a great way to play that. But I think that it's a cascading level of interest from there. If a salon an ETF comes next, I think it's going to be an even smaller allocation. So I think we'll see more folks do what. State Street SSGA has been doing, which is partnering with folks to figure out ways to do

active management in this space, to put these into portfolios, to put them in context, in other words, to make them less of a speculating vehicle and more of an investable asset. Anna, what about that? He gave you the opening there. State Street Global Advisory, you're one of the few big ETF players that aren't participating in the Bitcoin or Ether ETFs. Do you have a strategy here? What's your thoughts on your... way of participating in this, if any. Yeah, Bob, I'm a big believer in digital assets. I think that whether we like it or we hate it,

we have to pay attention because this is where the money is going, this is where investors are. And I think that digital assets are going to really change the financial industry in the next 10 years. But I'm not excited about single cryptocurrency because the space is crowded. I'm not going to launch Bitcoin number 12 or number or either number six or number seven, that's not exciting to me.

But what's exciting to me is digital asset 2.0. What is the next version? How do we use all of the single components in active strategies to build a portfolio? And that's why we partnered with the Galaxy Capital because we think that the expertise lies with crypto natives. We bring the best of what we do with TTFs. They bring their knowledge when it comes to digital assets.

That's 2.0. Now, this partnership with Galaxy, can you tell us a little bit more about it? What does this involve? Well, Galaxy will subadvise a number of portfolios with us. So we will actually use their intellectual capital to build the solution-oriented portfolios. It's not going to be about the Bitcoin, it's not going to be about the entire digital assets ecosystem. How do this currency play a role in a portfolio? How do we hedge those currencies?

If people like a Bitcoin but they don't like the volatility, how do we hedge the volatility within a portfolio? Interesting way to do this. So you'll come back and tell us more about this partnership as it evolved? I will, promise. All right, thank you very much. Appreciate that. We hit a lot of topics here, folks,

but we got two of the best in the business here. We got a well-known big shot, even bigger shot than he was. And one of the great ETF experts in the world here, Dave Notting's with us. 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. Financial Futures Dave Nautic continues with us now. Dave, it was a great

discussion with Anna. This rotation seems to be real. We are getting generally money into small caps and value for the first time in ages. You seem to be unsure whether it's going to last for a long period of time. And yet the summer is looming. right now. Yeah. And we see normally a hiccup in the summer. It's not unusual to see late July, August, September, hiccups are happening. Yeah, it could be rough. Yeah. I think I'm naturally skeptical that we can call five good days in the Russell, you know, the beginning of a you know, lifetime rally. There's an enormous amount of options interest in things like IWM,

the I-Share ETF covering the Russell 2000. I mean, we're talking like hundreds of billions of dollars of notional trading on that. And so consequently, there's a lot of folks out there managing their risk. And that's going to mean money in and out. Like a lot of people were short in the hedge community, some of what we've seen is probably unwinding those positions. But by the same token, I don't think you can say that's all of it. Because if you look across the ETF ecosystem, you're seeing all sorts of funds get

a bid that haven't seen flows in ages. Equal weight sectors, equal weight S&P 500, extended market. funds. Those funds have been dormant for ages. All of a sudden they're getting billions of dollars in flow. So it's not just a small cap story. It's a not mega, not you know, mag-7 story. I would note

we've seen some modest money going into cyclicals, big-cap cyclicals, and this is traditionally value plays. Industrials, materials, some energy, some banks. Defensive, like consumer staples, not a big move.

yet. So I would say it's broadening out a little bit. Now today, of course, let me ask about the election. We have seen a little bit of a shift here today because of the comments on Taiwan from the Trump camp. And so semiconductors are down. Taiwan semi

is down. Small caps interestingly held up very well in the beginning. And at a week and midday, it seems like people are sort of light, just lightning up in general right now. Yeah, I think it's really tough for investors to try to make any kind of call about, like, should I be in semiconductor? Should I not be in semiconductors?

Should I be in aerospace? Should I not be in aerospace? Based on what we're hearing in the election cycle news, right? This is going to be volatile. Tomorrow, I'm sure Trump will come out and say something that's very pro-chips and pro-TSMC, and then all of a sudden those are going to rally back up 3%. I think we're in for a lot of this kind of politically induced volatility. So I think it's tough to really try to trade those sectors.

of the sectors we were talking about with Anna earlier, the one where I think you can kind of say is almost an apolitical observation is defense stocks. Because let's just be really honest among adults here, regardless of what happens in the U.S. election. Literally in any scenario, good, bad, and different, whatever your views are, we are headed towards a more volatile geopolitical world. We have two fairly hot wars going on right now. We have Eastern Europe re-arming itself for the first time since World War.

two, we've got buildups in Asia. Like, people are arming up. That's going to be good for defense stocks, like it or not. It almost has nothing to do with what America does in the next five years. And I'm looking at the markets today, and it's the middle of the afternoon. And you can see, here's a day when defensive stocks are doing well.

So healthcare like United Health and Johnson and Johnson are up, Chevron's up, Procter & Gamble is up, Coca-Cola's up. The Dow in general is up right now up 200 points on a day with the and he down 70 points, you can go many years with not seeing that kind of behavior. That's a little weird. It's an odd inversion. But what it says to me is it's a bit of a mega cap repudiation, right? The reason I'm going to guess SPX is down is probably the mega caps.

I don't have a sheet in front of me to look at it, but, you know, the difference between D.J.I. and SPX is largely a bunch of those mag seven stocks. Let me just ask you quickly about pricing. Anna, of course, is with State Street Global Advisors. And they, for their funds, many of their S&P funds, they offer essentially two types of ETH. They offer a low-cost core, spider core portfolio series, which has very low fees, three or four basis points. And then others that cover the same index that are higher price. So SPY is what, nine basis points.

Right. Even gold has the same thing. Right. An expensive gold and a cheap gold. So is this fee war kind of over? I mean, we did this story for a number of years until finally everything hit three basis points, and that was sort of as low as anything can go. Is there any further observations we can make about this price work?

What we're going to see now is the sort of barbelling and fees. So we'll continue to see things that are a little expensive, 12, 15, 25 basis points. Those will continue to get pressed down to the marginal cost of production. So that's going to be in the tens, right? So we'll see that continue to compress. So the AUM weighted fees will still see come down because people will keep buying cheap beta. On the other end of the spectrum, we're going to have a continued rash of derivatives-based products that probably charge north of 1%. Whether they're buffered products, whether they're equity income products, whether they're 2x leverage Tesla,

all of those things which now use the freedom we have in the derivatives interpretation from 611. All these products play in the same playing field. they all charge vastly more than any of the cheap beta indexes. We're going to see a lot more of those products. So we're going to see both more expensive product and more cheap product. Not a lot in the middle. I don't think you're going to see a big resurgence in 50 basis point funds. Yeah.

I agree with you. And it seems like we're not going to get much lower than that. And yet it's amazing to me how many of these funds, some leverage an inverse, charging 90 basis points. Well, and we should acknowledge there are a handful of funds out there that do charge zero, right? The SoFi series is still extant. There are a bunch of funds that have waived fees. If you go sort and pick your sorting tool and sort by expense ratio, you'll find six, ten funds that currently have zero expense ratios. That is not proven to be marketing catnip.

There are not a lot of people out there who are shopping for free. Three basis points is $3 for $10,000. It's ridiculous. If you go to $2 for $10,000, the world is not going to necessarily beat it. I would rather pay the marginal cost of production than worry about who is. Yeah, agreed. All right, Dave, thank you very much. That does it for this week's ETF Edge, the podcast.

Thanks everybody for listening. Join us again next week or go to etfedge.cc.com.