ETF Edge - With Interest Rates Stuck, What’s a Bond Investor To Do Now? 2/21/24

Episode Date: February 21, 2024

Cash versus corporates versus active fixed income strategies… What’s the best place to park cash now whilethe Fed figures out its next move (or not).  Hosted by Simplecast, an AdsWizz company. See pcm.adswizz.com for information about our collection and use of personal data for advertising.

The ETF Edge podcast is sponsored by InvescoQQQQ, supporting the innovators changing the world. Investco Distributors, Inc. 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 we're breaking down what it all means for investors. I'm your host, Bob Pizzani. With the timing of the Fed's next move in question, what is a bond investor to do right now? Here is my conversation with David Botsett.

He's the Schwab Asset Management's Head of Innovation and Stewardship. And Nate Jeracy, he's the ETF store president. So David, at the last ETF conference, last week we were in Miami Beach, you and I chatting. And we were talking about 2023. It was the year short-term treasuries. It was the year money market funds. But 2024 seems to be shaping up to be something a little bit different than that. What's going on?

Where's the flow? What are you telling people? Yeah, we're seeing more flow in the intermediate space of the fixed income curve. I think people are starting to realize that we're kind of at the peak of interest rate increases, so we're looking to reposition the fixed income portion of their portfolio to take advantage of where interest rates are likely to go next to. So explain this to the viewers. The reason you should consider going from, I say, a short-term fund, which is, what, less than a year? Yes.

In maturity to something that's more intermediate. Intermediate means, what, three to five years? Three to five years, sometimes out to ten years. And the reason you should be considering doing that is why? Because when interest rates come down at such point, you not only get the income from that bond, you get price appreciation. Because yields and prices of bonds are the inverse. So basically, rates are not going to be, rates are going to be coming down, the shorter term rates, your expectations. Yes.

And going towards the intermediate side of the curve there, the middle of the curve, the chance of them coming down is less? What's the point here? In most cases, it is less. And that's what the yield curve is showing us. It's the yield curve. You're actually seeing higher rates on the short end. Right. But the long-term expectation is where those intermediate terms are today.

So it's likely to see less likely for those to come down. You'll be able to capture that yield for a longer period of time. You know, Nate, you and I've been talking about this as well. And you've been telling me fixed income is a bit of a challenge for investors and even advisors right now. What are the issues as you see them and where do you see the money going right now? It's interesting because if you looked last year, over a trillion dollars went into money market funds, which made sense in many ways.

Investors were content to scoop up 5% plus yields, call it a day, they didn't have to hassle with decisions around duration risk or credit risk or whether the Fed could actually orchestrate a soft landing. The challenge now though is should investors stay parked in cash or should they venture out on the duration and credit spectrum? I don't think there's necessarily an easy answer here, other than if you stay parked in cash,

you're obviously taking on the risk that if rates do come back in, you're going to leave some return on the table. I think to what David was speaking to, from my perspective, I think taking on some duration risk makes sense, but I wouldn't go too far out on the curve. I just don't,

the risk return dynamics getting too far out on the long end don't make a ton of sense to me. On the credit side, I do think it makes sense to look at corporates. You don't just have to stay in treasuries as an investor, I would favor investment grade over junk. And if you look at flows this year in the ETF space, we have seen flows into that short to intermediate part of corporates. So do you agree with David's point that it makes some sense to consider moving more into

the intermediate part of the curve? Less chances rates are going to go, it'll be more stable. Does what David say makes some sense? I do with the one caveat being that if we look at how the Fed has handled this battle against inflation, and even go back to a couple of years ago when they were slow to react as we started seeing the CPI data come in, if you're starting to go out on the curve, you're making the bet that the Fed

is actually going to get everything right this time. And they very well made. The data looks like that's where we're heading, but that's not a sure thing. And that's why I want to go too far out on the curve because I don't know that, look, inflation data could still continue to come in hot. The last print we saw was,

was higher than the market anticipated. So the Fed may stay higher for longer, and I just think you have to be cognizant of that as an investor. So, David, your point is we're already seeing inflows into these intermediate term corporate bonds. Schwab's got a bunch of them. How about, I like to flip it around. What are we seeing outflow from? We were talking about tips last year, Treasury, inflation, protected securities. These are bonds that are indexed to inflation. So we should be seeing outflows, right? If inflation is going down, the value of tips should decline, right? Yes. And that was a very popular investment two years ago. It was. And we did see that, especially in the second half of last year, where we saw outflows from the tips ETFs across the marketplace. So outflows from there,

and that makes some sense, right? Okay, we don't need it as much. All right. Now, I want to go back to Nate's point about corporate bonds. Corporate bonds had a huge rally at the end of 2023, along with everything else, guys. As you know, yields going down, prices up. But the yields are backed up, you know, recently in the last month or so. So prices are down, but there's also been inflows here. And I want to show you the yield differential here.

This is very important because here's your risk here. You're getting 5.6% yield for corporate bonds. I think this is your yield right now, versus 4.3% for comparable treasuries. And again, I've been taking this off, I believe it's Schwab's both intermediate term. ETFs. So there's what you're getting compensated. There's your extra risk right there, 5.6% versus 4.3. Can you make an argument right now for owning corporates over treasury giving you? You're

getting 1.3% higher, 1.3 percentage points higher. And I think that's agree with what Nate was saying there is there is a case to be made right now where there is a yield pickup that's sufficient to warrant corporates over treasuries at a similar duration level. Yeah. So you're getting 100 basis points in incremental yield there. Yeah. So, I mean, do you agree with this, Nate? I mean, it seems to make sense to me. If you're assuming right now that there is no imminent risk to the economy, that there's no credit risk, and I'm not even talking about high yield,

I'm just talking about corporate. I think that 5.6 is fairly attractive versus 4.3, again, assuming we don't have enormous risk in the economy, which would create, you know, credit risk here. Yeah, the assumption is the key, yeah, the assumption that you just made, that's the key part here, because if the Fed, botches this soft landing, then clearly that's going to present some risk to corporates. What's interesting to me is if you look at the flow data right now so far this year, money has come out of ultra-short and short-term treasury ETFs and even floating rate treasury

ETFs. And we've seen investors going further out onto the curve into longer-dated treasuries, as we've talked about earlier, but also on the corporate side. You look at the flows. We've seen flows in a multi-sector bond ETFs, such as B&D, and AGG, and then on those investment-grade corporates, particularly on the short and intermediate part of the curve. ETFs like V-C-I-T and VCSH and LQD, those are leading the way. So investors are clearly circling around this area right now. Yeah.

Honestly, as an investor, I made fun of my mother last year who called me in March and said, Robert, I'm at the bank. She was a head bank teller for years at the bank. The girls are telling me, I can get 4% of my one-year CDs. she said, I was getting 0.3% now. And I said, Mom, that's a good deal. And she said, well, Robert, I'm excited about it. I said, well, the banks are not because they're going to have to pay you more to keep that money in your bank account and not put in a one-year CD.

And she said to me, Robert, I can care less about the bank's profitability. I got nothing from them for years. And millions of people did what my mother did. Just what Nate was telling me about, including putting money into short-term bond funds as well as, you know, money market funds. I think that's exactly right. But when you start to think about those investors, I would argue that there's caution to be had. Your mother, she's taking it from her bank account to go into the CDs. You know, those are top the dollars typically you're going to allocate to short and intermediate term bonds. Yeah, she's not going to suddenly buy Nvidia. Exactly.

Exactly. Right. Very sticky money. But five points, doesn't this strike you as more normal than it was a few years ago. You know, normal to me, four, five percent on a 10 years seems a lot more normal than 1 percent a few years ago. People thought that was, suddenly got used to that, 3 percent, 30-year mortgages. That's not normal. It never has been like that. And now everybody's whining that they can't get a 3 percent 30-year mortgage. I'm sorry, it was 11 percent when I bought my house in 1985. It's come down, thankfully. But 6 percent is a lot more normal, historically. than 3%. It is. We've been living in this long

bond market rally for so long. We're finally through that. We're in a much more normalized environment. I actually think it goes back to the old 60-40 portfolio, which 18 months, 24 months ago, we said, was broken. And suddenly that type of allocation makes sense again because we're in a more

normalized rate environments. I remember two years ago at the ETF conference, zero discussion about bonds because nobody wanted anything to do with it. Nobody's going to do it. And now look how fast things change around. Speaking of active management, Nate, I know you mentioned it, active fixed income were a huge story at the exchange we were all at a week ago in Miami. So explain to the viewers, what does active get you in bond portfolios versus passive? Well, first of all, just to your

point, it was unbelievable. From my perspective, actively managed fixed income ETFs were absolutely the conference darlings at exchange. It was a huge topic. And it's crystal clear to me that ETF issuers are focusing on this category for several reasons. I think one issuers see that there is white space here. Because if you look at most ETF categories, they're pretty saturated, but active fixed income is one where issuers believe they can still offer some value and perhaps innovate a little bit. And that really gets into your question that, you know, I think the value here is given the market dynamics that we were just discussing. I think some investors, because of that challenge, they're comfortable handing the keys over to an active manager to help solve that.

You know, does the Fed get this landing correct? Should you take on duration risk? Should you take on credit risk? Instead of an investor or advisor making those decisions, they're more comfortable handing that over to an active manager to solve. And I think the other thing here, too, Bob, is if you look at the historical track record of active management, you and I know the data very well. on the equity side, which isn't good.

The data does look much better for active managers on the fixed income side. And so I think investors and advisors are a bit more open to active management within fixed income compared to the equity side. I guess the question is how much real value is this going to add in the long term? I mean, Nate hit upon the key point here. Indexing is pretty saturated. I mean, we've got all of the, look how successful Schwab was in moving into this space. You're the fifth largest provider, largely on indexing.

And you guys just moved right in because you have such a large base of users out there. You were able to successfully make a big splash in the ETF space. And yet, we know the industry has to grow, and the way to grow is byactive because that's not saturated. My question, though, as an old Jack Bogle disciple, is, are they really adding a lot of value? Do you feel? I mean, Nate apparently thinks that they are. Some of them probably do. Are there advantages to being active?

I'm dancing around the question, which is, is there something unique about bond trading that allows quicker innovation? You know, the guys in equities, they always say, oh, wait a volatility comes. That's when the active guys are really going to do well. And it's never proved to be true. They generally do not. Is there any academic evidence that active management and bond funds and they can react quicker will make some kind of deal? I'm trying to make a case here for the viewer. Why would I bother?

Why would I add, if I have a nice portfolio of ETFs that are indexed, what is the value proposition in adding active management? Does it help? Does it do outperformance? Does it tampen down volatility? I think you look at and you say, what am I, what's the bigger concern of my portfolio? If it's cost indexing is the way to go. If you're looking for the potential to outperform, active and fixed income has demonstrated the ability to do that over time. Let's just use aggregate bond index.

You know, it's one that many ETFs track. Well, the exposure you're getting to treasuries versus corporates versus mortgages is dependent upon the amount that's issued in each of those categories. You're just tracking that index. Over time, it's performed well, and managers can demonstrate they can closely track that index. But if you think in this environment, that should be more heavily weighted to corporates over treasuries because of the yield differential, that's something an active manager can do. You get my point here, Nate, right?

You're an average guy like me, and you've got an index portfolio of S&P and, you know, small cap value, et cetera, in a global bond market. Could I, could you make a case why I would add an active management component to this? Does it tampen down volatility? Does it improve returns? I guess what's the value proposition here? Well, look, first, I think you know I am an old school indexing proponent, and so I think it's always tough to beat. index-based investing. That said, my experience is that a lot of investors and advisors, they're very comfortable when it comes to the equity side of the equation, doing some active

management on their own, but they're not as comfortable in the fixed income space. And so when the environment is challenging, like I think we're in now, because, again, while yields have come up, we haven't had this type of environment for several decades. And so I think that they're much more comfortable being able to outsource that to an active manager and feel like maybe there is some value proposition there that they can squeeze out a little bit of extra yield without taking on as much risk. And if you look at the historical data, it is better for fixed income on the active side. Still not great. But it makes sense to me why investors are looking to active managers in this environment. Okay.

I want to move on. You get my point, folks. I'm skeptical about the active management thing. Remember, they charge more. So the alpha has got to be even more pronounced to make up for the higher costs. Okay? Jack Bogle, got to go back to that. I want to move on a couple of topics.

This is a sensitive issue for me, obviously. And Vitya's earnings are out today. Now, look, we've had a lot of discussion at this ETF conference last week about the concentration risk in the S&P 500 and the importance of diversification. The RIAs, the investment advisors, they were beset. by investors calling up saying, oh, why am I not more in the Magnificent Seven? Or why am I too much in the Magnificent Seven? So how does Schwab think about this?

What do you tell your investors about? You know, we really talk to them about using a combination of cap-weighted and smart beta. We have a lineup within our offering, the Schwab Fundamental Index ETFs. They select and weight constituents by non-price measures. So therefore, you're not as high. concentrated to those magnificent seven. But when you combine it with market cap, you kind of get the ebbs and flows. You get the momentum from the market cap. You get that better diversification. So be more specific. You're saying use... They select the securities in the index based upon

non-price weighting. So they think about earnings and fundamental factors. Like quality stuff we consider. Exactly. In which case, you underweight those momentum-oriented securities that can be a counterbalance to traditional market cap-weight. Do you have a quality ETF? This sounds like you're describing that. It's not a quality. That's the Schwab Fundamental Index ETF. So we've got a suite of those. What's the symbol for that? We've got several of them. FNDF is our international, which is one of our larger ones in that space. Yeah. So do you agree with this, Nate? I mean, the diversification issue was a big topic last week. And so what was funny was to watch the panel on this, tie them

up and not saying essentially, no, you shouldn't be throwing a lot of money into Magnificent Seven, but as an alternative, sell your clients on momentum. You'll M-T-U-M or sell it on quality, Q-U-A-L, and these are E-T-F symbols we're throwing out folks here. And it was funny, Nate, to watch everybody sort of tie themselves into knots trying to say, well, there's proxies that you can use for the Magnificent Seven that aren't exactly the Magnificent Seven. So does this all make any sense? diversification risk is a genuine issue. Yeah, I think there are two very important points to be made here. I mean, you look right now, the magnificent seven stocks comprise nearly 30% of the holdings in the S&P 500.

So seven stocks represent 30%, which is about as concentrated as we've seen the S&P 500. But the points I would make here are one, this is what you sign up for when you invest in market cap weighted industry, right? It's important to remember that investors who have been invested in the S&P. 500 have received the benefit of this concentration as stocks of power higher. So that's obviously a positive. Now, on the other hand, to what David was hitting on, look, I don't think there's any question. Concentration does present some risk here, and there are different ways you can approach it. You can look at smart beta ETFs. You know, from my standpoint, I just think the overall diversification in a portfolio is critical. So we have mid-caps stock, small-cap stocks, international stocks. It's not necessarily

shun market cap weighted indices, it's to make sure you don't have everything in the S&500. I am not as worried as everybody else. First of all, this has happened in the past, this 30% number you keep mentioning. In the late 90s, there was an intense concentration, same way. And even with the nifty 50s, 70 years ago, I think the top 10 stocks were close to 30% of the S&P at that time. So this is not unprecedented. The great thing about owning an index is it's self-corrects eventually. You just like you partake in the advances of the Magnificent 7, if other stuff, equal-weighted stuff starts moving up, you will participate in that, even if you're in a market-cap-weighted index. So I am not as worried as everybody seems to be.

And Nate makes a really strong argument for the case for diversification, right? Not only the S&P, but mid-cap, small-caps. You are diversified in the S&P, though. That's the point, too. But also looking back at rebalancing your portfolio when it gets out of whack, understanding, what is my strategic allocation? How do I stay there? I want to get a second top again before we got to go here. And that's, guess what, spot Bitcoin ETFs. Of course, you can't go by a week without mentioning that. So we've had, what, $5 billion, Nate, in flows in five weeks. So we've had these 10 spot Bitcoin ETFs. They've been successful. They track well. But characterize the flows. To me, the overall flows

seem still fairly modest. Much of it is coming out of gray scale and going into the other ETFs, Bitcoin ETFs. Your thoughts on this, Nate? Well, I would counter that a little bit. I mean, you look here to date. Two spot Bitcoin ETFs are in the top eight of all ETF flow getters this year. So the I shares Bitcoin Trust, Ibit. That's number three in inflows. And then the Fidelity-wise origin Bitcoin fund, tick our FBT, that's eight. But as you were saying, overall, spot Bitcoin ETFs have now taken in over $5 billion in net flows in just over five trading weeks.

So that's nine new ETFs that have taken in over $12 billion because the Grayskill Bitcoin Trust has had over $7 billion. outflows. In my mind, I don't think there's any way to characterize that is anything other than a monumental success. Again, five trading weeks, five billion in net flows. Now, what happens moving forward? We'll see. But a lot of these ETFs are just now getting approved on various platforms. I think advisors are just now getting comfortable with these ETF. So I think there's a positive, a pretty strong tailwind behind this. What was interesting to me at this, listening to the conference was a lot of the, half of the RIAs seem very interested. The other half seem terrified of the legal consequences. You know, Gary Gensler filed a shot across the bow at all

of these people when he conceded the Grayscale case and said, may I remind all you people out there, you RIAs, that you have reg best interests that requires suitability requirements, and that means you better be darn careful about selling Bitcoin to Grandma, as I like to call it. You could potentially get sued there. So I'm sure some of the RIAs I talked to were clearly uncomfortable with what's the legal requirements for me to follow. This is new. We don't. know, right? And where does it fit in the portfolio? Talk about diversification. Where does it slot in? What's the right percentage if it is a right, right allocation for clients? Well, what about Schwab? You guys haven't done anything, right? Is there any consideration? Well, I can never

comment on what we may be considering in the background. What I can say is we'll do the same thing we always do, and that's put the investor first. Understand what the investor needs are, take that in, and that guides our product development. What are you reading from the Charles Schwab playbook or something here? Do you memorize that sense? I've interviewed Charles Schwab. I know him. I know. And That's exactly what Charles Schwab would say. You sounded like Charles Schwab over there. It's high compliments. Go work for Charles.

Go work for Charles Schwab. Oh, wait, you do work for Charles Schwab. 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. We continue the conversation with Nate Geraci ETF stores president. Nate, thank you for sticking around. We had a wide raising conversation there about the ETF trends. looking at the panels last week at the ETF conference, a couple of things struck me as very interesting.

One, a lot of the panels were not so much what kind of ETFs the RIA should be buying. These are registered investment advisors. They're the people who buy these ETFs. Not you should buy this particular ETF that is an international over this one, but more on managing your business as an RIA. and I thought that was interesting. It seems like a lot of RIAs, a lot of advisors out there really need help managing their businesses, whether it's a back office function because they don't know how to do the payroll, or they don't know how to pay their taxes, or they don't know how to talk to clients. There were several panels on how it's educating the client on not understanding how trading works,

investing works, which seem to be very important. Am I picking up on something here? Yeah, I think what you're hitting on is something that, I've seen a lot of where if you look at the RIA space, you have advisors who they're either very sales-oriented. They know how to work with clients, but they're not business operators. They don't know how to actually build a business and operate the back end of a business. And so they need that assistance.

Or on the flip side, you have somebody who's a really good business operator, but perhaps they're not a great advisor in terms of being able to communicate with clients. And so what some of those panels we're hitting on is solving that problem. depending upon which skill set an advisor has. I think that's one. I think the other piece of that, Bob, is that one of the things that we're seeing in the ETF space is the proliferation of ETF model portfolios, where advisors are effectively outsourcing that investment management piece. And once you do that, if that's not of concern, then you start focusing on the business side of the equation and how to run a business, how to best communicate with clients. And so I think

that's what you were picking up on. Yeah. So in all these businesses, there's always a rainmaker. Rainmakers are people who bring in clients and who know how to bring in clients. And then there are people who are better managing the clients. And then there are people that are better just at, frankly, just running the business overall. And this has always kind of existed in businesses. I think we're starting to see that in the RAA space. The other thing that interested me was there's always a few panels on hot investing trends. And every year there's a panel on international investing and how RIAs and individuals, you know, what's, how is international investing looking? This year, Zip, not a single panel discussing international. And China did not even

exist, which was a hot topic a couple of years ago. And China had just fallen off the face of the earth. It seems to me like everybody seems to think China is, the political risk is so high that it's not worth talking about even. I was just striking how little there was about investing anything outside the United States. I can summarize this in a nutshell, which is you and I have been going to these conferences for what 15 plus years?

And at every one of these conferences, to your point, there are multiple panels on international stocks and how this is going to be the year for international. And I think what's happened is we've had a decade plus of significant international stock. underperformance, and investors are finally throwing in the towel. China's Exhibit A here with what's happened. Now, you and I also know that typically at the point investors throw in the towel is usually when the tie turns, and perhaps that's what we'll see this year. Maybe it's a good contrarian

indicator, but I think it's very simple in that for any advisor, any investor who's had a diversified portfolio where they've had a fairly sizable allocation to international, they have significantly underperformed. And if you're an advisor, year after year goes by with that underperformance, clients start asking questions. And I think advisors are the way from international. Now, again, is that the right answer moving forward? Probably not if we look historical. It sounds like a buy. It sounds like a buy to me. I mean, based on, sentiment is so negative in a classic way. You hit it there. It sounds like a buy to me. It really does. Although I have to say, underperformance for years and years really does weigh on you.

And at some point, you have to say this is not a cyclical thing. It's a structural thing where the U.S. economy is structured or capitalism is practiced in the United States in a slightly different way than its practice, even in France, for example, where the means of production is more highly owned by private individuals and corporations. And that makes the allocation of capital more efficient. that increases profits. I'm trying to figure out why is this persistent outperformance from the U.S. That seems to me to be a logical answer. The structure of capitalism as it's practiced in the United States. Am I off base on that? Well, I think all of that makes sense. But I think even if you just look in the public markets and you look at the magnificent seven and you look at the cash that those companies are generating, you look at their balance sheets, you look at their revenue across the globe. It's not obviously just in the United States.

there's a very compelling argument to be made that if you invest in those companies, you do have international exposure. I don't know that I subscribe to that, but it makes sense to me that investors would feel that way. And when you see the returns that those companies have generated, it's tough to then go into underperforming international stocks. No, Jack Bogle used to always point out and question the need to own a separate international fund

when 40% of the earnings or of the revenues, is the S&P 500 go outside the United States or outside the United States. So I completely, I think your point is very well taken. My point about these companies and how big these tech companies has been is this happens because of innovation in the United States and the way it's practiced here, the way the corporations are set up, the way the tax structure is set up.

I think innovation occurs here because the way the system is set up in the United States that makes it this kind of capitalism easier to produce, wealth, I think, is what I'm getting at. All right, we're getting off on a little bit of a tangent here. The other point that's interesting to me is the slow maturation of the ETF business. So we're now at $8 trillion in assets under management. Every year money keeps coming in another trillion, another trillion, a little less in mutual funds. But most of the money, I know you're excited about active, most of the money still goes into indexing. It's just the slow drip into S&B 500 funds,

some big cap, some large small cap funds. The industry is pretty mature at this point, and I do understand why they're eager to push active management, but in one hand, it's nice to see. On the other hand, it's a little sad to see because the industry is now entering this middle age where they are scrambling to figure out how do you keep it growing because it's owned by big companies.

It's owned by Black Rocks and Vangards and Schwabbs and Fidelity that are interested in trying to figure out how do you get a certain amount of growth every year? Well, the industry has definitely reached middle age. We're over 30 years old now, which, by the way, makes me feel even older, or really old. The industry has matured. You now have the biggest names and asset management involved here.

And as it pertains to active, you're right. I think we're going to continue to see flows into index-based ETFs. That's not going to change. They'll take the lion's share of new money coming in every year. I think what these traditional managers who are getting involved in the ETF space see, though, is their mutual fund business continuing to die. And they still see the growth within the ETF space. And what their expertise in, by and large, is on the actively managed side. So I think we're going to continue to see the proliferation of active strategies.

That doesn't mean when I say, you know, I'm bullish on it. I'm bullish on the growth of active. I'm not necessarily saying that investors should load up active strategies in their portfolio. I think you can like to manage or see that. Thank you, Nate. Always a pleasure talking to. Nate Terracie from the ETF store, and that does it for the ETF Edge and Goh podcast. Thanks for listening.

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