Archive for June, 2015

HOUGAN & PERON: LOW-COST ALTERNATIVE TRANSCRIPT

 

Investors are abandoning traditional, actively managed mutual funds in favor of “passive” index funds, particularly exchanged traded funds, or ETFs. Wall Street has taken note and is offering a wide variety of ETFs to attract investment money. How do you tell the difference between a good ETF and a bad one? When is it better to invest in an ETF? When is a traditional mutual fund the wiser choice? ETF experts Matt Hougan, CEO of ETF.com, a leading ETF research firm and Matthew Peron, head of Global Equity at giant wealth management firm, Northern Trust provide the answers you need to make the best investment decisions on this tenth season premiere.

CONSUELO MACK: This week on WEALTHTRACK, investors are flocking to passive index funds, especially exchange traded funds or ETFs. Should you join the migration? How to tell a good ETF from a bad one with index fund experts, ETF.com’s Matt Hougan and Northern Trust’s Matt Peron is next on Consuelo Mack WEALTHTRACK.

Hello and welcome to this special 10th anniversary edition of WEALTHTRACK, I’m Consuelo Mack. Yes, we launched this program at this time, in the summer of 2005. Our mission then and now is to help you, our viewers, and ourselves, build financial security for a lifetime. So this week we are delving into the two biggest trends in investing that are really coming into their own in the past decade. Money is pouring into passive, index funds and specifically into exchange traded funds or ETFs. Global assets in ETFs just broke through the 3 trillion dollar mark. There are nearly six thousand ETFs and Exchange Traded Products to choose from, listed on 62 exchanges in 51 countries, although more than two thirds are in the U.S.. Unlike index based mutual funds, started in 1974 by Jack Bogle at Vanguard, ETFs which were created in 1993 by State Street with its S&P 500 SPDR ETF, can be bought and sold like ordinary stock shares on a stock exchange. They are also extremely tax efficient, for reasons we will explain in a moment. However similar to traditional index mutual funds, ETFs are low cost. That feature has become a huge draw for investors.

According to a recent report by Morningstar analyst, Michael Rawson, 95% of flows into funds of all types over the last ten years have gone into funds in the lowest cost quintile. And the biggest winners by far have been passive funds, especially ETFs.

Passive funds now account for 31% of total fund assets covered by Morningstar, up from 14% a decade ago. ETFs are gaining market share fast. They now account for 14% of mutual fund assets up from only 4% ten years ago.

The largest ETF and the most heavily traded security on any stock exchange is State Street’s pioneering SPDR 500. However the variety of ETFs offered is exploding. They come in all shapes and sizes. They are based on broad market indexes as well as tiny niches. For instance one of the most popular slices recently has been baskets of Japanese and European export companies hedged against the yen and the euro.

ETFs are available in stocks, bonds and commodities with different flavors being created every day. That means it is becoming more of a buyer beware product. How to tell the difference between a good ETF and a bad one? When should you use them, when not?

This week’s guests are ETF veterans, as both analysts and users. Matt Hougan is the CEO of ETF.com, a leading authority on Exchange-Traded Funds. Prior to becoming CEO he was President of North America for the firm where he oversaw its core online and print media properties, ETF.com and ETF report. Hougan writes for The Wall Street Journal, has been a 3 time member of Barron’s ETF roundtable and is an ETF columnist for The Journal of Financial Planning.

Matthew Peron is Senior Vice President and Managing Director of Global Equity at Northern Trust, a leading investment management firm with nearly a trillion dollars in assets under management. Among his responsibilities is overseeing what the firm calls its “Engineered Equity Strategy” which it describes as a middle way between active and passive management. Northern Trust was one of the early users of index mutual funds and ETFs. 80% of its global equity assets, nearly $400 billion dollars worth are in indexed strategies.

I began the interview by asking both of them why ETFs have become so popular.

MATT HOUGAN: They are so popular. They’re rapidly taking market share from traditional mutual funds, and the reason is simple. They are on average lower cost. They’re more tax- efficient, and they provide the kind of targeted exposure that makes sense in this sort of macro-driven market. So if you want to target China or you want to target Brazil, there’s a way to do that. If you’re worried about rates rising, there are tools to do that. So you have low cost, tax efficiency, targeted exposure. They’re the right tool for today’s market. That’s why they’re growing.

CONSUELO MACK: And Matt Peron, at Northern Trust you’ve been using passive index funds for years, and Northern Trust is one of the top five global indexers as a matter of fact?

MATT PERON: Correct.

CONSUELO MACK: You’re also using ETFs now and have been for a while. What is the attraction to ETFs?

MATT PERON: Well, we launched our FlexShares ETF platform about four years ago for a lot of the reasons that Matt mentioned which is that it has tax efficiency and other advantages that we want to make sure we offer to our clients, and so we see it as a strategically important place to be for our firm and for our clients.

CONSUELO MACK: So what’s the big advantage that ETFs have over mutual funds, Matt?

MATT HOUGAN: For traditional index funds.

CONSUELO MACK: Yes.

MATT HOUGAN: Well, they tend to be a little more tax-efficient and, of course, you can trade them intraday which you can’t do with a mutual fund. You can only buy that at the end of the day, and you can also get certain exposures in ETFs that aren’t available in mutual funds. You can buy gold. You can buy those individual countries or sectors. Those are just more liquid, easier to trade. You can trade them intraday. There’s still a place for mutual funds as well. It just depends on what kind of portfolio you’re building, whether it’s a retirement account or a taxable account. Different structures can make sense in different portfolios.

CONSUELO MACK: Okay, and we’ll talk about that a little bit later, but Matt Hougan, let me follow up with you. On ETF.com you analyze ETFs. You rank them. What makes a good ETF versus a bad ETF?

MATT HOUGAN: Great. There are three questions you have to answer when you look at an ETF. First you have to ask, is it low cost and does it track its index well? Remember these are supposed to track exactly on an index. So you want to make sure that the fund company is doing their job. You can find that data at ETF.com or places like Morningstar. You want to make sure they’re liquid, because unlike a mutual fund you have to trade it, and when I say, are they liquid, what I mean is, is the spread relatively small? Because you have to pay the spread between the bid and the ask every time you trade. You want to see that certainly be inside 10 cents. Five cents is better. One cent is obviously fantastic.

CONSUELO MACK: And you look at that when you’re evaluating ETFs, what the spread is and liquidity.

MATT HOUGAN: Absolutely yes. We look at the expenses, the tracking, the spread, and then the last thing which is probably the most important thing is the actual portfolio. So the biggest mistake people make with ETFs is they say they get exposure to one particular thing. They say they give exposure to technology stocks or China, and they assume that they’re all the same. But if you take 2014 for instance, the difference between the best performing China ETF and the worst performing one was over 40 percent. That’s a big number. So you have to take the time to look inside. Make sure the fund is giving the exact exposure you want, and then make sure it’s a good ETF. It tracks well. It trades well and it’s low fee. Then once you do that, you have a fund that’s ready to buy.

CONSUELO MACK: Okay. And at Northern Trust, Matt Peron, you use not only your own ETFs as you just mentioned, but you also use outside ETFs. So how do you evaluate them?

MATT PERON: That’s right, a lot of the same ways that Matt was speaking about. For our wealth clients we’re going to evaluate the ETF. Make sure all the structural issues that Matt mentioned with emphasis on the portfolio construction, making sure it’s constructed intelligently and it’s going to deliver the exposure we want for the clients, and that goes for our own funds as well as the external funds that we use.

CONSUELO MACK: So what kind of ETFs, Matt Hougan, are the most popular right now?

MATT HOUGAN: Well, the most popular ETFs are the biggest, broadest ETFs generally, so ones that give full exposure to the U.S. market, ones that give full exposure to the bond market. Those get the giant amount of assets, and that’s great because most people’s portfolio should be anchored with those broad, low-cost exposures. ETFs are great at that.

CONSUELO MACK: So that would be the same with, again, the indexed mutual funds as well. It’s the S&P 500.

 

MATT HOUGAN: That’s exactly right.

CONSUELO MACK: And is it the same big players? Is it the Vanguards, the BlackRocks?

MATT HOUGAN: It’s Vanguard. It’s BlackRock. It’s State Street, but there are two other areas that are really growing fast right now. One is currency-hedged exposure. So maybe you want to buy exposure to Europe but you don’t want exposure to the euro. There are ETFs that let you do that. Five years ago you had to be a big institution to do it. Now my father can do it in his Schwab account. Right? And the other one is Smart Beta. These are ETFs that take traditional index exposures and tweak them. They try to find a way to outperform the market a little bit, and there’s a wide variety of strategies, some great, some not so great, but they’re attracting real assets because they give people a low-cost tool that might provide risk-adjusted outperformance against the market.

CONSUELO MACK: So the Smart Beta funds, they are not really completely passive. They’re not based on a known index. These are being created by fund companies, and so the index itself is actively managed how it’s put together. They are picking and choosing what securities go into it, and then it’s passive once the index has been created. Is that right?

MATT HOUGAN: That’s right. So they’ll look at the market, and they’ll identify some way or reason they think they’ll get outperformance. Maybe they think stocks that aren’t very volatile will outperform over the long haul, so they’ll design an index that picks only the stocks that are the least volatile in the market, and they’ll buy those in the fund and then they’ll run on up. The great thing about this is in times of yore you would have an active manager who effectively did the same thing, but they would charge a percent or more. Now you can get this same exposure because it’s quantitatively designed. It’s in an index. You set it and it’s easy to manage for maybe 40 basis points or 30 basis points, less than half the cost. So you get the same kind of result for a third or half the fee. It’s a great outcome.

CONSUELO MACK: And Matt Peron, let’s talk about what Northern Trust has been doing for years in fact. It’s called Smart Beta now, but you called your strategy “Engineered Equity”. So tell us about what that is and why you think that’s actually a middle way between passive and active management.

CONSUELO MACK: Right. So we’ve been offering this strategy that’s called “Engineered Equities” which, much as Matt described, it’s part of that smart beta category if you will, although our take on it is they’re much more targeted towards what we call compensated risks. So what these are, are factors or groups of stocks in the market that will move together, have certain characteristics and a risk return profile that you understand its pattern, and you can understand how to implement it and how to capture those advantages for your clients.

CONSUELO MACK: Matt Hougan mentioned one which is low volatility. So what you call the like factor or style, their factor tilts or styles, so low volatility is one. Quality, value, dividend yield, small size. Why have you chosen those types of styles in particular, and why are they so important for us to understand as investors?

MATT PERON: Well, those factors that you mentioned we believe are compensated factors. That means you can earn typically above average risk-adjusted returns or above the market risk-adjusted returns. You can also deploy them in your portfolio strategically. So for people with longer horizons who can take volatility, they can have a value-tilted strategy. For someone who has a shorter time horizon, a low volatility strategy might be appropriate for them, and so you can really tailor it to the risk profile of the individual.

CONSUELO MACK: But we’re finding more products coming out that are really slicing these very narrowly. Right?

MATT HOUGAN: Oh, there’s an incredible boom in products because people are seeing them attract assets, so everyone has their own particular flavor. So you can get down to micro factors or niche areas of the market. I like what Matt said about finding those that focus on compensated risks. The best Smart Beta ETFs are drawing on work that’s been going on in academics and quantitative finance for years and years and years. There are a number of well studied factors that have proven themselves out over decades, and the best Smart Beta ETFs are capitalizing on those. What you have to worry about are some of the Smart Beta ETFs or “Smart Beta” ETFs, that are maybe focusing on more fad-like things, narrow niche areas of the market that sound good and are in the papers but maybe haven’t proven themselves over five, ten, fifteen, twenty years.

CONSUELO MACK: So Matt Peron, speaking of academic research, that’s very important in the kind of factors and styles that you use as well, right, in your ETFs?

MATT PERON: That’s right. So we want to make sure that the factors that we use are well researched and supported in the academic literature, that we can bear them out in our own empirical testing from data sets that we’ve built going back 50 years and therefore they are well supported and we are confident that we can deliver them and they’ll give you the risk and return profile that we expect.

CONSUELO MACK: Okay, so what kind of a premium do these kind of factor tilts give you? What should we expect from the kind of indexes that focus on those kind of styles?

MATT HOUGAN: Oone thing about investing we all know is there’s no free lunch. So these factors that we’re talking about are targeting things in the market that maybe add a little bit of risk to your portfolio, but the idea is the pay off or more than pay off if you hold them for long periods of time. So we mentioned earlier value. Value stocks have possibly more risk than growth stocks. Maybe they’re a little bit challenged, but as you hold them over long periods of time you get paid off. One important thing about Smart beta ETFs which I like to emphasize is you have to hold them for long periods of time. It’s too easy to get caught up in a Smart Beta ETF that beat the market for the past three years, buy it, see it underperform for a year and sell it. That’s the worst possible outcome. People do naturally chase returns, and they want to see those returns repeated, but these are designed to deliver over three years, five years, ten years. If you’re not going to hold it for a substantial period of time, you’re better off just buying a plain index fund, because there will be periods when you underperform, and you have to have the stomach to see that through.

CONSUELO MACK: So why is “Engineered Equity” as you call it at Northern Trust or Smart Beta, why is that the middle way? Why are you getting the best of both worlds?

MATT PERON: Well, if you combine the active which is really about delivering excess returns, but if you get them through these systematic factors that I was talking about, then you can still get excess returns provided that, as Matt says, you hold it over the cycle. Hold it for a long time, but you get also the efficiency of indexation which is nice, very cost efficient.

CONSUELO MACK: And explain, Matt Hougan, the tax efficiency aspect. Why are they so tax efficient?

MATT HOUGAN: Sure. Well, think about a mutual fund. If you and I own a mutual fund and we bought it 10 years ago, and the price has gone up and you sell your shares, the mutual fund has to sell stock to give you cash. When it does that, if it bought stock that’s gone up in price, it creates a capital gain. At the end of the year it has to pay it out to all the other shareholders including me. So because you sold that mutual fund, I have to pay tax at the end of the year. The way ETFs work are different in two ways. One, when you want to sell your ETF, you just sell it on the open market to another investor. So the ETF doesn’t have to sell shares to raise cash to pay you. You get them from Matt who bought it on the open market. And then, if a large institutional investor redeems shares, because that happens in ETFs, what happens is the ETF company doesn’t sell shares to give them cash. Instead it kicks out the underlying stock that it has, and not only that but it will look at the underlying stocks that it holds and says, “These ones have big embedded capital gains. If we ever had to sell them, we’d be in trouble. I’m going to give that to you, Mr. Institutional Trader, and you worry about it.” So what you see in ETFs is they’re continually cleansing out capital gains. You have ETFs that have been around for 20 years which have negative embedded capital gains. They’ve never paid out a capital gains. It’s just a beautiful structure. It’s inherently more tax efficient.

CONSUELO MACK: So when do you make the distinction and the recommendation to a client whether they should own an actively managed mutual fund or a more passive ETF?

MATT PERON: Right. So the first and most important question is to back up and zoom out and see what is the right strategy for the client first and foremost. What are the right strategies that you need to implement, and then it’s to determine the best to fulfill or implement that strategy, whether it’s a mutual fund, active, passive, ETF, and those can be different for different regions and markets. They can be different for different client goals. So they get down to client-specific issues, but the most important thing is to back up and see where is the client in the lifecycle. What are the goals that they’re trying to achieve, and design the right strategies. That’s the dominant factor. You get that right and then you worry about how to fulfill.

CONSUELO MACK: So are there any general rules of thumb, Matt, as far as use of mutual funds are concerned versus ETFs in clients’ portfolios?

MATT PERON: I would say there’s not really. It’s really more about what strategy. Where do we have the most confidence in delivering the strategy? So it really is strategy by strategy, and it’s all about ensuring we get the outcome we want for the client.

CONSUELO MACK: But are there strategies that are missing in the ETF universe, for instance, where you’ve got to go to the mutual fund world, or you’ve got to go to individual accounts that you’re managing?

MATT PERON: Certainly I would say that there are situations where an active manager makes the most sense, and you’d really want to use an active mutual fund in that case. That’s one example.

CONSUELO MACK: Okay. And you feel that way, too, Matt Hougan. Right?

MATT HOUGAN: That’s the big difference, the place where there are mutual funds that there aren’t ETFs is in the active particularly equity markets because ETFs have to be fully transparent on the active side. They have to say what they own every day. Equity managers who are on the active side don’t like to do that. So you don’t see a lot of active equity ETFs with significant exposure. If you find an active equity manager that you love and you trust them and you believe they’ll continue to deliver returns, you’ll probably have to buy that in a mutual fund, and that’s just fine. There’s nothing wrong with mutual funds. It’s just in many situations ETFs are better.

CONSUELO MACK: And yet we’re seeing some star managers managing ETFs. Right? So is that going to be a big trend?

MATT HOUGAN: I think it’s going to be a huge trend.

CONSUELO MACK: You do.

MATT HOUGAN: I mean you’ve seen particularly on the bond side …

CONSUELO MACK: So Bill Gross, for instance, is one.

MATT HOUGAN: Bill Gross and Jeffrey Gundlach.

CONSUELO MACK: Jeffrey Gundlach.

MATT HOUGAN: And Jeffrey Gundlach had the most successful mutual funds in the world. He felt compelled to enter the ETF market. And why? Because ETFs are stealing one or two percent of market share from mutual funds each and every year because clients are demanding them in particular areas, and if you’re a manager, you want to be where the clients want to be. So offer it in a mutual fund for people who want it that way. Offer it in an ETF for people who want it that way, and let your investors decide.

CONSUELO MACK: And yet with these star managers, are you seeing their funds come down to a competitive ETF level or … ?

MATT HOUGAN: What we’ve generally seen is them price the ETF shares the same way they price their institutional mutual fund classes. So if you’re a big investor with $5 million, you can buy a mutual fund at very low fees. If you’re a regular investor with a thousand bucks, you can now get the same fee on that ETF, so that what we’re seeing. They’re competing. They’re different access vehicles, but that’s about where the price point is sorting out.

CONSUELO MACK: And Matt Peron, what is missing in the ETF universe? I mean where would you like to see products created? What areas?

MATT PERON: Well, one of the things that we’re working on are fixed income ETFs because the indexes in the fixed income world are very flawed. They’re not perfect, and there’s a real opportunity. So we’ve launched a number of fixed income ETFs to address these gaps if you will in the market and looking at applying some of the engineering work we did on the equity side to the fixed income side. So that’s something we’ve launched off our FlexShares platform recently, and we’re excited about that.

MATT HOUGAN: If I can jump in there, I would agree. Fixed income indexes are silly. The way they work is you invest more in the things that issue more debt. So why would you invest the most in the most indebted companies or countries? One thing Northern Trust has done, they have an ETF. I think it’s SKOR.

MATT PERON: That’s right.

MATT HOUGAN: Which they take corporate bonds, and instead of just investing in the most heavily indebted companies, they look at the credit of those companies and actually invest the way any sort of intelligent person would do.

CONSUELO MACK: That’s a novel idea. Not.

MATT HOUGAN: And it’s shocking. It didn’t exist until these guys came to market with it. So of course that’s smart. You wouldn’t loan money to the heavy debtor. You would loan money to the guy who’s never borrowed money but needs a little bit today.

CONSUELO MACK: So that’s the same argument, though, that’s being used against capitalization-weighted indexes is that you’re paying up for the most expensive stocks. So in this case you’re saying the same applies in fixed income, and the same applies in the ETF world. Right?

MATT HOUGAN: That’s.. Well, yeah. So there’s a Smart Beta gold rush. So everyone’s coming to market with Smart Beta strategies. And guess what? All of the back tests look unbelievable. No one launches a fund with a bad back test. That just doesn’t happen. The question is, what happens going forward? So my advice to people is to look at the methodology. See if it makes sense intuitively. Is it founded in academic research? Is it clear and simple, or is it a black box with 27 different calculations? Because if it’s the latter, they probably fine tuned that so the back test looked pretty good. If it’s a simple factor drawn from academic finance that you’ve seen over and over again, chances are it’s going to persist.

CONSUELO MACK: It is time for the one investment for a long-term diversified portfolio. So Matt Peron, what would yours be?

MATT PERON: I would say for a younger investor, a value strategy, and for someone older or closer to retirement, a low volatility strategy.

CONSUELO MACK: All right, and why is that? Why value for someone younger and a low volatility for someone who’s older?

MATT PERON: Because as we spoke about earlier, value tends to be more volatile but will provide longer excess return over longer time horizons, and the data’s very clear on this. We spoke about it earlier that over rolling five-year periods or longer, the chances of outperforming the index is quite high.

CONSUELO MACK: In a value strategy.

MATT PERON: In a value strategy.

CONSUELO MACK: And the low volatility …

MATT PERON: Low volatility strategy. Obviously when you’re near retirement you want to have less opportunity for risk, for permanent loss of capital. So a strategy that varies less, that doesn’t vary so much would be more appropriate in that case.

CONSUELO MACK: Okay. And Matt Hougan, what would your choice be for a long-term diversified portfolio? MATT HOUGAN: It would be deeply boring, Consuelo. On my website I have the world’s lowest cost ETF portfolio. It’s six ETFs. It provides exposure to 4,000 stocks and all the bonds in 40 different countries for an expense of eight basis points. That’s 0.08 percent. If you have a portfolio that you’re still paying active fees on the core for a percent or more, getting into something … it doesn’t have to be that portfolio, but something like that that’s below 10