Fine-tuning portfolios with active ETFs
Tune in to hear Dr. David Kelly and Bryon Lake, Global Head of ETF solutions, discuss the evolution of active ETFs and how they can help build better portfolios.
Dr. David Kelly:
New and innovative technologies have disrupted industry's time and time again, creating more efficient ways to reach desired outcomes. Consider the music industry. While we all still listen to the same music, the ways that we listen and the types of music that we tune into have changed over time. The financial services industry is no exception, and the options for investing today look far different than they did, say, a hundred years ago. The exchange-traded fund, or ETF, is one example of these technologies changing the ways that we invest. Investors may associate ETFs with passive management, but the recent growth of actively managed ETFs is challenging that assumption. For today's episode, I've invited my colleague, Bryon Lake, global head of ETF Solutions here at J.P. Morgan Asset Management, to help us learn more about active ETFs and how they can help in building better portfolios. Now let's get started. Bryon, welcome to Insights Now.
Bryon Lake:
It's a pleasure to be here, David. Thank you.
Dr. David Kelly:
So you're managing our ETF business, and I know that it has grown and evolved in so many ways over the last few decades. Can you give us a sense of that evolution?
Bryon Lake:
Yeah, we're actually in an interesting time right now. We're 30 years into the ETF industry. So the first ETF was launched back in 1993. What we've seen is the ETF industry obviously growing from basically zero to now over $10 trillion globally, which is actually a cumulative average growth rate north of 20%, actually closer to 22, 23%. There's never been a rolling five-year period where ETF assets haven't doubled. So this has been a very transformational thing within the asset management industry.
Dr. David Kelly:
Can you give us a sense of some of the attributes that have been added? I know we are seeing tremendous growth in active ETFs right now. But relative to, it used to be buy individual security, then you buy mutual funds, then you buy index funds, can you talk a little bit about why active ETFs represent the evolution of that?
Bryon Lake:
Yeah, this is great. I always like to make the point of how fortunate we are to be in this industry. I think the asset management industry is the best industry in the world. I mean, our goal is literally to help people achieve their financial goals, whether that's saving for retirement or education or any of these number of great things that people are doing. And I think ETFs are playing a big part in that evolution. One of the analogies that I like to use to kind of bring this to life for people is how we consume music. And that's evolved quite a bit over the years. And David, I don't want to age you, but my guess is the first album that you ever bought, maybe you didn't stream it on Spotify, perhaps it was on a disc, probably one closer to-
Dr. David Kelly:
Oh, yeah. You'd go out and you'd buy a new album and you'd open it up and they had these beautiful album covers. That's a lost art. But going from that to CDs, cassettes, then streaming.
Bryon Lake:
That's exactly right.
Dr. David Kelly:
Yeah. Same thing with ETFs.
Bryon Lake:
That's exactly right. It's the same thing that we're seeing in the asset management industry, how we access the markets, the wrappers, the medium, if you will. So in the music analogy, it's the record player, the CD, the tape cassette, streaming, if you will. In our industry, it's individual stocks to mutual funds to investment trusts, other wrappers onto the ETF. And one of the reasons that you and I and many of your listeners and viewers would like to stream their music over one of the major streaming services is the convenience that comes along with it. It's incredibly convenient. You have every single song in the history of mankind in your pocket on your phone, and you can consume that in such a convenient way. You can hit the button and you're listening to that one. You want go from classical to hip hop, you can absolutely do that. So it has all these conveniences.
What I like to point out is, that gives you control. You are now control of your musical destiny. And I think ETFs have similar qualities to that. There's a tremendous amount of conveniences to the ETF wrapper. For one, it trades throughout the day, so you have a constant price on what that ETF is. Maybe people don't need to invest all throughout the day. In fact, we obviously don't advise that. But understanding what is happening in your portfolio real time, managing risk real time is absolutely a benefit of doing that. Understanding what you own.
So knowing what you own, being able to do due diligence, understanding the companies that are in there, the securities that are in there is a big difference. There's also some tax benefits to the ETF wrapper. Some wrappers, at the end of the year, if they have capital gains, they're forced to distribute that. An ETF has some mechanisms which allow it to not avoid the taxes, but give the investor the control of when they'll actually experience those taxes. So there's a number of benefits that make it incredibly convenient to build portfolios using the ETF technology. And ultimately, that gives the investors more control.
Dr. David Kelly:
And then we saw a lot of growth last year in active ETFs. Do you think that were the things about last year that made that particularly apt, sort of flow of money?
Bryon Lake:
Yeah. So the history of the ETF industry, the first ETF was around the S&P 500, just one of the major benchmarks that we know investors follow. And the early development of ETFs was more around passive, passive index-based investing. In fact, for years that was synonymous, passive and ETF was kind a synonymous thing. But that'd be a little bit like, using our music analogy, only being able to listen to country music, for example. Maybe we love country music, but it's maybe not appropriate for every single type of scenario that you might find yourself in. Maybe you want to have a workout, you need something a little more upbeat. Maybe you're more relaxing on the weekend, you want to read and you're listening to some classical music to kind of invigorate yourself into that moment.
What we've seen now is, distinctly, we have the ETF technology, the wrapper itself with all the conveniences that we talked about, trades throughout the day, tax efficient, transparent, but now we're taking active investment capabilities and delivering those within the ETF wrapper. there's a lot of benefits to active management. You talk about a lot of those in all the work that you do. I kind of boil it down to three high points, is one, active management gives you the opportunity to outperform. A benchmark can only deliver you the benchmark. Maybe that's a good outcome, but it can never beat itself. So it gives you the opportunity to outperform. Active management can manage risk. So a portfolio manager that is touching every single security that goes into the portfolio, they know what they own. Of course, on the equity side, that's super important. But think about on the fixed income side where duration matters and credit quality matters and one bond defaults. And the way that that can impact your portfolio really matters.
And then the third thing active management can do is it can deliver an outcome, lower volatility or a higher income or something like that. So you take the benefits of the ETF wrapper, the benefits of active management and bring those two things together. You pointed it out in the question. So active management had a breakout year in 2022. Going into the year, it was 5% of overall ETF assets. It accounted for north of 20% of the net flows into ETFs last year. And that's continued this year as well, actually. So coming into this year, it was a little more than 5%, just under six. It's accounted for 30% of the net flows into ETFs this year. So investors are really embracing ETFs and particularly embracing active ETFs.
Dr. David Kelly:
I can see that both from a positive side because it allows you to do risk management. But also, the other big advantage is, if you think there's some hype and fluff in parts of the market, active managers can avoid some of that which is very important for long-term investors who don't particularly want to just ride whatever wave until it inevitably breaks.
Bryon Lake:
It's a great point. I mean, if you think about even just earlier, this year, we had some of the tech mega cap names that became huge weights within the broader benchmarks. Of course, that was driving some of the performance, but also that was building risk. And if you looked at some of those companies and the multiples that they were trading off of, that didn't seem sustainable. So an index is always going to take the market cap waiting times the issuance, and that's going to be the weight within the index.
Dr. David Kelly:
So you end up overweight in the overhyped.
Bryon Lake:
You're overweight the overvalued and underweight the undervalued by rule. So active management does have the opportunity to correct for that. And we do think that that obviously a big distinction.
Dr. David Kelly:
You talked about a lot of flows into active ETFs last year. Where's the money coming from?
Bryon Lake:
It's coming from all sorts of places as you'd expect. I think new money into the market is now embracing the ETF. So if you look at some of the demographic stuff, it's definitely the younger investors that are thinking about a more modern way to build their portfolio. But we're also starting to see investors that maybe didn't get the outcomes that they wanted in some of the other vehicles that they were using over the last couple of years and so they're migrating over at the appropriate times into ETFs as well. We've seen that as a trend now for a number of years. And I think, just like any innovation, that will take time, but steadily, the consumers and investors will embrace the ETF wrapper as kind of their default wrapper. And we will continue to see that.
Dr. David Kelly:
So particularly, newer investors are embracing active ETFs. But, of course, there's also a lot of not-so-young investors who are sitting on huge wads of cash right now. There's over $5 trillion sitting in money market funds right now. A lot of this is long-term saving money. It's not many people intend to spend today or tomorrow. It should be a long-term investment, but it's not. So what would you say to those people about having that big a cash allocation in what was supposed to be a long-term portfolio?
Bryon Lake:
Yeah, maybe I should word it differently. Instead of young, it's young at heart. If you're thinking about how you want to build your portfolio, there's a couple of things that we know to be true. We know that taxes can negatively impact your portfolio. We know that high fees can negatively impact your portfolio. And ETFs have pretty good answers for both of those things. So we are seeing a lot of investors contemplate some of the active strategies that we have. They like active management, and we know that that's a big part of the industry and always will continue to be for all the things that we've talked about. So if they can get that in the convenience of the ETF wrapper, I think that will behoove them well.
Dr. David Kelly:
Yeah. I think it used to be this idea that, well, cash is liquid, but of course active ETFs or ETFs are liquid too.
Bryon Lake:
Yeah.
Dr. David Kelly:
I mean, if you want your money quickly, you can get your money quickly. And I think the other thing is, I'm sure you and I have preached this for many years, if it's long-term money, it needs to be long-term investments. The history suggests that when you're at a peak CD rates, we may well be close to peak CD rates, the rate looks juicy, but almost always there's a better alternative over the next year. Either long rates come down and the stock market does well, but almost always something else does better. So long-term investors really need to embrace long-term assets in a diversified way.
Bryon Lake:
Could not agree more. I think the returns of investments in 2022 kind of shook people, and I think a lot of investors were a bit offsides with how they wanted to have their portfolio position coming into this year. And to your point, when you're seeing some of the money market rates and CD rates at the levels that they are, that's kind of attractive. But exactly to your point, I think it's really important for investors to understand what the long-term prospects are.
We know equity risk premium offers a very attractive return. And for investors to rebalance their portfolios right now potentially out of some of those cash that's on the sidelines in order to participate in the growth of some of these great companies, I think is important. And you've said this as well, but with higher rates brings more discipline to balance sheets. So the companies that people will be investing in have this discipline now because it has to kind of meet this hurdle rate, and I think that's coming into the market in a very positive way. So I think these companies are going to be healthier than ever.
Dr. David Kelly:
So clearly, a lot of people are excited about ETFs and active ETFs, but I suppose there are some people who have some concerns. So what sort of objections do you hear when you talk about this?
Bryon Lake:
In my mind, it's still just kind of an awareness conversation. So if you think about the US landscape, you've got about $31 trillion across mutual funds and ETFs, of which $7 trillion is in ETFs, so just over a third, something like that. We're seeing ETFs grow at about 2% a year versus mutual funds. So that overall pie, ETFs are gaining share versus that. It's awareness. It's understanding that there's this new vehicle out there that offers me all of the things that I know and love, a great portfolio manager that's done very well by me over the last couple of years or over the very long term that's now available to me in this new ETF wrapper. And the fact that even active ETFs exist is still kind of surprising to some investors. They still think that it's passive and they still think that it's primarily a benchmark story, but the active ETF story on the equity, and I stress heavily on the fixed income side, is still such an important story that I think it's an awareness thing.
Understanding how ETFs trade I think is a really important aspect for investors to look at. It's quite intuitive. It's just like if you bought any other stock in the past, you go on your trading system and you can do a limit order, you can do a market order, all those sorts of things. It's just changing the habits of how you used to invest to this new thing. Maybe in the same way that bringing back the music analogy, we used to get the CDs and we put them in our Discman or whatever, and we'd listen to them in that way. And then changing to a device that downloaded it into an MP3, and then listening to that, it was behavioral change, but once you made that switch, you never went back because you really were excited about the convenience and the control that digital music gave you. And that's what we're seeing with ETF investors as well.
Dr. David Kelly:
I guess I realized that I've been in the industry as long as active ETFs or ETFs have been around. I've witnessed the entire evolution, and it's been a dramatic and exciting story to this point. But story's not done. Where do you see ETFs going from here?
Bryon Lake:
Yeah, you're exactly right. We're just getting started. There's no better time to be an investor. You have thousands of ETFs available to you to build the exact perfect portfolio for what you are trying to achieve. And I think having that variety is really important with all the conveniences, and I know I'm repeating myself, but the conveniences and the control that they offer you, I think that's really interesting.
I think as more of these active ETFs achieve their three-year and then five-year track record and investors say, "Holy smokes, these are some of my favorite managers that are running ETFs. These are great portfolios that I'm going to want to put into my portfolio." So we're projecting out, the ETF industry right now globally is about $10 trillion. I think it doubles over the next five years to about $20 trillion. And I think active ETFs could be somewhere between 10 and 20% of that overall pie. Now remember, it's coming off about 5% today, so I'm actually making a pretty bold prediction there. But I think as investors understand the benefits that it brings them and that education comes through and more variety managers that they really enjoy and have followed closely over their careers, they're going to see that as a bright future.
Dr. David Kelly:
So broad growth in assets under management, ETFs growing faster than assets under management, and active ETFs growing faster within industries.
Bryon Lake:
Even faster, yeah.
Dr. David Kelly:
That's a lot of growth.
Bryon Lake:
Yeah, no, I've joked with others. If the ETF industry, like I said earlier, is growing at 22% a year, active ETFs growing at north of 30% a year, if we were sitting in Silicon Valley, venture cap companies would be throwing money at this industry. This is a very exciting industry, and the reason it's growing so fast is because investors that understand this like it. It's doing what it's supposed to do. They're enjoying that, and that's a big part of the outcome. So there's a tremendous amount of that.
And as we know in this industry, when people are putting money to work they're entrusting, they're entrusting the asset manager, they're entrusting the vehicle to do what it's meant to do, and ETFs have been, one of the other things I hear is, "Well, ETF's been stress test." Well, it's much better than that. We've had some pretty stressful scenarios over the last, let's call it three decades, as I said, and ETFs have come through that with flying color. In fact, one of the interesting things that I was pointing out to someone earlier today is, the Fed, as part of their quantitative easing program in response to COVID, actually bought fixed income ETFs as part of that program. And it wasn't just the biggest one. They bought a smattering of fixed income ETFs, and so the stress test was good enough for the Fed. Now they've used it as part of the QE program.
Dr. David Kelly:
Yeah, I mean, we've seen the two biggest bear markets and the two biggest recessions since the Great Depression all in the lifetime of the ETF industry.
Bryon Lake:
That's exactly right. And you know what happens every time? Is the ETF industry grows faster coming out of it because money is in motion, investors are looking for new solutions. Maybe some of the capital gains that they had embedded in their portfolios are no longer there, and so they want to put a new game plan in place and they tend to embrace ETFs.
Dr. David Kelly:
That sounds like some exciting times ahead.
Bryon Lake:
Yeah, we're excited and we're just going to continue to keep our head down and delivering the best that we can to investors.
Dr. David Kelly:
Well, thank you, Bryon, for joining us in Insights Now.
Bryon Lake:
It's been a pleasure.
Dr. David Kelly:
Our next episode of Insights Now, I'll be joined by Mike Conrath to discuss the different strategies and considerations for investors saving for retirement. I'll then thank you all for watching and speak with you soon.
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