September 22, 2020
The events of the past few months have forced advisors to think differently and with the upcoming election, we do not expect this change anytime soon. In mid-August, we held a discussion on industry trends and how advisors can stay ahead of the curve to help build and maintain wealth for their clients.
Participants in the discussion:
- Brendan O’Neill, CFA, BNY Mellon | Pershing – Director of Advisory Solutions, Lockwood
- Matt Forrester, BNY Mellon | Pershing – Director and Chief Investment Officer, Lockwood
- Stephanie Pierce, BNY Mellon – Chief Investment Officer of ETF, Index and Cash Investment Strategies
There has been a continuous debate over the last several years surrounding active and passive investing, and where ETFs fit within this argument, with many people thinking of ETFs and passive investments as synonymous. However, this isn’t necessarily the case. So why do investors think it is?
Approximately 98% of ETFs are currently in passive or rules-based strategies. While it’s easy to understand why many investors think ETFs and indexing are the same thing: they’re not. Indexing means to invest in a portfolio that tracks a benchmark and indexing strategies can be accessed in ETFs, mutual funds, separately managed accounts and other vehicles. ETFs are investment vehicles that can offer the diversification of a mutual fund with the intraday liquidity of a stock, and while the majority of ETFs today are passive, both active and passive ETFs are available to investors, and importantly, active ETFs are one of the fastest growing areas of retail product development in the industry today.
ETFs have been available as investment vehicles for a good number of years now. What are some of the developments that have occurred in the industry?
As described above, many early ETFs were passive strategies but today we have several ETFs that are inbetween active and passive. We might call them active strategies or smart beta ETFs. They use a set of mechanical rules to revise and index, and they’re typically lower cost than pure active strategies. As a result of evolutionary industry developments, these products are currently gaining the most traction.
How has the trend for the use of model portfolios developed with regards to the use of ETFs?
We believe an increasing number of advisors are adopting model portfolios to manage additional regulatory burdens, as well as to maximize their time allotted to speaking with clients and managing their business. In our opinion, adoption of a model portfolio could help an advisor improve performance and gain efficiencies in the way they work. There are different ways for an advisor to use a model portfolio, or access one. However, Lockwood has noticed more consumption of ETFs via models than as standalone vehicles.
How do model portfolios fit with the idea of objectives-based investing?
Many investors think about their investments through the lens of specific financial goals or objectives. So, as an example, an investor might say to us, “show me how to grow my portfolio,” or they might say, “give me a consistent cash flow,” or, “whatever you do, don’t lose my money.” Objectives-based investing is a way of constructing client portfolios that are designed to help meet one or more of these goals. Of course, no investment strategy or risk management technique can guarantee returns or eliminate risk in any market environment. For an investor who wants to grow their portfolio, that portfolio may be comprised of low-cost, tax-efficient investments that seek to deliver capital gains and beat inflation over a full market cycle. For a client who is looking for consistent cash flow, that portfolio is more likely to be focused on current income and liquidity to meet ongoing cash flow needs or liabilities. Finally, for a client who doesn’t want to lose money, the portfolio would likely seek to minimize downside volatility and loss of principal. This goals-based approach, which is very intuitive to investors, is also the foundation on which we are building BNY Mellon ETF models, which are slated for later in the year.
In today’s market with interest rates at historic lows, how can investors, looking for that consistent cash flow, manage their portfolios to maintain the income they require? Are there specific parts of the market that they should be thinking about?
One of the biggest drivers of the search for income is the changing demographics of the country. As the population ages, mandates are moving from pure accumulation to income generation, preservation and even decumulation. One consequence of this is the decreasing emphasis on the traditional 60/40 portfolio, and increasing use of objectives-based investing, as described above. Fixed income, which is traditionally where investors turn for income, is struggling in this low-rate environment prompting some investors to consider dividend growth or high-dividend equity strategies.
However, sticking to fixed income, one area we have seen growing interest is in high-yield strategies. The economic uncertainty created by COVID-19 has driven fixed income ratings agencies (Moody’s, Fitch, S&P) to downgrade several investment grade bonds to high yield status, meaning that many investment grade strategies have been forced to sell these securities, also known as fallen angels. This forced sell off, together with concerns that the economic slowdown may negatively impact corporate earnings and balance sheets, have created some attractive valuations in the high-yield market. In an environment where many investors are struggling to find yield of any kind, we have seen growing interest in the BNY Mellon High Yield Beta ETF, which uses a credit model to filter out bonds at risk of default or downgrade. It also uses trading techniques to reduce transaction cost drag, which is a big challenge for most high yield managers.
We’ve also seen growing interest in the BNY Mellon Short Duration Corporate Bond ETF. It’s a high-quality fixed income instrument with durations of one to five years in corporate bonds. The investment team behind each of these ETFs has been managing investments in this way for multiple market cycles over three decades and has a great deal of experience navigation low rate environments.
For many years, critics of ETFs always questioned how the vehicle would perform in times of extreme market stress. Well, ETFs were put to the test in February and March. How did they hold up during that period?
This is something that we have had a lot of dialogue around with clients. BNY Mellon’s index business is the seventh largest index business in the US1 and was one of the early leaders in basket trading. We believe ETFs really demonstrated their mettle during the extreme volatility that we saw earlier this year.
In fixed income markets, the most liquid corporate securities typically trade one to two dozen times a day. ETFs on the other hand trade much more frequently. In March, when there was a liquidity issue, ETFs essentially became one of main tools of price-discovery in the marketplace. If a fixed income ETF was trading at a 5% discount to its net asset value, then that told us bond prices were actually 5% higher than where the market really thought they should trade. This makes us believe that asset value discounts and premiums are features of ETFs, not flaws. Corporate bonds generally don’t trade that frequently, so in times of large price dislocations, it can be hard for the market to price them, and ETF discounts and premia provide some visibility into where the market should be. In addition, in a market where it’s difficult to find liquidity, ETFs generally provide that liquidity even if they are trading at a spread.
There were some instances where there was a disconnect between the prices of the ETFs and the net asset values, but we think that was providing you with much needed liquidity. We think that ETFs demonstrated their value during this period of volatility, and we think that’s something that people will continue to see going forward in different market environments.
What are some of the other advantages ETFs could provide to investors?
This relates to an earlier point about the innovation of the vehicle rather than the underlying holdings. To keep this simple, ETFs are generally much more tax efficient than comparable mutual funds, and that’s due to the way redemptions are managed. ETFs typically manage redemptions via what we call an in-kind transfer of assets to the redeeming participant. This mitigates, the need for the ETF to sell appreciated assets to fund the redemption, which is typically what drives capital gains payouts in mutual funds. When assets are delivered from the ETF via an in-kind transfer, no capital gains are realized, even if the securities being transferred have appreciated in value. So, this embedded mechanism within the ETF structure allows investors to have more control over the timing of their tax liabilities based on when they take an action or specifically based on when they generally sell their position.
Another option for investors would be to consider municipal ETFs. Whilst the asset base for this type of product is currently quite small, we are seeing similar growth rates. With an increase in marginal tax rates coming into play, taxexempt securities could be a good option.
What are your current thoughts on the disconnect between the market and the economy? How should advisors be thinking about allocating their clients’ capital?
It sounds like a cliché, but we believe diversification is a real tool in market environments such as this. As we touched upon earlier, a lot of model-based solutions can really help with diversification across asset classes, as well as diversifying across risks. With the upcoming election, we believe there is a great deal of uncertainty still to come. We do not know how long the governments around the world, but also here in the US, will be able to sustain the stimulus programs they have initiated as a result of Covid-19.
Investors should consider the investment objectives, risks, charges and expenses of a fund carefully before investing. To obtain a prospectus, or a summary prospectus, if available, that contains this and other information about a fund, contact your financial professional or visit im.bnymellon.com/etf. Please read the prospectus carefully before investing.
ETF shares are listed on an exchange, and shares are generally purchased and sold in the secondary market at market price. At times, the market price may be at a premium or discount to the ETF’s per share NAV. In addition, ETFs are subject to the risk that an active trading market for an ETF’s shares may not develop or be maintained. Buying or selling ETF shares on an exchange may require the payment of brokerage commissions.
ETFs trade like stocks, are subject to investment risk, including possible loss of principal. The risks of investing in the ETF typically reflect the risks associated with the types of instruments in which the ETF invests. Diversification cannot assure a profit or protect against loss.
Diversification cannot assure a profit or protect against loss.
Bonds are subject to interest rate, credit, liquidity, call and market risks, to varying degrees. Generally, all other factors being equal, bond prices are inversely related to interest-rate changes and rate increases can cause price declines. High yield bonds involve increased credit and liquidity risk than higher-rated bonds and are considered speculative in terms of the issuer’s ability to pay interest and repay principal on a timely basis. Investing in foreign denominated and/or domiciled securities involves special risks, including changes in currency exchange rates, political, economic, and social instability, limited company information, differing auditing and legal standards, and less market liquidity. The use of derivatives involves risks different from, or possibly greater than, the risks associated with investing directly in the underlying assets. Derivatives can be highly volatile, illiquid, and difficult to value and there is the risk that changes in the value of a derivative held by the portfolio will not correlate with the underlying instruments or the portfolio’s other investments.
Recent market risks include pandemic risks related to COVID-19. The effects of COVID-19 have contributed to increased volatility in global markets and will likely affect certain countries, companies, industries and market sectors more dramatically than others. To the extent the fund may overweight its investments in certain countries, companies, industries or market sectors, such positions will increase the fund’s exposure to risk of loss from adverse developments affecting those countries, companies, industries or sectors.
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Views expressed are those of the author stated and do not reflect views of other managers or the firm overall. Views are current as of the date of this publication and subject to change. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission.
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