Talk Your Book: J.P. Morgan's Guide to ETFs

0:00Today's Animal Spirits Talker book is brought to you by J.P. Morgan asset management. Check out J. jpmorgan.com slash power of active to learn more and make sure to check out their JPMorgan Guide to ETFs, which comes out on a quarterly basis on their website. Remember, that's jpmorgan.com slash power of active. Welcome to Animal Spirits, a show about markets, life and investing. Join Michael Batnick and Ben Carlson as they talk about what they're reading, writing and watching. All opinions expressed by Michael and Ben are solely their own opinion and do not reflect the opinion of Ritholtz Wealth Management.

0:33This podcast is for informational purposes only and should not be relied upon for any investment decisions. Clients of Ritholtz Wealth Management may maintain positions in the securities discussed in this podcast.

0:47Welcome to Animal Spirits with Michael LeBan. On today's show, we talk with John Mayer. He's the chief ETF strategist at J.P. Morgan Asset Management. And also the lead singer of... Sorry, I couldn't remember. Okay. I saw my counter ones. And then Cheyenne Hussain, who is the head of U.S. investment specialist, global fixed income currency and commodity group at JPMorgan Asset Management. And we got to talk about the guide to ETFs. You know, I'm a guide to aficionado. I don't know if you know this about me. It started back in the day. Well, I don't know if this is 100 % accurate, but let's just go with it.

1:19It started with Dr. Kelly's guide to the markets. They branched out. They do guide to retirement, right? Guide to alternatives. Guide to ETF. Which is, I think, the newest part of the lineup. So we go through that today. They have wonderful charts. It's always a ton of stuff. And there's always a good little tidbit or piece of information in these guides about, like, oh, I've never thought about that. Or I've never seen that before. And there was a lot of that today that we talked to on the podcast. We spoke on the pod last week. And we were talking. Jeffrey Patak was engaging with us on Twitter.

1:52Jeffrey from Morningstar about, like, where is all the money coming from? Because these numbers, like the fact that VOO, the Vanguard S &P 500 Index Fund ETF, is doubling to previous record flows. We had more inflows into ETFs this year than in the crazy times of 2021. And we're thinking like, all right, are these conversions? And the guys on today's show said, probably not. I mean, that's a small part of it. So what is it? It's just, is it a reflection of animal spirits? Pun intended. Is it just, these are just better structures? And I think it's all of the above. But - It's a host of things.

2:35Yeah, I think maybe it is that a lot of these ETFs that are getting the biggest inflows, they're just, they're new products. So the biggest one that surprised me that we actually didn't get to on the show was they show global ETF AUM over time. So there's roughly$10 trillion in the US. There's more than 14 trillion globally. and they show going back to 2014 is how far the data goes back. It was like a little over$2 trillion in global ETF assets then. So it's gone from$2 trillion to$14 trillion. It's like 20 % CAGR compounded annual growth rate for those who don't know. And the growth rate has actually been bigger for the rest of the world than the U.S.

3:10So the rest of the world has grown 26 % and the U.S. has grown 18%. They were coming from a smaller base, but that actually surprised me. So ETFs are not just a U.S.-based phenomenon. They're growing like gangbusters around the world as well. Yeah. So, all right, we got into a lot of it. Don't want to step into too much of the material. With no further ado, here's our conversation with John and Cheyenne.

3:31Gentlemen, welcome to the show. Thank you for having us. Thank you. All right. Yesterday on Animal Spirits, Ben and I were talking about the record-setting year of inflows that we're seeing in 2024. I think it's like$921 billion into ETFs and surpassing 2021's wreck. And we're like, how, where is all this money coming from? And one of the areas that I'd be curious to get some insight on is how much of this is like a mutual fund conversions from the likes of dimensional funds and others, or is this, is that not part of the equation? Is this really like net new money? So I don't know who wants to take this first, but where is all this money coming from?

4:11Yeah, I think I'll, I'll take a shot at this. This year it's been a record flows, like you said, it's like almost a trillion dollars. It's amazing. And I don't think it's coming from conversions from mutual funds. Certainly some former mutual fund consumers are buying ETFs because of the benefits of the ETF structure. But I think that is really the answer, is that the benefits of the ETF structure is really being made apparent. Liquidity, transparency, tax efficiency. But people are just discovering that? Well, I think there's a few things that are going out of play. First of all, the active story really is starting to resonate.

4:49So you have$10 trillion in assets in the US, 8 % of those assets are in actively managed ETFs. But this year, 30 % of the flows have been at active. So why is that? I believe the answer is two things. One, there's an acceptance by portfolio managers that it's okay to reveal your underlying portfolio. Nobody cares. Good luck trying to replicate a thousand different fixed income securities in an ETF. Go for it. If you can do that, great. That's one thing. The second is there were regulatory changes that occurred in 2019 that facilitated active managers getting into the space. That was step one. Step two is that you're now coming up with three and five-year track record.

5:37That enables many of the active managers to get on existing platforms, some of the large wire houses. So I think that is really helping to accelerate the growth combined with the fact that you have these unique benefits of the ETF structure. So no, they're not just discovering the ETF structure, but there's a few other parallels or verticals at play. This is like a consolidation story maybe then because there's all these different funds that you have. You have closed-end funds. You have mutual funds. You have all these different maybe people in individual securities. I guess maybe some of the people that would have been stock picking in the past go, why am I going to pick a handful of stocks when I can just buy a basket in any ETFs?

6:17Is it a consolidation story? So I think there's two things at play. One is it's a realization story and one that there's access to managers that weren't previously available, particularly on the active side. And once some folks accepted that the ETF structure is more tax efficient, it's a better structure, now it can access these great managers using that structure. I think that's accelerating the story. Cheyenne, do you think that this is reflective of investors' appetite for risk? Or is that really not the story here? Is it just, listen, money is always coming into the market, bonds, stocks, and this is just a preferred vehicle.

6:57And maybe before you answer that, I'll give you a data point from our friend Todd Sohn over at Strategas. He shared a chart showing the cumulative mutual fund flows going back to 1984. And if you look at equities, I mean, I'm sure you've seen a chart like this. It's just rolling over. There's a lot of money coming out of mutual funds. So is it less of a reflection of investor appetite and more just where investors are allocating their money? So are we going to see record flows every year? I think it's partly a reflection of both, right? So you have portfolios that are generally maybe a bit more conservative, whether you think about the elections, uncertainty around the Fed and whatnot.

7:30And so you have risk-taking coming back to the market. And I think the preferred vehicle of choice has been increasingly in the ETF wrapper. And it was a good point that Ben brought up in terms of the application of the ETF structure. When you look at fixed income in particular, it is pretty interesting where it's a highly diverse and segmented market, which on a bond-by-bond basis can be really tough to transact. It's relatively liquid. So the ETF structure was revolutionary in the sense of providing liquidity to the fixed income market and a much easier way to transact in that market. The first kind of manifestation was in a passive sense.

8:07And now you're seeing the active piece pick up. And I think, Mike, exactly like you noted, there's an element of risk taking. So you look at the benchmarks in fixed income, there's not a lot of risk in those benchmarks outside of duration, interest rate risk, right? You don't have the level of credit risk maybe you'd want in today's environment if your expectation is around a soft landing. So it's pretty wild. I mean, I pulled up some stats, but you look at just within fixed income, within ETFs this year, 34 % have gone into active versus 15 % last year. That represents$93 billion year to date versus$33 billion last year, just in active fixed income ETFs alone.

8:43So Mike, to answer your question, I think it's a bit of both in terms of flows into the space, but then also the ETFs being a preferred wrapper. And you meet with different platforms, different RAs and advisors. It's an easier way to transact. Operationally works out quite well. So I think there's a variety of factors, as John has noted. I want to get into the fixed income side of things. But first, on your guide to ETFs, you have this chart in here on thematic ETF AUM. And this really surprised me looking at this. I've never seen it like this. So you showed this chart, and it looks like a meme stock chart, basically.

9:19So in 2020, thematic ETFs had, I don't know,$25,$30 billion under management, then it shot up immediately to almost 130 billion. Now it's come down and basically leveled off. And even though there's more ETFs in the space in terms of the numbers, the thematic AUM has declined and kind of sputtered, which is surprising to me because I would have assumed that more of the active money would have been going into these thematics. So what happened here? Was it just a sort of a meme stock thing where people got really excited about these kind of plays and then they gave up on them a little bit? Well, allow me to answer.

9:53I know you guys But Ben, that was the ARK complex. That was the five ARK products. Well, not exclusively. I think that started it. And then you saw a lot of issuers get into the thematic space. You saw a ton of new issuance in the thematic ETF space, whether it be robotics or AI or EVs. And then COVID happened. And there was just a huge appetite for risk. And then 2022 happened. And then you saw a huge fall off in assets and thematics. Remembering thematics are typically small and mid-cap companies, and they certainly got beaten up. And then the AI story, there was the intersection of the AI story, and thematics really just became AI and 10 stocks.

10:38And I think that really kind of changed the story of, like, am I going to go buy solar or wind or a robotic CCF, or am I just to buy something that has NVIDIA, Microsoft, and Google in it? And I think that's what happened. Balchunas tweeted yesterday, VOO watch, that's Vanguard's S &P 500 ETF. He said, VOO is a day or two away from hitting$100 billion in the year-to-day flows in absolutely absurd feed. The old record is$50 billion set last year. So we doubled the old record into Vanguard's S &P 500 ETF, the most boring, obviously most liquid, like most traditional ETF. And then you have things like NVIDIA's 2X levered ETF, which now has more assets.

11:20Todd Stone tweeted this. Now it's more assets than ARK, which is kind of wild. And then you've got everything in between. So you mentioned like a year like 2022, there's innovation serving investors. So 2022 was a huge year for income-oriented products. Obviously, your Jepi product was the kingmaker that year. And then there's been a lot of innovation in that space. There's been the Buffett ETF. So I think you're right. Like Balthunas calls them the hot sauce ETFs. There's so many different flavors of active that are really like having a moment right now. Yeah, no, I think that's fair. And to your point about the S &P 500 ETFs doubling in assets, you should be concerned there because what's driving performance in the S &P 500?

12:03It's 10 names, right? There is evidence the market breadth is widening out. As market breadth widens out, that's where you want an active manager. Sure, you're going to be still exposed to the beneficiaries of the AI story, but there's another 490 stocks that potentially have some opportunity. And when as implied correlations are declined and you have the opportunity with stocks moving in different directions to outperform, that's where the benefits of an active manager combined with active managers getting more into the ETF space from the mutual fund business. That's why you're seeing kind of these large flows into actively managed ETFs.

12:46You have a chart in here that shows all the key players in the active ETF space. And it's kind of interesting to me because it's not like the biggest mutual fund players are the biggest ones in the active ETF space. And so the top of the list is DFA, and then JP Morgan is second, and First Trust, and Avantis. And I think for people outside the investment industry, I would be kind of surprised by the names. How did J.P. Morgan build this? And what's the breakdown of assets here in terms of, I guess, like stocks and bonds and active versus other types of funds? Well, I think that 2019 was really an inflection point.

13:23So first of all, J.P. Morgan has been involved in ETFs for the past decade or so. But we have a deep bench of active managers, and we've always been very successful in the mutual fund arena. Now, the regulatory changes in 2019 that allowed for custom-inkind basket, negotiated basket, additional tools to portfolio managers, that was kind of the realization moment that, well, this business is probably changing over time. And given that this structure and the benefits of the structure and given that 85 % of the secondary training occurs on the secondary market, which would allow portfolio managers to more efficiently manage their portfolio, gave us the insight into saying, well, this is where the market is heading because of the benefits, the improvements in the structure, the modernization of the structure.

14:20And so over time, we've come out with different strategies that use our existing bench of active managers into this kind of more modern structure. And other players, like you mentioned on this list, have certainly saw that as well. But we are really leaning into it because that structure is just a better structure. And if you look at the capital gain story, it's always a story, right? So in 2023, about 100 of 3 ,500 ETFs paid a capital gain, both active and passive. Not many. Mutual funds, 30 % in 2023, much higher in previous years. So it all comes back to we're leaning into the better structure and the future.

15:04And I think that's what's happening. So you talk about the better structure. Active mutual funds have had outflows forever. Active ETFs, it just seems like the money is just pouring in every year. So you guys have a chart showing US ETFs and mutual net flows by year. And every year, there's positive flows into ETFs. And we talk a lot about – Josh wrote a piece like a long time ago called The Relentless Bid, How Advisors Are Allocating Money. And it's just – there's no selling from advisors, the people that control most of the money. But is it possible to have net outflows out of ETFs? I guess I'm trying to figure out where is the money coming from?

15:43Is it just people making money and investing it? Is it that simple? First of all, there's a lot of money in money markets right now. It's about$7 trillion. And we believe that that cash should be allocated. I'm going to pass it over to Cheyenne to talk about it in terms of money being allocated from cash and why cash should be moved to fixed income, different parts on the duration spectrum. But one other point is it's a newer market in terms of ETFs. ETFs are, yes, positive flows consistently since they've come out in 1993. We expect that to continue just because of the dynamics. And yes, money, there's new money being made.

16:24There's existing money market to be deployed. There is a transfer of wealth. So perhaps Cheyenne could kind of opine on that. I mean, one perspective also to add to that, I mean, think about what the Federal Reserve has done over the last decade, right? Injected a tremendous amount of money into the financial system. So there's a lot of money that needs to be put to work in addition to the$7 trillion that are sitting in money market cash-like instruments. So I think there is a strong bid there from a risk-taking perspective that is driving these flows. So it's not totally, I don't think, dramatically surprising given how investor portfolios have been positioned.

17:02But then also just the amount of money that needs to be put to work is truly, it's tremendous. You guys mentioned the active fixed income space. I think a lot of people don't realize that when you buy a total, it's really easy to replicate the stock market, right? a total stock market index fund effectively is the total market. Maybe it doesn't include some microcaps or pink sheets or whatever, but you can effectively get 99 % of the stock market. When you buy a total bond market index fund, it's harder to replicate that. The aggregate is essentially what people look at as the total bond market, but you have a great chart in one of your white papers that shows, I think it says nearly half of the US bond market is not represented in the Bloomberg US aggregate index.

17:43So no munis, no high yield, very little asset backed agency. So it doesn't necessarily cover the whole market, which is, I guess, because the fixed income market is just a lot bigger. So maybe talk about how that fits into the idea of using active management in fixed income. Yeah, happy to talk to that. So exactly then, as you mentioned, the ag index, which is the broad representation of the US bond market, only representing roughly half the market, which is an interesting thing to think about. And that index was conceived in the early 80s. And so back then, the most represented and liquid tradable areas, it's really treasuries, agency mortgages, and investment grade credit.

18:25So those are the three major components of roughly a third, a third, a third that are represented in the aggregate index. You look at the broad market, you mentioned kind of asset back. I mean, securitized credit alone is roughly a$3 trillion market. That's roughly 10 % of that is represented in the ag index. High yield not represented at all. Sorry to interrupt you. Yeah, go ahead. So one of the reasons that a lot of these areas aren't in it is because they're newer, faster growing segments of the fixed income market and the index just never really adjusted? So it's two things. Yes. So it's the rules that have been put in place at inception.

19:01But then also, particularly within Securitize, you've had more issuance in 144A securities. So these are more private placement securities as opposed to going through broadly syndicated deals. And so 144A process doesn't mean it's lower quality. It just means it's issued via private placement. A lot more issuance has taken place in securitized via that process. So that's inherently not included in the benchmark. It's a rule that's included in the ag index. So that's effectively why that whole segment of the market or a large proportion of that market is excluded. But yes, Ben, to answer your question, what was a broad representation of the market at that time is not a true reflection of the market as it stands at the moment.

19:43I mean, look at the size of the global fixed income market. I mean, just to put in perspective, it's$141 trillion in size. You have 3 million unique securities that are included in the global fixed income market, right? You compare that to the equity We market$115 trillion in size, 9 ,000 securities. There is a lot of opportunity within fixed income from an active perspective. And it's tough for a benchmark to give full representation. And it's not just the ag, but you look at the front end of the curve. There aren't great indices to position on the front end of the curve either. What's your best approach or best reflection on the front end?

20:21It's really the one to three year GovCredit index. So half government, half credit. not fully representative of the bond market and the opportunity that you can glean in the front end of the curve. So it's the structures that were put in place at inception of these benchmarks that are reflective. And you have an index like the universal, for example, the aggregate universal. But even then, you have marginal increase to high yield, marginal increase to emerging market debt. It's still very disproportionately skewed towards duration risk as opposed to credit risk. You guys have a killer chart showing treasury ETF flows since the Fed's first rate increase.

20:57And what jumps out to me are long treasuries. And people were talking about this TLT in 2022. As these bonds got killed, you saw investors run into a burning building. And that never, ever happens. There's no other scenario where investors run into a fire. And they've continued to do so. It really stands out. So you plot long treasury, intermediate, short, ultra short, and this is the head scratcher. What do you think is going on here? I think one thing to think about within things like TLT or LQD, I mean, these ETFs have grown into just as much financial instruments as they are investment vehicles.

21:40And the inherent investor base is not only retail, but also institutional in nature. And so you have a lot of motivations that are maybe not purely economic in the sense of maybe liability-driven investing, for example. So I think you have a variety of investors in the space that are not investing on a pure, kind of on an isolated basis, just looking at TLT, but looking at maybe matching liabilities, matching risk within a portfolio. So that's one thing I would point to is the increasing or the large representation of institutional investors, which use these ETFs as financial insurance. But John, would you add anything to that?

22:16Yeah, I mean, that's on point. So if you look at some of the larger ETFs like TLT or SPY, they're used for various different reasons. They're not just retail going into gain exposure to long duration necessarily. And if you could identify the holding period for some of these, you would probably see that the holding period is rather short. So while long treasuries of late have not done well, they're being used for different reasons by different consumers. So back to the active fixed income thing, you guys have a great chart here that shows that most active fixed income managers actually outperform, which is the opposite of the equity space.

22:54Usually it's equity managers have had a very hard time outperforming, especially the past 10 years or so where the biggest stocks have been the biggest winners. And so that's a hard. But in the fixed income space, you see more outperformance. I don't have the exact numbers, but you kind of show a breakdown here. My question to you is, is that outperformance skill or is it taking more risk because you're going out in the credit spectrum? And maybe it doesn't matter because, again, a lot of these benchmarks don't have all that. But how much of it is just taking different credit risks? And does that really matter?

23:24Yeah, it's interesting in the bond market. I don't think it's necessarily a reflection of taking more risk. I think it's being thoughtful with your risk and potentially looking both in active plays within the index and then even moving outside the index. So, for example, one point I would bring up is the index itself, due to its construction, is an index of adverse selection, as we'd say, in the bond market, where the index is going to be more geared to and have exposure to those borrowers that are more indebted, which is kind of counterintuitive in nature. So you can actually, as an active manager, mitigate some of that risk, where, for example, investment-grade credit, where there's a larger proportion in BBB, you can manage those risks from an active perspective and also take positioning within the IG credit market.

24:11So for example, year to date, we've done quite well over weighting financials, which have actually obviously done quite well post the election. The other thing to note within agency mortgages, for example, just given issuance and mortgages, right? What's the nature of mortgages in the index? So this is the second most liquid asset class behind US treasury debt. They're predominantly lower coupon mortgages. So you look at 2022, where rates moved higher, those mortgages on average lost 13 % versus higher coupon mortgages lost roughly 7 % to 8%. So for an active manager, it's not about taking on more risk.

24:51I can make the decision and say, I don't want to own those lower coupon mortgages. I'm going to replace that with higher coupon mortgages. And I can manage for that, what they call negative convexity, that risk that mortgages introduce as rates move higher. But then, Ben, you're absolutely right, where you can move outside the constraints of the benchmark. So as I mentioned, you know, Securitas credit is roughly$3 trillion market. So that doesn't necessarily mean taking on more risk where you can sit in higher portions of capital structure, single A rated or higher, where you're getting very strong levels of collateralization, i.e.