Total time: 28:17
0:03
Roman: Welcome back to the Sage Advisory Podcast. I am Roman Samuels, I’m the regional consultant here at Sage. And I'm with my good friend, Komson Silapachai. How are you?
Komson: Hey Roman, how are you?
Roman: I'm doing great man. So I'm gonna, I'm gonna mix things up. I'm going to just throw out maybe a statement that I hear from advisors all the time: are mutual funds dying, are they going to be obsolete in the future? What would you say to that?
Komson: I mean, when you look at the market, ETFs, there's 2,000 existence, it's, you know, it's really exploded in size at 3.4 trillion assets. Mutual funds, there's 9,000 of them in the U.S. with $19 trillion in assets. So when people talk about the demise of mutual funds, you gotta think about really the size, you know that it is today. And, you know, it has its place.
0:54
Roman: Yeah, well, you're saying it seems like is, hey, it's not a war, right? It's not an either or both are serving different things. They're designed to do different things. Why would, you know, a mutual fund be a better choice? Or would it be a better choice for a certain investor versus an ETF?
1:14
Komson: I think a mutual fund typically is going to be active. So most of the assets in mutual funds are active management. And what I mean by that is, they have a stated benchmark. That portfolio manager of the mutual fund will then try and outperform that benchmark through various active strategies, primarily security selection. ETFs, on the other hand, they're both open-ended, ETFs are open-ended as well. However, 99% of assets under management are indexed in an ETF product. So the, for someone that's looking for a wide range of active strategies, I think they would gravitate more towards mutual fund, because the historically there's been more active strategies within that type of fund structure. Now, you're seeing a lot of active strategies launch in ETF land, you know, we're still not there yet, as far as size, but you're seeing a few ETFs really, really getting critical mass on the active side.
2:19
Roman: So it sounds like what you're saying is underlying the mutual fund and ETF discussion is another discussion that's at work here. And that discussion is active versus passive. And where investors are putting assets, under passive strategies are active strategies. And we've definitely seen from the advisor community and from the retail investor, a tremendous movement over the last few years into passive strategies. It's got some folks wondering, will there be a place for active management? Or will it all become passive at some point in time? And these are questions we've been hearing from advisors in the field, what would you say to a question like that?
Komson: Passive has really grown due to a number of reasons. So number one, when you talk to anyone that's in the investment space, what is the most common index? Typically it’s going to be the S&P500. That's your large-cap U.S., that's the thing that's performed really the best out of most of the major indices globally. And so oftentimes, folks will say, well, like, why do I need to pay, you know, anyone to select securities for me in an active strategy, when I can I just look on, you know, in the paper on TV, and the top strategy is being passive and S&P500. So I think one of the things is, we've been in a bull market led by the most headline index out there. The second one is the proliferation of asset allocation strategies. I think one of the benefits of ETFs is it provides a lot more of a niche-type index. So it's passive, but now you're able to get Germany, you know, country allocation. You're able to get machine learning, and thematic strategies, very niche strategies that I think that you couldn't get in an index fashion in the mutual fund space. And so with those choices, these asset allocators are able to structure portfolios, and while they’re “passive,” there are a lot of decisions -- and I call them active decisions -- in constructing the portfolio. And we talked about asset allocation the last episode, you know, creating that portfolio is an exercise that's nontrivial. You have to determine the risk profile, you have to make sure that the things you put into portfolio are going to achieve that, you know, the best return for your risk, and you got to remain diversified. And some people are more return-seeking, they want to be more concentrated in particular asset classes -- ETFs now provide the wide breadth of things where you can express those views. And so a lot of folks have allocated to those strategies. And so you're seeing kind of, when you look at just a line chart of passive versus active, yes, passive has really gone up. But a lot of that growth has been because some of these niche strategies are providing you; whereas before a manager would have to go out and buy a, you know, basket of individuals securities to get exposure to the retail sector. Now there's an individual retail ETF.
5:16
Roman: It's not so much that the growth of ETFs means that active management is not there anymore, what you're saying is, in large part, the growth of ETFs is because active management is continuing to evolve into other arenas
Komson: The way I would frame the active versus passive debate would be to step outside of it and say, that's the wrong question to be asking. There is no truly passive way to invest, you have to always make a decision on staying invested, make a decision on, you know, your set of investments. And I think that that's, you know, when we talk about active management, and as it was before, it was, you know, we're going to delegate -- we, whether it's asset manager or advisor, a client -- was delegating active management to say, “Okay, well, I just want equity exposure, I'm just going to buy this fund, they can do anything with it.” Now you're delegating some of it, you're saying, “Hey, I want to be in these market segments. So I'm going to actually allocate to these passive structures.” But in the U.S. equity piece, or in the fixed income piece, I'm going to allocate it to this fixed income manager on the active side, because I think there's outperformance to be earned there. But all these other niche strategies, or all these other industry, or country, bets I want to have, you can still you allocate to those passive strategies.
6:38
Roman: Yeah, there's this, there's this room that opens up to start blending, okay, where do I want to get alpha, maybe I'll choose an active manager there. And for the rest, maybe I go passive. But it also sounds like what you're saying is that what ETFs do a little bit differently than the mutual fund is the ETF, primarily so far, is designed to give the investor access to a market segment’s return, rather than providing the investor the potential to outperform that market segment, which is really what a mutual fund comes in, and tries to say, right? A mutual fund, and please correct me if I'm wrong, but a mutual fund tends to come in to say, Okay, if your market segment is large cap value, and I'm a mutual fund, I'm benched against the S&P, I'm going to put together a portfolio that is trying to outperform that market segment. Versus most of the ETFs out there are coming in and saying, I'm just going to try and give you access to that market segment’s return.
7:37
Komson: Yeah, and I think I would add to that and say, active mutual funds would be saying, Hey, I want to outperform, you know, the index by security selection. ETFs, yes, they're going to be either replicating the index in a full replication strategy, or just something that, like you said, you're tracking error, which is the standard deviation of returns versus a benchmark, is going to be a lot smaller in these index strategies.
8:03
Roman: You know, moving a little bit deeper into maybe some of the differences that exist between an ETF structure and a mutual fund structure -- I get a lot of questions from advisors who they say to me, you know, Roman, I've heard that ETFs are more tax efficient, I've heard they're better for liquidity. I've heard that they can be traded like a stock versus a mutual fund. But I do sense that within these advisor questions, they're trying to understand why ETFs might be a little more tax efficient than mutual funds, or why they might be a little more liquid. Could you talk to us about some of those structural differences, and why ETFs tend to have that type of reputation?
8:45
Komson: One of the great facets of ETFs is that they are exchange traded. You can trade them like a stock, it's real time so you're -- at noon or 1pm, you can get in and out.
Roman: Versus a mutual fund, which you know, would basically, the NAV would readjust once a day.
Komson: Exactly. It has daily liquidity. Also ETFs, as I mentioned before, typically, passive. 99% of assets are passive whereas mutual funds are typically active. And so the artifact of those two effectively trends in these different types of products means that ETFs typically have a lower cost. So you're seeing fees, expense ratios in ETFs be much lower than they are in mutual fund space. And that's because there are a lot of passive index strategies within ETFs; it’s a lot more scalable. ETFs are a little bit more transparent. So you can see these positions on a daily basis. Mutual Funds typically reveal positions on a quarterly basis.
Roman: And is this because the mutual fund manager is in some way, shape, or form trying to protect the secret sauce that leads to the mutual fund’s outperformance? Where an ETF is, you know, really just kind of opening the hood and saying, you know, here's what the ETFs gonna buy, basically?
10:02
Komson: Well, the rules around reporting are just the rules of those types of fund structures. And so it's not really a result of the intent of the portfolio manager. It's really just a, it's just an artifact of those types of funds. Now, if you're a portfolio manager with a really good active strategy, and you don't want to “tip your hand every single day” and show every one of your positions, a mutual fund structure may be more advantageous and say, Look, I'm going to give you the outperformance, you just invest with this portfolio for X amount of time, and, you know, you're going to get quarterly transparency. An ETF typically is going to be indexed and a daily transparency ETF is not really -- there's not really an advantage or disadvantage for the portfolio manager because you're not trying to outperform market.
10:48
Roman: Is it fair to say that the ETF portfolio for the most part is not really changing, right? What they're buying -- An ETF is really just buying the same, you know, basket, depending on the criteria, is that fair to say? That’s right there, I can see how that would lend itself to an ETF product being more tax efficient, because a lot of times if a mutual fund manager is buying and selling securities more actively than an ETF, that could potentially result in capital gains, and those capital gains are passed on to the shareholders of the fund. Versus an ETF might be doing a lot less buying and selling than its mutual fund counterpart. Is that fair to say?
11:29
Komson: Right. And so there are really two big parts of why ETFs are structurally more tax efficient, and you hear this cited all the time. And so there's a lot of confusion around this. But the first one is that because they're more passive, there's gonna be less trading. So that's exactly getting to what you're saying, there's going to be less turnover in the portfolio as a whole. The second one is a little bit more nuanced. And it's through the creation and redemption process. And so let me go through kind of how a mutual fund, if you were to buy or sell or try to put in cash into fund to buy shares or redeem shares to get cash, how that works in order to create shares or redeem shares, it's a cash process. So what that means is when you infuse cash into a portfolio the portfolio manager then has to go out and buy those shares in the market, take the cash from you, and then buy the shares in the market. When you redeem cash, the portfolio manager will then have to sell those securities, and at the end of the day return that cash to you. Now there's a few implications for that. First implication is mutual fund managers will sometimes have to carry an allocation of cash in order to meet those redemptions. When you carry a structural allocation to cash you may have cash drag. The second one is you know in the redemption process, when you're selling those securities in order to meet, let's say, Roman you’re redeeming shares. In order to meet your redemption, as a portfolio manager, I have to sell the shares to give you the cash. If I'm selling shares with a low-cost basis, generating some capital gains taxes on the fund, giving cash you Roman -- now that capital gains taxes on the fund are borne by all the resulting shareholders of the fund. And so that's a disadvantageous situation where, you know, shareholders of the fund are paying capital gains taxes. And that's part of the portfolio management process of mutual funds. Now, in ETFs, that creation/redemption is really different. Most ETFs trade on a secondary market, which means that when you're buying or selling an ETF, you're buying or selling that fund from another person on an exchange. And so no shares being sold or bought by the portfolio manager in response to you buying and selling shares. You see what I’m saying?
13:53
Roman: You're not necessarily interacting with the fund company directly. You're selling your shares to another buyer of those shares in a secondary market. Versus with a mutual fund, when you're selling shares, you're selling shares back to the fund company, is that correct?
14:07
Komson: Exactly. And so now when you have a situation where that supply and demand on the secondary market is mismatched, so there's a net creation of shares, or a net redemption of shares, then you go to the primary market, and that's where you interact with the underlying holdings. But there's also another kind of wrinkle, it's called in-kind. And so what that means is, you, Roman, you're buying ETF shares from a broker, that broker will then go, either they're going to be an authorized participant, or they're going to go through what's called an authorized participant, which is another broker, so to speak. That authorized participant that's a special class of broker dealer, they're the ones that are going to be dealing with the portfolio management company. And the way they're going to do that is they’re going to take your cash, buy securities, and then exchange those securities for the fund themselves. Now, on the flip side, if you’re redeeming cash, the portfolio manager, they're not selling shares like they are in mutual fund land. They're giving those ETF shares to the authorized participant, authorized participant that has to sell those shares into the market, convert them to the shares, sell them in the market, give you the cash. And so at the fund level, there's no turnover. Like there is in mutual funds. And so there's a lot less capital gains taxes. So you can go, and I'm not saying it eliminates them all, but it minimizes them relative to mutual funds.
15:32
Roman: Just the mere operational functionality of how investors buy and sell shares makes it such that an ETF should have lower capital gains implications is what you're saying.
Komson: Exactly. So when you look at some of these higher turnover ETFs typically, you know, some of them have upwards of 300% turnover, but they haven't paid capital gains taxes in years.
Roman: Right there. That's, you know, one reason why an investor seeking more tax efficiency in their portfolio might gravitate to an ETF product. Because let's say they want exposure to large caps, they could buy a large-cap mutual fund, or they could buy a large-cap ETF, and generally speaking, all things being equal, the ETF product would have fewer tax implications, or should have fewer tax implications than its mutual fund counterpart.
16:24
Komson: Exactly. And I want to focus on the point that the taxes that I'm referring to are the taxes within the fund that you would have to pay as a shareholder.
Roman: Right. This is a good distinction, because there are two levels of taxation in an investors journey, there's them buying and selling the product. And then what we're talking about is at the fund level?
Komson: Right. So when it let's say, you, you bought into an ETF and a mutual fund at a really good time, and you really made a lot of capital gains on it, you would have to pay capital gains taxes in the same manner, it's just the fund structures are different. And so I want to make that distinction.
Roman: Yeah, that's a good distinction to make. So for anybody out there listening, what we're trying to distinguish between is the transaction between the retail investor buying shares of a mutual fund, or shares of an ETF, and then a few years go by, the shares of the mutual fund go up in value, the shares of the ETF go up in value, and then the investor sells their shares of that investment product. At that time, they would realize a capital gain and have to pay those capital gains taxes. And that is one level of taxation. But then the second level of taxation is the investor who owned the shares of the mutual fund throughout the years that they own that mutual fund, that mutual fund manager was buying and selling a lot of securities inside of that portfolio, generating additional capital gains that that investor is also on the hook for. Versus the ETF counterpart, generally speaking, will have less of those at the fund level -- capital gains implications. And that's what we're trying to say, that is one of the reasons why the ETF product tends to get this reputation of it's more tax efficient. Talk to me a little bit more about the liquidity aspect of mutual funds versus ETFs as well.
18:20
Komson: So the liquidity aspect is really different between ETFs and mutual funds. ETFs can be thought of as a stock, you know, effectively, so you still have market impact. So, what do I mean by market impact? If you're a large investor, and you're buying or selling a thinly-traded ETF, that ETF, you buying or selling on exchange, you can affect the price given how deep the market may be for that ETF at a particular point in time. Let’s say you want to buy more than it's listed at on the screen -- and this is a problem for very large investors -- but, you know, I think we run into this problem, you have to really watch how liquid the ETF is. Whereas mutual funds, if you want to buy shares of a mutual fund, it's a daily process. And so, the portfolio manager typically will have a little bit more free reign as to how to create those shares, especially if they're active. And so what you need to do is just create those shares on a daily basis. And you don't have to worry as much about market impact. Theoretically, that may be borne internally in the fund, but ETFs, you can kind of see it. Also, if you're trading ETFs, there will be trading costs. So just like when you're trading a stock, the reason why we really like using ETFs is because we trade securities all day on our trading desk, primarily fixed income, so we're mindful of the liquidity situation in exchange traded funds.
19:43
Roman: Yeah, if I was to summarize, one of the reasons why liquidity on the ETF product is different from the mutual fund product is because on the ETF product, there's an exchange. And that exchange has supply and demand forces at work that really aren't as noticeable than, say, the exchange of shares in a mutual fund. For instance, when you talk about the thinly-traded mutual fund, you know, you're referring to a fund, an ETF, that has, say, a fairly low daily average of volume of shares trading hands. Let's say 30,000 shares, just for the sake of example. If an order came in for an ETF to offload 50,000 shares, and the average volume of that ETF was 30,000 shares in any given day, that order alone can affect the overall price of that ETF product in a way that's more noticeable.
Komson: The best way to trade that is to interact with the authorized participant, create those shares. That's kind of an avenue that we have when we're managing the liquidity of these ETFs.
Roman: Versus say, a mutual fund comes in, and if the same thing occurred in a mutual fund, it wouldn't really have the same impact on price that it might have on an ETF, because of this exchange that exists, essentially.
21:07
Komson: Right, the mutual fund, the liquidity management really goes to the portfolio manager of the fund, not yourself. So you're going to create shares or redeem shares. And that manager will then manage that liquidity themselves to deliver that cash or create the shares for you. And that’s struck at what's called net asset value at the end of the day. On the ETF side, it's really trading, you’re the one that is managing that liquidity risk, which I think you know only really applies to large investors, or unless you're trading extremely thinly-traded ETFs as an individual investor.
21:44
Roman: This might segue nicely into a discussion about Sage, and how Sage uses ETFs. Because we were approached by some of our fixed income clients back in the ‘90s to really try and open up their equity exposure. They said, hey, you're doing a great job on fixed income, we want some equity exposure. And at the time, we really had two different products that we could look at. We could say, okay, we can put together a portfolio of mutual funds, or we can use ETFs. And we decided to go with ETFs. And this was back in, I don't know, was it ‘98, ‘99, somewhere around there?
Komson: It was in ‘98.
Roman: And there were 29 ETFs around at that time, if I'm not mistaken. So why did we decide that ETFs were how we were going to do this?
22:29
Komson: So in 1998, there were really three ways you could manage an equity portfolio. For us, it was like you mentioned, either mutual funds or ETFs. But you could also manage a full-on equity portfolio, where you're selecting securities yourself. I think the reason why we chose to go with ETFs at the time was because it really fit in with our investment process and the way we think about the world. And so one of the big pillars of how we manage money is we try and manage our, what we call our key risk decisions, rather than a bottom-up framework. And so what that means in fixed income is that we try and select the right sectors, and then we try to fill those buckets: security selection, bottom-up security selection just wasn't really our M.O. at the time. And so what we wanted to do was find a technology that allowed us to have an asset allocation-type framework, a top-down framework that would give us liquidity. ETFs really fit the bill at the time. Although there were 29 ETFs, the growth of these niche strategies I told you about gave us region, sectors, styles, and market cap, smart beta -- gave us tools to be a better asset allocator. So we've developed this process over time. And so, in 1998, we started investing in ETFs, we created a strategy then, and over the next 20 years we developed equity strategies, fixed income strategies, balance, target dates. And so we've kind of run the gamut now of managing different types of ETF strategies.
24:01
Roman: So really, underlying our ETF philosophy was this idea that we wanted to be in control of the key risk decisions. And after that, we just wanted to passively index against the market segments that we had an interest in. So in wrapping up here, investors going forward, now we've got, how many ETFs? Do we have now, 2000, 3000, somewhere in that ballpark?
Komson: About 2000 in the U.S.
Roman: Okay. So, you know, it's probably fair to say that ETFs are going to continue to, you know, proliferate and we're going to get more and more ETFs coming onto the market. What do you really see as some of the things that investors should be thinking about now, going forward into this world of whether I pick mutual funds, whether I use ETFs, whether I use an active manager, whether I use a passive approach. What are some of the things that you would be trying to instill in advisors who are trying to advise clients?
24:59
Komson: Well, I think that there's been quite a bit of growth in ETFs, and I think that will continue. You're going to see more active managers come to the ETF structure. And so I think that's really the next phase of the ETF industry, is seeing more and more active strategies. You know, one of the great things about, and I forgot to mention this earlier about ETFs is, you know, really, since we started in ’98 until the mid-2000s, the U.S. market structure -- So, the way that equities are traded in the U.S., there was a fundamental shift. And so you hear a lot about high frequency trading, electronic trading, algo trading --that really came in place in about 2005, 2006. And so, the market has really evolved to be able to trade across different venues. There used to be two major exchanges, NYSE and NASDAQ. Now, there's nine-plus exchanges. And so then there's a ton of off-exchange venues where you can trade this, these things. And so I think that given the proliferation of market structure and electronic trading, it allows more efficient trading of ETFs. So authorized participants can use technology to our advantage to create and redeem baskets. And so I think that it will allow the further growth of the ETF industry into other types of strategies, like active strategies. I think for folks looking to invest active/passive, I think we mentioned this before, you know, we're going into a period where volatility is going to be higher you know, the Fed is pulling out of the market. I think flexibility will be key. I think we at Sage are proponents of having some sort of active strategy within your investment mix. We're big believers in ETFs because of the flexibility it gives us, the intraday nature, the transparency. And then they're, on average, they're lower cost, are much lower cost. And so, you know, we think that's, that's a more efficient way to access the market.
27:06
Roman: Well, Komson, it's been a pleasure. Thanks for all the insight. And thanks for tuning in to Sage Advisory and we'll see you next time.
27:16
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