Speaker 1:
From the library of the New York Stock Exchange at the corner of Wall and Broad Streets in New York city, you're Inside the ICE House, our podcast from Intercontinental Exchange on markets, leadership and vision and global business. The dream drivers that have made the NYSC an indispensable institution of global growth for over 225 years. Each week, we feature stories of those who hatch plans, create jobs, and harness the engine of capitalism right here, right now at the NYSC and at ISIS 12 exchanges and six clearing houses around the world. And now welcome Inside the ICE House.
Pete Asch:
Welcome Inside the ICE House. I'm your host, Pete Asch. Last year began and ended with volatility, which had long been absent from the longest bull market in history. Add in a mix of geopolitical issues from a government shutdown to US/China trade talks to the federal reserve raising rates, and it's safe to say that 2018 was marked by uncertainty. The biggest difference between the market of 2018 and past periods of increased risk was the presence of exchange traded funds, which now represent between 25 and 40% of trading volume on any given day. ETFs, an investment vehicle born out of the market volatility of 1987 and designed to limit individual equity exposure, just faced their biggest test since becoming a major player in investment strategies. The just-released 2019 US Exchange-Traded Fund study, sponsored by BlackRock and conducted by Greenwich Associates, captures institutional investors' reaction to 2018 in the ETF space.
Pete Asch:
The survey, also known as the Greenwich study, has been commissioned by BlackRock for the past nine years. The 2019 edition captured the behavior of 181 institutional investors, from portfolio managers to traders, to research analysts. The group represented a wide range of institutional types with three quarters managing over $1 billion. Joining us today to help us break down. Some of the findings of the report is BlackRock's Brendan McCarthy. What actions did institutional investors take to account for increased risk due to volatility and uncertainty? How did ETFs fare against actively managed funds over the course of 2018? We'll find out after the break, but spoiler, those two questions may be related.
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Pete Asch:
Our guest today, Brendan McCarthy, is a managing director at BlackRock responsible for the US market's coverage team and the institutional product consulting team. Brendan joined BlackRock in 2016, after 15 years working at Goldman Sachs in the securities division. And he joins us today Inside the ICE House. Welcome to the library, Brendan.
Brendan McCarthy:
Thanks, Pete. It's always great to be downtown at the New York Stock Exchange and in the ICE House here. So thank you very much.
Pete Asch:
Anytime. So you cover a pretty broad spectrum, it sounds like. How does the US market coverage and institutional product consulting teams fit into the larger BlackRock ecosystem?
Brendan McCarthy:
So that great question, and one I'm often asked to explain. Effectively, we're part of the greater capital markets team at the issuer, iShares. Our job within markets coverage and product consulting is to work with clients on product choice, all the nuances that go into the ETFs, understanding how they work in terms of portfolio construction, tax nuances, how they compare to other ETFs, how they compare to mutual funds. And then we also work with clients on implementation guidance, as in, I've made my product choice. How do I trade? How do I execute? What's that going to cost me? So effectively, our markets coverage and our product consulting team are a group of specialists that work with our institutional clients on all things product and implementation.
Pete Asch:
And so those clients are the people represented in the study and also who need to react to that study. The respondents were overwhelmingly concerned with risk in 2018, particularly Q4 with that volatility. Have you seen that shift the defensive strategy that a lot of them were testing to taking?
Brendan McCarthy:
Definitely. And your point about the clients we're talking about, it's really a wide group of institutional clients, everyone from hedge funds, asset managers, pension funds, sovereign wealths, ETF strategies, you name it, really institutional clients across the spectrum. And to your point, yes, 2018 saw a lot of different things in the marketplace, and how people were managing risk and how they used ETFs definitely came hand in hand. It's different from each client, but what was consistent across most, and in most of the respondents to the survey, was using this instrument, using ETF in ways that mitigate risk, in ways that offer access to new exposures, in ways that sometimes are just a more cost effective hedge. So a variety of different clients, a variety of different users, and a variety of different use cases, really.
Pete Asch:
And so our listeners, some may obviously work for these institutional clients, but almost all would be retail investors. What can someone sitting at home managing their 401k, or maybe do a little day trading, learn from how these institutional investors are allocating their funds?
Brendan McCarthy:
That's a great question. And there was one part of the survey that I really liked because it comes to life for us every single day when we're talking to institutional clients. But I think it's applicable to retail as well in that, what are the different applications of use for ETFs? And things that are listed here are tactical adjustments, core allocation, rebalancing, portfolio completion, international diversification, liquidity management, transition management, risk management, interim beta, cash equitization, long and lend. That's a mouthful, right? That's a lot of different things, but from an institutional perspective, that's what they use ETFs for.
Brendan McCarthy:
But when I think about those 10, 11 things that were listed, they really come down to three things that I think retail can really appreciate. And that's what are ETFs really being used for? One, market access. How can I get involved in a market or an exposure easily? Two, liquidity. Obviously, ETFs have the benefit of dual liquidity, primary and secondary trading. And three, building blocks. How can I use a handful of ETFs, one, two, five, ten, whatever it is, to build the portfolio I want? So when I look at the institutional applications for ETFs, the list really does go on and on. But if you think hard about it, it boils down to those three things. Market access, liquidity, and building blocks. And I think anyone, retail or institutional, can appreciate that.
Pete Asch:
Yeah. Now, I touched on the intro, that the creation of the ETF goes back to actually a response to that 1987 volatility. The bull market really mitigated a lot of that volatility. So now you're really seeing that test. So how did iShares do against sort of more actively traded investment vehicles?
Brendan McCarthy:
Yeah. That's a question that comes up quite a bit. It's hotly debated. And just, you talk about the late '80s, early '90s, and it's incredible to think about... When I started my career in the late '90s, ETFs were called a hundred billion dollars. And look where they are now. So they truly stood the test of time. All different market cycles and environments, high volatility, low volatility, they've grown throughout all of that, and they've become more diverse. I think what's important if we look back at last year and we answer questions about how did ETFs behave in certain market environments, I look at last February, almost a year ago this month, this week, really, when we saw the VIX spike. What happened with the ETFs then, and what happens typically when volatility increases? What you see is an increase in trading volumes of ETFs. Institutional clients in times of heightened volatility, in times of heightened risk, will often go to the vehicle that can express their view accurately, and most importantly, quickly.
Brendan McCarthy:
ETFs are blunt instruments that provide exposure to a country, to a sector, to a thematic, to a factor. In times of stress, in times of heightened volatility, you'll see clients, institutional clients react and use these instruments to hedge themselves, express an exposure quickly. And we've seen this time and time again. And you mentioned at the very beginning, the percentage of secondary volumes that ETFs are, it's gone from some 20, 25% last year, averaging north of 30% this year. In times of stress, and the fed period I point to last year, ETFs were almost 40% of market volumes. So I think that speaks to the fact that they are standing up in times of stress and that institutional clients are gravitating to them in the same way that they gravitate towards futures and other derivative products in times of stress. They go where the liquidity is.
Pete Asch:
And if we stay in last year for a minute, we can take it back to August, 2018. There were a lot of reporting going on about the slowing of that asset inflows into ETFs. We're looking at this report now that includes the entire year of 2018. So both the February volatility, that mid-summer where low volatility suggested there might be a slowdown in the inflows. Let's get into those numbers. What are you seeing for those institutional investors? How much are they putting into ETFs at the year end?
Brendan McCarthy:
Yeah, I mean, December was incredible, right? We definitely saw record volumes come in, in December into year end. And a lot of that was chewing up portfolios into year end, a lot of that was repositioning, and a lot of that was preparing for 2019. So, I think it's important to understand that the market will always dictate what clients are doing. Not any sort of vehicle. The market is going to dictate what's happening. Right? And what we see, any ETF issuer will see, is, depending on what the market is telling you, we'll see movements in asset class. We're seeing that even right now at the beginning of the year where we're seeing reallocation to emerging markets. We're seeing reallocation to certain factors like quality. We're seeing reallocation to certain sectors like real estate. People are positioning accordingly. And typically, asset allocation is going from one asset class to another. So what you referenced last August in terms of the slowdown, part of that was people taking risk off the table. And that was very much driven by the market dynamic, not necessarily any sort of vehicle.
Pete Asch:
So you're looking at this report. It gives us a snapshot of what's happening today, but projecting a little bit, do you see a sustained growth in ETFs? Or are we leveling out?
Brendan McCarthy:
Yeah, I think we're going to continue to see growth. And it goes back to what I said earlier around diversification of use and diversification of user. Take an example around a country fund, for example. If I were to say the MSCI Japan product, EWJ, you may see a pension fund using that as an asset allocation vehicle. You may see a hedge fund using that to short. You may see an asset manager using it as an overlay. People are trading options on it. You have one single product, in this case EWJ, that is being used in a variety of different ways by a variety of different people. I think that diversification of use and diversification of user is only going to continue to grow. We see that in this paper, we see that when we asked the respondents to this paper how they're using ETFs, and I don't think that's going to change.
Brendan McCarthy:
And when I think about where this growth is coming from, and BlackRock and iShares has done some work on this and written about it, but there's really four areas of growth that we're we're projecting. One is just simply cost. People want low cost products. I mean, I think there's no debating that. The concept of fee-based advisory, that's something that is going to present a tailwind for lower cost products like ETFs. Fixed income. We haven't touched on fixed income yet, but the concept of indexing in fixed income is still early, early days. And that is a significant area of growth.
Brendan McCarthy:
And then the final thing is what we've been talking about, which I think is really one of the most exciting ones, is just the concept of using index products to trade actively. And I'll repeat that again because I think it's important to emphasize. People are using index product to trade actively. And that may take some folks aback in the institutional space, but that's what we see. We see it every day, active managers using these index products. And I would classify an index product as an ETF, a future, a swap, any broad-based blunt instrument that gives you index, sector, thematic, factor, exposure. People are using them strategically. People are using them tactically. I don't see that stopping.
Pete Asch:
I want to touch on something you brought up, that idea of fees. I mean, competition in the ETF space is quite fierce. Fees are kind of doing that run to zero. In fact, last week, Charles Schwab and Fidelity both announced they would expand commission fee trading to hundreds of iShares ETFs. How does an announcement like that impact your institutional investor business, but also how those shares trade?
Brendan McCarthy:
The announcement that clients can trade ETFs commission-free, that's good for ETFs, for sure. It just takes a friction away for the retail investor who wants to execute ETFs. So we think that is certainly positive. How it impacts the trading of ETFs, I go back to that diversification of user. Before I mentioned in the example of MSCI Japan and EWJ, all the different users coming in there. The one I didn't mention was the retail user, which is a big, big part of the marketplace. Let's not discount that at all. But the retail clients are certainly expressing their preference for exposure via ETFs as well. So I think it just brings added diversification to the use of the product. The more people using the product for different reasons means more liquidity in the market. More liquidity in the market often leads to tighter bid-ask spreads, deeper book. We're sitting here at the New York Stock Exchange so that's music to your ears, obviously, tighter bid-ask and deeper cues, of course. So I think it's nothing but positive to get more people using ETFs.
Pete Asch:
After the break, we turn our attention to a couple of Intercontinental Exchange's favorite topics for 2019, the bond market and fixed income. We will be right back.
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Pete Asch:
Welcome back. Before the break, Brendan McCarthy, managing director at BlackRock, and I were discussing just a few of the findings that can be found in the most recent Greenwich report. One of the areas of interest to us here at Intercontinental Exchange is fixed income. BlackRock has several fixed income ETFs that they've brought to market. What did the research and the study show you about how your institutional client are allocating funds into those and using them in their investment strategies?
Brendan McCarthy:
I think what was most promising information that came out of the report, and something that we've had a lot of conviction around, is that institutional investors are now really looking at fixed income ETFs. Institutional investors, again, being asset managers, pension funds, insurance companies. And those are the ones that are really spending time trying to understand the fixed income ETFs in terms of the ecosystem, the mechanics, and the product suite. So the big takeaway from the Greenwich report for us was really confirmation that portfolio managers, fixed income portfolio managers, fixed income traders on the institutional side, are taking a deeper look at this access tool for this asset class.
Pete Asch:
And so when you're going in and interfacing with these clients, where does this now fall on the spectrum of the tools at the beginning to really start to dig into?
Brendan McCarthy:
It's certainly growing. And I think the survey respondents showed significant interest from those institutional investors in terms of, in the next six to 12 months, many indicated that they will be using fixed income ETFs. And what's interesting is they're using them in many similar ways that equity investors have used ETFs in the past. Market access tools, operational efficiencies, cost effectiveness, liquidity sleeves. So a lot of the use cases of the ETFs for fixed income are very similar to what we've seen from equity PMs in the past.
Pete Asch:
And sitting here on the corner of Wall and Broad where the very first bond market in US history was launched, the average investor knows to look at the bond news, what's going on with the yield curve and corporate debt, but what's going on in the bond ETFs world?
Brendan McCarthy:
Yeah, no, and that's actually a great point, right? Because here you have fixed income products trading on a listed exchange, which I think for the traditional cash bond buyer, that still takes a bit of time to get their head around. And so it's understanding, how is the fixed income ETF built? What are the mechanics? What is the exposure? Explaining to them things like the duration, the yield, the sector breakdown, explaining to them how the index works, the construction, how we replicate the index in the ETF. All this education is still required for the institutional fixed income client to get to a level of comfort and understanding how the fixed income ETFs are built. Now, I think great progress is being made there. And we're seeing that in terms of use cases in volumes on exchange. Fixed income ETFs across high yield, across investment grade, across emerging market debt, cash-like products. The volumes that we're seeing in the secondary market, and then the follow-on primary activity is significant and is growing.
Pete Asch:
So we've been talking about the growth of the overall ETF industry, and then now focusing on fixed income and bonds. We're talking about 5 trillion of assets under management in early 2019. What are you projecting, not just for fixed income, but the overall industry?
Brendan McCarthy:
Sure. We've done some work and put some projections in place where we see the global ETF industry going to about 12 trillion US dollars globally by 2023. And where's that coming from? It goes back to what I mentioned earlier, those four areas of growth, being cost, people want low cost products. This concept of fee-based advisory, being a tailwind for low cast products, fixed income, which we obviously were just talking about, and that concept of active investors using index products actively. But what I get really excited about, though, in that number, that $12 trillion projection, is the fixed income side. Because if you look at where we are right now, of the 4.8 trillion that you mentioned, 3.4 of that is in the US. And of that 3.4 in the US, 2.7, roughly, is equities. And the balance, call it 700 billion, is fixed income.
Brendan McCarthy:
It is still really early, early days for fixed income. And you look at the broad universe of fixed income derivatives of cash bonds. The current AUM, the current assets of fixed income ETFs is really quite small. So I think what gets us very excited about the fixed income opportunity and what this paper, the Greenwich paper, really drew out from institutional clients was the use cases that we've seen proven for equity investors, institutional investors, in terms of market access, liquidity, ease of use, operational efficiencies, et cetera, et cetera, many of those of same types of use cases are applicable to the fixed income space as well.
Brendan McCarthy:
We discussed earlier just the concept of indexing in fixed income is still quite new. And this paper also drew out that institutional clients are becoming more comfortable with indexing in the fixed income space. We're seeing most institutional clients really use your core standard exposures in the fixed income space, high yield, investment grade, cash products. Well, we're seeing that grow and develop. You're seeing more institutional clients using things like emerging market debt. You're seeing clients use more short- and mid-duration products much more flexibly than they have in the past.
Pete Asch:
2018 was the 25th anniversary of the ETFs. That asset management has been increasing. And so has the types of ETFs available to the market. If you look back over the last two years, iShares has actually rang the bell more at the New York Stock Exchange than any other company because of launching these ETFs. What are your expectations about these more niche products? Is that going to stay mostly in the retail space or are you expecting some of your institutional clients to begin to engage?
Brendan McCarthy:
Yeah, there's always the question of, who adopts first, retail or institution? And I don't think we have a great answer to that. I think you could debate both sides. But I think retail is often a first mover with some of the nichey products. And as soon as liquidity builds and use case builds, you will see institutional adoption. But it really just depends on the exposure. And that's important as we sit here and have a discussion about this innovative vehicle for investments. We can't forget that exposure drives everything, and it's really going to be, is this attractive from a portfolio perspective? Does it achieve the investment needs of either insti or retail? So again, it really just depends on what is the exposure that the ETF is bringing to the client base?
Pete Asch:
You're getting ready to jump on an airplane, heading out to Chicago to meet with clients. When you walk into that room, what is the number one takeaway that you're going to want those institutional clients to know?
Brendan McCarthy:
I think with the Greenwich survey reports is that there are multiple institutional investors using ETFs for multiple reasons, and that ETFs are now very much a critical tool for portfolio construction.
Pete Asch:
So ETFs just can't be ignored by institutional clients or the retail investor. Thanks so much, Brendan, for joining us on Inside the ICE House.
Brendan McCarthy:
Thanks, Pete. Appreciate you having us here.
Pete Asch:
That's our conversation for this week. Our guest was Brendan McCarthy, managing director at BlackRock. If you like what you heard, please rate us on iTunes so other folks know where to find us. Got a comment or question you'd like one of our experts to tackle on a future show, email us at [email protected] or tweet us at NYSC. Our show was produced by Theresa DeLuca with production assistance from Ken Abel. I'm Pete Asch, your host, signing off from the library of the New York Stock Exchange. Thanks for listening. See you next time.
Speaker 1:
Information contained in this podcast was obtained in part from publicly available sources and not independently verified. Neither ICE nor its affiliates make any representations or warranties, expressed or implied, as to the accuracy or completeness of the information and do not sponsor, approve, or endorse any of the content herein, all of which is presented solely for informational and educational purposes. Nothing herein constitutes an offer to sell, a solicitation of an offer to buy any security, or a recommendation of any security or trading practice. Some portions of the proceeding conversation may have been edited for the purpose of length or clarity.
