Animal Spirits Podcast Summary: "Talk Your Book: J.P. Morgan's Guide to ETFs"

Release Date: December 2, 2024

In this episode of the Animal Spirits Podcast, hosts Michael Batnik and Ben Carlson engage in an in-depth discussion with John Mayer, Chief ETF Strategist at J.P. Morgan Asset Management, and Cheyenne Hussain, Head of US Investment Specialist, Global Fixed Income, Currency, and Commodity Group at J.P. Morgan Asset Management. The episode centers around J.P. Morgan's quarterly publication, "The Guide to ETFs," exploring the current landscape, trends, and future directions of Exchange-Traded Funds (ETFs).

1. Introduction to J.P. Morgan's Guide to ETFs

[00:47] Michael Batnik opens the conversation by introducing the guests and the focal point of the discussion: J.P. Morgan's Guide to ETFs. He highlights the comprehensive nature of the guide, noting its rich charts and insightful data that offer new perspectives to investors.

[01:29] John Mayer reminisces about the evolution of J.P. Morgan's guide series, tracing its origins to Dr. Kelly's Guide to the Markets and its expansion into various domains, including retirement and alternatives. He emphasizes that the ETF guide is the latest addition to this informative lineup.

2. Record ETF Inflows in 2024

The episode delves into the remarkable surge in ETF inflows in 2024, which have reached a staggering $921 billion, surpassing the previous record set in 2021.

[03:34] Ben Carlson raises a critical question regarding the origins of this influx: Are these funds primarily conversions from mutual funds like Dimensional Funds, or are they entirely new investments?

[04:11] Cheyenne Hussain addresses this by attributing the inflows not just to mutual fund conversions but significantly to the inherent benefits of the ETF structure—liquidity, transparency, and tax efficiency. She notes that while some funds may convert from mutual funds, the bulk appears to be net new money entering the ETF space.

[04:40] John Mayer adds that the active management narrative is gaining traction within ETFs. He points out that although only 8% of U.S. ETF assets are actively managed, 30% of the flows this year have been directed towards active ETFs. This indicates a growing acceptance and preference for actively managed ETF products.

3. Growth of ETFs Globally

A significant highlight from the guide is the global expansion of ETFs.

[02:35] Michael Batnik shares a surprising statistic: Global ETF Assets Under Management (AUM) have surged from approximately $2 trillion in 2014 to over $14 trillion today, marking a 20% Compound Annual Growth Rate (CAGR). Notably, the growth rate outside the U.S. is even higher at 26%, compared to 18% in the U.S., underscoring that ETFs are a global phenomenon rather than being confined to the U.S. market.

4. Active ETFs and Regulatory Changes

The discussion transitions to the rise of active ETFs, facilitated by regulatory changes.

[04:42] Cheyenne Hussain explains that regulatory reforms in 2019 were pivotal in enabling active managers to enter the ETF space. These changes included provisions for custom creation baskets and additional tools that made the ETF structure more accommodating for active management strategies.

[05:13] She further elaborates that active ETF managers are now building three to five-year track records, which have been instrumental in gaining acceptance from major platforms and wirehouses. This regulatory environment, combined with the structural benefits of ETFs, has accelerated the growth of active ETFs.

5. Benefits of ETF Structures

The conversation underscores the multifaceted advantages of ETFs that contribute to their growing popularity.

[04:40] Cheyenne Hussain highlights the tax efficiency of ETFs, noting that in 2023, about 30% of ETFs paid capital gains, a stark contrast to mutual funds where only about 0.1% did. This efficiency, coupled with the ease of trading and transparency, makes ETFs an attractive vehicle for both individual and institutional investors.

[06:19] Michael Batnik posits that the surge in ETF flows could also be part of a consolidation trend in the investment landscape, where investors prefer the simplicity of ETFs over multiple investment vehicles like closed-end funds, mutual funds, or individual securities. This consolidation allows for broader market exposure with fewer complexities.

6. Thematic ETFs: Boom and Bust

The guide provides an analysis of thematic ETFs, which have experienced volatile growth patterns.

[09:03] Michael Batnik brings attention to a chart depicting the rise and stabilization of thematic ETF AUM. Thematic ETFs ballooned from $25-30 billion in 2020 to nearly $130 billion, before leveling off despite an increase in the number of thematic ETF offerings. This pattern suggests a speculative surge followed by market normalization.

[09:58] John Mayer identifies the inception of thematic ETFs with the Ark Innovation Funds, which catalyzed issuer interest in thematic investing. However, events like the COVID-19 pandemic and subsequent market corrections in 2022 led to a decline in AUM as investors shifted focus towards concentrated themes like AI, favoring large-cap winners over diversified thematic plays.

7. Active Fixed Income ETFs and Performance

A significant portion of the discussion focuses on the active fixed income ETF space, which has seen robust inflows and notable outperformance.

[17:59] Ben Carlson elaborates on the challenges of replicating the bond market compared to equities. He highlights that existing bond indices, such as the Bloomberg U.S. Aggregate Index, cover only about half of the total U.S. bond market, leaving vast opportunities for active managers to exploit unrepresented segments.

[22:16] Cheyenne Hussain underscores that broad representations like the Aggregate Index exclude significant portions of the bond market, such as high-yield and asset-backed securities. This exclusion provides active managers with ample room to maneuver and generate alpha by accessing areas not captured by standard benchmarks.

[23:24] Michael Batnik raises a critical point about the outperformance of active fixed income managers compared to their equity counterparts. He questions whether this is a result of skill or risk-taking.

[23:24] Ben Carlson responds by asserting that the outperformance is less about taking on additional risk and more about thoughtful risk management and strategic allocations. Active managers can optimize their portfolios by overweighting sectors like financials, which have performed well, and replacing less attractive components such as lower coupon mortgages with higher-yielding alternatives.

8. Fixed Income Market Indices and Active Management Opportunities

The inadequacy of traditional fixed income indices to encompass the full spectrum of the bond market presents unique opportunities for active managers.

[17:59] Ben Carlson notes that traditional indices were designed in the early 80s and primarily include Treasuries, agency mortgages, and investment-grade credit. However, the current fixed income market, which is valued at $141 trillion, includes millions of securities with diverse characteristics not captured by these indices.

[18:46] Michael Batnik adds that the exclusion of newer segments like high-yield and emerging market debt from major indices means that active managers can tap into these areas to enhance returns without necessarily increasing risk.

[20:51] John Mayer introduces a discussion on Treasury ETF flows, particularly focusing on long Treasuries, which have defied typical market behaviors by continuing to attract investment despite unfavorable conditions.

[21:28] Ben Carlson suggests that instruments like TLT (iShares 20+ Year Treasury Bond ETF) and LQD (iShares iBoxx $ Investment Grade Corporate Bond ETF) have evolved into financial instruments serving both retail and institutional investors, each with distinct motivations such as liability-driven investing.

9. Treasury ETF Flows and Institutional Use

The persistent inflows into long Treasury ETFs warrant further exploration.

[21:28] Ben Carlson explains that large ETFs like TLT are utilized by a diverse investor base, including institutions that may use them for specific financial strategies beyond mere investment, such as matching liabilities or managing portfolio risks.

[22:45] Cheyenne Hussain adds that these ETFs often have short holding periods, suggesting active trading strategies rather than long-term investment holds. This dynamic usage contributes to their continued inflows despite fluctuating bond prices.

10. Future Trends in ETFs

The episode concludes with insights into emerging trends and potential future developments in the ETF landscape.

[28:33] John Mayer brings up the prospect of private credit ETFs, which encapsulate illiquid securities within a liquid ETF wrapper. While recognizing the potential, he expresses uncertainty about their effectiveness and the regulatory challenges involved.

[29:01] Ben Carlson responds by reflecting on the evolution of fixed income ETFs, emphasizing that the success of fixed income within ETFs over the past two decades suggests continued innovation. However, he remains cautious about the inclusion of private credit due to liquidity concerns and regulatory frameworks.

[30:23] John Mayer humorously anticipates potential issues with private credit ETFs, such as significant discrepancies between ETF performance and the underlying assets during market stress.

[30:13] Cheyenne Hussain anticipates a gradual rollout of private credit ETFs, suggesting that initial offerings will be modest before broader adoption.

[31:23] The conversation shifts to derivative-based ETFs, with Cheyenne Hussain predicting an increase in options strategies and covered call ETFs, driven by demographic shifts and the demand for higher income products.

11. Conclusion and Resources

The episode wraps up with the hosts thanking the guests and providing information on how listeners can access J.P. Morgan's Guide to ETFs.

[32:43] John Mayer mentions that the guide is available on the J.P. Morgan website and the Insights app, encouraging listeners to utilize these resources for a deeper understanding of the ETF marketplace.

[32:55] Michael Batnik reiterates the value of the guide and provides contact information for further inquiries.

Key Takeaways:

• Record ETF Inflows: 2024 has seen unprecedented ETF inflows, driven by both new investments and structural advantages of ETFs.

• Global Growth: ETFs are experiencing rapid growth worldwide, not just in the U.S., reflecting their global appeal.

• Active ETFs: Regulatory changes have catalyzed the rise of actively managed ETFs, which are increasingly attracting significant capital.

• Thematic ETFs: While thematic ETFs surged during high-risk periods, they have since stabilized, indicating a maturation of the market.

• Fixed Income Opportunities: Traditional bond indices fail to capture the entire bond market, providing active managers with opportunities to outperform through strategic allocations.

• Institutional Use of ETFs: ETFs like TLT are versatile tools used by both retail and institutional investors for various financial strategies, contributing to their resilience.

• Future Innovations: The ETF space is poised for further innovation, including potential developments in private credit and derivative-based ETFs.

For those interested in exploring these topics further, J.P. Morgan's Guide to ETFs is an invaluable resource, offering quarterly insights and detailed analyses of ETF trends and strategies.