At the 2017 Inside ETFs Conference, we got a chance to sit with the head of fixed income ETF portfolio management at VanEck, Fran Rodilosso. We discussed fixed income ETF industry trends, how the fixed income smart-beta space is evolving, interest rate volatility and other investment insights. We also got a chance to talk about how VanEck differentiates itself.
ETFdb.com: Tell me a little bit about yourself and your role at VanEck.
Fran Rodilosso (F.R.): My official title is head of fixed income ETF portfolio management at VanEck. I’ve been managing fixed income ETF portfolios at VanEck for five years now. My day-to-day responsibilities include being a lead portfolio manager on all of our taxable ETFs, which include a suite of American market-oriented ETFs, a couple of U.S. high-yield-oriented ones – including our fallen angel one, which got a lot of attention last year.
I’ve been a fixed income trader or portfolio manager for 24 years. A lot of my experience and history have been on the emerging markets side. So I’ve done a lot in credit and, particularly, in emerging markets.
ETFdb.com: Given the rising rate environment in the U.S., how will this affect VanEck’s lineup of fixed income ETFs?
F.R.: We are prepared for the impact of higher rates, just in terms of anticipating them. Higher rates aren’t as bad for fixed income products as is interest rate volatility. Our bigger fears this year are uncertainty and big swings. Regardless, we have products that are more rate sensitive and products that are less rate sensitive. We have some products that are internationally based, like our VanEck Vectors J.P. Morgan EM Local Currency Bond ETF (EMLC ). A lot of interest rate volatility might cause a risk-off trade, and investors could sell their emerging markets debt. That wouldn’t be the direct result of higher rates, but rather just the volatility and uncertainty that causes a risk-off trade.
A more orderly movement toward higher rates, a normalization, might not be so bad for some of our emerging market or high-yield products. It could point to strength in the global economy and rising inflation, which could be good for a lot of emerging market commodity exporting countries. Our investment grade muni funds are going to be highly interest rate sensitive, but they are tools we still think a number of investors are going to want to use and to integrate into their portfolios.
ETFdb.com: How do you think VanEck differentiates itself from other issuers?
F.R.: We have always tried to find, on the fixed income side, areas of the market in which there is large beta that has not been provided intelligently in a cost-effective way with an ETF structure. We’ve also taken to approach markets with greater difficulty to access, where we want to provide the ability to access in an intelligent and effective way.
One way we set ourselves apart is that our PM team is built with a lot of experience on the active side. Particularly, Jim Colby and I have been active managers in the space for many years. Our ETFs are passive. Jim’s job and my job is 100 percent to track our indexes and manage liquidity of the funds. VanEck relies on having deep in-house knowledge. When you’re dealing in emerging markets, or high-yield municipal debt, and you’re using various sampling and optimization techniques that you need to use to track these indexes, it’s important to have a knowledge base in where to find liquidity, where to find bonds, and how settlement works in local emerging market countries, so you can make sure when there are outflows that you can manage the funds to meet those outflows, for instance. That knowledge goes beyond our desks.
We have active teams on the mutual fund side and a lot of spaces where our broad ETF suite resides. So, including emerging market debt, natural resources and emerging market equity, this describes a lot of our ETF suite. We have very strong active teams and we spend a lot of time talking. We’re managing the track, but we want to be hyper aware of all the risks and the asset classes in our passive strategies – just as we are in our active strategies. We think it’s important; we think it’s how you’re supposed to manage. Because we need to be able to inform our clients, we need to be able to speak intelligently, not just about the upside, but also the downside.
ETFdb.com: I also noticed VanEck has a few ETFs that are considered smart beta. What would you say are some of the benefits and risks of smart-beta investing?
F.R.: Some of us internally use the term smart beta, but we think of it more as intelligently designed indexes. I actually think they play a very good role. Just like any formulaic approach to a market, which a lot of smart-beta indexes and funds are, they don’t always work and there are potential pitfalls. But the great thing in a passive ETF structure about having a smart index – an index that rebalances based on some fundamental waiting or some non-standard market beta weighting – the absolute transparency, I think, is a huge advantage to investors. If they can understand the strategy, then they know what they’re getting.
The other really interesting aspect is that because they remain passive funds from a portfolio management point of view, they are incredibly disciplined. The discipline adds value to the portfolio management process. The one fund that I manage which a lot of people think of as quasi smart beta is our fallen angels ETF; it’s a subset of the U.S. high-yields universe. It’s not rules-driven in the sense that there’s a value screen or some fundamental factor, it’s just taking a subset of the high-yields universe which was the original issue high yields. We believe there are various reasons that part of the universe has outperformed the broad high-yield market.
But when these fallen angels are falling into our universe, falling into the Merrill Lynch index that we track, if you’re an active manager it might take a stronger stomach to say, “this has just fallen 20 points over the last six months. It looks like this credit is not only falling from investment grade to high yield, but it might’ve been quite stressed for some time.” The fact is a lot of damage, in terms of the price of the bonds, tends to be done before they come into this angel index. It’s basically a contrarian strategy. As a passive manager, I’m saying: I want to track; I want to keep an eye on; I want to be aware of some of these credits, or true falling knives. They may present a liquidity issue down the road if there’s a default or a lengthy restructuring process. On the other hand, my primary job is to track my index; you need to be disciplined. They may not love the credit, but it was at par a year ago, and it’s at 75 cents on the dollar now. The market has corrected in price.
So, two great advantages of smart beta are its high discipline and transparency.
The danger in smart beta is the back-testing element; you need to see something work in practice. I think investors are pretty aware of that. I think they’re rightfully skeptical of a new idea whose concept hasn’t been proven in a real portfolio. So, as long as investors are aware of that and are patient, I think there will continue to be good ideas out there in the space.
For a full list of Smart Beta ETFs, click here.
Fixed Income ETFs
ETFdb.com: How do you see the fixed income Smart Beta ETF space evolving over the next few years?
F.R.: Relative to the equity space, it has been slower and it will continue to be a slow progression, but it will grow.
Fixed income transactions costs are higher, so you can’t have quite the same level of turnover as in smart beta equity. In some of the smart beta equity, you can’t do massive rebalancing in one shot; the transaction costs would be more prohibitive.
More intelligently designed indexes are things on which VanEck tries to differentiate itself. Indexes that put a premium on certain aspects of quality in the credit space. People will continue to look for new ways to get exposure to that in international and emerging markets. For any spread-oriented product, there will be many attempts to find a way to differentiate.
Investors like returns, so they’re going to see a product and they’re going to watch it for one, two, three years before they start “piling in.” Providers are going to have to sustain that outperformance over longer periods of time. There will probably be more misses than hits, but I think all the providers are going to be taking swings at it.
Use our ETF Screener to find all fixed income ETFs.
ETFdb.com: Do you see liquidity as being a concern for the fixed income ETF space, given that the market is not yet as evolved as equities?
F.R.: I think the liquidity backdrop for fixed income is simply different from equities. You can rely on a fairly robust, deep and liquid market in U.S. Treasuries, and certain agency paper, and some parts of the certainly investment grade corporate market. But clearly, fixed income ETFs have grown. These are over-the-counter markets, a lot of bonds don’t trade every day. A very small percentage of the bonds and the indexes trade on any given day in some markets. From the start, liquidity was a concern in the space and managers have had three jobs:
- Creating or using indexes that are investable, which is not as automatic as any equity space.
- Finding a way to track those indexes, and having baskets available to do creations and redemptions for market makers that allow for fairly decent liquidity in the secondary market for those ETF shares.
- And, tracking via sampling technique rather than being able to replicate those indexes at all times.
This is not just speaking of VanEck. The industry as a whole in fixed income ETFs has done a pretty good job. It has proven itself.
A lot of the ETFs you have read about that could be systemic risks, these are unlevered, highly transparent structures and they may have a lot of volatility of assets under management. What has happened in the high yield space, for instance, is the industry as a whole has availed itself very well at dealing with that flow. The ETF should be representative of the liquidity of that underlying asset class. This means certain fixed income ETFs are going to appear less liquid. That may not always be seen in the bid-ask of the shares, but it might be seen in how wide the swings are in a discount and premium of that ETF versus the net asset value.
Investors, particularly institutional investors with very large orders where the creation and redemption process has to be used, are going to experience liquidity of that underlying asset class.
What’s great is as an ETF gets larger and larger, more and more of the day-to-day trading activity happens in the secondary market, which is almost a bit of a liquidity arm: You get more liquidity from the underlying market by trading in that secondary market, but I don’t think ETFs have promised to be any more than that.
All that being said, we have new liquidity rules for mutual funds and ETFs applied by the FCC this year. Basically, it will require a higher level of reporting, which, again, will mean more information for both regulators and investors. This will force managers to take higher ownership of the liquidity aspect. But, for certain asset classes, liquidity is always a concern. It always has been for a lot of bond ETFs, and that has not changed. We think ETFs have played a big role in market makers in bond ETFs. They have become very active in those bond asset classes, long positions and short positions. I think they’re actually adding liquidity to the secondary market for non-ETF users.
ETFs themselves are a liquidity vehicle. So, from an end investor point of view, we think they’ve brought more liquidity to the space, and certainly more price discovery. The less liquid secondary market tends to freeze up, the ETFs don’t. That’s when you’ll see the move into a big discount in that asset value, but at least it’s a benchmark; it’s a price discovery mechanism.
For more Fixed Income ETFs information, go here.
Lower ETF Fees
ETFdb.com: I also want to talk about the trends in the industry. In particular, I want to focus on one trend for now: the fees war that is happening. Blackrock cut its fees on 15 major ETFs in October of last year. Then Charles Schwab followed suit, and Vanguard also cut some fees in some of their ETFs. Where do you see this fee war heading? Do you see these fees being lowered only for the major high AUM ETFs, or for the smaller issuers and ETFs as well?
F.R.: There’s a cost of doing business. I think fee pressure is a reality across the board. But I guess how far you come down will depend upon the asset classes and the costs of investing or doing business in those areas. So, in other words, I don’t think you’ll see the whole ETF universe in under ten basis points. But the fee pressure is a reality, no matter which asset class you’re in. The floor may be different for different asset classes. That’s my view.
ETF vs. Mutual Funds
ETFdb.com: In terms of retail investors and financial advisors, do you think ETFs and mutual funds over the long term can play nicely together in a portfolio? Do you think that portfolio management is heading towards ETF-only portfolios?
F.R.: We are not of the philosophy that ETFs replace mutual funds. I have a personal belief that active management works well in that mutual fund structure because they lack transparency. Whereas a lot of active managers like to maintain an ETF structure, I think that makes it difficult to put that together with the intraday market making, which to my mind requires complete transparency to the market makers. For ETFs, I don’t think passive by definition can completely replace active. Once you get to a certain level of passive, life becomes easy again for active managers. I don’t think we’ve gotten to that equilibrium yet.
Passive is being used more and more as an active tool because ETFs have diced and spliced the market and people are using sector ETFs, for instance, in active asset allocation strategies. Asset allocation, sector rotation and all those strategies have proven to be more effective ways of active management than “stock picking.” So ETFs have become a tool for active management, and I think that rule is going to continue to rise.
Final Comments and Insights
ETFdb.com: What are some of the key insights you’re getting from this Inside ETF Conference so far?
F.R.: What I’ve seen so far is an affirmation that there’s a growing comfort level with ETFs across a range of asset classes and that there will be continued usage. So, I see more advisors at this conference coming to talk about non-core asset classes, for instance, and using ETFs.
ETFdb.com: Do you have any final comments you wish to make?
F.R.: I don’t think the idea was to try to get into our specific funds, so I tried not to talk about our funds too much. We’ve spliced the muni market into short, medium and long parts of the curve, even the short intermediate and the long intermediate. We’ve done the high-yield portion and even the short-term high yield. Someone could actively allocate them on different ETFs, not just ours, but within the muni space. It’s not just that an ETF has to be the passive choice and that’s what you hold for 20 years, but you can rotate your holdings. In that space, we think we provide a very complete solution set.
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The Bottom Line
Fixed income ETFs offer a great way to gain exposure to that asset class. Though they may have some liquidity issues, as Mr. Rodilosso pointed out, that’s just part of the asset class as a whole. In fact, ETFs in the secondary market may provide better liquidity than fixed income assets in the primary market. If you’d like to find out more about VanEck’s lineup of ETFs, click here.
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