At the Morningstar ETF Conference, we gained insights from Jeremy Schwartz, Director of Research, and Anita Rausch, Head of Capital Markets, at WisdomTree. During our conversation, Jeremy and Anita discussed emerging markets, ETF trading and liquidity, the rapid proliferation of ETFs, ETF due diligence and implied liquidity.
ETFdb.com (ETFdb): Please tell us about yourselves and the career trajectory that led you, Jeremy, to become Director of Research and you, Anita, Head of Capital Markets at WisdomTree.
Jeremy Schwartz (J.S.): I was working with Professor Siegel at Wharton and I helped him on his two books, “Stocks for the Long Run” and “The Future for Investors”. There was a natural synergy with the research that WisdomTree was doing independently. We came in to validate their initial research when they were trying to get funding from Michael Steinhardt. Professor Siegel ended up investing in the company, and I joined on as senior strategy advisor; WisdomTree brought me on to lead research.
Anita Rausch (A.R.): I started in the industry in operations at Morgan Stanley for ETFs, after which I moved over to ETF trading from 2002 to 2013, split between Morgan Stanley and JPMorgan. My start in operations helped me to become very familiar with the ETF structure and risk associated with it, as well as valuing and pricing ETFs. After that, I wanted to do something different, and the ETF issuer side was the natural next step for me. I am the Head of Capital Markets at WisdomTree. Our job, as the Capital Markets group, is to manage the relationships with the market-making community that stands between the ETF issuer and the investors. We also act as trading consultants for WisdomTree’s client base.
ETFdb: Should every investor have exposure to emerging markets?
J.S.: The simple answer is yes. A globally diversified portfolio is, broadly speaking, 50 percent U.S., 40 percent developed world, and 10 percent emerging markets. Investors tend to be overweight to the U.S. markets and underweight internationally. I think that is making a big bet on the U.S. The U.S. has done incredibly well over the past five years. That’s exactly why you should be globally diversified today, because the probability of the U.S. being the best performer over the next 10 years is much less. It’s more likely that the international markets are going to outperform the U.S. markets. You should probably have an overweight position given stronger relative growth rates, lower current valuations and diversification benefits.
ETFdb: What would you say is the biggest misconception that investors have regarding emerging markets?
J.S.: There is a perception that emerging markets (EM) is inefficient, and therefore investors need an active manager. At WisdomTree, we have two strategies that have nine years of history: WisdomTree Emerging Markets High Dividend Fund (DEM ) focusing on high dividend emerging markets, and WisdomTree Emerging Markets SmallCap Dividend Fund (DGS ) focusing on emerging market small caps. Both have beaten more than 90% of all active managers since they’ve been around. I think these strategies challenge the notion that you need an active manager for EM.
ETFdb: What are some of the reasons for DEM’s and DGS’s outperformance? Can you elaborate on the selection process that you use to unearth these companies?
J.S: Any index is essentially a combination of what stocks you select and how you weight them. In the case of (DEM ), we start off with a broad dividend-weighted universe. We select the top 30% companies within the high yielding segment, where the market is sorted by dividend yield. The companies are weighted by the total dividends they pay. We always rebalance every October back to the dividend. We are always selling expensive companies and buying cheaper companies. On the other hand, (DGS ) looks at the companies within the bottom 10% of total market cap in the same broad dividend-weighted universe as DEM. DGS weights the companies just like DEM, and rebalances them every October.
We like dividends as a factor, because we feel it is the most objective of the different fundamentals. A dividend in China is the same as a dividend in Russia or Brazil; you don’t have to worry about the accounting standards in different countries. This helps in managing corporate governance risk.
ETFdb: A recent Bloomberg article cited the average turnover for an ETF as roughly 900 percent. Given such turnover in ETFs, could this be a potential danger moving forward?
A.R.: Much of the ETF trading is concentrated in the top 25 to 30 ETFs. These top ETFs are beta; they are tools for the entire community and typically trade more than their underlying securities. The remaining ETF universe is investment vehicles, and are typically focused strategies.
In my opinion, these trading vehicles do not present a danger in any way for a variety of reasons. First, they reduce transaction costs. The exchange-listed nature of ETFs allows investors to buy and sell exposure away from the fund; they can reduce costs, and buy and sell from each other using the ETF creation/redemption mechanism. Secondly, even though investment vehicles don’t trade as much, it doesn’t mean that they can’t trade as much. You have to look at how much the ETF trades, and then compare it to how much the ETF can trade.
ETFdb: Often times, many retail investors and financial advisors will screen out certain ETFs if they don’t meet a threshold value for the average trading volume screen criteria. Can you discuss the concept of trading liquidity not being equal to the average daily trading volume? How can investors use implied liquidity to increase the breadth and depth of the ETFs they’re actually looking at?
A.R.: The ETF is a wrapper for an underlying set of securities. Average daily volume (ADV) tells investors what the fund has done in the past, not what it is capable of doing. Implied liquidity looks at the liquidity of the underlying securities and not just the ETF wrapper. Firstly, implied liquidity calculates how many shares of each underlying component are in one creation unit of the fund. Secondly, the measure calculates how many ETF shares it would translate into while being no more than 25% of the 30-day average trading volume of the most restrictive security in the entire ETF basket. Essentially, what implied liquidity tells you is how many shares you can trade over one day without moving the price. This is incredibly powerful when added to ADV. I encourage all investors to look through the wrapper at these characteristics, in addition to the characteristics of the wrapper itself.
ETFdb: What advice would you give investors when it comes to picking an emerging markets ETF?
J.S.: We are big believers for currency hedging when it comes to developed markets, such as Europe and Japan. We don’t suggest currency hedging strategies for emerging markets because they have high interest rates.
Factor investing is becoming a huge part of the EM ETF space. We believe dividends is one of the important factors to focus on. Screens that we use include dividend growth, ex-state-owned and quality. Our quality screen, for instance, focuses on criteria such as return on equity and return on assets. I think if you want to buy EM today, you would likely want to focus on high dividend-paying EM companies. To me, (DEM ) represents what people are currently looking for in emerging markets.
ETFdb: Can you discuss the differences between trading equity and fixed income ETFs? Is there a liquidity illusion when it comes to fixed income ETFs?
A.R.: The on-exchange transparent nature makes it easier and more quantifiable to trade equity ETFs. The over-the-counter nature of fixed income makes fixed-income ETFs harder to value.
Just because they are ETFs, investors think that there is either an illusion or a promise of liquidity. In reality, an ETF is just a wrapper; it is not promising anything. An ETF only transfers the same characteristics of the underlying securities; it does not guarantee or promise liquidity. On both the equity and fixed-income side, there are liquid and illiquid individual securities. And those same characteristics are going to be transferred to the ETF if those individual securities are added to the ETF.
ETFdb.: What type of advice would you give investors when it comes to ETF trading due diligence?
A.R.: Many investors use screens – such as minimum ADV, minimum AUM and minimum bid-ask spread – as criteria for screening ETFs. In reality, investors should set their strategy first, and then move onto the implementation stage. The minimum selection criteria should not be put on the ETF wrapper; it should be put on the underlying securities. ADV and AUM should be put into a broader context and used in addition to the same characteristics of the underlying basket.
ETFdb: What advice do you have for investors during volatile periods with respect to ETF trading?
A.R.: First and foremost, in a highly volatile event, you must manage your stop-loss orders, because stop-loss orders turn into market orders. Market orders are extremely dangerous and price insensitive. What I advise most people is to not trade. If you can wait beyond those small pockets of excessive volatility, then that’s the best option. I would also recommend to not trade in the first 15 minutes and the last 15 minutes, because that’s when traders know the least, which means spreads are going to be wider.
ETFdb: How do you see the broad ETF industry and ETF-trading practices evolving over the next two to five years?
J.S.: There is a lot of innovation happening in the ETF space. Long-short equities within the alternatives category is still in its infancy. Dynamic currency hedging and options strategies are also in their infancy. There’s a shift towards factor fixed income. This innovation will continue to progress; it’s still early days.
A.R.: Trading is becoming incredibly more competitive globally. I think ETFs are going to continue to proliferate over the next five years, and that there will be disclosure rules all across the globe with respect to fees. The trading community will ultimately gear up to support all these ETF products. The trading community has a legitimate role in the markets, since they are conduits for all the ETFs and their underlying assets.
The Bottom Line
Emerging markets have considerably lagged the U.S. markets in recent years. However, WisdomTree argues that emerging markets should be an overweight in investor portfolios given its diversification benefits, low valuations and higher growth rates. Furthermore, WisdomTree encourages investors to look through the ETF wrapper and utilize implied liquidity to increase the breadth and depth of the ETFs they are looking at.