The current market environment requires that investors seek income and fight inflation at the same time and, thankfully, a growing variety of ETFs make that completely possible, David Mazza, head of ETF investment strategy for State Street Global Advisors, said in an interview.
IndexUniverse Correspondent Cinthia Murphy caught up with Mazza on the sidelines of last week’s Morningstar ETF conference, where Mazza also argued that rising correlations in asset markets have a lot more to do with the uncertain macroeconomic environment than with the broad accessibility of the ETF.
Murphy:If we look at the markets in general, it seems investors are seeking yield as well as inflation protection these days. Do you see these two factors as driving forces in the ETF space right now?
Mazza : I do. It’s actually interesting:One would think that income generation—or the need for it—and inflation protection might be mutually exclusive. But in today’s investment market, and the ETF’s ability to harness that market, those two elements have actually began to converge.
With central banks having policies to keep interest rates at very low levels, traditional sources of income have now been compressed for years, and regulators are basically signaling to the market that that compression will remain. That’s created the need for investors to think of income from a global perspective—from a total portfolio perspective. There’s no longer going to be just one source of income.
It’s no longer just about fixed income or equities. Now, within equities, you have to start thinking about whether you need a tilt for dividends to have a portfolio that has a greater focus on current income rather than capital appreciation, but one that still has that potential for capital appreciation. Within fixed income—which we often think of as a more traditional source of income—we have already seen this year big inflows into high-yield ETFs like JNK, HYG, and now we have begun to see interest in FEZ, which is a euro stocks portfolio.
The income potential from FEZ is very good:49 out of its 50 companies pay dividends. They also tend to be high-quality global brands that, while domiciled in countries like France or Germany, are still selling to many markets. They are global in scope, and therefore have the ability to weather the negative headlines coming out of Europe.
Murphy:How does the growing concern over inflation play into that?
Mazza : Taking that back to the inflation side, yes, you don’t need to necessarily see actual inflation coming through. The way CPI might be measured could be low for the next six months, the next year or the next two years. But the expectation component has certainly risen. Investors might be thinking:“Do I need to brace for that potential inflation environment now? Do I need to look at all the sources of inflation protection again?” And that protection comes from REITs, TIPs, global natural-resource equities and commodities.
What’s interesting is that within that real assets suite, investors have the ability to tilt portfolios toward things that may actually be driven more by expectations such as equities and commodities versus those that are driven by inflation risk such as TIPS where you actually see the coupon change. So, I think these two things are coming together at this point in time, which is kind of interesting.
Murphy:Do you put currencies in that inflation-combating real-assets mix?
Mazza: Our firm doesn’t have currencies in our real-assets portfolios because currencies are somewhat different. I think that where the currencies story comes in is in the idea of gold as a currency. Investors have well-understood that gold was always considered a currency historically, but because it’s taken out of the earth, it’s also like a commodity.
What’s interesting is that gold’s actual return paths and volatility profile may show that it’s somewhat different than a traditional commodity and even a traditional precious metal. That’s why in today’s environment, the idea of gold having some currency component, or being a potential replacement for the exposure, that you as an investor may have to have different currencies has been garnering greater attention.
Murphy:Is this a market where smart beta makes more and more sense as it allows investors to express so many different views in a very uncertain economic time?
Mazza : I think the reason why we are seeing a proliferation of product development and increased usage from investors of this advanced-indexing approach is indeed for those reasons you are pointing out. But in the end, the need for diversification keeps coming up. That’s truly what matters for any kind of investor.
The ability to have more precise exposure to low-volatility equities, or dividend-paying equities, or to be able to tilt portfolios toward something that may make sense in a particular market—all of these things are increasingly important. We are beginning to see that growth expand, the interest is there, and from a product development perspective, it may certainly be an area of increased focus for many firms.
Murphy:As far as diversification goes, much has been said about rising correlation among asset classes, and many have suggested that ETFs play a part in that phenomenon. Where do you stand on that issue?
Mazza : What I would say about ETFs and correlation is that correlation is driven by the macroeconomic environment, in research that I’ve done. The reason is that ETFs are a vehicle that investors can use; they really provide access to different market environments. The correlation of stocks has certainly risen, I won’t deny that. But going back to before ETFs even existed, we saw periods when correlation spiked, such as during the crash of 1987, or during periods like the Great Depression. What you do see is that when those periods of uncertainty are removed from the market, correlation decreases again. Through thick and thin, diversification matters.
Recently, the growth of ETFs such as SPY and other funds has less correlation to the market environment than things like consumer confidence indices, or initial jobless claims. What you see is that consumer confidence tends to decrease a lot during recessionary periods, and in periods of uncertainty, correlation increases. There’s somewhat of an inverse relationship. If jobless claims are trending upward, and kind of peaking, correlation might be peaking at the same time.
Mazza (cont'd.): This year is a great example of that. The year started off with a little bit of a higher correlation environment, but more recently, some of the worst-case fears related to Europe have been removed from the market, and correlation has decreased; it is now closer to just above historical averages—the historical average is about 0.25, 0.26 from 1993 to August 2012, and at last check is about 0.33. That’s much more reasonable than what you’d have seen a year ago when the S'P downgraded the U.S., a time when some of the highest correlation of individual stocks ever was observed.
ETFs, because they have transparency, cost efficiency, liquidity and tax efficiency, allow investors to transact and get exposure to markets that may be more difficult to access at first blush, because it’s a market that’s driven by macroeconomic concerns. I think ETFs really provide access to all types of investors to be able to perform well or have the potential to perform well in markets of that nature. So, ETFs can help diversify and help investors navigate difficult markets.
Murphy:Let’s talk about SPY. It’s headed for its 20 th anniversary. What are some of the lessons from its 20-year history?
Mazza : It’s remarkable to think about the story of SPY, having humble beginnings in 1993 and the growth that’s been seen through today. And it’s funny because you can tie a lot of the ETF growth to these periods of stress in the market. While the AUM in the ETF has been steadily growing, when the shocks happened, investors realized that this ETF would have allowed for things like intraday trading, and broad-based exposure to the U.S. market very easily, so you can look at SPY’s growth as a staircase, meaning it might look gradual, but those uncertain periods really allowed for boosts in growth.
Going forward, SPY is called the granddad of ETFs for a reason:1) it’s the first; 2) it’s the largest and most liquid security in the world. And it’s really become a part of the financial ecosystem. It offers investors the ability to transact in a way that they couldn’t before. And I think that all of the benefits that have driven ETF growth for the past 20 years will continue to make sense in the next 20—transparency, liquidity, cost-efficiency, ease of use. From an investment environment standpoint, I don’t see those benefits going away.
Murphy:Without taking away from SPY’s success story, it’s also interesting that almost 60 percent of SSgA’s ETF assets are tied to only two funds:SPY and GLD. Does that concern you?
Mazza : We are very proud of the growth of SPY and GLD, and we are not embarrassed to admit it. But I would say that sometimes that large AUM and that huge growth mask some of our other products that have seen tremendous growth over the years. Funds like JNK, or the Select Sector ETF suite, and industry ETFs. But when you have SPY and GLD, everything else may actually pale in comparison. So we like to look at not just flows on an absolute basis, but flows as percentage of assets.
One example of our success, for instance, is FEZ, which is close to $1 billion, and it started the year with far fewer assets; these are pockets in our product lineup that investors are beginning to notice. The liquidity side of SPY and GLD will remain paramount for investors, but the rest of our lineup is certainly diverse and robust; we have 114 ETFs now, with over $300 billion in assets. Our growth opportunities are very strong.
Murphy:Are actively managed ETFs one of those areas for growth opportunities as far as product development goes?
Mazza : While it’s still early days with our active asset allocation ETFs, we do see this as a potential area of growth. We are taking the benefits of ETFs as passive underlying vehicles to showcase our institutional asset management capability. We’ve been managing portfolios for many years such as endowments and foundations, through the ETF space. The opportunity set there is quite exciting.
Murphy:Tell me your view on the ongoing price war among ETF providers—most recently headlined by Vanguard’s move to drop MSCI indexes in 22 funds for lower-cost benchmarks. Is SSgA going to fight to keep sector SPDRs the cheapest in market?
Mazza : From an investment standpoint, the decrease of expense ratios is great. Investors are now able to access products at a cheaper fashion. But expense ratios are just one component of the ETF due diligence framework. What index is being used? What’s the underlying methodology? Does the fund manager have the ability to track it and replicate it? And also from liquidity side, while you could have a very-low-cost ETF, does it actually trade? Is your total cost actually higher because you need to trade it, say, on a monthly basis? Expense ratio gets a lot of headline attention, but to me, there’s a lot more to the ETF story than just expense ratios.
SPDR Barclays Capital High Yield Bond ETF (JNK)
iShares iBoxx $ High Yield Corporate Bond Fund (HYG)
SPDR Euro Stoxx 50 ETF (FEZ)
SPDR S'P 500 ETF (SPY)
SPDR Gold Shares (GLD)
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