Back-to-school ETF primer

Transcript

Dina Ting (DT)

Hi, I’m Dina Ting, Head of Global Index Portfolio Management at Franklin Templeton. Thank you for tuning in! I’m joined today by my colleague, Dave Mann, Franklin’s Head of Global ETF Product and Capital Markets.

Now that we’re heading into a new school year, we thought it’d be fun to offer a back-to-school primer on all things ETF, recap the events of the summer and discuss our thoughts for the rest of the year. As you know, fall is a chance to restart or reposition.

So, Dave—now that we’re going through what is another busy time at Franklin, we’re seeing the Federal [Reserve] rate cuts as top of mind for many investors and we also saw the new SEC [Securities and Exchange Commission] approvals on crypto. What do you think is top of mind for clients as they’re returning to their fall schedules?

David Mann (DM): First Dina, thanks for having me. Funny to hear this topic because I was at my son's high school back-to- school night last night, so I got to meet some of the teachers, which is always fun. So, I guess working backwards, there's been a lot of focus on crypto ETFs and what's interesting, to your question, is as all the regulations and the debate and whether crypto exposure should even be offered in an ETF form, a lot of the questions were almost back to the basics of ETFs.

So, are they going to work properly? Will creations and redemptions work properly? Will the ETF trade in line with the price of the underlying token, etc.? And what's interesting is that I've now been in the ETF industry over 20 years, and it's not the first time I've heard this particular question.

And so if I kind of go back in time, originally it was, ETFs that hold equities and would the ETF arbitrage work to keep the intraday price in line? And it worked great. Then, then it was emerging markets. Hey, would it work for emerging markets funds? You know, especially when some of those underlying markets are closed. Once again, those ETFs worked as expected. Fast forward to gold bars, to silver bars to fixed income. The question became, hey, what if it's not a fully replicated index? What if it's a basket of bonds? What if it's active ETFs? Every step along the way, there were questions about whether the ETF vehicle would work as expected. It was no different for the crypto funds. And, fast forward a few months here into the summer and those ETFs have worked as expected. So that's been great to see.

DT: What can you tell us about the drivers of ETF growth and the adoption trends that you’re seeing?  Given the recent volatility that we’ve experienced, are there shifts that investors should consider now?

DM: Yeah, so I'd answer that one two ways, Dina. One may be more big-picture and one more specific. So, from a bigger-picture perspective, it's been very—I'll even call it heartwarming—to see the increased adoption of active ETFs. So oftentimes, especially in the early days of my career within ETFs, I think investors just equated ETFs with index exposure. It was almost synonymous. And post the change of regulations, the ETF rule from a few years back, it's great to see investors now getting more and more comfortable with gaining exposure through active ETFs. And I think, last year and so far this year, we're right around 30% of net inflows into active ETFs. That's been great to see.

Part two of your question is investors using ETFs to get exposure to the asset class they want based off what they think that macro environment's going to be. And I would say there have been two main trends. One, it's hard to ignore artificial intelligence and growth stocks. There's been a big rally in the Magnificent Seven.¹ We don't have to get into all those details. ETFs have been a great way to get exposure, both from an index and active perspective. And part two, lots of eyes on the Fed. When are [interest] rates going to finally come down? We've seen a lot of fixed income investing as investors try to read the tea leaves of what the Fed might do and position their fixed income portfolio accordingly.

DT: The active adoption or the active ETF flows, you've seen that quite a bit in the United States. How do you expect that to translate into the rest of the world?

DM: In terms of breadth of the products and assets, the US ETF market is the biggest. In July, for example, investors poured a little over $120 billion into US ETFs. That was the second-highest monthly total on record, behind almost US$130 billion, which was in December of last year, and that was the fourth month ever with inflows north of $100 billion.²

Oftentimes, a lot of global markets will sort of identify what's been working in the US markets and then apply that to their local markets. Looking at something like Europe as an example, it wouldn't shock me as the active adoption in the US increases, if we start seeing that trend carry over to global ETF markets. You know, it might take a few years to see it happen. But also just the education that inherently there's nothing different from an ETF operational perspective. I think when those global markets see that, I think it wouldn't shock me if all of a sudden active adoption increases.

DT: So for investors looking at active ETFs, would you say the process for fund selection is different from that of other active strategy vehicles like mutual funds or separately managed accounts?

DM: It shouldn't be. We often will try to be vehicle-agnostic when we're talking about our particular strategies. Even though, back to the earlier point, I do think historically mutual funds have been associated with active investing, even though there are plenty of index mutual funds, just as ETFs have been synonymous with indexing even though there are lots of active ETFs. So the short answer's no. Just as with any due diligence process, it’s key to understand the active strategy, understand the philosophy, understand the team, go through all your risk-adjusted metrics and Sharpe ratios and information ratios to understand, what that portfolio manager and the ETF is doing differently than the benchmark. And then, investors can make an informed decision.

DT: Touching back on your fixed income comment, I know now everybody's expecting a rate cut in September. How would investors look at that upcoming event and potentially consider repositioning their portfolio?

DM: So yeah, looking at fixed income, all eyes have been on the Fed. The last time I checked the odds of the number of rate cuts, it's kind of one and a half, so it could be one or it could be two. If there's a more dovish approach, I would think that would be beneficial for riskier portions of the of the bond market, like high yield, allowing those companies to refinance their debt and even something like bank loans, you know, from an income standpoint, I think would still be attractive.

DT: Yeah, and I think the ETF vehicle, as Dave, you alluded to earlier on, has evolved so much that all these strategies are readily available across the various different ETFs. It’s truly a vehicle that democratizes all these strategies beyond institutional investors to anyone with a brokerage account.

DM: Well, Dina, one of the nice things about the ETF vehicle is investors can get active exposure, they can get index exposure, they can get fixed income exposure, target exposure. And one of the nice things about back to school from a global perspective is kids from all across the world are going back to school. So I'd love to hear your thoughts on what you're seeing from a global perspective. There's been a lot of interest in India, Indian equity markets, Korean equity markets, Taiwanese equity markets. So maybe just, any comments you have on the global equity markets I think would be good to hear.

DT: Thanks for the questions. Yeah, as you know, being based in the US, we tend to focus on the US and the returns on the US, of course, have been outperforming international for the past decade. But that hasn’t always been the case. In fact, if you look at the performances of international versus US, there are periods of around 10 years or so when one dominates the other.

And so from a domestic-investor perspective, having international exposure not only adds to your diversification, but also to your potential return. You’re getting a new return from a completely different market that has different drivers in terms of the return performance. You asked about India. It’s probably one of the favorite markets of late. And it has become a really big market in comparison. It has bypassed South Korea and Taiwan in terms of the market capitalization size.

It’s become the second-biggest market among emerging markets. And it's not without any reason, right? There are so many drivers. One is their GDP, their shift from a service economy to manufacturing economy. There’s their ability to attract foreign direct investment. And more importantly, they have enough of a labor force to support the growing needs of labor. It's probably the only major economy that is not declining so rapidly. If you look at World Bank population projections for the next 20 years, the age dependency ratio for the US and China are both expected to worsen from 2024 estimates, which are already higher than the current global average of 40%.³ This ratio of so-called “dependent age” people, either under age 15 or over age 64, is the percentage of those who rely on the primary labor force that falls between those ages. Japan’s already-high ratio of 71% is estimated to shoot much higher to 91% by 2044⁴ unless the government can find more progress from their policy changes. But if you look at India, not only should its ratio continue to be the lowest among these four countries over the next two decades at about 47%, but the dependent demographic estimate increase is just 50 basis points higher than it is now.⁵

DM: Interesting, so India’s favorable demographics are unique for their benefit in driving output. So Dina, one more question from me. You know, a lot of eyes are on the US elections, but, obviously, there’ve been a lot of global elections over the past few months. So maybe, you can give us a few thoughts on the elections in general and what you've seen from a global perspective.

DT: Yeah. This year has been a somewhat special one because more than 50% of the population has gone or will be going to cast votes. In the US, of course we now have a new front-running Democrat candidate for president. But the election surprises and drama haven’t been limited to just the US. If you look at Mexico, which elected its first female president, we saw a lot of violence surrounding that vote. And then even in India, where a landslide win by Modi was expected, the surprise there was that despite winning, he actually struggled in his victory. And I think what's interesting is: What do elections have to do with market returns? That’s the question, right? It really varies. The impact varies across countries as well. Some would say that in the US, it matters less, but it can matter more for international markets. And part of that is not because of just who the leader is, it's more about the policy and how it will impact each of the economies and the subsequent growth that comes from that. So it's the fall [autumn]. We are near the end, but there's still a lot of possible drama left for the rest of the year.

DM: Right. And, of course, besides election-related politics, there are also geopolitical risk considerations. Do you think these are already baked into equity prices?

DT: Possibly. But that’s also a good reminder that market uncertainty often leads to short-term volatility so we believe many investors are better off focusing on their long-term investment strategy and staying diversified. There are some longstanding geopolitical threats, like for example in Taiwan and South Korea. The nuclear threat posed by North Korea is one driver of the “Korea discount,” as we call it, but we believe there is more to it than just that. The Korea discount refers to the low valuations placed on South Korea’s stocks relative to those in other countries.

Since Japan’s corporate reform measures have sparked an economic reawakening for Japan, Seoul has also been embarking on reforms to counter the so-called discount that tends to drag down valuations of its firms.

So, yes, there’s much short-term uncertainty that can distract investors from their long-term strategies. September and October also tend to be historically tough months for stocks.

The US elections are still very hard to call so we’ll need to have another chat to take the pulse of investments for the rest of the year and next year. But for now, thanks for your time, Dave.

DM: Sounds great, Dina. Looking forward to our next chat!