The surge in ETFs: A great growth story

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Tom Salopek: Hi, welcome to Research Recap on J.P. Morgan's Making Sense podcast. I'm Tom Salopek from Cross Asset Strategy. I'm joined by my colleague, Bram Kaplan, head of Americas Equity Derivatives Strategy and author of the popular J.P. Morgan Global ETF Handbook. And we’re here today to discuss trends in ETF Markets. Bram thanks so much for joining me today.

Bram Kaplan: Hi, Tom. Thanks so much for having me.

Tom Salopek: So ETF market's been growing dramatically in recent years. What do you think's driving the surge in popularity?

Bram Kaplan: Yes, I mean, ETFs have certainly been a great growth story, and they've become an increasingly important part of the investment landscape. ETFs' total asset under management has been growing by nearly 20% per year on average over the last 10 or 15 years, and now sits at around $14 trillion globally, with around $10 trillion of that in the US. And it's not just that their asset base has been growing strongly, but also that the number and breadth of products available is also growing. As for why they're so popular, I like to think of ETFs as the next evolution of funds. Like mutual funds, ETFs allow investors to get exposure to a professionally managed, diversified portfolio of assets by trading a single security. But they improve on mutual funds in a number of ways. First, they're better trading vehicles than mutual funds. They trade like stocks and offer intraday liquidity and continuous trading and pricing, while mutual funds are only priced at the end of the day. You can also trade options on many ETFs to tailor your risk profile or go short the fund if you want a position for the portfolio to fall in value. Secondly, ETFs are more transparent, as most of them report their holdings daily, while mutual funds normally only do so once a quarter with a lag, which gives investors better visibility on what they're invested in. And finally, ETFs offer a number of financial benefits for investors. Compared to mutual funds, ETFs generally have lower fees. And in the US, ETFs are typically more tax efficient, thanks to the ability to create and redeem shares in kind. This ability to do in-kind transfers means that ETFs can rebalance their portfolio and accommodate outflows from the fund without delivering taxable gains to holders. All this is not to say that mutual funds are going to go away. They still have a large asset base, and not every strategy makes sense in an ETF.

Tom Salopek: So, Bram, what do you see as some of the biggest trends in ETFs right now?

Bram Kaplan: So in terms of emerging focus areas, I would say that the biggest themes in ETF markets at the moment are actively managed ETFs, option-based ETFs, fixed-income ETFs, and cryptocurrency ETFs. All of these areas are seeing strong growth in assets, large inflows, and many new innovative products being launched. In addition to these hot areas, from an investor flows perspective, I would highlight a few trends. So this year in equities, it's been mostly a US-centric story, as the bulk of inflows have gone into US domestic equity funds. But we've been seeing very strong inflows to China equity funds recently after the country announced a set of comprehensive policy-easing measures in late September. Within sectors, investors have primarily favored tech, given strong interest around the AI theme. And we've seen a moderate rotation from defensive to cyclical sectors. And in styles, we've seen a rotation from low vol to both growth and value factor exposures. Within fixed income, there have been very strong flows into pretty much every category of bonds, apart from inflation-linked bonds that have fallen out of favor. Inflation-linked bonds were popular in the first couple of years of the pandemic as CPI surged to around 9%, but they've seen outflows for the past couple of years as the disinflation process has played out. We've also seen investors lengthening their duration for most of this year as the Fed cutting cycle approached, by rotating from short to long-term bonds. And in commodities, we've seen significant outflows from gold from the middle of last year until the first quarter of this year, which is surprising given the metal's strong price performance. The flows have started to come back over the past couple of months. On the flip side, we've seen diminished interest in two previously hot areas: thematic and ESG ETFs. Investors have largely shunned the thematic ETF space over the past couple of years, even as AI has become a key investment theme in the market. While AI-themed funds have seen inflows, they've paled in comparison to the size of the inflows into the thematic space that we saw during the innovation-led thematic ETF boom a few years ago. And outside of AI themes, money has been funneling out of the rest of the thematic space overall recently. And in the ESG segment, we've seen both limited investor flows and few new products being launched in the US over the last couple of years. I'd attribute this lower investor interest to ESG's underperformance at the start of the Ukraine war as commodity prices surged, as well as the politicization of ESG in the US and controversies around definitions and methodology.

Tom Salopek: Thanks for that, Bram.

Bram Kaplan: So, Tom, I've talked about recent flows we've been seeing in ETFs, but I'm curious to get your perspective on where we could be heading. So the strong US labor market print that we saw earlier this month appears to signal a higher chance of a soft landing, which would be unprecedented if realized. If that's where we're heading, what implications do you believe this could have for markets and, by extension, investor flows in ETFs?

Tom Salopek: As we're heading into a rate-cutting cycle, I think this is one of the big questions we've been facing is why are you cutting rates? Are you cutting rates because of growth risk? Are you cutting rates because of disinflation and soft landing? It's been a pretty confusing year in terms of the jumps we've made. So earlier in the year, we were looking at re-acceleration, then second quarter, high for long, third quarter, the July, August pullback you talked about, it was growth risk. And now with the labor market print back to soft landing. So it's been a bit of a roller coaster from the asset allocation regime standpoint. But I think we have to entertain the possibility that we can achieve the soft landing, which would be a bit unprecedented, given that you've had a very deep yield curve inversion, a very long-lasting yield curve inversion. And I think the thing that makes it all possible to see something so unprecedented is that if you saw the labor market weakening that we've had in other market cycles, you're cutting for growth risk, labor market weakens, and stocks go down. However, in a period when you're cutting for soft landing, stocks go up. And in terms of why the soft landing might be achievable, I said the labor market weakening we've had is such a tight level, high level. And so effectively, the weakening we've had only gets us to a pre-level of labor market softening. And so that's why it's possible. So this is one of the big things that people are thinking about. Of course, at the same time as soft landing hopes are up, we also have geopolitical stress is elevated. And at the time of this recording, the VIX is around 21. So definitely elevated risk concerns there. But other things to think about on the asset allocation side are that we have to make this transition from cash balances to the extent that investors have been avoiding duration due to negative carry inverted yield curves. Now, as you go into rate cutting, investors have to think about how to lock in high yields, which are going to disappear with rate cutting. So that's one of the big reallocations to think about. And finally, something to throw out there is the question that gold might be under-owned in the ETF space with the idea that if stocks fizzle, if tech does not reassume leadership and look at more defensive allocations like gold, which tend to rally as you go into rate-cutting periods in the history. So yeah, just on the back of that, how do you see these flows emerging given some of the stuff that I just talked about?

Bram Kaplan: Yeah, it's interesting. I guess that bodes well then for continued strength and flows into the fixed income space broadly with some rotation out of the short end and out of money market type exposures and into the longer end, perhaps higher-yielding products like credit. And as you mentioned, and I talked about earlier, the fact that we've been seeing outflows from gold for most of the past year that have started to turn around the past couple of months, those inflows presumably could continue.

Tom Salopek: I mean, there's also the question of something we've been seeing for the past decade, which is active to passive flows. Can you talk about how those are shaping up? Do you expect the current trends to continue?

Bram Kaplan: Absolutely. So, I mean, since the great financial crisis, we've seen a strong and persistent shift from actively managed to passive funds, particularly in equities. In fact, we've seen over $4 trillion of capital moving in that direction just over the past decade. Investors have been gravitating to the passive space given its broadening product suite, transparency, and lower fees. Initially, I would characterize this shift as being mostly from a rotation from active mutual funds into passive ETFs. But now, ETFs are starting to take an increasing share in the active space too. Even as the broader rotation into passive continues, we're seeing strong growth in actively managed ETFs. Over the past four years, active ETFs have accounted for the majority of new ETF launches in the US, and their AUM has quadrupled as issuers are moving many of their flagship active products into the ETF wrapper. But it's still early days for the active ETF space, and I believe they have a long runway ahead since mutual funds still have a 96% market share of active fund assets. So going forward, I expect continued strong growth for active ETFs, but for this growth to come largely at the expense of mutual funds rather than passive ETFs.

Tom Salopek: Looking at the earlier period of a few months ago when vol was a bit more muted in the neighborhood of around 12 or so, there was this question about whether option sellers, zero data expiry option traders were dampening volatility. And of course, there's been a slew of option-based ETF to take advantage of that sort of alpha source. Can you talk a little bit about the impact they've had on market volatility? Obviously, this has been very much in focus. When we look at this July-August pullback, August 5th managed to produce the biggest intraday spike in the VIX that we've seen since the history of the VIX started in 1990. So can you talk a bit about that space? And of course, this always brings back memories of this transition from 2017 to 2018, very wild, quiet period in 2017, followed by the very ugly start to 2018 with Volmageddon. Are we going to have a replay of Volmageddon?

Bram Kaplan: Yeah. So as I mentioned earlier, option-based ETFs are one of the hottest growth areas over the last few years. For example, the assets under management in these funds have grown sixfold over the past three years to around $130 billion currently. Let me give you a little bit of background on these funds before we get into the vol regime and what happened in August. So there's two main strategies in this space. The first is call overriding funds that are generally marketed to investors as high-income strategies. These funds sell covered calls to generate income by monetizing option premia, which is then distributed to investors via dividends. And the second category is buffer ETFs that offer investors a hedged equity exposure. So these funds overlay an equity portfolio with an option-based hedging strategy in order to limit the losses that it could face. Aside from these two main segments, we've also seen a variety of other option-based ETF strategies launching recently. For example, there's several funds that trade the popular zero-day-to-expiry options that you mentioned, ETFs that replicate the payoffs of retail-structured products, and funds that embed tail hedges. Call overriding is the largest option-based ETF segment. It accounts for around 60% of the total assets under management. These funds, in our view, have been supplying large amounts of short-dated options, which has been one of the major factors dampening market volatility over the past year or so, another being, of course, the zero-day-to-expiry options or ultra-short-dated options that you mentioned earlier that are predominantly sold by end investors. And the combination of the two have been effectively suppressing market volatility, both by selling option premia, as well as the way that dealers on the other side need to hedge these exposures that requires them to effectively dampen market volatility through their hedging activity. As many will remember, the last time that we had a big buildup in a short volatility ETF strategy, it ended badly. That's the Valmageddon episode that you referred to earlier. The large investment into inverse VIX exchange-traded products caused a VIX spike in early 2018 that resulted in large losses for investors in these strategies. But this time, the situation is different, since unlike the VIX products, overriding strategies don't use leverage, and they have no need to unwind when volatility surges. Even so, on August 5th of this year, we saw a large VIX spike that very much resembled the 2018 Volmageddon episode. But the difference is, in this case, option-based ETFs weren't the cause, and they didn't suffer large losses from the event.

Tom Salopek: Thanks so much, Bram, for joining us and clarifying the differences between now and this 2018 episode. Of course, when you have leveraged positions and having to cover those short positions, causing the Volmageddon, as opposed to now you're dealing with covered call overriders, and it's a different situation. So thanks for clarifying that. And thank you all for tuning in to J.P. Morgan's Making Sense podcast.

Bram Kaplan: Absolutely. Thanks so much for having me.

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