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John Bryson: Hello, and welcome to the Portfolio Intelligence Podcast. I'm your host, John Bryson, head of investment consulting at John Hancock Investment Management. As always, the goal of this podcast is to help investment professionals deliver better outcomes for their clients and their practice. Topics we'll typically address include advisor business‐building ideas, capital market updates, the latest trends in portfolio construction, and unique insight from our veteran portfolio managers across our global network. Today, I'm thrilled to be joined by Will Creedon, the director of ETF capital markets at John Hancock Investment Management. Will spent the majority of his career in trading and portfolio management focused activities, focusing on equities, derivatives, and FX for several hedge funds and asset management firms. He spent several years at Ocean Wood Capital, a multibillion‐dollar global hedge fund in Boston and in London, where he was responsible for global trading and portfolio strategy. Will, welcome to the call.
Will Creedon: Thank you, John, thanks for having me. Great to be with you.
John Bryson: Excellent. So, ETFs have exploded in popularity. We've seen that across the board. Not everyone uses them yet, but we're getting pretty close. But maybe you can go over some of the basics of ETFs and how they differ from mutual funds.
Will Creedon: Sure. I think as more and more ETFs come to market, as you said, that the user base of ETFs is certainly expanding even more so than it has with the tremendous success in ETFs over the last 10 to 15 years. We're still seeing advisors every day become more and more familiar with ETFs. And it's really not uncommon to have that very basic conversation of what are the primary differences between an ETF and a mutual fund. Many of our advisor‐based clients at John Hancock Investment Management are traditional mutual fund users, so it's not that difficult of a conversation to have, but there is some nuance to it. An ETF, as a reminder, always is a 40 Act (Investment Company Act of 1940) mutual fund legal structure. So there is an extremely high level of similarity between that of a traditional mutual fund where it holds a pooled investment of stocks or bonds trying to ultimately achieve an investment objective. But really where the rubber meets the road and the difference is that structural difference of the fund being exchanged traded. Really, the name says it all. And that concept for the advisor to actually go and take the steps needed to purchase or sell that ETF the way they have traditionally done single stocks has been a bit of a transition for some of our clients. And again, it's the meshing of that single‐stock transactional nature, where you can do it throughout the course of the trading day. All the John Hancock ETFs are listed on the New York Stock Exchange, much like shares of IBM or Microsoft are listed on the New York Stock Exchange or NASDAQ. But it's still that concept of an ETF, while it's exchange traded, is still valued and ultimately governed performance‐wise by the underlying stocks or bonds that it holds. And that is essentially what the investors are going to buy and sell, is that end exposure of all those underlying stocks. So in summary, it's the meshing of the traditional 40 Act structure of a traditional mutual fund and the fact that an ETF is in fact a 40 Act fund, but then making the link to investors actually having to develop a process and an understanding of the capital market dynamics when it comes to buying and selling the ETFs on a particular exchange.
John Bryson: Got it. And because you stress that it is traded, we're going to talk about some of the best practices of trading ETFs. But before we get there, one of the other benefits we hear a lot about with ETFs is the tax efficiency. And we've seen a lot of individuals and advisors and investment professionals take advantage of the market volatility and try to tax‐loss harvest. And they're using ETFs in this case for the first time, maybe. What is it structurally about ETFs that make them so tax efficient?
Will Creedon: Yeah, great question, and it's really a common question among our ETF investors. And really the “secret sauce” of an ETF is in fact the way that it processes those investor flows into and out of the fund. John, you've heard me describe over our time together at John Hancock, as well as to many of our underlying investors, that it's the way that that ETF grows and shrinks in terms of cash flows that's different than a traditional mutual fund that gives ETFs that tax‐efficiency advantage over the holding period of any given investor. And to simplify that, I think the illustration that we like to use at John Hancock is one of viewing the life of an invested dollar in a traditional mutual fund really gets summarized as cash in through a mutual fund and a PM (portfolio manager) has to buy stocks with that cash, and then when an investor wants to redeem that mutual fund, they redeem their fund shares back to the fund company, and a portfolio manager needs to raise cash by selling stocks in order to meet that redemption in cash for the end investor. And in the mutual fund world, it's when a portfolio manager sells stocks or bonds to raise cash, that is the taxable event. So as they process cash flows on a daily basis, they are processing them in cash. And all of those cash transactions are what result in potential capital gains consequences that then need to be distributed to fund shareholders. But taking a step back and looking at what we like to call the secret sauce of how an ETF is able to avoid those capital gains is that when an investor goes to purchase or redeem shares of their ETF, they do not go directly to the fund company. They in fact go to, in our case, the New York Stock Exchange, just like they're buying a share of Apple stock or ExxonMobil stock. They are interacting and taking their cash to the New York Stock Exchange and interacting with brokers. So you're not sending your cash directly into the fund for which the PM needs to make purchases and then consequently make sales in order to raise cash. You just simply deal with a broker on the floor of the New York Stock Exchange. And key to ETF tax efficiency is when you go to sell your ETF shares, you sell them to a broker on the New York Stock Exchange. And that broker takes your ETF shares and they redeem those fund shares back to the fund company. But instead of a portfolio manager of an ETF having to sell stocks to raise cash to deliver back to that broker, key to ETF tax efficiency is that the portfolio manager of an ETF simply sends out a basket of securities to that broker in a similar dollar equivalent to what they redeemed in fund shares, and that basket gets transferred out of the fund in an in‐kind fashion. So it is not in cash, which is taxable. The ETF is redeemed in kind, which is nontaxable. So each and every day as investors are entering, and most importantly, exiting an ETF, the ETF's portfolio manager is not selling stocks to raise cash. They are simply sending baskets of securities out to the brokers, which in the ETF ecosystem are known as authorized participants or APs, but that's just a fancy term for broker. That PM is sending out baskets of securities in‐kind and an in‐kind transaction is nontaxable. ETFs never accumulate capital gains over the course of a year based on investor activity.
John Bryson: I'm glad you said that. I think the key for folks is the in‐kind transaction, and these authorized participants, these brokers, they're not clients of the market, they're part of the mechanics of the market. So they have the privilege, if you will, to trade those securities in kind, and that's what makes the ETF tax efficient. Is that the best way to think of it?
Will Creedon: Absolutely. An ETF ecosystem is one of full transparency. So there's rarely a question by investors or by these brokers and authorized participants or by PMs of what is getting transferred in kind of back and forth, because it's a fully transparent ecosystem for the most part.
John Bryson: Yep. Another highly touted benefit of ETFs is that transparency. So those are some of the nuts and the bolts of ETFs that will help our clients understand why they're tax efficient and how they're a little bit different from a traditional mutual fund. But let's get into the trading of ETFs. With your background as a trader, you mentioned that ETFs trade real time throughout the day, just like any stock would. What are some of the best practices individuals should be aware of in terms of trading with securities?
Will Creedon: Yeah, it's something we talk with our clients on, on an ongoing basis is that transaction of an ETF, as it occurs on exchange, is a very integral part of the investment experience for an ETF client, because at the end of the day, the better and more efficient the execution can be, the better the performance that the end investor is going to capture. So in the first couple quarters of 2020 here, the market volatility has certainly made that investment experience all the more important and all the more critical to understand what some best practices are. But what we've been advising our clients since we've been in the ETF market at John Hancock Investment Management is really, you can simplify it down to three simple rules of the road. When you're talking about trading any stock or any ETF during periods of market volatility or on any given trading day, we think the three easiest rules of the road in terms of ETF trading can be simplified as beware of the market open, use limit orders over market orders when possible, and the third is know where your professional trading resources lie and how they can support you and ultimately help you achieve best execution for your clients. Unpacking those just a little bit. Beware the market open. When the market is opening in New York at 9:30 A.M. Eastern, that is the least efficient time for any investor to transact in a stock or an ETF. The market's just opening, it's digesting news, the volatility and the transaction spreads, or the cost of buying and selling are at their widest point. So if you are an end investor in an ETF and do not critically need to transact right around 9:30 Eastern, we highly recommend you avoid the first 15 or 20 minutes of the trading day. You let markets settle. You let bid/ask spreads narrow, and then you transact in the most efficient way. That kind of leads into the second rule of the road, which is use limit orders over market orders. Now this becomes even more critical is if you're using a larger order in dollar size. If you're an advisor and you're making an allocation change across your practice where you're buying into more equities versus fixed income, or buying more international equity versus domestic equity across your practice, and it's a large trade in terms of the dollar impact to your overall asset allocation book, that's where we think a limit order is all the more critical. We often advise our clients to execute off of the bid/ask spread in that ETF. That goes for single stocks as well, but don't always go off the last traded price. That might be 5 minutes old, 10 minutes old. And with markets being as volatile as they've been, you want to know where and how to obtain the bid/ask spread quote in real time through your brokerage platform. And that's where you would set your limit price off to transact in any ETF. And the third rule is know where your trading resources lie. And for most of our advisor clients in the U.S. for John Hancock Investment Management, this is another way of saying your home office or your broker‐dealer's dedicated trading desk. Most of the major broker‐dealers in the U.S., the RIA (registered investment adviser) custodian platforms, they have professional trading desks dedicated to support their advisors executing in stocks and in ETFs. And they are at no extra cost to the advisor, and they are your conduit to achieving best execution, especially during periods of high volatility like we've seen in the past couple of quarters, as well as orders that might be large in terms of their impact on your practice and your asset allocation. So again, to summarize, beware market open, use limit orders, and know where and how to find your professional trade resources.
John Bryson: Excellent. Decades of experience summed up right there for some of the best practices. Will, you mentioned the volatility this year. We've been talking about it from a lot of different aspects with advisors on a regular basis, but let's talk about the ETF space. As we saw, prices were falling and trading volume spiked. How did the ETF ecosystem plumbing work if you will? How was that environment? How did the ETFs hold up?
Will Creedon: Sure. It's a question that always garners a lot of attention during periods of intense volatility, and this past quarter was no different. We saw a lot of attention and a lot of inquiries and questions into how that ETF plumbing is going to function during periods of heightened activity and heightened volatility. And I would say I'm happy to say that yet again, the ETF ecosystem and ETF plumbing, so to speak, passed the test of volatility with flying colors. In close to the 15 years that I've been trading in U.S. and global capital markets, I would note that in the first quarter of 2020, we saw some of the highest volume and dollar values traded in the history of U.S. markets. So we saw trading volumes soar to nearly $1 trillion of value on given days during that March and April COVID‐driven period of volatility. And I'd also say that nearly 40% of that activity was conducted in U.S.‐listed ETFs. So you're talking about $300 to $400 billion worth of transactions occurring on a given day in ETFs, and there was not one reported outage of an ETF trading, not one failed redemption or gated redemption of an ETF. And we're happy to say that across all asset classes, equity, fixed income, international equity, and commodity currency, there were no structural glitches or issues reported during that period of heightened volatility. So I do think it's a question that will continuously come up, and I think that's a healthy thing for the ETF and the investor community in general. We always want to better understand the mechanics, better understand the plumbing. But again, I've been happy to see that regulation has progressed, market structure has progressed, and certainly technology has progressed in such a way that we're handling historically high periods of activity and volatility really in an unparalleled way within the ETF ecosystem.
John Bryson: Okay. That's super helpful. A followup to push on it a little bit more. So the ecosystem held up very well. What about spreads? We know there's a difference between the discount in the premium of an ETF, and that'll widen at times when markets get volatile. How did that play out during COVID and maybe specifically dig into fixed income, because that's been a question we see on a lot of investors’ minds.
Will Creedon: Absolutely. It garnered a lot of media attention. We saw a lot of articles written, a lot of blog posts being penned about this dynamic of, as you said, specific to fixed‐income ETFs, this dynamic of ETFs trading at significant discounts to their net asset value. So to just clarify for everyone—an ETF being a 40 Act mutual fund, like we said at the outset, they do go through a process where they strike a NAV (net asset value) at the end of the day. But as we also discussed earlier, an ETF does not trade at its NAV. It trades on exchange between two willing parties, buyers and sellers, at an agreed‐upon market price. And really the disconnect between that market price and the fund's end‐of‐day NAV is what is expressed as a premium or discount. So during the market volatility in March and April, some of the more esoteric fixed‐income asset classes and fixed income ETFs saw their market prices at material discounts to their NAV. And what we discussed with clients as well as other market participants and regulators is simply the structural differences between that agreed‐upon market price and the end of day NAV, and I think the most simple way to look at it, or perhaps the easiest way to illustrate it, is that a market price is obviously executed in real time. So it is a real‐time reflection of market volatility and perhaps most importantly in this period of recent volatility, it's a reflection of liquidity demanded by the marketplace. A fund's end‐of‐day NAV, and this would go for a mutual fund's end of day NAV, that is a pricing methodology that occurs in order to determine the value of underlying holdings, but that methodology in many respects for a mutual fund or an ETF does not take into consideration liquidity demands at any given instant for the underlying assets in the portfolio. So in fixed‐income asset classes like we saw in March and April, there was an extremely high demand for liquidity. Investors were raising cash and they were doing it across vehicles. So both in mutual funds and ETFs. And the reality was the more ETFs transacted in that late‐afternoon period where investors were raising the most amount of cash, the further that liquidity stress is going to drive a discount between a market‐based price, for which we always remind everyone that there is also a willing buyer. So there are buyers purchasing those ETFs at a significant discount to a seller, but then over the subsequent days, as more of the ETFs’ underlying portfolio of bonds gets traded and ultimately marked to market, the dynamic that we noticed in this period and in periods of past volatility are those NAVs, both of mutual funds and ETFs, they revert closer and closer each passing day to those market‐based prices of the ETF. And we saw that again in this period. So in summary, those market‐based prices of ETFs, they act as a price discovery mechanism. As I said, as liquidity is demanded, they act as the instant and real time price discovery vehicle for fixed‐income asset classes, and over the subsequent days and weeks, those NAVs of both ETFs and mutual funds eventually caught up. So again, I think it's a reflection of a healthy and functioning ecosystem. It's always just important to understand the structural differences and really to understand which one is going to suit you and your clients and their needs over their investment horizons.
John Bryson: Okay. And I think to some extent, that's almost like the fourth rule of the road that I think you spend time talking about. It's also when you're investing in ETFs, recognize that they have liquidity and the underlying securities they invest in have liquidity, and you need to understand the dynamics of that liquidity, because that's going to have a big impact on the cost, if you will, of trading at ETF. So in volatile periods, be careful if you have an illiquid security that you're invested in, is that a fair way to think of it?
Will Creedon: That's a great example. And that played out in the market in the different asset classes. The more illiquid that underlying fixed‐income asset class, let's say high yield municipal bonds, a rather illiquid asset class, the more potential there is for that market‐based price of an ETF versus the NAV of an ETF to disconnect. Because again, it's simply a derivative of what that underlying asset class is pricing at that is going to reflect what the ETF is pricing at. So John, it's always a good practice to not only know what exposures you're getting when you're investing in an ETF, but also what the liquidity characteristics of those exposures are. They’re going to be a lot different than investing in a large‐cap equity fund versus that of a high‐yield municipal international bond fund.
John Bryson: Excellent. So the last question I have for you, with this volatility, with ETFs becoming more and more popular, and the flavors of ETFs that are available more and more popular, any investment opportunities that you're seeing present themselves to the marketplace that our listeners should consider?
Will Creedon: Yeah. It's certainly been an interesting tape over the first two quarters of 2020 here. And some of the things that have caught our attention on the John Hancock ETF desk has been, first, I would say the amount of dispersion that we've seen among sectors. You've seen some real sector leadership emerge out of sectors like the technology sector, the media and communications, or communication services sector, and even to some extent, healthcare, as that sector works through finding a vaccine for the COVID virus, you've seen some extremely impressive leadership out of those sectors. But on the flip side, perhaps more so than we've seen in any other periods since maybe the financial crisis, you've seen some unbelievable laggards as well. Really entire sectors not participating in the recovery we've seen since the March, April lows, and the sectors that come to mind there, energy, even financials, as the Fed has once again embarked on historic stimulus to get us and the globe through this unprecedented period, interest rates have once again gone back down to that zero bound, so you really haven't seen much of a recovery in the financial sector. So a lot of the discussions we've been having with our clients and advisor clients are how can they take advantage of that? And that can be played out in many ways. We've seen investors playing simple sector funds. John Hancock has a lineup of sector funds, but also you're seeing a lot of new, almost next generation type sector or thematic plays, whether they are robotics or green energy or things like that, where you've seen real leadership pull away from more legacy or historic investment opportunities that were availed to clients. So again, we've seen the more and more innovation in the ETF sector, whether it’s a single‐factor expression or a thematic expression or a sector expression of exposure, the ETF wrapper continues to innovate and offer clients that ability to tweak the dials in a more refined way. And again, this tape over the past several months has just driven more and more opportunities to do that and investors can try to capitalize on it.
John Bryson: Thank you, Will. To our listeners, we're always trying to find ways to deliver better outcomes and help advisors and investment professionals deliver better outcomes. If you understand the intricacies of how ETFs work and the best ways to trade them, we do think that can improve your outcome. So we took a little bit of a different twist on today's podcast, but we hope you found some value with it. If you'd like to hear more, please subscribe to the Portfolio Intelligence Podcast on iTunes or visit our website jhinvestments.com to read other viewpoints and other ideas on macro trends, portfolio construction techniques, business‐building ideas, and much, much more. Thanks so much for listening to the show.
ETF shares are bought and sold through exchange trading at market price (not NAV), and are not individually redeemed from the fund. Shares may trade at a premium or discount to their NAV in the secondary market. Brokerage commissions will reduce returns. A commission is charged on every trade. It is important to note that there are material differences between investing in an ETF versus a mutual fund. ETFs trade on the major stock exchanges at any time during the day. Prices fluctuate throughout the day like stocks. ETFs generally have lower operating expenses, no investment minimums, are tax efficient, have no sales loads, and have brokerage commissions. Mutual funds trade at closing NAV when shares are priced once a day after the markets close. Operating expenses may vary. Most mutual funds have investment minimums and are less tax efficient than ETFs; many mutual funds have sales charges and they have no brokerage commissions. This material does not constitute tax, legal, or accounting advice, is for informational purposes only and is not meant as investment advice. Please consult your tax or financial advisor before making any investment decisions. John Hancock ETFs are distributed by Foreside Fund Services, LLC in the United States, and are sub advised by Dimensional Fund Advisors LP in all markets. Foreside is not affiliated with John Hancock Investment Management Distributors LLC or Dimensional Fund Advisors LP. This podcast is being brought to you by John Hancock Investment Management Distributors, LLC, member FINRA,SIPC. The views and opinions expressed in this podcast are those of the speaker, are subject to change as market and other conditions warrant and do not constitute investment advice or a recommendation regarding any specific product or security. There is no guarantee that any investment strategy discussed will be successful or achieve any particular level of results. Any economic or market performance information is historical and is not indicative of future results, and no forecasts are guaranteed. Investing involves risks, including the potential loss of principal.