In a wide-ranging interview, David spoke with Tom Keene and David Gura, co-hosts of Bloomberg Surveillance, about what is driving record-setting inflows into exchange traded funds (ETFs) this year, the firm’s approach to building smart beta portfolios, and the role of ETFs in retirement plans.
Tom Keene: What is the number-one theme of ETFs?
David Mazza: Right now, what we’re seeing in ETFs is actually record-setting inflows in 2017, surpassing 2016’s record-setting inflows, even through the first nine months of the year.
Tom Keene: Why is that?
David Mazza: What I think we’re seeing is that investors are flocking toward ETFs to take advantage of the fact that you can get diversification like you can with a mutual fund, but you also have the ability to have liquidity, transparency, and tax efficiency. So that’s been the big driver. What we’re seeing is flows into equity ETFs and fixed-income ETFs. Fixed-income ETFs continue to bring in record-setting flows as that market is getting more challenging for investors to create diversified portfolios, and ETFs can help with that.
David Gura: Talk a bit about the diversification of smart beta portfolios. You do a wonderful analogy in one of your notes, to go into a salad bar and there are all these options available to build the salad that you want. How has this changed? How has smart beta changed?
David Mazza: That [diversification] actually has been the driver of the ETF industry as well. Investors have focused historically just on the active versus passive spectrum. On the one hand, passive is just seeking to track an index. On the other hand, active management is looking to beat that index. What smart beta, or factor investing, does is sit in the middle of that. It takes advantage of the techniques and insights active managers have used but creates rules around that. So, I can create rules around finding the cheapest stocks. That’s value. I can create rules around identifying stocks that are trending. That’s momentum. On the other hand, I can do the same things with things like quality. So when we think about that salad bar, you have a lot of options. When it comes to passive, active, and now smart beta, you actually have even more options to choose from to build whatever particular outcome that you’re seeking in your portfolio.
David Gura: Talk about the rules or the strictures you can put around a portfolio like that. Are there infinite possibilities?
David Mazza: Technically, there could be, but what you really want to be is principled. What you want to have, first thing, is intuition. So I can go out and create any factor I want, any portfolio. All stocks with the letter “A,” all stocks with the letter “M,” and it might turn out with the back test that it looks great. But that means nothing. The first thing is, when it comes to these strategies, you have to have some kind of economic insight. You have to say, is there a behavioral bias? Why does value work over the long run? Well, humans are humans, right? We bid up the price of growth stocks from time to time and then they come back down to Earth. On the other hand, value works because maybe those companies are riskier. But you have to have that intuition, you have to have robustness around it, and it has to be investable.
Tom Keene: Within retirement plans, are people over-diversified in ETFs? It’s big in 401(k)s. Should I own two funds? Should I own 20 funds? Should I own seven funds? When you pull ETFs into that, is there a risk of doing too much, of owning too many?
David Mazza: What’s interesting is that ETFs are just beginning to tap into the retirement market. It’s historically been led by mutual funds. When it comes to diversification, we think investors should be outcome oriented and think about whatever goal they have. It’s not just adding new assets or adding new ETFs to meet whatever particular number [an investor may] have in mind. It’s saying my [desired] outcome is actually a smoother ride through time. So maybe a low-volatility ETF makes sense to me. Or my outcome is to try to outperform, so I’m going to look for value stocks or look for size factor to help with that.
David Gura: To go back to something you touched on earlier, how much have ETFs changed? Or has the popularity of ETFs changed as a result of the challenging nature of the environment we’re in right now?
David Mazza: Because of the challenging environment we have been in for investors to parse through the macroeconomic information and the political situation, ETFs have certainly disrupted the market. What they really are at their simplest is a basket of securities that allows you to implement an investment over the long run or over shorter or medium time periods. And when it comes to doing so in a low-cost way, ETFs really have pioneered and propelled that forward. That’s why we’re seeing investors move into that space because they can have more control over their portfolios with ETFs.
Tom Keene: You use a lot of food analogies in your ETF studies. What are some of your food analogies?
David Mazza: One of the big things we like to think about is, people are looking at this smart beta space and saying: Is it a fad? So one of the first things I think about is, are we talking about smart beta as a cookie or a cronut? The cronut, as we know, is very tasty. It certainly caught on over time, but is it going to sustain a hundred years like the cookie has? I believe smart beta will because it allows you to take advantage of the tools that active managers have used but do so in a low-cost, rules-based fashion.
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These views represent the opinions of OppenheimerFunds, Inc. and are not intended as investment advice or to predict or depict the performance of any investment. These views are as of the publication date, and are subject to change based on subsequent developments.