Michael Cafiero and Aaron Kehoe, Brownstone
IAUM: Welcome to the Insurance AUM Journal Podcast. My name is Stewart Foley, and I’m standing with you at the corner of insurance and asset management with two great guys that are going to give us A View From the Desk, which is a new segment for us. We’re talking with people who work on trading desks in various asset classes, and we want to bring their expertise to you so you can get a close up view of markets. The two guys we’ve got today, we’re very fortunate, Mike Cafiero and Aaron Kehoe from Brownstone. Welcome, guys.
Mike: Thanks for having us.
Aaron: Hi, Stewart. Thanks for having us.
IAUM: First of all, you’re welcome. We’re here to have some fun and see how it works. Mike, can you tell me just a little bit about brownstone and what it is that they do and where their sweet spot is and so forth?
Mike: Brownstone is a trusted trading partner, liquidity provider, and a pioneer in electronic trading. Every day Brownstone actively values and trades millions of unique securities, including corporates, hybrid bonds, municipals, structured credit products, and ETFs. Brownstone works with asset managers, registered investment advisors, and some of the largest insurance general accounts.
IAUM: Terrific, thanks. Your respective roles on these desks, you guys both, Mike, you trade a broader set of asset classes than Aaron does, or how do you two fit together?
Mike: Just my background, I really grew up trading ETFs and working in ETFs at iShares back when they weren’t even owned by BlackRock. The whole idea of my background working through ETFs, it gave me a lens into many different asset classes. As we all know, ETFs cover everything from fixed income to equities, to commodities, specialty products, et cetera, so I overall had a full multi-asset lens throughout my entire career. Over the years, I’ve worked on sell-side trading desks and nearly two years ago, I moved to Brownstone. Once I got to Brownstone, our effort was, hey, Brownstone’s involved very well in the corporate space, but if we can invest and get our equity and ETF business in place, I think we’ll have a total solution.
Mike: My day to day is I work with our multi-asset group to provide liquidity and products directly to insurance general accounts, covering corporates, hybrids, ETFs, securitized products.
IAUM: Perfect. Aaron, are you in a similar vein?
Aaron: Yeah. Mike and I work closely together. My background, not too dissimilar. I started off on the exchange floor 20 years ago trading ETFs and all I’ve ever really I’ve been involved with his ETFs. When I say that, funny enough, just ETFs, but just like Mike said, it’s taken me through almost every asset class that’s possibly imaginable to invest in because you know, they’ve continually figured out new ways to be innovative with ETFs and provide liquidity and access to investors through the ETF wrapper. Through my career, I’ve kind of been able to be introduced and learn and get involved with lots of different asset classes.
Aaron: As the rise of fixed income ETFs have sort of started to take hold a decent amount of time ago at this point, but it really kind of come into their own over the last let’s call it five years, maybe even 10, I really started to focus into that space specifically. When I was looking at a place that would make a lot of sense for how to kind of combine what ETFs offer from a fixed income perspective and then having a fixed income landscape behind me, Brownstone made a ton of sense with their access to such a broad reach of client bases that are sort of very comfortable trading bonds in a fixed income side of things.
Aaron: As these ETFs have sort of ingrained themselves into the market, it’s a great opportunity to marry and offer value to those clients who are now looking at these new products and trying to figure out how they fit into their investment strategy.
IAUM: It’s interesting, right? Mike, you and I have been friends for quite a while. My sense is that the understanding… I mean, I think most people know what ETFs are, but the level of understanding is uneven, right? How ETFs are created, how they’re destroyed. Yeah, everybody knows what they are, they trade during the day and so forth. Can you give us a quick sort of overview of the ETF landscape just sort of in terms of the different types of funds, the different strategies in those funds, just kind of a high level overview, and then we’ll get into some more specifics in just a second.
Mike: Yeah, absolutely, Stewart. There’s over 2,500 funds listed now and four trillion plus in assets. It’s pretty difficult to sort through that ETF landscape, but I think what you need to look at first, and most folks are familiar of that, largely they’re passive vehicles, right? They track an index that’s either replicated or optimized in order to get that performance of what the underlying index is looking at. For example, if you look at most ETFs in the space that are replicated, say the S&P 500, those ETFs are tracking that index and they’re essentially a sum of its parts. They own all 500 individual securities. But what happens when it’s more of a complex index that it’s trying to track such as say, the Bloomberg, Barclays, US Agg index, right?
Mike: It’s made up of thousands of underlying securities in the US Agg market. Well, in that case, the ETF issuer has portfolio managers who’ll go out and pick a subset of securities in order to track the index without having to actually buy the index. In that case, instead of replicating, they’re optimizing with a smaller piece to track that index as well as they can, and they do very well. I would say on the passive side, largely that’s where you’re seeing focus, but there’s a few other areas that continue to grow, one being factors. Over the number of years, we’ve always known value and growth, but you’re starting to see ETFs with a specific factor waiting, working off of a particular benchmark, so call it momentum, quality size.
Mike: Continue growth in the factor space. Active ETFs are now in the marketplace. Large asset managers can wrap their own strategy into an ETF. They disclose what’s inside of the portfolio every day. They give full transparency, which is unique, but the beauty is is that you can get access to a proven, active strategy in a low cost ETF wrapper. Actually in the last two months, we’ve actually seen the launch now of non-transparent ETFs. They hit the marketplace where it can be an active strategy that’s not disclosed to the market every day. The portfolio manager behind the strategy is protecting their strategy from the marketplace, but it’s still able to trade on exchange.
IAUM: That’s interesting.
Mike: Pretty unique.
IAUM: A lot of evolution, right? You spend a lot of time in the insurance GA space and that’s our primary audience. People listening to this are overwhelmingly in the insurance GA space as investment professionals or whatnot. There’s a lot of talk about ETF use. Some people say, “Ah, yes, a lot of guys talk in their own book.” You’ve told me offline that you’re seeing a lot of increase in the use of ETFs. View from the desk segment is for you to tell the market what’s really going on. What are you seeing in terms of insurance company use of ETFs in their GA?
Mike: I have. It’s been a work in progress between folks like myself and the ETF issuers getting insurance companies comfortable with what ETFs really are and how to implement them. I think overall, what we’re finding is that they’re a liquidity tool for every insurance company out there. There’s no reason why they shouldn’t just look at them just as a tool, not a solution, right? We trade corporates and all structured credit with large insurance companies. We know that’s what they do well, but for the time that they don’t want to spend on just pure exposure, ETFs become a great tool. I think if you look at a few factors of why it makes sense, I think first off is really liquidity.
Mike: We all know dealer’s balance sheets aren’t what they were and it’s become more difficult to source bonds. The beauty of the ETF is you have secondary market liquidity where buyers and sellers are matched on exchange. Now, if there’s not enough liquidity on the exchange, ETFs have a creation redemption mechanism that allows for transactions in the primary to allow for liquidity in the actual ETF. I think one area of importance, and we’re seeing that right now, is you saw a dry up in terms of new issuance. That’s certainly has returned lately, but the whole idea of duration matching and managing flows of a portfolio, ETFs are a great tool to target credit and duration just as a liquidity sleeve.
Mike: My idea is, hey, focus your time on where you need to focus on, but for quick and easy exposure, you certainly get that in ETFs, whether it’s in equities or fixed income across the board. I think two more factors… Yeah, go ahead.
IAUM: Yeah, no, I was just going to say, I mean, you mentioned it just a second ago, I think a lot of people were saying, “Oh, these ETFs, wait until there’s vol, wait until there’s vol.” What did you see in terms of behavior through what I think most people would agree is one of the most volatile periods markets have seen period? What kind of behavior did you see? Any dislocations?
Mike: We saw ETF stress tested and perform in many circumstances. 2008 certainly through the month of March, I think just to kind of hone in though on just some of the uses in terms of just making insurance general account’s lives easier and the portfolio manager’s lives easier, forget just some of the volatility. I think Aaron, who can speak pretty well to that. I just wanted to really just hone in on one huge factor that I missed was that years back, the NAIC through the SVO published a list of ETFs eligible to report it as a Schedule B bond, which was a huge opportunity now for insurance companies to implement ETFs as a solution. Then just rounding out my other thought on why insurance companies need to give a good look on ETFs in general, it’s just the costs.
Mike: Trading costs are inline with equities, which are significantly lower and lower. I think in many cases, ETFs are trading at a penny wide spread. You get exposure at a very, very narrow spread to domestic, international investment grade bank loans. It’s very compelling. Then lastly, I would say the issuers, right? The folks that actually package ETFs, they’re offering ETFs with an expense ratio of just 10 basis points, Stewart. To get full exposure at those levels, it’s certainly worth the look. Overall, I think it’s a great tool, but I think my partner here, Aaron, will certainly do a good job of walking us through what we are seeing in terms of ETFs and volatility.
Aaron: Yeah. I mean, I think in terms of volatility, what we’ve seen just recently, the last and a half, two months, and what we’ve seen throughout the last 15, 20 years and even 25 years of ETF existence is that ETFs continued to perform as they promised and what they promised is transparency and liquidity and real time access to pricing. What we kind of got to witness last month with such an extreme spike in volatility and liquidity needs and sort of so much uncertainty in the market is people flocked to the most liquid of assets to help manage and express hedge and basically get into and out of positions based on various needs that were going on last month in their own portfolios.
Aaron: We saw this across lots of different liquid asset classes, commodities, treasuries, and ETFs, and sort of what we kind of got to witness is the actual triumph performance that an ETF basically provided investors were continuous trading, continuous access to markets. Some of the things that started to come up in light of this is what they called “dislocations” from net asset value, the underlying portfolio of ETFs as these ETFs were trading in real time. What we’ve kind of continually seen in fixed income ETFs is that as an ETF, it is a living breathing vehicle that trades completely independent and on its own from its underlying asset class.
Aaron: What I mean by that is that the underlying bonds in the fixed income example are not necessarily trading at the same pace that the ETF is trading at. What we’ve continued to witness in part of the structure of the fixed income market is when you have instruments that don’t trade for a certain amount of time, the pricing becomes stale. Especially as volatility increases, those still prices and their disconnect from what’s actually pricing in the markets can become greater. I think that’s what we started to see last month.
Aaron: When you’re looking at products like HYG, LGD, TLT, JNK, BKLN where you’re starting to see one, two, three, 4% discounts to their “net asset value,” what I think you’re starting to recognize and what ETFs are actually providing as a window into the underlying market is that those underlying asset prices that are our fixed income bonds are stale and old. The ETF is actually giving the market a better look into people’s opinions of where those assets should be trading. As you take a look at those dislocations, these ETFs were trading at such an increased amount of volume from their average daily volume from the time before that you’re actually getting people who are realizing the benefits of these products and actually using them as tools to help manage the risk and exposure that they need [inaudible 00:15:01]
IAUM: Thanks. That’s interesting to me about how the separation there with regard to stale pricing and so forth. I mean, I didn’t know that. It’s good stuff. I think you guys, maybe you can both weigh in on this. As we wrap up here, what are recent flows and themes?
Aaron: No, I think it’s actually pretty exciting to see what’s happened. I mean, obviously we are in a true testament part of our sort of investment community in terms of how we are changing dynamics of what’s going on in our space. You have certain players that are now defining the rules and the games of how investing operates, right? Take the fed, for example, that has basically come out and said that they are going to backstop so many different companies in so many different ways. One of the ways they chose to express that was by adding ETF, the fixed income ETFs, to their asset buying program. If you take a look on the first announcement when they made that back in March, those sort of dislocations that we were discussing actually completely changed course.
Aaron: We went from seeing perceived discounts to seeing perceived premiums from those asset values because these ETFs were now being sort of endorsed by the fed as good collateral for loans. Ultimately, what we kind of experienced was a huge rush of investment into these ETFs. We saw continuous asset management grow and grow and grow. I think probably in the top five or six fixed income ETFs, we’ve probably seen 25 or $30 billion flow into them since that late March announcement, and then obviously the fed made an additional announcement and added more ETFs to that program.
Aaron: We’ve seen nothing but people sort of plowing into these asset classes and these ETFs to, one, help get exposure that they know is going to be good collateral, and then two, into some products that are being sort of endorsed by the fed and in their actions.
Mike: I think just to add to in terms of what we just went through, we would get phone calls from clients saying whether or not they use ETFs, just keep them on their screen just to keep track of where the market is. They’re seeing these optical premiums or discounts. I just said take a step back and look at the portfolio you own right now. With ETF, you’re able to move a tremendous amount of assets in one swift trade. If you take a look at your portfolio, that optical “premier discount” is certainly going to be there and much larger to the tune of five or 7%.
Mike: I think the whole idea of ETFs now just being a price discovery tool, at a minimum, they’re going to pop up on more and more trader screens and portfolio manager screens just from a pricing standpoint, but what we’ve seen in the snapback in the marketplace and what Aaron mentioned in terms of fed stepping in, certainly unprecedented and long awaited I think for ETFs that they’re here to stay they’re viable and they’re tested, but largely what we’ve seen in the month of April, we’ve seen tremendous flows back into fixed incoming ETFs. I think portfolio managers realize that, hey, I need to source this liquidity tool.
Mike: Overall for the year, and year meaning through the end of April 2020, we’ve seen $58 billion flow into equity ETFs, 30 plus billion into fixed income ETFs. But the month of April, the snapback that was witnessed, you saw our fixed income flows a third larger than what you saw in the equity space. Continued focus and we certainly expect it to continue on.
Aaron: One other quick point to that is obviously April was a tremendous month for new issuance in the investment grade corporate space and the corporate space in general. I think it was close to $300 billion. Usually a trend we’ve seen is when there’s an unusually large new issue calendar, ETF assets tend to be reduced because people who are using ETFs as a holding container until they had something new to buy and then they’d sell off these ETF assets to raise the cash to buy the new issue or to put their money to work, I think it’s an interesting phenomenon that we saw just going through this past month. It’s probably the largest month of issuance ever that we’ve seen and then we’ve still seen ETF assets grow alongside of that.
Aaron: I think that’s an interesting phenomenon that maybe one of those dynamic changes that we’re discussing. ETFs are clearly becoming a bigger and bigger piece of people’s arsenal and tools that they deploy to use.
IAUM: That’s fantastic. Well, thanks for being on, guys. That was certainly around the horn and back on ETFs and how insurance companies are using them with a couple of industry experts, Mike Cafiero and Aaron Kehoe from Brownstone. Guys, thanks for being on. I want to mention to everybody that just check out our new website. It just went live yesterday and our new Insurance AUM Directory of Insurance Asset Managers. It’s our first one, first annual. You can find our podcast on all the major platforms. If you like us, please rate us, share us, tell your friends. We appreciate that. Thank you for listening. My name is Stewart Foley, and this is the Insurance AUM Journal Podcast.