ETF Masterclass with Ben Woloshin and Brad Kotler of SSGA

Stewart: Insurance companies are using ETFs more than ever before, and that's our topic today. Thanks for joining us, my name's Stewart Foley, I'm your host of the InsuranceAUM.com podcast, and I'm joined by Ben Woloshin and Brad Kotler, of State Street Global Advisors. Gentlemen, welcome.

Brad: Thanks-

Ben: Thank you, Stewart.

Stewart: So we'll start this one like we start them all, what's your hometown, first job, fun fact? Ben, I know you better, how about starting us off?

Ben: Okay, sure. So hometown, born and raised in Chicago, Illinois, and live in New Jersey at the moment. And in terms of a fun fact, I've traveled to over 40 countries in my life, and about half of those professionally as well, and remind me of the third one?

Stewart: First job.

Ben: Oh, my first job, yes.

Stewart: Not your fancy one. Not a fancy first job. Your first job, The first one.

Ben: I worked at Poochie's Hotdog stand in Skokie, Illinois when I was in high school.

Stewart: You worked at Poochie's? Oh, that place is awesome. Very nice, well done. Okay, how about you, Brad? What's your hometown, first job, and fun fact?

Brad: So I grew up in Rockland County, New York, which is about 20 to 25 miles north of Manhattan. I currently live in Fairfield County, Connecticut. My first job was collecting shopping carts at a Bradley's in a strip mall down by me, I think that was 13 or 14.

Stewart: Nice work.

Brad: And a fun fact is I have two children, two daughters.

Stewart: Very nice. Thank you. So professionally speaking, Brad, you're a vice president of the Spider Group, you focus on sales, execution, and trading. And Ben, you run the Spider effort in the insurance area. Can you talk just a little bit about your professional backgrounds, both of you?

Ben: Sure, I'll start off. I entered the securities industry in the... Well, let's call it a while ago. My first role was working with teachers in the 403(b) space. And then I started working in the mutual fund business, mostly on the retail side, but started developing an expertise in the insurance space through the annuity market. And then started working internationally as well, hence the 40 countries, in both the mutual fund and insurance space. And then had a variety of roles in product development, distribution at both insurance companies, asset managers, as well as on the investment banking side. And I entered the ETF industry just about 10 years ago, working exclusively with insurance companies.

Stewart: And Brad, you have a client-facing role on the sales and trading side, right?

Brad: That's correct. So my current role is client-facing, as you mentioned, and the conversations I'm having with our clients, and that ranges everywhere from the institutional side, down to the private and independent wealth side, is discussions and education around the ETF structure, around helping clients find the appropriate product for the exposure and liquidity demands that they have. And then helping them understand the best way to access the market, so developing trade strategies based on their best execution needs, and really getting them comfortable with the use case that they are using the ETF for, and helping them understand that the liquidity that the product offers is appropriate for their use.

Stewart: And it's really an important point, because as you, I think, would both agree, insurance companies don't buy things they don't understand, and it's imperative that they understand the structure of the ETF, and how it's put together, and how it comes apart, and all that sort of stuff, and that's what we want to talk about today. And I'll direct this one to Ben, what is an ETF, at a high level?

Ben: At a very high level, an ETF, it's a pooled investment security that operates very much like a mutual fund. Typically an ETF tracks an index, a sector, or a commodity, but unlike a mutual fund, an ETF can be bought or sold on an exchange, and an ETF can be structured, really, to track anything, from an individual commodity, as I mentioned, to a large and diverse collection of securities. I should also mention that ETFs can be passive, just tracking an index, basically, or it could be active as well. And so as I mentioned, an ETF is a basket of securities that trades on exchange, the ETF share prices fluctuate all day as the ETF is both bought and sold, which is different than a mutual fund, which strikes an NAV every day after the close.

And then ETFs can really, I like to say, they can really allow an investor to invest in any vertical or horizontal slice of any market you could think of in the world. And then at the same time, ETFs, even though everything underneath them is sophisticated, and we have portfolio managers just like any active strategy, or any other investment strategy, we do offer very low expense ratios for most of the vehicles that we have, and then there's fewer what I would call friction in terms of commissions and things of that nature.

But at its base level, I really view an ETF as a technology that allows investors, and in this instance, professional investors and insurance companies, to access portions of markets where they either want to express a view, or that they need to help match their assets and liability. But investors can range from the most sophisticated insurance CIOs, to retail customers. And then I would be remiss if I didn't mention that SSGA did create the first ETF, SPY, which many people have heard of, but in the ETF ecosystem, there's over 3000 ETFs in the U.S., really representing trillions of dollars in assets under management. So it's grown up over a long period of time, but growing very, very rapidly, and we can get into adoption a little bit later in the insurance space, but definitely become a very key tool for professional investors in the way that they manage money.

Stewart: And you use the term, Ben, ecosystem, and I'll just direct this to Brad, can you talk a little bit about the ETF ecosystem, how these things get put together, taken apart, and how they trade?

Brad: Sure. So in ETF, and what makes it so unique and where a lot of the beneficial attributes come as far as investing goes is, the creation redemption mechanism. And so, if you think about compared to a closed-end mutual fund, ETF shares, for the most part, can be created if there is buy-side demand, and redeemed if there's sell-side demand to keep the appropriate amount of shares outstanding for clients. So just because there is a very large buyer of... You can talk about T-bills, or investment grade credit, those are very large markets where there's underlying constituents that are available to be brought into ETFs in a diversified manner. So authorized participants, which issuers like State Street partner with, are constantly creating and redeeming shares based on buyers and sellers in the market so that there isn't significant market impact or demand and supply imbalances for investors that are looking to invest or divest.

So that's certainly is very appropriate, and a very important way that the price of the ETF remains in line with the price of the underlying securities. So if your APs and market-makers providing liquidity, and you have investors demanding that liquidity, and you also have a lot of different use cases that, within using an ETF, that offer enhanced liquidity, so you have this whole securities lending market, so investors can borrow shares for whatever purposes they need, you have the ability for investors to use total return swaps on ETFs, where ETFs would be the hedge for that total return swap for specific use cases and investor types that want the derivative format. There are investors that use ETFs to embed into other products, and this is typically a use case used by the bank.

So there's a lot of different investor types, of course you have your core buy and hold, you have your more tactical trading counterparties, and then you have ETFs as a financial instrument we call it, where use cases for the ETF that aren't necessarily buy and hold, but hedging, and for derivative use. So all of this use creates this turnover of product, and enhances the liquidity, because so many people are using the ETF for different reasons at once, and that we typically see as increasing volumes available, and collapsing bid-ask spread in ETF. And that's a big driver of why we often see ETFs bid-ask trading tighter than the underlying basket.

Stewart: Yeah, and that's what I was going to ask you is, is there a way to compare the liquidity of an ETF to the underlying basket? Are there generalities that you can state about... Because liquidity is a topic that insurance companies care about a lot. Could you just address the liquidity side of things just for a moment?

Brad: Yeah, absolutely. So if you think about a brand new ETF, has no holders, and it's just been launched, and you can use any asset class that you want. For an investor looking to buy that ETF, there isn't going to be, really, a lot of secondary market liquidity available. There's not someone selling shares that you can buy from them where you pair off at the exchange, and collapse bid-ask spread. So a new investor is going to access the market at the spreads of the basket. So that's kind of how it starts, and then once you've built up a holder base, and there are many different investors buying or selling that ETF all at once but for different reasons, kind of what I mentioned before, then you start to see the bid-ask spread collapse because someone's willing to sell an ETF at a price where you're looking to buy it, then you don't have to worry about what's happening with the bid-ask spread and the constituents of the basket.

The implication is, there isn't necessarily going to be new shares created to redeem, it's just two investors meeting in an all-to-all market that can trade inside the spread of the basket. So that's really 
important, and that's why a lot of times people say an ETF's liquidity and bid-ask spread should be, at worst case, the bid-ask spread of the basket, but in most cases for these developed products that have a strong liquidity profile, we see spreads significantly inside.

You could think about the high-yield market, and you could say... Well, high-yield trades at let's say 50 basis points-wide for the conversation purposes, a lot of the most robust high-yield ETFs trade a basis point-wide. And that's because there are sellers and buyers transacting at the same time, and we don't necessarily have to care about where the holdings are, and the cost to source those whole things, because you're just buying what somebody else is selling, and you're agreeing at a point of centralized liquidity, which is the exchange, and so we see remarkable upticks in reduction of transaction costs. That is one of the benefits of the structure, and why clients tend like to ETFs over mutual funds.

Stewart: Yeah, that makes a lot of sense. I guess the other side of it, Ben, is to talk about insurance company use of ETFs, our mutual friend Raghu Ramachandran in S&P has written a paper every year on the use of insurance companies' use of ETFs, and the numbers keep getting bigger, and bigger, and bigger, and there's a lot of very solid reasons for that. But what can you talk to us about with regard to insurance company usage of ETFs in particular?

Ben: So there's a lot of them, and this is why I mentioned at the outset that we really do view the ETF, it's an investment vehicle, obviously, but it also is a technology, and that investment technology can be used by insurance companies for a lot of different things. So, we see insurance companies using the ETF as a long-term core holding, it could be in a commodity product, it could be an equity product. It's mostly fixed income, however, just given the nature of the insurance company asset and liability profile. It could also be used as interim beta. So let's say an insurance company is having a difficult time sourcing securities from their traditional sources, like an investment bank, or a broker-dealer, they can go into a core holding, say a high-yield type holding product such as JNK for a period of time, until which they can source the securities.

And then at that point, they may decide to hold onto the ETF long-term, either they can't source an inappropriate price, or just... Like the individual holding that they've got from an ETF perspective. Another interesting use case is scale in a subsidiary account. As we know, in the insurance world, insurance companies, especially large ones, have entities all over the United States, all over the world in some cases. A very large, mega insurance company might have a small subsidiary, and it's difficult to replicate parent portfolio in a much smaller subsidiary. So rather than trying to replicate say, 1,000 line items in a small subsidiary account, you can build a portfolio using 5 to 10, maybe, even in some cases, depending what you're looking for, with 1 to 2 ETFs, which is a really interesting use case.

Another use case is sourcing hard-to-access asset classes, such as emerging market debt. And we've seen lots of insurance companies who might not have an EMDESK using the ETF as a way to access that market. The other thing I wanted to mention, two things, actually, that Brad mentioned, that I wanted to expand on a little bit, is the in-kind creation and redemption process, there's a tool within that, that's in-kind, so you can source securities, and ETF is really a wrapper, and you can actually crack that wrapper open, and in some cases, take delivery of the underlying securities. And so as I mentioned, there may be some hard-to-source securities that an insurance company wants to own on their balance sheet or expressive view, to the extent they can't source it, again, through traditional sources, they can use the ETF mechanism to do so.

And the same thing actually works in reverse as well. So let's say an insurance company has a separate account, or they own a whole number of securities that, perhaps, they can't get a mark on, they can call us, Brad and his team, and we can see if those individual securities match up with a particular ETF, and if they do so, working through an AP, this is not something that's done directly through the ETF issuer, but working through an AP, it can actually deliver those securities to the AP, and then take delivery of the ETF. And instead of having multiple line items, again, they can have one line item in the form of the ETF. And the last thing I'll mention, which is becoming very popular in the insurance space, especially with large, very liquid ETFs, I mentioned ETFs as a technology, they're also a financial instrument. So we're seeing a lot of insurance companies nowadays buying the ETF, going long on the ETF, and then lending the ETF out to generate additional revenue for the balance sheet.

And so if there's a lending market, which in these volatile times there certainly is, because there's always someone who wants to express a view, especially on our most liquid tickers, and I would say, throughout any ETF issuer, their most liquid tickers, there's likely a lending market that can create a situation where the insurance company employs a long and lend strategy as well, which is very interesting, again, because it gives, even though yields are higher, to say the least, it does give additional income to the insurance company balance sheet. So those are just two examples.

Stewart: Yeah, I've heard the term AP a couple of different times, and I want to make sure that we're defining that. When you use the term AP, what do those letters mean?

Ben: I'll defer to Brad on that one, but it's authorized participant, and we work with many of them, but that's Brad's world.

Brad: Sure. So just as Ben said, authorized participant. These are counterparties who are legally allowed to create or redeem shares, which means deliver an appropriate basket of securities to an ETF fund, in exchange for new ETF shares, or deliver shares in for redemption, and receive an underlying basket of securities. So it's an agreement that is built between, often broker-dealers, who legally sign up to become authorized participants in certain types of ETFs, and they're allowed to participate in those transactions, facing the ETF fund.

Stewart: When I do these podcasts, I kind of put myself in the seat of a CIO, and I say, "Well, if I want to buy ETFs in a meaningful way..." And we talked about some use cases, but I mean, if you're one million dollar insurance company and you want to make an EMD allocation, how do you do it? And obviously, ETFs is a very efficient and effective way to do that, but if I want to understand this market a little bit better, can a client work with the Spider capital markets team, i.e. you, Brad, how do I do that?

Brad: Sure. So often we work with the full sales force of the ETF issuer, so that accurately describes the relationship between Ben and I, and all of our other salespeople. And so along the investment process, from the research, to the desired exposure, the selection of that, and then vetting out all the different ETFs for finding the most ideal exposure based on the index, so that's due diligence. Once we get to implementation, oftentimes the salesperson will put me in touch with the PM and trading team at the investor, and we'll talk about a lot of things, from, what are their best execution requirements, who's going to be trading, actually, executing the orders? What are the priorities for the order? So are you looking to trade the risk all at once? Are you looking to take advantage of the ETF structure, and do a working order in the market? Are you looking to benchmark yourself to some trading value like a NAV or a TWAP, or the high or low of the day?

Of course, there are multiple benchmarks that you can use, and we'll develop a trade strategy using those things, so I'll bucket those as client priorities. And then you have to take a look at the ETF itself, and the secondary market profile of the ETF, and lastly, understand what the liquidity profile of the underlying securities are and then the trade size really is the last part, and you develop the strategy that optimizes all of that.

And so if you're looking to minimize market impact for an ETF that doesn't trade very much, but has a pretty deep pool of liquidity in the underlying, then perhaps you use a block trade. If you want to minimize market impact and take advantage of what you perceive as somebody selling in the market while you want to buy, perhaps you do a VWAP over a certain time period when the underlying securities are most active. So you can look at fixed income, a lot of fixed income, we can speak about credit trades between 9:30 and 12:00. And so we can just really seek to optimize what the client needs, and what's available out there from the ETF and it's underlying. So we work a lot with doing that and building strategy, and TCA.

Stewart: Okay, so TWAP, VWAP, and TCA, help me with those.

Brad: Sure. So TWAP is time-weighted average price. So that's an order type where you're just saying, "Buy 1,000 shares every minute for the next half hour." So you're not taking into account anything other than buying the same amount of shares over a pre-determined range of time. A VWAP, volume-weighted average price is, you're buying shares, but you are participating in the market, meaning if nobody else is trading shares while you are, your volume will be a little bit lower, and then as the broader market for that ticker starts to increase volume, you will also, in your order, will start to buy or sell more. So you're going along with the pace of the market, and that's often a strategy used, and widely used to minimize market impact. TCA is just trade cost analysis. So that's a little bit different, that's not an order type like the other two, but that's just a general term for what we do, which is help the clients understand what it might cost to trade a certain ticker of an ETF, at a certain time of day, using a certain order type.

And so you could say buying this ETF, XYZ over two hours might cost eight basis points. I'm making numbers up, but just as example. So you have eight basis points of impact, maybe versus arrival, but you look at the price before you start your order, you can call it $55, you look at the price afterwards, $55.04, so that's something like eight and a half basis points of impact, and so that's your TCA. Just giving clients a ballpark for how much they may move the market with a certain order, in a certain ETF, traded with a certain order type.

Stewart: That's really helpful. I love doing podcasts because I learn a lot. I get to talk to smart guys like you two, and it's terrific. I think no insurance investment discussion is ever complete without a regulatory comment, so Ben, can you talk a little bit about the regulatory treatment of ETFs for insurance companies?

Ben: Sure. And you're absolutely right, so we can have all the, as an industry, have all the interesting exposures in the world, but if capital treatment is punitive, that makes that exposure obviously less attractive to the insurance company. So without an NAIC designation, the ETF, even if it's a core investment-grade fixed income product, would be treated as an equity, because these are traded on exchange, like equities. However, since 2004, so quite a while, the National Association of Insurance Commissioners has provided designations for, nowadays, close to our over 200 ETFs, with designations for favorable capital treatment, depending what the underlying exposure is. So like I said, there's over 200, including preferred stock products as well. Of course, each insurance company is regulated by their state of domicile, so ultimately, even though the NAIC provides designations, and as an industry, this isn't just a Spider thing, as an industry, we work closely with our insurance company clients to gain those designations.

And I should mention, we have 29 products that have NAIC designations. Of those 200, we work closely with the insurance companies, and at the same time, we work closely with the state regulators as well. I'll get into the state part in a moment, but just on a high level, the NAIC designation helps the insurers grab more favorable RBC treatment. As I mentioned, without an NAIC designation, the bond ETF would be considered a common stock, and with the NAIC designation, the bond ETF can be classified as a long-term bond issuer obligation on Schedule D filings. So you mentioned earlier, the studies that S&P and Raghu put out, part of that high growth trajectory is due to the fact that we have these designations.

We also, as an industry, along with the NAIC, have worked to allow for ETFs to gain favorable accounting treatment through the election of systematic value valuation, and of course, we don't opine on individual accounting treatment, but we do have white papers and guides to help the insurance company through that process. So like Brad, from a capital markets perspective, from a regulatory perspective, we also work closely with the insurance companies to help them understand that treatment, but ultimately, it's between them, their accounting teams, and how the state views the ETF. And on that note, with the state, as I mentioned, each individual state, they may or may not provide guidance to the insurance companies. And so for example, New York, just about a year ago, had provided very, very clear guidance to New York domiciled insurance companies, with several guidelines for an ETF specifically to be allowed to be held on an insurance company balance sheet for a New York domiciled insurance company.

This is high level, the ETF must be over a billion dollars. It must allow for in-kind creation and redemption, so now that we're all experts on that, we know what that means. It must follow a passive index. It must follow the 1940 Act, and interestingly, and this could provide for a longer discussion for another podcast, interestingly, the New York Department of Financial Services mandated that the ETF must also have a rating from an NRSRO, another acronym, nationally statistically recognized rating organization, on top of the NAIC designation, which is also a requirement.

New York really wants the ETF to look like a bond, and so adoption... New York specifically, not to go too far on that tangent, it's been really quite strong. And then I should also mention that there are some states, there's pending legislation, or regulation, or guidance, depending on how you look at it, in states such as Massachusetts, Iowa, and some others that have already opined, like Texas and Wyoming, but many states stay silent, so they don't, say allow or disallow, they just defer to the NAIC, and then it's really up to the insurance company to work closely with their in-house compliance team, regulatory and accounting to make sure that it fits well from a balance sheet risk, and regulatory profile.

Stewart: That's really interesting. The state-level regulatory treatment is key to these folks, the insurance guys, they need to know how that's going to be treated, so it's interesting to get that level of specificity around that guidance. So at the end of the day, the trend is clearly up on ETF use by insurance companies. It seems as though, I mean, with the number of NAIC designations that are out there, your number I think was 200 or so. Obviously, adoption is becoming very mainstream. Just to wrap it up, what's a couple of takeaways as you look forward here at ETF use by insurance companies?

Ben: Yeah, so I think there's really three main ones. The first one, really piggybacking on Brad's discussion is that, ETF, it stands for exchange-traded fund, the T is traded, and that's probably the most important part of how clients transact, it's the only part, how they transact in these securities. So working with an ETF issuer that has a robust capital markets and client experience team is really critical. So there may be 200 products with NAIC designations, but really understanding and working closely with an issuer in that ecosystem is super important. That can range from just direct contact, or Bloomberg Chats for example, are employed pretty extensively. And also really getting a handle on what I like to call pre-trade analytics, and post-trade analytics, to really understand, as Brad was mentioning, all the dynamics that go into working with the ETF.

The second thing I would say is that even though, last year in 2021, about a billion and a half U.S. dollars were added to general account portfolios, that sounds relatively small in terms of overall insurance assets, it's actually growing at a really rapid rate. And so in terms of holdings, it's about 45 billion, and growing quite rapidly, and in double digit growth over time. But I would say, to the insurance company audience, there's not one particular asset class that I would suggest that makes sense. I would say all of them. So if you're looking for core fixed income, as I mentioned before, there's an ETF for that. If you're looking for interim beta, you can look at the ETF ecosystem, I'll say, to find what makes sense for you. Many insurers obviously also have equity books. If you're concerned that your individual equity products are benchmark-hugging, why not buy the benchmark, and look at ETF portfolio. If you're concerned that you have too many line items, again, ETF, or a small portfolio of ETFs can help out with that.

And then lastly, going back to the first point, I would say that even though we're growing really rapidly in the space, it's still a relatively small fraction. And working closely with your issuer is really paramount, and we're here as an industry to really help out, and that ranges all the way from the capital markets piece, to the regulatory piece. And so we don't view any questions as bad questions, we like getting the questions. And so I would say, just work closely with your issuers, and get to know the ecosystem, because as balance sheets have contracted on Wall Street, these products have taken on new significance, and again, subject for another podcast, but look no further than the Fed's buying program back in 2020, is really an endorsement as these instruments, instruments being ETFs, as a financial tool, again, or as a technology that can really help out institutional investors manage their balance sheets, specifically insurance companies.

Stewart: Thank you. I really appreciate it. I've learned a lot today, I learned a bunch of new terms. I feel like I understand this market much better than I did at the beginning of this thing, so thanks for being on. We've been joined by Ben Woloshin, head of Spider Insurance, and Brad Kotler, Vice President of the Spider Group, sales, execution and trading from State Street Global Advisors. Gentlemen, thanks for being on.

Brad: Thanks for having us.

Ben: Thank you, Stewart.

Stewart: Thanks for listening. If you have ideas for podcasts, please email me at podcasts@insuranceaum.com. My name's Stewart Foley, and this is the InsuranceAUM.com podcast.

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