Fixing Your Interest - Getting Active: The Evolution of ETFs

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VOICE-OVER: Welcome to Fixing Your Interest. In today’s episode we look at how the ETF market is evolving - and why active strategies are playing an increasingly important role.

Host Tina Adatia, PIMCO’s Head of Public Strategies in EMEA, is joined by portfolio manager Martin Svorc, Portfolio Manager, and Jean-Baptiste Faure, ETF Capital Markets Specialist

Together, they unpack what active ETFs are, challenge some of the misconceptions around them and explore active versus passive ETFs.

They’ll also look at how investors are using active ETFs in practice, how liquidity really works, and where opportunities are emerging in today’s market environment.

TINA: JB, Martin, welcome! Today we're gonna be discussing the changing face of the ETF market, and there is really a lot to discuss and I can't think of two better people to kind of have this discussion with today, but we're gonna go through a bunch of different topics, so we just wanna get right in actually.

And maybe, start JB with you. I mean, you oversee the capital market function for PIMCO on the ETF side. You with the team are managing over 60 billion of ETFs from a capital market's perspective. So maybe to start off on the basics, tell us what is an ETF for those people that don't know?

JB: Yeah, sure. Well, thanks Tina for having me here. It's really nice to be with both of you to discuss ETFs, 'cause it definitely is a hot topic at the moment. For those of the audience that don't know what an ETF is, an ETF is simply a vehicle that combines the diversification of a fund and the tradability of a stock.

And so what that means is that you have intraday liquidity. So for example, you could buy an ETF in the morning after the market opens, and you can sell that same ETF in the afternoon before the market closes. And a direct benefit of that is that you can see the price of your investment straight away. So if you're looking into your brokerage account, for example, or you go on an exchange website or a specialized website, you see straight away how much your ETF is worth and at what price you can sell it for, or if you want to add more at what price.

And it's different from some other financial instruments, for example, where in some cases you'll only find the price at which you bought in a day or two, or you can trade only at certain selected points. So that's a big plus of ETFs. And another one is the, I'd say the capacity of the wrapper to evolve because as we all know initially, ETFs were passively tracking equity benchmarks. So things like the S&P 500 or the Euro stocks 50.

And then we've seen fixed income ETFs, and then we've seen commodities ETFs and what we've called thematic ETFs where you can access a specific theme like AI or robotics. And more recently we've had crypto ETFs and also ETFs that start incorporating options that start looking a little more like structured products. So for an investor the ETF is a tool to build a diversified portfolio. And I think that's what really appeals to investors.

TINA: I think that point you make about the fact that it's a wrapper and it gives you access to lots of different types of financial instruments and access to, you know, whether it's fixed income or equities or some of the other things you suggested, I think does seem to make it quite versatile particularly for the end investor. But given that point that you made around, kind of different products and things like that, historically, who was buying ETFs and are you seeing that changing at PIMCO at all?

JB: Yeah. So historically in Europe, the early adopters of the ETFs were institutional investors. So you had insurance, pension funds, asset managers, and they were using ETFs for their large scale allocations. And then what we've seen was wealth managers and private bankers started to use ETFs as well to build their portfolios.

And over the past few years, a really recent trend that we've seen, particularly since COVID is the emergence of retail investors, which is driving inflows quite strongly in Europe at the moment. And that's helped by the online platforms, what we call neobrokers, and also the emergence of savings plans, where in the store will put a certain amount of money on a monthly basis, and then that money can get invested following the model of the platform that they're actually using.

So these are some of the most typical investors, but there's many more types of investors. You can think of sovereign wealth funds. You also have central banks that use ETFs and hedge funds of course. So the user space is really very diverse.

TINA: So have the products’ mix expanded because the user base has expanded or do you think it's a bit of both?

JB: It’s probably a bit of both, right. The more products you have, the more track record you have and therefore the more choice you have for clients. 

TINA: It gives different types of clients coming in then, right?

JB: Exactly.

TINA: Martin, if we kind of zoom in on some of the comments that JB made about kind of the fact that ETFs were pretty much synonymous with passive investing and you know, how that has evolved when you kind of think about from a fixed income perspective how should they be thinking about active and passive?

MARTIN: So I think that's right Tina. Many people associate ETFs with passive, and that is because the massive growth that we have seen in the ETF industry has been driven by passive equity investing. And there is this misconception among investors that passive is cheap and therefore it must be better. And that might be a reasonable thing to do in equities.

After all, it's hard to beat the equity market if you look at the historical data that tells you active managers struggle to beat the equity markets. But if we expand this into fixed income, I think we really need to question this assumption and we need to ask ourselves, is it really the best idea to invest into bonds passively? And we believe it's not.

Very simple reason is, if you buy a passive bond fund, what you are signing up for is the index performance, minus fees, minus friction, and you give up any potential for alpha, any potential for outperformance. And that, unlike inequities that's real in fixed income, it is a little bit easier to outperform the bond market.

TINA: Alright. I mean, I don't think many people appreciate that. I think when they think they're buying a passive ETF, they're gonna get the global Agg or whatever, or the S&P 500 as their return. But I think what you say to the point of like frictions and pricing, like it just cannot be underestimated to be fair.

So why is it, in fixed income? What is it particular about the bond market that makes it sort of full of structural inefficiencies.

MARTIN: Yeah, so bond markets are different. They are bigger, they're much more complex than equity markets.

TINA: What's the size of them, about?

MARTIN: $150 trillion. Yeah, they're massive. So think of just different types of bonds that we have, different issuers that issue bonds. You have governments, government related sectors, corporates, securitized emerging market issuers in many currencies, there is many other types. So just, you know, the types of instruments is much broader than inequities.

And secondly, if you think within an issuer, so pick a company that you like and you say you want to invest in it, in stock, your choice is basically there is one stock for you to buy, and maybe two if you're generous, but a company can have hundreds of bonds, there is different coupons, currencies, parts of capital structure maturities much more complexity, they're much more choice, right. Quite important point is also around market participation.

What you see in fixed income markets is the percentage of entities which are in the bond market but are non-economic, that means they buy or sell bonds, but their primary objective is not to make money or to maximize returns.

They are pursuing a different set of objectives. So a few examples, you have central banks, they would buy or sell bonds to conduct monetary policy, or you have banks that would buy bonds because they need to hold them against their capital requirements, pension funds, insurers, they would often just match liabilities and optimize for accounting type of metrics.

All that combined is very large. It's estimated that over 50% of bond market activity is driven by these non-economic entities. That creates a lot of inefficiencies, which active investors can look to take advantage of. And I think it's also we're talking about the issue of indices or index replication, more related to actual portfolio management.

Again, comparing those two, if you want to run an equity fund against the S&P 500, well you need to buy 500 stocks, right? That should be reasonably simple. You can do it probably on your phone.

A typical fixed income benchmark, the global Agg has 32,000 securities. It's just not practical to buy them all. You have frictions like taxes, market access issues in some countries and others. So just to replicate that index is much harder in fixed income.

And what also comes with that is a typical fixed income benchmark is much more dynamic because a bond has a maturity date, that means it only exists for a period of time. You will generally see many more securities leaving a fixed income benchmark. A new securities enter.

So this index rebalancing element is just much bigger factor in fixed income investing. So that's a complexity, another layer of complexity that investors have to navigate, but also it creates an opportunity.

TINA: Right. Okay. Yeah, no, I think that point around complexity is very important, but I think there's kind of two pieces from that I see, which is like  that passive doesn't give you the return. That actually index replication is not that efficient actually to be fair. But also on the active side, you can exploit kind of more structuring efficiencies of the bond markets.

And I think that point you made about the 50% in sort of non-economic buyers, I think is a huge one to be fair. Martin, you manage a global government ETF when you kind of think about that and you compare that to maybe some of your other funds that you manage and other accounts that you manage for clients, do you manage the ETFs differently to the mutual funds?

MARTIN: I think the short answer is not really. The ETF wrapper in itself doesn't make a lot of difference. Whether we manage an ETF or a mutual fund or a separate account for a client, we would apply the same investment process that we do at PIMCO, which we have been doing for over 50 years. 

So, from when we think about alpha generation, from a top down perspective, we would look to have macroeconomic tilts in terms of duration, yield curve management, country allocation is very important from a bottom up perspective we would look to rotate sectors. We would look to understand and exploit relative value between different instruments. Pick the best issuers, pick the best bonds on the curve.

That's very much similar, regardless of the wrapper. What makes a little bit of a difference is the actual  nature of the mandate and the investment guidelines.

TINA: Yeah, no, fair enough. I think that makes sense, but the point I think you're making is for you, to your point, JB, it's really just a wrapper and that you are taking kind of the best kind of investment opportunities within that universe and within that guidelines and delivering it in the way that the client wants with some of the benefits that you already kind of chatted about on the side of liquidity and intraday pricing and and pieces like that.

So, I think that completely resonates. I mean, Martin, maybe taking a little bit of a track,  you've already kind of started hinting at the fact that you look at duration and you look at curve and there's lots going on in the market and you and the global team, you're managing over 150 billion of global bond mandates. When you look at the environment today, how are you positioning today?

MARTIN: Yeah, so it's an environment where we have quite a bit of uncertainty because of the situation that's going on in the Middle East. There's a lot of conversation around energy prices, what it means for inflation and growth globally. So it's not an environment where you want to be too bold or too narrow, but broadly speaking, if you look at the valuation across fixed income, if you look at yields, starting level of yields, they look pretty attractive.

So I think it's a good environment to be investing in bonds from beta perspective and also thinking about relative positioning against our benchmarks. We have overweights, we prefer overweights to duration in our portfolios. We also think it's a very good time to diversify globally. We have a global economy that is going through a series of shocks. We had the tariffs last year, we have the AI rollout, there is an energy shock going on right now. 

All of these dynamics, they impact different economies across the globe differently. So global cycles are not exactly synchronized. And also from a valuation perspective, when we look across the global fixed income landscape, there is many countries where in high quality fixed income we can pick up yield. So, to give you a few examples, the UK looks pretty good.

Australia select emerging markets, it has a really good environment to diversify globally, plenty of opportunities. But we can get additional yield, additional pickup, which looks pretty attractive as well. So government agencies in select countries or agency MBS in the US look quite good and we will look to have some overweights there.

TINA: Okay. So lots of active opportunities to have in addition to coming under some of the structural inefficiencies you highlighted. But I do wanna kind of take maybe some of that point you made around structural inefficiencies and talk about. Is there something that you're doing today to exploit some of those structural inefficiencies in spite of, kind of what's going on in the world?

MARTIN: Yeah, I think, again, start with the benchmark. If you're a passive investor and your job is to minimize the tracking error to a benchmark, many times you will be forced into buying things where you don't really see value just because they're in the index, right? You have to replicate the index. Now, as active investors, we can actively evaluate each piece of the bond market.

We can look at the risk premium that we are getting paid in each bond. We can evaluate the risks and we can choose to own what we like and not only what we don't like. So that's one example. Another one is, I already talked about the issue that bonds have a maturity date. That means when a bond matures, typically they are reissued and refinanced.

What that means is you have these issuers of bonds, corporates, sovereign, they need to sell billions of dollars of new debt month after month. How do you sell billions of dollars worth of anything in a short period of time? You make it a little bit cheaper.  And that little bit cheaper is called new issue premium or new issue concession.

That is something which we as active investors can actively evaluate and choose to capture. A passive investor would miss out on that because the security gets added to the benchmark several weeks after it's been issued and by then the pricing is already corrected.

TINA: JB now quick question for you. Like linking some of the points that Martin made about kind of what's going on in the world today. Have you seen kind of a change? I wanna get into liquidity a little bit more, but just briefly, have you seen a change in sort of the liquidity dynamics in fixed income as a result of this kind of conflict or…

JB: So I mean, recently obviously spreads have been a bit wider. I think if they widen in the underlying market, they will likely also widen in the ETF market, although that's not always the case. And it's often the case that you can see ETFs that actually trade tighter in beta spreads than their underlying bonds.

If we take a step back and think about the evolution of ETFs from the past 10 or 15 years, obviously things have changed quite a lot. As we all know, the assets and the management of ETFs are going from a milestone to a milestone every month, every year. I think we're now above 3 trillion euros in Europe of assets in our management. So that means we've had a lot of new investors coming to the ETF and the traded volumes have increased.

So that usually benefits liquidity as you see my investors. And another thing that's worth highlighting is because of these increased volumes, we've seen more banks and market makers also stepping in to provide liquidity. So what that means is that they're competing for the flow.

So that also helps narrowing the beta spreads and they're also providing more liquidity because there's more of them. So you can do bigger sizes more efficiently and also faster because these companies are involved investing in technology and things like that.

So the market has evolved for the interest of the end investor, I'd say, there’s deeper liquidity and if you focus specifically on fixed income, I think the bond market or the fixed income markets is also evolving in a positive way for ETF.

So for example I think it used to be a very [inaudible] type of market, the bond trading, and it's becoming more and more electronic, which means less friction and it becomes easier to trade it, which ultimately benefits to the actual ETF if the underlying is easier to trade, it's better for the ETF and for market makers as well.

And banks who provide prices to clients they've had a few more tools in their pocket to manage their risk more efficiently and price the ETFs status. So for example, nowadays they can trade CDS, bond futures, rate futures. I think we hear a lot also about PT or portfolio trading where you trade a big portion of bond in one go for one price. So all of this is really helping the fixed income ETF ecosystem. I think maybe, Martin,in PTs. I know we hear a lot about these

TINA: What is, sorry, what is PT?

MARTIN: PT is portfolio trading. It's very common in corporate credit. And basically it means you are not trading bonds for single line items, but you can trade a whole basket of bonds, sell a hundred in one go. And that's been a genuine innovation in the market. Corporate credit is a good example. In the old days it was actually quite cumbersome to trade corporate credit. And going through the line items, now we can do it all in one go.

But not only that, it's not only about convenience, but also about liquidity. Because of this innovations like portfolio trading and ETF, it's all part of this overall ecosystem. What it means is market intermediation is a lot cheaper for market makers. It's less balance sheet intensive, which then translates into the actual liquidity that we are seeing. It costs a lot less to do those trades.

TINA: Okay. So I think we've kind of gone around, we've had a lot of discussions. For me it's kind of interesting that you can take all the benefits of the ETF and in the past people kind of didn't have much choice in what they bought.

They had to kind of buy passive, but now you can take those benefits, be that kind of liquidity, intraday pricing, ease of execution, and you can still get access to, kind of, some of the best options from an investment point of view, particularly kind of in the fixed income market.

So I think that intersection actually makes it very attractive. You know, for me, I think when I think about kind of what else we've discussed today that I think resonated with me is like look from what you've all said, ETFs are a really versatile tool and we've seen lots of investors kind of adopting that and kind of moving forward. It does seem to be still from your comments, JB that passive is still very dominant, but that active is really catching up.

And when we think about the active space, given some of those structured inefficiencies in the bond market, given the complexity that we see in the bond market, the non-economic buyers, active can really add value, whether it's in an ETF form or a mutual fund form.

And we think this kind of gives you the best of, kind of both worlds. So I think for that we've run out of time, so we should wrap it up for today. But thank you again Martin and JB and thank you everyone for listening!

MARTIN: Thanks for having us.

JB: Thank you.

VOICE-OVER: Thanks for joining us on Fixing Your Interest as we explored the evolution of active ETFs and their growing role in portfolios.

Stay with us as we continue to navigate the challenges and opportunities across the investment landscape.

For deeper insights, analysis and resources, visit PIMCO.com.

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