Proposed private asset ETFs in focus: what are the risks and opportunities?

Private market assets have traditionally been more difficult for retail investors to access, but new proposed ETFs may change that. Joining us now to discuss is Andres Rincon, Managing Director and Head of ETF Sales and Strategy with TD Securities. Andres, great to have you back on the show.

Thank you for having me, as always.

All right. One of the great things when we have you on the show, many great things, but you always have this view as to what is coming in the market. We've actually talked about private assets on the program before. Now, the ETF world may be getting in there. Explain it to us.

I mean, the ETF market just couldn't resist how much demand and interest there is in this market. As you mentioned, there's so much talk about private assets. And there's also a large need and want for these assets. So the ETF industry has been trying, for a long time now, to actually get into the industry.

But, I'll be honest, it has been a while since the ETF industry has been at a conflict, let's say, because this is a very interesting filing. And we had a similar discussion back in the day when the first bond ETF was launched in Canada. It created a lot of discussion between both sides, that some people agreed with it, some people didn't agree with it.

At the end of the day, the ETF industry is exploring ways to introduce private assets within the ETF structure. And what we had last week was the first filing from a large issuer, in this case State Street, that is partnering with Apollo, which is a very large private asset manager, to launch what they are calling or labeling the first private credit ETF in the US.

Now, just to be clear, because there's a lot of news around this, is that it actually is mostly public bonds or public credit that is in this fund, but it has a small sleeve that is in private credit. So let's decompose it a little bit. So the fund is expected to have, at least the fund and investment grade private credit, and then to have a up to 15% in private assets, and also another portion in what we call BDCs, and CLOs, and other assets that are relatively illiquid, but with longer settlement cycles, so closer to the private asset world.

So the combination of the real private asset securities that will be in there, plus some other securities like BDCs and CLOs, it will give a larger than 50% portion of this fund that will be in, let's say, private assets. What's really interesting is that they are really working within the regulations in the US. In the US, if you're a fund, you're already allowed to own 15% in illiquid assets.

But they've never really done an ETF structure because it's very hard to make markets in a liquid structure, which is an ETF, on an illiquid product. And so State Street has been working with Apollo to be able to provide liquidity in this illiquid sleeve. And so the market makers are now able to potentially quote on this. Just to be clear, this is just a filing, hasn't launched--

The proposed ETF.

That's right. The SEC has to still review it and approve it, if they will. So we don't know if it will launch or not or when it will launch. But it's very interesting because we went through similar discussions, once again, through the launch of the bond ETFs. And there were a lot of skeptics at the time. And now, bond ETFs are 30% of the market.

And, as you mentioned earlier, private assets are something that a lot of the advisors and a lot of investors, in general, want. And the State Street ETF will at least give advisors and clients, if it launches, some exposure to that market.

What would be the risks here for an advisor? If this does end up being a successful proposal, this kind of product comes to market, what do investors need to think about in terms of risks?

I can think of several risks. And, really, at the end of the day, people have to understand that this is a illiquid asset that this fund will be holding. And I do believe that the issuers, including State Street and future issuers, if this works, will do a great job in trying to put a price on this private asset on a daily basis.

Remember, as market makers, we have to quote it on a daily basis and price it on a daily basis. So they'll do their best job. But at the end of the day, if there is a lot of supply, if people are selling out of this ETF quite a bit and there is a credit event or there is some risk to the market, volatility to the market, you will likely see a bit of a dislocation there in the pricing of the asset itself.

So you might see, in the same way that you see the bonds move lower, a credit bond, because it also has some bonds in there, you may also see the private assets move lower. How it will move, it's hard to know. So there is some uncertainty, is what I would say in terms of the risk, as to how that asset class or that asset class will move and behave within that ETF, given that it will probably be a little bit more public than your traditional private asset, which has a lock up, which will really be fairly fixed for a period of time. Generally, valuations on the private assets have been on a monthly or less regular basis, while in the ETF it will be on a more often basis.

All right. Interesting stuff and interesting things to consider there. You mentioned volatility there. It was an interesting summer.

We got a bout of it in August. We had a bout of it to begin September. We're awaiting to see where all of this heads. Amid all that, you are looking at some of the defensive sectors. What were you seeing there?

Yeah. So a lot of the investors, I know you've mentioned this, we've seen some volatility throughout the markets. But the street tends to be, or has been, a lot more bullish than we've expected, given what the market has been doing in terms of volatility. So some things that are interesting in the market we're seeing a lot of interest in is defensive sectors.

So these are your sectors that are better protected in a downturn. So think of a health care, a consumer staple, a utility, things that, regardless of the environment, the output of these companies won't really change that much because people still need their toothpaste. People still need health care. People still need their electricity.

So all these things, as an investor, obviously, you know investors will likely need it. So there, obviously, will still be in-demand regardless of the condition. So there are different ETFs here in Canada, and a great number of them in the US, that cover these markets.

And we're seeing a lot more interest in these ETFs despite the market basically being a lot more bullish in investing in broad market. So just as an example here in Canada in health care-- XHC from iShares ZUH from BMO, and utilities ZUT and XUT from iShares and BMO, and consumer staples XST and STPL from BMO. So those are just examples of ETFs that are covering these sectors both globally and/or Canada, US that give investors exposure to these defensive sectors.

Now, in this market, too, it's been interesting to watch it move in some areas that are sensitive to interest rates. Interest rates have been coming down, and we have seen dividend plays, obviously, getting a little bit more attention-- important, though, I guess, if you're talking about ETFs, about the cash distributions, right? If you're looking for yield, it all comes through the distribution.

Yeah. You know what's interesting? We did an analysis on how ETFs fare in terms of gathering of assets depending on the asset class that they're looking at, but also depending on the objective of the ETF.

So what we found is if you have, let's say, a broad market ETF or, just in general, that an investor wants to buy this ETF for growth, let's say, then the frequency doesn't matter that much. Because at the end of the day, you, or I, and the public is buying the ETF because they want broad exposure, like the S&P 500, let's say.

So do you care that it distributes its yield on a monthly, weekly, quarterly basis? For the most part, the investor doesn't care as much. That's not one of the main metrics that they see.

Now, if you are buying a product because of its yield, then that is a key attribute of the ETF. And what we've seen, let's say bonds in general, for example, they pay their income not on a weekly or monthly basis-- let's say quarterly. But what we've seen is the greater demand for payments on a shorter basis, weekly or monthly.

And what we've seen, a lot of these products that are yielding, that are bought for their yield, like bond ETFs and especially covered call ETFs, they've all tended to focus around monthly. And we're now seeing some go to weekly. And there is a tight correlation between your distribution, how often you distribute or the frequency of the distribution, and the assets that you're gathering in both those asset classes.

Once again, if you are an investor and you have monthly needs, like you need to pay your bills, you have to pay your car, and other things and you need cash at the moment, then, obviously, you will want to prefer a product that gives you that servicing in that cash on a monthly basis, which is why you see now some funds move to weekly, because there are also some investors that need to have weekly demands.

So we're seeing more and more funds launch with weekly distributions. And let's just be clear-- the underlying doesn't distribute weekly, but the ETFs will take a little bit from every distribution and will distribute it more evenly across weeks or months. So it is an interesting fact that we see a lot more demand for these ETFs that distribute on a monthly basis, let's say, just because there is a need from investors for a monthly cash.

Fascinating trend in the market. Ultimately, though, when we have you on, we talk about the fund flows and which directions the money is moving in. What are you seeing there?

As I mentioned earlier, it's been very heavily focused on equities this year. The way we would put it is last year was the year of active and fixed income. That's because, for the first time, fixed income dominated flows in Canada and the US to some degree, but active also had a very big year.

Just as the year turned, we're seeing now most of the flows go into broad equity markets, indexed markets. So a bit of a 180 from last year to this year. And it's been mostly US equity-focused. Let me put it into perspective.

If you look in the US, about 50% of every dollar that went into the ETF world has been in a US equity-focused fund. And about the same number in Canada is about 37%. So, as you can imagine, US equity funds have been very, very popular in the US.

Now, fixed income still seeing decent momentum, continues to see. But this year has been a bit of a turnaround versus last year. And it's really interesting, given the volatility you mentioned earlier, that US equities, specifically, has been of interest. I think what's also in play is the geopolitical events globally have scared a lot of the global investors, to some degree, which has led them to focus more on the US for now.

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