Will investors return to municipal bond mutual funds after massive outflows in 2022? How has the move by retail investors into separately managed accounts and exchange traded funds affected the landscape? How much of a role does ESG play in retail investing? Join Peter O'Neill, Director and Senior Fixed Income Portfolio Manager, at Bank of America, and Blake Lynch, Head of Business Development, IMTC
Lynne Funk: (
Hi, good morning, everyone and welcome to today's Bond Buyer Leaders session. I'm Lynne Funk, executive editor at The Bond Buyer. Today's session is titled the changing landscape of retail investing. I'm very excited to welcome to the discussion Peter O'Neill director and senior fixed income portfolio manager at Bank of America and Blake Lynch, head of business development at IMTC. Welcome to you both.
Peter O'Neill: (
Thanks. Great to be here.
Blake Lynch: (
Thanks Lynne.
Lynne Funk: (
Great. So let's get into it. With massive outflows from municipal bond mutual funds in 2022, it poses a question and that is, will those investors return or is the market in a transition to perhaps a more professionally run retail space? We've seen some growth in muni exchange traded funds this year, and they still only make up about 2% of overall muni holdings. SMA management, separately managed account management, which we're going to talk a lot about today, has been increasing exponentially over the past few years. So we've seen retail holdings drop, but it can be somewhat misleading, in a way because they're moving into the ETFs, the SMAs, but there are fewer direct retail holdings. Peter, why don't you kick us off? And the first question is as municipal managers are shifting the services they offer, how is that impacting the retail landscape overall?
Peter O'Neill: (
I wouldn't say necessarily from, from my seat that SMA managers are shifting in terms of the services they offer. But I would say that the services that an SMA manager like myself, and the advantage of investing in an SMA account has increased in importance over the past couple of years. We're coming out of a very long bull market within fixed income. And a lot of investors haven't necessarily seen the type of volatility that we've seen over the past couple of years. I point to 2020, where we voluntarily shut down the economy. A lot of muni investors were super nervous about the muni market, specific sectors within the muni market. Definitely certain credits in the lower-quality space. And when they invest in separately managed accounts, one of the advantages is that they're able to see the holdings in their account.
Peter O'Neill: (
They're able to see the quality of the bonds. They hold the structure of the portfolio in particular, their final maturity. And when you're investing within an SMA portfolio, you're investing with an entire team and you have portfolio management. We have our in-house credit team that reviews every bond that we buy at time and purchase and monitors over the life of the holding, as well as our trading desk that gets superior execution for the retail investor. So during 2020, one of the things that we were able to do was we were very proactive with our clients where we would reach out, address any concerns that we had within these certain sectors, you know, point to different credits within their portfolio that experiencing some price declines, give the outlook. And because of the credit work that we had done at the initial investment, we didn't feel even throughout, March, April, 2020, there was any default risk with any of the bonds that we held in any of our clients' accounts.
Peter O'Neill: (
And so when we reached out to them, we reminded them that one, you have a final maturity date. And two, we bought these bonds at an attractive acquisition yield. And even with the volatility that we've seen in the market over the past month or two, your cash flows do not change. And as long as we don't feel that these bonds are going to default and we don't, and here's our views on why you're gonna get your money back on X date. And that seemed to bring a lot of comfort to our investors, knowing what they hold and knowing our opinions on those credits.
Lynne Funk: (
Blake, did you want to add anything to that to start?
Blake Lynch: (
Yeah, I definitely agree with, Peter's comments there. The one thing that I would say is, as we experience a lot of volatility in the municipal space this year, there are definitely some people who are looking to expand their SMA capabilities. And one thing we're hearing a lot about is around, specifically tax loss harvesting and municipal fixed income accounts. I'm sure this is probably a standard practice for Peter and his team, but a lot of these people who have been historically buy-and-hold investors are now really exploring different technologies that can help them scale that tax loss, harvesting, and actually implement that into portfolio. So if I'm seeing anything really change, it's really around doing workflows more effectively. I I think that tax loss harvesting on within SMAs is definitely something that has really been brought to the forefront this year.
Peter O'Neill: (
I one hundred percent agree. We've done that a lot for a lot of our clients. We can take advantage, by selling, locking in a loss and then repositioning the portfolio, in picking up more yield and generating more income for a lot of our clients. So that's definitely been a benefit.
Blake Lynch: (
And just to add on that point, I think one thing that we're seeing a lot of increased transparency in the space as well is the rise of the ECNs and ATSs out there. There's now more offers available that people can parse through to actually dig into those SMAs and try to find bonds in the market that can help improve the quality or yield of portfolios like Peter's mentioning, and that is driven by in-house research.
Lynne Funk: (
Okay. So maybe we can talk a little bit about how we know the muni market is generally averse to change. How perhaps technology, and the more bespoke nature of SMAs, is changing, how both money managers and investors interact with the asset class.
Blake Lynch: (
Yeah. I'm happy to kick it off. I think it's definitely an industry that's lacked innovation for, you know, a number of decades. Starting off in the space myself I could see a lot of the inefficiencies with a lot of the legacy platforms that were out there in the market. What we've seen is a lot of emphasis on the equity workflows and helping equity managers. And then what resulted was these equity-focused systems actually being pushed down upon fixed income managers and, you know, it really didn't give them the tools they needed because they just very different, like retrofitting an equity system and put some bandaids onto the fixed income workflow. That's not right. And really what that resulted in is people having to move off system, right? So they're working out of Excel doing a lot of manual workflows to accomplish daily tasks.
Blake Lynch: (
We all know that the muni market has historically lacked a lot of transparency, whether that's the OTC nature, but things like Emma have helped with that, BondLink has actually helped for new issues, new issuers, and actually helping issuers match with investors. There's tons of new services out there that are adding transparency to the municipal market. But I think one of the biggest problems that the industry faces is the regulation. And there's no standardization of this reporting, that has been a huge problem for muni managers, because every individual credit has its own individual research that's required where. Where we're really coming in is helping people digest that data faster. We provide a platform that can help integrate different data sources. So you can work within a single platform and see all the information you need to get from portfolio construction through execution and working with some of those people I mentioned earlier, we're able to help our clients get better outcomes for their investors.
Peter O'Neill: (
I would add to that in saying that improved technology has definitely has helped with our efficiencies and abilities to scale our business. It has also helped in terms of customization by creating rules and guidelines around portfolios, whether or not a client wants to be up in quality, wants to avoid different sectors. We can create rules and guidelines around that in order to give them a better experience in terms of oversight, compliance, it has been an absolute game changer for us. I mean, I can remember back — and this isn't that long ago — where it used to take five different systems to execute one trade, and now, you know, we've improved our technology and the system that we have allows us to implement all of our market ideas across the entire book. And again, that allows our clients to execute on these opportunities in a much quicker and efficient way.
Lynne Funk: (
So can you then maybe talk a little bit about the, the automation process? Is that making munis a little bit more say, better democratic? Smaller investors being able to access access the muni market?
Peter O'Neill: (
Well, I think from my seat, it has allowed us for certain strategies to lower our minimums in the muni market, which definitely opened it up to more investors. I think the rise of ETFs, even though it's still only about two, two and a half percent of the overall market, has definitely, again, given another avenue for smaller investors to participate in the market. Blake mentioned EMMA. I mean, that is again a great tool that investors are able to look up certain CUSIPs that they hold in their portfolio. If they're able to get trade activity pricing, they're able to look up new issues coming to market. This is all things that were never available to the retail investor. And so I think to Blake's point, transparency is the key or what was lacking really in the muni market. And I think there's still a ways to go, but I think from where we were to where we are, it's been a great improvement.
Blake Lynch: (
Yeah. I would echo those comments. I think the one thing with ETFs in particular that is particularly interesting to me having come from an ETF background, at a previous asset manager was that a lot of the ETFs out there today tend to be debt weighted indices. So even though they're easily accessible for a lot of these smaller accounts, there's still the most indebted companies have the highest weight within those indices. I think, with what we've seen from strategic beta and active ETS coming to the market, there's definitely some ways to get better exposures to fixed income than there was a few years back. But, like Peter mentioned, I think it's still in its infancy. But in relation to the automation, I think Peter's comments around compliance and investment guideline monitoring, and being able to act upon portfolios at scale. What we've seen this year are a lot of asset managers coming to us, trying to figure out, you know, we have this minimum here, how do we move it here so we can access more of the market? And I I think the lowering of minimums is definitely a place that technology can help service some of those smaller clients.
Lynne Funk: (
When you think about customization, can you talk a little bit more in detail about how SMAs add that value more efficiently — more data, more research — how does that customization work out for clients, Peter? You want take that first?
Peter O'Neill: (
Absolutely. I think 2022 is a great example of how SMAs can really add value for clients in terms of customization efficiency. Year to date through, I think July, we had $76 billion of outflows from the muni market, that made mutual funds sellers. They also had to sell some of these higher quality names that were more liquid in the market, which caused spread widening. We were able to take advantage of that in our SMA accounts for our clients. The only reason why we were able to pick them up at better pricing, wasn't so much a credit concern, but it was just a technical issue in the market. And so I think that's, you know, one of the ways that we're able to capitalize. Another point is that for clients, even if they wanted to raise cash, or they were nervous about the market in the first call it six, seven months of this year, you know, we could point again to that final maturity and say, if you need to raise cash, you don't necessarily need to be a forced seller, right?
Peter O'Neill: (
You can let these bonds mature, and then we can either A, move that cash out, or B, keep that cash on the sideline. Another advantage of working with an SMA account is this is your specific strategy. And so if even in 2020 or year to date, the client becomes nervous about the market, whether or not it's from a credit standpoint or an interest rate standpoint, we can make adjustments, right? And they can say, for example, if we have a client that is in an intermediate strategy, beginning of the year, we were investing out to let's say, 10, 12 years, the client is nervous because, every headline that comes out, chairman Powell becomes more and more aggressive. And they say, you know, we want to shorten our overall duration. As bonds start to mature, we only want to go out to two years, right. Or we just want to buy variable rate demand nodes that, necessarily won't be impacted by interest rates moving higher. So I think that flexibility of us being able to make that shift for clients, is a real advantage of investing with a separately managed account.
Lynne Funk: (
Blake, did you want to add anything there?
Blake Lynch: (
Yeah. I'll jump in here. I think all those points are fantastic. I think one of the things that we're hearing a lot from even home offices, such as kind of these large aggregators of wealth managers and RAs, um, is that their advisors are demanding more and they're demanding more customization and that's not coming from the advisor necessarily. That's actually coming from the individual. That's rolling up to the advisor, that's rolling up to the home office. So what we're seeing a lot of interest in is having something that's flexible to meet those customization needs of those clients. So a lot of home offices have a ton of new initiatives around offering these in-house solutions to their advisors, to better service their clients. Again, everyone wants customization nowadays and customization at scale is a huge initiative we're hearing day in and day out. And by offering a customized solution to an advisor, they can better service their clients, which leads to better firm outcomes in general. So I know Peter probably experiences that a lot in his seat, but with the insane investment policy statements and investment guidelines we've been seeing here, we know that the there's ton of new demands in having a system that can appropriately take in those demands and implement those into portfolio management is definitely kind of changing the game.
Lynne Funk: (
Environmental, social and governance factors. With a growing interest in munis via ESG factors, how is this affecting portfolio management?
Peter O'Neill: (
I think that ESG in the muni market, which, you know, you mentioned is, is a topic du jour, is it still pretty undefined, right? I think it's still on, it's pretty much in its infant stage. There's still a lot of discussions. There's no real standardization, but I think it's a pretty easy fit because a lot of projects within the municipal bond market have benefits for the environment and for social aspects within the ESG world. Being able to use the muni market to get some of that exposure for clients makes a lot of sense, in my opinion. It's definitely something that our clients are coming to us in talking about and wanting to implement in their strategies for the clients that we have done some work in the ESG space.
(
Most of those portfolios are more of a hybrid model, where we don't go a hundred percent in ESG, but we definitely try to have some type of allocation there so that the client can at least feel as if we're moving in the right direction. I think as time goes on, I think it will play a bigger role. I was looking at some data recently and I think year to date, ESG issuance is up around 20%. It's definitely increasing, in terms of what issuers are bringing to market.
Blake Lynch: (
I think you summarize it really well. I think one of the things, when I was focused a little bit more on ESG is that there really was no uniform definition and whether ESG or impact investing all of these things have slightly different meaning. One of the things I think is particularly interesting is the S. Now that the SEC has come out and said, anybody issuing products with an ESG lens has to be very transparent about what their ESG strategy is. So I think as far as this affecting overall portfolio management, I think people now need to focus more on looking at what ESG criteria is, and what's important to them, but also figuring out how to put it into action. So I've spoken to some firms who take different sources for E S and G and what they end up doing is aggregating those all together and producing a score, but they want to see all of those individual metrics in their portfolio management decisions. So having some, some area where they can aggregate that together and look at it all at once, I think that that's a new, additional layer of analysis that's required on these muni portfolios, but again, to Peter's point muni's and ESG play very well together, just because a lot of these are funding, public improvement projects.
Peter O'Neill: (
And I'd also note that, you know, with the recent Inflation Reduction Act, you know, $370 billion is dedicated to energy security and climate change. And again, that puts really well in terms of the municipal bond market, whether or not it's, low income housing, you know, schools, universities on the social side. Bridges, water, sewer, on the environmental side.
Lynne Funk: (
So then one, you know, the question I have then is what are the challenges? Because if we do see so many people, so many folks in the industry, and outside of the industry saying that munis are a natural fit, you know, what challenges face are we facing here to, to either incorporate this? Is it just, is it just the lack of a standardization? What else is there?
Peter O'Neill: (
I would say that's the biggest challenge, right? It's clarity, in terms of what falls, the standardization of what falls, what is there, there's no real rubber stamp out there that is going to say this is an ESG bond. So I think once that comes into play, I think you'll see continued issuance, and then taking more of a forefront within the market. But again, even if you looked across the entire of the bond market, really, it's pretty subjective in terms of, investors and rating agencies are all going to have different opinions on what falls within that bucket. And I feel that you could really look at probably 80 to 90% of the issues in, in the MUN bond market and come up with a reason of why they fall into the ESG bucket. And so once we get some clarity around exactly what does qualify, will be the next step in terms of increasing, in terms of the amount it comes to market.
Blake Lynch: (
Yeah, I think, I think the only other piece of that is the education component. I think when it really comes down to it, investment managers spend a lot of time in the ESG space, and I think where we really need to focus some of the effort here is educating the individual investors well, to help them better understand what exactly they're getting invested in. And is it ESG, is it SRI or is it impact and how, how do those different strategies benefit the particular individual? Because obviously with ESG tends to be a little bit more flexible. On the equity side, you could have, you know, an oil and gas company in there because it ranks the highest of across its peers in the, as, or in the G space, for example. So, while S and G tend to be more exclusive, and excluding certain investments from that.
Lynne Funk: (
Okay. So change gears a little bit more can, and perhaps Blake, you could kick us off, you know, how can you talk about how, from your perception, how firms are maybe starting to aggregate data into maybe a single platform?
Blake Lynch: (
Yeah, I think it's really unique when working with different investment managers where they're getting their sources of data from, and, historically there's been a lot of silos in the investment management space. So what we're hearing more from investment managers, wealth managers, RIAs, and even home offices are trying to figure out a way to give a better solution for portfolio managers and that's having everything located within a single source. So when, when looking in the market today, it's important to find data aggregation platforms that can help you see everything in a simple workflow. This helps you get from portfolio construction from research's best ideas, put them into action and get them executed, in a much more seamless fashion than ever before. This is giving tremendous benefits to investment managers. They're accomplishing their workflows 150 times faster than they previously could.
Blake Lynch: (
And this is resulting in and better outcomes for their clients because you know, the bond that they liked, they know exactly where it fits within 20 seconds versus having to scan all your portfolios, figure out what the criteria is, and then try to put it into action. I think, um, by having all of compliance, investment guidelines, your targets, all of the individual customization you need, plus accessing live inventory and figuring out exactly where that fits that that workflow has just been enhanced so much in the past five years. And, um, I think that's really where data aggregation comes in and seeing your key inputs and putting them into action.
Peter O'Neill: (
Yeah, I would say that, you know, Blake, he nailed it in the sense of being able to, again, look across all the portfolios in the SMA space, see a bond in the market, that we think is attractive in being able to know that we can use this bond in these call it 10 or 15 accounts, the amount and how quick we're able to execute, um, and move and make sure that our clients get invested and best execution. It's been an absolute night and day in terms of where we were to where we are now.
Lynne Funk: (
What do you both say then to perhaps people, in the industry, folks who are worried about decreasing head count losing jobs because of technology and the fear of that in the industry, how do you both look at that from your seats?
Blake Lynch: (
Yeah. I mean, I've working at a technology company. I think there's definitely, we've run into this, this debate and fear quite a bit. But what we're seeing is that everyone's trying to scale their operations. They're not necessarily trying to reduce head count, but where we can really add the most value is helping portfolio managers and research personnel and traders be more efficient in their workflows. So if you, if you think back, think of a woodworker, for example, if you had a screwdriver and a screw and you were putting together a bunch of chairs, that's a pretty manual task, similar to municipal portfolio management, finding the right bond can take a very long time, but when given a drill or given a tool that helps on the allocation side of things, that's where technology can come in and say, Peter could only manage 200 portfolios now, but with a tool he could manage 400 portfolios. Basically what we're just trying to do is make people more efficient and help them accomplish their workflows quicker and give them back time in the day to really focus on adding alpha for their clients or speaking to clients more in general, to help win more business.
Blake Lynch: (
And I think that's really where technology is coming in and helping people in the space.
Peter O'Neill: (
I would say that the improved technology in the SMA space allows portfolio managers, research, traders, more time to focus on clients. The market, out there rather than having to go line by line and figure out, where this bond can go, we're able to do it and, and it just frees up our time. Right. And it's just a better use of our time if the technology allows us to allocate and to operate more efficiently. So I just think it's a shift in resources, right? I think you still need the same amount of people. I just think that what you're going to be able to, or what people are going to be able to do with their time, and for their clients, is only going to improve,
Lynne Funk: (
To shift gears a little bit here. Oh, sorry. Blake, go ahead.
Blake Lynch: (
Yeah. I was just going to say, at the end of the day, you need the portfolio manager in the seat running technology, because while there's a lot of talk about AI, it's really not, not the same as somebody who has X number of years in the industry who actually can build the customized rules and parameters into the platform that helps the technology with making those investment decisions.
Peter O'Neill: (
And I would also say one more thing with the muni market and, you know, one of the reasons why it's been sso slow to change, right? And so slow to have or incorporate this technology is because of the sheer amount of CUSIPs and issuers in the market. Right? You can't necessarily build that out, right. You can't go out in the market and say, buy me a GO bond, because if you look at an Illinois GO versus, you know, a Maryland GO, they're not the same thing. Right. So you still need that human factor, to be able to know the market, know the credits, and because of how the muni market is structured, and the sheer volume of different issuers out there, I don't feel that technology is going to completely eliminate the need for the human factor.
Blake Lynch: (
Completely agree.
Lynne Funk: (
Blake, can you talk about direct indexing perhaps? wWhat are your thoughts about direct indexing in the muni space?
Blake Lynch: (
Yeah, we're, we're hearing a lot of talk about direct indexing or custom indexing in the space. And, um, when you actually take a look at a, a bond index, I think that's when people start to go, oh, Hey, how do I actually do that with 14,000 different line items? Right. It, we do think it is a bit of a marketing term, but there's substantial growth to be had here. And with custom indexing specifically, what we're finding is a lot of people are taking this direct or custom indexing approach, whichever marketing term you'd like to use, but really just isolating characteristics. I recently read a report, by an associate, that highlighted assets and direct indexing. We're expected to grow at an annualized rate of 12% over the next five year, year-over-year, that's supposed to surpass a trillion in assets by 2025. So this is a huge growth story. And I think it's something that we're hearing quite a bit and people are trying to figure out what exactly does it mean and how do I put it into action and the most common way we're hearing it specifically in the muni space is by building characteristic based model portfolios tied to it.
Lynne Funk: (
Could you perhaps maybe talk a little bit about how best managers may be starting to bring assets in house versus outsourcing that data, excuse me, outsourcing that task?
Blake Lynch: (
Yeah, I'm happy to add here. Again, going back to the home office comments, I made a bit earlier on, I think people are starting to realize that they have internal resources that they can leverage to help meet the customization needs of those individual investors and advisors who roll up into home offices. So what we're seeing is a lot of those types of companies, whether it's a home office and RIA aggregator actually offer fixed income services in house. So that's enabling those home offices to bring more, keep more assets in house to actually manage those portfolios themselves. A lot of those teams already have trading teams and they already have people specializing in fixed income. So it was a really seamless transition for some of the firms that recently, we've started working with and it just enables greater customization and more assets in house,
Lynne Funk: (
Peter, anything to add there.
Peter O'Neill: (
At BofA we have other fixed income managers on the platform, but we've built out our internal capabilities at the private bank and on the Merrill Lynch side, and it's continued to be a big growth within the CIO office. I agree with Blake in the sense that it's definitely something we're focused on. It's definitely something that has been growing since I started here at the firm back in 2011, and I think it's going to continue to grow.
Lynne Funk: (
One of the things that I've been hearing from quite a few folks is really looking at these outflows from mutual funds this year. And the fact that some folks say there's no way to recoup that, right? There's no way to regain that. That mutual funds are going to see that the inflows back in. So I guess I'm curious just to broadly how, you know, how do SMAs kind of maybe fit in this, fit into that picture of, are they, is that where some of those mutual fund outflows, or is it a pivot into SMAs? Is that, is that what you two are seeing?
Peter O'Neill: (
I would say that the mutual fund outflows that we saw, you know, this year were more based on the volatility that we saw in the market, right. I don't necessarily feel that it was a shift in investment strategy from a mutual fund into an SMA account. I would say that investors that I work with have definitely seen the benefit of being in an SMA account. I feel that you know, on an asset allocation side, like I had mentioned before, or in-house capabilities continue to grow, here, where we're seeing a lot more in terms of flows, dedicated to our SMA platform, our internal platform, rather than them putting their clients into mutual funds going forward. And what we've seen really in, and that really has to do more with the overall asset allocation where, you know, they're bringing down equities and fixed income is finally attractive. Right. And so I think a lot of those flows that we're starting to see is, is people, rebalance portfolios are coming directly to our group in the SMA space.
Lynne Funk: (
The shift is exactly what you're suggesting. Now's like, what happens now, you know, is it a shifted to SMA? So Blake, do you have anything to add there?
Blake Lynch: (
I would just say that demographics plays a great part in this too. I mean, there was some volatility in the muni market and, Peter mentioned before some, some opportunities to improve quality and things of that nature. But, you know, with equity markets and fixed income markets being in a bull market for so long, and now finally, we get some volatility in the muni market. And now if you look at the highest tax bracket, some people are getting up to 6% taxable equivalent yield from muni investments. So now more than ever, the muni market looks great and looks really attractive for these baby boomers who are moving into retirement age and are really seeking both protection of principle and income from their investments. And everyone likes to avoid taxes when they can. So we combine all those three things together. I think it's kind of like a perfect storm to, for demand, even increase further in munis as we're entering kind of a questionable period, as far as potential recession, on the horizon, the historical default rates of munis definitely, lead to investment in environments like this. For sure.
Lynne Funk: (
Well, is there anything else that either of you would like to add before we, before we sign off here, any final closing thoughts on generally that you know, where, where you see, you know, Blake, you kind of just touched on it that thats the munis are perhaps on the rebound here, but anything else you both would like to add before we head out?
Peter O'Neill: (
I would just like to say that one, thank you so much. This has been great. Even though a majority of the volatility that we'll probably experience over the course of this year has already happened, I definitely think that you know 2020 was a real wake up call to investors. The value of having a full team, whether it's portfolio managers, credit analysts, and investing in the SMA space, really has its advantages. I think that there could still be some volatility over the course of this year, as we head into the third, the fourth quarter. But it's ever evolving. And when things are ever evolving, personal opinion is you want a lot of flexibility in your portfolio. You want to be nimble, and you don't want to be subject to other investors in a combining of funds.
Blake Lynch: (
Yeah, I would just agree. Thank you both for being here with me, I appreciate the opportunity, Lynne. I just wanted to say, as you're thinking about technology, if anyone out there is thinking about technology and wants to share some insights, please feel free to reach out, happy to share with kind of what I've been hearing from other people in the industry and check out imtc.com to learn a little bit more about what we're doing in the SMA space, but excited to see what happens throughout the rest of the year here.
Lynne Funk: (
Great. Thank you so much to you, both for joining today. Really appreciate it and thank you to all our viewers and listeners. Hope to see you all again soon. Thanks from The Bond Buyer and I hope to see you all soon, take care.
