Principal’s Kim On Building An ETF Lineup

IMN and Ritholtz Wealth Management’s Evidence-Based Investing Conference (West) is June 25-27 in Dana Point, California. Paul Kim, Principal Global Investors’ head of ETF strategy, will be on one of the first panels of the conference. Here, he discusses his upcoming panel and his firm’s approach to the ETF space.

ETF.com: You’re on one of the earliest panels at the conference, The Launchpad: Exploring New ETFs. What are you planning to talk about?

Kim: I thought it would be a great chance to talk about, obviously, [the recent launch] of the Principal Active Global Dividend Income ETF (GDVD), and our launch of the Principal U.S. Small Cap Index ETF (PSC) in late 2016, to discuss how active managers are generally taking the approach of either offering smart beta and/or active.

Obviously, they can't compete with the Schwabs and Vanguards, so how do active managers who are new entrants in an increasingly crowded field of 80-ish ETF providers stand out?

I’m planning to cite GDVD and PSC as examples of ETFs where we found ways to scale up.

PSC, for smart-beta funds, is doing exactly what we had hoped, which is beat the market-cap-weighted competitors, such as IWM [iShares Russell 2000 ETF] and IJR [iShares Core S&P Small Cap ETF], by a lot since inception. GDVD is doing the same.

But Stephen Clarke of NextShares is on the same panel, so he might ask why GDVD is a disclosed ETF. Why did we get comfortable disclosing that rather than trying to push it into a NextShares vehicle, since we were a consortium member?

I’d like to talk about the pros and cons of using an established vehicle versus one that’s starting to get traction and has the benefit of not having to disclose its holdings on a daily basis.

ETF.com: What is your take on that?

Kim: In terms of the advantages, in many cases, portfolio managers have a black or white view on whether they're willing to disclose or not. And if they're in the camp that they don’t want to disclose, it’s not a pros and con.

There’s one path forward, which would really be one of the now-increasingly different approaches to nontransparent ETFs that are proposed or the version that’s already approved. That’s the only route you have, if they're clearly in the camp of not disclosing.

What are the two major concerns of disclosure? One is front-running. You don’t want to get somebody to decrease your alpha potential by trading ahead of you, or moving the market before you start trading so that you get a worse execution.

And the other is more of a business concern. It’s called “free riding.” Basically, you spent all this time researching and coming up with a great portfolio or company, and somebody, the very next day, gets the same position. Guess what: They're going to capture 99.9% of the move alongside of you, even though you’ve spent the millions of dollars on your investment cases.

In GDVD, we were not as concerned about the front-running. It’s a very liquid asset class and a very liquid part of the equity world. These are generally the larger-cap, high-quality names. Plus, it’s a buy-and-hold, long-term, low-turnover strategy.

In that case, whether someone waits three months and disclosed in a report or disclosed on a daily basis, once you're in it, it doesn’t really matter for us.

ETF.com: Principal is known as an active shop overall, and your biggest ETFs are actively managed. How does active management fit in with the conference’s evidence-based theme?

Kim: It’s right down the fairway. Why do I say that? There's invest-by-your-gut or “I like this company” or “I read the prospectus” or “I met the management.” That’s all increasingly rare in this world, and that approach is not very prevalent across Principal.

The more common approach looks at screens, using qualitative or quantitative filters to get to an investable universe, and then fundamental research thereafter. You have a lot more scenario analysis, a lot more amazing analytics these days.

You can have views on the macro factors of your portfolio. Is it too much in growth and not enough in value? Is it high quality? Whatever factor tilt you have, today’s technology and computing power allows you to be able to look through to that.

I would say from a capabilities perspective, active managers are definitely using more evidence-based investing. It’s basically saying, “Let’s think about risk management. Let’s think about understanding how a portfolio is positioned. Let’s understand what explicit risks we’re taking. Where are we compared to the benchmark? Under what scenario would this portfolio perform well? Under what scenario will it not?”

That’s basically evidence-based. You're looking at probabilities. You're looking at a statistical approach to diversifying your portfolio and understanding what's in the final product. Fixed-income managers have been doing that for a long time.

They’ve thought about factors, but they just call it different things. Duration or interest rate risk is a factor. Credit risk is a factor. All these factors are how they look at the overall portfolio.

Equity managers have now caught up, where they can say, “I’m now overweight value and underweight quality.”

Certainly, our portfolio managers are already at that stage and thinking about building diversified, very robust portfolios, with factors in mind. That’s really why we can both provide active strategies—which take advantage of all those tools—and smart-beta strategies. We’re very proficient, and have been doing that for almost 20 years.

ETF.com: Principal offers a lot of variety in its ETFs given that there’s only seven of them. There’s active, there’s smart beta and there’s thematic. How do you develop your ETF ideas?

Kim: We do have a destination in mind, i.e., we’re going to build a broad set of smart-beta strategies that could be used to allocate across domestic and international equities. We have a few of the pieces launched, and we should have more coming down the road.

We’re also, at our core, an active shop. So where various investment teams want to be in the ETF world and are willing to disclose, we’re opportunistically offering those strategies.

And then third, if you played a long game of getting to a destination, a lot of it is just sequencing around seeding. So when someone is interested in a particular product idea that you had hoped to launch in the next two to three years, that gets pulled up to the front and that comes out.

ETF.com: How do you decide whether a strategy’s going to be packaged as an index-based ETF or as an active ETF?

Kim: That’s a multipart question. Do you have an existing strategy in that space? Do you want to disclose a window into that strategy? That’s part of it—your willingness to be transparent and active. Or do you take your thinking and put it into an index instead, and get maybe 60-80% of that upside? There are pros and cons.

Cost becomes a factor. If you look at the competitive world and the margin looks reasonable, and you could come out with an active strategy, great. If you can't, and the fees are low for that exposure, you're probably more likely to come up with a passive strategy that’s at a slight premium. You don’t want to go too far above, so cost is a factor.

In our smart-beta lineup, we’re trying to check the boxes in different sorts of exposures, so that even where we may eventually offer an active strategy, we’ll still try to complete a smart-beta lineup.

Last but not least is the critical seed process—can you identify some seed investors? Do they have a preference for an active product? Or are they, by preference or guidelines, going to want an indexed approach?

We’re not an active or passive shop, we’re an active and passive shop. We manage nearly $50 billion in passive strategies, mostly in our mutual funds and separate accounts. For us, this is not that big of an evolution. We’re just adding a vehicle to the lineup, basically.

ETF.com: The last two ETFs Principal launched had seed money. How important is the seeding issue when you're developing and launching an ETF?

Kim: Whenever you can get greater assets into an ETF, the more readily you can get it onto distribution platforms, the more readily you can market it to advisors and larger investors who don’t want to own a significant portion of an ETF.

Scale is beneficial. It really accelerates the growth trajectory of an ETF to have sufficient scale. If you don’t, it’ll take longer, but a great ETF idea will grow. If you deliver what you want to deliver—and claim to deliver—chances are you're going to attract flows. But it just may take a lot longer for that message and awareness of that ETF to become meaningful.

Once you get onto platforms, that helps accelerate the growth even faster. It’s a pre-platform scale versus a post-platform scale these days. It certainly helps you get on platforms faster to have assets under management, though that is not the only thing, obviously. You need trading volume. You need some performance. And you need to be able to tell your story.

But again, it all starts with qualifying to be placed on distribution platforms.