The Future of ETFs
Barron’s gathered the ETF industry’s leaders to discuss what will drive growth, some needed changes, and how you should invest.
By Beverly Goodman
The exchange-traded-fund industry is much like Greek life on a college campus: It’s a bit rowdy and full of friendly competition, everyone speaks in letters as shorthand, and they all grew up together, in a sense. Put four industry leaders in a room and the ebullient trash-talking immediately begins.
But these four are some of the best minds in the fast-growing, yet also maturing, business. There’s $2.8 trillion in 2,000 ETFs in the U.S., according to research firm XTF, but those figures belie the extremely concentrated makeup of the industry. More than 80% of assets are held in just three firms—Vanguard, BlackRock and State Street (STT)—all of which are represented at this roundtable.
Joel Dickson is global head of investment research and development for Vanguard Group, which manages $4 trillion in assets, including $600 billion in 70 ETFs. Mark Wiedman is global head of iShares and Index Investments at BlackRock, which has $5 trillion in assets under management, $1 trillion of which is in its 334 or so iShares ETFs. Jim Ross is executive vice president of State Street Global Advisors and global head of SPDR ETFs. The $2.5 trillion firm is home to $450 billion in ETFs, including the oldest and largest, the $242 billion SPDR S&P 500 (ticker: SPY).
Tony Rochte is president of Fidelity Investments’ SelectCo, its sector investing unit. Prior to joining Fidelity in 2012, he had six-year stints at both State Street and iShares when it was owned by Barclays.
Fidelity, which manages $2.2 trillion, has $6 billion in its own ETFs, a relatively small figure, though impressive, given that it essentially began its ETF business just three years ago. Its brokerage arm has $270 billion in ETF assets under administration.
While traditional mutual funds still hold the lion’s share of fund assets, with $16.5 trillion, ETFs are coming on strong, with twice as much in assets as they held just four years ago. To learn what the future may hold, read on.
Barron’s: Let’s dispense with the topic absolutely no one here wants to discuss—the active-versus-passive debate.
Jim Ross: This is a pretty tired debate. ETFs are thrown in on the passive side, yet they’re used for active implementation by probably more than 50% of the people using them.
Tony Rochte: This debate doesn’t even exist if you talk to a professional. Financial advisors view themselves as architects using building blocks, index products alongside actively managed funds.
That’s how we think about it, as well.
Mark Wiedman: We reject even the idea of active versus passive. All portfolios are active. How you build that portfolio is an active decision. When people talk about active versus passive, they are really talking about price—high-cost versus low-cost funds.
Rochte: Price is critical, especially as advisors move to a fee-based model. According to Cerulli Associates, in 2004, 21% of the advisor market was 100% commission-only and 41% was fee-based.
At the end of 2015, only 3% of advisors had a purely commission business, and almost 80% were fee-based. It is not just individual investors looking for low-cost products; it is a change in the advisory business that’s really a tail wind for the growth of ETFs.
There has been a lot of talk about passive being a bubble or worse, while others, Barron’s included, have argued that the more money that goes into passive strategies, the more opportunity there will be for stockpickers.
Wiedman: That is dead right, but 25 years too early. Only one-sixth, or 16%, of the U.S. stock market is indexed. We are literally trillions away from an “over-indexed” world. We’ll know when we get there—when active managers on the whole produce neutral returns, net of fees.
Joel Dickson: I disagree a bit with that…
Wiedman: Game on.
Dickson: Yeah. The last few decades have seen a big shift into professional management among what were formerly retail investors. That changes things. If someone is going to have consistent stock-picking success, somebody else has to consistently lose. That used to be the retail investor. You can see this in the Federal Reserve’s flow of funds data over the past 45 years. We’ve gone from 20% of household assets under professional management to now more than 60%. And that’s probably understated. Outperformance is harder when everyone is a professional.
Wiedman: Actually, I agree with Joel. As the world has become much more institutionalized, competition has gotten much more intense. Trillions have flowed into all forms of institutional money management, and they are competing against each other in a zero-sum game.
Do advisors and retail investors use ETFs differently?
Rochte: Individual investors and advisors are both focused on asset allocation and unique exposures.
We looked at the 18 million brokerage accounts—just over 40% of our platform are retail investors and 57% are advisors—and found that the retail segment is growing faster, and it skews towards high-net-worth, sophisticated investors. The average holding period for equity ETFs is almost 20 months.
Dickson: At Vanguard, it is just under three years for ETFs; 3½ for mutual funds.
Wiedman: You actually let your investors sell?
Dickson: Every now and then.
Do investors have the right tools to evaluate exchange-traded funds?
Ross: I worry constantly about the number of ETFs and whether investors understand what’s in them, and how they will meet their goals. But the tools are available.
Wiedman: The market has spoken; clients have voted—almost 100% of the money going into ETFs is going to simple vehicles from established firms. There are thousands of ETFs, but investors have figured out how to find the good ones.
So your unbiased opinion is that because Vanguard, iShares, and State Street ETFs took in $243 billion, or 87% of all ETF inflows for 2016, that’s evidence that investors are well informed. OK. What don’t they know?
Dickson: That ETFs trade all the time is an overstated advantage. The market environment for an ETF is not just the value of the underlying securities; it’s also the premium and discount of the ETF itself. With a mutual fund, your trade won’t settle until 4 p.m., but you know you’re going to get the value of the underlying securities. ETFs are price-certain; you know what price you’re buying or selling them at, which could be different than the value of the underlying securities. Mutual funds are value-certain; you may not know what the price will be, but you’ll get the value of the stocks it holds—no more, no less. That’s the trade-off.
Wiedman: That’s like saying I’m going to close my eyes, and since I don’t get the price until 4 p.m. I’ll feel better. The advantage of the ETF is you know exactly the price you are getting. The concern is not the ETF; it’s the fragility of the U.S. equity markets. Dealers and investment banks are smaller, and they are not able to commit capital under stress. Institutions have to be careful about throwing orders into a yawning gap at the open or the close when volatility can strike. The ETF just makes naked the underlying pricing volatility that already exists.
What do you mean, the market is fragile?
Wiedman: Equity markets depend on market makers to price securities. Those market makers used to be well-known global banks, but since the financial crisis, those banks have faced regulations that make the cost of capital more expensive, and therefore market-making more expensive. While the daily market is still very liquid, during a stress event, like a macroeconomic shock, the ability of banks to step in has been greatly reduced. The markets today are effectively priced by small firms no one has ever heard of, and they are not equipped to operate in times of stress.
Dickson: The fragility is not the market-making community. Exchanges need to be modernized for the types of instruments people are now trading. The centralization is not there to get the imbalances appropriately dealt with. We as an industry have been trying to get the exchanges to think about that.
Yes, especially since Aug. 24, 2015, when high volatility caused prices for U.S. equity ETFs to fall much further than those of the stocks they owned. Market makers were flying blind—unable or unwilling to take the risk inherent in setting fair prices. There were nearly 1,300 separate five-minute trading halts in more than 400 stocks and ETFs, and a fifth of all ETFs fell more than 20%, while just 5% of individual stocks declined by that much. All of this happened after rules had been implemented in the wake of the 2010 flash crash. So what needs to happen now?
Ross: The exchanges don’t have consistent rules around opening trading in a stock. It’s not because they’re looking for a competitive advantage; it’s just how they’ve grown. All the firms here, along with many others in the industry, have formed a coalition to work with market makers, the exchanges, regulators, and others within the ETF ecosystem to harmonize some of these rules.
Dickson: There is a bit of a mismatch in terms of how trading reopens in a security that has been halted, so there can be unintended consequences on days of marketwide volatility. Historically, most rules around market structure have focused on preventing fallout from single-security events. We need to change that focus to how extreme events affect baskets of securities, like ETFs.
Wiedman: In times of severe stress, traders need harmonization and simple market protocols so they don’t need to think very hard about whether to buy or sell. That’s an important part of protecting U.S. equity markets and the ETFs that depend on it.
How can investors protect themselves?
Ross: There will, at times, be tons of volatility in the market—don’t trade at those times.
Wiedman: There’s another very simple rule for investors: Don’t use market orders. Use limit orders.
Market orders are filled at the going price; limit orders require investors to decide at what price they’re willing to buy or sell, limiting the risk of paying too much or selling too low. If limit orders are the best way to trade, why is the default option on almost every brokerage platform—including Fidelity’s and Vanguard’s—a market order?
Dickson: Some of this is just legacy practice. There is also a client-service and customer-risk element to the market/limit order debate. A market order says, “I want to purchase the security now, regardless of price.” If you don’t fill that request—even if it’s in the investor’s interest to put some price protection around the trade—you’re opening yourself up to a decent amount of liability in not having followed the customer’s orders. There are also client-servicing issues—what if the client is buying and selling at the same time, and one part of their trade goes through, but the other doesn’t? Now you’ve got a settlement problem.
Wiedman: The real story here is that ETFs work literally almost every second. They trade when the underlying markets are troubled or even closed. You can buy and sell Japanese equities right now, even though the markets in Japan are closed. That’s magic.
Ross: ETFs trade well virtually all the time. SPY has traded at less than a penny spread for 3,000 consecutive trading days.
Rochte: After 9/11, SPY was used as a price-discovery mechanism. The same was true for single-country ETFs as far back as the Asian contagion in the late 1990s.
How does an exchange-traded fund act as a mechanism for price discovery?
Ross: Regarding Sept. 11, a lot of stocks hadn’t begun trading when the market opened, but SPY was trading, using prices from the previous close for some stocks. As those stocks opened, the index value went to where the ETF was trading. When everything opened, it all converged.
Wiedman: People use ETFs in stressful markets to define the new price. It is where liquidity pools find new prices. One of the great examples of this was in the high-yield crunch in December 2015, when the best way to gauge the price of high yield bonds was to look at two different ETFs—HYG and some other ticker.
Those two ETFs accounted for more than half of all high-yield trading on one day, 25% for the month.
The ticker you conveniently forgot was HYG’s biggest competitor, JNK, the SPDR Bloomberg Barclays High Yield Bond.
Wiedman: That might be it. Those two gave clarity and transparency to pricing in high yield.
Dickson: ETFs reflect the underlying market; they don’t dictate them. That’s an important distinction.
Ross: Another important distinction is the transparency. That same December, there was a mutual fund [Third Avenue Focused Credit] that caused a lot of consternation because it couldn’t sell some of its holdings. An ETF wouldn’t have had the same problems because the ETF provider could do an in-kind exchange. Also, investors would have seen the holdings and the prices every day.
The ETF industry is remarkably concentrated in terms of assets and products. There are 2,000 ETFs, yet just 19 or 20 of them from your firms account for more than a third of all ETF assets. Can this domination continue? What happens to the dozens of firms and hundreds of ETFs that make up the rest of the market?
Wiedman: I’m trying to think of an answer that I can give in public. Jim, your reaction?
Ross: I’ll answer it. First of all, we’ve seen many dozens of new ETF sponsors in the last three to five years.
There are also ETF start-ups that have grown up, like WisdomTree, which is now the fifth largest ETF sponsor in the U.S. Can that continue? Yes. There is opportunity for new entrants. Also, the fastest-growing ETF markets are outside the U.S. The industry could get to $25 trillion by the end of 2025.
Rochte: That’s an aggressive number. We don’t have the manufacturing capability that the three gentlemen next to me do at their firms. But we have a big platform; our brokerage handles 11% of U.S. ETF business.
You’ve also launched 20 ETFs in the past few years—starting with 11 sector ETFs in 2013, three actively managed bond ETFs a year later, and six factor ETFs last fall—and now you have $6 billion in Fidelity ETFs.
Rochte: Over the past five years, only five firms have raised more than $1 billion in ETFs, according to Credit Suisse; Fidelity is one of them. More than 50 ETF players have less than $1 billion in assets.
We have a partnership with BlackRock for core passive ETFs; they do it very well. When it comes to manufacturing our own ETFs, we want to add expertise or real differentiation.
Wiedman: The barriers to entry are very low; barriers to success are much higher.
What are the barriers to success?
Wiedman: There’s not a crying need for new entrants to come in and compete with broad-market exchange-traded funds at rock-bottom prices. Instead, they are coming in with niche, higher-priced products.
Dickson: Four out of every five dollars in ETFs are in broad-market, capitalization-weighted funds.
That said, though the three of us have 82% of the market, we are the ones fiercely competing on price.
Wiedman: We have a brutally competitive, concentrated marketplace.
Dickson: True. But this concentration wasn’t BlackRock’s decision or Vanguard’s decision or State Street’s decision—it is a result of the independent decisions of millions of investors, choosing the products they think best meet their goals.
Rochte: New products must differentiate themselves. And distribution is critical.
Dickson: That’s true. You’ve got providers throwing spaghetti against the wall and hoping something sticks. If it does, it can be very profitable, but you are going to be a smaller player. New entrants with brand names and good distribution, like Fidelity, Schwab, or Pimco, can get assets early on.
Rochte: Consolidation among smaller firms will continue.
How does the industry grow?
Rochte: The next decade is not about new products. It’s about wrapping ETFs in an active strategy. That can be via a robo-advisor, or sophisticated ETF strategist, or firms that provide “paper portfolios” for advisors to implement.
Ross: I’m going to completely disagree with Tony, because I really enjoy doing that. It’s true that packaging ETFs is a growing business; we offer ETF managed portfolios, as does everyone else at this table. But the underlying growth is the ETF usage itself. We’ll see new products, especially in what everyone but me likes to call smart beta.
Nobody likes to call it that, but no one has come up with a better alternative.
Ross: I think all four of us agree with that.
Smart beta is a broad term for an index organized around an investing philosophy, rather than weighting stocks according to their market capitalization, as most ETFs do.
Rochte: Academic research has shown that four factors—quality, value, momentum, and volatility—perform very well over time. But they don’t perform well all of the time.
Ross: The challenge with smart beta, whether it is single factor or multi-factor, is that you have to stay the course.
Dickson: We now have upward of 30 low-volatility ETFs. How do you differentiate among them?
“Education” ends up being marketing from 30 different providers. So people look to performance as the indicator of the better product. That’s a real worry. It is just like traditional active management; there are long periods of underperformance. Not only do you have to stick with it; you have to rebalance to it.
Flows into smart-beta ETFs are down—nearly $70 billion went into smart-beta ETFs in both 2014 and 2015. Last year, it was less than $40 billion. That’s a big drop.
Ross: There is a bit of fatigue around smart beta. People don’t know how to evaluate them. I’m going to predict the future here, which is really a bad thing.
Wiedman: Go for it. Just don’t put a date on it.
Ross: I’ll put a date on it. In five years, there will be a headline in Barron’s saying that retail investors have underperformed using smart beta.
Dickson: They already have.
They have—and I think we’ve used that headline already.
Ross: You can reuse headlines. This gets back to due diligence. If you don’t have conviction in an ETF, don’t invest in it.
Rochte: There can be unintended consequences with factor investing. Look at the MSCI Momentum index in the last quarter of 2016; it was underweight financials. Financial stocks rose tremendously after the election in November. That’s why our factor ETFs are sector neutral.
What other areas are ripe for new products?
Wiedman: Most growth in the next five years will come from new clients, and deeper penetration with existing clients. But in terms of new products, fixed income is massively under-indexed. Investors think about just one major index, which skews heavily toward the countries and companies that issue the most debt. Bond indexes need to be reconsidered.
You’re referring to the Bloomberg Barclays U.S. Aggregate Bond Index, better known as the Agg?
Wiedman: Yes. Many active managers just buy whatever is not in the Agg, like emerging market bonds, in order to beat it.
Ross: We’re having an active/passive debate, if I’m hearing this right.
Wiedman: No, we’re talking about the decomposition of what really is beta return.
Ross: I agree 100% the Agg is not a great benchmark. Active managers have outperformed it on a routine basis in the past one, three, and five years.
Dickson: We can debate the merit of factor investing in stocks, but in fixed income there are clearly two factors that drive the market—rate and credit.
Wiedman: This is important, what Joel is getting at. The great active managers, including those at our firm, spend a lot of time thinking about how to manage rate and credit risk efficiently. What doesn’t yet exist in the fixed-income world is a careful analysis and decomposition of how much of an active manager’s return comes from simply riding those risks, versus security selection. In equities, that’s the whole game. In fixed income, that conversation hasn’t really begun. The Agg is the only frame of reference for many investors. We can do smarter indexing, either via indexes that capture more of the market, like IUSB, which includes emerging market debt, or indexes that target investor goals, such as higher income or shorter duration.
So a lot of ETF growth will come from fixed income?
Ross: Yes, especially as insurance companies continue to understand the fundamental changes going on in fixed income, they will look to ETFs.
Wiedman: Institutional managers of all kinds struggle to trade bonds cheaply. They have to pay a lot more today to trade fixed-income than they did before the financial crisis.
How will robo-advisors, which offer investors asset-allocation models at much lower prices than they’d pay a human advisor, change the ETF business?
Wiedman: Robo technology will change the world, but when we talk about robo-advisors, we’re mostly talking about stand-alone players that don’t have any friends. Online-only banks died, but online banking conquered. Robo technology, especially from the players at this table, could transform wealth management. ETFs will get sucked into that.
Dickson: The disruption of robos is not that they use ETFs; it’s in how investors get their portfolios. Robos lock people into an advisory relationship much earlier, and that money is usually fairly sticky.
Wiedman: The Silicon Valley robos are not going to be around long enough to enjoy that sticky money. Their cost of client acquisition is too high, as are the regulatory hurdles. Robos will change the way investors expect to be advised, and they are going to reset the price. But it’s the established wealth managers who will win. Joel, what’s the price on your service?
Dickson: It’s staggered, but it starts at 30 basis points [0.3%] and goes down, the more assets you have.
Wiedman: That’s the revolution.
Rochte: What industry hasn’t been disrupted by technology? Even the full-service broker/dealers are building digital advice models. Financial firms spent $19 billion on fintech last year. But whether it’s competition or “co-opetition” remains to be seen.