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By Ben Johnson, CFA and Jeremy Glaser | 12-07-2016 02:00 PM

Year in ETFs: Big Flows, Lower Fees, More Niche Funds

Morningstar's Ben Johnson looks back at asset growth this year, the 'fee war,' and the increasing complexity and low usefulness of many new products.

Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. As 2016 comes to a close, I'm here with Ben Johnson, he is our director of global ETF research, to look at the year in review for ETFs.

Ben, thanks for joining me.

Ben Johnson: Glad to be here, Jeremy.

Glaser: Let's start by just looking at the numbers of how the ETF industry has grown over the last year. Has its growth really continued apace?

Johnson: The growth of the ETF industry has continued apace. So, as of the end of November, what we saw is that in U.S.-listed exchange-traded products there were in aggregate nearly $2.5 trillion worth of investors' money invested there. That represents about 16% growth relative to the end of 2015, and that figure has nearly doubled over the course of the past five years. And that growth has really been organic in nature, it's important to note. It's been driven by net new flows. So, as of the end of November, what we had seen for the year-to-date in 2016 was $224 billion worth of net new inflows into U.S.-listed exchange-traded products, and that's on pace to be an all-time record by the time we close the books on 2016.

Glaser: If there's been these big flows into ETFs, where are those investor dollars going? Is it just to a handful of funds, or is it more broadly distributed?

Johnson: Well, if you rank order the current roster of 1,950-plus ETFs by their assets under management, what you see is that the top 100 of those ETFs account for nearly three quarters of all of the $2.5 trillion, nearly, worth of assets under management. They've also accounted this year for nearly three quarters of all flows.

Now, if you get a big more granular in that analysis, what we've seen this year is of the $224 billion that's flowed into ETFs as of the end of November, 90% of that $224 billion in net new money coming into ETFs has gone into ETFs with a fee of 25 basis points, that's 0.25%, or less. What we've also seen is that two thirds of those flows have gone into ETFs that are Morningstar Medalists, so that have been recently awarded a Morningstar Analyst Rating of either Gold, Silver, or Bronze.

So, what these figures tell us is that in aggregate, investors in ETFs are keeping it simple. They are keeping it cheap. They are allocating their hard-earned money to ETFs that offer exposure to broadly diversified indexes that are available at a very low price.

Glaser: Some good news there. What other positives have there been in the industry over the last year?

Johnson: What we've seen in 2016 was actually a continuation of a trend we've seen over the course of the past number of years which is another sort of front, another flare up in what's been referred as an ETF fee war.

So, earlier this year, we saw Fidelity actually of all firms, slash fees across its range of index funds as well as ETFs. Fidelity has refreshed, rebranded, and repriced what was once its Spartan index fund lineup, which now features a number of funds that are actually priced below competitive offerings from Vanguard. Subsequently, what we saw in October is that BlackRock iShares cut fees across a number of its iShares Core ETFs. Just days later, Charles Schwab cut fees to the point where they were in every case 1 basis point lower on those competitive offerings that had just seen their fees reduced at the level of BlackRock iShares. So, there's this almost leapfrogging that has been going on with respect to certain core portfolio building blocks, uber-low cost and near-free beta on offer from these providers.

Glaser: We've seen these moves, but you don't necessarily think that it's a huge difference for most investors, who aren't going to see a big change.

Johnson: No. So, if you think of every 1 basis point differential in fees, so every 0.01% that you might be able to save in fees, if you look at that and assume a $10,000 investment, that's going to save you a $1 in any given calendar year with respect to your fees. You could certainly unlock a lot more sort of embedded costs, tax costs in particular if you were to consider in a taxable account switching from one ETF to another. So, it's certainly not something that's advisable.

So, while every basis point matters, while cost matters, these 1 basis point fee differentials are going to do, I think, more to move the needle from the ETF sponsors from the point of view of brand recognition, perception of marketing than they will necessarily impact investors' bottom lines.

Glaser: You think 2016 is also notable for what hasn't happened and that's a big trading dislocation with ETFs.

Johnson: Absolutely. So, if you'll recall, on Aug. 24 of 2015 what we saw was another incidence of what has been widely referred to as a Flash Crash, but more specifically is a breakdown in the mechanics of ETF trading, of ETF pricing, which reversed itself, I should stress, in fairly short order, has known root causes. Many of those root causes have subsequently been addressed in a very meaningful way. What we saw or did not see in 2016 was a recurrence of any such breakdown in the underlying mechanics of ETF trading, of ETF pricing, even in the face of what were some very noticeable, very meaningful geopolitical events, be it Brexit in the U.K., be it the outcome of the U.S. presidential election. What we saw throughout 2016 is that ETFs generally traded quite well. We didn't see any sort of relapse, any sort of recurrence of the type of event that we saw on Aug. 24. of 2015.

Glaser: Let's turn to the negative side of the ledger. What didn't work so well in the ETF industry this year?

Johnson: So, I think if you look at what continues to take place with respect to product development, so in 2016 what we saw or what we've seen to-date is that there have been 223 new ETFs brought to the marketplace. That ranks fourth among all calendar years going back to 1993, and what you see amongst those 223 ETFs is that the average sort of level of usefulness at the margin is very low. What we're seeing is increasingly niche, increasingly complex, increasingly high-priced offerings being brought to market.

As I mentioned before, investors generally speaking aren't taking the bait given that most of the new money coming into ETFs is going into very low cost, very broadly diversified funds. But certainly, there are these sirens out there on the rock, be it the obesity ETF or the whisky ETF or there is now an ETF that brings sort of factor investing into the context of water-related stocks. There are all these newfangled and in some cases, very niche, very gimmicky ideas that don't have any real usefulness for your average investor.

Glaser: This adds a lot of complexity. Is there anything happening to try to reduce it, or is it just a more confusing landscape for investors?

Johnson: Well, I think what you also see on the other hand of the ledger is that 2016 was a record year for ETF closures. So, we've seen 114 exchange-traded products that have been shuttered to-date. I would expect that as time goes on that number will only continue to grow as a lot of sort of the spaghetti that providers have been slinging against the wall in recent years ultimately fails to stick.

Glaser: Then let's look maybe into future if you have record openings or close to record openings but also record closures, what's next? What do you see happening in 2017?

Johnson: Well, I think, at a very high level in 2017 and beyond is that you'll see the continuation of the trend that developed long before 2016, which is, a migration toward very broadly diversified, very low-cost core portfolio building blocks. I would expect that that top 100 ETFs, the Morningstar medalists, however you want to define this cohort of funds, is going to continue to retain the vast majority of ETF assets, is going to continue to see the majority of net new inflows.

What I think you'll begin to see accelerated on the margin is demand for solutions, of one form or another, to repackage those into a diversified asset allocation. So, we see this today in the form of ETF managed portfolios many of which are being brought to market by the ETF sponsors themselves. So, the likes of BlackRock, Vanguard, State Street, and Schwab are taking their ETFs and they are building a diverse range of either strategic asset allocation portfolios or outcome-oriented portfolios that target a certain level of risk or a certain level of income.

So, for every DIY investor out there who is perfectly able and willing to build their own portfolio using these individual funds, there are also a huge number of DIFM or do-it-for-me investors that are looking for someone else to do the heavy lifting in building that portfolio. So, it could take the shape of an ETF managed portfolio. It could take the shape of an ETF-of-ETFs, so an ETF fund-of-funds. It could take the shape of delivery through a digital-advice solution, what we see going on with the robo-advisors, many of whom had previously been independent and have recently been acquired by some of the ETF sponsors themselves. So, case in point being BlackRock, who acquired a robo-advice shop called FutureAdvisor, is just another sort of arrow in their quiver that they are going to try to use to build solutions on behalf of their end clients, of their end investors using their building blocks oftentimes exclusively.

Glaser: Ben, thanks for the review of the year.

Johnson: Glad to be here, Jeremy.

Glaser: For Morningstar, I'm Jeremy Glaser. Thanks for watching.

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