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By Ben Johnson, CFA and Karen Wallace | 06-28-2017 01:00 PM

News From ETF Land: Record Flows and Quincy Jones

Ben Johnson says we've seen nearly $100 billion of new money invested in ETFs so far this year, and he urges a focus on true investor-centric innovation.

Karen Wallace: For Morningstar, I'm Karen Wallace. Here to discuss a few recent trends in the ETF universe is Ben Johnson. He is director of global ETF research for Morningstar.

Ben, thanks so much for being here.

Ben Johnson: Thanks for having me, Karen.

Wallace: So, first, let's talk a little bit about some fund flow news into ETFs. What's been going on there?

Johnson: ETFs are off to a record start to the year. So, we've seen nearly $100 billion of new money invested in ETFs through the first five months of 2017. And what we've seen is that flows have been going in one of two directions--generally in. And what's in this year through the end of May is stocks from somewhere other than the United States of America. So, collectively, if you look at flows into ETFs in the Morningstar U.S. foreign large-blend category and the diversified emerging-markets categories, what you've seen across those two categories is that collective $51 billion in net new flows through the first five months of the year. So, investors are pouring more and more of their money into stocks from regions outside of the United States.

Meanwhile, they are still showing U.S. stocks some love. So, what we've seen simultaneously is, about $27 billion of net new flows into ETFs in the U.S. large-blend category, so those are ETFs like the SPDR S&P 500 ETF, SPY, which is the largest S&P 500 Index ETF. So, on a relative basis, allocating more toward overseas stocks that from a valuation perspective look relatively cheap, pairing back somewhat on U.S. stocks, though still adding to their positions, looking relatively rich here at stateside versus market outside the states.

Wallace: I also wanted to touch on another subject and that's as investment in passive vehicles is growing, if that's sort of a concern from a valuation standpoint or just from a market standpoint that there's so much passive ownership of assets.

Johnson: ETFs are not in the driver's seat with respect to valuations, with respect to price discovery. There was a recent research piece from Goldman Sachs that showed that ETFs now own about 6% of the overall market capitalization of the U.S. equity markets. So, the tail is by no means wagging the dog. The growth in ETF, in my opinion, is by no means affecting price discovery in the markets at large because they represent an ever smaller portion still of actual trading in those stocks, and that's where price discovery actually takes place.

Now, that's not to say that one day many years from now, if ETFs and index mutual funds grow to represent an even larger portion of the overall markets, that there might not be some issues. But until such a day where markets become so inefficient that there are $100 bills lying just unattended on the ground for active managers to pick up and pocket, and we see no evidence of that yet, and if you are going to look for evidence, you can look in our own Active/Passive Barometer report. And what we see there is that active managers are having as difficult a time as ever adding value relative to their benchmarks.

So, I will unofficially sound the all clear for the time being, but urge that investors keep a close eye on this, because it could come that one day, when ETFs and index mutual funds on a much larger portion of the market than they do today, that $100 bills will be plastering sidewalks.

Wallace: OK. Well, we'll look forward to that. Switching gears a little bit, there was some filing recently about the Quincy Jones ETF. What is that, Ben?

Johnson: I don't know how to react anymore, to be quite honest. And we've long since gone from a point within ETF land, and product development in particular, that's crossed the border between true investor-centric innovation and just product proliferation. So, the fact that there has been a filing now for a Quincy Jones ETF tells me that we're way beyond that border, and that all of the useful innovations, the useful mousetraps that could be brought to bear for investors have long since been covered off. They've been on the market for some time; their fees have come down over time; their trading volumes and assets have grown with time. And what you see if you size up the marketplace now, there are in excess of 2,000 exchange-traded products on the menu. The 100 largest have about three quarters of the assets. They've gotten about three quarters of the flows over the past three years. They are uniformly broadly diversified, dirt cheap. They are basic core portfolio building blocks that are very useful for a wide spectrum of investors. Focus your time, attention, allocate your money in the direction of those funds, and if nothing else, get a chuckle out of the Quincy Jones ETFs that are in the works.

Wallace: Thanks so much for being here to share your perspectives.

Johnson: Thanks for having me.

Wallace: For Morningstar, I'm Karen Wallace. Thanks for watching.

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