2020: The Year in ETFs

Susan Dziubinski: Hi, I'm Susan Dziubinski with Morningstar. 2020 was a challenging year for investors. Joining me today to talk about the top ETF stories for the year is Ben Johnson. Ben is Morningstar's director of global research.

Hi, Ben. Thank you for being here today.

Ben Johnson: Thanks for having me, Susan.

Dziubinski: Let's kick things off by talking a little bit about flows to ETFs in 2020. How did they shape up?

Johnson: What we saw were tremendous flows into ETFs, into fixed-income ETFs, in particular. I would say that 2020 was a banner year for bond ETFs. We saw record flows in part stimulated by the fact that the U.S. Fed stepped in and backstopped the bond market in the early part of the year. And as part of their program to do so, they acquired ETFs for the first time, used the ETFs as an efficient tool to break in, in this case, investment-grade and sub-investment-grade corporate bonds, by buying some of the ETFs that invest in those corners of the marketplace, and effectively support that segment of the market and ultimately the market more broadly. And what we saw is that after the Fed made the announcement that they were going to do so, before buying a single share of a single bond ETF, the market responded, and flows followed. And we saw absolutely tremendous record-breaking inflows into bond ETFs of all types and not just corporate bond ETFs.

Dziubinski: Let's talk a little bit about the performance of ETFs in 2020, particularly during the bear market that we saw in the first half of the year.

Johnson: What we saw with performance in the ETF universe really followed the performance of whatever the underlying was. I think it's important to remember that ETFs themselves are just a wrapper. They're just an investment vehicle, and they're an investment vehicle that offers investors very cost- and very tax-efficient exposure to a wide array of different corners of the market and different investment strategies from active, to passive, to in between. You can get access to gold. You can get access to emerging-markets small caps. So, ultimately, where markets went, ETFs followed. And what we saw this year, just given the market environment, is that they went all over the map.

Now, during the course of the COVID-induced drawdown, what we saw is that equity ETFs tended to get beaten up pretty badly. Fixed-income ETFs held up relatively well. Gold ETFs, in particular, saw a tremendous amount of interest, much as they did coming out of the global financial crisis when investors were first worried that the world as we knew it was coming to an end. And then, subsequently, we're looking to gold as a potential inflation hedge, given all of the various measures that the Fed in the U.S. and other banks around the world had to take to step in and to backstop markets to keep things afloat.

Dziubinski: Now, you suggested that we've reached a tipping point in the balance between mutual funds and ETFs. How so?

Johnson: Well, the evidence is clear, and it's clear in flows this year, in particular, where we've seen hundreds of billions of dollars flowing into ETFs and hundreds of billions of dollars coming out of mutual funds. And I think investors increasingly are coming to the realization, as I described before, that ETFs aren't synonymous with any one thing in particular. They're not synonymous with indexing. They are merely a more efficient means of getting exposure to different corners of the market, different investment strategies. And I think if you look at what we've experienced over recent years, years of persistent, in some cases, very sizable taxable capital gains distributions from open-ended mutual funds, it's really put the relative tax efficiency of the ETF wrapper into ever greater, ever sharper focus. I would say that a wider array of investors are coming to this recognition, beginning to use ETFs in their portfolio or using them in greater proportion to other investment vehicles within their portfolio.

The other key point that we saw this year was a tipping point of sorts away from mutual funds, again, as a distribution vehicle, as a way of consuming strategies as reflected in the launch of new actively managed, non-transparent ETFs from the likes of American Century, Fidelity, and T. Rowe Price, who have taken some of their flagship strategies and are putting them now on a new chassis, bringing them to market in a format that is more readily accessible, more fee efficient, and more tax-efficient than their open-ended mutual funds. We've recently heard the announcement of a number of asset managers, including Dimensional Fund Advisors, converting existing mutual funds to an ETF. In particular, Dimensional is looking to change six of its tax-managed mutual funds into ETFs in 2021. These are, in some cases, funds that have been spitting out taxable capital gains to their investors who are clearly tax-sensitive if they are investing in tax-managed strategies. The ETF is ultimately going to help shield them from having similar adverse experiences in the future.

I think we're going to continue to see more and more assets re-platformed off of mutual funds and onto ETFs. And not just ETFs, I would argue. I would say the asset management industry and investors over the years have been moving away from mutual funds, not just toward ETFs in a taxable setting, but we've seen a similar trend away from mutual funds to things like collective investment trusts in the retirement space. These are just newer formats, more investor-friendly formats, largely because they are less costly than their mutual fund predecessors. ETFs are just one of the beneficiaries of what we've seen, which has been large and persistent outflows from mutual funds.

Dziubinski: Well, Ben, thank you so much for your perspective on 2020. And Happy New Year to you.

Johnson: Thanks. And Happy New Year to you, too, Susan.

Dziubinski: I'm Susan Dziubinski for Morningstar. Thanks for tuning in.