Will ETFs Survive Mass Customization?

Eduardo Repetto, the CIO of Avantis Investors and former co-CEO and co-CIO of Dimensional Fund Advisors, discussed factor investing, the valuation of speculative assets, and the future of packaged products, like exchange-traded funds and mutual funds, on Morningstar's The Long View podcast.

Given the growing appeal of highly individualized investment portfolios--and personalized solutions such as custom and direct indexing--Repetto offered his thoughts on the enduring benefits of ETFs. He also addressed the implications of recent trading frenzies and Avantis' unique take on factor investing.

Here are a few excerpts on ETFs and market efficiency from Repetto's conversation with Morningstar's Christine Benz and Jeff Ptak:

Will Custom and Direct Indexing Ever Beat Out ETFs?

Benz: Some are arguing that technology will usher out packaged products like ETFs and mutual funds in favor of personalized solutions, direct indexing, and custom indexing. What's your take on this possibility? Is it one you're preparing for or talking about as a firm?

Repetto: It's very interesting, because direct investments, or model delivery portfolios, or separate accounts provide a tool for investors who have particular needs. Imagine, for example, that you have a certain set of constraints that no one else has; you don't want to invest in specific kinds of companies because of some personal or family issue. If that's the case, and you want an ETF or a mutual fund, you probably won't find what you're looking for because of your personal considerations. A mutual fund or ETF is created with many people in mind; your particular considerations are probably not going to be included in that strategy.

A separate account or direct indexing probably allows you to maintain particular considerations in your investments. Now, it's true that costs have gone down dramatically, so people can have even fractional shares today. So, for a very low amount of money, you can have a fully diversified portfolio with a lot of names because you don't even have to buy a share--you can buy a fraction of a share. That development is also something that says, "Wow, holding individual securities is probably going to become big in the future."

Now, when you have an separately managed account or direct indexing, you don't have the tax advantages of an ETF. ETFs have big tax advantages, and an ETF is good to rebalance inside the ETF structure and shield shareholders from big capital gains distributions. You cannot do that when you hold individual securities. This is because whenever you want to rebalance the portfolio, you are selling that security and realizing the capital gains. ETFs provide benefits that you cannot find with an SMA or with individual securities in your portfolio. For certain investors, an SMA, a separate account, or holding individual securities is the right solution because they can't find a commingled strategy in an ETF that will deliver what they want.

On the other side, if your particular considerations are common constraints, you're probably better off with an ETF. You achieve lower fees, you have better taxation, and it's more efficient and better diversified. It just depends on what the investor wants.

ETFs are winning the battle when compared with mutual funds. Mutual funds are 1940 technology, whereas ETFs are very recent technology. The cash flows are revealing people's preferences. ETFs are growing; mutual funds are shrinking. And direct indexing is somewhere in between. It's growing. It has a lot of benefits, and it can help you customize your portfolio in a way an ETF cannot, but it doesn't have the tax advantages that an ETF has.

We have many offerings available. We have our mutual fund; we have SMAs; we have ETFs. We explain the advantages or disadvantages of each option so that people can decide based on their personal circumstances which structure is best for them.

Do Market Prices Really Reflect a Company's or an Asset's Prospects?

Ptak: On the Avantis website, you've stated: "We believe market prices represent an unbiased view of a company's prospects and risks and that paying lower prices for our share of future cash flows has the potential to produce outperformance versus a benchmark." Until relatively recently, we were seeing a frenzy in things like meme stocks, crypto, NFTs, SPACs, and other speculative assets. How do you reconcile that frenzied behavior with your above statement that market prices represent an unbiased view of a company's or an asset's prospects?

Repetto: That's a classic question. Are markets efficient or not? And what does it mean? How can it be that some assets are priced this way, and without rationale? Well, this is where behavioral finance meets rational markets. You price a company, applying a discount rate to the future cash flows of the company. And you say, well, something that is riskier should have a higher tax rate. However, it's also based on preference and that discount rate. If no one likes something, that discount rate will be higher, and the price will be lower. If everyone likes something, the price will be higher, and the discount rate will be lower. So, the discount rate itself contains a behavioral component. That's why we think about finance as a humanistic science. There is a behavioral aspect that affects prices--which is important.

How are these components connected? Well, the behavioral aspect might be persistent, or it might change. You can't say for certain if a price will move in a particular way. It might be there forever. There might be information beyond what we know. This is important, because when we're thinking about the price of a company, we're thinking about how the company is being priced, how the market decides on that price. If the market arrives at a price by considering a company's risks, opportunities, and those of the surrounding competitors, it affects investors' preferences.

You have to consider the preferences of the people investing in a company. Preferences of different kinds. You see environmental, social, and governance is becoming bigger and bigger, for example. This all factors into the price, but we cannot really predict if that price will go up or down tomorrow. What we can do, though, thanks to financial science, is say, at this price, this company has high or low long-term expected returns. But I emphasize long term.

And that's information that we use. We use that price, together with a lot of fundamentals, to determine if a company is attractive from a long-term expected-return point of view. That's how we reconcile and use that information. We recognize the behavioral aspects that push prices up and down.

You mentioned SPACs, for example. Well, at the given price, buying those SPACs is certainly not a good long-term investment. We cannot tell you when the correction will happen (in this case we can after the fact), but, if we're going to deploy money thinking long term, that's probably not the right place to put it.

This article was adapted from an interview that aired on Morningstar's The Long View podcast. Listen to the full episode.