The Active Role of Passive ETFs

Jason Stipp: I'm Jason Stipp from Morningstar, reporting from the first annual ETF Invest Conference in Chicago.

What's next for the ETF industry?

Here with me to offer his take is Matt Hougan. He is editor of IndexUniverse.

Thanks for joining me, Matt.

Matt Hougan: Glad to be here.

Stipp: Several things I want to talk to you about, pick your brain a little bit. I know you're very closely watching, and write about, the ETF industry.

ETFs have held up pretty well as some other managed products, certain kinds of mutual funds have seen assets flow out of them since the market crisis.

We're continuing to see lots of interest ETFs, new ETF products, new ETF players. Where do you see the growth of the ETF industry right now? Is it reaching a maturity or is it still ramping up?

Hougan: No, it's still ramping up. I think you're seeing a sort of fundamental change in the way investors approach the market. From one focused on stock-picking, to one focused on tactical and strategic asset allocation, where they're using beta products or beta-plus products in an ETF wrapper to generate alpha themselves individually as supposed through individual securities selection. And I think that process is just in the second or third or fourth inning. It's still getting going. I think it's a major shift.

Stipp: So, really what we're seeing is, although these are in and of themselves are often passive investments, managers are actively using them in different combinations to be an actively managed investment product?

Hougan: Absolutely. The idea that indexing is on the rise, classic, passive Bogle-style indexing, I'm not so sure I agree with that. The idea that index-based investments used in the active ways, as you described, that's absolutely what's going on.

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Stipp: So, I wanted to ask you about that, speaking of active management, because we have seen that some money has left actively managed mutual funds and gone into, in some cases, index funds or passively managed funds. But yet at the same time we're seeing some new filings for active ETFs. So that seems to be the next big thing in the horizon, is actually within an ETF an active management.

Is this what investors want? Do they want an actively managed ETF or do they want that tool kit and they'll actively manage themselves?

Hougan: I don't know. I mean, it was pretty clear at the conference earlier today, I think it was Ben Fulton who said he's not getting phone calls with people clamoring for active ETFs. I think a lot of those filings that you're seeing are actually placeholders. They are companies like Janus or T. Rowe who may want to get into the ETF space at some point, want to stake their flag in the ground there, but might not necessarily launch that.

I don't really thing the ETF wrapper lends itself to active managers particularly well. I think most active funds are sold and not bought, and I have my doubts if that will become a major part of the industry going forward.

Stipp: So, active ETF just one of any kind of ETFs that's releasing. We do see filings for new ETFs continue to come in. What's your take on the kinds of the ETFs you're seeing now? Obviously, we've seen a lot of the ETFs covering the major market indexes. I know that you had written on IndexUniverse recently about a questionable filing for a smartphone ETF. Is it starting to get a little ridiculous in some ways?

Hougan: It seems to go in waves of ridiculousness, right. We had the HealthShares, which opened, covering dermatology and those closed, and you could see that coming a mile away. Now we have filings for smartphone ETFs. There are a lot of ETFs that don't make sense, where you actually can't create an intelligent portfolio.

That's all noise. But there are good ETFs hitting the market, good new ETFs. ETFs in alternative asset categories, smarter commodities exposure, VIX exposure, things investors and advisors really want, which they haven't had previously. But that's not to say that every filing is a good one. There is a bunch of junk out there.

Stipp: Sure. And you mentioned in part of your answer there about some funds that you saw closed, that you could see them needing to close at some point. When should an ETF close, there are lot of ETFs that are still out there that maybe haven't garnered that many assets. Should these still be there? And I know you've written about this as well.

Hougan: It's a controversial point. Yes, I get a lot of grief about this one, but my position is, I want ETFs to deliver a good experience to investors. I want anyone who buys an ETF to get the returns they expect in a package that is efficient and low-cost and does its job.

The problem with these tiny ETFs that linger on the market, what I call "zombie funds" is, they trade at very wide spreads. Maybe they have trouble tracking the index, because they don't have enough assets to accurately replicate that index. And as a result the investor gets a bad experience.

So, if you've had a fund that's been on the market for two or three years, still has less than $10 million in assets, trades at wide spreads, it might be better for everyone if that fund collapses, particularly if it's not first in its category. If it's the only fund in its category, maybe that day will come, maybe the Greece fund will become hugely popular, but if it's a "me too" product, we really just don't them.

Stipp: So, last question for you and this has a little bit to do about the number of ETFs that we've seen as well and what it means for fund companies and the profits that fund companies make. In a lot of cases, we have new providers coming on and they are offering products that are similar to other ETFs that are out there and so really the big differentiator is the price, the expense ratio, and we've seen some fund companies also offer no transaction fees in some cases on some platforms.

From a competitive standpoint, are these going to end up being profitable for fund companies if they get the kind of traction that they want or are they going to try to get money from them some other way?

Hougan: Right, it's a how low can you go question, right? I think there are two ways. A couple of ways you can make money on an ETF. Schwab launching six basis points ETFs, they are not making any money on those. You know that and I know that. They are bringing people into the Schwab family and hoping they open money market accounts and hoping they do other trading and making money that way.

The other way these companies make money is on securities lending. That's the dirty little secret in the ETF industry. A company like iShares makes as much money from lending securities from those portfolios as it does from charging expenses. So, I think you'll eventually see a zero expense ratio ETF that makes all of its money from securities lending. That's a huge, profitable market. Often the fund companies take the revenues out of that. So, don't just look at the expense ratio. You know those guys running the fund companies are smart. They will figure out a way to make a buck.

Stipp: Well, very interesting insights. Thanks so much for being here with us today and answering the questions.

Hougan: Anytime.

Stipp: From Morningstar I am Jason Stipp. Thanks for watching.