Investors Stay With Vanilla Amid Tremendous ETF Flows in '17

Christine Benz: Hi, I'm Christine Benz from Morningstar.com. Exchange traded funds surpassed previous asset gathering efforts in 2017. Joining me to discuss this and other trends in ETFs in 2017 is Ben Johnson, he's director of global ETF research for Morningstar.

Ben, thank you so much for being here.

Ben Johnson: Thanks for having me, Christine.

Benz: Ben, asset flows are really the headline. I know it's something that you monitor closely. You mentioned that on both an absolute and new money level ETFs have seen just some tremendous growth in 2017.

Johnson: That's exactly right, Christine, and I think if we weren't talking about tax reform or cryptocurrencies, we might say that 2017 was the year of the ETF. What we've seen through this point in December is nearly $459 billion of net new flows into U.S. exchange traded funds. Now that absolutely smashes the last annual record, which was set just last year. In 2016, what we saw was $285 billion of net new money flowing into U.S. ETFs. The absolute figure is staggering on a standalone basis as well as relative to prior records. As measured in terms of organic growth. Take that $459 billion and then divide it by the asset base as of the beginning of this year, and what we see is that on an organic growth basis this is the strongest year the category has seen since 2012.

Benz: Let's talk about some of the main types of ETFs that have been gathering assets. What have been the biggest beneficiaries of this overall trend?

Johnson: Flavor of 2017, has been vanilla. If you were to look at the roster of the top asset gatherers at individual ETF level, what you see is a smattering of S&P 500 ETFs, ETFs that track the MSCI EAFE Index, other developed ex-U.S. equity benchmarks, the Bloomberg Barclays Aggregate Index. These are uniformly very broadly diversified ways to achieve a very suitable exposure to an asset class. They are uniformly very low cost. Investors' preferences in 2017 have been skewed decidedly toward vanilla.

Benz: Advisors certainly are making that choice for some investors' as well. Advisors are saying you want to keep the costs low and I want to be able to have fairly easy to maneuver exposures within my client portfolios.

Johnson: That's absolutely the case. Advisors, I would argue, are probably more firmly focused on fees than they've ever been. Simultaneously another key trend that we are seeing in the advice space is more and more advisors are outsourcing some or all of their responsibilities with respect to portfolio management and portfolio construction. A key driver of ETFs' growth in 2017, and I think what will be a key driver of ETFs' growth in the years to come, is the growth ETF model portfolios. These are asset allocation models, some very straightforward, very strategic. Others more tactical that use ETF either in the majority or exclusively, and what we've continued to see in 2017, and indeed I would argue even an acceleration of this trend, is the growth in ETF models that are delivered by all sorts of ETF model builders; be those home office personnel, major wire houses like Merrill Lynch, Morgan Stanley, UBS; be those more direct to consumer models.

Benz: Some of the robo-advisor type products.

Johnson: Precisely. If you look at Charles Schwab as an example, they experienced tremendous growth in their ETF line up in 2017 and much of that is attributable to the success of Schwab intelligent portfolios, their so-called robo platform.

Benz: Strategic beta, obviously that's been an area of growth for some firms, but you mentioned that it hasn't been quite as impressive as in previous years. What's going on there?

Johnson: Well, what we've seen to-date through this year is that strategic beta ETFs will grow at a slower rate relative to their more mundane predecessors …

Benz: The vanilla stuff you were talking about.

Johnson: ... the vanilla stuff, for the first time since 2009. That's a trend that's been in place for a number of years that they have been gaining market share. I would argue the deceleration this year has its roots in the trend that I've just described which is the growth of these ETF models. These ETF models tend to be delivered at a very low cost, they tend to favor more vanilla, more static, more mundane building blocks. That disadvantages somewhat these newer, more nuanced, more complex, and more costly strategic beta ETFs.

Benz: Let's talk about the fund family level, which of the firms have been the biggest asset gatherers?

Johnson: What we've seen in 2017 is that of the $459 billion in net new flows into exchange traded funds, 73% of that has gone to either BlackRock iShares or Vanguard, which is a tremendous sum. If you are to add Charles Schwab into the mix, and their very rapidly growing ETF lineup, what you see is that those three combined have accounted for nearly 80% of net new flows into ETFs on a year-to-date basis.

Benz: Is it because those three tend to be the biggest purveyors of some of those very low-cost, core, vanilla building blocks that you have been talking about, is that why they've been the biggest winners so far in 2017.

Johnson: Almost uniformly the case. If you are to zero in on the funds in those firm's lineups with the largest year-to-date flows, what you see is exactly that. Both iShares and Vanguard have their S&P 500 ETFs featuring among this year's top five asset gatherers. Charles Schwab has a complete suite of both plain-vanilla building blocks as well as what have been some very successful fundamentally weighted ETFs, that continue to amass billions upon billions of dollars in new investor money.

Benz: In terms of new products, and obviously a lot of firms are trying to get in on the action, but let's talk about some of the new launches in 2017. Can you generalize about where firms seem the most enthusiastic about launching new products?

Johnson: It's a great question, and it's awfully difficult anymore for providers to come up with the next great idea. I liken it to showing up at the beach around 2 P.M. on sunny day …

Benz: No space.

Johnson: ... sunny day, everyone's laid down their towel and you are going to have to fold your towel in half and park it next to the garbage can that's probably got a swarm of bees around it. Because what investors want has long since been claimed, it's been taken. What we see at the margin are some interesting developments and there are instances where we've seen newer funds come to the market in 2017 that improve upon predecessors by virtue of being either less expensive or more broadly diversified. But those increasingly are the exception rather than the rule. What we tend to see now are products that are increasingly niche, there are number of sort of politically themed or I would argue politically charged ETFs that have come to the marketplace this year. We've seen a raft of filings for either sort of block-chain themed or bitcoin futures based exchange traded funds. There is very little white space left.

The other interesting trend we've seen this year, and it's a trend that's really been in place for I would say a few years now, is names that you would traditionally associate with active management, coming to market with suites of single factor ETFs and then one or a handful of multifactor ETFs. That role up those individual factor exposures. Notable developments this year being JPMorgan's launch of a suite of single factor ETFs. Oppenheimer's launch of a suite of single factor ETFs as well as a multifactor ETF. This is a playbook that is well worn that's being executed by a number of different asset managers, that feel the pressure to participate in the ETF category.

Benz: Looking forward if I ask you to bring out your crystal ball for 2018, do you expect that many of these trends will continue, that ETF providers will continue to compete on cost, that investors' will continue to cast their lot with the more vanilla products?

Johnson: I think that investors are going to continue to show an expressed preference for the lowest cost, most stable, most transparent, and most tax efficient building blocks. I think the risk becomes as fee pressure continues to mount and begins to spread outside of the more basic market-capitalization-weighted total stock and total bond market type exposures, is that investors run a risk of missing the forest for the trees. If they are to focus on what are ever-smaller differences in fee levels, they run the risk of overlooking the fact that many of the indexes that underpin these funds are going to deliver vastly different outcomes even though they might have similar labels--value for example.

I would urge investors as every last basis point gets squeezed out of these funds' fees to reorient their focus toward the index methodology, toward the process that drives how these funds' portfolios are built. Because that ultimately is going to matter far more over the long term than saving a buck or two in fees a year.

Benz: Costs are important, but definitely understand what you own.

Johnson: Absolutely.

Benz: Ben thank you so much for being here to share your insights.

Johnson: Thanks for having me.

Benz: Thanks for watching. I'm Christine Benz from Morningstar.com.