ETF Inflows Trailing at the Half

Christine Benz: Hi, I'm Christine Benz for Morningstar.com. Exchange-traded funds have seen $120 billion in new asset inflows so far in 2018, but that's off the pace of 2017. Joining me to provide a midyear halftime report on ETFs is Ben Johnson. He is director of global ETF research for Morningstar.

Ben, thank you so much for being here.

Ben Johnson: Thanks for having me, Christine.

Benz: Ben, let's talk about this headline number on flows--$120 billion sounds like an impressive number, but it is off substantially from 2017, the pace in 2017. What do you think the reason for that is?

Johnson: A lot of it has to do with the fact that it's lapping a really difficult comparison if you look at the first six months of 2017. $120 billion amounts to about half of what ETFs had gathered by way of net new assets at this point last year. 2017 was a gangbusters year for the category. ETFs as a whole gathered far more new money than any one had anticipated. I would owe a lot of that just to the prevailing market environment, which was far more favorable last year than it is this.

Benz: Right. Little bit of volatility so far this year.

Johnson: Investors are being a bit more cautious in terms of where they are taking risks, how they are taking risks, and if they are taking risk at all.

Benz: Certainly, flows aren't going to actively managed funds, but they are not quite as strong into ETFs so far this year either. Let's look at some of the categories that have been seeing significant inflows. What is topping the list?

Johnson: If we look at the Morningstar categories that have gathered the most net new money for the year to date, the foreign large-blend category is at the very top of the list collecting nearly $24 billion in net new money. A not-so-distant second is the short-term bond category; ETFs in that category have collected nearly $20 billion in net new assets thus far this year. I would attribute that mostly to investors' growing concern about rising rates and the path that the Fed has laid out with respect to their plans to further raise rates in the future.

Benz: Now, foreign large blend, I know that more broadly speaking, we have been monitoring investor inflows into foreign stock funds generally. Is that just part of that overall trend?

Johnson: I think it's part of that overall trend and that's been attributed to a number of different things. Part of it is relative valuations. At least at face value, foreign equities look relatively cheaper versus U.S. equities. There are a number of other factors that might attribute to that.

If you drill down actually in this particular category at a fund level, there's one interesting phenomenon at play here, specifically, a multibillion dollar swap between two substantially similar funds. We have seen billions of dollars this year flow out of the iShares EAFE ETF, EFA is the ticker for that one, and into its sibling ETF, the iShares MSCI EAFE Core ETF, IEFA is the ticker for that. The differences between the two--the Core ETF is more broadly diversified and substantially cheaper. Its fee is 24 basis points less. A large portion of the money that flowed into one and out of the other was actually driven by a trade by a model ETF portfolio maker or fabricator manager at Merrill Lynch, who said, we're going to get broader diversification at a lower fee; this seems like a great deal; we want this one, not that one.

Benz: You noted to me before we got started that these model portfolio builders have kind of been the taste-makers in terms of some of the funds that have been getting big flows. Let's talk about that development. Is it that these firms are responding to advisors' need for help in terms of pulling together some of these portfolios of ETFs?

Johnson: That's a huge piece of what's driving the growth in ETF models more broadly. ETF model-making takes a number of different forms. It could be teams at individual wire houses like Merrill Lynch, Morgan Stanley, UBS, that are building ETF model portfolios that advisors within those wire houses are ultimately managing, too, on behalf of their clients. There are other cases where the ETF sponsors themselves are delivering models to advisors either on a paper basis or in some cases, in an ETF of ETFs. There's also instances of the digital advice solution, or the robo-advisor, many of whom use ETFs exclusively. ETF model builders of all stripes are now having more clout and more influence on ETF product development and the direction of ETF flows than ever.

Benz: When you look at the ETFs that have been seeing the biggest inflows, you have mentioned a couple of the categories. But on a fund by fund basis, are there any commonalities you see when you look down the list?

Johnson: I don't think there's necessarily any commonalities in terms of the underlying exposures. If there are threads that run through that are common throughout, it's that investors are generally keeping it simple, they are keeping it very inexpensive. They are investing in the least costly, most broadly diversified market cap-weighted exposures that are on the menu. If we look at the flows on a year to date basis, what we see is that two thirds of that $120 billion has gone into ETFs that charge a fee that is 10 basis points or less.

Benz: In terms of new product launches, are there any that you think are notable that have come out in this first half of 2018?

Johnson: The one trend that we have seen thus far this year that has been the trend in ETFs and even funds before ETFs is sort of persistent spaghetti slinging. The waterfront has been long since covered with the most broadly useful, the most inexpensive market-cap-weighted exposures that have the broadest relevance to the largest number of investors …

Benz: And that's what people are buying.

Johnson: … and that's what people are buying. But there's also a lot of hot dot chasing that's going on and most recently, what we've seen is a raft of new launches that try to capitalize on all things blockchain-related, including a China-focused blockchain ETF more recently. Artificial intelligence is another theme among this sort of latest handful of pasta that's getting slung against the wall. Most recently, an ETF that tries to marry the insights of Jim Rogers with artificial intelligence, with the ticker BIKR, Jim Rogers being well-known as an avid motorcyclist. There are going to be more gimmicks to come. This will never cease, but fortunately appears investors aren't being distracted by these shiny objects. They continue to dedicate most of their money to the tried and true, the least expensive of the bunch.

Benz: Ben, always great to get your insights. Thank you so much for being here.

Johnson: Thank you for having me.

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