Ben Johnson: Index Funds Are Not 'Zombie Investors'

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Our guest on this week’s episode of The Long View podcast is Ben Johnson. Ben is Morningstar's director of global passive research. In that role, Ben leads a team of analysts who conduct research on index mutual funds and exchange-traded funds and publish research on the global passive investing industry.

Before assuming his current role, Ben was director of ETF research for Europe and Asia and served as the editor of the Morningstar ETFInvestor newsletter. Prior to that, Ben served as a senior equity analyst at Morningstar covering the agriculture and chemicals industry. Before joining Morningstar in 2006, Ben worked as a financial advisor for Morgan Stanley. He holds a bachelor's degree in economics from the University of Wisconsin, as well as the Chartered Financial Analyst designation. In 2015, Fund Directions and Fund Action named Ben among the 2015 Rising Stars of Mutual Funds. 

Background
Ben Johnson articles and videos on Morningstar.com 

Growth of Indexing
“Investors Still Pouring Money Into Passive Funds,” by Christine Benz and Kevin McDevitt, Morningstar.com, July 29, 2019. 

“Have Fee-Based Models Won the Battle ... or the War?,” by Ginger Szala, ThinkAdvisor, Feb. 21, 2019. 

“End of Era: Passive Equity Funds Surpass Active in Epic Shift,” by John Gittelsohn, Bloomberg.com, Sept. 11, 2019. 

“Retail Distribution Review: Effects on Fund Fees in the UK,” by Jackie Beard, Morningstar blog, Nov. 9, 2018. 

“Passive Investing Hasn’t Taken Over the World,” by Barry Ritholtz, Investment News, Oct. 1, 2019. 

Risks in the Growth of Indexing
“The Big Short’s Michael Burry Explains Why Index Funds Are Like CDOs,” by Reed Stevenson, Bloomberg.com, Sept. 4, 2019.

“Market-Cap-Weighted Index Funds Not Broken,” by Ben Johnson and Jeremy Glaser, Morningstar.com, Oct. 3, 2018.

“Bogle Sounds a Warning on Index Funds,” by John C. Bogle, The Wall Street Journal, Nov. 29, 2018. 

“Passive Fund Providers Take an Active Approach to Fund Stewardship,” by Hortense Bioy, Morningstar.com, Dec. 6, 2017.

“Indexing Impact Fears Overblown,” by Ben Johnson and Jeremy Glaser, Morningstar.com, Sept. 8. 2016. 

Retirement Plans
“Use of Index Funds in 401(k)s Increasing,” by Rebecca Moore, PlanSponsor, June 21, 2019. 

“Here’s the Real Reason Why Your 401(k) Fees Are Falling,” by Darla Mercado, CNBC.com, May 9, 2018. 

“Using ETFs in a Retirement Plan,” by Susan Dziubinski, Morningstar.com, Sept. 9, 2016.

Commissions and Fees
“Fidelity’s Free Funds and the Changing Brokerage Business,” by John Rekenthaler, Morningstar.com, Aug. 8, 2018. 

“Looking Past the Fidelity Zero Headlines,” Christine Benz and Ben Johnson, Morningstar.com, Aug. 9, 2018.

"Schwab to Drop Commissions on U.S. Stock, ETF and Options Trades, Slamming Online Broker Stocks," by Ciara Linnane, Marketwatch, Oct. 1, 2019. 

"E-Trade Drops Commissions on Trades, Joining Schwab, TD Ameritrade in Brokerage Fee War," by Maggie Fitzgerald, CNBC.com, Oct. 2, 2019. 

“Are No-Commission Trades Good for Investors?” by Christine Benz and Ben Johnson, Morningstar.com, Oct. 2, 2019, Morningstar.com. 

Indexing Market Segments
“Everything You Need to Know About Strategic-Beta ETFs,” by Ben Johnson, Morningstar.com, April 8, 2016. 

“Are High-Yield ETFs Junk?” by Alex Bryan, Morningstar.com, April 26, 2017. 

“Indexing in Less-Efficient Markets,” by Alex Bryan, Morningstar.com, Oct. 5, 2016. 

“An Overview of the Passive Bond Funds Landscape,” by Christine Benz and Alex Bryan, Morningstar.com, March 22, 2018. 

“Better Bond ETFs?” by Alex Bryan, Morningstar.com, Aug. 3, 2016. 

“Are There Viable Alternatives to Traditional Bond ETFs?” by Christine Benz and Alex Bryan, Morningstar.com, June 29, 2016.  

“Introducing Two New Morningstar Bond Categories,” by Sarah Bush, Morningstar.com, May 2, 2019. 

Morningstar Analyst Report for iShares 20+ Year Treasury Fund (TLT)  
Morningstar Analyst Report for iShares iBoxx $ High Yield Corporate Bond ETF (HYG)  
Morningstar Analyst Report for SPDR Bloomberg Barclays High Yield Bond ETF (JNK)

“6 Questions about Low-Vol Investing,” by Susan Dziubinski, Morningstar.com, Sept. 8, 2017. 

Morningstar Analyst Report for iShares Edge MSCI Min Vol USA ETF (USMV)  

“A Checklist for Assessing Dividend ETFs,” by Ben Johnson, Morningstar.com, June 29, 2016. 

“Not All Dividend ETFs Are Created Equal,” by Ben Johnson, Morningstar.com, Aug. 25, 2017. 

Morningstar Analyst Report for Schwab U.S. Dividend Equity ETF (SCHD)
Morningstar Analyst Report for Vanguard Dividend Appreciation (VIG)

Transcript

Jeff Ptak: Hi, and welcome to The Long View. I'm Jeff Ptak, global director of manager research for Morningstar Research Services.

Christine Benz: And I'm Christine Benz, director of personal finance for Morningstar, Inc.

Ptak: Our guest this week is Ben Johnson. Ben is Morningstar's director of global passive research. In that role, Ben leads a team of analysts who conduct research on index mutual funds and ETFs and publish research on the global passive investing industry.

Before assuming his current role, Ben was director of ETF research for Europe and Asia and served as the editor of the Morningstar ETFInvestor newsletter. Prior to that, Ben served as a senior equity analyst at Morningstar covering the agriculture and chemicals industry. Before joining Morningstar in 2006, Ben worked as a financial advisor for Morgan Stanley. He holds a bachelor's degree in economics from the University of Wisconsin, as well as the Chartered Financial Analyst designation.

In 2015, Fund Directions and Fund Action named Ben among the 2015 Rising Stars of Mutual Funds. We're pleased to have him as our guest.

Ben, Welcome to The Long View.

Ben Johnson: Thanks for having me.

Ptak: So, maybe we'll start with the big picture question. Indexing used to be viewed as--it was a bit of a backwater--viewed as sort of a quirky approach, enthusiasts maybe would engage in it, but not the wider market. Now it's huge by some measures. And so, I think that one of the basic questions that one would have observing that trend is, Why has indexing taken off the way it has?

Johnson: Well, it's a great question. I think there are a lot of different reasons that explain the growth in indexing and especially, I would say, the growth we've seen in the past decade or so. I think, early on, it was just a tough sell, right? I mean, from the very beginning, index was labeled as being un-American. And that, I think, is a brand that stuck with it for quite some time. It was effectively the ultimate freeloading strategy. You're aspiring to do nothing more than just owning the market. You're sufficing. You're sitting tight. You're just letting the market do the heavy lifting for you and not setting out and being enterprising and cunning and intelligent and wielding all of the many talents that God gave you to try to do better than the market.

In no other field does it apply that just kind of sitting tight and being happy with doing nothing yields good results, right? I mean, you don't get to the top of Mount Everest by failing to train; you don't win a marathon by failing to train; you don't win a spelling bee by failing to train, by failing to try.

Whereas in indexing, it just fundamentally breaks that logic. You can let the market do the heavy lifting and have a perfectly good result if not a far better result than you might get through a variety of different approaches. And part of that just (goes) to costs, right, which I think explains a lot of this most recent leg of the growth that we've seen in indexing is growing awareness around the importance of costs that also counterintuitively in investing--to channel, the late Jack Bogle--the less you pay, the more you're likely to get.

So, if you pay Ferrari prices, you're going to find yourself in all likelihood behind the wheel of a lemon. If you pay lemon prices, you pony up for a Honda Civic, you're going to get long-term Ferrari-like performance, which is very counterintuitive.

And I think that growing awareness, coupled with shift in the economics of advice--not just in the U.S., but this is a phenomenon we see globally--where many advisors are moving away from transaction-driven models of doing business towards fee-based ones. There's a real incentive there for them, if they want to retain the rents that they're keeping, to maintain the economics of their practice at a level that allows them to live comfortably, that they're going to squeeze the fees out of the asset-management products that they use on behalf of their clients. So, that more of that accrues to them in the form of a fee that oftentimes they're charging as a percentage of assets under management.

So, that's going to ultimately favor indexed products as well, be it index mutual funds, be it exchange-traded funds. So that, I think, is a huge leg of growth, a huge factor driving the growth of indexing more recently, as is that same awareness within defined-contribution channels, and you see that as manifest either in the growth of target-date funds that are made up of index funds, or the increasing prevalence of a la carte index mutual fund options on 401(k) menus. And the 401(k) for most young investors, for most small investors, is their retirement vehicle of choice. It might be their only retirement vehicle. So, it's really a confluence of all of these different factors, be it psychological, be it economic, be it sort of these structural trends that we see in place that have driven the growth of indexing to levels that we see today.

Benz: Indexed equity mutual fund assets recently overtook active in the U.S. So, can you put that in a broader context? Let's talk about other asset classes. So, fixed income, as well as international equity. And also, you oversee a global team. What trends do you see globally? Is this a mainly U.S. phenomenon at this point? Or is it happening overseas as well?

Johnson: Well, the growth we've seen in indexing is it's really a global phenomenon. And we've reached certain milestones in the U.S. I think, if you zoom out more broadly, what you'll see is that indexing still represents a minority of total global market cap, if you zoom out and look at the total global stock market. But, certainly, it's a materially higher level than zero, which is where it was if you go back to the middle 1970s.

So, if you go into other markets, you look at, say, Europe, you look at Australia, you look at the margin markets like Canada, what you see is the same phenomena that I described earlier is specifically as it pertains to the advice markets. Whereby, in many cases, take the Retail Distribution Review, or RDR, in the U.K., by means of pen stroke, by means of regulation, there was an outright ban on commission payments, which did away with one incentive and introduced a new one. So, it did away with the incentive for U.K. independent financial advisors to recommend products, recommend funds that offered these commission payments to them on behalf of their clients and towards recommending index products, which charge lower fees, they're moving towards increasingly fee-based business models. So that realignment of incentives is underpinned, has fueled the growth of index mutual funds, in particular in the U.K. market. And what you see is in increasingly global marketplaces, that all of these regulators, all of these different organizations are learning from one another, and real-time are sharing best practices, are moving more and more in the same direction, which ultimately, is one that is very investor-friendly.

Are there still some wrinkles that need to be ironed out? Are there still some unforeseen consequences that may result from all of this? Absolutely. But, generally, moving investors towards lower costs, moving advisors towards better alignment, greater transparency, I think, is unequivocally a good thing for the end client, for the end investor.

Ptak: The uptake has been less in some markets, though. I think of Canada. I was just in India. There's not nearly as large a passive market there. And so, based on what we've observed in other markets where the uptake has been significantly more, what do you find tend to be sort of the condition precedent, the prerequisites for indexing adoption in some of these markets, where perhaps it hasn't been taken up?

Johnson: Well, the markets where indexing has not penetrated nearly as much tend to be characterized by fairly monolithic and almost unshakable distribution, and distribution that largely centers through and takes place in the conduit that is very large, entrenched banks that operate in kind of a near-oligopoly type structure.

So, I think Canada is an interesting example of exactly that, where your average Canadian investor may walk into a BMO branch, when they get their first paycheck, open up a checking account, and do business, be it checking, be it savings, be it investment management, with BMO from that day until the day that they die.

And you've got a very sort of streamlined, very impenetrable, very unshakable distribution channel in that example, and in many others. Some of the big markets in continental Europe, if you look at a market like France, are very similar in that respect. And that's not conducive to indexing because the incentives aren't there. They're not aligned in such a way between the purveyor of the asset-management product, the advice in the end investor, as they might be in other markets where distribution is more fragmented. So, if you look at, obviously, the U.S. market, the U.K. market, the Australian market, those markets have been, as is readily evident, far more conducive to the growth of indexing.

Benz: Apart from the global trends, let's get back to the U.S. and sort of think about asset classes. It always seemed like U.S. large caps were--well, it was the earliest place to get widespread adoption of index funds. How about the other major asset classes? It seems like slowly, but surely, we've been seeing greater uptake of international equity index products, as well as fixed-income index products.

Johnson: That's absolutely right. And part of it, as you alluded to, Christine, just has to do with availability. The U.S. equity index exposures were the first ones available on the market. And there are other more sort of far flung, more esoteric corners of the market that, especially in their early innings just didn't lend themselves well, not just to indexing, frankly, but were otherwise uninvestable. I mean, there are certain emerging markets, if you think of markets like China or India, that for many retail investors, once upon a time, were only accessible through maybe a closed-end fund or something of this sort.

So, as more and more markets have opened up, it's become more feasible and less costly to offer indexed exposures to those markets. Many of the indexes that actually underpin the ETFs, the mutual funds that are available to investors today, didn't even exist if you go back three decades or so ago.

So, it's not just the growth of indexing, but it's all of these necessary precursors that have to line up to make indexing really even feasible. So, as you look today, now, investors are spoilt with choice. They have broad-based exposures that can cover virtually every corner of the market, every rung of the market-cap ladder, and each and every corner of the market, all the way down to things that are very fine, very esoteric, and, in some cases, outright gimmicky. We're just, I think, a week or two removed from the launch of the first-ever vegan ETF.

So, all of those hindrances, all those obstacles, all those costs that in some way prevented the growth of not just indexing but investing more broadly, have come down with time. And now we're in a scenario where the world is investors' oyster.

Ptak: I want to come back to bond indexing a little bit later in the conversation. But one topic I thought we could take up--a part of the market, which is a bit more saturated by indexing--is U.S. equities. And we had famed hedge fund manager, Michael Burry; he recently came forward saying that indexing is a bubble. I think that he was referring primarily to U.S. equities. What do you make of that?

Johnson: I think Burry's comments were sort of missing a lot of different aspects of what's going on here. First and foremost, just at a very high level, like the most macro level you can think of, is that all investors collectively own the market. And market prices in aggregate are set by the decisions of all investors. And if there's any concern, I think, investors should have as it pertains to the growth of indexing is what this means for price discovery. So, the market's ability to set fair and accurate prices for any given stock in any given corner of the global market.

So, while indexing today accounts for a larger share than ever of global stock market capitalization of the amount of outstanding bond issuance, it accounts for a tiny minority of trading volume. And even when indexes trade, more often than not indexes are price-takers. They're trading at, say, market on close prices because they want to track their index, and that's the price that is imputed in their index, for example, in the case of most stock market benchmarks.

So, there's no informational content in indexers' trades. There's very little trading activity as scaled against all trading activity that emanates from index products. So, I think we're a very long way from having to be worried about any sort of distortionary effects that indexing as a means of accessing the markets, as a means of investing in the markets, has on the markets and their ability to price securities fairly. There's still a huge number, more so than there ever have been before, of very intelligent, very well-equipped people that are out there making decisions about what these stocks, what these bonds are worth on a day-in and day-out basis, that I'm not losing sleep at night over this, I don't think anyone should. That's not to say we couldn't get to that point. It's just probably decades in the future if we ever arrive at it.

Benz: So, even Jack Bogle sounded a concern note about the growth of indexing. So, as index fund share of outstanding shares continue to rise, do you think at some point regulators will step in and force some of these firms or funds to break up? And if so, what are the implications for investors?

Johnson: Never say never. So, I wouldn't say "no" outright. What I will say is that it would be unwise. Any of the various proposals that have been put out there, many of which have been put forth by members of the academic community as to how we might go about breaking up index funds, if you will, just would do a huge disservice to investors. So, as an example, there's one that posits the idea of only allowing index portfolios to invest in one security, one stock, for example, from any given sector, from any given industry. That would be massively disruptive. It would be costly, and it would sacrifice all of the gains that investors have made now over the course of decades, moving towards an era today where investors can buy a U.S. total stock market index portfolio and pay no fee, or at least a nominal paltry fee on it. And all of the diversification benefits that are inherent in being able to own the entire stock market in one portfolio for a cost that is that low--it would be disruptive; it would be misguided.

Benz: Well, let's just talk, Ben, about what the thought process would be behind such a proposal. What would they be trying to achieve by putting in such strictures?

Johnson: You know, quite candidly, it's not clear to me. I think if there's one key concern, it has to do probably more so with governance than anything else. Concerns around the consolidation of the voting power in the hands of an ever-smaller number of very large and ever larger asset managers, notably, the big three in BlackRock, in Vanguard, and in State Street. To the extent that unwinding kind of the index complex, if you will, would do anything to further support standards of governance or anything, frankly, that would precipitate into something good for the end investor, I don't see how you connect those dots, quite frankly.

I think if there are any real concerns--or the most pointed concerns that have been raised have to do more so with governance and as we document in all of the work that our colleagues Jackie Cook and Hortense Bioy have done around the degree to which the managers of these index portfolios are trying to move the needle. As it pertains to governance, they're doing a lot of good work. And they're doing a lot of good work because they have to, because all of the stakeholders that are involved are putting them into ever sharper focus. So, it's incumbent upon them not just as a fiduciary, but as a voice for all of their many millions of investors around the world, to try to get the firms that they invest in to do what's right for their end investors.

Ptak: Yeah. I know that there was an argument that was rattling around an industry suggesting that passive funds were free-riding and that their governance and engagement practices were especially lax, just given the fact that they don't have the incentives to go in and engage with firms the way, say, an active shop would. I think you refer to some of the research that we've done on that, it debunks that. Where did Morningstar come down based on the research that it conducted into this issue?

Johnson: Yeah. So, many index portfolios, I think, the one term I can recall that was thrown around was that they're "zombie investors" when it comes to their engagement with corporates. What we found is that they're anything but zombie investors. That all of these firms--not all of them, but the majority of the largest firms--have made meaningful investment in staffing up teams that are dedicated to researching key issues that are being presented on the proxies of their investee companies, to regularly engaging with managements and boards of directors at all of these companies. And they have every incentive to do so because they don't have any other option. They can't bail because these companies are part of their portfolios, being indexed portfolios come hell or come high water.

So, that makes them very much bound to the outcomes that are going to be delivered by these firms and provides every incentive for them to engage with them. And indeed, that's what we've seen. There are some items that they've paid more attention to than others. But one way or another, they are anything but the zombies that they've been characterized as being by some.

Benz: Before we leave the bubble question, I'd like to talk about investor expectations with respect to index funds because that's something that I've been kind of carrying around as a worry that investors have not only had the attraction of low fees with index funds, but they've also had really strong performance in absolute terms and certainly in relative terms. And those things can shift around a little bit over time. Is that a concern, do you think, Ben, that some of the investors who have been gravitating to index products might be sort of Johnny-come-lately said they might just turn around and leave if the relative performance of an S&P 500 tracker drops to like the 72nd percentile over a three-year period? Is that a worry for you?

Johnson: 100%. Johnny-come-lately, I think is a fair characterization of the imagery that pops into my mind of a lot of not just newly minted index investors, but new investors full stop. There's a whole generation of investors that over the course of the past 10 years have known nothing but fairly benign market conditions that might not have still lingering memories of the global financial crisis or the tech bubble that sort of influence their behaviors, influence their attitudes towards markets and towards investing. So, that's a real concern of mine, too.

To the extent I think that in the minds of many that indexing can be unjustifiably conflated with some sense of like safety or security as opposed to just very starkly what it is--which is just owning the market at a reasonable cost--and the market is going to do what it's going to do. That's what you've signed up for. I think, on the flip side of the coin, that's one of the behavioral, sort of, pluses of indexing, but I don't know if that necessarily is jelled in the mind of many of the Johnny-come-latelies as you've described.

Ptak: And so, where will they scatter to? Do we think that's going to send them back to active funds or to the safety of an asset class that's performed better and perhaps they'll choose the passive that gives them exposure to that? Like, has there been a mindset change where they've committed themselves to indexing but perhaps they've chosen the wrong asset class in their haste to get a piece of the action there?

Johnson: Yeah. Great question, Jeff. And what I would say is, time will tell, but if history is any guide, it's going to be whatever is done relatively better as of late. So, if they've got a U.S.-equity-heavy portfolio, which I would imagine many young investors who fit that Johnny-come-lately mold would have a portfolio that skews more towards equities, they might move to cash, they might move to fixed income, you name it. Will they move to active? Difficult to say. Will they move at all? Also difficult to say.

As we were discussing before, a lot of the growth in indexing has come through investors' regular contributions to their 401(k) programs, be it via target dates, be it via a la carte. Mutual funds and what we've seen there in terms of patterns of investor behavior is some of the best behavior that we've ever measured because they're kind of setting it and forgetting it, the target-date funds, the qualified default option in their plan. They're making those biweekly contributions, and they're generally leaving it alone. So, time will tell.

Benz: Is there a case for ETFs in 401(k)s?

Johnson: I don't think there's any case for ETFs in 401(k)s. If you look at the vehicle, the three common items that are touted about the ETF vehicle are low costs, tax efficiency, and tradability. So, low costs will oftentimes be a push. Depending on the menu that you've got with your employer, oftentimes, you're going to have options that offer the same underlying exposure at the same cost, if not a lower cost, relative to an ETF option.

The tax efficiency is mute because it's a tax-preferred wrapper. So, that tax-deferral mechanism, that is, ETFs' in-kind creation and redemption, doesn't mean anything in the context of a 401(k) plan. And tradability, God forbid anyone's day-trading their nest egg. So, that becomes a push, too. If there's one case I can see for it, it would be in the context of plans for much smaller employers that might not have the level of assets that would allow them to enjoy the level of pricing that a larger plan sponsor might. And there are offerings out there already where ETFs can come in through sort of a backdoor, if you will.

So, Schwab, for example, has a target-date mutual fund series where the underlying holdings are actually ETFs. So, if there's any way for ETFs, I think, to make any meaningful in-roads into the 401(k) space, I think it's with smaller plan sponsors, and it's probably through an arrangement such as that.

Ptak: Maybe we'll stick with retirement plans for a minute. Is there any evidence that plan sponsors, those who are responsible for putting together plan menus and overall governance of a defined-contribution plan, are overdoing it with index funds? As I think you mentioned earlier in the conversation, we've seen quite a move towards index products within 401(k) plan menus. And so, you know, could it be a form of performance-chasing? Or are just people derisking to excess, where they feel like the lowest cost possible is going to mitigate risk, but they're unwittingly subjecting their participants to another form of risk, maybe by denying them other options that would help them to reach their objectives better?

Johnson: I think derisking is a fair characterization. And I think only a natural response, given the number of lawsuits that we've seen levied against employers for either offering limited choice or overly costly choice within their defined-contribution plans. So, if there's a real risk, it's one that investors could potentially be forgoing returns that they would have received from active managers that had formerly been part of that menu that were unjustifiably, unfairly, given the boot. So, that could potentially be a real opportunity cost.

But your average plan sponsor may or may not be equipped to understand whether or not there's a real potential opportunity cost there. It's something that you can only really readily size ex-post. So, I think out of an abundance of caution, you've seen many employers just move in the direction of offering, in many cases, all indexed offerings to derisk, as you characterized it, Jeff, entirely because it's just not a risk they're willing to assume.

Benz: Ben, you and I, over the years have talked a lot about the price wars among ETFs and index funds. They seem to be moving towards zero. So, Fidelity already brought out a line of zero-fee index funds. So, the question is, Are the salad days of ETFs and index funds over? And what do you think the industry will look like in, say, 10 years? Will it just be the big three that you talked about? Will any of these next year providers be left standing? What's your take on that?

Johnson: Yeah. Tough to say if the salad days are over. I think, suffice it to say, many are sort of at the end of their rope as it pertains to all of this fee fighting. I think it's reached, if not the end, near the end of its logical conclusion, which is that you can get a broad-based portfolio--combine as few as two funds in a portfolio--that allows you to own virtually every stock and bond at the planet for less than 10 basis points.

So, that is fundamentally a fantastic destination to have arrived at if you're an investor. Could it go a little bit further? Yes, it could go a little bit further, but every last basis point means less and less. So, what does the industry look like going forward? Difficult to say. I mean, there're interesting developments, as many of the asset managers now are moving increasingly away from a la carte fund sales to selling not just slices but whole pies.

So, we see growth in the model portfolio space, be it in ETFs, be it in mutual funds, where they try to leverage their existing expertise in asset allocation and in building model portfolios on behalf of their clients to differentiate themselves because there's no room left for differentiation when it comes to broad-based market-cap-weighted index products.

So, how do we differentiate? The first sort of avenues for differentiation were in factors, what we call strategic-beta, smart-beta, you name it. There's avenues for differentiation in the realm of ESG. But directionally what you're seeing, I think, is a movement more and more towards the provision of model portfolios, which are increasingly in demand from advisors who are moving away from security selection, fund selection, portfolio construction, and outsourcing more and more of that all the time to lean up their operations, to get more efficient, to focus more of their time on things that will really move the needle for their end clients.

I think asset managers, be it through models, be it increasingly through almost pivoting to become, in some cases, software manufacturers--developing portfolio management tools, portfolio analysis tools that they're now also providing directly to their clients, to some large advisor platforms in some cases. It's a fundamentally different asset manager from, you know, the heyday of the star stock-picker on a front-end load and a wholesaler that was coming through your local Smith Barney branch, your local Dean Witter branch with a briefcase full of fact sheets and an armful of sandwiches, talking about how their large-cap value fund was the best thing since sliced bread.

So, it's moving in a fundamentally different direction, one towards, I think, the end investor at the end of the day, which is a fundamentally good thing. But what it looks like 20 years from now, I can say with confidence--fundamentally different than what we see today. What specifically those contours are is really anybody's guess.

Benz: So, is there a risk that we've all been so focused on these product fees, and they've come way, way down, but we've maybe taken our eye off the ball of other fees that might be cropping up and eroding overall returns? Can you talk about some of those and the ones that investors should be paying attention to?

Johnson: So, I think while it's easy to celebrate, there's reason to celebrate the compression of all costs, explicit and measurable. There's reason to be concerned about the growth of costs that are increasingly implicit and immeasurable. So, when I say, "implicit and immeasurable," I think of things like opportunity costs, for example. So, depending on who you do business with, you may have a cash balance that's sitting in a proprietary product that may be earning a below-market rate. That's an implicit cost. And if I've got 10 grand parked in a cash account that's earning 20 or 30 basis points, that opportunity cost I'm incurring--not earning 2% or more--means way more in terms of my long-term outcomes than saving a basis point or two in explicit, very transparent costs on the investment products that are in my portfolio.

So, that's something that I personally am very concerned with. It's difficult enough, I think, for investors to wrap their minds around those things that they can see and measure. It's going to be far more challenging still for them to wrap their minds around the things that they can't see and might not ever be able to measure.

Ptak: Where does indexing not work? There's no shortage of examples, just given the breadth of capital markets and the different strategies that populate it. But maybe if we can telescope in on the ETF market and examples of things where indexing simply hasn't been as efficacious, for whatever reason? What examples come to mind?

Johnson: I think, first, it makes sense to maybe take a step back and talk about what makes it work and where it works best, which I'll take the posterchild example being the U.S. equity market. So, when we look at index-tracking funds, be they mutual funds or ETFs, and we think about the funds' processes defined chiefly by the index methodology, first on our checklist is representativeness.

So, when you look at that index, how adequately does it capture that investment opportunity set in that particular corner of the market? So, in U.S. stocks, the U.S. total stock market index, that's market-capitalization-weighted, definitionally captures the entire spectrum as it pertains to that opportunity set. So, that's something we view positively.

So, where indexing tends to work less well, where there are more opportunities for active managers, are those corners of the market where it's more difficult, it's more costly, it's probably impossible to offer that full spectrum in terms of coverage of the underlying index. And the posterchild for that would be a corner of the market like high-yield bonds, where if you look at the indexes that underpin investable products, which are all ETFs, as it stands today, they have to be cut to fit for that purpose. So, they put in place certain credit screens, certain liquidity screens, you name it, that by definition leave out a meaningful portion of the opportunity set that's available to an active manager in that space, where active managers historically have been able to add considerable value by loading up on kind of a liquidity premium. So, investing in less liquid bonds that tend to offer higher returns as compensation for being less liquid, that are able to load up on more credit-risky securities that, by definition because they are more risky in some gradations anyway of the high-yield credit spectrum, may offer higher returns. They can also, incremental to that in bond markets more broadly, do a little bit of homework as it pertains to credit analysis, which definitionally any credit-focused index-tracking product is not going to do.

I would say that it occupies a spectrum. U.S. large caps are one extreme, an area where indexing works very well; high-yield, if not at the other extreme, certainly near it, where indexing does not work nearly as well. And by virtue of that, we tend to have a dimmer view of index products that offer exposure to that corner of the market, which is ultimately expressed in our Morningstar Analyst Ratings for funds that invest in that segment.

Benz: Let's talk about fixed income, ETFs, index funds. Talk about the Bloomberg Barclays Aggregate Index as a maybe core or sole fixed-income holding for investors. What they're getting? What they're maybe missing? How do you and your team approach fixed-income indexing?

Johnson: So, we look on a case-by-case basis. And as I was alluding to earlier, a lot of it has to do with how representative is that particular index of the opportunity set in that category. And if you look at the Agg in particular, by virtue of a recent splitting of our Morningstar Category, the legacy intermediate bond category into a core and a core-plus category, the Agg actually is much more representative of its new, sort of, peer group.

Benz: So, just discuss, Ben, generally what's the complexion of core versus core-plus?

Johnson: So, core is straight down the middle of the fairway. There's not a lot of credit risk in there. You're going to see investment-grade bonds, a mix of government securities, and high-quality corporates. When you start adding "plus," effectively what you're doing more often than not is adding other forms of risk, chiefly credit risk. So, funds in that core-plus category are going to go further afield. They're typically going to have a larger increment of more credit-risky bonds in that portfolio, dabbling in high-yield bonds …

Benz: A Pimco Total Return is core-plus.

Johnson: Exactly.

Ptak: … So there's prepayment risk that probably one would find in a core-plus strategy that you wouldn't find in sort of a more core type of strategy, certainly the Agg, correct?

Johnson: 100%. So, when we frame that fund, that bond index fund, in the category--that's the first measurement we're doing--is, how representative of its sort of opportunity set is that particular index? If you park the Agg in that new core category, it's far more representative than it had been in the legacy category. And, ultimately, it delivers what you would expect from a bond fund, which is something to serve as ballast within a portfolio setting, something that diversifies equity risk, which is you go, sort of, further afield and into the core-plus category, you're dealing in risk premia that are more correlated with equity risk. A lot of those bond funds tend to be not as good from a diversification standpoint as a traditional core bond fund might be.

Ptak: What do you think the future of what's called "smart beta," we call it "strategic beta," in fixed income? We've seen a proliferation of products that have focused on strategic beta. So, typically, this is factor tilting, sort of, rules-based strategy in equity securities, less so in fixed income. And so, what's it going to take for the industry to break through and make the sort of headway in fixed income that it's made in equity?

Benz: And maybe first just define strategic beta and factor investing just so everybody can follow along?

Johnson: Yeah. So, strategic-beta, factor investing, smart beta, whatever you want to call it, is just old wine in new bottles, first and foremost. Factors have been something that have been floating around in, first and foremost, academia now for years. They've been commercialized in various forms. What it is is just different characteristics of be it stocks or bonds that historically have lent themselves to better than market performance.

So, things like value and momentum, which I tend to think of as the two bedrock factors. Value means buy what's cheap, avoid what's dear. Momentum means buy what's been performing well in the hopes that it will continue to perform well. So, there are a number of these characteristics that have been documented. And now that they're out there, they're in the open, they can be measured, you can craft portfolios, and ultimately make indexes that look to sort of codify an approach to harnessing these factors. The market has been proliferated with different ETF and index fund options that try to do exactly that.

So, most of the growth that we've seen to-date has been in the equity space, where if you look at the U.S. market, strategic-beta ETFs, per our definition, have about a fifth of assets under management in ETFs. If you look at fixed income, while there have been products that have been brought to market, penetration is relatively low, and I think will remain so. And I think that has a lot to do with the fact that the real risks that you can expose yourself to in the fixed-income market are less in number and far easier to gain exposure to already through implements that are already out there on the marketplace.

So, if you think about, in particular, interest-rate risk and credit risk, there are ETFs out there, TLT being the iShares 20+ Year U.S. Treasury ETF, that sees massive inflows and outflows on a regular basis as investors out there on the marketplace are using that as a means of expressing their outlook on interest rates. You see that expressed similarly in massive and regular and very noisy inflows and outflows into certain high-yield ETFs. So, iShares has a high-yield ETF HYG; State Street has one JNK, where, if I want to express my view on credit risk, that's effectively my easy button for doing so. It's a publicly listed security. It trades all day, every day, much like an individual equity. Investors are pulling that lever already.

So, you know, what's left maybe in terms of an audience for these products would be kind of a "do-it-for-me" type crowd, be it an advisor or an individual investor. But I would argue that many of them continue to be very well-served by active fixed-income managers, who not only are pulling those two levers but are rolling up their sleeves and doing their homework on individual credits, looking at the markets more broadly, you name it. Active management in fixed income has not been nearly as challenged as it has been in equities. So, I think all of these various factors, the availability of, kind of, implements that already allow investors to pull these levers, better success rates amongst active managers in fixed income, make the ground for strategic beta in bonds far less fertile than it's been in equities.

Benz: So, you mentioned investors trying to express various opinions on market segments using some of these products. Let's just talk about investors' performance with ETFs. And we look at dollar-weighted returns here at Morningstar. We call them "investor returns." What do you see when you look not just at the subset of factor or strategic-beta ETFs, but just ETF investors in general? Can you tell how they perform relative to just simply buy-and-hold investors?

Johnson: The short answer is, Christine, we have no idea.

Benz: It's super hard to tell.

Johnson: What I liken it to trying to define trends in ETF flows, especially for some of the largest products, is the world's most frustrating game of Clue. So, you know, candlestick, and let's call candlestick, in this case, SPY, the SPDR S&P 500 ETF, the oldest of them all. What you don't know is who bludgeoned who with the candlestick nor in what dark corner of the Clue mansion, because what you don't have with ETFs that you do have in the case of mutual funds is a look through to who that end shareholder is. Nor do you have any understanding as to what their motives might be because ETFs are just a package at the end of the day and their packaging makes them kind of a Swiss Army knife of sorts because they can do a lot of different jobs for a lot of different types of investors. They can be bought and hold. And you can have them in, kind of, a core portfolio if you're an individual investor or an advisor. You can sell them short. You can trade options around them. Some of the underlying indexes now have futures contracts on them. Much like stocks you hold in your portfolio, you can lend them out to someone else and earn a fee for that. So, they are a much more dynamic vehicle; they can be used in so many different ways by so many different types of investors that it's impossible to divine motive or really read anything into this activity that you see.

Benz: So, all kinds of coming and going. But it's really hard to tell what anyone is really doing.

Johnson: All kinds of coming and going. And it varies across the product set, I should say. So, there are products that have kind of taken on a life of their own and become capital markets instruments and are used by everyone from mom-and-pop to high frequency traders, things like SPY; I mentioned before TLT, HYG.

There are other things that clearly have more of a core appeal. When it boils down to it, whether or not ETF investors might be more inclined to trade or to get cute--to do things that could potentially be self-destructive. The best research that I've shown is that traders will trade irrespective of what the instrument in question might be. Once you control for that proclivity to trade, ETF investors and traditional fund investors--the differences in behavior between those two groups is almost indistinguishable.

Ptak: So, against that backdrop, Schwab announced recently that it was eliminating commissions on a broad swath of investments, given investors' proclivity to hurt themselves through overactivity, succumbing to impulse. Is that good or bad?

Johnson: I think it's neutral, to be honest. I think trade commission's going from $4.95 to zero, I don't think is going to change the DNA, the fabric, of any of those clients. As I mentioned before, I think the traders will continue to trade. They may ultimately wind up paying more to trade. By virtue of the fact that those trades are ultimately being sold down the road, they might get poor execution in some cases than they would otherwise if that order flow was not being executed internally. And the people who aren't inclined to trade will continue to not trade that frequently. In many cases, a lot of these clients weren't paying to trade to begin with, either because they weren't trading or because they were trading exclusively those ETFs that had been on one of these platforms' commission-free lists or they otherwise had free trades in their pocket that they had at their disposal. So, I think this really moves the needle, probably for a small minority of clients on those platforms who accounted for the overwhelming majority of trading activity.

To the extent that some RIAs that clear with some of these platforms are able to do in a more cost-effective manner on behalf of their clients across multiple client accounts, I think that's marginally positive, but I don't see this as in any way moving the needle on investor behavior going from less than $5 to now nothing.

Benz: Ben, I'd like to get your take on Dimensional Fund Advisors, DFA. It's a shop that straddles indexing and active. They were ahead of their time in a lot of ways in terms of cultivating a following among independent advisors and sort of inculcating them in their way of managing money. Now, everyone seems to be chasing the same advisors and trying to inculcate them in similar ways. What becomes of DFA given that they have some imitators now and some real competition?

Johnson: Yeah. I mean, I think, what's the old saying? Imitation is the sincerest form of flattery. And if you look at all the imitators out there on the marketplace today, I would imagine there's a number of people down in Austin, Texas, who are probably blushing. Because--not just looking at DFA's approach in terms of a systematic approach to portfolio construction that is very near indexing but is indexing with discretion embedded in their strategies is an element tilting towards certain factors. As we discussed before, it's also been a strategy that's looked more holistically at portfolios, client portfolios, and taking that same core strategy and applying it across--their genesis was in small caps, but they evolved into offering kind of a full equity offering--a full fixed-income range, so that once clients bought into that philosophy, they never had to really leave the building. Low costs for them were something that they delivered right out of the gate and was a key differentiating feature and just kind of inculcating their clientele in that philosophy, in that culture, in that approach, in that discipline, I think really set them apart for quite some time.

You fast-forward today and you see a lot of these imitators now catching up, offering kind of soup-to-nuts product offerings, driving down costs to the extent that if you look at certain DFA portfolios, they actually look a little bit out of step with the times.

Benz: Higher costs than peers.

Johnson: Relatively higher costs versus peers. And as I alluded to before, kind of a move towards models, to being able to meet all of your needs, kind of, under one banner, whatever that asset manager's banner might be. So, I think to the extent that they've very quietly moved the market in this direction to an extent, especially to the extent that they were out in front of the RIA market, which has been the fastest-growing subsegment of the advice market, that's ultimately accrued to investors' benefit. So, they might not always get the credit they deserve in that respect. But there are certain areas where the market is not only caught up but also moved past them to an extent.

Ptak: Is there any evidence that investors have loved certain of the more established factors, value and size to death? We've seen those styles really struggle in the past 10, 15 years. And so, based on the evidence, or I should say, the research that we've conducted or other evidence that's emerged in industry, are there indications that they've been a victim of their own popularity?

Johnson: Yeah. It's difficult to say that any one factor has been a victim of its own success or a victim of its own popularity, especially if you look back at the long history of a lot of these factors. I think the first thing that's important to understand is that there's a lot of decay. There's a lot of sort of error that gets led out of these factors as you go from kind of the ivory towers of academia to the investable reality of factors.

So, these factors are documented by people down the street at the University of Chicago. And it's a long-short portfolio, which many investors can't implement. It's done in a frictionless environment. So, it assumes no trading costs, no taxes, which isn't the reality that investors face. So, by the time you remove all of these nice ideas that survive in a white paper but fail hard when it comes to implementing them in a real long-only portfolio, there's less meat left there. It's like the old Wendy's commercial, like, Where's the Beef? Like there's not much beef left by the time you get to a long-only value portfolio.

And even then, the payouts of these factors tend to be very sporadic. They go through very long droughts. What causes that payout? Oftentimes, you'll see it coincides with some sort of key turning point in the broader market. So, the technology bubble is a perfect case in point where on the way up, everybody was heralding the death of value and then as soon as the pinprick happened at the top, value made a pretty meaningful comeback.

We've been in a pretty similar market environment. I mean, history doesn't repeat, but it rhymes, and at least, the broader trajectory of the market has been up and to the right for the better part of the past decade. So, we haven't really had one of those hinge moments that would kind of either put the nail in, say, value's coffin or allow value to kind of rise from its grave. So, it's difficult to say whether or not popularity will ultimately become the undoing of some of these factors. What I would say with some degree of certainty is the more popular they become, the more people try to chase them, the lesser the payout will likely be, and where's the beef will again become the question, especially if you go through one of these periods where there is a payout, but the payout in terms of magnitude isn't as great as it might have been historically.

Ptak: So, do you think min-vol investors--min-vol has been a popular format, low vol, low beta--do you think investors in those types of strategies should be especially wary at this point?

Johnson: Hugely popular. And that's one that's been interesting, too, because it's behaving in a way that isn't as advertised and isn't as, kind of, necessarily matches with the historical performance of that factor. So, historically, investing in less-volatile stocks produce better risk-adjusted returns, not absolute returns, but risk-adjusted returns relative to the market because you had shallower drawdowns. So, you had a shallower hole to dig yourself out of when the market cratered.

What we've seen more recently--so the payoff for that was that you sacrifice some of the upside--but what we've been seeing in the recent market environment is that that strategy has actually been outperforming the broad market, which, kind of, flips the script on its own history. So, it'll be interesting to see how that plays out. Certainly, as you look as manifest into flows into some of the more popular ETFs, iShares USMV being kind of the posterchild for the category, you've seen billions of billions of dollars poured into this fund. A lot of that's probably chasing performance.

What happens if we hit a hinge moment in the market? It's difficult to say. Does it look like what you would expect from a minimum volatility portfolio based on history, or does it look something more like the Nifty 50 bubble, where people got a little too keen on high-quality stocks and priced them at such a premium that it took decades to recoup and rebound?

Ptak: On the flip side, what's an example of a maybe a strategic-beta or factor-based strategy, which hasn't gotten that kind of love from investors and yet fundamentally appears attractive through the different lenses that we would view it through as analysts?

Johnson: Yeah. So, there are a number of different subcategories within the strategic-beta camp that we think are interesting. Some of the ones that are more popular amongst the investors that we tend to deal with are those that focus on equity-income strategies. So, I think of prominent examples being like the Schwab U.S. Dividend Equity ETF. SCHD is the ticker there. Vanguard Dividend Appreciation ETF; VIG being the ticker for that one. These kind of meld a few different factors almost under one umbrella.

So, equity-income orientation, in the case of SCHD, simultaneously a bit of a quality and a value bent to it. In the case of VIG, a bit of a quality bent to it. So, you get a few different things all going on at the same time. That quality orientation lends itself to a more favorable risk profile, shallower drawdowns, growing income streams, which especially I think amongst those currently in retirement looking for sources of income has some appeal. I wouldn't say by any measure, though, that those are necessarily overlooked. That's a category within the broader strategic-beta bucket that continues to be one of the largest but certainly isn't receiving the degree of attention, as you know, something like low-volatility in the USMVs of the world have been especially in recent months.

Ptak: Well, Ben, this has been a great conversation. Thank you so much for your time and your insights and for being our guest on The Long View.

Benz: Thank you so much, Ben.

Johnson: Yeah. Appreciate it. Longtime listener, first-time caller.

Ptak: Thanks again. Thanks for joining us on The Long View. If you liked what you heard, please subscribe to and rate The Long View from Morningstar on iTunes, Google Play, Spotify, or wherever you get your podcasts.

Benz: You can follow us on Twitter at Christine_Benz.

Ptak: And at SYOUTH1, which is S-Y-O-U-T-H and the number 1. Finally, we'd love to get your feedback. If you have a comment or a guest idea, please email us at TheLongView@Morningstar.com. Until next time, thanks for joining us.

(Disclaimer: This recording is for informational purposes only and should not be considered investment advice. Opinions expressed are as of the date of recording. Such opinions are subject to change. The views and opinions of guests on this program are not necessarily those of Morningstar, Inc. and its affiliates. Morningstar and its affiliates are not affiliated with this guest or his or her business affiliates unless otherwise stated. Morningstar does not guarantee the accuracy, or the completeness of the data presented herein. Jeff Ptak is an employee of Morningstar Research Services LLC. Morningstar Research Services is a subsidiary of Morningstar, Inc. and is registered with and governed by the U.S. Securities and Exchange Commission. Morningstar Research Services shall not be responsible for any trading decisions, damages or other losses resulting from or related to the information, data analysis or opinions or their use. Past performance is not a guarantee of future results. All investments are subject to investment risk, including possible loss of principal. Individuals should seriously consider if an investment is suitable for them by referencing their own financial position, investment objectives and risk profile before making any investment decisions.)