Johnson: 2019 Was the ‘Year of Zero’ for ETFs

Christine Benz: Hi, I’m Christine Benz for Morningstar.com. As 2019 winds down, Morningstar director of ETF research, Ben Johnson, is calling it the “year of zero.” He’s here with me today to provide a recap of the year in ETFs.

Ben, thank you so much for being here.

Ben Johnson: Thanks for having me, Christine.

Benz: So, Ben, before we get into the zeros, let's just recap some of the big numbers for ETFs. We continue to see really strong inflows into exchange-traded funds for one thing.

Johnson: Definitely. So, for the year to date through the end of November, what we've seen in terms of net new inflows into ETFs is a total of $274 billion in net new money coming into the category. So, it's on track to potentially be the second-largest year of net new flows ever in the history of ETFs, which dates back to 1993. So, big year by any stretch of the imagination, though I'm dubbing it "the year of zero." Interesting as you begin to unpack that $274 billion figure is that it's for the first time ever looking like it's going to be a year where net new flows into fixed-income ETFs outstrip net new flows into equity ETFs.

Benz: And it's been a great year for equity investors.

Johnson: It's been a tremendous year for equity investors.

Benz: And bond investors, but less so.

Johnson: And fixed-income investors. It's a good year to be an investor all around.

Benz: True.

Johnson: But what I would say is that this reflects probably any number of different things because ETFs, being a very dynamic vehicle, are used in a multitude of different ways by a multitude of different types of investors. And I think, most notably, fixed-income ETFs are increasingly being looked at as a source of liquidity, a new avenue of accessing the bond markets for fixed-income investors who may be more accustomed to transacting in individual bonds or baskets of bonds and have only more recently gotten familiar with and comfortable with bonds wrapped in an equitylike security. So, that I think is a secular story that will continue to play out for the foreseeable future: ETFs as an avenue for access for bond investors in an environment where sort of more-traditional means of accessing bond markets and bond market liquidity has dried up quite considerably.

Benz: How about in terms of providers? Are you still seeing the lion's share of flows go to the very biggest firms, the Vanguard and iShares of the world?

Johnson: Absolutely. So, if you're just to rank the top 10 providers by assets, what you see is that those top 10 have accounted for 90%-plus of net new flows for the year-to-date. They account for 95% of the $4.3 trillion in assets under management in this space. So, the rich, kind of, continue to get richer and with good reason, because they were some of the first to market. They were some of the first to market with the most broadly useful, the most suitable products for the biggest number of investors. And generally speaking, they've continued to share the benefits of economies of scale with their end investors in the form of ever-lower fees. And what was interesting to see in terms of flows this year through the first 11 months was that two thirds of net new money, that $274 billion, went into ETFs with an expense ratio of 10 basis points or less. So, investors continue to be focused, continue to express a preference for the very cheapest of the cheap on the menu.

Benz: OK, and that dovetails with something you said just a minute ago, which is that big broad products, those are the ones where the assets are going, right?

Johnson: Absolutely. So, if you just rank order the top ETFs by new inflows for the year to date, most of what you see is very much ho-hum, down the middle of the fairway, total stock market, total bond market index exposures. That said, there's some interesting exceptions to that rule. Most notably, one iShares ETF, the iShares Edge MSCI USA Minimum Volatility ETF, USMV is the ticker for that fund. It's a fund that we think highly of. It receives a Morningstar Analyst Rating of Silver. Interesting fund to the extent that it offers investors equity market exposure with less volatility. It's got a bit of a backstop built into the index methodology; looks to produce the least volatile portfolio it can using the MSCI USA indexes as its starting point. That fund for the year to date has seen $12.3 billion of net new inflows. So, clearly, it's captured a lot of money. It's captured investors' attention. That trend is turned more recently, but I think it speaks to the fact that people are waiting for the other shoe to drop here. We've been in a great market environment for a very long period of time. I think people are becoming incrementally more cautious as we move ever further into the future.

Benz: Right. So, let's get into the zeros. Let's talk about where we are seeing zeros. Brokerage commissions essentially going away for ETF investors.

Johnson: Brokerage commissions going away almost everywhere for ETF investors if they were paying any to begin with. There were a lot of places where there were commission-free ETF menus to begin with. I view the elimination of that arrangement as a positive over the long run for ETF investors to the extent that paying 4.95 to trade a fund is no longer going to factor into their decision. I also think to the extent that the asset managers who sponsor these ETFs were paying these platforms to participate in those programs, it could, in theory, remove what was effectively a potential floor, or at least an impediment to those funds' fees going lower over time, as they got ever bigger. So, I view this as a positive.

There is the question of whether or not making something free, specifically trading in this case, will create a tendency to trade more on behalf of investors who now aren't going to pay commissions. My opinion is that--and I always channel my inner Taylor Swift here--is that traders are going to trade. People who are inclined to trade weren't being stopped by $20 commissions, they weren't being stopped by $10 commissions; $5 certainly wasn't stopping them. I think people who are looking to regularly reinvest, now ETFs look ever more attractive, because there's that last little hindrance, especially as compared to, in some cases, mutual funds, that's been removed, that makes that ETF versus mutual fund decision even more difficult than it was to begin with.

Benz: You've also made the point that maybe you're not paying commissions, maybe your index fund is not charging you anything to own it. But take a look around and make sure that you're not paying fees somewhere else--that you may be actually paying more fees.

Johnson: Yeah, the firms who are offering these nominally free arrangements aren't doing so out of the goodness of their heart. They're monetizing your business. They're monetizing your hard-earned assets in some way, shape, or form. So, it's important to try to understand: How exactly is their revenue being generated off of the assets that I've invested with this firm? I think the most important one to be aware of, which could be lurking somewhere, is opportunity cost. So, the one that we've discussed previously that's been discussed more broadly is the opportunity cost of foregone yield, say, on a cash savings account. So, I might earn 20, 30 bps on my cash where I could be earning 200 basis points. That's a lot of $5 trades that are nominally free that I'm effectively just giving away and then some by earning substandard yields on my cash balances. So, I think that's one to be aware of.

And in other cases, I think the opportunity cost is even more difficult to measure. And it has more so to do with the underlying exposure offered by some of these funds now where differences in fees are measured in a small handful of basis points. But the differences in a lot of these funds' long-run returns might be measured in percentage points. We have no way of knowing which fund might perform any better or worse now that we've controlled for fees over a long period of time. So, investors really now need to roll up their sleeves and do their due diligence on the underlying processes, especially as defined in the case of index-tracking ETFs by their index methodology.

Benz: Right. Right. Such a great point. Let's talk about what's been going on on the regulatory front with the SEC in relation to the exchange-traded fund world.

Johnson: Yeah, so another big development in ETF-land this year was the SEC rule, which we've been waiting on for years now. ETFs as a category, again, date back to 1993. So, in my mind, I view this as kind of an attempt by the SEC to form an eggshell around what is now a fully grown chicken in the ETF category, which is great because it brings a standard set of expectations of guidelines, of policies around what is an ETF and what is not an ETF. So, there are a large number of ETFs as we know them today and a larger number still of assets that are actually in funds that are outside of this new SEC rule. But I think the important thing for investors is something that we advocated for in our own comment letter to the SEC was to level the playing field for issuers with respect to the use of custom baskets. So, these baskets, creation and redemption baskets, are how stocks and bonds move into and out of ETFs' portfolios. Historically, only a select subset of ETF providers could customize those baskets, to cut them to fit, to minimize tax implications of redemptions from the fund, for example. This ability has now been afforded to all ETF providers. And I think from an investor's perspective, that's a great thing because it creates a level playing field, a standard set of expectations, and could yield greater tax efficiency for a number of different types of ETFs and, I think, active ETFs in particular. So, it further bolsters that key proposition that's really appealing for taxable investors.

Benz: Ben, great perspective. It's always terrific to hear your thoughts. Thanks for being here.

Johnson: Thanks for having me.

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