How Did the First Half Pan Out for Passive Funds?

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Christine Benz: Hi, I'm Christine Benz from Morningstar. Amid the pandemic and its related economic effects, it's been a tumultuous first half for passively managed funds and funds in general. Joining me to recap the first half in passive products is Ben Johnson. He's Morningstar's global director of ETF research. Ben, thank you so much for being here.

Ben Johnson: Thanks for having me, Christine.

Benz: Ben, let's start by talking about performance. It's really been quite a topsy-turvy year so far. Talk about how passively managed funds have performed relative to active. I think that there had been some who had argued that a really tough market environment would be an environment when actively managed funds might have a chance to shine. Did that pan out in the first half and especially in the first quarter?

Johnson: Well, it's been an incredible year performance-wise. It is certainly gut-wrenching as far as many investors are concerned and if you fell asleep under a tree in January and woke up just in the past few days, you would be astonished to open up the newspaper, read all the headlines, and see that the markets generally reclaimed a lot of the ground that they lost. And when you look specifically at how active funds--both stock-pickers as well as bond funds--performed during the very worst of the episode that we experienced in the first quarter, what you saw is that, despite many claims to the contrary, they didn't necessarily save investors' bacon. So, I looked specifically at all active U.S. stock funds and how they performed relative to their Morningstar Category index. And from the peak of the market in February to the depths of the drawdown in late March, what you saw is roughly half of them managed to outperform their category index during that period.

You go over to the realm of fixed income, and what you saw is roughly a third of bond portfolio managers outperformed their category index during that same stretch, which speaks to the fact that many of them were structurally a longer credit risk and also shorter duration during the period where credit risk got absolutely punished and interest rates dropped. So, I think this concept that active managers will reliably outperform in environments like we experienced earlier this year belongs in the same category as Santa Claus and the Easter Bunny. It's a myth, it's one that perpetuates itself. It's one that I think perpetuates itself because people want to believe and we want people to ultimately behave well. Because what matters more than anything is the longer-term picture and not just any one air pocket that we might hit in the market.

Benz: How about fund flows? I think we can kind of them as a lens into investor behavior. What have we seen during this period? What types of funds do investors seem to be preferring?

Johnson: Well, we've seen a tremendous amount of volatility in fund flows, and fixed-income flows in particular, we saw a mass exodus briefly earlier this year, and what we've seen subsequently is that investors have been allocating billions upon billions of dollars to fixed-income ETFs, in particular, which as measured by flows have been the most popular category for the year to date. So, as of late June, fixed-income flows together accounted for roughly 46% of total net new flows into all ETFs. So, part of that is a bit of a safety trade.

And I say a safety trade because if you look more broadly, what we've seen is also a massive inflows into gold-backed exchange-traded products. So, people have flocked to precious-metals-backed and specifically gold-backed exchange-traded products for the first time in years. And there are a variety of factors at play there. I think gold has long been seen as a safe-haven asset. Investors might be worried about inflation in the future, just given the massive amount of spending that the Fed and the government more broadly have undertaken, not just in the U.S. but globally. Gold has gained as a result and performed quite well in the process, too.

On the other side of the coin, what you see is that there's been a mass exodus from foreign stock funds and diversified emerging-market ETFs in particular, which are at the top of the leaderboard in terms of categories as measured by net outflows for the year to date.

Benz: How about new fund launches? I know you and the team keep tabs on the comings and goings and some of these ripped-from-the-headline-type products that we've seen recently. What's been coming out in terms of new fund launches?

Johnson: We've seen three interesting trends for the year to date in terms of new product launches in the ETF space. The first is actually a continuation of a trend, which is we've seen a number of new ESG ETFs come to market. Many of them launched in recent weeks by BlackRock, which is following through on a commitment it had made earlier in the year to round out its ESG suite, its broader product catalog. So, in most recent weeks we've seen a new entrant from iShares in the bond space of broad-based ESG bond ETFs. They also recently launched the first ever allocation ESG ETFs. So these are interesting new additions to the ever-growing menu of ESG ETFs and funds more broadly.

The other theme we're seeing is the gradual rollout of new actively managed, nontransparent ETFs. Now that's a mouthful, and it's a relatively new format, a new template for bringing active strategies to the market and an ETF wrapper, one that allows the managers of these portfolios to keep their cards close to the vest, to not show their portfolio every day to the marketplace. It'll be interesting to see how investors respond to these products, many of which are going to be replicants of active funds that we've long thought highly of, funds backed by the likes of T. Rowe Price and Fidelity. So, we've seen some of those come to market. They're more in the pipe that will likely be rolled out later this year.

The third interesting trend is something that seems to perpetuate itself, which is there's always a new thematic ETF coming out to capitalize on whatever the theme of the day might be. And the most recent theme is really what's going on around us, right? It's related to this global pandemic and the fact that we're working from home, and we're working from home because we're trying not to get sick and not to get others sick. So, we've seen a number of thematic launches that have tried to capitalize on this current moment, the most recent of which trades under the ticker WFH, short for working from home, which attempts to roll up a portfolio of stocks that are going to benefit from the fact that we're all living and working and shopping in this virtual environment, and many of us will be for the foreseeable future.

The other two are looking to capitalize on the trends that might get us out of this current moment in this virtual environment, that are investing in those healthcare companies that are investing against in trying to find some sort of a resolution, some way out, be it a vaccine or something else to help us to fight against this virus. The ticker of those two funds, cute as ever for thematic funds, are GERM, G-E-R-M, and most recently VIRS, V-I-R-S. What I would say about these funds is the same thing I would say about any thematic fund is that investors need to understand that these are often designed more so with scalability in mind than they are with long-term investment merit. They tend to be launched at the precise moment where everyone's bought into this theme. Valuations tend to be very rich, and as a result, investors might be set up for disappointment if they are in some way distracted to and ultimately latch onto one of these shiny new additions to the ever multiplying menu of thematic funds.

Benz: Well, that's a really good point. And it seems like every time we talk about what has been going on in terms of which funds are gathering all the assets, it still seems that investors, when it comes to ETFs and other passively managed products, really are gravitating toward the big vanilla total-market index, for the most part they're not really monkeying around with some of these more-narrow investment types.

Johnson: And that's exactly the pattern that we continue to see when we look at flows, Christine. So as much as it's fun to talk about cute funds based on cute concepts with cute tickers to match, really investors are sticking to their knitting. They're looking at mainline broad-based diversified funds, funds that we think highly of that allow them ready access to the exposures that investors need at the core of their portfolios, that support low fees if they're charging them anything at all.

Benz: Ben, always great to get your perspective on a really wild and wooly first half. Thank you so much for being here.

Johnson: Thanks again for having me.

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