Low-Cost Building-Block ETFs Drive 2018 Growth

Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. I'm here today with Ben Johnson. He is our director of global ETF research. We are going to look back at the year in ETFs.

Ben, thanks for joining me.

Ben Johnson: Thanks for having me, Jeremy.

Glaser: Looking back at ETF headlines, some of the big ones that people are talking about--maybe like the launch of the vegan ETF--but you think that wasn't really the important story, that's not really what's driving growth in the industry or these novelty ETFs?

Johnson: No, the story in 2018 has really been the story of the past two-plus decades in the ETF space, which is, whatever is capturing headlines--be it the potential launch of a vegan ETF, bitcoin, blockchain, marijuana, you name it--is not actually what's driving growth in the ETF space. What's driving growth in the ETF space is low-cost building-block ETFs. These ETFs are sort of the Swiss army knife of the ETF category. They can do a lot of different jobs for a lot of different people.

You take, for example, an ETF like the iShares Core S&P 500 ETF. That's an ETF that can be a core portfolio position for an individual investor. It can be used in place of a futures contract by an institution. These ETFs, and ETFs in fact that have fees less than 10 basis points, have accounted for 63% of the $275 billion or so in flows through mid-December into ETFs at large. They don't capture headlines because they are not sexy; they are very utilitarian. But they do a great job for a huge number of investors.

Glaser: Looking at those building blocks, one of the other big trends was using those to actually create model portfolios. What's behind that, or what do you think is next in that space?

Johnson: Another key driver of growth in the ETF categories is the rise of what I call model builders. Model builders being a variety of different entities that are now increasingly using ETFs exclusively to build model portfolios and deliver them to a variety of different client types. This could be home-office teams at large wire houses like Morgan Stanley or Merrill Lynch that are taking the views of the house that they reside in and expressing those views in ETF model portfolios that advisors within those channels are then delivering to their end clients.

This could be, if you come further downstream, manifest itself in so-called robo-advisors or digital advice solutions. If you are investing with, say, Schwab or even a Merrill Edge, you might be able to access as a small individual investor a ready made ETF model portfolio or one that's customized to meet your specific circumstances. Increasingly, what you are seeing is that the ETF sponsors themselves are refashioning themselves as model builders as well. Taking their own raw ingredients, their own ETFs and repackaging them into model portfolios as well, moving away from selling individual slices to increasingly selling whole pies to advisors and in some cases, direct to individuals and ETFs of ETFs.

Glaser: Historically, we may have thought of ETFs and passive investing as synonymous. But we've seen active ETFs really take quite a few flows in 2018.

Johnson: Active ETFs have had really their best year ever. What we've seen is this is a category that's punched above its weight in 2018, came into the year accounting for about 1% of overall ETF assets. They have accounted for 10% of flows for the year to date and this is largely because some of the original actively managed ETFs, some of the most successful actively managed ETFs have been funds that focus on the very short end of the yield curve. These are very safe harbor-type strategies applied by very successful firms like PIMCO. The poster child for this subcategory of actively managed ETFs would be the PIMCO Enhance Short Maturity ETF, MINT the ticker for that particular fund, which has had a tremendous year in terms of inflows. Markets have gotten shaky; interest rates have begun to rise. Investors have flocked into these ETFs as well as short-duration bond funds of all types as they have sought safe harbor.

Glaser: Ben, thank you.

Johnson: Thanks for having me, Jeremy.

Glaser: For Morningstar, I'm Jeremy Glaser. Thanks for watching.