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First-Quarter Proves Positive for ETFs

Ben Johnson, CFA
Christine Benz

Christine Benz: Hi, I'm Christine Benz from Morningstar.com. As the first quarter winds down, investors continue to barrel into very low-cost exchange-traded fund products. Joining me to provide a recap of the first quarter in ETFs is Ben Johnson. He's Morningstar's director of global ETF research. Ben, thank you so much for being here.

Ben Johnson: Thanks for having me Christine.

Christine Benz: Ben, let's just do a quick stage setting, talk about the market environment in the first quarter. In some ways, you say it was really just a reversal of what we saw in the fourth quarter of 2018, right? 

Ben Johnson: Well, the entirety of 2018 really. If you look at calendar 2018, as far as investors were concerned, there was no place to run and no place to hide. Virtually everything went down last year. And what we've seen thus far in 2019 is a reversal of that trend--that virtually every Morningstar Category on a year-to-date basis has posted positive returns. And you see that manifest--sort of a return of investors' risk appetite--in ETF flow data. So what we've seen is a return to healthy flows that have been roughly $50 billion on a year-to-date basis that have flowed into exchange-traded funds. And most of that, if you look through the lens of Morningstar Categories, has gone into the U.S. large-blend category, so that would capture things like S&P 500 ETFs, total stock market ETFs. It's gone into diversified emerging markets, and it's gone into corporate bonds. So as you can see, as evidenced by these flows, investors have a bit more appetite for risk this year certainly than they did last year.

Christine Benz: And then within categories, investors continue to gravitate to very low cost, you call them vanilla, product types. Let's talk about that.

Ben Johnson: Absolutely. So if you were just to look through the lens of fees and isolation and flows into ETFs that charge a fee of 10 basis points, of 0.10%, or less, those have accounted for the majority of net new flows. Now these ETFs tend to be uniformly sort of dull, boring, uninteresting. Very vanilla, broadly diversified, market-capitalization-weighted, and charging razor-thin and ever razor-thinner, expense ratios with time. While the menu has continued to expand--it's become really somewhat saturated--investors' preferences--their selections from this menu--continue to channel into the largest, the most liquid, the lowest-cost funds that are on offer.

Christine Benz: And then in terms of providers, we are seeing most of the flows going to just two firms, iShares and Vanguard. Let's talk about that.

Ben Johnson: So over two thirds of net new flows on a year-to-date basis have gone to those two players. Actually, as of today, the two are neck and neck in terms of the flows race. I think Vanguard has collected maybe a hundred grand more in net new money than iShares has for the year to date, and as a result, Vanguard's market share within ETFs has actually edged up a little bit. IShares' has slipped, albeit just very marginally. And I think this is inextricably linked with the trend we just discussed which is the trend towards all things vanilla, broad-based, very inexpensive, very broadly diversified. And it just so happens that these two players--as well as others, if you include at the margin State Street, which has benefited from a flows perspective from the launch of their portfolio series of ETFs, as well as Schwab, which has continued to make an absolute run at the top five here and has amassed immense amount of money, largely owing to the fact that they have what's for all intents and purposes, an effectively, sort of captive distribution platform working with their brokerage platform--those four have really gotten kind of a stranglehold on this large core of the market, which is all things dirt cheap and vanilla.

Christine Benz: One thing that I know you and the team follow very closely have been these fee cuts that we've seen across providers. And one thing that you and the team have noted and I think maybe investors on the outside looking in probably haven't been paying attention to this is that some of those fee cuts are driven by considerations for portfolios that are run internally. So let's talk about that, talk about how in some cases the fee cuts may in fact relate to needing to populate these portfolios with the lowest-cost products.

Ben Johnson: So many of the largest ETF sponsors have begun to pivot away from selling individual slices of the pie, so an ETF that offers exposure to U.S. large caps or to a diversified core bond index, you name it, and towards building models. So they've created all of these raw ingredients, and I liken it to going into your local Chipotle--I've got 20 stainless steel buckets in front of me, each with a different ingredient and I can go from one end of the line to another and come out with 78,000 different kinds of burritos based on how I combine those things. So, the sponsors are moving towards mass customization, meeting the needs of a diverse client base by doing all of these different configurations with those raw ingredients, the ETFs at the portfolio level. So I would argue that at the margin, what we've seen and what's been called the fee war, could be as much a defensive move as it is an offensive one. So naturally you would think that edging out your competitor by a basis point or two here or there with fees would be an attempt to gain market share and absolutely that's part of the story. But I would argue that from a defensive perspective, as more and more of these sponsors are using proprietary products to build proprietary models, they want to be cautious about creating the appearance of any potential conflicts of interest. So if I'm going to have three like funds that are effectively identical, and I'm going to come into the market with a fourth fund, say tracking the U.S. total stock market index, and I'm going to use that fund in my own model portfolios, I reduce the risk of people raising their eyebrows about my using my own fund in my own models if I price it 1 basis point below the three incumbents than I would if I had priced it at parity. So I think there's an optics risk of sorts that many sponsors may be looking to hedge against as more and more of them use their proprietary funds and their proprietary model portfolios.

Christine Benz: Well, let's talk about these model portfolios. Who's using them? What are they intended for?

Ben Johnson: There's a variety of different investor types that are using these portfolios. The main area of growth has been in the intermediary space. So as more and more advisors have gone from picking stocks and throwing in the towel on picking stocks, to picking funds and throwing in the towel on that, to building portfolios themselves and now increasingly throwing in the towel on that exercise, they're saying, "Just show me. Give me the model itself. I know my client, I know what fits for them. Let's line up this information so that I can pull a model directly off the shelf, from whatever platform I might be using." So you see evidence of this phenomenon in the wire houses, you see evidence [of] it in the RIA community, who might custody client assets with say a TD Ameritrade or a Schwab. These models are being delivered to a variety of different client types and a variety of different means across the investor spectrum.

Christine Benz: OK, Ben. Another busy quarter in ETFs. Thank you so much for being here to provide a recap.

Ben Johnson: Thanks for having me.

Christine Benz: Thanks for watching. I'm Christine Benz, from morningstar.com.