State Of ETFs 2017 Presentation

State Of ETFs 2017 Presentation

Here's Dave Nadig and Matt Hougan's presentation from last week's Inside ETFs.

Reviewed by: Matt Hougan
Edited by: Matt Hougan

[Editor’s Note: The following is a revised version of the State of ETFs keynote given at InsideETFs on Jan. 23.]



Each year, we kick off InsideETFs by looking at the year that was, and giving our thoughts on what we think is in store for the ETF industry in the coming year, and beyond. This year, however, feels a little dark.



After all, 2016 was the year we lost Bowie, Prince and Leonard Cohen. No more Heroes, no more Purple Rain, no more Hallelujah. That’s a rough year.



But for ETFs, the story was different. ETFs had a very good year indeed, maybe one of the best years ever. 

$284 billion is a lot of money. That was the net flows into ETFs in 2016. That’s almost $1,000 for each man, woman and child in the United States.



In fact, it’s a record. And not in the way most records are made, by just inching over an imaginary line from the past. This was a blowout. This was Michael Phelps in a Shark Suit racing against the local YMCA team.


And yet even that understates the magnitude of what happened in 2016, because the mutual fund number was propped up by flows into index funds. If you just ignore vehicles and look at the flows out of active and into passive across all kinds of funds, the real number is even more astounding. It’s over $844 billion. That’s $1.6 million a minute. Count to four. That’s $100,000 that moved from active to passive.



Things are so bad for active managers that the active manager pulling in the most assets last year was actually Vanguard, and the list of managers gaining assets gets pretty thin from there. 



And it’s not just flows. We’ve seen this continuous increase in the use of ETFs as trading vehicles. This chart, which we show every year, is the ETF share of trading across all the exchanges in the U.S. Not only have we settled in around 30% of the dollar value on all exchanges, importantly, we’ve started to break the longtime connection between volatility and ETF trading. The connection still exists: On a volatile day, you still get an increase in the importance of ETF trading. But the measured correlation between the CBOE VIX index and ETF share-of-trading has gone from the high 70s in 2013 to the low 60s now. 



Figure 1
(For a larger view, please click on the image above.)


And at the same time, the industry is starting to feel awfully crowded. This fantastic chart from Victor Lin at Credit Suisse, arguably the best data analyst in the ETF space, maps out each issuer by the year they entered, and their assets. Just look at all the issuers on the right who’ve come in who have yet to cross $1 billion. This market is crowded, and it’s getting harder, not easier, for a new entrant to gain scale.

Still, overall, it’s a positive record: new players, record volumes, record flows. The ETF industry is becoming a dominant force in asset management, which has led some in the traditional active space to get concerned.



This was the title of a paper by Sanford Bernstein last August (which we covered extensively at This wasn’t a blog post, but a deeply researched attempt to address the “what if everyone indexed?” problem. The arguments aren’t exactly wrong, but the conclusions are a bit inflammatory:



The thing is, while we could argue about the math, the hyperbole of this is so dramatic it can’t help but seem like sour grapes—as if Fraser-Jenkins is chasing another famous Inigo:




In all seriousness, however, it does seem like there is a certain inevitability in the ETF market right now. 



The world we live in today isn’t a dark one of dying capital markets, whatever the pundits say. It’s actually a world of a kind of ETF Manifest Destiny, where it’s written on tablets somewhere that there’s an ETF for every asset class, and it shall be virtually free to own.



That’s close to the world we’re already living in. There’s now an ETF for pretty much every area of the market you could possibly want to own, from cash to liquid alts. The landscape is well and truly covered.



And it’s not just a matter of coverage. ETFs have a strong network effect, which is to say—unlike active funds—they’re getting better as they get bigger. Consider the costs. People underestimate this. Active managers have been “travel-agented.” They’ve been replaced by a new technology, and ETFs have gotten cheaper almost faster than computers.



This is a portfolio I track on called the World’s Lowest-Cost ETF Portfolio.  

It holds the lowest-cost ETF in every area of the market, from global equities to bonds, REITs and commodities. It gives you exposure to more than 4,000 stocks, 800 bonds and 20 commodities. And thanks to ETFs, you can buy it with a blended average expense ratio of just 0.08% a year.  

Think about that. A few years ago, a midsize institutional investor would have killed to get this portfolio at this price, and now, anyone can buy it, all from the comfort of our brokerage account. It’s the greatest deal in financial history.

And it speaks to the fact that ETFs are tremendous tools. But it also speaks to us coming to the end of the line a little. If the fees on this portfolio drop to literally zero, you’ll save $800 in a year in a million dollar portfolio. That’s not anything, but in the scope of a $1 million portfolio, it’s largely irrelevant. The smallest timing difference on a rebalance will gain or lose you that much in a given year. Just having one trade go slightly wider than you expect will cost you $900. 



And for that reason, the chart that we’ve been tracking for years, predicting the ETF industry crossing the mutual fund industry in 2025, is looking right on track. In fact, it’s looking like we might get there sooner, with a little luck. 




But for individual advisors, it’s not quite as sunny.

Look: It’s been 10 years. If you were at Inside ETFs 2007, or indeed if you’ve been there for any of the last 10 years, you’re an ETF advisor. That means you’ve had this incredible tailwind at your back. You’ve been riding it forward, and your adoption of ETFs has not only accelerated the industry, you’ve gotten to these calm, still waters at the end of this great run.

But we think that’s changing. We think the next 10 years will look a lot different than the last 10 years. You know it, your clients know it and issuers know it. 

In a way, you’ve been acting like a small institution for the past 10 years, and that’s been great. But now, it’s not enough. Now, if you want to succeed, we’d argue, you need to start thinking like a large institution. So what does that mean?



Well, if you read the headlines, you’ve probably been thinking that smart beta was the future. And certainly you’d be OK thinking that. The ETF industry has been all-in on this. Institutional investors were early adopters of smart beta, and they plowed into early entrants like the FTSE RAFI products, and the MSCI-based quality mix products and the low-vol ETFs.



But the reality is, this market is not growing like you might think. Yes, smart beta is growing, but the early days of currency hedging and min-vol flows have largely faded. Growth has come down. 



And if you look at where the growth has been in 2016, a lot of it is in funds many people might not consider smart beta. We’re big-tent folks here, so we look at pretty much anything that’s targeting single factors as smart beta, so that means Vanguard’s Value Index ETF, VTV, is the top of last year’s charts, with $5.3 billion in inflows.



And if you look at what’s happened in fees, we think it’s coming down too. In 2015, Goldman launched its large-cap smart-beta product at 9 bps, setting a low bar on smart beta. In reality, the market for smart beta is more like 25-50 bps, but that’s still well down from just a few years ago, when factor and smart-beta products were more in the 75 bp range. There’s only one way these product fees go—it’s manifest destiny all over again. 




Perhaps more importantly, there’s not a lot of evidence that investors are particularly good at using these products. We’ve been tracking dollar-weighted returns in ETFs for the last year, and the reality is, ETF investors as a whole aren’t any better at picking their entry points than anyone else. This shows you how far off the headline returns the average investor is in a handful of dividend products, and lo and behold, they’re not great at timing, and this is the pattern you see across almost all smart-beta ETF categories. 



It’s a little better when you get to some corners of the market—USMV investors seem to be a bit more buy-and-hold, for instance. But the message is clear—smart beta isn’t a cure-all. In fact, charts like this make me think advisors are more important than ever. Advisors are the front line. They’re the ones who can keep investors from making the dumb mistakes. By all means, they need to get good at picking and using smart-beta ETFs—like big institutions are—but just keeping investors from themselves is probably half the added value.



The second big part of the next wave in ETFs is, believe it or not, active management. Now it’s easy to think that the age of active is over. It’s easy to think that Jeff Gundlach, DoubleLine’s chief smart guy—here badly Photoshopped into The Governator’s body—is the last great active manager. But the truth is, there’s a real appetite for active management, particularly among institutions.



In fact, consider that Gundlach’s flagship ETF, TOTL, just had its first outflow in two years. That’s like hitting holes-in-one 18 holes in a row. Yes, performance was solid here, but this is just an incredible record of investor interest.



There are now 168 active ETFs—about 10% of the industry. And over 40 were launched just last year. These are all fully transparent active funds. Imagine what happens when we get an entirely new SEC in a few months. The dam on nontransparent active will surely break, and that means even more traditional active managers enter the mix. 



So what does that mean for you? Here’s the problem: It turns out picking active managers is really hard. The WSJ has been doing this ongoing study of the shift from active to passive, and putting together some great charts. This one is our favorites. The left shows the top 20 fund managers for the 10 years ending 2005, and then how they did in the 10 years after. We all know this—past performance is no guarantee of future returns. And if active comes back, you’re going to have to figure out where it fits in your ETF due diligence process. But again, make no mistake, the big institutions are working through these problems, and you’ll need to be doing so as well.



Smart beta and active are two parts of the ETF market where we already see funds with real traction—there’s real product with real assets, and there has been for some time. But this next area seems like pretty new territory for a lot of advisors I talk to—impact investing and funds focused on environmental, social and governance issues. It’s an area institutions have been in for quite some time, but has really never caught on with retail investors and financial advisors. We think that’s going to change. 




First, let’s look at where most of the wealth is in this country. Unsurprisingly, it’s with the baby boomer generation. And what’s about to happen to them?



Short answer: They’re about to pass all that money down a generation. This excellent chart from Cerulli Associates points to almost $30 trillion in assets that will be handed down over the next 30 years. In fact, it’s already starting to happen. 



Overall, the U.S. pension system has been in net-disbursement territory on and off since the ’90s, as the defined benefit market dried up. 



But even if you just look at the 401(k) market, we’re seeing sustained net-distributions really for the first time ever. That’s money coming out of 401(k) plans, and either being spent on goods and services, or reinvested, or handed down a generation.



Now, the good news is that study after study shows that millennials love ETFs. This study from BlackRock suggests 70% of millennials will use ETFs in the next year. That’s a big deal. Problem is, most advisors aren’t well-situated to capture these investors.




Some of the issuers are simple: Millennials simply prefer to communicate differently, often asynchronously and intermediated by technology. And most advisors will have to rethink their communication strategy and their relationship building strategy. Most often, the first contact with the inheritor of a significant account will be when they show up with their elder parent. And they’re going to have different interests than their parents. And they’re going to have different preferences about their investments.



In particular, millennials are far more likely to expect an advisor to have ESG concerns as a primary factor in picking investments. This study from FactSet suggests that over 60% of high net worth investors under 35 expect ESG to be a first-screen on any holding.



And the industry knows this. That’s why we’ve seen a raft of new product launches and new filings just in the last year. Most of the impetus for the moment is coming from institutions. The SPDR SSGA Gender Diversity Index ETF (SHE), for example, was launched with hundreds of millions of dollars from the CalSTRS retirement system.

We predict that in 2017 and beyond, you’ll continue to see institutions demanding—and funding—ESG ETFs, and it’s only a matter of time before the millennial wave catches on too. Whether advisors recognize the trend early enough to adjust their practices will separate the winners from the losers.



Why end with a picture of Harvard? A few reasons. First, we think the age of advisors acting like small institutions—with this incredible ETF-wind at their back—is mostly over. Success with ETFs going forward means thinking more like a large institution: focusing hard on investor outcomes and preferences, and using smart beta, active and ESG products to refine exposure to a razor’s edge.

But it’s also a bit of a cautionary tale. Harvard is literally the largest college endowment, with over $35 billion, and yet, for the past 10 years, an overreliance on underperforming internal trading has led to subpar performance, leading to a recent layoff of 50% of the endowment’s staff. Harvard’s now going to follow in the footsteps of most major institutions, and focus on selecting the best external money managers—both active and passive—to manage the school’s assets.

That kind of shift—from picking investments to focusing on the big picture—is the same kind of shift we imagine most advisors will be going through in the coming years.

It will be interesting to watch.



Matt Hougan is CEO of Inside ETFs, a division of Informa PLC. He spearheads the world's largest ETF conferences and webinars. Hougan is a three-time member of the Barron's ETF Roundtable and co-author of the CFA Institute’s monograph, "A Comprehensive Guide to Exchange-Trade Funds."