ETFs still improving after 25 years
28 February 2018 | Topical insights
January 2018 marked the 25th anniversary of the launch of the first exchange-traded fund. In this interview, Matt Hougan, CEO of Inside ETFs, which produces ETF conferences and webinars, reviews the state of the ETF market in the United States. He examines the reasons that ETFs became a juggernaut, explains how they are transforming the fixed income sector and describes how they are changing the advice profession.
Mr Hougan is not affiliated with Vanguard, and Vanguard does not make any representation regarding his views.
What is the single biggest contribution ETFs have made to investing?
Matt Hougan: ETFs are levelling the playing field between the big guys and small investors, and that's a wonderful thing.
Investors of all types can get institutional-quality portfolios at institutional prices. That's a phenomenal offer. ETFs have put pressure on the entire financial system – from active managers to advisers – to provide more value for service. ETFs help to make the system more transparent, and that can be a force for good in that it pressures people in the system to be more honest and trustworthy. There will always be con artists among us, but that game is getting harder. In many ways, ETFs are helping to change the culture of finance.
What are some hurdles the ETF industry has overcome in the last 25 years?
Matt Hougan: The biggest hurdle was that you had to educate people on what ETFs were and give them a convincing reason to change. It was not easy for the industry to get over that initial hump.
Trading and market-making have become more efficient than they were 25 years ago. You used to have to trade ETFs with one market maker, and the spreads would widen when that market maker went to lunch. Now there's a large ecosystem for ETFs. Even new ETFs tend to trade with tighter spreads because the market has become so efficient at arbitraging away price gaps.
What has been your biggest surprise in the development of ETFs?
Matt Hougan: I would be lying if I said I expected ETFs to be what they are now, a US $3.5 trillion industry in the United States. We thought they were exciting, but we didn't see that.
What has also surprised me is that, until the last two years, it took so long for fixed income ETFs to gain traction. ETFs are great for equities, but they are transformational for the fixed income market. There was no fundamental reason for the delay.
How are ETFs transforming fixed income?
Matt Hougan: The core benefits of ETFs are that they can be low-cost, tax-efficient, tradeable and liquid. Those are incremental advantages in equities since a broad-based equity ETF is quite similar to the institutional share class of a broad-based equity index mutual fund.
But ETFs do something magnificent in fixed income and particularly for corporate bonds. Corporate bonds are traded in a horrible market where evil things lie. There are still 1-percentage-point spreads on some individual bonds, and things trade on appointment. If you don't have the right relationships, you can get unfair pricing. ETFs take corporate bonds out of the darkness and into the light. Investment-grade1 and high-yield bond ETFs trade on spreads that are a penny wide, while individual bonds are traded at spreads of 50 basis points or more. ETFs make it fairer for everyone.
Bond ETFs bring all the same advantages as equity ETFs, plus they compensate for the horrors of the market for individual bonds. It's amazing. That's being recognised now, and we're seeing accelerating and record flows into bond ETFs. But I'm surprised it's taken years to get there.
What are the most common misconceptions you encounter regarding ETFs?
Matt Hougan: There are these myths about ETFs, or indexing, destroying the world. That's a misconception that won't go away; it seems as if it gains currency – and then is debunked – almost every three years, like clockwork. Yet any analysis based on data shows that it's not true.
For example, one assertion is that ETFs lead to the misallocation of capital because they destroy the ability of the market to reward well-run companies. But the actual data suggest otherwise. Index correlations are falling, and the dispersion of the S&P 500 Index is the greatest it's been in a long time. The idea that only so much of the market can be in market-capitalisation-based index products or price discovery will be subverted is reductio ad absurdum. In the real world, using actual data, there is just no sign that this is the case.
The same thing is true of another anti-ETF assertion: the idea that the common ownership of securities leads to collusion in pricing. There is the famous paper2 that suggests that this may be true, but that paper is overwhelmed by reams of serious research suggesting that it's not.
There is also a bit of misdirection in these arguments. To put these arguments forward but ignore the massive savings of index-based products for everyday investors is capricious and wrong. Lower costs help people secure their retirement and send their kids to university. That is a massive societal good.
There are now about 2,000 ETFs listed on US markets, and more ETFs launch nearly every day. Can the market support this many products?
Matt Hougan: I remember when the first story about ETFs covering the entire market came out, back in 2002. We're 1,800 ETFs later. So I don't want to short-change the creativity of the ETF industry. Could there be 4,000 ETFs? Of course there could.
Eventually, we will get a significant number of active funds in an ETF wrapper. That evolution will take place in the next ten years. Many of the 6,000 mutual funds listed in the US will migrate over to the ETF wrapper, so that should allow the absolute number of ETFs to rise substantially.
How are ETFs changing the advice profession?
Matt Hougan: ETFs have brought two major trends to advice.
The first trend is that a large number of advisers have taken active management responsibility from active managers and put it in their own hands. They are building portfolios of ETFs and deciding what tilts to make and what factors to gain exposure to, as opposed to outsourcing these decisions to active managers.
The second trend is that ETFs have changed the focus of the advisory business from managing money to managing people's behaviour and lifestyle. ETFs are an investment vehicle, so it is odd to say that they've taken advisers away from money management. But they have.
Advisers can now build an institutional-quality portfolio with broad diversification at the push of a button. Given that that is now a commodity, many are realising that it makes sense to focus, instead, on what really matters, which are their clients – to improve clients' behaviour, so they don't sell at the wrong time, and do life planning to improve how clients are saving and spending. That's not to mention more technical matters, such as taxes or retirement drawdowns, in which advisers can serve clients. ETFs are driving the shift to things that add more value.
Over the last three or four years, since robo-advisers have become big, the level of interest in our articles, conferences and webinars that are focused on financial planning issues has increased significantly. This is not a majority paradigm yet, but it's growing rapidly.
It sounds contradictory to say both of these trends are under way at the same time, but they are. The truth is that advisers can add more value through the second trend – managing people's behaviour and lifestyle. If I were entering the advice business today, I would anchor my practice around financial planning and behavioural coaching.
What's your view on factor-based investing?
Matt Hougan: The big picture: I like the idea that we are continually exposing the fact that high-priced active managers are mostly doing a beta service, and we're giving investors a low-cost way to access those betas.
I'm concerned about factor investing, however, because I'm worried about investor behaviour. Factor products may need to be held for long periods to deliver their promised returns. I worry a little bit that factors will drive investors to chase performance. The burden will be on asset managers and advisers to make sure investors know that when they buy this fund or ETF, they should plan on holding it for five, seven or ten years. Or else they should just buy a broadly diversified index fund. Factors have good potential. There are some great product designs, but I worry about the gap between product return and investor return.
Where do you see the most competition in the US ETF industry, and where is there good cooperation?
Matt Hougan: It has gotten extremely cutthroat between liquidity providers. They've stopped fighting over pennies, or even tenths of pennies, and now they're fighting over hundredths of pennies. That market is extremely competitive, which is great for investors.
There's reasonably good cooperation in the ETF industry in speaking with regulators and in supporting investor education. Asset managers have put a lot of work into creating excellent materials for investors and advisers, as well as providing core education about products.
What will likely be the biggest catalyst moving forward?
Matt Hougan: The biggest catalyst to future ETF growth is simply momentum. Remember, unlike a mutual fund, a small ETF is a bad ETF in many ways. It trades at wide spreads and may have tracking difficulties, and it has a variety of other problems. But once ETFs get larger, particularly for broad-market equities, they just get better. A large ETF is more liquid and tax-efficient, and costs less, than a small ETF. So now that we have had some success in ETFs, it's just going to snowball. In other words, a primary driver of continued growth will be the network effect in ETFs that makes them better as they get bigger.
The last shoe to drop may be retail. Retail investors remain a minor part of the ETF industry, in part because of transaction costs and fractional-share accounting. But those issues are slowly fading with the rise of commission-free trading programmes and similar ideas. We'll know retail investors have arrived when you see an ETF ad on the Super Bowl broadcast. Anyone want to bet that won't happen in the next three years?
It's been an amazing 25 years, and the growth has been incredible, but I think we're just getting started. I think we'll double the assets in ETFs in the next five or six years. We're still in the early stages of growth.
1 A bond whose credit quality is considered among the highest by independent bond-rating agencies.
2 José Azar, Martin C. Schmalz, and Isabel Tecu, 2017. "Anti-competitive effects of common ownership." Journal of Finance.
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