‘Pundits’ See More ETF Growth; Reduced Active Management

Morningstar’s Ben Johnson: ‘ETFs eliminate idiosyncratic risk by removing humanness’

(Photo: Jim Tweedy) (Photo: Jim Tweedy)

Tom Lyndon, editor and publisher of ETF Trends, tells the story of meeting with some mutual fund executives about five years ago who, when asked about ETFs, said, “It’s just a fad.”

That “fad” has turned into a $2 trillion juggernaut, and now it’s mutual funds, with $14 trillion under management, that, with active managers, are seeing a shrinking future.

This was one insight passed along in the “Meet the Pundits” panel at the Morningstar ETF Conference in Chicago. Moderated by the Financial Times’ Robin Wigglesworth, the consensus was ETFs would keep growing, both in number and in popularity.

Matt Hougan, CEO of Inside ETFs, said, “The traditional active manager is sort of like people driving cars: they know in 5 to 10 years the idea of humans driving cars is absurd because cars driven by science and math are infinitely safer ... same with management.

“A human driving a portfolio of stocks will seem insane.” The field largely will be indexing and smart beta programs, he added, with a small part for active managers, such as hedge funds. “Mutual funds will keep shrinking, and the tide is not going back,” he said.

Ben Johnson, Morningstar director of global ETF and passive strategies, noted part of the growth of ETFs is due to the seven-year bull market, but he said it’s also due to the “wholesale changes in how advice models are delivered to investors, so ETFs are very simple, stable, tax efficient and very low cost building blocks that lend themselves well to fee-based advice, to be manned by humans or pure digital advice or a combo. Much like the Internet, ETFs are an advancement in investment technology.”

Wigglesworth focused on the cost factor of ETFs vs. active managers, and the relative performance of both, noting the high 2/20 structure of hedge funds and lagging performance [Bloomberg wrote in February 2016 that the HFRI Index returned 18.3% annually from 1990 to 1999, and just 3.4% annually over the last 10 years]. Is this the end of the $2.9 billion hedge fund business?

“There already are hedge fund replication ETFs in development that do hedge fund type strategies,” Hougan said. “ETFs will expose the fact that a huge swath of hedge funds are closet indexers.”

Johnson noted ETFs have taken the decisions active managers have made historically and codified them to become passive. Hougan agreed: “It’s a new form of active management. Design is active, implementation is passive.”

Lyndon pointed out another difference with ETFs and active management: “There are no rock stars in the ETF space: no Peter Lynches of the world who people follow. There are few people behind ETFs, which takes out the emotion.”

Johnson noted, “ETFs eliminate idiosyncratic risk by removing humanness.”

Has the ETF market become too crowded, with troublesome niche entries? Wigglesworth asked.

All panelists agreed there were those very niche ETFs, which probably wouldn’t grow large enough to hurt anyone if they busted. “Look at individual stocks,” Hougan said. “People have chased individual stocks forever.”

ETFs have not been without any problems, and one solution has been implementing a limit order default, Johnson said. “That can encourage better behavior and better execution,” he said. “The biggest risks remain in the broader ecosystem.”

Hougan said TD America implementing the limit order as a default “was genius.”

Lyndon worried about how robo advisors might work during a 20-30% correction. Hougan said he had a robo account and kept getting text and e-mail updates from it during the Brexit siege. “It prevents customers from making mistakes during periods of stress, and is a better communicator than an advisor who takes a couple days to get back to someone.”

So what about further growth? Wigglesworth asked. Lyndon saw the growth continuing in ETFs as institutions are increasingly adopting them. He also noted there was “huge” opportunity in global and emerging markets.

(Related: ETFs Will Be in DOL’s Crosshairs)

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