ETF Expert Corner

Bloomberg’s Eric Balchunas Highlights Key Trends in ETFs & Investing

December 6th, 2016 by ETF Store Staff

Eric Balchunas, Senior ETF Analyst at Bloomberg, highlights several key trends shaping the investment landscape, explaining the potential longer-term implications to investors.



Transcript

You can listen to our interview with Eric Balchunas by using the above media player or enjoy a full transcription of the interview below.

Nate Geraci: I'm now very pleased to welcome to the program, Eric Balchunas, Senior ETF Analyst at Bloomberg. Eric covers ETFs for both Bloomberg TV and Bloomberg Radio. Earlier this year, Eric published a book on ETFs that's titled The Institutional ETF Toolbox, a book I'd certainly recommend for any ETF investor. As I mentioned earlier, Eric, he just does an excellent job of looking at the bigger picture trends occurring in ETFs and investing. That's what we'll be focusing on today. Eric is joining us via phone from Philadelphia. Eric, great to have you back on the show.

Eric Balchunas: Great to be here, guys.

Nate Geraci: Eric, first, let's just start with ETF flows year-to-date. According to ETF.com, there's been nearly 225 billion dollars in new ETF creations, that's through the end of November. ETFs are on track for a record year in terms on new assets. Is this just more of the same in terms of investors looking to lower costs and index based options? Or do you think there's anything new to this story?

Eric Balchunas: There is some more of the same. I have a bar chart showing the flows going back ten years. For the past three years, they've been around 250 every year. They're at this consistent quarter of a trillion dollars in flows each year, seems to be where they're at. That could pick up with the DOL rule. We'll see. What I find interesting is that ETFs tend to take in more money than mutual funds lose. So what's happening here? What you find is that even though the big story is ETFs being a lower cost, more tax efficient version of a mutual fund, institutions like using them for a variety of purposes. They almost see them as a replacement for a futures contract or a swap. With regulations, the banks have had less interest in serving those types of securities, so institutions, I think, are another participant in this market. It's interesting for the first time, I think ever in investing, you have both the biggest investors and the smallest ones using the same products and paying the same fee which I think is part of why people will say ETFs have democratized investing.

Nate Geraci: Eric, this trend of investors pulling their money out of active mutual funds and moving to passive funds and ETFs. Obviously, this isn't a new trend. There's been about a 1.5 trillion dollar shift over the past three years alone, but it does seem like this has received a lot more attention from the main stream media this year. I know back in October, the Wall Street Journal ran a lengthy series on the dying business of stock picking. It was almost hard to believe. But because of this attention, I think some investors are now wondering whether we've reached peak indexing. I'm curious, where do you think we're at in this shift? Do you think active and passive are cyclical? Or is this a more fundamental shift that we're in the midst of?

Eric Balchunas: First of all, this question gets asked a lot. Right now, we're at about 30% in indexed based products. But keep in mind, a lot of ETF usage is being used very actively. People are looking to get alpha by changing the weightings on their ETFs. It's not necessarily purely a buy and hold Vanguard index fund. That's about two trillion dollars, so the other two is more active people using ETFs more actively, like building blocks. Now, in terms of the bigger trend, the media is definitely on this. However, as an analyst, I have unwrapped this trend. I've found a greater trend. I think the mother of all trends is high cost to low cost. I call it the great cost migration, because if you isolate flows by investment vehicle buckets, then if you look at just actively managed mutual funds, some are taking in money. Vanguard and DFA's active mutual funds have net positive flows on the year. Then, there's some active mutual funds that are crushing their benchmark but losing money. Billions in outflows. The difference is that Vanguard and DFA charge 20 and 36 basis points whereas the other ones that even though they're beating benchmarks but they're seeing outflows are expensive. Same thing with ETFs, if you look at the average ETF fee, it's 50 basis points, .50%. The average asset weighted fee is 25 and the average fee of the top 20 that are seeing the most flows is 12. So investors, no matter what bucket you look at, they just have a nose for the cheapest products and that's where they're going.

Nate Geraci: You mentioned the DOL fiduciary rule, I'm curious, where do you think that fits into all this? Assuming nothing changes with the Trump administration, this is set to go into effect in April. What further impact do you expect that to have on investment costs? And more broadly, ETF flows?

Eric Balchunas: My metaphor for this is that the DOL rule is akin to a tailwind hitting an airplane that's halfway to its destination. That plane is flying already. It would be nice, but it's not necessary. Larry Fink of BlackRock says it's worth about a trillion dollars quickly. I think you might see that 250 billion a year in flows basically double or triple. Without the DOL rule, it could be just a little more of a tortoise move towards where that plane is going anyway which is to a world where people are getting low cost, mostly passive investments. Shops like you guys have been doing this for a long time. You even see bigger companies now starting to go to a fee-based model and being fiduciary. It really shouldn't have to take a rule that advisors are supposed to look out for the best interests of their clients.

Nate Geraci: Eric, when you look at outflows from actively managed funds, I know a point that you've made in the past is that because we've been in a bull market for going on 8 years now, that's sort of masked some of the pain for active fund companies since net assets have still grown because of the increases in stock prices. I think a natural thought would be that a bear market could really be the death knell for some of these active fund companies. On the flip side, I think you could make the case that one of the reasons active funds have been losing investor dollars is because of the bull market. Active funds just can't outperform when everything is going up. I guess my question is, even if this is a fundamental shift we're seeing to passive investing, what do you think happens to active fund flows when the market finally turns down? Does that change anything?

Eric Balchunas: I've studied this because I get this feedback a lot from the stock analysts I work with. They say, "Oh, this is cyclical." If you look in 2008, I isolated active mutual funds. Two thirds underperformed in 2008 when the market went down 36%. Two thirds went down more than their benchmark. So it's the same thing, whether the market is up or down, the S&P Index versus passive report numbers seem to persist. What I think the difference is and the reason this is a secular change, and this is a theory which isn't proven but is building more with me, is that the internet is really the big variable here that didn't use to exist. People were used to getting a quarterly report. They had no other real benchmark unless they talked to somebody at a barbecue or something. But now, there's blogs, there's shows like yours, there's the internet and the spread of information has wizened investors up. So I think it's more permanent. In terms of your question about these big active shops being in trouble, that's an understatement because listen to this. The active mutual fund companies, take Janus for example, it's seen 40 billion dollars in outflows over the past 5 years, but its assets went up from 80 billion to 110 billion. It's made more money even though it lost half of its customers. This is a business where as long as the market goes up, it can cover up those revenue losses. If the market goes flat or goes south, I think you're going to see a lot of companies teaming up, joining forces. You could see a conglomeration of just a couple asset managers at the end of this sort of creative destruction.

Conor Kelly: Eric, this is Conor Kelly. On that point of the flows that have gone out of active mutual funds. You retweeted something that Matt Hougan over at ETF.com wrote recently. He thinks that mutual funds will be quote, "Banished to the dust bin like typewriters have been replaced by computers." Do you think that is the end game for mutual funds?

Eric Balchunas: This is where it gets complicated. This is why I sort of stick to my great cost migration, because an index fund from Vanguard is still a mutual fund and they're not going anywhere. They're taking in 150 billion dollars this year. They tend to take in about 40% of all this movement to passives. Then, you've also got funds like DFA and Vanguards which again are net taking in money. I don't agree with Matt completely. I think that the mutual fund structure clearly is lacking compared to the ETF in certain ways, but I'm just not sold on that yet. The other thing that would have to happen would be the 401k market would have to bump them out. Right now, that's their Alamo. ETFs are just going to have a hard time penetrating that. Again, I see this as sort of a tortoise move over to the ETF side, but it's not going to be complete. The only thing I can guarantee you, at least from the data, is that everything is going to go lower cost.

Nate Geraci: Again, we're visiting with Eric Balchunas, Senior ETF Analyst at Bloomberg. Eric, you mentioned Vanguard. Boy, Vanguard is just vacuuming up investor dollars. I haven't seen November flows yet, but through October, Vanguard had taken in nearly a quarter of a trillion new dollars. As you know, they have the unique structure where the company is owned by the funds, which are owned by the fund shareholders. So they can return profits to fund shareholders through lower fund expenses. Can anybody compete with Vanguard on cost?

Eric Balchunas: It's very difficult. I think Vanguard has something else going for them that isn't low cost or the index thing and that's trust. I really get to the heart of the matter here. If you look at the 80s, the 90s and the 2000s, all of this money came in to the fund industry and nobody really passed on economies of scale like they were supposed to. That was the promise of the 12b-1 fee. Only Vanguard did. They're the ones whose average fee went from like 60 to like 13 over those 20 years. They've built up a trust with their investors that is so strong, it gets to the point where their investors don't even sell when the markets turn. They're trained. They've gotten into this trust with them that I think a lot of shops, the trust is broken. Investors have felt like they didn't get value for their money. That's going to be difficult to repair. So, yeah, it's going to be tough to compete with Vanguard. The numbers they're putting up are ridiculous. However, other companies are going to probably join forces and try to create their own economies of scale to push costs down to at least be in the ballpark of Vanguard.

Nate Geraci: What about somebody like iShares? I think obviously, iShares has investors' trust. iShares is the largest ETF provider and somebody who competes directly with Vanguard. What's the end game for somebody like iShares? Because they have lowered fees on many of their core ETFs to compete with the Vanguards and Schwabs of the world. I think it's tough to make a whole lot of money charging three or four basis points on an ETF. They don't have the structure that Vanguard does. Is this simply a loss leader approach for iShares since they have a much larger suite of other less plain vanilla ETFs?

Eric Balchunas: To a degree. I think they're also thinking they can just get enough money where they can break even or make a little money on scale, but I think with iShares, where they're fortunate is that they came in early. They have multiple products, almost half of the categories. The iShares ETFs are the most liquid. That's huge. There are institutions who will just never use the less liquid product even if it's a fourth of the price. So iShares liquidity is a huge benefit. If you look at the flows over the past three years, BlackRock has beaten Vanguard. This is the one turf where Vanguard doesn't win. I mean they win because they take in about 100 billion dollars every year, but iShares does beat them. You've got to tip your hat to them because it's some place where somebody figured out how to compete with Vanguard. iShares is doing, I think, a phenomenal job. That's why I say it used to be the big three, but it's becoming the big two because if you look at the flows of the last three years, BlackRock and Vanguard account for 72% of all net cash into ETFs.

Nate Geraci: All right. I want to switch gears and touch briefly on more recent ETF flows. Since the election, U.S. stocks have performed very well. Bonds and gold have taken a hit. Are you seeing this reflected in fund flows? I'm curious, has there been anything else that has stood out to you over the past month or so?

Eric Balchunas: Everybody got Trump wrong in the political punditry class and they got him wrong in the investment punditry class. Gold was supposed to be the way to play an outside Trump win, maybe bonds. Safe havens, right? The exact opposite happened. What's remarkable to me is that U.S. stock ETFs took in 48 billion dollars since the election in November basically. That is more than they've ever taken in in a month. The second best month for them this year was the month after Brexit. Ironically, it seems like investors like populism. It's contrary to what you would think. I say Trump is both a catalyst and a challenge. The way he's a challenge is just unpredictability: terrorists, you're not quite sure of his policies completely. So there could be some unpredictability there, but I think business does think he's going to lower taxes and be on their side. If businesses start spending money because they've stored their cash, that could be really good for both the stock market and the regular economy.

Nate Geraci: Obviously, since the election, we have seen yields spike up and so bonds have not performed well at all. I know you recently wrote a piece titled "ETFs that work for rising interest rates." You walked through several different ETF options if investors had concerns about rising rates. Is this the next popular ETF trade? We had currency hedged ETFs in 2015, and low volatility earlier this year. Are rising rate ETFs next?

Eric Balchunas: Yeah, potentially. It's interesting though. I always refer to currency hedged ETFs as central bank surfboards and interest rate hedged ETFs as central bank lifeboats. These are how you stay above rising rates. The difference though is that currency hedged ETFs were the only way to really do that. The thing with bond ETFs is that you could go into short duration stuff. You could go into floaters. Interest rate hedged ETFs are another option for you, but there's several ways to deal and laddering. Those target date maturity bond ETFs have quietly gathered about 12 billion. One guy in my book was quoted as saying, "That's how your grandfather used to do it. You ladder." There's all kinds of ways to deal with the Fed. I don't think interest rate hedged will be as big as currency hedged ETFs, but certainly, they are lined up like a clone army, ready for rates to rise. They've been ready for the past five years. There's been a few false alarms, but it looks like the alarm bells are going off again. We'll see if it's the real thing this time.

Nate Geraci: Again, we're visiting with Eric Balchunas, Senior ETF Analyst at Bloomberg. Eric, before we let you go, I did want to ask you about ETF proliferation. This is a topic we've covered a lot on the show this year. We now have a whiskey ETF, there's a drone ETF, a 3D printing ETF. Do you consider these ETFs value adds for investors? Or do you think ETF launches have gotten out of hand?

Eric Balchunas: This a great question. I get this a lot. Yes and no, it depends. I have two tests for new thematic ETFs: overlap and volatility. Most are volatile so you have to sort of accept that. Let me give you the example of a video game ETF. It sounds like a joke. It's ridiculous. However, it's only got 4% overlap with the big tech ETF and zero overlap basically with the S&P. Here's the thing, people don't understand that indices from S&P and MSCI are very stingy with who they let in. A company has got to really be around for a while. It's almost like they only let full grown adults in. These niche ETFs that go out and try to capture companies in their toddler or teenage years are actually, in my opinion, a value add for a satellite position if you are bullish on that industry and like the fundamentals. In addition, they lower the volatility of going into an area like that and they sometimes have M&A targets. In a way, if you get lucky with the 3D printing ETFs, had two stocks bought by GE and that helped it pop about double the tech ETFs. I would look at the overlap. Then, there's other ones that repackage some S&P 500 stocks, put on like a new age label. To me, those are more gimmicky because you already own those stocks. You're just getting something you already own in a different package.

Nate Geraci: Quickly here, while we're on the topic of niche ETFs, do you think the Winklevoss Bitcoin ETF will ever be approved? I know that if it does, there's going to be a media feeding frenzy over this ETF. I thought maybe you and I could get a head start on talking about this.

Eric Balchunas: I actually wrote a piece saying five reasons it should be approved. I think that look, when you have an ETF, like remember that China A Shares ETF that came out. That was launched a little before it probably should have been, but it helped sort of get liquidity over there. A lot of the best market makers looked at the area. You're right, the media feeding frenzy will definitely keep it honest. I do think that ETFs have a history of breaking new ground, so I would support it now. I think it's a wolf in wolf's clothing. Nobody is going to be misled that this thing is really dangerous. It's Bitcoin. People know Bitcoin is sort of an odd area. It's other ETFs that sound innocent that are dangerous, like the oil ETFs that I would worry more about.

Nate Geraci: Eric, with that we'll have to leave it there. As always, just fantastic insight into ETFs. By the way, we need to get you out here to Kansas City at some point for one of your Bloomberg ETF events. It seems like you've held them in just about every other city. We need to get you to Kansas City for your tour stop. I promise, we'll get you some of the world's greatest barbecue.

Eric Balchunas: I would love that. I'll put it on the calendar for next year.

Nate Geraci: Okay. Thanks. That was Bloomberg's Eric Balchunas. Again, Eric is a great follow on Twitter. His Twitter handle is @EricBalchunas. That last name is B-A-L-C-H-U-N-A-S. You can find his book, The Institutional ETF Toolbox, on Amazon. Again, highly recommended. This is an excellent resource whether you're new to ETFs or if you consider yourself an ETF expert.