ETF Expert Corner

Charles Schwab’s D.J. Tierney Talks Recent ETF Trends, ETF Due Diligence

March 20th, 2018 by ETF Store Staff

D.J. Tierney, Managing Director & Client Portfolio Strategist at Charles Schwab Investment Management, discusses their low cost approach to ETFs, recent ETF trends, and the important of ETF due diligence.



Transcript

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

Nate Geraci: Our guest today is D.J. Tierney, Managing Director and Client Portfolio Strategist at Charles Schwab Investment Management. Charles Schwab is currently the fifth largest ETF provider in the country. They offer 22 ETFs, with over $1 billion invested in those ETFs. Schwab also happens to be one of the fastest growing ETF providers as well. Schwab offers an extremely low cost, core lineup of ETFs that has really helped drive their asset growth. Schwab has certainly not been shy about aggressively competing on cost with some of the other large ETF providers, something we'll discuss here today. D.J. is joining us via phone from San Francisco. D.J., our pleasure to have you on the program.

D.J. Tierney: Thank you, Nate. Pleasure to be here. Thanks for the opportunity.

Nate Geraci: D.J., before we talk specifically about Schwab's approach to ETFs, I wanted to ask you about the broader ETF landscape. Of course, ETFs had a record year last year. They stormed out of the gate early this year before we saw the market correction back in February, but then last week was another record week in terms of ETF inflows. As you look at the overall landscape right now, what do you see? What are some of the key ETF trends that stand out to you?

D.J. Tierney: As you mentioned, 2017, record industry inflows. The investment vehicle itself is clearly resonating with investors across the country. Underlying that, what was really noteworthy last year, was the makeup of asset classes that saw inflows. A lot of people were surprised to hear that 34% of all the inflows last year went into international equity ETFs. You really saw investors and advisors focusing globally outside the US. Beyond that, over a quarter of the inflows were into fixed income, also surprising to a lot of people to hear. If you take those two, a majority of the flows actually did not go into US equities. But last, but not least, US equities did get 38%. That's last year, and what we're seeing in 2018 is a continuation of a few of those trends. One, yes, the flows are healthy year-to-date. Two, international equity is leading the charge. And then the other trend that I didn't mentioned that you kind of touched on is just the aspect of low cost. If you look at over the 2,000 ETFs that are out there, a relatively small number of them have expense ratios of 10 basis points or less. But those funds garnered over half the flows last year. This year, it appears that's even accelerating further because over two thirds of the flows this year have come into single digit basis points funds. So low cost is winning, and advisors and investors are using ETFs to diversify their portfolios beyond just US equities.

Nate Geraci: On this topic of low cost, obviously Charles Schwab does have some of the lowest cost ETFs around - expense ratios as low as three basis points, or $3 for every $10,000 invested. Can you talk a little bit about Schwab's approach here? Why has cost been such a focus?

D.J. Tierney: Well, we think it's a differentiator. We think it's really important for long-term investments. If you think about the average US consumer, someone will drive around the block looking for a gas station that's selling gas for five cents less a gallon to save $5 on their fill-up, and maybe $75 or $100 a year by shopping for gas. If you can lower your expense ratios on a portfolio by 10 basis points, that's $500, $750 for a year for a typical portfolio. Over 20 years, the compounding growth, it can be thousands. For a career for somebody it could be hundreds of thousands of dollars of impact over the long haul. So what we do at Schwab is we're ruthless on focusing on cost internally. We're focusing on products that we can build, scale, and then we pass on those benefits to our investing clients.

Nate Geraci: On that note, I know at Schwab there's a very strong emphasis placed on something called the total cost of ETF ownership. Can you perhaps expand on that? Maybe explain what it means and why it's important for investors to understand.

D.J. Tierney: Sure. It's a great point. Most investors and advisors will focus first and foremost on the expense ratio of an ETF or an indexed mutual fund, and that's the right place to start. That is generally the biggest cost component. But beyond that, the total cost encompasses transaction costs, like trading commissions. That's the explicit cost of a transaction. Implicitly, all asset classes have a bid-ask spread as well, the underlying liquidity. ETFs will have different bid-ask spreads. We like to focus on our ETFs that have one to two pennies of a bid-ask, which is about as good as you can be for a stock. So bid-ask spread, and then beyond that, what's the tracking error of the ETF? How well does the ETF deliver what its underlying index is doing? If you look at OERs, expense ratios, trading commissions, bid-ask spreads, and then the tracking performance of the ETF, those are the big all-encompassing components of cost.

Nate Geraci: D.J., going back to ETF growth, I know Schwab conducts a pretty comprehensive survey of ETF investors each year. The most recent survey found that 56% of millennials say ETFs are their investment vehicle of choice. Actually, most millennials expect ETFs to be their investment vehicle of the future as well. Why do you think that is and what do you think that says about the future of ETFs?

D.J. Tierney: I think it's constructive for the continued growth of ETFs, because millennials are our largest generation in the country and they're growing and their functional assets are growing faster than any other demographic. So the fact that they're embracing ETFs is good for the vehicle. To our study, just to mention, it’s an annual - we've been doing it for seven years. The most recent was released in September of last year. What's great about it is that we pull over a thousand individual investors between the ages of 25 and 75 with a minimum of investible assets who have purchased ETFs and we ask them questions. What's great about a seven-year trend, seven years of data, we can see the growing enthusiasm that we've seen year-to-year across all demographics. But millennials are different. My personal theory is that the millennials had the benefit of ETFs being in the landscape when they came online as investors. They're the first generation where ETFs were firmly established, so it's just very normal for them to see them. They are part of the generation that's focused on low cost for all things, shopping online and investing. They're cost-conscious and I think ETFs deliver the best value so they recognize that.

Nate Geraci: Our guest today is D.J. Tierney, Managing Director and Client Portfolio Strategist at Charles Schwab Investment Management. D.J., obviously there are many positives with the growth ETFs, and I don't think there's any question ETFs are going to continue experiencing tremendous growth, but on the other hand, there are now nearly 2,200 ETFs available to investors. So perhaps one downside to the growth is it is making the ETF due diligence process much more difficult. There's more homework investors must do before investing. I know this is an area you spend a lot of time focusing on. You specifically advise on ETF due diligence. We've obviously talked about cost today, what do you believe are some of the other most important considerations investors should take into account as they evaluate different ETF options?

D.J. Tierney: It's a very valid point, that the landscape's getting crowded. Not just more ETFs, but more ETF providers. If you go back 10 years ago, there were really only 12 ETF issuers. Now, here we are with over 100, and of the 100, over 100 ETF issuers and providers, a third of them have started their businesses in the last three years. So you have a lot of new players. So, new ETFs, new providers, and also new complicated strategies. We've spent time here, we embrace the role in trying to help investors and advisors navigate this landscape, and we've come up with a due diligence process. We think that you should look at the provider. We think that you should look at the structure. We think that you should look at the exposures. What does the fund really own? Look at third party relationships, like who's the index provider. And then lastly, take a good look at the risk practices of the ETF and the ETF provider, to see what they're doing to protect your downside.

Nate Geraci: D.J., for the average investor, you mentioned looking at the ETF provider, what are some things specifically that they might look at?

D.J. Tierney: Look at their track record. Actually we published a quick hit piece, nine key questions to ask a provider, back in January. Look at the provider's track record. How long have they been in the business? Have they ever closed an ETF? What's their success rate with ETFs they brought to the market? You know, ETFs are tax efficient, but not all ETFs are tax efficient. How is the provider track record for providing tax efficiency? How committed are they? Do they have a dedicated capital markets team? Do they have a distribution strategy? Really, what you want to do is you want to gauge the provider's chance of long-term success with an ETF, because this is the other downside to the growth of our industry - we're breaking records for fund closures. Both 2016 saw new highs for industry, and we've already had 11 closures here in the first few month of 2018. So we want our investors to have the best chance of success, and if you really vet a provider and you look at their track record, you're more likely to have long-term success with your ETF.

Nate Geraci: Something else you mentioned was looking at the index provider and I don't know for the average investor that that's always something that they dig into. We know there's a lot of new providers who may be self-indexing, some ETF providers are switching index providers. How should the average investor approach this topic of looking at the underlying index provider?

D.J. Tierney: I guess tenure and actually time in the market. There's a lot of strategies in indices that are coming out with back-tested data without time in the market. There are brand names out there, like for us domestically we use the Dow Jones indices. There's other brand names that a lot of investors and advisors will recognize for having been in the market for a decade of more, and that's a good place to start, just time in the market.

Nate Geraci: Again, our guest is D.J. Tierney, Managing Director and Client Portfolio Strategist at Charles Schwab Investment Management. D.J., what about strategic beta, or quote-unquote smart beta ETFs? Currently there's, what, 650 to 700 smart beta ETFs on the market. I know Schwab offers a lineup of fundamental ETFs. Can you maybe tell us how Schwab views the smart beta landscape and how you think investors should approach the growing number of options here?

D.J. Tierney: We think that the good news for investors is that there's more choices, and strategic beta or smart beta can add differentiated investment results to a portfolio and another way to diversify, even within the same asset class. You can have market cap and you can have strategic beta, side-by-side, and then rebalance. We think that can offer perhaps superior risk-return attributes over the long haul. So we think there's a place for them, it's just complicated. It goes back to the due diligence process. All of the components of evaluating the index and the exposure and the structure of a fund become even more important in a more complicated strategic beta strategy. So our fundamental approach, which we have a 10-year track record for in a mutual fund form and we've had over three years in our ETFs, we pride ourselves on that it's pretty simple. We can explain the strategy quickly to investors and we can show time in the market, we can show return attribution over the last 10 years. That's what we think investors and advisors should do, is look at time-tested strategies that they can understand.

Nate Geraci: And D.J., with smart beta do you think - is this a replacement for active strategies? Do you think it complements core index strategies? Where do you think smart beta belongs in a portfolio?

D.J. Tierney: The challenge for that question Nate is that smart beta means so many different things. There are smart beta strategies that are looking to replicate active strategies. There are smart beta strategies, unfortunately, that look a lot like market cap. So you really need to look at the individual exposures. You need to look at the stated strategy of a fund. And then you need to delve into the actual portfolio, and then make a decision on whether this is offering you something differentiated to market cap, or something that if it's going to try and replace active, hopefully it's got attributions of low cost and proven time in the market to give you the faith that it's going to do that.

Nate Geraci: Alright D.J., we have just a couple of minutes left here - before we let you go - going back to the Schwab ETF investor survey I mentioned earlier, one of the takeaways from that survey was that there's still an opportunity for more ETF education. I'm curious, any thoughts on what more should be done in this area? How can the ETF industry as a whole help better educate investors on ETFs?

D.J. Tierney: It's a responsibility maybe of a major provider, like Charles Schwab. It's something that we're constantly working on, our ETF education series. We're putting out curriculum on trading strategy. As you mentioned, this ETF due diligence guide that we've published. We think it's our responsibility as a provider to help investors better understand the product. We're happy to partner with people like you to get the word out. Even though ETFs are growing, even though they've been embraced by the millennials, there still are many, many thousands of investors out there that could benefit from the low cost diversification they bring.

Nate Geraci: Well D.J., with that we'll have to leave it there. Really appreciate you joining us on the program today and we certainly hope to visit again down the road. Thank you.

D.J. Tierney: Thank you very much Nate. Big fan of your show.

Nate Geraci: Thank you. That was D.J. Tierney, Managing Director and Client Portfolio Strategist at Charles Schwab Investment Management and you can learn more about Schwab's lineup of ETFs by visiting schwabetfs.com, that's schwabetfs.com.