ETF Expert Corner

ETF State of the Union with Vanguard’s Rich Powers

September 26th, 2017 by ETF Store Staff

Rich Powers, Head of ETF Product Management at Vanguard, offers an ETF “State of the Union”, discussing everything from smart beta and active ETFs to record ETF inflows and fee competition.



Transcript

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

Nate Geraci: I'm very pleased to welcome to the program Rich Powers, Head of ETF Product Management at Vanguard. Vanguard is currently the second largest ETF provider in the country. They offer 70 ETFs. Those ETFs have approaching $800 billion invested in them and I think to many investors, Vanguard is synonymous with low cost investing and they have no doubt moved to forefront of the ETF space as well. Rich is joining us via phone from Pennsylvania. Rich, great to have you back on the program.

Rich Powers: Hi Nate and Conor, good to talk to you again.

Nate Geraci: Rich, my hope today is that we can have you provide sort of an ETF “State of the Union” – so we're going to attempt to cover a lot of ground - but perhaps the most natural place to start is by simply looking at year-to-date ETF flows. Through last week, $325 billion of new money has flowed into ETFs in 2017. $287 billion went into ETFs during all of 2016, which was an annual record. We've already eclipsed that with several months to go. What's been your assessment of what we've seen so far this year? Has anything in particular stood out to you in terms of ETF flows?

Rich Powers: Sure, Nate, it's been a remarkable period of time and it's been a common part of the conversations we have with our clients. If you look at any given month in 2017, what you would see is a two to three standard deviation event in terms of cash flows relative to ETF history. You actually have to start before 2017, this trend really took off in Q4 of last year, specifically right after the election where you had a series of events unfolding. So much so that Q4 of last year and Q1 of this year, about $280 billion went into ETFs in that six month period. That's the greatest cash flow, period, for ETFs or mutual funds in the entire history of the industry. A remarkable development there. I'll point to a couple things that really could be attributed to the success of ETFs over the last year. One is probably more in the cyclical camp, the election itself. You had a lot of views of the world that financial regulation would get better, regulation in general would loosen up, and that infrastructure investment would happen. That was a bit of a catalyst for ETF adoption. And then secondly, from a cyclical standpoint, market returns have been great. Whether you're looking at equities or fixed income, US or international, investors have enjoyed very good returns. That's helped ETF adoption accelerate a bit. There are a couple cyclical things I'd point to, Nate. You alluded to this at the outset. Certainly a shift from high cost active to passive, growing comfort with fixed income ETFs is certain a really important development and then lastly, I would just point to regulatory change. The DOL rule and obviously it’s still working its way through the process, but a lot of firms have begun to pivot towards that rule and what it meant for their business and that led them to conclude that low cost, particularly in the ETF vehicle was an attractive choice for them to make for their clients.

Nate Geraci: Rich, you mentioned market returns and obviously the strong market performance over the past eight or nine years has been a nice tailwind for ETFs. There's no doubt that's helped fuel the growth. I'm curious, what do you think happens when market sentiment turns? Because it seems like one of the biggest sales pitches from higher cost, actively managed products is that they'll help protect to the downside. Could a nasty bear market do anything to change the longer term growth trajectory of ETFs?

Rich Powers: The conventional wisdom is that an active manager will be able to intervene and foresee a market downturn and therefore protect their investors if the markets pull back relative to an index strategy which is, by definition, fully invested. The actual data doesn't necessarily support that. But there are active managers who are successful and have been able to make those changes, but there's been no data that suggests that someone can do that consistently and that the same investor, that a large pool of investors can do that well. The case for index investing and ETFs remains strong regardless of the market environment we find ourselves in. That said, because so much of the assets in ETFs remains in equity ETFs, if there is a pullback in the equity market, could we expect a little bit of a slowdown in terms of the pace of adoptions for ETFs? That would be a reasonable conclusion.

Nate Geraci: Rich, obviously we're very close to the industry and what's happening with the ETFs, but one thing that's just been unmistakable to us is that as ETFs have grown in popularity, it does seem like there's also been a corresponding rise in ETF fear mongering. Just last week, Deutsche Bank came out with a piece saying ETFs hadn't been tested yet and they could actually trigger the next major financial crisis. We've also seen claims that ETFs cause bubbles, they're weapons of mass destruction, they increase volatility, they decrease volatility, the list goes on and on. For the sake of time, we're not going to unpack each of these but I'd love to hear how you view this fear mongering. Where do you think it stems from?

Rich Powers: Probably the core of the concern comes from one, ETFs have been very successful and indexing, in particular - even broader than ETFs - has been successful and so that has implications for many folks in the industry. Many active managers are seeing challenges to their business as a consequence of indexing and ETFs becoming much more popular. It's causing cash outflows so I think that's part of the reason. Part of it is because something that's been so successful, gosh, what am I missing here? There's got to be some type of risk. I think that drives the view. But what's really interesting about it is that if you look at ETFs, even though they've grown pretty remarkably over the last decade or so, they’re still a relatively small piece of the overall asset management puzzle, about $3 trillion in assets relative to almost a $20 trillion business. This idea that there's some type of systemic risk built into ETFs, I think there's a faulty premise there because it's still a relatively small piece of the assets that are in play and even the trading of the underlying securities that happens. Most of that, again, remains to be done by traditional active managers.

Nate Geraci: Our guest today is Rich Powers, Head of ETF Product Management at Vanguard. Rich, let's talk specifically about Vanguard, and I mentioned earlier that to many investors, Vanguard in synonymous with low cost. As a matter of fact, I saw that last year Vanguard lowered expense ratios on 42 ETFs which is just remarkable to me. I know you and I have talked in the past about Vanguard's unique structure where the company is owned by the funds which are owned by the fund shareholders. Can you explain this again for listeners who may be unfamiliar with the Vanguard structure? How does this impact expense ratios?

Rich Powers: The structure of our organization flows through in everything we do at the individual fund level. To refresh everyone, Vanguard is structured as a mutual organization such that the funds in the Vanguard lineup own the Vanguard Group and, therefore, the individual investors and the advisors and the institutions that own our funds own the Vanguard Group. What that means, practically speaking, is that we don't have an outside party for whom we're making profits or we don't have public shareholders for whom we're making profits. Rather, any revenue that arises that exceeds the costs that we encounter managing the organization gets plowed back into reducing expense ratios for the funds or investments in the organization that allow us to offer new and better services to our investors. We call it the flywheel such that as Vanguard captures more and more attention and more and more investor cash flows, that allows us to reduce the cost that we encounter in managing Vanguard Group, which allows us to capture the attention and cash flows of more investors, which allows us to reduce costs and so it's been a very virtuous cycle really throughout our history. But the last decade or so it's accelerated in a meaningful way.

Nate Geraci: Rich, obviously we think the Vanguard structure and really the overall fee competition surrounding ETFs, we think that's a wonderful thing for investors. But I've got to tell you, I've been trying my best to consider whether there's a potential downside to this and let me try to explain what I've come up with here and I'd love to get your thoughts. If you look at the ETF landscape today, Vanguard and BlackRock are raking in the lion's share of new ETF assets - and there are a few other lower cost providers as well - but it seems obvious that it's going to be extremely difficult for other fund companies to compete in the ETF space. Especially in plain vanilla products, but I also think it's getting increasingly difficult in the smart beta category as well. My question is this: does the fee competition stifle ETF innovation at all? If smaller, upstart ETF providers are having a difficult time keeping the lights on because of this ruthless fee competition, do think that impacts creativity in the ETF space?

Rich Powers: As you pointed out, the majority of ETF assets are in market cap weighted index products that we and couple of other competitors offer and offer at a really low cost. But you've absolutely seen a huge influx of new products and entrants to the market that is bringing exposures and maybe different ways to deliver the product to investors beyond what we or the incumbents offer in the marketplace. To the extent the narrative is that competition is stifled or creativity has been stifled, the facts don't necessarily comport with that as you look at the number of new firms that have entered the market, the number of new products that have been launched. There continues to be a great level of innovation happening in the market. That said, what you're finding is that many investors are simply saying, "I don't want this additional complexity of some of these more esoteric products. I prefer a straightforward product where I know where my costs are going to be and I have a high degree of certainty that my results are going to mirror some segment of the market." I think that’s part of the beauty of an ETF is that, and market cap weighted index ETFs in particular, is that it removes some of the risk that perhaps investors have fled from more esoteric active strategies where a level of complexity potentially gets in the way of them achieving their long-term goals.

Nate Geraci: It's interesting that you mentioned that - one of the areas where we have seen a lot innovation but also growing complexity is in the quote/unquote smart beta ETF category. This has actually been one of the fastest growing segments of the ETF universe. According to ETFGI, assets in the US hit $560 billion at the end of August. Any thoughts on this category? I know Vanguard does have a handful of ETFs that could be classified as smart beta with VUG and VTV and VIG, but perhaps not the same way other providers think of smart beta. How do you view this space?

Rich Powers: Smart beta, strategic beta, factor funds, we think of them in a very similar vein and effectively what they are is active strategies. Any time you construct a portfolio that departs from the market cap weighted portfolio, you're taking an active tilt and that tilt you're taking could be towards smaller companies or companies with stronger balance sheets or have value characteristics. These are all reasonable strategies to consider and maybe even implement but, Nate, you hit on a really interesting issue, is that the prolific number of strategies that attempt to deliver value exposure or quality exposure has made it complicated for the end user to consider. That's why as we've gone out and talked to a whole swath of clients about the topic, we would suggest that the due diligence required to evaluate these strategies is increasingly like the due diligence that you would conduct if you were considering a traditional stock picking portfolio. Who are the people involved? What's the process? What's the underlying investment case for this strategy to hold water and deliver value? Is it repeatable and can it be done in a relatively low cost way? It's these strategies just require a little bit more effort and discretion before making the allocation because in many ways, I think they're active strategies that an investor would want to know well in advance what they're buying in the same way they would want if they were buying an individual stock or bond picker.

Nate Geraci: Again, we're visiting with Rich Powers, Head of ETF Product Management at Vanguard. Rich, earlier this month the SEC indicated it was planning on approving Vanguard's request to offer actively managed ETFs and more specifically, ETF versions of Vanguard's existing actively managed mutual funds. I'm assuming you can't speak directly to these ETFs yet, but I wanted to ask you about the transparency required by the ETF structure. I know other active fund companies have appeared hesitant to offer their strategies in a ETF wrapper because they don't want to disclose holdings on a daily basis or essentially, they’re afraid of being front run. Do you think those fears are legitimate? If not, why do you think other fund companies have been somewhat slow to launch active ETFs?

Rich Powers: Just to give your audience a good sense for things, Vanguard's been doing active for a long time. We have a trillion dollars in active mutual fund assets. Our filing here, our request here is to enable us to offer active strategies to those investors who have an ETF preference. As we think about what we'll do, we're not able to talk specifically as to what those strategies will look like at this point in time, but our view is that around the transparency component, we've gotten comfortable with the fact that there are certain strategies that could accommodate the transparency that's required of the ETF structure. Maybe not all strategies can do that. The historical narrative around why active managers have been loath to reveal their holdings day-to-day and therefore consider the ETF structure has to with effectively showing their secret sauce and allowing everyone to see when you're scaling into a name or when they're scaling out of a name. That's precluded them from considering the ETF as a very viable structure. But you have seen certain firms get comfortable with it over the last couple of years. Mostly on the fixed income side, but more recently a couple traditional active firms have gotten comfortable with it so that's an interesting development. The other thing that's happening is that there are some novel structures that have been proposed to the SEC to create an ETF like structure but not reveal daily holdings in way that they're currently compelled to in the exemptive relief that exists today. You'll see more innovation in this area. Whether the marketplace adopts it and the products deliver on their promise, we'll have to wait and see. But I definitely think you'll see much more activity here from us and others as it relates to active ETFs.

Nate Geraci: How difficult do you think it's going to be for some other traditional active mutual fund companies to compete in the ETF space if they haven't already developed an ETF strategy? We talked in the first segment about Goldman Sachs launching a smart beta ETF at nine basis points. Obviously, I look at firms like Vanguard and similar firms who are coming up with a coherent strategy to exist in the active ETF space. How do these other traditional active fund companies compete if they haven't developed that strategy yet?

Rich Powers: Many of those firms are full of talented people who have really interesting insights and are creative in terms of how they can potentially deliver value to investors. That will push them to potentially offer products in this space. They'll have to probably be a bit more transparent and perhaps occupy a space that's not currently occupied or well developed in order to create some space for themselves. Lastly, the idea of keeping cost at the front of their mindset when developing new products would enable them to have a higher probability of success than perhaps what they're enjoying in other parts of their business. We've done studies on this, others have done studies on this. The single most important and predictive factor in the success of an active strategy is the costs of the portfolio. The lower the cost, the better the opportunity for that manager to deliver outperformance relative to their benchmark. To the extent that these firms are thinking more critically about cost and its role in the design of a new product, then they'll have more of an opportunity to deliver something that's valuable to investors.

Nate Geraci: Lastly Rich, we have just a few minutes left here, I did want to briefly touch on bond ETFs. Vanguard currently offers 54 stock ETFs and 16 bond ETFs but, as it turns out, the bond market is actually much larger than the stock market. I did see a stat from Vanguard that more than 50% of today's bond ETFs were launched in the past four years, so clearly ETF providers are seeing the opportunity in this space. What do you see as the opportunities in fixed income ETFs?

Rich Powers: The last couple years have been pretty interesting in terms of adoption of fixed income ETFs. As you know, fixed income ETFs got about a 10-year late start relative to equity ETFs. The first fixed income ETF was launched about 15 years ago. The first equity ETF was about 25 years ago. There's this natural catch-up period for fixed income that's happening. Increasingly, also, what you're seeing is that the investors have gotten comfortable with the idea that fixed income instruments can fit into this ETF vehicle, which is effectively an equity instrument. And then lastly, institutions are looking at fixed income ETFs as a viable alternative for either long-term investment or short-term investment because of changes in the dealer market or because of regulatory changes that are happening. There's a number of forces that are unfolding that have been in support of fixed income ETFs. So much so that about 30 to 35% of all cash flows into ETFs the last two years have gone to fixed income products and that's in contrast to the fixed income ETFs only representing about 20% of the ETF universe. Fixed income ETFs are growing at a pretty rapid clip relative to their current asset base.

Nate Geraci: Rich, with that we'll have to leave it there. Really enjoyed the conversation today. We hit on just about every major topic surrounding ETFs right now. We certainly appreciate your time. Thank you.

Rich Powers: My pleasure. Great talking to you again.

Nate Geraci: That was Rich Powers, Head of ETF Product Management at Vanguard.