Jonathan Steinberg, the chief executive officer of the New York-based ETF firm WisdomTree, spoke recently with IndexUniverse.com Managing Editor Olly Ludwig as part of our ongoing look into the world of self-indexing. Steinberg is adamant that there’s nothing wrong with the way his firm does self-indexing, providing useful perspective given comments we’ve heard from others on the topic of self-indexing, including Alex Matturri of S&P and Steffen Scheuble of Structured Solutions AG.
Steinberg stressed that the self-indexing that WisdomTree helped pioneer goes to the heart of how the company has sought to distinguish itself with dividend- and earnings-focused securities screening in the world of ETFs. On a separate topic, Steinberg also said that the recent slowdown in new ETF fund filings and rollouts is sure to reverse as the economy heals and investor confidence again flows.
Ludwig: I wanted to ask you about self-indexing. Can you describe your broad approach?
Steinberg: We create all the intellectual property on the indexes. And then we have an index-calculation agent calculate the indexes, which is very good use of our resources and their resources. But it’s very different from paying basis points on growth of assets. It’s just a flat fee, so it’s a very cost-effective mechanism as you scale.
Ludwig: And that flat fee is annual?
Steinberg: Yes. And before we get more into this, let me just say one thing: Before ETFs, when you were an index provider—like an S&P or a Russell—you sold your intellectual property, or you licensed your intellectual property for a flat fee. So when Vanguard had their Vanguard 500 fund, they paid S&P a flat fee of $100,000 or something. It wasn’t until ETFs that the index providers changed their business model and started to charge on growth and assets, thus participating in the growth of the funds. It’s historical—it’s a subtlety, but I just want you to be aware of it.
Ludwig: OK. As you probably know, there's quite a lot of filing traffic at the SEC requesting exemptive relief to self-index. And without fail, your firm, IndexIQ and Van Eck—all three of you—are always mentioned as sort of legal precedents.
Steinberg: Yes, we were the first.
Ludwig: Right. So, is what you just described in terms of fee structure essentially a back-to-the-future kind of thing, that, if this self-indexing thing really takes off, it’s in some ways an attempt to move back to the way things once were before the ETF, which is to say the flat fee, like Vanguard paid to the S&P for its Vanguard 500 Fund?
Steinberg: Well, yes and no. Let me take you back to 1998, 1999, 2000: When I was looking at the business in those early days, and I wanted to get into the ETF industry, there was no way to compete with an S&P and a Russell and an MSCI on cap-weighted indexes, or more significantly, with Vanguard on cap-weighted indexes. Look at the problem that iShares and State Street face with Vanguard: There's no way to differentiate.
So WisdomTree was attempting to do something better. We worked on index construction, and that became the basis of our equity platform today—fundamentally weighted, dividend- and earnings-based ETFs.
Steinberg (cont'd): Also, when Wisdom Tree wanted to get into the business of being an ETF sponsor, we knew that Vanguard would eventually be a major force in the industry, even before they fully embraced it. If WisdomTree wanted to be an asset manager in the ETF industry, we needed to do something that was differentiated from Vanguard and, quite frankly, better. Better returns, with less risk. Our performance, since inception on equities, on something like more than 70 percent of our funds—from one-, three- and five-year time frames since inception—are delivering better returns on an after-fee basis than the cap-weighted indexes that pretty much have no fee.
Ludwig: Let’s get back to self-indexing for a moment. The big players in the indexing space argue that there is a conflict of interest inherent in this whole idea of self-indexing, that if you're creating the index, and you're also running it, you might tweak the index to improve performance. Can you address that?
Steinberg: The first thing I would say is, flat out, no. It is not a conflict of interest. And I don’t see how it can be. We create the intellectual property. And we have a third party do the calculation. We also use subadvisors—Mellon Capital for equities and Western Asset Management for fixed income.
So WisdomTree itself doesn’t actually touch the money. We’re not managing the money. We have a subadvisor managing the money, following the rules that are being calculated by a third party. And when we have additions and deletions to the indexes, we treat it just the way S&P does. We announce them in advance. SoI think it’s a nonevent.
Ludwig: So the whole notion of conflict of interest is sort of spurious and opportunistic on the part of businesses that feel maybe a little threatened by what you're up to?
Steinberg: Well, I would say it’s not so different from active management battling against Vanguard in the early days, saying, “Oh, Vanguard is just trying to match the market.” Everybody is trying to defend their business model. I think we stand on high moral ground.
So Vanguard licenses a third-party index. Well I’ve taken it one step further. We own the intellectual property. We stand behind it. We care. Up front we spent millions of dollars and years getting to where we are on our index strategy, our product strategy. But as you scale in assets, it becomes much more profitable over time.
Ludwig: At the end of the day, for you this whole notion of self-indexing is very much synonymous with these dividends screens and earnings screens, right?
Steinberg: Yes. It was crucial to our product strategy, and it also allowed Wisdom Tree to introduce size segments internationally. Before WisdomTree, the index providers did not have small-, mid- and large- size differences. They only had total markets, and they didn’t have international sectors. So we pioneered all of that. It came through controlling the intellectual property.
Ludwig: I also wanted to talk about the WisdomTree brand. You're not huge, but you're growing. You're boutique-y. Can you comment on what you think it is that is resonating with investors?
Steinberg: I wonder what you would have said about Vanguard in 1976. Was it boutique-y?
Ludwig: In terms of assets under management way back then? Yes, probably I would have said that.
Steinberg: The only reason WisdomTree is boutique-y is we’re young. We surrender nothing. We believe we are delivering a better product. And in fact, there was no global suite of dividend-based strategies—we created that. We were early in seeing how much people need income, and how demographics were driving people to be more in a retirement mode—taking money out of the markets and needing a steady stream of income.
Ludwig: Are you worried at all about Rob Arnott’s suit against you over fundamental indexing?
Steinberg: I don’t want to go in that direction, unless you really want to go in that direction. But you should pull up our responses in 8-K filings. We’re highly confident in our responses. Fundamental weighting goes back many, many years.
Ludwig: Can you share any general observations about the ETF industry? Whatever the explanation, there seems to be a slowing in the past several months, both in terms of actual new funds going into registration and rollout of new funds. And yet the assets keep rolling in.
Steinberg: First of all, the numbers are very skewed this year, because virtually all of the robust rollout numbers are because of iShares. iShares rolled out third and fourth executions in every category that exists.
But the pullback is not about ETFs, in my opinion. It’s about investing—it’s a very labored, lethargic environment for investing. Money isn't moving around. There is a breakdown in confidence. There are lots of macro issues that people are dealing with. As an example, in 2007, ETFs took in about $140 billion. And in 2008, ETFs took in about $180 billion. But then, for the next three years, we took in, as an industry, $115 billion to $120 billion. So over the last three years, we’re significantly off of our highs, in terms of inflows.
But still, ETFs have taken in 50 percent of the industry inflows as compared to mutual funds. So we’re doing well, relative to other structures. But in the aggregate, it’s a very labored environment for money flows.
Ludwig: So, given some kind of return to normality following this balance-sheet recession, might we see some of those numbers from the glory days' return?
Steinberg: I am assuming that there will be a moment in time where the numbers are explosively larger than what we’re seeing today in inflows. If you go back to the late '80s and the early '90s, there were firms—American Funds, Fidelity, Vanguard and Janus—who could take in $80 billion to $100 billion alone in their fund families. So the whole ETF industry is only doing about $120 billion for the last three years. And yet we’re leading product structures. We’re doing better than mutual funds or hedge funds.
Now there is a fear that we’ve lost a generation of investors. But I don’t think that’s the case. There's no way to live to 100 and retire if your money isn't working for you. So I think you’ll see much larger numbers.
Ludwig: Right. So then a zero-sum game between the ETF and the mutual fund is likely to continue and perhaps grow more pronounced?
Steinberg: I believe ETFs offer investors a better investing experience, flat out: full transparency, liquidity, tax efficiency, one share class, no incentive fees. We can inspire investors to come back into the markets. I don’t think we’re ever going to see mutual funds go to 90 percent of the inflows like they were. We will continue, as an industry, to take market share. And eventually we will become the dominant force in asset management, because it is a better investing experience.
Ludwig: Do you have any thoughts about how active ETFs are likely to do? The success of Bill Gross’ Total Return ETF after its launch on March 1 this year has spawned a whole cottage industry of speculation. It’s the second-most-successful launch since (NYSEArca: GLD). So, is the second coming of the ETF going to be in an active wrapper?
Steinberg: I think it’s terrific. It’s just one more example of ETFs being the preferred vehicle, that ETFs are winning converts. There are a number of examples of that. One is Vanguard’s embrace of ETFs. Vanguard is one of the most trusted brands in all of financial services. And it’s important that they're a part of the ETF industry.
BlackRock, the world’s largest asset manager, buying iShares is another example. If you look at their flows, I believe most of BlackRock’s inflows come from ETFs, while they have outflows in their traditional structures.
Then you have a star manager like Bill Gross come in and show the traditional active mutual funds that it’s possible to be successful and beat the market in an active approach, in a transparent ETF transparent approach.
And incidentally, that’s exactly what WisdomTree proved earlier than anyone. We had the original “active” ETFs. Whether you want to call WisdomTree rules-based active, or fundamentally weighted indexing, we are definitely not beta. If you're not beta, what are you? We are offering an active-like experience for investors.
Ludwig: And so is that the more likely scenario going forward, the active-like phenomenon that you guys have served up, rather than the bona fide stock or bond pickers like Gross and his ilk carrying the day?
Steinberg: Bill Gross is unique. He has a tremendous individual brand and track record. I believe that if Warren Buffett wanted to launch an ETF, it would be immensely successful. He wouldn’t have to build his track record in real time. Money would flow.
For we humans, WisdomTree, we need to build our track record. Lucky for us, our live track record is what we thought it would be, and that is better than cap-weighted indexing.
If CalPERS is taking hedgies out, ETFs may be coming back in.
‘Smart beta’ almost surely means loss of more market share for active managers.
Be careful of your assumptions (and headlines!) about volatility ETFs.
WBIG hedges in some areas and bets big in others.