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Behind Closed Doors, ETFs Are All The Rage

Behind Closed Doors, ETFs Are All The Rage

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Some 2,000 asset managers and advisors landed in Chicago for the annual Morningstar Investment Conference last week, where they spent the better part of three days talking about markets and the economy. Discussion ran the gambit of all matters related to investing, but conspicuously missing was a whole lot of meaningful talk about exchange-traded funds.

Yes, there were some key ETF pundits in attendance like Research Affiliates’ Rob Arnott, and Portfolio Solutions’ Rick Ferri and ETF portfolio due diligence expert Brooks Friederich, from Envestnet, to name a few. There were a few panel discussions centered on ETF portfolios and strategies. But there weren’t all that many people talking about ETFs in the massive exhibit hall of Chicago’s McCormick Place.

To be fair, this is an investment conference that’s primarily attended by mutual fund managers. Morningstar hosts an all-ETF event in the fall every year where we talk about nothing but ETFs.

But if you consider that the ETF market is the fastest-growing segment in the financial world today, expanding at roughly a 25-percent-a-year pace and now boasting more than $1.85 trillion in assets in the U.S. alone, it’s not absurd to expect ETFs to creep into conversations about money management in the hallways of a large conference such as this one.

What’s interesting is that it seems that the relative silence about ETFs among mutual fund managers is apparently just seemingly. Behind closed doors, sources told me, conversations are raging between these asset managers and the indexing world about their inability to go on ignoring the ETF space, and their need to find a way in.

These managers want in, but they’re struggling to find a way that doesn’t completely eradicate their mutual-fund-fees gravy train.

That’s understandable. Who can compete with strategic broadly diversified ETF portfolios that cost a “whopping” 5 or, maybe, 10 basis points a year? The low fees ETFs are often heralded for represent, in a way, a real barrier to entry for many mutual fund managers.

Uber-Cheap Funds

There are those who’ve managed to succeed—perhaps none more impressively than a company like Charles Schwab.

Schwab has found a way of making money in the low-cost ETF world by launching a roster of proprietary, uber-cheap funds that quickly found a following, but did so by having these strategies be loss leaders. The real money in ETFs for Schwab is coming mostly—we are told—from the OneSource platform, where ETF issuers pay to have their funds offered in a one-stop-shop ETF marketplace investors can easily access, and trade commission free.

But Schwab’s making-lemonade-out-of-lemons success story is hard to replicate, particularly by smaller firms.

Perhaps one of the most compelling opportunities some of these managers are considering right now is the growing demand for alternatively weighted ETFs, or so-called smart beta or strategic beta funds.

The reason for that is simple: These ETF strategies typically cost more. A fundamentally weighted ETF, for example, costs anywhere from 22 to 95 basis points in expense ratio, and most of them charge about 40 or 50 bps on average.

That’s five to 10 times more than what providers like Schwab and Vanguard charge for their plain-vanilla strategies—a price tag many mutual fund managers and advisors seem far more comfortable with, some industry sources say.

The good news is that nonmarket-cap-weighted funds that offer alternative flavors of risk for a bigger price tag are indeed catching on. Investors are looking for creative—and effective—ways of finding income and capturing returns in this post-crisis global environment marked by sluggish growth.

Opportunity beckons. Mutual fund managers know it. They might not be willing to openly talk about it just yet.

 

 

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