About this episode long viewBrian Armor, Director of North American Passive Investment Strategies Research, Morningstar Research Services. Morningstar ETF Investor Our newsletter covers index investing, capital flows, Bitcoin ETFs, and more.
Below are excerpts from Mr. Armor's conversation with Christine Benz and Dan Lefkowitz.
Can we slow the rise of index investing?
Dan Lefkowitz: I wanted to start with a major milestone we recently achieved in the US market. That is the fact that passive strategies currently account for the majority of assets in funds and ETFs, with a global share of around 40%. Our colleague John Rekenthaler recently wrote that index funds have officially won. Is there anything that could slow the rise of index investing?
brian armor:Right now, it's a runaway freight train. But no, it's a long-lasting trend. And I think the real reason it worked so well was because of the cost story. Passive investing has low fees, lower transaction costs, and greater tax efficiency. It will be difficult for active managers to consistently beat this. This is because passive managers need to outperform passive managers on a gross basis and by more than the difference in fees.
To take a step back, indexes are currently concentrated in market cap weighted indexes. So I think the S&P 500 has the highest concentration of top 10 stocks over the past 50-odd years. So I think there is an opportunity for active investors. And then there's the zombie flows that come from passive management, where it's like savings coming in and going out to the market, where active managers can really find an advantage. A rough stretch in a market-cap weighted index may not be enough to throw passive stocks off the mark. But active managers' best chance to get back to the top is to cut costs and take away the superpowers of passive managers.
Transitioning from active to passive management
Christine Benz: I'd like to dig deeper into some of these themes and some of the performance trends you and your team have observed. But stick to the flow of money: Investors have historically preferred actively managed bond funds, but even that seems to be moving toward passive management in recent years. Can you talk about that? Because the basic case for an active strategy in fixed income seems to be stronger than in stocks, but perhaps you could dig deeper into that and what you're looking at from a flow perspective.
armor: If you draw a straight line, you go from active mutual funds to active mutual funds to passive ETFs. And that generally applies to bonds and stocks in general. For example, I think it makes the most sense to be passive in areas where the richest information is embedded, such as stock prices and U.S. Treasuries as an example of bonds. Large blend style funds, these types of stocks have the broadest coverage and are the quickest to react to changes in information about a company. So they tend to be very well priced, and passive managers can actually free ride on that pricing by active managers and bounce it back to investors at a lower cost. How do you index the bond market? If you base it on market weighting, you end up investing the most in the issuers with the most debt. In some cases, this involves highly liquid markets such as core bonds and US Treasuries. These are suitable for passive investing. And if you look at the aggregate of bond funds, a large part of that aggregate at the moment is U.S. Treasuries. However, for things like municipal bonds, for example, there is some inefficiency in the selection of municipalities. They do not participate in the publication. To some extent, they may get some of the leftovers. But it's generally easier for investors to understand what passive funds are trying to do. And these expectations and low fees are appropriate for most people.
Advisors, model portfolios, and capital flows
lefkowitz: Many advisors these days may only focus on ETFs. I also write about models and model portfolios. What role do they play in the flow?
armor: In that sense, distribution has changed, with advisors moving to fee-based advice rather than commission-based advice. And what that means for investors is that they often turn to cheaper funds: ETFs and index mutual funds. As ETFs become more active, the number of ETFs available will also increase. We have seen that model portfolios are a very good option for advisors who can simply follow a script without spending too much time on asset allocation. The model portfolio therefore provides a complete portfolio, i.e. all his ETFs in which you can invest according to the model. And it's been a very good tool for investors and has driven some trends as well. The Model Flows Landscape report was recently published by his Manager Research here at Morningstar. And the model portfolio is growing very quickly. For example, IShares has the largest model portfolio. They work closely with advisors to understand the changes they are making and provide performance attribution analysis to provide to clients. But last March, the company moved from the iShares ESG Aware ETF ESGU to the Quality Factor ETF QUAL. And that led to a $5 billion outflow from ESGU to QUAL. It's having a pretty significant impact on the market.
Vanguard, Blackrock, State Street
benz: Talk to your provider about what they're looking at from a flow perspective. It looks like the big three – Vanguard, BlackRock, and State Street – are increasing their market share, but if you could talk about how the spoils appear to be going to a few companies. I'm happy.
armor: The biggest one got even bigger. I would even go so far as to say that Vanguard and iShares are in their own tier now, and only State Street is in the next tier. But a lot of that is down to scale. The company is expanding its operations, expanding its strategy, and being able to offer lower costs, putting pressure on other companies to catch up. We're at the point where Vanguard might actually capture iShares soon. They have been winning the flow battle for the past few years. However, there are two ways to increase your assets. One is new flows, net investment, and the other is the performance of existing assets. Vanguard is therefore leaning a little more towards equity assets, which means it could be boosted by a strong stock market and take over as a top ETF provider. And in the active ETF space, changes are occurring among the largest providers. Dimensional converted its first mutual fund into an ETF about three years ago and is already the largest issuer in the active ETF space. And options-based strategies are a big growth engine for active ETFs, and JPMorgan is really reaping the benefits.
