ETFs: The New Manifest Destiny?

ETFs: The New Manifest Destiny?

By Paul Kovarsky, CFA Posted In: Economics, Future States, Investment Topics, Portfolio Management

Assets in exchange-traded funds (ETFs) have soared across the globe in recent years, eclipsing the $4.5-trillion mark at the close of 2017.

This astronomical growth raises a number of questions not only about the future of ETFs, but also about that of the investing world more generally. For perspective on these questions, we spoke with Inside ETFs chairman Matt Hougan, one of the ETF space’s leading luminaries.

Hougan is the co-author, with Dave Nadig and Joanne M. Hill, and including contributions by Deborah Fuhr and Steven A. Schoenfeld, of the CFA Institute Research Foundation monograph A Comprehensive Guide to Exchange-Traded Funds (ETFs), and will speak at the Inside ETFs Canada Conference in Montréal, along with Eric Balchunas and other ETF thought leaders, on 21 and 22 June 2018.

Below is a lightly edited transcript of our conversation.

CFA Institute: You literally wrote the book on exchange-traded funds (ETFs). How did you go from being an active mutual fund manager specializing in biotech, no less, to someone who, according to Barron’s, took to ETFs with the “zeal of a convert”?

Matt Hougan:  Short answer: hard-won experience. That job with the active fund was my first real job in finance. I was attracted to being an active manager by the seductive stories we see in the press of these swashbuckling masters of the universe who are able to use their intellect to pick stocks that will outperform.

I felt confident that if I applied myself and worked extraordinarily hard I could be one of those managers. While I did a fine job, what I learned during my time at that active fund was that consistently beating the market, particularly after cost, is extraordinarily hard. I learned it firsthand.

It’s a humbling experience to tackle a project and give it your all and then realize that no matter how hard you work or what good team you assemble, the odds are stacked more or less against you.

That led me to a bunch of reading in the space. I read the fundamental works by [Burton] Malkiel and [John] Bogle and others. I studied the math myself. I came to the conclusion that in almost every case, with a few possible exceptions, indexing is the right approach.

Was there a particular “aha moment,” a strike of lightning that turned you into an ETF zealot?

The thing that really convinced me was when I dug deep into the data on emerging market managers.

There’s, again, a very seductive story about emerging market managers bringing huge resources to bear on markets that should be relatively inefficient, where information discovery isn’t perfect, where personal relationships may give you the upper hand.

Despite all that, the majority of the active emerging market managers underperform and they underperform drastically.

Even in the most difficult market with the most potential information asymmetry, the average manager can’t outperform. It became overwhelmingly obvious to me that the majority of investors and the majority of their assets should be invested in passive funds.

And ever since then you have been a faithful believer in the power of indexing?

Yes, one more thing that became really important to me was a realization of the potential positive behavioral impact of index funds. I feel like people chase hot managers. The data backs this up: Investors give up 1%, 2%, 3%, 4% a year chasing performance, buying managers after they’ve beaten the market and selling out at the bottom of their relative performance trough.

I think there’s a behavioral element that’s advantaged, as well, when you participate in index funds. You set it and forget it.

The accumulation of that experience gave me the zeal of a convert. I’ve been on the index and ETF train ever since.

You forecast that ETFs will supplant mutual funds in the United States by 2023. Does a similar manifest destiny apply to the birthplace of ETFs — Canada?

For starters, I think you should use the phrase destinée manifeste in Montréal.

To answer your question — yes, ETF dominance will be the case all over the world for two reasons. Let me explain what those are, and then talk about how I think the evolution of the Canadian ETF market will be a little bit different than the US.

Part of that manifest destiny is driven by the efficiency argument we just went through. In every market you look at — it doesn’t matter where you are — the vast majority of index‑based funds will outperform the vast majority of active managers over time. That’s true everywhere.

The second piece that drives that manifest destiny is the industry‑wide trend toward more transparent fee disclosure. Part of the reason I think active managers did so well — aside from a strong run of performance in the 1980s — was that investors didn’t realize the fees they were paying for those funds. A lot of the trend in the US that drove the adoption of ETFs was the emerging trend of RIAs and independent advisers who are fee first and had a fiduciary duty to their clients.

I think in Canada, as discussions around CRM3 start to intensify, focused on fees and transparency, investors will realize as well that paying 2% for an underperforming, actively managed fund is absurd.

The financial world is becoming more efficient in the funds space. That’s true in every country around the world, and I think it will be massively true in Canada, where average fees for mutual funds are extraordinarily high.

The difference in Canada is that we are going to skip the adolescent phase of ETF development and go straight to the full‑form adult phase. In an adolescent ETF world, the vast majority of assets are in equity ETFs, and exposures are simple and passive.  In the fully formed world, equity and fixed-income ETFs are more balanced, rules‑based strategies are important, and there’s a fully fledged set of thematic ETFs. And that’s what we’re seeing today in Canadian ETF flows.

Might skipping those “awkward teen years” leave investors ill prepared to distinguish among the different ETFs when building their portfolios?

I always tell people that the amount that pundits like me talk about products should be inversely related to the amount that you’re invested in them. The vast majority of your assets should be in the most boring, plain-vanilla, broad‑based exposures to the market that you can get.

If you get excited about a cannabis ETF, crypto ETF, or thematic ETF, that’s fine, but those should be shrinkingly small parts of your portfolio. The vast majority should be broadly diversified stocks and bonds.

The key to separating great ETFs, from mixed ETFs, from toxic ETFs, is asking yourself the question, “Does this ETF really give me exposure to the area of the market that I’m trying to get?” Usually, if it’s an S&P 500 or a TSX ETF that’s tracking an index, the answer is yes. You’re trying to buy exposure to that index, and the ETF does it basically perfectly.

Where it starts to fall apart and get difficult is as you move into thematic ETFs. The challenge with some thematic ETFs is that the exposure that you’re getting is not particularly pure play. You think you’re buying exposure to cyber security or blockchain or what-have-you, but in fact you’re getting diversified exposure to a broad‑based industry like technology. That can be a problem.

Then as you get to more complex ETFs — levered ETFs, inverse ETFs, etc. — those can be potentially toxic. Buyer beware.

If you want to spice up the edges with more exotic funds, make sure that the allocations are measured in the single percentiles. Then you should be okay.

That makes sense at an intellectual level, but some might counter your zeal for the boring and safe with the need for excitement, a desire to outperform. The ETF community has been trying to marry the two — active management and ETF efficiency — to satisfy this desire for years. So how long will we have to wait before a fully fledged set of active, non‑transparent ETFs becomes an investable reality?

Let’s start from the premise that I think this active, non-transparent ETFs is a solution looking for a problem. I don’t think investors are sitting up at night wishing they had the chance to buy non‑transparent active exposure in an ETF wrapper.

The downfall of traditional actively managed mutual funds is not the relative efficiency of an ETF versus a traditional mutual fund wrapper. Yes, ETFs are more efficient. Yes, they are more liquid. Yes, they have certain tax advantages in certain countries. Yes, they can be a little bit cheaper.

But those are all marginal benefits. The big issue is that no one has wants exposure to traditional, human stock picking, active equity management in any wrapper. Even if there were a non‑transparent active ETF, I don’t think anyone would buy it.

Moreover, we’ve seen that transparent, actively managed ETFs can succeed and don’t suffer any apparent harm from front-running, which is the big bugaboo that non-transparent ETFs are trying to avoid.

That said, I do think regulators will eventually approve one of the many non‑transparent, active ETF proposals out there.

I’ve studied those proposals and spoken with market makers about them. I think that they would function fine.  So if I had to guess if regulators would approve some version in the next five years, I would say “yes.”  But I would argue that it’s not important. It’s like the last gasp of a dying industry.

The world is moving to one where people like to invest in transparent and largely rules-based products.

Going back to the behavioral point, can it be a double-edged sword? On one hand, the rules‑based framework does remove the potential behavioral flaws associated with chasing hot stocks. Counterbalancing that, might the inherent transparency and liquidity of ETFs tempt people to market time them?

I think it’s a canard to suggest that ETFs’ intraday liquidity encourages most people to trade them more often than they would a traditional mutual fund. There is certainly a new class of investors who day trade ETFs. That class of investors used to day trade single stocks. I think that is the replacement that’s happened. I think actual investors — people who are buying and holding exposure — never really cared whether they get executed at 2 PM or at 4 PM. Daily liquidity is plenty of liquidity to shoot yourself in the foot with, if you are inclined to do that.

I think the people — and there are plenty of them, including plenty of people I respect — who look at the high trading volume in ETFs and imagine that that is long‑term investors acting poorly are just mistaken. I think those are day traders doing single stock replacement and arbitragers.

The bulk of the behavioral influences of ETFs are beneficial. It gets you into a rules‑based framework. It encourages and almost enforces broad‑based diversification and allows you to get exposure to a wide range of asset classes. It’s a net behavioral benefit to the world.

Every country has home-country bias, but in Canada a typical investor has a very substantial investment in local markets — despite Canada being only 2% to 3% of the global economy. Moreover, there is a notable concentration in a few prominent sectors, such as commodities, real estate, and financials. How can ETFs influence these dynamics?

One of the major positives of the ETF industry is that it’s opened up the world to investors. I think of it this way: Let’s say you are an investor in Canada and you are interested in more exposure abroad. You probably haven’t heard of Turkiye Garanti Bankasi, but it’s the largest company in Turkey. There’s zero chance that you would go out and proactively invest in just that stock. There’s a much higher chance that you have an opinion about Turkey, where Turkey is headed, and that you’re willing to invest in a broad‑based Turkey ETF.

The same thing is true in a place like China. I think very few investors could, say, identify who Tencent’s top competitors are or its position in the market, but they know that they want exposure to China. They’re willing to get that in a broad‑based wrapper.

Because the ETF allows for easier access to international investments, I think it marginally encourages people to look beyond their home borders.

Everyone in a country is familiar with the equities that are the leaders in that country. That’s not true as you go across borders, whereas an ETF makes for an easier on-ramp. Now, it doesn’t solve home bias. People still wake up, they read their local newspaper or their local websites, and they read about the industries that are local to them. Home bias will be with us forever. But I think ETFs are maybe the best tool for getting people to think more broadly.

What about the foreign exchange risk for Canadian dollar (CAD)-denominated investors?

Generally speaking, history would suggest that having diversified exposure to global currencies is a net benefit. I’d be willing to bear that currency risk, particularly if you are investing over long periods of time.

The risk that you bear is that currency markets are volatile. We’ve certainly seen the Canadian dollar move significantly against, say, the USDX index, or even any global basket of currencies over the last 15 or 20 years.

You do bear some basis risk, particularly if you have planned significant withdrawals at any particular point in time. To the extent that you want to hedge that basis risk away, you can do that, to some degree, in currency‑hedged vehicles.

But over the long term, currency risk is a risk worth bearing.

What are you most excited about in the ETF space?

I honestly think this is the most exciting moment for ETFs in the last five or six years. I say that for a few different reasons. One is that they’ve reached this level of maturity in investor consciousness, where people understand what ETFs are and how they work. ETFs are now competing on a more level footing with other exposures like mutual funds or closed-end funds, and when they compete on a level footing, they tend to win. Therefore, I think the asset gathering pace will accelerate.

I’ll also say that product development, particularly in the fixed‑income markets, but also in equity, is better than it’s been in recent years. I think some of the research into applying rules‑based smart beta strategies to the fixed‑income space is really exciting. I think the nature of how we get fixed‑income exposure is going to change dramatically in the next few years, away from traditional market cap to smarter strategies.

I’m excited about the potential application of artificial intelligence and other technology‑driven, rules‑based engines to the ETF space; I recently joined the board of one ETF firm, Equbot, that is using AI to drive stock-picking. It’s a really exciting area of the market.

And finally, I am mostly just excited about growth. I think that trend is going to accelerate dramatically over the next few years. I’m more bullish on ETFs than I’ve been in a while.

My last question brings us back to the start of this conversation. Looking at your Twitter feed, your most popular tweet was only a couple of months ago. The number of “likes” is so high, it’s like an October 1987 market crash at 22 standard deviations above the average. Do you know what that tweet was about?

What was it?

It was about you leaving full‑time ETF research and switching to cryptocurrencies!

It’s very exciting.

I should say, I’m still actively engaged in ETFs. I’m still the chairman of Inside ETFs and participating in the development of the agendas there. I’m keeping my eye on the space. It’s still my first love.

But I’m really interested and engaged by what’s going on in the cryptocurrency space for a few reasons. One, I think it’s potentially a generationally important technological breakthrough. I think the argument for a stateless, permission‑less store of value is very strong, and the opportunity for smart contracts and other applications are truly significant.

I’m also excited by the intellectual challenges of the cryptocurrency space. I work for a company called Bitwise, which created the first cryptocurrency index fund. We are doing fundamental work on how to index the space. Those questions, while they are largely solved in equity and bonds, remain open in crypto. It’s just hugely intellectually exciting to engage with questions like what is market cap and free float in the crypto space. I’m an index nerd, and that stuff appeals to me.

Then, finally, I think, and the studies would suggest, that a small allocation to crypto we’re talking 1% to 3% has historically improved a portfolio’s risk‑adjusted returns, if it’s systematically rebalanced.

I think the gating factor to more people being invested in crypto is education and understanding. One of the things I did in the ETF space was spend a lot of time doing ETF 101 presentations, helping make the on-ramp for an investor used to mutual funds moving into ETFs a little easier to bear.

I plan to do the same thing in the crypto space, doing a lot of crypto 101 presentations, trying to add institutional quality content to the crypto market, to make it seem a little bit more normal, and to balance both the benefits and the risks of crypto so that people can make appropriate investments.

I still love ETFs. I also love crypto. I’m excited by both. I hope at some point, those two worlds merge together. That will be an exciting day for me as well.

Spoken with the zeal of a newly minted cryptocoin convert! Good luck with the next leg of your journey and thank you very much for the insights, Matt.

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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.

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