Olly Ludwig: For ETF industry enthusiasts, the winter has become something to look forward to—that is if you’re fortunate enough to attend the annual Inside ETFs conference. It’s always balmy in Hollywood—Hollywood, Florida, that is—and the meeting truly is a showcase for how important ETFs have become to investors and advisors.
Welcome to Vanguard’s Investment Commentary podcast series. I’m Olly Ludwig, and in this month’s episode, “Inside Inside ETFs,” recorded on February 21, 2019, we have the good fortune of hearing from Rich Powers, Vanguard ETF Product Management Head, to get his eyewitness account of this year’s action in Florida.
Rich, thanks for being here today.
Rich Powers: Thank you, Olly. Good to be here.
Olly Ludwig: So let’s get right into it. I want you to set the stage. Inside ETFs—this is your fourth year, right? And I presume it’s getting more spectacular. Joe Montana, Michael Lewis, and then, of course, ETF industry stalwarts like Matt Hougan and Dave Nadig. And this industry is big, it’s growing, assets are coming in—it’s got a big future. So set the stage for me.
Rich Powers: Yeah, it’s got all that. I mean there’s lots of investment things you can learn about, there’s some entertainment. It’s a fantastic place, actually, to gather all these different disparate industry participants that very rarely ever are in one room together. You have 2,000 people there who cover areas such as the asset management industry, ETF issuers, index providers, exchanges, advisors. Just runs the gamut, market makers, and so I find it to be incredibly valuable. This is the best year for me by far, and this is the fourth year I’ve attended just because of the quality of the conversations I was able to have with clients, with index providers, and with the press. The press were there and they want to hear all about what we’re talking about.
Olly Ludwig: I heard an analyst a couple years ago, when I attended, call it the “Happy Conference.” This is an industry in full blossom. Business opportunity abounds, everybody’s in good mood, lots of meetings to attend. Can you speak to that a little?
Rich Powers: I have to say, yes, there is a lot of enthusiasm there, and optimism. There’s plenty of new firms who are just getting their feet wet when it comes to being a part of the ETF industry. Remember, ETFs are only 25 years old, whereas mutual funds are, like, coming up on almost a century of being around. And so, certainly a young industry, and there’s constant talk of the innovation that’s happening in the ETF industry. And I think there’s a certain element of truth in that there are new product concepts that are coming that can help investors improve their outcomes.
I’ll also say there’s probably a little bit too much spaghetti-at-the-wall type of product development that happens as well. But by and large, I’d say what investors come to the conference for, and ultimately decide to do with their portfolios, it’s well intentioned. They’re trying to get smart, make better decisions, and build better outcomes for their clients.
Olly Ludwig: Now, at the risk of forcing this issue, it’s hard to talk about ETFs without talking about declining costs for investors—and easy to talk about that when you’re at Vanguard, right? We talk about $715 million in estimated cumulative savings from expense ratio reductions over the past 7 years, based on total assets.1
This is what we can tell the world that we have brought in terms of value to clients. Speak to that whole question or phenomenon of declining costs as it relates to your experience at Inside ETFs.
Rich Powers: It was a thread that ran through a lot of the conversations that happened either with clients or in the sessions themselves, really, to the acknowledgement of the fact that when you look at cash flows in the industry, be it ETFs or mutual funds—but certainly very specifically in ETFs—that the large majority of flows are finding their way into the lowest-cost products.
It’s not an accident. I think all the academic work that’s been done by many industry participants, the work that our own Investment Strategy Group has done to shine the light on the virtues of low-cost investing, are starting to kind of bear fruit, if you will, in investor behavior.
Olly Ludwig: Now if we can drill into this cost issue just a little bit—Vanguard is a pioneer in putting downward pressure on investment costs, and it’s clear that other funds providers are now offering lower-cost strategies, which is a good thing for investors. That being said, what is Vanguard cooking up? Everyone is waiting for the next move from Vanguard which has been a leader. Anything that you could bring into focus right now?
Rich Powers: Yes, we’ve been cooking up low cost for 40 years now, Olly, so it’s not anything new for us, but just thrilled that more and more firms are doing that because what it means is that investors have a better shot of getting value for their investments. So that’s a wonderful thing.
The kind of development that’s germane to ETFs is that by the time of this recording, ten of our ETFs will have reported lower expense ratios than their Admiral Share mutual fund counterparts. And that’s a departure from historical relationship, where ETF expense ratios and the Admiral Shares had identical expense ratios.
And that just simply reflects the fact that more and more investors are buying our ETFs. About $1 in $3 that’s coming to the Vanguard complex over the last three years has gone into the ETF share class, while ETFs only represent 20% of our assets. So just incredible organic growth in our ETF lineup, and that allows us to take that scale and return it to shareholders in the form of a lower cost.
Olly Ludwig: I would be remiss if I didn’t talk about fixed income. Huge subject. It’s a much bigger market than the stock market. Easy to forget that considering how easy the stock market is to talk about. Talk a little bit about what came into focus down there. And the context of my question is, you know, the Federal Reserve now appears to be pausing in its rate-tightening campaign, inflationary pressures in the macro economy clearly remain muted, even ten years after the global financial crisis. It’s got to be a hot topic, yes?
Rich Powers: Absolutely. A number of different sessions, but very specifically, our own CIO, Greg Davis, his keynote was focused on expectations for future returns across the asset classes, but certainly drilled down a little bit deeper on fixed income.
And why that’s important I think is that you’ve seen a pretty dramatic change in the complexion of future return expectations for fixed income. And that’s because of what you talked about before. The Fed was raising rates, that provided higher yields for many bonds that’s allowed us at Vanguard to come up with an assessment that 3% to 3.5% future ten-year returns for investment grade fixed income is a potential path forward. That’s about a percentage point higher than it was a year ago. And so I think, naturally, investors are interested in that given maybe where we are in terms of the Fed rate cycle.
The other really interesting point here is that you point out how big the fixed income market is relative to the equity market. Yet if you look at just the ETF universe as a microcosm of that, fixed income ETFs are only 20% of the total ETF asset base. So that tells me that there’s a lot more uptake that fixed income ETFs have in front of them in terms of advisors, institutions, individuals using them as a tool in their portfolios.
Olly Ludwig: Now I’m shamelessly promoting you, Rich, but I believe you wrote an article in ETF Perspectives Magazine recently in which you talked about the growth of fixed income ETFs. And clearly, the flows are there. So are there signs that this relatively small space of the bond ETF universe currently is going to become more prominent in investment portfolios going forward?
Rich Powers: First of all, I love a shameless plug, so thanks for that, Olly. No, definitely, I think fixed income is going to have a bigger role in investment portfolios. We see that in the client conversations we’re having. You referenced the cash flows, it’s manifested itself there. I think there’s been some long-held myths around fixed income ETFs and whether the liquidity they provide can be kind of tied back to the liquidity of the underlying securities, which may not be as liquid. There’s concerns around their ability to kind of withstand market shocks.
But we’ve had plenty of observations over the last 15 or so years where fixed income ETFs have stood up to that test, be it the global financial crisis, the “taper tantrum” of a handful of years ago, and even just the prospect of the Fed raising rates over the last year or so, fixed income ETFs have actually shown they’re up to the challenge.
Olly Ludwig: Right, and the flows into fixed income ETFs suggest that investors and advisors are really understanding the point you just made.
Rich Powers: Yeah, I think that’s absolutely right. Increasingly, the conversations are around which products could help them meet a certain objective, whereas I’d say a couple years ago when I first came into this role, it was more demystifying some misconceptions that investors had around fixed income ETFs and whether or not they could withstand market volatility or they had the liquidity that they are presented to have.
Olly Ludwig: Now another subject that seems very important is the subject of ESG strategies—environmental, social, governance screens that are for investors who want to make a difference in their investment portfolios.
People love to talk about it. It has a lot of mindshare, to use the industry jargon. And yet in terms of market share, ESG doesn’t seem to have fully taken off. And I wanted you to speak a little bit to that subject as it applies to the Inside ETFs conference this year.
Rich Powers: That was also a really popular topic amongst many of the sessions that we had during the conference. In fact, actually, it came up during the live webinar that we had done down there. We had a number of panelists on that webinar—Eric Balchunas from Bloomberg, I’d probably put him in the camp of being a skeptic of ESG having a really, really bright future, pointing to the fact there’s been very little adoption.
Olly Ludwig: Oh, I’m glad you mentioned Eric. He knows a lot about ETFs. Listen to this, from the live webcast that you took part in. This is what he says about ESG:
Eric Balchunas, during Vanguard’s live webcast at Inside ETFs:
I bring up Jerry Maguire, “Show me the money.” ESG ETFs get the best press known to man. It’s every week there’s a great article on ESG. The issuers are excited. The surveys say they want them, but the money trickles in. That’s being, you know, positive about it. $1.7 billion in ESG flows last year. That is not much in a 318 billion-dollar a year. That gets their total assets at $7 billion. It’s like 0.2% of the total assets.
Olly Ludwig: So, what are your thoughts about that, Rich?
Rich Powers: My counter to that would simply be, we’re still in the early days of ESG investing. And even in the earliest days of index investing, investors were skeptical and there was these thoughts that this won’t really turn into very much. And, gosh, the index investing story clearly has.
I’m not suggesting it’s analogous to ESG at this moment. But, recognizing where we are in terms of people thinking about this type of topic and then asset managers delivering products into the marketplace, one might suggest that the products that have been delivered into the marketplace over the last five or ten years maybe weren’t meeting investor needs and preferences there. And, in fact, the need for products that helped an investor build a portfolio that reflected those preferences, but didn’t so narrowly define that, that it created a lot of tracking error for those advisors or institutions who were thinking about building that portfolio.
Olly Ludwig: From a flows perspective, Vanguard brought two strategies to market, right, in late 2018? Doesn’t look so bad, does it, at first blush in terms of investor interest in these new strategies?
Rich Powers: We’re really happy. We launched a U.S. equity ESG-focused fund and an international equity ESG-focused fund in September of this past year. Both the products are off to a really good start, but then they combined as of this point hold over $250 million in investor assets.
What’s been really reassuring is the quality of the conversations we’ve been having. So, we’ve talked to individuals, financial advisors, endowments, consultants about these products. And there’s been some significant resonance in terms of what we’re trying to deliver in this portfolio, recognizing that those products aren’t a solution for everyone.
They are broad based, they consider the common filters that you hear about when you think about ESG, so things like alcohol, tobacco, firearms. There are some other filters as well. But we’re not bringing products to a marketplace that will kind of address every single investor’s preference when it comes to this topic but there’s broad applicability to, I think, these products.
Olly Ludwig: Thank you. I wanted to, as I said a moment ago, drill in a little bit to your experience on that live webcast, which I watched. It’s really very high quality. A lot of good discussion. Obviously, you were there, Charles Thomas was there from the Capital Markets’ desk here at Vanguard and a couple of external guys. You mentioned Eric Balchunas of Bloomberg and also Todd Rosenbluth of CFRA. High-quality discussion.
Was there anything in that discussion that you would want to tease out and bring into focus now, or perhaps something you didn’t get a chance to talk about when you were down there doing that live webcast?
Rich Powers: You say high quality as though you’re kind of surprised that that was actually the conversation. But I kid. No, it was great to actually have some Vanguard experts as well and some industry experts to talk about a range of topics. Certainly the ESG topic came up.
One interesting area that we explored, quite a bit actually, was looking at popping open the hood and understanding what’s in your ETF, not just simply looking at the price tag as the beginning and ending point of an evaluation process.
Increasingly what you see is, say, a large-cap U.S. equity product with one benchmark, compared to two or three others with different benchmarks. They deliver different exposures to their clients in many cases, and oftentimes that results in different performance.
And so I think, increasingly, as prices particularly for U.S. equity and broad-based fixed income portfolios or expense ratios are gravitating towards the low single digits, the idea of considering other factors in the evaluation criteria was pretty prominent in our conversation. So exposure, spreads, whether the platform you’re trading on has a commission-free offer or not. I guess I’d be remiss, also, to not mention tracking error.
All of that I think is going to create probably more value for an investor. I think that’s maybe the key thing that kind of stood out for me is making sure that price isn’t the first and last place you go when looking at products.
Olly Ludwig: Right. All that discussion, that very detailed analysis—we’ll call it ETF due diligence, right? If you’re an advisor choosing investments on behalf of clients, it suggests a growing sophistication. And I presume, if you want to bring all this home, what your experience was in Florida, that we are witnessing an industry—as I said at the beginning—in full growth mode. But the sophistication, the awareness, the specificity of the questions, the reservations, it’s getting a lot more, as I said, sophisticated, a lot more detailed, yes?
Rich Powers: You definitely saw that in the questions that were posed to the panelists from the audience. I saw that in the client conversations I had as well, that where we were spending our time was not so much simply explaining here’s the price, here’s the performance. It was much more let’s understand what’s different about this product from a methodology standpoint that sets it apart from the two or three other products that an investor can choose from?
Olly Ludwig: Got it. And as far as closing thoughts, you know, mutual funds, open end mutual funds versus ETFs, the utility of ETFs, clearly, these things are coming into focus. People are appreciating something out there called the ETF that’s really making a splashy showing in the investment management industry, yeah?
Rich Powers: Sure, definitely. I think certainly funds have a valuable place and serve a lot of investors really well.
But what you’re seeing is more and more investors come to the table in terms of considering ETFs as a way to build a portfolio. Be it an individual, an advisor, an institutional investor, there are certain utility features of an ETF.
For instance, particularly for advisors and individuals, this idea of the ETF being a great tool for something like tax-loss harvesting, where a mutual fund probably isn’t the best tool because most fund companies have a frequent-trading policy that would kind of frown upon that type of activity.
The ETF is certainly a great tool for that, because any costs that are incurred by that trade are absorbed by the investor who’s making that trade, but they’re doing it with the knowledge of there’s a benefit, which is I’m going to harvest some losses that I might be able to use to offset future gains in my portfolio.
Olly Ludwig: That’s great that you finished with an emphasis on lowering costs or declining costs. So thanks very much for joining me today, Rich. It’s been really a pleasurable and informative discussion.
Rich Powers: Great chatting with you, Olly.
Olly Ludwig: To learn more about Vanguard’s thoughts on the markets, the economy, and other various financial planning topics, be sure to check out our website. Also, remember, you can always follow us on Twitter and LinkedIn. Thanks for listening.
1 Regarding the $715 million in savings Vanguard has brought to clients over the past seven due to declining expense ratios, Vanguard used cumulative figures for all share classes of Vanguard’s U.S.–domiciled index mutual funds and ETFs from the 2012 calendar year through the 2018 calendar year. Estimated savings is the difference between prior and current expense ratios multiplied by average assets under management (AUM). Average AUM is based on month-end assets, which are then averaged over the 12 months of the calendar year. Ending assets are as of December 31, 2018. Source: Vanguard.
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