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Ben Johnson Morningstar

ETFs Don’t Create Risks; Investors Do

Ben Johnson, the global ETF research director for Morningstar, on the evolution of ETFs, the (so far) lackluster demand for active strategies, and the unwarranted fear that ETFs pose a threat to the markets.

There has been much buzz in the exchange traded fund world recently about active trading strategies. Ben Johnson, director of global ETF research for Morningstar says active ETFs can be beneficial to the extent they can widen access and improve the pricing of active strategies.

Investors don’t face buying minimums like with some mutual funds. Meanwhile, fees and taxes can be low compared to mutual funds. But there isn’t much enthusiasm for them among providers, who aren’t eager to reveal their portfolio every day, he notes. If regulators approve non-transparent, active ETFs, that could get the ball rolling, Johnson says.

He spoke about these issues and others in a recent interview. What are the biggest risk for financial advisers and their clients when it comes to ETFs?

Ben Johnson: It’s important to understand that an ETF is just a packaging structure. It’s a unique structure that packages and distributes a variety of investment strategies. The key risks are those related to the underlying strategies and exposures. That’s everything from total stock market indices, which aren’t all that risky, to niche strategies that are more concentrated in volatile corners of the market—leveraged exposure to junior gold miners, for example.

Then there are risks unique to the packaging. Like stocks, ETFs are traded on an exchange. I have seen many advisors have bad experiences when it comes to point of execution. Some of them are accustomed to mutual funds, dropping a ticket any time during the day and receiving net asset value for that day. Given that ETFs trade all day, it creates a learning curve for advisors unaccustomed to trading in real time.

For example, on Aug. 24, 2016, the market hit an air pocket, and ETF pricing went haywire. As the market goes down, orders get filled at prices that have little resemblance to the value of the underlying securities in ETFs. But these are very rare occurrences, and the risks can easily be mitigated by looking before you leap. Be cautious in ETF trading: just use limit orders, and you’ll get that price or better.

WM: What about concerns that at some point ETF investors will dump shares en masse, exacerbating a market downturn and sparking volatility?

BJ: ETFs don’t create that risk. Investors do. Futures were widely believed to be behind the stock market crash of 1987, and ETFs were borne out of that. When mutual funds were developed in the 1960s, people fretted that unsophisticated retail investors would buy and sell at the wrong time, exacerbating market downturns and manias.

But in the crash of the early 1960s, it was professionals who caused the volatility, and if anything, the retail [mutual fund] investors served as a stabilizing force. ETFs are just a new format to buy and sell securities, like mutual funds decades ago. The commonality is that investors are made of flesh and blood, so a fight-or-flight response kick in. Whether it’s a stock or ETF is irrelevant.

WM: What about the risks of leveraged and inverse ETFs?

BJ: Leveraged ETFs present risk to those who don’t understand the underlying mechanics. In most contexts, the damage is done. There was misuse of leveraged and inverse funds during the financial crisis. Since then they have been exiled from most major advisor platforms. They have carved a niche of their own user base that understands them well. Of course, they are still out there for people to misuse. That risk is always present.

WM: What are the most important recent developments in the ETF space?

BJ: There’s a continuation of the race to zero with respect to fees on ETFs that offer broad exposure to various corners of the market. Fees matter. Any fee we don’t pay adds to compounding. You can get a broadly diversified equity ETF for 3 basis point, and for bonds, it’s 4 basis points. That’s immensely important. Beta is now effectively free.

For advisors, there is a change in tack: a new effort by ETF providers to provide a more intense focus on solutions. After nearly 25 years of breaking Humpty Dumpty into bits, there are 2,100 ETFs on the market. Providers are building model portfolios and selling them to advisors and directly to individuals. That includes Vanguard, BlackRock, State Street and Schwab. They have made good headway.

From the point of view of the investor and advisor, it’s the grocery store dilemma. Everything looks good, and you walk out with things you can’t possibly make a meal out of. To the extent that fund sponsors provide a ready meal, it helps to solve the dilemma.

WM: What are your thoughts on active ETFs?

BJ: They have potential to the extent they can widen access and improve the pricing of active strategies. They widen access by trading on an exchange, reducing the barrier for smaller investors, who might face minimum investments in mutual funds. Also, many actively managed ETFs have fees below mutual funds. They have the potential to be cost efficient and tax efficient, given their in-kind creation and redemption mechanism.

But I haven’t seen much enthusiasm for them, except Pimco, DoubleLine and Davis. You have to publish your portfolio on a daily basis, and most managers prefer to not be the only one at the poker table showing their hand. Right now, prevailing winds aren’t blowing toward active management. We have seen a shift toward passive. But [if regulators approve] non-transparent, active ETFs, that might spark interest.

WM: What new developments do you see coming down the pike for ETFs?

BJ: New developments will most likely be more of a distraction than a useful innovation. The flavor of the last two-plus decades is plain vanilla. The top 100 ETFs have three-fourths of the $3 trillion total. The common thread is they’re incredibly inexpensive and usually broadly diversified, market cap-weighted indices.

WM: How well do you think financial advisers handle ETFs?

BJ: Advisers have done well by their clients in directing the money to very diversified ETFs with low expenses. These are some of the best portfolio building blocks your money can buy.

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