Does DFA’s mutual fund-to-ETF conversion toll the death knell for the US mutual fund industry? Comment from BNY Mellon’s Slavin and leading US financial planner firms on that, plus ESG and crypto
Trading has just commenced for the ETFs converted from US mutual funds by Dimensional Fund Advisors (DFA), with USD637 billion under management, with Nicole Hunter, head of capital markets, announcing that the firm is ‘just getting started’.
The official conversion of four US tax-managed mutual funds into active, transparent ETFs, extends its existing ETF offering that launched in 2020. With this conversion, Dimensional becomes one of the largest active ETF issuers in the industry with over USD30 billion in combined ETF assets under management.
Much has been written about whether this move will have any repercussions on either of the investment industries involved. Ben Slavin, Global Head of ETFs, Asset Servicing, BNY Mellon says: “While Guinness Atkinson was the first to execute a mutual fund to ETF conversion, Dimensional takes it to another level given the size of the firm and the amount of assets they converted. They came into the ETF business a year ago and this vaults them towards shooting distance of the top 10 leader board.
“It is kind of amazing what is happening here, and a blue print that other managers are keenly looking at. The trend line has been persistent over the last few years that you have seen record inflows into ETFs but also persistent outflows over time in mutual funds. In 2020 that delta between mutual fund outflows and ETF inflows grew to a record level. It’s hard to declare that the mutual fund structure is dead but certainly ETFs are continuing to take market share.
“My personal belief is that it will be interesting to see what happens when we see another market hiccup. In a risk on environment again what we have seen historically is money coming out of mutual funds and ETFs and when it comes back in, the mutual funds are not taking 100 per cent of that money back.
“It’s relatively easy to understand as since we have had a bull market there have been large embedded gains in taxable accounts. If that were to reverse it would potentially remove one barrier for investors to convert their holdings from a mutual fund to an ETF.”
Chicago-based Chad Carlson, President and Co-CIO for BDF Private Wealth agrees on the tax point. “I believe this is more about costs and taxes than mutual funds vs ETFs,” he says. “The ETF wrapper in many ways is more attractive from a long-term tax deferral advantage, however, it is by no means a panacea. For example, if taxes are a non-issue and you don’t worry about trading intra-day, assuming costs are equal, there’s really no push to ETFs.
“To us, any investment decision needs to start with the strategy of the investment decision. If you limit yourself up front to the choice of vehicle, then you are making the decision with your eyes partially closed. You have to have conviction in the strategy and then find the best vehicle type to execute that strategy in.”
Omaha, Nebraska-based Orion Advisor Solutions’ Chief Investment Strategist, Rusty Vanneman, feels that things are changing at a more fundamental level, believing that ETFs will continue to take market share from mutual funds.
“It’s not likely we will ever see the strong organic growth in mutual fund assets, outside of market appreciation, like we experienced in past decades,” he says. “That said, mutual funds are still appropriate investment vehicles as they are professionally managed, have reasonable costs, are regulated and so on and make sense for many investors. This includes investing in retirement plans where taxes are not a consideration. Also, at present, it is easier to invest in mutual funds than in ETFs as you can trade in fractional shares, there is no bid-ask spread doing trades, you can only buy once a day, etc.”
Ben Littman (pictured), CIO for Pure Financial Advisors, with USD3.29 billion under management and based in Southern California, believes that ETFs provide a number of advantages over mutual funds. He says: “Don’t get me wrong, I am still totally comfortable having client assets in low-cost factor or index based mutual funds but similar ETFs tend to edge them out in several categories.”
For Littman, the issue to date has been the lack of product mix in the ETF space for factor (smart beta, or re-weighting schemes other than market cap) funds. But he believes that is changing rapidly with firms such as DFA getting into the game as well as Avantis and also some more traditional players like Vanguard and BlackRock coming forward with dedicated factor ETFs.
Littman refers to a recent read on the ETF industry, ‘ETF Portfolio Management’ by Dr Scott M Weiner of Janus Henderson. “ETFs are clearly more tax efficient than mutual funds due to the creation/redemption process and the ability to exchange out low basis shares in the primary market without creating a taxable event for end investors,” Littman says. “In fact, the iShares Momentum ETF (MTUM), which is generally considered a high turnover strategy, has never distributed a capital gain since inception. There are also less administrative expenses internally for ETF’s compared to traditional ’40 Act funds which contributes to the lower expense ratios across the board when compared to mutual funds.
“I used to think that the potential for ETFs to deviate from NAV was a negative compared to mutual funds. But if you look at the arbitrage mechanisms market makers have in place to drive ETFs towards NAV, it seems there are several industry forces at work to price ETFs accurately.”
Dave Alison, COO and Founding Partner for Ohio-based C2P Enterprises, believes that the traditional passive mutual fund space is under threat. “I think there are certain active managers that are continuing to find ways to compete in the mutual fund space and retain market share from the ETF world, but advisers and investors are seeing the benefits of tax and fee efficiency in the ETF space outweigh the benefits that many traditional mutual fund managers have awarded over the last few decades.”
Carlson believes that one of the leading strengths of ETFs is the diversification that comes along with these types of investments. “By allocating to a fund, you can get tens, hundreds, or thousands of holdings all in one,” he says. “If you broaden that out to having a longer list of ETF/investment vehicles, now you have an extremely diversified portfolio that is easy to see on a piece of paper what it is invested in.
“The other part for ETFs that is enjoyed by clients is with regards to the tax efficiency. I have yet to see a client get upset about not having a year-end capital gain distribution. This of course means an eventual tax may just be deferred, but it allows for even more control over the tax situation which can be helpful. This is especially true in an ever-changing tax environment.”
For Ohio-based Alison, the tax-efficiencies that ETFs provide are appealing over other collective investments for larger investors. “For smaller investors, the fact that most custodial firms have gone to no transaction fees pricing for ETFs allows an adviser or investor to create a broader portfolio with more positions without having to worry about trading and rebalancing costs to diminish growth. Both larger and smaller investors like the inter-day price movements vs mutual funds closing price at the end of the day,” he says.
In terms of the diversification that ETFs offer, some have found themselves unexpectedly caught up in the passion for meme stocks. Slavin comments: “The most important thing on meme stocks is this mantra in the ETF space of ‘know what you own or look under the hood’. Whether it’s an ETF or an index that has a meme stock as a constituent, there will be a large disparity of performance.”
Know what you own applies in thematic ETF investing as well, he believes. “Thematic ETFs continue to attract a lot of investor attention and the differential can be quite stark. A recent piece of research on the performance of blockchain ETFs found the spread of performance showed a 70 per cent differential in ETFs that had blockchain or something similar as their theme.”
And one of the most popular types of ETFs over recent years has been the active variety. Slavin says: “The trend line in product development in active ETFs is outpacing the assets to some degree and there is a further filter between active transparent and active non transparent. The data is skewed a bit in the US because of the performance of ARK and its asset gathering abilities.
“We have seen some volatility in ARK’s portfolios, and a pull back with some performance reversing, but flows are remarkably resilient there which does speak to a different type of investor. There are much more tactical movements in thematic ETFs where retail investors especially are moving money around at a higher and higher velocity. But this is not true in ARK, where the money came in and the shareholder base has stayed – there seems to be more of a willingness to buy and hold over a longer time period.”
Vanneman has a comment on active ETFs: “ETFs are generally considered ‘passively-managed’, meaning they are tracking a benchmark,” he says. “While passively-managed ETFs are still the more popular choice for ETF investors, there is much more interest in ‘actively-managed’ ETFs that are trying to outperform a benchmark. I would expect this trend to continue, particularly as more traditional mutual fund investment firms introduce ETFs.”
Slavin has noted that the semi-transparent ETF structure that protects the intellectual property of the active ETF is slow to gain traction. “There is more flow into active ETFs that are fully transparent versus the non or semi-transparent variety, which are sitting at less than USD2 billion in terms of aggregate assets.
“Regardless of the desire to invest in the meme stocks, the bigger macro point is the rise of retail investors in the US, trading individual stocks, ETFs and crypto as well, all bundled together. But we have seen again a big uptick in investor interest in ETFs and that retail segment has been playing in ETFs across the board.”
In terms of ETF product types, Alison says: “I think the demand for continued targeted and even microtargeted ETFs within certain sectors will continue to gain interest and traction. In addition, growing fixed income alternatives in today’s low interest rate environment where investors are searching for yield.”
Two investment themes have dominated the beginning of this year – ESG and cryptocurrencies.
Carlson says that the demand for ESG investing among his US client base differs from client to client. “For the clients that do care about this, it is quite important and there is a desire to have a portfolio mimic their personal values. We have long been able to help clients design ESG related portfolios that keep our investment strategy intact yet emphasise their values.
“However, looking backward this was more reactive if a client brought it up. Today, we have proactive portfolios and communication around this because we have an expert here, Drew Gibbons, who has taken up the passion to make sure we are designing and communicating well on this front. This was most recently on display last week with a webinar event Drew did on this last week which had over 100 people registered to participate.”
For Carlson, there is a more granular approach to ESG being asked about within ETFs. “This could be focused on board composition, a niche environmental factor, or other cause. However, we are finding much more success for clients being able to implement that through an SMA. The customisation of this to the person is highly preferential on our end and I believe will continue to take up more and more of an allocation as technology ease and trading cost minimisation comes into play,” he says.
Orion’s Vanneman agrees on the ‘client by client’ nature of ESG needs within portfolios. “It’s important to a minority of our clients, but to those that it is important, it is very important,” he says. “For those investors who care, it then comes down to finding the proper investment vehicle to match their interests and values.”
Southern California’s Littman says: “We have seen a rise in interest in the ESG space and have a few different options available to accommodate clients there whether it is a portfolio of ESG screened ETFs or accomplished through Direct Indexing.”
Littman believes that the investing world needs a fixed standard for ESG reporting. “I still think the investing community as a whole is waiting for a Global Standard in which companies are required to report ESG (or non-financial-based) metrics. Also, a longer track record of ESG performance would be helpful in the investment decision process,” he comments.
BNY Mellon’s Slavin comments that from an ESG product development perspective, the US seems to be starting to catch up to Europe with two iShares products that set the record for initial seeding. “Those products were record setting but it’s at the institutional investor level where the green shoots are happening,” he says.
“Where we are seeing immediate traction in the market is ESG through a thematic lens not quite as much as on a broader based strategy. Effectively integrating ESG into many of these broad-based products in different ways is where the story might play out.”
And he agrees with Littman that a gold standard for ESG factors would be a helpful development. “One of the challenges is with advisers and retail investors who are confused about what it means and some of the standards used to filter ESG data for portfolio construction purposes.”
And the craziness of the volatile cryptocurrencies, and the potential launch of a US bitcoin ETF continues to be the subject of endless debate. Slavin says: “The latest SEC statement dashed optimism that the approval of a bitcoin ETF was imminent. Ultimately you are going to see the SEC work their way through the outstanding issues and try to resolve some of the matters in the regulatory framework that will allow these products to assist.”
“In Canada, we are servicing 14 of the 16 crypto products listed on the TSX and we are attached to a number of the US filings. The Canadian regulator has taken a progressive attitude to digital assets and they are successful to date.
“It was recently tested when we saw some pretty significant volatility in the underlying assets in bitcoin and ether and reports are that they held up remarkably well - doing as well as they were supposed to, providing a source of liquidity, price discovery and reasonable tracking and there has been additional flow into the products.”
In terms of demand, the financial planners all comment that cryptocurrencies have been heavily talked about in recent months. Alison says that his firm has been receiving more requests about crypto products. “But I believe it was primarily a bi-product of the media hyping it while it was skyrocketing growth. It has certainly tapered off over the last couple months,” he says.
Both Littman and Carlson report more requests, with Littman ‘monitoring’ the situation and Carlson commenting that the requests are coming in from clients, more for thought and to see if they are missing out than anything else. “Only a handful of clients have truly chosen to allocate dollars to this space, and when this has been done, this has been done outside of our direct management,” he says.
Carlson finds the space quite interesting, yet the investment complexion challenging. “As we are designing portfolios for long-term goal achievement supported by an academically based portfolio, crypto has a challenging way to get a seat inside that portfolio. The volatility and costs are too high along with the anticipated regulatory risk.
“For those that are interested, we make sure to talk to them about how much they can afford to lose in the context of their financial plan so there is not a risk exposure that puts long-term pressure on their plan. In many ways, we liken cypto to the internet. We believe blockchain to be an incredible, likely game changing technology. But that doesn’t mean the early companies, coins, are going to be the ones that lead to market success. Just look at Google vs. Lycos or other search engines.”
Meanwhile Vanneman at Orion says increased requests for crypto products are partly because of the dramatic price movements and sensational media headlines. “But it is also increasingly so because many investors are learning more about crypto investments – what they are and how they work. For a frame of reference, the typical investor that we work with still has less than 1 per cent of their assets in crypto-related investments, that we know of, but that number is growing,” he says.