Over the past decade, the rise of ETFs and the decline of the (actively managed) mutual fund has quickly created giant ETF behemoths like iShares, Vanguard, and State Street, while putting immense pressure on (actively managed) mutual fund companies, with US equity mutual funds in the aggregate experiencing cumulative net outflows since 2008. In turn, this has led a wide range of asset managers to try to adopt their own ETFs, seeking out ways to bring their active management process to a form of actively managed ETF (in a structure that limits their risk of being front-run on large trades).
In this week’s #OfficeHours with @MichaelKitces, my Tuesday 1PM EST broadcast via Periscope, we look at this emerging trend of actively managed ETFs, and why I am very skeptical that active ETFs will ever gain much traction amongst financial advisors.
Ultimately, the key trend to recognize is that the shift of financial advisors from being commission-based to the AUM model over the past decade has shifted the entire financial advisor value proposition. The pressure is now on advisors themselves to show the value they're creating in the portfolio design and management process. Which means they can't just buy active mutual funds - or actively managed ETFs - that the client could have bought themselves in their own online brokerage account.
Instead, financial advisors have been adopting their own internal portfolio design and investment management processes, aided by the growth of the AUM model itself that allows independent advisory firms to be larger than ever before and more capable of having their own investment process. Yet given the limited size of even the largest advisory firms, it's still challenging for most advisors to manage individual stocks and bonds. ETFs became the perfect intermediate portfolio building block.
Which means in the end, the explosive growth of ETFs and their adoption by financial advisors over the past decade may be less about a shift from active to passive, and more about a form of disintermediation where financial advisors are eliminating third-party active managers and bringing the process in-house instead (or if they do outsource investment management, they go to a TAMP or SMA solution that is not available to consumers directly). Yet if this is the case - advisors are looking to bring active value that clients cannot access themselves - it suggests that the push of fund companies to offer actively managed ETFs in the hopes that they can share in the growth of the ETF marketplace may turn out to be nothing but a mirage.
(Michael’s Note: The video below was recorded using Periscope, and announced via Twitter. If you want to participate in the next #OfficeHours live, please download the Periscope app on your mobile device, and follow @MichaelKitces on Twitter, so you get the announcement when the broadcast is starting, at/around 1PM EST every Tuesday! You can also submit your question in advance through our Contact page!)
#OfficeHours with @MichaelKitces Video Transcript
Welcome everyone! Welcome to Office Hours with Michael Kitces!
I want to talk today about the rise of ETFs, and actively managed ETFs in particular. As many of you know, I'm a partner in an advisory firm, I write this blog, and actually a big part of what I do these days is a lot of consulting with companies that serve advisors. Everything from technology vendors to asset managers. And one of the most common questions I've been fielding lately from asset managers trying to work with us as advisors is:
"What's the deal with advisors and actively managed ETFs? Is this going to take off?"
Shifting Asset Flows From Mutual Funds to ETFs [Time - 1:00]
I want to talk today about that theme of actively managed ETFs.
First of all, when we talk about ETFs in general, I won't be the first to recognize the massive growth of ETFs over the past decade or so. If we go back to the 2008 financial crisis, since then equity mutual funds in the aggregate have seen a net decline in asset flows. Equity ETFs, on the other hand, have added net flows of close to $1 trillion dollars. I think the total size of the ETF marketplace is now over $3 trillion dollars. It was a miniscule fraction of that just 10 or 15 years ago.
What's Causing The Shift From Mutual Funds To ETFs? [Time - 1:58]
So, we're witnessing this massive shift in asset flows. And now, a lot of fund companies are trying to figure out is what's driving the shift? What's causing it? What's making this happen? Is it because investors are abandoning active management and going to passive, where ETFs are the quintessential passive vehicle?
Or perhaps ETFs are just doing better because they're cheaper. Now obviously some of the cheaper costs of ETFs is because there's no active manager in the picture to get paid. But to be fair there are also structural benefits to ETFs that help them to be cheaper. The biggest of which is just that with a mutual fund, the fund company itself is the record keeper that gathers all the information about the mutual fund shareholders, keeps record of who's a buyer, who's a seller, what trades occurred, map them appropriately to the right investors, and make sure everyone's got their appropriate share price based on the calculated NAV.
So there's this record-keeping overhead burden for mutual funds, that ETFs don't have to deal with because at the end of the day it's simply a share and the investors do their own trading and set their own price. And we already have an existing brokerage account infrastructure to facilitate holding ETFs, the way that we already hold stocks and bonds.
So there's been this view from mutual fund companies, where they've said, "We feel disadvantaged because the mutual fund structure has some higher overhead administrative costs. If only we could get to ETF structures, and get rid of that layer of administrative costs and bring our costs down a little, maybe we could get the actively managed asset manager complex growing again by driving lower-cost actively managed funds?"
And certainly we've seen a non-trivial amount of research now coming forward that says that part of the problem with active managers is just the cost. For some active managers, they actually do add value on a gross return basis, they just don't add value net of costs. So, maybe if we can bring the costs down, the adoption of actively managed funds will pick back up again with lower-cost net outperformance.
At least, this is the view of some active mutual fund managers. And so they're looking at launching active ETFs, and trying to figure out whether it will allow them to (re-)gain some traction on their funds.
But I have to admit, I think we're going to find their efforts largely fail. At least, amongst advisors.
Why Advisors Won't Be Looking for Actively Managed ETFs [Time - 3:41]
And here's why: I think they heyday for actively managed mutual funds amongst advisors already ended, about 10 to 15 years ago.
If we dial the clock back 30 years ago, back to the 1980's and 1990's, that was really the heyday of mutual funds. Because that was the heyday of when a "financial advisor" was a mutual fund salesperson. That was what we did. We used to be stockbrokers, then discount brokerage eliminated stock brokering, and you couldn't make your money stock brokering. So, we sold bundles of stocks in the form of actively managed mutual funds, and asset managers paid us to distribute them. We got commissions, we got some 12(b)-1 fees, and the growth of the mutual fund industry was mutual funds paying advisors in the forms of various types commissions and trails to sell their funds.
Now, that started to change in the past 10 or 15 years, driven primarily by a technology change. The internet showed up. Online brokerage accounts showed up. And suddenly consumers could buy their mutual funds directly online. Why buy from a registered representative of a broker-dealer, when I can buy the mutual fund directly from E-Trade or Schwab.com and I can find the "good funds" from Yahoo Finance or Morningstar.com or Kiplinger Magazine?
So, the financial advisor business just wasn't in mutual fund sales after the early 2000s. We started backing away from it. The advisor had to find the next value proposition. And we did, at least for those of us on the investment side of the industry: we became asset-allocators. We'd say to clients "Anybody can pick a mutual fund, but we give you a broadly diversified asset allocated portfolio, and then we'll manage it for you on an ongoing basis!"
This led to the rise of wrap accounts, the rise of the registered investment advisor, and the explosive growth of the AUM model, all built around this idea that:
"I don't just sell you some mutual funds and plug them into your portfolio. I build you an entire asset-allocated portfolio for you, and then monitor and manage it for you on an ongoing basis."
How The AUM Business Model Changed The Financial Advisor Value Proposition [Time - 5:50]
Now, here's the next dynamic that shifts. As the AUM model grew, it led to further changes in the advisor's value proposition. Not just because we went from mutual funds salespeople to asset allocators, but because we changed the nature of our business. When you go from a commission-based distribution business to an asset management business, suddenly your incentives change as an advisor.
Simply put, as an advisor I now get paid to actually give my clients good ongoing service, because they retain as clients paying ongoing fees. So we've seen the growth of wealth management firms, the huge increase in financial planning activity, and an ongoing rise in the number of CFP certificants. Because now, we have an opportunity to deliver financial planning and get paid for it on an ongoing basis.
The second dynamic, though, that crops up with the growth of the AUM model is as advisors, we've just started making big businesses the way we never did before. Technically, big advisory firms are still tiny micro-businesses relative to the U.S. business landscape. But relative to the advisory industry, we have made huge businesses since we shifted from being mutual fund salespeople, to asset allocators and portfolio managers.
After all, when you dial the clock back 20 years, a big advisory firm was an advisor and had one or maybe two admin staff, whose salaries were basically covered by 12(b)-1 trails to do the basic servicing when clients called and asked questions. Which is sort of the point of the 12(b)-1 fee, to cover the cost of handling some of that servicing.
But when we shifted to the AUM model and suddenly, advisors were building on a 1% AUM fee, firms started getting big. Because at a 1% AUM fee, I can hire a material number of staff to give awesome service to my clients, and I'm incentivized to do it because I want to retain my clients, because that lets me retain revenue and have an excellent business.
So suddenly, we went from advisors who were all tiny solos working under broker-dealer platforms, into independent advisory firms that had tens of millions, then hundreds of millions of AUM. By a couple of years ago, it was a race to be a billion-dollar firm. Now, the biggest firms are racing for who can get first to $10 billion, and there's a couple that are already north of that.
So the whole landscape has shifted. And the reason why that's meaningful from the perspective of mutual funds and ETFs is it makes it possible for the advisory firm to actually start doing the portfolio management hands on. This is a key point. This is actually the biggest, I think, under-discussed change about what's happened as the advisor business model has evolved over the past ten to 15 years.
How Large Advisory Firms Are Disintermediating Mutual Fund Managers [Time - 8:38]
In today's environment, when the client pays me as a financial advisor to "manage their portfolio" by whatever process I have, the expectation, increasingly, is the client is paying me to manage the portfolio. And if the client pays me to manage the portfolio, they're not so happy when the first thing I do is buy other active managers to manage the portfolio. Because at some point, the client says, "Why am I paying you, if all you do is give my money to them? If all you're going to do is buy their funds, I can buy them directly and cut you out of the middle!"
In other words, advisors risk getting disintermediated, if you're going to be doing ongoing portfolio management but you're just picking third-party funds to put into the portfolio. So the pressure came on us as advisors: you have to play a more direct role in managing the portfolio.
So advisors starting doing it. I've seen more and more firms started creating their own internal investment teams. Some of them actually hire CFAs, and build a whole investment infrastructure around themselves, as the firm gets larger. Some then even start offering TAMP platforms to other firms. And you see RIAs buying other RIAs so actively in part because they've built an investment process, and now they want to leverage it by offering it to other folks. So financial advisors started actually becoming hands-on asset managers, in a way that they really never were before.
Now, the interesting dynamic that has cropped up is advisory firms started becoming hands on asset managers, but most of us are still not big enough to do individual stock picking and bond picking. We've got a little investment infrastructure, but not that much investment infrastructure. And so, advisory firms started asking "How can we add value, some kind of management value, but not be doing individual stock picking?" And what we landed on were ETFs.
Why Financial Advisors Quickly Adopted ETFs [Time - 10:19]
After all, ETFs are perhaps the perfect intermediate-size portfolio building block for financial advisors. They're more diversified than just buying stocks, so my clients still keep the diversification value. But I can manage, I can trade, I can tactically adjust, amongst the ETFs.
This allows advisors to say "My value is creating for you a better, more targeted, better-tilted, more efficient asset-allocated diversified portfolio", in a world where we already know the dominant portion of investment returns are dictated by asset allocation. So as advisors, we took control of the asset allocation design process, and we used ETFs as the building blocks in order to do it.
And that has been changing the whole investment landscape. It's important, too, because it suggests that the shift from advisors using mutual funds to advisors using ETFs is not really an active-versus-passive change. It's an outsourced-investment-management versus internal-investment-management change. In other words, I believe that part of what we're actually seeing with the growth of ETFs amongst advisors is basically, as advisors, we're disintermediating mutual fund managers and saying, "No, no, I'm going to do the investment management process myself." Or if not me literally, the investment management team of our firm, with all the resources and structure and process that we built up.
That's the huge change underway. It's not just about passive versus active. It's about who's delivering a layer of active value. And, of course, how active is it, right? I know a lot of firms that are still mostly passive with their ETFs, but do make some tactical shifts. They're not necessarily day-trading them as an all-in and all-out thing. But maybe they're adjusting factor weightings by dialing up on small cap or value, and then watching small cap and value get overvalued and then saying, "Now, we're going to dial back on small cap, and we're going to dial up international." And then the advisor watches the dollar move, and then Brexit happens, so they begin to dial up gold instead.
And so tactical shifts start happening as the advisor begins managing amongst asset classes. Of course, we can do this with the "Go-Anywhere" mutual funds. But "Go-Anywhere" funds haven't really taken off as much. And again, I think that's because the advisor doesn't buy the go-anywhere fund. The advisor wants to feel like they're the ones delivering the value with the portfolio design process. So if they believe in "Go Anywhere", they do the go-anywhere process themselves, and save the client the active mutual fund managers expense.
Why Actively Managed ETFs Probably Won't Succeed [Time - 12:39]
So bringing all this back to our original theme about why I'm very skeptical that actively managed ETFs will succeed, at least with advisors.
It's because even if they're cheaper and they're using the ETF structure, there are a growing number of advisors that don't want to outsource that part of the value chain anymore. At least, not to mutual funds or ETFs that clients can buy in their own brokerage accounts. It begins to feel like a redundant cost layer for the client. After all, from the client's perspective, if your advisory firm can be a portfolio manager and add value, I don't want to pay your costs and the active manager's costs; I want to pay your costs, because I hired you [and your firm].
And so I'm very skeptical that actively managed ETFs are going to get much traction, because of this dynamic. As advisors, we have disintermediated active managers and mutual funds, and we use ETFs to bring a layer of active management or portfolio design value ourselves. And what that means is that if we do see any traction start building in actively managed ETFs, it's going to primarily be as a direct-to-consumer success, not in the advisor channel.
And of course, that's assuming the actively managed ETFs can figure out how to make all this work at all with the challenge of transparent ETFs and the risks of front-running. Perhaps Eaton Vance's exchange-traded mutual fund structure NextShares will work, as a hybrid thing that is less transparent. But again, even if we see some activity, I suspect what we're going to find is that it's more on the direct-to-consumer end, not by getting advisor adoption.
Now, to be fair, if the companies can get the costs down enough and deliver some positive alpha out of their actively managed ETFs, perhaps some advisors will show up. If there's value being added, that is justified beyond my advisor fee, because the ETF manage is doing what they do to add value, an advisor would still consider that.
But if anything, I suspect, if we see growth around active ETFs at all, it's more likely because advisors actually start building active ETFs themselves instead. This has actually already begun to happen on a small scale; for instance, Meb Faber does it with his Cambria ETFs, and Wes Gray does it with his ValueShares and MomentumShares ETFs. These are RIAs that are actually building their own ETFs, taking advantage of some of the unique tax efficiencies of the ETF structure, to run their own proprietary strategy as the advisor.
The Future Of Financial Advisors Is Not Paid Product Distribution [Time - 15:03]
A key point to recognize in this shift as well, that fund companies seem to miss... I think fund companies are still treating us advisors as though we're their product distributors. We distributed their products for years, and they paid us in commissions for it. But the change that's happened is, we're functioning less and less as product distributors anymore. We're looking to get paid for our advice and value-add, even if we have to strip out the active mutual fund's cost layer to do it.
Thus, while a 1% AUM fee may look familiar, it's less and less often a 1% trail in the C-share mutual fund anymore. Now it's increasingly a 1% portfolio management fee, paid by the client not the asset manager. And the client expects us to deliver value for that fee, or we're getting fired. And when the pressure is on the advisor to justify their AUM fee and what value they're bringing - hopefully we're doing it through financial planning - but the pressure comes on advisors as well to say "Then I've got to find the lowest-cost solutions, and I have to add value in how I design the portfolio, monitor the portfolio, and manage the portfolio on an ongoing basis. Which means the burden is on me as an advisor. So I don't necessarily want to delegate that out to mutual funds that the client could have just bought themselves in a brokerage account."
Notably, since the biggest 'risk' for the advisor is to sell a mutual fund (or actively managed ETF) the client could have bought themselves, third party asset managers that work directly with advisors, such as TAMPs and SMAs, have retained more success. I'll admit that I'm biased, because our firm has a TAMP offering for independent advisors as well. But that works because it's not something clients would buy themselves in their brokerage account, the way they could an actively managed ETF.
So I'm very skeptical about the success of actively managed ETFs. Not because the structure is necessarily fundamentally flawed. Not because this is an active-versus-passive issue, because I don't think it actually is. Because the advisors who believe they can add value in active, do try to do so; but we're doing it by building our own investment teams and infrastructure. We try to do it ourselves. I can debate about whether that's good or bad - as there's probably a couple firms that should be outsourcing that process and not trying to build it themselves - but when you look at all the discussion we have about the downward pressure on fees, and this question of whether the 1% AUM fee is going to buckle, I think you're seeing the first round of this already. But it's not advisors cutting their 1% AUM fee to compete. It's advisors squeezing fees by refusing to pay active managers, and bring it in-house at a lower cost to the client instead.
So we'll see how this plays out. I guess for a couple of actively managed ETF providers that are trying to build this, best wishes to you; hope you can prove me wrong, for your sake. We will see how it plays out.
But again, I think the whole shift of mutual funds to ETFs that we've seen isn't just about ETFs as a superior; it's that the growth of advisory firms themselves has actually brought investment management in-house, and that this ongoing decline of active management is not necessarily because all advisors are going passive, it's simply because they don't want to outsource it to funds that their clients could have bought directly without them. And then if the advisor is going to be a little more active, most of us don't have firms that are deep enough to do individual stock and bond selection, and ETFs provide a more convenient building block, so we've begun to tactically manage the ETFs. Especially since the returns are driven by the asset allocation anyways.
So I hope that's helpful food for thought about the current landscape, the potential of actively managed ETFs, and whether they're going to gain traction or not. I've been fielding more questions about this from both advisors and the companies I consult with, so I thought we'd sound off on it for "Office Hours."
So thanks again for joining us. We really are going to get back to the regular schedule soon, 1 p.m. East Coast time on Tuesdays going forward from here. I know it's been messy because I was traveling for weeks and weeks for speaking engagements for so many advisor conferences. Finally, the pace is dialing down as we head into the summer season, so we'll get back to our regular time.
In the meantime, I hope this has been helpful for all of you, and have a great day!
So what do you think? Do you use ETFs in your portfolio with clients? Why? Is it about being passive, or using ETFs as the building block to add portfolio design and/or management value yourself? Are you looking to adopt actively managed ETFs if/when/as they become available?