Author Q&A With Bloomberg TV’s ETF Expert Eric Balchunas by Gavekal Capital Blog
In our most recent book club selection — The Institutional ETF Toolbox — Author Eric Balchunas outlines what investors need to know about the changing landscape of investment products in a fast-moving format that makes this book well worth any investor’s valuable time. Balchunas quotes early adopters and power users of ETFs to illustrate how investors helped to create this class of products and share how the best of the best are using them.
We wanted to know what’s new in ETFs since the release of the book, so we sat down with Eric last week in New York after he finished his fourth TV segment of the day. He shared what’s next for ETFs, how investors will find performance in the future, and how he became Bloomberg’s go-to guy for ETFs.
Q&A: Bloomberg TV’s Eric Balchunas on ETFs
Gavekal Capital: How did you become an ETF expert?
Eric Balchunas: After college I was a financial reporter for Institutional Investor. I made the move to PR because I wanted to see the other side of the keyhole of all these press releases I was receiving. When I started at Bloomberg I was blown away by the place. It looked like an electric beehive. After spending a few years in PR at Bloomberg, I decided to drastically switch things up, and I went to work for the Bloomberg’s Princeton data office. This was a move from a talking profession to a data-oriented profession. Now I was looking at mutual fund data and not using my communication skills at all. Gradually, as I got used to working with the Bloomberg terminal I began to combine the data analysis and communication skills together. ETFs were beginning to gain a lot of steam –remember this is back in 2006 so ETF AUM was not nearly as large as it is now –and I quickly realized that I could become Bloomberg’s go-to guy on ETFs. So I combined all of my skills and tried to get in front of the oncoming ETF wave. Initially I worked with a team to build out ETF functions on the Bloomberg terminal. If you have a Bloomberg Terminal and type ETF <GO>, that is a function that I helped to create. ETF <GO> is invaluable for understanding an ETF and figuring out why it performs the way it does. In the book I compare ETFs with like names to show how each one performs differently and how differently they are constructed. ETF <GO> is the culmination of all of that work.
Gavekal Capital: Did the idea for the book come from working on ETF <GO>?
Eric Balchunas: It definitely played a part. While working on the ETF function, I was going on TV more and more during Bloomberg’s ETF segments. People kept telling me I should write a book on ETFs. Gradually, I began to think about writing a pamphlet, something I could hand out to friends and family at dinner parties to help them lower their investment costs. So the genesis of the book was my sitting down to draft this little pamphlet. When my editor heard about it, he introduced me to Bloomberg Press. The first pitch for the book was actually directed at retail investors. The publisher declined because there are more retail-oriented books in the marketplace. They wanted a book directed at institutions, so I set to figure out how the bigger institutions in the financial world were using ETFs.
The book is about 60% what I was going to say about the retail side and 40% new research on how institutions use ETFs. For parts of the book, I was writing and learning at the same time. I interviewed investors of endowments, foundations, retirement plans, big ETF providers, Jack Bogle, ETF strategists and early adopters. The interviews allowed me to use expert quotes to explain some of the more complicated aspects of ETFs. I interviewed about 60 people and included about 300 quotes in the book. Readers have told me they really enjoy the first-hand stories from practitioners about how to use ETFs.
Gavekal Capital: Your book came out in August 2015, what’s changed since it was released?
Eric Balchunas: The biggest change is there have been roughly another 100 ETF launches since last August. In terms of major trends in the ETF world, I don’t believe much as changed … yet. In a couple of years, we will see some of the more exotic ETFs take hold. For example, in the book I discuss interest rate-hedged ETFs and liquid alt ETFs, which have still yet to have their day. I did this on purpose because smaller ETFs and asset classes will eventually become more important as time goes on.
Gavekal Capital: What’s the next big ETF trend investors should be watching?
Eric Balchunas: Smart beta is going to be a very big deal. Smart beta is where all the new products are coming from, and that’s where managers can find some interesting ways to try to beat their benchmark. We are already seeing large institutions wade into this space. Since the release of the book, Goldman Sachs and JP Morgan have launched smart beta ETFs.
Perhaps the biggest industry shift on this front has been from Fidelity, who announced they are going to be releasing smart beta ETFs based on their own indices. This is huge! They are taking their secret sauce, turning it into a rules-based index and tracking their own index. That way, even though they will be earning less money, they are still in the game and their profits aren’t transferring to a competitor.
Gavekal Capital: Looking out over the next 5-10 years, do you expect ETFs to continue on the current trajectory and take a larger share of the pie?
Eric Balchunas: Without a doubt. Right now there is about $2T in ETFs and another $2T in index mutual funds. The active mutual fund marketplace is much larger at around $13T. If we look back at recent history and conservatively project trends into the future, I expect about $250B per year to bleed out of the active money management world into passive management. ETFs will get the majority of it.
Gavekal Capital: So in 4-5 years, index investing will reach parity with active from an AUM standpoint?
Eric Balchunas: Yes, that sounds about right.
Gavekal Capital: Why will ETFs take the larger share of flows?
Eric Balchunas: Because there are so many new, interesting products being launched every day. Right now, the mutual fund industry dominates the ETF industry in terms of number of products. There are roughly 16,000 mutual funds when you consider all the various share classes. Currently, the number of ETFs is only about 2%-3% of that amount. Right now, when people go looking for ETF investments, there are only one or two options per benchmark index. This means investors who prefer more options tend to focus on mutual funds. And typically, the analysis on that side of the business starts with who has been performing best recently. The funds that have performed the best get hyped up by the media as well. This helps drive mutual fund flows and ironically, it is usually the case that an active manager starts to underperform just as flows starting going their way. So it’s this weird cycle that ends up transferring money out of the public into the financial world through fees. In the future, instead of chasing performance through active managers, investors will move into ETFs. It’s quite possible that instead of looking at peer group analysis or analyzing active managers, we’re going to start comparing differences among passive managers. High level institutions already do this when they pick an SMA manager. This type of due diligence will eventually be the norm in retail as well because it’s not all that hard to do. We just need data services to provide a simple ratings framework such as the one I propose in my book, modeled after how movies are rated.
Gavekal Capital: Are ETFs a disruptive technology for the financial industry?
Eric Balchunas: Yes. I think the way Napster, iTunes, and the MP3 in general disrupted the music industry is similar to how ETFs are disrupting the money management industry. In finance, high fee active management is analogous to the record industry selling $17 CDs in the 1980s and 1990s. Even as the manufacture of CDs dropped precipitously, the record industry never lowered the price. They were never willing to pass on any of the cost savings to their customers. One way to look at selling CDs is to think of it as a form of forced bundling. Rarely do music customers want all of the songs on an album. Usually, they will want three or four songs but the way the record industry worked 20 to 30 years ago was that they forced consumers to buy an overpriced album in order to hear the three or four songs they wanted. So in effect they were overcharging for forced bundling. This is what the mutual fund industry has been doing to their clients. They have been selling expensive, and many times underwhelming, active management products to customers for a high price. The average investor doesn’t care about active or passive, they just want equity returns so they have enough money for retirement or their kids’ college tuition. And the unspoken truth in the business for a long time has been that investors didn’t even know they didn’t want high priced active management. But this is changing. Investors are realizing they don’t want to pay high investment fees, and the media has caught on and is helping to educate investors why they should focus on fees in addition to performance. The record label companies saw their revenue cut in half from about $20B to $10B in just 15 years. For financial firms, revenue could decline by 70% as investors simply move from active managers (where the average fee is 72 bps) to ETFs (where the average fee is 20 bps). Over the past seven years, we have seen over $4T in assets move from paying on average 72 bps to 20 bps. However, because of the market rally since 2009, the AUM pie has gotten so big that it has helped mask this massive drop in revenue.
Whenever the next bear market occurs, the money management industry will be hit twice as asset prices decline and more money transitions from high-fee to low-fee products.
Gavekal Capital: If you thought the money management business was hurting before, watch out.
Eric Balchunas: Right. And this is why I think what Fidelity is doing is so important. Instead of losing 100% of their money management revenue to a passive fund or ETF, they are willing to take a 70% haircut and offer their own lower priced products.
Gavekal Capital: Given the tax efficiency and lack of capital gains you describe in the book, ETFs seem to be ideal long-term holdings, but the turnover stats you cite don’t support this. Why?
Eric Balchunas: This is a great question. I agreethat tax efficiency is a huge benefit for advisors especially. Keep in mind that when you look at turnover, the most traded ETF in any category is going to draw in the big institutions because of liquidity. They also bring in a lot of day traders. For the largest ETFs in any category, the holding period duration is skewed lower by these market participants. When you look at some of the smaller issuers in each category, that’s where you will see much lower turnover numbers. For example, if you look at the Vanguard or Charles Schwab offerings in each category you see they have very low turnover rates. Investors are using these ETFs much more for long-term holding purposes.
I think for investors that truly understand the tax efficiency of ETFs, it is a very big deal for them. For example, Wes Gray of Alpha Architect is quoted frequently in my book. He turned all of his strategies into ETFs because of the tax efficiency issue alone. So for taxable investors, like family offices, the tax efficiency is a huge deal. We need more education on these kinds of benefits.
Gavekal Capital: As we move to an ETF world, how important is the role of the portfolio manager?
Eric Balchunas: ETF portfolio managers are often overlooked but this is an important role. In the most basic sense, an ETF should lag the index by the amount of the expense ratio. But there are ways a clever manager can gain a few basis points here and there such as through securities lending and how he or she rebalances the index. ETFs are a game of basis points. As an ETF manager you can lend out 33% of the stocks in the ETF, so depending on what part of the equity market one is in, one can pick up a few basis points. In some cases, such as in the small cap space, investors are actually paid to own the ETF. What I mean by this is the ETF outperforms the index even after fees so it has positive tracking difference. Hedge funds are primarily the investors who borrow stocks from ETFs to short them. About 80% of the shares that are borrowed from ETFs are borrowed by hedge funds. So hedge funds are paying a retail product fee to borrow shares and you, as an investor, essentially get your exposure for free. In a striking change, you are actually making money off of hedge funds! ETF providers are using all of their college degrees, Ph.Ds. and skills for a cause that benefits the average investor by creating investment products that track as closely to the index as they can. It’s almost like a transfer of wealth from large financial firms back to the investor, which rarely happens in the financial world. One challenge facing the industry is that indexing is just kind of boring to talk about. We are a competitive culture that likes to put high achievers, whether it is in sports or in business, on a pedestal. Passive management doesn’t really lend itself to that type of thinking. The ideal passive manager is trying to pass on index returns as much as possible to its investors. He or she isn’t trying to beat that index, so it’s a much different message than what has traditionally been used to market financial products. One way I think the passive management industry can differentiate will be to deliver that index return with as little tracking error as possible. Amazingly, even with the explosion in the number of ETFs available, I think there are only about 12 ETFs that track the same index, so there isn’t a lot of competition from ETF providers to keep their tracking difference down at the moment. As more money flows into the space, more ETFs will track the same indices, and this will create new ways of comparing ETFs.
Gavekal Capital: Any advice for financial advisors?
Eric Balchunas: People are always going to want to beat the market, and now we have this new generation of smart beta ETFs that are trying to do that. ETF pickers are sprouting up and that’s going to be a whole new industry –consultants and experts who focus on smart beta ETF due diligence. Go look up the 13F filing for Windhaven, an ETF strategist that manages all ETF portfolios. If you want to know what an advanced ETF user looks like, take a look at how they allocate. They manage about $13B and use about 35 different ETFs, some of them you never heard of before. They are the Jedi Masters. Any advisor looking to learn more about ETFs can take a look at their holdings, maybe mingle with them at a conference. I quote these experts throughout the book because we can learn a lot from early adopters.
Read the full interview below.
Catch Eric every Friday on Bloomberg TV during his weekly ETF report. The Institutional ETF Toolbox is available at Amazon.com.