ETF Edge - ETFs and Mutual Funds: Same Share Class a Game Changer? 8/28/23

Episode Date: August 28, 2023

CNBC’s Bob Pisani spoke with Gerard O’Reilly, Co-CEO and CIO of Dimensional Fund Advisors – along with Ben Slavin, Global Head of ETFs at BNY Mellon. They discussed a hot trend in the ETF business that’s been the talk of the town for many industry observers – the same share class debate, or treating ETFs and mutual funds as both under the ETF wrapper. Vanguard’s been doing it for years, but now that the same-share class patent is expiring, will the SEC agree to renew it? In the “Markets 102” portion, Bob continued the conversation with Ben Slavin from BNY Mellon. Hosted by Simplecast, an AdsWizz company. See pcm.adswizz.com for information about our collection and use of personal data for advertising.

The ETF Edge podcast is sponsored by InvescoQQQQ, supporting the innovators changing the world. Investco Distributors, Inc. Welcome to ETF Edge, the podcast. If you're looking to learn the latest insights on all things, exchange traded funds, you're in the right place. Every week, we're bringing you interviews, market analysis, and breaking down what it all means for investors. I'm your host, Bob Pisani. Today on the show, we'll discuss a hot trend in the ETF business. Same share class debate, treating ETFs and mutual funds.

Equally, Vanguard's been doing this for years, a factor that's helped fuel its rise to become an ETF powerhouse. We'll also dive into a little active versus passive debate for good measure. Here's my conversation with Gerard O'Reilly. He's the co-CEO and CEO of Dimensional Fund Advisors, along with Ben Slab and he's the global head of ETFs at BNY Mellon. Gerard, educate us a little about, why is this potentially important, having ETFs and mutual funds in the same share class? What does that mean? And you do have to get SEC approval for this. What are the chances go give it to you? Yeah, I think that's the big story here, Bob, is that the SEC gave approval for this type of a structure to one firm 20 years ago and haven't given it to other firms since

then. And there are many firms now, I think, that are going to try get approval for this type of structure from the SEC. And why would they do that? When it comes down to a very simple economies of scale argument, Bob, is really what it is at their core, and that if you can pool many different types of investors in one investment vehicle, then that gives you the potential to lower expense ratios and provide economies of scale and value for service to many different types of investors. And in this particular instance, you have investors who typically invest in mutual funds for their retirement accounts and may invest in ETFs for their taxable money.

And those investors potentially could get the access to the same type of investment vehicles, the same investment vehicles, in fact, if indeed more firms were able to offer ETF share classes of mutual funds. So I think that it's a good development for investors if the SEC were to begin granting this exemptive relief to more fund sponsors around the country. Would this be, well, it's a little confusing with people to understand this. The exemptive relief and the, that was granted the Vanguard was for their passive funds. Is what you're asking for them to allow this for both passive and active? and why did they make a difference back 20 years ago? So what we're asking for is for all of our funds to get that exemptive relief.

And then if the SEC were to grant that, then it would be fund by fund and conversations with the Mutual Fund Board to decide which funds to offer that share class ETF for. Our funds are not the traditional active funds in terms of stock pickers, Bob, but we do have a systematic approach that goes beyond indexing, because we think indexing leaves some money on the table, as does that traditional stock picker approach. So our funds, we often characterize as having the best of both in terms of some of the good characteristics of indexing

and some of the good characteristics of active implementation. And so, yes, we're asking it for that. I think if you go back 20 years, Bob, there were very few, if no, ETFs that were non-index. And what we've seen since the ETF rule in 2019 is 800-plus new ETFs come to the marketplace, that are characterized as active or non-index ETF. So I think the landscape, the ETF landscape, is very different today than it was 20 years ago.

Ben, what would this do for the ETF space? I mean, we've got, what, 7,000 mutual funds, some huge number. Could they all add an ETF share class to their funds at this point? I mean, a lot of fund families have already launched separate ETF classes, right? I mean, we've already done this. Do they really want to make it easier to move out of a higher fee, mutual fund, they didn't do a lower fee ETF? Some people may not want to do this. Some funds may not want to. That's certainly part of it. I think Gerard raises a great point. The industry has

evolved quite a bit in the last 20 years. I think that's absolutely fair to say. But this could be a game changer for the ETF industry. You're right. There are thousands of mutual funds out there that theoretically could issue an ETF share class. The biggest untapped space here is really the retirement assets that are in the mutual funds that are more than six trillion in assets that really has been largely untapped by the mutual fund managers. And, you know, really, there's a lot of comfort here. Vanguard's been operating this for more than 20 years successfully. And the technology certainly exists from an ETF standpoint. And also, this is very common in other markets around the world. So, you know, this is something that could be a win-win, both for the asset managers,

but the shareholders as well. But the biggest piece is the retirement business, right? I mean, how much money is there in the 401K is like $6 trillion, right? So the problem in the past is the ETF business can't break into that. Would this be a sort of back-door way to do that? I'm trying to figure out what happens here. Well, absolutely true. ETFs have had a difficult time breaking into the retirement market,

but reality is that in this case, it just makes it easier. and certain economies of scale to benefit shareholders who are in the mutual fund class, who maybe have retirement assets, as well as the ETF shareholders, by sharing a common pool of assets. In addition, I think when we're looking at active ETS, instead of starting from scratch, you're certainly in a position where the asset managers can start with that performance track record, which is incredibly important for investors to be able to do their due diligence as they're looking for different products, whether that be in their taxable accounts or the retirement assets.

Gerard, the SEC has to approve this. Can you give us some timeline? They haven't said anything, right? And what are the chances to approve it or not approve it? You know, game this out for us. Yeah, this fits under a process called seeking exemptive relief from the SEC. And it's a reasonable process because mutual funds operate under the 1940 Act, which kind of governs most of how they operate.

And from time to time, a manager will come with an idea that kind of sits a little bit outside that 1940 act, but can be good for the end investor. And so you go through a process with the SEC whereby they give you exemptive relief in order to implement that good idea. There's no time frame under which the SEC has to grant exemptive relief once it's been requested.

But typically you start to engage almost straight away with the staff and with the commissioners to explain why this could be a good development for the end investor. And, you know, when you talk about the retirement space, for me, it's more of a case of those economies of scale and also the flows out of mutual funds that we've seen into ETFs. They don't have to happen. You don't have to have all that trading and all those unnecessary costs. If more managers can offer ETF share classes, it could potentially give the way for an investor who wants to have an ETF versus a mutual fund to exchange their mutual fund shares for ETF shares without actually having to trade. So there's lots of benefits to come with the economies of scale, and you can stay mutual funds in the retirement space and still get those benefits by pooling with ETFs in the taxable space.

Because often they're the same people. It's not that they're different people. It seems like a no-brainer to me. This would help a lot of people and potentially, you know, I mean, I don't think it would save necessarily money going out of mutual funds and into ETFs. But what concerns would block approval? So I've heard this potential conflict is that mutual funds have to sell shares when they face redemptions, and that incurred trading costs, but an ETF can instead hand a parcel of securities to an authorized participant. So there's different costs here. And I've heard it said the SEC is concerned about those different costs in the past. But all the shareholders would bear the cost of the portfolio there, and it would be uneven potentially.

Is that a real concern overall, given the advantages here? Yeah, there are some concerns that the SEC could raise. And the reality is we don't know for sure. It's been close to 20 years since the SEC has really publicly opined on this. But certainly this concept of tax contagion where trading in the mutual fund could theoretically spill over to ETFs and create some capital gains. The reality is that, you know, we think there are several ways to potentially mitigate that and potentially think that both share classes. could theoretically benefit from having these two classes sit by side. Also, there are a few other issues that the SEC could raise. Again, I think dimensional and others in the industry have done a good job trying to articulate or knock down some of those arguments. One is certainly around the potential for cash drag or the cross-subsidization of costs between the share class, making sure that there is no additional friction or cost borne by one share class. the other. The reality is most of those, especially in larger products, is de minimis.

And we think, again, the benefits will likely outweigh any implications that there might be for shareholders around those costs. It seems like a no-brainer to me. You get choice. You get tax advantages. You get lower costs. The trading really helps here. This seems to be a big help, Gerard, for a lot of funds who want to keep their mutual funds. class. So I know dimensional, you guys converted several mutual funds last year in the last few years to ETSs. Others have not. I guess would adopting this structure provide a way to let investors choose their preferred share class? That seems to me what it is here, but I'm trying to figure out what the concerns might be. Yeah, there's two big benefits here in my view. One is choice,

and I think that can be a benefit to the end investor. You've nailed it. spot on. And then the other is the economy is a scale, but also to the point of cash flows in a mutual fund. In an active or non-index fund, like what dimensional manages, so it's broadly diversified, is systematic, it has low turnover. We typically use cash flows to benefit all of the investors in the fund. If we get a cash flow from a client subscription or redemption or from a corporate action, we're buying stocks that we want to buy on that day and selling stocks we want to sell on that day anyway and the cash flow actually makes us more efficient, not less efficient. So I think in this new world where you have a lot of non-index type strategies in ETF format

and mutual fund format, cash flows can actually be a benefit to all. So for me, those are choice and economies of scale and the benefits of flexibility to me are very straightforward, very obvious. Another question is raising it high enough within the SEC that the SEC prioritizes the issue and hopefully you know makes a move and does something good for all of the end investors in the industry. I want to move on, Ben. I'll talk you about active ETFs in general.

This is something dimensional does as well. They're having a moment here. Cash flow, 25% of total industry ETF industry cash flow in the first half of 2023 was active. That's a new record for a half year period. What's driving this? You know, active ETSs have come a long way, and we've seen this trend accelerate. So it's the flow, but also the product development has continued to accelerate in this space as well. So we've seen the majority of products launched in the ETF wrapper the last three years be actively managed of one stripe or another.

And we also see this trend continuing from money coming out of mutual funds. Again, there's that trend again, right, that we're just talking about, but money coming out of mutual funds into the ETF structure. And that's exactly what we've seen this year. So some of it is investor behavior just where we're at this part of the market cycle. Others are just simply a structural shift in terms of how investors are consuming active. It's money coming out of active mutual funds into active. It's not money flowing, pouring out of passive funds into active. This is the problem I have with this.

Oh, active's coming big story. like suddenly passive is losing. It's not. So, Gerard, much of this active category that attracting flows are dimensionals, right? I mean, you have a systematic rules-based strategies that have active implementation. Stock picking still doesn't work, I guess. I'm trying to get to the point here is that the active guys like to turn around and say, ah, you see, active is fantastic. This means stock picking works again.

That's not really what's going on here, right? Yeah, I think there's a lot of different flavors of active these days relative to 10 or 20 years ago. We're active men stock picking our market timing. Basically, anything that's not an index these days is called active. And the data show that indexing leaves money on the table. It's too rigid. The rules are not adaptable enough to adapt to different types of market environments. And the data also show that traditional active stock picking or market timing also leaves money on the table.

The way that we look at it is both of those have their strong points. And so we have the benefits of indexing, broad diversification, low turnover. We're not trying to outguess market prices, a systematic approach, and an active implementation in how we implement the strategy day in, day out. And so when you look at who's winning, who's losing out there, when we're gaining flows from many of our clients and the ETF side of things, often it is from index funds, where they see that they can have the benefits of indexing, but in this type of a structure,

it doesn't leave as much money on the table. So I think that it's become a more nuanced kind of discussion, Bob, is just active, passive. There's lots of different shades and flavors these days. But you guys have always, I call it passive plus what dimensional does. It's active, but it's a passive, and there's an overlay above it. I can't help but bring up a study I covered last week.

There was a study done recently about long-term stock performance. I've never seen a longitudinal study like this. and it came to some rather remarkable conclusions. It looked at the entire global stock market, 64,000 stocks over a 31-year period from 1990 to 2020. I've never seen a study this big. It took years to do this, and it found that the majority of companies

did not outperform treasury bills over this time. Only a handful of stocks accounted for the bulk of the wealth creation in the stock market. Here's an example. Five firms here, Apple, Microsoft, Amazon, Alphabet, and Tencent, which is a China company, accounted for 10.3% of the $75 trillion in global stock market net wealth created in that 31-year period. This is rather remarkable. And look at this. In this 31-year period, only 44% of U.S. stocks outperform U.S. Treasury bills.

And Ben, what's remarkable is they studied 17,000 stocks in the United States. And some people wrote and said, there's not 17,000 stocks. There's not even 5,000 stocks in the Wiltshire 5,000. There is it because they're all gone. They came and went over that 30-year period, highlighting the fact that companies come and go, and we tend to just emphasize the companies who are the winners who keep staying in the S&P 500. But it's a rather remarkable study. I know this is tangentially related to what we're talking about, but I never failed to bring up the point that stock picking is really, really hard to do.

It's absolutely, and we've seen these lines blurring for quite some time. And I think the ETF has been the forefront of that. So certainly what Dimensional is doing and other. really what I would call rule space active or smart beta indexes, as they're sometimes called, are all trying to really find a way to gain some kind of alpha, obviously, in the market. And again, the ETFs have been at that forefront. That said, it really comes down to when an investor is looking at an ETF, a mutual fund, or whatever the structure is, it's that after-tax, after-fee performance that really matters.

And if you look at the broad-based benchmarks, the S&Ps 500s, even the NASDAQ 100, certainly more recently, they're really tough to beat. Really tough to beat. And especially over those three, five and longer-term horizons, not surprised at all to see that. Yeah. Gerard, U.S. stocks are again outperforming. What is this, 12 years in a row, 13, something like that. A lot of investors are wondering if global diversification is still worth the effort. Now, Gerard, I know you're very big on this.

You've said many times to me and on our air, global diversification is still worth the effort. Now, given plenty of U.S. stocks have global exposure already, why are you so persistent in that argument that you make about global exposure? Well, consistent with the study that you just mentioned, and that's consistent with prior studies that find in any given year, any given time period, it's often a small number of stocks that drive the positive returns of the market. But the trick is you never know which of those stocks are going to drive those returns in advance. And it's the same at the country level. While you may have a three or four or a ten year period where one country has done well relative to others, investing is forward looking. It's not looking in the rear view mirror.

It's forward looking. And you don't know over the next three, five, ten year which country is going to provide that high level of performance. So just invest globally. Diversification is your buddy. You can get it relatively inexpensively these days with different types of of investment vehicles, and it gives you access to many thousands of companies out there. And the truth is, is that you don't know which of those companies are going to be the winners

from a price return perspective or a total return perspective in the next five or ten years. But if you have a little bit of all of them, the data kind of support that on average, you're going to be doing better than those that have concentrated portfolios. You know, everything he's saying is preaching to the choir here. I'm, you know, everything he said, I believe. And mean reversion is a powerful thing. It's about time. And yet, 10, 12 years.

It's a long time here. Is there a structural reason why U.S. stocks outperformed? Does it have to do with our legal systems? Does it have to do with how easy creative destruction? And it is to create and destroy companies here in the United States. There's got to be, I mean, I've had my own opinion, but there's got to be a structural reason this is happening to some extent. It's not all equal across, you know, the playing field is not completely level. Yes, to all of that. I think are all factors in why or that might explain what's going on here.

I certainly think, you know, from a return perspective, it's also about the dollar. And obviously, that's been a huge driver of the return profile for international investing. And now you just recently, obviously, we've seen the dollar rally. You've seen ETF investors come out of the market, not surprisingly. at least on their on this tactical positions. And that, you know, for both equities and certainly on the fixed income side, is also another driver that is, you know, really provides our unique position in the financial markets, given what, you know, global investors may or may not view as the direction of the

USD versus everything else. But all the other structural reasons, and I think, and then some, would apply here. Yeah. All right. Yeah. It's always fascinating to talk about this subject to the best guys in the business. Now it's time to round out the conversation with some thoughtful analysis and perspective to help you better understand ETFs. This is the Markets 102 portion of the podcast.

We'll be continuing the conversation with Ben Slabin from B&Y and Mellon. And Ben, we had a long discussion about active management getting in. But a lot of traditional funds are continuing to get into the ETF space. I was really struck when GMO, which is Jeremy Grantham's fund, announced that they would be getting into the ETF. business is about as old school as you get, Jeremy Grantham, and they're going to launch a quality ETF that would focus on actively managed and high quality stocks. Quality is having a moment in the last two years. But this really says something to me. When you get a Jeremy Grantham, basically throwing in the towel, I guess.

Well, we've seen a steady stream of active managers look to launch product and have successfully launched product. I mean, just look, in the last couple of years, you've seen Capital Group come in, Morgan Stanley Investment Management, and they just keep coming. And from my seat, we are seeing clients, traditional asset managers,

continue to come to us looking for ways to get into the ETF market or structure a new product or convert mutual funds into ETFs. And I think this trend does not seem to be slowing down. In fact, it seems to be

accelerating. So where do we go from here? You know, it's, I've been struck by the fact that it's been a pretty slow year in terms of inflows. We've been used to seeing six, seven, eight hundred billion dollars a year going into ETFs. Money slowly come out of mutual funds. And yet it's been slower this year. It's picking up. We've seen a shift, right? So the first quarter was somewhat unique. I mean, we saw investors go to cash chasing after those money market fund yields, and certainly there was a risk-off environment as a backdrop. And so two things happen. One is we saw flows muted. Second, more interestingly, we saw product development also slowed down. And that's something that we haven't seen in a few years because we've been on this record pace. Now,

going forward in the last couple months, maybe the last week or two, setting that aside just given where markets are at. We've seen flows pick up, you know, certainly in June and July, quite substantially. We've also seen, we've also seen it. Talk to Mike there. Go ahead. Continue. Yeah, we've also seen, we've also seen a little bit of a sort of a change with respect that those asset managers who were active for the most part sitting on the sidelines, and now they've really started to come in and aggressively start to launch product. Don't think we're going to hit a record this year, but I think we could come pretty close.

Yeah. The money is largely into short-term bond funds, and yet equity ETFs haven't seen much inflows at all this year. I'm trying to figure out, is this just because what's been going on in the markets in general? It's just a year for short-term bond funds and money market funds. Yeah. I think certainly it's market-driven. It's also the simple fact that some of these products, with the exception of those that have converted with large pools of assets, simply are new products. They don't have investment track records. And a lot of the legacy asset managers, like you mentioned, GMO, for example, there's a lot of work to do to shift your marketing and distribution to be able to successfully raise assets and honestly just create awareness for investors to invest in these products, get them accessed on platforms. and basically rise above all the clutter and noise that's out there with all the new products coming to market.

I keep waiting for this tipping point where the rush of money out of mutual funds into ETS becomes very obvious. But it's sort of like a drip-drib. It just keeps happening year after year after year. There's no year where you can say, oh, this is the year when everything sort of changed, for example. It's just more of the same. I mean, last year was a record in terms of the delta between outflows from mutual. funds into ETFs. And I think that Delta was a little more than a $1.5 trillion. So that's the difference between, again, money coming out of funds into ETFs, like $900

billion into ETFs. And then you saw, excuse me, out of mutual funds, then about 600 plus into ETFs. Not quite as extreme this year. But again, we'll see what happens, you know, depending on where markets are at towards the end of the year. We keep waiting for the retirement market to crack a bit. I mean, it's amazing how much money is still locked up in mutual funds. Most of the big funds now allow you to have a index fund option, for example. Fidelity, for example, has a Fidelity S&P 500 index fund essentially. I don't know how many basis points, but it's fairly small. Is that enough to do this to sort of crack the retirement market? Well, certainly, look, the trend of passive is in place for quite some time, right?

So that's old news. I think on the retirement space, it's interesting. First of all, mutual funds are also getting competition in the retirement space, not just from ETFs, which again has been small in the retirement space for different reasons, but also from collective investment trust, which is a different structure that has become quite popular in the retirement space specifically around target date funds, which are effectively asset allocation products and have been the default option for many retirement plans. And how are collective investment trusts different than mutual funds?

They're regulated separately. And, you know, ultimately those products that are in that collective investment trust are ultimately not regulated by the SEC, but have similar characteristics to mutual funds. And typically they're operated by a trustee with a separate regulatory oversight from the banking regulators versus the SEC. but for most investors are not even aware that that would be, that it's not a mutual fund for many investors. But obviously it's all disclosed, but it operates mostly the same way.

It's a little bit cheaper to operate. And that's one of the reasons why they're able to offer, you know, these passive products at even a lower fee and bring them to market a little bit easier than you would in a traditional fund. I'm betting that the, if we continue the up market, I'm betting we'll see more money going into equity mutual funds. I can't believe there's not a lot of FOMO out there, that everybody who rushed to put their money into four or five percent money market funds

with the S&P up 15 percent this year aren't sitting there saying, oh, gee, I know some of these people were people pulling out of their bank accounts, but I can't believe that we're not going to see a little bit of FOMO at some point. Look, I have a little bit of FOMO in my own portfolio, but I would say certainly that cash is on the sidelines and they're, you know, waiting to come back into the market. But what we've seen, Bob, is in these market cycles, when money comes out of the market, so it comes out of a mutual fund of whatever type it is, it goes to cash. Yeah. What happens?

The mutual fund is not picking up 100%, you know, in returning of those assets. And that number continues to decline every single market cycle. And I think that's exactly what we're going to see this time around. Agreed. All right, Ben, thank you very much for joining us. Ben Slavin. Slaven is the managing director and global head of ETF from BNY Mellon. And thank you for listening to the ETF Edge Podcast.

InvescoQQQQ believes new innovations create new opportunities. Become an agent of innovation. Invesco QQQ, Invesco Distributors, Inc.