With Martin Small, Managing Director, Head of U.S. iShares at BlackRock
ETF Industry Growth
Martin Small heads up BlackRock’s US iShares, an important player in the ETF (Exchange-Traded Funds) market which has launched 340 ETFs focused on US stocks and bonds and has 1 trillion dollars under management. BlackRock is the largest provider of ETFs in the world, and the US iShares division comprises the lion’s share of BlackRock’s ETF business. Steve hosts Martin for a conversation that delves into the history and evolution of ETFs, the differences between ETFs vs mutual funds, and the future of ETFs as a core component of investor portfolios.
The first exchange traded funds were created in the 90s as “plain vanilla” index funds that sought to include all of the stocks in cap-weighted indexes like the DJIA or S&P 500. Index ETFs replicate the returns of major indexes by owning shares of every company in that index. Small describes the incredible growth in ETFs – which now represent 3.5 trillion in funds – over the ensuing two decades by comparing it to the growth of hedge funds, which took 60 years to reach the 3 trillion in assets mark. Equally striking, ETFs have diversified over this same time period to “cover the entire investable universe,” as Small puts it. ETFs now offer investors access to bond markets, emerging world markets, inverse (short) positions, volatility indexes and much more.
The ETF vs Mutual Fund Comparison
Steve asks Martin if the ETF industry’s evolution towards a larger number of more specialized funds could be fairly described as a movement from the “passive investment” approach of index funds to a more actively managed approach common to mutual funds.
Small concurs with this overall picture, but delineates some of the difference between ETFs and mutual funds that remain. He argues that the flourishing of new ETFs in the past decade reflects investor interest in particular outcomes aside from just mimicking stock indexes, as well as improvements in the data and technology side of indexation. These outcomes might be a rate of growth, lower risk or better diversification, for example. Many of these desired outcomes, as well as traditional mutual fund strategies like “screening” an index for companies that meet certain criteria can be used as rules – an algorithm – to define specialized ETFs.
Returning to the question of the differences and similarities between ETFs and mutual funds, Small points out that both share a structural similarity: each is composed of a “wrapper” and then the mechanics of what happens inside that wrapper. He notes that both are created by investment companies with an independent board of directors and both are governed by the FCC. They offer scale by allowing shareholders to pool their money and access lots of different parts of the market through other people’s infrastructure, namely asset managers. As far as differences are concerned, perhaps the most important – for their customers – is that ETFs are lower cost, due in large part to a tax efficiency they enjoy which mutual funds do not. To oversimplify, ETFs manage in-fund transactions in a way that does not trigger capital gains taxes the way that most mutual funds do; as with owning shares of stock, taxes are only paid when ETF shares are sold. Mutual funds also tend to have larger teams of researchers and analysts supporting the fund manager, which adds to the “expense ratio” paid by shareholders. There are significant differences too in terms of the internal components of ETFs and mutual funds. Mutual funds are invested in assets determined and continually tweaked by fund managers, whereas ETFs generally track an index in a hands off, programmatic way. Because of the success of ETFs in the marketplace, their more consistent returns and lower cost ratios, mutual fund managers are feeling pressure to take on more risk in their stock selection. It is difficult to design an ETF that imitates the investment strategies of a mutual fund manager, though increasingly ETFs are moving towards greater complexity, and Small alludes to work being done at BlackRock to merge some of their “high-performing return-seeking strategies” with an ETF structure into “transparent active ETFs.” One of the main drivers of this initiative are the tax and transactional efficiencies of ETFs, where baskets of stocks are bought or sold “in kind” instead of in cash, thereby avoiding a capital gains triggering event.
Mutual Funds Underperform Benchmark Returns
Steve asks Martin to delve into the assertion that most mutual fund managers fail to outperform the benchmark indexes they are measured against. Small’s answer is that the veracity of this statement depends on which specific markets or “style boxes” (mutual fund allocations) are being talked about, but for the most popular markets index funds beat mutual funds 80-90% of the time. Small chalks this up to the expense ratios of mutual funds, which frequently drain 100 basis points (1%) or more from their returns. This puts fund managers in the unenviable position of generated “excess returns” (above benchmarks) just to compensate for their fund’s higher expenses.
The Future of ETFs Looks Bright
Their conversation concludes with a discussion of the trend of investors shifting from managed funds and stock picking to indexed ETFs. BlackRock recently commissioned a survey on this topic and Short describes the phenomenon of ETFs rise as a “disc man to ipod moment,” and one that is seen across broad demographics. He notes that the ETF industry is still only a fraction of the size of the mutual fund business – 3.5 trillion in assets vs 21 trillion – though ETFs are growing very quickly and taking market share away from mutual funds. Small found a lot of cause for encouragement in their surveys results, which showed that ETFs are replacing stock and bond holdings in “the heart of the portfolio” for many financial advisors. Holding periods for ETFs – the length of time that investors are holding onto to their ETF funds – are up dramatically, now averaging around 5 years. He’s also excited by the performance of ETFs in the millennial demographic, which are buying in at a greater rate than older investors. He argues that because of their experience with the 2008 market meltdown, millennials are more sensitive to the need for diversification. By all appearances, ETFs are speaking to millennials because of their lower cost, competitive performance and diversification. Small sees reason to believe that ETFs are seen as a “luxury good,” offering a “personalized experience at great value that you can buy sitting at home in your pajamas in your fidelity brokerage account.”
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Steve Pomeranz: Martin Small is head of BlackRock’s US iShares. As you may know, iShares is the largest provider of exchange-traded funds in the world, and, as of September 2016, they have over 790 of these ETFs out there and are managing one and a quarter trillion—that’s with a “t”—of assets under management. Martin Small, as I said, heads the US iShares portion, which has one trillion dollars under management and 340 ETFs. So, it’s an important part of the marketplace and an ever-growing part of the marketplace. So, I’ve asked Martin to join us today. Welcome to the show.
Martin Small: Thanks, Steve, great to be here. Thanks.
Steve Pomeranz: You know, Martin, it’s been 24 years since the first ETF hit the market, the famous SPY, the s-p-y. The industry has come an amazingly long way. Give us a little history of how the growth has been.
Martin Small: It is quite incredible. If you walk back to the ‘90s, you basically had the creation of some of the first exchange traded funds, and today you have an industry that globally is about three and a half trillion dollars. For a comparative set, if you think about the alternatives business in hedge funds, for example, it took 60 years for hedge funds to hit three trillion dollars of assets, and it took the ETF industry roughly about 20. So, the ETF business has really only been around about as long as the internet but has grown, basically, at the same exponential and very strong rate.
I think what’s most interesting about it, though, is that the ETF business started out mostly in equities and mostly with very plain vanilla index exposures.
Steve Pomeranz: Yeah.
Martin Small: It has really changed over the course of its life to be something that covers the entire investable universe. So, we would have started in traditional US equities, developed market XUS equities like EFA, and increasingly moving into things like emerging markets, but today you can get different cuts of emerging markets through country funds, so we have 62 individual country funds on our iShares ETF lineup, all of which are the individual building blocks of the MSCI all-country world index. But you can also own, for example, fixed-income ETFs across different interest rates spectrums, across different tenors, maturity sectors, fixed income investment grade credit high yield. Increasingly what we’re doing is not just slicing markets thinner—meaning large cap small cap, US non-US—but increasingly being able to give exposure to drivers of investment returns and things like factor and smart data strategies.
Steve Pomeranz: Okay, hang on, hang on, Martin, just hang on because there’s a lot of industry terminology that your using, so let’s back up here a little bit. Actually, the first area, we all understand that it started in US stocks because they were the most liquid and, I guess, the most obvious. Then, it moved overseas. You mentioned something called EFA; well, that’s just like the benchmark of stocks that are from companies that are domiciled in foreign countries, and emerging markets that you mentioned as well.
So the whole industry has expanded and it has gotten more specific. It’s moved over to the bond market, right? There are lots of fixed income investments available. So, we have US, we have overseas, we have fixed income available. Generally, ETFs are considered to be passive investments like an index fund. You know, a list of stocks—listeners may be familiar with the Dow Jones Industrial Average, which is just a list that people make up of 30 important stocks; the S&P 500 is one. These ETFs are basically wrapping those lists together so you can participate in that. But now that is even changing, Martin, so let’s get into that a little bit. So now the ETF market is moving some way, in some fashion, from passive investing—just wrapping these indexes—to what was traditionally the domain of mutual funds, which is more active investing. What’s going on there?
Martin Small: The interesting thing is that we traditionally had ETFs that, as you said, Steve, are index funds. They track well-established indexes that you know and, when you turn on the TV, you see those indexes as the depictions of what is the market doing—the S&P 500, MSCI Emerging Markets, the Russell 2000 for small cap stocks. Those are the depictions of the market. However, as people have evolved their investing needs, sometimes they don’t just want the market return, they want an outcome. They want higher income; they want lower risk; they want better diversification. Through advances in data and technology and indexing methodologies, we’ve been able to index outcomes that we previously weren’t able to do 10 years ago or 5 years ago. So, today we can index, for example, a basket of value stocks in the same way that a value hydrocodone online manager in a traditional mutual fund might provide exposure to value stocks. We can index stocks that have less volatility than the market in things like our US Minimum Volatility Fund. All these things are advances in what is indexation as an investment style, period. I think that’s where the market is going.
Steve Pomeranz: What is the difference between a mutual fund, which may have an active manager, someone who has a discipline and a strategy for buying certain kinds of stocks—you mentioned value stocks…there’s all different ways to do these growth stocks, in particular. What’s the difference between having a team or an individual manage that and ETFs managing in that fashion?
Martin Small: There’s two components to your question, Steve. The first of which is about the wrapper, a mutual fund versus an exchange-traded fund. The second of which is, well, what’s inside and what are the investments strategies and investment outcomes that are delivered inside of those wrappers. So, in the wrappers, mutual funds and ETFs actually have more in common than they do differently. They’re both professionally managed investment companies with an independent board of directors that here in the US are governed by FCC rules and the Investment Company Act of 1940. They all provide scale to investors by allowing shareholders to pool their money and access markets through other people’s infrastructure, namely asset managers. Finally, they both provide access to lots of different parts of the market. The difference with ETFs, generally, is that ETFs tend to be lower cost and tend to follow indexes as you said. They also tend to have tax efficiency that mutual funds don’t. What’s inside is the next piece, which is, traditionally, the mutual fund world has been designed to provide access to strategies that we can’t index. So, things we can’t index are how a particular investment manager feels about buying IBM versus AT&T versus Google versus Apple stock on any given day of the market. Those are traditionally based on research strategies, on insights into the marketplace, and even emotions and intuitions about what markets might try to do. In general, the security selector, the stock-picker, is trying to beat the market, trying to provide an outcome that is different than the index.
For most of the ETF industry what we’re trying to do is give you the market return and track an index. We are increasingly entering into a space that’s in the middle. Some of the techniques used by stock-pickers are screens. They screen a particular index. We screen the Russel 1000 value for high- quality companies with strong balance sheets that have low leverage and have grown the dividend. That type of strategy can be reduced to a set of rules that can be put into an index, and that’s the part of the index marketplace that is ultimately delivering an outcome that is different than the traditional cap-weighted indexes, and it’s pushing active managers to take more security selection and stock-picking risk to differentiate themselves from things that can be indexed.
Steve Pomeranz: Is that the reason that, in general, the internal expenses in ETFs are lower than those of actively managed mutual funds because, basically, it’s a developed algorithm or formula that’s being operated, basically, by computers and not necessarily human beings?
Martin Small: You have a mix of both technology and human being that make index funds, I think, incredibly scalable. So, you have an element of being able to track large indexes and being able to bring the benefits of scale and portfolio management techniques through technology that make those very efficient to operate. When you have a lot of scale and you can transact large baskets of stocks and bonds in a very efficient way, it allows you to pass on those benefits of scale to your shareholders in the form of lower expenses. When you keep large volumes of research analysts and have to buy lots of research in order to power your business, you tend to have a higher cost base that requires a higher expense ratio.
Steve Pomeranz: Sure, sure. There’s a lot of talk about how most mutual funds or active managers don’t beat their commensurate benchmarks or the indexes against which they’re measured, like the S&P 500. Is that an accurate statement and can you give me some more granularity to that?
Martin Small: For the most part, you have to be very specific about which markets. Across style box equities, the traditional large blend and growth categories and large cap, mid cap and small cap, the track record has largely been that index funds beat roughly 80 or 90%, depending on the style box of the active mutual funds in the corresponding category. A big reason for that, Steve, is cost, which is simply if the average expense ratio for an active fund in a given style box is 80, 90 or 100 basis points, close to 1% and the corresponding style box ETF costs 8 basis points or even 4 basis points. Right there, the manager has to generate a tremendous amount of excess performance over the index just to compensate for the difference in expenses.
Steve Pomeranz: It brings to mind the question that I’ve been thinking about. Another area where ETFs are more attractive than the average mutual fund is when it comes to taxes. Mutual funds are required to pay out any realized gains that they had at the end of the year and because of a certain kind of mechanism within ETFs, they’re really not required to. They act more like you’re buying an individual stock. You really only pay taxes when you sell it or you take a loss or you take a gain, but only when you sell it. So, this has been uneven playing field now for so many years, where ETFs have been given this advantage because of their structure. Do you see mutual funds working to come the way of the ETF? In other words, get that active management inside an ETF, maybe at higher cost, but at least be able to capture the tax efficiency?
Martin Small: I think we are headed to a world where you’re going to see more convergence between the technology of ETFs and traditional active manager strategies. Here at BlackRock, we are going to advance the case for using the tax efficiency and transactional efficiency of ETFs, but being able to take some of our high-performing return-seeking strategies and put them into ETFs, transparent active ETFs, where we disclose the holdings.
The reason for that is exactly the one that you isolated, which is the tax efficiency, because it transacts its business in kind, and not for cash, is of great value to shareholder on a net after-tax returns basis. One of the things that we talk an awful lot about with financial advisors, which are our primary client base here in our US business, is you have to pay attention to net after-tax returns.
Steve Pomeranz: Yes.
Martin Small: The asset management industry, for the most part, talks to you about asset-class returns or fund-level returns. At the end of the day, your clients are paying taxes. 97% of our iShares ETFs in the United States distributed zero capital gains in 2016 and for a rolling 5 year period, the mutual fund industry is about 50%.
Steve Pomeranz: Yeah. Well, you know I’ve been using ETFs for countless years. I don’t think I’d go back to the 24 years when they first started, but for, at least, 10 or 15 years. That advantage has been significant to me as an advisor, being able to control the taxes in a portfolio, and I saw that right away. It just kind of occurs to me that the mutual funds industry is losing assets to the exchange traded fund industry, so I’m sure they’re lobbying congress to try to get those active strategies inside an exchange traded fund package.
My guest is Martin Small; he is the head of BlackRock’s US iShares. That’s a big deal because BlackRock is the largest provider of ETFs in the world, and they have 1.25 trillion dollars under management and the US portion of which Martin Small heads has a trillion of that. We’re talking to a guy who really understands and knows the market and has a very good idea of what the future looks like. So, let’s talk about the future here, Martin. Your company recently did a survey covering many different areas. One question was, right now, based on the current statistics, how much of investor’s assets are sitting in ETFs versus mutual funds versus individual stocks?
Martin Small: Right now, we have a US ETF marketplace that is about 2 1/2 trillion dollars and a global ETF marketplace that is about 3 1/2 trillion dollars. When you compare the 3 1/2 trillion dollars of ETFs with the entirety of the asset management industry and mutual fund industry, in particular, the ETFs industry is small. There are about 21 trillion dollars of mutual fund assets globally; I think it’s about 14, 15 here in the US alone. So, the ETF industry has a long way to go to catch up with the traditional mutual fund industry. That said, the ETF industry is growing fast, and we knew the ETF business was growing fast. We had about 287 billion dollars come into ETFs in 2016 in the US. We were proud to take in about 108 billion here in our US ETF line, but we really wanted to understand why are ETFs growing so fast? What are the faces, the attitudes, the “why” behind ETF growth? So we surveyed over 1,000 individuals, over 400 professional financial advisors in our BlackRock ETF Pulse survey. The survey results are in and I found them incredibly compelling. It’s just ETFs aren’t only for breakfast anymore. More than half of the investors surveyed are going to buy an ETF in 2017. Most interestingly to me, 80% of advisors already own ETFs and 100%—about 94% of advisors—said they’re going to buy another one in 2017. ETFs are really moving into the heart of the portfolio, basic replacements for your allocations to stocks and bonds. I think that’s a real sea change. It’s a Discman to iPod moment that we’re having here.
Steve Pomeranz: You know talk about that idea of Discman to iPod, what’s the acceptance among millennials and what is the acceptance among the baby boomer generation of ETFs?
Martin Small: Those are the two big things, Steve, that really stood out to me from the survey. The first of which was holding periods—is that ETF holding periods are going up. We would have seen a number of years ago 18 months. Two or three years ago, 24 months, maybe 3 years. Now, across millennials, genX, boomers, silvers, ETF holding periods have gone up to 5 plus years. The millennials are growing this category the fastest; 33% of millennials are owning ETFs today, versus about 25% of genX, boomers, and silvers. My hypothesis on this a little bit, when you dig into the survey, is that millennials came of age with ETFs, so they’re not seen as new or exotic. They also were very scarred by the 2008 financial crisis and watching their 401ks turn into 201ks. So, they’ve developed deeply into their brains this need for diversification, and ETFs are low cost, diversified, offer competitive performance, so they’re very much as, I think for a millennial, the equivalent of today’s luxury good. It’s a personalized experience at great value that you can buy sitting at home in your pajamas in your fidelity brokerage account.
Steve Pomeranz: Wow, I feel like I want to go to Amazon and buy one.
Anyway, my guest is Martin Small. Unfortunately, we are out of time, but Martin Small is the head of BlackRock US iShares. BlackRock is the largest provider of ETFs and has the most of assets under management.
To hear more about this conversation, to find out more about BlackRock and to find out more about our show, don’t forget to go to StevePomeranz.com P-o-m-e-r-a-n-z. No “t” no “c-e” just “z.” Just Pomeranz. Thanks, Martin.
Martin Small: Thank you, Steve.