The financial system is working "surprisingly well" despite the volatile market year — a year on track to be the second biggest for flows into U.S. exchange-traded funds after 2021, according to Dave Nadig, financial futurist at data and analytics firm VettaFi.
Nadig, an ETF expert, recently answered ThinkAdvisor's questions on what's happening with these increasingly popular vehicles — and what investors might expect for ETFs and the financial markets in general in 2023.
Nadig encouraged attendance at a February conference about positioning ETFs in client portfolios and how advisors are running their businesses better around ETFs.
Here is an edited version of our interview.
THINKADVISOR: How has this year's market affected what's happening in ETFs?
DAVE NADIG: Broadly, what we've seen happen in this downturn is what we've seen happen in frankly every downturn since 1993, which is when things get squirrely, when we have major asset class drawdowns, people universally sell their underperforming actively managed mutual funds and they buy low-cost index-based ETFs.
Every time that happens it acts like a foot on the accelerator of ETF adoption versus traditional mutual funds. That has been even more the case than usual this year.
Currently (early December) we're sitting at about $800 billion out of traditional mutual funds, of which about $500 billion is fixed income.
So that's just an enormous tsunami of capital fleeing the traditional mutual fund structure. Meanwhile we're sitting close to record flows, we'll probably close this year with something like $600 billion in inflows in ETFs. … You can make that somewhat causal connection that this was an opportunity for investors and advisors to reconfigure their portfolios into more efficient solutions.
Overall every asset class has had net inflows on the ETF side of things. We've also seen active management really have a role in there, something around 10%, 15% of the flows have gone into active managed products.
With the markets hit so hard, were people looking to save anywhere they could?
There's some of that. There is a tax-loss harvesting piece of this as well. If you've been a long-term investor in some actively managed mutual fund, it may have been underperforming for the last four or five years but it was still positive. … There hasn't been an opportunity to sell anything at a loss because pretty much everything's been sitting there at a gain.
That's a conversation an advisor can have with their client, to say, "Hey look, we haven't been happy with the performance of this fund for the past four or five years, we just took a bath on it, now is the time to sell it because, hey, we've got some gains over here on the other side of the portfolio, or hey, we're going to bank those gains and at least write a couple grand off your income."
Now is a great time to do that. And when people do that they tend to rotate into like but not identical types of exposures (on the ETF side).
So this is an opportunity to get into a lower-cost, more tax-efficient vehicle?
Exactly. The average ETF has an expense ratio … nearly half a percentage point cheaper than the average actively managed mutual fund. And so that matters over the long term, obviously. That message has come across. If you look at where the money is going inside ETFs as well, it's pretty easy to see what's been going on.
Vanguard has just been absolutely hoovering up assets. They're currently the second largest asset manager in the ETF space behind BlackRock, but they're only about $300 billion behind. Which sounds like a big number, but in the ETF space, honestly, the way flow trends have gone, Vanguard could be bigger than BlackRock in the ETF space by April.
And that is a sign that the message around low-cost indexing … has really gotten out there, not just to advised clients who have been ahead of that curve, but to the broader retail market.
Is actively managed the fastest growing area for ETFs?
It's certainly one of the fastest areas. It's where we've seen a lot of launches this year. …
I think we're up over 400 products this year that have come to market. (Bloomberg reported 422 new U.S. ETF launches this year as of Dec. 7.) The good news is if you look at what types of products have come to market, most of them are pretty useful, meaning they're filling a niche or they're exploiting a particular distribution area that may have been uncovered.
Things like the single stock ETFs, very narrow point solutions for traders who needed individualized solutions. Some thematic products, dividend products, a lot of fixed income activity, individual bond slices … those are real innovations that are changing how people build portfolios.
How do actively managed ETF expense ratios compare to competing products?
The good news for ETF investors is, pretty universally, an actively managed strategy that has a mutual fund clone or similar type strategy, the pricing on the ETF side is almost always the institutional pricing or better.
So the ETF really is not competing with those old A shares that nobody really buys anymore on the retail mutual fund side of things, it's really competing with institutional asset management. It's competing with SMAs (separately managed accounts) that institutions are using. …
It's almost universally true that if there is an active strategy available in ETF format, it's probably about the cheapest way to get that exposure.
