By Rusty Vanneman, CLS Investments
- Being a fiduciary means acting in a client’s best interests.
- Striving for lower costs is part of being a fiduciary, but it’s not the only factor.
- When it comes to ETF fund flows, costs are clearly a top consideration for investors.
Attributes of a Fiduciary
In the investment world these days, fiduciary is a hot word and for good reason. It’s a long-term, win-win situation. Advisors working first and foremost on behalf of their clients, instead of their own interests, is a win for investors and a win for the investment management profession.
The definition of a fiduciary is a person or organization that owes to another the duties of trust and good faith and pledges to act in the other’s best interest. This sounds obvious, but how is that faith typically measured, monitored, and managed? I believe there are three ways being a fiduciary is conventionally measured.
First, advisors are moving toward fee-based business models and away from commission-based. I believe this is a very good trend, but I acknowledge many long-term investors who buy loaded mutual funds will often pay less in fees and have better investor experiences than those who frequently trade no-load mutual funds. With that said, I believe the fee-based model in general should help improve investor behavior as advisors counsel staying balanced instead of emphasizing a sense of urgency. I believe a fee-based model is better in the aggregate and the long-term behavior gap, which is the difference between an investment’s return and the investor’s return (taking into account cash flows in and out of the investment), will improve as more advisors adopt a fee-based model. Since behavior is the biggest cost to investors, this is a very positive change.
Second, being a fiduciary also means doing the necessary research to ensure a portfolio is appropriate and security selection is sound. Again, I believe this is a clear win, particularly for investors who work with advisors who offer independent, disciplined research and open-architecture investment opportunity sets.
Finally, fiduciaries are generally expected to seek lower costs. Of course, lower costs are positive for investors. When calculating potential returns, costs should always be part of the equation. In all of our expected return calculations at CLS Investments, we use costs (including estimated transaction costs) as an input. But, lower costs don’t always mean the better strategy, solution, or product. Like any service or product, is the lowest cost always best? The lowest-cost advisor is likely not providing the counsel and services of a reasonably priced advisor. The lowest-cost investment strategy is likely not providing the same level of attention and service as a reasonably priced strategy. Bottom line, the lowest-cost investment product may not provide the exact exposure or return or risk characteristics as a reasonably priced one.
Costs Are a Leading Driver of ETF Flows
However, in the ETF industry, costs are the leading driver of investment flows, and increasingly so. The table below reviews fund flows this year (through August 31) and shows several interesting facts.
· 55% of all fund flows this year have gone to funds with expense ratios of 10 basis points or less.
· More than 80% have gone to ETFs with expense ratios of 20 basis points or less.
· Fewer than 5% of flows have gone to ETFs with expense ratios of 60 basis points or more.
· Smart beta ETF investors are a bit more relaxed on demanding the lowest expense ratios, but it’s still clearly a dominant factor.
· Only with actively managed ETFs does it appear expenses do not dominate flow. A remarkable near 40% of net flows into actively managed ETFs have expense ratios above 90 basis points.
Lower costs have always been a factor in determining popular funds, but that trend has only accelerated in recent years. For example, the table below shows total ETF assets under management (AUM as of December 31, 2016) broken out by the same expense ratio bands. In short, expense ratios still explain why some funds are larger, though lower-cost ETFs don’t have as much AUM as they did with 2017 flows.
Transaction costs should also be considered. Important metrics to include when considering ETF costs are bid-ask spreads. The table below shows several bid-ask spreads (in increments of 5 basis points). It is very interesting to note that how well an ETF trades appears to be an even more important factor for determining flows year-to-date, even for actively managed ETFs.
Reviews of 2016 AUM levels show ETFs that trade at more attractive bid-ask spreads simply dominate. However, flows in 2017 point to an even greater emphasis on lower bid-ask spreads than the 2016 AUM totals.
I recognize there is a chicken-and-egg dynamic when it comes to bid-ask spreads. Funds that become popular will see their bid-ask spreads tighten, but many investors and traders will only use ETFs with low bid-ask spreads.
What this data also shows is that in order to launch a new ETF, it is important to ensure it has a competitive expense ratio and it trades well. This means the ETF should be even more appealing to short-term traders than long-term investors. If an ETF has a great long-term investment thesis behind it, and it trades well, it should be a success.
The emphasis on more advisors becoming fiduciaries has been a good move for investors. In my opinion, that includes steadier investment counsel and better investment research. It has also meant a higher emphasis on lower costs, which is a positive trend, all else being equal. But, simply buying the cheapest ETFs and disregarding other factors, such as market exposure and the attractiveness of the underlying holdings within the ETF, is possibly being overly emphasized.