Bryan Armour: Is Index Investing’s Superpower Unstoppable?

Listen Now: Listen and subscribe to Morningstar’s The Long View from your mobile device: Apple Podcasts | Spotify | Google Play

Our guest this week is our colleague, Bryan Armour, who is director of passive investment strategies research, North America, for Morningstar Research Services. Bryan is also editor of the ETFInvestor newsletter. Before joining Morningstar in 2020, Bryan spent seven years working for Finra, the Financial Industry Regulatory Authority, conducting trade surveillance and investigations specializing in exchange-traded funds. Prior to Finra, he worked for a proprietary trading firm as an options trader at the Chicago Mercantile Exchange. Bryan holds a BA in Economics from the University of Illinois and the Chartered Financial Analyst designation.

Background

Bio

Passive Investing and ETFs

“Index Funds Have Officially Won,” by John Rekenthaler, Morningstar.com, Feb. 13, 2024.

“Active Funds Fell Short of Passive Peers in 2023,” by Bryan Armour, Morningstar.com, March 12, 2024.

“It’s Official: Passive Funds Overtake Active Funds,” by Adam Sabban, Morningstar.com, Jan. 17, 2024.

“ETFs vs. Mutual Funds: The Benefits That Really Matter,” by Bryan Armour, Morningstar.com, Feb. 6, 2024.

“2023 Model Portfolio Landscape,” Morningstar.com.

“Markets Are ‘Fundamentally Broken’ Due to Passive Investing, Says David Einhorn,” by William Watts, marketwatch.com, Feb. 9, 2024.

“How Fund Fees Are the Best Predictor of Returns,” by Russ Kinnel, Morningstar.com, Jan. 12, 2016.

“Cage Match: Traditional Index Funds vs. ETFs,” by Christine Benz and Margaret Giles, Morningstar.com, Oct. 20, 2023.

“Global Fund Flows: 2023 in Review,” Morningstar.com, Feb. 6, 2024.

“A Closer Look at Vanguard’s Newest Core Bond ETFs,” by Dan Sotiroff, Morningstar.com, Feb. 12, 2024.

“3 New ETFs That Stand Out From the Pack,” by Ryan Jackson, Morningstar.com, Aug. 30, 2023.

“Converting Mutual Funds to ETFs: What to Make of the Trend,” by Daniel Sotiroff, Morningstar.com, April 11, 2023.

“How to Choose a Great Dividend ETF,” by Dan Sotiroff, Morningstar.com, May 17, 2023.

“The Best and Worst New ETFs of 2023,” by Bryan Armour, Morningstar.com, Dec. 19, 2023.

Bitcoin and Covered-Call ETFs

“Spot Bitcoin ETFs Are Here. Should You Invest?” by Bryan Armour, Morningstar.com, Jan. 11, 2024.

“Grayscale’s Victory Over the SEC Doesn’t Mean a Spot Bitcoin ETF—for Now,” by Bryan Armour, Morningstar.com, Aug. 30, 2023.

“Should You Buy a Covered-Call ETF?” Video interview with Bryan Armour and Ruth Saldanha, Morningstar.com, June 14, 2023.

Securities Mentioned

iShares ESG Aware ETF ESGU

iShares MSCI USA Quality Factor ETF QUAL

ARK Innovation ETF ARKK

Grayscale Bitcoin Trust (BTC) GBTC

JPMorgan Equity Premium Income ETF JEPI

Global X Nasdaq 100 Covered Call ETF QYLD

Vanguard’s High Dividend Yield ETF VYM

BlackRock Flexible Income ETF BINC

Schwab High Yield Bond ETF SCYB

T. Rowe Price Capital Appreciation Equity ETF TCAF

2x Bitcoin Strategy ETF BITX

YieldMax AI Option Income Strategy ETF AIYY

Other

“The ETF Rule: What It Is and Why It Matters,” by Irene Huhulea, Investopedia.com, Jan. 25, 2024.

Bryan Armour: Index Investing Is a Runaway Freight Train

A Morningstar researcher discusses rising passive share, bitcoin ETFs, and the future of active management.

(Please stay tuned for important disclosure information at the conclusion of this episode.)

Dan Lefkovitz: Hi, and welcome to The Long View. I’m Dan Lefkovitz, strategist for Morningstar Indexes.

Christine Benz: And I’m Christine Benz, director of personal finance and retirement planning for Morningstar.

Lefkovitz: Our guest this week is our colleague, Bryan Armour, who is director of passive investment strategies research, North America, for Morningstar Research Services. Bryan is also editor of the ETFInvestor newsletter. Before joining Morningstar in 2020, Bryan spent seven years working for Finra, the Financial Industry Regulatory Authority, conducting trade surveillance and investigations specializing in exchange-traded funds. Prior to Finra, he worked for a proprietary trading firm as an options trader at the Chicago Mercantile Exchange. Bryan holds a BA in Economics from the University of Illinois and the Chartered Financial Analyst designation.

Before we begin the discussion, I should say that I’m part of Morningstar’s Index group and we license to ETF providers, but we will not be discussing any investable products tracking a Morningstar Index today. In fact, Bryan’s team doesn’t cover them.

Bryan, thanks so much for joining us on The Long View.

Bryan Armour: Thank you both for having me.

Lefkovitz: Absolutely. Well, we wanted to start off with a major milestone that we hit recently in the US market, not referring to the bitcoin spot ETFs that started trading, but the fact that passive strategies now account for the majority of assets in funds and ETFs and on a global basis, passive share is about 40%. Our colleague, John Rekenthaler, recently wrote that index funds have officially won. So, do you see anything that could slow the rise of index investing?

Armour: It’s a runaway freight train right now. But no, it’s been a long, persistent trend. And I think the real reason why it’s done so well is because of the cost story. Passive investing comes with lower fees, lower trading costs, greater tax efficiency. And that’s going to be hard for active managers to beat consistently because they have to beat passive on a gross basis and then by more than the difference in their fees as well.

To take a step back, indexes are concentrated right now, market-cap-weighted indexes. And so, I think the S&P 500 is the highest concentration in top 10 holdings in the past 50-some years. And so there is an opportunity for active investors, I think. And you have these zombie flows that are coming from passives where it’s like savings come in and just go out to the market where active managers could really find an advantage. And so, a rough stretch for cap-weighted indexes might not be enough to move passives off the mark. But the best chance for active managers to get back on top is to cut costs and take away passives’ superpower.

Benz: Well, we want to delve into some of those themes and some of the performance trends that you and the team have observed. But sticking with fund flows: It had been the case that investors were preferring actively managed fixed-income funds, but even that seems to have shifted toward passive over the past several years. Can you talk about that because it seems like the fundamental case for an active strategy in fixed income is stronger than is the case for equities, but maybe you can delve into that and what you’re seeing in terms of flows?

Armour: So, in general, we’re seeing—if you draw a straight line, it’s from active mutual funds, going out of active mutual funds into passive ETFs. And it’s generally true across the board for fixed income, equity, and so on. And so, it does make the most sense, I think, to go passive in the areas where there’s the richest information embedded in prices of stocks, for example, or US Treasuries as a fixed-income example. So, large-blend-style funds, those types of stocks have the widest coverage, the fastest reaction to changes in information about the companies. And so, they tend to be priced very well, and passives can really free ride that pricing by active managers and kick it back to investors for a lower cost. Where there are some issues, like you said, or how do you index the bond market? And if you go by market weighting, then you end up investing the most in the most indebted issuers. So, in some cases, for core bonds, for things like Treasuries—very liquid market. And so, those are fit for passive investing. And if you look at like an ag-bond fund, that’s a huge chunk of the ag right now is Treasuries. But something like muni bonds, for example, there is some inefficiency in selecting munis. They’re not taking part in the issuance. So, to some extent, they might get some of the leftovers. But just in general, it’s easier for investors to understand what a passive fund is going to do. And those expectations and low fees are a good fit for most people.

Lefkovitz: And it seems like a lot of advisors these days might be ETF only. I know you’ve written about models as well, model portfolios. What role are they playing in flows?

Armour: So, there’s been a shift in distribution in that sense where advisors are moving to fee-based advice instead of commission-based. And what that means for investors is that they’re going to push toward cheaper funds, which often means ETFs or index mutual funds. And then if they do go active, then—ETFs are growing a menu, and we’ve seen model portfolios come as a really good option for advisors where they can just follow the script rather than spending too much time with asset allocation. And so model portfolio gives you the full portfolio of here are all the ETFs that you can invest in to follow the model. And it’s been a really good tool for investors, and it’s pushed some flows around, too. We just had the Model Flows Landscape report come out recently from Manager Research here at Morningstar. And model portfolios are growing extremely fast. And iShares, for example, is one of the biggest model portfolios. They work really closely with advisors to help them understand the changes that they’re making and give them performance attribution analysis and things like that to pass on to clients. But last March, they shifted from their iShares ESG Aware ETF, ESGU, to their Quality Factor ETF, which is QUAL. And that led to a $5 billion outflow of ESGU into QUAL. And so, it’s ending up having some pretty significant ramifications in the market.

Benz: Let’s talk about providers and what you’re seeing in terms of flows to providers. It seems like the big three—Vanguard, BlackRock, State Street—have grown market share, but maybe you could just talk about that, how the spoils do seem to be going to fewer firms.

Armour: The biggest have gotten bigger. And I would even say that Vanguard and iShares are in their own tier now and then State Street is alone in that next tier. But a lot of it has been scale. It’s been being able to scale their operations, scale their strategies, and offer them for low costs, which then put pressure on others to catch up. And we’re at a point where Vanguard might actually catch iShares soon. So, they’ve been winning the flows battle the past few years. But there’s two ways that assets can increase. One is new flows, net investment, and the other is performance of the existing assets. So, Vanguard does have a little bit more of a tilt toward equity assets, which means they could be boosted by a strong stock market and actually take over as the top ETF provider. And then in the active ETF space, there’s been a shift in the largest providers. Dimensional converted their first mutual fund to an ETF about three years ago, and they’ve already taken over as the largest issuer in the active ETF space. And then options-based strategies have been a huge growth engine of active ETFs, and JP Morgan has really benefited from that.

Lefkovitz: Well, we want to get back to all those topics that you just touched on. But I wanted to ask you, Bryan, there’s this perennial question of whether the rise of passive share has led to market distortions. And we had a comment recently from David Einhorn, a prominent hedge fund manager, saying that passive investing has fundamentally broken the market. Wondering if you have a perspective on that?

Armour: It depends where you’re coming from in your perspective on how you’re seeing the market. Because from David’s perspective, I think, he runs long-short hedge funds, for example, and the market is less reactive potentially compared to what it used to be. So, it’s difficult for that type of strategy to efficiently realize mispricings of individual stocks, and shorting is expensive. And so, the longer the lead time to realizing it, the greater the cost and then the more different ways that things can go awry. So, from most investors’ perspectives, though, they don’t have access to these hedge funds. Their investment minimums, there are all sorts of different things that prevent the average investor from buying into these things.

So, it goes back to my original thought on zombie flows. There are opportunities for active managers. Right now, it’s just slower for the market to catch up. The flip side is for average investors, it’s been overwhelmingly positive. You get cheaper, better-performing strategies in most cases. Our colleague Russ Kinnel long showed that low fees are the best predictor of future success. And so, it may not be the best outcome for David Einhorn’s clients, but a vast majority of investors don’t even have access to his hedge fund. And so, it’s a clear net win for investors. And he continued on in his comments after saying that passive investing had fundamentally broken the market by saying that he had adapted. And that’s really, like any strategy from two decades ago, is less likely to work today anyway. So, it’s really adapt or die. And it sounds like he didn’t complain about it. He’s just changed his strategy to better adapt to it.

Benz: Your team’s remit is passive investment strategies. You’re vehicle agnostic. So, I guess, we wanted to ask about index funds, traditional index funds versus exchange-traded funds. It does seem like the flows have very much gone to ETFs. Advisors seem to be articulating a strong preference for ETFs. I guess the question is, is that overdone? I know that there are tax efficiency benefits with ETFs versus traditional index mutual funds, but maybe you can talk about that?

Armour: Comparing index ETFs to traditional index funds, that tax efficiency, that is the crown jewel of ETFs doesn’t apply as much. I would agree with that. First of all, Christine, you wrote a wonderful article for Morningstar.com on this subject. I encourage everyone to read that that’s interested in this conversation. But ETFs tend to have lower fees and tax efficiency. So, the lower fee portion of that still remains. Often their fees are priced closer to retirement plan share classes than retail investor share classes. And then when net flows are going in and out, ETFs can swap holdings for shares in kind, which doesn’t create a taxable event. So, there’s advantages for the ETF, but the problem is that for a traditional index fund, a broad index fund, the fee differences are pretty minimal. And then they’re typically market-cap weighted, so they aren’t trading much and they’re not realizing many capital gains. And so, ETF’s tax advantage is minimal. The difference really comes down to flexibility, I would say, and ETFs are easier to trade in and out of, but those trades come at a small cost like crossing bid/ask spreads, premium or discounts to NAV. But I think this is what Jack Bogle’s initial dislike of ETFs, where it came from, is that the ease of trading could actually be to investors’ detriment if they end up over-trading.

Benz: I wanted to just follow up and stick with this tax efficiency question. I do feel like there’s confusion about fixed-income ETFs being particularly tax-efficient. Like they might have some tax efficiency benefits relative to an active fund, but generally they’re not all that tax-efficient. So maybe you can talk about that, Bryan.

Armour: Unfortunately, interest income is not a capital gain. So, the tax efficiency is purely on capital gains. If the price of the security you hold goes up and you sell it, that price from where you bought it to where you sold it is a capital gain. Interest income is separate from that. It will be taxed as normal income. And so similar also to dividends, these distributions are not incorporated in the tax efficiency of ETFs. And so, if you hold something like long-dated Treasuries and the price of yields go down, then you could potentially have a much more tax-efficient vehicle in an ETF in that circumstance. But for most of the time when prices are relatively stable and most of total return is coming from interest, then the ETF wrapper doesn’t gain any advantage over a mutual fund.

Lefkovitz: I wanted to get back to actively managed ETFs because it’s a space that’s growing very fast and wanted to delve a little bit more deeply. So according to our asset flows data, actively managed ETFs grew 37% in 2023, while passives grew just 8%. Bryan, what’s behind the growth of Active ETFs, do you think?

Armour: I think there are two main reasons. The SEC passed the ETF rule in 2019, which really just made launching ETFs and management of ETFs more efficient by allowing custom-creation redemption baskets is probably the primary reason for Active ETFs. But number two is, Active ETFs are meeting investors where they are. And so, starting with that second point, the increased use of ETFs, the flows going into ETFs really drives asset managers’ interest in launching ETFs and accessing other potential clients. In some cases, it could be, but in most cases, it’s not replacing mutual funds, it’s really just accessing different clients.

For the ETF rule, creation/redemptions, the way the pro rata baskets used to work prior to the ETF rule is, effectively a market maker would go out, buy all the stocks of the S&P 500, for example, in the correct proportion. They would hand those over to an ETF provider. They would get ETF shares back. If they wanted to redeem those ETF shares, then they would get the stocks back. And by doing that in-kind transfer, they never have a taxable event that occurs.

What’s changed is that they no longer get a pro rata slice of the portfolio. Now they have the ability to use custom baskets. So, if you think of an active manager that holds Nvidia, a year ago, it was a $100-something dollars and it got up to $700 recently. And that would be a $600 capital gain you’re sitting on. You could negotiate a custom basket with a market maker to basically get rid of all your Nvidia and take no capital gains on any of that gain. And so, the benefits from custom baskets are tax efficiency. It also pushes some of the trading costs. If you’re using the custom basket for portfolio management, then those trading costs are borne by the market maker, not you, because the transaction is in kind. And then it’s just another tool for PMs. And so, we’ve seen the uptake by some traditional mutual fund providers in response. You can see the increase in products in assets and flows start after 2019 after the ETF rule was enacted. And since then, Dimensional Fund Advisors, Capital Group, T. Rowe Price, Morgan Stanley have all started to dip their toes into the ETF market.

Benz: I think I heard someone characterize active ETFs as the last gasp of a dying industry, the active asset-management industry. Do you think that’s too harsh?

Armour: No. I mean, yes, I do think that’s too harsh. I disagree with that comment. There are still use cases for active. Like I said, there’s still plenty of opportunities in the ETF wrapper. Mutual fund providers still have a major role in retirement plans. We’ve seen growth of CITs and other vehicles to gain more efficiencies there as well. But we’re still in the early phases of active ETF trend. And just now we’re starting to see portfolio managers accept greater transparency. And so, star managers like BlackRock’s Rick Rieder, T. Rowe Price’s David Giroux launched their first ETFs last year. So, I think it’s actually an exciting time. There’s a lot going on in the ETF space. It’s not the end of asset management overall.

Lefkovitz: Are there areas where you think that active ETFs won’t work so well?

Armour: There are strategies where ETFs aren’t as effective as mutual funds. And a prime example of that would be discretionary active in illiquid markets or small caps or something where there isn’t as much liquidity in the underlying stocks. So, for example, ARKK, the ARK Innovation ETF, there is a direct correlation between flows and performance back in 2020, 2021 when it was going up and down dramatically. But capacity is a concern. It’s something that strategies need to be aware of before going into the ETF wrapper because ETFs can’t close to new investors. And that’s something that has led active ETF providers like Dimensional, Avantis to really lead because they have very well-diversified portfolios. They hold a bunch of stocks and then they tilt things the way they see fit. But the more discretionary active, smaller portfolio-type active strategies don’t seem to do as well in the ETF wrapper.

Benz: I wanted to go back to the tax efficiency of active ETFs, active equity ETFs specifically. It does seem like based on what you’ve said that there would be tax efficiency benefits of the active ETF relative to an active traditional mutual fund. But how about relative to a passive, say, total market ETF, that’s still going to be more tax-efficient, right?

Armour: Well, it’s actually going to be pretty close because there are instances where, depending on how the active manager deploys their strategy in the ETF wrapper—if you look at like Dimensional, Avantis, those are more well-diversified portfolios, but they’ve never realized, or most have never realized, a capital gain. Capital Group, T. Rowe Price have had very minimal capital gains in the ETF wrapper. They had none last year between both of them. So there really isn’t much more to gain from a tax efficiency perspective than that. And so, it just really depends on the strategy though.

Benz: So, the low-turnover piece is crucial, it seems like, right?

Armour: It’s low turnover, but it’s also when you redeem ETF shares, when you have a custom redemption basket, you can put your highest capital gain security as a higher weight in the portfolio and when you redeem it out, you get rid of it and then you can bring it back in at a higher cost basis. And so there are ways to gain tax efficiency beyond just limiting trading. And so that’s really where the biggest advantage has been for active ETFs.

Lefkovitz: Bryan, Vanguard launched some active bond funds in December and your team, when you wrote about them, put active in quotations. Can you talk about those?

Armour: So, Dan Sotiroff does a great job of distilling down the strategies of the new Vanguard bond funds. I believe, one is Core, one is Core-Plus Bond Fund. He put active in quotes because these are well diversified bond funds that are meant to be sit at the core of your portfolio and they’re low cost. In general, they hold duration in line with their benchmarks. So, in a lot of ways, that’s a passive approach where they then add an increment of active is by taking on a little bit more credit risk than their benchmark. And then they look to generate alpha a bit through individual bond selection. But generally, they’re matching the characteristics of their benchmark. And then the fee is very close to passives. So, with incremental benefits, by taking on a little bit more risk and be more thoughtful about which bonds they hold.

Benz: We wanted to ask about active versus passive performance, which you’ve already alluded to, but you’re involved in this semiannual active Passive/Barometer Study, which looks at the success rates for active funds relative to passive in different categories. First, maybe you can talk about what a success rate is, how we define that, and also what you’ve observed having looked at these data over the years?

Armour: So, we’re actually about to publish year-end 2023. So that might even be out by the time this comes out. But we look at success rates for active managers across different categories and holistically. But what we’re looking for is, does an active fund beat the average passive fund? And we look at that as an equal-weighted average of all passive funds within that category. So, we create the peer group, we create the benchmark. This way it’s not like an index where there are no fees, or it’s held to the index construction rules or anything like that. If you were going to pick up the average passive fund, would this active fund beat it? And so, success rates generally over the long term are lower than 50% and in certain areas of the market significantly lower than 50%. And so, if you look at large-blend category, for example, like I alluded to before, there’s incredible coverage of those stocks that sit in that portion of the market. And so, the prices, it’s really hard to carve an edge for an active manager because all the information is priced in. And so, what we’ve seen is over the long term, not only are success rates low, but active managers tend to lag the average passive peer significantly for the ones that do survive. And so that’s one thing with success rates. We look at not only do they beat the average passive fund, but they also have to survive over the period. So over longer-term periods, very difficult to beat passives, but over the short term, things can be pretty noisy.

Lefkovitz: And what have been some areas where active has been successful?

Armour: So, the key is there are two different things that dictate success for active funds. Number one, what are the odds of picking a winner? And then number two, how much can you win versus how much can you lose? And so, indexes prefer liquid markets, ones where the information is embedded in the price quickly and the index funds can represent the market well. Illiquid markets tend to be tougher to index. They usually have to create index rules to get around some of the more illiquid holdings, which creates opportunities for active managers to find advantages over their index peers. So, some of the ones that usually as you go down the market-cap ladder from large cap to mid-cap to small cap, success rates will increase. If you look at like foreign small/mid versus foreign large-blend, actives tend to do better in the smaller-cap area. Real estate is another example. Emerging markets tends to be better for actives. And bonds is more of a mixed bag, but high-yield bonds, active managers tend to do better than core bond funds.

Benz: We wanted to ask about these waves of mutual fund to exchange-traded fund conversions and also ETFs being created as a share class of a mutual fund. You referenced, Bryan previously, DFA having done some of these conversions over the past few years, but maybe you can talk about what’s going on there.

Armour: I believe there’s been about 70 mutual fund ETF conversions at this point. It depends on the strategy at hand. So DFA, they originally moved over some of their tax-managed strategies because the ETF wrapper, for the reasons I discussed, is more tax-efficient. And then also they have these extra portfolio management tools through the use of in-kind creation/redemption baskets. And so, for them, it made sense. If there are complications with strategy fit, like I said before, they can’t close to new investors in the ETF wrapper. So small-cap, more-niche strategies, it might not make as much sense to convert over to ETFs. But generally, what happens is, one day a mutual fund wakes up as an ETF and that track record is still there. But it’s not a panacea for mutual fund managers. DFA has experienced significant inflows, but some of the other ones that converted have actually been seeing outflows. It’s not automatically by joining the ETF market do you see inflows.

And then the other caveat for mutual fund ETF conversions is it doesn’t work if assets are held in retirement accounts. Generally speaking, retirement accounts are built for mutual funds for end-of-day NAV pricing and intraday pricing and nonfractional shares of ETFs make it really hard to switch over. So generally speaking, those with higher retirement account assets or more-niche strategies will find it hard to convert to ETFs.

Benz: And how about the idea of an ETF being created as a share class of an existing mutual fund? I think that was originally a Vanguard innovation, but now other firms have jumped onto that.

Armour: And their patent expired early last year for that. We’ve seen Dimensional, Fidelity, Morgan Stanley, a few others apply for that same treatment, and the SEC is currently reviewing those applications. But I think there the advantage is if you do have retirement assets, if you do have some reason, distribution, or whatever reason that exists that you want your mutual funds, but you also want to reach ETF investors, then this is a really good way of doing that. And some of the ETF, if it gets large enough, some of those creation/redemptions, the in-kind creation/redemptions can actually enhance the tax efficiency of the mutual fund share classes then. But the downside for the ETF investors is if investors are redeeming their mutual funds, that could create some capital gains taxes and that could make their way over to the ETF shareholders.

Lefkovitz: Well, let’s get to bitcoin, the moment that many listeners are waiting for. This has been one of the biggest stories in ETF lands in recent years. SEC approved ETFs tracking the spot price of bitcoin. We now have several bitcoin ETFs. So, what have you observed watching this space since these funds started trading in January?

Armour: I think the biggest thing at the beginning was fee wars broke out at the 11th hour. And we saw a very consistent lineup of fees between 19 basis points and 25 if you exclude waivers, the one outlier being Grayscale Bitcoin Trust, which converted to an ETF from a private trust into an over-the-counter trust now currently an ETF for the first time. And they are charging 1.5% and big reason why is because they came in with large assets and they have investors in their asset base that have large capital gains they’re sitting on. They know they’re not going to leave and switch to a different bitcoin ETF. But there’s a huge disadvantage for new investors by investing in GBTC. But the rest are all very tight in terms of fees in that 6-basis-point range.

But so far since it started trading, the liquidity ecosystem has been very strong. So, there was a batch approval. Nine new ETFs were approved for trading on the same day and then Grayscale also converted. So, there are 10 new ETFs on Jan. 11. And the existing funds in the market, so GBTC is an example, but also futures-based bitcoin ETFs, and then futures on the Chicago Mercantile Exchange, and spot bitcoin itself creates a whole liquidity ecosystem where market makers can hedge between all these different products, and they can look for arbitrage between them. And so, it’s led to really tight bid/ask spreads and very strong liquidity overall. And then they’ve gathered considerable assets. IShares and Fidelity currently lead the pack. I believe there’s now four ETFs over $1 billion. Maybe I shouldn’t even say that at this point because it’s all going to change by the time this goes live.

But they’ve gathered considerable assets. IShares and Fidelity are leading the pack. Bitwise and ARKK are really in that next tier. And they’ve lived up to the billing in terms of volatile performance. Early investors were hit with an immediate 15% drawdown. They’ve already reversed the course and are up since their inception. So overall, it’s gone extremely well for the bitcoin ETFs. But obviously it’s been a volatile few weeks for the ETFs in terms of performance.

Benz: So how about for investors? I guess setting aside the merits of crypto and bitcoin, how about the introduction of ETFs for investors who would be inclined to invest in these assets? Do you think that this is a development for the greater good?

Armour: Well, it’s a positive development for crypto investors. I think it’s better than what currently existed prior to the spot bitcoin ETFs hitting the market. So, there are futures ETFs that had launched in 2021. And there are some frictions in rolling futures that made it underperform the price of bitcoin on its own. GBTC charged 2% and operated like a closed-end fund prior to becoming an ETF. It created all sorts of problems for investors. And crypto exchanges are very expensive to trade on. There’s always a concern of losing your key or how are you going to custody all your bitcoin. So, it’s a good thing for crypto investors in general. But to some extent, I don’t think most investors need to speculate on bitcoin. So, to me, overall, it’s more of a distraction than a benefit for investors.

Lefkovitz: And Vanguard has sat it out. Curious what you make of that.

Armour: So, Vanguard has shown no interest in launching a bitcoin ETF themselves. But a step further, they don’t even make the other bitcoin ETFs available to their investors. And so, they believe it’s speculative. There’s no inherent economic value or cash flows and volatility can wreak havoc on portfolios. Our research has found the same—in terms of it’s very difficult to create a fundamental value for bitcoin. What should it be worth? And we’ve shown that the volatility has a pretty big impact on portfolios, even in a very small allocation like 5% or lower. To some extent, I almost feel like the SEC refusing to approve the spot bitcoin ETF actually gave bitcoin more legs and got more attention for bitcoin. And in the same vein, Vanguard takes the decision out of investors’ hands. And I don’t really feel strongly either way. But in general, sometimes it gives it more power to say no to it.

Benz: Are there any other areas that you’re watching for regulatory approval or maybe new product development? There’s naturally been talk of non-bitcoin crypto ETFs. But I’m wondering if you’ve heard anything about that or other areas?

Armour: The current one in the queue for the SEC is spot ethereum. So, ethereum futures ETFs already exist, but the spot version is the next one waiting on approval. SEC is currently taking the same course as it did with bitcoin. So, it’s been just delaying decisions and waiting until the last second until they get a hard deadline to actually make a decision. But in the same vein as bitcoin, since a futures ETF already exists, they would really struggle with explaining why they would be able to deny spot ethereum versus approve the futures ETF. So, the likely outcome is approval for ethereum, but it is a little bit different than bitcoin, so it remains in flux. Beyond that, we’ve seen all the common product variants that exist in ETF form already filed to come into the market like covered-call versions of bitcoin ETFs, leverage, inverse. But these are things that most investors shouldn’t really take interest in.

Lefkovitz: And then covered-call ETFs that are tracking equity indexes, those have been very popular recently. What do you think is behind that trend?

Armour: I don’t know how the hot trend in the market flipped from meme stocks to covered calls. It’s a little bit of whiplash for investors. But it’s been an astonishing trend in terms of assets and product development. It seems like a covered call is being slapped on every single strategy from single stocks to Bitcoin to S&P 500. JPMorgan Equity Premium Income ETF, JEPI, is the poster child right now. It’s over $30 billion in assets, and we actually cover this ETF. It’s sensible approach, low-risk strategy. But most covered-call strategies are highly tax inefficient. In the same way we were talking about bond ETFs earlier, the premium received from covered calls is not considered a capital gain. So that’s something that will be distributed as income that investors will have to pay taxes on and then reinvest if they’re not using the income for personal uses. And there’s a huge opportunity cost for covered-call ETFs. So, Eugene Fama’s doctoral thesis remains true today where the distribution of market returns have fat tails. So that means there are more extreme gains and losses than expected from a normal distribution of returns. And so, we always talk about downside risk and how that can set investors back. But the same is true of missing out on the best months or years for an investment. And so, it doesn’t make sense to give up the good fat tail and keep exposure to the bad one for covered-call strategies. Because what you’re doing is you’re selling upside and cashing in that expected volatility and taking the income instead of and capping upside. And so, a prime example would be Global X Nasdaq 100 Covered Call ETF, which is QYLD. It launched in December 2013. And it’s basically like QQQ except with a covered call attached. And it’s trailed QQQ by an annualized 10 percentage points since its launch in 2013. So QQQ over that whole time is up 450%. QYLD is up 100%. So, it’s a substantial opportunity cost that you’re giving up with covered calls.

Benz: Sticking with some of the fads in the ETF space, we wanted to ask about strategic beta, smart beta, factor investing, whatever you want to call it. It seems like just a few years ago, maybe five years ago, that was like the hot topic. Maybe you can talk about what you’re seeing these days in that strategic beta area.

Armour: It’s slowed down for sure. There’s not as much attention from investors or inflows coming in. But generally speaking, there’s still solid strategies. It’s something similar to active investing, except they codified it to track an index of some of the active risks that it takes. And so, it’s still a reasonable investment thesis. The biggest problem has been that market-cap weighted and growth stocks have really done the best. And most of strategic beta is about value. It’s low volatility. It’s some of these things that haven’t kept pace with the market overall over the past decade or so. And so, it’s sort of swung out of favor, but it’s still a very good option for investors.

Lefkovitz: Dividends seem to be an area within strategic beta that remains popular with investors, probably for income. I think your team recently upgraded some dividend-focused ETFs. What was behind that?

Armour: So, when dividend ETFs or strategies are done well, their portfolios can tap into cheap stocks with strong fundamentals, and when done poorly, they can fall victim to value traps. So those are stocks that their prices are dropping alongside their business as their business deteriorates. And so, what we saw from these four dividend ETFs is they have very steady approaches. We’re seeing a lot of consistency in their holdings and their factor exposures over time. They have resilient portfolios, and they really do a good job of addressing the value traps. So, what ends up coming out of that is a strong risk/reward profile. So, it’s typically for those ETFs that are performing similar to the market in terms of returns but with lower risk. And there’s a couple different ways that they get there and between the four ETFs two are dividend growth ETFs, which is, you’re looking more at quality companies that have been steadily growing dividends for eight to 10 years, something like that. And then the high dividend yield strategies look for above-average yielders, but then they pair back some of the risks that can come with that by controlling Vanguard’s High Dividend Yield ETF, for example, takes the top half of dividend yielders and market-cap weights it, and that effectively takes out some of the risk of value traps. But overall, they just give a really solid combination of value, quality, profitability that has tended to work well over the long term and basically all markets.

Benz: I wanted to ask about thematic funds, which is another trend that was really popular just a couple of years ago, things like AI or clean energy. Interest seems to have cooled in those types of products as well. What have you observed in that space?

Armour: It has cooled. Absolutely. I think a lot of investors were burned in 2021, 2022 when thematics were hitting a fever pitch and then markets turned south and a lot of the growth stocks, a lot of the ESG stocks that had done so well in 2020 dropped significantly. And so, it still gets tons of attention. Thematics is nothing new, but it tends to do really well when there’s a market bubble. And so, lots of product development in 2000 and 2007 and 2020 and then shortly thereafter, markets dropped. But AI, I’ve talked a lot about AI ETFs, especially with reporters and that’s something that my friends would ask about. And the problem with AI ETFs is it’s really hard to define the theme and which stocks fit within AI. So, Nvidia is the one that’s held in all AI ETFs, but from there, there’s very little consensus about what stock counts as AI. And some hold Amazon and Apple and Google and Microsoft. And then some hold these small companies that develop chatbots or robots that are more AI directly. And so, there’s not a great way to capture the trend as it currently stands. And that’s often the case with thematics in general. It’s something that will stick around. I think there will still be investors interested in it because the narratives are so strong. But generally speaking, it’s really hard for investors to perform well in those types of ETFs.

Lefkovitz: Bryan, wanted to get your thoughts on direct indexing—taking an index and then making some adjustments, customizing, personalizing. This is an area that got a lot of discussion a few years ago as an alternative, even a rival to ETFs. What are you seeing in the direct-indexing space?

Armour: Direct indexing is hard to make available to everyone. There’s lots of considerations with smaller accounts, how are you breaking up fractional shares, and there’s a lot more risk taken on by the asset managers doing this for smaller investors. So, it’s really targeted toward wealthier investors. But with an ETF, like I said, a lot of the benefit from direct indexing that they talk about is tax-loss harvesting. In general, in ETFs, you can already do that without needing to tax-loss harvest. So, there’s not a significant advantage for direct indexing over just holding an ETF. I think it’d be more about the personalization, the customization of the strategies depending on the particular investor. And so, it remains a high-net-worth strategy. I don’t see it as something that’s going to help the everyday investor.

Benz: I wanted to ask about this annual list that you put out of best and worst ETFs. It’s instructive not just for the specific funds that you’re flagging, but it also gives a sense of what we think are useful vehicles that address a real investment need versus just products that might be beneficial only to the asset manager or sponsor. Can you take us through a couple of case studies on your 2023 best and worst list?

Armour: Definitely. So, this is a fun activity that team all weighs in. We all vote on which ETFs we believe are best and worst. So, we go through like a nomination process and vote on them. And so, there’s a couple of different ways that new ETFs can really break into the market. And so, most of what we think of ETFs like S&P 500 ETF, Total Market—that’s already been done. So, the way our asset managers can differentiate new ETFs is by giving access to something that doesn’t currently exist in the market or improving on an existing asset class.

And so, the two best new ETFs that we highlighted last year—one of them was a BlackRock Flexible Income ETF, which is Rick Rieder’s first ETF that he’s launched. So, he was Morningstar’s 2023 Outstanding Portfolio Manager of the Year. And he’s had a long track record of success and it’s something that’s new that investors couldn’t get in the ETF wrapper before. And so, it’s been just a new way for active ETF investors to engage with ETFs.

And the other best new ETF was Schwab High Yield Bond ETF. What I liked about that one is it was almost like the Vanguard effect in bonds where they come in, they cut expense ratios, and force others to cut with them. This one played out a little differently, though. They came in at 10 basis points, which was the lowest fee on the market in State Street. And State Street then cut their High Yield Bond ETF to 5 in response, and then Schwab shortly thereafter cut theirs to 3. So, in the course of a couple months, the cheapest high-yield bond ETF went from 10 basis points to 3. And then in response, you saw other asset managers cutting their fees, maybe not down to 3 basis points, but to 8, to 5. So, it’s really created a fee war, or at least a fee skirmish in high-yield bonds.

Another good example would be T. Rowe Price Capital Appreciation Equity ETF. There’s a mutual fund strategy. It’s multi-asset. This is equity-only, the ETF, but the mutual fund has been closed to new investors for a number of years. So, it’s really opened the doors for investors and to David Giroux and into that strategy, at least the equity portion.

In terms of worst ETFs, it’s often these types of strategies that tend to help the issuer more than investors. And the first one was this 2 times Bitcoin Strategy ETF. So not only is this futures-based but it’s also leveraged to 2 times. It’s just really unnecessary. I mean, bitcoin is highly, highly volatile. There’s been several times where they’ve experienced over 40% drawdowns in the past five years without leverage. And so, this is just unnecessary, and then they add almost a 2% fee on top of it. It’s just really playing into some of investors’ worst habits and trying to cash in on those. Another one is YieldMax, AI option-income strategy. So, it looks like it might be AI thematic ETF, but that’s actually a stock with the ticker AI. So, it’s a single-stock ETF, and then they sell a covered call against it. Why investors would need to buy this and for this particular stock that has only a $3 billion market cap is beyond me. I think it’s just taking advantage of the fact that its ticker is AI, to be honest.

Lefkovitz: Well, Bryan, thanks so much for sharing your insights. This has been great.

Armour: Absolutely. Thanks for having me on.

Benz: Thanks for being here, Bryan.

Thank you for joining us on The Long View. If you could, please take a moment to subscribe to and rate the podcast on Apple, Spotify, or wherever you get your podcasts.

You can follow us on Twitter @Christine_Benz.

Lefkovitz: And at Dan Lefkovitz on LinkedIn.

Benz: George Castady is our engineer for the podcast and Kari Greczek produces the show notes each week.

Finally, we’d love to get your feedback. If you have a comment or a guest idea, please email us at TheLongView@Morningstar.com. Until next time, thanks for joining us.

(Disclaimer: This recording is for informational purposes only and should not be considered investment advice. Opinions expressed are as of the date of recording. Such opinions are subject to change. The views and opinions of guests on this program are not necessarily those of Morningstar, Inc. and its affiliates. While this guest may license or offer products and services of Morningstar and its affiliates, unless otherwise stated, he/she is not affiliated with Morningstar and its affiliates. Morningstar does not guarantee the accuracy, or the completeness of the data presented herein. Morningstar shall not be responsible for any trading decisions, damages or other losses resulting from or related to the information, data analysis, or opinions, or their use. Past performance is not a guarantee of future results. All investments are subject to investment risk, including possible loss of principal. Individuals should seriously consider if an investment is suitable for them by referencing their own financial position, investment objectives and risk profile before making any investment decision.)